FROM EDITOR’S DESK Dear Niveshaks,

Congratulations on your second anniversary. Thank you

for having me as the guest editor of your anniversary issue
and giving me the opportunity to express my personal views
Niveshak on some of the milestones that shaped the financial world.
Volume III These are very fascinating times that we live in – much has been written and
ISSUE VIII analysed since the inception of the recent financial crisis in 2007 which will result in
having a deep impact on our mindsets and actions in future atleast for a while. It is
August 2010 important to note that this crisis has been handled in a concerted manner globally
and should also have singular ramifications for good or bad. Regulations are get-
ting dusted off and rewritten.
Faculty Mentor Since the early 20th century, time and again the financial world has been
N. Sivasankaran shaken by major events that have brought about lasting reforms in the financial
world. To my mind much of these events have to do with liquidity and investor
confidence.
The financial panic in 1907 triggered by the collapse in a copper trust re-
THE TEAM sulted in NYSE falling by about 50% from its peak and second highest bankruptcy
filings to that date – retracting liquidity and confidence. There was no overarching
governing body to step in and return normalcy. It eventually led to the creation of
Editor Federal Reserve System. Indeed, a very positive development.
Bhavit Sharma The Roaring Twenties led to the Great Crash in 1929 and a chain of events
which resulted in a decade long economic slump in industrialized nations and
severe macroeconomic problems – unemployment, decline in money supply and
GDPs; Dow reached its nadir point in July 1932. Subsequently the Congress passed
Sub-Editors the Glass Steagall Act in 1933 which required a separation between commercial
Durgesh Nandini Mohanty banking and investment banking operations to resolve conflicts and to control
speculation. The Act was later repealed in 1999 and was blamed to be one of the
Hitesh Gulati many causes of the current subprime crisis.
Sumit Kedia Post World War II, the Japanese government created an environment which
Tanvi Arora encouraged savings. Credit was easy and with so much money available for invest-
Upasna Agarwal ments, speculation was inevitable and it resulted in too much money chasing assets
and led to an economic bubble between 1986 and 1991 in real estate and stock
prices. The ‘bubble-burst’ hit very hard and lasted for more than a decade only to
be worsened in the recent crisis. It also resulted in the development of Yen carry
Creative Team trade which eventually collapsed in 2008.
Bhavya Aggarwal Asia has grieved as well during 1997-98 when the Thai Baht collapsed on the
Swarnabha Mukherjee back of de-pegging the currency from USD and significant outflow of foreign debt
from Thailand into US-denominated assets due to rise in interest rates in US. This
made the country effectively bankrupt and the contagion spread to neighboring
countries affecting Indonesia and South Korea most. It was a reminder of the fact
that foreign exchange reserves are important and Exchange rate regimes are dif-
ficult to maintain. The Asian economies have more than recovered since then but
not without suffering some permanent currency devaluations.
With this backdrop I think it was not very difficult to imagine (of course in
hindsight) that the Governments will do a good job of steering the world out of
All images, design and artwork the crisis and they have by and large succeeded so far. However what seems to
are copyright of be different this time around is that we have not seen as many bankruptcies and
permanent loss of capital (keeping history in perspective) – Assets have mostly just
IIM Shillong Finance Club changed balance sheets and that may be something to worry about.
I have brought you a long way to make a small point that when markets are
too confident and shooting up, think if what’s driving it is sustainable, because all
©Finance Club said the law of gravity still prevails.
Indian Institute of Management Wish all of you a great life.
Shillong
Ghanshyam Das Khandelwal
www.iims-niveshak.com Head - Strategic Transactions Group,
HSBC Bangalore
Disclaimer: The opinions expressed in this editorial are personal to the author and do not reflect those
of the HSBC Group.

Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears
no responsibility whatsoever.
 FROM EDITOR’S DESK
My journey with “Niveshak” started since February 2009 when I joined IIM
Shillong and took the assignment as ‘Faculty Mentor’. By that time Niveshak had
already passed its journey of 6 months and did establish a rapport and a niche of
its own among all premier business schools of the country. Niveshak is a completely
students’ initiative where they take care of collection of articles, compilation of inter-
Niveshak
ested reading materials, sequencing etc. One has to see to believe the amount of Volume III
efforts that are required to publish each and every issue of Niveshak. In its pursuit for
excellence, articles contributed for publication are examined with every rigour and ISSUE VIII
we can ensure that each of them has to pass through a thorough scrutiny before it August 2010
is considered for publication. The Niveshak team, mainly comprising of participants
who have apt in finance area, has to face a tough time in selection of articles to be
published in each issue. Our Contributors Include
Niveshak, by the time, has achieved so much popularity among premier b-
schools that a large number of articles are received every time. The job is further
toughened for selection of best article for the month. The articles are blind reviewed DoMS, IIT Delhi
for such selection. The present Niveshak team, who has taken the baton from the DoMS, IIT Chennai
founding batch, has taken the challenge of keeping the Niveshak flag high. The DoMS, IIT Roorkee
publication has been regular and I was thrilled to find that the team was so sincere
about it that took every care to see that the issues come to light even during the
FMS, Delhi
internship period. That is the success and cutting edge of Niveshak. Niveshak, as it Great Lakes, Chennai
implies ‘investors’, it is true for all. The contributors of articles are investing their ideas, IIFT, Delhi
knowledge for its better dissemination, they are sure get to get their return on invest- IIM, Ahmedabad
ment as their ideas are widely circulated by Niveshak, We appreciate the time and
effort invested by eminent personalities who shared their views with the Niveshak IIM, Bangalore
team in each issue. IIM, Calcutta
At the juncture, when Niveshak is coming out with its 2nd Anniversary issue, IIM, Indore
I wish all the success to the Niveshak team for putting their sincere efforts in making IIM, Kozhikode
Niveshak of IIM Shillong flying high.
IIM, Lucknow
Subhrangshu Sekhar Sarkar IMNU, Ahmedabad
(Ex- Faculty Mentor)
IMT, Ghaziabad
Dear Knowledpreneurs,
JBIMS, Mumbai
It is indeed a joyous moment for me to pen this message in the second an-
niversary of Niveshak, a core service rendered by the finance –facturing division of KJSOM, Mumbai
Rajiv Gandhi Indian Institute of Management, Shillong. This issue is very special for all MDI, Gurgaon
the equity holders in Niveshak as offers an opportunity to look back the cherishing MIB, Delhi
memories about the golden past.
NITIE, Mumbai
I feel it as a great privilege to on- board the energetic team Niveshak in the
place of Prof. S. S. Sarkar under whose guidance the team has been adding value to
NMIMS, Mumbai
the Valuizens of the emerging and empowering economy. SCMHRD, Pune
It is my duty to place record of my sincere appreciation to the edit-mates of SIBM , Pune
this publication for having lived their dreams of demystifying the happenings and SIIB, Pune
conceptions in Finance, the truly dynamic domain of management. The edit-mates
wouldn’t have seen their dreams in reality without the inspiration, guidance, and
SIMS, Pune
mentoring provided by the Karta of the team RGIIM-S, Prof. Ashoke K. Dutta. SIOM, Pune
It is time to express our sincere thanks to the contributors of articles, opin- SITM , Pune
ions, analytical insights and experience sharing whose inputs made new meanings SJMSoM, Mumbai
in the lives of uncountable budding corporate czars such that they join INDIA INC Sydenham, Pune
with a focus to create surplus.
The proof of a good magazine lies in its readership. Niveshak is blessed
TISS, Mumbai
with a good reader base consisting of a optimal mix of academia, practitioners and VGSOM, Kharagpur
knowledge sailors in the likes of you, who collectively and individually mean “Mean- Wellingkar, Mumbai
ing to its existence”. Be it foot-ball or IPL season, examination or internship , you have XIM, Bhubaneshawar
been with us in our noble efforts to ease our progress in reaching “ZERO”, the great
number which means “Nothing” and “Everything”. XLRI, Jamshedpur
On behalf of the team, I take this opportunity to invite each one of you to
join us through your contribution of articles/opinions and consumption of the ser- ©Finance Club
vice provided by us, such that we as a team help each other in tallying our balance Indian Institute
sheets in career. Let me recall the saying”The key to success lies in 4 words : AND
of Management, Shillong
THEN SOME MORE………..”
N. Sivasankaran www.iims-niveshak.com
(Faculty Mentor)
Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears
no responsibility whatsover.
 CONTENTS
Niveshak Times
06 The Month That Was
Cover Story
Milestones that shaped
the world of finance

PERSPECTIVE 16 The Years of

44 Mapping the Perforations Hyperinflation
58 Participatory Notes and
India 19 Asian Financial
Crisis

24 The Black Tuesday

FinSight
08 Value Investing 28 The Lost Decade

40 Rise of the Lamb

A case for investing in Africa 31 Acceptance of
Currency Boards
CONTENTS
Tete-a-Tete
He Speaketh
37 Stress Tests... Unlocked

10 Sanjeev Gupta
CEO
Sanlam Investments
Emerging Markets FinGYaan
48 Investment Strategies
51 Outward FDI Policy
India vs China

34 Dr. Paul Shrivastava 54 The Shadow Still Follows

Director
David O’Brien
Center for Sustainable
Enterprise
Concordia University

finlounge
13 Crossword
 www.iims-niveshak.com
The Niveshak Times
GOVERNMENT’S PROPOSAL COULD MAKE ACQUISITIONS
MORE EXPENSIVE FOR INDIAN COMPANIES.
Tanvi Arora
Team Niveshak
Market watch
In the last month, consistent foreign fund in-
flows led to the Sensex crossing the psychological
18,000-mark and touched a two-and-a half-year high
last week. Foreign institutional investors have in-
fused over Rs 16,000 crore in July.
The BSE benchmark Sensex closed the week
ending on August 6 at 18,143.99 points, a gain of
275.70 points or 1.54 per cent over its last weekend’s
level. The NSE nifty-fifty also shot up by 71.65 points
or 1.33 per cent to 5,439.25 points from its previous
week. The revival of indices can be attributed to fac-
tors like monsoon, healthy auto sales and strong
manufacturing and services sector data. The indices
like consumer durable, IT, small-cap, mid-cap, Realty
The Month That Was
and Bank closed at a positive note. Foreign Insti-
tutional Investors (FIIs) buying was another major
factor for the movement in Sensex.
Sensex lost 1.4 percent and closed at 17,868
during the week (July 26 – July 30), while Nifty ended
the week at 5,361 down by 1.6% over its previous
weekend’s close. During the week BSE Mid-cap and
Small-cap indices were lost 0.3% and 1% respective-
ly. Poor performance by some big corporate houses
and weak global sentiment hurt the upward journey
of local markets this week.
The Sensex ended the week at 18,130.98, as
against the last weekend’s level of 17,955.82, show-
ing a rise of 175.16 points or 0.98 per cent, its high-
est closing level since 6th February 2008. The NSE-50
share Nifty also gained by 55.20 points, or 1.02 per
cent, to end at 5,449.10 as against the last week-
end’s level of 5,393.90. The market was volatile in
this week as traders were engaged in getting in-
dulged in their short as well as long positions to the
August-series derivatives contract to be expired on
July 29, leading to see-saw movements.
Exemption of 25% public float norm on
PSUs
The finance ministry has exempted state-
owned firms from the recent rule that requires listed
companies to achieve at least 25% public holding
within three years after some of them said they
will not participate in disinvestment if the rule was
forced on them. Public sector firms will now have to
maintain a minimum public float of only 10%, the
6 NIVESHAK VOLUME 3 ISSUE 8 August 2010
finance ministry said in a notification.
The modified rules also gave a breather to the
private sector companies. They will have to com-
ply with the minimum 25% public float within three
years but they will now have flexibility in how the
limit is reached, without the annual 5% increase
mandated in the current rules.
The finance ministry had amended the rules
to the Securities Contracts (Regulation) Act on June
4, asking companies to lower their promoter hold-
ings in order to increase opportunities for common
investors and also increase free float to discourage
manipulation.
But many public sector firms like CIL and Na-
lco as well as the department of disinvestment had
sought a review of the norms saying that it would
impact the valuation and keep them away from the
stake sale programme. Many PSUs had agreed to
get listed because the government wanted to divest
stake in them and not because they needed to raise
funds, they had argued.
FATF welcomes India in its team
On June 25, India became the 34th country to
join the Financial Action Task Force (FATF). This puts
India into one of the most critical standards-setting
bodies in international finance, and will have far-
reaching ramifications both for global capital operat-
ing in India, and the ability of Indian firms to under-
take exports of financial services.
In 1989, recognising the emerging complexi-
ties of money laundering in a world of technological
and financial innovation, the G-7 and the European
Commission established the FATF. This is an inter-
governmental body aimed at creating a global policy
environment that would combat money laundering
and terrorist financing, by writing standards and
monitoring the worldwide implementation of these
standards.
India would be benefited by being a part of
FATF by providing the comprehensive toolkit for law
enforcement agencies to be able to track the money
behind terrorist attacks, both within India and from
other countries. Also, it would facilitate combination
of an open approach to global capital with enforce-
ment against terrorism and money laundering. An-
other dimension lies in the country emerging as an
 www.iims-niveshak.com
The Niveshak Times
RBI INCREASED ITS POLICY RATES AS PART
OF ITS EFFORTS TO CONTROL INFLATION.
exporter of financial services.
Changing structure of GST
The terms for the goods and service tax (GST)
could get diluted. The finance minister Pranab
Mukherjee proposed a new structure for the tax that
includes major concessions for the states. The con-
cessions include imposing different tax slabs that
don’t include petroleum products, alcohol, electric-
ity, and real estate. Under Mukherjee’s proposal,
starting next fiscal, there’ll be a 20% tax on goods,
a 12% tax for so-called mass items, and a 16% tax
on services. Those rates will then start merging until
they reach a uniform 16% in three years. The GST
aims to replace several indirect taxes and create a
common market across the country. It’s scheduled
to be rolled out on 1 April 2011.
And while the Centre may have made many
concessions to states on GST, it’s looking to take
control of key aspects of the tax. The draft constitu-
tional amendment proposes to give the Centre veto
powers over rates. On the flipside, the Centre will
not be able to change GST rates by itself.
Government makes acquisition expensive
Another major government’s proposal could
make acquisitions more expensive for Indian com-
panies. The market’s regulator, Sebi, suggested an
overhaul of takeover regulations that will make life
easier for incumbents and harder for corporate raid-
ers. As per the proposed changes, the threshold for
open offers will go from 15% to 25%. But once a
company crosses that mark it will also have to make
an open offer to buy 100% of the company’s shares.
Under existing rules, buyers only need to make open
offers for 20% after acquiring a 15% stake.
First quarter results
Some of India’s most important banks an- meltdown.
nounced their quarterly numbers this month. HDFC
Bank met analysts’ expectations with its net profit
shooting up almost 33.9% to Rs812 crore in the quar-
ter ending June. Net interest income rose 29.4% to
Rs2,401 crore.
Yes Bank announced a 56% increase in net
profit to Rs156 crore. Its net interest income climbed
67% to reach Rs262 crore. Its numbers were driven
by strong credit growth that came largely from 3G
auction payments.
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
Reliance Industries posted record profits. Net
profit for India’s biggest company rose 32% to more
than $4,851 crore. Revenues did even better, shoot-
ing up eighty-five percent to nearly sixty thousand.
RIL’s profits were boosted by its oil and gas
business. The company’s gross refining margins re-
covered to $7.30 a barrel in the first quarter. In 2009’s
first quarter, those margins were at $6.80 per barrel.
While RIL’s profits are looking up, some broker-
ages are downgrading shares of the company. They
predict a fall of Rs20-39 from their initial projections
of the company’s target price. The downgrade has
been prompted by delays in ramping up gas output
from RIL’s KG basin fields.
Modified monetary policy
The Month That Was
India’s monetary policy went through a greater-
than-expected tightening this time. The RBI increased
its policy rates as part of its efforts to control infla-
tion. Along expected lines was the hike in the repo
rate by 25 basis points to 5.75%. The surprise was
the reverse repo, which was increased by 50 basis
points to 4.50%. The repo is the rate at which the
RBI lends to banks, while the reverse repo is the rate
at which banks park their excess cash with the RBI.
CDS is back
Some may call them financial weapons of mass
destruction, but credit default swaps are back on the
agenda in India. The RBI once again proposed intro-
ducing the instruments in local markets. It’s inviting
comments to its draft guidelines until the fourth of
October. At present, those guidelines demand users
buy a CDS only if they have an underlying exposure.
That effectively prevents CDS’s from being used a
trading instruments. CDS’s allow lenders to insure
themselves against defaults by borrowers. They
were widely blamed for worsening 2008’s financial
7
 Nand Sharma
Cedar St. Capital (MIT, IIT Alumnus)

“Value Investing”- What it is investing” is like an initial phase of

The author, through
this article, presents
his views on Value
Investing and differ-
entiates it from what
he calls it as “emo-
tional investing”.
FinGyaan
and Does it still makes sense?
Most of us- especially the
younger generation would not be-
lieve much in value investing. The
reason- there is no quick money
to be made in such investing. The
whole concept of investing revolves
around the idea of making mon-
etary gains on available capital and
we would want to make as much as
possible and as soon as possible.
Let’s discuss this further. Ac-
cording to my experience, invest-
ing can be divided into two broad
categories- one is “value investing”
and the other I coin as “emotional
investing”. What is the difference?
Well, value investing is like a
marriage – a long term relationship
with the significant other. Value in-
infatuation with a girl. You are liv-
ing in your dream world and think
that every penny you invest would
grow multiple folds. You are too de-
pendent on market opinion and are
always looking for some excitement
to happen. You are not much con-
cerned about the company funda-
mentals- in fact you tend to ignore
it. Emotional investors do not want
to know reality. All they want to hear
is when is the stock going to dou-
ble and triple in near future. Every
news, every market response and
every opinion starts making sense.
Every chart, every company ticker
becomes important to you- whether
you understand things or not. You
start participating in this vast sea
of “economic demand and supply”

without understanding the funda-

vesting is based on your knowledge mentals of the market.
of a particular business –its finan-
cials, its growth potential, market So which one is for you?
penetration and saturation and Well, it depends what your
management. It means you under- investment goals is. If your invest-
stand the business and to some ex- ment goal is to preserve your capital
tent how it is likely to behave in the
and make good (not gigantic) gains,
future. When you are buying a stock,I would recommend value invest-
FinSight

you understand that you are buying ment. But if you just want some ex-
a piece of a business and hence you citement and want a roller coaster
are more logical and rational in your
ride – at times making some and
decision making. Your emotions are then losing a lot- you should aim
not wavered by market’s ups and “emotional investing”. Although, it
downs and public opinion. does not make sense but it does
On the other hand “emotional satisfy our human need of getting

The process of value invest-

ing starts with knowing the
business and thus, as finance
professionals, you should know
how to read the financials
statements of a company.

8 NIVESHAK VOLUME 3 ISSUE 8 August 2010

involved and experiencing some adrenaline rush. any product and what is the general market trend
But beware- it may cost you money and a burnout for such products?
in terms of your investing career. 3. How does the management look like? What
is the reputation of the management?
How to get started with value investing
Once you have a positive answer on these
Investing usually has more to do with your
questions, you might be able to find some compa-
thought process than the subject matter itself. Ben
nies in which you are ready to invest.
Graham and Warren Buffett (a must read- intelligent
investor) says that while investing you are not com-
peting with your neighbor or the market. In fact, you
become your worst enemy in an investing game and
thus you should be extremely careful while develop-
ing your thoughts regarding investing.
The process of value investing starts with
knowing the business and thus as finance profes-
sionals (either working or someone involved in ac-
tive investing) you should know how to read the
financials statements of a company- income state-
ment, cash flow, balance sheet and other schedules
which goes in populating these statements. It is
amazing that even MBA’s would not know how to
read these statements with proper caution. Get a
course of these statements or find someone who
can teach you. This is the basic start of you getting
involved in an investing game. The financial state-
ments tell you the current state of the company.
How much profit the company is making, how much

FinGyaan
cash does the company have and how much assets?
These become very important while evaluating a
business. You shall be able to calculate the book
value of a share once you know financial statements
and would be able to do your own calculations of
finding undervalued shares.
Once you understand the fundamentals of
business, then you might want to check the follow- FinSight
ing:
1. How do the financial statements look like?
Are they making sense and does they have any dis-
crepancies?
2. What is the market hold of the company?
Can the company still expand or do you think it has
saturated the market? Is the company coming with

Nand works as an associate with Cedar St Capital facilitating capital investment opportu-
nities in the emerging markets. Previous to Cedar, Nand worked as an analyst with CTPS
buidling mathematical models for travel demand forecasting and capital allocation. Nand
completed his masters from MIT in econometrics/transportation and his bachelors from IIT.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 9

 Speaketh
Story

sanjeev gupta
CEO-Sanlam Investments Emerging Markets
Cover

Sanlam Investment Management is the Investment Management business of the SAN-

LAM group, the largest financial services group of South Africa.
He

Sanjeev has an in depth experience and an exemplary track record in setting up and manag-
ing financial services businesses in emerging markets. This experience has provided him with a
In an exclusive in- deep insight into the contractual savings industry, financial markets development, government
policy reforms and economic policies in such economies.
terview with Team
He also sits in the Boards and Investment Committees of various Private Equity Funds in
Niveshak, Sanjeev
AoM

the African region. He is a Fellow of the Indian Institute of Chartered Accountants and a
Gupta- CEO Sanlam Member of the Investment Analysts Society of South Africa. He also holds an AMP from
Investments Emerg- Oxford University.
ing markets, gives catered to.
Niveshak: Most of the Indians still
his views on the cur- park their investments in risk free op-
rent status of Indian tions like fixed deposits etc. We also
In India, from the target market of
about 60 million households or 400
Perspective

see people’s blind trust over LIC

financial services at a
million people; if you take out top
time when other better options are
market. He also talks available in the market. It is probably 5%, the rest look at investment more
about Sanlam’s phi- due to financial illiteracy. Can you from a safety and capital protection
point of view rather than wealth cre-
losophy & strategy throw some light on this with respect
ation and long term gains perspec-
to India?
and its future expan- tive. The added factor, in terms of
sion plans in India. Mr Gupta: In India, as we all know, investing in financial markets, is
less than 1% of the population are that the industry itself is very new.
investors and less than 6-7% of their I would like to argue that the level
savings are invested through finan- of corporate governance, transpar-
FinGyaan

cial market products. I feel there are
a few issues here. One, of course, is
the general lack of financial literacy
or lack of awareness and understand-
ing of how financial markets work and
poor financial savvy on the part of the
savers in India. The second thing is
that although the total savings pool in
India is huge, on a per unit basis, the
FinSight
ency or the interaction with the
investors and the level of informa-
tion or analysis that is possible into
listed stocks requires much more
work and better comprehension by
investors. If we look at the listed
companies in India today, in ma-
jority of the companies, significant
holding is by promoters or a few

actual amount of discretionary sav- domestic institutional investors like

ing as available to an Indian family or
an Indian household is pretty small.
It’s just a fraction of their salaries or
worse still- their incomes are sporadic
and not consistently earned over the
year in predictable tranches. Thus,
arguably, the defensiveness that you
see in their approach towards invest-
ment is understandable as the mar-
gin of safety and the level of volatility
that can be absorbed is limited. In-
vestors can only start thinking about
long term horizons once their comfort
zone and buffer level broadens and
the liquidity needs for emergencies is
LIC; which means that the free float
is very small. This leads to a kind
of discomfort as it creates liquidity
challenges and insider trading type
concerns – however misplaced they
maybe. People normally don’t trust
what they don’t understand and a fi-
nancial intermediary led hype driven
investment strategy which has been
the hallmark thus far in the MF in-
dustry simply does not evoke the
faith that the conservatively minded
hard working Indian saver is looking
for. Confidence building therefore is
a function of all these factors as fear

10 NIVESHAK VOLUME 3 ISSUE 8 August 2010

and ignorance are potent combinations `product push` driven selling strategies and perhaps

He
Cover
by default encourage the raising of standards within
In general our regulatory environment is actually the investment process and investment proposition
quite strong and proactive. Regulators are doing

Speaketh
itself. Now the time has come when you have to
good work. But I think the distribution community or make the whole opportunity set relevant to the vast
the intermediaries have to play a bigger and respon-

Story
pool of savers . Initiatives like the ones by IDBI are
sible role in not only raising awareness levels but creating awareness but they have their own disad-
wean out poor market practices. To a very large ex- vantages too unless its supported by mature and
tent, the distribution community suffers from lack of proactive advice at the point of sales. Without good
laid out minimum qualification standards and finan- quality advice backed by good quality research, a
cial acumen criteria for intermediaries to be able to little bit of knowledge or limited awareness can also
sell and distribute financial products. In the rest of be dangerous.
the world where there are more sophisticated mar-
kets, you have a control over who is advising and Niveshak: IRDA has said that it will ensure that

AoM
selling financial products and how its being done. ULIPs (and other products) sold by agents are based
Awareness and education level has to go up here on the financial profile of the individual being ap-
in India before savers will trust and invest in any proached and not on the fees. In your opinion, how
significant manner. feasible is this? What concrete steps can be taken to
implement this at the grassroots level?
Thus, people go for risk free products and LIC’s sta-
tus as a household name. This has played into fa- Mr Gupta: After SEBI removed the upfront commission

Perspective
vouring guaranteed products instead. linked with Mutual Funds; the expectation was that
the business of selling the various financial prod-
As you know, the financial sector reforms’ biggest ucts and the basis of incentivising the intermediary
gainers were the current incumbents, not the new would be a level playing field across the spectrum of
players so much as yet. Indians have a respect for financial services. IRDA has won the battle to over-
their own financial institutions whereas this is not see the rules over selling of insurance products. The
necessarily the case in other emerging markets. freedom to sell at what are much higher charges
Indians also have the tendency of not sharing their with much less transparency continues unabated
financial realities and issues like their salary or as- currently. Thus unwittingly the market has gravitated
sets with the financial advisors that easily. Thus it toward a bias toward buying/selling of ULIPs which

FinGyaan
becomes very difficult for financial advisors to sug- are arguably nothing but investment products in the
gest or recommend a suitable product as per their garb of insurance products.
needs, financial position and risk appetite under
It’s a fact that ULIPs are opaque products since you
such contraints. In a nutshell, the current situation
don’t see the underlying investment, charges and
owes its genesis to issues related to governance,
selling commission. All you are promised is a return.
regulation, culture, flawed distribution methodology
But remember that any guarantee in anything in life
and indifferent knowledge within the distribution
comes at a cost and ULIPS are no different. Those
system.
guarantees don’t come cheap.
Obviously these are all evolving and improving by
FinSight
But IRDA has got one big advantage in the sense that
the day and the market itself represents a huge op-
insurance, in itself, is sold through tied agents and
portunity which will be harvested as trust, faith and
understanding goes up. regulated entities; not anybody can sell it. Therefore,
IRDA has got a very major tool through which to con-
Niveshak: Certain financial institutions have started trol what is happening in the market place simply by
promoting awareness and knowledge to the investors regulating the industry players all of whom report to
like the initiative started by IDBI. What impacts, in it in any case and it has jurisdiction over.
your view, does this make?
SEBI on the contrary has limited control over the
Mr Gupta: Of course… this sort of initiative is neces- selling practices of the Mutual Funds.
sary. But then this generally raises only the curios-
ity level and doesn’t necessarily translate into any Thus the fact that IRDA plans to educate people is a
deeper understanding. What really has to happen good step but I think what really needs to happen is
is that the quality of the middle man (the advisor) that the industry itself has to take the responsibil-
has to go up. You already know that SEBI has re- ity as well. All banks, AMCs, insurance companies
moved commissions associated with Mutual Funds are the custodians of savings in this country. So if
as an effort to prevent mis-selling and discourage they don’t take the responsibility, no regulator can

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 11

 do enough that actually will be sustained over the
longer term.
He Speaketh
Niveshak: Our readers would like to know about
Sanlam’s philosophy and strategy in India so far and
how does Sanlam make sure that the appropriate fi-
nancial products are sold to their clients.
Mr Gupta: Sanlam started its life insurance foray in
India in 2005 when they went into a joint venture
with Shriram group in Chennai. Because of the regu-
latory limits, we have only 26% of the ownership.
We provide the JV with product support, system sup-
port and actuarial support.
We then set up a general insurance business with
Shriram and now a Wealth Management business
with the SMC group, which currently is ranked as
India`s 5th largest stockbroker and among the top
10 in terms of IPO mobilisation
The financial services industry in South Africa, which
is our home base, is highly developed. We have
been operating out of there for 94 years now and
have had to deal with issues like how things evolve,
how masses react and how products should be mar-
keted amidst changing legislation and paradigms.
The essence of our strategy in India is that we are
not product pushers or asset gatherers but regard
products as means to an end- be it to meet invest-
ment needs or as a tool to mitigate and manage
financial risk .
We regard ourselves as risk managers and Invest-
ment Managers i.e. we either underwrite risk or
manage investment aspirations.
We try to build durable relations with the existing
distribution system including banks, agents etc and
aim to provide the tools and training for them to
extend quality advice to the target market.
The bottom-line to our strategy in India is plain and
simple - we see India as a strategic opportunity and
not a short term opportunistic one. Our financial
models work on that basis as we commit capital to
build what is necessary to sustain a business over
the long term and not to create immediate gains that
may be unsustainable. The consensus view around
“The essence of our strategy in India is that we are not product pushers or asset gatherers but
regard products as means to an end- be it to meet investment needs or as a tool to mitigate and
manage financial risk .”
12 NIVESHAK VOLUME 3 ISSUE 8 August 2010
the projected exponential leap that retail financial
services is poised for in India needs to be tempered
with caution and managed with sophistication and
responsibility. Only then will the canny Indian saver
trust and invest with us and grow with us.
Niveshak: Can you throw some light on Sanlam’s
future plans in India?
Mr Gupta: We have, as of now, two joint venture
partners. One is with Shriram Group and the other
with SMC group. SMC group is a Delhi based stock
broking and insurance distribution company and Sri-
ram, amongst other things is one of India’s largest
financier of second hand trucks. The question arises
that why we chose them given the fact that these
are two relatively unknown smaller companies . The
reason is that our target market in not the ‘frothy’
layer. We feel that the opportunities lie in the tier-2
and tier-3 segments and we want to target those
particular segments. That’s why we chose Shriram
group which has got relations with that layer. Similar
is the case with SMC group. SMC has close to 2200
offices across India . These are small offices which
you will find in most of the tier-2 and tier-3 cities
with loyal customers.
Our focus is to be able to market and distribute
quality insurance and asset management products
and gain market share through superior advice and
investment performance.
The driving force is not top down. The driving force
is to work with this distribution system, the network
and relationship with tier-2 and tier-3 businesses of
our partners and other related players and develop
products that are needed and understood. Once we
have built a strong foothold there based on quality
and commitment; the business to serve these cli-
ents and deliver on their expectations will take off
and flourish on its own steam.
CROSSWORD
Down
1. Warren Buffet hates me

3. I buy your Receivables and

make a living out of it

4. I am a Stock Index in BRIC

7. I am an Instrument in finance
whose best ally is Risk because
when Risk goes up, my value
increases

FinLounge
(Note: All the clues given refer to Financial terms and not personalities
unless explicitly mentioned)

Across
2. I am neither a bond nor equity but have features of both

5. I take Inflation along and leave growth behind

6. US companies love me because using me in the Accounts saves Tax

8. I am Greek and in a (cor)relation with the market

9. Japanese believe in acquiring me Just in Time and I am related to 6 Across

10. I have changed my value in recent times and guess what your magazine chose me as their cover story for
that!

All entries should be mailed at niveshak.iims@gmail.com by 10th September 2010 23:59 hours
One lucky winner will receive cash prize of Rs. 1000/--

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 13

 The Years Of
Hyperi nflation
Cover Story
Manbir Singh Tandon & Gaurav Thakur
IIM Shillong
Imagine that one day the en-
Inflation is some-
tire currency of a nation is collected,
thing that is inher- kept in a large heap and its value is
ent to any economy estimated in terms of U.S. dollars. It
but hyperinflation would be expected to be in order of
billions or trillions of dollars, right?
is something that What if someone tells you that
must be avoided at the value of the entire currency
any cost. A histori- is worth one thousandth of a
cal analysis of such dollar! You would know it
then that the nation is in
major occasions a period of severe hyper-
when hyperinflation inflation.
has reached ex- Traditionally,
tremes and has had inflation in a small
magnitude is con-
significant impact on
sidered to be
world economy has
been carried out to
good
understand where
for an
we stand today in e c o n o m y.
this regard. Developing countries try to
maintain an inflation rate of
3-5% as it reflects the good health
of the economy wherein demand
still exceeds the supply and not dra-
matically so. However, as history has
shown us, there have been times
when the rate of inflation has gone
spiralling and out of hand. Such a
situation, in which a currency loses
value exceedingly rapidly and the
prices rise steeply, is called hyper-
inflation. There is no clear demarca-
tion in terms of inflation rate for it
to qualify as hyperinflation; howev-
er, an inflation rate of above 50% is
generally labelled thus.
Such is the severity of hyperin-
flation that its sustained protraction
cannot be a result of a single shock.
Only, a plethora of hits one after an-
other can take an economy into such
dire straits.
A sundry of hyperinflation sce-
narios have been witnessed over time,
especially since the inception of the
twentieth century: Germany (1922-
23), Greece (1944), Hungary (1946),
16 NIVESHAK VOLUME 3 ISSUE 7 JUly 2010
Taiwan(1949), Yu-
goslavia (1994)
and the more re-
cent crisis in Zimba-
bwe (2008). In most of the
aforementioned cases, the
primary cause of
hyperinflation
boils
down
to ex-
cessive
liquidity
generated in
the market by the government as
a means of taxation. Understanding
this principle of revenue generation
by the government is quite simple.
Every government must print cash
commensurate to the gold reserves
it holds. If then, the government
prints more money, it effectively
lowers the value of the currency
i.e. even though an average citizen
of the nation holds x units of cur-
rency, it’s value after dilution falls
to less than x units and as a result
the government earns. In such a
scenario, the average citizen sees
no point in holding on to the money
he/she has and tries to spend it as
soon as possible before the currency
value falls further. The demand for
goods, whose value is unaffected by
nation’s currency dilution, thus in-
creases. Such a practice, if not tem-
pered down early enough, is unsus-
tainable. The demand soon becomes
overwhelmingly higher than the sup-
ply and prices skyrocket. To enable
its citizens to buy the necessities of
life, the government further injects
money into the market resulting in
further dilution of currency, people scrambling to
get rid of the cash, more demand for goods and
yet higher inflation rate. Thus a vicious circle of de-
mand, supply and inflation rate is formed.
Let us now turn back the pages of history and
revisit some of the worst hyperinflation periods that
affected the world economy as a whole:
Germany (1922-1923): Arguably the most fa-
mous hyperinflation till date, Germany’s fall into
the hyperinflation trap began after the end of World
War-1. The Allied Powers forced Germany to pay
huge sums of the magnitude of 132 billion Marks as
reparations for the damages caused in the war. This
amount was widely deemed to be way too high than
Germany could afford. As a result all the revenue
earned was directed towards debt payment and the
wages of ordinary workers and citizens of Germany
began to take a hit. The situation kept on becom-
ing worse over the next year, when France attacked
Ruhr, a major industrial and production hub of Ger-
many, to recover their debt. In retaliation, the then
German government (Weimar Republic) foisted the
employees to go on strike. This decision had cata-
strophic consequences. One was that the supply of
money for debt repayment was squeezed. Secondly,
the number of unemployed grew drastically. As a
result the government had to pump in more liquid-
ity so that the unemployed could be sustained. The
businesses raised their prices and the government
injected still more money. The value of Reichsbank
marks fell dramatically from 60 Marks to a dollar
in 1921 to 1000 Marks to a dollar in mid-1922. The
present currency notes could no longer be used and
they were replaced by notes of higher denomina-
tion. The rate of inflation spiralled and in October
1923 it reached its peak value-29,500%.
At this rate of hyperinflation the prices of com-
modities doubled every 3.7 days! Currency notes
of denominations of the magnitude of 50,000,000
(50-million) Mark and 1,000,000,000 Mark were print-
ed.
There were only certain section of people that
benefitted from this situation - borrowers. They
easily paid off their debts with Reichsbank Marks
that were worthless given the scenario. Finally the
Weimar Republic decided to replace the Reichsbank
Mark with a new currency Retenmark in November
1923. A promise was made by the German govern-
Such is the severity of hyper-
inflation that its sustained
protraction cannot be a result
of a single shock.
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
ment that the new currency could be converted to
a bond having value in units of gold. This was per-
Cover Story
ceived as a promise to stem the flow of cash into
the market and the move resulted in recovery of the
economy as the inflation rates slowly came down
and normalcy was restored.
Greece (1942-1944): Another instance of hyper-
inflation was seen during the World War II, when
Axis powers occupied Greece. The government of the
Greece made three consecutive efforts to curb the
situation in the country. The first attempt made by
the government could not bring the stability and the
situation could be controlled only after 18 months,
when price level stability was achieved by enact-
ing fiscal reforms and founding a central bank. The
highest denomination before the 1941 was 5000
Drachmai. But during the hyperinflationary period it
went up to the 1, 00,000,000,000 Drachmai. After the
currency reforms the exchange rate in 1954 was 1
Drachma = 50,000,000,000,000 Drachmai (1944).
Hungary (1946): Even though Germany’s hyper-
inflation is more spoken about, it still did not record
the highest inflation rate ever known. That dubi-
ous distinction goes to Hungary where the hyper-
inflation rate recorded at its peak was a whopping
4.19×10^19. This astounding rate of inflation meant
that prices in Hungary doubled every 15 hours. The
root cause of hyperinflation was associated to the
aftermath of World War-II. The damages caused in
the war resulted in a supply shock. The Hungarian
currency ‘pengo’ lost value drastically. A new curren-
cy ‘adopengo’ was created for taxation purposes. On
January 1946, 1 adopengo equalled 1 pengo. By July
1946, 1 adopengo equalled 2×10^21 pengo. It was
during this time that the highest denomination cur-
rency note known till date was issued. Its denomina-
tion was 10^20 or 100 quintillion Hungarian pengo.
Hungarian pengo banknotes being swept away
from the streets
The policies adopted by the Hungarian govern-
ment were commendable given the grim situation
at hand. They started off lending to business enter-
prises at negative interest rates. Further, the busi-
nesses were happy to employ more and more labour
given the low wages required to be paid. The op-
portunity cost for employees was minimal given the
remnants of the World War and as a result expecta-
tions were low and they accepted whatever they got.
17
 The production rate increased rapidly and recovery prices increased by 5 quadrillion percent (5 with 15
followed. In August 1946, the Hungarian pengo was zeroes after it).
replaced by a new currency- Forint.
Conclusion
Cover Story

Yugoslavia(1989-1994): The decision of financ-

The rigours of history have many lessons to
ing budget deficit by printing money, made by Tito
teach us in regard to hyperinflation. Few have taken
(the then President of Yugoslavia), and communist
note of this and have benefitted. One of the best
party’s irrational financial policies led Yugoslavia into
examples of hyperinflation control came from Bolivia
the second worst hyperinflationary period (1989-
where they managed to eliminate it within a few
1994) in the recent history with the inflation rate
months. The measures adopted by them were:
of five quintillion percent. During this period prices
doubled every 16 hours on an average. All this was • They linked their currency to a stable foreign
attributed to the faulty measures taken by the gov- currency (in their case, the US dollar)
ernment to finance its operations. People could not • They froze government spending
use their hard •
cash kept in Theystopped
banks due to printing
difficult re- currency
strictions im- • They
posed by the lifted all
government. price con-
The prices of trols
goods were
so high that •
the citizens They dereg-
could not buy ulated their
anything from economy
the free mar- How-
ket. They were ever, his-
forced to stand tory can
in long queues only teach
at government us if we
run stores for intend to
erratically supplied ration and PDS. The prices of the look back and learn. As is the case with humankind,
gasoline were so high that most people left driving the lessons learnt during periods of crisis are just
and opted for the public transport. But even transit as easily forgotten during the periods of prosperity.
system of Yugoslavia could not bear the high oil pric- Today, Zimbabwe stands testimony to how little dis-
es and was short of funds to carry on its operations. tance we have covered till now and how long is the
All construction projects were closed down during path that still needs to be treaded…
this period and unemployment exceeded 30 percent.
The government imposed price controls on
producers to curb the inflation. But even produc-
ers could not bear the rising inflation and simply
stopped producing. Bakers stopped baking breads
and Belgrade was without bread for a week. The
price control policy introduced by the government
affected almost every industry. Finally in 1993 the
government introduced a new currency unit where
1 new dinar was equal to the one million of the
old dinars. Between October 1993 and January 1995

History can only teach us if

we intend to look back and
learn.

18 NIVESHAK VOLUME 3 ISSUE 8 August 2010

 Asian Financial Crisis

Cover Story
Ankur Choraria
SJMSOM,IIT Bombay
Introduction most half of the total capital inflow
to developing countries. The econo- The Asian financial
The Asian financial crisis start-
ed in Thailand with the financial col- mies of Southeast Asia in particular crisis was a period
lapse of the Thai baht caused by the maintained high interest rates at- of financial upset
tractive to foreign investors looking
decision of the Thai government to
for a high rate of return. As a result,
that gripped much
float the baht, cutting its peg to the
the region’s economies received of Asia especially the
USD, after exhaustive efforts to sup-
port it in the face of a severe finan- a large inflow of money and expe- “Tiger Economies”
cial over extension that was in part rienced a dramatic run-up in asset of South East Asia
real estate driven. At the time, Thai- prices. At the same time, the region-
al economies of Thailand, Malaysia,
between June 1997
land had acquired a burden of for-
eign debt that had made the coun- Indonesia, Singapore, and South Ko- and January 1998.
try effectively bankrupt even before rea experienced high growth rates The depths of the
its currency collapsed. As the crisis of 8–12% GDP in the late 1980s and Asian financial crisis
spread, most of East Asia witnessed early 1990s. This achievement was
widely acclaimed by financial insti- led global leaders
a sudden and unprecedented col-
lapse in asset prices, corporate and tutions including the IMF and World to express concern
financial fragility, and a drastic eco- Bank, and was known as part of the that the crisis could
“Asian economic miracle”.
nomic slowdown and a precipitous spread globally, and
rise in private debt. Causes these concerns were
This section highlights what used to justify an
has been identified as some of the
intervention by the
main causes of the East Asian crisis.
Various factors were at play during International Mon-
the crisis and it is likely that a con- etary Fund (IMF).
fluence of factors were responsible Economists took a
for the events that occurred. The
various causes presented below are
number of impor-
Figure 1: Significant events as reflected not meant to be taken in isolation tant lessons away
by the regional stock market MSCI Far but have been identified as some from this financial
East ex Japan index, Jan 1st 1997 = 100 of the more significant components crisis and the cri-
In just over 12 months, the re- that may have led to the emergence
of the crisis sis highlighted the
gion’s stock markets, once among
the largest in the world saw their 1. Structural Issues global nature of the
market capitalisation shrink by as 2. Macroeconomic issues economy
much as 85% in US dollar terms.
3. Financial Market Issues
Similarly, East Asian currencies de-
preciated sharply beyond the levels Structural Issues
needed to maintain export competi-
Issues relating to deregulation and
tiveness, with some currencies fall-
ing by 50-80% against the US dollarliberalisation of the financial sector
by end-July 1998. East European and Most of the economies worst
afflicted by the crisis had undergone
Latin American currencies also expe-
rienced some speculative pressure financial sector deregulation and lib-
eralisation, and also capital account
in the latter half of 1997, but gener-
ally fared much better. liberalisation. Some economists have
argued that these attempts, which
History were aimed at enhancing the finan-
Until 1997, Asia attracted al- cial sectors of these economies, in

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 19

 fact exposed them to certain risks arising from the
integration with the international financial markets
when they were not prepared to face such risks.
Cover Story
tory reforms were viewed to be partial and incom-
plete giving rise to loopholes which were exploited
by firms. The absence of a strong culture of enforce-
ment and accountability led to prudential limits being

Prior to deregulation and liberalisation, banks

were typically kept profitable by limits on allocation breached on a regular basis without penalties being
and the volume of bank lending and also interest imposed. This coupled with the fact that financial
rate ceilings on deposits. Deregulation and liberali- institutions were now operating in more demanding
sation saw banks operating in a more competitive and liberalised environment proved a potent mix.
environment where their interest margins narrowed Only three jurisdictions had ratios which were sig-
significantly. Also, quantitative limits on exposure to nificantly higher than the minimum set by the Ba-
single clients and sectors were also relaxed, result- sel Capital Accord, in spite of Asian banks operating
ing in over-exposure to single borrowers and specu- in riskier or less well diversified environments. The
lative sectors such as real estate. factors above are also likely to have contributed to
the development of a credit boom in and the rapid
Capital account liberalisation allowed domestic
leveraging of several East Asian economies.
institutions access to the international capital mar-
ket and this coupled with weak regulation resulted Disclosure and corporate governance issues
in excessive risk-taking and an over-accumulation Inadequate disclosure and weak corporate gov-
of short-term external liabilities by the banking and ernance allowed significant problems to build up in
corporate sector. the financial and
Underdeveloped corporate sectors
debt markets of many of the
worst-afflicted ju-
Many of the
risdictions. Inter-
worst-afflicted
national investors
economies had un-
and external cred-
derdeveloped debt
itors due to a lack
markets and, as a
of due diligence
result, an over-re-
on their part and
liance on banks as
due to the lack
the primary vehicles
of transparency
for financing. Lack
arising from inad-
of a well-developed Figure 2: Performance of Far East ex-Japan, Emerging Market and equate disclosure
domestic debt market World stock price indices (Morgan Stanley Capital International and weak corpo-
meant that the Asian Indices, US$)
rate governance
banks which mainly
on the part of domestic financial institutions and
had a short-term deposit base found it difficult to
corporations became reluctant to roll over maturing
hedge long-term lending. Most Asian banks typically
short-term debt and to hold domestic currency-de-
tried to limit apparent maturity risk on their respec-
nominated securities for fear of an imminent correc-
tive balance sheets by lending at floating rates to
tion. This contributed significantly to the erosion of
long-term borrowers. This provided illusory protec-
confidence and in part exacerbated the initial viru-
tion to the extent that the sudden, sharp and sus-
lence of the East Asian crisis.
tained interest rate increases which occurred during
the speculative attacks on their respective curren- Financial market
cies rendered many long-term borrowers insolvent
thus transforming interest rate risk into credit risk. Currency market activity
One of the most significant features of the East
Regulation and supervision of financial institutions Asian crisis was the rapid and severe round of cur-
Another problem was weak or ineffective regu- rency devaluation experienced by the South East
lation of financial and banking institutions. Regula-

In just over 12 months, the

region’s stock markets, once
among the largest in the world
saw their market capitalisa-
tion shrink by as much as 85%
in US dollar terms.

20 NIVESHAK VOLUME 3 ISSUE 8 August 2010

 funds.
OTC and off-balance sheet activity

Asian countries. The speed and ferocity with which
this devaluation was transmitted from one currency
to another stirred heated and controversial debate
as to the exact role played by currency market activ-
ity in the East Asian crisis.
The volatility from the currency market spilled
over to domestic equity markets and subsequently
unsettled the real economy in many of the crisis-
stricken economies of East Asia. The prolonged
weakness and instability of regional currencies is be-
lieved to have unnerved portfolio managers with an
exposure to the region. These managers would have
shifted their portfolios into currencies of “stronger”
economies, in this case the US dollar, from some of
the perceived “riskier” emerging markets which had
limited capabilities to support their currencies. This
reallocation effectively created a sharp downward
spiral in the currencies which ultimately drew fresh
impetus in the form of domestic corporations buying
foreign currencies to hedge their respective foreign
currency exposures.
Lack of transparency in currency market activ-
ity resulted in an opaque environment which sty-
mied and frustrated policy makers in their attempts
to monitor market activity and take the appropriate
policy response. Also, the fixed or heavily managed
exchange rate regimes adopted by many emerging
markets essentially rendered these economies vul-
nerable to market participants who had sufficient
Cover Story
The use of over-the-counter instruments (in
particular, derivatives) and off-balance-sheet items
may have contributed to the severity and dynamics
of the current financial crisis. OTC products may have
played a significant role in the massive build-up of
private short-term foreign debt in several emerging
market jurisdictions. Monitoring of the OTC instru-
ments was difficult because of opaque accounting
processes and disclosures and this helped market
participants to circumvent domestic capital controls
regulations.
Macro-Economic Causes
Capital Flow Surges & Monetary Policy
In the early 1990s, a cyclical downturn in global
interest rates coupled with the search by interna-
tional investors for higher yields and diversification
opportunities, among other factors, led to the start
of the private capital flows to developing economies.
Global capital flows afforded developing countries
the opportunity to smoothen their consumption and
investment patterns and also brought along with it
the accompanying benefit of “knowledge spill-over”
and improved resource allocation. However, these
capital flows were not totally without cost as they
also brought along with them significant risks.
On the macroeconomic front, capital influx in
relatively rigid exchange rates-regimes tends to be
favoured by many developing countries as a means
of providing a nominal anchor for the domestic price
level for maintaining a competitive export posi-
tion. This increased economic activity, inflationary
expectations and real exchange rate appreciation.
Moreover, excess liquidity was channelled into asset
markets and thus fuelled an asset price bubble. The
rapid expansion of the economies also led many of
these countries to run significant current account
deficits.
This combination of a credit boom, wrongly
allocated funds, lax monetary policy and an asset
price bubble, driven by a surge in capital inflow in-
creased the local currency denominated wealth of
the economy. However, the vulnerability of the mac-
ro economy to sudden reversals in capital flow also
increased significantly. The baht devaluation caused

Most of the economies worst

afflicted by the crisis had
undergone financial sector
deregulation and liberalisa-
tion, and also capital account
liberalisation.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 21

 investors to reassess and readjust their portfolios
across a number of markets, geographically and by
asset. However, at that stage, the macro economy
was in no shape to absorb the adverse shocks as-
Cover Story
ist movements also intensified in Southeast Asia as
central authorities weakened.
Further long-term consequences included re-

versal of the relative gains made in the boom years

sociated with this portfolio readjustment and a crisis just preceding the crisis. Nominal US dollar GDP per
ensued. capital fell 42.3% in Indonesia in 1997, 21.2% in Thai-
Loss of competitiveness arising from exchange rate land, 19% in Malaysia, 18.5% in South Korea and
policies 12.5% in the Philippines. Per capita income in East
Asian countries also decreased considerably. Within
The loss of competitiveness arising from the East Asia, the bulk of investment and a significant
real exchange rate appreciation was also accompa- amount of economic weight shifted from Japan and
nied by a decline in the global demand for key Asian ASEAN to China and India.
exports such as semiconductors and electronics.
The situation was further exacerbated by dampened Outside Asia
demand from a sluggish recovery in the Japanese After the Asian crisis, international investors
economy. Finally, increasing competition from low- were reluctant to lend to developing countries, lead-
cost countries meant that East Asian countries ex- ing to economic slowdowns in developing countries
perienced not only declining export volume but also in many parts of the world. The powerful negative
export prices. shock also sharply reduced the price of oil, which
Consequenc- reached a low of $8
es per barrel towards
the end of 1998, caus-
Asia ing financial pinch
The crisis in OPEC nations and
had significant other oil exporters.
macro-level ef- This reduction in oil
fects, including revenue contributed
sharp reduc- to the 1998 Russian
tions in values financial crisis, which
of currencies, in turn caused Long
stock markets, Term Capital Man-
and other as- agement in the Unit-
set prices of ed States to collapse
several Asian Figure 3: Performance of emerging market currencies against after it had lost $4.6
countries. The the US Dollar (July 2nd 1997-July 27th 1998) billion in 4 months.
nominal US dollar GDP of ASEAN fell by US$9.2 bil- Many nations learned from the crisis and quick-
lion in 1997 and $218.2 billion (31.7%) in 1998. Many ly built up foreign exchange reserves as a hedge
businesses collapsed and as a consequence, mil- against attacks, including Japan, China, and South
lions of people fell below the poverty line in 1997– Korea. Pan Asian currency swaps were introduced
1998. Indonesia, South Korea and Thailand were the in the event of another crisis. However, interestingly
countries most affected by the crisis. enough, nations such as Brazil, Russia, and India be-
The economic crisis also led to a political gan copying the Japanese model of weakening their
upheaval, most notably culminating in the resigna- currencies to restructure their economies so as to
tions of President Suharto in Indonesia and Prime create a current account surplus to build large for-
Minister General Chavalit Yongchaiyudh in Thailand. eign currency reserves.
There was a general rise in anti-Western sentiment,
India
with George Soros and the IMF in particular being
singled out as targets. Islamic and other separat- The output growth in India slowed from 7-8% in
1994-96 to 5.5% in 1997-98. The slowdown resulted

Many nations learned from

the crisis and quickly built up
foreign exchange reserves as a
hedge against attacks.

22 NIVESHAK VOLUME 3 ISSUE 8 August 2010

mainly from domestic factors, particularly the stall-
ing of the structural reform process and the dete-
FIN-Q Solutions

Cover Story
rioration in government finances, rather than the
regional crisis. During the crisis, India was a rela-
tively closed economy with exports comprising only July 2010
8% of GDP, and only about 13% of the exports were
directed to the rest of Asia (excluding Japan). This 1. Hari Narayana, current
meant that the adverse effect of the crisis on the
balance of payments and domestic activity was rela-
Chairman of IRDA
tively modest.
IMF Role 2. Adjustable-rate mortgage
The IMF created a series of bailouts (“rescue
packages”) for the most affected economies to en-
able affected nations to avoid default. The IMF’s sup-
port was conditional on a series of drastic economic 3. Tokyo Stock Exchange
reforms influenced by neoliberal economic principles
called as the “structural adjustment package” (SAP).
The SAPs called on crisis-struck nations to cut back 4. Compass BPO
on government spending to reduce deficits, allow
insolvent banks and financial institutions to fail, and
aggressively raise interest rates. The reasoning was
that these steps would restore confidence in the na- 5. April 1, 2011
tions’ fiscal solvency, penalize insolvent companies,
and protect currency values.
The effects of the SAPs were mixed and their 6. Treynor is similar to the
impact controversial. Critics, however, noted the Sharpe ratio, with the differ-
contractionary nature of these policies, arguing that
in a recession, the traditional Keynesian response ence being that the Treynor
was to increase government spending, prop up ma- ratio uses beta as the measure-
jor companies, and lower interest rates. The reason- ment of volatility and Sharpe
ing was that by stimulating the economy and staving
off recession, governments could restore confidence Ratio uses standard deviation
while preventing economic loss. of the fund.
For most of the countries involved, IMF inter-
vention has been criticized. The role of the Interna-
tional Monetary Fund was so controversial during 7. $25.50
the crisis that many locals called the financial cri-
sis the “IMF crisis”. Many commentators in retro-
spect criticized the IMF for encouraging the develop-
ing economies of Asia down the path of “fast track 8. Cisco/TravelersHarry Mar-
capitalism”, which led to the liberalization of the kowitz
financial sector (elimination of restrictions on capital
flows); maintenance of high domestic interest rates
to attract portfolio investment and bank capital and
pegging of the national currency to the dollar to re- 9. Firm A’s CFO will be higher
assure foreign investors against currency risk. and CFI lower

The role of the International

Monetary Fund was so contro-
versial during the crisis that
many locals called the finan-
cial crisis the “IMF crisis”

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 23

Cover Story
KUMAR RAGHVENDRA
IIM Shillong
“Anyone who bought stocks in
The article talks
mid-1929 and held onto them saw
about the day which most of his or her adult life pass
is perceived to have by before getting back to even.”
sparked the great -Richard M. Salsman
depression. It was On October 29, 1929, it was the
day of the great crash on the New
day when the vol- York Stock Exchange (NYSE). That
ume on stocks trad- event, a 30-point, 11.7% drop to
ed set a record that 230.07 from the previous day’s close,
triggered bank failures. On Monday,
has not been broken
October 28, more investors decided
for nearly 40 years. to get out of the market, and the
slide continued with a record loss in
the Dow for the day of 13%. The next
day, “Black Tuesday”, October 29,
1929, about 16 million shares were
traded. The market lost $14 billion in
value that
day. The
volume
on stocks
traded that
day was
a record
that was
not broken
for nearly
40 years.
Between
early Sep-
tember and the end of October 1929
the market lost a total of 40% in
less than 8 weeks. By the end of
the slide some pundits conjectured
that the market might actually go
to zero. From its high of 386.10 in
September 1929 to its low of 40.60
on July 29, 1932, the market had lost
a total of 89%. What followed was
– “the Great Depression”, a 10-year
economic slump. Black Tuesday had
Anyone who bought stocks in
mid-1929 and held onto them
saw most of his or her adult
life pass by before getting back
to even
24 NIVESHAK VOLUME 3 ISSUE 8 August 2010
such an impact that the market did
not recover from the lows of 1929
until 1954, long after World War II, 25
years later.
Why did Black Tuesday happen?
“The house of cards came tum-
bling down and we have no one to
blame but our own greediness and
desire to be rich without having to
work for it.”
-Anonymous.
The crash followed a specula-
tive boom that had taken hold in the
late 1920s, which had led hundreds
of thousands of Americans to invest
heavily in the stock market. A signif-
icant number of them were borrow-
ing money
to buy more
stocks. By
August 1929,
brokers
were rou-
tinely lend-
ing small
investors
more than
two thirds
of the face
value of
the stocks they were buying. Over
$8.5 billion was out on loan, more
than the entire amount of currency
circulating in the U.S. at the time.
The rising share prices encouraged
more people to invest; people hoped
the share prices would raise further.
Speculation thus fueled further rises
and created an economic bubble.
The average P/E (price to earnings)
ratio of S&P Composite stocks was
32.6 in September 1929, clearly above historical huge across the world. Not only did it lead to the
norms. Most economists view this event as the most New Deal in America but more significantly, it was

Cover Story
dramatic in modern economic history. On October a direct cause of the rise of extremism in Germany
24, 1929, with the Dow just past its September 3 leading to World War II.
peak of 381.17, the market finally turned down, and What caused the Great Depression, the worst
panic selling started. economic depression in US history? It was not just
What followed the Black Tuesday? – “the one factor, but instead a combination of domestic
Great Depression” and worldwide conditions that led to the Great De-
pression.
“I’m cautious about using fire. It can become
• Stock Market Crash of 1929
theatrical. I am interested in the heat, not the
flames.” • Bank Failures: Throughout the 1930s over
9,000 banks failed. Bank deposits were uninsured
- Andy Goldsworthy
and thus as banks failed people simply lost their
savings. Surviving banks were unsure of the eco-
Did the “Black Tuesday of 1929 crash spark nomic situation and concerned for their own surviv-
The Depression?”, or did it merely coincide with
the bursting of a credit-inspired economic bubble?
The issue is still of academic debate. The decline in
stock prices caused bankruptcies and severe macro-
economic difficulties including contraction of credit,
business closures, firing of workers, bank failures,
decline of the money supply, and other economic
depressing events. The psychological effects of the
crash reverberated across the nation as businesses
became aware of the difficulties in securing capital
markets investments for new projects and expan-
sions. The Wall Street Crash is usually seen as hav- al, thus stopped giving new loans. This exacerbated
ing the greatest impact on the events that followed the situation leading to less and less expenditures.
and therefore is widely regarded as signaling the • Reduction in Purchasing across the Board:
downward economic slide that initiated the Great With the stock market crash and the fears of further
Depression. economic woes, individuals from all classes stopped
Some bank failures, no doubt, are also to be purchasing items.
expected. In the circumstances will the banks have • American Economic Policy with Europe: As
any margin left for financing commercial and indus- businesses began failing, the government creat-
trial enterprises? The position of the banks is with- ed the Smoot-Hawley Tariff in 1930 to help protect
out doubt the key to the situation, and what this is American companies. This charged a high tax for im-
going to be cannot be properly assessed until the ports thereby leading to less trade between America
dust has cleared away. Throughout 1930, consumer and foreign countries along with some economic re-
spending continued to decline which meant busi- taliation.
nesses cut jobs thereby increasing unemployment.
• Drought Conditions: While not a direct cause
Countries across the globe were affected and many
of the Great Depression, the drought that occurred
protectionist policies were created thereby increas-
in the Mississippi Valley in 1930 was of such propor-
ing the problems on a global scale. Herbert Hoover
tions that many could not even pay their taxes or
was president at the beginning of the Great Depres-
other debts and had to sell their farms for no profit
sion. He tried to institute reforms to help stimulate
to themselves.
the economy but they had little to no effect. By 1933,
unemployment in the United States was at a stag- What were the lessons learnt from the
gering 25%. The effects of the Great Depression were Black Tuesday & the Present World?

Market declines are often the

long-term investor’s friend
because they provide an oppor-
tunity to buy investments at a
lower price.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 25

 “Experience is a hard teacher because she agreement that the adoption of restrictive trade poli-
gives the test first, the lesson afterward.” cies was destructive and counterproductive and that
- Vernon Law similarly succumbing to protectionism in our current
slump should be avoided at all cost. Lacking other
Cover Story

Commercial and Investment Banks instruments with which to support economic activ-
In 1932, the Pecora Commission was estab- ity, governments erected tariff and nontariff barriers
lished by the U.S. Senate to study the causes of the to trade in a desperate effort to direct spending to
crash. The U.S. Congress passed the Glass-Steagall merchandise produced at home rather than abroad.
Act in 1933, which mandated a separation between The main effect was to destroy trade which, despite
commercial banks, which take deposits and extend the economic recovery in most countries after 1933,
loans, and investment banks, which underwrite, is- failed to reach its 1929 peak, as measured by vol-
sue, and distribute stocks, bonds, and other securi- ume, by the end of the decade (Figure 1). The ben-
ties. After the experience of the 1929 crash, stock efits of comparative advantage were lost. Recrimina-
markets around the world instituted measures to tion over beggar-thy-neighbour trade policies made
temporarily suspend trading in the event of rapid it more difficult to agree on other measures to halt
declines, claiming that the measures would prevent the slump.
such panic sales. The impression one gleans from both contem-
For the vast majority of the 20th century, com- porary and modern accounts is that trade policy
mercial and investment banks in the U.S. were sepa- was thrown into complete chaos, with every country
rated by the Glass-Steagall Act, put into place after scrambling to impose higher barriers.
the stock market crash of 1929. This prohibited banks Figure 2 illustrates this for tariffs. Tariff rates
from accepting deposits and underwriting securities, rose sharply in some countries but not others. The
splitting the industry. While the vast majority of the history of the 1930s would have been very different
effects of the Glass-Steagall act were repealed with
the passing of the Gramm-Leach-Bliley Act of 1999,
it shaped the growth of the financial industry and
is obvious even today, as most banks remain in a
specific field. Now, after the sub-prime the scenario
for the commercial and the investment banks have
changed further, primarily after the crash of Lehman
Brothers.
Panic
Panicking is the last thing you want to do in
a market crash. Market declines are often the long-
term investor’s friend because they provide an op-
portunity to buy investments at a lower price. Base
your investments on principles, not predictions. The
three most important principles are look to the long
term, properly diversify your portfolio, and focus on
good-quality investments. had other countries responded in the manner of,
say, Denmark, Sweden and Japan. It is important to
Protectionism
understand why they did not.
The Great Depression of the 1930s was marked
Figure 3: World trade and production, 1926-1938
by a severe outbreak of protectionism. What do we
know about the spread of protectionism then, and The answer, in a nutshell, is the exchange
what are the implications for today? rateregime and the policies associated with it. Coun-
While many aspects of the Great Depression tries that remained on the gold standard, keeping
continue to be debated, there is all-but-universal their currencies fixed against gold, were more in-

The average P/E (price to

earnings) ratio of S&P Com-
posite stocks was 32.6 in
September 1929, clearly above
historical norms.

26 NIVESHAK VOLUME 3 ISSUE 8 August 2010

clined to impose trade restrictions. tionist fashion.
In contrast, countries abandoning the gold The problem, to the contrary, is that the coun-

Cover Story
standard and allowing their currencies to depreci- try applying the stimulus worries that benefits will
ate saw their balances of payments strengthen. They spill out to its free-riding neighbours. Fiscal stimulus
gained gold rather than losing it. Cutting the curren-is not costless – it means incurring public debt that
cy loose from gold freed up monetary policy. Without will have to be serviced by the children and grand-
a gold parity to defend, interest rates could be cut, children of the citizens of the country initiating the
and central banks no longer bound by the gold stan- policy. The protectionist danger is still there, in other
dard rules could act as lenders of last resort. words but, insofar as the policy response to this
Exchange rates slump is fiscal rather than just monetary, it is the
active country, not the passive one that is subject to
The exchange rate (foreign-exchange rate or the temptation.
FOREX rate) between two currencies specifies how
much one currency is worth in terms of the other. It
is the value of a foreign nation’s currency in terms
of the home nation’s currency. This finding has im-
portant implications for policy makers responding to
the Great Recession of 2009. The message for today
would appear to be “to avoid protectionism, stimu-
late.” But, how? In the 1930s, stimulus meant mon-
etary stimulus. The case for fiscal stimulus was nei-
ther well understood nor generally accepted.

Figure 3: Average tariff on imports, 1928-1938, percent-

age
Today the problem is different because the
policy instruments are different. In addition to mon-
etary stimulus, countries are applying fiscal stimulus
to counter the Great Recession. Fiscal stimulus in
one country benefits its neighbours as well. The di-
rect impact through faster growth and more import
demand is positive, while the indirect impact via
upward pressure on world interest rates that crowd
out investment at home and abroad is negligible un-
der current conditions. When a country applies fiscal
stimulus, other countries are able to export more to
it, so they have no reason to respond in a protec-

Today the problem is different

because the policy instruments
are different. In addition to
monetary stimulus, countries
are applying fiscal stimulus to
counter the Great Recession.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 27

 The L S T Decade
Cover Story

Jaideep Singh & Ashish Kumar Rander

In the midst of recov-
ery phase from crisis
of 2008, the author
draws a parallel with
the much similar lost
decade of Japan
and elucidates the
key learning from
this.
MDI, Gurgaon
After World War II, Japanese
economy recovered very rapidly and
achieved a record economic growth,
which was mainly due to investment
by United States and partly due to
economic interventionism shown by
Japanese government through their
Ministry of International Trade and
Industry (MITI).
The main characteristics which
differentiated Japanese economy
during this time, called “economic
miracle”, were the cooperation of
various closely knit groups called
keiretsu; strong enterprise unions;
good relations with government bu-
reaucrats; and guarantee of lifetime
employment provided in large cor-
porations and unionized blue-collar
factories.
The period of boom between
1955 and 1961 made the way for
“Golden Sixties” – the decade asso- The Lost Decade
ciated with the ‘Japanese economic
miracle’. From 1983 – 1992, Japanese
economy grew at a CAGR of around
3.8%.
Formation of Asset – Pricing
Bubble
The Japanese asset bubble re- tempts to restore the financial sec-
sulted in a 51% average growth rate tor’s health, which failed and a de-
in housing prices and 80% increase cade of stagnant growth started.
in commercial property values from
1985 – 1991. This rapid growth creat-
ed overconfidence in market which
was not prepared for any kind of cor-
rection. Since the peak, asset values
have fallen over 40% (as of 2008).
Mainly due to export boom in
1970s, there was a huge amount of
capital inflow and investors were
looking to cash in on this opportuni-
ty by having a stake in the country’s
growing role in the World Financial
System. During the boom, individu-
als as well as firms had built up large
pool of savings and started investing
these resources in real estate. This
rapid rate of investment increased
the value of land, buildings and oth-
er investments exponentially, which
encouraged even more investment,
which in turn led to speculation in
belief that values, and hence re-
turns, will keep on increasing.
This appreciation of asset
prices made Japanese banks bor-
row money from foreign markets.
This sum was lent throughout the
Japanese economy. By 1991 Japanese
banks had reserves of only 3 trillion
yen to cover the 450 trillion yen they
had lent out.
At the close of this boom dur-
ing the 1980s, collapse in house and
stock prices did hit the Japanese fi-
nancial sector very badly, leaving
the banks weighed down with bad
loans. There were a number of at-
Japan’s meltdown started with

The main characteristics which differentiated Japanese economy during the “economic miracle”
were the cooperation of various closely knit groups called keiretsu; strong enterprise unions; good
relations with government bureaucrats; and guarantee of lifetime employment provided in large
corporations and unionized blue collar factories.

28 NIVESHAK VOLUME 3 ISSUE 8 August 2010

bursting of twin asset bubbles. Rising real estate
and stock prices, coupled with financial liberal-
ization, encouraged banks to go for risky lending.
Banks outsourced credit checking to different moni-
toring agencies that reported to Sales departments
who had been given aggressive targets. With asset
prices soaring and credit growth rising at a very
rapid pace, tax regulations, coupled with high level
of competition among various financial institutions,
led to advances being made on the basis of expecta-
tions of asset appreciation rather than cash flow ex-
pected from the borrower. During these years, banks
were writing mortgages which were having elevated
loan-to-value ratios. Even lending to businesses was
negligent with some companies using stock as col-
lateral to get bank loans. As and when house and
share prices fell, many loans went delinquent.
To cope with the growing volume of NPAs on
their balance sheet, banks started issuing debt to
raise capital and started making even riskier loans
to protect their margins. Regulators failed to provide
any kind discipline, due to the fear that this might
lead to collapse of some major financial institutions.
This caused a slowdown in credit growth as banks
swept their nonperforming loans under a rug.
Steps taken to revive the economy
Financial regulators were slow to respond to
the crisis. Being careful with policies which led to
failure of regulators to punish poor performers al-
lowed spread of ‘zombie firms’, referring to the in-
stitutions which did not go bankrupt, because of
guarantees provided by government, but were in a
situation where they were unable to lend as their
balance sheets were crowded with NPAs. Japanese,
being wary of banks, started taking money away
from Retail Banks, the advantage of which was taken
by Japan’s Postal Services Agency, which took depos-
its but did no lending. This movement of funds put
further pressure on the credit growth, constraining
firms’ access to credit and limiting their expansion
plans.
To try and stimulate credit growth, the Bank
of Japan started cutting rates, but very gradually as
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
shown in graph. It is questionable whether more ag-
gressive moves would have helped in stimulating
Cover Story
credit growth, since retail banks had to struggle a
lot in order to attract any deposits from Japanese
during the lost decade, limiting their ability to in-
crease lending. Also, in addition to this, demand for
new loans was affected by a long period of defla-
tion, which increased the actual interest rates, hurt-
ing borrowers.
Even the regulatory and fiscal reforms were de-
layed. After years of questioning over using public
funds to bail out banks, Japan’s parliament finally
passed a huge bank rescue package (costing ¥60
trillion) in October’1998 and proposed to use these
funds for three major purposes.
Almost half of the funds were used to recapi-
talize banks that were considered weak but solvent,
while the remaining amount was for liquidation of
insolvent banks and full deposit protection was pro-
vided for account holders in these institutions.
Unfortunately, this approved package did not
lead to any recovery of the banking system. Total
spending was only ¥10 trillion, with most of which
was used to bring up ailing institutions rather than
to eliminating ‘zombie banks’. Apart from less
spending, the method of attempting to buy bad as-
sets was not able to identify actual problem and was
not aimed at closing insolvent banks. Eventually, it
became unsustainable to fund the banks and finally,
consolidation took place, which resulted in only four
national banks being left in Japan.
Lessons to be learnt from the Lost Decade
• Importance of Monetary Policy –Monetary pol-
icy acts as one of the most important tools in the
hands of the government to avoid a Japanese-like
situation. But the actions should not be limited only
to change in interest rates and money supply, but
disposal of failed banks and debtors is also neces-
sary. In Japan, the Ministry of Finance (MOF) ordered
banks to hide their failure to put off the clearing of
bad loans. So, banks continued window dressing of
their accounts supported by the MOF.
• If the failure of bank/firm can’t be avoided, the
sooner it is accepted and disposed, the better it is
for the economy. The Japanese government refused
to accept the failure and continued to pump-in
money into loss making firms to help them survive,
which led to increase in Gross Bad Loans from 12 Tril-
lion Yen in 1992 to 100 Trillion Yen in 2003.
• Fiscal Policy is not very effective –Japanese
government repeatedly tried to rescue the economy
by infusing emergency fiscal stimulus, which result-
ed only in increase in amount of government deficit,
to 180% of GDP. As many banks and companies were
insolvent, the money supplied by the government
29
 was used to make up ‘zombie firms’ which looked
alive but in fact were dead.
• Consistency in Tax Policy – The Japanese gov-
ernment gave a tax cut through reduction in income
Cover Story
tax in 1994. This helped in stimulating economic
growth. But, from 1994 to 1995, Japanese economy
began experiencing modest growth partially. Defla-
tion in 1995 led to reduced government revenues. In
an effort to stem surging debt, the consumption tax
was increased from 3 percent to 5 percent in 1997,
which slowed down the economy again. Again the
government gave a tax cut spread over two years
from 1998 to 1999. Such inconsistency in the tax pol-
icy, especially the rise in the consumption tax gave
a severe blow to the efforts of the Japanese govern-
ment to revive the economy.
• Ease money promptly after the crash – Since,
Bank of Japan (BOJ) failed to stop the bubble, it
did not change its very tight monetary policy after
the bubble burst in January’1990. It was only after
July’1991, that the BOJ eased the monetary policy.
They were too cautious as they were afraid of a sec-
ond bubble. As a result of this, real estate as well as
stock prices fell to less than one-fifth of their peak.
• Government should not Bailout all the Sick
Banks – Japanese government made a mistake of
giving cash bailout to sick banks and companies to
prevent their collapse but this only aggravated the
situation as the banks and companies had no incen-
tive to improve their balance sheet by themselves. It
was only in 2002 that an economist, Heizo Takenaka,
became Minister in charge of Economy and Finance.
He changed the “soft landing policy” of his prede-
cessors and said “I don’t think there are too big
banks to fail” in an interview. This aroused a panic
among bankers and so they stopped postponing the
Japanese, being wary of banks, started taking money away from retail Banks, the advantage
of which was taken by Japan’s Postal Services Agency, which took deposits but did no lending.
This movement of funds put further pressure on the credit growth, constraining firms’ access to
credit and limiting their expansion plans.
30 NIVESHAK VOLUME 3 ISSUE 8 August 2010
disposal of bad loans.
• Effectiveness of Interest Rates – The interest
rate is not very effective under deflationary condi-
tions, but money supply can help in restructuring
the economy in such conditions. The Bank of Japan
made the interest rate zero in 1999, which did not
improve the crisis, because the real interest rate
was still high due to deflation. Since 2001, the Bank
of Japan began the quantitative easing policy that
supplied huge amount of money, which helped the
banks and companies restructure themselves more
easily.
• Political Leadership – The biggest problem
faced by Japan in reviving its economy was lack of
good political leadership. The political leaders were
hesitant to take drastic steps to revive the economy.
They only wanted to show people that they were
trying to revive the economy and retain the votes.
Heizo Takenaka, Minister-in-charge of Economy and
Finance, was one of the few to take the hard deci-
sions which were necessary for the revival.
US Financial Crisis and the Lost Decade
The US Financial crisis is quite similar to Japa-
nese lost decade. Economists like Krugman fear that
US might be going in the direction of Japan. Both the
meltdowns started in much the same way – with
busted stock markets and real estate bubbles. With
both the United States and Japan, the market ma-
nias were initiated due to loose credit policies, con-
tinued under the lack of oversight from government
regulators, market analysts or such private-sector
sentinels as credit-rating agencies, and were finally
resulted into a frenzied financial conflagration by
the promise of easy profits.
So, USA should take lessons from Japanese
Lost Decade and should avoid the same mistakes
that were made by the Japanese Government. The
US Government took a step in the right direction by
not bailing out all Sick Companies and creating a
fear in the companies to improve their operations
with the help of the Lehman example. Also, quick
action on the part of the Federal Reserve helped US
to avoid the Japanese-like situation but still there is
a need for them to realize that they are not yet out
of trouble and should keep in mind the learning’s
from the Japanese Lost Decade.
 e n c y B o a r d s
e p t a n c e o f Curr
Ac c
What is currency board?
A Currency Board Arrangement
(CBA) is a form of fixed exchange
rate regime where complete conver-
sion of the domestic currency into
chosen reserve currency is guaran-
teed by monetary authority at fixed
rate. Board’s liabilities are backed
entirely by foreign currency reserves
and money supply is endogenous-
monetary base is determined by
foreign exchange reserves. Currency
reserves are maintained at around
110-115% of monetary base (M0).
Primary reason for adopting CBA is
to bring credibility to monetary pol-
icy-lower inflation and maintenance
of exchange rate (no unexpected de-
valuation of currency).
Unlike central banks, currency
boards have no discretion in mon-
etary policy. They do not determine
money supply or interest rates. Since
board maintains an absolute peg
with reserve currency, interest rates
and inflation of domestic country
closely follow anchor country with
interest rate differential representing
currency and country specific pre-
mium (covering risks from possible
lack of liquidity, term structure and
default risk) and expected devalua-
tion (if CBA is abandoned) (Mollen-
tze, 2002)
Normally, CBA assumes free
capital mobility for reserves to have
direct link with changes in money
demand. Also currency board can-
not hold domestic assets. Hence it
cannot grant loans to government.
In certain cases (e.g. Bulgaria and
Lithuania), it holds government de-
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
Cover Story
Nirmal Sharda
IIM Ahmedabad
posits. But it is considered a major
deviation from standard currency Milestones of the last
board arrangement since it disturbs century won’t be
the direct link between changes in complete without a
the balance of payments and mon-
etary base. (Hanke and Sekerke,
mention of currency
2003). boards. The author
CBA have various forms. In through this article
its most extreme form, there is no talks about currency
central bank and money supply de- boards, its history,
pends completely upon changes in
reserves. A more prevalent model advantages and
is a combination of currency board finally concludes the
and central bank where ultimate re- article with a case
sponsibility for maintaining fixed ex-
study on Argentin-
change rate, automatic convertibility
and long-term policy rest upon cur- ean crisis.
rency board.
History of currency board
The first currency board was
established in Mauritius in 1840 (un-
der British rule). At one point, there
were over 70 currency boards across
British Empire. Primary purpose of
colonial government for using CBA
instead of pound sterling currency
was to keep seigniorage income.
(Williamson 1995:5) Popularity of cur-
rency boards lasted till 1950s when
there were over 50 currency boards
worldwide. Despite their exceptional
historic performance (fewer specu-
lative attacks and rare instances of
their failure), during decolonisation
period, newly independent coun-
tries, perceived them as symbol of
colonisation and chose to adopt in-
dependent monetary policy (Ghosh
et al 2000) By 1980s fewer than 15
currency boards remained.
The first modern currency
Unlike central banks, currency
boards have no discretion in
monetary policy. They do not
determine money supply or
interest rates.
31
 board was introduced in Hong Kong in 1983 when
it pegged its currency to US Dollar. During the 1990s
several transition countries introduced currency
boards following macroeconomic imbalances (ex-
Cover Story
pletely solves the time-inconsistency problem since
no surprise monetary actions are possible. Standard
peg system does not solve this problem because
they have relatively easy escape route. Ghosh et al

cept Lithuania) including Argentina (1991), Estonia (2000) find evidence for ‘credibility effect’-lower in-
(1992), Lithuania (1994) and Bulgaria (1997). Major flation for a given increase in money supply in case
proponents of currency boards were Steve H Hanke, of CBA.
Lars Jonung and Kurt Schuler. Since the only theoretical difference be-
Advantages of currency boards tween the interest rates in domestic country and
anchor country is currency and country specific risk
Oliva et al (2001) provide evidence that his-
premium and expected devaluation, a reliable CBA
torically inflation and money growth was on aver-
allows convergence of their interest rates and do-
age lower while GDP growth was higher in currency
mestic interest rates remain close to international
board economies. (Table 1) Ghosh et al (2000) also
level. (Mollentze, 2002)
found the same results and further explained that
the inflation difference reflects both lower growth Advantages of CBA also relate to optimum cur-
rate in money supply (‘discipline effect’ ) and lower rency area theory. This approach eliminates un-
inflation for a given amount of money growth rate certainty of floating exchange rate among member
(‘credibility effect’). countries and facilitates economies of scale. (Salva-
tore 1998:656) An optimum currency area has great-
No of Mean Me- Mean Me- Per Govt. er price stability because random shocks in different
ob- infla- dian M2 dian cap- bal-
serva- tion infla- M2 ita ance regions tend to cancel out each-other. It also saves
tions tion GDP (% of costs of official interventions in foreign exchange
GDP) markets. But CBA might be fragile in case of price/
cur- 112 5.6 3.9 12.1 11.1 3.1 -2.7 wage rigidity to adjust to shocks or asymmetric real
rency shocks across member countries. (Goldberg, 1999)
board
other 1,089 22.3 8.4 25.1 13.7 0.9 -4.6 Disadvantages of currency boards
Float 714 43.1 9.2 47.4 16 1.7 -4.3 A typical criticism of currency boards is that
Full 1,915 29 8.4 32.7 32.7 1.3 -4.4 they impart a deflationary bias to growing econo-
sam- mies as money supply might not corroborate to in-
ple
creases in money demand. Excess demand for mon-
Oliva, Luis A, Batiz, and Amadou ( 2001), Discipline, Sig- ey-coupled with an unresponsive money supply-will
naling, and Currency Boards result in aggregate demand for goods lagging behind
CBA impose restraints on the fiscal and mon- production capacity causing decrease in prices and
etary policy of government and bring credibility to capacity remaining unutilized. But in light of em-
its commitment towards lower inflation and main- pirical evidences, deflationary bias hypothesis was
tenance of exchange rate. Buiter (2000) supported discarded by 1990s. Schuler reported that historic
fixed exchange rate system for small economies inflation under CBA-although lower than under cen-
primarily for its credibility factor. Throughout world, tral banks-is “substantially positive” and economic
CBAs have been applied successfully in crisis situa- growth was higher.
tions like high-inflation and stagflation (e.g. Argen-
Treadgold (2006) lists three reasons that in-
tina, Estonia, Lithuania, and Bulgaria) and banking
hibit deflationary bias: 1) access to overseas funds
crises (e.g. Estonia in 1997/98. Their impact during
through international banks during economic growth
1997-98 East Asian crisis has been to moderate in-
2) Increase in the money multiplier due to decline in
crease in interest rates and minimize its volatility,
currency people hold in increased money supply (ev-
thereby averting banking crisis. (Oliva et.al. 2001)
idence provided by Hawkins from Nigeria and Gha-
Furthermore, historically, CBAs faced fewer specu-
na) and declines in reserve/deposit ratios of banks
lative attacks and ‘virtually no involuntary exit’.
( no minimum reserve requirements) 3) increase in
(Ghosh et. al. 2000)
velocity of money with increase in economic growth
Oliva et al (2006) use a two-period-model to due to income inelastic nature of money demand
compare signalling power of CBA with standard peg. and availability of more liquid assets.
They assume a longer term commitment in case of
currency board than standard peg and prove that Disadvantages of currency board arrange-
when expectations on inflation are formed, it is pub- ment
lic information whether the currency board will still One major disadvantage of CBA is that mon-
be in place in the next period. Hence, CBA com-

32 NIVESHAK VOLUME 3 ISSUE 8 August 2010

etary policy fails to adjust to domestic circumstanc- Banking system should be able to absorb temporary
es. Government cannot use monetary policy to fight interest rate shocks.

Cover Story
against recession or unemployment. Furthermore Lastly, country should have stable terms of
currency board system transfer external shocks di- trade because the real exchange rate adjustment
rectly into system. needed to accommodate shock is more quickly
Currency boards limit money supply to avail- achieved through nominal depreciation. Foreign
ability of foreign currency reserves. A country might trade basket should be well-diversified.
not have sufficient reserves to match money de-
mand. It will cause interest rates to rise at exorbi- Case study- Argentinean crisis (1999-2002)
tant levels triggering bankruptcies. Though increased Despite the popular opinion about the failure
interest rates will ultimately increase foreign capital of currency board in 1999-2002 Argentinean crisis,
inflow (hence money supply), banks might fail in academic community attribute it to inappropriate-
early stage itself specially if there are broader finan-ness-and not failure-of CBA. Argentina failed to meet
cial or political factors affecting investor confidence.the essential pre- conditions for cur-
Also currency boards cannot act as lender of last rency board. During
resort. It makes commercial banks more 1999-2001, Argentin-
vulnerable to panic at- ean peso faced a
tacks. sharp appreciation
CBA is vulner- (pegged to USD)
able to speculative with simultaneous
attacks. During Argen- depreciation in
tina crisis (1994-95) and Brazilian Real re-
Hong-Kong crisis (1997- sulting in loss of
98), speculative attacks competitiveness
caused large capital out- of Argentinean
flows resulting in high in- exports. Also,
terest rates. (Roubini 1998) both Europe
In August 1998, Hong-Kong and Brazil had a share more
monetary Authority had to than double than US in Argentinean exports.
intervene actively to defend its cur- Clearly, its peg against Dollar didn’t fit well with its
rency peg from devaluation. trade structure. Argentina also failed to maintain fis-
cal prudence and in 2000, its external debt reached
Prerequisites for currency board as high as 52.6 percent of its GDP from 33 percent in
Domestic business cycles must synchronise 1994. Lastly, Argentina had rigid labour markets and
with anchor country and anchor country must have wages failed to adjust downwards in response to
a strong share in the foreign trade of domestic coun- adverse terms of trade.
try. Another requirement is flexible wages/prices as
sticky wages/ prices might cause constant overvalu-
ation of currency (since nominal exchange rates can-
not adjust) in case of high inflation.
Gidlow (2000) underscores political willingness
for currency board’s ability to impose fiscal disci-
pline. Government must be willing to give away its
focal and monetary flexibility in favour of credibility
and stability.
Country should have a financial system with
adequate supervision since interest rates fluctuate
significantly in response to changes in capital flows.

CBA is vulnerable to specula-

tive attacks. During Argentina
crisis and Hong-Kong crisis,
speculative attacks caused
large capital outflows resulting
in high interest rates.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 33

 Speaketh
Story

Dr Paul Shrivastava
Director, David O’Brien Center for Sustainable Enterprise, Concordia University
Cover

Paul Shrivastava, Ph. D. is the David O’Brien Distinguished Professor of Sustainable En-
terprise, and Director of the David O’Brien Center for Sustainable Enterprise at the John
He

Molson School of Business, Concordia University, Montreal.

Dr Shrivastava has over 25 years of experience in management education, entrepreneurship,
In this interview Dr and as a consultant to major multinational corporations. He has launched several entrepre-
neurial ventures. In 1998 he founded and till 2004 was President and CEO of eSocrates,
Paul Shrivastava
Inc., a knowledge management and online training/education software company based in
talks about the
AoM

Allentown, PA.
ecological cost of Dr Shrivastava received his Ph. D. from the University of Pittsburgh. He was tenured As-
the unsustainable sociate Professor of Management at the Stern School of Business, New York University. He
industrialization has published 15 books and over 100 articles in professional and scholarly journals.
taking place on our
planet. Financial Niveshak: Sir, our readers would like global warming. So the question is
Perspective

to know something about the initia- how to go about controlling carbon

Services industry tives that you have undertaken in the emissions. One of the ways of con-
being the chief pro- fields of sustainability and finance. trolling carbon emissions is pricing
vider of capital to carbon. So you can price carbon by
Dr Shrivastava: We have started a Cen-
these industries can ter at John Molson School of Busi-
putting a tax on carbon emissions
or you can create a cap and trade
persuade them to ness, Concordia University called the type system that encourages com-
switch to more eco- David O’Brien Centre for Sustainable panies to move away from carbon
friendly processes, Enterprise. We are running several re- emitting technologies. This means
search programs, the most important
helping them be- changing everything we do. We have
FinGyaan

of which deal with trying to make sus-
come more competi- tainability a main concern for major
tive and efficient in corporations in the financial services
the process. industry. This brings together a group
of finance managers from the largest
banks, insurance companies, portfolio
managers and financial consultants in
a round table discussion to explore
how sustainability can be incorporat-
ed into business models in the finan-
FinSight
to focus on the ecological footprint
of every single process involved and
then try to make it less carbon in-
tensive. So this will require huge
investments in technology, energy,
production, logistics and infrastruc-
ture. And since banks and insurance
companies have financial exposure
in all of these industries, they need

to understand the future risks and

cial sector. There are two main driv-
ers of sustainability in finance. One is
global climate change and the other
is the increasing loss of biodiversity.
Both these drivers create financial
imperatives. With regard to climate
change there is a lot of scientific data
that due to the kind of industrializa-
tion and the level of energy consump-
tion that we are doing (mostly fossil
fuel based) we are dumping too much
carbon in the earth’s atmosphere and
this is not a sustainable thing. So
there is a concern that if we don’t put
a price on carbon, then there will be
liabilities of carbon, how to price the
risks and how to change their busi-
ness models. So that’s what our ini-
tiative is trying to understand and
develop. The second driver of sus-
tainability in finance is ecosystem
bio-diversity. Various industrial pro-
cesses are causing tremendous loss-
es in bio-diversity. There are many
industries which are dependent on
natural resources such as extractive
industries, - mining, minerals, oil,
and forest products industries which
depend on wood for paper and pulp.
Even agriculture can be bracketed

34 NIVESHAK VOLUME 3 ISSUE 8 August 2010

along with the above mentioned industries. So all
these industries that are very directly linked to natu-
ral resources are now realizing that the cost of eco-
systems services that is being lost is actually very
large. It is several times the global GDP. We don’t
know how to actually price biodiversity losses and
this science is still developing. But the concern is
that over another five to ten years the measurement
of these costs is going to become pretty robust. Then
people will insist that somehow the companies bear
those costs. I will give you one example, the BP Oil
spill. BP is saying the cost of the spill will be the lost
income of the fishermen and the pollution which
would come to something around 3 to 4 billion dol-
lars. They have allocated up to 20 billion dollars for
the clean up and recovery from this spill. And this
is something that they can easily absorb. But an NGO
has done a study about the ecosystem services that
are now going to be lost because the Gulf and Mis-
sissippi River delta are highly polluted and they put
the bill for clean-up and full recovery at 1.3 trillion
dollars. Their United Nations Environment Program
has done a very good economic and scientific study
called ‘The Economics of Ecosystem Biodiversity’ to
show this. The study says that every ecosystem is
providing large quantities of free services. If we take
the rain forests, the main value of rain forests is not
in the trees but in the aquifer that underlies the rain
forests that provides water to 300 million people in
Argentina, Brazil and Chile. So if you cut the rain for-
ests, you lose the trees and you can price that, but
what about the water that will disappear because
there are no trees on top? So this kind of knowledge
about bio-diversity that is starting to emerge is go-
ing to increase the cost of all extractive and natural
resources based industries by an estimated 15 to
20% at a minimum. This means many of the projects
that are currently funded under a set of assump-
tions wouldn’t be valid anymore. So if you combine
global climate change and biodiversity, you see the
emergence of a whole different kind of economics
- call it low carbon economics. I am working on a
book to be published next year by Greenleaf Press
about managing carbon crisis from a corporate per-
spective. The program that I am doing here basically
aims to help the financial services industry under-
stand the phenomenon of sustainability and then
change their business models and continue to grow
..
If a bank invests in a power plant utility company which uses 90% coal and oil, then the bank
can make a suggestion that the oil is going to become progressively more expensive and the
carbon footprint of oil is high.
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
and become more competitive.
He
Cover
Niveshak: Do you focus on all the sectors which
could add to carbon footprints or is there any par-
Speaketh
ticular sector that you have identified?
Story
Dr Shrivastava: We are not focusing on any one sector
in our program. But there are a couple of sectors
that are going to become more important. One is
renewable energy and the other is what we call the
carbon markets. Carbon credits have been around in
the European Union markets for the last 5-6 years.
Following these trends, other countries are putting
AoM
up large carbon trading exchanges as well.
Niveshak: Can you tell us something about how you
actually go about measuring the cost of carbon foot-
print that is out there in the environment?
Dr Shrivastava:The key questions are how to measure
the cost and who should pay for the cost. There are
Perspective
several methodologies that have been developed
to measure the ecological footprints of various in-
dustries. In highly industrialized countries which in-
clude Europe, United States of America and Canada,
there are government and private databases (such
as TruCost, Globe Scn, GRI etc.) that are tracking and
measuring the carbon footprints and ecological per-
formance of companies. The measures may not be
perfect as of now, but there is enough understand-
ing in this regard. The bigger challenge is to figure
FinGyaan
out exactly who pays for the extra costs of doing
business in a more sustainable manner. The consen-
sus right now is that the industrialized or developed
countries should bear most of the economic bur-
den and develop and transfer the technologies to
developing countries because developing countries
still need to continuously expand their economies
to meet the minimum needs of their own people.
The developing countries are willing to invest money FinSight
into it but their demand is more transparency on
how the money is spent. They want the developing
countries to follow some disciplines on their own
economies. This is where the current disagreement
lies. This is what led to the failure of the Copenha-
gen talks where all the nations gathered to come up
with a climate treaty but failed because they had
no agreement on how it was to be implemented.
But we expect a better understanding between the
35
 countries in the next two to four years about how compound and managers are still struggling to find
the money can be transferred in a way that every- a good methodology. Though there is a lot of innova-
body feels it is being used effectively in controlling tion taking place, there is no norm established yet.
He Speaketh

carbon emissions.
Niveshak: How pertinent is this for a sector like Fi-
nancial Services which doesn’t have much of carbon
footprints?
Dr Shrivastava: Financial Services doesn’t have direct
carbon emissions although one could argue that they
have huge exposure to it. For example, let us look at
the Swiss Banks which are probably the world’s larg-
est banks and are making investments all over the
world, into mining companies, real estate and power
projects. And all their clients’ portfolio is at risk now
due to the hidden carbon costs which they don’t
fully understand. So their direct footprint is not very
high but their indirect exposure to carbon risks re-
mains extremely high. If a bank invests in a power
plant utility company which uses 90% coal and oil,
then the bank can make a suggestion that the oil is
going to become progressively more expensive and
the carbon footprint of oil is high. So it would be
better if they design a strategic plan in which they
put in at least 20% renewable and then move to
50% renewable so that their carbon exposure of the
utility company and hence that of the bank gets re-
duced over time. Similarly financial companies need
to comprehend the risks involved in the loss of bio-
diversity being caused by their client’s operations.
Niveshak: Are there any particular international
standards or procedures by which the banks can
judge how sustainable those companies are in which
they are investing their money?
Dr Shrivastava: There are no widely accepted norms
and standards yet, but there is a lot of research
being done about what the carbon risks are. The
Global Reporting Initiative (GRI) puts up some re-
ports on sustainability performance. Besides, there
are sustainability indices that are now being created
for publicly traded companies on stock exchang-
es like the New York Stock Exchange and Toronto
Stock Exchange. Dow Jones has a sustainability in-
dex. There are sustainability indexes at a national
level too that measure the sustainability of entire
economies. There is a lot of data that is starting to
Niveshak: What are your thoughts about inculcat-
ing sustainability in the value chain of the company?
Dr Shrivastava: This is more along the lines of what
our center is doing, trying to view the enterprise
as a set of vision, inputs, throughputs and outputs.
And in each of these four elements of the enterprise,
there is opportunity for extracting eco-efficiencies.
On the inputs side, there is energy and raw ma-
terials that companies can economize on. On the
throughput side, cost cutting can be done in logis-
tics, transportation, inventory and production sys-
tems. On the output side which is products, eco sen-
sitive products and ecologically sensible packaging
can be designed. In everything that organizations do
today they have ignored the idea of eco efficiency.
They have focused largely on labor efficiencies and
to some degree on financial efficiencies. The onus
now is on the shoulders of the management to fo-
cus on eco efficiencies and there is a huge amount
of potential and opportunity to do this in a way that
makes the company competitive.
Niveshak: What would be your message to the stu-
dent community? In what direction should we pro-
ceed to enforce the vision of sustainability?
Dr Shrivastava: Sustainability is better understood by
the student generation today than by the previous
generations. Leadership has to come from your gen-
eration because it is you who will inherit this world.
Even if you see institutions and organizations react-
ing slowly to the call of sustainability, you as stu-
dents should take leadership and distinguish your-
selves by doing projects in the area of sustainability.
A green orientation or sustainability orientation that
is very much required in the future can also make
you more competitive in the job market.

We are running several research

programs, the most important of
which deal with trying to make
sustainability a main concern
for major corporations in the
financial services industry.

36 NIVESHAK VOLUME 3 ISSUE 8 August 2010

 Stress Tests... Unlocked
Rishabh khandhar & Deep mehta
IIM Shillong
Recently the EU stress tests D: Committee of European
have been in the news and we will Banking Supervisors (CEBS) in close Stress Tests are the
help you make sense of it. Read on cooperation with the ECB, the Euro- buzz word these
pean Commission and participating days with the PIGS
national supervisory authorities of economic crisis tak-
Rishabh [R]: Hi, I have a ques-

Tete-a-Tete
respective nations, has developed
tion which has been bothering me
the methodology and identified the
ing the headlines.
quite a lot these days, are you free? With such tests be-
common assumptions for the entire
Deep [D]: Yeah sure, carry on. exercise. ing used seldom but
R: What exactly are these EU R: How exactly is this done? being associated
stress tests? What does it mean? Can you elaborate on the methodol-
Why? How? with huge impor-
ogy followed?
D: Hold on! One question at a tance, has made
D: They have developed a
time. EU stress tests are designed to simulation model where in the as-
these tests quite
show whether banks have enough sets and liabilities of the bank are mysterious. These
capital to cushion their losses in a fed in the system depending on tests need to be
number of different scenarios, in- what the banks have disclosed in
cluding the deterioration of the Euro- unlocked and this
the last filings. This simulator then,
pean economy or renewed problems runs tests to determine the present
interview-cum-article
coming up with sovereign debt. The value of all the bank holdings - be deals out on the
EU banks are being tested on wheth- it bonds, houses owned, collaterals various aspects of
er they can withstand a shrinking etc. by considering factors such as
economy and a drop in the value of
the stress tests in-
unemployment, GDP, bad loans and
government bonds. cluding the historical
sovereign debt.
R: So it’s done for all the banks perspective.
R: Wait, wait, wait...What ex-
across EUROPE? Won’t that be diffi- actly is this sovereign debt? What is
cult? a bad loan?
D: Not exactly. Lenders that ac- D: All the countries take loans
count for 65 percent of the EU bank- from other countries, banks in order
ing industry comprising 91 banks to fund their activities so as to sus-
will be tested, including 14 German tain the growth. Sovereign debts are
banks, 27 Spanish savings banks, the liabilities that government of a
6 Greek banks, 5 Italian banks, 4 country owes to other governments
French banks and 4 British banks. or central banks of other nations.
The European Union has 27 nations, Recently you must have heard that
but no banks from Bulgaria, Czech countries like Greece have defaulted
Republic, Estonia, Latvia, Lithuania, on the loans they have taken and
Romania or Slovakia are being test- as a result had a tremendous im-
ed. pact on the banking system of other
R: Who is handling all these? countries which had financed these

EU stress tests are designed

to show whether banks have
enough capital to cushion their
losses in a number of different
scenarios.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 37

 loans, which now have a low chance of being repaid
and hence have turned bad.
R: Is this method full proof? Can it be credible?
D: Let me tell you about the assumptions that
have been taken. Regulators have told lenders the
tests may assume a loss of about 17 percent on
Greek government debt, 3 percent on Spanish bonds
and none on German debt. It predicts the EU econo-
my will grow by 1 percent this year and 1.7 percent
in 2011.
Yes, I do agree that regulators are underesti-
mating probable losses on government bonds.
Tete-a-Tete
R: What if a bank fails the test? Does it mean
it is bankrupt?
D: Not at all. It would be superficial to use
this stress-test as an indicator of the stabil-
ity of individual European banks.
A bank that failed this
test is by no means
insolvent. The results
of the stress test pro-
vide information as to
whether a bank would
remain sufficiently capi-
talised in case the shock
as described in the test
would occur, not necessar-
ily that this will likely occur
given the current macro-eco-
nomic circumstances. More-
over failed banks will receive
government help to prepare
them for the future.
R: So which banks failed? What is
happening to them now?
D: Till date 7 EU banks have failed the tests
out of which were five Spanish cajas (unlisted sav-
ings banks), Germany’s Hypo Real Estate, and the
Agricultural Bank of Greece. The finances of the cajas
were hit by the collapse of a Spanish construction
and property boom, while the German banks made
oversized bets on global financial markets before
the 2008 meltdown. They have failed to maintain a
minimum 6% Tier-1 capital ratio.
R: What? What?
There is also concern among
some analysts that different
countries could use different
methods to test their banks,
adding up to the confusion.
38 NIVESHAK VOLUME 3 ISSUE 8 August 2010
D: In simple terms Tier-1 capital ratio is the
core measure of a bank’s financial strength. It is
composed of core capital which consists primarily of
common stock and disclosed reserves (or retained
earnings) among other things.
R: But I have heard that there is a lot of criti-
cism about the tests globally. Why is that happen-
ing? Is there something wrong with these tests?
D: The first thing investors should remember is
that there is no unified regulator in Europe as is in
many other major economies or zones. There is also
concern among some analysts that different coun-
tries could use different methods to test their banks,
adding up to the con- fusion. The 25 EU member
states set their own prudential stan-
dards and capital rules,
and even have their own
accounting rules to boot.
Unlike in the U.S., where
authorities have been
regulating banks on a
national basis for de-
cades, in the EU such
a regime remains a
future goal. Experts
believe regulators
should be apply-
ing a 20 percent
haircut on Greek
bonds and 7 per-
cent on Spanish debt
which would be more realistic.
Even the IMF has now lined up among
those who criticize the EU’s stress tests. In a “health
check” report, the IMF recommends full disclosure
of stress test results to guarantee credibility of the
tests.
R: So for a normal investor like me what do the
results signify?
D: First please understand that it is a hypo-
thetical test done and is a possibility in the future.
Anyways, answering your question, it depends
on your relationship with one of the banks that
needs more working capital.
• If you have an account at one of the banks that
failed the stress test, your money is safe as long as
the bank does not declare bankruptcy.
• If you have a credit card from one of the trou-
bled banks, you need to watch the terms of your
credit card. All banks are reducing their credit risk
and trying to raise money in any which way they can
and so your bank may raise your credit card interest
rate and/or fees. You need to be updated with any
such thing.
• If you have a mortgage loan with one of the
troubled banks, the stress test results probably
means very little as long as your financial well-being
lead to many banks failing it. So, some banks fail-
ing would seem realistic. For the banks that have
passed the test, they would be more willing to lend
to each other. And the solid banks could sell bonds
to raise money that they could in turn lend to busi-
nesses and consumers, promoting economic growth.
Regarding the flaw, disclosing the methodology so as
to make the process more transparent would have
surely made the tests more credible. But this is lack-
ing here. Also, Tier 1 capital, which includes hybrid
debt and other non-equity instruments, has been

Tete-a-Tete
widely discredited and investors no longer trust it.
is solid. As long as you pay your mortgage, even a
Secondly, it does not consider the scenario of a hy-
failed bank won’t affect you. The bank that holds
pothetical sovereign default. So some inherent flaws
your mortgage might change, but you still have a
are there in these tests.
contractual obligation that specifies the terms and
conditions of your loan that won’t change. R: Any final thoughts...
• If you own stock in one of the D: The EU needs to move forward from these
troubled banks, there is more in- simulated stress tests and complete a unified
vestment risk now that the stress system for monitoring and public
tests are done and can get you disclosure for EU banks.
into trouble waters if the stocks The current state of af-
are not left at opportune time. fairs in terms of public
data on EU banks is an
R: I vaguely remember
embarrassment to every
that the US had also done sim-
member nation.
ilar tests in 2009 after melt-
down and now EU is doing In India’s case, state-
it. Why? controlled banks fared well
during the global financial
D: There have been
crisis, despite a widespread
discussions that the U.S.
liquidity squeeze. Only ICICI,
stress tests were more
the nation’s largest private-
about restoring confidence,
sector bank, required explicit
not measuring financial soundness. The
liquidity support from the central
same is debated about the EU. The assumptions in
bank during the downturn. Indi-
the U.S. stress tests were soft and virtually all of
an banks are healthy and can withstand unex-
the banks passed. The U.S. government had already
pected levels of stress in terms of credit and market
guaranteed the liabilities of most U.S. banks, Gen-
risks as the amount of bad debt(non-performing as-
eral Electric and General Motors, and a variety of
sets) is less, but rising inflation, high government
other formerly non-bank companies. Thus the stress
borrowing and a likely surge in capital flows are the
tests are seen as an exercise to express confidence
key challenges to financial stability in India.
that the European banks are healthier than investors
have feared and thus boost the market sentiments R: Thanks, this really helped clear many of
and trigger investments. many doubts.
R: What about EU stress tests? What is the flaw D: My pleasure !
here?
D: See, all banks passing the tests would mean
the tests were useless and stringent test would

There have been discussions

that the U.S. stress tests were
more about restoring confi-
dence, not measuring financial
soundness.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 39

 Rise of the lamb...
A case for investing in Africa
Shivaji Yadav
IIFT, Kolkata
With the globally Africa’s economic pulse has
quickened, infusing the continent
changing scenario, with a new commercial vibrancy.
Africa is coming up Real GDP rose by 4.9 percent a year
as a niche market for from 2000 through 2008, more than
twice its pace in the 1980s and ’90s.
the investment pur- Telecommunications, banking, and
poses. Despite the retailing are flourishing. Construc-
existing problems, tion is booming. Private-investment
there are lots of fac- inflows are surging.
tors supporting the To be sure, many of Africa’s 50-
plus individual economies face seri-
progress of the con- ous challenges, including poverty,
tinent. Africa always disease, and high infant mortality.
had the natural Yet Africa’s collective GDP, at $1.6
trillion in 2008, is now roughly equal
resources but now it
to Brazil’s or Russia’s, and the conti-
also has the demand nent is among the world’s most rap-
and also, the con- idly growing economic regions. This
tinent has aligned acceleration is a sign of hard-earned
progress and promise.
the other aspects in
While Africa’s increased eco-
its favor by expand- nomic momentum is widely recog-
ing globally. With nized, its sources and likely staying
countries which are power are less understood. Soaring
either diversified prices for oil, minerals, and other
commodities have helped lift GDP
economies, oil ex- since 2000. Research shows that re-
porters or transition sources accounted for only about a
economies, Africa is third of the newfound growth, the
rest resulted from internal struc-
bound to result in a tural changes that have spurred the
successful economic broader domestic economy. Wars,
diversification along natural disasters, or poor govern-
FinSight
with higher exports ment policies could halt or even re-
verse these gains in any individual
to encourage invest- country. But in the long term, in-
ments. ternal and external trends indicate
that Africa’s economic prospects are
strong.
The key reasons behind this
growth surge included government
actions to end armed conflicts,
improved macroeconomic condi-
tions, and microeconomic reforms
to create a better business climate.
40 NIVESHAK VOLUME 3 ISSUE 8 August 2010
More than a resource boom
Africa has benefited from the
surge in commodity prices over
the past decade. Oil rose from less
than $20 a barrel in 1999 to more
than $145 in 2008(source: McKinsey
Global Institute). Prices for minerals,
grain, and other raw materials also
soared on rising global demand. Yet
the commodity boom explains only
part of Africa’s broader growth story.
Natural resources, and the related
government spending they financed,
generated just 32 percent of Africa’s
GDP growth from 2000 through 2008.
The remaining two-thirds came from
other sectors, including wholesale
and retail, transportation, telecom-
munications, and manufacturing.
The key reasons behind this
growth surge included government
actions to end armed conflicts, im-
proved macroeconomic conditions,
and microeconomic reforms to cre-
ate a better business climate. To
start, several African countries halt-
ed their deadly hostilities, creating
the political stability necessary to re-
start economic growth. Next, Africa’s
economies grew healthier as govern-
ments reduced the average inflation
rate from 22 percent in the 1990s to
8 percent after 2000. They trimmed
their foreign debt by one-quarter
and shrunk their budget deficits by
two-third.
Finally, African governments
increasingly adopted policies to
energize markets. They privatized
state-owned enterprises, increased
the openness of trade, lowered
corporate taxes, strengthened regulatory and legal
systems, and provided critical physical and social
infrastructure. Nigeria privatized more than 116 en-
terprises between 1999 and 2006, for example, and
Morocco and Egypt struck free-trade agreements
with major export partners.
Global economic ties
Although Africa is more than a story about re-
sources, it will continue to profit from rising global
demand for oil, natural gas, minerals, food, arable
land, and the like. Demand for commodities is grow-
ing fastest in the world’s emerging economies, par-
ticularly in Asia and the Middle East. Despite long-
standing commercial ties with Europe, Africa now
conducts half its trade with developing economic re-
gions (“South–South” exchanges). From 1990 through
2008, Asia’s share of African trade doubled, to 28
percent, while Western Europe’s portion shrank, to
28 percent, from 51 percent.
This geographic shift has given rise to new
forms of economic relationships, in which govern-
ments strike multiple long-term deals at once. Chi-
na, for example, has bid for access to ten
million tons of copper and two million tons
of cobalt in the Democratic Republic of
the Congo in exchange for a $6 billion
package of infrastructure invest-
ments, including mine improve-
ments, roads, rail, hospitals,
and schools. India, Brazil, and
Middle East economies are also
looking forward to new broad-
based investment partnerships
in Africa.
The global race for commodities
also gives African governments more
bargaining power, so that they can negotiate better
deals that capture more value from their resources.
At the same time, Africa is gaining increased access
to international capital. The annual flow of foreign
direct investment into Africa increased from $9 bil-
lion in 2000 to $62 billion in 2008—relative to GDP,
almost as large as the flow into China. While Africa’s
resource sectors have drawn the newest foreign
capital, it has also flowed into tourism, textiles, con-
struction, banking, and telecommunications, as well
as a broad range of countries.
The rise of the African urban consumer
In 1980, just 28 percent of Africans lived in cit-
ies. Today, 40 percent of the continent’s one billion
people do—a proportion roughly comparable to Chi-
na and larger than India. By 2030, this share is pro-
jected to rise to 50 percent, and Africa’s top 18 cities
will have a combined spending power of $1.3 trillion.
Companies achieve greater economies of scale by
their fixed costs over a larger customer base. And
urbanization is spurring the construction of more
roads, buildings, water systems, and similar proj-
ects. Since 2000, Africa’s annual private infrastruc-
ture investments have tripled, averaging $19 billion
from 2006 to 2008. Nevertheless, more investment is
required if Africa’s new megacities are to provide a
reasonable quality of life for the continent’s increas-
ingly large urban classes.
Meanwhile, Africa’s labor force is expanding,
in contrast to what’s happening in much of the rest
of the world. The continent has more than 500 mil-
lion people of working age. By 2040, their number is
projected to exceed 1.1 billion—more than in China
or India—lifting GDP growth. Over the last
20 years, three-quarters of the conti-
nent’s increase in GDP
per capita
came from
an expand-
ing work-
force,
t h e
rest
f r o m
higher
labor pro-
FinSight
d u c t i v i t y.
If Africa can
provide its
young peo-
ple with the
education
and skills
they need,

Expanding intra-African trade

will be one key to the future
growth of the transition economies,
because they are small individu-
ally and their prospects would
improve as regional integration
creates larger markets.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 41

 this large workforce could become a significant
source of rising global consumption and production.
Africa’s diverse growth paths
While Africa’s collective long-term prospects
are strong, the growth trajectories of its individual
countries will differ. Classifying the continent’s larg-
est countries according to their levels of econom-
ic diversification and exports per capita highlights
progress towards two related objectives:
• Diversifying the economy. In the shift from
agrarian to urban economies, multiple sectors con-
tribute to growth. The share
of GDP contributed by agri-
culture and natural resources
shrinks with the expansion
of the manufacturing and
service sectors, which create
jobs and lift incomes, raising
domestic demand.
• Boosting exports to fi-
nance investment. Emerging
markets require large invest-
ments to build a modern
economy’s infrastructure. Ex-
ports are the primary means
to earn the hard currency
for imported capital goods,
which in Africa amount to roughly half of all invest-
ment. This is not to say that African countries must
follow an Asian model of export-led growth and
trade surpluses, but they do need exports to finance
the investments required to diversify.
History shows that as countries develop, they
move closer to achieving both of these objectives.
Most African countries today fall into one of the three
broad clusters: diversified economies, oil exporters,
transition economies. Although the countries within
each segment differ in many ways, their economic
structures share broad similarities.
FinSight
banking, telecom, and retailing, have accounted for
more than 70 percent of their growth since 2000.
They are among the continent’s richest economies
and have the least volatile GDP growth. With all the
necessary ingredients for further expansion, they
stand to benefit greatly from increasing ties to the
global economy.
Looking ahead, these diversified economies
face the challenge of continuing to expand exports
while building a dynamic domestic economy. Apart
from Egypt, their exports have grown much more
slowly than those of other emerging markets, in part
because they have
unit labor costs
(wages divided by
output per worker)
two to four times
higher than those
in China and India.
Like other middle-
income countries,
such as Brazil, Ma-
laysia, and Mexi-
co, these African
states must move
towards produc-
ing higher-value
goods. They have
started to do so—witness South Africa’s and Mo-
rocco’s automotive exports—and should continue to
build on their comparative advantages, which in-
clude proximity to Europe and facility with European
languages.
The diversified economies can also expand
their manufacturing sector, particularly food pro-
cessing and construction materials, for local and
regional markets. This move could increase exports
and reduce the need for imports, easing these coun-
tries’ current-account deficits.
Oil exporters: Enhancing growth through

Diversified economies: Africa’s growth en- diversification

gines
The continent’s four most advanced econo-
mies—Egypt, Morocco, South Africa, and Tunisia—are
already broadly diversified. Manufacturing and ser-
vices together add up to 83 percent of their com-
bined GDP. Domestic services, such as construction,
Africa’s oil and gas exporters have the con-
tinent’s highest GDP per capita but also the least
diversified economies. This group—Algeria, Angola,
Chad, Congo, Equatorial Guinea, Gabon, Libya, and
Nigeria—comprises both countries that have export-
ed oil for many years and some relative newcomers.

Rising oil prices have lifted their

export revenues significantly; the
three largest producers (Algeria,
Angola, and Nigeria) earned $1
trillion from petroleum exports
from 2000 through 2008, compared
with just $300 billion in the 1990s

42 NIVESHAK VOLUME 3 ISSUE 8 August 2010

Rising oil prices have lifted their export revenues
significantly; the three largest producers (Algeria,
Angola, and Nigeria) earned $1 trillion from petro-
leum exports from 2000 through 2008, compared
with just $300 billion in the 1990s. Economic growth
in these countries remains closely linked to oil and
gas prices. Manufacturing and services account for
just one-third of GDP—less than half their share in
the diversified economies. Natural resources ac-
counted for just 35 percent of Nigeria’s growth since
2000, and manufacturing and services are growing
rapidly. Banking and telecom, in particular, are ex-
panding, thanks to a series of economic reforms.
Since 2000, the number of Nigeria’s telecom sub-
scribers increased from almost zero to 63 million,
while banking assets grew fivefold.
The oil exporters generally have strong growth
prospects if they can use petroleum wealth to fi-
nance the broader development of their economies.
But like petroleum-rich countries in general, those
in Africa face acute challenges in maintaining politi-
cal momentum for reforms, resisting the temptation
to overinvest (particularly in the resource sector),
and maintaining political stability—in short, avoiding
the “oil curse” that has afflicted other oil exporters
around the world.
Transition economies: Building on current
gains
Africa’s transition economies—Cameroon, Gha-
na, Kenya, Mozambique, Senegal, Tanzania, Uganda,
and Zambia—have lower GDP per capita than the
countries in the first two groups but have begun the
process of diversifying their sources of growth.
Expanding intra-African trade will be one key
to the future growth of the transition economies,
because they are small individually and their pros-
pects would improve as regional integration creates
larger markets. If these countries improved their
infrastructure and regulatory systems, they could
also compete globally with other low-cost emerging
economies. One study found that factories in the
transition countries are as productive as those in
China and India but that the Africans’ overall costs
are higher because of poor infrastructure and regu-
lation—problems that the right policy reforms could
fix.
If recent trends continue, Africa will play an
increasingly important role in the global economy.
By 2040, it will be home to one of the five planet’s
young people, and the size of its labor force will top
China’s. Africa has almost 60 percent of the world’s
uncultivated arable land and a large share of the
natural resources. Its consumer-facing sectors are
growing two to three times faster than those in the
OECD countries. And the rate of return on foreign in-
vestment is higher in Africa than in any other devel-
oping region. Global executives and investors cannot
afford to ignore this. A strategy for Africa must be
part of their long-term planning.
The time for businesses to act on those plans
is now. Companies already operating in Africa should
consider expanding. For others still on the sidelines, FinSight
early entry into emerging economies provide oppor-
tunities to create markets, establish brands, shape
industry structures, influence customer preferences,
and establish long term relationships. Business can
help build the Africa of the future. And working to-
gether, business, governments, and civil society can
confront the continent’s many challenges and lift
the living standards of its people.

For companies still on the side-

lines, early entry into emerging
economies provide opportunities to
create markets, establish brands,
shape industry structures, influ-
ence customer preferences, and
establish long term relationships.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 43

 MAPPING THE PERFORATIONS
Twisha Chatterjee
JNU
The Alma Mater of capitalism
A thorough study
Amidst the basic principle of
of the economic
a capitalist economy, of continu-
theories, the article ally rising productivity, monopolis-
traverses the entire tic competition, effective banning of
history of paradigm genuine price competition in mature
economy, is a major economic con-
shifts in international
straint of chronic lack of effective
economics, delv- demand. Rising surplus tendency
ing into the various and excess capacity generally im-
plies that real wages rise less than
economic and politi-
productivity, causing labour unrest,
cal causes that led to weakening wage based consumption
such changes and and ultimate culmination into “atro-
the consequences phy of net investment’. The general
Perspective
nature of the capitalist economy is
thereof.
extremely peculiar in its own way,
with inevitable inflation and debt
deflation being ingrained within the
system, which causes the spin out.
Economy does not always adhere to
the well defined vision of equilibri-
um and the tendency of the system
to seek sustainability that Smith and
Walrus propounded.
Illusion of Impeccability
The financial crisis of the past
and of the contemporary can be
best analyzed in the view of the
“Financial Instability Hypothesis”
which heavily draws upon Schum-
peter and Minsky. Investment in a
capitalist economy mostly takes
place through exchange of present
money for future money, ie, capi-
tal is traded through liabilities. The
principal financial relationship links
the creation and the ownership of
the capital assets to the structure of
the financial relations and changes
in its structure. The complexity that
Instability or a crisis in a capi-
talist economy is not caused
through exogenous shocks to
generate varied business cycles,
but that they are a product of the
internal dynamics of the capital-
ist system
44 NIVESHAK VOLUME 3 ISSUE 8 August 2010
accompanies such a system in pres-
ence of government intervention
and refinancing institution renders
the system of its inherent instability.
Therefore, it is primarily a theory of
system influenced by debt and the
manner in which it is invalidated.
The movement of the system in the
generic view from hedge finance to
that of speculative finance and final-
ly the slip over to Ponzi finance am-
plifies the deviation tendency. This
is however to
echo the fact that instability or
a crisis in a capitalist economy is not
caused through exogenous shocks
to generate varied business cycles,
but that they are a product of the
internal dynamics of the capitalist
system and that of its designing in-
tervention and regulation that keeps
the economy operating within rea-
sonable bounds. Foster was indeed
right when he wrote: “Despite its
fabled creative destruction and the
proliferation of waste, the system
was unable to overcome a chronic
tendency to market saturation”
I attempt here, in fact reli-
giously to trace the Financial trajec-
tory over a period of 50 years, during
which the economy underwent ma-
jor prolific changes enmeshed with
writhing crisis in every subsequent
period—a flaw that capitalist econo-
my is bound to succumb to.
Faltering Gold Standard
The gold standard happened
to be a way of organizing interna-
tional monetary affairs before 1913,
spreading to a greater part of the
world until the end of the 19th century. The exchange
rate stability and the hackneyed monetary policies
that it achieved is not a norm but indeed an excep-
tion—a historical truth usually denied through time.
Britain’s single dominance in the world market pro-
tected her BOP status and helped sterling maintain
its grip in the international economy. Its lending and
outward looking trade policy helped relieve pressure
on Bank of England. Since this period can be traced
with its ever increasing buoyant multilateral trade
and openness, the gold standard remains one of the
most celebrated system of its era. The monetary au-
thorities enjoyed insulation which supported their
commitment of gold convertibility. This coupled
with the markets’ con-
fidence caused traders
to purchase a weak cur-
rency, which minimized
the rate of intervention
and discomfort, other-
wise needed for stabil-
tripolar international monetary system was not
stable and compelled gold bloc to suspend convert-
ibility and depreciate its currency. The Glass Stea-
gall Act of 1932 in the US was followed by America’s
departure from the gold standard which prompted
other countries to follow suit. This meant return to
managed floating.
There has not been any single consensus on
the causes of Great Depression. While some adhere
to the fact that it was a mere accident caused by
the 39 month, 8-9 year, and fifty year cycles, the
Keynesians are of the view that it was fuelled by the
decline in US spending resulting from a downturn
in the housing. Monetarists on the other hand attri-
bute it to the failure of
the monetary policy.
However, we also
witness idiosyncratic
views which ascribe
the deflation of the
1930s as a consequence

ity. As gold discoveries
recede in 1890s height-
ened pressures of liquida-
tion of the system, along
with the rapid growth of
US, which ensured pelvic
shocks to the global financial
system. After the establishment of
the floating exchange rate in the first half
of the 1920s, the first countries to reestablish
gold convertibility were those that were subjected
to the pains of hyperinflation: Austria, Germany,
Hungary, and Poland. The inflation was fuelled by
paper money used to finance government deficits,
which also resulted in the breakdown of the mon-
etary economy.
Viewing the crisis latitude
The great depression hit the system hard with
instability spreading to the industrial core by 1931,
accompanied by sustained banking crisis, as Minsky
has predicted. They were eventually compelled to
suspend convertibility and impose exchange con-
trols. By 1932, there were 3 distinct blocs: (a). Re-
sidual gold standard countries led by US; (b). Ster-
ling area (Britain and countries pegged to pound);
(c).Central and eastern European countries, led by
Germany, where exchange control prevailed. The
Perspective
of the inflation of 1920s.
However, economists like
Kindleberger do attribute the
consequence to that of an ordinary
financial crisis. The rise in the stock
prices from March or April 1928 to
October 1929 took place against a
very vulnerable financial structure
and an already feeble economic position.
This led to a cut in the long term lending by the
US to German and other peripheral regions. This fur-
thered them into sharply rising interest rates, and
aggravated by the New York stock market specula-
tion they moved into short term lending. When in-
terest rates rose it entailed a cut in the spending
for automobiles and housing in the US, which ac-
counted for business downturn by June 1929. When
Clarence Hatry was exposed as a swindler, the trig-
ger led to the stock market collapse culminating into
Black Thursday and Black Tuesday, where the crisis
in London pulled call-loans back from New York. The
depression eventually spread through the decline in
global commodity prices, leading to a default in bank
loans and hence its failures, culminating in declin-
ing money supply. However, since commodity prices
fell more than the decline in money supply, the real
money rose during the first year and a half of the

Growth of finance relative to

the real economy also meant
the appearance of financial
bubbles that carried the risk of
bursting

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 45

 depression. As weak banks in Germany and Austria
were also collapsing, the provision of lender of last
resort also fizzled out. This led to the establishment
of the IMF, responsible to finance imbalances in in-
ternational payments and to maintain orderly ex-
change rate regimes. Britain was weakened by war
and was thus unable to improve situations, the US
and France were unwilling to. The collapse pelted
down from Austria to Germany to England, Japan,
The US and ultimately the Gold Bloc. The trauma
was September 1931 entailed the appreciation of the
dollar against the pound, which also enabled Japan
to recoup with a “beggar thy neighbor policy” of
depreciation. The depreciation of the sterling had a
mandatory effect on the decision of the Gold bloc to
convert its dollars immediately into gold, which was
wrongly responded by wrong policy action of raising
interest rates.
On the other hand
if we analyze the crisis
of the 1980s, we find a
Perspective
credit card bills etc. There was a rise in corporate
debt too and the influx of the very infamous junk
bonds, with simultaneous reduction in corporate
stocks. The enormous swelling of the world liquid-
ity associated with the policies of the 1970 and 1971
led to the breakdown of the system of the fixed ex-
change and the adoption the floating exchange rate
in 1973. Inspite of floating rates, capital continued to
move freely, which was certainly not anticipated, be-
cause asset holders generally overlooked exchange
risk in the long run.
The 1970s were primarily a period of inflation
with sellers’ rather than buyers’ market. In the 1980s
, the dollar rose steadily from 1981 to 1985 and fell
from 1985 for the next 2 years. US farm prices which
got reduced due to the rising dollar, could not re-
vive much once dollar
started declining.
Thus the events
of 1920 and 1930
helped conclude 3

set of reasons not quite things:

distinct to that of the
1. M o n e t a r y
Great Depression, but
policy entailed a trade
that the similarity of
off between internal
fundamentals in it. The
and external policies
displacement which
set off the boom was 2. C h a n g e
the sharp rise in the was an inevitable part
oil prices at the time of the international
of the Yom Kippur war capital flows.
in November, 1973. It 3. The centre
was a situation like the of gravity shifted from
third World debt, where some countries like Mexico the UK to the US, which meant greater uncertainty,
financed oil production, Brazil borrowed to expand hegemony and crisis in the international financial
production of import-competing or export expanding market.
goods to enable the payment of higher oil imports.
Fleeting promises of Bretton Woods
The government aimed to resolve this debt issue
by continued lending of new money by commercial As the system moved to the Bretton Woods,
banks while they persevered to clear up outstanding departing from the gold standard, 3 fundamental
debts. Based on bank borrowing, there was a run- changes were achieved:
up of farm prices in the 1970s, leading to a massive 1. Pegged exchange rate became adjustable
decline in the 1980s. What actually happened was 2. There was no need of deflationary policies
that banks had loaded themselves with mortgages for BOP stability
at relatively low interest rates, but when interest
3. Controls were instituted to check volatile
rates rose after 1971, they had to borrow at a higher
capital flows, along with the IMF mastering the sta-
rate in order to sell assets, but at substantial losses.
bility front.
Consumer debt also kept rising with increased trips,

Where the need was to mobilize

savings, increase physical invest-
ment, innovate etc. , the countries
were left at the mercy of ruthless
financial liberalization, which
aggravated the fragility of pegged
exchange rates.

46 NIVESHAK VOLUME 3 ISSUE 8 August 2010

 However, the exchange rate stability was open
markets with largely an illusion than a success. Rob-
ert Triffin, Belgian monetary economist, observed
that Bretton Woods could not sustain excess de-
mands for reserves through the growth of foreign
dollar balances which made it dynamically unstable.
As current account convertibility was restored in the
1958, the political situation did not allow central
banks to eliminate payments deficit by tightening
monetary policies. The Bretton woods Agreement
forced governments to deny that parity changes
were contemplated and to suffer embarrassment
if forced to devalue. Amidst an interlocking web
of political and economic bargains, such a system
is bound to disappear. Finally the formation of the
European Monetary System and the introduction of
floating exchange rate in the 1980s, preceded the
Asian crisis of 1997, the repercussions of which are
still felt till the present age.
The Asian Crisis
The Asian Crisis is surprising as it occurred
against the backdrop of political and economic sta-
bility, with Asian Tigers exhibiting consistency unlike
other crisis prone developing countries. China, Indo-
nesia, Malaysia, Singapore all grew at rapid rates be-
tween 1992 and 1995, with the flip side being large
current account deficits. In 1997, the dollar rose
against the yen, creating competitiveness problems
for the Asians. The collapse of the Bangkok Bank of
Commerce in mid-1996 was equivalent to an early
warning. Thailand’s inevitable crisis occurred with
the drying up of international reserves in its central
bank. The Asian crisis echoed the fact that countries
with weak banking systems were most prone to cri-
sis. As investors under such situations crawled for
exits, the exchange rate weakened, causing a vicious
spiral.
The crisis also illustrates the pressures mak-
ing for greater exchange rate flexibility. Where the
need was to mobilize savings, increase physical in-
vestment, innovate etc. , the countries were left at
the mercy of ruthless financial liberalization, which
aggravated the fragility of pegged exchange rates.
However, the real cause has been the speculative
growth of the credit-debt system and Financialisa-
tion in the whole new era of neoliberal economic
policies.
It is indeed an irony that emerging economies are now massive dollar creditor, yet the US economy
lies outside the ambit of their control and in turn dictates their terms, which has further social and
environmental transformative implications.
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
Conclusions
The postwar trend towards of greater exchange
rate flexibility is a direct consequence of rising inter-
national capital mobility. So controls were instituted
within the system, which meant incompatibility lev-
els between free trade and fettered finance, which
ultimately led to the demise of the Bretton woods
and then of the EMS. The crisis in the early to mid
1970s culminated into stagflation although inflation
was viewed as the real culprit which required eco-
nomic restructuring.
During the last forty years (1970-2010), the US
economy, and the world economy as a whole—de-
spite rapid growth in parts of Asia—has experienced
a secular slowdown, the same general tendency to
stagnation affected Europe and Japan as well. The
current crises of the very recent years also reverber-
ates the very fundamental flaw of the entire Capital-
ist economy where there are several countervailing
factors insufficient and inefficient to keep the sys-
Perspective
tem away from sinking. Growth of finance relative
to the real economy also meant the appearance of
financial bubbles that carried the risk of bursting.
These crisis stricken distressed conditions are just
the methodological slip over from one phase of de-
velopment in Capitalism to other, namely:
1. From Accumulation to Finance
2. From Finance to Financialisation
3. From Financialisation to Monopoly capital-
ism
4. From Monopoly capitalism to Neo-Liberalism
This brings us to the most important implica-
tion that the vicious trap of imperialism, globaliza-
tion and Financialisation has on the periphery of the
world capitalist economy. It is indeed an irony that
emerging economies are now massive dollar credi-
tor, yet the US economy lies outside the ambit of
their control and in turn dictates their terms, which
has further social and environmental transformative
implications.
Should we then wait for the demise of Capital-
ism or that of civilization as a whole?
47
 Investment trategies
Sumit kedia & upasna agrawal
Team Niveshak
An Investment Strategy is a set
Investment strate-
of rules, behaviours or procedures,
gies are something designed to guide an investor’s se-
that is very integral lection of an investment portfolio or
to the world of fi- a particular stock of any company.
Usually the strategy will be revolve
nance, stock markets around the investor’s risk-return
and investment in trade off: some investors will pre-
general. Each inves- fer to maximize expected returns by
tor has his or her investing in risky assets, others will
prefer to minimize risk, but most will
own strategy to tell, select a strategy somewhere in be-
some succeed and tween such that the element of risk
earn good returns, involved does ensure a set amount
of return which is always got in the
while others fail but
investments made.
the mantra is not
to perish but keep Basic Types of Strategies
Investment strategies is some-
trying. In this article
thing that has been pretty widely re-
we discuss the vari- search upon and there are number
ous requirements of researches still going on but com-
for any strategy and ing up with some thing that will as-
sured 100% returns, well that is not
the facets that need possible. Some of the basic types of
FinGyaan
to be looked into, investment strategies are discussed
along with some of below:
the standard strate-
Growth Investing
gies based on which Growth investing strategy in-
the whole invest- cludes the search of stocks that have
ment world runs. A a potential for growth. The latter
means that at a certain point in time
special section on the price of the stock will rise. As a
Warren Buffet has result, growth investors target young
been mentioned to companies that have the potential of
exceeding its peers in the industry or
emphasise the im-
sector. An example of such compa-
portance of simplic- nies is the technology oriented ones
ity followed by the that began their development during
strategies for the the 1990s. Now, most of these com-
panies are prosperous leaders in the
current market sce- field. The investors that bet on the
nario. mere idea, which in their beginning
was all that such companies were
able to offer, now enjoy their profits.
However, it is important to be able
to spot those companies that are to
succeed. You should also keep in
mind that growth investing implies
48 NIVESHAK VOLUME 3 ISSUE 8 August 2010
risk in its nature since some of the
young companies may fail in their
innovative activities. Just because
an industry as a whole is growing
it doesn’t mean that growth stocks
are bound to emerge. If the barriers
to entry are low, new companies will
come into the marketplace, making
it difficult for any one company to
increase earnings and profitability.
Value Investing
The target stocks of value in-
vestment strategy are those that
are undervalued by the market. This
means that the price of the stock is
lower than the real value of the com-
pany that has issued it. Such stocks
have been overlooked by the market
in its chase after what is considered
hot at the moment. In order to de-
termine whether the stock is of a
value type, most investors refer to
its price to earnings ratio. If it is low,
then the market is unwilling to pay
more for the stock. However, if you
are a value investor make sure that
there are no other reasons for the
low price of the stock, such as an in-
ner problem within the company. If
there isn’t such, then purchase the
stock and hold it until the market
recognizes its real value and cor-
rects the price.. With time you will
become more focused and able to
identify yourself with only one of the
investing strategies.
Income Investing
Income investors are charac-
terized as the most conservative
ones. The major goal of these inves-
tors is the acquisition of income.
As a result they aim at companies
that pay on regular basis dividends,
which are of a stable and high na-
ture. Additionally, these companies
are large and well-established. Peo-
ple that are most often found in this
category are those that are nearing
their retirement. Even though this
investing philosophy does involve a degree of risk, money, there will be times when we will take a loss.
it is still qualified as one of the most conservative. Taking a loss is extremely difficult and one needs to
be prepared emotionally and financially to take one.
What you need to consider when choosing Learn from the past and don’t put all of your eggs in
an Investment Strategy? one basket. Spread out your money, also known as
Investment strategy as we know is something diversification. Diversifying your investments allows
that is very crucial and critical both for an individual to pick out different stocks, some riskier than others
and as well for any fund house or fund manager. and can choose other investments that guarantee
Both of the parties require handsome returns on the returns like precious metals and government bonds.
money they have invested, more so when they are Get an education
entrusted of providing higher returns to their cus-
tomers. Also when it comes to choosing the right in-
vestment strategy, spend time researching practi-
Time Frame cally everything there is to know about the stock
The first thing one need to consider when talk- market and investments. A financial advisor can be
ing about investing is TIME. How long would you like relied upon, but it is wise to spend time gaining an
your investments to sit and grow? When you are education on your own so you can track your invest-
planning on retirement you need to consider invest- ments.
ing as a long-term approach. Part of investing comes Asset Allocation
down to choosing if you want to participate in short-
term investment or if you want to play it safe and Diversification is something that everyone
put money in for the long haul. It depends on the knows is a good thing but is never implemented it in
age profile of the investor as well. totality. There are various asset classes like shares,
property, alternative assets, fixed income securities,
Risk cash. Also alternative assets such as private equity,
The next thing one must look into is how much infrastructure and hedge funds provide the growth
risk one is willing to take on. When one talks about opportunities. The amount allocated between the
investing, risk is inherent. The more risk is taken, growth assets and defensive assets is what sets
the higher the returns that are available or one can apart each of the strategy taken up by the various
wind up losing everything. However must be will- investors.
ing to take on some amount of risk when you play
around with the stock market and other investments Oracle of Omaha

FinGyaan
because no risk no returns is the mantra out here. One talks/writes about investment strategies
One nice thing about risk is that one has the option doesn’t bear a mention to the Oracle of Omaha, one
to choose a hierarchy of it. There are people that of the greatest investor of our times, Mr. Warren Buf-
are comfortable with some risk, but not too much fet is not at all justified. He works on his own tenets
risk. Usually these people stay out of the day trading and no doubts they have been supremely success-
drama and stick to something simpler like mutual ful. His entire approach is to focus on the value of
funds. Having a good mutual fund manager to buy the business and its market price. Once Buffett finds
and sell stocks for you is a great way to remove part a business he understands and feels comfortable
of the risk and to still have a great return, although with, he acts like a business owner rather than a
complete dependency on a third party with your stock market speculator. He studies everything pos-
money is a bit of foolishness. sible about the business, becomes an expert in that
Loss field and works with the management rather than
against them. In fact, often his first act on buying
Although all invest with the hope that will make
shares in any company is to grant the managers his

Investment Risk Characteristics

profile tolerance
Conservative Low Invests around 60 to 70 per cent of assets in income assets such as fixed interest
and cash. Focus on capital stability and income rather than growth.
Balanced Average Maintains a balance (e.g. 50:50 or 60:40) between growth and income assets. This
strategy aims to balance risk and income with long-term capital growth.
Growth High Invests around 70 to 80 per cent of assets in growth assets such as shares and
property. Aims for higher growth over the long-term while cash and fixed interest
exposure limits risk.
High growth Higher Invests around 90 per cent of assets in growth assets such as shares and property.
or aggressive Focus is on long-term growth.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 49

 proxy vote for his shares to assure them that he has
no intention to try and move the company away
from its core values. Buffett champions the value
investment strategy, and puts no credence in day to
day movements in share prices, the impact of the
economic mood overall or any other external factors.
He maintains a long-term perspective at all times,
and never loses sight of the underlying value of a
business.
The 4 basic tenets of Buffet are the ultimate
guiding philosophy for his strategy. One is business
tenets which details about the simplicity of the busi-
ness and the future prospects of it. Next tenet deals
with management and the rationality of the same.
Then comes the financial tenets which comprise of
focus on ROE via calculation “owners earnings” and
assessing for companies that have high profit mar-
gins. In short for every dollar retained created one
dollar of market value for investor. Market tenets
is the most significant since it deals with valuation
of the business and finding if its undervalued and
thereby go ahead with investment. This is the most
critical skill and what differentiates Buffet from other
investors and makes him the King of Value Investing.
These are the values that need to be developed
and honed for a long term and just goes to show
that strategies can be very simple, but implementa-
tion should be very organized to the core.
Strategies at times of Uncertainty
A situation where earnings growth is rising at
FinGyaan
with the current projections if the situation doesn’t
change. Indian exports are going to be worst affect-
ed and will continue to be affected by these and
remain depressed. Overseas financing being eyed by
Indian firms and their bid for expansion and acquisi-
tions will be under hold and seen with lot of reluc-
tance. Domestic consumer spending itself can take a
severe beating if the increments and compensation
are pretty improper. All these paint a very grim pic-
ture of the Indian economy, right? But we think that
the investors should still invest and not totally lock
up their money in savings. This is to say because,
the measures being taken by the government and
the central bank have been towards pro-saving and
all possible measures to keep economic growth on
track, taming down inflation to lower levels and con-
trolling the huge broiling up fiscal deficit has been
the main focus, and they have been able to achieve
some success on each of these fronts. Thus, signal-
ling that GDP growth is imminent though not at the
same rates as it was being projected before Greek
crisis.
We think that any buying during such a period
should be very cautious and with proper thought
given to it. Slow systematic buying strategies will
yield better returns by lowering average price of ac-
quisitions. Commitment of long term funds is not
that much advisable since a possible huge correc-
tion might wipe out huge amounts and then end-
ing in selling them at loss to cover other expenses.
Companies that are heavily dependent on exports or

a very good and projected to continue rising in the
near future, while share prices are falling, is pret-
ty unusual. It can be attributed to various reasons
around the globe and the world of finance. We can
see it happening now, and it could continue, given
the panic in Euro Zone and the lack lustre data com-
ing up from US regarding the various domains. Also
the possibility of an Asset Bubble in China and the
poor housing data that has been doing rounds in
the market is not helping the matters any further.
Normally, one would expect long-term investors to
be happy at the chance to invest in profitable busi-
nesses at lower prices but is that the case currently?
The last time there was a crisis of these dimen-
sions in 2008, it triggered a 15-month bear market
that knocked more than 50 per cent off index values
and significant on GDP. Several things may go wrong
on debt infusions must be avoided. The reasons are
obvious since export growth will be slow or negative.
Debt will also be very hard to come by and expen-
sive as well. Expansion plans everywhere are likely
to go on hold. Also, have a look at potential markets
of the company under consideration and the percent
of revenues that they get from various demographic
locations. Decisions should be based on that as well,
since if the troubled area like the Euro Zone here
is major contributor, the company is for sure under
turmoil. Look for attractive valuations with regards
to the current balance sheet, rather than strong
growth prospects. A low-debt company that is avail-
able cheap is less likely to suffer dramatic erosion in
valuations. The best strategy once again is to invest
in a staggered manner on the downside.

The reasonable man adapts

himself to the world. The un-
reasonable one persists in try-
ing to adapt the world to him.
Therefore all progress depends
on the unreasonable man.

50 NIVESHAK VOLUME 3 ISSUE 8 August 2010

 Outward FDI Philosophy
Outward Foreign Direct Invest-
ment (FDI) flows from developing
countries, like China and India, espe-
cially from the large companies have
of late, generated significant inter-
national interest. As per the Boston
Consulting Group (BCG) study, con-
sidering the top hundred companies
from the developing world involved
in outward FDI, more than sixty are
from India and China. Predominant-
ly, Foreign Direct Investments are
done for acquiring assets outside
the country. (Assets largely take the
form of companies operating in de-
veloped and developing economies).
A typical example is the acquisition
of Corus (an English company) by
Tata Steel, an Indian company. This
is an outward FDI from India.
Traditionally, Indian companies
have been into international acquisi-
tions much longer than the Chinese
companies and have steadily gained
the tacit knowledge and intellect to
deal with the complex management
issues relating to managing interna-
tional businesses. However, China in
the last two decades has acquired
several international assets with the
help of its huge foreign currency re-
serves.
China and India’s history and
success of outward FDI
The outward FDI of the United
States (US) for 2008 stood at $250
billion. Chinese, outward FDI during
2008 amounted close to $60 billion
and that of India stood at $20 billion.
Though the outward FDI of India and
China are lower than the US, their
Traditionally, Indian companies have been into international acquisitions much longer than the
Chinese companies and have steadily gained the tacit knowledge and intellect to deal with the
complex management issues relating to managing international businesses.
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
India vs China
Kumar Saurabh
IIFT, Kolkata
growth has been significant. In re-
cent years, the Chinese companies Indian companies
have become very aggressive; aver- have been into the
age overseas acquisition during the global acquisitions
1980 was around Rs. 4,500 crores
per annum, equivalent of about half
from a very long
a billion US$, which climbed to an time as compared
annual average of around Rs.12,000 to China. This has
crores during the 1990; Rs. 30,000 helped India in gain-
crores by 2004 and Rs.125,000 crores
by the year 2007. In 2008 it amount-
ing required knowl-
ed to Rs.200,000 crores. edge and intellect to
In the last two years alone close handle any intricate
to Rs.200,000 crores, or an equiva- management issues
lent of $40 billion, has been invested
relating to interna-
by Indian companies abroad; when
we compare the same numbers with tional businesses.
amount spent by Indian companies China had since
in domestic acquisitions, it is less
beginning adopted
than Rs.50,000 crores, or one fourth
the outward FDI figure. Over the last
a differing attitude
four years Tata Group alone has spent towards global ex-
close to Rs.100,000 crores in various pansion. But now it
small sized and large global acquisi- is also catching up
FinGyaan
tions. Other Indian groups like Aditya
Birla, Essar and Bharti have all been with international
very active in global acquisitions, as acquisitions through
well. Companies like Jindal Steel and its large foreign cur-
Godrej have also shown activity in
rency reserves.
term of overseas acquisition. Given
the sheer size of such investments;
outward FDI by India and China has
grabbed the attention of the interna-
tional community.
Differences in Underlying
Philosophy
There is a fundamental differ-
ence in the underlying philosophy
of the Chinese and the Indian com-
panies with respect to outward FDI,
and overseas acquisitions. When we
51
 say philosophy, we mean the objective for which the supply of semi skilled and cheap labor. China has
overseas acquisition is being pursued. The reason been unable to put to use this key competence in
for such differences is attributed to the diverse po- their global acquisitions. Due to these shortcomings
litical systems and the overall development strate- China has been unable to add value to its overseas
gies of the two countries, which is of late blurring. acquisition of professionally managed global brands.
Chinese Philosophy Chinese companies have failed in their acqui-
Large Chinese companies are run with the sition attempts and inappropriately managed their
support from the government. There is strong in- global acquisitions; for example, failure of Chinalco
terference of the Chi- to acquire the Australian
nese government in the mining company, Rio Tinto
day-to-day operations and its failure in execut-
and functioning of these ing the North Rail Project
companies. The Chi- in Philippines. But things
nese government heav- have started to improve;
ily influences the prior- and one can see a spurt
ity and rationing of the of investments by Chi-
global investments by nese companies in acqui-
the Chinese companies sition of well-run profes-
and most of the outward sional companies abroad,
FDI of China till 2004 has although few, which in-
been towards energy clude Lenovo’s acquisi-
security (the Chinese tion of IBM’s ‘think’ per-
government wanted to sonal computer business
secure its long term oil and Nanjing’s acquisition
needs). Most Chinese of the British car maker
state run oil companies MG Rover. Others include
have heavily invested China’s Bluestar acquisi-
in oil fields around the tion of Belgium’s Adisseo
world, including in Africa brand.
and Russia. With foreign The sector specific
currency reserves in Chi- investments too are get-
FinGyaan

na close to US $2,000 bil- ting diversified from the

lion, liquidity is abundant and is a major driver for
the Chinese overseas acquisition; China’s cumula-
tive outward FDI is around US $150 billion. Compara-
tively, India’s investment is in the range of US $70 to
US $80 billion.
Till recently, China shied away from acquir-
ing professionally run companies possessing strong
brands, which has remained a forte of Indian acqui-
sitions. Lack of international experiences and man-
agement talent and cultural and language barriers
are being cited as reasons why Chinese companies
have not been confident to manage geographically
diversified operations, away from mainland China. If
we analyze the key competencies of Chinese compa-
nies, it is their ability to manufacture low cost prod-
ucts for the developed world using their large-scale
traditional energy related investments, with invest-
ments flowing into information technology, manu-
facturing, consumer durables, mining, internet,
green technologies, agriculture and fisheries. Such
a paradigm shift in the outward FDI philosophy is
likely to position China in a competing stance with
Indian corporate for attractive overseas assets, in
the future.
Off late not only China, but other high growth
developing economies like Brazil and South Africa
too has shown significant level of outward FDI. These
countries, together with India and China are control-
ling around 15 percent of the global Gross Domestic
Product (GDP)
Indian Philosophy
The outward FDI philosophy of India, contrarily,

Off late not only China, but

other high growth develop-
ing economies like Brazil and
South Africa too has shown
significant level of outward
FDI.

52 NIVESHAK VOLUME 3 ISSUE 8 August 2010

rests on very different fundamentals. Governmen-
tal interference in functioning of Indian corporate
sector, for example is virtually non-existent. A large
pool of Indian professionals having experience with
multinationals and global corporations abroad, have
over the last few years moved back to India due
to its economic prosperity. They have been able to
relate and deal with global corporations and under-
stand management practices; and as a result many
large and professionally run Indian companies have
been successful in acquiring global and multination-
al companies.
Performing stock markets, good flow of for-
eign investments, a strong rupee, easy access to
and availability of funds, both domestic and foreign
currency, are resulting in fundamentally strong eco-
nomic conditions in India. This gives an impetus to
move forward with more outward FDI deals. Con-
sistent and reasonably good corporate results have
also left significant liquid cash, which is also a key
driver for increased outward FDI. Further, the global
economic crisis has provided attractive investment
opportunities for the Indian companies; as a result
India’s global acquisitions have been much greater
than their domestic acquisitions. In line with the
Chinese outward FDI model, state owned Indian
companies like Coal India, Oil and Natural Gas Corpo-
ration and Indian Oil Corporation have also created
significant levels of outward FDI in securing energy
assets. These companies are expected to pursue this
more aggressively in the near future.
Indian companies have reached a stage of
maturity in their management style and strategic
planning for their operations. To that extent Indian
acquisitions abroad have been founded on a strong
fundamental synergy seeking behavior with their
global acquisition targets. For example acquisition
of Corus by Tata and Novelis by Hindalco are not
knee jerk reactions; they have been well thought out
acquisitions keeping in mind the strategic synergies
that will arise.
Talking about Tata Steel’s acquisition of Corus,
Tata Steel had the worst productivity record dur-
ing the 1990. In order to improve its competitive-
ness, it injected new technologies spending billions
of dollars; and by the end of the 1990. Tata Steel
became the world’s most efficient steel maker. The
company evolved a strategy to acquire global steel
Performing stock markets, good flow of foreign investments, a strong rupee, easy access to and
availability of funds, both domestic and foreign currency, are resulting in fundamentally
strong economic conditions in India. This gives an impetus to move forward with more outward
FDI deals.
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
maker Corus, producing high value added steel hav-
ing a capacity of around 20 million tonnes. Through
this acquisition, Tata Steel not only enhanced its
overnight steelmaking capacity multifold, but also
secured sophisticated manufacturing technology, ac-
cess to high value western customers and achieved
lower input costs. This is what we call strategic fit!
On similar lines Tata Steel also acquired companies
in other attractive markets like Singapore-based Nat-
Steel and Millennium Steel in Thailand. The syner-
gies proposed in this acquisition were very strategic
and well thought out. The management expertise of
the Tata Senior management and its advisors helped
the company successfully conclude this acquisition.
A second example in this category is the acqui-
sition of Novelis by Hindalco. What was the strategic
fit in this acquisition? Hindalco being primarily an
‘upstream’ manufacturer of raw aluminum boasted
about higher profitability in comparison to other alu-
minum manufacturers, but volatile sales price often
pulled down its overall profitability. Hindalco wanted
to become vertically integrated by getting into value
added aluminum products in the form of sheets and
foils, (known as ‘downstream products’), primarily
to stabilize its overall profitability. Profitability of the
‘downstream’ business is lower than ‘upstream,’
but is less volatile and also provides access to high
value added customers, sophisticated manufactur-
ing processes and access to technologies. Acquisi-
tion of Novelis provided this strategic fit to Hindalco.
FinGyaan
This is hailed as one of the most successful acquisi-
tions in the Indian history.
Hence we can say that Indian companies have
good strategies, founded on solid planned rationale;
combined with effective managerial skills in suc-
cessfully acquiring large global brands. Cultural and
language compatibility has also helped the Indian
acquisitions to be successful, especially in the task
of post acquisition integration. The Chinese compa-
nies having failed in their acquisition attempts due
to lack of the above knowledge, have pulled up their
socks and have started to acquire professionally run
western companies and are high on the learning
curve. Over time the philosophies of both the coun-
tries are likely to converge and pose stiff competi-
tion to each other and to the others in a growing
global market.
53
 THE SHADOW STILL FOLLOWS...…
Anurag Lakhotia & Jasdeep Singh
NITIE, Mumbai
The global trillion dollar casino supervision from the regulators
Standing at a mam-
has been broken and the status quo • Are home to ubiquitous finan-
moth size big would not remain the same again. cial innovation and structured finan-
enough to be the They have proved to be no better cial products
second largest econ- than robbers and have robbed us in
• Are biased towards speculative
omy of the globe, millions again. We are referring to
trading mechanisms and
the shadow banking the global meltdown and that the
• Make it difficult to identify the
system that led to this catastrophe –
system has become actual risk bearers due to inherently
the shadow banking system!
an indispensible long intermediation process
part of the financial Shadow Banking – the name
The Rise of Shadow Banks
suggests
world. It is neces- Last few decades have wit-
Shadow banks are essentially
sary that the top nessed the simultaneous and com-
financial intermediaries with assets
brains understand similar to commercial banks, but
plementary development of three
the nitty-gritties of processes.
with a liability structure like invest-
this system, and aid ment banks. These banks conduct First, the amount of credit
its directed growth maturity, credit, and liquidity trans- available with commercial banks
formation but lack access to central kept on increasing pertaining to
with enough regu- prudential regulation and mounting
bank liquidity. A variety of non-bank
lations to minimize firms — investment banks, mortgage competition. Second, banks started
any probability of REITs, finance companies, the hous- managing investment funds, as well
a recession in the ing GSEs come under this classifi- as offering asset management ser-
FinGyaan

future. cation. Shadow banks intermediate vices through their departments.

credit through a wide range of secu- Third, a gamut of institutions came
ritization and secured funding tech- in to play a role similar to those of
niques such as ABCP, asset-backed commercial banks.
securities, collateralized debt obliga- The figure below denotes a
tions and repo. bubble formed at the heart of a fi-
nancial system which drove one of
It’s different from commercial
the biggest lending booms in history,
banking!
and collapsed into one of the most
Commercial banks have always crushing financial crises ever seen.
operated under the glaring sun of The inception of shadow banking
regulations. Depositors always know witnessed the notions that
that there is a “lender of last resort”
• Widening the scope of banks’
to protect them from hidden risks.
activities would let them reverse
Shadow banks, on the contrary:
long-term secular deterioration in
• Are exempt, to a large extent to competitiveness.

We’ve had a global banking

failure, and it’ happened in every
part of the world. It’s almost like a
power cut that went right across the
financial system. And we have got
to rebuild that financial system.

54 NIVESHAK VOLUME 3 ISSUE 8 August 2010

 among the worst “toxic” debt. Later on, these banks
started designing “synthetic” versions of these in-
struments, backed by credit derivatives and not by
the loans granted. According to the Wall Street Jour-
nal, the SIVs had issued US$ 1.5 trillion in commer-
cial papers till mid-2007

The Descend
Creative financing was the key in propelling
the global financial system to hazy new altitudes,
before leading the way into the nadirs of a systemic
• Free market discipline would force non-depos-
crisis. It was all splendid while an ever-larger ap-
itory “shadow banks” to make sound credit risk-
plication of leverage put upward thrust on the as-
return decisions.
set values. Until, of course, convention was turned
• Even if shadow banks failed to make good
on its head, starting with a run on the ABC’ (asset-
credit decisions, taxpayers would not be burdened
backed commercial paper) market in August 2007,
by their resulting bankruptcies.
the near demise of Bear Stearns in March 2008, the
It led to formation of three expanding bubbles: de facto nationalization of Fannie Mae and Freddie
in property valuation in the U.S., in mortgage cre- Mac in July 2008, and the actual death of Lehman
ation, again, principally in the U.S., and in the shad- Brothers in September 2008. The mad run against fi-
ow banking system, not just in the U.S. but around nancial intermediaries raised requests for withdraw-
the world. als in late September 2008, producing a new and
Over the last 40 years, shadow banking system colossal round of deleveraging, casting even darker
raised capital and invested in assets, which included obscurities on the prospects of such funds.
much of the “toxic” debt of the previous decades. Between June 2007 and November 2008, there
However, irrespective of all this, shadow banks con- were many especially dramatic events in the pro-
tinued to fly much below the radar of traditional gression of the crisis, with strong influences on the
bank regulation. global interbank markets.

FinGyaan
Investment banks created SIVs which were At this stage, the NBFC’s were subject to a real
highly leveraged, off-balance-sheet entities as in- “bank run against non-banks”. In the process, the
struments to issue collateralized debt obligations institutions, seeking to survive, actively sold their
(CDOs) and other structured derivatives that were assets, for which there still was a market available
entailing a significant weakening of their prices.
Bankruptcy of many mortgage banks had
speeded up a process of shrinkage of this massive
“parallel financial system” which gave birth to ever
more complex and obscure innovations. The crisis
laid bare the obsolescence of the dispersed supervi-
sory structures, due to the degree of interconnection
among the different financial institutions.
Indeed, it is unambiguously the case that there
was and is something special about a real bank, as
opposed to a shadow bank! The evidence was the
partial re-intermediation of the shadow banking sys-
tem back into the sovereign-supported conventional

It is unambiguously the case

that there was and is some-
thing special about a real
bank, as opposed to a shadow
bank!

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 55

 banking system. There too was a mad scramble by even though they are making lesser and lesser loans
the remaining shadow banks to transform them- and still holding billions of bad, delinquent debts.
selves into traditional banks, so as to eat at the The reported profits may be from trading activities. It
same sovereign-subsidized capital and liquidity caf- is quite easy to show very high level of profits by the
eteria as their former stodgy brethren. trade of assets that do not have a real market price.
The Current Scenario The reported profits may also be getting generated
The bankruptcy of insolvent institutions and
the disappearance of the more exotic instruments’
liquidity are gradually leading to a gradual recon-
struction of the global financial world. The systemic
risk of an entire financial system breakdown makes
the adoption of a better system of regulation and
supervision more and more inevitable. The question
remains, whether the shadow banking has lost its
prime and is moving toward its end, or is it on the
verge of a revival.
The “shadow banking” system of the US, al- by “quid-pro-quo” trades.
though having lost an amount close to $4.5 trillion
Also, the amount of rehypothecation has been
from its peak of 2007-08, has liabilities still standing
on an upswing just after the recession. Rehypoth-
at a humongous $16 trillion, which is much higher
ecation occurs when the collateral posted by a prime
than the approximately $13 trillion of the traditional
brokerage client (e.g., hedge fund) to its prime bro-
bank liabilities. This can be seen from the graph
ker is used as collateral also by the prime broker for
mentioned above.
its own purposes.
The relief packages given out by the various
As evident from the graph on the next page,
governments in lieu of the bailout money were aimed
the rehypothecation funding has seen an increase
at saving and restructuring of the various troubled
from its low in May 2009. This process was a major
firms. Majorly, the TARP was aimed at the saving
player in the greatest recession that the world en-
of these “too big to fail” banks. The major reason
countered after the Great Depression.
FinGyaan

for providing bailout amount to these banks was to

inject capital into them so as to get credit flowing On top of all these things, the large banks still
into all the businesses. But the banks seemed to be reap government subsidies. Reports from the Wash-
interested in other activities. The commercial and ington Post say that banks with more than $100 bil-
traditional loans given out by the banks have come
down from 20 percent of total asset value to around
10 percent now. This means that these banks are
not really into the business of making loans to other
businesses.
But still, most of the major banks have been
making record profits with Goldman Sachs, Merrill
Lynch, Morgan Stanley, and the investment banking
division of JPMorgan Chase reporting $22.5 billion in
earnings in the first three quarters of 2009.
Now it is not possible to say with certainty, how
these banks are able to generate such high profits

Creative financing was the

key in propelling the global
financial system to hazy new
altitudes, before leading the
way into the nadirs of a sys-
temic crisis.

56 NIVESHAK VOLUME 3 ISSUE 8 August 2010

 tem. First and foremost, it is important to create
prudential regulation for systemically important
shadow banks. Such shadow banks should be
subject to the same limits on risk taking as other
banks. Also, supervisors of large banks that re-
port on a global consolidated basis may need to
enhance their understanding of the off-balance
sheet funding that these banks receive via rehy-
pothecation from other jurisdictions. One other
option is close regulation of securitized prod-
ucts. Also, a centralized clearinghouse needs to
be established for derivative trading. One final
proposal could be to create a regulated exchange
for credit default swaps and other financial de-
rivatives through which banks and other finan-
cial institutions will be required to trade these
instruments. With eyes filled with optimism we
have all moved ahead. But, the question still
lingers, “Are we out of the shadow, or are we
getting deeper into it?”

FinGyaan
lion in assets are getting a competitive advantage by
being able to borrow at interest rates which are 0.34
percentage points lower than rates charged to the
rest of the industry. This advantage was only 0.08
percentages in the pre-crisis era.
Also, with the amount of credit disappear-
ing from the market, the federal government had
stepped in to revive the lending in the securitiza-
tion market. For the same Term Asset Based Security
Loan Facility (TALF) was introduced.

What can be done ahead???

The experience of this recession has provided
ample learning to the financial brains of the world.
The time now is ripe to take major steps that can
provide a directed path to the shadow banking sys-

Shadow banks should be subject

to the same limits on risk
taking as other banks.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 57

 Participatory Notes and India
Harsh Bhardwaj
IIM Shillong
Remember the time when you
The article exposes
started investing in the stock mar-
the current status of kets, how many documents you had
Participatory notes to submit and get verified, filling of
in Indian market and forms, providing proof of residence,
PAN number and so on. You could
its associated risks have easily avoided these complica-
and rewards. tions had you been a foreign investor
and invested through Participatory
Notes commonly known as P-Notes.
These PN are not only easy to
invest with but have also caused a
lot of financial troubles. Back to the
time when recession occurred and
the whole world was in its grip be-
Perspective
cause of the heavy dependency on
the US and its famous Investment
Banks, India could have been easily
insulated because of its strong and
conservative banking system, but
that was not to happen because of
our own perfidious financial deriva-
tive called as “Participatory Notes”
(PN).
Derivatives have caused the
downfall of the US market and so
was the reason for ours too. Lets
have a look on what is Participatory
Notes and how did it affect us during
the recession of 2008.
Participatory Notes
Participatory notes can be de-
fined as the financial instruments
used majorly by hedge funds which
are not registered with SEBI but are
allowed to invest in Indian securi-
ties. From the definition itself you
can make out that without any re-
cord of ownership anyone can invest
any amount of white or black money
in the Indian market. It encourages
Regulators fear that investing
by the Participatory Notes can
cause instability and volatility
in the Indian Market.
58 NIVESHAK VOLUME 3 ISSUE 8 August 2010
those foreign investors who are bull-
ish on the Indian scrips and anony-
mously want to invest in the scrips.
Regulators fear that investing by the
Participatory Notes can cause in-
stability and volatility in the Indian
Market. They are also known as “P-
Notes”.
Why P Notes
Since the foreign investment
is limited to FIIs where the investor
has to register with SEBI and has to
disclose its full identity, PNs have
become a way to circumvent this
law when investing in Indian stock
markets.
Who can invest in P-Notes
Following entities can invest in
P-Notes:
i. Any entity which is regulat-
ed or supervised by a central bank
ii. Any entity which is super-
vised by a securities or future com-
mission
iii. Any entity which is a mem-
ber of securities or futures exchange
The finance ministry’s atti-
tude towards PN is unprecedented
in world’s financial history. It is a
piece of paper issued by designated
financial institutions abroad such
as Fidelity Investments and Morgan
Stanley, which does not carry any
detail except the money worth, and
can be purchased by anyone with
cash even without disclosing to any
authority his or her name and the
source of the funds. To add to that,
the Government, by a special order,
exempted PN from the purview of
any regulatory authority in India namely RBI and
SEBI.
As a result billions of dollars flowed into the In-
dian stock market without any accountability which
could easily flow out whenever FIIs wish. And it
takes no genius to guess why the PN were exempted
from the purview of the regulatory bodies- to allow
the Black money of the politicians and the corporate
to be invested in the market and gain returns from
it. The money which was earlier lying in the foreign
safe haven could now be legally invested and mul-
tiplied.
Just to explain the enormity of the problem,
when the Lehman Brothers collapsed, PN to the tune
of $60 billion flowed out of the system without any
notice which caused the fall of our stock market to
unprecedented levels. The markets can easily be
manipulated by the entry and exit of these PNs and
the ultimate loser is the common man, who stays
invested in the stock market by their hard money,
expecting to recover. The cause of recession in India
was not the sub prime crisis but the Participatory
Notes.
The government has signed a treaty with Mau-
ritius which allows companies who have even $1
of paid capital to invest in the Indian stock market
which has increased the flow of foreign funds in the
country but it is as dangerous as profitable, a trailer
of which we have already seen.
Since the PN is an instrument which is ma-
jorly used by the hedge funds, it has the capacity to
cause a lot of volatility as hedge funds are opportun-
ists and are not invested for long. The RBI’s concern
to ban the P-Notes was aggravated by three factors.
First the appeal pending in the SEBI vs. UBS case
where SEBI banned UBS from issuing P-Notes after
the historic crash of 2004 known as black Monday
accusing UBS of giving false information of their end
clients.
The second point was when after the Ketan
Parikh scandal, the Parliamentary Committee raised
a concern about the suspicious role of P-Notes in
the rigging of stock markets. Lastly they were also
believed to be involved in the Asian Tiger Economic
Crisis of 1997 and Mexico Financial crisis of 1994.
SEBI has also proposed a ban on the PN issu-
ance by sub accounts of FII with immediate effect.
The regulation is against the PN and not FIIs as at
The lack of opportunities in
the developed market makes
us a very lucrative option for
investment and hence we don’t
need to resort to measures such
as PN.
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
any given time there is somewhere around 25-30%
of money invested in the form of PN in the stock
market which is not a very comfortable fact.
Current Scenario
The use of P-Notes is now falling out of favour
with the foreign investors. Compared to the high us-
age of 55% during 2007 the share of PNs now is at
13% only. The usage of PNs have been falling since
SEBI put a cap of 40% as the maximum extent to
which PNs can form a part of overall Asset Under
Management(AUM). The other cause can also be the
higher cost of investing through PNs. Moreover SEBI
has also made the registration of FII a very simple
and transparent process thus encouraging investing
through FIIs. As per March 2010 there are 1170 FIIs
registered with SEBI with 5397 sub accounts. Such
direct investments could have resulted in the low in-
vestment through PN. Also SEBI is closely monitoring
the transactions through PN and its subsequent ban
on Barclays Bank Plc and Societe Generale from issu-
Perspective
ing P Notes for inadequate disclosure and misrepre-
sentation of facts could also have acted in lowering
the attraction of PN.
Another reason for this could be the lacklus-
ter performance of the hedge funds in the first two
months of this year. During this period, Eurekahedge
India recorded negative returns of 1.78 and .56 per-
cent in the months of January and February. Such
poor returns could have forced the fund houses to
direct their investments in other directions.
Value of holding %of PN in total FII Assets
10-Jan 131938 14
10-Feb 124177 13
9-Dec 168632 14
9-Nov 129943 16.5
9-Oct 124575 16.5
The PN system is blatantly discriminatory and
seems to favour ghost investors. Any self respect-
ing market would not allow such things to happen.
We have to realize that it is the funds which need
the market and not the other way round. The lack
of opportunities in the developed market makes us
a very lucrative option for investment and hence
we don’t need to resort to measures such as PN.
We need to have confidence in India growth story
and ban the PN.
59
Cover Story
AoM
Perspective
FinGyaan
FinSight

60 NIVESHAK VOLUME 3 ISSUE 8 August 2010

ANNOUNCEMENTS
ARTICLE OF THE MONTH
The article of the month winner for August 2010 are
First Prize (Rs. 4000): Nirmal Sharda, IIM Ahmedabad
Second prize (Rs. 3000): Manbir Singh Tandon & Gaurav Thakur, IIM Shillong
Third Prize (Rs. 2000): Jaideep Singh & Ashish Kumar Rander, MDI Gurgaon

FinQ Winner
The FinQ Winner for the month July 2010 is
Rajesh Beriwal
of IIFT, Delhi
He receives a cash prize of Rs.500/-
CONGRATULATIONS!!

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