Mega Bailout Plan

Ayush Pathak,
B.Com,Financial Modeling,
Financial Analyst
S&P Hyderabad

There was a big announcement on October 25th about recapitalization of banks. Center announced a capital injection of Rs. 2.11 lakh crores. And with this news, I am motivated to write another blog on this describing why it is needed? Impacts of it, how it will work, etc..
So, let’s start with basic with a question,

What is capital injection?

Capital Injection is the supply of new money into the system (economy) or in a company or in an institution in the form of cash, equity or debt. This is generally done to make the financial condition of any sick company/companies better. Generally, capital injection is treated as the last option to make things better. It generally helps to unfreeze the credit instantly or fix the capital crunch problem. It may also have some bad impacts which are discussed later.
The last capital injection by a government into an economy, which I remember, is done by the US government in 2007-08 crises and they also treated this as very last option to unfreeze their credit system. Which now the US fed has started to unwind their balance sheet and reduce their debt.

Why Capital Injection in India? Are we in any crises?
The centre decided to do a bailout of Public Sector banks by injecting Rs. 2.11 lakh Crore or nearly 326 Billion USD, which is a huge amount, to treat the NPA problem of the Indian Banks.
Indian banks have nearly Rs. 8.29 lakh crores of NPAs and this is I think a severe threat to the Indian economy. Today, most banks are not able to lend further because of this huge NPA on their balance sheet. They are facing a problem of Capital Adequacy Ratio, which is defined as the percentage of bank’s capital to its risk-weighted assets like making a loan. According to Basel III, banks need to maintain the capital ratio of no less than 8%, but due to many defaults on the bank loans, the bank loses their capital and now the state came when banks are finding it difficult to maintain the minimum capital ratio and hence the credit seems to be frozen.
Let me tell you, in an economy, credit plays a very important role. Credit has an ability to create a modern economy and lack of credit can even destroy the economy. Credit helps shopkeepers to maintain their shelves, run their business and in many ways.
In India, we are facing a situation of lack of credit and the result of it can be seen in Indian GDP growth rate. From nearly 7-8% of growth we came down to 6-7% last year and then in the September quarter we grew by just 5.7%. Many say that demonetization and GST have pulled us down, but I think, it’s not only these two factors, we have a huge NPA problem as well which is pulling the growth down. And this needs to be dealt soon and in the best way possible. The government thinks Capital Injection is the best way to work.
I think, to handle a situation of dealing with a problem of NPAs, government and RBI should find some different way. As I first stated that capital injection should be the last option and this is mostly used at the time of crises. And I think we are not currently into a situation of “Crises”. So the answer to the question “Are we into Crises?” is “No, at least for now, we are not.”

How Government Plans to Do it?
To the best of my knowledge and understanding, the government has planned to buy Rs. 18000 Cr worth of shares through its budgetary allocation and then government issue bonds which might be called as ‘Banks Recapitalization Bonds’ for Rs 135000 Cr. which will further be used to buy more banks’ shares. So, in all government planned to inject 18000Cr. + 135000cr. that is 153000Cr. by itself.
The government bonds are yet not into a clear picture like how will they be issued, what will be the maturity? Or to whom they will be issued? Etc.. There is a belief that the bonds will be issued directly to the banks, so that banks can raise further capital from the market. Further capital is like 58000Cr Rs. which will sum up to total capital injection of 211000Cr Rs in the system.

What actually is done here?
This is actually a masterpiece idea of financial engineering. It is like, first, government give banks money and purchase their shares then Government Issue bonds which will certainly be bought by the banks. This means now banks give money to Government to buy more shares of banks. Banks will now have bonds of the government which can be used to issue new bonds in the market which has an underlying asset of government’s bonds.

Is it good to give Money to banks?
Well, we are giving money to someone whose sole job is to make money because it fails to make money. Perhaps, it doesn’t seem like a good idea but we are stuck in a jam. Indian banks seem frozen. So giving money to banks is like giving them a lifeline.
However, giving money to banks can only be fruitful if and only if, banks will book NPAs as their loss and clean out their balance sheet as soon as possible.
Banks have resisted themselves to clean their balance sheet till now because of the lack of capital they have. If they have booked losses earlier, they would have failed to maintain the minimum capital ratio requirement and therefore they have to call back their loans outstanding. Investors also would have lost trust in them and they would have also pulled their money out which further worsen their situation. But now as they are getting money from the government, they can book their losses and can clean up their balance sheet. It will not be any harm to the banks if they still resist or extend their loss booking as there is no such provision of it. However, the government can now force banks harder to book losses. So ultimately, it all depends on banks if the plan for government go successfully or not.

What Can Go Wrong?
I think, if banks do not book their loses and acted upon the capital injection which they were supposed to do, everything might go wrong. 2.11 lakh is not a small amount. It is a big capital injection and if this not used properly, it will result in hyperinflation problem.
I think, in India, there is always a huge demand for credit and if everyone starts getting it easily then it may cause a hyperinflation. We may say the greed of the bank may also increase and they go an extra mile to lend more. When the banks’ pockets are again full of money, they will lend it more and even to sub-prime customers and this may cause more default and increase in NPA.

What about the Bonds?
With the new capital injection of bonds, I seriously think that the yield of the fixed income securities will go up. With the capital injection, the short-term securities will be the first to react upon it and the yield on those will first increase. The long-term securities also will not remain unaffected. Even 10-year T-Bill of India will have its yield increased.
We will definitely be going to see some increase in inflation after the capital injection and which will increase the yield of every fixed income securities. We may soon find the RBI also increasing the rates to control the inflation. And now this could also lead to an end of low-interest rate cycle. There is also a potential threat to Indian fixed income securities as the yield of US T-Bill is also increasing. It reached near to 3%. This will further increase the yield of the Indian bonds.

What Problem the recapitalization bonds may cause?
The government bonds are issued to take a share into the banks. The government will have a certain percentage of ownership into the banks. When the government issues the bonds, it will certainly be bought by the banks and then the government will use that money to purchase shares of the banks. And with the help of the government bonds, banks will able to raise the further capital and issue more shares into the market.
Increase in the number of shares in the market will lead to lead to dilution in the EPS of the share. This means if you today have a share of a bank of EPS say 10Rs then after government’s purchase of the new shares it may come down to say 5Rs. So, the current holdings into the banks may get diluted with the increase in the share of government in the banks. The government is going to be an owner in the banks.

How Government describes this?
The government has a say in this as it will not be creating any problem and this is well planned financial structure. And hopefully, it should be well planned.
Previously, looking at the government’s figure about the disinvestments and all, the fiscal deficit target of 3.2% seems to be achievable. But with this new plan of government, I think this year, the fiscal deficit will going to increase. The government says it’s just shares in exchange for cash. The whole scene doesn’t look this. There are a lot of moving parts which have a lot of risks involved. The government has taken a huge risk by giving money to the banks. We may end up into hyperinflation, if not monitored properly. I think in near future the inflation is going to increase and fiscal deficit is going to widen up. This is an additional debt on the balance sheet of the government.

Well, I think that is pretty much about something which we can call “A mega-bailout”. I just recommend stay away from the long-term fixed income securities and expect inflation. Rates will be increased, yields will go up. So plan your investments accordingly as it may affect you as well.
Stay safe and keep learning.

What causes Inflation?

Ayush Pathak,
B.Com,Financial Modeling,
Financial Analyst
S&P Hyderabad

Commonly inflation is referred as rise in level of price in a particular period of time. The value of say 1 INR which can buy any particular good may not be able to buy the same quantity of good a year later. The Value of 1 INR is changed over a year time. This change in the value of currency of any country is called inflation.

Types of Inflation—
On a broader basis the inflation are of two types. They are as follows—

  • Demand- pull inflation—The demand pull inflation occurs when the demand of the commodities are rising rapidly than the supply of the commodities. This will let the price of the commodities go up and hence result in the demand- pull inflation.
  • Cost-push inflation—The cost push inflation occurs when the cost of production increases over time. When the cost of raw material increases the cost of production also increases and as a result the manufacturer has to increase the selling price to maintain the profit margins. This rise in the selling price is termed as the Cost- push inflation.

Another form of inflation are Hyperinflation and deflation—

The hyperinflation is the situation of inflation in which the rate of inflation goes out of control. For example the situation happened in Zimbabwe in 2008 when the inflation went over 1 billion percent but fortunately it last for a very few time.

The situation of hyperinflation mostly faced by the emerging economies and this situation leads to fail in monetary system of the country.

Deflation is the situation opposite to the hyperinflation. This type of scenario is also mostly faced by the emerging economies and in this situation the prices of the commodities fall uncontrollably. There can be many causes of deflation like increase in unemployment which leads of less expenditure by the people of the country that means less demand in the market for the goods leads to cut in labor cost with the decrease in the production which further worsen the situation of unemployment and this will turn down the tax collection by the government and the price of the goods and services keeps falling. The best example of the deflationary situation is the Great Depression of 1929 in US.

Both deflation and hyperinflation situation is difficult to control and may lead to abolish the monetary system of the country.

What Causes Inflation to change??

Inflation is majorly affected by the demand and supply of the goods and services. Other than demand and supply of the goods and services the inflation is also impacted by many other factors like change in monetary policies of the country, change in fiscal policies of the country, confidence of the investors on the local currencies, political little bit and many more.

The demand and supply of goods and services to affect the inflation is already been explained in Demand- pull inflation in which the rise in demand in comparison with the rise in supply will increase the inflation and vice-versa.

Another major cause of inflation to change is the change in the monetary policies of the country. A decrease in the lending rate will increase the supply of the currency in the market which means the INR will then be easily available to the borrowers at the lower cost. As a result more the money flow in the market the more will be the inflation. Whenever the availability of the currency increases it will straight away leads to increase in the inflation. On the other hand if the lending rates are increased that means now loans or money is available at higher cost of borrowing then the demand for the loans will reduce and this help to pull down the inflation.

Inflation also gets affected when the savings rate of term deposit rates are increased or decreased. When the term deposit rate is increased then it will attract many foreign investors to invest in the various securities of the country and this will strengthen the currency globally and hence reduce the inflation. The inflation may rise if the foreign investors pull out their money when the saving rates and the term deposit rates are reduced.

The confidence level of the various investors on the currency may also impact the inflation rate of the country. The confidence on the INR will make the investors to buy the INR and hold it which will make the INR strong globally. For the country like India which has a high imports a strong currency will help in reducing the cost of imports and will bring down the cost of goods and services which ultimately reduces the inflation. Therefore a strong and stable currency will attract the foreign investors to invest in India which increase the demand for the INR which in result helps in controlling the inflation.

Inflation can also be slightly affected by the fiscal policies of the nation. Increases in taxes will leaves with less money with the people and hence reduce their purchasing power of the buyers. This ultimately reduces the inflation on the other hand, taxes on customs and imports will increase the cost of imports/ this leads to the price hike of that goods and services.

Is Inflation necessary??

Many people say that inflation is the cause of price hike and this degrades the value of their investment of the period of time. So it’s better not to have inflation or to have a zero inflation country.

Well that’s not really true. Even world’s most developed nation USA also has an ideal inflation rate of 2% +/-1%. A minute inflation is necessary for every country. A minute inflation gives a cover from falling into the deflationary situation. So it’s better to have some rising price scenario then facing a difficult problem of deflation.

PEARSON

Returns the Pearson product moment correlation coefficient, r, a dimensionless index that ranges from -1.0 to 1.0 inclusive and reflects the extent of a linear relationship between two data sets.

Syntax
PEARSON(array1,array2)
Array1 is a set of independent values.
Array2 is a set of dependent values.

Remarks

• The arguments must be either numbers or names, array constants, or references that contain numbers.

• If an array or reference argument contains text, logical values, or empty cells, those values are ignored; however, cells with the value zero are included.

• If array1 and array2 are empty or have a different number of data points, PEARSON returns the #N/A error value.

• The r value of the regression line is:

Example
PEARSON({9,7,5,3,1},{10,6,1,5,3}) equals 0.699379

INTERCEPT

Calculates the point at which a line will intersect the y-axis by using existing x-values
and y-values. The intercept point is based on a best-fit regression line plotted through the
known x-values and known y-values. Use the intercept when you want to determine the
value of the dependent variable when the independent variable is 0 (zero). For example,
you can use the INTERCEPT function to predict a metal’s electrical resistance at 0°C
when your data points were taken at room temperature and higher.

Syntax
INTERCEPT(known_y’s,known_x’s)
Known_y’s is the dependent set of observations or data.
Known_x’s is the independent set of observations or data.

Remarks

• The arguments should be either numbers or names, arrays, or references that contain numbers.

• If an array or reference argument contains text, logical values, or empty cells, those values are ignored; however, cells with the value zero are included.

• If known_y’s and known_x’s contain a different number of data points or contain no data points, INTERCEPT returns the #N/A error value.
The equation for the intercept of the regression line is:

Example
INTERCEPT({2, 3, 9, 1, 8}, {6, 5, 11, 7, 5}) equals 0.0483871

COVAR

Returns covariance, the average of the products of deviations for each data point pair.
Use covariance to determine the relationship between two data sets. For example, you
can examine whether greater income accompanies greater levels of education.

Syntax
COVAR(array1,array2)
Array1 is the first cell range of integers.
Array2 is the second cell range of integers.

Remarks

• The arguments must be either numbers or names, arrays, or references that contain numbers.

• If an array or reference argument contains text, logical values, or empty cells, those values are ignored; however, cells with the value zero are included.

• If array1 and array2 have different numbers of data points, COVAR returns the #N/A error value.

• If either array1 or array2 is empty, COVAR returns the #DIV/0! error value.

Example
COVAR({3, 2, 4, 5, 6}, {9, 7, 12, 15, 17}) equals 5.2

CORREL

Returns the correlation coefficient of the array1 and array2 cell ranges. Use the correlation coefficient to determine the relationship between two properties. For example, you can examine the relationship between a location’s average temperature and the use of air conditioners.

Syntax
CORREL(array1,array2)
Array1 is a cell range of values.
Array2 is a second cell range of values.

Remarks

• The arguments must be numbers, or names, arrays, or references that contain numbers.

• If an array or reference argument contains text, logical values, or empty cells, those values are ignored; however, cells with the value zero are included.

• If array1 and array2 have a different number of data points, CORREL returns the #N/A error value.

• If either array1 or array2 is empty, or if s (the standard deviation) of their values equals zero, CORREL returns the #DIV/0! error value.

• The equation for the correlation coefficient is:

Example
CORREL({3,2,4,5,6},{9,7,12,15,17}) equals 0.997054

YIELD

Returns the yield on a security that pays periodic interest. Use YIELD to calculate bond
yield.
If this function is not available, run the Setup program to install the Analysis ToolPak.
After you install the Analysis ToolPak, you must enable it by using the Add-Ins
command on the Tools menu.
How?

Syntax
YIELD(settlement,maturity,rate,pr,redemption,frequency,basis)
Settlement is the security’s settlement date. The security settlement date is the date after
the issue date when the security is traded to the buyer. Dates may be entered as text
strings within quotation marks (for example, “1/30/1998” or “1998/01/30”), as serial
numbers (for example, 35825, which represents January 30, 1998, if you’re using the
1900 date system), or as results of other formulas or functions (for example,
DATEVALUE(“1/30/1998”)).

Maturity is the security’s maturity date. The maturity date is the date when the security
expires.
Rate is the security’s annual coupon rate.
Pr is the security’s price per $100 face value.
Redemption is the security’s redemption value per $100 face value.
Frequency is the number of coupon payments per year. For annual payments, frequency
= 1; for semiannual, frequency = 2; for quarterly, frequency = 4.

Basis is the type of day count basis to use.

Basis Day count basis
0 or omitted US (NASD) 30/360
1 Actual/actual
2 Actual/360
3 Actual/365
4 European 30/360

Remarks

• Microsoft Excel stores dates as sequential serial numbers so that it can perform calculations on them. Excel stores January 1, 1900, as serial number 1 if your workbook uses the 1900 date system. If your workbook uses the 1904 date system, Excel stores January 1, 1904, as serial number 0 (January 2, 1904, is serial number 1). For example, in the 1900 date system, Excel stores January 1, 1998, as serial number 35796 because it is 35,795 days after January 1, 1900. Learn more about how Microsoft Excel stores dates and times.

• The settlement date is the date a buyer purchases a coupon, such as a bond. The maturity date is the date when a coupon expires. For example, suppose a 30-year bond is issued on January 1, 1996, and is purchased by a buyer six months later. The issue date would be January 1, 1996, the settlement date would be July 1, 1996, and the maturity date would be January 1, 2026, which is 30 years after the January 1, 1996, issue date.

• Settlement, maturity, frequency, and basis are truncated to integers.

• If settlement or maturity is not a valid date, YIELD returns the #NUM! error value.

• If rate < 0, YIELD returns the #NUM! error value. • If pr _ 0 or if redemption _ 0, YIELD returns the #NUM! error value. • If frequency is any number other than 1, 2, or 4, YIELD returns the #NUM! error value. • If basis < 0 or if basis > 4, YIELD returns the #NUM! error value.

• If settlement _ maturity, YIELD returns the #NUM! error value.

• If there is one coupon period or less until redemption, YIELD is calculated as follows:
where:
A = number of days from the beginning of the coupon period to the settlement date (accrued days).
DSR = number of days from the settlement date to the redemption date.
E = number of days in the coupon period.

• If there is more than one coupon period until redemption, YIELD is calculated through a hundred iterations. The resolution uses the Newton method, based on the formula used for the function PRICE. The yield is changed until the estimated price given the yield is close to price.

Example
A bond has the following terms:
February 15, 1999, settlement date
November 15, 2007, maturity date
5.75 percent coupon
95.04287 price
$100 redemption value
Frequency is semiannual
30/360 basis
The bond yield (in the 1900 date system) is:
YIELD(“2/15/1999″,”11/15/2007”,0.0575,95.04287,100,2,0) equals 0.065 or 6.5 percent

RECEIVED

Returns the amount received at maturity for a fully invested security.
If this function is not available, run the Setup program to install the Analysis ToolPak.
After you install the Analysis ToolPak, you must enable it by using the Add-Ins
command on the Tools menu.
How?

Syntax
RECEIVED(settlement,maturity,investment,discount,basis)

Settlement is the security’s settlement date. The security settlement date is the date after
the issue date when the security is traded to the buyer. Dates may be entered as text
strings within quotation marks (for example, “1/30/1998” or “1998/01/30”), as serial
numbers (for example, 35825, which represents January 30, 1998, if you’re using the
1900 date system), or as results of other formulas or functions (for example,
DATEVALUE(“1/30/1998”)).

Maturity is the security’s maturity date. The maturity date is the date when the security
expires.

Investment is the amount invested in the security.

Discount is the security’s discount rate.

Basis is the type of day count basis to use.

Basis
Day count basis
0 or omitted US (NASD) 30/360
1 Actual/actual
2 Actual/360
3 Actual/365
4 European 30/360

Remarks

• Microsoft Excel stores dates as sequential serial numbers so that it can perform calculations on them. Excel stores January 1, 1900, as serial number 1 if your workbook uses the 1900 date system. If your workbook uses the 1904 date system, Excel stores January 1, 1904, as serial number 0 (January 2, 1904, is serial number 1). For example, in the 1900 date system, Excel stores January 1, 1998, as serial number 35796 because it is 35,795 days after January 1, 1900.
Learn more about how Microsoft Excel stores dates and times.

• The settlement date is the date a buyer purchases a coupon, such as a bond. The maturity date is the date when a coupon expires. For example, suppose a 30-year bond is issued on January 1, 1996, and is purchased by a buyer six months later. The issue date would be January 1, 1996, the settlement date would be July 1, 1996, and the maturity date would be January 1, 2026, which is 30 years after the January 1, 1996, issue date.

• Settlement, maturity, and basis are truncated to integers.

• If settlement or maturity is not a valid date, RECEIVED returns the #NUM! error value.

• If investment _ 0 or if discount _ 0, RECEIVED returns the #NUM! error value.

• If basis < 0 or if basis > 4, RECEIVED returns the #NUM! error value.

• If settlement _ maturity, RECEIVED returns the #NUM! error value.

• RECEIVED is calculated as follows:
where:
B = number of days in a year, depending on the year basis.
DIM = number of days from issue to maturity.

Example
A bond has the following terms:
February 15, 1999, settlement (issue) date
May 15, 1999, maturity date
1,000,000 investment
5.75 percent discount rate
Actual/360 basis
The total amount to be received at maturity (in the 1900 date system) is:
RECEIVED(“2/15/1999″,”5/15/1999”,1000000,0.0575,2) equals 1,014,420.266, or $1,014,420.27

PRICEMAT

Returns the price per $100 face value of a security that pays interest at maturity.
If this function is not available, run the Setup program to install the Analysis ToolPak.
After you install the Analysis ToolPak, you must enable it by using the Add-Ins
command on the Tools menu.
How?

Syntax
PRICEMAT(settlement,maturity,issue,rate,yld,basis)

Settlement is the security’s settlement date. The security settlement date is the date after
the issue date when the security is traded to the buyer. Dates may be entered as text
strings within quotation marks (for example, “1/30/1998” or “1998/01/30”), as serial
numbers (for example, 35825, which represents January 30, 1998, if you’re using the
1900 date system), or as results of other formulas or functions (for example,
DATEVALUE(“1/30/1998”)).

Maturity is the security’s maturity date. The maturity date is the date when the security
expires.

Issue is the security’s issue date, expressed as a serial date number.

Rate is the security’s interest rate at date of issue.

Yld is the security’s annual yield.

Basis is the type of day count basis to use.
Basis Day count basis
0 (zero) or omitted US (NASD) 30/360
1 Actual/actual
2 Actual/360
3 Actual/365
4 European 30/360

Remarks

• Microsoft Excel stores dates as sequential serial numbers so that it can perform calculations on them. Excel stores January 1, 1900, as serial number 1 if your workbook uses the 1900 date system. If your workbook uses the 1904 date system, Excel stores January 1, 1904, as serial number 0 (January 2, 1904, is serial number 1). For example, in the 1900 date system, Excel stores January 1, 1998, as serial number 35796 because it is 35,795 days after January 1, 1900.
Learn more about how Microsoft Excel stores dates and times.

• The settlement date is the date a buyer purchases a coupon, such as a bond. The maturity date is the date when a coupon expires. For example, suppose a 30-year bond is issued on January 1, 1996, and is purchased by a buyer six months later. The issue date would be January 1, 1996, the settlement date would be July 1, 1996, and the maturity date would be January 1, 2026, which is 30 years after the January 1, 1996, issue date.

• Settlement, maturity, issue, and basis are truncated to integers.

• If settlement, maturity, or issue is not a valid date, PRICEMAT returns the #NUM! error value.

• If rate < 0 or if yld< 0, PRICEMAT returns the #NUM! error value. • If basis < 0 or if basis > 4, PRICEMAT returns the #NUM! error value.

• If settlement _ maturity, PRICEMAT returns the #NUM! error value.

• PRICEMAT is calculated as follows:
where:
B = number of days in year, depending on year basis.
DSM = number of days from settlement to maturity.
DIM = number of days from issue to maturity.
A = number of days from issue to settlement.
Example
A bond has the following terms:
February 15, 1999, settlement date
April 13, 1999, maturity date
November 11, 1998, issue date
6.1 percent semiannual coupon
6.1 percent yield
30/360 basis
The price (in the 1900 date system) is:
PRICEMAT(“2/15/1999″,”4/13/1999″,”11/11/1998”,0.061,0.061,0) equals 99.98449888