The Financial Bomb Is Ticking Away
The failure of the credit rating agencies to blow the whistle in the Rs90,000 crore Infrastructure Leasing & Financial Services (IL&FS) scam,  business as usual despite 55 prosecutions filed by the ministry of corporate affairs (MCA)  against Pricewaterhousecoopers (PwC) auditors, the STC/Ispat scam – all these once again,  not only expose the  rampant corruption and  the blatant complicity of the regulators,  but also deliver a frightening message:  a huge financial bomb can explode any moment. 
 
Last month, credit rating agency ICRA Ltd, the local affiliate of Moody’s Investors Service, sent its managing director and chief executive Naresh Takkar on leave pending an enquiry into “anonymous" allegations against them by an executive. The complaint had been forwarded to the Securities and Exchange Board of India (SEBI).
 
The complainant had alleged that ICRA’s top brass had meddled in assigning high ratings to IL&FS and its subsidiaries. As is well known, since last September IL&FS has defaulted on its debt payments, triggering a liquidity crisis in the financial services market.  
 
Takkar was soon joined by Rajesh Mokashi, managing director and chief executive of credit rating agency CARE.  Mokashi was also sent on leave, pending completion of the examination of an anonymous complaint received by the SEBI.
 
The proponents of ‘Corporate Governance’, perhaps the most misused word in Indian corporate circles, couldn’t have been happier.  After all, what more can be expected from professionally managed boards.  But can one person in any organization be responsible for the entire mess? A few other insights expose the deep malaise. 
 
Role and Importance of Credit Rating Agencies
 
Credit rating agencies are supposed to be manned by professionals who understand the financial position and business plans of a given entity, are tuned in to the industry outlook, market challenges, state of the economy etc.. Such strengths, insights, due diligence and financial analytics are then put to work to assess the ability of its client, i.e., the borrower to meet its credit obligations on the due dates.
 
The result so arrived at is expressed as the number of times the cash flows of the concerned entity are expected to cover the repayment obligations. The higher the coverage, the stronger the repayment capacity. The credit ratings are used by various stakeholders like the lenders, investors, suppliers.
 
Distress Signals Ignored Conveniently
 
Until July last year, India’s credit rating companies had put out investment grade ratings on billions of dollars of corporate debt raised by the IL&FS group and its subsidiaries. The first signs of trouble came in June 2018, when the special purpose vehicles tied to IL&FS Transportation Networks Ltd., a group subsidiary, defaulted on its debt obligations. More defaults in other parts of the empire followed in August and September. Finally, the rating agencies were forced to downgrade the rating status to default in September 2018.
 
In October 2018, the government was forced to dismiss the IL&FS board and replace it with six eminent persons of its choice led by the well-known and respected banker, Uday Kotak.
 
The IL&FS case is a prime example of locking the stable door after the horses had bolted. The credit rating agencies had clearly failed to discharge their prime responsibility. 
 
Major Gaffes
 
For ICRA, IL&FS was not the only blunder. The investigative capabilities of a media house which exposed its gross inadequacies should have put it on high alert at least five years earlier.  
 
In  its edition of January 17,  2012, the Times of India reported that but for “Other Income” of Rs200 crore, Pricewaterhousecoopers Pvt. Ltd., and two of its network audit firms, Price Waterhouse (PW) and Lovelock and Lewes (LL) would have reported heavy  losses for the financial year ended 2010-2011 instead of the “made up” profit  reported.  
 
The glaring impact of the said “Other Income” could not have been missed even by a novice (See table below):
                                                       
For FY 10-11.  All figures in Rs. crore
 
 
ICRA conveniently overlooked what even a blind man could see.  Despite a note in the audited accounts of LL, that the other income was on account of funds received from a foreign company apparently in violation of existing statues, ICRA did not deem it worthwhile to probe this either.  Not only that.  It upgraded   both the long term and short term ratings of Lovelock and Lewes for 2011.  While upgrading the ratings, its report specifically stated that, “ICRA has taken a comprehensive view of the operations of various network firms of PricewaterhouseCoopers International (PwC), operating in India while assigning the ratings”. 
 
Clearly, the term:  “professional skepticism” meant little to ICRA. It again chose to turn a blind eye and even put out a notice in FY 11-12 when similar amount of funds were alleged to have been received again. It re-affirmed the ratings assigned earlier. 
 
How many more undetected IL&FS scams are waiting to explode is anybody’s guess. 
 
Waste of Precious Judicial Time
 
The “Other Income”, as was later alleged in a PIL, was nothing but camouflaged investment by Pwc Services BV, Netherlands in Indian audit firms in violation of the Foreign Exchange Management Act (FEMA), foreign direct investment (FDI) guidelines, Chartered Accountants Act etc. The Hon’ble Supreme court, vide its judgement dated 23 February 2018 ordered, amongst other actions, investigation by the Enforcement Directorate and the Institute of Chartered Accountants of  India (ICAI) into the receipt of these  foreign funds by various Pwc entities.
 
All the time and effort of the Supreme Court spent in this case could have been saved had ICRA done its job properly. Takkar was also at the helm when this gross malfeasance happened in Pwc’s case.  But to be fair to him, should he be the only person to be blamed? 
 
Credit rating agencies boast of multiple layers of a review.  What about the complicity of other wise men/women?  A junior manager who was handling the Pwc case when the above major blunder was committed, is now allegedly a senior vice president with ICRA !
 
55 Prosecutions Against Pwc Auditors Filed By MCA
 
An RTI enquiry by this author revealed in September 2018 that MCA had filed a mind boggling 55 prosecutions against Pwc auditors. The prosecutions were filed under section 227 of the Companies Act, 1956. 
 
Simply stated, section 227 is most critical to the interests of the shareholders and various stakeholders. It puts the onus on the auditors to report to the members of the company whether the balance sheet and the profit and loss account give a true and fair view of the affairs of the company. Violation of this section amounts to gross dereliction of duty by an auditor and can be highly detrimental to the interests of the stakeholders. 
 
As per the RTI disclosure, one Pwc partner was involved in 33 prosecutions, another one in 19 !! That the regulator for the audit profession, i.e., the Institute of Chartered Accountants turned a blind eye to this, should be hardly surprising given my earlier article.
 
A director level person from another rating agency, Fitch’s Singapore’s Office, left the firm after he was found to have violated Fitch’s Code of conduct in the IL&FS. At least some organisations walk the talk.
 
Praful Patel/Air India scam
 
The Enforcement Directorate and the Central Bureau of Investigation (CBI) have only now  started questioning former civil aviation minister Praful Patel in connection with an aviation scandal dating back to 2008-09. Patel is being investigated for alleged corruption and causing humungous loss to Air India by giving up its profitable routes and timings in favour of national and international airlines. 
 
STC/Ispat scam
 
Pramod Mittal, the younger brother of global steel tycoon, Lakshmi Mittal was the promoter of Ispat Industries Limited (IIL) and also the chairman of his overseas empire by the name of Global Steel Holding (GSHL).  He had made London his base almost two decades back. 
 
IIL’s debts soared past Rs8,500 crore in 2002 after two restructurings by its lenders  under the corporate debt restructuring scheme and generous write-offs. At a time when IIL could not service even its interest payments, its board meetings, attended by senior bankers, were held in 7 star hotels! 
 
Grapevine has it that thousands of crores of rupees were siphoned off  including money for  the setting up of Global Steel Holdings Ltd (GSHL), headquartered in the Isle of Man and for other personal interests. The overseas business was largely funded by the State Trading Corporation (STC), a public enterprise, for procuring raw material for its Philippines operations between 2005 and 2010. Despite frequent defaults, GSHL continued to draw additional amounts solely because of its political patronage and connivance of STC officials and other lenders.  
 
At the last count, Pramod Mittal owed more than Rs2200 crore to STC. Chances of even partial recovery were extremely slim.  Various criminal cases and even a look out notice for him and his family had been issued by ED. No one from STC/any other lender was however touched. 
 
By a quirk of fate, STC recovered the whole amount! Pramod’s defaults were coming in the way of Lakshmi Mittal’s acquisition of Essar Steel and it is said that he cleared the entire dues of his younger brother so that his larger plans for India were not stifled. 
 
While this pretense of cat and mouse continued in India, something striking happened in Bosnia. Pramod Mittal was arrested in Bosnia on 24 July 2019 and released only after paying a hefty €12.5 million ( appx. Rs100 crore). Mittal was held for suspicious transfer of nearly €11 million from Lukavac (Bosnia)-based GIKIL (Global Ispat Koksna Industrija) which is a joint venture between GSHL and Coke and Chemical Conglomerate owned by the government of Bosnia. 
 
Different tales, same story
 
The above cases expose only the tip of the dirty underbelly of corporate India which continues to flourish, thanks to rampant corruption and pliable regulators.  Even these cases have come to light decades later but only after irreparable damage has already been inflicted. 
 
One has to be extremely unlucky to get caught in India. The size of undetected corporate scams is anybody’s guess.  Non-performing assets (NPA) of banks of Rs10 lakh crore can be safely taken to be understated.    A huge financial bomb is waiting to explode any time. 
 
There is however a silver lining to all this:  India can learn a lot from Bosnia if it wants to be a $5 trillion economy by 2025.
 
(Sarvesh Mathur is a senior financial professional, who has earlier worked as CFO of Tata Telecom Ltd and PricewaterhouseCoopers.) 
 
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    COMMENTS

    Satish Mathew

    4 days ago

    These regulater entities are waste and needed to be restructured.

    nadeem

    1 week ago

    Seems like we are heading towards tough times..!

    pravin banker

    2 weeks ago

    Excellent article and point well made. I know first hand since I was advisor to PM for three years 2004-2007 , al be it for his Bulgaria operation, not Bosnia. I was also negotiating with IL&FS Parthasarathy and his executives to buy out a loan they made to Stemcor - about USD 110 million - around 2015. Even though the loan was shaky, Stemcor having defaulted I was advisor to Stemcor late former Chairman Ralph Oppenheimer. Not only did IL&FS refused to sell but they increased the line and capitalized interest.
    Around 2001 I marched into Robert Wolf's office with a revelation. RW was the Chairman of UBS Americas and UBS had underwitten some $5 billion in loans - the Osprey bonds- for Enron. The debt was supposed to be collateralized . What I discovered was that the then CFO Fastow had shifted the collateral, pledging it for some bank loans. Wolf was livid and soon not only ditched their remaining exposure but shorted the shares which cratered quickly from over $30 per share to under $1. Alliance - a big shareholder - finally dumped at 27 cents.

    I recall Ken Lays lament. Senators could be bought cheap, a mere $100,000. Investment Bankers could be bought for a million .. BUT those damn auditors. They want 25mm plus. Enron's auditors were Arthur Anderson who looked the other way when the collaterals were shifted. The government forced Anderson into bankruptcy.

    REPLY

    nadeem

    In Reply to pravin banker 1 week ago

    Thumbs up to you too....!

    RBI Cuts Repo Rate by 35bps to 5.40%
    The Reserve Bank of India (RBI) on Wednesday reduced its repo rate (short-term lending) by 35 basis points (bps) to 5.40% in its third bi-monthly monetary policy review for 2019-20.
     
    Following the move, the reverse repo rate (short-term borrowing) stands at 5.15%. Subsequently, the marginal standing facility (MSF) and the Bank Rate have also come down to 5.65%.
     
    In a statement, RBI says, "The monetary policy committee (MPC) notes that inflation is currently projected to remain within the target over a 12-month ahead horizon. Since the last policy, domestic economic activity continues to be weak, with the global slowdown and escalating trade tensions posing downside risks. Private consumption, the mainstay of aggregate demand, and investment activity remain sluggish. Even as past rate cuts are being gradually transmitted to the real economy, the benign inflation outlook provides headroom for policy action to close the negative output gap. Addressing growth concerns by boosting aggregate demand, especially private investment, assumes the highest priority at this juncture while remaining consistent with the inflation mandate."
     
     
    RBI says, all members of the MPC unanimously voted to reduce the policy repo rate and to maintain the accommodative stance of monetary policy. Four members Dr Ravindra H Dholakia, Dr Michael Debabrata Patra, Bibhu Prasad Kanungo and Shaktikanta Das (RBI governnor) voted to reduce the policy repo rate by 35 basis points, while two members Dr Chetan Ghate and Dr Pami Dua voted to reduce the policy repo rate by 25 bps. 
     
    Speaking with reporters, governor Das said the RBI's MPC found 35bps sufficient for the time period, as 25bps would have been 'inadequate' and 50bps would have been "excessive".

    He had dropped a hint on this possible move in a speech earlier in the year.

    "A thought comes to my mind that if the unit of 25 basis points is not sacrosanct and just a convention, monetary policy can be well served by calibrating the size of the policy rate to the dynamics of the situation."

    "...and the size of the change itself can convey the stance of policy. For instance, if easing of monetary policy is required but the central bank prefers to be cautious in its accommodation, a 10bps reduction in the policy rate would perhaps communicate the intent of authorities more clearly than two separate moves—one on the policy rate, wasting 15bps of valuable rate action to rounding off, and the other on the stance, which in a sense, binds future policy action to a pre-committed direction," he added.

    Talking about the liquidity crisis, the RBI governor says the situation in the country is easing and that the banking system currently has abundace of liquid money. The statement gains significance as the economy is going through a slowdown, with a major reason being lack of liquidity and the eventual lower demand.
     
    According to the central bank, industrial growth in India, measured by the index of industrial production (IIP), moderated in May 2019, pulled down by manufacturing and mining even as electricity generation picked up on strong demand. In terms of the use-based classification, the production of capital goods and consumer durables decelerated. However, consumer non-durables accelerated for the third consecutive month in May. The growth in the index of eight core industries decelerated in June, dragged down by a contraction in petroleum refinery products, crude oil, natural gas and cement. 
     
    "High frequency indicators of services sector activity for May-June present a mixed picture. Tractor and motorcycle sales—indicators of rural demand – continued to contract," RBI says adding "Amongst indicators of urban demand, passenger vehicle sales contracted for the eighth consecutive month in June; however, domestic air passenger traffic growth turned positive in June after three consecutive months of contraction. Commercial vehicle sales slowed down even after adjusting for base effects. Construction activity indicators slackened, with contraction in cement production and slower growth in finished steel consumption in June. Import of capital goods – a key indicator of investment activity—contracted in June."
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    Deviations from Fundamental Economic Principles Will Not Last Long
    Economics is a relatively young discipline. Over its short history, it has established certain fundamental tenets based on which appropriate policy decisions can be taken. Evidently, these principles have served the discipline well and proven their worth over time. One such principle is exemplified by the Phillips curve. 
     
    Proposed by the British economist AW Phillips, the Phillips curve posits an inverse relationship between unemployment and inflation. Thus, a lower unemployment is synonymous with high inflation and vice versa.
     
     
    This relationship seems to have broken down in the US in recent times. The US is currently enjoying a relatively high growth at 3.1% per annum, which has reduced unemployment to 3.6%, the lowest in the last 50 years. 
     
    Automation inspired improvement in productivity, the emergence of the gig economy, huge global savings leading to comfortable liquidity and the tax cuts two years back, many reasons have been attributed to the strength of the US economy.
     
    According to the Phillips curve, such low unemployment should be accompanied by high inflation and therefore, high nominal interest rates. Surprisingly, the current interest rate in the US for a 10-year bond is just over 2% and the annualised inflation rate is 1.6%! 
     
    What is also surprising is that the world over there is a threat of a downturn. Europe is struggling to avoid a recession and China’s gross domestic product (GDP) growth rate has weakened to its lowest level since 1990s.
     
    India has seen a drastic reduction in its GDP in the span of less than a year and Japan is forever struggling with the demons of its low growth rate. It would be safe to aver that sluggishness is a distinct feature of the world economy today. Are we witnessing a decoupling of the US economy from the rest of the world? How is a high growth of this magnitude associated with such low inflation? What are the implications for the Indian markets?
     
    One of the most important outcomes of the global sluggishness is low inflation and low interest rates. Governments world over have been apprehensive of pump priming investments, fearing a downgrade in rating. 
     
    It has therefore become virtually the default responsibility of the central bankers to keep the economy in good shape. Central bankers have not hesitated to reduce interest rates at the slightest hint of a dip in GDP growth rate and have, in fact, committed to do so in future also. 
     
    The low inflation and interest rates benefit the US economy in three ways. First, low inflation leads to a significant increase in real wages and a substantial boost to consumption demand. 
     
    Second, low inflation and interest rates are beneficial to the stock market, which has been performing exceedingly well for a long time. Finally, business finds it easy to raise funds at attractive rates. Neflix recently issued junk bonds at historically low rate of 5.4%.
     
    The US is a huge economy, the largest in the world and like all large economies, its dependence on exports is relatively limited, at 12% of its national income. 
     
    Moreover, a large part of the export basket is price inelastic and the demand remains stable despite poor growth in importing countries. 
     
    Hence, sluggishness in other economies does not have a significant impact on US exports while the consequent low interest rates prove highly favourable.
     
    The prevailing situation is extremely favourable to India, and possibly other emerging markets. While the strong health of the US economy should help exports, the comfortable global funds position should see financial flows continuing in large volumes, something that the Indian economy needs desperately. 
     
    The comfortable liquidity position has prevailed for the last decade, with central bankers being liberal in ensuring low interest rates. The inflow of funds not only bridges the gap between savings and investment in India, some of the inflow also seeps into the stock market ensuring continued buoyancy.
     
    What about the future? As always, many factors could play party pooper. In the immediate future is the dark shadow of the trade war between the two largest economies, the US and China, that is expected to significantly hit global trade and may lead to weakening of the forces of globalisation. 
     
    There is an apprehension that having experienced the longest ever recovery period, a downturn in the US economy is around the corner. A significant factor is the inverted yield curve which has usually been a harbinger of recession. 
     
    The standoff between the US and China would definitely hit global trade and impact growth rates. However, I don’t expect it to reduce liquidity; in fact, the opposite should happen. Responding to lower growth, central bankers are likely to pump in further liquidity. 
     
    Second, just because the current expansion has been the longest in US history does not imply it will reverse soon. Economic expansions do not commence with a prominently, pre announced end date. 
     
    If the conditions aiding growth continue, there is no reason to assume a reversal. Many countries have experienced much longer expansionary periods, including Australia which is in its 28th year of uninterrupted positive increase in its GDP. 
     
    As far as the inverted yield curve is concerned, its ability to predict a recession has over the years weakened. Since the 2008 financial crisis, bond pricing no longer reflects economic conditions. Bond prices are now determined more by regulatory action and quantitative easing. 
     
    It is expected that any sign of recession will be met with significant quantitative easing by the US Fed. Comfortable liquidity conditions with low interest rates are likely to continue in the foreseeable future, a boon for the Indian markets.
     
    A word of caution is warranted. There is invariably a tendency to assume that conditions prevailing at any point in time are likely to continue in future. Even if economic theory points to a fallacy in such a thought process, ‘this time is different’ is an assertion repeated ad infinitum. 
     
    We must however remember that deviations from fundamental economic principles do not last forever. Economic principles have a habit of asserting themselves eventually, despite long periods of failure to uphold themselves. 
     
    When they do, the impact is always brutal. There is no harm in swimming with the tide, but prudence is advised in being prepared for the reversal when it happens, as it surely must.
     
    (Sunil Mahajan, a financial consultant and teacher, has over three decades experience in the corporate sector, consultancy and academics.).
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    COMMENTS

    PRADEEP KUMAR M S

    3 weeks ago

    I have been sitting on cash for the last two years waiting for the fall 😂

    B. Yerram Raju

    3 weeks ago

    Author has brought the text book to the position. Low inflation, Low unemployment and low interest rates are a queer combination. Further, economics built on rational behavior does not any longer hold validity as man invariably behaves irrationally.

    After Fed cut its rates, Down Jones index dropped; stock markets fell all over the world. There is more uncertainty now than ever. No one is able to say whether we are heading towards another major recession although every one is suspicious about it When stimulus is not required it is being extended.
    The case of India is different. We are travelling against the wind.

    Manufacturing is looking downwards amidst a yet-to-settle uncertainty in the financial sector. ECBs are made more attractive. Sovereign Bonds are floated.
    Market sentiment is down. FPIs are slowly exiting. There is benign inflation. Credit markets are yet to find a green herring.

    The fundamentals are on the changing curve. They are still evolving and bending towards behavioral economics. It is not just economists that got NL as much as physicists and psychologists. Interdisciplinary approaches are altering the fundamentals of economics.

    We are listening!

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