Twice shy

Once bitten by the global meltdown, India has to hedge its growth story

Is history repeating? Various multilateral and Indian agencies are once again forecasting mouthwatering economic expansion for the country in the current year. This sounds familiar. Rewind to a couple of years ago, when India was expected to notch above 8% growth for the next few years despite the first signs of credit crisis in the US markets. Then, as now, growth projections were based on domestic consumption. The theory of decoupling was being bandied about. There was buzz about imminent capital controls to slow the foreign exchange inflow to cap inflation and interest rates. A few months down the line, there was a dramatic reversal in the situation. The concern was to insulate the Indian economy from the drying up of liquidity in global markets. The Indian government followed the US and China in announcing a fiscal stimulus package including cut in excise duties to pump up demand. The central bank loosened money supply. This had the desired impact. The markets bottomed out and doubled their value from their lows in the last fiscal as foreign funds started coming back on prospects of India repairing the imbalance in its expenditure and revenue following funds mopped up from the domestic market by a clutch of PSUs, successful auction of third-generation spectrum and broadband and wireless access , and hike in fuel prices. Growth is back on track, particularly since the second half of the previous fiscal. Manufacturing output in the first few month of the current year too is rising. Tax revenue is buoyant, eliminating the need to completely withdraw tax breaks. The markets have broken out from the 17,000 levels. Do these signals signify that the worst is over for India? What has changed that India can afford to ignore the still raging storm in the developed economies?

The IMF has imposed austerity measures in Greece to bail it out of its sovereign debt default crisis. Outlook of the euro zone is still cloudy. Japan’s growth remains flat. The slow recovery in the US is neither accompanied by spurt in jobs nor investment by the corporate sector, raising fear of deflation as the US Federal Reserve has no more scope to lower interest rates. China is under pressure to let its currency appreciate and is putting cap on money supply, which will slow its and, consequently, global growth. If not recession in west, India’s inflation partly contributed by food grain demand-supply imbalance and partly by foreign capital inflow, has the potency to effect a slowdown as the central bank makes credit costly. Yet, there is increasing decibel levels about decoupling on one hand and how global Indian markets are becoming. Cross-border mergers and acquisitions and fund raising imply repercussions on the bottom line of the parent and the home country beyond depreciation in contract value. So will things be different this time? The Indian economy can remain immune from withdrawal of foreign portfolio investors if the global economy once again dips into the last leg of recession if it can ensure that capital expenditure plans including capital market forays of a host of companies in the private and public sectors are not derailed and companies dependent on export revenue are not hurt. This would probably call for another round of fiscal and monetary stimulus and, thus, would be a setback to current efforts of nursing the country’s finances to sound health.

Hopefully lessons have been learnt from dealing with the past crisis. The first is that textbook prescriptions for economic health may not always work. There should be no hurry to rollback the fiscal stimulus neither to tighten money supply till the US and the euro zone economy are decisively out of danger. To have higher interest rates even as other countries are offering money at rock bottom rates will turn India into a speculators’ market. What about inflation? The current spell of inflation is spurred by shortage of food grains and rising consumption. A normal monsoon this season is expected to tame food grain prices. High interest rates will no doubt douse consumption but will also impede efforts to expand capacity to meet demand. Recent resources mopping efforts through PSU divestment and spectrum sell-offs as well as movement towards freeing fuel prices from control should ease government pressure on the bond market, contributing to keeping rates mild. Also, volatile markets should not deter it from going ahead with PSU divestments even if this is at throwaway prices. It could do this in bits, whetting the appetite of investors. This would set the markets on fire, benefiting even the private sector. What the recent global meltdown has done is to recognize the role of governments in making and breaking markets. If there were conventional responses to the past crisis, the future may call for out-of-the-box solutions. For instance, governments using the derivatives market to shape up events to meet ends. It is now recognized that the futures markets contributed to crude oil shooting past the US$ 140 a barrel mark and collapsing to US$ 33 a few months later. During periods of uncertain outlook, stable currency and commodity prices can provide comfort. With commodity prices rising but yet to reach the pre 2008 levels, this is the ripe time to undertake hedges. China is following the tradition route of buying up mines and oil exploration rights. Opec says it is comfortable with the current US $75 a barrel level. So why not tie up supply for the next few years at this level through the commodity futures market? Funds for undertaking this exercise can be raised by floating a sovereign Betting on India’s Growth (BIG) fund (with apologies to Anil Ambani), opened exclusively for foreign institutional investors. If the central bank can intervene through various tools at its disposal to guide the rupee to keep the import bill manageable and at the same time not hurt exporters, surely it is time for the Central government to lead by example by staying on top of the commodity cycle by writing contracts to calibrate prices. The bottom line is to ensure that events do not overwhelm us.

Trust deficit

Front-end loading by mutual funds has come an end. When will front running by brokers?

It is not the best of times for the securities business. On one side is market volatility that is scaring investors and resulting in dwindling volumes. On the other hand is the increasing pressure from regulators for transparency in proprietary trading and thus squeezing margins. Despite evidences of excesses committed by governments, greed, recklessness and questionable operating procedures adopted by those who manage investors’ money are blamed for the current market turmoil. The outburst of Securities and Exchange Board of India chief at a recent conclave of fund managers and the ban on a mid-rung official at HDFC Asset Management Company have brought to the fore the trust deficit between investors and market intermediaries. Dismissing the highly paid fund managers as “aggregators”, C B Bhave, the Sebi boss, bluntly questioned the existence of the highly hyped fund industry. If the ban on front-end loading of expenses has resulted in display of withdrawal symptoms by the mutual fund industry, front running is the recurring theme at brokerages. Efforts to separate and discourage proprietary trading face an uphill task and so also the practice of incorporating various loads by mutual funds. Online trading may have eliminated the price variation between placement and execution of order but not completely neutralized brokers or their employees from taking positions ahead of their clients. Entry loads may have disappeared but not exit loads. Indeed, Sebi seems to have completed a full circle from blaming brokers for most market ills and encouraging investors towards mutual funds in the 1990s to embarking on a do-or-die mission to cleanse the money management industry over the past year. It does imply that the regulator would either prefer investors to undertake direct exposure to the cleaned up secondary market to handing over funds to others or that the practices at asset management companies are no better or worse than those at brokers.

Are the mutual fund industry and the brokers facing flak for systemic flaws? The mutual fund industry was supposed to be a via media for the retail investors to take exposure to the equity and debt markets. Instead, the primary reason for its existence seems to be for the bulk investors, that is companies. This is in spite of capping quid-pro-quo transactions of companies diverting cash to the fund for use to boost their stock prices. There are many reasons for this state of affairs: First is of course the volume game, which fattens fees. Once a fund builds a comfort level with the company, both save on distribution charges. This makes selling to retail investors an expensive proposition. Hence, there is tendency of AMCs to lock in their fees through loads, especially for smaller amounts, rather than fees based on performance Second is the high capital requirement to float an asset management company, which increases reliance on corporate clients and permits entry to companies, banks and financial institutions. It also leads to fluctuation in corpus on large withdrawals. The third is the taxation angle. Dividend from equity mutual funds is tax free, while interest on fixed deposits is not, attracting corporate subscribers. The fourth is the illusion of security-of-a-fixed-deposit-cum-returns-of-the-stock-market combo created by the mutual fund industry by using the personal finance media. Ranking of schemes only reinforces the mirage. Unlike stocks, which discount forward earning, mutual fund investors are lulled into opting for schemes based on track record in spite of the Sebi-inspired disclaimer of past returns being no guide to future performance.

Decimating mutual fund is as impractical and counterproductive as trying to do away with brokers. There is a symbiotic relationship between the two. Brokers need institutional investors to boost volumes. Fund managers rely on brokers to offload or mop up shares in bulk without causing price tremors. At the same time, there is a need for serious introspection by these market intermediaries to find out how they could go about their business without frustrating their clients and the regulator. The mutual fund industry has been a proponent of self-regulation. To aspire for this status, mutual funds must put a cap on large subscriptions, bring down asset management and expense charges, and base fees on returns generated or performance in comparison with benchmarks.. A certain portion of this fee can be shared with distributors. This will ensure there is no mis-selling of schemes based on commission as well as survival of the efficient. Sebi should ease capital requirement norms to reduce AMCs’ dependence on corporate subscriptions. This has facilitated companies and financial institutions rather than experienced money managers to float mutual funds. It is now accepted that smaller corpuses are easy to manage and give better returns. The ceiling on each mutual fund’s holding in the equity capital of a company undermines the necessity of large asset base. Moreover, funds with modest corpuses can focus on mid-caps and bring about welcome changes in their corporate governance, thus increasing market depth. More funds with personalized service would widen the basket for high net-worth investors looking at PMS to cater to their needs. Brokers, too, would be able to spread their risks instead of depending on handful of funds for volume business and to resist the temptation of running ahead of their clients as the mass of orders of a small sized mutual fund may not be adequate to influence the course of the market. Swift punishment such as suspension of registration, which will hurt the broker for lax internal compliance, can do what well intention regulations on inducing transparency in proprietary trading cannot.