Chalk and cheese

The troubled aviation sector can learn survival skills from the embattled telecom sector

Mohan Sule

After telecom and mining, another showcase of the reforms era is in the news for the wrong reasons. Unlike the telecom and mining sectors, the aviation sector has hit an air pocket not because of any scandal but due to operational deficiencies. Yet, just like the telecom and mining sectors, the problems of the sector can be traced to policymaking and the players’ ambition to gain market share. The open-sky policy introduced in the early 90s allows anyone with a borrowed aircraft or two to start an aviation company and fly on any domestic route with a serviceable airstrip by paying the fees for landing rights. It was the promoters’ headache to work out the math of balancing the cost of aviation turbine fuel, servicing the lease, maintaining the fleet and staff wages with passenger fares. In contrast to telecom and mining, which are considered basic businesses with little value addition to differentiate one player from another, the aviation industry has been associated with glamour and adventure right from the times of the eccentric aviator Howard Hughes. Even our own JRD Tata achieved a larger-than-life image not merely by making steel and producing commercial vehicles but after his triumphant return from a solo flight from Karachi to Mumbai via Ahmedabad  in a Puss Moth aircraft in 1932 before launching Tata Aviation, which later became Air India International. Not surprisingly, airlines till the end of the last century spent huge amount of money to build brands and loyalty.

The first batch of private sector aviation players was a motley crowd of poultry farmers, unknown entities alleged to be fronts for underworld elements, wheelers and dealers sensing another opportunity to earn returns, and industrialists keen to diversify. In the process, they failed to interpret the market signs correctly. The market was no doubt expanding. The emerging middle class wanted an option to the rickety services offered by Indian Railways. A diet of subsidized fares had hampered the domestic state carrier’s capacity to expand. There was, however, a limit to the premium first-time fliers were willing to pay for better services. Competition on the trunk routes resulted in fare war as in the telecom sector. There was incipient demand for feeder routes. To break even, it was essential that the aircraft had a minimum number of passengers per flight. To ensure this, there was no alternative for the new entrants but to woo the budget-conscious travellers. Among the casualties of this realisation was Damania Airlines, whose promoters were not adequately capitalized to sustain a fancy airline. Sahara Airlines decided to sell to Jet Airways, and Air Deccan to Kingfisher. Low-cost carriers SpiceJet and IndiGo gained popularity. Despite the consolidation and increase in passengers, airlines have not been able to stem the flow of red ink due to the surging prices of ATF, with crude oil crossing the US$100 a barrel in 2008. The brew turned potent on volatility of the dollar following the sovereign debt crisis in Europe and the hardening of domestic interest rates.

A striking feature of the current turbulence in the aviation sector is its similarity with the problems of the telecom sector. One is the wafer thin revenue per user. In spite of being among the fastest growing and the largest in the world, both the industries are not making profit even as they are gaining more users. This means there is demand for the service provided but the economics of providing the service is not viable. Telecom companies have halted the race to offer airtime at throwaway prices. Instead they are concentrating on the creamy layer to ensure decent usage. Airlines either have to follow the no-frills model or use the heavy rush on the metro routes to subside flights to tier I and II cities. Another option is pooling ground services or to carve up the feeder routes among themselves. Telecom services providers are sharing tower resources and till recently were inking 3G roaming pacts with those in other circles to provide users a seamless experience. At the same time, there are two glaring irritants that are unique to the aviation players. One is the subsidy provided by the Central government to Air India to keep its fares low. This provides a benchmark for passengers to compare private airlines. The second, and crucial, cause of grief is ATF. One way to tide over the problem would be to have a variable component in the air fare, linked to the fluctuation in the previous day’s crude price. After 9/11, may top-of-the-line airlines including Swiss Air and US carriers Delta and United Airlines went bankrupt, sending out a clear message that the era of discount flying is here. This means airlines like telecom services have become commodities rather than brands.

Mohan Sule

Short circuit

Rajat Gupta’s shortsightedness and the UPA government’s short-term policies are remarkable for their destructive power

Mohan Sule

The fall of Rajat Gupta in the insider trading scandal in the US can be viewed as a proxy for the India Growth Story: euphoria followed by disappointment. Gupta was the first-generation immigrant who vaulted to the top of Corporate America on merit. This was what the new Shinning India was all about: education and hard work were the capital to invest in the opportunities thrown open as licence raj was dismantled. Instead, the reforms consolidated the position of the entrenched conglomerates as sectors monopolized by the public sector were transferred to the private sector oligarchs with ties to the ruling party or to those entrepreneurs willing to pay a premium. Telecom, aviation and mining, the three showcases of reforms, abound with tales of rules bent to create a distorted playing field. The problem stems from Indian policymakers’ reluctance to let go the barter system and cling to the constituency of a welfare state, sitting at odds with the idea of individual initiative to become wealthy where the field is leveled for all. Despite intellect, and not legacy, being solely responsible for his success, Gupta could not differentiate between gossip and leaking sensitive information to a hedge fund manager. It would be easy to attribute the downward revision in India’s growth to about 7% from 9% for the current fiscal to the euro-zone debt crisis and the slow recovery of the US and Gupta’s woes to a cultural clash in ethics and values. In the end it all boils down to wrong calls of judgment.

Wrong calls on restricting bidders to circles and categorizing them on technology  sowed the seeds to the scandal that saw the corruption of the second round of sale of second-generation telecom spectrum. The underselling exposed the worst-kept secret of policy making in India: the minister-bureaucrat-corporate sector nexus. As a result, first-generation entrepreneurs have to adopt unconventional means to gate-crash into the exclusive group. Top this with inordinate delays in clearing projects such as Vedanata’s acquistion of  UK-based Cairn’s stake in its Indian joint venture to explore oil and gas or South Korean Posco’s desire to mine bauxite in Orissa. Even when bills are introduced to bring clarity to issues such as acquiring land for infrastructure projects or awarding mining rights, the laws are biased against the investors. With elections happening in some corner or the other round the year, most legislations are written either with timidity or brazenly to woo a chunk of the voters. The out-of-control rise in prices is another spoiler. Initially, liquidity caused by foreign portfolio investment was held responsible. There was even talk of imposing capital controls or levying a withholding tax as done by some other emerging economies in South-East Asia and Latin America. Later, the flow of foreign investment into the stock markets slowed down due to the sovereign debt crisis in Europe but headline inflation showed no signs of receding. It was then realized that surging food prices was the primary contributor. An expanding middle class and those lifted above poverty by the rural employment schemes were fuelling consumption of food items and boosting their prices.

A good southwest monsoon was expected to cool down foodgrains on higher output. Instead of a resolution, the problem has got compounded. The minimum support prices were increased recently to insulate farmers from the anticipated downturn in prices. In the meanwhile, the Reserve Bank of India has ramped up interest rates 13 times in 19 months, further hurting manufacturers already battling costly raw materials. The bottom line is prices remain untamed in spite of higher interest rates and slowdown in foreign capital inflow. The spurt in the wholesale price index caused by protein-rich diet and that by dollars chasing assets have to be viewed as separate events requiring different treatment. Yet the central bank has adopted a one-size-fits-all strategy. Making the RBI’s job more difficult is the government’s borrowings to fund social welfare programs on the eve of a clutch of crucial elections. Thus, instead of becoming the center of gravity by leading the recovery of global economy with structural reforms to make investment in infrastructure projects attractive, undertaking prudent fiscal measures to keep inflation under check, and speeding up PSU divestment, policies tailored for a limited purpose — establishing footprints in the Uttar Pradesh election to pave the way for the fourth generation of the Gandhi family to rule India — have short-circuited India’s Growth Story just as Gupta’s alleged desire to gain a quick entry into the millionaires’ club destroyed his reputation built over years of hard work and brilliance.

Mohan Sule

Where does the buck stop?

 

Ask what you can do for Air India and SBI, the government seems to be telling taxpayers

By Mohan Sule 

 

The protesters occupying the streets housing financial institutions and stock exchanges in the US and Europe are united in their disgust at corporate greed but not on how to wean away companies from their gluttony. Their anger seems to be directed at the bailout of too-big-too-fail corporations with taxpayers’ money. Arguments that doing nothing would have had a contagion effect, sweeping away other stakeholders including minority shareholders, clients, suppliers and employees with exposure to the failed institutions, do not appear to have made much of an impression. Many of these once-tottering empires have started making profit and returned government funds but their turnaround has had no impact on job creation. Instead of bringing growth back on track, the chain of events has resulted in economic slowdown. No wonder the rich countries of the euro zone are reluctant to foot the bill of the spendthrift members who have taken on too much debt to make their present comfortable at the expense of their future. The events of the past three years, therefore, have put a question mark over government intervention. A company gets another chance only if the opportunity is used to clean up the balance sheet. This means its shape and size are altered as divisions are hived off and employee strength trimmed. Allowing companies to collapse, viewing their extinction as a natural process of evolution, is a gamble. The hands-off approach to Lehman Brothers resulted in a credit crunch and meltdown of equities around the world.

The bailout of state-owned UTI in 2001 has been a turning point in the Indian government’s approach to sick companies. The quick intervention by pumping liquidity through government bonds prevented the domino effect from spreading to the stock markets. The bull-run that followed helped the mutual fund to repay the government. Since then, the landscape has changed drastically. The government has become proactive. Mergers and acquisitions have been reckoned as an important solution to the problem and not obstructed as happened in 1983, when NRI Swraj Paul tried to take over Escorts, whose assets were not producing the desired returns to the shareholders. A government-appointed committee shepherded Satyam Computer Services, felled by an accounting fraud by the promoters, through the auctioning process. Financial institutions encourage corporate restructuring instead of turning their back on the borrowers. This is in contrast to the pre-reforms era. It was common to stretch the death pangs of sick units by referring them to the Board for Industrial and Financial Reconstruction. Mumbai’s textile mills were allowed to wilt under a prolonged labor agitation. At the other extreme, government took over companies considered vital for the economy or simply because they were found to be profiting from the demand-supply mismatch. Overnight in 1969, 14 privately owned banks were forcibly converted into public sector. Air India, the international airline started by JRD Tata in 1948, was nationalised in 1953.

Now, these two showcases of socialism are in a state of disrepair. Air India is on the verge of bankruptcy. Lack of powers to take market-oriented decisions, dip in passengers following 9/11 in 2001 and meltdown of financial markets in 2008-2009, and rising fuel prices have resulted in losses. The merger with Indian Airlines in March 2007 to create a single entity for operational efficiency has not met with success. It is facing debt of Rs 67000 crore and seeking equity capital of nearly Rs 49000 crore as against Rs 2000 crore pumped in so far. Dithering over an IPO, first planned in 2005, to bring in additional capital has proved costly. A complete sell-off or partial divestment to Indian or foreign investors could give it a chance to recuperate. This looks unlikely considering the paralysis in decision making at the Centre. The condition of SBI is not as serious but the situation is more complex as it is listed. Being majority owned by the government, the bank’s priority is fulfilling social obligations. No wonder, it has to increase its provisioning for bad loans, as per the recent Reserve Bank of India directive. In view of the stock’s plunge to 52-week low, the Rs 23000-crore rights issue to meet its tier I requirement looks remote in the short term. Instead, the government would be infusing around Rs 10000 crore. Unless it pads up its capital, around 7.5% of the assets now, the proxy for the Indian economy won’t be able to grow its loan portfolio. Indeed, a sad commentary on India’s ambition to expand 9% per annum over the next decade. It would be instructive to know what the Wall Street Occupiers would have to say of the government using taxpayers’ money to bail out taxpayer-owned companies mismanaged by it.

Mohan Sule

Primary issue

Institutional and private equity investors should be made to act as filters before IPOs are offloaded to retail investors

By Mohan Sule

Though the market has recovered after dipping below 16,000, the need to revive investors’ confidence in equities has never been more urgent than now. After Lehman Brothers was allowed to collapse, there was unanimity among central banks and governments around the world about the dangers of letting the markets drift to the bottom and then wait till they bounce back on their own. There was no appetite for a repeat of the decade-long Great Depression of the 1930s, or Japan’s lost decade of the 1990s. The composition of the current crisis differs from that in 2008, when a credit-crunch threatened to stall the economy. Central banks had to pump in cash to keep the wheels of industry moving. Second, inflation was low, which allowed leeway for printing more money. This time, emerging economies are concerned about too much of liquidity stoking inflation and are prepared to sacrifice growth to tame price indices. In the US, the Federal Reserve is swapping short-term government bonds with longer dated ones to replace short-term pessimism with optimism about future. The increase in bad assets of banks in China and India, as the downgrading of SBI implies, also discounts loose-money policy. The bottom line is risk aversion rather than access to loans is the issue now.  Fiscal stimulus, initiated soon after the global meltdown three years ago, may compound inflation. Governments, therefore, are looking at other means. For instance, the Indian government has indicated reduction in stock-market transaction levies. The market has welcomed the move.

The finance ministry needs to go one step further and bring down the short-term capital gain (STCG) tax to 10% in the limited window of opportunity available in the run-up to the Direct Taxes Code, with peak STCG tax at 30%, to be implemented from the next fiscal. Besides short-term measures, it should also overhaul the capital-raising framework. Sebi initiated many reforms during the dull phase a decade ago, while preparing the market for better days that followed from 2003. In 1999-2000, procedures for the participation of foreign institutional investors (FIIs) in the primary and secondary markets were eased. By 2003, the number of FIIs exceeded 500, with over 1,500 sub-accounts. Due to FII interest, the Rs 100-billion ONGC IPO in March 2004 was oversubscribed in 10 minutes. T+5 rolling settlement was introduced in 2000 for dematerialised scrips and was expanded to cover more stocks with the facility of automated lending and borrowing mechanism or modified carry-forward system in any stock exchange. Trading in futures contracts based on the BSE’s Sensex and S&PCNX’s Nifty index began in June 2000. Norms for private placement were tightened in 2003 to provide for more disclosures. At the same time, there were missteps. At the height of the dot-com boom in 1999-2000, Sebi allowed tech companies  to offload only 10% post-IPO share capital instead of 25% mandatory for issuers in other sectors in an attempt to revive the primary market. This blatant pandering to the fancy for tech stocks eventually boomeranged with investors getting stuck in illiquid counters as software companies are not capital guzzlers.

Similarly, the response to offer individual investors, who have 5o% quota, shares at a price determined through book building has ranged from lukewarm to overwhelming. The procedure allows issuers and FIIs to create appetite for high-priced offerings. The spinoff is post-listing stampede for exit. At the same time, there is no interest in issues without substantial institutional participation. With the deepening of the investor pool, issuers prefer private placement with institutional investors rather than go through book building to mop up the mandatory retail subscription. The result is the entry of small-sized issues shunned by big investors. The present volatile times, therefore, are appropriate to review the primary market. The initial focus of reforms should be on small and mid caps, which have the maximum scope for appreciation and mischief. These issuers should be made to place their IPO/FPO with domestic and foreign funds, who should offload the capital to retail investors after three years. Only venture capitalists should be allowed to offer for sale shares of startups. By inserting the filter of institutional investors, Sebi would ensure that only equity checked for quality would be available in the market. After obtaining a stock at reasonable pricing, institutional investors would be compelled to monitor the company to create long-term value instead of thinking of making short-term gains. Issuers would be spared of catering to retail investors out of compulsion rather than choice. Thus, issuers as well as institutional and retail investors stand to benefit.

Mohan Sule

Game changers

The outcome of the ONGC FPO, the Sebi-MC-SX tussle, and interpretation of ‘control’ will offer clues to future

By Mohan Sule

Numbers do not always make the market go round. Market optimism factors in honesty of the promoters, track record of executing projects, vision going ahead, and also non-promoter holding. Of late, the government’s response to crises, barriers to trade and foreign capital, and political stability are impacting investor sentiments. The decision of Standard and Poor’s to lower US’s sovereign rating was not merely on fears of debt default but also stemmed from the ugly partisanship of the political parties in raising the debt ceiling at the eleventh hour, keeping world markets at the edge. Companies and governments may follow the law to the letter but violate the spirit, thereby losing out in the battle for perception. Take three recent cases. Timing an issue is the prerogative of the issuer, who would want the best possible price for his offering. Alas, the premium depends not only on past financial performance and outlook for the company but also on an intangible variable called market sentiment, which could be influenced by factors beyond the control of the company. Yet many companies patiently wait out for the right time. This they do quietly because of the cooling off period enforced by the market regulator before any important financial event. Yet, on 15 September, a day before the pricing of ONGC’s FPO, the government raised the price of petrol. The stock shot up to close over 5.6% the next day in the belief that the oil explorer’s subsidy burden would come down. Despite the boost, the issue was postponed for the third time this fiscal as the issuer, that is the government, and the investment banks failed to agree on the pricing.

The market regulator’s silence could perhaps be attributed to its preoccupation in reaching a compromise with the promoters of MCX-SX. By end September, Sebi would have decided if Financial Technologies and MCX, both promoted by Jignesh Shah, are ‘persons acting in concert’ and their joint stake of 10% breaches the cap of 5% shareholding by an individual or entity in an equity trading stock exchange. The “business-like” option, according to the Bombay High Court, was to address the concerns of the promoters of MCX-SX and seek guarantees and undertakings or issue fresh show-cause notice and put forth new arguments to promote “a competitive scenario and not monopolistic situations”. Without ruling if the regulator’s interpretation of non-compliance by the promoters of MCX-SX with the Manner of Increasing and Maintaining Public Shareholding in Recognised Stock Exchanges Regulations was correct or rigid, the court wants Sebi to show flexibility as more players would benefit consumers. Yet the stand taken by the promoters of MCX, while hauling the National Stock Exchange to the Competition Commission of India for not imposing transaction fees in its currency derivatives segment, has resulted in increase transaction costs for investors. A dissent note by two members to the ruling by the CCI against the NSE said the intervention would only hurt the consumer, which is against the spirit of the competition regulation.

The issue of shareholding and what constitutes control is also occupying centre stage in the second-generation telecom spectrum allotment scandal. The CBI says Swan Telecom is an associate of Reliance Telecom and Loop Telecom of the Essar group, thereby violating regulations that prohibit mobile phone companies from holding more than 10% stake in two different service providers in the same area. But the law ministry has told the department of telecom that two firms can be associates of each other if a parent company owns more than 50% stake in both and concept such as ‘control’ has to be ignored’. Sebi’s new takeover code defines ‘control’ mainly in terms of a person or a group of persons exercising the right to appoint the majority of directors. The Companies Bill of 2009, refers to controlling interest enabling a member or group exercising the largest voting power in a general meeting of the company. In fact, the ministry of corporate affairs is planning to incorporate the definition of ‘control’ in the Companies (Amendment) Bill of 2011 based on what is contained in the Sebi’s latest takeover code. These three examples give rise to several questions. How does the regulator resolve the conflict of interest between the government’s role as a maker of policies with macro economic implications and as the largest shareholder in the beneficiary of the policy? Can the need for competition override other concerns including existing regulations and is it to benefit the players or the consumers? Can two departments of the government interpret a law differently? How the government, the regulator and the courts answer these concerns will determine the sanctity of the markets.

Mohan Sule

The Indian way

The sovereign wealth fund should comprise investments of retail investors to spread the benefit of foreign inflows

By Mohan Sule

Many bogus reasons have been put forward against India setting up a sovereign wealth fund. These funds, goes one argument, are typical of autocrats such as the UAE and Kuwait. Yes, the US, Australia and Japan do not seem interested but Norway and Singapore, both democracies, though the latter a benign dictatorship, have their own funds. Exporters of natural resources such as Saudi Arabia and Russia, it is pointed out, use sovereign funds to manage their wealth. Yet Venezuela is still to enter the fray. Countries with a current account deficit, where foreign exchange inflows through exports, services and remittances are lower than outflows through imports, should keep away. This has not prevented Brazil from establishing one. May be India can prove to be another successful exception. It is not the government’s job to maximize wealth through portfolio investment, goes another conventional wisdom, nor should it be in the business of acquiring companies. Instead, countries should use their cash surpluses to build social infrastructure or leverage them to cut taxes to boost productivity. The problem is India cannot be conveniently compartmentalized. Similar to developed countries, its economy is manufacturing and knowledge based. At the same time, there is a large public sector, whose objective is to create jobs as well as to ensure equitable distribution of resources at fair or even subsidized prices. Just like other emerging economies, it attracts foreign capital flows but, unlike many of them, is dependent on import of commodities and is not export oriented. Like China, the domestic market is a magnet for overseas investors but, in contrast to the Communist giant, the foreign investment is not sufficient to blunt the energy-import bill. With characteristics of both the developed and emerging markets, India is uniquely placed. Rather than splitting hair over if it should have a sovereign fund, the need is to debate how the fund should function.

China’s plentiful reservoir of foreign exchange eliminates the need for better returns as long as it keeps the yuan undervalued for export competitiveness. More than high prices, it is worried about disruption in supplies of commodities. As a result, its sovereign wealth fund’s overreaching objective seems to be to snap up mines and oilfields for domestic consumption rather than to make profit from them. India, on the other hand, is trying to make its public sector market oriented by divesting government stake and use the proceeds for welfare programs. It is getting out of many core sectors in favor of the private sector, opting for royalty sharing. The country is betting on nuclear energy to reduce dependence on oil for energy needs. As such there is no need for the sovereign fund to buy assets abroad to secure commodity needs, which can be done by private companies or even public sector enterprises like ONGC Videsh. Hence, India’s sovereign fund will need to have a goal that is different from that of other countries. It could be a mix of buying stakes in overseas companies directly or through the stock markets, using the derivatives market to hedge against commodity price fluctuations, or diversifying the country’s asset base by investing in governments bonds and real estate abroad.

In a marked departure, India’s sovereign fund should be based on retail subscription by selling dollar-denominated units. The Indian currency mopped up can be used to sterilize foreign capital, which otherwise the Reserve Bank of India buys to keep the rupee from appreciating, but triggering inflation in the process. The benefits of foreign investment, therefore, would be spread across investors rather than remaining confined to a set of stocks or companies. Like in the primary market, the ceiling for subscription should be Rs 2 lakh to ensure a diversified base. The fund can combine the features of close- and open-ended schemes, with a 10-year lock-in from the date of subscription, which would always be open. The investment mix can comprise local and overseas bonds, equity and other assets. In fact, the sovereign wealth fund could also bid for PSU divestment stake or distressed assets abroad, hold them and dispose them to local investors later. The government may retain the call option to buy back units once the assets have generated returns above inflation or distribute dividends to those who prefer to continue till maturity, when units could be redeemed at net asset value. A sovereign wealth asset management company with professional fund managers would be a better option to the central bank. India, thus, can show the world how to harness its huge human resources and, in the process, spread wealth to investors rather than the government treasury being the sole beneficiary.

Mohan Sule

Towards transparency

To insulate from government interference, chiefs of regulatory bodies need to be confirmed by parliamentary committees

By Mohan Sule

Even as India was riveted by the tug-of-war in the political capital between the government and anticorruption crusaders over creating a watchdog to monitor those in places high and low, another equally riveting drama continued to unfold with its twists and turns in the financial capital. The first act began as the three-year tenure of the then Securities and Exchange Board of India chairman, C B Bhave, was winding up. A whisper campaign referred to his stint at the National Securities Depository, one of the two repositories of investors’ demat shares. Hundreds of fake demat accounts were discovered in June 2005 to overcome the proportionate allotment system: more the number of shares applied for, higher the chances of allotment. Another obstacle for some retail investors was the Rs 1-lakh ceiling, now raised to Rs 2 lakh, on investment in the primary market. Nonetheless, the then finance minister, P Chidamabaram, sought out the NSDL boss to head the capital market regulator early 2008. Bhave went on to lead Sebi for the next three years with aplomb, executing many investor-friendly reforms. A year prior to the expiry of his tenure, the new finance minister, Pranab Mukherjee, even proposed extending his term for another two years in accordance with the new norm of granting a five-year course to chiefs of autonomous bodies. Suddenly, well into his last year, allegations about Bhave’s role, though he had recused himself from the decision, in suppressing a Sebi probe into NSDL sprung up.

In the meantime, the Sebi chief got into a spat with insurance companies for selling unit-linked insurance plans, or Ulips, with characteristics similar to mutual fund products, antagonised the mutual fund industry by banning commission to distributors disguised as entry loads, invited the ire of the ambitious promoters of commodity exchange MCX by exposing their plan to start an equity trading bourse without sticking to ownership parameters, and brought big players such as RIL, the ADAG and the Sahara group under the regulatory scanner. Eventually, the finance minister announced the appointment of a super financial regulator under his chair whose apparent purpose is to coordinate between the various regulators such as the Reserve Bank of India, the Insurance Regulatory Development Authority of India and Sebi to avoid turf wars. Initially, the antipathy towards Bhave did seem a genuine outlet of outrage against the double standards adopted by Sebi in dealing with an entity, which was headed by him earlier, and other market players and issuers. At the same time, events unfolding at UTI, whose boss was the replacement for the departing Bhave at Sebi, necessitated fresh examination of the timing and motivation of the campaign against Bhave. T Rowe Pice, the single largest shareholder of UTI, complained that a finance ministry bureaucrat was holding up the appointment of its nominee to head the mutual fund in favour of a relative. The same official had blithely retorted to the finance minister a year ago that it was too early to consider the proposal to extend Bhave’s term. Subsequently, one of the retiring members of Sebi has accused the finance ministry of interference and harassment through tax evasion investigation.

One of the major acts of the new Sebi boss was to bring back the entry load as a flat fee of Rs 150 for investment above Rs 10000 per scheme. An upfront fee is a better option than charges embedded in the subscription. Yet, it raises questions. Will this amount, constituting 1.5% of the eligible threshold, incentivise distributors to sell products for a lower subscription? The fee will be negligible for higher investments, implying that the structure will benefit high networth investors. The new takeover code too seems to be sensitive to promoters’ concern of lack of bank finances for takeovers by raising the minimum open offer size by a marginal six percentage points rather than addressing the anxiety of the minority shareholders of getting stuck in an illiquid counter. Meanwhile, the banking industry is set to be opened to industry houses despite protest from the RBI governor. At a time when accountability of lawmakers and law dispensers is occupying center stage, it seems appropriate to review the process of selecting heads of regulatory bodies. The government’s appointments need to be ratified by a parliamentary committee through televised hearings to allow the nation to understand their guiding philosophy. This way, they would derive power from the people and do what is right for the people whose interests they are supposed to safeguard. Also, it would avoid energy-sapping controversies like those that dogged Bhave as these could be dealt with during the confirmation hearings so that the incumbent is free to carry out his responsibilities, unburdened by past calls.

Mohan Sule

Collateral damage

The frequent bouts of market surge and fall are turning investors and companies risk-averse and will lead to political instability

By Mohan Sule

While tabulating the gain or loss of investors’ wealth following a sharp surge or a steep slide in market capitalisation, what is often missed is the unseen benefit or damage of the market’s sudden upturn or downturn. In a bear phase, investors shy off even from stocks available at attractive valuations and companies concentrate on maintaining liquidity and meeting working capital needs to keep operations running. This behavior was as predictable as the periodic market cycles. After the Great Depression of 1930s, when the stock market crash in the US in October 1929 triggered a decade-long recession round the world, the alternate swings in the market were fairly routine, with long bull phases mixed with short bouts of recession. The US basked in a bull phase for the entire 1990s. The interruption by the dot-com bust at the turn of the century lasted for about three years before the liquidity-fuelled market took stocks to historic highs. This familiar comfortable cycle got disrupted in 2008, when the mortgage bubble busted. It required the collapse of Lehman Brothers for the realisation of the downside of globalisation. The loose money policy followed by countries hurt by exposure to real estate debt resulted in flight of capital to high-growth areas rather than being ploughed into their domestic economy, hitting domestic job creation. The gusher of forex inflow bolstered currencies of developing countries, blunting the competitiveness of local enterprises and at the same time boosting the cost of inputs, fuelling inflation. Simultaneously, the unwillingness or inability of the US and many European economies to either cut spending or raise taxes ballooned their debts, culminating in a showdown in the US, with President Obama forced to agree to cut spending without any tax increases as a price to increase the debt ceiling.

Yet, after the initial panic following the downgrading of the US’s credit rating, markets calmed, taking comfort from history. Soon after the meltdown three years ago, monetary authorities around the world printed money to make available credit to industry. Governments offered tax concessions to individuals as well as companies. This time, too, the expectation is that the US Federal Reserve will undertake a third round of quantitative easing by buying bonds from the market. Will history repeat? There are some differences. First is the limited breathing space for governments, especially in the US and Europe, to announce fiscal stimulus due to their huge debt. Central banks will have to shoulder the burden of revving up the economy. Many monetary agencies in the emergencies economies are handicapped due to inflation stubbornly appending their growth as more and more of the population is lifted above poverty. Their hope lies in the market meltdown pulling down prices of agri commodities, base metals and energy. Going by past experience, their expectation may be short-lived as speculators go long on these commodities in anticipation of a bounce-back on renewed consumption by emerging economies. For developed countries, these export markets could provide an opportunity to revive their home economies. So like the 2008, when panic gave way to optimism in bust a year’s time — the recession in the US was officially declared over in 2009 — this time too the global economy could spring back sooner than expected.

At the same time, the short spells of boom and bust could permanently change the way investors and companies manage their money. Besides turning with a vengeance to unproductive assets like gold, only those with a horizon of three to five years may turn to equities. This means markets may witness short spells of intense volatility and trade range-bound for protracted periods, thereby reducing chances of quick gains. Uncertain about future direction, investors will increasingly turn to derivatives to hedge their downsides, thereby sucking volumes from the cash market. For companies, even a quarter will be too long to give guidance as markets change their complexion in days. As a result, the tendency will be to hoard cash rather than pay out dividends and become cautious while embarking on capacity expansion or acquisitions, unsure what the landscape will offer two or three years hence. On the flip side, competitors will be forced to share some services or merge to survive rather than to grow. Cost-cutting will become a recurring theme rather than a means resorted during a slowdown. The casualty will be job creation, leading to political instability around the world. The Arab spring; riots in London; the unrest in Israel, Greece, and Spain; the disgust over corruption in India; and the outrage over the high-speed train accident in China are signs of things to come.

Mohan Sule

Pledging shares

Promoters intending to use their holdings as collateral should offer ordinary shareholders the right of first refusal

By Mohan Sule

A market reeling under negative news is ready to believe the worst of companies whose promoters have used their stake to raise funds. The issue of pledged shares had flared up first during the downturn following the global economic meltdown of 2008-09, when promoter Ramalinga Raju was found to have borrowed against his holdings in Satyam Computer Services. One company even changed hands on the failure of the promoter, who had used his entire stake in the company as collateral, to buy back the shares. Pledging shares against loans is not the exclusive practice of promoters. Even small investors use their portfolio to meet emergency needs or as a leverage to make further investments. The problem starts when the market begins its slide, depreciating the value of the pledged shares. Earlier, small investors had no way of knowing about these off-market deals till Sebi late January 2009 ordered disclosure from companies whose promoters had pledged more than 25,000 shares or 1% of the company’s equity, whichever is less, in a quarter. Instead of calming the market, the move towards transparency has made matters worse. There is stampede to liquidate stocks whose promoters have pledged shares. So promoters face a dilemma. If they pledge shares to meet working capital requirement, a common reason, the revelation defies the purpose as the value of the collateral undergoes a rapid slide, thereby making the task difficult. Promoters who want to pledge their holdings to raise funds for consolidation of their ownership or acquisitions may find the tables turned: from being hunters they become preys. The lender may sell the shares even to competitors to get a good price though their market price may have eroded substantially post disclosure.

The irony is that most promoters pledge their shares during a bull run rather than a bearish phase. Getting a good price is part of the reason. This is the time when they need funds to undertake expansion or diversify. Going through organised channels is time consuming, requiring subjecting their companies to due diligence. Or the institution may have exhausted the sector quota. Besides, too much loan skews the debt-equity ratio and makes the company vulnerable to swings in interest rates, going forward. Issuing fresh equity leads to dilution of earning, especially for long gestation projects, as well as controlling stake. Instead, pledging of shares can be quick. For the lender the upside is that instead of holding stocks that may turn dud when the bull bubble is pricked, he can make a neat profit from the pledged shares by selling them to rivals. This is what happened in the case of Great Offshore. But this is a lose-lose situation for the retail investors. First, the news itself creates panic in the belief that the promoter is in trouble. Not all promoters pledge their shares for official reasons. They may need funds in their personal capacity. Many small investors take exposure to a company because of the comfortable promoter holding. According to market wisdom, higher the promoter holding, greater is his commitment to the company. The prospect of the promoter losing his grip, therefore, is worrisome for these investors. Reduction in their equity can also curb promoters’ decision- making and execution prowess.

In view of the unease of ordinary investors, promoters of late are opting for private placement, thereby setting a benchmark price for the stock. This route also bolsters investor confidence in the company. Those investors worrying about earning dilution get an opportunity to exit at a premium. A follow-on offer or a rights issue allows investors to take fresh exposure, invariably at a discount. The lower price also acts as a floor for those who want to quit. Though a burden, debt is seen necessary for capital-intensive companies to grow business. At least there would be some long-term gain, goes the logic. Pledging of shares signifies loss of confidence by institutional investors and lenders in the promoter or in the reasons for mopping the resources. The market views it as an act of selfishness of the promoter, who wants to maintain his holding and, at the same time, raise money. It also means existing shareholders have to gear for a free fall in the stock’s price soon after the disclosure. Only a hostile takeover can reverse the course. Making promoters to go public of their pledged holdings is a welcome but just the first step in protecting ordinary shareholders’ interest. Sebi must now make it mandatory for promoters to give ordinary shareholders the right of first refusal. The offer, at about prevalent market price, should come with a call option. Failure to redeem could give strategic investors or competitors an opportunity to bid for the shares. This would ensure a safety net as well as boost valuations in the long run. Not only promoters, even ordinary shareholders would be in a win-win situation.

Mohan Sule

Bailing out mutual funds

Like the breakup of UTI into two, risk-averse and high net worth investors require separate options

By Mohan Sule

Till July 2009, asset management companies charged an entry load, which was deducted from subscription, to meet selling expenses. Since the scrapping of this model on complaints of non-transparency, the regulator has been toying how to compensate distributors. Retail investors’ lukewarm response to online trading, despite listing of even open-ended schemes, too, seems to have spurred the rethinking. Conveniently sidestepped is the fact that Sebi has not done away with distributors’ commission. It has allowed AMCs to use up to 1% percentage point from the exit load for marketing costs. Besides, distributors can negotiate their fees directly with subscribers. Even before this scheme’s efficacy could be tested, new fund offers dried up as AMCs and distributors decided investors would be reluctant to pay an upfront fee. Embedded in this reservation is the acknowledgement that even the previous method of payment would not have got investors’ sanction had they been aware of the subtractions, which varied across AMCs and schemes. As returns cannot be guaranteed, the basic selling point of AMCs has been that mutual funds offer a safer route than investing directly in the stock market as experts manage the money. The experience of investors, however, has been different. Very few schemes outperform the market or give positive returns during a downturn. Even the protection of capital is uncertain. Not surprisingly, there is resistance to online transactions despite the brokerage outgo being much less than the entry load-levied by AMCs earlier.

What can be done to break the impasse? Lessons can be drawn from the bailout of the then biggest mutual fund in the country in 2003. Sales of UTI’s flagship open-ended scheme, US 64, lagged behind redemption during the market turmoil triggered by the flight of capital from South East Asia in 1997. Due to asset-liability mismatch, the government-sponsored fund was unable to meet its promises. Subsequently, the Central government decided to repeal the UTI Act, 1963, splitting UTI into two companies. UTI-I comprised US-64 and assured return schemes. NAV-based schemes were handed over to UTI-II, which has evolved into the present UTI Asset Management Company. The government issued securities to UTI-II to buy out the risky assets of
UTI-I and invest in fixed-income instruments consistent with its commitment of assured returns. US-64 investors opting out were guaranteed repurchase at Rs 12 per unit. Those who wished to continue were offered tax-free dividends and exemption from capital gain tax. After the market resumed its bullish phase, UTI was able to repay the government’s capital infusion and UTI I was extinguished on redemption of all the schemes. What are the conclusions? The financial services industry cannot offer a universal product catering to all segments of the market. The mutual fund industry has to change track to attract the risk-averse investors. In the initial phase, most of the AMCs were mainly set up by banks unable to grow their balance sheets due to restrictions on lending and borrowing and industrial houses viewing mutual funds as a transition to setting up banks. There is now a need to bifurcate the industry.

One category would be made up of the present dispensation, preferring new launches to grow the business. These funds can be mandated to invest only in the top 200 companies by market capitalisation. The returns on these schemes would be not very exciting but adequate for the small investors whose priority is capital protection. These AMCs can charge a flat fee. The second category would comprise funds floated by talented money managers who would attract investors on the basis of their performance. Right now, the mutual fund industry uses the sponsor’s brand to lure investors rather than the track record of its fund managers. Naturally, the capital requirement to enter this space would be smaller than Rs 10 crore, say, between Rs 2 crore to Rs 5 crore. These funds would take exposure to stocks excluding the top 200. Mid and small caps offer the highest growth opportunities but at the same time are volatile. By linking marketing and AMC fees to performance, the funds can attract investors with risk appetite. Presently high net worth investors prefer portfolio management schemes. These are loosely regulated and could be encouraged to convert themselves into mutual funds. The survival of UTI was considered important for the government to pump in Rs 18600 crore between 1998 to 2003. Similarly, a drastic restructuring of the mutual fund industry is crucial to gain investor confidence. The problem is not the mode of trading or commission but performance, which will get sorted out once investors become aware of the risk-return options available.

Mohan Sule

Silver linings

Companies’ efforts to shed fat and collaborate with competitors should be supplemented by relaxation in regulations

By Mohan Sule

The downsides of an economic slowdown are erosion in wealth of investors and squeeze in the margin of companies. Yet a downturn can have its upsides. The correction provides an opportunity to investors who had booked profit on signs of heating or those who were rather late in spotting winners for stock-picking. For companies, it is time to sit back and assess their expansion and diversification. How much of the quest for growth has proved counterproductive by unnecessary dilution of equity or burdening the balance sheet with debt? The lackluster market and high interest rates are triggers for spring cleaning by hiving off emerging businesses and subsidiaries without strategic synergy so as not to drag down the parent. Recently, Bharti Enterprise, the holding company of Bharti Airtel, sold off its entire 74% stake in the insurance joint venture with Axa of France to Reliance Industries. Earlier, Piramal Healthcare divested its formulations business to Abbott Laboratories of the US. The cash so obtained can be either used to reduce debt, for buybacks to improve valuation or ploughed back into the core business. Slump sales become fashionable. The most surprising exit was the decision of the promoters of Ranbaxy Laboratories to vacate in favour of Daiichi Sankyo of Japan mid 2008 as the bull-run was winding down. The process implies lack of sustaining power in face of changing regulatory environment.

It is during sluggish stock movements that the absence of a vibrant mergers and acquisitions market, mainly due to the controlling stake of Indian promoters, is sorely felt. Imagine the benefits to investors of a hostile raid on a company whose returns on assets are mediocre. Investors in telecom stocks would have been out of their misery if a foreign player were to mop up the shares of the 2G scam-tainted companies. In fact, a slowdown also provides a window to promoters to consolidate their holding through creeping acquisitions. In the short term, the move provides support for the stock but, in the long term, makes it illiquid and volatile. The government seems to have realised the importance of free float for efficient price discovery. A minimum 25% public holding is required to stay listed. Going further, the threshold level should be raised to 40% and eventually 51%. This would encourage more foreign portfolio investment and perk up the interest of retail investors. Hard times also see increasing collaborations between companies under pressure from competition. This is gaining traction in the tech sector across countries. Microsoft is working with Nokia to develop the operating system of the latter’s smart phones and tablets. Google has tied up with a host of competitors of Apple including Samsung for its Android operating system. Chip makers, too, are signing up with specific handset makers. In India, promoters of late are realising the benefit of such arrangements. Telecom companies are sharing tower infrastructure.

A year ago, the promoters of East India Hotels invited Mukesh Ambani to thwart ITC’s ambitions.Companies are also leaning to distribute functions that support their core business to others, a phenomenon whose prominent beneficiary has been the tech sector. Even assembly-line functions are now being outsourced for specialisation and efficiency, particularly in the automobile and pharmaceutical sectors. Companies also become innovative to cut costs. The FMCG sector has introduced the concept of trimming package size without sacrificing price to maintain market share while passing on the rising cost of inputs. Some go shopping for distressed assets. Tata Motors swooped on Jaguar-Land Rover early 2008 and is now reaping the dividend of the turnaround. Not only companies, even governments, regulators and central banks can contribute to revive the economy as seen post the Lehman Brothers’ collapse when central banks and governments acted in coordination to inject liquidity and introduce fiscal stimulus packages. Another way is to relax well meaning but stiff regulatory norms to keep the interest of issuers and investors alive in the market. The NDA government encouraged tech companies to list only 10% of equity and appointed a divestment minister to revive the primary market. Sebi recently increased the limit of retail participation in IPOs and FPOs from Rs 1 lakh to Rs 2 lakh. Now the UPA government should temporarily scale back the short-term capital gain tax to 10% from 15% to boost trading volumes. An aggressive divestment program by lining up profit-making PSUs, rather than those in the red, at a steep discount to the market price could be a neat counterbalance to the UPA government’s rural tilt, which has provided fuel for growth as well as for inflation.

Mohan Sule

Back to the old order

The smashing listing of a business networking site and the flop debut of a commodity trader send confusing signals

By Mohan Sule

Half way into the year, and the contradictions characterising 2011 seem to be becoming more pronounced. Even themes coexisting amicably have shown divergent trends as illustrated by the march of gold and silver even as base metals are correcting on concerns of consumption from China and India following tight money policies. In another indicator of its dichotomy, the market rebounds if growth data are below expectation because, the logic goes, this would slow the central bank from ramping up interest rates. Bank, automobile and real estate stocks rise, as a result, without pausing to wonder how these sectors will keep their momentum if purchasing power falters. Signs of investors adapting to this challenging environment are becoming obvious with the doubling of LinkedIn, a business networking web site, on debut and the fall of commodity trader Glencore below its offer price in the largest-ever IPO on the London Stock Exchange around the same time, marking the end of an era when a bull run bolstered stock prices across the board and a bearish phase pulled down valuations. In another contrast, the primary market in Hong Kong is booming with issuers, especially luxury retailers who are supposed to be the first to feel the effects of slowdown, lining up to list. As against this is the listless primary market in India, where issuers are opting for the quicker and efficient private placement route with bulging private equity funds. It remains to be seen if the rollout of the next phase of divestment by the Indian government brings back foreign investors, and the end of quantitative easing this month pushes US issuers to the trading ring.

Going forward, the cracks within the emerging markets could deepen as India hopes to douse the heat of inflation through normal monsoon while China faces the gloomy prospect of drought. The opening up of China in the 1980s and its entry into the World Trade Organisation in 2001 has changed the balance of power. The dot-com bust at the end of the last century contributed to the imbalance, accelerating the migration of manufacturing to China and back-office services to India. The subsequent easing of credit by the US Federal Reserve leaked to economies that had opened up, boosting global growth rates. As a result, lenders became emboldened to take on risky assets on their balance sheets. The re-allocation of resources around the globe to achieve maximum returns meant that some pockets recovered faster than the others due to the varying degrees of their reliance on the domestic and export markets and standards of control exercised by the regulators. The consequence has been a change in the complexion of economies, gradually or overnight. Exports have become the fulcrum to maintain growth for inward looking economies like China and India despite their huge domestic market even as the revival of the export-tilted US economy hinges on its real estate sector. No wonder, both India and China want to keep their currency undervalued despite being major importers of commodities.

The change in the orientation of the Indian pharmaceutical industry from the domestic market to overseas opportunities tellingly highlights this transformation. Eventually, many top Indian companies will get most of their earnings from exports or will sell out to foreign competitors. The automobile industry, too, is tipped to earn more revenue from outsourcing than sales in the home market in a few years despite the rise in domestic consumption. Tata Motors is an apt example. In fact, with companies like TCS and India Hotel Company in its fold, most of the Tata group’s sales will be from overseas businesses. The Aditya Birla group’s aggressive expansion in the commodity space also exposes it to global markets. Reliance Industries’ margin fluctuates on back of its fuel exports. Even emerging sectors like telecom are scouting abroad for growth. Bharti Airtel could soon get valuations assigned based on its earnings in the African region. As manufacturing in China slows down, confirmed by Glencore’s tame debut, a counterbalance to keep the world economy humming is sorely needed. Talks of another tech bubble emerging, therefore, are making investors across the world nervous in view of the setback to the US economy by the previous one. The success of LinkedIn and the anticipated huge valuation for Internet firms Facebook and Groupon and the downturn in commodities and commodity stocks should, on the contrary, be viewed as the imminent resurgence of the US economy on the reemergence of the knowledge industry, which was eclipsed by the commodity-based housing bubble during 2003-07. The importance of networking and bargain shopping is never felt more than in the present contradictory environment of inflation and slowdown.

Mohan Sule

India’s Abbottabads

By Mohan Sule

Wrong response to inflation, weak corporate disclosures, and silence of fund managers are testing investors’ patience

The discovery of Osama bin Laden in a military town near Pakistan’s capital has raised questions about that country’s preparedness in nabbing terrorists and detecting intrusions. Investigations will eventually reveal whether it was complicity or incompetence. Alas, our neighbour does not have proprietary stake on complacency and carelessness. If only the US Federal Reserve had noticed that cheap mortgages were fuelling asset bubbles. In India, the conspiracy to sell scarce second-generation telecom spectrum at throwaway prices to favoured companies happened in the heart of the capital, with everyone else too cynical or compromised due to compulsions of coalition politics to put an end to the looting. Similarly, there are many more Abbottabads in the country, with forces inimical to the well being of the economy lurking in the neighbourhood of policy makers and regulators, waiting to be confronted. One of the most insidious threats is inflation. Apart from the Reserve Bank of India, which scaled down the growth target for the current fiscal early this month, even finance minister Pranab Mukherjee has admitted that it would not be possible for the country to achieve 9% growth if inflation is not tamed. What he did not do was to identify the long-term contributors to the present situation excluding temporary factors such as disruption of foodgrain supplies and spurt in oil and metal prices. A constant factor for India will be the demand surge from rural areas triggered by the tilt of the present government: loan write-offs for farmers and employment schemes, which have provided liquidity to this segment.

At the same time, there is timidity to undertake painful reforms including phasing out of subsidies, taxing farm income and aggressive PSU selloffs to blunt the spending. Instead of a precision attack, like that undertaken by the US Navy Seals on bin Laden’s compound, the RBI has been enlisted for carpet bombing by ramping up interest rates. The drone attacks are inflicting damage throughout the economy already reeling from high commodity prices. The chain reaction is inducing across-the-board price spiral. Already, investors are dumping companies that are absorbing input costs for fear of losing market share. In contrast, China recently fined Unilever for trying to pass on the raw material costs to consumers. Right now, the economy needs higher capacities to cater to expanding demand so as not to affect prices adversely. The rising interest rates are sure to hinder rather than help in bolstering production. Costly money could also boost non-performing assets. The increase in provisioning by SBI in the last fiscal has raised concerns about the health of our financial services industry. If low cost of money fuels bubbles, high cost pricks them, causing pain all around as seen after the collapse of the property market in the US. Higher interest rates also attract hot money from hedge funds on the lookout for arbitrage opportunities, turning the domestic currency volatile and scaring long-term investment from pension funds.

Besides insider trading, unwillingness of companies to issue clarifications and the habit of going into denial mode before confirming the ongoing buzz are undermining the confidence of investors in the sanctity of the markets. Of the lot, the IT sector is held as a mirror to companies in traditional industries. Yet, the succession struggle in Infosys Technologies and the abrupt top-level changes at Wipro have highlighted Indian companies’ difficult transition to become transparent. Even those with substantial foreign equity stake are reluctant to open up as illustrated by the lack of clarity on the terms of the split between the Hero group and Honda Motors. Another puzzle is the silence of institutional investors even as egoistical promoters diversify into unrelated ventures, using up their cash or taking on debt. Local and foreign funds choose to remain mum or make a quick exit instead of publicly chastising these megalomaniacs. Not a single institutional investor has demanded that promoter-CEOs of listed companies linked to the allotment of second-generation spectrum withdraw from day-to-day management. Only the Norwegian partner, Telenor, suggested that the boss of its joint venture with Indian collaborator, Unitech Wireless, step aside till the probe reached its logical conclusion. Not surprisingly, the Indian promoter rebuffed this sensible suggestion. If the Apple board could sack its founder-CEO, why cannot independent directors speak out? In fact, this could win back the trust of investors in these companies. The important thing for the government, regulatory authorities, companies and institutional investors is to demonstrate that they are responsive to the needs of ordinary investors and the absence of adequate reaction is not a result of insensitivity.

Mohan Sule

Market triggers

Dollar, political stability and reforms will determine the course of the market in the current fiscal

By Mohan Sule

Now that the market has discounted the March 2011 quarter results and normal monsoon forecast, what will be the next triggers in the coming fiscal? The most important indicator will be the pace of foreign fund inflows, which had slowed down early this year on the strengthening rupee, but returned end of the last quarter on the weakening of their borrowing currency, the yen. Since the collapse of Lehman Brothers, resulting in recession in the developed economies and slowdown in the emerging markets, it is now clear that movement of funds into and out of a country is not solely dependent on its economic health. Many external factors such as currency equation, availability of cheap credit and valuation of assets in comparison with investment opportunities elsewhere figure prominently. Here, the moves of Federal Reserve chairman Ben Benanke will have to be followed. So far he has resisted calls to release US interest rates from the near-zero level due to anxiety that any steps to rein in the rearing inflation could be at the cost of the incipient recovery. Yet, end April, he announced the phasing out of the second installment of quantitative easing, or liquidity injection, by June, which could put pressure on interest rates and boost the dollar, a requisite to attract investment into the US. These are indeed contradictory signals. The US needs a weak dollar to boost its exports. At the same time, it cannot ignore pressure from China, its largest creditor, which holds most of its foreign exchange reserves in dollars. For the currency market as well as for companies selling overseas and importing raw materials and components this translates into volatility.

A strengthening dollar, however, will be good news for exporters to the US, particularly China and India. Tech companies, facing rough weather of late due to the weak recovery in the US, could be the biggest beneficiaries as long as the American economy does not blink in the process. Besides currency, foreign funds prefer countries with stable government. The world is not looking particularly attractive in 2011. Earthquake off Japan has set back the third largest economy at least by a couple of years. Oil is heating on unrest in the Arab region. A year ahead of change at the top, China’s present leadership has unleashed an unprecedented wave of repression to crush any signs of Jasmine revolution. The Chinese intend to decelerate over the next few years to insulate the country from overheating. How will the restless population, used to their economy expanding at an average 10% over the last decade, take to a growth rate of 7%? If the Chinese government can manage this transition “harmoniously”, the recent correction in surging prices of oil and base metals will sustain unless India, expected to gallop at 9% this fiscal, steps in as a substitute. The government is stable but has been weakened politically due to the various scams. It is doubtful if it has the appetite to undertake second-generation reforms including allowing more foreign investment in insurance and opening the retail sector. Even the announced aim of collecting Rs 40000 crore through PSU divestment looks ambitious: it was able to mop up Rs 22000 crore last fiscal as against the target of Rs 40000 crore despite a buoyant market and absence of any political danger.

Slowdown in foreign fund inflow against the backdrop of recovering US and EU economies too could make it difficult to get attractive valuation. The picture could reverse, if the government takes the bold step to sacrifice some amount of premium to bolster the domestic market. It is not only PSU stake sell-off that will be required to keep the economy humming. How the besieged government tackles subsidy will be interesting to watch. Petrol prices have been raised seven times totaling Rs 10 per litre last fiscal and another hike is in the offing now that the assemble elections to the five states are over. Oil marketing companies could get some more relief but will continue to incur losses. Fertiliser stocks have been looking up of late not only in anticipation of good rainfall but also on hints of freeing urea pricing. The firmness of resolve will depend on which way the results to the five state elections go because cutting the subsidy bill is bound to contribute to inflation. Not only that, awarding of infrastructure contracts, which have been picking of, too, will suffer if the government turns lame-duck. High interest rates, surging commodity prices, and a freeze on reforms and the resultant impact on foreign portfolio investment pose a challenge that could unnerve even a competent government. The baggage of corruption will make the task even harder if painful but necessary measures to keep the economy on course are viewed with suspicion by a cynical population or worse paralyses decision-making.

Mohan Sule

New rules of the game

After coordinated action to avert global meltdown, limiting the euro zone crisis and capping the yen, focus should turn to commodities

Mohan Sule

Can we return back to those days of the last decade when interest rates were low, liquidity was aplenty, economies were galloping, the markets were booming and newer companies were emerging on the trading screens to bet on? Look at the landscape now, from east to west. Power outages in Japan have disrupted supply chains across the world. China and India are battling inflation. The uprising in the Middle East has raised fears of prolonged turbulence disturbing the flow of crude. The sovereign debt crisis in the euro zone has spread to Portugal even as the European Central Bank has started increasing interest rates. The dollar is plummeting as the US Federal Reserve is stubbornly resisting calls to do so despite signs of recovery in the face of flat jobs creation and soft housing prices. Stock markets have become volatile as foreign portfolio investment moves in and out in search of arbitrage opportunities. The current turmoil and future uncertainty, however, have not dimmed the luster of commodities, which are continuing their bull run triggered last year in the belief that the worst is over for financial markets after the bail-out of big investment banks. Within the commodities group, bullion and industrial metals, at any given time, move in opposite direction. The upward movement of precious metals is dictated by fears that the good times are coming to an end, while the buoyancy in base metals stems from anticipated economic growth. This time, though, the correlation has come apart.

Gold and silver have become a separate asset class, de-linked from other investment options and assuming a form that suits investors at that point of time: hedge during inflation and an avenue to channel profit from equities. Base metals and oil, however, continue their connection with economic cycles. Just as the futures and options prices of forward contracts influence the cash market, positions taken by various participants for different reasons affect spot prices of commodities, too. The major difference is that while the impact of the sentiments in the stock market is restricted to buying and selling by investors to make or book profit, without making much of a difference on the day-to-day operations of the companies, unless they are preparing to raise capital, trading on commodity exchanges affects the spot prices of consumables, benefiting or punishing producers and users. Derivatives enable investors to bet big as well as cap risks, artificially altering the demand-supply equation. This was amply evident in the rise of crude oil in anticipation of decline in output from Libya, and even Saudi Arabia, on concerns of internal turmoil. Similarly, the Japanese currency took off immediately after the earthquake on expectation of investors who had borrowed in yen to invest in emerging markets liquidating their assets to repatriate back home and insurance companies selling their overseas assets to pay damage claims. Eventually, G7, the group of rich countries, had to pump in yen to cap the rise.

Excluding the concerted action by the European Union to bail out their members defaulting on sovereign debt, this was the second time that a group of countries was acting in unison after the Lehman Brothers’ crisis and resultant economic meltdown, which saw coordinated quantitative easing by central banks and fiscal stimuli by governments around the world. The IMF’s recent pronouncement that it is willing to help emerging countries to manage their capital flows better after all else including interest rate hikes and capital control measures such as taxes have failed is one more step towards institutionalising the process of managing the global economy. As most of the emerging economies save for Brazil and Russia are net importers of commodities, attention should shift to controlling their galloping prices. From the experience of the Organisation of Petroleum Exporting Countries, producers of metals should know that after a point rising prices can be self-defeating, resulting in global slowdown and inflation in the domestic economy. Equity markets have circuit filters. Exposure to stocks in the derivatives segment too is limited to the outstanding shares of a company. There is no such fencing for taking positions in the commodities futures market. Banning trading, as India does quite often, would be a disservice to large consumers who would want to protect themselves from future price volatility. Perhaps compulsory delivery rather than squaring off for contracts bought, at say 5%, above the current spot prices could induct some sobriety. If not, the alternative will be political instability, particularly in the emerging markets.

State of the market

The recent fall and bounce-back indicate India will attract foreign investment on availability of cheap credit
By Mohan Sule

Three recent but separate events, if viewed together, reveal the state of the market. The first is the advertising splash heralding the new chief of the Securities and Exchange Board of India. As head of UTI Asset Management Company prior to his new posting, the issues facing the mutual fund industry obviously would at the top of mind for U K Sinha. The ad splash to prompt investors to shift to online trading of mutual units, though unexpected, was therefore not surprising. Ever since the ban on entry load took effect, mutual funds have been disappearing off the radar of investors and not because of their lack of interest. Rather, asset management companies have stopped pushing mutual fund products. Going online has eliminated the need for distributors, both for AMCs and investors. Instead, investors now have to seek online brokers. Mutual funds are the only or the first step to exposure to the stock markets for many of them. Accustomed to home visits by their friendly neighborhood distributor, they now not only have to compare online brokers to choose but also get a demat account. Sticking out in this episode is the glaring disinterest displayed by fund houses in enlisting subscribers. As a result, Sebi had to take the initiative, which ideally should have been coming from asset management companies or even online brokers, which would be the end beneficiaries. What this means is that despite their public proclamation of love for the small investors, the prime motive of new launches by AMCs was to collect funds to earn management fees. All the talk of harnessing the power of the retail investor to checkmate the brute power of foreign funds through mutual funds is just wishful thinking. The disinclination of online brokers to aggressively woo mutual fund investors also shines a light on their business model. Competition has beaten down broking charges to such an extent that the piddling investment through systematic plans holds no charm for these brokers, who would rather procure institutional business.

The second puzzling trend is the return of foreign funds since end of March after beginning to pull out from early this year, complaining of high inflation and interest rates and the endemic corruption that has spread rather than diminished along with the reforms process. Recovery in the US economy and signs of stability in the Euro zone overwhelmed the attraction that these investors had for high yielding Indian paper. So, why has there been a reversal from outflow to in inflow of foreign portfolio investment barely three months? Headline inflation remains stubbornly high. Food prices are cooling but non-food prices are heating up. The central bank has increased its lending rate by 200 basis points and borrowing rate by 250 basis points in the year to March 2011 and could ramp them up further by 50 to 75 basis points during this year. There has been no downward revision by the government or the central bank in the growth figure projected in the budget, which is anyway being taken with a healthy skepticism by foreign investors, who are factoring in the contribution of inflation in padding up the GDP. Instead of bottoming out, the fall of the government in Portugal suggests more euro nations could get caught in the sovereign debt crisis. Notwithstanding the lackluster housing starts and job data, US auto sales have spurted despite costly fuel, indicating that the recovery, though slow, is holding. What has changed is the availability of money. Following the earthquake off Japan and the resulting devastation, G7 countries pumped in yen to cap its appreciation, thereby taking the global economy back to the old days when arbitrageurs borrowed in low yielding yen to invest in high return emerging markets.

The lesson from this changing complexion of the market is foreign investors are not prepared to buy anything Indian irrespective of valuation, disrupting the secular up or down movement of the market. Irrespective of optimistic growth forecasts, the market will remain attractive as long as easy money is available and there is opportunity for quick returns. As soon as there is overheating, funds will move to another and return once the market cools down. Perhaps this could explain why Warren Buffet has still not invested in a single Indian company during his recent high-profile visit. The investor with a Midas touch has repeatedly said he invests in companies he understands. This leaves out hi-tech and emerging sectors. His biggest investment outside the US so far has been is his purchase of 80% stake for $4 billion in metal tool cutting maker in Israel. He has spent $230 million for 10% stake in a Chinese battery company making green cars. Instead he has become an agent for the non-life insurance of Bajaj Allianz. What does this say for the Indian market unless investors uncharitably dismiss him as out of touch in view of his clean chit to his deputy who purchased shares of a company before recommending it to his boss? One of the ways to look at it would be that most of the frontline companies whose businesses he understands are expensive despite Buffet’s remarks triggering a rally in the market. It also implies that the next big thing in India would be insurance. The taste of things to come is the Rs 3000-crore Nippon Life Insurance deal for 26% equity stake in Reliance Life Insurance. Buffet’s foray into the Indian market could also be a subtle reminder to the Indian government to open up the sector with the muscle to step in to substitute foreign investors to calm the markets during volatility.

Mohan Sule

A lopsided field

The charging of Corporate America’s Rajat Gupta and the 2G spectrum scam show the system favours insiders

If the Niira Radia tapes blew off the lid on the cosy collaboration between media and companies they cover, the secret recordings of phone conversations of a US hedge fund promoter, Raj Rajaratnam, has entangled respected figures on Wall Street and even Corporate America. The similarity between the investigation into the throwaway sale of second-generation (2G) telecom spectrum and the trial to press charges of conspiracy to profit from illegal stock tips is the shortchanging of ordinary investors by insiders. Rajaratnam has been accused of cultivating a network of spies in various companies to alert him of possible breakthroughs or deals. He is said to have made $45 million by trading in 35 different stocks. The informants ranged from scientists as well as corporate movers and shakers such as Rajat Gupta, the first Indian to head the global consultancy firm, Mckinsey, and also a director of MNC Proctor & Gamble. While still being on the board of Goldman Sachs, Gupta was believed to have disclosed the impending $ 5-billion investment by Berkshire Hathaway into the investment bank. Rajaratnam, whose hedge fund Galleon once managed $7-billion assets, has dismissed these charges, claiming that he spoke to officials of various companies as part of research. His lawyers have compared Rajaratnam to a dogged investigative journalist, working with disparate sources to collect as much data as he could about the companies in which he invested. What is trading on insider information to prosecutors is “detailed meticulous research into company fundamentals” to the defending team, which has called him “a distinguished and an exceptional analyst and portfolio manager”.

The thin line dividing trading on legal and illegal information makes it as difficult to determine guilt as does policy makers’ response that revisions in framework are often made as a reaction to the altered dynamics of the market place rather than to enable a few to profit. Yet companies that have managed to bag the first round of 2G licences have blamed the eagerness of the new entrants for the changes in policy, while the latecomers have accused the older ones of trying to restrict competition. The first-mover advantage was mostly enjoyed by Old Economy groups. Ideally their entrenched positions should have been under threat due to the opening up of the economy. Instead, their effortless entry signifies how easy it is for dominant businesses to consolidate their status at the top of the pole by pressing the appropriate levers of powers to get rules customized to fit their shape and size. The winners of the second round of 2G licences were tier II companies that had won their spurs on the eve of liberalisation in tightly-controlled sectors. Most of the asset management companies are offshoots of industrial groups, just as telecom services providers are, and are set to become even more influential as the Reserve Bank of India prepares to hand them licences to run banks. Even among the Old Economy group, there are companies with excellent corporate governance record and lots of cash like Bajaj Auto, which have not ventured into unnecessary diversification, least of all telecom and real estate. L&T manufactures capital goods and also gets revenue from infrastructure construction, but has refrained from turning into a developer of residential and commercial properties.

These companies perhaps smelled the stink and balked at the compromises that certain emerging sectors entail. The fear is that, in the absence of fresh entrepreneurial talent, the Indian economy would be run over by oligarchs as in Russia. It is understandable if a power distributor wants to put up plants to generate energy and bid for oil and natural gas blocks to ensure smooth supplies. But why should the group provide telecom services and make movies as well? One of the last global conglomerates is General Electric of the US, which manufactures equipment for the power and healthcare sectors and also owned broadcast television network NBC, before selling in December 2009 a controlling 51% stake to cable operator Comcast, with an option to divest its remain holding after seven years. Of late, however, a majority of GE’s revenue is coming from financial services. How difficult it is for newcomers to gatecarsh into the exclusive club comprising established players, politicians and bureaucrats is illustrated by the meteoric rise and fall of Shahid Balwa, the promoter of real estate company DB Realty and the second-round winner of 2G licence, who is now alleged to have sought finances from outside the mainstream channels. What should investors do? Should they take exposure to a trailblazing stock knowing well that the growth is based on promoter-politician nexus? Or should they snap up a mutual fund providing solid returns based on insider information? A cruel dilemma, indeed!

Mohan Sule