46th Financial Advisor Practice Journal

D-D-D-Danger!
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Volume 46 / September 2010
FINANCIAL ADVISOR
PRACTICE JOURNAL
JOURNAL OF THE SECURITY ACEDEMY AND FACULTY OF e-EDUCATION
SAFE UPDATES – KEEP INFORMED

The Securities Academy and Faculty of e-Education
Editor: CA Lalit Mohan Agrawal
D-D-D-Danger! Watch behind you
Editorial preamble
1.1 LIQUIDITY DRIVES THE HERD
The Sea of Liquidity
Investors need to realise the strength of the assets lies in its

diversity and not its apparent homogeneity. Cats and dogs do
not usually frolic in the same meadow. But in the financial
marketplace, the relationship between various asset classes
has never been so intimate.
The price behaviour of any single market variable is

sufficient to reveal how the entire financial universe is
stacking up on a particular day. When investors are feeling
frisky, they will simultaneously bid up all risk assets from
copper to currencies; conversely, when risk is off, the relative
sector performance of all major equity markets shapes up
accordingly, as does the direction of every asset class.
Such mind-numbing herd behaviour is typically reflective of incredible stress in the system. Correlations
between different US stocks were at such lofty levels during the height of the 2008 global financial crisis
and prior to that during the stock market crash of 1987.
Although most indicators of systemic risk – from credit spreads to options prices – have eased
considerably since early 2009, correlations remain as stretched as ever (they normally drop significantly a
year after a recession ends). It is popular to attribute the high degree of synchronisation between different
markets to globalisation.
Studies indeed show a secular increase in the co-movement of business cycles in the industrialised world
over the past century and correlations between various markets have obviously strengthened over the past
few decades due to a reduction of capital controls, deregulation, increased trade and a convergence in
policymaking goals across the world.
Still, it is strange that correlations are well above the rising long-term trend line at this stage of the
business cycle, and this suggests that some other factor is at work…It’s the Sea of liquidity
Abnormally-low interest rates have led to a surge in financial market liquidity; ebbs and flows in liquidity
now dictate many trends across the world. Exposure-driven investing has also become much more popular
in the current environment with an increasing number of market participants using passive investing
vehicles such as exchange-traded funds (ETFs) to put fast money to work.
Liquidity also helps explain the so-called ‘financialisation’ of commodities that have historically shared a
weak relationship with stock price movements. Commodities now move completely in sync with
monetary trends as investors seek to use ETFs in order to gain access to hard assets. Demand and supply
fundamentals play a rather secondary role to financial flows in the commodity pits with prices of oil and
copper increasingly disconnected from physical inventory data.
Liquidity can even help explain why US corporate profitability has surged despite an anaemic economic
recovery. Companies have used low interest rates to cut their debt, thereby reducing expenses related to
interest payments and creating significant operating leverage.
Given the importance of liquidity in setting so many trends, it is hardly surprising that the marketplace is
obsessed with whether China will take its foot off the monetary brakes or if the Fed will engage in another
round of quantitative easing. These macro concerns are subsuming all micro details, as was evident last
month when the suggestion of some easing in China’s monetary policy stance was enough to send global
markets higher even though economic growth data was disappointing.
The problem is that policymakers worldwide are trying to get growth back to pre-crisis trajectories by
running very expansionary monetary and fiscal policies. However, the underlying economic fundamentals
are not as supportive of higher growth due to excessive debt in the system.
The tug-of-war between policy activism and the lack of a naturally-strong growth impulse has resulted in
most global markets swinging back and forth within big fat trading ranges this year. While it is hard to
envisage what will change the current dynamic, rationality will eventually return where investors again
start to differentiate between various markets. Nowhere is this more relevant than in emerging markets.
The sea of liquidity has engulfed this asset class as well and the correlation between stock markets of all
mainstream developing countries is running at near all-time high levels even though fundamentals vary
considerably in the developing world.
The reference to emerging markets is as if they are homogeneous entity with much talk of the global
balance of power shifting from the West to the East, and of all developing countries destined to converge
with the industrialised world. This is great marketing gimmickry but distorts the underlying reality, as the
characteristics of various emerging markets can’t be more different.
The Per-capita incomes
For a start, per-capita incomes in the various emerging markets are all over the map, making the growth
profile of each very divergent. Per-capita incomes in South Korea and Taiwan are in excess of $15,000
while those in Brazil, Russia and Turkey are just shy of the $10,000 mark, and those in India and the
Philippines are well under $2,000. The upside potential for economic convergence is, therefore, much less
in South Korea and Taiwan, especially since they are struggling to make the transition to becoming
services sector-oriented economies.
The Pattern of recovery
More importantly, the pattern of recovery from the global financial crisis has varied considerably in the
emerging market world. China, India, Indonesia, the Philippines and South Korea have all experienced a
V-shaped rebound. Russia, Mexico and Taiwan have witnessed more of a U-shaped upturn even as many
eastern European nations from Hungary to Romania have yet to register a meaningful growth.
The industrial production cycle
The dispersion in the industrial production cycle between various developing countries is currently at its
highest level in recent history, but the difference between their stock market returns is close to record
lows. Investors’ lack of discrimination is also evident in the fact that the gap in valuations between
different emerging markets are running well below the norm.
Making distinctions among the markets has historically been the most powerful driver of returns in this
asset class but, of late, the global liquidity wave and the resulting fad to bracket all emerging markets
together has dwarfed other factors.
The overall returns of emerging markets in the coming years are unlikely to be as strong as they were for
much of the last decade given their higher valuations now and faint prospect of another growth surge of
the kind seen in the 2003-07 boom years. Accordingly, a back-to-basics strategy will involve that
investors dissect each country’s fundamentals.
The strength of emerging markets lies in the diversity they offer.
For instance, their credit profiles present remarkably-varied growth prospects in their respective financial
sectors. Loan penetration ratios in South Korea and China are similar to many troubled developed
countries while the low levels in Latin America and parts of eastern Europe provide ample scope for
credit growth.
Exposure to global trade and capital flows also differs considerably. Many Asian countries still rely quite
heavily on export growth whereas eastern Europe is more dependent on capital flows to fund growth. The
nature of any external shock will determine the vulnerability of these countries.
The currency is another important driver of returns in emerging markets, and here too the potential for
future returns throws up a contrasting picture. Currencies of commodity exporting countries from Russia
to Brazil look expensive while those of some Asian and eastern European nations such as the Korean won
and the Polish zloty appear cheap.
At some point, investors will start to make necessary distinctions and appreciate country specific factors.
A uni-dimensional world is not a sign of healthy global economy as it suggests that markets are still in the
throes of a boom-bust cycle with liquidity offering artificial support to keep the old regime going. After
all, the rule of nature dictates that cats and dogs stick to playing in their own meadows.
1.2 STOCK MARKETS
World bourses will remain correlated
All eyes are fixated on how Wall Street closed last night.
We get our daily dose of Asian cues from Topix, Kospi,
Hang Seng and Shanghai every morning.
And thereafter, we follow the London FTSE, German

DAX and French CAC as they open for trading as also
Dow, Nasdaq and S&P futures, whom Indian stock
markets track second-by-second.
Every evening, we are all ears to FII net inflows and

outflows.
Why are plummeting US new home sales important to an

average Indian stock market investor?
Because slower US new home sales means slower consumer spending on washing machines and dryers,
dishwashers and refrigerators. Copper, zinc and nickel, all near multi-month highs, could give back much
of their recent gain if fixed investment growth merely slows than nosedives in China. Would this not
impact revenues of Indian steel, aluminium and copper producers?
And would it not lead to lower demand for Indian software embedded in the microprocessor chip that runs
the washing machines, dryers, dishwashers and refrigerators?
And why is high US unemployment relevant to Indian investors?
Because it leads to lower consumer demand – reflecting in lower US GDP – which leads US companies to
cut costs to maintain their bottomline. Thus far, they have been turning to low-cost destinations such as
India. Now, they are trying to focus on topline growth. Besides, high unemployment levels have driven
down wages of workers in states such as Arkansas to India-equivalent levels.
Floods in Pakistan ravage cotton crops that, in turn, impact global cotton prices. Does this not affect our
textile companies?
Poor crop of tea in Sri Lanka affects world tea prices as much as poor crop of Arabica coffee beans in
Brazil affects cost of our daily morning cup of the hot beverage.
Historically, the average number of trading days that the US has gone in the opposite direction of Asia
over a 50-day period is 22. That means the US trades in the same direction as the Asian markets on a
daily basis about 56% of the time.
The Directional Indicator does fluctuate from low levels of correlation to high levels of correlation, and
we just ended a period where they were trading in tandem more often than not.
Over the last 50 days, however, they have gone in the opposite direction 22 times – right in-line with the
historical average.
1st week of August – Sensex up 276 points
Daily review 30/07/10 02/08/10 03/08/10 04/08/10 05/08/10 06/08/10

Sensex 17,868.29 212.92 33.62 102.61 (44.61) (28.84)
Nifty 5,367.60 64.05 7.90 28.30 (20.75) (7.85)
Weekly review 30/07/10 06/08/10 Points %

Sensex 17,868.29 18,143.99 275.70 1.54%
Nifty 5,367.60 5,439.25 71.65 1.34%
2nd week of August – Sensex up 23 points
Daily review 06/08/10 09/08/10 10/08/10 11/08/10 12/08/10 13/08/10

Sensex 18,143.99 143.51 (67.51) (149.80 3.71 93.13
Nifty 5,439.25 46.90 (25.45) (40.10 (2.15) 33.65

Sensex 18,143.99 18,167.03 23.04 0.13%
Nifty 5,439.25 5,452.10 12.85 0.24%
3rd week of August – Sensex up 235 points
Daily review 13/08/10 16/08/10 17/08/10 18/08/10 19/08/10 20/08/10

Sensex 18,167.03 (116.25) (1.93) 208.27 197.82 (53.12)
Nifty 5,452.10 (33.80) (4.15) 65.00 61.05 (9.55)

Sensex 18,167.03 18,401.82 234.79 1.29%
Nifty 5,452.10 5,530.65 78.55 1.44%
4th week of August – Sensex down 403 points
Daily review 21/08/10 23/08/10 24/08/10 25/08/10 26/08/10 27/08/10

Sensex 18,401.82 7.53 (97.76) (131.95) 46.71 (227.94)
Nifty 5,530.65 12.85 (38.40) (42.75) 15.55 (69.20)

Sensex 18,401.82 17,998.41 (403.41) (2.19%)
Nifty 5,530.65 5,408.70 (121.95) (2.20%)
End of the month – Sensex down 27 points
Daily review 27/08/10 30/08/10 31/08/10

Sensex 17,998.41 33.70 (60.99)
Nifty 5,408.70 6.75 (13.05)

Sensex 17,998.41 17,971.12 (27.29) (0.15%)
Nifty 5,408.70 5,402.40 (6.30) (0.12%)
Yearly/Quarterly/Monthly Review
Month December December December March June July August

2007 2008 2009 2010 2010 2010 2010
Sensex 20,206.95 9,647.31 17,464.81 17,527.77 17,700.90 17,868.29 17,971.12
Points Base (10,559.64) 7,817.50 62.96 173.13 167.39 82.83
% Base (52.26%) 81.03% 0.36% 0.99% 0.95% 0.46%
Indian Equities Not Cheap: Jim Rogers
India is perhaps going to open its market to foreigners to make it easy for all foreigners to buy and sell
shares in India. If India does that, that will make me to have to scratch my head and think a lot more about
India. Indian shares are certainly not cheap and they have gone up a lot, but if they are finally going to
make the Indian stock market open and accessible to everybody, that having to go through a bunch of
hoops or a bunch of rigmaroles, that is certainly going to attract more and more investors to India. Now,
they have to make the currency convertible, they have to follow through on a lot of things, but if India is
going to do that, it would have to make me reconsider my views on India.
Investment guru Jim Rogers reiterates that he sees another recession hitting some countries in 2012.
Excerpts from the interview:
Every 4 to 6 years throughout history, we have had recessions in most countries in the world, including
the United States. So, all I said was about 2012. We may be overdue for another one. The same things
have run that cause all recessions. Things get too hot, they cool off. We have had these cycles for
hundreds of years throughout history. Other things can happen. We can have sudden wars, we can have
panics, we can have epidemics, and we can have droughts. Many things can cause bear markets. They
have come along and slowed economies. They have been coming along from 4 to 6 years from many-
many decades, nothing unusual about that. I was surprised if people seem to think that I have said
something outrageous. That is just normal history.
Shivers down the spine again and again
Like malaria, the shivers come again and then again. In May
and June, it was fear that some sovereigns may turn insolvent
and the possibility of a meltdown in Europe was no longer a
remote possibility. In the past few weeks, it is about uncertain
growth prospects in the US and, by extension, to Europe and
the rest of the world.
A major international financial newspaper carried the headline;

China shows further signs of slowing. Bond prices have risen,
developed-country equity markets lost 2-3 % and the US dollar
began to harden and oil went down - the reflexive action today
when risk appetite weakens, that is, spirits begin to sag.
Several events have contributed to the run-up to this bout of the shivers.
The reported slowdown in China has the potential of serving as a powerful topping. About China, there is
always that pall of mystery. Nobody really understands how an economy of this size could grow at 10% a
year for more than 30 years in a row. So, there are always apprehensions and in a supportive climate this
can greatly add to the shivers. Chinese industrial output growth in July and June was 13.4% and 13.7%
respectively, down from 17%, 18% and 21% in the previous months.
Likewise, import growth and loan growth showed easing. Is this 'slowdown' the source of so much morbid
fear? Not quite. The fear is really about (a) is there a debt-fuelled bubble in China (mostly in real estate)
as all the spectators suspect? And (b) is this bubble going to burst? The answer is, of course, that nobody
really knows, and all previous fears of a hard landing in China never materialised, even mildly. But in the
climate of fear, this is the other bogeyman. In the grammar of apprehension now current, it is truly a G-2.
The US Federal Reserve has downgraded its outlook for the US economy and decided to keep its balance-
sheet size constant by using principal redemptions on its portfolio of government and private bonds to
make fresh purchases of longer-dated government securities. That seems to be a standstill option, not a
stepping-up of monetary expansion. That makes sense. Perhaps, the US needs to do something about
improving the competitiveness of its domestic sector. Raising H1-B visa fees, increasing the scope and
intensity of regulations governing private business and legislating new mandates that appear to raise the
cost of doing business, one would surmise, is perhaps not the way to go.
Nobel laureate Paul Krugman in his latest column opens with the line 'The lights are going out all over
America - literally'. It needs hardly be said that if the forces of light have to win the day, massive fiscal
stimulus is unsurprisingly the only solution. Unfortunately, this is not a George Lucas movie but about
real life, enormous stakes and people in the hundreds of millions.
In conclusion, how should we in India view these developments? Surely, someone can, on the basis of the
June IIP numbers, start a wail that about how India, too like China and the US, is seeing a slowdown.
We must also recognise that, there is much that needs to be done in order to make the 9%+ target a
sustainable growth path. And that includes addressing the numerous supply constraints, whether it is in
agriculture, food logistics, power and coal or in the incipient tendencies to push rent-seeking protectionist
ideas. In all this, the onus is entirely on us - not global issues - to take the right approach and do the
correct thing and do it effectively.
2.1 INDIAN ECONOMY
It’s a world’s fastest growing economy by 2013-15
A new report by Morgan Stanley finds that the India is poised to

accelerate its growth rate to 9-9.5% over 2013-15, even as China
will cool down to a more sedate 9% by 2012 and to 8% by 2015.
India has one of the lowest median ages among the major
economies. When an economy prospers, first its death rate and then,
its birth rate falls. As this trend proceeds, there is a big bulge in the
working age population while the non-working population (the
young and the old) shrink as a share of the population. The
lowering of the dependent (non-working) population to working age population ratio has twin effects.
One, it allows people to save a large proportion of their income, raising the country’s rate of savings; two,
it boosts the number of people who work and contribute to growth.
Thanks to structural reform, the additional hands available for work find work. Even with stagnant per
capita output, the sheer increase in the number of workers would raise GDP growth. With reform pushing
up productivity per worker, GDP would rise even faster.
Globalisation gives additional job opportunities, additional capital to augment rising domestic savings and
additional know-how. With this happy combination, the report expects India to become the world’s
fastest-growing economy. Real GDP growth in China has averaged 10% annually over the past 30 years,
compared with 6.2% in India. During this period, China’s GDP grew 16 times to $5 trillion whereas
India’s rose seven times to $1.2 trillion. China’s exports (including services) surged 65 times over this
period to $1,330 billion while India’s exports increased 22 times to $250 billion.
China has overtaken Japan to become the world’s second-largest economy. China’s demographic
transition pushed up its savings rate above 30% in 1985, while India’s savings rate crossed that level only
in 2005. India’s consumption level will now come down, even as China’s will rise.
Underlying the Morgan Stanley forecast is the assumption that India will significantly jack up its
expenditure on infrastructure and in plant and machinery. Infrastructure expenditure has gone up from
5.4% of GDP in 2005 to 7.5% in 2009 and is poised to go up to 8% of GDP in 2010. Over 2012-17, the
forecast is that India’s infrastructure spend would be $1 trillion as compared with $530 million over the
previous five-year period.
Another assumption is on the quantity and quality of the young people coming into the workforce. While
India will be the largest contributor to the world’s workforce – all of 136 million people – over the next
10 years (fully a quarter of the entire world’s additional workforce), China will add just 23 million.
The report also assumes that less than 5% of those who enter the workforce will be illiterate in India in
the next two-three years, and that there would be a big jump in the number of young people, who go to
and finish college, making India the largest contributor to the pool of tertiary educated workforce in the
world.
All these changes would be supported and complemented by further reform by the government in fiscal
consolidation, opening up of retail to foreign direct investment, public sector reform and divestment, and
improvement in governance that would reduce transaction costs.
2.2 INDIA
Plans that fulfil people's aspirations
India has the second fastest growing economy in the world, after
China. The ‘unbinding’ of the Indian economy has enabled many
Indians to grow very wealthy. However, the Indian economy is not
yet providing enough opportunities for young people in all parts of
the country to earn a decent living.
At the recent meeting of the National Development Council

(NDC), chief ministers of several states – J&K, the north-eastern
states, the left wing extremism affected states, and even Punjab –
said their states desperately needed more opportunities for young
people to earn incomes through jobs or entrepreneurship. Some went so far to say that it would be better if
the economy grew at 7% and created more jobs, than if it grew 10% without creating enough jobs, thus
creating conditions for social unrest and even violence. We need 10% and more jobs.
India’s growth story is at a critical juncture, as is China’s. Neither can sustain its growth without
addressing issues of perception: of equity and inclusion in economic growth. Ideas of democracy and
human rights are stronger within India than in China. Also information is more accessible across India
through an open media. So, strategies for economic growth must be more closely intertwined with the
politics of change in India than in China.
In India, it is not only the pace of growth that will impress people, but also the pace of their inclusion in it.
Those who are being left behind, including tribals, do not want to be mere passive beneficiaries of state
handouts and corporate philanthropy. They want to be respected, earning their own incomes and growing
their own wealth. People need ‘skills’ to get jobs and earn incomes, and the goal of providing skills to 500
million Indians must be pursued.
The prime minister concluded his address to the NDC with a call for innovation in government
institutions to reflect changing circumstances and expectations. Policymakers must rethink measures of
national aspirations and approaches to realising them.
National planners must consider not only the financial measures of a country’s performance, such as
GDP, investments, and savings, but also better measures of the quality of its environment, society, and
governance. Ultimately, what planners measure and monitor must matter to people. Therefore they must
listen to people while making their plans. The youth of any country is its future. This is truer for India,
with its large young population, than other countries. Not only must India’s planners plan for India’s
youth, they must use the energy and aspirations of India’s youth to make their plans.
A year ago, the young CM of J&K warned that youth feel they are not being heard and included. When
words are not heard and understood, he predicted, frustration with the way things are going will spill onto
the streets, expressed in stones and sticks. Therefore, the Achilles heel of democratic India’s growth story
is the crumbling of institutions in which dialogue and debate should take place, such as Parliament and
state assemblies, and the weakness of processes in which those who are not included should be heard
while preparing plans – at the Centre, in the states, and within their localities. For India to be a large
economy, as well as a happy country, people must feel included in the planning. Therefore, we need
innovations in the way plans are made for India to realise its people’s aspirations.
2.3 INDIA INC
Mitigating risk for a smoother drive
As the world begins to emerge from economic recession, few

would doubt that Indian companies stand on the threshold of
an exciting period of opportunity. Our economy has fared
better than most during the lean times, and has a momentum
that is still noticeably absent in the west. Indeed, Indian
companies are arguably better equipped than ever to capitalise
as the global economic climate begins to return to normal.
Evidence of the increasing global stature of Indian companies

can be seen in many sectors. The recent acquisition of Zain
Africa by Bharti Airtel, for example, placed the Indian
company among the world’s top five telephone operators. Tata Steel’s acquisition of Corus had a similar
impact. And the list goes on.
Even among those Indian companies for whom global expansion is not an immediate priority,
opportunities are significant – buoyed by the consumer boom and resulting rises in domestic
consumption. However, amid all this well-founded optimism, it is important for Indian companies not to
get carried away. As they seek to take advantage of the favourable conditions by expanding, introducing
new offerings or building innovative new delivery models, they will need to deal with a range of new
strategic, operational and financial risks.
Companies with strong risk management processes are more likely than others to succeed in securing
growth capital and in negotiating the increasingly tortuous global regulatory landscape. A proper
Enterprise Risk Management (ERM) approach can make risks more visible before they impact an
organisation. The problem is that in most Indian companies, risk management is relatively immature, and
has been configured with the very low threshold of Clause 49 in mind.
While it is clear that a failure by western organisations to deal appropriately with risk has itself played a
significant role in creating the recent recession, the fact remains that ERM is an area where Indian
companies can learn much from their western counterparts. A recently conducted review of the ERM
policies and practices of large western corporations like Boeing, Coca-Cola, Cisco Systems, Microsoft
and Shell identified six key lessons for the leaders of Indian companies.
No two ERM programmes are alike:
ERM programmes must be designed on a ‘one-size-fits one’ basis, developed to match the corporate
culture, because engagement with the business drives the ultimate success of any ERM initiative.
It is never too early to start:
Formalising risk management early in the growth cycle pays dividends later on because risk processes
will be better integrated within the organisation. Companies that set aside the implementation of ERM
because they want to focus on other priorities can, of course, still succeed, but they must expect serious
troubles as the organisation adapts to work with the new risk-based approach.
There are many interpretations of ERM focus:
Risk management programmes tend to fall into one or other of two groups, according to whether they
focus mainly on strategic risks, measured and managed qualitatively (an enterprise level approach) or
more on operational and financial risks, measured and managed quantitatively (an enterprise wide
approach).
Some more sophisticated programmes marry both approaches in a single, integrated framework.
Determining which approach to adopt is an important decision point for any company.
Strategic and emerging risks may pose the biggest threat:
Those companies whose ERM programmes focus mainly on strategic and emerging risks generally do so
because these are perceived to pose the biggest threat to the success of a business or even its very
survival.
Risk management must be resourced to the right level:
ERM programmes are often resourced by very small teams, but if a programme is not properly
institutionalised, and depends too greatly on the personal equity of a single person or small group, ERM
itself may cease to exist when that person leaves the organisation or takes on other responsibilities. It is
vital that ERM is not pursued in a half-hearted manner.
The relationship between ERM and the business itself is crucial:
ERM programmes must work alongside business management in a complementary, supportive role, but
responsibility for risk must remain with the business itself. Lines of communication must be determined
and crucially, they must start with ‘tone at the top’ because programmes that are driven by the board
and/or the CEO are most likely to be successful.
Indian companies that can take these six lessons on board can develop world-class risk management
programmes that will allow them not only to control the downside of risk, but also to identify and
embrace its upside in the form of new opportunities to do business more effectively, more efficiently and
more profitably.
2.4 INTERNATIONAL
Welcome To The Recovery: Geithner
THE devastation wrought by the great recession is still all too real for
millions of Americans who lost their jobs, businesses and homes. The
scars of the crisis are fresh, and every new economic report brings
another wave of anxiety. That uncertainty is understandable, but a
review of recent data on the American economy shows that we are on
a path back to growth.
The recession that began in late 2007 was extraordinarily severe, but
the actions we took at its height to stimulate the economy helped
arrest the freefall, preventing an even deeper collapse and putting the
economy on the road to recovery.
From the start, President Obama made clear that recovery from a
crisis of this magnitude would not come quickly and that the recovery would not follow a straight line.
We saw that this past spring, when the European fiscal crisis posed a serious challenge to the markets and
to business confidence, dampening investment and the rate of growth here.
While the economy has a long way to go before reaching its full potential, latest data on economic growth
show that large parts of the private sector continue to strengthen. Business investment and consumption –
the two keys to private demand – are getting stronger, better than last year and better than last quarter.
Uncertainty is still inhibiting investment, but business capital spending increased at a solid annual rate of
about 17 percent. Together, private consumption and fixed investment contributed about 3.25 percent to
growth. Even the surge in imports, which lowered the rate of increase of G.D.P., actually reflects healthy
and growing American demand.
As the economists Ken Rogoff and Carmen Reinhart have written, recoveries that follow financial crises
are typically a hard climb. That is reality. The process of repair means economic growth will come slower
than we would like. But despite these challenges, there is good news to report:
• Exports are booming because American companies are very competitive and lead the world in many
high-tech industries.
• Private Job growth has returned – not as fast as we would like, but at an earlier stage of this recovery
than in the last two recoveries. Manufacturing has generated 136,000 new jobs in the past six months.
• Businesses have repaired their balance sheets and are now in a strong financial position to reinvest
and grow.
• American families are saving more, paying down their debt and borrowing more responsibly. This has
been a necessary adjustment because the borrow-and-spend path we were on wasn’t sustainable.
• The auto industry is coming back, and the Big Three – Chrysler, Ford and General Motors – are now
leaner, generating profits despite lower annual sales.
• • Major Banks, forced by the stress tests to raise capital and open their books, are stronger and more
competitive. Now, as businesses expand again, our banks are better positioned to finance growth.
• The government’s investment in banks has already earned more than $20 billion in profits for
taxpayers, and the TARP program will be out of business earlier than expected – and costing nearly a
quarter of a trillion dollars less than projected last year.
We all understand and appreciate that these signs of strength in parts of the economy are cold comfort to
those Americans still looking for work and to those industries, like construction, hit hardest by the crisis.
But these economic measures, nonetheless, do represent an encouraging turnaround from the frightening
future we faced just 18 months ago.
The new data show that this recession was even deeper than previously estimated. The plunge in
economic activity started an entire year before President Obama took office and was accelerating at the
end of 2008, when G.D.P. fell at an annual rate of roughly 7 percent.
Panicked by the collapse in demand and financing and fearing a prolonged slump, the private sector cut
payrolls and investment savagely. The rate of job loss worsened with time: by early last year, 750,000
jobs vanished every month. The economic collapse drove tax revenue down, pushing the annual deficit up
to $1.3 trillion by last January.
The economic rescue package that President Obama put in place was essential to turning the economy
around. The combined effect of government actions taken over the past two years – the stimulus package,
the stress tests and recapitalisation of the banks, the restructuring of the American car industry and the
many steps taken by the Federal Reserve – were extremely effective in stopping the freefall and restarting
the economy.
According to report released by Alan Blinder and Mark Zandi, advisers to President Bill Clinton and
Senator John McCain, respectively, the combined actions since the fall of 2007 of the Federal Reserve,
the White House and Congress helped save 8.5 million jobs and increased gross domestic product by 6.5
percent relative to what would have happened had we done nothing. The study showed that government
action delivered a powerful bang for the buck, and that the bank rescue on its own will turn a profit for
taxpayers.
We have a long way to go to address the fiscal trauma and damage across the country, and we will need to
monitor the ups and downs in the economy month by month. The share of workers who have been
unemployed for six months or more is at its highest level since 1948, when the data was first recorded,
and we must do more to ensure that they have the skills they need to re-enter the 21st-century economy.
Small businesses are still battling a tough climate. State and local governments are still hurting.
There are urgent tasks to be undertaken to reinforce the recovery, and Congress should move now to help
small business, to assist states in keeping teachers in the classroom, to increase investments in public
infrastructure, to promote clean energy and to increase exports. And while making smart, targeted
investments in our future, we must also cut the deficit over the next few years and make sure that America
once again lives within its means.
These are considerable challenges, but we are in a much stronger position to face them today than when
President Obama took office. By taking aggressive action to fix the financial system, reduce growth in
health care costs and improve education, we have put the American economy on a firmer foundation for
future growth. And as the president said, no one should bet against the American worker, American
business and American ingenuity. We suffered a terrible blow, but we are coming back.
2.5 WARNING SIGNALS
Obama says economy not growing fast enough
President Barack Obama said the US economy was expanding, but not quickly
enough, and there was no "magic bullet" that will fix its problems. The batch
of grim economic data was something his administration had anticipated.
Gloomy reports on gross domestic product and housing have raised fears the
fragile economy could slip back into a recession or face a lengthy period of
growth that is too slow to make much of a dent in the 9.5 percent
unemployment rate.
Obama faces a dilemma in trying to reassure Americans about the economy

without appearing to be out of touch with frustrations, which have been rising
over the sluggish growth and scarcity of jobs.
The economy is the top issue in the November 2 congressional elections, where Obama's Democrats are
bracing for potentially big losses to Republicans. Obama gave little indication of any new proposals that
might be unveiled in the near future. He noted that that the "short-term politics" of the election season
might make it hard to get such measures passed. "We're in the silly season – political season,” he said.
But he urged the US Congress to pass some of his existing proposals such as plans aimed at spurring
lending to small businesses and tax breaks for such firms.
"We should be passing legislation that helps small businesses get credit, that eliminates capital gains taxes
so that they have more incentive to invest right now," he said. "There are a whole host of measures we
could take. No single element of which is a magic bullet."
GDP, the measure of total goods and services output within US borders, was revised down to 1.6 percent
from an earlier estimate of 2.4 percent, according to the Commerce Department. Sales of previously
owned US homes have plunged to their slowest pace in 15 years.
Federal Reserve Chairman Ben Bernanke said the central bank was ready to take further steps if needed to
spur economic growth but some analysts’ say the Fed is limited in what it can do because interest rates are
already at ultra-low levels.
Obama also faces constraints on his ability to act.
The White House has said the $862 billion stimulus package he pushed through Congress last year saved
millions of jobs and prevented the economy from sliding into a more severe decline. But Republicans
contend the sluggish growth shows the stimulus has not worked and they say it has only served to bloat
the US budget deficit. Criticisms of the stimulus and concerns over the deficit might make it hard for
Democrats to make the case for additional fiscal measures.
Obama said it was important to balance the need to help the economy in the near term with ensuring the
budget deficit does not explode in the future. He said the deficits resulted from the "incredibly deep
recession." But Obama added: "We've got to keep on pushing to grow the economy. But we've also on the
medium term and the long terms have to get control of our deficit."
European Economy at Risk of Double-Dip Recession
Nobel Prize-winning economist Joseph Stiglitz said the European

economy is at risk of sliding back into a recession as governments
cut spending to reduce their budget deficits.
“Cutting back willy-nilly on high-return investments just to make

the picture of the deficit look better is really foolish,” Stiglitz, a
Columbia University professor, told Dublin-based RTE Radio in
an interview broadcast today.
Euro-area governments stepped up efforts to cut their deficits to

below the European Union limit of 3 percent of gross domestic product after the Greek crisis earlier this
year eroded investor confidence in the 16-member currency union. While the economy expanded at the
fastest pace in four years in the second quarter, the recovery is showing signs of weakening.
“Because so many in Europe are focusing on the 3 percent artificial number, which has no reality and is
just looking at one side of a balance sheet, Europe is at risk of going into a double-dip,” Stiglitz said.
Growth in Europe’s services and manufacturing industries slowed more than economists forecast in
August and German investor confidence slumped to the lowest in 16 months. Moody’s Investors Service
said yesterday that “risks to economic growth are clearly to the downside” in the euro-region economy.
‘Weak Growth’
The average budget deficit in the euro area will probably widen to 6.6 percent of GDP this year from 6.3
percent in 2009, the European Commission forecast in May. The Greek government aims to pare its
shortfall, the region’s second largest, from 13.6 percent of GDP last year to 8.1 percent this year and to
within the EU limit in 2014, it has said. The country has cut wages and pensions and increased taxes to
stave off a default.
At 14.3 percent of GDP, Ireland had the highest deficit in the euro region last year. The shortfall will
narrow to 11.7 percent this year, excluding the cost of bank bailouts, the commission forecast.
“Obviously, Ireland by itself is too small to determine what happens to Europe as a whole,” Stiglitz said.
“But if Germany, the U.K. and other major countries follow this excessive austerity approach, Ireland will
suffer.”
Stiglitz said that with companies still cutting jobs, he doesn’t expect economic growth to strengthen
anytime soon.
“The problem is that we aren’t getting out of this current crisis very quickly,” he said. “What we’re doing
is setting ourselves for a longer-term Japanese-style malaise of weak growth for an extended period of
time. It’s very disturbing that people are talking about a new normal” with unemployment as high as 10
percent “which would be devastating.”
3.0 MUTUAL FUNDS
No Entry Load Regime- The Aftermath
It was in August 2009 that Sebi banned entry loads for mutual
fund investments. A year down the line, the mutual fund
industry is yet to fully come to terms with the changes, which
have transformed the face of the mutual fund industry. The
decision has hit the fund business and the regulator has made it
clear that there are no plans to review it. The challenge before
both asset management companies as well as distributors is
how to quickly adapt to these changes and get going. A
beginning has already been made.
Prakash Thakkar is a happy man today. His business is doing

fairly well. By tweaking his business model and by
streamlining his short term business goals, Mr Thakkar has
ensured not only a reasonable stream of income, but is also
building a strong clientele. A year ago, Mr Thakkar was probably as apprehensive as many others in the
MF distribution business, who have now been compelled to shut down their businesses, due to a
regulatory fiat which changed the entire course and direction of their businesses.
Before the Sebi regulation came into force, an entry load or an upfront commission of close to 2.25 % on
the amount invested was charged by fund houses from investors. MF houses used to pay commission to
distributors in lieu of their services in reaching out, marketing and selling MF products to the investor
from the amount collected through entry loads.
As the commission amount was automatically deducted from the principal amount of the investment, few
investors were aware of the fact that their investment would get automatically reduced by about 2.5% and
that only the balance 97.5% was getting invested into the scheme. Those who were aware of it would
demand that their distributors repay a part of such commissions, usually 1% to 1.5%, to them in cash.
It was to curb this very practice and to make MF investments more transparent and customer-friendly that
Sebi introduced the no-load regime last year, where the onus of collecting a fee from the investor fell on
the distributor alone. Today, any investor seeking to buy an MF product through a distributor has to
mutually agree upon the commission payable to a distributor for his services.
While the intentions of the regulator were well meaning, the industry is yet to reconcile itself to the
changes which have been carried out.
The no-load regime has forced many small time distributors to shut shop, since convincing an investor to
pay money for services rendered while investing in a financial product such as an MF is not easy. For
investors having long been used to getting a part of their investment as cash back from the distributor, it
will take a while for them to get used to the new regime.
Even those who have continued with the MF business have diversified their business to include other
financial products such as insurance, bonds, post office savings schemes and corporate deposits, where
the distributor, even today, can pass on a small part of the commission received by him, to the investor.
For the MF industry, the last year has been quite trying with net flow of funds into equity schemes having
virtually dried up. In the past 12 months, since the abolition of entry loads, the MF industry has seen a net
outflow aggregating '11,560 crore from equity schemes. With distributors reluctant to aggressively push
MF schemes, the number of new fund offers (NFOs) launched by AMCs has also seen a sharp decline,
both in terms of numbers as well as collections. Compared to collections of nearly '30,000 to 40,000 crore
in the years 2006 & 2007, the year 2010 has so far witnessed collections of just about '2,000 crore through
the sale of NFOs. These collections are worse considering that even during the financial meltdown of
2008, new launches had managed to collect close to '15,000 crore.
Given this bleak scenario, there are not many who are bullish about the prospects for the MF industry.
Distributors such as Prakash Thakkar, who work at the grass root level, have taken these challenges in
their stride. So what have Mr Thakkar have done to stay on course.
Mr Thakkar, today offer their services free of charge to their investors. Thus, their only source of income
from this business is the commission paid to them by the MF houses. The fund houses today pay an
upfront commission ranging from 0.5% to 1.25% and a trail commission ranging from 0.4-1% depending
on each fund house. Thus, while some fund houses are compensating their distributors by paying a higher
upfront and a lower trail commission, others are doing the opposite.
While the upfront commission is just a one-time affair, payable when a distributor gets a fresh investment
for the fund house, the trail commission is payable each year on the total accumulated corpus of the
investor, till the time investor does not redeem his investments. The trail commission, in absolute terms, is
thus bound to go up each year as the corpus of the investor grows with the market. It is this trail
commission that the distributors are now targeting, to stay afloat.
Let us assume that a distributor manages to get business aggregating '1 lakh in the first year. Going by the
current commission structure, his income in the very first year would be an upfront of about '500.
Assuming a 10% return on investment, by the end of year one, the investment would swell to '1.1 lakh. At
0.75%, the trail commission earned on this corpus is about '825 taking the total commission earnings of
the distributor to '1,325 in year one.
With each passing year, till the time the investor stays invested in the MF scheme and his investment
continues to grow with the market, the distributor's trail commission will also grow in absolute terms. For
instance, if we assume the MF scheme to return about 10% each year, then by the end of the fifth year,
this initial investment amount of '1 lakh would have grown to about '1.6 lakh and the distributor's trail
commission thereon would grow to about '1,200 by the end of the fifth year as against '825 in the very
first year on the same amount of investment.
We have assumed, in this case, that the distributor handles business of '1 lakh in the very first year. But
with many small-time distributors having shut down their businesses and existing distributors offering
their services free of charge to the investors, it is very likely that these distributors will see a growth in
their business, in terms of rising number of investors with each passing year.
Assuming a growth rate of about 20% in business each year and a 10% return on the MF each year, by the
end of the fifth year, this distributor is likely to have built a corpus of about '8.18 lakh earning him a trail
commission of about '6,000 in the fifth year. The distributor would have also earned an upfront
commission on the fresh business brought in that year.
While the above is a hypothetical illustration, many distributors in the country today have begun to adapt
this model to survive in this business. As this business model requires the investor to stay invested for a
longer period of time, distributors have started to recommend to investors only the better-performing
schemes. They are also encouraging investors to stay invested for long.
This is quite contrary to the earlier practice where the distributors were often criticised for mis-selling
MFs to their investors by influencing them to switch over to new schemes at frequent intervals as part of a
concerted effort to earn a high upfront commission.
Even sales of new fund offers (NFOs) which were earlier sold aggressively by the distributors, have now
been hit as distributors are now pretty cautious before telling their clients to invest in any such NFO from
a fund house whose performance track record is not good.
The distributors now cannot afford to lose a customer in this volume driven business, with their trail
commissions linked to the performance of the scheme recommended by them to their customers.
Though it sounds easy, the fact remains that even with this model in place, distributors are finding it
difficult to break even, considering the amount of time and energy they now need to invest in for each
transaction, especially in small towns and cities.
However, if Parag Sonavane, a certified financial planner (CFP) from Mumbai is to be believed, the MF
industry is today a place for only serious players who have the foresight to capitalise on business from a
long-term perspective.
Given India's favourable demographics, with an increasing number of younger people joining the work
force, many distributors such Prakash Thakkar and Parag Sonavane believe that there is still a huge
market for them to expand their business.
There are also difficulties in convincing an investor to pay the distributor. IFAs such as Mandar Bhanage
believe that it is only a matter of time before Indian investors begin to value the importance of financial
advisory services. If the free advisory-cum-distribution services offered by distributors today yield
healthy returns for investors, then these investors are bound to value their advice in monetary terms in the
future too.
This free advisory model adopted by many distributors today in fact appears to be influenced by a popular
marketing practice adopted by many retail and FMCG companies which distribute free samples of their
product to gauge its acceptance in the market before a formal launch. The onus is now on both fund
houses and distributors to ensure that investors stay the course in an economy which is bound to grow at a
healthy clip over the next few years.
4. FINANCIAL SECTOR: TRANSFORMING TOMORROW
Good, Bad and Ugly
Why were some countries with similar financial systems, operating under the same set of global rules,
less affected than others in the recent global financial crisis? There are many reasons and as time goes by,
many more will emerge. But one that is increasingly finding resonance with policy makers is simply
‘better supervision’.
4.1 FINANCIAL ADVISORS:

Weigh impact on investors:
Supervision
In a financial world that lurched from excessive controls to virtually no controls, following the Big Bang
in the UK, supervision was regarded a dirty word. Supervisors were seen to play catch-up to savvy market
participants who devised clever and clever tricks to out smart them. The world had no patience for their
doddering ways. Now, that the world has grown wiser and too-clever-by half bankers are seen for what
they are – too clever for their own good, supervision has once again gained respectability.
What makes for better supervision, and how can countries identify and provide the right set of incentives
and the institutional and operational framework to enable “better supervision”? A recent IMF paper
zeroes in on the key features:
Good supervision is intrusive.
Supervision is premised on an intimate knowledge of the supervised entity. It

cannot be outsourced and it cannot rely solely or mainly on offsite analysis.
Supervisors in the financial sector should not be viewed as hands-off or distant
observers, but rather a presence that is felt continuously, keeping in mind the
unique nature of financial supervision.
Good supervision is sceptical but proactive. Supervisors must question, even in good
times, the industry’s direction or actions. Supervisors cannot act only after
operations have gone off the rails. In a sense, supervision must be intrinsically
countercyclical, particularly in good times. Prudential supervision is most
valuable when it is least valued; restricting reckless banks during a boom is
seldom appreciated but may be the single most useful step a supervisor can take
in reducing failures.
Good supervision is comprehensive. Even while recognising the limitations of their

scope, supervisors must be constantly vigilant about happenings on the edge of
the regulatory perimeter to identify emerging risks that may have systemic
portents, and draw the proper implications for the institutions they supervise.
This includes unregulated subsidiaries, affiliates, and off-balance sheet structures
associated with regulated institutions. This also includes the systemic risks posed
by systemically important financial institutions (SIFIs) and those arising from
interconnectedness and cyclicality.
Good supervision is adaptive. The financial sector is a constantly evolving and innovating
industry, and this has great benefits to the real economy. Supervisors must be in a
constant learning mode - new products, new markets, new services, and new risks must
be understood and responded to appropriately. They should follow closely changes in
business models of financial institution to determine whether any potential systemic
risks are building up during this process.
Good supervision is conclusive. Supervision has many facets,

from offsite reporting to onsite examinations to enforcement actions.
Supervisors must follow through conclusively on matters that are identified as
these issues progress through the supervisory process. As anyone who has
been involved with the supervisory process can affirm, the work of following
up on inspection findings to their final resolution is laborious, painstaking,
and unglamorous, but in the long run, critical to bringing about change. Every
identified issue, however small, needs follow-up and no matter can be left
without conclusion.
Bringing about good supervision: The authors identify two pillars that support good supervision: the
ability to act and the will to act. The will to act is ensured if there is a clear and unambiguous mandate,
operational independence, accountability, skilled staff and a healthy relationship with industry. Further
the policy and institutional environment must support both the supervisory will and ability to act; that
includes a clear and credible mandate, which is free of conflicts; a legal and governance structure that
promotes operational independence.
4.2 FINANCIAL PLANNERS
Value unlocking for all stakeholders:
Innovation
To innovate, or not to innovate, that is the question being asked in the financial sector, both here and in
the mature markets abroad. The Reserve Bank of India has put out a discussion paper on the issue of
introducing credit default swaps (CDS), financial instruments meant to mitigate risks and insure against
default on loans, bonds etc. But then CDS, and certain other instruments of ‘high finance,’ such as
collateralised debt obligation, CDO, which led to massive issuance of structured products like mortgage-
backed securities, have been blamed for much of the excesses that precipitated the global financial crisis
of 2007-09. A recent working paper at Wharton, said to be the holiest of the holy academic centres of
finance, essays a more nuanced, balanced perspective on financial innovation.
The study does aver that there is a mix of ‘good and bad financial
innovations,’ but on balance, finds ‘more good ones than bad ones.’ It
goes on to call for a conducive environment for such innovation, and
underlines the need for close oversight and proactivity on the part of
policymakers, such as the ‘need to spot rapid growth in any particular
asset class, for this tends to be a strong sign of potential excess.’
The paper elaborates that innovations in finance in the past several

decades have improved payments, saving, investment and risk-bearing
activity across the board, and in ways that are convenient and
economically beneficial.
The simplest example of a financial instrument is a bank deposit. But as

one progresses from innovations meant for consumers – payments,
saving and consumer-lending products – on to those serving financial
institutions, institutional investors and corporates, to better finance investment and allocate risk, it can
mean much complex structuring.
The paper reiterates the need for the standardisation of financial instruments – essentially contracts –
noting that bonds are nothing more than standardised loans. On CDS, for instance, what’s proposed is the
‘creation and extensive use of a central clearing house for standardised trades.’
The study posits that in the run-up to the financial crisis, some innovations, for example CDOs were
‘poorly designed,’ while others, like CDS, ‘were misused.’ Besides, the ‘explosive’ growth of CDOs in
the US should have been a warning sign ‘that something was amiss,’ never mind the bipartisan political
intention to encourage home-ownership for all and sundry. When the housing bubble went bust, it led to
massive default on mortgage payments, with the result that CDOs worth tens of billions of dollars become
toxic assets, and fast – Hence the credit crisis. The paper adds that it is necessary to distinguish between
the innovation it-self, and ‘how it can and may be used or misused.’
It goes on to make the point that just because financial instruments can be and have been misused, one
glaring example being the failure of insurance behemoth AIG to set aside sufficient reserves for its CDS
commitments, ‘it does not mean that the instrument itself has no or even negative social value.’ The paper
says that had a central clearing house for CDS been in place, AIG ‘could never have issued CDS in the
quantities it did,’ as properly enforced margin requirements would have prevented such a reckless stance.
The fact remains that CDS–the first modern CDS was created in 1997–do bring about much better
allocation of resources economy-wide.
A typical CDS pays the purchaser upon a pre-defined event of default on a loan or bond. Abroad, in the
larger markets, practically anyone can offer such a product. But in practice, the CDS market is dominated
by ‘a handful of major banks, which use the instruments to hedge against the default of their borrowers.’
In the process, what’s reduced is the amount of capital banks are required to hold for regulatory purposes.
The implication is that the freed cash can be on-lent and used elsewhere. Banks also trade such
instruments among one other, on their own account or on the behalf of customers, who may want to hedge
against the possibility of their supplier or borrower de-faulting, or speculate on the outcome.
In the latter case, the purchaser of the CDS ‘may not have an economic interest in the underlying debt.’
But such a move would anyway add liquidity and depth to the market. And yet the RBI in its paper seems
totally opposed to such third-party CDS. It surely needs to reconsider. The working paper notes that over
90% of CDS are written to cover corporate defaults. Also, only about 1% of CDS insure mort-gage-
backed securities, heavily blamed for the financial crisis. The point is that the availability of ‘loan
insurance’ that CDS provides to customers does boost access to credit, thus making it more convenient to
borrow, invest and trade.
The way ahead is to have a central clearing house to impose margin and capital requirement on all dealers
in CDS, so as to prevent the kind of runaway sales of derivative contracts without corresponding reserves,
a precursor to the financial crisis. The bottom line is that it is necessary to ‘distinguish the benefits of
financial instruments, as properly used and managed, from its mis-use’, concludes the study, with a
cautious welcome for new financial products.
4.3 INCLUSIVE CEOs
Innovative responses to problems
Stimulus
The Great Recession of 2008 reached the farthest corners of

the earth. Here in Australia, they refer to it as the GFC: the
global financial crisis. Kevin Rudd, who was prime minister
when the crisis struck, put in place one of the best-designed
Keynesian stimulus packages of any country in the world.
He realised that it was important to act early, with money

that would be spent quickly, but that there was a risk that the
crisis would not be over soon. So, the first part of the
stimulus was cash grants, followed by investments, which
would take longer to put into place.
Rudd’s stimulus worked: Australia had the shortest and shallowest of recessions of the advanced
industrial countries. But, ironically, attention has focused on the fact that some of the investment money
was not spent as well as it might have been, and on the fiscal deficit that the downturn and the
government’s response created.
Of course, we should strive to ensure that money is spent as productively as possible, but humans, and
human institutions, are fallible, and there are costs to ensuring that money is well spent. To put it in
economics jargon, efficiency requires equating the marginal cost associated with allocation – both in
acquiring information about the relative benefits of different projects and in monitoring investments –
with the marginal benefits. In a nutshell: it is wasteful to spend too much money preventing waste.
While the focus for the moment is on public-sector waste, that waste pales in comparison to the waste of
resources resulting from a malfunctioning private financial sector, which in the US already amounts to
trillions of dollars. Likewise, the waste from not fully utilising society’s resources – the inevitable
consequence of not having had such a quick and strong stimulus – exceeds that of the public sector by an
order of magnitude. Cutting back on high-return investments – such as education, infrastructure and
technology – just to reduce the deficit is truly foolish. Indeed, if one is concerned with a country’s long-
run debt, as one should be, such deficit fetishism is particularly silly; since the higher growth resulting
from these public investments will generate more tax revenues.
4.4 CREDIT COUNSELORS
Resolve convertibility and recompensation issue:
Economic principles
John Stewart Mill vs. the ECB: Economic prescriptions that are distilled from political prejudice rather than historical
experience have little hope of any use in times such as these
One of the dirty secrets of economics is that there is no such thing as ‘economic theory’. There is simply
no set of bedrock principles on which one can base calculations that illuminate real world economic
outcomes. Unlike economists, biologists, for example, know that every cell functions according to
instructions for protein synthesis encoded in its DNA. Chemists begin with what the Heisenberg and Pauli
principles, plus the three-dimensionality of space, tell us about stable electron configurations. Physicists
start with the four fundamental forces of nature.
Economists have none of that. The ‘economic principles’ underpinning their theories are a fraud – not
fundamental truths but mere knobs that are twiddled and tuned so that the ‘right’ conclusions come out of
the analysis. The ‘right’ conclusions depend on which of two types of economist you are. One type
chooses, for non-economic and non-scientific reasons, a political stance and a set of political allies, and
twiddles and tunes his or her assumptions until they yield conclusions that fit their stance and please their
allies. The other type takes the carcass of history, throws it into the pot, turns up the heat, and boils it
down, hoping that the bones will yield lessons and suggest principles to guide our civilisation’s voters,
bureaucrats and politicians as they slouch toward utopia.
Not surprisingly, we believe that only the second kind of economist has anything useful to say. So what
lessons does history have to teach us about our current global economic predicament?
In 1829, John Stuart Mill made the key intellectual leap in figuring out how
to fight what he called ‘general gluts’. Mill saw that excess demand for
some particular set of assets in financial markets was mirrored by excess
supply of goods and services in product markets, which, in turn, generated
excess supply of workers in labour markets. The implication of this was
clear. If you relieved the excess demand for financial assets, you also cured
the excess supply of goods and services (the shortfall of aggregate demand)
and the excess supply of labour (mass unemployment).
Now, there are many ways to relieve excess demand for financial assets.
• When the excess demand is for liquid assets used as means of payment – for ‘money’ – the natural
response is to have the central bank buy government bonds for cash, thus increasing the money stock
and bringing supply back into balance with demand. We call this ‘monetary policy’.
• When the excess demand is for longer-term assets – bonds to serve as vehicles for savings that
move purchasing power from the present into the future – the natural response is twofold: induce
businesses to borrow more and build more capacity, and encourage the government to borrow and
spend, thus bringing the supply of bonds back into balance with demand. We call the first of these
‘restoring confidence’, and the second ‘fiscal policy’
• When excess demand is for high quality assets – places where you can park your wealth and be
assured that it will still be there when you come back – the natural response is to have creditworthy
governments guarantee some private assets and buy up others, swapping them out for their own
liabilities and thus diminishing the supply of risky assets and increasing the supply of safe assets. We
call this ‘banking policy’.
Of course, no real-world policy falls cleanly into any one of these ideal types.
Right now, the European Central Bank (ECB) worries that continued expansionary fiscal policy will
backfire. Yes, it argues, having governments spend more money and continue to run large deficits will
increase the supply of bonds, and thus relieve excess demand for longer-term assets.
But if a government’s debt emissions exceed its debt capacity, all of that government’s debt will become
risky. It will have relieved a shortage of longer-term assets by creating a shortage of high quality assets,
and so be in a worse position than it was before.
The ECB contends that the core economies of the global North – Germany, France, Britain, the US and
Japan – are now at the point where they need rapid fiscal retrenchment and austerity, because financial
markets’ confidence in the quality of their debt is shaken, and may collapse at any moment. And
policymakers are falling into line: in late July, Peter Orszag, director of the US Office of Management and
Budget, said that the coming fiscal consolidation in the US over the next three years will be the country’s
deepest retrenchment in 60 years.
Yet, as we look at the world economy, we see a very different picture: one in which markets’ trust in the
quality of government liabilities of the global North’s core economies most certainly is not on the brink of
collapse.
We see production 10% below capacity, and we see unemployment rates approaching 10%. More
importantly for near-term economic policy, we see a world in which investors have enormous confidence
in core economies’ government debt – for many, the only safe port in this storm. In these circumstances,
we can be sure of what Mill would have recommended.
4.5 RISK MANAGEMENT CONSULTANTS
Educate – Engineer and Enforce:
Macroeconomic policies
The divergence between macroeconomic policies in India and those

in the advanced economies in recent months has been striking.
Fiscal tightening has been under way since fiscal 2009-10 itself.
Monetary policy too has been progressively tightened in recent
months although it is not as tight as some would like.
In the advanced economies, talk of exiting the fiscal stimulus has

not been matched by strong action everywhere. There are serious
doubts as to whether this is the right time to begin a big exit despite
the fact that public debt has reached its highest levels in years. Monetary tightening is not happening.
In the US, the Fed is expected be accommodative in its forthcoming monetary policy announcement.
The divergence in policies between India and the advanced world reflects divergences in underlying
economic conditions. In July, the International Monetary Fund’s World Economic Outlook revised its
forecast for world economic growth from 4.2% in April to 4.6%.
But this is based largely on expectations of high growth in emerging markets. There is not the same
optimism about economic prospects in the advanced economies.
Nouriel Roubini, who is credited with having the forecast the global financial crisis, maintains that a
double-dip recession is very likely, especially in Europe and Japan.
The global financial crisis drew a massive and concerted response from governments in the advanced
economies. A massive fiscal and monetary stimulus was adopted. The stimulus worked. It helped a slide
into another protracted depression. The world economy recovered and then it appeared to gather steam.
So what has gone wrong with the script in recent months?
Well, Greece was undoubtedly a big shock to the world economy. Not because Greece in itself poses a
problem for the world economy but because it was a symptom of a broader malaise: fiscal overstretch.
We have known that governments can spend their ways out of trouble in a recession, but economists insist
this is possible only so long as government borrowing does not breach certain limits. There is a sense that
once government borrowing reaches 90-100 % of GDP, markets will become averse to supporting further
government borrowing.
When Greece happened, people started looking closely at fiscal deficit projections, public debt-to-GDP
ratios and current account imbalances in the advanced economies and were horrified at what they saw.
They concluded that there was no choice but to cut back on the fiscal stimulus. It appears that the
recovery is not strong enough to withstand a big exit. Governments in advanced economies are in a fix as
to how fast to move in respect of exiting the fiscal stimulus. There is not much that monetary policy can
do to provide more stimuli when interest rates are as low as they are today.
It is not just the absence of freedom of action in respect of fiscal and monetary policy in the present
conditions that worries markets. There have been renewed concerns about failures in the banking sector.
Banks in the advanced economies hold large amounts of government debt, so the Greek debt crisis
revived fears of another banking crisis.
Regulators in the EU ran stress tests on 91 banks. They claimed that the tests showed that the banks could
withstand a setback to the world economy except for seven small banks. But the tests have been criticised
as being not adequately stringent. Whether there is an implosion in banking again or not depends on
whether the EU economies can muddle through long enough without a major default.
The Indian situation presents a refreshing contrast. Most forecasts for Indian economic growth have been
revised upwards and the revisions are seen as credible despite the uncertainties in the world economy.
Growth is expected to be anywhere in the range of 8.5-9 %. There is a clear roadmap for an exit from the
fiscal stimulus. Monetary policy has become tighter with fighting inflation the priority now.
The PM’s council of economic advisers thinks the projected rise in the savings and investment rate in
2010-11 and 2011-12 provides a firm basis for a return to growth of 9%. In 2007-08, our savings rate was
36.4%. It declined in 2008-09 and 2009-10 thanks to government dis-savings caused by the need to
provide a fiscal stimulus. Thanks to the fiscal corrections introduced subsequently, the savings rate is
expected to rise to 35.5% in 2011-12, enough to finance an investment rate of 38%. An investment rate of
this order, in turn, can easily deliver growth of 9%.
But this begs the question: what happened to the coupling thesis? In 2008-09, we found that we were far
more dependent on global economic conditions than we had supposed. As the global crisis peaked, our
growth rate dropped to 6.8%. Why should things be any different if the advanced economies were to go
through another recession?
There are reasons to expect a different outcome now. We were coupled with the world economy not so
much through trade as through our dependence on capital flows. In a time of financial crisis, there is a
flight to safety and out of emerging markets. This impacts domestic interest and exchange rates. It also
impacted corporate investment in India as corporate investment had been financed by foreign borrowings
to a greater extent than suspected.
In the months ahead, these adverse factors may not come into play. A setback to global growth is unlikely
to translate into a financial crisis. Investors are bullish about growth prospects for India and are unlikely
to exit en masse if the world economy falters. Indian companies unwound much of their exposure to
foreign debt during the crisis and will not have run up similar exposures again.
These propositions will be tested if there is a double-dip recession in the advanced economies. If they
hold up, that would give us a new basis for confidence as to India’s growth prospects. Unlike in 2003-08 ,
growth of 9% would be less vulnerable to the vagaries of the world economy. It would be more
investment-driven with infrastructure as a key driver. We would then be having the best of both worlds:
the benefits that go with integration and the lack of vulnerability that comes with being driven by
domestic demand and financed by a high savings rate.
4.6 CONTINUING LEARNING CENTRES
Take informed decisions:
Systemic risk
In the past two years, two dangerous episodes of financial instability and
sudden changes in market dynamics have hit the world economy. More are
likely, because the global economy is out of balance in several respects as
it emerges from the crisis, particularly in terms of sovereign debt and the
structure of global demand.
Systemic risks drive most crises, and pose a challenge for several reasons.
First, they are not easy to detect with confidence, and are even more
difficult to prove. Second, predicting the exact timing of a break point
(when bubbles burst, markets lock up, and credit freezes) is, and will likely
remain, beyond our ability. Finally, crises are highly non-linear events,
which mean that they occur without much warning.
Periodic outbreaks of instability impose high social costs on those who had the least to do with causing
them. If repeated, this pattern may erode confidence in financial markets and regulators, which could well
lead to heavy-handed regulation, the expansion of the state, and retrenchment from globalisation.
But the problem is even more serious. The financial and economic crisis is morphing into a sovereign
debt crisis in advanced countries. Financial and economic imbalance can lead to dangerous fiscal
imbalance, as tax revenues plunge and social insurance and bailout expenditures rise.
The International Monetary Fund suggests that as much as 75% of the “fiscal stimulus” in the advanced
countries comprises non-discretionary counter-cyclical measures. Undetected imbalances and systemic
risk make fiscal policies seem prudent when they are not. Spain, for example, was not running a fiscal
deficit coming into the crisis. But its revenues and expenditures were in part determined by a highly
leveraged real-estate bubble.
Extreme fiscal imbalance can also lead to a growth trap in which fiscal consolidation has such a large
negative effect on growth as to be self-defeating. Greece is probably a case in point. Eventually, the only
way out is to reset the value of liabilities via restructuring or inflation.
If systemic risk can cause this kind of cascading sequential imbalance, then the “sovereign” needs to be
alert, competent at identifying rising systemic risk, and able to take corrective action early.
We are about to get a comprehensive package of re-regulation focused on capital requirements and
leverage, transparency , ratings and other sources of information , incentives, conflicts of interest and
limits on the scope of financial firms, consumer protection, and resolution mechanisms. The hope is that
such reforms will reduce the likelihood and severity of systemic risk.
But that doesn’t deal with global imbalances and other contributors to and signs of instability. In addition
and as a complement to re-regulation, we need a comprehensive systemic risk monitor.
Some prominent policymakers and analysts, however, argue that oversight aimed at identifying and
stemming systemic risk is futile. With incomplete models of risk dynamics and a complex and constantly
changing global financial system, detection is, they argue, either impossible or so prone to error that the
effort would be counter-productive. Asset bubbles are hard to identify with certainty.
If sceptics are right, then we should accept that we will periodically be out of financial and fiscal balance
without knowing it in advance. Thus, we should also accept the need for much more conservative fiscal
positioning than was thought necessary even three years ago.
In statistics and the theory of decision-making under uncertainty, errors are inevitable. There are two
kinds. One is to reject a true proposition; the other is to accept a false one. Let’s call them RWT (reject
when true) and AWF (accept when false). The issue can then be framed as follows: in the context of
detecting and responding to systemic risk, which of the two types of errors has the higher expected costs?
Opponents of prudential oversight of systemic risk take two different positions.
One is that the AWF error won’t occur, because there are no reliable ex ante signs of rising potential
instability. Looking for them is a waste of resources. Instability just strikes like lightning. This seems
wrong.
In the 2008 crisis, for example, some analysts issued warning signs, and some investors noted and
responded to them. Admittedly, these warnings did not add up to an ironclad case, and they certainly
didn’t predict the timing of the break. But the signs were there.
A second position accepts that there are warning signs, but that they are so unreliable that responding to
them would do more harm than good. This implies that AWF has a higher expected cost than RWT,
because there are a lot of false positives and/or the cure is worse than the disease. One can accept that
there are costs to AWF. But RWT is costly, too, as we have seen, so the aggregate negative effect of the
policy response to false positives (AWF) would have to be large to be convincing. I am not convinced.
There may be a deeper bias at work. In business and investing, choices under conditions of uncertainty are
made all the time, and mistakes are routine. By contrast, developed country policymakers’ default stance
seems to be that proactive or pre-emptive measures require a high degree of certainty, owing to a deep-
seated belief that financial markets are stable and self-regulating.
If one believes that market instability is rare, then it is reasonable to refuse to act unless there is a
compelling case to do so. In light of experience, the view that the financial system is only exceptionally
unstable or on an unsustainable path seems at least questionable.
Based on new theory and experience, we may eventually conclude that policy responses to systemic risk
are impossible to devise, and that the costs of the AWF errors are higher than the RWT errors. But we
should at least conduct the experiment, assigning responsibility to a new or existing institution that has
access to information, deep analytical talent in both financial and macroeconomic analysis, and is
relatively free of conflicts of interest. The analysis should be made public and could influence perceptions
of systemic risk and market behaviour, thereby increasing self-regulatory capacity of the system.
4.07 ISSUES OF THE PRESENT
Freedom to get & fail in the system of free enterprise: Keynes, Hayek or both?
Spend or save
To spend or save, what is the need of the hour is the question doing the
round of economics and other journals, print and online. ‘The austerity
debate’, is followed by ‘the deficit debate’, which in turn is followed by
the Economist inviting experts to discuss the same issue. The views are
as multifarious as the debates, but the issue being discussed is perhaps
the most significant policy issue facing the world economy today, as
Nobel laureate, Paul Krugman, an avid and outspoken participant in the
debate wrote recently.
Received wisdom, in the form of economic theory, has relatively little to offer. There is the brilliant
Keynes advocating deficit spending to boost sagging demand and depressed business expectations. But
there is also the no less brilliant Nobel Laureate, Friedrich von Hayek pointing out that while the main
deficiency during recessions is investment, the world’s troubles are because of imprudent borrowing and
lending by public authorities, who mortgage budgets of the future and tend to drive up the rate of interest.
According to Hayek, the right way to help revival is to abolish old habits of lavish expenditure, and
abolish the restrictions on free trade and free movement of capital.
Economic theory has two apparently diametrically opposite views, responsible perhaps for the present day
policy conundrum.
How does one proceed?
One needs to start with asking several questions, answers to which will automatically begin to untangle
the apparently entangled issue.
Firstly, there is a set of questions related to the context.
What is the nature of the particular economy in respect of which prescriptions are being made? Is it an
open economy or a closed economy? Is it a free-market economy or a planned economy, and if so to what
extent? Is the nature of the economy likely to change with the answers to the basic question being
debated, and how will that impact the fundamental impulse to progress, which has been the bedrock of
progress in that economy? What is the current level and nature of unemployment in the economy? How
will this be affected by the decision to spend or save?
A second set of questions pertains to the specific fiscal parameters of the particular economy. What has
been the level and nature of past deficits and government and private debt, which determines the present
scope for incurring deficits? What has been the level of past economic growth? Does this limit the
prospects for future economic growth? What are the likely fiscal multipliers? If positive in overall terms,
which are the specific sectors where they are highest? How will the impact of fiscal deficits be shared as
between the domestic and external economy in a flat, and yet not quite flat world?
There is a similar set of questions with respect to the potential for monetary policy effectiveness. What is
the level of interest rates? Of inflation? Other possibilities of quantitative easing? Are there ways of
making credit move to deserving sectors, without leading to irresponsible lending, as seemed to have
happened when crisis first struck?
In addition to this not quite brief list of questions related to overall context and fiscal and monetary health,
questions related to confidence parameters, of both business and consumer, need evaluation. These core
indicators in respect of economic fundamentals are inevitability linked to credibility of governance and
other institutional structures. In the case of the US economy, credibility of the Treasury, Federal Reserve,
SEC and other regulators would be the relevant gauge.
For UK, it would be the corresponding economic and financial institutions and regulatory agencies.
Credibility of these institutions has got eroded over a period of time, and needs to be rebuilt laboriously
and patiently, in order to enable economic policy to succeed. Public spending will enable digging out of
the economic hole, provided the concerned agencies spend on programmes, which lead to construction of
worthwhile assets, and create jobs in fields where unemployment exists. But if such public spending only
leads to throwing greenbacks or other bills into bottomless pits, no private sector or other agency will be
able to dig them out, and generate confidence to rebuild the economy out of its present recessionary
stance.
The critical issue facing the developed and developing world alike is the need to restore and rebuild
institutional credibility and trust. This is the magic wand, the Midas touch, or the missing element in the
puzzle, which when in place, will ensure automatically that the right answer is found in each individual
context — to spend, to save, or just wait for natural impulses of progress to find their way. Keynes and
Hayek, would then be not on different streets, nor would Wall Street and Main Street or Fleet Street for
that matter! Truly a utopian vision, but one worth working towards.
5.0 BANKING SECTOR
New Bank Licenses
Indian Apex bank, The Reserve Bank of India released on its

website, the Discussion Paper on “Entry of New Banks in the
Private Sector”. The paper seeks views/comments of banks,
non-banking financial institutions, industrial houses, other
institutions and the public at large.
The main highlights of the discussion paper are:
1. Minimum capital requirements for new banks and

promoters contribution
Minimum capital requirements for new banks and promoters contribution, recommends minimum capital
requirement at more than Rs. 300 crore. It has also put in for discussion, the probability of having an
initial minimum capital of around Rs.500 crore with a condition to raise the amount to say Rs.1000 crore
within a period of say, 5 years.
2. Minimum and maximum caps on promoter shareholding and other shareholders.
It has put up 4 models here:
Retaining the current approach of requiring promoters to bring in a minimum of 40% of capital with lock-
in clause for 5 years and the threshold for other significant shareholders to be restricted to maximum of
10% with the requirement to seek acknowledgement from RBI on reaching 5 % threshold and above.
Promoters too would have to dilute to the extent required in a time bound manner say, 5 years after the
lock in period.
Retain the general threshold for the shareholders at 5% of the capital but raise the threshold for promoters
and other significant shareholders to say 20% in the long run. Higher shareholding could be considered
exceptionally subject to increasingly stringent criteria.
Allow promoters to hold their initial shareholding of 40%
Follow the Canadian model, where approval thresholds are 10%, 20% and 30% where Ministerial
approvals are required for acquiring such shareholding
3. Foreign shareholding in the new banks
Aggregate non-resident investment including FDI, NRI and FII in these banks could be capped at a
suitable level below 50% and locked at that level for the initial 10 years.
4. Whether industrial and business houses could be allowed to promote banks.
Here, RBI has put forth a discussion why only industrial and business houses that have predominant
presence and experience in the financial sector could be allowed to set up banks subject to other due
diligence process. It has also put forth safeguards to address the downside risks of Industrial and business
houses promoting bank. It has also looked at the possibility of industrial and business houses being
allowed to take over RRB’s, before considering allowing them to set up banks.
5. Should Non-Banking Financial Companies be allowed conversion into banks or to promote a

bank
Here it has put forth points for and against NBFCs being allowed to convert into banks or promote banks.
In that, it has specifically highlighted that in the case of conversion of NBFCs promoted by large
industrial and business houses, it is imperative that it should not be engaged in real estate activity, directly
or indirectly.
6. Business model for the new banks
It has considered the situation where status- quo could be maintained, where new banks could be licensed
under the usual conditions. And then it has laid stress on the business model which could be required to
clearly articulate the strategy and the targets for achieving significant outreach to clientele in Tier 3 to 6
centers (i.e. in populations less than 50000) especially in the under banked regions of the country either
through branches or branchless models.
As was expected, the RBI has justified the need to have more banks to get more inclusive growth, to
spread the geographical need. The impetus is given on getting more rural banks, not more in the already
overcrowded urban areas. The message sent out strongly by RBI through the discussion paper is – it will
provide licences to a limited number of new banks.
Drawing from its past experiences, the lessons RBI has learnt are – banks promoted by individuals,
though banking professionals, either failed or merged with other banks or had muted growth. Experience
with small banks has not been encouraging. Local Area Bank models have inherent weakness, with
corporate governance issues being prime. Ditto for urban co-operative banks, and small deposit taking
NBFCs. Moral of these lessons - Only those banks that had adequate experience in broad financial sector
will do well.
Suggestions or comments have to be submitted to RBI on or before 30th September 2010. After receiving
feedback, comments and suggestions on the possible approaches discussed in this paper and detailed
discussions with the stakeholders, comprehensive guidelines for licensing of new banks would be framed
and applications invited for setting up new banks. RBI has not stipulated any timeline for that though.
6.1 TAX UPDATES
Amendment in Rules Relating To TDS
The Central Board of Direct Taxes have amended the Rules relating
to TDS provisions -- date and mode of payment of tax deducted at
source (TDS), TDS certificate and filing of ‘statement of TDS’ (TDS
return) – vide Notification No.41/2010; SO No.1261(E) dated
31.05.2010. The amended rules will apply only in respect of tax
deducted on or after 1st day of April 2010.
Forms for TDS certificate have been revised to include the receipt
number of the TDS return filed by the deductor. Now the TAN of the
deductor, PAN of the deductee, and Receipt number of TDS return
filed by the deductor will form the unique identification for allowing tax credit claimed by the taxpayer in
his income-tax return.
Government Authorities (Pay and Accounts Officer or Treasury Officer or Cheque Drawing and
Disbursing Officer) responsible for crediting tax deducted at source to the credit of the Central
Government by book-entry are now required to electronically file a monthly statement in a new Form No.
24G containing details of credit of TDS to the agency authorised by the Director General of Income-tax
(Systems).
Due date for furnishing TDS return for the last quarter of the financial year has been modified to 15th
May (from earlier 15th June). The revised due dates for furnishing TDS return are
Sl Date of ending of the quarter Due date

No. of the financial year
1 30th June 15th July of the financial year
2 30th September 15th October of the financial year
3 31st December 15th January of the financial year
4 31st March 15th May of the financial year immediately following the
financial year in which deduction is made
Due date for furnishing TDS certificate to the employee or deductee or payee is revised as under
Sl Category Periodicity of furnishing Due date

No. TDS certificate
1 Salary Annual By 31st day of May of the financial year
(Form No.16) immediately following the financial year in which
the income was paid and tax deducted
2 Non-Salary Quarterly Within fifteen days from the due date for
(Form furnishing the ‘statement of TDS’
No.16A)
6.2 SECURITY LAWS UPDATES
Two Steps Back for Takeover Rules
An advisory committee of Sebi has come out with a new set

of regulations seeking to replace the existing takeover
regulations. The recommendations that seek to bring more
fairness to shareholders of listed companies will have the
unintended consequence of stunting the market for control.
The first problem with the regulation is that it increases the

tender offer trigger from 15% to 25%. The argument made is
that the corporate scenario has changed since the existing
regulations were enacted in 1997. The committee ignores the
recent mandate of the finance ministry to companies to have a
minimum float of 25% that will dramatically reduce promoter shareholding over the next three years. If
promoter shareholding reduces, public shareholding increases, thus making shareholding more
fragmented. In other words, if you could control a company with 15% in 1997, you could do so with, say,
10% or 12% going forward. That is an argument for reducing the 15% threshold, not for increasing it.
The second issue is with respect to raising the minimum tender offer from 20% of voting capital to 100%
of public shareholding. This is based on the assumption that all shareholders must get an exit if there is
substantial acquisition of shares or control. In fact, the move raises the costs of acquisitions by a factor of
several times for an acquirer, making the possibility of a tender offer itself remote.
Thirdly, the report seeks to allow creeping acquisition, i.e., small purchases of 5% in a year, only to
promoters. It does this by allowing creeping acquisition to only those holding above 25%. While a similar
rule exists today at the 15% level, moving the threshold to 25% ensures it protects promoters. The
rationale of allowing creeping acquisition is that so long as you are acquiring shares slowly, and given
that shareholders know about this through disclosures, shareholders can exit in the secondary market.
FOURTH, the regulations completely short-circuit the delisting regulations. Delisting a company
worldwide is a difficult process. This difficulty is fair because when a company raises public money on
the promise that it would be listed, to tell shareholders one fine morning that their shares will no longer be
listed and they ought to, therefore, sell their shares at today’s market price is unfair. This is what the
proposed takeover regulation does by permitting delisting by paying a price close to the current market
price. It is also in stark contrast to the current delisting regulations that allow delisting only if the
promoter acquires shares through a reverse book-building process.
Similarly, the regulation defines a financial year as one that begins on April 1. The definition implies that
though creeping acquisition is supposed to allow an acquisition of 5% shares a year, if you acquire shares
on March 31 and April 1, you can acquire 10% in two days.
Overall, on balance of the good, the bad and the ugly, there appears no compelling reason to sink one-
and-a-half decades of law and jurisprudence. It should be remembered that a mistake will be costly. A
poor market for control doesn’t just mean reduced takeover activity; it means promoters will be less
efficient as they don’t have to care about the threat of takeover in case of poor management of the
company. It’s bad for corporate governance, good for inefficiency. It would be better to clean up the
obvious mistakes of the existing regulations and let the big picture of the current regulations remain.
7.0 INFLATION
Inflation reflects growth dynamics in India: Christopher Wood
Hello everybody. I will be running through some charts which were

still first with the situation in the West. Then I will move on to charts
on Asia and India.
To start with the US situation, the total amount of debt in the system
has been going down ever since the credit crisis erupted in 2007-2008.
This the first time total debt has been falling in America since the
Great Depression. Next you see US total net credit market borrowings
and you can see the rate of growth of borrowing has been going down
despite the big kick up in Federal Government borrowing.
We have seen a big rally in US government bond prices this year, as

telling you the trend nominal GDP growth is lower and that means the
trend earnings growth, trend revenue growth in America is also going
to be lower. Everybody said that the Treasury bond market is going to collapse and the Fed printing
money inflation is coming back. But the key point about the US is if the trend over the past 3 months has
extrapolated forward, US CPI inflation will turn negative in October. Clearly that consensus was
completely wrong. Even with the stock market rally the bond market did not sell off.
The bond market is telling you that nominal GDP growth is slowing; it is telling you that it is not a normal
recovery. Right now this is a very important point because the US bond market is sending one message
and the US stock market is sending another message and basically investors have a decision to make - do
they believe the bond market is giving the correct signal or the stock market?
My assumption is that it’s the bond market and my experience is that the bond market is no way
smarter than the stock market 90% of the time.
Meanwhile the classic monetary measures are highlighting the fact that we are not in a re-leveraging
cycle; we are still in a deleveraging cycle. The Velocity of money in circulation is declining. It’s
deflationary. And this highlights the growing deflationary threat. Besides, money supply growth is going
down. In US bank lending. Again, no real sign of any kind of meaningful pick up. That’s why inflation is
not an issue, that’s why Mr. Bernanke is now looking for an excuse to resume quantitative easing.
The big picture is still deflationary. However, in terms of macroeconomic shocks that could cause another
steep fall in global equities this year for the rest of 2010, I still believe there is going to be another sharp
decline in equities like we saw in April and May. It’s more likely to be triggered by the Eurozone where
you have systemic risk relating to government debt.
How early we go down depends on whether there is another bout of risk aversion or markets are just
focusing on waning growth. For now the jury doubts on whether these European countries can make the
fiscal adjustments being demanded by the Germans, but people should understand that the Germans have
a completely diametrically opposite view to the Americans - they simply do not believe that fiscally
stimulating is the way to get yourself out of the economic problem.
So right now the weaker part of Euroland has embarked on a fiscal adjustment which is intrinsically
deflationary, given the downturn they are facing.
In Asia and countries like China and India, falling inflationary pressures are going to be bullish and
everybody is going to realise it does not make sense to worry about inflation in countries like India. The
good news is that you have inflation because that reflects the fundamental growth dynamic.
Asia is a fundamentally healthy story unlike the West. In my view, the peak of the Asia ex-Japan index
you saw prior to the credit crisis will be exceeded sooner or later. Valuation wise, Asia is trading in line
with the US on the 12-month forward PE basis. In my view, sooner or later Asia is going to trade at a
sustainable premium over the West because the fundamental growth story is so superior.
From an Indian standpoint that was obviously positive. I think oil is going this week to be as high as it’s
going to get on its counter trend move. Clearly if you are more bullish on oil, you will be more bearish on
India and this is my long only portfolio on Asia or ex-Japan.
I started this portfolio beginning of fourth quarter 2002, sent about 25 to 30 stocks in it, mostly large cap.
I cannot have any cash and it’s long only and is basically playing the domestic story in Asia as always.
Mostly has the biggest weight being in India because India since always has been my favourite equity
story in Asia. It’s still got a big weighting in India.
We probably had a big inflation scare at the start of this year. In my view, it’s fundamentally silly to
worry too much about inflationary pressures in Asia.
We should be celebrating the fact that there is inflation because if there wasn’t an inflationary pressure in
Asia, it would mean the world is facing a global depression because there is no growth dynamics in the
developed world. So I am glad there is inflationary pressure. Having said that inflation is going to be
coming off in India for the rest of this year which means that concern should recede. The central bank will
continue to tighten incrementally. I think that’s sensible given the external environment, but I think
incremental tightening that the RBI is doing is enough to upset stocks here unduly.
The Indian banking sector is a capitalist banking system unlike the Chinese system. So when the
economies slow, the banks slow their lending whereas in China they were ordered to lend more. Now the
credit cycle is picking up again, that’s a very healthy development. We are looking at about 20% loan
growth in India this year. But I think the most important positive points of all is that the credit cycle is
being led by infrastructure loans, not personal loans. This raises the key point which in my view is the
critical bearable for the Indian macroeconomic story this year and for the next 5 to 10 years is whether we
can get an infrastructure cycle playing out.
The fact that infrastructure loans are leading the credit cycle is anecdotal evidence that is happening. If we
get infrastructure happening in India, it’s quite possible that India can grow at 9% plus a year for the next
5 years at least, if not 10 years, which means that India in my view is going to be growing more rapidly
than China. In my view a more basic trend growth in China is going to be 8% and that’s a growth rate that
Chinese Communist party is going to be comfortable with. So the higher growth rate in India than in
China, if the infrastructure story happens, is going to raise the profile of the Indian story globally.
Clearly if I am wrong and infrastructure does not happen in India, the whole Indian story becomes much
less interesting. It’s not a disaster, but the country only grows just 5%-6%. So this is fixed investment
relative to GDP in India. I am expecting this line to pick up again. Car sales, two-wheelers sales are going
up. So the consumer story is still perfectly good story in India. It has picked up with the monetary easing,
but as I say the key variable for me is infrastructure.
In terms of risks to the Indian markets, probably the biggest risk to the Indian market is simply the huge
amount of foreign money. My own guess is that the next time there is a global hiccup, foreigners will sell
India less aggressively than in 2008 for the simple reason that India has shown it can decouple from the
US economic cycle.
The other point is the fact that foreign investors stay much in India is basically confirmation that India is a
good story and those foreign investors who have not yet invested in India are all desperately waiting for a
correction. So they can invest, that’s the mindset of them.
India is not cheap, but it’s not expensive in the context of Indian stock market history and in my view the
Indian stock market will continue to trade at a premium to Asian and mother of emerging markets because
the Indian market is like one big growth stock and growth stocks trade at a premium.
Inflation falls to single digit at 9.97% in July
The annual rate of inflation fell into single digits in July after hovering at over 10% for five months. The
wholesale price index-based inflation rose to 9.97% in July, below 10.55% for June and a Reuters forecast
of 10.39% for the month. The lower-than-anticipated figures will provide some relief to the embattled
government, which has come under severe criticism for its management of prices. However, headline
inflation for May has been revised upwards to 11.14% as compared to the provisional figure of 10.16%.
“Policy rates had some impact (on sliding inflation) but there are also base factors,” finance minister
Pranab Mukherjee said, adding that inflation would moderate in the coming months.
The Reserve Bank has already lifted key policy rates four times this calendar – a total of 100 basis points
– and was widely expected to do so again its mid quarterly review on September 16, after industrial
growth slipped to a 13-month low for June. In its July 27 review, the central bank said the balance of
policy stance has moved to controlling inflation from supporting growth but the weaker than expected
industrial growth to 7.1% for June may force it to take stock.
8.0 MISCELLANEOUS UPDATES
The Importance of Capital Inflows
Prior to the recent global credit crisis, India achieved above

9% GDP growth for three years in a row (2005-06 to 2007-08).
We believe a strong global growth environment and large
capital inflows played a significant role in this growth
acceleration trend.
The 2008 credit crisis abruptly interrupted this story, pushing

the country’s GDP growth down to 6.7%, reminding us of the
importance of capital inflows, which we believe was
underappreciated by policymakers during the pre-crisis period
. As the adverse impact of credit crisis in US ebbed, the capital
inflows into India have again accelerated. The net capital
inflows during the 12 months ended March 2010 were about $54 billion (4.1% of GDP). This compares
with an outflow of $4.7 billion (–0 .8% of GDP, annualised) during the six months ended March 2009.
Unfortunately, the trend in capital inflows into India is highly influenced by global risk appetite more
than the growth opportunity in India.
The trend in capital inflows into India follows the same momentum as that for other emerging markets.
India has high domestic savings to GDP and, prima facie, some may argue that the damage from the
reversal in capital inflows should be negligible, but clearly, the recent trend indicates that is not the case.
Capital inflow influences the macro environment through multiple routes.
First, India remains dependent on capital inflows to fund its current account deficit. Indeed, a strong push
to domestic demand supported by loose fiscal and monetary policy is not only resulting in higher inflation
pressure but also widening current account deficit.
During the 12 months ended March 2010, current account deficit was $38.4 billion (2.9% of GDP). If
capital inflows slow down significantly or turn into outflows, exchange rate will depreciate significantly
and domestic liquidity environment will tighten. While the Reserve Bank of India (RBI) does respond
with measures to offset decline in forex reserves by injecting liquidity, its response, by its very nature, has
to be reactive with some damage to financial market confidence being inevitable.
Second, capital inflows into India tend to be in nature of high-risk capital. Indirectly, this large source of
risk capital acts as a catalyst to private corporate capital expenditure. To put the size of capital inflows in
context, in the 12 months ended March 2010, capital inflows were 4.1% of GDP compared with private
corporate capex of about 12.5% of GDP, as per our estimates.
Third, domestic risk capital allocation behaviour tends to be highly correlated to global markets. The
domestic stock market, which is another major source of high-risk capital, is highly correlated to
developed world equity markets. Foreigners own about 17% of the domestic equity market and about half
of the free float available to them. Their decisions to sell domestic equity stocks tend to have a very large
price impact. Moreover, financial market risk aversion tends to influence the consumer confidence and,
therefore, discretionary private consumption.
Fourth, net external surplus – capital inflows in excess of current account deficit – tends to keep real
rates low. When inflows spike up, it tends to influence the overall cost of capital in the country. For
instance, when capital inflows spiked up to $107 billion (8.7% of GDP) during 12 months ended March
2008, it made it difficult for the RBI to increase effective cost of capital in order to slow the aggregate
demand growth. In other words, even if RBI were to sterilise the increase in liquidity – by forex
intervention: buy dollars, sell rupees – the positive impact in the form of lower risk premia in domestic
funding markets remains.
Recall that during the period of this systemic sudden stop in capital inflows, the domestic financial system
also suffered from risk aversion. Cost of capital spiked up and capital market funding almost came to
grinding halt. Companies, particularly small and medium scale entities, with good business fundamentals
suddenly lost access to capital, turning them into non-performing borrowers in the banking system. This
added to banks’ risk aversion. Bank credit growth decelerated sharply. Private corporate capex to GDP
declined to 12.7% of GDP in 2008-09 from 16.1% of GDP in 2007-08. Discretionary private consumption
also suffered significantly.
In this context, the duration of global financial market risk aversion affecting capital inflow trend is
important. After the credit crisis-led downturn, fortunately, the global financial markets turned around
quickly with the aggressive policy response from G-20 governments supporting a quick revival in growth.
We believe that if the global financial markets had remained in depressed mode for longer, it would have
caused deeper damage to growth environment. For instance, large equity capital inflows since April 2009
helped rehabilitate the corporate sector balance-sheet. Several large real estate companies could easily
raise equity capital helping them to deliver, thus preventing them from becoming delinquent borrowers.
If the global financial markets had remained in risk-averse mode for longer, the damage to domestic
financial system would have been much larger affecting its ability to provide credit. The damage to
corporate sector confidence would also have been severe.
Bottomline: while India’s domestic savings rate has increased significantly over the last 5-6 years, the
importance of capital inflows remains high. If sovereign concerns in Europe or double dip in the US
causes a major risk aversion in global funding markets in the near term, capital inflows into India will be
affected despite its attractive growth outlook ex-ante. While the government had some room to implement
a counter-cyclical fiscal policy during the 2008 credit crisis, we believe that government’s ability to
initiate another round of fiscal stimulus will be limited this time around.
Similarly, room to cut interest rates is also limited considering that policy rates are already very close to
multiple-year lows. Hopefully, a global risk aversion that we may see, if at all, would not be as deep as
seen during the credit crisis and will last for a shorter time.
9.0 KNOWLEDGE RESOURCE
The Rush to Safe Assets
It is now more than two years since the global financial meltdown,
but the global economy still suffers from severe economic
imbalances on account of large current account deficits run by
some countries and the huge foreign exchange reserves that are
held by the surplus countries. In 2006, the US current account
deficit accounted for as much as 2% of world GDP. These
imbalances have come about because of several factors. In the
1970s, it was inflation in the West on the back of the oil cartel
raising crude oil prices to stratospheric levels that transferred
unimaginable wealth to a very few in west Asia.
In more recent times, it has been the insatiable appetite for cheap consumer goods in the West that has
helped some Asian countries accumulate huge foreign exchange reserves. The large foreign exchange
reserves held by the trade-surplus countries have, in turn, created a massive demand for safe assets for
investment of these surpluses, and this is seen as one of the root causes of the global financial meltdown
in 2008.
Over the last decade, while the robust export-led growth in several countries in the emerging market space
led to generation of significant current account surpluses , these markets have not attained the maturity to
create sufficiently-liquid stores of value in which the surpluses can be invested. These surpluses,
therefore, find their way to safe assets that are largely issued by the developed countries.
Among such financial assets are sovereign and quasi sovereign bonds issued by nations that are seen to
respect property rights and have well-tested bankruptcy procedures, resilient, liquid and deep financial
markets with minimal risks of government expropriation.
Some developed countries are privileged to be in a position to issue large volumes of these safe assets that
has resulted in falling yields on their bond issuances. The incessant rise in gold prices can also be largely
ascribed to the growing demand for safe assets.
In his recent paper on this subject, Ricardo Caballero of MIT has argued that it is this insatiable hunger
for safe debt instruments and the scarcity of such instruments that created the setting for the large global
banks to exploit the opportunity. These banks effectively addressed the safe asset shortage phenomenon at
a profit by creating synthetic safe assets from the securitisation of lower quality ones by slicing and dicing
them to various tiers, ably assisted by willing credit rating agencies but at the cost of exposing the
economy to the systemic panic that unfolded in 2008.
It is worth considering the possible policy options that are available to address the acute shortage of safe
assets. The surplus countries can moderate their demand for safe assets by partly investing in riskier
assets. The memories of the Asian financial crisis of the mid-1990 s are possibly too fresh for these
newly-surplus countries to consider taking higher levels of risks with their reserves.
Despite the current global slowdown, over the last 12 months itself, Asian countries have generated a
current account surplus of around three quarters of $1 trillion. Their holding of foreign exchange reserves
is in excess of $6 trillion, around two-thirds of the global foreign exchange reserves.
The key takeaway from the global financial meltdown of 2008 and the ongoing sovereign credit crisis is
that a suitable framework should soon be put in place for addressing the potential systemic problems that
has widespread acceptance across countries. Such a framework would need an agreement on the holding
of a diversified portfolio of assets across the risk spectrum by the surplus countries instead of a
concentrated portfolio of safe assets.
The diversified investment portfolios of sovereign wealth funds of countries such as Singapore, Abu
Dhabi, Norway and even China in a small way are examples that more of the surplus nations would need
to follow. The surplus countries have a significant stake in the stability of the global financial system and,
therefore, the choice before them is to either facilitate an orderly adjustment in the global imbalances or
run the risk of defaults on the huge financial claims held by them that they can ill-afford. Getting an
agreement in place to address the massive global imbalances, therefore , should not be an impossible task.
Another policy alternative is for the asset-producing countries to supply adequate triple-A assets even
beyond their fiscal needs that, in turn, would require them to invest in riskier assets themselves. The
Troubled Asset Relief Program (Tarp) that enabled the US government to purchase assets and equity from
financial institutions to strengthen the financial sector in the aftermath of the subprime mortgage crisis is
an example of such a policy in action.
Although the programme was much criticised, in retrospect, it should be conceded that it was indeed
appropriate for solving the systemic crisis because the fear that the government would be left holding
companies such as General Motors, Citigroup and AIG for several years have not come true. Most of
these investments made to bail out the marquee US companies have been repaid and the rest appear to be
on track to repay.
While Tarp was a fire-fighting exercise, it is worthwhile developing a widely-acceptable institutional

mechanism to manage systemic risks in an orderly manner with private investors absorbing the
consequences of most shocks, but the government providing some form of mandatory fee-based insurance
against a large systemic event.
The move to increase capital requirements of banks has to be seen in this light. Another alternative is to
have contingent capital injections in banks through convertible bonds that get compulsorily converted
when the financial strength of a bank falls below a pre-determined threshold. The imbalance between the
demand for, and supply of, safe assets has indeed worsened over the last two years, with several sovereign
bonds being downgraded and many others on the verge of being downgraded.
It takes several years to set right such imbalances even when effective policy interventions are in place. It
is, therefore, imperative that an institutional mechanism to address such systemic problems is put in place
soon.
Liquidity Offering Artificial Support

To Keep the Old Regime Going
www.mi7safe.org
Alka Agarwal
Managing Trustee Mi7
Financial Literacy Mission

A crash course of financial literacy
Missions Seven Charitable Trust

120/714, Lajpat Nagar, Kanpur - 208005
Phone 0512-2295545, 9450156303, 9336114780
E-mail at: safe@mi7safe.org
Financial Advisor Practice Journal: September 2010: Volume 46 > D-D-D-Danger! Watch behind you

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D-D-D-Danger!

Watch behind you

SAFE UPDATES – KEEP INFORMED

Investors need to realise the strength of the assets lies in its

The price behaviour of any single market variable is

The Per-capita incomes

The Pattern of recovery

The industrial production cycle

The strength of emerging markets lies in the diversity they offer.

And thereafter, we follow the London FTSE, German

Every evening, we are all ears to FII net inflows and

Why are plummeting US new home sales important to an

And why is high US unemployment relevant to Indian investors?

Daily review 30/07/10 02/08/10 03/08/10 04/08/10 05/08/10 06/08/10

Weekly review 30/07/10 06/08/10 Points %

2nd week of August – Sensex up 23 points

Daily review 06/08/10 09/08/10 10/08/10 11/08/10 12/08/10 13/08/10

Weekly review 06/08/10 13/08/10 Points %

3rd week of August – Sensex up 235 points

Daily review 13/08/10 16/08/10 17/08/10 18/08/10 19/08/10 20/08/10

Weekly review 13/08/10 21/08/10 Points %

4th week of August – Sensex down 403 points

Daily review 21/08/10 23/08/10 24/08/10 25/08/10 26/08/10 27/08/10

Weekly review 21/08/10 27/08/10 Points %

End of the month – Sensex down 27 points

Daily review 27/08/10 30/08/10 31/08/10

Weekly review 27/08/10 31/08/10 Points %

Month December December December March June July August

Sensex 20,206.95 9,647.31 17,464.81 17,527.77 17,700.90 17,868.29 17,971.12

Points Base (10,559.64) 7,817.50 62.96 173.13 167.39 82.83

% Base (52.26%) 81.03% 0.36% 0.99% 0.95% 0.46%

Indian Equities Not Cheap: Jim Rogers

A major international financial newspaper carried the headline;

A new report by Morgan Stanley finds that the India is poised to

At the recent meeting of the National Development Council

As the world begins to emerge from economic recession, few

Evidence of the increasing global stature of Indian companies

No two ERM programmes are alike:

It is never too early to start:

There are many interpretations of ERM focus:

Strategic and emerging risks may pose the biggest threat:

Risk management must be resourced to the right level:

The relationship between ERM and the business itself is crucial:

Obama faces a dilemma in trying to reassure Americans about the economy

Obama also faces constraints on his ability to act.

European Economy at Risk of Double-Dip Recession

Nobel Prize-winning economist Joseph Stiglitz said the European

“Cutting back willy-nilly on high-return investments just to make

Euro-area governments stepped up efforts to cut their deficits to

Prakash Thakkar is a happy man today. His business is doing

4.1 FINANCIAL ADVISORS:

Good supervision is intrusive.

Supervision is premised on an intimate knowledge of the supervised entity. It

Good supervision is comprehensive. Even while recognising the limitations of their

Good supervision is conclusive. Supervision has many facets,

The paper elaborates that innovations in finance in the past several

The simplest example of a financial instrument is a bank deposit. But as

The Great Recession of 2008 reached the farthest corners of

He realised that it was important to act early, with money

The divergence between macroeconomic policies in India and those

In the advanced economies, talk of exiting the fiscal stimulus has

So what has gone wrong with the script in recent months?

Opponents of prudential oversight of systemic risk take two different positions.