Can state governments never default? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster
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Can state governments never default? 

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In this issue:
» Europe's two speed economy
» No respite for Posco despite green nod
» Should retail investors follow FIIs while investing in equities?
» Piped Gas, CNG likely to cost more from April
» and more....


00:00
 
India is a decentralized democracy of one billion inhabitants and 28 states. More than half of central government expenditures are undertaken by state and local governments. In order to fund these expenditures, the state government issues bonds.

State government bonds (called as State Development Loans) are debt issued by state governments to fund their fiscal deficit. Most states in India like the centre run budgets where expenditure is higher than revenue leading to deficits. SDL issues are managed by the RBI, which also makes sure that the SDL's are serviced by monitoring escrow accounts for payment of interest and principal.

State governments also raise money by issuing bonds through state level undertakings (SLU). SLUs are companies managed by state governments and the bonds issued by them are backed by the state government. They also offer higher return than SDL.

Thus as banks shut their doors, arms of different state governments are turning to provident funds (PFs) to raise money. According to Economic Times, at least seven state undertakings are in the fray to sell debt to PF bodies. Four of them have already launched their offerings. But are bonds issued by SLU default free? Should PF, gratuity funds and banks invest in these bonds especially since most of the SLU are loss making?

The starting point for constructing investment portfolios is the risk free rate of return. Generally, government bonds are considered risk free as it is widely believed that a government will never default on its obligations. SLU instruments provide high returns with a level of security as they come with state government guarantees. Still, they face the risk from any major deterioration in state finances, be it for natural calamity or something else, which may result in dilution of the guarantee. Some funds don't invest due to fear of credit risk and defaults because of a few instances in the past. Often, it can also be difficult to invoke state guarantees following a default.

Thus, the misnomer that state and central governments can never ever default need to be done away with. And that loss making state undertakings are issuing bonds to PFs needs to be viewed with caution. The municipal bond market in the US had a terrible run in 2013 needs to be a lesson for investors. Else India may be headed to its own government debt crisis.

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01:12  Chart of the day
 
The job market has its fortunes linked to the state of the economy. In a slowdown, companies cut costs to protect margins and so jobs added are few. Even as India struggled with poor demand in 2013, the job market picked up in tier 2 and tier 3 cities. IT, BPO and banking sectors were the big job creators in 2013. According to Business Insider, Ahmedabad was the front-runner among tier 2 cities in new job offers, followed by Indore and Jaipur. Together the three cities added 2.5 lakh jobs during the year particularly in the pharmaceutical and BPO sectors. Among major cities, Delhi topped the list with 8.6 lakh new job offerings out of which 10,245 jobs were fresher jobs. Bengaluru and Mumbai were the other big cities where new jobs were added.

Which Indian cities created maximum jobs in 2013?


02:00
 
The Bank of England and European Central Bank kept their policy rates unchanged last week at 0.5% and 0.25% respectively. However, when it comes to the future it seems their outlooks might be slightly different. Or as mentioned on CNN's website, both the banks are facing different set of challenges. While things are seemingly improving at a rate faster than expected in England, quite the opposite is happening in the Euro zone. Growth in the Euro zone seems to be in question following the sharp decline inflation rates in the region - which led the central bank to cut rates to 0.25% in the previous month. The bank is currently taking a wait and watch approach, keeping its eye on the inflation levels. The challenge the bank faces now relates to risk of deflation. And all this comes in at a time when the regional unemployment figures stand at a high rate of 12%! In the UK, things are quite the opposite. Unemployment levels are likely to come below the 7% threshold mark faster than expected. This is due to the accelerating growth rates in the region. What would be the future course of actions the two central banks would be interesting to see! But from the looks of it, it does seem that the ECB would continue to go the Fed way.

02:40
 
Reforms and legal clearances alone cannot and do not guarantee long term investments into India's infrastructure. The environmental approvals that marked the end of Korean steel maker POSCO's eight year long wait is a case in point. Many corporates thought that celebrations were on the anvil. Especially with India's infrastructure story kick starting yet again. However, as an article in Firstpost points out, any celebrations and optimism may be premature. For the initial set of approvals are not just insufficient but also have several loose ends before the project can come on stream. For now, the project has received the nod from the Union Ministry of Environment and Forests (MoEF). It may also get the National Green Tribunal (NGT) for felling of trees on the land acquired for the project. However, the Korean miner has yet to get any clarity on the approvals for the captive port necessary for the project. And unless and until that is fetched, POSCO, despite its long term commitment, may not be willing to invest a penny into the project. Whether such a long and winding wait for project approvals will continue to hurt FDI into India is anybody's guess. However, what investors need to reckon is that political intent alone is not the answer to India's infrastructure problems. Moreover, the haste in approving long pending projects barely months before elections is also questionable.

03:20
 
FII flows have quite an impact on the movement of stock markets in India. So it is hardly surprising that these flows are widely tracked. But does that mean that you should let FIIs influence your decision while investing in stocks? It is natural that when there is huge inflow into certain stocks, the interest in such stocks gets piqued. But it is essential to understand the reason for such large scale buying. Are these FIIs investing for a valid long term fundamental reason? Or are they looking to make a quick buck? Similarly, when there is a large scale sell off, once again understanding the reasoning behind the same becomes important? Is something wrong with the fundamentals of the company? Or is it more a case of FIIs requiring liquidity and hence they are selling in large numbers?

Because central banks in the developed world have unleashed a wave of liquidity, FIIs have been putting this money into many emerging markets including India. Hence, stock prices in India have surged. At the same time, when news of the US Fed starting its QE taper first began to make rounds, there was heavy selling on the Indian bourses. Which is why, basing your investment decision on FII movements is not prudent we believe. Choose stocks after taking into account the soundness of the business model and quality of management. And if a large scale sell off by foreign institutional investors (FIIs) in these stocks results in the prices being attractive, then an investor should take an opposite view and consider buying those stocks instead.

04:00
 
It's been almost half a year since the Government surprised us all with the announcement of gas price hike. It is quite ironical that while for other economies like US gas costs have quite come down, for India the case is just opposite. Beginning from April this year, the domestic gas prices are likely to double. With higher gas prices charged for piped natural gas (PNG) and compressed natural gas (CNG), the common man is likely to bear the brunt. However, whether this price hike brings any positive change in the supply scenario is something that is yet to be seen. Another important thing to take note of is that even Reliance Industries Ltd that has failed miserably on the supply commitments will also be allowed to charge gas prices in lieu of the bank guarantee. The guarantee has been demanded to cover the liability if the gas hoarding charges against the company are proved. We believe that once again the company has been given undue favour despite taking national strategic resources for granted. As far as gas hoarding allegation is concerned, nobody knows when such charge will be proved; if at all there is a way to prove it.

04:35
 
After opening the day on a mixed note, Indian stock markets is trading on a strong footing. At the time of writing, the benchmark BSE-Sensex was up by 247 points (1.2%). While sectors such as Healthcare, Metals, Power and Realty are witnessing maximum selling pressures, IT and Banking stocks are gathering favour. Barring, China and Singapore stock markets, all other Asian indices are trading firm.

04:55  Today's investing mantra
"You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets." - Peter Lynch
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3 Responses to "Can state governments never default?"

Sunjoy

Jan 14, 2014

The very thought of PF funds getting invested in State Government Undertakings Bonds is frightening. How can I withdraw my PF ?

Like 

Nandn

Jan 14, 2014

There is risk to every thing and I can not think of any product which is risk free.

Like 

Vipul Gor

Jan 13, 2014

State Government, in India will not default, as RBI debits the overdraft account of the respective State and make the payment.

Like 
  
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