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Friday, October 31, 2008

Fuel price, Inflation, Savings

It's time to visit your portfolio and weed out investments whose inflation-adjusted returns is low or negative

On June 4, the central government announced a price hike of Rs 6 per litre of petrol, Rs 3 on diesel and Rs 50 per LPG cylinder, together with customs and excise duty cuts in an attempt to save the oil marketing companies from bankruptcy. Oil marketing companies buy crude oil from the international markets and distribute it in India. India imports 73 percent of its petroleum needs as the production of crude oil here is very little.

The price of crude oil in the international markets has nearly doubled from a low of $60 per barrel in May 2007 to $130 a barrel in May 2008. The retail price of crude in India, administered by the government, has not been raised since 2004. Hence, these oil marketing companies have been running a very unprofitable business of buying crude at high prices and selling it to domestic consumers at low prices. In this process, they have accumulated mind-boggling losses of Rs 2,000 billion and were facing a severe liquidity crunch.

These firms were losing Rs 21.43 on the sale of every litre of petrol, Rs 31.58 per litre on diesel Rs 35.98 per litre on kerosene while losses on LPG were Rs 353 per 14.2-kg cylinder. Oil marketing companies therefore lost money every time they made a sale due to their inability to peg their selling prices to the purchase price of crude. To defuse this crisis, the government raised fuel prices by an average of 13 percent with full knowledge of its impact on inflation.

Impact on inflation

The current annual wholesale inflation is already high at 8.1 percent. The government expects the effect of price hike on inflation to be marginal at around 60 basis points. Others, however, are not so positive about the impact of the price hike. Crisil, the rating agency, felt that it would push up inflation by 95 basis points taking into account both direct and indirect impacts. Out of this, the direct impact will be 51 basis points with the highest contribution coming from the hike in the LPG price. The indirect impact, which will be felt over the course of the next few months, will be 44 basis points.

Economists are of the opinion that inflation will flare up to a 15-year high of 14 percent due to the price increase. A rate of nine percent would be the highest inflation since 1995.

A high inflation rate affects the consumer at the retail level and the corporate profits too. The cost of living rises and the consumer has to pay more for the same goods and services. At the corporate level, the higher cost directly impacts the bottom line. Their inability to pass on the price increases to the consumer further squeezes their margins. This in turn directly affects the stock markets, which prices future earnings of all companies listed with it. The fuel price hike caused the Sensex to lose nearly 400 points on Wednesday, June 4. Investors' reaction reflected the anxiety about the likely impact of the fuel price hike, which was more than what the market expected.

Now, all eyes will be on the Reserve Bank of India (RBI) as inflation is now beyond its comfort zone. Whether the RBI will raise the cash reserve ratio (CRR) or even raise interest rates is now a matter of conjecture. But economists feel since price pressures are largely beyond its control, and the RBI will maintain a measured response to fight inflation by managing CRR in the banking system rather than raising interest rates, which could impact growth.

Impact on savings

Inflation not only increases the prices of all food grains and services but also impacts your retirement corpus. It increases the amount you have to save up. For example, if you feel Rs 10 lakhs is a good amount retire with at the age of 60 and inflation is at five percent, you will have to save up Rs.33.86 lakhs to afford the same cost of living 25 years hence. The farther away you are from retirement the more you have to save to maintain the same earning power. These calculations are at an inflation rate of five percent and a higher inflation only pushes the quantum further up.

Hence, it makes immense sense to revisit your portfolio and weed out those investments whose inflation adjusted returns are very low or even negative. Exploring investment avenues that would protect your capital from being eroded by inflation is a must in these uncertain times.

Tuesday, October 28, 2008

When can Indian stock markets recover? Crude oil prices, Global cues, Policy Action, Political scenario

The domestic markets will recover if there is a drop in oil prices. The volatility seen these days is expected to continue for some more time

Watch for:

  • Crude oil prices

  • Global cues

  • Policy Action

  • Political scenario

The stock markets are in a bear phase. In fact, the markets are witnessing one of the worst phases in the recent past. Last week, on Monday, the bourses were in the red by $50 billion. The markets lost all the gains of the current year in market value with a depreciation of close to $50 billion on that day, amidst a fall of over 500 points in the benchmark Sensex. The Sensex plunged 506 points to close at 15,066 points - it's the lowest in the current fiscal.

The cumulative market capitalisation of all the listed companies fell below the Rs 50 trillion mark. Out of this, nearly half the loss, amounting to about Rs 1 trillion, was contributed by the 30 biggest blue chips, which constitute the Sensex. The Sensex has also shed close to 6,200 points from its all-time high of 21,206 points reached earlier this year. By the end of last year, the total market value of all the listed companies was approximately Rs 72 lakh crores - a gain of close to Rs 35 lakh crores - during the year. However, following the recent downslide on the bourses, more than half of the total gains registered during 2007 have been wiped off.

Crude oil prices

Analysts expect the Sensex to stay around the 14,000 level for some time. One of the major reasons for the fall includes the rising inflation rate, fuelled by the rising oil prices. A surge in crude oil prices, and drop in the Dow index, led to a knee-jerk reaction in the Asian markets. If crude falls below $138, there could be a recovery which will impact domestic markets. With crude prices having crossed $139, a recovery in equity values now depends on a softer trend in the price of crude.

Global cues

A similar trend can be observed in other markets too. European stocks too fell due to the rising crude prices and weak employment data in the US. The markets are reacting to the impact of a high fuel bill and a slowdown in the US economy. The situation in the US is getting worse, going by the unemployment figures. The are chances of the domestic markets sliding further. There are fears about Europe also, as the central bank there has clearly indicated the possibility of a hike in interest rates.

The outflow from foreign institutional investors (FIIs) can cause further declines. FIIs have already sold $5 billion this year. They will feel the pressure to unwind positions since all off-shore derivative instruments (ODIs) need to be extinguished by March 2009 and there is a limit of 40 percent for assets under custody on ODIs in the cash segment. FIIs control a bulk of trading activity on the bourses. Any sell-off by the FIIs can trigger major falls in the market. FII actions determine market sentiments.

The stock markets' reaction was due to adverse news coming in from all corners - abroad and local markets. Inflation is the main cause to weigh down market sentiments.

Policy Action

The Government's recent move to hike petrol and diesel prices will have a cascading effect on inflation, considering their higher weight age in the wholesale price index (WPI). Already there are fears that the inflation rate is likely to cross nine percent in the weeks to come and may even move to double digits.

A further rise in inflation would trigger a sharp reaction from the Reserve Bank of India (RBI), which has already indicated that it will take tough measures to tackle it. The RBI is expected to effect a hike in the cash reserve ratio (CRR) for banks, which will tighten liquidity, to tame inflation. The RBI may hike the short-term interest rates also. The RBI governor had said the situation was extraordinary in respect of oil prices and that the basic approach of the bank was to carefully manage liquidity conditions. Rising oil prices and inflation could pose major problems for the mounting deficit situation. Rising crude oil prices are likely to put pressure on the deficit front, as 70 percent of domestic oil consumption is sourced through imports. This means a problem for oil marketing companies, which could face higher under-recoveries, as the oil price offered to the consumers is hugely subsidised. The macro environment continues to worsen due to rising oil prices, higher inflation, and the increasing fiscal and current account deficits.

Many individual investors have stopped investing in equity. The turnover on the bourses has been low. There has been a predominance of put options, which indicates that traders expect a decline in stock prices.

A recovery in Asian markets and decline in oil prices will help domestic markets come back. The domestic markets, however, will continue to be volatile for the next few months.

Monday, October 27, 2008

Few tips to tackle high prices & Inflation

Consumers have been feeling the heat of rising inflation for the last few months. Though the number seem to have come down marginally to 12.14 per cent (for week ended Sep 26), there seems to be little respite. Such times force the individual to take a relook at their savings strategy and monthly budgets. The basic idea is to do things smartly to save on costs. Of course, there is a rising interest burden as well that makes things worse.

In such uncertain times, your investments need to deliver higher returns to break even. For instance, if the inflation is touching 12 per cent, you will have to earn 17-18 per cent pre-tax (for the highest income bracket) so that there is no capital loss.

While keeping idle cash in banks may seem like a safe and secure strategy, it can never protect the purchasing power of your money and will lead to wealth erosion. But cash certainly has its uses. It can be used to retire or reduce high-cost loans.

Also, make long-term investments in gold and equities to beat the inflation in the long run. At every sharp dip, you can increase the equity exposure in-line with your asset allocation.Gold is also a good idea, if the scaling is done in a staggered fashion. Though in the short term, gold might not deliver, it will always do well in the over time. Some jewellers are offering gold without any additional making charges now.

Even investment in residential property is a good hedge, but some correction is due in the prices.

As far as your monthly budget goes, have a savings budget rather than an expense budget. During high inflationary and interest rate periods, do not succumb to the pressure of reducing your saving. Instead spend smartly.

Some of the smart spending measures that you can take up include cutting down on areas that are a part of lifestyle inflation. These would include:

  • Reduce your expenses on watching movies. Rather watch them on off-days when ticket prices are substantially lower.

  • Eating out can be an expensive affair. For most professionals today, dining or having lunch outside constitute a significant part of their monthly expenses. Reducing the frequency could be a good idea. In fact having more parties at home can be a cheaper idea.

  • Electricity bill is another area where cost-cutting can be done. Instead of keeping the home AC on for several hours, use it for a few hours less. Similarly, switch off the appliances and lights when not in use.

  • Cut your fuel costs. Using public transport or car pools could be a cheaper option.

  • Go to the big malls once or twice a month and stock up on your grocery items. This can insulate you from not just rising food prices but also lower your transportation costs.

  • Avoid big purchases. Smart spending does not mean being stingy but focusing on your priorities and expenses that should be done (Children's tuition fees is certainly far more important than eating out several times a month or taking a short vacation.)

  • For people, who cannot control their mobile expenses, should opt for pre paid cards.

  • Most importantly, do a monthly review of your credit card and bank account statements. This would help you to pin-point areas where expenditure can be cut. For instance, recently when I checked one of my dormant accounts, I realised that the bank was charging me Rs 500 every month even though, I was told there will be no charges.

Friday, October 24, 2008

CRR, Repo Rate hike/cut by RBI and its effects

INDIA, like many other economies, has embarked on a long, difficult road to check runaway prices. It’s now evident that policymakers will hike interest rates till it hurts and pulls down demand. The central bank as well as the government are willing to sacrifice a bit of growth to douse inflation — an issue that has captured the collective imagination.

On Tuesday, the Reserve Bank of India hiked the benchmark short-term rate by 50 basis points, about 25 bps more than what the market had expected. Bonds and equities reacted sharply.

Soon, home loan seekers and corporate borrowers will feel the pinch, since borrowing money will now be far more costly. RBI has not only raised the benchmark repo rate — the rate at which banks borrow from the RBI — from 8.5% to 9% with immediate effect, but has also hiked the cash reserve ratio (CRR) for banks by 25 bps — a measure that will drain Rs 9,000 crore from the banking system.

Given the outright hawkish policy stance, it’s clear that RBI will not hesitate to take more policy actions if he thinks that inflationary expectations have not been adequately checked. However, there is a growing perception that the Indian economy, in its current stage, may be better prepared than before to absorb the rate shocks. Thus, the price it will have to pay would be smaller than feared.

Money market is reflecting interest rates at levels last seen in 1999, a period characterised by a deep slowdown. Some of the more pessimistic analysts predict a bear market of indefinite length and a growth in the region of 7%, though the latter is still high by world standards.

The RBI, however, still expects 8% growth. The optimistic view is that if RBI is able to bring down inflation to 7% by the end of the fiscal — which is its target — the rates can start coming down. However, some forecasts peg inflation as high as 15% by October, which would surely mean higher rates.

Banks are readying plans to raise lending rates by at least 50 basis points over the next few days, keeping in mind the central bank’s message to moderate loan growth.

Most banks will look at revising rates only next month since the rate hike kicks in from August 30. Meanwhile, they will review the liquidity position, hours after the policy review. The prime-lending rate (PLR) of most state owned banks range between 12.75 and 13.25%.

For a long time, these banks had not hiked rates, but now with the rising cost of funds, especially deposits, they do not have the leeway to absorb these costs. Deposit rates are also bound to go up, but the returns will be negative considering that inflation is running at double digits.

The RBI is pulling out all stops to ensure that inflation, which at 11.89% is at a 13-year high, can be lowered to 7% towards the end of this fiscal. More importantly, Reddy wants to douse the inflationary expectations. The policy tools, which it put to use while unveiling the first quarter review of the monetary policy, may well strain household budgets and force company managements to re-work their numbers.

Analysts may differ about the growth projections for this fiscal, but Reddy believes that given the healthy investment and savings ratio, the Indian economy can chug along at a decent pace. Capital formation as a percentage of GDP was 35.9% in FY07, while savings grew by 34.8 % in FY07. Even if GDP growth was to temper at 8% in 08-09, India would still be the second fastest growing economy in the world after China.

The Indian banks had grown their loan books at a blistering pace of over 30% in the three years starting from ‘04-’05. Last year, RBI tried to nudge banks to pare lending and focus on credit quality. Yet, some banks had registered a loan growth of well over 30% annually. Banks have been told to review their business strategies to combine long-term viable financing with profitability in operations. Lenders will now have to ensure the health of their loan portfolios, a pre-emptive move to stem any build-up of bad loans with a slowdown looming ahead.

From Auto To Home, Rates To Go Up Across Segments

RETAIL lending rates across most products — auto loans, personal loans, and loans against securities — are likely to go up by, at least, 50 basis points in the coming weeks. But banks may prefer to tread cautiously, as further rate hikes could push up defaults and hit demand. Bad loans have been rising across most retail products in the past few months.

Retail loans are seeing a lower growth in the past few months. It grew by almost 16% as on May 23 compared with 24% the previous year. The two fastest-growing segments in banks’ retail loan portfolio are credit cards and education loans, according to RBI.

Auto loans, which have seen a rate hike of around 1.5% in the past few months, are likely to see another rate hike of 50-75 basis points. Demand has already seen a drop in July.

Defaults in car loans have already seen around a 20% hike in the past one year. Even though rack rates are at around 16%, customer rates are at around 13%. For the past few months, incidentally cash deals have started increasing. Also, down payments by customers have increased.

Bankers are also worried on the fiscal health of dealers in both car and two-wheeler segments, as they feel that some loans are likely to turn bad over the next few months. Already, banks have been reducing loans to this segment for the past quarter.

The two-wheeler segment could see a 50 basis point hike in interest rates. However, bankers are also waiting to see how manufacturers are reacting to the current rate hike. Already rates in this segment are one of the highest at between 24-26%. Delinquencies in this segment have seen a sharp rise with the result that some of the financiers have already gone out of the segment.

In the personal loan segment, rates are already hovering around 19%. This segment is supposed to be a bit more inelastic in demand compared with other retail loans. Bankers are likely to hike rates in this segment by a maximum of 50 basis points. Moreover, defaults are rising even among the higher end of the portfolio. Most bankers concurred that demand for loans have come down by around 15% in July as higher rates have started affecting demand.

NPAs, which were at around 4%, have now risen in some cases to as high as around 7%. Most banks and non-baking finance companies have already adopted a slower growth in this product because of the rising bad loans. Most banks are also likely to increase rates on other secured products like loans against securities.

Put your money where your mouth is

FOR Indian investors, the past three years were stellar in terms of their returns, especially for those with an exposure to equity. However, the equation has changed completely since the start of this year, as oil and other macro-economic concerns have occupied the centre-stage. Managing money has become more complex.

What should you do with your money?
With cash reserve ratio (CRR) rates being hiked by 25 bps and the repo rates by 50 bps, the stock market was bound to react negatively. Post-policy announcement by the Reserve Bank of India, the market entered a sell mode which saw the Sensex losing 557 points to close at 13792. Investors pretty much attuned to getting high returns over the past three years are now wondering where to invest their money.

Direct Equities And Equity MFs
As far as equities go, it has been a bit of a rough ride from the start of this year. Investors have not had it easy, with the Sensex losing as much as 32%. Sectors like real estate and banking have dropped by over 50%. While it is not the time to sell one’s investments, a selective restructuring of one’s portfolio with a bias toward large-caps could be a good idea.

With inflation, interest rates and oil still remaining concerns, equity markets may well remain range bound till the end of 2008. Investments will have to be stock-specific. We would prefer stocks where valuations are cheaper relative to their peers,.

Those investing in equity should have a long-term perspective, simply because of the volatility that could prevail in the short-term. The consensus is that a time frame of less than a year should be avoided. The risk-reward ratio for equities looks favourable from a perspective of a year and a half or two years. Investment in mid-caps and small-caps, if they are made, should be done with a 3-5 perspective.

Debt MF / Fixed Deposits (FD)
Interest on fixed maturity plans (FMPs) and fixed deposits is likely to move up, as banks will be forced to pay more for borrowing funds. If you fall in the higher tax bracket, you could consider liquid funds and FMPs that offer a post-tax return of around 9-9.5% and 10%, respectively. If you fall in the zero-tax bracket, fixed deposits will qualify as a viable option.

Hikes in CRR and repo rate result in an economic downturn. Gold also acts as a hedge against inflation. Portfolio allocation to gold can be increased marginally by 5%.

Ulips demand may slow down

THE Reserve Bank of India’s (RBI) monetary measures, which have pushed up interest rates and depressed the stock market, will hit sales of unit-linked insurance plans (ULIPs). With the benchmark BSE Sensex falling by a third after touching its peak of over 21000 points in January 2008, those who have invested in ULIPs in the third quarter of 2007-08 have seen an erosion of their savings.

Insurance companies have managed to record a decent growth because of an expanded distribution network, but sales appear to be easing. Until early 2008, ULIPs have been the main channel for retail investment in the stock market. The measures could see a marginal shift from ULIPs to traditional products. A small shift would be good for us because we have been wanting to reduce the share of premium from ULIPs to around 70% from 85% in 2007-08.

The rise in yields has also given an earning opportunity on the fixed income side. He said that investors do turn cautious about equity investments, when the market turns volatile. But there are income funds under ULIPs as well. But the long-term structural platform of unit-linked investment plans remains intact. And for those not concerned about the short-term volatility in stocks, it is the right time to buy. Premium from new policies has fallen close to 7% for the life insurance industry. This has been largely on account of a decline in sales by LIC. Private companies have grown at over 50%, but their growth has seen a moderation from last year. Private companies are, however, confident that investments in ULIPs will continue to grow.

Floating Rate To Help New Borrowers When The Cycle Turns

NEW borrowers would be better off taking a floating-rate home loan. Despite the fact that the interest rate is likely to go up in the near future. a floating rate still makes sense.

The advantage of a floating rate scheme — where rates move in line with the bank’s benchmark Prime Lending Rate (PLR) — is that the borrower will benefit when the interest rate cycle turns. Thus, in a falling interest rate regime, banks will be under pressure to lower the home loan rates. Lending will not remain as high as it is now. The rate cycle takes a turn every three to five years.

If a borrower is bent on taking a fixed-rate loan, just to avoid uncertainties and possible cash outgo, s/he must carefully read the loan document before signing on the dotted line. Most banks insert a reset clause in the fixed rate home loan agreement. This means that the bank will have the right to revise the home loan rate even if the borrower had opted for a fixed rate. For instance, in case of SBI, the interest rate reset happens at the end of every two years from the date the loan has been disbursed. For Bank of India, the reset is at the end of every five years. HDFC, the biggest home loan player, is among the few lenders with an absolute fixed rate.

However, the difference between the floating and fixed rates is very high — as much as 300 basis points in case of big lenders like HDFC and ICICI Bank. Understandably, most borrowers are discouraged to take a fixed rate loan. More so, because rates will soften once the interest cycle turns after a few years.

Borrowers also have an option to split the loan amount into fixed and floating. Here, a part of the loan is at a fixed rate and the balance is at a floating rate. While many banks offer this, most insist on a reset clause with the fixed rate.

A borrower should look at a fixed rate loan if it’s a 10-year loan and a floating rate if the loan duration is longer. Or, they can go for the part-fix, part-floating option.

Meanwhile, those who have taken loan at floating rates will have to pay more. Most banks are likely to take a call on the rate hike by next month since the CRR hike will come into effect only after a month.

In case of a 20-year loan, a 25-bps hike will mean the EMI going up by Rs 17 for every Rs 1 lakh loan amount; in case of a 50-bps hike, it will be Rs 34 and in case of 75 bps, the EMI will rise by Rs 51. Similarly, if it is a 15-year loan, a 25-bps hike will push up EMI by Rs 16 a month, a 50-bps hike by Rs 33, and a 75-bps hike by Rs 50.

Wednesday, October 22, 2008

How best to tackle Inflation - Part III

How you can fight back

  • Review your emergency fund requirement. Keep six months' expenses as emergency funds, mostly in short-term debt funds such as inflation- and tax-efficient FMPs.
  • Examine your health and life cover. With costs going up, you need to bump up your life and health covers. Go for low-cost, high-cover term plans and floating health covers to bridge the gap. avoid large idle savings and bank balances. Invest in short-term debt funds like FMPs.
  • Defer large loan-based purchases. Avoid large EMIs that will stretch your finances more. Go for your first home if you can afford the down payment and EMI.
  • Prepay high-cost loans. Start with your floating rate home loan. Remember, no investment option will provide guaranteed returns that equal the higher interest payout.
  • Seek capital gains and dividend instead of interest. Interest income gets taxed at your income tax rate. Long-term capital gains and dividends from equity and equity MFs are tax-free, but taxed at 10 per cent without indexation and 20 per cent with indexation if coming from debt funds. Dividends from debt funds are tax-free post dividend distribution tax.
  • Continue staggered investments in equity and equity MFs. Carry on with your systematic investment plans (SIPs) in equity funds. For fresh investments, seek large-cap funds from OLM 50 that are likely to benefit from a rebound along with blue chips they predominantly invest in.
  • Diversify into international funds and gold. Gain from the upsides in well-performing equity markets in other countries by investing in international funds. Investing in gold (up to 5-10 per cent of your corpus) will give your portfolio a stable growth.
  • Avoid interest rate-sensitive stocks. This includes sectors such as real estate and auto. The best bets would be large-cap pharma and FMCG stocks currently available at attractive valuations.

Tuesday, October 21, 2008

What drives crude oil prices?

Why oil prices fluctuate and result in volatility in the stock markets

Crude oil is one of the most basic global commodities. Fluctuation in the crude oil prices has both direct and indirect impact on the global economy. Therefore, the prices of crude oil are tracked very closely by investors the world over. Crude oil prices have gone up to record levels of USD 100 per bbl after reaching a high of USD 145 per bbl (rise of around 70 percent from previous year's levels).

The price variation in crude oil impacts the sentiments and hence the volatility in stock markets all over the world. The rise in crude oil prices is not good for the global economy. Price rise in crude oil virtually impacts industries and businesses across the board. Higher crude oil prices mean higher energy prices, which can cause a ripple effect on virtually all business aspects that are dependent on energy (directly or indirectly).

There are many factors that influence the global crude oil prices including technology to increase production, storage of crude oil by richer nations (one major indicator that is tracked closely is the US crude oil inventory data), changes in tax policy, political issues etc. In the recent past, we have seen many factors influencing the prices of global crude oil.

These are some of the important factors that influence crude oil prices globally:


A large part of the world's crude oil share is produced by OPEC (Organization of Petroleum Exporting Countries) nations. Any decisions made by OPEC countries to raise the prices or reduce production, immediately impacts the prices of crude oil in the global commodity markets.

Natural causes

In the recent past, we have seen many events driving volatility in the crude oil prices. Events like a hurricane hitting the oil producing areas in the US have driven the crude oil prices in global markets.


Oil producers and consumers build a storage capacity to store crude oil for immediate future needs. They also build some inventories to speculate on the price expectations and sale/arbitrage opportunities in case of any unexpected changes in supply and demand equations. Any change in these inventory levels triggers volatility in crude oil's prices which in turn creates ripples in the stock markets.


The demand of crude oil is rising sharply due to high growth and demand from the emerging economies. On the supply side, the major sources of supplies are still the same as they were in the last decade. This is another factor that is influencing the prices of crude oil upwards.

Crude oil inventories have demonstrated a highly cyclical pattern in the recent past. Usually, crude oil inventories increase in the summer months and decrease in the winter months. This is because cold temperatures in the winter increase the use of energy for heating in many cold countries. The demand for fuel goes above supply and results in a need to tap inventories.

Likewise, during warm summer months, supply generally exceeds demand and petroleum inventories build up. Hence, the crude oil prices drop. Crude inventory levels provide a good signal of the price direction.

India imports more than 80 percent of crude requirements from oil producing countries and therefore fluctuations in oil prices are being tracked more closely in the domestic markets. Prices of essential commodities like crude are also one of the prime drivers of inflation in the global economy. As we get more globalize, domestic firms and investors need to understand the world economy and financial markets well, in order to respond to the new realities of India as an open economy better.

Monday, October 20, 2008

How best to tackle Inflation - Part II

Prices on fire

Why inflation rose to a record high...

  • Rising oil prices. At an all-time high of $140 per barrel, oil prices have more than doubled from $64 a barrel in April 2007, fuelling inflation.
  • Rising food prices. A global shortage of food grains, such as wheat and rice, has made the food prices index shoot up by about 10 per cent, pushing up inflation.
  • High commodity prices. High prices of commodities such as steel and cement due to their less-than-adequate supply has made industrial production, housing, roads, airports and other crucial infrastructure more expensive.
  • High cost of funds. To combat inflation, the central bank is sucking out excess money from the economy by increasing cash-reserve ratio and increasing repo rates so that less money chases the limited supply of goods and services. This, however, is also driving up the cost of existing funds, that is interest rates, adding to inflation.
  • Rupee's eroding purchasing power. Rising prices are eroding the value of what the rupee can buy vis-a-vis other currencies such as the dollar. The rupee's fall of around 8 per cent in the last six months has made major imports like petroleum and edible oil costlier, fuelling inflation.

...and why it will continue to remain high
  • New era of high oil prices. With little prospect of increase in international oil supplies, production declines in some oil producing countries, increasing oil production costs, taxes on oil exports by producing countries and speculative investments in oil by large international investors, besides continuing high oil demand, oil prices are expected to remain high.
  • No respite from high food prices. While the situation of shortfall in supply is likely to improve in the next 6-8 months, higher input costs in the form of costlier diesel, seeds, fertilisers and the like will neutralise the impact of enhanced food supply.
  • Uninterrupted rise of commodity prices. As most stock markets across the world test lower levels, investments by institutional investors pouring into commodities is expected to keep commodity prices high. Also, with no sign of demand for commodities from high-growth countries like China tapering off, no relief seems to be in sight.
  • High interest rates to continue. As long as high prices remain, with limited fiscal policy options, the Reserve Bank of India will either make attempts to suck out money or ensure status quo. This will mean continuing high interest rates and inflation.
  • continued pressure on the rupee. Various domestic and international macroeconomic factors are expected to keep up the pressure on the rupee, which will make imports more expensive.

How high inflation will affect you

  • Higher Budgets. Get ready to pay more for vegetables, groceries, especially soaps, detergents, packaged food, personal and public transport, as well as for services such as couriers.
  • Costlier loans. You can expect costlier loans, especially car and personal loans. New home loan rates are likely to go up even as the tenure or EMIs of existing home loan rates go up.
  • More expensive recreation. Higher airfares along with lower purchasing power will make international travel more expensive even as domestic leisure becomes costlier.
  • Dent on returns. Fixed income options such as bank fixed deposits and monthly income options will give negative returns after adjusting for inflation, impacting senior citizens, single parents and risk-averse investors such as those with many dependents. Impact on corporate profitability via higher costs will bring down stock prices.
  • Higher taxes. To raise more money to cushion vulnerable parts of the population the government might impose higher taxes, cesses and surcharges on goods and services.
  • Lower infrastructure growth. Upcoming road, airport, power and port projects will witness cost escalations and might see slow downs.
  • Some layoffs and lower pay hikes. Hard hit sectors such as aviation could see some layoffs while most sectors are likely to witness lower pay hikes. This may be especially true in the IT and the BPO sectors.
  • More austere workplace. Expect fewer office parties and conferences, reduction in amenities, office travel and allowances as employers try to cut corners to save costs.

Saturday, October 18, 2008

Crude Oil prices hold key to growth momentum

Some global factors that have a bearing on the domestic economy

The sharp rise in oil prices was the last straw for the market that was trying to cope with lower GDP growth, higher inflation and flight of foreign institutional investor (FII) funds. Indeed one can wonder whether the economic scenario can get any gloomier than what it is today.

Oil prices remain high

It all started with the oil prices shooting up. They touched all-time highs of $145 per barrel. Crude oil prices had corrected to $100per barrel only to go back to higher levels.

There are several theories attributed to this recent increase in the crude oil prices. Some say that cost of production has increased while others say that more speculative money is invested in crude for quick speculative returns. Usually, investors buy commodities such as oil as a hedge against inflation when the dollar falls. A weak dollar makes oil less expensive to investors dealing in other currencies. Hence, analysts are of the opinion that the dollar's protracted decline is the primary reason oil prices have doubled over the past year.

Countries heading for financial crisis

Meanwhile, high crude prices continued to threaten the macroeconomic balance of many countries. It could cause structural damage to their economies. The current account deficit of many countries is ballooning and is a matter of great concern. Countries that have sufficient foreign exchange reserves may survive while others may end up with a financial crisis. According to reports, a $10 increase in the crude oil prices may reduce India's GDP growth by about 0.3 percent and increase inflation by 1.2 percent. Hence, prolonged periods of high crude prices will be very detrimental even for India with its sufficiently large foreign exchange reserves.

But crude sustaining at these high levels for a long period of time is untenable. As the price of crude increases it will lead to a sharp decline in demand and thereafter price. Some analysts believe that the Organisation of Petroleum Exporting Countries might increase oil production, easing the supply pressure, and thus help drive down oil prices. However, the moot point here is, when will the price of oil come down. Whether the crude oil price will decline after damaging many of the global economies or will it decline a little early before irreversible damage is done in the form of contraction in growth.

Repo rate hike

The Reserve Bank of India (RBI) was hoping to control inflation by tinkering with the cash reserve ratio (CRR), but crude prices sustaining at higher levels forced the RBI's decision. Oil companies are importing oil at USD 135 per barrel and recovering it post price hike at around USD 70-75 per barrel. This difference, which is now over $10 billion a month, is funded by fiscal deficit. As dollars are required for purchase of crude, the RBI will have to dip into foreign exchange reserves to supply dollars and has to release some money out of the Market Stabilisation Scheme (MSS) to compensate the use of foreign exchange reserves. This could even cause interest rates to go up in India. Ideally, each country would like to have positive real interest rates. If inflation is between nine and 10 percent, you have to move towards a higher interest rate regime to maintain the real rates. So, the 0.25 percent repo rate hike could be a small step to further increase the interest rates.

Sacrificing growth to control inflation

An attempt to move to a higher interest rate regime in a calibrated manner could slacken growth. The RBI's focus has shifted to controlling inflation as inflation continues to remain high. Currently, the economy can absorb this 0.5 to one percent growth in interest rates, if we can still grow at 7.5 to eight percent. India's ability to grow in a high interest rate environment will be tested now. As of now there is no visible evidence of a slowdown in the growth momentum.

Investors have to wait and watch how things will pan out in the future. A cooling down of oil prices is crucial, as an increase in interest rates and its subsequent pressure on growth will all depend on it. Everything boils down to one single factor and that's the oil prices.

Friday, October 17, 2008

How best to tackle Inflation - Part I

The inflation fire is now an inferno. It singed wallets on its way from 4.7 per cent in July 2007 to 8.86 per cent in May 2008. It did not stop there, but shot up to a 13-year high of 12.64 per cent for the week ended July. Much of this recent rise is being attributed to the pervasive impact of the increase in the state-administered prices of oil products on 5 June. That looked inevitable after international oil prices rose to an all-time high, up to $140 a barrel last month. Worse, this inflation is not expected to go south anytime soon.

Why high inflation is here to stay - Oil aftershock. With little chance of increasing global supplies, higher extraction costs, production cuts and export taxes in some oil producing countries, and speculative investments in oil by large international investors has buttressed price pressures due to continuing high demand for oil.

Rising food prices - A worldwide shortage is driving up food prices. In India, oil seed prices are 20 per cent higher than a year ago. While food supplies are expected to increase over 6-8 months, higher costs of inputs (diesel, fertilisers, and seeds, among others) would likely continue to keep prices high

High commodity prices - High prices of commodities such as iron and steel and edibles have been responsible for about a fifth of the spike in price rise. With stock markets worldwide falling, large international institutional investors are buying commodities, further pushing up their prices and inflation, a trend unlikely to change soon.

Expensive funds - On 24 June, the Reserve Bank of India hiked the cash-reserve ratio and the repo rate (rate at which it lends to banks) by 50 basis points each to reduce liquidity and weaken inflationary pressures. This has raised banks' cost of funds and, thus, making cost of production higher. With limited policy options, it could do so again.

Weaker rupee - With a rapid price rise you need more rupees for the same amount of imports, making imported products or those with high import content such as edible oils, costlier. Expect more of the same.

Money shock
The immediate impact of high inflation will be pressure on household budgets, and lower savings, both for now and the future. Higher interest rates are pushing up EMIs. Inflation-adjusted returns from fixed income options, be it fixed deposits or pensions, have gone negative.

Five-year term deposits paying 8.5 per cent when inflation is 11.5 per cent are giving real returns of -2.69 per cent. So, the value of what you get back is lower than what you put in. The future's not rosy either. Higher costs due to high inflation is likely to dent corporate profitability, putting downward pressure on stock prices.

Some sectors, such as aviation, could see layoffs, while fewer people will be hired by IT, BPO, and banking and financial services companies. A recent services employment report for April-June 2008 by staffing company TeamLease said ITeS lost the most (-24 points) on its index of increasing employment.

Your action plan
As always, to tackle the situation, you will have to keep existing outflows down, skip new large expenses, bump up your savings, and invest in higher return options at, perhaps, marginally higher risk.

Enhance emergency funds, life and health covers. The 3-6 months' worth of expenses that you keep aside in liquid assets such as fixed deposits for emergencies will need to be increased. Life and health covers may need to be augmented. Bridge the gap with low-cost term plans and family floaters.

Avoid large savings account balances. Drain your bank account into short-term debt funds such as fixed maturity plans. At 9-10 per cent returns, the real rate of return for FMPs may be negative in the short term. But, we expect inflation to lower by the last quarter of 2008 after which returns will turn positive.

Prepay your home loan. As home finance rates are set to climb higher, prepay your floating rate loans. No investment option will currently give assured returns to match the higher interest outgo.

Opt for capital gains and dividend instead of interest. Interest income is taxed at your income tax rate while capital gains taxes are lower or zero. Also, short-term capital gains are taxed at higher rates than long-term gains, which can even be zero. Dividends in your hands, whether from stocks, equity or debt mutual funds, is tax free.

Continue with equity investments. The only way to beat inflation is to keep investing in equity. Carry on with your existing systematic investment plans in equity funds. For fresh investments, seek larger cap funds from OLM 50 - they are likely to rebound first, along with the blue-chips they primarily invest in.
If you want to pick up stocks, invest in stages and go for value buys. History is on your side. If you had invested in the Sensex after the markets recovered from the tech bust in 2004, you would be sitting on gains of about 150 per cent even now. Avoid interest rate-sensitive stocks such as real estate and auto. Go for large-cap pharma and FMCG stocks, which are more stable.

Diversify in international funds and gold. Over the last six months, while the Indian market was falling by over 30 per cent, international funds fell by a little over 13 per cent. As before, we will yet again recommend that you invest 5-10 per cent of your portfolio in gold exchange-traded funds and gold mutual funds as periods of high inflation witness a surge in gold prices.

This will shore up the minimum long-term growth of your overall investments.
High inflation has terrible repercussions on the future of our money. Luckily, we have enough weapons in our arsenal to fight and win the war against it. Time's come to pull out all stops.

Wednesday, October 15, 2008

Why food prices are rising across the globe

Rough weather

Among the cyclical factors that have been at work are random adverse weather conditions that have reduced harvests in key producing countries. World wheat production declined in 2006 because of a 60% reduction of output in drought-hit Australia. Flooding in parts of South Asia and pest infestation and cold weather in Vietnam reduced harvests as well in 2007, particularly for rice.

Depreciating rupee

Depreciation of the US dollar against currencies of major Asian rice exporters had the effect of raising dollar prices. The steep decline of the US dollar against all major currencies in the past one year and its declining to record lows have contributed to increase in the prices of ‘soft’ commodities including wheat, whose prices are denominated in US dollars.

Hoarding of food grain

Precautionary demand for food stocks in many countries is contributing to food grain price increases. Public food grain agencies and private traders in many countries are replenishing their depleted stocks in the wake of the surge in international prices of rice and wheat. There have been many instances of raids on private traders who are accused of hoarding food grains to push up prices and create opportunities for making windfall profits in the domestic markets. Such options to contain price hikes are difficult to implement and have increased prices in the domestic market of many countries including that of Bangladesh and the Philippines.

Policy responses

Sustained policy responses (export bans, price floors etc.) of key rice-exporting countries including China, Pakistan, Vietnam, and India have increased price volatility and uncertainty in the international rice market. Export bans and price controls imposed by some countries have reduced supplies in the world rice markets and increased uncertainty about future rice supplies, contributing significantly to the surge in rice price especially since the end of 2007. Although Kazakhstan, Ukraine, and Uzbekistan also imposed bans on wheat exports, the latter two have withdrawn the bans recently. Nonetheless, this contributed to wheat price volatility. Lack of efficient logistics systems and infrastructure for food grain marketing and distribution in several countries tightened the market further as experienced by Afghanistan, Bangladesh, Nepal, Philippines, and Tajikistan.

Rising energy cost

Rising energy prices and energy intensity of the agricultural sector have increased the cost of critical inputs like fertilizer, fuel, and power. World energy prices have increased rapidly in recent years, with per barrel oil prices rising by an average of about $10 per year between 2002 and 2007 in nominal terms and by slightly less in real terms (ADO 2008). Both irrigation and fertilizers are critical inputs to the production of high-yielding varieties of food grains, and these are energy intensive.

Attention bio fuel

The diversion of cereal use from food to produce alternative fuel (bio fuel) is increasing as oil prices become higher. Bio fuel demand has contributed to the food crisis in several ways. Since 2000, cereal use for food and feed increased by 4% and 7%, respectively, while cereal demand for industrial purposes like bio fuels jumped by more than 25% (FAO 2007). Annually 100 million tons of food grains (corn) are being converted into bio fuel. In the US, ethanol subsidies have increased the use of corn for bio fuel production from 6% of total crop production to 23% in the past 3 years.

Diversion of land

Land is also being diverted to urban/industrial uses and competition for scarce freshwater resources between agriculture and industry and residential uses also has adversely impacted the supply growth that is structural as societies undergo urbanization and industrialization. An ADB study 31 shows that the water available for agriculture has already declined sharply over the past several decades, particularly in Asia. Water scarcity will be increasingly challenging for China and India, where irrigation water consumption as a share of total consumption is projected to decrease by 5-10% by 2050 compared with 2000.

Weak policies

Policy inadequacies and weak institutions undermine incentives for agricultural production. Policy interventions such as food grain support prices, input subsidies, involvement of public agencies in food grain imports, marketing, and distribution tend be ineffective over the medium term and inhibit supply increases. Food subsidies currently amount to $1 billion in Bangladesh and $16 billion in India. Such subsidies have also contributed to wasteful use of water resources, degradation of land, and imbalances in fertilizer use. Indian states of Punjab, Haryana, and Western Uttar Pradesh, the main success “stories” of the Green Revolution era in India, are now suffering from severe soil degradation, groundwater depletion and contamination, and declining yields.

Monday, October 13, 2008

FDs v/s Debt Funds

Fixed deposits (FDs) are a safer investment option when compared to debt funds. Debt funds are sensitive to interest rate fluctuations unlike an FD which offers a fixed interest rate for a fixed tenure.

But the most important difference between these two is the tax treatment on gains.

The interest earned on a fixed deposit is to be added on to your income irrespective of the term of the FD. Further, there is no distinction between short or long term capital gains tax in FDs. This overall reduces the yield of a fixed deposit, especially if you fall in the 30 per cent tax bracket.

What makes debt funds a better choice is the tax treatment on its gains. Just like FDs, if you redeem a debt fund within one year then you need to add the gains to your income (Short term capital gains). In case you redeem the investment after one year (long term capital gains) you can avail the indexation benefit.

Friday, October 10, 2008

Beat volatility by diversifying the investments

Staying invested may not be the best option if you have chosen wrong funds or poor script

If you were to take a look at the performance report of the mutual fund industry, you won't find too many impressive performers in the last couple of quarters. While the stock market in general has lost over 30-35 percent in the last two quarters, the scenario is even more ghastly in the case of mutual funds. Many aggressive funds have lost as much as 40 percent and most new funds are sitting on a loss of nearly 50 percent. The current scenario is bound to make the investor worry.

For those who made an entry into equity a few years, ago, the current scene is bound to be more painful as they are faced with negative returns for the first time. The uninterrupted Bull Run from 2004-08 had made many forget the realities of risk associated with equity. In fact, many dabbled in mutual funds too like stocks. Some even thought that with mutual funds, there was no risk as the fund manager was expected to manage returns.

If investors equated mutual funds with stocks, you can't blame them because some of the fund managers too functioned like individual investors. In many cases, fund managers chose to bet on stocks which had price earning ratios of 60-80 and property ownership was the key driver for stock-picking rather than core business. Needless to say, some of these aggressive funds have begun to settle at the bottom of the table. The current market scenario is an eye opener for investors. To start with, mutual funds need to be looked at from a long-term perspective and investors need to go for a careful combination of different themes and sectors. For instance, while sector funds can be out performers in a bull market, they carry their own baggage of risks. As a result, you need to go in for the right mix while choosing funds. Even if you opt for sector funds, the exit has to be an integral part of the strategy, as these funds suffer from cyclical underperformance. Ideally, you need to look for a contrarians view with respect to sector funds as this strategy can pay handsome gains.

Besides having the right mix of themes, investors also need to focus on the past performance and the ability of funds to cut down their losses in a volatile market. Unfortunately, here, not too many funds have a track record of over five years, which means most funds have not been tested in a weak market. While that definitely makes the task of choosing the fund tough for investors, you can combat this factor through your own strategies. For instance, you need to look at the option of lump sum and the SIP route for wealth creation. Investors should acquire the habit of profit booking. While the long-term investment strategy pays, it is also important for investors to keep an eye on their goals and cash flow needs. For instance, an investment made for the specific expenses like education needs a close monitoring and you need to book profits from equity funds and transfer them to capital-protected or debt funds to fund the expenditure, closer to the event. Or else, a spike in the market can change the value of the portfolio and defeat the very purpose of the investment.

One of the options would be to fix a target for the corpus in terms of amount or in terms of returns, and you can use products like systematic withdrawals or systematic transfer funds. These would ensure better management of profits and take care of expenditure funding too.

Wednesday, October 8, 2008

7 ways to stretch your marketing budget

MARKETING isn’t just an expense; it's an investment. The key is to market smarter and fully utilize your marketing budget. Here are 7 ways to stretch your marketing rupees and increase your bottom-line profits:

Use free publicity:

It costs you nothing and builds credibility and awareness. So look for opportunities to be involved with community activities.

Speak at local organizations:

Every organization is looking for speakers for their monthly meetings, so offer to share your knowledge with them. You'll get exposure to groups as an expert and meet lots of new people who might be potential clients.

Write articles:

Contribute to newsletters, newspapers, industry journals and your own Web site. Sharing information builds name recognition, which helps bring in clients.

Create a Web site:

Websites are a must. You're missing a great opportunity if your business doesn't have a presence on the web. It’s a very cost-effective way of letting people know about you and your products and services.

Partner with others:

Look for businesses with complementary services to create cooperative advertising campaigns so that you have a pool of money.


Look at ways that you can get more involved in the organizations you already work with. This helps build your name recognition by being involved on committees.


Networking is the most effective way to meet people. People like to do business with others they know. Networking takes little money, but it does take a time commitment because you must be consistent in your networking efforts.

Marketing is an important part of any business operation. The challenge is finding cost-effective ways to get your name out without going over your allotted budget. Strategic planning is important so that you have a purpose with each marketing dollar you spend. Some people will just randomly select marketing activities, which is a huge waste of dollars. Creating a marketing plan that incorporates the above seven tips will help you have a focus and a variety of venues to reach existing and potential clients and keep your financial picture on track.

Monday, October 6, 2008


Looking for ways and means to insulate your investment from rising prices? Here are some strategies to stay tight and right

CHECKED your transport, grocery and utilities bills recently? You’d sure be losing sleep over ever-increasing prices. What’s worse, inflation figures look alarming and have already notched new peaks, fuelled by the recent hike in crude oil prices. The spiralling affect of inflation can not only derail your investment approach but also dwindle your returns. Here’s an investment guide on how you can insulate your portfolio against the menace of inflation.


In the current scenario of rising prices, analysts feel there is a need to review your financial plans and investment portfolio as the expenses and corpus required to achieve financial goals may increase. You need to shuffle your portfolio in such a manner that it can generate better inflation-adjusted returns. Also, you should avoid investments in illiquid assets with fixed returns as these restrict the chances of generating higher returns it’s advisable if you can try to exit from such investments and re-deploy the amount in asset classes that generate better inflation-adjusted returns.

It is, however, important that before re-adjusting your portfolio, you should keep certain factors in mind such as the cost involved for re-adjustment, risk appetite, and current and future financial needs. There are no magic bullets in investing and re-adjusting. It won’t make you rich overnight but what it will do is to significantly reduce your risk without affecting your returns. He advises that you should not re-adjust your investment portfolio in a hurry or just because of certain external reasons which are not in your control. Otherwise, you may end up losing in a big way, he cautions.


If you feel your current investments are not generating the expected returns, you can start looking for avenues where the risk and returns are different from your existing investments. The investments, however, should not have correlation with the risk factor. Art would be a good bet, you can also invest in private equity and international funds but these are also not risk free. They come with their own share of risks. Some capital protected funds also can be looked at.

Financial Planners hold the view that investing in the right scripts is still the best hedge against inflation. Though they are vulnerable in the short run if the economy weakens, in the long run, they will yield a good inflation-adjusted returns, you can raise investment in gold. Historically, gold has proved to be the perfect hedge against inflation. So if you’re looking to leverage on gold, investing in gold mining and producing companies may also enhance returns. You may further consider other investment options such as commodity funds, arbitrage funds and capital protection bonds with partial equity exposure while re-constructing your portfolio.


Financial Planners believe that while attempting to beat inflation, you should build a sound portfolio of equity, debt and other investment instruments, tailored to suit your financial goals and risk appetite. For this purpose, you can compute the inflation-hedge ratio, which gives a rough indication of how well is your financial position, including how well your portfolio is protected against inflation. For instance, 1.5 inflation-hedge ratio would mean that current portfolio return is 1.5 times of current inflation. This ratio should be improved to keep your portfolio returns much higher than the inflation rate. Accordingly, you can change your investment approach and invest in higher return asset classes, such as equity, for long term and enhance the returns.

Diversification of investment is another important factor that can act as a hedge against inflation. The whole idea is not to put all your eggs in one basket. In other words, if you invest in a wide range of assets such as stocks, gold, real estate, mutual funds, bank fixed deposits and government bonds, where prices behave differently, the overall risk of your portfolio will be lowered.


In the current scenario, when commodity prices are skyrocketing, you should look to increasing inflation-adjusted returns of your portfolio. This, however, shouldn’t be the only reason for changing your asset allocation. It is ideal to ride through the volatility and not panic. But if you want to review your portfolio, it should be aligned with your goals, in a high inflation scenario, asset classes such as equities, commodities, real estate and gold should be preferred over fixed income instruments as they usually generate returns higher than inflation over a period of time.

Times are tough. But if you follow these simple steps, you may well insulate your returns from the rise in inflation.



  • Arbitrage funds

  • Capital protection bonds

  • Gold funds

  • Shares Commodity funds

Friday, October 3, 2008

All about Interest rate hike and its effect

An increase in the repo rate has put small businesses on the back foot yet again. How will they cope this time?

IT is well known that small and medium enterprises (SMEs) are among the worst affected, when interest rates rise rapidly. Accordingly, these companies have been starved of funds of late, with the surge in interest rates in the last few months threatening to cripple their growth.

In such a scenario, further rise in interest rates was the last thing these companies were expecting. But, contrary to such hopes, the Reserve Bank of India (RBI) early in June hiked the repo rate—the rate at which banks borrow from the central bank for short-term—as part of its attempts to contain inflation.

The hike at 25 basis points raised the repo rate to 8% has resulted in the banks’ lending getting costlier. This has left SMEs fuming as it comes at a time when they are coping with rising raw material costs and an uncertain business outlook.
Domestic apparel supplier Bang Overseas is among those affected. For some time now, suppliers like us have been on the receiving end as retailers had been bargaining hard for prices. Somehow, we were managing the demand side but now the repo rate hike has left us with no choice but to borrow at higher rate. This increases our input costs, while the price we get for our products keeps getting lower if we want to remain in competition.

Going by the existing rate of inflation, which touched a 13-year high of 11.87%, it appears SMEs will would have to endure more pain as the central bank is unlikely to halt its monetary tightening measures soon. Economists expect few more hikes in the repo rate and the cash reserve ratio (CRR)—the minimum cash banks need to hold with the RBI—in its attempts to check inflation.

“We think there has to be significant further tightening to arrest inflationary expectations, second-round effects and demand pressures. We now expect the RBI to hike another 100 basis points (BP) through a combination of raising the repo rate (50 bp) and the cash reserve ratio (50 bp) over the next three months,” says a recent client note by Goldman Sachs economists.

This hike in the repo rate is signal from the RBI to banks that deposit and lending rates are headed higher. When the central bank hikes the CRR, it aims to mop up money available with commercial banks, thereby leaving behind little money for them to lend. In the last many months, the central bank has used CRR as a measure to fight inflation. A host of monetary tightening measures by the RBI in the last couple of years has resulted in banks’ lending rates rise by 5-7%.

The jump in lending rates has hurt SMEs more than their larger counterparts who have been able to bargain better with banks on borrowing rates. Also, with various other fundraising options such as overseas borrowing and quasi-debt instruments at their disposal, larger companies have never really been short of cash. SMEs have been unable to tap these sources due to their smaller balance sheet size and lack of adequate credit ratings.

The recent stock-market crash has dealt an additional blow to these SMEs with their promoters unwilling to sell their stake to private equity firms or other institutional investors, at lower valuations.

The hike in repo rate has definitely affected our winery business because it requires us to depend on banks for loans. Since loans are more expensive, we have to look at alternate ways to pump money into our business, though we hope this situation does not continue for long, and does not become worse here onwards

In India, most SMEs are heavily dependent on banks for their credit requirements unlike, say, in the UK where SMEs have been able to raise funds through the Alternative Investment Market (AIM). While there are plans for a dedicated stock exchange for small and medium enterprises (SMEs) to tap the capital market, analysts are unsure about the success of such a venture as proposals indicate that access could be restricted to a limited investor base.

Lack of funding options for SMEs may prove to be detrimental to the growth of the economy since they contribute roughly 40% to the country’s total domestic production, and close to 50% of India’s total exports. Analysts point out that though all emerging companies have been affected by the recent hike, the worst hit are the ones in the real estate sector. Mid-sized firms, excluding real-estate and construction entities, have been raising funds at 11-12% from local market, while the smaller ones get finance at roughly 14% against 7-10% earlier. Real estate and construction companies are said to be borrowing at 17-18% or more. There is lot of liquidity crunch for players in real estate space due to the repo rate hike. Though a player in this space can pump funds in his business through various means, borrowing from banks is the most important.

Bankers say higher interest rates are deterring the expansion plans of several emerging companies. Most of them are not only going slow on expanding their existing capacity, but also deferring their M&A plans due to lack of funds. Earlier, entrepreneurs were thinking of diversifying investing abroad and even in India and but now they are more cautious. Moreover, banks have also turned cautious about lending to them fearing defaults in a deteriorating business environment. We have to be cautious while extending loans in this situation and so it’s obvious that some emerging companies may not be very happy with the banks. A senior executive at Polyplastics, a Haryana-based auto component company, says, Getting a loan for our business has become immensely difficult post the repo rate and this has definitely affected our business in many ways.

But, not everyone is glum about the situation. If you see the rise has just been nominal at 25 basis points and moreover the fixed deposit rate has been increased too, so that is an additional income for the people borrowing from us. Yes, the repo rate could affect SMEs marginally but one must also consider that earlier lending rate of 7% was unrealistic and now the present rate is more realistic. Presently, we lend to emerging businesses anything between 14 to 16 percent but that has not resulted in less number of companies lining up for credit.


Recently the RBI hiked the repo rate (the rate at which it lends to banks) to 8% This could affect SMEs who depend heavily on bank borrowings unlike their large counterparts The lack of alternatives such as quasi-debt instruments and overseas borrowings put SMEs at a disadvantage

Wednesday, October 1, 2008

Crude oil relation with gold prices

CRUDE oil prices in recent times threatened to breach the $150 per barrel mark, and later fell to $123 levels, clocking an appreciation of almost 30% in the year. In fact, higher oil prices have been sending shivers down the stock markets worldwide, as if the recent global financial crisis was not enough to unnerve them.

Back home, Indian stocks are down by around 30% in the current year. Inflation has already reached double digits at 11.98% and is showing no signs of respite, adding fuel to the fire.

I would start with an interesting conversation I heard recently. I happened to be at an oil trader’s dealing room. I asked the chief dealer, “What’s happening to oil? It is down 20% from its peak. Will you buy now?” He answered: “Oil’s down due to speculative unwinding of long positions and a growth scare in developed countries, which might result in lower demand for the scarce commodity.”

He then called someone in Iran, a member of OPEC, an association which controls around 40% of the global oil output. I heard him saying, “So the skirmishes between Israel and Iran continue? And the usual problems in Iraq, Nigeria, etc, also continue with supplies remaining vulnerable to serious disruptions. US stockpiles are down, no new oil discoveries.” He hung up the line. I was sure that his next reaction would be to buy more crude oil, since according to him, supply remained vulnerable.

Surprisingly, his next call was to someone in South Africa: “How’s the mining industry doing? Any increase in the output in gold? Will the gold mines continue to face power disruptions from Eskom?” The response from the other side was “no” for the first question and “maybe” for the second one. He said: “Ok, buy gold worth $5 million.” I was shocked, and was compelled to ask: “Hey, after your last phone call, I was convinced that you would immediately place orders to buy more crude oil. Where does gold come into the picture? He was grinning from ear to ear and proceeded to show me a chart.

He asked me: “What do higher crude oil prices do to the general price levels in the world?” I said: “Of course, higher crude oil prices fuel inflation, since most of the demand for oil is inelastic.” He further probed: “Is gold a kind of proxy currency?” I said: “Yes. In fact, in the 1900s, many countries in the world had gold standards — gold was used as a medium of exchange.”

Let’s presume that gold was the currency now. How much gold would be required to buy a barrel of crude oil? Or how many barrels of crude oil will be required to buy an ounce of gold? The answer is around 7.3 barrels of crude oil would fetch one ounce of gold. This ratio is known as the ‘gold-oil ratio’.

He continued his questions: “Paper currencies like US dollar tend to lose their purchasing power over the years, why?” I replied: “Simple — due to inflation.” As time passes, paper currencies can’t buy the same amount of oil which you could have bought years ago. And the final words of wisdom came from him: “But gold is different. It preserves value — better known as a store of value — and that’s the reason why gold is used to hedge inflation.”

He said: “Look at the very long term chart, the average number of barrels required to buy one ounce of gold is around 14.5, which is now at 7.3.” I nodded in affirmation and said: “That’s because crude oil has moved up sharply from $38 in 1980s to $123 (high of $144), whereas gold has not moved in tandem. It is still trading near $910 per ounce, a little more than the 1980s high of $850 per ounce.” He jumped up and said: “Bingo, now for the gold-oil ratio to reach its long-term average of 14.50, at current prices, either the crude oil price has to move down to $63 or the gold price has to move up to $1,700.”

As I was leaving his office enlightened, I thought with the current uncertain geo-political situation in oil-rich countries such as Iran, Iraq and Nigeria, and with no new discoveries, crude oil seems unlikely to move down to say $63 levels for the gold-oil ratio to reach its long-term average of 14.50. In that case where would gold go?

With the US on the brink of a recession, financial crisis still not over, inflation not abating on higher food and commodity prices and the US dollar depreciating, all the positive factors for a gold price rise are in place.

The most appropriate way to buy gold is to buy a gold exchange traded fund (ETF) on the NSE. It is as easy as buying any other stock. The units are held in demat form in your account, thus eliminating the need to hold gold in the physical form

Acquiring gold via ETFs ensures no hassles of storage, security, quality, insurance, transportation, making charges and others. The fund house stores all the gold backing — each unit in secured vaults — and also has it completely insured. The price of gold ETFs reflect the domestic gold prices, less expenses. There is also a Gold Exchange Traded Fund which charges very low expenses. Moreover, easy liquidity and price transparency is ensured as they are listed on the NSE.

Later in the evening, I reflected on how much the relationship between crude, inflation and gold is important for investment decisions. And, how easy and convenient it is to buy gold and hold it without any worries — especially in times like these, with high crude oil prices, high inflation and falling equity markets.

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