US Elections and India

Last Wednesday the world got a very important news - Mr. Barack Obama being re-elected as the president of the United States of America. However it is such a news that would not leave even a single country in the world unaffected. For India there were mixed feelings.

For the India IT industry this news is considered to be somewhat bad  because of the stricter visa rules that would make it difficult for Indian IT industry to send their people to the U.S. where lie the majority of its customers. 

However if we look at the global economic scenario this news is not bad at all. The world is well known by the phrase "fiscal cliff" by now. Mr. Obama is believed to take a softer stand with respect to tax reforms and reducing the fiscal spending of the U.S. thus benefiting the growth f both the U.S. and the world economy and hence the Indian economy as we will see more FIIs investing heavily in growing markets like India. By December this year the decision regarding the fiscal cliff is expected to come making things much more clear.

On the other hand India must take care that the internal policies must not act as a hindrance to the investments. There are several reforms which await the winter of the parliamentary session for their approval. So there is one more reason to wait for this December.

Parth Pandya

SIMSREE Finance Forum

The Golden Rules of Investing

Earlier this year some folks from the U.K. came to our house to make videos in which I pontificated about passive investing. Some of the material will be included in longer pieces on their site but short snippets are also available there.

Here is one on my views of the two most important rules of investing:

The Golden Rules of Investing (Video)

The Capital Asset Pricing Model in Brief

Here is a very short video made at our home by the folks at sensibleinvesting.tv. In it, I explain the essence of the Capital Asset Pricing Model. As one can imagine, I have said more (much more) elsewhere.

Here is the link:

What is the Capital Asset Pricing Model?

What is US "Fiscal Cliff" actually?

When everyone thought that US and the world will be better if Obama won his presidential re-election again, world equities markets today declines with US being the most serious market by dropping more than 2%. What's the reason? Answer: Fiscal Cliff ?

Hmmm... Then, what is fiscal cliff actually which many of us on the street do not even heard about this new term before. No worry, Finance Malaysia blog did his homework over here. Share this out if you like.

Understanding Fiscal Cliff...

The US fiscal cliff refers to the effect of a series of enacted legislation which, if unchanged, will result in tax increases, spending cuts, and a corresponding reduction in the budget deficit. With Obama retaining the presidency, it sends the signal that it's US government policies will pretty much stay the same as previous 4 years. Ben Bernanke will stay as Fed chairman, which also meaning that the open-ended liquidity and bond buying programs will continue, fueling risk taking appetite of equity and fixed income markets for the foreseeable future.

Budget deficits, projected through 2022. The "CBO Baseline" shows the effects of the fiscal cliff under current law. The "Alternative Scenario" represents what would happen if Congress extends the Bush tax cuts and repeals the Budget Control Act-mandated spending reductions beyond the end of 2012.

However, Obama has to resume his duties in a very likely divided congress, with Republicans controlling the House and Democrats controlling the Senate. With this political deadlock and the looming "Fiscal Cliff", that's the reason why US market sink this morning.

Good or Bad?

If you understand it, the so called "Fiscal Cliff" is not something bad, in which its purpose is to reduce budget deficit of US. What investors worried was the measures being taken will slow the already slow growth rate of US economy, subsequently the world economies including Asia. But, without the intention of reducing budget deficit of US, would you be more confident? Of course NOT, because US would never able to not walk out from the brushes. Right?

By now, you should be able to understand the term. Meanwhile, some analysts have argued that "fiscal slope" or "fiscal hill" would be more appropriate because while the cumulative economic effect over all would be substantial, it would not be felt immediately but rather gradually as the weeks and months went by. Hahaha...

Magical Thinking about Pension Plans

This year I was fortunate enough to be awarded the Lillywhite Award for extraordinary lifetime contributions to Americans' economic security. Dallas Salisbury, President of the Employee Benefit Research Institute which sponsors the award, presented it to me at the Pensions and Investments Defined Contribution Conference in San Francisco, California. The following is a slightly edited version of my invited remarks thereafter.

I started studying pension funds when most people had defined benefit plans. No decisions. You worked, you got paychecks. You retired, you got smaller paychecks, You died, your partner got even smaller paychecks. He or she died, the paychecks stopped.

Now defined benefit plans survive mainly in the government sector. Social Security of course. And pension plans for government employees. But they can teach us something about defined contribution plans.

Take CalPERS. It covers non-teaching state and many local government employees in California. And, officially, it is substantially underfunded. This is based on the assumption made for funding by the CalPERS actuaries that their portfolio of bonds, stocks and exotica will return exactly 7.5% every single year. Moreover, they value assets at an average of past values.

Magical thinking. Bad economics.

Almost every economist who has looked at similar pension funds concludes that assets should be valued at market and that liabilities should be valued by determining the cost of a low-risk government bond portfolio that could provide the funds to pay the benefits already earned. For CalPERS this portfolio would be primarily in TIPS since their benefits are mostly indexed for inflation.

When the liabilities are valued with good economics, the extent to which CalPERS is underfunded is not just substantial – it is woeful.

But this is a Defined Contribution conference. Employers in the DC world have no liabilities and mark assets to market – in some cases every day. No magical thinking. Good economics.

Yes, but...

Sometimes in projecting the amount that should be contributed to a defined contribution plan there is magical thinking. We or our employees may assume the portfolio will earn 7.5% or so per year for sure. The market may go down, but if so it will feel sorry for us and go back up in short order.

But the good news is that we are getting better in helping employees get a sense of both expected return and risk in the accumulation phase.

But not always in the decumulation phase.

As the baby boomers enter retirement, every part of the financial industry is lusting after their money. Financial advisors have strategies for managing investments and spending. Insurance companies have traditional annuities and guaranteed withdrawal plans. Mutual funds have retirement income products. Employers have extensions of 401(k) plans. Everyone wants a piece of the action.

For good or bad reasons, left to their own devices, retirees invest relatively little in traditional annuities, foregoing the significant advantages of pooling mortality risk.

Moreover, thanks to Chairman Bernanke and his counterparts around the world, low-risk investments currently offer paltry nominal returns and negative real returns for all but the very longest horizons.

What's an investor to do? A frequent answer is this. Invest in risky securities, which should provide higher returns. Spend on the assumption that returns will be 7.5% (or so) per year. Not to worry, returns may vary, but they will average out in the long run. Once again, magical thinking and bad economics.

So what should financial professionals, do? One answer is to use Monte Carlo analysis with a sensible market model to generate possible scenarios for future investment returns, then use the results to help investors understand the true implications of alternative decumulation investment and spending strategies.

Admittedly, neither the creation or the communication of such ranges of outcomes is easy. But investors need to understand that if they take market risk, someone will be exposed to that risk. If something bad happens, it is going to happen to someone. It might be them or it might be their beneficiaries. Their financial advisor, investment company or employer may get smaller fees, but won't bear the majority of the impact. And if insurance companies take market risk, they do so at their peril or, worse yet that of the taxpayers who might have to bail them out.

Pooling can't help – when the market crashes it takes almost all the players with it.

If your investments are subject to market risk, so are the prospects for your spending and/or that of your beneficiaries. Even the cleverest financial strategy can't magically make market risk disappear.

So, I implore all those who help people save and invest for retirement and then use their savings sensibly in retirement. Please avoid magical thinking and bad economics. Employees and retirees deserve better.

Betala banktjänstemän med obligationer i stället för aktier!

Ibland överraskar EU-byråkraterna med att leverera något som jag gillar. Liikanen-kommissionen lyckades med denna bedrift härom veckan. De förslår bl.a. att bankanställdas bonusar (delvis) ska betalas med bankens obligationer i stället för med bankens aktier. Detta tycker jag låter som en bra idé då det torde sänka riskbenägenheten hos bankirerna och då en stor (större) del av bankens investerare faktiskt är obligationsägare snarare än aktieägare. På det viset har principalen (den typiska investeraren) och agenten (bankchefen/tjänstemannen) förenliga incitament.

Jag har nyligen skrivit en artikel Executive Compensation Based on Asset Values om detta som är publicerad i Economics Bulletin 32 (2), (2012) 1498-1502. Artikeln kan nås här och handlar om hur ledningen i bolag, framförallt banker, kan kompenseras på ett sätt som är konsistent med investerarnas mål. Jag förslår att man använder kreditderivat för att lösa problemet med corporate debt som inte handlas på marknaden.

Auction - The only way of allocating Natural Resorces to Private Firms?

The article is written by Khushal Shah and Chetan Dhawan from SIMSREE in the Arthneeti Article Writing Competition (September 2012)

 

Dr Manmohan Singh is standing at a very precarious position today. The Comptroller and Auditor General of India, in his recent report, has pulled up the government for financial wrong doing due to its policy of allocating captive coal blocks to private companies without a competitive bidding procedure. Dr Singh has justified his stance by arguing that the CAG has gone wrong with its numbers and that it is the government prerogative to decide on policy regarding allocation of natural resources. Has Dr Singh erred in handing out coal blocks for free and subsequently justifying the government’s decision?

To answer this let us first look at how the allocation of natural resources started in India. The Mines and Mineral Development and Regulation Act was enacted in 1957 when we hardly had any information about the extent of our natural resources. Also, there was very limited private investment. Under such a scenario, the government promoted first-cum-first-serve scheme whereby any willing investor was given the lease and the license to extract the minerals.The reason for implementation of the scheme being that ultimately the method of allocation of natural resources including airwaves, coal, minerals, oil and gas, forest land, to name a few, should also take into account public interest which includes within its ambit the larger economic perspective and not merely financial gain. However the recent revelations by the CAG accusing the government of causing a notional loss of lakhs of crores of rupees to the national exchequer and the prima facie reports by the CBI accusing several government ministers of nepotism indicating collusion between corporates and bureaucrats call into question the feasibility of a first cum first served allocation policy for any natural resource.

            Today, we are faced with such a low level of public trust that the auction process is seen as the 'best' way to ensure adherence to transparency and openness in resource allocation and maximising revenues to the government. Even the apex court, following 2G spectrum revelations, commented that ‘If scarce natural resources were to be alienated by the state, then the ‘only’ legal method was a transparent public auction’. So why is it that an ‘auction’ is perceived to be the only best possible method?

            To answer this, let us first see how resource allocation under auctions takes place. Generally in this scheme government comes up with a ‘Base Price’, which is the minimum price at which the government expects to sell the resource. The bidders are then expected to bid above the base price based on their perceived value of the resource. The bidding goes on till only one highest bidder remains. Now the resource is allocated to the bidder at this discovered highest price.Since the entire process is transparent,chances of collusion and corruption reduce drastically, securing the best possible price for the government.Perhaps, we can take a clue from the recently conducted 3G auctions which took place by means of an online auction. The bidding went on till the highest bid was realized. The process ensured transparency during the entire process by means of specially designed secure software. Clearly, an auction is a way to determine market demand and price. But why fixate on auctions as the only way to ensure market orientation, transparency and efficiency in the allocation and pricing of natural resources in India?

While auctions could be a ‘preferred’ option since they bring about transparency and secure the best possible price, revenue enhancement cannot be the only consideration while allocating natural resources.The disposal and distribution of natural resources has to be made in accordance with the sector specific requirement of each natural resource. The method of distribution of natural resource has to take into account the nature of natural resource and economic policy underlying the effective utilisation of such resource. There are various other factors such as national inclusion, service affordability, final product pricing, rural penetration etc that have to be taken into consideration to arrive at informed and reasoned decision of the methodology of allocating natural resources.           

Apart from these there are certain problems which the government might have to overcome before it can enforce the auction policy for all natural resource.First, the Centre has to convert this policy to law by way of amending Section 11(2) of the 1957 Act to auction natural resources like minerals, which is time-consumingFor example, the government tried to amend the Act to introduce auctions for allotment of coal blocks in 2004, but has not yet finalised its modus operandi.Secondly, the past experiences of some State Government for allocating leases by competitive bidding have not been encouraging. In 1991, Odisha suddenly realised that mining gemstones by the State-owned Orissa Mining Corporation was not remunerative and decided to auction gem-rich blocks by competitive bidding through Orissa Mining Corporation.The State Government identified 12 such blocks for aquamarine and sapphire in Bolangir and Kalahandi districts for a reserve price of Rs 20 lakh. Out of 12, the State Government could auction only five blocks for Rs 22 lakh. Thirdly, the Supreme Court in its order of February 2 this year observed that while allocating natural resources through auctions, the doctrine of public interest within the framework of the Constitutional rights of the people has to be adhered to, which is not possible if the government adopts only auction route for allocation of all natural resources. For example, if we auction fish resources of the Bay of Bengal, the Japanese trawler companies may bid the highest price, but the livelihood of the east-coast fishermen will be in jeopardy. Fourthly, it is observed that the cost of buying at a high price from an auction is more often than not passed on to the final consumer. For example the recent auction of third generation airwaves did fetch the government a huge sum, but the services have not found widespread acceptance among the general public because the companies, in order to recover the bid price, had to price these services at a higher price. Compare this to the allocation of 2G spectrum. It is widely believed that while the awarding of 2G spectrum on a so-called first-come-first-served basis in 2008 may have caused massive losses to the exchequer, the consumers, nevertheless, benefited from call rates dropping due to the entry of new mobile operators and very low call rates.

Another alternative for allocation of natural resources which can be beneficial to both the government and the companies can be a royalty based mechanism. A royalty based mechanism is similar to a tax based on assessed value of a property.The royalty should be tied to the market prices, rather than a fixed amount. A royalty based mechanism would enable the government to charge royalty at the current market price, rather than at the beginning when the resources are allocated. It would ensure continuous supply of revenue to the government. Since the royalty is associated with the actual market price, it would ensure higher revenue generation for the government. The time period for revising the royalty value should not be kept very long. Although the royalty based mechanism is prevalent in India, the royalty amount is fixed and revised every three years, which is a very long period considering the fluctuations in the prices.

            Considering the diverse needs of the country, it would be very difficult to pin point on a specific policy as the best alternative, given that the main aim of the government is to bring in transparency and safeguard the resources belonging to the country. Auctions are meant to allocate scarce resources in a transparent manner. In case the government wants to deviate from market based pricing, driven by overriding public concern, then the rationale behind policy making must be clearly manifested. In the larger public interest, if prices of end products need to be kept at a threshold, then the good or service should be subsidised at the consumer end rather than at the input end. Ensuring that benefit given at the input end to corporates will be passed on to the consumer is very difficult.The best choice would be the one which would ensure sustainability, effectiveness and transparency in the utilisation of the scarce natural resources.