Wednesday, June 4, 2008

Under recovery vs. losses

Reported daily under recovery of oil marketing companies (OMCs) is Rs. 450 Cr, when India’s crude import basket is over $100/barrel (Rs. 26.42/Litre)[1]. As this rate, wouldn’t the combined net worth of the three OMCs (IOC, BPCL and HPCL) would be “ZERO” in just 6 months time? Fortunately, the answers is NO.

At gross under recovery level of Rs. 500 Cr/day, OMCs net under recovery is Rs. 120 Cr/day and net loss is estimated at Rs. 22 Cr/day or Rs. 8,000 Cr for FY09[2].

1) Under recovery sharing mechanism -
a. Government shares 42.7% of gross under recoveries (GUR) through issuance of Special Oil Bonds.
b. Upstream (E&O) companies share 33.33% of GUR
c. Only 24% of GUR is born by OMCs, also referred as net under recovery

2) Calculation of GUR is such that it computes notional loss (opportunity cost or lost profit) rather than the actual losses. GUR calculation includes -
a. Notional trade parity price of refined products
b. Marketing margin
c. Margin on retail pump outlet
d. Various other charges/margins, apart from costs

We estimate in-built profitability of more than Rs. 28,000 Cr. for three OMCs in the calculation of GUR, estimated GUR for 2007-08 at Rs. 77,303 Cr, and net under recovery at Rs. 18,553 Cr. It suggests OMCs actually made profit in their retail operations in FY08 of Rs. 9,500 Cr.

With the crude basket continuing above the $130/barrel (in April, the Indian basket averaged $105.77), projected GUR in fiscal 2008-09 is Rs. 180,000 Cr. If OMCs are to share 24% of GUR, their net under recovery would be Rs. 36,000 Cr. Even at this rate their combined net worth would not be ZERO until 2020. However, OMCs would certainly be out of cash for running the operations.

Let’s take a look at calculation of GUR for OMCs in order to estimate their survival period without any change in support mechanism by government. OMCs are present in both the refining and distribution of petroleum products. We look at both of these segments.


Gross Refinery Margins (GRMs)
Average Indian GRMs in 2007-08 stood at Rs. 2.65/Liter. CRISIL Research expects GRMs to average at a much higher level of Rs. 4.76/Liter. Product price rise is expected to surpass the crude prices rise, and change in the heavy-light crude mix for Indian basket, to 61.4% heavy and 38.6% light in 2007-08 from 59.8% heavy and 40.2% light in 2006-07, would further help in increasing the Indian GRMs.

On average Indian refineries operate at near 100% capacity. We conservatively estimate daily GRM (net of under recovery) of IOC - 36 Cr. (annualized 13,100 Cr.), HPCL - 13 Cr. (annualized 4,700 Cr.) and BPCL - 16 Cr. (annualized 5,800 Cr.) (See Annex-1 for details, estimated OMCs annual refinery margins is Rs. 24,000 Cr.). Apart from GRM, refineries also earn profits on their pipelines and inventories, which by no means are marginal.

Marketing and distribution

Now coming to the calculation of under recoveries for OMCs, gross under recoveries are notional loss of profit, rather than actual loss!! Broad heads under which cost is build up from refinery gate price (Trade Parity Price) to the consumer level consists of operational and functional costs of marketing companies and duties and levies. We present the notional price build up for Delhi for April’08 below:

Marketing Margin
Marketing margin represents return on net fixed assets employed in the marketing of various products by the oil companies. OMCs get 12% return on net fixed assets with grossing up the same for corporate tax at 30%, surcharge at 10% and education cess at 2% resulting in pre tax return rate at 18.09%. We estimate OMCs to earn marketing margin of Rs. 1,600 Cr.

Retail Pump Outlet Charges
The overall component of retail pump outlet cost including return is Rs 354 per KL. Margin on retail pump outlet of Rs. 263 per KL. The actual cost as per audited accounts for the year 2005-06 varied between Rs. 86 .18 per KL to Rs. 94.87 per KL exhibiting weighted average for all the four public Sector Oil companies at Rs. 90.99 per KL for 2005-06. We estimate OMCs to earn RPO margin of Rs. 1,700 Cr.

Terminalling Charges
Rs. 41 per KL as terminalling charges as compensation to refineries for providing facilities for marketing activities in price build up of petrol and diesel. OMCs buy their product requirement from their own refineries, we estimate OMCs benefit of Rs. 400 Cr. due to terminal charges for 2007-08 to be IOC – 227 Cr., BPCL – 100 Cr., and HPCL - 80 Cr.

Interest on Working Capital
Interest on working capital has been considered at 20 days’ cost of sales excluding depreciation at State Bank of India prime lending rate 12.25%. Most of the OMCs working capital loans are at way below BPLR!!

Marketing Costs
The actual cost claimed by OMC as per audited accounts for the year 2005-06 vary from Rs. 413 to Rs. 463 per KL and the weighted average cost of all the four companies (IOC, HPCL, BPCL and IBP) for the year 2005-06 is Rs. 428.34 per KL. The cost in the price build up is Rs. 425.43 per KL with escalation at the rate of 4% on a y-o-y basis from 2002-03. Marketing cost build up is Rs. 590 per KL in Apr’08.

Stock Loss
Stock loss at 0.5% of cost of sales for petrol and 0.125% of cost of sales in case of diesel in the price build up.

Delivery Charges
Rs 66 per KL to under recovery of delivery charges in case of the price build up.

Domestic Logistic Adjustment Factor
Depending upon the availability of product at the refineries and the markets attached to those refineries for the purpose of pricing. Such movements result in additional logistic cost to OMCs for which Rs. 100 per KL is provided in the price build up.

Demand Draft Charges paid to dealers (RPO surcharge)
Demand draft charges are additional element of cost for the purpose of build up of purchase price at Rs 35 per KL for MS and Rs 20 per KL on HSD.

Rs. 322.75 per KL in case of petrol and Rs. 406.73 per KL in case of diesel is included as weighted average equalized freight from the ports to various depots while determining ex-storage selling prices. However, over time most of OMC have shifted to pipelines for transportation of the fuel from refineries to depots, hence resulting in savings.

[1] 1 Barrel of Petroleum = 42 US gallons = 158.9873 litres = 0.1364 tonnes.
Exchange rate 1 US$ = 42 INR
[2] We estimated in-built profitability of Rs. 28,000 Cr, gross under recovery for FY09 at Rs. 180,000 Cr. and net under recovery of OMCs at Rs. 36,000 Cr. Resulting in loss of Rs. 8,000 Cr. [3] IOC reported GRM of $9.02/barrel for 2007-08. CPCL achieved GRM of $8.47/barrel for the year 2007-08, net of under recoveries.

Thursday, May 22, 2008

Economics of Cycle-Rickshawaala

Before starting to talk about the economics of cycle rickshawaala, let’s look the evolution of these street entrepreneurs, first. Cycle rickshaw has evolved from being hand pulled to leg operated tri-cycle rickshaw, utilizing technological evolution of cycle chains. Subsequently these cycle-rickshaws are giving ways to auto rickshaws running on petrol/diesel or CNG gases! Going towards the same fate as of hand pulled carts that we now see in old Indian movies only!

As incomes rise, people switch from using the non-polluting, energy-saving bicycles and non-motorized cycle rickshaw to highly polluting motorcycles and three-wheelers, and taxi, resulting in a dramatic increase in air pollution. Despite the environmental benefits of the cycle rickshaw and the economic importance of the industry particularly to low income families, public attitudes towards the cycle rickshaw in India are negative. Negative attitudes about the cycle rickshaw are based on views that their use is exploitative to the driver, the vehicles are not safe, and are backward. Much of the stigma against the vehicle was based on its perception of being 'backward.' In fact, the current vehicles in operation are 'backward,' in the sense that the technology being used was developed more than fifty years ago based on indigenous modifications of a British-designed bicycle, and only very limited modifications have occurred since then.

However, cycle rickshaws offer something which most of the ‘modern’ public transport vehicles do not: energy conservation! People might wonder why would we need energy if not for vehicles. Do you want your fan to be running in the hot Indian summer or not? Well they are not the ones to be blamed it’s the unawareness about the severe shortage of energy options. Countries are struggling to keep their economy growing in the era of energy shortages. Recent spike in global crude oil prices are just one symptom of much worrying phenomena.

Let’s try to look at how can economy benefit from wide usage of cycle and cycle rickshaws. I’ll start with cycle against the motor cycle and alike. Cost saving both for the rider and for the economy due to saving on fuel, steel is obviously the first one. Second benefit would be in form of reduced air and noise pollution. Third one increased employment, wondering how? Well production of one cycle compared to one motor cycle requires 30% more labor! More people employed means more wide distribution of growth, reduction in poverty, increased happiness and last but not the least reduced crime rate.

Moving on to the economics of cycle rickshawaala……

Friday, May 2, 2008

Annual Monetary Policy 2008-09

- Bank rate, reverse repo rate and repo rate kept unchanged
- Following a CRR hike by 50 bps on April 17, the ratio hiked by further 25 bps to 8.25%, with effect from the fortnight beginning May 24. This cumulative hike of 75 bps is expected to suck out liquidity worth Rs 277.5 billion
- Survey on GDP growth for 2008-09 in the range of 8.0-8.5%
- Inflation target raised from 5 to 5.5%, with a medium-term objective of 3.0%
- M3 growth to be contained within the range of 16.5-17.0%
- Deposits projected to increase by around 17%
- Growth of non-food credit to be contained around 20%
- The limit of bank loans for housing enhanced from Rs 20 lakhs to Rs 30 lakhs for applicability of reduced risk weights at 50%
- Indian companies allowed to invest overseas in energy and natural resources sectors such as oil, gas and coal in excess of the current limits

RBI Governor Yaga Venugopal Reddy is known to often surprise the market and the annual policy review this time around showed him being true to form again with his decision to raise the cash reserve ratio for the third time without touching key policy rates.

The Monetary Policy of 2008-2009 comes in the backdrop of a slowing economy facing a sudden and a sharp surge in inflation. The WPI-based inflation touched 7.41% in March way above the virtual roof (RBI’s comfort zone of 5 per cent). The growth moderating effects of tight monetary policy over the last two years are still coming through and a moderating global economy is reducing the external stimulus to growth. Also, the inflationary surge is largely because of higher food, metal and energy prices. This is creating strong supply side (cost-push) inflationary pressure on the economy with significant threats to growth.

As monetary tightening is more effective in controlling demand-driven inflation, the central bank faces a difficult choice of balancing downside risks to growth along with upside risks to inflation. In our April 2 note (“Inflation: through the roof – way forward?”) we forecasted the inflation number to hover in the range of 7-7.5% and for last four weeks it has. We expect inflation figure to slow down due to the fiscal measures taken on supply side along with further tightening of money supply in the range of 6-6.5% for next few weeks, and to be in the range of 5.5-6% until June’08.

Money is the ultimate commodity because all prices have only money in common. And it is the only thing that a central bank directly controls. With increase in CRR by 75bps in three fortnights, would force banks to reduce their short-term deposit rates to contain their borrowing cost and to protect their margins. Such action would also impact the deposit growth contain M3. As of the aggregate deposits mustered banks are required to park 25% of their net demand and time liabilities in SLR securities and 8.25% of as CRR balances with the RBI. Only the balance 66.75% of total deposits along with the borrowings, are available for deployment towards advances. If lending rates and the yield on investments remain constant, SCBs as a whole have had to take a hit of 7 bps (annualised) on their spreads and net profitability margin solely due to CRR increases.

The move enhancing the limit of housing loans from Rs 2 million to Rs 3 million is a positive one and may partly help in addressing the current slowdown in housing loan disbursements. The enhancement of loan limit will, positively impact the capital adequacy of banks, with a 25% savings in capital charge. This measure might indirectly create a cushion of margin money in the event of a likely fall in property prices.

Policy document says, “It is critical at this juncture to demonstrate on a continuing basis a determination to act decisively, effectively and swiftly to curb any signs of adverse developments in regard to inflation expectations”.

Though most of the inflationary pressure is imported and not necessarily due to supply shortage. Mostly due to soaring commodity prices in global market due to weakening dollar, as most of the commodities are denominated in dollar. Such impact is clearly visible in crude oil prices, world oil demand grew by just 1% annually over the past two years while crude oil prices had shot up by over 90% in dollar terms, hitting $120 a barrel. Over 70% of the price rise in just few months, oil was at $70 in late August.

According to Wall Street Journal, since 2003 the dollar price of oil has climbed far more rapidly than has the euro price – 273% in dollars, compared to 146% in euros. Had the dollar merely retained the same purchasing power as the euro, today's price of oil would be below $70 a barrel.

Monday, April 28, 2008

Oil facts

Govt. OMCs viz., IOC, HPCL and BPCL sell about 2 Million Barrel Oil daily to retail consumers. Their combined under recovery for rise in each dollar of crude price is $2 Million or Rs 8 crore, approx.

At the current selling prices of their finished products, there is no under recovery for Crude at about 51 $ per barrel. In H-1 2007-08, the average price of Indian basket was about $69 per barrel thus resulting into daily under recovery of Rs 144 crores and total under recovery of about Rs 26,208 crores.

The daily under recovery for the given prices of Indian basket in H-2 comes out to be as under:

The estimated under recovery of about 69,700 Crores as estimated by the Govt. for the year of 20007-08 is based on Crude prices of 70$ per Barrel for the entire year of 2007-08. Currently when the Indian basket is ruling around $100 per barrel, the daily under recovery of OMCs is about 400 Crores. Petrol is being sold at a loss of Rs 8.74 a litre, diesel at Rs 9.92 per litre, kerosene at Rs 20.53 a litre and LPG at Rs 256.35 a cylinder.

As per the loss sharing mechanism of oil marketing companies, the GOI issues oil bonds to the tune of 42.7% of under recoveries, 33.33% of the loss if born by the E&O companies and remaining by the marketers.

The price of India's crude oil basket, which comprises of Oman-Dubai sour (high sulphur) grade crude oil and Brent dated sweet (low sulphur) crude oil in a 61.4:38.6 ratio, has averaged $101.23 a barrel so far this month as against $99.76 per barrel in March and $92.37 per barrel in February.

The high oil prices have resulted in the country's oil marketing companies losing over Rs 77,300 crore in 2007-08 as they sell petrol, diesel, LPG and kerosene at subsidised prices. At current crude oil prices, the revenue loss of these companies is expected to go up to around Rs 150,000 crore in 2008-09.

Friday, April 4, 2008

Rating credit rating agencies?

Credit rating agencies (CRAs) are once again in line of fire for unfathomed concerns: ratings are obligatorily through financial regulation, the CRAs operate in an oligopoly; there is conflict of interest, because they are paid by the issuers of the securities they rate, not by investors; and they are unaccountable because their ratings are deemed opinions and thus protected as free speech.

In terms of the issuer-fee conflict, we have heard a number of points made in the past by investors and CRA’s responses to them. Investors argue that since the fee does not get generated without a deal, being benevolent at issuance and revisiting the credit after the deal is in the market, makes perfect sense. This evidently creates an ostensible stress in the decision making process. Any rating action/assessments that prevents an issuer from accessing the market such as an unduly harsh opinion or demand (and transparent) set of metrics and forward expectations could imperil the deal, and hence no fee. That action presents additional risks since the CRA can always revisit later after the deal is in the market, describing this act of theirs as "surveillance of credits". CRAs fight hard to establish their “transparencies” by making their rating rational available for subscription and they even sell their rating models obviously with disclaimer!! And they call their ratings free, public good!

The CRAs are obviously in a tough position here. If they move too fast, they get lambasted. If they move slowly, they get lambasted. None of these issues can be comfortably palliated. Switching to an investor-pays system might seem the obvious answer, but it’s highly improbable that enough investors would cough up to make the business viable, CRAs fear this may put them out of business.

Another solution might be for them to be much more transparent about their criteria and expectations that are built into ratings so investors can better assess what the risks are when they rely on the ratings. For example, clear statements of time horizons for achievement of specific metrics, downside target ratios that would prompt a downgrade, expected growth rates for an industry, or any other tangible and quantitative yardstick that would improve the ability of the investor to make a more informed assessment.

More competition should help, but it might just as easily lead to a race to the bottom, as agencies vie to offer the best terms to issuers.

Making CRAs legally liable for their opinions would scare them out of the business.

The most beckoning reform, in theory, would be to end the regulatory dependence on ratings and let investors draw their own conclusions from “expert” opinions and market data, as they do with equity investment.

A more practical approach might be to let the CRAs get on with their house-cleaning while introducing a reform borrowed from the accounting industry: a board, made up of industry types, investors and academics, charged with policing their analytical techniques and governance.
Another reform is in offing! Indian CRAs seem to be moving in the direction of getting their act together. Recently CRISIL launched complexity level classification (simple, complex and highly complex) of capital market instruments reflecting the ease of understanding and analysing the risk elements in these instruments. Complexity levels help the investor determine the degree of sophistication and due diligence required to understanding the risk and factors involved in such instruments. Needless to say a simple financial instrument is nor necessarily less risky than a complex instrument. These complexity levels are being provided free of charge to all users. However, it would have been helpful if they also provided their rational for classifying one instrument as highly complex over complex/simple rather than just providing with the criteria. For example why Real Estate Investment Trusts are classified as highly complex and commodity futures as complex? Further refinements may follow, in all it’s a welcome move by CRA.

Credit Rating: National vs. Global Scale

Distinguishing national scale credit ratings from global scale ratings are of critical importance due to the potentially large difference in implicit default risk between the two scales. For example, a company's local currency bonds issue may get a global scale local currency rating and a significantly different national scale rating.

National scale credit ratings provide opinion on an obligor's creditworthiness (that is, issuer credit ratings) or overall capacity to meet specific financial obligations (that is, issue credit ratings), relative to that of other entities and specific obligations in a given country. In contrast to global scale ratings, national scale ratings are based on a comparative credit risk of active obligors, including the sovereign government, within one country, and exclude direct sovereign risks of a general or systemic nature. Given the focus on credit quality within a single country, national scale ratings are not comparable between countries.

National scale ratings typically provide a finer demarcation of credit risk among local obligors than is possible with global scale, as the latter spans the full range of global credit quality and incorporates international comparative risk factors, including direct and indirect sovereign risk considerations. National rating scales are of the most value where sovereign and other credit risks skew global scale ratings to low levels in the country and where local issuers and investors are predominant players on the domestic markets. Such a compression of ratings at lower levels is fairly common among the emerging market economies.

Sovereign risks (for example, direct constraints such as potential exchange controls) and country risks (for example, indirect effects from government policies affecting exchange rates, interest rates, taxation, regulations, infrastructure and labour markets) may compress the range of global scale ratings of obligors in the country, reducing or even obscuring differences in credit standing that would otherwise be evident in the absence of these sovereign and country risks. For example, sovereign and country risk factors in Mexico result in a narrow range of global scale ratings, with many of global scale ratings compressed in the 'BB' and 'BBB' rating categories. While the potential impact of sovereign risk is a critical consideration for cross-border financing, direct sovereign risks of a general or systemic nature, which affect most national obligors to a similar degree, are of less importance to local participants in the national financial markets who find that national scale ratings are useful in providing the most precise ranking of relative credit risk available for obligors within their country. Even though national scale ratings are meant to confer an opinion of relative credit risk within a domestic context that is not to say that they are fully isolated from sovereign risk considerations and other international comparative risk factors.

Key Characteristics of National Rating Scales
National rating scales exclude certain direct sovereign risks of a general or systemic nature, including the potential risk of foreign exchange controls. As a result, obligors and obligations with global scale ratings constrained by systemic, direct sovereign risk may have national scale ratings that are higher than the sovereign's rating on that scale, though such cases would necessarily be limited to countries where the sovereign's national scale (ns) rating is less than 'nsAAA'.
• National and global rating scales are broadly consistent in terms of the rank order (from highest to lowest credit quality) of ratings.
• National scale ratings are an expression of the relative creditworthiness of obligors and obligations in a particular country, and are based on a comparative analysis of that country's active obligors (this is in contrast to the all-encompassing international comparative context of global scale ratings).

Given the focus on relative creditworthiness, the strongest entities in the country, including the sovereign, often receive the highest possible rating on the national scale, provided the country is not experiencing an acute and widespread financial crisis that imperils the debt service capacity of even the strongest local debt issuers.

Underlying default risk differs from that of global ratings
The global scale and national scale rating usually imply substantial variations in the default probabilities associated with any particular rating category on the global and national scales. For example, the implicit default risk associated with a global scale rating of 'AA' could be significantly lower than the risk inherent to a national scale rating of 'nsAA'.

The difference in implicit default risk between global scale and any given national scale is a function of the degree of sovereign and country risks in the economy and, to a lesser extent, the distribution of credit risks among active obligors in the country. In order for the national scale to provide adequate differentiation in credit risks for obligors active in the local market, it follows that the higher the sovereign and country risks associated with the national economy, the higher the default risk that is embedded in the national scale. For example, a national scale serving an economy with medium sovereign risk and a predominance of low-grade, global scale ratings for active obligors (for example, Russia) would have lower global scale, local currency ratings corresponding to each category on the national scale than would be the case for a national scale serving an economy with low sovereign risk and a predominance of intermediate grade, global scale ratings for active obligors (for example, Taiwan).

It is important to note that the methodology underlying national rating scales results in a nonlinear relationship between the global scale rating grade and its corresponding national scale rating grades as one moves down the credit risk spectrum from high to low credit quality. That is, one cannot simply add a certain number of rating levels to a global scale local currency rating to determine the corresponding national scale rating. Rather, the degree of difference between the two rating scales in terms of the assigned letter-grade generally increases as one moves up the rating scale towards the strongest credit rating assigned in the country. For example, an entity carrying a global scale local currency rating of 'BBB' in a medium-risk sovereign nation may well be rated as high as 'nsAA' or even 'nsAAA' on that country's national scale, underlining not only the higher degree of default risk embedded in the national scale but, most important, the inherent quality of national scales to provide greater differentiation in credit standing, particularly at the upper end of the rating spectrum. On the other hand, the rating gap is smaller, if it exists at all, at the bottom end of the rating spectrum, pointing to the ability of national scales to provide an adequate warning of the risk of default.

Reflecting the increased scope for differentiation of credit risk, national scale ratings are more sensitive to changes in credit risk and, in turn, are likely to change more frequently and to a larger degree than global scale ratings. That is, a given change in the business or financial profile may affect an issuer's national scale rating but not its global scale rating, or alternatively may translate into a revision of both ratings but one that is more pronounced on the national scale.

Wednesday, April 2, 2008

Inflation: through the roof – way forward?

Inflation in India (WPI based) has already risen through the virtual roof (RBI’s comfort zone of 5 per cent) and is still going strong, largely because of higher food, metal and energy prices. This is creating strong supply side (cost-push) inflationary pressure on the economy with significant threats to growth in short term. Inflation has spurted in three weeks to a 14-month high of 6.68% on 15 March. It was 5.11% on 1 March and 5.92% on 8 March. The current fiscal measures announced by the government may help in curtailing the inflationary expectations however the WPI figures for next few weeks may still be ranging between 7-7.5 percent.

We are back to the bad old times of high interest rates and high inflation, which hit the common people (read “voters”) the most. Elections are due in next year and “voters” well known for their abrasive punishment to the governments in under delivering on price front and moreover with high interest rates.

The government has already used a series of import duty cuts to boost domestic supplies with a promise of more cuts to follow and has also resorted to banning exports. In the short run, the benefits of price controls in curbing inflation expectations may outweigh the detrimental effects. As inflation is mostly driven by food, as a result of supply shocks, rather than caused by excess aggregate demand. In the longer run, however, the damaging effects of price controls on incentives and efficiency will outweigh the benefits.

Under current situation, the monetary policy may very well look for a further appreciation of exchange rate, since bulk of this rise is coming from higher global commodity prices, without changing interest rates to make sure that aggregate demand conditions continue to be consistent with supply-side initiatives. Cost of appreciating rupee would be in form of reduced exports, without further widening the trade deficit though, due to high crude imports trading well above $100/barrel!

In medium term, interest rate reduction is imminent but only after the inflationary expectations cool-off, and good monsoon holds the key here. The important factor to note here is that the ban on food exports, low import tariff would eventually hurt Indian farmers, pushing them away from food grain production to cash crop productions. This could very easily bring India in the spiraling inflationary pressure!

Widening Trade Deficit - Matter of concern?

According to the DGCI&S release on India’s exports, imports and trade balance, India’s trade deficit stood at whopping $72.5 billion during April-February 2008 as against to $49 billion during the same period previous year. Imports grew by 30.2% while export grew by 22.9 percent during the same period. Preliminary data on India’s Balance of Payments (BoP) for the third quarter (Q3) i.e., October-December 2007 of the financial year 2007-08, reveals a current account deficit (CAD) of $5.4 billion, bringing April-December 2007 CAD to $16 billion ($14 billion in last year for the same period).

On surface this doesn’t look like good news, however looking at the sources of change in the current account provides interesting reflections. Merchandise exports recorded a growth of 34.9 per cent in Q3 of 2007-08 as compared with 20.9 per cent in Q3 of the previous year. Net invisibles continue to do well, growing from $ 12.8 billion in Q3 last year to $20 billion this year. What changed, to cause a larger trade deficit, was a sharp rise in imports.

Exports were at $41.7 billion during the quarter compared to $30.9 billion in the Q3 of the previous year. This was a decent, though not starring performance. However, imports blastoff up to $67 billion during the quarter against $47.5 billion in Q3 of 2006-07. With a sharp surge in imports but not in exports, the trade deficit widened to $25.4 billion, as against $16.5 billion during the corresponding period of 2006. Given the net invisibles earnings the current account recorded a deficit a deficit of $5.4 billion.

A rise in imports is worrisome when caused by external shocks such as a rise in higher oil prices. However, import figures show that during Q3, what really changed was non-oil imports, capital goods rose sharply by 53 per cent. Oil imports, as per the DGCI&S data, increased by 21.7 per cent in April-December 2007 (39.4 per cent in April-December 2006). According to the Ministry of Petroleum and Natural Gas the volume of oil imports increased by 11 per cent in April-December 2007. The commodity-wise export indicated that growth in exports of petroleum products (35.4 percent), engineering goods (22.4 per cent) and gems and jewellery (25.5) remained the major drivers of export growth.

Non-oil imports such as capital goods are leading indicators for growth in industry. They increase when domestic and/or export demand is strong. The sharp rise in non-oil imports over Q3, hence, augurs well for India. We would be lamenting, if there was a slump in imports growth!

Under some circumstances, CAD can signal economic problems that call for changes in economic policies. However, it at best provide mixed and ambiguous evidence about appropriate economic policy changes because the current account agglomerates a large array of underlying economic factors. Sometimes it results from new investment opportunities created by technical change, leading countries to engage in net borrowing on world markets to finance those investments. At other times, it results from reductions in net national savings rates, due to changes in consumer confidence that lead to changes in consumer expenditures, or due to changes in tax rates that affect after-tax savings rates, or due to changes in government fiscal positions that affect national savings. India’s CAD today reflects three main factors: (1) increase in investment opportunities; (2) low rates of saving; and (3) economic disruptions in other economies.

Current accounts involve inter temporal trade, CAD means that the Indian trades claims on its future production for current goods and services. Economists often suggest that a CAD threatens future economic problems if current spending falls on consumption rather than investment. That is not the case in the India today, where CAD has financed an investment boom. As a matter of pure accounting, we can divide factors affecting CAD into those affecting investment and those reflecting national savings. The major factor responsible for the deficit is the high rate of investment in India. A secondary factor is the low savings rate. Evidence over many countries and time periods shows that growth rates of exports and imports are procyclical, rising and falling with the growth rate of real GDP. However, exports typically vary less than imports; consequently, the trade deficit is distinctly procyclical.

While Indian CAD results partly from Indian conditions and policies, they also reflect conditions and policies in other countries. Credit crisis in western economies and, more recently, slowing US economy, may have contributed to the Indian current account deficit. These factors have also contributed to appreciation of the rupee on foreign exchange markets.

Thursday, March 27, 2008

Sovereign Wealth Fund

Existence of Sovereign wealth funds (SWF) goes back to 1950s, the interest in their magnitude and workings have gained interest only recently. The first SWF was the Kuwait Investment Board, a commodity SWF created in 1953 from oil revenues. SWF is a special purpose vehicle of the government, funded by foreign currency assets, mandated with high return expectations. Unlike official reserves, which are usually held in short duration treasury bonds serving short term currency stabilization and liquidity management, the SWF portfolio has a product mix of different fixed income, equity, commodity and realty instruments. The management of assets under SWF is separate from the management of the official reserves. Since the investments are in foreign markets, there would be no inflationary pressures due to sterilization (which would be the case with use of the reserves for infrastructure funding). SWFs are mainly the national foreign asset funds often termed as stabilization fund, petroleum fund, investment authority, pension fund and likes.

The SWF club has over 30 members and dozens others have shown interest, including India. Media reports that in a move to better utilize its $300 billion of foreign exchange reserves, the government of India is considering a SWF with an initial corpus of $5 billion. SWF expected to reach $15 trillion by 2015 from its current level of $2-3 trillion, are larger than all the world’s hedge funds combined. Abu Dhabi Investment Authority with $875 billion of assets is one of the super funds, all of which have assets over $100 billion. These funds are The Government Pension Fund of Norway ($380 billion); Government of Singapore Investment Corporation ($330 billion); Kuwait Investment Authority ($250 billion); China Investment Corporation ($200 billion); Singapore's Temasek Holdings ($160 billion); and the Stabilization Fund of the Russian Federation ($155 billion). As a proportion of GDP the five largest funds are ADIA, Brunei ($30 billion), Kuwait, the Qatar Investment Authority QIA ($60 billion) and Singapore's GIC.

The debate about the risks and opportunities of sovereign wealth funds is similar to that of hedge funds. Concerns are that their operations are opaque and not regulated by any single authority. Most of SWF are non-transparent and do not report their holdings or strategies to the public (except few like Singapore and Norway). However, the question is whether any authority other than a multilateral organization can meaningfully regulate a sovereign who owns the funds. Some believe they are passive investments, while others fear they are a matter of national security. These are causes for concern for many people, investors, and governments; and may fuel the fires of financial protectionism. There are reports about Germany drawing up plans to stop strategic assets falling into the hands of “giant locust funds” controlled by Russia, China and West Asian governments. This turnaround is surprising as, till recently, the developed world were the advocates of globalization with capital freedom and foreign investment as its centerpiece. Sympathetic to emerging economies were cautioning about ‘excessive’ build-up of reserves and investing them in low-yielding US Treasuries.

The current observed trend is that these SWF buy into private equity firms thereby giving them an indirect presence in the countries where these PE firms invest. China Investment Corporation (CIC), China’s SWF, with an initial corpus of $200 billion (almost 87 per cent of India’s total forex reserves) made an indirect foray into India through its substantial $3 billion stake in US-based private equity group Blackstone. Among the top three private equity funds active in India, Blackstone already has stakes in even defense supplier MTAR Technologies and was in the race for the troubled public sector financial titan Industrial Finance Corporation of India (IFCI). Singapore government’s Temasek has been the largest investor in Bharti Infratel deal.

While, the argument continues that the Indian government should float such a fund or not, there are various sovereign wealth funds that have already forayed into the country!

List of SWFs compiled from various sources: