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INVESTOCRAFT 2013


INVESTOCRAFT 2013


INVESTOCRAFT 2013

Letter from the Editor 2012 was a good year for the equity markets after a lacklustre performance in 2011. The issues that mired the markets in 2012 were homemade issues unlike in 2011 which was mired by Sovereign Debt Crisis in the Developed Countries. The government moved from the state of “Policy Paralysis” to a state of “Policy Impotence” and stayed in the same state for most part of the year. By last quarter of 2012, the government woke up from the long slumber. There was some action on the policy front such as allowing FDI in sector such as Retail and Insurance. With the elections approaching in 2014, the compulsions of keep the Growth story alive and kicking would be key driver to keep the reform process on and to be active in the policy front. Even in these times, states with good policies and encouraging governments such as Gujarat have been able to receive huge investments. The benchmarks returned more than 20 percent in the year 2012. The bond markets and flow of foreign funds indicate that equities could be headed for newer peaks in 2013 and a few years to come. The rate sensitive sectors such as Banks, Real Estate and Infrastructure could be the next big movers in the markets. However, the risks on account of effects of fiscal cliff and rating downgrade still exist. Other than equities, another asset class that is expected to witness good action would be the Real Estate Sector. The primary driver for the sector would be the faster GDP growth and softening interest rates. The sector has grown significantly in the last decade, but the growth in the next few years would be sustainable one with structural changes. There are significant policy reforms that are in pipeline such as the Real Estate Regulation Bill and Land Acquisition and Rehabilitation and Resettlement Bill. The Low Cost Housing is also expected to get a boost, with the Reserve Bank of India (RBI) allowing the real estate developers and housing finance companies to raise upto $1 Billion through external commercial borrowing (ECBs) for this purpose.

SENIOR EDITORIAL BOARD

MADUSUDANAN RAMANI (Editor-in-Chief)

ANKIT JOHRI

HARISH SV

PRIYA CHHABRIA

SNEHA AGARWAL

The 10-year bonds in India are yielding less than 8% for the first time in close to two years. Little effort from the government has brought a lot of confidence in the markets. State Bank of India CDS spread on its five-year bonds, which acts as a proxy of Indian sovereign bonds SIDDHANT ANTHONY JOHANNES (Layout & Design)


INVESTOCRAFT 2013 among foreign investors, has fallen from close to 400 basis points on June 1st 2012 to close to 200 basis points by end of the year. With foreign investors perceiving lower default risk, it would be easier for corporates and the government to raise debt. The year of 2013 promises to be year of Structural Reforms that would provide us with a good financial system for the Indian Growth Story to sustain for years to come. The magazine brings along a set of articles that provide in-depth analysis of the issue that the capital markets are facing and some potential solutions to them. We would like to thank our readers and contributors for their constant support, wonderful articles and critical appreciation. It is this amazing response and encouragement that encourages us to improve. Kindly send in your suggestions and feedback to investocraft.editorial@gmail.com. Investocraft Editorial Team Team Investocraft

Visit us at: www.investocraft.com Investocraft blog: http://investocraft-nmims.blogspot.in/ Facebook page: https://www.facebook.com/pages/Investocraft-Magazine/150607915074986 JUNIOR EDITORIAL BOARD

Deepesh Ganwani

Pratik Jain

Tanvi Mittal

Chakshu Aggarwal

Khushboo Shah

Ravi Srikant

Tejaswi Kns

Apeksha Shah (LAYOUT & DESIGN)


INVESTOCRAFT 2013

Index


INVESTOCRAFT 2013

Long Term Corporate Debt Market in India Rajeswari Sengupta, Assistant Professor, IFMR & Vaibhav Anand, IFMR Capital Why do we need a Long Term Debt Market? At the current time, when India is endeavoring to sustain its high growth rate, it is imperative that financing constraints in any form be removed and alternative financing channels be developed in a systematic manner for supplementing traditional bank credit. In this context, the development of long-term debt markets – corporate debt and municipal debt – is critical in the mobilization of the huge magnitude of funding required to finance potential business expansion and infrastructure development. Before we discuss the evolution and current state of the Indian corporate debt market, it may be useful to discuss the rationale and need for long-term debt markets, in general as well as in context of the Indian economy. The critical role played by long-term debt markets in supporting economic development, especially in emerging economies are listed below.

Ensuring financial system stability A liquid corporate bond market can play a critical role because it supplements the banking system to meet the requirements of the corporate sector for long-term capital investment and asset creation. Banking systems cannot be the sole source of long-term investment capital without making an economy vulnerable to external shocks. Historical and cross-sectional experience has shown that systemic problems in the banking sector can interrupt the flow of funds from savers to investors for a dangerously long period of time. Indeed, one of the lessons from the 1997 Asian financial crisis has been the importance of having non-bank funding channels open. In the aftermath of this crisis, a number of countries in the region, including Korea, Malaysia, Singapore and Hong Kong, have made progress in building their own corporate debt markets. Spreading credit risk from banks balance sheets more broadly through the financial system would lower the risks to financial stability. Bond financing reduces macroeconomic vulnerability to shocks and systemic risk through diversification of credit and investment risk.

Enabling meaningful coverage of real sector needs The financial sector in India is much too small to cater to the needs of the real economy. A comparison of the asset size of the top ten corporates and that of the top ten banks (as shown in Figure 1 below) reveals that banks in India are unable to 1


INVESTOCRAFT 2013 meet the scale or sophistication of the needs of corporate India. Needless to say, the financial system is not big enough to meet the needs of small and medium-sized enterprises either. While these are pointers to the fact that the banking sector in India needs to be larger than its current size, they are also clear indicators that debt markets need to grow manifold to ensure that the financial sector becomes adequate for an economy as large and as ambitious as India’s.

Figure 1 - Comparison of the Asset Size of the top ten corporates and exposure limits of the top ten banks above reveals the disparity in credit demand and supply

Panel A: Assets of top 10 corporates (2011) 

Panel B: Capital funds and exposure limits of top 10 banks (2011)

Creating new classes of investors Commercial banks face asset-liability mismatch issues in providing longer-maturity credit. Development of a corporate debt market will enable participation from institutions that have the capacity as well as aptitude for longer maturity exposures. Financial institutions like insurance companies and provident funds have long-term liabilities and do not have access to adequate high quality long-term assets to match them. Creation of a deep corporate bond market can enable them to invest in longterm corporate debt, thus serving the twin goals of diversifying corporate risk across the financial sector and enabling these institutions to access high quality long-term assets. Thus, access to long-term debt opens up the market to new classes of investors with an appetite for longer maturity assets and thereby helps prevent maturity mismatches.



Reduced currency mismatches The development of local currency bond markets has been seen as a way to avoid crisis, not only by supplementing bank credit but also because these markets help

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INVESTOCRAFT 2013 reduce potential currency mismatches in the financial system. Currency mismatches can be avoided by issuing local currency bonds. Thus, well-developed and liquid bond markets can help firms reduce their overall cost of capital by allowing them to tailor their asset and liability profiles to reduce the risk of both maturity and currency mismatches.



Term structure and effective transmission of monetary policy The creation of long-term debt markets will also enable the generation of market interest rates at the long end of the yield curve – thus facilitating the development of a more complete term structure of interest rates. A deeper, more responsive interest rate market would in turn provide the central bank with a mechanism for effective transmission of monetary policy.

Indian Corporate Debt Market : Current Status India has been distinctly lagging behind other emerging economies in developing its longterm debt market (LTDM), be it corporate or municipal bonds. The equity market has been more active, developed and at the centre of media and investor attention. Traditionally, larger corporates have used bank finance, equity markets and external borrowings to finance their needs. Small and medium enterprises face significant challenges in raising funds for growth.

Comparison with other countries In India, the proportion of bank loans to GDP is approximately 36%, while that of corporate debt to GDP is only 4% or so. In contrast, corporate bond outstanding is 70% of GDP in USA, 147% in Germany, 41% in Japan, & 49% in South Korea. The size of the Indian corporate debt market is very small in comparison to both developed markets, as well as some of the major emerging market economies. For a sample of eight Indian corporates that featured in Forbes 2000, corporate bonds account for only 21% of total long term financing. In contrast, corporate bonds account 3


INVESTOCRAFT 2013 for nearly 80% of total long term debt financing by corporates in the four developed economies of USA, Germany, Japan and South Korea. In these countries, the share of corporate bonds is close to 87% for corporates graded above BBB and 66% for the rest. Corresponding figures in major emerging economies such as South Africa, Brazil, China and Singapore, are 57% and 33% for corporates rated above BBB and those rated at BBB or below respectively. Drawing on the cross sectional experience of G7 countries since the 1970s, it is estimated that the overall capitalization of the Indian debt market (including publicsector debt) could grow nearly four-fold over the next decade. This would bring it from roughly USD 400 billion, or around 45% of GDP, in 2006, to USD 1.5 trillion, or about 55% of GDP, by 2016. This growth, if not crowded out by public sector debt, could result in increased access to debt markets for Indian corporates.

Comparison with the G-Sec Market and Equity Market In India the long-term debt market largely consists of government securities. The market for corporate debt papers in India primarily trades in short term instruments such as commercial papers and certificate of deposits issued by Banks and long term instruments such as debentures, bonds, zero coupon bonds, step up bonds etc. In 2011, the outstanding issue size of Government securities (Central and State) was close to Rs. 29 lakh crores (USD 644.31 billion) with a secondary market turnover of around Rs. 53 lakh crores (USD 1.18 trillion). In contrast, the outstanding issue size of corporate bonds was close to Rs. 9 lakh crores (USD 200 billion). Moreover, the turnover in corporate debt in 2011 was roughly Rs. 6 lakh crores (USD 133 billion) whereas in 2011, the Indian equity market turnover was roughly Rs. 47 lakh crores (USD 1.04 trillion).

Some challenges in the Indian market The total corporate bond issuance in India is highly fragmented because bulk of the debt raised is through private placements. Small and medium-size enterprises are unable to access the debt markets. Furthermore, trading is concentrated in a few securities, with the top five to ten traded issues accounting for the bulk of total turnover. The secondary market is also minuscule, accounting for only 0.03% of the total trading.

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INVESTOCRAFT 2013 Development of the domestic corporate debt market in India is constrained by a number of factors viz: low issuance leading to illiquidity in the secondary market, narrow investor base, high costs of issuance, lack of transparency in trades and so on. The market suffers from deficiencies in products, participants and institutional framework. All this is despite the fact that India is fairly well placed insofar as pre-requisites for the development of the corporate debt market are concerned. There is a reasonably welldeveloped government securities market, which generally precedes the development of the market for corporate debt securities. Another emerging economy, South Africa for instance, witnessed nearly a decade long public sector debt market reform before the market for corporate debt securities began to develop. The major stock exchanges in India have trading platforms for transactions in debt securities. Infrastructure also exists for clearing and settlement in the form of the Clearing Corporation of India Limited (CCIL). Finally, the presence of multiple rating agencies meets the requirement of an assessment framework for bond quality.

Indian Corporate Debt Markets – The Supply-Side Issues The peculiar issue with the Indian corporate debt market is not that it faces challenges due to a lack of adequate infrastructure. In fact, India is fairly well-placed insofar as the pre-requisites for the development of a corporate debt market are concerned. In spite of this, Indian corporate debt markets are yet to witness the level of activity that an organized financial market should. Some of the issues are structural and a few are regulatory road-blocks. These issues have been categorized into supply-side, demandside, secondary-market issues and risk & hedging related issues. The total corporate bond issuance in India is highly fragmented because bulk of debt raised is through private placements. The private placement route requires that the issuer makes an offer to select a group of investors, no more than 50, to invest in the debt securities for issue. However, corporates are known to circumvent the 49 investor cap in private issuances by making multiple bond issuances for many groups of 49 investors or satisfying the greater demand through immediate secondary market transfers upon the completion of the primary issue, thus diffusing the issue among a

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INVESTOCRAFT 2013 greater number of subscribers. Therefore there is a clear need to remove impediments that hinder the development of the institutional side of the market. The dominance of private placements has been attributed to several factors, including ease of issuance, cost efficiency and primarily institutional demand. Furthermore, trading is concentrated in few securities, with the top five to ten traded issues accounting for bulk of the total turnover. The SEBI Issue and Listing of Debt Securities Regulations 2008, in Ch III, Sec 20 lays out conditions for private placement which include, requiring compliance with The Companies Act of 1956, obtaining credit rating, listing of securities, mandating disclosure standards as per Sec 21 that stipulates the documentation and disclosure requirements (detailed in Schedule I of the Regulations ). The private placement disclosure and documentation requirements are viewed by the market to be comprehensive yet not being too onerous in terms of compliance. On the other hand, the disclosure and documentation requirements for public placement of securities are viewed by the market as being extremely onerous and difficult to comply with. In addition to the Schedule I requirements for private placements, public placements also have to comply with additional disclosure requirements , as specified in Schedule II of The Companies Act of 1956. These are an exhaustive set of disclosures in three parts. The first part contains general information, capital structure information, terms and issue particulars, information on company, management and project as well as information on all companies under the same management, and finally management perception of risk factors. The second part contains additional general, financial, statutory and other informational disclosures. With such an extensive set of disclosure requirements for public issues, it seems to us that the market has been avoiding this route for issuing bonds. For instance, The Patil Committee Report lays out the following statistic that highlights corporates’ preference for the private placement route as against the public:

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INVESTOCRAFT 2013 The figures above are consistent with findings of the Patil Committee.

Analysis of the Private Placement Market

Table 2 above indicates that over the years, number of issuances by the private sector has been much more than that of the public sector. However, the volumes of the private sector have been lower than public sector. This indicates that the average size of issue by private sector corporations has been close to INR 1 billion as against the larger size of public sector issuances amounting to INR 4 to 5.5 billion over the years. As shown in Table 2, resources mobilised through private placements in private sector spiked in 2009-10 but came down in 2010-11. There was close to 120% hike in issues placed during 2009-10 by the private sector. Comparatively, public sector issues increased marginally by around 1% during the same period. What is also evident from Table 2, is the tremendous cost differential, with public issuances on average seven times as expensive as private issuances. This could have further driven market participants to favour the private route. Analysis of issues and volumes of private placements by financial and non-financial corporates reveals that the financial corporates dominate. However, in terms of growth, volumes placed by financial institutions grew by 71% while the same by non-financial institutions grew by 62% from 2008-09 to 2009-10. The pie chart below corroborates the finding that financial institutions have dominated the number and volume of issues over the years.

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INVESTOCRAFT 2013

In the winter of 2005, the High Powered Expert Committee (HPEC) on Corporate Bonds & Securitisation led by Dr. R.H. Patil made a variety of recommendations to address the prevailing issues in the corporate bond market. The recommendations were spread across three broad areas – (i) Primary Market, (ii) Secondary Market and (iii) Securitisation. One of the primary recommendations to address supply-side issues was enhancement of the issuer base. The Patil Committee recommended that in order to reduce the time and cost of public issuance, the disclosure norms and listing requirements be reduced. The Committee also recommended that in the case of issuers that are already listed, these requirements be reduced even further. In December 2007, SEBI vide circular dated December 03, 2007 amended the provisions pertaining to issuances of Corporate Bonds under the SEBI (Disclosure and Investor Protection) Guidelines, 2000. The changes to the guidelines were as below: (a) For public issues of debt instruments, issuers now need to obtain rating from only one credit rating agency instead of from two. This was done with a view to reduce the cost of issuances. (b) In order to facilitate issuance of below-investment grade bonds to suit the risk appetite of investors, the stipulation that debt instruments issued publicly shall be of at least investment grade has been removed. (c) Further, in order to provide issuers with desired flexibility in structuring of debt instruments, structural restrictions such as those on maturity, put/call option, conversion, etc have been done away with. In May 2009, SEBI issued a Listing Agreement for Debt Securities that provided for a simplified regulatory framework for the issuance and listing of Non-Convertible Debentures (NCDs). The circular released by SEBI was split in two parts. The first part prescribed incremental disclosures for issuers that were already listed and the second part pertained to issuers who were unlisted and prescribed detailed disclosures for them. To conclude, the supply-side issues in the Indian corporate debt market remain primarily cost related and to some extent related to heavy disclosure norms, some of which have recently been simplified through regulatory changes. Hopefully the steps taken by regulators to address these issues will help deepen the bond market development further, by promoting more public issuances in multiple categories. 8


INVESTOCRAFT 2013 Indian Corporate Debt Markets – The Demand-Side issues A study of the investment norms for banks, insurance companies, pension funds, and provident funds helps to understand specifics of the investment bottlenecks that may have prevented the development of a well-functioning corporate debt market in India. According to the eligible Statutory Liquidity Ratio (SLR) investments (as per Master Circular – Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) issued on July 01, 2011), banks are required to hold 24% of their liabilities in cash, gold, central and state government investments, thereby leaving non-government bond market instruments completely out of the picture. For a life insurer it is very important to generate high returns while maintaining asset quality to avoid credit risk. In India, the norms for insurance company investments are made in the Insurance Regulatory and Development Authority (IRDA) Investment Amendment Regulations, 2001, and cover the following businesses: life insurance, pension and general annuities, unit linked life insurance, general insurance and reinsurance. The only section of the Act that allows for long-term, non-government investments are the infrastructure and social sector investments of 15+% and unapproved investments of 15%. Further, according to this Act, the pensions and annuities businesses cannot have any portion of their funds invested in non-government linked investments. Investment regulations governing life businesses require that at least 65% of assets be held in various types of public sector bonds. Funds are permitted to invest in corporate bonds, but the category of “approved investments” only includes bonds rated AA or above. Bonds below AA (which are rare in India), can be held in unapproved assets. Then again, total unapproved assets cannot exceed 15% of the portfolio and are subject to exposure norms limiting exposure to any company or sector. In practice, insurance companies hold less than 7% in unapproved assets. For instance, according to the ICRA, SBI Life’s exposure to equity and unapproved investments has been around 6% only. A major part of investments (approx. 47%) for life and pension businesses is thus being held in G-Secs and other government approved securities which are relatively safe instruments. Poor appetite for corporate bonds is also on account of the lack of a secondary market – thereby making such an investment a buy and hold play which, considering the long tenor, is decidedly a sub-optimal investment. In other words, the investment norms of insurance companies, banks, pension funds in India are heavily skewed towards investment in government and public sector bonds which acts as a detriment to the corporate bond market development. Without long-term investors like pension funds and insurance companies investing in corporate debt, it is difficult to see how the corporate debt market will take off. The adverse effect of this legal/regulatory lacuna on corporate debt market is further aggravated by the fact that the high fiscal deficit of the Government of India (GoI) is financed by the issue of GoI bonds or government securities (G-Secs). The fact that the Fiscal Responsibility and Budget Management (FRBM) Act – that required the GoI to

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INVESTOCRAFT 2013 reduce its deficit to sub-3% levels by 2009 – has been put in abeyance in the wake of the financial crisis of 2008, implies that the fiscal deficit has been going up and government bond issuances continue to finance this deficit. This has effectively served to further crowd out private corporate debt issuance. The highlights a few major issues:  

The high level of G-Sec issuances in the Indian debt market, The low level of corporate bond issues; both these issues are inter-related since large government debt issuance on account of high fiscal deficit has a crowding out effect on corporate debt, Market preference for very safe AA+ assets with no market for issuances below AA thus creating a very thin debt market; As shown in the following graph, the volume of bonds rated below A is around 5% of the total issue.

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INVESTOCRAFT 2013 The High Powered Expert Committee (HPEC) on corporate bonds and securitization also popularly known as the Patil Committee made a few recommendations on enhancing the investor base-an important demand-side issue that was subsequently addressed in part by the SEBI. We detail here the recommendations of the Committee and actions taken thereafter by the SEBI.

In order to enhance the investor base and diversify its profile, the Committee recommended that the investment guidelines of Provident/Pension Funds be directed by the risk profile of instruments rather than the nature of instruments. The Committee also recommended an increase in investment limits for Foreign Institutional Investors (FIIs). In the “Plan for a unified exchange traded corporate bond market” – a report of the internal committee of SEBI in 2006, it is mentioned that the point it to be taken up with the Government and Reserve Bank of India (RBI) wherever relevant – “So as to encourage the widest possible participation for domestic financial institutions, IRDA, the Central Board of Trustees of the Employee Provident Fund Organisation (EPFO) and the Pension Fund Regulatory and Development Authority (PFRDA) should modify their respective investment guidelines to permit insurance companies, provident and gratuity funds, and pension funds respectively to invest/ commit contributions to SEBI registered Infrastructure Debt Funds.” In July 2011, the EPFO put out requests for proposal while appointing custodians of Securities of EPFO. The document listed the investment guidelines for EPFO fund managers alongside terms and conditions and duties of custodians. Though the prescribed pattern of investment for EPFO favours investments in central and state government securities, it allows upto 30% to be invested in any central government securities, state government securities or securities of public financial institutions (public sector companies) at the discretion of the Trustees. Of this, 1/3rd is permitted to be invested in private sector bonds/securities which have an investment grade rating from at least two credit rating agencies, subject to the Trustees’ assessment of the riskreturn prospects. Demand-side issues remain trickier to resolve as they are tied to a variety of other regulations on investment and an over-arching prescription for “safe investments” i.e. for instruments rated AA and above. Understandably, demand exists only for such instruments and the market caters to this demand, creating in turn a thin-market. A market for high-yield bonds is practically non-existent, suggesting that risk-return profiles are uniform throughout the market, which need not necessarily be the case. Moreover, much of this lack of appetite is also linked to the lacklustre secondary market in corporate bonds. Investors in any market would require an active platform where they would be able to liquidate their assets or square off positions if need be, especially in a high-yield market. In the case of India’s fledgling secondary market in corporate bonds,

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INVESTOCRAFT 2013 market activity is highly bunched up at one end of the market at all times, making holding fixed-income securities riskier unless they are being held till maturity. In keeping with the Patil Committee’s recommendations, investment guidelines that are directed by risk/return profile of investments and investor appetite rather than the nature of investments will help boost demand for a wider range of debt securities and hopefully help in building a deeper, more active market with varied investor profiles. Our next post in this series will aim to uncover a few pertinent secondary-market issues, and their effects on corporate bond market development or lack thereof.

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INVESTOCRAFT 2013

Gujarat: A Template for the Rest of the States Tanvi Mittal, NMIMS The State of Gujarat is classified as one of the leading industrialized states in India and has earned itself the sobriquet of being the “Growth Engine of India�. The state houses several private companies, public enterprises, multi-national corporations and is the host of small-and medium-scale business units. The state has become one of the best places in India for the manufacturing of textiles, pharmaceuticals, and agro-based and petrochemical products and is also popular for its physical and social infrastructure facilities. Gujarat is also one of the states in India where there is an excellent environment and is aptly supported by a responsible and proactive bureaucratic system. Even though Gujarat has been known for entrepreneurial spirit, it has made good policies and taken good decisions in the last decade that has facilitated high level of growth at a high base. With a share of about 12.5%, Gujarat has the highest share of the total outstanding private sector investments (including both domestic and foreign private sectors) across India as of June 2012, according to a study by Associated Chambers of Commerce and Industry of India (Assocham). Of the total outstanding investments in Gujarat worth over Rs 14.8 lakh crores, private sector accounted for over Rs 10.3 lakh crore thereby registering a share of about 70% in the overall investments across the state. Out of the 20 emerging industrial States in India, Gujarat tops in terms of investments, followed by Maharashtra, Andhra Pradesh, Odisha and Karnataka which, together, attracted 54 per cent of all investments in India during the last seven years, according to an Assocham report. AP

Tamil Nadu Uttarakhand States

Kerala Karnataka India Bihar Haryana Gujarat 0.00%

2.00%

4.00%

6.00% Growth Rate(%)

Source: Retaining the edge, Mckinsey, CII 13

8.00%

10.00%

12.00%


INVESTOCRAFT 2013

Flow of private investments is decided by the attractiveness of investment opportunities as the ultimate consideration of any investment is profitability. That is a reason why big corporate houses of the nation such as Essar, Torrent, Reliance, Shell, Tata, Adani and many others have chosen Gujarat over other states. Gujarat offers Bureaucratic efficiency through its acts such as Single Window Clearance Act, infrastructure facilities, and ease of land acquisition, tax concessions, product market conditions and exit policies which make it a private investment haven. The investor-friendly policies in Gujarat along with state-wide gas grid, rich gas reserves, round-the-clock power supply, tremendous rail and road connectivity within the state and to other parts of the country, large consumer base, easy availability of hardworking and skilled manpower and simple and transparent procedures for investment, all these combined factors make Gujarat a business-friendly state and an ideal destination for making an investment. The role of Gujarat in ancient trade and commerce goes back to Indus Valley Civilization. It has a long and ancient history of maritime trade across the world. Gujarat since time immemorial has been renowned for its entrepreneurial spirit. Gujarat also has the advantage of having a strategic location in terms of having the Longest Coastline of 1600 km with 18 active ports across the State. Today, Gujarat handles 35% of the cargo of India. All these are the indicators on the basis of which India's ascendance is recognized. And it's clear that Gujarat's contribution in them is substantial. Gujarat is one state that has evolved constantly and has diversified its industrial base substantially. In the year 1960-61, textiles and auxiliaries were the major contributor to the economy of the state. In the span of over 49 years, the industrial spectrum has completely transformed and refined petroleum products has emerged as one of the largest industrial groups having 33% share, followed by chemicals having 21% share. Other important groups include agro and food products (8.5%), textiles and apparel (6.9%), basic metals (6.2%), machinery and equipment (2.7%), non-metallic mineral based products (2.5%), plastic and rubber products (1.8%), furniture industry (1.4%), 14


INVESTOCRAFT 2013 fabricated metal products (1.4%), electrical machinery (1.2%) and paper and paper products (1.1%). The industries in Gujarat produce a wide variety of products. The sectors that keep attracting investments are petrochemicals, chemicals, drugs and pharmaceuticals, minerals, ceramics, gems and jewellery, textiles, automobile engineering, IT, power and ports. Over a period of time, Gujarat has also succeeded in widening its industrial base. At the time of its inception in 1960, the industrial development was confined only to four major cities namely Ahmedabad, Baroda, Surat and Rajkot and some isolated locations such as Mithapur and Valsad. Today, almost all the districts of the state have witnessed industrial development .Such a massive scale of industrial development has been possible on account of judicious exploitation of natural resources, such as minerals, oil and gas, marine, agriculture and animal wealth. The discovery of oil and gas in Gujarat in the decade of 60s has played an important role in setting up of petroleum refineries, fertilizer plants and petrochemical complexes. During the same period, the state government has also established a strong institutional network. Gujarat Industrial Development Corporation (GIDC) established industrial estates providing developed plots and ready built-up sheds to industries all across the state. Institutions were also set up to provide term finance, assistance for purchase of raw materials, plant and equipment and marketing of products. Later, District Industries Centers (DICs) were set up in all the districts to provide assistance in setting up industrial units in the form of support services. All these initiatives have made Gujarat to emerge as the highly industrialized state in the country today.

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INVESTOCRAFT 2013 The state government in Gujarat has made constant efforts to attract investments by formulating acts such as Single Window Clearance Act which aims to cut down the phenomenon of red-tape in the state. Through this act, project proposals can be made online and all the necessary permissions can be obtained under a single window, making procedures easier and reducing the time required for clearance of a project and this has further motivated the entrepreneurs to invest in the state. The state also organizes the prestigious Vibrant Gujarat Global Investors Summit (VGGIS), an initiative of Gujarat state government to attract foreign investment for the development of Gujarat. It aims at bringing together the business leaders, investors, corporations, thought leaders, policy and opinion makers. VGGIS organized in 2003, 2005, 2007 and 2009 attracted investment proposals of Rs.18,72,437 Crores and the 2011 summit resulted into inking 8380 MOUs and getting investment proposals of over Rs.20.83 lakh Crores. Till March 2012 the State has received acknowledgement of 10,537 Industrial Entrepreneurs Memorandum, with an estimated investment of Rs.10,33,314 Crores which is approximately 11.86 percent of total investment in the country. The event has also been successful in creating employment opportunities for people in tourism, handicrafts and knowledge sectors. The summit has been able to put Gujarat’s mark on the Global map and has become an epitome of success for attracting futuristic projects and investments in the State. At a time when the whole nation is plagued by policy paralysis, scams and everyone is talking about lack of macro-economic management, the model of development in Gujarat can be seen as the silver lining. When it comes to Gujarat one constantly hears of clean administration, responsible bureaucracy and a progressive government which has its focus on long term development of the state. Gujarat’s success story could very much be used as a template by the rest of the nation.

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INVESTOCRAFT 2013

Banking Amendment Bill: Licensing all the way Pratik Jain, NMIMS & Chakshu Aggarwal, NMIMS "Since the bill is too important for me to pass, therefore I am bringing the Bill dropping the controversial clauses," Finance Minister P Chidambaram said, and this paved the way for the Banking Laws (Amendment) Bill, 2011. The seeds of the Banking Amendment bill were sown by the former finance Minister Mr. Pranab Mukherjee while presenting the budget for the financial year 2010-2011. Indian Banking Industry has come a long way since the nationalization of banks in 1969. Now the banking system needs to grow in size to meet the demands of modern economy. Besides this, there is also a need to extend the geographic coverage of banks and make the banking services more accessible. The new banking bill will cater to these requirements and will lead to financial inclusion The salient features of the Banking bill and its possible implications on banking sector are: a) To Enable banking companies to issue preference shares, rights issue (increase the authorized capital) without being limited by the previous ceiling of maximum of Rs. 3000 crores Implication- This provision would be helpful to banks in raising capital as and when required without approaching the RBI for these approvals. Besides, this provision would also aid the Banks to comply with the tier-1 capital and capital adequacy requirements in accordance with the Basel-III norms that the banking sector is expected to comply with starting from 1st April, 2013 b) Increase in voting rights of investors in private sector banks subject to maximum of 26% while in case of state run banks to 10% Implication- The increase in voting rights may lead to higher interest from investors (both domestic and foreign) in the scrip of various public and private banks. A change in the shareholding patterns of banks in the short term can be expected c) To empower RBI to collect information and inspect associate enterprises of banking companies Implication- This gives RBI the power to investigate the books of the other associates of the banking companies and will lead to more transparency and regular checks in the lending process of these banks d) To provide for primary cooperative societies to carry on the business of banking only after obtaining a license from RBI

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INVESTOCRAFT 2013 Implication- Earlier, the cooperative credit societies had to register with the Registrar of Co-operative societies whereas the credit societies with paid-up capital of more than 1 Lac came under ambit of RBI. Most of these co-operative societies kept their paid-up capital below this level to avoid the regulatory purview of RBI over them. With this amendment, RBI will issue new guidelines regarding the capital requirements necessary to register as a cooperative credit society. These societies will have to comply with the norms specified by the RBI within one year or face suspension of their operations. e) Competition commission of India will have powers to regulate anti-competitive practices and would also have powers to approve mergers “We must create at least 2 or 3 world-size banks. China has done it. And if India wants to be and as it will be the third largest economy in the world…we must also have one or two world size banks and some consolidation is inevitable” said PC Implication: This provision will pave way for mergers and acquisitions of banks in India and it will be win – win for both acquirer and target bank. Smaller target banks will benefit from the high class banking services and lower transaction costs of larger banks whereas large acquirer banks will benefit from the larger penetration of smaller banks and will thus help in consolidation of banking sector. On the other hand, there is no reason to abandon the current practice of consortium (syndicate) financing as it spreads the risk among many banks. Concentration of risk in a single bank entity can also have serious implications on the bank’s balance sheet and asset quality. Also merging the weak public sector banks with the ones performing well can render the stronger PSU banks weak. f) To empower RBI to issue new banking licenses to eligible entities Draft Guidelines for eligibility: The initial draft guidelines to be eligible for license are as follows: 

   

Eligible promoters: The entities should be owned and controlled by residents having successful track record along with sound credentials and integrity for more than 10 years. Entities\groups with income or assets of 10 percent or more from real estate of broking activities are not eligible. Corporate structure: The new banks will be set-up through a wholly owned Non-operative Holding company registered with RBI as NBFC Minimum capital requirement: The minimum capital requirement as per the guidelines is Rs.5 billion dollars. Foreign shareholding: The non-resident shareholding in the entity should not exceed 49 percent for the first 5 years. Corporate governance: At least 50 per cent of the directors of the NOHC should be independent directors.

Implication: This provision of bill will lead to revamp of the banking sector. The increase in number of banks will extend the geographic coverage of banking sector as well as will lead to the credit growth.

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INVESTOCRAFT 2013 The Licensing Thump to The Stock Markets The reform drive started by UPA-II in September of 2012 also consisted of initiating the process of issuing banking licenses. On back of expected banking amendment bill authorizing RBI to issue new banking licenses, stocks of many NBFCs expected to be front runners in getting new banking licenses rallied. It was observed that this rally had enough fuel to beat the banking Index. Statistics quoted below justifies the veracity of statement. On one hand where BSE_BANKEX rallied 16% in this period, rally in the below NBFCs expected of getting banking license was higher. One of the reasons behind this rally is the earnings potential which investors feel that would increase once these institutions get the banking license. Market price on 9/18/2012 46.15 785 1,100

Name of The Company L&T Finance M&M Finance Bajaj Finance Ltd Shriram Transport and Finance 620.5

Market Price on 1/1/2013 89 1126.55 1357.05

Return % 92.84% 43.50% 23.36%

757.2

22.03%

But historical data available suggests otherwise. There is more to this rally than what meets the eye. It has been observed that those financial institutions which were earlier beating banking index on back of being top contenders for getting banking license actually fail to beat the BANKEX once they are established as banks. Instead of increase in their earnings, earnings of these new banks start to decline and so does the stock price. Table below sheds more light on this fact. As it can be seen, most of NBFCs after getting the banking licenses have failed to beat the bankex. One of the reasons behind this decline in earnings and stock price is the regulatory restrictions that these banks are subjected to once they get the banking license. CRR and SLR requirement takes toll on the profits of these banks as it brings down the amount of credit that they can offer to borrowers. Though the cheaply available CASA deposits is one of the positives of being a bank, it takes a lot of time for a new bank to garner sufficient CASA deposits to actually benefit them. The newly formed banks also have to invest in technology, people and branch network expansion which have its own cost. The newly formed banks will also be mandated to open 25% of their branches in the rural unbanked regions (population of up to 9,999, according to 2001 census). These rural branches may severely affect the profitability of the NBFCs. A peek into the historical returns data tells that the NBFCs srcips have rallied significantly a year prior to announcement of the license and have generally underperformed the benchmark Bankex after the announcement of License and commencement of bank operations. Hence with the RBI expected to dole out new license in the coming 12-18 months it could be a good opportunity to buy into the some of the expected NBFCs and sell at the time of announcement.

19


INVESTOCRAFT 2013 Bank

Kotak Mahindra Bank Yes Bank Axis Bank Ltd HDFC Bank Ltd IndusInd Bank ICICI Bank Ltd Centurion Bank Bank of Punjab Global Trust Bank DCB Bank IDBI Bank Times Bank

The parent that Share price of received the the parent banking license before the announcement of banking license/ or listing price (Rs) Kotak Mahindra 17.2 Finance Ltd

The delisting Share price price / CAGR during existing Price the investment period

Returns given by benchmark during the same period

649

45%

26%

UTI Ltd

66 16

382 1,015

28% 36%

14% 22%

HDFC Ltd

33

653

18%

13%

IndusInd Bank

32

355

21%

17%

ICICI Ltd

149

61

-10%

-1%

Centurion Bank

16

41

12%

22%

Bank of Punjab

10

48.6

16%

16%

Global Trust Bank

10

0

-10%

5%

DCB Bank IDBI Ltd Times Bank

57 41 10

44 100 9.4

-4% 11 -11

11% 23% -11%

The performance of various Holding companies after the issuing of licence vis-à-vis BSE BANKEX The bill is an effort of the government to boost the banking sector and also achieve its goal of financial inclusion. But there are some fronts on which government need to be careful so that the bill does not reap any negative results. The increase in number of banks in the country will lead to increased competition in the banks, the impact of which could be there on the margins of the banks as they will reduce their rates to allure more customers. RBI will have to keep a strong check on these type of anti – competitive practices which was one of the reason for 2008 U.S financial crisis. Although fundamentals of Indian banking industry are strong but one thing that should be kept in mind is that bankers are made of same cloth. Another front where RBI has to be careful is in the selection of entities to which licenses will be issued. Many NBFCs in order to comply with clause of having 25% of branches in under banked areas open the branches in these area but do not put them to use and also to comply with the provision of having capital requirement of 5 billion will fulfill it through other arms of the corporate house

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INVESTOCRAFT 2013 they are part of and in the process the aim of financial inclusion will not be achieved. So in order to safeguard the banking sector against this RBI should restrict the amount of deposits that can be raised from other arms of same corporate house and should also make sure that all the branches are functional. If these fronts are taken care of , then only the bill will serve the purpose for which bill is framed.

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INVESTOCRAFT 2013

Bonded to Equities! Sudeep Mallya, NMIMS The world of Finance has divided into silos of equities market and debt market. The events of one market are assumed not to impact other market. But in reality the events of one market impacts the other market in a significant manner. These two instruments are used to finance any venture and it is imperative to look at both the markets to determine the funding mix to optimize value. The article attempts to study the various indicators from the debt market and what they indicate about the returns of equity markets for present and forward returns. The risk in equities as an asset class is measured as Equity Risk Premium and the risk in Debt is measured as a Bond Default Spreads. These two indicators along with the ratio between these two parameters can be used to determine the kind of financing mix. The graph below depicts the Implied ERPs, Default Spreads for a Baa Rated securities and ratio of ERP to Baa Spread. It can be noticed in the graph that in the 15 years when the ratio of ERP to Baa Spread was close to 1, a ratio of less than 1 indicates that the equity as instrument is cheaper than debt adjusted for risk. First time this happened was during the dotcom bubble when it was quite easy to raise equity and the second time this happened was 2008 after the crisis when debt defaults spreads widened significantly. The ratio was been highest in 2006 in the last 15 years at 3, it would have been appropriate to raise more debt than equity.

Such an analysis in the Indian context might not be great value as the thin debt markets would make it difficult for the Indian Companies especially the ones with lower rating to raise debt. These companies typically raise debt from banks and who have their own proprietary method of pricing credit.

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INVESTOCRAFT 2013 Predicting Equity Returns using Bond Market Even though bond markets in India are not developed the way they are in the west, but there are still enough indicators to understand the Indian Equity Markets. The Indian yield curve has a lot of information embedded about market views on future growth in various terms, inflation estimates and liquidity position. All these are key factors that drive sentiments in the market and key factors to forecast equity returns.

Indicators used for prediction of Equity Returns    

Value Assigned to Future Growth Yield Curve Modified Yield Curve (derived using Local Short Term Rate) Modified Yield Curve (derived using US Long Yields)

Value Assigned to Future Growth In the industry, the long term government bond yield is used as the Risk Free Rate. However, professionals from the Damodaran’s school of thought would argue that it should be the government bond yield minus default spread that should be used as the Risk Free Rate. But let us keep this difference of opinion apart from this article and use the government bond yield as the risk free rate as used widely in the industry. When the economy is doing well, the bond yields would increase. The bond yields would also increase if there is high level of inflation due to the action of the central bank. In the first case the negative impact of higher rate is far less than the positive impact on the cash flows of the companies due to a better economy, which leads to a better performance of the equities as an asset

23


INVESTOCRAFT 2013 class. But if there is a high inflation, the impact of higher risk free rate is more negative on the value. Value Assigned to Future Growth (VAFG) is calculated by capitalizing the Trailing Earnings capitalized at the cost of equity using a constant Equity Risk Premium (ERP) and the 10 year bond yield as the Risk Free Rate. It tries to measure the relative attractiveness of bonds and equities. Using a constant ERP of 6 percent and the 10 year bond yield, the current level of VAFG is 48 percent, as against the long term average of 51%. Currently, VAGF indicate more value in equities than bonds on a relative basis and indicate a 15.7 percent CAGR return from the equities on a 10 year horizon. Yield Curve Yield Curve is the curve of rates of the government bonds/bills of different maturities plotted across time. Difference/spread between the 10 year bond Yield and the 91-Day bill indicates the future economic growth and can be used as a good indicator for long term equity returns. If the short term rates are falling faster than the longer term, then the growth in the economy is expected to pick-up. When the inflationary pressures fall, the short term rates also fall. If the inflation pressures fall, short term rates tend to fall and leading to an economic recovery. The spreads are not increasing, implying that the inflationary pressures are receding. This means that equity markets are past the worst.

Modified Yield Curve (derived using Local Short Term Rate) It is liquidity that drives the equity market returns in the short run. The modified yield curve, difference between trailing earning yield and 91-day treasury yield, is used primarily used to measure liquidity. This spread and three year forward equity returns have shown a strong correlation in past.

24


INVESTOCRAFT 2013 The Modified Yield Curve indicates domestic liquidity in relation to share prices and can be used to predict the medium term (3 years) equity returns. Medium term equity returns are likely to be lower than the long term growth predicted other parameters at 10 percent CAGR. The short term returns could increase to the long term average if the short term rates could decrease by 75-100 basis points (BPs).

Modified Yield Curve (derived using US Long Yields) The other Modified Yield Curve is derived from spread between the earning yield and the US 10 year Bond yield. Since 1991, the correlation of the Indian markets and equity returns with the world markets has been increasing on account of higher economic integration. The bull rally in the Indian markets has been primarily fuelled by the Foreign Institutional (FII) funding. The liquidity in the foreign equity markets is instrumental in driving the returns 25


INVESTOCRAFT 2013 of from Indian Markets. This modified yield curve is meant to capture the effect of short term liquidity and indicate the one year forward returns from the equity markets. This modified yield curve measure the global liquidity positions and its impact on Indian equity markets. This can be used to predict the short term (1 Year) equity returns. This indicator predicts a strong performance in the short term. This indicator predicts that the equity markets could give a return of 49 percent for the one year period Oct’2012Sept’2013.

Conclusion If the indicators of the bond markets are anything to go by then, the equities as an asset class scores over the GILTs for long term. The average equity returns from the longer tenure is far more than from the shorter tenure. The bright outlook for equity market stems from global liquidity positions. To have a sustained bull market, the domestic liquidity must improve and short term interest rates should fall if the bond market indicators are considered.

Note – Data points for this article were from Morgan Stanley – India Strategy and Aswath Damodaran’s Website.

26


INVESTOCRAFT 2013

Is that Gold Loan Really Shining? Ishan Agarwal, NMIMS Gold and Black Gold (Crude Oil as it is sometimes referred to) have been giving sleepless nights to our Finance minister since a very long time. Black Gold for obvious reasons, since it accounts for one-third of India's total import bills; but why is gold pestering our finance ministry? Well there are two issues here; one that, after Crude Oil, Gold is the second highest contributor to India's import bill and that most of the gold that gets imported lies idle in homes in the form of coins, biscuits and jewellery, thus drawing money out of productive resources of the economy. So do Gold loan companies have a role to play for the Indian Economy?

BACKGROUND Gold loan companies have been in focus ever since the R.B.I tightened regulatory norms on them in March 2012. These new norms were considered by some experts as a slow killer which could hamper the rapid growth of such organisations by limiting the value of loans given on pledged gold, increasing the capital requirements of such NBFCs and capping the interest rates chargeable on such loans. Such regulatory interference was expected from the R.B.I to check the rapid growth of the sector which many experts believed was another bubble in the making. Another issue was the mushrooming of many small ticket-size gold loan companies in different parts of the country. Many experts predicted this regulatory action by the R.B.I as a dampener for one of the fastest growing industries. Barely 9 months into the regulation, has the RBI seemed to have changed its thoughts on gold loan companies from being a threat to the economy to the one which could actually channelize savings in to the economy. The R.B.I working group in the first week of January 2013 has proposed changes in its report which aim to encourage Gold loans by such companies and increase the loan to value from 60% to 75%. So, what makes the Central Bank of the country change its stance on Gold loan companies? Let us probe into this, going deeper into issues related to gold and gold loan companies. 

The Concept of Gold Loans and History Historically, Gold has been a valued commodity, especially in India where it is considered auspicious and has been kept as an asset in an average Indian

27


INVESTOCRAFT 2013 household in the form of coins, jewellery and other forms. The issue with such kind of asset is that it is bad for the economy. How? Firstly, take into account the fact that India is a net importer of gold. So, whenever an average Indian purchases gold in any form, it ultimately adds to the import bills of the country, thus resulting in depleting foreign reserves. Secondly, assume that if a person purchases gold worth Rs. 10,000 and keeps it in the locker of his house, this means that this Rs. 10,000 kept in the form of gold is drained out of productive resources in the country. Now this is where Gold loan companies step in. These companies provide loans by taking gold as collateral. Now this money, obtained by the borrower by pledging gold can be used by him in his business, for his emergency needs or some other productive purpose. Compared to the other markets in the world, the gold loan business in India is a big one. Until a decade back, most of the gold loan financing was done in the unorganised sector by pawnbrokers and money lenders. However this scenario has changed with the entry of organized players such as NBFCs and banks. These players now command around 30% of the total gold loan market. The organized gold loan market in the country has grown at a rate of 40% CAGR from 2002-2012. At just 1.5% of the total stock of gold in the country at present, gold loans have a huge potential to grow. Add to the fact that India is one of the largest markets for gold accounting for about 10% of the total stock of gold in the world. Rural India accounts for 65% of this gold stock. The demand for gold in the country follows the regional trends, where south India accounts for 40% of the gold stock, west accounts for 25%, and north around 20-25% and east around 10-15%. 

Role played by Gold Loan companies in India ďƒ˜ Driving Financial Inclusion: One of the main roles played by gold loan companies is financial inclusion for the untapped population of the country. Financial inclusion is now a national priority and gold loan companies can be a useful tool to attain this objective. ďƒ˜ Encouraging Monetisation: In India, only a small part of the total gold stocks held by its citizens is monetised, depriving the economy of the much-needed liquidity. Borrowing against gold facilitates economic activity thus contributing to the economy.

28


INVESTOCRAFT 2013  Tapping the Multiplier Effect: Gold loans in India are typically small ticket loans falling within the definition of micro-credit in the country. In gold loans, delinquency rates are well below 1% and any productive activity can be financed year after year without need for periodic replenishment. In contrast, in micro-credit models where recovery rates are low, a significant portion of the funds is lost in each disbursement cycle. In the long run, this cumulative compounded cost to the economy is heavy.  Extending Efficiency Gains: Gold loans have become a form of immediate borrowing to the ,average person similar to the way a credit card is for the well-off common man. These small-ticket loans disbursed promptly help kick-start and keep alive micro-entrepreneurship.  Discouraging Usury: As organised gold loan companies are expanding their foot print in India, they are slowly eating in to the unorganized gold loan market mainly operated by pawnbrokers or money lenders. This type of reduction of dominance of the unorganised market is good for the country and the common man. Last, but not the least, these companies also contribute to the national exchequer in the form of corporate taxes.

The future of Gold Loan companies There are many factors which will determine the future of Gold loan companies in India. Some of the factors can be explained with the figure below:

29


INVESTOCRAFT 2013

Source: Muthoot Finance Annual Report, 2011-2012



Challenges for the sector: The major challenges faced by Gold loan companies today are: ďƒ˜ Stringent Loan-to-Value Norms: Capping the loan-to-value of gold loan companies is a welcome move by the R.B.I, however capping it to very low levels can have an adverse effect on the sector because this may make it unattractive for borrowers who do not have additional gold holdings to make up for the shortage. This may drive them to the unorganised sector, to which these norms don't apply. The R.B.I in its regulation in March 2012 had capped the L.T.V at 60% which was considered too stringent by industry experts. The R.B.I working group report in January 2013 proposes to increase it to 75%. ďƒ˜ Negative perception of the Sector: The regulatory measures introduced by the R.B.I were intended to standardize the Gold loan sector and prevent a growing bubble, too many regulatory announcements in a short span of time and adverse media comments have created a negative perception of Gold loan companies in India. Other challenges faced by the gold loan sector in the country are o Very volatile gold prices in the global commodity market o Access to cheaper sources of funding o Changing common man's perception about gold loans.

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INVESTOCRAFT 2013 Conclusion: With the Government of India now determined to monetise gold savings of its citizens to increase money in productive resources of the country, gold loan companies offer one of the best platforms for the activity. The Government can leverage on the strong local reach and distribution channels formed by these organisations to tap gold into the economy even in far-flung villages of the country. Total Gold stock in the country is estimated at 18000 tonnes and only around 1000 tonnes of it is estimated to be lying with gold loan companies and banks. Also, India's organised gold loan sector could grow substantially in the coming years by tapping the unorganised part of the sector. An effective L.T.V of around 75%, coupled with strong business focus and customised products, this sector can potentially attract small borrowers, self-employed professionals, agriculturalists and artisans. These factors when catalysed by the right policies of the R.B.I can be beneficial to both, the overall Indian economy as well as the gold loan sector. So yes, we conclude that gold loan players are here to stay. Not only stay but grow too. So it really won't be a bad idea investing in a Muthoot or a Manappuram!! Oh Wait, do your analysis before hitting the trade!!

31


INVESTOCRAFT 2013

Fiscal Cliff-Hanger Chakshu Aggarwal, NMIMS & Ravi Srikant, NMIMS The phenomenon that had been giving nightmares to economists of the biggest economy of the world is “Fiscal Cliff”. It has been termed as the biggest event in US economy since 2008 financial crisis that has the potential of pushing US economy back into recession. Let us have a look at what lead to formation of this cliff and how did the US economy go about resolving it.

BACKGROUND George .W. Bush during his tenure as US president in 2000 had brought some changes to the tax code popularly known as Bush Tax cuts. Before the tax cuts, the highest marginal income tax rate was 39.6 %. After the cuts, the highest rate was 35%. These tax cuts lowered the marginal tax rates for almost all US tax payers. Owing to the sunset provisions of Bush Tax cuts that were to expire in 2010, these tax cuts were extended during the presidency of Barack Obama through a series of acts: EGTRRA, JGTRRA and tax relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010. The extension was for 2 years. Owing to the increasing Budget deficit and debt of the US government, the Budget Control Act was passed in 2011 in which the US congress agreed to increase the debt ceiling under the provision that the US has to reduce the expenditure by $1.2 trillion in the 10 years following the expiry of the Bush tax cuts on 31st December 2012.The Budget Control Act was a poison-pill deal designed to force them to find a less austere compromise. If no deal was reached, then the spending cuts would have come into effect from 1st January2013 that has been termed as fiscal cliff by Federal Reserve Chairman, Ben Bernanke.

WHAT IS FISCAL CLIFF? “Fiscal cliff “ refers to the effect of expiring Bush tax cuts and spending cuts by the U.S government that would have come into effect from midnight of December 31, 2012 if republicans and Democrats had not been able to agree on how to reduce the nation’s budget deficit and debt.

IMPLICATIONS OF FISCAL CLIFF The combined effect of the tax increases and spending cuts would have reduced the deficit by around $600 billion. Over the long run there would be a reduction in the U.S public debt by around $7 trillion as compared to an increase of around $10 trillion if the

32


INVESTOCRAFT 2013 present policies were allowed to continue. The risk, however was that the U.S economy would contract next year sending the economy into a recession again. The table below shows how the Fiscal cliff would have impacted the US economy:

Fiscal or Economic Measure

CBO Baseline

Alternative Scenario

Federal deficit in FY2013

$641 billion

$1037 billion

Economic growth in FY2013

−0.5% of GDP 1.7% of GDP

Unemployment rate for October thru December 2013

9.1%

8.0%

Public debt in 2022

58% of GDP

90% of GDP

The baseline scenario represents a scenario in which the tax cuts expire and spending cuts take place. The alternative scenario represents a scenario in which present policies continue and neither the tax cuts expire nor the spending cuts take place. The enactment of fiscal cliff would have reduced the public debt of US to 58% of GDP but would have sent the economy into a recession.

Out of a deficit increase of $10-11 trillion in the 10 years from 2013-2022, $7 trillion could have been saved had the existing policies been allowed to expire under the Fiscal cliff. The deficit for FY13 would have reduced to $600 billion as opposed to $1.2 trillion the previous year.

THE FISCAL DEAL IN THE ELEVENTH HOUR ON 31st DECEMBER 2012 The Senate passed the American Taxpayer Relief Act on January 1 as a compromise solution. Some of the provisions of the act were 1. Taxes on individuals earning more than $400,000 and couples earning more than $450,000 was increased from 35% to 39.6%. 2. The capital gains tax was increased from 15% TO 20% 3. Removal of tax deductions and credits for incomes over $250,000 for individuals and $300,000 for couples 33


INVESTOCRAFT 2013

4. Estate taxes would be set at 40% of the value above $5,000,000, an increase from the 2012 rate of 35% of the value over $5,120,000. 5. Payroll tax cuts would expire The bill provided for $600 billion in tax revenue over ten years, about 1/5th of the revenue that would have been raised had the Fiscal cliff occurred. The total deficit from 2013-2022 would increase by $4 trillion compared to the baseline projections. Add in the financing costs and the deficit would increase by $4.5 trillion over the 10 years. The deficit for FY 13 is now projected to be $1 trillion compared to $1.2 trillion the previous year The Budget Control Act contained Spending cuts of $110 billion per year split evenly between defence and non-defence discretionary spending. If the US Congress could not come up with other spending cuts of similar size, the spending would have to be reduced by sequestration. For FY11 discretionary spending was $1.3 trillion and defence spending was $700 billion. It is estimated that defence spending will be around 2.7% of GDP as compared to 3.5% at the moment. The spending cuts, which would have kicked in on January 1 2013, have been delayed by 2 months.

34


INVESTOCRAFT 2013

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INVESTOCRAFT 2013

The Petersburg Paradox Harish Srigiriraju, NMIMS “Price is what you pay and value is what you get” –Warren Buffet Everything in this world has a price and not paying the right price will always create problems. Warren Buffet waited for about 30 years before he bought Coca-Cola. He waited for that long only to get the right price which will then give him the necessary returns. Many of the M&A deals have failed only because of paying more than what was necessary. It is essential not only to select good assets for investments, but also to pay the right price to acquire them, and this brings us to the concept of St. Peterburg Paradox Petersburg Paradox is a paradox related to probability and decision theory. It is an essential theory to understand the behaviour of an investor and pricing decision. The problem and its solution were first presented by Daniel Bernoulli in 1738. Assume that a casino offers a play where there is an unbiased coin which is tossed at each stage. The prize money starts with one rupee and doubles every time a tail appears. At any point of time if the head appears, the game ends and the player can take away the money earned so far. Now think about how much would you be willing to play for this game? As per the probability theory since there is a payoff which is unlimited, it would suggest that a player should ideally be willing to put any amount of money to play this. However, people would not be willing to pay a high price for this. In a survey conducted in 2004 on an average, people were ready to play it by paying up around 25 Rs. Now what is the reason behind people paying up so less despite the possibility of unlimited payoff? Few theories can be used to explain this phenomenon. The “Expected Utility Theory” explains this on the basis of diminishing marginal utility of money but this might not be true in most of cases. The “Probability Weighting theory” gives less weight to unlikely events but contrary to this it was observed that people give more weight to unlikely events. Can it be explained based on the fact that the casino cannot have infinite resources? How much ever finite the resource are, this does not explain the low amount the players are willing to pay. This paradox can be explained in two ways. One with the help of the “von Neumann and Morganstern axioms” where it can be explained that the investor does not take decisions only based on the expected payoff but always on the basis of the risk taking ability and the payoffs are thus risk adjusted. As per the “Erodig Theory” the time averages maybe different from space averages and the probability theory should only be used when the systems are erodig in nature. To make things simple, it implies that the expected gains increase with the increase in number of games. So if only one game is played, the probability theory will not hold true. These two theories explain that there is a rationale behind the paradox which is based on risk aversion.

36


INVESTOCRAFT 2013 Similar to this paradox are real life situations which investors face in order to decide the price for a particular stock. For high growth companies, it is often assumed that the payoffs are unlimited and any price paid can be justified. However this is absurd as the payoffs even if unlimited, has to be risk adjusted and hence there is always a right price for everything. In my recent encounter with Ashwath Damodaran, someone asked him if he was willing to invest in a company with very good growth prospects but corporate governance issues. His answer was a bit surprising but logical when he said he would definitely invest but only at the right price.

37


INVESTOCRAFT 2013

About NMIMS The School of Business Management (SBM) is the torchbearer of NMIMS, University Mumbai. SVKM's Narsee Monjee Institute of Management Studies (NMIMS) has, ever since its inception in 1981, been a leader in management education in the country. It offers more than 50 programs across various disciplines, such as Management, Technology, Science, Pharmacy, Architecture and Commerce. The NMIMS Deemed-to-be University has over 6000 students and more than 300 faculty members who represent an eclectic mix of rich industry and academic experience.

MBA CAPITAL MARKETS Program Introduction Human life began with evolution. Thus, to change for the better, to improve, to innovate, and to evolve is inherent to mankind. A disciplined way of innovation – sorting, stabilizing, standardizing and finally sustaining is of utmost importance or business conglomerates to effectively cater to wants, especially in the dynamic world of finance. As human wants get more complex, the idea of Capital in the financial world gains further importance. With this in mind, identifying and seizing new opportunities to sustain the growth of these complex businesses entails a completely different skill set. The Bombay Stock Exchange (BSE) along with NMIMS started the MBA (Capital Markets) program in 2006, specifically to address this demand. MBA Capital Markets is a specialized course in capital markets, which is offered only at NMIMS Mumbai. The curriculum offered as part of this program is prepared in consultation with BSE, industry experts and senior faculty members of the institute. The Agreement entered into between The Stock Exchange Education and Research Services, a public trust established by the Bombay Stock Exchange and NMIMS in March 2005 became the platform for the setting up of the BSE-NMIMS Centre for Capital Market Studies to further research and studies in the field of Capital Markets. The program strives to train students into becoming decision makers along with exercising social sensitivity, keep a broad strategic vision, and become responsible to assume higher corporate responsibility. All this is being enhanced through a superior degree of skill in interpersonal relationships. A great deal of emphasis is also placed on experiential learning. Students are required to work on a number of corporate and academic research projects during their two years on campus.

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INVESTOCRAFT 2013

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Investocraft_Annual Edition