Niveshak July by abhi ram

Niveshak THE INVESTOR

Rbi’s monetary policy tightening Pg. 11

VOLUME 4 ISSUE 7

July 2011

CDS ARRIVES IN INDIA Pg. 20

FROM EDITOR’S DESK Dear Niveshaks,

Niveshak Volume IV ISSUE VII July 2011 Faculty Mentor Prof. N. Sivasankaran

THE TEAM Editor Rajat Sethia Sub-Editors Alok Agrawal Deep Mehta Jayant Kejriwal Mrityunjay Choudhary Sawan Singamsetty Shashank Jain Tejas Vijay Pradhan Creative Team Vishal Goel Vivek Priyadarshi

All images, design and artwork are copyright of IIM Shillong Finance Club ©Finance Club Indian Institute of Management Shillong www.iims-niveshak.com

The possible downgrade of US Treasury security dominated the headlines this month. S&P, Fitch, Moody have all warned of a possible downgrade, if US fails to raise its debt ceiling by the August 2 deadline. If the US defaults on its T-bills, something which it last did way back in 1979, the repercussion would be severe both for the US and the global economy. To make matters worse, the economic data from US indicate a stalling economy and a possible QE3 on cards. The expectation of QE3 has already made Gold prices to rally, which was already rallying hard on the back of fiscal concerns in Eurozone. In general, the monetary easing would create more volatility for commodity prices. In the last two instances of QE, money created in US went out into emerging markets and created bubbles in the commodity space, principally in oil but also in gold and other metals. Meanwhile, the euro zone’s debt drama has lurched from one nail biting scene to another. First Greece took centre stage, then Ireland, then Portugal, then Greece again and now Italy. Each time European policymakers reacted with denial, followed at the eleventh hour with a half-baked rescue plan to buy time. With Italy now at the centre stage of the debt crisis, it is clearly a new phase for the Euro debt crisis. No longer confined to the small peripheral economies of Greece, Ireland and Portugal, it has hurdled over Eurozone’s giant like Spain and Italy. On the domestic front, the Indian economy is resilient, but the happenings over the past six months have not been right for the investor’s sentiments. The policy stance of the government in various fiscal matters and the recent Mumbai blasts have clearly increased the political uncertainty and affected the economic environment in the country. The Government has a lot of ground to cover if the target economic growth is to be achieved. The severe lag in the decision making process of the Government over the last few months, because of the various civil protests, has halted progress across sectors and affected the economic growth. Meanwhile, persistently high inflation and interest rates have hit business as well consumer confidence. The business, particularly the micro, small and medium enterprises (MSMEs) are cutting down on investments while the consumer led sectors such as the auto and housing are also experiencing slowdown due to high interest rates. RBI is further expected to increase the repo rate by 25 basis points at its monetary review, slated for July 26. It would be 11th time that RBI would be raising rates since early 2010. However, the inflation still remains high and a cause of concern for the policy makers. This issue brings to you some more interesting and insightful topics. The cover story this month focuses on the draft microfinance bill posted by Ministry of Finance recently, its implications and the way ahead for the Indian microfinance industry. The article of the month explores the issue of savings rate deregulation, the pros and cons, and the steps RBI should take in this matter to benefit both banking institution and common people. Other articles in this issue focus on the impact of RBI monetary policy tightening, the role of securitization in structuring debt portfolio and the impact of CDS introduction in India. Lastly, the Classroom this month explores the topic of Capital Account Convertibility. Hope you find the issue an interesting read.

Rajat Sethia (Editor -Niveshak)

Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears no responsibility whatsoever.

CONTENTS Niveshak Times

04 The Month That Was

finsight

08 Role of securitization in

structuring debt portfolio

Cover Story PERSPECTIVE

11 RBIâ&#x20AC;&#x2122;s Monetary Policy Tightening

14 Regulatory Uncertainity in the Microfinance Industry

FINGYAAN

20 CDS arrives in India

Article of the month Interest rate deregulation

Classroom

27 Capital Account Convertability

FINLOUNGE Fin-Q

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The Niveshak Times

OVERALL, GROWTH IS ESTIMATED TO BE MARGINALLY HIGHER AT 8.6% THIS YEAR OVER 2010-11 LEVELS OF 8.5%” – FINANCE MINISTRY

TEAM NIVESHAK

The Month That Was

IIM, Shillong

Moody downgrades Portugal sovereign bonds to junk status Moody one of the top three credit rating companies has slashed ratings of Portugal’s sovereign bonds by four levels to Ba2 placing these bonds in junk territory. The agency’s decision to downgrade the sovereign bonds rating is driven by its concerns over the Portuguese government’s ability to meet the deficit reduction and debt stabilization targets laid before it as a part of its loan agreement with EU and IMF. Portugal is struggling to cut down spending, increase tax compliance, achieve economic growth and support banking system. Moody is also skeptical about the need of a second round of official financing for Portugal before the troubled nation can return to capital rates. Other premier rating agencies, S&P and Fitch are also critical of Portugal’s handling of the fiscal crisis and have rated its sovereign bonds as BBB-, the bottom of investment grade range. Eight European banks flunk stress test European Banking Authority announced the failure of eight banks in Europe in its stress test. Five banks in Spain, two in Greece and one in Austrian could not pass the test meant to check their ability to withstand prolonged recession. Banks were deemed to have failed if they slid below a 5% core capital pass mark in the face of a theoretical slide in stock, bond and property prices during a twoyear recession. 15 other banks just managed to scrap through the test with a margin of less than 1%. The failed banks are required to produce firm plans by September to plug capital shortfalls by the year-end, with their home government ready to help with funds if needed. The funding needs for these banks are estimated at 2.5 billion Euros. Specific Media buys Myspace from News Crop for $35 million News Corp has divested its majority stake in

NIVESHAK

Myspace for $35 million, a fraction of $580 million the media giant once paid for the same holding in 2005. The huge gap between buy and sell price for News Crop for its stake in Myspace marks the failure of News Corp investment and also shows the unpredictable preference of investors in social networking world. Advertisement firm Specific Media along with singer Justin Timberlake will acquire News Corp’s stake in Myspace. After this deal News Corp’s holding in Myspace will come down to 5%. The deal is in sharp contrast to the sky high valuations being commanded by Web based startups like Zynga, Linked In, Twitter, etc. IMF gets its first woman chief French Finance Minister Christine Lagarde has been elected to the post of managing director of IMF. The election of Christine Lagarde is the first time a woman has been elected to the top job at IMF. Lagarde takes over from Dominique Strauss Khan who quit the post in the wake of the sexual assault controversy surrounding him. The election was in line with a convention dating back to the creation of IMF according to which Europe has always held the top job at the international money lender. RBI puts a cap on MF investments by banks RBI has placed a ceiling on banks’ investment in liquid and short term schemes of mutual funds. As per the new regulation, banks are allowed to invest up to 10% of their previous year net worth in “liquid/short term debt schemes (by whatever name called) of mutual funds with weighted average maturity of portfolio of not more than one year”. banks which had more than 10% of their net worth invested in these schemes, are now “allowed to comply with this requirement at the earliest but not later than six months” from the date of notification. According to current estimates, liquid funds-schemes with up to 90-day maturity-manage about Rs 1 lakh crore of banks’ funds. The RBI decision is

VOLUME 4 ISSUE 7

july 2011

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The Niveshak Times

tiple accounts of a single person or company and attempt to hide higher value transactions. RBI had in 2002 have made it mandatory for banks to share monthly details of all accounts where cash transaction of more than Rs 10 lakh have taken place with the Financial Intelligence Unit (FIU), India. Market capitalization of Tata group crosses the $100 billion mark Steel to telecomm conglomerate, TATA group’s market capitalization crossed the $100 billion mark on 1st July. The cumulative market capitalization of all the listed companies of TATA group rose to Rs 4, 47, 351 crore, based on their share prices at the Bombay Stock Exchange. Considering the INR/USD exchange rate of Rs.44.5855/ 1 USD on 1st July, 2011 the market capitalization of TATA group comes approximately to $100.33 billion. The Tata group comprises of nearly 100 operating companies, but only about 30 of them are listed in the stock market. Notable among the incorporated companies are Tata Consultancy Services, Tata Steel, Tata Motors, Tata Power, Indian Hotels, Titan, Voltas and Tata Communications. Standard Chartered mops up 10% holding in Redington Standard Chartered Bank’s PE arm has acquired 10% stake in Redington India, the oldest distributor of IT products in India for rs.365 crores. Stanchart’s fund, which manages assets worth $550 million, bought the shares from promoter Redington Mauritius and Synnex Mauritius, a unit of Taiwanese IT distributor Synnex Technology International Corp. Redington Mauritius sold 3.05 crore Redington India shares at an average price of Rs 91.90 per share following which Redington Mauritius stake has come down from 28.80% to 21%. The $4 billion Redington India is part of the Singapore-based Kewalram Chanrai Group.

The Month That Was

expected to take out about 50-60% of this, which is about Rs 50,000 crore to Rs 60,000 crore, from the fund industry. While this would surely dent the total AUM of mutual funds, on the positive side, fund houses barely earn anything from liquid funds. Vedanta acquires 10% stake in Cairn India NRI metal tycoon Anil Aggarwal led Vedanta Resources acquired 10% stake in Cairn India, the Indian arm of Scotland based explorer, Cairn Energy for $1.5 billion. Vedanta acquired 191.92 million stocks of Cairn India at Rs 355 a share which required a total cash payout of around Rs 6,813.16 crore. Following this purchase Vedanta’s stake in Cairn India has risen to 28.5%. However even after this sale Cairn energy continues to be the majority shareholder of Cairn Energy with 52.2% holding. Vedanta continues to work with Cairn Energy to secure the necessary consents to complete the purchase of a further 30% of the fully diluted share capital of Cairn India. The Cabinet has approved the deal subject to Cairn Energy or its successor agreeing to cost recovery of royalty in the Rajasthan fields. Headline inflation in June stands at 9.44% Headline inflation as measured by WPI rose from 9.06% in May to 9.44% in June fuelled by the rise in prices of fuels like kerosene, cooking gas and kerosene along with manufactured products. The index for the fuel and power segment (which has a weight of almost 15 per cent in the WPI basket) stood at 12.85 per cent year-on-year basis in June. Prices of manufactured products (which have a weight of around 65 per cent in the WPI basket) went up by 7.43 per cent year-on-year in June. RBI tightens grips on recalcitrant banks in last six months: As the centre continues to grapple with the black money menace central bank RBI has taken the cooperative banks to task for flouting Know Your Customers (KYC) norms and Anti Money Laundering (AML) guidelines. Since the beginning of year as many as 48 co op banks have been slapped penalties between Rs.1 to 5 lakhs on the above mentioned charges. The main accusation against these erring banks has been that they allow mul-

S&P AND MOODY THREATEN TO LOWER US CREDIT RATING

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FinSight

Perspective TheFinGyaan Month That W as

AoM

Market Snapshot

Source: www.bseindia.com www.nseindia.com

MARKET CAP (IN RS. CR) BSE Mkt. Cap Index Full Mkt. Cap Index Free Float Mkt. Cap

67,84,834 28,21,882 14,99,290

LENDING / DEPOSIT RATES Base rate Savings Bank rate Deposit rate

9.25% - 10% 4% 8.25% - 9.10%

Source: www.bseindia.com

CURRENCY RATES INR / 1 USD INR / 1 Euro INR / 100 Jap. YEN INR / 1 Pound Sterling

44.37 63.87 56.45 72.34

RESERVE RATIOS CRR SLR

6% 24%

POLICY RATES Bank Rate Repo rate Reverse Repo rate

6% 7.50% 6.50%

Source: www.bseindia.com 1st to 22nd July 2011

Data as on 22th July 2011

NIVESHAK

VOLUME 4 ISSUE 7

July 2011

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Market Snapshot BSE Close 18,722 7,046 8,463 8,859 12,909 6,711 13,711 4,110 6,418 5,933 14,762 9,189 2,570 8,566 2,204

% change -1.33 2.80 3.73 0.38 -0.05 0.86 -2.01 1.41 0.24 -3.36 -2.71 -1.24 -1.73 -0.46 8.79

Perspective The

Open 18,975 6,854 8,159 8,826 12,915 6,654 13,993 4,053 6,403 6,139 15,173 9,304 2,615 8,605 2,026

AoM

Index Sensex MIDCAP Smallcap AUTO BANKEX Consumer Durables Capital Goods FMCG Healthcare IT METAL OIL&GAS POWER PSU REALTY

FinGyaan Month That Was FinSight

The

role of securitization in structuring debt portfolio

Arivazhagan G D

IIM Ahmedabad

FinSight

The recent increase in interest rates is exerting pressure on the cost of debt financing for many financial institutions. Securitization has helped these commercial banks, NBFCs and micro finance institutions manage their costs to reasonable levels.

Background Necessity is the mother of invention even in the financial world. Recent increase in interest rates and changing regulatory norms are forcing companies to explore options to minimize their cost of debt. Securitization has come to rescue many NBFCs and Micro financial institutions (MFIs) offering many benefits while commercial banks have been securitizing on a large scale since 2002. Shorter maturities and enhanced credit ratings make it attractive for the investors to invest in asset backed securities (ABS) through securitization. With the scope of investors expanding, NBFCs and MFIs have found securitization an attractive option for liquidity financing. Companies like Manappuram Finance which are limited to the gold loan market were able to withstand the shocks of the regulatory changes in 2010 with the help of direct assignment/securitization. The financial market in India is now witnessing the increasing role of securitization in debt portfolio. In 2010, outstanding US mortgage debt was about $9 tril-

lion which was about 6 times Indiaâ&#x20AC;&#x2122;s GDP. In India, debt markets are still at an evolutionary stage that is very much similar to that of equity markets prior to the reforms in early 1990s. Though securitization market in India was brought into existence in 1990s, it matured only post-2000 with narrow band of Investors. SARFAESI Act, 2002 allowed banks to ease on the mounting pressures of NonPerforming Assets (NPA) in their portfolio. Securitization has become one of the disposition strategies for the banks since then. Earlier the banks used to move to the debt recovery tribunals to recover the debt in case of default which resulted in significant amount of funds getting locked in the process. A speedy mechanism was required for banks to recover their debt without going through the stringent requirements of foreclosure of the assets. SARFAESI act of 2002 made provisions for registration of securitization companies (SC) and asset reconstruction companies (ARC) in India. Banks would ei-

Securitization has come to rescue many NBFCs and Micro financial institutions (MFIs) offering many benefits

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July 2011

concentrate on their core business while maximizing recovery value of the assets transferred because the ARCs are expected to have industry expertise in loan resolution. The SPVs in order to attract the investors can do credit enhancement of their securities through external sources like surety bonds, third party guarantees and letter of credit. Credit rating agencies like CRISIL, ICRA, etc, have started rating the securities issued by the SPVs. The highest credit rating securities easily catch the eye of the investors to invest in. The cost would be normally about 25 to 50 basis points higher than a 30 to a 60 day commercial paper for a highly rated security with a safe underlying asset in the balance sheet of SPV. Companies started using securitization for a several asset classes - lease rental receivables (L&T), aircraft receivables (Jet Airways), sales tax deferrals (Govt. of Maharashtra), power sector receivables (Karnataka power Sector), sovereign lease receivables (Indian Railways), etc. In India, the role of securitization is widely increasing as companies are finding it a potential source of debt financing. Interestingly, micro finance institutions too have participated in securitization and companies like IFMR capital have been specializing on it. It is to be remembered that in most of the micro finance loans, there are no asset back up in case of default. It is just through word of mouth that most of the loans are disbursed. The return is proportionate to the risk profile in these institutions. Securitization is proven to be a source of debt for these institutions. When the MFI sell their debt portfolios to the SPVs, the latter can enhance the credit rating of its securities from external credit agencies. Agencies like CRISIL rate these securities

FinSight

ther sell or lease the financial assets (e.g., Mortgage loans) to the SCs and ARCs for a purchase consideration. The financial assets sold can be either existing loans in the bank’s balance sheet or the NPAs in the disclosure of Annual statement. The process would completely transfer the assets from the balance sheet of the bank to the ARC’s. This process is called “true sale” in securitization if there is no recourse option available for the ARCs. Generally, the purchase consideration would be negotiated based on the valuation done by the ARCs. The ARCs in return would either try to dispose the assets or would hold it in anticipation of potential cash flows. They may also raise funds from the Qualified Institutional Buyers (QIB) by issuing securities and giving the investors the right of interest in the underlying assets. The above process can be technically explained through securitization. The banks that sell their loans through “true-sale” concept are called originators. The ARC will setup a bankruptcy remote entity called special purpose vehicle (SPV) to hold the sold bank’s assets in its balance sheet. The SPV would act as a separate entity in the eyes of the law. The SPV would in turn issue securities to the investors like mutual fund companies and FIIs, giving them the right of interest in the underlying assets (e.g, mortgage loan). The banks get benefit firstly in terms of immediate liquidity as the sale is mostly through cash consideration, secondly as a capital relief for the business as this acts as a source of funding and thirdly as a relief from regulatory issues instead of going through the debt recovery tribunals for debt recovery. Banks are also able to

The banks get benefit in terms of immediate liquidity, a capital relief for the business and as a relief from regulatory issues © FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

FinSight

based on the history of payments, probability of default, credibility of the originator and various other factors. The investors would be interested in investing in securities of higher credit rating of this type as they are expected to give much higher return than most of the debt market instruments. If the micro finance institution is able to perform efficiently, then securitization would serve an efficient source of funding for MFIs. Unlike in US, mortgage backed securities are not popular in India but asset backed securities are. Investors like mutual fund companies need to list their NAVs on daily/weekly basis and hence would require low re-payment in securitization. 12 to 18 months would serve as a good duration for investors of this kind. The rational investor wants to look for a considerable return and based on the market performance in the next financial year, their investment plans might change. The micro finance loans securitization mentioned above are mostly of 1 year duration. Few regulatory norms have also encouraged companies to source funds through securitization. Gold loan market in India is one such area where the recent regulation from RBI had stated that loans by banks to gold loan companies would be removed from priority sector lending. Incidentally, almost all the major gold loan companies have had about 50% of their source of debt from banks through priority sector lending. In the late 2000s, the cost through priority sector lending was about 8 to 9% and now all the companies in the gold loan business have to face a hike in cost of about 250 to 350 basis points. As an immediate reaction to this, companies have been seeking to increase their debt portfolio in non convertible debentures and commercial papers up to a limit allowed by credit rating agencies. Manappuram, the second largest private company in the gold loan market has sorted assignment/securitization as a source of raising funds. The cost of funding through securitization is expected to

be less than that of a bank loan without priority sector advantage. This new source of debt would help the company keep its cost of debt as low as possible. Securitization in gold loan market poses few challenges compared to other conventional asset backed security market. The nature of loans in the gold loan market is likely to be of short duration. The average duration of the gold loans as reported by major players: Muthoot Finance and Manappuram, is about 90 to 100 days. The investor who wishes to have his funds locked for say 12 months would not be interested in this security as there would be reinvestment and prepayment risk. To attract the investor a higher yield than a normal asset backed security would be required. It is important to note that the cost of debt even with a premium for re-investment and pre-payment risk would still prove beneficial to companies like Manappuram as the cost are expected to be less than that of a bank loan without priority sector lending. The Indian financial market has not been able to realize the full potential of securitization due to several structural and legal impediments. But still new asset classes like MFI loans and the gold loans are opening up and the companies have found securitization as an efficient source of funding. With regulatory ease, more investors would be expected and more asset classes are expected to open up for securitization.

The Indian financial market has not been able to realize the full potential of securitization due to several structural and legal impediments 10

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RBI’s Monetary Policy Tightening Deepak Agarwal & Manish Manhar

RBI’s Dilemma The RBI can control at the most only 2 variables of impossible trinity. RBI’s reaction to these variables is provided below: 1. Core Inflation Inflationary pressures in India were initially triggered by a supply shock from poor monsoons in 2009, which led to a rise in food prices. In addition, rising oil and commodity prices too exerted pressure on inflation. This warranted monetary tightening, which the RBI initiated through a 25 basis points hike in March 2010. 2010-11 ended with WPI inflation at 9 % as against the revised target of 8 % despite eight rate hikes totalling 200 basis points by March 2010. Of late, inflation has become generalized, with rising core inflation and upward pressure on wages. Against this backdrop, there was hardly any doubt that the RBI will continue to raise rates. The RBI chose the tactic of increasing rates in baby steps with a sharper 50 ba-

sis points rate hike in repo and reverse repo rates. Outlook There appears to be no respite from inflation. Besides the supply-side now even the demand-side pressures have exacerbated sharply. Though food inflation has moderated somewhat; it still remains at an elevated level. Inflation will remain high in 2011-12 and outside RBI’s comfort zone, reflecting strong persistence. Upside risks persist from higher commodity, food and metal prices. Therefore, we expect average inflation in 2011-12 to be in the range of 7.5-8.0 %. 2. Interest Rates The Reserve Bank of India (RBI) hiked the repo rate by 50 basis points (bps) to 7.25 % in its annual monetary policy on May 3, 2011. With a change in the operating procedure, the reverse repo rate would be fixed at 100 bps below the repo rate and the marginal standing facility (MSF) rate at 100 bps above it. Future Projection It’s expected that the global economic recovery would not stall but the pace will come down most importantly when the United States has stepped up its efforts to bring down the fiscal deficit to 4.1 % by 2014. Nevertheless, the real economic output could remain under pressure due to the effect of increasing government debt. Provided herein is India’s stock of money for the last three fiscal years, which is above 20 %. However, it is now falling significantly back to 15 %, and it shows the RBI’s action in policy rate is working, which means the monetary policy has a certain effect on the core inflation problem and would make an impact on the demand side but it is not sustainable as the government’s borrowing plans are on track.

IIM Bangalore

Over the past year RBI has tightened its monetary policy in order to tame inflation which had increased to uncomfortable levels. With the inflation showing no respite, the RBI has a tough task ahead to manage the interest rates, inflation and economic growth in the country.

Perspective

According to the RBI the new monetary tightening policy has been formulated on the basis of 3 factors 1. The ever increasing commodity prices 2. Fluctuations in Inflation 3. Expectations of demand reducing In reaction to these rate hikes, the benchmark 7.80 %, 2021, bond yield rose by 2 basis points to 8.35 % after the policy announcement, the benchmark 5-year swap rate was broadly unchanged at 7.72 % after falling sharply before the policy announcement, the 1-year swap rate too held its ground at 7.99 %. Also the main share index was down 0.4 % and was indifferent to policy measures. After having a look at these market sentiments lets analyse the current scenario and the reasons behind the same.

GDP at factor cost Agriculture, Forestry & Fishing Industry Mining & Quarrying Manufacturing Electricity, Gas & Water Supply Construction Services THTC FIRB CSPS

2009-10 8.0% 0.4% 8.0% 6.9% 8.8% 6.4% 7.0% 10.1% 9.7% 9.2% 11.8%

2010-11 8.5% 6.6% 7.9% 5.8% 8.3% 5.7% 8.1% 9.4% 10.3% 9.9% 7.0%

2009-10 2010-11 GDP at factor prices PFCE GFCF Exports less Imports Gross Domestic Capital formation GFCF Change in Stocks Valuables Discrepancies

9.1% 7.3% 16.4% -5.5% -1.8% 13.8% 7.3% 90.8% 54.2% -133.6%

8.8% 8.6% 4.8% 17.9% 9.2% 9.3% 8.6% 7.4% 24.8% 473.0%

Perspective

Fig 1. Permanent increases in the monetary base foreshadow eventual increases in inflation that can increase, rather than reduce, unemployment.

Lower money supply has side effects too as it will increase the cost of credit further, and it will reduce the access to credit. Moreover, the stock markets could not function properly in this environment since the economic activity is hit and will eventually reduce the value of people’s savings. However, the RBI has only one choice - tight monetary policy to tame inflation by giving up the India’s ambitions of double digit economic growth. 3. Economic Growth Rate and Unemployment GDP growth slows to 7.8 % in the fourth quarter of 2010-11. For 2010-11 as a whole, gross domestic product (GDP) grew by 8.5 % from 8.0 % a year earlier due to better performance of agriculture, construction and financial services. However, on a quarterly basis, GDP growth weakened. It hit a 5-quarter low of 7.8 % in the January-March quarter. Despite this, GDP growth is expected to moderate in 2011-12 to 7.7-8.0 % due to high inflation and rising interest rates. Together they are expected to pull down investment and consumption growth. Agriculture, in spite of a normal monsoon, will decline due to high base. Current Scenario India currently is struggling from inflationary spiral in which due to rising inflation central bank has taken anti-inflationary stance and due to its policy domestic growth has taken a hit. All major indicators are hinting for inflation from all directions. Recent developments are discussed here.

In its mid quarter monetary policy review RBI has stated its anti-inflationary stance. It has indicated clearly that it is ready to forego some growth in short term in order to control inflation which currently stands at 9.06% in May, almost double the tolerable limit. Inflation is still outside the comfortable zone despite raising key rates more than 10 times since June 2010. RBI has even advised banks to come up with better risk management capabilities as there might be deterioration in asset quality due to high interest rates. Despite raising key rates again and again inflation level remains at uncomfortable level. Wholesale price based food inflation was at 9.13% in June. It is increasing despite having a high base of 22.93% last year that translate to overall increase of 32% in two years and thus showing a very grim picture. Government’s decision of increasing diesel price by Rs 3 is going to add more fuel to inflationary fire. This increment in justifiable in the light that international crude prices has stayed above $100 since last June and as per analysts there is very little chance of it coming down. Experts say this increment in fuel price is going to add 60 to 70 basis points to headline inflation . Non-food manufacturing inflation was at 8.5% way above the medium term trend of 4%. This is cause of concern because of first its non-volatile nature and second this clearly shows that finally from suppliers and producers the costs are being passed on down the chain.

However, the RBI has only one choice - tight monetary policy to tame inflation by giving up the India’s ambitions of double digit economic growth 12

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es in world economy. 2. Government Outlook of the Policy The finance minister said a tight monetary policy over an extended period could impact the country’s economic momentum – ending up by moderating growth rate. Due to the rate hikes the investment decisions might be postponed – affect is already being seen in the Real Estate and Auto Industry. The govt experts are of the view that RBI should wait for some more global data before taking any further decisions on the same. Views on Government expenditure The central bank’s ability to control inflation and inflationary expectations is influenced by the stance of the fiscal policy. Excessive government expenditure used to prop up consumption demand, rather than investment (creating productive assets), runs the risk of rising demand beyond the potential of the economy, thus pressuring inflation. While government expenditure growth has slowed down in recent quarters, the fiscal stimulus that had been undertaken during 2008-09 and 2009-10 when private consumption demand, which accounts for close to 60 % of aggregate demand, led to a sharp increase in nominal income sharply, there raising risk to inflation, as consumption demand outpaced supply potential, especially in agriculture. Fiscal stimulus focused on investment tends to raise the supply potential of the economy, thereby exerting downward pressure on inflation.

Perspective

Policy Makers on the Current Scenario 1. RBI Policy In its mid-quarterly monetary policy review RBI has clearly mentioned its anti-inflationary stance. There are chances of increasing rates further by 50 basis points in next one or two months due to recent increment in fuel prices. RBI has clearly stated that slowdown in short term in unavoidable since headline inflation is still outside the comfortable zone. RBI has indicated the inter-linkage of Indian economy with international macroeconomic changes poses risk. Sovereign debt risks are still looming and growth is moderating in due to fiscal consolidation stance of many countries. Still high commodity prices in international market and oil prices will be reflected in inflation numbers in emerging market economies. Lead indicators such as GDP numbers, IIP numbers all are indicating a slowdown in near term. IIP number also tells a different story; new base of 2004-05 reveals growth of above 8% in both halves in this year while as per old base it showed a deceleration of 5.5% from 10% in second half from first half. So somewhere a doubt creeps whether these all number games are due to different bases. The effects of monetary actions taken by RBI are showing some impact. Recent data for month of June has shown that one of the interest rate sensitive area Automobiles has shown decline in growth rate. All the major 11 manufacturers has shown decline in sale of 4% due to increase in interest rates as well as high fuel prices. In international market prices of commodities eased up that will give a relief to Indian firms . So on 17th of June when RBI increased rates for 10 time in last 15 months, it reflected a sense of panic in RBI’s actions to control inflation. They should have waited for their earlier moves to show some result before going ahead with this increment. This forecast of below normal monsoon will further fuel expectations and will nullify the effect of increase in interest rates intending to curb demand side inflation. So RBI has two fold challenge in front, maintaining its stance of anti-inflation as well as to keep the growth pace smooth in whole scenario of chang-

Conclusion Three things need to be kept in mind while assessing the impact of monetary tightening in the coming year. Firstly, the monetary policy impacts inflation with a lag, which could be as long as a year. So the tightening that was initiated since March 2010 is likely to come into effect in the current fiscal. Secondly, the inflation-reducing effect of interest rate hikes also depends on the fiscal stance. This implies that the fiscal deficit should be kept under control to complement the RBI’s demandmoderating actions. And last, the behaviour of commodity prices and food inflation (contingent on monsoon patterns) will be critical in shaping the inflation trajectory. Luckily or unluckily none of these factors can be controlled by monetary tightening.

RBI has two fold challenge in front, maintaining its stance of anti-inflation as well as to keep the growth pace smooth in whole scenario of changes in world economy © FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

Cover Story

Regulatory Uncertainty in the Microfinance Industry

Jayant kejriwal & rajat Sethia

Team Niveshak

The developments in Andhra Pradesh which is the hub of microfinance industry in India over the past six months have clearly demonstrated the impact of political risk on the MFI industry. The present story analyses the draft MFI bill posted by Ministry of Finance recently, its implications and the way ahead for the industry.

Introduction The Indian microfinance sector presents a strong growth story. Its growth performance was impressively sustained through the liquidity crunch and continued at an increased rate thereafter. As of March 2011, the MFIs in India reported a client base of 24.8 million with an outstanding portfolio of more than $2 billion. Over the past five years, the sector has delivered a CAGR of 86% in the number of borrowers and 96% in portfolio outstanding. The fiscal year 2011 was a landmark year for the Indian microfinance industry. With SKS completing an Initial Public Offering, the Indian microfinance industry has for the first time successfully tapped the public capital markets. During the first half of the year, the industry

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continued its growth path, but in the second half the industry faced regulatory constraints emanating from the Government of Andhra Pradesh. This led to a reduction in the industryâ&#x20AC;&#x2122;s disbursements and consequently loan book. The AP-MFI act hindered microfinance operations in the State, which until then was the role model state and accounted for nearly 40% of the industry. The AP MFI Act, which was aimed at curbing irresponsible players in the sector, increased regulatory uncertainty as it was unclear whether the MFIs should follow the State Government Act or the RBI guidelines. The RBI set up the Malegam Committee to look into all aspects of microfinance. The committeeâ&#x20AC;&#x2122;s report effectively addressed all concerns regarding microfinance

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stop paying their loans, making it illegal for the micro lenders to ask for weekly repayments and also required them to get a no objection from the local authorities before providing for a second loan to a borrower, bringing a jolting halt to the Rs. 20,000 crore industry in India and exposing the inherent problems in the sector. In the wake of the Andhra Pradesh micro finance crisis in 2010, concerns were expressed by various stakeholders and they felt there was a need for more rigorous regulation of non-banking financial companies functioning as micro finance institution. The Malegam committee was constituted to study issues and concerns in the MFI sector. The Committee submitted its report in January 2011 in which it recommended (i) creation of a separate category of NBFC-MFIs; (ii) a margin cap and an interest rate cap on individual loans (iii) transparency in interest charges (iv) lending by not more than two MFIs to individual borrowers (v) establishment of a proper system of grievance redressal procedure by MFIs and (vi) continuation of categorisation of bank loans to MFIs, complying with the regulation laid down for NBFC-MFIs, under the priority sector. After discussing the recommendation with all the key stakeholders, RBI accepted the broad recommendations of Malegam committee, subject to certain adjustments. More recently, the Ministry of Finance posted draft legislation governing the microfinance industry where it has proposed RBI as the sole regulator of the microfinance industry. The legislation aims to supersede all the local rules – including the stringent law passed by AP Government last year. The Micro-Finance Regulation Bill The Microfinance Institutions Development and Regulation Bill, unveiled recently, envision a larger regulatory role for the Reserve Bank of

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as it suggested that the RBI should be the sole regulator for NBFC-MFIs, re-emphasized the priority sector status for microfinance and laid out detailed guidelines on operational aspects as well. The Ministry of Finance recently posted draft legislation for the microfinance industry which the industry welcomed and the only listed company SKS Microfinance rallied in the stock markets. The present story deals with the draft legislation, its implications and the way forward for microfinance industry. Background The origin of Microfinance in india can be traced back to the early 1970s when the Self Employed Women’s Association (SEWA) of the state of Gujarat formed an urban cooperative bank, called the Shri Mahila SEWA Sahakari Bank, with the objective of providing banking services to poor women employed in the unorganised sector in Ahmedabad City, Gujarat. The microfinance sector went on to evolve in the 1980s around the concept of SHGs, informal bodies that would provide their clients with much-needed savings and credit services. From humble beginnings, the sector has grown significantly over the years to become a multi-billion dollar industry, with bodies such as the Small Industries Development Bank of India and the National Bank for Agriculture and Rural Development devoting significant financial resources to microfinance. Today, the top five private sector MFIs reach more than 20 million clients in nearly every state in India and many Indian MFIs have been recognized as global leaders in the industry. Microfinance industry had recently come under the scanner when the Andhra Pradesh(the State that accounts for nearly a third of microfinance business in the country) government passed an ordinance calling the borrowers to

As of March 2011, the MFIs in India reported a client base of 24.8 million with an outstanding portfolio of more than $2 billion © FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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India and propose that all microfinance institutions with net-owned funds of over Rs.5 lakh should register with it. The RBI will define and fix what the Bill calls “an annual percentage rate”, to be charged by private MFIs, and also set the range within which it can operate. That rate will include interest, processing fees, service charges and any other charges or fees that are payable by the borrowers. To ensure that the charges are not excessive, the RBI will stipulate that the rates should operate within the ‘percentage of margin’ to be decided by the apex bank. The Bill attempts to create an overarching structure that would include NABARD, the agency that currently oversees the microfinance sector. RBI proposes to cap the sums MFIs can lend to each individual. For instance, even as MFI can lend a maximum of Rs 50,000 to a customer, the repayment period is high at two years, which means this customer cannot be lent more funds till then. MFIs also cannot diversify to other areas as there is a strict criteria that 75 per cent of the loans should be allocated to the collateral free income generation segment. The Bill has also proposed a ‘Micro-Finance Development Council’ to frame policies, schemes and other measures for orderly growth of the sector. Vijay Mahajan, the founder of Basix Microfinance says, “The Bill achieves the golden mean between affordability for the borrowers and sustainability for the providers. If this had come about in 2006, there would have been no malpractices of the kind we have seen in the sector.” Implications After the AP government passed stringent laws against microfinance companies and loan recovery mechanisms, the growth of MF industry was hit hard. Loans worth crores of rupees (around 7000 crore) could not be recovered. Banks and PEs refused to lend to MFIs for fear of under recoveries or charged very high interest rates up to 18-20%. Now, the fact cannot be ignored that Micro-finance could empower rural India and is one of the biggest means of attaining financial inclusion in the country. It empow-

ered women and encouraged them to take loans for productive purposes. The RBI sensed that some intervention was needed at this level to bring fresh blood to the sector and hence came up with the regulation bill. The bill proposes the RBI to be the sole regulator for the industry, with of course NABARD and state governments at the backdrop. The bill defines entry norms for companies into the industry, interest and margin caps, and loans roll out pattern and recovery norms. It has brought much relief to the sector, as they are sure of the regulations and the regulatory body. It has come at a much needed time

Figure 1: Shares of SKS Microfinance rallied after the draft legislation came out

and can act as a boost for the sector. The current move can be positive for the banks as well as they have around Rs 20,000 crore of exposure to MFIs. If the lending and repayment cycle for MFIs resumes, they may have a better credit standing with banks. But given the low threshold for registration envisaged under the Bill, the number of MFIs that will come under the regulatory scanner may be too large for any meaningful supervision. Another problem with capping the interest rates low is that it will push the small MFIs out of business who don’t have scale to bring down costs. If the Bill hopes to create an enabling environment for the microfinance sector, involving too many agencies may be counter-productive. Even if the RBI becomes the sole regulator of the sector, the fallout of coercive recovery practices including suicides is a subject that has to be addressed

If this had come about in 2006, there would have been no malpractices of the kind we have seen in the sector

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FIN - Q JUNE 2011

20 F and 6 K

IPO

Centurion Bank

Economy

The first Indian woman CEO of a Foreign Bank

John Bogle

Sundaram Finance

Payment Float

SERI International Finance Limited.

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by the state. The amount of additional work that is required to monitor the sector constantly is huge, and may be a tough task for the RBI. Way Ahead From industry perspective, it’s definitely a much welcomed and awaited move. Though the AP government has already raised concerns over the validity of a lot of provisions in the bill, it would be interesting to see how it folds up finally when it’s put into execution. Also important would be to see whether treating MFIs as extended arms of banks can help in actually financing them. Another interesting observation would be how many MFIs could survive the low margins and stringent recovery norms. As it is, SKS investors have given a thumps up to the bill, with the stock hitting the ceiling twice within the same week, one thing to look out for would be how many more MFIs would line up to raise public money for lending purposes. The future may be bright if the RBI continues to keep its hold over the sector. Conclusion The strength and sustainability of the Indian microfinance business model lies in the fact that it is serving a large unmet need for financial inclusion. It has thus far successfully tackled challenges that have been faced other financial service providers in meeting the demands of this sector through creative product innovation with awareness of the segment’s particular needs and capacities and use of the joint liability group mechanism to manage risk. The model has been successful in maintaining excellent portfolio quality even with extremely rapid expansion over the last few years. The large size of the currently unbanked population in India and diversity of geography means that the microfinance sector has great potential for continued high growth. With the right policy support from the Government, the sector will flourish and help in mitigating poverty and promoting livelihood among the poor people.

10. Money spent towards the pay ment of influential persons

The current move can be positive for the banks as well as they have around Rs 20,000 crore of exposure to MFIs

As Niveshak enters its fourth year of existence, we plan to come out with a special issue featuring analysis of various Indian Sectors. For this purpose, we invite Sector Analysis Reports for the Anniversary Edition of Niveshak. The sectors should be chosen from the topics on the next page:Following Guidelines must be adhered to while submitting your entries for the event• Please send all the relevant excel files, if any • The report should be a minimum of 5 pages and maximum of 7 pages The Sector Reports can be tentatively structured around the following points. These are only indicative points and other points specific to a particular sectors can be included in the Report. • Introduction • Major Players • Major Segments within the sector • Current State o Industry Concentration o Trends o Pricing Power/Price Competition o Industry Capacity o Market Share Stability o Industry Lifecycle • Macro and Micro Environment • Industry Driver and Challenges • Competitive Analysis • Financial Analysis

H S up A C izes s. r R / P to 00 0 , 0 1

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Perspective

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nIVESHAK Anniversary Edition

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Chemicals

Capital Goods

Power

Telecom Banking and Financial Services Automobiles Pharmaceuticals

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Oil & Gas FMCG

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ÂŠ FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

CDS arrives in India Nilesh Anandpara & Mukta Sagar Rakshit

NMIMS Mumbai

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The Reserve bank of India came out with Credit Default Swap (CDS) guidelines to allow corporate entities to hedge against their bonds. Given the “popularity” of CDS after 2008 crisis, several issues and concerns have been raised that have to be addressed in future.

What is a Credit default swap (CDS)? A CDS is a privately negotiated bilateral contract that serves as a kind of insurance against credit risk. The buyer of protection pays a fixed fee or premium to the seller of protection for a period of time and if certain pre-specified “credit event” occurs, the protection seller pays compensation to the protection buyer, thus insulating the buyer from a financial loss.

ing credit risk on corporate bonds. Such entities are not permitted to hold credit protection without having eligible underlying instrument as a hedged item. Users are also neither permitted to sell protection nor permitted to hold short positions in the CDS contracts. However, they are permitted to exit their bought CDS positions by unwinding them with the original counterparty or by assigning them in favor of buyer of the underlying bond. Users as defined by RBI include Commer-

Figure 1 : Working of CDS, Source : RBI

A “credit event” can be a bankruptcy of a company, called the “reference entity,” or a default of a bond or other debt issued by the reference entity. If no credit event occurs during the term of the swap, the protection buyer continues to pay the premium until maturity. There are two categories of participants in CDS: • Users: Entities permitted to buy credit protection (buy CDS contracts) only to hedge their underly-

cial Banks, PDs, NBFCs, MFs, Insurance co., Housing Finance cos. PFs, Listed Corporates and FIIs. • Market-makers: Entities permitted to quote both buy and/ or sell CDS spreads. They would be permitted to buy protection without having the underlying bond. Market makers as defined by RBI include Commercial banks, standalone PDs and NBFCs. CDS on Indian companies’ US$ denominated bonds are active in

The RBI, on May 24, 2011, came out with guidelines for plain vanilla OTC singlename CDS for corporate bonds in India 20

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lend more than the gross exposure limit by hiving off risky assets from their balance sheet. This will spur the activity in the bond market as investors will be able to hedge the credit risk component. However, the assumption that CDS market will help bring about better price discovery of corporate bonds is debatable. While CDS spreads can be known, it is difficult to estimate the extent of the spread attributable to liquidity and credit components of risk. GILTS traded comprise around 80% of the secondary market trades, compared to trades of AAA and AA+ corporate bonds. Until the corporate bond market becomes vibrant, it is a little premature to believe that we are going to get active trading in bond markets. The issue of illiquidity in the corporate bond market cannot be effectively addressed by CDS. As Mr. S Gopinath, former Dy. Governor, RBI pointed out, availability of cheaper external commercial borrowings is one of the several reasons for failure of domestic corporate bond market to take off in India. RBI’s draft guidelines specifically emphasize that CDS may be written on corporate bonds issued by special purpose vehicles SPVs of rated infrastructure companies. This is expected to boost the flow of funds to infrastructure projects. However, due to the execution risk involved, banks clearly won’t invest in the infra sector, where around 90% funding comes from government. CDS is an enabler and not the solution per-se for problems afflicting the infra space. As per Parekh Committee Report on the India Infrastructure Debt Fund, comprehensive financing norms, insurance and pension reforms coupled with participation of large insurance companies and public sector banks would be critical in boosting this sector. Has RBI been cautious enough? The decision of RBI to introduce CDS in a calibrated manner is a result of learning from the financial crisis of 2008. During the peak of the financial crisis, the notional value of debt on which protection had been bought and sold was several times the outstanding value of debt.

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the US, UK and Singapore financial markets (e.g. ICICI, Tata Motors, Reliance Industries, Bank of India, SBI, IDBI bank). Indian entities are a part of the CDS market indices - like ‘Markit iTraxx Asia Ex-Japan’. CDS in India The RBI, on May 24, 2011, came out with guidelines for plain vanilla OTC single-name CDS for corporate bonds in India that would allow users and market markers (with sound financial and good track record) to participate in CDS from October 24. Following are some of the important guidelines: 1) The capital adequacy requirement (CRAR) for banks has been brought down by 1% to 11% and the requirement of core capital has been brought down by 1% to 7%. 2) NBFCs and primary dealers (PDs) will require a minimum CRAR of 15% and minimum net owned funds of Rs 500 cr. 3) Banks and NBFCs that desire to use CDS should not have net non-performing assets (NPAs) above 3%. 4) Foreign institutional investors (FIIs), MFs, insurance companies will be allowed to buy credit protection only to hedge their credit risk as users. 5) CDS will be allowed only on listed corporate bonds as reference obligations. CDS can also be written on unlisted but rated bonds of infrastructure companies. Besides, unlisted/unrated bonds issued by the SPVs set up by infrastructure companies are also eligible. 6) Users would not be permitted to hold naked positions (CDS position without the underlying bonds) Impact of CDS on Indian Corporate bond market CDS on corporate bonds are believed to increase the depth of this market. Take for instance, a bank that has reached the group or individual exposure limit for a particular corporate can buy protection for a specified amount. Thereby it can

RBI guidelines are too restrictive from the buyers’ perspective as they don’t allow CDS buyers to unwind the protection by entering into another offsetting contract © FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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Figure 2: CDS Position of Institutions

It is mandatory for the CDS User group entities to have real underlying exposure to the corporate debt on which they seek protection. For instance, one needs to hold L&T issued debt to buy CDS written on it. This constraint aims at preventing speculation. Restrictions on naked CDS positions (taken without underlying exposure) would mean that the spreads on CDS may be higher. However, this higher spread to lower the risk element is justified. Concerns with the current form of implementation • Contract Unwinding Restrictions RBI guidelines are too restrictive from the buyers’ perspective as they don’t allow CDS buyers to unwind the protection by entering into another offsetting contract. CDS protection cannot be sold by the buyer to another party and has to be unwound only with the original counterparty. This makes it cumbersome to unwind the CDS contract. • Credit Risk Flow Paradox – Net CDS Buyers and Sellers Hedgers and speculators that offset each other lend vibrancy to CDS market. This helps in minimizing the CDS spreads and improves liquidity in bond markets. However, market infrastructure and regulation are required to keep excessive

build-up of net positions in CDS in check, as evidenced in the global financial crisis [AIG & other insurance firms being net CDS protection sellers]. RBI guidelines stipulate that User Entities can buy and Market-Maker Entities can buy and sell CDS. The paradox is that – research and surveys indicate [see figure 2] exactly opposite credit risk flow observed in global CDS markets. Banks and PDs are net CDS buyers as they are exposed to corporate credit risk, whereas insurance companies and MFs in search for spreads over risk-free rates, end up being net CDS sellers. Imposing selling restrictions on them, hampers both CDS market depth and bond market liquidity. • Financial Firms’ Risk Management By placing CDS buy/sell position restrictions, speculative short positions will remain with banks and PDs, which are primarily long on credit risk due to their intermediation activities. Standardization of financial firms’ risk management across RBI, SEBI and IRDA is a better approach, opines NYU Prof. Viral Acharya. The way forward would be – [a] Audit hedge positions and exempt them from margin requirements (except for basis risk due to maturity mismatch) [b] Levy upfront and variation margins on speculative positions on daily basis and [c] Impose concentration limits on corporations relative

Under RBI guidelines, bilateral margining of CDS positions market participants is allowed.

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• Bilateral Margining – Systemic Risk Concerns Under RBI guidelines, bilateral margining of CDS positions market participants is allowed. Global experience from financial crisis has shown that bilateral margining does not adequately reflect systemic risk concerns. (Guideline 4.1.1 mandates market-makers to report their CDS trades on reporting platform of CDS trade repository. Also there is CDS Form II – Fortnightly Regulatory Reporting, stating Net Position, among other things.) Since the overall CDS positions disclosure would be to RBI, and not to all market participants, banks wouldn’t know the appropriate margin they should charge to counterparty. So also, the margin disclosure requirements do not contain information on the collateral being posted on positions. Therefore the regulators would not be able to ascertain potential exposures of marketmakers and the build-up of systemic risk. • ARCs Role The exclusion of Asset Reconstruction Companies (ARCs) and other entities dealing in distressed assets also needs to be addressed. In the event of default, these companies would help in price discovery. Conclusion RBI’s calibrated attempt to introduce CDS on corporate bonds is praiseworthy. It would definitely help boost bond market depth but it would be naïve to consider it to be panacea for this market. Also, given the above mentioned concerns, CDS market would take off gradually with active participation and consultation of the market participants and regulators.

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to their capital and liquidity and overall CDS positions to mitigate their “jump to default” risk. • CCP’s Role Globally, markets are moving towards central clearing [CCPs, central counterparties] of standardized CDS contracts to mitigate counterparty risk and provide additional transparency. Also, CCP is able to observe all positions and impose position limits accordingly. In US, the Dodd-Frank Act further prescribes e-trading of CDS. RBI’s guidelines don’t make provision for either of the above, though technical committee recommendations point in this direction. As seen from Asian markets, in the initial phase, when liquidity in the market is low, the CCP would not have enough collateral to guarantee trades. If it charges high margins to tackle this problem, high transaction costs would deter market participants. Thus, though CCPs help limit counterparty and settlement risks which are inherent in OTC markets, RBI is correct in not enforcing it right away. Initially, CCIL can operationalize the settlement on a non-guaranteed basis. (CCIL already acts as CCP for FOREX forwards and short duration swaps) • Credit Event Restructuring Though the Internal Group Draft report recommended exclusion of restructuring as a credit event in the earlier stage, RBI guidelines allows restructuring as one of the credit events. ‘Restructuring’ needs to be approved under BIFR, Corporate Debt Restructuring CDR mechanism and corporate bond restructuring. The definition of various credit events are to be defined by FIMMDA in the bilateral Master Agreement. In US and Europe, CDS contracts typically trade with ‘Mod R’ and ‘Mod Mod R’ convention respectively. Recent financial crisis has made US industry to consider dropping restructuring as a credit event altogether. Indian CDS market would be served well if restructuring credit event is left out initially, considering the issues involved with it.

RBI guidelines allows restructuring as one of the credit events.

Will interest rate deregulation benefit the common people?

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Ankush gupta & Ankush saraf

The deregulation issue so far has been a double-edged sword for the Central Bank and that is probably the reason they have issued a notice inviting public opinion on the same. High rate of interest can be possible even by maintaining all accounts online as has been adopted in Australia.

IIM Shillong

Mr. X considered himself a very smart guy. He used to plan and loved to execute his plans even for the most trifling things in his life. So when it came to his only child’s college education, how could he falter? He wanted his child to study management in a premier institute. So, he asked an IIM student about his cost of education and started collecting money in the bank’s savings account. He garnered a whooping million rupees which was the fees during his time for the education. But Mr Planner did a mistakehe didn’t account for the time value of money. By the time his son reached college, his father’s hard earned money couldn’t support him. Mr. X worked very hard throughout his life only to be cheated by the savings account rate. Savings accounts is generally defined as the account maintained at any credit institution or bank where money is deposited and fixed rate of interest is earned. There has been this general tendency in Indians that we have to work hard and save more money in the bank for a comfortable future. It is this thinking that drives Indians to be the world’s topmost savers of money. According to statistics, the share of bank deposits as a percentage of household financial assets in India is almost 54.9%. As of last financial

year a total of 302,831,224 lakh rupees have been deposited in the savings accounts alone across the country. Savings accounts are considered to be one of the most liquid forms of cash and are used extensively across the breadth of the nation. A whooping Rs.1, 53, 38,489 lakhs accounts stands for the testimony of this fact. Generally people maintain a savings account for two purposes – one is for transactions and the other for earning interest. If we talk about transactional aspect it is no doubt the cheapest in the world but earning interest - it erodes rather than add value to it. Savings account rate farce Consider the fact that for last two years average inflation has been in tune of 9% and if you consider the recent interest rate of 3% you are actually losing money. And to add to the fact the interest was earlier calculated on a monthly basis on the minimum sum between the 10th and last day of the month. If you make an analysis, the average interest rate comes out to be a mere 2.8%. Let’s assume that an individual deposits Rs. 100 in the bank. Let’s take two very extreme cases. Consider case 1 when the Mr. Dumb deposits money on the 11th of the month and withdraws it on the last day of the next month. For the 51 days when the individual keeps the money in

Generally people maintain a savings account for two purposes – one is for transactions and the other for earning interest. 24

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Savings Account) ratio in the Indian banking sector is one of the highest in the world and so is the Net interest margin (The margin between the interest rate of lent money and deposited money), so a hike in the interest rate can be easily absorbed by the industry. Lastly, the market itself will discover the price when left to it and will also improve the monetary policy transmission and will increase innovativeness of the markets. Advantages of Deregulation First and foremost, the advantages would be to the most naïve group of investors who don’t have the skill or time to invest their money in other instruments. Secondly, if market is deregulated it will create differentiation amongst all the players offering both automatically and axiomatically. Third, it will create new and customer oriented offering which will increase the customer satisfaction and will be beneficial to the customers in the long run. Fourth, it will bring some parity to the system where money when deposited gives a mere 4% and when loaned demands a whopping 12- 14%. The savings rate deregulation will also increase the financial inclusion in the country where only 54% of the population has a bank account and will also increase the saving tendency of the individuals to a further level. Pitfalls of Deregulation The savings accounts in the country offers a host of benefits like cheque book facility, physical withdraws, deposits and others. The cost of maintaining a savings account in the country is one of the lowest in the world. And as they say there is no free lunch, under such a scenario the rise in the savings account rate will in turn cause decrease in the quality of services offered or worse, cause an increase in cost of availing those services. According to the Managing Director of one of the leading banks of the country the Banks will pass on the rate hike and borrowers will have to pay more. Savers will not gain either because account maintenance and other charges will rise. The banks will pass on

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the bank the interest earned on it is surprisingly zero, so the bank enjoys this money for 51 days at no absolute cost. Now consider case 2 where Mr. Smart deposits money on the 9th of first month and withdraws it on the 1st day of the second month. For these 21 days he keeps his money in the bank, he earns a handsome 5.6%. Though these are two extreme cases, the average scenarios as acknowledged by RBI and BCSBI( Banking Codes and Standard Board of India) comes out to be a mere 2.8% and to add to the miseries these interests were credited on a quarterly or even half yearly basis. Although now the Central Bank has increased the savings rate to 4% and the daily interest rate calculation is also implemented but they are credited only quarterly or in worst case half yearly so there are no substantial benefits for the same to the common people. Why Deregulation? The investor class of senior citizens, pensioners, people in rural areas and people below poverty line have an exorbitant dependence on the savings accounts. In most of the cases savings accounts is their only investment avenue. Their interests are severely hampered when the rate earned is substantially lower than the average inflation of the country. Secondly, savings accounts rate is the only rate which is directly controlled by the government. Government doesn’t have direct covenant on any other banking rate. With over 300 scheduled banks, over 70000 branches, over 1,53,38,489 lakh accounts and 3028312,24 lakhs of deposit market in India, it is matured enough to handle the autonomy in terms of fixing the savings accounts rate. Thirdly, the banks already have differential services concept for the people maintaining minimum threshold of deposit over a period of time. Free Locker facility, small amounts of overdraft, free drafts and privileged customer status are just a few of them. So the concept of competition for the market share would not be new. Fourthly, the CASA (Current Account

The CASA (Current Account Saving Account) ratio in the Indian banking sector is one of the highest in the world and so is the Net interest margin © FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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their burden to the customers and the common man in the end will again be left with nothing in hand. Another major concern of the banks and the premise on which almost all the banks are opposing such a hike is the fear of increase in the Asset-Liability mismatch. As of now majority of the savings account deposits are channelled to the lending arms of the banks and since Net Interest margin are high, the banks obtain substantial benefits, but when the savings rate increases then in that case there are chances of liabilities increasing and worse a chance of increasing more than asset on the account of the loan defaults. A Way Out The deregulation issue so far has been a doubleedged sword for the Central Bank and that is probably the reason they have issued a notice inviting public opinion on the same. Deregulating or not deregulating both has its advantages and disadvantages. One of the things which banks can go for is that they could divide the savings accounts into two different types. First are those accounts where the amount of money deposited is above a threshold level. These accounts will have a limitation on the number of the transactions in a month, which in turn will decrease the operating costs of these types of accounts. Hence, a higher rate of interest can be proffered to these kinds of accounts. Such an experiment has already been started in the countries like UK and Australia where the savings accounts are mainly maintained on an online basis. No cheque books are issued and all the transactions are on online basis and even the physical presence of the people in the banks are not entertained. India with its growing broadband penetration is capable of handling such a transition. Another kind of accounts could be called the transactional

accounts where the people can freely come to bank and get their transactions done. Facilities like unlimited withdrawals, cheque book, ATMs and phone banking can be given to the customers. Since the cost involved for the banks will be more so the bank can offer low interest rates to the customers. This carrot and stick policy will work well in the country like ours where there are different strata of society and each stratum has different needs. Another way for the central banks is to tie up the returns of the savings account to a policy and optimum policy in this regard could be the reverse repo rate (the rate at which the central bank takes loan from the other banks). It will make more sense when the banks offer to the customers the returns linked to the rate at which they park their excess funds. Whatever step Central Bank takes, it has to be extra cautious because it would be a historical step in the history of the country. In times of financial uncertainty and all time high inflation they can they match up with the interests of people. Moreover, to prosper in a rising economy like ours, interest of both banking institutions and the common people should be served.

One of the things which banks can go for is that they could divide the savings accounts into two different types.

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CLASSROOM FinFunda of the Month

Capital Account Convertibility DEEP mehta

Team Niveshak

Sir, few days back I read that “India Development Report” released recently mentions something about “A calibrated approach to Capital Account Convertibility”. What is it? Yes, yes sure. Please be patient. I will tell you all about it.In any city, you see that there are traffic lights to regulate the flow of traffic. City planners have designed them to prevent people to control themselves from over-driving and being reckless. Similarly, RBI is the planner of our country’s currency mechanism and they have installed a tool called “Capital Account Convertibility” (CAC) to prevent investors from being in an over-drive mode. Got it?

Oh yes. Listen…Convertibility of a currency determines how easily capital can flow in or out of a country. A currency is fully convertible if it can be freely converted into currencies of other countries, and vice versa. If you walk into any bank and ask for dollars they would give it to you straight away in exchange for rupees – no questions asked! Fuller convertibility implies that you are free to take money in or out of your country without any restrictions. Similarly, a foreigner is also free to take his money in or out of your country without any restrictions. This creates super linkage between your domestic currency and other currencies – No roadblocks! Also, your markets are also more sensitive to currency fluctuations. Quite obvious, isn’t it?

Ok ok. So, in India we have some restrictions in place. Like? Today, CAC involves your transactions dealing with exports, imports, remittances, income, transfers,etc. However, reasonable restrictions in public interest are still imposed. For instance, a resident Indian can remit money only under the permissible limits. India currently encourages foreign direct investments in infrastructure and certain other sectors and foreign fund inflows into local stock markets. However, it has set a cap of $20 billion of foreign investments in corporate bonds and $10 billion in government bonds. I hope you are getting what I mean…

Classroom

You are creating all the more confusion and curiosity in me. Please sir, can you be more specific?

Stop.Stop.Stop. You are absolutely wrong! India does not have full capital account convertibility. In fact, it is more prudent for developing countries to have some control on capital. You should know that RBI was the first bank to propose CAC in 1997 in order to ensure Third world economies are able to transact with globalised market economies. But inflation, domestic markets, competition are all sensitive to capital inflows and outflows. India, too, is more vulnerable to any sudden stops or reversal of capital inflows than countries with current account surpluses as its foreign exchange reserves mostly comprise borrowed resources. We have a current account deficit of 3.4% up from 2.9% in the last fiscal. This is unsustainable. We do not have tight measures to restrict CAC as its just about enough to fund our deficit. But, in the longer run this is not going to be enough.

So, this means, our country, too, has been progressively moving towards greater capital account convertibility. Thanks a lot, sir. I am now no longer ignorant about these Greek. All of these jargon makes a lot of sense Oh wow! This means India has full now. See you later… capital account convertibility? And fuller convertibility leads to good business opportunities. Good markets.

FinLounge

FIN-Q 1.

Capital Employed is equal to _________

Hedge funds that invest in several other funds are called as____________.

An order which is activated when a price crosses a limit is _________ in F&O segment of NSEIL.

Ram feels bearish about XYZ Ltd. and sells ten one-month XYZ Ltd. futures con tracts at Rs.6, 00,000. On the last Thursday of the month, XYZ Ltd. closes at Rs.610. He makes a _________. (assume one lot = 100)

Ram took loan at interest rate of 15% per annum when expressed with annual compounding. What is the equivalent rate if Ram will take loan with continuous compounding?

The certain return providing the same utility as risky portfolio is called as___________.

Ratio of yield of top rated corporate bond to the ratio of intermediate bond is called as_______.

Where a commodities trade cancellation is permitted and trading member wishes to cancel a trade, it can be done only with the approval of the ___________.

What is the outstanding position on which initial margin will be calculated if Mr. Madanlal buys 800 units @Rs.1060 and sells 450 units @Rs.1055?

10.

In which market does a buyer & a seller do not know each other?

All entries should be mailed at niveshak.iims@gmail.com by 05th August, 2011 23:59 hrs One lucky winner will receive cash prize of Rs. 500/-

NIVESHAK

VOLUME 4 ISSUE 7

July 2011

ANNOUNCEMENTS

ARTICLE OF THE MONTH

The Article of the Month winner for July 2011 are Ankush Gupta & Ankush Saraf of IIM, Shillong They receive a cash prize of Rs.1000/-

Fin-Q Winner

The Crossword Winner for the month June 2011 is Pradeep S. of NITIE Mumbai He receives a cash prize of Rs.500/CONGRATULATIONS!!

ALL ARE INVITED

Team Niveshak invite Sector Analysis Reports for the Anniversary Edition of Niveshak. The sectors should be chosen from the following list- Oil & Gas, IT, Banking and Financial Services, FMCG, Capital Goods, Power, Telecom, Automobiles, Pharmaceuticals and Chemicals. References should be cited wherever necessary. Please send all the relevant excel files, if any. The report should be a minimum of 5 pages and maximum of 7 pages. Instructions »» Please email your sector analysis with file name and subject as <Title of the Report>_<Institute Name>_<Author’s name/Group’s name> by 05 August 2011. »» The report must be sent in Microsoft Word Document (doc/docx), Font: Times New Roman, Font Size: 12, Line spacing: 1.5 »» Mention your e-mail id/ blog if you want the readers to contact you for further discussion »» For other details check out page 18 of this issue.

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