Pension Fund and the Unorganized Sector

Unorganized sector constitutes the segment of workforce whose activities or data is not regulated under any legal provision and there are no regular accounts maintained. Currently there are c. 363m unorganized sector workers in India (ca. 85% of the Indian labor force). This sector provides large scale employment and contributes to the national product significantly.

Major characteristics of the unorganized workers are:

- largely live below the poverty line

- suffer from low literacy levels

- are migrant in nature and

- are dispersed all over the country

In order to improve their quality of life it is imperative to cater to the following

- pension

- healthcare

- life insurance

- accidental unemployment insurance

- unemployment security and

- maternity needs

c. 44% of the unorganized sector avails of life insurance schemes via LIC / GLIC. Healthcare provisions are difficult and expensive to set up not to mention the many hurdles they present. However, setting up of dedicated pension fund will not only address the primary requirement of pension but can also be extended to cater to the last three requirements on the above list.

At present the old age support available to this sector in particular are:

- private savings

- family support

- selected central and state government schemes

- extending working life

Private savings are generally not available and where available are not adequate[1]. Family support is on the decline. Government schemes have limited scope in terms of adequacy and coverage[2]. Extending working life is not a viable option[3]. It is evident that there is a pressing need to develop old age security schemes for this sector.

Core functions of a Pension Fund

1. Reliable collection of contribution / taxes and other benefits
2. Correct payment of benefits
3. Incase of pre-retirement loans ensure timely repayment
4. Secure financial management and productive investments
5. Maintaining an effective communication network (data collection / record keeping)
6. Timely production of financial statements and reports

In order to establish a fund that can deliver on these core functions the following challenges need to be met

1. Assess the segment of unorganized workers[4] that has the capacity to make regular contributions. This analysis should contain data on the segment’s earning capacity, their spending and savings habits and what their ideal saving level and contribution be. From there it can be deducted how to generate pension contributions:
1. Via redirection of discretionary expenses
2. Via redirection of existing savings
3. Via future real increase in income

In addition, to incentivise contributions and help the establishment of a fund, corporate sponsors need to be sought to match workers’ contributions

2. A team of like minded skilled professionals needs to be assembled to
1. educate the target the audience and market the fund
2. manage the corpus to generate positive returns
3. administer demographic/earning changes in the sector
4. constantly work internally and externally to expand the quality and scope of services provided

3. An effective MIS system needs to be designed for record keeping and monitoring of
1. individual fund inflows and outflows
2. earnings of individual funds
3. loans and repayments
4. tax or subsidy collection
5. generation of timely reports

4. Accumulated balances should be invested in economically productive, growth enhancing investments[5]

5. Understanding legal and regulatory requirements, restrictions and proposed developments for such initiatives

6. Most importantly design and manage the financial corpus to deliver

1. Adequate coverage and level of protection
2. Affordable, profit making and sustainable service
3. Robust framework which can withstand economic shocks

Government of India recognizes the need to implement social security for the unorganized sector[6]. Thus it has embarked upon the highly ambitious pension plan reform scheme addressing the entire Indian labor force. In case of the unorganized sector in particular, this scheme plans to establish a voluntary contribution mechanism. There is a mention of outsourcing the administrative tasks to the private sector under a licensed and registered program. Government of India has sought help from the Asian Development Bank in this respect.

As a part of this “joint effort” a survey was conducted that generated the following results:

1. 2/3 of respondents have not given any thought to retirement planning
2. c. 20m have shown willingness to join a national pension fund based on
1. Financial capacity
2. Interest rate
3. Age between 30 – 50 years
3. most people (38% - 45%) mistrust private banks
4. most people trust nationalized banks (mistrust percentage 0% - 2%)

A commercial set-up is required to make this initiative productive and sustainable. While government support is crucial to the setting-up and longetivity of such a fund, it cannot be run by the state. Western governments are running into the red with their state run social security schemes. This business to be sustainable and profitable needs to be a private operation run by a team of like minded, experienced professionals dedicated to the success of this operation. India needs to bridge this gap at the earliest to ensure economic prosperity and inclusive growth.

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[1] Research conducted shows that Indians in general do not start early enough retirement

[2] There is financial limitation and existing schemes are either limited to certain states or sub-segment of unorganized workers

[3] By 2045 it is estimated that India will reach a declining share of working age population of the total population

[4] The most vulnerable segment of this sector is that of women (in particular widows). While not only do women earn less than men, they are 10 times less likely to own property. Thus it could make sense to have special funds created to cater to women and widows. However, to start with the initial corpus might not be significant enough and hence this has to come as an offshoot of a positive return generating fund.

[5] This could lead to scalability of the operation to microfinance, emergency loans against savings etc.

[6] Certain state governments also see this need and there exist a handful of schemes trying to address this in their own way. For e.g. there are 5 welfare funds set up for beedi workers created from the cess that is collected from the manufacturers, Maharsahtra government offers unemployment security etc. However all these efforts are disjoint

Corporate Debt Market in India - Need of the Hour

Indian regulators have drawn a lot of criticism from global market participants for their limited initiatives towards liberalising the domestic capital markets. From a pure policy point of view, some of this criticism is probably unjustified. However, the lack of attention given to the development of a healthy and liquid public corporate debt market is definitely worth raising some questions.

Both domestically and internationally, volumes have been published on the lack of a public corporate debt market in India, its desperate requirement for the country’s growth and also the remedial measures that need to be adopted by the regulators. While the knowledge base has existed for the last several years, there is no concrete curative action in sight yet.

The current global economic crisis heightens the need for thriving and transparent public corporate debt markets in India for two main reasons. One, there is a lesson to be learnt from lax lending disciplines and overburdened balance sheets, and secondly and more importantly is the need to disassociate the country’s growth from a desperate need of international capital.

The sub-prime crisis was more than just lending gone wrong; it was money lent incorrectly. In the hay days of the housing boom, US institutions were extending mortgages to students who had no income in sight for years to come. The idea was that these would be bundled with more credit worthy assets and risks would be averaged. In India, the banking system is similar in this “risk averaging” approach; however, the shallow markets raise the stakes involved. The large, mid and the small cap (and hence diversified risk base) companies borrow (working capital and term loans) from the same banks domestically and in foreign currency. The same banks also fund the promoters who own majority of the equity in these companies. Further, the treasuries of these banks subscribe to the equity of the listed entities and are even dependent on the same corporates for fee income. In the absence of any derivatives, all this risk is kept on the balance sheet of the banks and majority of the lending is done by a handful of domestic (mostly public sector) banks. This overdependence on the small banking network creates a potential systemic risk.

There are those who argue that Indian banks have survived the current crisis better than their foreign counterparts. This has largely been due to the high savings to GDP ratio that the country has, which exists with the domestic banks in the form of deposits. So in short, if there was a crisis that was to happen, it would be the average Joe in the country that would suffer like those in the West are currently. A thriving public corporate debt market would take away some of this risk away from the banks.

It would be incorrect to say that there is no corporate debt market in India currently. There is one, but it is not “public” in the true sense and most definitely it is not liquid. Most of the corporate bonds are subscribed to by banks (no surprises here) or by institutions such as LIC. The pricing of the bonds is done not based on a market benchmark but based on the return expectation of the subscribing investor. Thus there is an entry mode but no exit mode. The exit is blocked by the mostly OTC traded market making sizeable transactions difficult and also by the fact that the return expectation of one institution may not be aligned with that of another institutional investor. In fact this probably also brings forth another point – had there been a public corporate debt market in India, maybe the marked to market valuations of Indian banks would have been different; probably leading to more sober balance sheets?

In any eventuality, a corporate debt market in India will necessitate ratings. This will be an impetus to improving corporate governance and financial discipline amongst Indian corporates. A liquid debt market in India will provide benchmark pricings, creating more transparency in the large cap sector and providing more assurance to the small cap sector when borrowing from banks. Public benchmarks will prevent price wars on loans which currently impair the domestic debt markets. Efficient pricing mechanism will also provide more comfort to overseas investors who are reluctant to participate in the illiquid and non-transparent domestic corporate debt market.

International investors do bring in much needed capital, however, in India, in recent times most of this has been speculative money as opposed to long term investments. This is evident in the fact that FII investments in the country exceed FDI investments. In order for the economy to grow and the income disparities to reduce, there are three key sectors of focus – agriculture, education and infrastructure (which includes energy). All these three sectors are capital intensive sectors with returns being generated over the longer run. These require long term commitment to each project invested in. Such commitment is missing from overseas investors. In fact even foreign banks participate only in a limited way in debt funding of long term domestic assets.

To use domestic capital more efficiently, for the growth of these three sectors, a liquid debt market will come in very handy. Companies, issuing non-convertible debentures currently, all subscribed to by LIC or the likes can then tap the public markets and raise incremental proceeds. India currently has approximately a 30% savings to GDP ratio, most of which is channelled to the countries’ public sector banks. With a thriving debt market, maybe the domestic savings can be used more efficiently and the savings to GDP ratio stabilised. With more diversified investments (away from banks and equity markets) and stable returns, the country’s population at large can benefit. And while it might seem that retail investor participation in debt markets would be difficult, active debt mutual funds provide an answer. In fact with the advent of the new pension reform scheme, pension funds can provide a large corpus for investing in the domestic debt markets. Investor education can also pave the way to making individuals realise the value of balancing their savings over asset allocations and averaging return expectations over a period of time.

India is a young country today with an average age of c. 25. As we grow older as a nation, we will need savings that generate stable returns and that are to some extent decoupled from risks to the financial sector. So along with corporate India, it is the nation on the whole that will benefit from a thriving local corporate debt market. Let us hope that the upcoming budget addresses this need of the hour with some proactive actionable suggestions. The rest we will then need to wait and watch.

Economic Impact of Mumbai Attacks

People have been debating about impact of last week's Mumbai attacks on the Indian economy. In the short run mostly the cinema and restaurant businesses will be impacted. However, in my view there will be no direct and immediate impact on the equity markets as there is no money left for the FIIs to pull out. In fact global investors such as Mark Mobius of Tempelton have reiterated in the last few days that India remains an investment destination despite the current turmoil.

The more major and indirect consequences are linked to the budget of 2009 in my view and here are my first thoughts:

1. If the defence budget was to increase to the detriment of infrastructure and education spend, then there will be a serious impact. These are the two most important sectors for economic growth and are screaming for cash. Not related to budget, the country needs to focus on investing in renewable energy from a long term and acquiring overseas carbon fuel sources for the short term, if we are to become an energy sufficient nation.

2. Any increase in taxes in the name of domestic security, will further reduce spending and hence cause a drain on the economy.

3. The biggest danger, however, would be an increase in the country's deficit due to increased or imbalanced defense budget. Then not only would the economy suffer directly but the sovereign credit rating would also be in jeopardy and that will cost India Inc as well.

Indian Economy - Approaching Times

The value erosion and the risk aversion that the global markets have witnessed in the last few days have hit India already. This, however, could just be the beginning. The high inflation, high oil prices and depreciating rupee have reduced the foreign currency reserves to c. USD 300bn. With an external debt of c. USD 221bn this makes the Indian economy quite vulnerable.

As of March 2008
GDP ---------- $ 1232.946bn
Current Account ---------- ($ 37.865bn )
External Debt ---------- $ 221.212bn
Trade Balance ---------- ($ 90.06bn )
As of July 2008
Inflation ---------- 12.36%
Foreign Currency Reserves---------- $ 296.869bn
Table 1: Selected Macroeconomic Data[1]

An initial analysis of the external debt components, however, brings some relief. Only a quarter of the outstanding amount is short term liability (including trade credit of less than one year). Moreover the country’s deposit base at c. USD 760.511bn (87% of the funding source of the Indian banking system) provides a comfortable cushioning. Further, c. 88% of these deposits are with the local banks whose balance sheets are minimally impacted vis-à-vis their foreign counterparts.

As of March 2008
Trade Credit ---------- $ 10.267bn
External Commercial Borrowing ---------- $ 60.019bn
Short Term Debt ---------- $ 44.313bn
Multilateral ---------- $ 39.312bn
Bilateral ---------- $ 19.613bn
Others ---------- $ 45.688bn
Total ---------- $ 221.212bn
Table 2: External Debt[2]

External Commercial Borrowings (ECB) comprise a quarter of the country’s external debt and that is a concern. Typically ECBs have a three to five year tenor and were issued in abundance from 2005 onwards. Thus there could be a refinancing wave about to hit India. Table 3, elaborates on the difficult refinancing conditions. The primary funding source for Indian firms is banks. Regulatory policy which is fighting inflation is constraining liquidity with the domestic banks. Foreign banks have very limited spare capacity at this point in time. In addition, the credit market has widened very significantly[3], implying that the cost of raising money will be much higher. The global capital markets are not conducive to any fresh fund raising ruling out any meaningful equity or public debt issuance. Hence, options for Indian corporates are limited.

As of March 2008
Bank Credit ---------- Rs. 174,566 cr.
External Commercial Borrowing ---------- Rs. 160,221 cr.
Equity capital Markets ---------- Rs. 64,502 cr.
Others ---------- Rs. 148, 202 cr.
Total ---------- Rs. 547,491 cr.
Table 3: Funding Sources for Indian Corporates[4]

With record profits in 2006 and 2007, Indian corprates could have the money to repay any debt maturing in 2008 and presumably in 2009 as well. However, the picture for 2010 maturing debt does not look promising unless the companies either raise the required money at the earliest or extend their debt maturity profile. 2010 becomes a critical year because it is not only India but Asia overall that has a significant redemption schedule coming up in 2010. A recent Morgan Stanley research puts the 2010 redemption figure at over USD 70bn representing 30%+ of the total outstanding Asian corporate debt.

Firms that require funding 10 – 15 months down the line for capex, refinancing or expansion should raise the money now whatever be the cost. On the one hand it will keep them away from competing for funding with everyone else a few months down the line and secondly it will allow them to focus on business opportunities. In short it will put them in a stronger position to capture the upswing in the market.

While everyone is examining their own houses, corporates should also start to recognize the importance of having a diverse and stable investor base on board. This should also extend to having a healthy mix of domestic and foreign banks in their core banking syndicate.

Size, influence and brand no longer ensure longevity. It is a time to go back to basics and tread ahead cautiously.

[1] Source: RBI Website, IMF
[2] Source: RBI
[3] Investment grade credit spreads have widened 100bps in 2 days and there is very little clarity on pricing of illiquid and high yield debt
[4] Source: RBI

Hard Underwriting - To be or Not to be

Securities Exchange Board of India’s (SEBI), recently suggested that all IPOs be accompanied by mandatory hard underwriting. According to the regulator, there is a lack of quality control in terms of equity paper being issued via IPOs, pricing can tend to be aggressive and there needs to be more through vetting of the business and the risks involved. All this in SEBI’s opinion can be rectified by placing the onus and risk solely on the lead manager via hard underwriting. I would beg to differ. Not only does hard underwriting further complicate the already warped Indian investment banking, it offers no long term solution at all.

Investment banking landscape in India lacks depth. There are very few institutions capable of executing meaningful transactions and still fewer with adequate capitalization to hard underwrite issues. Thus with hard underwriting we risk placing a big chunk of Indian equity in a few hands. What happens in situations akin to the current volatile markets? There is a high probability that the underwritten stocks (if not already placed) would be sold at any level at which a bid was available. Result – a significant freefall of the Indian equity markets. Biggest losers – retail investors. In bull markets it is those investment banks with deep pockets that would undercut competition, resulting in IPOs being concentrated in a few hands. This would further curb any deepening of the Indian financial system. So from a macro view, hard underwriting will not serve the nation well.

The key phases involved in an IPO are due diligence, preparation of research and the finally pricing and allocation. Due diligence is a process whereby the lead manager (or the underwriter) assesses the suitability of the company to list on an exchange and verifies the facts presented. In order to ensure thorough vetting of the company and its risk factors, this process should be “independent”. Research subsequently constitutes of an “objective” presentation of the business and the valuation methodology. This is undertaken by sector experts to produce a comprehensive report. Valuation of the company should not be “influenced” by the views of the issuer or of the corporate financiers working on the mandate. Given the increased risk for a lead manager in a hard underwritten issue and the absence of Chinese walls in Indian banking system, this independence absolutely stands to be blurred and maybe significantly. Thus instead of advocating hard underwriting, SEBI should work towards strengthening Chinese walls in Indian investment banking to ensure systematic evaluation of businesses. At the same time efforts should be made to enforce arms length dealings between the issuer, investment banks and the individuals in these two fraternities.

The next key step is that of pricing and allocation. Majority of an IPO is subscribed to by institutional investors. These are sophisticated investors with global experience and access to information and tools which enable them to take well informed decisions. Not only do institutional investors meet the management to evaluate merit of the company but also conduct their own valuation exercise. The research provided by the lead manager is only a starting point. It is the institutional investors' own analysis that finally decides whether they will participate in the IPO and if yes at what terms. When hard underwriting a transaction, lead managers keep a buffer as protection against any price or demand mismatch. This leads to potentially underpriced issues, causing a loss for the issuer (notwithstanding the higher fee charged for hard underwritten deals). However, price discovery achieved via an offering to institutional investors (as a bookbuilding proposition) leads to optimal pricing and sizing as dictated by markets. (This is obviously assuming independence of investors from the issuer and the issue itself.) Bookbuilding thus offers a more relevant and sustainable solution to achieving reasonable pricing.

Last is the point of quality, which can be quite subjective. The quality of business is not just defined by its profitability but also by its management and shareholders. With most Indian firms being family owned, management is not where one can have immediate influence. However, SEBI can influence the shareholding pattern of Indian corporates. Given the thriving mutual fund industry in India, SEBI should consider curbing direct retail participation in IPOs (currently 30% - 35% of an IPO is reserved for the retail investor and a further 10% - 15% for HNIs). This will not only protect retail investors (mutual funds tend to be less volatile than equity markets) but also avoid participation from seemingly unrelated (to the issuer) but actually in-concert investors. In addition, the minimum dilution levels for promoters should be increased; thus increasing true free float and hopefully leading to improved corporate governance (with increased institutional participation).

Instead of looking at a quick fix, SEBI needs to consider the process as a whole and attack each problematic step in cohesion. There needs to be increased accountability and responsibility placed on each of the involved entities– the issuer, the investment banks, the investors and the regulator itself. Only then will we witness sustained discipline in primary Indian equity market.

Has India Really Arrived?

The July 9th edition of the Economist carried an article with the title “Overconfident India”, claiming that “Indians are complacent about the perils of multi-lateral diplomacy, and much else”. The article which had a very condescending tone evoked a variety of responses from the Indian diaspora in London. There were some who felt that recently the Economist has taken a holier than thou approach towards emerging markets (recently the publication carried a similar article on Russia) which should soften. A few opined that the general judgemental nature of the bi-weekly magazine is on a rise and creating a bad taste in their mouths. Strangely some people I met were indifferent to this article as in their view it made no difference what the Economist had to say, India had arrived. And then there was a bunch, admittedly a minority, which did think the article was based on strong arguments and stating only the obvious albeit a little too abrasively.

After having read and re-read the article and having discussed it with a number of people, I have been trying to figure out where is it that I stand. I am not sure that the tone of the article is acceptable but then the truth of the content cannot be ignored either. As difficult as it is for me to admit, I have to be truthful and say that I do believe that we Indians have let the bull markets drive our confidence to a point where it is now bordering on arrogance. Like the group of indifferent Indians we would like to believe that India has arrived on the global map and we can demand the moon and the stars and the world should deliver.

However, is it really true that we can still tempt global investors to pump their money into our country which desperately needs foreign investment? Is FDI in India still as viable an opportunity? Will FII money get the same returns in India as opposed to say the Middle East? Has India Inc generated sufficient confidence with investors to back them in difficult times? Have our regulators worked with a larger view in mind? Is our legal framework strong enough to handout timely judicious decisions? These are questions that need some honest answers in order for us to be able to really review as to how truly India has arrived.

In the last few years, it is a fact; India has received a record amount of foreign investment. While lower than some other emerging markets, the capital inflow into India had been rising until the credit crunch started. However, if one inspects more closely, most of that investment came as all global investors wanted a piece of the action. The numbers also justify this. From April 2007 – March 2008, while the FDI in the country was c. USD 29.89bn, net FII into the country was also similar at c. USD 29.40bn. In fact this FII figure would have been higher had the market not tanked in 2008 when foreign investors were net sellers of c. USD 10.64bn in the months of February and March. Hence my conclusion that investors came into India to gain from an upward momentum in the stock market not with an intention to invest from a long term basis. This in itself should indicate that we as a country have not arrived. People are not buying into our long term strategy yet.

An infrastructure deficit country, representing a USD 500bn opportunity in the next four years, India should be able to attract a lot more FDI. What is rather interesting is that the highest FDI has come into the services sector (financial and non-financial) which is almost 2.5x that of infrastructure inflow. In fact the cumulative FDI figures from April 2000 – March 2008 indicate that the most attractive investment proposition has been the services sector with 22.64% (financial and non-financial) share of the entire pool, with infrastructure accounting only for 9.35%. There has to be a reason for foreign investors not putting money into Indian infrastructure. Yes, initially infrastructure was a closed sector; however, even with 100% ownership being permitted the sector is not attracting investors. Is it the absence of independent regulators? Is it the fear of governments not being able to fund annuities? Is it the absence of quality strategic partners? There needs to be a reason for this slow moving inflow. And we need to address this. In the absence of a domestic corporate debt market and limited availability of bank funding currently (both domestically and internationally) are we planning to fund the entire spend via equity markets, PE funds and sovereign reserves?

Well it can be proposed that infrastructure and FDI represent areas where interest is just beginning to develop and so over the coming years there is tremendous potential. I will buy that for a while. Let us turn our attention to India Inc in that case and see if we as a country have given the world enough confidence to invest in our propositions because that is the key to unlocking the dollar inflow. Indians are well known for their entrepreneurship and that has never been of any concern. However, corporate governance in India has questionable for quite some time now. To quote our premier Dr Singh from his recent (July 01, 2008) speech at the Jubilee year celebration of the Institute of Chartered Accountants of India, “….I do not find adequate attention being given to corporate governance. Unless Indian firms come to be recognized world wide for good corporate governance they will not be able to compete globally in an increasingly interdependent integrated world. In the era of protectionism few bothered about corporate governance and transparency in accounting and management. Such laxity, however, is no longer possible.” For the head of the nation to say this is publicly indicates that corporate governance is indeed an issue which needs to be addressed. The question is how are we addressing this.

Corporate governance depends on the commitment of managements towards integrity and transparency in business. The legal support provided by the judiciary also goes a long way in determining corporate governance standards in a county. Most of our businesses are promoter backed businesses with decision centres being at the helm of the family. While professionals are employed, in a number of cases, these individuals do not have the authority to make judgement calls. Why talk only about the corporates. Even Indian banks (public and private sector) which have offshore branches have a system where by all decisions are made by the same central committee in India. This decision making process behind closed doors does not suggest sufficient transparency. With a lack of autonomy and accountability it is difficult to retain talent which impairs management quality. With families owning majority of the voting rights in corporate India, sometimes via cross holdings, achieving an impartial vote is difficult. Concentrated shareholding also greys the area between generating shareholder value and creating personal wealth. It becomes even more critical, in countries like India, for the law of the land to protect rights of the shareholders. The English common law legal system, which India follows, could come to our rescue here. India in fact ranks highest in the shareholders’ rights index with a score of 5. However, the rule of law index which measures the implementation of written law shows a different picture. India ranks 41st out of 49 countries ahead only of Nigeria, Sri Lanka, Pakistan, Zimbabwe, Colombia, Indonesia, Peru and Philippines. In fact our judiciary has limited capacity to deal with securities cases. While High Courts of Delhi, Mumbai, Kolkatta and Chennai are equipped to deal with such cases, they can only deal with the cases that belong within their territorial jurisdiction and only if the claim is above a certain threshold.

India’s ranking in the global corruption perception index is not spectacular either. As a nation we rank 74th, down four positions from 2006. That does not sound like progress. In fact Transparency international reports that Indians below the poverty level cough up almost INR 9bn annually to pay for basic necessities such as electricity. In addition, recently the attitude of the Indian government toward the German government offering free information on un-accounted money belonging to Indians, lying in Liechtenstein, has raised eyebrows. While other nations have taken the information provided, Indian government has taken no action and only maintained silence. This does not speak well about our attitude towards transparency and curbing corruption.

Corruption can be cleansed with time and corporate governance can be developed with time. These arguments could be put forth. Well then let us see how our regulators stack up. As opposed to dealing with one or two regulators, Indian corporates need to deal with the government of India, the Reserve Bank of India (RBI) and Securities and Exchange Board of India (SEBI). While the government formulates big picture policies, the RBI and SEBI are responsible for implementation and execution. There is a clear lack of co-operation and co-ordination between the government and the regulatory bodies. Take for example the 2007 budget speech of the finance minister. He announced that post the February 2007 budget, short selling for institutional investors would be permitted. There was no action taken by SEBI until late 2007 when it was announced that short selling would come in effect on 21 February, 2008, however, there is still no sign of this being put into operation anytime soon. Similarly, the same budget spoke about exchangeable bond issuance being permitted. The RBI published the guidelines only in early 2008 and even then the execution framework has not been detailed. For a country that is looking to invite investors these delays just seems too long and irresponsible. And while these are just two instances, many more such examples exist. Investors do not wait for anyone but the right opportunity and if when the cash is available our policies are not, the country will lose out as it has in the past. In fact with multiple bodies governing inflows into India, it is already tedious to set up vehicles investing in the country.

When investigated closely, there is not a single stakeholder of the Indian economy totally developed and ready to take on responsibilities and accountabilities full on. There is still a long way to go for each party involved. How can we then claim that India has arrived?

India is indeed on a growth path, a path that will lead us towards prosperity. However, it is naïve to assume that we have arrived simply because we have been seeing witnessing inflows of capital. It is presumptuous and pretentious. Since the economy has only opened 16 years ago we have only started seeing the colour of money in the recent times. This does not illustrate our supremacy in any way. If we want to continue on the growth path then as a country we need to come out of the current very difficult environment. The global financial markets are in turmoil. Domestic inflation is increasing rapidly caused by the rally in oil prices. A net importer of oil, with subsidies on oil, Indian deficit is only widening. To curb the inflation we need to increase domestic rates which in turn will slow the growth. And a net import economy we have a weak rupee (the rupee depreciated c.9% since Jan 2008) which does not bode well again does it? Let us not forget that we also need to fund the rising food costs and an upcoming election which will eat into the exchequer’s reserves. These are difficult times. Times which call for prudence and perseverance. Times which call for collective measures to be taken. It is high time for India to wake up and smell the coffee!

It is about Capital

The first three posts of this blog have dealt with Foreign Currency Convertible Bonds as these instruments have created quite a stir with respect to India of late. From 2004 – 2007 this frenzy was an upbeat one, however, now it is one of some concern. Till about July 2007 Indian issuers were keeping global investors busy with their sea of FCCB issuance. Then before the credit crisis could hit India, came the RBI crunch, hitting Indian corporates with its overnight change in guidelines prohibiting raising overseas debt. All this in a bid to stop currency appreciation! A well thought out decision or pulling the last trick out of the hat? There are arguments to be made on either side. Anyway the end result was that issuance of FCCB from India dried and the corporates were left grappling with trying to find newer mechanisms to raise cost efficient financing.

Soon after the new RBI guidelines were issued on August 7, 2008, the credit crisis started to deepen. Global credit spreads which had had been at five year lows began to increase. Within a span of few months, the high yield spreads had almost doubled. Coupled with this increase came a downturn in the equity markets. In the first half of 2008, this southward journey of global equity markets has caused significant losses. What this has meant for FCCBs is that they have lost value in the interim. With underlying equity trading at lower levels the expected appreciation to reach conversion thresholds is now higher than before. Also, most FCCB issuance from India is in the form of zero coupon convertible bonds implying that the rate of accretion is the highest (please see the previous post for an explanation) and hence the requirement for share appreciation still higher. This has brought about a huge interest from media speculating on corporate profit erosion due to FCCB issuance etc. While it is absolutely incorrect to suggest that FCCB redemption will result in corporate profit erosion (see the first post of the blog for my views) there is some concern that needs to be expressed on how some of these bonds have been structured and whether the issuers did take into consideration the worst case scenarios before signing the dotted line.

One of the main issues here is the amount of money that was raised by a singe corporate using the FCCB product. Traditionally a corporate should refrain from raising more than 25% of its free float (shareholding held outside of the core and strategic investor circle) via a convertible bond. This is to ensure that at the time of conversion there is minimum impact on share price and in case of redemption the repayment is not disproportionate to the company’s market capitalization. The issue size to free float ratio is where a lot of mid cap Indian issuers were aggressive (or shall I say in some cases very aggressive). Today with some of these stocks down 50% - 60% and with the redemptions being at 30% - 40% premium to the issue price, a handful (thankfully!!) of issuers are looking at repaying over a 100% of their market cap in a couple of years. This is a situation that could have been averted successfully had the issuers, bankers and investors all worked in tandem. May I even add the regulator to this list?

Let me elaborate on my standpoint here. Corporate issuers in bull and bear markets have believed that their stocks are grossly undervalued. This belief becomes stronger in the bull market scenario where access to capital is easy and buyers abound. Thus the long term view remains for the share price to increase. Premiums demanded on the convertible bond thus are sometimes beyond the reasonable. At the same time the desire to grow is tremendous resulting in a natural attraction toward the premium redemption or zero coupon structure. Both these situations combined imply that an instrument which should be used as a hybrid is being structured more akin to debt. In addition to these two points, there is also a want to raise as much cheap money as possible. Thus issuers desire the maximum issue size to be availed via one single issuance. All these point to a non optimal issue for the balance sheet.

While the corporate client has expectations, bankers have the expertise and foresight. While advising clients, sufficient education needs to be imparted to explain the impact on the balance sheet in the best and the worst case scenario. The corporate should be provided sufficient data to make an informed decision about the suitability of FCCB for the capital structure. Structuring and pricing needs to result in an optimal product minimizing distress situations in markets such as current. Post issuance after market support is critical for the issuer in terms of regular follow ups and trading updates. Regular meetings between investors and issuers ensure that full transparency is maintained at all times.

This brings me to the point of investors. There are investors who do not read offer documents at the time of issuance. Could there be clauses not favorable for investors leading to disputes alter on? Could there be unanswered questions or unread risks? While questions about financial health and business strategy of the issuers are given fair importance, liquidity of underlying shares and market cap of issuer also needs to be considered carefully.

Where does the regulator fit in though? Well Indian regulators have given substantial thought to capping the yield to maturity (at issuance) of FCCB at issuance with the aim of preventing marginal credits coming to market. What about hard underwriting provided by lead managers? Many a time this can only aid marginal issuers achieve their motives. What happens when all equity gets concentrated in one hand? The issuer risks imparting excessive control to one entity and in case of a sale such as that undertaken by Bear Stearns earlier in 2008, the share price comes under pressure. With non converted issues, the FCCB comes under pressure and distress sale could result which could also impact the stock price. With the Indian banking landscape still not being deep enough, hard underwriting could lead India Inc indebted to a few financial institutions. Over reliance on a select group of institutions for financing cannot be the best way forward for a growing economy or is it? Hard underwriting prevents the company from achieving the best possible pricing, which does not serve the best interests of shareholders. While the promoters, the major shareholders hold big chunks of the stock, the regulator needs to protect the interests of the retail investors. The other factor for the regulator to consider is the following - with some of the debt trading at a discount and balance sheets being under pressure, should they not allow early refinancing (currently repayment of debt prior to the minimum maturity of 5 years is not permissible)? It could potentially provide some companies room to breathe.

Another example of a need for all stakeholders to work together is the on-going derivatives saga in India. Admittedly that has nothing to do with the investor community. The corporates would like to claim that the bankers who sold them derivative contracts did not explain the working of these instruments completely. I would beg to ask whose responsibility was to ensure that all impact on the balance sheet was understood completely. If the derivative transaction was entered into to hedge a USD exposure for a company with costs and revenues in INR and to some extent in USD, then why was the contract a USD/JPY swap? Where does the JPY figure? If the bank did indeed sell a USD/JPY swap were they really advising the client in the client’s best interests? Should the regulator not consider allowing open market derivative transactions?

Today mid sized corporates are ready to sue the banks throwing good money after bad money in long drawn legal battles. Only if the CEO, CFO and the board would take informed decisions in the best interests of the company. Only if bankers were to act with caution and prudence. Only if investors asked all the questions they should. Only if the regulator looked at all aspects of a market. Only if……I could continue, however, I guess it is about capital in capital markets and efficiently working efficient markets remain a hypothesis.