The Curious Case of Quiescent Inflation & Negative Yielding Junk Bonds

One of the most important questions being asked in financial media today appears to be, “Is the Phillips Curve Dead?”

Before I go jump into the analysis of whether that is the case and what impact will it have on the future course of monetary & fiscal policy, let me give me a brief explainer about the concept of The Phillips Curve.

A.W. Phillips stated that there was a trade-off between unemployment and inflation in an economy. He implied that as the economy grew, unemployment went down, this lead to tighter labor markets. Tighter labor markets warranted higher wage increases. Companies, in order to maintain their margins, would pass this higher input cost to the consumers which would then be reflected in the CPI (Consumer Price Index- a gauge of inflation) that we refer to.

You could say this was the case before the 1980s, however, since then, the relationship between the two seems to have hit a “rough patch” or flattened out.

Source: Bank for International Settlements (BIS)

The above chart regresses PPI Inflation (%) with the growth in Unit Labour Costs (%). As defined by OECD,

“Unit labor costs (ULC) measure the average cost of labor per unit of output and are calculated as the ratio of total labor costs to real output.

A rise in an economy’s unit labor costs represents an increased reward for labor’s contribution to output. However, a rise in labor costs higher than the rise in labor productivity may be a threat to an economy’s cost competitiveness, if other costs are not adjusted in compensation.”1

Just from the chart, one can infer that the slope of the regression, R2 or the link between PPI inflation and ULC growth has flattened significantly when you compare the data pre and post 1985.

Hence, I would like to devote a major portion of this article on exploring the structural changes in world economies that have led to this compelling phenomenon.

Lower bargaining power emanating from a declining share of income that accrues to labor

  • A June 2018 research paper titled, “Productivity and Pay: Is the link broken”2 suggests, that post-industrialization (or since the 1980s), median compensation grew by only 11% in real terms, and production workers’ compensation increased by a meagre 12%, compared to a 75% increase in labor productivity. Since 2000, average compensation has also begun to diverge from labor productivity.
  • Apart from the weaker link between the above two variables, the continued sluggishness in wage growth can largely be attributed to productivity growth being far weaker than it was before the crisis.3

Globalization & The Threat of Production Relocation

  • The increased integration of production and complex supply chains connecting advanced economies with emerging market economies, outsourcing along with the relatively smooth and easy flow of money and information across borders have forced workers in rich countries to compete with those in poorer ones
  • The IMF World Economic Outlook (2017) attributes about 50% of the fall in labor share in developed economies to technological advancement, with the fall in the price of investment goods and advances in ICT encouraging automation of routine tasks

Declining Path of Unionisation

As unionization declines, the collective bargaining power of employees starts diminishing. For example, in the United States % of employees enrolled in a trade-union membership has steadily declined from 20% to 10% over the past few decades.

This makes it more difficult for the workers to capture a larger share of the productivity gains enjoyed by the firm as a whole.

Hence, we observe that wage growth in real terms has hardly seen a meaningful increase.

The shift from manufacturing to service economies and the era of automation

  • With the heightened contribution of artificial intelligence and automation in the manufacturing process, firms are able to substitute labor with capital and even the high-quality blue-collar jobs are at stake.
  • From an economic efficiency standpoint, it makes sense for a firm to get more work done for the same or lower cost than to waste resources in hiring and training employees. This could partly explain the delinking of productivity and wage growth.
  • With global PMIs crashing into contraction territory across the world economies due to a host of factors such as dollar strength seen in 2018 (80% of global bank trade credit is denominated in dollars), uncertain CapEx or investment environment due to trade wars among others, we have seen consumption stayed relatively resilient.
  • This may be partly attributed to the transition of economies reliance from manufacturing to services, as a result, the share of employment in services has also jumped in recent years.

Quantum Pricing & Long Term Inflation Expectations

  • The traditional theory states that wages are stickier than prices. If so, profit margins should ideally rise if demand increases. However, after studying firm-level behavior we observe that they tend to abstain from margin expansion for the sake of higher market share. Also, firms unable to generate sufficient sales tend not to reduce prices proportionately to avoid losing cash to meet their rising debt and interest burdens (which explains why we saw inflation falling less than expected during the GFC).
  • Firms have since been engaging in “Quantum Pricing” where firms may change the quality or composition of their products to adjust for production cost volatility instead of increasing prices across the board. This, in turn, makes prices stickier while keeping margins stable. It becomes increasingly complex for mainstream macroeconomic models to capture such structural shifts in pricing affecting inflation.4
  • In a nutshell, all the above factors along with weak cyclical pressures drag longer-term inflation expectations lower (as observed by the 5Y5Y forward breakeven inflation, etc). Lower expectations through their negative feedback loop anchor inflation lower to some extent.5

Low Rates, Asset Price Inflation & The Lure of Negative Yields: Glimpse

Markets have set their expectations in stone for rates being “lower for longer” due to the inflation dynamics stated above, secular stagnation going forward and maybe even price level targeting by central banks.

In an environment where markets will pounce on anything with a positive real yield, there may be a real risk of financial instability arising from irrational bidding of risk assets which cannot be more prominently observed than from the negative-yielding junk bonds.

You are essentially paying companies with significant credit risk for (the privilege of) borrowing funds from you!

It may sound absurd but what if I tell you that this negative-yielding Japanese/European debt may in certain cases provide you with a dollar yield that is even higher than the positive yield that you get in treasuries? In other words, (for example) -0.1% (¥) > 2.5% ($)

I shall follow up on the mechanics of how this kind of sorcery is possible (along with the risks associated with the same) in part II of this article.

References:

  1. Retrieved from https://stats.oecd.org/glossary/detail.asp?ID=2809
  2. Stansbury, A. M., & Summers, L. H. (2017). Productivity and Pay: Is the link broken? (No. w24165). National Bureau of Economic Research
  3. IMF World Economic Outlook, April 2019
  4. https://www.bis.org/events/ccaresearchconf2018/rigobon_pres.pdf
  5. IMF Blog “Euro Area Inflation: Why Low For So Long?”
Author
Harsh Shivlani
Team Leader– Fixed Income & Derivatives
(M.Sc. Finance, NMIMS – Mumbai. Batch 2018-20)

Connect with Harsh on LinkedIn
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Impact of MSME on Indian Economy

INTRODUCTION TO MSME

The Micro, Small and Medium Enterprises (MSME) sector has emerged as a highly vibrant and dynamic sector the Indian Economy over the last 5 decades. MSME Sector has been one of the most focused sectors in prospects of Investments and has contributed significantly for our country’s Social Development as well as Economic development. MSME has also promoted women empower and has helped in generating largest employment opportunities at lower capital cost, next only to agriculture. It has helped abundantly by promoting the term ‘Entrepreneurship’. MSME have merged as complementary to large industries as ancillary units and they are widening their domain across all sectors of the Indian Economy as well as producing a range of Products and Services which will help to meet the needs of not only domestic market but International markets also. Government of India has never failed to support MSME in all ways possible and have promoted MSME sectors by starting a number of Schemes and other Incentives for them. The Ministry of MSME runs Various Schemes aimed at financial assistance, Infrastructure development, technology assistance and Upgradation, skill development and training, enhancing competitiveness and market assistance of MSMEs.

GOVERNMENT SUPPORT TO MSME

The ministry of MSME is doing its best to help MSMEs reaching new high and contributing more and more to The Indian Economy. The ministry recently came up with some Policy Initiatives like:

  • Ease of Registration Process of MSMEs- Udyog Aadhaar Memorandum
  • Framework for Revival and Rehabilitation of MSMEs
  • MSME Data Bank
  • MyMSME
  • Direct Benefit Transfer in the M/o MSME
  • GST rollout & Ministry of MSME
  • Digital Payments
  • Grievance Monitoring
  • MSME Samadhaan: To Address Delayed Payments to MSEs
  • MSME- Sambhandh
  • Technology Centre Systems Programme(TCSP)
  • Partnership with Industry
  • International MoUs
  • MoU with NSIC for provision of services for MSMEs
  • Swachhta Pakhwada by Ministry of MSME
  • National Scheduled Caste / Scheduled Tribe Hub

These Policies are being formulated to help MSME reach new heights and contribute more in Economic and Social Development of the Country. The Schemes by Government help MSMEs Financially/in-kind for their betterment. Government of India has Supported and Promoted MSME Sector not only on Domestic Levels but in International Markets also. The contribution made by MSME in development of Economy and Social Life in backward areas has been spectacular.

ROLE OF MSME IN INDIA

The MSMEs have been a great contributor to the expansion of entrepreneurial endeavours through business innovation. Since past 9 Years MSME have contributed around 29% in GDP of India(Source: CSO, Ministry of Statistics & Programme Implementation). The Gross Value added by MSMEs in contribution to Indian Economy as on 2015-16 was INR 1,24,58,642 Crs.

In India 324.88 Lakhs MSMEs are located in Rural Areas whereas 309 Lakhs MSMEs are located in Urban Areas. Shockingly 630.52 Lakhs of these MSMEs falls under Micro Sector whereas 3.31 Lakh MSME falls under Small sector and only 0.05 Lakh falls under Medium Sector(Data as per MSME Annual Report 2017-18). MSMEs have a big impact on Micro Sector helping small entrepreneur’s achieving their dreams.

Not only was these, it also seen that 22.24% of the ownership of these Enterprises in rural areas were of female. In urban areas Female ownership of these enterprises came around 18.42%. MSME have led a movement in supporting Female entrepreneurs and have helped them in achieving their dreams. One more interesting fact is that 50% of MSMEs in India have ownership of OBCs followed by 12.45% of SCs and ST having ownership of 4.10%. In total ~66% of MSMEs in India are owned by Socially Backward Groups.

Estimated number of MSMEs (Activity Wise) is as follows:

Activity Category

Estimated Number of Enterprises (in Lakh)

Share(%)

RURAL

URBAN

TOTAL

Manufacturing

114.14

82.50

196.65

31

Trade

108.71

121.64

230.35

36

Other Services

102.00

104.85

206.85

33

Electricity*

0.03

0.01

0.03

0

ALL

324.88

309.00

638.88

100

*Non-captive electricity generation and transmission and distribution by units not registered with the Central Electricity Authority (CEA)

MSMEs have helped women entrepreneurs, socially backward groups in excelling and have been a major player in generating employment. Truly Micro Sector has been a major contributor in Social and Economic development of our nation.

Following Table shows how MSME helped in Employment Generation:

Activity Category

Employment (in Lakh)

Share(%)

RURAL

URBAN

TOTAL

Manufacturing

186.56

173.86

360.41

32

Trade

160.64

226.54

387.18

35

Other Services

150.53

211.69

362.22

33

Electricity*

0.06

0.02

0.07

0

ALL

497.78

612.10

1109.89

100

*Non-captive electricity generation and transmission

Interestingly, out of the total Estimated Employment Generated around 97% are generated by Micro sector which shows how it has been aiding in development of our nation and shaping a bright future.

MSME Sector has always been supported by Government and Big industries in every ways possible and MSME have returned the favour.

“No dream is too big and no dreamer is too small” these saying have been proved right as the smallest of enterprises have supported millions of peoples dream by providing them with employment.

*The figures were taken from the government MSME Annual Report of 2017-2018

Author
Aditya Majmudar
Volunteer- Equity Research & Valuation
(MSc Finance, NMIMS Mumbai. Batch 2018-20)

Connect with Aditya on LinkedIn

Fintech in India- A Global Growth story

FinTech has emerged as a relatively new industry in India. The year 2018 was a big one for the Indian financial technology and financial services ecosystem. With $2.34 billion being raised across 145 deals, fintech finally unseated ecommerce from the top of the list after years of dominance.

So, what really is FinTech?

In short, it is an industry that comprises of companies(such as insurance, asset management, payments) that use technology to offer financial services. Initially, FinTech started its trial by setting its operating base in the banking industry. But over the last five years, it has seen tremendous development and has expanded to insurance and asset management companies as well. 
By leveraging machine learning, FinTech companies are looking to analyze customer expectations and their responses.

In today’s digital economy, a whole new generation of FinTech’s, including nimble new start-ups with cutting edge technology have boomed alongside behemoths and are now valued more than many traditional banks and financial services firms.
We are witnessing specialization in many of the global fintech centres – London emerging as a hub for investments into open banking solutions, while China has become well known for facial recognition associated with biometric technology and Israel, a centre for cybersecurity.
India, however is yet to find a niche to focus on or a specialization, despite the mass availability of smart-technology talent.
As different hubs emerge around the world and technologies become more mature, specialization will be key to further develop India’s fintechs and continue to lure billions of dollars in investments and talent. Being the jack of all trades in different technologies and solutions, from mobile payments to credit scoring, digital banking and peer-to-peer lending, may have worked at the initial stages of fintech development, but the future will be dominated by specialists. 

To answer the many queries we have about fintech, its utilization and growth in the future, I decided to go ahead and take a personalized approach about this. I prepared some questions I had in mind about FinTech in India, and figured the ideal approach to know more would be to ask people who themselves are part of this industry.

I went ahead and interviewed two people, one who works as an Analyst in ‘Advanced Analytics’ division of MasterCard, and the other who is a Head of Sales and Alliances at Airpay. Both had a lot to say about matters relevant to this field, since a lot of work is being done in India to promote FinTech as a rising industry. Here is what they had to say about it.

Me-

How is the growth of fintech being supported in India?

MC-

India is doing pretty good in terms of fintech and it’s mostly coming from start-ups. Though one of the concerning facts is that most of them are eventually bought by foreign investors so won’t be completely fair to say that India has its in-house fintech innovation or technology. But with Indian government taking great initiatives like launching apps BHIM and UPI interface for P2P payments, it’s a great step towards our contribution to the fintech world.

AP-

  • A large unbanked and untapped market in India has been driving in private players willing to bet on it.
  • The Digital India initiative by the GoI has broadly laid down the framework for going digital and you cannot truly be a digital economy without Fintech.
  • The PMJDY led to financial inclusion of the masses, which has been leveraged by Fintechs to grow.
  • The exponential growth of smartphone adoption, along with some of the lowest mobile data rates have brought the next round of Indians online, which will further fuel digitisation of payments, insurance, etc.
  • The NPCI has been actively involved in churning out cutting edge payment methods like the UPI, which has again spurred adoption of digital means.

Me

There are namely 4 spheres of Fintech: In the systems sphere, in the B2B sphere, in the B2C sphere and B2G sphere. How do you think these are getting impacted, whether interdependently or not?

MC-

I think we are experiencing a major shift in our focus from P2P to B2B or B2C. The P2P space is quite evolved now unlike B2B or B2C space which has great potential. And, when it comes to B2B space, it’s both Corporates and Small Business where we need to focus because one is much more higher in revenue and the latter one is much more in number. There is still a lot of informal lending when it comes to business space and there is a lot of potential to not only improve payments systems in that space from both cost and speed perspective but also, come up with new technology to encourage small business to start using digital ways of money transfer.

B2C is also evolving everyday where every business is trying to value their customer much more than ever and give as personalised recommendations or offers as possible.

AP-

There are definite overlaps in the various spheres and a huge opportunity to create a unified platform. The effort has already begun with the BBPS infrastructure, which brought C2B and C2G payments on a single platform.

Me-

FinTech is reshaping categories and disrupting incumbents across a number of financial services sector categories. These include ‘Savings, Personal Finance, Investment & Wealth Management, Insurance, Block chain & Crypto, Lending & Unsecured Credit, and most significantly, Payments. Could you highlight more on the payments system, considering how big it is, not only in India, but all across the globe?

MC-

Gone are the days when people used to stand in long queues in banks to deposit/withdraw money for their personal use or to transfer it to somebody else. We are also trying to come out of the cheques world which takes 2-3 days for payment processing. This is the age of fast and quick technology, we want everything simple, fast and secure. You press the button while you’re sitting at home and you can transfer money from 1 part of the world to another. This is already embraced by P2P payments world and companies are coming up with efficient and cheap solutions for Small Business and even large corporates. We are yet to capture the full potential of corporate space but fintech is headed in the right path and card acceptance in Small Business and Corporates is a start of it. So yes, payments system has been modified highly not just for ease but also to make it more secure.

AP-

As they say, data is the new oil. Payments are the final layer to any business activity. It is your final signature when doing business with an entity. This payments data generated through digital payments is a rich source for creating patterns and understanding consumer behaviour. We see Fintech as an enabler or a partner for the existing ecosystem, helping them reach out to untapped markets and helping them to create a consumer profile using alternate data points.

Me-

38% of the world’s population lack a basic bank account and an even greater proportion lack the simplest of insurance and investment products. Do you think FinTech, particularly in the form of mobile money, is an essential part of the solution for this or it could face barriers?

MC-

If we just talk about India, out of 1.3B population, we have 800M mobile users. With such high penetration of mobile in India, fintech in the form of mobile money is an essential part of the solution. Apps like Paytm which cater to small business and small local merchants making them reach out to each and every person in India in turn, facilitating P2P, B2C, C2B, B2B payments. Anyway, the future is mobile or maybe something even smaller where 1 device could serve the purpose of everything so it does make sense that we are trying to fit in every payment form in there.

AP-

Absolutely! Digital payments give the customer a footprint that banks and insurance companies can leverage. It is redefining the metrics that a traditional bank or an insurance company would use to evaluate a customer and use the alternate data points to curate the best products. Even for existing consumers, Fintechs are helping the large legacy players get down to the brass tacks of profiling and provide products that stay current and relevant. For example, sachet insurance is a great innovation that does away with larger bulky and one-size-fits-all products and gives the consumers exactly what they want and presents the insurer another opportunity for product uptake

Me-

Is it a boon for cyber security or are we just unaware of how much of our personal data is actually out in the cloud? Fintrusion? A survey said online fraud could reach $25.6 Billion by 2020. Views on this? So, is fintech actually increasing cyber security?

MC-

There is definitely new technology coming up for cyber security and it is surely needed when it is so easy to do an identity fraud or any kind of fraud for that matter because technology will have certain limitations too. Definitely, most of the people are unaware of the quantity/quality of their personal data in the cloud and even, if they are have some idea, they aren’t educated enough on its misuse. And with this whole fintrusion, there is growth of the idea of “privacy” and people are becoming more cautious while sharing their personal data with various websites/apps. But fintech is definitely coming up with increased cyber security. Country like India has 2 step authentication which is a good measure to avoid fraud. Not even that, banks are also coming up with different algorithms to identify fraud and mitigate it in the best possible manner. But there is need for more and at much faster rate especially with new payment methods like Card on File, Contactless, etc. coming in.

AP-

Every innovation comes with its own set of risks. We feel the problem here is that the push is mostly on product adoption, rather than consumer education and then eventually adoption. So rather than being reactive, all the stakeholders must be proactive when it comes to data security and consumer awareness.

That said, there is a whole segment of entrepreneurs and technologists working on data security & fraud prevention, so as the industry matures, we should see this challenge being mitigated.

Me-

50.2% globally saying they do business with at least one non-traditional firm for banking, insurance, payments or investment management, with the percentage reaching the highest in Asia-Pacific (58.5%). How do you think the consumer response has been to fintech since its inception?

MC-

Asia Pacific has a lot of developing countries which is one of the major factors as to why they do business with at least one non-traditional firm. People are still stuck to their old ways and will definitely take time to come up to speed in terms of learning new technology. But overall, fintech has been growing quite fast in these countries and even in better way because fintech isn’t just reaching the consumers or large corporates but also small business or local small merchants which are more prevalent again in developing countries rather than developed countries. China has their own payment system and they are closed to the idea of having the same payment system as the rest of the world but that definitely makes them more secure and India has 2 step authentication which is again unique to it but again, mitigates a lot of fraud already. And because there is a lot of untapped potential and cash is still a king in Asia Pacific, the growth of fintech will be the highest here.

AP-

The consumer response till now has been positive, albeit not uniformly. While banks and traditional institutions invoke trust, the generation coming into the workforce (with disposable income in hands and a key drivers of consumption) values speed and customer experience equally, if not more. That said, there is still an entire section of the population that intrinsically thinks of new-age Fintechs as risky. This trust deficit hampers a digital-only strategy. So as a Fintech, our ideal sweet spot is to partner with the traditional institutions to combine the trust that banks inspire with the speed and customer experience that Fintechs offer.

Author
Purnima Dutt
Volunteer- FinTech
(MSc Finance, NMIMS Mumbai. Batch 2018-20)

Connect with Purnima on LinkedIn

LET JET GO: A SAGA FROM BOOM TO BUST

INTRODUCTION

Naresh Goyal founded Jet Airways in 1993 with a fleet of four leased Boeing 737 aircraft. At a time when private airlines had just started coming up in India, Jet Airways, a full-service airline, grew fast to become India’s largest international carrier.

However, with budget airlines such as SpiceJet and Indigo entering the fray, the aviation industry became highly competitive. Being budgeted airlines, SpiceJet and Indigo started to offer low airfare, forcing Jet to lower its fares too. But it continued to offer full services which lead to increasing operational costs and forcing it to keep borrowing from banks to stay afloat in the market. Macro-economic changes such as a rising fuel costs and weakening rupee also hurted it further.

It has consistently been one of the India’s top three airlines in past decade. Jet Airways was founded by ticketing agent turned entrepreneur Naresh Goyal, after India ended a state monopoly on aviation in the early 1990s. It’s now 24 per cent owned by Abu Dhabi’s Etihad Airways PJSC and controls 13.9 per cent of India’s market, one of the fastest-growing in the world.

As a slide of budget carriers started flooding the market in the mid-2000s, offering no-frills, yet on-time flights, Jet Airways began dropping fares even some to below cost. On top of that, provincial taxes of as much as 30 per cent on jet fuel added to its expenses, while price-conscious Indian travellers refused to pay a premium for on-board meals and entertainment. Unlike budget operators, full-service airlines such as Jet Airways offer most of such amenities for free.

PROBLEM IN FINANCIAL STATEMENTS

In the first quarter of FY18, Jet posted its first quarterly loss of Rs 1,323 crore in 12 quarters. This was compared to a profit of Rs 53.50 crore in the same quarter a year ago. While it said that it has been working on operational efficiency but the loss only widened with each passing quarter. As we can see in the graph below:

STEPS TAKEN TO STAY OPERATIONAL

In August, it asked its employees to take a haircut of up to 25% on their salary as a part of the cost-cutting measure. In September, it stopped offering free meals on economy class bookings. And in October, there were reports that the airline had laid off nearly 30 employees from departments such as engineering, security, sales and senior-level executives from the in-flight services department.

REASONS TO TURN FROM ‘JET SET GO’ TO ‘LET JET GO’

Reason 1: Acquisition of Air Sahara

On January 2006, Jet made its first attempt to acquire Air Sahara. This news was received with mixed emotions amongst the investors in the market and analysts even suggested that Jet had overvalued Sahara. Even after getting a go ahead from the Indian Civil Aviation Ministry, the deal fell apart due to disagreement on the price. Lawsuits were filed by both the companies seeking damages from each other.

Then in April 2007, this time Jet Airways managed to buy Air Sahara for INR 1,450 Crores.

Why Jet wanted to acquire Sahara?

  • Jet airways will get access to leased fleet of 27 aircrafts of Air Sahara with its Infrastructure and Logistics
  • It will give more coverage to the areas where Air Sahara is not yet present
  • Jet will get more airlines pilots and maintenance facilities
  • They will get to capture more market share that will be around 42%

Why this deal was not a success?

  • The merger guidelines didn’t talk about aircraft hangars, check-in counters, cargo warehouses, passenger lounges and other such airport facilities post the acquisition
  • The Jet asked for 20-25% discount on its bid, stating that the merger was over-valued
  • Jet was expecting economies of scale to benefit for them but there was an upcoming merger of Air India and Indian Airlines which could have been a direct competition and a major threat to this merged entity.

Reason 2: Naresh Goyal’s inefficient management control

Experts say that there was a fault in Goyal’s management style. His decision to have a single management team, headed by himself, running all Jet’s operations was a critical mistake. Analysts say he should have had one team running the full-service carrier and other running the budget flyer. Jet lacked a concrete business model and played with it often, which confused investors and its passengers alike.

Several experts recently asked Naresh Goyal to exit as that could have been a way for Jet’s survival, since any investor coming on board wanted to take the control and hence due to immense pressure he had no other option but to step down.

Reason 3: Debt burden

Goyal has also been accused of making bad investments and failing to address the company’s deteriorating financial predicament while borrowing heavily. They spent more than they earned and also kept accruing debts. They have a total of Rs 8500 crores of debt in their books and they are trying to sell off their planes with hopes of fulfilling the debt but failed to do so.

Reason 4: Sale of stake to Etihad Airlines

In year 2013, Jet airways sold 24% of stake to Etihad airways for INR 2000 crores. This was also a year in which Jet faced a debt problem. And hence, it ends up taking competitive advantage of the new policy change allowing Foreign Direct Investment (FDI) in private sector. Even after having a 24% stake then, Etihad Airlines were not having major say in the functioning of the airlines. In March 2019 also when Naresh Goyal reached to Etihad, the maximum fund that they were agreeing to invest was INR 4200 Crores and with several conditions.

Reason 5: Purchase of mixed fleet

The other mistake was the purchase of mixed fleet of 10 wide-bodied Airbus A330 and Boeing 777 planes. Unlike his peers, Goyal decided to have only 308 seats, much lower than the global standard of 400, in order to give his customers a premium offering. He lost a fourth of the potential revenue in the process.

Reason 6: Fluctuating Crude Oil prices

All of India’s carriers are sensitive to fluctuations in global crude oil prices because they are major importers of oil. When the rupee is weak, which it has often been over the past year or so, fuel becomes more expensive, which is the largest expense for airline industry. Increasing oil costs and the Indian rupee hitting its lowest last year affected all Indian carriers. IndiGo and SpiceJet also reported massive losses but their books were resilient enough to survive the quarterly losses. However, Jet’s books were saddled with debts. “Jet Airways failed to manage its balance sheets and was caught out by these cyclical changes in the industry,” Mumbai-based economist Ashutosh Datar told AFP.

THE BEGINNING OF AN END

  • National Stock Exchange (NSE) announced that there will be no trading in Jet Shares w.e.f. 28 June 2019. Hence this lead to the fall in the share by 44%.
  • Jet owed SBI an amount worth of INR 8500 Crores. Jet Airways also owes over INR 10,000 Crores to its vendors as rental for aircraft which it had failed to pay up. At its peak, the airline was flying as many as 120 planes, most of which were on the lease. Jet Airways also owes around INR 3,000 Crores to around 23,000 employees who have not been paid since March 2019.
  • Future of, Jet depends on the new lenders, who are currently interested in buying it. But the problem is, lenders are not doing a great job and secondly they didn’t give them funds to keep pulling its operations. This is one of the reasons for shutting down business.
  • No one is interested in buying Jet’s grounded airplanes as there is no benefit for them in the books of huge debts. The books also consist of a huge expenditure in turnaround plans and salaries.
  • A lot of current slots of Jet has been taken off by other airlines.
  • Hinduja Group and Etihad Airways PJSC are nor proceeding to resurrect. Jet airways met with Ethihad Airways PJSC and Hinduja Group to look into the offer put forwards by them. But the lenders were not ready to accept the terms of the offer and decided to opt for insolvency proceedings instead. Hinduja’s offer would have meant that the lenders would take 95% haircut on their fund based exposure to Jet airways. “As far as bidding for Jet Airways is concerned, the Hinduja Group has taken a back seat now,” said a report. “The promoters of the group feel that it’s too risky for them to get involved (with Jet Airways) at the moment, due to ongoing government investigations and the recent insolvency pleas submitted by operational creditors at the National Company Law Tribunal (NCLT).”
  • In September, the income tax department raided Jet and drafted a report in February 2019. “The investigation report has found tax evasion of over INR 600 Crores. There were some transactions concerning a Dubai-based entity, which were of a suspicious nature,” an income tax official said.

    According to the investigation report, such payments were allegedly in excess of permissible business transactions under the Income Tax Act and is not considered as allowable expenses. “The survey was conducted at the time when Jet Airways was delaying the announcement of its June quarter result,” an income tax official told.”These are excessive payments made with the intent to divert funds abroad, so as to evade taxes.”

NCLT VERDICT

NCLT admits SBI insolvency plea against jet airways. It also asks (Insolvency Resolution Professionals) IRP to take hold of all its assets. IRP must try to close jet airways in 3 months. It asks IRP to first report it on July 5, 2019 and after every 15 days the report is been asked to be submitted. As this matter is of national importance, they gave them 90 days instead of 180 to resolve the issue related to Jet.

There is a hope as someone will come up with a resolution plan and aircraft will take off and employment will be secured again.

Other financial and operational creditors can also file their claims. National Aviator Guild will be filing claims on behalf of pilots before the IRP.

CONCLUSION

Jet Airways is on the verge of Bankruptcy. However, there are still some hopes for it. This case was taken by lender to NCLT and the application was accepted by NCLT then the company will proceed under IBC. Boards of directors have to step down and insolvency professionals will take over the Jet. This might revive the bids for the company as previously keen bidders wanted a change of management. This might give Jet their old good flight.

Author
Apoorva Goenka
Team Leader- Equity Research & Valuation
(MSc Finance, NMIMS Mumbai. Batch 2018-20)

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EFFECTIVE EXCHANGE RATES

EFFECTIVE EXCHANGE RATE (EER)

The EFFECTIVE EXCHANGE RATE (EER) is an Index which describes the strength of a currency relative to a basket of other currencies. This rate measures the value of domestic currency against the weighted value of a basket of foreign currencies. The weights used to derive the rates, reflect the foreign countries’ share in the trade of the domestic country. Thus the EER is used to compare the domestic country’s performance against its most important trading partners. The Effective Exchange Rates are always derived as an Index i.e. out of 100.

The EER is used as an indicator to comprehend the domestic currency’s international competitiveness in terms of a group of foreign exchange rates which cannot be understood by just examining the individual exchange rates of the domestic currency and other foreign currencies.

EER is used in studies in economics as well as policy analysis for international trade. Foreign Exchange Traders who engage in currency arbitrage make use of EERs. It is used to measure the equilibrium value of the domestic country’s currency, to identify the underlying factors of the domestic country’s trade flow and analysing the impact of factors such as competition and technological changes on the country and also the trade weighted index.

NOMINAL EFFECTIVE EXCHANGE RATE (NEER):

The Nominal Effective Exchange Rate (NEER) is calculated as an unadjusted weighted average rate at which the domestic country’s currency exchanges for a multiple foreign currency basket. The NEER is an indicator of domestic country’s international competitiveness in terms of the Foreign Exchange Market.

REAL EFFECTIVE EXCHANGE RATE (REER):

The Real Effective Exchange Rate (REER) is the NEER which is adjusted to relative movements in any national price or cost indicator of the domestic country and the foreign countries. REER relates to the Purchasing Power Parity (PPP) Hypothesis.

While the fluctuation in NEER accounts only for the variation in the nominal exchange rate of the domestic currency against basket of foreign currencies, the REER also accounts for the variations in the inflation differential in relation to the foreign countries.

CALCULATION OF THE EFFECTIVE EXCHANGE RATES BY THE RESERVE BANK OF INDIA (RBI)

The Reserve Bank of India (RBI)    derives the Effective Exchange Rates (EER) in Nominal and Real Terms. These rates are calculated by the institution on a monthly and annual basis. The RBI calculates two Indices – Broad and Narrow.

  1. Narrow Index – The Narrow Index is calculated taking 6 major Trading Partner countries of India into consideration. The countries are USA, UK, China, Japan, Hong Kong, and EURO Area. The EURO Zone comprised of 12 countries in 2004-05 which further increased to inclusion of 19 countries. These 6 currencies together accounted for around 40% of India’s International Bilateral Trade in the year 2004-05. China and Hong Kong together accounted for 9% in 2004-05.

  2. Broad Index – The Broad Index is calculated taking 36 Trading Partners of India into consideration. They are Argentina, Australia, Bangladesh, Brazil, Canada, Taiwan, Egypt, Indonesia, Iran, Israel, Kenya, Korea, Kuwait, Malaysia, Mexico, Vietnam, Nigeria, Pakistan, Philippines, Qatar, Russia, Saudi Arabia, Singapore, South Africa, Sri Lanka, Sweden, Switzerland, Thailand, Turkey, UAE, China, Hong Kong, Euro, Japan, UK, USA. The Euro Zone comprised of 5 countries which further increased to inclusion of 12 countries. These 36 regions accounted for nearly 61% of India’s Foreign Trade and 67% of India’s Exports in the base year i.e. 2004-05.

FORMULA

  • Nominal Effective Exchange Rate (NEER)
  • Real Effective Exchange Rate (REER)

TERMS OF THE FORMULA

e

Exchange rate of Indian rupee against a numeraire

ei

Exchange rate of Foreign Currency ‘i’ against the numeraire

(e/ei)

Exchange rates

Numeraire

IMF’s Special Drawing Rights (SDRs) in indexed form.

P

Price index of India (CPI is used as proxy prices)

Pi 

Price index for trade partner country ‘i’ (CPI is used as proxy prices)

(P/Pi)

Relative prices (Or called as Deflator)

n

Number of countries covered in the Index other than Home country

wi

Normalised, Geometric average of India’s Bilateral Trade (Exports + Imports) of preceding 3 years

CERTAIN MAJOR DEVELOPMENTS WHICH HAVE TAKEN PLACE IN NEER AND REER BY RBI

  • With effect from January 1, 2002, common currency EURO replaced the existing national currencies of the EUROZONE. This is due to the introduction of EURO – Notes and Coins.
  • The European Commission (Eurostat) introduced the Harmonised Consumer Price index (i.e. HICP) which is now used in place of the individual consumer price indices.
  • There was a significant shift in Trade Relations of India across different countries. Thus, a change was also made in the currency basket and trade weights. These changes were mainly because of the developing and emerging economies.
  • During the year 2002, the Base Year for the Wholesale Price Index (WPI) used for the calculations was changed to 1993-94. This brought a change in the Base Year for the 36 Currency Basket Index.
  • With effect from November 2005, the 6 Currency Index replaced the 5 Currency Index.
  • With the launch of the new Consumer Price Index (CPI), REER based on CPI has been calculated. The base year for the index is chosen to be 2004-05, this is to make the CPI based REER consistent to the WPI based REER.
  • Although from January 2011, the New CPI-C (i.e. Consumer Price Index – Combined) whose Base Year is 2010, is available, a back casted index CPI-IW (Consumer Price Index- Industrial Workers), since January 2001, is used for calculations.

CENTRAL BANKS AND INSTITUTIONS WHICH DERIVE THE EFFECTIVE EXCHANGE RATES

  • Central Bank of each Country derives the Effective Exchange Rates for their respective Domestic Currencies.
  • Here are some Central Banks and Institutions which calculate the Effective Exchange Rates (EER).

Institution

Reserve Bank of India (RBI)

Bank for International Settlements (BIS)

Organisation for Economic Co-operation and Development (OECD)

European Central Bank (ECB)

International Monetary Fund (IMF)

Federal Reserve Board

Bank of England (BOE)

World Bank

Currencies

Indian Rupee

52 Currencies

43 Currencies

Mainly EURO and certain other currencies

184 Currencies

United States Dollar

Sterling and 10 Non-Sterling Countries

94 Currencies

 

Calculate Indian Rupee Effective Exchange Rates

Do not calculate Indian Rupee Effective Exchange Rates

Base Year / Reference Year

2004-05

2010

2015

1999

2010

2006

1990

2010

Basket Size

Narrow- 6 Currencies; Broad- 36 Currencies

Narrow- 27 Currencies; Broad- 52 Currencies

46 Currency Basket

EER-18, EER-19 and EER-38

184 Currency Basket

Advanced Foreign Economies – 7 Currencies; Emerging Market Economies- 19; Broad- 26 Currencies

Narrow- 15 Currencies; Broad- 24 Currencies

 

Trade Weights

Bilateral (i.e. Import + Export)

Double Weighting

Double Weighting

Double Weighting

Double Weighting

Bilateral (i.e. Import + Export)

Double Weighting

Double Weighting

Base Period for Weights

2004-05

Updated every 3 years & Chain-Linked

Updated Annually & Chain-Linked

Updated Discretely & Fixed

Updated Discretely & Fixed

Updated Annually & Chain-Linked

Updated Annually & Chain-Linked

Updated Discretely & Fixed

Deflator

Consumer Price Index

Consumer Price Index

Consumer Price Index

Consumer Price Index, Producer Price Index, Unit Labour Cost in manufacturing (ULCM), Unit Labour Cost in total economy (ULCT) and GDP deflator

Consumer Prices is the deflator used for most of the countries. For certain countries even Unit Labour Cost and Normalised Unit Labour Costs

Consumer Price Index

Consumer Price Index

Unit Labour Cost in manufacturing

  • The above Graph shows a comparison of the Real Effective Exchange Rate for the Indian Rupee calculated by the different Institutions RBI, BIS, OECD and ECB on a monthly basis.
  • The indices are calculated by shifting the base year to April 2010 using the splicing technique to make the indices of the different institutions comparable.
  • From the graph it can be observed that the movement of all the indices is in the same direction.

REVISIONS TO THE EFFECTIVE EXCHANGE RATES

The following revisions have been proposed for the Narrow Index i.e. 6 Currency Basket Effective Exchange Rate which is calculated by RBI.

NARROW INDEX

 

Existing

Revised

Index

6 Currency

8 Currency – Advanced Countries

8 Currency – Important Trading Partners

Notation

6C

8CA

8TP

View

 

Similar to the Advanced Foreign Economy Basket of Federal Reserve Board.

Incorporation of the Major Trading Partners of India of the past 10 years

Basket Size

6 Currencies

8 Currencies

8 Currencies

Countries Included

USA, UK, China, Japan, Hong Kong, Euro Area

USA, Australia, Canada, Hong Kong, Sweden, Switzerland, UK, Euro Area

USA, UK, United Arab Emirates, China, Hong Kong, Saudi Arabia, Singapore, Euro Area

Total Trade Weights of the Basket for the year 2010-11

39%

20%

49%

Base Year

2004-05

2010-11

2010-11

Deflator

Consumer Price Index (2004-05)

Consumer Price Index (2010)

Consumer Price Index (2010)

Methodology

Fixed Base

Chain-Linked

Chain-Linked

  • The above graph shows a comparison of the Narrow Basket REERs with the USD/INR Exchange Rate.
  • The Effective Exchange Rates for 6 Currency Basket, 8 Currency Basket for Advanced Countries and 8 Currency Basket for Important Trading Partner Countries are plotted on the primary axis with Base Year 2010, while the USD/INR Exchange Rate is plotted on the secondary axis.
  • The existing 6 Currency Basket REERs with 2004-05 as original Base Year have the Base Year shifted to 2010 using splicing method in order to make the indices comparable with the revised indices.
  • From the graph it can be observed that the existing and revised REERs are having a similar trend and are moving in the same direction.
  • The Effective Exchange Rates and the Exchange Rates share an Inverse Relationship.
  • This means that when REER appreciates (increases in value), the Indian Rupee strengthens i.e. it appreciates. [ (Foreign Currency / Indian Rupee) drops in value]
  • On the other hand when REER depreciates (decreases in value), the Indian Rupee weakens i.e. it depreciates. [ (Foreign Currency / Indian Rupee) increases in value]
Author
Vhabiz Lala
Volunteer – Equity Research & Valuation (M.Sc. Finance, NMIMS – Mumbai. Batch 2018-20)

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Could Libra be the end of the petrodollar?

Let us start with, “What is the petrodollar?”; The petrodollar system is an exchange of oil for USD between countries that buy oil and those that produce it. The origin of the petrodollar can be traced back to the Bretton Woods Agreement, which replaced the gold standard with USD as the reserve currency. Under this agreement, the USD was pegged to gold, while other global currencies were pegged to USD. However, due to massive stagflation, President Nixon in 1971 declared that USD would no longer be the exchange for gold to boost economic growth for the U.S; this led to the petrodollar system, where the USA and Saudi Arabia agreed to set oil prices in USD. This meant that any country that wanted to buy oil from Saudi Arabia, would first have to buy USD. This leads the rest of the OPEC to also follow the same system. The next obvious question that anyone would ask would be, was this petrodollar good for the U.S?

The petrodollar system elevated the USD to the global reserve currency and via this, the USA enjoys a trade deficit and is also a global economic hegemony. As anyone who needs to buy oil needs to first buy USD, this makes USD the most dominant currency in the world. This gives the USA an exorbitant privilege. This essentially means that the USA can fund its current account deficit by issuing dollar-denominated assets at extremely low rates of interest. However, this could come to an end in the near future.

  • One of the reasons for this is that China and Russia have been setting up deals with Oil rich nations, without the use of the USA.
  • The USA historically has been forcing its foreign policy using the petrodollar. However, in the recent past, the USA was unable to do this. Iran, Russia, and Ukraine have signed a 5-year trade deal worth $20 billion. This will not take place in USD and includes the sale on Iran’s oil. Venezuela and Iran also signed a similar oil trade deal.

Could Libra replace the petrodollar?

Unlike most other cryptocurrencies, Libra is backed by real assets. It’s often referred to as ‘stable coin’ because it is backed by real assets and is linked to a basket of diversified global currencies and low-risk bonds. So, via Libra, you could immediately send money all over the world with negligible fees. Facebook is working on Libra along with companies such as Uber, eBay, PayPal, Visa, etc. So, the global acceptability of Libra should not be an issue. Therefore, as Libra is stable and could be accepted globally, we could price Oil in the international market in Libra instead of USD.

Author
Neil Jha
Team Leader – Fintech
(M.Sc. Finance, NMIMS – Mumbai. Batch 2018-20)

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Litigation Funding – Making a market out of the courtroom

Litigation funding, also known as litigation financing or third-party litigation funding refers to the financing of lawsuits from a third-party. A third-party funder can pay some or all the expenses related to the dispute in return for a certain share in proceeds of the disputes. In case the litigation is not successful, the funder has to bear the costs. A third-party funder can also buy litigation claims of an involved party.

Litigation funding can be broadly classified into two sections – consumer financing and commercial litigation funding. Consumer financing refers to pre-settlement funding or plaintiff advances. Wall Street mainly focuses on commercial (corporate) litigation funding. These are non-recourse cash advances hence they’re investments and not loans. Litigation funding has been around since the 1960s in England and Wales but the modern-day commercial litigation only gained popularity in around 1990s in Australia. Two of the biggest names in this space are – IMF Bentham (ASX: IMF), an Australian firm is the world’s first publicly listed commercial litigation funding company and Burford Capital (LON: BUR), a London based capital market company providing specialized finance to the legal market.

Source – Financial Times

Over the course, litigation funding has garnered a lot of traction from various funding institutions. Endowment funds, savvy investors, family offices et. al., has been allocating their funds to lawsuits. As the returns are not correlated to equity and bond market, this acts as an attractive alternative investment class that manages to offer investors with double-digit returns when the other asset classes are underperforming. Making litigation funding a rapidly growing alternative asset class and a multi-billion-dollar industry. The litigants’ interest in alternatives ways to fund their hourly-legal fees and large-scale unrealized commercial litigation claims has been a driving force for this sector.

One of the biggest and popular investors in litigation financing deals have been Hedge Funds. A typical structure of a deal is as follows –

Let’s say, a litigation financer will invest around $200,000 and the case happens to settle for 10 times of that amount. The financer will get back the first $200,000. Plus 100% of the initial investment. Along with that, they will get a percentage of the settlement amount. Generally, the percentage varies from case to case but a general range is between 10 to 20 per cent. Let’s say in this case the cut is 15%. So, first, the financer will get the initial investment along with that 100% of the initial making it $400,000. And then 15% on the balance amount giving $240,000. Hence the total amount received by the financer is $640,000 on an initial investment of $200,000, giving a 220% return. What if the case settles for $500,000? The same structure will be applied. The financier will get the initial investment of $200,000 plus another $200,000 and then 15% on the balance i.e. $15,000. So, the total amount received by the financer is $415,000, giving a return of 107.5 per cent. In case there is no win, the finance wins nothing. Just like in stocks, the loss is limited to the investment and that being said, the firms protect their risks pretty aggressively. The funds conduct extreme due diligence before investing in the case, therefore, they wouldn’t invest unless they have a good shot. Hence, legal financing being completely independent of the stock market makes it an attractive alternative investment option.

Source –Bloomberg

Recently, Blackrock along with a few other investors purchased claims worth INR 1,750 cr of Hindustan Construction Company (HCC) in March 2019. This move will help HCC to prepay a debt of INR 1250 cr, including an entire term loan of INR 942cr. And the balance INR 500cr will be utilized to fund the working capital and business growth. HCC will transfer the beneficial rights of the claims to a special purpose vehicle (SPV) which is controlled by the consortium of investors. The agreement also specifies that in case of recovery of claims and awards being more than the threshold, the excess amount will be transferred to HCC. This abovementioned move will help HCC to get rid of the mismatches in the cash flows caused by prolonged litigation cycles.

Another example from earlier this year, also captures the essence of investments in litigation space. Baupost Group, a US-based hedge fund, purchased legal claims worth $1 billion against a utility company PG&E. The fund purchased the claims against PG&E as a hedge on its investment in the company’s stocks.

Basically, after California’s wildfires, PG&E’s stock plummeted by 80%, leaving the company in $30 billion in debt and almost facing bankruptcy. However, the fund in a process of subrogation purchased the claims against PG&E which was originally held by the utility company’s insurer. The fund paid around 35 cents on the dollar for those claims, now has the rights to sue the company in which it has the investments. This is not the first litigation claim which the hedge fund has purchased.

The above two examples showcase how far the institutions, hedge funds and various other investors are willing to go when it comes to capitalizing on legal claims. Connection Capital LLP, a private equity firm based in London invests on behalf of its wealthy clients in litigation funding and legal claims.

Having a right fund manager can help to generate outsized returns but it’s difficult to figure out if there is too much capital chasing this asset class and also how do litigation fund managers find a quality of case inventory in the packed global market?

Author
Isha Khuteta
Team Member– Alternative Investment Funds
(M.Sc. Finance, NMIMS – Mumbai. Batch 2018-20)

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