What’s up, Doc?

Volume 45 / August 2010

FINANCIAL ADVISOR
PRACTICE JOURNAL
JOURNAL OF THE SECURITY ACEDEMY AND FACULTY OF e-EDUCATION

SAFE UPDATES – KEEP INFORMED

The Securities Academy and Faculty of e-Education
Editor: CA Lalit Mohan Agrawal
 What’s up, Doc?
Editorial preamble
1.1 ENOUGH OF KEYNES
Electorate do not favour a fresh Keynesian-style stimulus

We have been going back and forth for a century. Keynes: I want
to steer markets. Hayek: I want them set free. There is a boom-
and-bust cycle and good reason to fear it. Hayek: Blame low
interest rates. Keynes: No it's animal spirits."

So goes the chorus of a popular rap anthem on YouTube these

days. Indeed, the rather arcane ideological debate between more
and less government intervention is now all the rage.

And, if the latest opinion polls in many developed countries are

anything to go by, the pendulum is swinging back in favour of Hayek with voters increasingly disenchanted
by the meagre results the massive stimulus efforts have yielded.

A New York Times-CBS survey released last month shows that an absurdly-low 6% of Americans
believe that the stimulus has created any jobs. A Quinnipiac University national poll reveals that 74% of
voters think the US is still in a recession, even though the economy has registered some growth over the
past year. The latest betting odds suggest that the Republicans are now favoured to win back control of
the House of Representatives in November 2010, an outcome that entails the Democrats lose a record
number of seats less than two years after an emphatic victory.

US President Barack Obama's popularity rating is currently at a new low as more voters disapprove of the
job he is doing. His calls for enacting further stimulus measures to boost growth are also finding fewer
takers in Congress as legislators sense that more and more Americans view rising debt as the primary
threat to their long-term well being.

Such voter vigilantism is not restricted to the US. Fiscal consolidation is in vogue in Europe as well. The
peripheral countries of the eurozone - including Greece, Ireland, Portugal and Spain - have adopted
austerity measures under duress because of both market and peer pressure from the core European
nations. Countries such as the UK are embarking on a sharp fiscal adjustment to achieve debt
sustainability in a pre-emptive manner.

Conventional thinking says that populism involves government handouts. That sentiment was reflected in
Bank of England governor Mervyn King's remarks during this year's UK election campaign, when he said
the party focused on getting public finances back in order 'would be out of power for a generation' . The
opposite happened with the Conservatives winning the election on a fiscal austerity platform and
subsequently committing to cut UK's budget deficit from 10% of GDP currently to nearly 1% by 2016.

The debt crisis in countries such as Greece is forcing voters to make tough choices amid growing
recognition that government spending has reached a point of rapidly diminishing returns. Government
spending as a share of GDP in many European economies has surpassed 50% and, even then, economic
growth has remained very weak over the past few years.

Younger voters in particular are demanding a reduced debt burden by favouring policies that will raise the
retirement age and cut the size of retirement benefits. Interestingly, in Sweden, long considered the model
welfare state, the centre right coalition led by the conservative Moderate Party has been gaining ground
over the left-leaning Social Democrats due to its more market friendly economic policies.
 What’s up, Doc?

Apart from fears that a higher debt burden will lead to a fiscal crisis, the electorate's aversion to more
stimulus spending stems from the fact that the enormous amount of money spent so far has barely changed
the economic situation on the ground.

In the US, for one, the current economic recovery has been one of the weakest in post-war history despite
the $787 billion in stimulus spending and unemployment has barely declined from its peak rate of more
than 10%. The limited benefits from the government largesse appear in fact to have flown
disproportionately to a privileged few; compensation to public sector employees and some of those in the
financial industry is approaching new highs.

Almost by definition, a stimulus involves bailouts that end up protecting existing inefficient players but
do not provide renewed vigour in the economy. Some sort of a Darwinian flush is necessary after a long
cycle to clear the ground for fresh crop to emerge.

And indeed capitalism draws its dynamism from a natural clearing mechanism.

Allowing boom-bust cycles to play out without government intervention served the US economy well in
the 19th century, when it emerged stronger after a downturn.

To be sure, policymakers carried the faith in the market's purging power too far in the 1930s when they
left the policy mix of tight money and high taxes in place well after the cleansing of the excesses from the
system. That resulted in the Great Depression, and when parallels were drawn to that era following the
meltdown in 2008, the impulsive reaction of policymakers was to do everything it takes to bail out the
economy. However, this time around, governments may have swung to the other extreme by not allowing
a meaningful clearing of the rot from the system and, thereby, legitimising a part of the debt binge.

Japan, for instance, has tried to prop up its economy for the past two decades through big fiscal spending
and various bailout packages. That has given rise to an increased share of the government in the economy
and an associated fall in productivity.

The US by nature is a conservative society with puritan values that does not like too large a role for the
government. Expectedly then, the electorate has started sending a message to the incumbents in
Washington that it has had enough with all the wasteful government spending given the little it has done
to revive growth and the prospect it has brought of higher taxes in the future. Small businesses, which
employ nearly 60% of the US workforce, are not hiring new workers amid concerns over a future hike in
taxes to finance the mounting debt load.

The Keynesians still argue that the global economy needs an even greater stimulus to prevent the
formation of a vicious spiral wherein sputtering growth yields even wider budget deficits due to declining
government revenues. They contend that worries over a debt crisis are overblown, as bond markets in
many of the leading economies from the US to Germany remain quiescent given the very weak private
sector demand. The Keynesian prescription is to plough in as much government spending as the bond
vigilantes can take - in other words, until bond yields rise a lot higher.

It seems the Keynesians do not seem to appreciate what the electorate wants. Voters are crying out for
lower deficits and less public spending, as they do not want to reach the point of no return for government
finances. The developments in Greece this year have spooked them, as it is apparent that once the bond
markets revolt, the only option left is to cut spending in a draconian manner.
 What’s up, Doc?

The electorate also perceives more government spending as a cover for special interest groups that
manage to corner much of the extra money for themselves.

This does not imply that fiscal austerity will immediately boost growth either.

A fiscal adjustment involves some short-term pain although it can foster growth in the medium to long
term, particularly if the route followed is less government expenditure rather than tax increases.

Herein lies the paradoxical problem: cutting deeply-entrenched government spending remains politically
difficult even in the wake of all the signals from voters. As a result, any progress in fiscal retrenchment
will be slow unless there is an outright debt crisis.

But it is clear that voters are in no mood for a fresh Keynesian-style stimulus spending and the politicians
who do not pick up that cue are likely to suffer at the polls. So, it is now back to Hayekian values that is
based on the belief that no one spends someone else's money better than they spend their own.

This is a radical departure from the popular thinking just a year ago, when the huge stimulus efforts by
policymakers had us believe that we are all Keynesians.
 What’s up, Doc?
1.2 STOCK MARKETS
Sunny side up, but stocks may correct

During the Second World War, governments realised that unrestrained talk
could cost lives. Now they are realising it can cost them money too. France is
suffering from unwise words of Francois Baroin, budget minister who said it
would be a ‘stretch’ to keep the country’s AAA credit rating. We also had
Japan’s new Prime Minister Naoto Kan pledging a fiscal policy overhaul to
reduce the country’s massive public debt, warning of a Greece-style meltdown.

Economists too are enjoying a bit of a renaissance. If Greece is the new

Lehman Brothers, Lehman Brothers itself was the new Argentina (2001), and
Argentina was the new CreditAnstalt (1931), and CreditAnstalt was the new
previous Argentina (1890), and the previous Argentina was the new South Sea Co (1720), which was the
new Philip II of Spain, who through his multiple defaults (1557, 1560, 1575 and 1596) managed
repeatedly to be the new himself.

Forecasts say gross general US government debt will hit 100% of GDP next year. But $4.5 trillion (47%)
of that is categorised as ‘intra governmental holdings’. US paid nearly double today’s interest levels (2.2
% of GDP) from 1984 through 1996, and that was during two mega bull markets.

There’s $1.84 trillion of cash on the balance-sheets of US corporations – up a record 26% y-o-y. While
high cash balances aren’t of themselves bullish, they typically lead business spending and investment.
Over the past four quarters, non-farm productivity in the US had its sixth-biggest jump since records
began in the 1940s. US unit labour costs are dropping at their fastest pace in 40 years. The 1.5% increase
in the average workweek that we have seen over the last seven months has only occurred two other times
in history. Those occurrences came in the first half of 1982 and the first half of 1996 – both at the start of
major bull markets.

Simultaneously, Chinese labour cost is rising. But labour costs can be a small fraction (7%) even for
labour-intensive industries like Foxconn. Investors are fretting slower-than-expected growth in Chinese
Purchasing Managers’ Index. Slower exports to Europe, disruptions caused by higher minimum wages
and restrictions on secondary property market all weighed. But the index was expansionary – 16th month
in a row. Just a few months ago, many fretted superfast Chinese growth would lead to overheating.

Historically, unemployment is a lagging indicator and shouldn’t be used to gauge improving economic
conditions. Since March 2009 low, Shanghai, S&P 500 and Sensex are up 12.5%, 51% and 114%
respectively.

Death crosses transfixed market chart-gazers round the world last week. They appeared over the London
FTSE, Euro-first 300 Nikkei 225 and nearly the S&P 500. A cross forms when an index’s 50-day moving
average, measuring its recent trend, dips below its 200-day moving average. It happens rarely – only four
times in the past decade for the S&P 500 – and many believe it signals a bear market. But dark crosses
have signalled four of the past two US bear markets, and five of the past two Japanese bear markets.

Whether done by rhetoric, as with BP’s dividend, or new laws, as with the UK bonus tax and the
Australian mining tax, new levies are on the cards.

Unrestrained talk and unbridled legislation could trigger a healthy stock market correction between July
and September 2010.
 What’s up, Doc?

Start of July 2010 – Sensex down 240 points

Daily review 30/06/10 01/07/10 02/07/10

Sensex 17,700.90 (191.57) (48.38)
Nifty 5312.50 (61.10) (14.30)

Weekly review 30/06/10 02/07/10 Points %

Sensex 17,700.90 17,460.95 239.95 (1.36%)
Nifty 5312.50 5237.10 75.40 (1.42%)

1st week of July 2010 – Sensex up 373 points

Daily review 02/07/10 05/07/10 06/07/10 07/07/10 08/07/10 09/07/10

Sensex 17,460.95 (19.51) 173.04 (143.45) 180.70 181.81
Nifty 5237.10 (1.20) 53.15 (47.95) 55.75 55.60

Weekly review 02/07/10 09/07/10 Points %

Sensex 17,460.95 17,833.54 372.59 2.13%
Nifty 5,237.10 5,352.45 115.35 2.20%

2nd week of July 2010 – Sensex up 122 points

Daily review 09/07/10 12/07/10 13/07/10 14/07/10 15/07/10 16/07/10

Sensex 17,833.54 103.66 48.70 (47.74) (28.70) 46.36
Nifty 5,352.45 30.55 17.65 (14.50) (7.40) 15.15

Weekly review 09/07/10 16/07/10 Points %

Sensex 17,833.54 17,955.82 122.28 0.69%
Nifty 5,352.45 5,393.90 41.45 0.77%

3rd week of July 2010 – Sensex up 175 points

Daily review 16/07/10 19/07/10 20/07/10 21/07/10 22/07/10 23/07/10

Sensex 17,955.82 (27.40) (50.28) 99.09 135.92 17.83
Nifty 5,393.90 (7.45) (18.45) 31.35 42.60 7.15

Weekly review 16/07/10 23/07/10 Points %

Sensex 17,955.82 18,130.98 175.16 0.98%
Nifty 5,393.90 5,449.10 55.20 1.02%
 What’s up, Doc?

4th week of July 2010 – Sensex down 263 points

Daily review 23/07/10 26/07/10 27/07/10 28/07/10 29/07/10 30/07/10

Sensex 18,130.98 (110.93) 57.56 (120.24) 34.63 (123.71)
Nifty 5,449.10 (30.50) 12.00 (33.05) 11.35 (41.30)

Weekly review 23/07/10 30/07/10 Points %

Sensex 18,130.98 17,868.29 (262.69) (1.45%)
Nifty 5,449.10 5,367.60 (81.50) (1.50%)

Market likely to consolidate in August series giving buying opportunities

Derivatives traders are optimistic about stocks in August, if the rollover data on expiry of the July futures
and options (F&O) contracts are any indication. Rollover, which involves carrying forward of the current
month contracts to the next month ahead of the expiry of monthly F&O contracts on the last Thursday of
every month, in Nifty futures to August from the July series, was 77%, higher than the average three-
month rollover of 69%, according to analysts.

The rollover in all stock and index F&O contracts to August was 82% compared to an average of 74% in
the past three expiries. Rollover in stock F&O alone was about 85%.

The cost of rollover has been on the higher side for long rollovers. Since a large number of stocks had a
positive rollover, it indicates the willingness of the bulls to carry forward their long positions.

Nifty August futures on Thursday closed at 3 points above the S&P Nifty, which closed at 5408.90, up
11.35 points, or 0.21%.

Among options, Nifty 5300 puts and 5600 calls saw the highest creation of open interest in the August
series. Analysts said it indicates traders expect the index to largely move in this range in the fresh series.

We believe the market will consolidate in the August series and we could see some correction, but it
should be viewed as a buying opportunity for long-term investors. For the next strong up move, the
market will look for a strong trigger as most of the positives on the domestic front have been factored in,
so positive developments on the global front will be needed.

National Stock Exchange’s volatility index (VIX), a measure of traders’ perception of near-term risks in
the market, closed at 18.33 on Thursday, largely unchanged from the previous day. Traders judge the
range between 16 and 20 for the VIX to be less risky.

Among sectors, the highest rollover was seen in sugar, power and construction, while engineering and
auto saw the weakest, according to analysts. Cement stocks also saw a strong rollover, which was higher
than the combined three- and six-month average. Ambuja Cements, which had a 3-month average rollover
of 63-65 this time, saw the rollover at around 75%. India Cements saw fresh long positions built in the
counter and saw a rollover of about 83%. Rollover in mid-cap stocks like Ruchi Soya Industries, GMDC,
Exide Industries, KS Oils, Godrej Properties, Core Projects was strong.
 What’s up, Doc?

Yearly/Quarterly/Monthly Review

Month December December December March 2010 June 2010 July 2010
2007 2008 2009

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

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

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

Sensex jumps for second month, but lags Bric peers"

The BSE Sensex rose for the second straight month in July after ending 0.7 pct lower on Friday, but
underperformed emerging market peers in the month, as the Reserve Bank's key rates hike and mixed
earnings limited gains.

The Sensex rose 0.9 percent in July, but underperformed China's Shanghai Composite Index, Brazil's
Bovespa and Russia's RTS Index, which gained between 9.9 and 10.6 percent so far this month.

So, for this month, we really had nothing much to cheer about.

High inflation, two consecutive interest rate hikes, mixed corporate results, all contributed to the
underperformance of our market this month. We expect Indian market to be volatile in August due to
uncertainty in the global markets.

But, for the year to date, the Indian benchmark has outsmarted its rivals other than Russia by notching a
2.3 percent gain. Its peers in China and Brazil shed 19.5 percent and 2.4 percent respectively while the
Russian benchmark gained 2.5 percent. Foreign funds have poured in $9.3 billion in Indian stocks in the
year to July 28 after a record $17.5 billion in 2009.
 What’s up, Doc?
2.1 INDIA
Asia, India and the West

Increasingly, as the facts pile up, the perception seems to change.

In the last three decades, the fact of Asian growth – the Asian
miracle economies, the Chinese behemoth, the incredible India
stories – were seen as embellishments to a world still dominated
by strong growth and economic prosperity in the developed West
– in the US and Europe .

Let us not forget that while there were periods of recession in both
the US and Europe, the last time that there was a really bad one
was in the 1970s that overlapped the first and second oil shocks.
The decade of the 1970s was the first time in the post-war world when the developed economies of the
West went through a really bad crisis. This also extended to the social sphere – and fed back into the
economic sphere – bringing about a deep transformation in cultural values and social attitudes.

Since 1980, the advanced economies have had a good run for three decades, which have also seen a total
decline in unrest and violent extreme fringe behaviour. The average rate of growth was 3.3% in the US
between 1980 and 2000, around 2.5% in the first decade of this century before the crisis set in, and little
over 3% for the entire three decades up to 2007. That is pretty good going for the largest and richest
economy in the world, notwithstanding the recessions in the early 1990s and at the turn of the century.

Likewise, western Europe also fared well during this period. The larger European Union registered
average growth of little over 2% in the period 1980-2000 and a slightly one of 2.5% in the period 2000 to
2007. For the advanced economies as a whole, growth averaged 2.7% in the three decades to 2007.

This pace of expansion on an already high base of income and development permitted the economies of
the developed West to put in place strong welfare measures, more so in Europe than in the US, and
maintain unemployment at acceptable, though high, levels. It allowed Europe to trade-off high
unemployment and other social benefits against unemployment levels that were much higher than in the
US. The Europeans more so, and the US to a lesser extent, chose a regime of fairly high taxation to fund
their enlarged public expenditure, and this, as evidenced by the experience of three decades, appeared to
be consistent with about 2% economic growth and its associated level of investment activism.

The crisis has reopened many of these issues, throwing a question mark on whether there was indeed a
balance, or whether this apparent balance was a path of slow and perhaps chronic decline in the pace of
productive activity. The pressure from rising expenditures has tended to push upwards both the fiscal
deficit and adjustments to tax rates. Whether this is sustainable and what its effects may be on the future
of economic activity and hence on employment and general economic well-being are open to question.

THE decision taken by European governments to pursue fiscal consolidation , for the most part by trying
to curb expenditure , is certainly a response to the probing questions that have been begun to be asked of
public finance in the developed West after the imbroglio in Greece and the perceptible stress in Portugal,
Spain, Ireland and Italy. Without doubt, the monetary union and common laws and regulations have
exacerbated the problems.

So, there is the larger proximate question about how Europe wishes to pursue first its monetary union and
second the regulatory union. The meaningful resolution of these questions, especially of the latter, is
inextricably linked to questions about the previous consensus on the trade-off between high publicly-
 What’s up, Doc?
mandated costs (including tax rates) and acceptable levels of investment, growth and employment. The
same question will also arise in the US, though perhaps not in all of its complexity or urgency.

Thus, the genie that the financial market crisis of 2008 has let out of the bottle bears upon the
transcendental choices in fundamental public policy. In that sense, the real crisis in the developed West
begins now. It cannot have an early resolution, but it will have one in the course of time. In case
memories are short, it is worth recalling the great challenges that Europe and later the US have
successfully faced and overcome: from the hundred years war, the centuries of battle and conflict as
Europe industrialised, and finally the devastation of the first and second world wars, as well as the rise
and fall of the Soviet Union, to emerge at every round as the dominant powers in the world.

In the interim, the focus of attention is on Asia. From being a sideshow, to a strange phenomenon widely
expected to undergo a sudden deflation, to being the central piece in the act. The IMF in its July 2010
Update to the World Economic Outlook has given even more powerful expression to this. The world will
now apparently run on the engine of China, India and the rest of Asia, fuelled by their robust domestic
demand and soaring intra-regional trade and investment.

Perhaps that will indeed be for some time, as long-term economic growth in developing Asia appears to
be robust. However, it would be incorrect to infer that the West, especially Europe, has entered terminal
decline – for demographic or whatever reason. That is not to say, defeat cannot be snatched from the jaws
of victory. Yes, the leadership of Europe and the US may fail to rise to the task of preserving the great
vitality of their economies that has powered them for so many centuries. I do not, however, share the
pessimism that failure here is inevitable.

As Asia expands and intensifies its regional trade and investment ties, it should take nothing for granted.
Success is never assured; it has to be earned. And in this, we should try and learn from the impact that
public policies have had on Europe and the US in long-term growth potential, i.e., the past three decades,
and closely follow their efforts to rejuvenate their economies.
 What’s up, Doc?
2.2 INDIAN ECONOMY
Moving Fast Towards USD 2 Trillion Mark

The Indian economy would grow to USD 1.72 trillion in 2011-12, moving
closer towards the USD 2 trillion mark, according to an assessment by the
Prime Minister's Economic Advisory Council (PMEAC).

The country's GDP at the market and current prices was measured at USD
1.31 trillion in 2009-10 and is estimated to be USD 1.52 trillion in the
current fiscal, the PMEAC said in its latest economic outlook.

Pegging the GDP growth at 9%, the economy would reach a level of USD
1.72 trillion in 2011-12. And if the 9% growth trend is maintained, India
would become USD two trillion economy in 2013-14 fiscal.

In the assessment, the PMEAC, headed by noted economist C Rangarajan, said that it is imperative for
India "to preserve conditions that will enable it to return to the 9% growth trajectory".

After slowing down to 6.7 per cent in 2008-09 and 7.4 per cent in 2009-10, the Indian economy is
projected to expand at 8.5 per cent this fiscal and by 9% in 2011-12.

Services and manufacturing sectors will remain the key drivers pushing the coveted growth to USD two
trillion mark. CRISIL's chief economist D K Joshi said, "Services sectors particularly transportation and
telecom sectors will lead the growth. Rising income levels and aspirations of people will further the
industrial output." Reserve Bank Governor D Subbarao in the first quarter credit policy review said, that
the lead indicators of service sector also suggest increased economic activity.

Finance Minister Pranab Mukherjee recently said, “If the tax reforms are implemented as planned from
next fiscal, the economy would get further push. The gain from GST will propel the country from one-
trillion dollar economy to two trillion-dollar economy in a short span of time."

Before the global economic slowdown since 2008, the Indian economy grew by over 9% for three years
in a row from 2005-06 to 2007-08 and expansion was maintained by industry and services sectors.
 What’s up, Doc?
2.3 INTERNATIONAL
Big Money tiptoes back to Europe

Whether the euro zone is at the middle or end of its existential sovereign
debt crisis, investors are starting to take a fresh look at the region's assets
and wondering if this year's market panic was overdone.

Few analysts would be brave, or rash, enough to sound an "all-

clear" on the regional financing storm – one seeded by Greek
government profligacy and dodgy statistics but which also exposed
flaws in the single currency's framework and spread rapidly to other
highly-indebted euro governments.

The global reverberations through April and May saw equity volatility .VIX .V1XI – the seismograph of
financial shocks – soar to levels not seen since the depth of the 2008/2009 global recession, even as euro
zone industrial production growth was roaring at an annualised rate in excess of 10 percent.

Spooked by a lack of visibility and heightened political risk, investors scrambled to reduce exposure to
euro government debt, underlying equity markets and banking stocks and the euro currency itself.

Conviction about the likely outcome was less important than the fact it was impossible to see a roadmap.

Yet after three months of infusing market prices with "tail risks" – or worst-case scenarios from cascading
sovereign defaults to banking system collapses and euro breakup – money managers are again looking for
opportunities to exploit the resulting price extremes in the event of more probable outcomes.

The question now is whether that euro asset phobia has run its course and whether EU policymakers –
backed by the Group of 20 leading world economies – have managed to create a firebreak with their May
10 rescue package for euro bond markets.

Two months on, a progress report shows the authorities have at least reached first base – stabilising bond
prices with selective buying by the European Central Bank and stopping the hysteria, contagion and self-
feeding spirals that forced Greece to be locked out of capital markets altogether.

Debt market premia for the peripheral euro zone governments, with the exception of Spain, are all below
pre-rescue levels. And despite a credit rating downgrade in the interim, Spain has continued to sell bonds
around the world to brisk demand. European equity markets .FTEU3 have rebounded by six percent,
while equity market volatility .V1XI has almost halved. Even the euro has managed to return within a
whisker of pre-rescue levels against the U.S. dollar.

Rescue reaches first base

So far, so good then; for euro governments, time has been bought to get parliamentary approvals for the
rescue; establish a special financing vehicle to act as future fireman; rebuild confidence in European
banks via stress tests and – crucially – pass austerity budgets to fill in widening fiscal holes.

For investors, the political fog starts to lift, visibility returns and they can resume what they do best –
assess valuations, high-frequency economic and earnings data and relative pricing.
 What’s up, Doc?
And in that regard, they find a premium on European blue-chip dividends over core government bond
yields at its highest level since the Lehman Brothers' bust in autumn 2008 and Thomson Reuters data
shows these equity risk premia almost two percentage points above historical averages.

Henry McVey, New York-based head of Asset Allocation at Morgan Stanley Investment Managers, told
clients this month, "Despite the fiscal austerity measures coming out of the region, we think that Europe is
now an interesting place to invest," "Now may be the time to consider shifting regional preferences out of
the United States and back toward Europe."

Such views were almost startling in their rarity this year – certainly after six months in which fund tracker
EPFR reported a net $12 billion exiting Western Europe equity funds.

Not to get carried away, McVey goes on to explain that a big price spike may not be warranted; public
cohesion around austerity plans was still a risk; and bullishness centered on rotating to core "value" stocks
rather than "growth" stocks.

But he added: "We now believe that – compliments of the Greek debt debacle – European financials and
energy companies have become more attractively priced."

Fund managers polled by Bank of America Merrill Lynch this month also showed extreme pessimism
easing and they reported that underweight positions in euro zone equity fell to almost a third of extreme
June levels.

Likewise, euro currency bears have also retreated and data from the Commodity Futures Trading
Commission shows speculative "short" euro contracts falling to a third of May peaks.

Even global demand for European government debt has re-emerged with Spain's international bond issue.

China's currency reserve managers are reported to have taken almost 10 percent of this month's 6 billion
euro debt sale – soothing fears that central banks were cutting euro exposure.

The euro zone has not imploded in a puff of smoke and, despite its many travails ahead; the investment
world cannot ignore the world's second biggest economy for long.
 What’s up, Doc?
2.4 WARNING SIGNALS
Does Japan face a Greek-like debt crisis?

Greece’s debt problems have highlighted the fiscal woes of Japan, but is the
world’s second-biggest economy really facing a Greece-like debt crisis? How
bad is Japan’s fiscal position?

By certain measures, Japan’s debt load is worse than that of Greece.

Japan’s outstanding long-term government debt is set to reach ¥862
trillion ($9.72 trillion) at the end of March 2011, or 181% of the
country’s gross domestic product. If short-term debt is added, Japan’s
liabilities will hit 197% of GDP this year and 204% in 2011, the
highest among advanced economies and far worse than Greece’s debt-to-GDP ratio of around 130%.

IMF warned in May that Japan was growing more vulnerable to sovereign risk, estimating the country’s
gross debt-to-GDP ratio at 227% in 2010.

Why does Japan have so much debt?

Tokyo’s debt burden is a legacy of massive government spending in the 1990s to support the economy as
it stagnated following the bursting of an asset bubble. An ageing population has meant rising social
welfare costs add considerably to government spending.

Will Japan default on its government debt?

Unlikely, Japan has a massive pool of domestic deposits to draw upon to fund its debt issuance. Japanese
household assets total some ¥1,400 trillion ($15 trillion); some three times bigger than economic output
and so providing a healthy pool of savings that can be funnelled into Japanese government bonds.

The government has almost no foreign currency-denominated debt obligations and more than 90% of
Japanese government bonds (JGBs) are held by domestic investors. Greece’s profile is the opposite.
About 70% of its sovereign debt is held by foreign investors.

Japan also has other avenues to raise funds. It is the world’s largest creditor nation, with net external
assets of ¥225.5 trillion. Unlike Greece, it enjoys a steady flow of foreign earnings from a current account
surplus. The yen’s status as a key international currency also helps Japan access external liquidity and
markets, and the ratio of Japan’s tax burden to national income is one of the lowest in the OECD, leaving
it room to raise taxes.

So what will the trigger points be?

Fears are growing that Japan’s ageing population will start drawing on their savings, forcing the
government to rely on foreign investors to fund its debt.

The savings rate, or savings divided by disposable income, is already falling as the population ages. It
stands at about 3%, down from over 10% a decade ago. But current yields on government bonds partly
reflect the fact that markets see no immediate problems in the Japanese government securing ready buyers
of its JGBs. Problems would occur several years in the future if the government fails to reduce its debt as
more savings are used by an ageing population.
 What’s up, Doc?

At around 1.120%, the 10-year JGB yield is roughly one-third the level of comparable US Treasury
yields, having been below 2% for more than a decade on deflation and near-zero short-term rates. Greek
yields on 10-year debt stand at more than 10%.

What are the government’s likely policy options?

The most obvious option is to raise the sales tax (currently 5%). But it is unlikely to happen for a few
years. The government could raise some Y¥2.5 trillion by raising the tax by 1 percentage point.

Besides, Japan’s public debt is mostly yen-denominated; Japan has the ultimate option of printing money
to prevent a debt default. As a member of the European Union, Greece has lost control over its currency
and monetary policy.

As noted by Kan, the consequences of a collapse in Japan’s finances would be different. Under such a
scenario, there might not be any country or agency like IMF able to rescue Japan, he said.
 What’s up, Doc?
3.1 MUTUAL FUNDS
Funds Launched During Slump Do Well

Buy when there is blood in the streets, even if the blood is your own. The old
adage on investing seems to have helped funds that launched even in the thick of
the stock market downturn in 2008-09. Most diversified equity mutual funds that
were launched between April 2008 and March 2009, a period during which
benchmark indices plunged to new lows, have managed to beat benchmark
indices and their category average.

Of the 10-odd diversified equity MFs that were launched during the period, a
vast majority have moved ahead of key indices for the 1-year and the year-to-
date period. Several funds have given a yearly return of between 22.2% and 39%.

Principal Emerging Bluechip that hit the market during the height of the global financial crisis was the
best among the lot gaining 44% in one year compared to the category return of 28.1% and the 17.1%
return generated by sensex.

During March 2009, when sensex was at (around) 8000 levels, the equity allocations of top ranked new
entrants in the diversified equity category was above 90% as compared to 80% of its peers. So when the
markets rebounded from the lows of March 2009, the call of higher equity allocations of these funds paid
rich dividends and the rest of the funds had to play catch up. In fact, first time entrants bagged top ranks
in the equity category in the latest CRISIL Mutual Fund Ranking announced for the quarter ended June
2010. The equity category saw 10 new entrants – six funds in the diversified equity segment and two
funds each in the large cap and small & mid-cap equity categories. In all, three out of the six new entrants
in the diversified equity category bagged the CRISIL Fund Rank 1.

Sankaran Naren, CIO, equity, ICICI Prudential MF said, "Any fund that invests in a downturn gets a good
brand value. A downturn helps (a fund) in increasing absolute returns. Investors are more interested in
getting better absolute returns. Absolute return measure how much an asset has gained over a particular
period and investing in a downturn helps in boosting it as units are picked at a low point.

The downturn has shown that value investing always pays off. You must have belief in the long term
outlook. However, industry officials caution that investing money on a regular basis alone can help in
generating the best returns. Instead of chasing the momentum during bull market and remaining on the
sidelines when the markets fall, investors would do well if they show consistency by going in for
systematic investment plans (SIPs).
 What’s up, Doc?
3.2 GOLD
A Good Investment for Risk-Averse Investors

Gold has been in a bull run for the past decade as it was supposed to be a
hedge against inflation and economic downturns. Going forward, it can
loose its tag of a hedging instrument, as gold is emerging as mainstream
asset on its own. While in the past, bulk of the gold demand was
accounted for by jewellery segment, now investment and speculation
demand dominate the scene.

This has kick-off the talk of a bubble in gold prices. However, this seems
to be premature as the probability of appreciation of the US dollar and rise
in short-term interest rate in Europe and the US has eased. The economic
recovery in the West remains fragile and real interest rates are likely to
stay negative; a perfect environment for gold investment to remain constructive. In addition to that central
banks flows can further boost gold prices as central banks around the world can increase their gold
reserves or slows their pace of sales.

According to world gold council, demand is expected to be strong during 2010, mainly driven by increase
in European and the US investment in the context of continued economic instability, sovereign risk and
the threat of a double dip recession. Concern over Greece’s public finances and debt contagion fears in
Europe have led to strong buying in particular for gold coins, bars and exchange-traded funds (ETFs).

According to long-term trends, increase in money supply tends to benefit gold prices in general. Increased
money supply to stimulate economy as done by the US and European countries is likely to increase gold
prices as more cheap money will be available to invest in the yellow metal. Adding to this, rise in GDP
growth in emerging economies will increase demand for luxury goods including gold further pushing
prices up.

Taking into account scenarios of both inflationary pressure for emerging markets and deflationary
concern for developed economies, gold can be the answer to hedge these risks. In the inflationary
environment, gold helps retain real purchasing power and saves investors from eroding real value money.
Some may argue that gold doesn’t give high returns in growing economy and expansionary phases.

But gold is a good investment for risk-averse investors as it saves investors from economic jerks and
downturns giving diversification benefit to the portfolio. In the deflationary environment, gold can act as
real money, better than various currencies as it is not backed by the public debt. High debt can be worst
thing to have in a deflationary environment as debt burden become more and more severe if deflation
grinds on. As gold is nobody’s liability /debt, instrument and require efforts to produce it is valued from
its relative demand and supply situation, and can act as a hedge in deflationary environment.

On supply side, production is likely to be constrained as a few newer projects come on to replace ounces
taken out of market by ETFs. With the possibility of sovereign defaults in European countries, yellow
metal can emerge as a hard asset that provide wealth preservation and risk diversification.

On the contrary, biggest threat for the ongoing bull run for gold would be significant change in the
interest rate environment. With the US showing slow signs of recovery, there is a possibility of
strengthening US dollar, which can put cap on gold prices. Adding to this given the greater dependence
on investment than actual consumption of gold, yellow metal can be highly dependent on sentiment and
policy driven corrections.
 What’s up, Doc?
3.3 PETRO PRICING
Spot the Difference

Circa 2002: “... the finance minister has announced the

dismantling of the administered price mechanism in the petroleum
sector from April 1, 2002. The pricing of petroleum products will
become market-determined ... LPG and kerosene would continue
to be subsidised with a fixed subsidy from the government for
another 3-5 years.” – Honourable petroleum minister Ram 0aik,
0DA (Global crude oil price $26.88 per barrel)

Circa 2010: “... the government has decided that the pricing of
petrol and diesel both at the refinery gate and the retail level will be market-determined ... Further
increases will be made by PSU oil marketing companies (OMC) in consultation with the ministry of
petroleum and natural gas... PDS kerosene and domestic LPG, the government has decided that the
subsidies on these products will continue.”- Honourable petroleum minister Murli Deora, UPA-II
(Global crude oil price at $78.86 per barrel)

The obvious difference between the two announcements – is the difference in the time, the government in
office and, most importantly, the global crude oil prices. But the similarities in the two official
announcements that come almost exactly after eight years (March 28, 2002, and June 25, 2010), prompt
more questions than answers. First: why is a stated policy being reiterated? The answer, as most know, is
simple. The price decontrol in the petroleum sector remained more on paper than in practice.

Barely a fortnight after the UPA government made this grandiose reform announcement – the
autonomous (sic) oil companies after a meeting amongst themselves and the ministry decided to review
prices of petrol only – as opposed to both petrol and diesel – on a monthly basis, which they would
announce after consultation with the parent ministry. Odd isn’t it? Diesel prices, the petroleum ministry
has announced, will remain under the government purview.

So, what was the major achievement as far as the petroleum-pricing reform was concerned? The
constraints faced by the present government are understandable. ONE , as is clear, global crude oil prices
are still ruling firm, and have been volatile for the last few years. With India importing close to 80% of its
energy requirements, high crude oil prices are always a huge challenge for the government. Not to
mention the high inflation – inflation today is ruling at 10.55% against 4.87% in 2002 – and the impact of
high fuel prices.

To be fair, the NDA government – thanks also the advantage that global crude oil prices were far lower –
allowed oil companies’ flexibility in fuel pricing for the first two years: the periodicity was fixed, revision
every fortnight in line with global markets, and the products decontrolled were petrol and diesel. But as
global crude oil prices moved up, the autonomy given to oil companies was gradually taken away and the
government took upon itself the job of fixing retail prices of all fuel, cooking or transport.

So, for investors looking into India’s petroleum refining and marketing sector, the policy on paper was
very misleading. Decontrolling petro-pricing does not reduce government control. It has been decided that
in case of a large increase or volatility in international oil prices, the government will suitably intervene in
the pricing of petrol and diesel. But this needs to be defined as to when and how – this has been left
unsaid. An answer to this question will be provided depending on how far an election is. For, isn’t petro-
pricing all about vote-bank politics?
 What’s up, Doc?
4.0 FINANCIAL SECTOR: TRANSFORMING TOMORROW
Financial Re-regulation

Around the world, the debate about financial regulation is coming to a head. A host of arguments and
proposals is in play, often competing with one another - and thus inciting public and political confusion.

4.1 FINANCIAL ADVISORS:

Weigh impact on investors:

Limit the scope and size

One approach to financial re-regulation – supported by arguments of varying

persuasiveness – is to limit the size and scope of financial institutions.

Some claim that smaller entities can fail without impairing the system, thus
sparing taxpayers the cost of a bailout. But if systemic risk emerges in ways
that are not yet fully understood, smaller banks may all fail or become
distressed simultaneously, damaging the real economy.

Moreover, few would disagree that, as the complexity of the system increases, gaps and asymmetries in
terms of information, knowledge and expertise are multiplying. Such asymmetries impair market
performance in a variety of ways, and conflicts of interest are particularly dangerous in such an
environment because they create an incentive to exploit precisely these advantages.

Rigorous disclosure requirements that include conflicts of interest are one way to limit the potential
damage. Or the conflicts can be limited by regulating the scope of financial institutions.

For example, asset management, distribution, underwriting and securitisation, and proprietary trading
would be separated in various ways. This approach has the added advantage of preventing different risk
profiles and their appropriate capital requirements from getting mixed up in the same entity.

There are two other ways to address complexity and asymmetries.

Impose restrictions on products: One, widely adopted in developing countries, is to impose restrictions on
products (for example, derivatives and hedge funds) on the grounds that the upside in terms of risk
avoidance far outweigh the costs – less access to capital and reduced risk spreading.

Reduce the information gaps or their impact: The other way is to try to reduce the information gaps or
their impact by regulating the expertise and incentives surrounding the rating process.
 What’s up, Doc?

4.2 INCLUSIVE CEOs

Innovative responses to problems

Limit the leverage

A second approach, on which there is substantial agreement in

principle, is to limit leverage.

The main argument is that high leverage contributes powerfully to

systemic risk – a condition in which asset prices move in a highly-
correlated way, and distress, when it occurs, spreads quickly.

Leverage is also partially caused by misperceptions of risk and

mispricing of liquidity.

It is desirable to constrain leverage, but not to the point of increasing

the cost of capital and investment.

At a somewhat deeper level, there are conflicting threads running

through the public debate surrounding the crisis.

One is the ‘perfect storm’ position: there were many failures, misperceptions, informational asymmetries
and complexities, as well as much repugnant behaviour, but it never occurred to market participants,
regulators or academics that the aggregate effect would be a near-collapse of the system .

Critics of that argument maintain that sophisticated players understood the systemic risks, didn’t care and
cynically played the game that they helped to create – in some cases for enormous profit.
 What’s up, Doc?

4.3 CREDIT COUNSELORS

Resolve convertibility and recompensation issue:

Establish the framework of shared responsibility

IT NOW seems universally accepted (often implicitly) that government

should establish the structure and rules for the financial system, with
participants then pursuing their self-interest within that framework. If the
framework is right, the system will perform well.

The rules bear the burden of ensuring the collective social interest in the
system’s stability, efficiency and fairness.

A better starting point is the notion of shared responsibility for the

stability of the system and its social benefits – shared, that is, by
participants and regulators. It is striking that no senior executive has laid out in any detail how his or her
institution’s expertise could be deployed in pursuit of the collective goal of stability. The suspicion that
underlies much of today’s public anger is that complex institutions, having influenced the formulation of
the legal and ethical rules, could do more to contribute to stability than just obey them.

The finance industry, regulators and political leaders need to create a shared sense of collective
responsibility for the system as a whole and its impact on the rest of the economy. This set of values
should be deeply embedded in the industry. It should take precedence over narrow self-interest or the
potential profit opportunities associated with exploiting an informational advantage.

Some will object that this idea won’t work because it runs counter to greedy human nature. Yet, such
values shape other professions. In medicine, there is a huge and unbridgeable gap in expertise and
information between doctors and patients. The potential for abuse is enormous. It is limited by
professional values that are inculcated throughout doctors’ training, and which are bolstered by a quiet
form of peer review.

By itself, such a shift in values and the implicit model that defines roles certainly will not solve the
challenge of systemic risk. Neither will fiddling with the rules. Taken seriously, however, it could help
provide an ongoing reminder of the importance of the financial sector to the broader well-being of the
economy. It might even help start rebuilding trust.
 What’s up, Doc?

4.4 RISK MANAGEMENT CONSULTANTS

Educate – Engineer and Enforce:

Investor protection:

Investor protection: two words that have spawned millions of articles and lectures but have lost their
meaning. Due to their ignorance, asymmetry of information dissemination and inability to react quickly,
retail investors are simultaneously the fulcrum and the victims of shenanigans.

That’s why the minimum investment is deliberately so enticingly small to enable a continuous supply of
fresh bali ka bakras. The farce starts at the nomenclature itself. There are no small or big investors – only
knowledgeable and ignorant. If you are big and ignorant, then you can take the hit. If you are small and
ignorant, then why the hell did you come into the market directly? If for quick gains, then be prepared for
even quicker losses and no tears need be shed on your behalf.

But the ignorant investor has yet to forget the syndrome of listing-day profits. In the 1990s, the at-par
highlight fooled everyone, including you know who.

The investor has also been inveigled into the web by the dangling of 100% tax exemption on dividends
that actually benefits the promoter-neta class. If dividends are exempt, why not bank interest? Risk? What
risk? Then why was a Rs 7,000-crore scam neatly salvaged? So that difficult questions were not asked?

The at-par story is still being played out today in the listing gymnastics enabled by a ridiculous price
band, 100% margin and a closed syndicate that kills any iota of price discovery. If full current price
discovery is allowed, then only long-term investors will come in. But this does not suit the promoter-
intermediary-fixer-operator mafia. The grey market is enabled by regulations!
 What’s up, Doc?

4.5 FINANCIAL PLANNERS

Value unlocking for all stakeholders:

Vanishing companies:

Vanishing companies: - A term of the mid-1990 s when capital

markets emulated the Bermuda Triangle.

The scam was attributed to fly-by-night merchant bankers.

While the licence raj was being dismantled in every other sector, a
new licence raj was coming up in the unlikeliest of places: the
capital market. Before ‘licensing’, there were hardly half a dozen
merchant bankers in the private sector.

Now, suddenly every steel, shipping, pharmaceutical, tyre, cement,

engineering and auto company had a merchant banking outfit at the
end of its production line. Merchant banking became the universal
by-product of every activity. On what basis were 1,500 merchant
bankers licensed? Sub-standard RTO licences result in traffic
accidents, and similar capital market licences result in scams.

Then came the famous demat scam.

In 2003, Mapin was introduced, a unique investor identity. First for

directors, promoters and corporates, it was to be extended to
individuals when, suddenly in 2005, the scheme was scrapped
without an alternative. Who was behind the scrapping? Why was it scrapped? Because the primary market
was on a roll and scamsters wanted no hindrance. The scam was facilitated by the scrapping of Mapin.
After the scam, PAN was made mandatory, but this could have been done when Mapin was scrapped.

Curiously, even the probe focused on addresses that had more than 500 accounts. How many ‘investors’,
even in a joint family, stay together at one address? Why was the probe focused on a number as high as
500? Probably because there were cases below that number that involved the high and powerful.

What other conclusion can you draw? Had PAN been made mandatory, there would have been no need
for ‘lucubration to examine lugubrious affairs’.

PAN was also deliberately not made mandatory for the stock market in the one-by-six scheme when you
needed it for a telephone or even a credit card. The deliberate loophole enabled operators to function
unhindered. They just kept each investment below Rs 50,000.

What about the Asba scam?

Scams are not just events that happen. Events that should happen but do not are also scams – silent scams.
As soon as demat became mandatory, Asba was feasible.

Many had written about it back in 2002-04 – I called it e- lien. All banks may not have been ready – so
what – investors could have migrated to those who were.
 What’s up, Doc?

But the nexus of promoters and bankers stymied this. Where did the investor protection mantra disappear?
Every paisa of interest earned by promoters on IPOs, from demat implementation to Asba announcement,
actually belongs to retail investors. Are the so-called protection forums even aware of this?

Stock market manipulation is enabled by the lack of free float of 25%.

Operators can swing the market at their own sweet will. And now they are smarter – they ensure that the
limits of swinging are not breached so that circuit breakers are set off. The shortfall in free float accounts
for the helium in the indices.

Market rumours are that promoters are also quietly trying to declassify themselves to conform to the
regulation through the backdoor. The fact that there is a rethink shows how powerful the promoter lobby
is. The relevant question is: why was the free-float regulation not implemented ab initio?

Look at the joke called the abridged prospectus – a sure cure for insomnia – has any forum thought about
doing something concrete? It present version is a smashed car-size truck and say: read this and invest!

And how about a real tough exam for retail investors before being allowed to open a demat account?
Those who fail will have to continue to read this in small print – mutual fund investments carry market
risk please read the offer document carefully before investing – in five seconds.
 What’s up, Doc?
4.6 CONTINUING LEARNING CENTRES
Take informed decisions:

Disasters sow seeds of success

Great disasters occur constantly.

The Asian financial crisis blasted the miracle economies of

Asia. The Great Recession of 2007-09 led to the
bankruptcy/rescue of the five top investment banks on Wall
Street, the biggest bank (Citibank), the biggest insurance
company (AIG), the biggest auto manufacturer (General
Motors) and the biggest mortgage underwriters (Fannie Mae
and Freddie Mac). The BP disaster in the Caribbean is the
greatest environmental disaster in history. Some people fear that
global warming will be the biggest manmade disaster of all.

Many NGOs and politicians want to retreat from cutting-edge technologies (deepwater exploration,
climate geoengineering) to avoid all risks. Others want to end or avoid innovation in economic and
financial issues, retreating into state-regulated cocoons.

Alas, these remedies will be worse than the evils they seek to remedy. The right approach is to learn from
disasters and combine innovation with greater safety. The wrong approach is to retreat from innovation.

Many Americans want to stop offshore oil exploration, saying the BP disaster shows that potential costs
exceed the benefits. This argument is bogus. If true, all offshore oil exploration across the world should
be banned, since environmental disaster can strike anywhere. Such a ban will quadruple oil and gas prices
and send the world into a Great Depression. That will be infinitely costlier than the BP disaster.

After the Great Recession, some point to the state-controlled banking systems of India and China as safer.
Yet, India merely proves that if a financial system is bound hand-and-foot, it will not have enough rope to
hang itself. Ratios of bank credit to GDP of 200% in some countries may have been too high, but India’s
50% is clearly too low, and has starved citizens of badly-needed credit. Over-controlled India escaped the
Asian financial crisis. But its Asian neighbours, though badly hit, had 5 to 20 times India’s per-capita
income. For Indians, with a per-capita income of $350, to gloat over the troubles of Thailand, with a per-
capita income of $3,000, was a case of sour grapes.

Indeed, India’s economic success in the last decade was aided crucially by financial liberalisation. The
lesson India learned from the crisis was to calibrate financial liberalisation, not abandon it.

The global system is also learning from the Great Recession. Right now, the proposed changes look
insufficient. But certainly, risk awareness has improved greatly.

Disasters will still occur. No innovation or new exploration is ever risk-free. But just as shipwrecks did
not stop exploration of the seas, so too economic and technological disasters should not stop economic
and technological innovation. Henry Petroski of Duke University has written a book, Success through
failure: The paradox of design. Its key lesson is that failures teach us more than successes. Failures lead to
radical design changes that are needed but are ignored in times of unbroken success.
 What’s up, Doc?
One example is the 1940 collapse of the Tacoma Bridge in the US. For decades, engineers had built ever-
longer suspension bridges, and this lulled them into overconfidence. The Tacoma disaster showed that
suspension bridges were vulnerable to high winds if their stiffness and girth were not specifically
engineered for safety. Subsequent suspension bridges, often longer than the Tacoma one, were made
stiffer, and sometimes had a second deck to combat high winds even if traffic did not justify it. Failure at
Tacoma bred success in ever-longer bridges, not a retreat into smaller bridges.

Airships in the 1930s used hydrogen to keep aloft. Then the Hindenburg, the world’s biggest airship,
caught fire and airship production ground to a halt. However, this soon led to airships being filled with
safe, inert helium instead of inflammable hydrogen. The sinking of the Titanic, the meltdown of the
Chernobyl nuclear reactor and the collapse of the World Trade Center in 2001 all forced engineers to
come up with new designs to combat risks earlier thought to be negligible.

The Exxon Valdez tanker was rock-wrecked by a drunken captain in 1989, and leaked enormous
quantities of oil into the sea. This spurred a global shift from single-hulled tankers to double-hulled
tankers that can withstand a crash. The Exxon Valdez disaster spurred Exxon to develop one of the best
safety records in the industry. The BP disaster will lead to vastly-improved equipment to thwart future
deep-sea disasters. Already four top oil exploration companies have decided to pool their safety and
rescue resources in the Caribbean.

This lesson should also apply to geoengineering to combat global warming. Pilot projects have begun to
pour iron ore into the sea to increase its carbon-absorption capacity. Simply spraying seawater into the
sky could create clouds that reflect back sunlight and combat warming. The same effect might also be
achieved by shooting aerosols and sulphates into space to reflect back sunlight. Many green outfits
oppose such geoengineering because of the risk of calamitous side-effects. Dumping iron ore in the sea,
for instance, could increase sea acidity and bleach corals. Yet, iron ore is one of the common minerals in
the earth’s crust, and must be abundant in seabeds already.

We should start with pilot projects to educate us on possible benefits and risks, and scale up after
adjusting for risks. Geo-engineering could be a far cheaper way of providing insurance against global
warming than carbon reduction. Many greens believe that humans should not tinker with nature, and will
be penalised for it. In fact, humans evolved from the hunter-gatherer stage only because exploration and
innovation is hardwired into their DNA.

Poet TS Eliot wrote, “We shall not cease from exploration. And the end of all our exploring will be to
return to where we started, and know the place for the first time.” Greens who fear exploration know very
little of the nature they claim to protect, and think that ignorance is bliss. Regardless, we humans must
and will explore every facet of nature. Then alone will we know the place for the first time.
 What’s up, Doc?

4.07 ISSUES OF THE PRESENT

Freedom to get & fail in the system of free enterprise
Risk of full-fledged crash continues to grow

Its not easy being an equity investor in the current macroeconomic environment as the markets try to
balance the domestic growth story with global uncertainties. This has translated into volatile markets and
insipid performance by frontline stocks across sectors.

Corporate results in the past few quarters have been encouraging, monsoon rains are likely to be normal,
the Indian economy is growing briskly, FII flows have been good and the Indian stock markets continue
to outperform world’s major indices by a comfortable margin. Everything appears perfect for the
beginning of another bull-run on Dalal Street. But then, it was no different in the last quarter of 2007 and
what followed it is part of folklore now. Will it be different this time?

Not really! The storm clouds have already started gathering

over the world economy and the risk of a small jolt
snowballing into a full-fledged crash continues to grow. All
the leading global economies from the US, Europe and Japan
to China are facing their own brands of troubles.

As we learnt it the hard way in 2008, it doesn’t take long for

economic troubles to seize financial markets. This is why, it
is the right time for Indian investors to hedge their bets and
protect their portfolios, just as Noah built his Ark when it was
still sunny, that can see them through even if a storm were to strike a few months down the line.

In the past three years, the world has witnessed the cycle of over-optimism followed by over-pessimism
that reached its trough in March 2009. The global economy as well as the markets has come a long way
since then, however, as it often happens, the recovery in the equity markets has been disproportionate to
rebound in the real economy.

As investors wake up to the long forgotten fears of a double-dip recession in the US, the Indian markets
curiously find themselves in a situation quite similar to that of the last quarter of 2007, when the
investment euphoria was at its peak globally. Although it is still early to predict exactly, there are enough
indications that prompt retail investors to be careful going forward.

How the current situation resembles the last quarter of 2007? Currently, India’s BSE Sensex, the oldest
benchmark index, is trading above a price-to-earnings multiple (P/E) of 21 consistently almost for a year.
The last time it had traded so strongly and so consistently was in the 12-month period trailing September
2007. And just when a number of market players started getting worried about valuations, investor frenzy,
led by the conspicuous theory of decoupling, drove stock prices even higher.

Four months later, when the meltdown struck, the Sensex was trading above a P/E of 27. In absolute
valuation terms, the current market situation is similar to what we witnessed in September 2007, and it is
more than interesting that the decoupling theory is again gaining currency. In view of the better economic
growth prospects, the BSE Sensex has outperformed the US market’s benchmark index, the Dow Jones
Industrial Average (DJIA), for the past several years.
 What’s up, Doc?
Accordingly, the Sensex has rightly enjoyed a premium valuation. However, the current level of premium
— the difference between the P/E of Sensex and P/E of DJIA, has gone up so much that once again one is
reminded of the last quarter of 2007. At present the Sensex is trading with a P/E above 21.5, as compared
to 14.1 for the DJIA, or a difference of 7.4 points. In the past 10 years, it was only in the October 2007 to
January 2008 period that the Sensex commanded such high premium over the DJIA.

Strong FII flows had been a key characteristic of the period prior to December 2007. In the 18-month
period leading to the peak of December 2007, FIIs had poured in almost Rs 100,000 crore in the Indian
markets. In the past 18 months, since the bottom of March 2009, the net FII inflows were in excess of Rs
130,000 crore. Increasing FII investments in the Indian debt, both corporate as well as sovereign, have
emerged as another important trend this time.

And this time round, the markets have been bloated with huge amounts of speculative money floating
around driven by globally low interest rates and accommodating monetary policy by the world’s key
central banks. The substantial outperformance of risky small-caps over sturdy large-caps during this
period could be taken as an indicator of this speculative investment trend. In the past one-and-a-half
years, the Sensex has almost doubled, however, the BSE Small Cap Index has more than tripled. In
comparison, a similar period leading to the peak of December 2007 was marked with more sober growth,
Sensex doubled while BSE Small Cap Index had gained 125%.

During that period, the rupee had appreciated nearly 15% to a high of 39.4 against the US dollar.
Although in the current rally, the rupee has not reached those high levels seen in December 2007, it has
appreciated consistently by over 8.5% from the trough of March 2009. It is mainly the economic turmoil
in Europe, which is driving investors in search of a safe haven from the US dollar, preventing the rupee to
appreciate further.

Global economic troubles

The stock markets tanked globally in May as the Greek sovereign debt problems brought back the
memories of the sub-prime crisis of 2008. But the impact proved short-lived with the markets soaring up
again in the past few weeks. This appears to be the initial phase of over optimism, which is disregarding
the inherent troubles of the world’s leading economies.

After a relatively strong initial recovery, the growth rates of most developed economies are already
slowing, despite the immense previous stimulus. In the past three months, more or less universally in the
developed world, there has been a disturbing slackening in the rate of economic recovery. As a result,
stock markets in the developed countries have grossly underperformed those in the developing ones,
notably India’s.

The developed countries such as the US, the UK and other European countries find themselves in a
dilemma. At one end, the high level of personal and sovereign indebtedness is risking a debt-servicing
problem. At the other end, an attempt to control the debt levels runs the risk of affecting the consumption
demand and grounding the already fragile economic recovery.

Amid this, the weak economic activity in these countries is leading to lower government revenues due to
their higher dependence on real estate taxes and capital gains, which have been dampened due to falling
asset prices. However, their commitments, particularly salary and pension, are hard to cut. As a result,
sovereign debt has reached alarming highs. Besides, these economies are facing prospects of under-
funded retirement benefits and healthcare costs as the numbers of beneficiaries grow faster than workers
due to an ageing population.
 What’s up, Doc?

In the long run, these high debt levels will have to be curtailed to a more sustainable level, which will
indeed be a long and painful process. The famous economist Nouriel Roubini recently mentioned that the
advanced economies will “at best have a protracted period of anaemic, below trend growth” as
deleveraging by households, financial institutions and governments starts to impact consumption and
investments. The process has barely begun.

The key changes happening

The global economics are undergoing a paradigm shift. The way investors view the world is undergoing a
change, which will continue well into the future and nobody knows exactly how things would stand a few
months from today.

US treasuries and US dollars, considered, could be in for a role reversal, if one looks at the country’s
burgeoning debt burden. Noted economist and investor, Mark Faber, recently compared the US
government’s current situation to a giant ponzi scheme, meaning the government will have to borrow
increasingly more to meet the interest obligations, which would ultimately shake the confidence that
investors keep in this asset class. While the reality may not turn out to be as grim as Faber has predicted,
the US is indeed facing a problem the magnitude of which is unheard of.

Just last week, the US Federal Reserve’s chairman Ben Bernanke warned the US Congress against
withdrawal of fiscal stimulus to bridge the budget deficit, insisting it was too risky for the recession-
threatened US economy showed an increase in weekly unemployment claims, a drop in home sales and
easing of economic activity.

At the same time, the equities, government bonds and currencies of the Asian countries are fast becoming
“hedges against the global risks”, something unimaginable in the past. By now, Asia has become the
world’s great hope for growth and this perception is, unsurprisingly, reflected in the equity market
valuations.

One major part of this Asian growth story, the Chinese economy, is also cooling off. Its government’s
efforts to curb overheating and contain the asset bubble are likely to result in the country’s economic
growth slowing to a range of 8-8.5% in 2010 from 11+% earlier.

At the same time, experts believe China is set to enter the phase where incremental demand for labour
will exceed incremental supply. Such a scenario will basically end the era of low-cost labour enjoyed by
the country. Such a transition would surely have far reaching effects on the country’s economy in the
years to come.

Conclusion

The wisdom that emerged after the large stock market shock of 2007-08 is that the decoupling only
referred to the economic growth of various regions and that the financial markets the world over didn’t
really decouple. This is also applicable to the current scenario. Although India’s economic growth should
remain above 8-8.5% in the next couple of years regardless of the global economic slowdown and it
remains an attractive destination for foreign investors, the same may not apply to Dalal Street.

High valuations have increased the risk of an abrupt shock if any of the fears related to double-dip
recession or European debt crisis become a reality. And the current indications are that the likelihood of
these fears turning true, at least partially, is growing with every passing day.
 What’s up, Doc?

Several market gyrations have made it clear that it is the liquidity and investor confidence that drive the
stock market performance, the economic growth plays only a supporting role. Needless to mention, both
these factors are extremely finicky and can change tracks fast. It is, therefore, imperative that domestic
investors keep a strict eye on global happenings and not get swayed by momentum when taking any long
term decision.

Recommendation

The range bound market offers retail investors an opportunity to churn portfolios and make them less
risky. A global economic slowdown can greatly hurt commodity businesses and high-beta stocks while in
the current scenario, where most advanced countries would rather depreciate their currencies, owning
export-dependent companies may not be wise. In fact, despite the Shanghai Composite’s
underperformance since August 2009, most of the companies focusing on China’s domestic economy
have done well.

An investor can avoid taking long-term bets for the time being and book profits on every market spurt.
Investors should simultaneously also increase the proportion of less risky, most stable, India-centric
companies that have history of generating strong cash flows and generous dividend payouts.
 What’s up, Doc?
5. BANKING SECTOR
Central bankers’ best suited for macroprudential regulator

Central bankers around the world failed to see the current financial crisis coming before its beginnings in
2007. Martin Cihák of the International Monetary Fund reported in July 2007 that, of 47 central banks
found to publish financial stability reports (FSRs), ‘virtually all’ gave a ‘positive overall assessment of
their domestic financial system’ in their most recent reports.

And yet, although these central banks failed us before the crisis, they
should still play the lead role in preventing the next crisis. That is the
conclusion, perhaps counterintuitive, that the Squam Lake Group, a
think tank of 15 academic financial economists, reached in recently
published report, Fixing the financial system.

Macroprudential regulators – government officials who focus not on

the soundness of individual financial institutions, but on the stability
of the whole financial system – are sorely needed, and central
bankers are the logical people to fill this role. Other regulators did no better in predicting this crisis, and
are even less suited to prevent the next.

David Cameron’s new government in the UK apparently came to the same conclusion when it announced
plans to transfer regulatory authority from the Financial Services Authority (FSA) to the Bank of
England. But agreement about the regulatory role of central banks is not widely spread. In the US, for
example, there is recognition of the importance of macroprudential regulation, but not of giving this
authority to the Federal Reserve. The newly-passed US financial-reform legislation entrusts
macroprudential policy to a new Financial Stability Oversight Council. That is good, but the US Treasury
secretary will be the council’s chairman, and the Fed, despite gaining some new powers, will for the most
part be only one of many members.

The head of the council is, thus, a political appointee who serves at the pleasure of the president. Recent
history shows that political appointees often fail to take courageous or unpopular steps to stabilise the
economy. A modern US president certainly remembers how difficult it was to convince voters to put him
where he is, and is perpetually campaigning to maintain approval ratings and to preserve his party’s
prospects in the next election. The Treasury secretary is part of the president’s team, and works next door
to the White House.

George W Bush won the 2000 election, despite losing the popular vote. In 2003, Bush chose as his
Treasury secretary John W Snow, a railroad president who, as Barron’s columnist Alan Abelson put it,
‘may not be the sharpest knife in the cabinet’. Snow obliged the president and gave unquestioning support
to his policies until leaving office in 2006, just before the crisis erupted. Under the new law, Snow would
have been in charge of the stability of the entire US economy.
One theme that Bush found resonated with voters in his 2004 re-election campaign was that of the
‘ownership society’. A successful economy, Bush argued, requires that people learn to take responsibility
for their actions, and policies aimed at boosting home ownership would inculcate this virtue on a broader
scale. That sounded right to voters, especially if it meant government policies that encouraged the
emerging real-estate bubble and made their investments in homes soar in value.

SNOW echoed his boss. “The US economy is coiled like a spring and ready to go,” he chirped in 2003.
Two years later, near the very height of the bubbles in the equity and housing markets, he declared, “We
can be pleased that the economy is on a good and sustainable path.”
 What’s up, Doc?

But, to Bush’s credit, he also brought in Ben Bernanke in 2006 as Fed Chairman. Not part of Bush’s team,
Bernanke was protected from political pressures by US’ long tradition of respect for the Fed’s
independence. The choice of Bernanke, an accomplished scholar, apparently reflected Bush’s acceptance
of the public’s expectation of a first-rate appointee.

The same problems occur in many other countries. People chosen in part to win the next election often
find their economic judgment constrained. A news story in 2003 reported, for example, that Australian
Secretary to the Treasury Ken Henry had warned of a ‘housing bubble’ there, but then quickly tried to
withdraw his comment, saying that it was ‘not for quotation outside of this room’. He did earlier this year
finally propose new tax policy to slow the still-continuing Australian housing bubble, but now he can’t
get his government to implement it.

By contrast, in recent decades, central bankers in many countries have gradually won acceptance for the
principle of independence from day-to-day political pressures. The public in much of the world now
understands that central bankers will be allowed to do their work without interference from politicians.
There is a tradition of the central banker as a worldly philosopher, who stands up for long-term sensible
policy, and this tradition makes it politically easier for central bankers to do the right thing.

In fact, while the world’s central banks did not see the current crisis coming and did not take steps before
2007 to relieve the pressures that led to it, they did react decisively and energetically as the crisis
unfolded, with coordinated international action. This was facilitated by the tradition of political
independence and cooperation that has developed over the years among central bankers.

The crisis has underscored the utmost importance of macroprudential regulation. Although our central
bankers are not perfect judges of financial stability, they are still the people who are in the best political
and institutional position to ensure it.
 What’s up, Doc?
6.1 TAX UPDATES
A Muse for Tax Design

Common sense told us that when you put a big tax on something,
the people will produce less of it. So we cut the people’s tax
rates, and the people produced more than ever before.

Fast-forward to the here and now, and the Centre seems much
focused on tax reforms, both indirect (read: levies) on production
and consumption, and direct (read: taxes) on income, so as to
rationalise rates and minimise distortions. Notice the moves to
have an integrated goods and services tax (GST) from the next
fiscal year with the empowered group of state finance ministers
very much involved, and the efforts to have a direct taxes code in
place after a process of consultation with all stakeholders.

When it comes to indirect taxes, it’s notable that the target combined GST is to be 16%, as indicated by
the Centre, after two years of transitory, slightly higher tax rates. It may not be a coincidence that in
Kautilya’s Arthashastra, it’s mentioned that the tax share of production, or bhaga, was pegged usually at
one-sixth.

Note that while the ancient treatise does detail a number of special levies, cess and surcharges to mobilise
additional revenue, complete with prescribed fees and service charges levied as a matter of routine, the
mode tax rate stipulated for a range of economic activities was 16%.

Now, what’s proposed is that in the third year of implementation, the indirect levies on production and
consumption would also add up to 16%. And as the integrated tax is to have both a central and state
component, it is envisaged that the central rate would be 8%, and likewise, the state rate would also be
8%. The plan seems to be to specifically address the issue of ‘vertical imbalances’, the apprehension that
a combined tax would worsen the tax revenue balance in favour of the Centre and away from the states,
with a higher central rate.

Further, the intention is that the 8% indirect tax be levied across goods and services. The objective being
to provide input tax credit and setoffs across the value chain, and across goods and services, and both at
the Centre and the states, so as to expressly avoid cascading taxes (read: tax on taxes) that distort the
effects of taxation and give rise, generally, to a high-cost economy.

Additionally, in the first year of the transitory period, what’s proposed is a lower 6% levy for certain
goods, and a standard rate of 10%, and both at the Centre and the states. It is envisaged the tax rate on
services is to remain 8%, both during the two-year transitory tax regime and beyond, and both at the
Centre and the states. And in the second year of the transition, the proposal is to continue with a lower 6%
rate for certain goods, and tweak the standard rate to 9%, again both at the Centre and the states.

The way ahead is to bring about a Constitutional amendment so that the states of the Indian Union can
generally tax services. Concurrently though, a panoply of tax design issues and especially of
administration and implementation would need to be tackled, with speed. In parallel, what’s required is
coordination and consensus-building both across states and between the Centre and states, on how to
narrow differences in tax rates and identify exemptions. The broad intention is to lower indirect levies as
a whole, and remove cascading effects, so as to boost production and consumption right across the board.
 What’s up, Doc?

However, in the indirect tax timetable unveiled last week, there seem several anomalies. Such highly-
taxed items such as petroleum products and potable alcohol are to be kept entirely outside the GST
regime. Ditto for electricity duty, a significant source of revenue for the states. By the way, Kautilya was
indeed categorical that leisure activities including consumption of liquor need to be taxed at a higher rate,
for the common good. However, it would make more sense to bring in automotive fuel, etc, under a dual-
levy regime, and slap an additional levy, with no input tax credit available on the additional tax.

The move would provide limited tax setoff on fuels for activities such as transportation and commercial
end-use, when none is available to date, and so would incentivise efficiency, which is surely
unexceptionable. Note that indirect tax reforms began back in 1986 at the Centre, with the concept of
modified tax on value added in production, for select items. The reform was later extended to other items
of manufacture, and service tax at the Centre was introduced subsequently in the early 1990s.

Still later, the states changed over to value-added taxes on consumption, between 2003-08, but rigidities
remain. Hence the need for a combined, integrated indirect tax. As for direct taxes, Kautilya does not
mention income tax. But a general expenditure tax at up to 25% was levied, the text reveals. Given that
the effective corporate tax rate today is a little over 20%, and further that profit-linked tax incentives and
exemptions are to be done away with as per the code, a nominal tax rate of 25% would make much sense.
 What’s up, Doc?
6.2 SECURITY LAWS UPDATES
MCX-SX moves HC over Sebi delay in trading nod

In an unprecedented move, MCX-SX, the stock exchange arm of

MCX, has sought court intervention to obtain Sebi’s approval to
offer trading platforms in equity and a slew of other instruments.
MCX-SX has filed a writ petition in the Bombay High Court
against market regulator Sebi, pointing out the delay in approval for
commencing operations despite complying with all regulatory
requirements. The petition will come up for hearing on July 28.

A copy of the petition was served to Sebi at the regulator’s Bandra

Kurla office. The exchange wants the court’s approval that it is in
compliance with regulatory guidelines and should be allowed to
commence operations in the equity segment.

In the application, which was filed before the high court, MCX-SX has appealed that pending the hearing
and final disposal of the writ petition, Sebi be directed to grant MCX-SX permission to start operations in
segments like equity, interest rate futures, futures and options, mutual fund schemes, small and medium
enterprises and debt instruments. At present, the exchange offers trading in currency derivatives.

MCX-SX was recognised as a stock exchange in September 2008, with the condition that promoters
reduce their stake to the Sebi-prescribed limit of 5% within a year.

When MCX-SX was formed, its promoters MCX and Financial Technologies (FTIL) owned 51% and
49%, respectively, in it. Their stakes fell to 37% and 33.9%, respectively, after divestment of shares
through primary and secondary offerings in 2009. In 2009, Sebi renewed the recognition of the exchange
for one year up to September 2010 on the condition that no new class of contracts in securities would be
introduced without complying with the MIMPS (Manner of Increasing and Maintaining Public
Shareholding in Recognised Stock Exchanges) regulations.

It was a Catch-22 situation. Here you had investors willing to invest but only after the exchange had got
approvals for equity and other products. On the other hand, the regulator made disinvestment mandatory
for approval to operate in other segments. To speed up compliance with the shareholding regulations, the
exchange obtained high court’s approval for a scheme of capital reduction and arrangement. MCX-SX
said Sebi was informed about the same in December 2009. The company undertook the capital
restructuring programme in April 2010 and post the recast, the two promoters of MCX-SX have reduced
their aggregate stake from 70% to 10% (5% each). But in the process, the promoter companies also issued
warrants to themselves, amounting to a 60% ownership in the company on conversion. The warrants are
convertible into equity shares any time after completion of six months from allotment and are also freely
transferable. But they do not carry voting rights. According to its high court filing, the company has
issued 617.1 million warrants to MCX and 562.5 million warrants to FTIL.
 What’s up, Doc?
7.1 INFLATION
How to Control Inflation

Let us start by welcoming the Reserve Bank of India’s (RBI) move to

have a mid-quarter review of monetary policy from now. In a fast-
changing and quite unpredictable macroeconomic environment, there
is a need for continuous assessment and policy action. By reviewing
the monetary policy every six weeks, RBI can provide a more realistic
and faster response to developments. This will also take the surprise
element out of the off-cycle actions, as noted by RBI.

Coming now to inflation, if we look at the headline index, we see that

inflation has been at double-digit levels since February 2010. Latest figures show that in June 2010,
headline inflation stood at 10.6%. Disaggregated numbers further show that while inflation in primary
articles has remained at elevated levels for an extended period, with inflation crossing the 15% mark in
recent months, the price rise phenomenon is now spreading to other segments as well.

Data shows that non-food manufacturing inflation has seen a rapid build-up, rising from near zero in
November 2009 to 7.3% in June 2010. This increase in prices of manufactured goods can be explained by
three factors. First is the incessant increase in prices of raw materials and industrial inputs. Second is the
upward revision in wages and salaries, with several companies renegotiating their compensation contracts
to match the higher cost of living. Third and most important is the recovery in economic situation with
demand holding at strong levels in the economy. This has led to an improvement in capacity utilisation
levels with some segments of industry now facing constraints to meet the rising demand.

The RBI is understandably worried about this increasingly generalised nature of inflation. It has made its
concern public and to clamp down inflation, it has introduced a series of quick and successive policy rate
hikes. On July 2, 2010, we saw the repo and reverse repo rates being hiked by 25 bps. On July 27, 2010,
RBI repeated the act, but this time, the reverse repo was hiked by 50 bps against 25 bps that was the
consensus view amongst economists who participated in Ficci’s latest Economic Outlook Survey.

With the RBI making it clear that the balance of policy stance has to shift ‘decisively’ to ‘containing
inflation’ and ‘anchoring inflationary expectations’, we can pre-judge the direction in which monetary
policy will move in the days ahead.

The question now is whether these moves will help in cooling down prices and bringing inflation back to
the more acceptable 5% level. In our view, the answer is both yes and no. The tightening of monetary
policy by RBI will be followed by an increase in lending rates by banks for all kinds of borrowers. Once
this happens, you will see some impact on industrial growth. The logic is simple: A rise in interest rate
will compress both consumption and investment demand and this, in turn, will impinge on industrial
activity. As a follow up, you will see some relief from capacity constraints and manufacturing inflation
will moderate.

This is what RBI is aiming at, and our experience shows that industrial growth will trend down and
manufacturing inflation will get controlled as expected. However, what happens to manufacturing
inflation alone does not determine the overall inflation situation in the economy. This is because we also
have a more volatile component of primary articles inflation. And this does not respond to monetary
policy manoeuvring. Controlling primary inflation, particularly food inflation, requires an altogether
different approach.
 What’s up, Doc?

Today, we are betting on a good monsoon that will give us a favourable kharif output. And once the new
crop comes into the market, food prices should settle down. However, this is not a solution to food
inflation. We cannot keep chasing the monsoon every year to keep food prices under control. We have to
realise that with high growth, rising incomes and aggressive development work being undertaken in rural
areas, food demand is increasing rapidly. And the only way to maintain price line here is to have a
sustainable policy for the farm sector. We have to increase productivity, match demand with supply and
ensure that higher output gets distributed throughout the country.

Improving the state of farm economy calls for some serious action:

In case of pulses, which is the main source of protein for a large proportion of our population, we need a
quantum jump in yields through intensive R&D. Additionally, government must put in place a robust
procurement mechanism for lifting the pulses output. Today, we rely only on Nafed for procurement of
pulses, and this has not proved to be an effective channel to extend benefits of higher MSPs to producers
of pulses.

In case of fruit and vegetables, we need to minimise the wastage ratio that can be as high as 40%. Here,
government must encourage private sector participation in building the required storage and
transportation infrastructure. The supply chain from farm to the market needs to be streamlined and
government must leverage the capabilities of private sector including foreign retail players in this
mammoth task.

In case of cereals such as rice and wheat, India has sufficient buffer stocks, but the real problem lies with
distribution. The public distribution system in the country has failed. We need to develop and alternate
mechanism to PDS. Also , when it comes to releasing food grain stocks in the open market, FCI should
extend selling smaller quantities of, say, 100 tonnes, at multiple locations through electronic platforms.
Bulk sales through routine tendering process slow down the response time to any shortages that may
appear from time to time.

By deploying monetary policy, we cannot hope to achieve medium- or long-term price stability. The
decisive action to tackle inflation has to be in the form of acceleration of farm sector growth and ensuring
comprehensive and timely distribution of agricultural produce. Also, focus must go back to economic
reforms, which will ease supply side constraints and bottlenecks.
 What’s up, Doc?
7.2 MISCELLANEOUS UPDATES
CPI Maoists among craftiest capitalists in India

Delivering what in a Leftist lexicon would rank as the ultimate insult

to Maoists, home minister P Chidambaram has called them “crafty
capitalists” and candidly admitted that the state was “helpless” in
preventing businesses from succumbing to their extortion.

“The CPI Maoists are among the most crafty capitalists in this
country. They do business in violation of the laws, they collect rents,
and they don’t pay taxes, which make them very crafty capitalists.”

The home minister said while he did not condone payments to Naxals, he understood the compulsions
faced by businesses. “Unless the State is able to provide them better security they will have to pay these
rents to protect their investments. I am not turning a blind eye, I understand their compulsions and I don’t
approve of it, but the State is helpless.”

Catapulted into the home ministry from finance in the aftermath of the 26/11 attacks in Mumbai, Mr
Chidambaram has won praise for his hard-line approach to security issues and for streamlining the
functioning of various intelligence agencies. While there have been no major terrorist attacks of the 26/11
variety under his watch, several states have seen a wave of Naxal violence, killing hundreds of people.
Embarrassingly for him, many of the victims have been members of security forces.

Mr Chidambaram said a major reason for the setbacks faced by the security forces was differing rules of
engagement. “The Naxalites can choose a place and time. They do not wear uniforms. They run a
guerrilla operation... The paramilitary forces have to function in a battalion, in company formations, in
uniform and they can’t fight like a guerrilla force.”

The home minister said political parties in some parts of Jharkhand had “unwritten understandings with
Naxal elements”, but clarified it was based on intelligence and not evidence. He did not name the parties.

The home minister also referred to the growing “trust deficit” between corporate India and tribals, which
has stalled several projects in mineral-rich states and was being widened further by opposition by NGOs.
“Today the tribals begin with some sense of distrust and that distrust is made deeper by a large number of
organisations which paint every attempt to bring in modern industry as an attempt to exploit the tribals.”

Famed for his attention to detail, a no-nonsense demeanour and an acerbic tongue, Mr Chidambaram’s
attitude has won him several critics, particularly in liberal intelligentsia, and including in his own party.
 What’s up, Doc?
8. INSURANCE
Ulips, joint mechanism and FSDC

There has been much attention, in the media, on inter-regulatory

conflicts in finance, and on the proposed institutional
arrangements on financial stability. While these issues have
been with us for a while, the present debate falls within the
context of announcements in the Budget 2010 speech.

In this speech, the finance minister announced the setting up of

an agency called Financial Stability and Development Council
(FSDC) to deal with financial stability and macro prudential
supervision, inter-regulatory coordination and financial literacy
and inclusion. Equally important but less noticed was the
announcement relating to the creation of a Financial Sector Legislative Reforms Commission (FSLRC).

Inter-regulatory conflicts, over products and policy that straddle regulators, are neither new nor peculiar
to India. The dispute about Ulips is only the most recent, and publicly visible, manifestation of this
problem. There are many other existing and future products where identical difficulties could arise.

The root cause is not regulatory cussedness or turf concerns: it is financial laws that are out of tune with
the present state of Indian finance.

As an example, consider the core question of the Ulip dispute: should a Ulip with 1% or 2% insurance be
treated as an insurance product, or like a mutual fund product? An answer to this question requires a
combined reading of Section 12(1B) of Sebi Act, 1992, Section 2(11) of Insurance Act, 1938, and
Regulation 3(3) of Irda Investment Regulations, 2000.

Some of these laws were drafted at a time when the country had one government monopoly insurance
company. Hence, these laws did not deal with the complexities of today’s financial system.

The law of 1938 did not deal with a statutory regulator, Sebi, which would be established more than 50
years later, which regulates other products that look like Ulips. These laws did not plan for the
complexities of a competitive insurance industry where sales practices evolve in response to profit
maximisation by private firms.

The recognition that financial laws require fundamental reform, rooted in a series of expert committee
recommendations, led to the FSLRC announcement by the FM in his Budget 2010 speech. To go to the
root cause of the problem requires a comprehensive and contemporaneous re-examination of all the
relevant laws. Such an effort needs to address overlaps and gaps, clarify roles of agencies, and bring laws
up-to-date with today’s requirements.

Drafting and enacting new laws after scrutiny by the Parliamentary Standing Committee will inevitably
take time. Until a full set of new laws is put into place, a mechanism to deal with the problem of inter-
regulatory coordination and conflicts is required to address the difficulties faced today. This issue has
been emphasised by the Joint Parliamentary Committee (JPC) that enquired into the Harshad Mehta scam
and the JPC that enquired into the Ketan Parekh scam.

For the foreseeable future, Indian finance will be regulated by multiple regulators. Given the fast paced
changes in Indian finance, greater and more effective inter-regulatory coordination is essential.
 What’s up, Doc?

The High-Level Coordination Committee on financial markets (HLCC) – created by a one-line letter of
MoF in the wake of the Harshad Mehta scam – does not treat resolution of inter-regulatory conflicts as
part of its mandate. By and large, it has not been very effective in resolving turf wars. A combination of
these factors motivated the creation of the FSDC. The Parliamentary Standing Committee for Finance,
headed by Murli Manohar Joshi, in its 19th report (April 2010) has welcomed this announcement.

TO SUM up, the FSLRC and the FSDC should be seen together as the long-term and short-term answers
to the felt needs and problems of the financial sector regulation. They are rooted in the recommendations
of many expert committees spread over many years. While these were being acted upon, the Ulip issue
broke out in the open, as a public conflict between regulators, leading to an impasse.

Though initially administrative solutions were suggested, the movement towards an ordinance seems to
imply a feeling that a problem embedded in ambiguity of law is best solved by amending the law. It has
been argued that the solution did not warrant an ordinance and normal parliamentary procedure for
enactment of legislations should have been followed. While there is considerable merit in this argument,
one also needs to keep in mind that the Ulip industry – not withstanding all the undesirable practices that
have come to be associated with it – is per se legitimate and entirely legal.

As a consequence of the regulatory disputes, the industry came to a sudden halt jeopardising a lot of
genuine economic interests. It is difficult for a democratic government to sit by and watch this happen.
The ordinance route perhaps needs to be seen in this light as well. To get back to the substance of the
ordinance, it essentially clarifies, with retrospective effect that Ulips are to be regulated exclusively by
Irda. In addition, a mechanism required for resolving similar disputes – were they to arise in future – was
added to the legal framework to fill up a vacuum. The relationship of this new statutory mechanism with
the proposed FSDC is something that will need to be worked out by the government and the regulators.

However, on the question of RBI’s inclusion in this mechanism, given that the proposed mechanism seeks
to resolve disputes amongst regulators who regulate financial markets and products – as distinct from the
interest rate setting of a central bank – ipso facto, this mechanism has to cover all products that potentially
involve more than one regulator and also cover all the relevant regulators. The attempt, as repeatedly
stated by the FM, is not to disturb the autonomy conferred by the law on regulators but to institute an
orderly mechanism to handle situations when regulation itself breaks down.
 What’s up, Doc?
9. KNOWLEDGE RESOURCE
Making sense of China's high savings rate

As the G20 struggles to find a way to resolve global imbalances,

China’s high savings rate – 50% of GDP – and by extension, its
falling share of consumption (private consumption is the lowest
among the world’s major economies) is bound to come increasingly
under the spotlight.

Indeed the popular Western, especially US, view is that China’s

‘excess’ saving is a key reason for global imbalances and by
extension, a major cause for the international financial crisis.

Is this a valid charge? In a recent BIS paper, authors Guonan Ma and

Wang Y point out that a rapid rise in the savings rate is rare but by no means unique to China.

Fast-growing Asian economies in their transition phases also experienced large and sustained rises in their
saving rates. Japan’s aggregate saving/GDP ratio rose by 15 percentage points during 1955–70, Korea’s
increased from 16% to 40% between 1983 and 2000 while India’s registered a rise of 10 percentage
points of GDP, reaching 38% in 2008.

What sets China apart from the experiences of Japan, Korea and India, though, is its large current account
surplus during this transition, as the Chinese saving far outpaced its already high investment.

No single theory or model provides a simple explanation for this. There is little evidence that high savings
are a function of subsidies and distortions.

However, some structural forces – including those associated with rapid economic growth, structural
transformation, a compressed demographic transition, large-scale corporate restructuring, and the
household and government responses to institutional changes as well as to the expected acceleration of
population ageing in one decade from now – could provide some explanation, regarding both the high
savings rate and the medium-term outlook.

Despite private consumption expenditure growing 8% – 10% per annum in recent years, China’s saving
rate remains considerably higher than its investment rate, resulting in a substantial current account
surplus.

Going forward, given the outlook of a relatively weak global recovery and an already high domestic
investment rate in China, private consumption is likely to play a critical role in sustaining a high rate of
Chinese growth.

The key challenge for Chinese policymakers is thus, to maintain robust internal demand while rebalancing
the economy more towards consumption. Both domestic structural factors and policy measures could
influence such a transition.

China is also projected to enter a phase of accelerated population ageing within a decade bringing with it
a decline in the rate of growth of its labour force, along with a declining household saving rate and a
slower pace of investment spending.
 What’s up, Doc?
While the rural-urban labour migration away from agriculture is likely to continue in the years ahead, as
the urban share of the population is projected to rise from the current 45% to 60% in a decade, there are
some tentative signs that China is getting closer to a turning point where there is a rise in labour’s share of
income, lower corporate saving and a greater personal consumption.

A key implication of this is that China’s saving rate is likely to plateau before long and may ease off from
the current 53% or even higher levels over the next 10 years.

Does that mean the famed Chinese savings and growth machine might revert to ‘normal’ in the not-to-
distant future? I would not like to take a bet on that!
 What’s up, Doc?

LIVING ON THE EDGE

Retail investors must not forget the lessons learnt from the last crash

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Alka Agarwal
Managing Trustee Mi7

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Financial Advisor Practice Journal: August 2010: Volume 45 > What’s up, Doc?