The `slowdown' in IIP consumer durables

In Financial Express today, Ila Patnaik examines the `IIP consumer durables slowdown' and finds it's mostly about bad data.

The moribund government bond market

India is a land of extremes. Right alongside the remarkable success of a reforms effort on the equity market, we got a remarkable failure of a reforms effort on the bond market. Manish Sabharwal & Digant Bhansali have a fascinating article in Economic Times on the slow death of the government bond market in India. This table is in the article:

Feature	03-04	04-05	05-06	06-07	07-08
Number of gilts traded > 4 times/week	27	14	9	6
Number of gilts that addup to 90% of volume	26	33	15	11	11
Volume of top traded security (%)	11	23	18	33	36
Share of NDS in volume (%)	0	0	53	79	84
Equity turnover (billion USD)	933	1051	1802	2564
Gilts turnover (billion USD)	365	216	164	221

It's astonishing to notice that from 2003-04 to 2006-07, a time of remarkable GDP growth in India coupled with a massive scale of government bond issuance owing to large deficits, government bond turnover dropped from $365 billion to $221 billion. Over this same period, equities turnover went up from $933 billion to $2564 billion.

The state of the market is visible in the turnover of the biggest single bond - this went up from 11% of the market in 2003-04 to 36% in 2007-08.

This is the period over which RBI implemented the Negotiated Dealing System, their vision for how the bond market should be transformed.

Modernising the monetary policy regime

Glenn Stevens has a great speech from 2006 telling the story about how Australia evolved out of the pegged exchange rate. Reading it is useful for thinking about India's policy questions about the monetary policy regime. As is typical with central banks from the first world, the writing quality of the speech is excellent. I was amused to see this story from the pre-1983 period:

The exchange rate management committee also sought to add a random element to the daily movements in the exchange rate, around the general trend appreciation, to reduce the predictability in the movements in the exchange rate and thwart the speculation.

It struck me that the thinking at RBI circa 2007 was not that different from the thinking of RBA pre-1983, i.e. over a quarter century ago.

Gloomy perceptions about PSUs and their consequences

Business Standard has a very insightful editorial on the oil industry:

Global oil prices are nearly $90 per barrel; the Indian crude basket is more than $80/barrel. The Indian consumer scarcely knows this, though, since domestic oil product prices remain firmly fixed, and by the look of it will remain fixed till the next Parliamentary elections are over. Petroleum Minister Murli Deora has managed to deliver this state of nirvana by getting the Cabinet to approve the issue of Rs 23,458 crore worth of oil bonds and by forcing the state-owned oil enterprises to absorb the rest of the expected shortfall of Rs 54,935 crore during the financial year. Given the 14 per cent share of fuel, power, light and lubricants in the wholesale price index (its 5.5 percentage points for LPG, petrol, kerosene and diesel), it is obvious that Mr Deora's role in keeping prices down has been an important one, because what is called under-recoveries on petrol now total as much as a tenth of its retail price, while for diesel it is even higher at one-fifth. The under-recovery gets still worse for cooking gas (40 per cent), and for kerosene (65 per cent).

This is price distortion of the worst kind, and is not without costs even if these are not immediately obvious. Consider the non-consumer side of the picture. The private sector Reliance Industries, which had been grabbing market share from state-owned oil firms, has virtually given up trying to sell its refined products in the domestic market (it does not get the subsidy that the government gives the state-owned firms) and has become instead the country's biggest exporter of petroleum products -- the share of oil product exports in total exports has risen as a result from 8.4 per cent in 2004-05 to 14.7 per cent in 2006-07, and may have climbed further to 18 per cent this year.

The state-owned oil companies, for their part, do not have the luxury of escaping into export markets and must suffer the vagaries of government policy, which has affected their bottom line as well as their investment plans. To take the figures for the current year, the firms will jointly incur a loss of over Rs 30,000 crore a fact that is not lost on investors. The result is that Indian Oil's share price now commands a price-earning multiple of barely 6.5 (about a quarter of the average Sensex stock), while in the case of Bharat Petroleum and Hindustan Petroleum, the P:E ratios are about 4.5 and 4.8. On a combined market capitalisation for the three firms of Rs 75,000 crore, they are valued at less than what just one of them should be worth and also less than the value of Reliance Petroleum, which is a new refining company that is still to start business but which is already valued in excess of Rs 80,000 crore!

This is a pointer to how much punishment the government is taking on the stock market. And since companies finance fresh investments by floating new shares and thus capitalising on their share valuation, what the government has done is to make sure that the hopelessly under-priced state-owned oil firms will not be able to play this game. So the oil-refining business will increasingly have only private sector investors who being unable to sell in the domestic market will be busy exporting their product while domestic demand is met by imports through the state-owned companies.

This bizarre denouement is what Mr Deora has achieved. Meanwhile, even as Mr Chidambaram counts the extra tax revenue being delivered to him by a buoyant economy, he should consider whether as much and more has been lost on the stock market because of the oil-pricing policy. If the government had an annual balance sheet wherein it had to assess the value of its assets (and liabilities) each year, instead of the outdated financial system that it calls its Budget, the disastrous trade-off would be obvious to everyone. Indeed, in today's accounting system, even the oil bonds that are being issued do not show up in the definition of what is the fiscal deficit. It is no wonder that most people are completely unaware of the cost of today's oil-pricing policy.

A similar phenomenon is taking place in banking. In banking, given the way capital requirements are structured, equity capital through a combination of retained earnings and external share issuance is critical for enabling deposit growth. Let's focus on some of the bigger banks [full list]:

Bank	Net profit	P/E
	Jun-07 Quarter
	(Rs. crore)
Allahabad	200	6
Bank of Baroda	331	10
Bank of India	315	11
Canara	241	8
Corporation Bank	202	9
Indian Bank	212	9
IOB	268	8
Oriental Bk. Commerce	200	8
Punjab National Bank	732	9
Syndicate	221	7
Union Bank	225	9
SBI	1426	20
Axis	175	38
HDFC Bank	321	41
ICICI Bank	775	36

(The net profits is for the June 2007 quarter since all the results aren't out for the September 2007 quarter. All banks with more than Rs.200 crore of profit in that quarter are in the table. The P/E is for September 2007.)

The same phenomenon that the BS edit describes, with oil companies, is visible here also. There's a striking pattern where `ordinary' PSU banks have a P/E of roughly 10; SBI is a PSU bank with a P/E of roughly 20; the three large private banks are at a P/E of 40.

Chidambaram on MIFC

Mr. Chidambaram said:

Given the current exchange rate, India is a trillion dollar economy. Outflows and inflows together account for nearly 106 per cent of the GDP. As the economy becomes more open and trade intensity increases, giant financial flows will be intermediated in India. India is a purchaser of international financial services. A recent report has estimated the value of these services at US$ 13 billion a year and has concluded that this will rise to US$ 48 billion by the year 2015. While India will continue to be a purchaser of financial services, we believe that there is an opportunity for India to become a provider of financial services as well. It is, therefore, our intention to make Mumbai an International Financial Centre. We commissioned a report for this purpose. The report is in the public domain and we are in the process of building a consensus on the key recommendations. It is our intention to make financial services the next growth engine for India.

The middle muddle

I have an article in Business Standard titled The middle muddle, about India's attempts at running an inconsistent monetary policy regime.

The backdrop to this is recent statements from RBI, SEBI's plans about restrictions on participatory notes and S. S. Tarapore.

Watch me talk about these events on CNBC on Wednesday morning.

Thursday (18th morning), and here's more of fun and games:

• I have a piece in Business Standard talking about how the overseas OTC derivatives industry on Indian equity underlyings works. There is quite a gulf between the rhythm of this business and the SEBI proposal.
• Surjit Bhalla says in Business Standard that the need of the hour is to get past the very `FII' framework.
• Akash Prakash says in Business Standard that in the short-term these proposed restrictions will bind.
• Ila Patnaik, writing in Indian Express, links up these events to larger questions of India's strategy on harnessing globalisation.
• Jayanth Varma, writing in Business Standard.
• This clarification from SEBI was useful, though ideally the drafting of their document should have been clear enough that it was not required. I'm curious - what time did this come out? In this age of realtime information flows and analysis, all documents should be timestamped! :-)
• What comes next in terms of capital controls, by Anindita Dey in Business Standard.
• An editorial, and an article by Eswar Prasad, in Economic Times.
• See this article by Ila Patnaik in Indian Express which points out how small PN-based inflows are, when compared with the scale of RBI's trading on the currency market. When the drumbeat was built up about the need for restrictions on PNs, a glance at the data would have helped keep things in perspective. But this wasn't done either in the case of PNs or in the case of ECB. What is needed is a shift away from this strategy of having no strategy, of only fire-fighting using ineffectual capital controls.

The Business Standard editorial is skeptical about what happened:

After a rambunctious day on the stock market, it is not clear how much of their objective the government and the market regulator have achieved with their late evening announcement of Tuesday. A de facto limit is proposed to be placed on the issuance of derivative participatory notes, which foreign institutional investors (FIIs) have been resorting to far more than in the past. This has created and will continue to create some selling pressure because of the unwinding of positions. And to the extent that these instruments were non-transparent (the actual investor could hide behind layers of intermediaries), the government may also achieve to a limited extent its goal of trying to stop the round-tripping of domestic money (which is believed to have been going into some active stocks).

The short-term liquidity pressures will fade, however. So while the stock market has been shaken out of its bull-market euphoria (which is welcome), and forced some overseas investors to also re-assess the level of regulatory risk (not so welcome), it is far from clear that anything longer-term has been achieved. If portfolio investment wants to come into India because — as the finance minister emphasised on Wednesday morning —nothing about the India story has changed, then all that the proposed step will do is to re-route the money through other windows, most of which remain open. That might explain why, after the initial crash, the market recouped most of its losses fairly quickly. The net drop in the stock index at the end of the day is less than 2 per cent, which makes it little more than an ordinary day in the office.

But the stock market was only the government’s subsidiary target, as became clear on Wednesday. The real objective was to slow down the inflow of money through the capital account (running at between 5 per cent and 6 per cent of GDP) and thereby to ease the upward pressure on the rupee — which has gained more against the dollar than almost all other currencies over the past year. This in turn had begun to slow export growth, and caused job losses in vulnerable sectors like textiles and leather goods. The government has tried to neutralise the inflow by sterilising the money coming in so that it does not impact domestic money supply, but has been only partially successful. The situation is still that if India continues to offer a rapidly growing economy and an attractive market that enthuses foreign investors, the money will continue to come in, especially when world markets are still awash with liquidity. The larger macro-economic management challenge therefore remains, and has not gone away simply because there has been a mini-crackdown on P-notes.

Sebi has said that it will ease the process of getting registered as an FII and thereby getting the regulator’s approval to operate in the Indian market. The question to ask is why such a licensing restriction should be there at all. Banks, which are required to follow the rules about knowing who is their customer, are perfectly capable of being the gate-keepers when it comes to funny money, and certainly no less capable than Sebi, which is manifestly unable to find out who is behind the P-notes. Once the Indian market is thrown open, the entire business of foreign portfolio investment should become more transparent, and the limits on foreign ownership in sectors and individual companies will operate as the fencing. Those who want to hide their identities may continue to operate through new tools thought up by the financial community, but that will leave the government and Sebi no worse off than today. Just as the foreign exchange crisis of 1991 was used to usher in overdue economic reforms, the P-note issue should be used to open up the capital market. The side-benefit of opening up will be that the capital market activity that now takes place offshore will mostly come onshore —which can only be to the country’s benefit and to the goal of developing Mumbai as a financial centre.

The final point which needs to be made is that the only long-term solution to the current challenges on financial flows is to improve the productivity and efficiency of the economy, so that producers and exporters neutralise through these gains the pressures that get transmitted through a more expensive rupee. This has to be accompanied by further opening up on imports, to absorb the capital flows which are coming in and which by all accounts will continue to pour in. This translates into action on a broad range of fronts, all of which are well known and have been stated often enough. The tragedy is that the government seems unable to do what is required, for a variety of political and administrative reasons, and is therefore trying to resolve systemic issues with Band-Aid kind of solutions, that most people realise, will not work.

Watching markets work

At 10 PM last night (Sunday night), news came out of a bomb blast at a movie theatre named `Shringar' at Ludhiana. Google news now has 32 news items about this. Some of these articles, and some of the television coverage, blurred the lines between this movie theatre and the listed firm named `Shringar Cinemas'. Many a viewer/reader might have felt that an outlet owned by Shringar Cinemas was bombed.

The CMIE website shows a clarification from BSE at 9:55 and from NSE at 10:26. Here are the underlying materials from NSE and from BSE.

Since trading starts at 9:55 AM, and the information in these announcements might not be common knowledge amongst all speculators, this made me wonder: Was there a false drop in the prices of Shringar in the early minutes of trading? Or, was there excessive turnover where some people made mistakes but smart speculators / arbitrageurs were able to catch this?

At first blush, based on this data from Yahoo finance, this does not appear to be the case; the market worked quite fine. In order to get a sense of what was going on, I compare Shringar against their peer PVR using the Yahoo finance website. Click on the picture to get a better look.