Problems pertaining to Reinsurance Business in India

Everybody is familiar with the term insurance. It is a contract entered between two parties where one party (insured) pays the other (insurer) an amount (referred to as premium) to compensate itself or a third party in case of some financial or personal loss. Thus, insurance is nothing but a way to transfer risks from one party to another party in exchange of a small amount. The question arises as to why a small amount is enough for the other party when the expected payout if that risk materialises is huge? The answer is simple. The party that insures the other collects these small amounts from thousands or lakhs or millions of people. Accordingly, these insurers work on probability and other complicated mathematical and statistical models to mitigate their risk and eventually turn out to be profitable by collecting these small amounts and paying for any claims lodged by the insured public.

However, the above risk management leaves one small loophole to be covered. What if an earthquake or a hurricane or a tsunami strikes and causes damage to lives and properties of thousands of people. Even a large insurance company would have to suffer huge losses in the form of extremely high payouts. Accordingly, these insurance companies also buy insurance protection to protect themselves against these situations. This phenomenon of buying insurance protection by insurance companies themselves is referred to as reinsurance. A reinsurer may be either a specialist reinsurance company, which only undertakes reinsurance business, or another insurance company. Some of the famous reinsurance companies of the world are – Munich Re, Swiss Re, Berkshire Hathaway (General Re), Hannover Re, SCOR, etc.

In India, insurance sector, moved from being an unregulated sector to a completely regulated sector to partly deregulated sector now. India being a developing country and one of the least penetrated insurance markets in the world, there is tremendous scope of growth for insurance and reinsurance business. Since the reinsurance business involves managing risks of the entities that themselves manage risks, it involves not only immense expertise but also huge amount of capital to run the business profitably for a considerable amount of time. It is these risks and the expertise required that makes it very difficult to become profitable. Presently, India has only one specialised reinsurer – General Insurance Corporation of India (GIC Re). Besides GIC Re, reinsurance contracts are entered by other Indian insurance companies or foreign reinsurers.

The above facts clearly indicate that if adequate support is given by the regulators and the Government, India can be a destination for large reinsurance businesses. However, there are certain regulations and rules that impede the growth of this business in India –

·        Every insurance company has to mandatorily cede (give away) 10% of its premium to GIC Re which then assumes 10% of the risk covered in that policy. If the insurance company wishes to reinsure above 10% of the policy amount, it can do so but has to preferably try to offer to Indian insurance companies and only balance left is to be offered to foreign reinsurers. However, no specific foreign reinsurer can reinsure risks individually in excess of 10% of the policy amount.

The above cession to reinsurers (whether mandatory or otherwise) fetches commission to insurance companies as they are getting business for reinsurance companies. Thus, what tends to happen is that when 10% of the mandatory or obligatory cession to GIC Re takes place, many loss making insurance portfolios are transferred to it which GIC Re would never have taken up if it would not have been mandated to do so. Recently, getting frustrated by the losses it has to bear on the obligatory business, GIC Re is planning to remove reinsurance commission on certain portfolios being ceded to them. Accordingly, this mandatory cession should pave way for cession in a manner a free market economy would have.

Furthermore, the attempt by the IRDA (Insurance Regulatory and Development Authority) regulations to retain maximum reinsurance business in India mandates insurance companies to try to offer these products to other Indian insurance companies first and then to foreign reinsurers. Rather than this, attempt should be made to appropriately capitalise Indian reinsurance sector by easing FDI limits from existing 26%. Even though the proposed Insurance (Amendment) bill plans to increase FDI limits to 49% only, it would be even better if this limit is increased to 74% or 100% for specifically reinsurance service providers due to huge amount of capital requirements for that sector. This would lead to reduced dependence of insurance companies on the obligatory services of GIC Re and unregulated foreign reinsurers.

·        Next absurdity that needs to be mentioned is that no amount is to be paid by foreign reinsurers as margins or a portion of premiums as a security to do business in India, unlike when GIC Re goes abroad to do business in Malaysia, Singapore, USA, etc.

Even though I am a staunch proponent of free market, capitalism and lesser regulated businesses but these situations should not be at the cost of security of stakeholders of the businesses. Suppose there is a claim and the foreign reinsurer is not in a position to pay due to some huge losses suffered recently in some other reinsurance operations, insurers in India would have to go abroad and fight the case (which would be a costly and time consuming affair in itself). Besides, the law mandates the insurer to pay the amount regardless of the recovery from the reinsurer. Thus, it would be a blow to the Indian insurer. However, if a portion of premium is held as security with the IRDA and such premiums from different foreign reinsurers are pooled together, they can create a sizeable reserve and can be used during dire times by IRDA to extend help to Indian insurers.

Even though foreign reinsurers should enjoy a rating of at least BBB (with Standard & Poor) or equivalent rating of any other international rating agency before any business is placed with them, it would still be a wise idea to collect some amount in the nature of security from them as mentioned above. Furthermore, some slight regulations on their operations with regard to Indian businesses are needed except just a mere review of the reinsurance treaty between insurer and reinsurer by IRDA.

·        Next, I would like to highlight is the problem of TDS (Tax Deducted at source) on payment of reinsurance premium by insurance companies. Reinsurance premium payments are characterised in the nature of income of the reinsurers by the tax department and thus, liability to pay TDS by insurance companies arises on payments made to either Indian or foreign reinsurers.

TDS and other forms of taxation lead to lower payments being collected by the receiver, which in this case is the reinsurer. To blossom the extremely low penetrated general insurance sector and the reinsurance pertaining to that sector, reduced or nil taxation on reinsurance premium is necessary so that easy pass-through of premium and easy mitigation of insurance risks can be done.

·        Lastly, I wish to comment on a proposed move by IRDA to cap the risks passed to reinsurance firms. It is proposed that insurance companies whose period of operation is upto 10 years can pass only 50% of their risks while the companies whose period of operation is beyond 10 years can pass only 30% of their risks.

IRDA contends that if an insurer has low retention limit, then such insurers only act as an insurance service provider than as a risk bearing insurer. However, I feel that this is one of the most absurd and unneeded moves proposed by IRDA especially when insurance business has such low penetration in India. Lower amount being passed to reinsurers means that to maintain higher amount of insurance premium collections, larger risk bearing capacity should be there, which entails higher capital requirements. Proposed move to induct FDI upto 49% from existing 26% may help somewhat but overall it needs to be mentioned that IRDA should not tell the insurers as to how to manage their risks or do their business. This move, if announced, would be nothing more than a fracture in the leg of a young footballer learning how to play well.

It is needed to be highlighted that regulations should not be introduced for regulations sake but should pave the way for growth of businesses in a manner conducive for all stakeholders. If the authorities take a note of the above issues and corresponding suggestions into account and of course other issues not mentioned above, India, with its extremely intelligent workforce can make reinsurance as one of the fastest growing businesses in the country.

Credit Default Swaps – Financial Weapons of mass destruction or effective way to mitigate credit risks?

In October 2009, the Reserve Bank of India (RBI) had announced in the second quarter review of monetary policy that it plans to introduce over-the-counter Credit Default Swaps (CDS) for resident entities and appointed an internal working group to finalise the operational framework in consultation with the market participants. Finally in May, 2011 the final guidelines on the same were published in the RBI website and the guidelines were made operational from December 1, 2011. Any person having advanced level knowledge of what happened in 2008 U.S. recession would have shivers down his spine whenever the names like CDS or CDOs (collateralized debt obligations) are mentioned. CDS and CDO are arguably, regarded as “exotic” derivative contracts that let the 2008 economic downturn to assume such massive proportions. Then why did the ever conservative and careful RBI introduce such a financial instrument in the Indian capital markets?

The above answer and the answer to the question mentioned in the topic can only be given if we analyse and understand few basic terminologies. Firstly, what is a derivative? A derivative is a financial instrument that derives its value from the value of the underlying instrument. Eg. A future contract is a derivative of the underlying equity share or commodity and would derive its value (that is, trade at a premium or discount) based on the value of share or commodity. Similarly, CDS is also a derivative. It is a credit derivative contract in which one party (protection buyer) pays a periodic fee to another party (protection seller) in return for compensation for default (or similar credit event) by a reference entity. CDS contract acts in the nature of an insurance contract (credit insurance). The entity or company or bond or share or asset on which CDS contract is made is referred to as “reference entity”. It can act as a great hedging tool in case the underlying asset tends to show drastic fall in price due to some events (credit events like failure to pay, restructuring and bankruptcy, etc.). In further simpler terms, CDS on a company that has filed for bankruptcy would trigger a credit event and entail payment as per CDS contract.  

Just by the above definition, it is crystal clear that a properly regulated and well structured CDS contract can create economic balance and financial discipline among the parties to the contract. However, it is not very hard to imagine the repercussions of a badly structured CDS contract. It can create economic havoc in banks and other financial institutions. In India, RBI has come out with regulations for CDS contracts for Indian banks and other financial institutions that allow CDS contracts to be pure hedging instruments. In other words, parties are not allowed to take “naked” positions in the CDS contracts or positions without having exposure to the underlying asset. Eg. A CDS on XYZ Ltd. 9% Bonds (maturity 10 years) can only be bought if one has bought the above mentioned bonds as then CDS would act as a hedge. Banks and few specified financial institutions would act as market makers in the above transaction. These regulations ensure the CDS market to act in its true spirit – insuring the credit risks but do not allow scope for widening the credit derivatives market.

These regulations are in stark contrast to the unregulated CDS market in the USA and Europe which exists even now. There, CDS can be used as a speculative as well as a hedging tool. Financial institutions can enter into sell or buy transactions in CDS regardless of any exposure to the underlying asset. When the market player enters into a CDS contract without having any exposure to the underlying asset, it is referred to as “naked” position. These “naked” positions which are speculative in nature are expected to account for 80 percent of the overall CDS market (which had outstanding contracts worth $62.2 trillion by 2007 end and falling to $26.3 trillion by mid-year 2010 but reportedly $25.5 trillion in early 2012). It is these positions that had created a financial bubble that ultimately burst in 2008. No doubt it was the default on subprime real estate loans (loans given to borrowers for buying houses who do not have credit worthiness) that was the base of the financial crises but CDS contracts on them actually sparked the massive economic fire. Some financial experts have described these “naked” positions being in the nature of buying fire insurance on your neighbour’s house. It creates a huge incentive to burn down the neighbour’s house as there is no insurable interest in that house. Similarly, a buyer of a CDS contract who does not hold any position in the reference entity would want the reference entity to “fail” or go bankrupt and thus, collect huge gains on the CDS contract.

Furthermore, the CDS market in the USA and Europe has few more interesting points. The reference entity is not a party to the overall contract of CDS (This is the same for Indian regulations also). The company’s bonds are traded on the stock exchange while CDS contracts that act as insurance against the exposure to the reference entity are traded over the counter between two contracting parties (having or not having exposure to the reference entity). However, an interesting point arises that the outstanding value of the bonds issued by the reference entity has no relation to the outstanding amount of CDS contracts traded against those bonds. Eg. The outstanding amount of bonds of a company may be $500 million. However, the outstanding contracts of CDS can be worth as much as or even greater than $5billion (10 times against value of those bonds).

There are arguments both in favour and against the overcapitalisation. Those against it would argue as to how can “protection” exceed the value of the “protected”. It is immoral and unethical and defies common sense. It promotes trading sans any substance to back them except for a contract paper. Wealth is generated in the most artificial fashion. Money flows and liabilities are assumed without any asset being purchased except bits of paper changing hands.

However, those favouring the overcapitalisation may argue that these contracts are totally independent to the reference entity and would be negotiated over the table (over the counter or OTC) between two parties – one who is willing to give protection and another party who is willing to buy that protection against any possible or hypothetical exposure to the reference entity. The fact that the outstanding CDS contracts are much more in value than the outstanding bonds stands pointless so long as there is a market and an appetite for a financial instrument (that is, there is a buyer and a seller for the contract). However, sometimes it so happens that the financial risks are so intertwined that these huge naked positions, rather than acting as any usual financial transaction have the power to create a financial “tsunami”. This is what happened when the investment bank Lehman Brothers’ got bankrupt in September 2008. Lehman Brothers’ had approximately $155 billion of outstanding debt but around $400 billion notional value of CDS contracts had been written that referenced this debt. Thus, not only lenders of Lehman Brothers’ were on tenterhooks after bankruptcy, but also those who had sold protection on such debt (that is, held a sell position on CDS contracts) were in deep financial trouble. Accordingly, even though marketability argument is fine, the collateral damage due to creation of these huge outstanding “naked” positions is a greater concern.

There are many more intricacies involved in CDS contracts and the even more complex CDOs (collateralised debt obligations) that caused the great financial trouble in 2008 and are still unregulated. No doubt, nobody wants regulation for regulation’s sake. Unregulated businesses in the private sector, throughout the world, have the potential to reach new heights, encourage innovation and lead to greater economic gain for the country and the world as a whole. However, sometimes regulations by the legislature are necessary if the businesses do not regulate themselves. CDS contracts need not be over regulated as is the case with India or unregulated as is the case with USA and Europe. The legislature should give enough room to widen the market but not let it attain monstrous proportions. In this way they would not be financial weapons of mass destruction but instead effective financial instruments to trade in and mitigate credit risk. 

Is diesel price hike & move on LPG cylinders by the Government justified?

Recently on September 13, 2012 the UPA Government among other decisions on FDI related issues, amid protests from Opposition and few allies, took a bold step of increasing the diesel prices by Rs.5 per litre and capping the purchase of subsidised LPG cylinders to 6 per year. Economists and market experts around the globe welcome this move by the Government amid rumours that the country’s rating would soon be downgraded by rating agencies across the globe unless the Government acts on the worsening situation of the country. The Opposition and allies like the Trinamool Congress (TMC) have cried foul on this move of the Government alleging that the Government is out there to “destroy” the country as these steps would hit the aam aadmi in a very harsh manner. Personally speaking, I support this move of the Government and would go on to saying that it was long overdue.

India’s fiscal deficit in the year 2011-12 was at an alarming rate of 5.9% of the GDP while the current account deficit was at 4.2% of the GDP. These are not comfortable figures. No doubt fiscal deficit is necessary for a developing country like India but not at the cost of an already extremely high inflation faced by the Indian economy and extreme depreciation of the rupee in the past one year. This four-fold problem of the country does not give much room for RBI to cut interest rates and bolster the economic growth of the country. Accordingly, the ball was and is still in the Government’s court to push for reforms and changes so as to control the situation. Accordingly, the Government moved and took steps on the following –

·        Certain FDI related issues (which would be discussed later in subsequent articles)

·        Hiking the price of diesel by Rs.5 per litre out of which Rs. 3.5 would go on to reduce the under-recoveries faced by the oil marketing companies (OMCs) and Rs.1.5 is hike in excise duty on diesel. The under-recoveries still faced by the OMCs on sale of one litre of diesel is Rs.13.5 post hike in diesel prices.

·        Capping the purchase of subsidised LPG cylinders costing Rs. 399 per cylinder to only 6 per year and subsequent cylinders would be purchased at market price which would be around Rs. 750 to Rs.800. This move has been partially diluted by the Government by removing the customs and excise duties on non subsidised household LPG cylinders to zero and furthermore, the Congress ruled states of the Government have increased the limit of LPG cylinders to 9 per year instead of 6.

·        No increase in petrol price was done although current under recovery of OMCs is about Rs. 6/litre. However, this loss was offset by reducing the excise duty on petrol by Rs. 5.30/ litre with no change in pricing done by the OMCs to ultimate consumer.

These bold steps taken above should be able to improve the situation of this country. No doubt the diesel price hike and the move on LPG would cause a risk of increasing the inflationary pressures in the economy and hit the aam aadmi but still this move is justified due to the reasons and arguments mentioned below.

For every litre of petrol/ diesel sold in the country, only 55-65% is non-tax portion and the rest is tax portion borne by the consumers. In short, due to the inelastic demand for these commodities, Government tends to treat these commodities as “tax collection agents”. These taxes are arguably high as the Government is running on huge fiscal deficits (when Government expenditure is greater than the Government revenue, excluding the borrowings made). If they reduce taxes on them, money needs to be raised from somewhere else. However, the price at which diesel, LPG and kerosene is sold in the country are at subsidised rates (petrol prices being deregulated from 2010 onwards, they are usually not sold at subsidised rates as much as possible). Now, one must be confused. On one hand, we are talking about high taxes on these fuels because of which these fuels cost high while on the other hand, we are talking about subsidy given by the Government on them. This can be explained below.

Companies involved in the exploration and extraction of crude oil (upstream companies) sell the petroleum products mentioned above to OMCs (downstream companies) at a particular price (say Rs. 60 per unit) which ultimately sell to consumers at cheap prices (say Rs. 53 per unit instead of market price of Rs. 63 per unit). Thus, OMCs end up declaring under-recoveries of Rs. 10 per unit (market price minus selling price). These under-recoveries are borne by both the Government and the upstream companies under a cost sharing arrangement notified by the Government from time to time. To bridge the under-recoveries which takes time to be disbursed, OMCs tend to take loans from the market or banks and end up paying huge interest costs as expense. Government, no doubt, collects the tax from the downstream and upstream companies upfront while disbursement of under-recoveries to OMCs (downstream companies) takes a lot of time which adds to the burden of the Government due to pending obligation (to pay to OMCs) from its side and interest burden on the OMCs.

Accordingly, hike in the price of diesel and limit on LPG cylinders is necessary to control the Government expenditure by reducing the subsidy portion and increase the Government revenue of the country. In other words, the fiscal deficit of the country would be reined in. It is important to do so as financing the fiscal deficit entails either borrowing by the Government or printing more money. Borrowing can only be done to a certain extent as the repayment of the principal and interest portions of the money borrowed on the sovereign bonds or from international institutions or other countries needs to be made. Furthermore, excess borrowings increases interest costs of the sovereign debt of the country which is already quite high for India. However, printing more money leads to increasing the money supply in the economy and if this money supply does not lead to increased productivity in the country, inflation is the outcome. Taking one step even further, high inflation leads to general lowering of living standards of people as compared to rest of the world and the currency depreciates. This depreciation of the currency refrain foreign investors from buying into asset markets of India and further selling by foreign investors in the asset markets of India and pulling out their funds from the country depreciates the currency even more. This depreciation of currency further harms the current account deficit of a net-import country like India leading to depletion of foreign exchange reserves of the country. Thus, it is all inter-linked - from fiscal deficit to inflation to currency to current account deficit. Even though people may argue fuel price hikes lead to high inflation in the short run, however, in the long run, considering the situation of a country like India, these hikes would be beneficial and prevent the downgrade by the rating agencies across the world. Preventing downgrade is necessary to maintain stable foreign exchange inflows in the country in the form of FDI and portfolio investments. A downgrade would lead to massive pull out of funds from the country leading to exchange rate reaching Rs.60-65 levels very soon.

In short, what has been explained above is similar to choosing between fracture of a leg versus a massive heart attack. Indeed when choice has to be made, one should not mind fracture. To conclude, I would say that the Indian economy is no doubt, a strong economy with great economists running the country very well as compared to rest of the world. Many times it is only the populist and coalition politics because of which many reforms tend to get side-lined or delayed. More than eight out of ten times it is politics that tends to win the battle over economics, but sometimes economics has to come out bold and strong and slash the sword on the face of politics when extremely needed. This time it was one such situation when economics has done so and we would all hope the economic decisions taken by the Government are not rolled back.

Excessive highs and suicidal lows of Asset Classes

Asset classes have a tendency to show extreme movements many times. Sometimes, they may be so generous that they may move up and scale new heights regardless of the fundamentals and political and economic scenario of the country or the world, while there may be times when unfavourable situations may make them go down so drastically that overall asset classes become ridiculously cheap. These wild movements of the asset classes, many a times, play havoc for a general small time investor/ speculator. It is at these times that general public lose faith in the markets and are driven by emotions while buying or selling asset classes. They tend to buy at the highest levels and sell at the lowest levels succumbing to the elation and depression respectively. However, a patient investor and an intelligent speculator would reap huge gains in these situations.

These extreme movements of the markets like the ones seen in 2008 (because of sub-prime crisis) or 2001 (because of technology bubble burst) or 1979-80 (because of silver market mania) are not a new age 20^th or 21^st century phenomenon. Trading in asset classes dates back to centuries and these movements also find their way in history. Let me apprise you all to the famous “Tulip mania” that gripped the Dutch as far back as first half of the 17^th century. It is generally and arguably considered as the first recorded speculative bubble in the history of asset markets-

Tulip was different from every flower because of its saturated intense petal colour and was regarded as a coveted luxury item in many parts of the world. Tulip grew from a bulb that normally takes 7-12 years to grow from the seed. Accordingly, bulb was a sought after commodity. Bulbs not infected by mosaic virus produced petals with single colours, while certain virus infected tulips produced petals with vivid and spectacular colours making them rare and desirable commodity. By 1634 as a result of demand from French, speculators began to enter the market. A formal futures market in 1636 was established by the Dutch where contracts to buy bulbs were bought and sold. The contract prices of rare bulbs continued to rise throughout 1636 but by November of 1636, price of common, non infected bulbs also began to rise. Besides the reason stated above, price rise was also due to the fact that the trading public was speculating that soon a legislation was under way which would convert the futures contracts entered into by the trading public for tulip bulbs into options contracts, thus, greatly limiting the liability of the buyer of tulip bulbs in the market as he can always pay a penalty amount (call premium) and avoid the contract in case the prices of bulbs fell. Accordingly, the prices rose to astronomical levels by the end of 1636 and early 1637. Everyone thought that the party will last forever. Higher prices would only go higher. People purchased at such sky high prices intending to resell the bulbs at a profit. Finally around February 1637, the “party” stopped and prices fell dramatically. While some economists are of the view that the fall in prices was due to  the outbreak of bubonic plague in Haarlem (a city in the Netherlands), others are of the view that the fall was due to halting of trading in tulip contracts by the Dutch authorities. Whatever be the case, one can imagine, at the peak, some of the bulbs costed around 10 – 14 times the annual earnings of a skilled craftsman while when the prices of the bulbs fell; the fall was so severe and intense that some of them collapsed 99% of the peak traded price.

The above event clearly highlights the fact that time and again, prices of asset classes have risen and fallen and would continue to do so in future also. Sometimes the rise may be quick while the fall may be painfully slow, while at times, it may be the other way around. However, many times it so happens that both the rise and the fall is so sudden that it does not give time to even experienced investors/ speculators to digest the fact. Accordingly, the investing/ speculating public tends to lose faith in the markets. As an Indian, I can personally recount many people losing faith in the stock markets after the sensational crash of 2008 when the Sensex fell from 21000 levels to as low as 7700 levels in the same year. It was very simple to understand that the level of 21000 was fundamentally not the right level to enter the market in January 2008, considering a major investment bank Bear Stearns’ two hedge funds had just collapsed in July 2007 and the whole investment bank was on the brink of a collapse. Furthermore, the US housing market was showing signs of extreme weakness due to default on sub-prime loans with many economists warning of a systemic collapse of the housing market. The concept doing the rounds that time was that India and some other emerging markets are decoupled (separated and insulated) from the happenings in the US. However, the “foolish” experts forgot to realise that in this era of globalisation, every country (except extremely backward/ tribal areas of the world) is linked to the other. Furthermore, if we analyse more, even the level of 7700 or so attained in October 2008, was so absurd that great quality stocks with relatively stable business outlook were available at throwaway prices. Both, the intelligent investors and the smart speculators could have and certainly may have made huge gains.

Thus, it is clear; the markets and asset classes will show absurdly high and low levels at times and it is upto the investing/ speculating public to make the best use of these movements. We are all aware that the prices of stocks, shares and commodities change on a daily basis even though the fundamentals surrounding them do not change so often. However, when we are speaking of excessive highs and suicidal lows of the market, we are speaking about change in fundamentals and other reasons governing their pricing and value. But, the highs become excessive and the lows become suicidal because of the psychology of people. If the value of an asset class is “1/2x” and the value determined by fundamentals is “x”, the prices would tend to rise inevitably. However, the speculative and “insane party” at times, tends to stretch the prices to absurd levels of “2x” or even “4x”. Such high prices are not sustainable for long term as sanity tends to enter the market sooner or later and the prices correct themselves to “x”. Conversely, an overvalued asset trading at “2y” may be fairly valued at “y” but while the prices tend to fall, they may fall dramatically downwards to values like “1/2y” or “1/3y” only to rise back again to “y”. No doubt, these excessive highs and suicidal lows cause immense pain to most of the speculators/ investors of asset classes, however it is also at the same time giving them an opportunity; an opportunity to reap huge profits from these situations. When the prices fall to absurdly low levels, the assets should be bought while when they rise to high levels, they should be immediately sold if kept in portfolio or short sold (and later bought at lower levels to square off the position). These movements should not be treated as an enemy that takes away wealth of investors/ speculators, but should be treated as a friend that gives them the golden opportunity every time to earn huge.

However, patience and discipline is the key. One has to master the art of valuation of asset classes and have conviction in one’s ability. For this, one should start with smaller amounts and over the years, try to hone and fine-tune the art of valuation in a strictly disciplined manner. If this is done properly, one would automatically start treating the excessive highs and suicidal lows as the best thing that could happen in the market and accordingly, make big bucks out of it. In the Indian scenario right now, we are seeing huge rise in the prices of real estate in many select urban pockets. Even the world recession of 2008-09 did not have any major impact in the prices of residential properties in areas like Delhi, Mumbai, Bangalore, Chennai, Ahmedabad, etc. This is primarily due to increasing urbanisation, better infrastructure in the above mentioned cities and the general trend of people living in smaller towns or rural areas to flock to those cities in search of jobs. However, even if we consider all these reasons and a few others also, such high prices may not be justified and we may soon see a downward spiral in prices in these areas. But, why the prices are still on the rise is due to the following reasons –

1.     Large amount of black money in the unregulated property market in India

2.     Greater personal interest of property brokers, who in collusion with real estate developers practically buy the properties on their own account many times and control their supply. Consequently, they later sell them at a substantial profit.

However, this “insane party” may either continue and real estate prices may further rise to even higher levels or the prices may move laterally for a long time now or they may fall. All depends on the uncertain future but if stringent regulations to control the real estate sector by having a real estate regulator (a proposal that has already been considered by the Central Government) is enacted or regulations like tax collected at source (TCS) on the sale of property (a proposal introduced in Finance Bill, 2012 but did not pass to become a law) is enacted, the prices of real estate in many urban pockets may take an immediate hit. Whether this hit may turn out to be a suicidal low for the sector is yet to be seen but all depends on investor/ speculator sentiment.

For every seller of an asset class, there is a buyer of that asset class and vice-versa. However, sometimes, buyers tend to dominate the pricing while at times sellers tend to dominate, leading to high and low prices respectively for the asset classes. But what an investor/ speculator should be aware of is “insanity” in the market and as much as possible try to benefit out of it rather than become another sheep in the herd. At this moment, I would like to conclude by quoting a phrase from Warren Buffett’s 2001 letter to shareholders of Berkshire Hathaway – “Try to be fearful when others are greedy and greedy when others are fearful”. This is the mantra to master the extremism and absurdity in the pricing of asset classes in the market.

Investment vs Speculation

A year and few months ago, I had a chance to meet Mr. Warren Buffett (The GOD of Investments) in Taj Palace, Delhi on March 25, 2011. It was the inauguration of his auto insurance agency business in India and whoever had purchased insurance on one’s car through Berkshireinsurance.com was eligible to be a part of the conference. Throughout the conference, Mr. Buffett was sitting in his chair with his reinsurance business head Mr. Ajit Jain answering questions about investments, economy and finance from journalists and audience. However, one of the interesting things to remark was the cans of coca cola on the table where he and his colleague were sitting. Buffett owns about 9% in coca cola and it is one of his most lucrative investments till date which he still owns since 1988 and does not mind advertising about it.

This is what I would call as an investment. The stock has withered through the recessions and the booms in the economy, has been overvalued and undervalued at times, but has made Buffett earn a great deal through dividends and appreciation in its value over time. Thus, investment can be defined as

An asset class being held for some amount of time and using that asset class as a source to earn sums in the form of interest, dividend or other forms of yield from that asset class along with safety of the purchase value of that asset class or appreciation in its value over the period of time held.

The above definition gives light to two most important aspects of investments –

·        Using the asset class as a source to earn interest, dividend, etc.

·        Safety of the principal value of the asset class along with reasonable chance of appreciation in its value (which is more important in case of asset classes not being fixed value investments).

Money put in any asset class not following the above two principles cumulatively would be regarded as speculation. Thus, investment and speculation are totally different galaxies in the universe of a financial market player. The two are as different as two sides of the same coin and should not be confused by the market player. In this article, we would restrict our focus on stocks and shares of the companies as the same are most highly traded financial instruments among retail players. Accordingly, as regards stocks and shares, we have to analyse few important factors in making sound investments viz. business stability and growth, asset structure, long term liabilities, cash flows and most importantly value at which the stock or bond is available. However, speculation would ignore all the above factors and concentrate on whole new set of factors like open interest, trend analysis, support and resistance levels, momentum in the market, etc.

One should not consider any bias towards investment or speculation while operating in financial markets as both give ample opportunities to make super normal profits in the long run. However, with speculation one has to be careful as it involves a degree of risk that an ordinary small market player may not be willing to take considering the small size of his portfolio and psychological fear of losses. Interestingly enough, these small market players are the ones that indulge in maximum “stupid” speculation and later on pay the price by suffering huge losses and vowing never to come back to the market (eventually the gambling streak in them makes them come back within 2-3 years).

One thing to note here is that speculation is not always “stupid”. “Stupid” speculation takes place when one intends to rely on intuition, rumours and advice from uneducated brokers (whose only job is to make you crack that deal so that they can earn their meal for that month). Speculation may also be intelligent speculation where the speculator takes the risk after weighing the pros and cons of the same. Eg. A stock falling for 3 straight sessions while its open interest has shot up would be in for a trend reversal in the fourth or fifth session and thus, an intelligent speculator would buy the stock and offload the same from his portfolio the moment his target is achieved. Unlike an investor, he would not enter into a relationship with the stock but would be fine with a short term fling and take the profits off the table. However, intelligent speculation usually involves vast amount of experience in the market and acumen to understand complex financial facts and figures much faster than ordinary crowd.

Thus, investment and speculation turn out to be two different fields. What is important is to segregate the portfolio and keep money aside for 3 things –

1.     Investments

2.     Intelligent and careful speculation (short term trades)

3.     “Stupid” speculation or gambling

Though as a focussed financial market player, I would not advice the last part but it is human tendency to gamble and ride on luck which cannot be avoided at any cost. However, what can be done is minimal amount should be kept for the same which should not affect the market player in any manner (psychologically or emotionally) if the same is lost due to “stupid” transactions. The market player should strive to be an intelligent speculator and investor both.

I would like to reiterate the fact that intelligent speculation would need vast amount of experience, skill and IQ level and thus, should be restricted to a few people only. Intelligent investment, on the other hand, is more of an art rather than an exact science. It would need a fair ability to analyse the following –

·        Business dynamics of the company,

·        Comparison with peers,

·        Understanding the financial health of the company (through analysing cash flows, long term liabilities, investments made, etc.),

·        Organic and inorganic growth prospects of the company,

·        Quality and integrity of the management,

·        Political and economic scenario in which the company is operating

After analysing the above, we should consider a situation as if we owned the whole company and wish to sell the company to some outsider (without considering the brand value and goodwill that we may have earned over time). Accordingly, we should arrive at a value for the Company and by dividing the same by the number of shares, we can arrive at a per share value. If the stock is trading at a value lower than that analysed, we should go ahead and buy the same.

While making sound investment decisions, the two main problems people encounter are the following –

1.     They first look at the value of the stock and then start analysing the company critically. This leads to bias in the mind of the investor and leads to his finding a value that is not commensurate with the analysis mentioned above.

2.     Sometimes the stock tends to remain undervalued for a long time (maybe for years on end) and the investor loses patience. No doubt market sometimes tends to ignore good stocks and they remain hidden gems for long but this should not be the reason to shun sound investment analysis and look for momentum driven and speculative stocks. The market player should be patient enough as investments require a very long time horizon which may, many a times, run into years.

In the end, I would like to conclude that while making any financial market decisions, one should remember the concept of Mr. Market in the famous book “Intelligent Investor”. The concept is stated as below –

Imagine you are partners in business with someone named Mr. Market who is very obliging indeed. Every day he comes to your door and tells you what he thinks your interest in the business is worth and furthermore offers to buy you out or to sell you an additional interest on that basis. Sometimes his idea seems justified by the business developments and prospects while at times, he lets enthusiasm or fears run away with him and propose absurd value. The fun part is that if you refuse to trade your business interest with him or buy more interest from him, he would come back to you the next day with a different value for it. Thus, you may be very happy if the business interest is sold at the value you want to sell it or if Mr. Market is enthusiastic, at a higher value. Without doubt, you will be happier to buy some interest in the business from Mr. Market if he is sad and depressed and want to sell you the same at a very low value. However, the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

Exactly the same is stock market; a place where not the market, but the financial market player has to make the right choice of buying, holding or selling the stocks while speculating or investing.

Structural Problem with Eurozone (Currency Crisis)

Euro, the official currency of Eurozone, is the second largest reserve currency and the second most traded currency in the world after the United States Dollar. The Euro is managed and administered by the Frankfurt-based European Central Bank (ECB) and the Eurosystem (composed of the central banks of the eurozone countries). As an independent central bank, the ECB has sole authority to set the monetary policy. The Euro has been adopted by 17 out of 27 member states of the European Union (EU) and the rest of the states have chosen to retain/ adopt their independent currencies.

However, despite the huge amount of planning by several economists and financial market experts alongwith the European lawmakers that led to the creation of Euro, Eurozone is now witnessing one of the worst currency crisis that could not have been imagined at its inception. This crisis had its seeds sown way back when the EU was created.

The currency Euro was never intended to be created keeping in mind the different political and social landscape of the countries participating in it. It was created as a facilitator in trade between the nations of the union and also with other countries of the world. In other words, it was a monetary union without a fiscal union (consisting of common taxation, pension benefits and treasury functions). Fiscal related law-making and monetary policies have to go hand in hand to create conducive atmosphere for a stable economic climate in the country. Seeing the situation of Greece and Spain on one hand and Germany and Netherlands on the other hand show us the vast difference in the economic landscape post the introduction of Euro.

Besides above, there is also no banking union to support the troubled banks in downgraded economies or banks owning huge amount of toxic debt from countries like Greece. However, a proposal for the same is under way to create a proper banking union to support the monetary union. Banking union would create an agency or body which would create greater integration among the member states of EU in the sense that the following can be introduced viz. bank deposit insurance, bank oversight, joint means of recapitalisation (injecting funds to meet short term obligations and resume the cycle of lending) or wind down of failing banks. Thus, a failing bank of Cyprus having huge exposure to Greek debt can be recapitalised. This way, the creditors of the bank in Cyprus do not have to worry a great deal and can settle for a minor haircut rather than an all out default. In other words, the financial contagion can be averted greatly. However, inflationary pressures can be a major risk due to excess liquidity.

Furthermore, the 17 nation currency union suffers from a problem of quick response. Every decision making process entails a unanimous agreement and not just a majority vote. This is quite justified also as a majority vote in the favour of easy monetary policy by many troubled EU nations can spell havoc for a current account surplus economy like Germany (which is one of the few nations in the EU at an extremely favourable position with long term interest rates less than 1.5%).

Among the other structural problems with the Eurozone is the inflexible single monetary policy. Individual member states cannot print money independently. In other words, they cannot create excess money supply in the economy leading to devaluation of their currency to make exports competitive and improve trade balance leading to higher and stable tax revenues. This is evident due to 17 nations following one single unit of currency. Though structurally, if the countries had different currencies, the Greek drachma would be trading at less than half the value of the Euro while the German Deutsche Mark would be far higher than Euro considering the stability of the economy and one of the lowest yields on its bonds.

Thus, the above mentioned problems clearly cast a doubt on the stability of the Euro as a currency. However, it is not only in the interest of Greece and Germany but in the interest of the entire world that Euro is not broken and no member nation exits the currency. This is because the exit would not only create huge financial ramifications and uncertainty in the foreign exchange market throughout the globe but also would hamper the confidence of an investor in global financial markets leading to a situation where Lehman collapse would seem like a walk in the park.