CAG Reports and the Markets

My column for Wealth Insight on the CAG reports is here. The article is reproduced below

CAG deserves the kudos of all right- thinking Indians for raising the level of public debate

The Comptroller and Auditor General of India (CAG) is not a position most people in India have been familiar with. This changed recently when CAG reports repeatedly made headlines claiming massive loot of the public exchequer. In August, a multitude of reports hit the Parliament — all pointing out lacunae in government policy and putative losses. The government’s spin masters went to work quickly. While some attempted to show that the CAG reports overstepped their mandate, others challenged the content of reports — in particular, the attempt to quantify losses arising to the public from flawed implementation of policy. Yet others have attempted to question the motives of the CAG.

Irrespective of the outcome, Vinod Rai — the incumbent CAG – deserves the kudos of all right- thinking Indians for raising the level of public debate. Every once in a while, a leader comes along who uses the full power of a constitutional authority. The Election Commission underwent such a change under TN Seshan. I hope this continues even after Rai demits office.

Analysis is succinct yet comprehensive
CAG has released a number of reports. For want of space, I discuss only the report on Ultra Mega Power Projects (UMPP) here. The report — something I recommend all to read for its lucid and incisive analysis is available at http://saiindia.gov.in/english/home/Recent/Recent.html. If only analysts wrote as clearly and authoritatively!

The report makes several points with regard to the allocation of UMPP licences and related coal reserves:
# The government did not follow its own rules — starting with appointment of the bid consultant
# Terms of the bid were altered to suit certain bidders (in particular Reliance power or RPL, the eventual winner), by diluting requirements of ownership, investment, and experience
# Extra land was allotted despite a study to show that it was in excess. No effort was made to recover the land despite it being established that it was in excess
# Allotment of coal blocks were made — in excess of the requirement — despite having no justification or study to show the need
# The excess coal was allowed to be diverted to another project — tariff for which was already determined based on the need to buy coal. This clearly amounted to violation of bid conditions in favour of Reliance Power
# The report quotes from RPL’s own estimates which put the extra gain to the company from the allotted coal to the tune of Rs 29,000 crore It is worth recalling that Tata Power has a case pending in the Supreme Court challenging the use of coal allotted for Sasan for Chitrangi Project (as approved by the Empowered Group of Ministers, or EGOM).

The defence
RPL’s defence is simple. They are not responsible for the excess coal, that the allocation of the extra mine has been ratified by the EGOM twice — once in 2008, and again in 2012. There are also somewhat gratuitous comments suggesting that CAG’s recommendation of reviewing the allocation of coal would result in India continuing to remain short of coal.

The argument is self-serving. Of course the allotment of mines has to be a government decision! The mines belong to the public and are being allotted. To suggest that this happens without intervention of the beneficiary is to stretch credulity to the point of breaking. To assert that without the mines being allotted to RPL, India would remain short of coal is laughable. First, the mines have not yet started delivering anything. Also, there are other perfectly capable companies that can mine the coal, and would pay for it.

The government’s defence is even more pathetic. To the primary allegation of extra allotment, the ministry of power has responded that the Attorney General of India has opined that the decision of the EGOM in 2008 was “well considered” — and hence the recommendation of the CAG that the extra allotment be withdrawn, may be ignored. It begs the question on why the EGOM allotted the extra mine in the first place, and why it felt imperative to overrule the conditions of allotment. Sample this: ‘The coal produced from these mines would be exclusively used in the Sasan UMPP.’

The other points are even more wishy-washy — and have been torn down in the report of the CAG itself with arguments that seem perfectly reasonable.

Greater transparency: churn in the index
The reports will now be referred to the Public Accounts Committee, where the matter is unlikely to result in corrective action. Given that this cannot be blamed on allies (unlike the 3G imbroglio), it would result in serious embarrassment for an already embattled government.

However, it may and hopefully will, result in a new and clearer policy of allotment of natural resources, in particular coal. Short-term, this may result in even slower decision making. Our shortage of coal is likely to continue. Longer term, the challenge of allotment of scare resources — airwaves, coal and iron ore, and even concessions to operate airports and roads — is likely to become more streamlined. Clear policies will remove the politicians’ ability to “seek rent” — a polite term for extracting money from public goods. With that, infrastructure companies will be less attractive to secondary investors — as unpredictable upsides are unlikely to occur. This may result in another shake up in the index. Currently 40 per cent of the index capitalisation is from companies dependent on energy, coal, and steel — all industries benefiting from ability to influence government policy. A reduction of this number over the next decade will represent the coming of age of the Indian economy.

Manipulation by design

My take on central banking as it appears in Wealth Insight here. The article is reproduced below:

Barclay’s CEO, Bob Diamond, recently lost his job. In the aftermath of the financial crisis in 2008, Tucker, Deputy Governor of the Bank of England (BoE), telephoned Diamond. Tucker, apparently, indicated that Barclay’s Libor rate “did not always need to be as high as (they) have (been) recently”. Diamond passed on the message to his team — who took this as indication from the BoE to report lower rates — which they proceeded to do. Investigations of this “rigging” have so far led to resignations of the Chairman, CEO and COO of Barclays. Barclays has been fined £290 million for this attempted “manipulation”.

Can’t “fix” rates on your own
The Libor is calculated (fixed) by Thomson Reuters on behalf of the British Bankers’ Association by taking a poll of a panel of banks (16 banks for pound, 18 for USD) just prior to 11 AM. The survey asks banks the rates at which they “think” they can borrow. No actual transaction takes place. It is at best an “oligopolistic” rate — a “survey” rate. The four lowest and four highest rates are then eliminated and the Libor is calculated by taking an average of the rest. If Barclays was consistently reporting higher rates than the rest, it would have been eliminated. Even an “in sample” bank will have a weight of about 10 per cent. Overall, any single bank can skew the rate only by a few basis points (1/100th of a per cent) at best.

In markets where money moves freely across borders, rates in one currency cannot dramatically differ across borders. One way to check if the Libor was completely out of whack is to check its correlation with the T-bills rate in the US — the rate at which the US government borrows. The US T-bill rate in turn tracks the Fed Fund rate — a rate which the US Federal Reserve “manages” by intervention in the money markets (which includes printing dollars when needed). As the graph on the next page shows, barring the spike in 2008 (caused more by liquidity tightening post Lehman), there seems to be no systematic drift in the value of Libor vs T-bills.

The elephant in the room
Policy statements of Central Banks are watched carefully — for one primary reason. As the monopolistic printer of money, the Central Bank in any economy is in the business of managing (manipulating) interest rates. It is what they do. It is their mandate.

In 2008, a sharp fall in housing prices — caused in no small measure by the US Fed allowing an asset price bubble to be formed, led central banks the world over to lower interest rates. This increased asset prices, thereby shoring up the balance sheets of banks. This was manipulation — as is all policy “intervention” by Central Banks. In that context, Barclays executives cannot be faulted for doing what they thought their regulator wanted them to do. It seems strange logic that the bank is being penalised for working on the directions of the Bank of England.

Banks — more equal than others
In a recent interview to Business Line, Dr YV Reddy, the former Governor of the Reserve Bank of India, is quoted as having said, “The government licenses banks to accept non-collateralised deposits — virtually telling people that your deposits are safe. The banks, in turn, agree to lend to government whenever the government wants. This is a compact. In some sense, it is the biggest con game going on”. The implied sovereign guarantee allows banks to leverage their balance sheet 10 times, magnifying the return on equity. The heightened risk is mitigated by the back-stop of the central bank. This sets up moral hazards. Bankers get incentivised for taking risks — if the risks materialise, the Central Bank steps in. Else, bankers receive outsize bonuses on profits from highly leveraged transactions.

Shared area indicate US recessions 2012 research.stlouisfed.org

Central Banks were set up with the objective to bring stability to the monetary system. In reality however, their intervention has led to increased volatility and boom and bust cycles. When the banks involved are “too big to fail”, the problem becomes that of the tax payers.

Unintended consequences
The power to manipulate markets is not easily controlled. Borrowers — corporations and consumers (home loans and consumption loans) — lobby central banks for lower rates irrespective of the economic situation. When was the last you heard a demand for higher interest rates when the economy was over-heating?
However, when growth slows, the clamour for lower rates rapidly rises.

Lobbying also ensures that shareholders are not penalised. In 2008 public money was liberally used to bail out banks in the US — directly through investment, and indirectly through monetary policy. The ownership of stressed banks and financial institutions remains with the original owners — a situation where profits are private and losses are public! Central planning for the economy has failed. Will centrally-planned monetary systems follow?

Whose side is SEBI on ?

My latest blog on SEBI's recent directives on Mutual Funds is here.  The post follows:

Assume we are living at a time when we still used boats to travel long distances. Imagine a large, leaky boat about to set out on a stormy sea. Imagine that this boat is about to make a journey that in the normal course will last over a year. Additionally, the boat has had a history of capsizing a few times in the past, often taking with it the passengers. However, each time, the owners are able to pull the boat out from the sea put up a few patches and declare it seaworthy. It would seem obvious that tickets for the trip would be hard to sell especially to people staying in the vicinity of the port of launch.

Now imagine that there is a regulator whose job is to protect the passengers. The regulator is charged with certifying the sea-worthiness of the boat so that the passengers have a safe journey. Over the years, seeing that the boat has not proven to be particularly safe, the regulator declares that all passengers have to decide for themselves what the journey is worth to them. Sellers of tickets are to be paid for their services directly by the passengers not by the boat owners. Meanwhile, the seas become stormier, and ticket sales fall.

The boat owners now demand that the ticket prices should be raised (They obviously form a cartel if you want to use the boats, you have to deal with them). This extra money is to be used partially for rewarding those who sell tickets to passengers. Importantly, more money is to be paid to those sellers who sell tickets to unsuspecting passengers, who live far away, and are therefore less likely to have heard of the experience of earlier passengers. Even more intriguingly, passengers who have already bought the tickets should be charged extra every time a "new" passenger from afar agrees to board the leaky boat. What should the regulator do?

It could of course ignore the lobbying of the boat owners, and insist that they spend money building a more robust boat. It could insist that boat owners pay more to cartographers who can help determine a less risky path to the destination. It could insist that buyers have a right to know that that besides the boat, there were other less dangerous paths to the destination as well. It could mandate the creation of boats that are safer. It could insist in fact, that their primary mandate was to protect the passenger, and not the well being of the boat owners.

What would you say of a regulator that instead, agrees whole heartedly with the boat owners, caps the payment to the cartographers, increases the price of the tickets and increases incentives for those getting unsuspecting passengers to the boat even forcing existing passengers to pay more. Who am I talking about replace "boat owners" with "Mutual Funds" and you have your answer.

Undoing its own logic

In 2009, SEBI decided to ban entry loads for mutual funds the argument then was that investors should determine for themselves what services of "fund advisors" people who sold them funds was worth to them. Investors could decide how much they would pay. A laudable objective.

This change effectively killed a whole range of distributors where clearly, the investor did not feel that enough value was being added to be worth paying. Inflows into equity mutual funds fell as well.

The moot point is whether the inflows fell as a result of poor market and fund performance or because of a lower distributor base.

A look at the graph above shows that the problem is not that the assets did not increase. Just that equity fund assets did not grow. Most equity funds in the period post the ban of entry load (August 2009) have delivered poor returns to investors (category average for 3 years for equity large cap has been 4.5% per annum while even liquid debt funds have delivered 7% per annum). Since the equity markets have performed poorly, long-only funds too have performed poorly some more so than others. Long-only refers to a situation where fund managers are only allowed to buy before they can sell. An alternative would be to sell first and then buy back at a lower price if the market were falling. Almost all mutual funds are "long-only". In such an environment, would it be expected that there would be a rush of investors into equity funds? Not in the view of this writer.

What therefore was the rationale to re-impose the entry load which is what SEBI has mandated as per its latest guidelines? Under the guise of increasing investor participation, SEBI has made the following changes (a) entry load has been increased if mutual funds were to raise money from centres other than the top 15. 

Astonishingly, it has allowed mutual funds to charge the extra load to other investors of the fund as well not only the far-away ones (b) it has passed on the service tax that was earlier paid by the asset management company to the investor (c) it has capped the brokerage that can be paid to the broker who provides research and trade execution to the fund house and incidentally provides the fund manager the inputs to enable him or her to make investment decisions after considering multiple view points.

The product is faulty, not the sales effort

First and foremost, SEBI could have allowed mutual funds to have investment styles which are not only "long-only". The market offers enough instruments today to allow a skilful fund manager to trade both ways and generate "alpha". By allowing manager to only buy, the ability to sensibly exploit shorting opportunities is unavailable to managers. The recent Alternative investment fund guideline is a step in direction of allowing shorting as well, but the large ticket size per investor (currently Rs 1 crore is the minimum per investor) is a big entry barrier.

Another could have been the ability to manage a multi-asset fund. Here of course the plethora of regulators offers an impediment. So we have the strange conundrum that each individual can be a "multi asset class hedge fund" by himself there is no bar for an individual to trade in equity, commodity, currency, gold or real-estate, but no investment professional or fund house can offer such an investment vehicle to investors. A mutual fund cannot invest in commodities for example an asset class that has done well in the same years that equity has performed poorly. But if this is the problem, should it not have been addressed?

Clearly this is a case where the wrong question has been posed and answered. Many representatives of mutual funds and distributors would have presented their view points to SEBI. I wonder how many investor associations did. 

The views expressed are the personal views of the author.