Prof. J. R. Varma: Article Abstracts

Rerating the Ratings

"Rerating the Ratings", Business Today, December 7-21, 1997, 144-149 (with V. Raghunathan)

In 1994 we published a research study which took a hard look at the rating record of India's premier credit rating agency, CRISIL, and showed that CRISIL ratings were too liberal by international standards, besides being internally inconsistent. In this paper, we re-examine CRISIL's ratings using its more recent record.

We find a phenomenal improvement in the internal consistency of CRISIL ratings in these three years. The internal consistency of CRISIL ratings is now on par with that on international rating agencies. CRISIL has also become much more stringent while awarding high ratings than in the past. CRISIL still seems to be more liberal than the US rating agency, S&P, to the extent of one rating designation; but this is a great improvement over the 1993 ratings where a CRISIL AAA rating might have merited a rating four rating designations lower by international standards.

We also compare CRISIL with a rating agency in another emerging market - the Rating Agency Malaysia (RAM). The rating experience of RAM is considerably less than that of CRISIL as of today and is quite comparable to CRISIL’s experience as it was in 1993. We find that the learning curve for RAM has been much steeper for RAM than for CRISIL, though RAM too has some way to go before achieving truly international standards.

Going beyond the credit rating industry, we argue that while creating new institutions as a part of financail reforms, we must not ignore the more difficult task of nurturing them in an environment which enables them to go through the learning process faster and shoulder their responsibilities better. If we falter here, we may find ourselves being left behind in the race.

The Union budget: Reforms are back on rails

"The Union budget: Reforms are back on rails", Times of India, March 4, 1997 (with V. Raghunathan)

One in a while, a budget comes along that radically changes growth expectations and changes the parameters within which assessments are made about future government policies. The 1997 budget is one of this kind. The signal from this budget are loud and clear: Reforms are back on track.

Impact on Sensex of Double Tax on Dividends

"Impact on Sensex of Double Tax on Dividends", Business Standard, February 27, 1997 (with V. Raghunathan)

The taxation of dividends has generated an active debate in recent months in the media. While the industry representatives have been critical of the double taxation of dividends, the Government seems to be questioning the very premise that dividends are double taxed in India. The argument that scrapping the double taxation of dividends will give the Sensex a much needed boost seems to have tilted the scales. What will be the impact of scrapping of dividend tax on Sensex? One finds that the standard valuation models of Gordon, Modiglliani, Miller et. al. suffer from too many shortcomings to be of much help in answering this question. First, many of them do not provide for differential tax rates, such as, corporate tax rate, personal tax rate on dividends and capital gains. Second, they deal with only a small number of variables at a time. And third, they implicitly assume the capital gains to the investors to be the same as the firm's retained earnings. In this paper, we therefore answer the question by employing one of our own models, which not only includes a wide range of variables and differential tax rates, but also captures the capital gains realistically. We estimate the impact on the Sensex to about 200 points.

Leasing Economics Under MAT

"Leasing Economics Under MAT", Economic Times, February 17, 1997 (with V. Raghunathan)

The levy of the Minimum Alternate Tax (MAT) has altered the marginal tax rate for most leasing companies, and many of them are facing difficulty in working out the lease rental taking MAT into account. This paper explains how to take MAT into account in lease evaluation. First, for companies coming under MAT, the tax rate applicable to all income and expenses is changed to the MAT rate of 30% of the normal corporate tax rates. But this change alone is not enough. There are items like depreciation and residual value which affect book profits and tax profits differentially. We define the MATable income stream to be the excess of book income over taxable income (for example, book profits on sale of asset) or the excess of tax deductible expenses over book expenses (for example, excess of tax depreciation over book depreciation). The MATable income is taxed at the MAT rate. If a company expects MAT to be repealed or relaxed, it may set the MAT rate to a rate lower than 30% of the normal corporate tax rate. The same methodology of computing the MATable income stream can in fact be used in the non leasing context also.

A Scam Screaming to Happen

"A Scam Screaming to Happen", Business Standard, February 6, 1997 (with V. Raghunathan)

Indian hire purchases (HPs) and leases are virtually identical in substance and should be treated alike for tax purposes. Either depreciation tax shield should be available to the lessor in both HPs and leases or in neither. Granting the tax benefit in one and not in the other opens the path to a form of tax trading - HP and lease back - which is more potent than even sale and lease back. sale and lease back is actually a very inefficient form of tax trading because it combines tax trading with a lender- borrower relationship. The key idea in HP and lease back is that instead of selling the asset outright, the seller-cum-lessee, transfers the asset on a HP basis to the leasing company. Since the sale is on HP basis, the leasing company does not have to part with the sale price up-front. The payment is made over a period of time in the form of HP rentals. At the same time, the leasing company leases the same assets back to the lessee on lease basis and collects periodic lease rentals. These two rentals - the periodic HP rentals from the leasing company to the seller-cum-lessee, and the periodic lease rentals in the opposite direction - can be substantially set off against each other. Essentially, at the end of all the paper work, the only money that changes hands is a periodic payment by the lessor to the lessee representing the lessee's share of the tax benefit arising to the lessor out of the deal. There is also the reverse HP and lease back deal in which a leasing company HPs an asset with a low depreciation rate to a loss making company and leases it back.

In short, we have a potential scam here screaming to happen! The easiest way for the CBDT to prevent such a scam is to put HP and leases at par - either by allowing the capital allowances to both or by taking it away from both.

The bootless bull chase

"The bootless bull chase", Economic Times, November 7, 1996

One should distinguish between the role of SEBI as a market regulator and the role of government as the formulator of national economic policy. It is not the function of the market regulator to manipulate micro structure of the market in order to nudge stock prices up or down. Any such attempt would amount to rigging stock prices. The job of the market regulator is to make markets more efficient and transparent and leave the direction of price movements to the free play of market forces. The government as the formulator of economic policy has a very different role to play. It controls the economic fundamentals that are the ultimate determinants of stock prices.

The Unfinished Agenda

"The Unfinished Agenda", Business Standard, October 21, 1996

Much was accomplished in the first couple of years of reform. In fact, some of what was pushed through in those two years would have been regarded as virtually impossible as little as a year earlier. Two major and lasting achievements of the last five years of reform were restoring the solvency of the financial system and ending the regime of financial repression. At the same time, financial reforms in India have avoided the kinds of financial crises that have engulfed liberalizers in other developing countries. However, there are some important areas where reform has accomplished very little. Somewhere during the second or third year of the reform process, financial sector reforms lost momentum for a variety of reasons. As a result of this slowdown, we are today left with two large areas of unfinished financial sector reforms: the dismantling of the structural and micro regulations that have accumulated over several decades of a command economy, and the institutional and technological modernization of the financial sector.

Takeover Code: Less Than What Meets the Eye

"Takeover Code: Less Than What Meets the Eye", Economic Times, September 18, 1996

The new takeover code proposed by the Bhagwati committee has been generally seen as comprehensive and well drafted. But the fact is, the code adds little value over the existing code of SEBI. Further, some provisions are retrograde while some lack rigour. (1) In one of the most pernicious steps, the new code blocks acquisition through an exchange of shares. (2) The stipulation of the Minimum Offer Price is discordant with the spirit of free pricing, and is a needless obstacle in the emergence of an orderly market for corporate control. (3) While appearing to allow conditional offers, the code effectively makes them unconditional by stipulating that even if the conditions are not met, the acquirer must acquire at least 20 per cent of the shares. This norm is unwarranted and would make transparent takeovers difficult. (4) The committee has shown excessive concern for incumbent managements by legitimising creeping takeover. (5) Together with the effective ban on stock offers, the requirement for an escrow account prevents takeovers by successful but cash strapped companies. Furthermore, the stipulated 10 per cent may be too low to achieve the desired objective. (6) The code also contains many drafting errors and ambiguities.

Yankee Bonds: Triumph of Pessimism

"Yankee Bonds: Triumph of Pessimism", Business Standard, September 10, 1996

In July-August 1996, Reliance Industries Limited made news with successful flotation of $100 million 50-year Yankee bond in the US markets. The latest Reliance Yankee bond was the first issue of such a long maturity by any issuer, sovereign or corporate, with this credit rating. Many commentators have argued that by subscribing readily to this and earlier bond issues by Reliance group, foreign investors are sending a strong signal about the creditworthiness of Indian borrowers in the world markets. What such a view ignores is that the borrower too is sending a strong signal by borrowing on such long maturity. Because of India's low credit rating, Reliance has been forced to offer quite high rates of interest on its bonds. By committing itself to such high cost borrowing for the next several decades, Reliance is sending a strong signal that it does not expect any significant improvement in the credit rating and concomitant reduction in this risk premium in the foreseeable future. If reforms are to a great extent a matter of changing the mindset of people, then the perceptions of the financial decision makers of our largest corporations do matter. If they do not have confidence in themselves and in their country, it is difficult for the reforms to succeed in making India a vibrant economy. Indeed, their perceptions could easily become a self fulfilling prophecy.

Do Barriers Work

"Do Barriers Work", Business Standard, August 5, 1996 (with S. K. Barua)

The reasons which are often given for introducing circuit breakers in the securities markets are: a) they prevent a sudden collapse of confidence, b) they provide time for payment and thereby reduce the risk of default, c) they provide time for market operators to think through and decide the stance they would like to take in the market. The first reason is extremely specious, since it mixes up cause and effect. The last reason given is even more specious. An open market provides an opportunity to trade but does not create a compulsion to trade. Finally, the argument about default risk is also not valid because exchanges can and should use margin requirements to deal with this risk.

On the other hand, there are several valid arguments against circuit breakers: a) they do not allow the markets to self- correct themselves, b) they may in fact exacerbate the trend by inducing higher volumes as the prices move close to the band limit, and traders become desperate to execute the trade before the circuit breaker takes effect, c) they create illiquidity precisely at times when liquidity is most needed by the market, d) when applied to only one market, they create arbitrage opportunities. We believe that regulators must allow a free play of market forces to determine prices of securities and do everything to ensure that reliable information which is the biggest facilitator of proper free markets, is available simultaneously and easily to all operators.

The Missing Ingredient

"The Missing Ingredient", Economic Times, August 2, 1996 (with Vivek Moorthy)

The RBI’s attempts to nurture the debt market are likely to succeed only if it adopts open market operations as the principal method of changing money supply. In other words, when it wants to change reserve money, even if for the purpose of accommodating government borrowing, it should do so through secondary market trades with the public in government securities. The RBI should fully refrain from directly accommodating the government’s borrowing by subscribing to government primary issues, as it has been doing so far. a liquid and well functioning market for government debt is a precondition for the emergence of liquid markets for corporate and quasi-government debt too. By fostering the growth of the debt market, open market operations also enable a well defined yield curve to emerge which can then provide prompt, continuous and usually accurate feedback to the central bank about the future inflationary consequences of its monetary policy decisions. Such a well defined yield curve will also enable the advent of financial derivatives for hedging interest rate and currency risk.

The Ghost Who Haunts

"The Ghost Who Haunts", Business Standard, June 27, 1996 (with S. K. Barua)

Under the proposed merger of Hindustan Lever Limited (HLL) and Brooke Bond Lipton India Limited (BBLIL), shareholders of BBLIL are to receive 9 shares of HLL for every 20 shares of BBLIL held by them. Minority shareholders of BBLIL are unhappy because the 20:9 or 2.222222:1 ratio is worse than the ratio of 2:1 (or more accurately 1.9:1) implicit in the market prices at the time of the announcement. Moreover, the awkward ratio of 2.222222:1 would leave small shareholders of BBLIL with a large percentage of odd lots after the merger. That the swap ratio was decided on the basis of the advice of two respected firms of accountants and two well known merchant bankers raises the question of how so many experts could together come up with such an unreasonable conclusion. The answer is that though the government abolished the office of the Controller of Capital Issues long ago, the ghost of his formula continues to haunt Indian companies as well as their accountants and merchant bankers. In this article we argue that this ghost must be exorcised if we are to be able to arrive at fair and reasonable valuations.

Misleading Investors with Impunity

"Misleading Investors with Impunity", The Hindu, May 22, 1996

Two examples in recent weeks have shown how easily issuers and merchant bankers can get away with grossly misleading advertisements for public issues.The first example was the reported decision of the Ministry of Finance to rescind the penalty imposed by the Securities and Exchange Board of India (SEBI) on SBI Caps for its role as lead manager of the infamous MS Shoes public issue. The second was the issue advertisements of the IDBI deep discount bonds which failed to mention that the IDBI had a call option to redeem the bond at various dates at various prices. I ran this bond through an interest rate option pricing model. The result: if the advertised deep discount bond (without call options) is worth the Rs 5,300 at which it was offered, the actual bond (with call options) for the issuer is worth only about Rs 4,800. This shows how significant the concealed information really is. As our capital markets become more developed, the most important element of investor protection is to ensure that the information given to investors is (to use SEBI's language) "true, fair and adequate to enable the investors to make a well informed decision". It is a matter of grave concern that issue advertisements in India flout this requirement with impunity.