Weekend Reflections – Week ending 10th August 2024

Week ending 10th August 2024

1. Markets

The Bank of Japan (BoJ) increased interest rates for the first time since 2007, leading to significant disruptions in both Japanese and global markets. This rate hike impacted carry trade strategies, where investors borrow in low-interest currencies like the yen to invest in higher-yielding assets. The strengthening of the yen due to higher rates has increased the cost of repaying loans, causing losses and leading to the unwinding of carry trades. This unwinding has triggered global selloffs, with the Nikkei 225 Index experiencing a 12.4% drop in a single day, the largest since 1995. Major Japanese companies, including those with Warren Buffett’s exposure, saw their stock prices fall by more than 10%. The BoJ later announced that there would be no further rate hikes, which led to a gradual weakening of the yen and a cooling of the markets.

In India, the unwinding of the yen carry trade, geopolitical tensions, and concerns about a slowdown in developed economies led to a 3% drop in the markets. However, by the end of the week, positive global cues resulted in gains, with the Nifty and Sensex closing higher at 79,706 and 24,368 on Friday. Bond markets in India saw yields soften to 6.87%. The global market turmoil, coupled with concerns about a US recession, led to a decline in global bond yields, with the 10-year US Treasury yield dropping to 3.78% before recovering slightly.

The unwinding of the massive yen carry trade, followed by a quick appreciation of the dollar-yen pair and a sharp correction in world equity markets, raised fears of a US recession and increased calls for faster-than-expected interest rate easing in the US. The BoJ’s announcement of suspending further hikes cooled the markets, and US markets responded with optimism, with all three broad indices ending the week up by 1.5%.

Goldman Sachs increased its estimate of the probability of the US slipping into recession next year from 15%. As a result, global bond yields have plunged, with the 10-year US Treasury yield falling by approximately 37 basis points to touch a low of 3.78% on 5th August, before recouping to 3.90%. The futures market is pricing in more than 110 basis points of cumulative rate cuts by the Fed by December 2024.

2. RBI

2.1 Key Takeaways from the 50th Monetary Policy Committee (MPC) Meeting:

1. Policy rates remain unchanged: Repo rate at 6.5% (unchanged for the 9th time).
   • Even if projected inflation is sliding towards its target, the other aim—financial stability—could prevent the RBI from easing monetary policy. Especially when growth is resilient, unlike in the US or Europe where predictions are for a recession, the RBI can continue to keep a tight leash.
2. Inflation projected at 4.5% for FY25:
   • While core inflation moderated, food inflation remains a significant concern, contributing over 75% to headline inflation in recent months.
3. GDP growth projected at 7.2% for 2024-25:
   • The RBI is sticking to its projections, though they differ from those of international agencies and credit rating institutions.
4. Introduction of a public repository for digital lending apps to combat unauthorized lending:
   • The RBI is concerned by the growth in unsecured lending despite the increase in risk weights and additional measures initiated last year.
5. Enhancement of transaction limits and introduction of delegated payments under UPI:
   • In line with average tax payments, the transaction limit has been increased to Rs. 5 lakhs. For transactions like IPOs, loan collections, and insurance, medical, and educational services, a higher limit has been permitted, aligning with increased usage.
   • Delegated payments will enable an individual (primary user) to allow another individual (secondary user) to make UPI transactions from the primary user’s bank account. The limit for such transactions will be set by the primary user. This will enhance UPI adoption in rural areas by linking to primary accounts situated in urban areas.
6. Continuous clearing of cheques to speed up the clearing process within a few hours:
   • The Cheque Truncation System (CTS) currently processes cheques with a clearing cycle of up to 2 working days using batch processing. This will now change to continuous clearing, reducing the time from T+1 to a few hours.
7. RBI has shortened the frequency of reporting credit information of borrowers to credit information companies (CIC) to 15 days from monthly intervals:
   • This move will provide a more up-to-date picture of a borrower’s indebtedness.
8. Concerns about increasing reliance on high-cost domestic short-term deposits causing misalignment and ALM risks caused by larger credit growth lagging deposit growth:
   • Concerns about violating Loan to Value norms and top-up loans on collateral without monitoring end use for speculative activities like gold loans.
   • RBI data shows that deposits rose 10.6% YoY as of July 26, compared to 12.9% in the same period a year ago, while credit grew at 13.7% compared to 19.5% a year ago.
   • While the proportion of top-up loans to the overall loan book is small, these unsecured lending segments have seen an average growth of 33% over the past couple of years, more than double the 12-14% growth in credit.
   • Banks have written off loans worth ₹9.90 lakh crore in the last five financial years, ₹1.70 lakh crore in FY24 compared to ₹2.08 lakh crore in FY23, as informed to Parliament on Tuesday.

2.2 RBI’s Draft Circular on Regulatory Principles for Managing Model Risks in Credit:

• RBI has expressed concerns over the efficacy of credit risk models used by banks and NBFCs in its draft circular issued last week. Model risks refer to unexpected outcomes arising from reliance on algorithm-based credit risk models by NBFCs. This is likely to come into force in three months, and lenders using credit models need to align those within six months.
  • While lenders use various models for borrower selection, credit scoring, and pricing decisions, the outputs are exposed to uncertainties as they are based on assumptions that may not manifest as envisaged in real-world scenarios.
  • Lenders need to put in place a board-approved policy on their model risk management framework to ensure prudence in their credit decisions. The board-approved policy should cover details of governance and oversight, including monitoring by internal audit, processes around model development or selection, and documentation for models deployed.
  • RBI’s concerns stem from the unfettered growth in consumption and personal loans driven purely by risk models. Probability of Default (PD) and Loss Given Default (LGD) could be built by lenders’ experience, and this will reflect in PD assumptions. Lenders may end up providing for this in case there are deficiencies in these models.

2.3 Back to Banks? – Supreme Court Decision Last Week on MSMEs:

• The Supreme Court reversed the earlier High Court decision that banks are not obliged to adopt the restructuring process on their own or that the framework, as revised from time to time, could not be said to be mandatory. This inferred that MSMEs must seek necessary restructuring from the lender. Banks argued that the SARFAESI Act overrides the provisions of the MSME Act and that the framework instructions were mere directories and not mandatory.
• The Supreme Court has held that banks and Non-Banking Financial Companies (NBFCs) are bound to adopt a restructuring process for Micro, Small, and Medium Enterprises (MSMEs) on their own without any application from the latter, as directed by the Central Government and the RBI in 2015 and 2016, respectively.

This appears to be a retrograde step as mandating banks to initiate restructuring without any initiative from borrowers who are primarily responsible—MSMEs—does not stand the test of stakeholder responsibility.

2.4 The Banking Laws (Amendment) Bill, 2024:

The Bill, introduced in the Indian Parliament on August 9, 2024, proposes several significant reforms. Here are the key features of the Bill:

1. The Bill allows depositors to nominate up to four individuals per bank account, compared to the current limit of one. This will provide greater flexibility and convenience for depositors and their legal heirs, ensuring that succession is handled more efficiently.
2. The threshold for what constitutes a ‘substantial interest’ in bank directorships has been raised significantly from the outdated amount of ₹5 lakh (set in 1968) to ₹2 crore. This amendment aims to reflect the current economic realities and ensure that the definition remains relevant.
3. Banks will gain more autonomy in determining the remuneration of their statutory auditors, allowing them to make decisions that better align with their financial strategies and requirements.
4. Unclaimed dividends, shares, and other financial assets will be transferred to the Investor Education and Protection Fund (IEPF). This move ensures that investors’ interests are protected and that the assets can be claimed or refunded as needed.

3. SEBI

3.1 SEBI Reversed Its Earlier Decision on Valuation of Tier I (AT-1) Bonds:

• The valuation of additional Tier-1 (AT-1) bonds by mutual funds shall now be based on yield-to-call.
  • The National Financial Reporting Authority (NFRA) has recommended that since the market practice for AT-1 bonds was to trade at prices closer to the yield-to-call, the valuation of such bonds on a yield-to-call basis—adjusted with appropriate risk spreads—would be consistent with principles of market-based measurement under Ind AS 11r reporting standards.
  • SEBI had earlier mandated that AT-1 bonds be valued with a 100-year period as perpetual bonds have no date for redemption. However, these bonds have call options at pre-announced intervals like 5 or 10 years, as per the terms of issue. Since none of the banks have relinquished the call dates, markets have been pricing these bonds on yield to the nearest call dates.

This long-awaited correction has been implemented, and yields on these bonds are expected to soften with demand surging further. It could not have come at a better time, as banks are resorting to more such issuances caused by lagging deposit growth compared to credit growth.

3.2 SEBI Proposed Uniform Timelines for Bonus Shares Issue:

• Under the current ICDR (Issue of Capital and Disclosure Requirements) rules, there are no specific timelines for the credit of bonus shares and trading of such shares from the record date of the issue.
  • Currently, after a bonus issue, existing shares continue to trade under the same ISIN, and the new bonus shares are credited and available for trading within 2-7 working days post-record date.
  • The shares allotted pursuant to the bonus issue will now be made available for trading on the next working date of allotment (T+2 day).

This is a welcome move as it is necessary to have uniformity and ensure the timely credit and trading of bonus shares. Prescribing timelines for credit and trading of bonus shares from the record date will help to ensure the timely implementation of the issue of bonus shares.

3.3 SEBI Issued Fresh Guidelines to Curb Front-Running Through Institutional Mechanisms:

• Asset Management Companies (AMCs) need to have an escalation process, whistleblower policy, and alert-based surveillance systems for detecting suspicious activities. A record of such alerts will be part of the mandatory half-yearly reports that AMCs submit to SEBI.
  • The onus of responsible conduct has been placed on the CEO or MD and the Chief Compliance Officer of the AMC.
  • AMCs shall also lay down Board-approved written policies and take action in case of potential market abuse by employees and connected entities. Any potential market abuse will have to be dealt with sternly, including suspension or termination of such persons/entities.

The latest measures are aimed at identifying and curbing misconduct such as front-running, insider trading, misuse of sensitive information, and fraudulent transactions in securities at Asset Management Companies. This follows the suggestions made in the consultation paper SEBI floated in May 2023. Experts acknowledge that while these measures might initially increase operational costs, they are expected to create a level playing field for all market participants in the long run.

3.4 SEBI Proposed a New Asset Class Positioned Between Mutual Funds (MFs) and Portfolio Management Services (PMS):

• This initiative aims to cater to investors with investible funds ranging from ₹10 lakh to ₹50 lakh, bridging the gap between MFs, which have lower ticket sizes as low as ₹500, and PMS, which typically require a minimum of ₹50 lakh. This new asset class will provide more flexibility and higher risk-taking capabilities within a regulated framework.

Key Features:

1. A minimum investment of ₹10 lakh.
2. Existing mutual funds with an average asset under management (AUM) of ₹10,000 crore over the last three years are eligible to launch products.
3. This asset class will offer “investment strategies” such as Long-Short Equity Funds and Inverse ETFs, which are currently not allowed under regular mutual funds due to their high-risk nature. These strategies can use derivatives beyond just hedging and rebalancing, providing greater flexibility and the potential for higher returns.
4. Limits on derivative exposure: gross exposure at 100% and single stock exposure at 10% of net assets, with exposure to ETFs limited to 50%.
5. Redemption frequency will vary from daily to annually depending on the investment strategy. To enhance liquidity, units of these investment strategies may be listed on recognized stock exchanges, especially for strategies with longer redemption cycles.

With MF AUM at ₹59 trillion and alternate assets, including PMS, recording a CAGR of 26% over the last five years, reaching ₹14 trillion, there is a growing need for a product with a higher risk appetite. This asset class draws parallels with similar products abroad, such as Hedge Fund Lite in the US and Inverse Funds in Australia, which offer high-risk, high-reward strategies with varying degrees of liquidity and cater to the evolving needs of more sophisticated investors in India.

3.5 SEBI Proposed Harmonizing Disclosure Requirements for Foreign Portfolio Investments (FPIs):

• SEBI proposed extending disclosure requirements to subscribers of Offshore Derivative Instruments (ODIs) or Participatory Notes (P-notes) and sub-funds of FPIs.
  • ODIs are investment vehicles used by overseas investors to gain exposure to Indian equities or equity derivatives. The ODI issuer remains the owner of the underlying securities, but the economic benefits of such holdings are transferred to the ODI subscriber.
  • Currently, FPI regulations state that ODIs can be issued by Category I FPIs to eligible persons after compliance with KYC norms. The FPI Master Circular of 30th May provides additional conditions like reporting of suspicious transactions, periodic review of systems, investment limits, and monthly ODI reporting, etc. However, these disclosure requirements are not applicable to ODI subscribers, which has enabled foreign investors to potentially circumvent granular disclosure obligations.
  • SEBI apprehends possible misuse of the FPI route for circumventing regulatory requirements due to potential regulatory arbitrage between investments made through ODIs or FPIs with segregated portfolios.

In view of these factors, SEBI has proposed to make the disclosure requirements applicable to FPIs directly applicable to ODI subscribers and segregated portfolios of FPIs. Obtaining such disclosures at a group level for global ODI subscribers may pose a significant challenge for the FPI and SEBI to correlate to those disclosures. Markets expect that implementation could see a possible decline in the value of ODI investments.

3.6 SEBI Unveiled Proposals for Liberalizing the Framework for Registered Investment Advisors (RIA):

• For Principal Officers and Assistants, the qualification requirement has been relaxed from a postgraduate degree with 5/2 years’ experience to a graduate degree in finance or related fields without experience.
  • Instead of undergoing exams every three years, tests are proposed only on certain developments in the investment space.
  • Mandatory corporatization is proposed upon reaching 300 clients or ₹3 crore in fees. The fee limit is applicable to advice on securities under SEBI regulations, not for insurance or bank deposits.
  • Net worth norms have been removed for individuals, and for corporates, they have been reduced from ₹50 lakh to ₹5 lakh for up to 1,000 clients and ₹10 lakh for clients above 1,000.

The liberalized regulations may attract more individuals to become RIAs and research analysts (RAs) and encourage formal routes to financial information, checking the rise of unregulated financial influencers on social media. This will help transition individual RIAs to corporate entities.

4. Economy

4.1 World Bank Study Released Last Thursday:

• A World Bank study released on Thursday warned that more than 100 countries—including India, China, Brazil, and South Africa—face serious obstacles that could hinder their efforts to become high-income countries in the next few decades. The report provides a comprehensive roadmap to enable developing countries to escape the “middle-income trap,” proposing a “3i strategy” for countries to reach high-income status.

Key Findings:

• It will take India 75 years, China more than 10 years, and Indonesia nearly 70 years to reach one-quarter of the US per capita if they stick to current strategies.
• Since 1990, only 34 middle-income economies have managed to shift to high-income status—and more than a third of them were either beneficiaries of integration into the European Union or of previously undiscovered oil.
• Drawing on lessons from the past 50 years, the report finds that as countries grow wealthier, they usually hit a “trap” at about 10% of annual US GDP per person—the equivalent of $8,000 today. The report calls it the ‘middle-income trap’ because that amount is in the middle of the range of what the World Bank classifies as middle-income countries.
• India needs to adopt a ‘3i’ strategy with a focus on investment, infusion, and innovation.

4.2 McKinsey Report Released Last Week:

• The contribution of family-owned businesses (FOBs) to India’s GDP is projected to reach 80 to 85 percent by 2047. Currently, FOBs contribute more than 75 percent of national GDP, one of the highest percentages in the world.
  • The report analyzed 300 publicly listed family-owned businesses, each with annual revenues of over ₹2,000 crore at least once in the past five years. According to the report, priorities often change following the founding generation. The initial focus on achieving high growth, even at the expense of liquidity, transitions to an emphasis on preserving wealth, which generally results in lower growth and performance.

4.3 Barclays Hurun India Report:

• The top three Indian family businesses’ interests equal Singapore’s GDP of $460 billion.
  • The Ambani family leads the most valuable family businesses list with a valuation of ₹25.75 lakh crore, followed by the Bajaj (₹7.13 lakh crore) and Birla (₹5.39 lakh crore) families.

4.4 HSBC India Services Business Activity Index:

• The index, released last week, indicated a slight dip in activity.
  • The index eased from 60.5 in June to 60.3 in July, still indicating expansion.
  • Domestic sales benefited from strong demand and a growing online presence, while export orders also rose significantly, driven by countries like the US, China, and Brazil.
  • However, rising input costs, particularly for labor and materials like eggs, meat, and vegetables, led to a 7-year high in service sector charge inflation.

5. PE/VC

5.1 H1 2024 IVCA Report – For the 6 Months Ending June 2024:

Private Equity:

• 431 Private Equity (PE) investments worth ₹1,21,718 crore ($14.63 billion).
• Funds with AIF vehicles participated in 244 investments.
• 233 DPIIT-registered startups raised PE funding worth ₹24,651 crore ($2.96 billion).
• 134 PE exits harvested ₹83,614 crore ($10.05 billion).
• India-focused funds raised ₹39,322 crore ($4.73 billion) across 27 funds.

Venture Capital:

• 278 VC investments worth ₹10,341 crore ($1.24 billion).
• Funds with AIF vehicles participated in 167 investments.
• 184 DPIIT-registered startups raised VC funding worth ₹6,685 crore ($803.17 million).
• 30 VC exits harvested ₹4,193 crore ($504 million).

5.2 Investments in Generative AI:

• Investments in the Generative AI space have seen significant traction since 2023, with the number of firms on the rise.
  • Compared to 18 transactions in 2023 aggregating $349 million, till June 2024, 15 transactions have been done aggregating $210 million so far.
  • Despite the funding winter, AI continued to be a major focal point for investors.
    • 86% of the new funding commitments in AI-backed startups.
    • 74% of the new deep tech startups in 2023 were AI-centric.
    • According to Nasscom’s Gen AI Tracker, Gen AI startup investments in India doubled between H1 2023 and H1 2024, even as the number of funding rounds nearly halved between H2 2023 and H1 2024.