Indian Economy, 5th edition (70 page)

Initial Public Offer (IPO) is an event of share issuing when a company comes up with its share/securities issued for the first time.

Price Band

A process of public issue where the company gives a price range (known as price band) and it is left upon the share applicants to quote their prices on it—the highest bidders getting the shares. This is a variant of share issue at premium but considered a safer choice.

ECB Policy

A prospective borrower can access external commercial borrowings (ECBs) under two routes, namely the ‘automatic route’ and the ‘approval route’. ECBs not covered under the automatic route are considered on case-by-case basis by the RBI under the approval route. The High Level Committee on ECB took a number of decisions in
September 2011
to expand the scope of ECBs which include:

(i)
High networth individuals (HNIs) who fulfil the criteria prescribed by SEBI can invest in IDFs.

(ii)
IFCs have been included as eligible issuers for FII investment in the corporate bonds long-term infra category.

(iii)
ECB would be permitted for refinancing of rupee loans of infrastructure projects on the condition that at least 25 per cent of such ECBs shall be used for repayment of the said rupee loan and 75 per cent invested in new projects in the infrastructure sector (but only under the approval route).

(iv)
Refinancing of buyer’s/supplier’s credit through ECBs for the purchase of capital goods by companies in the infrastructure sector was approved. This would also be permitted only under the approval route.

(v)
ECBs for interest during construction (IDC) that accumulates on a loan during the project execution phase for companies in the infrastructure sector would be permitted. This would be subject to the condition that the IDC is capitalised and is part of the project cost.

(vi)
Renminbi (RMB) – the Chinese currency – was approved as an
acceptable currency
for raising ECBs subject to/limit of US $ 1 billion within the existing ECB ceiling (allowed only through the approval route).

(vii)
The existing
ECB limits
under the automatic route were enhanced from US $ 500 million to US$ 750 million for eligible corporates. For borrowers in the
services sector,
the limit has been enhanced from US$ 100 million to US$ 200 million and for
NGOs
engaged in
micro-finance
activities from the existing US$ 5 million to US$ 10 million.

(viii)
INR (rupee) denominated ECBs would be permitted from foreign equity holders to ‘all eligible borrowers’ except in the case of ECBs availed of by NGOs under the automatic route.

During the financial year
2012-13
the external commercial borrowings (ECB) policy was further liberalized via the following steps –

•
Enhancing the limit for refinancing rupee loans through ECB from 25 per cent to 40 per cent for Indian companies in the power sector;

•
Allowing ECB for capital expenditure on the maintenance and operation of toll systems for roads and highways so long as they are a part of the original project subject to certain conditions, and also for low cost housing projects;

•
Reducing the withholding tax from 20 per cent to 5 per cent for a period of three years (July 2012 - June 2015) on interest payments on ECBs;

•
Introducing a new ECB scheme of US $10 billion for companies in the manufacturing and infrastructure sectors;

•
Permitting the Small Industries Development Bank (SIDBI) as an eligible borrower for accessing ECB for on-lending to the micro, small, and medium enterprises (MSMEs); and

•
Permitting the National Housing Bank (NHB)/Housing Finance Companies to avail themselves of ECBs for financing prospective owners of low cost /affordable housing units.

RGESS

On
November 23, 2012
, the government notified a new tax saving scheme called the Rajiv Gandhi Equity Savings Scheme (RGESS),
exclusively for first-time retail investors
in the securities market. This scheme provides 50 per cent deduction of the amount invested from taxable income for that year to new investors who invest up to Rs. 50,000 and whose annual income is below Rs. 10 lakh.The Rajiv Gandhi Equity Saving Scheme (RGESS) will give tax benefits to new investors whose annual income is up to Rs. 10 lakh for investments up to a maximum of Rs. 50,000. The investor will get 50 per cent deduction of the amount invested from taxable income for that year. Salient features of the scheme are as follows –

•
The scheme is open to new retail investors identified on the basis of their permanent account numbers (PAN).

•
The tax deduction allowed will be over and above the Rs. 1 lakh limit permitted allowed under Section 80 C of the IncomeTax Act.

•
In addition to the 50 per cent tax deduction for investments, dividend income is also tax free.

•
Stocks listed under BSE 100 or CNX 100, or stocks of public-sector undertakings (PSUs) that are Navratnas, Maharatnas, and Miniratnas will be eligible under the scheme. Follow-on public offers (FPOs) of these companies will also be eligible.

•
IPOs of PSUs, which are scheduled to get listed in the relevant financial year and whose annual turnover is not less than Rs. 4,000 crore for each of the immediate past three years, will also be eligible.

•
Exchange-traded funds (ETFs) and MFs that have RGESS-eligible securities have also been brought under the RGESS.

•
To benefit small investors, investments are allowed in instalments in the year in which tax claims are made.

•
The total lock-in period for investments will be three years including an initial blanket lock-in of one year. After the first year, investors will be allowed to trade in the securities.

The broad provisions of the scheme and the income tax benefits under it have already been incorporated as a new
Section-80CCG
of the Income Tax Act 1961, as amended by the Finance Act 2012. The operational guidelines were issued by SEBI on
December 6, 2012
.

CREDIT DEFAULT SWAP (CDS)

CDS is in operation in India since October 2011 – launched in only corporate bonds. The eligible participants are commercial banks, primary dealers, NBFCs, insurance companies and mutual funds.

CDS is a credit derivative transaction in which two parties enter into an agreement, whereby one party (called as the ‘protection buyer’) pays the other party (called as the ‘Protection Seller’) periodic payments for the specified life of the agreement. The protection seller makes no payment unless a credit event relating to a pre-determined reference asset occurs. If such an event occurs, it triggers the Protection Seller’s settlement obligation, which can be either cash or physical (India follows physical settlement). It means,
CDS is a credit derivative that can be used to transfer credit risk from the investor exposed to the risk
(called protection buyer
)
 to an investor willing to take risk
(called protection seller).

It operates like an insurance policy. In an insurance policy, the insurance firm pays the loss amount to the insured party. Similarly, the buyer of the CDS – the bank or institution that has invested in a corporate bond issue – seeks to mitigate the losses it may suffer on account of a default by the bond issuer. Credit default swaps allow one party to ‘buy’ protection from another party for losses that might be incurred as a result of default by a specified reference instrument (a bond issue in India). The ‘buyer’ of protection pays a premium to the seller, and the ‘seller’ of protection agrees to compensate the buyer for losses incurred upon the occurrence of any one of the several specified ‘credit events’.
Thus CDS offers the buyer a chance to transfer the credit risk of financial assets to the seller without actually transferring ownership of the assets themselves.

Let us try to understand it by an example – suppose Punjab National Bank (PNB) invests in Rs. 150 crore bond issued by TISCO. If PNB wishes to
hedge
losses that may arise from a default of TISCO, then PNB may buy a credit default swap from a financial institute, suppose, Templeton. PNB will pay fixed periodic payments to Templeton, in exchange for default protection (just like premium of an insurance policy).

CDS can be
used for different purposes
in a financial system –

(i)
Protection buyers can use it to hedge their credit exposure while protection sellers can use it to participate in credit markets, without actually owning assets.

(ii)
The protection buyer can transfer credit risk on an entity without transferring the under lying instrument, reap regular benefit in terms of lower capital charge, seek reduction of specific concentrations in credit portfolio and go short on credit risk.

(iii)
The protection seller will be able to diversify his portfolio, create exposure to a particular credit, have access to an asset which may not otherwise be available, and increase the yield on his portfolio.

(iv)
Banks can use it to transfer risk to other risk takers, create capital for more lending.

(v)
Distribute risk widely throughout the system and prevent concentrations of risk.

Some analysts have serious
apprehensions
about CDS.
George Akerlof
, Nobel prize-winning economist, in 1993, predicted that the next meltdown will be caused by CDS. In 2003 investment legend 
Warren Buffet
 called them as ‘weapons of mass destruction’. The former US Federal Reserve Chairman 
Alan Greenspan
, who betted big on CDS said after the ‘sub prime’ crisis that ‘CDS are dangerous’. A leading US weekly the 
Newsweek
described CDS, ‘the monster that ate Wall Street’. Many Indian experts had the opinion that ‘CDS will not stabilize the economy rather could lead to destabilization’.

CDS contract are dangerous because they can be manipulated for mischief. It’s all about the insurable interest which is never there as it is used for
speculation
. A derivative that amounts to an insurance contract with no insurable interest is bad. But do the speculators have insurable interest?  No they don’t have any! The US ‘sub prime’ crisis was a fallout of such CDS contracts – one defaulting and another claiming the ‘protection’ finally resulting into the defaulter of the insuring company – overnight the biggest US insurance giant, AIG went bankrupt. So happened with many US banks also.

The most damaging aspect of CDS is that the credit risk of one country/region gets exported to another country/region very smoothly and silently – thus there is a serious chance of ‘contagion effect’ suppose there are defaulters there – the thing which happened during the US ‘sub prime’ crisis.

SECURITISATION

This is the process of issuing ‘marketable securities’ backed by a pool of existing assets such as auto or home loans. After an asset is converted into a marketable security, it is sold to an investor who then receives interest and principal out of the cash flow generated from servicing of the loan. Financial institutions such as NBFCs and microfinance companies convert their loans into marketable securities and sell them to investors. This helps them get liquid cash out of assets that otherwise would be stuck on their balance sheets.

Global experience shows that if the value of the underlying asset falls then securitised assets lose value as it had happened during the US ‘sub-prime crisis’ – home loans against which securitised assets were sold to insurance companies and banks lost value, which in turn resulted in a crisis. To prevent such crises, the RBI has taken some precautionary steps in this regard – it has asked companies to hold securities for a certain minimum period:

(i)
While NBFCs need to keep assets for six months – a minimum retention requirement of 5-10 per cent to ensure that they have a continuing stake in the performance of securitised assets.

(ii)
Micro Finance Institutions (MFIs) need to hold them for three months.

Since it was allowed in India by the RBI, it has been in news – whether the ‘securitisations trusts’ will need to pay tax on it. Meanwhile, the
Union Budget 2013-14
has cleared the air on the issue – there should not be any additional income-tax if the income distributed by the trust is received by a person who is exempted from tax. This is expected to bring back mutual fundss into the securitisation market.

CORPORATE BOND IN INDIA

Economic vibrancy coupled with sophisticated state–of–the–art financial infrastructure has contributed to rapid growth in the equity market in India. In terms of market features and depth, the Indian equity market ranks among the best in the world. In parallel, the government securities market has also evolved over the years and expanded, given the increasing borrowing requirements of the government. In contrast, the corporate bond market has languished both in terms of market participation and structure. Non-bank finance companies are the main issuers and very small amounts of finance are raised by companies directly. The
Economic Survey 2010-11
(p.116), cites many reasons for the less-developed bond market in India –

(i)
Predominance of banks loans;

(ii)
FII’s participation is limited;

(iii)
Pensions and insurance companies and household are limited participants because of lack of investor confidence; and

(iv)
Crowding out by Government bonds.

The
Economic Survey 2011-12
concluded
15
that there is now ample empirical research to corroborate Schumpeter’s conjecture that financial development facilitates real economic growth. The depth of the financial markets and availability of diverse products should, therefore, not be treated as mere adornment but as critical ingredients of inclusive growth.