Growth at Risk for Inflation Management: Review of Credit and Monetary Policy for the year 2008 – 09

As expected after the release of Macro Economic and Monetary Development survey report, Reserve Bank of India (RBI) had continued to take harsh measures to check demand to control inflation in the country. In its survey report on the eve of release of much awaited first quarter review of annual statement on Credit and Monetary Policy for the year 2008 – 09, RBI had mentioned that an adjustment of overall aggregate demand is needed.

The RBI in its survey had painted a gloomy picture for the economy. A survey conducted by the central bank said India’s gross domestic product (GDP) would grow 7.9 per cent this year against the earlier projection of 8.1 per cent. Adding to the grim forecast was the RBI’s assessment that the inflation rate would remain a concern, owing to high global oil and food prices. The government’s finances are also expected to be under strain on the back of high oil and fertilizer subsidies, farm debt waiver and the implementation of the Sixth Pay Commission recommendations.

The Centre has budgeted for a fiscal deficit of 2.5 per cent of GDP and global rating agencies have already raised concerns over the government missing the target. The bad news doesn’t end here. The RBI’s Industrial Outlook Survey of private sector manufacturing companies pointed out that fewer respondents expected the overall situation to improve in the July-September quarter. The only good news is a better forecast for export and import growth. But even that came with a rider of a higher trade deficit. Another cause of concern is the outstanding balance on credit cards rose 87 per cent till the end of May to Rs. 26,600 Crore, raising worries for bankers during a period of economic slowdown.

Aimed at bringing down inflation from the present around 12 per cent to 7 per cent by March 2009, the central bank increased the Cash Reserve Ratio (CRR) for the fourth time and raised short term lending rate to banks (Repo rate) third time this fiscal. In the background of unrelenting inflationary pressure, RBI had announced stringent measures of hiking mandatory cash reserve of the banks by 25 basis points to 9% (CRR = Cash reserve ratio) and its short term lending rate to them (Repo Rate) by 50 basis points to 9%, to suck up an estimated Rs 20,000 Crore from the market. RBI is still optimistic on inflation when it assures that inflation has almost peaked and is expected to move sideways from hereon. I think that inflation is still to see the peaks unless, crude oil and commodity prices declines. The above way to curtail down the inflation measures can’t be a welcome move for current UPA Government, which has to face general election in 2009 as in short run these measures can’t be more effective.

Above move will increase EMI’s on Home, Consumer and other loans with RBI’s hawkish credit policy as I expect at least 0.5% up trend in the banks lending rates. At the same time in its Quarterly Review of Annual Policy Statement RBI wiped out any hopes of interest rate easing in the near future. Increase in CRR and Repo rate would derail India Inc’s programme of borrowing for their industrial expansion and modification, as the cost of borrowing would go up. This will also make difficult to achieve GDP growth target which was earlier forecasted between 8 – 8.5% and revised by RBI in its review to 8%.

This move is double whammy for banks, it just means a direct increase in fund cost and liquidity is being squeezed, interest margins, loan growth and credit losses of the banks will be under severe pressure after this policy. RBI in its post policy review, made it amply clear that banks would need to take the profitability pressure in their Income Statement. With the upward movement in CRR and Repo rate, there is a dual negative impact on the banks bottom line. Roughly at new level of CRR bank has to keep additional around Rs 2,60,000 Crore more with RBI, considering an average 9% yield, that mean Rs 23,400 crore is the reduction of profit in a year. The negative impact on banks financial statements doesn’t end here; the bond values are also not taking the key rate changes with optimism. As increase in CRR and Repo rate lead to macro deterioration with bond yields going up and bond value sliding. In the first quarter bonds have managed to hold their bottomlines, but I don’t think they can do the same now. I think that increase in CRR and Repo rate will not only affect banks, their lending’s, but also stock markets, manufacturing, agriculture and realty sectors, besides equally adversely affecting deposits. Reaction of the above can also be seen in the sharp negative movement in sensex on the day when the policy is announced.

By the increase in CRR and Repo rates the RBI seems to be telling the banks to increase lending rates. As banks are not paying attention to the RBI’s repeated appeals to moderate lending growth which was a cause of concern for supervisor. Credit growth till July 4, on a year-on-year basis, was almost 26%, compared to 24.6% during the same period last year. This, coupled with lower deposit growth this year, has led to a rising credit deposit ratio. As abnormal growth in credit deposit ratio could mean that banks are over stretching themselves to keep their income intact.

A high credit-deposit ratio also indicates that a bank is not paying adequate attention to asset liability management. If many banks are indulging in this, cumulatively it poses a threat to overall systemic stability.

One good point about this policy review is the clarity of central bank to move ahead in a single-point agenda of controlling inflation, unlike in the past when inflation control was balanced with economic growth.

Besides the pressures from global commodity markets, the economy may also have to bear the burden of higher subsidies, loan waivers and increased salaries of government employees once the Sixth Pay Commission recommendations are implemented. With the downward movement in the GDP growth, Governments commitment for higher subsidies, loan waivers and increased salaries of government employees under Sixth Pay Commission is questionable.
When on one hand RBI is going ahead in the direction of Financial Inclusion and emphasizing on credit quality and credit delivery for employment – intensive sectors and on the other hand borrowing cost is increasing with an increase in CRR and Repo rate. I doubt how two issues contrary to each other can be resolved.

Conclusion: When the capital market is not encouraged, bond values are sliding, banks income statement is having a negative impact, growth numbers are coming down and inflation is not targeted in the short run, then I don’t consider playing with CRR and Repo rate will result into what is targeted out of them. I think this is not the correct thing to do now as it will have its negative affect on growth momentum, which is the only hope in the current economic scenario.

Dr Gourav Vallabh
Professor (Finance)
XLRI School of Business and Human Resources
Jamshedpur - INDIA
gvallabh@xlri.ac.in

FINAX - Associate Members 2008-09

A new year.... A new team.... Finally Team FINAX is back to full strength with the addition of 6 associate members from the Batch of 2008-10.

- Team FINAX

Evolution of the Infrastructure sector

We keep hearing a lot about dynamics, industry dynamics and how a whole sector has evolved over a period of time. Infrastructure has been one such sector which has seen a paradigm shift in the recent times. The infrastructure that we talk about is not just limited to real estate but encompasses a diverse range of sub-sectors like Telecom, Roads, Airports, Ports, Highways, Oil and gas, Metals, Irrigation and Mining.

The government was quick to realize the fact that if the Indian economy is to grow at a pace of 9% annually then the spending in infrastructure should grow at about 12%. To speed up the growth it could not rely on its executing arms, so they thought of a novel way to rope in private participation and came up with BOT (Build-Order-Transfer) model of awarding projects.

Earlier the construction space used to be a low risk and a low return business, but with the XI five year plan envisaging a massive investment in the infrastructure arena, the game has changed altogether. The government plans to set up UMPP (Ultra mega power projects), the NHDP program divided into six phases plans to construct more than 53000 kms of road. A large number of private ports are also being developed by various private construction giants; an area which up till now was only dominated by the government agencies.

To put in an more structured format the whole new paradigm shift can be attributed to the following four factors

1. Increase in Number of projects: The construction companies are being awarded bigger projects than ever before. The average length of the roads used to be between 10-20 kms on a cash contract basis to the constructor. Now the average road length awarded is to the tune of 100 kms on a BOT basis. More than 38000 kms of road construction needs to be awarded according to the NHDP on a BOT basis. Power sector has also seen a lot of new projects coming up in the form of merchant power plants and UMPP's. With the increase in the size of the project there is a requirement for larger working capital and a bigger balance sheet to fund the activities and sustain the business.
2. Complexity of the projects: With time, the complexity of the projects have increased. It is difficult to construct and maintain a 100 km highway as compared to a 10 km one. Smaller companies are thereby being forced to enter into contracts with the larger companies in order to qualify the technical requirements for the bidding process.
3. Trend of commodatization:There has been a constant increase in the prices of two major expenses of these companies

· Material cost: Steel, cement, bitumen and aggregators make up most of the material cost for these companies and the constant increase in the prices of these raw materials is making life difficult for these players and is compressing the margins.

· Personnel Cost: The IT boom and the compensation packages paid by the IT companies cannot be paid by the these companies due to which there is a constant attrition of people and these days it is becoming more and more difficult for these players to get civil engineers into the business.

4. Own Equipment: More and more companies have now started to own the equipment rather than relying on subcontracting. This has led to a margin expansion for these companies.

Now the only question that remains to be answered is - will the focus of the coming governments be in alignment with the present government. A difference in focus of the next government can sound a alarm bell ringing for these companies.

MAY THE GOVERNMENT BE WITH THEM :)

- Vivek Jain
Student, Business Management (2007-09)

Short sales make a come back in India – will it work?

India saw the reintroduction of the short sales and corresponding stock borrowing and lending program on 21^st April 2008 which had so famously been banned in 2001 after the stock market scams. For the uninitiated, short sales refer to selling stock without holding it and buying back later. To complete the settlement the player doing the short can borrow stock and hence the need for stock borrowing and lending program. However, that’s not the only utility of the SLBM (stock lending and borrowing mechanism).

I had been following this news for quite some time as the discussion has been happening for some years now. However, when the final picture came out, I was a touch disappointed. It is therefore no surprise that more than a week later, we see that the program hasn’t taken off at all with absolutely no interest in the SLBM (check www.nseindia.com for daily trades under this category). Much of the focus in the recent past has been on the earnings (as this is not just the quarter end but year end as well), inflation, monetary policy and the derivatives losses that companies are facing (along with the courtroom drama), that’s not the only reason for short selling and SLBM to escape the eye of the big investors.

To start with, short selling is allowed only in selected scrips which are also traded in the F&O section. The SLBM is a exchange traded order driven mechanism unlike its OTC counterparts in many parts of the world. Trading is allowed only 1 hour everyday in the morning and there is a fixed settlement cycle of T+7. To add to that margins apply to the institutional investors as well (to bring them to a level playing field with retail investors). The question is when F&O are available, what extra benefit would short sales and SLBM bring especially in the light of complex margin requirements. One of the reasons could be reverse arbitrage where prices in the cash market are at a discount to the futures prices in which one would like to borrow securities, sell in cash market and buy in the futures market. However, this is not possible as SLBM works only for 1 hour in the morning and it cannot be anticipated whether reverse arbitrage opportunities would be present. Also, in these uncertain times, no one would like to commit to a fixed settlement time frame of T+7

I also read that banks and insurance companies are not allowed to short as this amounts to speculation. That further takes away a large chunk.

So, it is hard to imagine the SLBM taking off in the current shape and though SEBI and exchanges are calling them teething issues similar to the ones faced at the time for compulsory demat trading, I believe more would have to be done to bring the players to the table.

- Saurabh Bagrodia
Student, Business Management (2007-09)

The post can also be accessed by clicking at the image

Reward and Risk!! - The India Volatility Index (VIX)

Risk and Reward go hand in hand. One need not be an ‘MBA’ to discover that. However, what exactly is risk? Talking to a friend who’s been actively trading in the equities (and now FnO) markets for the past few years, I realized few people have an answer to what exactly risk is or how to quantify it. After a couple of courses on financial management and a few readings of some sections of Brearly and Myers later, I have a bit more clear answers to the question on risk than I had a year back. However, what if i hadnt joined XLRI or had not known about the greatness of Mr Brearly and Mr Myers?

If everyone knows returns and risk go hand in hand and there is no point talking about one in isolation with the other, why is it that everyone just talks about the rise and fall of sensex (or any other index depending on the country you are; or all the major global indices if you are an MBA student) without giving heed to how volatile (or risky) the movements have been? I happened to meet an old friend at CCD last evening, for the first time after he has completed MBA from a global Indian Bschool (which now also ranks pretty high in FTs list of global Bschools) and he said the risk is also included in the index as the underlying valuations which form the basis of an index take risk into account. While he’s right in a way, the question is not on the valuation or levels of the index, but on the overall returns vis-à-vis the volatility (risk) of the index itself.

NSE, the premier Indian stock exchange seems to have opened its eyes to this fact and thus the recent introduction of VIX, India’s own Volatility Index. So, what exactly is this VIX? In the words of NSE, “Volatility Index is a measure of market’s expectation of volatility over the near term”. The Indian markets have not just been amongst the best performing over the last few years in terms of the returns, they have also been pretty open to changes and in the introduction of new products. We have come quite a way since the inception of futures and options less than 10 years ago. The volumes have been on the rise, the mini contracts have been introduced and we have also been listed on other exchanges. So, it came as no surprise when NSE decided to introduce the VIX.

I’m staying away from explaining what VIX is, how is it calculated and what is its interpretation as I am in process of understanding the interpretations myself. However, in short, VIX is a measure of the implied volatility in the near term (30 days) calculated using the near and mid month option prices. The calculation methodology is exactly same as used by CBOE. However, the VIX figures in their brief history raise a few questions.

The VIX in India fell 16% on 7^th Apr, went up 21% a couple of days later and again fell by 20% the very next day to rise 10% again a day later. If the VIX keeps behaving the same way, one would have to take a call on the utility of the index or NSE would have to figure out ways to find better methods than just simply copying the CBOE. Also, no wise investor would trade into such a ‘volatile’ ‘volatility’ index. CBOE introduced the VIX in 1993 and it took them 11 years to start trading into the VIX. Are we ready for the index in its current form and calculation methodology? Is the options market liquid enough (especially the mid month contracts) to give a meaningful figure? NSE has also said “There is no intention to introduce tradable products based on the India VIX in the immediate future. Once market participants are comfortable, India VIX futures and options contracts can be introduced in the Indian markets, based on regulatory approvals, to enable investors to buy and sell volatility and take positions based on the movement of India VIX”.

My take would be India VIX would not require 11 years (may be not even half that number) to start trading. But the options market would have to become more liquid or the methodology redefined (or maybe even both) before we find any meaning in the index.

On more futuristic thoughts, I’d like to believe we would also see the exotic volatility indices, the ones that measure the volatility of the volatility indices :) Happy investing!!

- Saurabh Bagrodia
Business Management, 2007-09

The post can also be viewed here

Union Budget 2008-09 - Comments on the agricultural sector

INDIAN UNION BUDGET (2008-09) (PART-01)

We start with our analysis of the Union Budget by doing the sectoral analysis of the most important sector in Indian context – Agriculture. Some may claim that agriculture has lost its importance over the years but the fact remains that more than 60% of the Indian population is still dependant on agriculture either directly or indirectly. With the focus on SELF RELIANCE & SUSTAINABILITY the Budget essentially considers the following problems & thereby increases allocations in the following-

Problems
Inefficient support systems
Low levels of technology & infrastructure
Marketing and warehousing bottlenecks
Low capital formation
Degradation of land and water resources

Increased Allocation For
Food storage and warehousing
Soil and water conservation
Agriculture research and education
Irrigation and flood control

The situation isn’t too promising as average yield per hectare in India (1.8 tonnes) is far lower than that of China (4.3 tonnes) and Japan (4.8 tonnes), surface water irrigation efficiency ranges b/w 25-40% in India; b/w 40-45% in Malaysia; and 50-60% in Japan. In the past three decades of Green Revolution, area under agriculture increased at 0.4% as compared to 3% increase in agricultural production. There have been stagnated yields and wide price fluctuations. There happens to be a strong relationship between per hectare yields of food grains and rural development.

ACTUAL PRODUCTION RELATIVE TO TARGETS (MISSING THE MARK)
CROP - AVERAGE (%)
Rice - 94.7
Wheat - 91.4
Coarse cereals - 94.6
Pulses - 87.7
Foodgrains - 93
Oilseeds - 85.3
Sugarcane - 98.7
Cotton - 93.7

The budget proposals relevant for the agricultural sector:
* National Commission on Agriculture has recommended market facilities for farmers within a radius of 5 km i.e. one market for every 80 sq km. Hence, density of markets/mandis needs to increase nearly five and half times
* Trading platforms like NCDEX, MCX needs further boost
* Cold storage units exist only in 9% of the regulated markets as of now

So, WHAT WOULD THE GOVERNMENT DO ABOUT THE ISSUES? Would it be only limited to policies, allocations, huge sums of money and no transparency??? Or is the condition going to improve. Would Indian agriculture really become SELF RELIANT & SUSTAINABLE??
These are some of the issues which need to be addressed, but at this point they don’t seem to be getting the attention they deserve. Probably one year from now (by the time of next budget) we might be in a situation to analyze these issues in greater depth and comment on-

“Whether promises would remain promises or this time the government would really make a difference.”

Alternately, double click on the picture to see the article

For Team FINAX
Ashutosh Taparia

New Members - 2008-09

As promised a few days back, the new senior executive members of the committee have been elected and they have assumed office. The committee is by no means complete yet as we await the other executive members who would be chosen from the batch of 2008-2010.

Please click on the image to see a larger view.