The Hindu Business Line : Monetary and real aspects of economy

How flexible is the rupee? What is driving OFDI (outward foreign direct investment) by Indian corporates? Are there alternative uses for India’s international reserves? Should India adopt an inflation targeting framework? How have the export structures of India and China evolved? What is the impact of exchange rate movements on inflation in India?

For detailed answers to these and more questions, dip into Monetary, Investment, and Trade Issues in India by Ramkishen S. Rajan ( www.oup.com ).

The collection of essays, co-authored with experts from around the world, focus on the monetary and real aspects of the economy.

“The chapters concentrate on important policy issues … The book also provides accessible overviews of recent research on the questions explored,” he says. Take, for example, the chapter on outward FDI, where the author observes that while India has become an attractive destination, the country is also becoming a significant source of outflows, as many Indian enterprises view outward investments as an important dimension of their corporate strategies. Foremost among the strategic drivers behind the internationalisation thrust, particularly via acquisitions, is resource-seeking, says Rajan.

“This has been the primary motivation behind overseas acquisitions by ONGC’s and GAIL’s oil-related equity abroad, the overseas acquisitions by India’s Suzlon Energy Ltd… and Hindalco’s acquisition of copper mines in Australia.”

He states that most of the overseas acquisitions undertaken by Indian companies recently have been aimed at accessing high-growth markets, buying brand names, acquiring technology, processes, management know-how, and marketing and distribution networks, and consolidating existing markets.

Rajan expects OFDI from India to grow in importance as Indian companies are beginning to face intense foreign competition at home and are intently looking to expand their overseas market shares.

An example he cites is of State Bank of India, which has forayed into Mauritius, Indonesia, and Kenya.

Similar drivers are seen behind the decision of software companies establishing facilities in developed countries such as the US (`reverse outsourcing') in order to acquire domain knowledge of clients and seek out new business opportunities. Likewise, "India's pharmaceutical companies have been attempting to seek new unregulated markets for their generic drugs, while also looking to acquire facilities that already have regulatory clearance in regulated markets like the US and western Europe."

The author draws attention to the fact that the policymakers in many Asian countries, like China and India, have been particularly keen on promoting an internationalisation thrust and have facilitated OFDI through a gradual liberalisation of rules governing capital account outflows and, in many cases, providing a financing mechanism to domestic firms looking to invest abroad.

Those watching the exchange rate fluctuations and wonder where the rupee is headed in the near future will largely benefit from the opening section in the book. The degree of flexibility of the INR against the USD has decreased steadily since 1996-97, the author observes, in the first chapter. He estimates that India has been sterilising about 70 per cent of the reserve accretion between 1998 and 2006.

As the country continues to liberalise its capital account, continued heavy management of the exchange rate will invariably complicate its overall macroeconomic policies, Rajan fears.

He argues that the more flexible the exchange rate regime, the keener will be the incentives for agents to undertake appropriate foreign exchange risk management techniques in response to the higher element of exchange rate risk, while simultaneously reducing the extent of moral hazard which could lead to `excessive' unhedged external borrowing (referred to as a `fixed exchange rate bubble').

"The introduction of these transaction costs and exchange rate risks may also help moderate the extent of capital inflows, consequently dampening the intensity of boom and bust cycles."

Imperative read.

Informative material.

Reaching microfinance to the poor

Poor women do not see finance in isolation, but as one of the resources they use in order to improve their livelihoods, writes Smita Premchander in Multiple Meanings of Money: How Women see Microfinance (www.sagepublications.com).

"Women may not regard economic development (or availing microfinance) as a goal, but see it as a limited means of improving their immediate livelihoods." And, livelihoods are commonly perceived as comprising assets, abilities and strategies by which households make a living and develop the capabilities to protect their income and assets, the author notes.

She says that in contrast to the subsidised credit and the commercial microfinance models which relegate the poor to the margins by making credit too costly for them. The SHG-bank linkage offers a way out by linking traditional development banking with a new market orientation. "This model has been made increasingly friendly to the poor, with the RBI (Reserve Bank of India) issuing guidelines that encourage banks to adopt flexible and easy procedures for SHG (self-help group) financing, to leave the groups free to manage their own money, to take consumption loans if needed."

Premchander is, however, critical of the blind spots. Such as, the national credit policies not bringing the SHGs under any banking regulations, and not recognising the financial risks that are inherent in these new forms of association, especially for poor women.

"The banking sector and the Government have formally recognised these as channels of credit and permitted them to have informal savings. However, the proliferation of unregulated SHGs also puts poor women's savings at risk, calling for further guidelines and measures."

One of the many evocative narratives in the book is about tribal women in Bastar (Chhattisgarh), who typically walk 6-8 km, carrying a child on the hip and carefully balancing a basket of minor forest products on the head, and maybe even trying to hold a bamboo umbrella to save the child from a drizzle or rain. A journey `taken on slippery paths, usually with two or three streams to cross, with at least knee or waist deep water.'

Given that the weekly transactions amounted to Rs 5 to Rs 10, these women rarely saw even a Rs 50 note, and few had seen a Rs 100 note, the author recounts. "When they began to save money, bringing a rupee or two to the group meetings, they did not know who should keep the money in between meetings. When savings reached Rs 100 or Rs 200, they usually divided it between two or three women for safekeeping."

An interesting extract from `field notes' is about a visit to a group in a remote village in Chhattisgarh. "We walked for three hours crossing two streams. When we reached the hamlet at 3 pm, women welcomed us and first we joined in a tribal dance with 40 of them. It began to pour, so we huddled into a small hut with 25 women for a discussion. As I glanced around, I felt overdressed in a salwar suit and dupatta, while these women wore only a half sari each."

Then begins a business game of sorts. "I tore pieces of paper from my pad to make serve as currency notes and handed to each different denominations totalling Rs 500 per woman. I explained that this was a loan that an agency was offering them, and asked what they would do with it; it had to be repaid with interest."

What was their reaction? A hushed silence for some time, Premchander reminisces. "Then one woman slowly counted and returned Rs 400 to me. When I asked her what she would do with the hundred retained, she said: `I will use Rs 50 to buy a sari, and with Rs 50, I will make and sell `Hariya' (liquor from paddy). One by one each woman returned some cash; not even one had considered a loan of more than Rs 100."

Towards the conclusion of the book, the author finds microfinance to be at the crossroads. "The sector has grown to incorporate a very large number of NGOs (non-government organisations), MFIs (microfinance institutions), banks and other public and private sector organisations providing a wide range of microfinance services. Such unprecedented supply should have been fully absorbed given a very large unmet demand."

The fact that this has not happened can be explained only by understanding the difference in the money offered and the money demanded, reasons Premchander. Since microfinance does not reach the poorer sections of the population, she emphasises that there is no alternative to providing credit at reasonable cost if the poor have to follow long-term sustainable livelihood strategies.

Recommended study.

Volatility smile

Quant, as a topic to study, may not bring a smile to the numerically-challenged among most us, who may, in all probability, wince at hearing that an active area of research in quantitative finance is the modelling of the volatility smile.

"Typically, a quantitative analyst will calculate the implied volatility from liquid vanilla options and use models of the smile to calculate the price of more exotic options," write Sasidharan K. and Alex K. Mathews in Option Trading: Bear Market Strategies (www.tatamcgrawhill.com).

They explain that in finance the `volatility smile' is a long-observed pattern in which at-the-money (ATM) options tend to have lower implied volatilities than other options. "The pattern displays different characteristics for different markets and results from the probability of extreme moves. Equity options traded in American markets did not show a volatility smile before the crash of 1987, but began showing one afterwards."

Opinions may, however, differ on whether the volatility smile using Reliance Industries call option (as portrayed in an example that studies the `call strike' and `implied volatility' from 1950 to 2600) seems more like a smirk than a beam.

A closely related concept that the authors explain is that of term structure of volatility, which refers to how implied volatility differs for related options with different maturities. "An implied volatility surface is a 3-D plot that combines volatility smile and term structure of volatility into a consolidated view of all options for an underlying."

For the avid, there is the GARCH (generalised autoregressive conditional heteroskedasticity) model to calculate volatility; it is based on the assumption that stock returns are heteroskedastic, which means the returns are not scattered evenly or homogenously during the observed period.

To those who have fallen off the chair while struggling to make meaning of all these, and who wonder what relevance a word such as `volatility,' something associated with liquids, can have to markets, here is some patient explanation. "The dictionary meaning of the word `volatile' is `moving lightly and rapidly about'. Another meaning for the same is `evaporating.' In the context of stock market, the term volatility is used to describe the uncertainty of the future price of the scrip or index."

Sample these recent news headlines: `Weekly review: Markets end weak amid volatile trades. Sensex volatile: ONGC, SBI, HDFC, ICICI Bk, BHEL decline. Sensex ruling in volatile zone, down 0.22 per cent. Sensex volatile; IT, banks, realty up, pharma, auto down.'

Volatility, which is an important factor in determining the option prices, is measured in terms of annualised standard deviation of the continuously compounded returns of the asset, the book educates. "Usually, it is used for quantifying the risk involved while trading in an instrument over a particular time period."

D. Murali

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