Niveshak Oct14

THE INVESTOR

VOLUME 7 ISSUE 10

October 2014

FEAR OR GREED?

FROM EDITOR’S DESK Dear Niveshaks,

Niveshak Volume VII ISSUE X October 2014 Faculty Chairman

Prof. P. Saravanan

THE TEAM Akanksha Gupta Apoorva Sharma Gaurav Bhardwaj Jatin Sethi Kocherlakota Tarun Mohit Gupta Mohnish Khiani Priyadarshi Agarwal S C Chakravarthi V All images, design and artwork are copyright of IIM Shillong Finance Club ŠFinance Club Indian Institute of Management Shillong

The month of October 2014 has seen many events taking place in India and around the world in politics as well as in the corporate sector. Assembly elections in Maharastra and Haryana have seen BJP gaining majority. Modi Factor has definitely passed the litmus test in both the states by gaining controlling majority of seats in both the states.

Second quarter results have been trickling in and although the results are satisfactory, the long-term sustained economic growth still remains elusive. Amid tepid demand, the sales remained sluggish and operating profit growth slowed down. Infosys Ltd was the only software services company among the top three to beat the street estimates. In the Automotive space, Hero Motocorp Ltd posted 58.6% jump in Q2 profits beating the street estimates.

E-commerce space has seen mega offers running across the month with Flipkart announcing Big Billion Day and Amazon running a Diwali Discount week. The founder chairman of DLF and five other senior officials of DLF were banned from accessing the capital markets for three years for not disclosing some details about three of its 357 associate companies during the 2007 IPO of the company. On account of this ban, the shares of DLF have plunged to record low. Later, the company applied for interim relief from the securities regulator. The corporates affairs ministry ordered for the merger of crisis-hit NSEL with the parent firm FTIL to help the affected investors to get their due. This is the first time in the history that the ministry has invoked a clause in the Companies Act for a forced merged in the private sector due to public interest.

Lately, Modi has inaugurated recently refurbished Sir Harkisondas Nurrotamdas Reliance Foundation Hospital in South Mumbai and encouraged manufacturing of advanced healthcare equipment. Dilma Rousseff was re-elected the president of Brazil with a very slight margin of 3%. Immediately after the result, the real depreciated by 2.3% and the Ibovespa benchmark stock index plunged by 3.7%.

On the magazine front, the cover story deals with the global economic scenario. It essentially deals with the trade and stock market scenario prevailing globally. The Article of the Month (AOM) deals with current account deficit and how royalty payments to the foreign parents of the Indian subsidiaries. It highlights how the policies of the government are affecting FDIs and FDOs (Foreign Direct Outflows). FinSight highlights the things done differently by the new RBI Governor. FinGyaan discusses about the recent sharp drop in the global Brent crude prices. Finpact analyses the RIL & RPL merger in detail. Finview has excerpts from the discussion with Mr. Ashvini Bakshi, VP, Credit Suisse. The discussion was mainly around risk management and M&A scenario globally.

We would like to thank our readers for their immense support and encouragement.

You remain our prime motivation factor that keeps our spirits high and give us the vigor and vitality to keep working hard.

Thank you.

Stay invested!

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Team Niveshak Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears no responsibility whatsoever.

CONTENTS Cover Story Niveshak Times

04 The Month That Was

Article of the month

10 ROYALTY: The Royal

14 Fear or Greed?

Payment to the Multinational Corporations

FinGyaan 18 Impact of Drop in Crude Oil Prices

Finsight

26 Things

Done Differently by the NEW RBI Governor

FinPact

22 RIL & RPL Merger

FINVIEW

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Interview with Mr. Ashvini Bakshi, VP, Credit Suisse

CLASSROOM

33 Fast Market

The Month That Was

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The Niveshak Times Team NIVESHAK

IIM Shillong Mr. Arvind Subramanian Appointed As India’s Next Chief Economic Advisor Oxford-educated US – based economist Arvind Subramanian, who is a Senior Fellow at the Peterson Institute for International Economics, has been brought in as the new Chief Economic Advisor for a period of three years on contract basis, in the pay scale of Rs. 80,000 from the date of appointment or superannuation, whichever is earlier. The post of CEA has been lying vacant since Raghuram Rajan was appointed as the RBI Governor over a year ago. The Finance Ministry did this appointment as a preparation for the Union Budget 2015-16. As the CEA, Subramanian will be the main go-to person for advice for the finance minister on macro-economic matters. The primary responsibilities, among others, will also include authoring the mid-year analysis and the Economic Survey.

Videocon Raising Rs 700 Crore Through IPO Videocon d2h Ltd, the satellite television arm of the Videocon Group, has filed fresh papers with the Securities and Exchange Board of India (Sebi) to mop Rs 700 crore through an initial public offering (IPO). Videocon d2h had received approval in March 2013, carrying a validity of one year, according to the Sebi’s Issue of Capital and Disclosure Requirements Regulations. However, the company did not launch due to bad market conditions. The company is also considering whether to raise Rs 50 crore through a pre-IPO placement of shares to institutional investors.

While the company has not disclosed the total number of shares to be sold in the IPO, the pre-IPO placement could be of five million shares. The company plans to use the funds for acquisition of set-top boxes, outdoor units and accessories thereof, repayment/ prepayment of certain indebtedness and general corporate purposes. IDBI Capital market Services, SBI Capital Markets, YES Bank, Enam Securities and UBS Securities India would act as book-running lead managers. The shares are proposed to be listed on the BSE. In July, the satellite TV arm of the diversified Videocon Group formally announced the change of its name from Bharat Business Channel to Videocon d2h.

L&T Finance Case: Sebi Reaffirms Market Ban

OCTOBER 2014

On Factorial Fund In a major insider trading case in shares of L&T Finance, Sebi today refused to vacate its interim ban on Factorial Master Fund, a Hong-Kong based fund founded by an Indian origin banker, from securities markets.

This hedge fund traded in derivative contracts of L&T Finance with Offshore Derivative Contracts (commonly known as P-Notes) through five different FIIs (Foreign Institutional Investors) ---- namely Macquarie Bank, Goldman Sachs Singapore, Merrill Lynch CM Espana, Nomura Singapore and Citigroup Global Markets Mauritius Ltd. The facts and circumstances, as alleged in the interim order indicate a device or artifice to deceive the investors in the securities market and make profit in a manner which was quite disruptive to the market equilibrium.

On examination of Bloomberg chat transcripts provided by CS, it is observed that on March 13, 2014, information like, ‘likely to come in at a steep discount about 70 types’ was being circulated amongst the members of Equity team of Credit Suisse.

Role Of Dlf I-Bankers Under Sebi Lens? Real Estate Giant Moves Sat Against Ban Order Securities & Exchange Board of India (Sebi) may examine the role of merchant bankers in DLF’s maiden equity offering in 2007, a prospect that has caused considerable disquiet among the fraternity.

Though the capital market regulator is yet to send a legal notice to any of the investment banks involved with the real estate developer’s initial public offer (IPO), bankers are worried about the implications of the recent Sebi order on the way they operate. Some bankers are in touch with Sebi officials to understand the regulator’s thinking about the ambit of their responsibility when it comes to disclosures made by clients, said three senior investment bankers aware of the interactions with the regulators. They spoke on condition of anonymity. Recently, Sebi barred DLF and its promoters from accessing the capital markets for three years for not disclosing material information to investors. DLF on Friday filed an appeal before the Securities Appellate Tribunal — a

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quasi-judicial body — challenging the order. I-banks involved in the IPO were DSP Merrill Lynch, Kotak, Citigroup, Lehman Brothers, Deutsche Equities, ICICI Securities, UBS Securities and SBI Capital Markets.

Government Deregulates Diesel; Prices To Be Linked To Market In a major reform push, the government deregulated diesel prices but hiked natural gas tariff by 46 per cent that will push up fertiliser, power, CNG and PNG rates. The deregulation of diesel will bring down rates by Rs 3.37 a litre from midnight tonight and will move in tandem with international cost from next month. This will be the first reduction in diesel rates in over five years. Diesel price were last cut on January 29, 2009 when they were reduced by Rs 2 a litre to Rs 30.86. Rates had since climbed to Rs 58.97. It will cost Rs 55.6 per litre in Delhi from tomorrow. After deregulation, government will no longer provide subsidy on diesel. The long-pending decisions in the oil sector were taken at a Cabinet meeting headed by Prime Minister Narendra Modi.

Against the backdrop of the steep doubling of rates to USD 8.4 recommended by Ranagarajan Committee and cleared by the previous UPA government, the government approved a 46 per cent increase in natural gas prices that will go up from current USD 4.2 per million British thermal unit to USD 6.17 per mmBtu from November 1.

Fall in Commodity Prices This month saw a major fall in commodity prices ranging from crude oil to precious metals, all in the expectations to the US Fed starting an up move in interest rates. Oil prices have also fallen due to the substantial increase in supply and weaker demand from the US & Europe. Oil prices currently hover around $83/barrel and these levels have not been seen since the mid of 2010. Involved in this selloff have been precious metals like gold and silver too. Gold prices after a staggering move in the past decade have been stagnant for most of the last 2 years and silver also is currently trading around a 3-yr low price. This development augurs well for the Indian economy as would reduce our CAD by $34 bn. Lower crude prices also act as a boon to the Indian industry which is heavily reliant on imported crude and a subsequent fall in petrol & diesel prices would positively impact the bottom lines of Indian corporates, thus further increasing the pace of the

economic recovery in India. Food prices have also moved downwards and this has certainly reduced Indian WPI which in September stood at a 5-yr low of 2.38%. This development would certainly help RBI in starting the downward revision of borrowing rates.

Hewlett-Packard Split Comes Investors Say Big Isn’t Better

as

More

Chief Executive Meg Whitman said that the two companies will be on very different courses. The new PC and printer business, HP Inc., will be milked for cash that will be earmarked for returns to stockholders. The other, Hewlett-Packard Enterprise, which Ms. Whitman will run, will focus on growth through a faster pace of investment in new products and through acquisitions.

That sort of split is typical in corporate breakups.

The thesis of trying to optimize shareholder value by either splitting off or maintaining a co-mingled business is one that is debatable by company.

However, if corporates were to split their businesses apart, it wouldn’t necessarily improve profitability.

It may increase the amount of overhead and cost of oversight.

Cancelled Coal Blocks To Be Auctioned The government has finally removed the suspense pertaining to suspended coal blocks. Power Ministry informed that all the coal blocks that were cancelled will be put to auction in the next three months.

This news will be a huge reprieve to the investors of the power generation companies as well as to the banks that have lent huge sums of money to the mining and power generation companies. The Power Ministry will be approaching the cabinet with a proposal to pool prices of imported coal and gas with domestically produced coal and gas. This would reduce the price of the coal and may free up to 100000 MW of power that was stuck due to fuel shortages.

Power sector companies are requesting banks to urge RBI for allowing a special dispensation for loans to this sector. In this special dispensation, they are requesting to restructure the loans of the whole industry by not charging any additional provisions upon banks. This provision of special dispensation seems far from possible since RBI didn’t give any special dispensation to 3G spectrum auction.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

The Month That Was

The Niveshak Times

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Article ofSnapshot the Month Market Cover Story

Market Snapshot

Source: www.bseindia.com www.nseindia.com

MARKET CAP (IN RS. CR) BSE Mkt. Cap

9381430.12 Source: www.bseindia.com

CURRENCY RATES INR / 1 USD INR / 1 Euro INR / 100 Jap. YEN INR / 1 Pound Sterling INR/ 1 SGD

LENDING / DEPOSIT RATES Base rate Deposit rate

10.00%-10.25% 8.00% - 9.05%

RESERVE RATIOS 61.229 77.7547 56.71 98.52 48.06

CURRENCY MOVEMENTS

CRR SLR

4.00% 22.00%

POLICY RATES Bank Rate Repo rate Reverse Repo rate

9.00% 8.00% 7.00%

Source: www.bseindia.com 25th Sep 2014 to 23rd Oct 2014 Data as on 27th Oct 2014

OCTOBER 2014

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BSE Index Sensex MIDCAP Smallcap AUTO BANKEX CD CG FMCG Healthcare IT METAL OIL&GAS POWER PSU REALTY TECK

Open

Close

% change

26626.32 9421.4 10510.99 17835.7 17859.88 9510.42 14385.53 7651.37 13855.85 10522.02 11649.26 10646.92 2000.26 7838.25 1628.49 5835.75

26752.9 9592.09 10642.69 17883.04 18948.89 9863.16 15245.91 7341.74 13929.77 10101.5 11281.25 10641.84 2092.69 8079.62 1432.29 5671.73

0.48% 1.81% 1.25% 0.26% 6.10% 3.71% 5.98% -4.05% 0.53% -4.00% -3.16% -0.05% 4.62% 3.08% -12.05% -2.81%

% CHANGE

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Article Market of Snapshot the Month Cover Story

Market Snapshot

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ROYALTY: The Royal Payment to the Multinational Corporations Saket Hawelia

IIM Shillong A perennial problem that India has faced since decades has been the problem of widening current account deficit. The issue has made sure that it features every year in the budget presentation with the finance minister constantly trying to establish an equilibrium of sorts between the importance of FDI (Foreign direct investment) and the security to the domestic manufactures to ensure they are not swept by the winds of globalisation. However, more often than not, the issue boils down to the question of whether the decision of FDI is balanced with an evaluation of what could possibly go out of the country as a result of FDI. In other words, whether an FDO (Foreign Direct Outflow) is assessed for every decision of FDI! As per the data from the World Investment Report of UNCTAD, the stock of FDI in India for the FY 2013 stood at whopping $220 billion, which is around 12% of the Indian GDP. This clearly

OCTOBER 2014

indicates that India is an attractive investment for the foreign companies, owing to cheaper cost of production associated with cheap labour availability. However, it is important to understand that a foreign company puts money into another country with the intention of earning a decent return on capital employed.

A multination would obviously want this return to be copious and continuous, with minimum restriction and risk associated. These returns might either be “ploughed back� in India which leads to an addition of the reserves for the host country or alternatively, the returns might be repatriated to the home country, in the form of royalties, dividends, payment for Information Technology or the CIF (Cost, Insurance and Freight) value of the imports; which of course leads to the drainage of the capital of the host country. Interestingly, of all the above, royalties that are paid by the Indian subsidiaries to the

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Article of the Month Cover Story

Fig 1: India GDP, Billions of US Dollars

foreign parents have drawn considerable flak in recent times, albeit, it’s just the academia which has been highlighting the issue.

Before, analysing and assessing how royalty payments are hurting the Indian economy it is important to understand what exactly royalty payments are. Royalty typically is used to refer to as a fee that is paid to someone owning a patent as a compensation for using the same.

Essentially, there are two key things that foreign companies offer India for which policies are made to win their favour and investments.

These include technology and branding. Thus, in this connotation, royalty refers to a fee for bringing knowhow and trademark from the foreign shores.

Before, April 2010, there were certain restrictions imposed by the Indian Government on the royalty remittances. For instance, in case of the technology transfer, the Indian resident firms were allowed to pay a maximum of $2 million plus 5 per cent of the domestic sales or 8 per cent of the international sales (exports) requiring no regulatory approval. However, if there was no transfer of technology, the cap on royalty payment was 1 per cent on domestic and 2 per cent on the international sales.

Come April, 2010 and all these restrictions were done away with retrospective effect from December 2009 by the Ministry of Commerce and Industry. This was done to provide incentive to the foreign investors. This immediately led to a “capital flight” with the multinationals enhancing the royalty payment leading to an immediate FDO (Foreign Direct Outflow) of earnings from the country. Accordingly, between 2009-10 and 2012-13, the outflows on account of royalty and fees for technical services have risen from 13% to 18% of FDI. Not surprisingly, therefore, the royalty payments have surpassed

dividend income, to become the largest source of earnings for the multinational companies.

According to a report published in Business Standard, in FY 2013, 71 MNC’S earned a mammoth Rs. 4,838 crores in the form of royalty as against Rs. 4,529 crores from dividends. The royalties have grown at a compounded annual growth rate (CAGR) of 31% since the removal of the cap by the Government. This is contrary to the net profit earned by the subsidiaries in India that have registered a CAGR of mere 10% for the same aforesaid period. The decline in the operating margins of the 71 companies surveyed 16.4% to 14.2% can largely be attributed to the growth of the royalty payments which appear as a cost in the financial accounts of these Indian subsidiaries.

No sooner did the Government realize that there was a flaw in the policy and that it was hurting the economy and the foreign exchange position of India, than it came up with corrective measures to amend the mistake done. However, the attempts were too feeble to stem the outflow. For instance, in the Union Budget 201314, the tax rate on royalty was raised to 25 per cent from 10 per cent which was upheld in the budget for this year as well. However, it is important to mention here that the increase in the tax was received with a lot of criticism by the global business community. Realistically speaking, though, the hike in the tax slab is of little consequence to the Indian economy with India having signed double tax avoidance treaties with most of the countries where the parent companies are situated. This in turn, implies, that in effect, the tax rate at which the royalties are charged comes down to 15 per cent at the most! The example of Mauritius, which happens to be the source of almost half of the FDI flows to India, the tax rate is a mere 10 per

© FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

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Fig 2: India Foreign Direct Investment, Millions of US Dollars

cent, as per the bilateral tax treaty signed by both the countries.

While some may argue that it is only natural for a foreign business organisation to repatriate the profit that its Indian subsidiary has made as the ultimate objective was anyways to maximise the profits of the parent entity.

In such a scenario it becomes important to answer precisely what exactly are the services provided by the foreign multinational for which such high royalty fee is charged. The ideal reply to this would be that the hike in royalty fee should be directly linked to the enhanced services provided by the parent company and the only measure by which the effectiveness of such services may be gauged is through the improved performance of the Indian subsidiary as reflected in the books of account of the latter.

Interestingly, a research study conducted by the Institutional Investor Advisory Services revealed that there was negligible correlation between the profits of the subsidiary with the payment of royalty to the foreign parent. The research involved a comparison of 100 BSE companies whose performances were mapped against the performance of 25 top Indian subsidiaries that were making royalty payments.

The period for comparison was taken as a 5 year research period; 2 years before the year in which the relaxation was made with regards to royalty payment and 2 years post it.

The results showed that the profit after tax of the former had grown at 42.7 per cent while the latter had grown only by 33.2 per cent. This clearly showed that the Indian companies listed on Bombay Stock Exchange was

OCTOBER 2014

superior to those 25 companies paying royalty and hence the payment of such royalty could be questioned on various grounds.

Maruti Suzuki is an apt example to support the above mentioned claim. In the financial year 2013-14, the royalty that was paid was 6 per cent of the sales, up from 2.7 per cent in 2007-08; while the earnings per share of the company has grown at a CAGR of 1% for the aforesaid period. In fact, the amount of royalty paid by Maruti Suzuki to its Japanese parent, Suzuki Motor, was more than the standalone profit figure of the company!

The incessant increase in the payment of royalty raises quite a few questions on the corporate governance front as well. While on one hand, the corporates do not refrain from justifying the need for privatisation for all activities, from water to education and on the other hand the rationale for increased royalty payment remains unexplained and undefined under the garb of “due diligent”. The new Companies Act does attempt to address this issue and promise an independent voice to the minority shareholders; but how effective it really would be in ensuring a better presentation of results with proper reasoning, only time would say.

No doubt that among those who are hit the most are the minority shareholders whose dividend income falls because of the increased “royalty cost”.

As far as the foreign parent is concerned, royalty income in excess of dividend has anyways been siphoned for them. There is absolutely no justification as to why the minority shareholders bear the cost of royalty, where in

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“royalty cost”. As far as the foreign parent is concerned, royalty income in excess of dividend has anyways been siphoned for them. There is absolutely no justification as to why the minority shareholders bear the cost of royalty, where in many case, like in the case of Asahi, a Japanese manufacturer belonging to the Mitsubishi Group, the company pays royalty despite no profit being generated at all. To quote the Economic Times, “The increase in royalty outflow is a very disturbing trend and needs to be addressed… a drain on the economy and huge amount of money is going back” The idea is not to say that FDI should not be allowed or that globalisation isn’t good. Just that the talks of FDI as a panacea to the problem of current account deficit, without considering the subsequent FDO is misleading to say the least.

To conclude, it is only natural to compare the existing situation with the British Raj where the peasants were required to pay a fixed lagan (tax) irrespective of the monsoons a f f e c t i n g the harvest.

The foreign corporations continue to make massive returns at the cost, sweat and blood of the Indians, the minority shareholders. Looks like little has changed since 1947!

© FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

Article of the Month Cover Story

many case, like in the case of Asahi, a Japanese manufacturer belonging to the Mitsubishi Group, the company pays royalty despite no profit being generated at all. To quote the Economic Times, “The increase in royalty outflow is a very disturbing trend and needs to be addressed… a drain on the economy and huge amount of money is going back” The idea is not to say that FDI should not be allowed or that globalisation isn’t good. Just that the talks of FDI as a panacea to the problem of current account deficit, without considering the subsequent FDO is misleading to say the least. To conclude, it is only natural to compare the existing situation with the British Raj where the peasants were required to pay a fixed lagan (tax) irrespective of the monsoons a f f e c t i n g the harvest.

The foreign corporations continue to make massive returns at the cost, sweat and blood of the Indians, the minority shareholders.

Looks like little has changed since 1947!

The incessant increase in the payment of royalty raises quite a few questions on the corporate governance front as well. While on one hand, the corporates do not refrain from justifying the need for privatisation for all activities, from water to education and on the other hand the rationale for increased royalty payment remains unexplained and undefined under the garb of “due diligent”.

The new Companies Act does attempt to address this issue and promise an independent voice to the minority shareholders; but how effective it really would be in ensuring a better presentation of results with proper reasoning, only time would say.

No doubt that among those who are hit the most are the minority shareholders whose dividend income falls because of the increased

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FEAR OR GREED?

Apoorva Sharma

IIM Shillong Introduction The International Monetary Fund (IMF) has cut its global growth forecasts for 2014 and 2015 and expressed concerns over the world economy never returning to the pace of expansion seen before the financial crisis. The global growth forecast stands at 3.3%. They say in the market, that calculated risk should be taken with cautious optimism. But, the astronomical PEs and the exuberance and euphoria in financial markets doesn’t seem to follow this. This is akin to many global economies. Financial markets describe the marketplace where buyers and sellers participate in trading of assets broadly including equities, bonds, currency and derivatives. This month, the new government came out with the much awaited new gas pricing formula making it market linked. The gas prices were hiked from $4.2/mBtu to $5.6/mBtu while diesel prices were cut by Rs. 3.37/litre. As a fallout, the market factored this news with Sensex closing at 1.23%, or 321.32 points, higher at 26,429.85, while the National STOCK Exchange’s 50-share Nifty ended 1.28%, or 99.70 points higher at 7,879.40 points on the day of announcement. The gainers were the auto industry, which was up by 2.17%. The State run oil marketing companies rallied with the oil and gas index up by 1.94%. The reason for this gain was not just estimated increase in profitability but a couple of integral factors like ease in inflation, lower government subsidies and a contained fiscal deficit. Even the Wall Street seems to be unstoppable with S&P 500 and Dow Jones Industrials reaching all-time

OCTOBER 2014

highs, at levels which remind us of pre dot com crash period.

Let us analyse the markets of US, India, Eurozone, China and Japan in the cover story for this issue of Niveshak.

Fig 1: US & European equities continued to rally in 2014

US Today’s stock prices have reached extremes and are on the fence where it could drop as much as 40% and get back to the long term average valuation as per the theory of mean reversion, which suggests that prices and returns eventually move back towards the mean or average. Corporate profit margins are high because of low refinancing costs resulting in higher EPS, earning per share. The cash to debt ratio on the books are deteriorating. The wages are still at lows. These high profits which people are betting on to justify the expensive stocks are also likely to return to its average but probably till then some would have missed

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Fig 2: Global Growth Estimates

selling opportunities.

The US economy has definitely performed beyond what was anticipated and it registered a growth of 4.2%. Now, the interest rates are set to be increased after five years of frantically pumping money into the economy. And, when this happens, the demand for stocks as an investment opportunity will not be so lucrative resulting in lowering of stock prices. The Wall street did get a flavour of it with T-Bill rates increasing to almost 0.27% from the almost zero level and high priced stocks like Google tumbling. It took nearly 25 years to correct the 1920’s extreme and the similar can await all of us to correct the current scenario wherein P/E ratios are the highest, the highest in the last 135 years and the interest rates at the lowest providing free money to drive the stock prices.

And Warren Buffet had rightly said, stock prices and economy growth are not always correlated.

Yet, equity markets have time to assess their risk assuming that the Fed rate hike will happen in June, 2015. A research studied the performance of S&P 500 index nine months prior to the starting point of each of the last 15 monetary policy tightening cycles and observed high volatility ranging from -2% to an average performance of nearly 10%.

Fig 3: US Dollar Movement

crores into the debt market. Overseas investors have pulled out nearly 800 crores from the stock market on account of profit booking since the beginning of the October, whereas the debt market saw enormous inflows in the same period. The FII flight has been basically because of the strengthening US dollar and the recovering US economy. This, pretty much has been the reason for decline in gold prices which investors consider a hedge against inflation and an alternative to US dollar investments. That probably is the reason why the reserve bank of India kept the rates unchanged on the 30th of September. Although we keep hearing of FII outflows in the news, stocks are still preferred over bonds as an investment opportunity for the

Fig 4: PE Ratios of US Equities

Š FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

Cover Story

Moving on to the currency market, the greenback will continue to strengthen, in particular against EUR and JPY. The main reason for this being interest rate differential and different positions in the economic cycle. Valuation measures based on the concept of purchasing power parity still indicate that USD in undervalued against the Euro by around 10%.

INDIA From the beginning of the year, foreign investors infused a net amount of INR 82,651 crores into the share market and a net of INR 1.25 lakh

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next few months until the disinflation process starts yielding results, interest rates are cut and bonds start giving attractive returns. Currently the interest rate on 10 year government bonds is 8.35% and the base rate is 8%, once YTM reduces, we can expect an increase in bond yields which will make it lucrative. Pankaj Vaish, head of markets for South Asia at the third-biggest U.S. bank, says “If you’re talking about the next six to 12 months, yes, preference would be for equities over bonds”. To add to this, a weak monsoon threatened to boost food costs in a nation where more than 800 million people live on less than $2 a day. This deters the possibility of any interest rate cut at least till mid-2015 given the target CPI of 6%. Another factor is that the corporate bond market in India is less liquid and not well developed which limits its demand although its return potential is more than the stock market in India. This might come as a surprise but the fact remains that the equity markets have been overvalued in contrast to the debt market. We can see from the figure below that the only growth period story in Indian stock market was from 2002 to 2007. Before that and after that the return have been lingering near 5%. Stocks have been rallying a lot on expectations since the time Narendra Modi formed the government as the centre and promised of structural reforms. The Make in India campaign has created hope for India becoming a manufacturing hub in the coming years. Now, if the reforms are delayed or not there, the market might have to pay for the euphoria, as was quite evident after the coal block allocation got cancelled recently hitting the banking sector, oil and gas sector and power sectors.

On the currency front, the rupee stands at 61.25 per dollar. It has been fluctuating based on the inflows and outflows of FIIs. Nevertheless, it is stable and expected to appreciate further.

EUROZONE The currency union is quite an exception to the broadly positive global outlook. Collectively the second largest economy, it is of huge significance to the World growth. Eurozone GDP growth was flat in Q2 and expected to only marginally improve in Q3. The inflation levels are very low at around 0.4% annualized rate and this might result in a downgrade from the current expectation of 1.5% growth in the next year. Italy and Spain have fallen into recession, Germany has also slowed down, with the only healthy economy being Spain. Purchase of asset backed securities will free the banks from the

OCTOBER 2014

Fig 5: 2 year Real Govt. Bond Yields

credit risk and encourage them to grant more loans raising liquidity. A large scale Quantitative easing programme needs to be planned out including purchase of government bonds, much like the United States; lower the euro to promote exports which alone is not sufficient; and raise inflation expectations.

Much like the three arrows of Abenomics, Draghi is focussing on greater monetary support, less fiscal tightening and accelerated structural reforms. In this endeavour, the greatest challenge is to make national fiscal policy and centralized monetary policy work in tandem which gets marred by political interests and constraints.

Weaker growth and geopolitical risk in Ukraine coupled with ECB cheap financing would result in noticeable decline in bond yields, one of the lowest. Corporates will be attractive compared to sovereign debt for investment as the latter category gives negative real yield. The investors will move to alternative stock markets. But, companies will stick to cheap debt financing to raise capital. The economics of demand and supply will reign, more demand for equity investment and less of supply raising the valuations.

On the currency front, Euro is expected to weaken further against USD because of interest rate differential. The currency fell to 1.27 versus dollar from 1.40 back in May. Post end of 2015, we might expect Euro to stabilize or even appreciate, but not before that.

CHINA China’s economy continues to show signs of weakness at a relatively modest growth. The banking regulator has said that the reserves that banks are supposed to hold with the central bank will be brought down further, third time in a row in a period of three months to stimulate banks to lend more to SMEs and first time

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Fig 6: PE ratios across markets

China and Japan held $1.28 trillion and $1.14 trillion in U.S. Treasury securities, respectively, as of July 2013. A fall in U.S. government bond prices would deplete the value of their reserves.

As the interest rates are low, around 6% and monetary policy loose to boost economic growth, therefore the debt market as an investment opportunity is not very lucrative. The Chinese stock market is rallying but it is not a cause for alarm because, they still remain under control compared to its global counterparts.

JAPAN The bank of Japan continued implementing its quantitative easing policy, focusing its bond purchase programme on shorter maturities.

Abenomics has not been able to reinflate the Japanese economy and hence the monetary policy easing has to continue in future at least till end of 2015.The program inflated the balance sheet of the central bank by around

50% of the GDP. The spill over has been on Yen, which is weakening, the global effects are lesser because maximum government bonds are held by domestic institutional buyers, banks and households. The stock index, Nikkei has been strong over the past three months. The corporate margins have not improved because revival of private domestic demand has not been achieved, the little that it has grew is because of cheap debt financing. The government proposes to cut corporate tax rate from current 35.6% to a range between 20 -29%. But, it does not look feasible at a time when the government is facing huge budget deficit. Deregulation, the third arrow of Abenomics is necessary since the loosening monetary policy is not sufficient for long term growth potential of the economy.

On the currency front, the yen is expected to weaken further given the monetary stance in the economy CONCLUSION Overall most analysts are heavy on developed market equities more on US, and lesser in UK and Japan because the latter have a potential of increased corporate earnings to justify the increased valuation and hence more scope for business investment, Merger & acquisition activities and share buybacks. In the debt market, investors are light on US, UK and Japan bond markets but heavy on Euro bond because they will have to resist the selloff once the US yields start picking up. The Geopolitical scenario will continue playing an important role in deciding the direction for financial markets. Russia’s economy is stagnating, because of the negative effects that resulted from its destabilization of Ukraine exposes Russia to huge downside risk.

Following recession in the first half, Brazil needs reforms and the future depends much on the results of the presidential election. The Brazilian electorate awaits the runoff between Dilma Rouseff and Aecio Neves.

A lot is happening around the globe, the financial markets have been tumultuous by the diverging growth prospects in the United States, all set to tighten its monetary policy next year on one hand. On the other, we have an ailing Eurozone and Japan that has submerged into contraction.

This volatility and uncertainty, demands the investors to think. Let us hope that judgement and prudence prevail!

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Cover Story

home owners in the current scenario. At the same time, measures have been taken to reduce shadow banking to keep credit activities under control, a mix of both these measures is what the central bank has been trying to do. Shadow banking is fuelled mainly because of interbank lending which has increased drastically in the past years. The government has therefore imposed a limit on this by mandating that such lending should not exceed one third of a bank’s liabilities nor should it exceed half on a bank’s tier 1 capital. One serious worry for China is the increasing level of government debt so much so that the local governments in China are not permitted to issue bonds or borrow from banks.

This happened because most of the borrowed funds were directed towards infrastructure projects which either failed or performed poorly.

Because of the imposition, there has been an increase in the off-balance sheet items.

Another point of concern could be that China and Japan are the largest foreign holders of U.S. Treasury debt, which demands quick action.

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FinGyaan

FinGyaan

IMPACT OF DROP IN CRUDE OIL PRICES Mohit Gupta

IIM Shillong

Since the month of June this year the price of crude oil has dropped sharply. Even though very recently the price of crude oil has increased a little but analysts believe that the prices of crude oil will hover below $100 per barrel in the near future. West Texas Intermediate (WTI) crude had held above $82 level after falling below $80 a barrel for the first time since June 2012 last week.

Brent crude price came down to around $85 per barrel in the European countries. All are now looking forward to the upcoming Organization of the Petroleum Exporting Countries (OPEC) meeting on 27th of November 2014 to determine whether major producers such as Saudi Arabia will limit production or they will continue to boost and increase their output to regain market share from their key competitors. Even though the next OPEC meeting for reviewing oil supplies is due in November but there are possibilities that an early decision on quotas can be taken.

This fall in prices of crude oil is mainly due

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to low demand by the consumers and due to oversupply by some of the Organization of the Petroleum Exporting Countries (OPEC) producers. One more critical factor which has complemented the falling prices is the increase in US production from shale as US is planning to be self-reliant for its energy needs. The level of impact of this drop in crude oil prices on Asian economies will vary.

Oil is a critical commodity for India. India relies on imports for its oil requirement. India is currently importing more than 66 percent of its oil requirement which constitutes 37 percent of total imports. Therefore a one dollar fall in the price of oil saves the country about 40 billion rupees. This has a threefold effect spread across the economy. The first effect is that if the average fall in oil prices will be around $4 per barrel in 2014 - 15 it will result in shrinking of the trade deficit by around $3 billion. Custom duty on gold imports led to the current account

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FinGyaan Cover Story

deficit to drop to $7.5 billion in the April-June quarter of this year. Adding on to that the drop in oil prices and the current account deficit should come down further and harden rupee against the dollar. We know that India is a very vulnerable economy when it comes to oil. The drop in crude oil prices will lead to lowering of import bills which will help in controlling current account deficit. Drop in oil prices will also lead to lower subsidy burden for the government.

In this year’s budget India’s subsidy bill was estimated to be around at Rs 2.6 lakh crore (2.03% of gross domestic product GDP) in which oil subsidies accounted for Rs 63,500 crore. The other major components of the subsidy bill were fertilizer subsidies of Rs 73000 crore and food subsidies of Rs 1.15 lakh crore.

If the volumes do not pick up substantially and if the current drop in prices of crude oil sustains, it will lead to a significant impact to the current account deficit and oil subsidy bill of government.

Petrol and diesel has been deregularized by the Indian government which means their local prices will follow and change according to the global prices. But still Indian oil marketing companies sell certain petroleum product like liquid petroleum gas

(LPG) and kerosene at lower than market prices leading to under recoveries for which they get cash subsidies from government. As the Governmemt of India has deregularized diesel under recoveries for diesel have trurned nil.

Over the past three quarters the Government of India had been increasing widely used auto fuel’s prices by 50 paise every month with the intention of bridging the gap with current market prices. If over a year there is a decrease of $10 in crude prices it would lead to a reduction of annual oil under recoveries of about Rs 35000 which will eventually translate into fiscal savings of about Rs 18000 which is equivalent to 0.15 % of GDP. If there is such a drop in prices it will also lead to lowering down oil imports by about $15 billion. Thus it is evident that a sharp drop in oil prices if sustained can have a meaningful impact on helping India’s twin deficits.

India’s crude oil imports rose to Rs 864875 crore (around $143 billion) in 2013-14 from Rs 784652 in 2012-13.

Second, the fall in international oil prices will reduce subsidies that help sustain the domestic prices of oil products. Petrol and diesel prices has been already decontrolled. It

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is kerosene and liquefied petroleum gas (LPG) that are still highly subsidized. And looking at the current actions and mood of the government it is very unlikely that government will make these to be market priced in the near future.

On petroleum products the total subsidy in 2013-14 was about 854 billion rupees and in the case of declining prices it will be reduced to the extent the international price of crude declines.

The advantage of this will mainly occur to the government and oil-producing companies such as ONGC. Consequentially the fiscal deficit that is projected at 4.1 percent of GDP in 2014-15 may be somewhat reduced.

Third, the fall in oil prices will have a positive effect with regards to inflation in India. But it will not be that strong as the consumption of oil in industries is not very high except in industries which produce products such as carbon black.

In India large ecosystem depends on crude. If there is a drop in crude prices it will lead to lowering of transportation cost, input cost of manufacturing and industrial goods which in turn will help in controlling inflation. One more critical fact is that the drop in crude oil price may lead to immediate impact on WPI (Wholesale Price Index) inflation but its impact on retail inflation would be reflected only with lag effect.

In WPI inflation fuel and power currently have 14.91% weightage. Now if we look at the flip side it is also possible that the drop in the price

OCTOBER 2014

of oil will adversely affect the budgets of many OPEC members and thus leading to a pressure situation where the decision to cut supplies can be taken before even the November meeting.

Moreover it is likely that the demand for oil may recover and increase with the onset of winter which may lead to prices crawling up again.

Looking at these scenarios the best path would be to take maximum advantage from the current drop in crude oil prices.

Now let’s see the effect of drop in crude oil prices on China. China is the world’s second largest net importer of oil. Based on the figures obtained in 2013 every $1 drop in the oil price helps China to save about $2.1 billion annually.

Thus if the recent fall if sustained China’s import bill will be lowered by about $60 billion. And moreover most of the goods that are exported from China are manufactured goods whose prices have not fallen. Therefore until and unless weak demand changes that it’s foreign currency will go further thus leading to a rise in living standards of citizens. Cheaper oil will also help the government clean up China’s filthy air by phasing out dirty vehicle fuels like diesel.

But the lighter fuels are costlier and going by the current plans drivers could have to pay up to 70% extra. If the prices drop further that will obviously help soften that blow.

Now let’s see which were the major countries negatively affected by the drop in price of oil.

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Russia faced a similar situation in mid 1980s when the oil prices dropped and thus leaving the indebted Soviet Union cash strapped. But if we see the current scenario Russia has built up reserves of $454 billion which will provide it cushion against oil price fluctuations. And more importantly the Rouble has fallen. Next year’s budget assumes a dollar is worth 37 Roubles so it balances with oil at 3700 roubles. A barrel currently costs 3600 roubles, because the currency has plunged 20% this year. With oil at $80 to 85 a barrel Russia would probably run a budget deficit of only about 1% of GDP next year.

The years of $100 a barrel oil also saw the rise of a Beijing consensus towards more economic interventionism. May be a period of $85 oil if that were to happen might usher in another shift in assumptions, attitudes and policies.

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FinGyaan Article of the Month Cover Story

If we see the case of Saudi Arabia, it can survive low prices because when price of oil was $100 a barrel it saved more of the windfall than it spent. The countries didn’t save are affected the most. Major ones among these are Russia, Venezuela and, Iran.

Earlier this month foreign reserves of Venezuela went below $20 billion for the first time in a decade due to a hefty service payment. $450m-500m off export earnings are lost by every dollar off the price of a barrel. The budget of Venezuela was already in trouble. The fiscal deficit was 17% of GDP in Venezuela last year. In order to overcome this issue the government printed Bolivares thus pushing inflation over 60%. This led to the halt of industrial production in Venezuela and S&P downgraded Venezuela’s debt to CCC+ last month. The impact of Venezuela’s oil related problems may be felt beyond its borders.

A program called PetroCaribe is run by the Venezuelan Government under which it provides cheap financing to countries in the Caribbean to buy Venezuelan oil. For Guyana, Haiti, Jamaica and Nicaragua annual deferred payments under PetroCaribe are worth around 4% of GDP. But it costs Venezuela’s government $2.3 billion a year. So if Venezuela decides to cut back this, its effect will create shock waves throughout the Caribbean.

Iran is facing even more grave problems than Venezuela. It needs oil at $136 a barrel to finance its spending, most of which were inherited from inefficient government of Mahmoud Ahmadinejad. Last year it spent about 25% of GDP ($100) billion on consumer subsidies. Moreover it is facing sanctions which means it cannot borrow its way out of trouble.

Hassan Rouhani took office last year and has re-established a degree of macroeconomic stability. According to the central bank for the first time in two years the economy grew in the second quarter of 2014. But he was elected on the promise of improving living standards. Now it is not yet clear whether lower oil prices will force further reforms and increase pressure for a deal with America over Iran’s nuclear program or whether falling revenues will boost support for conservatives.

In case of Russia the impact will be not very high at least for the initial period. The draft budget for 2015 of Russia assumes oil at $100 a barrel.

If the prices go below that then it will become difficult for the President of Russia Vladimir Putin to keep the spending promises he made.

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RIL & RPL Merger S C Chakravarthi V

IIM Shillong

The merger of Reliance Petrochemicals with Reliance Industries Limited (RIL-RPL merger), the largest merger in the Indian Corporate industry took place in the year 2002. This merger took place in a record time of 7 months. Just like any other merger, this merger was also aimed at improving the shareholders’ wealth by decreasing the costs, increasing the revenue and thereby generating more profit. RPL being a subsidiary of RIL was merged with RIL with an aim to strengthen the balance sheet of RIL. Both the companies recommended a swap ratio of 1:11 (i.e. 1 share of RIL for every 11 shares of RPL).

Reliance Industries Limited is the India’s largest private sector company on all fronts of financial parameters. It was the first company to feature in the Fortune Global 500 list of ‘World’s largest organizations’. According to Fortune, RIL was amongst the 30 fastest climbers and RIL also occupied a place in the list of world’s 400 best big companies. With reference to a US publication-Business week in collaboration with Boston Consulting Group, RIL ranks among the 25 most innovative companies.

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Reliance Refineries Pvt. Ltd, which later got renamed as Reliance Petrochemicals was incorporated in September, 1991. It started off with a refinery project with a capacity of 9 MTPA whose cost was around $1.23 Billion (Rs. 5142 crores). The project was planned to be completed within 5 years from its inception. But due to the scaling up of proposed capacity of the plant from 15 MTPA to 27 MTPA by the group, the project was delayed. Hence, RPL started production only in the year 2000 and by then it has already incurred a cost of $3.4 billion (Rs.14250 crores).

But then, it had become the world’s largest grassroots refinery. RPL was only promoted by RIL, not its integral part. Had RPL been a part of RIL, the funds required to commence RPL project would have been taken in the form of equity capital at the market price of RIL shares or by taking appropriate fresh debt, which would have caused the Debt/Equity ratio of RIL to be 1.5. In 1993, RPL came out with a public issue of Triple Option Convertible Debentures (TOCD) and in September, 1993, RPL went for largest ever public issue of Rs.5142 crores ($1.22 Billion).

The rationale for choosing TOCD by RPL is that

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crores and the offer price was Rs.60 per unit, similar to the issue in 1993. This issue was able to draw an overwhelming response and the issue was oversubscribed by over 50 times.

Seven years after its first merger, Mukesh Ambani went for another merger with RPL in order to consolidate its position as the largest firm in the private sector from the point of view of sales and profits. Hence, there was a re-merger of RIL and RPL in March 2009. There was no similarity between the two mergers.

In 2002, the merger happened on the back of tough times for RIL’s main business of petrochemicals where it had seen a sustained fall in the earnings growth in the two of the three quarters and also the economy was down at that time which was leading to further demand contraction. Similarly, a couple of quarters before the merger in 2009, RIL faced difficult times and there were rumors all around the market about the potential losses, currency exposure and its foray into retail business.

The merger of 2002 was dated back to April, 2001 and it was speculated that this was done in order to cover up for the under-performance of RIL by combining cash-rich RPL with itself.

Similarly, the merger of 2009 was dated back to April, 2008 with a retrospective effect. This can be observed from the fact that the share price of RIL in Feb 2009 was averaging around Rs.300, whereas in April, 2008, it was averaging around Rs.621. Similarly, in Feb 2002, the average share

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Article of the Month FinPact Cover Story

the commissioning of the plant takes 5 years and then only the first barrel could be rolled out. So, it was designed in such a way that warrant conversions were allowed only after 48 months of the IPO and the principal and interest related to non-convertible debentures could be paid out only during 6th, 7th and 8th years of operations. When the project was already in 5th year of its installation, it was expected that the commissioning of the plant will take at least another 2-3 years, because of the scaling up of the production capacity of the plant, but by 2000, the operations of RPL got stabilized.

This was the starting point of the Jamnagar refining hub and over time, additional capacity was added. RIL group always follow a class strategy of commissioning and executing capitalintensive and large projects on the balance sheets of new companies and once the project is successfully implemented and it has stabilized its operations, initiate a merger with RIL. By this way, RIL reduced the risk of project execution, RIL’s balance-sheet is not affected by external equity or debt taken for the commissioning of the project. In league with this strategy, RPL was merged with RIL in 2002 at a swap ratio of 1:11, which most of the investors felt was not a favorable one.

Then again in 2005, to create an export oriented refinery in Jamnagar, Gujarat, there was a demerger of Reliance group and RPL went public in April 2006. The size of this issue was Rs.2700

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price was hovering around Rs.70 and the same was around Rs.90 in April, 2001.

The above graph illustrates the variation of the share value of RIL every month beginning from 1st January, 2008 till 1st October, 2010. Here, we can observe that the share value in 2009 is less than that of 2008 and this is the reason why the merger was dated back to April, 2008 as explained above.

The merger in 2002 benefited RIL in terms of large depreciation cover and also with added tax benefits. In the 2009 merger also, RIL enjoyed tremendous tax benefits that RPL was availing from Special Economic Zone. These benefits include tax exemption for 100% of RPL profits derived from exports and 50% of profits derived from domestic operations for 5 years after the merger in 2009. Also, there were exemptions on the excise duty and service taxes for products and services, stamp duties on land transactions and loan transactions.

Another similarity is that the merger is always skewed in favour of RIL shareholders. In 2002 merger, the swap ratio was 1:11 and the same in 2009 merger was 1:16.

The only difference between the merger in 2002 and 2009 seems to be the lack of synergy between the two companies RIL and RPL. The original RPL used to supply naphtha to RIL’s petrochemical complexes. The same level of synergy was not evident during the merger of 2009. As already discussed, both the mergers in 2002 and 2009 happened so that RIL gains from large size of the balance sheet of RPL and also avail tax benefits

(SEZ benefits).

The RIL-RPL merger in 2009 is considered as India’s 10th largest M&A deal ever with allshare merger deal value of about Rs.8500 crores between the two Mukesh Ambani group’s firms.

This merger resulted in the issuance of 6.92 crores new shares by RIL. There was an increase of 4.4% in equity base from Rs.1574 crores of shares to Rs.1643 crores and the promoter holding in RIL reduced from 49% to 46%. This merger resulted in RIL operating two of the world’s largest and complex refineries and owning 1.24 million barrels per day.

The proposed merger was expected to improve the net profit of RIL considerably and this can be observed by a sudden spike in the profits of RIL, from Rs.16236 crores in 2009-10 to Rs.20286 crores in 2010-11. Also, an increase in the share capital, which is a direct effect of the merger, can be observed (Rs.1574 crores in 2008-09 to Rs.3270 crores in 2009-10). Similarly, there was a sudden surge in the market capitalization of RIL from 2008-09 to 2009-10.

The following table presents some of the financial ratios for both pre and post 2009 merger: From the above analysis, it can be seen that there is a sudden dip in Debt/Equity ratio because of the shares that were issued during merger and also there is an improvement in the earnings per share from 2010-11 onwards. There is not much variation in the P/E ratio before and after the merger. ROE increased gradually in 2011-12 which meant that the company was using its shareholder’s money efficiently.

Fig 1: Variation of share value of RIL

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2010-11 20286

09-Oct 16236

08-Sep 15309

07-Aug 19458

06-Jul 11943

3273

3270

1574

1454

1393

162825

148267

133901

124730

78313

62

49.7

49.7

105.3

82.2

463.2

419.5

401.5

560.3

440

0.44:1

0.46:1

0.63:1

0.45:1

0.44:1

7.47 0.12

8.44 0.11

8.08 0.11

5.32 0.15

5.35 0.15

Table 1: Financial ratios for both pre and post 2009 merger

2013 2012 2011 32995 26974 33280

2010 18245

Net Cash From Operating The merger helped in sourcing crude oil for the complex integrated refinery and aiding in marketing of fuels such as diesel and gas. RIL’s 33 mtpa refinery at Jamnagar together with RPL’s newly built 29 mtpa export refinery made it the largest refinery in India and thus giving a huge competition to state owned Indian Oil Corporation (IOC) with 50.7 mtpa refining capacity. The merger led to a greater flexibility in operations planning as integrated energy companies have higher valuations when compared to stand alone companies. It can also be observed that postmerger, cash flow (especially from operating activities) has improved from 2009 to 2011. This proves that there was a good amount of synergy between the two companies and the merger really helped in improving their efficiency in operational activities. This improvement in cash flow can also be attributed to the simplification of group’s corporate structure.

Post-merger (2009), RIL has become one of the world’s largest refining companies. It occupied the 5th place in world’s most complex refineries.

After the 2002 merger, the annualized EPS of RIL increased from Rs.26 to Rs.28.8 per share. RPL on stand-alone basis enjoyed AA+ rating from CRISIL. Its rating was upgraded from BBB+ to AA+ within a year of the merger. In recognition of the proposed merger (2002), CRISIL reaffirmed

AAA rating to RIL. Also, the same rating was continued even after 2009 RIL-RPL merger.

However, the merger did not help in improving the stock price of both RIL and RPL. There was a drop in shares of RPL by as much as 8.3%, but later recovered to Rs. 74.60 (2.3% lower). RIL also followed the same trend in which there was a drop of 4.2% and before the closing of the stock exchange, it was 3.84% lower than its price of Rs.1217.4 on the Bombay Stock Exchange. But this is not a surprising phenomenon, because it is generally observed that companies go for Mergers or Acquisitions its stock value is bound to come down at least in the short-run, which may later correct iself if the synergies of the merger are realized and the merged companies are performing good. Hence, in this case RIL is no exception to this fact.

Currently, RPL has interests in downstream oil business. It has also got into a strategic alliance with Chevron India Holding Pvt. Ltd, a wholly owned subsidiary of Chevron, U.S.A., which currently holds a 5% stake in the company.

Despite the fact that the deal appeared in favour of RIL shareholders, they lost and RPL shareholders gained. Overall, it can be said that this deal of RIL and RPL was done with an ‘empire building motive’ along with the intention of spreading risk and return among the two companies.

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Article of the Month FinPact Cover Story

2011-12 Profit for the 20040 year Equity Share 3271 Capital Reserves 32005 and Surplus Earnings per 61.2 share Book Value 507.3 per share Debt/Equity 0.41:1 ratio P/E 8.29 ROE 0.57

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Things Done Differently By The New RBIGovernor Prakhar Agrawal & Priyadarshi Agarwal

IIM Shillong

Raghuram Rajan has recently been conferred with Euromoney’s Central Bank Governor of the year award 2014 in Washington. This is the latest addition to the various recognitions he has earned on the global arena. But it gains significance because of the extensive stabilizing effects Rajan’s policies had on the volatility faced by the Indian economy in mid-2013. In this article, we will have a look at the things done differently by him.

Opening of the economy in the early 1990s led to a rapid development of the country with private enterprises taking the lead. In the ensuing years, capital intensive, mega projects were set up and India was able to

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achieve astounding growth rates of over 9% in the boom years. But India’s promise remains repeatedly dented by governance missteps. The Indian state is still fettered by its old design to manage the levers of the economy. Politics and unreliable bureaucracy have led to stalling of efforts to bring in the necessary change to keep the momentum of the economy intact and the resulting cost to the country has been visible in the past 3-4 years. A number of selfinflicted wounds brutalized economic output to an average level of sub 5%. The growth in private-sector investment and production has been derailed. It has been a very Indian crisis, wasteful years of badly needed development.

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The inflation has hit 10% since 2009. The current account deficit was over 3% of GDP in 2013, which indicates the failure of the supply side of India’s economy to meet excess demand. A series of governance errors under the former Congress includes delayed environmental clearances for upcoming projects, challenges with respect to land acquisition and infrastructure bottlenecks.

The real challenge came up in the year 2013 when the US Fed started tapering which instilled fears among the investors. While the effect was felt in almost all stock markets across Asia, India was the worst-hit because of a complete dependence on FII investment, compounded by a worsening fiscal deficit and poor growth.

During August-September 2013, the rupee dropped to its historic lows against the dollar.

It was in early September 2013, when Raghuram Rajan took charge as the Reserve Bank of India governor. His immediate contrarian solution was to tighten monetary policy and adopt a new approach to stabilize the rupee by emphasizing the battle to contain inflation as the principal anchor of monetary policy.

Rajan took some radical steps in the first few months. Rates were hiked to the positive surprise of the market. This was against the views of a large number of monetary policy committee members who favoured keeping rates on hold or even looser conditions. The market consensus at the time was that a pro-cyclical hike in rates would be counter-productive by savaging demand in an ailing economy. Payments for import of oil had been causing major hurt to

the currency exchange rate. The special forex swap window for oil marketing companies was opened, providing dollars via a forward swap agreement to reduce pressures on the rupee.

The central bank offered concessional interest rates to raise the foreign currency deposits, which helped fetch $34 billion via oil marketing companies and other large-scale industries and helped stop the slip in currency rates.

The Reserve Bank put in place a number of exceptional measures to tighten liquidity with a view to dampening volatility in the foreign exchange market. These measures had raised the effective policy rate for monetary policy operations to 10.25%. The intent has been to maintain tight liquidity conditions at the short end of the term structure until the measures designed to alter the path of the Current Account Deficit and improve prospects for its stable funding take charge.

Rajan said, “I thought we needed to change the market language – not by direct interventions in the market but by signalling that we cared about the long-term value of the rupee. The key point of this strategy was to send a very strong message about inflation. In that process, you don’t kill growth [by hiking rates to a high level solely for the short-run aim of attracting inflows].”

Since then, growth has rebounded to reach a two-year high. The rupee has now gained 10% against the dollar on a year-on-year basis and inflation has fallen by over two percentage points. It has convinced many of the leaders

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in India’s financial community that finally they have a central bank governor with the instincts and operational skills to help drive the country’s economy forward.

While inflation has been an important concern for all the previous governors, Rajan’s focus on consumer-price index rather than the lower wholesale-price index has been the biggest change in policy. Monetary operations have been characterized by effective employment of repo rate. Measures to inject liquidity into the banking system and stabilize the current account, such as a swap window for bank deposits from the non-resident Indians, served as a crisis circuit-breaker by courting badly needed capital. These measures, in tandem with an easing of fears over the Fed’s loose-money policy, have strengthened India’s credibility as a stable economy to invest in. They also gave prime minster Narendra Modi’s reform-minded Bharatiya Janata Party breathing space to address fiscal and supply-side issues when it assumed office in May. His decisions have made him a darling of Indian media and analysts and has gained recognition from politicians as well who were reluctant to accept his unorthodox solutions to the problems of the economy.

In this respect, it becomes imperative to highlight the effect of Rajan’s image of an acclaimed international economist on India’s condition, especially at the time of his taking over the reins of RBI. Rajan is a professor at Chicago Booth School of Business and was the Chief Economist at the International Monetary Fund from 2003 to 2006. But the biggest event was the prediction of the Financial Crisis in 2005, well before it took place, which brought him into the limelight. This prediction was bashed by almost all fellow economists at the time. This image of an economist with a knack of accurately reading the pulse of the economy was the major factor which calmed the investors in the fragile Indian market of August 2013.

Mr. Rajan has now introduced an inflationtargeting regime. The rationale for lower rates is clear. Household savings rates have fallen from 12% of GDP in 2007-08 to 7.2% in the last year capping the supply of risk capital. India’s high interest-rate regime has crippled the development of a corporate bond market. It has also made investment projects dependent

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on an inefficient and capital-constrained statedominated banking system. India remains dependent on inconsistent pools of foreign capital to finance investment, which makes the economy prone to external shocks. Lower inflation and lower interest rates would build up risk capital to finance India’s industrialization.

Inability to generate domestic pools of savings would leave Indian markets hostage to external fortune, reflected in current-account deficit shocks and capital outflows.

But Rajan remains undefeated. He estimates the 6% inflation target for January 2016, and 4% thereafter in the long term. Rajan argues inflation in India is very much a monetary phenomenon, and that the efficacy of the repo rate as a transmission channel should not be dismissed. He says: “I do think there are aspects of CPI a central bank has some effect on. In any case, if food inflation is picking up in a secular way, you are ultimately responsible for that, since this is part of the inflationary experience of the people. In any case, food inflation exerts second-round effects, such as wage inflation and construction prices.”

Till now the RBI governor has been successful in restoring confidence in Indian markets, while embarking on a hold of relatively uncontroversial reforms. These include a distinguished regime for financial institutions, new norms for recognizing impaired loans for the banking industry and the development of the interest rate-futures market.

But the second year of his three-year term will require political nous to deliver on a flurry of reforms such as establishing a rate-setting committee, building up day-to-day management of the RBI, and curbing judicial oversight of the central bank as financial regulator. Rajan is also urging the government to meet deficit targets, pushing for subsidy reforms and seeking to liberalize the banking system.

Interview with Mr. Ashvini Bakshi, Vice President, Credit Suisse How do you think the 2008 Financial Crisis impacted the risk management scenario in the world and what are the important risk management measures erected by the banks worldwide especially in terms their hedging strategies?

Let me give you a background and at that time I was in the middle of 2008 and at that point of my career I was in Saudi Arabia. I was headhunted in London to head one of the biggest banks of Saudi Arabia and that’s the Al Rajhi bank group and at that time I had excess liquidity, I was rich with lot of money in my books and at that point we also had the bailout. We had all the major investment banks coming to the kingdom and asking assistance of the king and the way Saudi Arabia works at that time was there is a king at there are 15-20 families that govern the kingdom or the entire Middle East and they invest a lot of money into other American and other global companies through SPVs and different routes. So to just give you an example, which is very often you here in the press is that of Al-Waleed group. He’s a famous guy of Kingdom holdings and owns Four Seasons and a stake in Citi bank. He bailed the Citi bank of in 1990. That’s the way it works. 2008 crisis was kind of anticipated was kind of anticipated from the books in 2001-2003 when I was in Canada.

You could see the lending happening in the subprime area which are risky people so you are bound to get a hit. A key thing coming out of 2008 is the Basel 3. Right now when I joined Credit Suisse, we have already implemented Basel 3 as of 1st of Jan, 2014. We are Basel 3 compliant, the first bank in the world. So in terms of your hedging strategy, we have got a lot of new governance coming out of Basel 3 like Credit Evaluation, CVA, DVA and lot of new complicated processes and we have banished

proprietary trading as well which had become very capital intensive, because if you want to do risky stuff you need to provide capital there so in the end when you do a return on that the pricing gets skewed. You try to think, hang on, am I making money on this kind of portfolio. So if you look back, the key things that came out were, if you were risk-prudent or risk-aware the Middle East didn’t have any problems. I worked in Canada in Bank of Montreal, we were clean then, and we didn’t take a single hit. So we had prudent risk practices and that point of time we followed what was right. We followed logic and you don’t need to make such complicated models as well. We went down with different IRBs and we certified with different banks. In one of the subsidiaries of a British Bank in America our methodology paper was approved by the FSA saying that our haircut methodology was one of the best in the world and they approved it and that was kind of team I worked with. Then all to say is that you can complicate risk management to the nth degree or you can make it simple, question is that. Your strategy is based on your portfolio, what kind of portfolio you have, do you have exotic products in it. But now globally from the regulators there’s been a line set, you they give advanced IRBs etc. I think Basel 4 would be a standardized approach where I can compare all apples to apples, that’s the plan there.

Fitch says that the core capital position of Indian banks is weaker that the position of many Asian banks. It also says that Indian banks need more than $200 bn to comply with Basel 3 and what do you think about the recent amendments to Basel 3 norms by RBI to reduce maturity period of bonds and allow them to tap

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retail investors to meet their Tier 1 capital requirements. If so, who would benefit the most from this the PSU banks or the private banks?

Let me give you a global context, because I have worked only for the past 3 years in India.

To tell you holistically, we have had to raise capital to meet our Basel 3 requirements. Other banks like Deutsche bank have done the same whereas others have divested parts of their businesses, because they you reduce your capital requirements but all in all yes Indian banks would have to raise money. The question is how do you raise money? Now if you look back at the history in 1991 when Glass-Steagall Act which was actually set up in 1930s, but when they saw the depression, they decided to seal the investment banks on one side and the commercial banks on the other side, which is a much safe avenue for your money. But when they made changes to the Glass Steagall Act in the Clinton era in 1999, that money which was sitting in the deposits where the return in low, they moved it into the investment bank. So that $1 which gave a meager return to the portfolio, suddenly was used to earn hundreds of dollars.

The thought this is a good machine out there. So if you go out that way, you see a lot of money flow and lot of it being wrecked and then came the 2008 crisis. In the Indian context, you have to have a clear watch is what your governor Mr. Rajan said and he is spot on. Open up and liberalize. Once you go to the Basel 3 norms, your infrastructure for reporting, banks’ people skills all have to go up. Your operational risk would be better measured. Say your ATM is not working, Bank of America is six-sigma compliant on ATMs, and they never go down. India needs to wake up to the fact that Indian banks need to improve their standards, their customer service levels and how do you do it? You do it by allowing everyone to come in, make it a level playing field for everyone for starters and along with that you need good legal framework and regulatory oversight where defaulters are held liable and promoters are held liable and that’s how it works in the US, there are assets are frozen and everything is taken away. You need to have better risk and government controls and

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the Indian legal system has to really tighten up here.

What is your take on the increasing NPA levels of the Indian banks since total NPAs of 40 listed Indian banks zoomed by over 40% from over $ 1.25 trillion 2011 to $1.97 trillion in 2012. Are the risk management practices adopted by Indian banks deteriorating which may lead to a crisis?

Globally the non-performing assets as compared to India are very low. But then if you look at the other side, where economic development is happening you’ll tend to have high default rates, you can manage that with certain guidelines.

In countries like Canada and Saudi Arabia, the size of the non-performing assets is quite small because you have a very strong credit appraisal system there. The individual rating systems has a high connectivity and mechanism there. On the retail side you have Experia and Equifax which manage your credit scores. In India, how do you measure credit risk on the retail side?

On the corporate side you have the S&P and the Moody’s to take take care of that part. If you look back at the models of Equifax, its model was robust and it worked in a very good way.

In the Indian context, the government has to encourage to put in infrastructure for easier credit appraisal, you should have a governance approach and you can’t have people tampering with it. Other BRIC countries like Brazil and other emerging countries like Indonesia have much robust systems for credit appraisal in place. On good thing for India is the Modi government coming to power and now he has to walk the talk and also he has to openly measure what he has done. 66% was a voter turnaround in the country this year, which was great and now you can’t pass the buck you got to take everyone with you be it the state heads or the governors to do it. This all is because when we do operational risk assessment, we do political stability checks and when your governments are not stable the sovereign credit rating goes down and your corporate credit rating gets hammered down and it becomes difficult to raise money and has other ripple effect, but as we move to a

better world and transparencies come up, we’ll on nepotism. There are countries like Singapore, have better systems in place.

Malaysia, South East Asia, Vietnam, Manila, etc. a lot is happening there because they are We boast about India’s preparedness creating and adapting to a lot of new ideas and for handling financial crisis in which coming up with better solutions. the conservatism and sturdiness of the Indian economy is highlighted that had earlier protected the economy during the 2008 crisis. On the other hand the world Let’s start with why India is not prepared. There is a skill set problem, where people extrapolate their abilities and achievements. Not just the qualifications, but the practical work experience is extremely important. There are also problems in the implementation of the systems. As example is the recent Goa crisis. It is difficult to even report the problem, solving it is the next step, which does not happen since people don’t except the problem. One key thing that I learnt in the western world is to become humble, accept the problem and then work to resolve it. But in India, the systems are such that there are instances such as inaccurate reporting, etc. Hence I think that the ratings are very fair rating and there is a need to stop the cover up operations of the actual situation. Customer bullying is prevalent where their transactions are not processed on time. There is a need for a lot of investment and infrastructure needs to be built. We need to go to the villages and start up programs such as loan resourcing and get into microfinance. I think Indian banks have a lot of potential and opportunities. There are a lot of problems out there. You need to open up the doors, the mindset of the leadership of the existing organizations and they should be open to get in some fresh blood and new ideas and create better solutions. Take the example of Apple, where even when Steve Jobs is no longer there, it is still doing product innovations and is among the biggest brands. There should be an opening of the mindset for accepting the change and keep changing with the time including the people’s perspective, skills and the way you work. If you don’t do that you would be left behind and I think that is where the Indian banks need to put an effort. The people must be promoted on the basis of competency not

In the coming years which region the M & A will happen the most.

From a global perspective, an M & A will happen when on both the sides are in agreement for the deal and there is value in it. The two companies will have to consolidate and the management will have to make efforts to take the merged entity to the next level and realize the synergies.

This will create more value for the share-holders as well. On the other side the bankers who put the deal together, the accountants and the lawyers come in there and make the acquisition happen. But ultimately the success rests on the realization of that. In the Indian context, appropriate norms need to be put in place. Like in South East Asia, a lot of work in Real Estate investment goes on, but that hadn’t happen in India up-till recently. There is a lot that can be done and I think India has got a fantastic government in place this time. I also feel that Mr. Rajan, if given the political autonomy, a lot of stuff can be pulled off.

Why is it important to consider the tax issues?

Let me give you a global context, because I In M&A, you look at a lot of different industries.

When you go to an industry that is concentrated then you start combining otherwise you can’t add shareholder’s value. Airline industry typically in America went through a consolidation phase.

Same thing in India could happen, now that the Airlines have become too difficult to manage there are consolidations happening. So typically in your lifecycle an M&A would happen when you want to get some synergies. So if the airline industry doesn’t do well then other industry in India can’t see that happening. But there is a reverse side to it as well. Like in Canada, there are four major banks, and each bank holds a position. Each has an equal share in market and the government doesn’t let them merge, since

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then if the banks mere merge, the pricing might get skewed and there might be some kind of possibility of monopoly. Hence there is to be balance to be maintained between monopoly and having apt competition. Sufficing amount of competition gives a good pricing, good service and is easier to regulate.

Basal reforms have gone to n degree. Christine Lagarde from IMF has also said that we are again heading into a volatile situation. There is concentration risk, European economy is heading into very difficult place, US is also recovering in and out manner, etc. So the world factors are changing and you need to maintain a balance.

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M&A are happening stock for stock.

This has been happening since a long time that the multinationals are using different methods to save on the tax liability. They look at different Legal entity structure to get the tax advantages.

In the global scenario, the process of M&A is extremely structured like sometimes it is a clean buyout, or a Brand acquisition, especially seen in the pharma industry.

Do you think risk management is getting importance in the management education?

I had started working in the Risk management field in 2001 and got into it in a big way. The structure which was there then was that the Head Risk manager reported to the CFO, because Basal I was only credit and market risk. Then came Basal II in 2004, it also had the operational risk and with Basal III it became more complicated.

So with Basal II, in the years 2002-03, the work started on implementation of the framework.

The Canadian Banks implemented stronger norms. Their capital ratios were higher than the rest of the world and all through the crisis they came out clean. At that time a new function was created, CRO and CFO and they were at power.

When 2008 happened, CFO went away and CRO became the most important guy. But the problem arises when you are taking away someone’s power in the boardroom structure, you have to go back to the politics that goes on there and

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all of a sudden you have a new person tell you how to run a bank in a better manner, which is a bit inhibiting for the CFO and CEO since they have been managing the corporates since a long time. But the Chief Risk Officer looks at what will hit me tomorrow or in the long run. He gives a predictive model to look into the future whereas accounting is past. So if you look at the two functions, accounting is a backward measure whereas risk is a forward measure.

This is where the opportunities comes for a CRO. Hence I feel that for anybody it is a fantastic career. If you have an analytical approach and would want to statistically question why the things happen in a particular manner, putting in new scenarios and parameters, then you are the right guy for that job. To be a risk guy you need to think out of the box. And today this profession is going across different industries cause you talk of enterprise management, you look at all types of risks globally, weather credit, market or operational risk, capital funding, model risk, and all other things. But with the risk guy in place an organization must be ready to take the shake-ups provided by them that question the convention. The world in changing and what may not good yesterday might fit in the today’s time.

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FinFunda of the Month

Fast market Akanksha GuPta IIM Shillong

Sir,recently while doing some research, I came across an old piece of news stating “The London Stock Exchange declared a fast market on July 7, 2005, after the city experienced a terrorist attack”. What is a Fast Market?

A fast market is a result of a sentiment change in the market. Heavy trading and highly volatile prices of securities characterize it. This may be due to an imbalance of trade orders, for example: only “buy” and no “sell” happening in the market. Its trigger can be any thing like a highly anticipated Initial Public Offering (IPO), an important company news announcement or an unforeseen calamity like a terrorist attack (in which case, there can be a situation of all ”sell”, no “buy”).

In a fast market scenario, the frequency of trading becomes so high that it leads to failure of accurate electronic updating of last sale and market conditions.

In such conditions, how do the markets function. Is there any special rule that applies to the markets or the trading halts?

Halting the trading is a solution to this situation of unusual trading, and is generally applied by many markets around the world, especially when there is a fall in prices.

This concept is known as a Circuit Breaker, where the sharper is the decline of the prices, the longer the trading is halted to prevent panic selling.

But in the case of Fast Market, the Fast Market Rule is applied, where when the exchange is not able to cope with the rapid change in prices, the trades in the market are allowed to occur outside the quoted ranges. The market makers do not have to quote share prices based on that displayed on the screens of the exchange, but they are still required to make firm quotes.

The purpose of both these approaches is to maintain an orderly market in chaos.

Sir, excuse me for interrupting, but can you please explain what do you mean by firm quotes and market makers.

Sure, let me explain the terms by an easy definition. A Market Maker is a brokerdealer firm that facilitates trading of the securities by accepting the risk of holding a certain number of shares of that security. They receive customer orders of buying and selling securities and match the order to make the transaction happen. A Firm Quote is the price quote on a security, that guarantees a bid or a ask price up to the amount quoted, i.e. the trader gets what he asks for and no negotiation is.

Thank you Sir. Coming back to the Fast Markets, are there any risks involved in such kind of trading?

Yes, there are many risks involved in Fast markets: • The “Real-time” price quotes may not be accurate and the size of the number of shares available at a particular price may change very quickly. This quote may be more indicative of what has already occurred in he market rather that the price that may be received.

• The orders are served at First-Come-First serve basis that may significantly affect the execution price.

• Since the prices are volatile and there is a backlog of orders, the total size of the quote may get split up into smaller blocks at significantly different prices.

Hence fast markets are very risky for trading by the investors. But, there are very rare events when a fast market rule is applied to the markets.

Thank you Sir for this insightful session. I am now able to understand the term and its implications in a better way.

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WINNERS

Article of the Month Prize - INR 1500/Saket Hawelia IIM Shillong October FinQ Winners 1 st Prize - INR 1000/Sashanka Paladugu IIM Shillong

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