Niveshak May14

THE INVESTOR

VOLUME 7 ISSUE 5

May 2014

The Chinese Debt BOMB Ticks

FROM EDITOR’S DESK Dear Niveshaks,

Niveshak Volume VII ISSUE V May 2014 Faculty Chairman

Prof. P. Saravanan

THE TEAM Akanksha Gupta Apoorva Sharma Gaurav Bhardwaj Jatin Sethi Kocherlakota Tarun Mohit Gupta Mohnish Khiani Priyadarshi Agarwal S C Chakravarthi V All images, design and artwork are copyright of IIM Shillong Finance Club ©Finance Club Indian Institute of Management Shillong

We hope that the month of May calmed down all the anxieties pertaining to new government and the higher market expectations related to the same. The month of May began with twin blasts in Chennai Central which have shaken the entire country. In these blasts, one person was reported to be killed and 14 other injured and the investigation is still on. The very next was a historic one in the Indian elections where Narendra Modi gave a thumping victory to BJP and there by the party was able make a simple majority in the Lok Sabha, which was only witnessed in 1984 elections (25 years before!!). Creating history, BSE Sensex and NSE Nifty touched all their time highs of 25000 and 7500 within a very short span of time. The 30 share index had a solid run for some few days during which it has surged 1470 points to hit a new life-time high of 25373.63 points. Owing to the huge loss in the Lok-Sabha elections, Bihar Chief Minister resigned from his post taking up full responsibility for the loss. Similar circumstances took place in the Congress party when both the president and vice-president of the party (Sonia Gandhi and Rahul Gandhi) offered to resign from their party post in lieu of the humiliating defeat faced by them. Before the swearing in of Narendra Modi as the 14th Prime Minister of India, another tragic event took place where in there was an attack on Indian Embassy in Herat, Afghanistan. On the business side, the major breakthrough this month was the merger of e-commerce majors of India Flipkart and Myntra. This merger is done in the expectation that their combined might can place them in a better position to take on Amazon which has been aggressively making its presence felt in the Indian online retail. On the international front, a nation- wide curfew had been imposed by Thailand’s military by dissolving the government and constitution because of six-month long anti-government protests. Credit Suisse agreed to pay a hefty fine of $196 million to settle charges that it violated federal security laws by providing cross-border brokerage without registering with the Securities and Exchange Commission. In this May edition of Niveshak, our editors have covered the story about the Chinese Debt Bomb, a major economic event that has recently gone almost unnoticed. The Article of the month this time is “Warren Buffet: Can his success be replicated?” which explains how Warren Buffet has become a successful investor and what are the key insights to be learnt. FinGyan section covers recent challenges in Liqidity management India by explaining the steps taken by RBI pertaining to Liquidity Adjustment Facility. Finsight article “Goldfinger” gives a good insight about the gold prices. The FinPact section discusses Energy Future Holdings buyout, which was a failed decision. Finview has the excerpts from Mr.Rajesh Gupta, senior manager from one of the leading private banks. Classroom section shares knowledge on prospectus. 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 vigor and vitality to keep working hard. Thank you. Stay invested!

Team Niveshak

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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

The Chinese Debt Bomb 10 Warren Buffet: Can His Suc- Ticks cess Be Replicated?

FinGyaan 18

Recent Challenges in Liquidity Management in India

Finsight

26 Goldfinger

FinPact

22 Energy Future Holdings Buy- 29 Mr. Rajesh Gupta, out

FINVIEW

Senior Manager, Leading Private Bank

CLASSROOM

31 Prospectus

The Month That Was

NIVESHAK

www.iims-niveshak.com

The Niveshak Times Team NIVESHAK

IIM Shillong RBI Eased Gold Import Norms Under 20:80 Scheme Under the 20:80 Scheme, Star trading houses and premier trading houses, which are registered as nominated agencies by the Directorate General of Foreign Trade(DGFT) now can import gold. With this move the number of institutions that import gold will go up and will increase supply of gold. Besides, it will also lead to fall in the prices of gold. The RBI had imposed severe restrictions on gold imports to combat the Current Account Deficit (CAD) and sliding rupee in July 2013. RBI prescribed a 20:80 formula, which tied imports with exports of gold. Under the 20:80 Scheme, an importer has to ensure that at least 20 percent of every lot of imported gold is exclusively made available for exports as finished good and the balance for domestic use. The facility was available to the selected banks only and other entities were barred from imports of gold. Welcoming Reserve Bank’s this decision; the World Gold Council (WGC) said this would help in increasing the official supplies. Flipkart India Pvt. Ltd’s Acquisition of Myntra.com Flipkart India Pvt. Ltd’s acquisition of Myntra.com will help add scale and gain share in the key fashion segment. This will help when the company plans an initial public offering (IPO) of shares, which is on the cards. Myntra’s chief executive officer Mukesh Bansal said that it aims to achieve sales worth Rs.20,000 crore by 2020, for which it needs to make a cash investment of $200 million (Rs.1,172 crore). Flipkart said it will invest $100 million in the fashion business after the deal. Both companies are running heavy losses and have had to repeatedly dilute equity to raise funds. Valuations of the companies are already absurdly high. Valuations of the companies are already absurdly high, with both being valued at about 1.6 times the value of annualized monthly sales. Sales here refers to gross merchandise value (GMV), of which the company’s revenue is likely to be only a fraction (the commission it earns on the sale). Competition is just picking up, with Amazon.com Inc. increasing its presence in India. What’s more, wiser from the experience in western markets, traditional retailers are increasingly offering online

MAY 2014

retail options for customers. Pure online retailers such as Flipkart and Myntra have little option but to continue offering discounts to attract traffic. Dell Regains Top Spot In Domestic PC Market In Q1 PC maker Dell grew 25% in the first quarter amid a declining Indian PC market that saw shipments fall 25.2% year on year owing to poor end-user demand. The overall Consumer PC shipments stood at 1.01 million units in Q1 2014, a drop of 4.3% sequentially over Q4 2013. Consumer’s sentiments plummeted further due to high inflation and soaring prices owing to rupee fluctuations. Concerns over the economic conditions remained a key drag and Q1 was no different HP, which dominated the India PC market in 2013 across all product categories, took the second place with a share of 20.4% in Q1 2014. Pricing, widespread retail presence, and strong support from channel partners ensured their lead in the consumer market, according to IDC. Lenovo, with 14.9% market share, took the third spot. NSEL Commences Remittance Of Payout To Unit-Holders Of E-Gold As a part of the financial closure of gold e-series contracts, National Spot Exchange Ltd (NSEL) today started making direct payments to over 21,000 unit-holders at the average rate of Rs 2,935.9925 per gram. NSEL had a total of 617.5 kgs of gold eligible for rematerialisation and financial closure. Pursuant to FMC issuing the NOC, the exchange had issued the circular on April 4 for rematerialisation/ financial closure of e-series settlement. NSEL went into trouble in July last year after two dozen counterparties declared their inability to settle payments amounting to Rs 5,600 crore to more than 13,000 investors. A total of 85.5 kgs of gold were released to the unit holders in the rematerialisation process. The remaining 532 Kgs of gold that were held by NSEL on behalf of unit holders were taken up for financial closure starting May 8. Of this, 477 kgs of gold was sold through auction which is 89.70 per cent of the stock available for financial closure, a statement issued here said. All eligible unit-holders of e-gold will get remittance to the tune of 89.70 per cent against their each unit of holding, while the remittance for their remaining 10.30 per cent will be given once NSEL auctions the remaining stock.

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For other metals, the auction is in progress and the direct payout will be released to eligible unit holders as per the circular issued by NSEL. Sensex Breaks All Barriers The BSE Sensex, which was range bound for most of the past 3 years, tore through all expectations and price targets set by brokerage houses and touched 25,000 on 16th May, when it was announces that the people of India have given Narendra Modi a clear mandate to run the country for the next 5 years. Narendra Modi, seen as a pro-business leader, who can quick and smart actions to heal the country’s economic issues and bring back the country to its high growth rates. A lot of money that was waiting on the side-lines to come into India gushed into the markets in hope of a stable government in India, which would kick-start the investment cycle in India. The wave has created such a positive sentiment that, a few brokerages who were still a bit sceptical of India have raised their targets on Sensex to 28,000 immediately after the Sensex hit 25,000. What remains to be seen now is how the BJP-led government would act in the coming months and the steps that they would take to make India one of the most preferred destinations for foreigners to invest in. Swiss Banking Giant Credit Suisse Pleads Guilty Credit Suisse has pleaded guilty to helping tax cheats i.e. thousands of US clients, to evade paying taxes to the US government. It has agreed to pay a $2.6bn (£1.5bn) fine. As per US Attorney, Credit Swiss conspired to help US citizens hide assets in offshore accounts in order to evade paying taxes. It is the biggest bank to plead guilty to criminal charges in the US in more than 20 years. The bank said the settlement would reduce its second-quarter net profit by 1.6bn Swiss Francs ($1.8bn; £1bn). The $2.6bn payment is the highest in a US criminal tax investigation to date, according to US authorities. However, as part of the agreement with US regulators, the bank will not lose its banking licence in the US. Mahindra Considering $684 Million Investment In New India Plant Infrastructure Mahindra and Mahindra Ltd is considering investing about 40 billion rupees ($684 million) in a new factory, as it readies new models for an anticipated pickup in sales. Pawan Goenka, president of Mahindra’s automotive and

farm equipment sectors, said the proposed new plant would have capacity to make 400,000 vehicles annually, and an announcement on its development would be made “soon”. Goenka said another option on the table was expanding Mahindra’s Chakan plant in western India. The company, India’s largest SUV maker, last year said it would invest 100 billion rupees over the next three years to increase production and boost research and development. The landslide victory last week of the pro-business Bharatiya Janata Party in the general elections have further raised hopes among auto executives that the new government will initiate reforms to kick-start the sluggish economy. Automakers in India have been battling two years of slumping sales as a slowing economy kept a lid on consumer spending, which was further burdened by high interest rates and fuel costs. Hindu nationalist Narendra Modi’s new government is expected to push ahead with major reforms to revive growth amid the country’s worst economic slowdown since the 1980s.The company is expected to roll out two new compact SUVs in 2015. Thailand In The Hands Of Its Army Two days after Thaialand’s army chief declared martial law, the country was seized by the army and rival protest camps were asked to disperse. The main reason for the protests was the tussle between the supporters of the former premier Thaksin Shinawatra and the opponents who are backed by the royal establishment. In order to bring back the situation to normalcy, the army has taken the control of power. This announcement of army control was made after the General summoning the rival factions to to find a compromise to end six months of anti-government protest. Unfortunately, the talks were failed and the army had to take over the country. In the history, the Thai armed forces have intervened in the politics of the nation for 18 times since the time the country became a constitutional monarchy in 1932. Hundreds of soldiers surrounded Bangkok’s army club hours before the coup announcement and the leader of the protest Suthep Thaugsuban was taken away. Till now, 28 people were killed and 700 were injured since the protests have begun.

The Month That Was

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Article ofSnapshot the Month Market Cover Story

Market Snapshot

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

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

85,93,245.88 Source: www.bseindia.com

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

LENDING / DEPOSIT RATES Base rate Deposit rate

10.00%-10.25% 8.00% - 9.05%

RESERVE RATIOS 58.483 79.8058 57.57 98.6725 46.73

CURRENCY MOVEMENTS

CRR SLR

4.00% 23%

POLICY RATES Bank Rate Repo rate Reverse Repo rate

9.00% 8.00% 7.00%

Source: www.bseindia.com 26th April 2014 to 25th May 2014 Data as on 25th May 2014

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

Open

% change

22688.07 7373.64 7597.34 13615.96 14910.3 6633.02 12589.52 6837.11 10619.78 8786.98 10432.38 9605.77 1741.18 6561.7 1472.17 4929.63

24693.35 8668.32 9128.04 14580.74 17523.13 8235.58 14775.05 6794.28 10073.03 8440.06 12538.05 11545.47 2287.46 8614.28 1976.96 4832.03

8.84% 17.56% 20.15% 7.09% 17.52% 24.16% 17.36% -0.63% -5.15% -3.95% 20.18% 20.19% 31.37% 31.28% 34.29% -1.98%

% CHANGE

Article Market of Snapshot the Month Cover Story

Market Snapshot

Article of the Month Cover Story

NIVESHAK

Warren Buffett: Can his success be replicated?

Yamini Sandeep

All the people in the world of finance must have had come across the legendary investor of all time, Warren Edward Buffett, at some point in time. His unmatched investment ability coupled with astute abilities of a turn-around CEO has earned him disciples all over the world. From becoming one of the top ten richest persons in the world to the top philanthropist in the world, his success is quite unprecedented and his road to success is indeed less travelled by. The purpose of this article is not just to eulogize the Oracle of Omaha, as he is fondly called, but to understand whether his success can be replicated by an ordinary human being and draw out key learnings from his exemplary life. Humble Origins Born to a US congressman Howard Buffett in the year 1930, Warren Buffett displayed interest in making and saving money even as a child. He went door to door selling chewing gum, CocaCola, weekly magazines etc. He spent $25 and purchased a pin ball machine which he placed in a local barber shop. It became so successful that he installed several machines in different shops within no time. He filed his own income

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IIM Lucknow

tax return in the year 1944. He graduated from the Columbia Business School where he learnt the basics of investing, which later became famous as Value Investing, from his teacher Benjamin Graham. Benjamin Graham was the author of â&#x20AC;&#x153;The intelligent Investorâ&#x20AC;?, a treatise on the philosophy of value investing. He started purchasing shares of a textile manufacturing firm called Berkshire Hathaway in the year 1962, and later took control of the firm.

He used it as a vehicle for future investments in companies all across the US. He owns companies which deal in insurance, candies, newspapers,

NIVESHAK

Article of the Month Cover Story

Fig 1: Warren Buffet Sector Holdings

rail roads, etc. and holds stakes in blue chip companies such as Coca-Cola, IBM, Goldman Sachs, American Express etc. He was placed in the Forbes 400 list for the first time in the year 1979 when his net worth was $620 million. Buffett, The Investor An investor who bought one share of Berkshire Hathaway at just over $11 when Buffett took control of the company 50 years ago, would have seen it soared to $190,000 in recent days, an annual return of 21% (Refer Fig 1). This performance is phenomenal especially when it has been replicated over such a long period of time. He thus stands as a living testament to contradict one of the guiding principles of finance, Efficient Market Hypothesis (EMH). EMH states that stock price of a company reflects all the available information and it is not possible to consistently achieve returns in excess of average market returns on a risk-adjusted basis. Berkshire is into all manner of business, from insurance to ice-cream parlors. Normally, such diverse groups suffer from “Conglomerate discount”; but Berkshire’s shares trade at a 40% premium to its book value. He outperformed the broader markets by investing in good quality-low risk stocks at a price lesser than its fair value, what he calls as ‘intrinsic value’. He invests only in the businesses he understands and calls it as his ‘circle of competence’, usually companies with stable earnings and hard-to-replicate business models. He followed the same approach even when the entire market is against his philosophy during

the dot-com bubble. He has never invested in any technology company for his belief that their earnings are difficult to be estimated (however, he invested in the tech giant IBM due to the unavailability of the companies that match his stringent criteria at a point in time). He also favors firms with good management and solid business model, although not currently making money. An Example of such an investment was Coca-Cola (after the “New Coke” failure) when he acquired around 7% stake in the company for a very low price, which later turn out to be the most successful investment of his career. Buffett, The CEO Buffett has become famous not just as an investor in many companies but also for his shrewd abilities of a turnaround CEO. He bought companies with inefficient management but distinct competitive business model and turned them profitable by his efficient capital allocation abilities. He gives complete freedom to the managers of the firms he owns. Such is the low-key profile maintained by Buffett that not many people in the US are aware of the holding company name Berkshire Hathaway, though it has around 80 companies under its wings. Can His Success Be Replicated? After feeling awe struck at the phenomenal success achieved by Buffett, let me try to answer the question posed by the title of this article. Can the success of Mr. Buffett be replicated? Many academicians and investors have dismissed Buffett’s success contrary to the efficient market hypothesis as statistical outlier. Some of them have attributed his success simply to luck,

Buffet outperformed the broader markets by investing in good quality-low risk stocks at a price lesser than its fair value, what he calls as ‘intrinsic value’. © FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

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NIVESHAK

Fig 2: Warren Buffet Style Portfolio Performance

the happy winner of a coin-flipping contest. However, the paper “Buffett’s Alpha” by the trio of Andrea Frazzini, David Kabiller, and Lasse Heje Padersen presents a lucid explanation to this important question. This paper showed that a Buffett-style portfolio can be designed and put into practice with sheer discipline. Buffett’s success appears neither to be magic nor luck but primarily due to his strict adherence to cheap, safe and high quality stocks combined with the shrewd use of leverage. He achieved a Sharpe ratio of 0.76, higher than any other mutual fund or stock with a history of more than 30 years. Sharpe Ratio is a measure of risk adjusted performance. It is calculated by subtracting the risk-free rate from the portfolio return and dividing it by the standard deviation of the portfolio returns. Although his Sharpe ratio is good, it is not super human. So how did he achieve such a phenomenal success? The answer lies in the use of leverage. He applied 1.6 to 1 leverage financed partly by the float received from his insurance business, GEICO. Because of the fact that an insurance company gets the capital

upfront and pays claims later, he ventured into insurance business and used the proceeds from it to finance his investments. Thus he could get capital at a very low rate of interest, around 3 percentage points less than that of the treasury rate. So how does Buffett select stocks to achieve such an attractive return over a long period of time? The answer lies in his selection of “safe” (with low beta and low volatility), “cheap” (stocks with low price-to-book ratios), and high-quality (stocks with profitable, stable, growing, and with high payout ratios) stocks. This philosophy is put succinctly in one of letters to the shareholders of Berkshire Hathaway: Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down To understand whether his success is due to the rare combination of a CEO and an investor, his returns are further decomposed into returns due to investments in public companies and returns due to investments in private companies. It turns out that the returns in public companies are higher which indicates

Buffett’s success appears neither to be magic nor luck but primarily due to his strict adherence to cheap, safe and high quality stocks combined with the shrewd use of leverage. MAY 2014

NIVESHAK

to prove that the stock markets are efficient and it is impossible to beat the broader markets consistently. He thus stood as the living proof to contradict the Efficient Market Hypothesis hands down. Importance of the competitive advantage of a business: Buffett puts so much emphasis on the margin of safety whereby he states that he takes care of his down side first and then thinks about the upside on the stocks he wants to purchase. His famous quote on the irrelevance of the management reads as “I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will” More than anything else, he is probably the only person in the world to put the meaning of investment in stock markets in two simple statements. “Rule No 1: never lose money; Rule No 2: don’t forget the Rule No.1” Happy Investing!!

Article of the Month Cover Story

that Buffett’s skill is mostly in stock selection. In summary, Buffett has gained a unique access to leverage which he has invested in safe, cheap and high-quality stocks. He kept himself aloof from the clutter of the Wall Street and kept on investing in stocks with his conviction in Value investing. Thus, his success does not appear as luck, but an expression that value and quality investing can be implemented in an actual portfolio. What Are The Key Learnings For Us? Having understood that the stupendous performance of Buffett’s investments is not due to the perceived ‘luck’ factor, let’s understand the key learnings from his life as a successful investor and CEO. Invest in Yourself: He was not very confident in public speaking during his initial days as an investor. Having understood the importance of speaking skills, he enrolled for Dale Carnegie public speaking course. Using what he learned, he taught a class on investment principles at University of Nebraska-Omaha where the average of the students enrolled for the course was twice his own age. His persuasion skills have helped him very much later in his days as an investor. He found the importance of something that he lacks at a very early age and invested in a course to master it. Very few of us feel the importance of soft skills and those who mastered those skills have achieved phenomenal success compared to those who have not even though they may have the same technical knowledge. “Investing in yourself is the best thing you can do. Anything that improves your own talents; nobody can tax it or take it away from you. They can run up huge deficits and the dollar can become far worth less. You can have all kinds of things happen. But if you’ve got talent yourself, and you’ve maximized your talent, you’ve got a tremendous asset that can return ten-fold” – Warren Buffett Power of Simplicity: Buffett still lives in the same 3-bed room flat that he bought 50 years ago in mid-town Omaha. He says that he has everything that he needs in that house. His house does not have a wall or a fence. “Don’t buy more than what you really need and encourage your children to do and think the same” - Warren Buffett Don’t remain an Orthodox: Warren Buffett kept his cool and followed what he believed in even when the stalwarts of finance have been trying

Cover Story

NIVESHAK

The Chinese Debt Bomb Ticks

Mohnish Khiani

IIM Shillong A major economic event that has recently gone almost unnoticed is China’s first corporatebond default. The company was a solar-energyequipment firm called Shanghai Chaori, a small, private, highly leveraged and not very important company. But its debt default draws our attention towards the state of the world’s 2nd largest economy. The Chinese economy is in the middle of a debt crisis, which is comparable to the likes of the one we saw during the fall of Lehman Brothers. The default of Shanghai Chaori was tiny by comparison as it could not make an interest payment on a $163 million bond outstanding, whereas Lehman Brothers owed nearly $613 billion when it collapsed. But this is just the tip of an iceberg that is currently about double the size of China’s GDP. By allowing Shanghai Chaori to go bust, the Chinese have signalled that they are no longer in denial about the debt crisis they are facing. This certainly matters in a country in which data and statistics are precooked and every economic move, which includes the run-up in debt itself, is planned. And this problem is fast approaching, as only last year Chinese banks wrote off more than twice the level of bad loans than they did in 2012. China, for years now, has been the driver of global growth. Its consumption and infrastructure booms have kept afloat thousands of mines, Chinese consumers have poured billions into the

MAY 2014

pockets of consumer goods companies around the world, and its state-owned enterprises have become the default bankers for energy, agricultural and other development around the world. China also holds more U.S. Treasuries than any other nation+ outside the U.S. itself. It currently consumes around 46% of the world’s steel and 47% of the world’s copper. In 2010, its export and import oriented banks had already surpassed the World Bank in lending to developed countries. In 2013 alone, Chinese companies made $90-billion non-financial overseas investments. If China catches a cold, the rest of the world won’t be sneezing, it would be headed for the emergency room. In the past few years, there have been many predictions that the Chinese real estate sector was about to implode at any moment. But these predictions have not borne out, but now is the time for the world to pay attention. Real estate activity indicators have been trending lower, and the downturn in the sector now threatens to turn into a bust. The default risks in the weakly regulated shadow banking sector and the rise in local government’s debt levels are alarming and real. Yet the government and the central bank have tools to limit the negative short-term consequences of these conditions. They have already deployed debt rollovers, bank bailouts and recapitalisations. Over a year ago, the head of emerging markets at Morgan Stanley Investment

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not know exactly what they’re buying into. The greater risk to China lies in the consequences of any mortgage bust. Real Estate investment has grown on to account for about 13 per cent of the GDP, roughly double the share in US’s GDP at the height of the bubble in 2007. After adding related sectors, such as cement, steel and other construction materials, the figure stands closer to 16%. The broadly defined property sector accounts for about a third of the fixed-asset investments in China and accounts for about a fifth of commercial bank loans but is used as collateral in at least twofifths of total lending in China. The booming property market has also produced huge revenues from land sales, which has fuelled

of the shadow banking units in China, which consists of leasing companies, trust companies, insurance firms and other types of non-bank financial institutions. The growth of China’s shadow banking system has been stupendous. In the year 2000, about 80% of all credit was supplied by the traditional banks, with shadow banks supplying a small portion of the rest. But by last year, the split between traditional banks and shadow banks was roughly 50-50. China’s debt to GDP ratio has also risen accordingly to over 200% currently. Such shadow banks typically lend money to industries by raising capital from wealth management products sold via traditional banks to retail investors who may

much of the local government’s infrastructure spending. The reason that things look different today is the realisation of a chronic oversupply. As the property slowdown has started to kick in, housing starts, completions and sales have turned significantly lower, especially outside the principal cities. Idle Inventories of unsold homes in Beijing are reported to have risen from seven to 12 months’ supply. But when it comes to homes under construction and total sales in tier 2 cities, the inventories of unsold homes has risen to about 15 months; and in tier three and four cities, it is about 24 months. The tightening of credit terms, which includes funding costs for property developers, especially

Cover Story

Management, Mr Ruchir Sharma, pointed out that China was pumping out credit faster than any other country in the world. That is not the real problem, but the problem is that much of it went into dubious public-sector investments rather than productive private enterprises. 5 years ago it took just over a dollar of marginal debt to create a dollar of economic growth in China, but today it takes about four dollars of debt to create a dollar of growth. At this rate, it takes a greater than 20-per-cent annual growth in debt levels to sustain China’s targeted 7.5 % economic growth. These are crisis numbers by any standard. Much of the credit expansion in the recent years has taken place due to the explosion

Cover Story

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in the vulnerable shadow banking sector, is taking its toll. Rates of return on infrastructure and commercial property, and cash flows for developers and local government, have been continuously deteriorating. The crunch in the real estate market, and the economy, will come when land and property prices fall more broadly across the country. If activity levels and prices weaken further, Beijing’s resolution to not to respond with traditional stimulus programmes is unlikely to hold for a longer time. Some steps may provide financial markets and the economy with some short-term relief. But if the Chinese government goes too far with its temporary adjustments, it will underestimate the essential strategy of rebalancing the economy, in which case the negative economic impact would be larger and would last longer. In the meantime, this easily borrowed money is finding ever-more creative ways to flow through China, through a gamut of complex schemes. Under one increasingly popular financing structure, called the trust beneficial rights or TBRs, banks are allowed to buy only the cash flow of a particular asset. It’s a complicated structure, with a simple, yet dangerous result: Using this, a bank can effectively lend to companies, but book the loan as an interbank asset, which is an investment, that allows the bank to assign a far lower risk weighting than in case of traditional loans. That, in turn, allows the bank to apply a lower capital adequacy ratio rating, which means that it has lesser money on hand to stop loans from going bad. Now, this is a perfect recipe for banking instability. But, a financial crisis in China isn’t the same as the one in the U.S. For one, Chinese debt is almost completely China-owned. A large chunk of it is in the public sector and the central government, which holds some $4 trillion in reserves can bail out firms at its will. Indeed, they’ve done that more than 20 times in the past two years, which shows how long the crisis has been brewing. In the near term China can let its debt crisis fester. That will only make things worse in the long run, as it would increase the moral hazards and slow down the economic growth, which may be as low as 5% this year, down from double digit figures seen a few years back. Even worse, the government is already using those figures as a reason to backtrack on its recent promises to reform the economy. Beijing is now talking about pumping more stimulus to keep the country’s growth rate around the 7% level, which it says is needed to keep the

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unemployment from reaching dangerous levels. Chinese authorities have allowed the country’s first corporate bond default, inflicting losses on small investors in a painful step towards making its financial system more marketoriented. Until now, Beijing had bailed out troubled companies to preserve confidence in its credit markets. But the ruling Communist Party has pledged to make the economy more productive by allowing market forces to play a much bigger role. A dangerous build-up of debt and the explosion of risky and poorly regulated shadow banking have raised serious concerns about the health of China’s economy. That’s why the Shanghai Chaori’s default has sparked fears that the country could be headed for a full-blown economic crisis like the one that slammed Wall Street in 2008. The concern is that the Chaori’s default will be the tip-off point for the unravelling of the Chinese financial system. The default could stoke fear in the minds of investors and bankers and make them believe that the companies they thought were safe bets could potentially turn out to be risky, and they could begin to reassess other loans and investments in other corporations also. In other words, they might start redefining what is and is not risky and be very fearful in lending out new loans. That could then lead to a credit crunch, when nervous bankers would become wary of lending money, or lending at affordable interest rates. More bankruptcies would result, if this happens. This would eventually cause the financial markets to freeze and this would end up transitioning from a Bear Stearns moment in China to a Lehman Brothers moment in China, when the entire financial sector melts down. Yes, it could be a “Lehman Brothers moment” for China, and since the global financial system is highly interconnected today, this fear would spread soon and that would be very bad news for the United States as well. Since the 2008 crash, the level of private domestic credit in China has risen from $9 trillion to an astounding level of $23 trillion. This is an increase of $14 trillion in about 5 years. Much of this “hot money” has flowed into bonds, stocks and real estate investments in the United States. This bubble of private debt that we have seen inflate in China since the Lehman crisis is unlike anything that the world has ever seen. Never before has so much private debt been accumulated in such a short period of time. In the recent past, all of this debt has helped China fuel its tremendous economic growth, but now a whole bunch of Chinese companies are realizing

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it’s quite evident that China has less room to manoeuvre now than it did 20 years ago. It is true that China’s closed capital and current account as well as the government’s tight control over the financial system makes China’s situation fundamentally different from that of countries with open capital and current accounts from where foreign investors can flee at any time if they get a cold feet over an overextended bubble. The great degree of central control over the economy which the Chinese government enjoys makes it inherently more difficult to predict the quantum of losses the demise of the credit bubble in China can bring about and such things aren’t easy to time to begin with. Will China be a drag or a boon to the global economy, remains to be seen?

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that they have got over leveraged. The situation is so grave that, it is being projected that Chinese companies will pay out the equivalent of a trillion dollars in interest payments this year alone. That number is more than twice the amount that the U.S. government would pay as interest in 2014. Trouble is, the Chinese government’s argument that more debt is needed to keep unemployment down, which no longer holds. As Ruchir Sharma points out, every percentage point of GDP growth currently creates around 1.7 million new jobs, up from 1.2 million jobs a decade ago. That means even 5% GDP growth would be able to keep the Chinese economy stable. So why isn’t the country putting in more efforts to deflate its debt bubble and change its economic model? The answer remains the same. As in the U.S., the political and economic elite have little impetus to change a system that has made them fantastically wealthy. While Beijing may allow firms like Shanghai Chaori, which are not systemically important, to default in order to convince people that it’s grappling with the debt issues, sate-level governments and public sector companies are still too big to fail. This is why it may not result in a Lehman Brothers moment. But it will make it much harder for the country to move to its next stage of economic development, given the fact that China has represented about a third of global growth since the 2008 financial crisis, has implications for all of us. But, history offers some reason to distrust the doomsayers. In the 1990s, amid another credit explosion, Chinese banks saw their nonperforming loans rise to at least 25 per cent of their portfolios – some believe the real number was as high as 40 per cent. In early 1999, GITIC (Guangdong International Trust & Investment Corp), went bankrupt, leaving investors with $4.4-billion in unpaid loans. Worried investors called China’s financial system among the worst on earth and predicted a severe economic collapse. It didn’t happen. Banks were recapitalized with $32.5-billion through bond sales, and some of the bad debts were tossed into a series of state-owned asset management companies. Growth slowed – from 13.1% in 1994 to 7.6% in 1999 – but by 2003, the economy was roaring on, at 10% again. The current situation is nonetheless a bit different. In the 1990s, China’s debt-to-GDP ratio stood at 25 per cent, which was far lower than most developed countries. But today, it’s far higher. By how much is very hazy, given the lack of solid official numbers and a vast deviation in external estimates. But

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FinGyaan

RECENT CHALLENGES IN LIQUIDITY

MANAGEMENT IN INDIA Rajiv S Rao & Sandeep Ramesh

SPJIMR, Mumbai

In the case of India, the ultimate goals of monetary policy, i.e., price stability and growth, have remained unchanged over the years. In the recent years, financial stability has been considered as an additional objective of monetary policy. The development of the money market over the years and relative stability in the call money market enabled the Reserve Bank to move away from quantity-based instruments to price-based instruments under its multiple indicators approach adopted since 1998. In June 2000, RBI introduced the Liquidity Adjustment Facility (LAF) and from November 2004 onwards, LAF was operated through fixed rate repo and reverse repo. This helped to develop interest rate as an important instrument of monetary transmission. In recent times however, two major weaknesses in LAF came to the fore. First was the lack of a single policy rate, as the operating policy rate alternated between repo during deficit liquidity situation and reverse repo rate during surplus

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liquidity condition. Second was the lack of a firm corridor, as the effective overnight interest rates dipped (rose) below (above) the reverse repo (repo) rate in extreme surplus (deficit) conditions. Recognising these shortcomings, a new operating procedure was put in place in May 2011. As per the new operating procedure, the weighted average overnight call money rate was explicitly recognised as the operating target of monetary policy. The repo rate was made the only one independently varying policy rate. A new Marginal Standing Facility (MSF) was instituted under which scheduled commercial banks (SCBs) could borrow overnight at 100 basis points above the repo rate up to one per cent of their respective net demand and time liabilities (NDTL). This limit was subsequently raised to two per cent of NDTL and in addition, SCBs were allowed to borrow funds under MSF on overnight basis against their excess SLR holdings as well. Moreover, the Bank Rate being

the discount rate was aligned to the MSF rate. The revised corridor was defined with a fixed width of 200 basis points. The repo rate was placed in the middle of the corridor, with the reverse repo rate at 100 basis points below it and the MSF rate as well as the Bank Rate at 100 basis points above it. The recent challenges in liquidity management have been analysed across four period’s viz. 1) November 2011 to June 2012 which saw the easing of liquidity conditions after sharp depreciation in the rupee value, 2) July 2012 to April 2013 when liquidity conditions eased temporarily and tightened again despite large injection of liquidity by RBI, 3) July 2013 to September 2013 when US Federal Reserve announced its intention to start tapering of the quantitative easing program (QE3) and 4) September 2013 to December 2013 when RBI rolled back the exceptional liquidity measures after volatility in foreign exchange markets decreased. November 2011 to June 2012: The liquidity deficit crossed the one per cent of NDTL level. This deficit was largely structural and caused in part by foreign exchange intervention that became necessary in the face of the sharp 19 per cent

depreciation of the rupee between end-July and mid-December of 2011. This sharp depreciation forced the RBI into sterilisation operations to stabilize the rupee. Increasing divergence between deposits mobilised and credit extended by commercial banks also contributed to the deficit situation. Finally, the deficit conditions were further aggravated by frictional factors like the build-up of government cash balances (especially advance tax) with the Reserve Bank that persisted longer than anticipated. RBI had to actively manage liquidity without compromising on the anti-inflationary stance through 1) Injection of liquidity by way of open market operations (OMOs), 2) Cut in cash reserve ratio (CRR) of banks and 3) a decline in currency in circulation and a reduction in government cash balances with the Reserve Bank. The overnight rates did not spike as in the past episodes of large liquidity deficits. They remained range bound within the formal corridor defined by the LAF reverse repo rate and the MSF rate. Despite the significant tightening of liquidity conditions, on-tap availability of ‘emergency’ liquidity through the MSF window capped the Reserve Bank’s operating target, viz., weighted average overnight call money market rate, and

Fig 1: Revised LAF Framework

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Fig 2: Current Dividend Yields of Major Markets

facilitated its range- bound movement. Monetary transmission, therefore, remained effective. July 2012 to April 2013: RBI undertook the second phase of the liquidity management when, consequent upon these policy measures, the liquidity deficit declined and returned to the Reserve Bank’s comfort level and remained mostly there until the beginning of November 2012. To pre-empt any prospective tightening of liquidity conditions arising out of frictional factors such as advance tax outflows, festive season currency demand and increase in the wedge between the growth rate of credit and deposit, the Reserve Bank reduced the CRR by 25 bps in September 2012 in addition to the 100 bps SLR cut effective from August 2012. Since November 2012, the inter-bank market again witnessed a tightening of liquidity conditions mainly due to the build-up of government cash balances and rise in currency in circulation with the liquidity deficit crossing the Reserve Bank’s comfort level of (-1) per cent of net demand and time liabilities (NDTL). The significant squeeze on liquidity creation and large build-up of government cash balances, the Reserve Bank resumed open market purchase auctions of government securities in early September 2013. RBI injected around 1.5 trillion rupees into the system, but large and persistent build-ups in government cash balances counterbalanced the measures to an extent. July 2013 to September 2013: A new challenge presented itself in the form of sharp depreciation

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of the rupee consequent to the sudden surge in capital outflows following indications of tapering of the US Fed’s quantitative easing programme (QE3). RBI resorted to an unconventional but effective approach through these measures 1) Hiked short-term interest rates and compressed domestic money market liquidity as a first line of defence. The measures taken included a 200 basis points (bps) hike in the marginal standing facility (MSF) rate to 10.25 per cent 2) Cap on daily LAF borrowing to 0.5 per cent of NDTL of respective banks as against the earlier practice of unlimited access against excess SLR holdings. 3) A hike in the minimum daily cash reserve ratio (CRR) requirement to 99 per cent from 70 per cent of the requirement 4) weekly auctions of cash management bills (CMBs) were also conducted to drain out the liquidity. September 2013 to December 2013: Taking into account the easing of the exchange rate pressures and evolving macroeconomic conditions, the Reserve Bank in its Mid-Quarter Monetary Policy Review (September 20, 2013) moved towards normalising monetary measures by implementing the following measures 1) Reduced the MSF rate by 75 bps to 9.5 per cent in September 2013 to reduce cost of funds. MSF was further reduced by 50 bps in October 2013. 2) The minimum daily CRR balance maintained by the banks was reduced to 95 per cent of the requirement from 99 per cent to provide banks with the flexibility to better manage their liquidity situation. 3) Considering inflation risks,

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policy would need to be carefully calibrated to balance price stability, growth and financial stability.

policy and to revert to the LAF repo rate as the operational policy interest rate. The constant vigilance by the RBI on liquidity management has returned some normality to the system. Credit growth has accelerated since mid-July 2013, partly due to the substitution of costlier money market sources of finance by corporates with bank credit. This has reduced the divergent trend between deposits mobilized and credit extended. While the RBI was able to effectively manage the volatility in foreign exchange markets through effective monetary policy transmission, it is confronted with three issues that need to be addressed: 1) decelerating growth, 2) comparatively high consumer price inflation and 3) external vulnerability. While managing the liquidity deficit conditions, RBI had to ensure that it does not deviate from its anti-inflationary stance. The double digit CPI index has been posing a challenge to the implementation of monetary policy. The significant wedge between wholesale price and consumer price inflation exacerbated the challenge for monetary management in anchoring inflationary expectations. It is important for the RBI to avoid financial disintermediation or financial repression if growth is to be revived on a sustainable footing. In a period of economic slowdown, a pro-growth monetary policy may push the interest rate down, but if the internal rate of return (IRR) falls at a faster rate due to depressed expected returns on investment, monetary policy stimulus may have limited effect. Factoring in these limitations and the three challenges enumerated above, monetary ÂŠ FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

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the repo rate was increased by 25 bps to 7.5 per cent. Finally, RBI signalled its intention to normalise the conduct and operations of monetary

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Energy Future Holdings Buyout: A failed investment decision Dwaipayan Chakraborty

IIM Shillong

Whatâ&#x20AC;&#x2122;s an LBO? Leverage BuyOut is a mechanism to buy a company partially or completely through borrowed sources of fundsE.g. If Nestle wants to buy Amul, but do not have required funds, it can raise debt from the market and later sell assets of Amul to pay-off the debt it cannot pay through the cash flows generated by both the companies. What is Private Equity? Private Equity consists of investors contributing funds tomake direct investments into private companies or buys majority shares of public companies eventually resulting in delisting of the public company. Capital for private equity is raised from retail and institutional investors, and can be used to fund new expansion and growth strategies or to strengthen its balance sheet. Once a balance sheet is strengthened, the Private Equity players exits from the company selling its assets and pocketing the profits. There is no emotion involved, no buzzwords like consumer-focus or brand equity, it is pure

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capitalism. What is the Difference between Buyout and Leveraged Buyout? In the case of a buyout or a management buyout, the management of the company retains its control and takes it away from the public. They usually do this when they see that the stock market is not doing enough justice to the fundamentals of the company and thus consolidates their control over the company In the case of a leveraged buyout, the PE firm that arranges the funds also aims to take control of the company. While a MBO is done to rejuvenate the company, LBO deal is done with the relentless pursuit of profit and can even mean liquidation of the company to pay off the debt obligations that were procured during the buyout. Most PE investments are highly leveraged and raise money from high risk instruments and junk bonds. Major players in the PE business Private equity companies hire the best brains and continue to attract the best talents. They hire fresh graduates from top B-Schools and

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penny for bailing TXU out. In 2007 TXU was again faced with a crisis keeping the companies financials in place and thus stuck the LBO deal under which the CEO of the company John C. Wilder will continue to manage the company. Although TXU Corp had a problem with managing its finances, its overall business prospect was good. Not many healthy companies want to sell themselves; most would prefer to use their capital to buy other companies. However, in TXU’s case, CEO John Wilder’s compensation package increased if the company shares were acquired at premium. Moreover at the time of buyout the market cap of TXU Corp. was $27.5billion with $12.3 billion in debt. A $47billion bid for the company was nothing but a money machine for the existing shareholders. Why Goldman Sachs came into the picture? The size of the deal for leverage buyout of TXU Corp was around $47billion. It is nearly impossible for any individual player to arrange for such a huge amount. Thus most LBO deals is initiated by a PE player and backed by an investment bank. In this case it was collaboratively initiated by KKR and TPG the PE players and Goldman Sachs as

Fig 1: A SPELT Analysis of the deal

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experienced professionals from top investment banks. The biggest players in the PE market are, Kohlberg Kravis and Roberts (KKR); Blackstone; TPG Capital and Carlyle Group. The Deal: Leveraged buyout of Energy future holdings What is TXU Corp.? TXU Corp or Energy Future Holdings as it is known today is an energy utility company, headquartered in Texas. The company derives bulk of its profits from coal and nuclear power plants and was instrumental in pegging the utility prices to the natural gas prices. Why TXU Corp. went for a LBO? TXU Corp. carved out its main energy producing subsidiary, ‘TXU Energy’ back in 2002. After a series of deals in Europe that did not pan out, TXU Energy and its parent company found it difficult to carry their debt. DLJ merchant banking came in with a $750 million investment in TXU Energy. A few months after the transaction, Warren Buffet bought one-third of DLJ’s stake for $250 million, a clear testament to the value proposition in the energy sector. At some point, DLJ exited this investment and earned a pretty

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the investment bank. LBO deals require a lot of hedge funds and junk bonds and Goldman Sachs was the leader in hedge funds in general and fuel-price hedging in particular. The deal also indirectly involved Citi Bank, JPMorgan Chase and Credit Suisse who sold loans of TXU corp. to help finance the private equity. Thus in a way the deal involved the very best and brightest of Corporate America. Why KKR and TPG were interested in buying TXU? Energy is a classic buyout category and being highly value driven has always attracted the eyes of investors. (Repetitive line)Although TXU Corp had a problem with managing its finances its overall business prospect was fine, the generation business of TXU was highly promising and under the leadership of its CEO the stock prices moved from $5.44 in Oct 2002 to $60 in 2007. Thus it proved to be a sound investment plan for a PE firm. These firms usually stay invested in highly volatile securities thus having a low-risk profitable firm like TXU would only hedge them against bad times. This motivated them to pay such a huge amount for the company and go ahead with the deal. TXU Corp was bought at 15% premium above its share price and 8.5 times EBITDA (earnings before interest, tax, depreciation and amortization). The deal was blessed by the regulators TXU Corp. had plans to go ahead with opening of 11 new coal plants to meet the growing needs of power and this decision faced huge backlash from the environmental activists as well as regulators. The LBO deal promised to close down eight of these plants and supported the mandatory emission and production limits as per environmental safeguard thereby environmental activists pushed and even lobbied for the deal. The deal also proposed to reduce the utility charges by 10% thus earning the blessings of the regulators as well who saw high value in public cost saving. Never before had an LBO earned so much support from the government that it appointed James Baker III, the former secretary of State as the advisory chairman. As the saga unfolded The deal agreed to split the original company into three units, power generation to be handled by Luminant Energy, transmission and distribution to be developed by Oncor Electric delivery and

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TXU Energy would manage the companyâ&#x20AC;&#x2122;s retail electric business. The structure of the deal includes a $33billion buyout of TXU equity and $12 billion in existing debts. To finance the same the buyers contributed $8.5billion in equity and $24.5 billion in debt thus the deal had around 80% in debt and 20% in equity. Although this kind of structure is very common in a LBO and even in some cases the debt-equity share is 90%-10%; for a company like TXU Corp. which was already operating at 0.85 debt to equity ratio, such a move raised questions like where these loans will be placed in a company that is already overleveraged. How the credit rating agencies viewed the deal? Immediately after announcement of the deal the credit rating agency S&P downgraded the TXU debts to below investment grade expressing concerns over the highly leveraged structure. It also put it on a credit watch with negative implication. The primary reasons cited were the promise by the buyers to reduce prices which would reduce cash flow and exposure to huge amounts associated with the plan to drop eight coalpowered plants and along with it a declining customer base of TXU. Moody argued, citing compromise on bondholderâ&#x20AC;&#x2122;s interest and found the deal risky and viewed it with scepticism. Fitch argued that that resulting company would cause a substantial indebtedness and also questioned the strategic direction of the company as well as likely changes in the corporate structure and how the firm would continue its financial practices after the deal. Usually PE firms employ a massive cost cutting strategy after acquiring a company, in the energy utility sector however such a strategy may imply a compromise on safety and dependability of the delivery. Investment objectives of all PE firms are with an objective to maximise the investment and profit from the company and is believed to have no respect for values. Even the cost saving to the customer which was promised was required till 2008 after which the firms were free to raise the prices, many saw it as a ploy by the buyers to increase the customer base and the hiking the prices. The electrical utility industry is crucial to

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its profits In most of the cases however PE firms exit the company before the repayment period is reached and thus save themselves from the burden of paying the returns to the bondholders. This entire junk bond thus places the LBO market on a morally wrong footing. The giant deal as it stands today: Unfortunately the deal materialised in Oct 2007 and in the very next year the world was to see the greatest financial crisis after the Great Depression of 1929. Despite involving the best brains of corporate America, KKR, TPG and Goldman Sachs could only recover 3% of their investments and the company as it stands today would file for bankruptcy next month. The deal was primarily based on rising gas prices instead the gas prices fell post 2008 crisis and a hydraulic fracturing created a surge in US Gas supplies. The company registered 10 straight quarterly losses since 2011 and Warrant Buffet was to quote the investment as one the biggest mistakes of his company. The bankruptcy filing would be the fifth biggest non-financial bankruptcy in the world. What is the insight from here? The best brains of corporate America took a company that was started in 1882, soon after the invention of incandescent light bulb to a bankruptcy. It is a lesson for all of us as budding managers to see where our goal lies in striking an investment deal. There was no question on the planning and execution of the deal but what it lacked was care for the society and was thus not sustainable. Sustainable leadership in the world of Finance is hard to learn given the models and case studies we learn are mainly developed out of the Game of Greed practiced in Corporate America. But as Dylan said the’ times they are a changing’, there will be a change where Finance caters not only to the 1% but to the whole 100% of the Globe.

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the growth of an economy and thus operating it on a soul motive to drive profits can have major repercussions on the society, thus the regulators should have been prudent in ensuring that such a play not only benefits the buyers but is in the interest of society’s long term interest. Because of the sheer size of the deal, the largest PE buyout in history the deal should have involved a lot of other stakeholders who should approved agreements reached between the Commission and the buyers. In order to ensure that the buyers actually delivered on their promise, it was mandated to remain under the public utility company of Texas. What drew Warrant Buffet into the deal? As stated earlier, despite the size of the deal investors saw the company as an extremely good investment option. Berkshire Hathway had earlier purchase stocks in TXU when it appeared close to bankruptcy and the sold it at hefty profits in 2004. This time Buffet was offered two bond issues, one was $1.1 billion purchase of 10.5% bonds at 95 cents on the dollar and another $1 billion of PIK-Bonds for 93 cents on the dollar. The drawing of Berkshire Hathway generated huge confidence among the investors and helped in further procuring of cheap debt. What’s so much about these Junk Bonds? Junk bonds are bonds issued by companies whose ratings are lower than BB, the high return is attributed to the weak underlying fundamentals of the company that makes it highly susceptible to defaults and hence investing in bonds is referred as junk investment and the bonds as junk bonds. LBOs use junk bonds as a cheap source of raising capital and especifically because of the high exposure to junk bonds that acquisition by a PE player is viewed with great scepticism and caution. Raising money through junk bonds means:: 1) The company is highly risky and can default on its bond payments , thus at the outset of the purchase the PE firms project the company as risky 2) Even if the PE firms are able to turn around the company they need to pay big interest amount from the cash flow of the company to its bondholders thereby lowering

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Goldfinger Ronak Ravindran

Bangalore University

For over four thousand years, it served as a symbol of power, glory, greatness, grandeur and status. Civilizations and empires lusted after it, even as it ignited wars and destroyed cities. It embellished the walls of palaces and tombs alike and its lustre drew men towards it like moths to a candle flame. Over the last century, gold has been hailed as the asset class of the highest echelon. Corporate prophets even went as far as calling it the ultimate bubble. Alas, no longer. In 2013, that dream run came to a resounding end. Gold, which has rivalled equities over the past 3 decades as the bestperforming asset class, plunged close to 30%, wiping out the gains that it had notched up in the past 2 years. The global crash of gold prices was eerily similar to the fate that silver suffered in the 1980s, following the devious trades of the Hunt brothers, who tried to corner and monopolize the silver market. Ever since the US went off the Gold Standard in 1971, gold has virtually seen an unstoppable rally but the asset class, which has always been perceived by governments as a natural hedge against inflation, saw its prices tumble from over $1900/oz to a

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little over $1300/oz, in the short span of a week. That crash, however, is not devoid of explanation and a multitude of factors snowballed into the terrifying tumble of gold prices worldwide. With Europe still suffering from the effects of a crushing recession, the deficits of some of member nations of the European Union have spiralled out of control, even as austerity measures struggle to kick in with full force. For now, the Scandinavian countries are in a safe spot and economic giants like Germany and France are managing to keep their heads above water. The PIIGS (Portugal, Italy, Ireland, Greece and Spain), however, havenâ&#x20AC;&#x2122;t been that lucky and now, Cyprus has joined the party. With a major banking crisis and a crippling deficit, the Cyprian Government is mulling over the possibility of dumping its gold reserves in the open market. This would potentially create a glut of over half a billion dollars worth of gold in the global bullion market. The Cyprian Parliament will take a decision on the matter soon but considering Cyprusâ&#x20AC;&#x2122; financial health, the move to dump gold is virtually sure-fire. If or when Cyprus does pull the

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plug on its gold, the other PIIGS, with their ballooning deficits, are sure to follow suit, which would lead to a much larger crash in gold prices. Spain, for instance, has a trillion dollar deficit to rein in and it would certainly use its gold reserves to ease the strain on its economy. Cyprus, however, is a nation in its own right and the Cypriot crisis unfolded only in March. After all, nations can and sometimes do topple markets by themselves. However, when it comes to the crash in gold prices, the trail leads to a certain individual, who had a major role to play. But that said individual is no ordinary man. The subject in question actually managed to break the Bank of England in 1992. In 1992, the world began to recognize the financial insight and might of George Soros. Soros, one of the world’s greatest investors and the founder of the Quantum Fund, took a sizeable position against the British Pound. When the British Government refused to raise interest rates or let their currency float in the same manner as other European countries, the British Pound crumbled and Soros made a fortune of over a billion dollars. His contrarian call against the British Pound worked wonders and this time around, Soros has zeroed in on the ultimate asset. Soros, who has always declared that he invests wherever he sees a bubble, was bullish on gold for the past 12 years and he built up a sizeable position in the world’s largest gold exchange traded fund

(ETF), SPDR. However, in the closing quarter of 2012, Soros liquidated over half of his holdings in SPDR and declared his bearish outlook on the asset. Moreover, Soros’ position on gold, which was valued at a few billion dollars, was no meagre one. When investors and fund managers learnt that Soros had cashed in, herd mentality set in and gold ETFs worldwide witnessed massive selling. The Cypriot banking crisis and the fiscal deficit troubles in the Eurozone, of course, compounded the problem. Several ETFs even had a problem delivering physical gold against the widespread redemptions. And it wasn’t just Soros who was at the centre of all the mayhem. PIMCO or Pacific Investment Management Company, the world’s largest bond fund, has also turned negative on bullion and this stance would have surely manifested itself in the liquidation of some its sizeable gold holdings. Sadly, the global bullion market, as large as it may be, is certainly not strong enough to withstand the combined financial might of a pair of punters like George Soros and PIMCO. After crumbling all the way to a level of a little over $1300/oz, gold managed to find some support and it has crossed the $1400/ oz barrier, even as value buying sets in. Gold, which normally moves in the opposite direction as crude oil, seems to have mirrored the fall in crude prices this time around. This may just be an aberration or it may be an omen for a much larger and more

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Fig 1: Gold Prices Stabilizes While Gold ETF Selling Continues

catastrophic double dip recession on a global scale. After all, gold and crude oil plunged hand-in-hand in 2008, in the 1980s and in 1929, just before recession and depression descended on the global economy. Gold prices may have stabilized for now but if the European PIIGS and Cyprus choose to dump their gold, all hell will certainly break loose and economic gloom and doom will surely become the order of the day. In the eponymous 1964 flick, Auric Goldfinger intended to radioactively contaminate the United States’ gold reserves at Fort Knox. This would have triggered a surge in gold prices worldwide, leading to a multi-fold increase in Goldfinger’s wealth, which was largely denominated in gold. However, before he could succeed with his devious plan, Goldfinger was vanquished by Sir Sean Connery, in the avatar of a certain Bond. James Bond. But that was back in 1964. This time around, in 2013, Goldfinger, having cashed out of his gold holdings just before the horrendous crash in which played no small role, seems to have come out on top. Just like in 1992, the financial world is in awe of Goldfinger’s timing and his contrarian call on the asset on which he had a bullish stance for well over a decade. And Goldfinger,

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obviously, is laughing all the way to the bank. Oh wait. Did I say Goldfinger? I meant Soros. George Soros.

MR. RAJESH GUPTA Senior Manager, Leading Private Bank

coming out with new guidelines/circulars and making them effective immediately. To read the conscience of the new guidelines/stipulations is imperative to ensure smooth compliance. Liquidity Adjustment Facility (LAF) is a tool used in monetary policy that allows banks to borrow money through repurchase agreements. This arrangement allows banks to respond to liquidity pressures and is used by governments to assure basic stability in the financial markets. Priority sector refers to those sectors of the economy which may not get timely and adequate credit in the absence of this special dispensation. Typically, these are small value loans to farmers for agriculture and allied activities, micro and small enterprises, poor people for housing, students for education and other low income groups and weaker sections. Banks have mandate for providing a specified portion of the bank lending to these specific sectors. Issuance of two new banking licenses How do you think that the banking goes with the RBI philosophy of rural growth. industry will evolve with the issuance of new banking licenses by RBI to two other Inclusive growth is the trending word companies? RBI has issued two new banking licenses in in current economics of growth and April 2014 to IDFC (Infrastructure Development development. According to you, what Finance Company), a financial services firm with is the role of one of the India’s leading special focus on infrastructure financing, and bank in promoting inclusive growth in Bandhan Financial Services, large micro lender. India? These institutions have strong presence in the The Indian economy has moved on a high under-banked regions of India which will help growth path for past two decades. Despite the in financial inclusion. The move is expected high growth, concerns have been raised over to enhance service delivery especially in rural the growth not being equally distributed. Here areas. Reportedly, they have been given a year comes the concept of Inclusive growth. It implies and a half to begin operations. The move will advancing equitable opportunities for economic participants during the process of economic also boost job creation in banking sector. growth which benefits every section of society. What would be the impact of number As a leading private sector player, promoting of regulations imposed by RBI on banks inclusive growth has been a priority area from related to LAF facilities, PSL’s, expansion both a social and business perspective. The Bank in rural areas etc. And how as a banker strives to make a difference to its customers, you deal with such stipulations imposed to the society and to the nation’s development by RBI? through its products and services, as well as RBI has become very active these days in through development initiatives and community What are your views on the new government and how do you think it would impact the banking industry in general? Sensex hitting 25K mark and rupee getting stronger itself defines the expectations of market from the new govt. Moreover, stable govt is viewed as Dawn of a new era. Also, the new PM’s priorities for next 100 days viz. education, health; infrastructure and investment reforms etc is a welcome move. I believe it would give banking industry the much needed strategic direction. New Finance Minister has signaled that it would take steps to make India an investment destination where there is stability of policy, taxation and fiscal measures. This implies that interest rates are expected to come down in order to make the economy competitive.

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FinGyaan

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outreach. Key focus areas are: primary health, elementary education, skill development & sustainable livelihoods and expanding access to financial services.

FinGyaan

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You must have made various strategic decisions in your careerâ&#x20AC;&#x201D;for example, about how to reallocate the business portfolio, where you might have tried your own tricks against the conventional way of doing things and the recommendation by your team. How do you do that? Although I have not taken any major strategic decision yet, I would like to highlight few key success factors in this industry. One has to be vigilant and updated with all the guidelines/ circulars associated with his/her profile and internal guidelines of the organization. The spirit of these guidelines should also be looked into. One should be aware of various products and services offered and terminologies used in the sector. Knowledge of market and economy is a must. In this industry, Service is a key deliverable. Quality service leads to customer satisfaction and one should in fact strive for customer delight. Customers want convenience in banking, hence latest technology plays very significant role. It also helps in lowering transaction costs and improving the quality of products. This is the reason why mobile banking and online banking are gaining momentum. Product innovation is another yardstick in banking industry. How to structure the products in a way that best suits clientâ&#x20AC;&#x2122;s requirements/needs is essential. Last but not the least, the industry is experiencing competitive environment these days. One has to be aware of products offered by other Banks and their pricing & terms to remain competitive. According to you what are the qualities of an Ace Banker? Apart from above, a banker needs to be wellinformed with current events and stock market, articulate, possess presentation skills. He/she should possess analytical skills and attention to detail. According to you where the Indian economy heading and what are the sectors that would steer the Indian growth story? Prospects of Indian economy are bright. India would see the growth story with revival of

MAY 2014

investment and business confidence. Three major constraints are: persistent food price inflation, financial distress of most infrastructure companies, and lack of jobs for young people entering the workforce. Improvement in these should be the priority and key agenda of new govt. New govt has clubbed together few separate ministries which will improve coordination, effectiveness and speed of decisionmaking. I expect that economic momentum will be back through decisiveness and improved confidence overall. Key sectors are: Food and Agribusiness, Healthcare, Life Sciences, Media and Entertainment, Telecommunications, Information Technology, Infrastructure. These are future businesses of India. Growth and development of these sectors would facilitate the overall development of the country.

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prospectus

FinFunda of the Month

Gaurav bharadwaj IIM Shillong

Sir yesterday my father brought a document file which he named as a prospectus. What does that mean sir? Prospectus is an invitation for investors to subscribe to shares issued by the concerned company. It contains all the information regarding company’s key personnel, profitability, pro-forma statements etc. It also tells investors about the number of shares that the company would offer and the price at which shares would be issued. But sir when I saw the document, it stated that you can subscribe to the company’s shares within a price band of Rs.45- Rs.60. If issue price is already disclosed by the company than, what does this statement mean? See, prospectus is not of one type. There are different types of prospectus like Shelf prospectus, red herring prospectus and abridged prospectus. So different prospectus quote prices differently. Some gives a price band and issue shares through book building and others quote a single price and issue shares on pro rata basis in case of over subscription. Can you please explain different types of prospectus? A red herring prospectus does not have complete particulars on the price of the securities offered and quantum of securities to be issued. The front page of the prospectus displays a bold red disclaimer stating that information in the prospectus is not complete, and may be changed if required. Shelf prospectus is generally issued by banks and financial institutions for a certain time period mostly 1

year, and it ensures that such financial institutions does not have to wait for regulatory approvals to raise capital within stipulated time period. Abridged Prospectus is a shorter version of the Prospectus and contains all the salient features of a Prospectus. It accompanies the application form of public issues. Sir! You talked about book building above. What is it? When is it used? Book building is a process of price discovery of shares depending upon the capital that company wants to raise, and the amount at which investors bid for the company’s shares. The process is directed towards both the institutional as well as the retail investors. The issue price is determined after the bid closure based on the demand generated in the process. Sir, institutional investors are so big and they make bulk purchases of shares of a company. Don’t they get any bulk discount compared to retail investors who subscribe to company shares in very small numbers? No, in case of an IPO or an FPO, everyone is issued shares of the company at the same price disregarding the quantity of purchase or the type on investor. But when a company goes for an acquisition of equity stake of another company, than they can get discount on such bulk purchase of equity. Thank you so much for all the information Sir!!!

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FIN-Q

1. After PwC acquired Booz and Co, what is its new name? 2. The first commercial cellphone Motorola Dynatac went for sale on March 13, 1984. What was its price then? 3. X is a metric that comprises of the stocks of the companies associated with a famous personality Y. Due to the power and influence of this celebrity Y, it is believed by some analysts that the stocks of index will always outperform their competition. Y also formerly held a position at the UNHCR. Identify X and Y. 4. This rule prohibits banks from proprietary trading and restricts investment in hedge funds and private equity by commercial banks and their affiliates. Which rule are we talking about? Name the act which the rule is a part of. 5. Mulberry raised prices of one of its luxury handbags range by 10 per cent. Interestingly, the demand for this range of handbags doubled. How would you classify this product in terms of economics? 6. Which country’s foreign market is known as ‘Rembrandt Market’? 7. Identify the person and the company he founded

8. Question (Connect the dots)

9. Question (Connect the dots)

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FIN - Q

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Swati Pamnani IIM Shillong

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