The Clash of the Titans Part I – Meet the Regulators

It decides how much your home is going to cost. It has a direct role in controlling inflation. But perhaps you already know about the role of the giant bank of the banks. Hundreds and thousands are trying to predict its next move every moment, some of them making money in the process and others losing it. Let us introduce you to some more delicate functions of the greatest and oldest regulator of the Indian marketplace. Every exporter, importer and anyone else exposed to price fluctuations of foreign currencies must follow the moves of this regulator, read the signs to predict its next move and here is why.

A brief background to the exercise

The story of independent India is rife with political controversies. Some of the major landmarks in this story are Land Reforms from independence till the 1970s, the Emergency of 1975, the Balance of Payments crisis in early 1990s and subsequent liberalization. The people behind each of these landmarks were closely connected with ground level politics – they were people closely involved with the freedom movement, or they were in the Government or were its fiercest critics in the Opposition party.

Welcome to the post-recession era. The political landscape of India is overshadowed by the turf wars amongst regulators of economic activity in India – SEBI (the capital markets regulator), IRDA (insurance sector regulator), RBI (banking, and to some extent, foreign investment), FIPB (exclusively for foreign investment), TRAI (telecom), and the Competition Commission (for competition and antitrust law). These are the bodies every foreign investor having an eye on the Indian market will closely watch.

In the last couple of years, each of these regulators have been feverishly involved and asserted their supremacy in the sphere of their operation. Sometimes, there have been conflicts of jurisdiction, and at others, ordinary political controversies where their genuine involvement as watchdogs, has helped them reinforce their importance in the eyes of investors. For any individual to have a comprehensive understanding of his field, it is important to note existing and proposed regulatory developments in it. These are often the small game-changers, which when together with other regulatory and legislative moves, redefine an entire industry’s landscape.

In this post and the posts that follow, we feature some of the key moves that have shaped the activities of India’s most powerful regulators in the recent past from an investor’s perspective. While all of them are not controversial, they have nevertheless been mentioned as they constitute small steps by which each regulator has asserted its presence and supremacy in its own respective domain and contributed to the development of the industry related to it.

In this post, we cover the Reserve Bank of India (RBI). In the posts that follow, we shall discover some of the most interesting moves taken by SEBI, Competition Commission of India and the Department of Telecom (DoT) and Telecom Regulatory Authority of India (TRAI).

Regulator One: The Reserve Bank of India (RBI)

Sector: Banking and Finance

The biggest problem of the RBI has been to control inflation. Its monetary policy has to straddle a fine line in order to maintain high growth rate and control inflation, both of which cannot always be simultaneously controlled. Apart from that RBI has brought out some significant changes in the past years – currency derivatives in 2008 and an innovative financial product known as STRIPS, which is described below.

a. Currency Derivatives

An example of a currency derivative transaction would be one where a person agrees to buy or sell a particular currency, say US dollar, at a fixed price (measured in, say, the Indian rupee, at Rs. 45), at a future date. This is a currency future. This ensures that the person entering the transaction is able to prevent his cost of the dollar from fluctuating wildly, as he has agreed to a price which he would buy at from the other party. Of course, if in the future, the dollar is actually cheaper (say, Rs. 43), he would have to pay the higher price, as his futures contract mandatorily requires him to buy the dollar at that price.

Trading has been permitted in currency futures since August 2008, just before the global financial crisis had struck. In 2008, as per the RBI Guidelines, trading in currency futures was limited to US dollars and Rupees, but in January 2010 it was extended to Pound Rupee, Euro Rupee and Yen Rupee. Trading in currency options has not yet been permitted. However, RBI and SEBI are planning to allow it very soon. Currency options would allow a person to choose whether or not he intends to purchase the dollar at the price mentioned in his contract, which will be determined by whether the currency at the given time in the market is cheaper or more expensive than what is mentioned in the contract.

b. STRIPS (Separate Trading of Registered Interest and Principal of Securities)

Another financial product is known as STRIPS, where the principal and interest component of a security are separated and sold separately. For example, a bond of Rs.60 may be stripped into an interest component of say, Rs.5 and a principal component of Rs. 55. The principal and the interest component are each sold at a discount to the face value, say, Rs. 45 for the Principal component and Rs. 2 for the interest component. Over the duration of the bond, the holder of the bond will get the amount stated in the face value of the instrument.

Why invest in STRIPS

STRIPS are useful for the following two reasons as they reduce ‘reinvestment’ risk. In an ordinary scenario, if a person has a 5-year bond of Rs. 60, say at 10 percent interest, he shall get an annual interest payment of Rs. 6. That interest payment of Rs. 6 would ideally be sought to be reinvested. However, interest rates would be different at the time the Rs. 6 is due, which means that the rate at which the payment can be reinvested may be lower than the original interest rate of 10 percent. An investor would have preferred a situation whereby he could get the same 10 percent over all the interest payments during the lifetime of the bond.

In the case of a STRIPS, the bond is sold at a discount to the face value and one redeems the entire face value of the bond at the time of repayment (5 years in the above example), which factors in the same interest rate for all the payments due over the entire life of the bond and pays it all in a lumpsum. Investors hence do not suffer the risk of falling interest rates.

In fact, post the recession, the United States has been in a near zero interest rate regime. Interest rates in India have also been very low since the recession. The reason for having low interest rates is that they discourage savings and encourage investment and consumption, which means that more goods are produced and consumed, which helps an economy to move out of recession.

Securities that can be sold as STRIPS

RBI has permitted stripping and reconstitution of limited Government securities. Their interest payment or maturity should be on January 2 or July 2, and they must not have a floating interest rate. Typically, a fixed rate of interest has a fixed percentage amount payable by way of interest, such as 10%, 15%, etc. In a floating rate of interest, the interest is payable depending on a variable rate, such as the LIBOR (London Interbank Offered Rate) or the MIBOR (Mumbai Interbank Offered Rate) plus or minus a certain percentage.

The converse of the stripping process is known as reconstitution, where the interest and principal are combined and sold together, and is permitted for the same set of securities.

This was a brief overview of some of the newer instruments introduced by the RBI. The next post shall cover some of the measures introduced by SEBI.