Niveshak 2011 by Zigu MBA

Niveshak THE INVESTOR

VOLUME 4 ISSUE 9

Who is bearing the burden..?

September 2011

FROM EDITOR’S DESK Niveshak Volume IV ISSUE IX September 2011 Faculty Mentor Prof. N. Sivasankaran

THE TEAM Editor Rajat Sethia Sub-Editors Alok Agrawal Deep Mehta Jayant Kejriwal Mrityunjay Choudhary Sawan Singamsetty Shashank Jain Tejas Vijay Pradhan Creative Team Vishal Goel Vivek Priyadarshi

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 world economy has been in a bad shape since some months now. The Fed’s announcement of $400 billion ‘Operation twist’ to stimulate the US economy sent global markets on a free fall. The earlier monetary easing by Fed ‘QE2’ failed to revive the US economy and the market seems to have lost faith that the new avatar of monetary easing is going to help either. The Indian markets fell by more than 4% on announcement of monetary easing by Fed, its highest fall in a single day since 2009. The volatility in all markets have increased to an unprecedented levels and the possibility of a double dip has increased further. Fear Index VIX, which is based on volatility has increased by 22% for Indian markets in September and has reached high levels for most markets. Adding to the woes is the Euro crisis which has been worsening every passing day. The possibility of a Greek default is now very real. The Euro crisis which was born out of fiscal profligacy and mispricing of credit risk has now attained a massive scale threatening the disintegration of Euro itself and no Euro zone country seems to be knowing the solution to the crisis. Meanwhile, the growth of Indian economy has stalled, thanks to RBI, which has been on an ‘interest hike’ spree for quite some time now. However, all the measures by RBI have failed to contain the inflation and the hawkish tone of RBI Governor is scary and an indication that interest rates can be increased further. Unlike the Americans, Indians do not live by credit, and hence a credit squeeze to contain demand may really not be effective in India. When inflation is driven by high prices of food and other basic necessities, a credit squeeze can hardly help, as Indians are unlikely to buy food on credit. This is not to argue that economic growth is the only priority and inflation does not matter, but it is simply unacceptable that economic growth is hurt while inflation remains unchecked. The fact is that the Government can do little to check inflation in an open economy. As a corollary, if commodity prices were to fall in the event of a double-dip recession, the government can hardly claim credit for bringing prices under control. When it is already known that the current inflation is largely driven by high food and raw material prices, squeezing credit to agriculture and allied activities can only make inflation more persistent. But inflation is a political issue and the government must show that it is taking efforts to check inflation. Hence these rounds of interest rate hikes. This issue brings to you some more interesting and insightful topics. The cover story this month focuses on the outlook of the world economy and whether the ghosts of 2008 will return to haunt us. The issue also features an article on the genesis of Euro Crisis and the way forward for it. Other article focus on downgrade of US, India’s fiscal deficit and whether dollar can replaced as the reserve currency in the coming years as the US economy is losing steam. The Classroom this month explains the topic of Currency wars. Last month, we celebrated our third anniversary with a special issue on Sector Reports. The Anniversary issue was a huge success with more than 100 entries for Sector Reports. We would like to thank all those who contributed the Sector Reports and made our anniversary issue such a success. Rajat Sethia (Editor - 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 Niveshak Times

Cover Story

04 The Month That Was

Article of the month

13 Indiaâ&#x20AC;&#x2122;s Fiscal Deficit

A ticking time bomb...

06 The Greek Debt Crisis

Who is bearing the burden?

Perspective 20 Euro Debt Crisis

10 World Economy Outlook

Stressed & Downgraded

Replacement of Dollar as Global currency Reality or Illusion

Finsight

The next looming danger

CLASSROOM

21 Currency Wars

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The Month That Was

www.iims-niveshak.com

The Niveshak Times Team NIVESHAK

IIM, Shillong

DEPB scheme closure scheduled on October 1

Telenor-Unitech JV to raise INR 8000 crore Norway based telecom behemoth, Telenor has initiated a process to raise INR 8k crore in its Indian JV with real estate giant Unitech. BNP Paribas has been roped in by the JV, Unitech Wireless to explore the fundraising options which may be availed by the company. Rights and debt issue are the two sources o f fundraising identified so far. Unitech is keen on raising funds through debt issue while Telenor is bullish about the rights issue. Telenor which has a controlling 67.5% stake in JV is also considering the option of inducting a second Indian partner in rights issue in case Unitech decides not to participate in the equity issue. The stay on the initial fund raising process has been lifted by the Punjab and Haryana high court that was held up due to Unitech’s opposition to the proposed rights issue.

The central government has decided to put an end to Duty Entitlement Passbook Scheme (DEPB), effective October 1, a move that reflects government’s resoluteness towards tightening of fiscal policies. This move will adversely impact exporters in engineering sectors like auto components, chemicals, pharma, textile and marine. The revenue benefit received by exporters on account of DEPB was around INR 8700 crore for previous year. The finance ministry has however assured the exporter community that the duty drawback items list upon which the exporters can claim benefit has been expanded to 4000 items to ensure that their revenues would not be affected by termination of this export promotion scheme. The expansion in the list of duty back items may be attributed to the addition of 2130 items in the soon to expire DEPB scheme. The termination of DEPB scheme has been perceived by some in exporter community as a signal of the beginning of withdrawal of export promotion schemes and other impetuses. Blackstone-Carlyle’s joint bid for Reliance Infratel on the cards: 12th successive policy rate hike by RBI RBI maintained its hawkish stance on interest rates with a 25 basis point increase in key interest rates to rein in on rising inflation. After this hike by the central bank the short term lending repo and borrowing reverse repo rate stand at 8.25% and 7.25% respectively. This interest rate increase has allowed RBI to cover some of its losses incurred on investment in foreign currencies and gold. Meanwhile the increase in petrol prices by INR 3.14 is expected to push up the WPI inflation by 7 basis points. The high food inflation despite normal monsoon has led RBI to point out structural demand supply imbalances as the cause behind the high food inflation.

September 2011

Seasoned private equity players, Blackstone and Carlyle group are keen on putting forward a joint bid for Reliance Infratel, the tower business of Reliance Communications. The bid values Reliance Infratel at $4 billion against R Com’s expectation of $5 billion. R Com is looking to sell its entire 95% stake in its tower division. A likely competition for this joint bid may come from another private equity consortium comprising of Apax Partners and Advent International. Investment bankers in charge of this deal had earlier approached strategic buyers like American Tower Company and Crown Castle who are interested in buying tower business in India. Fortis Healthcare to acquire group company Fortis Healthcare India (FHI) is ready to acquire its international arm, Fortis Healthcare International Pte Ltd. in an all cash deal from its promoters Malvinder Mohan Singh and Shivinder Mohan Singh, whose joint stake in Fortis Healthcare International is 100%. The promoter brothers also hold 80%

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NIVESHAK

stake in FHI. The combined entity resulting from this acquisition will have consolidated revenues of $1 billion with equal contribution from both the companies. The deal will enable FHI to enter into international markets like Hong Kong, Australia, New Zealand, Sri Lanka, Singapore, Vietnam and UAE. The size of the deal is estimated to be around $1.5 billion. Given the all cash nature and size of the deal, the huge payout to be made by FHI for acquisition may limit the international expansion plan of the domestic healthcare giant.

tem and will enhance competition in mobile computing. Motorola Mobility will remain a licensee of Android and Android will remain open. Google will run Motorola Mobility as a separate business.” The acquisition is considered by industry analysts as an attempt by Google to build a strong patent portfolio that represents a formidable defense against competitive threats from Microsoft, Apple, etc. The company holds approximately 14,600 granted patents and 6,700 pending patent applications, worldwide, as of January 2011.

Softbank makes $200 million investment S&P’s unexpected downgrade of Italy’s credit into InMobi rating Bangalore based mobile advertisement company; InMobi has received a $200 million investment from Japanese internet company, Softbank. The proposed investment will be made in two equal tranches - an immediate influx of $100 million in September followed by remaining $100 million in April next year. The deal which is touted to be one of the largest in mobile advertising space has an estimated value of around $1 billion. Estimates by Crunchbase, a database of technology companies has placed Inmobi at second position in global mobile advertisement network behind market leaders Google. InMobi has the network to reach out to 340 million customers in 165 countries with more than 47 billion ad impressions on a monthly basis.

Standard and Poor downgraded Italy’s credit rating by one notch to A/A-1 citing concerns over poor growth prospect and political instability plaguing the country and maintained a negative outlook on the country. The Italian government reacted on expected lines dismissing concerns raised by S&P by saying that such concerns were misleading and far removed from reality. The government assured the Euro lenders community that it is taking sufficient measures within its capacity to keep debt crisis under control and referred to the 59.8 billion euro austerity plan in the Italian parliament. The downgrade came as a surprise to market that exGoogle acquires Motorola Mobility in a pected Moody to come up with the downgrade first. $12.5 billion deal ICBC ventures into India The $12.5 billion acquisition of Motorola Mobility by Google is the largest acquisition by the search engine company till date. The deal is an all cash deal as a part of which Google has agreed to pay

$40 per share of Motorola Mobility. The statement about the deal posted on the investor relations page of Google’s website mentions – “The acquisition of Motorola Mobility, a dedicated Android partner, will enable Google to supercharge the Android ecosys-

Industrial and Commercial bank of China (ICBC), the world’s largest bank with a market capitalization of $234 billion has set up its first branch in BandraKurla business region in Central Mumbai in India. Sun Xiang has been appointed as the CEO of ICBC operations in India. The Chinese banking behemoth will make an initial investment of $100 million and will primarily deal with corporate clients in sectors like power, telecom and infrastructure in which Chinese companies have a presence in India. ICBC is also the world’s largest bank in terms of profits and market capitalization. The start of ICBC’s branch operations in India is a part of the long term plan of the bank to increase its share of international business (as a percentage of total business) to 10%.

The Month That Was

The Niveshak Times

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Cover Cover Story Story

Who is bearing the burden? Tejas Pradhan & Vivek Priyadarshi

Team Niveshak

It was May 2010, when problems in Greece were taken seriously by the international community and Greece was offered a bailout of Euro 110 billion by the EU and the IMF. In the same month “Greece Debt Crisis” was the cover story of Niveshak. Our editors Sumit and Upasna analysed the current situation then and provided possible future implications. Most of their views, like just by implementing austerity measures Greece would not come out of the crisis, combined action by all EU members (not just France and Germany) would actually help Greece and the weakening of Euro vs the Dollar, have come to be true.

September 2011

The CRUX of the CRISIS It started just before the 2009 Greece elections when the Government confessed that the fiscal deficit which was claimed as 2% till now was actually 6%. An inquiry by the European statistical institute found it to be a whopping 15%. Unnecessary government spending, low lending rates and lack of proper reforms had pulled the rug from under Greece’s feet after the global economic recession of 2009. It did not have the money to fund its own debt. The EU and the IMF stepped in to bail out Greece with a loan of Euro 110 billion at a stage when debt to GDP ratio was above 112% (in 2009) and the fiscal deficit was at 12%.

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Consequences for the EU GREECE REMOVED FROM THE EU This would be an extreme measure to save the Euro and the EU the reason being that EU would then have to consider severing ties with the other PIIGS (Portugal, Ireland, Italy and Spain) who are in a situation similar to Greece. The removal of these five members would then threaten the existence of EU and the EuroZone as the purpose of its formation was to make the region function as a single entity having common currency, ease of movement of people among other things. With these five nations not in the group there would be no meaning of other members staying together. THE EU AGAIN BAILS OUT GREECE The EU can be held equally responsible for Greece’s condition today. A point that EU has failed to understand right from the time of its inception is that though logically it might be a single economy but structurally it is a group of countries which have different economic and financial strength and hence different aspirations. France and Germany, the two biggest economies of the Eurozone have modelled the Eurozone economy based on the developed economy model of their own country. This can be found out from the fact that Greece was lending money at very low interest rates, a phenomena common to developed economies like France and Germany. Greece being nowhere close to the might of France and Germany was funding social security of its people which amounted to 50% of its GDP. For every three Euros spent in the Greece economy, one Euro was coming from the EU, instead it should have come from Greece itself. It is because of the above reasons that the EU again bails out Greece. The biggest hurdle in this process is the unwillingness of France and Germany to fund the bail out. Both these countries had funded more than a third of the previous bail out of Euro 110 billion. They do not want to make this as a habit where they have to fund the bail out of another country,

which does not show the intention to revive its economy, with the hard earned money of its citizens. This practice of bail out if continued in future would lead to political unrest in France and Germany. EU DOES NOT BAIL OUT GREECE This seems to be a remote possibility. If EU does not bail out Greece it will default on its debt which would send ripples not only through the EU but through the global economy. The other major economy the United States is still suffering from its own problems. Germany and France together hold roughly Euro 40 billion of the previous bail out in the form of Greek bonds. If Greece defaults then German and French banks would come down to its knees, leading to the failure of two biggest economies of the Eurozone. THE FUTURE OF EURO One of the reasons of formation of the Eurozone and the common currency Euro was to reduce dominance of the US dollar as Eurozone ($16.2 trillion GDP in 2010) was the only economy that was ahead of the US ($14.5 trillion GDP in 2010). But because of the failing economies in Europe investors are slowly losing faith on the Euro. The Euro fell 9.7% from 4th May 2011 to 23rd September 2011, a span of five months. The failure of Euro has led to investors holding hard cash in US dollars. As US came close to defaulting on its debt, investors are preferring hard cash than government bonds as the currency of a country is the promise to pay the bearer a certain denomination of money. With investors round the globe hoarding USDs as a safe haven, the value of USD has appreciated compared to most of the global currencies. Euro has also suffered from the same. Going forward, if the Eurozone still suffers from ailing economies – PIIGS (Portugal, Ireland, Italy, Greece and Spain), Euro would never be able to challenge the dominance of the USD. Moreover the well to do economies of the Euro zone would not trust the Euro. Meanwhile the laggards would still continue to enjoy the benefits of a strong currency, Euro, which they could

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not have afforded had they not been a part of the union. In the future if the EU wishes to make Euro as strong as the USD it should first aim at strengthening the economies that constitute it. There should a large number of strong economies and lesser number of weak ones so that the strong can support the weak in times of need. With just two big economies, France and Germany, holding the debt ridden economies, it would never develop a Eurozone which can be sustained for a long time. It should also ensure by the means of checks and balances that all the members are working hard to make the Eurozone strong and that nobody is a free-rider. Consequences for the Global Economy There are three ways in which the euro zone crisis could spill over to the Asia Pacific economies which have otherwise been on a robust recovery path from the 2008 recession. These are cost of sovereign debt financing, impact on trade due to moderation in demand and the possibility of increase in the cost of credit due to its impact on the banking sector. We study the possible impact of the debt crisis on the world economy through these three channels. Consequences for the United States Standalone the economic crisis in the Eurozone should not affect the US but in a scenario where the US economy is already in a precarious position, negative news from the euro zone may just nudge it into a double dip recession. US accounts for almost 10% of the total exports of the Eurozone. Thus a flagging demand from the euro zone would add to the gloomy economic outlook for the US. From a banking perspective, U.S. banks are exposed to the euro area for US$2.7 trillion, largely reflecting claims towards France (US$643 billion) and Germany (US$623 billion). These claims account for 29% of total US foreign exposure. Exposure to France and Germany accounts for 14% of total foreign exposure. Exposure to the peripheral economies under stress is modestâ&#x20AC;&#x201D;claims on Greece, Ireland, and Portugal account for 3% of total foreign exposure. Thus the US exposure to the euro zone is limited to the relatively stable countries like Germany, France and to a lesser extent to Italy. Hence US would be hit only if the crisis becomes systemic and spreads to other countries in the Euro zone. However the impact could be severe if the crisis spreads to the countries such as France as can be seen from the amount of exposures US has to countries such as France and to a smaller extent Italy. Consequences for Asia Pacific Before the euro zone crisis the financial market considered the sovereign debt of most developed nations as relatively risk free. This notion has been changed and the possibility of default has been ac-

September 2011

tively factored in the pricing of government debt. This would have significant impact on the borrowing costs of countries such as Japan which have a very high debt to GDP ratio. Moreover the cost of private borrowing would increase as it is calculated on the basis of a risk premium to the countryâ&#x20AC;&#x2122;s bond rates. However the impact of these risks is not very high as the financial markets realise that the higher growth potential of these countries and that most of their debt is denominated in their local currencies. The EU is the second largest export market for the Asia Pacific economies accounting for 15% of the total exports, just behind the United States. The devaluation of the euro would make Asian goods costlier in these markets and this coupled with the weakness of these economies, the exports of the Asia Pacific region would take a hit. Having said this, the peripheral regions which are affected by the crisis currently constitute a lesser portion of the market compared to the nations of Germany and France. Moreover the uncertainty surrounding the US adds to the possible impact on trade if the crisis spills over. Most of the banks in the Asia Pacific region do not have any significant European bond holdings hence the risk of losses for these banks is limited. There are many who fear a possible seizure of the interbank lending similar to that which occurred in the 2008 crisis. However the two scenarios are different as in the last crisis, most of the banks did not know the actual amount of exposures to the subprime lending different banks had and hence there was a collective reluctance to lend to each other. In the current scenario, banks are aware of the exact amount of exposures each of them has. Additionally this not being a sudden event they have already planned for different scenarios which could occur which was not the case in 2008. Hence the risk of financial contagion to regions outside the Eurozone is limited. Consequences for India Indiaâ&#x20AC;&#x2122;s exposure to the affected Eurozone countries (PIIGS) is minimal. These countries together account for just 4.4% of the total exports and just 1% of the FDI inflows. However the global risk aversion which will set in after the crisis would see large amount of FII outflows which would lead to significant downtrend on the stock markets. Sectors such as IT which are significantly exposed to global markets such as US would be impacted while the domestic demand would remain largely unscathed. Thus there would be a short term slowdown in the growth of the economy but the long term growth prospects would remain to be driven by domestic factors. What now? Considering the grave implication to the world economy in the event the crisis spreads to larger countries such as Italy and France, this contagion

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should be avoided with the utmost urgency. For this it is necessary that the size of the bailout fund (EFSF) be increased. Currently the EFSF cannot support Italy were it to default. Only when the EFSF is strengthened enough to pay significant amount of PIIGS debt would the financial markets be calmed. The United States has asked that the fund be leveraged to improve its capacity. Many feel that a large contribution for this must come from Germany as it is in its best interests to keep the euro afloat. The euro is cheaper than a standalone German currency because of the weaker peripheral economies comprising the EU. This aids Germany as it can export more easily and exports are the prime reason why the German economy is the strongest in the region. In addition to these short term measures, fixes to the crisis are being deliberated. One such idea is of a voluntary debt rollover. Under this plan, as the Greek Bonds mature over the next three years, 30% of the maturity value would be paid back in cash to holders and the remaining would be voluntarily reinvested by most banks in new 30 year zero coupon Greek Bonds. This rollover would be under the condition that 30% of the rollover amount is parked with a SPV which invests in AAA rated bonds with similar maturities which can pay back the principal to banks in case Greece defaults on payments on the 30 year bonds. Thus the technical classification of a default is avoided while Greece is required to pay just half of its amount due. However this plan is criticised by many as one which just delays the inevitable. According to the calculations by the

economist intelligence unit, the effective interest rate for Greece on such a rollover is as high as 11% which is unsustainable in the long run. Another idea which is being looked upon is that of Eurobonds. The idea of a Eurobond is to combine the borrowing of all the countries of the euro area by issuing common bonds for the entire euro zone. This would result in greater liquidity and lower default risk as it would average it out over all the countries. The main benefit of these bonds is that it would be less severe on the outliers who find that their borrowing costs increase astronomically in the event of a crisis forming a kind of self-fulfilling prophecy. Thus this would be a step on the path of a greater fiscal union than what is present currently. Lastly, the Eurozone needs to realise that they need to win back the the confidence of the market to entice business and investments. The current lack of it can be seen in the bond yield spread and the rates of credit default swaps which indicate the return an investor requires in providing loan to a particular country. The biggest challenge would thus be to drive austerity measures and investment growth hand in hand which by their very nature are contradictory and hence require a detailed and structured execution plan. Conclusion Most of the measures suggested above call for a political handling of the challenge more than a financial one as it would involve convincing various stakeholders to pay in some measure for the financial indiscretions of the southern countries. In the long term the roots of the crisis which include unchecked spending coupled with a dysfunctional monetary union need to be addressed. Unless there is a greater fiscal union for the EU countries there is a risk that the same drama would play itself again. The mistakes committed in the past may be repeated again in absence of a lasting solution to the crisis from EU countries.

ÂŠ FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

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Cover Story Perspective

Stressed & Downgraded Ankit Srivastav

IIFT, Delhi

The global economy is currently in doldrums marred by weakening US economy, Euro debt crisis and a loss of confidence among business and investors. The current article explores the various facets of global economy and the way forward for it.

Wild could get wilder, that is what the world witnessed in the 2nd week of August’11 when the Swiss interest rates plunged into negative territory. It meant that if one wanted to lend Swiss francs or make a deposit in the next year, then he would have to pay for that privilege. It was not that similar situations had not been witnessed in the past not just the short term rates but the future markets had also predicted negative rates until 2013. In a world fraught with spill overs, it only signalled the ominous and not so surprisingly US and Europe occupied the centre-stage. Back in March’11, European banking authority (EBA), haunted by the ghost of the recessionary past, penned even adverse a scenario for the stress test. Stress test was initially formulated to serve as a supervisory tool to assess the resilience of banks to hypothetical external shocks. The result of the test for European banks was published in July’11 and eight banks reportedly failed. These included five banks in Spain, two in Greece and one in Austria. 16 other banks, as shown in the exhibit, just managed to scrap through the test with a margin of less than 1%. Consequently, what makes matters worse in Europe today is the thinning patience of German tax-payer. They were reluctant

Even prior to the rating downgrade there had been fears of US dollar slipping from the status of world’s reserve currency

September 2011

about bailing out Greece, but agreed eventually, showed even greater a discomfort over Ireland and Portugal, but stepped up. Now that Europe’s debt crisis is threatening economic giants like Italy, Spain and most recently France, German public needs to take stock of how much can they take from their less-disciplined neighbours. Around the same time, US Fed also announced its stress test results. The rosy picture shared suggested “significant improvements” in both economic conditions and the capital positions of US financial institutions. The world breathed a sigh of relief but it lasted only till the regulators had not spotted an anomaly in the deployed 10 year Treasury bond yield which at 2.26 was far lower than 2.79 as was suggested in the scenario. To makes matters worse now, the banks’ ability to generate earning growth would come under further pressure with the central bank’s decision to keep the rates ultralow until at least the end of 2013. Rating Fiasco Post 2008, US had taken prudent measures to push consumption and growth back on track; however the statistics still showed 11.1% projected unemployment for the year 2012. Despite that investors and agencies alike, revered US as a safe investment of funds.

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Perspective Cover Story

But their judgement got questioned on August 6th 2011, when the entire world stood shocked to learn that Standard & Poor’s had downgraded the U.S.’s AAA credit rating. S&P’s downgrade would definitely hurt even as strong an economy as US and despite continuous efforts to keep interests low it is bound to result in increased cost of mortgages, auto loans and other types of lending over the long term as they are all tied to the interest rates paid on Treasuries. S&P had already put the U.S. government on notice on April 18 stating that it risked losing the AAA rating unless the lawmakers agreed on a plan by 2013 to reduce budget deficits and the national debt. It had indicated $4 trillion as the preferred reduction in spending. In response to that the US lawmakers on Aug 2 put in place a plan to enforce only $2.4 trillion in spending reductions over the next 10 years in addition to agreeing to raise the nation’s $14.3 trillion debt ceiling. What followed next was an expulsion of US from Triple-A debt club leaving only 15 countries (and the very small Isle of Man) intact in it. The downgrade, more broadly, reflects that the effectiveness, stability, and predictability of American policymaking and political institu-

tions have weakened at a time of ongoing fiscal and economic challenges. The US economy is bound to enter a negative feedback loop, with every drop in stock prices deteriorating the investor confidence further. In the light of fresh evidences that the U.S. home sales and manufacturing are weakening, the risk of a recession is now about one in three, according to Bank of America and Morgan Stanley. Recession threats for Europe are looming equally large and the cornerstone for which had been conceived at the same time as US’s. In the wake of Lehman crash itself European banks were far more highly leveraged and far more dependent on short-term wholesale funding. Half of America’s lethal sub-prime assets had been bought by institutions in Europe only. And the offspring are now emerging with a visible slowdown in the growth rate of German’s and France’s economy to 0.1 percent and zero percent respectively in the AprilJune quarter. The industrial production for the 17 nation Euro countries also has fallen 0.7% in June compared to May. The problem is on both sides of the Atlantic and the root is simple: too much debt, and too little

It is common opinion now that QE2 was a failure and the world already anticipates negative results from QE3. © FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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Cover Story Perspective

political will to deal with the consequences. The exhibit enclosed points to this problem. Sluggish economic growth and unfavourable debt to GDP balance have set the stage for a series of prospective rating downgrades in the form of Germany, France and UK. Japan, however, despite the highest Debt/GDP ratio, has only recently been on the radar for a downgrade. This was due to its intervention in foreign exchange markets to stop the rise of the yen post the earthquake that annihilated its economy. Threats of a Double Dip Recession Even prior to the rating downgrade there had been fears of US dollar slipping from the status of world’s reserve currency. And a downgrade away from AAA is like a small step towards credit risk brewing in the economy, something which any country would ike to avoid. The US economy, the world’s largest by market price and the purchasing power parity was never imagined to succumb, and thus the threats of double dip recession seem more real. Double dip recession means when gross domestic product (GDP) growth slides back to negative after a quarter or two of positive growth. A double dip recession study carried out by economists from Deutsche Bank AG, who reviewed US economic history all the way back to the 1850s, revealed that double dip recessions were exceedingly rare and the current situation is not akin to one. It stated that out of 33 recessions that had taken place since 1854 two of the three double dips happened in the years prior to World War II – in 1913, and in 1920. The third and the more relevant double dip recession took place in early 1980s, where the underlying cause was inflation. With deflation just as likely as inflation in the current scenario, a repeat of the 1980s is unlikely and rock bottom interest rates are a testimony to that. Disaster Management In case of Europe, Germany does not have the option to break away from the Euro zone. The proposition could create further trade imbalances and slowdown its growth. Instead Angela Merkel

by agreeing to triple or quadruple the current $625-billion bailout fund can push for a common finance ministry with sweeping powers to set taxes, limit debt and control deficits of Euro zone countries. This closer fiscal integration could then pave way for a smooth introduction of collective “Eurobonds” to replace government bonds issued by individual countries. US, on the other hand, can take heart from the fact that the world has still not turned a blind eye to it. Even in the face of a downgrade the yields of Treasuries are low because there is nowhere else for the people to go. Amid concerns that global growth is slowing and Europe’s sovereign debt crisis is spreading, investors still view dollar assets as amongst the safest. Post downgrade decline in fuel prices has also played in US’s favour by lowering commodities prices. This would in turn also lower energy and food costs, freeing up consumer purchasing power and slowing inflation. A show of strength by sectors such as retail in US and a consistent level of job growth are all favourable signs. It is common fact now that QE2 was a failure and the world already anticipates negative results from QE3. US must take into cognizance that its problem is more fiscal in nature and that they have failed to cut spending and raise revenue enough to reduce budget deficit. Thus, cutting entitlement programs such as Social Security and Medicare would be steps in the right direction. However, under the threat of default, an agreement on raising the debt ceiling is akin to compromising the spending ability of future generations to come. In financial trouble, US faces the challenge to reconcile deficit control with measures to stimulate its economy and create jobs. In the end, a concerted effort would be required from both US and Europe to safely steer the world through another economic downturn.

US must take into cognizance that its problem is more fiscal in nature and that they have failed to cut spending and raise revenue enough to reduce budget deficit

September 2011

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Aashish Chhachhi & Ankit Kesri

XLRI, Jamshedpur The Indian growth story over the past decade has turned heads across the globe to take notice of an economic super power in the making. However, cracks are now beginning to appear partly as a result of global scenario and in part due to neglect of fundamental aspects. High inflation, surging current account deficit, widening fiscal deficit are just a few of the macroeconomic indicators that portend a shaky outlook. Fiscal deficit and current account deficit (twin deficits as they are referred to commonly) are an unwelcome proposition for any economy. A yawning fiscal deficit forces the government to borrow to meets its expenses, crowds out private investment, hurts interest rate sensitive sectors such as infrastructure and above all eats into economic growth. A lower growth with an increased deficit further inhibits the country ability to meet its obligations leading to a fall in credit ratings and a consequent rise in borrowing costs essentially asphyxiating the country in a debt trap. This debt trap inhibits the governments’ ability to spend on welfare schemes in the future. This combination of deficits makes the economy extremely susceptible to any shock as was witnessed during the 1991 crisis as the economy needs both domestic and foreign borrowing to nullify the deficits. US, Spain and Greece are few countries that face the same peril and their current state is an excellent indication of this fact. This article makes an attempt at exploring India’s fiscal deficit situation by challenging the viability of the underlying assumptions and estimating the capacity of the current system to finance it.

Fiscal Deficit Estimation It is defined as government expenses less revenues and stood at 3.69 lakh crore (4.7% of the GDP) for FY11. While a y-o-y trend suggest a sharp plummet from 6.3% in FY 10, reading the fine print shows

that barring a onetime revenue stream from the 3G auction and divestment the figure would have stood at 6.1% of the GDP. The current numbers for Q1 FY 12 are 4 times of the corresponding FY 11 numbers and represent 40% of the budgeted estimate (BE) for FY 12 signalling an ominous situation on this front. The macro environment since the budget was announced has witnessed tectonic shifts with the US downgrade and spread of the European sovereign debt contagion and we analyse the expected fiscal deficit for FY 12 as follows.

Tax Collections The BE growth of 9% seems unrealistic now with likely softening in exports and high inflation. Consensus estimates peg it in the vicinity of 7.5%. Lower growth will lead to lower tax receipts (direct tax buoyancy 1.94 and indirect tax buoyancy at 0.84). Thus the fall in direct tax will be 0.154 lakh crore while that in indirect taxes is 0.055 lakh crore (BE at 5.32 and 3.92 lakh crore respectively). Subsidies Indian crude basket for FY 11 hovered at $ 80/bbl resulting in a Rs 78000 crores under-recoveries to the OMC’s (Oil Marketing Companies) of which the government tab stood at Rs 21000 crores. The revised subsidy burden under the assumption of average crude basket of $110/bbl is computed below: If the sharing pattern suggested by the Kirit Parikh Committee report were to be followed, the upstream companies can be expected to shoulder to 38.5% of the tab (based on FY11 burden sharing) leaving a minimum of Rs 1105.67 Billion to be footed by government. As the government wants to tame inflation (which rules out passing the burden onto the consumer) and exercise fiscal rectitude one can conclude that the maximum possible amount will be foisted on the OMC’s. A fundamental analysis of the key financials of the OMC’s on a target debt to

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cash flow ratio of 6 indicates a maximum additional debt capacity of Rs 240 billion. Thus, government will have to foot Rs 865.67 billion (Rs 86,500 crore) towards petrol subsidies this year versus BE of Rs 23,600 crore in the absence of price hikes.

Fertilizer Subsidy In 1992 prices of all fertilizers except urea were decontrolled leading to a sharp increase in use of urea. To fix this anomaly government proposed the introduction of Nutrient Based Subsidy scheme wherein subsidy will be provided based on nutrient contents of fertilizers. Currently the fertilizer subsidy can be classified into three categories: a) Imported Urea: This component of fertilizer subsidy is very volatile because international urea prices movement. Subsidy on imported urea increased 66% from 2007-08 to 2008-09 (Rs 6606Cr to Rs 10891Cr). The budget estimates for the year 2011-12 stands at Rs 6983Cr but any upward movement in international prices can inflate this figure substantially. b) Indigenous Urea: This subsidy is intended to protect urea manufacturers. The quantum of this subsidy is also increasing because of increasing input prices, increasing production and stable selling price of urea (just an increase of 10% in 10 years; Rs 4600/ton in 1999-2000 to Rs 5070/ton currently). The budget estimates for the year 2011-12 stands at Rs 13308Cr and represents 27% of the fertilizer subsidy bill. c) Decontrolled fertilizers: Government sells P, K based fertilizers to farmers at concession price. Current budget estimate for the year 2011-12 is Rs 29707Cr and it forms 60% of the total fertilizer subsidies. Government revised their budget estimates for fertilizer subsidy from Rs 49997Cr to Rs 63000Cr on March 4, 2011 Food Subsidy Food subsidy is currently provided in form of distribution food grains through Public Distribution

System (PDS). Agricultural produce is procured from farmers at minimum support prices to replenish the buffer stocks (held by Food Corporation of India) as well as for distribution to through PDS. Hence, part of the government subsidy goes towards the carrying cost of buffer stocks. The budget estimates for food subsidy given by government for 2011-12 were Rs 60573Cr. The budget estimate needs to be revised due to two factors. Firstly, India has consistently witnessed food inflation close to 9% during most of year 2011 and it is expected to hover around that figure till at least October 2011. The minimum support price of paddy was increased by Rs 80/quintal (increase of 8%) in June 2011. Secondly, National Advisory Councilâ&#x20AC;&#x2122;s (NAC) recommendations on Food Security Bill propose to provide 35kg of food grains per month to about 75% of the population at a price not more than half the MSP. This leads to an estimated increase in food subsidy by Rs 23000Cr according to NAC. But

according to Rangarajan Committee report, if investment on additional storage capacity and higher MSP are taken into consideration, the estimated increase in food subsidy will be Rs 35000Cr. This pegs the total food subsidy figure for 2011-12 at Rs 99570Cr if Food Security Bill is implemented in its current form. The estimate of revised fiscal deficit as a % of GDP uses the FY 12 GDP as Rs 84.38 lakh crore (7.5% yo-y growth). Clearly the figure is alarming by any measure and financing it becomes our next concern.

In 1992 prices of all fertilizers except urea were decontrolled leading to a sharp increase in use of urea.

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been often forgotten in the India Shining story. This calls for strong leadership and aggressive reforms. GST & DTC are potent tools to widen the tax base without burdening the middle class with high taxes. This model has proven to be successful as has been witnessed by the steady decrease in tax rate alongside an upbeat tax revenue collection on account of a widening tax net. On the expenditure front, the concept of subsidies in India is out dated and backward looking. While a food subsidy is justified on account of the huge below poverty line population (BPL), an efficient transmission of the same through the UID system is necessary to eliminate pilferage. Petroleum product subsidies are a sham as the government taxes these products on one hand and gives a subsidy to the OMC’s on the other. The Kirit Parikh Committee Report reflects that the government earns net positive revenue on these products by this mechanism. The complex muddle of the current oil pricing mechanism should be done away with and abnormal taxes on these products be slashed. This should reduce inflation and set in the virtuous growth cycle which in turn will bring higher tax collections for the government. Cleansing the oil sector will attract private participation. This is necessary to reduce our import dependence and decouple the economy from oil price shocks capable of paralysing the economy. With 30% of the imports being petroleum products, such an initiative will help narrow down the second of our twin deficits also namely the trade deficit. These fundamental measures should go a long way in checking the runaway fiscal deficit and add many more golden years to the Indian growth fable.

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Financing the revised fiscal deficit The government may finance the deficit internally or externally. Internal financing is preferred as it eliminates exchange rate risk and provides a last ditch option of printing currency to meet commitments. This is reflected in the historical GoI borrowing trends with the 3 year average external borrowing at 3.3% of GFD. On the internal financing front, banks through the SLR route, mutual fund and life insurance companies drive government market borrowings. The BE of gross market borrowing stood at Rs 4.17 lakh crore for FY 12. The broad money supply (M3) is expected to increase by 15% in FY 12 from Rs 65lakh crore to Rs 75lakh crore. The additional Rs 10lakh crore will contribute to SLR deposits of banks to the tune of Rs 2.4lakh crore (24% SLR). Given the current riskaverseness in the markets an additional Rs 1.77lakh crore of market borrowing to meet the BE seems dicey. Even if we add Rs 0.175lakh crore of external borrowings, the unbridged deficit works out to be Rs 0.945lakh crore. This brings us to the options the government has to meet its expenses: a) Increase the M3 further: This is a sure shot recipe for higher demand side inflation. Given the current fight against a 9% + WPI number, it is definitely not an option worth exercising. b) Borrow Additional Funds from market: Such a move will drive up interest rates, suck out liquidity and dent investment retarding future growth as a result. Moreover to get the borrowings in the current environment a high interest rate needs to be offered which drives up the borrowings costs and disturbs future fiscal balance. c) Foreign Borrowings: These will be hard to come by given the flight to quality and risk-aversion in the global capital markets. d) Divestment: The most likely option that will be exercised to sugarcoat a worrying fiscal deficit. While this is a viable one time option it’s no panacea to the fundamental deficit problem India faces. This income may still not be sufficient and increased market borrowings are highly likely. Recommendations & Conclusion It is high time we plugged the deficit gap that has

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Replacement of as Global currency Reality or

Illusion

Udit Maheshwari

Welingkar Institute of Management

A high fiscal deficit and not-so-good situation prevailing in the US economy has raised certain questions and concerns over US dollar as the reserve currency. This article discusses the various factors responsible for dollar being the reserve currency, whether they still hold true, and the alternatives to this system.

September 2011

From oil to gold, coffee to coal, the global price of all commodities is quoted in dollars, making it the most sought after currency in the world. The US Dollar got the status of global currency in 1944 near the end of World War II and the dominance continues till date. There have been numerous reserve currencies over the centuries, but none were more widely accepted than the US dollar since 1944. While the US dollar has fluctuated widely in value over the 65 years since its designation as the reserve currency, its credibility has come under the most intense scrutiny ever in the last few years. The US dollar peaked in value in 2000-2001 and has been suffering a significant decline ever since. With a proposed record $1.56 trillion deficit, there are uncertainties about the reserve status of the dollar. As a result, there are talks around the world to end the dollar’s status as the world’s reserve currency and replace it with a better alternative. The question is, replace it with what? The US dollar is by far the largest reserve currency in the world; many commodities around the world are priced in dollars; and most international transactions are settled in dollars.

How the Dollar became global currency Before questioning the status of dollar as reserve currency, we have to first understand the factors that were responsible for giving dollar a global status and if those factors still prevail in the present scenario. Only then can we infer whether we should think about the possibility of replacing dollar or not. A. Bretton Woods System Bretton Woods System was a fully negotiated monetary order among the world’s major industrial countries in the mid-20th century to govern monetary relations among each other. The planners at Bretton Woods established the International Monetary Fund (IMF) with the duty of monitoring and supervising the system and the International Bank for Reconstruction and Development (IBRD), which today is part of the World Bank Group, was charged initially with role of assisting the reconstruction of Europe’s devastated economies. It was this era in which US dollar became a global currency and this forces us to analyse the dominant factors that were responsible to make US dollar a global currency. Harry Dexter the US economist, negotiated for Bretton

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• Huge Debt: - In the past, countries pegged to dollar because it was strong enough to help countries to grow, but with the subprime crises and then recession, US has landed into huge debt of $12.311 trillion and now it requires rebuilding. • No longer a promising consumer: - A consumer who is at the verge of insolvency can’t be promising. In case of United States, even though it may recover but, it is facing a deflation i.e. in 2009 its annual inflation was -0.4%. Alternatives to dollar The dollar can be replaced by any of the three alternatives:Replacing dollar by another currency It can be easily inferred that after dollar, it is the euro which covers maximum portion of the global reserve. Also with its past ten years growth rate in the global reserve euro tends to be the undisputed winner against the other two alternative currencies (yen and pound sterling), when it comes to the confidence - level. The best way to infuse euro in the global system is by legalizing oil trades in euro. Once oil trade is mandatory in euro all countries will be forced to keep euro as their key reserve currency. However, with the reserve currency status, euro will have to shoulder responsibilities too. All the countries in the euro-zone will have to be major importers of goods and services and only then the rest of the world would accept euro as a reserve currency. If the countries in the eurozone have a trade surplus, then the rest of the countries won’t have sufficient euro reserve to carry on their international trade with member countries and as a result all the member countries would resort to other currency reserves. But, by taking euro as a global currency, chances are that after some time the world economy would be at the same position as it is right now. This is because replacing one currency by some another currency won’t help much in solving the situation; the world economy would be again

From oil to gold, coffee to coal, the global price of all commodities is quoted in dollars, making it the most sought after currency in the world. © FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

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Woods System and infused dollar as a global reserve currency. He was able to negotiate in good terms, because all the conditions favoured US at that time. • Gold reserves: - In 1945, the US authorities held approximately 70% of the world’s gold reserves. This was the major factor that influenced countries to peg their currency against dollar and each currency was allowed to fluctuate by plus or minus 1% either side of the parity. This is because dollar itself was fixed to the price of gold at $35 per ounce. The idea of fixing the dollar to the price of gold was to provide confidence in the system. It was reasoned that the foreign central banks would be more willing to hold dollars in their reserves if they knew that it could be converted to gold. • Biggest consumer: - After world war II, the US proved to be the biggest consumer. According to the economist Robert Triffin - The Bretton Woods system works, only if US maintains a trade deficit and other countries maintain a surplus, then other countries would be able to maintain a dollar reserve and thereby would be able to prevent their currency from appreciating. And if a currency appreciates, then the dollar would depreciate and dollar had pegged itself to gold i.e. $35 = 1 ounce of gold. So a depreciated dollar would either have to shed more gold when asked by an appreciated currency or else dollar has to devalue itself against gold. Thus, dollar has no other option under the Bretton Woods but to keep on importing goods and thereby allowing other countries to maintain dollar reserve through trade surplus. The above mentioned reasons were key influencers for dollar to become a reserve currency. Present Scenario The factors that prevailed in the past that enabled US dollar to become a global reserve currency may or may not exist in the present scenario. One has to analyse whether those factors prevail today or not and if they don’t, then replacement of dollar can be thought of.

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dependent on just a single currency. Abolishing the concept of currency as a global reserve Special Drawing Rights (SDRs) can be thought of as an option to the current problem of depending on just a single currency. The SDR is linked to a basket of currencies with a weight of 44% for the dollar, 34% for the euro, and 11% each for the yen and pound sterling. If India wants to use its SDRs, it will typically ask the IMF for dollars in exchange. The IMF will debit India’s SDR account, credit America’s SDR account, ask the US for the corresponding dollars, and hand these to India. In case of SDRs, the risk of depending on just a single currency would get distributed in four different currencies. However, when it comes to implementing SDRs, there are various issues that surface up. Firstly, before becoming a separate international currency, the SDR will remain a derivative of the dollar and a few other major national currencies. As a result of which any change in the constituting currencies economies would bring in a change in SDRs value. Thus, SDRs are anchored in four existing currencies, and do not constitute an independent new currency. Also, since dollar holding a 44% share in SDR and if SDR is made a global currency, then any turmoil in US economy will have an adverse effect on SDR and thereby on the world economy. Introducing a new global currency This alternative may seem ambiguous, but at the UN’s Bretton Woods conference in 1944, John Maynard Keynes put forward this idea. And till date, it seems logical enough and can be thought of. One of the reasons for financial crises is the imbalance of trade between nations. Countries accumulate debt partly as a result of sustaining a trade deficit. They can easily become trapped in a vicious spiral: the bigger their debt, the harder it is to generate a trade surplus. International debt wrecks people’s development trashes the environment and threatens the global system with periodic crises.

As Keynes recognised, there is not much the debtor nations can do. Only the countries that maintain a trade surplus have real agency, so it is they who must be obliged to change their policies. His solution was an ingenious system for persuading the creditor nations to spend their surplus money back into the economies of the debtor nations. He proposed a global bank, which he called the International Clearing Union. The bank would issue its own currency - the bancor - which was exchangeable with national currencies at fixed rates of exchange. The bancor would become the unit of account between nations, which means it would be used to measure a country’s trade deficit or trade surplus. Every country would have an overdraft facility in its bancor account at the International Clearing Union, equivalent to half the average value of its trade over a five-year period. To make the system work, the members of the union would need a powerful incentive to clear their bancor accounts by the end of the year: to end up with neither a trade deficit nor a trade surplus. But what would the incentive be? Keynes proposed that any country racking up a large trade deficit (equating to more than half of its bancor overdraft allowance) would be charged interest on its account. It would also be obliged to reduce the value of its currency and to prevent the export of capital. But - and this was the key to his system - he insisted that the nations with a trade surplus would be subject to similar pressures. Any country with a bancor credit balance that was more than half the size of its overdraft facility would be charged interest, at a rate of 10%. It would also be obliged to increase the value of its currency and to permit the export of capital. If, by the end of the year, its credit balance exceeded the total value of its permitted overdraft, the surplus would be confiscated. The nations with a surplus would have a powerful incentive to get rid of it. In doing so, they would automatically clear other nations’ deficits.

All the countries in the eurozone will have to be major importers of goods and services, then only the rest of the world would accept euro as a reserve currency

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ties. This kind of shift in approach is mostly seen by corporate houses but not by countries as a whole. Also, US is considered as an open economy and have always promoted the same, but when presently its interest is at stake, it changed its open economy policy. History has always challenged US yet it has always been a superpower. This is just because of its flexible policy - attitude towards downturns and its say in all the decisions pertaining to world economic policies. Conclusion In this article, we discussed the various factors that were responsible for the dollar to attain global currency status. We validated that whether those factors are still prevailing in the present scenario and also checked the confidence level in global reserve through trend analysis. The comparison and analysis proved that the factors no longer exist, so we can think of replacing dollar. Then we analysed the alternatives available against dollar and the mechanism as to how they would function. We also uncover the negative impacts of replacing dollar on the global economy and as to how US still tends to maintain a dominating position over the world economy. We conclude that since dollar is deeply infused in the global financial system it would not lose its dominance in the global reserve in the next two decade. Also, if replacement of dollar is considered, then world economy would go for euro, which is the next best alternative. Logically the world economy should go for a new currency as suggested by Keynes, but since it is against the interest of developed nations so it won’t get implemented.

Since dollar is deeply infused in the global financial system it would not lose its dominance in the global reserve in the next two decade. © FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

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Replacement of dollar reality or illusion Before drawing out a conclusion as to whether dollar would get replaced or not, two notable implications should be considered which would prove to be hindrance to the replacement of dollar. Reserves Any alternative which is implemented against dollar should be in a position to absorb dollar from the economies. If the alternatives are not in a position to absorb dollar, then member countries would resort to US or the monetary authority concerned to convert dollar reserves into the new alternative reserve currency (i.e. euro or SDRs or bancor). If the concerned authority is not in a position to convert dollar reserves, then the world economy would be at stake. Dominance of US as a business entity Strength of the Economy United States is the largest domestic economy in the world. Its GDP is estimated to be around $14.2 trillion in 2009, which is 3 times the world’s second largest economy, Japan. In the past as well, it has maintained a very high level of output per person and keeps on doing that in the present. Also American labour market has attracted immigrants from all over the world and has one of the world’s highest immigration rates. It has been ranked 2nd, down from 1st due to economic crisis, according to Global competitiveness report. It has world’s largest and most influential financial market Stable and flexible political system The US political system is highly stable and level of corruption is quite low as it is evident from the corruption perception index by Forbes in which US is rated from 7 – 7.9 out of 10 and ranked 19th. Also the US economy is highly flexible in its approach in tackling economic situations which is visible in the present scenario, where in spite of being a capitalist economy, understanding the present down turn, it shifted itself to a socialist economy by giving bailout packages and nationalizing the private enti-

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EURO DEBT CRISIS

THE NEXT LOOMING DANGER Nilesh Anandpara, Sandeep Baid, Rashi Agarwal

nmims, mumbai

Current scenario on the Euro Debt crisis and policy view Ensnared in the ensuing debt crisis, western world is confronted with pressing problems, viz. - rescuing embattled financial system, restoring investor confidence, halting the contagion, and effecting timely, complementary, sustainable and effective fiscal and monetary policy responses. The crisis which had its genesis in a) fiscal profligacy, b) lack of deeper macro-economic integration, c) private sector excesses, d) availability of cheap credit, e) mis-pricing of the credit–risk, and f) stopgap policy making is compounded by coupled markets & socio-political issues. The EU & IMF policies viewed it as a liquidity issue and failed to address possibility of insolvency, systemic inter-dependence between banking and sovereign crisis, and concerns of growth and structural reforms. Historic origin of the crisis [Exhibit 1] Post EMU formation 1999, with the deepening of an integrated EU market, diminishing country risk premia, narrowing sovereign bond spreads – there was a sharp fall in real interest rates, especially in peripheral countries. This led to rapid expansion of credit demand, which in part created and nourished financial and economic imbalances which were unsustainable. For e.g., institutional and psychological factors fu%

Real GDP Growth

Employment Growth

Greece Ireland Portugal Spain Italy France Germany Euro Area US

4.1 6.5 1.8 3.7 1.5 2.2 1.6 2.2 2.8

1.3 3.7 0.7 4.3 1.5 1.0 0.6 1.4 1.2

Real Private Consumption Growth 3.8 5.9 2.3 3.9 1.2 2.7 0.9 2.0 3.4

eled an asset price bubble in real estate, drawing resources away from productive activities, inflating bank loan books and exposing them to sector-specific shocks. Fiscal profligacy by peripheral governments, hot capital inflows, rapid economic growth, and surging imports coupled with rising wages [Exhibit 2] led to declining competitiveness, mounting public debts and current account deficits. [Exhibit 3]. The 2008 financial crisis only acted as a trigger to this perilous position waiting to explode. Why the international community needs to sit up and take notice? Today Europe accounts for around one third of global GDP, of which 90% is generated by the EU, the world’s

Exhibit 2 : Slower growth of services sector in Europe than in the United States. Source: McKinsey Global Institute– European growth and renewal: The path from crisis to recover

Real Public Consumption Growth 4.1 6.1 2.2 4.9 1.9 1.6 0.8 2.0 2.1

Real Gross Fixed Capital Formation Growth 6.3 6.7 0.1 6.1 2.6 4.1 1.3 3.0 3.1

Export Volume Growth 6.4 8.4 4.9 5.3 2.9 3.8 8.0 4.6

Import Volume Growth 6.0 8.2 4.1 8.3 3.8 5.7 6.1 6.2

Exhibit 1: Main Macro Variables revealing increased consumption activity in PIGS in the period. Source: OECD Economic Outlook No 88 & OECD Stat - Average over period 1999-2007

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renewal in Europe

largest economic area. Presently, European Banks have US$ 2.16 trillion debt exposure to PIIGS. A collapse of financial systems in some euro member nations could have a domino effect in other members & non-euro countries carrying a significant exposure to euro sovereign bonds and private debt. About a quarter of China’s record foreign currency reserves of more than $3 trillion are held in euro assets. Developing Countries [DC] contribute 58.3% [€ 869 billion – 2010 – source: Eurostat] of EU’s imports. A significant decline in real demand will have a far-reaching impact on economy of these DCs. Analysis of previous policy attempts to tackle similar crisis and the way forward Sovereign borrowing via govt. bonds, increases complexity due to the increased number of creditors. The most common methods employed to address a debt crisis include Debt Rescheduling, Debt Restructuring, Provide new credit to ease liquidity situation & facilitate imports for future import substitution & export promotion as shortterm measures. The long term measures include policies for prevention of a spiraling liquidity and banking crisis and providing a conducive economic climate that enable the sovereign to operate competitively in international credit markets.

Exhibit 4: Sovereign Spreads to German Bunds projecting return to pre-euro level. Source: Nomura Global Economics Report: Europe Will Work, March 2011 Note: Data represented here is the simple average of Austrian, Irish, Belgium, Netherlands, Italy, Spain and France 10yr government bond spreads to 10yr Bunds

Exhibit 5: Financial Repression as a way out. Source: BCG: Collateral Damage – Stop Kicking the Can Down the Road

However, certain debt restructuring issues faced by debtors still remained viz.: (a) exorbitant debt servicing requirements, (b) reliance on one or two export-oriented commodities, (c) significant weakness in terms of trade of commodities, and (d) entrance of rogue vulture hedge funds. To address these concerns, policies such as export credit facility, ensuring NPV terms with other options, economic program to set on the path to recovery, setting up of a centralized authority to monitor debt and negotiate debt restructuring terms, SDRM, CAC and the Chapter 9 bankruptcy proposal. These moves ensured the interests of majority of the creditors and didn’t aim at unanimous decisions. A decade of wars, tax exemptions, US Govt. subprime crisis response – fiscal loosening, QE 1 & 2, TARP program increased public debt and necessitated raising of debt ceiling. Nonetheless, US fundamentals are strong and ratings downgrade reflects political gridlock and policy making ineptitude. Eurozone specific measure and the gap to be plugged The Eurozone has put in place a specialised mechanism of EFSF & EFSM to safeguard financial stability under supervision of the EC. Its primary functions involve raising funds in capital markets and semi-annual review of the economic condition of

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Initially problems were viewed as short-term liquidity issues, focusing on immediate debt relief. Subsequently, policies such as the Brady Plan recognised the need for development policies apart from the existing debt strategy. It tied up contributions from the IMF and World Bank, thereby increasing the accountability of debtor nations to the creditors. It involved explicit quotas for interest support (40%) as well as standby loan facility (25%). It also recognised the need for relaxation of legal, taxation, regulatory and accountExhibit 3: Bourgeoning Public Debt. Source: McKinsey Global ing constraints, in order to remove disincentives Institute: Beyond Austerity: A path to economic growth & or incentivise debt reduction.

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the member nations. Although lessons from the past have helped shape relief packages and policies, some issues are yet to be addressed The Eurozone members are subject to varied economic risks; however this aspect is not factored into the yields. For example, The Greek bonds had a risk premium of 1796 bps over the German Bund, in spite of a significantly riskier economic environment. With cheap availability of overseas funds, Greece ‘bit more than it could chew’ resulting in a drastic upward shift in yields upon the revelation of its economic vulnerability. [Refer to Exhibit 4] Proposed Strategic policy making [Refer to exhibit 5] The suggested policy would primarily aim at the following 3 objectives(A) Plan to restore banking-sector soundness Exchange offers, negotiated in private between Eurozone Bank Committee and the sovereign debtor, wherein the latter would offer medium to long term, replacement bonds or credit agreements for the existing bonds. This would entail creation of special accounting, tax and regulatory treatment for the restructured Eurozone debt by the EU. • Urgent recapitalisation of systemically important banks using public funds and the EFSF. • Register EFSF as a bank to borrow from the ECB, with sovereign bonds it buys as collateral. This arms-length arrangement would be much better than having the ECB buy bonds itself. • Encourage banks’ consolidation to cut [operational] costs and improve capital ratios. • Minimise stock flow adjustment and diminish the snow ball effect . • ECB should ensure a loose monetary policy by not increasing short term interest rates, especially in times of fiscal austerity (B) Revising EU assistance mechanism and restructuring of public debt where required • Haircut realized over several year time horizon that allows EU banks (a) to control the magnitude of the losses; (b) to distribute the losses over the life of the new instruments; and (c) strengthen their balance sheets with a new credit in part guaranteed by the EFSF/EFSM • Value recovery by effecting GDP warrants. • Issuance of Euro joint bonds, reducing borrowing costs for the profligate and overcoming issue of mis-pricing of credit risk associated

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Exhibit 6: Relative Unit Labour Costs, 1999-2007. Source: Nomura Global Economics Report: Europe Will Work, March 2011

with sovereigns. [Red Euro-Bonds above Debt/ GDP of 60%, Blue Euro-Bonds below this limit] • Debt-for-equity, education, environment and poverty swaps (C) Enhancing Domestic Reforms, Growth, and Competitiveness • Ensure labour market flexibility (reforms in welfare and pension policy and employment protection legislation), focus on education and technical skills and boosting product market competitiveness (remove high barriers to entrepreneurship & restrictive product market practices). [Refer to exhibit 6] • Debt burdened nations need a well-designed privatization scheme instead of a fire-sale to raise cash • Structural, supply-side measures – Improve growth prospects in prudent and profligate countries alike by investing in core businesses. • Not only the size, but also the form, of the fiscal retrenchment is important. Fiscal consolidations that cut expenditure, rather than raise taxes should pave the future sustainable growth path • Incentivise the debtor nations to invest in capacity creation for import substitution and export promotion measures by providing a credit line facility thereby facilitating the economic recovery Although the recovery is expected to be fragile and sluggish, these policies have a better chance of avoiding debt contagion, recession and stagnation.

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Pochineni Shalini

IIM Shillong

the market. These factors can ultimately lead to inflation, and therefore affecting the entire economy. The impact of the inflation can vary, depending on the pervasiveness of the currency. For Example, inflation in the USA is bad news to the entire world economy because the US Dollar is widely used by most the countries. Sir, recently there has been a lot of talk about the currency wars between US and China. What exactly do we mean by currency wars? Well, currency war is nothing but the competitive devaluation of currency. Devaluation is the decrease in the value of a countryâ&#x20AC;&#x2122;s currency relative to that of foreign countries to attain a lower exchange rate. But why would a country want to devaluate its currency? I always thought a stronger currency is a positive indicator! This is a general misconception. The strategy a country adopts to deal with its currency depends on various factors. Devaluation of currency has its own advantages. As the value of the local currency decreases, it makes the exports cheaper. This makes them more competitive in the foreign markets, thereby increasing the revenue for the parent country. It also helps in boosting employment, as there is a demand for more products in the foreign market. So, depending on the situation, countries go for devaluation of their currency. These strategies are often adopted during recession. Yes sir, now it all fits in. But there has to be some downside to this, right? Absolutely, there are always limitations to every phenomenon. What we need to understand is that while on one hand exports become cheaper, on the other, our ability to buy foreign goods decreases because the imports are now expensive. Also the local firms would not reduce the costs of the products as they rely on devaluation, which will anyway increase their competitiveness in

Sir, all this is very interesting. But how actually can a country devaluate its currency? Countries adopt many ways to devaluate their currency. One of those is by infusing more money in local currency into the market. This will automatically result in its devaluation. Another way is by selling its own currency to buy the currencies of other countries, which will lead to the reduction of its value. Okay, this should mean that each country would want the other country to have a stronger currency. No, not exactly. A country would want the other countries to have a stronger currency only if it has a positive balance of trade, i.e. if it has higher exports than imports. Oh! I see. Then what exactly is the problem between China and US? It is a similar scenario between US and China. China is complaining that devaluation of US dollar has resulted in inflation while US wants China to appreciate the Yuan, so as to make Chinese products more expensive in the US market. It is very important for you to understand this as this war has aggravated in the current scenario and might pose a threat to the world economy. Thank you sir. The articles on currency wars will definitely make more sense from now on.

ÂŠ FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

Classroom Cover Story

CLASSROOM FinFunda of the Month

CURRENCY WARS

FIN-Q 1. Governments should automatically reduce taxes during economic slumps and increase taxes during economic boom are an example of activist strategy of monetary and Fiscal policy. (true or False) 2. A bond is paying 6,5% coupon rate/annum, semiannually,FV 100,what will be the effective annualized yield ? 3. Which types of risk is involved while trading Government bond? 4. In options trading, market risk for buyer is…………. but for seller it is…………….. 5. You bought 100 shares of M&M at 1000. The current market price is 1050. At what price must you place a stop loss order to prevent losses beyond Rs.5000 ? 6. Book Building is a ………auction while a normal public issue is a ……….. auction in India 7. The interest rate of a bond quoted in the secondary market is called the……….. 8. What is LEAPS? Define it. 9. A trader who is willing to quote both bid and offer prices for assets is called………. 10. You buy an option to sell 100 shares of EIL at 2400. The premium is Rs.10 per share. The price of EIL goes up to 2500 on maturity. What is your profit or loss on the option?

All entries should be mailed at niveshak.iims@gmail.com by 15th October, 2011 23:59 hrs One lucky winner will receive cash prize of Rs. 500/-

September 2011

WINNERS

Article of the Month Prize - INR 1000/Aashish Chhachhi & Ankit Kesri XLRI, Jamshedpur

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