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ERA of germAn hyperinflAtion, Pg. 19


November 2012


FROM EDITOR’S DESK Dear Nivehsaks,

Niveshak Volume V ISSUE XI November 2012 Faculty Mentor Prof. P. Saravanan

THE TEAM Editorial Team Akanksha Behl Akhil Tandon Chandan Gupta Harshali Damle Kailash V. Madan Nilkesh Patra Rakesh Agarwal New Team Anchal Khaneja Anushri Bansal Gourav Sachdeva Himanshu Arora Ishaan Mohan Kaushal Kumar Ghai Nirmit Mohan Creative Team Anuroop Bhanu Kritika Nema Neha Misra Venkata Abhiram M.

All images, design and artwork are copyright of IIM Shillong Finance Club ©Finance Club Indian Institute of Management Shillong

The gripping excitement of the presidential elections in the US finally came to an end with the re-election of Barack Obama to the White House for another 4 years. This has evoked mixed emotions from the governments and public worldwide. China would perhaps be the most happy with the outcome. The first major test of the President would be to avoid the fiscal cliff, the possibility of which looms large over the US. The focus has now shifted to the all-important once in a decade transition in most populous country on earth. The 18th National Congress of the Communist Party in China witnessed the nomination of a princeling, Xi Jingping as the next President of the country and Li Keqiang as the next premier. This high profile meeting also saw the number of Standing Politburo Committee members reduced to 7 from 9. The world has already started speculating the anticipated behavior from the next leader of the economic powerhouse. In India, with most ministries acknowledging the need for a body to steer the large investments, the proposal for the National Investment Board is all set to be presented before the cabinet in the coming days. This institution will make India an easier place to do business. The rupee remained weak throughout the month hovering around Rs.55 per dollar. The country expects some major reforms from the Winter Session of the Parliament which started on November 22. This issue brings to you some more interesting and insightful reads. The cover story this month focuses on the nomination of next president of China, Mr. Xi Jinping and discussions revolve around the possible trajectory of reforms and economic growth under his guidance. The article of the month explores the concept of restructuring of banks, a revival strategy for dwindling financial economy, which leads to the formation of a Good and a Bad Bank. Other articles in this issue focus on the need of diversification for Gulf Cooperation Council (GCC) Economies and Country Risk for Multinational Corporations. Lastly, the Classroom this month explores the topic of Phantom Stocks. Also, the Editorial Team of Niveshak, is pleased to introduce to you our new team, which has been selected to carry on the legacy of Niveshak. They are: Anchal, Anushri, Gourav, Himanshu, Ishaan, Kaushal, Kritika, Neha and Nirmit. Please join us in welcoming them to Team Niveshak. We are confident that the new team will not only meet but surpass your expectations in this and the coming editions. Keep supporting them the way you have been doing to us. With a new team, comes a new section. We are glad to introduce a new section Fin-istory, which will aims at critically analyzing history’s most significant events and provide an insight as to how they altered the status quo of the financial world. The present and the next 2 issues will cover significant events during the first quarter of the 20th century. This section will replace the widely cherished column, Fin Perspective. We would also like to thank our readers for their constant support through wonderful articles and appreciation. It is your endless encouragement and enthusiasm that keeps us going. Kindly send in your suggestions and feedback to and as always, Stay invested.

Team Nivehsak Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears no responsibility whatsoever.

CONTENTS Cover Story Niveshak Times

04 The Month That Was

Article of the month

08 Bank Restructuring

12 China at the Crossroads

FinGyaan 16

Country Risk for Multinational Corporations



GCC Economies and their need for Diversification


19 The Era of Hyperinflation in

Germany (1914-1923)


25 Phantom Stocks

The Month That Was



The Niveshak Times Team NIVESHAK

IIM Shillong

Second Innings for Obama Barack Hussein Obama, America’s first black president, captured a second White House term defeating Republican challenger Mitt Romney. The president won his home state of Illinois as well as Romney’s home state of Massachusetts -- where the Republican previously served as governor. His eyes welled with tears as he thanked the people who showed faith in him and re-elected him in the most critical of times. Obama got a second chance from voters despite high unemployment and a weak economic recovery. With the victory, Obama will face the challenge of leading a country facing chronic federal deficits as well as sluggish economic growth. The president’s most immediate concern is the “fiscal cliff” of scheduled tax increases and spending cuts, which if not taken soon, can crush the U.S. economic recovery. He pledged to work along with Republican leaders in Congress to reduce the government’s budget deficit, fix the tax code and reform the immigration system. 2G Spectrum auctions – a big flop The government’s plan to raise INR 45000 crore through 2G spectrum auctions was a flop show as the auctions lasted just two days, receiving bids worth only INR 9407 crore. Only 55% of the total spectrum offered was sold, with no buyers for the most lucrative Delhi and Mumbai circles. None of the five companies participating in bidding made any offer for pan-India airwaves for which the reserve price was set at INR 14,000 crore, a rate considered high by the industry. Poor response to the 2G telecom spectrum auction will make it difficult for the government

Novemberr 2012

to keep fiscal deficit in check and meet the revised target of 5.3 per cent of the Gross Domestic Product (GDP) in 2012-13. Finance minister Chidambaram said that the auction has not ended yet and there will be another auction for the unsold spectrum before March 31. Diageo acquires majority stake in United Spirits World’s largest spirits company Diageo and Mallya’s United Spirits sealed a deal giving the British company complete control over India’s largest spirits producer. As per the deal, Diageo will hold 53.4% of the enlarged USL share capital at an aggregate cost of above INR 11,000 crore and Mallya will continue in his current role as Chairman of USL. Mallya said the deal is a Win-Win situation for both Diageo and USL, the seeds for which were sown nearly six years ago. The market took this deal positively and the shares of USL zoomed by 35% on 12 November, 2012 The Diageo-USL deal has definitely revived the hopes of lenders of Kingfisher Airlines, who have been trying to get Mallya to re-capitalize the company through equity shares. But Mallya said that the deal has no implications for his cash-strapped Kingfisher Airlines, as both are independent businesses. Eurozone back in recession The Eurozone has fallen into a double dip recession, as the debt crisis managed to slowdown single currency’s big two economies – Germany and France. The French and German economies both managed 0.2 percent growth in the July-to-September period but still could not save the 17-nation bloc from contraction as the economies of The Netherlands, Italy, Austria and Spain shrank. GDP of the 17 country bloc grew


by 0.2 percent in the third quarter, down from 0.3 percent growth in the previous quarter. Two continuous falls of 0.2 percent in the second quarter and 0.1 percent in the third means a double dip recession for Eurozone. Five Eurozone countries: Greece, Spain, Italy, Portugal and Cyprus are at the center of Europe’s debt crisis and are being imposed with austerity measures. The resolutions for the Eurozone debt crisis rely on Germany and France to supply enough support to allow these nations to apply austerity measures to get their debt ratios under control. Economists said that recession will extend until the end of the year and the year 2013 too promises little better than stagnation. RBI cuts CRR rates to 4.25% The Reserve Bank of India cut the cash reserve ratio by 25 basis points to 4.25 % leaving its key policy rates unchanged in its second quarter (July-September) monetary policy. CRR is the portion of deposits banks are mandated to keep with the RBI. This is the fifth CRR cut since January 2012. The revised ratio will infuse Rs. 17500 crore liquidity into the system. The reduction in the CRR is intended to pre-empt a prospective tightening of liquidity conditions in the economy, thereby keeping liquidity comfortable to support growth. The RBI has kept the policy rate unchanged since the global backdrop remains broadly the same. Moreover, during this period even though domestic activity has picked up, inflation is on the rise again. National Investment Board The Union finance ministry has finalized a cabinet note for creation of the National Investment Board (NIB) to expedite infrastructure projects. Big projects across sectors will come under the direct monitoring of the board after it is set up. This will help in clearing the backlog of pending projects held up due to delay in approvals from various ministries. As per the cabinet note, the projects having investment of Rs 1,000 crore or

upwards in sectors such as roads, mining, power, petroleum, natural gas, ports and railways shall be monitored by the board. The board will be headed by the Prime Minister. The NIB will be supported by a secretariat that will be supervised by the Finance Ministry or the Prime Minister’s office and will identify the key projects that need to be monitored on continual basis. But NIB is caught in a turf between the Finance Ministry and the Environmental Affairs Ministry. The Environmental Minister, Jayanthi Natarajan has raised objections against this proposal. It says that the proposed National Investment Board, if formed, will be an undemocratic authority that can overrule India’s Environment Ministry. IKEA proposal to set up stores in India approved by Commerce Ministry: Anand Sharma The Department of Industrial Policy and Promotion gave a nod to Swedish furniture major IKEA’s proposal to invest Rs. 10,500 crore to set up stores

in India. The application is now with Foreign Investment Promotion Board. The application of IKEA includes setting up of 25 single-brand retail stores in India over a period of time. After the clearance given by FIPB, the proposal will have to be finally cleared by the Cabinet Committee on Economic affairs (CCEA). If approved, this would be the largest investment in the singlebrand retailing ever, since the government has allowed foreign direct investment in this sector in January.


The Month That Was

The Niveshak Times




Article Market of Snapshot the Month Cover Story

Market Snapshot


MARKET CAP (IN RS. CR) BSE Mkt. Cap Index Full Mkt. Cap Index Free Float Mkt. Cap

6,489,886 3,081,087 1,571.732

LENDING / DEPOSIT RATES Base rate Deposit rate

9.75%-10.50% 8.50% - 9.00%


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

55.35 71.37 67.24 88.30



4.25% 23%

POLICY RATES Bank Rate Repo rate Reverse Repo rate

9.00% 8.00% 7.00%

Source: 30th October to 23rd November 2012 Data as on 23rd November 2012

November 2012


BSE Index Sensex

Open 18642.01

Close 18506.57

% change -0.73%


6582.36 7048.85 10294.86 13192.97 7050.74 11126.17 5714.70 7508.69 5663.94 10177.38 8435.75 1973.00 7213.43 1788.53 3283.25

6597.42 7057.11 10558.86 13178.67 7476.93 10630.36 5815.39 7703.04 5733.43 9801.24 7987.56 1920.10 7003.98 1869.11 3399.91

0.23% 0.12% 2.56% -0.11% 6.04% -4.46% 1.76% 2.59% 1.23% -3.70% -5.31% -2.68% -2.90% 4.51% 3.55%



Article Market of Snapshot the Month Cover Story

Market Snapshot



Article of the Month Cover Story



Restructuring Sachin Pal

IMT Ghaziabad The world was still on the path of global recovery led by the financial sector post the subprime mortgage crisis when the Eurozone crisis caught it midway and stalled its progress. This article discusses the concept of restructuring of banks which leads to the formation of a Good and a Bad Bank. The concept has been used with great success in the past and is a valuable solution for banks seeking shelter from the financial crisis. It has been in news for quite some time now, the latest being the creation of so-called bad bank by Spanish government in an effort to revive its dwindling financial economy. The Bad-Bank Model The concept of Bad Bank is quite simple on paper. The bank divides its assets into two categories. Into one stack go the assets which have become illiquid and risky and toxic securities that puncture the backbone of the banking system. Troubled assets such as nonperforming loans may also be included in this stack. The bank may also choose to add non-strategic assets

Figure 1: Formation of a Bad Bank from a Good Bank

from businesses which no longer fit either in its portfolio or its business strategy and thus wants to exit, no longer wanting to keep them on its books as it seeks to lessen risk and deleverage the balance sheet. The ones that are left are the good assets that represent the ongoing business

November 2012

of the core bank and that shall increase the bottom line of the bank. The reason for segregating the two is again simple as the bank wants to keep the dirty fishes out of its pond in an effort to stop the bad assets from contaminating the good ones. A mixture of the two bundles can make the investors and counterparties uncertain about the bank’s financial health and performance and more importantly its future and money security, thus directly affecting its core banking operations of borrowing, lending, trading, and raising capital Implementation of the idea of Bad Bank is as complicated as anyone can think of. A lot of thinking goes on in the creation of the new entity and there are a lot of considerations involved which typically include organizational, structural, and financial trade-offs. The effect of these choices on the bank’s liquidity, balance sheet, and profits can be difficult to predict, especially in the current crisis. Structure The bad bank is structured in a way that it does not appear in the consolidated balance sheet of good bank. For this purpose the bank can have a minority stake in the new entity with sufficient funding from external sources needed to capitalize the bank. Funding The bad bank must be capitalized in order to function. Typically two options are available for funding a bad bank: • Debt • Equity Private investors, with a focus on distressed situations, may be attracted to invest in order to gain ownership with significant control over the new entity. The required capitalization will typically depend on: • Portfolio of assets



Article of the Month Cover Story

Table 1: Various Bank Support Programmes in the US

• Valuation of the assets • Anticipated loss levels Banks typically formulate this structure as this move is likely to improve the credit ratings of the good bank as well as improve their growth outlook. The biggest challenge for bad bank is the valuation of troubled assets. Different methods may be used to value the assets to be transferred depending on the asset class, quality etc. However, in all cases, the bad bank pays very less percentage of the nominal value or the book value of the assets and receives the assets at a significant amount of discount or haircut on its the purchase price. Here we discuss three different types of restructuring that took place in the past. Each of these restructuring was carried out in a different manner. The US TARP was Fed backed Asset Guarantee program, the Irish NAMA was formed as a Special Purpose Vehicle with capital injection from government and private investors in return for equity stakes whereas the RBS was taken over by the UK government. Asset guarantees differentiates itself from good bank-bad bank

model in a way that doesn’t involve transfer of assets but just provides asset guarantee. US TARP Program The United States government started the Troubled Asset Relief Program (TARP) in an effort to stabilize the financial sector at the time of subprime mortgage crisis. The Treasury announced its intention to buy senior preferred stock and warrants from the nine largest American banks by forming an aggregator bank. The proposal called for the federal government to buy up to US$700bn of illiquid mortgagebacked securities with the intent to increase the liquidity of the secondary mortgage markets and reduce potential losses encountered by financial institutions owning the securities. Maximum authorized TARP disbursements was later reduced from US$700bn to US$475bn under various programs. TARP operated as a “revolving purchase facility” with a set spending limit of US$250bn at the start of the program, with which it purchased the assets and then either sold them or held and collected the “coupons” from the banks. The

Figure 2: Consituents of a Bad Bank



Article of the Month Cover Story


maximum limit for facility was kept at US$350bn subject to approval. The participating institutions had to meet certain criteria in order to benefit from the program. According to the terms of agreement, TARP bought warrants and preferred shares that paid annual dividends in the range of 4-6% during the first five years which increased to 8-10% in the following years. According to the latest figures released on the federal government website in July 2012, it has recovered US$351.46bn out of the total of US$467.21bn which it invested under bank support programs, credit market programs and treasury housing programs. RBS break-up RBS, the 285-year-old UK based bank, reported a loss of £24.1bn in 2008. A bulk of RBS’s loss stemmed from a £16.2bn write-down of assets, which was mainly linked to its purchase of ABN Amro – a bank heavily exposed to the sub-prime crisis. Its underlying losses totaled £7.9bn. Prior to this incident the biggest annual loss of any UK corporation was the £14.9bn loss reported by Vodafone in 2006. RBS made massive changes to its structure

following the loss. It put £325bn of toxic assets into a new government insurance program. UK Government’s Asset Protection Scheme provided RBS with a capital injection of £25.5bn and catastrophe insurance for the riskiest assets. The primary purpose of this equity injection was to make new Tier I capital available to the UK banks and restructure their finances. Under the lighter touch terms agreed with the UK Government in November 2009, RBS would bear the first £60bn of losses and the Treasury would bear 90% of losses thereafter. The fee for this insurance would be £700 m for the first three years and thereafter £500 m annually. The new terms allowed RBS to exit the APS at any time subject to meeting the capital adequacy requirements and repaying the Treasury for any shortfall in fees due. Following the placing of open offers in December 2008 and April 2009, HM Treasury owned around 70.3% of the enlarged ordinary share capital of the company. This new capital took form of B shares, which did not carry voting rights at general meetings of ordinary shareholders but were convertible into ordinary shares and

Table 2: Summary of Loan Acquisitions

November 2012


qualified as core Tier I capital. Following the issuance of B shares, HM Treasury’s holding of ordinary shares of the company remained at 70.3% although its economic interest rose to 84.4%. Investors welcomed news of the scheme, and as a result its share prices went up. According to a news update run in May 2012, RBS was poised to announce that it had repaid the emergency funding received from the British Government after reporting a surge in profits for the first quarter of 2012. Ireland’s Bad-Bank NAMA Irish financial crisis stemmed from the financial crisis of 2008 and the country entered into an economic depression in 2009 with the banks bearing the brunt of the ailing economy. In April 2009, the government proposed the formation of NAMA through a Special Purpose Vehicle (SPV) known as National Asset Management Ltd and controlled by the holding company National Asset Management Agency Investment Ltd. The NAMA SPV (Master SPV) structure had a subscribed capital of 100m. 49% of this capital base (i.e. 49m) was advanced by NAMA and 51% by private investors. Three private investors, namely, Irish Life Investment Managers, New Ireland Assurance and a group of clients of Allied Irish Banks Investment Managers, had each invested 17m in the vehicle and took 17% stake each in the SPV. The Master SPV was a separate legal entity and was jointly owned by private investors, who owned 51% of its equity and therefore had the majority vote, and NAMA, which held the remaining 49%. NAMA was then geared up way above typical EU banking limits, taking on debt 35 times its paid-up capital. In its first phase of operation, it acquired a portfolio of 11,000 loans from the major Irish banks with


Article of the Month Cover Story

Figure 3: Formation of NAMA

a nominal value of €71bn and paid €30.4bn for the loans, representing an aggregate 57% discount on the book value of these loans. In exchange for these loans, NAMA issued Government-guaranteed securities to the five participating financial institutions. Although the SPV had its own Board, NAMA retained a veto power over all decisions of the Board that could affect the interests of NAMA or of the Irish government. The Master SPV ran with the objective of making a profit on the purchase and management of the assets it purchased. The Draft Business plan assumes a life of 11 years for NAMA from 2010 to 2020 with full repayment of the loans issued by NAMA/Irish Government by the end of 2020 along with cumulative interest on the loans. The Draft business plan expects a default rate of 20% on the €77bn of principal, and repayment of €62 bn. Taking all the adjustments into account, it expects a cumulative positive cash flow of €5bn from this entity. Ireland’s controversial new “bad bank” (NAMA), thus, is one of the biggest property banks in the world after it completed the acquisition of developers’ loans worth more than €70bn and gained control over the loans on hotels, housing estates, shopping centers and development sites across Ireland, the UK, mainland Europe and elsewhere. Conclusion European crisis began over two years ago. Market pressure on Europe has boiled up and then eased several times in response to political and economic developments and subsequent policy responses. A permanent solution to Europe’s problems is unlikely to emerge before year-end, leaving markets vulnerable to extreme fluctuations, as well as the tail risk of a disaster scenario. EU policymakers appear determined to provide the necessary support to avoid the disaster, but the crisis continues to intensify. In the present scenario, restructuring of the banks leading to the formation of bad bank looks inevitable and the latest move by the Spanish Banks over bad bank creation hints us over segregation of troubled assets to alleviate the pressure on the financial institutions and the financial system. Whether a good bank– bad bank structure takes the precedent form like that of NAMA or a novel form is not clear at the moment and will be driven by policy and politics in the months to come.


Cover Story



CHINA AT CROSSROADS Himanshu Arora &Nirmit Mohan

Team Niveshak The world economy in the next one decade is going to be affected more by the nomination of Mr. Xi Jinping as the head of the next economic powerhouse than by the re-election of Mr. Obama at the helm of the matters in the White House. China, as it stands today is the world’s second largest economy, which under the reign of the current leader and Mr. Xi’s predecessor, Mr.Hu Jintao, quadrupled in size and stood close to $7.9 trillion at the start of 2012. Its exports stand at a whopping $1904 billion, the largest in the world. China has been contributing to global growth more than the United States and accounts for one third of the global GDP growth in the world. According to Jim O’Neill (famous for coining the term BRIC), this decade belongs to China where it will contribute to global growth more than the US and Europe combined. Out of the Fortune top 500 companies, 73 (most of which are state owned) have their roots in China, the major ones being Sinopec, China National Petroleum, State Grid and ICBC. But, with the growth rate declining to a single digit (a rate many countries still only dream of), last 2 years haven’t been too encouraging. If the trend continues for long, it will spell some loud alarm bells for the world economy. Mr. Jintao, in his last state of the nation address, hinted at a few reforms that are imperative to reverse this downslide. The buck now stops at Xi who in effect will take over not only as the leader of China but also of the global economic health. Introducing Xi: The Princeling Xi Jinping, the present Vice President of China

November 2012

and an eminent figure in the Communist Party, is set to take charge of China in March 2013. His father, Mr. Xi Zhongxun, was a hero alongside Mao Zedong and held the position of Deputy Premier from 1959 to 1962 before falling out of favour with Mao for his moderate views and therefore was relegated to obscurity. Thereafter Xi was sent to a countryside where he spent close to seven years living with the people at the bottom of the economy, working tirelessly on the farm fields to make a living. He had thus been exposed to the lavish lifestyle of a prospective premier and has also seen poverty in its true sense; a grooming, many consider ideal for a person set to rule over one fifth of humanity. Xi, promises to be different from his predecessor. The man responsible for the successful organization of the Olympics (read Xi) talks freely about his love for Hollywood movies and sports. Recently, he even apologized for keeping his audience waiting. Such welcome gestures have been missing from the mechanical voices and plastic smiles of party leaders before Xi. These gestures might not necessarily reverse the direction of China’s GDP growth rate in the last 8 quarters, but will definitely send out a positive signal to the world, for which the dragon has been a nation tough to approach. Also, his familiarity and openness towards western economies signal that a much needed change in the functioning of the economy that is driving the world growth might be a possibility. Though the party has entrenched beliefs and to turn that over might not be an easy task for one man, but Xi is the ray of hope




Cover Story

Fig 1: GDP Growth Rate of China

that the world in general and China in particular needs when the global economy is going through one of the toughest phases. Can Xi Jinping generate the transformation that China needs? The beginning of its new year hardly resembles the one of a year ago. In China, inflation and public resentment are on a high. Overseas, China’s external environment has also weakened significantly and its relations with the major powers and its neighbours are at the worst ever since the dark days of the Tiananmen Square crackdown in 1989. From Mr. Xi’s first address to the citizens of China, it seems that government is in pursuit of policies intended to reduce corruption, allow privatisation into sectors monopolized by the State Owned Enterprises (SOEs), and rebalance the economy from its focus on public investment. Let’s take a look at some of the major challenges that stare in the face of the new Politburo Head, and a few of the possible solutions. 1. Economic Growth China’s image as the driver of the world economy first came hurling onto the world screen after the global economic crisis of 2008 from where it emerged unscathed. Immensely hit manufacturing sector worldwide gave Chinese exports a major boost, but in the last few quarters, the sluggish economic growth has caught up with the booming Chinese markets. Also, the manufacturing sectors in the EU and the US have started recovering. Hu Jintao, in his address at the 18th National Congress, made references towards making the Chinese economy consumption-driven to sustain the impressive numbers. A strong family structure that demands savings and lack

of festivities in the country makes it harder to increase consumption. The Chinese premier Wen Jiabao also showed his concern when he said “Our problem of unbalanced, unharmonized and unsustainable development is still prominent, especially, the imbalance between investment and consumption.” Xi will have to address this issue sometime soon. This will require giving more impetus to the private enterprises and loosening control on some of the tightly held vital industries. Monopolies in the most populous country are not an efficient way of functioning and will only prove a bottleneck for increasing consumption. 2. Privatisation An attempt to Privatisation was made by Wen Jiabao (the premier set to make way for Li Keqiang), when Beijing rolled out a series of guidelines, then popularly known as the “new 36 articles”, promising to encourage private investment in key sectors. But these next generations of tougher reforms were never met by the Hu-Wen government. Many entrepreneurs felt that they dared not compete with the SOEs because of the fear that any money they invest may be lost forever. With the state banks favoring SOEs, the financing issues also make entry barriers high for the private entrepreneurs. In order to stir up this weak confidence in the government’s dedication to reforms, Xi Jinping with his business friendly approach, is best suited to take up a small number of well-chosen early reforms in an effort to change the overall policy environment and lay foundations for revolutionary reforms for future. 3. Corruption As Hu-Wen government wind down 10 years of


Cover Story



leadership that witnessed prosperous economic growth, it was also a decade that stirred up popular discontent over problems including corruption and income disparity. Lately, a couple of Corruption investigations have been targeted at high-level leaders, most notably former Politburo member Bo Xilai who was accused of obstructing the investigation into the murder of an English businessman and unspecified corruption while in office. Xi in his preliminary party address called upon to the old Chinese proverb “Things must first rot, before worms grow”. He also referred to the Arab phenomenon wherein he felt that such long term accumulation of incongruity can lead to system failure thereby signaling firm reforms to check corruption in the country to prevent any kind of civil unrest. 4. Energy Sector China’s rapid strides in growth have augmented thermal generation capacities (refer Figure 2), which are now creating some of the world’s most complex environmental challenges. It has now become the World’s biggest emitter of Greenhouse gases (China-26%, US-16% and EU-11%) accommodating 20 of the world’s 30 most polluted cities. Going as per reviews by many experts, renewable technology is the next wave which China is expected to witness. Though Xi did not make any explicit remark in this regard, this is one imperative measure that he needs to bring about if China has to sustain its carbon footprint.

FIgure 2: Generation Mix of China

5. Peevish Public China is a state not highly known for the liberty that it gives to its citizens. Most of the internet websites are blocked or the content is highly censored. Internally developed social media services like Facebook and Twitter (both of which are banned in China), are growing in popularity

November 2012

Figure 3: Graph of Income Disparity

and a culture of microblogs is emerging fast in the country. All this has led to many like-minded people coming together to discuss and protest against the autocracy. It is not going to be very easy for Beijing to forcefully take down these rebels. A better and more feasible method will be, to gradually introduce reforms that can give it citizens a proper channel to direct their dissents. The magnificent growth experienced by the country has helped many to rise out of poverty, but at the same time income disparity in the country has touched new heights. The following graph (Figure 3) gives a picture of the levels through the last few years. This has led to a growing dissatisfaction amongst the people and an ever reducing faith in the government. The high profits from the enterprises need to be shared with the common people. The government spending in sectors like healthcare, education and social security (around 30%) is way below the average spending in the other developing countries (52%) and needs to increase in order to make headway in reducing this stark disparity. Land grabs form another major source of public protests and contribute more than 60% of the total public outcries. The reforms against the corrupt officials included in these grabs are in the pipeline and hopefully will soon see the light of the day. This is one easy way in which Xi, whom not many Chinese know, can win over the trusts of the masses. 6. Demographics Population ageing is often misunderstood as a problem of Developed Countries. However, with rapid decline in fertility rate, most drastic trends of population ageing have been observed in China. As per the estimates (Figure 4), the median age is projected to be 46 years (presently 35 years) by the year 2040, as compared to India’s 31(pres-



Cover Story

Figure 4: Median Age of the Population in China and India Source:

ently 25 years). Also, the working population is anticipated to start shrinking from 2015, adding pressure on the current remunerations and thus overtaking EU in terms of Senior citizens. This long-term consequence of China’s drastic fertility decline is mainly attributed to the “onechild policy”. The policy confines Chinese couples to have only one child, unless both partners were themselves the only children, resulting into young people paying for the pensions and healthcare of the elderly. Many think tanks support scrapping of this policy, which would result in younger population and could help restore China’s fertility rate. A policy decision in this regard will take at least 25 years to get younger workforce to support Chinese export hubs and service industry, without which a very high median age by 2040 will set alarm bells ringing loudly in the country. 7. International Relations Though many believe that China would stick to its customary preferences for international relations and the next generation young leaders would refrain from making major changes till the senior leaders retire from the Politburo Committee, Xi’s flexible mind can push towards improving the bilateral relations with Japan and the other Tiger economies. In case of India, it’s an opportunity to start on a fresh note, as neither Xi Jinping nor Li Keqiang has visited India and the special representative Dai is set to retire. The first signal of whether Xi is considering a fresh look at the Sino-India relations would come with the appointment of the next special representative for boundary talks. Selection of Dai’s assistant will signal continuity in policies, whereas a new representative might indicate a change. As the head of TWF (Tibet Work Forum), there are high chances that Xi’s ut-

most priority will be to confront the current wave of self-immolation among Tibetan monks and their protest against the Communist government. Thus, pursuing talks with Dalai Lama might lead Xi to look towards India in a favorable demeanor. Conclusion With the world economy going through a vulnerable phase, any change is bound to be greeted as one having a sense of sanguineness. China goes into transition at a time when certain reforms and policies can breathe a new life into the sentiments of the 7 billion people and put the global economy on a rising trajectory. But, expecting Xi to bring about these changes quickly might be expecting too much. Even though his smile and confidence might make us believe that the reforms are not very far, it’s worth keeping in mind that he belongs to a party that has deep rooted beliefs and promotes only those to the cabinet who have been tested and groomed over the years to function in the way the party wants them to. Five out of the seven Politburo Committee members are quite aged and can be counted upon to resist these reforms. These five members will make way for younger, more charismatic leaders after five years. Xi and Li are here to stay for the next one decade. Perhaps it will be after 5 years when President Xi and Premier Li, supported by the enthusiastic Politburo Committee members, will actually take it upon themselves to set their house in order.




Article FinGyaan of the Month Cover Story





GLIM, Chennai

Emerging markets in the second world nations have changed the face of globalisation. Companies from mature markets now vie to gain maximum share of the pie in the new markets, resulting in the birth of MNCs or multinational corporations. The term ‘local’ is evaporating in terms of product development as all products are competing with foreign brands in the domestic country or in the global market. However while evaluating the financial aspects of a company and its overall business risk, political or socio- economic conditions need to be considered which differ from country to country. The country risk must be considered while evaluating a project in order to find the overall risk of the emerging markets; else the project valuations may paint an incorrect picture on the ROI (Return on Investment). Country risk is relevant only when risk cannot be reduced by having a global portfolio or when there is a low correlation among the markets in which investments have been made. So to calculate the cost of investment in any country, an additional country risk premium must be estimated. The CAPM model was initially developed to calculate the domestic risk but with the changing times and unavailability of theoretical justification, various models have evolved to analyse the riskiness of projects in various countries. The basic CAPM model is used to evaluate the cost of equity, which in turn acts as an input to the WACC (Weighted average cost of capital) calculations. The WACC can then be used to discount the cash flows of a project to find the viability. As per CAPM model, Re = Rf + (Rm-Rf) The Rf is the domestic rate of interest of the country

November 2012

in which investment is made and cannot be negotiated. Thus the second portion of the equation (Rm-Rf) i.e. the market risk premium can be fiddled with, or an additional component can be added to include the country risk premium. The developed economies usually have a low market risk premium of around (4-5%) while the emerging economies have a high market risk premium of around (89%). Also, in most of the emerging economies, market risk premium may be dominated by a huge market capitalization of a few or sometimes only one company. For e.g. 35% of Rm in Helsinki was due to Nokia. This example justifies the reason for inclusion of country risk in project evaluations. There are mainly two approaches to estimate a country’s risk. First is the historical risk analysis wherein the country’s bond ratings, default spreads, standard deviation of the equity etc. are taken into account. The country bond default spread method calculates the difference between the yields of the dollar denominated country bonds and mature market treasury bonds for the same time period. This method carries the default risk given by rating agencies. The second method, namely, Relative Equity Market Standard Deviation consists of calculating the relative standard deviation of one country with respect to the standard deviation of another country and then multiplying the risk premium of other country with relative standard deviation will give the country risk premium. But this method might not work well for emerging countries which have low standard deviation because markets are non-liquid


Equity Risk Premium_Country = Risk Premium_US * Relative Standard Deviation_ Country Country Risk Premium_Country = Equity Risk Premium_Country-Risk Premium_US But there exists a problem of data availability and reliability with historical approach. Thus, yet another method to measure country risk is by the valuation of equity risk premium in perpetuity. This method usually involves the calculation of present value of dividends in perpetuity with the assumption that the markets are correctly priced. Besides adjusting the equity premium, country risk can also be included by adjusting the cash flows in reaction to a political turmoil, economic regulations etc. However this would mean that the cash flows are adjusted to the real situation rather than the incorporation of country risk. There are various models for the valuation of emerging markets and country risk like the Lessard’s model, Goldman-Sachs model, Godfrey- Espinosa model etc. All models are based on modified versions of the basic CAPM model to incorporate the country risk. As per Lessard’s model Re = Rfdomestic + MRP * (Beta_project * Beta_ country) where Beta_country = Sigma_country/Sigma_ domestic Beta of the country measures the volatility within the country or the country risk while the Beta of the project measures the unlevered risk of being in the industry. It does not take the company risk into

account but the industry risk in general. The Godfrey- Espinosa model is given by Re = Rfdomestic + yield spread + MRP * sigma_ country/ SIgma_world This model includes the country risk form of exchange rates or currency risk. The project specific risk is ignored. If the ratings of a country are increased then the yield spread increases, equity return increases and so does the working capital. Investment then becomes riskier and it discourages investment. Besides the country risk, the main question is, whether all companies are exposed to this risk or are there any exceptions. In reality, every company is not exposed to this risk and country risk should be considered only for each individual company and in fact it should be ideally considered at an individual project level, but this would be highly taxing and we mostly look up to generalized models. Thus it can be generalised by calculating the firm’s exposure to country risk. There are various methods to do so. The Bludgeon approach assumes that all companies in the market are exposed to country risk while the Beta approach assumes a company’s exposure to country risk is proportional to its market risk exposure, given by: 1. Bludgeon method: Cost of equity = Risk-free rate + Beta (Mature market premium) + Country risk premium 2. Beta approach: Cost of equity = Risk-free rate + Beta (Mature market premium + Country risk premium) The lambda approach is the most preferred approach which converts the CAPM model in a two factor model i.e. it includes an additional component to calculate the country risk factor. Its determinants can be revenues derived from the country, production

.. Various models for the valuation of emerging markets are the Lessard’s Model, Goldman-Sachs model, GodfreyEpinosa model, etc. © FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

FinGyaan Cover Story

Relative Standard Deviation_Country = Standard Deviation_Country/Standard Deviation_US


Article FinGyaan of the Month Cover Story



facilities in a country and the country specific risk management techniques used by the company. The only constraint is that these determinant data, except the revenue, is not publicly available. Expected return = Risk-free rate + Beta (Mature market equity risk premium) + Lambda(country risk premium Lambda can be measured by any one of the 3 variables Revenue, Accounting earnings or market prices: • Revenue: Lambda-Percentage of revenues in the country for company J/Percentage of revenues in the country for average company.The country specific revenue for an average company can be found by the % of GDP for domestic economy. • Accounting earnings: A Company’s earnings are exposed to country risk but frequency of calculating earnings are less, earnings can be smoothed to remove effects of risk and risk is not immediately reflected in earnings. • Market prices: Lambda is the slope coefficient when monthly stock returns are regressed against those of the government bonds. This method has standard errors and also data availability is a problem. A company’s exposure of country risk comes from its operations which can be measured using above techniques of discount rates. At the end, all models revolve around the basic CAPM. Choice of a model will depend on the external scenarios and assumptions suitable for an individual project or company. Many multinationals prefer holding company structure or from the financial side, a non-recourse debt structure, in order to insulate the parent company from any significant losses in the subsidiaries or holding companies. Including the country specific risk at the subsidiaries level becomes even more important as the lower returns from the subsidiaries can cause ‘Bullwhip’ effect, magnifying the losses at the parent company level. The ‘Glocal’ world with local economic regulations and geo-political output has ever increased the need to incorporate the country risk in project valuations, so that the MNCs can get a better picture of the future returns of their investments made.

FIN-Q Solutions OCTOBER 2012 1. “OSHA”, Occupation Safety and Health Administration 2. X - Scott Sullivan Y - Worldcom 3. Mitt Romney’s Five Point Plan 4. Punjab National Bank 5. X - Jump from the Atmosphere Y - Felix Baumgartner Z - Red Bull 6. Eric, as the car is used as a collateral 7. Starbucks 8. Robert Vadra 9. Tata Global Beverages, announcement of JV with Starbucks 10. Peter Oppenheimer, CFO of Apple

November 2012




Finistory Article of the Month Cover Story

IN GERMANY Anushri Bansal


INTRODUCTION Before the World War I, Germany was a prosperous country. It had a currency backed by gold and leadership in expanding industries like optics, chemicals and machinery. In 1914, the German Mark stood at equal footings with the currencies of other nations such as the British Shilling, the French Franc, and the Italian lira with respect to the US dollar. Things changed drastically as time passed and in 1923, Germany was hit by the wildest inflation of all times where it took 200 billion marks to buy a loaf of bread. The hardworking people in Germany found that savings of their life would not buy them even a postage stamp. The question that arose was how did this happen in a nation which was being run by intelligent and democratically chosen leaders? How did some people manage to save their money while some made fortunes out of these speculations? It all started when World War I broke out on 31st July, 1914. The Central bank of Germany, The German Reichsbank, suspended redeemability of its notes in gold in order to prevent a run on its reserves. The German government took assistance from Reichsbank for all its funding for the war. Since increasing taxes would upset the people, the government borrowed money, most of which were discounted and monetized by Reichsbank. By the end of the war, the amount of money in circulation rose fourfold and price index by some 140%. The

floating debt of Reichsbank increased to 55 billion from 3 billion marks. The wholesale price index rose from 1 in 1913 to 2.17 in 1918 i.e. it increased by more than 100%. During this time, inflation was still in bounds. The German mark followed the same fate as that of the British pound - weaker than the American dollar but stronger than the French franc. By February 1920, the episode of inflation had run its course. For the next few months, price index was comparatively stable and the German mark gained its position in comparison to the foreign currencies. Consecutively, the prices of imported goods fell by around 50%. This opportunity of maintaining a stable currency was lost by the government due to issuance of more money which led to increase in currency circulation by 50%. The floating debt of Reichsbank increased by 100% which served as a fuel for a new outbreak. The prices rose by 700% by July 1922. The continuous printing

Fig 1: Value of one gold mark in paper marks


GreatDepression, Volker rule, 1991 LPG reforms in India and the most recent Eurozone Crisis remind us about how these events affected the world economy. In lieu of this, Team Niveshak launches a brand new section “FINISTORY” to sensitize its readers about such historical events.


Article of the Month Cover Story Finistory


of currency notes by Reichsbank led to increase in price index by leaps and bounds. This marked the beginning of the period of hyperinflation. The following table shows the wholesale price index from 1914 to 1923: July 1914 Jan 1919 July 1919 Jan 1920 Jan 1921 July 1921 Jan 1922 July 1922 Jan 1923 July 1923 Nov 1923 Source:

1.0 2.6 3.4 12.6 14.4 14.3 36.7 100.6 2,785.0 194,000.0 726,000,000,000.0

Figure 2: Wholesale Price Index

Figure 3: Inflation Growth rate The table clearly shows that the period from mid1922 to November 1923 witnessed the wildest inflation of all times. The image given below shows the timeline and the rate at which inflation rose. CAUSES OF CONTINUED RISE IN INFLATION 1. Continuous issuance of currency by the government: The government flooded the market with new currency without considering the rising inflation rates. Subsequently, inflation led to events that reinforced the need for printing of currency. Lack of political courage to stop all these events aggravated the problem. 2. Speculative motive of people: Though the people of Germany were suffering badly from the rising inflation, there were few who benefitted from these events and were taking advantages to fulfill their speculative motives. Many

November 2012

business houses accepted it happily because it wiped off the debts they owed to people. The workers thought that inflation was good because they were getting higher wages but later they realized that they were actually suffering a cut in their real incomes. 3. The Treaty of Versailles, 1919: The Treaty of Versailles was a peace treaty which was signed between Germany and other countries at the end of World War I. The main clause of this treaty was the “War Guilt Clause” which forced Germany to accept the whole responsibility to initiate World War I. This burdened Germany with reparation payments. It was believed that these payments would strip off Germany of its gold reserves, wealth and foreign exchange which would lead to bankruptcy. This led to fall in value of Mark in terms of Dollar. These payments coupled with rising inflation led to spiraling hyperinflation in Germany in 1923. 4. Decreasing true value of money: During the war, it was seen that the rate of inflation lagged behind the rate at which the government was printing currency. But gradually, when the people of Germany lost their confidence in the currency, the prices jumped faster than the rate at which government could print new currency. The total currency which was being circulated in gold value fell from a level of 7428 million marks in the year 1920 to a mere 168 million in 1923. EFFECTS OF CONTINUOUS RISE IN INFLATION In order to discharge its foreign reparations, the government of Germany depended heavily on foreign capital. Foreigners transferred capital to Germany to the amount of 15.7 billion marks in the period of 1914-1922. According to data from Deutsche Bank, citizens of foreign countries held Mark balances and participated in the loss making short term capital export to Germany. The nations in descending size of national share were:

Figure 3: Monthly average exchange rate Source: ‘Societe Generale’ Feb 2012


USA Spain Austria Italy Holland Poland Switzerland Greece Great Britain

1918 20% 1919 35% 1920 36% 1921 36% 1922 11% 1923 02% Source: The German Inflation, 1914-1923 By Carl-Ludwig Holtfrerich Figure 4: Share of total bank deposits by foreigners bank balances

The table clearly shows that foreigners held a significant share in the bank deposits in the early years of inflation. Thus, they could easily affect the bank’s liquidity by altering the bank’s net liability position towards them. Foreigners started trading in Mark out of speculative motives which further aggravated Germany’s situation. The rising inflation in Germany had an impact on other nations as well. Germany tried to delay the stabilization of its currency and allowed depreciation of the mark. By doing this, Germany was able to eliminate its private mark debts to foreigners. This in turn led to German economy getting relieved of considerable obligations. The currency depreciation also worked in the political sphere. The Allies of Germany were convinced to reduce its reparation payments which led to decrease in debt owed by German state to foreign governments. The continuous monetary instability in Germany also affected the exporting countries as depreciation of its currency led to cheap products in foreign markets. Due to continued inflation, people tried to get rid of the money as soon as possible and tried to convert them into fixed assets. People bought goods and companies invested money in machinery, thereby converting working capital into investments. Though certain industries did rise during this period, but under this surface of prosperity, there were heaps of waste and inefficiency in terms of useless machinery. Rational resource allocation became impossible due

to fluctuations in cost prices and wages. Level of bankruptcies reached to 815 per month in 1923 which came down to 10 per month in 1924. On the whole, most of the energy and wealth was wasted in unproductive channels i.e. in speculation, paperwork and unprofitable equipment. RECOVERY OF GERMAN ECONOMY After all this upheaval and destabilization of the currency, measures were taken to stabilize the economy. A new bank was created in November 1923 in lieu of a currency reform. This bank, named as Rentenbank, was created to issue a new currency termed as the Rentenmark. The money could be exchanged with bonds which were supposed to be backed by land and industrial plant. Each Rentenmark was valued at one trillion old paper marks. A total of 2.4 billion Rentenmarks were created and after that point depreciation stopped and inflation ceased. This new issue of currency did not lead to inflation because it tackled the root cause of the initial rise in inflation. Earlier people had lost confidence in the currency. The government tried to instill the confidence of people in this new currency by announcing that this currency would be stable in value. The backing of the currency with property seemed to give it some value. Another important reason of stable economy was that the government limited the amount of Rentenmarks that could be issued. In its attempt to curb inflation level, Reichsbank stopped extending credit to those business houses which stimulated inflation. All these efforts led to huge rise in demand for consumer goods and growth of agriculture and building activities. All those bank deposits, mortgages and bonds which had lost their value during the period of inflation got some value after stabilization. CONCLUSION From all the events that happened in Germany, we can conclude that certain decisions of the government led to continuous rise in inflation and monetary destabilization in the country. The Treaty of Versailles added fuel to the fire and the loss of confidence of the people in the country’s currency led to further aggravation of the problem. Once the stabilization process began, situations started improving. In the sphere of domestic politics, inflation affected a massive redistribution of income and wealth in an egalitarian direction.


Finistory Article of the Month Cover Story

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Finsight Cover Story



GCC Economies and their need for diversification Pavan Kumar R and Sathesh Kumar S

BIM, Trichy

The Gulf Cooperation Council, also known as the Cooperation Council for the Arab States of the Gulf, is a political and economic union of the Arab states bordering the Persian Gulf and located near the Arabian Peninsula, namely Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates. Hydrocarbons (oil and gas) is the single largest sector in almost all the GCC states, in most of which it also provides some 80% of export earnings and government revenue. These countries also hold about 30% of the world’s total proven hydrocarbon reserves. The GCC’s collective GDP stands at $1.386 trillion today and is expected to touch $2.3 trillion by 2020. Its foreign assets are estimated to be worth $1.7 trillion and foreign liabilities are limited to the tune of $500 billion. The region has seen surprisingly stable & relatively high growth even after 2008 despite the American housing bubble burst & the euro crises. The present year’s GDP growth rate of 5% is well above global average & also much higher than what analysts


forecasted for 2012. Though the Global economic crisis is leading to reduced oil consumption in the Western world, sustained increase in petroleum prices and growing oil demand in the developing nations (like India & China) has made the economy of GCC look strong as of now. But now even developing countries – powerhouse economies are showing signs of slowing down on economic and the oil demand front. Also the restoration of Libyan oil this year is exerting a downward pressure on oil prices and GCC members, particularly Saudi Arabia will be expected to curtail production to compensate for this increased supply situation. Also one of the other drivers of growth in the region is the heavy government spending. Countries like Qatar have already drawn up a strategy on how to spend their reserves (till 2020) and in what ventures they will want to invest. The contribution of non – oil sectors to GDP is increasing in GCC countries albeit, at a slower rate. These include Banking, Finance, manufacturing

Change in global oil demand 2011 2012 1.0 0.9 1.3 1.1

1.3 1.2 1.4 1.1

Figure 1: Change in global demand

November 2012

Total in 2012 90.5 89.0 89.8 89.3



Article Finsight of the Month Cover Story

Figure 2: GCC: Real Economic Growth

Figure 3: GCC Current account balance

& tourism. The governments of GCC countries are very keen on providing huge capital investments to develop these sectors. Even now about 43% of GDP contribution for GCC is through oil mining & refining. Hence, they are currently expanding and modernizing b a s i c infrastructure and raising educational standards, w h i c h will enable them to gradually move towards a more advanced and servicesoriented economic model. Still, t h e short term high growth rates are expected to be, in part, sustained by the government stimuli to diversify the industrial base and reduce the region’s heavy dependence on oil and gas revenues.

they are pursuing economic diversification with unprecedented urgency during high oil prices, rather than doing so when prices go downward. The logic behind this could be the longstanding pressure from international financial institutions over the last decade to develop a non-oil economy; and also a consideration that oil in these countries may not last forever. The overall lack of diversification makes the region, and its banks, vulnerable to political, economic and credit risks. GCC nations’ banks will continue to face challenges with loan defaults because the six economies aren’t diversified and a few companies dominate many businesses. A gradual shift away from traditional government-driven, large oilbased enterprises to industries such as telecommunications, finance and tourism is necessary to create new avenues for economic growth.

The combination of higher average oil prices and a nearly 10 percent increase in GCC oil production (led by Saudi Arabia) have prompted a sharp rebound in regional current account surpluses. Indeed, The GCC is likely to have a larger current-account surplus than either Japan or Germany in 2012-13 as high oil prices boost exports Although imports have also continued to grow, hydrocarbon export earnings have surged propelling the GCC current account surplus to over $300 billion this year (23.6 percent of regional GDP) on total exports of over $950 billion. With such wealth, it is a matter of incongruity that

Demand for oil in developed countries continues to decline, and demand for oil in emerging economies will continue to rise. But this might not continue for a long time. Countries around the world are adopting alternative energy sources such as bio-fuels and electric cars to reduce their oil dependency. There is a strong call by the G20, G8 and the Rio Summit to phase out fossil fuels. Once this begins to happen, especially in developing countries, it will have a



Article Finsight of the Month Cover Story


Fig 1: Member Countries of GCC huge impact on the consumption of fossil fuels, especially oil. GCC governments will have to accept the fact that the demand for oil will not continue to grow in the coming years and the issue will have to be addressed soon. The GCC states have young and rapidly growing populations, the majority of which are under 20 years of age. Creating jobs for the GCC’s youth is a key policy priority for all the GCC governments, in order to make the most of their human resources and to avoid the possible social problems and political risk that can be associated with high rates of unemployment. Traditionally, the civil service has been a major source of employment for Gulf nationals, but this approach to job creation creates overstaffed bureaucracies and is increasingly expensive to maintain. Oil and gas production is not a labor-intensive business, and therefore another reason to diversify is the imperative to create more jobs in more labor-intensive industries. Some GCC states are already experiencing sporadic shortages of electricity and gas, while water supplies are already strained and food shortages loom as risks for an import-dependent region. A key challenge for the Gulf in the next decade therefore will be to manage energy, water and food resources to ensure both high living standards and sustainable growth in the long term. Aware of these challenges, Gulf Arab states are undertaking a variety of measures

to ensure long-term sustainable growth that include: 1. Introducing energy-efficiency measures; 2. Investing in clean fuel and renewable energy supplies; 3. Improving water efficiency; 4. Investing in new water desalination capacity; and 5. Buying or leasing agricultural land abroad. Investing in improved agricultural productivity in developing countries, combined with greater stability in world markets, is probably in the longterm interests of the Gulf countries. Following the emerging guidelines for foreign investments would help GCC countries if they focus on existing land and resource rights, transparency, consultation with all affected, economic viability, environmental and social sustainability, and strengthening food security.

.. GCC governments will have to accept the fact that the demand for oil will not continue to grow in the coming years and the issue will have to be addressed soon.

November 2012



Sir, yesterday while reading an article in the newspaper, I came across a term “Phantom stocks”. Could you please explain what it means?

Phantom Stocks DArshana Nair IIM Shillong

Phantom stock is mostly issued by closely held or family-owned companies who want to incentivize management and other employees without granting them equity. This way the company avoids the dilution of its ownership rights and wastage of shares which can be issued to the general public, rather than to the employees.

Article of the Month Classroom Cover Story

CLASSROOM FinFunda of the Month

If they are not real stocks, how are they accounted for by the company?

Phantom stock is a method for companies to give their management or employees a bonus if the company performs well financially. It provides a cash or stock bonus based on the value of a pre-decided number of shares, to be paid out at the end of a specified period of time.

Phantom stock accounting is simple. They are treated in the same way as deferred cash compensation. An entry for the amount accrued is made as a liability to the business. A decline in value would reduce the liability. Phantom stock payouts Sir isn’t this the same as the Employee are taxable to the employee as ordinary income and tax deductible to the company. But they are also subject to Stock Option Scheme? the rules governing deferred compensation. In case of any violation by the company, penalty taxes are imposed. No. I will tell you the difference between the two. Under ESOP, a company What benefit does the company get from provides its employees with the option to own issuing phantom stocks? the stocks as a privilege of having worked in the company.However under phantom stocks, the employees are not issued real stocks. The problem of motivating and retaining They only receive the benefits that are given to the key employees without giving away your other shareholders. They are basically cash bonus plans. company’s equity can be solved by the use of a phantom stock plan. Many company owners are hesitant to provide key employees In that case, does the phantom stock with an actual company ownership interest. Such an holders also receive dividend when it is declared ownership interest would likely entitle key employees to the shareholders? to notice, inspection, and voting rights. Additionally, these key employees would be able to hold the company The Company can pay out dividend responsible for a breach of fiduciary duties. Thus, to the phantom stock holders, if it wants to. phantom stock is a great way to share the economic In case it decides to do so, the dividend is value of your company without the hassle of giving taxed as ordinary income in the hands of the up company stock. This way, the employees will also employees and is tax deductible to the employer. be motivated to perform better.Thank You Sir. Now I have a clear understanding of the Depository Receipts. Sir, who issues a phantom stock?

Thank you sir. Now I have a good idea about the concept of phantom stocks and why they are issued.



FIN-Q 1. An upward sloping yield curve reflects the fact that investors require a term premium that increases at longer maturities, which macroeconomic theory are we talking about? 2. “X” is a facility provided by RBI for adjusting liquidity which works on the lines of repo rate; it came into effect from May, 2011. Identify X? 3. Identify the company

4. Identify the bill formed from a tax rule which specifies tax rates for individuals in the highest income category. 5. He became a Union Minister with Indian National Congress in power during 1980’s and later held a key position at the Planning Commission of India during Bharatiya Janata Party’s tenure in 2000’s. Identify the person. 6. X is a former CEO of Y, one of the largest financial institutions in the U.S. Had it not been for a broken backbone, he would probably have gone on to play football. He earned the name of ‘knife’ for his cost cutting policies. X also oversaw the comfortable sailing of Y through the crisis of 2008 even after being advised by the Federal Reserve Bank to sell it. X has been portrayed in 2 Hollywood movies, one of them being a BBC and the other being an HBO production. Name X and Y. 7. Bank X faced severe financial distress in March 2009 which prompted the company to take strategic move pertaining to stocks. Company Y took the same move pertaining to stocks later in July 2009. Determine X, Y and identify the move taken by X and Y. 8. A chart developed in the 1870’s by an Asian country using lines to show levels of supply and demand for certain assets 9. Identify the famous concept in the field of economics

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