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  • 8/9/2019 Niveshak April10 Issue

    1/26FIN-Q PG.24 The Gold, oil and US dollar relationship Pg.18

    THE INVESTOR VOLUME 3 ISSUE 4 April 2010

  • 8/9/2019 Niveshak April10 Issue

    2/26Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bearsno responsibility whatsoever.

    F R O M E D I T O R S D E S K

    NiveshakVolume III

    ISSUE 4

    April 2010

    Faculty Mentor

    Prof. S.S Sarkar

    Editor

    Bhavit Sharma

    Sub-Editors

    Durgesh Nandini Mohanty

    Hitesh Gulati

    Sumit Kedia

    Tanvi AroraUpasna Agarwal

    Designers

    Bhavya Aggarwal

    Swarnabha Mukherjee

    All images, design and artwork

    are copyright of

    IIM Shillong Finance Club

    Finance Club

    Indian Institute of Management

    Shillong

    www.iims-niveshak.com

    Dear Niveshaks

    It was January 2008 when our sensex touched its peak of 21000. Then came

    the scary October 2008 when it slid to 8000 mark. And now, again, it has swiftlytaken a big leap to pat the 18000 mark. What a roller coaster ride it has been.

    One of the important pulling factors behind this upside swing has been the drastic

    monetary steps such as slashing CRR by 300 basis points taken at that point of time

    which infused confidence as well as liquidity in the market. However, looking at it in

    a short frame of time, I see that the things are a bit unusual. In an ever-volatile stock

    market, I find it tough to recall the last time, when the broad based indices Nifty

    and Sensex remained stagnant for the past six months. But this has been the case

    with Indian stock market since October last year. It has been lurking roughly in the

    same range of 17000 to 18000.Another food for thought for many Niveshaks is the

    fact that Sensex is not really far from its all time high. And at the same time, many

    stocks especially in the information technology, banking and pharmaceutical indus-

    tries have already reached their all time highs. That leaves investors and people like

    us confounded to the future course of the market.

    The euphoria is not restricted to India only. World stocks are also slowly inch-

    ing close to their respective 18 months high on signs of improving global growth

    but the Europe remains on the backseat due to prevailing worries about Greeces

    debt problems. The recently released strong U.S. data from jobs to manufacturing

    has spurted hopes that the worlds biggest economy will come out of woods soon.

    In addition to this, the present dynamics of global oil price movement and curren-

    cies exchange rate is expected to have a lasting impact on the global economy.

    Strengthening U.S. dollar has brought some correction in the oil price which had

    reached its 18 month high of 87 dollars a barrel. Rising rupee against dollar will alsogive import based Indian companies an advantage but it may come in the way of

    RBIs monetary policy tightening if it chooses to slow down this rise. All of these

    factors along with the recently released strong IIP numbers and annual reports by

    Indian firms make us believe that the Bull Run is here to stay.

    In continuation with our sustained endeavour to get the latest insights from

    the corporate, we welcome Ms Deepali Bhargava, Economist for ING Vysya

    Bank as the guest of this issue of Niveshak. An illustrious economist - Deepali has to

    her credit, consistent & accurate directional calls on inflation, interest rates and INR.

    In a special session with her, she has talked about the Indian economys recovery

    path, recent RBIs monetary policy and some issues related to exchange rate poli-

    cies.

    This issue of Niveshak brings to you some more interesting and insightful top-

    ics. In the contemporary fierce competition in markets and race for showing higher

    profits and growth, many companies manipulate their financial position and results

    to hide the true picture of their financial health. The repercussions of this are in

    front of us. We saw numerous accounting scandals resulting in bankruptcies and

    fall of some major firms like Enron, WorldCom etc in the recent past. But the ques-

    tion arises as to what are the different means of manipulating financial statements.

    So our cover story addresses this question by elaborating various ways of fudging

    financial accounts and statements and means to detect such abnormalities. Hope

    you find this issue an interesting read.

    Stay invested with us!!

    Bhavit Sharma

    (Editor-Niveshak)

    EDITORIAL TEAM

  • 8/9/2019 Niveshak April10 Issue

    3/26

    Niveshak Times

    04The Month That Was

    C O N T E N T S

    PERSPECTIVE

    21 Nivesh In Indian Population

    Cover Story11 Window Dressing the

    Financial Statements

    Finsight18 The Gold, Oil and USDollar Relationship

    Fingyaan

    15 Catastrophe Bond Market

    Article of the month

    06 Banking The Unbanked

    finlounge

    14 FinToon

    24 Fin-Q

    SHe Speaketh

    09 Ms. Deepali Bhargava

  • 8/9/2019 Niveshak April10 Issue

    4/26NIVESHAK VOLUME 3 ISSUE 4 April 2010

    Lobbying for FDI in multi brand retail

    The government has launched discussions be-

    tween ministries about opening multi-brand retail

    to foreign direct investment (FDI), stepping gingerly

    into an issue that has been demanding a lot of at-

    tention for the last few years in the national sce-

    nario. The Indian government allows up to 51% for-

    eign investment presently in single-brand retail, but

    has been reluctant to allow any foriegn investmentin multi-brand retail. The rules allow foreign multi-

    brand retailers only through franchise agreements

    with local players. Large players in the Retail Indus-

    try such as US-based Wal-Mart and Germanys Metro

    AG that operate in the so-called cash-and-carry ven-

    tures in India have long been clamouring for opening

    up front-end retail.

    The retail industry deserves a lot of importance

    today as it is the second largest employer in the

    country. For a change, in the last few months, thegovernment has been airing its views on opening up

    retail, dwelling on its benefits, possibly to deflect

    the storm of protests it could set off. The govern-

    ment has said in various forums that FDI in multi-

    brand retail will enhance supply-chain efficiencies,

    give farmers better earnings and reduce wastage.

    RIL to buy out 40% in Atlas shale gas

    Reliance Industries (RIL), the countrys larg-

    est company has agreed to buy a 40% stake in a

    US shale gas venture of Atlas Energy for a whop-ping $1.7 billion, giving serious competition to Exxon

    Mobil and Frances Total in the race for a fuel that

    may change the global energy economics. It will

    invest $340 million in cash for the stake and pay

    Atlas drilling expenses of up to $1.36 billion over

    the next five-and-a-half years. The deal values per

    acre of shale at $14,167, compared with $14,000 an

    acre paid by Japans Mitsui & Co in a similar deal.

    The importane of Shale gas is increasing by the day

    as it represents a growing source of energy and isexpected to constitute 20% of the overall gas pro-

    duction in the US over the next 10 years.Gas locked

    in shale formations is expected to account for 50%

    of US supply by 2035, up from 20%.Despite the early

    trials of exploration of some US companies began

    exploration nearly two decades ago, they did nottaste success due to lack of technology and inter-

    est form big energy companies. Given the stagnant

    reserves, many oil companies now see shale gas as

    a major source for the future.

    Bharti gets its share of the Zain deal for

    $10.7 bn

    Bharti Airtel, Indias leading telecom service

    provider has finally taken the huge leap to fulfill

    its global ambitions. It sealed a deal on Tuesday to

    acquire most of the African assets of Kuwaits Zain

    Telecom. The $10.7-billion deal, including $1.7 billion

    of Zains debt, was signed in Amsterdam, the base

    of Zains African unit. With Zain Africas 42 million

    customers, Bharti Airtel will have 179 million sub-

    scribers, making it the worlds fifth-largest mobile

    phone operator.

    Standard Chartered drafts red herring for

    listing by IDRs

    This is one of the most significant develop-ments in the recent financial history as this is the

    first issue of IDRs, the Indian counterpart of global

    depository receipts and American depository re-

    ceipts, by an overseas company after guidelines

    were framed in 2004. Secondly, these depository re-

    ceipts represent equity shares of Standard Chartered

    held by an overseas custodian based on which

    an Indian depository issues rupee-denominated re-

    ceipts or IDRs to Indian investors Indian IDR hold-

    ers will, in effect, own equity shares of a foreign

    bank and also be able to trade in them as the re-

    ceipts will be listed on our stock exchanges. IDRs

    provide foreign companies a platform to directly

    raise capital in India but had not, for a variety of

    reasons, including somewhat restrictive regulations

    compared to American or global depository receipts,

    found favour with overseas companies so far. The

    IDR listing of StanChart is a first in this direction.

    Greece decit worse than anticipated

    Greeces budget gap last year was worse thanfeared. This news triggered a fresh slide of asset

    prices in Greece and other debt-choked European

    countries. The news hurt financial markets waning

    hopes for Greece to bring its swelling national debt

    Niveshak Times

    The MonTh ThaT Was

    Team Niveshak

    Durgesh Mohanty & Tanvi Arora

    www.iims-niveshak.com

  • 8/9/2019 Niveshak April10 Issue

    5/26FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 5

    The MonTh ThaT Was

    under control, and increased pressure on Athens to

    seek billions of euros of emergency loans from theEU and the International Monetary Fund.

    The Greek government posted a budget deficit

    of 32.34 billion or 13.6% of gross domestic prod-

    uct in 2009, not the 12.7% which it had reported ear-

    lier. The deficit might be revised again, by between

    0.3 and 0.5 percentage points of GDP, because of

    uncertainty about the quality of Greeces data and

    accounting procedures.

    The incoming socialist government said

    Greeces 2009 budget deficit would be twice as big asthe previous estimates and four times EU ceiling.

    RBI reviews monetary policy yet again

    The RBI raised the two key policy ratesre-

    verse repo and repoby 25 basis points each, and

    left banks with Rs 12,500 crore less to lend with a

    25 bps increase in the cash reserve ratio (CRR). This

    rate hike is seen as moderate by any standard in

    the current circumstances. Therefore, most bankers

    think RBI will have to raise rates as well as increasethe CRR in small doses during the year.

    Banks borrow from RBI at the repo rate while

    parking (or lending) surplus funds at the reverse

    repo rate. After the increase, the repo and reverse

    repo rates are 5.25% and 3.75%, respectively. The

    CRR, which is like a tax on lenders, is the slice of

    customer deposit that banks have to set aside as

    cash with RBI. After the 25 bps CRR hike, from 5.75%

    to 6%, banks will have Rs 12,500 crore less to lend

    from the fortnight beginning April 24.

    RBI began tightening in January when it raised

    the CRR by 50 bps in two stages. This was followed

    by the 25 bps increase in repo and reverse repo in

    March. While RBI has been slower than its counter-

    parts in Australia and Israel in raising rates, it has

    been quicker in reversing the cycle than the Chinese

    central bank and monetary authorities in many ad-

    vanced economies.

    IRDA tells postal dept to fall in line

    The insurance regulator has demanded thatthe countrys postal department adhere to its norms

    while selling insurance products, triggering a poten-

    tially damaging row between the two and forcing the

    finance ministrys intervention.

    The postal life insurance has over 15 million

    policy holders. It offers two life insurance schemes,Postal Life Insurance and Rural Postal life Insurance

    with a corpus fund of Rs 14,000 crore and Rs 4,000

    crore, respectively as on March 2009. All insurance

    products offered by the DoP are not covered by IR-

    DAs rules and regulations.

    Under the Insurance Act 1938, Section 118 (C),

    life insurance schemes run by several state govern-

    ments for their employees and the Postal Life Insur-

    ance Scheme of the central government dont come

    under the IRDA purview. The insurance regulator islooking to extend its reach.

    IRDA-SEBI war takes new turn

    Last year, life insurance companies, including

    LIC, were served show-cause notices by SEBI, ques-

    tioning them on sale of Ulips without obtaining the

    market regulators approval. The insurance regula-

    tor responded broadly saying SEBI did not have the

    remit or the jurisdiction to regulate Ulips. The turf

    war took a fresh twist when on April 9 Sebi issued

    orders to 14 life insurance companies, banning themfrom selling new policies or renewing existing ones.

    The market regulator said these companies have to

    register with SEBI for marketing and servicing such

    products. SEBIs order may compel investors to sur-

    render their policies prematurely, leading to a sig-

    nificant loss to both investors and insurers.

    The issue came to a boil over IRDA telling insur-

    ance firms to continue selling Ulips, a day after capi-

    tal market watchdog Sebi barred 14 insurers from

    selling these products without its approval.

    What makes the issue complicated is the fact

    that both the regulators have armed themselves

    with legal opinions supporting their case to regulate

    Ulips. Following the meeting between the chiefs of

    Sebi and Irda and senior finance ministry officials,

    both the regulators have decided to restore status

    quo and keep in abeyance the orders issued by both

    during the weekend.

    This means that the insurance industry will not

    be staggering for now from selling Ulips. But the pre-vailing uncertainty might put off new investors.

    Niveshak Timeswww.iims-niveshak.com

  • 8/9/2019 Niveshak April10 Issue

    6/26NIVESHAK VOLUME 3 ISSUE 4 April 2010

    oM

    The Indian financial system es-pecially the banking has weatheredthe storm of the recessionary wavethat swept across the world thankstwo pillars firmly fixed in its culture:exposure to risk & ethics. Havinghad a firm footing the time has comethat the benefits of the same reachout to all stratas of society and cor-ners of the country. A person cannotstand on its own without personal

    and financial security.Even after 60 years of Indian

    independence, 1/3 of our populationis still illiterate (let alone financiallyliterate) and at least 26% of the pop-ulation still lives under the povertyline. Financial inclusion would re-sult in all round economic develop-ment of our nation. Nationalizationof banks in 1969 was an effort tochannelize to funds to industrial and

    business units which were starvedof funds, even though the govern-ment policy was to encourage small,tiny and cottage and village indus-tries. Further consolidation of banksand liberalisation of economy start-ed in the early 1990s saw peoplegetting exposed to various financialproducts. At the same time, a largechunk of people have still remainedimmune to basic banking facilitieseither due to insufficient earningsor to easy credit facility availableto money lenders. Around 41% ofIndian population is unbanked andcoverage of basic financial servicesin rural areas is 39% against 60% inurban areas.

    The financially excluded sec-tions largely comprise marginalfarmers, landless labourers, orallessees, self employed and unorga-nized sector enterprises, urban slum

    dwellers, migrants, ethnic minoritiesand socially excluded groups, seniorcitizens and women. While there arepockets of large excluded popula-tion in all parts of the country, the

    North East, Eastern and Central re-gions contain most of the financially

    excluded population. A stable andhealthy financial service sector cre-ates trust among the people aboutthe economy and only with this trust(which has legal validity) could astrong, stable and an inclusive econ-omy be created.

    Reasons for Banking Exclusion

    The low coverage of banking &financial services is due to followingreasons:

    Lack of awareness, low in-comes, social exclusion, illiteracy act

    as barriers for the masses.

    Too many formalities, branchdistance, unsuitable products, lan-guage & the attitude of the staff to-wards people.

    Lack of proper Infrastructuredue to inaccessibility & location ofthe rural habitats.

    Strategies to Reach Banking to

    the Bottom of the pyramid

    Challenges are many and theseare being tackled but there is longway to go before we achieve allround financial inclusion and provid-

    Financial Inclusioncannot and should

    not be just seen as

    a buzz word but

    should replicate

    an effort to make

    mainstream financial

    services accessible

    to all sections of the

    population. It is a

    conscious attempt at

    trying to bring the

    un-banked people

    into banking. Finan-

    cial Inclusion does

    not merely mean ac-

    cess to credit for the

    poor, but also other

    financial services

    such as Insurance.

    Welingkar Institute of ManagementAbhishek Sarkar & Sreejit Gopinathan

    NKING THE UNBANKEDB

  • 8/9/2019 Niveshak April10 Issue

    7/26FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 7

    AoM

    ing banking services is just one amongst them.

    Financial Awareness to masses

    Most of the people in this segment are scepti-cal to open a bank account because of their nonfinancial background.

    Hence, we should begin by spreading finan-

    cial literacy & awareness among them. Teachingshould be done in simple languages (preferably re-gional language) using various audio-video teachingaids. This education should begin from school level& can be clubbed with Sarva Shikhan Abhiyan ofthe government. Since, people trust on those who

    teach their children. Stories, Pictures, Cartoon strips,Jig Saw puzzles can be used to imbibe the impor-tance of banking in the people. Local semiliterateor educated people can help us in this initiative. Weshould keep them regularly updated through GramPanchayat Meets & help them realise their needsrather than expanding the business of banking asenvisaged by commercial banking sector.

    IT Technology & Mobile banking

    Technology has reduced the distance betweennations & people and the same can be leveragedto deliver banking services to the un-banked. Mo-bile technology has its presence pan India andcan be used as a tool in providing access to vari-

    ous facilities at their fingertip. The mobile marketin India has witnessed an increas-ing no of subscriber base from ruralIndia, largely due to the decliningmobile tariffs & availability of lowcost handsets in the country. Peoplewho are not comfortable with bank-ing are more comfortable using theirmobile phones. So, mobile bankingcan be used as medium to makethem banked. The Basic credit trans-

    actions (debit /credit) can be doneusing mobiles as done in Africa. To-day with 3G and Wimax coming intopicture the telecom operators canprovide all the banking functions in

    a platter to the rurals. To begin with banks can tie upwith telcos and ask them to provide mobile phonesenabled desired services to people from the villageswho are well versed with the device and ask themto serve as an intermediator in facilitating the finan-cial transactions. These intermediators can providedwith some commission for the same. Slowly, when

    the villagers are becoming familiar with it they canalso be given training for the same. This will notonly save operational cost & infrastructure cost forthe banks but also increase the reach of the banks.It will also make the banking operations conve-nient, safe, reliable and transparent. The pilot proj-ects of smart cards for opening bank accounts us-ing biometric identification implemented in AndhraPradesh should encouraged further. Also, the samechannel can be used for providing other financialservices such as insurance.For this we need to scale

    up our IT & telecom infrastructure as traffic of finan-cial transactions is going to increase in tandem withcoverage of more & more villages. However the paceat which the technology is being is used to providesuch facilities needs to be at a faster rate or else thedream of complete financial inclusion will remainmere on paper.

    Star Network Model of Distribution

    The star network distribution model which isa common computer network topology can used totarget the masses. For instance, when adopted by a

    bank, the various marketing functions will be per-formed by the branches i.e. Leaf Nodes whereas theprocessing is done at the central office i.e. the Cen-tral Node. That means the task of reaching out to themasses will be done by the Leaf nodes. It is easierto adopt as it gels well with the existing distribu-tion networks. This model provides a multichannelreach to banks. The following diagram depicts vari-ous distribution channels which helps us in tappingthe BOP easily.

    CO-OPERATIVE/COMMERCIAL BANKS: These are

    the ones which have their local presence in the vil-lages. Urban banks can have refer-ral tie-ups with them can pass theirproducts to masses through them.

    SELF HELP GROUPS (SHGs)/NGOS: SHGs & NGOs can also provean effective medium of credit dis-tribution to the masses. Currently,most of micro-credit activity hap-pens under the banking modelthrough NABARDs linkage with the

    SHGs. Currently, there are about 2.3million SHGs covering 35 millionpeople from the BOP. The Grameenbank model of BanglaDesh is be-

  • 8/9/2019 Niveshak April10 Issue

    8/26NIVESHAK VOLUME 3 ISSUE 4 April 2010

    With globalisation, the gap

    between various nations are

    bridged, banking to rural

    masses can link up the gap

    within India under the um-

    brella of nancial inclusion

    oM

    ing followed here. We can take the example of SHGmovement Kudumbasree in Kerala which helped itattain 100% financial inclusion. This was possible bybringing together the agricultural department, theRevenue departments, the Panchayats (Local Self-Governance), the D.R.D.A and the State Poverty Erad-ication Mission.

    MICRO FINANCE INSTITUTES (MFI): Microfinanceis a gift to us by Bangladeshi economist Muham-mad Yunus. MFIs are basically sitting at the core ofthe matter. They have helped people to help them-selves. They have brought paradigm shift in peo-

    ples outlook that poor people are worthy of beingbanked. Also, the rate of defaults is very less in spiteof having higher rate of interests.

    POST OFFICES: Post offices have a very widecoverage all over the country. They can be used asdistribution partner for easy credit. Moreover, peo-ple are more familiar with the environment & staffwhich reduces their apprehensions. Post Offices canissue a POST Office Card Account as started in UKwhich can be substitute for bank accounts.

    BUSINESS CORRESPONDENTS (BCs): Business

    Correspondents form the face of the banks or fi-nancial institutes to masses. They can be the routethrough which the importance of banking can com-municated at the grass root level. Retired Bank Of-ficers, Government servants, Sarpanch (Chief), LocalTeachers & Other key important who are from theBOP should be made BCs. They can easily convincethe people in opening the bank accounts & increasenetwork using their familiarity & quality of trust.

    Offering Simple Products & Processes

    Banks need to offer simplified products revolv-ing around the needs of BOP. To comply with KnowYour Customer Norms banks can use the existing UIDproject or biometric cards. They need to minimisetheir formal approach of banking & bring an infor-mal touch in the whole banking experience. Banks

    should start by offering Zero balance & No Frills Ac-count to these BOP people. Also, ensure that the ac-counts are not dormant. For this they can come upwith schemes such as offering low interests & pre-cedence in getting loans to those who are having atleast one transaction per month. This will encouragethem to open account & carry out transactions. In-dia is a country with diverse demographics where inthe languages changes every 5o kms. So, Banks cancustomise & offer community-wise or region-wiseproducts which will be more easily accepted. Banks

    need to connect with the emotions of these people& understand the reasons for their borrowings suchbuying crops, house, marriage, start new shop, etc.The credit cycle should be aligned with crop cycle forfarmers. The mahajans or the money lenders are thebiggest competition to the banks. We need to under-stand the differences in them. The money lendersprovide easy & any time cash, also they dont askfor any collateral. They treat poor people as users& not customers. To reduce the competition banksshould make these mahajans as BCs and offer them

    commissions. Also, they can be treated as HNIs & begiven other incentives.

    Conclusion

    The obvious question which might come to ourmind is why we need to bank the BOP which maynot be profitable. The simple answer is low profitsin high proportion can become a gold mine. More soits about empowering the people because a countrycan be accurately judged not just by GDP numbersand growth rate but more so by the well being ofits people. Poverty alleviation can achieved throughfinancial inclusion.

    With globalisation taking a big leap, the gapbetween various nations are bridged, banking to ru-ral masses can link up the gap within India underthe umbrella of financial inclusion.

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    SheSpeaketh

    Deepali Bhargava,

    in this interview

    with, Team Nive-

    shak opines aboutthe state of the

    economy at present

    and the trajectory it

    is expected to tra-

    verse. In light of the

    RBI annual policy

    attempting to deli-

    cately balance the

    rising inflation andgrowth recovery, a

    peek in the dynam-

    ics of the Indian and

    world economy is

    what this interview

    has to offer.

    Niveshak: There are talks that theGlobal and Indian economy areon the recovery path. What doyou have to say about it? How

    do you see the Indian macroeco-nomic scenario panning out inthe next couple of years?

    Ms. Bhargava: Indian economy is wellsustaining the growth momentumentering in to 2010-11. Leading in-dicators are hinting at continuedrecovery. Services sector is likely tocatch up with the industry sectorin 2010-11 when we expect it to re-cord over 9% growth. The big boostis likely to come from 1) enablerslike the arrival of 3-G facilitatingtelecommunication growth 2) strongemphasis on infrastructure revivingconstruction 3) higher tourist arriv-als and 4) deleveraged bank balancesheets pulling up bank profitability.

    Revival in domestic demand is likelyto be complemented by a pick-up onexports. IMF has projected an expan-sion of 5.8% in world trade volumein 2010 vs. a contraction of 12.3% in2009, which is a positive for Indiatrade. But, among other factors, thecompetitiveness will be determinedby the extent, if any, of CNY revalu-ation and also RBIs comfort withthe pace of INR appreciation. Takingthese factors into account, we fac-tor in a 10% growth in exports. Bankcredit is likely to play a key role infinancing growth. We, hence, pencilin 8.2% GDP growth for FY11.

    Niveshak: What do you have tosay about the RBI annual policy?Is it in accordance with the gen-eral market sentiments?

    Ms. Bhargava: RBI recently raised itskey rates repo, reverse repo andCRR by 25 bps to each to 5.25%,3.75%, 6.00% respectively. Thoughthe recent rhetoric by RBI may havehinted at a policy shift towards con-taining inflation, the April policyreport seems to be more balancedwith a focus on risks to growth. RBIis not in a hurry to move ahead ofthe curve in the wake of uncertain-ties both on the inflation and growthfront RBI sees monsoons as a keyuncertainty as both inflation soften-ing and growth pick-up are contin-gent on a normal monsoon.

    A low rate hike now also gives RBImore time to evaluate the growthsituation and impact of earlier ratehikes. Upside risks to inflation arelikely to sustain for long, in thepresence of rising global commodityprices and demand side pressuresbuilding up. Outlook for growth, at8% for FY11, is expected to be fi-nanced by 20% growth in credit and17% growth in money supply - levels

    that are not consistent with an over-heated economy. Hence, we stick toour call of gradual and consistentrate hikes in the current rate hikecycle. We expect a cumulative 125bps of Repo and Reverse Repo hikein FY11

    Niveshak: India has witnessedstrong FII infows in the capi-tal markets for quite some timenow. FIIs have been consistent-

    ly building up their portfolio inthe top BSE and NSE companies.Where do you see the FII and FDIinvestments heading in the com-ing quarters?

    Deepali BhargavaEconomist, inG Vysya Bank

    Deepali Bhargava joined ING in August 2008, and is India Economist for ING VysyaBank. Deepali has to her credit, consistently accurate directional calls on inflation, interest ratesand INR.Prior to ING, Deepali was an economist with the treasury of ICICI Bank for 3 years withfocus on India research. She has a Masters in Economics from The Delhi School of Economics.

  • 8/9/2019 Niveshak April10 Issue

    10/260 NIVESHAK VOLUME 3 ISSUE 4 April 2010

    RBI sees monsoons as a key

    uncertainty as both inationsoftening and growth pick-up

    are contingent on a normal

    monsoon.

    p

    Ms. Bhargava: Continuity of foreign inflows in thecurrent year will be contingent upon inter-countrygrowth differentiation, interest rate differential,growth expectations in the FDI sensitive sectors, andglobal liquidity. India, with expectations of 8% plusgrowth, will likely be one of the top contenders forflows going by the first two reasons. Services driven

    growth will be a positive, as services have been theprimary driver of FDI inflows since 2000, account-ing for 22% of total FDI inflows from Apr00-Dec09.The likely facilitators for FDI in 2010-11 will be: 1)3G auction and higher FDI approvals in telecom 2)Increase in FDI deals between emerging markets 3)Government mulling FDI hike in defense production4) government considering allowing foreign invest-ment in LLP.

    The other factor global liquidity has been a prima-ry determinant of foreign inflows. With 65% positive

    correlation between global liquidity (calculated atan aggregated index of money supply for the majoreconomies) and FII flows in the last two years, thegoing will likely continue to be good as the majoreconomies recover and with a build-up in positiverisk environment. On the other hand, as G-3 startswithdrawing excess liquidity, flows in FY11 (ING es-timates: USD 20 bn) will turn more volatile and willlikely end-up aggregating lower vis--vis FY10 (USD30 bn). But an increase in short-term trade credit(with a revival in trade) and ECB (as recovery gainsmomentum) will likely fill the gap. Hence, we expect

    capital account surplus to increase to USD 68 bn inFY11 vs. USD 62 bn (estimated) for FY10. The painpoint will be a widening in current account as oilprices go higher and non-oil imports stage a recov-ery. With export growth likely to fall short of importgrowth, current account deficit is likely to widen to2.7% of GDP in FY11 (from 2.5% in FY10) assumingaverage oil price of USD 90/bbl.

    Thus, from the balance of payments point of viewthough appreciation pressure will exist due to a bal-ance of payments surplus, it may not be very ag-

    gressive. Greater RBI intervention may further stemthe appreciation pressure. Risk of surge in oil pricesand hence local inflation will likely imply greatervolatility for INR in FY11. We target 42.8 on USD/INRby fiscal-end.

    Niveshak: The IIP numbers were released re-cently. According to you what impact will it

    have and what factors will impact it in nextquarter?

    Ms. Bhargava: Though the broad growth number hasmoderated, 3-month seasonally adjusted annualizedgrowth rate for IIP recovered to 23% in both Jan andFeb 2010, reflecting strong momentum in IIP in these

    months. Going forward, a moderation in y-o-y IIPgrowth is likely on negative base effect.

    The key drivers - consumer durables and capitalgoods - continued to record stellar growth at 30%YoY and 44.4% YoY respectively. Consumer non-durables continued to be a laggard. Going forward,a possible reduction in automobile sales, followingwithdrawal of fiscal stimuli, may impact consumerdurables growth negatively.

    But we assess that the trend is upwards as eco-nomic recovery gains a firmer ground

    Consumer non-durables, on the other hand, aver-aged a meager growth of 1.3% YoY Dec09-Feb10 onhigh food prices. Recovery in this segment will behugely contingent upon the performance of mon-soons. A normal monsoon and higher rural incomesare likely to be positive for both consumer durableand non-durables.

    Niveshak: What do you think about the ren-minbi (Chinese yuan) exchange rate policy andwhat will be impacts of the changes if any?

    Ms. Bhargava: The USs interest in Chinas co-opera-tion on Iran and Chinas interest in adopting a moremarket-based exchange rate mechanism suggestcompromises are possible. We remain of the viewthat Beijing will align the renminbi-dollar tradingband, now +/- 0.5%, with the bands for the non-dol-lar cross rates, +/- 3% by the end of June. We expectthis will produce a one-off 3% appreciation in therenminbi to the strong end of the trading band. Wethink other Asian currencies will appreciate by up tothe amount the renminbi appreciates. Renminbi ap-

    preciation is a monetary tightening, which is nega-tive for global growth. We think increased growthangst would cause the dollar to appreciate.

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    11/26FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 11

    CoverS

    tory

    Financial reporting refers to the manner in whichthe companies show their financial position to inves-tors, creditors and other interested parties by preparingfinancial statements. Financial statements data is usedto evaluate a companys past performance and current

    financial position in order to form opinions about the abil-ity of the company to earn profits in the future. Recentyears have seen numerous accounting scandals resultingin bankruptcies and demise of some major firms. Lookingback we see that these scandals have occurred wheneverthe managers have felt the pressure to meet market ex-pectations. Accounting practices have improved over theyears, but companies still find ways and means to getaround the stated rule to tweak their financial results.The challenge for the financial analyst is to look not onlyat the malpractices of reporting but also at the quality of

    reporting.In general accounting parlance, high financial report-

    ing quality is defined as reporting which results in a fairpresentation of the companys operations and financialposition. The article is an attempt to show how compa-nies utilize creative accounting to overstate their financialposition and performance. Companies that manipulatetheir financial position often try to increase their earn-

    ings power in the current or future peri-ods to create the appearance of a strongfinancial condition or performance. This

    makes it easier for them to obtain linesof credit at low interest rates, as well asissue debt financing on better terms. Themanagement might also be motivated tooverstate assets or understate liabilitiesto make the company appear more liquidand solvent. The balance sheet can evenbe used to store earnings for futureperiods. The results can be a misleadinggauge of earnings power and financialcondition.

    Generally Accepted Accounting Prin-ciples (GAAP) can be exploited by thefirms to achieve a specific outcome whilemeeting the letter, but not the spirit ofthe accounting standards.

    Low quality earnings can be a resultof:

    1) Use of acceptable accountingpractices that misrepresent the econom-ics of a transaction.

    2) Restructuring transactions toachieve a desired outcome.

    3) Exploitation of the intent of theAccounting Principle

    WindowDressing

    The

    Financial

    Statements

    ...painting arosypicture

    Team NiveshakHitesh Gulati

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    Companies that manipulate

    their nancial position try tocreate the appearance of a

    strong nancial condition or

    performance.

    v

    y

    Misrepresentation

    LIFO Method of Inventory Reporting

    Inventory calculations and reporting are a ma-jor factor involved in the analysis of merchandis-ing and manufacturing companies. Such companiesgenerate their sales and profits mainly through in-

    ventory transactions. An important consideration indetermining profits for these companies is measur-ing the cost of goods sold when the inventories aresold. Inventory costs typically change from period toperiod and the choice of inventory cost flow methodaffects the firms income statement, balance sheetand several other financial ratios. Additionally, thecost flow method can affect the income taxes of thefirm and hence affects the cash flow position of thefirm.

    The various methods of reporting inventory are

    the weighted average, specific observation, FIFO andthe LIFO method of accounting. Among these themethod which is of interest here is the LIFO meth-od. The method assumes significance because of itsability to significantly lower taxable income. The LIFOmethod assumes that the companies sell their mostrecently purchased inventory units first. The endinginventory under this method thus consists of thoseunits that have been held the longest and valued attheir historic costs. Conditions favoring use of LIFOmethod arise when the unit costs of inventory rise

    over time and the inventory quantities are generallyconstant or increasing.

    The consequences of LIFO method are that theCost of goods sold reported under LIFO is higherwhen unit prices of inventory rise over time. Thisleads to a lower reported net income and hencesaves Income Tax for the firm. Lower income taxexpense under LIFO means that the operating cashflows for the period are higher. The reported inven-tory value under FIFO is higher than under LIFO andhence the creation of a LIFO reserve which is the

    difference between the FIFO inventory value and theLIFO inventory value.

    LIFO results in FIFO results in

    Higher COGS Lower COGS

    Lower Net Income Higher Net Income

    Lower taxes Higher taxes

    Lower Inventory balances Higher Inventory balances

    Lower Working Capital Higher Working Capital

    Higher Cash flows (lesstaxes paid)

    Lower Cash flows (moretaxes paid)

    LIFO method of reporting inventory is not per-mitted under the IFRS. However companies reportingaccording to the US GAAP can use the LIFO method

    of reporting inventory provided that they use themethod for tax reporting as well as accounting pur-pose. The companies that use the LIFO methodare required to disclose in their financial notes theamount of LIFO reserve.

    Phantom Prots

    LIFO liquidation occurs when a firms inventoryquantities are declining. In this situation, the olderlower costs are included in the Cost of Goods sold.This results in reporting a higher profit margin underLIFO. However the higher profit margin is not sus-tainable and is hence known as Phantom profits.Hence the firm cannot liquidate its inventory infi-nitely as it well eventually run out of goods to sell.

    Depreciation Methods

    Depreciation is the systematic allocation of theassets cost over time. Depreciation may be reportedusing the straight line, accelerated or units of pro-duction method. Typically companies use the straightline method for financial reporting and an acceler-ated depreciation method for reporting taxes. In the

    accelerated methods of depreciation, more deprecia-tion expense is recognized in the early years of anassets life as compared to straight line depreciation.This results in lower net income in early years underthe accelerated methods as compared to the straightline method. Companies might also use longer use-ful lives period for the purpose of depreciation andamortization than their economic life to show lowerexpenses on the income statement.

    Re- Structuring transactions

    Capitalization vs. Expensing of Expenditures

    When a firm makes an expenditure, then it caneither capitalize the cost as an asset on the balancesheet or expense the cost in the income statementfor the period. Expenditures related to long-lived as-sets are included as part of the recorded value ofassets on the balance sheet if they are expectedto provide economic benefits for a period of time

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    The challenge for the nancial

    analyst is to look not only atthe malpractices of report-

    ing but also at the quality of

    reporting.

    CoverS

    tory

    greater than one year and are hence said to be capi-talized. Alternatively expenditures are treated as anexpense if they are not expected to provide benefitsin future period.

    Capitalized expenditure is treated as an invest-ment cash outflow. However an expenditure that isexpensed appears as operating cash outflow in theperiod it is made. Expensing thus reduces the netincome in the period it is made as compared to capi-talizing which results in greater reported profitabilityin the year of reporting.

    Capitalizing Expensing

    Total Assets Higher Lower

    Shareholders Equity Higher Lower

    Income Variability Lower Higher

    Net Income (1st year) Higher Lower

    Net Income (subsequent

    years) Lower Higher

    Cash flow from operations Higher Lower

    Cash flow from investing Lower Higher

    Debt Ratios Lower Higher

    Interest Coverage ratio (1styear)

    Higher Lower

    Interest Coverage ratio (sub-sequent years)

    Lower Higher

    Operating vs. Financial Lease

    Certain companies structureleases in the form of operatingleases in such a way so as to achieve desirablefinancial ratios (low debt ratios and high return onassets). Because a financial lease is economicallysimilar to borrowing money to purchase an as-set, the lessee company (borrower of the asset)records the leased asset and the related debt onthe balance sheet. The income statement in caseof a financial lease reports the interest expensealong with depreciation expense.

    An operating lease however is similar to rent-

    ing an asset. In an operating lease, only an incomeexpense is recorded on the income statement whileno asset or liability is recorded on the balance sheet.Debt on the balance sheet and expenses on the in-come statement are thus higher in the early yearsof a financial lease. Hence firms often prefer to re-port leases as operating leases as it results in higherprofit and better solvency position in early years as

    compared to an identical company which reports thelease as a financial lease.

    F inancia l

    Lease

    Operating

    Lease

    Total Assets Higher Lower

    Liabilities Higher Lower

    Net Income ( early year ) Lower HigherNet Income ( subsequentyears )

    Higher Lower

    Cash flow from operations Higher Lower

    Cash flow from financing Lower Higher

    Debt Ratios Higher Lower

    Exploitation of the Intent of the Account-

    ing Principle

    Use of market value method

    Mark to market method of accounting requiresa company to report accounts on the balance sheetat their fair market values rather than at historicalcost. Under the mark to market method of account-ing forwards, swaps, options, energy transportationcontracts are allowed to be shown at their fair val-ues. However the use of mark to market method ofaccounting for other types of contracts is somewhatunusual and presents ample opportunities to distortrevenues and income as the management desires.

    Mark to market method has also been criti-

    cized in the case of derivatives as outlandishassumptions, projections and account-

    ing can result in both parties re-porting substantial profits for longperiods. According to Warren Buf-

    fet, the practice of reporting mark tomarket leads to mark to myth in the

    case of derivatives.

    Equity Method of Accounting

    Companies can account for the investmentsin a separate business or entity under the consoli-dation method or the equity method depending oncontrol on the subsidiary. Unfortunately, this leavesthe door open to companies that want to concealand manipulate the true performance of their sub-sidiaries or joint ventures.

    Under the equity method, the investment isrecorded at cost and is subsequently adjusted to

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    According to Warren Buffet,

    the practice of reporting markto market leads to mark to

    myth in the case of

    derivatives.

    v

    y

    reflect the share of net profit or loss and dividendsreceived. The method limits the information avail-able for investors. For example, a company couldoverstate interest coverage in order to change theleverage ratios of the subsidiary.

    Classication of Recurring items

    Certain companies try to move Gains up theincome statement and report them as revenuesand report expenses as Losses. Only those itemsshould be reported as income and expenses that areexpected to recur over subsequent years.

    Conclusion:

    Companies can manipulate their financialstatements in many different ways. However, inves-tors can detect these practices by simply readingthe financial statements a little more closely. Some

    of the means to detect abnormalities that should belooked at include:

    Abnormally high growth compared to peers:Although high growth of a firm could be a result of a

    distinct competitive advantage that a firm possess-es, it is quite likely that it could be a case of abnor-mal accounting practices being followed by the firm.

    Operating Cash ow out of line with re-

    ported earnings: If a company reports positiveearnings but negative operating cash flows, then

    this could be a signal of some wrong doing on thepart of the management.

    Fourth Quarter Surprises:Unusually high rev-enues or low expenses in the fourth quarter of ayear should be scrutinized with detail as well.

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    Special condition: if the issuer

    suffers a loss from a catas-

    trophe, then its obligation to

    pay interest and/or repay the

    principal is either deferred or

    completely forgiven.

    FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

    FinGyaan

    WHAT DOES CATASTROPHEBOND CAT MEAN?

    It is a high-yield debt instru-ment that is usually insurance linkedand meant to raise money in case ofa catastrophe such as a hurricaneor earthquake. It has a special con-dition that states that if the issuer(insurance or Reinsurance Company)suffers a loss from a particular pre-defined catastrophe, then the issu-

    ers obligation to pay interest and/orrepay the principal is either deferredor completely forgiven. For example,if an insurer has built up a portfo-lio of risks by insuring propertiesin Bangladesh, then it might wishto pass some of this risk on so thatit can remain solvent after a largehurricane. It could simply purchasetraditional catastrophe reinsurance,which would pass the risk on to re-

    insurers. Or it could sponsor a catbond, which would pass the risk onto investors. In consultation with aninvestment bank, it would create aspecial purpose entity that wouldissue the cat bond. Investors wouldbuy the bond, which might pay thema coupon of LIBOR plus a spread,generally (but not always) between3 and 20%. If no hurricane hits Ban-gladesh, then the investors wouldmake a healthy return on their in-vestment. But if a hurricane were tohit Bangladesh and trigger the catbond, then the principal initially paidby the investors would be forgiven,and instead used by the sponsor topay its claims to policyholders Ad-vantages of CAT bonds are that theyare not closely linked with the stock

    market or economic conditions andoffer significant attractions to inves-tors. For example, for the same levelof risk, investors can usually obtaina higher yield with CAT bonds rela-tive to alternative investments. An-other benefit is that the insurancerisk securitization of CATs shows nocorrelation with equities or corpo-rate bonds, meaning theyd providea good diversification of risks.

    WHY INVEST IN CAT?

    Investors choose to invest incatastrophe bonds because theirreturn is largely uncorrelated withthe return on other investments infixed income or in equities, so catbonds help investors achieve diver-sification. Investors also buy thesesecurities because they generallypay higher interest rates (in termsof spreads over funding rates) than

    comparably rated corporate instru-ments, as long as they are not trig-gered.

    Key categories of investorswho participate in this market in-clude hedge funds, specialized ca-tastrophe-oriented funds, and assetmanagers. Life insurers, reinsurers,banks, pension funds, and other in-vestors have also participated in of-ferings.

    HOW IS IT RATED?

    Cat bonds are often rated by anagency such as Standard & Poors,Moodys, or Fitch Ratings. A typicalcorporate bond is rated based onits probability of default due to theissuer going into bankruptcy. A ca-

    Natural disasters

    would no longer be

    able to take a death-

    ly toll on Insurance

    companies with the

    arrival of Catastroph-

    ic Bonds or CAT

    bonds. This article

    runs through the de-tails about the issue

    and the circumstanc-

    es of triggering of

    a CAT bond. It also

    explains in detail

    their rating and their

    significance in an

    emerging economy

    like India.

    BIM TRICHYDEBDIPTA MAJUMDAR

    CATASTROPHEBOND MARKET

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    Advantages of CAT bonds

    are that they are not closely

    linked with the stock market

    or economic conditions and

    offer signicant attractions to

    investors.

    6 NIVESHAK VOLUME 3 ISSUE 4 April 2010

    FinGyaan

    tastrophe bond is rated based on its probability ofdefault due to an earthquake or hurricane triggeringloss of principal. This probability is determined withthe use of catastrophe models. Most catastrophebonds are rated below investment grade (BB andB category ratings), and the various rating agencieshave recently moved toward a view that securities

    must require multiple events before occurrence of aloss in order to be rated investment grade.

    HOW ARE THEY TRIGGERED?

    The sponsor and investment bank who struc-ture the cat bond must choose how the principalimpairment is triggered. Cat bonds can be catego-rized into four basic trigger types. The trigger typeslisted first are more correlated to the actual lossesof the insurer sponsoring the cat bond. The triggertypes listed farther down the list are not as highly

    correlated to the insurers actual losses, so the catbond has to be structured carefully and properly cal-ibrated, but investors would not have to worry aboutthe insurers claims adjustment practices.

    Indemnity: triggered by the issuers actuallosses, so the sponsor is indemnified, as if they hadpurchased traditional catastrophe reinsurance. If thelayer specified in the cat bond is $100 million excessof $500 million, and the total claims add up to morethan $500 million, then the bond is triggered.

    Modelled loss: instead of dealing with the

    companys actual claims, an exposure portfolio isconstructed for use with catastrophe modellingsoftware, and then when there is a large event, theevent parameters are run against the exposure da-tabase in the cat model. If the modelled losses areabove a specified threshold, the bond is triggered.

    Indexed to industry loss: instead of addingup the insurers claims, the cat bond is triggeredwhen the insurance industry loss from a certain perilreaches a specified threshold, say $30 billion. Thecat bond will specify who determines the industry

    loss; typically it is a recognized agency like PCS.Modified index linked securities customize the in-dex to a companys own book of business by weight-ing the index results for various territories and linesof business.

    Parametric: instead of being based on anyclaims (the insurers actual claims, the modelledclaims, or the industrys claims), the trigger is in-

    dexed to the natural hazard caused by nature. So theparameter would be the wind speed (for a hurricanebond), the ground acceleration (for an earthquakebond), or whatever is appropriate for the peril. Datafor this parameter is collected at multiple reportingstations and then entered into specified formulae.For example, if a typhoon generates wind speeds

    greater than X meters per second at 50 of the 150weather observation stations of the Japanese Meteo-rological Agency, the cat bond is triggered.

    Parametric Index: Many firms are uncomfort-able with pure parametric bonds due to the lack ofcorrelation with actual loss. For instance, a bond maypay out based on the wind speed at 50 of the 150stations mentioned above, but the insurer loses verylittle money because a majority of their exposureis concentrated in other locations. Models can givean approximation of loss as a function of the speed

    at differing locations, which are then used to givea payout function for the bond. These function ashybrid Parametric / Modelled loss bonds, and havelowered basis risk as well as more transparency.

    LET THE CAT OUT OF THE BAG

    The Economic Survey 2009-10 has suggestedthe introduction of catastrophe bonds in the Indianmarket, to transfer insurance risk arising out of nat-ural calamities such as earthquakes, hurricanes andfloods, to the capital markets. The survey said:

    Popular abroad

    Cat bonds are popular in some of the marketsabroad, especially in the United States and Europe.

    Insurance or reinsurance companies can issuethese bonds and place them with various investors.This helps them transfer a part of the risks to theinvestors.

    The insurance company can further invest themoney generated from selling the bonds.

    Cat bonds can be issued by the Government

    or financial institutions. Investors can get a slightlyhigher return when compared to other securitiesand it also offers them an opportunity to diversifytheir investments. But if the catastrophe is of hugeproportions, then investors can lose the capital.

    The insurance company then uses the amountraised against Cat bonds to pay policy holdersclaims, said Mr K. G. Krishnamoorthy Rao, Chief Ex-

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    A catastrophe bond is rated

    based on its probability ofdefault due to an earthquake

    or hurricane triggering loss of

    principal.

    FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 17

    FinGyaan

    ecutive Officer, Future Generali India Insurance Com-pany.

    Alternative to reinsurance

    Insurers can use this tool as an alternative toreinsurance. However, according to insurance indus-try officials, neither the capital markets nor the In-

    dian insurance industry is developed enough for theintroduction of these types of bonds.

    This is a risky instrument. Who knows whatwill happen when insurance companies move awayfrom core insurance practices, said an insurancecompany official.

    WHY ITS IMPORTANT FOR INDIA?

    There was a recent earthquake in Chile the5th most powerful in the last century lucky it didntexact a higher toll. Insurance companies arent: They

    are on the line for losses up to $8 billion, making thisthe second costliest earthquake for them in history.Insurers in the West have been trying to mute therisk of such Black Swansevents that almost no onepredicts but that everyone suffers fromfor sometime. In the late 1990s, they developed a new prod-uct called a catastrophe or cat bond. After hurri-cane Katrina in 2005, activity in this market on WallStreet jumped from near zero to $14 billion. Now, theoffice of Indias chief economic adviser has noticedit, too. The Economic Survey notes that there isscope for introducing (this instrument) in countries

    like India. There are grounds for scepticism here,but its worthwhile for regulators to at least examinethis bond.

    The first is that of Indias immature capitalmarkets. Its true that the low level of financial liter-acy dampens much financial activity; however, thisbond caters to a sophisticated investor set, offeringa security unlinked to the usual market volatility. Soregardless of the weak bond market, this bond canthrive, depending on insurance.

    Though, second, the current state of the insur-ance market isnt promising either. According to apaper last year by Crisil and Assocham, Indias insur-ance business commands 0.6% of its output, againstthe world average of 2.14%. Still, as incomes riseand as more employers offer benefits, this markethas only room to expand.

    Third, Indias regulators, who have been con-

    servative enough to realize that innovation aimed atdiversifying risk can end up increasing it, may notwarm up to it immediately. But just as they haveslowly but surely allowed interest rate futures or cur-rency swaps, catastrophe bonds could pass muster.

    All of this points to a long time horizon. Which,given the risks of overnight financial liberalization,is surely a relief.

    FIN-Q SolutionsMarch 2010

    1. General electric

    2. 1862

    3. Swaps

    4. X is Mad Money; Y is CramerBounce

    5. Rebalancing

    6. Small Order ExecutionSystem (SOES)

    7. Royal sun alliance& Sundramalliance

    8. Sir John Templeton

  • 8/9/2019 Niveshak April10 Issue

    18/268 NIVESHAK VOLUME 3 ISSUE 4 April 2010

    While the US accounts for

    only 4.5% of the worlds popu-lation, it consumes 20.25% of

    the worlds fossil fuel-based

    energy.

    FinSight

    Kaustubh KolharJBIMS

    The price of oil ispoised to rise steadi-

    ly as the supply/

    demand imbalance

    increases and the

    dollar declines. As

    this happens, the

    price of precious

    metals will climb

    until they eventu-

    ally catch up to their

    historic ratios. If the

    oil producers start

    demanding Euros,

    dinars or precious

    metals in payment

    for their product,

    the decline in the US

    dollar will accelerate

    while the price of

    precious metals will

    explode.

    Of the various vulnerabili-ties traditional financial assets areexposed to, a rising oil price is ofparticular concern. In 2004, oil hitan all-time high of $56 per barrel,up 366 percent from the $12 low of1998, and up 75 percent since Janu-ary 2004.

    Generally, an increasing oilprice results in increasing infla-tion, negatively impact the global

    economy, particularly oil-dependenteconomies such as the US. Apartfrom increased transportation, heat-ing and utility costs, higher oil pricesare eventually reflected in virtuallyevery finished product, as well asfood and commodities in general.Furthermore, there is evidence thatglobal oil production is peaking andthe flow will soon be in permanentdecline.

    The majority of oil reserves arelocated in politically unstable re-gions, with tensions in the MiddleEast, Venezuela and Nigeria likely tointensify rather than to abate. Be-cause of frequent terrorist attacks,Iraqi oil production is subject to dis-ruption, while the risk of politicalproblems in Saudi Arabia grows. Thetiming for these risks is uncertainand hard to quantify, but the impli-

    cations of Peak Oil are predictableand quantifiable, and the effects willbe more far-reaching than simply arising oil price.

    Oil - A major contributor to

    US prosperity:

    The US has enjoyed inexpen-sive oil-based energy for nearly a

    century, and this is one of the primefactors behind the unprecedentedprosperity of its economy in the 20thcentury. While the US accounts foronly 4.5% of the worlds population,it consumes 20.25% of the worldsfossil fuel-based energy. It importsabout 70% of its oil, but producesonly 10.7% and consumes 25.9% ofthe world consumption. Because ofthis dependency on both oil and for-

    eign suppliers, any increase in priceor supply disruptions will negativelyimpact the US economy to a greaterdegree than any other nation.

    Hubbert Curve:

    In the early 1950s, M. KingHubbert, one of the leading geo-physicists of the time, developed apredictive model showing that alloil reserves follow a pattern calledHubberts Curve, which runs from

    discovery through to depletion. Inany given oil field, as more wellsare drilled and as newer and bettertechnology is installed, productioninitially increases. Eventually, how-ever, regardless of new wells andnew technology, a peak output isreached. After this peak is reached,oil production not only begins todecline, but also becomes less costeffective. In fact, at some point in

    this decline, the energy it takes toextract, transport and refine a barrelof oil exceeds the energy containedin that barrel of oil. When that pointis reached, extraction of oil is no lon-ger feasible and the reserve is aban-doned. In the early years of the 20thcentury, in the largest oil fields, it

    THEGOLD,OILANDUS RELATIONSHIP

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    19/26FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 19

    According to Dr. Colin Camp-

    bell, one of the worlds leadinggeologists, the world consumes

    four barrels of oil for each one

    it discovers.

    FinSight

    was possible to recover 50 barrels of oil for each bar-rel used in the extraction, transportation and refin-ing process. That ratio of 50-to-1 ratio has declinedto 5-to-1 or less. And it continues to decline.

    Using analytic techniques based on Hubberts

    work, oil and gas experts now project that world oilproduction will peak sometime in the latter half ofthis decade. We are now depleting global reservesat an annual rate of 6%, while demand is growingat an annual rate of 2% (and that growth rate is ex-pected to triple over the next 20 years). This meanswe must increase world reserves by 8% per annumsimply to maintain the status quo, and we are no-where near achieving thatgoal. In fact, we are sofar from it that, accord-ing to Dr. Colin Campbell,

    one of the worlds leadinggeologists, the world con-sumes four barrels of oilfor each one it discovers.

    Oil and other met-

    als:

    There are numer-ous social, economic andpolitical implications related to worldoil production peaking in the next few years,

    but our concern here is to examine how a risingoil price is linked to precious metals. The answerto that question begins with the historical desire ofArab producers to receive gold in exchange for theiroil. This dates back to 1933 when King Ibn Saud de-manded payment in gold for the original oil conces-sion in Saudi Arabia. In addition, Islamic law forbidsthe use of a promise of payment, such as the US

    dollar, as a medium of exchange. There is growingdissention among religious fundamentalists in SaudiArabia regarding the exchange of oil for US dollars.

    Oil, gold and commodities have all been pricedin US dollars since 1975 when OPEC officially agreedto sell its oil exclusively for US dollars. From 1944until 1971, US dollars were convertible into gold bycentral banks in order to adjust for any trade imbal-ances between countries. Up to that point, the priceof gold was fixed at US$35 per ounce, and the priceof oil was relatively stable at about US$3.00 per bar-rel. Once the US ceased gold convertibility in 1971,OPEC producers were forced to convert their excessUS dollars by purchasing gold in the marketplace.This resulted in price increases for both oil and gold,until eventually oil reached US$40 per barrel andgold reached US$850 per ounce.

    Today, apart from geopolitical threats in oil-producing regions, supply/demand imbalances fromPeak Oil and increasing demand from developingcountries, the price of both gold and oil can be ex-pected to increase as the US dollar declines. Withan ever-increasing US money supply, growing tripledeficits and mounting debt at all levels, the US dollaris likely to continue the decline that began in 2001.S i n c e then, foreign holders of US dollar

    assets have already lost 33% oftheir investment.

    There have been discus-sions among Arab nations

    about pricing oil in Islamicgold and silver dinars. If

    this happens, other produc-ers may follow suit and optout of accepting US dollarsfor oil. Demand for the cur-rency will plummet, send-ing the dollar into a freefall

    while demand for Euros, goldand silver soars.

    Gold during the recession period:

    During the recession period, as the financialmarkets tried to find a bottom while banks wentbankrupt and more and more investment scandalscontinued to pop up on the radar destroying inves-tors life savings literally over night, the FED contin-ued to pour billions of USDs into the system. The

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    Over the last 50 years, gold

    and oil have generally movedtogether in terms of price, with

    a positive price correlation of

    around 80 percent.

    FinSight

    USD has been consistently stronger, even though theFED continued to dilute the world with more dollarson a monthly basis. Gold has also been increasingin value, reaching $1000, as foreign currencies de-clined.

    In addition, Middle Eastern oil producers wouldbe forced to diversify their vast US dollar holdingsinto precious metals and other currencies to protectthemselves from further losses. As losses mount,other large, non-oil producing, US dollar holderssuch as Japan, China, Korea, India and Taiwan wouldseek to diversify out of US dollars. Eventually, thiscould result in a dollar sell-off and a correspond-ing increase in oil and gold prices.

    Oil and Gold Correlation:

    Over the last 50 years orso, gold and oil have generally

    moved together in terms of price,with a positive price correlation ofaround 80 percent. During this time, the p r i c eof oil in gold ounces has averaged about 15 barrelsper ounce. However, with recent soaring oil prices,the relationship has strayed far from this average.The gold-oil ratio reached a 10-year high of 25 asthe global recession erodes demand for energy com-modities and investors abandon monetary assetsin favour of the safe haven metal. While oil pricesrecently set an all-time high of $56 per barrel, gold

    prices have not kept pace and the oil:gold ratio fellto an all-time low of 7.5:1.

    The size disparity between oil and gold mar-kets must also be considered. While annual goldproduction is approximately US$35 billion, annualoil production is US$1.5 trillion, by far the largest-trading world commodity. As oil prices increase anddemand for US dollar diversification increases, therewill be an ever-expanding number of petro dollarsand other offshore dollar holders chasing a relativelysmall amount of bullion ounces.

    Gold: The Saviour

    Goldisconsideredtobealong-termhedge

    against inflation. That has been empirically justifiedby research conducted by the World Gold Council(June 2006).

    Intheshort-run,thegeopoliticaltensionsor

    periods of uncertainty spark an uptrend in the price

    of precious metals. Precious metals may be consid-ered to be a hedge against geopolitical tensions orsevere crises.

    The r e is an inverse relationship be-tween the Commodity Pre-cious Metal Price Indexand the US Dollar Index.This relationship is also

    substantiated by the em-pirical findings of the World Gold

    Council which shows that there is a neg-ative relationship between the price of gold

    and the US dollar.

    During recessions the US

    dollar typically appreciates in valueand the price of silver, platinum and pal-

    ladium decline, keeping true to the inverse re-lationship mentioned above.

    Duringrecessionaryperiodsthepriceofgold

    and the US dollar appreciate together, failing the in-verse relationship in the short-run. In the long-term,the inverse trend between gold and the US dollarholds, just not during recessions.

    The above suggests that gold is a long-termhedge against inflation and a short-term hedgeagainst crises.

  • 8/9/2019 Niveshak April10 Issue

    21/26FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 21

    Perspective

    Human population tripled in

    the 20th century, but during

    the same period the world per

    capita output quadrupled thus

    improving the quality of life

    for everyone.

    Most of the Indians plan to in-vest in mutual funds, gold, property,

    IPOs or stocks but have you ever giv-

    en a thought of investing in human

    population? If not, then why?

    The Indian population clockhas already clocked 1,151,068,507and is still ticking fast enough toquestion if this ever growing popu-lation is generating poverty or eco-nomic prosperity. At first sight, it

    appears that this huge population isa curse to our economy. It is also aliability for the nation. More peoplemeaning more mouths to be fedthat ultimately makes the nationsuffer from poverty, corruption andill governance. Many of us even be-lieve that a growing population willsimply guttle the planet, and lead tofamine, disease and death of civili-sation as we know it.

    But a serious thought and re-search would counter the above ar-gument. Infact there is no correlationbetween the growing population anda falling economic and social pros-perity. The statistics below wouldvouch for that non-correlation:

    Countries Pop. Den-sity (perkm2)

    GDP percapita $

    China 136.12 2033.90

    India 328.29 816.60Japan 337.23 34022.94

    Germany 230.89 35270.36

    Singapore 6386.29 30082.46

    Belgium 339.71 37384.34

    UK 246.88 38849.97

    Hongkong 6348.61 27071.62

    Table 1 Source: www.nationmaster.com/

    Countries Pop. Den-sity (perkm2)

    GDP percapita $

    UAE 55.012 28611.84

    Australia 2.886 37433.85

    Canada 3.405 38439.78

    USA 30.71 44155.00

    Mozam-bique

    24.21 377.69

    Ethiopia 71.739 183.13

    Table 2 Source: www.nationmaster.comThe above statistics evidentlyacquits population from the chargethat it causes poverty. Highly pop-ulated states can both be rich andpoor. Singapore with the highestpopulation density (per sq. km) of6386.29 generates 40 times the In-dias GDP per capita. Similar is theobservation for sparsely populatednations. Hence population growth isnot the factor that causes poverty or

    miseries. So does that mean popula-tion growth causes economic pros-perity? Let us try to find that out byanalysing the statistics below.

    Indias Population

    Year Pop.(m)

    LEB(yrs)

    IMR FGP(mt)

    FGP/per-son

    1901 238 23 210 _ _

    1911 252 21 204 _ _

    1921 251 27 219 _ _

    1931 271 31 174 _ _

    1941 319 32 161 _ _

    1951 361 42 146 52 14.4

    1961 439 46 129 83 18.91

    1971 548 51 129 105 19.16

    1981 684 54 110 133 19.44

    1991 846 58 92 168 19.86

    2000 1000 62 72 200 20

    The article targets

    the behavioural

    aspect of the In-

    dian economy and

    the investments be

    ing made overall.

    The general feeling

    amongst the masses

    is that growing population is a curse

    but the article does

    bring it is as a po-

    tential bless ing for

    the economy only if

    proper investment is

    made in the human

    beings.

    NITIE, MumbaiRahul Goyal

    Nivesh inIndianPopulation

    Densely

    Populated

    Countries

    Po

    or

    Rich

    Sparsely

    Populated

    Countries

    Poor

    Rich

    Table3So

    urce:www.censusindia.gov.in

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    22/262 NIVESHAK VOLUME 3 ISSUE 4 April 2010

    Statistics tells us that Street vendors and hawkers form a major part of over 90% of Indiasworkforce which earns its livelihood in the informal sector. As a matter of fact this sector ac-

    counts for 63% of the countrys GDP.

    p

    Legend:LEB: Life Expectancy at BirthIMR: Infant Mortality Rate per 1000 live birthsFGP: Food Grain Production

    It can be seen that with the rising populationIndia has actually done better in terms of food grainproduction and availability. Life expectancy has in-

    creased and mortality rate has come down. With ris-ing population India has become self sufficient andhas indeed prospered.

    At this point somebody may put forward an ar-gument that with rising population India is runningout of resources. But the fact is: India is not andneither would any other country. Let us go throughanother piece of statistics to prove that:

    Metal 1980 1990Percentage

    Change

    Copper

    (195.56 lbs.)

    $200 $163 -18.5%

    Chrome(51.28 lbs.)

    $200 $120 -40%

    Nickel(63.52 lbs.)

    $200 $193 -3.5%

    Tin(229.1 lbs.)

    $200 $56 -72%

    Tungsten(13.64 lbs.)

    $200 $86 -57%

    Table 4 Source: London Metal Exchange

    It can be seen that the cost of various metals

    (resources) has decreased over a decade despite thepopulation increase. It also means that natural re-sources will progressively become less scarce, henceless costly, and will constitute a smaller proportionof our expenses in future years.

    Nearly every datum from life expectancy andinfant mortality rate to health indicator, to price ofnatural resource and consumption good like fooditem, to environmental quality, things have bettered.Human population tripled in the 20th century, butduring the same period the world per capita outputquadrupled thus improving the quality of life for ev-eryone.

    People are actually wealth creators. They createwealth because they are inherently non self-suffi-cient. They need the services of other humans forwhich they need to have wealth. People specializeand create staggering volume of services and prod-ucts. They drive innovation. Hence more the popu-lation, greater the division of labour would be and

    hence greater would be the prosperity.To support the above argument let us analyse

    statistics given in Table 5: The table gives the mostpopulous cities of India with their State GDPs. TheTop 5 most populous cities of India also happen tohave their states GDP in the Top 5 slots barring Del-hi. The most populous State of India, which is Uttar

    Pradesh (which is not shown in the table) ranks 2ndin GSDP.

    Rank CityPop.

    (2010)State/UT

    Rank:GSDP

    Rank:CitiesGDP

    1 Mumbai 13,830,884 Maharashtra 1 1

    2 Delhi 12,565,901 Delhi - 3

    3 Bangalore 5,438,065 Karnataka - 4

    4 Kolkata 5,138,208 West Bengal 4 2

    5 Chennai 4,616,639 Tamil Nadu - 5

    6 Hyderabad 4,068,611 Andhra

    Pradesh

    3 6

    7 Ahmedabad 3,959,432 Gujarat 5 7

    8 Pune 3,446,330 Maharashtra - 8

    9 Surat 3,344,135 Gujarat - 9

    Table 5 Source: India: largest cities and towns and sta-tistics of their population. World Gazetteer. http://www.

    world-gazetteer.com

    The inference that can be drawn from thesestatistics is that despite of being highly populated,these states have been doing extremely well. Even ifwe take the GDP per capita of these states or citiesthe Top 10 would more or less remain the same. Be-cause of the sincere efforts put by people of variousspecialisations like politicians, academicians, stu-dents, doctors, engineers, architects, street vendors,dhobis, barbers, labourers etc rapid urbanisation ofthese states happened. Wherever the concentrationwas thick, there was greater prosperity simply be-cause there was greater division of labour.

    Human beings have the ultimate resource withthem i.e. their minds and the ability to comprehend.These resources when invested in along with propertraining, development and skills building initiatives,

    would give the highest ROI compared to other avail-able risky investment options in market. With thisstatement, I, out rightly, want to make two thingsclear. Firstly I didnt advocate for investing in humanbeings just to make them doctors, engineers, politi-cians, managers only. Even Street vendors qualifyto be the people whom we can invest heavily in.Secondly for prosperity, human beings need not be

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    People specialize and create

    staggering volume of services

    and products. They drive

    innovation.

    Perspective

    educated at all.Both the statements may have surprised you.

    But let us try to understand the reasoning: Statis-tics tells us that street vendors and hawkers forma major part of over 90% of Indias workforce whichearns its livelihood in the informal sector. As a mat-ter of fact this sector accounts for 63% of the

    countrys GDP.For a wide array of

    products - fromfruits and veg-etables, togarments,toys, andm a g a -z i n e s- streetvendors

    p r ov i dean effec-tive distri-bution chan-nel, on whichboth producers andconsumers rely. Streetvendors not only create em-ployment for themselves through theirown entrepreneurial skills, but also help generateemployment in agriculture as well as small-scale in-

    dustry. Hence we can say that street vendors are avital and vibrant part of the Indian economy (Source:www.petitiononline.com).

    So street vendors turns out to be a potentialwhere we must heavily invest. They must be givenvending licenses and, on lines of SEZs Hawing zonesmust be created to let them operate freely. But thesad part is that we are investing blindly in setting upof mammoth buildings, malls, multiplexes etc whichdont even hold a respectful contribution in nationsGDP.

    From the above example it is clear that dho-bis, street vendors, hawkers, and autowalas are allpotential entities to invest in and it is primarily be-cause they have minds, skills and ability.

    Evidently the above example explains the sec-ond point too, that, for a nation to prosper, it is notmandatory for each and every one to be educated.What they must have are skills. The argument mayseem unintelligent because right from the beginning

    we have been fed into our minds that without edu-cation we will be nothing. But the fact of life is thatwe humans are everything.

    It brings us to the conclusion that all humanbeings are potential contributors. They all mustget equal opportunities to grow and prosper. There

    should not be any bias towards educated

    and uneducated, poor and richor men and women. Each

    one of us has someor the other role

    to play in thee c o n o m i cs y s t e m .With thisc o n f i -dence, hu-man be-

    ings withtheir mind

    and abilityto trade will

    generate numer-ous wealth by doing

    what they can do bestin a free market economy. It will

    also enable them to look upon themselves andtheir brethren as a huge asset. Surely, investing inhuman beings is one Nivesh that will reap the ben-

    efits for hundreds of years to come.There are jobsa-plenty there

    Ill be a watchman,waiter, doctor

    Even a politicianif I dare!

    I am there where millions liveAnd a million dreams come true.

    I am not a liability I am an asset to accrue.

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    FinSight

    FinLounge

    F I N - Q1. In a recent decision by RBI, the infrastructure finance companies (IFC) have also been

    included in the NBFCs. What has been kept the minimum capital adequacy ratio for thesenewly included NBFCs?

    2. What is the worlds largest gold exchange traded fund and silver exchange traded fund?

    3. In which of the following countries is prevalent the Pay as you earn (PAYE), awithholding tax system?

    (A) USA

    (B) UK

    (C) Australia

    (D) Germany

    (E) China

    4. What term became popular after the newspaper report of Watergate Scandal in the year1973?

    5. Which is the first Indian bank to commence operations in Singapore?

    6. Which bank is promoted by 20th Century Finance Corporation and Keppel Tatlee Bank ofSingapore in India?

    7. He is the pioneer in mutual fund industry and often referred as the Father of IndexFund investing. He created the first S&P 500 Index fund. Identify this famous person?

    8. Which financial services giant is referred as the Thundering Herd?

    9. Which countrys currency is known as Drachma, which in Greek means to grasp?

    10. By how many basis points were CRR and reverse repo rates hiked by RBI in the latestcredit policy released on 20th April?

    All entries should be mailed at [email protected] by 10th May, 2010 23:59 hours

    One lucky winner will receive cash prize of Rs. 500/--

  • 8/9/2019 Niveshak April10 Issue

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    A N N O U N C E M E N T SARTICLE OF THE MONTH

    The article of the month winners for April 2010 areAbhishek sarkar and Sreejit Gopinathan

    of Welingkar Institute of Management

    They receive a cash prize of Rs.1000/-

    FINQ WINNERThe FinQ Winner for the month March 2010 is

    Harshil Suvarnkar

    of JBIMS

    He receives a cash prize of Rs.500/-CONGRATULATIONS!!

    ALL ARE INVITEDTeam Niveshak invites article from B Schools all across India. We are lookingfor original articles related to finance & economics. Students can also contrib-ute puzzles and jokes related to finance & economics. References should becited wherever necessary. The best article will be featured as the Article of theMonth. and would be awarded cash prize of Rs.1000/-

    Instructions Please submit your article with the file name and the email subject as __ by 10 May 2010. Article must be sent in Microsoft Word Document (doc/docx), Font: Times New

    Roman, Font Size: 12, Line spacing: 1.5 Please ensure that the entire document has 1500-2000 words The cover page of the article should only contain the Title of the Article, the

    Authors Name and the Institutes Name Mention your email id/ blog if you want the readers to contact you for furtherdiscussion Also, if certain entries which could not make the cut to the Niveshak will get

    figured on our Blog in the Specials section

    SUBSCRIBE!!Get your OWN COPY delivered to inbox

    Drop a mail at [email protected] Niveshakwww.iims-niveshak.com

  • 8/9/2019 Niveshak April10 Issue

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    COMMENTS/FEEDBACK MAIL TO [email protected]://iims-niveshak.comALL RIGHTS RESERVED

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    Indian Institute of Management, ShillongMayurbhanj Complex,Nongthymmai

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