Blue Economy – Sagarmala Financial Engineering: Yet Another Dig. Skeletal Sketch of an Upcoming Talk in Somnath, Gujarat.

Authorized Share Capital in the case of Sagarmala happens to be INR 1000 crore, and is the number of stock units Sagarmala Development Company Limited (SDCL) has issued in its articles of incorporation. This ASC is open, in that share capital isn’t fully used, and there is ample room for future issuance of additional stock in order to raise capital quickly as and when a demand arises. SDCL can increase the authorized capital at anytime with shareholders’ approval and paying an additional fee to the RoC, Registrar of Companies. 

Capital Budgeting: Business determines and evaluates potential large expenditures/investments. Capital Budgeting is generally a long-term venture, and is a process that SDCL would use (and uses) to identify hat capital projects would create the biggest returns compared with the funds invested in the project. The system of ranking helps establish a potential return in the future, such that the SDCL management can choose where to invest first and most. Let us simply call it the first and most principle of budgeting. Blue Economy that instantiates itself via Sagarmala in India has options to choose from as regards its Capital Budgeting, viz. 

1. Throughput analysis – This defines the main motives behind a project, where all the costs are operating costs, and the main emphasis is on maximizing profits in passing through a bottleneck. The best example for Sagarmala speculatively thought out is the marking of Western Shipping Corridor for container traffic and posing a livelihood threat to traditional fishermen. Throughput is an alternative to the traditional cost accounting, but is neither accounting, not costing, since it is focused on cash flows. It does not allocate fixed costs to products and services sold or provided and treats direct labour as a fixed expense. Decisions made are based on three critical monetary variables: throughput, investment or inventory and operating expenses. Mathematically, this is defined as revenue minus totally variable expenses, the cost of raw materials or services incurred to produce the products sold or services delivred. T = R – TVE. 
2. Net Present Value (NPV) – this s the value of all future cash flows, either positive or negative over the entire life of an investment discounted to the present. NPV forms a part of an intrinsic valuation, and is employed for valuing business, investment security, capital project, new venture, cost reduction and almost anything involving cash flows. 

NPV = z₁/(1 + r) + z₂/(1 + r)² – X

      , where z₁ is the cash flow in time 1, z₂ is the cash flow in time 2, r is the discount       range, and X is the purchase price, or initial investment. NPV takes into account the timing of each cash flow that can result in a large impact on the present value of an investment. It is always better to have cash inflows sooner and cash outflows later. this is one spect where SDCL might encounter a bottleneck and thereby take recourse to throughput analysis. Importantly, NPV deliberates on revolving funds.  

3. Internal Rate of Return (IRR) – this is an interest rate at which NPV from all cash flows become zero. IRR qualifies attractiveness of an investment, whereby if IRR of a new project exceeds company’s required rate of return, then investment in that project is desirable, else project stands in need of a rejection. IRR escapes derivation analytically, and must be noted via mathematical trial and error. Interestingly, business spreadsheets are automated to perform these calculations. Mathematically, IRR is:

0 = P₀ + P₁/(1 + IRR) + P₂/(1 + IRR)² + …. + P_n/(1 + IRR)ⁿ

, where P₀, P₁,…, P_n are cash flows in periods of time 1, 2, …, n. 

 With a likelihood of venture capital and private equity expected in Sagarmala accompanied with multiple cash investments over the life-cycle of the project, IRR could come in handy for an IPO. 

     4. Discounted Cash Flow – this calculates the present value of an investment’s future            cash flows in order to arrive at  current fair value estimate for an investment. Mathematically, 

DCF =  CF₁/(1 + r) + CF₂/(1 + r)² + CF₃/(1 + r)³ + … + CF_n/(1 + r)ⁿ

, where CF_n are cash flows in respective n periods, and r is discount rate of return. 

DCF accounts for the fact that money received today can be invested today, while money we have to wait for cannot. DCF accounts for the time value of money and provides an estimate of what e should spend today to have an investment worth a certain amount of money at a specific point in the future. 

       5. Payback period – mathematically, this is defined as: 

Payback Period = Investment required/Annual Project Cash flow

This occurs the year plus a number of months before the cash flow turns positive. Though seemingly important, payback period does not consider the time value of investment/money, and is quite inept at handling projects with uneven cash flows. 

As a recap (and here, here, here)

Sagarmala is a 3-tier SPV structure

Private Players/PPPs OR EPCs/Turnkey – the latter are used for projects with high social impact or low IRR. 

Expenses incurred for project development will be treated as part of equity contribution by SDCL, or, in case SDCL does not have any equity, or expenses incurred are more than the stake of SDCL, SPV will defray SDCL. Divestment possibilities cannot be ruled out in order to recoup capital for future projects. 

Global Significance of Chinese Investments. My Deliberations in Mumbai (04/03/2018)

Legends:

What are fitted values in statistics?

The values for an output variable that have been predicted by a model fitted to a set of data. a statistical is generally an equation, the graph of which includes or approximates a majority of data points in a given data set. Fitted values are generated by extending the model of past known data points in order to predict unknown values. These are also called predicted values.

What are outliers in statistics?

These are observation points that are distant from other observations and may arise due to variability in the measurement  or it may indicate experimental errors. These may also arise due to heavy tailed distribution.

What is LBS (Locational Banking statistics)?

The locational banking statistics gather quarterly data on international financial claims and liabilities of bank offices in the reporting countries. Total positions are broken down by currency, by sector (bank and non-bank), by country of residence of the counterparty, and by nationality of reporting banks. Both domestically-owned and foreign-owned banking offices in the reporting countries record their positions on a gross (unconsolidated) basis, including those vis-à-vis own affiliates in other countries. This is consistent with the residency principle of national accounts, balance of payments and external debt statistics.

What is CEIC?

Census and Economic Information Centre

What are spillover effects?

These refer to the impact that seemingly unrelated events in one nation can have on the economies of other nations. since 2009, China has emerged a major source of spillover effects. This is because Chinese manufacturers have driven much of the global commodity demand growth since 2000. With China now being the second largest economy in the world, the number of countries that experience spillover effects from a Chinese slowdown is significant. China slowing down has a palpable impact on worldwide trade in metals, energy, grains and other commodities.

How does China deal with its Non-Performing Assets?

China adopted a four-point strategy to address the problems. The first was to reduce risks by strengthening banks and spearheading reforms of the state-owned enterprises (SOEs) by reducing their level of debt. The Chinese ensured that the nationalized banks were strengthened by raising disclosure standards across the board.

The second important measure was enacting laws that allowed the creation of asset management companies, equity participation and most importantly, asset-based securitization. The “securitization” approach is being taken by the Chinese to handle even their current NPA issue and is reportedly being piloted by a handful of large banks with specific emphasis on domestic investors. According to the International Monetary Fund (IMF), this is a prudent and preferred strategy since it gets assets off the balance sheets quickly and allows banks to receive cash which could be used for lending.

The third key measure that the Chinese took was to ensure that the government had the financial loss of debt “discounted” and debt equity swaps were allowed in case a growth opportunity existed. The term “debt-equity swap” (or “debt-equity conversion”) means the conversion of a heavily indebted or financially distressed company’s debt into equity or the acquisition by a company’s creditors of shares in that company paid for by the value of their loans to the company. Or, to put it more simply, debt-equity swaps transfer bank loans from the liabilities section of company balance sheets to common stock or additional paid-in capital in the shareholders’ equity section.

Let us imagine a company, as on the left-hand side of the below figure, with assets of 500, bank loans of 300, miscellaneous debt of 200, common stock of 50 and a carry-forward loss of 50. By converting 100 of its debt into equity (transferring 50 to common stock and 50 to additional paid-in capital), thereby improving the balance sheet position and depleting additional paid-in capital (or using the net income from the following year), as on the right-hand side of the figure, the company escapes insolvency. The former creditors become shareholders, suddenly acquiring 50% of the voting shares and control of the company.

The first benefit that results from this is the improvement in the company’s finances produced by the reduction in debt. The second benefit (from the change in control) is that the creditors become committed to reorganizing the company, and the scope for moral hazard by the management is limited. Another benefit is one peculiar to equity: a return (i.e., repayment) in the form of an increase in enterprise value in the future. In other words, the fact that the creditors stand to make a return on their original investment if the reorganization is successful and the value of the business rises means that, like the debtor company, they have more to gain from this than from simply writing off their loans. If the reorganization is not successful, the equity may, of course, prove worthless.

The fourth measure they took was producing incentives like tax breaks, exemption from administrative fees and transparent evaluations norms. These strategic measures ensured the Chinese were on top of the NPA issue in the early 2000s, when it was far larger than it is today. The noteworthy thing is that they were indeed successful in reducing NPAs. How is this relevant to India and how can we address the NPA issue more effectively?

For now, capital controls and the paying down of foreign currency loans imply that there are few channels through which a foreign-induced debt sell-off could trigger a collapse in asset prices. Despite concerns in 2016 over capital outflow, China’s foreign exchange reserves have stabilised.

But there is a long-term cost. China is now more vulnerable to capital outflow. Errors and omissions on its national accounts remain large, suggesting persistent unrecorded capital outflows. This loss of capital should act as a salutary reminder to those who believe that China can take the lead on globalisation or provide the investment or currency business to fuel things like a post-Brexit economy.

The Chinese government’s focus on debt management will mean tighter controls on speculative international investments. It will also provide a stern test of China’s centrally planned financial system for the foreseeable future.

Global Significance of Chinese investments

BASEL III: The Deflationary Symbiotic Alliance Between Governments and Banking Sector. Thought of the Day 139.0

The Bank for International Settlements (BIS) is steering the banks to deal with government debt, since the governments have been running large deficits to deal with the catastrophe of BASEL 2-inspired mortgaged-backed securities collapse. The deficits are ranged anywhere between 3 to 7 per cent of the GDP, and in cases even higher. These deficits were being used to create a floor under growth by stimulating the economy and bailing out financial institutions that got carried away by the wholesale funding of real estate. And this is precisely what BASEL 2 promulgated, i.e. encouraging financial institutions to hold mortgage-backed securities for investments.

In comes the BASEL 3 rules that implore than banks must be in compliance with these regulations. But, who gets to decide these regulations? Actually, banks do, since they then come on board for discussions with the governments, and such negotiations are catered to bail banks out with government deficits in order to oil the engine of economic growth. The logic here underlines the fact that governments can continue to find a godown of sorts for their deficits, while the banks can buy government debt without any capital commitment and make a good spread without the risk, thus serving the interests of the both parties involved mutually. Moreover, for the government, the process is political, as no government would find it acceptable to be objective in its viewership of letting a bubble deflate, because any process of deleveraging would cause the banks to offset their lending orgy, which is detrimental to the engineered economic growth. Importantly, without these deficits, the financial system could go down the deflationary spiral, which might turn out to be a difficult proposition to recover if there isn’t any complicity in rhyme and reason accorded to this particular dysfunctional and symbiotic relationship. So, whats the implication of all this? The more government debt banks hold, the less overall capital they need. And who says so? BASEL 3.

But, the mesh just seems to be building up here. In the same way that banks engineered counterfeit AAA-backed securities that were in fact an improbable financial hoax, how can countries that have government debt/GDP ratio to the tune of 90 – 120 per cent get a Standard&Poor’s ratings of a double-A? They have these ratings because they belong to a apical club that gives their members exclusive rights to a high rating even if they are irresponsible with their issuing of debts. Well, is that this simple? Yes and no. Yes, as is above, and no is merely clothing itself in a bit of an economic jargon, in that these are the countries where the government debt can be held without any capital against it. In other words, if a debt cannot be held, it cannot be issued, and that is the reason why countries are striving for issuing debts that have a zero weighting.

Let us take snippets across gradations of BASEL 1, 2 and 3. In BASEL 1, the unintended consequences were that banks were all buying equity in cross-owned companies. When the unwinding happened, equity just fell apart, since any beginning of a financial crisis is tailored to smash bank equities to begin with. Thats the first wound to rationality. In BASEL 2, banks were told to hold as much AAA-rated paper as they wanted with no capital against it. What happened if these ratings were downgraded? It would trigger a tsunami cutting through pension and insurance schemes to begin with forcing them to sell their papers and pile up huge losses meant to absorbed by capital, which doesn’t exist against these papers. So whatever gets sold is politically cushioned and buffered for by the governments, for the risks cannot be afforded to get any more denser as that explosion would sound the catastrophic death knell for the economy. BASEL 3 doesn’t really help, even if it mandated to hold a concentrated portfolio of government debt without any capital against it, for absorption of losses in case of a crisis hitting would have to exhumed through government bail-outs in scenarios where government debts are a century plus. So, are the banks in-stability, or given to more instability via BASEL 3?  The incentives to ever more hold government securities increase bank exposure to sovereign bonds, adding to existing exposure of government securities via repurchase transactions, investments and trading inventories. A ratings downgrade results in a fall in value of bonds triggering losses. Banks would then face calls for additional collateral, which would drain liquidity, and which would then require additional capital as way of compensation. where would this capital come in from, if not for the governments to source it? One way out would be recapitalization through government debt. On the other hand, the markets are required to hedge against the large holdings of government securities and so short stocks, currencies and insurance companies are all made to stare in the face of volatility that rips through them, of which the net resultant is falling liquidity. So, this vicious cycle would continue to cycle its way through any downgrades. And thats why the deflationary symbiotic alliance between the governments and banking sector isn’t anything more than high-fatigue tolerance….