Bitcoin: How it works & Why You should/should not choose it.

Bitcoin: How it works & Why You should/should not choose it.

bitcoin

How Bitcoin transactions work?

Bitcoin transaction takes place through a wallet which is simply a mobile app or a computer program that allows the users to maintain as well as send and receive Bitcoins. Once installed, it generates an address for the user.

All the transactions ever carried out using Bitcoins is saved in a backend database ledger called “block chain”. Block chains are replicated graph data structures that store all Bitcoin activity in an encoded form in terms of public keys. Each block consists of a number of transactions. The blocks serve to timestamp the transactions that it contains and guarantee its validity. The block chain is available to all the system users. High end encryption techniques using digital signatures are used to maintain authenticity of transactions. The simplicity in the transaction process makes payments easier to make than debit or credit card purchases without a merchant account. Payments are made from application software by entering the recipient’s address, the payment amount, and pressing send. However, the underlying system is complex. The transactions are broadcasted between the users and confirmed by the bitcoin network in the next ten minutes by an intelligent process of mining. This is the process by which new bitcoins are created.

This system allows users to mine Bitcoins by sharing their processing power, reducing the load on its servers and thus get rewarded with Bitcoins in the proportion of the work done by their systems in creating a block (i.e. performing numerous calculations to solve a mathematical problem). The reward for solving a block is period dependent and is halved every four years. Also, as the number of people involved in generating new coins increases, the difficulty of the mathematical problem also increases.

Advantages of Bitcoin

precious

Bitcoin offers a higher degree of freedom than that offered by the banking system. Any amount of money can be transferred instantaneously and there are no hassles like bank holidays, cross currency risks etc. The payments are either free or charged very low processing fees and there is also protection of personal information due to its simple payment procedure where personal details are not required to be entered. The use of military grade encryption through it cryptographically secure protocol offers strong protection against identity and monetary theft thus reducing risks for both – buyers and sellers. The transparency of the transactions due to its block-chain structure ensures real-time verifiability and maintains trust amongst its users.

Disadvantages of Bitcoin

The major disadvantage lies in the liquidity risk involved in holding Bitcoins as there is a limited acceptance for Bitcoins, being a virtual and unregulated/illegal currency. Also, as seen over the last year there is a high volatility in value of Bitcoin due to the small market size in terms of coins available for circulation and the actual user base which shies away merchants and users from accepting this currency. Although, this may decrease in the future if the Bitcoin market matures.

Bitcoin software is still in a beta stage and there is stilldevelopment work to be done in terms of features and services in order to improve reliability and acceptability amongst the users.

Anonymous nature of Bitcoin also make it dangerous as there are lots opportunities and incentives for money laundering. There is no third party verification of transactions which reduces the cost of money transfer but also makes it impossible to trace any thefts or wrong doing. An alphanumeric private key is used to secure transactions made by individuals and if this long key is lost or stolen, individuals cannot reclaim the key and their money is lost. There have been many instances of theft of Bitcoins from individuals and exchanges which are impossible to trace and this makes Bitcoin a very perilous investment option. These days’ people are even weary about fiat money like dollar, INR, and are investing in real assets like gold, real estate etc. which makes it harder for Bitcoin to become a widely used currency.

Bitcoins in India

According to SourceForge, since the launch of Bitcoin in the country on November 9, there has been 35,648 downloads. Kolonial, a restaurant in the posh area of Worli, Mumbai has started accepting payment through bitcoins thus becoming the first Indian eatery to accept the currency. The only other business establishment in India which accepts bitcoins is Castle Blue Spa and Saloon in Mumbai. Microsoft Ventures, a Bangalore based technology start-up accelerator has offered to lend its office space for the country’s first Bitcoin meet up in 2014.

In countries like Germany, Canada, Thailand, Bitcoin has got legal status. But RBI is sceptical of using Bitcoin as the digital currency. According to RBI, “it poses significant financial and security risks”. RBI in its circular on December 24th, 2013 cautioned that there is no established framework for recourse to customer problems /disputes / chargeback. It may also lead to money laundering and help the financing of terrorism as there is an absence of information in these peer-to-peer anonymous/pseudonymous systems.

RBI fears that Bitcoins can also be used for illicit and illegal activities. For example, Bitcoins were used on Silk Road, an online black market for illegal drugs that was shut down by FBI earlier this year where the agency also seized $28.5 million worth of Bitcoins. Another such website included “Assassination Market”, a crowd-funding service website that lets users contribute Bitcoins anonymously towards a bounty for political assassinations.

This RBI warning caused various domestic exchanges including India’s largest Bitcoin exchange – Buysellbitco.in which even faced police raids to temporarily suspend their operations. However, after Unocoin, an Indian Bitcoin exchange resumed its operations on 8th January 2014, other exchanges are soon expected to follow. Advocates of Bitcoin and related entrepreneurs recently formed “Bitcoins Alliance India” to advocate and lobby on their behalf.

Future of Bitcoin

The conventional currency of the ‘fiat money’ is viable because of the backing of the government and the sense of reliability and stability it offers. There is no way that the government and central banks would allow a rogue currency to flourish. Perhaps a wise guess would be that there will be some regulations on Bitcoin and it may serve as a niche financial product for exchange in OTC markets.

Virtual currencies, in contrast to traditional payment systems, are not regulated; and hence the legal uncertainty around these currencies constitutes a challenge for the government authorities. Bureaucracy is a danger to Bitcoins well seen by the recent suspension of all Bitcoin exchanges by OKPay. A mounting pressure on online money exchanges from US regulators have resulted in smaller Bitcoin organisations finding themselves suddenly unbanked and the banks simply now insist that they do not wish to provide them with accounts any more.

Sudden rise in Bitcoin value has generated high interest among speculators. As a result of frenzy currency speculation, its value against the dollar is highly unpredictable. Traders have turned their attention to it (Bank of America began publishing research on it). This threatens to turn it into a Ponzi scheme – its price fluctuates manically as the slightest hint of action or inaction from regulators, or comment from self-proclaimed experts. This volatility makes it difficult for Bitcoins to gain acceptability as genuine currency, because businesses will be wary of accepting a currency whose value is so unpredictable.

In order to succeed and be popular, it needs to first become a widely used medium of exchange. For that to happen, Bitcoin should be able to be convertible into something else. It could be convertible simply into commodities, but it also needs to be generally and widely accepted for that to happen. Bitcoin must be convertible into fiat currency like pounds, dollars and Euros etc. to suffice for the stores that do not accept Bitcoins. Another problem is there needs to be some entrance for the Bitcoin into the current international financial system.

Many international financial systems have a connection with the US system. And if the US bureaucracy which oversees that US financial system happen to decide that it doesn’t like people dealing with Bitcoin, or if it doesn’t like people who in turn deal with people dealing with Bitcoin, then much is the possibility that Bitcoin won’t have access to the international financial system. It is not a matter of only pure legality. Bitcoin itself certainly isn’t illegal, also paying for something with it isn’t, and subsequently changing $ into $B isn’t and so on. But there are various regulations about who can do what with whom in the financial system that could be of a help for a determined bureaucracy to freeze someone out of it.

What happened with WikiLeaks signifies the above said. It’s not a mere coincidence that the world’s banks gradually stopped to process donations for WikiLeaks. Just the smallest hint that there might be more audits than usual would be just enough to steer a bank away from handling Bitcoin (or say WikiLeaks) transactions. And clearly that’s where the WikiLeaks matter ended up – at one point of time, the only way to donate was through Bitcoin.

It is not known what the US bureaucracy has in store for Bitcoin, but various refusals and withdrawals of banking services has something to do with it. Pressure is rumoured to be put on people not to handle the currency and hence the Bitcoin currency is likely to fail. People’s Bank of China too prohibited financial institutions and payment institutions from dealing in Bitcoins after making it very clear that it doesn’t consider Bitcoin a currency or legal tender, and that it shouldn’t be used to pay for real goods and services.

On the other hand, Bitcoin boosters believe that Bitcoin doesn’t actually need any of the rest of the financial system. They think it is so good that it will be able to replace it. The debate would be best answered in the time to come.

References

 

Bitcoin: Currency of the future?

Bitcoin: Currency of the future?


bc

Bitcoin

Have you heard of a currency that has gone up 200,000% within a year? There is but only one currency – Bitcoin (abbreviated as BTC). The Bitcoin concept has become so popular that its features and future are even discussed at investment conferences. This has attracted many well-known investors including the Winklevoss twins of Facebook fame who believe its value can easily touch USD 40,000 from the present roughly USD 900.

Bitcoin is a digital currency and the first crypto-currency (a concept first described by Wei Dai) which is claimed to have been developed by an unknown person or group known as Satoshi Nakamoto in 2009. The market size is estimated to be USD 4 billion with around 12 billion bitcoins in circulation.

Mt.Gox USDbtc all time arith (1)

Fig: Value trend of Bitcoin on Mt. Gox (in USD)

 

The cryptographic protocol and software used in Bitcoin are open source. Bitcoins are snippets of code that use encryption to prevent counterfeiting and double-spending. It is pseudo-anonymous in the sense that its ownership is anonymous but the transactions are transparent. Complex algorithms control the supply of Bitcoins which can be generated or “mined” by running a program on a powerful computer. Bitcoins grow at a rate known to all parties in advance (it grew at a rate of 25 coins per 8 minutes on 11th April 2011). The total number of Bitcoins can’t exceed 21 million (which will be reached in around the year 2140) but their value depends purely on market forces. It is a purely virtual currency which is not backed by any security or government obligation. Its value is determined by the demand and supply forces, is traded Bitcoin exchanges like BTC China, Bitcoin 24 and Mt. Gox.

Screenshot from 2014-02-18 16:23:23

Fig: Life of a Bubble (Expected Life of Bitcoin)

Nowadays, Bitcoin is increasingly being accepted as a mode of payment for products and services by vendors that accept Bitcoin payment such as WordPress, Reddit, OkCupid. There are even mobile apps that allow Bitcoin payment and spot trading facility. Surprisingly, many start-ups have been listed on the Global Bitcoin Stock Exchange where bonds and stocks can be traded. The ‘cryptocurrency’ wave has hit the world of financial markets and there have been a lot of speculations as to what the future unfolds. Understandably, there has been apprehension of wide spread money laundering and criminal fraud due to complete anonymity of Bitcoin transactions. Also, Bitcoins at present is highly volatile and the graph below shows the fluctuation in its value over the past two years.

Alternatives to Bitcoins

Bitcoin is one of the many virtual currencies which presently exist. Some of the other popular virtual currencies include:

  • Litecoin: It is a peer-to-peer currency enabling instant payments also based on the bitcoin protocol and its network is scheduled to produce about 84 million currency units.
  • Peercoin: It is the first cryptocurrency whose creation was inspired by bitcoin and is based upon a proof-of-work system.
  • NovaCoin
  • NameCoin
  • Protoshares
  • AnonCoin
  • MegaCoin

Though being different from Bitcoins, the following virtual currencies were popular in the past:

  • WebMoney: It is a virtual payment system which aids internet users for conducting real time transactions using WebMoney unit
  • Pecunix: It is a digital currency backed by gold
  • World of Warcraft Gold: Designed by Blizzard Entertainment, it is a virtual currency that is used by a popular online role-playing game
  • Nintendo Points: It is a virtual currency which has been established by Nintendo and it can be redeemed at Nintendo’s games/shops
  • Linden Dollars (L$): It is a virtual currency wherein digital characters can be customised
  • There have been instances where some virtual currencies have ceased to operate like:
  • Facebook Credits: It was a virtual currency that was introduced by Facebook in 2009 and ceased its operation in 2012. It allowed users to buy virtual goods in the form of applications on the Facebook platform
  • Liberty Reserve: It was a centralized currency based on Costa Rica which promoted itself as the oldest, safest and most popular payment processor. It was shut down by none other than the U.S. government due to accusations of money laundering

 

What is the future of Bitcoins, What is its status of Bitcoins in India? Please read on to Bitcoin: How it works & Why You should/should not choose it.

 

References:

 

The European Union’s Doom

The European Union’s Doom

eu

Trading across the borders of nations with amiable relations and tensions or wars between belligerent countries has long been prevalent. In the 1940s (i.e post World War period), most of the European nations were mostly in wars with each other.  To pacify the continental relationships and to increase trade amongst the nations, European Coal and Steel Community was founded by six nations viz Belgium, France, Germany, Italy, Luxembourg and the Netherlands.  However there followed continued cold wars and protests between the Eastern and Western Europe. Hence Treaty of Rome was signed in 1957 to allow people and commodities to move throughout Europe. Many countries joined in and eventually a single market and a common currency were achieved amongst 27 member states which today comprise of the European Union.

It is important to understand that primarily there are five levels at which trade or economic integrations happen. First is the “Free Trade” whereby tariffs between member states are significantly reduced or abolished between the member states. Tariff is the tax imposed upon the imported goods and its reduction can boost economic efficiency greatly. Second is the “Custom Union” when not only “Free Trade” has been established but the member states or nations impose the same tariff to the non-member nation. Thus competitiveness amongst the union is decreased and a greater unification happens. Third is the “Common Market” when the factors of production are rendered mobility across the borders of the member states. Therefore a worker of a member country can freely work in any other state/country of the union. Fourth is the “Economic Union” when the monetary and fiscal policies are harmonised and also a monetary union via a single currency is seen. Fifth is the “Political Union” when a common government exists between the member states, thus reducing the sovereignty between the members.

Today European Union stands at the fourth level of economic union with a single currency, free trade and liberal mobility of labour and commodities across the member nations.  However after the subprime mortgage crisis when many US based financial institutions crashed due to loan payment delinquencies and the Greek debt crisis when suddenly the markets entitled the Greek bonds a “junk” status after news of exceptionally high Greek government debt reached the market, the very backbone of the Union was shaken. But the current news of its member state Cyprus’s financial failure has struck it really bad. Certainly there’s been a crash in Europe. They’ve so far avoided the depression part although not everywhere as Greece is under threat, Spain possibly along Portugal lined up for a non-cash economy. Clearly, there are more ways to get into a depression than just cascading bank failures but looking into Friedman’s explanation, we know that cascading bank failures can cause one. And the way not to have those is deposit insurance.

What have been done in Cyprus? They’ve removed deposit insurance. They’ve therefore removed one’s defence against bank failures by calling it a tax. The bailout to the economy through high tax levy on savings and funds in the banks was something unexpected and not even in the wildest dreams of the people who had entrusted their life-long savings to the banks with expectations of having them intact or incremented in future. If the citizenry believe that they don’t have deposit insurance any more then there shall be more mass withdrawals from banks leading to more bank failures. And cascading bank failures are exactly the thing that could tumble Europe into a new and probably a deeper depression.

Inflation Gone Wild-Hyperinflation!

Inflation Gone Wild-Hyperinflation!

 inflation_1811026bAs the word suggests, Hyperinflation occurs when the rate of inflation goes very high, sometimes over 5-10% per hour, and it’s almost impossible to curb the rate of inflation. In such a scenario, price level quickly increases and the value of currency keeps on decreasing. The price of goods continuously increase and the supply of money increases with it. Such a condition occurs when a country is under huge debt which it tries to pay by printing more and more currency, which eventually hits its economy very hard. It is generally associated with wars and its aftermaths, social changes in the country leading to a condition where revenue from taxes is lower than the spending of the country.

Causes of Hyperinflation

Hyperinflation occurs when government has no way of generating money in the economy, other than printing money. This rapid increase in the supply of money is not concurrently met by the growth in output of goods and their supply.

Since the inflation grows sometimes even on hourly basis, the value of currency also goes down at the same rate. If 1000 units of a currency are used to buy footwear at a particular time, same amount may not suffice for even 50% of its cost after a few hours. This leads to a situation where shopkeepers tend to hoard things because the same thing will give them a greater value in sometime. People may also tend to hoard the essentials as there is a constant fear that the same good may not be available after few hours. Thus people buy ample quantities of food or other essentials, which makes their supply in the market low and this again further leads to increase in prices

Thus it leads to a vicious circle where government prints money to spend on its people which further leads to increase in prices and in turn government has to print more money again.

Countries hit by Hyperinflation

One of the most famous examples of Hyperinflation is Weimar Germany after 1st world war. The Treaty of Versailles assigned the blame of war to Germany and it was to pay reparations to the Allies. In order to pay these reparations, Germany began mass printing of notes to buy foreign currency, which further increased the inflation rate in Germany and devalued Papiermark(German currency). Inflation peaked in Germany in November 1923 and at that time the inflation rate was 29525 %.

Hungary after World War 2 recorded worst inflation ever. The highest denomination in mid-1946 was 100, 000, 000, 000, 000, 000, 000 pengo. The rate of inflation at that time was 41.9 quintillion percent.

One of recent instances of hyperinflation occurred in Zimbabwe. Zimbabwe after its independence in 1980 began land reforms, which focused on taking land away from white farmers and giving it to black farmers. As a result, food production in Zimbabwe suffered and eventually revenue from exports of food were badly hit. Thus in order to meet its spending the government had to print more money with higher values. The inflation rate went highest in November 2008 to 7.96 billion percent and in January 2009, $100 Million banknote was issued.

Effects of Hyperinflation

The most serious concern associated with hyperinflation is that it transfers wealth from the hands of people to the government. It wipes out the savings of the people, and triggers hoarding of goods. Economy is hit badly and the investors lose trust in the country.

To end Hyperinflation, the government takes drastic measures such as cutting down its expenditure heavily or altering the currency basis. One way can be use of a foreign currency as national unit of currency. Also, the Central Bank becomes very stringent about maintaining price stability to avoid any recurrence of hyperinflation.

 

A Bumpy Ride for FDI

A Bumpy Ride for FDI

FDI_1

Indian politics and media in the latter half of 2012 put FDI in retail on center stage. The reasons were quite vivid. In a show of audacity, the United Progressive Alliance government has decided to further open up the retail trade sector to foreign investment. Foreign investors will be permitted to enter the hitherto prohibited multi-brand retail segment and hold equity of up to 51 per cent in the units established. Other sectors to open up FDI in India are Aviation, Pharmaceuticals, Insurance and Pension.

Two sides of the coin

Facing the threat of having its credit rating downgraded to junk, the Indian government has been running out of time to show it is serious about fixing an economy that has been hard-hit by a global economic crisis and political gridlock at home. Finally, despite all the opposition and without having the consensus of alliance, UPA opened up the gates for the foreign companies in a desperate attempt to save the sinking economy. This move is nothing short of a declaration that UPA would proceed with implementing its agenda of economic reform, irrespective of whether there is majority support for, let alone a consensus on, that agenda.

The claims that FDI will bring in loads of employment and solidify the looming economy are contrary to the fact that the immediate and direct effect of FDI would be a significant loss of employment in the small and unorganised retail trade which would be displaced by the big retail firms. Prices paid to and returns earned by small suppliers, especially in agriculture, would be depressed because a few oligopolistic buyers dominate the retail trade. Moreover, once the retail trade is concentrated in a few firms, retail margins would rise, with implications for prices paid by the consumer, especially in years when domestic supply falls short.

Even if the postulations made by the UPA government turn out to be true, as vivid from the fact that India’s foreign direct investment inflows grew by over 65% year-on-year to $1.94 billion in October, according to the Department of Industrial Policy and Promotion (DIPP), yet the scenario won’t turn around overnight.

Hurdles in the way

The decision of implementing the FDI has been left to the states and most of the states have already rejected the concept as whole. Due to such strong opposition, most of the organizations have decided to wait till the clouds of mystification disperse and the scenario becomes clear for investment.  Even after the state’s blessings, which is unlikely to happen in most of the cases, large retailers would need to acquire large swathes of land in prime areas, which is a monumental task. Secondly, companies like Walmart are able to reap supply-chain efficiencies in the U.S. because of a strong infrastructure. The same thing can’t be said of India. Thirdly, taking into account that Indian consumer is a very complex persona, organized retail seems to be a small fish that would neither threaten the livelihoods of “kirana” shops, as portrayed by the Opposition, nor restore the financial health of the nation, as hoped by the government.

The road for FDI turned out to be quite a rough one in India. Whether it was inside the parliament or outside it, the issue turned out to be a centre stage for all the controversies. The step to let FDI in multi-brand retail didn’t go down well with Opposition parties and erstwhile UPA ally Trinamool Congress, which decided to withdraw support from the government over the issue and others, including hike in diesel prices. The issue stalled proceedings of Parliament till the government agreed to a voting on allowing of FDI in multi-brand retail that it managed to win, thanks to the abstention of Samajwadi Party and Bahujan Samaj Party.

Just when the government thought it was done with the issue, Wal-Mart’s disclosure in the US that it spent close to $ 25 million since 2008 on its various lobbying activities, including on issues related to “Enhanced market access for Investment in India”, created furor again. The company, however, stressed that it did not pay bribes to anyone in India. It was IKEA that made news continuously in the single-brand segment. The Scandinavian retailer wanted the government to relax the clause for mandatory sourcing of 30 per cent from MSMEs. After months of dialogue, the government relented and relaxed it for single brand segment which seems to be a favor done to IKEA.

On one side exist the exaggerated claims made by the government that FDI will be beneficial for the economy as well as common man and on the other side stands the small retailer who is genuinely worried about his livelihood supported by the opposition. Now that the foreign retailer have been granted a foothold in the market, only time will tell if the arrival will kill the neighborhood kirana stores or they will co-exist.

Fiscal Deficit and FRBMA

Fiscal Deficit and FRBMA

 

FiscalDeficit1_190

Finance Ministry is trying hard these days to curtail the Fiscal Deficit somehow which is currently as high as 5.3% of the GDP. What is this fiscal deficit? What is this buzz all about? Fiscal deficit takes place when a government’s total expenditures exceed the revenue that it generates (excluding money from borrowings). In simple terms, it is the difference between the ever increasing expenditure and small income.One can not think of utopian economic situation in a developing country like India and to have zero fiscal deficit as it will slow down the economic growth of the nation.

Too much of economics? Let’s try to analyze things in a simpler way. Suppose you have 30,000 bucks as your monthly income and your total expenditure for a certain month is 35,000. Now you need to raise the additional money required somehow and luckily you have a very generous friend of yours who is ready to lend you the difference. So, in such a case 5,000 will be your fiscal deficit. Doesn’t seem to be much of a problem right? The real lies problem lies with how you are going to spend that 5,000. It won’t be much of a problem if you want to buy a camera or invest the money once only but it can create a huge trouble if the expenditure is recurring one let’s say treating your girlfriend.

The next month, supposing your income remains flat and you are not able to meet your ends once again, you again approach one friend or the other and someone comes up to the rescue and provides you money without asking for the principal amount immediately and just demands the interest. You were already in need of more money and adding to your worries are now the interest liabilities. The problems get compounded. You now start curtailing on the capital part and your new loans are just for running the system. A scenario is reached when the interest payment by you requires loans from him. And this is the situation when your are doomed and things have got really messed up.

This is exactly the current situation of India. For benefit of the people and sometimes just to fulfil the political motives, government has been giving subsidies on oil even to the rich people driving SUVs more than it can sustain and to add to the problem are various bills passed just with the motive of staying in power. As a result we have a huge fiscal deficit piling up in front of us and we don’t have enough money to run the existing system. Hence, government keeps on borrowing money to pay the interests only. Unlike an individual who may or may not get loan from his friend, there are many agencies who are bound to lend money to the government, be it RBI or any other bank.

Suppose you are in a similar kind of situation. All you wish for is you had a ‘money tree’ or a currency printing machine with you. The government is one step ahead of you as it has control over the currency flow in the country, though indirectly. Consider this, if the government prints currency rampantly but the production is constant, it will lead to increased inflation as more money in the economy chases the same amount of goods. Curtailing the fiscal deficit by printing money can have damaging effects and can burst the whole economy. A classic example in this context is of Zimbabwe which had inflation rate of 300,000% at one time.

FRBMA

After the enactment of liberalization policy, billions of liabilities were being added every year. A major part of the revenue collection through tax went alone to interest payments. In the light of need of change, government introduced the Fiscal Responsibility and Budget Management Act (FRBMA) in 2003. The main purpose was to eliminate revenue deficit of the country and bring down the fiscal deficit to a manageable 3% of the GDP by March 2008 by reducing it at a minimum rate of 0.3% annually. The Act provided that the government shall not borrow from the RBI except under exceptional circumstances where there is temporary shortage of cash in particular financial year.

However, due to the 2007 international financial crisis, the deadlines for the implementation of the targets in the act was initially postponed and subsequently suspended in 2009. In 2011, given the process of ongoing recovery, Economic Advisory Council publicly advised the Government of India to reconsider reinstating the provisions of the FRBMA. With the upcoming elections in 2014, one can not believe that current government will take any harsh steps for the enactment of FRBMA and curtailing the fiscal deficit as it involves short term pain and the government doesn’t want to take risk. Considering the ongoing scenario, it’s hard to predict whether FRBMA will actually come into existence or not and how will India be able to manage its Credit Rating.

Credit Ratings and the Credit Rating Agencies

Credit Ratings and the Credit Rating Agencies

Credit

Credit Rating evaluates the credit worthiness of debt instruments, companies, governments, local bodies, etc. based on a robust and clearly articulated analytical framework. Credit rating agencies evaluate the debtor’s ability to pay back the debt and the likelihood of default. These agencies evaluate the qualitative and quantitative information for a company or government. The analysts of these credit rating agencies have an access to the non-public information of companies. The largest credit rating agencies which tend to operate worldwide are Moody’s, Fitch, Standard and Poor’s, Dun and Bradstreet. In India, CRISIL is the largest and most influential credit rating agency.

Ratings are based on experience and judgment rather than mathematical formulae. Credit ratings are used by individuals and other entities for deciding whether the company will pay its debt obligations or not. A poor credit rating indicates that there is a very high risk of defaulting.

CRISIL (Credit Rating and Information Services of India Ltd.) covers more than 45,000 entities in India including over 30,000 SMEs. It is the undisputed leader in the field of ratings, research, risk advisory, etc. Standard and Poor’s has the majority of stake in CRISIL. Some of the debt obligations rated by CRISIL are:-

  • Non-convertible debentures/bonds/preference shares
  • Commercial papers/certificates of deposits/short-term debt
  • Fixed deposits
  • Loans
  • Structured debt

Apart from the debt obligations, the entities which are rated by CRISIL include:-

  • Industrial companies
  • Banks
  • Non-banking financial companies (NBFCs)
  • Infrastructure entities
  • Microfinance institutions
  • Insurance companies
  • Mutual funds
  • State governments
  • Urban local bodies

According to CRISIL, their credit ratings are

  • An opinion on probability of default on the rated obligation
  • Forward looking
  • Specific to the obligation being rated

But they are not

  • A comment on the issuer’s general performance
  • An indication of the potential price of the issuers’ bonds or equity shares
  • Indicative of the suitability of the issue to the investor
  • A recommendation to buy/sell/hold a particular security
  • A statutory or non-statutory audit of the issuer
  • An opinion on the associates, affiliates, or group companies, or the promoters, directors, or officers of the issuer

India’s Credit Rating

            Slowing growth rate, depreciation of rupee, high inflation, rising fiscal deficit have been the issues of serious concern for India in the recent past. Credit rating agencies have a negative outlook towards India. At present, India’s credit rating is BBB- (According to Fitch and Standard and Poor’s), the lowest investment grade rating. There have been warnings that India’s credit rating can be further downgraded to “Junk” status or to the speculative grade which puts India in the danger of being the first BRICS group of fast growing economies to be downgraded to “Junk” status. A credit rating downgrade would make it more difficult for the government and corporates to raise foreign loans and they would end up paying higher interest rates as well. The negative outlook will also lead to foreign investors turning more cautious about putting their money in the country. This reduction in the flow of much-needed foreign funds would adversely impact investment and increase pressure on the weakening rupee.

Government has announced reform measures, such as increasing domestic diesel price by about 12% and allowing up to 51% foreign ownership in multi-brand retail stores. The government also announced plans to increase the foreign ownership limit to 49% in insurance companies. In addition, the cabinet approved foreign investors owning up to 26% (or 49%, depending on the successful enactment of the amended insurance laws) in pension-related businesses. After a long wait, the government seems to have reignited reform efforts, and that bodes well for the future development of India and to make it an investment friendly economy. Can these reforms be the light at the end of tunnel? Looking at the present situation, we can just speculate it.