The Big Mac Index is an informal way of measuring the purchasing power parity (PPP) between two currencies As stated in the Economist, it "seeks to make exchange-rate theory a bit more digestible".

· The Big Mac Index was introduced by The Economist in September 1986

· The index also gave rise to the word burgernomics.

It is based on the principle that the rate between two currencies should naturally adjust so that a sample basket of goods and services should cost the same in both currencies.

In the Big Mac Index, the "basket" in question is considered to be a single Big Mac sandwich as sold by the McDonald's fast food restaurant chain. The Big Mac was chosen because of the high degree of standardization of the BIG MAC burger across many countries around the world, with local McDonald's franchisees having significant responsibility for negotiating input prices.

Hence the index enables a comparison between many countries' currencies. Some menu items are market specific, which would hinder a comparison, if used. Still other menu items are specially priced, such as the dollar menu in many U.S. restaurants consisting of sandwiches and other items that cost $1.

The Big Mac PPP exchange rate between two countries is obtained by dividing the price of a Big Mac in one country (Home currency) by the price of a Big Mac in another country (foreign currency). This value is then compared with the actual exchange rate; if it is lower, then the first currency is under-valued (according to PPP theory) compared with the second, and conversely, if it is higher, then the first currency is over-valued.

For example, suppose the price of a Big Mac is $2.50 in the United States and Rs.100 in India; thus, the PPP rate is 2.50/100= 40. If, the actual USD rate is 1$ = Rs. 45 then USD is under-valued (40<45)>

The burger methodology has limitations in its estimates of the PPP. In many countries, eating at international fast-food chain restaurants such as McDonald's is relatively expensive in comparison to eating at a local restaurant, and the demand for Big Macs is not as large in countries like India as in the United States.

Social status of eating at fast food restaurants like McDonald's, local taxes, levels of competition, and import duties on selected items may not be representative of the country's economy as a whole. In addition, there is no theoretical reason why non-tradable goods and services such as property costs should be equal in different countries: this is the theoretical reason for PPPs being different from market exchange rates over time. Nevertheless, the Big Mac Index has become widely cited by economists.

MORE WHEN WE DO THE TOPIC IN THE CLASS!!!!!!

So the much awaited credit policy is out and our Reddy "garu" has pulled out some surprises (although not nasty ones).Let us look at some of the fall outs of the policy announced yesterday:

• RBI has told the corporates, banks etc to be "vigilant and well prepared" to deal with higher volatility on the rupee dollar front - which means--- guys I am not going to put too much effort into restricting rupee appreciation - so you guys take care of yourself
  
• This is a good sign ... I have long been of the opinion that too much protection is being given to the exporters - while this was necessary in the early stages of the development - it should have been stopped once our FX reserves touched 200 bnUSD. Moreover the exporters of our country have been pampered to the hilt and should now realise that they should grow up.
• CRR hiked by 0.50 bps to 7%
• This move will suck out close to Rs.13500 crores out of the system - not a major cause of concern for treasuries - because the liquidity floating around in the system is estimated to be around Rs. 1 lac crores. The bond yields reacted yesterday - but this was only a reaction to the announcement and is likely to settle down today. We have seen that the excess liquidity in the system was arising primarily due to the fact that deposits were growing rapidly while advances was showing a declining trend. This coupled with the RBI pumping rupee to support the dollar led to huge liquidity float in the system. Of course the banks will now have to make the effort of pushing advances and reduce costs on borrowings i.e. deposits.
  
• Ceiling of Rs.3000 crores on reverse repo discontinued:
• With the removal of this ceiling the call rates will now gravitate towards this rate which is presently at 6%
• Long term repos to be introduced:
• I have mentioned in my lectures that the short term yield curve is characterised by a zig zag pattern owing to volatility and unpredicability in the short run. With the introduction of 14 day and 28 day repos we might see some smoothening of this segment of the yield curve.
• GDP growth at 8.5%
• This growth has primarily been driven by the services and industrial sector - the farm sector outlook is still uncertain. Like discussed in the class - the RBI is faced with a dilemna of managing a high GDP growth on one hand and reigning inflation on the other.A High GDP together with a monetary system sloshing in liquidity is sure indicator of high inflation in the days to come - this will also result in higher interest rates (this is already indicated by a upward move of the CRR

The coming few months should be interesting as RBI unfolds its plans to tackle the strange situation that India is in now My call - we should see some tightening of the interest rates in the medium term and the RBI is likely to adopt a push pull strategy to control inflation and dollar.

RUPEE APPRECIATION AND AS 11

The rupee has appreciated 10-11 per cent against the dollar in recent times. Accounting Standard (AS-11) of the Institute of Chartered Accountants of India (ICAI) governs accounting of foreign currency transactions and translations. Those who have long-term loans in dollar such as external commercial borrowings (ECBs) have to book huge gains on account of this fluctuation, when re-stating the balance-sheet. Is this correct?

The rupee appreciation in the past few weeks was very fast and it is difficult to assume that the appreciation will sustain in the long run. How do we proceed to simultaneously comply with the standard and recognise the currency volatility? We have to be prudent while recognising income and booking losses. The gain on account of the appreciation may not be sustainable, and hence is it prudent to recognise the same in the profit and loss (P&L) account? Can it be a good practice, not to recognise the income and pass it on to an exchange risk administration reserve to meet future liabilities? Is AS-11 equipped to meet this scenario?

Prudence is no longer an objective of most accounting framework. Fair presentation is. Therefore, it is important that assets and liabilities are represented at fair values. In the case of forex loan, fair presentation would be to account for the loan at the exchange rate prevailing on the balance-sheet date. As a corollary, the corresponding gain/loss is recognised in the `profit and loss' account (where else can it go?).

It would be incorrect not to recognise the gain, since it would tantamount to creating a secret reserve. It is also not appropriate to suggest that the gain is not being recognised, since exchange rates can cause the reverse moment in the future. What if they do not? Accounting cannot be based on prediction.

Just another point, if the loan was used for financing a fixed asset, then the exchange difference may very well be termed as a borrowing cost under AS-16 and to that extent the same may be capitalised or de-capitalised.

RELATIONSHIP BETWEEN INTEREST RATES AND INFLATION

It is typically a positive relation. In other words, both tend to move either up or down together. However, the caveat is that interest rates will always follow inflation rates or, put simply, when inflation goes up, interest rates go up and when inflation comes down, interest rates tend to fall.

The reason behind this relationship is fairly simple as also complex. Inflation tends to happen when an economy is `overheating' much like what is happening in India now. Of course, inflation also happens when central banks print a lot of money or when macroeconomic policies go bad. However, in this case, let's assume that the central bank and government are largely following `correct' policies. This assumption is necessary because the relation between inflation and interest rates becomes clearer.

Money is the engine of any economy. Let's start from the time when money is cheap or in other words, there is a low interest rate. This is also called `loose money policy'. Because of this cheap money, people borrow to start businesses, invest and so on; the price they pay for the money is interest. Over time, a virtuous cycle gets created where this money generates more money and people tend to become richer.

India is the best case where this has happened in the last few years. Interest rates were low in India and people and companies have borrowed liberally for a variety of things. People bought houses, cars, TV sets and so on and companies built factories, etc. When this happens, economies will typically go through what is known as a boom phase with GDP, incomes, and profits rising rapidly. All this increases the demand for goods and we all know that prices of goods depend on demand and supply. Over time, demand builds and slowly outstrips supply as is happening in India now. When that happens, prices of goods tend to go up and that results in inflation because most of these goods are usually part of a basket that constitutes the Wholesale Price Index or the Consumer Price Index.

To `cool' the economy, central banks will raise interest rates. The intention here is to slow demand and, in effect, decelerate the economy. However, this is a tightrope act because interest rates must be raised just enough to cool the economy but not send it into a recession. When interest rates are increased, money becomes costlier and that is known as `tight money policy'. What the central bank hopes is that when it increases rates, people and companies will borrow less and therefore there will be less purchases and investments. This usually cools the economy. During this cooling period, GDP growth usually slows, companies' profits are reduced and people are less likely to spend. Over time, inflation drops and as it does, the central bank will usually lower interest rates to again kick-start the economy and the cycle continues.

However, it is important to understand that the above explanation is very broad and that there are many factors that go into this sometimes complex relationship.

- The article has been written by Sunil Rongola who is Economist, Murugappa Group. The views expressed are personal and has appeared in Hindu todya

PLEASE DO MAKE SURE TO GO THROUGH THE SECTION ON THE RIGHT TITLED " Articles I would recommend - these are enormously useful for CA Students"


srini

hey guys,
please visit my blog linked : http://www.srininewsblog.blogspot.com

It has a section Hindu business line - mentor - this section often contains interesting news for CA students. e.g. on 16th of July it had the solution of a problem in costing which came in May 2007 solved by Mr. PV Ratnam. It also contained an article as to constitution of audit paper in the finals - keep an eye on this blog

Well so much for the so called ethics, professionalism, laptop toting personnel, cutting edge technology by the so called big 4 ......

Deloitte to Pay $130 Million to Parmalat Shortly

Deloitte had settled with Parmalat to pay US $149 million for its role in the bankruptcy of the Italian dairy company.

Now it is time to pay....Parmalat SpA says that Deloitte have a few days to come up with the money, and apparently Deloitte will pay $130 million as a first installment.

The first signs of the economy cooling down is showing: the runaway growth in bank loans is finally losing some steam. For the first time in 6 years, banks have recorded an absolute dip in loans given to individuals and Corporates.

Latest RBI figures reveal that aggregate non-food credit extended by banks declined Rs 30,532 crore between April and June 22 to Rs 18,17,955 crore. Though a slow credit demand is normal in the first quarter which is lean season, for the first time in 24 quarters, banks are seeing their loan portfolio shrink. Significantly, it’s happening at a point when deposits parked in banks are recording the highest quarterly growth of over Rs 1,00,000 crore.

The point to note here is that while the deposits are at a record volume - the loan portfolio is reducing - while this is good as far as the FM is concerned because he is achieving the objective of cooling down an overheated economy - the question is what happens to the banks - they will pay interest on the deposit on one hand while on the other hand the loan portfolio
shrinking.
The central bank has given enought indication that it is not comfortable with the fierce loan growth. Since last year, it has implemented series of rate hikes to cool down the economy and diffuse bubbles in various markets. The monetary actions may be finally showing results.

From the corporates side, the corporates are more inclined to borrow from alternative sources which are available at a relatively cheaper rates. But with global PE funds tripping over their feet to fund indian ventures - mid cap segment is gravitating more towards equity.

And anyway equity markets seem to be in a tizzy and spiralling northwards .....

Interesting ruling for section 54 and 54F of the Income tax act

Special bench of Income Tax Appellate Tribunal vide a significant ruling AIT-2007-205-ITAT affecting investment decision of sellers and buyers of real estate has ruled that exemption under sections 54 and 54F of the Act would be allowable in respect of one residential house only. If the assessee has purchased more than one residential house, then the choice would be with assessee to avail the exemption in respect of either of the houses provided the other conditions are fulfilled. However, where more than one unit are purchased which are adjacent to each other and are converted into one house for the purpose of residence by having common passage, common kitchen, etc., then, it would be a case of investment in one residential house and consequently, the assessee would be entitled to exemption.

• The Special Bench was constituted to decide the following question of law:

“Whether, the phrase “a residential house” used in sub-section (1) of section 54 and 54F means one residential house or more than one residential house independently located in the same building / compound / city?”

• The Revenue contended that exemption under sections 54/54F of the Income Tax Act, 1961 would be available only in respect of investment made in one residential house. On the other hand, the assessee contended that the exemption under the aforesaid sections would be available even if investment is made in the two house properties though distantly located from each other.
• The assessee and her husband were co-owners of a residential flat at “Gulistan” situated at Bhulabhai Desai Road, Mumbai, having 50% share each. In the year under consideration, the said flat was sold for a total consideration of Rs.3.03 crores on 12.8.1984. The share of the assessee in the sale consideration of Rs.3.03 crores on 12.8.1984. The share of the assessee in the sale consideration amounted to Rs.1.515 crores. The assessee re-invested the sale proceeds in purchase of ½ share in these two flats were purchased by the husband of the assessee. The assessee claimed exemption u/s 54 of Rs.76.44 lacs against long term capital gain arising from the sale of her share in the residential flat at Bhulabhai Desai Road, Mumbai. However, the assessing officer was of the view that exemption was available only in respect of investment in one residential house. Accordingly, he restricted the exemption to Rs.47.79 lacs being the investment in the flat at Erlyn Apartment, Bandra. On appeal, the CIT(A) held that exemption was available in respect to investment made in both the flats.

Observations of Special Bench:

· The real controversy is about the true meaning of the expression “a residential house” used by the legislature in sections 54 and 54F of the Act. According to the Revenue, it means, one residential house while, according to the assessee, the word “a” means “any” which in turn means “one or more than one”.

· The word “a” is ambiguous as it has no definite meaning. Various meanings are given to the word “a”. It not only means “one” or “any” but it has various other meanings depending upon the context in which it is to be used. Therefore, the cardinal principle of interpretation cannot be applied and consequently, the intention of legislature has to be discovered by resorting to the aids to the interpretation. One of the rules of interpretation is to find out the context in which such word is used by the legislature.

· The legislature has used the words “a” and “any” with reference to investment of capital gain / sale consideration in certain asset or assets. The legislature was not oblivious regarding the meaning of these two words. The word “any” has been used by the legislature in sections 54B, 54D, 54E, 54EA, and 54EB while the word “a” has been used in sections 54 and 54F of the Act. This clearly shows that the legislature intended different meanings to be given to these two words. A close reading of these sections shows that legislature intended to allow exemption in respect of investment in more than one asset by using the word “any”. Section 54E allows exemption in respect of investment in any specified asset. Explanation 1 to sections 54E defines the “specified asset”. It includes various assets in which investment can be made by the assessee who are eligible for exemption u/s 54E. There is nothing to indicate that investment is restricted to any of the specified assets. Had the legislature intended to restrict investment in any one of the specified assets, it would have used the words “in any one of the specified assets” instead of “in any specified asset”. This clearly shows that the word “any” has been used where the legislature intended investment in more than one asset. Similarly, in section 54EB, the legislature has used the words “in any of the assets specified by the Board”. Similar is the position in section 54EA. Section 54B and section 54D also used the word “any other land” and “any other land and building” respectively. The expression “any other land” is an expression of widest amplitude and, therefore, its meaning cannot be restricted to any one piece of land. On the other hand, the legislature has used the word “a” in sections 54 and 54F. Had the legislature intended for investment in more than one asset, it could have easily used the words “in any residential house”. Superfluous words are not used by the legislature. Different words “a” and “any” have been deliberately used by the legislature to convey different meanings. Therefore, in our humble view, the legislature used the word “a” where it intended investment in one residential house only and used the word “any” where it intended investment in one or more assets.

· However, we are in agreement with certain decisions of the Tribunal relied on by the learned counsel for the assessee wherein exemption was allowed in respect of investments in two adjacent or contiguous units converted into one residential house by having common passage / stair case, common kitchen, etc. intended to be used as singly house for the residence of the family. As already observed, the intention of the legislature is that investment should be made in one residential house. So long as the house purchased is one even after conversion, the exemption would be available. On the other hand, if the investment is made in two independent residential houses, even located in the same complex, then, in our opinion, exemption cannot be allowed for investment in both the houses. However, the choice would be with assessee to avail exemption in respect of any one house.

In my earlier blog I had written about a derivative instrument called the credit default swap. The ET on 28th June 2007 carried an article about how banks are offering equity linked notes to woo rich investors. This is a clear indicator of how our markets are maturing in a big way.

Citibank and DSP Merrill Lynch have issued equity linked notes to raise resources. The equity linked notes are basically debt instruments issued at a discount with certain additional payoffs being made on the happening or non happening of certain events. To cite an example A Ltd can issue a debenture at Rs.100 which will be repayable on maturity at 100+3 = Rs.103. It can however contain a rider which says that if the Nifty falls / rises by more than say 30% any time between the date of allotment and the date of redemption the repayment will be say Principal + 20%.

This kind of a product provides capital safety plus the opportunity to participate in a equity rally by the investor, while for the borrower it may enable him to issue such paper at a lesser rate than what he would had to offer on a pure debt instrument. These bonds will be rated and traded on the NSE. However as of right now due to lack of depth and knowledge of the product it is likely to be a OTC product with limited liquidity. However if a number of company (say the index companies) start coming out with such an instrument then it will be quite possible to create a basket derivative of such instruments.

This also means that credit rating agencies in India which have so far been rating predominantly vanilla products will have to gear themselves up to deal with such sophisticated instruments. Like I keep saying - exciting times ahead!!!!!!!!

DERIVATIVES -
AN INTRODUCTION TO CREDIT DEFAULT SWAP

Credit default swap: Two parties enter into an agreement whereby one party pays the other a fixed periodic coupon for the specified life of the agreement. The other party makes no payments unless a specified credit event occurs. Credit events are typically defined to include a material default, bankruptcy or debt restructuring for a specified reference asset. If such a credit event occurs, the party makes a payment to the first party, and the swap then terminates.

Another way of putting it:
The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.

For example, the buyer of a credit swap will be entitled to the par value of the bond by the seller of the swap, should the bond default in its coupon payments.

Use of CDS by commercial banks
Commercial banks use credit default swaps to manage the credit risk associated with making large loans to their corporate customers. If a borrower defaults on a loan or another predefined credit event occurs, the counterparty providing the insurance purchases the defaulted asset.

Credit default swaps are a very common form of Credit Derivative. The objective in many credit derivatives, including default swaps, is to split market risk from credit risk; doing so effectively reduces a bank's exposure and its risk of loss.

A CDS is often used like an insurance policy, or hedge for the holder of debt . The typical term of a CDS contract is five years, although being an OTC product almost any maturity is possible.

An Example A fund has invested Rs 10 croreds worth of a 5 year bond issued by Risky Corporation. In order to manage their risk of losing money if Risky Corporation defaults on its debt, the fund buys a CDS from Derivative Bank for a notional amount of Rs.10 crores which trades at 200 basis points. In return for this credit protection, the fund pays 2% of 10 crores (Rs. 200,000) in quarterly installments of Rs. 50,000 to Derivative Bank. If Risky Corporation does not default on its bond payments, the fund makes quarterly payments to Derivative Bank for 5 years and receives its 10 crores loan back after 5 years from the Risky Corporation. Though the protection payments reduce investment returns for the fund, its risk of loss in a default scenario is eliminated. If Risky Corporation defaults on its debt 3 years into the CDS contract then the premium payments would stop and Derivative Bank would ensure that the fund is refunded for its loss of Rs. 10 crores Another scenario would be if Risky Corporation's credit profile improved dramatically or it is acquired by a stronger company after 3 years, the pension fund could effectively cancel or reduce its original CDS position by selling the remaining two years of credit protection in the market.

P.S. This is not a technical note but just to give you an idea and introduction as how flexible derivatives can be !!!!

Accounting Standard (AS) 20, ‘Earnings Per Share’ is mandatory in nature, in respect of enterprises whose equity shares or potential equity shares are listed on a recognised stock exchange in India.

An entity which has neither equity shares nor potential equity shares which are listed nee not calculate and disclose earnings per share.

But, if that enterprise discloses earnings per share for complying with the requirements of any statute or otherwise, it should calculate and disclose earnings per share in accordance with AS 20.

Part IV of the Schedule VI to the Companies Act, 1956, requires, among other things, disclosure of earnings per share.

Accordingly, it has been clarified that every company, which is required to give information under Part IV of the Schedule VI to the Companies Act, 1956, should calculate and disclose earnings per share in accordance with AS 20, whether its equity shares or potential equity shares are listed on a recognised stock exchange in India or not.

Call rates have fallen to absurd levels of 0.10% which means banks are lending to each other almost free. This is an indication of how much surplus liquidity is sloshing in the economy. RBI has placed a cap of Rs.3000 crore cap on the amount that the banks can place with RBI on repo - this effectively means that even RBI is scared of being saddled with the huge liquidity at the disposal of the banks. However this situation seems paradoxical - on the one hand you have so much of liquidity in the system while on the other hands interest rates on lending rule between the 12-14% band.

RBI has announced auction of dated securities of Rs.9000 crores and the cap on the repo would force the bank to subscribe to these bonds if call rates continue to rule at these absurd japanese levels.So this excess liquidity could be a temporary phenomena - however this raises questions on other issues - If call rates were ruling at such levels banks should be making a beehive to purchase government securities to take advantage of arbitrage opportunity provided by the rate differential - Imagine borrowing Rs.100 at 0.01% and investing it in a security which will give a 7.39%. However this has not happened which indicates that the banks are not comfortable investing in government securities at this point of time and would rather lend in call at almost free of cost.

Sharp and fleetfooted corporates would look to take advantage of this opportunity to issue short term corporate papers like CPs etc. However there might be reluctance on the part of the banks to subscribe to these issue as at the back of mind every one knows that these kind of interest levels are only short term phenomena.

This high liquidity scenario can be attributed to a couple of reasons: a redemption of a bond infused Rs.20000 crores into the system. Moreover in a bid to support the rupee the RBI has continuously been buying dollars and hence pumping rupee into the system. Rupee has touched an alltime high of Rs.40.28 and seems likely to breach this also.... Overall .... Interesting times ahead --- keep watching this space

Sharpe Ratio
This ratio measures the ratio of return earned in excess of the risk free rate (normally Treasury instruments) on a portfolio to the portfolio's total risk
Portfolio risk is measured by the standard deviation in its returns over the measurement period. In other words it tells you how much better did you do for the risk assumed.

It is measured by: (Portfolio return - Risk free return)/Std deviation of portfolio

The Sharpe ratio is an appropriate measure of performance for an overall portfolio particularly when it is compared to another portfolio, or another index such as the Nifty, Mid cap index etc.

It tells us whether the excess return generated was due to smart investment or was due to a very high risk taken by the fund manager.

Treynor ratio
This ratio is similar to the above except it uses beta instead of standard deviation.
It's also known as the Reward to Volatility Ratio.
It is the ratio of a fund's average excess return to the fund's beta.
It measures the returns earned in excess of those that could have been earned on a riskless investment per unit of market risk assumed.
It is measured by : (Avg Portfolio return - Avg risk free return)/beta of portfolio

Notes:
It would be useful to remember that any portfolio consists of two types of risks - systemic or market risks and non systemic risks.

Systemic or market risks represents the movement in portfolio due to movement in the market. This relation between the portfolio and the market movement is what is measured by beta. Hence Treynors measure measures the excess return per unit of systemic risk taken.This is the reason why it is generally said that Treynors' measure is a good approach to evaluate well diversified portfolio.

Non systemic risks represents scrip specific risks.This is represented by the standard deviation of the portfolio. Hence sharpe measure uses this to measure the excess return generated per unit of risk of the portfolio itself. If you have a non diversified portfolio then it doesnt make any sense to compare it with the market indices because the movement of the scrip will rarely be influenced or will have no direct linkage to movement in indices.

What is "Alpha"


This is the difference between a fund's actual return and those that could have been made on a benchmark portfolio with the same risk- i.e. beta.

So it is basically used to measure the relative performance of two funds having the same beta. i.e. comparing apples to apples. This gives a reasonable good measure of a fund manager's performance and could be used for devising incentive strategies for the fund manager

Hope you found the above useful

RBI has launched a full out war on inflation. It has raised CRR to 6.5% (from 6%) and Repo rate to 7.75% (from 7.50%). The interest on CRR has been halved to 0.5%. This will hit the banks on two fronts - the banks will be forced to keep more resources with the RBI in the form of CRR (almost to the tune of 16000 crores) and the money so kept will earn lesser interest also. The drop in the CRR rate is likely to shave off Rs.2000 crores from the banks bottomline. In addition to the above move the RBI will mop up a further Rs.6000 crores through the market stabilisation scheme. The above steps would make the cost of funds for the banks to go up which would force them to increase the lending rates.

It is widely perceived that an unbridled growth in M3 is the cause of such inflation. Reacting to the news the call rates shot up to 80% yesterday and the bond yields have gone up substantially. The 10 year benchmark government securities was being dealt at slightly less than 8% and the chances are that on Monday it will rise further. The fall happening on the last trading day of the fiscal is likely to have an impact on the balance sheet of most of the banks as they will have to make higher provision for depreciation in their bond portfolio.


The scenario for the first half of the next fiscal also doesnt seem to be too bright - In the first half the government will raise Rs.92,000 crores via issue of government bonds out of which more than 20000 crores will be through issue of bonds with maturity of more than 20 years


The rupee dollar front also seems to be witnessing high volatility with rupee touching 43.78 to a dollar before settling down to 43.45 at the close yesterday. This surge in rupee in the last week is sure to knock off the pants of exporters for whom such a move is a direct hit on their bottom line.

On the corporate front, we might witness a surge of corporates borrowing abroad in foreign currency to access cheaper funds. This will no doubt add to the already swelling forex kitty which is expected to touch 200 bn $

Be ready for further hikes in the interest rates in the near future!!!!

CALL RATES / RUPEE - DOLLAR MOVEMENT

On 20th of this month the call rates shot up to 70% (even though this was on stray deals). The reason being attributed to this is the liquidity crunch arising out of advance tax outflows. However, I feel that this stray spike in the call rates is no indicator of long term fundamentals on the interest rates. It was just a single day anamoly and should be treated as such. I have time and again reiterated the necessity of a strong banking system for capital account convertibility. However the banking systems' state on tuesday only shows the immaturity of our banking system. Normally there is a liquidity crunch at the end of every quarter when the corporates pay advance tax. This crunch is even more pronounced during the last instalment to be paid in March. Keeping in mind the kind of bottom line growth the corporates have been posting during the last year, any sane person would have known that tax outflows for the FY 2006-07 would also be very high. Hence some tightening should have been expected and the banks should have prepared themselves beforehand. Moreover remember in my previous blog on CRR I had mentioned that the last tranche of CRR hike would result in some tightness as it would immediately follow the tax outflows. Had the banks carefully planned their cash flow positions they need not have pressed the panic buttons and let the call zoom to such rates.

Foreign banks and the new generation private sector banks, in their drive to maximise profits, are overstretching themselves by lending much in excess of their deposits. The excess lending is financed through short term borrowings (including call).These banks would have no option but to keep borrowing irrespective of the rates to fund their lending. This is what is called as asset liability mismatch. While this mismatch might yield good profits under normal situation, however when there are sudden spikes in the short term rates it could create problems for the banks.

Rupee Dollar Movement
We have been studying this in MAFA. Now you can see this happening in real life. Rupee has appreciated from 44.25 to a $ on 22nd February to 43.45 to a $ yesterday. Clearly this would hit the exporting companies very hard. The dollar proceeds received by such export companies would now realise much less than what it would have realsied on 22nd February. (Except of course for people who had taken forward cover). This appreciation of rupee vis a vis the dollar will straight away knock off a significant portion of the top line as well as bottom lines of such companies. Of course exporters who have planned and seasonal exports wont be hurt much as they would have taken forward covers but for industries which thrive on spot orders (especially commodities) the hit would be higher.

One can see a linkage between the rupee dollar movement and the call money rates. As the call rates shot up treasury managers would have sold dollar and bought rupee resulting in the dollar depreciating vis a vis the rupee.

US Fed keeps interest rate unchanged
The US Fed did not change the interest rate and kept it unchanged at 5.25%. So possibly we can also heave a sigh of relief and hope for some respite from the continuosly increasing interest rates. PM Manmohan singh on Wednesday played down the fears of overheating in the economy, saying rise in inflation rate is a temporary phenomenon as growth impulses in India are very strong.

(BAD)GET for 2007-08

While I have not still looked into the fine prints of the budget, this budget seems to be more politically driven than anything else. Possibly the loss of elections in two northeastern states would have weighed heavily on the congress while announcing the budget. Anyway, getting on to the budget - if you recollect reading my earlier blog my view the government needs to closely monitor the commodity markets to keep a watch on unncessary speculation seems to have been bang on.

Before we go into the direct taxes lets have a look on the feel good factors for the economy as a whole:
Growth rate acheived - 9.6% (well on course for the targeted 10%)
Manufacturing sector grows by 11.3%
Service sector gorws by 11.2%
Per capita income increase by by 7.4%
Savings rate estimated at 32.4%
Investment rate estimated at 33.4%
Total Forex reserve stands at USD 180 bn
Avg inflation 5.4%
Merchandise exports exceed USD 100bn
Service exports exceed USD 125 bn
Government to aquire RBI's stake in SBI (has set aside 40000 cr for this purpose)
CST rates reduced from 4 to 3%
Lot of thrust given on Primary and secondary Education (a seperate cess called Higher Education Cess introduced)

Now lets look at some of the Direct Tax proposals:
Weighted deduction for approved inhouse research extended for another 5 years
Section 40A - earlier if any payment in excess of Rs.20000 was made by cash only 20% of the expenditure was disallowed. From now on the entire expenditure will be disallowed.

ESOPS will now be taxable as a fringe benefit. As a result of this the value of ESOP which will be taxed as Fringe benefit will be considered as cost of aquisition in computing capital gains arising on sale of such shares.

The term capital asset for the purpose of capital gains now includes jewellery and work of art (earlier these were excluded from the definition of capital assets)

Cap on investment under section 54EC - a maximum cap of Rs.50 lacs has been put on investment in specified bonds (NHAI and Rural electrification bonds)

Section 80CCD to apply to non government employee also

Section 80E - now available for higher education of the assessee's relative also (earlier it was only for self higher education) - relative means only spouse and children.

Section 80D- limit has been raised from Rs.10000 and Rs.15000 (senior citizens) to Rs.15000 and Rs 20000 respectively.

Section 80IA now available for companies engaged in laying and operating a cross country natural gas distribution network.

Section 10 incomes to be included while computing Minimum alternate Tax.

Section 115 O - Dividend distribution tax increased from 12.5% to 15%

Section 115R - Dividend Distribution tax for Money market Mutual funds 25%

I have not dealt with the changes in procedures and TDS in this blog.

Hope you find this helpful

REDDY GOES BOOM:2 : --- (CRR)azy kiya re........

Refer my earlierblog titled : Reddy to go northwards " where I had said that we can look forward to some more turbulent times as far as interest rate scenarios is concerned. It has been proved right by the recent move yesterday by the RBI governor to hike the CRR rates to 6% (from the earlier 5.5%).
The hike will be implemented in two phases of 0.25% each on Feb 17th and March 3rd. The move will suck out a total of Rs.13,500 crores from the system and has been spurred by the RBI's concern over the current trends in inflation which in the recent past has touched 6.8%. What needs to be seen is how far will this move be successful in achieving the goal of inflation supression. Rising commodity prices has been troubling the government for some time now - however what is to be analysed is that how much of the commodity inflation is on account of consumption demand and how much can be attributed to the operations of an erstwhile bull who is now rumored to be playing a big role in the commodities market. If the demand in the other sectors like realty etc does not subside (this may happen if the realty sector continues to rise on account of demand and is not deterred by the high cost of funds) then the prices will go up anyway inspite of the CRR hike. Infact in such a case the CRR hike may spur a disproportionate inflation because the builders will pass on the higher interest burden to the buyers.

The 2nd phase of the hike on March 3 will have a higher impact on short term money rates as the timing of the hike will coincide with year end payments like taxes etc. (though one might argue that there will still be 27 days for the year end and by then the money will be back in the system).

Impact on deposit rates:
The move will benefit the fixed deposit investors as banks are likely to raise the interest rates on term money. We seem to be heading towards days where a double digit interest rate will be a reality after a long time. But the flip side is that consumer loans and housing loans will now become costlier.

Impact on Yields and government securities.
If I were a bond dealer, right now I would be wishing to just run away from this market and rather be sitting on a beach side in Hawai with a lei around my waist. A bond market is the last place I would be wanting to be in today. The yields will take a beating and will move northwards and the longer term securities segment could witness a gory blood bath.

The securities market has been ailing for some time now and this move is likely to pull out the oxygen from the market and leave it gasping for breath. The fall in the prices will affect the mark to market valuations of the banks and the impact will be seen in the banks balance sheet for the ye 31.03.2007.

Impact on corporates:
Corporates now face the prospect of a higher financing costs which is likely to hit the bottom lines and the impact of the same will be mostly felt in the next FY 08-09. Corporates who have borrowed at floating rate will be left holding the short end of the stick.

Stock markets
Banking stocks took a beating yesterday in the light of the interest rate movement northwards. The PSU banks are likely to be the most hit as their ability to pass on the interest rate hike to the consumer will not be absolute keeping in mind their social responsibilities. Moreover as mentioned earlier in this post, the balance sheet of most banks will take a serious knocking on the mark to market process - especially in the longer duration securities. In fact at the time of my writing this blog SBI is trading at 1102 - 6% lower than previous day closing

The road ahead
If the inflation figure stays above 6% then we cant rule out the possibility of further hikes. Rupee will also face some pressure as the rate hike in the long run as continuous rise in the interest rates are perceived as weakening of economy. However in the short run we can see some dollar inflows to take advantages of interest rates arbitrages.

Other steps being taken
The government has decided to ban the exports of wheat to curb the price rise in wheat. But in my opinion the government needs to have a closer look at the factors in play in the Indian commodities markets and curb excessive speculation. It is time that we realise that unregulated speculation in the commodities markets doesnt benefit the farmer in the immediate run and only results in affecting the common man as a consumer who will have to bear the brunt of increased price.

Special Purpose Vehicles (SPVs) are in the news these days what with the banks and FIs and the corporates using this powerful tools for various purposes.

Banks and FIs and financial companies use this for undertaking off balance sheet financing or for hiving off their slow moving assets, while corporates are using this tool for funding their acquisitions e.g. TATA - Corus deal.

The use of SPVs originated in the US of A in the 1980s as a method of undertaking tax efficient transactions by establishing companies in tax havens like Cayman islands or Isle of Mann / Gibraltar etc.

However with the passage of time the usage of this product has spread across the globe and for varied uses other than tax efficient transactions.

So what is an SPV?
An SPV is a firm or legal entity established to perform some narrowly-defined or temporary purpose. The sponsoring firm accomplishes that purpose without having to carry any of the associated assets or liabilities on its own balance sheet. The purpose is achieved "off-balance sheet."

Usage of SPV
From the initial use of the SPV to enhance tax efficiency, SPVs are now used for a wide variety of transactions as the financial markets have become more and more sophisticated:
               Securitising loan portfolios of a bank
               Securitising financial assets such as:
               Auto loans
               Credit card and hire purchase receivables
               Finance leases
               Aircraft operating leases
               Real estate mortgages
              Aircraft and ship financing
              Catastrophe bond issues (CAT Bonds - I will be writing on this shortly)
              Specialised financing deals, such as Ijara financing (Ijara financing will be covered in another discussion in this blog)

How is the tool of SPV used?
The originating company transfers its assets into a specially formed company called the SPV. The SPV then issues bonds or notes which are backed by the receivables generated by the assets transferred to it. The investor investing in such bonds / notes does so by evaluating the SPV as a standalone entity and not as an arm of the originating company. Hence an SPV does not impose any strain on the credit limits of the originating company.

How is the ownership of an SPV structured?
The SPV may be a subsidiary of the originating company or may be a "orphan entity"

By its very nature, an SPV must be distanced from the sponsor both in terms of management and ownership, because if the SPV were to be owned or controlled by the sponsor, there is no difference between a subsidiary and an SPV.

In most of the cases an SPV is used either for enhancing tax effeciency or for off balance sheet financing. In the case of an SPV being used for tax purposes the originating company does not directly participate in the ownership of the company. The ownership of SPV in such a case is vested with a trust which is formed for this purpose.

In the event of an SPV being used for off balance sheet financing the originating company only has a partial ownership in the SPV. This is because if the entire ownership of the SPV was vested with the originating company then the financial statement of the originating company will have to incorporate the balance sheet of the SPV as well which in turn defeats the very purpose of the SPV.

Advantages of off balance sheet financing
Off-balance sheet financing is attractive from a risk management standpoint. When assets and liabilities are moved from one balance sheet to another, the risks associated with those assets and liabilities go with them. For example, if a firm transfers credit risky assets to an SPV, the credit risk goes with those assets.

What is a pass through certificate (PTC)?
A pass-through is a security issued by a special purpose vehicle. The SPV holds assets and pays the pass-through's investors whatever net cash flows those assets generate. In this way, the SPV's assets and liabilities are automatically cash matched, so there is no asset-liability risk.

Risks associated with an SPV?
Like any finance structuring tool SPVs come with their own inherent risk of misuse. A classic case of misuse was demonstrated by ENRON which created a number of SPVs (almost 3000) to hide its risk debts.

Why do investors prefer subscribing to SPV notes rather than lend to originating company

Although the subscribers are supposed to be taking the risk on the SPV itself, in most of the case the originating company takes a moral responsibility to repay in case of a default. Hence in practice an SPV can never go bankrupt. Therefore the pricing of the notes should not include any risk premium on account of bankruptcy.However this logic does not apply to the originating company as it is susceptible to bankruptcy risk. Hence the investors might prefer investing in an SPV note at a slightly lesser rate than what they would demand for the originating company note.

But this does not mean that there are no strings attached to the SPV route. Setting up of an SPV would involve a fixed cost and the originating company might not be able to claim the tax break on the interest paid by the SPV

How is a SPV bankruptcy remote?
An SPV is bankruptcy remote i.e even if the sponsoring company goes bankrupt the creditors cannot seize the assets of the SPV. Typically it is structured in such a way that it is ineligible to be a debtor under the US bankruptcy rules - how to structure this kind of an entity is a seperate topic matter for discussion.

TATAS SING IN C(H)ORUS

Every Indian has been celeberating the aquisition of corus by Tatas and is probably justified in doing so.

But as finance professionals one needs to look in the financial viabiity or other wise of the whole thing.

The TATAs have aquired Corus at 9 times EBIDTA which is almost double than what Mittal paid for Arcelor.

Moreover, Standard & Poor’s, the international rating agency has put Tata Steel on the watch list with negative implication. However, the agency has maintained its ‘BBB’ long term corporate rating after the Corus acquisition.

Further if one considers the fact that the steel cycle is almost nearing its peak any fall in the demand for steel is likely to impact the top line.

The borrowings required for funding this aquisition will be huge and irrespective of the debt equity mix adopted for funding this - there is likely to be considerable strain on the TISCO bottomline.

It would be interesting to observe the funding pattern to be adopted by the TATAs as this is the largest aquisition by an Indian corporate. The mode of funding adopted might be a guide post for other corporates planning on aquisition in the future.