NIVESHAK

THE INVESTOR VOLUME 3 ISSUE 4 April 2010

FIN-Q PG.24 The Gold, oil and US dollar relationship Pg.18

FROM EDITOR’S DESK
Dear Niveshaks
It was January 2008 when our sensex touched its peak of 21000. Then came
Niveshak the scary October 2008 when it slid to 8000 mark. And now, again, it has swiftly
taken a big leap to pat the 18000 mark. What a roller coaster ride it has been.
Volume III One of the important pulling factors behind this upside swing has been the drastic
ISSUE 4 monetary steps such as slashing CRR by 300 basis points taken at that point of time
April 2010 which infused confidence as well as liquidity in the market. However, looking at it in
a short frame of time, I see that the things are a bit unusual. In an ever-volatile stock
market, I find it tough to recall the last time, when the broad based indices — Nifty
Faculty Mentor and Sensex — remained stagnant for the past six months. But this has been the case
Prof. S.S Sarkar with Indian stock market since October last year. It has been lurking roughly in the
same range of 17000 to 18000.Another food for thought for many Niveshaks is the
fact that Sensex is not really far from its all time high. And at the same time, many
EDITORIAL TEAM stocks especially in the information technology, banking and pharmaceutical indus-
tries have already reached their all time highs. That leaves investors and people like
us confounded to the future course of the market.
Editor The euphoria is not restricted to India only. World stocks are also slowly inch-
Bhavit Sharma ing close to their respective 18 months’ high on signs of improving global growth
but the Europe remains on the backseat due to prevailing worries about Greece’s
debt problems. The recently released strong U.S. data from jobs to manufacturing
Sub-Editors has spurted hopes that the world’s biggest economy will come out of woods soon.
Durgesh Nandini Mohanty In addition to this, the present dynamics of global oil price movement and curren-
Hitesh Gulati cies’ exchange rate is expected to have a lasting impact on the global economy.
Sumit Kedia Strengthening U.S. dollar has brought some correction in the oil price which had
Tanvi Arora reached its 18 month high of 87 dollars a barrel. Rising rupee against dollar will also
give import based Indian companies an advantage but it may come in the way of
Upasna Agarwal
RBI’s monetary policy tightening if it chooses to slow down this rise. All of these
factors along with the recently released strong IIP numbers and annual reports by
Indian firms make us believe that the Bull Run is here to stay.
Designers
Bhavya Aggarwal In continuation with our sustained endeavour to get the latest insights from
the corporate, we welcome Ms Deepali Bhargava, Economist for ING Vysya
Swarnabha Mukherjee
Bank as the guest of this issue of Niveshak. An illustrious economist - Deepali has to
her credit, consistent & accurate directional calls on inflation, interest rates and INR.
In a special session with her, she has talked about the Indian economy’s recovery
path, recent RBI’s monetary policy and some issues related to exchange rate poli-
cies.
This issue of Niveshak brings to you some more interesting and insightful top-
ics. In the contemporary fierce competition in markets and race for showing higher
All images, design and artwork profits and growth, many companies manipulate their financial position and results
are copyright of to hide the true picture of their financial health. The repercussions of this are in
IIM Shillong Finance Club front of us. We saw numerous accounting scandals resulting in bankruptcies and
fall of some major firms like Enron, WorldCom etc in the recent past. But the ques-
tion arises as to what are the different means of manipulating financial statements.
©Finance Club So our cover story addresses this question by elaborating various ways of fudging
Indian Institute of Management financial accounts and statements and means to detect such abnormalities. Hope
Shillong you find this issue an interesting read.
Stay invested with us!!
www.iims-niveshak.com
Bhavit Sharma
(Editor-Niveshak)

Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears
no responsibility whatsoever.
CONTENTS
Niveshak Times
04 The Month That Was
SHe Speaketh
09 Ms. Deepali Bhargava

Cover Story Finsight

18 The Gold, Oil and US
11 Window Dressing the Dollar Relationship
Financial Statements

Fingyaan
15 Catastrophe Bond Market

Article of the month

06 Banking The Unbanked
PERSPECTIVE
21 Nivesh In Indian Population
finlounge
14 FinToon
24 Fin-Q
 Niveshak Times www.iims-niveshak.com

The Month That Was

Durgesh Mohanty & Tanvi Arora trials of exploration of some US companies began
Team Niveshak exploration nearly two decades ago, they did not
taste success due to lack of technology and inter-
Lobbying for FDI in multi brand retail est form big energy companies. Given the stagnant
The government has launched discussions be- reserves, many oil companies now see shale gas as
tween ministries about opening multi-brand retail a major source for the future.
to foreign direct investment (FDI), stepping gingerly Bharti gets its share of the Zain deal for
into an issue that has been demanding a lot of at- $10.7 bn
tention for the last few years in the national sce-
Bharti Airtel, India’s leading telecom service
nario. The Indian government allows up to 51% for-
provider has finally taken the huge leap to fulfill
eign investment presently in single-brand retail, but
its global ambitions. It sealed a deal on Tuesday to
has been reluctant to allow any foriegn investment
acquire most of the African assets of Kuwait’s Zain
in multi-brand retail. The rules allow foreign multi-
Telecom. The $10.7-billion deal, including $1.7 billion
brand retailers only through franchise agreements
of Zain’s debt, was signed in Amsterdam, the base
with local players. Large players in the Retail Indus-
of Zain’s African unit. With Zain Africa’s 42 million
try such as US-based Wal-Mart and Germany’s Metro
customers, Bharti Airtel will have 179 million sub-
AG that operate in the so-called cash-and-carry ven-
scribers, making it the world’s fifth-largest mobile
tures in India have long been clamouring for opening
phone operator.
up front-end retail.
The retail industry deserves a lot of importance Standard Chartered drafts red herring for
today as it is the second largest employer in the listing by IDRs
country. For a change, in the last few months, the This is one of the most significant develop-
government has been airing its views on opening up ments in the recent financial history as this is the
retail, dwelling on its benefits, possibly to deflect first issue of IDRs, the Indian counterpart of global
the storm of protests it could set off. The govern- depository receipts and American depository re-
ment has said in various forums that FDI in multi- ceipts, by an overseas company after guidelines
brand retail will enhance supply-chain efficiencies, were framed in 2004. Secondly, these depository re-
give farmers better earnings and reduce wastage. ceipts represent equity shares of Standard Chartered
— held by an overseas custodian based on which
RIL to buy out 40% in Atlas shale gas
an Indian depository issues rupee-denominated re-
Reliance Industries (RIL), the country’s larg- ceipts or IDRs to Indian investors — Indian IDR hold-
est company has agreed to buy a 40% stake in a ers will, in effect, own equity shares of a foreign
US shale gas venture of Atlas Energy for a whop- bank and also be able to trade in them as the re-
ping $1.7 billion, giving serious competition to Exxon ceipts will be listed on our stock exchanges. IDRs
Mobil and France’s Total in the race for a fuel that provide foreign companies a platform to directly
may change the global energy economics. It will raise capital in India but had not, for a variety of
invest $340 million in cash for the stake and pay reasons, including somewhat restrictive regulations
Atlas’ drilling expenses of up to $1.36 billion over compared to American or global depository receipts,
the next five-and-a-half years. The deal values per found favour with overseas companies so far. The
acre of shale at $14,167, compared with $14,000 an IDR listing of StanChart is a first in this direction.
acre paid by Japan’s Mitsui & Co in a similar deal.
The importane of Shale gas is increasing by the day Greece deficit worse than anticipated
as it represents a growing source of energy and is Greece’s budget gap last year was worse than
expected to constitute 20% of the overall gas pro- feared. This news triggered a fresh slide of asset
duction in the US over the next 10 years.Gas locked prices in Greece and other debt-choked European
in shale formations is expected to account for 50% countries. The news hurt financial markets’ waning
of US supply by 2035, up from 20%.Despite the early hopes for Greece to bring its swelling national debt

4 NIVESHAK VOLUME 3 ISSUE 4 April 2010

 Niveshak Times www.iims-niveshak.com

The Month That Was

under control, and increased pressure on Athens to The postal life insurance has over 15 million
seek billions of euros of emergency loans from the policy holders. It offers two life insurance schemes,
EU and the International Monetary Fund. Postal Life Insurance and Rural Postal life Insurance
The Greek government posted a budget deficit with a corpus fund of Rs 14,000 crore and Rs 4,000
of € 32.34 billion or 13.6% of gross domestic prod- crore, respectively as on March 2009. All insurance
uct in 2009, not the 12.7% which it had reported ear- products offered by the DoP are not covered by IR-
lier. The deficit might be revised again, by between DA’s rules and regulations.
0.3 and 0.5 percentage points of GDP, because of Under the Insurance Act 1938, Section 118 (C),
uncertainty about the quality of Greece’s data and life insurance schemes run by several state govern-
accounting procedures. ments for their employees and the Postal Life Insur-
The incoming socialist government said ance Scheme of the central government don’t come
Greece’s 2009 budget deficit would be twice as big as under the IRDA purview. The insurance regulator is
the previous estimates — and four times EU ceiling. looking to extend its reach.

RBI reviews monetary policy yet again IRDA-SEBI war takes new turn

The RBI raised the two key policy rates—re- Last year, life insurance companies, including
verse repo and repo—by 25 basis points each, and LIC, were served show-cause notices by SEBI, ques-
left banks with Rs 12,500 crore less to lend with a tioning them on sale of Ulips without obtaining the
25 bps increase in the cash reserve ratio (CRR). This market regulator’s approval. The insurance regula-
rate hike is seen as moderate by any standard in tor responded broadly saying SEBI did not have the
the current circumstances. Therefore, most bankers remit or the jurisdiction to regulate Ulips. The turf
think RBI will have to raise rates as well as increase war took a fresh twist when on April 9 Sebi issued
the CRR in small doses during the year. orders to 14 life insurance companies, banning them
from selling new policies or renewing existing ones.
Banks borrow from RBI at the repo rate while
The market regulator said these companies have to
parking (or lending) surplus funds at the reverse
register with SEBI for marketing and servicing such
repo rate. After the increase, the repo and reverse
products. SEBI’s order may compel investors to sur-
repo rates are 5.25% and 3.75%, respectively. The
render their policies prematurely, leading to a sig-
CRR, which is like a tax on lenders, is the slice of
nificant loss to both investors and insurers.
customer deposit that banks have to set aside as
cash with RBI. After the 25 bps CRR hike, from 5.75% The issue came to a boil over IRDA telling insur-
to 6%, banks will have Rs 12,500 crore less to lend ance firms to continue selling Ulips, a day after capi-
from the fortnight beginning April 24. tal market watchdog Sebi barred 14 insurers from
selling these products without its approval.
RBI began tightening in January when it raised
the CRR by 50 bps in two stages. This was followed What makes the issue complicated is the fact
by the 25 bps increase in repo and reverse repo in that both the regulators have armed themselves
March. While RBI has been slower than its counter- with legal opinions supporting their case to regulate
parts in Australia and Israel in raising rates, it has Ulips. Following the meeting between the chiefs of
been quicker in reversing the cycle than the Chinese Sebi and Irda and senior finance ministry officials,
central bank and monetary authorities in many ad- both the regulators have decided to restore status
vanced economies. quo and keep in abeyance the orders issued by both
during the weekend.
IRDA tells postal dept to fall in line This means that the insurance industry will not
The insurance regulator has demanded that be staggering for now from selling Ulips. But the pre-
the country’s postal department adhere to its norms vailing uncertainty might put off new investors.
while selling insurance products, triggering a poten-
tially damaging row between the two and forcing the
finance ministry’s intervention.
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 5
 B NKING THE UNBANKED
Abhishek Sarkar & Sreejit Gopinathan
Welingkar Institute of Management

Financial Inclusion The Indian financial system es-

pecially the banking has weathered
cannot and should the storm of the recessionary wave
not be just seen as that swept across the world thanks
a buzz word but two pillars firmly fixed in its culture:
exposure to risk & ethics. Having
should replicate had a firm footing the time has come
an effort to make that the benefits of the same reach
AoM

mainstream financial out to all strata’s of society and cor-

services accessible ners of the country. A person cannot
stand on its own without personal
to all sections of the and financial security.
population. It is a Even after 60 years of Indian
conscious attempt at independence, 1/3 of our population
trying to bring the is still illiterate (let alone financially
literate) and at least 26% of the pop-
un-banked people
ulation still lives under the poverty
into banking. Finan- line. Financial inclusion would re-
cial Inclusion does sult in all round economic develop-
not merely mean ac- ment of our nation. Nationalization
of banks in 1969 was an effort to
cess to credit for the channelize to funds to industrial and
poor, but also other business units which were starved
financial services of funds, even though the govern-
such as Insurance. ment policy was to encourage small,
tiny and cottage and village indus-
tries. Further consolidation of banks
and liberalisation of economy start-
ed in the early 1990’s saw people
getting exposed to various financial
products. At the same time, a large
chunk of people have still remained
immune to basic banking facilities
either due to insufficient earnings
or to easy credit facility available
to money lenders. Around 41% of
Indian population is unbanked and
coverage of basic financial services
in rural areas is 39% against 60% in
urban areas.
The financially excluded sec-
tions largely comprise marginal
farmers, landless labourers, oral
lessees, self employed and unorga-
nized sector enterprises, urban slum
dwellers, migrants, ethnic minorities
and socially excluded groups, senior
citizens and women. While there are
pockets of large excluded popula-
tion in all parts of the country, the
North East, Eastern and Central re-
gions contain most of the financially
excluded population. A stable and
healthy financial service sector cre-
ates trust among the people about
the economy and only with this trust
(which has legal validity) could a
strong, stable and an inclusive econ-
omy be created.
Reasons for Banking Exclusion
The low coverage of banking &
financial services is due to following
reasons:
• Lack of awareness, low in-
comes, social exclusion, illiteracy act
as barriers for the masses.
• Too many formalities, branch
distance, unsuitable products, lan-
guage & the attitude of the staff to-
wards people.
• Lack of proper Infrastructure
due to inaccessibility & location of
the rural habitats.
Strategies to Reach Banking to
the Bottom of the pyramid
Challenges are many and these
are being tackled but there is long
way to go before we achieve all
round financial inclusion and provid-

6 NIVESHAK VOLUME 3 ISSUE 4 April 2010

ing banking services is just one amongst them.
Financial Awareness to masses
Most of the people in this segment are scepti-
cal to open a bank account because of their non
financial background.
Hence, we should begin by spreading finan-
cial literacy & awareness among them. Teaching
should be done in simple languages (preferably re-
gional language) using various audio-video teaching
aids. This education should begin from school level
& can be clubbed with Sarva Shikhan Abhiyan of
the government. Since, people trust on those who
teach their children. Stories, Pictures, Cartoon strips,
Jig Saw puzzles can be used to imbibe the impor-
tance of banking in the people. Local semiliterate
or educated people can help us in this initiative. We
should keep them regularly updated through Gram
Panchayat Meets & help them realise their needs
rather than expanding the business of banking as
envisaged by commercial banking sector.
IT Technology & Mobile banking
Technology has reduced the distance between
nations & people and the same can be leveraged
to deliver banking services to the un-banked. Mo-
bile technology has its presence pan India and
can be used as a tool in providing access to vari-
ous facilities at their fingertip. The mobile market
in India has witnessed an increas-
ing no of subscriber base from rural
India, largely due to the declining
mobile tariffs & availability of low
cost handsets in the country. People
who are not comfortable with bank-
ing are more comfortable using their
mobile phones. So, mobile banking
can be used as medium to make
them banked. The Basic credit trans-
actions (debit /credit) can be done
using mobiles as done in Africa. To-
day with 3G and Wimax coming into
picture the telecom operators can
provide all the banking functions in
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
a platter to the rurals. To begin with banks can tie up
with telcos and ask them to provide mobile phones
enabled desired services to people from the villages
who are well versed with the device and ask them
to serve as an intermediator in facilitating the finan-
cial transactions. These intermediators can provided
with some commission for the same. Slowly, when
the villagers are becoming familiar with it they can
also be given training for the same. This will not
only save operational cost & infrastructure cost for
the banks but also increase the reach of the banks.
It will also make the banking operations conve-
nient, safe, reliable and transparent. The pilot proj-
ects of smart cards for opening bank accounts us-
AoM
ing biometric identification implemented in Andhra
Pradesh should encouraged further. Also, the same
channel can be used for providing other financial
services such as insurance.For this we need to scale
up our IT & telecom infrastructure as traffic of finan-
cial transactions is going to increase in tandem with
coverage of more & more villages. However the pace
at which the technology is being is used to provide
such facilities needs to be at a faster rate or else the
dream of complete financial inclusion will remain
mere on paper.
Star Network Model of Distribution
The star network distribution model which is
a common computer network topology can used to
target the masses. For instance, when adopted by a
bank, the various marketing functions will be per-
formed by the branches i.e. Leaf Nodes whereas the
processing is done at the central office i.e. the Cen-
tral Node. That means the task of reaching out to the
masses will be done by the Leaf nodes. It is easier
to adopt as it gels well with the existing distribu-
tion networks. This model provides a multichannel
reach to banks. The following diagram depicts vari-
ous distribution channels which helps us in tapping
the BOP easily.
• CO-OPERATIVE/COMMERCIAL BANKS: These are
the ones which have their local presence in the vil-
lages. Urban banks can have refer-
ral tie-ups with them can pass their
products to masses through them.
• SELF HELP GROUPS (SHGs)/
NGOS: SHGs & NGOs can also prove
an effective medium of credit dis-
tribution to the masses. Currently,
most of micro-credit activity hap-
pens under the banking model
through NABARD’s linkage with the
SHG’s. Currently, there are about 2.3
million SHG’s covering 35 million
people from the BOP. The Grameen
bank model of BanglaDesh is be-
7
 ing followed here. We can take the example of SHG
movement Kudumbasree in Kerala which helped it
attain 100% financial inclusion. This was possible by
bringing together the agricultural department, the
Revenue departments, the Panchayats (Local Self-
Governance), the D.R.D.A and the State Poverty Erad-
ication Mission.
AoM
Offering Simple Products & Processes
Banks need to offer simplified products revolv-
ing around the needs of BOP. To comply with Know
Your Customer Norms banks can use the existing UID
project or biometric cards. They need to minimise
their formal approach of banking & bring an infor-
mal touch in the whole banking experience. Banks
should start by offering Zero balance & No Frills Ac-
count to these BOP people. Also, ensure that the ac-
counts are not dormant. For this they can come up
with schemes such as offering low interests & pre-
cedence in getting loans to those who are having at
least one transaction per month. This will encourage
them to open account & carry out transactions. In-

dia is a country with diverse demographics where in

the languages changes every 5o kms. So, Banks can
customise & offer community-wise or region-wise
products which will be more easily accepted. Banks
need to connect with the emotions of these people
& understand the reasons for their borrowings such
buying crops, house, marriage, start new shop, etc.
The credit cycle should be aligned with crop cycle for
farmers. The mahajans or the money lenders are the
biggest competition to the banks. We need to under-
• MICRO FINANCE INSTITUTES (MFI): Microfinance stand the differences in them. The money lenders
is a gift to us by Bangladeshi economist Muham- provide easy & any time cash, also they don’t ask
mad Yunus. MFIs are basically sitting at the core of for any collateral. They treat poor people as users
the matter. They have helped people to help them- & not customers. To reduce the competition banks
selves. They have brought paradigm shift in peo- should make these mahajans as BC’s and offer them
ple’s outlook that poor people are worthy of being commissions. Also, they can be treated as HNIs & be
banked. Also, the rate of defaults is very less in spite given other incentives.
of having higher rate of interests.
Conclusion
• POST OFFICES: Post offices have a very wide
coverage all over the country. They can be used as The obvious question which might come to our
distribution partner for easy credit. Moreover, peo- mind is why we need to bank the BOP which may
ple are more familiar with the environment & staff not be profitable. The simple answer is low profits
which reduces their apprehensions. Post Offices can in high proportion can become a gold mine. More so
issue a “POST Office Card Account” as started in UK it’s about empowering the people because a country
which can be substitute for bank accounts. can be accurately judged not just by GDP numbers
and growth rate but more so by the well being of
• BUSINESS CORRESPONDENTS (BCs): Business
its people. Poverty alleviation can achieved through
Correspondents form the face of the banks or fi-
financial inclusion.
nancial institutes to masses. They can be the route
through which the importance of banking can com- With globalisation taking a big leap, the gap
municated at the grass root level. Retired Bank Of- between various nations are bridged, banking to ru-
ficers, Government servants, Sarpanch (Chief), Local ral masses can link up the gap within India under
Teachers & Other key important who are from the the umbrella of financial inclusion.
BOP should be made BCs. They can easily convince
the people in opening the bank accounts & increase
network using their familiarity & quality of trust.
With globalisation, the gap
between various nations are
bridged, banking to rural
masses can link up the gap
within India under the um-
brella of financial inclusion

8 NIVESHAK VOLUME 3 ISSUE 4 April 2010

 Deepali Bhargava
Economist, ING Vysya Bank
Deepali Bhargava joined ING in August 2008, and is India Economist for ING Vysya
Bank. Deepali has to her credit, consistently accurate directional calls on inflation, interest rates
and INR.
Prior to ING, Deepali was an economist with the treasury of ICICI Bank for 3 years with
focus on India research. She has a Masters in Economics from The Delhi School of Economics.

Niveshak: There are talks that the
Global and Indian economy are
on the recovery path. What do
you have to say about it? How
do you see the Indian macroeco-
nomic scenario panning out in
the next couple of years?
Ms. Bhargava: RBI recently raised its
key rates – repo, reverse repo and Deepali Bhargava,
CRR – by 25 bps to each to 5.25%, in this interview
3.75%, 6.00% respectively. Though with, Team Nive-
the recent rhetoric by RBI may have
hinted at a policy shift towards con- shak opines about
taining inflation, the April policy the state of the

She Speaketh
report seems to be more balanced economy at present
Ms. Bhargava: Indian economy is well with a focus on risks to growth. RBI
sustaining the growth momentum is not in a hurry to move ahead of and the trajectory it
entering in to 2010-11. Leading in- the curve in the wake of uncertain- is expected to tra-
dicators are hinting at continued ties both on the inflation and growth
recovery. Services sector is likely to
verse. In light of the
front RBI sees monsoons as a key
catch up with the industry sector uncertainty as both inflation soften- RBI annual policy
in 2010-11 when we expect it to re- ing and growth pick-up are contin- attempting to deli-
cord over 9% growth. The big boost gent on a normal monsoon.
is likely to come from 1) enablers
cately balance the
like the arrival of 3-G facilitating A low rate hike now also gives RBI rising inflation and
telecommunication growth 2) strong more time to evaluate the growth growth recovery, a
emphasis on infrastructure reviving situation and impact of earlier rate
hikes. Upside risks to inflation are
peek in the dynam-
construction 3) higher tourist arriv-
als and 4) deleveraged bank balance likely to sustain for long, in the ics of the Indian and
sheets pulling up bank profitability. presence of rising global commodity world economy is
prices and demand –side pressures
Revival in domestic demand is likely building up. Outlook for growth, at
what this interview
to be complemented by a pick-up on 8% for FY11, is expected to be fi- has to offer.
exports. IMF has projected an expan- nanced by 20% growth in credit and
sion of 5.8% in world trade volume 17% growth in money supply - levels
in 2010 vs. a contraction of 12.3% in that are not consistent with an over-
2009, which is a positive for India heated economy. Hence, we stick to
trade. But, among other factors, the our call of gradual and consistent
competitiveness will be determined rate hikes in the current rate hike
by the extent, if any, of CNY revalu- cycle. We expect a cumulative 125
ation and also RBI’s comfort with bps of Repo and Reverse Repo hike
the pace of INR appreciation. Taking in FY11
these factors into account, we fac-
Niveshak: India has witnessed
tor in a 10% growth in exports. Bank
strong FII inflows in the capi-
credit is likely to play a key role in
tal markets for quite some time
financing growth. We, hence, pencil
in 8.2% GDP growth for FY11. now. FIIs have been consistent-
ly building up their portfolio in
Niveshak: What do you have to the top BSE and NSE companies.
say about the RBI annual policy? Where do you see the FII and FDI
Is it in accordance with the gen- investments heading in the com-
eral market sentiments? ing quarters?

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 9

 Ms. Bhargava: Continuity of foreign inflows in the
current year will be contingent upon inter-country
growth differentiation, interest rate differential,
growth expectations in the FDI sensitive sectors, and
global liquidity. India, with expectations of 8% plus
growth, will likely be one of the top contenders for
flows going by the first two reasons. Services’ driven
growth will be a positive, as services have been the
primary driver of FDI inflows since 2000, account-
ing for 22% of total FDI inflows from Apr’00-Dec’09.
The likely facilitators for FDI in 2010-11 will be: 1)
3G auction and higher FDI approvals in telecom 2)
Increase in FDI deals between emerging markets 3)
Government mulling FDI hike in defense production
4) government considering allowing foreign invest-
ment in LLP.
The other factor – global liquidity –has been a prima-
ry determinant of foreign inflows. With 65% positive
correlation between global liquidity (calculated at
an aggregated index of money supply for the major
economies) and FII flows in the last two years, the
She Speaketh
going will likely continue to be good as the major
economies recover and with a build-up in positive
risk environment. On the other hand, as G-3 starts
withdrawing excess liquidity, flows in FY11 (ING es-
timates: USD 20 bn) will turn more volatile and will
likely end-up aggregating lower vis-à-vis FY10 (USD
30 bn). But an increase in short-term trade credit
(with a revival in trade) and ECB (as recovery gains
momentum) will likely fill the gap. Hence, we expect
capital account surplus to increase to USD 68 bn in
FY11 vs. USD 62 bn (estimated) for FY10. The pain
point will be a widening in current account as oil
prices go higher and non-oil imports stage a recov-
ery. With export growth likely to fall short of import
growth, current account deficit is likely to widen to
2.7% of GDP in FY11 (from 2.5% in FY10) assuming
average oil price of USD 90/bbl.
Thus, from the balance of payments point of view
though appreciation pressure will exist due to a bal-
ance of payments surplus, it may not be very ag-
gressive. Greater RBI intervention may further stem
the appreciation pressure. Risk of surge in oil prices
and hence local inflation will likely imply greater
volatility for INR in FY11. We target 42.8 on USD/INR
by fiscal-end.
Niveshak: The IIP numbers were released re-
cently. According to you what impact will it
“RBI sees monsoons as a key
uncertainty as both inflation
softening and growth pick-up
are contingent on a normal
monsoon.”
10 NIVESHAK VOLUME 3 ISSUE 4 April 2010
have and what factors will impact it in next
quarter?
Ms. Bhargava: Though the broad growth number has
moderated, 3-month seasonally adjusted annualized
growth rate for IIP recovered to 23% in both Jan and
Feb 2010, reflecting strong momentum in IIP in these
months. Going forward, a moderation in y-o-y IIP
growth is likely on negative base effect.
The key drivers - consumer durables and capital
goods - continued to record stellar growth at 30%
YoY and 44.4% YoY respectively. Consumer non-
durables continued to be a laggard. Going forward,
a possible reduction in automobile sales, following
withdrawal of fiscal stimuli, may impact consumer
durables growth negatively.
But we assess that the trend is upwards as eco-
nomic recovery gains a firmer ground
Consumer non-durables, on the other hand, aver-
aged a meager growth of 1.3% YoY Dec’09-Feb’10 on
high food prices. Recovery in this segment will be
hugely contingent upon the performance of mon-
soons. A normal monsoon and higher rural incomes
are likely to be positive for both consumer durable
and non-durables.
Niveshak: What do you think about the ren-
minbi (Chinese yuan) exchange rate policy and
what will be impacts of the changes if any?
Ms. Bhargava: The US’s interest in China’s co-opera-
tion on Iran and China’s interest in adopting a more
market-based exchange rate mechanism suggest
compromises are possible. We remain of the view
that Beijing will align the renminbi-dollar trading
band, now +/- 0.5%, with the bands for the non-dol-
lar cross rates, +/- 3% by the end of June. We expect
this will produce a one-off 3% appreciation in the
renminbi to the strong end of the trading band. We
think other Asian currencies will appreciate by up to
the amount the renminbi appreciates. Renminbi ap-
preciation is a monetary tightening, which is nega-
tive for global growth. We think increased growth
angst would cause the dollar to appreciate.
 Cover Story
Financial reporting refers to the manner in which
the companies show their financial position to inves-
tors, creditors and other interested parties by preparing
financial statements. Financial statements data is used
to evaluate a company’s past performance and current
financial position in order to form opinions about the abil-
ity of the company to earn profits in the future. Recent
Window
years have seen numerous accounting scandals resulting
in bankruptcies and demise of some major firms. Looking
back we see that these scandals have occurred whenever Dressing
the managers have felt the pressure to meet market ex-
pectations. Accounting practices have improved over the
years, but companies still find ways and means to get
around the stated rule to tweak their financial results.
The
The challenge for the financial analyst is to look not only
at the malpractices of reporting but also at the quality of
reporting.
Financial
In general accounting parlance, high financial report-
ing quality is defined as reporting which results in a fair
presentation of the company’s operations and financial
Statements
position. The article is an attempt to show how compa-
nies utilize creative accounting to overstate their financial
position and performance. Companies that manipulate
their financial position often try to increase their earn-
Hitesh Gulati
ings power in the current or future peri- Team Niveshak
ods to create the appearance of a strong
financial condition or performance. This
makes it easier for them to obtain lines
of credit at low interest rates, as well as
issue debt financing on better terms. The
management might also be motivated to
overstate assets or understate liabilities
to make the company appear more liquid
and solvent. The balance sheet can even
be used to “store earnings” for future
periods. The results can be a misleading
gauge of earnings power and financial
condition.
Generally Accepted Accounting Prin-
ciples (GAAP) can be exploited by the
firms to achieve a specific outcome while
meeting the letter, but not the spirit of
the accounting standards.
Low quality earnings can be a result
of:
1) Use of acceptable accounting
practices that misrepresent the econom-
ics of a transaction.
2) Restructuring transactions to
achieve a desired outcome.
...painting a rosy picture
3) Exploitation of the intent of the
Accounting Principle

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 11

 Misrepresentation
LIFO Method of Inventory Reporting
Inventory calculations and reporting are a ma-
Cover Story
jor factor involved in the analysis of merchandis-
ing and manufacturing companies. Such companies
generate their sales and profits mainly through in-
ventory transactions. An important consideration in
determining profits for these companies is measur-
ing the cost of goods sold when the inventories are
sold. Inventory costs typically change from period to
period and the choice of inventory cost flow method
affects the firm’s income statement, balance sheet
and several other financial ratios. Additionally, the
cost flow method can affect the income taxes of the
firm and hence affects the cash flow position of the
firm.
The various methods of reporting inventory are
the weighted average, specific observation, FIFO and
the LIFO method of accounting. Among these the
method which is of interest here is the LIFO meth-
od. The method assumes significance because of its
ability to significantly lower taxable income. The LIFO
method assumes that the companies sell their most
recently purchased inventory units first. The ending
inventory under this method thus consists of those
units that have been held the longest and valued at
their historic costs. Conditions favoring use of LIFO
method arise when the unit costs of inventory rise
over time and the inventory quantities are generally
constant or increasing.
The consequences of LIFO method are that the
Cost of goods sold reported under LIFO is higher
when unit prices of inventory rise over time. This
leads to a lower reported net income and hence
saves Income Tax for the firm. Lower income tax
expense under LIFO means that the operating cash
flows for the period are higher. The reported inven-
tory value under FIFO is higher than under LIFO and
hence the creation of a “LIFO reserve” which is the
difference between the FIFO inventory value and the
LIFO inventory value.
LIFO results in FIFO results in
Higher COGS Lower COGS
Lower Net Income Higher Net Income
Lower taxes Higher taxes
Lower Inventory balances Higher Inventory balances
Companies that manipulate
their financial position try to
create the appearance of a
strong financial condition or
performance.
12 NIVESHAK VOLUME 3 ISSUE 4 April 2010
Lower Working Capital Higher Working Capital
Higher Cash flows (less Lower Cash flows (more
taxes paid) taxes paid)
LIFO method of reporting inventory is not per-
mitted under the IFRS. However companies reporting
according to the US GAAP can use the LIFO method
of reporting inventory provided that they use the
method for tax reporting as well as accounting pur-
pose. The companies that use the LIFO method
are required to disclose in their financial notes the
amount of LIFO reserve.
Phantom Profits
LIFO liquidation occurs when a firm’s inventory
quantities are declining. In this situation, the older
lower costs are included in the Cost of Goods sold.
This results in reporting a higher profit margin under
LIFO. However the higher profit margin is not sus-
tainable and is hence known as “Phantom profits”.
Hence the firm cannot liquidate its inventory infi-
nitely as it well eventually run out of goods to sell.
Depreciation Methods
Depreciation is the systematic allocation of the
assets cost over time. Depreciation may be reported
using the straight line, accelerated or units of pro-
duction method. Typically companies use the straight
line method for financial reporting and an acceler-
ated depreciation method for reporting taxes. In the
accelerated methods of depreciation, more deprecia-
tion expense is recognized in the early years of an
asset’s life as compared to straight line depreciation.
This results in lower net income in early years under
the accelerated methods as compared to the straight
line method. Companies might also use longer use-
ful lives period for the purpose of depreciation and
amortization than their economic life to show lower
expenses on the income statement.
Re- Structuring transactions
Capitalization vs. Expensing of Expenditures
When a firm makes an expenditure, then it can
either capitalize the cost as an asset on the balance
sheet or expense the cost in the income statement
for the period. Expenditures related to long-lived as-
sets are included as part of the recorded value of
assets on the balance sheet if they are expected
to provide economic benefits for a period of time
greater than one year and are hence said to be capi- compared to an identical company which reports the
talized. Alternatively expenditures are treated as an lease as a financial lease.

Cover Story
expense if they are not expected to provide benefits F i n a n c i a l Operating
in future period. Lease Lease
Capitalized expenditure is treated as an invest- Total Assets Higher Lower
ment cash outflow. However an expenditure that is Liabilities Higher Lower
expensed appears as operating cash outflow in the
Net Income ( early year ) Lower Higher
period it is made. Expensing thus reduces the net
Net Income ( subsequent
income in the period it is made as compared to capi- Higher Lower
years )
talizing which results in greater reported profitability
Cash flow from operations Higher Lower
in the year of reporting.
Cash flow from financing Lower Higher
Capitalizing Expensing
Debt Ratios Higher Lower
Total Assets Higher Lower
Shareholders’ Equity Higher Lower Exploitation of the Intent of the Account-
Income Variability Lower Higher ing Principle
Net Income (1st year) Higher Lower
Use of market value method
Net Income (subsequent
Lower Higher Mark to market method of accounting requires
years)
a company to report accounts on the balance sheet
Cash flow from operations Higher Lower
at their fair market values rather than at historical
Cash flow from investing Lower Higher cost. Under the mark to market method of account-
Debt Ratios Lower Higher ing forwards, swaps, options, energy transportation
Interest Coverage ratio (1st contracts are allowed to be shown at their fair val-
Higher Lower
year) ues. However the use of mark to market method of
Interest Coverage ratio (sub- accounting for other types of contracts is somewhat
Lower Higher
sequent years) unusual and presents ample opportunities to distort
revenues and income as the management desires.
Operating vs. Financial Lease
Mark to market method has also been criti-
Certain companies structure
cized in the case of derivatives as outlandish
leases in the form of operating
assumptions, projections and account-
leases in such a way so as to achieve desirable
ing can result in both parties re-
financial ratios (low debt ratios and high return on
porting substantial profits for long
assets). Because a financial lease is economically
periods. According to Warren Buf-
similar to borrowing money to purchase an as-
fet, the practice of reporting “mark to
set, the lessee company (borrower of the asset)
market” leads to “mark to myth” in the
records the leased asset and the related debt on
case of derivatives.
the balance sheet. The income statement in case
of a financial lease reports the interest expense Equity Method of Accounting
along with depreciation expense. Companies can account for the investments
An operating lease however is similar to rent- in a separate business or entity under the consoli-
ing an asset. In an operating lease, only an income dation method or the equity method depending on
expense is recorded on the income statement while control on the subsidiary. Unfortunately, this leaves
no asset or liability is recorded on the balance sheet. the door open to companies that want to conceal
Debt on the balance sheet and expenses on the in- and manipulate the true performance of their sub-
come statement are thus higher in the early years sidiaries or joint ventures.
of a financial lease. Hence firms often prefer to re- Under the equity method, the investment is
port leases as operating leases as it results in higher recorded at cost and is subsequently adjusted to
profit and better solvency position in early years as

The challenge for the financial

analyst is to look not only at
the malpractices of report-
ing but also at the quality of
reporting.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 13

 reflect the share of net profit or loss and dividends
received. The method limits the information avail-
able for investors. For example, a company could
overstate interest coverage in order to change the
Cover Story
distinct competitive advantage that a firm possess-
es, it is quite likely that it could be a case of abnor-
mal accounting practices being followed by the firm.

leverage ratios of the subsidiary. Operating Cash flow out of line with re-
ported earnings: If a company reports positive
Classification of Recurring items earnings but negative operating cash flows, then
Certain companies try to move “Gains” up the this could be a signal of some wrong doing on the
income statement and report them as revenues part of the management.
and report expenses as “Losses”. Only those items
Fourth Quarter Surprises: Unusually high rev-
should be reported as income and expenses that are
enues or low expenses in the fourth quarter of a
expected to recur over subsequent years.
year should be scrutinized with detail as well.
Conclusion:
Companies can manipulate their financial
statements in many different ways. However, inves-
tors can detect these practices by simply reading
the financial statements a little more closely. Some
of the means to detect abnormalities that should be
looked at include:

Abnormally high growth compared to peers:

Although high growth of a firm could be a result of a

According to Warren Buffet,

the practice of reporting “mark
to market” leads to “mark to
myth” in the case of
derivatives.

14 NIVESHAK VOLUME 3 ISSUE 4 April 2010

CATASTROPHE BOND MARKET
WHAT DOES CATASTROPHE
BOND – CAT MEAN?
It is a high-yield debt instru-
ment that is usually insurance linked
and meant to raise money in case of
a catastrophe such as a hurricane
or earthquake. It has a special con-
dition that states that if the issuer
(insurance or Reinsurance Company)
suffers a loss from a particular pre-
defined catastrophe, then the issu-
er’s obligation to pay interest and/or
repay the principal is either deferred
or completely forgiven. For example,
if an insurer has built up a portfo-
lio of risks by insuring properties
in Bangladesh, then it might wish
to pass some of this risk on so that
it can remain solvent after a large
hurricane. It could simply purchase
traditional catastrophe reinsurance,
which would pass the risk on to re-
insurers. Or it could sponsor a cat
bond, which would pass the risk on
to investors. In consultation with an
investment bank, it would create a
special purpose entity that would
issue the cat bond. Investors would
buy the bond, which might pay them
a coupon of LIBOR plus a spread,
generally (but not always) between
3 and 20%. If no hurricane hits Ban-
gladesh, then the investors would
make a healthy return on their in-
vestment. But if a hurricane were to
hit Bangladesh and trigger the cat
bond, then the principal initially paid
by the investors would be forgiven,
and instead used by the sponsor to
pay its claims to policyholders Ad-
vantages of CAT bonds are that they
are not closely linked with the stock
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
DEBDIPTA MAJUMDAR
BIM TRICHY
market or economic conditions and
offer significant attractions to inves- Natural disasters
tors. For example, for the same level would no longer be
of risk, investors can usually obtain able to take a death-
a higher yield with CAT bonds rela-
tive to alternative investments. An-
ly toll on Insurance
companies with the
other benefit is that the insurance
risk securitization of CATs shows no arrival of Catastroph-
correlation with equities or corpo- ic Bonds or CAT
rate bonds, meaning they’d provide
a good diversification of risks.
bonds. This article
runs through the de-
WHY INVEST IN CAT?
tails about the issue
Investors choose to invest in
and the circumstanc-
catastrophe bonds because their
es of triggering of
return is largely uncorrelated with
the return on other investments in a CAT bond. It also
fixed income or in equities, so cat explains in detail
bonds help investors achieve diver-
sification. Investors also buy these
their rating and their
significance in an
securities because they generally
pay higher interest rates (in terms emerging economy
of spreads over funding rates) than like India.
comparably rated corporate instru-
FinGyaan
ments, as long as they are not trig-
gered.
Key categories of investors
who participate in this market in-
clude hedge funds, specialized ca-
tastrophe-oriented funds, and asset
managers. Life insurers, reinsurers,
banks, pension funds, and other in-
vestors have also participated in of-
ferings.
HOW IS IT RATED?
Cat bonds are often rated by an
agency such as Standard & Poor’s,
Moody’s, or Fitch Ratings. A typical
corporate bond is rated based on
its probability of default due to the
issuer going into bankruptcy. A ca-
Special condition: if the issuer
suffers a loss from a catas-
trophe, then its obligation to
pay interest and/or repay the
principal is either deferred or
completely forgiven.
15
 tastrophe bond is rated based on its probability of
default due to an earthquake or hurricane triggering
loss of principal. This probability is determined with
the use of catastrophe models. Most catastrophe
bonds are rated below investment grade (BB and
B category ratings), and the various rating agencies
have recently moved toward a view that securities
must require multiple events before occurrence of a
loss in order to be rated investment grade.
HOW ARE THEY TRIGGERED?
The sponsor and investment bank who struc-
ture the cat bond must choose how the principal
impairment is triggered. Cat bonds can be catego-
rized into four basic trigger types. The trigger types
listed first are more correlated to the actual losses
of the insurer sponsoring the cat bond. The trigger
types listed farther down the list are not as highly
correlated to the insurer’s actual losses, so the cat
bond has to be structured carefully and properly cal-
ibrated, but investors would not have to worry about
the insurer’s claims adjustment practices.
Indemnity: triggered by the issuer’s actual
losses, so the sponsor is indemnified, as if they had
purchased traditional catastrophe reinsurance. If the
layer specified in the cat bond is $100 million excess
of $500 million, and the total claims add up to more
than $500 million, then the bond is triggered.
Modelled loss: instead of dealing with the
company’s actual claims, an exposure portfolio is
constructed for use with catastrophe modelling
FinGyaan
dexed to the natural hazard caused by nature. So the
parameter would be the wind speed (for a hurricane
bond), the ground acceleration (for an earthquake
bond), or whatever is appropriate for the peril. Data
for this parameter is collected at multiple reporting
stations and then entered into specified formulae.
For example, if a typhoon generates wind speeds
greater than X meters per second at 50 of the 150
weather observation stations of the Japanese Meteo-
rological Agency, the cat bond is triggered.
Parametric Index: Many firms are uncomfort-
able with pure parametric bonds due to the lack of
correlation with actual loss. For instance, a bond may
pay out based on the wind speed at 50 of the 150
stations mentioned above, but the insurer loses very
little money because a majority of their exposure
is concentrated in other locations. Models can give
an approximation of loss as a function of the speed
at differing locations, which are then used to give
a payout function for the bond. These function as
hybrid Parametric / Modelled loss bonds, and have
lowered basis risk as well as more transparency.
LET THE ‘CAT’ OUT OF THE BAG
The Economic Survey 2009-10 has suggested
the introduction of catastrophe bonds in the Indian
market, to transfer insurance risk arising out of nat-
ural calamities such as earthquakes, hurricanes and
floods, to the capital markets. The survey said:
Popular abroad
Cat bonds are popular in some of the markets

software, and then when there is a large event, the
event parameters are run against the exposure da-
tabase in the cat model. If the modelled losses are
above a specified threshold, the bond is triggered.
Indexed to industry loss: instead of adding
up the insurer’s claims, the cat bond is triggered
when the insurance industry loss from a certain peril
reaches a specified threshold, say $30 billion. The
cat bond will specify who determines the industry
loss; typically it is a recognized agency like PCS.
“Modified index” linked securities customize the in-
dex to a company’s own book of business by weight-
ing the index results for various territories and lines
of business.
Parametric: instead of being based on any
claims (the insurer’s actual claims, the modelled
claims, or the industry’s claims), the trigger is in-
abroad, especially in the United States and Europe.
Insurance or reinsurance companies can issue
these bonds and place them with various investors.
This helps them transfer a part of the risks to the
investors.
The insurance company can further invest the
money generated from selling the bonds.
“Cat bonds can be issued by the Government
or financial institutions. Investors can get a slightly
higher return when compared to other securities
and it also offers them an opportunity to diversify
their investments. But if the catastrophe is of huge
proportions, then investors can lose the capital.
The insurance company then uses the amount
raised against Cat bonds to pay policy holders’
claims,” said Mr K. G. Krishnamoorthy Rao, Chief Ex-

Advantages of CAT bonds

are that they are not closely
linked with the stock market
or economic conditions and
offer significant attractions to
investors.

16 NIVESHAK VOLUME 3 ISSUE 4 April 2010

ecutive Officer, Future Generali India Insurance Com- servative enough to realize that innovation aimed at
pany. diversifying risk can end up increasing it, may not
Alternative to reinsurance warm up to it immediately. But just as they have
slowly but surely allowed interest rate futures or cur-
Insurers can use this tool as an alternative to
rency swaps, catastrophe bonds could pass muster.
reinsurance. However, according to insurance indus-
try officials, neither the capital markets nor the In- All of this points to a long time horizon. Which,
dian insurance industry is developed enough for the given the risks of overnight financial liberalization,
introduction of these types of bonds. is surely a relief.
“This is a risky instrument. Who knows what
will happen when insurance companies move away
from core insurance practices,” said an insurance
company official.

WHY IT’S IMPORTANT FOR INDIA?

There was a recent earthquake in Chile – the FIN-Q Solutions
5th most powerful in the last century – lucky it didn’t
exact a higher toll. Insurance companies aren’t: They March 2010
are on the line for losses up to $8 billion, making this
the second costliest earthquake for them in history.
Insurers in the West have been trying to mute the
1. General electric
risk of such Black Swans—events that almost no one
predicts but that everyone suffers from—for some 2. 1862
time. In the late 1990s, they developed a new prod-
uct called a catastrophe or “cat” bond. After hurri-
cane Katrina in 2005, activity in this market on Wall 3. Swaps
Street jumped from near zero to $14 billion. Now, the
office of India’s chief economic adviser has noticed 4. X is Mad Money; Y is Cramer
it, too. The Economic Survey notes that “there is
scope for introducing (this instrument) in countries Bounce
like India”. There are grounds for scepticism here,

FinGyaan
but it’s worthwhile for regulators to at least examine 5. Rebalancing
this bond.
The first is that of India’s immature capital
markets. It’s true that the low level of financial liter-
6. Small Order Execution
acy dampens much financial activity; however, this System (SOES)
bond caters to a sophisticated investor set, offering
a security unlinked to the usual market volatility. So 7. Royal sun alliance& Sundram
regardless of the weak bond market, this bond can
thrive, depending on insurance. alliance
Though, second, the current state of the insur-
ance market isn’t promising either. According to a 8. Sir John Templeton
paper last year by Crisil and Assocham, India’s insur-
ance business commands 0.6% of its output, against
the world average of 2.14%. Still, as incomes rise
and as more employers offer benefits, this market
has only room to expand.
Third, India’s regulators, who have been con-

A catastrophe bond is rated

based on its probability of
default due to an earthquake
or hurricane triggering loss of
principal.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 17

 THE GOLD, OIL AND US RELATIONSHIP
Kaustubh Kolhar
JBIMS
Of the various vulnerabili- century, and this is one of the prime
The price of oil is
ties traditional financial assets are factors behind the unprecedented
poised to rise steadi- exposed to, a rising oil price is of prosperity of its economy in the 20th
ly as the supply/ particular concern. In 2004, oil hit century. While the US accounts for
demand imbalance an all-time high of $56 per barrel, only 4.5% of the world’s population,
up 366 percent from the $12 low of it consumes 20.25% of the world’s
increases and the 1998, and up 75 percent since Janu- fossil fuel-based energy. It imports
dollar declines. As ary 2004. about 70% of its oil, but produces
this happens, the Generally, an increasing oil only 10.7% and consumes 25.9% of
price of precious price results in increasing infla- the world consumption. Because of
tion, negatively impact the global this dependency on both oil and for-
metals will climb eign suppliers, any increase in price
economy, particularly oil-dependent
until they eventu- economies such as the US. Apart or supply disruptions will negatively
ally catch up to their from increased transportation, heat- impact the US economy to a greater
degree than any other nation.
historic ratios. If the ing and utility costs, higher oil prices
are eventually reflected in virtually
oil producers start Hubbert Curve:
every finished product, as well as
demanding Euros, food and commodities in general. In the early 1950s, M. King
dinars or precious Furthermore, there is evidence thatHubbert, one of the leading geo-
physicists of the time, developed a
global oil production is peaking and
metals in payment predictive model showing that all
the flow will soon be in permanent
for their product, decline. oil reserves follow a pattern called
the decline in the US Hubbert’s Curve, which runs from
The majority of oil reserves are
discovery through to depletion. In
dollar will accelerate located in politically unstable re-
any given oil field, as more wells
while the price of gions, with tensions in the Middle
are drilled and as newer and better
precious metals will East, Venezuela and Nigeria likely to
technology is installed, production
intensify rather than to abate. Be-
explode. initially increases. Eventually, how-
cause of frequent terrorist attacks,
ever, regardless of new wells and
Iraqi oil production is subject to dis-
new technology, a peak output is
ruption, while the risk of political
reached. After this peak is reached,
problems in Saudi Arabia grows. The
oil production not only begins to
timing for these risks is uncertain
decline, but also becomes less cost
and hard to quantify, but the impli-
effective. In fact, at some point in
cations of Peak Oil are predictable
FinSight

this decline, the energy it takes to

and quantifiable, and the effects will
extract, transport and refine a barrel
be more far-reaching than simply a
of oil exceeds the energy contained
rising oil price.
in that barrel of oil. When that point
Oil - A major contributor to is reached, extraction of oil is no lon-
US prosperity: ger feasible and the reserve is aban-
doned. In the early years of the 20th
The US has enjoyed inexpen-
century, in the largest oil fields, it
sive oil-based energy for nearly a

While the US accounts for

only 4.5% of the world’s popu-
lation, it consumes 20.25% of
the world’s fossil fuel-based
energy.

18 NIVESHAK VOLUME 3 ISSUE 4 April 2010

was possible to recover 50 barrels of oil for each bar- dollar, as a medium of exchange. There is growing
rel used in the extraction, transportation and refin- dissention among religious fundamentalists in Saudi
ing process. That ratio of 50-to-1 ratio has declined Arabia regarding the exchange of oil for US dollars.
to 5-to-1 or less. And it continues to decline. Oil, gold and commodities have all been priced
in US dollars since 1975 when OPEC officially agreed
to sell its oil exclusively for US dollars. From 1944
until 1971, US dollars were convertible into gold by
central banks in order to adjust for any trade imbal-
ances between countries. Up to that point, the price
of gold was fixed at US$35 per ounce, and the price
of oil was relatively stable at about US$3.00 per bar-
rel. Once the US ceased gold convertibility in 1971,
OPEC producers were forced to convert their excess
US dollars by purchasing gold in the marketplace.
This resulted in price increases for both oil and gold,
until eventually oil reached US$40 per barrel and
Using analytic techniques based on Hubbert’s gold reached US$850 per ounce.
work, oil and gas experts now project that world oil Today, apart from geopolitical threats in oil-
production will peak sometime in the latter half of producing regions, supply/demand imbalances from
this decade. We are now depleting global reserves Peak Oil and increasing demand from developing
at an annual rate of 6%, while demand is growing countries, the price of both gold and oil can be ex-
at an annual rate of 2% (and that growth rate is ex- pected to increase as the US dollar declines. With
pected to triple over the next 20 years). This means an ever-increasing US money supply, growing triple
we must increase world reserves by 8% per annum deficits and mounting debt at all levels, the US dollar
simply to maintain the status quo, and we are no- is likely to continue the decline that began in 2001.
where near achieving that S i n c e then, foreign holders of US dollar
goal. In fact, we are so assets have already lost 33% of
far from it that, accord- their investment.
ing to Dr. Colin Campbell, There have been discus-
one of the world’s leading sions among Arab nations
geologists, the world con- about pricing oil in Islamic
sumes four barrels of oil gold and silver dinars. If
for each one it discovers. this happens, other produc-
ers may follow suit and opt
Oil and other met- out of accepting US dollars
als: for oil. Demand for the cur-
There are numer- rency will plummet, send-
ous social, economic and ing the dollar into a freefall
political implications related to world while demand for Euros, gold
oil production peaking in the next few years, and silver soars.
FinSight
but our concern here is to examine how a rising
oil price is linked to precious metals. The answer Gold during the recession period:
to that question begins with the historical desire of During the recession period, as the financial
Arab producers to receive gold in exchange for their markets tried to find a bottom while banks went
oil. This dates back to 1933 when King Ibn Saud de- bankrupt and more and more investment scandals
manded payment in gold for the original oil conces- continued to pop up on the radar destroying inves-
sion in Saudi Arabia. In addition, Islamic law forbids tor’s life savings literally over night, the FED contin-
the use of a promise of payment, such as the US ued to pour billions of USD’s into the system. The

According to Dr. Colin Camp-

bell, one of the world’s leading
geologists, the world consumes
four barrels of oil for each one
it discovers.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 19

 USD has been consistently stronger, even though the of precious metals. Precious metals may be consid-
FED continued to dilute the world with more dollars ered to be a hedge against geopolitical tensions or
on a monthly basis. Gold has also been increasing severe crises.
in value, reaching $1000, as foreign currencies de- • T h e r e is an inverse relationship be-
clined. tween the Commodity Pre-
In addition, Middle Eastern oil producers would cious Metal Price Index
be forced to diversify their vast US dollar holdings and the US Dollar Index.
into precious metals and other currencies to protect This relationship is also
themselves from further losses. As losses mount, substantiated by the em-
other large, non-oil producing, US dollar holders pirical findings of the World Gold
such as Japan, China, Korea, India and Taiwan would Council which shows that there is a neg-
seek to diversify out of US dollars. Eventually, this ative relationship between the price of gold
could result in a dollar sell-off and a correspond- and the US dollar.
ing increase in oil and gold prices. • During recessions the US
dollar typically appreciates in value
Oil and Gold Correlation:
and the price of silver, platinum and pal-
Over the last 50 years or ladium decline, keeping true to the inverse re-
so, gold and oil have generally lationship mentioned above.
moved together in terms of price,
• During recessionary periods the price of gold
with a positive price correlation of
and the US dollar appreciate together, failing the in-
around 80 percent. During this time, the price
verse relationship in the short-run. In the long-term,
of oil in gold ounces has averaged about 15 barrels
the inverse trend between gold and the US dollar
per ounce. However, with recent soaring oil prices,
holds, just not during recessions.
the relationship has strayed far from this average.
The gold-oil ratio reached a 10-year high of 25 as The above suggests that gold is a long-term
the global recession erodes demand for energy com- hedge against inflation and a short-term hedge
modities and investors abandon monetary assets against crises.
in favour of the safe haven metal. While oil prices
recently set an all-time high of $56 per barrel, gold
prices have not kept pace and the oil:gold ratio fell
to an all-time low of 7.5:1.
The size disparity between oil and gold mar-
kets must also be considered. While annual gold
production is approximately US$35 billion, annual
oil production is US$1.5 trillion, by far the largest-
trading world commodity. As oil prices increase and
demand for US dollar diversification increases, there
will be an ever-expanding number of petro dollars
and other offshore dollar holders chasing a relatively
small amount of bullion ounces.
FinSight

Gold: The Saviour

• Gold is considered to be a long-term hedge
against inflation. That has been empirically justified
by research conducted by the World Gold Council
(June 2006).
• In the short-run, the geopolitical tensions or
periods of uncertainty spark an uptrend in the price

Over the last 50 years, gold

and oil have generally moved
together in terms of price, with
a positive price correlation of
around 80 percent.

20 NIVESHAK VOLUME 3 ISSUE 4 April 2010

 Nivesh in Indian Population
Rahul Goyal
NITIE, Mumbai
Most of the Indians plan to in- Countries Pop. Den- GDP per
vest in mutual funds, gold, property, The article targets
sity (per capita $

Sparsely Populated Countries

IPOs or stocks but have you ever giv- km2) the behavioural
en a thought of investing in human UAE 55.012 28611.84 aspect of the In-
population? If not, then why?
Australia 2.886 37433.85 dian economy and

Rich
The Indian population clock
has already clocked 1,151,068,507
Canada 3.405 38439.78 the investments be
USA 30.71 44155.00
and is still ticking fast enough to ing made overall.
Mozam- 24.21 377.69
question if this ever growing popu- The general feeling

Poor
bique
lation is generating poverty or eco-
nomic prosperity. At first sight, it Ethiopia 71.739 183.13 amongst the masses
appears that this huge population is Table 2 Source: www.nationmaster.com is that growing pop
a curse to our economy. It is also a The above statistics evidently ulation is a curse
liability for the nation. More people acquits population from the charge but the article does

Perspective
meaning more mouths to be fed that it causes poverty. Highly pop-
that ultimately makes the nation ulated states can both be rich and bring it is as a po-
suffer from poverty, corruption and poor. Singapore with the highest tential bless ing for
ill governance. Many of us even be- population density (per sq. km) of the economy only if
lieve that a growing population will 6386.29 generates 40 times the In-
simply guttle the planet, and lead to dia’s GDP per capita. Similar is the
proper investment is
famine, disease and death of civili- observation for sparsely populated made in the “human
sation as we know it. nations. Hence population growth is beings”.
But a serious thought and re- not the factor that causes poverty or
search would counter the above ar- miseries. So does that mean popula-
gument. Infact there is no correlation tion growth causes economic pros-
between the growing population and perity? Let us try to find that out by
a falling economic and social pros- analysing the statistics below.
perity. The statistics below would India’s Population
vouch for that non-correlation: Year Pop. LEB IMR FGP FGP/
(m) (yrs) (mt) per-
Countries Pop. Den- GDP per
son
sity (per capita $
Table 3 Source: www.censusindia.gov.in

km2) 1901 238 23 210 _ _

Densely Populated Countries

1911 252 21 204 _ _

China 136.12 2033.90
1921 251 27 219 _ _
Poor

India 328.29 816.60

1931 271 31 174 _ _
Japan 337.23 34022.94
1941 319 32 161 _ _
Germany 230.89 35270.36
1951 361 42 146 52 14.4
Rich

Singapore 6386.29 30082.46

1961 439 46 129 83 18.91
Belgium 339.71 37384.34
1971 548 51 129 105 19.16
UK 246.88 38849.97 1981 684 54 110 133 19.44
Hongkong 6348.61 27071.62 1991 846 58 92 168 19.86
Table 1 Source: www.nationmaster.com/ 2000 1000 62 72 200 20

Human population tripled in

the 20th century, but during
the same period the world per
capita output quadrupled thus
improving the quality of life
for everyone.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 21

 Legend: hence greater would be the prosperity.
LEB: Life Expectancy at Birth To support the above argument let us analyse
IMR: Infant Mortality Rate per 1000 live births statistics given in Table 5: The table gives the most
FGP: Food Grain Production populous cities of India with their State GDP’s. The
It can be seen that with the rising population Top 5 most populous cities of India also happen to
India has actually done better in terms of food grain have their state’s GDP in the Top 5 slots barring Del-
production and availability. Life expectancy has in- hi. The most populous State of India, which is Uttar
creased and mortality rate has come down. With ris- Pradesh (which is not shown in the table) ranks 2nd
ing population India has become self sufficient and in GSDP.
has indeed prospered.
Rank:
At this point somebody may put forward an ar- Rank City
Pop.
State/UT
Rank:
Cities
gument that with rising population India is running (2010) GSDP
GDP
out of resources. But the fact is: India is not and 1 Mumbai 13,830,884 Maharashtra 1 1
neither would any other country. Let us go through 2 Delhi 12,565,901 Delhi - 3
another piece of statistics to prove that: 3 Bangalore 5,438,065 Karnataka - 4
Percentage 4 Kolkata 5,138,208 West Bengal 4 2
Metal 1980 1990
Change 5 Chennai 4,616,639 Tamil Nadu - 5
Copper 6 Hyderabad 4,068,611 Andhra 3 6
$200 $163 -18.5%
(195.56 lbs.) Pradesh
Chrome 7 Ahmedabad 3,959,432 Gujarat 5 7
$200 $120 -40%
(51.28 lbs.) 8 Pune 3,446,330 Maharashtra - 8
Nickel
Perspective

9 Surat 3,344,135 Gujarat - 9

$200 $193 -3.5%
(63.52 lbs.)
Tin
$200 $56 -72%
(229.1 lbs.)
Tungsten
$200 $86 -57%
(13.64 lbs.)
Table 4 Source: London Metal Exchange
It can be seen that the cost of various metals
(resources) has decreased over a decade despite the
population increase. It also means that natural re-
sources will progressively become less scarce, hence
less costly, and will constitute a smaller proportion
of our expenses in future years.
Nearly every datum from life expectancy and
infant mortality rate to health indicator, to price of
natural resource and consumption good like food
item, to environmental quality, things have bettered.
Human population tripled in the 20th century, but
during the same period the world per capita output
quadrupled thus improving the quality of life for ev-
eryone.
People are actually wealth creators. They create
wealth because they are inherently non self-suffi-
cient. They need the services of other humans for
which they need to have wealth. People specialize
and create staggering volume of services and prod-
ucts. They drive innovation. Hence more the popu-
lation, greater the division of labour would be and
Table 5 Source: “India: largest cities and towns and sta-
tistics of their population”. World Gazetteer. http://www.
world-gazetteer.com
The inference that can be drawn from these
statistics is that despite of being highly populated,
these states have been doing extremely well. Even if
we take the GDP per capita of these states or cities
the Top 10 would more or less remain the same. Be-
cause of the sincere efforts put by people of various
specialisations like politicians, academicians, stu-
dents, doctors, engineers, architects, street vendors,
dhobis, barbers, labourers etc rapid urbanisation of
these states happened. Wherever the concentration
was thick, there was greater prosperity simply be-
cause there was greater division of labour.
Human beings have the ultimate resource with
them i.e. their minds and the ability to comprehend.
These resources when invested in along with proper
training, development and skills building initiatives,
would give the highest ROI compared to other avail-
able “risky” investment options in market. With this
statement, I, out rightly, want to make two things
clear. Firstly I didn’t advocate for investing in human
beings just to make them doctors, engineers, politi-
cians, managers only. Even Street vendors qualify
to be the people whom we can invest heavily in.
Secondly for prosperity, human beings need not be

Statistics tells us that Street vendors and hawkers form a major part of over 90% of India’s
workforce which earns its livelihood in the informal sector. As a matter of fact this sector ac-
counts for 63% of the country’s GDP.

22 NIVESHAK VOLUME 3 ISSUE 4 April 2010

educated at all. we have been fed into our minds that without edu-
Both the statements may have surprised you. cation we will be nothing. But the fact of life is that
But let us try to understand the reasoning: Statis- we humans are everything.
tics tells us that street vendors and hawkers form It brings us to the conclusion that all human
a major part of over 90% of India’s workforce which beings are potential contributors. They all must
earns its livelihood in the informal sector. As a mat- get equal opportunities to grow and prosper. There
ter of fact this sector accounts for 63% of the should not be any bias towards educated
country’s GDP. and uneducated, poor and rich
For a wide array of or men and women. Each
products - from one of us has some
fruits and veg- or the other role
etables, to to play in the
garments, economic
toys, and system.
maga- With this
zines c on fi -
- street dence, hu-
vendors man be-
provide ings with
an effec- their mind
tive distri- and ability

Perspective
bution chan- to trade will
nel, on which generate numer-
both producers and ous wealth by doing
consumers rely. Street what they can do best
vendors not only create em- in a free market economy. It will
ployment for themselves through their also enable them to look upon themselves and
own entrepreneurial skills, but also help generate their brethren as a huge asset. Surely, investing in
employment in agriculture as well as small-scale in- human beings is one Nivesh that will reap the ben-
dustry. Hence we can say that street vendors are a efits for hundreds of years to come.
vital and vibrant part of the Indian economy (Source: There are jobs
www.petitiononline.com). a-plenty there—
So street vendors turns out to be a potential I’ll be a watchman,
where we must heavily invest. They must be given waiter, doctor
vending licenses and, on lines of SEZs’ Hawing zones Even a politician—
must be created to let them operate freely. But the if I dare!
sad part is that we are investing blindly in setting up I am there where millions live
of mammoth buildings, malls, multiplexes etc which And a million dreams come true.
don’t even hold a respectful contribution in nation’s I am not a liability I am an asset to accrue.
GDP.
From the above example it is clear that dho-
bis, street vendors, hawkers, and autowalas are all
potential entities to invest in and it is primarily be-
cause they have minds, skills and ability.
Evidently the above example explains the sec-
ond point too, that, for a nation to prosper, it is not
mandatory for each and every one to be educated.
What they must have are skills. The argument may
seem unintelligent because right from the beginning

People specialize and create

staggering volume of services
and products. They drive
innovation.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 23

 FIN-Q
1. In a recent decision by RBI, the infrastructure finance companies (IFC) have also been
included in the NBFCs. What has been kept the minimum capital adequacy ratio for these
newly included NBFCs?

2. What is the world’s largest gold exchange traded fund and silver exchange traded fund?

3. In which of the following countries is prevalent the Pay as you earn (PAYE), a
withholding tax system?
(A) USA
(B) UK
(C) Australia
(D) Germany
(E) China

4. What term became popular after the newspaper report of Watergate Scandal in the year
1973?

5. Which is the first Indian bank to commence operations in Singapore?

6. Which bank is promoted by 20th Century Finance Corporation and Keppel Tatlee Bank of
Singapore in India?

7. He is the pioneer in mutual fund industry and often referred as the Father of Index
Fund investing. He created the first S&P 500 Index fund. Identify this famous person?

8. Which financial services giant is referred as the “Thundering Herd”?

FinLounge

9. Which country’s currency is known as Drachma, which in Greek means ‘to grasp’?
FinSight

10. By how many basis points were CRR and reverse repo rates hiked by RBI in the latest
credit policy released on 20th April?

All entries should be mailed at niveshak.iims@gmail.com by 10th May, 2010 23:59 hours
One lucky winner will receive cash prize of Rs. 500/--

24 NIVESHAK VOLUME 3 ISSUE 4 April 2010

ANNOUNCEMENTS
ARTICLE OF THE MONTH
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Abhishek sarkar and Sreejit Gopinathan
of Welingkar Institute of Management
They receive a cash prize of Rs.1000/-

FINQ WINNER
The FinQ Winner for the month March 2010 is
Harshil Suvarnkar
of JBIMS
He receives a cash prize of Rs.500/-
CONGRATULATIONS!!

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