Niveshak Feb15

Niveshak THE INVESTOR

VOLUME 8 ISSUE 2

FEBRUARY 2015

FASTEST GROWING ECONOMY?

FROM EDITOR’S DESK Niveshak Volume VIII ISSUE II February 2015 Faculty Chairman

Prof. P. Saravanan

THE TEAM Abhishek Bansal Akanksha Gupta Apoorva Sharma Bhawana Saraf Gaurav Bhardwaj Jatin Sethi Kocherlakota Tarun Maha Singh Gulati Mohit Gupta Mohnish Khiani Palash jain Prakhar Nagori Priyadarshi Agarwal Ramesh Jaiswal Rahul Bajaj Sandeep Sharma S C Chakravarthi V Vishal Khare

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

Dear Niveshaks,

The month of February has seen many events taking place in India in politics, economics as well as in the corporate sector. Results of Third quarter earnings declared this month ended up disappointing the investors as annual profit growth has been the worst in last five quarters, with the aggregate net profit of 2,941 companies declining 16.9 per cent. The January WPI inflation dropped to a five and a half year low of -0.39% on falling prices of manufactured products and fuel items. Inflation in fuel and power segment was negative at -10.69%, while for manufactured products it was 1.05%. On the Make in India front, PM Narendra Modi inaugurated American multinational General Electric’s (GE) first manufacturing plant in India. The plant will manufacture a range of diversified products for sectors such as energy, aviation, and oil & gas transportation. On the e-commerce front, Alibaba signed a deal to buy a 25% stake in Indian mobile payments and ecommerce platform Paytm. On the political front, AAP leader Arvind Kejriwal took oath as the eighth chief minister of Delhi, promising to make Delhi the first corruption-free state and act against communal elements. The AAP had won 67 of the 70 seats in Delhi decimating Congress and leaving only three seats for the BJP. The government announced the a capital infusion of Rs 6,990 crore in nine state run banks based on new efficiency parameters such as return on assets and return on equity. US technology giant Apple Inc. became the first company to reach a market value of $700 billion. Earlier in January 2015, Apple Inc had recorded highest quarterly profit of 18 billion US dollar in corporate history worldwide after the company sold 74.5 million iPhones in quarter ending December 2014. The government changed the base year for GDP calculation from 2004-05 to 2011-12. This resulted in sharp revision of the India’s 2013-14 GDP growth numbers to 6.9% from 4.7%. The cover story of this issue delves deep into parameters behind GDP revision providing various angles to look at this revision. Flipkart is gearing up to raise the largest Indian IPO by raising $4 billion dollars. Our article of the month discusses the valuation of Flipkart and the hypothesis of it being overvalued. In 2013-14, India had topped the chart of remittance inflows, by receiving a whopping $69.6 billion, followed by China with $60 billion and the Philippines with $25 billion. Fingyan article Outside Money – Inside Economy will take you through the intricacies of remittance and its impact on the Indian economy. Finsight discusses the impact of Basel III norms on the Banking sector. FinView has the excerpts from Dr. Madalasa Venkataraman who gives her views on Real Estate Investments. Classroom section shares knowledge on Swaps. To end this brief note, we would like to thank our readers for their immense support and encouragement. You remain our prime motivation factor that keeps our spirits high and give us the vigour and vitality to keep working hard. 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

10 Is flipkart over valued at $7 Billion

14 India â&#x20AC;&#x201C; The fastest growing

economy in the world: true or just an eye wash

FinGyaan 18

OutsideMoney Economy

Inside

Finsight

The Basel Capital Accord: The Journey and Way Ahead

FinLife 22

FINVIEW

29 Interview With Dr. Madalasa

Wealth Management: Make Venkataraman,Lead Researcher, Your Own Portfolio IIM Bangalore

CLASSROOM

31 Swap Market

The Month That Was

NIVESHAK

www.iims-niveshak.com

The Niveshak Times Team NIVESHAK

IIM Shillong RBI’s new gold lending norms to make hedging easier

negative 0.17 per cent from the provisional estimate of zero, the data showed.

The Reserve Bank on Feb 18th lifted the ban on imports of gold coins and medallions by banks and trading houses. The RBI in a notification also said banks are permitted to import gold on consignment basis. Domestic sales will be, however, permitted against upfront payment only. Speaking on the above circular, S Subramaniam, CFO, Titan Co said the RBI move was more on the credit side – there was issue on credit on gold imports for domestic consumption but that has now been clarified. The gold metal loan authorised by domestic banks will now be available for domestic consumption. The most welcome development of this easing in gold lending norms is that hedging will become easier. Although it does not change things too much for the company per se because earlier also RBI had liberalised gold loan credit for some four-five banks and they were already getting credit, said Subramaniam. However, now the ban has been lifted and all banks can provide credit.

The data comes after the index of industrial production showed a growth of only 1.7 per cent in December while retail inflation stood at 5.11 per cent, well below the RBI’s comfort level of 6 per cent.

Inflation turns negative at (-)0.39 pct in January, food prices stay high Headline inflation declined to a five-and-a-half year low of (-)0.39 per cent in January on the back of a sharp decline in prices of fuel and manufacturing products. However, the food prices remained high, the data released by the commerce and industry ministry showed. According to the Wholesale Price Index (WPI), which gauges the headline inflation, while fuel prices declined by 10.69 per cent in January compared to a decline of 7.82 per cent in December, the rate of price rise in manufactured products was 1.05 per cent compared to 1.57 per cent in the previous month. However, the food inflation continued to remain high at 8 per cent compared to 5.20 per cent in December as pulses, vegetables and cereals became dearer. The WPI stood at 0.11 per cent in December while the November data was revised downwards to a

FEBRUARY 2015

Infosys Buys US-Based Panaya for $200 Million Kerala and Goa have become the first states in the IT major Infosys announced the acquisition of USbased Panaya for $200 million or Rs 1,250 crore. This is Infosys’ second largest acquisition since the September 2012 deal to acquire Zurich-based Lodestone Holding. New Jersey-based Panaya provides cloud-based quality management services for enterprise applications; its clients include companies such as Coca-Cola, Mercedes-Benz and Unilever, among others. The all-cash deal is expected to close before March 31, 2015, Infosys said in a statement. “Panaya’s acquisition reflects Infosys’ execution of its Renew and New strategy to enhance the competitiveness and productivity of current service lines by leveraging automation, innovation and artificial intelligence,” the company said in a statement. The acquisition comes at a time when Infosys, India’s second-biggest IT outsourcing company, is betting on new technology to boost growth. Under chief executive Vishal Sikka, Infosys has been making big bets on automation and other new technology like artificial intelligence and cloud-based services as the company tries to regain some lost ground from rivals like Tata Consultancy Services. RBI eases some restrictions on shadow bank lending The Reserve Bank of India (RBI) eased lending regulations governing the country’s shadow banking industry, removing investor limits and the need for collateral guarantees on standard debt transactions. The RBI said shadow banks would henceforth be able to conduct non-convertible transactions valued at 10 million rupees ($160,000) or more unsecured, and such issuance would no longer be limited to 200

www.iims-niveshak.com

NIVESHAK

investors.Restrictions would remain on debt of less than thatvalue that is not convertible into equity, and on all convertible debt, the RBI said.

similar investigations or regulatory proceedings.

India’s shadow banks, known as non-banking financial firms (NBFCs), are widespread and include housing finance companies and consumer finance firms that lend small sums to individuals.

Foreign direct investment (FDI) in India almost doubled to $2.16 billion in December 2014, compared to $1.10 billion in the same month of 2013.

The central bank also said NBFCs would not be permitted to transfer the proceeds of non-convertible debt issues to affiliates. Shadow banks are lending heavily to sectors like infrastructure without full banking licenses and without being subject to the tougher rules imposed on commercial banks - even as the country’s regular banks struggle with a pile-up of bad loans after years of reckless lending. HSBC gets summons from Indian Tax Dept, fears significant fines Facing a multi-nation probe for alleged tax evasion, money laundering and unlawful cross- border banking solicitation, global giant HSBC said it has been served summons by the Indian tax department. The bank said it is being probed by tax authorities in many other countries as well with regard to alleged irregularities by its Swiss banking unit and there could be significant amounts of fines, penalties and/ or forfeitures imposed on it. Separately, the UK-based bank said it has also received subpoenas and requests for information from the US and other authorities with respect to certain US-based clients of an HSBC company in India.

FDI rose 27 per cent to USD 21.04 bn in AprilDecember 2014

During the April-December period of the current financial year, FDI rose by 27 per cent to $21.04 billion against $16.56 billion in the same period last fiscal, the data by Department of Industrial Policy and Promotion (DIPP) showed. Among the top 10 sectors, telecom received the maximum FDI of $2.67 billion in the ninemonth period, followed by services ($2.29 billion), automobile ($1.58 billion), pharmaceuticals ($1.21 billion) and computer software and hardware ($971 million). During the period, India received maximum FDI from Mauritius at $5.89 billion, followed by Singapore ($4.31 billion), the Netherlands ($2.57 billion), the US ($1.48 billion) and Japan ($1.42 billion). In 2013-14, FDI stood at $24.29 billion against $22.42 billion in 2012-13. Healthy inflow of foreign investments into the country help in balancing the country’s balance of payments and stabilise the value of rupee. India is estimated to require around $1 trillion over five years to overhaul its infrastructure sector, including ports, airports and highways to boost growth.

A leaked list of over one lakh account holders in HSBC’s Swiss banking unit, including 1,195 Indians, recently became public, prompting authorities in India and many other countries to launch their investigations to ascertain whether these accounts had illicit money stashed abroad. Giving an update on the case in its annual report, HSBC said it is cooperating with the relevant authorities, while adding that it was possible that other tax administration, regulatory or law enforcement authorities will also initiate or enlarge

The Month That Was

The Niveshak Times

www.iims-niveshak.com

35000

2,500

30000

2,000

25000

1,500

20000

1,000

15000

500

10000

5000

-‐500

-‐1,000 25/02/15

24/02/15

23/02/15

22/02/15

21/02/15

20/02/15

19/02/15

18/02/15

17/02/15

16/02/15

15/02/15

14/02/15

FII

13/02/15

12/02/15

DII

11/02/15

10/02/15

BSE

09/02/15

08/02/15

07/02/15

06/02/15

05/02/15

04/02/15

03/02/15

02/02/15

01/02/15

31/01/15

30/01/15

29/01/15

-‐5000

BSE

Market Snapshot FII, DII Net turnover (in Rs. Crores)

Article ofSnapshot the Month Market Cover Story

NIVESHAK

-‐1,500

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

MARKET CAP (IN RS. CR) BSE Mkt. Cap

10346378.17 Source: www.bseindia.com

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

62.0468 70.4293 52.28 96.0298 45.69158

CURRENCY MOVEMENTS 1.50%

INR/1 USD Euro/1 USD GBP/1 USD JPY/1 USD SGD/1 USD

1.00% 0.50%

LENDING / DEPOSIT RATES Base rate Deposit rate

10.00%-10.25% 8.00% - 8.75%

RESERVE RATIOS CRR SLR

4.00% 21.50%

POLICY RATES Bank Rate Repo rate Reverse Repo rate

8.75% 7.75% 6.75%

0.00% -‐0.50% -‐1.00% -‐1.50% -‐2.00% -‐2.50% -‐3.00%

FEBRUARY 2015

Source: www.bseindia.com 29-Jan-2015 to 25-Feb-2015 Data as on 25-Feb-2015

www.iims-niveshak.com

NIVESHAK

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

Open

% change

29559.18 10808.44 11369.11 20209.63 23439.08 10786.9 17077.58 8233.2 15581.27 11152.77 10298.15 10053.06 2201.68 8406.28 1718.83 6154.08

29007.99 10701.11 11254.82 19632.82 21475.41 10408.62 17399.48 8654.08 15541.16 11968.21 10382.12 9469.38 2232.04 7955.22 1757.75 6415.96

-1.86% -0.99% -1.01% -2.85% -8.38% -3.51% 1.88% 5.11% -0.26% 7.31% 0.82% -5.81% 1.38% -5.37% 2.26% 4.26%

% CHANGE

% Change TECK, 4.26% REALTY, 2.26% PSU, -‐5.37% POWER, 1.38% OIL&GAS, -‐5.81% METAL, 0.82% IT, 7.31% Healthcare, -‐0.26% 1

FMCG, 5.11% CG, 1.88%

CD, -‐3.51% BANKEX, -‐8.38% AUTO, -‐2.85% Smallcap, -‐1.01% MIDCAP, -‐0.99% Sensex, -‐1.86% © FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

Article Market of Snapshot the Month Cover Story

Market Snapshot

Niveshak Investment Fund

Done on 30/6/14

Informa(on Technology

CONS NON DURABLE (5.89%)

HCL Tech.

GODREJ CONSUMER Wg:5.89% Gain:28.82%

(13.18%)

Infosys

Wg: 5.02% Gain : 32.00%

Wg: 3.83% Gain : 39.11%

Britannia Wg:4.69% Gain : 104.17%

TCS

Wg: 4.33% Gain : 7.80%

FMCG (20.64%) Colgate HUL

Wg:5.91% Gain : 25.05%

Wg:4.62% Gain:25.86%

BANKING (6.09%) Wg:5.42% Gain : 15.13%

Auto (10.04%)

Pharmaceu(cals (16.27%)

Dr Reddy’s Labs Wg:4.24% Gain:12.62%

Lupin Wg:7.20% Gain : 47.40%

HDFC Bank

Wg: 6.09% Gain : 12.62%

Chemicals (6.71%) Amara Raja BaS Wg:4.19% Gain : 19.36%

Tata Motors Wg:5.85% Gain : 25.02%

ITC

Asian Paints Wg:6.71% Gain:25.93%

MISC. (4.83%)

MANUFACTURING

Titan Company Wg:4.83% Gain:-‐12.93%

Page Industries

(5.23%)

Wg:5.23% Gain:9.20%

Performance Evaluation

As on 26th February,2015

February Performance of Niveshak Investment Fund

Performance of Niveshak Investment Fund since IncepCon

104 103

102

180

101

160

100

140

120 100

60 20 15 b-‐ Fe 2-‐

-‐1

4 -‐D

-‐1

-‐O 31

-‐S

-‐1

ug -‐A

n-‐

-‐Ju

-‐1

-‐M

n-‐

Values Scaled to 100

-‐Ja

NIF

Sensex

0 ay

15 03/

02/

15 02/ 25/

15 02/ 20/

15 02/ 15/

15 02/ 10/

15 02/ 05/

31/

01/

-‐M

Risk Measures: Opening Por+olio Value : 10,00,000 Standard DeviaCon : 16.40%(Sensex : Current Por+olio Value : 15,32,140 13.50%) Change in Por+olio Value : 53.214% Sharpe RaCo : 2.93(Sensex : 2.97) Change in Sensex : 40.23% Cash Remaining:269785 Comments on NIF’s Performance & Way Ahead : This month the ﬁnancial market in India started with

the conCnued momentum that was gained in the January 2015 aTer the much needed rate cut by the Reserve Bank of India on 15th January. The market in the second half of the month onwards has traded on correcCon side on account of disappoinCng quarterly results and weak global markets. The BSE Sensex during the month (Till 26th feb) recorded a negaCve change of 1.28 %, and the por+olio recorded a posiCve change of 1.56% . On internaConal front, the upbeat US Housing data increased the chances of Fed ge]ng flexible on increase of interest rates. The Brent crude touched the levels of $55, gaining as much as 30% since mid January during the month, with OPEC choosing not to cut the output and compete with Shale and other sources. Concerns over Greeks Bankruptcy also kept the markets under check and extension of tough bailout deals could have further repercussions. Towards the end of this month, the union budget would be presented by Hon’ble Finance Minister , important areas like Direct taxes, Custom duCes and other leviables like GAAR and GST could see some important changes and announcements . The por+olio did not witness any re shuffle during this month, however we expect some sell offs of overvalued stocks and other reshuffles in the next month owing to budget, crude prices, legislaCve reforms and other domesCc and internaConal developments.

Article of the Month Cover Story

NIVESHAK

Is flipkart over valued at $7 Billion Borampalli Ravali Preethia

NIIE,Mumbai Introduction In 2007, when Flipkart was founded, online retail sector in India was in its infancy. Internet was not an available resource for an ordinary man at that time. Even International players like Amazon and eBay didn’t enter the Indian market. At the same time, Flipkart entered the market and played a key role in the growth of online retail market in India, as India has become one of the largest online markets in the world. Flipkart also adapted to the Indian conditions by introducing cash on delivery, knowing there is very less usage of credit cards and online payments in India at that time. Since 2007, online retail market in India had a compounded growth rate of 56% every year and Flipkart outperformed this rate every year. As of 2014, In India, online retail is just 0.5% of overall retail and 7.9% of overall organized retail sector. This also indicates that online retail has much growth potential in India. In recent years, mobile commerce is playing an important role in online retail industry in addition to social networks. New sites are exploding every day, and the mobile commerce plays a significant

FEBRUARY 2015

role in expanding the market, and it overcomes the internet connectivity issues in towns and villages. With all these amazing prospectus of Flipkart and Indian online retailing, Is the valuation figure attached to Flipkart is justified? Let’s look at the fundamentals of Flipkart that play a significant role in its valuation. Revenue Growth The e-tailing giant is presently in the growth phase and is making no profits, a common phenomenon observed in all the startups and young growth companies. As we know that the company with continued negative earnings and cash flows doesn’t have any value, young growth companies like Flipkart are expected to make revenues in the future. The expected revenue growth at Flipkart will be the composite effect of factors like expected growth rate in Indian online retail business and expected market share of Flipkart in the future. As, Flipkart is keen in making its presence across the countries, and it is anticipated that its revenue is not only dependent on just Indian online retail

NIVESHAK

operating margin of 10% by 2025, and settle as a mature business firm as that of Amazon today. To provide the perspective- Online retail giant Amazon had 5% margin till 2010, and now it dropped to 1%. Re-Investment It goes without saying that every company in order to grow have to reinvest in the business. Growth is nothing but how much we reinvest (Reinvestment rate) and how well it is invested (Return on Reinvestment). As the revenues of Flipkart are expected to grow massively in the near future, there is a need to reinvest in the business in proportion to the expected revenue growth. Till now, Flipkart has done reinvestment both in terms of technology and acquisitions. Globally, online retail firms have sales to capital ratio of 2.26, means every rupee reinvested in the business generates 2.26 rupees as incremental revenues. This number can be adapted in the case of Flipkart too, due to its efficient past growth. Cost of Capital Cost of Capital of Flipkart is presently at 16.86% considering the risk of the company, present risk-free rate and the risk premium. With the new government in power, the Indian macroeconomic conditions are expected to be in a better shape at least by the next ten

Article of the Month Cover Story

market but also the global market. At present Flipkart has the market share of nearly 32% in the Indian online retail market and is assumed to grow to 40% within ten years. Therefore, Flipkart will have 40% of Indian online market share and also 20% of its revenues from outside India (as Flipkart’s founders aspire to take the firm global). Analysts project that the Indian online retail market will cross $100 bn by 2025. According to the above estimates, revenues of Flipkart is projected to be at $50 bn by 2025, which are just 35% lower than that of Amazon’s 2013 revenues and 20% below the Google’s revenues in 2013 and 4.6 times greater than Facebook’s 2013 revenues. Operating margin Flipkart at present has negative operating margin of nearly 4.62%. It has invested huge capital (both its revenues & Capital raised from VC’s) in supply chain, advertising and developing applications and website to increase its market reach. Online retail is the sector in which all the players offer products with similar discounts for the same pool of customers. The firm can differentiate itself from others in the area of delivery m e c h a n I s m and reliability. This eventually results in the lower o p e r a t I n g m a r g I n s. Flipkart since its inception has reinvested enormous amounts of capital to enhance these areas that created them an absolute competitive advantage. Flipkart with its efficient supply chain management and competitive advantage is expected to have an

Article of the Month Cover Story

NIVESHAK

years. Thus, Flipkart sâ&#x20AC;&#x2122; Cost of capital would be reduced to 13.77% at its stable growth period due to reduced risk premium and risk-free rate by the time it evolves as a matured company with low beta. The Valuation Taking all the above factors and estimations into consideration, Flipkart is valued through discounted cash flow valuation and the value of the firm (or equity, as no debt) obtained is $2.52bn, way below its $7bn Valuation. In addition to this, Flipkart also has given stock options to its employees, which further reduces the value (ESOP were not deducted, due to unavailability of data) Flipkart is overvalued by nearly 1.78 times. One of the main reasons for overvaluation is investors high expectation of growth in Online retail sector. In the same way, they are pricing (relative valuation) Flipkart by comparing it with Amazon and Alibaba, in terms of estimating the future growth and market share. Misjudging the Market Growth Any sector cannot have high growth throughout its life span. Similar to the firms, sectors to attain stable growth after substantial high growth period. Online retail sector being no exception, is in its stable growth stage in US at present. This is the reason investors are flooding funds to Indian online retail sector in the recent years rather than funding US online retail startups. But one should note that Indian online retail market too will reach its stable growth period. Investors

FEBRUARY 2015

and founders of e-Commerce Companies are now banking high on Mobile Commerce. In spite of the high mobile phone penetration, growth in the m-commerce may not be in par because of the conservative nature of the Indian customers who prefer to buy goods offline. Comparison with Alibaba Many analysts compare Flipkart with Alibaba in terms of both valuation and growth, as

they are market leaders in the eCommerce business. Though both of them belong to the markets that are growing at high CAGR, there are many differences between them in terms of market share and operating margin. Unlike Flipkart, Alibaba has a its presence in different e-commerce segments like Business to consumer, consumer to consumer, the mobile market and online payment segments in China. In all these four parts, Alibaba is a market

NIVESHAK

Article of the Month Cover Story

leader with a huge presence. In addition to this, Alibaba has significant operating margin of 50% at present and is expected to continue with the same in future too. The Amazon Story Amazon was also valued in its initial days at very high price, but later market prices it correctly, that’s for the dot com bubble for correcting the valuation. After watching Amazon and Alibaba’s success, investors are betting high on Indian market and Flipkart. In both US and China, those respective companies were able to gain absolute monopoly till day in terms of market share. In 1994, Amazon entered with the unique business model, and it was the first of such kind in the eCommerce business. It is also important to note that it is one of those dotcom companies survived the dotcom bubble burst. Thus, Amazon has gained not only high market share but also perfect monopoly in the online retail business. Flipkart, though it leads other firms in terms of market share in India at present, it lacks the monopoly that Amazon and Alibaba have. Flipkart will face problem in gaining such a huge market share in India in future, mainly due to new entrants and strong existing players like Snapdeal and Amazon who already have considerable market share and are going good in terms of both revenues and strategic investments. In 2007, Flipkart was started with the same idea and business model of Amazon but made changes according to Indian market. After few years, Snapdeal also worked with the similar model and was successful in gaining the market share. Therefore, it is the adaption to

the market that is gaining market share in India. So, there is a lot of chance for firms with deep pockets like Amazon to snatch away market share from Flipkart. Maybe, it is the big expectations on the growth potential that is making Flipkart look big for investors. Relative valuation perspective Although intrinsic valuation determines the value of the company by considering all the fundamentals like growth rate, risk in the company and estimated cash flows every year, Most of the investment banks and Investors value the company on the basis of relative valuation, as it is easy and simple method to evaluate the company by comparing with other companies in the sector by using multiples of number of clicks obtained or revenues generated. The company on relative valuation gets overvalued if the sector itself is overvalued. This comes right in the case of Indian online retail sector. Being in young growth sector, with less number of comparable firms, Flipkart’s Valuations were done solely on the market expectations and belief.

Cover Story

NIVESHAK

India – The fastest growing economy In the world: true or just an eye wash

Palash Jain & Bhawana Saraf

IIM Shillong Introduction The Gross Domestic Product (GDP) is like the godfather of all the economic indicators. Renowned economists, bankers, businessmen, investors, policy-makers and the media, all seem to be obsessed with this number, whose single or double-digit value can spark much hysteria and generate talking points for many of these stakeholders. Recently there has been a hue and cry about the change in the methodology by which India calculates its GDP. The Ministry of Statistics and Programme Implementation recently announced a change in the method of calculation of GDP which has baffled almost everyone including businessmen, economists, investors and international communities.

FEBRUARY 2015

Taken at face value, India recently became the fastest growing major economy in the world after its statisticians changed the way they measure Asia’s third-largest economy and showed that it clocked faster growth than China in the December quarter. It marks a dramatic turnaround for an economy that just some time ago was assumed to be struggling to gain momentum under Prime Minister Narendra Modi’s reform-minded government. Prior to Modi’s election last May, the economy had undergone its weakest phase of growth since the 1980s. But the question still remains whether there actually has been a turnaround or this is just a numbers play. The Indian government recently changed its method of measuring GDP, replacing factor costs with internationally accepted market prices.

NIVESHAK

the real GDP is measured in accordance with the prices and structure of the economy in a base year. The GDP figures for a one-year period become less relevant over time, that’s why the base year needs to be changed periodically. For India the base year changed from 2004-2005 to 2011-2012. This was one of the reason why India’s GDP growth rate for the year 2013-2014 was revised to 6.9%, much higher than earlier estimate of 5.1%. The usual norm in almost all major economies is to revise the base year after every 5 years. After all, the biggest use of GDP at an international level is to have an accurate measure of economic performance in the recent time. There could be multiple reasons for such a large but positive change. One of the reason could be changes in the technology or trends which were absent earlier. For example many things which are important in consumption basket today like Mobiles, Communication services, Digital goods, E-Commerce did not have much impact on the economy earlier. Today these services are extremely important and therefore must be accounted for in the GDP calculation. So Why This Conundrum? While the GDP growth figure shot up with the new calculations, the absolute GDP figure was essentially the same as it was before, making it difficult for economists to understand where the new-found growth came from. While the new numbers reveal that last year the economy had recovered strongly, some economists are still sceptical. Most of the other indicators of that year suggested growth was sputtering. Other indicators such as index of industrial production (IIP), trade and tax collection figures suggest that the economy is still suffering from slack. On one hand one part of the government has been saying that tax collections are slow due to a slowdown in the economy, another part of the government is saying that GDP growth has been strong. This means that either one part of the economy is not taxed or there is an issue with the data. This has confused the economists and has made it difficult for them to make further economic predictions. The change in GDP calculation methodology has not only confused the economists but also the central bank. The Governor of RBI, Mr. Raghuram Rajan also has no clarity on the new method. “We do need to spend more time understanding

Cover Story

The Statistics Ministry said that the country’s economic output is projected to grow at 7.4% in this fiscal year compared to 6.9% in the previous year. Growth for the previous three months has been revised sharply to 8.2% from an earlier figure of 5.3%. As a result, India has officially overtaken China as the world’s fastest growing economy with a growth of 7.5% in the December quarter. China grew by 7.3% in the most recent quarter. What Changes Did The Government Of India Introduce? Two new changes were introduced by the Indian Government in its way to calculate the GDP of the economy. These are: 1.While calculating GDP, price rise or inflation in the economy for the period is an important factor taken into consideration. This price rise involves considering a base year to assess the price change. The base year has been changed from 2004-05 to 2011-12. 2.The second change is regarding the calculation methods. Before the change in methodology, India used to calculate its GDP based on factor prices. However, after this announcement, the GDP will be calculated at market prices. Factor cost is defined as the price received by the producers of a good or service, which is not the same as the market price of a product, since there are taxes involved which needs to be paid to the government. Thus, Factor Cost=Market Price – taxes + subsidies. Why Was This Change Needed? The government said that its benchmark to measure the economic growth will henceforth be based on market prices, not on factor costs. The older method tabulates economic activity based on the cost of production, whereas the new method is based on the amount paid by the consumers. Most countries and international bodies calculate GDP based on market prices. Thus, in order to have better comparison with other international economies, this change was required. Also the new method incorporates more comprehensive data on corporate activities and spending by households and informal businesses. For the base year change, GPD cannot be forever calculated on a single base year and the base year need to be continuously revised. The new method of calculating is rebasing under which

NIVESHAK

Cover Story

the GDP numbers,” Rajan had said on February 3 after releasing the bi-monthly monetary policy of the central bank that retained the forecast of 5.5 per cent GDP (based on old method) growth in 2014-15. “We will be watching the February 9 release with great care and dwell deeply into what we see there. At this point, it is premature to take a strong view based on these GDP numbers.” he had said. Industry chamber Assocham said the revision was confusing as “investment is yet to revive, consumer demand is not returning with a significant pace despite a sharp reduction in crude oil prices.” This is also contradicting to the claims of Ministry of Statistics that there has been high growth in the economy. The latest data shows that while sectors like agriculture, mining, hospitality and public spending slowed in 2014-15 compared to the previous year, key sectors such as manufacturing, construction and financial sectors grew at a faster pace than the previous year. Experts are particularly surprised at the higher sectorial numbers for the manufacturing and financial sectors reported by the new series because this is not reflected in data on factory output and bank credit. With nominal GDP projected at Rs.126.5 trillion for 2014-15 from Rs.113.4 trillion a year ago, the size of the economy is projected at $2.1 trillion at the current level of dollar exchange rate at Rs.61.7. At the turn of the millennium, Indian GDP was about $481 billion and by 2007, it was measured at $1.2 trillion. This means that it had grown two-and-a-half times in seven years. And effectively, in a span of 14 years the Indian

FEBRUARY 2015

economy has grown more than four times. This seems unbelievable! The number also doesn’t mean much in terms of per capita income and India will remain a lower middle-income economy. Its economy will have to grow by at least four times and its population remain at the same level for it to become an upper middle-income economy. Other key indicators of GDP like inflation is not showing encouraging signs. The latest data shows that inflation for the month of January has fallen below zero to -0.39%. This also questions whether the GDP has actually grown at such a high pace. Impact Of This Change A step of this magnitude will create a ripple effect in the Indian economy. The 2014-15 fiscal deficit and current account deficit are likely to decline to 4.3% of GDP (4.6% earlier) and 1.6% of GDP (1.7% earlier) respectively. The Finance Minister of India, Mr. Arun Jaitley, is widely expected to increase capital spending and offer tax breaks to the under-performing manufacturing sector. But with GDP data showing the economy suddenly cruising again, the fiscal stimulus could fuel inflation. Also revised GDP data may make it harder for him to assess the size of the fiscal stimulus required to help re-establish the economy to the even higher growth rates needed to generate jobs for millions of young Indians entering the work force. Even Mr. Raghuram Rajan, who switched the monetary policy in January with the first interest rate cut in 20 months, faces a similar predicament; whether to lower interest rates again. This will push back the timeline for rate cuts and any hope of an off-cycle rate cut in

NIVESHAK

Cover Story

March, even if the budget is consistent with low inflation-driven fiscal policy does not exist now. There also can be political impact of such decisions. The opposition, Congress, may claim that there was high growth during their tenure using this method which will belittle the current government’s claim of low growth during its predecessor’s tenure. One of the key reasons which led to election debacle for Congress was lack of economic growth for a long period.

The new method is in line with the global practices and also gives a clear picture of the economic activity. Although the timing of such a change can be questioned with the political factors involved, it does integrate the reflections on economic activity at the global spectrum. The previous methodology of GDP Computation had certain loopholes which have been fixed with the modifications. For example, IMF’s world economic outlook projections are not based on factor costs. This led to a state of confusion, with IMF’s projections turning out to be very different from the Government’s. With respect to the base year change, it is the only way which ensures that the products and services included in the GDP calculation remain contemporary and reflect the present state of the economy. For example, the change in base year has included the recycling industry which was not incorporated in the earlier GDP computations. Similarly trading activities by manufacturing firms are included in that sector’s share. Global investors use growth prospect figures for investment allocations between countries – GDP is a key metric here. So recalculation of India’s GDP growth at 6 per cent as the average of the last three years from 4.6 per cent may help investors view India in a more favourable light. Although there is scepticism among the policymakers with regard to the change in methodology, in our opinion the alignment with the global practices would certainly help in better comparison and greater However, the new calculations show that the future prospects. economy had already revived by the time the new government had come GDP had grown strongly during the UPA tenure. Recommendations © FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

NIVESHAK

FinGyaan

OUTSIDE MONEY | INSIDE ECONOMY

Paras Parekh

IIM Shillong The world as we know is changing, and is changing fast. We have developed a better means of travel and communication facilities which has, in turn, enabled movement of people across the land. To make a better life for themselves, people do all sorts of things, one of which is going to greener pastures. According to the World Bank data there are over 230 million international migrants, people born in a country other than in which they live. To understand the hugeness of this number, if all the migrants were a country, its population would be greater than that of Brazil and that would make it the 5th largest nation in the world in terms of population. These people, mostly from developing or under-developed economies send money back home for the well-being of their

FEBRUARY 2015

family members. The topic of this article is this money, also known as- Remittances. Remittances, according to the World Bank definition, includes transfer of cash or kind from migrants to their relatives back home. The new edition of the Balance of Payments Manual (BPM6, IMF 2008) states that personal transfers include all current transfers whether in cash or in kind between resident and nonresident individuals independent of the source of income of the sender and regardless of whether the sender receives income from labor, entrepreneurial or property income, social benefits, any other types of transfers; or disposal of assets and the relationship between the households regardless of whether they are related or unrelated individuals. These amounts

NIVESHAK

FinGyaan Cover Story

of unrequited money maybe small in terms of individual transactions but in total adds up to billions of dollars and hence these have come to represent one of the largest flow of international funds. In many cases these remittance flows have been more than the total FDI and FII inflows to the country. For the year 2013, the total global remittance flow was $410 billion, which was almost three times the total international aid of $135 Billion. India was the largest recipient of these flows with $71 billion followed closely by China at $60 Billion and Philippines at $25 Billion. For economies like Tajikistan, Bangladesh, Nepal and many more, these flow of funds form a substantial portion of their GDP. According to 2012 data, Tajikistan tops the list with 48%, followed by the Kyrgyz Republic at 31% and Nepal at 25%. Also, for many countries the total remittance flow exceeds their own foreign exchange reserves. Talking about India, the FDI inflows in 2013 were $28 Billion and FII inflows were $20 Billion. Comparing these numbers to that of the remittance India receives, we can understand the magnitude of the impact it has on the Indian Economy and similarly on other developing economies. World Bank data estimates that by 2016 the total remittance from the developed world to the developing world

countries would increase to $500 billion and total global remittance (includes those to high income countries) would touch a record of $707 Billion by 2016. “Remittances act as a major counter-balance when capital flows weaken as happened in the wake of the US Fed announcing its intention to reign in its liquidity injection program (QE). Also, when a nation’s currency weakens, inward remittances rise and, as such, they act as an automatic stabilizer,” said Kaushik Basu, Senior Vice President and Chief Economist at the World Bank. From the words of the former Chief Economic Advisor to the Government of India, we can understand that remittances play a major role in the economic development and macroeconomic stability of emerging economies. Remittances is one of the most stable and least controversial source of funds to an economy and hence policy makers can play a huge part in maximizing the output from this resource. Talking about the benefits, one of the major impact such flows have is on the development of human capital of the recipient country. This money acts as a life-line to the poor people. It helps them to better support their families in terms of nutrition, healthcare and education and hence has a very direct impact at the grass-

Article FinGyaan of the Month Cover Story

NIVESHAK

root level of the recipient economy. There have been many studies conducted which shows that in countries like Nepal and Bangladesh, remittances have contributed immensely in improving the overall human life by bringing down the school dropout rate, infant mortality rate and gender inequality. Other benefit is that the migrating labor also brings back with him good sanitation and life style practices which can improve the standard of living not only of his relatives but also of the community. According to the Migration Policy Institute report, a 10% increase in per capita remittance can reduce the number of people below poverty line by 3.5%. Also an IMF (2007) report states that an increase of 10% in the share of remittance in the countryâ&#x20AC;&#x2122;s GDP would lead to a fall in the number of poverty affected people by 1.5%. Because of the increased income, consumption as well as investment increases. Families usually use the extra funds to pay off debt, buy assets or simply to improve their standard of living. Also, the risk taking ability improves because of the extra cushion of funds. This encourages people to undertake risk-taking ventures which have a better profit margin like being self-employed. As there is a source of fund which can take care of the daily needs of money, a person can think of expansion and hence be in a better position to provide for his family. At the macro level, these huge inflow of funds have an impact on major macroeconomic variables like GDP, consumption and foreign exchange rate. Multiple studies done in

FEBRUARY 2015

the past have found a positive relationship between remittances and the GDP growth. One study done by Adelman and Taylor (1990) found that in Mexico, one dollar brought back or sent back would increase the GNP from anywhere between $2.69 and $3.17 depending on the household income group. Similarly, Ekanayake (2008) in his research on the effects of remittances and FDI inflows concluded that these inflows significantly improve the growth in an economy. Also, a lot of research went into understanding the effects of these inflows on the consumption and investment behavior especially in the developing countries. Adams (2005) concluded on the basis of research done on a set of families in Guatemala that people, at the margin, spend more on human capital development like education and comparatively spend less on consumption. Remittances also form a very important source of foreign exchange for an economy and a stable flow of remittance can ease pressure on meeting the short run demand for forex. Also they have a counter cyclical property, inflow increases when the host economy faces a slowdown and hence these flows act as a balance. If the economy is in recession, migrants usually send more money back to facilitate the consumption expenditure and hence in a way boost the total expenditure. This effect also increases when the domestic currency depreciates and the migrants want to take advantage of the exchange rate. But by sending more forex back home, they help in increasing the demand for the domestic

NIVESHAK

8%, which means for every $100 sent, the family would receive only $92. This case is worse in low volume channels. The average cost of sending money to Africa is 12% while the average cost of sending money within Africa is over 20%. For other countries the cost could be as high as 90%, which in turn promotes transaction of money through unofficial channels. Along with the cost associated with transfer, there is cost associated with currency conversion, taxes and other regulatory norms. If we were to include all the above mentioned cost, and the psychological and emotional cost associated with the separation from a loved one, it is to be seen whether the benefit is worth the cost or not. “The Sun doesn’t shine or set anywhere without shining on some members of Indian Community” Motwani K Jagat (1994) In 2013, India received the largest share of the total global remittance which made up over 4% of GDP. There are over 22 million Indian living in over 110 countries across the world. According to a research conducted at IIM Ahmedabad, about 4.5% of households receive remittances regularly, of which a maximum part goes to the states of Kerala, Punjab and former Andhra Pradesh. The Indian policy makers could leverage this huge inflow so that the associated costs can be minimized and the benefits derived be maximized. India currently has a very attractive interest rate policy where the interest earned is tax free and is freely repatriable. Also Indian government should more aggressively promote financial instruments like foreign currency bonds so that more and more of remittance money can be routed into investment. The government could also look into schemes like business counselling and entrepreneurship development programs for migrants. Such schemes would focus on training the migrants on better ways to invest the funds and in assisting them to plow back these funds into productive ventures when they return home, so that remittances could be used in the most productive manner in a way that it is beneficial to the individual as well as the Indian Economy.

FinGyaan Article of the Month Cover Story

currency and hence the currency appreciates. These inflows also help to improve the credit worthiness of the receiving country. Along with all the benefits, there are also some apprehensions that have been raised in the various studies conducted to understand the other side of the coin like potential repercussion of such huge inflows and also the cost involved in the remittance driven migration. Let us first consider cost to the recipient countries. Though a lot of studies have been conducted that show positive correlation between the inflows and the consumption, many studies show that the effects are not very clear. This could be because a substantial proportion of remittance inflow goes into funding consumption needs, which is less beneficial to the economy than expenditure in saving and investment. Also, migration of skilled and unskilled labors can help in generating better numbers in terms of unemployment level but that would only be for a short term and this would kill any incentive for changing the systems to improve employability conditions in the domestic economy. The migration of skilled labor would additionally hurt the economy because of the loss of expertise of the migrating labor. Also inflow of foreign remittance money could lead to high inflation resulting in increased prices of goods and services. Also, such inflows of foreign money lead to an appreciation in the domestic currency which can be good for importers but is bad for exporters. Any erratic fluctuations in the short run could lead to massive losses for the exporting companies. There is also a cost associated with the inflow of labor for the host country. Inflow of skilled and semi-skilled labor who are ready to work at a cheaper cost compared to domestic workers result in an increased level of unemployment in the country. Also, there are concerns that the migrating workers consume much more of the free public goods than they pay for it in the form of taxes. Another major type of problem that exists is the cost of transfer of funds. Money transfer companies have fees structures which makes it difficult for the poor people to send the money across at minimal cost. The global average is

Article of the Month FinLife Cover Story

NIVESHAK

Wealth Management: Make Your Own Portfolio Prakhar Nagori

IIM Shillong Portfolio could be termed as a mixture of various outlays of investment done by you, or in short “Asset Allocation “ Why Manage Wealth? It’s your hard earned money, why not manage it? Why shouldn’t your money earn more money for you? Well these questions would certainly seem obvious to you, but these are the questions that matter a lot as you grow old. This is a materialistic world where money has gained a lot of importance and for one’s sustenance and better livelihood, one desires for more and more wealth. For the purpose of generating huge wealth we need to manage our money in an efficient way and that is where Portfolio Management comes into play. Portfolio could be termed as a mixture of various outlays of investment done by you, or in short “Asset Allocation”. What Is An Ideal Portfolio? This is a very common question asked by everyone, but my frank answer to this question would be there is no such “Ideal Portfolio”. As every person is different in some way or the other, his/her portfolio would also be of a differing nature. The portfolio would vary on various basis such

FEBRUARY 2015

as Income–Expenditure of the person, risk taking capacity of the person, assets/liabilities, life stage of the person, state of the economy and many more. Usually there are three Portfolio styles, namely, Aggressive, Moderate and Conservative. An aggressive portfolio is aimed at high returns taking high risks into account. This is the most volatile portfolio which mostly depends upon the news flows from the environment. A Moderate portfolio lies between high risk-return portfolios and low risk-return portfolios with moderate returns over moderate risk. The movement of such portfolios is usually consolidated for a longer duration with some volatility in between. Lastly, a Conservative portfolio is a less risky affair where the major returns are equivalent to risk free returns generated by government securities. There is negligible volatility in such type of investments unless something unusual happens. Portfolios could also be divided on the basis of following three aspects i.e. growing your wealth, managing your wealth and protecting your wealth. Growing your wealth is a necessary step for affecting the other two aspects, for which it is required to follow a strict and disciplined

NIVESHAK

Article of the Month FinLife Cover Story

investment approach on the basis of your risk taking ability. First of all you need to figure out your needs in accordance with time. This will help you to invest in a better way to fulfil these needs. Managing your wealth is as important as growing your wealth, otherwise growth chart can take a reverse movement at any time. Thus, managing your wealth by evaluating your portfolio on a periodical basis is very important, along with studying about the sectors in which you have invested in, by way of performance updates, report analysis. Earning is not just for the sake of today, but also for tomorrow, for you and your family. This is where the third aspect of Portfolio Management comes into play i.e. protecting your wealth. Growing and managing would give you enough of wealth but it is like a wave, going up and down. Thus, to gain maximum out of it we need to protect it by the means of risk management, diversification, hedging or insurance. Integrating all three aspects of growing, managing and protecting your wealth while creating a portfolio will ensure that you successfully utilize the huge earnings potential of your savings. As discussed Portfolio Management is “Asset Allocation” and when this allocation is done in an optimum way would result into wealth maximization. A portfolio could be a blend of assets like:• Equity – Investment in Primary & Secondary Markets • Mutual Funds- SIP’s • Debt Instruments- Bonds & Debentures • Bullion- Gold, Silver, ETF’s • Insurance – Life Insurance, Term Insurance, Health Insurance

• Borrowings & Credit Card • Real Estate – Property, REITS • Deposits- Fixed , Recurring & Flexible Recurring • Cash & Savings Let’s talk about a few of the asset classes mentioned above: • Cash, Savings and Deposits- Cash and Savings should be the amount the person requires for his daily expenditure as well as certain amount that is needed to be kept for emergency purposes. Deposits are very less risk fixed return investments where you get quoted returns. In fixed deposits you maintain a certain amount for a specific period and earn a specified amount. In recurring deposit and flexible recurring deposit you set a goal of the amount you want to accumulate and thus deposit certain amount on a periodic basis, where you would be getting returns on a fixed rate along with your amount deposited on the maturity of your recurring deposit. The main difference between two types of recurring deposits is that one demands a regular payment of specified amount, whereas in the other one you may deposit any amount at any point of time, just the returns would then vary accordingly. Real Estate (Property /REITS) – Owning your own home is almost every man’s dream, and a very important investment decision with huge capital outflow. Not only owning home plots, even commercial spaces these days have become an investment methodology which every other person is going for because of the tremendous increase in property rates which can give good returns. Undoubtedly, property is a good investment, but one should also see the opportunity of returns on it. While investing in a property, many things are to be kept in

Article FinLife of the Month Cover Story

NIVESHAK

mind like legality of the property, potential earning capacity and being a huge and long term investment you are not blocking your funds just on the basis of buying–selling it on a short term basis for smaller gains. REITS i.e. Real Estate Investment Trust is a good option for those who can’t invest huge amount. In REITS you invest in a company which operates and monetizes from the real estate it owns. This may be in the form of residential/commercial property, hotels, malls etc. Thus, investing into it would also make you a partner in its profits. • Borrowings & Credit Card: Some people might think that taking a loan and credit card should be avoided and a person should suffice with what he has in his hands, but I would like to propose a different approach for the same. For example, you have limited money right now but you have two great investment opportunities with minimum risks. Let say you are purchasing a house as well as making another investment at the same time, and you are well aware that you could reap benefits out of the investment and pay back your loan from your future earnings. Then why should you suffice for one, when you can get a loan at a lower rate than your rate of return? Also, there are tax benefits on housing loans which relatively reduces their cost. The same case is with the use of credit card, if you are spending in your limits then you are losing on the interest portion as well as the opportunity cost by paying through debit card rather than swiping your credit card. But then there is one big issue with these facilities - huge penalty and credit default because of late payment. Thus, to pay the requisite amount at the required time is

FEBRUARY 2015

a necessary element if you avail these facilities else they would really cost you quite a lot. • Insurance – Investment in insurance takes care of your risk portion as well as act as a long term investment plan. Also, new types of Insurance covers are coming up like term plans, which have an advantage of larger life cover and low premium but it provides no returns. These plans comes in health insurance category, which is also an important part of the portfolio as it takes care of the hospital bill in undue circumstances. Awareness about the plans and their benefits is necessary before you buy them. These are not just for you, but for your family as well. They might seem as a cost but investing in them, for sure, is not a bad investment. • Bullion – Gold/Silver/ETF’s – India is a country where households are quite fond of buying yellow and white metal as this is not only an Investment for them but also a matter of pride. But, I would like to bring to light a point that investing a major chunk of your wealth for better returns might not be a very good idea, as these days the price change in these metals is quite volatile in nature. Thus investment in bullion has become a high risk return investment. One should invest by keeping this thing in mind. ETF’s are exchange traded funds where a person need not buy physical bullion but the exchange buys it for him and keep it safe for a nominal charge. It delivers him the same quantity in his demat account which could be sold anytime he wishes. • Debt Instruments- Bonds & Debentures – These are quite less volatile and less risky instruments bearing a fixed rate of interest.

NIVESHAK

Article of the Month FinLife Cover Story

These are offered by both government and Corporates to get money from the market. In case of exchange traded debenture’s/bonds the returns might vary with change in interest rates but if you hold them till maturity you will be eligible for specified returns. These instruments are given credit ratings as per the risk attached with them, the better the rating the less risky the asset would be. • Mutual Funds/ SIP’s – Mutual Fund investment is where you invest in a fund which is managed by fund managers who have prior knowledge and experience in the industry. They are the ones who make investment decisions for the money which is deposited by numerous mutual fund investors. The mutual funds are of various types as required by the investors namely, debt fund focussing on long term debt investments, liquid funds focussing on short term gains by investing in money market, equity funds which invests in the equity markets and balanced funds which mix match the above stated investment methodologies. SIP’s are systematic investment plan which are applicable for both equity market and mutual fund. Here, a person designates certain amount of money to invest regularly on a monthly basis in a stock or mutual fund for the purpose of accumulating it at an average price with outlay in small portions of money. • Stock Markets /Equity Markets: To some people this would be a shining star but to others, it is next to gambling. Investing in

stock markets is one big aspect of portfolio management as many people link portfolio management to equity management. Investing in stock market needs a whole lot of back end study including the fundamental and technical research of the stock and sector you wish to invest in. Not only this, you would also have to look for the right time to invest in the stocks as equity markets are quite volatile in nature. A large foray of stocks are available in various sectors and industry, what you can do is make a diversified portfolio by selecting companies from different sectors on the basis of your study of the companies. Also there are high dividend yield stocks which could possibly be a regular income stock for you. Further, you can segregate your investment on the basis of short term/ long term investments, amount of money to be invested and risk appetite of the investor. A blend of all the above assets as per your preferences and risk taking capacity would help you make a better and efficient portfolio which in turn would help you manage and maximize your wealth.

Article of the Month Finsight Cover Story

NIVESHAK

The Basel Capital Accord: The Journey and Way Ahead Aishani Sharma

SIMSPune

The Subprime crisis has put various global banking institutions under the spotlight for all the wrong reasons. Can a challenging and stringent regulatory framework be a cure for the same? The rapid pace of globalisation over the past few decades has resulted in the emergence of a highly integrated, interdependent and complex global financial system. This emphasizes the need for a universally standardized regulatory framework which can assist in regulating and channelizing the resources of the global financial (banking) system in an efficient, effective and equitable

FEBRUARY 2015

manner. Accordingly, the Basel Capital Accord was introduced by the Basel Committee on Banking Supervision (BCBS), under the guidance of the Bank for International Settlements (BIS) in the year 1988. The main objective of these norms is to facilitate the development and functioning of a strong, prudent and resilient international banking system. The Basel I Capital Norms provided guidelines on the holding of minimal capital requirements for banks and primarily focused on credit risk, which refers to the risk that a borrower can default on any type of debt by failing to make the required payments. Every asset in the banking

NIVESHAK

Finsight Classroom Cover Story

system has different credit risk levels attached. For instance, loans that are secured by a letter of credit are riskier than a mortgage loan that is secured with a collateral. Thus, various assets need to be measured and weighted with their respective credit risk levels and their summation is known as the ‘Risk Weighted Assets (RWA)’ of a bank. The ratio between the total capital of a bank and the RWA is known as the ‘Capital Adequacy Ratio’ (CAR), the ratio which protects banks against excess leverage, insolvency & keeps them out of difficulty. According to the Basel I norms, this ratio needs to be maintained at 8%. Moreover, the assets have been categorised on the basis of different risk levels or weights attached which are 0, 10, 20, 50 and go up to 100%. However, a bank is also prone to two other types of risks, namely operational risks and market risks. Operational risks arise from breakdowns in internal procedures, people and systems and market risks arise due to external factors like the economic situation, socio-political conditions, natural disasters, etc. These were not considered during the formulation of Basel I regulations. Moreover, the above mentioned categorization of risks were found to be narrowly classified defined for the complicated real business world. These issues combined with a limited global participation (mainly from G-20 countries) hampered the effectiveness of Basel I regulations, thereby encouraging the Bank for International Settlements (BIS) to include more countries and paving the way for its successor, the Basel II Norms. The second set of the Basel regulations (2006), integrated all applicable provisions of Basel I and introduced certain amendments. The Basel

II Norms were based on 3 pillars. The First Pillar: Minimum Capital Requirements; The Second Pillar: Supervisory Review Process; The Third Pillar: Market Discipline. The first pillar, minimum capital requirements requires banks to cover credit, market and operational risk. Here, the capital of a bank is divided into three tiers. Tier 1 Capital, which is the most liquid and crucial component mainly comprises of permanent shareholders’ equity and disclosed reserves. The Tier 2 Capital is comparatively less liquid in nature and includes undisclosed reserves, revaluation reserves, general provisions, loanloss reserves, and hybrid capital (combination of debt and equity instruments). The Tier 3 Capital includes loan instruments which are of low priority. Within the Capital Adequacy Ratio of 8%, highest composition is of Tier 1, followed by Tier 2 and Tier 3. The whole rationale behind this classification was to improve the quality of capital in banks. The second pillar, supervisory review process mainly aims at ensuring proper supervisory processes that ensure the effective implementation of the various regulations through their own internal risk assessment processed. The third pillar, market discipline, gives a set of disclosure requirements that provide information on the capital, risk exposures, risk assessment processes & overall capital adequacy levels. Unfortunately, the Basel II Norms were ineffective in controlling the sub-prime crisis (2008). Due to various technical loopholes and manipulations, there were alarming discrepancies between the reported and actual capital levels of banks. For example, intangible assets like goodwill, which have minimal liquidity were included in the

Article of the Month Finsight Cover Story

NIVESHAK

calculation of capital. Thus, when the banking system was hit by the crisis, the institutions did not have adequate ‘real’ capital to survive. The lessons from this episode led to the formulation of the Basel III Norms. The Basel III capital accord was introduced in the year 2010 and is expected to be implemented completely by the year 2019. In order to make these set of regulations more holistic and stringent than its predecessors, the following new ratios have been introduced: Capital Conservation Buffer:- Within the CAR levels of 8%, this new buffer of 2.5% needs to be maintained by banks which would help them to absorb losses, especially in periods of tight liquidity levels. Countercyclical buffer:- Along with the capital conservation buffer, Basel III has introduced a countercyclical capital buffer which ranges from 0 – 2.5%. This requirement is made for periods of excessive credit growth and by triggering this ratio, the excess liquidity in the system can be optimized. Liquidity Requirements:- For this requirement, banks need to maintain two ratio’s namely the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) at 100% levels. The LCR requires institutions to hold a sufficient buffer of “high quality” assets that can be converted into cash within 30 days. The NSFR requires institutions to have more sources of stable funding such as retail deposits, savings accounts rather than risky instruments like certificate of deposits. Leverage Ratio:- This ratio requires the Tier I capital to represent at least 3% of total assets, in order to prevent excessive build-up of leverages (amount of debt) on the banks. On paper, the Basel Capital Accord appears to

FEBRUARY 2015

be well drafted and prudent. Yet, the world has seen their paralysed effectiveness in handling various financial crisis. The actual effectiveness of the regulations can only be appreciated with strict and timely implementation by the respective Central Banks. This need to go hand in hand with the objective of financial inclusiveness and not contradicting the same. For instance, Indian Public Sector Banks need to raise INR1.5 to INR2.2 trillion, or US$26 to US$37 billion between FY 2015 & FY 2019 for the full implementation of Basel III norms. According to an analysis by Firstpost, at least five banks have Tier-1 capital adequacy ratio less than 8 percent. This challenge has been caused mainly due to the high amount of NPAs. But, can crucial, yet “non-performing” sectors like agriculture be ignored by Government banks? Every economy has certain sectors that can possess high volatility and uncertainty (like the real estate market) thereby making it crucial for regulators to ensure that such sectors are specified and prohibitions should be made to optimize (if not minimize) exposure to the same. Strict penalties, at national/international levels need to be imposed in cases of manipulative non-compliance. In a nutshell, if the various global and national macro-economic factors are considered, the regulations are improvised continuously, enforced diligently and are inclusive of higher number of countries, the Basel Capital Accord can lead to the formation of a healthy, wealthy, and progressive banking system.

Interview With Dr. Madalasa venkataraman Lead Researcher, Real Estate Research Initiative, IIM Bangalore

Real Estate blocks a huge amount of money in one’s portfolio. Is it good to invest in Real Estate in current scenario where the Indian Stock market is at its peak? To answer the question, RE in its current form has a very different risk return profile from that of stocks, and in the current context where stock markets are zooming, investment in housing by investors -has definitely taken a hit. The historical situation in India is that the equity market was not really very well developed and debt market is still lagging. Hence, the investment options available to people were real assets and Indians intrinsically seem to have great fascination of owning a house. There are some problems associated with the real estate which is not there with the capital market. In the capital market, investors have the option to diversify their portfolio via index funds. However, in the real estate market the portfolio is accumulated in one single property with a single developer. So at the age of 60 when people have the maximum amount of financial capital, there is no way to diversify their unsystematic risk in portfolio terms. Also there are not many insurance products available as well there is a lot of litigation in land. However, there are still some factors why people invest in RE, which are more to do with behavioural finance reasons as well as with levels of financial literacy. So while stock markets are performing well, people purchase real estate not just because of risk/return profiles, but more from a solid demand from the end-user consumers.

When the other portfolios are performing as well as the real estate portfolio, is it justified to take up so much unsystematic risk? The studies at the research initiative seems to show that the real estate is not giving the commensurate returns to the apartment owners who has bought the house but to the person who is aggregating the land to actually develop. The individual who invests in real estate do not trust capital market instruments because the level of financial literacy is very low. Hence, if one looks at the equity markets which gives a return of 15% annualized over the past five years, real estate is unable to give that kind of consistent return. Also, there is a very large behavioural aspect associated with investment in real estate. People are rooted to home ownership idea. They consider it a safe investment, so when you ask an average man on the street they will tell you that the property prices will not come down. Unfortunately, in our RE markets, time in the market substitutes for fall in prices. For instance - there is a 43 month inventory supply overhang in Delhi and 36-39 months in Mumbai which means that about 3 years of oversupply is prevalent in the market. Looking at the perspective that prices have not come down but have been prevailing at the same level for 2-3 years implies that there has been a deterioration in real value terms. The real estate market is not at all competitive in the sense that there is so much cartelisation that it is not a buyers’ market, it is still sellers’ market so as individuals we are price takers rather than makers. So yes, it is not a good idea to take up so much of unsystematic risk, especially if real

FinView Cover Story

FinGyaan

NIVESHAK

estate serves purely an investment motive. Is it good to have real estate as a part of your personal portfolio? Maybe not to the extent of having 75% of our portfolio in real estate by buying multiple houses. One does not want to invest in capital markets as still the question of financial literacy is there. People look at their investments as a medium of earning returns. They then try to hold the returns in the safe assets, similar to what prospect theory dictates. So one is earning returns in something which is a risky asset and take the generated return investing in a safe asset. Hence, real estate falls into the category of capital protection. Thus the prices of real estate do not fall. Another problem with having real estate as a part of portfolio is that it does not provide exit option. Having said this, RE is a good asset class to hold from a diversification perspective - is there a way to limit our exposure to the high unsystematic risk, or to economically exit from this illiquid investment? That is the burning question Will Indian Retail Investors look forward investing in REITS? How does that benefit them without exposing them to high risk?

FinGyaan

FinView

If a retail investor wants to invest in commercial real estate which could actually produce income and also be tax advantageous, it would not be possible in the current context. One would have to invest in a single property, typically residential - and bear the unsystematic risk. One cannot hold a part of commercial asset or a bunch of commercial assets where the unsystematic risk has been diversified. This is possible only through a structure like a mutual fund for real estate income producing properties. This is where REITs come into play where retail investors can invest in real estate ownership with income producing characteristics. REITS also assist developers because it provides them a good exit option on long term projects with long gestation periods where their cash is tied down for long periods of time.

FEBRUARY 2015

What opportunities do you see for an IIM Grad who would like to practice Wealth Management as a profession? Any suggestions for a person who would like to pursue wealth management as a career? Wealth management is actually picking up because this is one area which is getting outsourced a lot from other countries. So if you look at the ANZ bank, the entire wealth management back-office and middle office was outsourced to India, the front office is still in Australia. Hence, the process intensive part of wealth management is getting outsourced to India from other countries. Thus there is a huge career opportunity here which is in setting up the systems, processes of how to actually create and sell these wealth management products. Also within India there is a huge demand for wealth managers because there is a huge growth of millionaires and billionaires in the Asian market. If you look at India and China, the number of people with huge wealth are actually increasing so these people are likely to require wealth manager services. The average income of the upper class and upper middle class in India is also increasing, they also need wealth management services. When you look at the competence of the people who are now selling these products, financial literacy as well financial regulation in India is fairly low compared to a lot of developed countries. There people who are at the managerial level and who will be able to organize this industry along the new roles would be needed, so that is where the transformative capacity of wealth management will come into play.

NIVESHAK

SWAP Market

FinFunda of the Month

Sir, I recently came across the term SWAP but couldnâ&#x20AC;&#x2122;t understand the term Swap market is an over-the-counter market and it involves the transfer of a series of cash flows between the parties on periodic settlement dates and for a specific time period. In simple terms, swap market can be viewed as the party going long on an underlying asset and taking short position on another underlying asset. SIr I got it but what are the uses of swaps? I will take an example of the current swap and explain you the concept. If a company X is based out of Singapore and another company Y is based in India and X wants a loan in INR and Y wants a loan in Singapore dollar, both these companies can enter into a swap contract to exchange the payments as they can take the advantage of getting loans at cheaper rates in their home currencies. Okay, what are the swaps that are most widely used? The different types of swaps include interest rate swap which is also known as plain vanilla interest rate swap, in which for example if one party gets interest at a fixed rate and the other gets it at a floating rate and if they are not comfortable with the fixed and floating rates, they enter into a swap in which the party who is getting the loan at a fixed rate would swap the payments with the counterparty who is getting it at a floating rate; the next type of swap is the currency swap which is already explained in the above question; then we have equity swaps which

Paladugu Sai Sashanka IIM Shillong

help the party to diversify its income without altering the original assets. It may involve swapping of the equity based cash flows to the fixed income cash flow; the next one is the credit default swap is a swap in which the seller of the swap will compensate the buyer in case of a default of the loan. But is it free from risks? As the swap market is over-the-counter, there is always a counter party risk and in case of an interest swap, the party who is initially getting a loan at a floating rate and swapped it for the fixed rate payments may end up paying more if the floating rate becomes less than the fixed rate. The credit default swaps played a major role in the 2008 financial crisis. Okay, if you want to terminate the contract before expiration, how do you do it? There are four ways to terminate the contract. Firstly, both the parties can enter into a mutually agreement and terminate the contract and the necessary payment should be done by one party to the other. Secondly, with the permission of the counter party, it is possible to sell the swap to a different party and move out of the contract. Thirdly, you can go for swaption which is an option to enter into a swap which offsets the existing swap contract. Lastly, you can directly enter into an offsetting contract to nullify the existing contract. Thank you for the session sir. Now I got more insight how the swap market works and its merits and demerits.

ÂŠ FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

Classroom Cover Story

CLASSROOM

WINNERS Article of the Month Prize - INR 1500/Borampalli Ravali Preethi NIIE, Mumbai

February FinQ Winners 1 st Prize - INR 1000/Ravi Kumar Singh IIM Shillong

2 ND Prize - INR 500/Palak Gupta IIM Indore

ANNOUNCEMENTS ALL ARE INVITED Team Niveshak invites articles from B-Schools all across India. We are looking for original articles related to finance & economics. Students can also contribute puzzles and jokes related to finance & economics. References should be cited wherever necessary. The best article will be featured as the “Article of the Month” and would be awarded cash prize of Rs.1500/- along with a certificate. Instructions »» Please send your articles before 10th March, 2015 to niveshak.iims@gmail.com »» The subject line of the mail must be “Article for Niveshak_<Article Title>” »» Do mention your name, institute name and batch with your article »» Please ensure that the entire document has a wordcount between 1500- 2000 »» Format: Microsoft WORD File, Font: - Times New Roman, Size: - 12, Line spacing: 1.5 »» Please do NOT send PDF files and kindly stick to the format »» Number of authors is limited to 2 at maximum »» Mention your e-mail id/ blog if you want the readers to contact you for further discussion »» Also certain entries which could not make the cut to the Niveshak will get figured on our Blog in the ‘Specials’ section

SUBSCRIBE!!

Get your OWN COPY delivered to inbox Drop a mail at niveshak.iims@gmail.com Thanks Team Niveshak www.iims-niveshak.com