Niveshak Dec15

FROM EDITOR’S DESK

CONTENTS

Dear Niveshaks,

Niveshak Volume VIII ISSUE XII DECEMBER 2015 Faculty Chairman

Prof. P. Saravanan

THE TEAM Aaron Keith Rego Abhishek Bansal Abhishek Jaiswal Aditya Kkumar Jain Anisha Khurana Ankur Kumar Ankit Singhal Anoop Prakash Bhawana Saraf Devansh Sheth Maha Singh Gulati Palash Jain Prakhar Nagori Rahul Bajaj Ramesh Jaiswal Sandeep Sharma Shreyans Jain Vishal Khare All images, design and artwork are copyright of IIM Shillong Finance Club ©Finance Club Indian Institute of Management Shillong

The month of December started on a positive note with GDP growth accelerating to 7.4% in September quarter and with the expectation that the government would meet its fiscal deficit target for this fiscal, although the Seventh Pay Commission’s recom¬mendation would put burden on the government. The RBI also kept its Repo Rate unchanged, which was as expected, and the governor said he would be pushing for the new base-rate calculation formula.

The month also saw heated debate over GST with the Opposition demanding scrapping down the 1% inter-state sale levy and capping the GST rate to which the government has partly agreed to by including it into in the law. Also the e-commerce companies lobbied to the government to keep them outside of the GST purview.

With the upcoming 4G services, companies like Samsung and Micromax, largest smartphone sellers in India, have shifted their focus on the devices which run faster on 4G network. To strengthen its sellers’ network Flipkart announced that it will give small working capital loans to all its strong network of 80,000 merchants.

The five-year high 9.8% IIP number for October was a big positive for the economy which showed that the economy may be finally out of glut and rising. After two-weeks of negotiations, India finally made it clear in Paris that due to its development agenda it cannot turn back on the coal, though the country is committed to increase its depen¬dence on renewable energy by seven-fold by 2022.

The month also saw the most awaited move by Federal Reserve which raised its rate by 25 bps for the first time in a decade. This ended the uncertainty in the market.

Finance Minister Arun Jaitely introduced Insolvency and Bankruptcy in Parliament which will help in winding up of failed business in 180 days and is in line with the global practices.

The cover story is an analysis of the Federal Reserve rate hike and its impact on the Indian market. The Article of the Month (AOM) discusses about the inclusion of Yuan in the IMF Reserve Currency basket. It talks about the growth of Yuan and the effect of the inclusion on the Chinese economy as well as world economy.

FinGyaan talks about the Derivative market and how it functions and what could be its implication. While the FinSight section analyses the reason as to what led to the delay in the growth of India.

This time around we have incorporated a new section named FinRewind which will talk about the major financial happenings of the past. This section will try to analyze the situation both subjectively as well as objectively. This issue has the Impact of the Bretton Woods Conference as its topic.

FinView has the excerpts from Mr. Rajat Mishra, Sr. Vice President , SBI Capital Markets Ltd. who gives his view on the Fed rate hike and the investment climate in the country. Classroom section shares knowledge on Factoring and Forfaiting. We would like to thank our readers for their immense support and encouragement. You remain our prime motivation factor that keeps our spirits high and give us the vigor and vitality to keep working hard. Thank you.

Cover Story Niveshak Times

04 The Month That Was

Article of the month

14 The US Fed rate hike – Impact

Great Leap Forward - China on India and the emerging markets embraced by IMF

10

FinGyaan 18 Derivatives- Changing Financial Times

FinRewind

26

Finsight

EMERGING INDIA: WHY SO LATE?

FINVIEW

22 Impact of the Bretton Woods 29 MR. RAJAT MISRA Conference

Sr Vice President, Infrastructure Group, SBI Capital Markets Limited

CLASSROOM

31 Factoring and Forfaiting

Stay invested!

Team Niveshak

www.iims-niveshak.com Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears no responsibility whatsoever.

NIVESHAK

www.iims-niveshak.com

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The Niveshak Times Team NIVESHAK

US Federal Reserve Hiked up rate by 25 bps The much anticipated rate hike came this month when the Fed inched up its key-lending rate by 25 bps for the first time in a decade.

The hike was on expected line. This came after the Fed was confident about the labour market. Howover, the Fed said that future hike will also incorporate a new dimension i.e. the foreign market situation which till now was not considered.

The move not only removed the uncertainty but also signals the strength of the US economy.

The Indian equity market cheered up the move with the BSE’s Sensex rising around 300 points and NSE’s Nifty rising by 93 points, both by 1.21%. Also rupee closed at 66.42 against the dollar, the highest in the three weeks during the period.

Signal of rising US economy is a big positive for the world economy. As the US economy comprises of around 25% of the world’s GDP, any growth in the country will have far-reaching effect. Also it is the only major developed economy which is showing signs of recovery.

The Fed was expected to raise its rate in its September meeting. But due to the Chinese market turmoil it did not take the move.

Mid-Year Economic Analysis Coming three months before the Budget, the Mid-Year Economic Analysis 2015-16 cautioned that the country may need more stimulus to pick up growth if it were to achieve targets as specified. The report made strong case for longer fiscal consolidation period, longer inflation targeting period, supports the new GDP formula and lays out plan for setting up of PDMA (Public Debt Management Agency).

The report highlighted that achieving this year fiscal target of 3.9% will not of any concern and can be reached comfortably. But repeating the same would be difficult next fiscal as the target for the FY17 is to bring down the fiscal deficit to 3.5% but due to Seventh Pay recommendation and defense pensions achieving the same would mean cutting capital expenditure.

The corporate sector is heavily indebted. If the

DECEMBER 2015

IIM Shillong inflation target could be delayed by another year, then the RBI will have more room for rate cut. The report strongly recommends for the same as reducing debt burden is necessary to spur investment in the country.

The country has adopted a new GDP formula in February. Because of this GDP figures were revised upwards. For example, for FY14 GDP was revised from 5% to 6.9%. This led to widespread criticism of the government.

The report makes it clear that the new formula is as per the global standard of measuring GDP on the market price as compare to factor price. Also it reinforces that the process of measuring GDP is independent from the day’s government.

To handle the Public debt, the government is planning to set up PDMA. The model will be based on some of the developed countries like US and UK. The independent office will be charged with selling debt on behalf of the government.

The report though support the case for the rising economy activities but also recommends measures to strengthen the process.

Insolvency and Bankruptcy Bill Introduced in Parliament As announced in the Budget, Finance Minister Arun Jately introduced Insolvency and Bankruptcy bill in the Parliament on December 21, 2015. The bill aims to replace the age-old system of allowing exit of the failed business and introduces steps that will quicken the process.

The bill talks of setting up of Insolvency and Bankruptcy Fund as well as Insolvency and Bankruptcy Board of India for speeding the process of declaring persons, firms and companies insolvent and ensuring payments to the creditors.

If passed and implemented as planned the bill will reduce the time required to wind up a sick unit to 180 days, which is the global average, from around 4 years in some cases in India.

Also to circumvent the obstacle of being in minority in the Upper House, the bill has been

NIVESHAK

The Niveshak Times introduced as Money Bill. This will curtail the power of Rajya Sabha in not passing the bill.

It is the high time that the bill becomes the law so that the sick units can be quickly winded up which has blocked lots of productive capital and also start-up will get boost as the investor will have the confidence in recovering their money if the business fails.

Five-Year High IIP Number, But Don’t Read too Much Coming on the back of the stronger GDP number of 7.4% in the September quarter as compared to the 7% in the first quarter, the five-year high 9.8% IIP number reinforced the government contention that the economy is rising rapidly. Though a little dipper analysis does not look as good as it sounds first.

This year Diwali was in November, compare to last year when it was in October. So, this year, factory productions were high in the month of October which was not the case the year before. In fact last year it was negative growth of 2.7% in October IIP. Hence due to lower base effect and more production this year, the whole data got magnified.

But this does not mean that the economy is still in ruckus. Most of the economic indicators are in positive. Also the rising car sales, which is the barometer of the health of the economy, confirms the rise in the economic activity of the country.

Taking Ties Forward With Japan and Russia The month also saw headlines with Russia and Japan, two long-standing partners of India, taking forward the economic ties with India.

India and Russia will together built multi-task helicopters which will be the first large-scale projects in the government’s Make in India initiative to encourage local and foreign firms to manufacture in India. Both countries also planned to work on multi-role fighter jets and transport aircraft. Russia will also build six nuclear blocks in India in the next 20 years.

Apart from the government-level initiatives, companies are also increasing ties with their counter-parts in Russia. ONGC is in talk to increase its share in Vankor oilfield which is owned by Russia’s top oil producer. Also Rosneft has signed a memorandum with

Indian Oil Corporation and Oil India Limited.

Russian government controlled Alrosa, a diamond company, which produces 27% of the all diamond produced in the world, will work with India.

The ties with Japan is not left behind. The highoctane Bullet Train project will get support from the Japanese government. Japan will support India in building the first Shinkansen Bullet Train in India which will ply between Mumbai and Ahmedabad. Both the countries are trying to hike up their nuclear deals with Japan insisting on safeguards while India focusing that the India-US deal would be the template. Japan also plans to set up 11 industrial townships across India as it aims to double up its investment in the country.

Economic ties with the both the countries will be a big thumbs up for India. This will not only provide the much needed capital and technological knowhow to the country but also balance the geo-political situation in the region.

Bucking the Trends, Companies Adopting Newer Ways As the chiche goes, change is the only constant, corporate India is also adopting newer ways to do business.

After the Delhi government announced the Odd-Even rule to cut down emission, companies are pushing their employees to avail measures like car-pool and public transports.

PwC is encouraging their employees to make greater use of metro by sponsoring their metro card. Other companies like KPMG, Coca-Cola etc. are also taking similar measures.

Another new trend can be seen by the e-commerce giant Flipkart. To strengthen its merchants’ network the company is going ahead with offering small loans to its large network of 80,000 merchants.

Online payment App, Paytm is planning to adopt the financial service offered by Alibaba.

Under the scheme the company plans to disburse small loans to about 500 million Indians by 2020. The aim to increase its presence beyond online retail. The company has borrowed around Rs. 150 crore for this purpose.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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The Month That Was

The Month That Was

4

6

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NIVESHAK

www.iims-niveshak.com

Article ofSnapshot the Month Market Cover Story

Market Snapshot BSE Index

BSE

26200

DII

1,500

FII

1,000

26000

500

25800

BSE

25600

0

25400 -500

25200 25000

-1,000

24800

-1,500

24600 30-12-2015

29-12-2015

28-12-2015

24-12-2015

23-12-2015

22-12-2015

21-12-2015

18-12-2015

17-12-2015

16-12-2015

15-12-2015

14-12-2015

11-12-2015

10-12-2015

09-12-2015

08-12-2015

07-12-2015

04-12-2015

03-12-2015

02-12-2015

01-12-2015

24400

-2,000

FII, DII Net turnover (in Rs. Crores)

26400

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

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

99,80,888 Source: www.bseindia.com

LENDING/DEPOSITRATES Base rate Deposit rate

9.30%-9.70% 7.00% - 7.90%

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

% change

Open

Close

-0.92% -3.01% -2.94% -3.40% -3.75% -1.29% 3.65% -0.16% 2.79% 1.48% 1.83% -1.78% 0.42% 1.06% 0.80% -1.84%

26201 19028 19932 14636 12491 7927 16335 10959 7139 9348 1909 1348 5957 11656 11016 6897

25960 18456 19346 14139 12022 7825 16931 10941 7338 9486 1944 1324 5982 11779 11104 6770

% CHANGE

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

66.42 72.60 55.17 98.55 46.95

CURRENCYMOVEMENTS 2.00%

INR/1 USD

Euro/1 USD

1.00%

0.00%

GBP/1 USD

JPY/1 USD

SGD/1 USD

RESERVERATIOS CRR SLR

4.00% 21.50%

REALTY, -1.78% PSU, -1.84%

POLICY RATES Bank Rate Repo rate Reverse Repo rate

7.75% 6.75% 5.75%

-1.00%

-2.00%

-3.00%

TECK, 0.42% Smallcap, 1.06%

Source: www.bseindia.com 1st Dec 2015 to 30th Dec 2015 Data as on 30th December 2015

1 IT, -0.16%

POWER, 1.83% OIL&GAS, 1.48% MIDCAP, 0.80% METAL, 2.79% Healthcare, 3.65%

FMCG, -1.29% CD, -3.75% CG, -3.40% BANKEX, -2.94% AUTO, -3.01% Sensex, -0.92%

-4.00%

DECEMBER 2015

© FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

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Article Market of Snapshot the Month Cover Story

Market Snapshot

NIVESHAK

Performance Evaluation

Niveshak Investment Fund

Done on 30/6/14

Bank (6.49%)

HCL Tech.

HDFC Bank Wg:6.49% Gain: 16.66%

Infosys

TCS

Wg: 4.41% Gain : 12.51%

Wg: 3.79% Gain: 33.81%

Wg: 4.06% Gain : -1.86%

FMCG(22.36%) Colgate HUL

Britannia

Wg:6.14% Gain : 27.18%

Wg:6.99% Gain: 195.16%

Wg:4.62% Gain : 22.24%

Amara Raja Wg:4.36% Gain : 20.07%

Godrej Consm.

Wg:6.89% Gain: 46.29%

Lupin Wg:8.01% Gain : 59.37%

Midcap Stocks (13.28%) Bharat Forge Wg:4.21% Gain: -2.77%

Kalpataru Power Wg: 4.36% Gain: -0.88%

Titan Company Wg:4.11% Gain: -6.70%

Chemicals (7.66%)

Pharmaceuticals (12.2%) Dr Reddy’s Labs Wg:4.19% Gain: 8.09%

Wg:4.61% Gain :-4.98%

145 135

99

125 115

97

105 95

96 95

Natco Pharma Wg: 4.71% Gain: 9.77%

Asian Paints Wg:7.66% Gain: 39.50%

Textile (6.16%) Page Indus.

Wg: 6.16% Gain : 25.07%

Performance of Niveshak Investment Fund since Inception

155

100

98

ITC

175 165

101

1/12 4/12 7/12 10/12 13/12 16/12 19/12 22/12 25/12 28/12

Scaled SENSEX

Misc. (11%)

Auto (8.59%) Tata Motors Wg:4.23% Gain: -12.25%

November Performance of Nivehshak Investment Fund

30-Jan-14 28-Feb-14 28-Mar-14 05-May-14 03-Jun-14 03-Jul-14 01-08-2014 02-09-2014 30-09-2014 31-10-2014 12-02-2014 31-12-2014 29-01-2015 27-02-2015 27-03-2015 29-04-2015 28-05-2015 25-06-2015 23-07-2015 20-08-2015 18-09-2015 20-10-2015 19-11-2015

Information Technology(12.26%)

As on 30th December 2015

Opening Portfolio Value : 10,00,000 Current Portfolio Value : 14,88,949 Change in Portfolio Value : 48.89% Change in Sensex : 26.65%

Scaled NIF Value Scaled to 100

Risk Measures: Standard Deviation : 19.93 (Sensex 10.63) Sharpe Ratio : 2.42 (Sensex : 3.78) Cash Remaining: 58,000

Comments on NIF’s Performance & Way Ahead : The Month of December saw the Central Banks play a major role in deciding the fate as well as the trend of the market. The RBI kick started the Month of December with its monetary policy On the 1st, it was soon followed by the Fed Rate hike on 17th. The stocks in the portfolio went with the tide, in what was a topsy-turvy month for Indian Equities.

The top gainers in the portfolio was HUL followed closely by Asian Paints, whereas the top losers were the TATA group companies i.e. Titan and Tata Motors.

In the coming month, we can expect a bit of stability returning to the markets, with all the major trigger events out of the way. With updates on the quarterly results expected in January focus will now shift on the performance of individual stocks.

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Great Leap Forward - China embraced by IMF

NIVESHAK

Figure 1: SDR Basket changes over the years (IMF Financial Operations 2015, 2015)

MahjabeenMirza Beg

Introduction The International Monetary Fund on 30 November 2015 agreed to include Chinese yuan to its basket of reserve currencies called Special Drawing Rights (SDR). The decision will be effective from October 2016 (Pramuk, 2015). The decision was backed by the United States, Britain and Japan and indicates that the international community expects China to have a major role in the world economic order (Hughes, 2015).

The IMF’s decision comes in the wake of a changing world scenario. It is reflective of China’s global emergence, the yuan being judged as a “freely-usable” currency and widely traded in FX markets (Press Release, 2015). The share of China in global exports amounted to 12.5% in 2014 much above U.S.’ 9%.

Over the past weeks, the Chinese government and the central bank have implemented a flurry of reforms and are expected to continue the same path.

Special Drawings Rights (SDR)

DECEMBER 2015

IIT DELHI

In 1969, IMF created the Special drawing rights or SDR, an interest bearing reserve asset, to supplement the reserves of its member countries (currently 188 countries). It is not a currency but a potential claim on the currency of its member states. The SDR holding countries can exchange their SDRs for these currencies (International Monetary Fund). The composition of the basket is reviewed every five years by the IMF Executive Board to ensure that it is reflective of the current status of the currencies and the yuan was rejected in 2010.

SDR’s Value The value of SDR is based on a basket of currencies- the euro, Japanese yen, pound sterling and U.S. dollar, come October 2016, Chinese yen will also be included in this basket (International Monetary Fund). Figure 1 traces the history of the changes in the SDR basket since its inception.

As of 4 December 2015, one SDR is equivalent to 92.68 INR, 1.386 U.S. dollar and 8.87 Chinese Yuan (IMF, 2015).

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The SDR interest rate is calculated based on “a weighted average of representative interest rates on short-term debt in the money markets of the SDR basket currencies” (International Monetary Fund) and is the basis for calculating the interest rate at which the IMF gives loans Growth of Chinese yuan (CNY) Renminbi (RMB) is the currency of China whereas Yuan is the name of a unit of the renminbi currency (Mulvey, 2010). The two terms are used interchangeably. China’s three decades of double-digit growth has transformed it into a leading trading nation; forecasted to surpass United States in 2020 (Jon M. Huntsman, 2015). Official reserve holdings of Chinese yuan have reached USD 70-120bn and more than 500 foreign entities have obtained access to China’s onshore bond market (Robert Minikin, 2015).

As of April 2015, the yuan’s real effective exchange rate stood at 130.5, which means that it is 30 percent stronger than the currencies of its trading partners as of 2010 (Murugaboopathy, 2015). Figure 2 depicts the appreciation of the yuan against a broad basket of currencies as per the data by Bank of International Settlements (BIS). In 2014, Yuan was a part of official reserve assets of 1.1% of countries up from 0.7% in 2013 (S.R., 2015).

The Standard Chartered Renminbi Globalisation Index (RGI), which tracks the progress of RMB business activity by tracking the internationalisation of offshore RMB in geographies and markets, rose more than 21-fold from December 2010 (Robert Minikin, 2015). Most of the undervaluation of CNY during the 2000s has been corrected, and the People’s Bank of China (PBoC) has also reduced the routine foreign exchange (FX) market interventions.

China has opened its capital account and since 2010 deregulation of capital account transactions have increased which has led to a gain in the momentum of the internationalisation of RMB. The ShanghaiHong Kong Connect programme launched in 2014 has further provided individual investors with the freedom to invest abroad.

Impact on China’s economy The inclusion underscores the growing dominance of China in the world market and a long-term economic decline of the U.S. China is working to reduce reliance on the U.S. dollar through the strengthening of the global use of the yuan (Curran, 2015).

The inclusion would give China a greater say in the international market. It is opined that

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will increase yuan’s acceptability as a global economy.

Impact on the world economy The inclusion would result in a greater stability of the global monetar y-financial system due to the variety in the SDR basket (Pramuk, 2015). The delay in Figure 2 Weights change after the inclusion of Renminbi implementing will help the users to in the short run the yuan may depreciate adjust to the changes and plan for further due to the market-driven exchange the changing scenario. For now, the yuan’s rate being implemented. It is expected that role will be limited but, in the long run, China China would respond with a greater number of may offer a complementary global monetary reforms to improve transparency and further system to the existing one. It may undermine to open up of capital account that will benefit the west’s ability to impose sanctions and China’s economy. The reforms will be gradual, countries may trade in yuan to safeguard and there would be hardly any impacts on against the sanctions. There would be less the economy in the short run. It could be an reliance on dollar and countries like India will overall positive for the Chinese equity market be able to trade in yuan so as to decrease the as this decision is a vote of confidence in the risk of fluctuating FX rates. workings of PBoC (Pramuk, 2015). Hayden Reliance on dollar affected the world economy Briscoe, of AllianceBernstein, is of the opinion in the financial crisis of 2008. The most recent that this decision could lead to inflows of up survey by BIS showed that 87 percent of the to $3 trillion over the next few years in China FX trading involves the dollar, such a financial (Chandran, 2015). Other countries may accept system that is dominated by a single currency yuan as a trade currency, and the Chinese is not a stable one. The dollar’s strength would government would lose control over RMB. not be affected right away due to the lack of In the long run, countries may start keeping full convertibility of RMB. yuan in their foreign exchange reserves that Euro’s weighting in the basket has dropped and it has faced the worst year in a decade.

Its value has decreased 13 percent against USD this year. It is prophesied that euro will be the worst affected by yuan’s inclusion (Chen & Ismail, 2015).

Some experts are of the opinion that since the SDRs have limited use and the usage is not widespread, there would be highly any implications for the world economy, and the Figure 3 Strong and Stronger, China's trade-weighted exchange rate (BIS, 2015)

DECEMBER 2015

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Figure 4 Offshore Renminbi market (Standard Chartered)

Figure 5 US Dollar to Chinese Yuan Exchange Rate (Reporter, 2015) decision is only symbolic (Roy, 2015).

Concluding Remarks The SDR has lost its significance since the breakdown of the Bretton Wood’s system in 1973. The SDR’s have limited use and form less than 4% of the total global reserves. Chinese yuan’s inclusion in the SDR will be a source of prestige and provide China political leverage.

The reserves in central banks in RMB will not increase in the short term but gradually over a long period. The RMB has a long way to go before it can replace the US dollar. The impact of this decision on the world economy is

dependent on the growth and health of China’s economy and China’s ability to implement reforms and increase transparency.

The opinion is divided among experts who believe that the decision is insignificant and only symbolic; and those who opine that this will have far-reaching effects in the long run.

Only time can tell who will be proved right.

© FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

NIVESHAK

NIVESHAK

The US Fed rate hike – Impact on India and the emerging markets

Abhishek Jaiswal

IIM Shillong Introduction Irrespective of another tumble in oil prices, the US Federal Reserve finally coughed up the courage to start the onward journey of tightening its monetary policies for the first time in seven years. Countries around the world and especially the emerging markets were feeling the jitters in anticipation of this decision. So, finally the D-Day came, and the US Federal Reserve raised the federal funds rate by 25 bps, from 0-25 bps range to 25-50 bps range on 16 Dec 2015. This is the first hike by the US Fed in over nine years. In the backdrop of the global financial crisis, policy rates in the US were reduced by 500 bps between Sep 2007 and Dec 2008, and policy rate has remained at 0-25 bps since then.

The backdrop The journey of cheap capital with the US Treasury started with the sub-prime crisis when the asset prices crashed, and the credit markets experienced a squeeze like never before.

Financial institutions faced heavy losses due to the exposure of exotic derivatives built around the hollow mortgage-backed securities. The US Fed as well as central banks around the world sprung into action and eased their monetary policies by lowering interest rates

JULY 2014

and purchasing securities to effect quantitative easing. This provided much-needed liquidity to the markets and cushioned the asset prices with controlled inflation.

Inter-linkages Before decoding the rationale behind the Fed’s decision and forecasting its impact on the world, it is important to understand the interdependencies within the global economy.

Investors’ borrow funds in low-interest currencies which usually are the western currencies. They leverage their positions and invest the funds in other risky assets around the world as emerging market stocks, currencies, commodities and alternative investments.

These assets carry premium returns for the extra risk inherent in them. This modus operandi is called carry trade.

Now, when US Fed increases interest rates, these investors reverse the carry trade to cover their positions. They dispose off the risky assets and payoff the loans taken in USD. These create a sell-side pressure on both the assets as well as the emerging market currencies leading to erosion in their value.

Moreover, there is a steady demand for USD in the global markets due to its acceptability as

an international currency. Hence, an increase in Fed interest rates creates a shortage of currency in the market which hampers liquidity. This increases the cost of repayment of the foreign commercial borrowings of Indian corporates and creates a downside pressure on the Indian rupee.

These are the multiple ways in which the US Fed rates impact the emerging markets in particular and hence the anticipation and excitement around its movements.

Rationale behind the Fed’s decision After a spree of stagnant lending rates, it was logical for the Fed to start putting a price to its funds and tighten the monetary policies by reversing its actions taken during the sub-prime crisis. The Federal Open Market Committee (FOMC) has made it clear that the two guiding factors for policy rates will be the unemployment rate and the inflation rate of the US economy.

With the unemployment rate sitting pretty at ~5.4 % in June 2015 compared to the target of ~5.2%, it seems to be in a controlled band.

Inflation, however, is much lower at ~0.1% compared to the target of 2%. This is not a worry as this inflation status has been driven by falling crude oil and commodity prices and not by a liquidity crunch in the domestic market. Hence, the US Fed has enough leeway to hike interest rates and initiate a security selling spree.

The FOMC indicated that it “expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate.” The FOMC’s average projection for the “appropriate” federal funds

rate at the end of 2016 dropped to 1.3% from 1.5%. For 2017, the average projection fell to 2.4% from 2.6%. This suggests a slower rate hike trajectory than expected earlier which is a positive.

Industry experts have stated that with this rate hike, US has announced that it is on the path to recovery and has reassured the emerging markets that it will phase out its new policies in a gradual manner. So the shock quotient taken out of contention, the global economy can plan out its measures in a prudent way and prepare its markets to face challenges responsively.

An outlook of the Indian market With news of the US Fed firming up its rates pouring in since the last couple of years, there was a deluge of funds outside India.

This made India’s currency, bond and equity markets face southwards. However, the Indian story has improved since then with recovery from the ~4.5 % to 7+ % growth phase and a pro-investment environment in lieu of the government’s policies.

A significant part of India’s recovery has been fuelled by the fall in crude oil prices. Being a heavy importer of crude oil, India covered its CAD from ~4.3% of GDP in FY12 to ~1.0% in FY16. Even the fiscal deficit has fallen by two percentage points. CPI Inflation has fallen sharply from ~10.2% in FY13 to ~5.9% in FY15. India’s forex reserves have been beefed up from the sub $300 billion in 2013 to $350 billion category currently.

The major macro-economic variables are improving as per the table below -

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Nearly $3 billion of funds have been eroded from the Indian markets since the Fed rate hike scare in 2013 whereas the economic scenario of India has improved in the same period. The global money managers are light on the emerging market assets currently and would like to balance out their portfolios in the coming days given the positive outlook being promised by these economies. This is a huge general positive factor for us.

effect of de-leveraging as explained above will see an exodus of funds from the US markets first. Given the growth prospects of the Indian economy and the improving investment scenario, it is expected that the FIIs will park a certain share of their funds in these markets for long-term growth.

The following graph shows the performance of Sensex the last time the US Fed had hiked its rates in 2004.

Impact on Indian Equities The investment in foreign equities is always driven by two factors – the first being the performance of the foreign companies whose stocks are being invested in and the performance of the foreign currency as it has a multiplying effect on the stock’s returns. Since the sub-prime crisis, the Indian stock market proxied by the Sensex is up by around ~70% (~15000 to ~26000) whereas the depreciation in the Indian rupee vs. the USD has been around ~30% (Rs.46/$ vs. Rs.67/$).

The market capitalization of indices around the world in USD terms paints a picture of

We can clearly see that the market fell sharply before the Fed rate hike but picked up post that. In fact, it continued to rally in spite of the following rate hikes. This time around, the drop in Sensex in the pre-hike period is not as bad as the last time. Moreover, the hikes in the next six months are expected to be much smoother compared to 2004. Hence, if Sensex follows the trend, we can expect a handsome return on the Indian Equities.

healthy investment in the US markets fuelled by expectations from the technology and social media stocks. The same period shows a reduced market cap of 11% in India. Hence, the

JULY 2014

Impact on Indian Bond Markets The uncertainty over the Indian bond market is greater compared to the Equities market.

There are two competing theories that drive investment decisions in bonds.

First, India has received $32 billion in investments since 2014. This has largely been due to the higher Indian bond yields. However,

the bond investments by foreign players are mostly short term and very sensitive to yield and currency fluctuations. Moreover, the Indian bond market is relatively illiquid and faces the maximum risk of exodus in turbulent conditions as investors are mostly risk-averse.

Second, this theory states that as the US Fed rate hikes are going to be slow upwards, the spread between the Indian bond yields and the US rates will be high. Hence, the market expects the Indian bond yields to drop and thus push up the asset prices. Low inflation and lower account deficits also point towards falling yields.

With market dynamics and technical analysis pointing in opposite directions, it is safe to hold on to the bond market investments and hope for the positive macro-economic variables to have an impact.

Impact on Indian Exports The immediate impact of the rate hike has expectedly been an outflow of funds towards the USD. The rupee has weakened to the 67/$ level. The Indian government’s statement of being ready for any eventuality suggests they expect more money to be withdrawn from the markets and have stored foreign exchange reserves to meet this.

This would have a positive impact on India’s export prospects. India’s goods exports have fallen for the 9th consecutive month and the share of services exports as a part of GDP has also shrunk. The rate hike spree will further strengthen the USD and provide a boost to the exports of the emerging markets like India. The widening current account deficit due to the expected propping up of the Rupee would be partly compensated by the positive balance of trade due to the possible increase in exports.

other three economies have already initiated monetary easing by lowering interest rates and weakening currencies to support investment and exports. Hence, US would face a ripple effect in the form of deflation which would be aggravated further by the hike in interest rates.

This step would be beneficial to China as the USD will strengthen and China will have the leeway to devalue further its Yuan to affect the trade equilibrium. With ~7+ percentage growth and availability of reserves, it is to China’s advantage to be responsive to the Fed rate changes.

Conclusion With the analysis done from multiple perspectives, we hold the view that the Fed policy tightening will have a positive long-run impact on the emerging markets, especially India. Softer oil prices and presence of forex reserves to cushion rupee volatility augur well for India’s future.

India being a commodity importer will always benefit from falling commodity prices. With the stable recovery of the Indian markets and improving corporate margins, the company valuations have also firmed up. Hence, the advice for the investors is to stay invested with a long horizon.

Impact of the Fed rate hikes on other big economies like China The four major growth engines of the world are US, Europe, Japan and China. Europe and Japan are facing deflation. China is slowing down growth and US is going through a period of muted growth. Except the US, the © FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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Times SIddharthGupta , RiteshKrGupta

XIM, Jabalpur

“Understanding the Underlying Implications of Investing in Capital markets” “The greatest advantage of using the derivative instrument is to hedge the portfolio of any systematic risk or specific risk. The trader can totally protect his capital by strategically using derivatives”

JULY 2014

Derivatives, such as futures or options, are financial contracts which derive their value from a spot price, which is called the “underlying”. It is an arrangement or product between two parties whose value derives from and is dependent on the value of an underlying asset, such as a commodity, currency, or security. The contract specifies the conditions, especially, the dates, resulting values and definitions of the underlying variables, the parties’ contractual obligations, and the notional amount under which payments are to be made between the parties.

Let us consider an example for simple understanding:Sugarcane farmers may wish to enter into a contract to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction would take place through a forward or futures market This market is the “derivatives market”, and the prices of this market would be driven by

One would argue that if these derivatives are similar to shares and bonds then why you would take the hassle of using yet another instrument in the already complex financial markets.

The few advantages derivatives possess over stocks are listed below: • They are highly liquid • They provide higher leverage than stocks • Require low initial capital requirement • Promote capital allocation • Lower risk than buying and holding stocks.

• It is just as easy to trade the short side as the long side.

The birth of derivatives had taken place in USA way back in the 1980’s where the technological developments had influenced the capital markets a great deal. The emergence of derivatives and development of the financial markets gave birth to the world’s top 5 investment bankers, namely, Goldman Sachs, Morgan

Stanley, Merrill Lynch, Standard Chartered, and Lehman Brothers.

Let me tell you how Derivatives have changed the financial markets: • Hedging: The greatest advantage of using the derivative instrument is hedging of the portfolio of any systematic risk or specific risk. The trader can totally protect his capital by strategically using derivatives • Speculation: The use of derivatives instrument enables market participants to speculate on anything, be it any stock, any index, interest rate, currency, or even the weather for that matter. Increase in speculative participation has not only led to the growth in terms of volume for the financial markets but has also led to conversion of Weak-Form Efficient Market Hypothesis to StrongForm EFM. • Arbitrage: Arbitrage is a deal that produces profit by exploiting a price difference in an instrument in two different markets.

Market participants make the financial markets price efficient by exploiting the slightest difference in price.

The use of technology on such broad-based market instruments has provided both operational and participative efficiency.

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Derivatives- Changing Financial

the spot market price of sugar which is the “underlying”.

Derivatives are a different product of the financial markets all together. They can be listed in any stock exchange or even OTC. Trading in derivatives is pretty much similar to those in shares and bonds.

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The infamous Harshad Mehta and Ketan Parekh used these inefficiencies to exploit the Indian capital markets way back in the early 1990s.

“Derivatives are financial weapons of mass destruction.”

- Warren Buffett The above quote has been rightly said by the world’s most renowned and respected trader.

The 2008 U.S. Financial Crisis draws its roots through the precarious and irresponsible use of complex derivative contracts without any intervention by the financial watchdogs. The excessive use of derivative contracts in the mid-1990s had made U.S. financial markets very attractive and lucrative. The OTC market was not covered under the purview of the Securities and Exchange Commission (SEC) of United States (similar to SEBI in India) which gave the participants a leeway to exploit the markets.

It was way back in 1996 when it all started.

The world’s top 5 investment bankers started complex ‘Collateralized Debt Obligations’ also called CDOs by converting risky junk loans to

highly volatile derivative instruments called ‘Credit Default Swaps’ and floating them to the stock markets, defrauding millions of market participants around the globe. This bubble eventually blasted in August 2008 in what we know as the Financial Crisis-2008.

Sounds complicated? That’s because it is.

Let’s simplify this.

The U.S Fed Reserve used a policy of excessive credit easing, which investors allowed millions of U.S resident’s access to cheap credit. These credits where in the form of housing loans, credit cards, bank ODs, personal loans, etc.

Common man had more money and started buying luxury goods. Concurrently, prices of residential homes between the years 2000 and 2005 shot up more than 415% on an average basis in and around the cities. The housing bubble had set in spreading jitters all around.

Some data revealed by the Fed Reserve in December 2007 stated that every American had a leverage ratio of about 33:1 which was way above the global average of 3:1.

The banks in the hindsight feared the recovery of these loans. They hedged themselves

by collaborating similar types of loans and creating Special Purpose Entities or SPEs to form structured bonds or Collateralized Debt Obligations (CDOs). These bonds although backed by junk loans had been given Investment Grade rating or AAA (Triple A) rating by the Big 3 credit rating agencies, namely Standard and Poor’s, Moody’s, and Fitch.

Who says only India is proxy to corruption?

These ‘Investment Grade CDOs’ were floated in the markets defrauding millions of investors around the globe.

The above diagram shows how the investment banks used combinations of complex financial

inefficiencies within legal boundaries. The investors and loan takers are mere guests to the party.

It is unfortunate that the regulators waited for the tsunami to occur and then take counter measures. Too little, too late!

The regulators have to take the onus for ignoring the destructive nature of the derivative instruments for so long. They have to maintain vigilance: searching for irregularities like blood hounds.

The 2008 Financial Crisis should act as a lesson to be learnt by all.

Derivative is a financial contract which derives its value from some underlying asset

TRIVIA

instruments to deleverage themselves and push the ultimate exposure to the investors.

Raghuram Rajan, the current RBI governor, the then chief economist of IMF was the first person to file a warning report with the Fed • Reserve en-lighting the state of affairs and the possibility of a global financial meltdown.

Lack of proper regulations in the financial sector had cost the common man his lifetimes’ • savings. The entire global economy crashed and came down to a catastrophic halt. The 2008 crisis changed the dynamics of the financial world. Because of the need to develop financial literacy among participants, more vigilant and accountable watchdogs arose. Accordingly, the SEC was empowered.

The larger question which comes to mind is who should be held responsible for such irresponsibility. The credit rating agencies • cannot be held accountable as they are independent private institutions and their task is limited to providing an opinion and not assurance. The banks cannot be held liable as they were merely cashing on market

DECEMBER 2015

• Derivative is a financial contract which derives its value from some underlying asset.

• Derivatives can be listed in any stock exchange or even OTC (Over the Counter).

If its exchange traded, Chicago Mercantile Exchange (CME) i.e. the Clearing House of Exchange is the counter party. Every trader (long or short) has to deposit a margin (as performance guarantee) whereas in case of OTC, there is no margin requirement.

Exchange traded derivatives are standardized and heavily regulated. On the other hand, OTC derivatives are customized and bear less regulations.

Special Purpose Entity/ Special Purpose Vehicle or Financial Vehicle Corporation, originally and still is used to isolate risk.

An organization can use such a vehicle to finance a large project without putting the entire firm at risk. Problem is, due to accounting loopholes, these vehicles become a way for CEOs to hide debt. It looks like a company doesn’t have liabilities, but it really does.

From originator to SPV, it’s the true sale of assets. If the Originator is bankrupt, the assets of SPV cannot be touched to satisfy the trade.

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Impact of the Bretton Woods Conference

because one party held all the cards. To put it in context US held two-third of all the gold at Bretton Woods and was financially the most powerful country in the conference. John Maynard Keynes represented Britain and the US was represented by Harry Dexter White.

White was very much obsessed with removing the Britain as the dominant global power as is very much evident from a memo dated 1936 where he said that “the more sterling countries there are, the stronger would be England’s position around a conference table should an international conference take place”. The entire setup of the conference had thus been designed so as to get out a certain outcome and the other nations had minimal power in deciding the outcomes.

After long negotiations the US agreed to

Rishabh Pandey

IIM Shillong The World War II had significantly impaired many of the world’s countries leaving their economic conditions in a morbid state. Due to this, the industrialized countries tried to protect their domestic industries using several means.

As a result, Europe and America devalued their currencies in the hope of boosting their exports. The rise in exports would boost domestic production and employment in the host country but would reduce production and employment in the competing countries.

However, if all countries, in a competitive behavior, devalue their currencies in the hope of improving their exports, no country would benefit in the end. Such efforts create uncertainty in the foreign exchange market and lessens incentives for trade among nations.

Other protectionist measures adopted by various countries consists of an imposition of quotas, voluntary export restraints, bans and high customs duties which leads to an almost zero trade among countries and worsening of trade, production, and employment opportunities everywhere. The countries having suffered a great deal of damage in wars were thus in dire need of serious restructuring to elevate and revive their economies. Much of these had been recognized during the inter-war period of WWI and WWII in the trade

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conferences organized by Allied Nations. It was realized to have a system where there is an enhanced co-operation in the global world and increased volume of trade via means of an easily convertible currency system. To solve this, more than 700 delegates from 44 countries in July 1944 attended the United Nations Monetary and Financial Conference in Bretton Woods, New Hampshire, which became famous as the Bretton Woods Conference. The main purpose of the meet was to enact a postworld war international monetary order. The two key issues that were to be discussed are: • Establish a stable system of exchange rates • How to fund the rebuilding of war-torn economies of Europe The conference is remarkable in a unique way because the conference was able to achieve its desired set of objectives and come out with multilateral institutions that were to shape the global finances forever. A meeting where the future of many economies were decided concludes without friction is a baffling incident in itself. The reason for this unrealistic result was such because the conference even though termed multilateral was, in fact, a bilateral one between the United States and the United Kingdom. The sweeping agreements of such scope were possible only

transfer post-war transitional assistance aid in the form of loans and not grants but only if Britain agreed to do the following three things: 1.

End imperial trade preferences: This is an arrangement by which Britain gave itself the privilege of access to the markets of its colonies and dominions.

2.

Britain would make the pound sterling fully convertible to US Dollar at a fixed exchange rate by a set date which was July

15th, 1947.

3.

Britain would accept US Dollar as the global unit of account at the Bretton Woods, a proposal they had massively resisted.

The US was tactfully using Britain’s impending bankruptcy and dire need of finances to reshape the global economic order. Even though Britain did realize the implications of these conditions, they agreed to the three terms because they felt they needed the US’ assistance in order to survive.

Two international organizations were thus born out of the Bretton Woods conference: • International Bank for Reconstruction and Development(IBRD), which today is known as the World Bank • International Monetary Fund(IMF) The purpose of World Bank was to help the warravaged Western world in reconstruction and the third world countries in their development programs.

The purpose of IMF was to take care of the issues of balance of payment and exchange rate management among member countries.

All of the participating countries agreed to value their currencies relative to the dollar, and the value of the dollar was pegged to the price of gold at $35 per ounce. Thus, Bretton Woods paved the way for the domination of the US dollar in the global market.

The concept of a third organization called the International Trade Organization (ITO) was also conceived during the same conference, however due to resistance by the US Congress it had an abortive beginning. What transpired instead was a General Agreement on Trade and Tariff (GATT) which took the trade liberalization efforts forward and later after several rounds of negotiations under its auspices led to the formation of what is today known as the World Trade Organization (WTO) which is responsible

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for liberalization of trade among its member countries.

The US was the major contributor of the funds to both the organizations, and hence it also gained

country. US thus tactfully took hold of all the strings of these countries using IMF to do economic surveillance over these countries.

Countries needed US Dollar to return these

the maximum voting rights empowering it with veto power over major policy decisions. The US many a times used this dominant position to enforce countries to acquiesce to its demands.

For example, The US forced British out of the Suez Canal by threatening them to withhold emergency IMF support and provoke a sterling crisis.

The countries at that point had only three ways of performing international trade: 1.

Through barter 2.

Through US Dollar 3.

Through gold exchange most of which lied with the US. Since each of the 44 countries’ currency was pegged to US Dollar, which was backed by gold, it became the global default currency for international trade. A country that now runs a current account deficit could take a loan from the IMF and World Bank which would be in the form of US dollar and in return, these institutions dominated by US would force its own terms and conditions on the debtor

loans and also for international trade. So countries in the competition of getting US Dollar started selling their products to the US cheaply. This ensured that the US has access to the best products of the world at best prices.

Due to cheap products, consumerism in the US boosted and pegged against global currencies which insulated them from the dangers of inflation. It also allowed the US to maintain a high level of current account deficit without having the need to devalue their dollar.

The extent of low prices at which products were available in the US can be gauged from the fact that it became the world’s largest producer of garbage solely because it was cheaper for them to buy a new product than to recycle an old one. The US granted additional funds to European allies in their rebuilding efforts under its Marshall Plan in return for making the Bretton Woods agreement happen. US offered similar aids to USSR, but Soviets who were well aware of the US’ motives turned down their offer.

The Flaw exposed:

DECEMBER 2015

To fuel huge military spending, its involvement in the Vietnam War, apart from foreign aids and investments, US government resorted to incessant printing of dollars but the printing of more dollars is not the same as mining more gold. As in real terms, it didn’t have enough gold to cover the promise that the US dollars circulating in the global market were making. The dollar thus became overvalued and subsequent US administrations of John F. Kennedy and Lyndon B. Johnson took several steps to support the dollar such as: • International Monetary Reform • Efforts to stem outflow of dollar • Restrictions on foreign lending • Foreign investments disincentives to discourage outflow • Co-operation with other countries However, none of them proved fruitful and holders of the dollar, in anticipation that the prevailing conditions would force the government to devalue the currency, started selling their dollars. This trend led to run on dollars and holders demanded back gold in exchange for their holdings. A run that took place on March 17th, 1968 took the US aback as they had gold reserves to support only 22% of the dollars printed and they couldn’t offer even these 22% and go bankrupt themselves.

Taking stock of the situation, President Richard Nixon on August 13th, 1971 called for a meeting and after two days of discussion unilaterally announced the suspension of US dollar’s convertibility into gold, without even discussing with the IMF. This decision sent shocks over the entire globe among traders who had amassed a huge sum of dollars as mothing now backed it. This incident led the global economy to move from a fixed exchange rate system to a floating exchange rate where the relative prices of currencies where determined by the supply and demand dynamics. The demand for the US dollar came down heavily, and it thus had to compete in the international market like every other country now. It devalued its currency to a great extent to boost exports and also levied a 10% additional tariff on imported goods. All this measures helped the US to reduce its current account deficit, and the strong manufacturing

sector helped the economy sustain itself.

Current Scenario: The Global Financial Crisis of 2007-08 that impacted the developed economies very much prompted many eminent thinkers to call for a new global framework for financial regulation.

On 26th, September 2008 French President Nikolas Sarkozy called for a rethinking of financial systems from the scratch. Any attempt now to redefine regulations would be very complex and less likely to come to fruition quickly as no country in the world holds the power that the US did in 1947. Countries are more aware of their needs and are in a better shape to negotiate their deals.

The IMF and World Bank are used nowadays by the US to penetrate markets that used to be non-existent in previous times. This is achieved by the means of Structural Adjustments used as conditions for the loans. These are enforced upon the borrowing nations as a pre-condition for the grant of loan. The countries are forced to eliminate subsidies and tariffs, privatize the state-run industries, cut back on several social sector spending and open FDI. All of these leads to an influx of foreign products in a market once held by local producers. The local population is severely affected by these measures. Though the stated purpose is to relish growth and help the economy become sustainable so that it can repay the loan, it often impacts the economy negatively and leads to further poverty.

Many emerging economies these days have matured very much and have reduced their dependence on the western financial institutions such as IMF for their capital requirements. Asian countries such as China has amassed good reserves in foreign exchanges to obviate themselves from the need to go to these institutions in case of a crisis. Emerging markets have also invested heavily in setting up of their multilateral financial institutions such as the New Development Bank by BRICS in regards to the shifting order in the global powers. An estimate suggests that combined GDP of BRICS would be more than the G7 (US, Canada, UK, Germany, France, Italy, and Japan) by 2032.

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EMERGING INDIA: WHY SO LATE? RAHULAGGARWAL

GLIM CHENNAI

India is not rising, but has already risen” remarked Barack Obama before embarking on his maiden visit to India in 2010. What seems peculiar is that, we are hearing this after 60 years since we established our own government. While countries like Japan, Korea, Thailand and China could accomplish 8% of growth in the 1970s, we were at the rates of the Second World War. India, has indeed risen.

Her economic and infrastructure growth have made tremendous strides since 1991. This article is a perspective into what delayed our growth till then.

Less Focus on Agriculture One of the first faulty approaches was laser sharp focus on heavy industry in the second Five year plan. Even after investing a lot of resources no firm could achieve world class status. E.g.

SAIL, only produces approximately 25 million tons even after 61 years of establishment.

BHEL is only able to cater to domestic markets and is also finding it hard to compete in that.

Then we have created a number of white elephants which accumulated a loss of Rs 20,000 crore last year. We should have actually focused on agriculture throughout India. Right from 1952 to 1975 our main focus should have been towards increasing farmer income. Apart

DECEMBER 2015

from making us self-reliant in food products, it would also have created a wide consumer market. When China started its reforms in 1978, the first 7 years were used in reforming agriculture. This provided the readymade market which supported its initial building phase of low cost industrial structure. As there were no globalization or free trade principles at that time, it would have helped in expansion of domestic industry of consumer goods. Our focus was on heavy industry whose products are not consumed by the general public. Since domestic market provides a cushion if global trade suffers, India would have had a security system for its industries. The rural market was the main cushion for consumer durables during the 2009 crisis. Increased income of the

masses would have helped in better literacy and development of social infrastructure. This would have increased indirect and direct tax revenues of the government.

Eliminating Income Tax on Agriculture

MRPTC act, FERA etc. This reduced the chances of our entrepreneurs of raising capital and establishing firms in home country. The southeast Asian approach would have helped fill the void of domestic consumption. We had good arable land which could have been used for agricultural exports. We also had large mining resources which these countries did not possess. Exports of these raw materials (which we are doing now), would have earned us foreign exchange 30 years ago. So like China we would have migrated to the heavy industries 25 years ago, which we are doing now. We should have sensed the changing direction of winds blowing right in our neighborhood. That time we could have levied high import duties and low export duties as there was no need of adherence to any free trade principles. Sooner or later this would have strengthened the local

The second faulty approach was eliminating the income tax on agriculture after independence.

This is a politically suicidal move now, so don’t expect this to be levied any time in the future.

But due to sentimental economics rather than real economics, during independence it was reduced to zero, when Nehru and the Congress party had the political clout to implement it.

Even the Kelkar committee suggested taxing agricultural incomes above Rs. 25000. We should tax the large farmers which are no less than 2 crores in number. As our income tax paying population consists mostly of the service class which is very low in number (3% of population) this would have helped us in Table 4 : Exports of Goods and Services (% of increasing our Tax/GDP ratio (abysmally low at 16% today) to levels of western countries (as high as 26%) . It would have added to the revenue coffers of the government and reduced dependence on foreign aid. Currently increasing the Tax/GDP ratio can be done only through taxing the already taxed sectors and the salaried class which will reduce their savings and reduce productivity.

Not adopting export growth model The third mistake we did was not learning from our peers. When the South-East Asian countries started focusing on export- oriented growth right from the 1960s, we in turn took a more inward approach with the likes of

industry as well.

Faulty Designing and Implementation of Social Welfare Programs Fourthly, we were immensely incapable in both planning and implementing our social welfare programs. Since the 1970s India has invested massive resources into several social capital programs with little returns. Desert development program, watershed development program etc. were poorly designed and left to the mercy of the incapable government machinery.

This was due to the perception in the government that the illiterate and the poor were incapable of thinking for the benefit of themselves. So, no real local government institutions were created from the start. The intellectual elite did

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not engage the local population in planning.

This was the state till late 2000s, when we saw an increased participation of local leaders due

to the emergence of the Panchayati Raj system.

However, this will require another 10-15 years to make a substantial impact.

Low Infrastructure and transportation Investment

Public

Finally, the last mistake we committed was not investing in heavy infrastructure and public transportation. Our political and bureaucratic elite believed in the idea that the poor could be uplifted only by doling out subsidies. If the same money would have been invested in road building, ports etc., both income and durable assets would have been created.

DECEMBER 2015

We are committing the same fault today with programs like MGREGA. The building of infrastructure was not a priority even by the year 2000 when we set up ambitious goals to improve it. The ruling elite never understood the advantage of public transportation. We saw decreasing investment share in both bus and local train investment as we moved from 1950s. They believed that to improve infrastructure you only need to build flyovers, mainly used by the car owing elite. Not till the last decade we have seen local metros in cities and building of BRTS. This would have increased productivity of workforce (saving workforce time during commutation), increased savings (labour transportation costs would be reduced) and MNCs w o u l d have more e a s i l y penetrated the Indian landscape (as skilled workforce is available at different areas and costs of location would be low).

If this would have happened earlier some of our cities would have resembled at least Shanghai.

But better late than never the good thing is that we have learnt our lessons and are moving in the right direction. We are designing our programs more locally, investing in public transportation, encouraging exports and moving towards a consumer oriented market.

I have bright hopes that the policies of both UPA and NDA (which are in fact similar) will make a positive impact by the next decade.

MR. RAJAT MISRA Sr Vice President, Infrastructure Group, SBI Capital Markets Limited

FinGyaan

Fig. Level and Growth of Exports

What according to you will be the impact of the recent Fed rate hike on the Indian Debt and Money markets?

Most analysts hold the view that even after the Fed has raised interest rates; it will be less severe for India than the other emerging markets.

IMPACT ON CAPITAL MARKETS Carry trade refers to borrowing in a low interest rate currency and investing in risk assets such as emerging market equities and debt. Indian markets, both equity and debt, have benefited from this over the past few years when the Fed reduced its rate to 0.25%. Foreign institutional investors (FIIs) have been net buyers in equity to the tune of $1,100 billion since January 2009 and over $500 billion in debt.

In anticipation of the impending rate hike, the US dollar had appreciated against other currencies—notably emerging market currencies. This had damaged carry trade, and liquidity in emerging countries’ capital markets. This Fed rate hike in the US is expected to increase the cost of borrowing there and reduce the trade-off for this equation.

In the short term, this is causing markets to correct. Bond market yields haven’t been as sharply affected by outflows, but after the US rate hike, some experts feel that there will be a shift towards US treasuries, which can hurt emerging market bonds.

On the other hand, if we consider fundamentals, a stronger US economy means higher consumption, which will benefit Indian exporters and the service sector. A stronger US dollar will make American exports uncompetitive and opens up an opportunity for other manufacturing economies like India.

CURRENCY IMPACT Large capital market outflows by overseas investors affects currency negatively. The Indian rupee has been depreciating in line with

other emerging market currencies as the dollar strengthens. But the fall in the rupee has been relatively lower thanks to the strong foreign currency reserves and better growth prospects of the economy. Nevertheless, rupee at levels of around Rs.66 per dollar is close to the low levels seen two years ago.

Despite the recent reduction of the repo rate by the RBI, the 10 year Government Bonds have seen a steady rise in yields. What according to you is the reason for this, and do you see the trend continuing in 2016?

The yield on the 10-year government bond has been rock steady at 7.7 per cent since the beginning of the year even after the RBI lowered its key policy repo rate by 125 points since January. But even after the steep 50-basis-point repo rate cut in the previous September policy, the yield on the G-Sec is now one percentage point higher than the repo rate (6.75 per cent).

There are two main reasons for this. One, in recent weeks, the US bond yields had hardened further. The second reason has been some challenge perceived by the markets about the Centre meeting its fiscal deficit target after the pay-outs under the Seventh Central Pay Commission.

Market players believe that the trend is temporary and there is scope for the yield to fall to 7-7.25 per cent levels in the coming months.

This might be mainly due to the fact that the government has reiterated its commitment to maintain fiscal discipline. Secondly, now that the uncertainty over the US Fed rate hike is done with, there is a chance of US bonds giving up some gains (assuming the Fed tone remains dovish about its forward guidance) and Indian bond yields moving lower.

From financing perspective, there is a shortage of both debt and equity. Many banks have reached sectorial limits and banks What impact has the Make in India policy of the

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Indian Government had on the investments in the infrastructure sector?

Reforms have been announced to boost manufacturing growth to 10 percent per year by promoting “Make in India”, an initiative aimed at creating 100 million jobs over the next decade and bringing manufacturing up to 25 percent of Indian GDP. The infrastructure sector will benefit from the following initiative: Investment to foster innovation and new technology development, including a USD 1.2 billion investment to develop smart cities and the creation of a USD 16 million development fund; Actions to facilitate Foreign Direct Investment, including an increase of the FDI cap to 100 percent in railways Actions to foster project execution, including the reforms of approval and clearance requirements and processes, including the rolling out of an online system designed to speed up approvals for development projects that might have environmental impacts; Promotion of locally developed solar and wind power equipment The recent move of the government to relax the cap on FDI in the defence and construction sector is a welcome. More changes like an increase in FDI cap, and the elevated investor confidence due to the new government are expected to rise helping the infrastructure.

What according to you is a major impediment to investments in the infra sector and what the possible alternatives that can be looked at?

The tough task for India to address competitiveness in global-scenario are noncost factors. To gain investor confidence and attract high FDI in the future, India would need to fix its poor infrastructure through investment in highways, ports and power plants. Radical labour reforms, simpler tax structure and easier access to formal credit mechanisms are also long awaited. Additionally, India will need to show dramatic improvement in its ease of doing business. Addressing these non-cost factors in spirit and also building a perception around these improvements in the international arena are crucial for India to succeed in future.

On financing side, there is a crunch of both debt and equity. Many banks have reached

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NIVESHAK

there sectorial exposure limits to infrastructure.

To overcome financial crunch, India needs to develop a vibrant bond and private equity market What role do you think GST will play in boosting investments in the infrastructure sector?

The infrastructure supply chain is being evaluated very closely under the GST bill. The bill proposes to widen the tax base with a reduction in the exemptions. Thus the major concern for the infrastructure sector is the discontinuation of the current exemptions and concessions in the GST rollout. The impact on the credit chains and costing also are areas of concern.

Coming to the industry specifics, the railway and port industry enjoys service tax exemption on construction, erection and commissioning services. Similar is the case of road construction services, but VAT is applicable on the material used for construction. Transport by rail the services are partially taxable, but full applicability comes into play for port services.

If you look at the mining sector, you will find that VAT is applicable, however most mining products are free from excise duty. With such a wide variation in indirect taxation prevalent the industry it remains to be seen how it will pan out in the GST regime.

There are already some talks on keeping the power sector out of the GST bill. This is again to provide a leeway to states, so that they can continue to earn from the electricity duty levied by them on the users. This has a direct bearing and impact on the power plants. They are unable to avail the input tax credit on taxes paid on coal and also on capital expenditure for setting up the power plants. This leads to an increase in the production costs of the power plants. If GST is applied on the inputs at a rate of 25% for the power plants, against the existing CST of 2% and service tax of 14%, with no relief on the sale side, it will kill the profitability and ultimately the viability of the power plants.

In the civil construction there is no input tax credit available against the payment of CENVAT and state VAT in the infrastructure projects. How the input credit on paid taxes gets transformed under the GST for the civil construction industry also remains to be analysed.

CLASSROOM

Factoring and Forfaiting

FinFunda of the Month

Sir, Last night I came across the term Factoring and Forfaiting, could you please explain what those terms are?

Well, the Term Factoring is used in trade finance when one party or a firm (the client), agrees to sell a portion of his trade receivables either with or without recourse to a financial institution (the factor). The Factor in return makes a part payment against these receivables (usually up to 80%), thereby providing the required liquidity to the client.

Sir, you mentioned recourse and nonrecourse, could you elaborate on the same?

Recourse factoring is a form of transaction in which the factor agrees to buy the receivables from the client. However, in case the third party that has to make the payment defaults, the entire amount can be recovered from the client itself. In non-recourse factoring, the factor bears the entire risk of default and the client is not obligated to make the payment I case the third party defaults.

What is Forfaiting then?

Forfaiting is a mechanism in which the export receivables of the Client are purchased by the financial institution (forefaiter) on a non-recourse basis. These transactions are usually backed by a letter of credit, bill of exchange, promissory note, etc. and hence have a lower credit risk. The client can obtain up to 100% financing under forfaiting

Aaron Keith Rego IIM Shillong

How is Factoring and Forfaiting Different?

While factoring can be used only for shortterm credit (up to 180 days), forfaiting is a long-term financing solution with credit period extending from 180 days up to 7 years. Also, factoring can be availed on any short-term receivables (domestic and export) whereas forfaiting can be availed only on export receivables.

Factoring is beneficial to companies that require additional services like credit assessment of customer, accounts receivable reporting, debtor follow-ups, etc.

Also, factoring helps the company in focusing on its core business by removing the responsibility of managing receivables.

Forfaiting is useful for those companies that have a large volume of cash flows that are uncertain in nature.

It helps them normalize their cash flows and helps improve their balance sheet by eliminating accounts receivable, bank loans and any contingent liabilities.

Sir, then aren’t they the same as bill discounting?

No, Bill discounting is a process in which the financial institution provides a financing against a bill of exchange only. This bill needs to be a trade bill, and hence, any other form of bills (e.g., accommodation bill) are not eligible for discounting.

Also, bill discounting is usually done on a recourse basis.

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