The Impending FCCB Conundrum

Foreign currency convertible bonds (FCCBs) have been issued by Indian companies, whereby investors have the option to convert these debt instruments into equity. Such conversion would normally occur when the market price of equity shares at the time of conversion is higher than the conversion price. But, with the markets now moving in the wrong direction, it is unlikely that the FCCB holders will exercise their conversion options. That means they will likely redeem the FCCBs, which partake the nature of repayment of debt. An event less expected by Indian borrowers, this would not only impose huge financial burden on Indian borrowers (who have to raise the cash to meet their obligations), but could also result in various accounting and other related issues.

These aspects have been covered in detail in this column by Rajrishi Singhal in the Economic Times.

(For more on FCCBs, and how they are different from Foreign Currency Exchangeable Bonds (FCEBs), please see this earlier post)

Update – July 10, 2008: See also this column in the Hindu Business Line

Differential Voting Rights: Some Further References

In earlier posts (here and here), this Blog had covered the issue of differential voting rights by Indian companies.

A recent column by Srikanth Srinivas in the Business World examines the business rationale for the issuance of shares with differential voting rights and also the pros and cons of such instruments. The key objectives that companies seek to achieve through shares with differential voting rights are to guard against shareholder activism (e.g. the kind initiated by hedge funds in U.S. and U.K. companies) and against hostile takeovers (so as to protect the interests of the promoters and incumbents in management). However, the column also advocates the exercise of caution on this front:

“How worried should investors be about differential voting rights? Making voting power proportional to economic ownership serves several goals. First, economic ownership gives shareholders an incentive to exercise voting power well. Second, the coupling of votes and shares strengthens the framework for corporate governance. Third, the power of economic owners to elect directors is a basis for legitimacy of managerial authority.

The evidence on corporate governance generally supports the importance of linking votes to economic interest. Voting rights are like property rights to cash flows of the company: decoupling economic and voting rights may benefit a controlling minority structure whose objectives may not quite coincide with that of the rest of the shareholders.

The issue also goes beyond just controlling minority structures. The derivatives revolution and other capital markets developments now allow both outside investors and insiders to decouple economic ownership of shares from voting rights. This decoupling — also called the new vote buying — is a worldwide issue. So before you endorse the idea of differential voting rights, think again.”

Similar issues have also been identified in an investing column in the Business Standard.

What is peculiar with differential voting rights is the timing of its emergence in the Indian markets. While differential voting rights have been existent in other economies such as the U.S. and Europe for some time, there is now a conscious move in some of those economies (particularly in continental Europe) to shift away from differential voting rights and towards a “one-share one-vote” rule citing corporate governance and control concerns that arise in shares with differential voting rights. The trend appears to be exactly in the opposite direction as far as India is concerned; only time and experience will tell whether differential voting rights will benefit the investors in such shares or impose further risk to their capital.

Research Paper: Achieving India’s Growth Potential

Just as the Indian economy reels from its double-digit inflation to the tune of approximately 11%, Goldman Sachs, the leading investment bank, has issued its latest research paper titled Ten Things for India to Achieve its 2050 Potential. This is part of a series of papers published over the last few years by Goldman Sachs covering the BRIC economies of Brazil, Russia, India and China.

The paper builds on Goldman Sachs’ Growth Environment Scores (GES), in which India scores below the other three nations. Further, it ranks 110 out of 181 countries, and for 7 of the 13 components India scores below the developing country average. The current report contains some prescriptions for India to achieve its potential by 2050, noting that “[h]aving the potential and actually achieving it are two different things”. This effectively boils down the lack of proper implementation of reforms that slow down economic progress.

The following are the key recommendations extracted from the paper:

“We highlight ten key areas where reform is needed. In all likelihood, they are
not the only ten, but we consider them to be the most crucial:

1. Improve governance. Without better governance, delivery systems and effective implementation, India will find it difficult to educate its citizens, build its infrastructure, increase agricultural productivity and ensure that the fruits of economic growth are well established.

2. Raise educational achievement. Among more micro factors, raising India’s educational achievement is a major requirement to help achieve the nation’s potential. According to our basic indicators, a vast number of India’s young people receive no (or only the most basic) education. A major effort to boost basic education is needed. A number of initiatives, such as a continued expansion of Pratham and the introduction of Teach First, for example, should be pursued.

3. Increase quality and quantity of universities. At the other end of the spectrum, India should also have a more defined plan to raise the number and the quality of top universities.

4. Control inflation. Although India has not suffered particularly from dramatic inflation, it is currently experiencing a rise in inflation similar to that seen in a number of emerging economies. We think a formal adoption of Inflation Targeting would be a very sensible move to help India persuade its huge population of the (permanent) benefits of price stability.

5. Introduce a credible fiscal policy. We also believe that India should introduce a more credible medium-term plan for fiscal policy. Targeting low and stable inflation is not easy if fiscal policy is poorly maintained. We think it would be helpful to develop some ‘rules’ for spending over cycles.

6. Liberalise financial markets. To improve further the macro variables within the GES framework, we believe further liberalisation of Indian financial markets is necessary.

7. Increase trade with neighbours. In terms of international trade, India continues to be much less ‘open’ than many of its other large emerging nation colleagues, especially China. Given the significant number of nations with large populations on its borders, we would recommend that India target a major increase in trade with China, Pakistan and Bangladesh.

8. Increase agricultural productivity. Agriculture, especially in these times of rising prices, should be a great opportunity for India. Better specific and defined plans for increasing productivity in agriculture are essential, and could allow India to benefit from the BRIC-related global thirst for better quality food.

9. Improve infrastructure. Focus on infrastructure in India is legendary, and tales of woe abound. Improvements are taking place, as any foreign business visitor will be aware, but the need for more is paramount. Without such improvement, development will be limited.

10. Improve Environmental Quality. The final area where greater reforms are needed is the environment. Achieving greater energy efficiencies and boosting the cleanliness of energy and water usage would increase the likelihood of a sustainable stronger growth path for India.

Perhaps not all these ‘action areas’ can be addressed at the same time, but we believe that, in coming years, progress will have to be made in all of them if India is to achieve its very exciting growth potential."

While the research paper does well to identify key concerns relating to growth and the areas to be addressed, it does pose some fundamental issues at a macro level. One of the criticisms that may be levelled against the paper is that it does not present any new findings or prescriptions, and all of those contained in the report are well-known and debated (with perhaps little concrete action being taken). But, this critique is more to do with the form and less with the substance of the matters covered.

More fundamental is the approach towards some of the solutions to the problems. Here, one finds that most prescriptions turn towards market-based models of economic policy and liberalisation—for instance the recommendations for removal of capital controls, for liberalisation of the financial markets and so on. It is important to note, however, that all of those solutions may not directly apply in the Indian scenario. There is a need to contextualise the prescriptions for reforms so that they appropriately fit into the Indian macroeconomic framework as well as with its past experience. Some of the ideas (and materials) that support this thinking are as follows:

(a) Commentators have argued that some level of restrictions and governmental regulation on economic and financial activity may be necessary in the context of developing economies. Joseph Stiglitz is a leading proponent of this view, as he strenuously makes his arguments in his book “Globalization and Its Discontents”.

(b) Similarly, as far as India is concerned, arguments have been made that it is India’s partially restrictive policies that have helped weather the recent global credit crisis or even the Asian financial crisis that swept the region over a decade ago (see an earlier post on this blog).

(c) It is also useful in this context to review Dr. Shankar Acharya’s critique of the Draft Report of the High Level Committee on Financial Sector Reforms headed by Dr. Raghuram Rajan, where the point has been made about the need for taking into accounting the realities in India while examining the nature of reforms.

Creating Debt and Securitisation Markets in India

One of the constant criticisms of the Indian financial markets has been the lack of a liquid and vibrant market for debt securities on the one hand and that for securitised instruments on the other. In separate moves announced on the same day (June 19, 2008), SEBI has sought to alleviate both these concerns.

Debt Securities

The SEBI (Issue and Listing of Debt Securities) Regulations, 2008 sets up the regime for issuance of debt securities by companies, public sector undertakings as well as statutory corporations, both by way of a public issue as well as on a private placement basis. Unlike in the case of equity securities, there is no requirement to file an offer document with SEBI for debt securities. Appropriate disclosures are to be filed with the stock exchanges, and they shall be displayed on the websites of the stock exchanges. Although the disclosure requirements have been seemingly simplified, they still have to comply with requirements of Schedule II of the Companies Act, 1956 (since SEBI does not have the requisite powers to alter the requirements of the Companies Act).

Securitised Instruments

The SEBI (Public Offer and Listing of Securitised Debt Instruments), Regulations 2008 provides for public issue and listing of instruments that are issued by a special purpose vehicle (SPV) that purchases receives through securitisation. Although securitisation transactions have witnessed a fair level of size and regularity in the Indian markets, these were confined in the past to private transactions. Securitised debt was incapable of being listed on stock exchanges as there was some doubt as to whether it was a “security” as defined in Section 2(h) of the Securities Contracts (Regulation) Act, 1956 (SCRA). But, that doubt was put to rest last year when the SCRA was amended to include an additional element in the definition of a ‘security’ in Section ((h)(ie) as follows:

“any certificate or instrument (by whatever name called), issued to an investor by any issuer being a special purpose distinct entity which possesses any debt or receivable, including mortgage debt, assigned to such entity, and acknowledging the beneficial interest of such investor in such debt or receivable, including mortgage debt, as the case may be;”

Since the SCRA paved the way for creating a market for securitized debt, the recent regulations represent a step towards implementation of this regulatory intent. The Regulations set out the details of the SPV, the manner in which it can acquire receivables as well as the form of instruments it can issue. Unlike the regulations on debt securities which are more focused towards disclosures, the regulations relating to securitized debt are overarching and even govern several substantive issues pertaining to the transactions. This is perhaps explainable by the fact that the past experience of regulators the world over with securitisation markets has not entirely been positive. Securitisation, by its very nature, enables risk-holders to spread that risk over a wide array of investors (especially in the case of public offering of securitised debt), and this can result in a rapid spread of that risk among a larger group of people. This is precisely what occurred during the sub-prime crisis whereby sub-prime mortgage debt that originated in the U.S. was spread using securitisation and CDO (collateralised debt obligation) instruments.

There is considerable detail in the regulations pertaining to securitized debt, which may even warrant a separate detailed post in due course.