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Volume 1, February 2013

Is India Hedged Against Systemic Risk?

CONTENTS Message From The Dean .................................................................................................................. Message From The Editorial Team .................................................................................................... Union Bank Financial Conference On Systemic Risk ......................................................................... Synopsis ............................................................................................................................................. Paper On “Is India Hedged Against Systemic Risk” By Dr. Gurbachan Singh .................................... Paper On “Is India Hedged Against Systemic Risk” By Dr. Manoranjan Sharma & Mrs. Archana Choudhary ............................................................................................................... Paper On “Is India Hedged Against Systemic Risk” By Dr. Rupa Rege Nitsure .....................................

STUDENT ARTICLE SECTION Don’t Build Dams During Floods ........................................................................................................ The Power Of Hydrogen: Macro-economic And Geopolitical Implications ....................................... Keynesian Economics ........................................................................................................................ European Debt Crisis Explained ........................................................................................................ Why Did Foreign Nbfc’s Fail In Indian Market Space ........................................................................ Innovation In Banking And Financial Services ................................................................................. Rupee Stabilization Measures ........................................................................................................... Snapshot Of Markets ......................................................................................................................... Competitions @ L’Attitude 13 05’ Organized By Fincom .................................................................

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Message From Dean Dr. Bala V. Balachandran

JL Kellogg Distinguished Professor of Accounting & Information Management, (Emeritus in Service) Northwestern University, Illinois, Founder and Dean, Great Lakes Institute of Management, Chennai, India.

scale followed by a huge nuclear disaster and finally a tsunami would all happen within just 28 hours in a country like Japan. In my opinion, if you want to be prepared for “unknown unknowns”, then certain fundamentals are absolutely needed and that is where careful analysis of systemic risk and an understanding of various financial trends is imperative. It is immensely useful and it needn’t be just for banks. It is a must for any organization and as a matter of fact, for every student who is graduating from this edifice as well. I do believe that we have to always be prepared and that is where the fundamental value of “Passion with Compassion” in everything we do is the need of the hour. Passion is however not sufficient. You need to have diverse abilities and knowledge and even these abilities aren’t good enough unless you have humility; ability with humility is extremely important. We should be able to think with a globalized mindset and that is why “Global Mindset, Indian Roots” is the motto of Great Lakes. And of course the most important ingredient for success is defined by YOU. You need to have that success with integrity. So study with integrity , prepare with integrity, work with integrity and then of course, succeed with integrity.

The 3rd Union Bank Financial Conference on Systemic Risk was a grand success with eminent personalities and speakers including the likes of Dr K.C. Chakrabarty , Dy. Governor of the RBI and Shri. S.K. Jain, Executive Director of Union Bank of India. In reference to systemic risk, what if I gave you a set of companies which were No. 1 or No. 2 in the entire world in their respective industries at one point of time; companies such CompUSA Inc., Circuit City, Lehmann Brothers or Hollywood video. They were at the top of their game in 2007, in 2008 all went bankrupt. None of these companies, which were once at the top, exist now. Although there are several reasons, one of them is that they didn’t evaluate risk especially systemic risk mainly due to complacency. I have always said that if you are on the top floor of an elevator building, the elevator has only one arrow going down. There is no other direction, so if you want to stay on the top floor with sustainable growth, there can be no weakness or negligence on anything. There are multiple forces in play, and one of them can be completely analysed if they go under systemic research, but there are also few new things happening that I’d like to call “known unknowns” and finally there are several “unknowns”. Uncertainties are inevitable but worrying is optional and planning is paramount. Yes, you can plan, you can anticipate uncertainties and plan for those so called known unknowns. But there are also some “unknown unknowns” which are now a frequent occurrence. Who would have believed that a highest recorded earthquake of more than 9 on the Ritcher

Having said the above, I wish all of you the very best in all your future endeavours. Delve into the world of Finance compiled by Team Finance 360 with updates on the various trends in the macroeconomics and capital markets space. Jai Hind!!


Message From the Editorial Team insider’s view as to the central bank / regulator’s ability and preparedness to deal with an exogenous financial “tsunami”! Assumptions of infallibility can be a chimera in a country with a yawning gap in its current accounts; a falling currency; a rising fiscal deficit; a stubbornly high inflation rate immune to the gravitational pulls of a rising yield curve; an infrastructure sector groaning under unhealthy debt equity ratios and a complete lack of bipartisan agreement on how to accelerate economic growth. We the public have been lulled into a false sense of security as we confused ourselves between the willingness of the establishment to nationalize our economic pain with their ability to do so – and there in lies the central question of this debate - CAN we tackle systemic risk if God forbid, as Vitalstatistix used to say that the “sky falls on our heads “?

In an age when we keep on wondering if the world is flat or round ; whether an institution is too big to fail ; if hedging magnifies risk ; globalization makes the national economies separate by less than six degrees or not – a conference on systemic risk is more than timely ! Actually, once we had the idea, the invited speakers jumped up and asked us why no one had thought of this before! We wanted to bring out the proceedings of the deliberations and delays made us cry out loud if contagion would set in before our distinguished panelists’ observations reached the general public! This issue of Finance 360 brings the proceedings of the 2012 Annual Conference of the Union Bank Center for Banking Excellence at Great Lakes. The 2012 is the 3rd Annual Conference held under the aegis of the Center and with the world in turmoil and the central bankers turning out to be the new captains of the global economic ships in these turbulent times, we wanted to turn away from the “PIIGS” countries inwards and focus the spotlight on ourselves.

So we bring you this lively discussion with the distinguished panelists on these burning issues. And our students have contributed with their insights on various macroeconomic and capital market issues which are topical and reflect the evolving views of learners.

In a country where the financial services sector is still dominated by public sector giants and government guarantees to their liability holders are a given, we wanted an

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And to top it off, no finance magazine is complete without its share of graphs that show a snapshot of the world that has passed us by !




Synopsis has increased to 3.2% as per end of March 2012. As a result, to cope up with the high loss estimates, the interest rates and capital infusions may have to be increased. This could again possibly lead to liquidity pressure within the system.

Standard & Poor’s(S&P) has downgraded India’s credit rating to BBB-.India is the first of the BRIC countries to be downgraded. There is also a possibility of further downgrade to junk status. Fitch has also downgraded India’s sovereign credit outlook to negative from stable. Corruption and lack of reforms have been cited as the reasons. There has also been an detrimental effect due to increased risk exposures to commercial real estate, capital market, venture capital funds and systemically important non-deposit accepting Non Banking Finance Companies (NBFCs).

Further, because of the negative investment outlook, there is a possibility of FII pull out from banks or a reduced FII inflow into the system. Rupee depreciation for last one year and falling IIP numbers for continuous three quarters is also adding to the current situation. Under these conditions, has India’s economic and fiscal prospects weakened? How hedged is India towards systemic risk? Can we expect regulators and supervisors to take appropriate macro-prudential measures, pre-emptively, decisively and proactively, rather than reactively to ensure consolidation process and create a more positive environment with regard to the growth outlook, material improvement in inflation and an improvement in the investment climate?

Indian banks have proven to be vulnerable to exposure in government debt. A sovereign downgrade of banks could impact the capital base of banks which could lead to increased cost of funding by banks and an eventual asset quality deterioration which has been one of the major concerns for RBI, as it poses a significant risk to the financial system. Even though the sovereign investment in government assets/securities for meeting SLR requirements is a safe 24%, the size of the net government borrowings is huge. Could this eventually create an unprecedented liquidity pressure within the system? Also the gross NPA of commercial banks

The forthcoming articles present views by our distinguished panelists on this contentious issue.


Shri S. K. Jain

Dy. Governor RBI

Dr. Gurbachan Singh Professor ISI, Delhi

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Executive Director Union Bank of India

Dr. Manoranjan Sharma Chief Economist & GM Canara Bank


Dr. Rupa Rege Nitsure Chief Economist & GM Bank of Baroda

Is India Hedged Against Systemic Risk?

Dr. Gurbachan Singh Professor, ISI, Delhi

of government bonds. These are rated low by international rating agencies. So there is a risk for banks which invest a large proportion of their funds in government bonds. At present, bank capital adequacy norms do not consider the risk in sovereign bonds but this will change once Basel III norms become operational.

Introduction Is India hedged against systemic risk? The short answer is yes and no. The long answer follows in this article. Before I explain, let me say that this write-up is on a vast topic but the space is limited. So I will be brief. I will avoid hard theory, data and bibliography here though the points made here can be substantiated. The views expressed here are based on my own research on the subject.

Second, consider the fiscal position of the Government of India (GOI). The debt to GDP ratio is high but is not alarming. However, the debt to revenue ratio in India is very high. This can be damaging. Moreover, there is concern about some state level debts (e.g. West Bengal). We also need to distinguish between liquidity and solvency. Even if the GOI and state governments are solvent in the long run context, there is a concern about possible liquidity problems in the short run. It is true that the real yields on GOI bonds are low which may indicate that government bonds are safe. However, this is deceptive because we do not have a truly market determined yield on GOI bonds, given the statutory liquidity ratio (SLR) regulation which ‘bails out’ the government. Furthermore, it is true that the GOI can raise funds from the Reserve Bank of

Before we begin, let us understand systemic risk. This runs through almost the entire economy unlike non-systemic risk which is confined to a part of the economy. Systemic risk relates to serious difficulties with regard to (1) non-performing assets (NPAs) or liquidity in financial institutions, (2) fiscal deficits, (3) current account deficit, (4) prices of financial and real assets, and (5) inflation. Let us consider each in the context of India. Usual possible systemic risks in India First, consider banks. There are rising NPAs in banks and other financial institutions in India. Banks also hold a large amount


prices in many parts of the world. We have still not learnt lessons from the sub-prime crisis in the US. Some people invest heavily in real estate and have inadequately diversified portfolios. This is not safe. So there can be a big risk for households and for the economy as a whole if real estate prices were to fall.

India (RBI) in one way or another and the RBI can print money to enable the government to redeem its bonds. However, this only takes us to another form of systemic risk – inflation. The reason is simple. Excess monetary expansion in such a situation can be inflationary. There is no free lunch. Third, current account deficit is an important concern though the situation has improved somewhat. Rupee has depreciated considerably in the last one or two years. This should hopefully start showing its positive effects on external balance in the near future. So the deficit problem on the current account is not as serious now as it was one year ago. On the other hand, the capital account too seems to be showing signs of improvement. Capital flows had slowed down for some time but the worst on this front seems over though we always need to be on the lookout. This is particularly true given the ratio of reserves to GDP, which is not as comfortable as it was some years ago. Our capital controls are leaky and a formal international credit line from the IMF is absent. So we need to take a lot of care.

Gold is, in normal times, hardly ever a cause of concern, given the nature of the asset. However, there has been a large investment (speculative?) demand for gold in recent years. So there is need for care though some hedge funds in the West take a different view. In another and very different sense in the long run context, gold is always a cause of concern. The intrinsic value of gold is low and the market price is high. So, we have a bubble of sorts (though there can be a debate about the meaning of intrinsic value).

Fourth, consider asset markets. Let us begin with the stock market. It is very difficult to predict this market. So let us make a relatively safe comment. The Indian stock market is not ‘grossly overvalued’ or ‘grossly undervalued’ at present, given the current information. By this account, the stock market prices in India are ‘stable’ from the viewpoint of systemic risk. There are also hardly any reports of high leverage in the economy. There is, however, a systemic operational risk that does still bother in India. There cannot be room for complacence here. The derivatives market has grown very fast in India in recent years but the market size is still small. So there cannot be much of a systemic concern here at this point of time.

Fifth, inflation has been high for several years now in India. There is, however, hardly any danger of inflation getting any worse in the sense of endangering systemic risk. This is not to say that there is no need to bring down the inflation rate. Less well known fragility Ask people about Indian banks and they say we are safe. Ask why? Then they say that banks are government backed. So far this is good. But then ask another question. What is the fiscal condition of the government?

Real estate prices are quite high in some parts of India relative to (a) ‘fundamentals’, (b) prices in other parts of India, (c)

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earlier, helped government finance its fiscal deficits. Given the assured supply of funds from banks for the purpose of financing fiscal deficits, it is not surprising then that we do not have a fiscal crisis.

Many would say that it is not good but the government usually does not have a problem financing its deficits or rolling over its debt. So in that sense the fiscal condition too is fine. But how come the financing of fiscal deficits goes through, given that the deficits are large and the ratings of GOI are low? The answer is that GOI can always borrow from banks. But wait a minute. We just said that banks are fine because they can rely on government support. So it is a somewhat circular argument. There are government-backed banks and there is banksbacked government. This is fragile interdependence. If people were to suspect that the fiscal condition of the government is not good, then there can be doubts about government-backed banks. The latter may see a decline in the level or in the growth rate of deposits. This can in turn make it difficult for banks to finance fiscal deficits. Well, we are in a fiscal crisis then. If there is a sudden withdrawal by depositors from banks too, then there is a banking crisis as well (Singh, 2010).

(b) There have been unanticipated jumps in inflation rate (mid-1960s, 1973-74, 1979-80, around 1990, around 2010). These reduce the real value of debt and hence bail out debtors both in the public sector and in the private sector. Inflation can also bail out the equity market and the real estate market. This is less well understood.

One may argue that banks in India have adequate capital and so banks are safe and sound. It is true that the GOI recapitalizes public sector banks (PSBs) now and then. It does so even though it runs large fiscal deficits. But where do the funds come from? Well, we know that the fiscal deficit is financed primarily by borrowing from banks under the SLR regulation. So let us put the pieces together. At the cost of oversimplifying, let us say that the GOI sells bonds to banks, raises cash and then recapitalizes banks. There is, in a sense, no net inflow of funds when the government invests in capital of PSBs. There is, hence, some kind of a question mark over the credibility of capital in PSBs in India.

So let us discuss this. Suppose there is a bubble in asset market. It can warrant a correction over time. In Japan, it has already taken two decades. In the US, it has already taken more than a decade. However, in India we have not witnessed very prolonged corrections in the stock market. Why? With inflation, a substantial increase in the general price level may `justify’ the rise in the stock market or in the real estate market in a much shorter span of time. The crashes in stock market prices in India may appear relatively smaller in nominal terms but they are quite large in real terms. But these are less visible due to inflation (e.g. the fall of Sensex from 2007 to 2012 is large in real terms).

(c) There are regular and somewhat institutionalized bail-outs (e.g. airline companies both in the public sector and in the private sector, tightening the licensing of new real estate projects when prices start moderating, change in importexport rules to protect firms or sectors, not allowing foreign educational institutes in one way or another, etc.). These kinds of explicit bailouts pre-empt financial crises.

The analysis so far does not sound very optimistic. But financial crises in India are much less frequent than in other parts of the world. How come? Are there some mitigating factors in India?

(d) There is considerable confidence in banks in India. It is possibly due to the fact that many are public sector banks. Even the private sector banks are viewed as having the backing of the government. There is a possible role of history of by and large banking stability in India since independence. It also helps that the general public does not ask whether or not the government itself is financially strong.

Mitigating factors (a) Though there has been liberalization in the financial sector since early 1990s, there was relatively not much of a change in the financial intermediation sector. The new exchanges like NSE, instruments like derivatives, regulatory bodies like SEBI, etc. are all liberalization measures and improvements in the financial markets and not in the case of financial intermediaries. There is financial repression in banks in the form of factors like cash reserve ratio (CRR), SLR, etc. The SLR regulation in particular has, as mentioned


The first three mitigating factors are economically costly. The fourth mitigating factor (d) is not a reliable factor or hedge against systemic risk.

It is interesting that Europe could have easily ‘solved’ the fiscal problem by (a) resorting to financial repression in banks to ensure demand for bonds of weak governments,

(b) opting for high inflation and indirectly defaulting on public debt in real terms, and (c) bailing out investors. But the Europeans did not do any of this in a significant way. It is also interesting that for a long time there was confidence in Euro denominated bonds even if these were issued by countries like Greece or Italy which had credit risk (as distinct from currency risk). But this kind of confidence was misplaced and eventually turned out illusory.

Second, the government needs to cut fiscal deficits. The usual emphasis is on cuts in subsidies. But there is also a need to reduce tax evasion and tax exemptions. It is, in my view, not as difficult as it is usually made out to be. Third, the public authorities in India can buy an international credit line, like Columbia, Mexico and Poland have done (Singh, 2012). This is cheaper than holding foreign exchange reserves as a safeguard against balance of payments difficulties. Next, given that there is considerable home bias at present, the public authorities can encourage ordinary households to invest abroad (so that all their eggs are not in the home basket). However, this will need to be done gradually over time given the present balance of payments situation.

Now the Europeans are confronting the systemic crisis expost. We, in India, are not doing this ex-ante even after the European experience (see Financial Stability Reports of RBI). But how come we have not faced a problem?

It is the growth, stupid!

Fourth, financial literacy is neither necessary nor sufficient. There is a need to use Prescription financial products (Singh, 2009, section 3). Investors may be required to consult a competent, independent, meaningfully qualified, and registered finance practitioner before they can make an investment. The finance consultant can write out a prescription on the basis of which an investor can buy financial products. This scheme is similar to that in the field of medicine. This big change in finance will require much more of formal and serious finance education in universities in India. (Given these changes, the GOI can consider meaningfully allowing hedge funds.)

Not only Europe but even Japan has gone through a crisis. This was around 1990 and Japan has yet to fully recover. The US has gone through a financial crisis and there are still considerable difficulties. But there has not been a financial crisis in India ever since the early 1990s. Why? In the final analysis, it is the growth, stupid! (if we may rephrase the more familiar expression in the US – it is the economy, stupid!) High growth rate can accommodate several weaknesses in the economy e.g. debt-GDP ratio can fall. However, the inherent weaknesses do take their toll even if financial crisis is avoided. So there is a need for policy changes.

There is a long delayed reform in the real estate sector. There is a need to remove or phase out ‘license-permit-quota Raj’ in the real estate sector. There is also a need to improve access to the judiciary so that (a) honest developers are not exploited by corrupt officials, and (b) house buyers are not exploited by unscrupulous developers. Further suggestions are: phase out subsidies on home ownership, reduce stamp duty, and increase circle rates particularly in North India.

Policy First, in banking, there is a need to reduce CRR, SLR, priority sector lending, and barriers to entry. There can be a role for private deposit insurance to take care of individual risks. We can confine government deposit insurance for taking care of systemic risk, if it is the case that bank capital, liquidity and regulation are inadequate. Banks need to use contingent bank capital. If there is little supply from the private sector, the GOI can step in with safeguards. Next, though banks may have been under-regulated in the US and elsewhere in the years up to 2007 and there was a need for tightening regulation there, this does not imply that there is a similar need in India. In some ways, banks are overregulated in India anyway. So there is no compelling need here to increase regulation. Finally, the GOI can gradually nudge banks to use indexed deposits (and indexed loans). This may to some extent reduce demand for gold as a hedge against inflation in India. In this context, the RBI can set an example by not holding much gold in its asset portfolio.

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Fifth, there is a need to adopt inflation targeting. It is true that this leaves out several important objectives from the purview of the RBI. However, these can be taken care of by an extended fiscal policy (Singh, 2012, chapter 11). Conclusion Is India hedged against systemic risk? There are the usual vulnerabilities. There is also a less well known fragility. There is fragile interdependence between banks and the government. However, nothing much untoward has actually happened in this regard in India and for a long time. This is because there


are five mitigating factors: (a) financial repression in banks, (b) high and volatile inflation, (c) somewhat regular explicit bailouts, (d) misplaced confidence, and (e) high growth (by international and historical standards). The first three have considerable economic cost. So we cannot take pride in the fact that there are less financial crises in India. Even if we do not face costs of an occasional financial crisis, we need to incur persistent costs of the first three mitigating factors. The fourth is not a reliable hedge against systemic risk. So it finally comes to relying on growth to take care of systemic risk. However, this has its own difficulties. High growth rate has to be a matter of choice and not a matter of compulsion for the purpose of taking care of systemic risks. So it is not a good idea to use growth as a way to take care of (and hide) systemic weaknesses. In any case, the fact that growth has so far taken care of systemic risks does not imply that the inherent weaknesses do not impose their costs on the economy. The policy implication is clear. There is a need to reduce the vulnerabilities and alongside reduce the role of costly or unreliable mitigating factors. Then there can be higher, stable and meaningful growth. (Paper was presented at the GL-UB Finance Conference, 27th August, 2012)


Is India Hedged Against Systemic Risk? Dr. Manoranjan Sharma Chief Economist, Canara Bank, Head Office, Bangalore

Mrs. Archana Choudhary, IRS

Commissioner of Income Tax, Bangalore

It is, however, important not to lose a sense of balance and perspective. For, despite all domestic problems and negative global cues, growth in the developing world continues to be still slightly above 4%. This works out to about half the pace of the boom years, when global GDP was at a record high from 2003 to 2007. At least 40 countries, along with India, grew rapidly because an unprecedented global liquidity enhanced global demand and investment appetite of riskier emerging market assets. India and other emerging nations benefited in terms of high export rates and record high capital inflows.

In recent times, there has been a great deal of debate and discussion about the deterioration in the macro-economic parameters of emerging countries in general and India in particular. While India is not significantly impacted by the global economic turmoil, it cannot remain impervious to the winds of change sweeping other countries. Further, the economic deceleration in India severely constrains the capacity to meet serious developmental challenges. The double whammy of fiscal and current account deficits, high consumer and industrial inflation, low real wage growth and a serious contraction in investment, hamper economic recovery. The lack of any real headway on issues like Goods and Services Tax (GST), Direct Taxes Code (DTC) is disconcerting because of the negative impact on tax buoyancy, collection efficiency and facilitation of one common market for India. Thus the ‘new normal’ has been characterized by a paradigm shift from a “high growth economy” to “stagflation economy” and the ‘irrational exuberance’ of five years ago has given way to unbound and ubiquitous pessimism.

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Considered in a proper historical and comparative perspective, India’s growth has followed a steady pattern for three decades with growth being 1.5 to 2 percentage points faster than the global emerging market average. Contrary to popular perception, India’s ranking among the world’s fastest growing economies did not undergo any major shift since 1980, when India extricated itself out of the quagmire of the Hindu rate of growth. This thesis can easily be substantiated by the fact India (in terms of the IMF’s list of 180 countries) ranked


29th in terms of its average growth rate in the 1980s, 27th in the 1990s and 26th during the last decade. Even during the heady days of robust, fast-paced growth 2003 to 2007, India’s ranking at 24 remained in this narrow band because ‘a rising tide lifts all boats’.

(109%), Malaysia (107%), Korea (107%), Thailand (81%), etc. Credit has to expand for sustained growth of income and employment.

With global growth decelerating, India’s GDP growth in FY 13 is likely to be sub-6% in FY 13, placing India somewhere between 25 and 30 in the global pecking order. Driven by 13% nominal annual growth rate India’s GDP is set to quadruple over the next ten years to reach USD 4.5 trillion by 2020. Goldman Sachs projected India to be the third largest economy by 2030.

Compared to EMEs and China, the Indian financial sector, particularly banking is more efficient. There are, however, persisting issues, e.g., lack of real progress on reformsgreater FDI, easier labour laws and disinvestments, possible rise in inflation and interest rates and lack of headway in critical infrastructure. These factors require an accent on manufacturing resurgence, agricultural transformation, reduced regional disparities and focus on employment, health, education and gender equality. Banking needs reoriented development strategies; increasing productivity- reforming labour laws, financial systems, legal environment, non-tariff barriers, more market-friendly investment policies; widely disseminating benefits of growth in technology and innovation.


STRENGTH AND RESILIENCE- OUTPERFORMED MOST ECONOMIES POST-REFORMS Despite the global financial meltdown, the Indian growth story remained intact largely because of India’s democratic polity, sequential economic reforms, prudential regulations and RBI’s calibrated policies. Indian economy recovered fast because of strong banking system, rising industrial output, improving exports, increased consumer spending and stock markets.

BANKING-ECONOMIC GROWTH DRIVER Indian banking is relatively much stronger vis-à-vis other Asian counterparts in terms of product range, range of

The strength and resilience of the Indian economy was reflected in out-performance despite ravages of the global financial crisis; strong domestic demand and sustained increase in per capita income. Let me do some number-crunching. India is the fastest growing economy (next to China); high foreign reserves ~ 4th largest in the world; rising per capita income ~ increased standard of living; higher disposable income; high telecom penetration ~ urban (103%), rural (18%); 525 million mobile users (2nd largest); demographic advantage ~ young work force (43% of population); major agrarian powerhouse. Going forward, strong ‘domestic consumption story’, high domestic savings, favourable demographics and sustained increase in per capita income will ensure continued economic growth. UNFINISHED DEVELOPMENTAL AGENDA The challenges of the present and the expectations of the future necessitate a leveraging of Demographic Dividend. The share of banking and insurance in GDP and share of banking and insurance in services has risen progressively. Bank credit to GDP stood at 55 % in 2009-10. It was, however, lower than Hong Kong (150%), China (136%), Taiwan (126%), Singapore


investment, financial options for depositors and financial health of primary and secondary capital markets. Return on equity and assets of the Indian banks are on par with Asian banks, and higher than those of US and UK. Indian banking remains robust despite global financial turbulence. During 2000-2012, Indian banking was characterised by growth with profitability. Gross NPAs reduced from 14 per cent to 2.9 % at end March 2012. (SCBs), costincome ratio fell from above 60 % to 45.3%, RoA increased from 0.69 % to 1.10 % (SCBs) and total assets rose from Rs. 1,151,000 crore to Rs. 52,93,817 crore (March 2011) for PSBs. There has also been a significant reduction in intermediation cost and rapid increase in business per employee. But as the Narasimham Committee Report-II (1998) put it: “the process of strengthening the banking system has to be viewed as a continuing one. There is no finite end to improving the levels of efficiency and profitability. Infact the system has to cope constantly with changes in the broader environment in which it functions and face (new) challenges that those developments impose on it”.

ATMs of 5x and huge mobile banking growth, the transaction banking paradigm is set to be redefined. There has to be a thrust on “the next billion”–income rage of Rs. 90,000Rs. 2,00,000; focus on SMEs; CRM and data warehousing to drive next technological revolution; investment banking to grow ten-fold, infrastructure financing to reach Rs. 20 trillion. KEY VALUE DRIVERS Buoyant business growth, diversified business portfolio and higher profitability increased retail lending in India in last five years at CAGR of 30 %. However, this growth occurred on a low historical base. Retail loans constitute 5 % of GDP vis-àvis about 35 % for other Asian economies. The level of retail banking penetration at 12 % of total loans and advances is also significantly low.

There is need for an accent on enterprise-wide risk management (ERM), improved integrated risk management mechanisms, streamlined systems and procedures and honing skill set for client selection, industry analysis, concentration, risk ratings, use of benchmarks, etc.

SYSTEMIC RISK The magnitude of global economic meltdown induced a belief about the collective failure caused by the conspicuous absence of the existing regulatory framework to deal with systemic risk in view of the manifest inability of financial markets to always self-correct, difficulty of detecting the signs of instability on an ongoing real time basis and huge costs of instability.

FUTURE GROWTH PROSPECTS There has been rapid growth but still there is vast latent potential of Indian banking. Growth will be powered by retail advances growing from Rs. 7.44 trillion in 2011 to Rs. 40.35 trillion in 2020 with housing being the major component. With wealth management growth of 10x, branches of 2 x,

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Cataclysmic changes in financial markets, financial products


and practices expanded cross-border banking, increased interdependencies between banks in different countries, intensified vulnerabilities and fuelled contagion risk. Many global banks had shifted their financing strategies, relying more heavily on market funding, and the associated liquidity disruption and shortfalls further amplified financial system fragility. Further several new and complex financial products were introduced into the markets. In many cases, the originators of these products did not fully understand the inherent risks due to the products’ complexity, or because the regulatory framework necessary to create the incentive for proper risk management were absent. In sum, all this amounted to a heady mix with disastrous consequences.

macroeconomic fluctuations, excessive exposure to sensitive sector and political interference in their operations. Jerry Bowyer in a recent article (Systemic Risk Is About CharacterMar 19, 2012) has succinctly summed up “Risk is not eventdriven; risk is character-driven. Events are not the cause; events are the effect of national character”. THE EURO CRISIS Initial worries about the solvency of Greece from late 2009 stemmed from high deficits, fake budget figures and low growth. But the problem of a sovereign debt crisis, which stemmed from rising government debt levels and a downgrading of government debt of certain European states, rapidly spread from Greece to Italy, Ireland, Portugal and Spain.

The developed economies went through a massive credit expansionary phase that created an extreme imbalance between lenders and borrowers. With the economies slowing and the debt-burden mounting, borrowers are having a hard time returning the money. George G. Kaufman and Kenneth E. Scott define ‘systemic risk’ as “the risk or probability of breakdowns in an entire system, as opposed to breakdowns in individual parts or components, and is evidenced by co-movements (correlation) among most or all the parts”. Systemic risk, which drives most crises, refers to the possibility that a highly non-linear event, such as, the failure of an individual firm, will seriously impair other firms or markets and even negatively impact the broader economy with high social costs on those completely irresponsible for causing the crisis. This debilitating process could trigger a vicious cycle of eroded confidence in financial markets and regulators, stringent regulation, the expansion of the state, and move towards protectionism. But what is worse is that the financial and economic crisis is morphing into a sovereign debt crisis in advanced countries. The International Monetary Fund suggests that as much as 75% of the “fiscal stimulus” in the advanced countries comprises non-discretionary countercyclical measures.

Post 2009, the problem of sovereign debt increases accentuated across the European Union (EU). But these problems acquired terrifying dimensions for Portugal, Italy, Ireland, Greece and Spain (PIIGS). PIIGS are characterized by high structural deficits, odious debts, low prospects for high and sustained growth and low productivity improvements. What worsened matters was globalized finance; lax credit standards during the 2002-08 period that fostered highly risky lending and borrowing practices; global trade imbalances; grim reality of the realty and pronounced deceleration in economic growth. Apparently prudent fiscal policies could be derailed by undetected imbalances and systemic risk.

From 2008 onwards, several episodes of financial instability and volatility in market dynamics devastated the world economy. These financial risk related issues increasingly highlighted the fragility of banking and finance and stress the inter-linkages of financial markets. The vulnerability of banking sector of developing countries is starkly reflected in

Fiscal policy choices related to government revenues and expenses; and bailout approaches to troubled banking


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industries and private bondholders, assuming private debt burdens or socializing losses also adversely affected the financial position of PIIGS. In this kind of disconcerting macroeconomic setting, slow GDP growth rates in PIIGS restricted growth in tax revenues and increased safety net spending. This caused a widening of deficits and debt levels beyond manageable proportions. Fareed Zakaria stressed: “Europe’s core problem [is] a lack of growth...Italy’s economy has not grown for an entire decade. No debt restructuring will work if it stays stagnant for another decade...The fact is that Western economies - with high wages, generous middle-class subsidies and complex regulations and taxes - have become sclerotic. Now they face pressures from three fronts: demography (an aging population), technology (which has allowed companies to do much more with fewer people) and globalization (which has allowed manufacturing and services to locate across the world)” (CNN Fareed Zakaria GPS-November 10, 2011). Plainly, then, Europe has been devastated by a triad of demography, technology and globalization. Consequently, a discernible improvement in the ground realities is contingent on a vastly improved macro-economic environment, particularly lower wages and greater inflow of foreign capital investment.

SYSTEMIC RISKS AND FINANCIAL STABILITY IN INDIA India was able to withstand the direct impact of global financial crisis. But risks to financial stability have increased in India as a result of unstable global economic conditions and deteriorating domestic macroeconomic fundamentals. RBI’s Financial Stability Report isolated four key variables that posed threats to financial stability in India: the global sovereign debt problem, the domestic fiscal position, the widening current account deficit and the structural aspects of food inflation. All these are areas, where immediate, easy answers may not be available. This is because working towards sustainability is a dynamic process that must essentially be viewed in the context of long-term issues- the issue of ushering in a new approach to increase the growth rates and make the growth process sustainable over the long haul. Financial stability in India implies ensuring uninterrupted settlements of financial transactions - both internal and external, maintenance of a level of confidence in the financial system amongst all the participants and stakeholders, and absence of excess volatility that unduly and adversely affects real economic activity. All these aspects are not just a random or disconnected set of activities but constitute a ‘system’, where different constituents form parts of an organic whole.

In any discourse on the debt crisis convulsing the 17-nation currency zone, it is commonplace to identify high debt levels as a critical factor contributing to the festering crisis. But it is not so commonly realised that the position of the EU looked “no worse and in some respects, rather better than that of the US or the UK” (The Economist Intelligence Unit). The budget deficit for the EU as a whole was 4.5% of GDP as against a whopping 10% for the US in 2010. Similarly, the EU’s government debt/GDP ratio stood at 87% in 2010 as against 100% in the US. This is not all; the situation becomes more interesting because, while there is at least a modicum of support on measures to reduce excessive deficits and debts in the EU countries, there is precious little sign of any agreement in the US. Further, private-sector indebtedness across the EU is markedly lower than in the highly leveraged Anglo-Saxon economies.

The RBI’s calibrated approach towards financial liberalization and its prudential oversight cushioned Indian economy from the direct impact of global financial crisis. Coordinated action

Again, the opaqueness of the world of global finance is clearly manifested in the fact that the United Kingdom has an even bigger debt/deficit/and private borrowing problem than the corresponding problem faced by the Eurozone.

February 2013


by the government and regulators helped to handle volatility in the financial markets. However, the global financial issues impacted the economy in the form of moderation in GDP growth, volatility in capital flows and equity markets, Sectors

exchange rate depreciation and persistently high inflation. Growth in Index of Industrial Production (IIP) (Base: 2004-05=100)


































Electricity Basic Goods

















Intermediate Goods








Consumer Goods








Index of Industrial Production (IIP)








Capital Goods

Source: CSO, Govt. of India Systemic risk can build up because of a single factor, but may very well develop through a combination of factors, such as, contagion (inter-connectedness) and common exposures, procyclical nature of financial system and prudential regulations (leverage and maturity mismatches), regulatory arbitrage due to limited perimeter of regulation (complex products, institutions, markets), financial innovation (opaque and poorly understood products) and OTC derivatives (inadequate infrastructure).

The new Margaret Thatcher biopic, The Iron Lady, quotes her: “Watch your thoughts, for they become words. Watch your words, for they become actions. Watch your actions, for they become… habits. Watch your habits, for they become your character. And watch your character, for it becomes your destiny! What we think we become. My father always said that”. So, where do we go from here? Evidently our options are limited in an environment, where most elements are critically in ferment. This requires an introspection based on a realistic assessment of the unfolding realities. The dynamics of the underlying forces at work require an accelerated reform process.

Major risks to financial stability in India include: 1. Global Macro-economic Instability - Deepening crisis in the Euro area and continued global slowdown contributed significantly to the deterioration in global risks. The developments in the Eurozone would impact Indian economy through trade, finance, capital flows and business confidence. Uncertain global economic environment pose challenges to the domestic growth and balance of payments outlook.

The RBI’s statement on “Macroeconomic and Monetary Developments First Quarter Review” (July 30, 2012) pointed out: “Decisive policy action, backed by credible commitment to a long-term strategy for correcting macroeconomic imbalances and stimulating investment, is crucial at this stage to revive confidence as well as provide space for monetary policy to help sustain growth while keeping inflation under control”. As the Prime Minister recently stressed, we need to reawaken the ‘animal spirits’ of entrepreneurs with improved governance and initiate second-generation economic reforms to reverse the slowdown in growth. The political and bureaucratic system has to provide the prerequisites to growth and facilitate decisive action on contentious economic issues.

2. Domestic Marco-economic Issues - decelerating growth, elevated inflation and inflationary expectations, large fiscal and current account deficits, low exports growth, low IIP growth. Financial and macroeconomic stability are interlinked and almost indistinct. GDP growth declined sharply to 6.5% during 2011-12 from 8.4% in the previous year. GDP growth slowed down to a decade low of 5.5%


An expenditure switching strategy is needed to reduce government’s revenue spending by slashing subsidies with enhanced capital expenditure to crowd-in private investment.

in first quarter of FY 13 as against 8% recorded in the corresponding period last year.

The deceleration in GDP growth was reflected across all the three segments of the economy – agriculture, services and industries. The downside risks to growth may persist given the uncertain global economy and moderation in investment demand and necessitates addressing issues impeding infrastructure.

Sharp deceleration of industrial growth and its various segments pose a serious down side risk to the GDP growth for FY 13. The Index of Industrial Production (IIP) for the month of July 2012 stood at 0.1% against a negative growth of 1.8% in June 2012. IIP was dragged down by fall in capital goods, mining and manufacturing sectors.

4. High current account deficit (CAD). CAD of 4.2% of GDP in 2011-12, which is the highest since the balance of payments crisis of 1991, has implications for India’s external debt position and, consequently, for financial stability. A widening CAD in the face of worsening global economic and financial conditions and muted capital flows has accentuated pressure on the rupee. The CAD is being increasingly financed by debt flows, threatening long-term sustainability.

Capital goods sector contracted by 5% in July 2012. Manufacturing output, which constituted 76% of overall industrial production, contracted by 0.2% in July 2012. During April-July 2012, IIP contracted by 0.1% (6.1%) with manufacturing sector growth at -0.6% (6.5%) and growth in capital goods at -16.8% (8.2%). Further, growth in consumer goods now also seems to be petering off. There is a high degree of volatility in month-to-month growth but the severe contraction in capital goods sector is a serious cause for concern. Capital goods recorded negative growth for the third consecutive month though the pace of contraction eased.

5. Inflation Risk. The persistence of inflation and inflationary expectations together with discernible slowdown highlights serious supply bottlenecks. While falling global commodity prices could aid in checking inflationary trends in the coming months, the potential impact of the lagged pass-through of rupee depreciation, suppressed inflation in energy and fertilisers and possible fiscal slippage pose a threat.

3. High Fiscal Deficit - Both fiscal and primary deficits have increased during 2011-12. Fiscal deficit was 5.9% in 2011-12. Fiscal risks remain elevated in FY 13. High fiscal deficit will widen the trade deficit an impact the BoP position. High fiscal defect also reduces the scope for further fiscal stimulus measures. Of the Rs. 5,69,616 crore Budgeted G-Sec Gross Borrowings for 2012-13, Rs. 3,36,000 crore (59 %) was completed till 12.09.2012.

February 2013

The Kelkar Panel report on fiscal consolidation has suggested raising resources through disinvestment and secondly cutting the non-plan expenditure to keep the fiscal deficit within 5.3-5.4 % against the budgetary target of 5.1 %.


All Commodities Primary Articles Manufacturing Fuel & Power

Mar 2012 7.69 10.41 5.16 12.82

Apr 2012 7.50 9.55 5.27 11.03

May 2012 7.55 10.88 5.02 11.53

Jun 2012 7.25 10.46 5.00 10.27

Jul 2012 6.87 10.39 5.58 5.98

Aug 2012 7.55 10.08 6.14 8.32

Retail Inflation Various CPI indices show a sharp rise in retail inflation from January 2012 onwards. Inflation Trends since January 2012 (in %) WPI CPI-IW Jan-12 6.89 5.32 Feb-12 7.36 7.57 Mar-12 7.69 8.65 Apr-12 7.50 10.22 May-12 7.55 10.16 Jun-12 7.25 10.05 Jul-12 6.87 9.84

CPI-AL 4.92 6.34 6.84 7.84 7.77 8.03 8.61

CPI-RL 5.27 6.68 7.19 8.01 8.11 8.54 8.94

RBI has stressed that despite significant slowdown in growth, there is only some moderation in core inflation and not in headline or CPI inflation. This is because of serious supply bottlenecks and downward ‘sticky’ inflation expectations. RBI’s first quarter review of Annual Monetary Policy Statement for 2012-13 revised the baseline projection for WPI inflation for March 2013 from 6.5% to 7%. Weak monsoons and recent hike in diesel prices will further stoke core inflation and increase inflationary expectations. 6. Volatility in Rupee. The rupee has been falling since August 2011 and breached the 57 dollar mark. The rupee slumped to an all time record low of 57.37 against US $ on June 22, 2012 (intraday). Rupee is depreciating because of European debt crisis, flow of funds to safehavens, higher dollar demand from oil importers, a widening CAD and a slide in equity markets. The rupee closed at Rs. 55.42 against the US Dollar as on September 13, 2012.

A depreciating rupee will exacerbate


CPI-Rural 7.28 8.36 8.70 9.67 9.57 9.74 9.76

CPI-Urban 8.25 9.45 10.30 11.10 11.52 10.44 10.10

CPI-Combined 7.65 8.83 9.38 10.26 10.36 10.02 9.86

inflationary pressures, increase fiscal deficit and weaken the balance-sheet of Corporate India. 7. Interconnectedness. The interconnectedness of institutions or markets has increased due to globalization, financial innovations, business strategies, technology and product characteristics. Traditional risk measurement approaches do not consider the interconnectedness. Despite these risks, the overall stability of the financial system remained robust with a sound banking system and a good regulatory architecture. The long term growth prospects of Indian economy look reasonably optimistic. Indian economy is one of the fastest growing economies in the world. Services sector was a major contributor and continues to be a positive contributor in the domestic outlook. Improved savings and investment rates, favorable financial market conditions, increase in capital flows, moderating inflation and positive business outlook would help the economy to broad-base the growth momentum in the long term. However, the medium term growth prospects depend largely on external macro economic conditions and proactive domestic policies. While incomplete models of risk dynamics and a transforming global financial system make detection of systemic crisis difficult, attempts can-and infact should- be made to identify the emerging pattern and initiate a broad spectrum of measures to discernibly improve the ground realities to meet ubiquitous risks to overall domestic macroeconomic prospects.

the performance of Scheduled Commercial Banks (SCBs) reveals a clear divergence in the earnings of private banks and pubic sector banks (PSBs). While the asset quality of PSBs has deteriorated, private banks have posted robust earnings growth driven by stronger topline (+25% yoy) and stable asset quality. In Q1, loans and advances grew strongly for both PSBs and private banks at +18% average for PSBs and ~24% for private banks. This growth partly benefited from rupee weakness for several important banks with significant global footprints.

2. Low deposit growth despite high interest rates. Less than 14%, the deposit growth rate as on March 31, 2012, which is the lowest recorded in the last decade, had forced banks to rely more on borrowed funds resulting in future liquidity risks.

INDIAN BANKING SYSTEM AND SYSTEMIC RISKS Despite the global financial meltdown, the Indian banks have displayed great strength and resilience and remained immune to major systemic crises. While Indian banks are well capitalized, the macro- economic slowdown has resulted in emergence of some risks in the banking sector. Some risks in Indian banking sector in the transforming socio-economic milieu, which could have systemic implications are:

In view of the serious crisis and the intensity and speed with which systemic problems spread to other markets, the scope for monitoring of financial markets has increased. Repeated market turbulences also demonstrate that promotion of financial stability is a collective responsibility of various financial market regulators. Central Banks, prudential regulators and other regulatory controllers have an important role to play in identifying potential systemic risks and stabilizing financial markets through durable reforms. This,

1. Asset Quality. An increase in slippage ratios, rise in the quantum of restructured assets and a high rate of growth in Non Performing Assets (NPAs) relative to credit growth implied that the concerns on asset quality of banks remain elevated. Gross NPAs for SCBs increased to 2.9% as at end March 2012 (2.4% at end March 2011). Q 1 Review of

February 2013

Domestic growth has been fairly modest at 15-17%, which also has been driven by agriculture and retail. Margins for most PSBs have been impacted partly due to higher slippages leading to interest reversals on loans and also due to rise in funding costs.


RBI, Securities and Exchange Board of India and Insurance Regulatory and Development Authority.

inter-alia, requires supplementing strong microprudential regulation through enhancement in quantity and quality of capital, raising of risk weight of instruments in the trading book, liquidity buffers, leverage ratio, etc.; and effective supervision with a macroprudential policy overlay.

In their attempt to develop a prudent system to monitor market developments and identify emerging systemic risks, the regulators have progressively streamlined regulation of non-banking entities; NBFCs owned by foreign banks, and regulated by RBI included in the Group concept with the foreign bank branches to contain the regulatory arbitrage though legally they do not form a Group; an elaborate prudential framework for systemically important non-deposit taking NBFCs; consolidated supervision of banking groups introduced in 2003 and strengthened subsequently. RBI is also the regulator of Payment and Settlement Systems.

The instruments of tackling time dimension of systemic risk (procyclicality) relate to reduced procyclicality of the minimum capital requirement, capital conservation buffer, countercyclical capital requirement, countercyclical provisioning, compensation policies, higher provisioning and/ or risk weights for rapidly growing sectors, LTV ratios, direct controls on lending to specific sectors, capital surcharges for systemically important banks, liquidity requirements, limits on currency mismatches and loan to deposit ratios.

Further, there are limits on Banks’ equity investment in individual financial subsidiaries/ affiliates; Banks are prohibited to enter activities not incidental to banking and also not allowed to set up subsidiaries for activities which banks are not permitted. Capital requirements for banks’ sponsoring of private pools of capital are based on reputational risk considerations.

Cross-sectional dimension of systemic risk is addressed by continuous monitoring of identified Systemically Important Financial Institutions (SIFIs) based on size, interconnectedness, substitutability and other critieria and calibrated prudential tools (capital, liquidity, leverage, etc.) for them. The policy frame of BCBS and FSB stresses a resolution mechanism and other measures to ensure that all financial institutions can be resolved safely, quickly and without destabilizing the financial system and exposing the taxpayer to the risk of loss. SIFIs, particularly, global SIFIs (G-SIFIs) have higher loss absorbency capacity to reflect the greater risks that these institutions pose to the global financial system. There is more intensive supervisory oversight for financial institutions which may pose systemic risk together with other supplementary prudential and other requirements as determined by the national authorities.

The regulators have also implemented measures for greater transparency and disclosure; and promote confidence in markets. For example, Basel-II implemented prudential limits on capital market exposure, thrust on Quality of regulatory capital: Tier I capital of banks should be at least 6% of RWA by

In the Indian scenario financial market regulators, especially the RBI has an important role in addressing systemic risks because key segments of Indian financial system (money market, Government securities market, forex market and commercial and cooperative banks, NBFCs) are regulated by RBI. High Level Coordination Committee on Financial Markets coordinates among

“Credits: Abhinav Verma & Vinay Kumar Great Lakes Institute of Management”


strengthening of the financial system requires the design and implementation of coordinated and concerted preventive measures and refocused strategies with a sense of urgency to address the weaknesses.

March 31, 2010, higher RW and / or provisioning requirement for exposure to sectors with high credit growth. Institutions should also share data and information with other regulators and supervisors both nationally and internationally to better assess risks emanating from various sources and regions.

The traditional face of banks as mere financial intermediaries has altered and risk management has emerged as their defining attribute. Accordingly, risks need to be mitigated by improving risk management techniques, adequate capital provision, sound supervisory and regulatory practices, transparency and macroeconomic stability. These changes could be helpful in bringing about this structural transformation – a transformation that is visible, measurable and quantifiable. This assumes importance because while we cannot change the direction of the wind, we can certainly adjust our sails to facilitate move to our destination - the destination being a high growth economy with a broad-based and sustained pattern of economic development.

Regulators need to improve their understanding of systemic risk, strengthen their ability to detect it and devise tools to mitigate it. Striking the right balance between financial supervision and overregulation is a challenge for Indian financial market regulators. STRATEGIC OPTIONS AND CHOICES The future global economic landscape, which is likely to be characterized by disconcerting defaults, financial repression measures and inflation, seems shrouded in extreme fear and uncertainty. The world economy is likely to experience an extended period of contraction and deleveraging. While leverage can be a catalyst for growth, “overleverage� can have dangerous consequences as clearly driven home by the global financial meltdown. In this overarching context,

February 2013

Thank you. (Paper was presented at the GL-UB Finance Conference, 27th August, 2012)


Is India Hedged Against Systemic Risk? Dr. Rupa Rege Nitsure

Chief Economist & General Manager, Bank of Baroda “borrowed funds” has increased. What is worrisome is that the distress dependencies between banks have risen and the systemic importance of the “most connected” banks has increased, warranting a closer monitoring of the banks”.

“Systemic risk” is the risk that arises because of the interconnectedness between different financial institutions. It means when some institution is unable to meet its obligations when due, will cause several other institutions also to default on their obligations when due. Such a failure may cause significant liquidity or credit problems and, as a result, could threaten the stability of or confidence in markets.

Unfortunately between June, 2012 (when the RBI published its Financial Sector Stability Assessment report) and now, both the global and domestic conditions have further worsened creating more pressure points for systemic stability.

As per India’s central monetary authority’s (RBI’s) latest available assessment (June, 2012), “the country’s financial system remains robust despite increase in risks to stability primarily due to global risks and worsening domestic macroeconomic conditions. Risks to domestic growth are accentuated by fiscal and external sector imbalances and persistence of inflation. Foreign exchange and equity markets continue to experience heightened volatility. While banks remain resilient to credit, market and liquidity risks thanks to their comfortable capital adequacy ratios, asset quality pressures have persisted and liquidity pressures have intensified. Both credit and deposit growth in the banking industry have decelerated and the banks’ dependence on

So far as the global conditions are concerned, economic malaise appears to be spread from Beijing to Berlin. The Eurozone is headed for its second recession in three years. Falling demand from debt-ridden Europe (China’s single biggest export market), has put the Chinese economy under pressure, with the ripples now being felt across the world. China’s once booming manufacturing sector is contracting at a faster pace than previously reported. Japanese exports slumped the most in six months in July as shipments to Europe and China tumbled. Exports from Taiwan, a key part of the global technology supply chain, fell for a fifth straight month


shows that the household sector’s financial savings rate in FY12 (at 7.8% of GDP) is the lowest since 1989-90.

in July and South Korea, home to major car makers, computer chip and flat-screen producers, recorded its sharpest export fall in July in nearly three years. The US too is widely seen as struggling to keep its pace of growth. The minutes from the US Central Bank’s latest meeting suggested that the U.S. Federal Reserve is likely to deliver another round of monetary stimulus “fairly soon” unless the economy improves considerably.

According to the CMIE, there has been a sharp increase in capex projects that have either been cancelled or put on hold and such projects amounted to Rs 5 trillion or 6.0% of GDP during FY12. In terms of sectors, maximum weakness is seen today in infrastructure (esp. power and roads), steel and textile sectors.

The central banks in the developed world have slashed interest rates to near zero and injected trillions of dollars into the money supply in their efforts to support growth.

The investment climate is vitiated due to indecisive coalition politics, delays in the implementation of some important structural reforms and high profile corruption scandals. Specific reforms that have been delayed are the passage of the land acquisition bill and a mining policy that will enable the entry of private players into the system.

The six consecutive quarters of slowing Chinese growth have also taken a toll on commodities markets, with falling prices and an uncertain outlook prompting miner BHP Billiton to shelve a US$ 20 billion expansion project in Australia.

The headline inflation (measured in terms of WPI) has been stuck above 7.0% since January, 2012 but the retail inflation (measured in terms of CPI) has been closer to double-digit level since April, 2012. If one looks at the data closely, CPIbased inflation has stayed above 5.0% (i.e., the RBI’s comfort level) since April, 2006. Persistent inflation has kept the monetary policy tight and interest rates elevated.

India’s domestic macro picture is also not very encouraging. The country has recorded the lowest growth rate in 201112 (FY 12) at 6.5% - lower than even the growth rate in the year of global crisis. The country has been seeing consistently falling growth rates since the fourth quarter of FY 11. Cumulative industrial growth has been in the negative zone (at -0.1%) during Apr-June, 2012. Investment sentiment has remained weak for the last 18 to 20 months. In just a year’s time, the growth in the credit of commercial banks (in terms of fortnightly averages) has decelerated from 21.4% in AprJun, 2011 to 17.7% in Apr-Jun, 2012. The output of domestic capital goods has been posting negative growth since June, 2011 and machinery imports’ growth has turned negative since May, 2012. Corporate profits have declined significantly since Oct-Dec, FY 11. The rates of savings and investment that had fallen sharply during the global crisis have not recovered to pre-crisis levels. In fact the latest data release by the RBI

While the consumer demand conditions have also started worsening, large national deficits around 9.0%-10.0% of GDP during the last four years and the current account deficit at 4.0% of GDP in FY 12 do suggest an overhang of demand despite persistence of inflation. The downside risks to growth and upside risks to inflation have further been aggravated by the weak monsoon this year. The monsoon deficit of the entire season till August 22 is quite high at 14.0% of the long-period average. According to reports, the monsoon deficit is affecting western oilseeds and cotton growing areas of the country. Even cereal and pulses production is under threat this year. These stresses certainly weigh on the Indian banking sector. A combination of slowing growth and higher interest rates means banks will have to struggle to grow business and asset quality concerns will be aggravated. Stagnation on the structural reforms front would worsen the asset quality of banks vis a vis large corporates, infrastructure projects, etc., while the stresses in agriculture and external environment would increase delinquencies in farm and small scale loans. Slowing revenues and higher provisioning burden on account

February 2013


Similarly, high fiscal deficits and the resultant high investment of banks in the government debt, have also increased the vulnerability of Indian banking industry. To avoid the build-up of systemic risks, the country requires complementary monetary and fiscal policies. The current economic slowdown combined with persistent, high inflation are primarily due to the political delays in returning to fiscal consolidation (the country has four years of high fiscal deficit), low agricultural productivity and weak supply side management (that includes various issues like procurement & public distribution system, politics of minimum support prices and food & fertilizer subsidies, absence of retail liberalization, etc.), worsening investment climate on account of infrastructure bottlenecks, acute slowdown in getting necessary government approvals and increased cost of doing business in India.

of elevated slippages are likely to drag the earnings growth of banks significantly. The lack of committed effort so far towards fiscal consolidation has increased the probability of a ratings downgrade for the country, which, in turn, would increase the spreads on the overseas borrowings by banks. As it is, domestic funding costs have remained elevated for banks for a couple of years due to persistent inflation. Coming now to the possibility of a systemic risk for India, one has to admit that the RBI’s focus on financial stability; its tight implementation of macro-prudential policy (like changing the risk weights on the banks’ exposure to sensitive sectors like real estate, NBFCs, commodities, etc.; the recent guidelines to limit the banks’ exposure to their group companies, etc.) have so far helped the nation avoid the build-up of systemic risks.

The RBI’s close monitoring of banks and dedicated attention to financial sector stability may not help for very long, unless the government kick-starts the investment revival by showing a strong sense of conviction. If the current trends continue, there is a possibility that we may return to the phase of chronically low growth and increased distress. India is definitely on a slippery slope.

However, a macro-prudential policy working in isolation is not enough to avoid the build-up of systemic risks. Banks are not likely to perform well and remain sound, when the real economy is performing poorly. Banking industry’s health is closely linked to the evolution of the net worth of its borrowers. Continuation of stagflationary conditions and the resultant high interest rates will lower investment further, and impact negatively on financial intermediaries.

Thank you. (Paper was presented at the GL-UB Finance Conference, 27th August, 2012)


Don’t Build Dams During Floods Priyanka Venkatesh

Great Lakes Institute of Management

We all love optimism. It is always tempting to get carried away by the ever blissful sounding “growth story� of India and remain oblivious to the actual state of the country which is currently facing many macro economical problems of fiscal deficit, unsustainable subsidies, low growth etc. India has entered the storm of globalization without a lifejacket. The Indian democracy, the largest in the world, has not always been guided by the objective of maximization of growth. Instead, there have been many occasions when the government has misused fiscal instruments, most notably budget and fiscal deficits to capitalize on its political gain in order to retain power. This they have attempted to do through various scheme based expenditures which have no return possibility to the exchequer what so ever. In this sense, the politicians and voters in India, have been found to be somewhat myopic. The voters want immediate benefits from the political parties and the parties adopt short term populist measures and resorts to distributive politics in order to strengthen its support base. Such acts of economic desperation mostly backfire and undermine the long term growth of the nation.

Not only has the share of revenue expenditure increased over time but, even within revenue expenditure, substantial expenses have been on interest payments and subsidies. This increasing ratio of revenue v/s capital expenses indicates that more funds are being allocated for less productive activities leading to a slump in growth over time. In the meantime, the government is unable to contain its fiscal deficit to under 5% of GDP due to large slippages in the expenditure cuts announced during various budgets. In the wake of the global financial crisis, when western nations instituted expansionary monetary policies and inflationary measures, the Indian fiscal policy responded with counter-cyclical measures of tax cuts and increase in expenditures leading to increased prices and inflation. More money in the hands of people but no proportionate increase in output because of a lax in monetary policies (among other factors) heralded the beginning of a period of stagflation. Not enough efforts have been taken to address sustainable inclusive growth. In the future, the focus should be on monetary tightening, bringing in new tax reforms and targeting social expenditures by improving infrastructure, developing small and medium enterprise sector and by building skills. Collaborative improvements in the formulation

The predominant view in India is that the rise in inflation in the last few years is due to supply shocks -of oil and agricultural produce. But this is not true as supply shocks are short term and get automatically adjusted in the long term and are not responsible for long term inflation. Hence inflation that prevails for more than one period must be demand induced. However in India, the supply-shock inflation has cascaded in to long term core inflation. Also the fiscal policy of India over the years indicates that the government, due to ulterior political motives, spends more on revenue expenditure compared to capital expenditure.

February 2013


and governance of public programs are critical to get desired results from public spending programs. India’s present policies for the agriculture sector are targeted towards short-term re-distributive measures. The agriculture sector is the source of livelihood for about 56% of Indians and 43% of land in India is used for farming but all this contributes to roughly only 17% of the nation’s GDP. Agriculture sector is still not well developed and faces a lot of problems resulting in low productivity of crops. Over the last three years the agriculture sector growth has averaged 2.1% with high inflation, while the non agriculture sector has grown five times as fast with much lower inflation. The dismal state of agriculture in the country is a cause of worry. The effect of this low growth due to lack of long term reforms on the economy and overall economic welfare is phenomenal.

implies increased costs, price risks and uncertainty. India’s large agricultural subsidies are hampering productivityenhancing investments, the lack of which is resulting in the farmers using archaic methods of cultivation.

Our government needs to also do a serious rethink on the subject of subsidies and evaluate their true usefulness. Are they benefiting the targeted people? Are they worth the cost of the resulting distortions in the market? Subsidies intensify the severity of the fiscal deficit problems over the long run leading to higher long term inflation. Providing subsidies should ideally be a short term stop gap arrangement to cushion people from the immediate effect of various shocks. There must be a holistic approach to the problems faced by the agricultural sector and the dependence on imported oil in India. For instance, measures to provide farmers the opportunity to fix prices for their products like in other sectors and allow them to export their produce without govt. intervention in labour, land and credit markets may help. Measures to encourage the use of alternate sources of energy may help too. There is also an immediate need for increasing agricultural productivity through technology and infrastructural improvements. Overregulation of agriculture

The major factor for our economic woes is policy failures and not external issues as exports are not the dominant factor of GDP and slack can be compensated by domestic demand. Private sector capital expenditure responsible for India’s past growth acceleration should be revived. The development of a home market for products with a mass consumption base has to be a priority with the government of liberalised India. Mere growth of the GDP at the macro level due to populist policies and reactionary revenue expenditure in billions does not solve the poverty and purchasing power of the people at the micro level. Mercantilist attitudes of politicians and some corporates has diminished entrepreneurs’ access to capital and led to hindered regional productivity, innovation, and growth. As RBI stops inflating, India will surge forward on a more sound foundation. The welfare of a country is enhanced when growth is sustained by the bottom rung of the society.


The Power Of Hydrogen: MacroEconomic and Geopolitical Implications Mahesh Venkitachalam & C.N.M. Lavanya

Great Lakes Institute of Management Why Hydrogen?

A project funded and run by European Union, India, Japan, China, Russia, South Korea and United States, in Southern France is trying to create the second element in the periodic table, viz., Helium, by colliding two atoms of Hydrogen. This primary reaction will generate significant energy. Meanwhile, in the World Hydrogen Energy Conference, automobile majors have all confirmed plans to produce hydrogen-fuel cell vehicles by 2015. These two unrelated events have drawn little media attention. However, the materialization of these two projects would have a very significant impact on the world economy since the Industrial Revolution.

Earth is an abundant source of Hydrogen. It is the most abundantly available element in the universe. So, the only problem that stands before Hydrogen fuel cycle is the perfection of technology to extract energy out of Hydrogen economically. This may be a very difficult technology to come up with, but scientists are bullish about the prospects of this technology materializing. Control of Hydrogen: Unlike the current struggle to control oil and natural gas, the world would have abundant supply of Hydrogen and the probability, of power struggles due to Hydrogen, is seemingly low.

Before dwelling into the implications, the importance of these two projects to the world economy is highlighted as under: In the year 2008, coal, natural gas and oil together contributed to almost 67% of the world’s source for electricity generation. However, burning any of these fossil fuels is not sustainable in the long-term. One of the available long-term options is for the world to go nuclear. Both nuclear fission and fusion are going to be prominent sources of energy of the world in the future.

Empowering poor: The disparity between the rich and the poor is startling. Inadequate access to electricity is, in a way, contributing to this problem. Access to Hydrogen energy would mean more economic opportunities. Unleashing the potential of Hydrogen energy, coupled with a good distribution network, would be the one of the foremost tools in lifting billions out of poverty.

Automobile majors are in the aggressive pursuit of plans to come up with hydrogen-fuel cell vehicles. Petrol and diesel will start to see diminishing sales in the coming decades and the significance of petrol in world economy will possibly be low by the middle of this century.

If all the countries could produce the energy that could satisfy their requirements, it would transform the balance of power. Local people would feel more empowered and communities would become more self-sufficient.

In this article, the macro-economic and geopolitical implications of these two transitions on the world economy are sought to be traced. A snapshot of the world economy somewhere around the mid to late part of this century has been provided towards the end of this article.

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The massive oil bill can be reduced by the oil/natural gasimporting nations. Fall in this expenditure would lead to a fall in the fiscal deficit, thereby consolidating the financial


positions of these countries. This would give more room to the decision-makers of these countries to address poverty in a much better way. The positive impact of hydrogen energy would have a pronounced impact in countries of South and South-east Asia.

losing out. The next phase of Industrial Revolution would bring about massive economic and geopolitical changes in the world economy, similar to the changes that the previous industrial revolution had brought about. Against this backdrop, one may believe that the world is heading towards an inclusive phase of growth, wherein the countries with ‘demographic dividend’ are likely to benefit more because of their sheer size. The role of Asia and Africa will purportedly see a rise in world economics and decisionmaking. However, this growth may begin to impact the energy surplus countries of today such as Russia, Canada and OPEC.

CLEAN ENERGy: Unlike the traditional sources of energy such as coal, oil and natural gas, hydrogen energy is sustainable and not harmful to the ecosystem. The by-product of converting hydrogen into energy is clean water. Such a source of power is very appropriate for the future.

Even though the significance of hydrogen as a fuel in this article has been written about, there are other sources of renewable energy, viz., wind, solar, jatrophabiofuel, to name a few, which are equally promising. Nonetheless, looking at the prospects that hydrogen is able to generate as a fuel and notwithstanding the contribution from other resources, it may be said that hydrogen will end up becoming one of the most important fountainheads of power in the future.

THE NExT INDUSTRIAL REVOLUTION: Energy has predominantly been the source of an industrial revolution. Opportunities have generally poured in as better methods of energy generation have come by. In the 19th century, coal and natural gas drove the Industrial Revolution. This created a significant change in balance of geopolitical power with Europe benefiting the maximum and Asia relatively


Raghunathan T & Pratik Kumar

Great Lakes Institute of Management

Keynesian Economics In this article, we intend to brief about the Keynesian economics and its practical implications in day to day life.

to 1932, Federal Reserve had cut its interest rate by 25 basis points about 20 times; hoping economy will stabilize the classical way. Keynes said that savings doesn’t follow interest rate cuts because the income effect and the substitution effect goes in the opposite ways. That is, as the rate of interest of loans decreases, commodities with greater demand in the market get sold at a greater rate. In addition, investments in plant assets or equipment were done with a longer time scale in focus. During times of paranoia, people were scared if the business will be profitable. Hence, the investments are not easily done by private parties. He also argued that savings and investments were not the primary determinants of the interest rates specifically in short run. Instead, the supply and demand for the money was a bigger concern in the shorter run. That is, even if there are huge savings, when there is a greater demand for the money, the interest rates will have to be cut. Finally, he felt that classical theory might not work in terms of adversities, because people may continue to hoard money expecting deflation. This might result in less trade there by creating a liquidity trap. This results in piling up of goods which results in unproductive inventory and in unemployment of large group of people.

Keynesian economics refers to a school of economic thought proposed by Lord John Maynard Keynes in his book, “The General Theory of Employment, Interest and Money”. This theory was introduced during the times of “The Great Depression”. Keynes stated that “Government must not be silent spectator, but should actively take part in spending money during times of crisis”. During times of crisis, Keynes observed that private sector usually led to inefficient macroeconomic outcomes which needs active fiscal/monetary policy from the government to stabilize output over the economic cycle. This was majorly because, many macroeconomic decisions when taken by a large group of people, results in excess supply; whereas the demand for the products are not felt to that specific extent. Classical theory of economics stated that, the market has a self-adjusting mechanism which brings back the economy to the real level of GDP. However, Keynes observed that, excessive saving, i.e. saving beyond a point led to serious issues which often resulted in recession or depression. He stated that the market doesn’t behave in a Laissez-faire way. His argument was four fold. During the time period of 1929

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Keynesian economics has been used extensively by the government across the world, especially during the 50s


investments. Further, the crowding out of private investments has happened due to reasons mentioned before.

and 60s. The methodology was successful in preventing the economy from overheating and also to prevent depression and big financial crisis. The latest use of Keynesian economics is demonstrated by the fiscal policy taken by the governments around the world during the financial crisis of 2008. However, there was a basic flaw in using the stimulus measures by the governments. When the economy goes into recession or a slowdown mode, the aggregate demand would fall and the unemployment rates would go up. If the government immediately stimulates the economy by the means of government spending, there would be positive as well as negative effects. The positive is that the private demand lost is replaced by the public demand which stimulates the economy back into shape. However, it also leads to crowding out of private investments as the government spending is essentially a deficit spending, and deficit spending is funded by issuing government bonds. So, as the demand for bonds goes up, the private sector investment gets crowded out. This is exactly what has happened to India in the aftermath of financial crisis of 2008. The fiscal policy was made very loose, which resulted in huge inflation while pulling the demand up; again to arrest inflation, monetary policy was tightened by RBI by increasing interest rates, which resulted in slowdown in

Hence, it is essential to use Keynesian economics in the right way. In fact, Keynes had advised to use fiscal stimulus only when there is persistent unemployment. This would ensure that inflationary pressure would not appear from the wages generated by government deficit spending. Further, if deficit spending is used during high unemployment, the extra money circulated in the economy would actually stimulate demand and encourage businesses to invest. The crowding out of investments would not occur in this case; however, if stimulus is given too soon, the higher employment can push the wages through the roof, creating inflation and also would not incentivise businesses to invest because of high cost of factors of production, and can also lead to crowding out effect. As the world has become more interlinked, the use of Keynesian economics in the right context is extremely essential. Present experience tells us that stimulus measures by all government across the world may not be the right response to a crisis; rather it has to be handled by the individual governments in the domestic context to keep the domestic economy in shape.


European Debt Crisis Explained Ankit Sethi

Great Lakes Institute of Management

European debt crisis has been in headlines for quite some time now. But why is that we all are talking about it? Many countries take Debt but what differentiates Europe (PIIGS*) from others i.e., they don’t have money to pay back. Now that’s a problem? To deal with this problem we have IMF, ECB, EFSF and many more. But why we have this problem. Let’s have a look at this from a broader point of view. When does your debt becomes a problem? Government debt + Banking System > 5x Revenue The above equation is a white paper equation of Debt as a part of the system. What this equations tells us this – if your banking sector and debt is huge, It’s difficult to government to bail out any one them in crisis. If both fall, some serious trouble is coming your way?

Now can you compare German economy with Greece? No, but Greece and others dint realised until the bubble burst in 2009 after the US financial outburst. These countries than had enormous amount of funds flowing primarily debt funding.

Some figures as per the equation- Ireland (43-45x), Greece (8-10x), Germany (8-10x) and many more. Now the question is why Greece is in crisis but Germany isn’t? Because Germany has a healthy economy with positive BOP*.

Reasons? It’s not that all the countries in European Union are going through bad phase. There are few countries that are overleveraged i.e., debt to size of economy is high. PIIGS* unfortunately are the ones who are over-leveraged. Italy’s Debt is 121%,Ireland is 109% and Greece is 168%.

As per the above graph, Current account is running in negative for PIGS* i.e., money is flowing out of the economy but in case of Germany money is flowing in. This money will end up in the banking sector. *PIIGS- Portugal, Ireland, Italy, Greece and Spain How it started? This all started with the formation of European Union (EU). In the year 1958, European Coal and Steel community was established which later became EU by the Maastricht Treaty in 1993. Euro was introduced as the single currency and countries started to join EU. So how did EU helped European countries? Before EU, countries like PIIGS* were borrowing at a much higher rate than other countries. With them coming together their borrowing rate fell. They started borrowing at rates on which Germany was borrowing.

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the same work ethics, retirement ages or budget discipline — you end up with German savers seething at Greek workers, and vice versa.

However each chose a different path to reach on above figures. Ireland wound up saving banks, Spain went through a housing bubble, tax revenues were not high for expenses but borrowing was less though. Greece not only borrowed but overspent, had less economic production and some creative account-keeping.

How it started? This all started with the formation of European Union (EU). In the year 1958, European Coal and Steel community was established which later became EU by the Maastricht Treaty in 1993. Euro was introduced as the single currency and countries started to join EU. So how did EU helped European countries?

Data as per Feb 2012- * this may have changed. Countries Japan Greece Italy Ireland Portugal Belgium France Germany UK

Debt as a % of GDP 233.10% 168.20% 120.50% 108.10% 101.60% 97.20% 85.40% 81.80% 80.90%

Unemployment rate 4.60% 19.20% 8.90% 14.50% 13.60% 7.20% 9.90% 5.50% 8.40%

Credit rating (Moody's) Aa3 Ca A3 ba1 Ba3 Aa1 Aaa Aaa Aaa

Before EU, countries like PIIGS* were borrowing at a much higher rate than other countries. With them coming together their borrowing rate fell. They started borrowing at rates on which Germany was borrowing. Now can you compare German economy with Greece? No, but Greece and others did not realize the same until the bubble burst in 2009 after the US financial outburst. These countries than had enormous amount of funds flowing primarily debt funding.

Who is at fault here- EURO or Union?


The golden question –was it a mistake to accept EURO as a single currency?

It’s not that all the countries in European Union are going through bad phase. There are few countries that are overleveraged i.e., debt to size of economy is high. PIIGS* unfortunately are the ones who are over-leveraged. Italy’s Debt is 121%,Ireland is 109% and Greece is 168%.

I seriously don’t feel that EURO was the problem here. Kindleberger book titled “manias crashes and panics” rightly state that it’s GREED that kills one and his/her country’s future. These over leveraged countries were facing some tough time in 2000. They started borrowing heavily through some financial instrument (which led to downfall of US economy) and other external ways. It was all going good until Greece realised they have mismanaged their accounts for quite some time now and the world should know about it. They totally disregarded the pledge they took under Maastricht treaty of having 60% debt to GDP ratio. If EURO was helping free flow of money, these economies used it to such extent that it became difficult from them to ride on this. When you have a monetary union you should also have fiscal union. Germany had strong fiscal policy but PIIGS don’t.

However each chose a different path to reach on above figures. Ireland wound up saving banks, Spain went through a housing bubble, tax revenues were not high for expenses but borrowing was less though. Greece not only borrowed but overspent, had less economic production and some creative account-keeping. Data as per Feb 2012- * this may have changed. Countries Debt as a % Unemployment Credit rating of GDP rate (Moody's) Japan 233.10% 4.60% Aa3 Greece 168.20% 19.20% Ca Italy 120.50% 8.90% A3 Ireland 108.10% 14.50% ba1 Portugal 101.60% 13.60% Ba3 Belgium 97.20% 7.20% Aa1 France 85.40% 9.90% Aaa Germany 81.80% 5.50% Aaa UK 80.90% 8.40% Aaa

Columnist Thomas L. Friedman wrote in June 2012: “In Europe, hyper connectedness both exposed just how uncompetitive some of their economies were, but also how interdependent they had become. It was a deadly combination. When countries with such different cultures become this interconnected and interdependent — when they share the same currency but not


Columnist Thomas L. Friedman wrote in June 2012: “In Europe, hyper connectedness both exposed just how uncompetitive some of their economies were, but also how interdependent they had become. It was a deadly combination. When countries with such different cultures become this interconnected and interdependent — when they share the same currency but not the same work ethics, retirement ages or budget discipline — you end up with German savers seething at Greek workers, and vice versa.

Who is at fault here- EURO or Union? The golden question –was it a mistake to accept EURO as a single currency? I seriously don’t feel that EURO was the problem here. Kindleberger book titled “manias crashes and panics” rightly state that it’s GREED that kills one and his/her country’s future. These over leveraged countries were facing some tough time in 2000. They started borrowing heavily through some financial instrument (which led to downfall of US economy) and other external ways. It was all going good until Greece realised they have mismanaged their accounts for quite some time now and the world should know about it. They totally disregarded the pledge they took under Maastricht treaty of having 60% debt to GDP ratio. If EURO was helping free flow of money, these economies used it to such extent that it became difficult from them to ride on this. When you have a monetary union you should also have fiscal union. Germany had strong fiscal policy but PIIGS don’t.

Country/ Borrowed from Greece Italy Portugal Spain Ireland Total

France 41.40 309 19.1 112 23.8 505.30

Spain 29.5 65.7 95.20

Who is affected? There are many sovereigns and private institutions that are affected by this debt crisis. Many countries invested their money as the RISK was pretty less as countries were part of one monetary policy. The reason why Germany, France are putting efforts is because their banks have lot of money invested across European Union. A default will push their economy into trouble. The amount of borrowing between private players and government is very high. Few figures (in billion Euros) dated 2011:

Portugal 7.5 19.7 27.20

Italy 2.8 2.9 22.3 28.00

US 6.2 34.8 3.9 49.6 39.8 134.30

UK 9.4 54.7 18.9 74.9 104.5 262.40

Japan 32.8 20 15.4 68.20

Certainty is still not certain. Still a ray of hope is alive. But the big question is – Is the lesson learnt?

As you can see US, France, UK and Germany had quite a lot of money stuck in PIIGS. The irony is Germany, France are contributing to EFSF, ECB to save themselves and the union. This is called Financial Contagion. If Greece had defaulted in November 2011, close to 83.2 Billion EURO would have been wiped off. That would have created huge pressure on Germany, US, UK and France. What happens now? The troika of European Commission, the International Monetary Fund and the European Central Bank is certainly putting lot of efforts to close the deals. Many private players were and will be asked to write off their debts. With EFSF being poured with Euros debt crisis will be over in near future.

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Germany 15.9 120 26.6 131.7 82 376.20

Credits: Sanleen N. Pal Great Lakes Institute of Management


Why Did Foreign NBFC’s Fail in the Indian Market Space? Abhinav Verma

Great Lakes Institute of Management “Slow and steady wins the race”. The irony of Indian NBFC market is defined by the vice-versa situation. Let’s go to late 90s. It was the time when many Foreign NBFCs entered Indian market into retail lending domain and the pioneer in changing the scenario were two major companies GE countrywide and Citi financial. In a matter of months, Indian lower middle strata with an average income of Rs 3000- Rs 6000 per month were considered as kings and for the first time they got the taste of unsecured lending. Everybody started thinking of spending today and paying tomorrow. The only thing they didn’t understand was the Interest rates. Big branches, sophisticated Relationship Managers, “Happy to Help” attitude of sales force made the credit easily available to people. It was an era of Small ticket personal loans (STPL) ranging from 10k to 50 k with an IRR ranging from 30 % to 50 %. These companies were on expansion spree and more and more branches were getting opened in almost every city with logic “More the spread, less the risk”. The credit parameters got simplified. Anybody with a copy of ration card and a newly opened bank account could have got a loan of at least 10k.

customer files stated getting cooked to the unprecedented levels. Being technology driven companies, both GE and Citi have automated the credit processes. With just inputting the customer bank account details and income details, the system showed the eligibility with the loan amount, tenure and interest rate that need to be charged. There were certain issues with any automated credit system; It was not able capture the seasonality of the business which can only be identified by a personal discussion. Small Indian traders work with a very high seasonality factor and their 75 percent of the annual turnover happen in a period of 3-4 months. In order to understand the customer requirement, it is essential for a credit underwriter to understand the business cycle and that skill was not present in the freshly passed out MBAs who were being made relationship managers.

Disbursement preference was usually given to quantity rather than quality. About more than 60 percent of the monthly disbursement used to happen in the last five days of the month. Most of the companies used to have sales force off the rolls with limited ownership and also an alternate channel in the form of commission agent, also known as direct sales agents (DSAs). The incentive or the commission structure was in the range of about 2-3 % of the amount disbursed and this attractive incentive structure gave way to the downfall of retail lending companies.

In order to reduce risk on one customer on one side and complete the targets on other, underwriters started the system of under lending in which they lend about 30-40 percent of the customer requirement. The other major reason for also the underwriting approval for that amount was in their signing authority. This whole process gave way to broker system whose major work was to apply on behalf of the customer at various financial institutions at the same time and take the disbursements from all the lenders. In this whole

By 2002, both the companies were disbursing more than 15k loans per month and huge incentives for the sales force gave way to “Greed” and they started playing with the system by educating customers with loopholes available like how to maintain transactions? , how much minimum balance should be there at least three months before the loan, the dates at which the balance should be highest. The


the lending space, Fullerton India credit company limited (FICCL), a fully owned subsidiary of Tamasek holdings, Singapore, and redefined the distribution system of consumer finance. They took the sales force on rolls to promote ownership, defined the distribution are of a branch to encourage relationship with customers and hired employees with totally different skill set for business loan lending and personal loan lending for salaried class to have better underwriting mechanism. Started from about 20 branches in 2006 they reached to the epitome of 1000 branches by mid 2008 and became the largest NBFCs in terms of distribution, only to come down to almost half the number by next year.

process broker used to take fixed brokerage which can even range from 10 percent – 25 percent of the total loan amount and this led to over leverage.

All these companies suffered from the same syndrome, very high orientation towards quantity lending rather than quality lending. On the other hand companies like HDB financial services (NBFC of HDBC bank), HDFC ltd, Muthoot finance have worked in the same environment and grown to the unprecedented levels. The only reason for their success is patience and readiness to change their credit underwriting policies and more importance to understanding customer business cycle and not income statements. To sight an example Muthoot finance hires Branch Managers who are retired bank employees and this gives them a cutting edge in terms of vast lending experience and relationship management skills.

This whole system lead to huge defaults, say a person takes a loan of 50k for a period of three years @ 36% flat with processing fees of 4 – 5 percent. He gets in hand around 47k and out of which he pays about 5k to the broker. The net he got was 42 k and he has to return around 150 k back. None of the business generates that much profit. By 2005 the reserving of the NBFCs was at all time high. They payments buckets were moving from 30+dpd to 60+dpd to 90+ dpd very quickly. Front level employees started changing the companies at a very short interval and no ownership of the lending portfolio was there at the bottom level. The model which was initially designed to be relationship based turned the customer into a commodity and Loan a run of the mill product.

In my view and lending company can have a profitable portfolio in Indian market if at all they have some patience, ready to unlearn and learn from the new experiences and can adapt to the different and ever changing culture of Indian terrain.

At the same time there was a new MNC which entered

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Innovation in Banking and Financial Services Mitika Bajpai

Great Lakes Institute of Management

A brief history of banks When the Gods in Rome in early 2000 BC started lending and depositing money they never thought that this would someday become so big an industry that will keep shaking the word from time to time. Banking has evolved over the years and changed radically after European renaissance in 14th century. “Banca Monte dei Paschi di Siena” was the first the bank setup in this era in Italy and which is in existence till date. After that in 1656 when European Bank issued the first banknotes and rapidly started changing the face of the industry. From latter half of 18th century and to the end of 19th century, more banks were opened In the region of North America specially United States. Some of the major banks of today the likes of Bank of America, RothSchield, Citibank,Deutsch Bank,JP Morgan etc… were incepted in this era only. And as per the total number of operating banks in the world are more that 1200 at present. Banking industry now has become very competitive. And innovation in various aspects of banking is much needed to not only grow but to survive as well.

jointly by Infosys and European Financial Management Association of European retail banks reflects that Corporate and Retail Banks are facing stiff competition in the market from new entrants and innovative business model. Survey results showed that every 4 out 5 respondent s said that innovation was extremely important for achieving growth and efficiency. Albeit the importance of innovation is clear another study done by Infosys and Asian Banker Research shows that only 18%.

Modern Banking and Innovation After the end of World War II Banking industry saw more modernization. As per an article published in Wharton today on “The history of modern banking” the banking as we see it today started from 1960 when Charles Sanford joined Bankers Trust in United States of America. The most important innovation that is attributed to Sanford is ‘originate-todistribute’ model of lending. By writing and then repackaging loans for sale to other market participants, Bankers Trust established a secondary market for loans. This freed up capital from loan originators’ balance sheets, which could then be used to generate even greater volume of finance.

Percentage Respondents

A perspective on Innovation in last decade Mckinsey did a global survey around 3-4 years back and what they found out was most executives saw innovation as a key driver of growth however most of them were of the view that Innovation is more challenging in financial services institution than for companies in other sectors. Similarly a survey done

banks in Asia have a formalized innovation strategy. Generally an innovation is perceived as a breakthrough product or


Global Recession and present

technology but in banking however it takes on additional dimension and that of the process. The processes surrounding a new product or technology are as important as their features and could add significant value by way of cost saving, improved productivity and so on. Most of these process innovation come through technological advancement, just see the face of banking today, Internet has been the forefront of channel Innovation heralding first online and then direct banking. The graph clearly shows the cost effectiveness achieved by technological advancement in banking channel.

Post the fall of Lehman Brothers and subprime crisis banks have been taking very conservative approach over the last two years as many have been consolidating their portfolio and innovating products had lost its importance and has taken a back seat. We have not seen many innovative products designed for customers during the consolidation phase, and rightly so, as the primary focus of Banks has been in cleansing their portfolio and tightening credit extension apart from being extremely guarded in getting only credit worthy customers in their books. Below diagram (Fig -3, Source – Asian Banker Research) shows sustainability of types of bank post subprime crisis. As per the current trend the Force of change in the banking industry is the rapid evolution of consumer wants and desires. Consumers are demanding anytime-anywhere delivery of financial services along with an increased variety in deposit and investment products. There are institutions which are investing on innovation. A survey was done by Infosys and the Asian Banker Research to gauge the change in investment done on innovation by banks. The graph (Fig-4) shows that in Southeast Asia around 59% banks have increased investment on innovation. Like the Singapore based Overseas Chinese Banking Corporation Limited (OCBC) was awarded as the most Innovative Bank in Asia Pacific Region at Banking & Payment Asia (BPA) Trailblazer Awards 2012 for their efforts in automating the processes and product excellence in payment innovation. According to Ching Wei Hong , who is COO at OCBC , now one can open an account at the bank without filing a single paper.

Courtesy: KPMG’s study on technology enabled banking transformation. ZOPA: a disruptive innovation In 2005 first of its kind a peer to peer lending company ZOPA was launched. Which acts as ‘Man in the middle’ and facilitates to loan process? Here borrower’s credibility is graded by a reference agency called Equifax and background checks for lenders are also done to ensure that they are bonafide. And a loan ranging from 2000-15000 pounds can be availed. In case of defaults lender’s detail are handed over to a third party agency which follows the same processes as typical High street banks for recovery. ZOPA has expanded its operations from UK to Italy and Japan as well. In the United States, several Credit Unions have tied up with similar online lending platforms. While the jury is still out on whether social lending is a serious threat to conventional banking, there is no doubt that its simple and cost effective proposition holds much appeal.

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A few success stories: Indian Context Yes Bank A relatively new born bank in the Indian Banking Industry, it was setup in 2004, which is now fourth largest private bank in India, received ‘The Financial Insights Innovation Award at the Asian Financial Services Congress, Singapore’ for the most effective use of technology in day to day business and operations of the bank. Apart from this Yes Bank is also recognized for innovative product offerings. Such Honey Farming where the bank extends small loan to honey farmers and farmers provide their honey as the collateral, Responsible Banking model which aims at developing innovative business solutions for social and environmental problems.

One more bank ‘La Caixa’ won the most innovative bank award for exemplary work in incorporating.

State Bank of India after taking lessons on rural banking from consulting giant Mckinsey is leveraging its breathtaking network in rural areas in India. SBI has launched an innovative program to educate the farmers about various crops and have launched ‘Kisan’ cards through these instruments they are able to build a relationship with the villagers. SBI has also setup innovative ‘Crorepati’ branches for their privileged customers to enhance the relationship with them.

the technological developments. Deustch Bank in Europe is also recognized for its strategic presence in Social Media. BNP Paribas has been very aggressive about innovations employees within the company are given opportunities to innovate and present their idea in various events. Some of the best ideas are then adopted by the company which contributes to the growth engine. Royal Bank of Scotland (RBS) innovated a smart phone app for banking and claims that transactions done over the years has reached a value of $2 billion.

The road ahead In the wake of economic crisis post recession in 2007-08 and now faced with stiff euro zone crisis banks are going to be the first victim and then it would boil down to other industries. The current economic scenario as well as very stiff competition in the market place has necessitated the innovation in banking institutions. As we have seen technological advancement or technology enabled transformation are on top of the priorities for innovation labs. The rise of mobile banking, smart apps on smart phones are delivering customers banking services on tap of their fingers. Privileged banking, NRI Account scheme are all possible because of high end technology and efficient CRM systems. There is no doubt that technology over the years has changed the face of banking and we can all only wait and hope to see more innovative products and services by the banks in the near future to come.


Rupee Stabilization Measures Srinivasan Iyengar

Great Lakes Institute of Management

Introduction: As per the market principle, when demand of any commodity increases its price increases. So, in our current scenario, due to the turbulent economic conditions (Euro crisis and high inflation), people (or nations) want to resort to safer currency (commodity) – which is dollar. Hence, in this case when demand of dollar w.r.t. rupee is increasing it would mean that value of dollar will increase that is one would need to pay more rupees to get one dollar. This is what is triggering the volatile exchange rate of the rupee against the dollar.

·The most obvious of all, is the RBI intervention by infusing dollars in the market. As of now the nation’s Forex reserves are over $ 300 billion (which covers 95% of the country’s external debt).So, RBI in the course of manipulating the rupee against the dollar would very soon run out of its dollars, if it keeps pumping its dollars into the market. Also, it is not a viable option in the long term. Also, since the dollar is a globally traded currency (having a far wider reach than any other currency), efforts by RBI to revive the rupee against the dollar won’t help much.

Major factors affecting the exchange rate : Differentials in Interest Rates (central banks exert influence over both inflation and exchange rates by changing the interest rates eg : REPO, CRR etc. ) Differentials in Inflation(relative inflation between trading nations, wherein the nation with lower inflation is in an advantageous position)

The Government should consider increasing the FDI in the sectors like the retail and aviation – wherein there are players ready to invest in India. (eg : In aviation sector , Singapore Airlines is ready to foray in FDI and in case of retail – IKEA ).

Current-Account Deficits(the balance of trade between a country and its trading partners) Public Debt(large-scale Bond financing to pay for public sector projects and governmental funding)

The impetus should on the development of the infrastructure, which will help to pump in dollars in the nation. (Though there are foreign players in collaboration to build infrastructural projects in India), the Government should reduce the redtapism in order not

Terms of Trade (agreement between trading nations eg : Most Favoured Nation). Measures by the Government and RBI to stabilize the rupee :

·to lose these investment opportunities by the foreign investors to others in the BRICS (Brazil, Russia,India,China, Russia)

The aim here is to increase the supply of the dollars in the market which in turn would help to project the country as “investment- friendly” in the global market.

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from State Bank of India and the remaining through the bids from 16 identified public and private banks). Though holding the dollar window for the oil companies is okay with respect to the minor volatility control in dollar/rupee (due to the various prices offered by the various banks), however in the long run, it would lead to the erosion of the exchequer.

Moves such as allowing foreigners to invest in Indian stocks, the liberalization of the NRE interest rates are a big welcome thereby inducing the Indians abroad to invest in India by incentivising them with higher rates of return and tax free accounts (for NRIs). ·Also, issuance of the Sovereign guaranteed bonds (debt bonds) to the NRIs at attractive interest rates would attract the foreign investment in the country.

The other option is the usage of the Nostro-Vostro accounts. The best example is that of the payments that were remitted to Iran by India for the crude oil import. (As per the payment mechanism, Indian oil refiners can pay up to 45 per cent of their oil imports from Iran in rupees. Iran will then deposit this amount in a separate account and utilise the money to import from India and make payments to the Indian exporters concerned.) Thus payment of mechanism being rupee, Iran can use this rupee to import non-durables from India like wheat etc. Thus, it would help to overwrite the base currency of the transaction from dollar to rupee. Also, it would facilitate the ease of the transaction by reducing a level of intermediate currency like dollar. [Conventional flow: Rupee US Dollar Local Currency (e.g : Iranian Rial or Saudi Rial.) So, by usage of the Nostro-Vostro accounts, the trading nations can eliminate the dollar’s role involved]. Also, this shifts the dependence of the rupee and spreads it over the other currencies, thereby immunising the rupee against the dollar. This practice can be implemented with the Gulf countries from which India imports majority of its oil.

By hiking the interest rates within the nation (making borrowing costlier for the banks), RBI can make it viable for the Institutes to borrow directly from the foreign markets. Also, the de-regulation of the interest rates on the export finance would help the exporters to raise money freely in the foreign currency without any limit on the interest ceilings. Also, moves like the freeing the manufacturing and infrastructure companies to borrow from overseas can be extended to the other industries as well. · Also, another option is the creation of the regional hegemony (similar to that of China in South-east Asia or Germany in Europe) in the Indian sub-continent, thereby creating more demand for its domestic produce which would help to bolster the rupee and help it shield from the global fluctuations.[e.g. : Chinese renminbi (Yuan)] However, the major factor contributing to influence rupee the most is the crude oil import. Currently, India imports more than 80% of its crude oil requirements and pays in dollar, which is one of the main reasons for continued depreciation of the rupee. There are certain workarounds for the same :

Another move by RBI is that the PSU oil companies will have to buy half of their daily foreign exchange requirements from a public sector bank and they can source rest from any other bank following competitive biddings. Presently, these oil companies, companies seek dollar quotes from multiple banks, giving an exaggerated impression of their demand for dollar. This leads of strengthening of dollar against the rupee – thereby leading to further depreciation of the rupee against the dollar. Thus, by varying the proportion of the amount of money that oil PSUs need to borrow from the public sector banks, RBI to an extent can hedge rupee from sliding against the dollar.

Opening of a dollar window for the oil companies to sell their rupees to the Central Bank and in turn purchase dollars from it at the daily reference rate. However, instead of selling rupees to the RBI, the oil companies can also sell oil bonds to the RBI. This would help to reduce volatility in the rupee by enabling oil companies to directly source a large part of their dollar requirement instead of buying large chunks from the market. (e.g. : Indian Oil Corp, currently buys a 20% of its daily forex requirement



Indian Exports

Indian Imports

February 2013


Indian Industrial Production

Indian Rupee movement



Gold Prices

Brent Crude Oil

February 2013


Competitions @ L’Attitude 13 05’ by FINCOM

Finovate Debt Restructuring and Valuation Competition With the world economy spiralling down and with the current market scenario looking murky, it is time “TO BE DISTINCT OR EXTINCT”. In FINOVATE this year, the focus is on key Indian firms. FINOVATE is an event that encompasses the detailed valuation of an Indian firm or restructuring model for the organization in India facing severe financial distress. With the world economy spiralling down and with the current market scenario looking murky, it is time to “BE DISTINCT OR BE EXTINCT”. In FINOVATE, this year, the focus is on key Indian firms. FINOVATE is an event that encompasses the detailed valuation of an Indian firm or restructuring model for the organization in India facing severe financial distress.

Portfolio Management - Online Trading Event Can one always beat the market? The efficient market hypothesis suggests otherwise. This Alpha Search is a challenge for students to demonstrate their skills in analyzing the opportunities and threats in financial markets and maximizing the return at any given risk. This challenge gives the students an opportunity to be a portfolio manager and discover the strengths and weakness in trading strategies in a virtual money environment.” Portfolio Management refers to the science of analysing the strengths, weaknesses, opportunities and threats for performing a wide range of activities related to one’s portfolio for maximizing the return at a given risk. This competition gives you a great opportunity to wear the hat of a portfolio manager and discover your skills/abilities of portfolio management in a virtual money environment.


FINANCE 3600 EDITORIAL TEAM Prof. Sanjoy Sircar Dr. S.K. Shanthi Glenn D’souza Priyanka Venkatesh Siddharth Venkataraman

February 2013



Finance 360 – Feb 2013  

Finance 360 – Feb 2013 – by FINCOM, Great Lakes Institute of Management, Chennai

Finance 360 – Feb 2013  

Finance 360 – Feb 2013 – by FINCOM, Great Lakes Institute of Management, Chennai