90) Why governments run up a fiscal deficit

We can broadly divide government expenses into two types: revenue expenses and capital expenses.

Whenever the dreaded beast of fiscal deficit starts walking, it is time for experts to start talking. Recently, Johnny heard three experts sorting out their differences. “The fiscal beast has lost weight because we have stopped free lunches,” said one expert. “No, it’s looking slim because of regular exercise,” said another. “No, no, it’s looking slim because it is wearing Bermudas,” countered the third expert. “What?” cried the other two. “Oh! Fiscal beast can deceive us by putting on make-up,” added the third expert. Johnny was really clueless. What kind of beast would love to wear Bermudas? Let us find out.

Johnny: Hi Jinny! Whenever the Union Budget is around, many experts start whipping the beast of fiscal deficit. Could you tell me what fiscal deficit is in the first place?

Jinny: Don’t call fiscal deficit a beast. You may unintentionally hurt the sentiments of many who think that deficits are not so bad after all. I will try to give you a neutral view.

The government needs money for its huge expenses. We can broadly divide government expenses into two types: revenue expenses and capital expenses. You can further divide these into planned and non-planned categories, but that may not be very relevant here. The government incurs revenue expenses in running its day-to-day business, whereas capital expenses include all expenses incurred by the government for creating assets. The money spent by the government for paying salary to its staff is revenue expense, and the money spent for constructing a hospital is capital expense.

These expenses ultimately come out of our pockets.

Johnny: That’s why we have to pay taxes, right?

Jinny: Yes, but taxes alone can’t take care of all the government’s expenses. So, there are other sources through which our government earns money. We can broadly divide the sources of government earnings into two categories: tax and non-tax sources. Tax sources include all the direct and indirect taxes, and non-tax sources include revenue receipts and capital receipts. Revenue receipts consist of a variety of things such as dividends received from public sector companies, fees, fines forfeitures, etc., received by the government. Under the category of capital receipts, we keep the money received from the disinvestment of public sector undertakings, recovery of loans, borrowings of the government, etc.

The main difference between revenue receipts and capital receipts is that revenue receipts are recurring in nature, which the government can expect to receive year after year, whereas capital receipts are a kind of one-time income. In your case, the salary you receive is your revenue receipt and the income you receive by selling your home is capital receipt. You might have noticed that the borrowings of the government are also included in capital receipts. This causes confusion. How can borrowed money be treated as part of income?

Actually, it is like covering a crack in the wall with borrowed paper. The government borrows money to cover the crack between its income and expenditure. But, to see the true picture, you need to put aside the borrowed thing first. So if you remove government borrowings from government income, you will see the gap between what the government is spending and what the government is earning. This difference is what we call fiscal deficit. It is expressed as a percentage of gross domestic product.

Johnny: Why does the government need to borrow money when it can print more?

Jinny: The government has two options for covering fiscal deficit: borrowing money from the market or printing more notes. Printing notes looks the easiest option. The government simply hands over its promise, written on a paper, and asks the central bank to hand over the money. But printing more money increases money supply and may cause inflation. It is a kind of invisible tax on your money. It reduces the value of the money you are holding. Borrowing from the market is considered a more decent and less painful way of covering deficits. However, excess borrowing from banks and financial institutions by the government may leave nothing for other borrowers. So, government borrowings have to be managed carefully. But you can’t continue to live on borrowings alone. Each borrowing adds to your already existing liability.

In the long run, cutting the fiscal deficit is the only option. You can do so either by increasing income or decreasing expenditure or simultaneously doing both. Increasing income requires raising taxes and fees, which may not work beyond a point. Stopping all wasteful expenditures is easier said than done. So, till you resolve all this, you may dress up the beast in Bermudas. It will give the beast a tamed look.

What:The difference between total government expenditure and total government income after removing total market borrowings is known as fiscal deficit.

How: The government can reduce its fiscal deficit by increasing its tax and non-tax income and reducing its expenditure.

Why: Reducing deficit is important because high fiscal deficit can lead to financial instability.

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

89) Why necessity is the mother of all taxes

A penny of taxes paid is a penny of deficits saved.

Tax jokes can make even a crocodile smile. That is why jokes and quotes on taxes abound. But our friend Jinny takes taxes quite seriously. She thinks that necessity is the mother of all taxes. A penny of taxes paid is a penny of deficits saved. That sounds like our taxman. Johnny, as usual, looks at the funnier side. He wonders why the tax penny has to come out of his pocket.

Johnny: February is the month of tax jokes. One of my friends went to a psychiatrist to get a certificate that he had lost all memory of his last year’s earnings. The doc was ready to certify so, provided he paid a hefty fee. My friend agreed. You know why?

Jinny: Why?

Johnny: He agreed because his tax planner was asking for an even higher fee.

Jinny: I don’t understand why people start pretending about memory loss when it comes to paying taxes. What you pay as taxes ultimately helps you.

Johnny: Really? I never realized that. I just thought paying taxes is one ugly choice that helps you to avoid an uglier consequence. Otherwise, what is the rationale behind asking people to pay taxes?

Jinny: The rationale is very simple. Our government acts like a big daddy in our life. It works to keep our life safe, sound and free from outside disturbances. It builds schools for children and hospitals for sick people. It makes better roads and flyovers to make our travels smooth. It does numerous other things that make our life more comfortable. For doing all this, the big daddy needs money. In fact, all of us need money. In our case, we work first and get paid later. But the big daddy gets paid first and works later. You may ask why that happens. Let the big daddy take rest if he can’t work without money. But look at it in another way. If the big daddy switches off all the traffic lights, you may not be able to reach your place of work. So it is better to pay your money as taxes and let the big daddy do his work. This helps in creating a mutually beneficial relationship between all of us.

Johnny: The government takes so many different types of taxes—direct, indirect and God knows how many other invisible taxes that we are not even aware of. This makes taxes so confusing.

Jinny: There is nothing to be confused about. Direct taxes are ones which are paid by the taxpayer directly. Personal income tax, which is paid by individuals such as you and me, and corporate income tax paid by firms are examples of direct taxes. Indirect taxes such as customs, excise, sales tax, service tax and value-added tax are paid indirectly. When you purchase a product or avail a service, along with the price, you pay the indirect taxes to your shopkeeper who, in turn, passes it on to the government. Personal income tax is paid only by those who earn more than the taxable limit but indirect taxes are paid by all and sundry. Personal income tax is progressive whereas corporate income tax is proportional and indirect taxes are regressive.

Johnny: Progressive? Regressive? Proportional? Are you talking about the mood swings of our political parties?

Jinny: Well, a regressive tax is one in which everybody pays the fixed amount as taxes irrespective of income. Indirect taxes such as sales tax, excise, and so on fall in this category. You and your neighbours pay the same tax for purchasing the same toothpaste. But your incomes may be poles apart. If your neighbour is earning Rs100 and paying Rs10 as taxes, he is paying 10% of his income as taxes. However, if you are earning Rs50 and paying Rs10 as taxes, you are paying 20%. This makes indirect taxes regressive. The burden is more on people earning less.

A proportional tax is one in which everybody pays a fixed percentage of income as taxes. If all firms are required to pay 30% of their income as taxes, then a firm earning Rs10 lakh will pay Rs3 lakh as taxes and a firm earning Rs20 lakh will pay Rs6 lakh as taxes.

In progressive tax, the rate at which you pay taxes increases with your income. The higher the income, the higher the rate of your tax. This seems a bit twisted. Why should people earning more be asked to sacrifice a higher percentage of their income as taxes?

But, the taxman has his own logic. Unequal sacrifice by people having unequal incomes helps in making everybody more equal. You should try to understand the logic of taxes with the spirit of a taxman. That may help you to keep your smile.

Johnny: Yes, it is better to smile than cry like crocodiles.

What:The government imposes direct and indirect taxes to meet its expenditure.

Who:Indirect taxes are paid by all people consuming goods and services whereas direct taxes are paid only by people earning more than the taxable limit.

When:The Union government presents its tax proposals every year in the budget.

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 atrealsimple@livemint.com

88) Slowdown in commodity derivatives trading

Policymakers have done little to contain speculation. There is nothing to indicate whether a buy/sell trade is a hedge transaction or a speculative transaction.

Mumbai, Feb. 28 The chapter on commodity futures market in the Economic Survey 2007-2008 makes an interesting reading. Admittedly, there is considerable slowdown in the growth of turnover on the futures market. The days of exponential growth seem to be over. Could it be a case of speculator fatigue? Clearly, trading volumes on National Commodity and Derivatives Exchange (NCDEX) actually declined sharply in 2007 (Rs 7,74,965 crore) compared with the previous two years. It may be attributed to the delisting of wheat and two pulses a year ago.

‘Not yet public’
Reference to Prof Abhijit Sen Committee which was set up exactly one year ago is conspicuous by its absence. Under political pressure, the Government was forced to announce and set up an expert group to examine the relationship if any between commodity futures trading and inflation. The group was asked to come up with finding within two months. The report is not public as yet.

No answer
Even today, there is no authoritative answer whether futures trading results in price spikes. On the other hand, the policymakers have done little to contain speculation. There is nothing to indicate whether a buy/sell trade is a hedge transaction or a speculative transaction.

In the US, transactions are distinguished as commercial (hedge) and non-commercial (speculative). There is no reason why we should not take a cue from the US commodity market regulator CFTC. The suggestion of recording the transactions as hedge or speculative was given to Forward Markets Commission (FMC) two years ago; and yet, the market is groping for correct information.

Talking about regulation of the futures market, the Survey concedes that the effectiveness of the market depends on the participation of all stakeholders. The Survey goes on to state: At the same time, it is important to ensure that such trading does not become an instrument for pronounced speculation.

Ineffective methods
Traditional methods of identifying and curbing speculative activities may not be as effective any more. The regulator needs to examine newer and more effective ways to bring greater balance between hedgers and speculators and treat the categories differently.

Making out weak case
The survey has also made out a weak case for allowing institutions to participate in the futures market. Where are the guidelines for regulating the aggregators or monitoring their activities? In addition, there is case for removing non-performing commodities from the trading platform.

The growth of turnover of Multi Commodity Exchange of India (MCX) has slowed down to a third from the previous years 200 per cent growth. Much of MCX’s turnover is from gold trading; and the yellow metal has been on a bull run. It is not uncommon that speculators rule the roost in a rising market.

Whether the same level of trading interest will be sustained in the (unlikely) event of a bearish phase for the yellow metal is something for everyone to think about.

A press release from MCX, quoting the Survey, said during 2007, MCX had become the eighth largest commodity derivatives exchange in the world with 68.9 million contracts traded. The exchange was the was among the three fastest growing commodity derivatives exchanges worldwide and the second largest in gold futures with 25.8 million contracts and the top most with regard to silver futures.

In 2007, MCX’s had domestic market share of 63% in contracts traded, the release said.

G. Chandrashekhar

Sourced from Business Line

87) Tackling excess volatility in the stock market

Markets are volatile by their very nature. There is, therefore, little point in decrying volatility, although an excess of it is certainly not desirable.

The Indian stock market is among the most volatile in the world. Between November 2006 and October 2007, the volatility of the Sensex and Nifty were 1.54 and 1.59 respectively as against 0.88 of Dow Jones, 1.06 of FTSE and 1.13 of Japan. Except the volatility of 1.69 of IBOV of Brazil, the volatility of the Sensex and Nifty during the same period were higher than that of indices of other developing markets such as MEXBOL of Mexico (1.33), JAISH of South Africa (1.15) and K LCI of Malaysia (1.05).

While the volatility of the Sensex and Nifty during December 2007 was relatively steady, during January 1-25, 2007 , it was abnormal with the Sensex fluctuating from a high of 21,113 on January 9 to a low of 15,332.42 on January 22.

It needs, however, to be noted that markets are volatile by their very nature. There is, therefore, little point in decrying volatility, although excessive volatility is not desirable. It, indeed, needs to be curbed.

Fall not unexpected

It is not as though that the fall in stock prices was unexpected. Price earnings of the Sensex and Nifty had sky rocketed to 28.17 and 27.01 respectively on January 9, 2008 as against the PEs of most of the global markets hovering around 15-20. This should have cautioned the regulators.

The drama witnessed in the latter half of January was not normal volatility but hyper volatility with a strong bearish undertone.

The overall fall in Sensex by 16.9 per cent from 20,728.05 on January 14 to 17,221.74 on January 24, 2008 was mainly due to massive sales by foreign institutional investors (FIIs), resulting in a fall in net investment by as much as Rs 12,735.50 crore.

With strong fundaments, both macro and micro, the steep fall witnessed in stock prices was not justifiable. It is true that sub-prime rate crisis in the US and also the slight slow down in corporate profits in the third quarter of FY 2007-08 would have some effect on the stock prices. Both these factors could have affected stock prices by, say, 5 per cent, but certainly not to the extent witnessed.

While there is universal acceptance of the imperative need to reduce volatility, there are differences in the approaches to do so. Here are some, both long-term and short-term measures, that merit serious consideration by the authorities concerned.

Curb FIIs’ holdings
The growth of shareholdings by FIIs needs to be curbed. With the net cumulative investment of over $65 billion, they account for about 25 per cent of the floating stocks and about 30 per cent of the deliveries.

The least that can be done is to reduce the share of qualified institutional buyers (QIBs) in IPOs from 60 per cent to 50 per cent and to peg the share of FIIs in the QIBs quota at 25 per cent, with the share of domestic mutual funds and other financial institutions at 25 per cent.

The share of retail individual shareholders can then be raised from 30 per cent to 40 per cent and the balance 10 per cent can be earmarked to non-institutional investors.

Besides, IPOs to retail investors should be mandatorily required to be offered at a discount of 5 per cent to the offer price to others. Floating stocks should be increased, which can be done by raising the minimum percentage of public offer for listing from 25 per cent to 40 per cent of the issued capital of a company. Even this is much lower than the 60 per cent that was the norm prior to the SEBI dispensation in June 1992. In addition, the requirement of holdings by the public in listed companies at 25 per cent/10 per cent should be rigidly enforced.

Finance to Stock Brokers
In an hour of crisis, stock brokers and investors need to be financed liberally by commercial banks. Most of the stock brokers demanded demand drafts or even cash for purchases.

It is worth recalling that when Dow Jones Index lost 507 points (22.6 per cent) wiping out about $500 billion on October 19, 1987 in a matter of hours, the then US Fed Chairman, Mr Alan Greenspan, ensured that the stock markets were flooded with liquidity. The markets recovered soon thereafter.

The RBI could have also ordered a cut in interest rates in this hour of crisis which would have stemmed the rot to some extent, in tune with the cut in the US Fed rate by 75 basis points to 3.5 per cent.

Moderate Margins
Another time-tested instrument to reduce the volatility of the market is to moderate the rates of margin, both in a sharply declining market and in a sharply rising market, which was heavily relied upon, prior to regulation by SEBI.

In a sharply declining market, margins on the short side should be higher so that it acts as a deterrent against sales and lower on the long side, while being adequate to cover the risk of a further fall in prices, encourages purchases. Similarly, in a sharply rising market, margins should be high on the long side and lower on the short side.

This instrument, among other instruments, such as curtailing the exposure limits, limiting speculative holdings, and so on, were heavily relied upon, with the approval of the Ministry of Finance, both during the bull phase from June 12, 1992 till April 22, 1992 when the Sensex rose by a phenomenal 243.0 per cent and also during the bear phase thereafter till November 1992 when the Sensex fell by 44.5 per cent.

These measures not only moderated volatility but also helped in ensuring that not a single default occurred during this period. What is essential is not to prohibit entry and exit at any point of time but to make it stiffer for purchases in a rising market and stiffer for sales in a declining market.

Market Stabilisation Fund

It is time that the proposal mooted in 2004 in the wake of Black Monday Crash on May 17, 2004, when the Sensex crashed by 842 points, to have a Market Stabilisation Fund, is reconsidered.

There is already a Market Stabilisation Scheme, aggregating to Rs 80,000 crore launched in 2004 to mop-up excess liquidity to sterilise the effects of foreign exchange accumulation resulting from large capital inflows.

There is no reason why a similar fund should not be set up to weather the shocks of stock market vibrations. A free market can occasionally be disastrous, as it has been seen several times in the various global markets, beginning with the South Sea Bubble in 1720 and including the great Wall Street crash in 1929.

The Indian stock market is no exception to this general rule. The crash that occurred in the wake of the border conflict with China in October 1992 and the disaster that followed the promulgation of Dividend Restriction Ordinance on July 6, 1974 are some of the instances of this general rule.

Shrewdly operated, the Market Stabilisation Fund should be able to make handsome profits, buying as it will in a steeply declining market and selling in a market dominated by irrational exuberance.

Stagger IPOs
The crash in stock prices in January 2008 was also caused by massive flow of funds into the IPOs of Reliance Power and Future Capital Holdings for which most of the investors, including QIBs, had to sell the existing share holdings. To avoid similar incidents , it is worth considering staggering the issues, as used to be done prior to the SEBI dispensation.

India claims to be an advanced market on a par with, or even a shade better, than the markets of developed countries.

Yet, we have a long way to go in dealing with matters such as reducing volatility of stock prices, enhancing the shareholding population, curbing the monopolistic trend, injecting full transparency in stock market operations, educating the investing public, and curbing several stock market malpractices such as manipulation of prices and insider trading.

M. R. Mayya

(The author is a former Executive Director, Bombay Stock Exchange.)

86) How the Sensex is calculated

For the premier Bombay Stock Exchange that pioneered the stock broking activity in India, 128 years of experience seems to be a proud milestone. A lot has changed since 1875 when 318 persons became members of what today is called The Stock Exchange, Mumbai by paying a princely amount of Re 1.

Since then, the country's capital markets have passed through both good and bad periods. The journey in the 20th century has not been an easy one. Till the decade of eighties, there was no scale to measure the ups and downs in the Indian stock market. The Stock Exchange, Mumbai in 1986 came out with a stock index that subsequently became the barometer of the Indian stock market.

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. (See below: Explanation with an example)

Due to 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.

The growth of equity markets in India has been phenomenal in the decade gone by. Right from early nineties the stock market witnessed heightened activity in terms of various bull and bear runs. The Sensex captured all these events in the most judicial manner. One can identify the booms and busts of the Indian stock market through Sensex.
Sensex Calculation Methodology

Sensex is calculated using the "Free-float Market Capitalization" methodology. As per this methodology, the level of index at any point of time reflects the Free-float 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. This market capitalization is further multiplied by the free-float factor to determine the free-float market capitalization. The base period of Sensex is 1978-79 and the base value is 100 index points. This is often indicated by the notation 1978-79=100. The calculation of Sensex involves dividing the Free-float 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 adjustments arising out of corporate actions, replacement of scrips etc. 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. Dollex-30 BSE also calculates a dollar-linked version of Sensex and historical values of this index are available since its inception.

Understanding Free-float Methodology

Free-float Methodology refers to an index construction methodology that takes into consideration only the free-float market capitalisation of a company for the purpose of index calculation and assigning weight to stocks in Index. Free-float market capitalization is defined as that proportion of total shares issued by the company that are readily available for trading in the market. It generally excludes promoters' holding, government holding, strategic holding and other locked-in shares that will not come to the market for trading in the normal course. In other words, the market capitalization of each company in a Free-float index is reduced to the extent of its readily available shares in the market. In India, BSE pioneered the concept of Free-float by launching BSE TECk in July 2001 and Bankex in June 2003. While BSE TECk Index is a TMT benchmark, Bankex is positioned as a benchmark for the banking sector stocks. Sensex becomes the third index in India to be based on the globally accepted Free-float Methodology.

Example (provided by rediff.com reader Munish Oberoi):
Suppose the Index consists of only 2 stocks: Stock A and Stock B.

Suppose company A has 1,000 shares in total, of which 200 are held by the promoters, so that only 800 shares are available for trading to the general public. These 800 shares are the so-called 'free-floating' shares.

Similarly, company B has 2,000 shares in total, of which 1,000 are held by the promoters and the rest 1,000 are free-floating.

Now suppose the current market price of stock A is Rs 120. Thus, the 'total' market capitalisation of company A is Rs 120,000 (1,000 x 120), but its free-float market capitalisation is Rs 96,000 (800 x 120).

Similarly, suppose the current market price of stock B is Rs 200. The total market capitalisation of company B will thus be Rs 400,000 (2,000 x 200), but its free-float market cap is only Rs 200,000 (1,000 x 200).

So as of today the market capitalisation of the index (i.e. stocks A and B) is Rs 520,000 (Rs 120,000 + Rs 400,000); while the free-float market capitalisation of the index is Rs 296,000. (Rs 96,000 + Rs 200,000).

The year 1978-79 is considered the base year of the index with a value set to 100. What this means is that suppose at that time the market capitalisation of the stocks that comprised the index then was, say, 60,000 (remember at that time there may have been some other stocks in the index, not A and B, but that does not matter), then we assume that an index market cap of 60,000 is equal to an index-value of 100.

Thus the value of the index today is = 296,000 x 100/60,000 = 493.33
This is how the Sensex is calculated.
The factor 100/60000 is called index divisor.

The 30 Sensex stocks are:
ACC, Ambuja Cements, Bajaj Auto, BHEL, Bharti Airtel, Cipla, DLF, Grasim Industries, HDFC, HDFC Bank, Hindalco Industries, Hindustan Lever, ICICI Bank, Infosys, ITC, Larsen & Toubro, Mahindra & Mahindra, Maruti Udyog , NTPC, ONGC, Ranbaxy Laboratories, Reliance Communications, Reliance Energy, Reliance Industries, Satyam Computer Services, State Bank of India, Tata Consultancy Services, Tata Motors, Tata Steel, and Wipro.

85) Securitisation of insurance risks

Securitisation of major risks arising from natural catastrophes is able to provide both insurers and investors who understand the risks with interesting opportunities in future.

Securitised risks have slid into a crisis of confidence and they have taken the financial market with them. There is a great deal of uncertainty around because players have invested in securities linked to US subprime mortgages without properly checking out the risks involved.

Packaging risks, syndicating them and offering them on capital markets is still the right way forward. Capital has to be put to work and earn us both prosperity and economic growth. What we are seeing in the current market is “teething problems”. Investors paid too little attention to a correct pricing of credit risks. Financial institutions assumed that the risk would not remain on the books for long and were over-reliant on rating agencies.

Today’s developments are taking place against the backdrop of a relatively solid real economy as has been the case in the financial industry in recent years. Wherever there is excessive growth, misconduct arises. But as during the dotcom boom and bust in 2000, also opportunities arise.

The investment instrument involving securitisation of risks is far from being dead, and neither can such assets be classified across the board as being “at risk”. One example of an increasingly important tool for the insurance industry is the cat bond. Irrespective of the risks underlying the product and the circumstances defined for triggering a cat bond, it is important to take a professional approach to the structuring and trading of products of this nature. Securitisation of major risks arising from natural catastrophes is able to provide both insurers and investors who understand the risks with interesting opportunities in future.

How does a cat bond work? Allianz announced the successful offering of an innovative catastrophe bond of an amount of $150 million in April 2007. This cat bond provides Allianz with protection against high severity losses incurred from earthquakes in the United States or Canada, not including California, and river floods in Great Britain. The bonds issued offer a return to investors of 3.15% over LIBOR and have a Standard & Poor’s BB+ rating. The insurance risk is modelled to be 0.54% per annum. This means that investors must reckon with an annual loss of 0.54% of their invested capital. They are compensated for this risk with a return that is 5.8 times higher. What looks like a small risk though, could in practice mean for a single investment that an investor looses his entire investment, if the unlikely event occurs. On a large portfolio of risks that have limited correlation with each other, however, the occasional loss will be less significant and should be easier to stomach.

In November, Allianz sponsored a second cat bond, which transfers to investors the risks of windstorms in seven European countries. The bond has a total volume of e200 million and uses a parametric index trigger, which is based on the measurement of wind speed at various locations.

The advantages of cat bonds are obvious. The sponsoring insurance company passes part of the risk to the capital market and thereby creates additional risk-bearing capacity. The reinsurance market is not always able to provide the issuer with this extra capacity. In the future, this gap could become much bigger if climate change takes its toll. In addition, cat bonds provide fully collateralised insurance cover with minimal credit exposure. The insurer is also able to smooth out the effects of fluctuations in income and equity capital by passing on peak risks. Insurance customers benefit from this practice because there is an overall increase in insurance capacity. Natural catastrophes remain insurable even if levels of claims reach dizzy heights as a result of climate change. Securities like cat bonds provide investors with exciting portfolio effects in addition to an attractive return, because there is little correlation between the occurrence of natural catastrophes and classic capital market risks. There’s also something in it for the community and the state. If major risks continue to be insurable in the private market, the need for governmental aid in the wake of catastrophes is reduced.

In the example above, earthquakes in the United States and Canada — except California — and severe river flooding in Britain were chosen because they represent high risks insufficiently covered by existing reinsurance. However, a large share of catastrophe risks remains uninsured in the first place. In the biggest individual case of financial loss to date, Hurricane Katrina caused $144 billion in total losses in the southern United States, only 49 billion of which were insured.

This indicates that the additional capacity provided through cat bonds and similar instruments opens up an attractive growth market for insurers with the necessary know-how. It is our objective as an insurer to maintain and extend the scope of insurance coverage against natural catastrophes. Diversifying risks in capital markets through catastrophe bonds is one way to expand insurability and the share of insured losses and to offer more protection to more people.

The popularity achieved by the most recent issues is a sure indication of the continued appeal of the securitisation of risks even in financial market turbulence. The outstanding volume of catastrophe bonds increased to around $15 billion in 2007. During the next few years, the securitisation of insurance risks has the potential to become even more important than it is today.

Werner Zedelius

(The author is a member of the Board of Management of Allianz SE )

84) TOWARDS A STABLE, SECURE AND SUSTAINABLE INDIAN MARKET

TOWARDS A STABLE, SECURE AND SUSTAINABLE INDIAN MARKET


Submitted
To
UNNATI-08
School of Management Studies
University of Hyderabad





Prepared
By
Ashish Bhagat
Sasmit Kumar Sahu
(Students of MBA Finance
Christ College Institute of Management
Bangalore)
Email: ashish.bhagat1@gmail.com
sasmitksahu@gmail.com
Mobile No. – 9886820900, 9945104327



Abstract

For the sole purpose of the study, the Indian Market has been subdivided into four segments - Capital Market, Forex Market, Debt Market & Financial Services market. The paper tries to highlight the need for stability, security & sustainability in the context of Indian market. The study also shows the reasons that have made the Indian market vulnerable to various external & internal risk factors. It deals with some of the contemporary issues vis-à-vis the global market scenario. It specially focuses on some of the regulatory norms pertaining to these markets, which questions the role of the regulatory bodies. The coupling of the Indian indices with various global indices has changed the face of the capital market due to increased foreign investments. The Insurance & Mutual Fund Industry is not mature enough to provide a potential investment alternative. The recent crash of bond prices shows that even the most secure Bond market is also not free from the epidemic of volatility. The volatile exchange rate due to unpredictable capital flow has exposed some major sectors to a higher exchange rate risk. It also shows the ways to use India’s huge Foreign Exchange Reserve efficiently. Also emphasis has been laid on the measures to make the markets a safe heaven for all the stakeholders.

Adam Smith once said the group does its best when each individual does his best. Incomplete - The group does its best when each individual does best for himself as well as for the group.
In parlance to this Indian Financial system will perform better if all the financial sectors do good for themselves as well as contribute together to build a secure, stable & sustainable Indian Market. A market is a place where risk can be shared by many people. For the sole purpose of our study the market has been divided into four segments, discussed in the paper.

Capital Market
The roughly 3,000 firms that are traded in India have a market value of Rs 57 lakh crore. Taking corporate bonds into account, the market has a value of roughly Rs 65 lakh crore, and the total turnover exceeds Rs.1 lakh crore per day on most days. This market has become the foundation of financing for India's corporations and is thus central to India's growth prospect.
Still Capital market of India can safely be called to be in its nascent stage in comparison with global standards. India stands at number 10th with market capitalization of more than US $1,090 billion. (see exhibit 1)
Irrational Exuberance
The ups and downs of the financial markets are always in the news. There is plenty to report. Wide price fluctuations are a daily occurrence on the Indian stock markets as investors react to economic, business, psychological and political events. Of late, the markets have been showing extremely erratic movements, which are in no way tandem with the information that is fed to the markets. The reaction to negative news is many times more than the reaction to positive news, which can be observed in any stock market index. (see exhibit 2) The reversal since January 10 shaved 16 per cent off the BSE Sensex, with many stocks losing much higher value.
There are two schools of thought that have divergent views on the reasons of volatility. The economists in their fundamentalist approach argue that these market movements can be explained entirely by the information that is provided to the market.
Others have argued that these movements have nothing to do with economic or external factors. It is the investor reactions, due to psychological or speculative motive, which exert a greater influence on the markets.
But our study shows that both are major contributors to the volatility prevailing in the Indian Capital Market.
Factors responsible for Volatility
i) IPO rating
Soon SEBI will be introducing IPO rating system, where all IPOs before floating in the market has to be rated by a rating agency. Though the motive behind this decision is investor protection, but our prediction says this will increase market volatility. The investors will relatively put more money in the IPO which has been rated higher to make listing gains & for other psychological reasons. The IPO which has been rated higher that can charge a high premium price as well. Hence the sell off will be huge on the first day of listing, which will contribute to the volatility. And because of not having a good rating many good IPOs may not perform well.
ii) Foreign Flow
It has been rightly said that the Indian indices are at the mercy of FIIs. The coupling of Indian indices with global indices has made the market more volatile. (see exhibit 3 & 4)Though the volume of purchase has gone up in the last 3 months, so as the sale, keeping the net investment almost same. This gives us an indication that the major chunk of the investment is for speculation purpose which makes the market more volatile.
iii) Insider Trading
Insiders in several small and mid sized companies did manage to offload shares just before the correction struck, with insiders “sells” exceeding insider “buys” during the correction period. During the week before the crash (when stocks were at or near life-time highs in some cases) 35 such insider trades were struck, two-thirds of which were sale transactions. Insiders make the severity of volatility more. Though it cant be stopped but real time reporting of these transactions should be done to SEBI, so that the market can keep be cautious.
iv) Grey Market
There are many vibrant under the rug grey markets exist, which is a parallel unofficial stock market. They operate both in primary & secondary market. This gives a wide scope for speculation contributing to severe volatility.
v) Dematerialization
One of the major steps of SEBI, was to introduce dematerialization of stocks, which reduced the bad deliveries in the stock market. This also had the added benefit of faster share delivery, which was reduced drastically from 45 days to 21 days. This reduced the inventory period for stocks during delivery. This results in higher circulation and lead to increase in the availability of stocks for trading. Thus the coupled affect of reduced inventory period and reduced bad delivery risk lead to higher volatility.
vi) Rolling Settlement
Rolling settlement was introduced to reduce the speculative activities, which ultimately increased capacity. This might be due to the free-fall in the share prices that occurred after the introduction of rolling settlement.
vii) The information boom
It has helped to provide information on stock movement round the clock. This has resulted in markets adjusting to such information faster than before which in turn increase market volatility. The information technology & Internet boom has resulted in real time information processing which makes the process faster & the index volatile.

Measures to Make the Capital Market Stable, Secure and Sustainable

i) Concept of Tobin Tax
If stock markets had shock absorbers, they would have a system to curb speculative profits and losses. When speculative profits are restricted, volatility will come down automatically. We need a tax law, can be called the stock market shock observer that penalizes those who make unearned profits by speculation. Nobel Prize winner Professor Tobin proposed a tax to curb currency speculation in international markets.
The Tobin Tax — a levy on the fluctuations in stock prices, should be equally effective in stabilizing stock markets. Then, every one who sells high (or buys low) pays a tax. That tax will become a disincentive to push prices too high or too low. Tobin Tax has never been accepted possibly because powerful vested interests make a lot of unearned money by speculation.
It is possible that sometime in the future, some Finance Minister will put into practice Professor Tobin’s idea. We may have to wait till that time for an equivalent of Tobin Tax to be imposed on stock market speculation too. The Finance Minister can do much more to reduce financial volatility than he realizes.
ii) Transparent Money Flow
The ban on the Offshore Derivative on participatory Notes was a move taken in the right direction. The country should receive only those funds that are accounted for and is transparent about the investor. It can be observed from exhibit 4 that a major chunk of the fund is used for speculation & the real net investment is very low. Hence the speculation done by FIIs should be discouraged with the help of instruments like Tobin tax.
iii) Low value derivatives.
The mini contract will definitely add further liquidity in the market, as more number of investors can trade with low value & volume. Such more steps has to be taken by exchanges with the cooperation of the regulator that will increase liquidity in the market, which will reduce the severity of volatility, as fair price discovery will be easy.
iv) Depth & Width
In a stable & secure market no single entity should be able to influence the market. The market should have depth & width as well. No market is perfect but should strive for perfection. The reservation of 30% in an IPO for retail investors has been a right move in this direction.

The market regulators have been trying their best to curb these speculative uprising but have not been able to keep it in control so far. We believe that such bubbles cannot be curbed by imposing circuit breakers or margins but by allowing free trade, new products & market expansion. A more analytical media reporting which highlights better risk management coupled with investor learning will surely lead to more stable market.

FOREX MARKET
India maintains an official policy of a managed float with no target or preannounce path for the exchange rate. Consistent with this, there has been significant flexibility in the exchange rate, although volatility has increased over time, but now it is at a level on par with that of other large emerging markets countries.
In nominal bilateral terms vis-a-vis the dollar, the appreciation has been particularly notable, reaching successive nine-year highs as it rose about 12 percent.
Amid sharply rising capital inflows, the Reserve Bank of India has intervened with the stated aim to smooth volatility in the exchange rate. During January–October 2007, intervention amounted to about $64 billion, consisting of purchases of foreign currency. This represents a sizeable increase over 2005 and 2006, when intervention through October registered around $15 billion. During 2007, intervention has been highly variable from month to month, ranging from under $2 billion (in August) to over $12 billion (in October) but has consisted entirely of purchases:

The appreciation of the rupee appears to be largely an equilibrium phenomenon.
Consistent with this, the rupee does not appear to be out of line with medium-term macroeconomic fundamentals. Export performance has remained favorable, underpinned by structural improvements in the export sector, and more broadly by strong productivity
growth. While intervention has risen in tandem with swelling capital inflows, empirical```
evidence suggests that intervention has served to dampen the volatility in the rupee, rather than to influence the level or rate of change in the currency. Going forward, continued efforts to maintain strong productivity growth, while allowing due flexibility in the currency, would be the best way to cope with any pressures on competitiveness likely to arise from any emergent currency appreciation pressures.

India’s foreign exchange markets can be traced back to 1978,when banks were permitted to undertake intra-day currency trades for the first time. However, market activity did not take off until after the adoption of a managed-floating exchange rate regime in March 1993 amid a series of ongoing financial and capital market that followed the recommendations of the Report of the High Level Committee on Balance of Payments. The gradual relaxation of capital account restrictions provided an economic rationale for the creation of onshore currency derivatives markets as corporates started tapping foreign markets.

India’s growing global financial integration, domestic currency derivatives trading has tripled since 2004 to nearly US$34 billion per day.The rupee’s share in global turnover of traditional foreign exchange products (cash, spot and forward derivatives market)3 more than doubled between 2004 and 2007 to 0.7 percent of global turnover (or US$26 billion per day)—remarkable given the 70 percent annual growth in global trading during recent years.

Despite the surge in currency derivatives trading, it lags that in other major emerging economies. At end-2007, the daily gross volume of currency derivatives turnover represented less than 20 percent of all foreign exchange trades in India. (See Exhibit 5)

Foreign-currency transactions in India occur mostly over-the-counter (OTC),with the Clearing Corporation of India Ltd. (CCIL) acting as settlement agent (it settles 90–95 percent of the interbank transactions in the U.S. dollar-rupee market).

Inter–bank currency swaps account for the largest share of currency derivatives turnover. Hedging can be performed through swaps and OTC inter-bank forward or option contracts—both cross-currency as well as foreign currency/rupee. Turnover in forward (US$2.5 billion daily) and swap contracts (US$3.1 billion daily) represent about
90 percent of gross daily derivatives trading. Options trading remains nascent, with trading around US$400 million daily.

REGULATORY FRAMEWORK
The currency derivatives market is regulated by the RBI, which issued comprehensive guidelines on derivatives in April 2007. In the wake of the Annual Policy Statement for the Year 2007–08 (April 2007), the RBI adopted a new regulatory framework for derivatives, which defines:
(i) a classification of market participation into market makers,who undertake derivatives transactions to act as counterparties, and users, who undertake derivatives transactions to hedge or transform risk exposure;
(ii) broad principles for undertaking derivatives transactions, including valuation and market pricing;
(iii) prudential measures to control the risks in derivatives activities, including an integrated risk management process; and
(iv) “suitability” and “appropriateness” of policies governing the due diligence of market-makers in offering derivative products.
Against the background of growing financial integration and benign macroeconomic conditions, the RBI is liberalizing foreign exchange markets as a critical element of continued capital market development. Regulatory efforts are underway to widen the domestic derivatives market, with a view to facilitating onshore currency hedging in India. The RBI recent raised hedging limits for documented exposures as the first measure in series of regulatory reforms.

Greater Hedging Flexibility
The latest move by the RBI to allow greater flexibility of hedging activities is a step in the right direction, but whether it will spark much wider participation in currency derivatives is not a surety. While more flexible use of options could help complete the derivatives market, it could also encourage hedging strategies that result in capital inflows.



Introduction of Currency Futures
Both OTC and exchange-based trading forums may be needed for the development of a well-functioning foreign exchange market, provided that they are supported by adequate infrastructure. OTC markets are essential for exporters and importers who need to hedge specific cash flows in a customized fashion.
Exchange-based markets may be needed for institutional investors seeking to manage wholesale positions.At the current stage of development, an exchange-traded currency derivatives market usefully complements the growing OTC market in India.
The introduction of exchange-based currency derivatives in the form of currency futures would broaden demand for hedging facilities and increase transparency in foreign exchange markets.Existing trading platforms in the equity market could be an alternative to creating separate currency futures exchanges.
Separate currency futures exchanges would fail to harness the economies of scale and scope of India’s established stock exchanges. Market participation during the initial phase of currency futures trading might be narrow.

Currency derivatives can provide important benefits for financial systems.
The sound management of currency risk is one of the most critical elements of adapting financial systems to greater globalization in order to preserve financial stability. Like other types of derivatives, foreign exchange derivatives facilitate risk diversification, promote efficient price formation, and enhance financial intermediation. They supplement cash markets, improve market liquidity, and facilitate the unbundling, decomposition and/or transformation of risk, which can be customized to risk preferences.

Currency derivatives markets are particularly important for countries like ours that have flexible exchange rates and are moving towards fuller capital account
convertibility.
In the context of a flexible exchange rate, well-functioning derivatives markets help reduce financial fragility by allowing the corporate and financial sectors to better manage their exchange rate risks, ease financial surveillance, and provide useful price signals about market views on economic and financial conditions. Currency derivatives also complement the development of domestic capital markets.

Debt market

It has been rightly said that the debt market in India though has width but does not have depth. More than 90% of the market is dominated by government Bonds & treasury bills. Corporate bonds account for less that 2%. Retail investor participation is restricted to 5% only. The secondary market has also not full fledged like secondary equity market. Debt market is a shock observer or safety net for institutional investors that take high financial risks. Recently the bond market has also seen volatility because of the interest rate fluctuations & the recent SLR status statement.

Recommendations
i) Time & cost of public issuance should be reduced
ii) Simplify disclosure and listing for private placement.
iii) Encourage retail investors to participate through mutual funds and exchanges if preferred.
iv) Increase transparency by ensuring all trades are reported, especially OTC trades.
v) Upgrade procedures of DVP to international standard.
vi) Widen investor base.

Banking Sector
The sector that that binds all other financial sectors is the banking sector. The stability of the entire financial market depends on how stable & sustainable the banking sector is. The recent Sub prime collapse has lead to a wakening call for all the financial institutions all round the globe and has laid emphasis on use of Basel-II norms for giving loans. Basel-II is based on the following three pillars.


The first pillar
The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk and market risk.
The second pillar
The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk, which the accord combines under the title of residual risk.
The third pillar
The third pillar greatly increases the disclosures that the bank must make. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately.
Mutual Fund & Insurance Sector
Indian indices should not move at the mercy of the foreign investments. For that the Domestic Institutional Investors have to be big enough. Mutual Fund & Insurance in India has not reached that level of maturity to dominate the indices. They should be big enough to provide healthy alternative investment opportunity to the retail investors to do passive trading. And also should be able to provide perfect diversification & hedging to minimize various financial risks. And also should be able to come for rescue when the indices start moving southward. The current AUM of mutual Fund industry is at more than Rs 4.68 lakh crore.

Reference:
1) Prof. Ajay Shah’s blog - http://ajayshahblog.blogspot.com/
2) Prasanna Chandra(2004), Financial management Theory & Practice, page 22 -36
3) http://www.rbi.org.in/statistics
4) http://www.sebi.gov.in/
5) http://www.amfiindia.com/
6) http://www.moneycontrol.com/
7) http://www.economywatch.com/
8) P.V. INDIRESAN, Shock Absorver-article appeared in Business Line on February 4th, 2008
9) http://www.imf.org/

83) What pricked the IPO bubble

The prospects for the business apart, returns on stocks offered through IPOs are subject to whether the market is in a bullish or bearish mood.

For those who have just begun to invest in initial public offers (IPOs), events of the last few weeks are bound to be bewildering and probably even upsetting. Offers said to be of good quality were withdrawn and an offer that was ‘certain’ to list at a premium disappointed. Isn’t book building supposed to result in efficient pricing of IPOs at all times? Just a few weeks ago, every IPO seemed to have rosy prospects. How could things change so quickly? It has everything to do with sentiment.

IPOs in bull markets

The prospects for the business apart, returns on stocks offered through IPOs are subject to whether the markets are in a bullish or bearish mood. In a bull market, IPOs tend to be aggressively priced and the book-building process that is designed to enable ‘price discovery’ too may be influenced by the overall mood of investors.
As you know, a company, in consultation with its investment bankers, decides the price band of the issue. A price band stipulates a floor price and a cap price and the price range cannot be more than 20 per cent.

In a book building process, it is left to investors to ‘discover’ the actual price of the offer, by bidding for shares at a price within that band. Qualified institutional buyers or QIBs, for whom 50 per cent of the shares on offer are reserved, play a key role in determining the price for the offer, given their professional investment expertise. Retail investors have the freedom to bid for shares at the cut-off price, which is the price ultimately determined by the company and the lead managers, based on the outcome of the bidding process.

Retail investors take cues from the subscription levels of the QIB portion of the offer. If the response from QIBs is strong, it is considered a vote of confidence in the company. By bidding at the cut-off price, retail investors ensure they are eligible for allotment.

In a bull market, this system is less than perfect. It becomes easier to justify stiff valuations because excess liquidity ensures overwhelming demand for the shares on offer. The pricing, therefore, gets distorted.

Over the past year, several offers were made at valuations that were at a considerable premium to similar stocks available in the secondary market.

But instead of shying away from these expensive offers, markets simply re-rated or bid up the price of existing listed players. Brokerage stocks were re-rated when Religare first tapped the market, as was Unitech when DLF went public. Let’s not forget the rush for power stocks upon the announcement of Reliance Power’s IPO.

Under these conditions, QIBs who wish to participate in a quality offer may be forced to bid within this exorbitant price band, even though they might, under different circumstances or in a different market, view the offer as expensive. Second, because of this IPO rush, QIBs too bid for shares at the upper end of the price band to guarantee their allotment.

This meant that you rarely had the benefit of obtaining shares at the lower end of the price band and improving your chances for listing gains. So much for price discovery!

Third, as more offers list at fancy premium, more short-term investors enter the primary market. This is not restricted to retail investors alone.

There could be some QIBs who enter the IPO game for listing gains alone. Which is why you need to view the over-subscription in the QIB portion with some caution, as it is not always indicative of the quality of the offer.

What went wrong?

So long as the bubble continues to expand, investors continue to make money from IPOs. But when sentiment takes a turn for the worse, the anomalies in the system manifest themselves quickly. This is precisely what happened in the recent offers.

As global developments rapidly unravelled, stock markets across the world tumbled. Foreign institutional investors who were facing the heat back at home became more risk-averse and were unwilling to pay high prices any longer. Weak response from QIBs forced some companies to lower the price band of their offer.

Companies are allowed to revise their price bands during the offer period; the floor of the price band can move up or down to the extent of 20 per cent. But in a market where stocks were being steeply de-rated, even a 20 per cent cut in valuations may not have been enough. Sentiment changed so quickly that investors withdrew their bids at the last minute, as in the case of the Emaar MGF IPO.

Poor responses to offers have resulted in some of them being withdrawn. This has robbed the sheen off IPOs and has dampened the performance of companies on listing.

Recent offers such as IRB Constructions and Shriram EPC have fixed the cut-off price at or closer to the lower end of the price band, an attempt to provide some room for listing gains.

The good news is that, for now, markets might shun offers where fundamentals are not in place. The bad news is that in their extreme pessimism, investors might avoid good quality offers as well.

All this makes you want to re-think investing in IPOs, doesn’t it?

Investing in IPOs
Actually, if market players have learnt their lessons from these events, you, as a retail investor, may be at a better advantage from now on when it comes to investing in IPOs. Offers might be more realistically priced, subscribers might be of better quality and chances of securing allotment are likely to be higher. This is why you should probably not give a fundamentally sound offer a miss, irrespective of secondary market conditions.

There is still no guarantee of listing gains. In fact, there is a need to moderate our return expectations from IPOs al together. But something has to be said for the lure of investing in a great company right from the time it opens itself to the public. Be a long-term investor and reap the gains.

Shanthi Venkataraman

82) IPOs: The rules of the game have changed

The poor institutional response to recent IPOs suggests a waning of liquidity and risk appetite at a global level. Investors need to re-draft their IPO strategy.

How swiftly the mood of the markets can swing from sunny optimism to extreme scepticism! The withdrawal of two big-ticket initial public offers (IPOs) by Wockhardt Hospitals and Emaar MGF this week underline how fragile the all-important factor called ‘investor sentiment’ really is. Barely three weeks ago, IPOs from Reliance Power and Future Capital Holdings sported record subscription figures, having garnered runaway response from every class of investor. The n, those rushing to hop on to the IPO bandwagon were hardly deterred by the stiff asking price or ‘execution’ challenges that faced these companies, both of whom rolled out their IPO at a rather nascent stage of their business. Yet, it is precisely these reasons that are now being cited for the unenthusiastic response to the Wockhardt and Emaar offerings. Institutional appetite waning

It is not merely individual investors, bruised by the recent blows to their net worth, who seem to have lost their appetite for IPOs in three short weeks.

Retail investors, in any case, tend to take their cues from the larger institutions; which is why IPO subscriptions tend to bunch up on the last days of the offer period.

The larger worry for Indian investors, and the markets in general, should be the extremely tepid response from QIBs (qualified institutional bidders).

That institutional investors cold-shouldered a globally recognised name such as Emaar in the hot real-estate sector, after lavishing their attention on a slew of lesser-known names in 2007, is disturbing.

This suggests a genuine waning of liquidity and appetite for risk, at the global level. A recent report from Thomson Financial states that globally a total of 21 IPOs, worth $6.3 billion, were withdrawn in January. India, until recently, was an exception to this trend; but no longer.

‘Superior’ growth prospects or not, liquidity remains the engine that powers stock markets. When it comes to liquidity, India’s primary market, much like its secondary market, depends heavily on the favour of global investors.

A good number of retail investors, in any case, were in the game mainly for listing gains. With present secondary market conditions making huge listings difficult, those on the speculative fringe may remain on the sidelines until the frenzy starts all over again.

Structural shift

This being the case, the failed IPOs may flag off two key trends for the stock markets in the months ahead. One, the flow in the IPO pipeline may dwindle as those with a limited track record rethink IPO plans.

Two, with global investors in a risk-averse mood, markets may no longer be willing to pay any price for a new business idea. Valuations, whether for new offers or already listed companies, may moderate. In the buoyant markets of the past few months, businesses and stocks that captured the imagination were able to justify sky-high values, on the strength of fancy “valuations” assigned to nascent businesses that were still on the drawing board.

These developments may also require retail investors in IPOs to make some changes in their investment strategy for the months ahead. The key takeaways for them from the turbulence of the last week are:

Listing gains are no longer a certainty. This means that investors cannot bank on flipping a stock on listing to recoup high funding costs incurred to bid for the IPO. Investors may be better off avoiding leveraged bets on IPOs, no matter how attractive the business or the “grey market” buzz on the stock is.

Investors should go back to evaluating every IPO much as they would a stock in the secondary market. Businesses that have alternatives in the listed space may no longer be able to command huge valuation premia, just because they are garnering funds through an IPO. Newly listed stocks may no longer remain islands of high valuation, with large trading volumes, in current market conditions.

Finally, while making their decision, investors should factor in the opportunity loss involved in taking the IPO route. Quite a few retail applicants to the Reliance Power IPO probably sacrificed attractive opportunities to buy into blue-chips of their choice when they were available at rock-bottom prices in the recent market correction.

A significant part of their funds was locked into the offer. Allocating only a portion of your overall equity portfolio to IPOs and participating only in high conviction ones may be the best way forward.

Aarati Krishnan

81) Why not custom-tailored MFs?

There is an information overload in the mutual fund industry because of the multiplicity of products. These products are generic and do not help clients meet their investment objectives. The mutual fund industry should instead focus on custom-tailored products that help investors achieve their horizon objectives. Such products will require minimal investor education.

In a mutual fund awards ceremony held recently, Dr C. Rangarajan, Chairman of the Economic Advisory Council to the Prime Minister, said that there was “indigestible information overload caused by the multiplicity of products in the mutual fund industry”.

The SEBI Web site, which showcases offer documents awaiting clearance by the capital market regulator, is a testimony to this deluge. You will find funds with generic names such as Long-term Equity Fund to those that propose to invest in the infrastructure sector.

Most of these funds have new names with same investment strategies as an existing family of funds.

The fund industry should instead construct investment vehicles that match the clients’ horizon objectives instead of launching generic funds. Such products will have fixed maturity and target specific investment objectives.

A 10-year Education Fund, for instance, will invest in assets that generate returns to finance the investors’ education costs 10 years hence. Such funds will better serve investors.

Importantly, the product will be easy to understand and will require minimal investor education.

Old wine, new bottle?

As with any other business, marketers of mutual funds need to understand customer psyche to peddle products.
Investors do not like buying units of existing funds at high NAV; they prefer buying units at Rs 10. Investors do not realise that it is the current market price of the assets in the portfolio that matters and not the actual NAV.

Suppose an existing fund invests in only one stock whose current market price is Rs 100. Assume that the fund has 100 units outstanding with total asset value of Rs 10,000. The NAV is then Rs 100 per unit. The unit-holder effectively owns one unit of the stock.

Now, suppose a new fund is launched that proposes to invest in the same stock at the same price of Rs 100 per share. Assuming that the fund sells 100 units at Rs 10 per unit, the unit-holder effectively owns only one-tenth of one stock! Essentially then, the current NAV reflects the market price — whether it is Rs 10 or Rs 100.

The strong preference for Rs 10 NAV prompts the mutual fund industry is one reason which continually introduce new products. With exposure to the same universe of stocks, one fund is hardly different from the other.

Custom-tailored products

What if the industry offers custom-tailored products?

Take a typical 30-year married couple with one child. Suppose their investment objective is to meet their child’s university-level education 20 years hence. They will have to invest in some generic fund such as India Opportunities Fund or Long-term Equity Growth and hope that their horizon objectives are met.

Fund-houses can instead tailor a 20-year Education Fund. Such a fund may invest in the same universe of stocks as that of the generic fund. The difference is that the portfolio manager will design an asset allocation policy that helps investors’ meet their future education costs.

There will also be good demand from investors who are currently excluded from medical insurance coverage. These are people in their late 40s who suffer from acute medical conditions.

A custom-tailored product will consist of a portfolio of stocks and bonds that will fold at age 65. So, if a fund is targeting 40-year olds, it will have a fixed-maturity of 25 years.

Of course, with a proliferation of such products, investors will require professional advice to choose from peer funds. But that is a far cry from the problem that they currently face- generic funds that have no specific horizon objectives.

Product structuring

Fund-houses currently offer fixed-maturity bond funds across the yield curve. Likewise, they can launch an education or health-care fund that has maturity ranging from five to 25 years or more.

There is, however, an important difference. Bond funds can easily horizon-match their objectives. The reason is that 10-year fixed-maturity plan will invest in a residual-maturity 10-year bond.

The fund will redeem the bond and return the proceeds to the investors. There is, hence, no price risk. This is the risk that a decline in asset prices at or near-maturity will prevent the fund from meeting its investment objectives.

That is not true of funds that have exposure to stocks. The reason is that stocks do not have finite life as bonds do. The fund will, hence, be exposed to price risk. Nevertheless, financial engineering can help fund-houses structure such products. Equity duration and portfolio immunization can help portfolio managers minimise the price risk at the horizon.

The mutual fund industry should probably focus its attention on such custom-tailored funds. Such a move will also force the investors to think about their long-term investment objectives. Will the industry take up the initiative to launch the generation-next products?

B. Venkatesh

(The author is a Chennai-based investment strategist. He can be reached at enhancek@gmail.com)

80) Is there a pattern in insider trades?

Insiders in several small and mid-sized companies offloaded shares just before the correction with insider “sells” exceeding “buys”.

By now, we know that most retail investors and fund managers were caught unawares by the brutal corrective phase in the Indian stock markets. The reversal since January 10 shaved 16 per cent off the BSE Sensex, with many stocks losing much higher value.

Some market gurus and investment experts may have warned of high valuations prior to the crash, but did company insiders sense the same? Or were they as surprised as the leveraged small investor? And how did insiders behave during the crash? Did they mop up shares because they saw value in their companies?

Business Line scanned the insider trading disclosures that all key management personnel, directors and beneficial owners of shares in a listed entity regularly furnish to the stock exchanges to discern a few trends.

In all, we screened 59 different insider trades (just before, in between and just after the correction phase) involving 53 big/medium/small companies operating across 25 different sectors. The scrutiny revealed interesting trends:

Insiders in several small and mid sized companies did manage to offload shares just before the correction struck, with insiders “sells” exceeding insider “buys” during this period.

The onset of the correction saw many insiders lose their nerve, much like small investors, to offload their stakes in their companies

Some promoters did use the decline in values to accumulate stakes in their companies, but waited for the correction to run its course before they did so.

During the week before the crash (when stocks were at or near life-time highs in some cases) 35 such insider trades were struck, two-thirds of which were sale transactions.

Divine timing

Sunil Duggal, CEO, Dabur India, Mr Ajay Kumar Vij, CEO, Dabur Pharma and Mr V Senthil Kumar, of i-flex Solutions b.v (Dutch subsidiary), booked profits on their holdings in the period from January 2 to 7. All these executives seemed to have timed their sales quite well to peaks in stock prices. Amongst well known names, a constituent of the promoter group of Suzlon Energy sold 65,100 shares, representing 0.02 per cent stake, just before the onset of the correction.

Only ten were buy trades, which indicates that a majority anticipated a decline in prices. A stake hike by the promoter of Oriental Trimex on January 8 and purchases by the chairman of Gateway Distriparks, who acquired 44,200 shares on January 7, were exceptions, where insiders bought shares just before prices reversed sharply. However, insiders who acquired shares just before the crash would today be sitting on notional losses of 35-47 per cent if they were to sell the newly acquired stock.

Crash landing

However, in a falling market, there seemed to be no material difference between the mentality of insiders and small investors. Like many retail investors, insiders too appeared to hit the panic button as the market fell ferociously with total sell trades (15) outnumbering the buy ones (11) during the rout. However, the fact that sales were timed to an early phase in the fall probably helped save these insiders a packet or two!

Insiders who sold during the correction have managed to save an average 30 per cent of wealth, by exiting those shares. A promoter of Crazy Infotech sold 5,000 shares on January 10 at around Rs 206 each; the stock is now trading at Rs 47!

Just as some insiders were spot on in timing their sales just before the crashsome others waited patiently for the crash to run its course before shoring up stakes in their companies.

A Director of Jaiprakash Associates bought some 2,000 shares on January 24 at around Rs 370 – a cheap entry point – as it stayed above Rs 440 levels even during the correction phase. This indicates that sometimes it pays to wait for turbulence to end in the market and then make fresh moves after figuring out a secular trend in the stock. This holds true even if one is a risk-taking investor. Long-term investments

The Indian promoter of Gateway Distriparks Ltd. (GDL) waited until January 21-22 to buy 8 lakh shares of GDL through an unlisted company- Prism International. The weighted average price of the stock had declined to around Rs 110 during January 21-22, compared to Rs.150-160 levels a scant seven days ago. The stock has now steadied in the Rs 106-110 band, reducing notional losses for the buyer.

The promoter of K S Oils persistently bought the stock through the correction from January 14-16 and then returned on January 21-22, in the process mopping up 28.78 lakh shares or a total 1 per cent stake in his own company. Due to his transactions being spread out over many days, the stock would have been accumulated at around Rs 92-93 levels.

This is far less than the high of Rs 142 per share hit by the solvent extraction company in January itself. As many long-term investors believe, if you like a company then a lower price is an opportunity to accumulate.

Like him, other promoters and key company executives also accumulated BSEL Infrastructures, Lime Chemicals, Rajshree Sugars, Garnet International and Ruchi Soya during the corrective phase.

Sitting on notional losses if they were to immediately sell those shares, these insiders seem ready to endure some temporary pain.

Tenable trends

Just two days after the corrective phase for the market as a whole took a breather, insiders continued to sell off stocks as the share prices of select companies continued to gravitate southwards. Gujarat Lease Financing, International Hometex and diversified major ITC saw sell trades from insiders in the January 23-25 period.

None of the large-caps saw any insider trades during these periods, which is noteworthy, as several frontline stocks suffered sharp reversals during this phase.

The possibility of heavy price swings might have prompted promoters as well as key employees to employ a ‘wait and watch’ approach. Our analysis reveals that generally insider trades happened in micro-caps or mid-caps.

As far as sectoral trends are concerned, smaller financial stocks like V B Desai Financial Services, VLS Finance and Wall Street Finance became very active before the crash with the promoters turning bearish on their stocks.
In metals (ISMT and Nissan Copper) and logistics (Gateway Distriparks and Patel Integrated), promoters or other insiders remained persistently bullish about the prospects of the companies, steadily buying their shares.

The Information Technology space saw quite a few instances of insider selling in small companies such as i-Flex Solutions, Northgate Technologies and Contech Technologies. These ‘sells’ have resulted in savings of 31 per cent, on an average, for the sellers.

Key pointers

Investors should watch out for a stream of insider sells in small and medium stocks, which might indicate that a decline may be round the corner.

Although the insider trading disclosures are not always immediately submitted to the stock exchanges, investors should keep a close watch on large deals involving promoters or top management buying/selling stocks.

Web site link for keeping a tab on insider trades:- http://corpfiling.co.in/InsiderTrading/InsiderTrading.aspx (You can also use the Advanced Search option in the left pane of the window to select various periods, exchange etc.) Leading financial dailies also carry selected insider trades in the stock quotes page(s).

Kumar Shankar Roy

79) Wrong call by RBI

The rupee is tightly pegged to the dollar, with movements between Rs.39 and Rs.40 per dollar. A very attractive `dollar carry trade' has sprung up. The private sector can earn 5 percentage points - without bearing any risk - by borrowing in dollars and lending in India. Fundamental principles of open economy macroeconomics suggest that it is not possible to have a pegged exchange rate, coupled with substantial openness on the capital account, and then sustain a large interest rate differential. The immediate opportunity for every CEO is to feast on the free lunch that has been gifted by RBI. Looking beyond, either the rupee-dollar peg will have to yield, or RBI will cut the short-term rate by 2 to 3 percentage points.

The interest rate differential is best computed between the 90-day secondary market rate on government bonds in the US and in India. It is shown as the blue curve in the graph on the right. Prior to March 2004, very high values - of above 3.5 percentage points - were found. It is not coincidental that at this time, RBI was buying dollars at a massive pace. The barchart superposed inside the same graph shows RBI purchases for each month, expressed as percent of reserve money. This hectic pace of reserves purchase from 2002 to 2004 was unsustainable, and led up to a breakdown of the exchange rate regime on 19 March 2004.

In the period after that, for a while, the stance of monetary policy was more sensible. The interest rate differential was smaller, and exchange rate flexibility was higher. There was less of a one-way bet, and for some time, no pattern of sustained and massive market manipulation of the currency market emerged.

From mid 2007 onwards, we are getting back into danger zone with a large interest rate differential once again building up, coupled with a tightly pegged exchange rate. On 31 January, the 90-day rate in the US was 1.9%. The Indian 90-day rate is roughly 7.2%, yielding a massive differential of 5.3 percentage points. From late-2007 onwards, the rupee has been tightly pegged to the dollar, with tiny exchange rate fluctuations between Rs.39 and Rs.40 per dollar.

Put together, this is a one-way bet. The private sector is being told:

"Borrow at near 1.9% in the US, somehow get the capital into India and get paid near 7.2% in return for bearing no risk at all. There is no risk of currency fluctuations because the rupee is tightly managed. At worst, you'll only benefit because of a rupee appreciation."

Suppose a person finds a way to borrow $1 billion in the US, bring it into India, and earn the interest rate differential of 5 percentage points, over a period of one year. He earns a profit of $50 million or Rs.200 crore for bearing no risk and doing no work (other than jumping past the capital controls). This is an attractive free lunch. If $100 billion now come into the country, it is a gift of Rs.20,000 crore to the private sector assuming a one-year holding period.

Every rational CEO in India is getting his financial advisors to find ways to exploit this arbitrage opportunity. It is not an accident that in the graph, we see RBI currency purchases (expressed as percent of reserve money) once again showing large values month after month. One key factor driving this is the enlarged interest rate differential.

The last time an interest rate differential of five percentage points was found was in 2002. The 2002-2003 period was an unhappy one for RBI where a `reverse speculative attack' led to a breakdown of the erstwhile exchange rate regime. Now, conditions are even more hostile for RBI. India's openness has increased greatly in the last five years. Flows on the current and capital accounts have roughly doubled, as percent of GDP, over these five years. If the policy framework of pegged exchange rate coupled with a large interest rate differential was infeasible in 2002-03, it is even more infeasible today.

What is being played out here is a nice textbook lesson in open economy macroeconomics. RBI has not woken up to the fact that India has changed, that India is now a de facto open economy. The maze of capital controls might earn a lot of diwali gifts, but over a trillion dollars still move in and out of the country every year. More than a thousand Indian companies have embarked on turning themselves into multinationals. An offshore subsidary can borrow, thus bypassing capital controls against ECB. Transfer pricing can be used to move capital across the boundary. Trade credit is being utilised for capital flows by all importers and exporters. NRIs send money to family in India, who then buy government bonds.

If capital controls were effective, RBI would not be facing an unprecedented struggle in pegging the exchange rate after having tried to close down ECB and PNs. India has embarked on de facto convertibility on the ground, even if not in the world view of policy makers.

The textbooks teach us that when the capital account is open, pegging the exchange rate gives a loss of monetary policy autonomy. Regardless of what RBI might believe is the appropriate policy rate in India, it has no choice but to keep a differential of no worse than 2 percentage points compared with the US Federal Reserve. By pegging the exchange rate, RBI has bowed out of the game of setting Indian monetary policy. The US 90-day rate is at 1.9%, therefore the Indian short-term rate cannot exceed 3.9% - or else the exchange rate peg has to break.

A separate discussion needs to take place about whether or not pegging the rupee to the dollar is optimal for India. But once the rupee has been pegged to the dollar, there should be no illusions about RBI having autonomy on setting the policy rate.

Mistakes like this are not an accident. The monetary policy framework that worked when India was a closed economy is being unthinkingly applied in a new India. But India has changed. It is wrong for RBI to bemoan this change, and demand that India be forced back into the straitjacket of `holistic' capital controls. On the contrary, it is the monetary policy framework that must change. A new monetary policy framework needs to be constructed, that is designed for a new India that is an open economy.