Impending recession and the aftermath

The bearish movement in Indian stock market in last couple of weeks draws everyone’s attention towards the world economy again. In the era of globalization, any significant move in the economy of big players is going to have well spread impact (Article on Decoupling theory). And if the movement is there in US economy no country will be left untouched...

The movement in the US economy started in the month of September with the Subprime crisis followed by credit crunch in the US market. All the major banks in US reported huge losses and Federal Reserve had to cut the interest rate first time after 2003 by 50 basis points (0.50%). The complete effect of subprime crisis was yet to be realized and that was evident with further writing off bad debt by major bank in 3^rd quarter of 2007. The economy started slowing down, and financial market came under much stress. Fed had to intervene again within 4 months of earlier cut and the interest rate was dropped by 75 basis points to 3.5%. This was again followed by reduction in benchmark short-term interest rate by 50 basis points to 3% within 9 days of previous cut. This was the most aggressive movement in interest rates since 2001, and is expected to keep the housing slump and the credit crunch brought on by a meltdown in the home-lending market from pushing the broader economy into the red.

But even after all these measures, the consumer spending in the U.S. increased at the slowest pace in last six months. The unemployment insurance jumped, U. S. economic growth slowed to 0.6% annual rate in the 4^th quarter from 4.9% in the prior three quarters. All these facts indicate towards an impending slowdown and countries need to hedge the movement to all possible extent.

Countries like India has got major exports in U.S. and reduced consumption rate will certainly impact the export business heavily. While, the export industries are already suffering with appreciation in Rupees and it will get worsen with any slowdown in demand abroad; the crude oil price had come down after the speculation on reduced demand by the world’s biggest energy consuming country U.S. This will relax the Indian oil companies a bit with reduced subsidy (more about Crude oil price and its impact).

The significant cut in interest rate by Federal Reserve is aimed to avoid any credit crunch and after the RBI (Reserve Bank of India) decision not to cut the interest rate, heavy credit inflow is expected in coming month. The volatility in stock market reflects the suspicious and bearish environment. The GDP in the year 2007 grew by 9.6% and growth is expected to be close to 9% in FY2008. The government needs to be well prepared for any uncertainty and be ready with flexible policy to avoid any major impact.

Economic Fundae -RBI Credit Policy- 2008

Recession waves roaring in U.S and the interest rate cut by the FED is sent as an abatement in response to it. Although it will benefit the recent sub-prime crisis, the impact of this rate cut to 3.0% in interest rate is far fetched.

As a common understanding we all know the interest rate cut will boost borrowing and hence economic activity. On the other hand this rate cut when done in isolation when the central bank in the rest of the world are not in a compulsion to do so, will leave the capital movement out the country. This is surely detrimental to the business in U.S. as the capital formation will be difficult. It also leaves the U.S dollar to loose value becuase of the interest rate differentials.

Largely the credit policy of RBI - the annual report of the policy measures by our central bank has laregly disappointed the Indian Industry which has to keep their investment plans in abeyance. Belying expectations of a softer interest rate regime, the Reserve Bank in its third quarter review of of monetary policy kept banks rate, repo rate, reverse repo rate and cash reserve ratio unchanged in a bid to maintain financial and price stability.

Now this stand by RBI is surely debately particularly given the current rupee strength. But certainly it is going to a be precautionary move against the price rise. Every single conservative policy has its toll in our growth story. One justification for this indifference is the shorter business cycles in India and the growth being fuelled by the capital inflows. As this is policy needs some time test which will be based on the growth in the country.

This particular scenario would have helped any one new to the macroeconomics to sum up all what we have seen so far - inflation, business cycles, interest rates, exchange rates. It may be unfavorable for many Indian Industries, but the current situation has certainly enhanced our learning in macroeconomics favourably!

Domestic Institutional Investors (DII) were the major buyers which held the markets

Domestic Institutional Investors (DII), which includes Mutual Funds, Insurance firms, and Domestic Financial Institutions (DFI) mainly banks etc., were the major buyers in the past week when the FIIs sold away heavily in the equity markets. While the FIIs have taken away Rs. 15,000 crores from the markets, DIIs have put in about Rs. 10,000 crores. Major part of DII money has come from insurance and financial institutions. Government had asked these institutions to place money in bluechip firms to give support to the markets. LIC, the biggest insurance firm of India, alone has been estimated to have put in $1 billion(Rs. 4000 crores) in the last week.
In the year 2008(till January 25, 2008) FIIs have sold worth Rs. 23,000 crores, while DIIs have bought worth Rs. 12,800 crores.

FII sold heavily in mid January crash

While the Mutual Funds started selling in the initial days of the previous week, they started pumping in the money during the fall of the stocks. FIIs on the other hand were about neutral in the week before but they suddenly started selling off heavily each day and even on last few days of the week when the sensex gained significantly, FIIs were net sellers to the extent of more than 1000 crores of rupees. Though the last day selling was very less compared to previous three days in which they sold about 2500 crores worth of stocks each day.

How good is ‘Decoupling theory for India, China and other emerging economies?

The Decoupling theory is that emerging economies like China and India are decoupled from the US economy. The view is that the emerging economies on one hand and US economy are now very less related. How good is that assumption?

If we look merely at the GDP growth figures China and India are accelerating at 11% and 9% per annum, while US is in a slow growth phase an may even enter into recession in the coming year. This may help us in believing the decoupling theory and that China and India can keep on growing without getting affected from the US economic condition.

If we look slightly deep into it and look at two major sources of GDP: consumption & investments, we will find that although US economy has experienced a slower growth, its consumption is in healthy growth phase, and the slowdown in overall growth is mainly because of slowdown in investment activities from US firms. The reason may be that a lot of money is moving in the form of FII and FDI to India and China. Even China and India export heavily to US, so a slowdown in consumption in US is bound to affect these countries, though the extent of the damage may be different.

Investors who believe in decoupling theory think a well diversified portfolio across Asian and American countries can give good returns even in the case of US recession. That may be too optimistic assumption and this is one of the factors behind the huge rally that was seen in the Chinese and Indian stock markets in the past year. But the recent tremors shook the belief and markets all over the world fell sharply in two days following news on US economic recession.

Earlier during the subprime crisis the decoupling theory got seriously challenged. The credit crunch that followed was not a US only phenomenon, though US was hard hit. The decoupling theory also underestimates the fact that economies are in era of globalization, and recession in one big economy is bound to cause some pain in other economies.

If we look at world economy, US constitute about 22% of world GDP, while China is about 11%, India 4.6% of world GDP. So if the world economy has to grow, a recession in US economy has to be countered by a bigger increase in other economies. The decoupling theory also suffered some blow when World Bank issued that Chinese and Indian economies are smaller than that estimated earlier.

The year ahead will only tell us how independent these emerging economies are from US and whether their growth can compensate for the world slowdown if US economy goes into recession.

Economic Fundae - Interest Rates

It is a really a good time to start with the economic fundamentals as there is so much happening across the globe with recession and our phenomenal growth story. It becomes easy to see what we are discussing in theory in the real life. Inflation is something most of the developing nation is fighting against. At least in India, the Reserve Bank of India has done a great job in controlling the soaring price rise that happened in 2007. But what are the policy that RBI has at its disposal to control inflation? These are largely the tools and policies different from the fiscal policy.

Before answering this question we will look into one of the important macroeconomic variable which connects the present with the future – Interest Rates. The rates which our bank pay is called as the nominal interest rate and this measure the increase in the value of the money we hold. It can be seen as the amount that we get paid for forgoing the consumption at present.

The other class of interest rates is called the real interest rates which are essentially the increase in the purchasing power. Think of a capital as a corn seed. The increase in value from the seed to the corn is the real increase in value. But due to the general increase in prices of other commodities – inflation our corn will fetch us more money than the actual value. This is called the nominal value which is the real value plus the inflation.
R = I – πe
This equation gives the relationship between the real interest rate and the nominal interest rate & inflation rate.

Why is there a fluctuation in the interest rate? This is dependant on the amount of money in circulation. Now the big question is whether the RBI sets the interest rate or sets the money circulation? It sets the money supply.

It is done through a series of steps called as the open market operations. In this the central bank buys bonds – a debt instrument, in exchange for money, thus increasing the stock of money, or it sells bonds in exchange for money paid by the purchasers of the bonds, thus reducing the money stock.

Now ask yourself this question, what will happen to the exchange rate if the central bank sells $1 billion from its foreign currency reserves?

We fairly understood about the strict monetary policy. Now it is time to see what is happening in the scenario of recession. The U.S central bank has announced a interest rate cut in order to combat the recession. By cutting interest rates the FED would be boosting U.S economy by making it cheaper to borrow. But it has its implication also in the spending habit. This artificial intervention of the central bank is rarely seen unless it is absolutely necessary to do so.

The other side is the reduction in the earnings due to the interest rate cut. This will immediately give arbitrage opportunity for investors to borrow money from the U.S banks and invest in a country like India where the interest rates are higher. Sensible isn’t? But is it what our finance minister will also be happy about? We will see in the subsequent article of the critical analysis of the forth coming budget and the interdependency of the various macroeconomic variables we have learnt so far.

Economic Fundae - Fiscal Policy

The big question that our finance ministry will face is how to react to the global recession and our stock market crash. Although these are issues which need correction from various economies, let us see what tools are at hand to control the economic fluctuation. Last year -2007 although we saw our GDP grow more than 8%, we were facing with issues like inflation. The Reserve Bank of India which is the principle organization in command of our economy was taking numerous measures to curtail inflation. What essentially were they doing? What is the role of government in these situations?

Fiscal Policy is use of government spending or tax policy to control aggregate demand-
The taxes that we pay are essentially the source of funds for our government. Now what kind of taxes we pay? Where does the money go?

To understand this we will revisit the equation which is worth remembering
GDP = C + I + G -NX

The G – Government spending composes of two components, the purchases of goods and services & government transfers – which include government spending on individuals without expecting any goods or service. In India we can think of this as the spending towards to rural development and poverty alleviation. But targeting government expenditures simply to reduce poverty is not sufficient; government needs to stimulate economic growth to help generate the resources required for future government expenditures. This becomes the rationale for a budget deficit.

The government can influence the consumer spending by controlling the taxes and the transfers. This is sensible because the more the tax we pay the less is our disposable income – which is our revenues minus the taxes (total income available to spend).

Now why would our government want to control aggregate demand? This is just to control the effects of recession – “Refer Economic Fundae – Business Cycle” or inflationary pressure.

What could it possibly do?
1. Increase government spending
2. A tax cut
3. A increase in government transfers.

This could be the opposite when our government has inflationary pressure.

But remember it is not that easy and it is not that fast to bring in a change. There is also a concept of multiplier to the effect of government spending- it is the ratio of the change in GDP to the change in aggregate spending. In simple terms if you sow Rs 100 you may end up reaping 200!

This multiplier effect may not be there if the government policy is to cut taxes or increase government transfers. This is because not all of the tax benefit you get may be spent, which is given by the marginal propensity to consume.

Now the budget is just a few weeks ahead, we often hear the terms like budget deficit (at least in my generation I have not heard of a budget surplus). What it means? Whether budget deficit is good or bad?

The budget balance is equal to the government savings which is governed by the following equation
S = T – G – TR
T- tax receipts
TR – Transfers

In general, the government runs budget deficits, when there is a recession and surplus when there is economic expansion. In India we have seen the politicians have the habit of wooing the voters by having a tax cut and hence a deficit budget. By doing so, Indian government have run in deep debts. Remember the interest payments for these debts, which are also funded by the taxes that we pay.

Now a novice person like me would think what if the government would print more money to fund the debts. Remember there is always a problem with the inflation.

Now you are all set to think in terms of the finance ministry tools. In the next article we will see how the central bank controls inflation.

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Economic Fundae - Business Cycles

Macroeconomics as a discipline is about the study of national economy, total output level, the general trend in employment. All this not only nation wide but also with respect to the global economy. I write this article as the stock market tanked 4000 points roughly about 20% in two days in reaction to the global recession- economic downturn. In the past century we have seen years of boom and bust between years, which is called the business cycle. What is happening today in the stock markets can be only a fraction of the impact which was there during the Great Depression- stock market crash of October 1929, but we can immediately strike a relationship in these events. But why is there business cycle, and what are reasons for the recession? This is a subject we are currently dealing with.

In fact we all would agree to the fact that the salary we get today is at least twice as much as our parents. This even after adjusting for inflation- which is the rise in the price level of goods and services have grown phenomenally. This is attributed to the long run growth of an economy. We are trying to address the issue of growth in the long run and the intermediate recession and expansion.

For an engineer turned management graduate like me trying to understand this phenomenon of recession would immediately associate with the unemployment, the effects of aggregate output and the government policy on these issues.

Looking at the issue of unemployment- the percentage of total number of people in the labour force who are unemployed. In general we have higher unemployment rate during recession and lower during expansion. The policy measures which are undertaken to stabilize the severity of the recession or to rein in the expansion are the Monetary Policy - which involves changes in the money, interest rates etc. & the Fiscal Policy- which involves changes in the tax policy or government spending etc.

Before going further to the discussion of recession, we will define what an open economy means. Until 1991, India had the policy of restricted trade regime, which essentially is the closed economy - the economy which does not trade goods or services with other countries, self sustained. This principle goes against what Adam Smith in his book mention of division of labour. A country should try and maximize its production in which it is generally good at. It is more of a focused approach rather than channelizing to all what an economy needs.

After 1991, India opened its economy to the world because of the crunch and the request by IMF to do so. Hence an open economy is one which trades with other countries. This is different from the closed economy dynamics with the exchange rates - which is discussed in the previous article.

There are numerous reasons for recession and it is measured by looking into the amount of business activity which is happening- Unemployment, industrial production etc. One should remember the effect of the "Paradox of thrift" - which is the reduction in spending forecasting a economic hard time actually leads to a slump in the economy and the business begins to layoff.

There were enough cues this time for the U.S economy slowdown and one article in our blog addressed the issue of "Merrill Lynch faces huge loss due to bad mortgage write-downs".

Long run growth is about the general increase in the standard of living. But remember we are all dead in the long run!!!

Where to get the FII and Mutual Fund investment activity in Indian stock/equity & debt markets?

FII (Foreign Institutional Investors) and Mutual funds activities are very important for short term traders to speculate the trend. Being major players most of the time their actions moves the market up or down. Fortunately SEBI (Securities and Exchange Board of India) publishes the total amount of buying and selling done by FIIs and Mutual Funds in the Indian equity and debt market.

The data are made available to the public through SEBI's website in the "FII / Mutual Funds Trends" column. The webpage gives the last trading day's activities by FIIs and MFs and has archives for each day of current month. To visit the archieves for periods earlier than one month another archive section for both FIIs and Mutual Funds is available. To access any historical data enter the closing date of that month and click 'go'.

According to a note on SEBI's website:

"Note: The data pertains to all the activities undertaken by FIIs in Indian Securities Market, including trades done in secondary market, primary market and activities involoved in right/bonus issues, private placement, merger & acquisition etc."

SEBI has a 'investors awareness campaign' and provides the investors with the latest data/information to help them make informed choices.

SEBI might impose price band on IPO listing day

After observing the volatility of price and volume of IPOs of different issue size, SEBI analysed the movement using parameters such as issue size, price variation on the day of listing and the variation on subsequent days. The analysis gave a clear indication of the pattern – a quite high volatility on listing day which was not sustained after that specially for issue size up to 250 crore. The regulator is looking at imposing a price band of 25% on the issue price on the day of listing for IPOs up to issue size 250 crore. The decision is yet to formalize and SEBI is waiting for comments and suggestion from public on this proposal on or before January 31.

This proposal will be welcome news for the long term strategic investors. These investors decide on investing on particular stock after an in-depth analysis of the business of the company. The high price on listing day which could not be sustained on subsequent days, disappoint such investors and might prompt them to book profit on listing day. Steady and sustained price discovery will make the investment fair and attract strategic investment.

On the other hand those retail investors, who do not have much ideas of the business of company and bid mostly on last day after looking at the number of times stocks is oversubscribed, might be discouraged. If a stock gets oversubscribed 10 times in retail segment then even after bidding for 1 lakh (maximum limit for retail investor), one is expected to get shares worth 10,000 Rs. With an upper cap in price on listing day to 25% this investor can not expect more than 2500 Rs return, that is effectively on his 1 lakh investment (as the amount of unallocated shares comes back only a few days before listing). Thus a 2.5% (2,500 of 100,000) return on 20 days (average time from the day of bidding closure to listing day) even in bullish market condition while investment in secondary market could easily fetch 10-15% return.

SEBI needs to look on this step from different aspects for a fair movement in market. One solution for this could be investing a part of total bid rather than full amount. Recently Reliance Power IPO had given option of investing 25% of total bid size. With retail getting subscribed for more than 15 times and Mr. Anil Ambani’s approach to give shares to all retail bidders, the 25% investment will cover the amount required for the allocated shares. The regulation is expected to come in next month and suggestion prom public could help SEBI in taking a pragmatic decision without hurting anyone.

Reliance Power IPO subscribed for more than market value of the Portuguese and Czech stock markets (Update 1)

As per Bloomberg, the bid for Reliance Power initial public offer (IPO) exceeded Portugal Market Value. The company is likely to raise more than Rs 10000 crore from this public issue excluding promoters’ contribution. This is the largest IPO in Indian market till date. The company sought to raise around 117 billion Rs ($3 billion) through 228 million shares on offer. The offer had got subscribed within 60 seconds on the day of opening and finally got oversubscribed by 73.04 times as per National Stock Exchange (NSE). The offer received an order worth more than $190 billion, which is equivalent to combined value of Portugal and Czech stock markets.

The 3’rd richest man of India, Mr. Anil Ambani will increase his wealth further with listing of this Stock. Reliance energy has got 50% stake on Reliance Power. Power stocks have driven the market well in the year 2007 and the trend is expected to continue. Reliance Energy share price increased from around 600 Rs in February, 2007 to more than 2400 Rs in January this year. The addition of Reliance Power is expected to receive a good demand in the market when it gets listed early next month.

The issue price was fixed at 450 Rs today (19'th Jan) and is expected to gain 300-400 Rs on the day of listing. With already $45 billion of wealth with him, Anil Ambani might take a leap with this addition in his asset and that could make him the richest person of the world. The next update from Forbes magazine on official ranking of richest people of the world will certainly bringing more Indians among top rankers. According to the earlier update from Forbes, the wealth of Ambani brothers together with L. N. Mittal and K. P. Singh is more than the 40 richest Chinese. This IPO was one of the most talked and coming month might change fortunes of many.

Economic Fundae - Exchange Rates

In any system it pays to standardize. Essentially this is been the case in every development over the years. We have always tried to find new opportunities in standardizing processes which will improve efficiency.

This can also be seen in the international trade, where people had looked into ways of standardizing the exchange of goods and service. We need to go back to history to see how gold standard worked and what lead to the Bretton Woods system. Much of our worries about raising rupee against dollar dates back to one of greatest move in history by the then President Roosevelt abrogated contracts in which payment was specified in gold.

This system in simple terms made countries to settle their internaional balances in U.S dollars, while the U.S. government redeemed other central banks holdings of dollar for gold at a fixed exchange rate of $35 per ounce. This system came to an end when U.S government was no longer able to redeem dollar for gold in 1971.

Now another question emerges as we probe further into the currency maintained by a country. How will the country decide on their currency?. What should be the growth rate of the currency?. What should be the quantity of the currency?

Gold standard served two purpose, one the domestic standard trying to determine the currency quantity and the rate of growth of money supply. This worked in tandem with the world's gold stock.

Next Gold also provided a standard for the international exchange. Consider the scenario in which U.S fixed the price of gold at $20 per ounce, and the U.K government fixed it at £4 per ounce, then the exhcnage rate equalled $5 per pound. This is called as the fixed exchange regime.

After 1971, we have the floating exchange rate. This works in a simple rule that the central bank of a country will not intervene in the rates set by the market. Hence the demand for a particular currency helps in determining the rates. This demand is because of the larger acceptance of the goods and services of a particular country.

Lets understand the rules of the floating exchange rates more and its interaction with the interest rates and inflation in the subsequent articles.

Economic Fundae - Inflation

Inflation in simple terms is the loss of purchasing power of a currency. If today 10kg of general items can be bought of 100 Rs, then after a year how much money will be required to buy the same amount of goods? Inflation gives an idea of that general increase in price of goods.

There are standard ways to measure inflation such as the Wholesale Price Index (WPI) and Consumer Price Index (CPI). WPI measures the increase in price of basket of goods at the wholesale level. It is measured weekly. CPI gives the measure of the cost of given basket of goods (Wheat, Pulse etc) and services which the consumer has to pay. CPI is always greater than WPI.

Although there are inherent problems with this measure which is largely attributed to the weights attached to the goods and services and also the changing quality which is very hard to quantify. This of course can have huge difference in the policy decisions. There can also be a cumulative wrong measurement due to these inherent problems in scientific methods in economics.

Now if we were to answer what an effect does it has on policy making and the other variables in macroeconomics, we need to understand a bit more of how the Monetary Policy and fiscal policy is taken.

Merrill Lynch faces huge loss due to bad mortgage write-downs

Last time when I wrote about Merrill Lynch posting record losses in its 93 years of existence, I knew some more pain was left, what the results exceeded all imaginations. Merrill Lynch reported fourth quarter loss of 8.6 billion USD from continuing operations. This is huge considering the profits it earned in 2006 - $7.5 billion. Total write-downs for this year so far have been around $16.5 billion. The breakup of the write-downs is like:
$9.9 billion - collateralized debt obligations (CDO),
$1.6 billion - sub-prime mortgages
$3.1 billion - bond insurance
$0.9 billion - residential mortgages
$0.2 billion - real estate investment

This is the second biggest write-down so far. Earlier Citigroup has written-down more than 23 billion dollars and reported close to 10 billion dollar loss in fourth quarter. Both these firms have been on a look-out for capital raising since last quarter and have successfully raised billions of dollars. But with the sub-prime crisis not coming to end these investment banks are poised to have a very tough time ahead.

Merrill had earlier replaced Stan O' Neal from the chief executive position following the sub-prime crisis. The new CEO of Merrill, Mr John A. Thain, has a lot of responsibility in bringing back Merrill to its original status. According to a report on Merrill Lynch's website, Mr. Thain said:

"While the firm's earnings performance for the year is clearly unacceptable, over the last few weeks we have substantially strengthened the firm's liquidity and balance sheet,.. In addition, a great majority of Merrill Lynch's key businesses delivered record results in 2007, and as I look ahead to 2008, the firm is intensely focused on continuing this momentum and delivering growth and increased profitability for our shareholders and employees."

With the declaration of results on 17 January Merrill's stock price fell by more than 10% in a single day. The stock has been falling since 2007 from a highs of around 100 to current price of 49.45 per share.

Applying Dividend Discount Model (DDM) to 'State Bank of India' (SBI)

Dividend Discount Model values a firm's equity on the basis of the future dividends that the company is expected to give. Discounting all the future dividends gives the value of the stock as this is the only money an investor is going to get if he keeps the stock till perpetuity.

The general valuation formula for DDM is:
P = D1/(k - g)

where
P - ideal price of the stock
D1 - dividends for the year 1
k - cost of equity/ discounting rate
g - growth rate of the dividends

There are some assumptions in this model which require careful use of this model for finding the intrinsic value of a stock based on its dividends.

We will use a live example of State Bank of India (SBI) to illustrate the use of DDM. The following is the last 10 year dividend history of the company:

Year End	Total Dividends paid (Rs crores)	PAT (Rs crores)	Retained Earnings (Rs crores)	Retention ratio, b
Mar-98	211	1861	1650	0.89
Mar-99	211	1029	818	0.8
Mar-00	263	2051	1788	0.87
Mar-01	263	1880	1617	0.86
Mar-02	316	2423	2107	0.87
Mar-03	447	3105	2658	0.86
Mar-04	579	3681	3102	0.84
Mar-05	658	4305	3647	0.85
Mar-06	737	4405	3668	0.83
Mar-07	737	4534	3797	0.84

Using this we find that SBI has policy to retain about 85% of their earnings and distribute 15% as dividends to its shareholders. The retained earnings add on to the shareholder's equity and should earn profits for SBI. For each year we also looked into the returns on the equity (ROE) for SBI. the data is as follows:

Year End	Retention ratio, b	ROE	Growth rate, g
Mar-98	0.89	21.2	18.8
Mar-99	0.8	10.3	8.2
Mar-00	0.87	18.2	15.9
Mar-01	0.86	14.7	12.6
Mar-02	0.87	17	14.7
Mar-03	0.86	19.2	16.4
Mar-04	0.84	19.7	16.6
Mar-05	0.85	19.4	16.5
Mar-06	0.83	17	14.2
Mar-07	0.84	15.4	12.9

We have calculated the growth rate of dividends using:
growth rate = retention ratio X Return on equity ; g = b*ROE
Since dividends next year will be equal to this year's dividends plus the earnings on the retained earnings of this year with SBI.

The average growth rate for the 10 year period was about 14.7%.

SBI paid dividends of Rs 14 per share in 2007. Hence D0 = 14.
D1= 14*(1+g) = 14 * 1.147 ~ 16

Finding the discount rate is the trickiest part of the valuation and it depends on many factors and can be estimated using CAPM or other similar models. For simplifications we will take cost of equity as given in this case. We will take cost of equity as 15% and assume that SBI will enjoy this high growth for next 20 years before settling at something less than India's GDP growth rate (~ 7 %) and find out the value in the next article. Till then you can try it on your own.

[Hint: SBI is currently trading at 2400]


[To be completed in next post...]

Terms to know

Asset - technically, its a resource "controlled bt the enterprise as a result of past events from which future economic benefits are expected to flow to the enterprise". To put ii simply it consists of the resources that an organization owns. Assets which are liquid, that is can be converted into cash within an year, are termed as current assets. Examples of current assets are inventory, current debtors etc. Other assets are known as long term assets and examples of these are plants and machinery, long term debtors etc
Liability - it is a "present obligation of the enterprise arising from past events , the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits". Or simply put, it is the amount that an organization owes. similar to assets, we can have current liabilities and long term liabilities. Current liabilities can be current creditors, provision for tax etc. Long term liabilities are long term loans etc.
owner's equity - also called equity or shareholders equity is the difference of assets and liabilities. It is the amount that owners own from the company. It increases by the investment made by the owners and decreases by distribution of assets among the owners (issuing of dividends)

Is India's growth rate slowing down?

India touched GDP growth rate of 9% last financial year. It is a big achievement for the country and initially people were apprehensive of sustaining over 8% growth rate for reasonable time. For the last three years India has continued to grow at more than 8% and last year it recorded 9.3% growth. All the while people have been talking of signs of heating of the economy. This fiscal year the growth has slowed down a bit but is still above 8% level. This slowdown has been indicated by Reserve Bank of India (RBI). According to the report a slowdown in the growth of demand has led a slow down in the growth of sales in the first half of 2007-08.

According to Moody's India's growth rate will come down to 8% in 2008 due to the tighter monetary policies taken by RBI to curb inflation. Goldman Sachs has also lowered India's growth to 7.8%.

Recession in United States of America is not likely to have any significant effect on the India's GDP growth as it is mainly domestically driven growth and the fundamentals are very strong.

The growth in the industrial production numbers jumped significantly in 2006-07 which had a major contribution in the GDP growth rate. Now, since the demand had decreased because of rising interest rates the industrial production index is feeling the direct pinch and has recorded slower growth. Automobile sales has shown very little growth over last year and the housing activities have also shown a slowdown.

Though these activities appears to put a lot of pressure on growth rates and may even be successful in short run. India's story is a long term and it has just started. One can easily bet on the long term growth prospects of the country.

Rupee appreciation and its after-effect

The rupee has witnessed around 12% appreciation last year, the most since at least 1974. On 16’th Jan 2008, it was quoting at 39.068 per US dollars (USD) against 44.28 at the end of 2006. The strong economic fundamental is one of the major factors for attracting Foreign Direct Investment (FDI). The appreciation got further strengthened by the sub-prime crisis in US. The sub-prime crisis in US led to fall in US market and investor started taking their money out. They looked for the best market to invest and found Indian market more attractive. According to Security and Exchange Board of India (SEBI), the net investment in India by FII was 19.53 bn USD in 2007 as compared to 8.87 bn USD in the year 2006, a 120% increase in the FII inflow. As per the data from commerce ministry, Foreign direct investments through august last year totaled $12.9 bn USD as compared to $11.1 bn for the whole of year 2006. This high inflow of money from the international market has increased the demand of rupee significantly and that has propelled the sudden surge in value of rupee against dollars. This could have impact on various aspects including trade, inflation and government policy as well.

International Trade:

The strengthening of rupee has made import attractive while it has severely impacted the export. Export growth slowed down to an average 17% till Oct, 2007 from 21.3% a year earlier. The current account (Account for export and imports) deficit widened in the three months through September to $5.5 bn, while the capital-account (Account for FDIs , FIIs and overseas borrowings) surplus more than doubled in the quarter to $34.75 bn. IT business is one of the worst hit industries with all the companies showing slump in growth. These companies have sought for government interference, which is yet to be addressed.

Petroleum Prices:

The soaring crude oil prices has always been a cause of concern for India oil companies with no say in the domestic pricing of petroleum products. The $100 per barrel crude oil would have left government with no other choice except increasing the oil price, which no government will be willing to do when hardly a year is left for the Lok Sabha election. The appreciation in rupee has helped government to compensate the high oil price to some extent.

Impact on Inflation:

January 2007 witnessed the highest inflation in last 3 years because of increased demand for pulses and general goods with supply constraints. The appreciation in rupee made import cheaper and hence decreased price, which led to decrease in inflation to almost 5 years low in December, 2007.

As the full impact of subprime is yet to be amortized and expected further cut in Federal Reserve interest rate, the rupee is expected to further appreciate to 38 per dollar by the end of this year.

What moves Sensex or Nifty?

We have seen in the previous post the constituents of Sensex/Nifty and their weights in the index. Lets see what is the effect of price change of a stock on the index. We will take the example of S&P CNX Nifty. As discussed before Nifty is an index based on full market capitalization i.e. the index is proportional to the sum of the market capitalization of all its constituent stocks. The weights of the stocks in the index will vary. Lets take the data of 31 December 2007 for understanding the concept. Nifty closed at 6138.6 on December 31, 2007. The top four weighted stocks in Nifty were:

Stock Name	Market Capitalisation	Weightage
	(Rs. Crores)	%
Reliance	4,19,043	11.89%
ONGC	2,64,568	7.51%
NTPC	2,06,879	5.87%
Bharti Airtel	1,89,100	5.37%
Total	35,22,527	100%

Suppose Reliance's stock price changes by 10%, how will Nifty change?
This is a very simple question. Since market capitalization is directly proportional to stock price, Reliance's market capitalization will increase by 10%. Assuming other constituents of Nifty unchanged this will lead to an increase in Nifty value by:

Change in Total Market Capitalization of all constituents of Nifty = Change in Market Capitalization of Reliance = 10% of 419043 = 41,904.3

New Total Market Cap = 35,22,527 + 41,904.3 = 35,64,431.3

New Nifty Value / New Total Market Cap = Old Nifty Value / Old Total Market Cap

So, New Nifty Value = 6138.6 * 35,64,431.3 / 35,22,527 = 6211.625

Change in Nifty value = 73.025
% change in Nifty = 1.1896%

We got that a 10% change in Reliance's stock price will change Nifty by 1.1896%. This is same as the weight of Reliance in Nifty. So, all this calculation was meaningless and we can find the change directly from the weight of that stock in Nifty :).

Nifty falls below 6000 mark first time in 2008 led by Mutual funds sell off

Indian stock market has seen heavy sell off in the past two days. The benchmark indices Nifty and Sensex have touched a low level of about 4-5% from the closing value two days back. We will try to analyse the reasons for this abrupt selling, but first we shall look into the trends of the Indian stock market for past one year. The following graphs are self-explanatory:

Variation of Nifty-50 over one year. Returns in excess of 50% in one year.

Past one month variation in Nifty index. Highly volatile. Nifty fell sharply in mid December 2007, and also rise sharply the next week. Touched new highs of 6300 in January 2008 before falling back sharply below the 6000 level in mid January. Will Nifty rise back sharply as seen in December last year, perhaps no one can say so for sure.

The last two days heavy sell off can be seen in this chart. On January 15, and 16 Nifty has fallen sharply and only in last hour of trading on January 16, bulls have tried to come back.

Reasons for sharp fall:

If we look at two big group of players in the Indian markets, the FIIs and the mutual funds, the perception of both are not same. While mutual funds have been one of major reason as they have sold off heavily in equities in the last two trading session, FIIs have been buying steadily though their activity has slowed down.
One of the apparent reason is the Reliance Power IPO, India's biggest IPO so far, which opened for subscription on January 15, 2008. The size of the IPO is about 3 billion dollars and it got fully subscribed within minutes of its opening. The excitement about the IPO has lead to it getting more than 10 times offer for subscription on the first day itself. This is remarkable considering the size of the issue. About 27 billion dollars have shifted to Reliance Power and it appears that a substantial part of it has been coming from the stock markets. There is a craze for IPOs and this has led to spectacular performance of the IPOs in the last year. Moreover, at levels above 6300 for Nifty many investors don't see any significant upside and have taken their money from stock market to the IPO which has higher chances of giving them 40-50% returns on listing.

Economic Fundae - GDP

Good Accounting turns data into information!

This article is aimed at people trying to understand the basics of national accounting.

GDP:Gross Domestic Product is the value of all the goods and services produced in the country within a given period. This includes all the goods and services produced in the geographical boundaries of the country irrespective of who produces. The other slight variant is the GNP which include receipts from abroad made as factor payments to domestically owned factor production. For example, part of India's GDP corresponds to the profits made by Hyundai Motors from its Indian operations. But these are part of the Korea's GNP because they are income of Korean-owned capital.

Although the difference is not significant in countries like U.S. it certainly is important where most of the countries labor is abroad working for a multinational company.

The fundamental national accounting equation will be as

Y= C + I + G + NX

Consumption spending by household sector, includes spending on anything under the sky. The only exception being the investment which people make in durable goods.

Then the government purchases are the government spending on the goods and services. Think of anything which government spends like laying roads, providing higher education etc. Again the only exception being the transfer payments. The transfer payments are those which does not get a service in return to government spending. This is logical as they are not a part of any of the current production.

The letter I in the equation refers to the Gross private domestic investment. In simple words, investment is associated with the business sector's adding to the physical stock of capital, which in turn will increase the economy's ability to produce output in the future.

The last term is the Net Exports, the difference between the exports and imports. They are to account for domestic spending on foreign goods and foreign spending on domestic goods. Confused, well we just finished the accounting of the entire nation. There is more than one reason to be confused, like most of our politicians.

Governments budget deficit is often a term we hear particularly in a country like India. This essentially means the difference between the government expenditures and the taxes received. Remember to include transfer payments as a part of government expenditures (which is slightly different from the government purchases)

Quick Fact:

GDP of India: (2007-08): 41,25,725 Crores of Rupees

Without further delay we will introduce you to other macroeconomic variables which are inflation, currency exchange rates, interest rates, monetary system and the business cycles.

BSNL may sell stocks worth $10billion (Rs 40,000 crores) through India's biggest IPO

Indian Government announced on monday that it may sell $10 billion(Rs. 40,000 crores) stake in BSNL, one of the India's biggest telecom company. This will be done through initial public offering (IPO) of shares and fund will be used for expansions plans. BSNL will be the second biggest telecom company in Asia after China Telecom by market capitalization.

The IPO will value the BSNL at Rs 400,000 crore, much ahead of Bharti Airtel, the country’s No.1 company whose market capitalization is Rs. 172,179 crores (January 14, 2007). BSNL will also become the India's second biggest listed company after Reliance Industries Limited(RIL) which has market capitalization of about Rs 448,193 crore.

On Tuesday India's biggest IPO so far will be opened for subscription. A $3 billion (Rs 11,700 crore) IPO by Reliance Power will break the previous best record of 9,190 crores by the real estate major DLF Ltd.

Soaring Crude Oil price and its impact on India

With the crude oil touching $100 per barrel in the very first week of the year, it is expected to brings a bitter taste all over the world except the oil-producing countries.

But how about India? India imports around 76% of its domestic demand and the increase in oil price is always a matter of concern for the policy-makers. But this time story is not all the same, while one side the international crude oil price is at all time high, the Rupee has appreciated by more than 12% which is highest at least last 20 years. The appreciation of domestic currency has offset the impact of high price to some extent.

The last increase in the domestic oil price was there in June, 2006 and which was followed with downward revision twice. The oil price has huge impact on general pricing and hence inflation. With the moderate and negligible increase in oil price government has well maintained the inflation and common man is happy about it. But, the bigger picture is quite ominous. The major supply of oil in India comes from the PSU’s like IOCL, BPCL, and HPCL. As per MoneyControl, Petroleum has an under recovery of nearly Rs 9.5, diesel Rs 11.3, LPG Rs 380 per cylinder, and kerosene Rs 21. This under recovery includes the marketing, which has to be shared equally between marketing companies (ONGC, GAIL etc) , upstream companies(IOCL, BPCL etc) and government .With crude oil price peaking all time high and subsidized petroleum price in domestic market, these companies are making huge losses. A part of loss is swallowed by the government by issuing oil bonds to these companies and rest partially compensated by the three marketing companies ONGC, Oil India, GAIL.

The political aspect of the pricing can also not be ignored. The central government coalition lost the election in Gujarat, Himachal and even in Punjab. The Lok Sabha election is going to be held in 2009 and government has to rely of appeasement approach. Left has already out its deep concern over any plan of increasing oil price.

Now, how the price moves in international market and what step government takes to tackle the situation is going to be quite interesting.

Monetary Policy

Monetary policy intends to achieve a balance between excess and shortage of money supply in the market/economy. These policies are concerned to the supply/control of money. It influences the pace and direction of economic activity, money supplies, interest rates, borrowing and price level.

In the case of shortage of money on the economy the growth gets hampered which has negative impact on the prosperity of people. On the other hand if there is excess of money in the market, the prices of goods and services goes up and severely impacts the poor. The government/RBI needs to make sure that the sufficient money is available with market for the growth without affecting the poor.

The main objectives of monetary policy are –

Maintaining the price stability

Inflation has strong negative impact on social welfare and needs to be maintained at lower level.

High and stable employment

Employment opportunities could be increased by higher investment and economic activities, which in turn requires availability of credit at reasonable interest rates.

Economic growth

Adequate credit is required for the productive activities and hence sound monetary policy is required for supporting the growth in an economy

Stability of exchange rates

Exchange rate (amount of dollars per Rupees) is a crucial factor determining a country’s position in the international trade (import and export). Increase in the exchange rate () discourages export and enhances imports and vice versa. The current increase in exchange rate(appreciation of rupees against dollars) had a negative impact on the IT industry which is mainly based on export.

Fluctuation in exchange rates makes the planning difficult for the traders and hence monetary policy should aim on preventing any sharp fluctuation in the exchange rate.

Sectoral deployment of finds

Depending upon the priorities laid down in the plans/by government, Monetary Policy (RBI) determines the allocation of funds and interest rates among different sectors. Examples: Priority sector lending; recent move to increase interest rate on housing loans.

Special Section for CAT / MBA entrance GD/PI Finance articles

This post contains the list of all the Finance articles, in this blog, that may be relevant for CAT or other MBA aspirants preparing for GD/ PI. You may send your request for any relevant article that you want on this blog.

We have two authors for this section: Saurav & Selwyn. They shall be presenting their views & relevant facts on the current topics in Finance.

So far we have these articles in this category. The list will get updated with the new posts.

List of economics articles:
Soaring crude oil prices and its impact on India
Monetary Policy
Rupee appreciation and its after-effect
Economic Fundae - GDP
Economic Fundae - Inflation
Economic Fundae - Exchange Rates
Economic Fundae - Business Cycles
Economic Fundae - Fiscal Policy
Economic Fundae - Interest Rates

List of economics articles:
Stock Markets Basics

To view all the posts with tag CAT in a single page.

How did various Indian stock market indices performed in 2007

Returns of the four major indices of National Stock Exchange(NSE) of India in the year 2007 are are:

CNX 100	CNX 500	Midcap	Nifty
56%	61%	78%	53%

While late rally in midcap stocks lead to its overall better performance, CNX500 also outsmarted Nifty50. This suggests that the appreciation of stock prices in the year 2007 was across the market and not limited to the stocks in benchmark indices like Nifty and Sensex.

The graph showing the variation within the year of the above indices:
Relative performance of the four indices is shown in the graph below:

Correlation of Sensex and Nifty

How much correlated are Sensex and Nifty? Lets look at the graphs of the two indices for last five years:Analyzing the data for last five years using regression shows a high correlation between them. Lets look at the picture for last one year.

Based on the past data, one can easily conclude that Sensex and Nifty are highly correlated indices.

Finding Beta of a stock

Beta is a measure of the systematic risk pertaining to a security. It is an estimate of the returns on a stock when the market changes by a unit percentage. A beta of 1 means that the stock is in perfect correlation with the market, if the market moves up by 1% the particular stock will also move up by 1% and vice-versa. There are many ways to estimate beta the most common one being using the historical data. Since beta estimates the returns using historical beta may not always yield the exact future returns, but most of the times they explain the trend.

Historical beta is calculated by regression of the stock return and market return for a particular time period unit. This may be daily, weekly, fortnightly, monthly, or quarterly depending upon the available data, accuracy required and relevance. The market returns are measured by taking the returns of some index which takes the representation of almost all the sectors of the market.

Lets find beta for State Bank of India (SBI). We have taken the returns on weekly basis and market as CNX-500. The data for the last five years up to December 15, 2007 have been plotted below.

Regression analysis yields the slope of the line as 1.156 which is beta.

The historical price movement of SBI and CNX till December 2007 is shown below.

What is BSE Sensex? What constitutes Sensex?

SENSEX (Sensitive Index) is the India's most popular stock market index developed by Bombay Stock Exchange (BSE) in 1986. SENSEX has 30 constituent stocks representing a sample of large, liquid and representative companies. The base year of SENSEX is 1978-79 and the base value is 100.

The Index was initially calculated based on the "Full Market Capitalization" methodology but was shifted to the free-float methodology with effect from September 1, 2003. The level of index at any point of time reflects the Free-float market value of 30 component stocks relative to a base period.

The selection of constituents in SENSEX is based on several factors including the listed history, trading frequency, rank based on market capitalization and liquidity, industry representation, etc.

The index is reviewed every quarter and in the case of a revision in the Index constituents, the announcement of the change is made at least six weeks in advance of the actual change.

The present constituents of SENSEX are:

Name	Industry
ACC Ltd.	Cement
Ambuja Cements Ltd.	Cement
Bajaj Auto Ltd.	Automobile - 2/3 wheeler
Bharat Heavy Electricals Ltd.	Electrical Equipment
Bharti Airtel Ltd.	Telecommunication
Cipla Ltd.	Pharmaceuticals
DLF Ltd.	Construction
Grasim Industries Ltd.	Cement
HDFC	Finance - Housing
HDFC Bank Ltd.	Banking
Hindalco Industries Ltd.	Aluminium
Hindustan Unilever Ltd.	Diversified
ICICI Bank Ltd.	Banking
Infosys Technologies Ltd.	Softwares
ITC Ltd.	Diversified
Larsen & Toubro Limited	Engineering
Mahindra & Mahindra Ltd.	Automobiles - 4 wheelers
Maruti Suzuki India Ltd.	Automobiles - 4 wheelers
NTPC Ltd.	Power
ONGC Ltd.	Oil Exploration/Production
Ranbaxy Laboratories Ltd.	Pharmaceuticals
Reliance Communications Limited	Telecommunication
Reliance Energy Ltd.	Power
Reliance Industries Ltd.	Diversified
Satyam Computer Services Ltd.	Softwares
State Bank of India	Banking
Tata Consultancy Services Limited	Softwares
Tata Motors Ltd.	Automobiles - 4 wheelers
Tata Steel Ltd.	Steel
Wipro Ltd.	Softwares

The weightage and market capitalization of the constituents of Nifty as on 11 January 2008 are shown below:

Name	Free-Float Market Capitalization (Rs. Crores)	Weight in Sensex (%)
ACC Ltd.	10,105.36	0.72
Ambuja Cements Ltd.	12,685.74	0.9
Bajaj Auto Ltd.	16,555.77	1.17
Bharat Heavy Electricals Ltd.	64,149.25	4.55
Bharti Airtel Ltd.	41,721.91	2.96
Cipla Ltd.	10,316.99	0.73
DLF Ltd.	30,585.98	2.17
Grasim Industries Ltd.	23,225.91	1.65
HDFC	72,575.42	5.15
HDFC Bank Ltd.	49,869.91	3.54
Hindalco Industries Ltd.	17,386.76	1.23
Hindustan Unilever Ltd.	24,753.83	1.75
ICICI Bank Ltd.	157,659.91	11.18
Infosys Technologies Ltd.	76,723.99	5.44
ITC Ltd.	58,650.90	4.16
Larsen & Toubro Limited	109,360.09	7.75
Mahindra & Mahindra Ltd.	15,231.08	1.08
Maruti Suzuki India Ltd.	12,982.17	0.92
NTPC Ltd.	33,678.60	2.39
ONGC Ltd.	55,905.85	3.96
Ranbaxy Laboratories Ltd.	10,326.60	0.73
Reliance Communications Limited	57,241.77	4.06
Reliance Energy Ltd.	37,925.18	2.69
Reliance Industries Ltd.	227,361.54	16.12
Satyam Computer Services Ltd.	26,113.26	1.85
State Bank of India	57,722.49	4.09
Tata Consultancy Services Limited	24,197.37	1.72
Tata Motors Ltd.	17,635.05	1.25
Tata Steel Ltd.	43,674.83	3.1
Wipro Ltd.	14,190.08	1.01
TOTAL	1,410,513.59	100%