PORTFOLIOTALK

Impact of Credit Policy on the Indian

Capital Markets
In the mid-term review of Monetary and Credit policy, RBI has proposed several issues of significance
for the capital markets. Normally a policy of this nature tends to influence all segments of the market. Let us see
how the policy is likely to impact the market from the eyes of a risk manager, a treasurer, a fund manager and
an academician.
The participants in the Portfolio Talk are: Chandru Badrinarayan, Head, Business Development, CRIS-RISC,
CRISIL; NS Kannan, Treasurer, IClCI Bank Ltd.; Nilesh Shah, Fund Manager, Franklin Templeton Mutual Funds;
and Prof. R Vaidyanathan, Prof. in Finance, Indian Institute of Management, Bangalore.

Reduction in the CRR would

increase the liquidity in the
system, which is placed at a
comfortable level already. Despite
the availability of liquidity, credit
off-take was not seen even before
the rate cut. What according to
you could be the rationale behind
yet another rate cut?
Chandru: The RBI's previously stated
objective is to reduce. the CRR levels to
minimum mandated levels of 3% and
the current policy move seems to be in
tandem with it. Thus, the present CRR
cut seems to be more for structural
reasons than to help revive credit offtake.

NS Kannan: The rate cut shows the

importance given to adhering to the time
table for gradually bringing down the
CRR to 3% level as mentioned in the
Tarapore committee recommendations.
Further, RBI has been providing the
system with ample liquidity and guiding
a soft interest rate policy framework.
CRR cut reiterates the commitment to
this overall policy. CRR cut assumes
great importance in this overall context.
Nilesh Shah: The present liquidity in the
market is courtesy the growth in the
foreign exchange reserves. Foreign
exchange reserves have jumped by
almost $10 bn from the beginning of the
year. RBI has been sterilizing this
liquidity via the auctions of government

@ ICFAI PRESS. All Rights Reserved.

The present CRR cut seems to be

more for structural reasons than
to help revive credit off-take.

C Badrinarayan,
Head, Business Development,
CRIS-RISC, CRISIL.
securities and open market operations.
RBI has promised to maintain
legitimate requirement of credit.
Probably in RBI's calculation of
liquidity they have factored in the need
to match traditional pick up in credit,
which normally happens around Diwali
time. This is probably the rationale for
introducing a CRR cut of a quarter
percent effective November 16, 2002
which will take care of any hitch in
liquidity which may arise due to
temporary off-take of Diwali credit.
Vaidyanathan: The rate cut would help
to some extent only. The sectors, which
are growing at more than 7% in the last
couple of years are, trade [wholesale
and retail], transport [non Railways],
hotels and restaurants and construction
and other business services. All these
activities require significant amount of
funds and they need to be financed
based on anticipated cash flows and not
on asset based

financing. Our banking system has not

put in place risk management systems for
"cash flow" based lending. By and large
they are geared to lend for manufacturing
activities and also based on assets as
collateral.
It is also to be noted that the market
knowledge and information regarding
these activities are not fully available
with the commercial banker on an
updated basis. The typical bank manager
of public sector bank has a two-to-threeyear tenure in a particular branch and is
also shifted across activities like foreign
exchange, administration, agricultural
finance, personal banking, training,
industrial lending etc. By and large, the
public sector banks have been geared to
"asset-based lending" rather than lending
based on the forecast cash flows. This is
all the more true of such activities like
trade, transport, hotels and restaurants,
construction etc., where there are
significant fluctuations in the

PORTFOLIO TALK
cash flows on a daily basis, In other
words, risk assessment capabilities are
not adequate in the context of these
activities. Also, funds need to be
available to these players without much
paperwork and based on personal
assessment. These activities are mostly
financed by the Non-Bank Finance
Sector NBFS,

Investor sentiment plays a key role

in giving direction to the stock
markets.
NS Kannan, Treasurer,
ICICI Bank Ltd.

The cut in the CRR is likely to

increase the liquidity in the system by
almost Rs. 3000 cr. The question
arises, is the equity market going to
benefit from this?
Chandru: No, the equity market would
hardly benefit from this move. There are
mainly two reasons for this. Expecting
interest rates to dip further, the
beneficiaries of this CRR cut viz., banks
find investing in the Debt market more
attractive than doing so in the equity
markets.
Secondly, banks and institutions are yet
to recover from the 2-year old equity
market irregularities and have adopted a
cautious attitude towards funding equity
markets directly or indirectly.
NS Kannan: While lower interest rates
should normally help equity markets,
experience both in India and in
developed countries like US, Japan has
shown that equity markets always do not
gain on account of lower interest riltes
and ample liquidity alone. Investor
sentiment plays a key role in giving
direction to the stock markets.
Nilesh Shah: The Equity market need
not benefit only from the systematic
liquidity. Traditionally though there is a
linkage between the Systematic liquidity
and the Equity Index, however the
decoupling has started happening. Equity
markets will be driven more by the
fundamental valuations and the prospects
of the economy. The systematic liquidity
could be one trigger but it cannot be the
sale driver for the Equity market to move
northwards.

bankers are cautious about lending to /

investing in equity markets after the
recent experiences of some of the
cooperative banks.
The Repo rate, which serves as a
benchmark for the short-term
interest rates have been reduced. How
is it going to affect the state of money
market and investors of Money
Market through Mutual Funds?
Chandru: The RBI's repo rate has
emerged as .a powerful short-term
interest rate signaler in recent times.
Debt markets have eagerly lapped up
the RBI's present and we have seen Gilt
and Corporate bond prices zooming
from pre-policy levels. However,
investors in money market or Liquid
mutual funds would stand to gain far
less than their counterparts in Gilt
mutual fund, mainly as call rates peg
themselves to the RBI's repo rate and
most Liquid funds have substantial
investments in the overnight call
markets.

Nilesh Shah: The cut in the Repo rate

will have an impact on the entire gilt
curve. If we see the Indian Government
securities curve it is very flat in nature.
The difference between one and twenty
year-paper is pretty low at less than 200
bps. World over that difference has been
fairly higher. The short end of the curve
have been artificially boosted by the
Reserve Bank of India by accepting
large amount of liquidity in their daily
repo auctions. By reducing the repo rate
it will have an impact on the entire yield
curve. It will also ensure that the shortterm rates will come down in future, The
lowering of short-term rates will
definitely impact money market mutual
funds in a negative manner. Henceforth
their incremental investments will be
done at rates, which will be lower.
Vaidyanathan: The reduction may not
affect much since this was factored in
already by the MMMF and other market
players.

NS Kannan: The cut in repo rates

The CRR cut is likely to have
would lead to call rates finding a new . been aimed at allowing the
anchor
rate
of
around
5.5%. government to borrow at a
Simultaneously other short-term rates
cheaper rate. But don't you think that
denoted by various instruments like Cp,
the falling yield on the papers is likely
T Bill, CD and swap rates (Mibor and
to do harm to the common investors,
Mifor rates) would tend to be lower.
especially those who invest in debt
While existing investors in MMMF
mutual funds?
would get the benefit of lower rates
Chandru: First of all. if the RBI
through higher NAVs, the new investors
wanted to engineer cheaper government
would get lower returns on their fresh
borrowing it need not have resorted to a
investments.
cut in the CRR in
Vaidyanathan: The Equity market may
not significantly benefit out of this since
December 2002

Portfolio Organizer

PORTFOLIO TALK
current times. It could have always added
the 3000 plus cr through means other
than CRR such as Repo or purchase of
securities
through
Open
Market
Operations.
Second, falling yields will fetch lesser
returns on fresh investments or reinvestment of interest incomes. However,
for those holding government paper or
any other negotiable instrument, the
capital appreciation would adequately
offset this reinvestment risk and provide
an excellent exit. opportunity and return
till date. Investors in debt mutual fund
therefore stand to reap windfall benefits.
NS Kannan: By and large commercial
Banks, Insurance companies and NBFCs
invest in GOI Sec. Lower interest rate in
the system helps them in bringing down
the cost of their liabilities and hence it
may not impact their profitability in the
medium-term, if duration adjusted
investments are made by them. Very
limited investments are made by retail
investors in GOI Sec., directly. Gilt
funds have been showing higher return to
investors over a period of time and hence
investors may not immediately withdraw
the money from them unless big interest
rate shock drives down the NAVs of
these funds. Other debt funds invest in
corporate papers as well and as long as
the interest rate remain soft and steady
the investor should get higher return on
tax-adjusted basis when the investment is
made in growth schemes.

Nilesh Shah: The CRR cut has been

done to maintain adequate liquidity to
meet the legitimate credit requirement.
Clearly the interest rates have fallen over
last couple of years by more than 700
bps. The biggest beneficiary of falling
interest rate regime is the biggest
borrower viz., Government of India.
Investors have benefited as well as lost
in falling, interest rate regime. The
present value of their investment has
appreciated handsomely in view of

Falling interest rates can pop

up

the

equity

market

and

investors can benefit by way of

higher equity valuation.

Nilesh Shah, Fund

Manager, Franklin
Templeton Mutual Funds.
falling rate regime. The Debt funds have
all delivered double digit returns, which
are quiet spectacular. However, their
incremental investment is also done at a
lower rate and if and when the interest
rate starts rising that will have a negative
impact for the investors. However,
falling interest rates are not necessarily
bad for investors. Falling interest rates
can pop up the equity market and
investors can benefit by way of higher
equity. valuation. Investors will have to
look at a portfolio approach to their
investments. They will have to have
exposure to the debt market, as well as
to the equity market. When the interest
rates start falling the equity market will
go up and net investors will still be OK.
When the interest rates start rising the
equity market probably will fall but net
investors will still end up making the
same money. So. for investors the key to
generating returns will be right balance
between the equity and the debt market
rather than complete exposure in debt
market or equity market.
Vaidyanathan: In a sense the position
of elderly is getting affected since the
deposit rates are falling and savings rates
like PPF etc., are affected. Government
may be able to borrow at comfortable
rates but the important point is whether
they are put to 'productive' use. If the
borrowing is used essentially for current
consumption then the borrowings at
reduced rates are not gong to help public
at large.

The credit policy has clearly

mentioned that the "Sensitivity of the

Lending Rates to further changes in
the Bank Rate is now relatively
weak", suffices to say that we are
almost at the hottom
so far as the interest rates are
concerned? In this scenario, do you
think there will be an investors'
preference towards floating rate
notes, assuming the rates can move
only northwards, in days to come?
Chandru: The statement clearly cannot
be interpreted as meaning that interest
rates are poised to rise from here.
Rather, the policy statement
talks
about the weak transmission mechanism
or the weak influence of the RBI's Bank
Rate over the Prime Lending Rate of
Commercial Banks.
Investor preference towards Floating
Rate Deposits is also a function of the
transparency and understanding of the
'Benchmarks' used in Floating Rates.
Ideally, these benchmarks should be by
reputed third party neutral agencies.
Very few investors can be expected to
trust floating Rate Deposits pegged
against a benchmark such as the PLR of
the same bank, which is the case most
often.
In the event of a bank utilizing a third
party benchmark for their floating rate
deposits, investors would prefer the
same when interest rates rise.

NS Kannan: In any case, well informed

investors would do well to invest in
floating rate instruments at.least some
Portfolio Organizer' December 2002

PORTFOLlO TALK
potion of their savings. This would be
integral part of a prudent investment
strategy. Unfortunately, the market risk
management tends to take a back seat in
long periods of continuously declining
interest rates.
Having said that, given the overall
liquidity scenario in the system, but for
strong event risks, investors may still
expect a low interest rate regime.
Nilesh Shah: We do not share the view
that interest rates have bottomed down.
Interest rates needs to be viewed in three
contexts:

.
.

The real interest rates.

Credit worthiness of Government.
Interest rate as a function of liquidity.

If we see the real interest rates in India

they are averaging somewhere around
4% to 4.5% World over the real interest
rates have moved around 0.25% to
2.00%. India is already taxing its
exporters by way of infrastructures
bottlenecks and lower labor productivity.
If we compound the fact further with
higher interest rates the exports will
become uncompetitive. Clearly there is a
need to reduce real interest rates which
effectively" means reduction in the
nominal interest rates.
Now the second point is the ability of the
government to service its debt. The
government has a fixed expenditure
defense salary pensions, subsidy and
interest payments. If you remove those
components out from its revenue income
very little amount is left for servicing the
interest rate. Now either the Indian
Government goes bankrupt like the
Argentinian
Government
or
the
government reduces the interest rate to
such an insignificant level whereby
servicing of loan becomes non-issue. I
think India is moving more towards that
direction where the interest rates will
continue to decline and a stage will come
at a time where the interest rate will be in
lower single digits numbers more
comparable
with
the
developed
economies rather than a developing

Government may be able to

borrow at comfortable rates but
the important point is whether
they are put to 'productive' use.

R Vaidyanathan, Prof. in
Finance, Indian Institute of
Management, Bangalore.
economy. The threat to that equation is
in the form of inflation and as inflation
becomes a non-issue with the
productivity growth and also integration
of global markets RBI can sufficiently
ease monetary policy to ensure low
single-digit interest rates.
The third point is available liquidity. We
expect Indian foreign exchange reserves
to go up foreign exchange reserves are
already at $65 bn plus and are expected
to reach $75 bn. Now with the
incremental liquidity coming into the
system. and not much of credit growth
happening this availability of liquidity
will keep interest rate low. We expect
interest rates to move southwards
courtesy a willing government who is
the biggest beneficiary of falling interest
regime, liquidity which will primarily be
driven by Higher foreign exchange
reserve growth and higher real interest
rate differentia.
Vaidyanathan: There is a perceived
preference for floating rates but the
important point about such a scheme is
the "anchor rate" and in India the
aggregate yield curve is not yet a settled
issue.

business cycles and market cycles.

Interest rate cycles are no stranger to
this. The trick however is to predict the
turnaround in the cycles.
The current dip in interest rates has been
unprecedented in so many ways. Though
there is plenty of conventional logic
pointing to a further dip in interest rates,
intuitively one feels that interest rales are
nearing a turnaround. For an investor
with a 3-5 ~:ear horizon this seems to be
the right time to switch from debt to
equity. However, an investor who is less
averse to risk can continue to ride the
debt market. Plainly put, as time goes by
the risk of being invested in the debt
market continues to rise.
NS Kannan: It is very difficult to
predict the performance of other funds,
as the performance would depend on the
quality, duration and strategy of the
funds and how much of proactive"
trading is being undertaken by these
funds. Equity markets would like to
watch closely the developments before
and after the run up to the budget and the
policy changes affecting the market
sentiments. Divestment activity would
be closely watched. Gilt funds could
perform better if interest rate on GO!
Sec., drop further from here: Other debt
funds' performance would depend on
GOI Sec., rates and credit spreads
dropping further from current low levels.

Last year, on the back of successive

rate cuts, debt mutual funds could
outperform equity mutual funds
across the board. How do you foresee
the performance of such schemes vis-vis the equity schemes in days to
come?
Nilesh Shah: Performance of debt funds
Chandru: Talking in a broader sense, and performance of equity funds are two
historically we have been witness to
separate things. Its like

December 2002

Portfolio Organizer

- -PORTFOLIO TALK
comparing oranges and apples, debt
mutual funds are different and equity
funds are different. Equity funds are
essentially high risk high returns
investment options, Debt funds are
steady products, they are there to provide
safe return with low volatility and clearly
there is no way an investor should
confuse a debt fund vis--vis equity'
fund, As explained earlier the key to
sustainable return is a right balance
between debt and equity. You need to
invest long-term money in equity for
generating higher return, Equity funds is
a good long-term bet. But at the same
time you need to put money in the debt
funds because it will give you
sustainance, it will give you ability to
meet your short and medium- term
requirement. So both the debt and equity
funds have a place in the portfolio of
investors,
Vaidyanathan: The performance of
equity or debt funds is importantly linked
with the performance of the economy
and the industrial sector rather than only
on rate issues. The industrial sector
should perform well and reach more than
5'% for equity to perform well.

Do you expect any innovation

taking place in the fixed income
market, speaking from the point of
change in regulation, investor
awareness or any other initiative to
increase the efficiency of the
services?
Chandru: Debt Index Futures to better
hedge interest rate risk, wider
participation of PSU Banks in the
Interest Rate Swaps market. better
clearing and settlement systems for
retail investors, Real Time Gross
Settlement System. Better Risk
prediction systems. Demystification of
the Fixed Income market by market
forces. Listing and trading of Indian
gilts abroad end vice-versa, are top of
the mind envisaged scenarios.

NS Kannan: Listing and trading of

interest rate futures and options. strips
trading would emerge as major areas in
fixed income market. We may also see
emergence of market makers. We could
also expect higher level of trading in
corporate bonds, down the rating
spectrum. With more and more
awareness of market risk management,

we
could
see
several
participating (and hence
deepening) in the fixed
derivative markets,

players
market
income

Nilesh Shah: Yes, we do expect lot of

changes happening in the Fixed Income
market in India which will bring more
transparency awareness more products
to suit the investors requirement We see
on a broad basis.
We see encouraging developments in;

. Securitization market.
. Interest rate derivative market.
. Strips in gilt market.
. Leveraged mutual funds.
. Dynamic mutual funds.

Vaidyanathan: The fixed income

market could undergo changes in the
next few years given the changes in the
screen-based system and integrating the
private
placement
markets
and
enhancing the corporate paper market. It
has a long way to go but the debt market
would get its due place.
The views expressed here are that of the
participants and not necessarily that of
the organizations they belong.

Fourteen Pages to Fame

The most famous insight in the history of modern finance and investment appeared in a short paper titled, "portfolio
selection". It was published in the March 1952 issues of the Journal of Finance", the only Journal then in existence for
scholars in the field. Its author was an unknown 25-yeer 'old graduate student from the University of Chicago named Harry
Markowitz. No one including Markowitz was aware that his paper would turn out to be a landmark in the history of ideas.
Investors face an especially cruel trade off, and that was what attracted Markowitz. Nobody gets rich squirreling money
away in a saving account. So investors cannot hope to earn high returns unless they are willing to accept the risks involved,
and risk means facing the possibility of losing rather than winning.
But how much risk is necessary?
The answers Markowitz developed to these questions ultimately transformed the practice of investment management
beyond recognition. The title Markowitz gave his paper reveals him as an innovator. The article focused on how to select a
'portfolio', a collection of assets, rather than on how to select individual stocks and bonds. His analysis shows precisely how
investors can combine their hopes of realizing the largest possible gain with exposure to the least possible risk.
,

Although his achievements would earn him a Nobel prize in Economic Science 38 years later, the paper languished for
nearly 10 years after publication, attracting fewer than 20 citations in the academic literature.
Source :' Peter L Bernstein in 'Capital Ideas'. The free press publication. A division of MacMi/an Inc, New York.

Portfolio Organizer' December 2002