Niveshak September 2009

THE INVESTOR



VOLUME 2 ISSUE 8



Cover Story

NIVESHAK

September 2009

AoM Perspective FinGyaan FinSight

Is It A Real Concern? ..



Build america bonds PG.CLUB, 22 spread and cricket pg. 06 © FINANCE INDIAN INSTITUTE OF betting MANAGEMENT SHILLONG 1

FROM EDITOR’S DESK Dear Readers,

Niveshak Volume II ISSUE 8 September 2009 Faculty Mentor Prof. S.S Sarkar

THE TEAM Editor Biswadeep Parida Sub-Editors Amit Choudhary Nilesh Bhaiya Sareet Mishra Sujal Kumar FinToonist Dilpreet S. Gandhi Saurav K. Bagchi Design Team Bhavya Aggarwal Sarvesh Chowdhury Swarnabha Mukherjee Tripurari Prasad

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

www.iims-niveshak.com

The global financial system is reminiscing the fall of Lehman Brothers, the event of September 15, 2008, that shook the world economy and sparked the worst financial crisis in generations. A year after, world is slowly but surely coming out of its tremor. The markets across the globe are continuously scaling new heights every week, backed with strong fundamentals from all the sectors. Hence with some level of confidence we can say the financial systems around the world have stabilized and the economy recovery is on its way. Whether this has been possible due to the resilience of economies and financial markets or the prudence of policymakers who responded to the crisis with massive macroeconomic stimulus and other measures to prop up their domestic financial system is already a burning topic of discussion. The Asian and European market is on upward trend which has been termed as “Cautiously Bullish”, is now waiting for the second quarter results of the corporate. The market sentiments and expectation across the globe has been positive for last three months, with almost all markets giving positive returns. The revival of US market and numerous signs recovery like positive home sales for the first time since 2007 and the growing of order book of manufacturing sectors have brought some cheers to the Wall Street. But the glaring fact which needs to be pointed is that the world is still looking up to US to pull the global economy from the crisis. China on the other hand is showing signs of recovering from the present crisis with the funding from government and bank lending. Today, China is one of the fastest growing economy of the world. We have covered this question whether China is the next economic superpower of the world and will overtake US is highlighted in this issue. India’s GDP growth for the first quarter of 2009 stood at 6.1%. This exceeds the consensus estimates and an improvement from the last quarter growth which was 5.8%. Hence given the global downturn these figures have brought some cheers to the investors in the Dalal Street and also to the policymakers of the country. But the fiscal deficit at 6.8% of GDP is hot topic of discussion among policymakers and economist. It’s not that only India is facing its worst fiscal deficit in past decade, most of the countries across the globe are facing the problem of huge fiscal deficit. US fiscal deficit stood 12.3% of its GDP. Our cover story is in line with these issues and gives a perspective whether to worry about fiscal deficit and what implication it will have on the recovery from the current crisis. We have also covered the topic of rising prices and falling inflation which have been making news every week. The basic of inflation calculation in India and the comparison of CPI and WPI method have been outlined. This issue also features the prospects of credit default swaps in India. An inside look into the Build America bonds have also been covered in this issue. I am glad to mention that this is the beginning of second year of Niveshak journey and would thank all our well wishers for their support for making the Anniversary issue a huge success. We will constantly try to scale new heights. Now in the outset of the recovery of the world economy it’s even more important to track the global cues and be informed. Economists and experts across the global have already stated that it may be ‘V’ or ‘W’ or even square root shape recovery. So it’s the time to keep a watch on the Bull and Bear fight in the global market and support the Bull to win the race. In the last we would like to thank Mr. Geert Linnebank, ex- Editor in Chief of the Reuters group for inaugurating our anniversary issue on 24th August. Stay Invested for the good times ahead.

Biswadeep Parida (Editor-Niveshak)

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

CONTENTS Niveshak Times

04 The Month That Was

finsight

22 Build America Bonds



32

Cover Story

Fiscal Deficit: is it a real concern?

fingyaan

14 Rising Prices And Inflation: The Illusion



article of the month

18 Credit Default Swap: In

India???

17 FinToon PERSPECTIVE

06 Spread Betting And Cricket 08 Is China The New America?

24 Fin-Q

finlounge

Niveshak Times

www.iims-niveshak.com

The Month That Was Tanvi Arora

IIM, Shillong

Market Watch Stock markets across the globe hit multi-month highs last week (September 7 - 11). In India, the benchmark indices Sensex and Nifty extended their gains to a sixth straight session last Friday and closed at 15-month highs. It was an interesting week to say the least. Monday, the markets opened with a gap lower, and there was a sharp follow-through lower on Tuesday. Once again the markets threatened to begin a larger correction, but by the end of the week they had regained the majority of their losses. The end result was a fairly balanced last month (17 August - 11 September). The news on the monsoon front turned out to be somewhat encouraging and FIIs, for their part, remained bullish and kept buying stocks almost right through the week. The past one month saw the market slip below 15000 mark due to monsoon worries and global concerns about the economic recovery. The first week, both Sensex and NSE Nifty closed with a loss of 1%. The next week saw the markets gaining steadily by adding around 4.5% on both the indices. The third week began with a negative note but rise in vehicle sales led to the auto market upsurge. The weekend of the third week saw an increase of 1.46% in Sensex and 1.1% rise in Nifty. The indices moved in almost the same trading band as that in the preceding week.

ing one of the worst airline disruptions in the country in recent years. Proposed Models of Dual GST Budget 2009-10 has indicated that there will be dual GST - a Central GST and a state GST. There are two ways of making it - one advocated by Finance Commission and one by the Empowered Committee. One Model envisions Central GST as an incorporation of Central Excise, additional excise duties, service tax and all cess and surcharges. Whereas, the state GST will combine VAT and various other service taxes as well as all state cess and surcharges. Second Model combines Central Excise (along with additional excise duty, etc.), service tax, sales tax (VAT) and all other state taxes together and makes a common base. Thereafter a certain percentage say is charged by the Centre and some part by the states.

Alarming New MAT Provisions It comes as a shock for over 250 companies as the government announces the new MAT provision. Large, capital-intensive companies in infrastructure, oil and gas, telecom, pharmaceuticals, real estate etc. will have to pay over Rs. 11,500 crore as additional tax in 2010-11 if the government enacts the proposed Direct Taxes Code in its present form. In a big blow for such firms, the draft code says companies will have to pay the higher of a 25 per cent corporation tax and a minimum alternate tax (MAT) of 2 per cent on their gross assets. Second, the basis for computing MAT has changed from book profits (15 per cent of the book profits at present) to gross assets. Third, MAT will have to be paid in even loss-making years, with no set-off against future profits. MAT is being sought as an additional burden, which would make sustainability difficult, especially in recessionary periods.

Jet’s Mayhem Jet Airways had last month terminated the services of two of its senior-most pilots, saying “their services were not required”. Later the two pilots, along with others, formed a trade pilot’s union body in the company, National Aviator’s Guild (NAG), and held a strike to protest their dismissal. The union has termed the sacking “an act of vendetta” and demanded their reinstatement. The deadlock between the two sides was resolved after hours of talks in Mumbai on Saturday, 12 September. The five-day strike by hundreds of pilots of Jet Airways ended late on Saturday night with the private airline agreeing to unconditionally take back four pilots it had sacked for forming a trade union NTPC and DVC Gets Approval and the pilots agreeing to resume flying at the earliTo aim at the power shortage in the country est. The rapprochement means most Jet flights will the government has approved an order of Rs. 40,000 begin to operate normally from 13 September, end-

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NIVESHAK

VOLUME 2 ISSUE 8

September 2009

Niveshak Times

www.iims-niveshak.com

The Month That Was crore for power equipment for the upcoming thermal power plants of NTPC and Damodar Valley Corporation. The proposals were made for induction of supercritical technology through bulk ordering for 11 units of 660 MW each by NTPC and DVC. After the government’s approval, power producer NTPC plans to float tenders for procuring the equipment for these 11 units within 45 days. RBI Surplus Shoots by Rs. 10,000 crore The Reserve Bank of India’s (RBI’s) transferable surplus to the Government of India for 2008-09 jumped 66.6 per cent to Rs. 25,009 crore from Rs. 15,011 crore in the previous year. This is primarily due to the domestic investments on account of an increase in ‘Interest on Domestic Securities and LAF operations’ and ‘Interest on Loans and Advances’. The surplus thus included Rs. 1,436 crore towards the interest differential on special securities converted into marketable securities for compensating the government for the difference in interest expenditure, which the government had to bear consequent on conversion of such special securities. TATA - Different Strokes Auto major Tata Motors today reported Rs. 329 crore consolidated net loss for the first quarter of this fiscal as compared to a net profit of Rs. 719.69 crore in the same quarter last fiscal. Although the management at Tata Motors says that the results are not comparable with the previous fiscal as the results for the quarter ended June 30, 2009 include the operations of JLR businesses, acquired on June 2. In the same week, Tata Power Company said its consolidated net profit jumped nearly three-fold to Rs. 572.65 crore in the first quarter ended June 30, 2009. Total income rose to Rs. 4,713.16 crore for the quarter ended June, against Rs. 4,069.34 crore in the same quarter corresponding year.

the front- and rear-chassis modules at new facilities from February. The facilities will be built adjacent to the Chrysler plant. They had been supplying Chrysler with chassis modules since 2006. This had send Hyundai’s shares up by more than 7 percent against a decline of 0.5% in the wider market. IOC Revamps Government-owned Indian Oil Corporation (IOC) strategize to invest around Rs. 60,000 crore in capacity-building in next five years and in turn, is aspiring to have 15 per cent of its revenue from petrochemicals in the next three years. There are various expansion plans in each respective sector. A new plant worth Rs. 14,000 crore is under construction at Panipat for propylene. Also, they intend to convert Paradip plant into a petrochemical complex. The company is also eyeing acquisitions of oil producing assets in Africa and South East Asia. The company also signs a joint venture with NPCIL with the aim of entering energy sector. The IOC also plans to expand its retail sector by adding 200 outlets each year.

Idea Demerges from Passive Infra Idea Cellular telecom operator got an approval from Gujarat high court for demerging its passive infrastructure to its wholly-owned subsidiary Idea Cellular Towers Infrastructure. Also, the company looks forward to its financial restructuring to adjust the amount of “non-compete fee” paid to the erstwhile promoters of Spice communications pending from the acquisition deal between the 2 companies. This news affected the shares of Idea cellular as it moved up by 0.80 percent whereas, Spice com shares raised by 17.5 percent.

Hyundai Mobis Wins Order from Chrysler Hyundai Mobis Co, in South Korea, has won a $2 billion order from Chrysler for chassis modules to be used for Jeep Grand Cherokee and Dodge Durango models. Mobis plans to begin pilot production of

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

5

Spread Betting & Cricket

Perspective

MOHIT KHEMKA

6

...What A Combination

IIM Shillong

Spread Betting as a Financial Instrument: Spread betting refers to a type of speculation that involves taking a bet on the price movement of a security. A spread betting company quotes two prices, the bid and offer price (also called the spread), and investors bet whether the price of the underlying stock will be lower than the bid or higher than the offer. The investor does not own the underlying stock in spread betting, they simply speculate on the price movement of the stock. Financial spread betting is a leveraged tool that gives investors the opportunity to trade the financial markets without ever taking physical ownership of the underlying instrument. For Example: A Betting company quotes the bid price of a stock as Rs. 500 and the offer price as Rs. 505. If the investor feels that the price of the stock will move up above Rs. 505, he can gamble and “bet” Rs. 10 on every rupee above Rs. 505 in a particular time frame. Suppose the price goes up to Rs. 520, the investor gains 15 x 10 = Rs. 150 as the profit; on the other hand, if the price goes down to Rs. Rs. 495, the investor loses 10 x 10 = Rs. 100. Many people think that financial spread betting is too risky. Subconsciously, they feel that investing in shares is ethically acceptable whereas betting has down market connotations and morally reprehensible. That is a pity, because the truth is quite different. You buy a share because you believe that the price will rise and you will make a profit. You bet on a share price for exactly the same reason. The only practical difference between buying a share and betting on the movement of the share price is that you need much more ready cash to buy the share. The costs of buying a share are much greater than placing a bet.

NIVESHAK

There are many attractions attached to financial spread betting. One of the key advantages of spread betting is “Leverage”. Very little capital is needed although a lot of money can be made from betting successfully. One can trade with a lot more than the deposit amount. So with Rs. 20,000 as deposit, an exposure to nearly Rs. 200,000 can be obtained if required. Spread Betting in Sports... In UK, Spread betting is legal and regulated by the Financial Services Authority. In the United Kingdom spread betting has come to resemble the futures market. It is so popular among the investors that it has spread to Sports betting too. The bets are usually on the outcome of sporting events or indeed on financial instruments, but the firms often offer bets on more arbitrary events - such as the number of corners during a football match or the total number of points a team will get in a Football league. Unlike fixed odds betting the amount won or lost can be very large, as there is no single stake to limit the maximum losses. However, it is usually possible to place a “stop loss” with the bookmaker, automatically closing your bet if the value of the spread moves against you by a specified amount. “Stop wins” are the opposite -- closing your bet when the spread moves in your favour by a specified amount. Consider this example: In a 50 overs cricket match between India and Australia, assume the spread for runs scored in 1st innings is 200250, the betting firm believes there will be 200 to 250 runs scored in total during the 1st innings. A bettor approaches the firm with the belief that there will be more than 250 runs scored by the team that plays first, the bettor ‘buys’ at Rs. 100 a run at 250. If the final total of the 1st team

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September 2009

is 275, the bettor has won, receiving (275-250) x 100 = Rs. 2500. If the final total turns out to be 200, the bettor loses (250-200) x 100 = Rs. 5000. A ‘sell’ transaction is similar except that it is made against the bottom value of the spread. For example: a bettor ‘sells’ at Rs. 50 per run at 200 runs. If the team scores 250, the bettor loses 50 x 50 = Rs. 2500. Often there is live pricing, which changes the spread during the course of an event allowing a profit to be increased or a loss minimized. The use of a “point spread” evens out the market towards an equal number of participants on each side of the spread. This allows a bookmaker to make a market by accepting bets on both sides of the spread. The bookmaker charges a commission and acts as the counter party for each participant. As long as the size of wagers on each side is roughly equal, the bookmaker is unconcerned with the actual outcome; profits instead come from the commissions.

Perspective

Cricket Betting in India... Must be legalized! In cricket, one can bet on the outcome of the match (win, loss or draw/tie), the toss, top scorer in the match or each team, top bowler in the match or each team; batting order, the manner of the dismissal of a batsman, total innings score, runs that will be conceded in the next over (odd, even, or more or less than the previous over) and so on. Since, huge amounts are at stake in betting, the bookies, especially the ones who operate illegally, may sometimes approach players or officials concerned to fix the outcome of what is betted on. Fixing the outcome of a match involves a vast network of connections. On-field actions, such as, which bowler would open the attack, the manner of dismissal and runs conceded in a certain over, can be easily fixed by the players or officials involved. The ghost of match-fixing started haunting the World Cricket community in a big way after the famous India-South Africa series in 2000. The lid of the game’s biggest scandal ever was blown off, when former South African captain Hansie Cronje & the then Indian skipper Md. Azharuddin were exposed in an embarrassing manner. Since then there have been numerous efforts by the International Cricket Council & the Cricket boards of respective countries to find a solution to such corrupt practices. But the efforts have not yielded any substantial results as yet. As it is rightly

said that “Prevention is better than cure”, the only solution that remains feasible to prevent this ghost from ruining the game is to legalize its existence! Now, who stands to benefit if this happens? It is estimated that about US$ 2 billion rides illegally on every international cricket match that is played in India. India has emerged as the financial capital of the Cricket world. Any kind of cricket betting is currently a criminal offence as per the laws of this land. It is high time that the Indian Government gave up its ostrich-like approach to betting and opened its eyed to the stark realities. If this activity is legalized, the amount of money that will be at stake is just unimaginable. Legalizing Sports betting has got many advantages. Firstly, it would help to remove any kind of unfair results in a match. If matches can be legally betted upon, curtailing match-fixing will not be a difficult thing to do for the cricket authorities and regulators. The whole betting activity would then become more transparent. Match-fixing could be detected in cases when the betting odds are abnormally lop-sided. Secondly, If Sports betting in India (Cricket in particular) is legalized and regulated by the Government through instruments like ‘Spread Betting’, the potential revenue for the Government from entertainment and other forms of Taxes is going to be magnificent. Earning thousands of crores just from Cricket betting would not be impossible for Indian Government. And it is not incorrect to legalize an activity in such a way that it is a Win-Win situation for all the stakeholders involved – the Government, the players, the Cricket Boards, the spectators and most importantly, the future of the great game itself! IPL – can be taken up as Pilot project: The celebrated Indian Premiere League has successfully corporatized cricket in India. There is involvement of large number of Business houses in IPL, which means that it is serious business for them. The Indian Government in conjunction with BCCI can think of legalizing betting in India by taking up IPL as a pilot project to see if the potential benefits can actually be materialized. It is high time that the Government initiates measures to regulate this currently illegal activity, and seizes the opportunities that galore in legalized betting!

The ghost of match-fixing started haunting the World Cricket community in a big way after the famous IndiaSouth Africa series in 2000 © FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

7

is china... ...the new america?

Perspective

Kanika Nayar

8

NMIMS, Mumbai

The question that remains to be answered is, “Will China be able to do its job of economic superpower as well as America did? Is China actually becoming the new America? Does it actually have all that is required to become the most powerful country of the world?”

History often has a way of surprising us and repeating itself, putting us back in the same situations as were there years ago, again not leaving us prepared to expect them. Roles are reversed and players have changed so fast that countries are not able to properly play their part. The situation after the World Wars is very similar to the situation of the world economy now. Britain, exhausted after the world wars, paved the way for United States; which then emerged as the economic superpower of the world. U.S. was the net creditor of the world, thus the leadership was easy to pass from the Debtor Economy (U.K.) to the Creditor Economy (U.S.). The same situation exists now except that the exhausted debtor economy role is being played by U.S. now and China has emerged as the creditor economy sitting on reserves worth almost 2 trillion dollars. China has the same power that U.S. had at that time. Applying the same historical principles of the period after the World wars, China would become the new U.S., inspired with the drive to manufacture more and more, becoming richer and richer, growing like crazy to overthrow the current reigning superpower. Post the economic reforms in 1979 till now, China’s GDP has been growing at a rate of around 10% per annum. The Chinese economy has grown 14 fold in real terms and its real GDP has also grown more than 10 folds. China has also transformed

NIVESHAK

into a major trading power. Chinese exports rose from $14 billion in 1979 to $1,429 billion in 2008, while imports over this period grew from $16 billion to $1,132 billion. However, towards the later part of 2008, China too suffered some ripple down effects from the financial crisis and there was a reduction in demand for its products. China is producing many IT graduates year after year. Many economists say that the new IT hub will move to China and that it’s not a question of “if” this will happen but “when” will it happen. History proves that authoritarian regimes yield high growth rates. This has happened in the case of Germany in 1930’s, Soviet Union in the 1950’s and now China in the 1990’s. At this moment, China is one of the fastest growing economies of the world. Being in such a situation, it was expected from China that China should come and save the rest of the world from drowning in the financial turmoil created. China, in its defence, did try to rescue the rest of the world. In the initial stage of the financial crisis, sovereign wealth funds from many countries especially China were pumped into European and American institutions. After pumping a lot of money China realised that the great deal of uncertainty in the world economy might make it lose millions, the risk which China was not prepared to take. China, though it has the financial backing to become the new US,

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is being said by many finance experts all over the world that the label “Made in China” will soon be replaced by “Owned by China”. China also surpassed America as the greatest driver of global economic demand. China has slowly become an important international player and is the league for the next superpower though all are not sure whether it was China’s primary intention to do so. In 2008, while the rest of the world was suffering because of the recessionary conditions, China was not. It was preparing itself for the 20 billion pound Olympics in Beijing and watching its domestic consumption go to levels higher than ever expected. The Olympics in Beijing has helped China in rising up further and may have proven to be a major factor helping China to become more powerful. The goal of the Yuan though, should be to eliminate exchange risk fluctuation, a necessity of the world at this point of time. If the Yuan becomes the global reserve currency then China will find itself in more pressure. It will be forced to develop its economy even more as its economic climate will affect countries all over the world. China though, may not be willing to open itself to such degrees of globalisation. What will China get in rescuing the world economy? This is a question China needs to ask itself before we can fully decide whether China is the new America. If China does replace America and the Yuan does replace the dollar, this is a change that will not happen overnight and will take the world a long time to digest and get used to. Is the world ready for such a big change? Is the dollar ready to give up? It’s too soon to answer those questions as China is not ready yet. But when China is ready, we will be able to witness whether the U.S. is stronger or China and watch the emergence of our superpower. Either the U.S. will emerge stronger than before or China will take its place or is there a possibility that another country becomes the superpower? Most economists are placing their bet on China and I too agree with that opinion placing my money on China.

Perspective

is still in nascent stages in some parts of its economy. The Chinese banking system, its aging problem, growing pollution, over reliance on exports, are just a few factors hindering the growth of China as the new superpower. China has a large treasure chest but lacks in a well developed financial system. It still has many people living below the poverty line, with wide income inequalities. The Chinese currency, Yuan, is in a strong position to become the global currency of the world and take the weakening dollar off the shelves. China holds 2 trillion dollars in assets, accumulated over a number of years. If dollar goes on weakening and America is not able to reduce the mountain of its debt, the big losers from this would be China. The world was sceptical whether Yuan would be made a convertible currency with its prices determined freely by the market. This would require China to reduce trade barriers and regulations which the world was sure that China would never agree to do. However, recently China has made big steps towards making Yuan freely convertible with other currencies, declaring open war to the U.S. that its currency is ready to be the reserve currency of the world. Though, China has not openly declared that its currency is ready to be the reserve currency of the world, they believe that it may be time for someone to step in and replace the dollar. There are though some road blocks stopping Yuan and thus providing a safe haven for dollar despite its continuous weakening. Absence of a derivative market for Yuan, absence of large market for Yuan denominated bonds, issues with encouraging banks to hold large sums of Yuan, are some of those hurdles. In the past few months China has signed currency swap agreements worth more than 95 million dollars with Argentina, Malaysia, South Korea, Indonesia and many other nations who are happy to be as far away from the shaky dollar as possible. In April, China announced that the Yuan can be used in overseas trade settlement in five cities - Shanghai, Guangzhou, Shenzhen, Zhuhai and Dongguan. China has also signed an MOA with neighbouring countries and Latin American countries as a first step of making the Yuan freely convertible. Chinese trade surplus in 2007 was 130 billion pounds and is continuing to increase steadily. It

Will the Yuan be able to save the rest of the world from drowning in the mounting US debt? Will the Yuan be the new “Dollar” for us? © FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

9

Cover Story

...is it a real concern? Abhinav Chugh & Nidhi Kaicker

FMS, Delhi

The recent (2009-10) Union Budget of India was presented against the backdrop of extremely challenging economic conditions worldwide. India’s growth rate has slipped from the highs of 9.0% to 6.7% in 200809. The fall in the growth might have been sharper had it not been for the fiscal stimulus of the government. While fiscal expansion is necessary to bring back growth to its previous levels, it is the increasing deficits that are becoming a cause of concern.

banks. While deficits are good in the sense that they help an economy get out of recession, there negative effects can be seen when it comes to financing these deficits. Because of deficit financing, the money stock increases in the economy which leads to Inflation (however it is argued that since the output also increases as a result of fiscal expansion along with the money stock, there might not actually be inflation). Greater deficits raise the accumulated debt and thus also raise the interest rate burden. Deficits can be reduced by What are Fiscal Deficits? increasing the revenue receipts (this Fiscal Deficit arises when the has not been done in India till now) government’s total expenditures or by reducing expenditure, or disin(current & capital expenditure) ex- vestment. ceeds the revenue receipts (i.e. total receipts of the government minus Overall Fiscal Trends Fiscal performance is conborrowings). A fiscal deficit can be financed by borrowing from the RBI tingent on the performance of the (Deficit Financing) or borrowing from economy. The economic downturn

10

NIVESHAK

took a serious toll on government revenues in 2008-09. The gross revenue of the central government grew by a mere 2.8 percent in 200809 compared to over 25.0 percent in the preceding year. Income tax and corporation tax growth fell to 7.2 and 10.8 percent, respectively, from close to 35 percent in 2007-08. The worst performers were indirect taxes, which shrank by 8.4 percent in 2008-09. Manufacturing sector is the key contributor to corporation tax and excise duties. With growth in manufacturing slipping to an anemic 2.5 percent, the poor performance of excise and corporation tax does not come as a surprise. The graph (next page) shows the trends in India’s fiscal deficit in the last decade As seen from the previous graph, India was able to comply with the Fiscal Responsibility and Budget

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Cover Story

Management Act (FRBM) laid in FY04 to bring fiscal discipline into the economy up to FY08. In fact, in the last five years, fiscal deficit has always been lower than the budgeted estimate owing to high GDP growth and compression in expenditure. The reversal in 2008-09 (6.2% deficit instead of the projected 2.8%) is due to expenditures which were not budgeted and revenues hit by lower growth. Both Income tax and Indirect taxes shrunk, the dent in manufacturing led to lower corporation and excise duties, and the external sector contributed lesser than expected customs duty. There was a moderate relief from service tax. Expenditure increased, along with NREGA, sixth pay commission and farm loan waiver, on two fronts: increased oil, food and fertilizer subsidies due to the global commodity prices; and fiscal stimulus required to restore growth rates in the wake of the global financial crisis. Fiscal Deficit in United States

The sharp deceleration of the US economy in 2008, under the weight of a significant housing correction and a banking crisis opened up the possibility of a severe recession bordering on a depression. As a result Government spending expanded enormously to stimulate the economy and compensate for the shortfall in other components of aggregate demand, particularly consumer expenditures. Above mentioned steps resulted in increase in fiscal deficit as a percentage of GDP to worrying heights - $1.75 trillion (12.3% of the GDP). One way that the US government can reduce its fiscal deficit and eventually pay down its debt is by the resumption of robust growth

via autonomous private-sector spending. So, if the trend rate of growth proves to be more modest than in the past, then the government’s plan to reduce its debt load primarily through the normal process of economic recovery may be difficult to achieve. And that leaves three other solutions: deeper spending cuts, higher taxation or inflation. Rising concern of the Fiscal Deficit post Budget

Higher fiscal deficit and an apparent lack of road map for reforms in Pranab Mukherjee’s Budget pulled down the Sensex, India’s most tracked equity index, by 5.83% or 869 points, the sharpest-ever decline on any Budget day. The recent Union Budget Speech mentioned the need to amend the FRBM to accommodate the business cycles. With several social and infrastructure initiatives announced, the government expenditure is projected to expand by 15%, though relief is expected under the subsidies head. On the revenue front, the tax receipts are expected to be lower and only a moderate increase in revenue can be expected from disinvestment and auctioning of 3G spectrum. This will keep the deficit under pressure and it is not hard to believe that 6.8% is not a very conservative estimate. • With states also allowed to borrow from markets even if their fiscal deficit increases to 4 per cent of their GDP against the current limit of 3.5 per cent, the combined fiscal deficit of India will easily touch the double-digit mark.

Higher fiscal deficit and an apparent lack of road map for reforms in Pranab Mukherjee’s Budget pulled down the Sensex

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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Cover Story

• With states like Rajasthan, Madhya Pradesh, Andhra Pradesh, Karnataka and Tamil Nadu facing 15-50% shortfall in monsoons, there is high likelihood that the government may have to allocate money to manage drought situations. • Fiscal deficit of 6.8% translates into Rs. 4 trillion of borrowing. The increased demand for funds by the government to finance its deficit will lead to mounting pressure on the interest rates in the coming fiscal year impacting the primary deficit severely. This will also crowd out private investment. • The only way fiscal balance can be restored is that tax revenues increases sharply in expectation of a new growth story, and disinvestment rises. However, it would be a miracle if such a sharp increase in government finances occurs over a short period of time.

Conclusion

The 6.8% fiscal deficit must be looked at with a pinch of salt. While it brings with itself the development of social and physical infrastructure making India a preferred investment destination, there is no doubt that the rising Fiscal Deficit is a concern to the Indian Economy; especially when the projected deficit appears to be a not – so – conservative number. The government must take corrective measure to restore the fiscal balance. The finance minister has already given confidence by saying that the government will not finance the fiscal deficit. The only signs of hope come from the GST, disinvestment revenues and lowering of the subsidy bill and off balance sheet liabilities.

»»»»»»»» No Need To Worry »»»»»»»» Sachin Ahuja

IMT, Ghaziabad Fiscal deficit is an economic phenomenon, where the Government’s total expenditure surpasses the revenue generated. It is the difference between the government’s total receipts (excluding borrowing) and total expenditure. Fiscal deficit gives the signal to the government about the total borrowing requirements from all sources. According to the view of renowned economist John Maynard Keynes, fiscal deficits facilitate nations to escape from economic recession. From another point of view, it is believed that government needs to avoid deficits to maintain a balanced budget policy. In order to relate high fiscal deficit to inflation, some economists believe that the portion of fiscal deficit, which is financed by obtaining funds from the Reserve Bank of India, directs to rise in the money stock and a higher money stock eventually heads towards inflation. Financial advisors recommend that the Government should not promote disinvestment to reduce fiscal deficits. Fiscal deficit can be reduced by bringing up revenues or by lowering expenditure.

tion led to an increase in fiscal deficit from 2.7 per cent in 2007-08 to 6.2 per cent of GDP in 2008-09. Growth rate of Gross Domestic Product dipped from an average of over 9 per cent in the previous three fiscal years to 6.7 per cent during 2008-09. The government has already come up with three fiscal stimulus packages in the past few months to boost economic growth. India’s overall Budget is consistent with the agency’s “stable outlook on Baa3 foreign currency and Ba2 (non-investment grade) local-currency sovereign ratings”. According to various agencies, many of the shortcomings in overall expenditure management and high debt overhang, are reflected in non-investment grade rating of Ba2 for the nation’s local currency. India’s fiscal position is a concern for the country’s rating. Fitch gives India a local currency rating of “BBB-minus”, its lowest investment-grade level, with a negative outlook. Still do we need to worry?

I do not think it is a cause for concern. Many analyst have tortured the numbers in evPresenting the Budget, Finance Minister ery way they could torture them, to see if there Pranab Mukherjee said that Fiscal accommoda- really is a relationship between the gross fiscal Impact

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doing better than it ever did in the past, which is amazing, because there’s hardly been any investment in agriculture in 30 years. Drought could hold negative ramifications for the economy, but fortunately, more area under irrigation, making our vulnerability to the monsoon decline. The problem is, the reservoir levels are quite low. And that low reservoir levels can lead to low hydra-power creation, which will have a negative effect on the southern states. I see the Deccan Belt being the most affected area if the rains are insufficient. I find that to be a bit of a problem. Agricultural sector will not grow as well as it could have, if rains were normal. As per discussion of CMIE’s projections for the commission of investments, “Based on our estimations, we are seeing Rs 5.5 lakh crore (Rs 5.5 trillion) of investments to get commissioned in 2009-10. I’m not talking about new proposals and outstanding numbers. It’s not about commissioning of new projects. Compare this to the Rs 2.2 lakh crore (Rs 2.2 trillion) that was commissioned last year, it’s easy to see how the industrial sector will benefit. “These (projects) are big steel mills, big farm projects, big power projects and a host of other investments. What happens is that when a plant is commissioned, it starts employing people, it creates demand for services, transport increases and (newly employed people) start spending; so overall you get a higher level of activity. The multiplier effect on the economy will very, very substantial.” And that’s the reason that I am not only optimistic about the industrial sector in 2009-10, I am fairly optimistic about the industrial sector going ahead. So even if investment activity begins to go down, which I expect due to fiscal deficit, industrial will continue to grow.

Cover Story

deficit and inflation, measured any way, or interest rates, measured any way and they found no relationship, that relationship is absent in the data for the last twenty years. So what are these economists saying?” The reason is not that the theory is wrong; it is just that the range of the gross fiscal deficit is still not bad enough to have an impact on inflation and interest rates. Which means that a 10% fiscal deficit -- Centre and state included -- is not something to get too worried about. The good thing is: we do worry about it. Therefore, we’re not testing the limits of the theory. So it’s good to be cautious.” There is a good likelihood that in 2009-10, India will turn out to be the fastest growing relevant economy in the world, at about 6.6 per cent, which is similar to what we saw in 200809. But this growth I’m talking about for 200910 is not actually the whole story, because behind this sits a very substantial increase in the growth of industrial production, which is what I think matters the most. And if there is going to be something that spoils the story, it’s going to be the services export sector. And our services sector is likely to suffer because our exports are not going to do very well. If the world economy is going to shrink by 3 per cent, and if world trade shrinks by about 10 per cent, it will take a toll on our imports and exports, which will impact our GDP. It will affect both trade and transport measurements. Still, the economy is doing reasonably well. Industrial growth rate should double this year. 2009-10 will be the seventh consecutive year of the agricultural sector not seeing a decline, and the fifth consecutive year with positive increase. Now that’s never been seen in India. That is a phenomenal thing to have. And that shows up in consumer domestic demand. And consumer domestic demand is our saviour, is the reason why the Indian economy is not as stressed as other economies are. Agriculture is

2009-10 will be the seventh consecutive year of the agricultural sector not seeing a decline, and the fifth consecutive year with positive increase © FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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Rising Prices & Falling Inflation ...the Illusion Durgesh Nandini Mohanty

FinGyaan

IIM Shillong

Lot of talks is going around regarding the discrepancy between the inflation and rising prices of food articles. In this article we will try to understand why food prices are surging when we had inflation in red.

If you like to talk about numbers for inflation, allow us to give you a news article “India’s annual rate of inflation was minus 0.21 percent for the week ended on August 22, up from minus 0.95 percent the week before. The rate turned negative for the week ended on June 6 for the first time since the new wholesale price index (WPI) series started in 1995. The inflation rate had last turned negative in 1977.” Now that baffles you. Negative inflation implies to the layman that the price level was lower during a given week, than it was over in an earlier period. Food prices have been rising for the past few months, yet our beloved ministers claim of negative inflation. That anyways is also unhealthy, but why is the discrepancy? When reality and statistics go in different directions, we have to accept that something is seriously wrong somewhere. Let us attempt to dig into the reality of Inflation.

Inflation and its Importance: Inflation is the rate at which prices of goods and services increase in an economy. Undoubtedly it is one of the most vital economic parameters today. Widely tracked by the media, inflation is always in news. So, what exactly makes it such a big shot? Inflation is a sign that the economy is growing. On the other hand, hyperinflation i.e. inflation gone ‘out-of-control’ in which money loses its value very rapidly (otherwise called debasement of currency) is considered detrimental for the economy. At the other extreme, an economy with no inflation has essentially stagnated. Consequently, the maintenance of an optimum level of inflation which is somewhere in between the extremes is what is required. Economists opine that inflation is considered to be a serious problem at over 10%. Anything over 100% could lead to hyper inflation and serious destabilization. Inflation between 2-4% is considered healthy. Inflation is one of the most

“India’s annual rate of inflation was minus 0.21 percent for the week ended on Aug 22, up from minus 0.95 percent the week before. The rate turned negative for the week ended on June 6 for the first time since the new wholesale price index (WPI) series started in 1995. The inflation rate had last turned negative in 1977”

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closely watched national economic statistics. The reasons for this are many. Firstly, the rate of inflation is referred to while formulating major government policies. It is used to index wages, salaries, pensions, and regulated or contracted prices. Secondly, a high and volatile level of inflation leads to shaky predictions about prices in the future. This creates an air of suspicion, hence leading to reduced inward investments in the country. And ultimately the economic growth of the country is seriously hampered. Last but not the least, inflation directly affects the living standards of the people because as the rate of inflation increases, the cost of all commodities also increases. In a country the responsibility of sustaining a stable inflation rate is assigned to the central banks i.e. the RBI in our case. They act like regulatory bodies and control the size of money supply primarily through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements, hence controlling the inflation.

Flaws in the System: After reaching a 13 year high of 11.05% in June 2008, inflation dipped to -1.74%, a 33 year low, in August 2009. This raised serious questions over the credibility of the method that is adhered to while calculating inflation. This is because the ground conditions in India are far from being reflected in the inflation rate. It is the international price of crude petroleum that single-handedly dictates our inflation rate, unnecessarily overshadowing the prices of the basic commodities that are required in the life of the ‘aam aadmi’ in India. For instance, even when the inflation rate is low, the prices of cereals, pulses and vegetables continue to rise. The prices of other products like fertilizers and pesticides that are very crucial to a primarily agrarian economy also defy the plummeting inflation and continue to swell. The price of crude petroleum which is given a high weight in the WPI pulls down the inflation rate and gives us a totally skewed picture, very different from the actual prevailing conditions. The list will only get longer if we state the injustice that a heavily biased WPI and hence the rate of inflation inflict on the people of the country. The facts say that out of the 14.22624% of the weight allotted to Fuel, Power, Light & Lubricants in the WPI, the largest chunk of 6.98963% i.e. half of it is assigned to Mineral Oils consisting of LPG, Petrol, Aviation fuel, Diesel, Kerosene etc.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

FinGyaan

Calculation of Inflation: To get an exact measure of inflation, theoretically, the average increase in prices of ‘all’ the goods and services available should be taken into account. But this is far from feasible. Hence certain concessions are allowed and a basket of goods and services that are indicative of the consumption patterns of the entire economy is considered. Mathematically, inflation rate is calculated as the percentage rate of change of a certain price index. A price index is a normalized average or a weighted average of prices for a given class of goods or services in a given region, during a given interval of time. In India we have adopted the WPI (Wholesale Price Index) for this purpose. In countries like the USA, UK, Japan and China CPI (Consumer Price Index) is followed for calculating inflation. For calculating the WPI, a set of 435 commodities and their price changes are used for the calculation. The selected commodities are supposed to represent various strata of the economy and are supposed to give a comprehensive WPI value for the economy. On a broader level, the 435 commodities are grouped into Primary Articles; Fuel, Power, Light & Lubricants and Manufactured Products. Primary Articles consist of food grains, fruits and vegetables, milk, eggs, meats and fishes, condiments and spices, fibers, oil seeds and minerals. Fuel, Power, Light & Lubricants consist of coal and petroleum related products, lubricants, electricity etc. Manufactured Products consist of dairy products, flour, biscuits, edible oils, liquors, cloth, toothpaste, batteries, automobiles etc. As WPI is a weighted average of the

commodities, the weights are derived based on the value of quantities traded in the domestic market. The corresponding group weights are 22.02525% • Primary Articles • Fuel, Power, Light & Lubricants 14.22624% • Manufactured Products 63.74851% The fiscal year 1993-94 is considered the base year and the WPI is assumed to be 100 for the same.

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The following two graphs show that inflation rate in India is largely dependent on the fluctuations in prices of crude petroleum as crude petroleum forms one of the major imports of the country. This glaring inclination towards Petroleum is better witnessed when we notice the weights conferred on the Primary Articles. For instance the weight of Food Grains (Cereals and Pulses) is merely 5.009% and that of Fruits and Vegetables is an ignominious 2.916%. In a country where approximately 25% of the population is wallowing Below Poverty Level and is struggling to fulfill the basic needs of life, the current split-up of the WPI cannot be justified.

Price of Crude Petroleum per barrel

The WPI has many other shortcomings besides the above mentioned one. In the WPI more than 100 out of 435 commodities have abstained to be important from consumption point of view. Secondly the WPI measures the general level of price changes either at level of wholesaler or at the producer and

does not take into account the retail margins. And finally services like health and education which constitute major expenditures of the people today are not included in the WPI. Therefore a change is inevitable. The sooner it is brought about the better. Either the WPI should be amended. Or shifting from the WPI to the CPI should be given a serious thought. Most of the developed countries had replaced WPI with CPI in the 1970s. Advantages of the CPI: The benefits of the CPI over the WPI are numerous. • Firstly, the CPI changes in the US correspond to the changes in the prices of around 80,000 items (in contrast to the 435 items in the WPI).They are included under more than 200 categories arranged into the following eight major groups: »» Food and Beverages »» Housing »» Apparel »» Transportation »» Medical Care »» Recreation »» Education and Communication »» Other goods and services • This represents a cross-section of goods and services purchased by urban households which represent almost 87% of the US population. Hence the method of calculation of CPI is much more inclusive of the entire population and the products, in contrast to India’s WPI. • Secondly, the CPI includes sales taxes and hence unlike the WPI takes the retail level into account. Therefore it reflects more accurately the way the price changes affect the end-user, the common man. • Thirdly the data collection is done in a more proficient manner. It is carried out by the Bureau of Labor Statistics (BLS) which makes sure that the products included are relevant to the consumers and the prices the latest. • Fourthly the WPI is calculated every week whereas CPI is calculated every month. This way the CPI gets us a better picture of the more sustained price changes, discarding the minor day to day fluctuations. Hence the government can rely on the inflation rate for formulating long term policies for the

Either the WPI should be amended. Or shifting from the WPI to the CPI should be given a serious thought.

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country. • Fifthly the BLS calculates the CPI for two population groups, one consisting only of wage earners and clerical workers (CPI-W) and the other consisting of all urban consumers (CPI-U). The wage earner and clerical worker population consists of consumer units with clerical workers, sales workers, craft workers, operative, service workers, or laborers. The urban consumers consist of professional, managerial, and technical workers who constitute the upper strata of the society. This classification indicates the price variations with respect to the different economic classes in the society. Hence no class gets overshadowed by the other and the needs of each can be specifically looked after by the government. • Also the CPI takes the price of services like education, health and recreation into account, unlike the WPI. Most importantly, the CPI is not a slave of the ups and downs in the international price of crude petroleum. There are two measures of the inflation according to the CPI, Core and Non-core inflation. The Core CPI index excludes products like energy with high price volatility. The non-core CPI index includes everything. Core CPI is important because

this is what the Federal Reserve (the central bank of the US that regulates inflation) looks at to decide whether or not to raise the Fed Funds rate. The Fed uses the Core CPI because the price of energy, specifically gasoline, is volatile and swings to the moods of the OPEC and the Fed’s tools to counter inflation are comparatively slower to act. It can take 6 - 18 months before the effect of a rate change can trickle down into the economy. Therefore, inflation could be high if gas prices have increased dramatically, but the Fed would not react until those increases have trickled through to the prices of other goods and services. Hence the inflation in this case is not solely dependant on the price of petroleum. Conclusion: After considering the advantages of the CPI, the necessity of a change in our system for measurement of inflation is more than evident. Presently, India is the only major country that uses WPI to measure inflation. The shift from WPI to CPI would make inflation a more exact indicator of where our economy is headed and hence it would not remain an illusion anymore.

FinGyaan

India gold prices neared their record high on Thursday, Sept 17th, with traders reluctant to stock the yellow metal even as festivals neared. It reached its highest value of Rs. 15,968 since Feb 2009

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

17

CREDIT

PDEFAULT A W

S

...In India???

AoM

Shuvabrata Nandi

IIM Ahmedabad

Satan’s financial tool of choice” Credit default Swaps are in the center of controversies after the recent financial crisis. In this article we will try to touch upon the basics of CDS, its features and nuances. We will also try to look, if Indian debt market is ready for such a complex financial instrument which is being blamed for its role in the global meltdown

Simply put, a credit default swap (CDS) is a kind of insurance against credit risk. Credit default swaps (CDS) are the most widely used type of credit derivative and are a powerful force in the world financial markets. The first CDS contract was introduced by JP Morgan in 1997 and by middle of 2007 the value of the market (in terms of the total notional of CDS outstanding) had ballooned to an estimated $45 trillion, according to the International Swaps and Derivatives Association (ISDA), which interestingly is more than twice the size of the U.S. equity market. The current notional of the all CDS contracts is assumed to be around $ 62 trillion by the ISDA. CDS contracts are in the centre of a major controversy after the recent financial crisis unravelled itself (especially with the bailout of AIG due to huge CDS exposure), receiving a lot of flak from regulators and common investors alike. Before we get into the details of the reasons for the existence of a huge CDS market and the purpose it serves, we would have a look at the basics of a credit default swap and its features and nuances. We would then look at the ways at which CDS can be used to speculate, and how these simple

looking credit insurance can potentially destabilise the financial system itself. A brief look at the state of Indian corporate debt market is also required to understand the whether there exists a need for credit default swaps in India. Finally, we have a look at the current regulatory stance on CDS in India and how has it evolved in the past, and we conclude on the decision to introduce CDS in India. Credit Default Swap Basics A credit default swap is a privately negotiated bilateral contract. The buyer of protection pays a fixed fee or premium to the seller of protection for a period of time (most liquid contracts are for 5 years) and if certain pre-specified “credit events” occur the protection seller pays compensation to the protection buyer. The premium paid by the protection buyer to the seller, often called “spread,” is quoted in basis points per annum of the contract’s notional value and is usually paid quarterly. Periodic premium payments allow the protection buyer to deliver the defaulted bond at par or to receive the difference of par and the bond’s recovery value. Therefore, a CDS is like a put option

The first CDS contract was introduced by JP Morgan in 1997 and by middle of 2007 the value of the market had ballooned to an estimated $45 trillion. 18

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Evolution of Global CDS Market The CDS market is an important market that has grown dramatically over a short period of time. The market originally started as an inter-bank market to exchange credit risk without selling the underlying loans but now involves financial institutions from insurance companies to hedge funds. The British Bankers Association (BBA) and the International Swaps and Derivatives Association (ISDA) estimate

that the market has grown from $180 billion in notional amount in 1997 to $5 trillion by 2004 and an astronomical $62 trillion by end of 2007. This rapid growth was spurred by the ISDA creating a set of standardized documentation. This standardized industry standards and benchmarks which greatly lowered the transactions costs to trading CDS. This rapid growth got halted for the first time in 2008 at the wake of the global financial crisis. The notional amount outstanding of credit default swaps (CDS) was $38.6 trillion at year-end, down 29 percent from $54.6 trillion at mid-year 2008. Notional outstanding, for the whole of 2008, was down 38 percent from $62.2 trillion at year-end of 2007. The $38.6 trillion notional amount was approximately evenly divided between bought and sold protection: bought protection notional amount was $19.5 trillion and sold protection was $19.1 trillion, with a net bought notional amount of $400 billion.

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written on a corporate bond. Like a put option, the protection buyer is protected from losses incurred by a decline in the value of the bond as a result of a credit event. Accordingly, the CDS spread can be viewed as a premium on the put option, where payment of the premium is spread over the term of the contract. It is important to note that the CDS contract is not actually tied to a bond, but instead references it. For this reason, the bond involved in the transaction is called the “reference entity.” A contract can reference a single credit, or multiple credits. (Nomura CDS Primer) The 2003 ISDA Credit Derivatives Definition provide for six kinds of “credit events” - Bankruptcy, Failure to pay, Repudiation / Moratorium, Obligation Acceleration, Obligation Default, and Restructuring. However, for market participants, bankruptcy, failure to pay and restructuring are the most significant credit events. It is also important to note that a written admission of a company’s inability to pay its debt must be made in a judicial, regulatory or administrative filing. ISDA master agreement for CDS includes four different ways to treat restructuring as well – No Restructuring (NR), Full Restructuring, Modified Restructuring and Modified Restructuring. (ISDA Credit Derivative Definitions, 2003) So, once a credit event happens, the buyer or the seller delivers a “Credit Event Notice”. Then, compensation is to be paid by the protection seller to the buyer via either 1. Physical settlement - the protection seller buys the distressed loan or bond from the protection buyer at par. Here the bond is called the “deliverable obligation”, 2. Cash settlement - the payment is determined as the difference between the notional of the CDS and the final value of the reference obligation for the same notional.

Why CDS is Used Now, let us look at the reasons as to why credit default swaps, touted as “Satan’s financial tool of choice” by the popular press, exist. Hedging (Bidirectional Trading in Credit): A CDS contract is used as a hedge or insurance policy against the default of a bond or loan. An individual or company that is exposed to a lot of credit risk can shift some of that risk by buying protection in a CDS contract. This may be preferable to selling the security outright if the investor wants to reduce exposure and not eliminate it, avoid taking a tax hit, or just eliminate exposure for a certain period of time. Please note that, such contracts don’t eliminate risk, and they don’t increase it. They just transfer the risk from one party to the other. But this enables those who bear a risk to protect themselves against it, and considering the huge volume of risk-taking that occurs daily in financial markets, the ability to redistribute risk has to be seen as very useful. A competitive market in credit default swaps contributes to the transparency of price-setting and thus to the efficiency of the whole process. This lowers the cost of financial risk management in general. Speculation: Credit default swaps allow speculators to “place their bets” about the credit quality of a par-

The 2003 ISDA Credit Derivatives Definition provide for six kinds of “credit events”

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ticular reference entity. With the value of the CDS market larger than the bonds and loans that the contracts reference, it is obvious that speculation has grown to be the most common function for a CDS contract. CDS provide a very efficient way to take a view on the credit of a reference entity. An investor with a positive view on the credit quality of a company can sell protection and collect the payments that go along with it rather than spend a lot of money to load up on the company’s bonds. An investor with a negative view of the company’s credit can buy protection for a relatively small periodic fee and receive a big payoff if the company defaults on its bonds or has some other credit event. Hence CDS solves the following issues faced by an active cash credit portfolio manager: - A manager who wants to take a long position cannot find enough of the bond to buy in the secondary market, receives insufficient allocations in the primary market, or else finds himself constrained by his own risk limits. - CDS allows an active manager to invest in foreign credits without currency risk At the same time there are some unique advantages of credit default swaps, which are briefly discussed below: a. Unfunded Instruments: As a general matter, credit default swaps are un-funded. That is, the protection seller does not post the notional amount of the contract into an account for the benefit of the protection buyer. This allows the protection seller to invest that amount elsewhere, earning a return. Thus, credit default swaps allow for unfunded exposure to credit risk, which facilitates a return that is higher than the underlying bond. b. Simplified Documentation: Credit default swaps also offer the advantage of simplified and standard-

NIVESHAK

ized documentation, which allows market participants to precisely tailor the credit risks to which they are exposed. ISDA does a great job in providing templates of master agreements to the market participants. c. Advantage of a Contract: Credit default swaps are contracts, and so the rights and obligations of each party can be whatever the parties agree to. This allows for the creation of essentially infinite variations on the basic credit default swap theme – from sovereign, to single name to basket products. (Derivative Dribble Blog on CDS) Corporate Debt Market in India At this juncture, it is imperative to look at the corporate debt market in India, which is essentially closely linked to the introduction of CDS in the country. Compared to very well developed equity and equity derivatives markets, corporate debt market in India is primitive at best, with daily turnover of around Rs. 1,000 Crores compared to a turnover of Rs. 100,000 Crores in equity markets. In comparison, in most matured economies debt market is three times the size of the equity market. Investment in equity being riskier, certain class of investors choose to invest in debt, based on their risk appetite and liquidity requirements. In fact, most investors like to spread their investments into equity, debt and other classes of assets for reasons of optimal combination of return, liquidity and safety. A vibrant debt market therefore enables investors to shuffle, reshuffle their portfolio depending upon the expected changes. Debt market, in particular, provides financial resources for the development of infrastructure. Due to this lack of depth in the domestic debt market, many large Indian corporate prefer FCCBs and Yankee Bond route for debt placement. Looking forward, Prime Minister Manmohan Singh says the country will need as much as $475 billion over the next five years to upgrade the country’s crumbling infrastructure and Indian companies may need to raise as much as $200 billion, according to estimates by Moody’s Investors Service. (Bloomberg.com) Hence, the question of credit risk becomes even bigger. Effective management of credit risk is, therefore, a critical factor in banks’ risk management processes and is essential for the long-term financial health of banks. Credit risk management encompasses identification, measurement, monitoring and control of the credit risk exposures. Although Indian banks are in a position to identify measure and monitor credit risk, they have no instrument to control or hedge their credit risk exposure. In the process of financial sector deregulation, interest rate

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risks and foreign currency risks are now effectively duces the effectiveness of such a CDS contract to be managed by derivatives, and the lack of credit de- traded on exchanges and denominated in INR. rivatives is a spot of concern for the banking comConclusion munity as well as the corporate in the country. Based on the discussion above and the pros Current State of Regulation in India and cons of CDS as an instrument to hedge credit exCurrently, CDS contracts are available on debt posure or to take a view on credit exposure, I think raised by Indian companies overseas. ICICI Bank it’s time that INR denominated CDS be introduced in Ltd., Reliance Industries Ltd., Tata Motors Ltd. and Indian Markets. For emerging markets like India the State Bank of India are among the 50 most-active following points need to be stressed upon: USD-denominated credit default swaps contracts in »» Being an efficient tool of pricing the risk of Asia, excluding Japan, according to a dealer survey credit default by the reference entity, the CDS marconducted by the International Index Co. in Frank- ket provides the most objective tool for pricing of furt. Bank of India, ICICI Bank, IDBI Bank, Reliance credit risk. This synthetic market is not affected by Industries and State Bank of India each have a 2% any of the inflexibilities and limitations of the cash weight in the 50 member Markit iTraxx Asia ex-Japan bond market – lack of availability, regulatory restricInvestment Grade 5-Year CDS Index (quoting at 125 tions, etc and hence CDS market can potentially bebasis points as on July 31st 2009), whereas Reliance come more liquid than the cash bond market in time Communications, Tata Motors and Vedanta Resourc- to come, which is already the case globally. es each have a 5% weight in the 20 member Markit »» Over time both single name and portfolio deiTraxx Asia ex-Japan High Yield 5-Year CDS Index fault swaps are going to get developed in the coun(quoting at 600 basis points as on July 31st 2009). try. Portfolio default swaps are particularly imporSo, there exists a vibrant CDS market for Indian enti- tant from the viewpoint of a bank transferring the ties already. risks of a portfolio – such as the SME loans portfolio, In response to this as well as the Percy Mistry through credit linked notes, which will allow much Committee report on “Making Mumbai an Interna- needed capital flow in the SME sector of India. tional Financial Centre”, Reserve Bank of India (RBI) Hence, keeping in mind all the benefits and has come out with draft guidelines on Credit Default potential troubles, here are the recommendations: Swap (CDS) per notification dated May 2007. In the »» Exchange traded CDS contracts of 5 year mawake of the financial crisis, there has been no furturity should be allowed in India with single name ther progress on the same, but according to recent reference entity (only of Indian origin) as well as news (July 24th 2009) the possibility of introducing CDS on exchanges as a part of measures to reform baskets formed through a CDS index. Cash settlethe debt market in India would be placed on the ment is preferred rather than delivery based settleagenda of the meeting of the high-level co-ordina- ment. This will be more transparent than traditional tion committee on capital markets next month as OTC CDS contracts. »» Market participants should be allowed to trade reported by business daily The Mint. in instruments tied to reference entities where they According to ISDA, guidelines proposed by RBI don’t have a credit exposure. This will potentially for trading credit-default swaps exclude a significant part of the domestic debt market and may limit increase the depth of the market and thereby allow growth in bank lending. Indian lenders have to own a more efficient price discovery. »» Considering that the loan portfolio is much the underlying notes in order to buy default protecas six times bigger than cash bond portfolio, loans tion and the securities must carry a public credit should be allowed to be referenced as well, which rating, according to the guidelines. (RBI Draft Guidelines on CDS) India’s loan market is as much as six again allows for broader participation times larger than the amount of Indian corporate Thus an efficient market of credit pricing and bonds in existence, according to Bloomberg calcula- exposure can be started in India. tions based on central bank data, and most loans don’t have a published rating. That significantly re-

ICICI, RIL, Tata Motors and SBI are among the 50 mostactive USD-denominated credit default swaps contracts in Asia © FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

21

BUILD AMERICA BONDS

FinSight

Seema Sharma

IIM Shillong

In order to overcome extraordinary challenges faced by USA due to financial crisis American govt is taking extraordinary steps, one such step is The American Recovery and Reinvestment Act of 2009 and implementation of build America bond program under this act. In this article we will try to find out the details of BAB and its implications

The entire world is facing the most severe financial crisis in generations. Budgets are being scaled back, government jobs are being cut, and services are being curtailed. These cuts contribute to a deeper recession, while restricting access to services at a time when the need for them is greatest. Turning things around requires innovative thinking. Extraordinary challenges require extraordinary action by the government to ensure the economy gets back on track and that millions of people get back to work. Creating the conditions for an economic recovery also requires addressing the challenges facing state and local governments in the midst of the current economic climate. US Government has taken many initiatives to tackle the prevailing recession and to re-establish the confidence of investors and consumers. These initiatives include the lowering of interest rates to ease raising funds and reduce the cost of capital. But these initiatives could not achieve success because of the cyclic nature of the business

and delay that happens because of the very nature of these monetary policies. One of the initiatives from US government is the Build America Bond program under the American Recovery and Reinvestment Act of 2009. These types of bonds are made available through government especially in the period of downturn. Let us understand more about them. What They Promise To Do? These bonds have been introduced by the US government to provide much-needed funding for state and local governments at lower borrowing costs. This will enable them to pursue necessary capital projects, such as work on public buildings, courthouses, schools, roads, transportation infrastructure, government hospitals, public safety facilities and equipment, water and sewer projects, environmental projects, energy projects, governmental housing projects and public utilities. Traditionally, tax-exempt bonds provide a critical source of capital for state and local governments, but the recession has sharply reduced their

There are two types of the Build America Bonds first one is tax credit and the second one is direct payment bonds

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September 2009

ability to finance new projects. Supplementing this existing market, the Build America Bond program is designed to provide a federal subsidy for a larger portion of the borrowing costs of state and local governments than traditional tax-exempt bonds in order to stimulate the economy and encourage investments in capital projects in 2009 and 2010.

Are They Better Than Traditional Ways? Let us compare this initiative of government with the existing ones. One of the important monetary policies in the recession period is the lowering of interest rates to maintain the investor confidence by ensuring easy availability of money. The problem lies in the delay involved in the process. At the same time the central bank has the responsibility of controlling inflation along with increasing the money supply. One more issue is that the decision of bank to reduce interest rates actually works against the government bonds because it leads to increase in the bond price and therefore reduces the demand for government bonds. On the contrary, the BAB concept is increasing the demand for government bonds and therefore is meant to help government projects. Another benefit with these bonds is the facilities given with these bonds can be withdrawn as soon as the need is felt, therefore there is no possibility of time lag. Though the BAB looks very promising prima facie but the actual performance is yet to be seen. The success of these bonds in America will actually trigger this kind of initiatives to tackle recession in other part of the world as well.

FinSight

How Do They Work? Build America Bonds are a new financing tool for state and local governments. The bonds, which allow a new direct federal payment subsidy, are taxable bonds issued by state and local governments that will give them access to the conventional corporate debt markets. At the election of the state and local governments, the Treasury Department will make a direct payment to the state or local governmental issuer in an amount equal to 35 percent of the interest payment on the Build America Bonds. As a result of this federal subsidy payment, state and local governments will have lower net borrowing costs and be able to reach more sources of borrowing than with more traditional tax-exempt or tax credit bonds. For example, if a state or local government were to issue Build America Bonds at a 10 percent taxable interest rate, the Treasury Department would make a payment directly to the government of 3.5 percent of that interest, and the government’s net borrowing cost would thus be only 6.5 percent on a bond that actually pays 10 percent interest. This feature makes Build America Bonds attractive to a broader group of investors, and therefore creates a larger market than typically invest in more traditional state and local tax-exempt bonds, where interest rates, due to the federal tax exemption, have historically been about 20 percent lower than taxable interest rates. They are attractive to investors without regard to their tax status or income tax bracket (e.g., pension funds and other tax-exempt investors, investors in low tax brackets, and foreign investors). Two types of the Build America Bonds are the tax credit and the direct payment bonds. The first type of Build America Bond i.e. tax credit provides a Federal subsidy through Federal tax credits to investors in the bonds in an amount equal to 35 percent

of the total coupon interest payable by the issuer on taxable governmental bonds (net of the tax credit), which represents a Federal subsidy to the state or local governmental issuer equal to approximately 25 percent of the total return to the investor (including the coupon interest paid by the issuer and the tax credit). The second type of Build America Bond i.e. direct payment bonds provides a Federal subsidy through a refundable tax credit paid to state or local governmental issuers by the Treasury Department and the Internal Revenue Service (“IRS”) in an amount equal to 35 percent of the total coupon interest payable to investors in these taxable bonds.

Direct payment bonds provides a Federal subsidy through a refundable tax credit paid to state or local governmental issuers by the Treasury Department and the Internal Revenue Service (“IRS”) in an amount equal to 35 percent of the total coupon interest payable to investors in these taxable bonds

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FinLounge

FIN-Q 1.

His company name was Grow More. Was famous for his Lexus which was not launched in India till then. Died in 2002 due to heart attack. India can never forget him. Who is this famous person?

2.

X was called Y till Jan. 1, 2001. Y was allegedly involved in Enron scandal, so to rechristen itself, it changed its name to X. X is headquartered at Bermuda. What are X and Y?

3.

What was started by PS Hariharan in 1961 and is characterised by its salmon-pink color?

4.

Identify the company and why is it in news?

5.

Identify the Ad.

6.

When this bank undertook a rebranding campaign associated with a name change, one of its executives remarked “The last time a bank actually changed its name in circumstances that did not involve a merger or a takeover was in 1955 when Imperial Bank was renamed State Bank of India”. What is the present name of the bank that we are talking about?

7.

James Tobin, Nobel Laureate proposed a character symbol as an indicator for the ratio of the value of the company according to the stock exchange it is listed in (market capitalisation) to the replacement value of the company’s assets. Which alphabet did he use for his theory?

8.

In 1694, William Patterson founded this institution which sold government bonds, issued government backed currency and later began to regulate the lending practices of banks. It eventually took control of the money supply. What?

9.

In the book ‘Around the World in 80 Days’, Phileas Fogg withdraws 20,000 Guineas from a bank. Name the bank.

10. In which country’s coins you can found the following lines imprinted, ‘This is the root of all evils’.

All entries should be mailed at [email protected] by 30th September 2009 23:59 hours One lucky winner will receive cash prize of Rs. 500/-24

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VOLUME 2 ISSUE 8

September 2009

TEAM NIVESHAK

ARTICLE OF THE MONTH

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