What will happen in 2014?

Everyone is preparing to say good bye to 2013

What an year from economy and stock market perspective!! Rupee crashed to records low during the year, but recovered. Economy growth recorded sub-5% levels, unimaginable couple of years ago. However, stock market - Nifty touched near record highs; although general market stocks continue to be sluggish. Inflation continues to be higher despite hike in interest rates.

I remember getting a presentation at the beginning of the year from a mutual fund who painted a very rosy picture for 2013. It stated that the banks will have a nice time because the interest rates had reached a peak in 2012. Because of the reversal of interest rate cycle in 2013, the economy growth would recover in India and this would lead to new stock market highs. It also predicted that Indian Rupee will strengthen to Rs 50/- due to the robustness in the economy.

How different or mixed was performance actually we witnessed. The interest rates were hiked as the 'black swan' of current account deficit hit the economy hard. Subbarao tried several tricks; however did n't had much impact.

Luckily, the change in guard in the RBI brought in some fresh and innovative thoughts and the actions taken by Raghu Ram has worked and controlled the devaluation of Indian Rupee.

One of the policies, Raghu Ram is also following is that of 'elevated' interest rates, which really hurts the economy. What is the reason for higher interest rates? Well it is a text book solution for several economic ills. One reason is inflation and the other (to a lesser extent) is the currency related reasons.

Financial thoughts still believe, inflation cannot be controlled by interest rate hike alone.

As we have mentioned in the previous posts in this blog, hiking of interest rates since 2010 achieved only lower and lower economic growth; inflation stubbornly holds its ugly head high. So, the interest rate hike is not a panacea for inflation - or it must be treated with other medicines as well. Well there is one medicine that can work - increase the supply side to ensure that too many cash is not chasing a few goods and services. But this is something the government policies must take care of. However, government is delaying its projects while private sector is not encouraged to take risks when even the reputed personalities like Kumar Aditya Birla is chargesheeted. Many construction contractors and villa project developers are also raided by Income-tax. India is a place of lot of opportunities; but be prepared !

So, part of the solution to the inflation also lies in good governance. Indians will get a chance to reduce the inflation by changing the current government and ushering in a more dynamic and proactive government.  It looks like Modi can deliver - although his election may make the minorities uncomfortable; nonetheless this is a risk that can be taken in view of the overall good of the country. Moreover, coming from the place of Gandhiji, he ought to show tolerance.

Then there is imported inflation - higher the devaluation, higher the inflation as 80% of the oil & gas requirements are imported. Hence, currency stability is a MUST. But the tapering threat is real and tapering has to happen. The good news is that Raghu Ram is preparing India for this big event. The defences are almost ready. CAD has reduced to about 3% now (from 6% during April 2013) and he has some more tools for fighting it out should the currency comes under attack.

So what would be the 2014 prospects be? Well of course, mutual funds and other stock market pundits will definitely come out with predictions that will look rosy due to several reasons. Financial thoughts will share the views shortly. 

Difference in Approach

No one doubts the entrepreneurial ability of Lakshmi Mittal. From a small steel factory in India, he has created a blistering business career in the global steel industry.

After establishing himself abroad as the Steel Baron , in 2005 Lakshmi Mittal came to India to set up a $9 billion investment to build a greenfield steel plant with a 12 million tonnes per annum production capacity. It was his dream project in his home country India. This would have created hundreds of thousands of jobs and would have added a few basis points to the Indian economic growth. However, Indian political web was so complex that after struggling in vain till 2013 (almost 8 years) Lakshmi Mittal surrendered his wish / desire of a 12 million tonnes steel plant. As Financial Thoughts understand Lakshmi Mittal has decided not to go ahead and criticized the Indian politics and decision making system harshly.

Now let us travel half-way across the globe and see how Lakshmi Mittal is treated. 

"I want to thank your CEO, Lakshmi Mittal, for investing in America and the Cleveland area," 

Obama said during his visit to the ArcelorMittal Cleveland Steel Factory in Cleveland, on 16 Nov 2013.

This year alone, the company has invested $70 million, resulting in creation of 150 new jobs. US president himself welcome and thanked Lakshmi Mittal for launching / rescuing steel mills and creating jobs.

Hope Indian politicians will learn from Obama as to how to treat business people who creates job and wealth for the nation.

Sharp Recovery in Indian Rupee - does it pose new challenges?

Indian rupee has recovered appreciably from the low of 68.845 on August 28. One of the important reasons is the policies initiated by new RBI Governor, Raghuram Rajan, a former International Monetary Fund chief economist credited with predicting the 2008 global financial crisis. His strategy was to attract substantial dollar inflow into the country through an attractive FCNR deposit scheme. Even banks (e.g. ADCB) in foreign countries such as UAE snatched the opportunity to launch leveraged FCNR deposit schemes which provided annualized returns between 12%-30% to those who opted for such schemes.

While several other nations opted for sovereign bond issue at similar junctures, Rajan prudently shifted the burden away from Govt. It is pertinent to note that the countries such as Italy who opted for Sovereign Bonds landed in trouble years later.

Indian Rupee now stands at around Rs 61/-. It looks like the bearishness in the Indian rupee is gone (at least in the near future) as Morgan Stanley's Kendrick forecasts the rupee will rally to 58 per US dollar in coming months. Whilst Rajan has stated that he is not a 'superman', his actions speaks volumes and he has a lot of proven expertise in the market and this ought to be a differentiating factor going forward.

It looks like those who are nervous about Indian Currency's future can take a sigh of relief.

Soon he may face another (rather unlikely, yet not impossible) problem of too much strength in rupee - because the economy is weak and too strong a rupee may not be good for economic growth.

Risk Management Course

Recently, I have taken a nine days intensive Risk Management Course for MBA students (S.P.Jain University; Dubai).  17 participants enriched their experience and learned new concepts in risk analysis and management.

Credit Risk, Market Risk, Operational Risk, Liquidity Risk and related topics were covered. The concepts such as Var, PD, EL, etc. were narrated with practical examples. Several case studies, including HBR case studies were analyzed by students 

Lot of handouts / lecture notes were also given on different topics such as Value at Risk, Market Risk, Different Methodologies of Value at Risk, Different techniques of Credit Risk Assessment, Credit Metrics, KMV, Operational Risks, etc.  

Value @ risk and its variants

Suppose you are going to initiate a trading position of $ 100 million involving market risk. What is the important question in your mind as you initiate this trading position?

Of course, you will be interested to know, how much you may lose on this investment.

This is a question that every investor asks when considering investing in a risky asset. Value at Risk tries to provide an answer to this question.

We will examine the following in this paper:

•           An overview of VaR

•           Pros & Cons of three methods used to estimate

WHAT IS VALUE AT RISK?

Value at Risk measures the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval – say 95%.

What does this 95% signify?

Say for example you have calculated VaR on an asset of $100 million.  Daily Var at 95% confidence level is $ 1 million. What does it mean?

It can be interpreted in two ways:

·         There is 95% chance that the value of the asset will NOT drop more than $1 million over any day.

·         Or, there is 5% chance that the value of the asset will drop more than $ 1 million over any day.

While Value at Risk can be used by any entity to measure its risk exposure, it is used most often by commercial and investment banks to capture the potential loss in value of their traded portfolios from adverse market movements over a specified period.  The focus in VaR is clearly on downside risk and potential losses.

There are three key elements of VaR – a specified level of loss in value, a fixed time period over which risk is assessed and a confidence interval. The VaR can be specified for an individual asset, a portfolio of assets or for an entire firm.

MEASURING VALUE AT RISK

There are three basic approaches that are used to compute Value at Risk, though there are numerous variations within each approach.

Approach I - Variance-Covariance Method (Risk Metrics fame)

Value at Risk and the usage of the measure can be traced back to the RiskMetrics service offered by J.P. Morgan in 1995. Publications by J.P. Morgan in 1996 describe that ther eturns on individual risk factors are assumed to follow normal distributions.  

Advantages & Weaknesses

The strength of the Variance-Covariance approach is that the Value at Risk is simple to compute, once you have made an assumption about the distribution of returns and inputted the means, variances and covariances of returns. However, there are three key weaknesses:

•                      Wrong distributional assumption: If conditional returns are not normally distributed, the computed VaR will understate the true VaR.  There could be far more outliers in the actual return distribution than would expect.

•                      Wrong Inputs: Even if the normal distribution assumption holds up, the VaR can still be wrong if the variances and covariances estimates are incorrect.

•                      Dynamic variables: A related problem occurs when the variances and covariances across assets and securities change over time. This is not uncommon because the fundamentals driving these numbers do change over time.

Approach II – Historical Simulation Method

To run a historical simulation, we begin with time series data – for example daily change in the price of the underlying. The key aspects of the historical simulation approach are:

•                      Assumption of normality is NOT needed.

•                      The second is that each day in the time series carries an equal weight when it comes to measuring the VaR

•                      Basically it is assumed that the history may repeating itself

Advantages & Weaknesses

Historical simulations are relatively easy to run, however they do have its weaknesses.     

a)      Past may not repeat: While all three approaches to estimating VaR use historical data, historical simulations are much more reliant on them than the other two approaches. For example, a portfolio manager of Oil Corporation that determined its oil price VaR, based upon past data would have been exposed to much larger losses than expected over during 2008 oil volatility. During July 2008, oil prices touched record high of $147/- per barrel but dropped below $ 40 during Dec 2008.

b)      Ignores Trends in the data: The approach takes all data points with equal weight. In other words, continuing the oil price example, it is assumed that the price changes from trading days in 2007 affect the VaR in exactly the same proportion as price changes from trading days in 2008. If there is a trend of increasing volatility, we will understate the VaR.

c)      New assets: The historical simulation approach is not suitable for new risks and assets because there is no historic data available to compute the Value at Risk. 

Approach III - Monte Carlo Simulation

Monte Carlo simulations rely on simulations to build up distributions. Once the distributions are specified, the VaR process starts. In each run, the market risk variables take on different outcomes and the value of the portfolio reflects the outcomes.

After a repeated series of runs, numbering usually in the thousands, you will have a distribution of portfolio values that can be used to assess Value at Risk. For instance, assume that you run a series of 10,000 simulations and derive corresponding values for the portfolio. These values can be ranked from highest to lowest, and the 95% percentile Value at Risk will correspond to the 500th lowest value and the 99th percentile to the 100th lowest value.

The strengths and weaknesses of the simulation approach apply to its use in computing Value at Risk. Quickly reviewing the criticism, a simulation is only as good as the probability distribution for the inputs that are fed into it. While Monte Carlo simulations are often touted as more sophisticated than historical simulations, many users directly draw on historical data to make their distributional assumptions.

Monte Carlo simulations become more difficult to run for two reasons. First, you now have to understand the probability for several (running into hundreds) market risk variables. Second, the number of simulations that you need to run to obtain reasonable estimate of Value at Risk will have to increase substantially

CONCLUSION

Are the estimates of Value at Risk same under the three approaches?

Historical simulation and variance-covariance methods will yield the same Value at Risk if the historical returns data is normally distributed. Similarly, the variance-covariance approach and Monte Carlo simulations will yield roughly the same values if all of the inputs in the latter are assumed to be normally distributed with consistent means and variances. As the assumptions diverge, so will the Var.

Which approach is the best to estimate of VaR?

The decision depends upon the risk manager, based on the task at hand. 

-          If you are assessing the Value at Risk for portfolios, that do not include options, over very short time periods (a day or a week), the variance-covariance approach does a reasonably good job, notwithstanding its heroic assumptions of normality.

-          If the Value at Risk is being computed for a risk source that is stable and where there is substantial historical data (commodity prices, for instance), historical method is suited.

-          If the historical data is volatile and dynamic and the normality assumption is questionable, Monte Carlo simulations do best.

Indian Rupee Fall - Poor RBI policies under Subba Rao

Indian Rupee is now 65 against dollar. This is a sharp fall from the 54 levels in late April 2013. This paper examines the following:

1.       Reasons

2.       Possibility of 1997 Asian or 1998 Russian crisis

3.       Unofficial Indian Funds Abroad' - A potential game changer

4.       Beneficiaries of the current fall in rupee

5.       Future Outlook

1.  Reasons

During 2005/6 period, the Indian Rupee (INR) had touched 40 levels which triggered a panic among exporters. It is stated that this was due to the weak dollar. During those days there were talks in GCC to remove USD peg. Thereafter the QE also increased the supply of the USD in the market. Thus abundant USD had made USD cheaper against INR. Moreover there were heavy demand for INR due to portfolio investments. Now the INR is under pressure due to lower Indian growth rate, which doesn't attract portfolio investments. On the other hand the portfolio investments seem to exit India. There are of course other factors such as tapering of QE by US Fed Reserve.  

2.  Remote Possibility of 1997 East Asian or 1998 Russian crisis

-         Short term currency exposure was high in both Asian and Russian crisis. The sudden exits created panic in the market. However even after settling the short term currency exposures there is sufficient  cushion in the current Indian situation.

-        East Asians also had high current account deficits and too much overseas debt. Quite a lot of overseas liabilities were of private businesses. In India, overseas corporate debt is relatively less and it amounts to only 29 per cent of all overseas obligations. Moreover vast majority of Indian corporates never tried overseas market due to strict criteria such as External Rating requirements, etc.

-         Short-term overseas debt was also very high in East Asia. World Bank data says short-term foreign debt respective to official foreign exchange reserves was high at 204 per cent in June 1997 for Korea, Indonesia (170 per cent) and Thailand (145 per cent).  As on today official Indian reserves are $ 280 billion and the short term debt is just a fraction of this amount!!

-         Private sector debt was too high for the Asian tigers. But Forex Debt to Exports ratio is much favourable in India

3. Unofficial Indian Funds Abroad' - A potential game changer

 

It  is an open secret that rich Indians and some of the leading politicians hold billions of dollars outside India. It defeats all logic for stacking up billions in Swiss & other European banks yielding low returns, this will have a positive impact on Indian currency situation. This category of unofficial funds range from $500m to $1.4 trillion.

 

See the link http://www.khaleejtimes.com/displayarticle.asp?xfile=data/international/2012/February/international_February536.xml&section=international&col

 

or http://timesofindia.indiatimes.com/india/Black-money-Indians-have-stashed-over-500bn-in-banks-abroad-says-CBI/articleshow/11871624.cms

 

Some of these funds will flow into the country at these levels . Another possibility is that Indian Govt will start initatives to attract some of these funds into India - this will be a game changer

This is over and above the normal NRI flows that have already gone up – if the NRIs including those who stacked millions abroad in Swiss Banks channel some funds into India, the crisis is over.

4. Beneficiaries of the current fall in rupee

Whilst NRIs, Software Industry & ancillary services, food, spice & related exporters, Pharma, etc will benefit, there is a different class of businesses who invested abroad since 2007 will also benefit.

Several leading Indian business groups - big and small - had invested abroad. The investments span across the globe including UAE, Qatar, Kuwait, UK, USA, Australia, Brazil and so on. These foreign assets are now having sharp value appreciation. A sample is given in the following table.

In fact this may be the right time for Tata Steel to offload its Corus Group investments, if it believes that this overseas investment will continue to be a drag on its profitable Indian operations.
 
 5. Future Outlook



Unreliable finance media in India

First of the financial media is unreliable - better to ignore most of their utterances. I have been watching what the financial media was saying ever since 5% growth was announced in Feb 2013. It was repeated in May 2013. The media said that Indian growth is much better than ‘mature economies’ and that Indian stock / business valuations were the cheapest in the ‘emerging markets’.  No sign of any panic – but since late June the mood changed suddenly with all kinds of negatives filling the media and with the foreign funds withdrawing to the better growth prospects “mature economies – read US and Europe’ India looks doomed.

This again reflects the fact that what financial media harps may be misleading. The real reactions of the investors are short term. 80:20 principle is applicable. 80% of the market moves are based on the reactions of the 20% of the investors. Such investors include grand daddies in the game such as Goldman Sachs and JPM.  

Beyond Headlines

-          Earlier this year Goldman sachs said Nifty to touch 6600  by year end;

-          JPM stated in August that Indian banks are now good buys

-          GS Singapore subsidiary buying into the Yes Bank. - it is a positive vote for Indian banking system.  http://www.moneycontrol.com/news/buzzing-stocks/goldman-sachs-singapore-buys-1862-lakh-sharesyes-bank_939300.html

Foreign Exchange Reserves

 Changes in FX reserves is critical Latest data as on 23 Aug shows a comfortable position as follows:

2. Foreign Exchange Reserves
Item	As on August 16, 2013		Variation over
			Week		End-March 2013		Year
	` Bn.	US$ Mn.	` Bn.	US$ Mn.	` Bn.	US$ Mn.	` Bn.	US$ Mn.
	1	2	3	4	5	6	7	8
1 Total Reserves	17,221.1	278,807.5	194.4	205.8	1,336.9	-13,238.7	1,125.5	-10,111.9
1.1 Foreign Currency Assets	15,551.4	251,561.1	190.2	211.7	1,425.1	-8,164.8	1,255.6	-5,095.7
1.2 Gold	1,267.9	20,747.0	-	-	-129.5	-4,945.0	-167.2	-4,967.7
1.3 SDRs	271.7	4,394.3	2.9	-3.9	36.3	66.7	29.0	37.7
1.4 Reserve Position in the IMF	130.1	2,105.1	1.3	-2.0	5.0	-195.6	8.1	-86.2

 

2. Foreign Exchange Reserves
Item	As on March 29, 2013		Variation over
			Week		End-March 2012		Year
	` Bn.	US$Mn.	` Bn.	US$Mn.	` Bn.	US$Mn.	` Bn.	US$Mn.
	1	2	3	4	5	6	7	8
1 Total Reserves	15,900.6	292,646.5	-24.7	-720.3	839.3	-1,751.0	839.3	-1,751.0
1.1 Foreign Currency Assets	14,126.3	259,725.9	-23.4	-689.4	821.2	-342.8	821.2	-342.8
1.2 Gold	1,413.8	26,292.3	-	-	31.3	-730.8	31.3	-730.8
1.3 SDRs	235.4	4,327.6	-0.5	-14.3	6.8	-141.7	6.8	-141.7
1.4 Reserve Position in the IMF	125.1	2,300.7	-0.8	-16.6	-20.0	-535.7	-20.0	-535.7

 

Despite all panic and headlines the reduction in the reserves is just $14 b between March and August. It is evident that there were inflows into the country and this will get stronger at the current levels of Indian  rupee (i.e. Rs 65 to dollar)

SEBI data for July 2013 shows that about USD 4 billion has been shifted out of FII during July 2013. http://www.sebi.gov.in/cms/sebi_data/commondocs/FIIInvestmentSector_h.html

It is evident that although there is some outflow of the foreign currency reserves, there are adequate balances to meet the demand of the short term funding i.e short term portfolio funds. If we consider the fact that about 20% -35% of this is owned by Indians abroad or by rich Indians or politicians through their be-namis, then the real impact going forward is quite comfortable.

Blame Subba Rao

 
Once again it is again proven that monetary policy is too important to be left to the whims and fancies of Governors. Whilst 'star' performer Alan Greenspan created all sort of troubles with his monetary policies, Subbarao was adamant to decrease 'Indian growth rate' to tame inflation. Hence he increased interest rates since 2011 which of course killed Indian growth and the FII interest in Indian market. Subbarao almost killed the golden goose. When he started hiking interest rates, INR was 46.90 against the dollar. Now it is 68.80 - a whopping depreciation of nearly 50%. One of the central bank duties is to ensure currency stability. Subba Rao has failed miserably in this. Of course this currency instability confuses the business community in the country - it is tough to plan ahead and engage in business transactions abroad.

Whilst Govt. of India has also contributed to the situation through its inaction and failure to control corruption and useless environmental laws, Subba Rao's RBI has also played a significant role through its poor monetary policies.

The good news is that he is moving out. The new comer is more savvy and with stronger connections abroad. Unlike Subba Rao who took pleasure in taking opposite stance to finance ministry of India, there is every possibility of better co-ordination under the new Governor.
 
Overall, there is no need to be panicky and this is the time to enter into some long term buys in Indian stock market. The consumption story in India continues to be strong. Investments in infra is picking up and this will lead to stronger story of investments in India from late this year.