Niveshak April 2012

Niveshak THE INVESTOR

VOLUME 5 ISSUE 4

April 2012

Union Budget 2012-13 Who won and Who lost?

Algorithmic, high frequency and flash trading, Pg. 08

The ‘africa cup’: advantage scapering dragon or loitering elephant, pg. 19

FROM EDITOR’S DESK Dear Niveshaks,

Niveshak Volume V ISSUE IV April 2012 Faculty Mentor Prof. N. Sivasankaran

THE TEAM Editorial Team Akanksha Behl Akhil Tandon Chandan Gupta Harshali Damle Kailash V. Madan Nilkesh Patra Rakesh Agarwal Creative Team Anuroop Bhanu Venkata Abhiram M.

All images, design and artwork are copyright of IIM Shillong Finance Club ©Finance Club Indian Institute of Management Shillong www.iims-niveshak.com

It is the budget season in the country and all the newspapers across the nation are abuzz with analyses of two of the most important budgets, the Railway Budget and the Union Budget.

The Railway Budget was seen as a golden opportunity for Trinamool Congress nominated Dinesh Trivedi to make a mark in Union Politics. However, with an increase in prices ranging from 2 paise to 30 paise per kilometer, across different sections of the Railways, Mr. Trivedi did his reputation no good. The budget will be remembered more for the political drama that unfolded between him and Ms. Mamta Banerjee. With strong demands to rollback the fare hike, Mr. Trivedi had no option but to resign leaving the TMC to nominate Mr. Mukul Roy as his successor.

The Union Budget rolled out no such surprises, with Mr. Pranab Mukherjee, now a veteran at presenting budgets, presenting a satisfactory blueprint for the next financial year. The crux of the budget was aimed at maintaining the delicate balance between growth (currently at 6.9%, but pegged to reach levels of 7.6%), inflation (which has seen a continued decline) and the burgeoning fiscal deficit (currently at 5.9%, but pegged to lower down to 5.1%).

For the individual investor, an increase in the income tax slab to Rs.2 lakh brings much cheer. However, the provident fund rate reduced by 125 basis points to 8.25% to offset some of the benefits. The auto industry is likely to take a hit, with an increase in prices highly likely. This is mainly due to an increase in excise duty to 12% from the current 10% levels. The retail sector saw some cheer with the FM committing to allow FDI in Multi-brand retail in the near future and also setting august as the deadline to implement Goods and Services Tax. Overall, the budget was in line with the expectations of many and did not dish out too many surprises. The cover story this edition, features a detailed analysis of the Union Budget, what it means for a company and to the individual.

The last fiscal seems to have overcome some of the gloominess that existed in the market, with top CEO’s pocketing handsome salaries. Indra Nooyi, the Indian born CEO of PepsiCo pocketed a hefty $17 million in compensation, while the Indian born CEO of Citigroup Inc., Vikram Pandit pocketed a handsome $14.5 million.

Protest-hit Maruti Suzuki has decided to invest Rs.900 crore more at its upcoming R&D centre at Rohtak. This comes in the backdrop of a strong shift in customer focus from petrol cars to diesel ones. The Rs.900 crore investment is over and above the Rs.1700 crore investment in the plant in Gurgaon, which is set to be operational by mid-2013.

This month’s issue brings to you an insight into the Union Budget of Indian Government 2012-2013. The article of the month explains the legal aspects of algorithmic, high frequency and flash trading. The issue also features interesting reads on the investment strategies of India and China in African continent, scenario of weather based insurance index in India and the concept of sovereign credit ratings. This month’s classroom section explains to you the concept of ‘Quantitative Easing’.

With summer placements about to begin for most of our readers, we, at Niveshak wish you all the very best in your respective internship stints.

We would also like to thank our readers for mailing their wonderful articles and appre¬ciation e-mails. It is your constant encouragement and enthusiasm that keeps us going.

Kindly send in your suggestions and feedback to niveshak.iims@gmail.com and as always, Stay Invested.

Team Niveshak Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears no responsibility whatsoever.

CONTENTS Cover Story Niveshak Times

04 The Month That Was

Article of the month

08 Algorithmic, High Frequency and Flash Trading

11

Union Budget 2012-13Who Won and Who Lost ?

Perspective 16 The ‘Africa Cup’: Advantage

Scampering Dragon or Loitering Elephant

Fingyaan

22 Sovereign Credit Ratings:

An Analysis of The Ratings Downgrades in The US and Euro Zone

Finsight 19 Weather Based Crop Insurance in India

CLASSROOM

25 Quantitative Easing

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The Month That Was

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The Niveshak Times Team NIVESHAK

IIM, Shillong

Threat of flying license of Kingfisher Air- India would not be directed by authorizations unless they are made obligatory by the United lines being cancelled Nations.

US nominee to lead the World Bank – an expert in global health Kingfisher Overturning a seven-decade tradition of having Airlines lacks aircrafts as well as reserves for officials with experience in finance or diplomacy, its day-to-day processes. They have not only as the president of the World Bank, President caused inconvenience to passengers by not Obama nominated Jim Yong Kim, president of meeting their flight schedule but have also failed Dartmouth College in New Hampshire and former to pay salaries to their employees for over four director of the Department of HIV/AIDS at the months. This resulted in the prospects of its fly- World Health Organization. Dr. Kim is a Koreaning license being cancelled. Also, the airline has American known for his work in fighting disease decided to limit its overseas flights operations in impoverished countries. The choice came as a to avoid more losses and also return its leased surprise as Washington’s past picks for the post aircraft. An explanation, for the same, needs to have had more standing be presented to the Directorate General of Civil in political circles. Mr. Aviation (DGCA) by Vijay Mallya. However, Civil Obama also broke the Aviation Minister Ajit Singh said that as per rules practice of selecting pothe licenses of an airline cannot be cancelled litically connected indias long as it has five planes and certain equity viduals for this post. The to run the business. Hence, shutting down of decision to nominate Dr. operations is call that Vijay Mallya would have Kim was taken in part to to take. counterweight disparageIndia to continue being an importer of ment from developing nations about the U.S. lock crude oil from Iran Oil Minister S Jaipal Reddy announced that India on the job. He has demonstrated a leadership will continue to import crude oil from Iran as style and charisma that would serve him well at long as the International law is not violated de- the bank. He is nearly certain to succeed Robspite financial sanctions made by the US against ert Zoellick as Washington has the largest single countries which do not cut Iranian oil purchases. voting share at the World Bank and is likely to The country’s purchases of crude oil, accounting get the support of the bank’s second-largest votfor about one tenth of its total crude imports, ing member, European nations and Japan. have been hampered due to banking difficulties Citigroup fails Fed Stress Test as most of the international banks are following A stress test conducted by the Federal Reserve the sanctions imposed by US and Europe and on 19 banks proved that Citigroup was amongst hence are not ready to route Indian payments the four banks, others being Ally Financial Inc., for Iranian oil. As a result, the two countries are MetLife Inc. and SunTrust Banks Inc., which failed considering making payment for oil partly in In- to pass the test designed to assess the necesdian rupees and the remaining through export sity of reserves to endure another catastrophe of various commodities and services from India. like the credit crisis of 2008. The test showed The country is however, looking forward to diver- that these four banks had less than 5% of capital sifying its sources of crude imports to reduce the set aside under Tier 1 capital ratio, thereby failrisks of dependence on any particular region. As ing to meet the adequacy standards. This decimentioned by the Foreign Minister S.M Krishna, sion was a disappointment to Citi, which had

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assured to increase its dividend above a notional 1 cent a share for the first time since its near downfall during the financial crisis. The group claimed that it failed only because of its planned capital-return plan.

Mahindra Satyam to merge with Tech Mahindra Tech Mahindra and Mahindra Satyam have decided to merge into a combined entity which would run under the aegis of C.P Gurnani, current Chief executive officer of Mahindra Satyam. The $2.4 billion entity is all set to become a major player in the competitive Indian software industry. The Board of Directors of the two companies fixed the swap ratio for the merger at 17 shares of Mahindra Satyam for every 2 shares of Tech Mahindra. The combined entity is India’s sixth largest IT service provider, with a market value of over $3billion and revenues in excess of $2.4billion. The roots of the merger can be dated back to 2009, when Tech Mahindra acquired the scam-struck Satyam computers, the then fourth largest IT service provider of India.

The news was well accepted by the bourses, as the shares of both the companies closed at a 5% high on the day of announcement.

Norms for gold loan NBFCs revised Citing concerns over the heavy borrowing and sale of bonds by Gold finance NBFCs, the reserve bank of India has tightened rules for lending against gold by finance companies, saying the rapid growth in such loans in the past few years had increased risks to the banking system and retail investors. The NBFC’s having atleast 50% of their assets in gold have been directed to maintain a 12% Tier 1 capital from April 2014. In addition to this, the companies have been instructed not to lend more than 60% of the value of their gold jewelry. Of late, these NBFCs have borrowed in huge numbers from the banks and the public.

Since these companies use Gold as collateral, it makes the entire system vulnerable to gold price movements. The central bank fears that a fall in

the price of gold, might lead to a collapse of the entire system. RBI has also banned companies from lending against bullion, primary gold and gold coins, leaving just jewelry.

BRIC nations eye multilateral development bank In wake of the faltering global economy, the BRIC nations of Brazil, Russia, India and China are considering creation of a multilateral development bank which would facilitate financing of projects in these countries as well as abroad. As per the statements doing rounds in the public domain, Brazil seems to be enthusiastic about the prospects of the deal. The leaders from the respective countries are scheduled to meet in India soon, where they are expected to sign a memorandum of understanding for the same.

SBI to be more customer focussed In another effort to become more customer friendly, State Bank of India announced that it will permit loan borrowers to switch to a lower interest rate. The decision is likely to affect a major chunk of its 17 lakh loan borrowers, and a gain of approximately Rs 6000 a month on a 20 year mortgage of Rs 50,00,000 can be ascertained. Recently, the bank also waived off prepayment penalty on loans. In another valiant effort SBI has cut its processing fee, and the fee now stands at 10.75% for home loans up to Rs 30 lakh, 11% for loans between Rs 30 lakh and Rs 75 lakh, and 11.25% for upward of Rs 75 lakh. The bank is setting strong standards in the highly competitive banking industry, which will be difficult for others to ape.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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Article Market of Snapshot the Month Cover Story

Market Snapshot

Source: www.bseindia.com www.nseindia.com

MARKET CAP (IN RS. CR) BSE Mkt. Cap Index Full Mkt. Cap Index Free Float Mkt. Cap

60,81,408 28,61,366 14,35,450

LENDING / DEPOSIT RATES Base rate Deposit rate

10%-10.75% 8.5% - 9.25%

Source: www.bseindia.com

CURRENCY RATES INR / 1 USD INR / 1 Euro INR / 100 Jap. YEN INR / 1 Pound Sterling

50.92 67.85 61.52 81.21

CURRENCY MOVEMENTS

RESERVE RATIOS CRR SLR

4.75% 24%

POLICY RATES Bank Rate Repo rate Reverse Repo rate

9.50% 8.50% 7.50%

Source: www.bseindia.com 13th March to 28th March 2012 Data as on 28th March 2012

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BSE Index Sensex

Open 17,772

Close 17,122

% Change -3.66%

MIDCAP Smallcap AUTO BANKEX CD CG FMCG Healthcare IT METAL OIL&GAS POWER PSU REALTY TECK

6,375 6,787 10,030 12,260 6,751 10,341 4,151 6,455 6,151 11,629 8,383 2,234 7,656 1,839 3,611

6,191 6,451 9,844 11,476 6,283 9,995 4,473 6,446 6,021 11,017 7,850 2,057 7,138 1,726 3,528

-2.89% -4.95% -1.85% -6.39% -6.93% -3.35% 7.76% -0.14% -2.11% -5.26% -6.36% -7.92% -6.77% -6.14% -2.30%

© FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

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Algorithmic, High Frequency Flash Trading

and

Are they anti-competitive?

What is the regulatory view

point?

Charan Kumar U

IIM Calcutta

Trading has been traditionally carried out in the stock exchanges, where traders negotiate on the bid-ask prices and make profit on the difference in spread or by using price differences of the same security in different exchanges (arbitrage). In the last decade, with competition becoming much intensive, traders began using fast computer systems to execute trades close to the speed of light. These computer systems used High frequency algorithms to take advantage of miniscule spreads for ephemeral periods, which is impossible to be performed by human traders. High Frequency Trading systems use algorithms which track miniscule changes in prices, ephemeral price arbitrages and execute trades with extremely low latency. With emergence of advanced technology new methods like co-location, flash trading and dark pools began to be used in the markets. High frequency trading systems can be simply viewed as a large group of market makers providing liquidity in the markets. But there are also shades of grey associated as some investors feels that these systems make money from the pockets of other investors by bypassing trades and acting as artificial pseudo- middlemen. This negative sentiment has been accentuated by events like the

Flash Crash of May 6, 2010.

This article attempts to analyse the different forms of HFT systems and their regulatory ambit with respect to the SEC and SEBI and whether the fears of some investors about unfair advantage to certain favoured traders using HFT systems is indeed true.

Co-location Co-location is a practice where exchanges build data centres and rent out racks of computing space to HFT traders for a fee and thus allow traders to position their computers as close as possible to the exchange’s servers to cut down a few microseconds off trading times. Co-location has become a controversial issue in recent times with a lot of question raised about its fairness and even legality in terms of offering equal opportunity for all market participants. If a broker hits the enter key faster than a HFT firm, then the broker should get the stock and not the HFT firm that paid co-location rent to place its server closer to the exchange. But currently with co-location that is not the case. Here, the issue is a market structure which threatens to thwart competition. Regulators including the US Securities and Exchange Commission and SEBI are concerned that whether this practice holds

High Frequency Trading systems use algorithms which track miniscule changes in prices, ephemeral price arbitrages and execute trades with extremely low latency. With emergence of advanced technology, new methods like co-location, flash trading and dark pools began to be used in the markets.

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to obtain information which can make the difference between competitors miles apart does not seem to be fair. This practise creates a twotiered market and even multi-tiered market depending on the resources of the traders. This is exactly the reason why SEC proposed to ban Flash Trading in 2009 stating the following reasons: • SEC states that flash trading could destroy fair competition and efficiency if flash trading were to expand to greater trading volume11.

• SEC states that banning flash orders could lead market participants to display more of their trading interest, thus providing additional price transparency.

Under Regulation NMS, a registered exchange or an ATS is prohibited from “imposing unfairly discriminatory terms that would prevent or inhibit any person from obtaining efficient access” to the trading centre’s displayed quotations at the best prices. An exchange will violate this rule if it charges access fee more than the limit set by the Regulation NMS. But the issue in Flash Trading is about the very practise of charging access fee to view data.

Presently, flash orders are permitted as an exception to Rule 602 of Regulation NMS under the Securities Act of 1934. However, the proposed ban has still not taken effect as lot of HFT lobbyists and industry executives are emphasising the fact that how flash orders benefit retail investors by lowering costs and even if a ban is initiated, it should not be a blanket ban and should exclude a few markets like the equity market.

From a legal viewpoint, Flash trading & HFT are primarily not used with the intention to defraud investors. The mechanism of HFTs like quote stuffing might create mispricing in course of action, but such instances have been rare. But such misrepresentation is in violation of sec 12 A (a), SEBI Act 1992.

Flash traders are disclosed quotes milliseconds before others see them and they disclose their

Flash trading allows a section of traders to view proprietary data feed and execute trades, but it does not create artificial rise or fall in prices of securities. Also the intent is to affect a trade for the trader himself rather than to induce purchase or sale by another trader. Though flashing involves dissemination of information, there is no evidence of artificial rise or fall of prices of securities. © FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

Article of Month Article of the the Month Cover Story

everyone on an equal footing.

The SEA (1934) requires that the “terms of colocation services must not be unfairly discriminatory, and the fees must be equitably allocated and reasonable” Exchanges must obtain approval of the SEC for offering co-location services to their customers. By approving the co-location services of NASDAQ, however, the SEC seemed to imply that this practice, by itself, is not ‘unfairly discriminatory’.

With respect to India, NSE has already entered into contracts with 60 members for the co-location facility. The members can place their trading servers close to that of the exchange for Rs. 22.5 lakhs. The available space is offered on a first-come-first served policy. The broker with the trading server next to the exchange engine has his price feed updated every 3 to 4 milliseconds as compared to a broker at a remote place whose feed gets updated once in 30 to 40 milliseconds. In an attempt to not leave aside anyone, NSE has developed a computer cloud model where in the IT infrastructure is shared with small brokers who cannot afford the highend servers used for HFT. This would mean not differentiating anyone with their capacity to invest. But is this enough? Does SEBI feel that it offers an equal ground for every market participant? This remains the much debated question.

Flash Orders Flashing is the process of disclosing specific orders/ quotes to only a special class of investors for a fee. It helps the exchange concerned to convert the unmatched trades into matched ones by providing an incentive (commission) to traders willing to take additional risk by executing such trades. It creates a scenario where both the flash participants and the flashing exchange are mutually benefitted.

Anti-competition vs Efficiency of markets - Flash Traders defend this practise by citing the general principles of competition applying to all industries where advantage due to technological advancement or inn patents is legal and valid.

While this competition among the Flash traders can be deemed fair, the practise of paying a fee

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executions only after trades are completed. The position of SEBI regarding this practise is unclear.

Defenders of Flash trading argue that there is no clear definition of ‘fairness’ in trading – “fairness-based arguments are difficult to employ in support of compelling disclosure of private information by large liquidity traders, particularly as regards transaction information and future transactions4”. They also cite references from section 9 a(3), SEA Act (1934) implying an ambiguous position on Flash Trading “circulation or dissemination in the ordinary course of business of information to the effect that the price of any such security will or is likely to rise or fall because of market operations of any 1 or more persons conducted for the purpose of raising or depressing the price of such security” Flash trading allows a section of traders to view proprietary data feed and execute trades, but it does not create artificial rise or fall in prices of securities. Also the intent is to effect a trade for the trader himself rather than to induce purchase or sale by another trader. Though Flashing involves dissemination of information, there is no evidence of artificial rise or fall of prices of securities.

The market regulators need to evaluate the tradeoffs and take a hard line here as the stakes are too high, especially after the flash crash of May 6 2010 which erased $862 billion in value from the markets.

Fat FingerTrade/ Freak Trade Freak trade arises in a situation when a large volume order on a specific stock/derivative is wrongly entered on some other stock/derivative by the trader’s mistake. The Indian flash crash on June 1, 2010, similar to the US flash crash on May 6, 2010, is attributed to a freak trade order entered by a trader causing a quick sell off in the market. The alleged cause for the crash is a freak order entered by an unidentified trader for 500,000 Reliance shares at Rs. 840 instead of putting the same for ICICI Bank stock that

was trading at Rs. 846. Immediately, Reliance shares came crashing down from Rs. 1028.60 to Rs. 840.55, a fall of 18% in a moment. Because of the high weight of Reliance in the Sensex, the index also fell by 442 points, a fall of 3%, within a minute. According to Bloomberg data, this caused a panic in the market and about 2.12 lakh Reliance shares exchanged hands within a minute. This unusually high number was almost 40% of the traded volume of the Reliance scrip the previous day. All in a minute!

Soon after this incident, SEBI is working on framing a policy for the stock exchanges to go through a stress test so as to better prepare them in facing flash-crash like situations in the future. Issues like across-the-board panic sale due to a steep fall in some stock (either due to a freak trade or due to stock-related bad news such as scams) and crashes due to large market orders interacting with a thin order book are keeping the regulator on its toes.

Dark Pools Dark pools, in simple terms, are trading platforms / exchanges that match buy and sell orders of large institutional investors with huge blocks of securities, in the process bypassing the central exchanges and carrying out off-market deals in a completely anonymous manner.

There are no stock quotes published all the time like in public exchanges. An electronic system is used for order-matching, prices fixed between the counterparties and transactions completed.

Dark pools raise the issue of equality of opportunity for all market participants. Dark pools can turn disadvantageous to the retail investors in the market as they are totally left out from the system and can’t participate in these trades.

To better understand why investors participate in a dark pool, let us consider an institutional investor like a large pension fund wanting to sell a huge block of a particular stock, say GE, in the market. Suppose the pension fund manager goes to a public exchange like NYSE with the big chunk of GE shares, every move of his is being closely watched by the market since these institutional investors act as the bellwether in the

SEBI started working on framing a policy for the stock exchanges to go through a stress test so as to better prepare them in facing flash-crash like situations in the future. Issues like across-theboard panic sale due to a steep fall in some stock (either due to a freak trade or due to stockrelated bad news such as scams) and crashes due to large market orders interacting with a thin order book are keeping the regulator on its toes.

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Stub quotes, cited to be the main villain of the May 2010 flash crash in the US, is a tool that market makers use to meet their obligation of maintaining two-way quotes continually in the market but in actuality are unwilling to provide liquidity.

© FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

Article of Month Article of the the Month Cover Story

market. Since all the bid and offer are shown Dec 6, 2010, realized this and imposed a ban on publicly in NYSE, due to the weight of the mul- stub quotes. Apart from this, the SEC has also tiple blocks sold and the technical pressure, the initiated a circuit breaker pilot program. Under last block of GE share sold by the pension fund this, trading would be stopped if certain equity might be much lower than prices moved more than the first block. Dark pools, 10% in 5 minutes. in contrast, guarantee abThe issue of a tradeFrom a legal viewpoint, solute anonymity. It cuts off that exists between section 9. 2(A) of the SEA away the opportunity of promoting efficiency & Act (1934) prohibits any market reacting before the competition among extrade practice with intent transaction is made as no to create price manipulachanges and the consedisclosure is to be mandation or deceive the marquent impartiality shown torily made to the public by kets by creating a scetowards normal investors the dark pool and any disnario of artificial pricing. has to be highlighted. The closure made is only done By using HFT systems to whole issue of whether post-trade. perform ‘quote stuffing’, to effect an outright ban Stub Quotes which is making random on HFT, Flash trading or non-executable orders A stub quote is an offer not has been hanging in to glean market interto buy or sell a security balance for about 3 years est in an order, the HFTs at a price that is far away now mainly because of might be in violation of from the prevailing market the trade-off described the above regulation. But price, say a bid at 1 cent above. Numerous litigasince the probability of a and an offer at $100,000, tions about the proposed crash due to stub quotes that if executed could lead ban, especially in the US, is very low until now to freak movements in the have failed chiefly due to and the traders try to price of the security and the argument of traders outsmart law by using a unnecessary market panic. about the consequent loophole in the same secStub quotes, cited to be cost of banning algorithtion 9.2(a) by saying that the main villain of the May mic trading outweighing there was no “malicious 2010 flash crash in the US, the benefits to smaller intent” while using the is a tool that market makpractice of quote stuffing. market participants.

This ers use to meet their oblimakes it difficult for lawNaked / Unfiltered / gation of maintaining twomakers to pass conclusive Sponsored Access way quotes continually in judgements on the issue the market but in actuality Naked or unfiltered acmaking it a matter of conare unwilling to provide licess is a practice that altention and debate that’s quidity. For example, if an lows HFT traders of varigoing on even as this arinvestor has put in a “sell ous firms to send orders at market price order” and ticle is being written. directly (and anonymousa stub quote of bid 1 cent ly) to stock exchanges usis the only order in the ing a sponsoring broker’s market, the stock falls from its current market ID. Exchanges might not get to know the identity price to 1 cent in no time. The same happened of the firms using naked access as the only way with a few stocks during the flash crash. There to know the same is the computer identificawere no safeguards in the US markets to pre- tion code. Naked access allows a reckless HFT vent this until recently. The SEC, with effect from trader to put in thousands of erroneous trade

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within the two minute period it might take to correct a market glitch. In November 2010, SEC approved a rule to curb the practice of naked access and prevent brokers from handing over their IDs to trading firms. According to Mary Schapiro, SEC chairman, “Unfiltered access is similar to giving your car keys to a friend who doesn’t have a licence and letting him drive unaccompanied. This proposal would require that if a broker-dealer is going to loan his keys, he must not only remain in the car, but he must also maintain control of it so that the person driving observes the rules before the car is ever put into drive.” HFT firms, though, have raised objections citing that addition of identifiers and pre-trade risk management practices will slow down their trading speeds.

On a concluding note, the issue of a trade-off that exists between promoting efficiency & competition among exchanges and and the consequent impartiality shown towards normal investors has to be highlighted. The whole issue of whether to effect an outright ban on HFT, Flash trading or not has been hanging on a balance for about 3 years now mainly because of the trade-off described above. Numerous litigations about the proposed ban, especially in the US, have failed chiefly due to the argument of traders about the consequent cost of banning algorithmic trading outweighing the benefits to smaller market participants. This makes it difficult for lawmakers to pass conclusive judgements on the issue making it a matter of contention and debate that’s going on even as this article is being written.

FIN-Q Solutions March 2012 1. SEBI, U. K. Sinha 2. Nakahara Prize, Japanese Economic Association 3. Bank for International Settlements 4. Help-Wanted Index – HWI 5. Corporate Dossier 6. Commissioner vs.

Mary Archer W. Morris Trust, Reverse Morris Trust 7. Buon Ma Thuot Coffee Exchange Center, Vietnam 8. Walt Disney 9. National Rural Employment Guarantee Act, 2005 10. Seagull Leafin

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Cover Story Article of the Month Cover Story

Union Budget 2012-13 Who won and who lost ?

Harshali Damle & Nilkesh Patra

Team Niveshak

This year’s Union Budget came amidst tons of expectations not only from our countrymen but also the entire global community. This article provides an analysis of the budget and the major take-aways for the common man. At the start, the finance minister stated five objectives of which focus on demand driven growth, expanding private sector investment and addressing supply side bottlenecks were considered to be high priority. The focus of this Budget was clearly on infrastructure and fiscal consolidation.

Economic Survey Summary The Union budget was preceded by the Economic Survey tabled by finance minister, Mr. Pranab Mukherjee. This document is useful for policymakers, economists, policy analysts, business practitioners, government agencies, students, researchers, the media, and all those interested in the development in the Indian economy. The major highlights of the survey are: •Indian Economy estimated to grow by 6.9% in 2011-12 •FY13 and FY14 growth estimates pegged at 7.6% and 8.6% respectively

•Agriculture growth projected at 2.5% in 2011-12 •Industrial growth pegged at 4-5% in FY12 •Inflationary pressures fade by the year end as food prices fall •WPI food inflation slumps from 20.2% in Feb’10 to 1.6% in Jan 12 •Fiscal consolidation could spur Savings and Capital formation Impact on Common Man The Union Budget could not meet the expectations of common men because of rising inflation. They had an expectation that this time they will get some major benefits from taxation.

They got some benefits from this budget but those cannot be categorized as major. There are changes in the tax slabs. Tax exemption limit is increased from 1.8lacs to 2lacs and the 20% tax slab is now from 5lacs to 10lacs. There will be no implementation of Direct Tax Code this year.

Because government did not have enough time as there were issues related to Anna Hazare, Food security bill and lot more. There is a new deduction called “preventive health checkup” included under Section 80D, where a person can include health checkup cost up to 5,000. Now ..

The Union Budget could not meet the expectations of common men because of rising inflation.

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people don’t have to pay tax on saving bank inter- infrastructure bonds apart from 80C, which was est income up to 10,000. introduced two years back, is not extended this year. So, there is no tax exAnother new tax deduction emption on these bonds. is introduced for equity investments, which is called Impact on Industry The budget can be as “Rajiv Gandhi Equity SavUnion Budget 2012 was considered to be a con- The ing Scheme”. In this scheme not that severe on the indusservative one with no try, which is contrary to the an investor can claim 50% big-ticket announce- expectation of people, beof his investments in direct equity up to the maximum ments. The budget cause currently the focus of investment limit of 50,000. is high on credibility the government should be But the investment has to compared to previous to increase revenue and debe locked for 3 years. This years. The numbers crease expenses to achieve scheme is only available to have been computed the target of lower fiscal people with taxable income Total planned outlay on realistic expecta- deficit. below 10lacs. STT transacin the agriculture sector has tions and projections been increased by 18% from tion tax has to be paid by the investors, whenever and deviations at year- Rs171bn in FY12 to Rs202bn in they make equity transacend would be minimal FY13. Agriculture estimated to tions. This tax was previunlike the situation in grow at 2.5% in FY12. Amendously 0.125%, but now it is the current year. Realis- ments are introduced to the reduced to 0.1%. ing that development FRBM Act as part of Finance There are some announceof infrastructure is cru- Bill 2012, the medium-term ments, which can make framework to lay cial for the projected expenditure negative impact on public. down a three-year rolling tarhigh future growth, a get for expenditure indicators.

The interest rate on EPF is now reduced from 9.5% to slew of measures have Endeavour to limit central 8.25% and this will be apbeen taken to channel subsidies under 2% of GDP in plicable from next year. As funds from public and FY13; to be further brought the service tax is increased foreign sources to this down to 1.75% of GDP over from 10% to 12%, people sector. Also, from the next 3 years. have to pay more on the general public point This budget has tried to simbill amount like telephone of view some positives plify the process of IPOs by re& internet bills, hotel & restaurant bills, flight charges coming from the bud- ducing their expenditure and companies to reach and several other services. get were introduction helping more retail investors. There The manufacturers pay a of Rajiv Gandhi Equity is a proposal to make it mantax called excise duty on Scheme and hike in datory for companies to isany kind of goods producpersonal tax exemption sue IPOs of Rs100mn and that tion. The excise duty is inlimit that will give them should be in electronic form creased from 10% to 12%, through countrywide broker much needed higher which means that manufacnetwork of stock exchanges. turers have to pay more tax disposable income The corporate tax rate remains now and they will put adthe same. The charge of Miniditional burden on consumers by making the goods mum Alternate Tax (MAT) has costly. The benefit of tax saving up to 20,000 on been extended to all persons other than compaThe Union Budget 2012 was not that severe on the industry, which is contrary to the expectation of people, because currently the focus of the government should be to increase revenue and decrease expenses to achieve the target of less fiscal deficit.

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Measures to curb inflation Increase in Agricultural Spending by 18% Reduction in Subsidies - Neutral Final Verdict- Neutral Market Reaction The flat markets showed what the investors thought of the Budget. Markets were expecting some comment on issues such as foreign direct investment in retail and aviation sector, but these were not touched upon. Another mildly positive step was the reduction in securities transaction tax (STT) for cash delivery-based transactions by 20% to 0.1%. Bond markets reacted negatively to the increased borrowing program that was announced. The Bond yields signaled thumbs down from the bond markets. The actual response and implementations of the proposals will have an effect on the market in the coming days. Also the investors are eying the RBI for acting on interest rates in April.

Conclusion The budget presented a realistic assessment of the current political and economic situation. Targeting fiscal deficit at 5.1% and 4.5% of GDP for the next two years, along with subsidy at 2% of GDP, are reassuring for optimists. However, there is a need for a balancing act in the midst of high fiscal deficit. There is a need to adopt strict measures to ensure the implementation of the proposals and plans to reach the planned fiscal deficit for the coming year.

No change in Corporate Taxation Implementation of GST Lack of major Direct Tax changes w.r.t deductions and slabs Increase in Infrastructure spending ..

The budget presented a realistic assessment of the current political and economic situation.

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nies claiming profit linked deductions. The definition of income deemed to arise in India has been widened with retrospective effect from April 1, 1962. This is significant considering the Supreme Court judgment in the Vodafone Case. Dividend from foreign subsidiary is permitted at a lower tax rate of 15% against the full tax rate to be permitted for a further one year i.e. up to March 31, 2013. In the multi-tier corporate structure, there is a proposal to remove the falling effect of Dividend Distribution Tax. This benefit was currently available only in a two tier corporate structure. The weighted deduction of 200% is available for investment in research and development in an in-house facility, which will be available for a further five years beyond March 31, 2012. There is a raise in the turnover limit from Rs6mn to Rs10mn for SMEs for compulsory tax audit. Weighted deduction at the rate of 150% on expenditure incurred on skill development in manufacturing sector would be available as per prescribed guidelines. Peak Customs Duty rate is kept unchanged at 10%. However, relief is provided for specific sector, especially those under stress. Full exemption is provided for coal mining project imports, reduction for mineral prospecting machineries, aircrafts & equipment imported for third-party maintenance, repair & overhaul. Relief is proposed to steel (import duty on flat products hiked to 7.5%). However, custom duty on Gold has been doubled (to 4% for standard gold, 10% for non-standard gold and 2% for gold ore and concentrate) to check the trend of rise in gold imports.

Major Takeaways Rise in Excise Duty and Service Tax

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The ‘Africa Cup’ : Advantage Scampering Dragon or Loitering Elephant

Mohit Mathur & Soumya Sarthak Mishra

IIM Rohtak

The last one-and-a-half decade has seen China and India, the world’s most populous and economically fastest growing countries emerge as Africa’s most important economic partners. It all started in the last decade of the twentieth century, when first China and later India, after breaking off from the socio-economic shackles of centuries of colonialism started on a path of modernization and economic development and lately results started to pay off in the form of sustained economic and military growth. This ever-burgeoning growth has led both the countries to look further for resources to fuel their robust march onto the status of global superpower. And Africa, lagging behind under the constrained economic aid of the West was the ideal ground to launch their initiatives. Though both China and India are South Asian behemoths and have a cultural heritage dating back to the ancient yore, their paths to investment in Africa couldn’t have been any more different. China, the manufacturing hub of the new economic order has centered on a no-political-strings attached policy of pouring money into the African continent and its foray has been led by the State-owned companies fully supported by the deep pockets of the Chinese government. On the other end of the spectrum, India has been a cautious player, less risk-seeking in its investment strategy and the Indian contingent has been led by the private sector and only recently has the Indian government entered the fray. The timelines in figures 1 & 2 highlight the difference in attitudes and actions taken by the respective governments to shore up their countries’ stocks in the continent.

CHINA: While China has had clear-cut objectives in mind vis-à-vis its African sojourn, India has approached on a multi-pronged plan which is versatile enough to accommodate humanitarian aid but not robust enough to successfully face-off and thwart the relentless Chinese highlight. In summary, the Chinese have gone the ‘hard’ way of doing busi-

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Fig. 1: Roadmap for China’s African involvement: Focus on Oil & Mining, Construction, Agriculture and Capital Equipment

ness with Africa while the Indians have adopted the ‘soft’ version.

INDIA: The ongoing relationship between Africa and the competing Asian duo has evolved over time and is currently dominated by competing interests in trade, investment, economic cooperation and the quest for influence. Trade between Africa and China has grown from $20 billion in 2001 to $122.3 billion in the first three quarters of 2011 while over the same period India’s engagement with Africa has risen from $8.5 billion to $49.1 billion with a target to

Fig. 2: Roadmap for India’s African involvement: Focus on Agriculture, Power, Pharmaceutical, Information & Telecommunication sectors, Small & Medium scale Enterprises

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reach $75 billion by 2015. China has outmaneu- every nook and cranny of Africa as highlighted vered not only India but also erstwhile largest in the following fig 4. business partners of Africa viz. Europe and USA. A crucial plank behind the success of these Asian The figure 3 depicts the African nations where nations is the role played by the state in guidthe Indians and the ing the Chinese have made market their presence felt and the with a plethora of s t a t e ’s wide-ranging inwillingvestments.

What ness to is interesting to intervene note in the figure is and exthat while the Chiperiment nese have reached with hetout to the most erodox interior and reclupolicies sive regions of the to re‘Dark Continent’, vive the the same can’t be economy, said of the Indian compete modus operandi. in global Speaking of the markets macro-economic and reramifications, the d u c e mind-boggling rate poverty of expansion of in the China-Africa and process India-Africa trade of movhas brought the ing in a Fig. 3: Chinese vs Indian investments in Africa Western and Eastfree-marern interests and ket direction. The hallmark of Indian entry into economic clout to a face off and the consequent Africa has been heavy investment in infrastrucdynamics are bound to affect the development ture, education, research and development of African countries and their international relacomplemented with versatile policies designed tions and place in the new pecking order. to enhance the competitiveness of local producIn the current scenario, the Chinese economic ers through technological retooling and workers’ bandwagon is viewed to be cantering away and retraining. Opposed to this, the Chinese have out of reach of its Indian counterpart. The Chi- relied on bringing in their cheap, indigenous nese government, in its African Policy Paper, is- Chinese labor and this has created disquiet sued in January 2006, declared its commitment amongst the local populace. to a new and strategic long-term partnership The deepening competition and the policies of with Africa based on the five principles of: China have led India to cast the former as a ‘fair1. Peaceful co-existence weather’ friend while presenting itself as an ‘all2. Respect for African countries’ independent weather’ friend of Africa. Chinese investment has choice of development path been more aggressive, with the Chinese stateowned enterprises enjoying both political and 3. Mutual benefit and reciprocity financial support to undercut other competitors 4. Interaction based on equality in general and Indian in particular. On the other 5. Consultation and co-operation in global af- hand, India’s relations with Africa include relafairs tively modest but highly valued aid, economic This proclaimed humanistic approach coupled cooperation and technical assistance programs. with the massive amount of economic capi- Energy security is writ large in the strategic intal being poured in by the Chinese has helped terests of both China and India as they continue them rake up massive investment projects in to expand in Africa. China’s two-pronged strat-

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can continent and egy of engaging the major Africritical intervencan oil productions by the Afriers (Nigeria, Ancan governments gola and Sudan) in order to negotiby offering them ate with the Asian integrated packsuperpowers is the ages of aid and need of the hour. low interest/inThe question that terest free loans now faces Africa and simultaneis whether there ously targeting exists a coherent the less visible African strategy African oil producers (Gabon, for harnessing the Equatorial Guinpotential develea) has helped opment spin-offs it score high on that could accrue the success ladfrom increased der over India investments, trade in gaining acand aid from the cess to Africa’s belligerents and if oil. The Chione does not exFig. 4: Quantum of Chinese FDI in Africa nese state-run ist, what should be oil companies China National Petroleum Corporation, Sinopec, done to create one.

China Gas, Chinese National Overseas Oil Cor- A look at the crucial socio-economic indicators poration et al have outmaneuvered their Indian shows China being way ahead of India on all counterpart Oil and Natural Gas Corporation time fronts and it is not predicted to change by the and again. However, despite these setbacks, In- forecasts of 2050 but a closer look reveals the dia has continued to look for niches where it demographic advantage will swing decisively in can maximize its comparative advantage and India’s favor. slowly but steadily converting its toehold in AfFurther, India may, in the medium to long term, rica to a firm foothold. gain considerable comparative advantage over Indicators Present Projected China due to its closer proximity to Africa, its (2010) (2050) historical ties, the sharing of English as a comCHINA INDIA CHINA INDIA mon language, the special niches to promote $ 4667bn. $ 1256bn. $ 70710bn. $ 37668bn.

GDP its friendship and its excellent educational and GDP per training opportunities and democratic systems. $ 3,463 $ 817 $ 49,650 $ 20,836 capita However, all this will depend on a tectonic shift 1.303 bn.

1.656 bn.

Population 1.347 bn. 1.21 bn. in India’s foreign policy, bureaucracy and the % Populacapacity to adapt its ‘low-cost high efficiency tion in 47 41 28 46 business model’ to the African ground realities 15 - 45 age group and the corresponding response of the African Table 1: Present and projected strategic developmental indicacountries. tors for China and India

From an African perspective, the emergence of China and India as important development partners will be able to address the prevalent critical infrastructure gap cheaply, less bureaucratically and in a shorter timeframe. The Asian giants’ engagement with Africa is growing by leaps and bounds, which simultaneously presents both opportunities and challenges for the Afri-

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CROP INSURANCE IN INDIA

Prashant Kulbhushan Sahni & Shivendra Sharma

XLRI, Jamshedpur

In recent years, there has been a growing interest in use of finance as a means of promoting development and economic growth. Within this context, terms like inclusive finance, rural finance and microfinance refer to the use of the innovative tools of finance which promote a more even distribution of income and poverty alleviation via inclusive growth.

But what does finance really mean for the rural citizens?

We have identified three aspects: Savings, Credit & Insurance. These tools are a hygiene factor for the urban; hence we may, at times, underestimate their importance. But in absence of a formal access to these, the lower income group has to face: 1. The vicious circle of high cost local debt 2. Severing of treatable medical emergencies 3. High impact of income variability and uncertainty 4. Exhausting of current resources leading to constrained future opportunities In fact a World Bank 2006 study indicated that rural people do borrow, but in absence of a formal system they rely on alternatives which are either very high in terms of cost or negatively impact their long term well-being. Specifically for insurance products, the study indicated that rural demand far exceeds the supply.

The primary benefits that the financial system can extend to the rural and the lower income groups are: 1. Capital provision for rural entrepreneurs - and promotion of income generation through credit 2. Reducing the impact of income variability - through affordable credit and agriculture insurance 3. Improving healthcare - through tools like community health insurance and healthcare financing 4. Enabling a steady living standard promoting sta-

ble growth and upliftment In this article we will focus on Agriculture Insurance product innovations, analysing the product design, implementation insights, benefit analysis and the open issues. We will focus on the products offered by two major private players in this area: ICICI Lombard & IFFCO Tokio.

Agriculture Insurance in India Agriculture insurance addresses goal no. 2 identified above. Crop yields are variable which leads to variability of income for farmers. The goal is to reduce this variability through insurance products and thereby promote a steady income.

There have been innovations in the recent past and both government and private sector products are in the offering. Based on the insurance basis used, these products can be classified into two broad categories: Weather Based and Yield Based.

This article focusses on weather based products and innovations.

Weather Based Insurance – Overview To a farmer, weather represents a risk. 89 % of the households surveyed as part of a study by Cole et al. in 2009 reported rainfall variation as the most important risk faced by them. In principle, we should be able to manage this risk. Weather uncertainties faced by a farmer have hardly any correlation with stock exchange movements. This means the risk should be largely diversifiable.

There have been significant developments in the arena of weather based crop insurance products as visible from the data for 2004-11.

1. Total Sum Insured crossed USD 3 billion in 2010-11, a 200% increase over the previous year 2. A rapid volume growth in past 7 years with total number of farmers insured reaching close to 1 Crore

Table 1: Weather and Crop insurance differences

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WEATHER BASED

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3. Claims as a percentage of premiums have been as high as 76% (a) High liquidity requirement for Insurers (b) A market for reinsurers 4. Low value of premium per farmer served combined with difficulty in reaching out to rural customers (a) Need to minimize administrative and transaction costs (b) Issue of financial viability (c) Need for channel partners – NGOs, commercial partners – which can reach out to customer at low cost (d) Space for technology innovations to reduce transaction costs Delivery Mechanism We saw in the overview section that there is a place for re-insurers in this arena given the high liquidity requirement of the weather insurance products.

We also realized the need for channel partners and technology innovations to reduce transaction and administration costs.

But the product design principles discussed above also imply that: 1. The design of the contract depends upon actuarial estimates of weather parameters 2. The pay-out depends on the actual values of these parameters 3. These parameters , cumulative rainfall in our case, vary locally These implications create the role of a delivery partner that can help reduce the transaction costs and act as an interface between local customers and the insurance provider. The above insights can help us understand the rationale behind general delivery structure and implementation innovations utilized.

The general delivery model is given in fig 1.

Distribution channels have been the key in the scaleup of these projects. The private insurance providers have joined with partners such as companies involved in contract farming or agricultural input

supply in order to take advantage of their existing links with farmers.

1. IFCCO-Tokio, for example, sells the bulk of its policies through the extensive cooperative network of its parent company, IFFCO Fertilizers 2. ICICI Lombard has worked with ITC, taking advantage of ITC’s Internet kiosks 3. ICICI Lombard is also working with contract farming operations such as that of PepsiCo for potatoes Apart from NGOs and microfinance institutions, specialized technology and delivery partners are also emerging which will help in reaching out to the customers and also lowering the transaction and administration costs.

1. ICICI Lombard – BASIX set up is an example in this area 2. FINO has emerged as a specialized transaction provider for banking services Contract Implementation Statistics Analysis It can be seen from statistics in tables 2 and 3 that IFFCO Tokio contracts were designed to cater more to cases of extreme rainfall shortage.

1. Hence IFFCO Tokio contracts have lower premium due to lower expected actuarial pay-out.

2. ICICI contracts were offered in two different categories of premiums – Low & High. Combined with the three phased system, they present greater flexibility.

3. ICICI contracts have greater pay-out possibilities hence greater premium.

Most Importantly: How will the farmer understand these contract differences and make an appropriate choice?

This is an open issue that we have listed down in the issues section.

A study that statistically analysed the rainfall insurance pay-outs indicated that even the ICICI policy: 1. Was expected to make actual pay-outs in only 11% of the cases 2. 95th percentile of the pay-out occurred at around Rs 200

Fig. 1: General delivery model

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Table 3: IFFCO Tokio Poilicies – Gujarat 2007. Rs. payout as a function of rainfall deficit from normal rain

3. Only in 1% of the cases the maximum pay-out was made Though the actual benefits accrued cannot be assessed with great accuracy, but we may still see that an ideal policy design would require extensive focussed analysis and critiquing, and we are still far from the target.

Open Issues

meaningful insurance cover decreases.

5. Premiums for private contracts were not subsidized and were therefore higher than for NAIS contracts (6–14% of the sum insured versus 2–3.5%) In 2007, a few state governments began subsidizing index insurance products offered by private insurance companies, paying 40–50% of the premium.

Possibilities & Improvements

There are many open issues but here we focus on the ones most relevant to weather based insurance.

The biggest of all is the ‘Basis Risk’.

1. Basis Risk – Index insurance is vulnerable to basis risk. Simply put, basis risk is when insurance payouts do not match actual losses – either there are losses but no pay-out, or a pay-out is triggered even though there are no losses. Obviously, if either of the basis risk situations occurs too frequently, the insurance scheme will not be viable, and may even damage livelihoods.

2. Literacy – Financial and even general literacy of the rural customer is an ever persisting problem while providing financial products and insurance is no exception. In many cases, the rural customer does not understand paying for a product which does not pay a guaranteed return.

Recent innovations in this area offer insurance coupled with credit or other similar products or contracts to overcome this problem to some extent.

3. Reliable and Extensive weather data – The current growth of weather station network in India is largely haphazard and devoid of a coordinated approach and integrated planning. (a) In order to attain the objective of an integrated data system for India, Public-Private Partnerships (PPP) and integrated planning at the National level should be taken up. (b) These centralized efforts have to be followed up by decentralized implementation in identified locations across the country.

4. As the distance of the rainfall recording station from the farms increases, the chance of getting a

Based on the discussion above, and related research, we have compiled a list of areas where innovation may be focussed going forward. These are given below: 1. Build partnerships with several insurance companies to overcome the underwriting limitations incurred by reliance on a single company 2. Intensification of investment (both private and public) in the network of weather stations throughout the country, particularly in rural areas 3. Improve product design for better correlation between indices and crop losses 4. Ensure products remain simple enough to be understood by farmers and other stakeholders 5. Financial literacy training for stakeholders 6. Exploring innovations such as money-back in case of no pay out 7. Insurance product combination offered could include both an early payment (based on a weather index) and a final payment (based on an area yield index).

This will help to avoid the problem of the insurance claim payment made to a policyholder not always reflecting the true loss incurred by that policyholder.

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Table 2: ICICI Policies – Gujarat 2006

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Sovereign Credit Ratings: An Analysis of the ratings downgrades in the US and Euro Zone

Credit ratings reflect the financial health of an economy. Major credit ratings agencies like S&P, Moody’s and Fitch periodically come out with such ratings based on the performance and financial environment in different economies.

Though the ratings are only indicative, it covers exhaustively a host of factors and hence any downgrade leads to financial implications across the globe and hence the threat of a domino effect looms large.

Pragati Sangal & Raghav Pandey

MDI, Gurgaon

2011 may very well be remembered as the year of sovereign credit downgrades.

Apart from the historic credit downgrade of the United States from AAA to AA+ by Standard & Poor’s (S&P), there was a slew of other high profile credit downgrades. The credit rating agency, Moody’s downgraded Italian & Spanish government bonds by two & three notches respectively. Thirteen days into 2012, S&P downgraded the credit rating of nine Eurozone sovereigns, including that of France from AAA to AA+. All throughout, Greece’s sovereign credit rating took a beating and is currently rated as junk status.

So what triggered these credit ratings and what are their implications?

United States Credit Downgrade On 5th August 2011, S&P downgraded the credit rating of the United States government from AAA (Prime Grade) to AA+ (High grade). The downgrade took place three days after the US congress raised the debt ceiling by $2.1 trillion from $14.3 trillion. However, the downgrade was not unexpected. S&P had put US debt on a

negative outlook in April 2011, and had said that it might lower the rating unless the government approves a $4 trillion deficit cut in the next ten years.

Even though there was dodgy analysis involved in the downgrade, which resulted in artificial inflation of the US debt by 8% by 2021, there were some solid reasons behind the credit downgrade.

• Mounting Public Debt In contrast to other AAA rated countries like Germany & Britain who have actively taken steps to stabilise and lower their debt to GDP ratio, America’s debt has been rising unsustainably as a share of its GDP. There have also been criticisms that plan to slash government expenditure by $2.4 trillion over the next ten years, which accompanied by the debt ceiling rise, are just not acceptable.

Fig. 2: U.S. GDP Growth rate in % change

Fig. 1: Soverign credit rating : Feb, 2012

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that the US economy has taken from the huge ramp up in housing and other debt that lead to the financial crisis. As the US population ages, healthcare & other social welfare costs are expected to rise further. In the long run, the US government may find that it will have to offer higher interest rates to find takers for its bonds. This is going to exasperate the growth problem in America, as corporations and the government find it harder to take loans and expand.

Fig. 3: U.S. Debt to GDP in % of GDP

• Lack of Political Will There have also been concerns about the lack of political will to take the necessary steps to curb the mounting fiscal deficit. American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges. It is unclear if the US government will end the Bush era tax cuts or tackle entitlements. This anaemic policy making and brinksmanship was the cause behind the US debt crisis which resulted in the increase in the debt ceiling. S&P has said that the US is likely to face a further rating downgrade if the government continues to extend the Bush tax cuts for the wealthiest Americans.

Implications Following the downgrade, US Treasury bond yields actually fell. Thanks to the combination of America’s status as a safe haven and the on-going crisis in the Eurozone, the US dollar’s special place as the world’s reserve currency reinforced this movement.

However, on an average, lower credit rating has led to higher bond yields and this may very well be the case with the US, over a long period of time.

Fig. 4: U.S. Govt Bond 10 year - Implied Yield

Gold prices also shot up, following the downgrade, as investors fled equity and other risky assets and looked for safe picks. However, since then, spot gold prices have somewhat moderated.

However, there are deeper implications for this historic downgrade. It is the latest and the biggest blow

Fig. 5: Spot gold price in USD

European Credit Downgrades The Eurozone crisis resulted in financial instability in the continent owing to large government debt in Greece and other countries. In January 2012, S&P downgraded nine European Nations including France, Austria, Malta, Slovenia, the Slovak Republic, Spain, Italy, Portugal and Cyprus. However, Belgium, Finland, Ireland, Luxembourg, The Netherlands and Germany were exempted from any downgrading which indicates relative confidence in their economies.

With the current trend, UK and Germany, currently enjoying the top notch status in the ratings also face a threat of a similar downgrade, as the outlook has been changed to watch and negative status.

The unstable economic and political environment in the Eurozone has led to a spate of ratings downgrades in the last year. The credit rating agencies have highlighted the following concerns: • Tightening Credit Conditions It is essential to ensure that easy credit is not available across the European countries that are already debt laden. With already soaring debt to GDP levels in various nations, easy access to credit facility must be tightened. Downgrading of credit ratings ensures that the interest rates for borrowing for these nations increase. On the other hand, expensive borrowing raises the risk of these nations to default, thus making the European Central Bank all the more responsible for a possible bail out option to ensure the consolidation of Euro. The fig 6 shows the magnitude of debts raised by European nations and explains why tightening of credit is essential.

• Disagreements among European policy makers Euro zone members failed to tackle the immediate crisis at hand and were unable to define measures

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• Slowdown in Recovery The global and US economic recovery has dragged on for the past 2 years at a slow pace. Given the backdrop of the Eurozone Crisis, several economists have lowered the estimated growth rate of the US GDP from 3% to 2%. Fiscal tightening & the Eurozone crisis have been a drain on the growth. The unemployment statistics are still grim, though they have improved over the last 6 months.

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to ensure greater economic, financial, and fiscal convergence in the longer term. European Central Bank’s hesitancy to go for bail out, citing its objective is to control inflation alone led to increasing the extent of troubles. The establishment of European Financial Stability Facility and European Stability Mechanism, the two funds meant to put an end to the debt crisis gave hope of revival, but majority of the burden lies unfairly on Germany and France. Also, the amount decided for bailout has been increasing, which now stands at £1.3 trillion making the bailouts excruciatingly painful. The recent default concerns with Italy and Spain could have been fatal for France which had the highest exposure to the debt. However, £780 billion were pledged by European leaders to protect safeguard against contagion. The ouster of governments in Ireland, Portugal, Greece, Italy, Spain, Finland and Romania has also indicated an unstable political environment.

Fig. 6: Public Debt and Debt to GDP 2010

• Higher risk premiums It was continuously being observed that a number of Eurozone sovereigns including some which were rated ‘AAA’ actually were riskier investments than as reflected in the ratings. This can be attributed to the phenomenon known as financial contagion which is the transmission of financial crisis across financial markets for direct or indirect economies.

Greece with the highest debt to GDP ratio, owes a large share to France and Germany, the two biggest economies of the Eurozone. But even France and Germany have more than 80% government debt to GDP ratios, which constrains their ability to bail out the PIIGS nations. Apart from Greece, Italy is another threat to the stability of Europe as it owes large amounts to defaulting nations.

• Low Confidence in Economy Reports have indicated that quarterly growth in the euro zone has fallen to its lowest rate in the last two years. This has led to raising the risk of economic recession in the coming financial year. The main

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reason for this is the high rates of unemployment.

In addition, various austerity measures are leading to wage cuts and increased tax burden on individuals which is leading to sluggish economic growth in various countries.

Fig. 7: European youth unemployment

Implications The immediate implications of the downgrading of the European credit ratings will come in the form of an increase in borrowing costs of the nations affected. This also leads to the instability of the European currency owing to a loss in confidence in the European economy. A credit rating downgrade is viewed as a negative sign in markets, thus, a few commercial banks may replace French bonds with bonds of Germany to hold only the highest-rated government securities. It also would lead to widening of the dividing line between France and Germany, with France being now considered less investment worthy than its competitive neighbour. A global financial domino effect is the biggest concern behind the Europe downgrades at this point of time.

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QUANTITATIVE EASING

Sir, yesterday while having dinner, I heard three of my seniors discussing the term quantitative easing. I tried to get involved in the discussion, but it all went over my head. Can you explain me what exactly is quantitative easing?

Hmmmm… It’s good that you are keeping your ears and eyes open 24*7.

Anyways listen. Quantitative easing is one of the monetary tools used by the central banks to augment the money supply in the economy. Usually, the central bank uses the indirect way of moderating economic activity, i.e. by varying the interest rates. However, in the case of quantitative easing, it influences the market in a direct way by buying government and corporate bonds directly from the banks. The intention is to ‘ease’ pressure off the market by pumping in more ‘quantity’ of money.

All right sir. But when does the central bank do so?

Quantitative easing is used when economy is in a deflationary mode. Banks are reluctant to lend funds to businesses as they fear a default. They find it better to invest in government treasury, which is safe and also provides a healthy return. This deprives business houses of funds, which results in a deceleration in investment activities, and gradually leads to a further fall in growth.

But central banks can also influence money supply by changing the interest rates. What is the need of quantitative easing?

The central banks generally use quantitative easing when reducing the interest rates does not give them the desired success in curbing deflation. Quantitative easing might be termed as the central bank’s last resort to bring the economy back on the path of growth.

Akhil tandon IIM Shillong Sir, why are central banks so worried when economy is experiencing deflation? Isn’t a fall in price good for the people, as it will help them in buying more?

No, not really. When people expect falling prices, they become less willing to spend, and in particular less willing to borrow. In such a scenario, just sitting on cash becomes productive for the investors, as the effective purchasing power of rupee held is on the rise. Business houses to shy away from borrowing, as the loan will have to be repaid in rupees which are worth more than the rupees they borrowed.

Also, when the prices are falling, people tend to postpone their demand for goods in anticipation of a further reduction in price. As more and more consumers think on these lines, the entire economy is engulfed in a slowdown.

Oh! I always used to think that lower prices are good. Anyways sir, how does the Central Bank go about executing Quantitative easing?

The central banks buy corporate and government bonds from commercial banks. In return, it just credits the commercial bank’s account with an equivalent amount, and thus artificially injects money into the system. This has a two-way effect on the economy.

Firstly, by buying the bonds held by banks, it pumps in money, which improves the bank’s lending capacity.

Secondly, as the central bank purchases bonds, it’s demand increases. With an increase in demand, the yield on bonds falls, thereby making it less attractive for the banks to invest in them. The investment proposals of business houses now appears more productive to them, and they readily extend credit to them. With the multiplier in operation, this gives a huge impetus to growth, and pulls the economy out of that deflationary spiral.

However, if too much money is created, it might lead to rampant inflation, which is again detrimental for the economy.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

Article of the Month Classroom Cover Story

CLASSROOM FinFunda of the Month

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FIN-Q 1. What are we referring to?

2. Name the type of auction in which the price on an item is lowered until it gets a bid.

3. This currency was called ‘Royal’ before adoption of the current name. Name the currency.

4. Identify this famous national landmark building.

5. Among all the currencies with distinctive identities, what is the unique feature of the pound sterling?

6. The first budget of independent India was presented by ________________.

7. This defense strategy (coined by Bruce Wasserstein) prevented hostile takeover of Martin Marietta by Bendix Corporation in 1982. Identify the term.

8. What term became popular after the newspaper report of Watergate Scandal in the year 1973?

9. The annual shareholder meeting for which organization is held in the Qwest Center in Omaha.

10. Which word connected to stock exchange has its origin from Latin for ‘money bag’?

All entries should be mailed at niveshak.iims@gmail.com by 20th April, 2012 23:59 hrs One lucky winner will receive cash prize of Rs. 500/-

April 2012

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WINNERS Article of the Month

Prize - INR 1000/-

Charan Kumar U IIM Calcutta

FIN - Q

Prize - INR 500/-

Neeraj Gupta XIME, Bangalore

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