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Pink Panther Volume 44 / July 2010

FINANCIAL ADVISOR

PPRRAACCTTIICCEE JJOOUURRNNAALL

JOURNAL OF THE SECURITY ACEDEMY AND FACULTY OF e-EDUCATION

JOURNAL OF THE SECURITY ACEDEMY AND FACULTY OF e-EDUCATION SAFE UPDATES – KEEP INFORMED T T

SAFE UPDATES – KEEP INFORMED

TThhee SSeeccuurriittiieess AAccaaddeemmyy aanndd FFaaccuullttyy ooff ee--EEdduuccaattiioonn

Editor: CA Lalit Mohan Agrawal

Pink Panther

Editorial preamble:

1.1

PINK PANTHER

Beware, 2010 is not 2004!

preamble: 1.1 PINK PANTHER Beware, 2010 is not 2004! India remains the best structural growth story

India remains the best structural growth story in the region. The sharp pace of recovery reflects the strength of India’s domestic demand-oriented model, which remains the best in the region. Low goods exports to GDP ratio of 15.5% (as of 2008) meant that the damage from global trade collapse was minimal in India.

More importantly, for India, capital inflows linkages are more important than the goods exports. A quick turnaround in global risk appetite from April 2009 has played an important role in the pace of recovery. Growth momentum has remained strong beyond the initial period (F2009) of payback from weak growth during credit crisis.

In fact, with the benefit of hindsight, it appears that unlike the developed world, India really did not need

the kind of push to aggregate demand through loose fiscal and monetary policies. Pre-election spending, wage hike for government employees and credit crisis related stimulus meant that consolidated national expenditure to GDP shot up by close to four percentage points between F2008 and F2010. In the context of actual trend in global growth and domestic demand in India having surprised on the upside, the withdrawal of stimulus has been very slow so far. After cutting repo rate by 425 basis points from the peak of 9% between September 2008 and April 2009, the RBI has lifted it up by only 50 basis points.

Although, the central government will report a reduction in fiscal deficit in F2011, this has been largely supported by one-off receipt items like telecom license fees and divestments. The expenditure to GDP (including off-budget oil subsidy) will remain closer to the peak in F2011 and the aggregate demand push remains intact. Timely reversal in monetary and fiscal policies will not take away the momentum of private sector growth but a delayed exit will increase the risks of transient spike up in inflation rate and widen the current account deficit to vulnerable levels.

A comparison to the 2004 rate hike cycle looks like the policymakers have been lifting policy rates at the

same pace as they did in the initial phase of 2004 cycle. However, not only the growth acceleration has been at a much quicker pace this time but also the starting point of policy rates is much lower in the current cycle. Indeed, the fiscal policy exit was faster in 2004 cycle as the government was already cutting expenditure to GDP before the RBI started lifting policy rates.

There are some key differences in this cycle versus 2004 cycle.

First, the capacity utilisation levels are different: Unlike in the previous cycle, when the recovery in growth gradually allowed adequate time for the private corporate sector to initiate capex plans, in the current cycle, the recovery in growth has been sharp and the business investment cycle was hit badly. Although, over the last few months investment has picked up, but for this work-in-progress to turn into commissioned capacity it could take about 12-15 months. As a result, the transition from low capacity to close to full capacity utilisation has occurred in a much shorter period.

Second, WPI inflation pressures may be similar but underlying consumer price pressures are different:

The WPI inflation trend appears to be largely similar compared with that in 2004 cycle. Although, in this cycle the headline inflation has been higher than last cycle because of food, the fact that food prices have been persistently higher now for many months, the risk of this weighing on generalised inflation

Pink Panther expectations is high as food forms a very large proportion of household consumption. Even food prices were to moderate, the high level of non-food WPI inflation (at 8.8% in May 2010) when capacity utilisation is becoming tight means that risk if generalised consumer price inflation pressures building up quickly is much higher in this cycle versus 2004.

Third, current account balance – deficit vs. surplus: In 2004, when inflation had reached 8.5% y-o-y in August, IP growth had accelerated to 9% y-o-y during the quarter ended September 2004. The current account was in surplus of 2.9% of GDP (4-quarter trailing as of June-04) as a starting point. This large current account surplus is also an additional indicator reflecting that aggregate demand was low relative to capacity. During the 12-months, ending March 2010 the current account deficit has already widened to 3% of GDP as per our estimate.

Fourth, banking sector liquidity condition: Like in 2004 cycle, in the initial phase of recovery while bank loan growth is accelerating, deposit growth is indeed decelerating. However, the banking system loan- deposit ratio is already high at 71.1% as of May 2010. Considering that statutory liquidity ratio is 25% and cash reserve ratio is 6%, loan-deposit ratio is close to the levels where major rise in credit growth will result in significant tightening in interbank liquidity. In December 2004, the banking loan-deposit ratio was low at 62.5%. Over the next 3-4 months, bank credit growth can accelerate to 25% y-o-y, while deposit growth will remain low in the range of 16-17 % y-o-y, unless the RBI lifts policy rates at a faster pace.

Fifth, asset prices: Another factor different from 2004 cycle is the trend in asset prices. Asset prices were subdued for a prolonged period of time until mid-2004. In this cycle, asset prices have remained closer to the peak after dip during the credit-crisis period.

Bottom line: Considering that over the last few months the pace of policy support reversal has been slower than warranted, the upside risks to GDP growth and corporate earnings in the near-term has increased. However, at the same time the investors should watch out for rising inflation expectations and widening current account deficit in the near term.

Any decline in capital inflows or a sharp rise in oil above $100/bbl would cause exchange rate depreciation – only adding to inflation pressure. Moreover, the size of the current account deficit will decide the shock to the domestic cost of capital in the event of the sudden stop in capital inflows. A big shock can hurt the domestic private investment cycle and corporate confidence, which the government appears to be aiming to boost right now.

domestic private investment cycle and corporate confidence, which the government appears to be aiming to boost

Pink Panther

1.2

STOCK MARKETS

Pink Panther 1.2 STOCK MARKETS Festival. Why global stocks are poised to rebound It has taken

Festival.

Why global stocks are poised to rebound

It has taken 23 years and a world market meltdown, but Oliver Stone's Wall Street: Money Never Sleeps, sequel to his 1987 hit film, has returned exactly at the time US Congress has introduced the Restoring American Financial Stability Act of 2010.

Ironically, the music in the film's trailer is the familiar opening of the Rolling Stones' Sympathy for the Devil. “Please allow me to introduce myself. I'm a man of wealth and taste,” croons Mick Jagger. The fictional embodiment of financial excess is played by Michael Douglas, who was given a hero's welcome at the Cannes Film

Even as actors in the Greek drama were seeking catharsis after their prevarication , the European leaders, calling to mind ex-US Treasury Secretary Hank Paulson's ‘bazookanomics,' agreed to a hefty rescue package to replace the water pistols at Greek riots with bazookas to shock and awe markets out of their predictions of doom. €750 billion is sufficient to buy the entire debt of Greece twice and still have enough left over to buy the debt of Portugal.

While the Greek tragedy was being played to the gallery, Portugal and Spain sold 10-year bonds at 4.05% and 4.52% respectively, in an oversubscribed auction. Now that Germany (safety net) is on board, the PIGS (Portugal, Ireland, Greece and Spain) may not even need to tap into the funds.

Greek crisis has enabled Germany to achieve a de facto 20% devaluation against the US dollar. It has made the BMW, Mercedes-Benz and Volkswagen cars cheaper in Beijing and Mumbai than they were six months ago. It has given a great fillip to manufacturing in Northern Europe.

The TED Spread – a measure of bank confidence to lend – has widened to 40 basis points from 28.4 basis points. The spread, which compares three-month dollar Libor and the overnight indexed swap rate, had surged to 364 basis points after the collapse of Lehman in September 2008.

Brazil today is an economic growth rock star. Eight years ago, Brazil faced 25% interest rates, massive government spending, currency devaluation and risk of default. Brazil's debt was $335 billion – almost as large as Greece's entire GDP today! President Lula ramped up a difficult austerity programme – almost 4% of GDP. Brazil received $30 billion in aid from the IMF, which investors feared was insufficient. Brazil is no longer synonymous with ‘hyperinflation’, but with growth, opportunity, Olympics.

The myth of the lazy Greeks: According to Organisation for Economic Co-operation and Development (OECD), Greek people work for much longer hours than Germans. Consequently, it might be just a myth that hard-working Germans had to bail out lazy Greeks.

Between 1989 and 1994, Greece, which accounted for the same share of the world's economic output as today, had interest payments, as a fraction of GDP, more than twice what they are now. Investors fret Germany's ban on naked short sales of European credit-default swaps. However, the outstanding credit default swaps on 10 European countries (including PIGS) are less than $108 billion. The entire CDS market is estimated to be around $11,000 billion. Besides, most CDS activity does not take place in Europe but in New York.

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PEOPLE are selling the euro, as if there is no tomorrow, and I believe there is a tomorrow for the euro. The austerity measures being adopted in Europe, in a sense of urgency, are much larger than the US (which also has a high deficit/GDP ratio) adopted in the heat of the sub-prime crisis.

Besides, the anti-euro trade is getting overcrowded. Euro speculator longs as a percentage of positions are essentially at all-time lows and hedger longs are as a percentage of positions at all-time highs. Europe is China's biggest export market – hence, fears of China selling its $630 billion eurozone holdings will not cut the mustard. Despite fears of China dumping US treasuries while the dollar was getting hammered, its holdings of US debt have increased $1 billion this year to date.

Chinese government isn't blind to the threat of rampant inflation outpacing the economy and has taken steps to rein in stimulus. Chinese monetary policy has taken the middle road — inflation-limiting but not growth-choking.

As long as monetary policy remains measured, there's no reason China's economy can't grow as it did during the last bull market. After all, reserve requirements, interest rates, and currency all rose then too.

There is apprehension that “Dr Copper” is diagnosing a double-dip. Copper prices bottomed at $1.34 per pound in December 2008 and even after recent declines are up 132% from that bottom. Falling oil prices leads to more purchasing power in the hands of consumers as we head into the peak summer driving season in the US. It is a deflationary trend that should help keep Fed rates low.

Market recoveries aren't smooth (see accompanying chart) – and gyrations along the course can easily spur emotion. Watching stock markets move is a great spectator sport, but not a great participant sport unless you're a market pro. Amateurs get whipsawed when they obsess over the market, minute to minute.

The PMI manufacturing indices for 23 international economies shows that only two (Greece and Hungary) are experiencing contraction. China's manufacturing data is nearly always lower in May over April. Emerging markets today are as large as Europe. Semiconductor sales in the Asia/Pacific region were up 72% year-over-year in March, aiding US exports.

Since 2006, Japan has seen five prime ministers: Koizumi (2001-2006), Abe (2006-2007), Fukuda (2007-

2008), Aso (2008-2009), and now Hatoyama (2009-10) – early exit of a PM will not come as a bolt out of the blue. There is an adage on Wall Street “Sell in May and Go Away”. Many investors wished they had. Global stock markets are poised to rebound in the near term. Perhaps, the new adage should be ‘Sell in

May

And come back in June'.

1 st week of June 2010 – Sensex up 255 points

Daily review

 

28/05/10

31/05/10

01/06/10

 

02/06/10

03/06/10

04/06/10

Sensex

16,863.06

81.57

(372.60)

 

169.81

280.49

95.36

Nifty

 

5,066.55

19.75

(116.10)

 

49.65

 

90.65

25.00

Weekly review

 

28/05/10

 

04/06/10

 

Points

 

%

Sensex

 

16,863.06

 

17,117.89

 

254.83

 

1.49%

Nifty

 

5,066.55

 

5,135.50

 

68.95

 

1.36%

Pink Panther

2 nd week of June 2010 Sensex down 53 points

Daily review

 

04/06/10

07/06/10

08/06/10

 

09/06/10

10/06/10

11/06/10

Sensex

17,117.89

(336.62)

(163.97)

 

40.79

264.19

142.87

Nifty

 

5,135.50

(101.50)

(46.90)

 

13.20

 

78.30

40.75

Weekly review

 

04/06/10

 

11/06/10

 

Points

 

%

Sensex

 

17,117.89

 

17,064.95

 

(52.94)

 

(0.31%)

Nifty

 

5,135.50

 

5,119.35

 

(16.15)

 

(0.31%)

3 rd week of June 2010 – Sensex up 506 points

 

Daily review

 

11/06/10

14/06/10

15/06/10

 

16/06/10

17/06/10

18/06/10

Sensex

17,064.95

273.22

74.66

 

50.04

153.82

(45.87)

Nifty

 

5,119.35

78.35

24.65

 

11.00

 

41.50

(12.25)

Weekly review

 

11/06/10

 

18/06/10

 

Points

 

%

Sensex

 

17,064.95

 

17,570.82

 

505.87

 

2.96%

Nifty

 

5,119.35

 

5,262.60

 

143.25

 

2.80%

4 th week of June 2010 – Sensex up 4 points

 

Daily review

 

18/06/10

21/06/10

22/06/10

 

23/06/10

24/06/10

25/06/10

Sensex

17,570.82

305.73

(124.86)

 

6.25

(27.70)

(155.71)

Nifty

 

5,262.60

90.70

(36.75)

 

6.60

 

(2.55)

(51.55)

Weekly review

 

18/06/10

 

25/06/10

 

Points

 

%

Sensex

 

17,570.82

 

17,574.53

 

3.71

 

0.02%

Nifty

 

5,262.60

 

5,269.05

 

6.45

 

0.12%

Last three days of June 2010 – Sensex

 

Daily review

 

25/06/10

 

28/06/10

 

29/06/10

 

30/06/10

Sensex

 

17,574.53

 

199.73

 

(240.17)

 

166.81

Nifty

 

5,269.05

 

64.45

 

(77.35)

 

56.35

Weekly review

 

25/06/10

 

30/06/10

 

Points

 

%

Sensex

 

17,574.53

 

17,700.90

 

126.37

 

0.72%

Nifty

 

5,269.05

 

5312.50

 

43.00

 

0.82%

Quarterly Review

Pink Panther

Month

December 2007

December 2008

December 2009

March

2010

June 2010

Sensex

20,206.95

9,647.31

17,464.81

17,527.77

17,700.90

Points

Base

(10,559.64)

7,817.50

 

62.96

173.13

%

Base

(52.26%)

81.03%

0.36%

0.99%

Illiquid Stocks Spring Back To Life

With the market moving in a narrow range for six months, there is renewed activity in some of the stocks that had gone into the dormant mode since the downturn began in January 2008. In the Bombay Stock Exchange, there were over 2,000 stocks in the illiquid category and close to 400 such stocks on the National Stock Exchange at the beginning of last year. The numbers have gone down substantially during the past few months.

Exchanges bring out the list of illiquid stocks in order to inform their trading members to exercise due diligence while trading in these securities either on their own or on behalf of their clients. Both the exchanges draw up the list of illiquid securities-based trading activity every month. From around 1,800 illiquid scrips in January 2009 in the case of BSE, it has come down to around 1,400 during April. Similarly, for NSE, the figure stands at a little over 100 compared to around 400 during the same period.

Even as there has been a significant drop of illiquid scrips on BSE in terms of absolute numbers, it still remains high at over 20% of the total number of listed stocks. In the case of NSE, the number of illiquid stocks stands at about 10% of total stocks. The number of shares listed on BSE is almost four times than those traded on its counterpart. A higher number of illiquid shares do not bode well for stock exchanges as it translates into a lower turnover.

A higher number of illiquid shares do not bode well for stock exchanges as it translates

Pink Panther

2.1

INDIA

Pink Panther 2.1 INDIA Rivers An Economy Enshrined in Nature A large number of our microeconomic

Rivers

An Economy Enshrined in Nature

A large number of our microeconomic activities depend on villages, forest, agriculture fields, rivers, hills and lakes. While maximising farm profit, planners should not ignore soil quality, groundwater, pollination and rising input costs. Policy intervention is vital to maintain a balance among our industry, agriculture trade, services and natural sector.

One hundred and twenty crore Indians cannot shift to urban centres and become software engineers, professionals and service providers. So, villages, forest, agriculture fields, rivers, hills and lakes need to survive in order to enshrine a large number of microeconomic activities.

Way back in the 1970s, fishermen from Cuttack city used to fish from the two mighty rivers the Mahanadi and the Kathajodi, which were flowing perennially on both sides of the city. They were happy, healthy and had surplus money to booze and dance during Dussehra festival. In the '80s when the rivers turned into narrow streams due to deforestation and silting, they did not find fish there. The income of nearly 3,000 fishermen in the city vanished. The rivers turned dry not due to industrialisation but due to deforestation and silting.

According to Central Soil & Water Conservation Research and Training Institute (CSWRTI) and National Bureau of Soil Survey and Land use Planning, an estimated 5,334 million tonnes of soil disappear every year due to erosion.

Thirty years back Brahmaputra and its tributaries had thousands of dolphins. Mindless fishing activities, use of fine meshed nets for catching smallest of fish and silting of river bed are the reason why the playful dolphins, which could have provided joy to tourists, have disappeared.

Forests

Like rivers, forest has the potential to provide jobs to a large tribal population. As more jobs are lost due to the current economic downturn, sustainable forest management could become a means of creating millions of green jobs, thus helping to reduce poverty and improve the environment.

A

unique study – Green accounting for Indian states and Union Territories – found the value of our forest

at

Rs 88,60,259 crore in 2003. There are hundreds of minor forest products like cane, wood, bamboo,

tendu leaves, tusks, medicinal plants and gums, etc, which have good demand in domestic and international market. Transparent supply chain, healthy cooperative societies, dedicated extensions services of the government and political will could earn good amount of revenue for the state. The ILO

Report 2009 estimates that the global market for environment products and services is projected to double

to $2,740 billion by 2020 from the present $1,370 billion per year.

Nearly 47.61 lakh artisans in India as per All India Artisan Census 1995-96 make high value addition to organic material available in nature. The artisans of Bastar make exotic wood craft, while the hill tribe in North-East India make hundreds of utility and decorative items from bamboo and cane.

Handicraft was the major items of export from India in the past. Pliny, the Roman officer and Encyclopaedist (23-79 AD) complained Indian luxury trade was depleting the Roman treasury to the

Pink Panther extent of 50 million sesterces annually. As per the Union government's Foreign Trade Policy 2009-10, all handicrafts exports to be treated as special focus products and entitled to 5% duty credit scrip. This may help the exporter to access world export market for handicraft worth $350 billion.

Agriculture

India can make use of its 20 agro ecological regions and 60 subregions which produce a large number of crops. Agriculture sustainability should be the theme of agriculture planning. G-8 ‘L' Aquilla Food Security Initiative, concluded on July 10, 2009, has committed $20 billion to sustain agriculture development in the developing nations in the next three years. The commitment has the apprehension that extreme poverty would grip 90 million more people across the world due to global slowdown. In fact, the food security initiative is a measure to correct the wrong done in the beginning of the 20th century.

Farming, forestry and fishing in 1913 accounts for 28% of employment in US, 41% in France and 60% in Japan and 12% in UK. Their dependence on those sectors has gone down to 6% now and ultimately leads to job loss in natural sectors.

Agriculture scientist M S Swaminathan had prescribed crop diversification as the solution for Vidarbha farmers' crisis as cotton crop ate up 70% of productive land in the region. While maximising profit from agriculture, planners should not lose sight of the soil quality, groundwater, pollination and increasing input costs. In the ’70s, coastal Orissa farmers used to cultivate a paddy variety called dalua after the normal harvest of paddy in December. Dalua used to mature within four moths and the farmers got two harvests in a year. Government constructed canals to sustain the paddy for about five to six years. When the river system collapsed after six years the highly thirsty dalua crop failed.

In India's vast and complex economy, conscious policy intervention is required to maintain a sustainable balance amongst industry, agriculture, trade, services and the natural sectors.

is required to maintain a sustainable balance amongst industry, agriculture, trade, services and the natural sectors.

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2.2

INDIAN ECONOMY

Pink Panther 2.2 INDIAN ECONOMY It’s time to face Post-Crisis Reality Check India sailed through the

It’s time to face Post-Crisis Reality Check

India sailed through the Great Crisis of 2008-09 without skipping a beat. But celebration may be premature. As the aftershocks in Southern Europe suggest, the post-crisis world is likely to remain a very treacherous place for some time to come. Although India has one of Asia’s most balanced – and therefore, resilient – macro structures, it can ill-afford to ignore ever-present stresses and strains in the external environment. For India, the crisis and its aftermath should be viewed as a wake-up call – a time to sharpen its focus on the challenges and opportunities shaping its development journey.

While resilient, India was hardly untouched by the recent crisis and recession – Manufacturing helped GDP grow 7.4% in FY10. But there was a major downshift relative to vigorous pre-crisis growth trajectories. However against the backdrop of a world that had tumbled into the deepest recession since the 1930s, India’s relative resilience was impressive.

India also fared well compared to others in the developing world. Unlike China, where the external demand shock posed a major threat to jobs and social stability, India’s more measured policy actions did not have destabilising post-crisis impact that resulted in property bubbles and deteriorating bank loan.

While the Indian economy has better balance than others in Developing Asia – namely, a greater portion

going to private consumption and services and less to exports and investment – India is hardly immune to shocks elsewhere in the world. To be sure, the export share of the Indian economy was only 24% in 2008

– far short of the 45% norm for Developing Asia as a whole. However, India’s 2008 export share was

more than double the 10.8% reading in 1998. At the margin, the delta (i.e., change) in India’s export share

– rather than its level – is what drives economic growth.

There is, however, an important twist to India’s increased exposure to external demand. In recent years, the composition of Indian exports has shifted dramatically away from the developed world toward its neighbours in Developing Asia. The US share of Indian exports was cut in half – falling from 22.8% in 1999 to 11% in 2009 – whereas the share going to Europe slipped from 27.6% in 1998 to 20.9% in 2009. Meanwhile, the portion going to Developing Asia essentially doubled from 5.6% in 1999 to 11.6% in 2008. While these shifts in the mix of Indian exports underscore a lessening growth impetus from developed markets, they hardly eliminate India’s vulnerability to lingering problems in Europe.

On balance, the ongoing repercussions of Europe’s sovereign debt crisis could well be an important headwind buffeting the Indian economy for the next several years. Lingering post-crisis aftershocks make it all the more critical for India to redouble its efforts on other aspects of its development strategy.

Domestic saving

Key in that regard will be to sustain the recent improvement in domestic saving. India’s gross domestic saving rose to 36.4% of GDP in FY2008 – up sharply from the subpar readings in the low 20s that had prevailed since the early 1990s and that increase was a major support to India’s recent increases in investment spending on both infrastructure and manufacturing capacity. However, on the heels of a sharp crisis-related increase in the government budget deficit, the domestic saving rate fell back to 32.5% in FY2009 – a downturn that must be reversed if India is stay the course of investment-led growth.

Exit strategy

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India followed the pack of developed countries and shifted its monetary and fiscal policy levers into unusually stimulative positions – actions that are not without attendant risks to underlying inflation.

So, India now faces the same dilemma as others – how to orchestrate an effective “exit strategy” from the emergency policies that were put in place during the crisis. And the exit strategy needs to be executed in what still looks to be a very shaky post-crisis global climate. At the same time, these delicate policy manoeuvres must be crafted in a fashion that preserves India’s ongoing development program.

Like most major economies, India is having a hard time restoring its policy settings to pre-crisis norms. Despite the impressive post-crisis rebound of the Indian economy – the Reserve Bank of India has unwound only 50 basis points of the 425 bp easing that was implemented during the crisis. While there are hints of more rate hikes to come, the RBI has yet to convert these hints into action. With non-food inflation on the rise both at the wholesale and retail levels, prolonged monetary accommodation is both inappropriate and worrisome. Moreover, the government’s latest budget points to limited reduction in the structural deficit in the current fiscal year. More meaningful fiscal consolidation is slated for 2011-12.

For an emerging economy like India, a delayed exit strategy spells potential risks to core development strategies. Key in this regard is fiscal-policy-induced impediments to national saving. On the heels of the recent surge in domestic saving, the corporate investment share of Indian GDP trebled in the seven years before the crisis – rising from around 5% in early FY2001 to 16% in FY2008 before falling back to near 13% in FY2009. If the crisis-induced fiscal stimulus remains in place for too long and the recent shortfall in domestic saving continues, the renewed widening of nation’s current account deficit is likely to persist. That could make it very difficult for India to restart its investment-led growth dynamic.

Large and rapidly growing developing economies like India and China cannot afford to take the lead from the West and cling too long to crisis-induced emergency policies. Deferred exits strategies are not without destabilising consequences. Surviving the crisis was one thing.

It’s now time to face up to a post-crisis reality check.

destabilising consequences. Surviving the crisis was one thing. It’s now time to face up to a

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2.3

INDIA INC

Phase-II of Global Recession

Pink Panther 2.3 INDIA INC Phase-II of Global Recession Phase-II of the global recession was always

Phase-II of the global recession was always going to hit the global economy. That Greece took the honours was purely incidental. The bigger issue is whether in saving the too-big-to-fail banks of the world, governments have overstretched themselves. This is the nagging fear that is disquieting the markets. Let's hope that Greece was the whole iceberg, not just its tip.

Unfortunately, that hope seems a little misplaced right now given the economic prognosis of other countries and of Greece itself. The central question is whether European governments have done enough to stem the tide. Is there a sufficient firewall against market attacks that will inevitably come as players punt that the future of the euro will unfold negatively?

At issue is whether European governments now have the stomach to carry out the dramatic cuts required to get their fiscal numbers back in sync. At the very minimum, it will take years of drastic belt tightening on the part of governments and the people to get back in some shape. This can only happen if taxes are raised while simultaneously curbing spending.

However, no government can take such drastic steps and hope to maintain its popularity. Given the fact that elections are due in most European countries in 2012 and '13, it will be difficult for most political parties in government to take the measures needed. Typically new governments, as in the UK, would find it easier to start afresh and not be wedded to old positions.

Blame can then more be easily assigned to outgoing governments. But given the absence of such a change, whether the incumbent governments have the stomach for difficult measures is a real question mark. This likely lack of willingness to take the right but difficult steps is a significant risk to global markets, as is the collective ability of the European Union to get it right.

As the euro depreciates, European exports do get more competitive but it throws the world economy out of kilter. China is re-evaluating the revaluation of the renminbi as Europe is its biggest export market. At the same time, there is a flight to safety to the dollar, making it harder for the US economy to maintain its own recovery. On the flip side, interest costs on its deficit financing will decrease as Treasuries strengthen due to the flight to safety.

But the biggest dangers still lurk in Europe. If speculators come to the conclusion that key European governments such as Spain, Italy, Ireland, Greece or Portugal (the so called PIIGs countries) lack the political will to implement the required tough measures, then those countries will find it harder and harder to borrow at reasonable rates. It will also be difficult for the European Union to backstop the larger governments even though the stakes will be huge.

For example, the total debt of Greece is $226 billion while that of Spain is $1.1 trillion – almost four and a half times larger. Of that, about $220 billion is owed to French institutions, a similar number to German institutions and about $120 billion to British firms. With 20% unemployment, Spain has one of the weakest economies in Europe. Meanwhile of Italy's gross debt of $1.4 trillion; about 40% is owed to France, which amount to almost half of the latter’s GDP. The interconnectedness of these economies is such that the weakest link will determine the strength of the EU.

WHAT does all this mean for India?

Pink Panther The Indian economy continues to do well on the back of its strong domestic economy. However, a continued global risk aversion would mean continued outflow from the Indian equity markets which continues to remain very sensitive to FII flows. For example, in May we had almost $2 billion of outflows (a scant 0.2% of the total Indian market cap) and yet the market lost close to 12% of its value. Second, access to cheaper external debt capital will diminish as happened in the second half of 2008. This will put more pressure on the Indian banking system as the primary provider of liquidity, and thereby make it harder for Indian corporates to invest to capitalise on the growth opportunities in the domestic market. Meanwhile, export-oriented companies will continue to suffer as overseas markets remain sluggish at best for the next several years.

Clearly risks remain embedded in the global economy and it will be a while before this plays out. The best case scenario is for slow growth in Europe, a continued slow pick up in the US, and stronger growth in the rest of the world. The worst case is outright recession in Europe for many more years, which pulls the US back into a double dip recession as its own stimulus fades in the second half of the year, with growth in other parts of the world also getting impacted.

Corporates therefore need to have plans in place for a wide range of possible outcomes. At the very least a tight focus on costs needs to continue, judicious expansions mostly based around domestic demand and very, very conservative balance sheet management with the bias being to raise capital whenever available. At the same time, assets will be available cheap in the developed world but the temptation to acquire must be carefully tempered.

There is no certainty that current forecasts of western market demand will be accurate going forward. Overseas talent – both expats and diaspora – will also be keener to work in India allowing companies to selectively upgrade their management pools. We will see more outbound M&As but increasingly to other emerging markets – corporates should carefully build cash for such opportunities. India's voice in the world will carry more weight.

History teaches us that rich economies go soft over time. The process of transition is gradual and hard to identify as it is happening. We are witnessing just such a tectonic shift. There will be many ripples in the global economic waters and Indian corporates will need to manage nimbly to sidestep the dangers while taking advantage of the opportunities. The good news is that they have the management quality and world view now more than ever to do so.

of the opportunities. The good news is that they have the management quality and world view

Pink Panther

2.4

INTERNATIONAL

India and Europe’s tribulations

2.4 INTERNATIONAL India and Europe’s tribulations The past month has been Eurocentric, and it continues to

The past month has been Eurocentric, and it continues to be so. It is an unfortunate case of delayed effect. After all, the Greece fiscal imbroglio was uncovered by the newly-elected government shortly after it came into power in October 2009. That is, by the standards of the day, a long time ago. So, why is it causing tremors now?

One may recall that there was a major fracas about Dubai in late November 2009, but once cousin Abu Dhabi stepped in and bailed Dubai out, it was over. The problem with Europe is that unlike the emirates, blood runs thinner than water.

It is well understood that when the question of confidence is raised, the best and the only way to respond is immediately. If you let the problem fester, it gets worse and contagion begins to spread.

Why, one wonders, were the authorities in the eurozone so slow in sorting out the problem in Greek? It was a fairly straightforward issue. The country had borrowed well beyond its means, concealed it, and is now facing a payment crisis. Either other members collectively pay out the cash needed to make Greece solvent for the moment, or suspend it from the eurozone and leave it to the care of the IMF, whose mandate it is to deal with external payments crises.

But the eurozone did not have a provision of extending collective assistance, nor was it willing to face the consequences. Further, as the markets caught on quickly, Greece was not the only one that had lived beyond its means and the idea of bailing out wholesale nearly half of the membership was simply beyond the capacity of the solvent few. Finally, the member countries perceived to be solvent by the rest – most prominently Germany – seemed to be understandably, vehemently opposed to the idea of such bailouts.

Greece joined the eurozone in June 2000. In 1998, its current account deficit (CAD) had been 2.8% of GDP, which jumped to 7.8% in 2000 and remained close to this level till 2005. In 2006, it soared to 11.3% and to 14.6% in 2008. In the nineties, the average CAD had been 2.5%, but it was 9.3% in the next decade. But Greece was not alone. Portugal had an average CAD of 1.6% till 1997, the year before it joined the eurozone. Thereafter, this number averaged over 9%. Spain, a comparatively large economy, had an average CAD of 1.7% between 1990 and 1997; thereafter, it was 5.4%.

In the boom years of 2005 to 2008, the CAD that these countries ran up was staggering: Greece 14% in 2007 and 2008, Portugal 10-12 %, Spain 10% in 2007 and 2008. Spare a thought for those lined up to join the eurozone: Estonia with CAD of 18%, Latvia 22% and Montenegro 52%.

Basically, the less industrialised members of the monetary union went on an unprecedented shopping spree fuelled by the magic that the euro bestowed on their ability to borrow and attract equity.

The policymaker was untroubled since they could argue that the liabilities and the assets were mostly in the same currency, i.e., the euro. But this pre-supposes that there is effective fiscal unification; that if one constituent turned insolvent vis-à-vis another, some federal authority would pay.

But in the eurozone, there is no such federal capability, since this function was supposed to flow from

Pink Panther everyone observing the Stability Pact whose strict observance, would keep all members of this club equally solvent. Europe now has to make up its mind on what to do, and it is quite a struggle.

It has been made worse by the unexpectedly jejune statements by people in high office who should be expected to know better. So, is this a new crisis in the making? Another subprime mess, with a Lehman coup de grace down the road? Hard to say, though one may note that in a recently reported poll, a staggering 53% of French respondents opined that their country could default over the coming decade. Such is the faith of the European citizens in their governments today. Of course, it could be argued that disillusionment is not restricted to Europe, as the same poll reported that 46% of Americans feel that their country could default too.

It is our take – and indeed our hope too – that this time round, the troubles will be much less severe than they were in 2008. For one, in 2008, many people had felt that their world was about to end in a bottomless abyss of disorder. Having survived, they have been inoculated to an extent.

Then again, the centre of the financial world is not in Europe, so what happens there affects the continent more than it does others. Finally, in this crisis of solvency, major European governments have enough strength to slow the decline, even if halting it may be beyond their power now.

For India, the European mess is not good news. The EU may enter into recession-like conditions and our exports to that region will suffer. The cost of credit is likely to rise for everyone and portfolio investors may become cautious, factors that can make the cost of financing new fixed assets in India higher than it may have been otherwise.

On the positive side, the experience of recovery in Asia will, sooner than later, generate a kind of discrimination in favour of this region that will be advantageous to us.

In India, the government has to shape domestic business confidence so that it can offset the adverse fallout of the troubles in Europe and that it can do by moving boldly on infrastructure and other developmental fronts .If the crisis in Europe persists, commodity prices will ease, which will also be a silver lining for us.

In summary, our destiny is in our hands.

We can grow rapidly and strengthen our economic base, even if the advanced world is facing difficulties.

To do this, we need to aggressively address the infrastructure, regulatory and other deficits, and focus on international trade and investment in the Asian and African regions.

regulatory and other deficits, and focus on international trade and investment in the Asian and African

Pink Panther

2.5

WARNING SIGNALS

Don't blame the Greeks for the crisis

Housewives in Greece and Spain didn’t blow up money as the world thinks they did. They are suffering because of a reckless Wall Street and central banks which didn’t want to upset the apple cart. The euro will survive, but the price would be volatility and turmoil. And soon, US markets will battle with another round of mortgage defaults and turmoil. ot our words. Joseph Stiglitz’s. One of the most outspoken critics of Fed and George Bush, Mr Stiglitz is “sufficiently pessimistic” about the world economy.

Men like him and Paul Krugman give politicians the intellectual ammunition to lead the government’s intervention in markets. But does he feel a moral obligation? In an exclusive interview, the obel Prize winner and Columbia University professor, speaks his mind even as he reminds the world that Washington is still not getting it right and that it’s being bought over by banks which are desperate to water down the new rules for financial markets.

It’s evident that Greece has no immediate fix and over the next decade, other regions of the world may face similar problems. Isn’t it time for leading nations to sit together and reset the entire global debt?

nations to sit together and reset the entire global debt? What’s clear is that the current

What’s clear is that the current approach in Europe is wrong. The current approach is to try to impose extreme austerity. That will lead to a weaker economy and lower tax revenues, and so the reduction in deficits will be much smaller than hoped.

It’s a kind of austerity which failed in Argentina. The current approach of saying that you just have to get rid of the deficit is not going to work and is going to push the world into a double dip or a global slowdown.

So, the only alternative is some form of debt restructuring. It is clear that if there was confidence in Greece, it could make step payments. This would be more like two situations – Brazil and Argentina. Brazil had a debt crisis which was helped over by liquidity. It even had a debt write-off. Once the market irrationalities had worn off, it started to grow and now no one thinks of Brazil as having a large debt problem. Most of the countries are, I think, in the Brazilian situation. If interest rate remains relatively low and market remains calm, then they won’t have any difficulties.

remains calm, then they won’t have any difficulties. But don’t you think that one day China

But don’t you think that one day China will have to take a haircut on US debt?

No. The US debt is different from other countries’ debt for the very reasons that US promises to pay dollars and the US controls the printing press for dollars. So it will always meet its debt obligations. The dollars may not be worth a lot. The question for the US is will those dollars that they pay is worth what they were worth when China lent the money. That’s a kind of haircut.

worth when China lent the money. That’s a kind of haircut. As long as countries can

As long as countries can go on printing money, we may move from one bubble to another. At the same time, we can’t think of going back to the gold standard

You are right. We understand that the gold standard does not have enough flexibility and it does not work for modern economy; while we are getting into difficulty in getting the other system to work.

Pink Panther Now, one of the fundamental problems is the dollar reserve system. The dollar reserve system is one in which there is excessive reliance on one country – the US – and its supply of money of debt is determined by domestic concerns and not by global concerns. One of the main suggestions of a UN commission I headed was the creation of a new global reserve system. China, France and a lot of other countries supported it. This should be the first priority for the long term.

The current crisis is really caused by the private financial sector. The lesson I take from it is that we have to make sure that we don’t allow the private sector to engage in that kind of excessive risk and not give them what they did. We did the right thing to rescue it. But now we have to live with the consequences.

Well, the Financial Regulation Bill does want to cut risks. But stifling rules could kill parts of the financial market and end up throwing the baby out with the bath water?

market and end up throwing the baby out with the bath water? No. Quite the contrary,

No. Quite the contrary, it’s not strong enough. It was watered down. The financial sector paid huge amounts of money to water it down and they succeeded. Just like they bought deregulation, they bought the bailout, and now they succeeded in watering it down, but not as much as they had hoped. This is, you might say, the partial triumph of democracy. But we don’t know whether they will keep it. The administration is on the wrong side.

For instance, one of the provisions is that the US government should not underwrite the risky derivatives that cost $170 billion in the case of AIG. Banks shouldn’t be engaged in gambling and there is a debate on whether AIG was engaged in gambling or insurance. Certainly, if it’s gambling, it should not be government-guaranteed. One provision is to say that if you are FDIC-insured, you can’t write these gambling policies, insurance policies. The administration and the Fed said that it’s an important part of the lending activity. It’s only a few banks that do it. If it’s an important part, it would not be just a few banks. It will be most banks.

Where does that put the future of the US financial sector?

America’s financial system was out of proportion to the size of our savings. We are the largest economy but our savings rate is very low. Our financial markets were larger than proportionate. The reason was that people believed that US markets knew how to manage risks and allocate capital. The lesson from the crisis is that they don’t know. It’s gambling with other people’s money. And that’s going to stop.

with other people’s money. And that’s going to stop. Talking about savings, in Japan, the number

Talking about savings, in Japan, the number of people retiring is more than the number of people saving. Soon, Japan may have to borrow externally to meet the deficit and that could push interest cost up

to meet the deficit and that could push interest cost up Japan’s debt-to-GDP ratio of 180%,

Japan’s debt-to-GDP ratio of 180%, is 50% greater than Greece and the only reason that it avoids trouble is that it doesn’t have to depend on outsiders. Also just to put things in perspective, Greece’s household savings rate is higher than Germany’s. So the notion that the Greeks were profligate is not true. Now, if Japan’s savings rate falls, it will have to depend on outsiders and that could in fact likely lead to higher interest rates. How much higher could depend on all market confidence. Markets have demonstrated a kind of irrationality – irrational exuberance and irrational pessimism. If interest rates remain low given Japan’s tax capacities, it can service the debt. So if global interest rates remain relatively low and people remain confident then I don’t think Japan is necessarily is going towards a crisis. But it’s not out of realm of the impossible.

Pink Panther

Be it Greece or Japan, you repeatedly talk of lower interest rates. But given the inflationary fears, you think that’s feasible?

given the inflationary fears, you think that’s feasible? I am sufficiently pessimistic about the global economy.

I am sufficiently pessimistic about the global economy. The forecast for US is that we won’t return to normal unemployment before the middle of the decade. So we are talking about an extended period of weak economy. If Europe, and probably the US, go on austerity packages that the financial community is pushing for, the likelihood is even greater.

So, euro and the European Monetary Union will survive

What happened in the last few months has been disappointing. Germany was reluctant to come to the assistance, and when it came to the assistance, the only fiscal framework they talked about is austerity not a solidarity fund. Greece’s problems are largely of outside its boundaries because its major export like tourism is down because of the global downturn. It had a structural problem, but most of the deficit is caused not by the structural problem but by the global downturn. So we are trying to correct the structural problem without doing anything about the surroundings.

problem without doing anything about the surroundings. The positive is that in the end Germany and

The positive is that in the end Germany and the other countries did come to the assistance of Greece. The benefit that Germany and others get from the euro is sufficiently great, the political commitment is sufficiently great and I think it would survive. But it would be on the basis of muddling through, which will mean a lot of global financial volatility. It doesn’t need fiscal union to survive, but what it does need is some form of assistance and more institutionalised than the current programme. There is a risk of it not surviving and that’s the price that is demanded of the countries. Spain is a good story as before the crisis it had a surplus. So no one can complain of a fiscal profligacy.

You have said there is a risk of another financial crisis within five to ten years. Where and why?

financial crisis within five to ten years. Where and why? The problem with developed countries is

The problem with developed countries is clearly very serious. In the US there could be a crisis of confidence in the dollar – we had it before in the 1970s. But it could also come from emerging markets because what has been happening is that to reignite the American economy we have been flooding the world with liquidity but that has not translated into lending in US. It’s again part of the free market ideology which is give money to the banks and don’t worry about what they do. But in the world of globalisation they are asking which the best place to invest is. And they are coming out with an answer that the best place is not US. Fed is creating liquidity which is going to other markets, and Fed is saying that’s their problem and not ours.

You had praised RBI and its resistance to some of the liberalisation. Is it a model for other countries?

Our regulatory structure was very flawed. People like (Henry) Paulson who helped create the problem was telling India that you should follow the American way. I am glad that you didn’t follow Paulson’s advice. So the point I am making is that even if you are fully advanced, you shouldn’t follow the Paulson way. But countries which are not fully developed might want to have different or more regulations or may have the ability to have more regulation. It’s not only that financial markets are more complicated and difficult so you have to have a regulatory structure that changes with the stages of development.

are more complicated and difficult so you have to have a regulatory structure that changes with

Pink Panther

In the next one-and-half years, a lot of US mortgage interest rates will again come up for resetting. Do you fear another spate of defaults and turmoil in the market?

fear another spate of defaults and turmoil in the market? Not fearing, we know it will

Not fearing, we know it will happen. We know that there would be more mortgage defaults. We expect the number in 2010 to be larger than 2009. Things are getting worse. That’s one of the reasons why I am not optimistic about a quick recovery. The administration has done almost nothing for the foreclosures. And there are two problems – one of the reset and of course that will get worse once the interest rates start becoming normal. The other problem is that more than a quarter of the mortgages are underwater as real estate prices have gone down by 30%. The one factor in this is that the US government has taken over the role of being the largest owner of the mortgages. So it may be that there will be fewer problems in the private sector and more in the public sector but its all part of the hidden bailout.

On the eve of the Chinese New Year, China raised the interest rates. There are fears of a blow-up in China, many of the infrastructure ventures are not earning enough. Isn’t it worrying?

Two things about China which is different from other countries are: first, it is sitting on $2.4 trillion of reserves. It gives a bit of cushion to handle some of the bad debts. The second: when you are a big economy that is growing at 10% a year, the mindset of what is excess capacity changes very dramatically. What you see, disappears before you know. It is true that they have had a supply side model for their economy and it worked mainly because of the success of the export-led growth. They could increase the supply and there is a global demand that always mattered. That model is running out of time. They know it and they are in the process of restructuring the economy and I think they will succeed in doing that. But that’s the major challenge.

succeed in doing that. But that’s the major challenge. And given the slowdown in Europe as

And given the slowdown in Europe as well as US, export-led economies will find it a problem.

as well as US, export-led economies will find it a problem. The export-led growth model will

The export-led growth model will have real trouble. India and China have a very big advantage as they have a vast domestic untapped market which they are beginning to tap. That’s why I am optimistic about India and China. Particularly China’s economic growth at this stage is very resource intensive. Urbanisation, steel base, food consumption – there will be a high demand for commodities which will benefit other developing countries. So their growth will be enough to help Latin America and some of the other emerging markets. But not enough to save Europe and America. In fact, it’s going to present a problem for the US and Europe as the prices of raw materials will go up.

In your book ‘Roaring Nineties’, you had hoped that the future US administration will address the issues which will improve the world as well America. Is there a chance?

The US is so absorbed by the crisis and domestic politics. It was Gordon Brown who took the initiative for G20. It was Brown and Sarkozy who said that we got to have a global regulatory framework. We don’t want to talk about a global reserve currency as long as we have to borrow a trillion dollars every year; we don’t want to upset this particular apple cart as long as people are willing to buy our bonds.

dollars every year; we don’t want to upset this particular apple cart as long as people

Pink Panther Men like you and Prof Krugman provide intellectual ammunition to politicians who then lead the government to intervene in the market. Do you feel a moral obligation that these things may not work out well?

Much of what we talk about is what I call robust interventions. By that I mean interventions that are simple enough that you don’t have to very fine tune to make them work, even if you have a bad president like President Bush. We have just seen that the government can be very dysfunctional. Paul feels much more about the issue of robust intervention that works even with the flawed institutions. But obviously it goes back to the dynamic view on regulation and taxation. Any system will have constant changes and so there will be mistakes. But then we have to say that we are ready to correct the mistakes when they become evident.

are ready to correct the mistakes when they become evident. We are now in the early

We are now in the early stages of a third depression: Paul Krugman

Recessions are common; depressions are rare. As far as I can tell, there were only two eras in economic history that were widely described as “depressions” at the time: the years of deflation and instability that followed the Panic of 1873 and the years of mass unemployment that followed the financial crisis of

1929-31.

Neither the Long Depression of the 19th century nor the Great Depression of the 20th was an era of non- stop decline – on the contrary, both included periods when the economy grew. But these episodes of improvement were never enough to undo the damage from the initial slump, and were followed by relapses.

We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression than the much more severe Great Depression. But the cost – to the world economy and, above all, to the millions of lives blighted by the absence of jobs – will nonetheless be immense.

And this third depression will be primarily a failure of policy. Around the world – most recently at last

Pink Panther weekend’s deeply discouraging G-20 meeting – governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.

In 2008 and 2009, it seemed as if we might have learned from history. Unlike their predecessors, who raised interest rates in the face of financial crisis, the current leaders of the Federal Reserve and the European Central Bank slashed rates and moved to support credit markets. Unlike governments of the past, which tried to balance budgets in the face of a plunging economy, today’s governments allowed deficits to rise. And better policies helped the world avoid complete collapse: The recession brought on by the financial crisis arguably ended last summer.

But future historians will tell us that this wasn’t the end of the third depression, just as the business upturn that began in 1933 wasn’t the end of the Great Depression. After all, unemployment – especially long- term unemployment – remains at levels that would have been considered catastrophic not long ago, and shows no sign of coming down rapidly. And both the United States and Europe are well on their way toward Japan-style deflationary traps.

In the face of this grim picture, you might have expected policymakers to realize that they haven’t yet done enough to promote recovery. But no: Over the last few months there has been a stunning resurgence of hard-money and balanced-budget orthodoxy.

As far as rhetoric is concerned, the revival of the old-time religion is most evident in Europe, where officials seem to be getting their talking points from the collected speeches of Herbert Hoover, up to and including the claim that raising taxes and cutting spending will actually expand the economy by improving business confidence. As a practical matter, however, America isn’t doing much better. The Fed seems aware of the deflationary risks – but what it proposes to do about these risks is, well, nothing. The Obama administration understands the dangers of premature fiscal austerity – but because Republicans and conservative Democrats in Congress won’t authorize additional aid to state governments that austerity is coming anyway, in the form of budget cuts at the state and local levels.

Why the wrong turn in policy? The hard-liners often invoke the troubles facing Greece and other nations around the edges of Europe to justify their actions. And it’s true that bond investors have turned on governments with intractable deficits. But there is no evidence that short-run fiscal austerity in the face of a depressed economy reassures investors. On the contrary: Greece has agreed to harsh austerity, only to find its risk spreads growing ever wider; Ireland has imposed savage cuts in public spending, only to be treated by the markets as a worse risk than Spain, which has been far more reluctant to take the hard- liners’ medicine.

It’s almost as if the financial markets understand what policymakers seemingly don’t: that while long- term fiscal responsibility is important, slashing spending in the midst of a depression, which deepens that depression and paves the way for deflation, is actually self-defeating.

So I don’t think this is really about Greece, or indeed about any realistic appreciation of the tradeoffs between deficits and jobs. It is, instead, the victory of an orthodoxy that has little to do with rational analysis, whose main tenet is that imposing suffering on other people is how you show leadership in tough times.

And who will pay the price for this triumph of orthodoxy? The answer is, tens of millions of unemployed workers, many of whom will go jobless for years, and some of whom will never work again.

Pink Panther

3.1

THE METAL DETECTOR

Be wary of the gold bugs

Panther 3.1 THE METAL DETECTOR Be wary of the gold bugs It is hard to drown

It is hard to drown in a sea of liquidity. That's the notion the bulls are keeping their faith in despite the myriad of structural problems in the global economy. But in what’s reflective of the widespread optimism on gold, even the bulls want to hold on to the yellow metal as a lifebuoy – just in case.

Gold is the best performing asset class this year and while most other financial assets have struggled to make their way back to pre- Lehman levels, the yellow metal is up by more than 50% since September 2008. As a result, gold is currently trading well above the long-term average levels relative to stocks and bonds and also in comparison to its own historical trend-line.

Flows have been flooding gold exchange traded funds, or ETFs; they nearly doubled last year, thereby taking the current stock of gold in ETF holdings to an equivalent of a whopping 186 days of global demand. ETF holdings for copper total 50 days of demand for the commodity in contrast while aluminium and zinc ETFs represent around 100 days of underlying demand. The daily turnover in gold ETFs – now at $3- $4 billion a day – is up nearly 10fold from levels of three years ago. Investment demand currently represents the largest component of overall demand for gold compared with a mere 4% just a decade ago.

Traditionally, jewellery purchases constituted the overwhelming majority of demand for the yellow metal, with India, China, Turkey and the Middle Eastern countries being the largest buyers. Jewellery demand has been on the decline over the past two years in reaction to the price surge caused by strong investment demand. In fact, jewellery demand contracted by as much as 20% in 2009.

The price increase suggests that supply has fallen way short of demand even though gold miners are making huge profits with the marginal cost of production estimated at $700 an ounce. The demand-supply dynamic is largely irrelevant in the case of gold at least in the short-term as it largely is an indestructible commodity. Almost all the gold that has ever been mined still exists and is 65 times the amount of annual mine production. With 51% of the 165,000 tonnes in above-ground stocks of gold held as jewellery, a large part of the gold holdings are not traded, thereby limiting the supply on the marketplace.

So is gold a worthwhile investment? It has effectively functioned as a store of value for many centuries, which literally means it has held its value after accounting for inflation. Over the past century, the price of gold has been virtually flat in inflation-adjusted dollar terms. It has therefore underperformed most other asset classes; US stocks and bonds yielded annualised real rates of return of 7% and 2% respectively over the past hundred years. Some of the best periods of gold outperformance have come about when the yellow metal has held its value when other asset classes have fallen. No surprise then that the most ardent gold bugs are folks who have a dire view of the world and little confidence in the financial system.

Gold has done particularly well during crises dating back to the US civil war in the mid-19 th century right up to the more recent financial meltdown. The IMF cites five major sovereign risk defaults since World War II; demand for gold got a boost during all of them. While history suggests that gold will hold its own if sovereign credit risks keep increasing, many myths surround the performance of gold.

For one, the wide spread belief that gold is a great hedge against inflation is a relic of the 1970s – a period of very high inflation and the best decade for gold prices. But the relationship between gold prices and inflation has been more erratic in subsequent decades when cyclical rises in inflation have not always

Pink Panther supported gold. The main reason for the strong price performance of gold in the 1970s was central banks were behind the curve on inflation with interest rates typically lagging inflation.

A catch-up element also played a role in gold’s 20-fold rise in that decade as its price was fixed at $35 an

ounce under the Bretton Woods system that prevailed from the mid-1940 s to the early 1970s. From the 1980s onwards, inflation targeting became more popular and central banks maintained much higher real interest rates to anchor price expectations and prevent a repeat of the 1970s inflation malaise.

Some investors are currently again buying gold in the belief that inflation will rise sharply in the years ahead on the back of ultra-lax monetary policies. However, other financial instruments such as inflation- protected bonds currently have very little long-term inflation expectations embedded in their prices and so represent a much cheaper way to buy insurance against an outbreak of inflation. Gold only performs well when real interest rates are either very low or negative. After all, gold is virtually a zero yielding asset and the opportunity cost of holding it is negligible only when real interest rates are meagre.

The other myth surrounding gold is that it an ‘anti-dollar’ play given the negative correlation between gold and the dollar during some periods. But as the past few months have shown, this relationship is tenuous with gold rising even in the face of a stronger dollar.

Although some Asian central banks have been diversifying their foreign exchange reserves to include gold as it constitutes just 2% of their total reserves, such diversification is not necessarily taking place at the cost of the dollar. Other currencies from the euro to the much-sought-after high-yielding currencies such as the Australian dollar have also been declining in value of late.

The main factor driving gold purchases by some central banks is TINA (There is No Alternative). Of course, as long as real interest rates are low, gold will likely find many interested parties but it is important to distinguish between absolute and relative performance.

Gold appreciated by 25% in 2009 but underperformed most global stock markets as risk aversion was on the decline and the low real interest rate environment that propelled gold higher benefited stocks and other industrial commodities even more. In 2008, gold ended the year marginally changed but was seen as a star given the carnage in other asset classes.

Some gold bugs are throwing about very aggressive price targets of $2,000 or $3,000 an ounce, from levels of just over $1,200 an ounce now.

If the yellow metal does reach those levels, it would form a bubble of epic proportions. Gold’s peak at

$850 an ounce in 1980 marked one of the biggest bubbles in post WWII history and the yellow metal then fell by more than 70% in the following two decades as real interest rates rose and the global economic environment improved significantly. At $1,800 an ounce in current dollar terms, gold would be at the same level as at the absolute peak in 1980.

The possibility of gold experiencing a melt up similar to that in 1980 cannot be ruled out. Multi-year

trends often end with a buying crescendo as bubbles are based on some fundamental development that eventually turns into a fad with prices varying significantly from the underlying reality. Gold is not yet in a bubble stage but is indeed expensive, trading well above the marginal cost of production and that was not the case for much of the previous decade when gold prices rose fourfold. From an asset allocation standpoint, owning gold at current levels makes sense only if an investor's view

of the world is outright bearish. If not, gold is likely to underperform other asset classes from hereon, in

line with its long-term performance history.

Pink Panther

3.2

CORPORATE BOND MARKET

Pink Panther 3.2 CORPORATE BOND MARKET Long road to Bond Street Nearly five years ago a

Long road to Bond Street

Nearly five years ago a landmark report by the Patil Committee laid out a road map for easier access of companies to long term finance. Suggestions on improving the structural framework of the corporate bond market have been largely implemented. But the key issue of widening the investor base still remains a challenge. As officials in the regulatory agencies prepare to take fresh steps to address this issue, experts are now calling for a more concerted attempt from all arms of the government.

In a recent meeting with top government officials, Subir Gokarn, deputy governor of the RBI, outlined the broad discretion that policy makers ought to follow to develop the local corporate bond market. Rationalising capital controls and convertibility, enabling market access and enhancing market liquidity were some of the key measures which need to be implemented. The challenges in India centred on driving demand from domestic investors, boosting market infrastructure and rationalising taxation.

Of course, none of these concerns are really new. Most analysts say the bond market in India is full of traders, but hardly any long term investors. They suggest all further policy should be directed at expanding this small community of investors. Regulators can fundamentally alter the market by discouraging private placement of debt by issuing companies. The universe of investors cannot be expanded unless every issue is subscribed to by a range of investors including households.

Ravi Narain, chief of the NSE says, “Bond markets have been abysmally shallow in every country in the world barring the United States and perhaps Europe.” The whole of Asia is very shallow as far as the corporate bond market is concerned. Our country can start with rationalising duty applicable for corporate bond trades. This will reduce the cost of transfer of debt securities.

Withholding tax has been a hurdle for the bond market. To ensure active participation by offshore investors and to make offshore financing more competitive, withholding tax needs to be removed. According to industry estimates, FIIs contribute close to 30% of the total volumes in the corporate bond market that have been rising since December 2009. They currently only invest in shorter tenure securities and exit their investments before it’s time to pay the 20% withholding tax.

Non-government pension funds could potentially be another major participant in the corporate bond market. This corpus is about Rs 4 lakh-crore. However, a large part of this is managed based on EPFO guidelines. So, even if the finance ministry gives them freedom to invest according to the liberalised norms, almost all of these funds will still remain parked in government securities. Policy makers need to change the current “category based” investment limits (private corporates, PSU issuers for instance) to “rating based” investment limits for PFs and insurance companies. Raman Uberoi, senior director, Crisil Ratings says such long term players can be allowed to initially invest in long tenure debt securities and in Greenfield projects rated up to the ‘A’ and ‘BBB’ categories.

Overall volumes in the secondary market for bonds have risen sharply over the past few months. While trades worth Rs 66,850 crore were reported on NSE, BSE and Fimmda for April 2010, the number was only Rs 31,000 crore one year ago. In fact, this is the highest-ever volume of reported trades in corporate bonds for a single month since reporting began in January 2007, according to official data. The time is opportune now to move all these volumes to the transparent and better price discovery mechanism of order matching platform. Then the dream of a corporate bond market as efficient as the country’s equities market may not be far away. This could in turn help fuel India’s next generation of infrastructure growth.

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3.3

EURO

Pink Panther 3.3 EURO Debt crisis brings euro to new normal Europe’s debt crisis will depress

Debt crisis brings euro to new normal

Europe’s debt crisis will depress the euro still further after it declined to the lowest level since 2006. For the 16 countries using the currency, that isn’t all bad. A drop over three to four years would benefit European exporters in countries such as Germany, where foreign sales help offset reductions in government spending and restraint by consumers concerned about inflation. U.S. exports, which President Barack Obama says he wants to double within five years, may become less competitive.

The euro depreciation is very good news for the region because the rest of the world economy is expanding. This is going to bring a welcome boost that may save the euro zone from outright recession.

Experts put the euro’s long-term “fair value” at between about $1.10 and $1.20. Their bets are that the euro still has ample room to go down before it goes up. It may fall below parity with the dollar in the first quarter of 2011, according to 43 forecasts compiled by Bloomberg.

The euro fell to the lowest against the dollar in more than four years on May 17 2010 and is down 14% this year as the fiscal crisis spreading from Greece undermined confidence in the currency. Purchasing power parity indicates the euro remains 9.8% overvalued against the dollar. The currency’s value is still higher than the weekly average rate of $1.1833 since its introduction in 1999. The euro’s all-time low was $0.8272 in October 2000; the peak was $1.6038 on July 15, 2008.

The euro may stick at lower levels for “three, four years” as Europe grapples with its fiscal crisis. The decline in the euro may hurt demand for the region’s sovereign bonds at the time when governments are issuing a record amount of debt. The $1 trillion lending backstop for indebted euro nations agreed to by European leaders on May 10 also won’t halt the slide because investors remain concerned about government debt, the growth outlook and trade imbalances within the euro area. Countries in the euro region are bringing forward fiscal tightening and that reduces a chance of a swift and strong economic recovery. The Frankfurt-based ECB probably will refrain from raising interest rates to help offset declining government spending in the region. Remember, combination of tightened fiscal policy and looser monetary policy historically leads to a weaker currency.

Even so, pressure on the ECB to raise rates may grow as the euro’s decline feeds inflation by making imports more expensive. European inflation accelerated to a 16-month high in April, the European Union’s statistics office said May 18. For European exporters, the euro’s biggest crisis since the monetary union’s debut is an opportunity after China overtook Germany as the biggest exporter of goods last year.

The super-competitive export machine of Germany is going to be compensated with a very, very weak exchange rate. Exports account for almost half of the German economy, making up 47 percent of gross domestic product in 2008, the latest year for which full data are available. The biggest losers will be U.S. exporters that face a rising dollar. A weaker European economy is not good for US.

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4.0

FINANCIAL SECTOR: TRANSFORMING TOMORROW

Ensure Proper Regulation

The global financial crisis has been a wake-up call to policymakers the world over. The unprecedented scale and complexity of the crisis is such that it is unlikely you will ever find experts agreeing completely either on the factors that led to the crisis and, possible safeguards against a future recurrence.

Was it poor regulation? Overly loose US monetary policy? Underlying global imbalances? The use of opaque and complex credit derivatives? Faulty executive remuneration models? Blind faith in market forces, to list just some of the factors touted as responsible for the spectacular meltdown in the global economy witnessed since the Great Depression? The jury is still out on the precise factors or combination of factors responsible for the crisis. But there is one issue on which there is rare unanimity among the wise men of international finance: the collateral damage caused by poor regulation of systematically- important financial institutions (SIFs). Following from this the next question is: what sort of information do we need about SIFs to ensure proper regulation?

4.1 FINANCIAL ADVISORS:

Weigh impact on investors

Filling the information gaps Consolidated statements

The Bank for International Settlements (BIS) has identified information gaps in five areas as critical for better regulation of SIFs and containing future crises. Regulators, for instance, have little or no information about the consolidated balance sheet of systemically important financial entities, their liabilities, their currency exposures, degree of interconnectedness and about non-bank financial entities such as off-balance sheet special investment vehicles, pension funds, insurance funds, etc. Yet each of these has a vital bearing on the final outcome of any regulatory effort. For instance, cross holdings between companies are now the norm rather than the exception. However, most of the data collected and monitored by regulators is on individual companies.

and monitored by regulators is on individual companies. The danger in this is that we could

The danger in this is that we could end up losing the wood for the trees. Thus, a financial conglomerate with interests in diverse fields such as banking, insurance, pensions, asset management and so on could well be submitting information on different aspects of its business to different regulators. And while an individual company may not be systemically important, the group as a whole could well be; but since it is not tracked as a conglomerate its importance is not fully appreciated.

Fortunately for India, the RBI, to its credit, has been alive to the dangers of this kind of a disaggregated approach. Hence its insistence on the holding company model for financial institutions; ring-fencing commercial banks to keep them immune from the consequences of the activities of related entities. However, the importance of consolidated balance sheets is yet to be fully appreciated even by the RBI. This is relevant since over the years corporate structures have become more complicated. The ramifications of inter-connected dealings can best be assessed from consolidated balance sheets. As the BIS points out, ‘the inability to “see” the consolidated balance sheet, either at the individual bank level or at the headquarter country level, means that the build-up of stresses at the systemic level cannot be monitored'.

4.2 FINANCIAL PLANNERS

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Value unlocking for all stakeholders

Filling the information gaps Liabilities' side

Filling the information gaps Liabilities' side Another information gap the crisis has highlighted relates

Another information gap the crisis has highlighted relates to the liabilities' side of bank balance sheets. In the past, analysts tracking the health of banks invariably focused only on assets – the quality of loan portfolios, share of NPAs, interest- sensitivity of investment portfolios and so on. Little or no attention was paid to the liabilities' side of bank balance sheets. Nor was there any appreciation of the difference between banks that depended heavily on inter-bank deposits, non-bank money market funds and wholesale deposits from large companies as distinct from those that depended on retail deposits; until the former collapsed when short-term money markets froze. Northern Rock is a case in point.

HERE again, the RBI has been ahead of its counterparts in the developed world in emphasising the need for a good ‘retail deposit base' and frowning on the dependence of foreign banks on the short-term money market. Yet we cannot really “see” any of these markets in our aggregate data. And when we cannot see them, we cannot assess the degree of maturity mismatch embedded in the system.

4.3 CREDIT COUNSELORS

Resolve convertibility and recompensation issue

COUNSELORS Resolve convertibility and recompensation issue Filling the information gaps Off-balance sheet exposures

Filling the information gaps Off-balance sheet exposures

The exposure of banks to different currencies especially off-balance sheet exposures is another challenge. In the past adventurism often went way beyond the dictates of prudence primarily on account of two factors. One, the pressure on managers to earn their bonuses and two, the fact that much can be hidden in off-balance sheet exposures. The problem here is that the position is never static, so central banks will have to develop a ‘sixth sense' and learn to recognise warning signals keeping in mind intangible aspects such as the culture of different SIFs. A Citi or ICICI Bank, for instance, is quite different from a State Bank of India and that difference will need to be kept in mind by regulators.

4.4 RISK MANAGEMENT CONSULTANTS

Educate – Engineer and Enforce

Filling the information gaps Interconnectedness of SIFs

The degree of interconnectedness of SIFs is another key indicator for measuring systemic importance. Bilateral interbank liabilities and system-wide aggregate exposures to particular counterparties are indicators of the inter-connectedness. Collection of such data is a challenge, but realisation by central banks of the importance of this is a first step.

Collection of such data is a challenge, but realisation by central banks of the importance of

4.5 TECH SAVVY PROFESSIONALS

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Take first step to ensure efficient and reliable system:

Filling the information gaps Non-bank financial entities

Filling the information gaps Non-bank financial entities Pre-crisis, off-balance sheet entities such as structured

Pre-crisis, off-balance sheet entities such as structured investment vehicles (SIVs) obscured the build-up of stresses in the financial system and exacerbated the problems when they had to be moved back onto banks' balance sheets. Therefore, non-bank companies particularly, pension funds, insurance companies and large corporates – should not be excluded from systemic monitoring exercises.

NBFCs are now on the RBI's radar and the bank does identify systemically important NBFCs and subject them to closer monitoring. But not large corporates. Is it possible to monitor such companies? Is it necessary to bail out non-banks? These are issues that are as yet unresolved. In the meanwhile even as central banks fill the information gaps identified by BIS they would do well

to develop the skills needed to track and recognise warning signals. No amount of data can fill in for that!

What is true at the level of individual SIFs is also true at the national level. Statistics compiled by national authorities, the IMF, the OECD and the BIS do not provide a complete picture. For example, the flow of funds statistics, the balance of payments statistics, the IMF's Coordinated Portfolio Investment Survey and the BIS locational banking statistics all rely on residency based data. Such data are insufficient for identifying vulnerabilities in any particular consolidated national banking system.

4.6 WEALTH MANAGERS

Map out the details to translate into benefits

System reforms The Planning Commission

into benefits System reforms The Planning Commission Speaking to members of the Planning Commission at the

Speaking to members of the Planning Commission at the first anniversary of UPA- II, Prime Minister Manmohan Singh called upon them to reform the role of the commission. The commission should be a ‘systems reform commission' to address the systemic problems of the 21st century, he said. Not only India, but the whole world is facing systemic problems that are endangering the sustainability of economic growth and human development. These systemic issues cannot be resolved with prevalent, non-systemic and compartmentalised approaches to planning and policymaking. Indeed, these approaches have contributed to the

Indeed, these approaches have contributed to the growth of systemic problems. A systemic approach requires

growth of systemic problems.

A systemic approach requires fundamental changes in the way we think and act. A

cartoon to teach systems’ thinking shows a boat whose one end is sinking into the

water with the other end lifting into the air. Some people are bailing furiously in the sinking end. In the other end, two men are gloating: ‘Thank goodness the hole

is not in our end of the boat!'

Pink Panther ‘No man is an island entire to itself’, poet John Donne said. We

Pink Panther

‘No man is an island entire to itself’, poet John Donne said. We cannot be safe within our man-made compartments because systemic problems cross state and national boundaries.

systemic problems cross state and national boundaries. Climate change and terrorism cross national boundaries. The

Climate change and terrorism cross national boundaries. The rich cannot be secure within their gated enclaves when there is poverty around. They cannot be smug about the future if only their children are well educated and well fed when hundreds of millions of poor children are not. Because those masses of children are supposed to give the demographic dividend on which the country is relying to sustain its economic growth. The essence of systems is that many things are interconnected in ways we may not realise.

The cartoon shows a man sitting securely on a chair, and also shows what the man cannot see. He has solved an immediate problem, but has set in motion a chain of events which will hurt him later. In a rush to solve problems, without appreciating interconnections, trains of events can be set off that can create even worse problems. They are not amenable to ‘silver bullet' solutions. For example, child malnutrition in India cannot be addressed only by nutritional supplements when children also suffer from disease and diarrhoea which washes out the nutrition. Many ministries and specialists must cooperate to make a difference. A new set of gauges is required for systems reforms.

4.7 INCLUSIVE CEOs

Innovative responses to problems

System reforms The four Ls for systems action

to problems System reforms The four Ls for systems action Systems action must follow systems thinking.

Systems action must follow systems thinking. Frustration with the slow pace of development often causes policymakers to revert to a theory of action. But systemic development requires a very different theory of action based on four ‘Ls’: Local action, Lateral connections, continuous Learning, and empowering Leadership.

The necessity of local empowerment is being appreciated in India. The people know best what they need. If they become the agents for change they want, then desired changes will happen. Therefore, policy actions must be directed to building local capabilities. Silo thinking and silo action cannot produce systemic action.

In systems many aspects must be coordinated as mentioned before. Therefore lateral connections must be built into the system for cooperation and sharing knowledge. The speed of learning, through the multiple experiments that a diverse system can undertake, and the speed with which that learning spreads across the system, will produce the ‘scale' required.

Finally, systems reform requires systems leaders. By dividing the system into silos, they become the point of coordination that all must look up to. And by keeping people dependent on them for wisdom they increase their power. The prime minister wants the Planning Commission to be ‘an essay in persuasion’. ‘Carrots and sticks' are adequate incentives for donkeys perhaps. Whereas people can be powerfully persuaded by ideas that touch their hearts. Systems leaders, and the Planning Commission, must persuade and lead, not only with the money and permissions they dole out, but with the power of their ideas too.

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5.

BANKING SECTOR

Grow, but don’t try to rule the world

5. BANKING SECTOR Grow, but don’t try to rule the world Emerging markets have come out

Emerging markets have come out of the sub-prime crisis better than the advanced economies. Banks are a play on the economy, so this is reflected in the condition of banks in advanced and emerging economies. In 2009, banks in the US, UK and elsewhere reported their lowest return on assets in years, if not decades.

Profitability of banks in India and China, two leading emerging markets, was not only high but higher than in pre-crisis years! The average return on assets in both India and China in 2007-09 was 1%. In the period 2004-06, the figures for India and China had been 0.8% and 0.7% respectively (Source: IMF's Global Financial Stability Report, April 2010). Banks in other emerging markets, such as Brazil and Russia, have also remained profitable although profitability declined during the crisis years.

At the turn of the century, most people thought it was only a matter of time before puny domestic banks in emerging markets were overrun by foreign giants as the markets opened up to competition . As a comprehensive survey of banks in emerging markets in the Economist (May 15-21) points out, this does not seem likely anymore.

On the contrary, emerging market banks could soon reach a size (measured by market capitalisation) comparable to that of their counterparts in advanced markets. Some are already there. China has three banks in the top 10 in the world. Brazil and Russia have one each. India's SBI is in the top 50. The question for emerging market banks is not whether they can grow. It is how fast they should grow; and whether a large overseas presence should be part of the growth strategy.

In the advanced markets, banks are still going through a process of de-leveraging consequent to the financial crisis. This is causing balance sheets to shrink. Credit growth, even when it resumes, will be slow. Emerging markets, in contrast, face the prospect of credit growth of 20-30 %. Many emerging markets, notably India, experienced this sort of growth during the boom years. It now looks set to continue given that the bank loan to GDP ratio is way below that in advanced markets.

Banks first need to judge whether it is prudent at all to grow the loan book at such a pace for years together. Rapid loan growth in a system is known to be one of the surer signs of an impending crisis. All too often, such growth is based on lax lending standards and it tends to fuel asset bubbles that collapse one day.

Credit quality is not the only issue. Operational risks mount when banks expand at a heady pace. Loan growth of 20-30 % requires expansion in branches, hiring of large numbers of people. There are bankers who will say that it is wise to forgo some opportunities and to ensure that growth is well managed.

On this point, one cannot generalise across emerging markets. In India, there are mitigating factors to the risks of rapid growth. High loan growth in recent years is partly on account of an under-tapped retail market. Nearly 50% of retail loans are home loans and these are among the safest loans to make.

Besides, rapid expansion in branches has mainly taken place amongst private banks. Public sector banks, whose share of the market is 75%, already have in place the branch network they need. Unlike in China, loan growth in India is not driven by lending to government institutions. Commercial loans are made mostly to a vibrant private sector. Finally, there are strong regulatory checks on exposure to risky sectors — real estate, the stock market, commodities.

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The second strategic issue for the stronger emerging market banks is whether they should seize the opportunity to venture into advanced economies now that banks in those economies are in disarray. Should emerging markets banks be making big acquisitions abroad?

The arguments against going global are compelling. One is the experience of advanced market banks. A telling example is HSBC whose acquisition in 2002 of the US consumer finance company , Household, proved a disaster. ABN Amro also came a cropper trying to become a global bank.

The only banks with a global presence that are making money are ones that have been long entrenched in foreign markets, such as HBSC, Standard Chartered and Citibank. Emerging market banks thinking of making foreign acquisitions need to worry about their lack of knowledge of overseas markets and the difficulties in managing foreign staff.

Then, there is the experience of emerging market banks themselves. Some Indian banks have had overseas branches for decades. Very few make profit. The contribution to total profit is negligible. Simply catering to the diaspora is not a viable proposition.

Some Indian banks talk of catering to Indian corporates that have ventured abroad. As Aditya Puri of HDFC Bank points out, the number is not large enough to justify a presence in foreign markets. Nor do Indian banks have the strengths to address the local market overseas.

A third reason against venturing abroad is that the regulatory climate has undergone a sea-change after the

recent crisis. India is not alone in being wary about letting in foreign banks in a big way. Other emerging markets feel the same way. The old argument that emerging market banks need to venture abroad so that they can better deal with foreign competition at home has lost its edge.

There is also greater appreciation in emerging market of the role of state-owned banks. The Indian model

of having a mix of state, domestic private and foreign banks, with state-owned banks having a significant

share, is widely seen as one that works. Even private bankers concede that state-owned banks have played

in

a role in anti-cyclical policies in the crisis. Emerging markets are unlikely to open up to foreign banks

in

a big way in the near future.

Emerging market banks will thus have the home market pretty much to themselves. They can hope to quickly attain world scale on the back of strong domestic market growth and restricted foreign competition. But world scale is not world class. Emerging market banks will still lack the repertoire of skills necessary to make an impact overseas. Global exposure, not global domination, is what they should aspire for. Grow, but don't try to rule the world.

Global exposure, not global domination, is what they should aspire for. Grow, but don't try to

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6.

TAX UPDATES

Revised Direct Tax Code – What you should know!

UPDATES Revised Direct Tax Code – What you should know! The much-awaited revised discussion paper on

The much-awaited revised discussion paper on the Direct Tax Code (DTC) is set in the public domain by the Manmohan Singh government. The earlier discussion paper on the Direct Tax Code Bill was released in August 2009 to receive public feedback and inputs on the proposals. The revised paper is said to have addressed some of these issues after attracting sharp criticisms from several quarters on various grounds.

The new simplified tax code, which is likely to be introduced in Parliament in the forthcoming monsoon session, is expected to raise tax slabs and lift the ceiling for tax-free savings. The new DTC will replace the decades old Income Tax Act.

At least, for now, there is some sort of relief from the amended proposal as compared to the previous one that intended to tax the savings at the last stage of withdrawal of the investments as per the Exempt-Exempt-Tax (EET) methodology of taxation.

Capital Gains

Under the proposal on the capital gains, the government intends to do away with the distinction between the short-term and long-term capital gains in a bid to bring simplicity in the taxation of capital gains.

The discussion paper recommends that the capital gains of the tax payer will be added to their total income. Thus, the tax liability of the assessee, on account of income from the sale of capital assets, would be in line with their income slabs. The capital gains will be considered as income from ordinary sources.

Now, this move will definitely hinder the long term savings. Currently, investments in stock market assets and equity-oriented mutual funds which are held for more than 1 year are considered as long-term capital assets and are not taxable. Whereas income from short-term investments that are held for less than 12 months from the date of acquiring such assets are taxable at rate of 15%.

The phasing-out of distinction between short-term and long-term capital assets may not provide incentive to an investor to hold their equity assets for a longer duration, if their actual investments are yielding capital gains over a shorter period of time frame. They may be tempted to book gains more frequently as and when available and take home the profits that are accruing, irrespective of the time period.

House Property

The earlier version of DTC code had proposed that the gross rent from house property that has been rented out be computed at a presumptive rate of 6% with reference to the cost of construction or acquisition. The second draft of DTC has done away with this presumptive rate of calculation for the gross rent. It recommends that the gross rent for taxation will be the actual rent received in case of houses that are let out. Deduction on interest payment for the loan taken by individual borrowers for acquiring (or constructing) a house property would continue to enjoy the tax benefit subject to a ceiling of Rs.1.5 lakh (only for one house that is used for residing purpose).

Minimum Alternate Tax

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A minimum alternate tax (MAT) is the one which is had to be paid by the companies that are enjoying various tax exemptions under different schemes. In the previous draft code, the Centre had proposed levying MAT on the asset base of the company – at the rate of 2% on the value of gross assets for all the non-banking companies. However, due to practical difficulties in calculating the MAT for the loss- making companies as per the older version of the proposal, the revised draft code set out by the government says that the MAT should be calculated on the book profits. Thus, the new proposal would ensure that the loss-making companies do not get away from their legitimate taxation liabilities. The modified directive on the MAT would come as a big relief to capital-intensive sectors such as infrastructure and capital goods among others.

Savings

On public demand, the finance ministry has agreed to abandon its previous proposal on tax retirement benefits under Provident Fund. In the absence of a social security scheme, the new proposal provides for an Exempt-Exempt-Exempt (EEE) method of taxation for the government provident fund, PPF and recognised provident funds. Even pure life insurance products and annuity schemes are approved under tax exempted categories. Thus, the government has proposed not to levy tax on the earnings from investments, made by the people, with intention of saving taxes in long-term saving instruments. However, withdrawals of savings above Rs.3 lakh will be taxed.

Foreign Firms and Flows

The revised tax code has sought to clear the ambiguity regarding the treatment of income earned by foreign institutional investors (FII) from securities transactions will be classified as capital gains and not business income, a step which could increase their tax liability. This modified status of income being classified under the capital gains would also make the FIIs eligible to pay advance tax installments, just like any other corporate.

The new code has also succeeded to address the concerns of the foreign firms on the issue of treaty override. The code clarifies that those foreign firms having a part of business operations in India for a certain period could be treated as a resident company liable to tax over here.

part of business operations in India for a certain period could be treated as a resident

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7.

INFLATION

India Raises Rates for Third Time to Slow Inflation

India Raises Rates for Third Time to Slow Inflation India’s central bank raised interest rates for

India’s central bank raised interest rates for the third time this year in an unscheduled announcement as inflation pressures from faster economic growth outweigh risks from Europe’s debt crisis. The Reserve Bank of India increased the reverse repurchase rate to 4 percent from 3.75 percent and the repurchase rate to 5.5 percent from 5.25 percent, according to a statement from the central bank in Mumbai on July 2, 2010.

Governor Duvvuri Subbarao moved, even as most central banks in the Asia Pacific are keeping borrowing costs on hold, after the government raised gasoline and diesel prices on June 25. Inflation continues to be above comfort level and last week’s fuel-price increase left the RBI with no choice. The bank will continue with its calibrated approach to exit as it weighs the global economic uncertainties.

Subbarao acted before the next scheduled monetary policy announcement on July 27 and after the financial markets closed today. He cited concern that price gains now seemed to be “very much generalised and that demand-side pressures are evident,” as a rationale for his decision.

The Reserve Bank will continue to monitor the macroeconomic conditions, particularly the price situation, and take further action as warranted.

India’s $1.2 trillion economy expanded 8.6 percent in the three months through March from a year earlier, the fastest pace after China among Asia’s major economies. Industrial production surged 17.6 percent in April, beating economists’ forecasts. That’s stoking price pressures. India’s benchmark wholesale-price inflation unexpectedly accelerated to 10.2 percent in May. Consumer prices paid by industrial and farm workers rose almost 14 percent in May, government data showed.

The government’s move to increase gasoline prices by 3.5 rupees and diesel costs by 2 rupees may boost the wholesale- price inflation rate by 1.3 percentage points. So, its inflation that India needs to worry about rather than Europe’s debt crisis. India’s economy is driven more by domestic factors.

Pressure increased on Subbarao to move rates higher with Chakravarthy Rangarajan, chairman of the Prime Minister’s Economic Advisory Council, saying on June 17 that inflation is at an “uncomfortable” level and some action by the Reserve Bank was called for.

Inflation is a politically sensitive issue in India, where the World Bank estimates more than three-quarters of the nation’s 1.2 billion people live on less than $2 a day.

Subbarao tightened monetary policy even as the banking system faced a shortage of money. Cash availability dropped after businesses withdrew money to pay quarterly tax and the government raised 1.06 trillion rupees from the auction of high-speed mobile phone permits and broadband internet airwaves to companies. To prevent the cash squeeze from hampering growth, the central bank has been adding money to the banking system since May. Easing liquidity and raising rates at the same time may seem apparently inconsistent, the central bank said. “In no way should they be viewed as inconsistent with the monetary policy stance of calibrated exit, which remains focused on containing inflation without hurting growth.”

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8.1

MISCELLANEOUS UPDATES

Protect yourself from fake online job offers and lotteries

Dear Sunil C,

from fake online job offers and lotteries Dear Sunil C, Virgin Atlantic is pleased to offer

Virgin Atlantic is pleased to offer you a job in London. You will get a salary of euro 6,900 per month plus family accommodation, free education for children, a brand new Toyota Camry, 15 days leave after every 90 working days and free flight tickets. To accept the offer, send a copy of your passport along with a demand draft of euro 1,000 towards visa processing fee to Virgin.

Sender: Dr Williams Carter Lee, HR department, Virgin Atlantic London Extension. Email: virginatlantic@london.com, virgincareer@london.com

Sunil, a 38-year-old chartered accountant in Delhi, pinched himself before calling out to his wife Sonia. A monthly salary of Rs 4.7 lakh was more than four times what his current employer, a private internet firm, was paying. Sunil was being offered a king’s ransom without even an interview and just based on his profile on a placement portal. Sceptical, Sunil decided to check the UK airline’s website. Its web address, virgin-atlantic.com, was different from where the email originated. And sure enough, the company’s career site had a warning against emails offering jobs. “It was embarrassing; Sonia had already broken the news to my parents and some friends before I realised it was a scam.” The job offer was part of an online racket, one of the innumerable scams operated by fraudsters sending mails and calling up people on various pretexts to extract money and personal details such as credit card numbers or banking passwords.

Such attacks by cyber criminals have intensified recently, fuelled by the growing use of the internet and mobile phones as well as the general desperation caused by a global downturn that has left millions jobless, mostly in the West. The situation is really bad. In the past two years, India lost more than Rs 115 crore to online banking frauds and the number of cases more than doubled last year. But this is just the tip of the iceberg. The actual size of the problem is much bigger, because the police, hamstrung by a lack of awareness of the Information Technology Act, frame charges under sections in the Indian Penal Code. This hides the exact figure of cyber crimes in India.

The RBI, which is on the verge of launching a television, print and internet campaign in 13 languages to spread awareness about online scams, is itself the target of attacks. Security software provider Symantec found phishing websites mimicking that of the RBI in March and April. The number of phishing websites spoofing state-owned Indian banks increased by 35% in March from the previous month, it says.

Easy prey

Online scamsters are found across the world, working in groups or on their own, creating websites and email addresses that are almost identical to those of well-regarded organisations. They send fake job offers and entice recipients with fictitious lotteries and false promises of several million dollars in inheritance. They call people pretending to be a bank executive verifying personal details and try to lure them to part with their internet banking passwords. They offer tickets for the football World Cup and urge people to send them money for visa charges or processing fees.

It is easy to fall for their tricks. Even the director of the US Federal Bureau of Investigation, an agency for which cybercrime is its third-highest priority after terrorism and counter-intelligence came close to falling victim. He was just one click away from sending information about his bank account to phishers.

Fraudsters can appear indistinguishable from original

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An ET journalist recently got a missed call from a Pakistan number. When he returned the call, a person calling himself Arjun Singh told the journalist that he had won a Rs 15 lakh lottery from Airtel, his mobile service provider. Singh claimed he was at an Airtel office in Mumbai, but hung up when asked why his phone number had Pakistan’s country code.

The fraudsters can appear almost indistinguishable from the original. They can issue certificates, letters and circulars on letterheads that are similar and provide telephone numbers and e-mail IDs that look genuine. Many have opened accounts with banks in India and advice people to deposit money in these accounts towards various charges, taxes and duties. Once the money is deposited, people mailing such offers withdraw the money and then vanish.

Crosscheck once-in-a lifetime offers

Around the same time as Sunil got his not-even-once-in-a-lifetime offer from Virgin Atlantic, Manish P, a software engineer with a Delhi-based company, got an email purportedly from Japanese electronics maker Sansui Technologies India. It was an invitation for the final interview for a Rs 2.5 lakh-plus job. He had to pay Rs 6,050 as surety before the company would send him flight tickets and hotel booking details to attend the interview in New Delhi on May 14. The money was to be deposited in favour of Ajay Kumar Gupta at Shivalik Mercantile Bank A/C no 169810100006001 by May 5.

Manish did not do it. Neither did Mike K, another software engineer working in Delhi, who received a similarly worded offer from Intex India. In this case, the surety amount of Rs 5,250 was to be deposited at EDC (Ernakulam District Cooperative) Bank A/C no 2489734535646 by April 7.

Experts say fraudsters use small banks to run such scams, because it is easy for them to evade detection. Also, it is easier to open and close accounts in smaller banks. Most of the small banks in India don’t have sufficient mechanism and technical know-how to detect frauds of such scale.

Beware of international lottery scams

Many Indians are also falling for international lottery scams. The RBI has said several times that the Foreign Exchange Management Act prohibits sending money abroad for securing prize money and awards or to participate in lottery and money circulation schemes.

Yet, many people break the law, only to be cheated. Racketeers are feasting on the upcoming 2010 Football World Cup with offers of prizes, free tickets and stay for the biggest event of the world’s most popular game. Thousands of e-mails and phone messages are crowding inboxes, informing recipients that they have won substantial sums as lottery awarded by world soccer governing body FIFA and South Africa’s World Cup Local Organising Committee, or brands associated with the tournament such as German sports goods maker Adidas.

Wake-up call

Mobile firms, banks and security service providers are employing advertisements, messages and webpage postings to alert their users about online fraud as most internet and mobile users don't play it safe. This is particularly so in India.

Pink Panther When it comes to interacting safely online, the awareness level of Indian web users is dramatically low. Nine out of 10 internet users in the country have experienced cyber threats. Yet, 83% of them do not check if a website is genuine.

Cyber criminals exploit lack of awareness

It is this lack of awareness that cyber criminals exploit, along with an ineffective legislative framework. In India, the IT Act does not cover online scams, which are considered cheating offences under the Indian Penal Code, making them bailable and allowing offenders to get away. Currently, the law is a toothless tiger against emerging cyber threats.

More developed countries have stronger cyber laws, but they are unable to check such scams because racketeers can operate virtually from any part of the world. And so far there has been no major international initiative to counter online fraud except for a European Commission plan to form an agency to tackle cyber crime.

No way to go after scamsters

Cyber security experts say there is no way companies can go after scamsters because it is not possible for them to do so. Anybody can potentially run such a racket from any corner of the world. Strong laws and their strict implementation are the only way to check this trend.

The Reserve Bank runs a ticker on its website, rbi.org.in, cautioning people about fictitious offers, lottery winnings and cheap fund offers. The upcoming mass awareness campaign will take its message to more people. But the hands of the regulators are tied. They don’t have the backing of the legislature yet. They can alert potential victims but cannot scare offenders.

It’s up to individual users to stay out of danger

So, it's largely up to individual users to stay out of danger. Remember, there are no free lunches. Do not believe in any unbelievable offer. Any law comes into play only after the crime has been committed. So, the best thing to do is to exercise due diligence and caution. A close look at the sender's email ID can prevent most such frauds. Several organisations such as ICICI Bank, Airtel, and TimesJobs.com run media campaigns against online frauds and issue security alerts to their users.

As long as you are alert, you can’t be duped. It’s only when you drop your caution and give in to the incredible’ offer of the fraudster that the problem starts.

It’s only when you drop your caution and give in to the incredible’ offer of the

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8.2

INSURANCE

New ULIP norms: What's in it for investors?

Insurance regulator IRDA’s decision to revamp the unit linked insurance plans or ULIPs has definitely put the focus on the investor which will also force the insurance industry to radically change the way they work. IRDA had announced drastic changes in ULIPs by increasing the lock-in period from 3 years to 5 years, cutting agent commissions and making it a long-term investment vehicle.

As per the new rules, all fees associated with a unit-linked plan will now have to be distributed over a period of five years and if you are saving for retirement, through a pension or annuity unit-linked plan, you will get a minimum guaranteed return of 4.5 per cent per annum.

Most feel the changes would make ULIPS more investor friendly and reduce malpractices like mis- selling.

The five year lock in period for a unit linked product will prevent churning of products and encourage long term investments. The overall charges will now have to be spread out evenly over the lock in period, thus, bringing down the commissions that are paid to agents. Some even get as much as 40 per cent commission in the first year. Also if a policy is surrendered or lapses, insurers will no longer be able to levy huge charges on investors.

It is not only investors but the mutual fund industry is also applauding IRDA’s move since they believe the gap between commissions that agents get for selling a ULIP versus a mutual fund will now reduce.

Insurers are already feeling the heat as they will now have to make big changes in the way they do business. What’s worse, ULIPS make up almost 60 per cent to 75 per cent of many insurers revenues.

So while the insurance industry braces itself for challenging times ahead, investors can breathe a sigh of relief which would surely make capital market regulator SEBI happy.

times ahead, investors can breathe a sigh of relief which would surely make capital market regulator

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9.

KNOWLEDGE RESOURCE

Pink Panther 9. KNOWLEDGE RESOURCE Financial exclusion by KYC As a person who has moved his

Financial exclusion by KYC

As a person who has moved his house and his city nearly half a dozen times in the past few years, what I dread is getting new bank accounts, telephone connections, gas connections, and sadly even transferring my existing accounts. Several months into my new house, many still elude me because I cannot show permanent address in the city I work in. This is an obnoxious demand from service providers despite the fact that I can show my passport and my driving licence with a permanent address in Delhi. In other words I can prove my identity but cannot seek services in another city despite such proof.

Several years ago, when I used to visit Ahmedabad for a winter teaching stint, I wanted to open a bank account and went to a neighbouring bank. I clearly had no permanent or temporary residence proof, given that I visit the city only for a few weeks a year. Predictably, the branch manager refused to entertain my application for opening an account despite my ability to show over 10 proofs of address though from another city. After much protestations that ‘know your client' (KYC) means knowing your client, not excluding him from transacting in your city, the manager refused to budge on the basis of ‘RBI KYC policy' . When I asked him his name so that I could complain against this weird policy, he changed his tone. Suddenly, where my passport and driving licence and many other documents were one moment insufficient to prove my identity, my business card which said ‘visiting faculty' satisfied his KYC norms the next moment.

Last week as I planned to move from Ahmedabad to Mumbai, I faced trouble even before reaching the city. My bank with which I have a trading account and depository account, sent me a letter that they would not change my address till I sent them a long list of documents which showed my residence. As I still don't have a place to live in Mumbai, the temporary address which I had provided cannot be used. In other words important financial documents and statement which belong to me will continue to be mailed to a wrong address which I would have left, on the grounds of KYC requirements of the depository. Thus important financial papers may get lost, solely on the grounds that providing an address for which I don't have extensive proof would violate the KYC norms.

I've had better luck with purely banking accounts. One private bank with which I bank, happily changed it to the temporary address based on a simple letter and with the caution that it mailed the address change to both the old and the new addresses, so that an imposter could not have my address changed without my knowledge. The State Bank of India, which has an outlet on the campus, refused to change it to the temporary address and was willing to mail it to my permanent address.

The experiences are clearly varied and inconsistent with each other and thus I suspect they may not really be the RBI policy. Whether or not they are RBI policy, they are clearly divorced from logic and common sense. What does know your client have to do with purchasing services where you can prove residence. This lack of logic pervades not just the financial sector but also other services. If I live in Delhi and travel frequently to Mumbai, I cannot get a Mumbai mobile connection as I will only stay in a hotel , or if I am a bit creative and want to twist the law, I will take it in a friend's name.

While I narrate my story, the story of financial and service exclusion is far worse for the upwardly mobile people from villages and small towns because of these policies. The gardeners , drivers, blue collar workers, even highly educated persons who move from their home for better opportunities are excluded

Pink Panther from vast swathes of services even though they can prove their permanent residence in their original hometowns and thus prove their identity and conversely that they are not terrorists or money launderers or whatever other thing they are not supposed to be.

We thus have a system where poor people including marginal farmers are excluded from the formal financial sector because of their lack of understanding or because of volatility in their incomes and expenditures . We also have a so called KYC system which systematically excludes the upwardly mobile middle class from financial inclusion. By one estimate, over 70% of temporary workers don't even have a bank account even though many of them earn over five or even ten thousand rupees a month merely because they do not have these identifications.

These people also stand disenfranchised because their election cards are hard to get at the place they actually live, as election cards cannot be shifted without a whole laundry list of proofs. This fact alone should be reason for politicians to move quickly to push for change. It is time we applied our mind to these policies and rationalised them, instead of making promises of some automatic rationalisation in the distant future based on yet another ‘unique' identity card.

making promises of some automatic rationalisation in the distant future based on yet another ‘unique' identity

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Consciously, Carefully and Powerfully www.mi7safe.org Alka Agarwal Managing Trustee Mi7 Financial Literacy Mission

Alka Agarwal Managing Trustee Mi7

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Financial Advisor Practice Journal: July 2010: Volume 44 > Pink Panther