SARFAESI Act, 2002 and its Interface with BIFR

(5^th September 2009)

-Surenderrao Komera

In India, Industrial sickness has been dealt with various legislations and there have been a series of changes from time to time in the legislations to efficiently deal with industrial sickness. These legislations continued to protect the debtors at the cost of the creditors by imposing the sanctions on the later. Over time such legislations caused inefficiencies in the functioning of banking and financial institutions (creditors). For instance SICA, 1985 (Sick Industrial Companies Act), by institutionalizing the Board of Industrial and Financial Reconstruction (BIFR) aimed at protecting the sick (potentially viable) industrial units by suspending all the legal and contractual proceedings against them. Given the prevailing legal framework in restructuring and liquidation of the sick units, the claims of the creditors on the sick industrial units continued to accumulate and thereby created hurdles in their efficient functioning. Particularly, these mounting non-performing assets created roadblocks in the functioning of the banking and financial institutions and undermined their competitiveness in the global financial markets.

By considering the recommendations of Narasimham Committee II and Andhyarujina Committee to address the concerns over the mounting NPAs of the financial institutions and to provide the necessary leap for the FIs to keep pace with international institutions, GoI enacted the SARFAESI act (Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest) in 2002. This act largely facilitates the asset recovery and reconstruction.

Interface with BIFR: SARFAESI act allows the banks and financial institutions to take possession of securities, sell them and reduce non performing assets without the intervention of courts, regardless of the reference of the firms to the BIFR. In a way SARFAESI act restricts the BIFR jurisdiction and allows the secured creditors to possess the corresponding assets without its discrimination. Thus SARFAESI act may be viewed as the legislative action that undermines the efficiency and relevance of BIFR in its pursuit of protecting the potentially viable industrial units. Hence, the note calls for the reexamination of the provisions of SICA in the light of changed institutional and legislative framework.

(Views expressed above are personal and comments and suggestions are encouraged)

Parametric tests Versus Non parametric tests

Prepared on 24^th July 2009

“Fewer or weaker are the assumptions, the more general are the conclusions”.

In statistics, unfortunately the most powerful tests are those which have extensive and stringent assumptions. With this assertion, I will be presenting the most prominent discussion of Parametric vs. Non parametric tests very briefly. The following write up reflects my personal (with nascent knowledge) bias for non parametric tests.

Parametric tests (t test and f test) are the tests that have certain assumptions about the population from which the samples are drawn. The strength of the results of such tests depends on the validity of those stringent conditions/assumptions. The prominent among them are.

• Observations must be independent
• Observations must be drawn from normally distributed populations
• Those populations must have same variance
• Variables are measured at least in an interval scale

Non parametric tests are the tests that make no assumption about the populations, but share few relatively weak assumptions with the parametric tests. They are:

• Observations must be independent
• Variables under study have underlying continuity.

However the concept of power of efficiency (by increasing the sample size) ensures that non parametric tests achieve the same strength as parametric test. Moreover the criticism of the non parametric tests over their usage of information (some non parametric tests ignores the sign, some convert the scale into ranks) may be answered by eliciting the answers to the following questions.

Ø How important is it that the conclusions drawn from the research are applicable to the generally rather than only to the populations with normally distributions?

Ø Which tests of the parametric and non parametric tests use the information appropriately?

The potential answer to the former question is presented in itself. The answer to the later one may be viewed from the perspective of possible assumptions one makes about the potentially unknown populations one deals with. The issue of comparing the parametric and non parametric tests may be highlighted by presenting the short summary of the advantages and disadvantages of the non-parametric test.

Advantages of Non-parametric tests:

ü The probability statements obtained from the non parametric tests are the exact ones, regardless of the shape of the underlying population.

ü For the very small samples (say N=8), there is no other alternative other than non parametric tests unless the parameters of the underlying population are known exactly.

ü Non parametric tests are suitable in the case of the samples that are drawn from various populations with different variances.

ü No other alternative than non parametric tests in the case of the samples involving nominal data.

Disadvantages of the non-parametric tests

• In the case of the samples that satisfy the underlying assumptions of the parametric tests, application of non-parametric tests is of wasteful given their power of efficiency
• Unstructured availability of literature about the non parametric tests may confine the researcher to employ the parametric tests though their validity is vague.

The author has heavily benefited from the extensive and provocative discussions with his fellow doctoral student Yoonus C. A at IFMR, Chennai; and the writings of Sidney Siegel. The comments on the draft by Nandhini R. are highly commendable. Finally, the author is solely responsible for any mistakes and constructive comments are highly respected.

Corporate Bankruptcy Law in India

In India, there is no comprehensive law or market mechanism that governs corporate bankruptcy. The way it has been defined, ‘industrial sickness’ goes beyond the general understanding of ‘bankruptcy’. It has been defined as the extreme state where accumulated losses exceed the net worth. The stringent policies that dealt with the industrial undertakings until late 1980s fueled the persistence of industrial sickness in the country. The MRTP act (1969) prevented the private sector companies from attaining globally competitive scales of operation through its stringent definition of ‘dominant undertaking’. The FERA (1973) and Import Substitution policies that were adapted created the insurmountable hurdles to the domestic entities in acquiring the innovative technologies and forced them far behind in modernization process. This resulted in the widespread industrial sickness thereby blocking of scarce resources in unviable activities. To deal with the industrial sickness, the Government of India took various ad-hoc measures such as constituting Industrial Reconstruction Corporation of India Ltd (IRCI) in 1971; setting up of state level inter institutional committees (1980) to provide rehabilitation assistance to sick and closed units. These ad-hoc measures were not effective as they could not forge the coordinated approach to deal with the problem. In 1981, the RBI set up a committee under the chairmanship of T. Tiwari to suggest on the possible legal options/mechanisms to effectively deal with the problem of industrial sickness.

Based on the recommendations of the Tiwari committee, the Government of India enacted the Sick Industrial Companies Act (SICA) in 1985. The purpose of SICA has been the early detection of sick or potential sick companies; determination of the potential viability and timely provision of remedial measures. The economic underpinning behind the purpose of SICA is to unveil the scarce resources that were hitherto blocked with the unviable unit. In order to implement various provisions of SICA, Board of Industrial and Financial Reconstruction (BIFR) was set up in January 1987 and became functional from May 1987. Initially BIFR covered only private entities, the government companies were brought under the BIFR jurisdiction in July 1991. The SICA applies to the companies satisfying the following criteria:

• Companies specified in the First Schedule to the Industries (D & R) Act, 1951, except the industries relating to ships and other vessels drawn by power
• Companies not being ‘small scale industrial undertakings or ancillary industrial undertakings’ as defined in Industries Act, 1951.

The criteria that BIFR follows in determining the sickness of a particular company is as follows:

• The accumulated losses of the company to be equal to or more than its net worth.
• The company should have completed five years after incorporation under Companies act, 1956. (before July, 1991 it was seven years)
• The company should have 50 or more workers on any day of the 12 months preceding the end of the financial year.
• It should have a factory license.

The companies satisfying the above criterion are reviewed by the body of experts who determines the viability of the company. Based on the observations, unviable companies are winded up and potentially viable companies are recommended for the re-organization process. The companies that underwent the re-organization process will be declared as ‘no longer sick’ as and when their viability is established (as and when their net worth becomes positive).

Reference:

- T.C.A. Anant and Omkar Goswami (1997), “Getting Everything Wrong: India’s Policies Regarding ‘Sick’ Firms” in Dilip Mukharjee (ed), Indian Industry: Policies and Performance, OUP, New Delhi.

- www.bifr.nic.in.

Suggestions and comments will be encouraged!

Conceptual ideas-II

What are the indirect taxes?

An indirect tax is a tax which is imposed on one person, but paid partly or wholly by another depending on the bargaining power between them. In the sense, indirect tax is conceived as the one which can be shifted or passed on. The prominent examples of the indirect taxes are sales tax, customs and excise duties, incidence of which is transferred to (partly) the ultimate customers. In India contribution of indirect taxes to the total tax revenue of the union government is around 47% in 2008-09.

What is the budget deficit?

In India, the term budget deficit is used to describe the position in the different accounts of the budget. That is on current or revenue account and on capital account. The combination of the state of these two accounts represents the overall state of the budgetary position. The budgetary position on the revenue account represents the current operations of the government, i.e., government administrative expenses which are financed by the tax revenue. The deficit or surplus in the revenue account would be carried over to the capital account. The surplus or deficit on capital account signifies the over all budgetary position. The method of financing budget deficits is known as the deficit financing.

Where does the government look for funds where there is deficit?

Deficit is referred to the excess of expenditure incurred by government over the receipts from levying taxes, fees and so on. To reduce or eliminate the gap between expenses and receipts, modern democratic governments lay their hands on the accumulated reserves, sale of government properties, issuing debt securities which are issued in the market through central banks, borrowing from external sources such as foreign governments and foreign financial bodies and least likely increasing the taxes. In India, the budget deficit of the union government is about six percent (5.63%) of GDP in 2008-09, when sub-national governments are taken together it is about 10% of GDP which is overwhelmingly high.

What is the long run impact of the piling of debt?

In the short run debt gives the relief from the budgetary mismatch. But the accumulation of debt increases the debt service burden on the economy in the long run. Though in the short run debt adds for the economic expansionary policies, it takes away much needed cushion in the times of extreme events and causes for the contraction.

What is the relationship between deficits and taxes?

The term deficit refers to the presence of excess government expenditure over receipts from taxes, duties, fees and so on. Increase in taxes thereby tax revenue is one of the options government can exercise in reducing the burden of deficit. But such an option of increasing taxes to meet the budgetary demands is less attractive to the democratic governments.

What is the relationship between deficits and unemployment rates?

Deficit financing is the most popular economic expansionary policies particularly in the context of emerging markets. In presence of resource crunch, most of the emerging economies resort to the deficit financing as a policy measure to increase the investment spending, employment opportunities thereby increased production. In a way deficit financing reduces the unemployment rates given the economy future resilient prospects to deal with the increased deficit.

What do you understand by the term ‘fiscal responsibility’?

The term fiscal responsibility may be viewed as it is composed with three dimensions; they are managing resources, minimizing the debt and preparing for the future. Managing resources involves assessing needs, setting priorities, and appropriating funds as well. Assessing the needs in various departments and allocating the resources is the crucial part of fiscal responsibility. Preparing and effectively tiding over the potential black swan events by maintaining possible cushion is the prominent dimension of the fiscal responsibility. Eliminating the wasteful expenses, optimizing the expenditure on social security measures are the possible ways to minimizing the debt. Indian government (including sub national governments) running the deficit of around 10% of GDP as on 2008-09, enacted the Fiscal Responsibility & Budget Management to phase out the fiscal deficit.

What are supplementary budgets? Why are they needed?

During the budget year unanticipated needs may arise that affect the central government budget. A particular deparment may, for example, need more money than planned. In such a situation, the Government can revise the central government budget by proposing an increase. This is known as a supplementary budget and proposals for supplementary budgets are submitted by the Government possibly twice a year.

Your suggestions and comments will be encouraged!

Conceptual Ideas!!

What are M1, M2 and M3?

M1 is the sum of the physical money that is held outside banks, travelers’ checks and demand deposits. M2 is M1 in addition to all time-related deposits, savings deposits, and non-institutional money-market funds. M3 is M2 as well as all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets. M3 is referred to as broad money supply and is usually the number referred to when talking about money supply. M1 is generally referred to as narrow money.

What is the impact of interest rate on the economic growth?

There is a general consensus that the growth of the economy is negatively associated with the interest rates prevailing in the economy. Interest rates in an economy has twofold effect on economic growth as they act as driving force for the investment activity on one hand (supply side) and stimulate the consumption expenditure on the other hand (demand side). In specific, moderately low interest rates not only drive the increased investment activity but also encourage the individual consumption expenditure.

What Does Nonperforming Asset Mean?

A debt obligation where the borrower has not paid any previously agreed upon interest and principal repayments to the lender for an extended period of time (say, 90 days). The nonperforming asset is therefore not yielding any income to the lender in the form of principal and interest payments. Increased nonperforming assets act negatively to the growth of the economy as the scarce capital could be holdup in unviable economic activities. It is a major concern for the emerging economies as they generally face the resource crunch.

What is a fiat currency?

Fiat currency or fiat money is a type of currency whose only value is that a government made a fiat that the money is a legal method of exchange (is usually the paper currency). Unlike commodity money it is not based on any other commodity such as gold or silver and is not covered by any special reserve. It means fiat currency doesn’t have any intrinsic value and its value depends only on the confidence holders have in the economy and its government. Most currencies in the present world are fiat currencies.

What are the leading, lagging and coincidental indicators?

Usually indicators are used to predict the future outcomes, particularly future trends of the certain economic variables. Some of these indicators are published by government bodies/private organizations eg. Inflation rate, …………..and some are observed in the market place eg. Bond yields. Depending on the prediction they make, such indicators are classified into leading, lagging and coincident indicators.

Leading indicators are the pointers towards the future outcomes. Bond yields may be considered the leading indicator for the trends in the equity markets.

Lagging indicators are of useful in reinforcing or confirming the event occurring or expected to occur. Unemployment rate may be viewed as lagging indicator for the performance of the economy. Falling unemployment rates confirms the encouraging performance of the economy.

Coincident indicators reflect the situations they signify. Increased per capita consumption is the reflection of flourishing economy.

What happens to the interest rates during deflation?

Deflation refers to the fall in the general price level. It is usually caused by the fall in aggregate demand which is in turn resulted from the decline of government spending, private consumption and investment spending. Deflation can also be the result of the fall in the supply of credit and increased interest rates. But once the deflationary situation is settled in, investors mostly become the risk averse and seek for the safe heavens such as investing in treasury securities. The increased demand for the treasury securities due to deflationary conditions brings down the interest rates and some times push the interest rates into the negative territory.

How does credit crunch affect consumption?

Credit crunch refers to the reduction in general availability of credit irrespective of the rise in interest rates. It has multifold effect on the consumption expenditure, particularly on the conspicuous consumption. On the plain grounds, lack of credit availability restricts the consumption on durable goods; on the other hand credit crunch dampens the consumer confidence by causing the steep fall in asset prices, reduction in investment rates and increased unemployment rates. The recent credit crunch resulting from the US housing sector crisis brought down the consumer confidence there by consumption expenditure.

What are the important components of the budget?

Indian budget, known as Union Budget is made up of revenue account and capital account. Revenue account comprises of government revenue mainly from taxes and government administrative expenditure. Capital account comprises of receipts and payments. Receipts on capital account include the loans brought about by the government through central bank from the market as well as other government bodies and profits from the government owned enterprises. Components of payments on the capital account include government investment expenditure on assets, infrastructure etc.

What are the direct taxes?

A direct tax is a tax which is imposed directly on the tax payer. It implies that in the case of the direct taxes the immediate impact and incidence of the money burden lies on the same person. The examples of direct taxes are personal income tax, wealth tax, tax on gifts etc. Most of the modern governments earn major chunk of revenue from imposing direct taxes. In India, contribution of direct taxes to the total revenue of the union government is 53.07% in 2008-09. This reflects the significance of the direct taxes as major source of revenue for the state.

Your valuable suggestions and corrections will be encouraged!!

Corporate Governance and Control

Definitions

•  It deals with the collective action problem among the widely dispersed shareholders in monitoring and controlling the management.
  
•  It deals with the conflict of interests between investors and managers. It is also referred to deal with the principal and agent problem. 

It is generally assumed that the maximization of the shareholders’ wealth is the primary objective of the corporate governance.  Is it an efficient (economic) outcome???

 It is a Pareto efficient – if

·        The ‘firm’ is viewed as a nexus of contracts; more precisely, is viewed as the nexus of complete contracts with creditors, suppliers, clients and employees; and open contracts with shareholders who has claim on the residual returns

·        There are no principal agency problem i.e., the interests of the managers are optimally aligned to the interests of the multiple principals.

If the above two conditions are satisfied, the maximization of shareholders’ wealth is Pareto efficient. But there are some arguments: Managers exclusively working for the shareholders’ wealth maximization may lead to certain inefficiencies:

• Excess risk taking by the managers in the presence of high leverage
• Underinvestment in the case of the debt overhang.

Sound governance mechanism reduces the cost of equity, in a way good corporate governance is in the interests of the firm itself.  Then why do we need external regulation??

• Block holders (institutional investors) may keep the higher bargaining power with them.  Eg. Block holders may go for the anti takeover policies which will not benefit the small or minority shareholders.
• Managers may lobby for the more discriminatory powers.
• To ensure the interests of the all the stakeholders

Why do the investors dispersed so widely?             

• Individuals’ wealth in relation to the investments is small
• Investors may want to diversify their risk by investing their limited wealth in various firms
• Investors’ may concern for the liquidity – a large amount of stock is very harder to sell instantaneously in the secondary market.
• Regulations on individual shareholding

So dispersion is inevitable.         

There are two oversimplified corporate governance mechanisms.

1. Anglo-American Model (market based model) -

Nurtured by USA and UK.

• Accords absolute priority to the shareholders
• Shareholders monitor the performance of the management through market mechanism
• As shareholders are open contract holders and having less contractual protection, the rules are framed to protect them.
•  Short term perspective
• Criticized as it encourages the management to get obsessed with the performance appraisal and pursue short term goals over long term objectives.

2. Long term Large Investor Model (Bank based Model) –

Nurtured and followed mainly by Japan, to some extent by Germany.

• Managements are monitored by the large investors, financial institutions
• Financial institutions do participate in decision making process
• Ensures low cost of capital
• Long term perspective
• Other stakeholders have more protection than shareholders.

III. Possible Lessons from the Japanease (slump) bear market

Before deriving the possible implications of Japanese prolonged bear market for the present mess in the global financial system, I would like to investigate possible factors that caused the boom and eventual burst in the Japanese economic system.  Here I will be discussing the issue from the corporate governance perspective, whether the corporate governance mechanism added the flame to these extreme events of business cycle?

 The oversimplified corporate governance mechanisms are of two kinds, one is Anglo-American Corporate Governance Mechanism (Market based system), pioneered by USA and UK; Bank based Mechanism, nurtured and followed mainly by the Japan and Germany (Germany in the later years tilted towards market based system), is the another one. Market based system gives absolute priority to the shareholders over other stake holders. It presumes that the shareholders do monitor and impose the discipline on the management through market mechanism. It is also argued to be of having short term perspective as market gauges the performance of the management on the regular basis in terms of quarterly/half yearly accounting statements. Where as Bank based system measures the performance based on the long term growth perspective. It accords the governance mechanism to the financial institutions that monitor the performance of the managements.  In a way financial institutions posses the major stake in decision making process under Bank based system. 

 Bank based system, providing the financial institutions access to internal information to assess the potential projects, ensures the low cost of capital to the firms. This came handy to the Japanese corporate world during the bull phase of 1980s, where as the firms in the rest of the world were cautious over the investments in the light of high cost of capital.  In a way Bank based system added the flame to the Japan’s Bull Run during the second half of the 1980s.  But the same system tightened the necks of the Japanese firms during the crash and the prolonged period of bear markets (till date) as the banks became overcautious given their increasing NPAs. Thus Japanese corporate governance mechanism steepened the crash in the asset markets and contributed to the ever ending bear market conditions.

 Anglo-Saxon model, according the corporate governance to shareholders (who monitor the management performance through market mechanism) makes the management obsessed with the quarterly performance appraisals. With its short term perspective, Anglo-Saxon Model encourages the management to pursue the short term goals by forgoing the long term objectives. In a way such corporate governance model practiced in USA, UK, and Europe might have forced the yester year mighty corporations into the history and eventually caused the present mess in the global economy.

(Comments and Suggestions are welcome!!)

II. Possible Lessons from the Japanease (slump) bear market

(It has been roughly four months that i promised to write on Japanese prolonged bear market).

Boom and depression are the two extremes of business cycle which are generally pursued to be caused by an array of economic factors such as over production, under consumption, over capacity, price dislocation, over confidence, overinvestment, over saving, over spending and discrepancy between savings and investments. The foremost celebrity monetary economist Irwing Fisher attributed the business cycles to the over indebtedness and thereby deflation.  In his own words, depression in the economy is result of over indebtedness which leads to distressed selling of assets. He articulated (in 1930s) the chain of factors that lead to depression in the following way….

Over indebtedness leads to a) distressed selling and b) contraction of deposit currency as bank loans are paid off and to a slowing down of velocity of circulation. The contraction of deposits and of their velocity precipitated by the distress selling causes c) a fall in the level of prices and d) a still fall in the level of corporate net worth, precipitating bankruptcies and e) a like fall in profits leads to concerns to the private – profit society to make f) a reduction in output, trade and employment. These losses, bankruptcies and unemployment leads to g) pessimism and loss of confidence which in turn lead to h) increased hoardings and still more contraction in velocity of circulation. All these factors cause i) complicated disturbances in interest rates.  Here the complicated disturbances in interest rates are vowed to my previous post on counter cyclical regulation.

The above lengthy introduction serves as the basis for my arguments on the possible lessons from the Japan’s prolonged bear market.

 From the humiliating defeat of 1945 war, Japan has raised to the second largest economy by 1989. The tremendous growth has been attributed to the hard work (Popularly known as Japan kind of doing) rendered by its citizens and supply led and export oriented policies adapted by the then governments. During the second half of the 1980s, Japan experienced a sea change, there was a sudden spurt in the asset prices, real estate prices reached unimaginable hights, stock markets were experiencing thumping Bull Run. High asset prices coupled with low/negligible unemployment rates, increased productivity and positive trade deficit prompted the irrational speculating activates. Though inflationary situation forced the Bank of Japan to keep the interest rates high, the capital gains from the asset markets (stocks/real estates) encouraged the investors to go for investing with borrowed money. Banks also added to this malady by promptly sanctioning the loans to the investing activities. There is hardly anyone who has not stepped into the band wagon of making quick buck. By the end of 1989 Nikkie index touched 39,000 mark which raised three times more than the economy’s growth. 

Such a growth led by the speculation coupled with over indebtedness became unsustainable and rate of growth of the asset prices slowed down, interest rates over took the capital gains. Thus as Fisher rightly mentioned way back in 1930s, the over indebtedness and higher interest rates forced the distressed selling resulting in steep fall in asset prices. The crash in asset market and resulted mass corporate defaults increased the proportion of distressed assets in banks’ books. Non repayments, delayed repayments and deposit withdrawals caused the banks to adapt conservative measures. Steep rate cuts by the Bank of Japan could not yield the desired fruits, moreover resulted in debt trap. Hesitant banks keep carrying the distressed assets on their books, resulting many defunct businesses were continued to float. Such an uncertain environment counter acted against all the monetary measures taken by the Bank of Japan, further steep cuts of interest rates forced the economy into deep debt trap. Hence, the failure of the transmission of monetary policies, continued business uncertainty forced the prolonged disarray in the Japanese economic system….(to be continued)

 (Comments and suggestions are welcome)

The author is highly benefitted from the writings of Irwing Fisher and Graham Turner.

Impact of regulatory/accounting arbitrage on the Returns from Distressed securities

Here my focus will be on distressed debt securities and my idea of distressed securities is broad enough in including the investments in non-performing assets of financial institutions. Investors are generally attracted towards distressed securities/assets to earn higher risk adjusted returns.  The prominent reason for such risk adjusted returns is the arbitrage opportunity created by the regulatory/ accounting process.

  The financial institutions in general and commercial banks in particular are highly regulated. Such regulatory pressures do create the opportunity for the investors to purchase the distressed loans (NPAs) at the attractive prices. Given the regulatory costs involved in having large amount of distressed loans, many banks prefer to sell the loans at the throw away prices (even at less than the recovery value).  Such behavior of the banks may be attributed to two reasons. First, tax laws allow the banks to deduct such losses from the EBIT. Second, market pursues the larger amount of NPAs thereby higher regulatory reserves as the negative information (may be market short sightedness). The buyers of these assets (may also include commercial banks) do place them in their trading account. As the assets in the trading account are marketed to market and no ‘regulatory’ reserves need to be held against the assets in the trading account, they provide the economic value to the buyers. Hence, the sellers of the distressed assets do sell them on the regulatory/accounting reasons where as buyers of such assets do buy them on the economic reasons.

 (Your comments and suggestions do inspire me the most. Thanks….)

Does the Counter Cyclical Regulation ensure the cycle free regime?

During the run up of 2004 to 2007 world economies in general and emerging economies in particular have experienced the highest levels of consumer confidence and corporate optimism. The increased purchasing power driven by increased investments and confidence among the economic agents (I mean corporate entities and individuals) has escalated the inflationary pressures around the world.  To counter such an imbalance in the system, the apex bodies around the world have resorted to counter cyclical monetary measures such as increasing the reserve capital (which may be used in the event of negative outcome). Such a counter cyclical regulated environment has forced the firms to incur more cost of capital than market requires.  In fact during the boom times, given the confidence level in the economy, the probability of default though is very remote; the cost of capital in the economy remained irrationally high. Hence such a regulatory environment prompted the firms to shift to unregulated or less regulated activities such as structured investment vehicles which in a way caused the present trough. 

 

Aftermath of the bursting of the bubble in the housing sector, almost all the apex financial institutions around the world resorted to the (traditional) counter cyclical monetary measures which are again proved to be irrational and may contribute to the potentially void results. The trouble in the housing sector has been translated into disastrous crisis in the financial sector by the so called counter cyclical regulations of the boom period. The resulted crisis has evaporated the confidence among the economic agents and drafted vague picture about the future prospects thereby steep fall in consumer demand, accumulated inventories and unimaginable job cuts. Given the present pessimistic environment, market demands a relatively higher cost of capital from the firms and financial institutions requires higher cushion in terms of higher reserve to tide over the potential uncertainty. Counter intuitive to such an end, the regulatory bodies brought down the reserve requirements of the financial institutions and virtually advocating the low cost of capital to the firms. The credibility of these measures in the event of possible corporate mass defaults is not only questionable but they may also pose the terrifying questions about the future systemic cushion…  (to be continued)

(Comments and suggestions are hightly respected)

Inital steps - 1: Board for Industrial and Financial Reconstruction (BIFR)

What is it about?

In 1981, the Governement of India set up a committee headed by Mr. Tiwari to suggest a comprehensive legislation to deal with the Industrial Sickness prevailed in the economy. Based on its report (submitted in 1983), the GoI enacted the Sick Industrial Companies Act in 1985 (SICA) and set up the  Board for Industrial and Financial Reconstruction (BIFR) in 1987 with the objective of determining (early) the sickness and expedite the rivival of potentially viable firms and closure of unviable firms.  It was expected that by rivival the idle investments in the viable firms will become productive and by closure the locked up investments in unviable firms will find their productive uses elsewhere.

What does it provide?

It works on the provision of timely detection of sick and potentially sick industrial companies, speedy determination and enforcement of preventive, remedial and other measures with respect to such companies. They do provide the legal protection for the speedy revival of viable and closure of the unviable firms. It facilitates the required financial assistance and also provides the managerial expertise.

What is the eligibility criteria?

• Firm to be reported to BIFR under SICA should be 5 years old after the incorporation.
• Accumulated loss of the firm has to be equal or more than its net worth (paid-up-capital + Reserves).
• Firm's workforce should exceed the minimum of # 50.
• It should have the legal status for its existance (license).

Curtesy of BIFR

Causes of inactivity at this blog!

Hi there,

It may be foolish to search for the reasons and  giving justification for almost sleeping state of this blog. But i promise that i will be making active from the second week of April, 2009 as i will be getting plunged into the academic research.

Japanease Slump and its Implications

Japanease stock index Nikkie touched 39,000 mark in late 1980s, today it is struggling around 9,000. Virtually there was zero growth for last two decades in the Asia's largest and world's second largest economy. Fiscal measures, monetary measures all failed one after another in bringing back the normalcy.  When one look into the reasons (Irrational credit expansion and reality boom) that caused the downfall of the Japnease economy, one certainly get scared of their future prospects from the current juncture.  

Here i would like to initiate for a year end debate on the possible causes for the continued slump in the Japnease economy. Particularly i invite the arguments on the following issues:

• Reasons for the failure of fiscal and monetary measures in Japan
  
• Why an average Japanease citizen save so high? (even after realising that their savings and investments have gone for a vain)
• Possible measures to be adapted to cure the Japanease truma
• Implications of prolonged Japanease slump to the current debacle of the global financial system

As i mentioned it is the year end debate, i request your valuable arguments and comments by the end of the current year.  I also hereby promise that your contribution will be duly recongized in my forth coming blog post on the same issue.

- 

ILA PATNAIK on FIIs (Financial Express)

Why did stock prices drop even though massive net sales by FIIs, or an en masse flight by FIIs from the country, did not happen? Stock prices are determined by the beliefs of lakhs of market participants across the country. These are the people who are watching industries, individual companies and making forecasts about the future performance of the companies. Some foreign investors participate in this kind of active stock speculation, but the bulk of it is done by domestic individuals. When global business cycle conditions became worse, these speculators started downgrading their optimism about the growth of profits and dividends on the part of Indian companies. This gave lower stock prices. The channel runs from news to forecasts to (primarily domstic and individual) speculators to stock prices.

Why does the media talk so much about FIIs even though their influence on stock prices is small? From the viewpoint of brokerage firms, what matters most is trading volume, because their fees are proportional to volume. Whether FIIs buy or sell, they generate fees for brokerage firms. FIIs tend to do business with a few large brokerage firms located in South Bombay who are focused on institutional investors. For these firms, FIIs are important customers. Journalists and television commentators tend to talk with a few big brokerage firms, and tend to think that FIIs are very important. They miss out on the thousands of stock brokers spread across the country, doing mostly retail business, who account for the bulk of activity on the stock market. The belief of the big institutionally oriented brokerage firms in Bombay, that FIIs are very important for their business, has got rubbed off into a broadly held belief in the media that FIIs are the most important participants in Indian financial markets.

Curtsey of Financial Express

IMF Guidelines!!?

The confidence in the financial markets across the world has been badly shaken. Almost all the countries are embarking on adapting possible measures to mitigate the damage. IMF in its recent Global Financial Stability Report (GFSR) came up with few principles that could form the basis for designing the measures for a restoration of confidence in these exceptional circumstances (i dislike to admit it as "crisis"). They are:

1. Measures should be comprehensive, clear and operational procedures have to be transparent. 

2. Measures taken by the countries across the globe should be consistent in order to maximize their impact while avoiding the adverse effects on other countries. (such as competitive devaluation of the respective currencies should be avoided)

3. Ensuring rapid response on the basis of early detection of strains.  This requires a high degree of coordination within each country among the different set of authorities and in many cases across borders.  (The acomplishment of this principle would have saved the edifice of the Northern Rock as it has been effectively done by the rare coordination of authorities in India in avoiding the possible Run on its second largest bank)

4. Measures adapted by the governments across the world should assure that the current interventions are temporary and taxpayers interests are protected. Governments should be accountable to all its stakeholders and conditions for the support (by way of bailouts) should include private participation in downside risks and taxpayers participation in upside benefits. Intervention machanisms should minimize possible moral hazard problem.

Additions and constructive comments are encouraged!!

The Scientist's Rating on my blog!!

Sounds crazy!!  But the analysis of my writings by http://www.typealyzer.com reveals how i think .........Check it out, here is the report

INTJ - The Scientists

The long-range thinking and individualistic type. They are especially good at looking at almost anything and figuring out a way of improving it - often with a highly creative and imaginative touch. They are intellectually curious and daring, but might be pshysically hesitant to try new things. 

The Scientists enjoy theoretical work that allows them to use their strong minds and bold creativity. Since they tend to be so abstract and theoretical in their communication they often have a problem communcating their visions to other people and need to learn patience and use conrete examples. Since they are extremly good at concentrating they often have no trouble working alone. 

What do you think.........??

Similar thought!

Here is an interesting piece from Ajay Dua (Formar Secretary, GOI), who expressed the similar ideas (expressed in my earlier blog posts) on present crisis and its policy implications.

http://economictimes.indiatimes.com/The_impact_of_slowdown_on_India/articleshow/3739273.cms

Also see the Ajay shah's piece in financial times

http://www.mayin.org/ajayshah/MEDIA/2008/infrastructure_spending.html

Unviable Suggestion!!

The present crisis over turned the basic idea of the capitalism that "the state should assume the role of facilitator rather than the role of regulator". It is quiet evident from the recent acts of the notable 'leaders of capitalism' as United Kingdom nationalized the private commercial and investment banks (pearls of capitalism), United States embarked on entering into the governing bodies of yesturdays corporate kingdoms. With the yesturday's statement, the Government of India took the anti-capitalist movement to the next levels.  Given the status of the economic environment, i propose to critically evaluate the Govt of India's move in asking the industry to cut the prices of the goods produced by them.

During the last couple of months, the Govt of India infused Rs. 2,80,000 crore through a host of monetary measures and another Rs 1,00,000 crore through various fiscal measures. Thanks to the cordinated efforts by Ministry of Finance and RBI, the inter bank rates have (virtually) came down to the normal levels (though i suspect the normalcy in terms of transactions among the banks). Here, one should question the effectiveness of the measures so far taken by the MoF and RBI. These have been initiated at a time when the transactions among the banks were virtually non-existent, call money rates were at their hights of around 23% and most importantly the banks were no where near the position of either continuing or renewing the expired credit lines to the corporates. As noted by the pink papers, these measures are successful as they claimed to be drived down the inter bank rates. Here one should understand the real picture  what made the inter bank rates to reach the normal levels?.  It would have been appreciated if the RBI & MoF measures improves the confidence among the banking community over the solvency of their peer and if they transferred the newly infused liquidity to the real economy through continuing and extending the credit lines to the industry. Hardly there is no evidence on this front, there is no evidence of either new or renewed credit lines (without additional restrictions) to the industry; there is no evidence of healthy inter bank transactions. Hence, it is very clear that the RBI & MoF measures reduced the demand for call money (thereby interbank rates) by boosting  the banks with the large chunk of easy money which has no signs of reaching the proposed ends (moreover it is reaching back to government coffers as banks are now heavily purchasing the government securites). Essentially, these measures so far taken have neither yielded  fruits to the (real economy) industry nor to the banking sector as they failed to improve the confidence among the ultimate economic agents (consumers).  Moreover, the steep fall in retail sales have jeoparadized  the industry (which never had the chance of earning super normal profits given the fierce competition resulted from opening up of the economy) prospects by resulting in accumulated inventories, and increased credit bills. At this stage, the viability of the earnest Minster of Finance statement may be questioned? It makes me to suspect that the Govt of India is still in the dreams of "strong fundamentals" and not yet ready to accept its vulnerability to the crisis. 

In this situation, the government should have the sole goal of 'improving the confidence' among the economic agents.  It may be effectively achieved by relying heavily on fiscal policy measures. That is increasing the benefits to the unemployed (social security measures), infrastructure spending  to boost the aggregate demand. The agrument against infrastructure spending in the prevailing situation is that they take too long to show the impact, but such an arument has no validity as the chances that this slump will be over anytime soon are virtually zero.  Hence, it may be reasonable to get such projects get rolling and slowly injecting the confidence among the economic agents.!! (as i blogged for quite some time ago).

 (http://surenderkomera.blogspot.com/2008/10/current-recession-policy-implications.html) 

(Constructive comments and suggestions are encouraged!!)

II. Derivatives and Monetary Policy: Implications for the Transmission Mechanism of Monetary Policy

The goal of the monetary policy is to ensure non-inflationary growth in the economy.  The intentions of the monetary policy are mostly transmitted through the financial sector, mainly through influencing the interest rates, exchange rates and availability of bank credit. Though there are wide variances in the financial structures in various countries, these issues assume greater significance in almost all the institutional arrangements.

Through Interest Rates:

With their low transaction costs and flexibility of product designs, derivatives increase the speed of portfolio adjustments and thus lead to the faster transmission of interest rate changes. On the other hand, financial derivatives are also the perfect instruments for the individuals who now can seperate the interest rate risk of an investment from its production risk at least for a while. The influence of monetary policy will sooner or later will get reflected in the real economy because the insurance obtained through derviatives will eventually expire. Moreover, the monetary policy so heavily influences the cost of such insurance. In a way financial derviatives provide inexpensive and efficient transmission of information to the modern and globalized economy.

Through Exchange Rates:

In the world with financial derivatives, it is much easier to engage in speculative positions on a particular country's currency without having any relationship to that country. It is not posible in the world without such derivative products. These kind of transactions effectively transmits the impulses of monetary policy to other parts of the region.

Through Bank Credit:

Monetary policy influences the volume and structure of bank credit if it were to control credit costs. The availability of financial derivatives in such an economy would likely to undermine the efforts of monetary policy given their capacity for substitution. This implies greater significance for the 'interest rate channel' than a 'credit chennel'.

(The author is greatly benefited from the writings of Gerd Hausler)

Constructive comments and suggestions are encouraged!!

I. Derivatives and Monetary Policy: An Introduction

I deeply regret for the delay in posting my discussion on this issue at the promised time. I really put a lot of effort in gathering and analysing the existing information about this topic.  After a deep thought i have decided to post my arguments on this issue through a series of 5 blogs.  At the outset, here i will provide the framework for such a proposed series. I hope you will receive it with the right spirit.

Introduction:

It is generally perceived that the central banks deal with derivatives exclusively in the context of supervision and regulation. There are few central banks (small) that gained the first hand experience with derivatives when trying to manage their exchange reserves more professionally. Ofcourse, this is a commercial action which may be significant in individual cases, but is not of a core cencern of a central bank. Given the exploding size of derivatives markets today, it is crucial to understand the impact of derivatives on monetary policy in particular and on today's financial environment in general.

The possible issues araising from the interaction of derivatives and monetary policy may be classified into four categories:

1. Impact of derivatives on the various aspects of the transmission mechanism for monetary policy.
2. Influence of derivatives on the targeting of monetary policy.
3. Usefullness of derivatives market in designing the monetary policy especially in providing policy makers with the valuable information about the market expectations.
4. Derivatives as an operational tool for the monetary policy purposes.

The discussion over these issues will be presented through the following series of five blog posts.

Constructive comments and arguments will receive due recognition!!

Break the Path Dependent Ideas!!

Eversince sub-prime crisis  initially unearthed during April 2007 in United States, it has been widely written and extensively discussed by the independent scholars, policy makers and so on saying that: the fundamentals of the Indian economy are extremly strong, India has not yet been integrated to the world economy. Hence, the possible impact of the crisis in the western financial system will be very mild on the Indian economy.  By naively subscribing to this view, RBI has maintained the real interest rate as high as 4% (three month rates), SEBI continued to control capital inflow by many ways such as restricting Paricipatory Notes untill early September 2008. Where as the central bank of US (Federal Reserve) kept the credit policy so loose that short term interest rates are in the negative territory during the period.

Almost a year later now after September 2008 which experienced the major collapse of financial system in the western world, we are now feeling pinch and observing the worst part of the effect in our economy.  Our stock markets have fallen steeply by almost 40%, inter bank call rates touched the peak of 23% unearthing the worst ever credit crunch. This resulted in either fully or partially abondened credit lines to the corportes and there by affected the indusrial production. The real estate markets in India have slowed down and the home prices in most of the cities are falling sharply.  In a way high degree of distress has been witnessed in the overall economy. This has disproved the perception of our policy makers over the 'strong fundamentals' and 'decoupled of the economy with the rest of the world', that is based on the position of India 10 years ago. 

 Coordinated effort of RBI, SEBI and Ministry of Finance:

Similar to most of central banks of the developed world, Ministry of Finance and SEBI led by the Indian central bank has now (after realising the true picture) come out with a series of positive steps to correct the system during the last three weeks. a 250 bps cut in CRR, a special window of Rs 20,000 crores to MF to ease the redemption pressure, reliease of Rs 25,000 crores under the loan weaver scheme, a 100 bps cut in the (repo rate) policy rate, a de facto 100 bps cut in SLR, the reversal of the mistakes on PNs of October 2007 and ease of FDI norms. All these measures seems to bringing back the normalcy in to the system as they resulted in bringing down the call rates to around 6% and reduced the panic selling in our stock markets (Indices have taken the northward direction!!) In a way RBI and SEBI exhibited the greater maturity in dealing with the present borrowed crisis without resorting to possible politically motivated measure of "banning of short selling".  Hence, it may be highly commendable to break the subscribing to the path dependent thinking process and accept the Indian economy as nascent market economy in arraiving at policy decisions !!

(The author has highly benefitted from the writings of Ajay Shah, Ila Patnaik and Arthur M Okun)

Comments and suggestions are encouraged!!

New dimension to Trade theory

You might be well aware of David Ricardo's 'Theory of Comepetitive advantage' which advocates that the countries which are relatively competitive enough in producing different goods/services should participate in trade ( E.g. you are a better baker and i am a better shoe maker, the trade between us improves the prospects of both of us). This basic idea of trade relevence dominated the thought of International economics and trade, in a way it laid the path of economic thinking of international trade.  

Paul Krugman is one of the first to realize that those kinds of path dependent models only explained about half of the trade in the world, and he became the first one to explain economicially why it (also) made sense that countries that are similar should trade as opposed to courtries that are differnt. He explains that  such trade between the countries that are similar, enables specialisation and large-scale production, which results in lower prices and greater diversity of commodities. The development of large scale production for the world market has contributed significantly for the enhancement of standard of living of most of the countrymen (mostly in developing counries)  by the way of attracting more people to cities and higher wage rates.  Paul in his path breaking work on trade theory showed how economics of scale influence trade and urbanization.

(The author has greatly benefited from the writings of Simon Kennedy and Rich Miller)

Comments and further contributions are encouraged!!

Current Recession: Policy Implications

Before going ahead with this weekend blog let me Congratulate PAUL KRUGMAN who has been honoured with the Noble prize for the year 2008 in Economics. His theoretical contributions to International trade and economic geography are detrimental in bagging the highest honour. In his recent piece in Newyork Times, the 2008 Noble Laureate in economics said that "it is politically fashonable to rant against government spending and demand fiscal responsibility.  But right now, increased government spending is just what the doctor ordered, and concerns about the budget deficit should be put on hold". In the following piece of my blog, i will try to relate his statement with the current global financial condition (I dislike to call it as "crisis").

Stock markets are finding new depths in most of the days, money markets, credit markets are vitually shut down. In addition to that we saw the falling retail sales so as the industrial production. All these prevailed conditions makes me to remember the recent recession of late 1990s resulting from technology bubble. The policy response to such recession was a success story.  The Federal Reserve could engineer that recession by cutting interest rate which resulted in the increased employment opportunites. But the current prevailing situation is different from that of the situation prevailed during late 90s in many ways. For quiete sometime Federal Reserve has been resorting to  interest rate cut to prevent the unemployment rates from raising for several other reasons of global slow down. This brought us to see the fed rate at around 1%, but there is no sign of declining trend in unemployment rates. Moreover, the decline in the retail sales caused the accumulated inventores, forced reduction of the industrial production and further retrenching of jobs. As per the old dated economic text books the current economic situation is precisely referred as the "Economic down turn" as a synonym to "recession".  How long our markets have to suffer from such epidemic? , is the trillion dollor question!!

In this situation there is not much can be done by the central banks. On the other hand, as J.M. Keynes advocates a lot that government can do through its fiscal measures - increasing the benefits to the unemployed (social security measures), infrastructure spending  to boost the aggregate demand. The agrument against infrastructure spending in the prevailing situation is that they take too long to show the impact, but such an arument has no validity as the chances that this slump will be over anytime soon are virtually zero.  Hence, it may be reasonable to get such projects get rolling and slowly injecting the confidence among the economic agents.!!

Constructive comments are honoured!!