PORTFOLIOTALK

Impact of Credit Policy on the Indian Capital Markets

In the mid-term review of Monetary and Credit policy, RBI has proposed several issues of significance for the capital markets. Normally a policy of this nature tends to influence all segments of the market. Let us see how the policy is likely to impact the market from the eyes of a risk manager, a treasurer, a fund manager and an academician. The participants in the Portfolio Talk are: Chandru Badrinarayan, Head, Business Development, CRIS-RISC, CRISIL; NS Kannan, Treasurer, IClCI Bank Ltd.; Nilesh Shah, Fund Manager, Franklin Templeton Mutual Funds; and Prof. R Vaidyanathan, Prof. in Finance, Indian Institute of Management, Bangalore.

Reduction in the CRR would increase the liquidity in the system, which is placed at a comfortable level already. Despite the availability of liquidity, credit off-take was not seen even before the rate cut. What according to you could be the rationale behind yet another rate cut?
Chandru: The RBI's previously stated objective is to reduce. the CRR levels to minimum mandated levels of 3% and the current policy move seems to be in tandem with it. Thus, the present CRR cut seems to be more for structural reasons than to help revive credit offtake.

The present CRR cut seems to be more for structural reasons than to help revive credit off-take.

C Badrinarayan, Head, Business Development, CRIS-RISC, CRISIL.

securities and open market operations. RBI has promised to maintain legitimate requirement of credit. Probably in RBI's calculation of liquidity they have factored in the need to match traditional pick up in credit, which normally happens around Diwali time. This is probably the rationale for introducing a CRR cut of a quarter percent effective November 16, 2002 which will take care of any hitch in liquidity which may arise due to temporary off-take of Diwali credit. Vaidyanathan: The rate cut would help to some extent only. The sectors, which are growing at more than 7% in the last couple of years a re, trade [wholesale and retail], transport [non Railways], hotels and restaurants and construction and other business services. All these activities require significant amount of funds and they need to be financed based on anticipated cash flows and not on asset based financing. Our banking system has not put in place risk management systems for "cash flow" based lending. By and large they are geared to lend for manufacturing activities and also based on assets as collateral. It is also to be noted that the market knowledge and information regarding these activities are not fully available with the commercial banker on an updated basis. The typical bank manager of public sector bank has a two-to-threeyear tenure in a particular branch and is also shifted across activities like foreign exchange, administration, agricultural finance, personal banking, training, industrial lending etc. By and large, the public sector banks have been geared to "asset-based lending" rather than lending based on the forecast cash flows. This is all the more true of such activities like trade, transport, hotels and restaurants, construction etc., where there are significant fluctuations in the

NS Kannan: The rate cut shows the importance given to adhering to the time table for gradually bringing down the CRR to 3% level as mentioned in the Tarapore committee recommendations. Further, RBI has been providing the system with ample liquidity and guiding a soft interest rate policy framework. CRR cut reiterates the commitment to this overall policy. CRR cut assumes great importance in this overall context. Nilesh Shah: The present liquidity in the market is courtesy the growth in the foreign exchange reserves. Foreign exchange reserves have jumped by almost $10 bn from the beginning of the year. RBI has been sterilizing this liquidity via the auctions of government

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cash flows on a daily basis, In other words, risk assessment capabilities are not adequate in the context of these activities. Also, funds need to be available to these players without much paperwork and based on personal assessment. These activities are mostly financed by the Non-Bank Finance Sector NBFS,

Investor sentiment plays a key role in giving direction to the stock markets. NS Kannan, Treasurer, ICICI Bank Ltd.

The cut in the CRR is likely to increase the liquidity in the system by almost Rs. 3000 cr. The question arises, is the equity market going to benefit from this? Chandru: No, the equity market would hardly benefit from this move. There are mainly two reasons for this. Expecting interest rates to dip further, the beneficiaries of this CRR cut viz., banks find investing in the Debt market more attractive than doing so in the equity markets. Secondly, banks and institutions are yet to recover from the 2 -year old equity market irregularities and have adopted a cautious attitude towards funding equity markets directly or indirectly. NS Kannan: While lower interest rates should normally help equity markets, experience both in India and in developed countries like US, Japan has shown that equity markets always do not gain on account of lower interest riltes and ample liquidity alone. Investor sentiment plays a key role in giving direction to the stock markets. Nilesh Shah: The Equity market need not benefit only from the systematic liquidity. Traditionally though there is a linkage between the Systematic liquidity and the Equity Index, however the decoupling has started happening. Equity markets will be driven more by the fundamental valuations and the prospects of the economy. The systematic liquidity could be one trigger but it cannot be the sale driver for the Equity market to move northwards.

bankers are cautious about lending to / investing in equity markets after the recent experiences of some of the cooperative banks. The Repo rate, which serves as a benchmark for the short-term interest rates have been reduced. How is it going to affect the state of money market and investors of Money Market through Mutual Funds? Chandru: The RBI's repo rate has emerged as .a powerful short-term interest rate signaler in recent times. Debt markets have eagerly lapped up the RBI's present and we have seen Gilt and Corporate bond prices zooming from pre-policy levels. However, investors in money market or Liquid mutual funds would stand to gain far less than their counterparts in Gilt mutual fund, mainly as call rates peg themselves to the RBI's repo rate and most Liquid funds have substantial investments in the overnight call markets.

Nilesh Shah: The cut in the Repo rate will have an impact on the entire gilt curve. If we see the Indian Government securities curve it is very flat in nature. The difference between one and twenty year-paper is pretty low at less than 200 bps. World over that difference has been fairly higher. The short end of the curve have been artificially boosted by the Reserve Bank of India by accepting large amount of liquidity in their daily repo auctions. By reducing the repo rate it will have an impact on the entire yield curve. It will also ensure that the shortterm rates will come down in future, The lowering of short-term rates will definitely impact money market mutual funds in a negative manner. Henceforth their incremental investments will be done at rates, which will be lower. Vaidyanathan: The reduction may not affect much since this was factored in already by the MMMF and other market players.

NS Kannan: The cut in repo rates The CRR cut is likely to have would lead to call rates finding a new . been aimed at allowing the anchor rate of around 5.5%. government to borrow at a Simultaneously other short-term rates cheaper rate. But don't you think that denoted by various instruments like Cp, the falling yield on the papers is likely T Bill, CD and swap rates (Mibor and to do harm to the common investors, Mifor rates) would tend to be lower. especially those who invest in debt While existing investors in MMMF mutual funds? would get the benefit of lower rates Chandru: First of all. if the RBI through higher NAVs, the new investors wanted to engineer cheaper government would get lower returns on their fresh borrowing it need not have resorted to a investments. cut in the CRR in Vaidyanathan: The Equity market may not significantly benefit out of this since December 2002

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current times. It could have always added the 3000 plus cr through means other than CRR such as Repo or purchase of securities through Open Market Operations. Second, falling yields will fetch lesser returns on fresh investments or reinvestment of interest incomes. However, for those holding government paper or any other negotiable instrument, the capital appreciation would adequately offset this reinvestment risk and provide an excellent exit. opportunity and return till date. Investors in debt mutual fund therefore stand to reap windfall benefits. NS Kannan: By and large commercial Banks, Insurance companies and NBFCs invest in GOI Sec. Lower interest rate in the system helps them in bringing down the cost of their liabilities and hence it may not impact their profitability in the medium-term, if duration adjusted investments are made by them. Very limited investments are made by retail investors in GOI Sec., directly. Gilt funds have been showing higher return to investors over a period of time and hence investors may not immediately withdraw the money from them unless big interest rate shock drives down the NAVs of these funds. Other debt funds invest in corporate papers as well and as long as the interest rate remain soft and steady the investor should get higher return on tax-adjusted basis when the investment is made in growth schemes.

Falling interest rates can pop up the equity market and investors can benefit by way of higher equity valuation.

Nilesh Shah, Fund Manager, Franklin Templeton Mutual Funds.

falling rate regime. The Debt funds have all delivered double digit returns, which are quiet spectacular. However, their incremental investment is also done at a lower rate and if and when the interest rate starts rising that will have a negative impact for the investors. However, falling interest rates are not necessarily bad for investors. Falling interest rates can pop up the equity market and investors can benefit by way of higher equity. valuation. Investors will have to look at a portfolio approach to their investments. They will have to have exposure to the debt market, as well as to the equity market. When the interest rates start falling the equity market will go up and net investors will still be OK. When the interest rates start rising the equity market probably will fall but net investors will still end up making the same money. So. for investors the key to generating returns will be right balance between the equity and the debt market rather than complete exposure in debt market or equity market. Vaidyanathan: In a sense the position of elderly is getting affected since the deposit rates are falling and savings rates like PPF etc., are affected. Government may be able to borrow at comfortable rates but the important point is whether they are put to 'productive' use. If the borrowing is used essentially for current consumption then the borrowings at reduced rates are not gong to help public at large.

The credit policy has clearly

Nilesh Shah: The CRR cut has been done to maintain adequate liquidity to meet the legitimate credit requirement. Clearly the interest rates have fallen over last couple of years by more than 700 bps. The biggest beneficiary of falling interest rate regime is the biggest borrower viz., Government of India. Investors have benefited as well as lost in falling, interest rate regime. The present value of their investment has appreciated handsomely in view of

mentioned that the "Sensitivity of the Lending Rates to further changes in the Bank Rate is now relatively weak", suffices to say that we are almost at the hottom so far as the interest rates are concerned? In this scenario, do you think there will be an investors' preference towards floating rate notes, assuming the rates can move only northwards, in days to come? Chandru: The statement clearly cannot be interpreted as meaning that interest rates are poised to rise from here. Rather, the policy statement talks about the weak transmission mechanism or the weak influence of the RBI's Bank Rate over the Prime Lending Rate of Commercial Banks. Investor preference towards Floating Rate Deposits is also a function of the transparency and understanding of the 'Benchmarks' used in Floating Rates. Ideally, these benchmarks should be by reputed third party neutral agencies. Very few investors can be expected to trust floating Rate Deposits pegged against a benchmark such as the PLR of the same bank, which is the case most often. In the event of a bank utilizing a third party benchmark for their floating rate deposits, investors would prefer the same when interest rates rise.

NS Kannan: In any case, well informed investors would do well to invest in floating rate instruments at.least some Portfolio Organizer' December 2002

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potion of their savings. This would be integral part of a prudent investment strategy. Unfortunately, the market risk management tends to take a back seat in long periods of continuously declining interest rates. Having said that, given the overall liquidity scenario in the system, but for strong event risks, investors may still expect a low interest rate regime. Nilesh Shah: We do not share the view that interest rates have bottomed down. Interest rates needs to be viewed in three contexts:

Government may be able to borrow at comfortable rates but the important point is whether they are put to 'productive' use.

R Vaidyanathan, Prof. in Finance, Indian Institute of Management, Bangalore.

economy. The threat to that equation is in the form of inflation and as inflation becomes a non-issue with the productivity growth and also integration of global markets RBI can sufficiently ease monetary policy to ensure low single-digit interest rates. The third point is available liquidity. We expect Indian foreign exchange reserves to go up foreign exchange reserves are already at $65 bn plus and are expected to reach $75 bn. Now with the incremental liquidity coming into the system. and not much of credit growth happening this availability of liquidity will keep interest rate low. We expect interest rates to move southwards courtesy a willing government who is the biggest beneficiary of falling interest regime, liquidity which will primarily be driven by Higher foreign exchange reserve growth and higher real interest rate differentia. Vaidyanathan: There is a perceived preference for floating rates but the important point about such a scheme is the "anchor rate" and in India the aggregate yield curve is not yet a settled issue. business cycles and market cycles. Interest rate cycles are no stranger to this. The trick however is to predict the turnaround in the cycles. The current dip in interest rates has been unprecedented in so many ways. Though there is plenty of conventional logic pointing to a further dip in interest rates, intuitively one feels that interest rales are nearing a turnaround. For an investor with a 3-5 ~:ear horizon this seems to be the right time to switch from debt to equity. However, an investor who is less averse to risk can continue to ride the debt market. Plainly put, as time goes by the risk of being invested in the debt market continues to rise. NS Kannan: It is very difficult to predict the performance of other funds, as the performance would depend on the quality, duration and strategy of the funds and how much of proactive" trading is being undertaken by these funds. Equity markets would like to watch closely the developments before and after the run up to the budget and the policy changes affecting the market sentiments. Divestment activity would be closely watched. Gilt funds could perform better if interest rate on GO! Sec., drop further from here: Other debt funds' performance would depend on GOI Sec., rates and credit spreads dropping further from current low levels.

. .

The real interest rates. Credit worthiness of Government. Interest rate as a function of liquidity.

If we see the real interest rates in India they are averaging somewhere around 4% to 4.5% World over the real interest rates have moved around 0.25% to 2.00%. India is already taxing its exporters by way of infrastructures bottlenecks and lower labor productivity. If we compound the fact further with higher interest rates the exports will become uncompetitive. Clearly there is a need to reduce real interest rates which effectively" means reduction in the nominal interest rates. Now the second point is the ability of the government to service its debt. The government has a fixed expenditure defense salary pensions, subsidy and interest payments. If you remove those components out from its revenue income very little amount is left for servicing the interest rate. Now either the Indian Government goes bankrupt like the Argentinian Government or the government reduces the interest rate to such an insignificant level whereby servicing of loan becomes non-issue. I think India is moving more towards that direction where the interest rates will continue to decline and a stage will come at a time where the interest rate will be in lower single digits numbers more comparable with the developed economies rather than a developing

Last year, on the back of successive rate cuts, debt mutual funds could outperform equity mutual funds across the board. How do you foresee the performance of such schemes vis-vis the equity schemes in days to come? Nilesh Shah: Performance of debt funds Chandru: Talking in a broader sense, and performance of equity funds are two historically we have been witness to separate things. Its like

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- -PORTFOLIO TALK comparing oranges and apples, debt mutual funds are different and equity funds are different. Equity funds are essentially high risk high returns investment options, Debt funds are steady products, they are there to provide safe return with low volatility and clearly there is no way an investor should confuse a debt fund vis--vis equity' fund, As explained earlier the key to sustainable return is a right balance between debt and equity. You need to invest long-term money in equity for generating higher return, Equity funds is a good long-term bet. But at the same time you need to put money in the debt funds because it will give you sustainance, it will give you ability to meet your short and medium- term requirement. So both the debt and equity funds have a place in the portfolio of investors, Vaidyanathan: The performance of equity or debt funds is importantly linked with the performance of the economy and the industrial sector rather than only on rate issues. The industrial sector should perform well and reach more than 5'% for equity to perform well.

Do you expect any innovation taking place in the fixed income market, speaking from the point of change in regulation, investor awareness or any other initiative to increase the efficiency of the services? Chandru: Debt Index Futures to better hedge interest rate risk, wider participation of PSU Banks in the Interest Rate Swaps market. better clearing and settlement systems for retail investors, Real Time Gross Settlement System. Better Risk prediction systems. Demystification of the Fixed Income market by market forces. Listing and trading of Indian gilts abroad end vice-versa, are top of the mind envisaged scenarios.

we could see several participating (and hence deepening) in the fixed derivative markets,

players market income

Nilesh Shah: Yes, we do expect lot of changes happening in the Fixed Income market in India which will bring more transparency awareness more products to suit the investors requirement We see on a broad basis. We see encouraging developments in;

. Securitization market. . Interest rate derivative market. . Strips in gilt market. . Leveraged mutual funds. . Dynamic mutual funds.

NS Kannan: Listing and trading of interest rate futures and options. strips trading would emerge as major areas in fixed income market. We may also see emergence of market makers. We could also expect higher level of trading in corporate bonds, down the rating spectrum. With more and more awareness of market risk management,

Vaidyanathan: The fixed income market could undergo changes in the next few years given the changes in the screen-based system and integrating the private placement markets and enhancing the corporate paper market. It has a long way to go but the debt market would get its due place. The views expressed here are that of the participants and not necessarily that of the organizations they belong.

Fourteen Pages to Fame The most famous insight in the history of modern finance and investment appeared in a short paper titled, "portfolio selection". It was published in the March 1952 issues of the Journal of Finance", the only Journal then in existence for scholars in the field. Its author was an unknown 25-yeer 'old graduate student from the University of Chicago named Harry Markowitz. No one including Markowitz was aware that his paper would turn out to be a landmark in the history of ideas. Investors face an especially cruel trade off, and that was what attracted Markowitz. Nobody gets rich squirreling money away in a saving account. So investors cannot hope to earn high returns unless they are willing to accept the risks involved, and risk means facing the possibility of losing rather than winning. But how much risk is necessary? The answers Markowitz developed to these questions ultimately transformed the practice of investment management beyond recognition. The title Markowitz gave his paper reveals him as an innovator. The article focused on how to select a 'portfolio', a collection of assets, rather than on how to select individual stocks and bonds. His analysis shows precisely how investors can combine their hopes of realizing the largest possible gain with exposure to the least possible risk.
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Although his achievements would earn him a Nobel prize in Economic Science 38 years later, the paper languished for nearly 10 years after publication, attracting fewer than 20 citations in the academic literature. Source :' Peter L Bernstein in 'Capital Ideas'. The free press publication. A division of MacMi/an Inc, New York.

Portfolio Organizer' December 2002