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Why UTI's bailout may not pinch

Abheek Barua and Aabhas Pandya

How big a hole is the UTI bailout going to burn in the government's pocket? Going by initial estimates, the size of the rescue package is Rs 14,561 crore (Rs 145.61 billion).

If this entire amount finds its way into the current year's fiscal deficit, that's roughly an addition of 0.6 per cent of gross domestic product.

So even if all other revenues and expenditures stayed on target, as did the budget forecast for GDP growth, the deficit will balloon from 5.3 per cent to 5.9 per cent of GDP.

However, the impact of the package might neither be immediate nor of this magnitude.

The nature of the schemes being bailed out, the timing of their redemption as well as the direction of asset markets are critical to what the burden on the exchequer is likely to be both in the short term and over a longer horizon.

There is, of course, an assumption implicit in this claim -that the government and investors are "rational". Thus, the government transfers funds as and when redemption pressures arise.

Also, investors redeem their units when it is most profitable to do so, at the highest possible redemption price.

But first, here are the basic facts about the bailout. The package is directed towards two sets of schemes:

• (i) The assured return schemes (ARS) that assure either terminal capital or a fixed dividend or both. These cumulatively account for Rs 8,561 crore (Rs 85.61 billion), according to the initial estimates.
• (ii) US-64, the open-ended balanced fund that is meant to be purely net asset value (NAV)- based but functions as an assured redemption price scheme. Rs 6,000 crore (Rs 60 billion) of the package is supposed to be earmarked for this.

These together constitute UTI-I, which will remain with the government. The pure NAV-based schemes constitute UTI-II that is likely to be privatised and does not need any financial succour.

Let's look at US-64 first. It guarantees a redemption price of Rs 12 to investors who hold less than 5,000 units and Rs 10 to those who hold more.

This redemption would be effective from May 2003 for an indefinite period. Small (<5000 units) unit-holders have actually been able to redeem their holdings at Rs 10 from August 2001 with a 10 paise increment every month.

Thus, analytically, UTI would be redeeming its units at an average price that lies between Rs 10 and Rs 12, depending on investor mix and redemption. Since the bulk of this scheme is geared to retail investors, we assume that 70 per cent is held by small investors. This works out to a weighted average price of Rs 11.40 per unit if we also assume that everyone redeems in May 2003.

The difference between this weighted average price and the current NAV is the shortfall per unit that needs to be bridged.

This is clearly based on a static scenario for the market. If debt or equity asset values were to rise over the period, the bailout need would be lower.

We use the 9 per cent return on the bond portfolio that the finance ministry has used for its calculations. Given this, the rise in the equity portfolio that would take its actual NAV up to 11.4 works out to 141 per cent.

Thus, no bailout would be needed for US-64 only if its equity portfolio were to rise by this amount.

This is a bit of a tall order. However, if equity values were to rise even by a small amount, it would reduce the amount needed for a bailout. Unfortunately, if the equity market were to dip further, more funds would have to be provided.

Thus, the impact of the US-64 bailout on the fiscal balance would depend critically on the direction of market movement in the interim period. It would also depend on the timing of redemptions.

Clearly investors would have an incentive to hold on till May 2003 to get the maximum possible redemption price of Rs 12 or Rs 10. Thus only a fraction of units might be redeemed before this. This means that the pressure on the deficit in the current fiscal year (2002-2003) might be quite small.

Will there be a rise in fiscal pressure in 2003-04 as investors rush to redeem units? The incentive for an investor to hold on much beyond May 2003 would depend on what he expects to happen to the NAV after that (assuming that subsequent redemptions are NAV based).

Clearly, expectations about the equity market will have to be extremely bullish to expect a NAV of more than Rs 10 or Rs 12.

However, the government might provide additional incentives to hold on to US-64 units by giving significant tax sops both in the form of dividend and capital gains benefits in the budget for 2003-04. This will reduce the need for government support.

As far as the 21 assured return schemes are concerned, there are two problems that have led to a need for government support.

These have promised returns in the range of 13 to 14 per cent while the actual earning is 7.5 to 8.75 per cent. They also "assure" capital at maturity, that is, redeem the units at a fixed price on maturity.

Some of the arguments with respect to US-64's sensitivity to asset price variations hold for these schemes. However, since their asset portfolios have a much smaller share of equity than US-64, the impact of equity price changes is likely to be much smaller.

The more important issue with respect to ARS is the timing of their redemption. These are spread over the next four years and consequently the fiscal impact would be distributed over this period.

The cumulative amount to be provided to the ARS adds up to just Rs 1,332 crore (Rs 13.32 billion) for 2002-03.

If we use this to build the worst-case scenario for the current year with 30 per cent of US-64 units being redeemed and a 10 per cent decline in the equity portfolio persisting, then the total bailout in 2002-03 would be just Rs 3,390 crore (Rs 33.90 billion).

If the scenario persists in 2003-04 and full redemption of US-64 happens, the burden will be Rs 6,800 crore (Rs 68 billion) next year.

These are extreme situations and the actual impact could be smaller. Besides, there is a possible gain from the sale of UTI-II in terms of a premium for strategic control.

This varies between 5 and 7 per cent of the asset value. This could work out to anything between Rs 800 crore (Rs 8 billion) and Rs 2,000 crore (Rs 20 billion), given current market conditions and could be used to plug the UTI-I shortfall.

This article should not be construed as a defence for the bailout. There are strong reasons why periodic rescue packages create moral hazards and stall any efforts towards significant change in the financial markets.

The sole point is that the purely fiscal argument against the rescue package may not be as strong as it is being made out to be.

(Abheek Barua is senior economist with the Crisil Centre for Economic Research; Aabhas Pandya is with Crisil Market Wire. This is excerpted from CRISIL Eco-view of September 2002)

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