Out of control

Movement of crude oil, currency and real estate will support
or mar budget calculations

By Mohan Sule

The finance minister has made his calculations. Over the next 12 months, the economy could play out as per the bets in the budget or skid as revenue does not pan out as expected or expenses, planned or untold, overshoot estimates. This could be because of internal or external factors. Rollout of reforms could improve sentiments but paralysis in decision making due to compulsions of coalition politics could prove to be a setback. External factors that could cast a positive influence would include a bounceback in the developed economies. Flare-up of geo-political tensions in some hotspots of the world, however, might affect liquidity and inflow of capital. As such the finance minister may have played the best cards available but there is always a joker in the pack to spring up a nasty surprise. Among the three most visible factors that could make or mar the markets in the fiscal ending March 2013, the most important is the movement of crude oil. After crossing US$100 a barrel in 2008 on surge in demand due to the bullishness in global economy, crude is once again testing these levels but not solely in anticipation of global economy’s resurgence. Rather it is due to trade sanctions on Iran, one of the major suppliers of oil to India, China and Europe. How soon the tensions in this region ease will not only determine the speed of recovery worldwide but will also provide a trigger for another spurt in prices. For India, crude is going to play a spoilsport till it dismantles the subsidy regime. Otherwise, expansion will be accompanied by a ballooning fiscal deficit, thereby trapping the country into a periodic cycle of growth-inflation-slowdown.

Of late, the conventional linkage of oil prices to inflation and, in turn, to interest rates is being severely tested. One of the reasons is the world is no longer flat. The bipolar globe consists of the developed and emerging economies. The flow of liquidity favors yields over everything else. Till recently, oil prices were capped by the slowdown in the US and recession in the euro-zone. Yet, India was coping with inflation caused by factors such as increasing consumption of protein-rich food and surging commodities on China’s insatiable appetite. The biggest surprise was India’s inability to attract arbitrageurs despite high interest rates. The attack on the rupee primarily stemmed from the credit crunch in the euro zone and not only from slowdown in growth arising from high interest rates and lack of progress on economic liberalisation. Dollars are flowing once again despite absence of any reforms as the European Central Bank has pumped funds at very cheap rates to lenders in Europe. The US Federal Reserve, too, is determined to keep interest rates at rock bottom for another two years. Foreign direct investment in multi-brand retail, insurance and banks, thus, may not be the keys to open the floodgates for capital inflows. Levelling of economic growth around the world from the present lopsided situation of high-wire and turgid countries would map the movement of funds from one spot to another due to specific reasons and not because of interest-rate differentials. This may take some time to happen. Till then, even deft budgetary juggling will continue to be in the danger of being overshadowed by circumstances beyond the finance minister’s control.

The shock of the the real estate market’s crash in the US, for instance, was not restricted to homebuyers. The contagion spread to Europe and rest of the world quickly as there were many other stakeholders involved ranging from mortgage lenders to financial institutions with exposure to derivatives based on loans of different types and tenures. Earlier, the health of the automobile sector was viewed to determine the well being of the economy due to its capital- and labor-intensive characteristics. Eventually, the industry shrugged off its local flavor to achieve a dispersed personality as supply chains were spread out to the most cost-effective geographies. Ironically, real estate, which should be the most indigenous industry as domestic conditions are supposed to have a bearing on the price tag and availability, has become the most vulnerable component in the global value chain. A boom or a slump transmits benefits or setbacks to different export-oriented sectors including commodities and financial services. Increasingly, its outlook is decided not only by the country’s growth rate but also by the price of oil as it impacts inflation and lending rates. In its endeavor to boost the economy, the budget might fuel real asset prices. This could make the exercise of lowering interest rates tricky for the central bank as it would not want to create asset bubbles. The bottom line is for all the hype and hope pinned on the budget to give a big push to the economy, the exercise has its limitations and comes with an expiry date.

Mohan Sule

Collateral damage

The drive to make the investment space safe has come at a price: marginalisation of retail investors by the issuers


By Mohan Sule

For all the hype about India’s growing middle class being the size of the entire population of the US, the Indian retail market is increasingly looking like a Rubik’s Cube: a tough nut to crack or easy to solve. Even as foreign multi-brand retailers, banks and insurers are lobbying hard to gain access, some of those who have set up shop are looking to exit. Take two recent examples. The Indian arm of Fidelity, US’s second largest mutual fund by assets, is scouting for buyers. Australian group ANZ, which quit India in 2000, reestablished a branch last year but British bank Barclays is pulling out of retail business to concentrate on corporate banking. Yet fast-food chains like McDonalds and Domino’s Pizza are rapidly gaining market share. All these investors are looking at the same middle-class market. Why is that some have been able to tap it while others have flopped? Two reasons are bandied about for this state of affairs. First is India’s boom is fuelled by consumption, at 58% of GDP compared with China’s 48%, rather than government and private sector investment. Demand for automobiles, food, education and travel are the manifestations. This is perplexing considering the domestic savings rate is about 25%, next only to that of China, which is being advised to boost consumption to level the lopsided growth fuelled by state investment and exports. This leads to the second proposition. Compared with real estate, gold or consumer goods, the financial services market is tightly regulated. Sebi’s preference is to create a secure environment even if it comes at the cost of risk-taking.

Ironically, capital market regulations were evolved to attract foreign investors, who wanted a transparent field. It is now becoming clear that the stricter rules have taken care of demand-side issues but not the concerns of suppliers. Compliance is increasing the expenses of intermediaries and issuers. Fidelity has reportedly complained of low entry load and asset management fees, an indictment of Sebi’s reintroduction of entry load as a flat upfront levy, discontinuing the earlier practice of embedding it as a proportion of the subscription amount. Similarly, foreign banks are hobbled by priority sector lending quotas and caps on branches. The Reserve Bank of India came out with a discussion paper on the roadmap for foreign banks early last year in view of India’s commitment to the World Trade Organisation to open up the sector. The recommendations are yet to be translated into policy. The recent freeing of savings rates means costlier retail deposits, the cheapest source of liquidity for banks. Disposing low margin business of retail lending makes sense for foreign banks cleaning their balance sheets and facing higher requirement of risk capital in their home countries following the collapse of Lehman Brothers in September 2008.

The Indian government does not seem to be perturbed by the sparse presence of foreign players in the retail financial services space. This could be for two reasons. First is the skepticism that foreign players share its goal of making banking accessible to all segments. Individual investors would be better off tapping the government’s high-cost borrowings served with the icing of tax deduction. Second could be the desire to ring-fence the small saver from any overseas contagion as well takeovers in the sector. The repercussion of this strategy is marginalisation of retail investors. Issuers are going overseas to raise resources not only for the depth of the subscription pool but also for cost-efficiency. Sebi recently permitted equity dilution through the wholesale route on the bourses to meet the minimum 25% public float requirement, eliminating lock-in of private placement and preferential allotments — a tacit admission that the retail base of investors is inadequate or dispensable. Diminishing chances of allotment in IPOs, increasingly dependent on applying at higher cutoffs and at maximum permissible limit, are also crowding out retail investors. The zero long-term capital gain tax has not emboldened small investors to build up an equity portfolio. Instead there is spurt in day trading as the investment outlook has shortened, with the markets plugged into global bourses. International events rather that domestic happenings influence the benchmark indices. The tortuous euro-zone bailout negotiations have the capability of shaping sentiments. The Supreme Court’s decision to cancel 122 2G telecom licences issued during the second round of spectrum sale had no impact on market movements. Inflows hinge on arbitrage opportunities created by volatility in local currency or interest rates rather than the long-term view of the economy.

Mohan Sule

Lessons to be learnt

Dismantle artificial barriers between demand-supply and strengthen oversight to nip monopolies

By Mohan Sule

India has always been a difficult place for foreign investors. For every multi-brand retailer like Walmart, who is eager to enter the country to tap the vast market, there is another disillusioned investor like Fidelity Mutual Fund, which wants to exit, frustrated by the maze of regulations that make accessing this huge pool difficult. Recent events have brought this dichotomy in foreign investors’ perception rather sharply. If the Supreme Court’s stinging rebuff to the finance ministry for levying capital gain tax on Vodafone’s acquisition of the stake of Hutchison, another overseas investor, in its telecom joint venture with Essar restored the confidence in India’s slow-moving legal system, the cancellation of all the 122 second-generation (2G) telecom licences issued on first-come-first-served basis in January 2008 has reinforced the view that India is too chaotic a place to do business, with frequent changes in the rules of the game offering no long-term stability. Two showcases of reforms with potential to power the India Growth story — telecom and aviation — have become examples of crony capitalism and the embedded bias against FDI in the political class. Sadly, India today is talked more for its corruption rather than being bracketed with China for its economic power. Nonetheless, some good may come out of the sorry events of the past days if some lessons are learnt. The first is the price of interference in the demand-supply equation can be heavy. The telecom sector is the prime example. There was cap on the number of players in each circle. Licences were issued based on technology. Foreign investors were barred. Eventually, the concept of unified services access was introduced, allowing  services providers to offer services across segments and technologies.The result was a boom in subscriber base as tariffs fell due to competition.

Yet, the awarding of the 3G spectrum shows that inferences from the earlier mistakes have not been drawn. Though the licences were auctioned, players were again restricted to circles. To get over the inability to offer pan India services, providers started inking roaming pacts with each other. This practice has been met with stern disapproval from the industry watchdog. Equally disastrous, says the second lesson, is doling out licences to equity investors masquerading as entrepreneurs rather than to those with the intention to stay and succeed. Selling part or entire stake by almost all those who bagged the 2G licences in the second round (though only Swan Telecom and Unitech Wireless have been charged by the CBI) for huge profit show that arbitrageurs benefit from lack of transparency. This should silence critics who maintain bidding raises the price of the end product or service as those acquiring the rights try to recoup their investment. This gives rise to the third lesson. There is no one-size-fits-all method to sell scarce natural resources. The expenses involved in drilling oil are fairly stable. But exploration rights are auctioned and the producers calibrate crude prices as per demand even while selling it on a first-come-first-served basis. This means even fixed pricing has a variable element. The problem arises when the cutoff is determined not by availability but to accommodate cronies as happened in the telecom space three years ago. Eventually, the corruption of the process proved self-defeating. The large number of entrants jeopardised the health of the telecom industry.

The conclusion that can be drawn is that if the price of the end product depends on demand rather than the cost of production, auctioning is the best method. Eventually, this will lead to levelling of the field, with the cost-efficient surviving the fluctuations in consumption. This leads to the fourth lesson. Imposing physical or financial barriers to limit players is harmful and so also restrictions on mergers and acquisitions, which constitute the market’s search for equilibrium. Second and third tier companies amalgamate to take on the number one player and the leader gobbles up smaller players to achieve economies of scale and stay profitable. This brings to the next lesson. There is need for a strong competition overseer who would step in to ensure that users have a choice in prices, products and services. The European Commission has nixed the proposal of the NYSE Euronext stock exchange and Deutsche Borse to merge for this reason. In India, the Competition Commission has yet to become assertive. Instead of hoping for regulatory or judicial intervention, it is time shareholders become vigilant and nip promoters’ grandiose dreams in the bud. For instance, if institutional shareholders had questioned why real estate companies need to diversify into telecom services, India would have been saved from seeing its image take a severe drubbing.

Mohan Sule