127) Pre-emptive action against further inflation

The RBI’s utmost concern has been to deal with the problem of surplus liquidity, which can further push up the inflation rate. It is in this connection that the central bank has chosen to raise the Cash Reserve Ratio by an additional 25 basis points from May 24.

The Annual Policy Statement of the Reserve Bank of India (RBI) is a laudable attempt to achieve the objective of growth with stability. The underpinnings of the proposals are designed to ensure that while they tackle the current problem of inflation, they do not, at the same time, derail the economy from the path of growth experienced in the recent period.

The objectives are clearly stated in terms of priorities which are price stability, well-anchored price expectations, orderly conditions in financial markets and the sustenance of the growth momentum.

The policy has been formulated in the background of certain important developments in the economy. Thus, the annual inflation rate, which was subdued for the best part of last year, has flared up recently above 7 per cent. This is primarily the result of a general shortage of basic necessities of life such as foodgrains and edible oils.

The cost-push to prices of industrial products flows from the increase in input prices due partly to imported inflation. As a result of the pre-emptive measures taken by the RBI in the earlier quarters, the expansion in non-food credit has come down to a manageable growth rate of 22.3 per cent in 2007-08 from 28.5 per cent in the previous year.

Money supply, as measured by M3, rose by 20.7 per cent. Although it was lower than the 21.5 per cent recorded earlier, it was still above the targeted 17.5 per cent.

However, Reserve Money increased by 30.9 per cent from 23.7 per cent in 2006-07. It was primarily attributable to the inflow of foreign funds, the bulk of which was sterilised by the central bank.

Thus, during April-December 2007, the net capital inflows amounted to $81.9 billion from $30.1 billion in the corresponding period of the previous year. It amounted to a growth of 172 per cent. The accretion to forex reserves, excluding valuation changes, amounted to $67.2 billion during April-December 2007 ($16.2 billion).

The overhang of liquidity of balances under the Liquidity Adjustment Facility, Market Stabilisation Scheme and government added up to a record of Rs 2,73,694 on March 27, 2008. It came down subsequently to Rs 2,43,879 crore on April 25, 2008.

Policy Measures

Thus, in the light of the foregoing developments, the foremost concern of the Bank has been to deal with the surplus liquidity, which can push the inflation rate higher.

It is in this connection that the central bank has chosen to raise the Cash Reserve Ratio by an additional 25 basis points from May 24. This is in addition to the hikes announced only a few days ago.

There is a clear warning that there could be a further increase in CRR in the future in addition to other measures, if warranted. In doing so, the RBI has set a target of growth in money supply at 16.5-17.0 per cent in 2008-09 and increase in non-food credit by 20 per cent. The rate for M3 has been decided in the expectation of GDP growth rate of 8-8.5 per cent.

This writer understands that, given the income elasticity of demand for money at 1.4, a statistic obtained from the Bank under the Right to Information Act (RIA), the real demand for money is around 12 per cent (at the higher growth rate). The additional 5 per cent is intended to accommodate (generate, according to this writer) inflation of 5 per cent.

Repo and reverse repo rates have been left unchanged for tactical reasons. At first sight, it gives the impression that rates in the system will not be raised. But, depending on the relative position of banks, there could be changes in deposit and lending rates since they are no longer eligible to get interest from the RBI on the cash balances impounded.

For the first time in recent years, the RBI has sought to undertake a review of loans to the agricultural commodity sector by banks. It has said that, in view of the current public policy concern in regard to trading in food items, banks are required to review their advances to traders in agricultural commodities including rice, wheat, oilseed and pulses as also advances against warehouse receipts.

They are further advised to exercise caution while extending such advances to ensure that bank finance is not used for hoarding. The first such review should be completed May 15, 2008 and forwarded to the RBI for carrying out a further supervisory review of the banks’ exposure to the commodity sector.

Commodity Advances
This advice to banks is a belated recognition of the kind of damage that could be caused by bank advances against the security of such sensitive commodities as foodgrains. While it is welcome, a few comments could be made. In the first place, edible oils also should be added to the list of commodities under surveillance. Second, one does not know how a bank manager could ensure that the credit he extends is not used for hoarding.

Where the State government has prescribed a stock level, any quantity above that limit could be treated as tantamount to hoarding. The excess should not be financed at all as it encourages the violation of government order.

Third, hoarding can be done not only by traders but by farmers, rice mills, oil mills, etc. According to one report, a considerable part of market arrivals of wheat in the mandis of Punjab are stocks hoarded from the last year’s harvest. This is recognised by the tell-tale sign of loss of lustre.

During the time this writer was in charge of the Selective Credit Control Desk in RBI he observed that if the groundnut oil mills in Saurashtra stopped crushing oilseeds early in the season, it was an indication of the raw material being hoarded for processing at a more opportune time in the off-season, when prices would go up. However, keeping in view that the manufacturers and processors needed stocks for their activities, the control was relaxed suitably for them as well as small farmers.

The RBI also needs to prescribe a proforma for the review so that the data can be consolidated at the all-India level. Otherwise, each manager will submit a report in the way he thinks fit, often in a narrative form and, quite likely, in the interests of customer relation, he will certify that there is no hoarding.

Basic Statistical Return 3 was prescribed in the past to collect monthly data on selected commodity advances.
The statistics were processed and reviews undertaken by the then Banking Division in the 1970s and 1980s, at the time of the formulation of the Busy and Slack Season credit policies. The data were available within a period of six weeks.

Recently, this writer requested the Bank under the RIA to provide him with data on commodity advances. He was particularly interested in wheat advances. The RBI was good enough to oblige him. But the time-series stopped at August 2007. What is the use of such data if available only with such a time-lag?

A. Seshan

(The author is a former Officer-in-Charge of the Department of Economic Analysis and Policy of the Reserve Bank of India. The views expressed are personal.)

126) A remedy worse than the malady

Banning futures trading in commodities will actually result in a further rise in prices.

The persistent demand of the Left parties to ban futures trading in commodities, backed by the Union Railway Minister, will actually result in a further rise in prices, as futures trading, if properly regulated, moderates the movement of prices. It will prove to be a remedy worse than the malady. Prices of tur and urad, trading in which was banned in January 2007, have not come down.

The prices of commodities, as of any other item, are determined mainly by the forces of supply and demand. Futures trading actually results in better price discovery, evening out distortions in prices prevailing in different mandis of the country, as electronic price tickers displaying the prices in the futures markets are splashed across the mandis by the leading commodity exchanges.

This actually gives proper guidance to farmers for realisation of better prices, and, above all, acts as a hedge instrument to several functionaries in the spot market, such as producers, exporters, importers, stockists and traders by transferring their risks arising out of adverse movements to speculators.

Role of speculators
Contrary to the common perception, speculators help in stabilising prices, and not in aggravating either a bullish or a bearish trend. They act not only as long purchasers, i.e., buying without any intention of taking delivery but also as short sellers, i.e., selling without owning the commodities.

Ceteris paribus, speculators act as purchasers when, as per their assessment, prices are depressed, and this acts as a check on the falling prices. As a result of their operations, when prices rise, and they feel that prices have risen high enough, they liquidate their positions by selling. This, in turn, helps to ensure that prices do not rise too high.

In the reverse direction, when prices rise steeply, as is the case presently in some commodities, speculators turn short-sellers, and this operation of short selling helps in arresting the price rise. When they feel that prices have fallen sufficiently, they liquidate their short sales by buying which, in turn, helps in checking the downward drift.

It also needs to be noted that speculators are neither permanent bulls nor permanent bears. They are speculators simpliciter, taking a view of the market at every level of price, and taking a bullish or bearish view of the market depending upon their perceptions. Speculators do not also act in concert.

The current rise in prices, particularly in oils and wheat, is due to the rise in the global markets and not due in any way to the operations in the commodity futures markets.

Thumbs-up from expert committees

The above averments have been backed by all the three expert committees appointed by the Government of India viz., the Dantwala Committee in the mid-1960s, Khusro Committee in early 1980s and the Kabra Committee (of which I was a member) in the mid-1990s. The Abhijit Sen Committee set up by the Government in March 2007, the report of which is not yet released, has also reportedly come to the same conclusion.

Apart from these committees, several empirical studies conducted world over, including India, by researchers, have clearly and unequivocally come to the conclusion that trading in futures and options has exercised a steadying influence on prices, moderating the troughs and peaks, and not aggravating in any way the volatility of the market.

Regulators must play dual role

The Forward Markets Commission (FMC) and commodity exchanges also need to alter slightly their approach to regulating the market. Presently, a neutral stand is adopted with regard to the level of prices, putting checks and balances on both the bulls and the bears to the same extent in a rising market as also in a falling market and thereby, in a way, reducing liquidity of the market and also in not achieving the objective of moderating the prices, as the restraints on both the bulls and bears are the same. It is necessary to take a view of the market at every level of the ever changing movement of prices.

When it is felt that prices are rising unduly, as is currently seen, the rates of margins, filters on rise, etc., have to be higher on the purchasers, to act as a deterrent, and lower on the sellers just to cover the likely loss in adverse movement of prices.

In a like manner, when prices drift downwards unduly, rates of margins, filters, etc. on prices, have to be higher on sales to check the slide and lower on purchases to cover the likely losses.

Regulatory instruments need to be sharpened to have a dual role, both as price protective and price deterrent. This was a well accepted concept when commodity markets started buzzing in the last four years. Crack down on ‘dabba’ trading

What needs to be curbed, indeed eradicated, is the flourishing ‘dabba’ trading, i.e., trading outside the recognised commodity exchanges by some brokers who match the buy and sell orders of clients, saving thereby transaction cost.

The volume of turnover in ‘dabba’ trading is estimated to be about Rs 40 lakh crore per annum, equivalent to the total turnover in all the recognised commodity markets.

Bereft of any prudential norms, ‘dabba’ trading can, and in fact does, exercise a harmful influence on the movement of prices in the recognised markets.

China example
It is also relevant to observe that, globally, almost all the market-driven economies have thriving commodity markets in derivatives both futures and options, the size of which is twice or thrice the size of derivatives in shares and stocks.

Apart from countries such as Russia, Romania and Serbia, China has been trading in commoditiy futures right from 1993. Zhenghov Commodity Exchange has a thriving futures market in wheat, cotton, sugar, rapeseed oil and green beans, while Dabian Commodity Exchange trades in futures contracts in soyabean, soyabean oil, soyabean meal, corn, palm oil and barley.

Shanghai Futures Exchange has a thriving futures market in copper, aluminium, natural rubber and fuel.

The solution is not to close the recently structured commodity markets opened after over four decades, but to strengthen the system by opening the options market, as futures and options are twins operating in synergy in the twin tasks of price discovery and hedging facility.

Needless to say, closure of the market will not solve the problem of rising prices. Markets will then go underground and tackling the illegal trading that will spring up all over the country will be a serious problem. Let us foster commodity futures markets and not take any knee-jerk action due to pressures from some political parties that may not understand the utility of these markets.

M. R. Mayya

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

125) Short straddles and strangles

Use these strategies only when you think that the underlying stock or index will experience little volatility in the near-term.

Over the last two weeks, this column discussed option strategies that are best suited for times of volatility; when you are sure of a movement in the market but not as sure on the direction of the move.

But what should you do when you think that the market or security will experience little volatility in the near-term? Exactly the opposite of a long straddle and a long strangle – a short straddle and short strangle. These deliver when volatility either remains the same, or decreases.

When to use these strategies?

Use these strategies only when you are sure that the price of the underlying is stagnating and will remain range-bound or sideways. That is, use them only when you expect volatility to either remain stable or decrease from present levels.

For instance, such strategies can yield decent profits when they are entered into, a week or two before the expiry date.

All things remaining the same, the option premium tends to erode as we near expiry and this helps when you have written (or sold) options. Note that both strategies profit from a time decay.

What is a short straddle?

A short straddle requires you to sell both a call and put option on the same underlying with the same strike price and expiration period.

Note that since the strategy involves selling of options you will receive option premiums, when you set this spread. However, you will be able to pocket this premium for good only when the underlying remains locked between the two breakeven points. Say you sell a short straddle on the Nifty.

You sell a Nifty 5000 put and call for Rs 200 and Rs 100 respectively. The breakeven for such a spread can be arrived at as follows:

Upper breakeven: Strike price + net premium received (in this case, 5300)

Lower breakeven: Strike price – net premium received (in this case, 4700)

You will be able to pocket the premium inflow of Rs 300 (or Rs 1500 per lot) only when Nifty closes between 5300 and 4700 levels.

Any move beyond these levels will expose the investor to the risk of the option being exercised.

So, the maximum potential profit point is only at the strike price at expiration, and large potential losses can happen, should the underlying move beyond range.

What is a short strangle?

A short strangle involves selling out of the money call and put options on the same underlying with the same expiry period. This strategy is quite similar to the short straddle.

However, it enjoys low-risk and low-return payoff. Low risk because the strategy offers a greater protection than short straddle since the underlying must move further to result in a loss. Low returns because the premiums received are lesser since options are out of the money.

The breakeven for this spread is calculated in the same way:

Upper breakeven: Strike price + net premium received
Lower breakeven: Strike price – net premium receivedRisk of exercise

A short straddle and short strangle involve selling of options, which makes these strategies highly risky. Selling an option, gives the buyer the right and not the obligation to buy/sell the underlying at a specified price on or before expiry.

So, if anytime before expiry, the underlying breaches the breakeven points, you stand the risk of exercise. This can result in unlimited loss, as opposed to buying of options that limits your maximum loss. While a short strangle enjoys a lower risk of exercise as against a short straddle, any dramatic change in share price or increase in volatility can prove very unprofitable.

So, if the underlying makes any unprecedented move, you should consider closing the options.

Alternately, you can limit your potential losses by purchasing out-of-the-money put and call options in comparison to the options sold previously.

While the cost of buying these options will reduce your profit potential, it also contains your loss; and hence a must for traders with a lower-risk appetite.

The fine print
Do not set this strategy for far month contracts. Remember, time value does not act against you and hence it will be more profitable to set these spreads in the near month (current month) contracts.

However, since they are essentially high risk strategies, enter them only when you are sure that the potential risk vs. reward scenario matches your own risk-taking ability.

Note that any undesirable movement in the underlying or increases in volatility pose a risk to your positions. This makes it imperative that you track your positions constantly.

Also be prepared to shell out some money for margin maintenance since you will be a seller of calls and puts.

Most importantly, make sure you have plenty of time and a strong heart, just in case the spreads turn out of the money.

124) Some profitable strategies for options traders

Ironically, trading in the derivatives market is skewed towards futures, though options offer higher returns due to non-linear payoffs. This article discusses a trading strategy that often converts a debit spread into a credit spread, and an alternative to downside averaging in the spot market.

Investor interest in derivatives trading has risen over the years. Trading, however, continues to remain biased towards futures. This is because the futures segment is easier to understand than options. Profit opportunities are, however, better with options because of the non-linear payoffs.

This article discusses two options strategies. One is a trading strategy while the other is an alternative to downside averaging, meant for traders sitting on losses. It is important that traders have a view on the underlying before they set-up these strategies. Otherwise, the positions will lead to losses, as options are wasting assets.Rolling up into bull spread

A bull call spread on Reliance Industries, for instance, can be set up for 35 points (times contract size of 75) with long May 2700 call and short May 2800 call. The trader’s view is that the stock is unlikely to move past Rs 2,800.

The problem with this strategy is that the May 2700 calls will lose more absolute value than the May 2800 calls if the stock sits still or moves down. This is because the profit due to time decay on the short-leg will not be enough to compensate for the loss in intrinsic and time value on the long leg.

To reduce the risk of loss, a trader can first set-up only the long-leg- buying May 2700 calls for 70 points. When the stock trades at Rs 2,750, the trader should sell the May 2800 call. The premium from the short-call will be higher, as the stock has since moved up.

Often, the premium received on the short-leg will be more than the premium paid on the long-leg. So, rolling into a bull-spread actually generates a net credit.

Suppose Reliance Industries moves to Rs 2,750 by May 7, the 2800 May call will trade at 80 points. Legging into spread will give a net credit of 10 points. If the stock sits at Rs 2,800, the position will generate a maximum profit of 110 points- the difference between the strikes plus the net credit.

Rolling down into bull spread
What if the stock declines by Rs 50 a week after the long-leg is set up? Then, the May 2700 call will trade at 40 points. Legging into a spread by selling a higher strike call will not help as the option will fetch a lower premium.

The trader should instead sell two May 2700 calls for total credit of 80 points. This will create only one short position, as the other will close-out the previous long position.

Next, the trader should buy the May 2600 call for 75 points. The position set-up will be a bull spread with 2600-2700 strikes.

Inside ratio spread

Investors often hold on to their loss-making positions. The following strategy is meant to reduce losses on such positions. Suppose a trader buys 75 shares of Reliance Industries at Rs 2,625. If the stock declines to, say, Rs 2,500, the trader will be tempted to buy more shares to average her cost! Averaging, however, requires more capital.

The trader can instead use options to stay profitably in the trade. Assume the view is that the stock could move back to Rs 2,575. The trader can set-up a call ratio spread. This involves buying one call at lower strike and selling two calls at higher strikes.

The trader can set-up this position with one long May 2550 call and two short May 2600 calls for net credit of 30 points, assuming that the stock declines to Rs 2,500 by April 30.

The portfolio now consists of one ratio spread and 75 shares. The total exposure is equivalent to two long positions (one long call and 75 shares) and two short positions (two short calls).

This strategy can be implemented only when the trader holds shares equal to or in multiples of option contract size.

If the stock continues to decline, the net credit of 30 points can act as margin of safety. If the stock moves to Rs 2,575 or Rs 2,600 at expiry, the 2550 call will expand to 50 points.

At a spot price of Rs 2,600, the ratio spread + long stock position will generate maximum profits of 25 points! So, the trader can essentially convert losses into profits.

Conclusion

The trader should equip herself with the following information before setting up the above two strategies. First, she has to have a view on the underlying.

Second, she should know the major support and resistance levels to gauge the likely turns. And third, she needs to choose the right option strikes. These strategies are just two of the many that an options trader can profitably set up. We hope to cover more such strategies in this column in the future.

B. Venkatesh

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

123) Making sense of some key technical indicators

Stocks move the way they do due to certain factors, which are captured by technical indicators. Here is a snapshot to read and apply.

If you are one of those investors who attempt to follow the technical analysts on television, most of the stuff the experts say might sound Greek to you. However, not all of it is that difficult to understand. Some technical indicators are fairly easy to understand and use.

Volume
Price is the most important indicator in technical analysis. Along with the stock price movement, we can correlate its volume behaviour for better forecasting. Volume is the number of units (shares) traded during a particular time period (it can be an hour, day, week, etc).

Though volume gets a step-brotherly treatment in relation to price in technical analysis, it serves the purpose of verifying the strength of the particular price move. Volume is plotted below the price chart. Take a look at the volume plotted below the price chart in chart 1. The investors/traders can keep an eye on volume movement along with price movement. This helps in forewarning them about an impending spurt in price movement when they observe a sudden spurt in volume (represented in the chart in circles).

This happens because company insiders (people in the know) buy or sell ahead of a major announcement.

Open Interest

Open interest is the number of outstanding contracts, in both futures and options, on a given day.

A long (buy) or short (sell) contract that has not been closed out or one that has not expired or been exercised is said to be an outstanding contract. Open interest increases when a buyer or a seller creates new contracts. This happens when the buyer initiates a fresh long position or the seller initiates a fresh short position. Conversely, the open interest decreases when the existing contracts are squared up or exercised or allowed to expire.

Chart 2 includes open interest plotted along with the price. A sudden spurt in open interest or a sharp decrease too can make an investor alert to a potential up-move or a reversal, as discussed below.

Stock prices either move up, down or sideways. Studying the volume and open interest action along with the price action assists the investor in resolving the strength of an existing trend, whether up or down.
If we notice that the volume and open interest are both increasing, then it is inferred that the current price trend (up or down) is likely to continue in its present direction.

When the increase in the stock price of a particular company is accompanied by an increase in volume and open interest, it implies that the investors/ traders are flocking to the counter. As long as fresh droves of investors/traders, reflected in high volume and open interest, are interested in a particular stock, the price will continue to move in an upward trajectory.

This holds true in a stock that is declining as well. When the stock price decline is accompanied by increasing volume and the open interest, it is inferred as bearish, the reason being that all the investors who bought the stock at higher levels are yet to exhaust their holdings.

The downward movement will end only when all the short-term investors have divested their holdings.

If we extend this logic further, the decline in volume and open interest indicates that the current price trend (up or down) of the stock is possibly close to end.

When the stock price of a particular company is rising along with the declining volume and the open interest, it is inferred as a sign of bearishness and that the stock’s uptrend may be close to an end.

This shows that investors are getting wary as the price moves higher and are unwilling to buy in cash or hold derivative positions in the stock. So the up-move loses momentum and can even reverse.

Similarly, when the stock price of a particular company is declining along with the decreasing volume and the open interest, it is inferred as signs of bullishness because the stock’s present downtrend may come to an end.

Decrease in selling pressure is generally perceived as a precursor to an increase in the stock price.

Yoganand D

122) A new real(i)ty on the ground

Companies active in the real estate space, rather than those used to managing equity or bond investments, may be better placed to get REMFs quickly off the ground. Realty assets are priced largely on a case-to-case basis and tend to be very region and location specific.

At last, the decks have been cleared for the launch of Real Estate Mutual Funds (REMFs) in India, with the Securities and Exchange Board of India (SEBI) notifying amended regulations for such products last week. For mutual fund investors, this may mean a welcome relief from the stream of new equity fund offerings, playing on every imaginable theme, that have clamoured for attention over the past three years. But don’t hope for this to happen too soon!

It may be some time before fund houses queue up to offer REMFs with the same enthusiasm that they now display for equity funds. Though SEBI’s recent notification clarifies some of the grey areas in REMF regulations relating to valuation and disclosures, getting such products off the ground may prove to be quite a challenging exercise for the existing fund houses. Realty cos better placed?

Investors confused about which equity fund to go for, usually benefit if they go by the pedigree of the fund house launching the scheme. For equity funds, factors such as the investment team’s experience and track record in managing Indian stocks, are key to a new fund’s performance. But the opposite may be true for REMFs.

Companies active in the real estate space, rather than those used to managing equity or bond investments, may be better placed to get REMFs quickly off the ground in the Indian context. That SEBI has stipulated a five year track record for realty players seeking to launch REMFs is a positive, as only seasoned players will then enter the fray.

Real estate, as an asset class, is not familiar ground to India’s mutual fund companies, given that their current asset base is dominated by debt, equity or, at best, combination products. This being the case, their entire investment team and security selection process has been built around selecting the best stocks and bonds for their fund portfolios.

That the real estate sector has been a relatively recent entrant to the listed stock market universe, also suggests that limited expertise may have been built by mutual funds in evaluating real estate markets and factors that drive it. Outsourced investment management?

A key factor that distinguishes Indian realty markets from the stock or debt markets is its relatively localised nature. Trends in the Chennai realty market, for instance, may bear no resemblance to those in the Mumbai market. Yet it is knowledge of these trends that may help potential investors identify the best investment opportunities in real estate. Unlike stocks and bonds where assets can be acquired for one transparent and common price, realty assets are priced to a large extent on a case-to-case basis and tend to be very region and location specific.

Under these circumstances, the current mutual fund sponsors may have to partner with external consultants from the domestic realty business or set up separate investment teams from scratch- who are specialised in the property markets, before they line up their first REMFs.

Indian arms of global asset management companies which already manage such products in other markets may have an edge on the processes used to select realty investments, but even this may not obviate the need to have a local team which closely tracks Indian property market trends. While MFs have actively outsourced functions such as accounting and customer service o third parties, investment management has hitherto been strictly an in-house function.

Tricky path
There are also other operational aspects to these funds that may be tricky to navigate in the beginning. The stipulations which say that REMFs will be required to maintain a minimum 35 per cent investment in direct real estate assets, with not more than 30 per cent in one city and no more than 15 per cent in one project, are designed to avoid concentration risks in REMFs.

However, this suggests that fund houses may have to get developers to specifically tailor projects to their requirements or may have to collaborate with other investors, to make sure their funds adhere to the stipulations.
REMFs may also require a much longer window to deploy the funds raised, and thus a much longer gestation period, than is the case with their current debt or equity fund offerings.

The daily NAV disclosures and listing requirements of such funds may also face a few challenges. Though NAVs of such REMFs are to be disclosed on a daily basis, it is unlikely that they will capture blips in property prices on a daily basis, as do the NAVs of existing equity or debt funds.

This is because the valuation of REMF’s property portfolios is bound to be a periodic, rather than a daily exercise.

The regulations stipulate that every asset that finds place in a property fund’s portfolio will be valued by two independent valuers, once in every 90 days, to determine its fair price. This suggests that material changes to the NAV may occur only at 90-day intervals, depending on when assets are acquired.

Given that REMF units are to be listed and traded on the stock exchanges, however, the market prices may be influenced by the market’s assessment of how a fund’s portfolio is actually faring and may not strictly lag the NAV, as with other closed end funds. Will this subject listed REMF units to speculative blips on the market? We may have to wait and watch on that.

Aarati Krishnan

121) Opposition to commodity transaction tax unwarranted

Apart from being a revenue measure, CTT would create record of transactions and help set-off an audit trail when needed.

An orchestrated chorus against the Commodity Transactions Tax (CTT) proposed in the latest Union Budget has been reverberating in the media for several weeks now. The shrill objections are now reaching a crescendo with screaming headlines.

From various commentaries heard and read, it can be safely inferred that most people are unclear about the working of the commodity markets, especially the differences between physical and derivative markets.

Brokerages, commodity exchanges and even the market regulator have banded together demanding removal of CTT. The latest is that the recommendation by the Prime Minister’s Economic Advisory Council to review the proposal has become the rallying point for all those opposed to the tax. Usually, those who are taxed make noises; but in the case of CTT even others have joined the protest party. The aggrieved persons - buyers and sellers in case of commodity transactions - may be justified in opposing the levy of a new dose of tax because the money would go from their pocket.

What is surprising is that the commodity exchanges too are vociferously objecting to the levy. CTT is not a tax on the exchange; it is a tax on transactions made on the exchange platform. Strictly, there is no liability as far as the exchanges are concerned.

But still they are opposed to CTT because of apprehension that imposition of tax may discourage trading and result in loss of trading volumes, and of course profitability of running an exchange. Although not an aggrieved party, the commodity futures exchanges seem to have jumped on to the ‘oppose CTT bandwagon’ in their own self-interest.

Worse, the commodity futures market regulator too has openly objected to the levy. Propriety demands that the market regulator maintain a stoically detached approach to such issues and not take sides.

So, should the CTT proposal be dropped? Or should the proposed rate of tax be cut?

Surely, the rationale of CTT, the quantum and its implications would have been discussed within the Finance Ministry before becoming a part of Budget 2008-09 proposals. Apart from being a revenue measure, CTT would create record of transactions and help set-off an audit trail when needed.

What has changed in the last eight weeks to warrant a review of CTT?

Nothing, really, except the objections raised by certain groups of interested persons. If the Finance Ministry were to review CTT and were to decide to either reduce the tax rate or withdraw the proposal, it is duty bound to explain the considerations that prompted the decision.

Whittling down or withdrawal of CTT cannot be merely on the basis of strong vociferous objections by a section of people. The credibility of the Budget proposal is at stake here.

Currently, Indian bourses are dominated by speculators. Participation by genuine hedgers is rather limited. Primary producers are virtually absent from the derivative market; and they are going to be unaffected by CTT. From the nature of transactions on the commodity exchanges, it is clear, the tax burden would fall largely on speculators who have no genuine interest in any underlying commodity but are in the market to take advantage of price movements.

Objection to CTT has taken many forms. One of the frivolous points is that Indian market participants will migrate to international exchanges. This is a highly exaggerated fear being spread by the exchanges. There is nothing to warrant such an expectation. Genuine hedgers in any case are allowed to participate in international exchanges.

Indeed, last year, the Reserve Bank of India permitted domestic producers and consumers of commodities, especially metals, to hedge their price risk in overseas exchanges, despite the fact that such base metals are traded on the domestic exchanges. The very fact that domestic hedgers prefer to go overseas suggests the failure of exchanges here to inspire confidence of hedgers.

Another scare being spread is that CTT would drive market participants into unofficial trading or dabba trading. Five years after nationwide online exchanges were established, if dabba trading still persists, it reflects rather poorly on the functioning of existing exchanges and on the effective working of the regulatory system.

Last but not the least, technically, for every official trading transaction on the exchange, the exchange itself acts as a counterparty. In other words, for every seller, the exchange is the buyer; and for every buyer, the exchange is the seller. It is the exchange which guarantees performance of the contract. Looked at from this angle, will the exchanges too be subjected to CTT?

G. Chandrashekhar

120) Why sub-prime is not a crisis in India

The amounts in the form of black money are large and mostly invested in real-estate and gold, two major areas of passion for the Indian middle-class. As long as a good portion of our economy and asset financing is by black income we need not worry about sub-prime.

Just like our fashion industry is affected by US trends, so also is our financial industry. Whether it is relevant or applicable is not material. If it affects US citizens then it should affect us since we are a major economy having all the ills of a developed economy.

In the medical field it is no longer fashionable to talk about malaria or TB or leprosy, but, instead, obesity and cosmetic surgery. So also in our financial system irrelevant issues are focussed upon and inconsequential matters occupy the centre-stage with the participants not knowing what they are talking about.

The sub-prime is the current fashion and even my milk-man, when queried the other day why he was late, answered that it was due to the sub-prime crisis.

The sub-prime (mortgage) crisis is an ongoing economic problem, manifesting itself through liquidity issues in the banking system owing to foreclosures which accelerated in the US in the last two years.

The background
The term sub-prime lending refers to the practice of making loans to borrowers who do not qualify for market interest rates due to various risk factors, such as income level, size of the down payment made, credit history, and employment status.

Sub-prime borrowing was a major contributor to an increase in home ownership rates and the demand for housing. The overall US homeownership rate increased from 64 per cent in 1994 (about where it was since 1980) to a peak in 2004 with an all-time high of nearly 70 per cent. This demand helped fuel housing price increases and consumer spending.

Between 1997 and 2006, American home prices increased by 124 per cent. Partly this is due to the encouragement for the consumption economy after the 9/11 disaster to boost activities based on consumer spending.

Some homeowners used the increased property value experienced in the housing bubble to refinance their homes with lower interest rates and take out second mortgages against the added value to use the funds for consumer spending.

US household debt as a percentage of income rose to 130 per cent during 2007, versus 100 per cent earlier in the decade.

The crisis began with the bursting of the US housing bubble and high default rates on “sub-prime” and other adjustable rate mortgages (ARM) made to higher-risk borrowers with lower income or lesser credit history than “prime” borrowers.

Loan incentives and a long-term trend of rising housing prices encouraged borrowers to assume mortgages, believing they would be able to refinance at more favourable terms later.

However, once housing prices started to drop in many parts of the US, refinancing became more difficult. Defaults and foreclosure activity increased dramatically as ARM interest rates reset higher.

During 2007, nearly 1.3 million US housing properties were subject to foreclosure activity. The issue is not only of lending, it is also about borrowers providing misleading or wrong information to be eligible to borrow, such as boosting their income.

Let us look at the Indian scenario. In India, banks provide at most 40 per cent of the credit requirements of the household, including for consumption purposes. A large portion of the requirements is met by non-bank institutions, including money lenders.

Also, a large portion of organised lending is with public sector banks, which are under the control of Government, and in any event Government is not going to allow them to go under.

Unlike the US situation, where the Government or Federal Reserve has to save banks from going insolvent by providing additional capital, here in India, they are owned by Government, which will facilitate with additional funds in the form of bonds or shares if need arises.

Role of Black Money
The housing sector in India is significantly different from that of the US. A good portion of the house financing is undertaken with black money.

In other words, the proportion of black to white may vary from 20 to 40 per cent depending on the location, registration charges, bribery to local authorities, etc. This is applicable to both commercial and residential real-estate and flats.

The borrowing from banks is based only on the white portion as it should be. The banks also lend on the basis of the earning potential (past earnings record) of the client.

The income-tax assessments of many individuals present a lower picture than the actual situation. In the US, banks need to discount the claims of the borrowers while in India, banks may have to boost the claims of the borrowers since assessed income is only a part of the picture. Hence the actual position of the borrower is much better than what is shown on the paper and the margin amount; the one financed by the borrower, is substantially higher than what is shown in the book due to financing of the asset (the house) partly by black income.

In such a situation, there is no incentive for the borrower to lose the asset since his stake is much higher than shown in the book of the banks. This is the real situation.

The problem with our banking sector is different. If operational risks are due to thousands working in our banks and if credit risk is due to hundred persons then market risk is due to ten or so in the treasury.

Some of our public sector bankers who are not very good in lending and credit risk management visualise themselves to be market wizards and are active in products they are not familiar with.

Some private sector banks are aggressive sellers of these products and the CEO of one of the companies that lost heavily due to exotic derivative products, claimed that his CFO is an “innocent” person who has been tricked into buying these exotic products.

Lending based on ‘calls’
The presence of black money or what one may call the hidden net worth of India has tremendous advantages in times of asset based lending and borrowing since only a part of the price of asset is seen, like the tip of the iceberg.

The other portion of the asset finance by the borrower from black fund makes it imperative for him to protect his position by meeting the obligations.

Then the obvious question is regarding NPA in these assets. That has to be understood by the elementary issue of lending for clients knowing well that it will turn in to an NPA.

This is called telephonic banking traditional style — where the telephone call from influential netas makes the lending possible. That has got nothing to do with sub-prime crisis. It is called lending based on calls — meaning telephone calls and not on credit-worthiness.

Borrowers’ stake
Actually, given our legal processes, which are very slow, there is an incentive for the borrower to walk away.
But given his stake he is not enthusiastic to do that. Hence the default rate in the home market may be due to wilful frauds or deliberate issues of connivance by the lender.

Even in the commercial property market, it is, again, not due to sub-prime but due to bad decisions of the bankers knowing fully well the non-viability of the project or due to “external pressures”.

The amounts in the form of black money are large and mostly invested in real-estate and gold, two major areas of passion for the Indian middle-class. As long as a good portion of our economy and asset financing is by black income we need not worry about sub-prime.

The stakes are high for the borrower to let go his asset. As it is said, there is a silver lining to every dark cloud — like the strength of our hidden net worth in dealing with sub-primes.

R. VAIDYANATHAN

(The author is Professor of Finance, Indian Institute of Management-Bangalore, and can be contacted at vaidya@iimb.ernet.in. The views are personal and do not reflect that of his organisation.)

119) Sovereign investing

India’s persistent current account deficit will make it difficult for anyone to justify the deployment of a sovereign wealth fund.

With India’s foreign exchange reserves climbing over $300 billion and capital inflows still surging in, it was only a matter of time before the notion of an Indian Sovereign Wealth Fund gained popularity. A few days ago, the Prime Minster’s Council on Trade and Industry, suggested a $5-billion Indian Fund to buy assets abroad. At first glance the idea is tempting. After all, given the low returns on investments by the Reserve Bank of India in US treasury bonds and western central bank securities and the high cost of managing the inflows, any move to earn higher returns on reserves considered more than adequate to meet external contingencies, would definitely be to the nation’s advantage. That is the rationale for Singapore, China and Abu Dhabi, among others, launching sovereign funds with corpuses that range between $300 billion (GIC of Singapore) and $900 billion (Abu Dhabi Investment Authority). By that token alone, the $5 billion Fund suggested by the Council is far too modest, assuming, of course, that the country can afford to have one in the first place. And there is the rub.

Leave alone the political flak that emerging-economy sovereign funds have been drawing from the West with their acquisitions in iconic Wall Street firms and sensitive properties such as ports. The question that must first be addressed is whether conditions are right for India to launch such a fund. More than size of the foreign exchange reserves, it is the nature of the current account that is crucial to determining whether a sovereign wealth fund is appropriate. Countries that do have one invariably enjoy massive current account surpluses occasioned by large exports of manufactured goods — China, for instance — or of such primary commodities as oil or gas, as with Abu Dhabi. India’s persistent current account deficit renders it difficult to assess the adequacy of reserves over and above which the “excess” could be deployed by a sovereign wealth fund.

Yet that does not mean India’s large reserves cannot be invested productively. Indian firms have been on an acquisition spree overseas with the RBI consistently raising the ceiling on forex use. Last year witnessed some of the most dramatic acquisitions by Indian entities of western assets. Unlike many sovereign wealth funds whose financial acquisitions have been eroding in value of late, India’s companies both in the private and public sectors have been drawing dollars to buy energy assets overseas that promise to create substantial value for the domestic economy. India may not need a sovereign fund to replicate these efforts.

118) Derivatives are like race cars

A derivative needs to be used by professionals. It is like a race car, part of the performance comes from the machine and part from the experience and capability of the driver.

In finance, derivatives are financial instruments whose value changes according to the changes in fundamental variables. Just like the Americans have heard about the term `sub-prime' for the last 12 months, Indians too have heard a lot about derivatives for the last month or so. Futures, forwards, options, swaps and what not? Financial products based on such complicated mechanisms will require more transparency.

But while transparency is certainly an issue as is understanding, the onus is also on the taker, that is, the company or the bank on its behalf. Systems and processes then become even more crucial. "It is like a race car, part of the performance comes from the machine and part from the experience and capability of the driver," tells Mr Omer Hevlin, Sales Director (Asia), SuperDerivatives (www.superderivatives.com).

SuperDerivatives is the benchmark for derivatives pricing and the leading provider of multi-asset front-office systems, risk management, revaluation and online options trading solutions.

Indian banks such as Centurion Bank of Punjab have leveraged their expertise to manage multi-asset portfolios of exotic options and structured products and calculate exposure in real time. But that's not enough. "Because they are still running their risk using TV (terminal values), rather than real time rates and volumes," Mr Hevlin told Business Line in course of an e-mail interaction from Singapore.

Excerpts from the interview:

Derivatives market is often shrouded in conscious secrecy or veiled transparency. Right from plain vanilla to exotic derivatives, what has been your experience?
-The market participants clearly require the right tools to arrive at the right price and fully understand the risks involved. Our goal is to lift the veil of secrecy and bring transparency to derivative pricing and valuation by empowering any market participant to obtain prices that reflect the fair market value for any derivative instrument, for any asset class.

What would be your take on the understanding of financial risks taken aboard by Indian companies?
-We believe that the position taken by a corporate needs to be well analysed and risks have to be clearly anticipated.

How can a product meant to serve as an insurance against fluctuating currency backfire?
-The product needs to be used by professionals. It is like a race car, part of the performance comes from the machine and part from the experience and capability of the driver.

SuperDerivatives is said to have its own pricing model. What makes it so special and unique?
-Prior to the advent of SuperDerivatives, options practitioners faced two major obstacles. The first one was price opacity. Practitioners could use the ubiquitous Black-Scholes formula to price vanilla options and with the same framework price all exotic options, although it was well known that the Black-Scholes approach produced prices significantly different than the actual market prices.

The leading traders from the top investment banks were able to compensate for Black-Scholes deficiencies by leveraging their experience in the market together with their vast computational resources to accurately price options - and those prices were closely guarded.

-Closely guarded prices, isn't that dangerous?
Thousands of less experienced professionals who traded options regularly - mostly from the buy-side (corporations and investment funds) - lacked the tools and expertise to price them accurately. As a result, the buy-side was dependent on the sell-side (banks) for trade design, price fairness and post-trade revaluation for complying with accounting standards in their P&L reporting. The inability to price options accurately made many people on the buy-side less active in options and severely limited the benefits that options could provide them and the world economy as a whole.

You were talking about the second challenge.
-The second challenge faced by options market practitioners was a lack of systems and infrastructure to support options business activity. Missing were effective solutions for pricing, analysis, market data feed, risk management and more. Only a few of the world's largest investment banks have the internal resources to tackle those challenges in-house.

According to you, what would be the total exposure of companies from Asian countries in the forex derivatives market?
-The marked-to-market losses in India are estimated to be between Rs 12,000 to 20,000 crore and the total market size is Rs 1,27,86,000 crore.

What are the gaps in skills and competencies that you find among the fresh crop of talent entering the derivatives sphere?
-The participants need to have a complete understanding of the extent of risk/losses that they would be exposed to when they enter into a structure.

More specialised courses need to be introduced by the educational institutions/ organisations. Professional and well-trained staff needs to be handling the treasury functions in small and medium enterprises (SME) which is currently not the case. For example: A person handling finance and accounts generally ends up taking care of treasury.

Do banks too need courses in risk management?
-Because they are still running their risk using TV values, rather than real time rates and volumes, same goes for their Greeks and credit exposure. (The Greeks are a collection of statistical values expressed as percentages that give the investor an overall view of how a underlying asset has been performing. These statistical values can be helpful in deciding what options strategies are best to use.)

Training, of course, would help as derivatives is an evolving market with products being introduced in the market on a regular basis. Hence, staying on top of the situation would help containing risks.

They need to be aware of issues like the volume input they are using to evaluate their risks is based on ATM volumes (an option is At-The-Money if the strike price is the same as the current price of the underlying security on which the option is written) volumes which are not enough for deep OTM options (Out-of-The-Money are those that would be worthless if they expired today).

What are the `must checks' that companies should ensure before entering into derivatives contracts?
-Do have the capability to assess future exposure of each deal and compare it to valid credit client before signing the deal.
-Do get the market Greeks and understand them before you sign a deal.
-Do follow the RBI guidelines and do not be tempted into transactions which don't address clients underlining exposure and financial hedging needs.
-Do invest in sales-force education.
-Do equip the sales-force with advanced sales tools and real time pricing platforms which are based on bank rates so that traders can control prices/volumes/spread on a real time basis.
-Do be able to provide your client with a clear Term Sheet of any transaction in real time.
-Do know what the maximum losses are that could be incurred while entering into a deal.
-Do take proactive measures to cut down on losses when the view goes against you.

D.Murali

Kumar Shankar Roy

Business Line

117) Countdown to Monetary Policy — Road ahead for the RBI

The trends in non-food credit, money supply and reserve money, which are among the major variables to be reckoned with in policy formulation, are somewhat mixed.

The one concern that may be expected to be at the centre of the forthcoming Annual Policy Statement of the Reserve Bank of India (RBI) will be the inflation — raging currently at more than 7 per cent.

The second point would be the slow-down in the growth of the economy — from the heady heights it has seen in recent years. However, to the RBI’s comfort, the controversy on the choice between price stability and growth has been settled by the Finance Minister emphatically declaring that he would prefer the former to the latter — given the impact of inflation on a large section of the population. Although the central bank can concentrate on fire-fighting measures to preserve the purchasing power of the rupee, it still has to ensure that there is soft landing for the economy.

The trends in non-food credit (NFC), money supply (MS) and reserve money (RM), which are among the major variables to be reckoned with in policy formulation, are somewhat mixed. Thus during 2007-08 the growth rate of NFC, including investments, was 21.9 per cent against 27.3 in the previous year. The percentage increases in the corresponding years in MS (M3) were 20.6 and 21.3.

Lagged Effect
As on April 11, 2008, RM grew by 26.4 per cent year-on-year in contrast to 22.6 per cent on the relative date a year back. Two points emerge from the data. In the first place, there is a deceleration in the growth of NFC and M3, although the latter is still above what the central bank desired. Secondly, RM continues to grow at an accelerated pace. The deceleration noted above is due to the lagged effect of the previous policy measures, especially in relation to the periodical hiking of Cash Reserve Ratio (CRR).

The growth in RM has been the result of the unceasing inflow of foreign funds adding to the net foreign exchange assets of the RBI due to sterilisation. Thus, as on April 11, 2008, these assets rose by a whopping 43.7 per cent year-on-year against 23.9 per cent earlier. The recent hike in CRR may partly impound the inflows that have occurred so far. But one does not know what the future has in store. It appears that despite the stock market crash, FIIs haven’t rushed to the exit door.

According to reports, FIIs are diverting their funds from shares to treasury bills of short duration, thus keeping the rupee funds in the country, for possible redeployment in the stock market at an appropriate time.

Surplus mode
It is somewhat difficult to get a clear picture of the surplus liquidity in the economy. After suffering from a shortage of funds during March, due to tax payments of customers necessitating the injection of liquidity by the RBI, the system is back in a surplus mode. However, the amounts have fluctuated widely. Thus, on April 7 and 11, the reverse repo operations of the RBI that absorb liquidity were Rs 37,370 crore and Rs 79,005 crore, the number of banks involved being 37 and 58, respectively.

However, on April 17, the amount came down to Rs 7,045 crore from 10 banks. The figures given above will undergo changes when the RBI presents more recent data. Some of the statistics are vitiated by the year-end syndrome with competitive window dressing by banks to project good images of themselves to the Government, the RBI and the public.

The RBI needs to look into the matter, if necessary by appointing an expert group, to tackle the problem by studying the practices in other countries. The CRR actually maintained by the system was 8.61 per cent, as on March 28, 2008, against the prescribed 7.5 per cent, and 8 per cent to be enforced soon.

Hardening interest rates

The actual ratio includes transaction balances for inter-bank settlements also. Banks may meet the shortages in CRR by disinvestments in the securities prescribed under Statutory Liquidity Ratio, if necessary. They are currently around 30 per cent of deposit liabilities as against the statutory minimum of 25 per cent. It would mean a decline in security values with a consequent rise in yields.

This, coupled with the increase in CRR, will lead to some hardening of interest rates in the system. Hence, there is no need for the RBI to raise the policy rates at this time.

As long as the system is not dependent on the central bank, the repo rate, like the bank rate, may not be effective in itself to influence the system. However, as the year progresses, there may be a need to raise the CRR further for the reasons described below.

There are a number of factors that point to a spurt in NFC and MS. The loan waiver, even if limited to Rs 60,000 crore, effectively means pumping that much money into the system by making fresh loans available to defaulters. Added to this will be the pressure arising from ‘inclusive banking’, which is the new mantra of the politician. Those who enter the system through nominal deposits would naturally expect a benefit in the form of a loan. It may not be long before the authorities issue instructions to the banks to sustain the interest of the new depositors in banking through overdrafts of limited amounts to meet urgent expenditures, so that they do not have to approach moneylenders.

Extra emoluments
The substantial tax benefits for individuals embedded in the Budget will mean additional consumption expenditure. Another factor that would add to MS would be the increase in salaries of all employees of the Government and the public sector due to the recommendations of the Sixth Pay Commission.

The extra emoluments would likely go into expenditure on items like consumer durables. The least that the Government could do is to credit the arrears of salaries to provident funds of the employees, instead of making cash payments, thus mitigating the impact on money supply.

One lasting contribution that Dr Reddy can make to an enduring monetary policy is to bring down the target for MS in 2008-09 to a non-inflationary level.

According to the information received by this writer from the RBI under the Right to Information Act, the methodology of estimation involves separate estimates of money demand and supply under the assumption of equilibrium in the money market, while ensuring the consistency of sources and uses of funds by the RBI, the banking sector and the Government. It uses 1.4 as the income elasticity of real demand for money.

It means that for every percentage increase in Gross Domestic Product (GDP), the real demand for money goes up by 1.4 per cent. Thus, to ensure equilibrium in the money market, it has to provide for additional money supply at 1.4 times the expected growth rate in GDP.

Withdrawal symptoms
Any extra amount like 4 or 5 per cent, provided to accommodate inflation, as has been the practice for nearly two decades, would only help to generate it. The RBI should ask itself as to what calamity would fall if this baker’s dozen of 4 or 5 per cent is not provided for. Would it be good or bad for the economy?

The central bank can always revise its target upwards if the trends in GDP point to a higher growth than predicted. Thus, if GDP is estimated to rise by, say 8.5 per cent in 2008-09, the targeted money supply should be around 12 per cent, not 17 per cent, as it is in the current procedure.

But such a drastic cut in the growth of money supply, called ‘cold turkey’ in professional literature to refer to a disinflation measure designed to reduce inflationary expectations, may be a shock to the system as it is drunk in liquidity.

It may lead to withdrawal symptoms! So the central bank could provide for, say, a 15-per cent increase in money supply, which should get closer and closer to the real demand for money in the future.

A. Seshan

(The author is a former Officer-in-Charge of the Department of Economic Analysis and Policy of the Reserve Bank of India. The views expressed are personal.)

116) Futures trading — Why the panel may be flummoxed

At the end of the discussion on the price situation in the Rajya Sabha on April 17, as the Minister for Agriculture, Mr Sharad Pawar, came to the end of his reply, a question was raised from the Left benches about the Government’s position on the forward markets. In reply, Mr Pawar mentioned that an expert committee appointed under the Chairmanship of Prof Abhijit Sen had been deliberating the issue for 14 months and was yet to submit its report, though it was to have done so in its report in the stipulated two-three months.

The Minister said that if the report was not submitted within the next 10 days, he would call for a meeting of experts on the subject and take a final decision on the future of futures trading, in the light of the severe opposition to these markets reflected during the discussions in the Rajya Sabha and in the recommendations of the Standing Committee on Agriculture on the subject. Coming from a politician and statesman of Mr Pawar’s vintage, this was an unusual statement.

Even presuming that Prof Sen’s panel had failed to show the necessary alacrity in respecting the time schedule, it would be unfair to decide the issue outside the Committee and punish the innocent market and the farmers for no fault of theirs.

Further, one wonders why the Minister took the trouble of appointing a Committee if he knew knowledgeable people who could be called for consultation.

Little innovation

Throughout the discussion in the Rajya Sabha, the Minister dealt at length on the efforts the government was making to ensure food security, by restricting exports and facilitating imports, and the mechanisms of CACP (Minimum Support Prices), Food Corporation of India (FCI) and the Public Distribution System (PDS). This, by itself, suggested that the government was thinking more of the traditional means of ensuring food security rather than experimenting with innovative and little understood mechanisms.

The statement by the Minister of Agriculture seems to have made Prof Sen’s position even more difficult. Last year, at about the same time, the matter of the utility, or otherwise, of the futures markets was brought to him for examination. Even though the terms of reference of the Committee did not so suggest, it was obvious that the government was apprehensive about what the futures market could bring in.

It was quite clear that the futures market was an unwanted baby — of a different gender from the licence-permits-quota type of market systems that the government had carefully nourished till then. Prof Sen’s problem was that the baby was indeed of a different gender but, despite the crude attempts at getting rid of it, was alive and kicking and threatened the basic structure of the traditional agricultural marketing policies based on CACP-FCI-PDS.

Terms of reference
The terms of reference of the Abhijit Sen Committee, as distinct from the unwritten agenda of the Government, were benign. The Committee was appointed in March 2007 to

i) study the impact of the operation of futures markets on commodity prices;

ii) suggest methods to minimise such impact, and

iii) recommend ways in which the farmer’s participation in the futures markets can be increased.

It was not the case that the futures market possibly had an inflationary effect. The problem was that forward trading and the futures markets resurrected by the NDA government go against the Central Government’s policies since Independence in respect of commodity markets based on Minimum Support Prices, procurement from Food Corporation of India and the Public Distribution System in the name of the weaker sections.

The opposition of the Left parties to the futures markets came essentially from the conviction that it belonged to the wrong — liberal — gender. It was hoped that the Sen Committee would give them the authority to abort it.

The mandate of the Sen Committee is simple enough. It is intriguing why the Committee is taking such a long time to submit a report which, it had been thought, could be submitted in just 90 days. The problem seems to be as follows. The Committee found little evidence to suggest any links between market price hike and volatility that could be directly linked to the operations of the futures markets.

Under these circumstances, all that the Committee had to do was to make recommendations about how the performance of the futures markets could be further improved by sanitising the spot markets, improving finance to the commodity markets and promoting farmers’ response by facilitating it.

Uncomfortable facts?
It is not that the panel was to study the desirability or otherwise of lifting/continuing the ban on the futures trade. The futures trade was resurrected in 1993 and, at least, three multi-commodity exchanges are doing pretty well with geometrical expansion of the volume of transactions.

Further, it shook up established notions that the commodity market should be eternally based on three pillars of CACP, FCI and PDS.

The Commission for Agricultural Costs and Prices (CACP) that would help determine the Minimum Support Prices; Statutory Minimum Prices are also, by corollary, the procurement prices;

The Food Corporation of India (FCI) that manages procurement of foodgrains and their conduit to different States; and

The Public Distribution System (PDS) that would ensure retail distribution according to decisions taken by the Government.

If the Committee submitted its honest findings the government would be forced to permit the normal delivery of the futures market infant. The problem for the Committee, probably, is that that would raise a number of very inconvenient questions that would make the candid recommendations unpalatable to the Government.

What purpose would the CACP serve in a situation where the futures market platforms offered not only a firm and timely indication of the prices to expect at the harvest but also provided an ironclad assurance, as also insurance, that farmers would be able to collect the prices? Further, since the commodity markets in India provide warehousing facilities, banking and finance, insurance as also negotiable warehousing receipts, what function would be left to justify the existence of Food Corporation of India, which had become notoriously unpopular with the farmers, most of whom see it as both inefficient and expensive? Lastly, with the procurement of the foodgrains decentralised, was it really necessary to create a separate PDS network for the benefit of the weaker sections of the population? Would that purpose not be better served by simply mailing the targeted people food stamps or smart-cards, which would also obviate the substantial diversion of foodgrains from the PDS system?

Sharad Joshi

(The author is founder, Shetkari Sanghatana and Member of Parliament — Rajya Sabha. He is also a member of the Abhijit Sen Committee on Futures Trading, and can be reached at sharad.mah@nic.in)

115) Global exposure: Enhancing returns from the emerging markets

The market has seen the launch of handful of global equity funds in recent times. Exposure to global equity should be viewed as a returns-enhancing strategy and not as a portfolio diversification measure. This article suggests an optimal portfolio construction process and explains why the global portfolio exposure should be restricted to emerging markets.

The Indian mutual fund industry has realised the importance of offering investors exposure to global equity markets. Several asset management firms have launched global equity funds since 2007.

At present, there are a handful of choices, ranging from Franklin Templeton’s Asia Fund to Birla Sunlife’s International Equity Plan, and some in between.

Investors often ask if constructing a global portfolio makes economic sense as a diversification measure.
This article aims to address the above question. Specifically, it shows that exposure to global equity is not a diversification measure but an optimal way to enhance portfolio returns.

It also shows why Indian investors should take global exposure to emerging markets and not to developed markets. The article also provides some suggestions on the portfolio construction process.Diversification?

Till the early 1990s, asset prices in most home markets had low co-movement with those in the other markets. This provided a case for portfolio managers to invest in global equity.

Of late, the rationale for global portfolio has been called to question. The reason is not far to seek. Globalisation has a side-kick — the contagion. When a major stock market tanks due to a financial crisis, others simply follow. The sub-prime crisis in the US is a case in point.

This contagion effect has led many to conclude that investing in global markets no longer offers an advantage over the home market.

Besides, the high co-movement among various global equity markets has led to weakening in relationship between stocks and bonds in the home market. So, the argument is that portfolio managers can engage in asset allocation in the home market as a diversification measure.

This argument against a global portfolio misses a point. A high co-movement between Indian and, say, Brazilian markets does not mean same returns in both the markets.

Besides, the co-movement is not so strong during normal market conditions. And it is this relationship that a portfolio manager is expected to exploit. Our argument for global portfolio, in any case, extends beyond the diversification principle.

Enhancing returns

It is optimal to construct a portfolio with a primary objective of maximising returns with appropriate risk management rules instead of adopting a diversification strategy that aims at minimising risk. A global portfolio fits within this returns-enhancing framework.

Asset prices in the emerging markets have typically outperformed those in the developed markets such as the UK and the US. A global portfolio exposure for an Indian investor within the returns-enhancing framework should, hence, be restricted to the emerging markets.

India has been one of the best performing emerging markets in recent times. The asset price growth could, however, slow down in the coming years.

An exposure to other emerging markets, therefore, provides a case for lifting the portfolio returns. For instance, the Brazilian or the Russian market could be on an uptrend when the Indian market is down for a country-specific reason.

Besides, it is important for a portfolio manager to generate alpha returns — the excess returns generated because of the manager’s skill.

There is a higher level of noise trading in emerging markets such as Pakistan and Russia.

This pushes assets to wander far away from their estimating intrinsic value providing a case for generating alpha. The developed markets do not present such a rich alpha-harvesting opportunity.

Global portfolio structure
So, what is the best composition for this global portfolio? Portfolio managers typically assign weights to each market and then pick the best stocks in each market.

This approach was optimal when the primary reason for a global exposure was portfolio diversification.

The emphasis here is to enhance returns. So, sector allocation is more important than country allocation. The portfolio construction process should not bolt together the Indian market and, say, the Indonesian market citing the low co-movement between the two during normal market conditions.

If the portfolio manager is of an opinion that the telecom sector is likely to do well, she should take exposure to the best stocks in that sector across emerging markets. Such an exposure could be, say, in an Indian company and a Taiwanese company.

So, if the telecom sector does well, the global portfolio would benefit because of its exposure to the Indian and the Taiwanese company.

If the Indian telecom stock is down for a country-specific reason, the global portfolio would still benefit if the Taiwanese stock is on the uptrend. If there is a contagion, the global portfolio will, however, decline.

It is, therefore, important for investors to buy global funds that take exposure in growth sectors across emerging markets.

Fund-houses should launch more funds to exploit alphas in the emerging markets. The objective is to enhance returns with appropriate risk management rules, not diversify risk.

B. Venkatesh

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

114) FIIs are still the kings

If you are keen to gauge where the market is headed, you need to pay more attention to the India calls of leading FIIs. They have taken a more bullish view of Indian stocks than domestic mutual funds.

Whenever Indian stocks go into a free fall on selling by FIIs, all eyes immediately turn to domestic mutual funds to see if they can do a rescue act. Collections mopped up by new funds and the cash coffers of the older equity funds are then eagerly dissected to see if domestic funds can step in where the FIIs left off.

But despite a sharp ramp-up in the size of equity assets managed by them, domestic mutual funds continue to be dwarfed by FIIs in their ability to move Indian markets.

This, and other interesting trends were revealed in an analysis by Business Line of the trading patterns and shareholding of mutual funds and that of FIIs over the past two years.

Domestic equity funds have ramped up their average monthly purchases of Indian stocks from a measly Rs 3,000 crore in 2003-04 to over Rs 17,000 crore in 2007-08 — a four-fold increase.

But this hasn’t helped them wield greater influence on market movements. For, FII buy has shot up nearly sevenfold over the same period to hover at about Rs 75,000 crore a month (even in the wobbly month of March ‘08). Both numbers are on a gross basis to capture the actual transaction volumes.

These numbers suggest that in a choppy market, you need to pay more attention to the India “overweight” or “underweight” calls of leading foreign institutional investors, than to the soothing noises made by fund managers back home.

FIIs appear to have taken a much more consistent as well as bullish view of the Indian market than the domestic MF managers. Sample these numbers.

FIIs have been net buyers in Indian stocks in 53 of the 63 months since the bull-run began in early 2003. Bouts of net selling by them have been few and far between, confined to brief episodes in August 2007, November 2007 and, recently, January 2008.

In contrast, domestic funds have alternated between bouts of selling and buying throughout this five-year bull-run.
They’ve sold stocks (on a net basis) in 28 of the above 63 months, about a third of the time. This suggests that domestic fund managers may be churning their portfolios, and taking profit-booking opportunities more frequently than the FIIs.

One key point to note here is that the periodic bouts of mutual fund selling on the bourses cannot be blamed on the retail investors in MF schemes. In fact, trends in inflows into equity funds suggest that far from panicking, retail investors have pumped in higher amounts into equity funds in the choppy markets of January, February and March 2008. MFs however, net sold stocks in two of these months.

This suggests that mutual fund selling activity may be triggered by dividend payouts or the managers’ view on the market, rather than by forced redemptions.

On opposite sides
Unexpectedly, domestic fund managers and FIIs seem to have diametrically opposing views on the markets. Months of heavy FII selling have usually seen domestic MFs buying into stocks.
August and November 2007 and January 2008 are clear instances where MFs lapped up stocks while FIIs were on a selling spree.

And, conversely, the months of September and October 2007 and March 2008 saw MFs in the exit mode even as FIIs bought into stocks. However, bouts of selling or buying by domestic MFs haven’t had much impact on market direction.

For instance, MFs were net sellers in September and October 2007, a period when the Sensex rose by nearly 30 per cent on the back of heavy inflows from FIIs.

On the other hand, January 2008 saw a massive correction in stocks (the Sensex suffered a 13 per cent loss), despite MFs making their till date biggest monthly net purchases of Rs 7,700 crore.

FIIs were net sellers to the tune of Rs 17,000 crore that month.

Corrective phases in the market have usually been triggered by FII selling, rather than by domestic funds exiting stocks. This explains why “global cues” rather than domestic developments, seem to hold so much sway over Indian stocks.

As long as the FIIs remained in the ‘buy’ mode, they were able to easily absorb any selling pressure unleashed by domestic funds.

The ultimate discomfiting takeaway from these numbers is that domestic fund managers, however bullish their view on the home markets, may not be able to save the day if the FIIs continue to be in a bearish mood.

Small wedge of pie

The limited influence that MFs wield over individual stocks compared to their foreign peers is also evident from the share of market cap held by them. Domestic mutual funds hold just 3.7 per cent of the total market capitalisation of NSE-listed companies today; while FIIs hold almost four times as much — 15.2 per cent.
This is based on the latest shareholding patterns disclosed by companies to the exchanges. As expected, FII dominance is the highest with large-cap stocks (market capitalisation of over Rs 10,000 crore). FIIs hold a big 15.7 per cent slice of this pie, while MFs make do with a tiny wedge of 3.2 per cent.

Domestic fund managers do have a clear partiality for mid-cap stocks, with high allocations to them relative to large-caps in their equity fund portfolios. But, contrary to what you would expect, this doesn’t give them greater buying power in this space.

FIIs, over the years, have deepened their investments well into the mid-cap space too and now hold as much as 15.6 per cent of the market capitalisation of the mid-cap universe (market cap of Rs 2,500 to Rs 10,000 crore). Mutual funds are far behind (see Table).

The one segment of the market in which MFs do compare to FIIs in terms of their equity stake is in small and micro-cap stocks. MFs hold 3.8 per cent of the small-cap universe (stocks with a market cap of Rs 1,000 crore or less), while FIIs hold 6.9 per cent.

Aarati Krishnan