Journal of FInance Vol 17

8/9/2019 Journal of FInance Vol 17

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1. THE END OF THE GREAT AMERICAN SHOPPING SPREE

Transfixed by unruly financial market, we may be missing the years biggest economic story: the end ofthe Great American Shopping Spree. For the past quarter-century, Americans have gone on anunprecedented consumption binge for cars, TVs, longer vacations and almost anything. The ever-expanding streams of consumer spending that pulled the US economy forward and, to a lesser extent, didthe same for the global economy.

How big was the consumption push? In 1980, American spent 63% of national income on consumergoods and services. For the past 5-years, consumers spending equalled 70% of GDP. At todays incomelevels, the difference amounts to an extra $ 1 trillion annually of spending. To say that the shopping spreeis over does not mean that every mall in America will close. It does mean that consumers will no longerserve as a reliable engine of growth. Consumptions expansion required Americans to save less, borrowmore and spend more; that cycle now seems finished. The implication: Without another source of growth(higher investment, exports?), the economy will slow.

Why did Americans embark on such a tear? In his book going Broke, psychologist Stuart Vyse ofConnecticut College argues that there has been a collective loss of self-control, abetted by newtechnologies and business practices that make it easier to indulge our impulses. Virtually ubiquitous creditcards (1.4 billion at last count) separate the pleasure of buying from the pain of paying. Toll-freecatalogue buying, cable shopping channels and Internet purchases dont ever require a trip to the store.Theres something to this. But the recent consumption binge probably has more immediate causes.

o One was the wealth effect. Declining inflation in early 1980s led to lower interest rates and led tohigher stock prices and, later, higher home values. People regarded their newfound wealth as asubstitute for annual savings, so they spent more of their annual income or borrowed more, especiallyagainst higher home values.

o The life cycle (aka demographics) also promoted the shopping extravaganza. People borrow andspend more in their 30s and 40s, as they buy homes and raise children. In the 1980s and 1990s, manybaby boomers were passing through their peak spending years. That reinforced the wealth effect.

o Finally, the democratisation of credit supported the shopping spree. At the end of World War II, itwas hard for most Americans to borrow. Since then, mortgages, auto loans and personal credit havebeen liberalised. By 2004, three-quarters of US households had debt. All these forces for more debtand spending are now reversing.

The stock and real estate bubbles have burst. Feeling poorer, people may save more from their annualincomes; its already much harder to borrow against higher home values. Demographics tell the samestory. Life-cycle spending drops among 55-to 64 years-olds they borrow less and their incomesdecline and thats where US household growth is now.

And credit democratisation? Well, the message of the subprime-mortgage debacle is that it went too far.Up to a point, the spread of credit was a boon. Homeownership increased; people had more flexibility inplanning major purchases. But aggressive and often abusive marketers paddled credit to people whocouldnt handle it. There are no longer large unserved markets of creditworthy consumers. Indeed, manyAmericans are overextended. In 2007, household debt (including mortgages) totalled $ 14.4 trillion, or139% of personal disposable income. As recently as 2000, those figures were $ 7.4 trillion and 103% ofincome. The resulting retrenchment of consumer spending is already being felt. Retailing Chains caughtin wave of bankruptcies, headlined The New York Times recently.


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2.1 SECURITY MARKETLocal investors go where FIIs fear to tread

FIIs may have turned bearish on the Indian bourses, but their domestic counterparts appeared to havetaken a bold call on the market, absorbing part of the fund-based selling in the past quarter. The bearmarket has seen a diversion of FII holding to local players like promoters, financial institutions and thepublic. Bombay Dyeing, Reliance Energy, RNRL, Tata Teleservices, HDFC Bank and L&T are a few

examples where domestic investors have increased their exposure while FIIs pared their stakessubstantially. Showing signs of maturity, retail investors could be seen buying beaten down stocks. Theforeign investors were net sellers of over Rs 12,000 crore, or $ 3 billion, during January-March quarter.

Sensex down 726 points on the last day of the fiscal 2007-08

Monday; 31st March 2008 Not a day goes without some bad news. And lately, much of it is homegrownsuch as rising inflation, slackening industrial output and change in accounting norms requiring Indiancompanies to disclose losses arising out of derivative contracts. The market is clueless as to how manycompanies have signed such deals. India was the worst performer in Asia on Monday; 31 st March 2008,with a sell-off in banking shares pulling down equity indices by over 4%. The Sensex shed 726.85 points,while 50-share Nifty ended down 207.50 points over the previous close.

31st March review 28/03/08 31/03/08 Points PercentageSensex 16,371.29 15,644.44 (726.85) (4.44%)

Nifty 4942.00 4734.50 (207.50) (4.20%)

Rising number of MTM losses worry investors: More and more companies providing for mark-to-market(MTM) losses on derivative trading has become a matter of concern among investors. There are fears thatcorporate earnings could come under cloud of MTM losses, which, in turn, would lead to some correction

in valuations already reeling under pressure of the current slump.

1st week of April 08 Sensex down 1.93%

Daily review 31/03/08 01/04/08 02/04/08 03/04/08 04/04/08

Sensex 15,644.44 (17.82) 123.78 82.15 (489.43)

Nifty 4734.50 5.05 14.65 17.40 (124.60)

Weekly review 31/03/08 04/04/08 Points Percentage

Sensex 15,644.44 15,343.12 (301.32) (1.93%)

Nifty 4734.50 4647.00 (87.50) (1.85%)

Inflation is the dominant concern A joke doing the rounds of Dalal Street is that it is the stock marketthat is leading the fight against inflation: by way of lower share prices. In a booming market, investors

would have told you that high inflation is not a bad thing as it is a reflection of the rapid growth in theeconomy. But this logic has no takers when FIIs are in retreat, high interest rates threaten to hurt

demand in the economy, and the world markets are in a state of flux.


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2nd week of April 08 Sensex up 3.03%

Daily review 04/04/08 07/04/08 08/04/08 09/04/08 10/04/08 11/04/08

Sensex 15,343.12 413.96 (169.46) 202.89 (95.41) 112.54

Nifty 4647.00 114.20 (51.55) 37.40 (14.05) 44.80


Sensex 15,343.12 15.807.64 464.52 3.03%

Nifty 4647.00 4777.80 130.80 2.81%

Growth in Indias industrial output in February 08 The Sensex recovered by 3% over the week amid prevailing uncertainty as investors found some respite in an unexpected growth in Indias industrial

output. Indias industrial growth at 8.6% in February was better than the market expectations that helpedrelieve fears of a possible slowdown. The output was a dismal 5.3% in January 08.

3rd week of April 08 Sensex above 16k mark, up 4.26%

Daily review 11/04/08 14/04/08 15/04/08 16/04/08 17/04/08 18/04/08Sensex 15.807.64 0 346.02 90.53 237.01 0

Nifty 4777.80 0 101.85 7.65 71.10 0


Sensex 15.807.64 16,481.20 673.56 4.26%

Nifty 4777.80 4,958.40 180.60 3.78%

Normal monsoon The BSE Sensex rose for the fourth straight session on Thursday on sustained buyingby funds as inflation eased amid reports of a normal monsoon. Buying activity picked up in financial

company stocks after reports that US banking Major JP Morgan Chase posted better-than-expected

quarterly results. Market watchers said an easing inflation rate amid the weather forecast reports of abetter monsoon this year were positive factors for the current rally.

4th week of April 08 Sensex above 17k mark, up 3.91%

Daily review 17/04/08 21/04/08 22/04/08 23/04/08 24/04/08 25/04/08

Sensex 16,481.20 258.17 44.54 (85.83) 23.04 404.90

Nifty 4,958.40 78.60 12.30 (26.50) (22.95) 111.85


Sensex 16,481.20 17,125.98 644.78 3.91%Nifty 4,958.40 5,111.70 153.30 3.09%

Inflation fully discounted Too much skepticism can at times be good for stock prices. Fridays 400-pointrally on Sensex is a testimony of that. Inflation is showing no signs of yielding, ICICI Bank has warned

that it will go slow on pay hikes, corporate earnings have been a mixed bag, and there are indicators that

the economy may be shifting into a lower gear. But all these factors did not deter bulls from lifting the 30-share Sensex past the psychological 17,000 mark for the first time in nearly two months.


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5TH week of April 08 Sensex up 1%

Market awaiting favourable Credit Policy -

Prudent and appropriate government and regulatory policies play a significant role in guiding marketsentiments. When we look forward to the RBI Credit Policy on April 29, 2008, we are hoping and prayingthat the Credit Policy sends out positive signals for the markets and the economy.

Indian markets have corrected more than any other emerging market and valuations of many goodcompanies are significantly down from the peaks they reached in end December/ early January. The GDPgrowth forecast at 7.5% for the Indian economy during the current financial year is still ahead of anyother competing economy.

There is enough money waiting in the wings for investments into Indian equities. There are funds sittingin the West Asian oil rich countries for deployment into India. Many cash rich Asian Central banks areplanning to invest in India. Even domestic institutions are sitting with huge cash waiting for a firm trendto emerge. A favourable RBI credit policy will push these fence sitters to start investing in Indian stocks.

Any measure which controls inflation without increasing the interest rates, would be appreciated by themarket and result in major gains. Increase in interest rates would cause a temporary set back for themarkets and may result in sell offs. However, long-term outlook of the Indian capital-market continues toremain positive irrespective of contents of credit policy. Long-term value investors like the pension fundsand the insurance companies, would start investing at every fall for building their long-term portfolio.

The macro economic survey

A survey conducted by the countrys central bank based on the responses from various professionaleconomic forecasters has indicated that the economy could grow at a healthy rate of 8.1% this fiscal. Withthe turmoil in the overseas credit markets, a slowdown in loan growth tempering demand in certainindustrial segments, many agencies and forecasters had recently pared their estimate of Indias economicgrowth for 2008-09.

But the survey a first of its kind by the Reserve Bank of India in line with the practice adopted by manycentral banks shows that the economy could expand by over 8%. This is the median of the responses of

professional forecasters. Over the past four years, Indias economy has grown at an average rate of 8.6%

with the figure for the last fiscal being 8.7%.

The survey further shows that the expectations for savings rate growth for this fiscal is still impressive35% while the rate of growth in investment is expected to be 36% of GDP.

However the worrylines remain. The macro economic survey released by the RBI on 28 th of April, a day

before the credit policy announcement has hinted that there could still be a need to tighten even inflationcools off in the near term. This is because it believes that financial imbalances can also build up in theabsence of overt inflationary pressures. This suggests that it is important for monetary policy frameworksto allow for the possibility of a tightening even if near-term inflation remains under control what mightbe called the response option.

The unveiling of the professional forecasters survey by the RBI could well help the market be better preparedfor policy measures and reducing the possibility of surprises.


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Market cheers Credit Policy -

The Reserve Bank of Indias surprise decision to keep key lending rates unchanged triggered a ferventbuying activity in stock markets with the benchmark Sensex and the wider Nifty spurting by over 360points and 100 points, respectively. RBIs projection of economic growth at a healthy 8-8.5% for 2008-09 and the Centres decision to extend the tax holiday scheme to export-oriented software technology

parks and refineries also aided sentiments.

Tax sops under STPI extended by another year -

In a huge relief for the IT industry, software companies have been allowed to enjoy benefits of thesoftware technology parks of India (STPI) scheme for another year. The government has extended the taxconcessions under Section 10A of the Income-Tax Act to March 2010. The scheme was to expire inMarch 2009 under the sunset clause provided in the scheme. On an average, IT companies would have arevenue benefit of at least 5-7% (on an effective tax rate). Normally, companies have about 50% businesslocated in the technology parks, export revenue from which is exempt from any kind of tax.

Daily review 25/04/08 28/04/08 29/04/08 30/04/08

Sensex 17,125.98 (110.02) 362.50 (91.15)

Nifty 5,111.70 (22.05) 105.85 (29.60)


Sensex 17,125.98 17,287.31 161.33 0.94%

Nifty 5,111.70 5,165.90 54.20 1.06%

MONTHLY REVIEW

Month March 08 April 08Date 31.03.08 30.04.08

Sensex 15,644.44 17,287.31

Points Base 1,642.87

percentage Base 10.50%


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2.2 INDIAN ECONOMYStill on a roll

There is far too much gloom in the public discourse on the economy than is warranted by facts. TheIndian economy is still on a roll in fact, the chief perceived ill, inflation, is an indicator of robust growthand resultant demand. Let us not make the mistake of talking ourselves into a mess.

Is there a slowdown? Yes, from about 8.7% in 2007-08, the rate of economic growth has been forecast tocome down to about 8%. Today, we see this as slow. It was the fastest the Indian economy grew in anyyear in the nineties. Further, theres hardly any other major economy in the world other than China that isexpected to grow 8% in this year. If the Indian economy grows 8% in the midst of a global slowdown:that should be considered terrific, not terrible.

The International Monetary Fund forecasts world growth in 2008 to 3.7%, down from 4.9% and 5%respectively in 2007 and 2006. The emerging markets that drive global growth in a manner not foreseen

even five years ago are expected to throw up a combined growth of 6.7% in 2008, after growing at 7.9%

and 7.8% in 2007 and 2006.

IMF expects global growth to accelerate a little to 3.8% in 2009, with the group of emerging countriesgrowing at 6.6%. Indias growth forecast for 2008 and 2009, at 7.9% and 8%, remains significantly higherthan for emerging economies as a whole and is bested only by Chinas numbers. However, China isexpected to lop off nearly two percentage points from its spectacular growth in excess of 11% achieved inboth 2006 and 2007. In contrast, Indias growth rate is projected to fail by less than one percentage point.By any yardstick, Indias economy is doing quite well.

Foreign investors lap up Indian depositories

FIIs might be selling in India but overseas its been a different story for depository receipts of Indiancompanies over the past three months. Foreign investors are lapping up Indian depositories. The totaltrading turnover of Indian companies on International Order Book (IOB, the depository receipts tradingplatform on the LSE) has risen 94% from $ 1.7 bln in the January March quarter of 2007 to 3.3 bln thisyear. Reliance Industries, SBI, Indiabulls Real Estate and L&T were among the scrips that have witnessedrobust trading activities.

Depository receipts (DR) represent stocks of a company trading on a foreign stock exchange. Many

Indian companies with global ambitions have floated their shares on bourses in London, Luxembourg andNew York to tap foreign investors.

The Sebi-imposed restriction on the P-Note route has resulted in investors buying Indian GDRs on the

IOB. British investors are also showing considerable interest in Indian GDRs. Institutional investors findit easy to invest locally as they are familiar with settlement modes; they are more comfortable deriving

benefits in dollar denominations as well.

According to equity analysts, even American Depository Receipts (ADRs) of Indian companies (onNYSE and NASDAQ) are witnessing sharp demand from foreign investors. A major portion of the rise inturnover could be attributed to the conversion of FCCB (into DRs) floated over the past two years. TheDRs of most Indian companies have bounced back after their fall in the recent market meltdown. Thebroad market perception in the US is that Indian stocks are relatively isolated from global concerns.


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2.3 INDIA INC: EXPENDING HORIZONSIndia Inc guns for the top league

India Inc has scaled global ranks and that too, across all sectors. Sample this: Indian consumer durablemajor, Videocon Group, is the third-largest manufacturer of colour picture tubes in the world and maysoon become the worlds third largest mobile phone maker if the Groups bid for Motorola Incs mobile- phone business goes through. It would displace Sony Ericsson and become the Worlds third-largest

handset producer after Nokia and Samsung.

Recently Tata Chemicals became the worlds second largest soda ash company in the world. Likewise,Tata Tea, which owns Tetley, rose from being a non-descript Indian player to become the second largesttea company in the world. Similarly, the Corus acquisition made Tata Steel among the five largest steelmakers in the world up from seventieth in the pecking order.

Indian firm Essel Propack, the worlds largest manufacturer of laminated tubes, has just acquired US-based Catheter and Disposables Technology (CDT). And Indian bike maker Hero Honda that hung on tothe position of worlds No 1 two-wheeler company for the seventh year in a row. In the same vein, thereare many other Indian companies that enjoy global position.

Vijay Mallyas UB Group became the second largest alcohol maker in the world, with over 140 liquorbrands, after it took over Shaw Wallace. Then there is Moser Baer, which is the second largest opticalstorage media manufacturer in the world. Its product range includes floppy disks, CDs, and DVDs, and ithas a presence in over 40 countries. But with the fear of an US recession snapping at the heels of theIndian growth story, will these conglomerates be able to hold on to their international ranking? Expertsreckon that they will.

The list does not end there. Ahmedabad based Arvind Mills continues to be the third largest denimmanufacturer in the world. Similarly, Pune-based Bharat Forge on the other hand, is the worlds secondlargest forging company. And on the slightly quirkier side, Standard Fireworks in Sivakasi enjoys theposition of being worlds largest pyrotechnic company. In the same vein, Gujrats Amul has also becomethe worlds largest milk pouch brand. Looking at the list, it seems that India Inc has bought itself nice pairof cross trainers to run faster, leap further and climb higher.

The biggest wealth creators

Government-run companies have been the bigger wealth creators in FY08, boasting of an additionalmarket capitalisation of over $ 120 billion. This is more than a quarter of the total increase in BSEmarket-cap during the year. The private sector was not far behind with eight individual firms adding $ 5billion plus each in market capitalisation during the last financial year. The top ten private sector firms, interms of absolute increase in market-cap in 2007-08 include Reliance Industries, L&T, Reliancepetroleum, HDFC, Jindal Steel & Power, Tata Steel, Sterlite, ITC, R.Com, and Essar oil.

Interestingly, just about half of the top ten private sector wealth generators during the year were part ofthe Sensex. This point to a large part of the India growth story is outside the broad market index. This ispart of a larger trend where firms under emerging business groups like GMR Infra, Jaiprakash Associates,Unitech, Suzlon, Adani Enterprise, and REI Agro have been among the significant wealth generators inthe country, all of them adding $ 1 billion plus in their market cap. And, DLF, Reliance Power and PowerGrid during the fiscal 08 were listed with market capitalisation of $ 27.5 billion, $ 17.9 billion and $ 10.3billion respectively.


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2.4 WARNING SIGNALS

World trade growth may slip 1% this year

The outlook for world trade bleak, with growth expected to dip to 4.5% from 5.5% in 2007. According tothe World Trade Statistics 2008, continuing strong growth in emerging economies like China and India isonly partly offsetting a sharp economic deceleration in key developed countries.

While Indias share in world merchandise exports at $ 145 billion has remained more or less static at1.06%, it rank among the worlds top service exporters has improved two places to 11 in 2007. Indiaexported $ 86 billion of services in 2007, accounting for 2.7% of global service exports. China, on theother hand, was the seventh largest exporter of services in 2007 with exports worth $ 127 billion. In

merchandise trade, China was the second-largest exporter after Germany. It exported goods worth $

1,218 billion in 2007, accounting for 8.8% of world trade.

The one percentage slide in global merchandise trade in 2008 is based on the assumption of a basicscenario of global GDP growth between 2.5% and 3%, the report said. This estimate is supported by theresults of the WTO Secretariats time series forecasting model which predicts a slowdown in the OECDareas imports of goods and services to 3%, a further 1.5% decrease from the already subdued rateobserved in 2007. The present economic growth forecast for developed markets is 1.1%, while fordeveloping countries, the growth is forecast at above 5%.

US home foreclosures jump 23% in Q1

Real estate data firm Realty Trac said: Home foreclosure filings jumped 23% in the first quarter from theprior quarter, and more than doubled from a year earlier, as more overextended borrowers failed to maketimely payments. One of every 194 households received a notice of default, auction sale or bankrepossession between January and March, for the seventh straight quarter of rising foreclosure activity.

Rick Sharga, vice president of marketing at Realty Trac said: Im more convinced that we havent seenthe peak of foreclosure activity yet, and the wave probably wont crest until late third or fourth quarter of2008. Nevada, California, Arizona and Florida had the highest foreclosure rates among states during thequarter. A buying frenzy by speculative investors had sharply inflated home prices in all of those statesbefore a slide into one of the worst housing markets in a century began in 2006. These states are nowinundated with unsold homes, many valued less than the size of the mortgage. The oversupply is pressingprices down, forcing some owners to walk away and escalating pressure to foreclose. Many homeowners, particularly those with adjustable-rate subprime mortgages, are struggling to make payments that haveskyrocketed when the loans reset.

One in every 54 Nevada households got a foreclosure filing in the first quarter, up 137% from a yearearlier. California had the second-highest rate of filing among states with one in every 78 households,

soaring by nearly 213% above the same period last year. The really insidious part is that, particularly ifyoure in a market with a glut of inventory, as more properties go through foreclosure they addproperties on the market that are effectively going to be coming in with distress pricing, which makes iteven worse, Sharga said. The share of vacant US home grew to a record high in the first quarter, ashomeowners struggled to find buyers and foreclosures escalated. The percentage of owner-occupiedhomes sitting empty rose to 2.9%, the third straight monthly rise, for a total of 18.6 million vacancies.With prices seen falling further at a time when there is an overabundant supply, some governmentmortgage relief programmer may not preclude foreclosures from mounting.


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3.1 MUTUAL FUNDMany happy returns for mutual funds on bull-runs fifth birthday

April, 18 has a special significance for cricket buffs and marketmen. The day marks the beginning of themuch awaited Indian Premier League cricket series and the completion of five years of bull-run on Indian

stock exchanges.

The great Indian bull-run according to experts, specially started on April 18, 2003 at a time whenSensex hovered around sub- 3000 levels. The Indian equity market (benchmarked on Sensex) hasmultiplied five times in just five years putting it amongst the best performing markets in the world. Onlyfour other countries Russia, Brazil, Indonesia and Mexico have managed to achieve this. While thenear- 25% correction since the beginning of this year raises questions on sustained buoyancy on Indianshares, analysts spreads the log-sheets to find answer to the mother of all questions who made moremoney in this bull run?

Its mutual fund managers as a community and not bulge-bracketed Foreign Institutional Investors whoachieved higher return; while FIIs collectively made an annualised return of 30% over the five-year period; it was 34% for Mutual Funds. In arriving at this, the cumulative investment by FIIs has beenconsidered along with the returns generated by the MF community as a whole. For the analysis, theportfolio of FIIs and MFs were analysed along with their net investment figures (Sebi data) over the five-year period to calculate internal rate of return.

Birla Sun Life Mutual Funds CEO A. Balasubramanian said: Investment strategy-wise, mutual fundsadopt a bottom-up approach. Most funds, over the past few years, have been able to spot out potentialwinners in mid-cap and small-cap segment and invest in them. In the initial years of the bull-run, mid-capindices outperformed large-cap indices by a huge margin. So to that extent, outperforming the Sensex wasan easy game as out-performance meant having higher exposure to mid-caps. For instance, in FY04,S&P CNX Midcap gave a return of 140%.

A rare opportunity on the platterLast couples of months have caused pain in global equity markets, and Indian equity markets in particularhave suffered the most. The Sensex has corrected by 30% from its all-time high achieved on January 10.There is no way to foretell when the sentiments will turn, or when the investor confidence will return.Existing mutual fund investors may be well advised not to allow panic. They need to remain focused ontheir financial goals and take a long-term view of the market. The longer one remains invested, the less isthe impact of volatility. And for the new investors looking for price-value gap, these are like rareopportunities on the platter. Investors with a 3-5 year horizon can take advantage of these opportunities bybuilding an equity mutual fund portfolio using the SIP route over the next 6-12 months.

Concept of good redemptionAt present, the stock market turbulence has not only derailed the day traders but even those mutual fund

investors who thought that fund managers will device the way to hedge their risks. KrishnamurthyVijayan, CEO, JP Morgan, puts his faith in the concept of a good redemption and a bad redemption.According to him, a good redemption is when a person exist a fund with a profit, either because he needsthe money or wants to book profits. A bad redemption, on the other hand, is when a person exists becauseof sheer frustration panic at the notional loss he has suffered. By and large, any redemption at this stage inequity is likely to be a bad redemption, unless the investor has invested in some theme, which is clearlydefunct now. I would suggest that investors use this opportunity to accumulate the funds where they haveconfidence in the portfolio.


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3.2 COMMODITY MARKETGovernment may take China route as way forward

In the wake of rising commodity prices, the Left has been constantly mounting pressure on thegovernment to ban forward trading in commodities, which come under the Essential Commodities Act.The government had earlier banned rice, wheat, arhar and black gram (urad) for forward trading.

The government may take the Chinese route to convince its Left allies that forward trading is importantboth for farmers and exporters. Just a week before the Abhijit Sen committee report on forward trading isscheduled to be submitted, deputy chairman of Planning Commission Montek Singh Ahluwalia said thatIndia cant ignore the active commodity market in China.

People dont realise that there is quite an active forward market for commodities in China. Also, events inIndia have shown that the ban on forward trading did not alter the underlying uptrend in wheat priceswhich reflects what is happening in world market. Equally, there are other products where forward tradingis allowed which have not experienced inflation.

Joseph Massey, CEO of Multi Commodity Exchange (MCX), pointed out that three of the Chinesecommodity exchanges Shanghai Futures Exchange (SHFE), Zhengzhou Commodity Exchange (ZCE),and Dalian Commodity Exchange (DCE) figure among the top 10 commodity future exchange in theworld. China may be a controlled economy but this is an indication that they too believe in market-driven pricing because of the advantage it offers to the entire supply chain connecting producers andconsumers. They have also realised that developing a well-regulated market is the only way forward tointegrate better with global market as each economy depends on international market for trade.

The Left, however, does not like the Chinese comparison. CPIs national secretary D Raja said, Left not bring the Chinese angle into it. Let the government prove that forward trading has actually helped thefarmers. We are demanding the ban as it has been counter-productive to farmers.

An analysis of four banned commodities by Centre for Monitoring Indian Economy (CMIE) has shownthat prices of rice, tur and wheat have increased despite the ban. For rice, there has been a price rise ofover 20% from the time of its ban. In fact, sugar and potato are two classic examples of commoditieswhich have forward trading and yet their prices have not increased over the last one year.

A recent study carried out by United Nations Conference of Trade and Development (UNCTAD) of five

leading commodity futures exchanges spanning the major developing regions Bolsa de Mercadorias & Futuros (BM&F), Brazil; Dalian Commodity Exchange (DCE), China; Multi Commodity Exchange of

India (MCX); Bursa, Malaysia; and the SAFEX Agricultural Products Division of JSE, South Africa

found that exchanges can yield critical impacts such as better sowing and selling decisions by farmers,

empowering the entire ecosystem through better transparency, quality standards and infrastructureespecially in developing countries like India and China.

The middle way

Banning futures trade in agri-commodities is akin to shooting the messenger. The government needs toput in place effective long-term solutions that enable proper price discovery after removing unwarrantedspeculative forth. This should include creation of a strong and effective regulator, which can act onintelligence it picks up from the market, and can take decisions independently. Additionally, measuresmust be taken to open up the spot market for commodities to allow freer movement of foodgrains acrossstate borders. Derivative trade cannot work efficiently in commodities where the government has asignificant role to play and where even the spot market is highly controlled.


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4. FINANCIAL SECTOR: TRANSFORMING TOMORROWFinancial literacy necessary, not enough

The financial crisis has shown that in the world of finance, we are all beginners. The difference betweensophisticated I-bankers and retail investors is being only one of degree. And, the Reserve Bank of Indiasdesire to improve the level of financial literacy in the country is unexceptionable. What we are less sure ofis whether asking banks to set up counselling centres as suggested in the RBIs Concept Paper on the

subject is the best way of going about the job.

The paper defines financial literacy as providing familiarity with and understanding of financial marketproducts, especially rewards and risks, in order to make informed choices.

In a country where the general literacy rate is just about 60%, financial literacy is all but non-existent.Investment in financial instruments is, more often than not, based on a tip here, a whisper there, seldomon a full understanding of the product in question. The risks associated with such mindless investment arenot high as long as it is in safe avenues such as bank deposits or government bonds. But it is a differentmatter altogether when it is in stock market instruments. Here there is no substitute for detailed reading ofthe prospectus/ study of company/industry, etc., something few retail investors are either willing orcompetent to do; nevertheless to the extent the RBI also has a developmental role, it is a worthy pursuit.

1. FINANCIAL ADVISORS:Weigh impact on investors

Learning curve

The RBI is taking proactive measures to prevent a US-type subprime crisis in India. The US crisis had itsgenesis, with American banks proving loans to those who cant afford repayment. It is widely felt that thecrisis could have been avoided if borrowers were more aware of their liabilities. While Indian banks aremore careful on home loans, aggressive marketing of products such as personal loans and credit cards to

vulnerable borrowers could give way to over indebtedness and results in these loans turning bad. To avoidthis, RBI has asked banks to set up credit counseling centres either individually or collectively that willwarn borrowers if they are raising loans beyond their means. Globally, credit counseling, already exists inthe US, the UK, Canada, Australia and Malaysia.

Two of the main conditions for setting up these centres are that they should provide free advice and

should not try to sell products by providing investment advice. Also, they should be outside a branch and

maintain an arms length relation with the bank. The central bank has said that it may convene a meetingof bank CEOs, the Indian Banks Association, Nabard, co-operative banks, experts and few NGOs to

discuss the concept and the mechanism to spread financial literacy. Going forward, RBI has expressed

intent to make credit counseling a part of banks fair lending codes.

In a concept paper, the central bank stressed the need for financial literacy since the common man doesnot have an access to complete information from the markets. The paper points out that the growingmiddle class in India is increasingly resorting to debt for funding consumption need. Against such abackdrop, credit counsellors may help borrowers by offering them sound advice on ways to restructurethe debt and better ways of money management. Going a step ahead, banks have been told to place allinformation relating to fees, interest rates, yields etc. on their website. RBI is now exploring the option ofdisplaying the consolidated data on all banks on its website and having a dictionary of common terms.


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2. FINANCIAL PLANNERSValue unlocking for all stakeholders

High finance laid low

What we call financial services insurance and real estate, as well as banking and securities trading.

In 1976, it was 15% of GDP; now its 21%. The expansion has produced many benefits more credit forfamilies and businesses, more investment choices for people for retirement and anything else, and moreinvestment capital for start-ups and smaller firms. However, the paradox of finance is that its virtues andvices come tightly packaged together.

Unfortunately, financial advances have also created periodic episodes of massive waste that threaten to

destabilise the entire economy. The subprime-mortgage debacle is not a rare exception. Before that, therewas the tech bubble of the late 1990s when anyone with a business plan ending with .com could getmoney from venture capitalists.

According to experts, there seems to be a regular cycle of financial innovation (good), imitation (good up to

point, because it provides competition) and finally suicidal excess. But the basic problem is that as long aspeople are benefiting from innovation and investors are making money, it hard to impose restraints on theexcesses. Only a crackup brings clarity.

It is often wrongly said that the present problems originated in the mindless financial deregulation begun

in 1980s, as if everything be fine if the old financial system remained. Actually, the old system dominated by banks and savings and loans collapsed. Many S&Ls failed when high inflation raisedinterest rates on their short-term deposits above the levels on their long-term mortgages. Banks sufferedhuge losses on energy, commercial real estate and developing-country loans. Securitisation and other newforms of financing filled the void left by weak banks and S&Ls. So, modern finance has a split personality. Greed, shortsightedness and herd behavior compromise its usefulness. Even, regulation

cannot cure this dilemma, because regulators cant anticipate all the problems and hazards.

Come clean on subprime:The State Bank of India chairman O P Bhatts admission that the banks corporate clients are likely to

suffer a loss to the tune of Rs 600-700 crore on account of currency derivatives puts paid to any hope thatpublic sector banks might have been more prudent and desisted from structuring questionable deals while

chasing profits. It has reported not made any provisions in its books, presumably because none of its

customers have taken the bank to court, unlike in the case of many private banks, though prudence would suggest the need to set aside some amount. A provision of $ 10 million has, however, been made on

account of mark-to-market losses due to exposure to subprime paper in its overseas market.

Clearly, foreign and private sector banks are not the only ones whove burned their fingers in the subprime crisis. As of now there is no reason to believe there is any systemic risk on account of such

losses; something the RBI governor has stated repeatedly. This is no doubt reassuring, but there is need

for much greater transparency and disclosure. Estimates of the total quantum of derivatives in the booksof Indian banks vary from Rs 12,800 crore to Rs 20,000 crore. Such a huge variance in the numbers and

the absence of any clear indication from the regulator only creates uncertainty causing the banking sector

to be re-rated downwards. RBI must set the record straight.


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3. WEALTH MANAGERSMap out the details to translate into benefits

Global economic & financial governance

Two key institutions the World Trade Organisation (WTO) and International Monetary Fund (IMF)

are central to global economic and financial governance. A third institute World Bank is oftenincluded in the list but its substantive significance is now limited. Most countries now have ample accessto private capital and the Bank is now a substantial net recipient of funds from the developing countries.

Sixty years of economic development has bought some major developing country players Brazil, China,India, South Africa and South Korea on the world stage. This has given rise to the need for a change inthe governance structure of the WTO and IMF. Interestingly, the response of the two institutions has beenquite asymmetric. The dominance of the developed countries in the decision-making process hasundermined the credibility of the IMF to effectively handle the financial flow crises and generated twokinds of responses:

o On the one hand, countries such as Russia and Argentina chose to effectively default on theirloans when hit by financial crises.o On the other hand, countries such as Brazil, China, India and South Korea went on to accumulate

large foreign exchange reserves to insure themselves against future crises.

Today, capital flows freely across a vast array of developed and developing countries. The improvedaccess of the developing countries to private capital markets, have resulted in considerably reducedlending by the IMF. Given the imperfect and asymmetric information in the capital markets, the threats offinancial crises will continue to loom large. And, these crises would spillover from one country to anotheron account of the interconnected nature of the markets.

Customer Appropriateness and Suitability PolicyMinister of state for finance Pawan Kumar Bansal said private sector banks, including ICICI Bank,

HDFC Bank, Kotak Mahindra Bank, AXIS Bank, Yes Bank, were active in derivative products. The banks

enter into derivative transactions with companies as a part of their business. Corporates enter into

derivative transactions with banks to hedge against adverse currency movements having bearing on theirearnings.

Under the RBI Act, derivative is an instrument, to be settled at a future date, whose value is derived

from change in interest rate, foreign exchange rate and other securities including interest rate swaps,forward rate agreements, foreign currency swaps and options.

The RBI had issued a circular in April 07 to provide a framework for undertaking derivativetransactions. The guidelines emphasised the need for a proper risk management framework, and

appropriate corporate governance practices. To protect the market-maker against the credit, reputation

and litigation risks that may arise from a users inadequate understanding of the nature and risks of thederivative transactions, the guidelines also provide that market-makers should adopt a board-approved

Customer Appropriateness and Suitability Policy for derivative business.


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4. INCLUSIVE CEOsInnovative responses to problems

Exotic Forex derivatives

Last year, the world subprime found its way into almost all dictionaries and was even awarded the

word of the year title. But that was last season. This time its Exotic, that has soured the flavour. Atleast this stands true for banks and corporates, which tried this recipe for garnishing their balance sheets.

As more and more companies come out in the open and knock the legal doors seeking an intervention, theforex derivatives losses may well turn out to be the subprime crisis for India Inc. And once again, thebanks have found themselves in the vortex of this financial crisis.

According to a Credit Suisse report, the size of the potential market-to-market (MTM) losses atcorporates is placed anywhere around Rs 120-200-billion. The report also states that the total hit for

Indian private banks is about $ 328-million.

Analysts may agree that the erratic currency movements may have triggered this blood bath but there isno consensus on whether it is the corporate house that went wrong or was it the banks zealousapproach, which made them enter into complicated derivative contracts.

Banks feel that theyve an iron-cast defence and most of these will fall flat when contested. As, these

options are not something new. They have been existed for a long time. In fact trading in these optionshad become a popular tool for profit management. The clients actually knew what product they wanted.

They just wanted to quote the prices from bank. There is nothing wrong with these products. Its just likea cricket bat in your hand; you need to know how to use it.

According to the Credit Suisse report, Indian banks have 25-30% market share among large and 60-65%

among mid size corporates in complex derivatives. Once the strong players (large corporates) knew thatits turning turtle they moved out. They have greater risk management tools. But it wasnt easy for midsize corporates. Another twist to this fairy tale, which went horribly wrong, is that since RBI doesntpermit significant open positions on forex, many Indian banks did the deals and in turn entered into backto back deals with foreign banks. It was so because Indian banks didnt have those exotic products, theybought it from foreign banks and sold them to corporates.

Though the situation may worsen from here on, some analysts believe that the concerns regardingpotential forex-derivative-related loses are overdone. The Credit Suisse report also states that it is unlikelythat losses for the bulk of the corporates individually will exceed a level that would significantly affecttheir ability to repay or to borrow (as corporate sector leverage is still extremely low).

The accounting regulator (ICAI) has directed companies to follow new accounting norms that wouldrequire them to disclose and provide for their derivatives losses with immediate effect. The ICAIannouncement requires corporates to tell the mark to market losses and disclose them separately.However, doubts are raised on the taxation part. Its not clear whether the companies can claim deductionon unrealised losses. For now it appears that the much relied upon forex derivatives may have turned intoproverbial Titanic for corporates and banks alike, as for survivors theyll have an exotic tale to narrate!


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5. CREDIT COUNSELORSResolve convertibility and recompensation issue

Financial risk (re) engineering

The recent upheavals in the world financial architecture have clearly brought the challenges in managing

risks through a business cycle. This is an era of exotic financial (re) engineering. The developed countries(and to some extent developing countries) have taken recourse of usage of derivatives in order to managerisk. Structured finance is yet another tool claimed to create high quality low risk securities out of arelatively riskier portfolio. There are now instruments to control the risk of weather, something, whicheven top science brains, could not achieve in past 200 years!

The derivative is an instrument whose price depends on price of some other underlying security. Forexample, an option is to buy or sell a commodity at a fixed price on a particular date. Now dependingupon the daily change in the price of that commodity, the price of this option too changes. Moderntechniques have given us the tools to transform any financial transaction into a software code that can betransferred from one party to another at the click of a button. And the derivatives can be sold or bought at

almost every moment till the actual date of buying and selling. However, the downside of the story is thatactual transfer of goods rarely happens. At settlement date, only money exchange happens.

In the same vein: welcome to world of weather derivatives, where parties will bid whether it will rain or

not on a day. And depending upon the actual event, exchange of money shall happen. If we rip off all

financial jargons, one may struggle to differentiate this from gambling.

Come to the era of structured finance! One collects promise of payments from a pool of borrowers (likemortgage borrowers), aggregates them and converts them into various tranches. Some of these tranchesbecome senior securities, some more junior. The senior once will have first right to get money in case ofdefault by borrowers. Thus they get an AAA rating from credit rating agencies. They are then sold in the

market as ready-to-buy-instruments. It can even so happen that, I took a mortgage loan and also hold apaper of security to which my own mortgage loan was also a contributor. The fact however remains that abad portfolio is a bad portfolio. And when the portfolio gets bust, all tranches face doom together. A casein example is the ongoing subprime crisis. These products merely reallocate risk and this in itself bringsthe greater peril. This is actually a risk magnification instead of risk management!

The critical thing to do is a proper and systematic credit risk assessment of the individuals. That is theonly way to manage risk in the true sense. Take for example the recent subprime crisis in the US. It isnow clear that the origin of the crisis in the US was a complete lack of a due diligence exercise done tofind out the antecedents of the people given loans (interestingly, believe it or not, even income records ofthe individuals were not checked while granting a housing loan). These risks are now being/have been

transmitted to other countries through this structured finance.

In the end, an interesting observation: The US economy has financed its era of high growth throughmonetising its current deficits from developing countries (China, for example) in the last decade or so. Now, in the era of (de) growth, the risk is being transmitted to other countries through sophisticatedfireplay. Let regulators be more cautious in identifying, and dealing with such fireworks. Let economicgrowth be based on core sectors and fundamental progress and not merely on financial indices.


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6. RISK MANAGEMENT CONSULTANTSEducate Engineer and Enforce

Satyajit Das, author of Traders, Guns and Money, has spent more than 31 years teaching and practising inthe exotic financial derivatives industry. Today, by his own words, Das sounds like a grumpy old manwho started his career as a banker, which was considered honourable profession. Your word was like abond and you abided by it. But things have changed now. I am not against change, if the change is good.

But there are no ethics in the business anymore. What we have is naked greed, he says.

Derivative fiasco:Derivative fiasco has happened in the world and now getting repeated in India. Indian companies haveused forex derivatives to meet quarterly targets and to meet analyst expectations. These derivatives havebeen used to make loans cheaper and in certain cases also to disguise certain borrowings with the use ofleverage. For a long time, these companies have made huge profits, but today things have changed andthey are not happy about it. It has happened across the world and its happening in India now.

The issue is slightly different in India. In most countries, banks actually do trade in exotic derivatives.Since they are the traders themselves, they are also the creators of these products. So, when companies or

firms buy these products from banks, the sellers of these products have more knowledge about thesederivative products than the firms who buy these products. But Indian banks do not really trade in theseproducts due to RBI guidelines. What they do is get into back to back dealing with foreign banks. Thus,Indian banks are selling the products that are created by foreign banks to Indian firms, which want tohedge their risks. The foreign bank remains safe. They dont have the credit risk of the client.

What one needs to understand is that both the Indian bank as well as the Indian firm does not understandthe product completely. When there is a problem, the Indian bank and the Indian firm sour theirrelationship or get into a legal haggle.

Derivative game:

This is the oldest game in the book. Many trades were based on the stability of the value of the yen andthe Swiss franc against the dollar. Stable currencies have always existed and banks to sell all kinds ofproducts have used them. There were many Asian currencies pegged against the dollar.

What people need to understand is that the stability of currencies that we see in a graph does not give anyreasons. In many cases, these graphs can be shown to prospective buyers who do not understand how tointerpret them. In such a situation, it becomes easier to sell them currencies that have economic orhistorical reasoning for their stability to investors who have no background of the forex market.

Naked greed:In the complex world, you cannot earn high returns all the time. In such a situation, the CFO has to

manufacture earnings. The real business is to make change. But to make change, it takes years. Themarkets want explosive earnings over a short-term horizon. For many of the CFOs, the remuneration isbuilt around ESOPs. This gives all the more reasons for the CFO to manufacture earnings than the coreproduct. This is what leads to all the problems. They take risks that they do not understand.

The financial literacy is necessary, not enough. However it totally depends on how you use it. Peoplewrite books and there are training classes, which are very lucrative, and this is an industry on its own.Finance is like psychology. There are no definite answers, but with the right tools we get an idea. If youunderstand the basic principles of finance and have some luck, you can end up making a lot of money.


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7. TECH SAVVY PROFESSIONALSTake first step to ensure efficient and reliable system

You can soon dial payments

Mobile-based payment systems will see the light of the day this year, with the central bank stressing on itsimportance. Though the number of banks offers mobile-based banking solutions for online fund-transfers

and utility bill-payments, they do not facilitate payment to merchants. Usage of mobile phones to spreadthe reach of banking is a tried-and-tested formula in many African countries, Korea and The Philippines.

It will enable an individual to make small-value payments via the mobile phone, instead of using a creditor debit card. Threat of frauds like skimming during card payments is well documented and payments viathe mobile phone will offer a hassle free system.

Moreover, RBI is looking at extending mobile-banking services to the large population, which does nothave access to banking facilities. The services will be cheaper alternative to banks setting up rural branches, and will also work in tandem with the business correspondent model. Remittance of fundsthrough mobile phones is another phenomenon that has caught on internationally. Two of the countrys

largest banks the State Bank of India and ICICI Bank, have been in the process of piloting a remittance-system in association with Airtel and mobile-service provider mChek.

According to RBI, the reach of mobile phones has been increasing at a rapid pace. There were about 231million mobile connections at the end of December 2007, and the pace at which this number is increasingis one of the fastest in the world. The fact that almost every household will have a mobile phone throwsup an opportunity for banks to set up a new delivery channel. Mobile-payment solution providers say theSIM card can hold all the relevant financial data and double up as a smart-card.

8. MICROFINANCE PROFESSIONALSDeveloping alternative credit delivery models

General Credit Card (GCC) scheme

Banks will now touch the lives of more Indians. The measures announced by the central bank will bringmore people under organized banking and make it easier for banks to fulfill their priority sector mandate.

Currently, banks give loans for non-farming activity (in rural regions) under GCC scheme. About 50% ofthe credit outstanding under the GCC is classified as indirect finance to agriculture. From now onwards,RBI has decided to permit banks to classify 100% of the credit outstanding under GCC and overdrafts upto Rs 25,000 against no-frills accounts in rural and semi-urban areas as indirect finance to agricultureunder the priority sector.

The measure is aimed towards financial inclusion, given that a majority of households in rural India stilldo not have bank accounts. The GCC is similar to personal loans taken by borrowers in villages. Theinterest rates on such loans vary from 9.5-10%. According to RBI norms, each bank has to lend 40% ofthe total loans to mandated sectors like agriculture, small-scale industries and housing. Besides, 18% ofthe overall credit has to be for farm sector which will also include the GCC. According to bankers, mostbanks were hard selling Kishan credit card to farmers for meeting their annual targets. Now, banks willtry to reach out customers to sell the GCC.


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9. CONTINUING LEARNING CENTRESTake informed decisions

Its back to school

Its back to school for loan recovery agents, who now need to complete a certificate course to comply

with new guidelines introduced by the regulator. Banks have been given a year to ensure that all recoveryagents appointed by them complete 100 hour of training and obtain a certificate from the Indian Instituteof Banking and Finance (IIBF). Worried over the huge reputational risk that the banking industry facesover adverse publicity, RBI has decided to review the policy, practice and procedure involved in theengagement of recovery agents in India.

At present, there is no educational course for the recovery agents. RBI has asked Indian BankAssociation (IBA) to formulate a certificate course in consultation with IIBF for direct recovery agents,with a minimum of 100 hours of training. RBIs objective is to sensitise recovery agents to borrower to borrowers rights and about the law of the land. Keeping in view that a large number of agents,throughout the country, may have to be trained, other institutes or a banks own training college may

provide the training to recovery agents by having a tie-up with the Indian Institute of Banking andFinance so that there is uniformity in training standards.

10. ONE-STOP-SHOPSDedicated to offer related services under a roof

The Raghuram Rajan panels report

The recently released draft report of the Raghuram Rajan-led committee on financial sector reformscarries the right tone on at least few broad macro-related issues. It correctly emphasises that Indian

policymakers should not take the wrong message from the ongoing financial mess in some developedeconomies that markets and competition do not work. Financial innovation typically leads financialregulation, and infrequent but sizeable disruptions can take place. But that does not mean we need to giveup moving forward rapidly. After all, a motorist does not give up driving because of a mishap.

Derivatives call for proactive policymaking

Derivative securities provide corporates and investors with routine opportunities for hedging and riskmanagement. But the real risk now is that the policy establishment would draw all the wrong conclusions,and simply deem derivative positions as akin to glorified gambling activity. Instead, it needs to firm up

accounting norms for derivatives, boost skill set in quantitative finance and shore up the fledgling or non-existent derivative markets here in India.

In tandem, whats needed is pedagogy and training in high-level quantitative economics, finance andstate-of-art modeling. An accounting background can be found quite wanting for modern finance. Inparallel, whats warranted is sound accounting treatment of derivative positions. Whats surely needed isproactive policy on derivatives.


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11. GLOBAL OUTLOOKGlobalisation works both ways:.

For the past 3-4 years, Indias growth acceleration trend has benefited more from the globalisation of

capital markets than from the globalisation of trade. This trend now appears to be reversing.Globalisation works both ways

Decoupling is inherently illogical

RBI governor YV Reddy mentioned while announcing the RBI quarterly review of monetary policy on29th April 2008, that there is no decoupling between India and international markets. Initially, when theproblem started in the US, many analysts believed that there was a decoupling. Not I. What I mentionedwas that you cannot have everybody benefiting from globalisation, but when the problem arises, youexpect decoupling.

In fact, decoupling is a theory, which is contextually convenient, but inherently illogical. Now, thegeneral analysis is, there may not be decoupling, but there can be a divergence in terms of effect. So thatis why you find that in advanced economies the impact on growth is large and in emerging markets theimpact is less. So there is a differential impact on EMEs and among EMEs. But directionally everybodywould be impacted.

A new theme in the countrys globalisation experience

Dr Manmohan Singh broaches a new theme in the countrys globalisation experience: a quest for proactive leadership of the process, instead of being merely a passive, albeit gainful, participant. Tobuttress his point, the PM cited three instances of global mismanagement that have serious implications ofIndia and other developing countries:

One, the global food crisis, aggravated by diversion of food crops to biofuel in developed countries;

Two, the cartelised rise in crude prices to the tune of 90% even as world demand has grown only at the rateof 1% over the last two years; and,

Three, the international finance institutions failure to come to grips with mismanagement of the financialsystem in developed countries, particularly the US, leading to severe distress in the global financial system,impacting growth around the world.

Indias voice must be heard on such matters. Be it the management of the world food economy, be it themanagement of the world energy economy, be it the management of the global financial system, orindeed, be it the management of global security. India has both a responsibility and a right to participatein the management of the global challenges.


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12. ISSUES OF THE PRESENTFreedom to get & fail in the system of free enterprise

The Tragedy of the Commons

Its a phrase that every student of economics is familiar with the tragedy of the commons: the conflict

over finite resources in situations where individual interests clash with the common good. It was first popularised by Garrett Hardin in the 1968 essay. The Tragedy of the Commons, where he gave thehypothetical example of a common pastureland in the village that was shared by local herders.

Since each herder would wish to maximise his yield, he would have an incentive to increase the size ofhis heard whenever possible. But this is where his individual interest clashes with that of the larger group.The herder receives all the benefits when his cows graze on the common land. But the pasture is degradedwith the addition of each successive animal so while the individual herder gains hugely; everyone usingthe pasture shares the costs. In other words, perfectly rational behaviour of individual shepherds leads toover-grazing and degradation of the pasture in the long term.

Global warming is a modern parallel. Each country in its bid to foster ever-faster economic growth would

like to pollute without restraints. But it can do so only at the cost of common environment. Substituteunderground water for common pasture or environment and you have another parallel most of us

living in the metros will be familiar with. In water-scarce cities each of us has an incentive to pump up themaximum amount of underground water but if everybody does that the water table will recede. Eventually

a day will come when we will not be able to suck out even a drop of water.

But this column is not about the tragedy of the commons, as it is commonly understood. It is about howthe phrase has acquired a new meaning in the context of the ongoing financial crisis. The crisis has shownfinancial meltdowns can have a huge systemic cost, i.e., the collapse of a single institution can have anadverse impact on the entire financial and macroeconomic system. But what is different, about the presentcrisis is that entities like investment banks and mortgage lenders are not part of the payment system and

hence they should not carry any systemic risk, and have been bailed out at taxpayers expense.

In the globalised era where capital is mobile, the actions of one country have an impact on the rest of theworld. In case of failure in one country, the cost of bailing out that country may be borne by the rest of theworld. Whereas Indonesia or Thailand could be allowed to go under (read suffer severe economicdownturn as during East Asian crisis) the US cannot. It must be bailed out because the consequences ofthe US economy capsizing are much too disastrous to contemplate.

For most of the last decade the US economy expanded its way out of trouble by flooding its economy andhence the world with liquidity. Today the consequences of that are being borne not only by the US but bythe rest of the world as well. The US, acting rationally to maximise its own welfare, much like the grazer

in Hardins example, has destroyed the system that served as the framework for modern finance.

The International Monetary Fund (IMF) estimates the full cost of the crisis at $ 1000 billion. Of this USbanks and other financial institutions are expected to bear roughly half, with the balance being shared bythe rest of the world. In the case of common pastureland, individual action led to depletion of finite,tangible resource. In the present crisis, individual action by the US has led to the depletion of an equallyfinite but intangible, common resource: FINANCIAL STABILITY.


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5. RBI QUARTERLY REVIEW OF MONETARY POLICYPress Release

Over the years this is the last in the five-year term the governor of the Reserve Bank of India, Dr Y VReddy, has perfected the art of walking the tight rope! The RBI, unlike many central banks but like theUS Federal Reserve, has always had to balance the imperatives of growth with those of price stability. Ithas not been easy; never more so than now when growth is slowing and inflation is picking up. With

policy prescription pulling in opposite directions slowing growth demands a reduction in interest rateswhile rising prices demand a hike. The RBI has to make a judgment call. Is growth more endangered thanprice stability? Or is it the other way round? Which is more important and what is the cost-benefit trade-off? The answer, in a democracy that is home to a third of the worlds poor even by the antiquateddefinition of a dollar a day, should be clear to all concerned.

COUNTER EXCHANGE

Measure Impact

Cash Reserve Ratio hiked Bank profits take a hit. Auto loans turn costly

Lower risk weight on home loans up to Rs 30 lakh Mid-sized loans could be cheaper

Regulations for mobile payment systems It will encourage even conservative banks toprovide mobile banking services

STRIPs introduced Corporate will find more takers for bonds

Banks asked to review sensitive sector portfolio Banks will lend more prudently

Oil companies allowed to hedge on internationalexchanges

Oil companies manage their risks better

Banks need to set aside more capital for off-balance sheet exposure

It will discipline banks in the derivative markets

More leeway for urban co-operative banks It will help its business environment to move closerto that of commercial banks

Financial regulation of systemically importantNBFCs

NBFCs relying on bank funds may face stricterregime

Fee-waiver for electronic settlements to continuefor one year more

It will boost electronic settlements

Exporters allowed to retain earnings overseas for alonger time

It will help them off-set losses on currencymovements

RRBs allowed to sell their loan portfolio It will provide liquidity to RRBs

Indian oil companies allowed to invest overseas insectors such as energy and natural resources

It will be profitable for large oil companies,especially the private sector players.


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6. SECURITY LAWS UPDATES

Daily margin

Stock broking firm will have to notify a client about the latters daily margin position from April 1 08,according to a directive from market regulator Sebi. The move follows a spate of complaints frominvestors that brokers have liquidating their positions citing insufficient margins though their margin

accounts had enough funds. The other common refrain is that investors are not told of the quantum ofmargin money needed to replenish the account. The regulator feels that if investors were informed aboutmargin positions on a daily basis, it would become easier for them to replenish margin accounts.

Short selling guidelines

Soon, the Indian stock markets will see short selling and the unveiling of the securities borrowing andlending programme. For long, if a market player reckoned that the price of a stock was overvalued, hecould sell it only on the futures segment in the hope that his judgment call was reflected correctly in thespot market. But that may not really affect the underlying share price, as in the derivatives market canwell decouple from the cash market. Now this is set to change. How short selling helps? By empoweringinstitutions to short sell, policymaker hopes that the process of price discovery will be more efficient.These large institutional investors control nearly a fourth of the market capitalisation, and are increasinglybecoming key constituents of the market.

Equity accounting

Corporate houses that have joint venture companies are set to see a major drop in their valuation and sizewhen they adopt international financial reporting standards, which would become mandatory in Indiasoon. The global norms for joint venture accounting are expected to deprive companies of the freedom toshow in their financial statements the revenue and assets due to them from jointly controlled companies.They will only be allowed to consolidate profits from joint ventures in their financial statements. In whatis called equity accounting. For example, a company having an investment of 49% in a JV that has aturnover of Rs 100 crore and a profit of Rs 10 crore can show in its books a proportion of revenue andprofits Rs 49 crore top-lines and Rs 4.9 crore as profit. Adoption of the IFRS would reduce the revenueto zero while retaining the profit of the parent at Rs 4.9 crore.

Daytradian: tough times ahead

Throughout the long bull-run thousands of people made handsome profits by trading daily in stocks. Theytrade on ups, the downs and even the sideways. After the Finance Minister announced in his Budget thathe plans to withdraw the tax rebate against STT, a tax levied on all transactions in the stock market, thingshave turned sour to them. Day traders across the country may be poor after the January crash but themarkets are now even poorer. With no participation from day traders, volumes have dried up and there is

simply no depth for any market player. Volumes enable participants to find much better prices for buyingor selling securities, leading to higher gains.

To explain STT implication with an illustration, suppose, a day trader earns a profit of Rs 300 on totalincome of Rs 1000 (expense of Rs 700), he pays 33% tax of around Rs 100. Assuming Rs 20 STT, thetotal tax liability will be Rs 80 on current calculation. According to the new proposal, on the sameincome, the expenses will now be considered as Rs 720 instead of Rs 700, as the STT will be consideredas an expense. So, the profit will be Rs 280, on which the trader has to pay tax of Rs 92, Rs 12 higher thanwhat he would have paid has STT not treated as expenses.


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7. LIVING WITH INFLATIONInflation control measures

Cabinet Committee on Prices meets on Monday (31/03/08) to assess the factors responsible for soaring prices; Committee of secretaries to meet on Tuesday (01/04/08) to discuss price scenario; Group of

ministers on prices headed by Pranab Mukherjee to meet on Wednesday (02/04/08) to review prices of

rice, wheat and procurement of edible oil; and Prime Minister Manmohan Singh has called a meeting of

state chief ministers to discuss price rise.

The UPA government came out with a slew of decisions to douse inflationary expectations. Politically,the government must be seen to be doing its best to curb inflation. Therefore, new measures such asscrapping import duty on edible oils, banning export of non-basmati rice and asking state government toimpose stock limits on traders should be seen as attempts to lower inflationary expectations. However, itis the external variable that will impact Indias inflation rate. If you juxtapose the domestic inflationconditions against global economic scenario, a very complex situation emerges. The RBI governorconceded this when he said the inflation rate was indeed unacceptably high. But he also gave comfort by predicting that in terms of growth and stability India will continue to be among the best performingeconomies in the months ahead. We can only hope and pray Dr Reddy is right.

Cement and steel companies told to hold & cut prices

Cement and steel manufacturers have increased product prices in a move that is likely to stoke inflation.

While cement companies have raised prices by 3-4% across India, steel companies have hiked prices of

long steel products or construction grade products by 18-20% through three-price revision in Marchalone. Cement companies have cited increased value added tax on bulk cement, and rising fuel prices.

Steel companies have increased prices due to higher input costs, taking the average price of products

such as channels and angles that are widely used in construction, to about Rs 45,000 per tonne.

Having introduced policy measures to douse inflationary pressures on the food front, the government isnow zeroing down on crucial input sectors like the steel industry to check the rising price index. Steel producers have been directed to reduce prices by 10% to 20%, failing which the government wouldintervene with fiscal measures that could soften prices. Steel has a weightage of just 0.3% in inflationindex, but its usage in industrial and household applications enhances the inflationary impact.

Centre rediscovering Nehru cap on galloping prices

The government is considering imposition of price ceilings on commodities if other measures to tameinflation fail. The finance ministry asked the CCP to issue a notification authorising ministries to invokesection 18G of the Industrial Development & Regulation Act, 1951. It has proposed that ministries anddepartments should be vested with the authority to impose price controls on essential commodities likesteel and cement. The Act the governments Brahmastra was last used in the 1970s to ring in prices

caps. Section 18G was all set to be repealed in the early 90s after the Narasimba Rao governmentsliberalisation moves. It was, however, retained when Congress party members insisted that it should notbe given up as it was part of the Nehruvian legacy.

After government push, steel companies cut pricesThe countrys top steel producers, including Tata Steel, SAIL and Jindal Steel on 3rd of April 08 decided

to roll back the price of long steel products, including construction grade TMT bars by Rs 2,000 per

tonne. The price cuts would be implemented immediately. The steel companies have also agreed reduces

the price of galvanised corrugated sheets use as roofing material for low cost housing. The steelcompanies have also agreed to address the issue of supply constraints resulting in higher prices of steel.


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Inflation flares up to 3-yr high of 7%The fight against inflation has just got tougher. Wholesale price-based inflation raced to a three-year highof 7% for the week ending March 22, 2008, as against a 13-week high of 6.68% for the week endedMarch 15, 2008. The last time inflation was above the 7% mark was in December 2004.

Drastic steps need of the hour

There seems no respite in sight as the heat of scorching inflation is being felt not just in the country butacross the globe. With commodity prices rising across markets, the governments fiscal measures such asduty cuts and export bans are unlikely to help. Many countries have put in place similar measures, whichmean cheaper supplies are disappearing fast.

World food prices rose 40% last year, according to the UN Food & Agriculture Organisation (FAO) andthe European Bank for Reconstruction & Development. The surge in prices has been led by dairy (up80%), oil (50%), and grains (42%). Dwindling cereal supplies amidst rising demand pushed up prices ofmost cereals, wheat and maize in particular, during 2007. The only exception was sugar, which declined32% after having increased 20% in 2005-06. The rising food prices are fuelling inflation globally and

have become a concern with many governments.

Government to target hoarding & profiteering, states told to monitor prices

Commerce minister Kamal Nath said that the government would not hesitate to act against hoarders andprofiteers. He said supply-side management is a challenge to controlling prices of essential commodities.We will not hesitate to take the strictest measures against hoarding and profiteering.

We may be among the worlds top producers of fruits and vegetables but start saying good buy to the daysof cheap food. Essential edibles are bound to remain pricey on the back of increasing demand-supply gapsand dicey weather, locally and globally. States have been asked to keenly monitor prices of essential

commodities and vegetables and take suitable steps to keep retail prices of these in check.

Inflation flares up to 40-month high of 7.41%An unabated rise in the prices of vegetables, food articles and steel has pushed inflation to a 40-monthhigh of 7.41%. Growing for the eighth consecutive week, inflation, based on the wholesale price index,rose 0.41% in the week ended March 29, from 7% in the previous week. Inflation, which was 6.54% ayear ago, last touched 7.76% during the week ended November 6, 2004. The common man was affectedmost by surging prices of vegetables that showed an increase of 4.1% during the week, while spices andpulses become dearer by 1.2% and 1.8% respectively in the wholesale market.

Metals, minerals catalyse Inflation

According to government estimates steel and minerals have the two leading factors, among othercomponents. Steel, which is used widely in consumer goods and construction, has a cascading effect onthe cost of living and is, hence, being increasingly monitored for inflation. According to analysts, excessdemand is also contributing to inflation. With the economy having grown above potential for the pastthree years, money supply growth at upwards of 20% and fiscal policy remaining loose, there continues tobe significant demand pressures, which are contributing to the acceleration in prices.


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Price rise could diminish reforms, warns PM

The prospect of prolonged food shortages and rising food prices poses a challenge to the worldcommunity. The gravest concern in India is the potential of escalating food prices to slow down povertyalleviation, impede economic growth and retard employment generation. The PM acknowledged that theworld food situation had become more complex due to the biofuel juggernaut factor. It is particularlyworrisome that the new economics of bio-fuels is encouraging a shift of land away from food crops.

Climate changes and global warming, the other key cornerstones of the drastic changes happening in theworld food scenario also came in for grave concern.

Rising prices to hit poorest countries

The fast rising prices will hit the poorest countries whose cereal import is expected to rise by 56% in2007-2008. A report by UN Food and Agriculture Organisation (FAO) said that about 37% increases ithad witnessed in 2006-2007. For low-income food-deficit countries in Africa, the Crops Prospect andFood Situation Report projects an increase in the cereal bill by 74%. As many as 37 countries worldwideare facing shortage of cereals. International cereals prices have continued to rise sharply over the past twomonths, reflecting steady demand and depleted world reserves. By the end of March 08 prices of wheat

and rice were about double their level of a year earlier.

FM declares war on inflation

Warning steel and cement makers against forming a cartel, finance minister made it clear the governmentwas ready to take tough measures. While emphasising that Centre will not hesitate to take more fiscal andadministrative measures to tackle rising inflation, he asked the state governments to join the war againstinflation and take stern measures against hoarders and black marketers. Mr Chidambaram added the statesshould take drastic steps against hoarding and the Centre would even sacrifice revenue to control inflationthat has surged to over 7%. However, we cannot panic at this stage despite relentless rise in prices.

MRTP told to investigate suspected tyre & steel cartels: Taking its fight against inflation forward, the government has asked the fair trade regulator MRTP Commission to probe into suspected cartel likebehaviour among major tyre and steel makers. The investigation wing of the quasi-judicial body on 16th

of April 08 issued notices to five major tyre makers and is preparing to issue notices to steel companies.

The regulator will seek details of the recent price rise, capacity utilisation, raw material cost, profit

margins and a host of other information to establish a meeting of minds and price parallelism.

Inflation down a tad to 7.14%The annual rate of inflation, eased to 7.14% for the week ended April 5 from the previous weeks 40-month high of 7.14%. Inflationary expectations continue to loom over the economy due to hardeningprices of commodities in the international market, and supply constraints on the domestic front. Thus,

inflation may be expected to hold up above 7% for the next 2-3 months.

RBI hikes CRR by 0.5% to cool down prices

The RBI on 17th of April, 2008 hiked the cash reserve ratio (CRR), the amount of depositors money thatbanks need to park with it, by half a per cent to tighten money supply, as part of concerted efforts with thegovernment to ease inflation. The hike, which would take CRR to 8%, will come into effort in two trancesof 0.25% on April 26 and May 10. The unscheduled hike comes ahead of RBIs annual credit policy for2008-09 to be unveiled on April 29.


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Giving the rationale for the increase in CRR, RBI said year-on-year wholesale price index-based inflation,which was 3.83% on January 12,2008 (at the time of third quarterly review of credit policy), increased to7.14% on March 29 and remained at 7.14% as on April 5 and its overall impact on inflation expectationsrequires to be monitored and moderated.

Monetary steps to cool prices of little use this time, say experts

There seems to be a near consensus among economists that containing inflation through monetary

tightening would prove counterproductive. Unlike in February 2007, when RBI successfully checkedinflation by raising rates, they argue, this time inflation is largely supply constraints led and not demandspull driven. Any credit squeeze would, therefore, hurt both demand and supply, leaving the gap betweenthe two largely unchanged.

In the current scenario hike in commodity prices due to supply constraints is the issue and not the money.Bank credit for the April07-February08 was up 16.7% over the same period last year. However theloans growth in April06-February07 was 22%. This is sure sign that demand pressure is cooling down.Thus further monetary tightening led fall in production would spell disaster for the economy finding hardto come over supply constraint led demand.

Core inflation, which excludes the prices of fuel and agri commodities, remained higher then the headlineinflation in March07-Febryary08. This implies that the major contributor to inflation was higher pricesof manufactured products. The growth rate of production of manufactured goods has witnessed 2.5%decline from 11.2% during the first ten months of 2006-07 to 8.7% in the same period of 2007-08.

The WPI of manufactured products had risen modest 3.3% in financial year 2006-07. But it went up 5.2%in April07-February08, a rate much higher than annual WPI for all commodities which stood at 4.1% inthe same period. Meanwhile, the rate of rise in prices of food-grains has declined in April07-February08down from 9.7% in 2006-07 to 6.3%, following improvement in supply condition.

Mospi secretary Dr Pronob Sen concurs, Prices of manufactured products had remained depressed earlierdue to excess production capacities and competition from imports. However, in 2007-08 higher inputcosts, drop in sales and lower price realisation because of fall in consumer demand, and higher borrowingcost reduced the margin. This affected the companys ability to invest and produce more, which led to afall in production, followed by rise in prices of end products.

Time for coordinated global action: Food versus fuel

Finance ministers from around the world, gathered in Washington for the IMF-World Bank meeting, havewarned that surging food prices could reverse progress on poverty reduction in the developing world.Many have called for a common effort to deal with the immediate problem of food prices, which havesurged 57%, according to the UN, in the past one year.

The World Bank has said there could be civil disturbances in at least 33 countries inhabited by the largestnumber of the poor. Inflationary expectations on food are such that people are reportedly hoarding foodgrains in relatively rich countries like Singapore, Malaysia and so on. This is bound to fuel furtherinflation, which in turn cause havoc with other macroeconomic variables. The first thing world leadersmust do is to arrive at an agreement that they will pursue a policy, which prevents national hoarding offood items.

Food surplus countries particularly have a responsibility not to get paranoid and impose a ban on grainexports. Developed nations like the US must review their current policy of diverting over 20% of theirmaize crop for making biofuels. The volume of grains used for biofuel equivalent to a full tank of a SUV


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could easily be the food supply for a person for a whole year! Some optimal balance must be struckbetween food and biofuels. A global consensus must be developed to deal with the food supply situationin the medium as well as long term. The medium-term solution could comprise easing trade anddistribution problems. Fortunately, most food importing nations have reduced agriculture tariffs to near0%, something the WTO could not achieve all these years! True, this is the short-term response but ther

Journal of FInance Vol 17

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