Niveshak September Issue

Niveshak THE INVESTOR

VOLUME 5 ISSUE 9

September 2012

Quantitative Easing

3

How will it effect the global economy?

the reality of real estate companies, Pg. 18

Is it the end of Dollar as world’s reserve currency?,pg. 14

FROM EDITOR’S DESK Niveshak Volume V ISSUE IX September 2012 Faculty Mentor Prof. N. Saravanan

THE TEAM Editorial Team Akanksha Behl Akhil Tandon Chandan Gupta Harshali Damle Kailash V. Madan Nilkesh Patra Rakesh Agarwal Creative Team Anuroop Bhanu Venkata Abhiram M.

All images, design and artwork are copyright of IIM Shillong Finance Club ©Finance Club Indian Institute of Management Shillong www.iims-niveshak.com

Dear Niveshaks, The major reforms announced by the US Federal Reserve as well as the Indian government and their timing and manner of announcements guarantee to boost the Indian economy and market sentiments at large. The US Federal Reserve’s third round of quantitative easing (QE3) helped to extend gains on global stocks and bonds, and strengthened the US dollar against euro and yen. A similar effect was palpable in the Indian rupee which gained against US dollar. This was further influenced by the government’s decision to raise fuel prices. Indian stock market has also seen some rise because of reforms relating to foreign direct investment (FDI) and disinvestment. The benefits of FDI, especially in the case of multi-brand retail, will accrue over time but investors have to wait for the political clearance. Apart from this, 49% stake in domestic carriers by foreign airlines, 49% in power exchanges, increase of foreign equity cap to 74% in broadcasting services will buy the government some time with the rating agencies, some of who have already put India’s sovereign rating on a “negative” watch list.

The government’s effort to reduce the fuel subsidy bill has helped the Reserve Bank of India to provide some monetary stimulus by reducing the CRR by 25 basis points and the RBI may also cut the rates in the future. These moves will be positive-both for the domestic stocks and currency. However, the ‘spillover’ effect of these initiatives on inflation cannot be ignored, which has already increased to 7.55%. Over all of these, the major force which drives the market is the political pressure which may roll back any of its latest reforms.

This issue brings to you some more interesting and insightful reads. The cover story of this month focuses on the US Federal Reserve’s latest effort- Quantitative Easing III. The issue also features an article on the future of Dollar as the reserve currency. The article of the month throws light on the full capital account convertibility. This issue also features other articles on the reality of real estate companies and LIBOR’s labor’s lost. The classroom section explains the concept of “CAT Bonds”.

We would 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 niveshak.iims@gmail.com and as always, Stay invested.

Team Niveshak

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

CONTENTS Cover Story Niveshak Times

04 The Month That Was

Article of the month

08 Full Capital Account

Convertibility: A Double Edged Sword?

11

QE3 and its impact on emerging economies

FinGyaan 14

Is It the End of Dollar As World’s Reserve Currency?

18

Finsight

The Reality of Real Estate Companies

Perspective 16 LIBOR’s Labour’s Lost

21 CAT Bonds

CLASSROOM

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The Month That Was

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The Niveshak Times Team NIVESHAK

IIM, Shillong

A fresh hope of reforms Government of India, in an unexpected but pleasing move, announced much awaited economic reforms on FDI in single brand & multi brand retail, civil aviation, power exchanges and broadcasting services. Though all the reforms come with certain conditions but the surge in market clearly showed the immediate need of these reforms. The foreign investors are now allowed 100% stake in single brand retail subject to certain conditions like ownership of the foreign investor and 30% sourcing from local small enterprises. Commerce Minister Anand Sharma also announced that foreign investors are now allowed to invest up to 51% in multi brand retail and open the stores in all the states and UTs subject to approval of the respective governments. The FDI in multi brand retail also comes bundled with certain conditions like 30% sourcing, minimum amount to be brought in by the foreign investor would be USD 100 million and at least 50 per cent of FDI should be invested in ‘back-end infrastructure’ within three years of the first tranche and outlets may be set up only in cities with a population of more than 10 lakh.

Wal-Mart also announced that with the reforms in place, they expect the first store to be opened within two years.

Government also approved 49% FDI in aviation sector providing relief to the bleeding domestic air carriers. Although the mood in the industry was upbeat after the announcement, most of the foreign carriers seem to be on wait and watch mode before making any commitments.

The Government also notified 49% FDI in power exchanges and 74 per cent foreign equity cap in broad-

July 2012

casting services like teleports, DTH, Multi System Operators (MSOs).

Diesel price up by Rs. 5; LPG cylinders cut to six a year Cabinet Committee on Political Affairs (CCPA), headed

by Prime Minister Manmohan Singh, announced a Rs. 5 hike in diesel prices and also restricted the supply of LPG cylinders at six domestic LPG (14.2 Kg) cylinders per annum. The diesel price including VAT will increase by Rs. 5.63 and any requirement of cooking gas above stipulated amount would have to be procured at market rate which is more than double of Rs 399 price--the price of subsidised 14.2 kg cylinder. The increase in diesel prices is considered to be inevitable to control the rising subsidy bill of the government. Non-revision of diesel, kerosene and cooking gas (LPG) prices as per market rates since June last year had resulted in almost Rs 140,000 crore of oil subsidy last year and would have risen to Rs 200,000 crore in case of inaction on the part of government. The reforms have brought a huge relief to Oil marketing Companies suffering from huge under recovery as a result of non-revision of fuel prices. The move is expected to reduce the under recovery amount by Rs. 5300 crore for the remaining part of financial year.

Federal Reserve announces QE3 to aid US recovery In a major announcement this month, America’s central bank announced that it will purchase $40bn (£25bn) of mortgage-backed bonds a month to stimulate the housing market and keep long-term interest rates low in the third round of quantitative easing. “By assuring the public that we will be prepared to take action if the economy falters, we’re hopeful that that will

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increase confidence, make people more willing to invest, hire, and spend,” Chairman Ben S. Bernanke said. The central bank also assured that it will continue its program to swap $667 billion of short-term debt with longerterm securities to lengthen the average maturity of its holdings. The move has been highly appreciated and at the same time harshly criticised by the concerned parties.

Unlimited bond buying programme gets backing of ECB In an effort to address the distortions in bond market and control the rising borrowing cost of struggling Euro Zone countries, ECB has agreed to Mario Draghi’s strategy of unlimited bond buying. The sovereign debt to be covered under the plan would be restricted to the bonds of maturity up to 3 years. The plan comes with certain conditions and would be suspended in case of violation of any kind. The move is expected to ensure struggling government’s access to funding to meet their requirements at low cost. IMF has also agreed to back the plan.

Christine Lagarde, the IMF’s managing director, said that the fund was “ready to help” with the European Central Bank president’s plan to staunch the euro zone crisis. The programme,on the other hand, has been harshly criticized by German Bundesbank Chief Jens Weidmann, as he appeared to compare Mario Draghi’s bond buying programme with the Goethe’s classic, where the money printing solves the kingdom’s financial problems but the tale ends badly with rampant inflation.

S&P lowers India’s 2012 GDP growth forecast to 5.5 per cent Deficient monsoon and poor investors’ sentiment has resulted in S&P lowering India’s GDP growth forecast to 5.5% for 2012-2013. Last month Crisil also lowered the GDP growth forecast from 6.5% to 5.5% and Nomura, in June,

lowered its forecast to 5.8%. “Although Asia Pacific has recorded strong GDP growth relative to other global economies, we have observed a continued change in the region’s economic barometer,” said S&P ratings in a statement.

“Additionally, the more cautious investor sentiment globally has seen potential investors become more critical of India’s policy and infrastructure shortcomings. The latter was recently highlighted by the power outage in early August that affected 20 of India’s 28 states,” the credit rating agency added. However, Prime Minister’s Economic Advisory Council differed from S&P in their growth forecasts. The country’s growth rate is expected to pick up in the second half of this fiscal and reach 6.7 per cent for entire 2012-13, said Prime Minister’s Economic Advisory Council Chairman C Rangarajan. The agency has also lowered the GDP forecasts for number of Asian economies including China, Japan, Korea, Singapore and Taiwan recently. The move has further put country’s investment grade rating at risk.

RBI cuts CRR by 0.25% to unlock Rs. 17,000 crore RBI in its mid quarter monetary policy review cuts CRR by 25 basis points to 4.50% to inject Rs. 17,000 crore worth liquidity in the system. The CRR cut will be effective from September 22, 2012. CRR has been cut by 150 basis points so far in 2012 by the central bank in order to fuel growth of the economy. RBI left repo and reverse repo rate unchanged at 8% and 7% respectively. “Since the first quarter review, while growth risks have increased, inflation risks remain…….In the current situation, persistent inflationary pressures alongside risks emerging from twin deficits — current account deficit and fiscal deficit — constrain a stronger response of monetary policy to growth risks,” RBI said. The central Bank also appreciated Government for actions to spur economic growth and contain fiscal deficit.

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The Month That Was

The Niveshak Times

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Article Market of Snapshot the Month Cover Story

Market Snapshot

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

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

65,05,150 30,87,121 15,86,541

LENDING / DEPOSIT RATES Base rate Deposit rate

10%-10.75% 8.5% - 9.25%

Source: www.bseindia.com

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

53.53 69.03 68.86 86.82

CURRENCY MOVEMENTS

RESERVE RATIOS CRR SLR

4.50% 23%

POLICY RATES Bank Rate Repo rate Reverse Repo rate

9.00% 8.00% 7.00%

Source: www.bseindia.com 31st August to 25th September 2012 Data as on 25th September 2012

September 2012

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BSE Index Sensex

Open 17558.00

Close 18694.00

% Change 6.47%

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

5996.00 6387.00 9338.00 11550.00 6259.00 9519.00 5408.00 7468.00 5752.00 9778.00 8298.00 1892.00 6973.00 1518.00 3253.00

6483.00 6903.00 10275.00 13105.00 6732.00 10895.00 5314.00 7379.00 5974.00 10563.00 8709.00 2033.00 7426.00 1841.00 3441.00

8.12% 8.08% 10.03% 13.46% 7.56% 14.46% -1.74% -1.19% 3.86% 8.03% 4.95% 7.45% 6.50% 21.28% 5.78%

% CHANGE

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Article Market of Snapshot the Month Cover Story

Market Snapshot

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Article of the Month Cover Story

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Full Capital Account Convertibility: A double edged sword?

Tanay Deshpande

In the 15th August edition of the Business Standard, Sajjid Chinoy, an economist at J. P. Morgan postulated the idea that the rupee’s slide against the dollar has underpinned a meaningful improvement of the trade deficit by a possible J-curve effect where Indian exports have become more competitive in the world market and certain imports have been significantly substituted. Against such a tide-turning backdrop, we explore whether it really makes sense to open up India’s capital account for free two-way investment. CAC convertibility has been an age-old question in India’s economic story ever since the freeing of the capital account (basically enabling citizens to exchange currency at market rates) revived the economy from the brink of insolvency in 1991.

The capital account is composed of four constituents- FDI, Portfolio investment, Debt investment (bank A/C loans, short term capital flows) and the Reserve account. Capital account convertibility (CAC) denotes the extent to which local assets can be converted into foreign capital assets at market determined rates of exchange. A fully convertible rupee on the capital account implies a free flow of assets to and from the country at the market determined currency exchange rate, independent of the amount being transacted. The advantages of CAC are evident- businesses would be able to

borrow at interest rates much lower than those offered locally, the ease of access to fast moving capital which would help improve the efficiency of local operations and firms would also be able to expand their operations abroad to tap into the overseas markets. Additionally, there would now be minimal transaction costs involved in dealing with securities denominated in a foreign currency.

The investments made by overseas corporations in India would spur domestic growth and would indirectly lead to a higher national income. On the flipside, the consolidation of foreign firms in the Indian market space may affect sustainable internal growth. Also, Indian transnational companies may choose to invest abroad and cut down on domestic investments. On the other hand, even these disadvantages are relatively minor compared to those described later in this article.

Reviewing the current scenario for CAC, the RBI has laid certain guidelinesi. The CAC would be aimed at benefitting those foreign firms which plan to invest more than $500,000 ii. Investments should be in semi-liquid assets (such as long term bonds) or liquid assets tied to static ones iii. Foreign institutional investors (FIIs) cannot use CAC to manipulate exchange rates

Capital account convertibility (CAC) denotes the extent to which local assets can be converted into foreign capital assets at market determined rates of exchange

September 2012

IIM Calcutta

NIVESHAK

of the developed world started piling their capital into the Tiger countries. In the span of 1992-1997, external debt for this region had become nearly 40% of the GDP. Net private capital flows into the 5 nations had shot up by 150% to $97b, out of which short-term private inflow represented 80% of the net capital inflow. This tremendous deluge of cash had made the financial markets of the Asian Tigers extremely liquid while asset markets were being driven into bubbles of unprecedented size.

Large CADs (current account deficits) piled up and the economy of these nations became so coupled with the external world that even a minor currency fluctuation could now pose serious systemic risks.

And then, the tide turned. A hike in U.S. interest rates to curb inflation and a wave of speculation regarding the plausibility that the Asian economies could not meet their deficit targets any longer drove investors away in a sudden frenzy. And soon enough, the prophecy that the East Asian nations might default on their debt became self-fulfilling.

Speculators aggressively charged in by shorting the Asian currencies and by the end of 1997, these 5 nations had a net outflow of private capital worth $112b, which amounted to a complete turnaround of $109b in 2 quarters from July to December 1997.

The result was massacre. Malaysia’s overnight lending rate skyrocketed to 40% due to a liquidity crunch. The Kuala Lumpur Stock Exchange fell by 50% and the Ringgit simultaneously devalued by 50%. The Rupiah depreciated 86% against the USD leading to a market capitalization of 75% being wiped out from the stock exchanges as the contagion spread to the real economy. Meanwhile in Thailand, the stock markets collapsed by 75%.

In another continent four years later, even when the Argentine govt. had followed IMF procedures to the hilt for opening up its economy- to the extent that even public sector corporations were foreign owned, paying hardly any tax to the government and currency flowed freely in and out of the country. The result was again disaster- debt expanded to 50% of GDP, yields spiraled upwards of 60% and the Argentine economy faced negative GDP growth for 3 consecutive years. Finally better sense prevailed when Nestor Kirchner rose to presidency on

CAC has been shown in the past to have a deeper effect on short-term FII capital flows rather than longterm FDIs

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Article of the Month Cover Story

iv. National banks are to provide collateral for capital flows headed in or out of India v. Furthermore, the RBI has deemed it necessary that India must have a sound banking system, a low fiscal deficit, tight regulatory surveillance on lending export competitiveness and sufficient import price elasticity before implementing full CAC However, in reality, a formal CAC would make little difference to retail Indian investors. Though Indian citizens cannot directly invest in foreign equities, they can still do so via the route of international mutual funds. Also since 2002, India’s foreign exchange policy allowed domestic companies to enter into mergers and acquisitions abroad without any case by case permission from the govt.

Currently, direct investment by an Indian company can be upto 400% of Net Worth and portfolio investment upto 50%; besides mutual funds can invest upto $7b overseas. Some firms such (e.g.Tata Motors) have also been listed on exchanges abroad such as the NYSE. Besides, In fact, in most emerging economies, the concept of partial CAC is implicit, without making it a formal arrangement of economic and fiscal policy.

Now, we head to the next level of the argumentCAC has been shown in the past to have a deeper effect on short-term FII capital flows rather than long-term FDIs. FDIs are much less liquid and have a more permanent impact on the real economy than FIIs, which are mostly directed towards portfolio & debt investment. The great dangers of FIIs lie in their short-term “hot money” speculative capital flows which can rapidly head in or drive out of an economy. This kind of large scale volatility can lead to sudden shocks in a nation’s financial system. The best examples of these kinds of capital shocks were manifested in the East Asian crisis of 1997, and more recently in the Argentine crisis of 2001.

In 1997, the East Asian Tigers were booming with a spectacular growth of 8-12% GDP. Their currencies were pegged to the dollar and interest rates were low since banks could borrow cheap and lend dear (in the form of US govt. bonds). As interest rates started increasing with growth and other avenues of investment such as Asian equity markets started opening up with CAC, investors from the US & rest

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25th May 2003 and applied Keynesian economics to devalue the peso, attract FDI, rely on import substitution and start building a war chest of forex reserves to cover debt restructuring.

All these instances regarding the hazards of CAC serve to illustrate the Impossible Trinity of public finance. An economy cannot simultaneously control both, domestic liquidity as well as the currency exchange rate, if the currency is capital account convertible.

In the first case, if the rupee is CAC and the govt. holds down the USD/INR exchange rate, this will attract a massive influx of foreign capital which will put an upward pressure on the exchange rate.

To counter this, the govt. can participate in open market operations which will mop up the foreign currency by selling bonds. Yet, this is a circle, and the sale of bonds will drive yields upwards, which can only attract more capital. Plus, the govt. incurs a slight loss as it sells the bonds for a coupon rate that needs to be marginally higher than the rate at which it will buy foreign assets to impediment rupee appreciation. Yet it is known that such sterilization is only a temporary defense against speculative pressures on currency appreciation.

The second flaw of sterilization is that the money that the central bank prints to absorb the foreign currency denominated liquidity will eventually find its way back in the nation’s economy through exports. This can soon give rise to runaway inflation.

In the second case, if the rupee is CAC and the govt. allows the rupee to appreciate, this will make imports cheaper, preceding an imbalance of payments and as a consequence, rampant inflation. To counter this, the lending rates (such as the repo & the BPLR) will have to be increased by the RBI & commercial lending institutions and this will in turn drive the currency upwards even faster.

Again, the cycle is unsustainable and the trinity of financial aims cannot be simultaneously achieved.

Instead, if we take a third case where the rupee begins to depreciate even as it becomes CAC, the scenario is even more hazardous. If the govt. tries to restrict the fall of the rupee in a capital convertible open market, speculators will swarm around the economy, heavily shorting INR, just as in the case of the East Asian crisis of 1997. This will cause the govt. to hold up the rupee by buying foreign currencies and assets and such open market operations at an unreasonable value of the USD/INR will finally end up depleting the forex reserves in India’s treasury. Again, this will be a terrible waste of taxpayers’ money. Likewise, if the govt. allows the rupee to slide, at least initially, the balance of

September 2012

trade will get skewed against India’s favor. This will cause a capital flight, deflation and a slowdown of the economy as the very reasons for which CAC was introduced would get eliminated. Foreign corporations would enter and consolidate the Indian domestic market and Indian businesses would never be able to compete with an undervalued currency. This scenario is very different from that of a closed economy such as China where currency devaluation would actually be welcome, which is also pointed out by the J-curve effect.

Hence, the only rational way to approach CAC is to impose a measure of capital control. Capital control essentially uses one of three routes- prohibition, transaction taxes or govt. clearance for capital flux.

Control is, in effect, the antithesis of full CAC. As is demonstrated by all the instances above, only an equilibrium combination of both can propel an economy towards stable growth. Methods to slowly implement CAC would be to first introduce domestic liberalization reforms before opening the external market. Many Indian businesses are shifting abroad simply because of the lack of operating efficiency in India compounded by policy paralysis, red tape and corruption. Opening up to CAC in such a situation where the rupee is naturally slipping against the dollar can cause immediate capital flight and a sudden stop of domestic growth as Indian businesses themselves move out.

However, in the end, the Indian economy must finally open up slowly to the world of international finance. A reduction in FDI inflow & outflow has gone hand in hand with a slowdown of GDP growth, a sharp decline of the rupee and increasing fiscal deficit. Foreign entrants can certainly make the market more competitive and efficient.

Hence, the only way to go about CAC is with warily with prudence, opening up only those sectors of the economy which need the reforms and by encouraging long term FDI as opposed to short-term capital flow. Long term debt contracts can also be encouraged and India needs to hold a war-chest of forex reserves with a credit-worthy and sound baking system before implementing CAC. Perhaps then, the route chosen by the RBI may prove to be the wisest. Probably, it might be better to wait, watch and learn for when the Indian econ-

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Cover Story Article of the Month Cover Story

QE3 and its impact

11

on emerging economies Rakesh Agarwal & Akanksha Behl

Team Niveshak Meaning of quantitative easing – the Central Bank’s last resort The monetary authority of any country can control the supply of money in the economy thereby affecting the interest rates prevailing in the economy. This is done for the purpose of promoting growth and stability in the economy. The monetary policy can be both expansionary and contractionary in nature with the aim of inviting businesses to expand or with the aim of curbing inflation. Mostly the Central Bank increases or decreases the money supply by buying or selling government securities or other securities from the market. Quantitative easing (QE) is an alternative monetary policy used by central banks to stimulate the national economy when traditional monetary policy becomes ineffective. QE influences the market in a direct way by buying government and corporate bonds directly from the banks. The intention is to ‘ease’ pressure off the market by pumping in more ‘quantity’ of money.

How and when does quantitative easing take place Quantitative Easing is used when the economy is in a deflationary mode and the interest rates reduction doesn’t curb deflation. Also, there is no further possibility of decline in the interest rates and the economy is still struggling. This situation is known as ‘Liquidity Trap’. The banks are reluctant to lend funds to businesses as they fear they will default.

They prefer investing in government treasury which is safe and also provides a healthy return. Due to this, business houses are deprived of funds which further results in a deceleration in investment activities and thereby leads to a further decline in

growth. The Central Bank, in such a situation, may fall back on its last resort to bring the economy on the path of growth. It would do this by performing quantitative easing. QE requires purchasing of a pre-determined amount of bonds or other assets like long-term Treasuries or mortgage-backed securities from commercial banks and other institutions.

This artificially injects money into the system. As the Central Bank purchases bonds, its demand increases. With an increase in demand, the yield on bonds falls, thereby making it less attractive for the banks to invest in them. The investment proposals of business houses now appears more productive to them, and they readily extend credit. With the multiplier in operation, this gives a huge impetus to growth, and pulls the economy out of that deflationary spiral.

However, if too much money is created, it might lead to rampant inflation, which is again detrimental for the economy.

Impact of QE1 and QE2 As per a recent research, QE has certainly been marginally effective in boosting the economic growth, but it has not been as effective as it was first projected.

The US Federal Reserve formally announced the employment of QE during the financial crisis in March 2009. It expanded the assets on its balance sheet from $800 billion to $2.93 trillion at the beginning of 2012 through a successive round of QE. These are popularly known as QE 1 and 2. The motive behind the policy was to boost the economy by shooting up credit and liquidity into the balance sheets of financial institutions and corporations thereby making an effort to reduce the credit crunch and the liquidity

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Article Cover of the Story Month Cover Story

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Fig 1: Effects of quantitative easing

Fig 2: FED balance sheet - S&P 500

trap caused as an aftershock of the downfall of the investment bank Lehman Brothers and the downturn that followed. The Fed did so by increasing the monetary supply through expanding the liabilities on its balance sheet and using the new credit to buy assets such as bonds, bank loans and mortgage backed securities, which had become illiquid in the wake of the catastrophe. It was hoped that the increased credit liquidity would make financial institutions more willing to lend money to other institutions and businesses, lowering interbank lending rates and thereby provide economic stimulus without causing excess inflation.

In November 2010, Fed announced the second round of quantitative easing, also known as QE2. It bought another $600 billion in long term treasuries over a period of 8 months.

As per IMF, “QE 1 and 2 have improved market confidence and reduced systematic risks in financial systems during the credit crunch in 2008 to 2009 in the G7 countries, which includes US and Britain.”

Moreover, it has been observed that through QE, Fed has been able to maintain low interest rate on treasuries despite a massive increase of 30% in public debt.

Also, it has stirred stock prices and created a wealth

effect in nominal terms. However, the dollar has been weakened due to employment of QE. Fed hasn’t been successful in reducing unemployment and it still prevails at a whopping 9%. Fed has also not been able to create a maintainable economic retrieval. The private sector still remains weak and can’t make up for the reduction in fiscal spending in the short term to keep the economy recuperating out of the stagnation at a sharp pace.

Quantitative Easing 3 The third round of ‘quantitative easing’ by the Fed comes only days after the European Central Bank committed to a fresh programme that allows it to execute potentially unlimited sovereign bond-buying, a widelyexpected bid to save the region’s currency. The preliminary idea behind another round of quantitative easing by the Fed is to boost ‘aggregate demand’ by putting more money in the customer’s pocket.

In its third round of QE, the Fed plans to buy $40 billion in mortgage-backed securities (MBS) every month for an indefinite period till the economy improves and unemployment reduces to an acceptable level. By buying mortgage-backed securities, it plans to lower interest rates for homeowners and other long-term buyers.

Fig 3: Civil employment-population ratio

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Article Cover of the Story Month Cover Story

Fig 4: Inflation in major emerging economies

However during the earlier quantitative easing programs by Fed, inflation in emerging economies soared on an average, particularly in China and India, while job growth in US hardly showed any signs of recovery.

Thus, precedence certainly lay to rest any hope that the third quantitative easing would be any different and actually achieve its said purpose.

However, this time around the Fed has targeted housing finance in order to prop up the faltering labour market and has pledged the ultra-low rates regime (between 0 and 0.25 per cent) to continue till mid2015. This is an ambitious response by the Fed and certainly a step in the right direction as it differs from the first and second QE programmes; however it remains to be seen if the plan would be successful.

Few concerns that have been raised repeatedly but never addressed include the risk of inflation and price rises in future and rationale for continuing the policy of low interest rates that hurt savers.

Following in the footsteps of the Fed, Bank of Japan also announced easing of monetary policy to support an economy feeling the pinch from a strong yen, widening fallout from Europe’s debt crisis and the more recent tension with its major trading partner China. BoJ has increased its asset buying and loan programme, currently its key monetary easing tool, by 10 trillion yen to 80 trillion yen, with the increase earmarked for purchases of government bonds and treasury discount bills.

All this monetary easing is certainly going to glut the global market with liquidity and fuel more speculation if proper checks and balances are not put in place.

Impact of QE3 on emerging economies With QE3, dollar will once again flood the global market and invariably find its way into the emerging economies that provide huge potential for growth. This will lead to pressure on export-oriented economy like China that will certainly experience currency appreciation.

To counter, China in-turn unveiled a series of its own measures last week to help stabilise export growth,

including faster payment of export tax rebates and boosting loans to exporters by cutting interest rates in June and July and injecting cash into money markets to ease credit conditions to support an economy that notched a sixth straight quarter of slower annual growth, at 7.6 per cent, in the April-June period.

Economic stimulus measures such as QE3 lower the value of the U.S. dollar and other fiat currencies. From that, investors flee paper assets for commodities such as oil, grains and precious metals. Thus, commodity prices like that of oil, food and precious metals go up, since “hot money” floods into them. Investors seeking protection from inflation, invest in gold; driving gold prices further. As a result, India which is the fourth largest importer of oil and largest importer of gold will face adverse effect on its trade balance deteriorating the already rickety financial condition (current account deficit) of the country. There is high probability that inflation which has remained persistently high may regain momentum on the upside bringing all the work put in by RBI to naught. In face of the adverse economic scenario, India was forced to adopt the path of economic reforms like reducing subsidy on diesel and LPG, increasing FDI limits in aviation, retail and broadcasting to revive the economy in spite of severe political backlash.

Meanwhile, Brazil, Russia, and other emerging economies are experiencing a similar situation. Weakness in advanced economies has reduced room for exportled growth and delayed structural reforms which are needed to boost private-sector development and productivity growth. This has dented investor confidence.

So the recent slowdown of growth in emerging markets is not just cyclical, owing to weak growth or outright recession in advanced economies; it is also structural.

What is needed in reality, are structural reforms that can not only spur the economy but also reduce persistently high unemployment in a sustainable manner for time to come.

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Article FinGyan of the Month Cover Story

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Is it the end of Dollar as world’s reserve currency?

Shubham Singh

Lal bahadur Shastri Institute of Management

What is Reserve Currency?

A currency which is held in considerable quantities by different governments as part of their foreign exchange reserves. It is also used for the products traded in global markets such as oil, gold etc. Reserve currency is also called as ‘Anchor Currency’.

US Dollar as Reserve Currency: Traditionally, US Dollar has been regarded as the reserve currency and for more than 50 years it has been the currency of choice used by various nations of the world to facilitate trade involving commodities such as petroleum, manufactured products and gold. This stature has had tremendous benefits for the U.S. financial system and the consumers, and it has given the U.S. government tremendous power and influence all over the world. Today, more than 60 percent of all foreign currency reserves in the world are in U.S. dollars. The Dollar became so dominant because of the following reasons: • The ease of availability of derivative instruments to hedge dollar exchange-rate risk and this makes the dollar the most convenient currency for corporations, central banks and governments alike.

• Dollar is world’s safe haven and during the time of crisis investors instinctively returns to it.

• Dollar gained heavily from the dearth of alternatives.

Threats faced by US Dollar: There has been a growth of viable alternatives: Euro and Chinese Yuan. With the changing times, market has evolved significantly and today, there is scope for more than one international currency to function simultaneously.

Recently there have been precedents where major oil producing nations have glided away from using dollar and this constitutes a major threat to petrodollar. Apart from this there have been reports from International FI’s like UN and IMF, issuing the need to move away from the US Dollar and towards a new world reserve currency.

A lot of this threat emanates from China, world’s 3rd largest economy. Seventy thousand Chinese companies are now doing their cross-border set-

September 2012

tlements in Yuan and thus freeing themselves from undertaking the foreign exchange transactions. Allowing Chinese banks, for their part, to do international transactions in Yuan will allow them to grab a bigger slice of the global financial pie.

Also, the status of dollar being safe haven is now lost mainly due to the financial crisis and the federal debt approaching 75% of US GDP. Reasons for decline of US Dollar as Reserve currency: From Fig 1, it is evident that the share of US Dollar as the world’s reserve currency is facing a gradual fall and has come down from 75 % in the late 90’s to around 58% in the last quarter of 2011.

Fig 1: Dollar Value Share of foreign exchange reserves in %

As shown in Fig. 2, the same duration saw growth of the Euro as an emerging reserve currency.

Also, the last few years have seen an increasing use of Yuan in settling Chinese trade. Fig. 3 shows an increasing use of Yuan in settling Chinese trade from the Q1 of 2010 to Q4.

So based on these figures and statistics, we can enumerate some of the reasons for the decline of Dollar as Reserve currency: 1. Dumping of Dollar as the reserve currency in bilateral trade by China, Japan and BRICS nations.

2. Chinese and the Russians have been using their respective currencies for trade.

3. China and UAE have decided to ditch US Dollar and to use their own currencies in oil transactions.

4. Despite sanctions against Iran by the Western

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Fig 3: Increasing use of Yuan for trade settlement Fig 2: Euro Value Share of foreign exchange reserves in %

world, the trade with Iran continues to be important aspect of many nations. Indian and Iranian deal of payment in Gold for the oil transaction is one such example of that.

5. Increased stress from international institutions like IMF and UN pitching in for the emergence of a new world currency.

6. China is the largest importer of oil from the Saudi Arabia, importing 1.39 million barrels of oil every day. Also there has been considerable Chinese investment in Saudi Arabia for the development of oil refineries. Hence, there is a possibility that this growing partnership will take deal away from petrodollar.

Impact on US Economy As the world moves away from the US dollar, there will no longer be an automatic jump in the value of US Dollar and this will have an adverse impact on the other major economies during the time of volatility surges.

With Dollar, Yuan and Euro being used as Reserve currency, no single currency will rise as strongly as the Dollar did.

The impact would be severely faced by the US companies who until now had the convenience of using their currency to pay their workers, importing parts and components, or selling their products to foreign customers. As of now they don’t have to incur the cost of changing foreigncurrency earnings into dollars or bear losses due to changes in the exchange rate but this will all change in the brave new world that is coming. American companies will have to cope with some of the same exchange-rate risks and exposures as their foreign competitors.

Conversely, life will become easy for European and Chinese companies and this will lend them competitive advantages.

Another important aspect for US economy would

be its failure to finance it budget deficits so cheaply in the event of decline in the demand for the US dollar. Also U.S. will not be able to maintain such large trade and current-account deficits, as financing them will be very expensive.

Reducing the current-account deficit will trigger increased exports which will make US goods more competitive in the global markets. This would mean that dollar will have to fall in the Forex markets thereby helping US exporters.

Conclusion With the changing financial situations and evolving markets, Dollar is no doubt facing a serious threat in being the reserve currency of the world.

However, favourably for US, recent turmoil seen in the European markets might have slowed its decline. Still, the major threat comes from Yuan. With its stature as an emerging power and with its new deals in the oil exporting countries, China will soon play a stronger role in world economy and the coming times might see Yuan emerging as an alternative reserve currency.

Š FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

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Article Perspective of the Month Cover Story

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LIBOR’S LABOUR’S LOST Anuj Narula & Prakash Nishtala

NMIMS, Mumbai

In 1598, William Shakespeare scripted the ribtickling comedy “Love’s Labour’s Lost”. The world has seen an unprecedented paradigm shift by then. But, now, the history seems to repeat itself. This time around, Barclays comes up with an ad nauseam thriller, “LIBOR’s Labour’s Lost”.

Prelude During the late 1984 and early 1985, the financial world felt an inalienable need to provide a standardized rate to facilitate the ever increasing usage of new financial instruments such as interest rate swaps, foreign currency options, and forward rate agreements, that’s when LIBOR, or the London Interbank Offered Rate, was born. Countries that rely on the LIBOR for a reference rate include the likes of United States, Canada, Switzerland and the U.K. LIBOR is the average interest rate estimated by leading banks in London. The Banks charge this rate for lending credit to other banks in the London Interbank Market. For instance, a multi-national corporation (MNC) with a very good credit rating may be able to borrow money for one year at LIBOR plus four to five points. LIBOR is calculated and published by Thomson Reuters on behalf of the British Banker’s Association (BBA) after 11:00 AM (usually around 11:45 AM) each day (London time) on a daily basis wherein they survey interbank interest rate quotes by 16 large banks. The submitted rates are, then, ranked and the mean is calculated using only the two middle quartiles of the ranking. So, if 16 rates are submitted, the middle 8 rates are used to calculate the mean. The calculated mean becomes the London Inter-bank Offered Rate for that particular currency, maturity, and fixing date. The rate at which each bank submits must be formed from that bank’s perception of its cost of funds in the interbank market. It is published for various currencies and for maturities ranging from overnight to one year.

BBA follows a typical, believed by many as immaculate, method for calculating the sacrosanct LIBOR for the day. LIBOR plays a much crucial role by not only providing information about the cost of borrowing in different currencies but it also actually influences it. LIBOR, the lingua franca of

September 2012

the banks helps them in figuring out what they should charge for not just home loans, but car loans, commercial loans, credit cards.

Plot (LIBOR… Lie More?)

So far the LIBOR’s journey was a dream run.

Right from its inception, it has enjoyed fame and acceptance in a world where change is the only constant. But, all was not rosy as it appeared. As every flick has its protagonist, this story had the Wall Street Journal (WSJ) as its saviour. In 2008, WSJ released a controversial study suggesting that some banks might have understated borrowing costs they reported for LIBOR during the 2008 credit crunch that may have misled others about the financial position of these banks.

To obliterate gloomy economic scenario, banks showed lower than actual interest rates. The lower interest rates therefore resulted in lower LIBOR and thus heaved up the confidence and increased lending. As LIBOR is the average of the interest quotes by different banks, so rigging of LIBOR would have involved many banks.

Why was the rate rigged in the first place? A close examination into the issue transpired that Barclays was itself facing rising interest rates; had it provided the same rates to BBA, it would have created an unhealthy picture on the bank’s financial stability and liquidity issues it was facing would have surfaced. So, in order to protect its own interest Barclays resented on reporting (read rigging) lower rates so as to present a merrier outlook to the outer world. The rigging happened between 2005 and 2009, as often as daily.

Creating a bang in the already turbulent banking world- thanks to Euro crisis, the WSJ report on rigging was welcomed with raised eyebrows and harsh criticisms. A fast-paced turns of events ranging from staunch investigations into the conversations of Barclays’ CEO Bob Diamond and the Deputy Governor of Bank of England to the Barclays’ public admittance of the rigging, the world witnessed abdication of three stalwarts of Barclays from the throne. Barclays Bank was fined a total of £290 million (US$450 million) for attempting to manipulate the daily settings of LIBOR.

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What’s the big deal?

Upshots on proletarian: If LIBOR is very high that means one needs to dish out more to avail the credit. If it’s maneuvered towards a lower rate, it implies that your interest earnings on savings account would be subdued. Hence, in either ways, a manipulation would lead to common man’s loss.

As it is used as a benchmark for deciding various rates across numerous banks including central banks or even EURIBOR, so at a macroeconomic scale, it has the potential to create many ripples in financial assets worth $500 trillion.

Mumbai Inter-Bank Offered Rate (MIBOR) - The Younger Brother In India, as the financial markets started developing, the need for a reference rate in the debt market was felt. The National Stock Exchange (NSE) on 15 June 1998, developed the Mumbai Inter-Bank Offered Rate, referred to as MIBOR, on the lines of LIBOR. These rates are calculated by a combination of two methods—polling and bootstrapping. In the polling method, like in the case of LIBOR, the data is collected from the panel of 30 banks which has a mix of public sector banks, private sector banks, foreign banks and primary dealers.

How safe is MIBOR? As MIBOR shares a similar DNA as that of its elder brother LIBOR, it might also have a little room to get manipulated.

But, MIBOR has its own merits over LIBOR which makes it a bit safer. Firstly, instead of omitting 2 highest and 2 lowest rates as is done in case of LIBOR, NSE uses a statistical technique called bootstrapping to separate the outliers and determine the mean rate. It is expected to help against any attempt by the market participants to come together and influence rates. Secondly, though in a less extent, the very fact of Indian banking system being largely dominated by public sector banks makes one to believe that MIBOR could not be affected by private players to satiate their own interests.

Learning from LIBOR scandal Prior to the exposure of scandal, proponents of LIBOR were too confident about its piousness.

Promoters of MIBOR such as Reserve Bank of India (RBI) should act proactively to tighten the possible loose links and to cover the undiscovered loopholes.

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Fig 1: Benchmark Interest rate Libor calculation Source: chasvoice.blogspot.com

The case in point is the possible switching over of MIBOR calculation to actual dealt rates on a trading platform. As India has online, screenbased trading of money market instruments such as call money, unlike voice-based markets in many countries, it makes sense to move to a transparent, actual screen based traded rate system which could capture actual MIBOR levels.

Epilogue As the Shakespeare’s classic had not only the King of Navarre involved in the promiscuity, he had an unflinching support from his three noble companions as well, on a similar line, even in this story Barclays is not forlorn, they reportedly, have support from many other players (refer to Exhibit 1) of the game. The immediate action in the current context should be to identify the hidden miscreants and subject them to serious punishments.

What we require today from regulators is not merely whipping fines on the perpetrators rather a system should evolve wherein there is no scope for manipulation at all.

The world is now hopeful that one day, preferably sooner than later, the system should get clear of all the malpractices and the market participants can again reinforce their faith in LIBOR. The time must come sooner when we could say, “LIBOR’s LABOUR’s WON!”

© FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

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Article Finsight of the Month Cover Story

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The Reality of Real Estate Companies

This article is a synopsis of the performance of the real estate sector in India during the last decade. It begins with the transformation of the sector from being family run businesses to having a professional structure. During the financial crisis in the US, the real estate stocks had fallen drastically but more than four years down the line, they haven’t been able to recover. There has been a massive erosion of wealth for the investors. The article tries to highlight the reason behind the fall and what can be done to improve the sector.

Avirup Chatterjee

TAPMI, Manipal Family run businesses are going on to become some of the largest corporations of India, dividing the gains among all its stakeholders. Sounds like India “shining” right?

That’s precisely what the real estate companies promised investors while coming out with the IPOs. That was during the years 2006 and 2007 in the midst of the real estate boom. Those who had missed the IT bandwagon did not want to lose another chance at what seemed to be the next big thing. The talk of the town was Roopa Purushothaman’s report on the future of India’s economy.

The two most important facets of a growing economy are power and infrastructure. According to the census of 2001, 27.82% of the population lived in Urban India, where the land mass was just 2.34%. Tier II and Tier III cities were being developed to support this ballooning population. The real estate companies started creating large land banks in these areas to fuel their growth.

A number of real estate companies came out with IPOs to cash in on this boom. Their red herring prospectus mentioned double digit growth pros-

pects along with large land banks as the reasons for high issue prices. Figure 1 shows the comparison of the book values vis-a-vis the issue prices.

The companies justified it as their discounted value of future earnings.

All the companies issued a very little percentage of their share capital as part of the IPO. The IPOs were over-subscribed up to 3 times in many cases. In retrospect, the causes for such enthusiasm can be attributed to the following events: • Government allowing FDI of up to 100% in the sector.

• Repealing of the Urban Land Ceiling Act in certain parts of the country.

• Positive outlook about India’s economic growth.

The Tumble Begins: After reaching astronomical heights, the share prices saw their first fall in the beginning of 2008, when news about the fall of banks in the US started coming. As the real face of the crisis evolved, stock markets all over the world tumbled and prices fell sharply.

The BSE Realty Index fell from a high of 13848.09 in January 2008 to its close of 1227.13 by the end of the year.

Fig 1: Book value Vs Issue price

September 2012

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Fig 2: The IPO’s as a % of post issue capital Fig 3: BSE realty

By mid 2009, the markets had substantially improved but a look at the realty index would make one feel as if the storm was yet to pass. It has now been more five years that most of the real estate companies came out with their IPOs, but none of them have even recovered their initial listing price.

The rumble behind the tumble It is a surprise today as to why the markets back then did not recognize the signs showing the prices being inflated. The most important reasons for their failure can be summarised as follows: • Sales figures inflated by sales to subsidiaries/ holding companies: Example: DLF Ltd’s top line increased by 224.81%, from Rs 1,242 crores in March 2006 to Rs 4,034.1 crores in March 2007. Of this Rs 2,207.1 crores came from sale of assets to DAL, one of its promoter group companies. Incidentally, their IPO came out in July 2007. It puts a question mark on the policies adopted by them. Was it done to show robust growth just before the IPO? The debate is left to the readers.

• Grossly overvalued: The companies were valued on the basis of NAV (Net Asset Value) models. The expected earnings from the future projects were discounted to arrive at the NAV per equity share. This formed the basis for deciding the issue price. The other comparisons used were the peer group P/E ratios. Everyone was following the script. The companies listed at that time were trading on P/E ratios as high as 174.4. Comparing this and arriving at an issue price on the basis of that was gross overvaluation.

• Rating Agencies: The companies were given “strong buy” or “buy” recommendations by most of the rating agencies. It is hardly a secret that the rating agencies have their own interests, which more

often than not come directly in the way of unbiased analysis.

The result is out there for all to see. Figure 4 shows the issue price and the present prices of some of the major real estate players in India, making it clear that a lot of wealth has been eroded from the markets.

Solving the Jumble Real Estate sector in India is the second largest employment generator, next only to agriculture.

The real estate sector contributes to about 5.3 % of India’s GDP. Despite its size, the sector is grossly unregulated. Involvement of black money, Ponzi companies cheating customers and the like are regular headlines now. The government as well as the real estate companies need to join hands to form regulations that ensure growth as well as the safety of stakeholders in this sector.

The Real Estate Bill, already drafted, could not be presented in the Parliament because of the reservations of some states. Getting a legislation passed on this is very important. After the sector was opened to FDI, there has been a sub-

© FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

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FIN-Q Solutions July 2012

Fig 4: Issue price and the present prices of some of the major real estate players in India

stantial inflow of investment into the country. At the same time, these investors need assurances that the sector is transparent. “In 2011, the RBI introduced strict and ponderous rules for bank lending to the real estate sector and this has made it even more expensive and cumbersome for banks to extend loans to real estate developers. Compared to developed economies, India still does not allow Real Estate Investment Trusts (REITs) and Real Estate Mutual Funds (REMFs)”.

Over the centuries, most wars have been fought over land disputes. Today we see protests happening across the country over land acquisition.

The real estate developers should keep in mind that they are building homes for people on the land of others. They have a social obligation to see that the affected people get adequate rehabilitation. It is high time that an independent regulator is set up to look after the functioning of the real estate companies. The regulator may consider setting up a public portal for monitoring real time projects. The financial dealings in various projects need to be made transparent to prevent the inflow of black money into this sector. This will not only help buyers make an informed choice but also will give confidence to equity investors about the governance of the companies.

1. Dundee Mutual Fund 2. Vatican’s Coin has the phrase printed on it 3. ANCON 4. Asset Stripping 5. Klaus Schwab 6. Starwood Capital Group Global, LLC 7. Iceberg Order - Place orders in small lots 8. Samit Ghosh 9. Robert Diamond, Barclays

10. Spain

September 2012

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CAT Bonds G. S. N. Aditya IIM Shillong insurance company would use this money to pay their claim-holders.

But won’t such bonds be very risky as the investor stands to lose everything in case the catastrophe occurs?

Sir, I was reading about a recent earthquake and came across a term called CAT bonds. Could you please explain what CAT bonds are?

Well, CAT bonds are short for Catastrophe Bonds. It is a high yield debt instrument, which is usually insurance linked and meant to raise money in case of a catastrophe such as an earthquake. Usually Insurance or reinsurance companies issue these bonds to various investors. This helps them transfer a part of their risks to the investors. Insurance companies can further invest this money generated through the issue of these bonds.

They were created in the mid-1990’s after the Northridge earthquake and Hurricane Andrew. In case of such a major catastrophe, insurance companies would incur damages which cannot be covered by the premiums and returns from investments using the premiums. In order to alleviate such risks, CAT bonds have been designed.

Oh I see. But how are they different from Regular bonds?

Good question. An insurance company issues CAT bonds through an investment bank, which are subsequently sold to investors. Unlike regular bonds where the principal is guaranteed to be returned at the end of the tenure, there is a special condition called as Trigger condition which determines if the investor stands to gain or lose at the end of the tenure of the bond. For example, if no catastrophe occurs during the tenure of the bond, the insurance company will pay a coupon to the investors and return the principal at the end of the tenure. However, if a catastrophe does occur, then the investors will have to forego their principal and the

Yes, that is a very valid observation.

CAT bonds are often rated based on its probability of default due to a qualifying catastrophe, resulting in a loss of principal. Catastrophe models are used to determine the rating. Most CAT bonds are generally given a rating of BB or B by credit rating agencies which are below the investment grade limit of BBB-.

Agencies such as Standard & Poor’s and Moody’s are responsible for the credit rating of CAT bonds.

Given their riskiness, why would somebody invest in such bonds?

These bonds often offer a higher return than other instruments in the market.

CAT bonds usually offer a coupon of LIBOR (London Interbank offered rate) plus a spread which can be as high as 20% in some cases.

Investors choose to invest in CAT bonds because their return is largely uncorrelated with economic conditions and the return of investments in other fixed income or equities. So CAT bonds help investors diversify their risk.

I haven’t heard a lot about these bonds in the Indian media. Are they available in India?

No. These bonds aren’t available in India yet. They are largely issued in the developed world.

India is exposed to windstorms, floods, earthquakes and other perils and hence the use of CAT bonds to mitigate natural disaster risks seems to be likely in the near future.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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CLASSROOM FinFunda of the Month

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FIN-Q 1. A momentum based strategy, this type of trading involves focusing only on the short term outlook of the market. It is an advanced trading strategy.

2. A typical insurance policy devised specifically for sheep owners and allied businesses who are indulged in the logistics of wool business.

3. X is an index used to assess the economic well being of the economy. It is calculated by aggregating the inflation rate and unemployment rate of the economy over a given period. A higher value of the index implies deteriorating economic climate.

4. Who is the first Indian woman to become the CEO of a foreign bank?

5. Identify. (Hint: Think basics of accounting)

6. The Tirupati Branch of Bank of Baroda has a unique offering in addition to its usual portfolio.

7. If Bullish and bearish are 2 ends of a continuum, what lies in the middle?

8. Who are the first two women to appear on the U.S. $1 coin?

9. Connect:

10. ______ options has features of both American and European auctions. The option can be exercised only on predetermined dates, typically every month.

All entries should be mailed at niveshak.iims@gmail.com by 10th October, 2012 23:59 hrs One lucky winner will receive cash prize of Rs. 500/-

September 2012

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WINNERS Article of the Month

Prize - INR 1000/-

Tanay Deshpande IIM Calcutta

FIN - Q

Prize - INR 500/-

Neeraj Gupta XIME, Bangalore

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