44rth Financial Advisor Practice Journal

8/8/2019 44rth Financial Advisor Practice Journal

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Pink PantherVolume 44 / July 2010

FINANCIAL ADVISORPPRRAACCTTIICCEE JJOOUURRNNAALL

JOURNAL OF THE SECURITY ACEDEMY AND FACULTY OF e-EDUCATION

SAFE UPDATES KEEP INFORMED

TThhee SSeeccuurriittiieess AAccaaddeemmyy aanndd FFaaccuullttyy ooffee--EEdduuccaattiioonn

Editor: CA Lalit Mohan Agrawal


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Pink PantherEditorial preamble:1.1 PINK PANTHER

Beware, 2010 is not 2004!

India remains the best structural growth story in the region. Thesharp pace of recovery reflects the strength of Indias domesticdemand-oriented model, which remains the best in the region.Low goods exports to GDP ratio of 15.5% (as of 2008) meantthat the damage from global trade collapse was minimal in India.

More importantly, for India, capital inflows linkages are moreimportant than the goods exports. A quick turnaround in globalrisk appetite from April 2009 has played an important role in the

pace of recovery. Growth momentum has remained strong beyond the initial period (F2009) of paybackfrom weak growth during credit crisis.

In fact, with the benefit of hindsight, it appears that unlike the developed world, India really did not needthe kind of push to aggregate demand through loose fiscal and monetary policies. Pre-election spending,wage hike for government employees and credit crisis related stimulus meant that consolidated nationalexpenditure to GDP shot up by close to four percentage points between F2008 and F2010. In the contextof actual trend in global growth and domestic demand in India having surprised on the upside, thewithdrawal of stimulus has been very slow so far. After cutting repo rate by 425 basis points from thepeak of 9% between September 2008 and April 2009, the RBI has lifted it up by only 50 basis points.

Although, the central government will report a reduction in fiscal deficit in F2011, this has been largelysupported by one-off receipt items like telecom license fees and divestments. The expenditure to GDP

(including off-budget oil subsidy) will remain closer to the peak in F2011 and the aggregate demand pushremains intact. Timely reversal in monetary and fiscal policies will not take away the momentum ofprivate sector growth but a delayed exit will increase the risks of transient spike up in inflation rate andwiden the current account deficit to vulnerable levels.

A comparison to the 2004 rate hike cycle looks like the policymakers have been lifting policy rates at thesame pace as they did in the initial phase of 2004 cycle. However, not only the growth acceleration has been at a much quicker pace this time but also the starting point of policy rates is much lower in thecurrent cycle. Indeed, the fiscal policy exit was faster in 2004 cycle as the government was already cuttingexpenditure to GDP before the RBI started lifting policy rates.

There are some key differences in this cycle versus 2004 cycle.

First, the capacity utilisation levels are different: Unlike in the previous cycle, when the recovery ingrowth gradually allowed adequate time for the private corporate sector to initiate capex plans, in thecurrent cycle, the recovery in growth has been sharp and the business investment cycle was hit badly.Although, over the last few months investment has picked up, but for this work-in-progress to turn intocommissioned capacity it could take about 12-15 months. As a result, the transition from low capacity toclose to full capacity utilisation has occurred in a much shorter period.

Second, WPI inflation pressures may be similar but underlying consumer price pressures are different:The WPI inflation trend appears to be largely similar compared with that in 2004 cycle. Although, in thiscycle the headline inflation has been higher than last cycle because of food, the fact that food prices have been persistently higher now for many months, the risk of this weighing on generalised inflation


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Pink Pantherexpectations is high as food forms a very large proportion of household consumption. Even food priceswere to moderate, the high level of non-food WPI inflation (at 8.8% in May 2010) when capacityutilisation is becoming tight means that risk if generalised consumer price inflation pressures building upquickly is much higher in this cycle versus 2004.

Third, current account balance deficit vs. surplus: In 2004, when inflation had reached 8.5% y-o-y inAugust, IP growth had accelerated to 9% y-o-y during the quarter ended September 2004. The currentaccount was in surplus of 2.9% of GDP (4-quarter trailing as of June-04) as a starting point. This largecurrent account surplus is also an additional indicator reflecting that aggregate demand was low relative tocapacity. During the 12-months, ending March 2010 the current account deficit has already widened to3% of GDP as per our estimate.

Fourth, banking sector liquidity condition: Like in 2004 cycle, in the initial phase of recovery while bankloan growth is accelerating, deposit growth is indeed decelerating. However, the banking system loan-deposit ratio is already high at 71.1% as of May 2010. Considering that statutory liquidity ratio is 25%

and cash reserve ratio is 6%, loan-deposit ratio is close to the levels where major rise in credit growth willresult in significant tightening in interbank liquidity. In December 2004, the banking loan-deposit ratiowas low at 62.5%. Over the next 3-4 months, bank credit growth can accelerate to 25% y-o-y, whiledeposit growth will remain low in the range of 16-17 % y-o-y, unless the RBI lifts policy rates at a fasterpace.

Fifth, asset prices: Another factor different from 2004 cycle is the trend in asset prices. Asset prices weresubdued for a prolonged period of time until mid-2004. In this cycle, asset prices have remained closer tothe peak after dip during the credit-crisis period.

Bottom line: Considering that over the last few months the pace of policy support reversal has been

slower than warranted, the upside risks to GDP growth and corporate earnings in the near-term hasincreased. However, at the same time the investors should watch out for rising inflation expectations andwidening current account deficit in the near term.

Any decline in capital inflows or a sharp rise in oil above $100/bbl would cause exchange ratedepreciation only adding to inflation pressure. Moreover, the size of the current account deficit willdecide the shock to the domestic cost of capital in the event of the sudden stop in capital inflows. A bigshock can hurt the domestic private investment cycle and corporate confidence, which the governmentappears to be aiming to boost right now.


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Pink Panther1.2 STOCK MARKETS

Why global stocks are poised to rebound

It has taken 23 years and a world market meltdown, but Oliver Stone's

Wall Street: Money Never Sleeps, sequel to his 1987 hit film, hasreturned exactly at the time US Congress has introduced the RestoringAmerican Financial Stability Act of 2010.

Ironically, the music in the film's trailer is the familiar opening of the

Rolling Stones' Sympathy for the Devil. Please allow me to introduce

myself. I'm a man of wealth and taste, croons Mick Jagger. Thefictional embodiment of financial excess is played by MichaelDouglas, who was given a hero's welcome at the Cannes Film

Festival.

Even as actors in the Greek drama were seeking catharsis after their prevarication , the European leaders,calling to mind ex-US Treasury Secretary Hank Paulson's bazookanomics,' agreed to a hefty rescuepackage to replace the water pistols at Greek riots with bazookas to shock and awe markets out of theirpredictions of doom. 750 billion is sufficient to buy the entire debt of Greece twice and still have enoughleft over to buy the debt of Portugal.

While the Greek tragedy was being played to the gallery, Portugal and Spain sold 10-year bonds at 4.05%and 4.52% respectively, in an oversubscribed auction. Now that Germany (safety net) is on board, thePIGS (Portugal, Ireland, Greece and Spain) may not even need to tap into the funds.

Greek crisis has enabled Germany to achieve a de facto 20% devaluation against the US dollar. It has

made the BMW, Mercedes-Benz and Volkswagen cars cheaper in Beijing and Mumbai than they were sixmonths ago. It has given a great fillip to manufacturing in Northern Europe.

The TED Spread a measure of bank confidence to lend has widened to 40 basis points from 28.4 basispoints. The spread, which compares three-month dollar Libor and the overnight indexed swap rate, hadsurged to 364 basis points after the collapse of Lehman in September 2008.

Brazil today is an economic growth rock star. Eight years ago, Brazil faced 25% interest rates, massivegovernment spending, currency devaluation and risk of default. Brazil's debt was $335 billion almost aslarge as Greece's entire GDP today! President Lula ramped up a difficult austerity programme almost4% of GDP. Brazil received $30 billion in aid from the IMF, which investors feared was insufficient.Brazil is no longer synonymous with hyperinflation, but with growth, opportunity, Olympics.

The myth of the lazy Greeks: According to Organisation for Economic Co-operation and Development(OECD), Greek people work for much longer hours than Germans. Consequently, it might be just a myththat hard-working Germans had to bail out lazy Greeks.

Between 1989 and 1994, Greece, which accounted for the same share of the world's economic output astoday, had interest payments, as a fraction of GDP, more than twice what they are now. Investors fretGermany's ban on naked short sales of European credit-default swaps. However, the outstanding creditdefault swaps on 10 European countries (including PIGS) are less than $108 billion. The entire CDSmarket is estimated to be around $11,000 billion. Besides, most CDS activity does not take place inEurope but in New York.


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Pink Panther

PEOPLE are selling the euro, as if there is no tomorrow, and I believe there is a tomorrow for the euro.The austerity measures being adopted in Europe, in a sense of urgency, are much larger than the US(which also has a high deficit/GDP ratio) adopted in the heat of the sub-prime crisis.

Besides, the anti-euro trade is getting overcrowded. Euro speculator longs as a percentage of positions areessentially at all-time lows and hedger longs are as a percentage of positions at all-time highs. Europe isChina's biggest export market hence, fears of China selling its $630 billion eurozone holdings will notcut the mustard. Despite fears of China dumping US treasuries while the dollar was getting hammered, itsholdings of US debt have increased $1 billion this year to date.

Chinese government isn't blind to the threat of rampant inflation outpacing the economy and has takensteps to rein in stimulus. Chinese monetary policy has taken the middle road inflation-limiting but notgrowth-choking.

As long as monetary policy remains measured, there's no reason China's economy can't grow as it didduring the last bull market. After all, reserve requirements, interest rates, and currency all rose then too.

There is apprehension that Dr Copper is diagnosing a double-dip. Copper prices bottomed at $1.34 perpound in December 2008 and even after recent declines are up 132% from that bottom. Falling oil pricesleads to more purchasing power in the hands of consumers as we head into the peak summer drivingseason in the US. It is a deflationary trend that should help keep Fed rates low.

Market recoveries aren't smooth (see accompanying chart) and gyrations along the course can easilyspur emotion. Watching stock markets move is a great spectator sport, but not a great participant sportunless you're a market pro. Amateurs get whipsawed when they obsess over the market, minute to minute.

The PMI manufacturing indices for 23 international economies shows that only two (Greece andHungary) are experiencing contraction. China's manufacturing data is nearly always lower in May overApril. Emerging markets today are as large as Europe. Semiconductor sales in the Asia/Pacific regionwere up 72% year-over-year in March, aiding US exports.

Since 2006, Japan has seen five prime ministers: Koizumi (2001-2006), Abe (2006-2007), Fukuda (2007-2008), Aso (2008-2009), and now Hatoyama (2009-10) early exit of a PM will not come as a bolt out ofthe blue. There is an adage on Wall Street Sell in May and Go Away. Many investors wished they had.Global stock markets are poised to rebound in the near term. Perhaps, the new adage should be Sell inMay .... And come back in June'.

1st week of June 2010 Sensex up 255 points

Daily review 28/05/10 31/05/10 01/06/10 02/06/10 03/06/10 04/06/10Sensex 16,863.06 81.57 (372.60) 169.81 280.49 95.36

Nifty 5,066.55 19.75 (116.10) 49.65 90.65 25.00

Weekly review 28/05/10 04/06/10 Points %Sensex 16,863.06 17,117.89 254.83 1.49%

Nifty 5,066.55 5,135.50 68.95 1.36%


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Pink Panther2nd week of June 2010 Sensex down 53 points

Daily review 04/06/10 07/06/10 08/06/10 09/06/10 10/06/10 11/06/10Sensex 17,117.89 (336.62) (163.97) 40.79 264.19 142.87

Nifty 5,135.50 (101.50) (46.90) 13.20 78.30 40.75

Weekly review 04/06/10 11/06/10 Points %

Sensex 17,117.89 17,064.95 (52.94) (0.31%)

Nifty 5,135.50 5,119.35 (16.15) (0.31%)

3rd week of June 2010 Sensex up 506 points

Daily review 11/06/10 14/06/10 15/06/10 16/06/10 17/06/10 18/06/10Sensex 17,064.95 273.22 74.66 50.04 153.82 (45.87)

Nifty 5,119.35 78.35 24.65 11.00 41.50 (12.25)


Sensex 17,064.95 17,570.82 505.87 2.96%

Nifty 5,119.35 5,262.60 143.25 2.80%

4th week of June 2010 Sensex up 4 points

Daily review 18/06/10 21/06/10 22/06/10 23/06/10 24/06/10 25/06/10Sensex 17,570.82 305.73 (124.86) 6.25 (27.70) (155.71)

Nifty 5,262.60 90.70 (36.75) 6.60 (2.55) (51.55)


Sensex 17,570.82 17,574.53 3.71 0.02%Nifty 5,262.60 5,269.05 6.45 0.12%

Last three days of June 2010 Sensex

Daily review 25/06/10 28/06/10 29/06/10 30/06/10Sensex 17,574.53 199.73 (240.17) 166.81

Nifty 5,269.05 64.45 (77.35) 56.35


Sensex 17,574.53 17,700.90 126.37 0.72%

Nifty 5,269.05 5312.50 43.00 0.82%


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Pink PantherQuarterly Review

Month December 2007 December 2008 December 2009 March 2010 June 2010

Sensex 20,206.95 9,647.31 17,464.81 17,527.77 17,700.90

Points Base (10,559.64) 7,817.50 62.96 173.13

% Base (52.26%) 81.03% 0.36% 0.99%

Illiquid Stocks Spring Back To Life

With the market moving in a narrow range for six months, there is renewed activity in some of the stocksthat had gone into the dormant mode since the downturn began in January 2008. In the Bombay StockExchange, there were over 2,000 stocks in the illiquid category and close to 400 such stocks on theNational Stock Exchange at the beginning of last year. The numbers have gone down substantially duringthe past few months.

Exchanges bring out the list of illiquid stocks in order to inform their trading members to exercise duediligence while trading in these securities either on their own or on behalf of their clients. Both theexchanges draw up the list of illiquid securities-based trading activity every month. From around 1,800

illiquid scrips in January 2009 in the case of BSE, it has come down to around 1,400 during April.Similarly, for NSE, the figure stands at a little over 100 compared to around 400 during the same period.

Even as there has been a significant drop of illiquid scrips on BSE in terms of absolute numbers, it stillremains high at over 20% of the total number of listed stocks. In the case of NSE, the number of illiquidstocks stands at about 10% of total stocks. The number of shares listed on BSE is almost four times thanthose traded on its counterpart. A higher number of illiquid shares do not bode well for stock exchangesas it translates into a lower turnover.


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Pink Panther2.1 INDIA

An Economy Enshrined in Nature

A large number of our microeconomic activities depend on villages, forest,

agriculture fields, rivers, hills and lakes. While maximising farm profit, plannersshould not ignore soil quality, groundwater, pollination and rising input costs.Policy intervention is vital to maintain a balance among our industry, agriculturetrade, services and natural sector.

One hundred and twenty crore Indians cannot shift to urban centres and becomesoftware engineers, professionals and service providers. So, villages, forest,agriculture fields, rivers, hills and lakes need to survive in order to enshrine a largenumber of microeconomic activities.

Rivers

Way back in the 1970s, fishermen from Cuttack city used to fish from the two mighty rivers the Mahanadiand the Kathajodi, which were flowing perennially on both sides of the city. They were happy, healthyand had surplus money to booze and dance during Dussehra festival. In the '80s when the rivers turnedinto narrow streams due to deforestation and silting, they did not find fish there. The income of nearly3,000 fishermen in the city vanished. The rivers turned dry not due to industrialisation but due todeforestation and silting.

According to Central Soil & Water Conservation Research and Training Institute (CSWRTI) and NationalBureau of Soil Survey and Land use Planning, an estimated 5,334 million tonnes of soil disappear everyyear due to erosion.

Thirty years back Brahmaputra and its tributaries had thousands of dolphins. Mindless fishing activities,use of fine meshed nets for catching smallest of fish and silting of river bed are the reason why the playfuldolphins, which could have provided joy to tourists, have disappeared.

Forests

Like rivers, forest has the potential to provide jobs to a large tribal population. As more jobs are lost dueto the current economic downturn, sustainable forest management could become a means of creatingmillions of green jobs, thus helping to reduce poverty and improve the environment.A unique study Green accounting for Indian states and Union Territories found the value of our forestat Rs 88,60,259 crore in 2003. There are hundreds of minor forest products like cane, wood, bamboo,tendu leaves, tusks, medicinal plants and gums, etc, which have good demand in domestic andinternational market. Transparent supply chain, healthy cooperative societies, dedicated extensionsservices of the government and political will could earn good amount of revenue for the state. The ILOReport 2009 estimates that the global market for environment products and services is projected to doubleto $2,740 billion by 2020 from the present $1,370 billion per year.

Nearly 47.61 lakh artisans in India as per All India Artisan Census 1995-96 make high value addition toorganic material available in nature. The artisans of Bastar make exotic wood craft, while the hill tribe inNorth-East India make hundreds of utility and decorative items from bamboo and cane.

Handicraft was the major items of export from India in the past. Pliny, the Roman officer andEncyclopaedist (23-79 AD) complained Indian luxury trade was depleting the Roman treasury to the


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Pink Pantherextent of 50 million sesterces annually. As per the Union government's Foreign Trade Policy 2009-10, allhandicrafts exports to be treated as special focus products and entitled to 5% duty credit scrip. This mayhelp the exporter to access world export market for handicraft worth $350 billion.

Agriculture

India can make use of its 20 agro ecological regions and 60 subregions which produce a large number ofcrops. Agriculture sustainability should be the theme of agriculture planning. G-8 L' Aquilla FoodSecurity Initiative, concluded on July 10, 2009, has committed $20 billion to sustain agriculturedevelopment in the developing nations in the next three years. The commitment has the apprehension thatextreme poverty would grip 90 million more people across the world due to global slowdown. In fact, thefood security initiative is a measure to correct the wrong done in the beginning of the 20th century.

Farming, forestry and fishing in 1913 accounts for 28% of employment in US, 41% in France and 60% inJapan and 12% in UK. Their dependence on those sectors has gone down to 6% now and ultimately leads

to job loss in natural sectors.

Agriculture scientist M S Swaminathan had prescribed crop diversification as the solution for Vidarbhafarmers' crisis as cotton crop ate up 70% of productive land in the region. While maximising profit fromagriculture, planners should not lose sight of the soil quality, groundwater, pollination and increasinginput costs. In the 70s, coastal Orissa farmers used to cultivate a paddy variety called dalua after thenormal harvest of paddy in December. Dalua used to mature within four moths and the farmers got twoharvests in a year. Government constructed canals to sustain the paddy for about five to six years. Whenthe river system collapsed after six years the highly thirsty dalua crop failed.

In India's vast and complex economy, conscious policy intervention is required to maintain a sustainable

balance amongst industry, agriculture, trade, services and the natural sectors.


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Pink Panther2.2 INDIAN ECONOMY

Its time to face Post-Crisis Reality Check

India sailed through the Great Crisis of 2008-09 without skipping a beat. But

celebration may be premature. As the aftershocks in Southern Europe suggest,the post-crisis world is likely to remain a very treacherous place for some timeto come. Although India has one of Asias most balanced and therefore,resilient macro structures, it can ill-afford to ignore ever-present stresses andstrains in the external environment. For India, the crisis and its aftermathshould be viewed as a wake-up call a time to sharpen its focus on thechallenges and opportunities shaping its development journey.

While resilient, India was hardly untouched by the recent crisis and recession Manufacturing helpedGDP grow 7.4% in FY10. But there was a major downshift relative to vigorous pre-crisis growthtrajectories. However against the backdrop of a world that had tumbled into the deepest recession since

the 1930s, Indias relative resilience was impressive.

India also fared well compared to others in the developing world. Unlike China, where the externaldemand shock posed a major threat to jobs and social stability, Indias more measured policy actions didnot have destabilising post-crisis impact that resulted in property bubbles and deteriorating bank loan.

While the Indian economy has better balance than others in Developing Asia namely, a greater portiongoing to private consumption and services and less to exports and investment India is hardly immune toshocks elsewhere in the world. To be sure, the export share of the Indian economy was only 24% in 2008 far short of the 45% norm for Developing Asia as a whole. However, Indias 2008 export share wasmore than double the 10.8% reading in 1998. At the margin, the delta (i.e., change) in Indias export share

rather than its level is what drives economic growth.

There is, however, an important twist to Indias increased exposure to external demand. In recent years,the composition of Indian exports has shifted dramatically away from the developed world toward itsneighbours in Developing Asia. The US share of Indian exports was cut in half falling from 22.8% in1999 to 11% in 2009 whereas the share going to Europe slipped from 27.6% in 1998 to 20.9% in 2009.Meanwhile, the portion going to Developing Asia essentially doubled from 5.6% in 1999 to 11.6% in2008. While these shifts in the mix of Indian exports underscore a lessening growth impetus fromdeveloped markets, they hardly eliminate Indias vulnerability to lingering problems in Europe.

On balance, the ongoing repercussions of Europes sovereign debt crisis could well be an importantheadwind buffeting the Indian economy for the next several years. Lingering post-crisis aftershocks make

it all the more critical for India to redouble its efforts on other aspects of its development strategy.

Domestic saving

Key in that regard will be to sustain the recent improvement in domestic saving. Indias gross domesticsaving rose to 36.4% of GDP in FY2008 up sharply from the subpar readings in the low 20s that had prevailed since the early 1990s and that increase was a major support to Indias recent increases ininvestment spending on both infrastructure and manufacturing capacity. However, on the heels of a sharpcrisis-related increase in the government budget deficit, the domestic saving rate fell back to 32.5% inFY2009 a downturn that must be reversed if India is stay the course of investment-led growth.


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Pink PantherExit strategy

India followed the pack of developed countries and shifted its monetary and fiscal policy levers intounusually stimulative positions actions that are not without attendant risks to underlying inflation.

So, India now faces the same dilemma as others how to orchestrate an effective exit strategy from theemergency policies that were put in place during the crisis. And the exit strategy needs to be executed inwhat still looks to be a very shaky post-crisis global climate. At the same time, these delicate policymanoeuvres must be crafted in a fashion that preserves Indias ongoing development program.

Like most major economies, India is having a hard time restoring its policy settings to pre-crisis norms.Despite the impressive post-crisis rebound of the Indian economy the Reserve Bank of India hasunwound only 50 basis points of the 425 bp easing that was implemented during the crisis. While thereare hints of more rate hikes to come, the RBI has yet to convert these hints into action. With non-foodinflation on the rise both at the wholesale and retail levels, prolonged monetary accommodation is both

inappropriate and worrisome. Moreover, the governments latest budget points to limited reduction in thestructural deficit in the current fiscal year. More meaningful fiscal consolidation is slated for 2011-12.

For an emerging economy like India, a delayed exit strategy spells potential risks to core developmentstrategies. Key in this regard is fiscal-policy-induced impediments to national saving. On the heels of therecent surge in domestic saving, the corporate investment share of Indian GDP trebled in the seven yearsbefore the crisis rising from around 5% in early FY2001 to 16% in FY2008 before falling back to near13% in FY2009. If the crisis-induced fiscal stimulus remains in place for too long and the recent shortfallin domestic saving continues, the renewed widening of nations current account deficit is likely to persist.That could make it very difficult for India to restart its investment-led growth dynamic.

Large and rapidly growing developing economies like India and China cannot afford to take the lead fromthe West and cling too long to crisis-induced emergency policies. Deferred exits strategies are not withoutdestabilising consequences. Surviving the crisis was one thing.

Its now time to face up to a post-crisis reality check.


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Pink Panther2.3 INDIA INC

Phase-II of Global Recession

Phase-II of the global recession was always going to hit the global economy.

That Greece took the honours was purely incidental. The bigger issue iswhether in saving the too-big-to-fail banks of the world, governments haveoverstretched themselves. This is the nagging fear that is disquieting themarkets. Let's hope that Greece was the whole iceberg, not just its tip.

Unfortunately, that hope seems a little misplaced right now given theeconomic prognosis of other countries and of Greece itself. The centralquestion is whether European governments have done enough to stem thetide. Is there a sufficient firewall against market attacks that will inevitablycome as players punt that the future of the euro will unfold negatively?

At issue is whether European governments now have the stomach to carryout the dramatic cuts required to get their fiscal numbers back in sync. At thevery minimum, it will take years of drastic belt tightening on the part of governments and the people toget back in some shape. This can only happen if taxes are raised while simultaneously curbing spending.

However, no government can take such drastic steps and hope to maintain its popularity. Given the factthat elections are due in most European countries in 2012 and '13, it will be difficult for most politicalparties in government to take the measures needed. Typically new governments, as in the UK, would findit easier to start afresh and not be wedded to old positions.

Blame can then more be easily assigned to outgoing governments. But given the absence of such a

change, whether the incumbent governments have the stomach for difficult measures is a real questionmark. This likely lack of willingness to take the right but difficult steps is a significant risk to globalmarkets, as is the collective ability of the European Union to get it right.

As the euro depreciates, European exports do get more competitive but it throws the world economy outof kilter. China is re-evaluating the revaluation of the renminbi as Europe is its biggest export market. Atthe same time, there is a flight to safety to the dollar, making it harder for the US economy to maintain itsown recovery. On the flip side, interest costs on its deficit financing will decrease as Treasuries strengthendue to the flight to safety.

But the biggest dangers still lurk in Europe. If speculators come to the conclusion that key Europeangovernments such as Spain, Italy, Ireland, Greece or Portugal (the so called PIIGs countries) lack thepolitical will to implement the required tough measures, then those countries will find it harder and harderto borrow at reasonable rates. It will also be difficult for the European Union to backstop the largergovernments even though the stakes will be huge.

For example, the total debt of Greece is $226 billion while that of Spain is $1.1 trillion almost four anda half times larger. Of that, about $220 billion is owed to French institutions, a similar number to Germaninstitutions and about $120 billion to British firms. With 20% unemployment, Spain has one of theweakest economies in Europe. Meanwhile of Italy's gross debt of $1.4 trillion; about 40% is owed toFrance, which amount to almost half of the latters GDP. The interconnectedness of these economies issuch that the weakest link will determine the strength of the EU.

WHAT does all this mean for India?


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Pink PantherThe Indian economy continues to do well on the back of its strong domestic economy. However, acontinued global risk aversion would mean continued outflow from the Indian equity markets whichcontinues to remain very sensitive to FII flows. For example, in May we had almost $2 billion of outflows(a scant 0.2% of the total Indian market cap) and yet the market lost close to 12% of its value. Second,

access to cheaper external debt capital will diminish as happened in the second half of 2008. This will putmore pressure on the Indian banking system as the primary provider of liquidity, and thereby make itharder for Indian corporates to invest to capitalise on the growth opportunities in the domestic market.Meanwhile, export-oriented companies will continue to suffer as overseas markets remain sluggish at bestfor the next several years.

Clearly risks remain embedded in the global economy and it will be a while before this plays out. Thebest case scenario is for slow growth in Europe, a continued slow pick up in the US, and stronger growthin the rest of the world. The worst case is outright recession in Europe for many more years, which pullsthe US back into a double dip recession as its own stimulus fades in the second half of the year, withgrowth in other parts of the world also getting impacted.

Corporates therefore need to have plans in place for a wide range of possible outcomes. At the very least atight focus on costs needs to continue, judicious expansions mostly based around domestic demand andvery, very conservative balance sheet management with the bias being to raise capital whenever available.At the same time, assets will be available cheap in the developed world but the temptation to acquire mustbe carefully tempered.

There is no certainty that current forecasts of western market demand will be accurate going forward.Overseas talent both expats and diaspora will also be keener to work in India allowing companies toselectively upgrade their management pools. We will see more outbound M&As but increasingly to otheremerging markets corporates should carefully build cash for such opportunities. India's voice in the

world will carry more weight.

History teaches us that rich economies go soft over time. The process of transition is gradual and hard toidentify as it is happening. We are witnessing just such a tectonic shift. There will be many ripples in theglobal economic waters and Indian corporates will need to manage nimbly to sidestep the dangers whiletaking advantage of the opportunities. The good news is that they have the management quality and worldview now more than ever to do so.


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Pink Panther

2.4 INTERNATIONALIndia and Europes tribulations

The past month has been Eurocentric, and it continues to be so. It isan unfortunate case of delayed effect. After all, the Greece fiscalimbroglio was uncovered by the newly-elected government shortlyafter it came into power in October 2009. That is, by the standards ofthe day, a long time ago. So, why is it causing tremors now?

One may recall that there was a major fracas about Dubai in late November 2009, but once cousin Abu Dhabi stepped in and bailedDubai out, it was over. The problem with Europe is that unlike theemirates, blood runs thinner than water.

It is well understood that when the question of confidence is raised,the best and the only way to respond is immediately. If you let theproblem fester, it gets worse and contagion begins to spread.

Why, one wonders, were the authorities in the eurozone so slow insorting out the problem in Greek? It was a fairly straightforward issue. The country had borrowed wellbeyond its means, concealed it, and is now facing a payment crisis. Either other members collectively payout the cash needed to make Greece solvent for the moment, or suspend it from the eurozone and leave itto the care of the IMF, whose mandate it is to deal with external payments crises.

But the eurozone did not have a provision of extending collective assistance, nor was it willing to face the

consequences. Further, as the markets caught on quickly, Greece was not the only one that had livedbeyond its means and the idea of bailing out wholesale nearly half of the membership was simply beyondthe capacity of the solvent few. Finally, the member countries perceived to be solvent by the rest mostprominently Germany seemed to be understandably, vehemently opposed to the idea of such bailouts.

Greece joined the eurozone in June 2000. In 1998, its current account deficit (CAD) had been 2.8% ofGDP, which jumped to 7.8% in 2000 and remained close to this level till 2005. In 2006, it soared to11.3% and to 14.6% in 2008. In the nineties, the average CAD had been 2.5%, but it was 9.3% in the nextdecade. But Greece was not alone. Portugal had an average CAD of 1.6% till 1997, the year before it joined the eurozone. Thereafter, this number averaged over 9%. Spain, a comparatively large economy,had an average CAD of 1.7% between 1990 and 1997; thereafter, it was 5.4%.

In the boom years of 2005 to 2008, the CAD that these countries ran up was staggering: Greece 14% in2007 and 2008, Portugal 10-12 %, Spain 10% in 2007 and 2008. Spare a thought for those lined up to jointhe eurozone: Estonia with CAD of 18%, Latvia 22% and Montenegro 52%.

Basically, the less industrialised members of the monetary union went on an unprecedented shoppingspree fuelled by the magic that the euro bestowed on their ability to borrow and attract equity.

The policymaker was untroubled since they could argue that the liabilities and the assets were mostly inthe same currency, i.e., the euro. But this pre-supposes that there is effective fiscal unification; that if oneconstituent turned insolvent vis--vis another, some federal authority would pay.

But in the eurozone, there is no such federal capability, since this function was supposed to flow from


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Pink Panthereveryone observing the Stability Pact whose strict observance, would keep all members of this clubequally solvent. Europe now has to make up its mind on what to do, and it is quite a struggle.

It has been made worse by the unexpectedly jejune statements by people in high office who should be

expected to know better. So, is this a new crisis in the making? Another subprime mess, with a Lehmancoup de grace down the road? Hard to say, though one may note that in a recently reported poll, astaggering 53% of French respondents opined that their country could default over the coming decade.Such is the faith of the European citizens in their governments today. Of course, it could be argued thatdisillusionment is not restricted to Europe, as the same poll reported that 46% of Americans feel that theircountry could default too.

It is our take and indeed our hope too that this time round, the troubles will be much less severe thanthey were in 2008. For one, in 2008, many people had felt that their world was about to end in abottomless abyss of disorder. Having survived, they have been inoculated to an extent.

Then again, the centre of the financial world is not in Europe, so what happens there affects the continentmore than it does others. Finally, in this crisis of solvency, major European governments have enoughstrength to slow the decline, even if halting it may be beyond their power now.

For India, the European mess is not good news. The EU may enter into recession-like conditions and ourexports to that region will suffer. The cost of credit is likely to rise for everyone and portfolio investorsmay become cautious, factors that can make the cost of financing new fixed assets in India higher than itmay have been otherwise.

On the positive side, the experience of recovery in Asia will, sooner than later, generate a kind ofdiscrimination in favour of this region that will be advantageous to us.

In India, the government has to shape domestic business confidence so that it can offset the adversefallout of the troubles in Europe and that it can do by moving boldly on infrastructure and otherdevelopmental fronts .If the crisis in Europe persists, commodity prices will ease, which will also be asilver lining for us.

In summary, our destiny is in our hands.

We can grow rapidly and strengthen our economic base, even if the advanced world is facing difficulties.

To do this, we need to aggressively address the infrastructure, regulatory and other deficits, and focus oninternational trade and investment in the Asian and African regions.


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Pink Panther2.5 WARNING SIGNALS

Don't blame the Greeks for the crisis

Housewives in Greece and Spain didnt blow up money as the world thinks they did. They are suffering

because of a reckless Wall Street and central banks which didnt want to upset the apple cart. The eurowill survive, but the price would be volatility and turmoil. And soon, US markets will battle with another

round of mortgage defaults and turmoil. ot our words. Joseph Stiglitzs. One of the most outspokencritics of Fed and George Bush, Mr Stiglitz is sufficiently pessimistic about the world economy.

Men like him and Paul Krugman give politicians the intellectual ammunition to lead the governments

intervention in markets. But does he feel a moral obligation? In an exclusive interview, the obel Prizewinner and Columbia University professor, speaks his mind even as he reminds the world that

Washington is still not getting it right and that its being bought over by banks which are desperate to

water down the new rules for financial markets.

Its evident that Greece has no immediate fix and over the next decade, other regions of the world mayface similar problems. Isnt it time for leading nations to sit together and reset the entire global debt?

Whats clear is that the current approach in Europe is wrong. Thecurrent approach is to try to impose extreme austerity. That willlead to a weaker economy and lower tax revenues, and so thereduction in deficits will be much smaller than hoped.

Its a kind of austerity which failed in Argentina. The currentapproach of saying that you just have to get rid of the deficit is notgoing to work and is going to push the world into a double dip or a

global slowdown.

So, the only alternative is some form of debt restructuring. It is clear that if there was confidence inGreece, it could make step payments. This would be more like two situations Brazil and Argentina.Brazil had a debt crisis which was helped over by liquidity. It even had a debt write-off. Once the marketirrationalities had worn off, it started to grow and now no one thinks of Brazil as having a large debtproblem. Most of the countries are, I think, in the Brazilian situation. If interest rate remains relativelylow and market remains calm, then they wont have any difficulties.

But dont you think that one day China will have to take a haircut on US debt?

No. The US debt is different from other countries debt for the very reasons that USpromises to pay dollars and the US controls the printing press for dollars. So it willalways meet its debt obligations. The dollars may not be worth a lot. The question forthe US is will those dollars that they pay is worth what they were worth when Chinalent the money. Thats a kind of haircut.

As long as countries can go on printing money, we may move from one bubble toanother. At the same time, we cant think of going back to the gold standard

You are right. We understand that the gold standard does not have enough flexibility andit does not work for modern economy; while we are getting into difficulty in getting the

other system to work.


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Pink PantherNow, one of the fundamental problems is the dollar reserve system. The dollar reserve system is one inwhich there is excessive reliance on one country the US and its supply of money of debt is determinedby domestic concerns and not by global concerns. One of the main suggestions of a UN commission Iheaded was the creation of a new global reserve system. China, France and a lot of other countries

supported it. This should be the first priority for the long term.

The current crisis is really caused by the private financial sector. The lesson I take from it is that we haveto make sure that we dont allow the private sector to engage in that kind of excessive risk and not givethem what they did. We did the right thing to rescue it. But now we have to live with the consequences.

Well, the Financial Regulation Bill does want to cut risks. But stifling rules could kill parts of thefinancial market and end up throwing the baby out with the bath water?

No. Quite the contrary, its not strong enough. It was watered down. The financial sectorpaid huge amounts of money to water it down and they succeeded. Just like they bought

deregulation, they bought the bailout, and now they succeeded in watering it down, butnot as much as they had hoped. This is, you might say, the partial triumph of democracy.But we dont know whether they will keep it. The administration is on the wrong side.

For instance, one of the provisions is that the US government should not underwrite therisky derivatives that cost $170 billion in the case of AIG. Banks shouldnt be engaged in

gambling and there is a debate on whether AIG was engaged in gambling or insurance. Certainly, if itsgambling, it should not be government-guaranteed. One provision is to say that if you are FDIC-insured,you cant write these gambling policies, insurance policies. The administration and the Fed said that itsan important part of the lending activity. Its only a few banks that do it. If its an important part, it wouldnot be just a few banks. It will be most banks.

Where does that put the future of the US financial sector?

Americas financial system was out of proportion to the size of our savings. We are thelargest economy but our savings rate is very low. Our financial markets were larger thanproportionate. The reason was that people believed that US markets knew how to managerisks and allocate capital. The lesson from the crisis is that they dont know. Its gamblingwith other peoples money. And thats going to stop.

Talking about savings, in Japan, the number of people retiring is more than the number of people saving.Soon, Japan may have to borrow externally to meet the deficit and that could push interest cost up

Japans debt-to-GDP ratio of 180%, is 50% greater than Greece and the only reason that itavoids trouble is that it doesnt have to depend on outsiders. Also just to put things in

perspective, Greeces household savings rate is higher than Germanys. So the notion thatthe Greeks were profligate is not true. Now, if Japans savings rate falls, it will have todepend on outsiders and that could in fact likely lead to higher interest rates. How muchhigher could depend on all market confidence. Markets have demonstrated a kind ofirrationality irrational exuberance and irrational pessimism. If interest rates remain lowgiven Japans tax capacities, it can service the debt. So if global interest rates remain

relatively low and people remain confident then I dont think Japan is necessarily is going towards acrisis. But its not out of realm of the impossible.


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Pink Panther

Be it Greece or Japan, you repeatedly talk of lower interest rates. But given the inflationary fears, youthink thats feasible?

I am sufficiently pessimistic about the global economy. The forecast for US is that we wontreturn to normal unemployment before the middle of the decade. So we are talking about anextended period of weak economy. If Europe, and probably the US, go on austerity packagesthat the financial community is pushing for, the likelihood is even greater.

So, euro and the European Monetary Union will survive

What happened in the last few months has been disappointing. Germany was reluctant to come to theassistance, and when it came to the assistance, the only fiscal framework they talked about is austerity nota solidarity fund. Greeces problems are largely of outside its boundaries because its majorexport like tourism is down because of the global downturn. It had a structural problem, but

most of the deficit is caused not by the structural problem but by the global downturn. So weare trying to correct the structural problem without doing anything about the surroundings.

The positive is that in the end Germany and the other countries did come to the assistance ofGreece. The benefit that Germany and others get from the euro is sufficiently great, thepolitical commitment is sufficiently great and I think it would survive. But it would be on thebasis of muddling through, which will mean a lot of global financial volatility. It doesnt needfiscal union to survive, but what it does need is some form of assistance and moreinstitutionalised than the current programme. There is a risk of it not surviving and thats the price that isdemanded of the countries. Spain is a good story as before the crisis it had a surplus. So no one cancomplain of a fiscal profligacy.

You have said there is a risk of another financial crisis within five to ten years. Where and why?

The problem with developed countries is clearly very serious. In the US there could be acrisis of confidence in the dollar we had it before in the 1970s. But it could also comefrom emerging markets because what has been happening is that to reignite the Americaneconomy we have been flooding the world with liquidity but that has not translated intolending in US. Its again part of the free market ideology which is give money to the banksand dont worry about what they do. But in the world of globalisation they are askingwhich the best place to invest is. And they are coming out with an answer that the bestplace is not US. Fed is creating liquidity which is going to other markets, and Fed is sayingthats their problem and not ours.

You had praised RBI and its resistance to some of the liberalisation. Is it a model for other countries?

Our regulatory structure was very flawed. People like (Henry) Paulson who helped createthe problem was telling India that you should follow the American way. I am glad that youdidnt follow Paulsons advice. So the point I am making is that even if you are fullyadvanced, you shouldnt follow the Paulson way. But countries which are not fullydeveloped might want to have different or more regulations or may have the ability to havemore regulation. Its not only that financial markets are more complicated and difficult soyou have to have a regulatory structure that changes with the stages of development.


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Pink Panther

In the next one-and-half years, a lot of US mortgage interest rates will again come up for resetting. Doyou fear another spate of defaults and turmoil in the market?

Not fearing, we know it will happen. We know that there would be more mortgagedefaults. We expect the number in 2010 to be larger than 2009. Things are gettingworse. Thats one of the reasons why I am not optimistic about a quick recovery. Theadministration has done almost nothing for the foreclosures. And there are twoproblems one of the reset and of course that will get worse once the interest ratesstart becoming normal. The other problem is that more than a quarter of themortgages are underwater as real estate prices have gone down by 30%. The onefactor in this is that the US government has taken over the role of being the largestowner of the mortgages. So it may be that there will be fewer problems in the private

sector and more in the public sector but its all part of the hidden bailout.

On the eve of the Chinese New Year, China raised the interest rates. There are fears of a blow-up inChina, many of the infrastructure ventures are not earning enough. Isnt it worrying?

Two things about China which is different from other countries are: first, it is sitting on$2.4 trillion of reserves. It gives a bit of cushion to handle some of the bad debts. Thesecond: when you are a big economy that is growing at 10% a year, the mindset of what isexcess capacity changes very dramatically. What you see, disappears before you know. Itis true that they have had a supply side model for their economy and it worked mainlybecause of the success of the export-led growth. They could increase the supply and thereis a global demand that always mattered. That model is running out of time. They know itand they are in the process of restructuring the economy and I think they will succeed in

doing that. But thats the major challenge.

And given the slowdown in Europe as well as US, export-led economies will find it a problem.

The export-led growth model will have real trouble. India and China have a very bigadvantage as they have a vast domestic untapped market which they are beginning to tap.Thats why I am optimistic about India and China. Particularly Chinas economic growthat this stage is very resource intensive. Urbanisation, steel base, food consumption there will be a high demand for commodities which will benefit other developingcountries. So their growth will be enough to help Latin America and some of the otheremerging markets. But not enough to save Europe and America. In fact, its going topresent a problem for the US and Europe as the prices of raw materials will go up.

In your book Roaring Nineties, you had hoped that the future US administration will address the issueswhich will improve the world as well America. Is there a chance?

The US is so absorbed by the crisis and domestic politics. It was Gordon Brown whotook the initiative for G20. It was Brown and Sarkozy who said that we got to have aglobal regulatory framework. We dont want to talk about a global reserve currency aslong as we have to borrow a trillion dollars every year; we dont want to upset thisparticular apple cart as long as people are willing to buy our bonds.


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Pink PantherMen like you and Prof Krugman provide intellectual ammunition to politicians who then lead thegovernment to intervene in the market. Do you feel a moral obligation that these things may not work outwell?

Much of what we talk about is what I call robust interventions. By that I mean interventions that aresimple enough that you dont have to very fine tune to make them work, even if you have a bad presidentlike President Bush. We have just seen that the government can be very dysfunctional. Paul feels muchmore about the issue of robust intervention that works even with the flawed institutions. But obviously itgoes back to the dynamic view on regulation and taxation. Any system will have constant changes and sothere will be mistakes. But then we have to say that we are ready to correct the mistakes when theybecome evident.

We are now in the early stages of a third depression: Paul Krugman

Recessions are common; depressions are rare. As far as I can tell, there were only two eras in economichistory that were widely described as depressions at the time: the years of deflation and instability thatfollowed the Panic of 1873 and the years of mass unemployment that followed the financial crisis of1929-31.

Neither the Long Depression of the 19th century nor the Great Depression of the 20th was an era of non-stop decline on the contrary, both included periods when the economy grew. But these episodes ofimprovement were never enough to undo the damage from the initial slump, and were followed byrelapses.

We are now, I fear, in the early stages of a third depression. It will probably look more like the LongDepression than the much more severe Great Depression. But the cost to the world economy and, aboveall, to the millions of lives blighted by the absence of jobs will nonetheless be immense.

And this third depression will be primarily a failure of policy. Around the world most recently at last


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Pink Pantherweekends deeply discouraging G-20 meeting governments are obsessing about inflation when the realthreat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.

In 2008 and 2009, it seemed as if we might have learned from history. Unlike their predecessors, who

raised interest rates in the face of financial crisis, the current leaders of the Federal Reserve and theEuropean Central Bank slashed rates and moved to support credit markets. Unlike governments of the past, which tried to balance budgets in the face of a plunging economy, todays governments alloweddeficits to rise. And better policies helped the world avoid complete collapse: The recession brought on bythe financial crisis arguably ended last summer.

But future historians will tell us that this wasnt the end of the third depression, just as the business upturnthat began in 1933 wasnt the end of the Great Depression. After all, unemployment especially long-term unemployment remains at levels that would have been considered catastrophic not long ago, andshows no sign of coming down rapidly. And both the United States and Europe are well on their waytoward Japan-style deflationary traps.

In the face of this grim picture, you might have expected policymakers to realize that they havent yetdone enough to promote recovery. But no: Over the last few months there has been a stunning resurgenceof hard-money and balanced-budget orthodoxy.

As far as rhetoric is concerned, the revival of the old-time religion is most evident in Europe, whereofficials seem to be getting their talking points from the collected speeches of Herbert Hoover, up to andincluding the claim that raising taxes and cutting spending will actually expand the economy byimproving business confidence. As a practical matter, however, America isnt doing much better. The Fedseems aware of the deflationary risks but what it proposes to do about these risks is, well, nothing. TheObama administration understands the dangers of premature fiscal austerity but because Republicans

and conservative Democrats in Congress wont authorize additional aid to state governments that austerityis coming anyway, in the form of budget cuts at the state and local levels.

Why the wrong turn in policy? The hard-liners often invoke the troubles facing Greece and other nationsaround the edges of Europe to justify their actions. And its true that bond investors have turned ongovernments with intractable deficits. But there is no evidence that short-run fiscal austerity in the face ofa depressed economy reassures investors. On the contrary: Greece has agreed to harsh austerity, only tofind its risk spreads growing ever wider; Ireland has imposed savage cuts in public spending, only to betreated by the markets as a worse risk than Spain, which has been far more reluctant to take the hard-liners medicine.

Its almost as if the financial markets understand what policymakers seemingly dont: that while long-term fiscal responsibility is important, slashing spending in the midst of a depression, which deepens thatdepression and paves the way for deflation, is actually self-defeating.

So I dont think this is really about Greece, or indeed about any realistic appreciation of the tradeoffs between deficits and jobs. It is, instead, the victory of an orthodoxy that has little to do with rationalanalysis, whose main tenet is that imposing suffering on other people is how you show leadership intough times.

And who will pay the price for this triumph of orthodoxy? The answer is, tens of millions of unemployedworkers, many of whom will go jobless for years, and some of whom will never work again.


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Pink Panther3.1 THE METAL DETECTOR

Be wary of the gold bugs

It is hard to drown in a sea of liquidity. That's the notion the bulls are

keeping their faith in despite the myriad of structural problems in theglobal economy. But in whats reflective of the widespread optimismon gold, even the bulls want to hold on to the yellow metal as alifebuoy just in case.

Gold is the best performing asset class this year and while most otherfinancial assets have struggled to make their way back to pre-Lehman levels, the yellow metal is up by more than 50% since

September 2008. As a result, gold is currently trading well above the long-term average levels relative tostocks and bonds and also in comparison to its own historical trend-line.

Flows have been flooding gold exchange traded funds, or ETFs; they nearly doubled last year, therebytaking the current stock of gold in ETF holdings to an equivalent of a whopping 186 days of globaldemand. ETF holdings for copper total 50 days of demand for the commodity in contrast while aluminiumand zinc ETFs represent around 100 days of underlying demand. The daily turnover in gold ETFs nowat $3- $4 billion a day is up nearly 10fold from levels of three years ago. Investment demand currentlyrepresents the largest component of overall demand for gold compared with a mere 4% just a decade ago.

Traditionally, jewellery purchases constituted the overwhelming majority of demand for the yellow metal,with India, China, Turkey and the Middle Eastern countries being the largest buyers. Jewellery demandhas been on the decline over the past two years in reaction to the price surge caused by strong investmentdemand. In fact, jewellery demand contracted by as much as 20% in 2009.

The price increase suggests that supply has fallen way short of demand even though gold miners aremaking huge profits with the marginal cost of production estimated at $700 an ounce. The demand-supplydynamic is largely irrelevant in the case of gold at least in the short-term as it largely is an indestructiblecommodity. Almost all the gold that has ever been mined still exists and is 65 times the amount of annualmine production. With 51% of the 165,000 tonnes in above-ground stocks of gold held as jewellery, alarge part of the gold holdings are not traded, thereby limiting the supply on the marketplace.

So is gold a worthwhile investment? It has effectively functioned as a store of value for many centuries,which literally means it has held its value after accounting for inflation. Over the past century, the price ofgold has been virtually flat in inflation-adjusted dollar terms. It has therefore underperformed most otherasset classes; US stocks and bonds yielded annualised real rates of return of 7% and 2% respectively overthe past hundred years. Some of the best periods of gold outperformance have come about when theyellow metal has held its value when other asset classes have fallen. No surprise then that the most ardentgold bugs are folks who have a dire view of the world and little confidence in the financial system.

Gold has done particularly well during crises dating back to the US civil war in the mid-19 th century rightup to the more recent financial meltdown. The IMF cites five major sovereign risk defaults since WorldWar II; demand for gold got a boost during all of them. While history suggests that gold will hold its ownif sovereign credit risks keep increasing, many myths surround the performance of gold.

For one, the wide spread belief that gold is a great hedge against inflation is a relic of the 1970s a periodof very high inflation and the best decade for gold prices. But the relationship between gold prices and

inflation has been more erratic in subsequent decades when cyclical rises in inflation have not always


23/41

Pink Panthersupported gold. The main reason for the strong price performance of gold in the 1970s was central bankswere behind the curve on inflation with interest rates typically lagging inflation.

A catch-up element also played a role in golds 20-fold rise in that decade as its price was fixed at $35 an

ounce under the Bretton Woods system that prevailed from the mid-1940 s to the early 1970s. From the1980s onwards, inflation targeting became more popular and central banks maintained much higher realinterest rates to anchor price expectations and prevent a repeat of the 1970s inflation malaise.

Some investors are currently again buying gold in the belief that inflation will rise sharply in the yearsahead on the back of ultra-lax monetary policies. However, other financial instruments such as inflation-protected bonds currently have very little long-term inflation expectations embedded in their prices and sorepresent a much cheaper way to buy insurance against an outbreak of inflation. Gold only performs wellwhen real interest rates are either very low or negative. After all, gold is virtually a zero yielding asset andthe opportunity cost of holding it is negligible only when real interest rates are meagre.

The other myth surrounding gold is that it an anti-dollar play given the negative correlation betweengold and the dollar during some periods. But as the past few months have shown, this relationship istenuous with gold rising even in the face of a stronger dollar.

Although some Asian central banks have been diversifying their foreign exchange reserves to includegold as it constitutes just 2% of their total reserves, such diversification is not necessarily taking place atthe cost of the dollar. Other currencies from the euro to the much-sought-after high-yielding currenciessuch as the Australian dollar have also been declining in value of late.

The main factor driving gold purchases by some central banks is TINA (There is No Alternative). Ofcourse, as long as real interest rates are low, gold will likely find many interested parties but it is

important to distinguish between absolute and relative performance.

Gold appreciated by 25% in 2009 but underperformed most global stock markets as risk aversion was onthe decline and the low real interest rate environment that propelled gold higher benefited stocks andother industrial commodities even more. In 2008, gold ended the year marginally changed but was seen asa star given the carnage in other asset classes.

Some gold bugs are throwing about very aggressive price targets of $2,000 or $3,000 an ounce, fromlevels of just over $1,200 an ounce now.

If the yellow metal does reach those levels, it would form a bubble of epic proportions. Golds peak at$850 an ounce in 1980 marked one of the biggest bubbles in post WWII history and the yellow metal thenfell by more than 70% in the following two decades as real interest rates rose and the global economicenvironment improved significantly. At $1,800 an ounce in current dollar terms, gold would be at thesame level as at the absolute peak in 1980.

The possibility of gold experiencing a melt up similar to that in 1980 cannot be ruled out. Multi-yeartrends often end with a buying crescendo as bubbles are based on some fundamental development thateventually turns into a fad with prices varying significantly from the underlying reality. Gold is not yet ina bubble stage but is indeed expensive, trading well above the marginal cost of production and that wasnot the case for much of the previous decade when gold prices rose fourfold.From an asset allocation standpoint, owning gold at current levels makes sense only if an investor's viewof the world is outright bearish. If not, gold is likely to underperform other asset classes from hereon, inline with its long-term performance history.


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Pink Panther3.2 CORPORATE BOND MARKET

Long road to Bond Street

Nearly five years ago a landmark report by the Patil Committee laid out a road

map for easier access of companies to long term finance. Suggestions onimproving the structural framework of the corporate bond market have beenlargely implemented. But the key issue of widening the investor base stillremains a challenge. As officials in the regulatory agencies prepare to take freshsteps to address this issue, experts are now calling for a more concerted attemptfrom all arms of the government.

In a recent meeting with top government officials, Subir Gokarn, deputy governor of the RBI, outlined the broad discretion that policy makers ought to follow to develop the local corporate bond market.Rationalising capital controls and convertibility, enabling market access and enhancing market liquiditywere some of the key measures which need to be implemented. The challenges in India centred on driving

demand from domestic investors, boosting market infrastructure and rationalising taxation.

Of course, none of these concerns are really new. Most analysts say the bond market in India is full oftraders, but hardly any long term investors. They suggest all further policy should be directed atexpanding this small community of investors. Regulators can fundamentally alter the market bydiscouraging private placement of debt by issuing companies. The universe of investors cannot beexpanded unless every issue is subscribed to by a range of investors including households.

Ravi Narain, chief of the NSE says, Bond markets have been abysmally shallow in every country in theworld barring the United States and perhaps Europe. The whole of Asia is very shallow as far as thecorporate bond market is concerned. Our country can start with rationalising duty applicable for corporate

bond trades. This will reduce the cost of transfer of debt securities.

Withholding tax has been a hurdle for the bond market. To ensure active participation by offshoreinvestors and to make offshore financing more competitive, withholding tax needs to be removed.According to industry estimates, FIIs contribute close to 30% of the total volumes in the corporate bondmarket that have been rising since December 2009. They currently only invest in shorter tenure securitiesand exit their investments before its time to pay the 20% withholding tax.

Non-government pension funds could potentially be another major participant in the corporate bondmarket. This corpus is about Rs 4 lakh-crore. However, a large part of this is managed based on EPFOguidelines. So, even if the finance ministry gives them freedom to invest according to the liberalisednorms, almost all of these funds will still remain parked in government securities. Policy makers need tochange the current category based investment limits (private corporates, PSU issuers for instance) torating based investment limits for PFs and insurance companies. Raman Uberoi, senior director, CrisilRatings says such long term players can be allowed to initially invest in long tenure debt securities and inGreenfield projects rated up to the A and BBB categories.

Overall volumes in the secondary market for bonds have risen sharply over the past few months. Whiletrades worth Rs 66,850 crore were reported on NSE, BSE and Fimmda for April 2010, the number wasonly Rs 31,000 crore one year ago. In fact, this is the highest-ever volume of reported trades in corporatebonds for a single month since reporting began in January 2007, according to official data. The time isopportune now to move all these volumes to the transparent and better price discovery mechanism oforder matching platform. Then the dream of a corporate bond market as efficient as the countrys equitiesmarket may not be far away. This could in turn help fuel Indias next generation of infrastructure growth.


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Pink Panther3.3 EURO

Debt crisis brings euro to new normal

Europes debt crisis will depress the euro still further after it

declined to the lowest level since 2006. For the 16 countries usingthe currency, that isnt all bad. A drop over three to four yearswould benefit European exporters in countries such as Germany,where foreign sales help offset reductions in government spendingand restraint by consumers concerned about inflation. U.S. exports,which President Barack Obama says he wants to double within fiveyears, may become less competitive.

The euro depreciation is very good news for the region because therest of the world economy is expanding. This is going to bring awelcome boost that may save the euro zone from outright recession.

Experts put the euros long-term fair value at between about$1.10 and $1.20. Their bets are that the euro still has ample room to go down before it goes up. It may fall below parity with the dollar in the first quarter of 2011, according to 43 forecasts compiled byBloomberg.

The euro fell to the lowest against the dollar in more than four years on May 17 2010 and is down 14%this year as the fiscal crisis spreading from Greece undermined confidence in the currency. Purchasingpower parity indicates the euro remains 9.8% overvalued against the dollar. The currencys value is stillhigher than the weekly average rate of $1.1833 since its introduction in 1999. The euros all-time low was$0.8272 in October 2000; the peak was $1.6038 on July 15, 2008.

The euro may stick at lower levels for three, four years as Europe grapples with its fiscal crisis. Thedecline in the euro may hurt demand for the regions sovereign bonds at the time when governments areissuing a record amount of debt. The $1 trillion lending backstop for indebted euro nations agreed to byEuropean leaders on May 10 also wont halt the slide because investors remain concerned aboutgovernment debt, the growth outlook and trade imbalances within the euro area. Countries in the euroregion are bringing forward fiscal tightening and that reduces a chance of a swift and strong economicrecovery. The Frankfurt-based ECB probably will refrain from raising interest rates to help offsetdeclining government spending in the region. Remember, combination of tightened fiscal policy andlooser monetary policy historically leads to a weaker currency.

Even so, pressure on the ECB to raise rates may grow as the euros decline feeds inflation by makingimports more expensive. European inflation accelerated to a 16-month high in April, the EuropeanUnions statistics office said May 18. For European exporters, the euros biggest crisis since the monetaryunions debut is an opportunity after China overtook Germany as the biggest exporter of goods last year.

The super-competitive export machine of Germany is going to be compensated with a very, very weakexchange rate. Exports account for almost half of the German economy, making up 47 percent of grossdomestic product in 2008, the latest year for which full data are available. The biggest losers will be U.S.exporters that face a rising dollar. A weaker European economy is not good for US.


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Pink Panther4.0 FINANCIAL SECTOR: TRANSFORMING TOMORROW

Ensure Proper Regulation

The global financial crisis has been a wake-up call to policymakers the world over. The unprecedented

scale and complexity of the crisis is such that it is unlikely you will ever find experts agreeing completelyeither on the factors that led to the crisis and, possible safeguards against a future recurrence.

Was it poor regulation? Overly loose US monetary policy? Underlying global imbalances? The use ofopaque and complex credit derivatives? Faulty executive remuneration models? Blind faith in marketforces, to list just some of the factors touted as responsible for the spectacular meltdown in the globaleconomy witnessed since the Great Depression? The jury is still out on the precise factors or combinationof factors responsible for the crisis. But there is one issue on which there is rare unanimity among thewise men of international finance: the collateral damage caused by poor regulation of systematically-important financial institutions (SIFs). Following from this the next question is: what sort of informationdo we need about SIFs to ensure proper regulation?

4.1 FINANCIAL ADVISORS:Weigh impact on investors

Filling the information gapsConsolidated statements

The Bank for International Settlements (BIS) has identified information gaps in five areas as critical for better regulation of SIFs and containing future crises. Regulators, for instance, have little or noinformation about the consolidated balance sheet of systemically important financial entities, their

liabilities, their currency exposures, degree of interconnectedness and about

non-bank financial entities such as off-balance sheet special investmentvehicles, pension funds, insurance funds, etc. Yet each of these has a vital bearing on the final outcome of any regulatory effort. For instance, crossholdings between companies are now the norm rather than the exception.However, most of the data collected and monitored by regulators is onindividual companies.

The danger in this is that we could end up losing the wood for the trees. Thus, afinancial conglomerate with interests in diverse fields such as banking,insurance, pensions, asset management and so on could well be submittinginformation on different aspects of its business to different regulators. Andwhile an individual company may not be systemically important, the group as awhole could well be; but since it is not tracked as a conglomerate itsimportance is not fully appreciated.

Fortunately for India, the RBI, to its credit, has been alive to the dangers of thiskind of a disaggregated approach. Hence its insistence on the holding companymodel for financial institutions; ring-fencing commercial banks to keep them

immune from the consequences of the activities of related entities. However, the importance ofconsolidated balance sheets is yet to be fully appreciated even by the RBI. This is relevant since over theyears corporate structures have become more complicated. The ramifications of inter-connected dealingscan best be assessed from consolidated balance sheets. As the BIS points out, the inability to see theconsolidated balance sheet, either at the individual bank level or at the headquarter country level, meansthat the build-up of stresses at the systemic level cannot be monitored'.


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Pink Panther4.2 FINANCIAL PLANNERSValue unlocking for all stakeholders

Filling the information gaps

Liabilities' side

Another information gap the crisis has highlighted relates to the liabilities' side of bank balance sheets. In the past, analysts tracking the health of banks invariablyfocused only on assets the quality of loan portfolios, share of NPAs, interest-sensitivity of investment portfolios and so on. Little or no attention was paid to theliabilities' side of bank balance sheets. Nor was there any appreciation of thedifference between banks that depended heavily on inter-bank deposits, non-bankmoney market funds and wholesale deposits from large companies as distinct fromthose that depended on retail deposits; until the former collapsed when short-term money markets froze.Northern Rock is a case in point.

HERE again, the RBI has been ahead of its counterparts in the developed world in emphasising the needfor a good retail deposit base' and frowning on the dependence of foreign banks on the short-term moneymarket. Yet we cannot really see any of these markets in our aggregate data. And when we cannot seethem, we cannot assess the degree of maturity mismatch embedded in the system.

4.3 CREDIT COUNSELORSResolve convertibility and recompensation issue

Filling the information gapsOff-balance sheet exposures

The exposure of banks to different currencies especially off-balance sheet exposuresis another challenge. In the past adventurism often went way beyond the dictates ofprudence primarily on account of two factors. One, the pressure on managers to earntheir bonuses and two, the fact that much can be hidden in off-balance sheetexposures. The problem here is that the position is never static, so central banks willhave to develop a sixth sense' and learn to recognise warning signals keeping inmind intangible aspects such as the culture of different SIFs. A Citi or ICICI Bank,for instance, is quite different from a State Bank of India and that difference will need to be kept in mindby regulators.

4.4 RISK MANAGEMENT CONSULTANTSEducate Engineer and Enforce

Filling the information gapsInterconnectedness of SIFs

The degree of interconnectedness of SIFs is another key indicator for measuringsystemic importance. Bilateral interbank liabilities and system-wide aggregateexposures to particular counterparties are indicators of the inter-connectedness.Collection of such data is a challenge, but realisation by central banks of theimportance of this is a first step.


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Pink Panther4.5 TECH SAVVY PROFESSIONALSTake first step to ensure efficient and reliable system:

Filling the information gaps

Non-bank financial entities

Pre-crisis, off-balance sheet entities such as structured investment vehicles(SIVs) obscured the build-up of stresses in the financial system andexacerbated the problems when they had to be moved back onto banks' balance sheets. Therefore, non-bank companies particularly, pension funds,insurance companies and large corporates should not be excluded fromsystemic monitoring exercises.

NBFCs are now on the RBI's radar and the bank does identify systemically

important NBFCs and subject them to closer monitoring. But not largecorporates. Is it possible to monitor such companies? Is it necessary to bail outnon-banks? These are issues that are as yet unresolved. In the meanwhile evenas central banks fill the information gaps identified by BIS they would do well

to develop the skills needed to track and recognise warning signals. No amount of data can fill in for that!

What is true at the level of individual SIFs is also true at the national level. Statistics compiled by nationalauthorities, the IMF, the OECD and the BIS do not provide a complete picture. For example, the flow offunds statistics, the balance of payments statistics, the IMF's Coordinated Portfolio Investment Survey andthe BIS locational banking statistics all rely on residency based data. Such data are insufficient foridentifying vulnerabilities in any particular consolidated national banking system.

4.6 WEALTH MANAGERSMap out the details to translate into benefits

System reformsThe Planning Commission

Speaking to members of the Planning Commission at the first anniversary of UPA-II, Prime Minister Manmohan Singh called upon them to reform the role of thecommission. The commission should be a systems reform commission' to addressthe systemic problems of the 21st century, he said. Not only India, but the whole

world is facing systemic problems that are endangering the sustainability ofeconomic growth and human development. These systemic issues cannot beresolved with prevalent, non-systemic and compartmentalised approaches to planning and policymaking. Indeed, these approaches have contributed to the

growth of systemic problems.

A systemic approach requires fundamental changes in the way we think and act. Acartoon to teach systems thinking shows a boat whose one end is sinking into thewater with the other end lifting into the air. Some people are bailing furiously inthe sinking end. In the other end, two men are gloating: Thank goodness the holeis not in our end of the boat!'


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Pink Panther

No man is an island entire to itself, poet John Donne said. We cannot be safewithin our man-made compartments because systemic problems cross state andnational boundaries.

Climate change and terrorism cross nationalboundaries. The rich cannot be secure within theirgated enclaves when there is poverty around. Theycannot be smug about the future if only their

children are well educated and well fed when hundreds of millions of poorchildren are not. Because those masses of children are supposed to give thedemographic dividend on which the country is relying to sustain its economic growth. The essence ofsystems is that many things are interconnected in ways we may not realise.

The cartoon shows a man sitting securely on a chair, and also shows what the man cannot see.

He has solved an immediate problem, but has set in motion a chain of events which will hurt him later. Ina rush to solve problems, without appreciating interconnections, trains of events can be set off that cancreate even worse problems. They are not amenable to silver bullet' solutions. For example, childmalnutrition in India cannot be addressed only by nutritional supplements when children also suffer fromdisease and diarrhoea which washes out the nutrition. Many ministries and specialists must cooperate tomake a difference. A new set of gauges is required for systems reforms.

4.7 INCLUSIVE CEOsInnovative responses to problems

System reforms

The four Ls for systems action

Systems action must follow systems thinking. Frustration with the slow pace ofdevelopment often causes policymakers to revert to a theory of action. But systemicdevelopment requires a very different theory of action based on four Ls: Localaction, Lateral connections, continuous Learning, and empowering Leadership.

The necessity oflocal empowermentis being appreciated in India. The people knowbest what they need. If they become the agents for change they want, then desiredchanges will happen. Therefore, policy actions must be directed to building local

capabilities. Silo thinking and silo action cannot produce systemic action.

In systems many aspects must be coordinated as mentioned before. Therefore lateral connections must bebuilt into the system forcooperation and sharing knowledge. The speed of learning, through the multipleexperiments that a diverse system can undertake, and the speed with which that learning spreads acrossthe system, will produce the scale' required.

Finally, systems reform requiressystems leaders. By dividing the system into silos, they become the pointof coordination that all must look up to. And by keeping people dependent on them for wisdom theyincrease their power. The prime minister wants the Planning Commission to be an essay in persuasion.Carrots and sticks' are adequate incentives for donkeys perhaps. Whereas people can be powerfullypersuaded by ideas that touch their hearts. Systems leaders, and the Planning Commission, must persuadeand lead, not only with the money and permissions they dole out, but with the power of their ideas too.


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Pink Panther5. BANKING SECTOR

Grow, but dont try to rule the world

Emerging markets have come out of the sub-prime crisis better than the advanced

economies. Banks are a play on the economy, so this is reflected in the conditionof banks in advanced and emerging economies. In 2009, banks in the US, UK andelsewhere reported their lowest return on assets in years, if not decades.

Profitability of banks in India and China, two leading emerging markets, was notonly high but higher than in pre-crisis years! The average return on assets in bothIndia and China in 2007-09 was 1%. In the period 2004-06, the figures for Indiaand China had been 0.8% and 0.7% respectively (Source: IMF's Global Financial

Stability Report, April 2010). Banks in other emerging markets, such as Brazil and Russia, have alsoremained profitable although profitability declined during the crisis years.

At the turn of the century, most people thought it was only a matter of time before puny domestic banks inemerging markets were overrun by foreign giants as the markets opened up to competition . As acomprehensive survey of banks in emerging markets in the Economist (May 15-21) points out, this doesnot seem likely anymore.

On the contrary, emerging market banks could soon reach a size (measured by market capitalisation)comparable to that of their counterparts in advanced markets. Some are already there. China has three banks in the top 10 in the world. Brazil and Russia have one each. India's SBI is in the top 50. Thequestion for emerging market banks is not whether they can grow. It is how fast they should grow; andwhether a large overseas presence should be part of the growth strategy.

In the advanced markets, banks are still going th

44rth Financial Advisor Practice Journal

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