Fraught with Fraud

Last week PNB announced that it was the victim of fraud amounting to more than Rs. 11,000 Crores. While this was not foreseeable, the story has been unravelling. PNB has fallen victim to other cases of fraud in the past. In fact, it began disclosing fraudulent transactions in January that are associated with the current case. Jewellers and traders of precious metals are considered risky borrowers, yet a large part of its loan book is linked to these entities.

The bank wasn’t defrauded overnight. A deeper investigation indicates that the fraud has been ongoing for seven years. To understand what transpired, it is important to analyse the instruments and mechanisms involved. Lenders who want to borrow foreign currency (for import/ export) often find that credit facilities are cheaper abroad and may not be subject to currency fluctuations. To do this, they approach Indian banks who offer them a LoU (Letter of Undertaking) in exchange for collateral (security). Using these securities, the Indian bank then guarantees the foreign bank repayment of the loan it extends to the borrower.

PNB claims that no collateral was taken in exchange for these LoUs. Additionally, none of these transactions were recorded and there appears to be an unspoken understanding between some bank officials and the borrowers. This implies collusion on multiple levels and a systemic failure of the bank, its auditors, and the regulator.

Effectively, this has opened a Pandora’s box and leaves room for more discoveries of fraud. Ideally, this should result in greater scrutiny and tighter regulation. From a corrective standpoint, it is likely that there will be the integration of systems within banks so that all transactions are recorded. In particular, PNB may not be recapitalized.

Market Outlook

This incident leaves a stain on the Indian banking system. Demand for Indian credit will take a hit, which could further spike yields. In light of these circumstances, it is important to continue to manage risk in debt portfolios. Investments should be made into secure avenues that will be shielded from market volatility going forward. High-quality, low-duration, ultrashort-term funds would be ideally suited to the current market scenario.

Trend Reversal

The recent weeks are seeing the trend turn in several areas. Investment flows are looking very different with the persistent selling of FIIs in Indian equity.

News flows are also not looking great in February. For instance, first we had the budget levied long term capital gains tax on equities. Then, SEBI banned overseas stock exchanges like the SGX from using Indian indices to create products. Now, the PNB scam and the risk of its contagion effect on PSBs. Finally, the rising prospect of early elections in end 2018.

But these are more in the nature of reasons to explain market direction. The real reasons seems to be far more serious and structural. The uncertainty of global commodity prices, risks to fiscal discipline being maintained, upward pressure on inflation, possibility of rising interest rates, and the alarming prospect of a return to coalition governance are clearly worrying global investors. The higher volatility in global markets is definitely not helping matters either.

After enjoying decent macro tailwinds for a very extended period of time, we seem to be heading into a phase of macro headwinds. Such a phase inevitably leads to a lot of top down basket selling of the indices by global investors. Events of the past few weeks seem to reaffirm the onset of this selling trend.

Will this trend grow into a flood or will it reverse quickly? We will know in the coming weeks.



“The safest and most potentially profitable thing is to buy something when no one likes it.”– Howard Marks

The Legacy of Janet Yellen


Janet Yellen took over as Fed Chair in February 2014 at which point she had already been with the Fed for a decade. Although no new financial crises occurred during her term, the job at hand was no less tricky. Yellen inherited the responsibility of reversing the quantitative easing (QE) program shortly after her predecessor, Ben Bernanke announced to taper it.

To put it simply, the QE program was used to combat the 2008 financial crisis. It injected liquidity into markets by buying debt securities. Effectively, the supply of money increased, and the cost of borrowing fell rates to near zero levels. Low interest rates were meant to stimulate economic growth. However, they had associated costs. Firstly, surplus liquidity could trigger inflation. Next, citizens were earning less from their investments. Lastly, there was a risk of another asset bubble building up, leading to a new crisis.

During her term, Yellen employed a cautious, planned, and calculated approach. Her focus was on bringing unemployment down. She avoided rash interest rate hikes by understanding that surplus liquidity would not result in runaway inflation. Rate hikes were conducted in a phased manner and the economy was prepared for each one. There has been a certain finesse and sense of judgment to these decisions.

It is often believed that a longer tenure would allow central bankers to act in the long-term interests of the economy. Yet, in her single term, Janet Yellen has managed to bring down unemployment to a 17-year low, keep inflation below 2% and economic growth at 3%. This shows promise of continued progress. Her successor, Jerome Powell, is likely to follow a similar approach, even if he entered at the start of a market correction.



Trouble comes in threes

”Trouble comes in threes” goes the proverb.

So, when the budget threw capital gains tax at our stock markets, we kind of knew that it was not going to be the end of bad news. The U.S markets quickly went into a steep fall on two sessions, sending global markets into turmoil. The Indian markets kept stabilizing after each day of turmoil in the US markets. But these are more in the nature of a habitual “Buy the Dip” strategy adopted by domestic mutual funds and retail investors.

Two trouble spots for our markets are now amply clear. The curious question is where can the third trouble spot emanate from for our markets? Inflows into mutual funds seem to be stable and show no imminent sign of slowing. There are no imminent worries for investors. People seem to show ample confidence by buying into corrections. FII selling is a spot of bother. But, their selling seems to be getting absorbed comfortably. So where can the third spot of trouble emerge from?

One potential trouble spot can be the global bond markets. Bonds can put equity in a bind. And the trouble will possibly start with the US markets and rattle global debt markets. This will set equity markets up for an earnings reset. An earnings reset can potentially lead to a valuation reset. We need to have a more risk averse approach to investing. Expect more trouble.


“Recognizing risk often starts with understanding when investors are paying it too little heed.”– Howard Marks

Building Confidence Through Conviction



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Monetary Policy Highlights: February 2018


Investment Strategy

With higher uncertainty in debt and equity markets, this would be the time to review asset allocation and manage risk. There is now an opportunity to construct a layered debt portfolio. A phased transition out of ultrashort-term funds into high-quality accrual funds may be warranted.

Policy Highlights

This policy indicates that the RBI has greater visibility into inflation and growth projections and are comfortable with the current stance and policy rates. While near-term inflation is on the higher side, the central bank expects inflation pressures to stabilize in the coming financial year. Rising crude and commodity prices will continue to push inflation upwards, but a normal monsoon and controlled food supply will moderate this effect. Further, oil prices have moved both ways in the recent past, making it difficult to be certain that they will remain at elevated levels.

Fiscal Slippages

The reserve bank has continuously cautioned against fiscal slippages. Last year, farm loan waivers were a concern. This year, it is the government’s fiscal deficit target. Fiscal slippages increase inflation and lower creditworthiness and will have a bearing on capital flows.

Global Factors

Across the world, bond markets are correcting. Advanced economies are witnessing higher yields now. For instance, the yield on the 10 Year US Treasury is trading close to 3%. A weaker dollar has caused oil and commodity prices to rise, increasing domestic inflation. All these global factors have contributed to the rise in domestic yields.



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Is the dream run over? Have markets crashed or have they paused?

One hears anxious investors simply abandon their confidence with every fall in stock indices. As the years advance and public participation in stock markets grow stronger, our patience for corrections simply isn’t enough.  Our impatience grows on us, our peers, and on those who are watching the stock markets from the outside.

When markets correct even 3%-5%, a whole lot of doomsayers start getting louder and louder. They question the market’s stability. Questions tend to get louder and louder, building into a market chorus. The market chorus usually grows either into optimism or pessimism, depending on the overbearing sentiment.

For now, it seems like there is a sudden shift from extreme optimism to extreme pessimism. The reason is the imposition of a small tax on long-term capital gains. Interestingly, existing profits have been protected, making that tax only on future profits. This makes the market look utterly irrational in its behaviour.

Actually, this budget reminds you of the James Bond film Skyfall. After all the expectation and hype, it has simply failed to bring a spectacular close to the four year Modi rule. The climax seems to have bombed. Going by the market box office verdict, the ending seems to be rather abrupt.  For investors, it is probably the time to be more pragmatic. One can take some solace in the lines of Adele’s much-awarded song, Skyfall.

Let the Skyfall

When it crumbles

We will stand together

Face it all together

At Skyfall

At Skyfall

After all, India is the most promising global investment story for the next five years. It would be a tragedy to lose ourselves to near-term investment myopia. Budgets don’t change the direction or outcome of the Indian growth story, they only change the subplots.



“Return alone—and especially return over short periods of time—says very little about the quality of investment decisions.”– Howard Marks

Budget 2018: The Debt Markets


New Instruments

Both SEBI and RBI will request larger companies to finance 25% of their borrowings from the market. Bond issues for the bank recapitalization, affordable housing, NHAI’s infrastructure projects can be expected. The government has indicated that a debt ETF will be launched similar to what was done for the Bharat 22 ETF in the equity space.

The Return of Deposits:

The exempt income from interest for senior citizens has been increased from Rs. 10,000 to Rs. 50,000. In addition, TDS on deposits has been removed. This effectively makes fixed, recurring, and post office deposits more attractive for senior citizens.

Rising yields, interest rate hikes, and better monetary transmission are likely to improve returns for all debt investors.

Reversal Of Flows

LTCG on equity instruments has been reintroduced. Equity as an investment avenue has lost some lustre. Dividends from equity are no longer exempt from tax. This means dividend income from balanced and equity mutual funds are taxable. As optimism in equity markets moderates and there is parity in the taxation of debt and equity instruments, there might be a reversal of flows.