Page 1



October 2012

Campaign Finance

Indian foreign exchange reserve, Pg. 08

Is the future of banks in India shaky?, pg. 18

FROM EDITOR’S DESK Dear Niveshaks, Niveshak Volume V ISSUE X October 2012 Faculty Mentor Prof. P. Saravanan

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

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

The month of October has witnessed some major financial events that are likely to shape the future of economic development globally. The Eurozone appeared last night to be in a stronger position to survive the debt crisis after EU figures revealed member governments cut their annual budget deficits last year. The EU statistics office, Eurostat, said the aggregate budget deficit in the 17 countries using the currency fell to 4.1% of GDP in 2011 from 6.2% in 2010 – the first year of the sovereign debt crisis. Ireland cut its annual deficit from 31% of GDP to 13.4%, while Germany brought the deficit on its annual budget down to 0.8%, Eurostat said. Greece, where the crisis started, had the highest debt ratio in Europe last year, reaching 170.6% of GDP, or €355bn (£289bn). It reduced its annual deficit to 9.4% from 10.7% in 2010 and 15.6% in 2009. The Greek Prime Minister, Antonis Samaras, said his government would receive €31.5bn in loans next month if the Athens parliament pushed through €13.5bn in spending cuts and tax increases, though it remained unclear that MPs would do so. In the United States, the presidential candidates battled it out during three high intensity Presidential debates and one Vice Presidential debate. While President Obama was terribly out of sorts in the first debate, which in effect highlighted, for the first time the vice presidential debate between Joe Biden and Paul Ryan. However, President Obama was much more focused than his Republican counterpart in Romney in the second and third debates, which has now marginally tilted the scales in his favor. Much was made of the lack of clarity and executional capability of Governor Romney’s five point economic plan and pundits widely believe that his policy would take America back to the days which has caused the mess they presently are in. Back home in India, the general sentiment is slowly but steadily improving. The stock market is seeing a continued bull run, raising hopes of a sustained economic recovery here. With the inflation numbers stabilizing, all eyes are now on the RBI to bring in effect a rate cut which would significantly increase liquidity in the Indian Markets and fuel growth. The Government has also given its complete backing for all the reforms affected last month and has made a plethora of investor friendly norms in an attempt to attract foreign investment. Starbucks opened its first outlet in India in Mumbai to a warm reception and encouraging opening weekend collections. Citigroup CEO Vikram Pandit resigned this month and now the banking giant is headed by Michael Corbat. With global growth slowing, majority of the banks are now aggressive on the retail banking front. This issue brings to you some more interesting and insightful reads. The cover story this month focuses on the growing concept of campaign finance. The issue also features articles on the future of banks in India, an interesting an insightful read on capital structure arbitrage, Indian foreign exchange reserve and an analysis of whether the MIST would obscure BRIC. We would also like to thank our readers for their constant support through wonderful articles and appreciation. It is your endless encouragement and enthusiasm that keeps us going.Kindly send in your suggestions and feedback to and as always, Stay invested.

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

CONTENTS Cover Story Niveshak Times

04 The Month That Was

Article of the month

08 Indian Foreign Exchange

11 Campaign Finance

Reserve: Not Glorious but Vulnerable Asset

FinGyaan 14 Capital Structure Arbitrage

–A New Bold Arbitrage Play


18 Is the future of banks in India shaky?

Perspective 16 Will MIST obscure BRIC?


21 Depository Receipts

The Month That Was



The Niveshak Times Team NIVESHAK

IIM, Shillong

Dragon slows down for 7th straight quarter The July-Sept quarter saw the Chinese economy slowing down for 7 quarters back to back. As per the National Bureau of Statistics, the GDP grew 7.4% in the third quarter from a year earlier, missing the government’s target for the very first time since the global financial crisis. The investors, however, were expecting a low number on accounts of low enthusiasm in the economy. While GDP growth at 7.4 percent would be cause for joy in recession-stalked developed economies, it represents a sharp slowdown for China, where GDP grew 9.2 percent in 2011 and has averaged an annual rate near 10 percent for three decades. On the other hand, the industrial production, retail sales and investment data were all slightly ahead of forecasts, however, and quarter-on-quarter GDP growth was strong, suggesting the worst may be over and the world’s No.2 economy will pick up in the final quarter - as a once-a-decade leadership transition gets under way in Beijing. Rajat Gupta sentenced for insider trading Rajat Gupta, former Goldman Sachs director, who was accused of sharing some privileged company information with a hedge fund manager, has been sentenced to spend two years behind bars. Mr. Gupta’s previous engagements included being the head of the prestigious consulting firm McKinsey & Co. and he also served as a director to Procter & Gamble. His philanthropic activities have garnered him support from all corners of the business world, as a number of big names such as Microsoft co-founder Bill Gates, former United Nations secretary general Kofi Annan have supported him by writing letters to the court. RILs chief Mr Mukesh Ambani has also

July 2012

vehemently supported Mr Gupta infront of the Indian Media. In addition to the imprisonment, he also faces a penalty of $5million. Citigroup CEO Vikram Pandit resigns with immediate effect In a surprising news to investors, Citigroup CEO Vikram Pandit resigns from his post on October 16 with immediate effect. Michael Corbat, previously chief executive for Europe, Middle East and Africa, was named to replace Pandit, as per the statement from Chairman Michael O’ Neill. In a conference call after the market has closed, Mr O’Neill said: “Vikram offered his resignation and the board accepted it.” The resignation comes immediately after the day bank reported an 88% drop in quarterly profits to $468m (£291m). Citigroup’s President and COO John Havens, a close associate of Mr. Pandit also resigned after his departure. The departure of Pandit leaves just two executives in charge of major U.S. banks they led in the financial crisis: James Dimon at J.P. Morgan Chase & Co. and Lloyd Blankfein at Goldman Sachs Group Inc. As per Citigroup’s most recent annual proxy filing, Vikram Pandit is not eligible for a “golden parachute” - a pre-negotiated severance payout. Suzlon all set to default Suzlon Energy Ltd is all set to default on the payment of $221million it raised by means of foreign currency convertible bonds. The cash strapped company requested the bondholders for a four month extension. The bondholders, however, rejected the plea. The company, which is the world’s fifth largest wind turbine maker, has been under pressure since the last couple of years on account of a slowdown in demand and mounting debt. Its bottom line for the quarter ending June was in red compared with a profit in that of the previous year. At the group level, Suzlon had net debt of Rs 13,017 crore at


the end of June, when its cash totaled Rs 1,372 crore. Kingfisher’s license suspended An order by country’s civil aviation regulator on October 20 has suspended the license of debt laden Kingfisher airlines. The airline’s permit had been suspended with effect from October 20 and would not be revived until it submits a concrete and reliable revival plan, a notification issued by the Directorate General of Civil Aviation said. Apart from huge losses and highly leveraged balance sheet, Kingfisher has also been facing regular strikes from its employees for non-payment of the salaries for past several months. With a little hope that any foreign investor will come to rescue of the airline at this stage, the banks that have lent to the airline are likely to act decisively to reclaim dues by invoking the pledges made by its promoter. Vijay Mallya, owner of the airlines was not in country at the time order was issued. Foreign stake cap of 10 per cent to include both FDI and portfolio funds Foreign investors, using the same investment vehicle for FDI and FII cannot hold more than 10% equity in a company, as per RBI. For some time now, it has been alleged that foreign investors initially invest in a company in the form of FDI and later also participate in the secondary market as FII’s to consolidate the holdings in a bearish market. But the rule now says that if the combined FII and FDI holdings in such cases exceed 10%, the investors are in violation of foreign exchange regulations and may have to go through the compounding procedure such as a warning or fine. The conflict arises because of the difference in interpretation of FEMA by the investors and RBI. While the investors were under the impression that the schedules of the act were investment specific and not investor or entity specific, RBI’s interpretation was opposite. As per experts it will be very difficult for the firms to have separate investment vehicles for different type of investment not only in terms of costs involved but also because of number of

compliance issues. IIP at a 6 month high in August After two consecutive months of contraction, the IIP numbers for the month of August have beaten market expectations. As per official data, the industrial production grew by a 6 month high of 2.7 per cent in the month of august. August proved to be the only month in this fiscal year so far, in which all three broad sectors—mining, manufacturing and electricity—showed growth. Both manufacturing and mining growth stood highest for this fiscal at 2.9 per cent and 2 per cent, respectively. However, if analyzed on a year on year basis, industrial output was less than 3.4%, which was the figure recorded for August 2011. DLF under scanner for dealings with Robert Vadra India against Corruption (IAC), the party headed by Arvind Kejriwal on October 5 accused Robert Vadra of illegal real estate dealings with DLF. As per the allegations, Robert Vadra bought around 41 premium apartments from DLF at minimal prices and subsequently sold them at huge profits. Arvind Kejriwal alleged that DLF gave an interest-free unsecured loan of Rs 65 crore to Vadra and these funds were, in turn, used to buy real estate assets from the company at huge discounts. A number of other irregular dealings between DLF and Robert Vadra were disclosed by IAC. DLF, while denying any irregularity in its dealings with Vadra, is under the scanner of various government agencies now for the dealings. DLF shares saw a huge drop after the allegations made by IAC.


The Month That Was

The Niveshak Times




Article Market of Snapshot the Month Cover Story

Market Snapshot


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

65,07,932 30,57,655 15,82,374

LENDING / DEPOSIT RATES Base rate Deposit rate

9.75%-10.50% 8.5% - 9.25%


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

53.81 69.50 68.51 86.53



4.25% 23%

POLICY RATES Bank Rate Repo rate Reverse Repo rate

9.00% 8.00% 7.00%

Source: 26th September to 29th October 2012 Data as on 29th October 2012

October 2012


BSE Index Sensex

Open 18644.54

Close 18635.82

% Change -0.05%


6474.49 6914.14 10236.58 13028.85 6735.28 10823.87 5330.76 7372.92 5960.72 10505.65 8680.90 2026.67 7408.96 1832.72 3432.90

6574.77 7043.62 10291.37 13180.61 7057.55 11136.81 5722.44 7498.69 5668.97 10183.88 8446.67 1972.36 7221.56 1787.36 3286.40

1.55% 1.87% 0.54% 1.16% 4.78% 2.89% 7.35% 1.71% -4.89% -3.06% -2.70% -2.68% -2.53% -2.48% -4.27%



Article Market of Snapshot the Month Cover Story

Market Snapshot



Article of the Month Cover Story


Indian Foreign Exchange Reserve NOT Glorious but VULNERABLE Asset Mayank Jain

Today, India claims of sufficient Foreign Exchange Reserve worth around $290 billion, substantially higher than the amount in 1991 which was less than even $ 1 billion. It includes dollar, euro, sterling and yen currency asset deposits, gold, special drawing rights and international monetary fund reserve positions. These are the assets under RBI and other monetary authorities and are primarily used for foreign payment obligations regarding import requirements and debt payments (primarily short term) in order to maintain the country’s credit worthiness. These are also used to stabilize the fluctuations in exchange rate of Indian rupee vs. foreign currencies, primarily dollar. In past the major debate has been about the most appropriate amount a country needs to hold in its forex reserve which is sufficient to fulfil the country’s near term payment obligations and simultaneously incurs the least possible opportunity cost. In 1996 Dr. Rangrajan committee emphasized that emphasis should be on payment obligations along with level of imports. Hence it was considered suitable to have enough reserves to meet the potential obligations in the timely manner. But today we also need to consider the sources of this huge build up in the reserves. Forex reserve takes into account all transactions in foreign currencies (outflow and inflow) which are essential to be passed through RBI. The major components of foreign currency in India have been net FIIs, net FDI, NRI deposits, remittances and ECB, while a substan-

tial portion of the same is drained every year due to continuously increasing trade deficit. Foreign Institutional investors have been the major source of forex till date. High growth rate of Indian economy over developed economies after the internet era and arbitrage opportunities due to interest rate differential prompted foreign investors to invest huge amount in Indian financial market (equity and bonds) and earn healthy returns. This move is although still regulated in order to check volatility and other important issues like money laundering but still FIIs constitute an important source of foreign capital for India and help to take care of rising current deficits. This continuous source of investment helped India to build a huge forex reserve and in a very short period of 6 years (2002-08) Indian forex reserves surged from 50 billion to 300 billion US dollars. This huge inflow resulted in rupee appreciation and in order to promote exports RBI had to repeatedly intervene which in turn resulted in reserve accumulation with RBI. Similarly FDI also contributed to forex reserve but due to capital account convertibility restrictions and other political issues its amount has been very less in comparison to FII. Simultaneously other issues such as lack of infrastructure and superior performance of China over India in terms of cheap labour, favourable government practices and better infrastructure have subdued the FDI trend in India. After global recession although FII maintained a positive trend, due to policy issues in India there has been a

Fig 1: Movements in foreign exchange reserves

October 2012

MDI, Gurgaon


continuous negative trend in net FDI. It is clearly visible through investors’ behaviour that their motive to bring forex in India has been to earn positive returns. FII’s motive has been short term return and hence it constitutes extremely volatile flows and corresponding investment has been termed as hot money. In case of FDI, investment is for the purpose of long term and it is possible only if investors will get a positive assurance of superior return for their investment in future. Thus as already witnessed, FDI and FII will bring substantial dollars in glorious periods but in future if situation worsens it would result in possible capital flight. As a rational being in both cases the investor would extract more foreign capital while exiting in comparison to amount invested in the beginning. So these are the remedies for short term future but in the long run these are like ultimate liabilities. In the current situation the serious concern for India has been to attract more FDI, not only for capital but to invest the amount productively to enhance its manufacturing base and hence reduce the current account deficit which would ultimately reduce its dependence on FIIs. India’s current account takes care of two major items, net of export and import and remittances. India has been one of the largest remittance recipients from the workers primarily in Arab countries and USA. India received about $ 66 billion in remittances in year 2011. This amount has been continuously rising after 2000 and also was a major source of foreign earnings for India at the time of recession. But it is very alarming that even after a very sharp rise in remittances, the total current account deficit is increasing at a fast pace. Simultaneously we can observe that India is presently a growing hub with huge potential. After recession it has been observed that many professionals returned back home from

foreign countries. So it would be farfetched to say that remittances would not increase much in future but it is like free foreign aid grant and hence not a solid reserve accumulation criteria.

Fig 3: Remittances vs. curretn account deficit

India’s share in global trade is continuously increasing. In 2011-12 Indian merchandise exports was worth around $ 300 billion but it was still less than corresponding imports of about $ 450 billion. Although the manufacturing and service trade gap was almost zero but in order to fuel its economy India has to import a substantial amount of crude oil from Arab countries which is the most essential and simultaneously a responsible commodity for huge trade deficits. The recent surge in oil prices resulted in huge trade deficits which could not be balanced even through invisibles remittances. After 1991 crisis the Indian policy was to import latest technology and advanced machinery from abroad in order to enhance the manufacturing productivity and capacity which would fulfil India’s own needs and would take advantage of its cheap labour and export those secondary products in order to earn foreign capital. India’s immediate response was several policy measures such as export promotion zones like SEZ, tax incentives, export related promotional schemes and reduced import duties on heavy machinery. Many small scale industries were promoted like apparels, gems and jewelleries and today these industries contribute around 40-50% to

Fig 4: Comparison of Fuel & Mineral Product segment in Total Merchandise Export & Import


Article of the Month Cover Story

Fig 2: FII and FDI trend in India sice 2000



Article of the Month Cover Story


Fig 5: Percentage contribution of different sectors in total merchandise export and Merchandise vs Service Exports

total merchandise exports. But there were strict labour laws in order to prevent labour exploitation and several incentives to MSMEs in order to protect them from big players. Although these policies benefitted Indian business through imports but due to inherent inefficiencies at a small scale and their incentives to remain small forever, India could not materialize the mass manufacturing revolution. Even today a substantial portion of Indian exports constitutes fuels and mineral products export like iron ore and agriculture produce and their share is continuously increasing in total merchandise exports. India has done substantial progress in high technology products exports like automobiles but even today only 70% of Indians are literate and hence the required technological skill is limited to a very small section of society. A large section of labour lacking in high technical skills could be absorbed in but even then India could not materialize its dream of being a large exporter of high labour and low technology intensive manufacturing products like garments, toys and plastic goods. Although India could compensate the same through service exports (especially IT) but it can be witnessed that after recession Indian IT companies are facing tough challenges due to reduced demand in developed western countries whereas India could maintain the healthy growth in merchandise export due to its geographic diversification and increased presence in Africa, Latin America and Asia. Hence in the present scenario the only way for India to manage its current account deficit is to enhance manufacturing and increase productivity through modernization of MSMEs. Another concern is that Indians’ investment in gold, a non-productive asset, is continuously increasing due to continuous slowdown but it has been suitably solved through increased duties. Other potential areas could be the government efforts in order to tap the huge resources of natural gas in India through private party participation and various energy conservation schemes through promotion of solar equipment, carbon credit

trading inside India and reduced subsidy on petroleum products. Finally we can consider India’s external debt. It is the part of the total debt that is owed to creditors outside of India. It includes debt to government, corporations and households by foreign creditors like ECB and NRI deposits. ECB being offered at low rates has been the preferable choice for corporate in the last decade. IIP, International investment position, the difference between an economy’s external financial assets and liabilities, is continuously decreasing and even in December 2011 the forex reserve was less than the country’s total external debt. Although ECB offer attractive rates to Indian firms in comparison to lending by Indian banks but the effective utilisation of that is susceptible to macroeconomic factors. A possible slowdown and exchange rate risk can expose corporation’s inefficiencies in meeting their payments schedules which in turn can deteriorate India’s creditworthiness. Similarly government offers high interest rates for attracting NRI deposits but it earns very low interest on forex reserves. Thus this phenomenon can be productive at healthy times but it eventually results in net foreign currency outflow from the Indian economy. We can conclude that although India holds a substantial forex reserves as an asset, it is susceptible to external factors and does not have a solid foundation base. To build a healthy reserve asset India needs to invest the same through a separate fund to access advanced foreign technology and build excellent infrastructure. We need labour intensive manufacturing friendly policies and special incentives for FDI with suitable regulations to enhance productivity and mitigate associated risks. It will attract more FDI and superior technology to promote manufacturing and export of valuable secondary products. This phenomenon will control imports, increase Indian manufacturers’ competitiveness, reduce government dependence on FII and NRI deposits and will enhance the healthy forex reserve.

Fig 6: Overall IIP of India

October 2012



Cover Story Article of the Month Cover Story

Campaign Finance on emerging economies Nilkesh Patra & Harshali Damle

Team Niveshak An election with integrity is important to promote values that we hold dear—human rights and democratic principles. Elections give life to the basic rights enshrined in the Universal Declaration of Human Rights and the International Covenant on Civil and Political Rights. The rise of uncontrolled political finance is a major loophole for the establishment of strong democracy everywhere in the world, and robs the democracy of its unique strengths— political equality, the empowerment of the disenfranchised, and the ability to manage conflicts peacefully. Rep. Lee Hamilton has even said that elections are more often bought than won. The two major sources of political influence in many societies are the candidates and the financial contributions to political parties. One of the countries, where this is true is the United States. The cost of financing a presidential campaign is tremendous. Millions of dollars must be spent on advertising, travel, mailings, and campaign staff salary. Funds for campaigns are received from two main sources – public (or government) funding and private contributions. The candidates’ need to raise and spend enormous amounts of money is accentuated by a system of weak and decentralized parties, singlemember-district elections, nomination by party primaries, limited public funding, and media intensive campaigns that emphasize image and personality over clear policy differences. But the inequalities in terms of wealth is very large in

the U.S., rich people including wealthy capitalists and big corporations play a dominant role in campaign finance and, thereby, exercise disproportionate influence over politics and public policy. Money may be the major factor of politics, but transfers of money in the political arena are not always transparent; however, they are potentially measurable in a way that many other forms of political action are not. This has made the study of campaign finance an important topic for social scientists who are interested in understanding the flow of power and influence within the political system. Let’s consider the example of United States. Campaign funds are the subject heading under which all books dealing with money in politics are compiled by the Library of Congress. Political Action Committee (PAC) and campaign identify the units that raise and spend money for political purposes. Each campaign (for federal office) has to run a PAC that reports revenue and expenses to the Federal Election Commission (FEC). Political Campaigns have a lot of expenditure, such as the cost of travel for the candidate, professional advice on topics like message and the direct costs of communicating with voters, such as billboards, television advertising and other channels. The types and purposes of campaign spending will change with the legal and social landscape that the campaign operates in. Foreign nationals are prohibited from making any contributions or ex-



Article Cover of the Story Month Cover Story


Fig 1: Total cost of US elections (1998-2012)

penditures in connection with any election in the U.S. Public Financing The public campaign financing programs are of two types: full public campaign financing programs and partial public campaign financing programs. In both types of programs, candidates first qualify by raising a small number of initial qualifying contributions from private donors. In full public campaign financing programs, qualifying candidates then receive a good amount of public funds to run their campaigns. In partial public campaign financing programs, qualifying candidates receive an amount of public funds equivalent to each subsequent private fund they raise. Regardless of the type of public campaign financing, based on actual electoral experience over more than three decades, that public campaign financing laws reduce the damaging impact of large campaign contributions on the political process, free candidates from the time spent on fundraising and increase the time they spend discussing issues with voters, facilitate public discussions and awareness about campaigns, increase public participation in the electoral process, and increase the number and diversity of political candidates. Funding campaigns from the government budget is widespread in South America and Europe. In many countries, such as Germany and United States, campaigns can be funded by a combination of private and public money. In some electoral systems, candidates who win an election or secure a minimum number of ballots are allowed to apply for a rebate to the government. The candidate submits an audited report of the campaign expenses and the government issues a rebate to the candidate, subject to some caps such as the number of votes cast for the candidate or a blanket cap.

October 2012

At the federal level in the Unites States, public funding is limited to subsidies for presidential campaigns. This includes a partial public campaign program for the first $250 of each individual contribution during the primary campaign, financing the major parties’ national nominating conventions, and funding the major party nominees’ general election campaigns. A small number of states and cities have started to use broader programs for public financing of campaigns. Private Funding Private contributions can have varied sources. Some candidates draw from their own financial resources. Individuals can contribute up to $2000 to the campaigns of a candidate who shares their views. Special interest groups form Political Action Committees (PACs) to contribute to political campaigns. Although PACs are limited to five thousand dollars per candidate per election, an interest group can form more than one PAC. This allows larger, wealthier groups to provide more money to a candidate who supports their cause. The rules are set out in the Federal Election Campaign Act, which limits individuals to giving $2,300 to their candidate per election cycle. They can, of course, give money to political action committees. Supporters can donate to PACs, which in turn can give up to $2,300 directly to a candidate and a lot more, $28,500, to a national committee. PACs can also spend an unlimited amount on “independent” advertisements, which means they can’t use the candidate’s campaign materials or even discuss their ad with the campaign team. Candidates who choose to raise money privately rather than accept the government subsidy are subject to significant administrative burdens and legal restrictions, with the result that most candidates accept the subsidy.



Article Cover of the Story Month Cover Story

Fig 2: Cost of elections for Democrats and Republicans (1998-2012)

Impact of increasing campaign expenditure In an era of explosive growth in campaign expenditure across older democracies, citizens lose faith in the electoral process. They suspect that wealthier citizens and corporations have greater influence in public affairs, and particularly on the media, notably by buying time and space for political advertisements. They understand that poorly regulated campaign finance diminishes political equality. However, no consensus exists on what constitutes best practice regarding political finance. Political finance is intricately bound to the political values and culture of a country. Nonetheless, good practices can be identified to form a minimum standard of integrity for elections, which require extensive transparency, regulation of donations and expenditures, and penalties for abuse. Also there is a need for reasonable control of private donations by placing quantitative limits on the size of donations, and through banning anonymous donations, foreign donations or criminal donations. The policy should be framed such that the public and private financing is balanced. Indian Scenario It is hardly a secret that political parties spend huge amounts during elections in India. But the economics of running an election campaign are a hush-hush affair. Little is known about the finances of political parties in the country. The parties normally request the top industrial houses asking for donations and about 90% of the top corporates in India are scared of political parties. They do not want to disclose who they are funding. In order to regularize donations for political parties industrial associations and business houses have asked for rules to make such funding transparent. The Confederation of Indian Industry has insisted it will not directly collect money to fund political

parties, but has asked its members to make donations to political parties only by cheque. According to the CII, donation by cheque is a transparent way of funding elections so that their members are not exposed to the charge of buying influence when they lobby for favorable policies. However, the provision that donations less than Rs. 20,000 need not be disclosed is being abused as a cover for illegal sourcing of funds. Political parties across the board are not interested in genuine reforms; such reforms would essentially be a threat to the prevalent political structure which suits their needs. The problem of political funding is such a complex reality that over the years there have been three basic proposals that the government wanted to implement to create transparency. • A legislation to regulate party funds -- distribution and spending of party funds during non- elections and elections • Maintenance of regular accounts by parties and making audited accounts available for inspection • State funding of elections ensuring more accountability and level playing field for all candidates • Regulations and control over corporate funding There were few more proposals already announce d by some economists. But no serious debate has taken place on these proposals. The result: Transactions between the donors and beneficiaries take place in secrecy. Conclusion It is completely within our ability to clean up the system, starting from monitoring expenditure to forcing parties to disclose their sources of finance. If not, we will really be leading towards what Mussolini said- Democracy is beautiful in theory; in practice it is a fallacy.


Article FinGyaan of the Month Cover Story



Capital Structure Arbitrage – A New Bold Arbitrage Play Madusudanan & Harish

NMIMS, Mumbai

What is Capital Structure? Capital Structure refers to the mix of equity and debt that a firm uses to finance operations of the firm. An ideal capital structure can be used to optimize the value of firm in a significant way. The Miller-Modiginalni (M-M) model on capital structure was one of the first theories to explain the use and benefits of capital structure in maximizing the value of the firm. Even though the M-M model suffers from naïve and impractical assumptions, it still forms the basis of subsequent research and thought process on capital structure.

2. Adjusted Present Value Approach – This approach tries to maximize the value of the firm by factoring the implied bankruptcy cost and the gains on account of tax shield to the value of unlevered firm. The tax shield can be calculated by using the marginal tax rate of the firm. The value of unlevered firm is obtained by discounting the cash flows by the cost of equity calculated by using the unlevered beta. Calculating bankruptcy is a difficult task as it is an implied cost and relatively a newer concept in the world of finance. Some of the methods that can be used to estimate the bankruptcy cost are • Using past Bankruptcies in the related industry • Altman Z score • Merton Model • Predictive Bankruptcies using option pricing models The value of the firm depends on the debt equity ratio of the firm. But markets are efficient and they do price the securities. But there are special times where one of the securities of the firm gets mispriced and leads to an arbitrage around the two securities.

Figure 1: Cost of Capital vs Debt-to-Value

When a firm borrows money as debt, it adds significant amount of value to the firm by way of tax shield. When the firm raises debt, the firm also incurs an implicit bankruptcy cost. The optimal debt equity ratio tries to maximize the value of the firm. Some of the more practical approaches than the M-M Model that could be used to arrive at the optimal capital structure are:1. Enhanced Cost of Capital Approach – The approach tries to generate a debt equity ratio that would minimize the cost of capital of the firm. As the firm increases the financial leverage, the levered beta of the firm would start to increase. Hence higher leverage would get reflected as higher cost of equity. Higher leverage would also mean the increase in risk for bond holders. This would lead to increase in yield of the bonds and fall in credit rating of the bond. The cost of capital at various leverage points can be studied to find the minimum cost of capital which would maximize the value of firm.

October 2012

Figure 2: Firm value vs D/E

What is Capital Arbitrage and how does it work? Historically, the arbitrage strategies have been built around correlation of related markets such as – cash, equity-equity derivatives and cash bonds-interest rate futures. Capital Structure Arbitrage is a relatively newer strategy that intends to derive benefit from mispricing the different liabilities of the same company. These were developed after the impact of credit derivative instruments such as credit default swaps was found on equity instruments of the same company.


The strategy works on the premise of exploiting lack of integration and synchronicity between the equity and the bond market. The strategy is primarily a bet on convergence of the anomalies in the pricing of different securities. The strategy works the best when the firms in financial distress, survive and fails the most when the firms end up in bankruptcy. It is far safer/less riskier than a “naked’ position in either market.

Link between Equity and Debt The credit risk of a company gets reflected in both equity and debt. The debt can be viewed as put option and equity as a call option. Hence, debt is less sensitive to company fundamentals than equity, especially when the fundamentals improve. Higher the leverage, the credit spread of the company increases, this increases the correlation between equity and debt. Generally, debt instruments with a rating of BBB-/BB+ are the best to execute the capital structure arbitrage strategies, as this is where the correlation between equity and debt is the highest. The reason why effectiveness of debt instruments with a rating of BBB-/BB+ improves is that these debt instruments are quite volatile and start behaving like equity to various developments of the firm. A typical Capital Structure Arbitrage • An investor believes either the debt or equity is under-priced • He purchases a put option on the equity and CDS on a cheap bond (with a high YTM) • He has built a kind of hedge by buying both these securities In case of a default by the firm, he receives the money from the put writer and the compensation from the CDS issuer. In case of recovery/non default, the investors benefit from the improvement in credit

position of the firm by holding CDS and lose the premium paid for put option. Some of the options a player has are– Traditional ways/strategies of benefitting from the capital structure arbitrage 1. Set-up trades between the debt and equity of a company 2. Play between senior debt and junior securities 3. Convertible Bond Arbitrage by purchasing convertible bond and shorting the shares in the delta hedge ratio Newer strategies 1. Equity Options 2. Credit Derivatives 3. Using both Equity options and credit derivatives Capital Structure Arbitrage can be implemented using Equity Derivatives. Deterioration in a company’s credit worthiness is often an indicative future decline in the firm’s equity stock price. Theoretically, the derivative market should take cognizance of this movement in the credit derivative market. In real time, the equity markets either over-react or under-react to these shocks in the credit derivative markets. In those times, the strategy to be used are companies whose equity prices have over-reacted, a call should be brought and companies whose equity prices have under-reacted, a put should be brought . Most of the capital structure arbitrager use a model to gauge the value left in a CDS after considering the price of the equity or vice versa. Most of the models used to calculate the spread are variants of the Merton Model. One of the studies done at University of Massachusetts, February 2004 on Capital Structure Arbitrage strategies suggests that “Results indicate that the strategy does not work in a predictable manner at the firm level but does quite well at the aggregate portfolio level”. This is one of the fastest growing strategies to get adopted. Most of the losses on this strategy are because of short history of this strategy, lack of academic literature and practical expertise of executing such trades on the same. In future, there would be more innovative instruments that would get developed around debt and equity. Development of such instruments and research in this area would enable the arbitrager to execute such strategy with a higher degree of effectiveness.


Article FinGyaan of the Month Cover Story

Potential Arbitrage opportunities exist in the market if the price of debt or equity cannot be justified by its capital structure. Capital Structure Arbitrage Theory involves taking long and short positions in different items on the liabilities of the same firm. One of the reasons why this strategy could be practically implemented with a “high degree of effectiveness” to benefit from the mispricing is the development of credit derivative market and instruments such as CDS and CLN.



Article Perspective of the Month Cover Story


Will MIST obscure BRIC? Chhavi Saluja

NMIMS, Mumbai

The term MIST has been coined by Jim O’Neil, the Goldman Sachs economist, to describe the next tier of emerging economies – Mexico, Indonesia, South Korea & Turkey. The traits shared by these nations are - a large population and a sizeable market, a large economy at about 1% of global GDP each and membership of the esteemed G20. Let us look at the dynamics of each economy. Mexico Mexico took a quantum jump to replace Brazil in emerging market index following China, India & Russia. The Mexican peso gained 0.3% on 3rd October 2012 after encouraging results of US employment and service sector data. US is Mexico’s chief trading partner, hence bounce in US economy could translate to boom in its neighboring economy. A host of benefits make Mexico an attractive destination for doing business, especially for US companies. For companies in US, Mexico is located in close proximity that reduces the transit time drastically as compared to China. This facilitates ‘just-in time’ delivery, curtails inventories and hence costs. All the more, Mexico’s legal system is much more favorable to US companies than that of China. Mexico’s trade with US is duty free. Chinese wages have surpassed those of Mexico in recent years. According to Nomura forecast, Mexican GDP will grow between 3.5% & 4.5% per year in the next decade. The private sector debt remains a miniscule 20% of GDP, while public debt is close to 35% of GDP. Inflation has been kept in an acceptable range of less than 4% and the fiscal position of the government is sound. The economy puts forward some challenges too. The most evident being the tragic war against cartels which left 55,000 people dead in 2012. Another challenge emerges from declining oil output due to lack of capital and craft to develop new fields. Mexico’s uncompetitive economy tends to block new marketentrants, with local oligopolies dominating the market. Taut labor laws & tax system exacerbate this situation. Investors need to be cautious when looking at Mex-


ico as an alternative to BRIC nations. Though the country faces certain risks, it has promising potential in the long run. Indonesia It boasts of consumer driven economy with a GDP growth of 6.5% in 2011 and 6.2% in 2010. Indonesia’s geographic location & demographic bestows it with multitude of advantages like sustainable productive workforce & easy access to ocean trade. The country has several feathers in its cap. Besides burgeoning middle class and thus rising incomes, unemployment rate is strikingly low at 6.3%. It has high literacy rates, consecutive current account surpluses & high proportion of young population. More than half of its population is under the age of 30. Most recently the country has received positive rating with Fitch upgrading the outlook from BBB- to BBB+. In spite of these opportunities, investors might have doubts investing in Indonesia due to the poorly developed infrastructure, particularly electricity and transportation, which pose a tough challenge. Expediting infrastructure investment can alleviate this. Complex regulatory environment & corruption are other areas affecting the economy. South Korea It is an export driven economy with a GDP growth of 3.6% in 2011. A $1.1 trillion economy, South Korea showcases high purchasing power and low unemployment rates. In striking contrast to most economies grappling with credit rating downgrades, South Korea, in recent weeks, has received its second credit rating upgrade up to AA- by Fitch. Korean economy is comparatively robust in the sense that it withstood global economic slowdown demonstrating its economic and financial stability. The country is producing impressive goods, thanks to the companies like Samsung Electronics that deserves the credit for Korean success. What adds to these strong points is the support of government for FDIs.

The term MIST has been coined by Jim O’Neil, the Goldman Sachs economist, to describe the next tier of emerging economies – Mexico, Indonesia, South Korea & Turkey

October 2012


On the flip side, there are several fallouts of this rapid growth. The inflation rate of Turkey is hovering around 10.4%, which is significantly above central bank’s target. While considerable FDI levels favors the economy, over reliance on foreign capital has widened its current account deficit to 10% of GDP in 2011. Turkey’s block of banking system is partly owned by Eurozone banks and Europe accounts for half of Turkey’s exports. In the face of these downsides, there is greater hope than apprehension, because the country is well posi-

Turkey The GDP growth rates of 9% in 2010 and 8.5% in 2011 might delight China. However, Turkey is not connected with a sustained raw materials demand from China. This can make the Turkish economy flourish in a world with little growth opportunities. The country has high FDI levels which are not directly correlated with GDP. This is evident from the fact that in ’06 and ’07 Turkey’s GDP grew by approximately 9%. FDI levels in ’07 were reduced to half, the GDP maintaining its position at 8.5%. FDI dropped in ’09 and ’10 but GDP growth remained intact. Hence the country will be resistant against fluctuating FDI levels. Public debt has fallen to 40% in 2011 from alarming 74% in 2002. Turkey’s recent unemployment rate is around 8.8%, which has steadily declined over the years. With these positive signals, the nation is augmenting wealth thereby creating a bright outlook.

tioned with an expanding domestic market. A recent research paper by Dani Rodrik of Harvard University illustrated that income per head has tripled to around $10,000 in less than a decade. Yet, the dangers of soaring foreign capital and current account deficit can ruffle the economy in times of crises. Conclusion MIST nations’ growth has outperformed that of BRIC in 2011. Yet the total GDP for MIST nations was $3.9 trillion in 2011, only one-third of BRIC’s GDP. Though the gap is considerable, the economies have tremendous potential to grow by leaps and bounds in coming years. This can be attributed to inviting geographic locations of these economies, favorable demographics and increasing productivity which act as catalysts for growth. With investor interests wavering in BRIC due to structural problems & over dependence on exports, MIST nations are expected to close the GDP growth gap in medium to long-term.

.. The economies have tremendous potential to grow by leaps and bounds in coming years


Article Perspective of the Month Cover Story

Despite these affirmative characteristics, the country is posed with challenges. Corruption makes it formidable for companies to do business. Also lack of currency convertibility and equity settlements across multiple accounts are few problems cited by MSCI, which gives South Korea a developing country status as opposed to other countries in MSCI index. The country currently does not feature in MSCI index, but is part of MSCI ETFs. Inflexible labor market & reliance on exports could make conducting business in this region more difficult.



Article Finsight of the Month Cover Story


Is the future of banks in India shaky?

There is no doubt that the financial sector of any country plays a pivotal role in its economic development. The story is no different in India. However, in recent times a number of factors like sectoral and concentration risks, increasing NPA, slowdown in investments due to poor sentiment as well as domestic macroeconomic factors have threatened the stability of banks in India. In this light, the important question that needs to be answered is whether the government has the will/ gumption to do what is necessary to ensure sustainability of the sector.

Isha Pandey

TAPMI, Manipal Recently, India has witnessed a plethora of policy and macroeconomic changes. It has also played host to a number of scams because of which the exchequer has faced losses to the tune of hundreds of crores. All these factors coupled with instability in the political environment of the country have given rise to a grave situation for the banking sector of the country. Today, the major issue faced by the banks of India is Corporate Debt Restructuring which is leading to an increase in Non-Performing Assets (NPAs). Increasing NPAs An advance account that ceases to yield income is a non-performing asset. The main reason behind the sharp jump in Non-Performing Assets is the loan given to State Electricity Boards and aviation industry. These industries require huge loans which are funded by the banks. However, the quality of credit is decreasing and the cost of funds is high. There is a rising concern regarding the asset quality. On the sectoral front, metals, textiles and infrastructure sectors were

among the major ones to contribute to this increase in NPAs. Paradoxically, while loans of the PSU banks are going bad faster than those of the private sector, the private sector banks have been steadily improving their asset quality over the past two years. The SEB loans have been a major stress mainly for the public sector banks (PSUs). The Figure 1 reflects how NPAs and restructured loans are increasing, especially in the Public Sector Banks. Rating Agencies Fitch Ratings maintains that impaired assets across the banking sector may exceed its initial forecast as the economy slows for the financial year 2012-13. The rating agency adds that absolute cumulative gross Non Performing Loans reported at India’s five largest banks - accounting for over a third of the system assets - increased by around 62 per cent in the first quarter of FY13. Fitch expects stressed assets in the system, including unseasoned restructured loans, to rise to about 10 per cent by FY13 end from 6.7 per cent in FY10.

Figure 1: Rising NPAs and restructured loans in public sector and private sector banks

October 2012



Article Finsight of the Month Cover Story

Figure 2: Debt levels in distribution sector

Figure 3: Debt of distribution entities

Increasing Single name concentration and sectoral concentration risk in banks Banks are facing credit concentration risks, namely, single name concentration and sectoral concentration. Single name concentration occurs due to uneven distribution of bank loans to individual borrowers. Sectoral concentration occurs through an unbalanced allocation of loans in productive sectors and geographical regions. 85% of the total NPAs of the banking sector are in real estate, infrastructure and priority sector lending. Also, the power sector has been a source of concern. Imported coal costs have hit the roof. The distribution companies are not being able to meet obligations as political ground realities make it impossible to change the rates in line with market demand. Figures 2 and 3 shows the sector concentration risk being faced by the banks due to the power sector. Nine states account for 80% of the debt. This reflects the single name concentration risk plaguing the banking sector. The rise in credit concentration risk has been exacerbated by the occurrence of coal scandal, 2G scandal and CWG Scandal. Banks had sanctioned loans when the allocation of coal and 2G had been done by inappropriate means. However, now if reallocation of coal blocks takes place, the Non-Performing Assets of the banks will increase. Corruption and adverse political environment have adversely affected the health of the banking system. The growing single-name and sector concentrations in these banks, together with funding pressures from rapid loan growth, have put pressure on the standalone creditworthiness of these banks. Slowdown in investments Apart from power and airlines, there has been a rise in the number of restructuring proposals in other sectors like road and steel. Also, the situation in India is not very conducive for growth. The capital markets do not facilitate raising equity easily. The demand is low and the interest rates are high. Projects get delayed due to environment clearances. There are around 89 big projects that are stuck be-

cause of lack of permission. All these factors make India very unattractive from the point of view of investments. In the absence of external investments, there is no alternate money source to fund growth in infrastructure transferring the entire burden on to the banks. The global scenario is on the brink of another economic meltdown. The European countries are India’s major investment and trade partners. The Eurozone crisis will slow down global markets and destabilize the global economy. This could adversely affect the capital flows into India and exports could decrease, creating further pressure on the banks as they will be the only source of funding available in the country. Unstable Domestic Macroeconomic situation The macroeconomic situation in India doesn’t look very good either. The growth rate is at it its nine year low of 5.5%. Lower growth leaves less money available with individuals which in turn restrict bank credit expansion and slow down movement of deposits. The fiscal deficit of India is very high. This affects the bond markets adversely and most banks suffer mark-to-market losses on bond portfolios. The capital adequacy ratio is a measure of the bank’s capital. The capital adequacy of Indian banks is the lowest in the world, except that of banks in Greece, Spain, Italy and France. This leads to higher capital requirements in addition to the need for regulatory compliance. All this impairs lending rates which further weakens growth. Relaxation of Provision norms for restructured loans Yet another issue that the banks are facing is loans turning bad. RBI predicts that around 15% of its loans might go bad. However, CRISIL has predicted that this number will go up to 30%. Banks currently need to make a 2% provision on standard assets that they restructure and a provision of up to 15% if the restructured loans turn bad. Banks take advantage of this relaxation and keep less money as provision by postponing the NPAs to the future by



Article Finsight of the Month Cover Story


restructuring these loans. However, these loans have bleak chances of turning around. Hence, the banks are essentially boosting their profitability at the expense of low provisioning by recording these NPAs, actually bad loans, as restructured loans. CRISIL, the rating company, says that loans restructured by Indian banks may increase sharply to Rs 3.25 trillion between 2011-12 and 2012-13, against the earlier estimate of Rs 2 trillion. There exists no alternative to restructuring as banks cannot recall advances already sanctioned and nor can they enforce securities as realizable value will not be equal to the debt outstanding.

FIN-Q Solutions September 2012

1. Momo Play 2. Wool growers floater 3. Misery index 4. Tarini Vaidya

Restructuring: How to handle it? So, the next issue is how to handle restructuring? The following steps can be followed to handle restructuring: • Establish viability of companies under current macroeconomic factors • If viability is proven, investment made in the project needs to be saved at any cost • This can be done by debt restructuring through concession in interest rates. However, before deciding to restructure, it is important to determine how sincere management is for revival of the companies In the light of the factors discussed above, it can be seen that the banking sector in India is currently facing a huge crisis and its future seems to be very unsustainable. For any country, its banking sector reflects the financial strength of the economy. Hence, if there is a collapse of the banking sector in a developing country like India, it will affect investments flowing into the country. India is already rated BBB- by the rating agencies. A crash of the banking sector will definitely bring it down to junk status. India cannot afford to do this and so immediate steps need to be taken by the government to address the concerns of the banks of the country.

October 2012

5. Deutsche Bank Headquarters (Credit and Debit) 6. Prasad laddu 7. Chicken Market 8. Susan B. Anthony and Sacagawea 9. P Chidambaraam

10. Bermuda


Depository Receipts Nitesh Kanthaliya IIM Shillong Yes Sir, now I understood that each ADR represents a share of foreign company in US.

Sir, yesterday I was going through some articles and I was amazed to know that Indian Stocks are traded in America. Is it really possible? Yes, absolutely. In fact, not only India, stocks of any foreign country can be traded in America. They use American Depository Receipts for the same. It is generally called ADR. Can you please explain ADR in detail? Whenever any non U.S. company wants to trade in U.S. Financial market, it is issued a negotiable security, known as American Depository Receipt or ADR. The individual shares of foreign companies are called American Depository Shares. After ADRs are issued, the stocks of the foreign company are traded in the same manner as that of a US based company. Ok Sir. But, I still do not understand that how are these ADRs issued? Hmmm. Let me clarify your doubts with an example. Suppose company ABC of Indian Origin wants to trade in US market. For doing the same, it has to deposit its share in a custodian bank. This is done usually by a broker. Once these shares are deposited, ADRs are then issued by the custodian bank. This ADR represents the shares of Indian based ABC which are traded in US market as if the company were listed in US stock exchange.

No. No. No. It is not this way. One ADR does not always represent a single share of the company. In fact, an ADR can contain either partial share or single share or multiple shares of the company. This is then priced accordingly. Say for example, a share of ABC trades for INR 46 in India. While ADRs are issued, 10 such shares are bundled to form 1 ADR. This ADR would thus be priced at 46*10= INR 460 or say US $10. This is the initial pricing. After an ADR is issued, it follows the law of Demand and Supply. Since we are trading in Foreign markets sir, aren’t there any risks associated with ADRs? Very Good. You are correct. There are certain risks associated with ADRs. ADRs are regulated by SEC. Nonetheless, ADRs are prone to exchange rate fluctuations, inflation and also arbitrage at times. But, most of the times, ADRs follow the trend of the home country shares. Sir, like America, do we have any depository receipts for India? Yes, of course. In India, like US, we have Indian Depository Receipts. Through the issue of these receipts, foreign equities can be traded in India. In fact, most of the countries have depository receipts to allow foreign equities to be traded in their countries. Thank You Sir. Now I have a clear understanding of the Depository Receipts.


Article of the Month Classroom Cover Story

CLASSROOM FinFunda of the Month



FIN-Q 1. Which government agency is responsible for handling whistleblower complaints brought under the Sarbanes-Oxley Act? 2. The SEC concluded X was indigent and unable to pay. X agreed to pay $13 million when he pleaded guilty. $2.2 million was the size of X’s trust fund, created out of one of X’s Y bonuses, that his wife was allowed to keep. Id X and the company Y. (Hint: X was the CFO of Y) 3. What is being described in this viral tweet? “One to the left; two, take it back now y’all; three, right foot let’s stomp; four, left foot let’s stomp; five, cha cha now y’all”. 4. X founded in 1894, had its first office in Lahore. X was founded after many attempts by social reformers like Dyal Singh and Lala Harikrishnan. X also has had the privilege of maintaining accounts of famous people like MK Gandhi, Nehru, Lajpat Rai etc. ID X. 5. Although the exact cost of the event X hasn’t been disclosed, Y’s suit costed Z approximately £12,442. ID X, Y and Z. 6. Matt and Eric are young men. Each has a good credit history. They work at the same company and make approximately the same salary. Matt has borrowed $6,000 to take a foreign vacation. Eric has borrowed $6,000 to buy a car. Who is likely to pay the lowest finance charge? 7. Caffe Latte Rs 95, Cappuccino Rs 95, Espresso Rs 80, Caramel Macchiato Rs 115, Caramel Frappuccino Rs 160. These are some of the items in X’s menu. ID X. 8. Some of the companies owned by X include: Artex, Blue Breeze Trading, North India IT Parks and Real Earth Estates. ID X. 9. ID the stock and explain the spike in Feb 2012.

10. X has a Bachelor’s degree from California Polytechnic State University, San Luis Obispo in Agricultural Business and an M.B.A. from Santa Clara University, and quite surprisingly is one of the leading executives of a top organization. ID X.

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

October 2012


WINNERS Article of the Month

Prize - INR 1000/-

Mayank Jain MDI, Gurgaon


Prize - INR 500/-

Abhijit Tibrewal IIM Shillong

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