Dabba Trading Comes to a Halt

As an aftermath of the Demonetization of old Rs. 500 and 1000 notes from the Indian Economy, expected results of curbing the Black Economy to a major scale seem to be positive at least from the stock market point of view. The recent news have shown that the illegal “Dabba Trading” has completely come to a standstill as traders face liquidity crunch with the highest denomination of Indian currency notes been demonetized and no longer considered a legal tender in the fastest growing economy in the world presently.

What is Dabba Trading?

Dabba Trading is an Indian Terminology, which is an illegal form of trading and is considered equivalent to Black Economy in the stock markets.

In dabba trading, a client buys and sells shares or index futures, with a broker who offers the outlawed service. The only difference here is that the trades are based on official (market) rates, but are not entered in any trading terminal and no securities ever change hands; they happen outside the purview of stock exchanges and regulators. The broker with whom the trade has been placed is the counterparty, just like a cricket or horse racing bookie. If the client makes money on the trade, the broker loses an equivalent amount, and if the client loses money, the broker gains by an equivalent account.

Everything is settled in cash. The 'brokerage' is higher than that for a regular transaction, and is usually in the form of a spread; the client will have to pay slightly above the market price in a buy trade and will get slightly below the market rate in a sell trade. Still the savings on margins that have to be maintained with stock exchanges for regular trades and savings on income tax (in case of profitable trades) more than make up for the higher brokerage.

How is Dabba Trading linked to Black Money?

There are brokers who specialize in what can be called ‘unofficial official’ trades for high networth traders who want to avoid the taxman’s glare. The trades are perfectly legal and routed through the broker’s terminal, but the profits and losses are settled in cash. Also, there are no records of the clients who transact with these brokers.

This is contravention of the SEBI rule that insists on all dealings between the broker and client being done through cheques. The 'cash broker' will enter all his clients' orders in his own proprietary book. If the client makes money, the broker pays him in cash, and if the client loses money, the broker collects in cash from him. The benefits for the clients are that they do not have to put up margins, and do not have to pay taxes on the profits earned. The broker charges a higher commission on these trades in return for the ‘facilities’ he is providing.

For this business to be profitable for the broker, there should not be a huge profit on his books at the end of the year. Else, he will end up paying tax on that money, since all the trades are shown in his name. Also, having a good client base is important. It is the cash collected from the losing clients that is paid out to the winners..

Many of the high-volume traders on Dalal Street, and even some of the so-called investment gurus, are known to route a sizeable chunk of their trades through brokers who settle in cash, to avoid tax. And while the brokers manage to balance their accounts at the end of year, the Income Tax department is only too aware of the cash transactions in the stock market and of the tricks resorted to conceal them. Still, with help from skilled chartered accountants and some accommodative assessing officers, the game has been going on for a while.

Effect of Demonetization

The Rs. 500 and 1000 notes, which made up 86% of the cash in the Indian economy, have been scrapped as a legal tender in the country since November 8, 2016. With this, the black market cash economy, which is considered to be consisting money in these denominations, has taken a big hit. Some of the dabba brokers who accept big trades, hedge their bets by taking an opposite position in the official market. This adds to the liquidity in the market.

Black money holders who indulged in Dabba Trading are facing a severe liquidity crunch and the trades of this kind have come almost to a halt and are in turn putting pressure on the stock prices.

So… Finally there are some positive results showing up for the bold step of demonetization that the present Indian Government has taken to curb the Black Economy. A Great News indeed!! The present effects of this may seem to be negative (in terms of Stock Market Reactions), but however, its long term implications seem to be much more positive and are expected to outweigh the present negative impacts.

- Harsh Pathak

Student and Core-Committee Member of Finance Club, MISB Bocconi - Bocconi India

Where is Oil Heading

Major Oil Indexes

Western Texas Intermediate (WTI) – WTI refers to oil extracted from the wells in the U.S. and sent via pirpeline to Cushing, Oklahoma and crude supplies are land-locked. The product is very light and very sweet, making it ideal for gasoline refining, in particular. WTI is the main benchmark for the oil consumed in the U.S.

Brent Blend – Roughly two-thirds of all crude contracts around the world reference Brent Blend, making it the most widely used marker of all. These days, “Brent” actually refers to oil from four different fields in the North Sea: Brent, Forties, Oseberg and Ekofisk. Crude from this region is light and sweet, making them ideal for the refining of diesel fuel, gasoline and other high-demand products. And because the supply is water-borne, it’s easy to transport to distant locations.

Brent is the reference for about two-thirds of the oil traded around the world, with WTI the dominant benchmark in the U.S. and Dubai/Oman influential in the Asian market.

Source: Intercontinental Exchange (ICE)

The preference for Brent crude today stems from the fact that it may be a better indicator of global oil prices. It's also still considered a sweet crude, despite having a higher sulfur content than WTI.

Although most Brent is destined for European markets, it's already used as a price benchmark for other grades.

As per Bloomberg, “Brent represents the Northwest Europe sweet market, but since it's used as the benchmarks for all West African and Mediterranean crude, and now for some Southeast Asia crudes, it's directly linked to a larger market."

Oil Market Outlook

Oil rose more than 1 percent today (November 7, 2016), boosted by a commitment from OPEC to stick to a deal to cut output.

Brent crude $ 46.20 per barrel at 17:30 IST, up 62 cents, or 1.36 percent, from the previous close. At the same time, U.S. West Texas Intermediate (WTI) crude was up 75 cents, or 1.7 percent, at $44.82 a barrel.

Mohammed Barkindo, Secretary-General of the Organization of the Petroleum Exporting Countries said at a conference in Abu Dhabi that the group (OPEC) was committed to an output-cutting deal made in Algiers in September.

Oil futures posted their biggest weekly percentage decline since January last week with Brent falling as low as $45.08, its weakest since Aug. 11, and WTI hitting $43.57, its lowest since Sept. 20. (Source: Reuters). There are also risks that the oil glut, which has dogged markets for over two years, could continue as OPEC's de-facto leader Saudi Arabia threatened to increase production. Even if Saudi Arabia does not follow through on that threat, its exports could rise.

"Saudi local oil demand is falling, and just maintaining current output could imply higher exports," Barclays bank said in an interview to Reuters.

What Major Oil Companies Expect…

In a recent report by Financial Times, Royal Dutch Shell and BP recently warned investors not to expect a strong rebound in oil prices next year as they set out plans for further cuts in spending to contain rising debts. The UK-listed oil majors both said they were planning for prices per barrel in the low $50s in 2017 — only a little above current levels — in a sign of the industry adapting to “lower-for-longer” market conditions.

Oil prices have stabilised in recent months after the sharp falls from $100-per-barrel crude two years ago but Shell and BP made clear they were not counting on a return to previous peaks.

“We see some firming in prices next year but nothing significantly north of what we see now,” said Brian Gilvary, BP’s chief financial officer, after announcing a 48 per cent drop in the group’s third-quarter earnings. Shares in BP closed down 4.5 per cent at £4.62 after publication of its results, which were dented by lower refining margins at the group’s downstream business as well as losses in upstream exploration and production.

Shell  reported an 18 per cent increase in profits which reflected heavy cost cuts after the group’s £35bn takeover of BG Group, completed in February.  However, Ben van Beurden, Shell’s chief executive, said: “Lower oil prices continue to be a significant challenge across the business, and the outlook remains uncertain.”

The more positive investor response to Shell’s results, meanwhile, reflected relief at its improvement from the prior quarter, when profits fell by 70 per cent (Source: Financial Times)

The continued squeeze on prices was reflected in the latest spending cuts outlined by BP and Shell.

Mr. Gilvary said BP’s capital investment would fall to about $16bn this year, down from an earlier forecast of $17bn to $19bn, and would remain broadly stable at $15bn to $17bn in 2017.

Shell said its capital spending would be about $29bn in 2016. This is almost 40 per cent less than the combined investment of Shell and BG Group two years ago. Spending would fall again in 2017 to about $25bn – the bottom end of Shell’s previous guidance of $25bn to $30bn – in an indication that oil majors intend to keep low spending.

Iain Reid, analyst at Macquarie, said: “They are making sure they do not crash and burn next year. They have cut capex down to almost the lowest possible level.”

In an interview with Bloomberg in Abu Dhabi, Bob Dudley, BP’s CEO said that he expected oil to touch $55 a barrel in 2017. He said, “Oil supply and demand is “generally” in balance, it’s just waiting until the stocks drain out.”

Eni SpA, an Italian multinational oil and gas company headquartered in Rome which posted a greater-than-expected third-quarter loss, is reducing capital expenditure at least through next year, its CEO Claudio Descalzi said in an interview with Bloomberg. As per Bloomberg reports, Eni is among major oil producers that are under pressure since crude prices plunged to less than half their 2014 peak levels. The company pumps crude in Iraq and is developing offshore natural gas fields in Egypt and Mozambique. Descalzi said oil prices would be high enough over the next three years for his company to maintain investment spending and its dividend. “Our number that’s good to cover our investment, and our operating cash flow is $50.” Prices could trade as high as $65 in the next three years, he said.

Exxon Mobil Corp. CEO Rex Tillerson, said:  “Capital spending will be “highly variable” from one producer to the next. There’s still a significant supply overhang and inventory overhang that needs to be worked through.

Energy investment will be 44 percent lower than expected from 2015 to 2020, compared with expectations before crude prices collapsed about two years ago, author and energy consultant Daniel Yergin said in an interview in Abu Dhabi. “‘When you look at all the postponements and cancellations, that will add up later in this decade,” he said.

Oil Outlook Ahead

According to a report by McKinsey & Company published in November 2016 – “Energy 2050: Insights from the ground up”, Fossil Fuels will dominate energy use through 2050. This is because of the massive investments that have already been made and because of the superior energy intensity and reliability of fossil fuels. The mix, however, will change. Gas will continue to grow quickly, but the global demand for coal will likely peak around 2025. Growth in the use of oil, which is predominantly used for transport, will slow down as vehicles get more efficient and more electric; here, peak demand could come as soon as 2030. By 2050, the research estimates that coal will be down to just 16 percent of global power generation (from 41 percent now) and fossil fuels to 38 percent (from 66 percent now). Overall, though, coal, oil, and, gas will continue to be 74 percent of primary energy demand, down from 82 percent now. After that, the rate of decline is likely to accelerate.

As per the Monthly Oil Market Report by OPEC released in October,

• ·         World Oil Demand

World oil demand in 2016 is seen to average 94.40 mb/d. In 2017, world oil demand is anticipated to rise by 1.15 mb/d, unchanged to average 95.56 mb/d. (Demand for OPEC crude in 2016 is estimated to stand at 31.8 mb/d, an increase of 1.8 mb/d over last year. In 2017, demand for OPEC crude is forecast at 32.6 mb/d, a rise of 0.8 mb/d over the current year).

• ·         World Oil Supply

     Non-OPEC oil supply in 2016 is expected to contract by 0.68 mb/d to average 56.30 mb/d. In 2017, non-OPEC supply is anticipated to show growth of 0.24 mb/d to average 56.54 mb/d, mainly due to new projects coming on stream in Russia. OPEC NGLs are expected to average 6.43 mb/d in 2017, an increase of 0.15 mb/d over the current year.

• ·         Demand for OPEC crude in 2016 is estimated to stand at 31.8 mb/d, an increase of 1.8 mb/d

     over last year. In 2017, demand for OPEC crude is forecast at 32.6 mb/d, a rise of 0.8 mb/d overthe current year.

According to Bloomberg data, “Oil producers in the North Sea are poised to ship the most crude in more than four years. This expected surge is in line with the expectations that OPEC will try to contain a global surplus with coordinated output cuts. Shipments of North Sea grades will increase 10 percent month-on-month to about 2.16 million barrels a day in December.”  The surge poses yet another challenge to the Organization of Petroleum Exporting Countries as it seeks to curb production to steady markets in a world with plenty of oil. OPEC ministers will meet in Vienna on Nov. 30 to decide how to trim output to a range of 32.5 million to 33 million barrels a day. Libya, Nigeria and Iran are claiming exemption from cuts because of their own circumstances, and Iraq has contested how its output has been measured.

While supplies from some nations outside of OPEC are indeed falling, non-members boosting their crude output include Kazakhstan, Brazil and Russia, which last month pumped oil at a post-Soviet era high (Source: Bloomberg). OPEC itself increased production to a record 34.02 million barrels a day in October, according to a Bloomberg survey of analysts, oil companies and ship-tracking data. In addition, the U.S. is now freely shipping its oil across the globe, following the removal of export restrictions last year.

On November 7, 2016, Mohammed Barkindo told reporters in Abu Dhabi that, Russia – the world’s biggest energy producer – is “on board” with an OPEC agreement to limit crude oil production to help re-balance the market. “OPEC producers remain committed to an agreement reached last month in Algiers to trim output, and cooperation from non-OPEC producers will help bring the oil market back into balance” he said. Russia is due to join OPEC for talks later this month in Vienna, where OPEC will convene for its bi-annual meeting.

The Organization of Petroleum Exporting Countries, which pumps about 40 percent of the world’s oil, is trying to persuade producers from outside the group, such as Russia, to join the cuts. OPEC wants to put the changes into effect when it meets in Vienna on Nov. 30. The group has held talks over the past weeks with producer nations Russia, Azerbaijan, Brazil, Kazakhstan and Mexico.

According to Bloomberg report, Russia, the world’s largest energy producer, pumped at a post-Soviet record of 11.2 million barrels a day last month. With new fields ramping up production and more due to start producing before year-end, its output may climb further. Energy Minister Alexander Novak indicated that Russia was willing to freeze production for six months or more, rather than cut, and only if OPEC reached an agreement first. Bottom of Form The Algiers accord helped push oil prices to a 15-month high above $50 a barrel, but crude has subsequently fallen as several OPEC states disputed production estimates that would determine the size of cuts by individual members of the group. Without a deal, OPEC will return to the policy of pumping without limits to secure sales.

Author and energy consultant Daniel Yergin said in an interview, “OPEC members Iraq and Iran represent a “sticking point” that needs a resolution if there is to be agreement to limit production. If there isn’t an agreement, it’s back to battle for market share.”

As per the World Economic Outlook report published in October 2016 by International Monetary Fund (IMF), by the end of FY17, Brent Crude is expected to see the levels of $51 a barrel sighting the fact that demand in Developed Economies will be stagnant and major of the growth in demand that previously came from them will be balanced by the growth in demand from Major Emerging economies like India and China.

From here, oil is seen to meet the levels of $53-55 a barrel. In the mean time, let us watch what happens in the U.S. presidential elections!! 

- Harsh Pathak 
Student and Core-Committee Member of Finance Club, MISB Bocconi

Insider Trading

In this post, we bring to you the concept of Insider Trading. Yes! The same thing which got Rajat Gupta, MD of McKinsey at that time and a co-founder of one of the leading international business schools in India, a 2 year jail in the U.S. federal prison.

The Birth..

Insider trading is something that has been around ever since the first stock markets opened up in the Netherlands in the 1600’s but its effects on investors and economies were not fully understood till the 20^th century

What Insider Trading means…

Insider trading refers to the trading of a company’s stock or other public securities by an individual who has access to non-public information (i.e. classified or privileged information) about the company or an upcoming event that could impact the markets

Punsishable?  Yes indeed!

Insider trading is considered wrong and illegal as it gives the people who posses privileged information and unfair advantage over the average investor and they could make much larger profits than an average investor, which makes it very unfair to the general investing community.

Notable Cases of Insider Trading

1.       Albert H. Wiggins
The Roaring 20’s : 1920’s America was gave birth to one of the most bullish markets ever seen by man, it was a market with almost no regulation which enabled a select few to put easily put up smokescreens and market operations to reap profits. One of the most famous of these was the Wiggins case in which the head of the Chase National Bank at the time, Alfred Wiggins shorted over 40,000 shares of his own company and made millions in the markets. The funny part was that there was no law against this at the time and it prompted the creation of a Securities Law termed as the “Wiggins Acts”.

2.        The Great Bilzerian
We are all aware of the flamboyant Instagram playboy Dan Bilzerian but few of us know how his father Paul Bilzerian made the millions of dollars he would later bestow upon his sons. In the late 80’s Pauls Bilzerian was involved in several cases of stock parking and greenmailing in which he used takeover information he has to get companies to buyback their own shares from him at higher prices. He was sentenced to 4 years in prison and a fine of 1.5 million dollars, but he still had enough money to leave his sons 100 million dollar trust funds.

3.       The Greedy Journalist
The Foster Winans case is unique not because of the volume of damages caused but rather due to the curious way in which it was carried out. Forster Winnans was a coloumist for the wall street journal who wrote a weekly stock profile column. Winnans had such an impact on the market that the stocks he wrote about often went up or down according to the contents of his article. Eventually Winnans began to leak information about his upcoming articles to traders who began using this information to make insider trades from which they gave Winnans a cut of the earnings.

4.       The Christmas Debacle
In Dec 2011 two HSBC traders were involved in a currency front running scam (stocking up currency in anticipation of a future transaction) in a deal handled by HSBC on behalf of Cairn Energy which involved a merger-acquisition in which the Pound Sterling for the transaction was to be sourced by HSBC. The traders took advantage of this situation and bought the currency in advance, resulting in extra and illegal profits for themselves and the bank. They were recently apprehended by the department of justice and a sensational audio clip was recovered with one of the accused describing the deal as,” ohhh, f*****g Christmas”.

Who is the Police?

1  United States : Insider trading is dealt with very differently in different countries. States like the US have very stringent regulations about insider trading as they have a long history with it and we all can learn from them. In the US most of the regulation and legislation is handled by the SEC and the enforcement and prosecution is carried out by the department of justice.

2   European Union : In 2014 the European standardized the legislation for insider trading in its member nations through the Criminal Sanction for Market Abuse Act in which all EU member states agreed to introduced prison sentences of 2-4 years for Insider trading.

3  India : In India most of the regulatory and legislative duties are performed by SEBI, which was empowered in the wake of the Harshad Mehta Scam in 1992. In India securities market legislation and enforcement is carried out by SEBI which acts as a watchdog for most sectors of the financial sectors and protection of Investor Interests.

And…… What is the IMPACT of Insider Trading?

In a broader perspective the entire market is considered a victim of insider trading as directly or indirectly the entire market is affected by the price fluctuations and misappropriations caused by the misuse of information by privileged parties. However even though the traditional opinion is that loss of confidence in the markets caused by insider trading harm the average investor and in extension the economy might be misplaced.

Several prominent economists including the Great Milton Friedman have argued that insider trading is one of the closest things to a victimless crime that exists in modern society. The basic theory is, insider trading a way to correct information asymmetry. The fact that information can be distributed to the entire market by the actions of a few privileged information holders should be treated as boon and the buying or selling pressure for a stock will automatically become a source of information for an investor.

The argument to legalize insider trading makes several arguments from the perspectives of free speech, and the fact that insider trading on negative information might actually save a lot of investors a lot of money. In reality however we are far away from ever legalizing insider trading as the act of giving and unfair advantage to certain investors over others seems to be enough of a deterrent to stop and talk of the legalization of insider trading. Only time will tell if this level of liberalization will ever be accepted in the financial markets of the world.

Here is the turning point but..

Insider Trading is legal!! Wait wait before having any thoughts…please read the Terms & Conditions ahead……

The legal version is when corporate insiders—officers, directors, and employees—buy and sell stock in their own companies. When corporate insiders trade in their own securities, they must report their trades to the Regulatory Body of the Securities Market.

- Arko Biswas

Student and Core Committee Member of Finance Club, MISB Bocconi

Relaince Jio - A Masterstroke or An Upcoming Nightmare for Indian Consumer?

The SCENE

Probably it happened for the first time ever that “Idea” came in after action!! Are you amazed the same way like I was with this news? Ok, let me come to the center story without beating around the bush. Bharti Airtel slashed its 4G data offering rates by 80% and soon after, Idea cut its 3G/4G rates by up to 67%. Coming up next is Vodafone that is expected to cut data offering rates soon. And guess who is the devil behind this master game… Yes!! You you’re right!! Reliance Jio it is!!!

The Mukesh Ambani-led Reliance Group, with its revolutionary product – Reliance Jio, is giving sleepless nights to major service providers in the telecom sector. Even before its commercial launch, Reliance Jio claimed to have 15 lakh subscribers of its 4G network. The SIM card of Reliance Jio comes bundled with LYF smartphones priced as low as Rs 2,999. Jio is offering 90 days of free unlimited 4G mobile Internet and voice calling in the SIM cards. And now, this offer has been extended to OEMs like Gionee, Karbonn, Lava and Xolo. A pricing masterstroke it seems!!

But the real question here is whether this entire scenario of data rate cuts, driven by Reliance Jio, is really beneficiating Indian consumers!!

Government’s Expectations v/s Expected Reality

The Government of India is expecting to raise $83 Billion from the mega sale of mobile frequencies, the biggest ever auction, starting from October 1, 2016. There have been, however, building doubts on the success of spectrum auction raised by industry experts who say that the base pricing of the base airwaves is quite high.

There is still another big underlying story that is expected to affect the sale of this spectrum.

Aggressive price war to retain the market share has already led the highly debt-laden carrier companies to lower their tariff rates by a highly substantial amount which is expected to give a blow to the revenues of the carriers. (On August 30, 2016 i.e. a day after Bharti Airtel declared a slash in 4G rates by about 80%, its stock fell by about 3%).

(Source: Bloomberg)

Adding to the headache of these companies is the gloomy outlook on the telecom sector. As per a report published by Fortune, between 2012 and 2018, the Indian telecom sector is set to lose $386 Billion due to the increasing usage of services like Skype, WhatsApp, Lync etc. with data tariffs falling continuously as a result of the service providers getting in a fierce price war to retain their market share.

(Source: Bloomberg)

As per Bloomberg’s latest report, India’s 12 wireless companies carry more than $61 Billion in debt. A credit ratings agency – ICRA (A Moody’s Investors Service Company) had recently estimated that in the scenario of high debt already on the books of carrier companies, falling revenues from voice calls and now the aggressive data tariff cuts by the service providers, the carriers may spend just $9.7 Billion in the upcoming auction.

What the Industry has to say…

When asked about their strategy of future business in India due to shift of consumers’ attention from voice calling to VoIP, Vodafone’s Head of Organizational Effectiveness said that, “At the moment we realize that the telecom is increasingly becoming a cut-throat market, our present strategy lies in making Vodafone a leading market player in India.”

On Reliance Jio’s product rollout, Idea’s chairman Kumar Mangalam Birla said in an interview with ET Now that Idea is going to bid very sensibly in the spectrum auction. “We have got a larger player like Jio entering the market with a large presence on the ground, in terms of huge asset base, a player with very deep pockets and it is bound to be disruptive. So, I think for all of us incumbents, it is going to be a tough two years but it will be exciting to see how it plays out” said Mr. Birla in the interview on July 27, 2016.

Worrying on the level of return that the auction shall give, Telenor ASA has said that it won’t be bidding in the auction as the return are not up to an acceptable level.

As per the estimates of International Data Corp., the Indian smartphone base will reach to 600 million by 2020. This requires improving the coverage would hence be crucial for the service providers. While Bharti Airtel has not commented their stance on the upcoming auction, Sunil Sood (Managing Director, Vodafone) has said that Vodafone will bid for the spectrum. It is further expected that Vodafone shall turn out to be the largest bidder in the $83 Billion spectrum auction starting from October 1, 2016.

Government in a deep soup?

While it is expected that the carriers will bid for just $9.7 Billion in the auction, it directly implies that the government will be facing a blow of $73 Billion (a huge amount!!!) leading to failure (87% expected shortfall) of the biggest spectrum auction that has ever happened in India (a major event!!). This in turn will raise doubts on the capability of government to meet/fulfill its projected economic activities. (Doubts on the capabilities of one of the most capable governments?? Definitely not a good news!!)

Blogger’s Comments

Over and above this, recent reports of the least exploration of oil this fiscal year since 1947 has put speculation among market analysts who are taking caveats at meeting the future oil demands. This substantial fall in exploration (least in the past 70 years) will soon lead to a shortfall in the oil supplies. A global spending on exploration has been already cut to $40 Billion this year from about $100 Billion in 2014, and this is in turn mounting more doubts on the future outlook of oil markets. Global benchmark Brent stood at $49.59 a barrel on August 30, 2016. With expected drop in oil supply and growing demand, if oil prices go up by a notable amount, it would further add to the import bill (oil imports make up 80% of India’s import bill), doing nothing but increasing headache of Indian government in addition to its reputation getting hampered as a result of the expected 87% shortfall in bidding participation ($73 Billion blow) in the spectrum auction.

Higher Import Bill & fair exports (in the face of stagnant global demand) => Higher CAD => Impact on Forex Rates => Higher Inflation => Lower Real Interest rates => Lower deposit in banks => worrying bank outlook => lower loan growth => New RBI governor Dr. Urjit Patel will find it difficult to cut repo rates => Market will raise doubts on Dr. Patel as a good governor => Doubtful outlook on Indian Economy => Investments in the economy affected => Dr. Raghuram Rajan’s work goes in vain (No, we don’t want this to happen!!!)

From one scenario, where consumers are seemingly getting an advantage of the gigantic data rate cuts by the carriers, looking at the expected broader macro-economic data, does the consumer actually seem to be getting the advantage? Is Reliance Jio actually benefitting Indian consumer?

Amidst our speculations, let’s wait and watch what actually happens on October 1, 2016. Stay tuned!!   

- Harsh Pathak

  Student and Core Committee Member of Finance Club at MISB Bocconi - Bocconi India

Rejuvenating The Indian Economy #2013-16

Committee formed by: Reserve Bank of India 

Committee’s Official Name: Expert Committee to Revise and Strengthen the Monetary Policy Framework

Chairman: Dr. Urjit Patel, Dy. Governor of RBI.

September 5, 2013 was the day when Dr. Raghuram Rajan took charge as the 23^rd Governor of the Reserve Bank of India succeeding Mr. Duvvuri Subbarao. As soon as he took over, he had a mammoth task – strengthening the monetary policy framework so as to stabilize the Indian economy which had inflation already surging to the levels of 11% before he assumed the office.

So how did Rajan answer? Abraham Lincoln said that, “If I had 10 days to cut a tree, I would spend 9 days sharpening the blade of my axe.” Rajan seems to have had taken a similar route by doing his favorite thing – form a committee to find out the real problem and attack it with a complete strategy.

Result: A committee headed by the then Dy. Governor of the RBI was appointed and was named ‘Urjit Patel Committee’ (Well this was not the only committee; our governor seems to be a lover of committees which led him form a few which were led by Nachiket Mor, Bimal Jalan etc. to address issues of Financial Inclusion, Bank Licenses respectively) 

Let us however focus on our topic of interest – Why, in 2013, did Rajan take the route of keeping inflation under control to stabilize the Indian economy?

Have a look at what options the Urjit Patel Committee observed to to strengthen the framework,

Location: RBI Headquarters, Mumbai

(Raghuram Rajan who had taken a leave from his teaching profession at the University of Chicago Booth School of Business is now chairing the meeting as the Governor of RBI)

Time: It is the year 2013 when this discussion is being held

Conference starts….

RaRa: Urjit bhai!! Have you completed the assignment?

UrPa: Yes sir, we have completed our group assignment

RaRa: Cool! Kya socha hai?? Kaise aage badhe apni India ki economy strong banaane ke liye? (What has your committee thought Urjit? How should we move forward on making our Indian economy strong?)

UrPa: Sir….

RaRa: Sir matt bolo bhai!! I am not a professor right now….

UrPa: We have found out three main anchors to frame monetary policy

1.      Focus on Exchange Rate

2.      Focus on Monetary Aggregates (GDP, IIP, Exchange rate, inflation)

3.      Focus on Inflation

RaRa: Apun log toh abhi Monetary Aggregates ke basis pe monetary policy bana rele hai na!! (We were till now framing our monetary policy on the basis of Multiple Indicators, right?)

UrPa: Absolutely sir!!

RaRa: Again you are designating me as ‘Sir’!!

UrPa: Sorry sir!!

RaRa: Urjit!!! One more time you call me that and I will give you D Grade in your assignment..

UrPa: Ok then, I will address you as ‘Raghu’

RaRa: Sounds cool!!

UrPa: Yes, Raghu!! So now let me take you to the pros and cons of each of these strategies

1. Our dear Monetary Aggregates Anchor….

UrPa: Raghu, right now we go by this route and under this method we need to gather the following data to frame our monetary policy,

1.      Index of industrial production (IIP), Consumer confidence

2.      Professional forecasts about GDP, inflation, unemployment

3.      Inflation data: WPI minus food, fuel.

After this, the governor will design the monetary policy (mainly repo rate), with following objectives/focuses:

1.      Increase employment

2.      Increase GDP

3.      Stabilize inflation

4.      Stabilize exchange rate

RaRa: What!!!?? You know what Urjit, this is not how you control a developing economy!! This is a many-to-many function that I learnt in mathematics during my high school before I joined IIT; this doesn’t work for framing a monetary policy for a country like India…. Have you found out the limitations of this method?

UrPa: Yes Raghu, we have enlisted some of the limitations of this technique,

·     First of all, Monetary Aggregates has no nominal anchor. Under this, we have IIP data, GDP data, consumer confidence, WPI, exchange rate and many other aspects to concentrate upon in order to frame our monetary policy!! Till now we never knew where to focus upon… Therefore it was on a larger scale ineffective

·  Since this strategy does not have a particular target, RBI has to continuously change its monetary policy to take care of different groups in the country viz.,

Therefore, the panel recommends to dump this idea to focus on monetary aggregates.

2. Exchange Rate Method

UrPa: Raghu, if we adapt this method, you will have a tough time with importers and exporters

RaRa: Urjit, I think you are aware that in your assignment, you have marks for proper explanation as well!!!

UrPa: Yaar, main abhi bolne hee waalaa tha!! (I was about to come to this point!!)

RaRa: Go on Urjit…

UrPa(To RaRa): If RBI adopts this strategy/method to frame monetary policy,

·         Out of the blue, you will first decide an ideal target exchange rate say 1$=Rs.70

·         Then you’ll try to amend monetary policy to control rupee supply in the market.

But, in our economy where we deal with both imports and exports, in order to take care of our Current Account, you will have to continuously change the monetary policy to keep the rupee stable.

We are moving towards increased globalization, where we have to deal with foreign economies; an effect on the foreign economies will directly affect the exchange rate which will invariably put us under pressure for changing the monetary policies. Thus we will be continuously exposed and become vulnerable to global jeopardizes and then we will have a tough time answering Arnab Goswami for our continuously changing policies.

RaRa (checking UrPa’s concepts): But, our economy is highly dependent on oil imports and the same contributes largely to the import bill. If I keep the exchange rate higher (make Rupee stronger against the USD), won’t it benefit on the account deficit?

UrPa: Raghu, you’re right!! But we also have exporters in our economy. If we make the rupee stronger, it will directly have a hit on the revenues of exporters => their business will be hit => low export incentives => lower revenues from exports => no significant effect on the CAD => purpose not solved => common man unhappy => take a firing from government, newspapers and Arnab Goswami

This method,

·    Will not be able to control the food inflation within the country and this step will directly be the one which only takes care of imports and exports i.e. international trade

·    Works well for a small economies as their population is small.

·   Serves the purpose for export-oriented countries like China, that can keep their exchange rates lower to get competitiveness in the global market.

·  Also, if RBI’s statistical projections go wrong, we’ll have to make new adjustments in the exchange rates to arrive to a balance again

All this will lead to à Government will not get the real scenario of where the economy is moving => Steps will lead to high inflation => Real interest rates become negative; Aam Aadmi will start investing more in safe foreign havens =>  Imports increased => payments have to be made in Dollars => Continuous imbalance in Exchange Rates => RBI will have hard time controlling the imbalance => Mixed speculations about Indian economy in the global market => wild forex trading => RBI screwed….

RaRa: Control Urjit!! Control!! We got the point….Well done!!

UrPa (Just recovering from a World War kinda mood): Thank you Raghu!!

RaRa: So now as per your committee research, the Monetary Aggregates and Exchange Rate anchors are not the correct ones. So the only option left out is targeting Inflation. Right??

UrPa: Absolutely sir!!

3. Inflation

RaRa: Urjit, before you begin on this, I would like to interfere and like to know how you will move forward explaining this because it would be no point if you have not got your basics updated ….

UrPa: Sure Raghu, please raise your concern!!

RaRa: India has been considering Wholesale Price Index (WPI) for measuring inflation. I was stunned when even Arvind (Arvind Subramanian) was supporting this. This is actually not the way. WPI does not consider the direct effect on end consumer. It is more oriented towards the effect on the inflation that companies face due to increase in price. The actual parameter that serves this is Consumer Price Index (CPI). We need to now change our way of measuring inflation. Even the leading economies in the world are taking this route as a measure of inflation!!

UrPa: Raghu!! These are exactly the points that we have focused upon while framing our report and doing our research. We have here discussed targeting inflation keeping CPI as the measure of Inflation. Also, I would like to add that you had discussed the same in the report of Financial  Sector Reforms that was chaired by you back in 2009.

RaRa: Yeah!! I remember that

UrPa: Raghu, would you also like to throw a light on this and explain the base on this because we all members present here enjoy the way you explain…

RaRa: Ok, Task Accepted!! So all members present here, please listen how this works,  

In this strategy, we will decide a Nominal Anchor – specifically CPI, to monitor inflation. Then we’ll fix an inflation-target (which I want to know if Urjit and his committee have derived or not) and adjust the monetary policy so that inflation remains within that range.

·   Understand that RBI has the supreme power in framing the monetary policy and once we will set our aim on controlling inflation in a certain range, nobody (not even the govt.) will be able to influence us on what to do. But, being concerned for aam aadmi,we will ensure that we take needful steps and they are also not affected. It will be my task of explaining and winning the confidence of India on our team’s stance!!

·  It will be easy to track progress as the CPI data is released after every 12 days and we’ll have a timely check if we have framed our policy correct

·  Also, aam aadmi will be able to understand what we at RBI are doing and whether it yielding result or not…

(Now, Harsh Pathak is a guest attendant at this RBI meeting and is feeling very much enthusiastic on this discussion and explanation given by Mr. Raghuram Rajan and wants to know more from the newly appointed governor regarding this highly sought method of controlling inflation)

HP (to RaRa): Sir…

RaRa: Yes Harsh, tell me. You have been sitting patiently for a long time now listening to our discussion. Please feel free to ask your doubt.

HP (already totally overwhelmed by RaRa’s invite): Thank you sir. I wanted to know more regarding why we should concentrate more on CPI because even this has many problems…

RaRa: Ok, like?

HP: The CPI has more than 50% weightage on components that are related to food and fuel. And our economy, having a gigantic size of black market affects the food inflation on a large extent and then we have the Agricultural Sector which is the largest economy activity in India highly dependent on monsoon. We do not have any control on these factors, but only make predictions. How about that??

RaRa: This is a good question!! Look, in line with what Urjit explained,

·
  If we focus on controlling the Exchange Rate, we would be exposed to black market movement and the climatic conditions throughout the global economies which would be even worse and we would have to, every now and then, adjust according to the global movements, which would be even worse.

·         In multiple aggregators, we absolutely have no idea where we would be focusing and that is even worst. Hence, it would be better if we concentrate on CPI itself because like you yourself mentioned, it has >50% weightage on food and fuel components, with the help of which we would be able to track the effect of the same on end consumers and that will help us control the policy better

HP: But sir, don’t we have CPI for Rural and Urban separately? Where would RBI target? Rural or Urban?

RaRa: Urjit, would you like to interfere?

UrPa: Yes, so Harsh… as per our report’s findings, we would take into account both of them which would be released as a data called ‘CPI combined’. We will control that

HP: But then don’t you think that the results of the policy that you frame will take several months to start showing up? Because, the data will be released every 12 days while the results take several months to show up!!

RaRa: Yes, but then any method you choose, it takes time to show results. Here, as CPI directly shows the effect of policy on end consumer, and this data being released every 12 days, we can plan our strategies on policy and keep a perfect track of the consumer reaction and thus we will have control over what will show up after several months – because, We Will Have a TARGET  

HP: Ok sir, but won’t this need a proper flow of information across government statistical departments which is very inefficient today?

RaRa: I will take forward your word and we will have a joint discussion with the Prime Minister regarding this!!

HP (again overwhelmed and with dreamy eyes): Sure sir!!

RaRa: Cooool!! Let me however explain further why we need to target inflation through CPI

In the past 3-4 years after the Great recession, nearly all the developing countries in the world have been successful in bring their inflation down from extremely high levels. Only we are such a country whose inflation has soared to extreme levels. Because of this we have reached this position,

Higher inflation => real interest rates decreased => makes people invest more in safe foreign havens than deposit in banks=> increase in CAD => rupee weaken => expensive fuel because of expensive import bill  => expensive manufactured products => even more inflation => TARGET not met

Our inflation has grown so much that we have landed in a position where our banks are giving out negative ‘real interest’. So, if Indians deposit their money in banks, the future value of a common man’s liquid cash decreases. We have been recently out of the real estate and housing sector bubble and this may not be much favorable for an investor. Hence, people tend to invest more in gold which again contributes to increase in the import bill which lands up in the flow as stated above which leads to even more inflation.

I however have a very arduous task of cleaning up the balance sheet of our banks and it would be tough for me to accomplish this if a common man’s outlook on banks remains negative. Because, when people invest money in safe foreign havens instead of putting it in bank=> businessmen get less loans => less expansion => low employment growth (if not decrease in employement) => less growth in GDP => even worse outlook in the eyes of global economies => again the tough cycle

So, my point is that if we want to make our monetary policy framework strong and in turn to make our economy strong, we should target on controlling inflation by maintain CPI as desired.

HP: Sir, right now I am so much satisfied with your explanation that I would, after this meeting, request you to be my guide on understanding our Indian economy as well as the global economy. I however, at this moment, am eager to know what target are we planning to accomplish in this line of controlling inflation through CPI numbers….

RaRa: Urjit, please take over from here…..we want to know the findings of your committee in this line

UrPa: Sure Raghu!! So, as per our findings and research, we have decided on a range for containing CPI. We should target CPI at 4% and then maintain it in the range of +/- 2% and hence the range is 2-6%

HP: Sir, why have you defined a range and not a specific and precise number as a target. Like you target only and only 4%. Why this +/-2% range?

UrPa: Harsh, CPI takes into account the inflation number of an entire nation and it is measured on the basis of several parameters. This means in oreder to target a specific and precise CPI number, you will have to fix a specific and precise targets for each and every component of the entire nation, and then it was you yourself who said that we are exposed to climatic jeopardizes, so how can we achieve this?? Thus, we will need a room to accommodate such shocks….

RaRa: Cool Urjit!! Cool!!

HP: Agreed sir…

UrPa: Don’t worry guys, I’m not getting over-excited. This is my normal way of talking. (Smiles with wide face). So, hence we have defined a range for containing inflation i.e. +/- 2%

HP: But sir, why only +/- 2% and not something else?

UrPa: This is because,

·         Intense research has shown that a minimum of 2% inflation is desirable for any growing economy

·         An inflation means prices are growing steadily. This gives incentives to businesses to expand => more employement => rise in economic activity => increase in GDP with low inflation

·         Research has also shown that inflation beyond 6.6% is not desirable. This negatively affects the economic activities because if inflation goes beyond this and if the per capita Purchasing Power does not grow equivalently, this will lead to negative implications on the economy and is not good for the common man’s growth.

HP: Ohhh…. I understood your point. I was just about to ask if we can have negative inflation target. But now I understand that this is not good for growing business sentiment. Any other factor apart from business??

UrPa: You have been going so much conceptually till now…How did you miss out on understanding this?? And I am surprised that though being a Gujarati, you think apart from business

HP (confused and with a small grin): Yesss…

UrPa: Don’t worry, it is good to be sometimes confused over things!!

RaRa: Looks inquisitively at Urjit

UrPa (seeing Rajan’s reaction): No, never be confused !!!!

(The whole committee has a loud laugh)

UrPa: Yes, there are effects of negative inflation apart from only that on business. Listen, 

Like, if prices of everything fall, then customs duty, VAT, excise duty, service tax- their collection will also decrease. Then government has less money to spend on education, healthcare, social sector, defense, law and order which leads to consequences like poverty, crime etc.

HP: Ohhhh….quite interesting!!

RaRa: Urjit, any real examples in this line that you found out as an explanation?

UrPa: Yes, we have live examples of Chile and Czech Republic let me give you all an example of Chile

·         Chile was facing CPI inflation as high as 29% during the late 90’s

·         But in the early 2000s, the RBI of Chile made the target “3% CPI (With +/-1% band)”=2-4% CPI

·         From the following graph, one can see Chile’s RBI has successfully managed to contain inflation within that 2-4% level.

RaRa: How do you recommend to move forward on this?

UrPa: Sir, as per our committee discussion, we have come up with the following timeline to contain CPI numbers,

In short, 0/12/24 (months) =>10/8/6 (CPI)

RaRa: So you say that we need to frame our policy to achieve these numbers?

UrPa: Yes Raghu. Absolutely!!

HP: Sir, what do you intend when you say on framing a proper policy?

UrPa: Repo rate under Liquidity Adjustment Facility (LAF) is our policy rate.

·         Reverse repo(RR) = Repo – minus 1%

·         MSF=Repo +plus 1%

RBI should not change this +/- 1% spread between RR-Repo-MSF. (unless in extreme situation) because unpredictable policy making will be not good for banking sector’s own business plans and tactical projections

HP: And sir, how will this lead to our target of containing inflation?

UrPa: Look, first you need to be clear that when Repo rate is lower than CPI, That’s why its ineffective. This is what has been happening till now and that’s why we were having very ineffective handling of Indian economy and none of the monetary policy frameworks worked.

Therefore, to fight inflation repo rate must be increased. We recommend that Repo rate should be increased so much that its higher than CPI. In other words, difference between Policy rate (Repo rate) and CPI should be “positive”, Only then Policy rate can fight inflation.

Now let’s see how this performs,

Banks borrow less from RBI => Banks will increase their loan interest rates (to maintain their profit margin => Less business expansion => Less new jobs created => Less income => Less demand => Reduction in prices of goods and services to attract and retain customers.=> Inflation reduced

HP: Now, I’m confused. I was informed here that we do not want to create a scenario where employment falls and business sentiment goes down because of less borrowing. Also, our GDP numbers will take a hit in this scenario.

RaRa: Harsh, I think Urjit has a legit point here. When a child goes on a wrong track, it is necessary to take extreme steps to bring her/him in discipline. Our economy has also totally gone out of control and we will have to take steps to bring it in discipline. We want to make it sturdy and strong on way ahead and we want to make it globally the front runner. Hence we will have to take such steps

UrPa (Now taking a sigh of relief after hearing the positive note from the governor): Yes!! Indeed the reason to take such a step!!

(The whole RBI board gives consensus to this recommendation…)

RaRa: Cooool!!! So Harsh how did you find our job @RBI??

HP: Sir, you all rock!!! What a discussion!!

RaRa: Haha….that’s why they call me the ‘Bond of Market’. I Do What I Do!!

HP: I can realize that very well sir!!

RaRa: Which university are you from by the way Harsh?

HP: Sir, I am from MISB Bocconi and I am an aspiring MBA graduate with a focus on Finance as a specialization

RaRa: Cooool!!! Now that we have come up with a consensus on the way forward, let’s rock ‘n’ roll!!

- Harsh Pathak, Student at MISB Bocconi - Bocconi University