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“The unorganized sector consists of all unincorporated private enterprises owned by individuals or households engaged in the sale and production of goods and services operated on a proprietary or partnership basis and with less than ten total workers”

All agricultural activities undertaken on agricultural holdings, either individually or in partnership, are in the unorganized sector. It excludes the plantation sector and other types of organized agriculture like corporate or co-operative farming.

“Unorganized workers consist of those working in the unorganized enterprises or households, excluding regular workers with social security benefits, and the workers in the formal sector without any employment/ social security benefits provided by the employers”.

The total employment in the Indian economy was 456 million, of which informal sector accounted for 393.2 million. The unorganized sector

constituted 86 per cent of total workers in 2004-05. Of the 393.2 million unorganized sector workers, agriculture accounted for 251.7 million and the rest 141.5 million are employed in the non-agriculture sector.The agriculture sector consists almost entirely of informal workers who are mainly the self-employed (65 per cent) and the casual workers (35 per cent).

The percentage of non-agricultural worker in the informal sector rose from 32 per cent to 36 per cent between 1999-2000 and 2004-05. These workers are mainly the self-employed (63 per cent). The rest of the workers in the non-agriculture informal sector are more or less equally distributed between the regular salaried/wage workers (17 per cent) and casual workers (20 per cent).

An overwhelming proportion of the poor and vulnerable population depend on the informal economy (i.e. workers in the informal sector

including the self-employed and the informally employed in the formal sector). Of a total workforce of 457 million in 2004-05, 92 percent or 420 million work in the informal economy (6 percent in the formal sector and 86 percent in the informal sector). The informal workers include:

•The self-employed in the informal sector

oStreet vendors

oMicro enterprises with less than ten workers

•Casual workers

•Regular workers in the formal sector without any employment or social security.

In agriculture, these workers include:

• Farmers

• 84 percent are marginal and small farmers operating not more than 2 hectares of land.

oWhile agriculture as a whole contributes to around 19 percent of GDP, the marginal and small farmers contribute 50 percent of the agricultural output.

•Agricultural laborers

oThe bottom layer of the occupational structure

oInclude a majority of workers from Scheduled Castes and Tribes

oConstitute around 89 million

oPoorest segment in the Indian economy from an occupational point of view

Non-agricultural Unorganized Sector

•There are an estimated 58 million enterprises employing less than 10 workers

•94 per cent have an investment in plant and machinery of Rs 5 lakh

•4 per cent have investment in Plant and Machinery of less than Rs 25

Effect of the Financial Crisis on the Unorganized Sector EmploymentThe Informal Economy- Saurabh Mithal & Avni Ahuja

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How the Financial Crisis affects the Informal Economy

During the period of growth (1993-94/2004-05), consumption expanded rapidly in the top two deciles, fueling the growth, but the benefits of this growth principally bypassed the vast majority of the population (77%) who remained poor or vulnerable with an average per capita daily consumption below Rs. 20. The slowdown, however has affected the poor and vulnerable people, engaged in the informal sector enterprises or informally employed by the formal sector.

The informal economy is impacted by various factors including the international economy, the formal sector, changes in domestic aggregate demand and the flow of credit.

Major ways through which the negative impact is being felt –

• Informal Employment, i.e. employees who do not have employment security or social security cover, constitutes 45% of the employment in the organized sector. Workers in all sectors – manufacturing, construction and services, have been affected by the crisis.

• Small producers and traders who are dependent upon export markets have been affected. They contribute more than 30 percent of exports but comprise the majority of workers in the export related sectors.These sectors have been affected by declining markets, higher input costs due to the sharp depreciation of the rupee, and lack of export credit.

• The share of the non-agricultural unorganized sector in the total credit has consistently been declining since the early 1990s. The unwillingness of the banks to lend to them is reinforced by strong competing demand from the organized sector in a situation of acute credit shortage.

• The domestic demand for employment and services of the unorganized sector has reduced, due to the slowdown in the organized sector, which provides for about a third of this demand, as well as the downturn in the economy as a whole. The adverse impact of the decrease in demand is being felt across diverse segments, including vendors, small retailers and manufacturers.

• The sharp upturn in the prices of food grains and the rate of inflation has affected all categories of workers in the unorganized sector by depressing their real income. These include the rural and urban poor including casual workers, the urban self-employed and rural producers in the unorganized sector, including the marginal farmers who are net buyers of food grains.

• Small producers, both in agriculture and non-agriculture, face import competition because of the fall in international prices of several commodities. Low prices in sectors such as cotton and oilseeds production have put additional pressure on the producers.

The combined impact of all the above effects on the informal economy would be

• An increase in livelihood insecurity

• Decline in income

• Intensification in the conditions of poverty and vulnerability

Recommendations by NCEUS to protect the Informal Economy

Enhance pro-poor public investment

Boost rural infrastructure, consisting of rural electrification, roads providing connectivity, housing, drinking water, sanitation, and rural production infrastructure.

Strengthen and expand NREGP

Ensure adequate employment in the rural areas, with full transparency safeguards and proper adherence to the guidelines. There is a need for better local planning, proper monitoring systems in order to ensure accountability and the establishment of a proper and independent grievance redressal mechanism.

The scope of NREGP should be expanded:

(i) Lift the ceiling on mandated 100 days of employment per household in order to achieve critically required levels of employment.

(ii) Strengthen the linkage of NREGP with Village Panchayats by giving them a greater voice in selection of works and implementation.

(iii) Allow the State Governments to undertake projects that are compatible and/or complementary to NREG projects.

Introduce an Urban Employment Guarantee Programme

Introduce an urban employment guarantee programme as a complement to the NREGP which would help to:

(i) construct publicly funded low income housing

(ii) provide electrification, water supply and sanitation facilities

(iii) introduce slum improvement programmes wherever feasible

(iv) organise low cost waste management systems

(v) undertake projects for greening urban areas to alleviate pollution

Strengthen and expand Self Employment Programmes

Rationalisation and expansion of self-employment programmes should be encouraged. The government should undertake measures to strengthen microfinance and to facilitate the graduation of microfinance to livelihood finance.

Special Programme for Marginal and Small Farmers

Focused measures to improve access of these farmers to formal credit to improve their incomes from both farm and non-farm sources on a sustainable basis. The Commission has made a number of suggestions to augment the flow of credit to these farmers, including changes in priority sector guidelines and credit guarantee which have become more urgent in the present context.

NCEUS has proposed that a Special Programme for Marginal and Small Farmers be taken up at this stage which will focus on capacity building, training, and support for non-farm enterprises. The programme can also include other elements such as land improvement and minor irrigation.

Enhancing access to credit to Micro Enterprises

These steps include changes in priority sector lending, extension of credit guarantee and changes in the legislative provisions for debt recovery. In addition, provide adequate export credit to the small producers who undertake exports.

Create a National Fund for Unorganized Sector (NAFUS)

Creation of a dedicated Developmental Financial Institution for the unorganized sector called the National Fund for the Unorganized Sector (NAFUS) which have an initial paid up capital of Rs. 500 crore, subscribed by government and public sector financial institutions. The objective of NAFUS would be to increase the share of the unorganized sector in total credit. This would have a substantial impact on employment, and create about 57 million jobs over a five year period, increasing GDP by about 1.68 %.

A Programme for Skill Development in the Informal Economy

NCEUS has suggested an Employment Assurance Programme for Unorganized Workers to provide on-job certifiable training in unorganized sector enterprises which would help them to get absorbed in the enterprises and get support to set up their own enterprises.

A National Minimum Social Security for Informal Workers

NCEUS suggested a universal but minimum level of social security for the workers. It consisted of

(i)! Sickness and maternity

(ii)! Disability and death

(iii)! Old age security

The NCEUS proposal is estimated to cost only half a per cent of GDP to the government for all the unorganized workers. The benefit of a universal national social security for unorganized sector workers would far outweigh the costs.

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Past Trends:

About global and Indian trends: Globally the last year (CY 09) saw M&A deals worth USD 2.1 tn being announced vis-à-vis USD 2.9 tn in CY 08 and USD 4.5 tn in CY 07; the deal scenario in India reflects similar pattern with total deal size worth USD 12.0 bn in CY 09 vis-à-vis USD 31.0 bn in CY 08 and USD 51.1 bn in CY 07. Similarly overall M&A and PE deal volumes have reduced drastically in the last two calendar years from their peak CY 07 levels.

Within the M&A space, domestic deals have been consistently increasing in terms of their deal size throughout last two calendar years vis-à-vis their CY 07 levels. Conversely, cross-border deals (both inbound and outbound) have been on a consistent decline throughout the last two calendar years both in terms of deal volumes and total deal size.

As far as PE deals are concerned, following the 2008 credit crunch, PE investors have been increasingly focusing on the operational management aspect of companies; this coupled with the shortage in fund availability has resulted in a cautious approach adopted by them,

accounting for a 33% reduction in PE deals in terms of CY 09 volumes over their 07 levels and a 36% reduction in terms of total deal size

About CY 09:

The year (CY 09) proved to be a year where following the financial slowdown, domestic companies preferred consolidating their domestic positions and showed restrain in cross border activities; slowdown however ensured a number of domestic deals were successfully completed owing to lower valuations in sectors as varied as Media, Hospitality, Commodities etc.

The sector with the maximum number of deals (both domestic & cross border) was IT & ITES with 64 deals through the year, while Telecom showed the maximum total deal size (~USD 2.7 bn for 13 deals); Oil & Gas showed the maximum average deal size ~USD 208 mn (~USD 2.5 bn for 12 deals). The biggest deal in CY 09 was domestic and from the Oil & Gas sector with Reliance Industries merging with Reliance Petroleum; deal size was ~USD 1.9 bn.

Cross-border deals took the worst hit in CY 09 both in terms of volume and deal size, with both deal volumes and size falling consistently through CY 08 and 09 form their CY 07 levls. This was mainly due to the financial crisis engulfing the developed foreign countries more than their developing Asian counterparts. The split between in-bound and out-bound cross border deals stood at ratio of ~1:1 in terms of volumes and ~4:1 in terms of total deal size, emphasizing smaller number of inbound deals but with larger deal size.

The silver lining in the deal space is however provided by domestic deals whose volumes rose marginally in CY 09 over their CY 08 levels and substantially in terms of total deal size consistently over two years from their peak CY 07 levels. Thus despite the fall in deal volumes from their peak 07 levels, total deal size has been on a consistent increase, indicating larger deals being the order of the day.

As far as PE deals are concerned, when comparing CY 09 levels with CY 08, despite a 13% reduction in deal volumes there was a 15% increase in total deal size thus indicating the similar trend as seen

When The Deal Goes Down...- Rishi Lalwani and Aseem Gulati

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for domestic deals, that of lesser number of deals but with a higher average deal size.

The year’s biggest deal (CY 09) was from the Real Estate & Infrastructure sector with DLF selling ~10% of its stake to British bank Fidelity & a bunch of other unnamed investors; deal size was ~USD 859 mn. The sector with the maximum number of deals was Banking & Financial Services (46) while Real Estate & Infrastructure was the sector with the maximum total deal size (USD 4.8 bn for 43 deals); Real Estate & Infrastructure was also the sector having the maximum average deal size standing at USD 111 mn.

About CY 10:

With a rising GDP growth rate, growth in the exchange market, stronger balance sheets of domestic companies, stronger domestic demand, and the government’s efforts in encouraging investments in priority sectors of the country, the Indian economy looks set to have a better year ahead in terms of investment opportunities, including mergers and acquisitions and private equity investments.

Total M & A deal volumes in the first four months of CY 10 have already reached 82% of their CY 09 volumes, with total deal size comfortably surpassing the entire calendar year (CY 09) deal value just four months into the current year, assisted mainly by the Bharti-Zain deal worth USD 10.7 bn. Domestic deals in the first four months of the current year have already almost reached their full year volumes for CY 09. PE deals are moving steadily with four-month volume reaching 40% of their full year (CY 09) levels.

The sector with the maximum number of overall deals (M&A and PE) was IT & ITES (with 31 deals during the first quarter of CY 10). Telecom was the sector which saw the maximum total deal size at ~USD 13.8 bn.

Future Outlook:

Factors such as proposed or executed relaxation in FDI restrictions in sectors such as Insurance, Defence, Retail, Real Estate, etc., subsequent increase in FDI equity inflows, increased risk appetite seen in domestic companies accompanied with stronger balance sheets to facilitate both cross-border and domestic deals, growing domestic demand and higher disposable incomes enticing global brands to set up presence in the Indian market, volatility in the stock market and corresponding apprehensions in raising funds via the IPO/FPO route by domestic firms owing to muted public response as evidenced in recent cases of NTPC, NMDC and few real estate companies, are encouraging factors for companies

to fulfil their fund requirement via the M&A and PE route. Sectors which look likely to evidence rigorous activity in the deal space are Oil & Gas, Real Estate & Infrastructure, Pharma/Healthcare and Telecom.

Sectoral Suggestions: Within the Oil & Gas sector, PSUs such as ONGC which has recently been inducted as a Maharatna which comes alongwith their increased financial and investing power coupled with a USD 25 bn earmarked amount for overseas acquisitions, private companies looking to buy oil and alternative gas units (such as Shale), may help the sector to boom in the deal space in this calendar year.

With a highly fragmented pharma/healthcare market (market leader with a mere 7% market share, inspite of the recent deal between Abbott and Piramal), there is tremendous scope for both foreign and domestic companies to acquire their counterparts from the Indian health industry.

With an increasingly concentrated domestic market coupled with lower call rate margins as evident from the ongoing tariff wars (still a major revenue earner for telecom in India) many domestic players could look for cross-border targets to escape from the choked up margins provided in the Indian telecom segment.

With the increasing difficulty for real estate companies to tap the IPO market for funding opportunities owing to muted investor response which in turn is a fall out of the volatility in the stock market especially for companies in this sector, last year’s trend of the sector getting majority funding from PE players looks set to continue

Conclusions:

Continuing credit crisis in Europe and US, consistent GDP growth in India and the relatively safer outlook of the country as an investment destination, volatility of the stock market and subsequent investor wariness to invest in IPO/FPO of companies from certain sectors such as Real Estate, Commodities, Power, Oil & Gas etc. thus indicating a possibility of companies looking to tap PE deals for their funding requirements, government’s efforts in relaxing FDI restrictions to encourage further foreign investments, etc. are encouraging factors pointing towards a healthier M&A and PE deal space in the years to come.

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Can India Become Another Greece?- Varun Arora

The sanctity of government backed securities in the mind of investors is a concept which needs no explanation. The perceived infallibility of the government, with respect to honoring its sovereign debt, amongst the retail as well as individual investors has been prevailing for centuries. However, the onset of the Eurozone (PIGS NATIONS) crisis, preceded by the Dubai World fiasco has dealt a major blow for one of the most venerated concepts in the financial world. Not a new phenomenon, the Sovereign Debt Crisis, has like a plague, infected the unsuspecting countries all over the world. Like a vanquishing serpent, this particular crisis has been wreaking havoc among the globally integrated financial markets and economies (to a considerable extent among the standalone ones too) worldwide. A consequence of imprudent government dispensing of finances, the crisis has reinforced the age old conundrum with regards to public debt and has infused new vigor among countries to pursue their liabilities, especially the external ones with astuteness. Even India too, whose financial systems have been lauded for their resilience, and has so far been alien to any macroeconomic peril, cannot at this stage afford to throw caution to the wind.

Even as the Indian economy celebrates its astounding rebound from the financial meltdown and posts enviable growth figures, the prospects of conjuring up unsustainable levels of liabilities lurks menacingly over the economic scenario. With revenue streams relatively plateauing over the years and expenditure bills which refuse to abate, it is not so hunky dory after all, as Manmohan Singh and his team would like us to believe. At this point, one could not agree more wiith Thomas Jefferson, the third president of the United States when he quipped, “I, however, place economy among the first and most important republican virtues and public debt as the greatest of the dangers to be feared”.

India is a nation which has consistently witnessed deficits throughout its economic history. Fiscal consolidation has been a matter of concern for India since Independence. The government has switched to the path of fiscal consolidation many

times but invariably it has failed to tread the planned path due to myriad reasons. In the past two years, the global financial crisis has dealt a major blow to the government’s plans. In this light, it becomes important to study the fiscal path for India and its ability to honor its liabilities.

Although population and illiteracy have long been considered the traditional limitations of India, it is however the lack of economic insight on part of policymakers with regards to management of public funds which has compounded the problems. With debt levels occupying more than two-thirds of the the GDP and fiscal deficits at 5.5 percent of GDP, India has a lot to worry about. These are levels, which major economies who have a default history and which are at pesent facing financial ignominy, have breached before hitting the panic button.Given the phenomenal growth, India has had over the years, the debt figure should have subsided. However it has only ascended, and at present stands at a precarious 81% of the GDP. It reflects how spendthrift the Indian government has been.

India’s tax revenues continue to be among the lowest in the world (17% of GDP as compared to an average global level of 30%), and apart from one time gains like the 3G auction fees, there haven’t been consistent revenue earning sources for the nation as such. Moreover, non-productive expenses like subsidies and defence expenditure as well as deplorable amounts of interest payments continue to claw away into the nation’s funds. Subsidies continue to be a migraine for the government as well as to the nation. With 16% of total expenses going to subsidies, it is hi-time the government takes a relook at the viability of these unproductive expenses and at the purposes it seeks to serve. Decontrolling and deregulation as alternatives need to be seriously given a thought. Even though the 3G and broadband spectrum auctions have fetched considerable revenues for the government, the potential of disinvestment to generate significant inflows ( 16 lakh crore is the stake of government in liquid assets, I.e the PSU’s) is immense and should not be discounted at this stage. A host of reforms, related to taxes, subsidy reduction and disinvestment can bring the

debt levels to around 65-70% (normal scenario) of GDP as well as the deficit to 3.5 of GDP ( close to the FRBM targets as well), which still by far are not stable, but in the Indian context, manageable.

A reduction in debt may be needed not only to attract a higher rating (e.g. the median country with a Fitch sovereign rating of A has debt-to-GDP ratio of only 45 percent), but also to remain in its current grade given the wide gap from its peers. Indeed, S&P put India’s credit rating under negative watch in early 2009.

However, from this point onwards if the new debt incurred is utilized to implement several of the government’s procrastinated reforms, it will be economically beneficial to the economy. If not, the already swelled up debt figures will ascend even greater heights and cause a contraction of the economy. India’s debt to GDP can vary between 85 % and 55% over the next 5 years. It all depends how governments view the debt situation and how eager it is to carry out the various reforms.

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‘Alternatives’ that spell opportunity- Sushant Gupta & Nakul Randev

The world of investment today extends far beyond equities and bonds. Although the alternative investments are still evolving in India, they are an option for those who are looking for hybrid features in an investment.

Alternative assets typically provide economic value that would not be found in a standard investment portfolio. They could be in the form of structured products, private equity funds, real estate funds, commodities or art funds. Also, investments in art, rare coins, rare stamps, fine wine, though not popular in India, are part of alternative assets. Tangible assets are regarded as secured assets all the more these days. The increase in appetite for newer, lucrative and structured investments is a clear sign of Indian markets maturing.

A painting by Hudson River School artist Frederic Edwin Church titled Winter on the Hudson in 1993 sold at auction for $34,500. In just thirteen years, the same painting was again sold; however, this time the seller earned a whopping $660,000. If the same seller purchased the work in 1993 and then sold it in 2006, the investor earned $625,500 at a compound annual return of twenty-five percent. Another alternative investment, i.e. wine cites, similar examples of favorable returns. 1982 Lafite Rothschild was the best performing asset of the last decade, beating equities, houses, oil, stamps and fine art.   A 12-bottle case of 1982 Lafite has increased in price b y 857% over the last ten years, from £2,613 to £25,000. Wine has also outperformed gold since reliable monthly records began in 1993 with fine wine prices rising more than tenfold compared to the price of gold which has only doubled in price over the same period. Over the past 2 decades, wine has shown consistent returns and is continuing to outperform the FTSE 100. According to Liv-ex (the Fine Wine Index), in the past 5 years the index has increased 133%, a performance bettered by none of the major share indices or gold. Diamonds, another asset class in this segment, are usually tax free, and you need not pay capital gains tax that makes diamond investment all the more worthy. As the cost for diamonds isn’t a free market price, but chiefly governed by the diamond syndicate, the cost price

has been constant for almost an entire century. The price has been constantly rising for a century with the exclusion of the years 1978 to 1980, acknowledged as the “diamond rush”. There is no other investment type that is as steady as diamond investment. Real estate is another option. Traditionally, treaded into for reasons such as security or having a roof over one’s head, it is now transforming into a more productive investment option. This metamorphosis has been hastened by the introduction of REITs and REMFs in India. Not to be left behind is gold. The fact that India is one of the world’s largest consumers of gold reaffirms the great Indian love story with the yellow metal. The basis for such fervor is that traditionally Indians consider gold as a symbol of wealth and prosperity. In the last few years, with prices spiraling upwards, small investors have been forced to keep away from this sparkling alternative asset class. Gold ETFs have now come to their rescue. The objective of such ETFs is to provide returns that closely correlate with returns generated by gold. The very low denomination (as low as 1 gm) is ideal for retail investors. Moreover, these are also backed by hallmark quality gold.

The returns on such investments undeniably surpass the returns on conventional financial instruments. For example, the past year saw the return of gold at 18.4%, while bonds averaged between 2.7 and 3.1%; astonishingly, American art accumulated a 34.6% compound annual rate of return during the same period. Mei and Moses investigated the correlation between American art index and the S&P 500 Total Return index. Using data from both indices, Mei and Moses discovered that American art and the S&P 500 produced a correlation coefficient of .22. This relatively low figure indicates that the American art market did not strongly follow the trends exhibited by the S&P 500 during the past fifty years. This information is important as it suggests that American art can act as a means to diversify one's portfolio and hedge against portfolio depreciation in times of stock market crises. A similar study done in the context of Russia, China and India shows that India exhibits the strongest Sharpe ratio of all the three emerging art markets and by far the strongest average annual return. Moreover, the Indian art index has a negative market beta and a nearly zero correlation with the S&P 500, which makes it another interesting investment for a well-diversified portfolio The economic case for investing in alternative investments is also compelling: supply is static - fine wine cannot be

replenished, exhaustible diamond mines etc  and demand far outstrips supply.   For example, wine châteaux cannot expand their vineyards to increase production as land is scarce, yields at harvest are kept low to ensure quality, weather impacts on production and every bottle opened is a bottle lost to bidders.   And similarly diamond mines cannot be replenished once exhausted.

A look at the fine wine market shows that Asia - particularly Hong Kong has established itself as the world’s second largest market (behind New York) for the sales of fine wines since all wine duties were abolished early in 2008.  Last year, Hong Kong sold £41 million worth of wine in 14 auctions. The city’s 2009 imports of the beverage rose 41% to £331 million. India too is emerging as one of the fastest growing markets for wine. Despite the country’s vast population of over 1.1 billion, the consumption of wine remains extremely low, indicating huge potential for growth in the coming years. Various factors such as favorable government policies, increasing disposable income, amplified wine marketing and influence of western culture are helping to drive India’s wine consumption. The Indian Wine Industry Forecast projects that wine consumption in India is expected to grow by 25-30% annually between 2009 and 2012.

Recently budding markets in China and India have such an enormous potential in terms of diamonds. India makes use of nearly one million diamond polishers. India polishes around 80% of the world’s diamonds. Indian export figures have been incessantly rising by 20% every year for the last 5 years. There is a huge demand for diamonds and the mines can’t generate as much as they could sell. The economy in India and China started already to boom and a new upper-class comes out which will drastically enhance the demand and the price for diamonds.

In a developing economy, real estate is a rewarding option and in India many who haven’t even heard about many financial investment instruments take it seriously. Alternative investment as a whole is still in the nascent stage in the country. But there is nothing to contemplate, when we are still having an underdeveloped equity and bond market. The ‘alternative investment’ market surely has a lot to offer. The depth and the complex nature sometimes makes it difficult to analyze. Even though the opportunity for getting higher returns may be alluring, the primary focus of such alternative strategies should be optimal portfolio

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Measurement of Intellectual Capital- Abhijeet Mallick &Akshay Gupta

WHAT IS INTELLECTUAL CAPITAL?

Intellectual capital (IC) is a collection of all the ‘non-financial assets’, which despite their non-financial nature helps in determining the value and the competitiveness of an enterprise. Intellectual capital includes ‘intangible assets’ that are the real source of creation of value in a company and is mainly the ability to create future value creation either through in house research or purchase of new technology from outside. Intellectual capital includes wide range of assets such as knowledge and skills used to manufacture goods and provide service that are propriety to company; knowledge of employees deemed critical for company’s success; loyal customers; management information systems and other information that might have value for a competitor that is not common knowledge.

ELEMENTS OF INTELLECTUAL CAPITAL

Intellectual Capital can be categorised into broadly following groups:

Internal: Represented by Human capital and Organizational capital. Human capital includes sum total of useful knowledge, competencies and skills of the employees. Organizational capital includes collective knowledge that cannot be attributed to an individual such as information systems, intellectual property, policies and processes.

External: Represented by relations that a company has with external bodies such as suppliers, customers, clients etc

The Intellectual capital can be further classified as:

Intangible assets: Intangible assets are defined as identifiable non-monetary assets that cannot be seen, touched or physically measured, which are created through time and effort to strengthen demand (goodwill, brand, trademark) and identifiable as separate assets. They are also the claims to future benefits that do not have a physical or financial form.

Immaterial assets: Immaterial assets are also those

assets which are created over time. These assets improve the efficiency of assets in the production process which transforms inputs into outputs. It includes patents, research knowledge, project specific human capital etc. Firms use processes standardization, research and development etc. as tools for improving the efficiency of inputs for the creation of immaterial assets over time.

Immaterial assets are those assets used in the firm’s permanent productive activity but they are not easily observed, measured and/or quantified. Immaterial values needed are calculated or proxies from immaterial asset and related accounts Agustín, Escuer and RamírezAlesón (2005)

IMPORTANCE OF INTELLECTUAL CAPITAL

The values of identifiable intangible and immaterial assets are important to:-

a) Shareholders and investors, for use in assessing the true worth of the companies and in evaluating capacity to turn around in the event of a mis-happening. A good example will be Satyam. After the fiasco, the company’s immaterial assets will be instrumental in the turnaround of the company as these assets can provide services which have quality flowing from the processes of production that have already been established and the knowledge that it has generated and the human capital that it has created over years. However because of the fiasco the brand value, i.e., intangible assets has been eroded which might make it lose clients. Thus leading to demand erosion due to diffusion of brand.

b) Management, as a useful tool for measuring performance of the company. Performance in terms of increased expertise and competence of employees over time etc adds value not less important than the traditional income statement items such as revenue and profits.

c) Financers, as a benchmark in assessing the borrowing capacity of a company for funding. Sophisticated lending institutions now recognize the value of certain intangible/ immaterial assets as security for loans.

Firms undertaking innovative activities typically hold specialized equipment and a large share of immaterial assets, such as patents, research knowledge, and project specific human capital. Hence, more innovative firms tend to have a different capital structure from less innovative ones, Puzzolo, Nucci and Schivardi (2004)

HOW TO MEASURE IC?

There are 2 general methods of evaluation of Intellectual capital.

1. Component by component evaluation

2. Financial Basis Measurement

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Component by component evaluation:

This includes valuation of company’s human, structural and customer capital. One of the methods is Skandia’s “Navigator approach based on Edvinsson Malone Model”. Another one is Brooking Model. We will be taking up Skandia Model for evaluation.

Financial Basis Measurement:

There are 3 measures of intellectual capital at the organizational level: Market to Book ratio, Tobin’s and calculated Intangible value. The idea of these 3 measures is to determine the value that the stock market gives to company and then compare this value with value from the balance sheet of the company. Any difference is attributed to intellectual capital not captured by our accounting systems.

Market to Book ratio:

This ratio assumes that company’s approximate worth is indicated by market value which is estimated by MPS multiplied by number of shares outstanding. Therefore the difference between book value and market value gives approximate measure of intellectual capital.

However this method has many shortcomings. Firstly stock prices are affected by many other economic factors not associated with assets. Secondly book values have depreciated historical costs which never coincide with “true” value of tangible assets.

Tobin’s “q”

This measure can be calculated as book value of a company adding back accumulated depreciation and making proper adjustments for price changes in different classes of assets from time of purchase. It is based on the hypothesis that market value of all the companies in stock market should be equal to their replacement costs. The theory says that if “q: is greater than 1 and greater than its competitor the company has ability to produce higher profits because of an intangible factor which is IC. However it suffers from drawbacks like how to adjust for price changes and get replacement costs which all have been hypotheses.

Calculated Intangible Value (CIV)

NCI research has given a method for companies to estimate total value of their intangible assets. This method is based on presumption that market value of a company reflects not only its tangible assets but also its intangible assets.

NCI RESEARCH MODEL:

The value of IC can be calculated in seven steps:

1. Calculate average pre-tax earnings for past three years.

2. Take average year-end tangible assets for same three years from balance sheet

3. Divide the earnings by assets to get return on assets (ROA)

Company’s Average ROA=AVG % EBIT of company for 3 years/Avg tangible assets of company

4. Find industry average ROA (IROA) for same three years.

Industry’s Average ROA=AVG %EBIT of all companies of sector for 3 years/Avg total assets of all such companies

5. Multiply IROA by company average tangible assets. Subtract this value from average pre tax earnings to get excess returns.

6.Calculate the 3 year average IT rate and multiply it by excess return.The result was subtracted from excess return to get an after tax premium attributable to intangible assets.

7. NPV of premium is calculated by dividing premium by cost of capital. This gives the value of intellectual capital in terms of currency.

This value is termed as Calculated Intangible value (CIV) which is a measure of company ability to use its intangible assets to outperform other competitors. However this is not the market value of intangible assets.

MV of intangible assets = Market Capitalization - Tangible assets.

Market value will reflect what it would cost for new entrant to create these assets from scratch. The values of all relevant data can be easily obtained from databases like PROWESS.

Limitations

The limitation of this model is it cannot be applied in case of companies ROA is less than Industry average ROA.

SKANDIA MODEL:

Organization IC as defined by Edvinsson and Malone was “iC” where ‘C’ is some absolute value of intellectual capital in currency and ’i’ is the organization coefficient of efficiency in using that value.

Some of the prominent IC Absolute measure (C) indicators are:

1. New Market Development Interests: This includes expenditure on development of new customers and clients like advertisements spend.

2. Industry development investment: This index measure participation of company in industry wide efforts like trade organizations, salaried to executives etc.

3. Change in IT development: Amount spent on IT initiatives.

4. Employee Training and development Investment: This includes training for both part time and full time employees regarding products and services for development of skills of employees.

5. Partnership/JV Investment:

6. Upgrade to EDI/Electronic Networking System.

7. New Patents/Copyrights: This includes investment on acquisition of new patents and copyrights purchased.

The coefficient C=N/X where N is the sum of the values of seven absolute indices and X is the number of those indices. Also to be noted is that this list is not definitive and exhaustive and other indices may be included as per industry. This list actually emphasizes what investors need to know about future value of company.

The next step is to create a countervailing figure that test these investments against real life productivity and value creation which is denoted by Coefficient of efficiency (i)

IC Coefficency (i) indicators are:

1. Market Share (%): This is computed on the basis of revenue generated by company in the year and total revenue of the Industry.

2. Customer Satisfaction Index (%): This is generally tested using a questionnaire and gauging the judgment and satisfaction level of customers. It mainly insists on three factors: Quality of product and services, after and before sales service and overall satisfaction level of customers.

3. Leadership Index (%): This index actually checks the leadership skills of managers in the company. This is again conducted using questionnaire method and value is generated using different methods.

4. Motivation Index (%): This measure calculates the motivation level of employees of company and conducted through questionnaire. To measure motivation 3 key elements are judged:

•! Performance Outcome expectancy.

•! Valence of Outcome

•! Effort performance Expectancy.

5. Index of R&D Resources/Total Resources (%): This measure the fund allocated to R&D out of the total resources. This index is calculated using the following formula:

R&D Expenditure during the year *100/Profit after Tax+Depeciation

6. Index of Training Hour (%):

It reflects the percentage of time the company devotes to training & development which is crucial to competitiveness.

7. Employee retention (%):

It is measured as (1-Employee turnover ratio).

Employee turnover ratio is calculated as follows:

Number of employees left during the year

Employees in the beginning of year + Employees

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THE VALUE OF IC IS OBTAINED BY PRODUCT OF i AND C USING SKANDIA MODEL

Accounting rules in other major jurisdictions – towards convergence

US accounting rules are the most comprehensive and onerous in the area of accounting for intangible assets and are only applicable to US companies and those non-US companies who have US registrations. However the rest of the world is moving towards the US model. International Accounting Standards (now referred to as International Financial Reporting Standards or IFRS) are becoming the preferred accounting and reporting format for much of the corporate world outside the US. The European Union will be using IFRS widely by 2005, Australia is proposing to introduce IFRS at the same time and these standards have already been adopted in many of the emerging economies worldwide

.

Current IFRS are similar to the US standards but there are some key differences, as follows:

•   IFRS will only recognise intangible assets to which the business has a legal right whereas US standards also recognise those to which it has an economic right. Therefore a US GAAP balance sheet will have more identified assets and less goodwill.

• Under US GAAP, in-process R&D acquired must be immediately expensed whilst under IFRS this asset is capitalised and amortised. Thus US GAAP profits take a hit immediately following an acquisition whilst those under IFRS smooth this over the next few years.

• Goodwill is still amortised under IFRS, usually over a maximum of 20 years and thus there is no impairment review unless a trigger event has occurred to suggest that goodwill is impaired.

As part of the formal convergence project to achieve truly international accounting standards, the IASB and the FASB are working together to remove as many of the differences between IFRS and US GAAP as possible. The major step in this direction affecting intangible assets is that the IFRSs relating to accounting for business combinations and intangible assets are currently

being revised to bring them more into line with FAS 141 and 142.

CONCLUSION:

The measurement of IC has become very relevant and more and more statutory bodies are recognizing the needs of standardizing the accounting standards and include IC in balance sheet. Valuation of IC is very essential to truly determine the value of an enterprise. However we can easily see that the paradigms of accounting are so strongly influenced by a tangible assets view that it is very difficult to give credit to the characteristics of IC on the balance sheet. Most importantly, accounting has difficulties in determining the value of IC. The absence of organized, transparent markets has so far been considered as an additional impediment to measure the value of IC. Since accounting follows the paradigm of recording business items at their price in a commercial transaction, only IC that is licensed or sold can be reflected on the balance sheet. Given the inherent multiple challenges in accurately determining the value of IC, coupled with the volatility of the value of some IC, it is no wonder that the accounting profession (and the market) fears that the reporting of a firm's IP may be considered as too subjective and risky. Furthermore, accounting has always been, and still is, very reluctant to anticipate future gains, overstate the value of assets or include assets on the balance sheet whose value is more volatile.

References:

•! Brooking, Annie, Intellectual Capital: Core Asset for the Third Millennium Enterprise, International Thomson Business Press, New York, 1996

•! Thomas A. Stewart, Intellectual Capital, (New York: Doubleday Currency), 1997

•! Edvinsson, Leif and Michael S. Malone, Intellectual Capital: Realizing Your Company's True Value by Finding Its Hidden Roots, HarperCollins Publishers, Inc., New York, 1997

•! Brooking.A.,Corporate Memory;Strategies for Knowledge Management. International Thomson Business Press, London,1999

•! Edvinsson, L. and Malone, M., Intellectual Capital. Harper Business, New York, NY, 1997

•! Lesser, E., Knowledge and Social Capital. Butterworth Heinemann, Boston,MA.

•! Stewart, T. Intellectual Capital. Currency Doubleday, New York, NY. Nahapiet, J. and Ghoshal, S. 1996. Social Capital, Intellectual Capital, and theOrganizational Advantage. Academy of Management Review, Vol. 23:2, pp. 242-266, 2000

•! Kuhn, T., Structure of Scientific Revolutions, Univ. of Chicago Press, Chicago,IL, 1962

•! Nucci, F., Pozzolo, A. and Schivardi,F., “Is firm’s productivity related to financial structure? Evidence from microeconomic data”. Banaca d’Italia, Research Department, 2004

•! Augustin,G., Escuer,M., and Aleson,M. “Spanish investment on material and immaterial assets” CREVALOR Research group, (DGA-Spain)

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MFI: Mutual Funds of India-Ankit Gangwar and Gaurav Kumar Somani

1st August 2009, was a historical day for the Mutual Fund Companies in India. The Indian Mutual Fund (MF) industry has witnessed one of its major alterations in its business processes on this day, as the ban on entry load in all MF schemes imposed by the market regulator Securities and Exchange Board of India (SEBI) came into effect. SEBI issued instructions that no mutual funds can levy any entry charges for investments but allowed distributors to claim a fee for their advice from investors. It also directed them to disclose commissions earned to clients. “Entry Load” is the upfront charge in form of fees levied by fund houses when an investor puts money in various schemes. This fee used to vary from 0% to 2.5%.

The ban on entry loads which was used by money managers to pay distribution commissions – is seen by insiders as a paradigm-shift to reform for the Indian market.

In the last one year, this move by SEBI has impacted the distributors and the Independent Financial Advisors (IFAs), as their margins took a hit because of SEBI’s action.

However because of the ban, it was expected that there will be a reduction in business and activity will slow down. The ban was supposed to change the intermediation that existed earlier, because of the revenue pool that fund managers and distributors work on and which they share between themselves will be reduced from August 1 onwards.

The act also discouraged unnecessary NFOs (new fund offers) because previously a distributor who was earning 2.5 percent commission was interested in churning people from one scheme to the other just to make sure he makes his commission. The following figure shows that how even during the recession period the number of NFO’s were higher whereas in the last one year when the stock index has almost doubled the NFO’s has reduced by significant number.

Figure 1 Number of NFOs, Source : Value Research

As per Value Research, a mutual fund tracker, in 2007, 79 new schemes were launched that collected Rs39,785.50 crore. In 2010 so far, MFs have launched 39 equity and hybrid schemes that collectively mobilized only Rs2,101.78 crore. The largest collection by an equity fund NFO in 2010 so far was Rs477.99 crore.

The business models have changed since now as distributors, who got an upfront fee from about 2.5 percent entry load that equity funds charged will now have no interest in making investors switch funds. Instead, they stand to gain more in the form of trail fees or the money they get from fund houses on continuous basis, if investors kept the money invested longer. Distributors in the last one year have been trying to evolve an advisory fee model and are attempting to get remuneration from fund houses for distributing products either in terms of upfront or increased trail

The ban had a big negative impact on India’s $137bn (€96.4bn, £86.2bn) mutual fund market, because distributors will have less of an incentive to promote new products offered by the mutual funds. Figure 2 how the industry has been hit badly and now needs to take design strategies and offers which may again pull investors and distributors to the MF companies.

Figure 2 Source: Association of MF in India

 As commissions went down, distributors at large stopped selling MFs. From August 2009 to June 2010, a total of Rs70,169 crore has gone out of MFs as redemption. This is way higher than the outflow of Rs33,510 crore from August 2008 to July 2009. Ever since entry loads were abolished, more

money has gone out of MFs than has come in. MFs saw a net outflow (more money went out than came in) of Rs7,529 crore against a net inflow (more money came in than went out) of Rs8,780 crore from August 2008 to July 2009.

In the past 1 year fund managers have faced growing competition from insurance and pension funds, since distributors marketed more products similar to mutual funds that were not hit by the entry load ban. After the ban the agents switched to selling products that fetched higher commission, such as unit-linked insurance plans (Ulips). As per data available, Rs1.09 trillion came into Ulips between June 2009 and March 2010. Although the cost of Ulips has come down through a series of regulations in the insurance sector, agents still make more money in Ulips compared with MFs

However the new structure has many benefits not only for the investor but many long term benefits for AMC’s, fund houses and the economy as a whole. The fixed entry load structure followed earlier, had an embedded conflict of interest for distributors. As distributors made a fixed sum on mutual funds irrespective of their performance, they had an incentive to push MF schemes, without investor needs. This led to multiple useless schemes and hindered long-term asset creation. In the current setup, the investor will pay a fee to distributors and has the option to negotiate it based on the quality of the service provided. In a nutshell, the new regulation will lead to long-term asset creation.

It is important to note that the problem of lower sales and need of huge distribution channels exist because the products offered by asset management firms are similar, if not same. Gold ETFs, for instance, are offered by seven asset management firms. The removal of entry load would encourage asset management firms to offer investment solutions. In other words, asset management firms would not actively sell individual products, because it will be difficult to do so. Rather, firms would look to offering a suite of products from their fund complex to enable investors construct a portfolio to meet their investment objectives.

Investors had been the largest beneficiary. They did have to visit personal finance Web sites that ranked funds based on three-year and five-year returns. Neither do they had to pay a part of their money to someone trying to force an unknown scheme on to them.

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Fuel Price Deregulation – like a bitter medicine- Lovesh Singla

On the 25th of June, 2010, The UPA Government. headed by Shri Manmohan Singh took a bold step in the direction of Economic liberalisation which none of the previous governments before his could. The Government. of India decided to deregulate the prices of petrol, i.e. to free it from the control of government. Deregulation means that retail prices of Petrol in India would be directly linked to the prices of Crude oil in International Market.

An effort to bring in this much needed change was made by previous governments as well, like that of NDA headed by Mr. Atal Bihari Vajpayee, but could never go ahead with the implementation because of lack of political will and election mandate. The Sundarajan Committee report in Feb 1995 favoured deregulation of the petroleum industry at one stroke. However the Strategic Planning Group on restructuring the Indian Oil Industry headed by the then Petroleum Secretary, Dr Vijay Kelkar , felt the switchover should be in a phased manner. Mr. Kelkar then chaired a committee dubbed the “R Group”, R for reform, which recommended opening the petroleum sector to private investment and deregulation of petroleum and petro product pricing.

Finally an Expert group was formed on “A Viable and Sustainable System of Pricing of Petroleum Products” and Dr Kirit Parikh was made its chairman. Dr Parikh committee submitted its report on 26th March to Indian Government. suggesting a possible route to achieve complete deregulation of petroleum products in India. In the step by step approach laid down by the Parikh Committee the prices of Petrol, Diesel Oil have been deregulated from control of Government but the prices of Kerosene Oil and LPG is still regulated. But the report categorically mentions that the kerosene subsidy benefitted only a small section of the poor people in the country, because 75% to 80% of the rural poor used biomass for fuel. Also, all subsidies, as a general rule, led to market distortions; and the kerosene cheaply sold through PDS outlets mostly found their way to open market for cashing in from the wide price differential. Cheap kerosene, diverted in this manner, was widely used to adulterate the pricey

diesel and petrol. Hence it even lays down a roadmap how Government can deregulate all petroleum products over a period of 18-24 months.

The Kirit Parikh Committee recommended in March 2010 that the current estimate of 2009-10 under-recoveries, which is around Rs. 45,571crore, should come down by 67% to Rs.15,120crore, in the following way

Effect of Oil Price Deregulation on Stake holders

It is said that “When Oil prices start heating up, whole nation starts running a fever”. It is rightly so because the prices of Oil affect the budget and lives of everyone, right from the Multi-national Conglomerate to a Daily wager. Increase in fuel prices not only affect due to increased expenses of personal transportation but it even has an spiral effect in the form of transfer of increased cost of transportation to final prices of Food items, vegetables, cement, iron ore and almost everything.

Effect on Indian Government

• The fiscal deficit of the Government as reported in Annual Budget 2010 was 6.9%, but the catch is that this figure does not include the Government bonds for Oil and Fertilisers. At the time of maturity of these Government. will have to honour them and if this figure is included in deficit, our FD reaches a scary and destabilising figure of 11-12%. In order to reign this figure, it was imperative that the additional load levied by petroleum subsidies be brought down. If all petroleum subsidies were to be slashed, deficit could be brought down to a more manageable 4.5% from 6.9%.

• Petroleum is a product with high Price elasticity, hence this price rise will lead to lower consumption of these fuels, hence bringing down India’s Import bill and saving considerable amount of Foreign Exchange.

• Increase in prices of petrol, diesel would lead to better profit margins for oil companies like BPCL, HPCL, IOCL etc and can lead to an increased cash flow for Government in form of taxes.

• Indian position and standing on global platforms for Climate change (Copenhagen Meet) has been battered down by developed nations which single out few of the developing nations for the subsidy given by them to their citizens.

Effect on Oil Companies

• Like mentioned above, this price rise will help reduce the under recovery of Oil companies like HPCL, BPCL etc helping them to improve their profitability, cash flows and ensure better returns for share holders

• Increased cash pool will allow these companies to bid and explore for new underground Oil stocks under NELP policy of Indian Government. Not only this, even overseas oil fields acquistions in Russia, Canada (Oil Sand), Africa etc. can be ventured into.

Effect on Common Man

• In the short term or as an immediate effect, a rise in prices of petroleum fuels will lead to increase in inflation. Indian economy is already going through the phase of High Inflation Rates (10%+) and the common is facing the brunt of such high CPI. An increase in fuel prices at this juncture are bound to increase the overall inflation rate.

• Due to increased prices, this will lead to more prudent use of resources by Citizens and hence overall less consumption of these resources leading to increased efficiency, lower population.

• As a chain of thought, Over a period of few years, if the under recovery due to fuel’s regulated prices was not checked, it could have lead to increase of Fiscal deficit to unmanageable proportions forcing Government. To service debts by either printing more currency or Selling off Government Assets, which would lead to runaway inflation in first situation and loss of face for the union in latter case.

• Finally due to costly fuels, there might be a strategic shift to renewable sources of energy leading to less dependence on the import of fuels and a better ecological balance.

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Niall Ferguson in his book, “Ascent of Money” explains how one of the  causes of the financial downturn was the fact that financial instruments had become so complex that their underlying risks became less apparent even to those who developed these instruments. Paul Volcker, former chairman of the Federal Reserve and an advisor to President Obama, has famously claimed,” I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy."

There exists a dichotomy today when we see the transformational effects of certain innovations that promote entrepreneurship and self employment and on the other hand instruments such as collateralised debt obligations and Credit Default Swaps that contributed to the economic crisis and put burden on tax payers all over the world. These new forms of securities put such a large gap between borrowers and lenders that   persons investing in these securities had no idea what they actually represented. No Icelandic pensioner knew that his life savings were being invested in mortgage backed securities (or for that matter, what “mortgage backed securities” meant)!

So, does this mean we should stop innovating in financial markets?

We should not forget that some of the most profound changes that led to so much prosperity and financial growth were a result of innovation. What is different here is that those innovations sought to simplify financial transactions and not the other way round. In fact we have seen a host of financial innovations that have not had anything to do with the crisis but in fact helped the world economy and businesses by making it easier for them to procure finance. E.g. Private Equity and Venture Capital.

We see the evolution of financial markets of the world as a series of Financial Innovations. History provides many examples: London's capital markets of the 19th century that led to the formation of the first Joint Stock Company: The Dutch East India Co. and America’s mid-20th century financial system that have led to such unforeseen progress in information processing, telecommunications and medicine that have been experienced in the last 30 years.

Then there is also the school of thought that says that financial and technological innovations are interlinked and one cannot exist without the other and it is very important to have both for a country

to prosper. Adam Smith described that at the heart of economic growth is increased specialisation and the use of more sophisticated technologies. With improved technology, come challenges of investment. Any new technology must be evaluated for investment since it may bring some new risks along with it. Thus, economic progress automatically leads to obsolesce of existing financial systems. Thus financial systems need to keep pace with economic progress else there will be a fall in quality of financial service leading to slowing down of economic growth. For example, post liberalization in India, many new technologies became available to the public. Firms diversified and became bigger. The IT revolution happened. All of this automatically led to the government allowing some new forms of securities to be traded in the market and banks coming up with new kinds of loan schemes and funds. So we can see that to a large extent, technological progress necessitates financial progress. Therefore financial innovation shall continue if we want to develop further scientifically.

Here, it is important to note that the role of a financial institution is seen as that of a facilitator. It is essential to realise that the financial system is not an end in itself but a means to an end and the

Did the financial crisis signal the end of financial innovation?- Aastha Chawla & Shefali Saroha

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the measure of the success of the financial system must therefore measure its success by the extent to which it accomplishes the broader societal objectives of extending prosperity by supporting industry and employment. A good financial system performs all of the above mentioned roles at low transactions costs. There are some financial innovations, such as the venture capital firms, that have facilitated the flow of funds to new enterprises. But there are also those transactions that developed as a product of this financial system but have been found to be used in creative accounting and tax evasion, activities that may enhance the profits of the companies employing them, but not the efficiency of the economy. They have helped governments and firms hide their financial doings from taxpayers and investors. We saw in the case of the Greek Debt Crisis how for years Greece managed to hide its actual public debt by using accounting principles to manipulate statements. And those benefiting from such deception have been willing to pay amply for it, with large profits to the

innovators, even if society as a whole loses.

Warren Buffett has said that derivatives were financial weapons of mass destruction. They were easier and more tempting to abuse than to use well especially when there were high monetary incentives for abuse. They made non-transparent transactions easier and lack of transparency always affects markets negatively. Some of the financial products increased the problems of information asymmetry (some powerful investors had more information than others), stretching the limits of moral behaviour. A similar argument can be made for Collateralised Debt Obligations.

Highly leveraged securities were sliced up, bundled and repackaged in markets both domestic to their origin (US) and foreign. These layers of transformation further hid their origins and toxicity.   Also, it was incorrectly assumed and through unsound assumptions proven that these securities minimise risk. This led some of the most credible credit rating agencies giving these

securities a three star rating. When the real estate markets, on whose assets these instruments were backed, collapsed, the very foundations of the financial system were rocked. In fact, even after much analysis and discussion on these aspects, most small and medium portfolio owning laymen still do not understand   how these securities work. Credit Default Swaps and in particular the naked CDS have also affected interest rates all over the world due to the intense speculation taking place in their markets.

All of these problems point to one direction: We need to simplify. This does NOT mean we cannot innovate. If we look closely, most innovations that changed the financial world simplified transactions: Concept of Joint Stock Company found a way to finance long voyages( and later large businesses) without incurring huge debt that had to be recorded regularly, banking sought one central unit to cater to borrowing and lending needs of a group rather than persons interacting on a one-to-one level all over the group and Microfinance is a simple idea that

lends money in small amounts but high interest rates to rural populations. An excellent idea always sounds simple and elegant but only after it is conceived! Before that it is as complex as CDOs/CDS etc! Today there is an even more pressing need for financial innovation coupled with good regulatory practices. We need new forms of investment through which individuals and companies can invest in businesses local as well as global and know the exact credit worthiness of their investments by understanding exactly how their money is being spent. There has to be more information disclosure on the part of investment banks.

Along with these measures, we as consumers should try and learn thoroughly about the securities we are investing in. Think: If the Icelanders knew that somewhere at the end of the chain their pension money was backed by nothing more than mortgages taken by Sub-Prime borrowers, would they have put their trust in these securities?

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Financial Regulation - How to prevent financial crisis in future?- Sridhar N & Girraj M

My first brush with financial crisis was at the age of 15. Uncle Sam, inspired by "Rich dad Poor dad", asked me to explore “investment opportunities” with his seed capital, which I promptly lent to friends, the expectation being to generate a return. Uncle Sam, unaware of my “splurge instincts” and “well informed” by my friends, of the investment returns they were paying, encouraged me with further capital investment. Moreover, daddy - Fed trusting my financial ingenuity incentivized me with more money. Lady luck blessed me more friends willing to borrow “pocket money” and pay even higher returns. The capital genie inside me awakened and bought “Housie games” and lent it on a “partial payment” to friends, popularizing housie games to an extent where friends were willing to buy and sell their “leveraged housie games” among themselves at higher prices albeit lower “shop price”. Crisis hit me when not only did my friends, bored by Housie games and unable to sell it to other friends, returned the games back, but also my “rich” uncle and dad asked me to return back the money. This got me thinking, how I could prevent such financial crisis in future.

As the cliché goes, “You can see history repeat itself if you live long enough” and we hit the analogous financial crisis in the later part of 2009, the worst since the Great Depression of the 1930’s. Summarizing the causes - US markets were flooded with capital that were diverted to housing assets during early 2000, financial innovation led investment banks securitize loans and lend to investors who, including the credit rating agencies, did not understand the risks involved in such products, lax economic policies and the regulator’s constant deregulation initiatives led to the current crisis.

Now as for containing such crisis in the future we propose the following 10 measures.

First, excess flow of capital into a particular asset class needs to be monitored and contained by Governments. Any creation of ‘bubble-like’ scenario must be identified and eliminated at an early stage requiring regulatory bodies to oversee macro level indicators along with managing

financial adequacy at individual organizations. This translates to my pocket money being regularly checked by Uncle Sam.

Second, securitized loans need to satisfy the same capital adequacy norms as the underlying asset would. This would require financial institutions and rating agencies to scrutinize and rethink the company’s investing strategy. Securitization would then be a means to diversify risk using balance sheet than taking risks outside of the balance sheet. This translates to my friends paying me adequate amount to cover the cost of the “Housie game”.

Third, asset transactions need to be valued based on marked to market model instead of valued at maturity model. Many financial institutions failed to assess the risk associated with the underlying distressed assets as their risk management models assumed value at maturity rather than the market value at a given point, resulting in false inflated prices in risk management models. This translates to the “housie games” being revalued as per the market price.

Fourth, in today’s modern free trade financial world that is completely integrated with global markets, regulatory bodies at global and local levels need tighter communication flow to disburse information and take quick action. The action could also involve local government institutions banning certain type of products in their markets or restricting the global market reach in its local markets, Indian public bank sector

shielded from foreign investments is a case in point.

Fifth, bankruptcy laws across markets need to be revamped to provide clear ownership guidelines of the bankrupt assets and the follow of liquidated proceeds. Currently, such laws have varied degrees of flexibility and the intervention of state is on a “need” basis. This translates to what measures Uncle Sam could take when my friends ask to return back their money spent on the housie games.

Sixth, Investor protection and Tax policies need to be overhauled to ensure adequate disclosures are done about the products sold to investors.

Seventh, transfer of risks from one product to another or from one market to another in an unrestricted manner is what resulted in the “contagion” effect of the financial crisis. Hence, to keep future crisis in check, we will need to ensure that additional rules are regulations are enforced on “transfer of risk” products such as derivatives and securitized loans.

Eighth, more transparency into the risk management practices of the financial institutions are critical to reducing the response time to a particular crisis.

Ninth, academicians have proposed a central clearing mechanism for settling derivative transactions. However, investment banks foresee huge costs in integrating and maintaining interaction with the clearing systems. Nevertheless, it is a perfectly valid suggestion keeping the long term risk mitigation ability built into the system.

Tenth, the suggestion is to create a pool of backup capital, in the lines of reserves of countries, for rescuing institutions in a country from failing over short time periods. Also, such institutions could be easily identified regularly by conducting “stress tests” on their balance sheet assets.

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The modern world has been engulfed by many a financial crises in the recent past. The most devastating financial crisis of the century occurred in 1929, which led to the Great Depression and since then, humans have been witness to many a crisis, and have managed to survive them all. Economists and other financial experts have outlined many a reason for these financial debacles. The irony is that despite many of the causes being similar, history tends to repeat itself and we are confronted with similar problems again and again. For example, after the Great Stock Market crash of 1929, one would have thought that people would learn their lessons and never repeat the same mistakes. Yet, a cursory glance of the history of the last 80 years shows that we have had many similar stock market crashes, and many of them occurring in the last few decades itself. So why is it that people fail to learn their lessons? Or is it that we choose to create such problems for ourselves? Many thinker and financial gurus have tried to answer the above questions, using their knowledge and expertise of the financial domain, but are unable to explain why such events should occur repeatedly and how to prevent their future occurrence. In my opinion, the answer cannot be arrived at simply through superficial financial analysis --- The problem is an intrinsic one, and would have to be investigated deep within the recesses of the human personality.

The recent years have seen one crisis after another. The crash of the housing bubble in the US and the subsequent financial tsunami that spread across the globe, wreaking havoc in the financial markets, has made people rather jittery about the competence of the financial tsars of the modern world. Just when people started thinking that the worst was over, a small European country with a rich ancient heritage sent the alarm bells ringing to wake people up from their self imposed slumber of denial. The country in question, Greece, had never been heard of before in the context of the world economy, but in 2009-10, it became one of the most watched economies throughout the world. The issue assumed even more significance considering that the world had just been through one of the worst financial crises of the century and it sparked fears about the recovery pattern following the dangerous “W” curve ---- the economy coming out of recession for a while only to sink deeper into recession. Before discussing further, it would be prudent to analyze the context which nurtured the eastern European crisis and allowed it to escalate into such massive proportions.

Since the last decade, the Greek economy has seen rapid growth, aided by huge foreign capital inflows into the country. The Govt. borrowed large amounts of capital to fund the public expenditure which was used as a means to keep the economy rolling and give an impression of prosperity. In fact, it is alleged that the Greek Government paid huge sums of money to companies like Goldman Sachs to hide the details of their actual level of borrowing from the overseers of the European Union. For some time, there was indeed prosperity in the country --- people were living better off, wages were increasing, exports were on the rise, pension benefits for retired personnel were increased and tourists were flocking to the country and filling the national coffers. Greece was having a dream run; the best time ever since the restoration of its democracy. But as with any dream, one has to wake up one day and face reality. The global financial crisis brought a harsh end to this phase of tremendous economic growth. The two major industries of Greece, tourism and shipping were hit hard by the downturn. Investors began withdrawing their money from the markets and funds became scarce. The paralysis of the banking system and lack of credit stalled all developmental activities in the country and the economy began to stagnate. The increased wages of laborers which were brought about by the Govt. to showcase its concern for the welfare of the people returned to haunt the same Govt. as a Frankenstein. The increased wages had pushed up manufacturing costs which meant that the country’s exports were no longer competitive in the global markets. With exports down, and a global credit crunch stopping all activities, the economy began to slowdown. However, the unsustainable level of Govt. debt was inevitably going to raise its ugly head ---- And as anticipated, it did. The country woke up to a rude shock when credit rating agencies such as Standard and Poor’s, Moody’s and Fitch reduced the Govt. bonds to junk status --- which meant that the Greek Government would be unable to repay its debts in full. Hedge funds and speculators took advantage of the situation and made the situation worse, like a bunch of hyenas jumping in to snap up the remains of a carcass devoured by a lion.

The crisis had by then reached huge proportions and threatened to bring down other countries as well with investors losing confidence in the European economies and withdrawing their money in large numbers. Had it not been for the bailout, the economy would have collapsed by now. The complete picture of the situation is still not clear, as much of the recovery is still underway

and thinking person would always be prepared to receive any rude shocks.

What becomes amply clear from the above analysis of the Euro debt crisis is the fact that the human race is inherently impulsive. Investors, politicians, financial analysts and the common public lack financial prudence, emotional stability as well as integrity. Humans are selfish by nature, unwilling to work hard and lacking concern for others. Excessive consumption, living beyond one’s means and the desire to acquire more in less time have always been the root cause of a financial crisis. Left to its own, the human population would turn the world into chaos and a state of anarchy would prevail. The evolution of the human being from nomadic hunter-gatherers to the present day civilized being seems to have been incomplete, leaving behind remnants of the original mind-set of our forefathers in our minds. Perhaps that can help explain why we are interested in hoarding wealth when we know we cannot take it with us to the grave or why we consume excessively given the chance even when there is no apparent reason to do so. In the above case, the crisis was brought about by a combination of human greed, a quest for power and subsequent wooing of voters and simple indifference. So who are the culprits of the crisis? Firstly, the banking and monetary system, for not regulating the flow of money and giving into the illusion of prosperity and the desire to get high returns in short times; Secondly, the Government which tries to woo its voters with sops despite the clear knowledge of the unsustainability of such actions and its ill-effects on the country’s economy; Thirdly, the credit rating agencies which failed to call a spade a spade and added to the illusion of prosperity in the Euro zone region, especially in Greece; Fifthly the investors and speculators who show a total lack of concern for others and try to make profits from others’ distress; and finally, the general population who cannot curb their consumerist tendencies even in the face of a crisis situation with total disregard for the other fellow-human beings residing in the world. These human traits are unlikely to go away easily, and as such, we are bound to see newer crises occurring at different times. This is like a self fulfilling prophecy ----“History repeats itself”. The irony is, despite knowing our weaknesses, we are unable to change ourselves for the better. It is as the disciples say toJesus in the Bible ---- “The Spirit is willing but the flesh is weak”.

Human Behavioural Patterns as a Cause of the Euro Debt Crisis- Azar Zia & Amarjot Singh

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BASE RATE REGIME AND ITS IMPLICATIONS-Durba Ghosh & Shinei Dutta

Till 1st July 2010 if one had to take a loan from bank then the bank would have used the Prime Lending Rate (PLR) as a reference point to calculate the rate at which the loan would be granted. PLR was the benchmark interest rate based on which the various financial institutions decided their interest rates on various types of loans. For example, a bank could say that the loan interest rate would always be 0.5 % above the PLR. This would mean that if the PLR changes (increases or decreases) by a certain amount, the interest rates on the floating rate loans, by that bank, would also change by that particular amount.

Problems with Benchmark Prime Lending Rate Regime: In this regime, all those who had been subjected to steep interest hikes in the past eagerly looked forward to see the interest rate cuts from their banks but this was completely left on the discretion of the bank. The factor which bank kept in view to be able to decide to give the lower rates only to new customers while keeping older customers at a higher rate was the Benchmark Prime Lending rate (BPLR). This rate was a reference interest rate, used as a benchmark while determining the interest rate for the customer. The interest rate that was finally passed on to the customer was the benchmark prime lending rate plus or minus a certain variable percent known as “Spread”. The value of this variable was left at the discretion of the bank to set and it used to depend on other factors involved in loan eligibility like the credit profile of the loan seeker etc. The banks gave loans to top corporate organizations at a rate below the BPLR and above the rate to others thus leading the others to indirectly subsidize for the former.

Also according to Reserve Bank of India (RBI) regulations, banks were required to make changes in existing loans except fixed interest rate loans, when the existing BPLR was changed, but this did not happen because the banks had been given the freedom to set the spread from the BPLR at whatever value they wanted to choose. So while they were able to provide attractive rates to new customers, they continued to charge a much higher interest rate for older customers.

Base Rate Regime: In an effort to put an end to the practice of retailers and small enterprises subsiding large companies, the RBI had mandated that all banks arrive at a base rate for lending after taking into account common

elements across all categories of borrowers and below which no lending can be done. This regime has come into effect from 1st July 2010 with the SBI announcing its base rate at 7.5 % on 29th June 2010. This policy is aimed at removing the opaque lending practices followed by banks, improve policy transmission and to do away with poor subsidizing the rich. Now the large corporate organizations that benefited from the so called subprime lending rate have to pay at least the base rate. The base rate will also favour borrowers when the interest rate falls, as the lenders would have to revise the base rate to reduce lending rates. Under this system, RBI has asked the banks to ensure uniformity and transparency in calculating the base rate.

Advantages of the new policy:

• Equality for Customers (Benefits to small borrowers): Base rate is something more than just a reference rate. Now banks would not be able to issue loans below the PLR to some preferred customers on cost of small borrowers. Also with the previous regime the banks had started undercutting due to which they would cut rates just to beat up the competition, and increase market share, by adding new customers. This is unlikely to happen under the base rate regime. Small customers will no longer subsidize the larger ones. The range between best and the highest rates is likely to narrow down. Also, the base rates would be changed for incorporating any changes in interest rates. This would ensure that the rate hikes or cuts are passed uniformly to the borrowers.

• Easier transmission of monetary policy to the economy: Whenever RBI made an upward revision in the policy rates, banks would also mostly increase the lending rates to reflect the upward move. However, when policy rates went down, rarely did the banks pass on the benefit to the public. This is termed as “Downward stickiness”. According to reports, between October 2008 and January 2010, the repo rate (rate at which banks borrow from the RBI) reduced by about 5.75 percentage points, but the PLR changed only by under 3 per cent. Also as the base rate is calculated, taking into account among others, the cost of deposits and the cost of keeping aside cash to meet the CRR and SLR requirements, this new system is expected to help banks align lending rates with policy rate changes by the RBI periodically.

• Transparency: Under the proposed system, RBI has asked banks to ensure uniformity and transparency while calculating the base rate, which is the floor rate for all loans. As the reports suggest, after the announcement of the new regime, the banks have also explained the calculations along with announcing the rate. Hence from now on when a customer applies for a loan he/she would know that the interest rate charged is the base rate plus a premium for the particular risk profile and tenure of loan along with cost of allocation.

Issues with the new regime: With the banks shifting to the new benchmark, there is uncertainty relating to how banks would price their home loans. Banks have indicated their base rates but there is no clarity now as to the ‘spread’ at which they would lend. There is also a clause under which the old borrowers have an option to shift to the base rate as the new benchmark. This optional clause is creating confusion because if a borrower refuses to switch to the base rate, then the banks have to administer two types of benchmarks i.e. base rate and BPLR. According to the latest reports the RBI is likely to soon announce a clause with a deadline for all loans in the erstwhile BPLR system for migration to the new base-rate model.

Impact on the Debt market: As pointed out in a report from CRISIL, the new regime will make the corporates to move to the debt market. The banks having competitive base rates and efficient treasury operations would benefit from the new scenario. However the competitive pressures are unlikely to impact the overall profitability of the banking system in a major way. According to CRISIL, the corporate organizations who used to avail short-term loans (estimated at 7 to 10 per cent of total corporate loans) will now like to move to the more attractive debt capital markets, through short-term instruments. They would also like to choose banks with lower base rates. The base rate for few private sector and foreign banks is lower by 50-100 basis points when compared to that of public sector banks whose base rate is between 7.5% - 8.25%. Therefore, the large private sector banks with more competitive base rates are now relatively better placed to maximise their market share in the short-term lending space.

However in the long-term lending space, no major

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On 2nd July 2010, after the close of banking hours, the Reserve Bank of India sprang a surprise by hiking both its repo and reverse repo rates by 25 basis points each. The repo rate is the rate at which banks borrow short-term funds, usually overnight money, from the RBI, while the reverse repo rate is the rate that the RBI pays on short-term funds parked with it by commercial banks. A basis point is one hundredth of a percentage point.

Why did the RBI hike rates? To understand that, a bit of background is necessary. As the financial crisis hit Indian shores after the collapse of US investment firm Lehman Brothers, the central bank cut interest rates dramatically and flooded the money markets with liquidity by reducing the cash reserve ratio (CRR) or the amount of funds that the banks have to keep with the RBI. This was in late 2008 and early 2009 and it was done to stabilize the economy. However, India was hit by a severe drought last year, but the economy recovered which led to widespread inflation in food prices. Initially, the central bank did not raise interest rates, reasoning that the recovery was still fragile and that inflation was due to the shortage of food supply, rather than because of demand pressures.

There is not much monetary policy can do to address inflation arising out of supply-side pressures. So it was only in January 2010 that the RBI decided to act, hiking the CRR by 75 basis points. By increasing the amount that banks have to compulsorily keep with the RBI, the move sucked out excess liquidity from the system. In March this year, the RBI increased its repo rate by 25 basis points to 5% and the reverse repo rate to 3.5%. Wholesale price inflation (WPI) was in double digits, while growth in gross domestic product (GDP) was on the path to recovery. Thereafter, RBI hiked rates again in April, with the repo rate going up to 5.25% and the reverse repo rate to 3.75%. It was widely expected that with a good winter (rabi) crop, food inflation would come down. Unfortunately, that did not happen. On the contrary, the year-on-year wholesale price inflation rate for May 2010 increased to 10.16% from 9.59% in April.

Meanwhile growth in the Index of Industrial Production rose to a very high 17.6% year-on-year

in April, indicating that industrial demand was buoyant. Other indicators, such as the survey-based Purchasing Managers’ indices for both manufacturing and services showed very high growth. Conditions were therefore turning ripe for a spilling over of inflation from food prices to other sectors. That is precisely what happened. Increasing demand enabled companies to hike the prices of their products. As a result, the non-food component of inflation in manufactured goods went up to 6.6% in May, or around two-thirds of the headline inflation number. The rapid pace of this demand pull inflation can be seen from the fact that inflation in the non-food component of manufactured goods was a mere 0.8% in December 2009. That set off the alarm bells and economists started saying that the RBI was not tightening monetary policy soon enough.

They said that the RBI must act quickly to dampen inflationary expectations or the economy would have to pay a high price in terms of runaway inflation. Some economists said that India had a structural problem with inflation. They said that the growing importance of structural factors, such as rising incomes, changing dietary patterns and low yields of agricultural products played a part in keeping the prices of primary products high. Moreover, the government continues to hike the minimum support prices of agricultural products, which adds to food inflation. So the problem, they argued, is not just a supply-side one, despite the government’s protestations. But while almost everybody expected the RBI to hike rates again after the high May inflation numbers came out, the central bank didn’t do anything.

That was probably because the Greek fiscal crisis shook the world economy at the time and for a while there were widespread fears that we could have another Lehman Brothers-type crisis on our hands. Stock markets tottered and there was a rush to safety by investors, which drove up the value of the US dollar. And although the Greek crisis was averted by a bailout arranged by the International Monetary Fund and the European Union, worries about other countries like Spain, Italy and even Hungary kept markets on tenterhooks. The net result was that policy makers feared that growth would falter once again and

the world economy would go through what they called a double-dip.

The other concern that kept the RBI from raising rates was domestic. Advance taxes are paid every quarter and this resulted in sucking out of funds from the banking system as tax-payers make their payments to the government. When the government spends the funds, the money comes back into the system but that takes a month or so and till then, liquidity is tight. In June, money flowed out of the system on account of payment of advance tax, but there was also another problem. Telecom companies had bid large amounts for being allotted spectrum for the 3rd generation mobile licenses and this money too went out of the banking system(the companies borrowed the bid amounts from banks) into the coffers of the government.

So liquidity was very tight in the money markets in June. Earlier, banks used to park their surplus funds with the RBI and earn 3.75% or the reverse repo rate. But with liquidity being tight, banks had no money to park with the RBI and had to borrow the money from RBI instead at 5.25% or the repo rate. The RBI therefore had to introduce special liquidity enhancing measures, such as buying bonds, which released rupees into the money market. But with GDP growing at 8.6% in the fourth quarter of 2009-10 and with growth expected to be around 8.5% this fiscal year also, the RBI had to act fast.

Outlining its rationale for increasing the repo and reverse repo rates on 2 July, the RBI said, “Significantly, two-thirds of WPI inflation in May 2010 was contributed by non-food items, suggesting that inflation is now very much generalized and that demand-side pressures are evident.” And hiking interest rates is the best tool to deal with demand-side inflation pressures. Also, the government’s recent hike in the prices of petroleum products is expected to add another percentage point to wholesale price inflation immediately, while second-round effects will be felt in the months ahead, according to the RBI.

The need for the RBI to raise interest rates- Rima Charavarty

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WILL EURO BE SAVED OR DOOMED?-Pranay Singh

The refrain of the 1990s award winning song, ‘Together:1992’ was ‘Unite, Unite Europe’. Shortly thereafter the European Union was formed by Treaty of Maastricht in 1993. The next wave of unification came in 1998 when European Central bank was formed and in 1999 when Euro was adopted as the common currency of European Union. With the introduction of euro it was proposed and hoped that it will be an efficient tool to narrow down and erase out the economic differences between the member countries of the European Union.

The euro was meant to be a monetary union, but not a political one. It was established for achieving the aim that the differences in wealth, would diminish in the member states as well. The participating states established a common central bank, but they explicitly refused to adhere to a common authority and a common rule for taxation. But also at the time of Euro’s creation, many worried about its long run viability. After the common currency’s first decade, increased divergence, rather than rapid convergence, has become the norm within the euro area, and tensions are expected to increase further. So what went wrong with a common currency which was introduced to challenge and dethrone the dollar’s supremacy in the financial systems?

EARLY BEGINNINGS, EARLY PROBLEMS

Differences between member states were already very large a decade ago. Euro became the common currency of a plethora of countries. On one hand there were wealthy countries like Germany and Netherlands while on the other end of spectrum were countries like Greece and Portugal. It became the currency of innovative and flexible Finland, and of Italy that lacked both these qualities. In 1999, the difference in lowest and highest inflation figures between the euro-zone countries was two percentage points. The difference had almost tripled, to 5.9 percentage points by the end of 2009. Also, the newly established European Central Bank (ECB), had to determine the appropriate interest rate for all members so as to propose a ‘one size fits all’ policy. But with the passage of time and increasing differences among euro countries the ECB’s policy changed to be described as ‘one size fits none’.

THE FORMING YEARS OF CRISIS

The common monetary policy in the euro-zone countries, and an integrated capital market with financial institutions was the vision of euro. The second problem was the smallness of the EU’s budget relative to those of the member states.

The vast part of government activity took place on a national level. But different governments had different degrees of fiscal policies and measures. Italian, Greek and Portuguese public debt became high. Ireland, with previously modest deficit and debt levels, also suddenly and unexpectedly faced the same kind of issue, owing to the government’s need to take over private debt from the banking sector. France and Germany had an inherently strong fiscal position. The Greek government turned out to be a liar. In 2004, Greece admitted that it had lied about the size of its deficit ever since 2000 which were precisely the years used to assess Greece’s application to join the euro zone.

THE TRAGEDY COMES CALLING

Today, Italy and Greece face serious debt issues amidst financial market concerns about the possibility of default or their leaving the euro zone. The gaps between German bond yields and Greek yields are currently reaching record levels . The price of default insurance has tripled. At 14% of GDP, Greece’s latest fiscal deficit is the largest of the euro-zone countries after Cyprus. Its debt-to- GDP ratio stood at 113% by the end of 2009. The imminent risk is that Greece will not be able to find the €53 billion it needs to service its debt, falling due in 2010 and the estimated additional €30 billion to finance the new debt resulting from its projected budget deficit.

The Greek disaster was made possible because its government deceived its European partners for years with fake statistics. The Euro zone is currently wrestling with fiscal Imbalance and sovereign debt risk, is fiscally fragmented and is unified politically partly only. Ireland grew in part due to large credit inflows into its “Banking Real Estate Complex.” The Irish banking system’s external borrowing reached roughly 100% of GDP. When the world economy dove in 2008-2009, Ireland’s dived deeper.

POSSIBLE AFTER EFFECTS

The fear of contagion and failure can spread over Europe. Greece can be the potential first domino to fall in a scenario that can result in a situation which can unfold that the Greek austerity measures do not suffice, the debt crisis deepens, and the risk of a sovereign default spreads to other European economies. As the Greek domino falls, countries like Portugal, Spain, and Italy would start to tumble, and a small economy’s crisis may turn into a major European calamity. The sovereign debt crisis might hit the real economy, with

Europe ending up in a vicious circle of even higher deficits, lower growth rates, exploding unemployment, and decreasing competitiveness.

THE IMMEDIATE SOLUTIONS

The rescue packages were put together on May 8-9 in Brussels. European Union created a European Financial Stability Facility (EFSF). A “special purpose vehicle” (SPV) has been established in Luxembourg, and can already count on hundreds of billions of Euros in guarantees from member states. There is an €80 billion program already agreed for Greece. The European Union countries agreed on a €500 billion credit line for other distressed countries. The International Monetary Fund added a further €280 billion.

AND EURO CAN BE SAVED

The ECB can and will become the scapegoat for failing of the Euro. If it keeps its interest rate too low for too long, countries like Germany and the Netherlands will continue protesting. If it hikes the interest rate, the southern euro-zone countries like Italy will complain. In that case, support for the euro, already fragile, will erode further, weakening the common currency and fueling even greater tensions. So what are the possible solutions that can save Euro? Possibly creation of a common “European Transfer Union” for the benefit of the deficit countries, including Portugal, Spain, Ireland and Italy with funds for this purpose provided by European Union can be a help.

The second option is also a viable one i.e. Greece going through a depression, and simultaneously reducing its wages and prices of commodities. Finally, Greece can leave the euro and as per its economic situation devalue its currency accordingly. But in the end Europe will have to realize that the most promising solution for all is to implement the institutional reforms, including the necessary fiscal framework that should have been in place when the euro was launched. It is not too late for Europe to implement these reforms because solidarity alone will not do anything.

But if Europe cannot do so, then it is better to admit failure and be ready to face a high price due to unemployment and human suffering in the illusion of an economic model which is flawed but was hailed as a vision of the European Union itself. which is flawed but was hailed as visionary.of European Union itself.

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Spend more to earn moreThe financial repercussions of lack of adequate number of quality faculty in higher education and the way out-Biral Rathi & Govinda Taparia

In today’s world, the significance of education cannot be questioned. That we need more and more highly qualified professionals to sustain the high growth rate is also beyond a speck of doubt. In this context, it may be heartening to know that India has the world’s largest higher education system (third largest by some estimates) but it is hugely more disheartening to know that India probably also has the largest shortage of teaching staff. Does this mean that our centers of higher education are simply an accumulation of brick and mortar without the basic ingredient of the required intellect? Seems like it. The Rama Rao Committee in 2006 reported that the total shortage of teaching staff in technical and engineering colleges alone is more than 40,000. The shortage of Ph.D’s exceeds 30,000 and Masters’ by over 24000. This is assuming a PTR (Pupil-Teacher Ratio) of 15:1. Universities in advanced countries have a PTR of 4:1.

Not much has changed over the last 4 years either. A recent Times of India article reported that 34% of teaching jobs lie vacant in India’s 22 central universities. The situation of State Universities is worse. However, this is only one part of the problem. The quality of existing faculty and the pedagogy they use is also a matter of grave concern.

The result of higher education should, inter alia, be to ready graduates for gainful employment. International Herald Tribune has assessed that “most of the 11 million students in the 18,000 Colleges and Universities across India receive starkly inferior training, heavy on obeisance and light on marketable skills… only a handful of graduates are considered employable by top global and local companies”. A joint survey conducted by FICCI and the World Bank found that 64% of all surveyed employers are somewhat or not satisfied by the quality of engineering graduates’ skills. What’s even more discomforting is the fact that a recent study made by a private organization PurpleLeap found that only 7% of engineering students are employable when skills such as communication, problem solving and technical knowledge are considered. The much touted “demographic dividend” might turn into a liability if right strategies are not implemented effectively as indicated in a report by CP Chandrasekhar and Jayati Ghosh.

Demand to far outstrip Supply

Government spend on education is growing by leaps and bounds in recent years. The 11th Plan

has envisaged an outlay of about Rs.2.70 lakh crores (at 2006-07 prices), out of which 30% is allotted to higher education. Private participation has also been rising in this sector with several private groups coming up with their management and engineering colleges. All this will create demand for teachers. Further, the recent bill cleared by the cabinet to allow entry of foreign universities in India will usher a new wave of demand for highly qualified teachers provided the bill is passed in the parliament. The demand-supply mismatch will further widen and this will put an upward pressure on the salaries of teachers. Though, this will increase the cost of operations of colleges, this increase in cost is rather called for and will help sustain the quality of colleges and students.

Lack of adequate faculty has also kept the PTR at a very high level of close to 28 in higher education centers as per Planning Commission’s 11th Plan Report.

Financial repercussions of Faculty crunch

The lack of adequate number of highly qualified teachers and high PTR has meant that most students who graduate out of colleges are not ready for gainful employment. NASSCOM and McKinsey have said that only 1 in 4 graduates are employable. Further, a billion dollars is spent on providing training to fresh hires. The amount that students themselves spend in bridge courses to ready themselves for employment is still unaccounted for. The lost productivity of the initial period, which varies from a few weeks to a few months, is enormous to say the least.

The Vicious Cycle and the Cascading Effect

Among the major repercussions of faculty crunch and the ensuing high PTR is the churn out of low quality students. It is worth noting that only a lit candle can light up other candles. Among these students, some of them go on to become faculties of education centers at all levels. Thus, a vicious cycle starts and cascades into lower school levels as poor quality of students are fed into the system as teachers. Poor teaching in higher education centers, consequently, has a cascading effect on students of lower levels. This is a dangerous trend that must be immediately arrested.

The fact that the quality of existing faculty is also going down can be adjudged from the quantum of research work they produce. A 2010 study by Shetty, et al of IISC covering select State Universities shows that not even 1 research work

per year is completed per faculty. In fact, the number is much below 1, Patna University showing 0.14 researches per year per faculty and Sikkim University even lower at 0.04.

Spend to reduce costs

Can such a critical shortfall of faculty be corrected? Can they be created out of thin air? We argue that costs have to be increased to ultimately reduce costs. By this we mean that salaries of teachers must be made competitive with corporate salaries, facilities should be given to them, research freedom and fund should be allotted without unnecessary hassles, and training of faculty should be prioritized in terms of providing them the industry experience. All this will increase costs in the beginning but hugely improve the quality of the outcome of higher education centers. Financially too, the productivity lost every year due to low employability skills of graduates will be saved and more than recoup the expenses made.

Very few students of premier institutes of higher education would prefer a research and teaching profession because graduates of some institutes in India earn as much as 2.5 times the faculty’s salary. In USA, this ratio is around 0.5. On the 15th foundation day celebration of NCTE (National Council for Teachers Education), Union HRD minister Kapil Sibal remarked that several benefits such as extending insurance, housing and health schemes, promotion avenues and career advancement must be looked at to attract talented brains to the teaching profession.

Increasing spend on research is an absolute must. Researchers in universities of advanced countries are handsomely rewarded for carrying out research works that are internationally accredited. Junior and senior fellowships should be increased drastically. According the Planning Commission, not even 30,000 crores of the allotted 84,000 crores for higher education in the 4th year of the 11th Plan has been spent by the ministry. Funding of research work should be made with the aim of taking part in international conferences. Further, money should also be spent on organizing summer schools to train teachers and arrange exposure of faculty to the industry.

Generous funding of R&D work will stop the brain drain taking place. If an appropriate environment is provided, scientists such as Pranav Mistry will not have to go to MIT to invent cutting edge technologies like Sixth Sense.