Friday, December 18, 2015

It does not hurt to be corrupt!

Why rent seeking is pervasive

Here is how the decision-tree for a public servant making a choice between remaining honest or becoming corrupt would look

Assume that the rent payout is Rs 100,000. Assume that the probability of a corrupt official getting caught is just 10% (a good approximation if we take the full career of officials even in the more corrupt departments). Assume also that only 25% of those accused of corruption actually end up being punished. And of those punished, it is not unreasonable to assume that just 10% get dismissed from service (in fact the actual number would be insignificantly small, or infinitesimal), while the rest escape with administrative penalties like cut in increments or reduction in ranks, all of which have the effect of reducing their salaries.

One of the important points to be borne in mind is that unlike other forms of theft and pilferage where it is easy to recover the booty, it is almost impossible to recover the rents collected by the officials. Therefore, whatever has been amassed is more likely to remain with the official. Further, except in cases where departmental materials have been diverted or government funds have been mis-appropriated, the major share of corruption cases involve taking bribes or personal favors for doing official functions. It is not practical nor possible to reverse such favors even if the employee is punished. In other words, the punishment only imposes an administrative penalty.

Let us make the following assumptions. We can assume a rent payoff of Rs 100,000. Assume that the financial implication of the reduction in salary is small enough to be irrelevant over the career of the official (a typical one or two increment cut in salary, with cumulative effect, has only marginal impact). Assume that the bribe required to get himself out is half the rent gained, or Rs 50,000. Assume that the environment has become so permissive that the peer-group stigma of being corrupt is minimal. Assume also that the salary foregone if dismissed is ten times (and at higher levels of the officialdom, the reverse is the case!) the rent gained, ie Rs 1000,000.

In the circumstances, the pay-off for each category would look like this
1. The expected value of a honest public servant is his salary
2. The expected value of a corrupt official, P(corrupt)
P(not getting caught)x(Salary+rent)+
P(caught)xP(bribe and escape)x(salary+rent-bribe) +
P(caught)xP(punished)xP(dismissed)x(rent+shame+salary foregone) +
P(caught)xP(punished)xP(penalized)x(lower salary+rent+shame)
= (approx)
Salary + 0.9x100,000 + 0.1x0.75x(100,000-50,000) + 0.1x0.25x0.1x(100,000-1000,000) + 0.1x0.25x0.90x100,000 = Salary + 90000+3750-2250+2250 = Salary + Rs 93750

As can be seen, the expected pay-off from taking a bribe of Rs 100,000 lakhs is salary + Rs 93,750. Now you decide whether to be corrupt or not!

why corruption was pervasive, arguing that it pays to be corrupt. A newer version of the decision-tree diagram below (please click to blow-up) captures the expectations and deterrents facing officials when they take bribes

A cursory examination of the extant administrative processes on disciplinary action would reveal that each of the probabilities - p, q, r, a, and b - are far closer to zero than one. Given this, the likelihood of the biggest punishment of a person being caught taking bribes and dismissed from service is (p)(q)(r)(a)(b), an infinitesimally small chance. In any case, the administrative processes make establishing a corrupt practice very difficult. And, even when caught, the current processes leave pretty much the whole share of the rents captured by the official in tact. So, given the stakes involved, if you do not mind the infamy and can manage the inquiry process (not very difficult), it clearly pays to be corrupt!

The probabilities and cost at each stem vary based on how strict the officer concerned with the task is.

My Reading

My Reading

1. India needs more of this type of market makers and peer-to-peer lending platforms which can credibly signal the credit-worthiness of borrowers by using non-conventional sources and strategies of credit assessments,
The financial tech startups are trying to evaluate credit risk using a wide variety of consumer data including the digital footprint of customers arising out of social networks, ecommerce, mobile usage and geo-location. For example, IndiaLends claims to capture alternative information points such as bank statement, utility data, social data and customer interaction with the website... Startups like IndiaLends do not lend money of their own. Using their technology platform, they connect consumers with banks and financial institutions which results in better rates for the borrowers and a reduction in overall default rates... where they differentiate... from the bank is in scientifically matching the right borrower profile with the most relevant lender and hence reducing inefficiencies that lead to lower loan approvals, higher interest rates and sub-optimal loan amounts.
2. The most obvious indicator of state capability weakness is the gross inadequacy of personnel in many critical public agencies. As against a global average of one policeman per 450 people, India's has one for 709 people, with the numbers being 1298 and 1282 for Bihar and UP respectively. 
The problem here is that any discussion on increasing personnel strength gets conflated with the mistaken belief that the government is already too big and needs to be pruned down.

3. Ian Bremmer points to this map of the world would could well represent the beliefs of ISIS
4. Economic Times has a story on the increasing use of robots among India's car manufacturers,
Robots have begun to take over an array of functions from humans at car plants in India. Volkswagen India has 123 robots at its Pune plant while Hyundai Motor India, the subsidiary of the Korean carmaker, has 400 robots at its factory in Chennai... The Ford Sanand plant actually has 453 robots in the shop floor, with up to 90 per cent of the work automated... The entire body shop, most of the paint shop and parts of the final assembly line in these plants are now automated. Robots are performing functions ranging from welding to foundry operations to laser applications.
But robots are not likely to displace humans any time in the foreseeable future,
Still, despite the many benefits, companies will not be in a hurry to replace labour simply because robots are costly. A robot does the work of three technical workers, but it typically costs between $3,00,000 and $4,00,000. In other words, automation is 10 times more expensive than manual labour
5. Business Standard has an article on the findings of the Ashok Misra Committee which examined India's unregulated professional course entrance examinations coaching industry. The report proposes the establishment of a regulator for the coaching industry. The report highlights the scale of the industry,
According to an a 2013 survey by Associated Chambers of Commerce and Industry of India (Assocham), titled "Business of Private Coaching Centres in India", the size of the private coaching sector was $23.7 billion, or Rs 1.41 lakh crore. The survey also predicted that by 2015, it would grow to $40 billion, or Rs 2.39 lakh crore. The survey had collected data from 5,000 students and parents across 10 cities. It revealed that 87 per cent of primary and 95 per cent of high school students in the major cities took private tutoring. This industry grew by 35 per cent in the previous six years.
6. Global corporate bond offerings have crossed $2 trillion for the fourth consecutive year on the back of continuing monetary accommodation and signals that the ECB may be willing to continue and expand the ongoing QE.
7. Roula Khalaf has a nice summary of the differences between Isis and Al Qaeda. This is interesting,
The Sahwa movement comprised a group of Iraqi tribesmen that collaborated with the US a decade ago to root out the Iraqi branch of al-Qaeda. That branch took its revenge: it eventually became the Islamic State of Iraq and the Levant, better known as Isis... Isis seems obsessed with al-Qaeda, from which it split in 2013 following disagreements over the goals of jihad in Syria. Since then Isis has distinguished itself from its parent through its savagery (there is no limit to the violence it is willing to inflict) and its move to create a caliphate in parts of Iraq and Syria. 
8. Nice article in NYT on how Isis sustains itself - "they fight in the morning and they tax in the afternoon". The article describes how Isis is running the legitimate revenue collection operations of a regular government,
The better known of the Islamic State’s revenue sources — smuggling oil, plundering bank vaults, looting antiquities, ransoming kidnapped foreigners and drumming up donations from wealthy supporters in the Persian Gulf — have all helped make the group arguably the world’s richest militant organization. But as Western and Middle Eastern officials have gained a better understanding of the Islamic State’s finances over the past year, a broad consensus has emerged that its biggest source of cash appears to be the people it rules, and the businesses it controls...
(Isis) has set up a predatory and violent bureaucracy that wrings every last American dollar, Iraqi dinar and Syrian pound it can from those who live under its control or pass through its territory. Interviews... describethe group as exacting tolls and traffic tickets; rent for government buildings; utility bills for water and electricity; taxes on income, crops and cattle; and fines for smoking or wearing the wrong clothes. The earnings from these practices that mimic a traditional state total tens of millions of dollars a month, approaching $1 billion a year, according to some estimates by American and European officials. And that is a revenue stream that has so far proved largely impervious to sanctions and air raids... 
In Raqqa, the Syrian city that is now the de facto capital of the Islamic State, a department called Diwan al-Khadamat, or the Office of Services, sends officials through the city markets to collect a cleaning tax — 2,500 to 5,000 Syrian pounds, or about $7 to $14, per month depending on the size of the shop. Residents go to collection points to pay their monthly electricity and water bills, 800 Syrian pounds, or roughly $2.50 for electricity and 400 pounds, about $1.20, for water. Another Islamic State department, the Diwan al-Rikaz, or the Office of Resources, oversees oil production and smuggling, the looting of antiquities and a long list of other businesses now controlled by the militants. It operates water-bottling and soft-drink plants, textile and furniture workshops, and mobile phone companies, as well as tile, cement and chemical factories, skimming revenues from all of them...
The group has taken over the collection of car-registration fees, and made students pay for textbooks. It has even fined people for driving with broken taillights, a practice that is nearly unheard-of on the unruly roads of the Middle East. Fines are also included in the punishments meted out for breaking the strict living rules imposed by the Islamic State. 
In this context, the prevailing strategy to contain them, involving targeting their oil production and smuggling operations is unlikely to yield results,
Ultimately, though, many officials and experts said the Islamic State would probably be able to cover its costs even without oil revenue, and that so long as it controls large stretches of Iraq and Syria, including major cities, bankrupting the group would take a lot more than blowing up oil tankers. “These are all going to be little pinpricks into Islamic State financing unless you can take their revenue bases away from them, and that means the territory they control,” said Seth Jones, a terrorism expert at the RAND Corporation... the old strategy for stopping the flow of money to terrorist groups like Al Qaeda, which was largely based on cutting them off from donors in the Persian Gulf upon which they depend, does not apply to the Islamic State. 
9. The $160 bn reverse takeover of US-based Pfizer (maker of Viagra) by the Dublin-based Allergan (maker of Botox), an investment company trading pharmaceuticals businesses, is classic tax-inversion. It enables Pfizer to use its accumulated overseas profits without incurring US tax liability, thereby saving atleast $21 bn in future tax liabilities. It also joins Burger King and Liberty Global as brands which have fled overseas to avoid tax payments.

Apart from tax inversion, as John Gapper writes, it also highlights a new trend in pharmaceuticals industry,
Pharmaceuticals companies used to be research enterprises that discovered and developed drugs. Then they became marketing giants, skilled at selling as many blockbuster pills as possible. Lately, they have turned into mergers and acquisitions machines, buying and selling medicines invented by others. It is hard to view their evolution as progress... Instead of taking their chances by investing in drug discovery themselves, some wait until a smaller biopharmaceutical enterprise has done so and then try to buy the rights. It is less risky and uncertain for investors but it also tends to be extremely expensive. AbbVie, for example, paid $21bn for Pharmacyclics this year, largely to acquire a single blood cancer treatment.
In this case, Pfizer is buying up Botox!

10. Finally, the ECB has extended QE, but not by as much as anticipated. Apart from extending its 60 billion Euro a month bond buying program for another six months till March 2017 or "beyond" and purchase municipal bond in addition to government bonds, it has also lowered the deposit rate to minus 0.3 per cent.

Saturday, December 5, 2015

Should you prepay your home loan or invest the money?

The home loan EMI is divided into interest and principal repayment, and the proportion of each changes over the years as the interest component falls and the principal rises. So, if person prepays the loan, he will find a large amount of principal still outstanding, while the interest would already have been paid, assuming full term. When a loan is paid in part, the EMI for the remaining period is reworked. However, this is also based on the assumption of a full-term repayment, where the interest is front-ended.
person might find that repaying the loan will shrink his personal balance sheet since only the house will remain as an asset. If, on the other hand, he invests the money, his asset base will diversify and become bigger. Given the stability in the income, person should have no problem paying the EMI. If there is a risk, he will not need to sell the house, but can sell the investment to repay the loan as required.
person should ensure that his investment does not grow at a rate lower than the one paid on the home loan interest. He should also ensure that the money is kept in shares, mutual funds or other instruments, which can be sold when required. The investment can appreciate over time and be available for other needs compared with the investment in house, which is not flexible and cannot be used as required.

Thursday, November 19, 2015

Power sector reforms

Power sector reforms - is this time different?

The markets have been largely appreciative of the latest round of power distribution companies debt restructuring. In this context, I am tempted to repost what I had written in the context of the 2012 debt restructuring. In particular, this graphic of the cumulative discom losses as a share of nominal GDP is very instructive - we are today at the same stage in terms of cumulative losses as in 2002.
So is this time any different? Atleast some do not think so.

Saturday, October 31, 2015

Indian economy reading links

Indian economy reading links

1. More confirmation that India's middle class may be much smaller than originally thought comes from the latest Credit Suisse Global Wealth Databook 2015. It finds a middle class of just 24 million adults, less than a fourth of China. This is confirmed by findings of recent Pew survey, the Government of India's own socio-economic and caste census, and by the income tax assessee base.
The report also finds disturbing trends on wealth dispersion, with the richest 1% and 10% Indians respectively owning 53% and 76.3% of the country's wealth, far more unequal than the US where the top 1% own 37.3% of the total wealth.
Highlighting the rapid widening of inequality, even as the national wealth rose by $2.284 trillion in the 2000-15 period, the richest 1% and 10% respectively claimed 61% and 81% of the increment.

2. More dismal news from Credit Suisse through the latest version of its status report on the debt levels of India's ten most indebted infrastructure firms. Their cumulative debt has risen seven-fold over the past eight years to reach 12% of all bank loans and 27% of all corporate loans, with debt levels rising for all the ten groups. Their interest cover dropped to 0.8 in 2014-15 from 0.9 in 2013-14, despite a significant share of interest being capitalized, and debt/EBITDA rose to 7. 
While the loans are standard in the bank books, 35-65% of the debt of four groups have been downgraded to default by rating agencies. In fact, the report points to auditor findings that 48% of the total debt, or $53 bn, was in some form of default, with $37 bn for 0-90 days and $16 bn for more than 90 days. It also estimates that 20-90% of the loans for some groups, aggregating to $48 bn or equivalent to declared banking sector gross NPAs, may be under severe stress. Taking all these into the count, the report estimates that the total NPA of India's banking system could be close to 17%.
Some of the groups have sold away their better-performing assets to raise capital, leaving them with an even greater struggle to repair their balance sheets. Faced with such levels of balance sheet problems, these firms have cut back on capital expenditure by 20-70%. Most worryingly, many projects have 20-70% cost over-runs, thereby pushing capital costs beyond their pre-loss replacement costs and leaving the projects unviable. 

It is most certain that many of these projects will have to be restructured with large haircuts and/or further equity infusions, maybe even public support. The aggressive traffic forecasts and tariff estimates that formed the basis of financial closure in road and power projects respectively may be impossible to realize. This coupled with the accumulated interest during construction and construction cost escalation may have made many projects insolvent. Any simple rescheduling of loans may be merely kicking the can down the road. 

3. Rajan Govil joins those questioning the GDP growth numbers based on underlying indicators. He points out that nearly three-quarters of August's 6.4% annual IIP growth are explained by four items - gems and jewelry, insulated rubber cables, heavy commercial vehicles, and electricity - whose out-sized growth rates are simply unsustainable. He also points to the unabated trend of declining credit growth - non-food credit growth was 8.4%, and that to industry and services was 5-6%. 

4. A new report by Bain and Co estimates private equity (PE) investments in India to touch $22.3 bn in 2015, exceeding the previous record of $17.1 in 2007. With this, PE would make up more than half the FDI into India.  
While this is an encouraging trend, its details need to be carefully parsed. Investments in consumer technology (e-commerce, aggregators, and other sharing economy firms), real estate, and financial services collectively made up 65% of all inflows and those into manufacturing is marginal. By its very nature, PE investors generally take positions in existing firms. A few large deals make up a disproportionate share of all PE investments - the top 25 deals made up 49% of 2014 PE investments. Finally, as the graphic below shows, the potential inflows from such sources is very small.
In any case, as I have blogged earlier, all such sources are a rounding error when compared to the country's credit needs, the overwhelming majority of which is met by the banking sector.

my reading

1. Polio is the new cross-border threat for India from Pakistan,
Experts warn that neighboring India, which succeeded in shedding its label as a polio-endemic nation three years ago, could face serious cross-border infection.
As immunization efforts flounder in Taliban-controlled northwest regions, the number of Polio cases reported have been growing, thereby raising the specter of cross-border infection. Yet another reason why India needs a stable and developing Pakistan.

2. Livemint has a graphic on judicial vacancies and case loads.

3. Arguably one of the most important macroeconomic debates in recent years has been over the relative superiority of fiscal austerity or expansion in combating economic weakness in developed economies. Two contrasting tales from both sides of the Atlantic.

In Spain, the Conservative Popular Party has pursued a vigorous austerity policy, slashing public spending in the middle of a recession and pushing through a series of labor reforms to improve external competitiveness. It has achieved internal devaluation through wage compression - wages have fallen in nine of the last fourteen quarters since the PP government assumed power. These measures appear to have succeeded, with output estimated to grow by 3% this year, Spanish exports have grown fastest rising from a share of 17% of GDP in 2007 to 23% in 2014, the number of Spanish companies selling abroad has risen 50% in the same period, and unemployment though still high has been declining. In contrast, in Canada, the center-left Liberal Party of Justin Trudeau recently won elections on an avowedly Keynesian platform.

4. Times points to this paper that evaluated the impact of seven cash transfer programs in Mexico, Morocco, Honduras, Nicaragua, Philippines, and Indonesia and found "no systematic evidence that cash transfer programs discourage work" and thereby promote lazy behaviors.

5. Business Standard points to another price transmission problem in India, in piped natural gas (PNG) distribution in cities. An 18% recent reduction in the regulated (by indexation) upstream price of natural gas (from $4.66 mBtu to $3.82 mBtu due to fall in global oil prices) translated to a mere 3% cut in the PNG price for consumers. As of June 2015, India had 2.8 PNG consumers in 11 states. 
The Indian Supreme Court had in July 2015 ruled that the Petroleum and Natural Gas Regulatory Board (PNGRB) had no powers to regulate transmission through CGD network and could only determine tariff for gas transmission through common or contract carrier pipelines. It, therefore, rejected PNGRB's claim to fix retail city gas prices. City gas distribution (CGD) firms are, therefore, currently monopolies and enjoy freedom from price regulation. They have marketing exclusivity for the first five years of their operations. Subsequently, the CGD network would be on "open-access", available to third parties to supply gas as a "common carrier", thereby ushering competition in the closed market. Once they become "common carriers", the PNGRB would have the regulatory powers to fix tariffs. However, the challenge then would, in all likelihood, be to get the incumbent network owners to not sabotage the open access arrangement. 

6. The digital traces left by mobile phones have emerged as one of the most exciting areas of studying human behavior in real-time, with the potential to frame public policy accordingly. Here are a few applications. 

LogAnalysis software developed by Emilio Ferrara and Co of Indiana University analyzes social networks developed from telephone calls (chiefs of gangs makes a few calls to trusted lieutenants who in turn disseminate the same widely and repeatedly) and compares them with crime data to identify (and pre-empt) criminals and crime locations. Adeline Decuyper and Co in Belgium monitored food consumption patterns by superposing an FAO household survey data with mobile phone calls data from Rwanda and found that airtime top ups correlated with purchases of high-value food items. Kevin Kung and Co at MIT used data from Ivory Coast, Portugal, and Boston and found that humans spent an hour daily commuting, independent of distance or mode of transport or the country, thereby validating the old Marchetti's constant (they assumed people's homes as where they made calls in the night and office as the location of calls during working days). Vasyl Palchykov and Co use the duration and frequency of telephone calls from a database of nearly 2 billion calls (age and sex of the callers were available) to tease out the changing patterns of relationships between men and women at different ages. Jameson Toole and Co use mobile data to study the economic and social impact of mass lay-offs by analyzing the changes in people's social networks. 

7. Andres Velasco points to the findings of Tulane University's Commitment to Equity Institute, which examined the impact of various fiscal policy instruments (direct taxes, indirect taxes, direct transfers, indirect subsidies like food and energy prices, and in-kind transfers like education and health care services) on inequality and poverty for Brazil, Chile, Colombia, Indonesia, Mexico, Peru, and South Africa,
The largest income redistributive effect is in South Africa and the smallest in Indonesia. Success in fiscal redistribution is driven primarily by redistributive effort (share of social spending to GDP in each country) and the extent to which transfers/subsidies are targeted to the poor and direct taxes targeted to the rich. .. South Africa’s result can be attributed to the combination of a large redistributive effort with transfers targeted to the poor and direct taxes targeted to the rich... While fiscal policy always reduces inequality, this is not the case with poverty. Fiscal policy increases poverty in Brazil and Colombia (over and above market income poverty)... meaning that a significant number of the market income poor (nonpoor) are made poorer (poor) by taxes and transfers. This startling result is primarily the consequence of high consumption taxes on basic goods... 
The marginal contribution of direct taxes, direct transfers, and in-kind transfers is always equalizing. The marginal effect of net indirect taxes is un-equalizing in Brazil, Colombia, Indonesia and South Africa. Total spending on education is pro-poor except for Indonesia, where it is neutral in absolute terms. Health spending is pro-poor in Brazil, Chile, Colombia and South Africa, roughly neutral in absolute terms in Mexico, and not pro-poor in Indonesia and Peru.
They calculate the marginal contribution of a tax or transfer (as the difference in inequality gini with and without the intervention) and the total redistributive effect (difference between market income gini and disposable or post-fiscal (disposable income plus indirect subsidies minus indirect taxes) incomes gini). 
Several counter-intuitive findings stand out - regressive taxes in Chile and South Africa are equalizing or neutral; the marginal contribution of contributory social security old-age pensions is un-equalizing in Chile, Mexico and Peru. 

Given this heterogeneity, to the question of whether direct taxes or indirect taxes and direct transfers or in-kind transfers are more effective at lowering inequality or reducing poverty, one can only say that "it depends" on its interaction with the other fiscal policy instruments already in operation.

Friday, October 23, 2015

The one graphic about India's learning outcomes that you should see

The one graphic about India's learning outcomes that you should see

The conventional wisdom on learning outcomes is that the country's state government public schools and low-end private schools are where the problem lies and their troubles have to do with poverty and other social issues. And that the remaining part of the country's education system is in good shape and those students can compete with the best in the world. This belief gets entrenched by the excellent performance of Indian students in international Math and Science competitions as well as the dominance of graduates from IITs etc in various professional fields.     

So, it comes as a surprise (HT:Lant Pritchett) when we examine the relative performance of Indian students at the top end of the achievement spectrum in the 2009 PISA tests which assessed a representative sample of students from the two best performing Indian states, Himachal Pradesh and Tamil Nadu. As can be seen, less than a percent of students in both states were above Level 4 (out of six levels) in the PISA test. The contrast with those countries that we aspire to match or even claim equivalence, atleast for the best and brightest among Indians, is staggering.
The comfort that we are better off comes from a cognitive bias. The immediacy of these kids engenders an availability bias, which makes people feel as though the schools where their children are going are as good as anything in the world. Sure, there are outliers, and they are the top 0.1% (or maybe 1%) or so of the schools.

Tuesday, September 8, 2015

Even the worst ELSS outperformed PPF over 15 years

Investments in equity-linked savings schemes (ELSS) of a mutual fund’s would yield higher returns compared to other fixed income instruments like public provident funds and national savings certificates (NSCs) over the past 15 years, if invested systematically. However, in a point-to-point comparison over the past 15 years, LIC Nomura Tax Plan, the worst performing scheme, delivered a return of just 6.91% over the period from 1 March 2000 to 30 April 2015. A PPF earned an average interest rate of around 8.50% over the same period.
But when investing in an equity scheme, it is essential to invest regularly. Had you invested systematically in the LIC Nomura scheme, the yield (IRR-internal rate of return) works out to 13.49% compared to a yield of 8.31% for the PPF. Therefore, if an investor made a single one-time investment in the mutual fund scheme, he would have underperformed a PPF. Making regular investments each year would have improved his yield.
LIC Nomura Tax Plan was the worst scheme over the 15-year period. HDFC Taxsaver was the best performing scheme with a return of 16.09% on a point-to-point basis. The CNX Nifty index delivered a return of 10.86% over the period. The average return of the 12 schemes available over the period was 13.45%.
A few percentage point difference may seem small, however, over 15 years, the power of compounding and investing systematically can lead to a huge difference in the final value. Investing Rs1 lakh each year in HDFC TaxSaver would have led to a portfolio value of nearly Rs1.14 crore at the end of the period in March 2015, a yield of around 24%. Had you invested in the LIC Nomura scheme, your portfolio value would be less than half of this at Rs47.71 lakh.
Investing in schemes of Franklin Templeton, ICICI Prudential and SBI Magnum too would have led to a corpus of over Rs1 crore.

There is no doubt that PPF is among the best long-term fixed income product, but investing in equity is the key to long term wealth generation. However, when investing in equity mutual fund schemes, one not only needs choose the right scheme but also needs to invest regularly to benefit from the volatility in the market through rupee-cost averaging.

Saturday, September 5, 2015

More on bond market distortions

FT points to a BIS paper by Valentina Bruno and Hyun Shin which draws attention to the spectacular growth of the now $1.7 trillion emerging market (EM) dollar bond market, which now outstrips even the more established US high-yield debt market. It claims the motivating factor for a significant share of these issuance as simply "carry trade" (borrow in cheap dollars and invest in higher interest rate securities at home) by EM non-financial firms. The authors examined firm-level balance sheet data for 3500 non-financial companies in 47 developed and emerging countries that issued dollar bonds in 2002-14,

The dataset combines bond issuance data with firm-level financial information. We find that firms with already high cash holdings are more likely to issue US dollar-denominated bonds, and that the proceeds of the bond issue add to cash holdings. The tendency to add cash is more pronounced during periods when the dollar carry trade is more favourable and is prevalent for emerging market firms. 
They find that the issuance is more likely when the local currency is gaining in value against US dollar. They also find that a large portion of this is raised by overseas subsidiaries of the EM firm. In fact, nearly half the international debt issuance by non-bank private corporates of EM countries in the 2009-13 period were by the firm's overseas subsidiary. In other words, these EM firms were pursuing a corporate version of "carry trade", as they seek to profit from financial arbitraging, rather than using the borrowings for investment purposes or for re-balancing their debt portfolio.
Their findings carry great relevance for policy makers in EM economies.

1. The scale and pace of such debt accumulation is staggering - it is estimated that the total outstanding USD-denominated debt of non-banks located outside the US stood at $9.2 trillion in end-September 2014, against $6 trillion at the beginning of 2010. In a matter of 2-3 years, fortunes can be reversed dramatically. It is one more, and increasingly large, channel of capital inflows into EM's when credit is plentiful, with all the attendant risks when sudden-stops ensue. The attendant risks are well documented.

2. A large part of the overseas issuance by subsidiaries come back to the firm headquarters as borrowings from the subsidiary. Such flows apart from increasing firm and country vulnerability to exogenous shocks, also raises a host of regulatory concerns. For a start, discriminating such flows from plain tax avoidance or even money laundering is very difficult. It creates a financial flows channel within each firm which facilitates transfer pricing and other similar policies aimed at avoiding taxes and evading various regulatory requirements.

3. The subsidiary which transfers money to the parent firm acts as a "shadow bank" or a "surrogate intermediary". Given that a significant share of these issuances were done by firms with strong balance sheets and deployed for financial investments, and held as cash, rather than capital investments, its effects on the domestic credit markets can be uncertain. The graphic below shows the increasing share of non-residential EM non-bank issuances.
4. The traditional measures of a firm's external indebtedness may no longer be a reliable estimation of the firm's true external debt exposure. It may be necessary to take into account, off-shore borrowings by subsidiaries, thought accurate information on this may not be very easy to get.
5. This is a powerful example of the distortions engendered by the extraordinary monetary accommodation in developed economies. As the authors show, it has distorted the incentives of yield-hungry fixed income investors in developed economies and non-financial corporates in EM countries, leaving both parties vulnerable when the tide turns. 

6. The carry trade by non-bank corporates in EMs is yet another reiteration of arguably the biggest failure of financial markets, its characteristic disciplining powers break down when credit is plentiful,
The size and maturity of issuance follow the pattern of risk-taking in financial markets, with periods of easy financing conditions being associated with larger issuance as well as longer maturities.
7. There exists wide heterogeneity among countries in issuances. India has among the lowest USD non-bank bond issuance of any large country.
However, this can change dramatically once the regulations are relaxed. Reversing the course or managing such issuances are virtually impossible. 

Where is India's middle class?

Where is India's middle class?

Livemint points to a Pew research work which highlights that while the global middle class (with per capita incomes more than $10 per day) has grown from 7% to 13% of total population in the 2001-11 period, nearly two-thirds continue to remain poor (less than $2 per day) or low-income. 
The income distribution barely shifted at the top half of the income ladder.
In India, while the share of poor declined from 35% to 20%, the middle income hardly changed, inching up from 1.4% to 2.6% in the same period. In fact, among all its major peers whose middle class share is more than 20% of the population, India is easily a disconcerting outlier in its middle-class share. 
This raises several disturbing questions about the country's long-term growth prospects. At 3%, those with middle class incomes and above constitute just 37 million, and is clearly not growing at a satisfactory enough rate to sustain very high economic growth rates. Simply put there aren't enough Indians around who can afford refrigerators and cars, shop at the malls, buy a house in a metropolis, send their children for management education or get treatment at Apollo hospitals, or take-off for annual vacations within the country. Further, since the stock of middle class is growing ever so slowly, the boost from the pent-up demand may be tapering off. Even doubling this estimate, assuming the Pew study is off the mark (which is unlikely given that the recently released Socio-Economic Survey of Indiapoints to similar trends), does little to minimize the concern.

Being smart with your fund picks

When making a buy or sell decision on a fund, it is essential to look beyond returns.

When it comes to fund managers and market strategists, this year's hero usually turns into next year's zero.

William Bernstien makes that statement in his book titled The Investor’s Manifesto. Bernstein is an American financial author, theorist and neurologist. His words are worth noting.
Irrespective of whether the decision is to invest or to liquidate, performance often becomes the sole deciding factor – an error that many investors commit unknowingly. While we vociferously advocate that returns remain an important indicator of how a fund has been able to deliver historically across varied market cycles, it is not the only factor. A more holistic approach is needed when evaluating a mutual fund from an investment perspective.
Top performing fund? Don’t live in the past!
Historical returns do provide an insight into what the fund has done in the past, but its predictive powers are definitely limited. A fund’s impressive performance is not guaranteed to be repeated in the future.
It is not without reason that the regulator, the Securities and Exchange Board of India, insists on the disclosure along the lines of: Past performance of the Sponsor/ Mutual Fund/ Investment Manager is not indicative of the future performance of the Scheme(s).
For one, performance could change if there is a change in the fund manager. It could change for better or for worse. Having said that, in most cases, it is not the issue of a fund manager change. It could simply be plain market dynamics; the stock bets that worked in the past may not work going forward. For instance, if the fund manager was stocking up on value stocks and the market favoured them, it would have worked to his benefit. If growth stocks were on a roll and value stocks were being punished, he would suffer. The stock bets that worked in the past need not work going forward.
Companies that were part of the portfolio and propelled the fund’s overall returns in the past may have either changed significantly in terms of their structure and/or their and ability to generate similar levels of return. In contrast, the constituents of the fund itself could have changed affecting the return profile of the fund.
Hence, while returns can be used as a starting or reference point, taking investment decision solely based on them could lead to financial disaster.
Top performing manager? But for whom?
Fund managers tend to have different styles, investment horizons and philosophies. Investors on the other hand tend to have varying investment goals and risk appetites. Since there is no concept of ‘assured returns’ or a ‘one size fits all’ solution in the mutual funds industry, evaluating a manager’s style and comparing the best ‘fit’ with individual investing preferences becomes essential.
A so-called top performing fund manager may be a disastrous fit for your portfolio. Let’s say he manages his fund in a volatile fashion, and while he delivers admirably, the highs and lows could churn your stomach. In that case, you should be avoiding his fund.
Understanding the styles and the differences across the investing patterns of different fund managers helps gauge the suitability of funds managed by them and prevents investors taking on additional unwarranted risks as part of their portfolio. It also encourages a higher level of investment discipline. Not all strategies are suitable for all investors. For example, large cap funds are typically considered as being lower risk as compared to a mid or small cap fund. You need to check whether the fund falls in the large-cap category, flexi-cap category, or mid-and-small cap category. You would also need to look at other parameters such as concentrated portfolios against highly diversified ones.
Investors need to first assess their requirement and then the fund’s suitability to meet their individual goals.
Don’t ignore costs.
Additional costs and increased fund expenses can eat into the income that an investor really makes. In John Bogle’s words, “The miracle of compounding returns is overwhelmed by the tyranny of compounding costs.” A higher expense ratio will tend to lower investment gains thus nullifying and/or lowering actual earnings. Bogle is an author and founder of the Vanguard Group.
Furthermore, the tax structure in India can have an impact on fixed income funds that are redeemed before the 3-year period, thus making the income from such funds taxable.
An exit load as defined by the fund documents is another factor to consider while redeeming investments. With all these different facets of costs come into play, it becomes important to take into account the actual income vs. the percentage returns that a fund is able to deliver.
In conclusion….
Investors often exit a fund due to its under performance just in time to see its returns take a 360 degree turn. While maintaining a long-term view is important, it is important to understand the reasons for short term aberrations and their possible impact over the long term.
Investment decisions should be based on a combination of fundamental strength backed by quantitative support. Look for consistency of returns and whether or not the fund manager’s style is in sync with the fund’s mandate. And don’t expect a blockbuster performance every year. William Bernstien’s words yet again: Mutual fund manager performance does not persist.

Source: Morningstar india  By Kavitha Krishnan |  02-09-15

Friday, September 4, 2015

Bond market distortions amplify capital flows volatility

Bond market distortions amplify capital flows volatility

One of the defining features of the post-Lehman cross-border capital flows has been the dominant role played by bond market investors. Whereas in the earlier periods, large commercial lenders were the primary overseas lenders, the onset of stricter regulations shifted the onus to shadow banks, asset managers. A BIS study has shown that overseas lending from the US banks and bond mutual funds (BlackRock, Franklin Templeton, Pimco etc) to emerging market non-financial issuers, companies and countries, has doubled since the crisis to $9 trillion. The extraordinary monetary easing in the US, accompanied by rock-bottom yields, left these fund managers with little choice but to search for yields in emerging markets (EM).

The growth in dollar-credit from the US investors to non-banks outside the US till June 2014 is shown below. The declining share of bank loans mirrors the sharp rise in bond market investments, especially to EMs.

The World Bank has estimated that corporates and sovereigns in emerging economies sold $1.5 trillion in debt in the five years to 2014, about three times that in the 2002-07 period. China, Brazil, and India were the largest recipients. India's off-shore issuance (to skirt around the domestic capital flows management regime) has risen significantly since 2009. 

The Times writes about the distortions engendered by these flows,
EPFR Global, a fund-tracking company, calculates that global bond funds have allocated 16 percent of their holdings to emerging-market bonds. Relative to the 2.5 percent recommended benchmark for these securities suggested by the Barclays aggregate bond index, that is a very aggressive bet... Among the many beneficiaries of this largess were commodity-driven borrowers such as the state-owned oil companies Petrobras in Brazil and Pemex in Mexico, the Russian state-owned natural gas exporter Gazprom, and real estate developers in China.
One of the more extreme cases of this bond market frenzy was Mongolia. In 2012, with expectations high that the relatively tiny economy would reap the benefits from China’s ceaseless appetite for raw materials, the government sold $1.5 billion worth of bonds, with demand from investors reaching $10 billion. That meant, in effect, that the country was in a position to borrow an amount twice the size of its $4 billion gross domestic product. Three years later, the International Monetary Fund is warning that Mongolia may not be able to make good on these loans... and the yields have shot up to about 9 percent from 4 percent...
Russian train companies easily sold dollar bonds, despite the fact that their revenues were earned in rubles. Even Ecuador, a country that defaulted in 2008, was able to raise $2 billion last year. Brazil, China, Malaysia, Russia, Turkey and others have sold more than $2 trillion in bonds, mostly to American mutual fund companies, since 2009. As this money flowed into their countries, financing skyscrapers in Istanbul and oil exploration in Brazil, economies and currencies strengthened. Now the reverse is occurring, led by a slowing Chinese economy, and as that money heads for safety, local currencies are plunging.
This highlights an inter-temporal asset-liability mismatch in the books of these asset managers. Their assets (bond mutual funds and exchange traded funds) are often in illiquid or hard-to-sell investments, whereas their investors are free to withdraw anytime. Since bond investors typically rush to redeem their positions when faced with such turmoil, especially in the currency markets, any panic-sale has the potential to trigger a forced-sale of infrequently traded assets, thereby unraveling the bond markets. On the debtor's side, the sharp devaluation of their currency that invariably follows such episodes adds to their debt burden.

This game of massive inflows where private corporations (and governments) leverage-up on plentiful external credit, followed by sudden-stops in response to shocks and panic flight to the exit gates has been replayed too many times to be kept track. A large share of such inflows end up financing hubris-driven projects with limited social value and/or doubtful commercial viability. The capital flights leaves in its wake the ruins of incomplete or failed projects with massive debts, battered corporate balance sheets, vulnerable banks (exposed to these corporations), and economies on the brink.

Countries like India which have been aggressively courting capital from asset managers like pension funds to finance their infrastructure investment requirements would do well to keep these lessons in mind as they go about this. Most infrastructure investments have their revenue streams in local currency. Financing such investments with foreign currency denominated liabilities is fraught with considerable risks. This is all the more so since the volatility engendered by cross-border capital flows, which has become all too frequent, does not discriminate between prudent and reckless borrowers. In any case, given the scale of the country's infrastructure financing requirements, foreign capital can at best be small change.

All this assumes even greater significance given that economic fundamentals are no insurance against the volatility induced by bouts of global financial market turmoil and that markets react excessively when faced with such uncertainty.

Wednesday, August 26, 2015

This time is no different - EM shocks spares none

This time is no different - EM shocks spares none

The contrast in economic fundamentals with the May 2013 US Fed taper-tantrum days and today's China contagion could not have been more stark. At that time India was one of the most vulnerable, even among the 'Fragile Five'. Now the country has become so much of a positive outlier that it does not even figure in assessments of emerging market (EM) risks.

The two graphics from FT conveys the relative strength of the Indian economy. The first conveys how insulated the country is from the two biggest risks - exposure to Chinese market and foreign currency bond borrowings.
The country is among the only two EM economies not overly exposed to the trifecta of unwinding Chinese leverage, US QE, and domestic debt. 

Clearly, India is as insulated as markets can be from any triggering exogenous shock, with its accompanying portfolio re-balancing by foreign institutional investors. Further, its macroeconomic balance, both domestic and external, as well as inflation, are stable. But the events of Monday shows that very little of this is material, atleast in the immediate aftermath of the triggering exogenous shock. The battering of the equity markets and the rupee this week, especially given the relative strength of the Indian economy and the depth of weakness among almost all of its emerging market peers (a position that it has never been in), is the strongest possible reminder that such global shocks are largely divorced from fundamentals and spares none. As the RBI Governor found out, no central banker (or anyone) has a magic wand to ward-off or talk up the markets. 

The trajectory of the current bout of market volatility in India will be contingent on the trends across other emerging markets. If the markets adjust to the potential adverse consequences of a Chinese slowdown or the Chinese government is able to postpone the denouement to its bubble valuations, the Indian market too would be calmed. However, if the EM weakness persists, the volatility will continue to haunt the Indian markets. In that case, stability will return only when the broader EM sentiments stabilize (and not with country-specific events), as happened in August 2013. 

This should also serve to put in perspective the despair that followed similar trends in the aftermath of the May 2013 taper-tantrum and the subsequent uptick that was popularly attributed to the entry of the new central bank governor.