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MARKETS RAJAWALI ON THE RISE: THE INDONESIAN BANKING SECTOR BY MELISSA LUKI ANDREANY It has braved the 1997 Asian Financial Crisis, withstood the turmoil of the 2008 global financial crisis, and is now one of the “Next 11” emerging economies: the Indonesian banking sector is one of the rare bright spots in today’s sluggish global economy. Standing at the confluence of a turbulent history and a future of opportunity, the banking sector of Southeast Asia’s largest economy is unique in the characteristics of its market and its financial institutions. It is worth a closer look in particular for the impact it has on one of the world’s largest emerging markets today.

of households earn less than USD 1,000 per month. Yet, this is accompanied by positive prospective growth in real household incomes across almost all income brackets (Fig. 1). With increasing incomes it is probable that Indonesians will become more interested in various banking services and financial products.

Market has large potential… … The World Bank estimated the size of the Indonesian population to be over 240 billion in 2011. This makes Indonesia the 4th most populous country today and the most populous country in Southeast Asia. This large population is overwhelmingly dominated by low- and middle-income earners: approximately 90%

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Fig. 1: Positive real growth in household income expected through and beyond 2011 (Source: Credit Suisse Emerging Consumer Survey 2011)

Domestic demand and consumption helped Indonesia to be ‘one of a handful of countries’ that avoided a recession during the 2008 financial crisis (Fitch Rating, 2011), and are likely to sustain the growth of Indonesia’s economy, including its financial sector, in the coming years. but is potential being fulfilled? However, it seems that more can be done before banks and financial institutions fully maximize the potential that this expansive population provides. In its 2011 Emerging Consumer Survey, Credit Suisse found that in 2010 37% of respondents in Indonesia had a bank account; this is far less than 92% in India and 83% in China (Fig. 2). PwC similarly claims that only 20% of the Indonesian adult population has ‘some sort of on-going financial relationship’ (OBG, 2012). The low penetration rate of banking services reveals much untapped demand that provides banks in Indonesia room to expand their operations organically, particularly as increasing real incomes raise Indonesians’ interest in financial products. Microfinance: To grow from below


Indonesia’s thriving microfinance scene acts as a major driving force for Indonesia’s banking industry due to its growth potential. According to the Cooperatives, the Indonesian banking service has only reached less than 25% of the over 50 million MSMEs in the country. This shows how much more growth can be afforded in microfinance products within Indonesia. Fig. 2: Smaller proportions of respondents captured by Indonesian banks than in other emerging economies (Sources: DBS investor presentation – “Danamon and DBS: A Combination for Growth”; Credit Suisse Emerging Consumer Survey 2011)

The substantial low-income group gives rise to a vibrant microfinance sector within the Indonesian banking industry. Microfinance loans, particularly to individual entrepreneurs and MSMEs (Micro, Small and Medium Enterprises), make up a sizeable portion of the loan portfolios of Indonesia’s banks: PwC found that in June 2011, MSME loans accounted for 53% of total lending. For Bank Rakyat Indonesia (BRI), one of Indonesia’s largest state-owned banks, loans to micro and medium-sized businesses accounted for approximately 37% of its total loan portfolio in 2011. Microfinance loans, which is the second largest segment of loans after retail loans, comprised 32% of total loans, an increase from 28% in pre-crisis 2007 (Fig. 3). Why do corporate loans make up only a small portion of Indonesian banks’ loans? This traces back to Indonesia’s past experience with the Asian Financial Crisis whereby liberal and unregulated lending policies left banks’ balance sheets burdened by leverage and susceptible to asset bubble bursts. Having learned their lessons, Indonesian banks became more conservative in their lending

which led to somewhat of a natural aversion to long-term loans like those funding infrastructural investments. Infrastructure projects typically require a ‘long gestation period before profits materialise’. The length of this period is ‘beyond the comfort zone of most Indonesian banks, whose loan officers expect to evaluate credit requests based on a faster turnaround’ (OBG, 2012). Given this context, combined with growing demand from low-income earners, microfinance naturally becomes a notable growth area within Indonesia’s banking sector.

Microfinancing clients keep the sector grounded and stable In addition to having growth potential, microfinance is also a robust sector. Interestingly, this can be attributed to the microfinance customer base: not only is local demand is substantial and continually strengthening, but good quality loans also arise from the consumer base. The behavior of microfinance clients has been found to contribute to the stability of the business. Microfinance borrowers particularly value the possibility of multiple loans in times of difficulty. Hence, to have access to multiple loans they make an effort to repay their loans

Business opportunities in microfinance aplenty

Fig. 3: Microloans and loans to small businesses contribute substantially to BRI’s loan portfolio (Source: Bank Republik Indonesia (BRI) Annual Report 2011)

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in a timely manner, thereby reducing the risk of payment defaults (Bramono, Chung, Eom and Lam, 2005). Such behavior could otherwise be induced by institutional factors, particularly incentives. Examples include partial interest rebates for timely repayments as borrower incentives and negative pledges equivalent to 10% of loan amounts in the form of forced savings. In the event of the borrower’s insolvency, the institution to which the borrower made his pledge guarantees claim to the borrower’s assets for repayment (this usually applies to sub-district credit institutions) (World Bank, n.d.). While the NPL (non-performing loans) ratio of 2.87% for the MSME segment was still slightly higher than the sector average of 2.74% in June 2011 (OBG, 2012), the aforementioned schemes could at least help to counteract the effects a difficult global business and trade environment. This in turn helps local businesses to repay their loans, which could prevent post-crisis NPL levels from rising too rapidly. Microfinance institutions also benefit from a stable, loyal customer base as a whole. Savers value the convenience, liquidity, security and professional service that microfinance institutions offer at affordable rates (Bramono, Chung, Eom and Lam, 2005). This builds a strong sense of customer loyalty amongst borrowers and savers alike. Coupled with a tendency towards risk-aversion, the vast consumer base of Indonesia’s microfinance sub-sector creates

robust business for financial institutions, which sustains both the microfinance industry as well as the banking sector as a whole through harsh economic times into an era of growth. Foreign banks: Acquiring a slice of the pie Indonesia’s banking sector, though largely propelled by domestic demand, has received considerable attention from outside the archipelago since the Asian Financial Crisis. Foreign banks wanting to acquire stakes in local banks were welcomed by the government because these foreign entities could help to recapitalize failed Indonesian financial institutions (OBG, 2012). More than ten years on, foreign banks, particularly Asian ones, continue to be attracted by Indonesian banks, because of the growth prospects offered by the Indonesian banking industry. Foreign banks benefit… Macroeconomic growth and opportunities in microfinance, as we have seen earlier, give banks good reasons to expand into Indonesia. Hence, institutions such as CIMB Bank and DBS Bank have looked or are looking into acquiring Indonesian banks to diversify their businesses geographically as well as sector-wise, complementing established corporate finance operations with up-and-coming microfinance and consumer finance operations

for more balanced portfolios. …and so do local banks Local banks can also expect to benefit from engaging in M&A transactions with interested foreign banks. Burgeoning local demand is beginning to take a strain on local banks’ balance sheets, with loan-todeposit ratios fast approaching the 100% mark. Foreign stakeholders can strengthen local banks’ abilities to provide capital, and similarly help local banks to more nimbly diversify their businesses into areas like long-term investment loans and corporate finance. Acquisitions may even provide a launch pad for Indonesian banks to expand their reach regionally, into other growing areas in Asia. But what about changes in regulation? Notable acquisitions of Indonesian banks include CIMB Bank’s acquisition of Bank Niaga to form CIMB Niaga in 2002, and DBS Bank’s pending $7.3 billion acquisition of Bank Danamon. It seems like M&A activity has just picked up, but will changes in government regulation bring this to a halt? In April and July this year, Bank Indonesia announced the lowering of foreign banks’ cap in ownership of local banks from 99% to about 40%. This threw DBS’ acquisition plans into doubt for a while, even though the bank has repeatedly stated its intention to go ahead once the change in regula-

Fig. 4: Singapore-based DBS bank’s acquisition of Indonesian Bank Danamon aids its diversification into consumer loans and microfinance (Source: DBS investor presentation – “Danamon and DBS: A Combination for Growth”)

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tion has been confirmed. For now, the uncertainty potentially holds back more similar deals but there remains also the question of how impactful this regulation will really be even once implemented. Bank Indonesia attached a caveat to this policy that allowed the cap to be raised up to 80% if acquiring banks were ‘financially strong’, with Tier 1 capital ratios of at least 6% (Grant, FT, 2012). So perhaps, while the regulatory authorities may be sending a signal of bringing foreign-local M&A activity under control, this area is still set to remain active for some time.

Future prospects: A Rajawali* set to soar The numerous growth opportunities that lie in the Indonesian banking sector can only serve to propel the country’s economy further which will bolster consumer demand and business activity in the low- to middle-income tiers. This sector, and the national economy as a whole, is worth keeping a lookout for in the medium- to longterm, particularly as Southeast Asia also starts gaining attention in the world economy as the up-andcoming drivers of a global economic recovery.

THE SICK MAN OF EUROPE BY VINH NGUYEN QUANG 2012 marks a crucial year for the French. A surge in unemployment rate, sluggish growth and a brutal drop in competitiveness are the three major threats that currently undermine the second largest economy of Europe. A strong France is a major step in getting the flagging European economy back on track. With the so-called “normal” style, François Hollande declared a clear victory in the race to l’Élysée over Nicolas Sarkozy whose reputation was dampened by a “bling bling” presidency. Although the socialist government has even greater control across France’s regions compared to its predecessors, François Hollande appears to be reluctant to implement necessary changes to his country. The unemployment question mark Unemployment has long been a structural problem in France

over the past 40 years. However, Mr Hollande faces a much bigger challenge than any previous French President, as his country is in an even worst situation, beset by a burdensome Eurozone crisis. Tracing back to 2000, the French unemployment rate has reached a record high (chart). There was a decrease to 8.3% in 2001 but overall, France is witnessing 3m unemployed. Along with poverty hitting 4.5m people and an image of “les banlieues” (suburbs) causing the riot in 2005, this could provoke a massive destruction in social structure. Compared to its peers in the Eurozone, French unemployment has reached an unsustainable figure, prompting the International Monetary Fund to give the country one of its most ominous warnings, painfully stating that France could fall behind Italy and Spain, whose labour market reforms have taken

effect. France’s structural problem in unemployment has undermined it in comparison to France’s closest neighbour, Germany. Both started with nearly the same level of unemployment at the end of the 20th century, yet Germany has been bold in its decision for labour market reform to quickly slash unemployment rate to a significantly lower figure of just over 6%. Adding on to the burden of unemployment “de longue durée” (long-lasting unemployment), it is the worsening European crisis that aggravates the excessive supply of labour. While there are 3m unemployed, French businesses do not hesitate to put more pressure on the key economic indicator by implementing many redundancy plans that the socialist government has tried to minimize but has barely succeeded. A plan of 8000 job cuts by the giant car maker PSA, judged “unacceptable” by the President, was finally implemented. What is more significant is that promises to take care of those that were laid off have not been carried out, which triggered a fall in the popularity of Mr Hollande. 700,000 jobs have been slashed as a result of a massive reduction in the size of French export companies. This type of “deindustrialisa-

(Source: European Commission)

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A vulnerable competitiveness

Image courtesy of dan / FreeDigitalPhotos.net

tion” not only contributes to a faster economic collapse but also poses a threat to Made-in-France products. Yes, labour cost is always the main theme behind every redundancy plan. Nevertheless, some argued that it is less important than other factors such as “the range of products, industrial base, strategy and access to easy finance”, according to Jean-Claude Mailly, general secretary of Force Ouvrière, one of the five major unions federations in France. Apart from the refusal to the “work more, gain more” policy of Mr Sarkozy that cost the economy 25bn euros and caused a discouraging sentiment amongst France’s major employers to hire more workers, the socialist government had just agreed to a massive tax break for companies of 20bn euros, which will expect to create 300,000 to 400,000 jobs until 2017, according to the French Prime Minister. Other short term plans have been put into place such as the establishment of a public investment bank

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enabling jobs creation or the “generation contracts” which are expected to resolve the shortage of senior employees as well as youth unemployment in French businesses. Yet, all of these plans have not touched on the deep rooted cause of French structural unemployment – a highly regulated labour market in which French entrepreneurs are demotivated to hire more employees. Reluctance towards labour market liberalisation still persists in the socialist decision-making process.

Competitiveness is another vital factor making the task even more onerous for Mr Hollande. During the early stages of the single currency, François Mitterrand, the last French socialist President, was still enjoying a trade surplus by which French share of world goods exports stood at nearly 6%, now it is 3%. Last year’s trade deficit was recorded at 84.6bn (chart), with a slip in the World Economic Forum’s competitiveness rankings to 21st from 15th in only 2 years, revealing the shocking truth about France’s competitiveness. The consequence is not only a sluggish growth which is incapable of raising GDP to meet its ambitious 3% target but also farreaching political implications in the relationship between the 2 biggest economies of Europe. Although the French president, who speaks fluent German, understands that the relationship with one of his most important counterparts, Ms Merkel is one of his top priorities, France’s economic struggles further widen Franco-German relations. A vulnerable competitiveness would certainly trigger different solutions to be implemented at the Eurozone

(Source: European Commission)


level, which a stronger economy such as Germany may oppose. In fact, we have seen Mr Hollande’s failures in persuading the German chancellor to make a decisive move towards a banking union. Moreover, competitiveness in France is of keen interest to big bosses and French would-be entrepreneurs. One of the main problems hampering business activities in France is a strikingly high tax rate. For instance, employer social-security contributions made up 30% of labour costs in 2011, compared to just over 15% in Germany or 10% in Britain. Faced by fierce protests from French business leaders, 20bn euros of tax breaks, as mentioned above, have been agreed to reduce the tax burden for French enterprises. Nevertheless, this dangerous loophole potentially passes into other forms of direct income taxes and possible public spending cuts in which French consumers will be hit hard. Despite a weak 0.2% expansion recorded in the third quarter, this business-favouring tactic can easily tip France into another round of recession, precipitating concerns from those who still think France’s financial market is a safe haven. However, the French is not in desperate need of big firms. “It has more big multinational companies in the global Fortune 500 than Britain”, according to the Economist. What it does lack is a large number of small and medium-sized businesses, which are always an important growth engine. Yet one might wonder why France has many big names in the competitive world market with such a stiff start-up trend. It must be acknowledged that big corporates such as L’Oreal were founded during the

(Source: European Commission)

glorious years of the last century in which entrepreneurship was fostered. Now, there are just over 4000 medium-sized companies. The underlying reasons can be traced to the business regulation system of France’s “anti-business” policy. For instance, the French faces up to 9 years, the highest figure in Europe, after which entrepreneurs can be discharged from debts in case of bankruptcy (chart).

Yes, the effect is enormous. For big businesses and “les PME” (small and medium-sized businesses), a combination of high taxes and complex regulation is key in driving businesses abroad. After the race to l’Élysée, David Cameron, – Britain’s Prime Minister, has talked of rolling out the red carpet for French big bosses wanting to escape the very leftist proposition of a 75% top tax rate for those earning more than 1m euros a year. For “les PME”, aspiring entrepreneurs settle down in foreign countries, highlighting the impossibility of starting up in France.

France’s Future “France is not a sick man of Europe”, said the French Finance Minister. Yet, when the Economist published its 14-page report, France was indeed the ailing man of Europe. With an unemployment rate of over 10% and a worrying lack of competitiveness, France is at risk of missing its budget target as well as heading towards another recession. Indeed no one doubts the need for reform in France. But is the government brave enough to do it?

Image: africa / FreeDigitalPhotos.net

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FOOD CRISIS OR NOT? PRICE VOLATILITY IN WHAT YOU EAT BY VARUN MALHOTRA

ket. Short-term trends include biofuel conversion mandates in US, EU and Brazil, futures market specula lation and trade restrictions. We end with implications and potential solutions to tackle these factors.

In the last five years, the world has which induces a fall in consumption witnessed three food crises – 2008, and more investment in production Weather and seeds 2011 and 2012. Globally, food priclater on. However, what we don’t es are best measured through the consider is that when price moveFundamental supply and demand FAO food price index which weights ments become increasingly uncerbehaviour sets the long-term price the US dollar price of several intertain and subject to extreme swings, as buying and selling of physical nationally traded food commodithen the efficiency of the price commodities takes place in cash ties. This index, which recorded 200 system begins to break down. This markets. This makes sense because in 2008, reached another high of is exactly what has been happencrop yields can hardly be switched 228 in 2011 and 212 in 2012 (until ing in recent years. Further, given on and off like a tap; spreading extra October, Figure 1). Price hikes octhat food markets are increasingly fertilizer and mechanization helps curred for different reasons over integrated in the world economy, but higher yields also need better these last five years. In 2008, high shocks in the international arena irrigation and productive seeds. The oil prices were time lag between the main culprit, dreaming up a reaching USD new seed and 147 per barrel, growing it comand feeding into mercially is ten to transportation fifteen years. In costs. To make addition, weather matters worse, is a critical varireduction in able that often stockpiles, lower experiences parcereal producallel disruption. tion and low For instance, this interest rates summer, the cenowing to global tral agricultural financial crisis belts in the US further contribexperienced their uted to the price worst drought in surge. In 2011, almost a century Image courtesy of adamr / FreeDigitalPhotos.net bad weather and much corn with wildfires in Russia and floods crop was wasted. Half-way across in Pakistan and Australia contributnow transpire and propagate to dothe globe, heat waves across Russia, ed to the price increase. This year, in mestic markets much quicker than Ukraine and Kazakhstan wreaked 2012, the weather again disrupted before. havoc on wheat crop followed with bumper crop predictions in US for drier monsoons affecting soybean corn and soybean crop. In this article, we examine longproduction in India. term and short-term factors that Given these price fluctuations, one cause fluctuations in food prices. Biofuel mandates in US, EU and Brazil may rightly think that they are both Long-term trends include fundanormal and necessary requisites mentals of supply and demand In less than a decade, some 15 perfor competitive market functionoften governed by weather and cent of the world’s corn production ing such that when a commodchanging food preferences of a rishas been converted from food to ity becomes scarce its price rises ing middle class in emerging marfuel. Given the mandate require-

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Figure 1 – The FAO Food Price Index. (Source: Food and Agriculture Organization, UN)

ments to mix gasoline with certain percentage of biodiesel or corn ethanol, 40% of the crop is estimated to be absorbed by ethanol companies. About a third then enters as feed required by meat and poultry business. So, when output falls, demands from competing sources tend to drive up prices to even higher levels. Finally, even if the worst production shortfalls are in corn and soybean, as is the case for this year, other commodities such as wheat are also affected, since they substitute for expensive corn. Another critical reason behind conversion of food into fuel is the sky-rocketing crude oil price. In 2008, when crude touched $147 a barrel, there was strong demand from the biofuel sector and recent disruptions in the Middle East have yet again put crude oil prices soaring higher than in the early part of the year. Traders play with food For most of the 20th century, only

farmers and food industry companies speculated on food. It helped them offset risks posed by fluctuating prices and production levels, and generally had a stabilizing effect on markets. But in the late 1990s, financial industry-led deregulation efforts opened food speculation to hedge funds and other people with only betting interests.

As a result, an additional factor came to alter the price equilibrium of food. In 2008, following the global financial crisis, as security portfolios began to show weaker returns, folks tried to figure out how to improve their investments, and many of them looked to the commodities

Figure 2 – Food price (blue solid line) and model simulation (red dotted line) that includes both biofuel mandates and futures market behaviour variables shown with ethanol supply and demand model (blue dashed line). (Source: New England Complex Systems Institute)

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world. And, as these commodity investments began to pay off, this new asset class increased in size. By 2008, over $200 billion in passive investment flowed into the commodities markets. In their ideal form, commodity markets should contain 70 percent commercial hedgers and 30 percent speculators but in summer 2008, they had 85 percent speculators and 15 percent hedgers. Some economists disagree, suggesting instead that futures markets have a stabilizing effect as traders merely react to price signals that eventually depend on market fundamentals. In this way speculation rather accelerates the process of finding an equilibrium price. Such theory, however, may not hold in the presence of trend-following investors or those with market power. For example, in the short term an investor might be attracted by the opportunities offered by the upward trend of a commodity price

although this development may not be based on any fundamental data. These speculative investments could strengthen the trend and push the futures price further from its true equilibrium. Implications Significantly large, unexpected price upswings are a major threat to food security in developing countries. Their impact falls heaviest on the poor, who may spend as much as 70 percent of their income on food. In 2011, food riots in the Middle East ultimately led to the Arab Spring, sparking social unrest in parts of Africa. Before in 2008, wheat and rice price hikes had already led to riots in 25 countries. The vulnerability of a country’s population to price increase and its dependency on food imports are key things to consider. For instance, in 2008, when major producer countries such as India re-

stricted grain exports to keep their domestic food prices down, panic spread across sub-Saharan Africa and parts of Middle East. Some governments turned to buying or leasing land in other countries on which to produce food for themselves whilst others tried to use food reserves to buffer volatility but these proved unmanageable, costly and ineffectual, especially because shocks lasted for extended periods of time. Ultimately, the middle class in these countries had to cut medical care and many were pushed into poverty. It is estimated that speculation in 2008 coupled with export restrictions pushed more people into poverty than occurred in the previous ten years. In 2011, price spikes again pushed 44 million people into poverty. Solutions For long-term factors such as weather and land allocation, there is much planning that needs to be

Figure 3 – Country’s vulnerability to global food price shocks. (Source: World Bank food price watch)

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done that will take its courses through science labs where hybrid seeds are produced as well as through politicians’ offices. In the short-term, the solution lies in two areas – reducing biofuel mandates and regulating the futures market. Within biofuels, reducing the amount of corn that is converted into ethanol may begin to stem the crisis. Recently, more than 175 US congressmen have called the Environmental Protection Agency to halt or lower its mandate on how much ethanol the country must use this year and the next. In the futures market, regulation is needed to curb speculation to ensure real price stabilization. The US Commodities Futures Trading Commission has adopted a position-limits rule, which is expected to take effect later this year, and is seen as a critical step in the Obama administration’s effort to regulate Wall Street’s role. Lastly, on the countries banning exports of grains, an improved public global surveillance system on export availabilities and import demands can help temper uncertainty. In 2012, countries in the APAC region came together and effectively decided not to impose export restrictions to control price rises in countries facing a food deficit.

Conclusion There really are only two over-arching concepts to consider – the cost to the average initial producer to make something available, and the value the average final consumer can derive from that same thing. Whenever these concepts become eclipsed by other considerations, prices end up forming out of thin air. Some of the price volatility we saw in food markets in the last five years has been a result of these other considerations. Whilst longterm factors are gradual, over the short-term, in order to prevent further crises in the food market, we recommend halting of government support for ethanol conversion and the reversal of commodities market deregulation, which enables unlimited financial speculation. If these steps are not taken into consideration, the spillover effects of a price rise in one commodity may affect other commodities, such as rice which interestingly has absorbed shocks better than any other food grain, given how closely connected the global food supply chain is today.

THE CASE FOR COPYCATS BY FERNANDO FERNANDEZ $1.05 billion. A few weeks ago, that was what a US grand jury found was the price of some Samsung icons too closely resembling the ‘rounded rectangles’ of Apple. Well, alongside certain other software and design patent infringement.

In just another chapter in the endless record of technological patents disputes, the message is clear: copying is wrong. Indeed, we have always been taught the necessity of intellectual property rights, which foster creativity within our economies. That imitation inherently

steals others’ ideas and, as such, kills the drive of the actual inventors. Copying is obviously wrong, because it destroys the holy grail of innovation. Innovation Necessary for Growth? Or does it? Firstly, in the interest of clarity, so-called copycat firms are not necessarily, or will be discussed as, those who illegally pirate goods. So how are imitations actually legal? This is because many national leaders actively retain weak property rights, with firms engineering carefully around patents. Hugely lower costs and risk for industries are clear advantages and, if history is any measure for the future, developing economies will need to rely on such strategies for international competitiveness. Along with many other nations, South Korea became a hotbed for firms imitating research of foreign inventions in the latter half of the 20th century, with rapid industrialisation soon following. Samsung, un-coincidentally Korean, was then a mere component assembler, accused of copying Sony’s technologies. However, with currently 421 places between the two electronic multinationals in Forbes’ ‘World’s Biggest Public Companies’ list, the imitators have certainly surpassed the unbeknownst masters. However, South Korean’s experience is hardly unique. While the United States could boast of Silicon Valley and its ‘innovative’ triumphs, they adopted European technologies during its industrial revolution. As did Japan, post-WWII, and of course currently China. Each again experienced their strongest growth figures during these periods, with China recently in double digits. Varying degrees of copycatting

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2010. This was more than Samsung, Nokia, or Motorola at the time. Indeed, innovation seems to quickly succeed imitation. To reverse engineer, identify, adapt and develop new products for a new market, surely requires some technical skill; even from these “scheming” copycats. R&D does take place. Products are high-tech. They are low-cost. The ability to incorporate all of these, within a hyper-competitive environment of other imitators, accelerates the creative cycle. Unique barriers in developing economies, such as volatility and poor policy, only drive innovation further, increasing the productive and costcutting nature of the firms.

Image courtesy of MR LIGHTMAN / FreeDigitalPhotos.net

has been practised by essentially all nations. But perhaps more interestingly, this has mostly occurred during the early stages of their economic maturity; preceding significant transformation. Imitation the Driver of Innovation? Today, we can certainly see exciting developments in the global economy. It is not the Western nations, surprisingly, but developing countries that are offering great business opportunities. Tremendously untapped mass markets are continuing to grow, with a new breed of consumer. The poor. Yes they existed before, but not to this market scale, or disposable income; or profitability. With foreign products expensive and ill suited, domestic firms largely take advantage by adapting their technologies. They

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imitate. Crucially, however, to meet local needs and budgets, the copycats themselves innovate. They go above and beyond mere imitation. This ‘frugal innovation’ is commonplace. From dirt-cheap mobile phones with flashlights in Africa to solar-powered ‘iPhones’ in China, new business models are applied to the technology copied. Take the Chinese company, Tianyu - originally just another Shanzhai phone manufacturer. However, increasingly creative imitation, with a focus on consolidated management and design for young professionals, they eventually broke through as a reputable brand. Introducing over 100 new products annually and taking merely 45 days to produce a new design, compared to at least 6 months by global rivals, Tianyu held 8% market share in China,

The Indian multinational conglomerate, Tata Group, serves as another example. They too ‘borrowed ideas’ from General Electric, Berkshire Hathaway, amongst others, describes their chief strategist, yet is now one of the most promising innovators in all worlds. They have developed their own business model of outsourcing business processes overseas, to now a global scale, and invented a $3000 Nano car that even the West craves. Imitation the First Step of Innovation? If we reconsider our other examples, there is a certain business trajectory that is paralleled. The US invented the aeroplane and mass production after ‘observing’ Europe, similarly with Japan and their automotive industry. It seems that, more than possibly leading to innovation, imitation is the first step. With proponents of such relatively young economically, the absorption of knowledge and technology is in fact crucial in their development. It is a huge step. What’s more,


emerging markets are now being differentiated with their individual consumers and demands; and, with this, myriads of innovation opportunities to cater to them. Still, this does not appease foreign firms who fume angrily at the Chinese government’s procurement policies; especially when talk of their double-digit growth pops up. Reason being, to enter the great market of China, many firms have to give up their intellectual property, and so their inventions themselves. In 2007, state television unveiled a new Chinese fighter jet, suspiciously similar to the Russian SU-27, that they suddenly stopped purchasing. Whilst an amazing feat of reverse engineering, this dilemma is mirrored in many other industries; the imitators are free to undercut competition and vastly profit in international markets. However, this Shanzhai culture is quickly becoming an image of the past. As China’s catch-up growth slows down, the government is focussing evermore resources on indigenous innovation. Plans to attract professionals back to China, with tax-free allowances and permanent visas in the 2008 Thousand Talents Program - as well as last year’s extension to ‘Foreign Experts’ - demonstrates a clear desire to spark off innovation. Beijing also houses Microsoft’s global research centre and, more importantly, 95% of employees there are Chinese. Therein lies plenty of opportunities to spread knowledge, technical capabilities and, in essence, the potential for homegrown innovation to indigenous firms. Already, China have become global leaders in green technology, exporting to the US and

Canada. And with billions of dollars of continued investment, imitation will continue to beget innovation. Incremental versus Disruptive Innovation? Then what is the difference between the two? Throughout, there has been this distinction, between incremental and disruptive innovation. The usually American ventures, such as the Internet are heralded as disruptive innovation, radically changing our use of technology; on the other hand, developing nations’ ‘incremental’ efforts are almost always looked down upon. But whilst larger firms in the West are capitally endowed, equally novel products are being created in developing countries at a fraction of the cost. We have looked at new business models developed, with levels of productivity even Western business leaders strive for. Perhaps we have grown too familiar with minimalist advertisements proclaiming the technological breakthrough of a generation, but

the smaller steps, tweaks perfecting goods to specific markets, are all the more important in tackling today’s global and diverse markets. Emerging economies are indeed hotbeds of such business innovation, mirroring Japan’s story in the 1950s. Presently though, the emerging have emerged and so now ponder as whether to remain with imitation or ‘advance’ to innovation. The US certainly decided decades ago, though comparing their growth with that of China’s, some economic commentators are already calling for a rethink. In fact, it is not a question of either or the other, but an inherent coexistence. The very nature of innovation - be it incremental or disruptive - is ever-changing. Both will spur each other on, and, rather than kill creativity, propel this virtuous cycle onwards. As we see the story develop in China, the nation is itself also evolving, architecting new sources of innovation for the rest of the world.

Image courtesy of Pixomar / FreeDigitalPhotos.net

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Imitation: Good or Bad? Unchecked, imitation can certainly be damaging. But to ignore its countless virtues? To remain a taboo for business leaders? Isaac Newton once remarked that ‘If I

have seen further it is by standing on the shoulders of giants.’ Indeed our greatest innovations have stood on the works of others; and to revolutionise further, this will only need to continue.

ARE LOW INTEREST RATES ENOUGH TO SAVE THE ASIAN ECONOMIES? BY TAN CHOR HIANG The on-going crisis in the European Union and United States has not only caused distress in the developed West, but also spill-over effects in the developing Asian economies in the East. Many Asian countries have found their export growth to be sluggish in light of the recent events, where they are facing a decline in their export revenue and competitiveness. Japan saw its exports slump by 5.8% in August, mostly contributed by the falling exports to the European Union. The Ministry of Trade and Industry of Singapore also posted a yearon-year decline of 0.7% of its GDP in the second quarter of 2012. This problem is exacerbated with the expansionary monetary policy that the Europeans and Americans are adopting, which is causing Asian currencies to strengthen against the Dollar and the Euro. While a stronger currency translates to relatively cheaper import for these Asian countries, their exports become less attractive in the global market, which ultimately causes a decline in export revenue. This proved to be especially detrimental to economies like South Korea and Singapore, which rely heavily on exports to drive their economic growth. This phenomenon has driven many export oriented countries to opt for cutting their interest

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rates, in a bid to revive their export and economic growth in the midst of the crisis faced by the European Union and the United States. Sluggish Export Growth Hurting Economies With slipping export and economic growth, many Asian countries are desperately cutting interest rates in a bid to cool down their appreciating currency, hoping to improve their export competitiveness. South Korea, the world’s seventh largest exporter, has seen its exports slump in seven out of nine months this year. Recent figures

published by the government also showed that its exports fell by 1.8% in September. While its exports to China, which contributes 23% of its total exports, rose by 1.1% as compared to last year, this increase provided to be insignificant to the great slump in exports to the European Union and United States, which contribute 20% of Korea’s total exports. This is especially crucial for South Korea, as exports contribute almost half of her economy. The monetary policy adopted by the US and European Union exacerbated South Korea’s plight, where the Korean Won continued to strengthen against the US dollar. As seen in Figure 1, the Korean Won, which is on a managed-float regime, has been gradually appreciating against the dollar since May 2012. While this may translate to cheaper imports for her residents, it causes Korea’s exports to lose competitiveness in the global market. This eventually contributed to the trade deficit of $4.7 billion in August, after many surpluses that Korea enjoyed before that. In light of this, the central bank of South Korea decided to cut interest rate in order to boost its do-

Figure 1: Korean Won against the Dollar (Source: XE currency)


mestic economy as well as its export competitiveness. Slashing interest rates will result in lower borrowing costs for businesses and consumers, and thus, this may translate to a stronger domestic economy which may help to negate the ailing export revenues. The central bank also hopes to slow down the appreciation of the Korean Won against the dollar with this move in order to save its export competitiveness in the long run. Philippines’s central bank decided to slash interest rates for the fourth time in the year in October. This is in light of the worsening export market that she is facing due to the Euro crisis. Its export revenue growth fell to eight-month low in August of 9%, with export earnings declining 9%. However, Philippines’s economy can be considered pretty resilient amongst its neighbouring countries. Perhaps it is due to the aggressive expansionary monetary policy that the Philippine government is adopting, which led to it emerging as the top performer in export growth in September 2012 in the region. She managed to attain a year-on-year increase of 22.8% in its export growth (Figure 2), leading way ahead of its Asian counterparts like Hong Kong (15.8%) and Vietnam (15.6%). In comparison, regional countries like Japan (-11.8%) and Singapore (-4.8%) both posted steep declines in exports. Another factor for Philippine’s resilient export growth could be due to the fact that a larger proportion (22.4%) of their exports are targeted at other Asian economies like China, Taiwan and Hong Kong. Hence, its export growth is less affected by the European countries and the United States, leaving it relatively unscathed compared to her Asian counterparts.

Figure 2: Comparison of Export Growth (Source: Malaya Business Insight)

Uncertain economic outlook worries countries with strong domestic demand Thailand surprised the community by cutting interest rates in October, four days after its governor noted that no easing was required at the current state. Moreover, figures

from the central bank still showed that the domestic demand is strong enough to negate the weakening exports. Also, the central bank is confident of its growth forecast of 5.7% for the year, despite the bleak economic outlook ahead. Besides, the Thai government is adopting expansionary fiscal policy, with increased public spending and higher public servant salaries, in a bid to boost domestic demand. China, with its huge domestic market, has also opted to cut its interest rates in July, the second time in just two months amid fears of a gloomy economic outlook ahead. This move to cut interest rates may signal a preemptive solution to the uncertain economic outlook ahead, where even economies with resilient domestic demand are not spared from the gripes of the crisis in the world’s major economies. Worries about Inflation While extensive slashing of interest rates may lead to an improvement in export competitiveness, it may be seen as a double edged sword

Image courtesy of vichie81 / FreeDigitalPhotos.net

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for some countries. India’s central bank rejected a proposal to cut interest rates, despite strong pressure from the government to do so. Inflation in India has been treading on a precariously high rate of 7.6%, exceeding the central bank’s expectation of 4-5%. Thus, it chose to reduce the cash reserve ratio by 0.25% for banks, hoping that this may boost its domestic demand. This is because India relies on imported crude oil for three quarter of its needs, and the easing monetary policy in the US and European country has worsened its inflation rate. Hence, slashing interest rates may not be a perfect solution for India, as she attempts to control its relatively high inflation rates in light of worsening export growth. India is also struggling to control its widening trade deficit, as exports fell for five consecutive months and deficit rose to its widest in 11 months. The central bank believes that cost-push inflation is the main

factor behind this phenomenon. Thus, it believes that slashing interest rates will not provide a remedy to the situation, and may instead exacerbate the inflation rate.

book, there were numerous social networking sites such as Friendster and Myspace that were intending to take on the bulk of this huge untapped market.

For the numerous countries opting for an interest rate slash in an attempt to revive their weakening exports, this cannot be a long-term or permanent solution to their problems Moreover, aggressive lowering of interest rates may exacerbate the problem of inflation that is occurring in certain countries, such as India (as previously mentioned). With low interest rates and a depreciating currency, import-reliant economies like India may also see its economy slipping into costpush inflation in the long run. Thus, countries need to strike a balance and work out a more effective long term solution to mitigate the slump in export growth.

In the late 1990s, user profiles became a central feature of social networking sites, allowing users to compile lists of ‘friends’ and search for other users with similar interests. New social networking methods were developed by the end of the 1990s, and many sites began to introduce more advanced features for users to find and manage friends. These newer generations of social networking sites began to flourish with the emergence of SixDegrees. com in 1997, followed by Friendster in 2002, and along with Myspace, these soon became part of the Internet mainstream.

FACEBOOK - FLASH IN THE PAN? BY OH JON KEAT AND LOW WAN TING If Mark Zuckerberg were to announce to the world that he is completely shutting down Facebook with immediate effect, would anyone volunteer to predict the consequences and resultant magnitude of such an announcement? For now, we shall stay away from those

speculations. The shift of social networking media to a Facebook-centric one is a testament to the legacy created by one of the greatest inventions in the 21st century. Never in human history have so many people owed so much to just one college student. How did Facebook become so influential in our lives? Where did it emerge from? With that, it is useful to investigate the precocious period of social networking. The days before Facebook

Image courtesy of Master isolated / FreeDigitalPhotos.net

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Before the prominent rise of Face-

When did Facebook jump on the bandwagon? In 2004, a college student in Harvard named Mark Zuckerberg launched a social networking site by the name of Thefacebook. At first, he restricted the site’s membership to Harvard students only. Through word-of-mouth, Facebook started to gain traction among students from other schools and it gradually expanded, allowing access to students from other Ivy League Universities in the United States. On September 26, 2006, it eventually opened up to everyone of age 13 and older with a valid email address. This is definitely a rational and logical move as Facebook functions as a network economy: the more people join, the more valuable Facebook becomes. So why did Facebook succeed whilst others failed? This was one major reason behind


Facebook’s success. As it turned out, Mark Zuckerberg was exceptionally far-sighted in his decision to keep the company growth to a minimum in their early days. He was very particular about the standard of Facebook. He did not want to compromise performance for revenue as his ultimate goal of launching Facebook had little to do with money. What has made Facebook different from the previous networking sites is that advertising space is at a minimum, a crucial factor in maximising browsing and reloading speed. This justifies the company’s slow growth at first, because if it was not for Zuckerberg’s patience, the speed of the website would have been compromised due to the increasing database size. Zuckerberg has never diverted from his long-term vision of using Facebook to make the world more interconnected. He has never intended to make Facebook a money-making machine. He has constantly turned down offers by major corporations to buy out Facebook. In an interview in 2007, Zuckerberg explained his reasoning: “It’s not because of the amount of money. For me and my colleagues, the most important thing is that we create an open information flow for people. Having media corporations owned by conglomerates is just not an attractive idea to me.” He restated these same goals to Wired magazine in 2010: “The thing I really care about is the mission, making the world open.” The rise of the Facebook Economy

Insistent on keeping its advertising space to a minimum, Facebook had to look to other sources of revenue to upkeep its daily operations. In May 2007, Zuckerberg announced that the privately held social networking site he founded in 2004 would open to third-party developers, transforming itself from a popular website to a platform on which other businesses can operate. Eight months later, more than 14,000 applications from third-party developers are live on Facebook, allowing users to do everything from flirting to browsing for books. With such applications come more people on board the Facebook train, and with more people come more developers vying for a share of the

Image courtesy of digitalart / FreeDigitalPhotos.net

revenue pie. This never-ending cycle is the reason why Mark Zuckerberg is estimated to be worth $13.5 billion in 2011, according to Forbes. He is effectively richer than Apple’s Steve Jobs, whose net worth stood Steve Jobs, whose net worth stood at $8.3 billion then. How did Mark Zuckerberg, the founder of a social networking site which essentially produces or sells zero tangible commodities, become richer than Steve Jobs, an inventor who has been making computer products and selling them since the 70s? This is an epitome of the power of the network economy, an economy where the value of network

inflates as the number of people using it grows, allowing many to acquire wealth from intangibility. IPO – where did it all go wrong? Facebook held its first ever Initial Public Offering (IPO) in May 2012. An Initial Public Offering is a type of public offering where shares of stock in a company are sold to the general public, on a securities exchange, for the first time. Through this process, a private company transforms into a public company. Initial public offerings are used by companies to raise expansion capital, to possibly monetize the investments of early private investors, and to become publicly traded enterprises. Facebook’s IPO was one of the biggest in technology, and the biggest in Internet history, with a peak market capitalization of over $104 billion. However, the IPO was poorly handled by the lead investment bank, Morgan Stanley. Many investors sued Morgan Stanley, Goldman Sachs Group Inc, JPMorgan Chase & Co and other underwriters along with Facebook, claiming that they were misled in the purchase of the social network firm’s stock. The plaintiffs said that the company and the banks did not disclose lower revenue estimates before the share sale and they have lost more than $2.5 billion within a week of the IPO. This glitch has since seen the Facebook brand taking a pretty big hit, with Facebook shares plummeting from the original price of $38 to approximately $20. With its share price plummeting by 50% since the IPO, Facebook has become the quintessential “showme stock,” with spooked investors sitting on the sidelines waiting for the company to make a compelling case. However, not all hope is lost

Markets | the analyst

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for Facebook. Its recent disclosure that mobile revenue accounted for 14% of the company’s advertisement sales, far exceeding what analysts had been predicting, has been a massive boost to investors’ confidence in Facebook. Facebook’s mobile progress is absolutely crucial because that area had been viewed as the company’s Achilles heel. In the weeks leading up to Facebook’s IPO, the company warned that it might be more difficult to make money off mobile users, as compared to those who access the service through its traditional desktop platform. As approximately 85% of Facebook’s revenue comes from advertising, its revenue is postulated to take a bad hit with the increased mobile usage as advertisements are not displayed to people who log on through mobile applications. Mobile revenue is rapidly becoming the holy grail of consumer In ternet companies. The industry is undergoing a profound structural shift due to the explosive growth of smartphones like Apple’s iPhone and Google’s Android devices. Simply put, users are increasingly accessing the Internet on mobile devices, and there is a general consensus in the industry that the locus

Figure 2: Chart (left) showing an increase in revenue and the growing proportion of revenue from advertising and chart (right) showing an increase in mobile monthly active users (Source: Marketing Land)

of computing is shifting away from the desktop and towards smartphones and tablets. Needless to say, given the growth of mobile usage, mobile advertising opportunities are immense and waiting to be exploited. However, Zuckerberg, being wary about cluttering up the website’s user interface with intrusive ads, has stood by his mission and refusal to tap on this lucrative opportunity. Despite this, Facebook is now slowly moving to place more ads in the News Feed, the central stream of updates on a user’s profile page. Future of Facebook – where next? The biggest challenge Facebook faces today is growth saturation. Since each person can technically

only have 1 Facebook account, the maximum number of Facebook goods is limited to the global population. Facebook might be a phenomenon, but it is banned in certain countries such as China. If Facebook can tap on the Chinese market one day, its potential to grow will be massive. It is also pertinent to highlight the recent acquisition of Instagram for US$1 billion. This is perhaps a signal of intent by the Facebook’s management in diversifying their revenue sources. Mark Zuckerberg’s vision for Facebook is more than just building a company. He wants Facebook to be a platform that connects people from around the world. As long as his desire to materialise his vision remains, Facebook is definitely here to stay.

Figure 1: Facebook Inc’s stock chart since IPO (Source: Google Finance)

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Markets | the analyst


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Fundamentals WHY ITALIAN REGIONAL BANKS LOVE CALLABLE-CONVERTIBLE BONDS BY FEDERICO SIANO Background The Italian capital market has always been relatively small-sized. At the end of 2009, according to the World Federation of Exchanges, the equity and bond markets represented, 1% and 7% of the world total capitalization respectively. Today the number of firms listed on the

Borsa Italiana Stock Exchange is 328 while the Nasdaq houses more than 3000 companies. However, the Italian market for securities is more sophisticated than someone could expect. In 2009, Italy’s Stock Exchange ranked 7th in the world for total derivatives turnover, a figure that had doubled between 1998 and 2007. A distinctive phenomenon involving

sophisticated financial instruments, currently characterizes the Italian bond market. The largest regional banks in Italy have issued callableconvertible bonds in the last 5 years. Why is this fact surprising? First, regional banks have never used structured finance. Their purpose is promoting local economic activities together with the well being of regional communities. Second, primarily unsophisticated investors have bought these bonds. But let’s analyse this issue step-by-step. A description of callable-convertible bonds

(Source: Association of Italian Regional Banks)

What is a callable-convertible bond? It could be thought of as a coupon paying bond that has two special features. First, the bondholder can convert one bond into a predetermined number of stocks of the issuing company – the bond is convertible into shares. Second, the issuing company can repay the face value of the bond before its maturity – the bond is callable. Why should a firm opt for such a complex security? The convertibility provision, on one side, offers two main advantages to the issuing firm: a lower coupon rate and the

Fundamentals | the analyst

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opportunity to address a positive signal to the market. The firm provides investors with an extra return component thus paying a lower coupon. But what is this (potential) extra return? Consider an investor who buys one bond that can be converted a year from now into

one share. When the bondholder exchanges the bond for the stock he loses the debt face value to get the share market price therefore the conversion is convenient only if the stock price exceeds the bond nominal value. That is the reason why, through convertibles, the is-

suer addresses a signal to the market: the company expects its shares price to rise. The call provision (see Table 2 and Figure 1 for details), on the other side, is best suited for decreasing interest rates expectations. In fact, lower rates induce the firm to callback its bonds and

The article analyses the case in which the call-back takes place at a fixed price (blue line): the face value. However, as the figure shows, there are circumstances in which the bond is callable at the market price. In these cases (red line), the call-back makes sense only if the market rate increases, causing a decrease in the bond price, thus inducing the issuing company to repay less than the bond face value. The blue and red areas show what are the two different strategies associated with different call provisions.

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Fundamentals | the analyst


issue new debt at a lower cost. However, this opportunity for the company represents a potential cost for the investor who could face a reinvestment problem – investing at a lower rate bearing the same risk or investing at the previous rate bearing an increased risk. That is why the issuing entity compensates the bondholder risk offering a higher coupon rate.

Table 3: Evidence on the high rate paid by the investigated securities

Alternative rationales Undoubtedly, if the Italian regional banks had followed the rationales described in Table 2 when issuing callable-convertibles this article would have been pointless. It can be demonstrated that this is not the case. To begin with, despite the convertibility option, these securities seem to offer a very high coupon rate. Secondly, the callable provision is completely useless if its purpose it to leverage on decreasing interest rates. Table 3 and Figure 2 summarise these findings. There is indeed something missing in this picture. Regional banks have added an additional provision to

(Source: Reuters 3000Xtra)

their bonds that has not been analysed yet: the opportunity to repay the bond in shares. Unfortunately, this complicates the puzzle. Why is this provision crucial? Saying it differently: what is its purpose? Banks can use shares, instead of cash, to repay their debt. If they run out of liquidity they are not at default risk. Moreover, they can reimburse the bonds nominal value through shares even if it is not convenient for investors to exercise their conversion option. To summarize, banks

have an indirect capital buffer, to be used in the case of a sudden crisis, which is far less expensive that a direct capital increase. In an economic crisis environment, in fact, investors would be available to participate to a capital increase only if the stocks were cheap, especially if the issuer is highly subjected to the crisis as a bank. Who is paying for these Bonds’ riskiness?

(Source: European Central Bank)

Fundamentals | the analyst

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It turns out that bondholders are paying for the advantages coming from these securities to the issuers. We know from economic theory that rational investors in an efficient market would not buy securities that are too risky for the return they offer. Even if we relax the Efficient Market Hypothesis, assuming the existence of non-rational investors, we would not expect to find that the majority of people buying these instruments are retail investors. However, the most of the analysed securities have been subscribed to retail investors. Who are the bondholders? For the most part they are the issuing banks’ shareholders and, even if Italian financial markets law guarantees bondholders anonymity, we have a direct and an indirect way to prove it. First, during annual shareholders meetings most of the shareholders express concerns about the convertibles they subscribed. Second, if we studied the market trade volumes of these securities we would discover they are particularly low, implying the bondholders are not interested in trading the bond but in getting the coupon and this behaviour is typical of investors who are both bondholders and shareholders of the firm. Regional banks shareholders are primarily the banks clients. This is a particular characteristic of these financial institutions in Italy. In more detail, these banks have a diffuse ownership which is dispersed among people who live in the regional area the bank supports through its financing. Shareholders have all the same importance during an assembly regardless of the number of shares they possess – this system is known as percapita voting right – and they feel very committed in sustaining their bank activities. This is the very reason why they have subscribed to callable-convertible bonds: they

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have always bought their bank’s debt and they are continuing to do so especially because of both their low level of financial education and the trustworthy relationship with their banks. Current bondholders have also been attracted by the high coupon rate offered by the analysed securities. However, they are not properly compensated for the risk they bear. In fact, on one side, the convertibility option has no value because of the low probability in exercising it. On the other side, the seemingly high coupon rate, which has been set to artificially attract subscribers, is an illusion due the opportunity to call back the bonds at any moment thus deleting the right to receive interests. Moreover, bondholders are very likely subjected to a risk which is typical of a shareholder and that is because the probability of a share repayment is high. Why? Because Italian banks are suffering from significant losses, as any other bank especially in the European Union, due the recessive macroeconomic scenario. Before issuing these structured securities they needed a capital buffer without issuing new stocks because the market would have discounted them significantly to take into account their high-implied riskiness. Therefore, Italian regional banks have exploited the privileged relationship with their shareholders, which are also their clients as we

have remarked, to issue a financial instrument that would have perfectly suited their need for fresh capital but that, at the same time, would have not been subscribed by sophisticated investors. Implications Are current bondholders happy with their investment? Most certainly not. This is very clear form several extracts from shareholders meetings transcripts: ‘Dear President let me just pose you this question: will I eventually be able to take advantage of the conversion option? […] I am really wondering if the bank is thinking of repaying the bonds in shares. This wouldn’t be ideal since the only positive aspect of this securities, their coupons, would disappear’. Moreover, it is interesting to note that up to now a good number of issuing banks has already exploited the share repayment option to strengthen their capital position.

Table 4: Callable-convertible bonds repaid in shares

The bondholders’ concerns should be taken into serious consideration by the issuers and this is because regional banks in Italy are damaging their relationship with their most important stakeholders, shareholders and customers, thus threatening their going concern together with the economic stability of the Italian banking system. Figure 3: The distinctive feature of Italian regional banks

Fundamentals | the analyst


ACTIVE INVESTING OUTSIDE OF ALPHA BY SIMON RIDDELL Students searching for jobs with investments firms are familiar with the hunt for alpha. It is the holygrail of investments and the primary measurement of skill. Traditional theory states that any investor can buy the S&P500 and gain beta exposure, but only a skilled investor can trade the S&P500 and make alpha by identifying inefficiencies. The issue is that while alpha and beta are useful for constructing a model of reality, it is an attempt to simplify the world to an equation. And as a result there are some serious flaws with the alpha-beta model. Often academic research suggests that active investing is a pointless game, since alpha across the board must equal zero. This is due to alpha being a measurement of return without risk, also known as beating the market. And for every winner there must be a loser, resulting in alpha amounting to zero over the whole market. This is the definition and theory behind alpha measurements; however the reality of measuring an entire market to zero-out the alpha is impossible. Viewing the primary goal in a market as only alpha returns is not selfconsistent. This model suggests the market is a zero-sum game. However, if all active investments switched to passive investing (not taking active bets) then the market would not change to reflect new information. This would cause the markets to become inefficient and to not reflect new information in the real economy. As a result the traditional

alpha-beta model suggests that most active investments firms are not actually contributing to social welfare and utility. Therefore it is important to search for a methodology that allows for the existence of active investments to make sense, while not requiring that the goal of active investment firms be to generate risk adjusted returns (alpha). Alpha as Unknown Beta Economist John Cochrane argues that alpha is actually beta that we “don’t know.” In simpler terms, if a hedge fund claims to have 2% alpha returns per year, it is more likely that they have unique exposure to risk premia. Some risk factors are not open to easy investments. For example, maintaining exposure to inflation risk on an emerging market junk bond portfolio or a carry-

trade. This would require a hedge fund with talent, infrastructure, and a great team. This firm would have to charge money to support its firm, and it might be one of only a few hedge funds to offer pure exposure to this risk. This hedge fund would be accessible only to high net worth individuals, would charge expensive fees, and would provide potentially high returns with low correlation to traditional investments. This is a useful service that investors wish to buy, and it does not require this fund to beat other investors. Consider the following example: Ten hedge funds all are predicting the outcome of a single firm over the next decade. Each one believes this firm is exposed to a few rare factors that suggest it will provide consistent returns. Each fund engaged buys the firm, and receives the returns. Depending on when each firm bought or sold this stock, there will be a group of winners and losers relative to one another if we only rate them based on their alpha value. However, each fund might have bought the

Image courtesy of jannoon028 / FreeDigitalPhotos.net

Fundamentals | the analyst

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firm for a different reason. Perhaps the fund that received the lowest return per risk ratio bought this firm based on research, which found that this firm was entering a period of low risk. While it may appear that they came last in the group of ten, they might have actually identified a period of calm and benefited from a lower risk exposure. And while they were rewarded less, as we would expect in an efficient market, the firm still satisfied the goals of their portfolio. The most important part of this example is that society is the winner. These hedge funds accurately priced stocks in their own self-interest, creating positive externalities. A traditional alpha model would instead revert back to the paradox of active investing. Are Market Anomalies really Anomalies?

Switching from alpha and beta to ‘unknown beta’ also allows for more satisfying explanations of market anomalies. In the past, market anomalies presented an issue. The rationale was that an informational inefficiency has now been identified, and arbitrageurs will exploit it and resolve the inefficiency. The reality was that anomalies, such as momentum, appeared to persist over time. However, if we instead consider these anomalies as unidentified risk factors it makes sense that they won’t disappear and instead will provide a risk premium. And as in my prior example, active management firms and hedge funds are just the institutions to provide these services. It is unlikely an individual investor can create complex products and programs to maintain specific exposure to exotic derivatives.

Also this model can properly explain investors that consider themselves non-quantitative value investors. In a peculiar way we can imagine these investors as has having a complex algorithm (in their brain), which they use to gain exposure to certain risk factors with high expected future risk premia. While a computer can complete incredibly robust data analysis, it cannot forecast human behavior and cultural shifts. As a result instead of delegating their analysis to a computer, value investors instead use their own brain to synthesize variables that are still off-limits to computers, such as a CEO with a limphandshake. A more robust example could be based on investments in Chinese agricultural firms. A team of clever value investors might predict that as GDP per capita increases more pork will be in demand. In this

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Fundamentals | the analyst

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example the team researched and chose a portfolio of stocks. Even if their portfolio doubled it is possible the firm earned no traditional alpha when compared to a standard market benchmark (as there was no inefficiency). Instead, they identified factors that they believe will be compensated strongly. Image courtesy of Sujin Jetkasettakorn / FreeDigitalPhotos.net

Once again, this new paradigm allows us to accept market efficiency without simultaneously claiming active investors who buy and sell stocks are playing a zero-sum game. After all, they are helping society by keeping assets properly priced. Reconcile Trading and Teaching This new form of analysis that focuses on complex risk premia rather than active vs. passive investing (and alpha vs. beta) helps reconcile what is taught in the academy with what happens in the field. There has been a long disagreement on market efficiency and active investing between professors and portfolio managers. However, it seems as though active investing and market efficiency can sit at the same table. A cursory look at new ETFs finds funds that are made to mimic hedge fund strategies, execute carry-trades in currency, and traditional S&P500 funds that now also sell calls. At the moment these funds do not have a strong track record and should be viewed carefully (and probably not traded). However, it is likely over the next few decades— particularly if equity returns remain anemic—we will witness products that focus on new risk-factors. If portfolio managers are better able to slice-and-dice their exposures, they will be more specific in factors that they hold exposure to, resulting in increased returns and lower factor correlations.

THE DECLINE OF KEYNESIANISM? BY OH JON KEAT Amidst the global recession that has hit the economies of America, Europe and Asia, there has been an increasingly fiery debate on whether institutions should pursue fiscal spending or austerity measures. Keynesian economics basically revolves around the idea of implementing fiscal and monetary spending to boost economic growth during a recession, while austerity revolves around spending cuts and tax rises. If it is most commonly argued that spending is the most effective solution, then why are most countries in Europe not spending their way out of debts? And in the case of the United Kingdom and the USA, why is growth taking place so slowly? USA In response to the financial crisis that transpired in 2008, President Barack Obama decided to pursue Keynesianism by injecting nearly $1 trillion of government stimulus. Obama promised at the time that if his stimulus bill passed, the unemployment rate would never exceed 8%, and would decline to 5.8% by May of this year. But in reality, it was

8.2% in May 2012, and the figure has hovered around in the 7-10% range for the last couple of years. It was not always the case that the country was in favour of Keynesianism. In fact, it has quite been the opposite. Keynesian economics arose in the 1930s in response to the Great Depression. It was adopted by the country in the decades that followed; however, by the 1970s, Keynesian policies had produced double digit unemployment, double digit inflation, and double digit interest rates, all at the same time, along with four successive worsening recessions from 1969 to 1982. Keynesian monetary policy involves running up the money supply to increase demand, with artificially lowered interest rates promoting more spending. That is where the inflation came from. President Ronald Reagan scrapped Keynesian economics for the more modern supply side economics, which holds that economic growth results from incentives meant to boost production. That results from reduced tax rates, which enable producers to keep a higher

Fundamentals | the analyst

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ries in the euro area being unable to repay or re-finance their government debt without the assistance of third parties. It only takes one country to exit the European Union for the sovereign debt crisis to aggravate into a potential meltdown that could spell a massive disaster not just for Europe, but also for the rest of the world.

Figure 1: The unemployment rates of USA during Ronald Reagan’s presidency (Source: AngryBear)

proportion of what they produce. It results from reduced regulatory costs, which also increases the net reward for increased production. This results from monetary policies maintaining a strong stable dollar, without inflation, which assures investors that the value of their investments will not be depreciated by inflation or a falling dollar, or threatened by repeated recessions resulting from policy induced boom/bust cycles, as in the 1970s.

Obama has remained steadfast with his belief in Keynesian spending, his biggest conundrum facing him in the near future revolves around how he is taking on the fiscal cliff that would result in increased taxes, spending cuts and a reduction in the budget deficit. If the latter does happen, it could very much reverse the effects and potentially ruin his stimulus spending over the years.

As of now, the unemployment rate is slowly decreasing. However, the fact remains that the improvement is taking far longer than expected. One of the reasons the employment number continues to drop is because people are leaving the workforce. If we were to calculate the unemployment rate with the same labour force participation we had in 2009, the real unemployment rate would be 10.75 percent; not a pretty picture at all. It is even worse when you consider that Obama promised that the unemployment rate would be less than 6 percent by today with his failed stimulus.

The situation in Europe is tricky to say the least. The on-going financial crisis has led to some coun-

In addition, the economy would likely suffer from inflationary pressures in the future. While Barack

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Europe

In the turmoil of the Global Financial Crisis, the focus across all EU member states has been to implement austerity measures, with the purpose of lowering the budget deficits to levels below 3% of GDP, so that the debt level would either stay below or start declining towards the 60% limit defined by the Stability and Growth Pact. The reason Europe chose the path of austerity measures is related to the belief that countries with healthy debt levels will be rewarded by the financial markets with higher confidence and lower interest rates. These conditions will naturally give rise to increased levels of investment activity, and subsequently GDP growth is achieved in these countries in the long term.

Figure 2: Comparison between unemployment rate & real unemployment rate (Source: Americans for Tax Reform)

Fundamentals | the analyst


Even though debt-ridden countries like Greece and Portugal are in dire need of expansionary policies, they are not able to implement them. Their growing budget deficits and debts mean that they simply cannot afford to implement tax cuts and government spending. If these countries do not pay their creditors in time, they might run the risk of default. For example, if Greece does not repay its creditors, a dangerous precedent will have been set. This will make investors increasingly nervous about the likelihood of other highly-indebted nations, such as Italy, or those with weak economies, such as Spain, repaying their debts. If investors stop buying bonds issued by other governments, then those governments in turn will not be able to repay their creditors - a potentially disastrous vicious circle.

Figure 2: Comparison of the Debt/GDP percentage ratios of various countries (Source: Plan B Economics)

that tax hikes and spending cuts during the most recent decade had indeed damaged GDP growth more severely, compared to what had been expected and forecasted in advance.

consequences of Keynesianism: stagflation, worsening deficits and currency devaluation. In the wake of the global financial meltdown, most institutions are now strongly advocating financial prudence. In

Image courtesy of Grant Cochrane / FreeDigitalPhotos.net

In the grand scheme of things, this might ultimately lead to the extreme scenario of a break-up of the EU. Hence, the EU has argued repeatedly that the only option for debt-ridden countries is to implement further austerity measures and structural reforms within the domestic economy to boost economic growth in the long run. Some economists believing in Keynesian policies, however criticized the timing and amount of austerity measures being called for in the bailout programmes, as they argued such extensive measures should not be implemented during the crisis years with an on-going recession. If possible, the implementation of such measures should be delayed until the years after some positive real GDP growth had returned. In October 2012, a report published by the International Monetary Fund (IMF) also found

Is Keynesian economics losing its grip? Even though the economic world is aware of Keynesianism, some countries still hold on to the belief that it is too risky and non-intuitive to spend more money to reduce debts. As we have seen, not many countries can afford to face the

the future, there will be greater restrictions imposed on governments when it comes to borrowing and spending. While there is no question that countries do need to implement expansionary policies to induce economic growth, such policies will need to be monitored and moderated to ensure long-term sustainability.

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Inside Analysis

THE PHILIPPINES: PHONE WARS BY OXFORD BUSINESS GROUP Competition in the Philippines’ telecommunications sector is heating up as the two main players in the market battle for subscribers. While both firms are likely to benefit through an increase in the number of consumers, this may come at a cost if profit margins are deeply impacted, as is expected.

$44.6m, compared to $61m for the same period in 2011. While service revenues increased to $502m from $414m, the company’s operating expenses – including outlays to upgrade its network – and subsidies climbed 42% to $270m from $190m.

Globe has been striving to ensure customer loyalty and woo clients away from rivals with subsidies by offering cut-rate services to subscribers. It is a strategy that may be paying off, as Globe said subscriber numbers reached 32.1m at the end of the third quarter, a rise of 9.8% since the beginning of the year. Though its performance was down – Globe’s nine-month revenue declined by 15% – Ernest Cu, the CEO of the company, said the result was to be expected in an increasingly

Mobile phone penetration rates are likely to break through the 100% barrier by the end of 2012, according to Smart Communications, a local wireless company. Service providers will need either to offer an improved and expanded range of products if they are to build on their client base or cut tariffs to attract new subscribers. Following the release of third-quarter results from the two largest telecoms firms, it appears that both companies have adopted a two-track policy of lower fees and improved services. On November 8, Globe Telecom, the second-largest telecoms firm, announced it had posted a 26% yearon-year (y-o-y) drop in net profits to

Image courtesy of nokhoog_buchachon / FreeDigitalPhotos.net

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increasingly tight market. “Despite the very challenging competitive environment, our business remains fundamentally strong,” Cu said in a statement accompanying the quarterly report. “We expect competition to escalate, particularly after the gains we have realised, but we are prepared for the challenge.” The Philippine Long Distance Telephone Company (PLDT), the country’s largest telecoms firm by stock market value, also reported a decline in profits for the opening three quarters of 2012. In a statement issued on November 7, PLDT said the lower profit returns were mainly due to the high level of industry competition that cut into its margins. The company’s net profit for the period was $700m, down 6.2% y-o-y, despite a 13% increase in revenue, which rose to $3.1bn. Like his Globe counterpart, Manuel Pangilinan, the chairman of the PLDT, attributed the weaker performance to the fierce rivalry in the marketplace. “We continue our steady financial performance as we wait for the industry situation to stabilise,” he said in a statement issued on November 6. “We hope to provide a better indication of when we can expect to return to the profit growth track when we announce our year-end results next March.” Again in line with Globe, the PLDT also saw customer numbers rise, with subscriptions reaching 68.6m, an 8% increase since the beginning of the year. Both market leaders are working to increase their product range, with the PLDT having held talks with GMA Network, a media content provider, to expand the scope

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of material on offer to its subscribers. Though these talks have been cut off, the PLDT has made it clear it is looking for media tie-ins for its smartphone and internet services. Globe is also looking to expand its market reach by taking over one of its rivals, Bayan Telecommunications (BayanTel). On November 6, Globe informed the stock market that it has tabled an offer to buy out up to 100% of BayanTel’s debts, which total some $200m. BayanTel has been in rehabilitation since 2004, paying off the interest and some of the capital of its debts to creditors, a process set to last until 2023. However, if Globe gets creditor backing for its debt buyout, BayanTel could be given a clean slate, and the way also cleared for Globe to take a major stake in the firm. In October, the two companies agreed to share 10 MHz of frequencies assigned to BayanTel, which will increase the scope of Globe’s network and enhance its service quality. A buy-in to BayanTel would give Globe a strong data-based revenue stream, with 55% of the firm’s revenue coming from corporate data services, as well as reinforcing access to the additional frequencies. It is likely to be some time before the dust settles in the Philippines’ telecommunications market, with Globe and the

Inside Analysis | the analyst

PLDT set to continue their efforts to win subscribers through pricecutting and broader services. However, with the economy continuing to expand and demand for higher-quality phones and services rising with it, the two should be able to maintain steady growth, even while paring back on profits. “This information is provided by Oxford Business Group the acclaimed global publishing, research and consultancy firm. To read more from OBG, please go to www.oxfordbusinessgroup.com”

Image courtesy of sritangphoto / FreeDigitalPhotos.net


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Careers THE ANALYST INTERVIEW: BAIN & COMPANY INTERNSHIP REPORTS BY LOW WAN TING Consultancy has increasingly been one of the top career choices by LSE students. In this issue of The Analyst, to provide our readers with some insight and advice on the career opportunities in Consultancy and the internship experience, we interviewed Ka Shun Cheung, currently a 3rd year Management undergraduate who completed a Summer Internship with Bain & Company. Q: Why did you choose consulting? A: There are two main reasons to why I chose consulting. My first encounter with consulting was when my father started his consulting business ten years ago. But the interest really sparked when I came under formal exposure to the industry while at LSE. One day, I hope to collaborate with my father as business partners in the consulting industry. The second reason is that consulting provides a great platform for developing highly transferable skills in a short space of time. This accelerated training is essential towards achieving my long term professional goal. From past project experiences and case competitions, I am certain that consulting suits my working style and approach to business problems. Q: What made you choose Bain to intern with amongst the consultancy firms? A: First of all, Bain & Company is one of the most pres-

tigious management consulting firms in the world, so its brand name and reputation will open many doors for me professionally. The internship experience is already attracting head-hunters to approach me with interesting job opportunities, such as a commercial strategy role in Saudi Arabia and a start-up in London. Secondly, Bain is known for its collegiate environment. I recall an instance when a full-time Associate Consultant from another project voluntarily offered to join me on store-visits. It was an extremely hot day and most people would rather stay inside the office. Yet, the colleague understood the time-consuming nature of the task and offered an act of kindness. He claimed that he was “living and breathing the corporate culture of truly adding value”, and it actually saved me 2 hours of data collection in the field. Finally, Bain’s employees are very open and honest to each other and to clients. In my opinion, honest feedback is perfect for continuous improvement, while open communication gets to the point directly and cuts those ‘beat-around-the-bush’ talk. This is reflected in Bain’s belief, “Our True North is our focus on client results – even when it means recommending actions that senior management might not want to hear”. Many clients therefore tend to contract for a Phase-2 Implementation Project, in which Bain consultants are entrusted with producing results after the initial recommendations. I am currently still working on a part-time basis on a year-long implementation project

Careers | the analyst

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(which is very rare in other ‘strategy houses’), as a result of its honest corporate culture. Q: Could you give a brief run-through of a day as an intern at Bain? A: Background – I work on a 3-member team (Project Manager, Consultant and an intern). Bain’s consultants previously recommended the FTSE100 client to sell its other product offerings to the market (i.e. multiple Market Entry Cases for each product). I joined the team for Phase-2 Implementation stage where I get to interact a lot with Senior Directors at the client’s firm, but Client’s regional headquarters and main operations are located in a different city, a 2 hour flight away. 7:30am – Crawl over to phone to answer Hotel morning call, but I go straight back to sleep. 7:45am – Phone alarm finally wakes me up. As I get ready, I listen to voice messages left overnight. Manager says his flight is delayed and asks the two of us to meet the client first. 8:15am – Iron my shirt and quickly grab some fruits from the buffet-style breakfast, before rushing onto a taxi with our luggage. Check my email on the way. 8:45am – Arrive at client headquarters and enter our satellite office at client site (the bulk of our project is focused implementation). The Consultant runs through a final check on all 96 slides and improvises the new run-down since the Manager will be late. Refine the presentation and fix the missing footnotes. Print out copies for everyone attending the meeting. 9:20am – Enter the conference room 10 minutes to calm myself down before the Global CEO, Regional CEO, CFO, COO, and other Directors arrive. They shake each of our hands – I briefly wonder if they will ask me how old I am. But no – they’re too professional for that, even though it’s probably one of the first questions on their minds. 9:30am – Most of the client’s Senior Management arrives and starts the important Monthly Progress Review Meeting. Present for 20 minutes on my analytical work and on the Manager’s section. Respond calmly to the CFO’s tough rebuttal while all eyes were on me. 11:15am – Come out of meeting with new follow-up actions and deliverables. I can also now focus on cleaning out my enormous inbox that piled up overnight. 12:00pm - The main partner dials in for post-meeting debrief, and reassures us with positive feedback from client’s CEO. 12:30pm – Grab lunch at a 5-start hotel with Consultant and Manager (who just arrived from airport) and

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Careers | the analyst

client COO and CIO. Receive valuable career advice from high-achievers. 1:30pm – Back at the Satellite Office to start doing some data-crunching and analysis. 2:30pm - Conduct literature research based on meeting outputs and tell my Manager about a key finding. Manager sends me off to the field to gather more data based on that finding. Cold-call client’s competitors to gather market intelligence on my way. 4:00pm – Come back with lots of raw data. Only have 30 minutes left to produce two slides to summarise the data for the Project Manager. 4:30pm – Finish my analysis on time and meet a Partner at the local office for coffee. 5:15pm – Meet with the Implementation Representatives from various level of the Client. Discuss the implementation schedule for the next two weeks. 6:30pm – Sales Director from client’s competitors gives me a call back. Persuaded him to give me sales figures that are crucial to our project, without him realising – Success! 8:15pm - It’s been a long but successful day. The team catches the last flight home. We discussed the to-do list for the coming week and general direction we will now take on for the project. Oh, how can I forget the “delicious” in-flight meal? 10:30pm – Plan out the rest of my night – which will include the gym, supper, and several hours spent incorporating the new data and creating slides. 2:30am – Send the slides to my case team members, in case my alarm does not wake me up in time for the 8am deadline tomorrow. Fall straight to sleep. Q: Tell me about one project that you have embarked on, the obstacles you have faced in that project, and how you have overcome it? A: The main Implementation project runs in parallel with multiple small tasks. I was in charge of the operational challenges faced with the new product categories launch. The biggest obstacle I faced was to understand the technical jargon and manufacturing process behind the Client’s high-tech products. I was clueless on most of it, until I started reading training manuals of products. I also conducted expert interviews with industry professionals. Finally, when I was able to grab a cup of coffee with the client’s Chief Operating Officer, I already knew so much about the technical specifications that I even found myself educating the Project Manager and Consultant on the latest research and development. Pro-activity and ability


to leverage expertise of others were crucial to overcome the obstacle. Q: What was the most challenging aspect of your internship and how have you overcome it? A: The most challenging aspect was time-management. Deadlines for major deliverables were measured by the minute and hour, and I never had the privilege of getting weeks and months in advance, like in university. A missing piece of analysis can delay the overall project progress. Therefore, it was extremely important to be highly-focused and effective while at work (Yes, no time for casual Facebook update). My schedule was also planned down to the minute and hour. I prefer blocking out dedicated time in my busy schedule to work independently, including checking work emails. Of course, I also had to be flexible in the case of spontaneous requests from clients and managers. Time management is definitely an art I still have yet to master. Q: How is the working culture like in the company? A: Bain & Company is named by Consulting Magazine as the ‘Best Firm to Work For’ for ten consecutive years, so that obviously says something about the firm. Other than the cliché attributes of friendly colleagues and interesting work, Bain also has an entrepreneurial, energetic working environment, where real business results are the focus and much less on the fancy graphics and titles on presentation slides. Regular social events, such as fancy dinner on a yacht, take place on Friday nights and the weekends, and even the Partners would attend them too. It also values its interns and employees, to the point where Bain even sponsored me, for the duration of my internship, a hotel accommodation five minutes from Bain’s office, since my house is rather far away. It is definitely a ‘Work Hard, Play Hard’ environment. Okay, well, maybe slightly heavier on the ‘work’ side.

More important, from a professional standpoint, I developed a strong network of influential individuals that I still keep in touch with. My constant exposure to Bain’s Partners and Managers, Client’s CEO and Senior Executives, and Industry and Competitor Professionals gives me access to many ‘Pearls of Wisdom’ from these high-achievers. Q: Do you have any tips to give to students who are starting their spring or summer internships? A: Understand the big picture – In consulting, it is okay to question the task itself. Seek to clarify why the task was given to you and understand how it will fit into the overall logic of the solution. Maybe your time can be spent working on something more productive. And whatever the outcome is, it demonstrates ‘intellectual curiosity’ that consulting firms desire. Be pro-active and go beyond the mile – If you want to stand out, it is not enough to just deliver what was asked for. Finish the currently task accurately and efficiently, and then ask for more work. Be able to multi-task – Sometimes, multiple things have to happen simultaneously and your to-do list can get very long if you cannot juggle well. Learn to plan your day well so you don’t have any ‘down time’.

Q: In your opinion, how has your internship experience developed you as a person? A: From a practical standpoint, an internship in consulting reinforced my interest in consulting and it certainly stands out on my CV. I also experienced an accelerated learning of business knowledge, technical jargons, and a range of soft skills that a university degree simply cannot offer.

Careers | the analyst

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The Analyst Michaelmas Term 2012 - Issue 6  

by the LSESU Finance Society Research Division