Do it yourself

Friday, June 14, 2019

Open the black box

Some food for thought

"A man may learn from his Bible to be a more thorough gentleman than if he had been brought up in all the drawing-rooms in London."

—Charles Kingsley (English clergyman, 1819-1875)

Word for the day

Hangdog (adj)

Browbeaten; defeated; intimidated;

First thought this morning

The Pakistan economy is facing one of its worst crises in past 7 decades. Growth is collapsing, unemployment rising, inflation is high, interest rates are prohibitive, current account is worsening despite massive currency devaluation, and reserves are ominously low.

While the government is negotiating a rescue package with IMF, the people at large may not be willing to take the pain associated with such package, e.g., fiscal tightening, higher taxes, further devaluation of currency, cut in government spending (including the sensitive defense spending), restructuring of Chinese Belt & Road debt etc.

The moot point is whether India is taking advantage of the situation to sort out pending issues with Pakistan!

I would like to answer this in affirmative. It is visible that funding starved mercenaries and their support groups in J&K are being neutralized at accelerated pace, despite some desperate last ditch attempts by them. Persistent refusal of Indian leadership to engage with Pakistan counterpart must also be adding to the pressure to act Indian pre condition of eliminating terror camps. Efforts to isolate Pakistan at various multilateral fora are also visible.

Some may believe that it is not adequate and we must use this opportunity for some direct action. I feel we are doing fine.

Chart of the day

Open the black box

In past 2yrs, since the IBC process started with RBI marking 12 largest default cases for immediate resolution, the progress has been rather mix.

Only 3/12 (Bhushan Steel, Monnet Ispat and Electrosteel Steel) of initial cases have been fully resolved so far. 2/12 cases (Lanco Infra and ABG Shipyard) have been declared irresolvable and undergoing liquidation process. The resolution in rest 7/12 cases has been impacted by frequent judicial interventions, poor NCLT strength, and/or lack of credible bidders. Technically, all these cases must have been resolved in maximum 180+90 day period. Currently, about one third of the total 1140 odd cases pending for resolution under IBC are facing delay beyond the statutory resolution period of 270days.

On positive side, by end of FY19, over 700 cases had been resolved under the IBC process. In FY19 alone lenders realized ~Rs660bn from the resolved cases. It is estimated that the recoveries may exceed Rs800bn in the current year FY20.

In 4QFY19 about 350 new cases have been filed for resolution under IBC. As number of new cases is increasing and resolution process is getting delayed, the market is naturally getting jittery. Any news (even unsubstantiated and unconfirmed) of delay or default in repayment of debt and/or interest due thereon is causing panic in market. It has led to irrational value destruction for investors in many cases.

This will surely be seen as an excellent opportunity by handful of "smart investors", but value destruction at this scale has weakened the overall structure of the market. Market participants at large are losing faith in market, threatening the whole "revival of domestic investors' interest in equities" prognosis that supported the markets well for past 3years. Diminishing flows in equity mutual funds in past 3months is just a small reflection of this.

The market reaction to a totally frivolous petition filed against India Bulls Housing Finance company also highlights the frightened state of market participants. Sharp fall in prices of all public sector banks after the brokerage firm UBS published a theoretical worst case scenario in NPA accretion a couple of days ago is also a case in point.

Most of the lenders have indicated in their recent commentaries that the NPA cycle may already have peaked in FY19, and from the current year a gradual improvement must be visible. Even some worst case scenario reports are indicating that NPA cycle may peak in the current year.

As an investor, I am faced with two questions here:

(a) Should I buy PSBs which in my view are definitely on their way up to recovery?

I believe yes, I must invest. The reasons are rather simple - most large PSBs are trading at valuation much lower than their long term averages; earnings are improving; asset quality looks set to improve; processes and controls are much stronger now as compared to 5yrs ago; government has show commitment for professionalization of management (BoB is a good sample case); consolidation has begun and is encouraging (SBI and BoB are good examples); CAR is improving and clarity on RBI capital reserve position after Jalan committee submits its report will improve further visibility of fresh capital infusion; credit market is reviving; they may regain some of the market share lost to NBFCs; setting up of more NCLT benches and evolution of judicial precedents may expedite resolution process of default cases, etc.

(b) How the market may be insulated from frequent knee jerk overreactions?

This is little complicated. I think the market participants, regulators and experts need to work together on this. So far the financial sector stress has been presented to the market as a black box.

This box needs to be opened, and investors and traders need to be informed about the precise current situation, potential risks and implications for the market.

For example, market participants must know the "Equity" part of the stressed debt and the "leveraged" part of it.

When a mutual fund scheme invests in the bonds of a corporate, it is effectively the same as investing in equity shares of that corporate. The asset management company that manages the MF Scheme is under no obligation for service or repayment of corporate debt. It is only an agent of the investors who have subscribed to the MF scheme. The risk of default by corporate in servicing the debt is completely borne by the investors. I refer to this as 'Equity" part of the stressed debt. Same is the situation with fixed deposits and NCDs directly subscribed by the investors. Any default in these has no implication for any other publically traded entity, unless such entity is an investor in these instruments.

On the other hand, when an NBFC or Bank lends to a corporate from the money borrowed from other lenders and depositors, the risk of default is borne by the respective bank or NBFC. This is the "Leveraged" part of the stressed debt. Any default in this part of the debt has implications for the investors in the lender, as it remains liable to pay to its lenders and depositors. Any default in leveraged part of the debt could have cascading impact and affect a number of publically traded entities.

So, if a default is made to a MF Scheme, ideally markets should not be rattled as much as we have seen in recent past.

Secondly, if the market is transparently informed that the total amount at risk in the six popular cases (Essel group, Jet Airways, DHFL, India Bulls, ADAG, Adani group), that have been frequently rattling the market, might not be more than 2-3qtrs profit of lenders, the chances are that market may not overreact to the news of a 7 days payment delay.

Another analysis that needs to be done is the notional gains made by the buyers of stressed assets vs. the losses incurred by the lenders.

For example, company X buys a stressed cement plant at 0.5x the replacement value of Rs120bn, while the lenders lose 60% of the Rs100bn due to them. Since the buying entity is a healthy going concern, the market should assess whether it should celebrate Rs20bn notional gain to the buyer, Rs60bn (0.5x of Rs120bn) additional business to the lenders or it should mourn loss of Rs100bn to lender 75% of which was already provided in previous years.

Thursday, June 13, 2019

Keep it simple

Some food for thought

"Rapine, avarice, expense. This is idolatry. And these we adore."

—William Wordsworth (English Poet, 1770-1850)

Word for the day

Esprit de l’escalier (n)

A perfect comeback or witty remark that one frustratingly comes up with only when the moment for doing so has passed

First thought this morning

Legendary Bill Gates in a tweet yesterday said, "I’m always amazed by the disconnect between what we see in the news and the reality of the world around us. As my late friend Hans Rosling would say, we must fight the fear instinct that distorts our perspective."

Unfortunately, this phenomenon is universal, not limited to US only.

In our case, while the media focuses on totally frivolous issues. Life threatening diseases like cancer, diabetes, obesity, have become epidemics. Water scarcity is at alarming level in many parts of the country. We are staring at yet another subpar monsoon. A new education policy is in the making that will impact the life of millions of children. But no one is debating these issues.

Instead they are making brouhaha over the recent Pakistan TV advertisement using IAF pilot Abhinandan as a prop is a point in case.

For records, I found the advertisement creative, controlled, funny and highly ambitious. Ideally, the creative minds on our side should have responded with a funnier and more impactful campaign. Instead our hysterical media celebrities and Twitter warriors took the mantle upon themselves and turned this into a ugly battle of national pride and popular sentiments.

Keep it simple

Former CEA Arvind Subramanian has resuscitated the debate over accuracy and authenticity of the national account data released by CSO. In recent past many economists and other experts have raised doubts over the methods and processes used by CSO in estimating and forecasting national income data. (You can read the paper submitted by Mr. Subramanian here)

The primary argument is that post change in the methodology in 2012, CSO might have been overestimating the GDP growth. This overestimation may have led to many policy distortions, especially tighter monetary policy that checked the demand and actually impaired the growth.

As per the paper, the high GDP growth numbers were not corroborated by a number of independent data like Cement & Steel sales, 2W sales, growth in exports and imports, Railway freight, tractor sales, IIP etc. during FY13 to FY18 period. While these numbers had shown a positive correlation with GDP growth during FY01 to FY12.

The paper cautions that an overestimation of GDP, essentially means distortion of many key statistics that are calculated using estimated nominal GDP as denominator.

For example, If nominal GDP growth is over-estimated it would mean that India’s tax performance (including the new GST) has been more impressive than currently believed. On the other hand, it would also mean that many important fiscal ratios (deficit/GDP and debt/GDP) are worse than currently believed, because the denominator in these ratios is nominal GDP, which could be lower than currently measured. It would also mean that the decline in financial savings that has caused much alarm is smaller than feared.

Without questioning the appropriateness of, or motive behind, the study in question, I feel that it is like someone seeking divorce from his/her spouse after 50yrs of happy and healthy marriage just because the spouse had an affair during college days. We all are ware that CSO methodology and processes may be inadequate. But that has been the case all along.

Moreover, Mr. Subramanian, while at the helm as CEA, not only approved the same statistics, but also actively marketed it to the unsuspecting citizens and the government it was duty bound to give right advice.

Regardless, of the CSO methodology, processes and GDP growth numbers released by it, and totally ignoring the league table of GDP growth data for various countries especially China, I suggest the following:

(a) Interest rates should purely be a function of demand and supply for credit. To smooth out the bubbles or fill in the gaps, the monetary regulator may temporarily manage the overall or sectoral supply of credit through various means, but it must leave the price of credit to be determined solely by market forces.

(b) Fiscal deficit should be measured against fiscal revenue only. All capital expenditure that results in creation of productive assets should be excluded from these calculations.

(d) Production (Value addition) GDP and expenditure GDP should be calculated separately by two independent agencies, so that any material mismatch is highlighted immediately.

(e) Qualitative data, like number of cancer patients, school drop outs, child mortality, air quality, student teacher ratio, patient doctor ratio, citizen police ratio, crime rate etc should also be given reasonable importance in data dissemination by government agencies.