Niveshak July 2010 Issue

8/9/2019 Niveshak July 2010 Issue

1/26BP at gulf of mexico pg.06 piicgs - doom for eu? PG.10

THE INVESTOR VOLUME 3 ISSUE 7 JULY 2010

Yuan De-Pegged


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 VII

July 2010

Faculty Mentor

Prof. S.S Sarkar

Editor

Bhavit Sharma

Sub-Editors

Durgesh Nandini Mohanty

Hitesh Gulati

Sumit Kedia

Tanvi AroraUpasna Agarwal

Creative Team

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

The other day I was wondering about what could have brought China an

indomitable competitive advantage which has not only helped it in achieving a

phenomenal GDP growth rate but also in making it resilient of the recession which

gulped most of the parts of the world 2 years back. A prolonged discussion with

one of my colleagues brought forth various points like labour cost, manufacturing

competence etc. One thing where our discussion ultimately boiled down to was

Chinas pegged currency. But recently we saw China making an announcement

that it will make Yuans exchange rate more flexible thereby breaking the currencys

23-month-old dollar peg. This move was welcomed by most of the stock indices of

the world with Sensex advancing by 1.7% and MSCI Emerging Markets Index by

2.4%. The S&P 500 was 1.2% higher, so were European stocks.

The dollar peg had come under intense fire from critics as Chinas export jug-

gernaut roared back to life, while much of the rest of the global economy remained

sluggish in the wake of the financial crisis. But China has ruled out any chance of

a major appreciation or one-off revaluation. So the question arises whether this

unpegging of currency will dampen this form of Chinas competitive advantage

in due course of time or it is just an intended move to placate critics of Chinas cur-

rency regime. Our cover story for this month answers this question by stating the

possible implications, or I should rather say repercussions, on China and rest of the

world.

The May issue carried an article on the much hyped SEBI-IRDA tussle that

had surfaced because of the insurance product ULIP. Well the insurance industry

regulator IRDA has emerged victorious in the regulatory turf-war, with the govern-ment ruling that it and not the market watchdog SEBI would oversee the prod-

uct. But what seem important for us are the steps taken by IRDA to ensure that

ULIPs sold by agents are based on the financial profile of the individual being ap-

proached and not on the fees. This, if implemented on a larger scale, will definitely

serve the purpose in the best interest of the investors. In the current edition, we

present to you a very interesting article on BP and the oil spill from one of its rigs in

the Gulf of Mexico. This focuses specifically on the financial aspects and impacts of

the oil spill, which contaminated a vast area of United States marine environment

and continues to have a serious impact on the ecosystem, on BP and the whole Oil

industry of the world.

Time indeed moves so fast. It gives me immense pleasure to inform you that

we, Niveshak, are at the doorstep of our 3rd year of existence and will celebrate

its second anniversary in the next issue. With this new beginning, let us revisit the

world of finance with all its failures and their learning from the last century. Yes this

is the theme for the next issue. We invite you to write articles on Milestones that

shaped the world of Finance for the Anniversary edition. However, you can also

send articles on any topic of your choice. For more information, please see the dec-

laration page of this issue. We look forward to your support and wishes to continue

this growth story at an exponential pace.

What a journey it has been.

Bhavit Sharma

(Editor-Niveshak)

THE TEAM


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Niveshak Times

04The Month That Was

C O N T E N T S

PERSPECTIVE

17 Clash of Titans

21 Governance Challenges inIndian Business

Cover Story14 Yuan De-pegged

Finsight

10 PIIGS - Doom for EU?

Fingyaan

18 Frontier Markets

Article of the month

06 BP at Gulf of Mexico

finlounge24 FinQ


4/26NIVESHAK VOLUME 3 ISSUE 7 JUly 2010

Change in Monetary policy

The Reserve Bank of India (RBI) raised theshort term key rates, repo and reverse repo ratesby 25 basis points each on the 2ndJuly 2010. Therepo rate has been changed from 5.25 to 5.5 and thereverse repo from 3.75 to 4 in an effort to contain in-flation. The wholesale price index increased to 10.2%in May from 9.6% in April.

Presently, the system is short of cash. Theshortfall is due to individual companies paying large

amounts of cash towards advance income tax andthe telecom companies paying the government forthe 3G license.

The increase in the short term rates will how-ever have no impact on the interest rates on corpo-rate and home loans as the banks are going to waitfor the July 27 policy review to make changes in theinterest rates. The banks are keeping the base ratesunchanged as of now as they expect a further risein the repo and reverse rates while keeping the cashreserve ratio(the deposits that banks have to keep

with RBI) untouched.The expected outcomes from the monetary

policy change is that inflation will be contained andinflationary expectations will be anchored going for-ward and the recovery process will remain unhurt.

ICICI Bank and Bank of Rajasthan Amalga-mation

The board of directors of Bank of Rajasthan an-nounced that its shareholders have approved theamalgamation with ICICI bank. The deal is an all-stock deal and was finalized at Rs 3041 crore. The

share swap ratio has been fixed at 25 shares of ICICIbank for every 118 shares held of Bank of Rajasthanon the record date. The amalgamation is subject tothe approval of the RBI and other such authorities.

ICICI, Indias largest private sector bank, cur-rently has 2000 branches. Post the amalgamation, itwill get access to not only the 468 branches oper-ated by Bank of Rajasthan but also will get controlof 58 branches of a rural regional bank sponsoredby Bank of Rajasthan. This will help ICICI bank to ex-pand its branches in areas where it has limited pres-ence and also to achieve its 3 year growth targets.

It is believed that RBI will approve of this amal-gamation inspite of strong opposition from the em-ployees of Bank of Rajasthan as it will bring downthe Tayal families stake in Bank of Rajasthan downfrom the 55% that SEBI claims it possesses. The bank

has been in controversy over the last few months. Inmarch SEBI banned 100 entities relating to the bankfrom all activities relating to the stock market as itwas investigated that these entities were corneringshares of Bank of Rajasthan in collusion with theTayal family and RBI had imposed a fine of Rs. 2.5million for violating guidelines and irregularities inits lending policy and information security system.The amalgamation could turn out be a win win situ-ation for both the company shareholders.

Fortis to acquire strategic stake in ParkwayHoldings, Singapore

Indias second largest hospital owner, For-tis Healthcare Ltd through its arm, RHC HealthcarePte Ltd have made an open offer to acquire all theshares that they dont currently own of Singapore-based Parkway Holdings at a value of SGD 3.8 pershare. The deal size is estimated to be around SGD3.2 billion. The bid is in response to Malaysias Kha-zanahNasional who wants to raise his holdings to51.5% from the current 23.8% has made an offer of

SGD 3.78 per share.Run by the two brothers Malvinder and Shi-

vinder Singh, Fortis Healthcare owns 25.3% stake inParkway Holdings. Parkway holdings Limited, listedon the Singapore stock exchange has a network of16 hospitals with more than 3400 beds in variousAsian countries like India, China, Malaysia. Post theacquisition, the two companies together-Fortis andParkway would create the largest healthcare pro-vider in Asia. The health-care spending in the Asiancountries is increasing by as much as 17% annu-ally and Parkways hospitals attract patients from

Indonesia and the Middle East, driving revenue frommedical tourism, which according to Fortis will reach$1.5 billion globally in 2010. Merging with Parkwaywill cut costs through coordinated purchases ofmedical equipment and drugs across a network of54 hospitals.

However, there is a strong possibility that Kha-zanahNasional will make a counter offer and therewill be some twists and turns before the deal finallygets closed.

Industrial Output at 11.5% in May

Industrial production grew at the slowest ratein seven months, down from 16.5% year-on-year in-crease in April to 11.5% from a year earlier in May.The main reason behind the slower manufacturinggrowth rate was not due to the fall in demand but

Niveshak Times

The MonTh ThaT Was

IIM Shillong

Ritika parasrAMPURIA

www.iims-niveshak.com


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

The MonTh ThaT Was

due to capacity constraints. The output lag that hadbeen there in the economy has already been filledup over the last few months and going forward themanufacturing sector is expected to witness an av-erage growth which is favourable for the economy.Amongst the sectors, capital goods and consumerdurables contributed most to the industrial growth.Capital goods sector clocked a growth of 34.3% y-o-ywhile the consumer goods sector rose at 23.7%. Themanufacturing sector grew at 12.3%

The WPI inflation moved up to 10.55% in June

from 10.16% in May. Capacity constraints with thedemand being robust will only lead to a further in-crease in prices. The Governments decision to freepetrol prices and raise other fuel prices is expectedto add another percentage point increase to theheadline inflation. The Indian government expectsthe economy to grow at 8.5% in the current fiscalyear as against 7.4% in the last year with a doubledigit industrial growth.

Inspite of the fall in the output numbers, webelieve that RBI at its monetary policy review on July27 will raise the interest rates in an effort to curb thedouble digit inflation. The increase in the rates willforce banks to raise their deposit and lending rateand thereby control inflation.

Infosys quarter results

Indias second largest IT software exporter de-clared its first quarter results which were lower thanexpected and reported a 2.42% dip in profits. Info-sys is an important proxy for other IT outsourcingcompanies in India, as it is the first to announce itsresults each quarter. The fall in the net profit wasmainly due to continuing pressure from the weaken-ing European region, currency volatility, pricing pullsand the burden of increased tax and wage hikes. Inthe first quarter the billing rates fell by 1.6% and areexpected to fall by 2% by the year end march 2011.Infosys mainly concentrates its business in Europeand the United States. The business in the US im-proved by more than 15% but the European marketwhich accounted for around 25% of Infosys revenuea year ago fell to only about 20% of the revenues.

The overall outlook of the IT Sector looks goodas the demand for outsourcing services is growing is

the US. Worldwide, its spending is expected to growat 9.3% in the current fiscal year. However, owing tothe concern of weakening of the European countriesand the European companies facing budget cuts, theIndian IT sector companies are likely to face uncer-

tainty on orders. Some European companies may beforced to decrease their IT spending or possibly de-lay or cancel some offshore projects. The sector isalso facing staffing challenges and to retain talent,the big IT companies are raising salaries which willfurther pressurize their bottom line. Lastly, the eurohas also vastly depreciated and worries that someEuropean countries could default on their govern-ment debts may result in reduced revenue and earn-ings from European clients to the Indian softwarecompanies.

RNRL and Reliance Power Merger

On 4th July 2010, the board of directors of Re-liance Natural Resources ltd (RNRL) and ReliancePower(RPower), both ADAG companies approvedthe merger of the two companies at a swap ratio of(1:4) which means that the shareholders will get oneshare of RPower for every four shares held of RNRLon the record date. The valuations were carried outby KPMG and will take around 6 months to get com-pleted subject to approvals from the shareholders ofRNRL and REL Power as well other regulatory nods.

RNRL, a gas transportation company wasformed for the purpose of supplying gas to ReliancePower for their electricity projects. In May 2010,the Supreme Court ordered that RNRL cannot tradein the gas that it has procured from RIL and it hasto provide it to the electricity generating units atthe same price at which it purchases it. The apexbody also ordered that the pricing has to be as perthe government pricing and not as per the earlierMukesh- Anil Ambani agreement. This caused Reli-ance ADAG to merge Reliance Power and RNRL.

Post the merger, RPower will become the do-

mestic power company with the biggest coal re-serves. It already possesses four billion tonnes ofcoal in Indonesia and India and henceforth will alsoown the four bed methane blocks and the 10% stakein oil and gas blocks in Mizoram allocated to RNRL.

The shareholders of both the companies arelikely to benefit as the merged entity will enjoyeconomies of scale since the gas supply and its us-age will be controlled by the same company as wellas the marketing margins will be reduced. Also,RNRL will move up the value chain from being a

company which has little or no earnings to beinga part of a bigger company. R Power, on the otherhand will benefit from the oil agreement betweenRNRL and RIL.

Niveshak Timeswww.iims-niveshak.com


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NIVESHAK VOLUME 3 ISSUE 7 JUly 2010

The article gives a

brief overview of

one of the most

severe oil spill catas-

trophes of the world

with a special focus

on the financial as-

pects.

Schlumberger (IIT Delhi Alumnus)Ankit Nagar

When the world is at the stageof Peak oil and efforts are beingmade to counter the declining pro-duction of hydrocarbons, the dam-aged rig of BP in Gulf of Mexico hasbeen leaking 60,000 barrels of oil perday from last 3 months. This gaugesthe severity of crisis in Gulf of Mex-ico caused due to explosion in theBPs deepwater horizon rig on 20thApril 2010. This explosion, which led

to an oil spill that contaminated avast area of United States marineenvironment and continues to havea serious impact on wildlife, the lo-cal fishing industry and regionaltourism, has put this fourth largestcompany in the world, BP, in the dol-drums. Let us delve into the detailsof the financial aspects of this crisisand its subsequent repercussions.

Crisis

This oil spill in the Gulf of Mex-ico has so far cost BP a mammothamount of $3.12bn (2bn) which ledthe oil giant to demand its partnersin the well to pick up at least partof the bill. The cost of the responseto date ($3.12bn) includes the costof the spill response, containment,relief well drilling, grants to theGulf States, claims paid, and fed-eral costs. Although BP is trying to

recoup some of its losses, it is stillsceptical about the scale of the sal-vage and clean-up exercise. This oilis now lapping up on the shores ofstates in the southern US. Not onlythis, BP is facing huge potential li-abilities as a result of the crisis.Many estimates put the eventualbill at $60bn (39bn).

When compared with the oth-er oils spills of the past in figure

given below, the gravity of this ca-tastrophe can be felt.

The battered company haslost about half its value since theexplosion on the Deepwater Hori-

zon on 20th April. The current priceis around $30 (NYSE) which is almosthalf its value before the mishap.

There can be three main factorsbehind the fall in BPs share price.

a. There are concerns over theeventual cost of spill. The amount isrising day by day and no-one knowshow big or how long the clean-upoperation will be. Even harder to

quantify is the subsequent bill forcompensation to businesses andworkers affected by the spill andfines that the US government hasasked BP to pay. This affects the pre-diction of future cash outflows fromthe firm. Although BP is setting up a$20bn compensation fund, the even-tual cost could be much higher thanthat.

b. The company has decided

to scrap its dividend for the year2010 after coming under pressurefrom the white house. The effecton the share price can be justifiedwith the famous dividend discountmodel. This will certainly disappointBP shareholders, some of whommay have chosen BP because, in thepast, it has been a regular dividendpayer. The last time that BP deferreda dividend payment was duringWorld War II.

c. Behavioural Finance whichsays that the fall in share price isdue to usual nervousness investorsdisplay when any company suffers



AoM

BP is going to nd it hard toaccess the capital markets forfunding while the full cost ofthe oil leak remains unclear.

adverse publicity oruncertainty surroundsits future.

With the fall infirms value, BP wasalso dropped outof the BBC index ofworlds biggest firms.Shell has again tak-en its place after BPovertook Shell as Eu-ropes largest oil com-pany just before theGulf oil spill.

Effect on credit

rating

BPs credit rat-ing has been droppedby Fitch to just twonotches above junkstatus, as the probable cost of the Gulf of Mexicooil spill continues to escalate. The news of Fitch cut-ting BPs rating from AA to BBB came after the USpoliticians demanded the company to deposit $20bn(13.58bn) in an escrow account to cover the cost ofthe Deepwater Horizon disaster. The reasons behindthis downgrading can be many. However one im-portant reason which comes to my mind is concern

that the balance between long-term and near-termcost payments of BP would become skewed muchmore heavily towards the near-term than previouslyanticipated if the escrow account was created.

Rescue Attempts

BP hasnt left any stone unturned in bringingthe situation back to normal since the day this ac-cident occurred. After a series of failed attempts tostop leakage, BP installed 2 containment systemsin June first week. These two systems continue to

collect oil and gas flowing from the Deepwater Hori-zons failed blow-out preventer (BOP) and transportthem to vessels on the surface. The 1st cap, installedon 3 June, takes oil and gas to the Discoverer Enter-prise where oil is collected and gas flared. The 2ndsystem, which began operations on 16 June, takesoil and gas to a vessel on the surface where bothoil and gas are flared. The companys latest plan to

stop the leak is toremove oil from theseas surface usinga giant ship knownas a skimmer. Butthe problems dontseem to end for BP.

Operations to skimoil from the sur-face of the waterwere suspended fornearly three daysbecause of Hurri-cane Alex.

In order tofind solace in thisdifficult period, BPdemanded almost

$400m from Anadar-ko and Japans Mit-sui Oil Exploration

Company, both of whom are minority shareholdersin the well. Anadarko owns 25% of the well and Mit-sui has 10%. Anadarko, however, has refused to ac-cept any blame for the disaster saying that it wasa sheer negligence on BPs part. If proved in court,which could allow Anadarko to escape its responsi-bilities under its joint operating agreement, it willmake things more difficult for BP.

Agreement with US govt

What brought some respite in the midst ofthis turbulent phase for BP was the agreement withUS government to put $20bn into a special escrowclean-up fund. Although it doesnt limit BPs liabili-ties nor cover fines and penalties but does elucidatehow BP will settle legitimate claims and clean-upcosts. However, it does come at the expense of thenext 3 quarters dividend payment which has beendiscussed previously in this article. This agreement

augurs well for BP with its share price rising by 7%on that day and Bank of America/Merrill Lynch cut-ting their rating on the company to Neutral fromBuy.

Investors Outlook

Inspite of BP share price reducing by over 50%in last 3 months, investors outlook about it is posi-


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In order to nd solace in thisdifcult period, BP demanded

almost $400m from Anadarkoand Japans Mitsui Oil Explora-tion Company, both of whom areminority shareholders in the well.

tive and the confidence intact. BP shares are con-sidered good value for bargain hunters. BP has largeinterests in Libya and is known to have a strongrelationship with officials in the country. This is whyLibyas sovereign wealth fund is also considering in-vestment in the beleaguered BP. Kuwaiti sovereignwealth fund has also shown interest to become the

so called strategic investor in BP.

Buyout possibility

Meanwhile the collapse in the share price hasled to speculation that BP may become a takeovertarget. This was expected to as come as its higherintrinsic value and prevailing investors confidenceabout BP. Few days back, investment bank JP Morganrecommended oil giant Exxon Mobil as a possiblebuyer, while Anglo-Dutch oil giant Shell has alsobeen mentioned. The Asian

players are also not outof picture from this. Someanalysts also suggest a po-tential role for state-backedoil companies such as Chi-nas PetroChina or KuwaitOil in the buyout.

Impact on Global oil

industry and future

oil supply

As BP struggles toplug the leaking well in Gulf of Mexico, the whitehouse has taken a harsh step by ordering six monthsmoratorium on deepwater drilling till special presi-dential commission comes up with new safety stan-dard after scrutinizing the causes of worst lapse ofsafety norms on Deepwater Horizon. Although themove was acknowledged by environmentalists butthis comes at the cost of halting work on 33 drillingrigs resulting heavy losses suffered by other operat-ing companies like Chevron, Shell and other service

companies. This freeze will directly impact the worldoil supply as Wood Mackinzie energy consulting es-timated 80,000 BOPD of oil being deferred by 2011.Strict permit to drill in deepwaters will further hit oilsupply with reduction in production by 350,000 BOPDin 2015 and 2016. As a result, the share prices ofoil service companies including Schlumberger, Hal-liburton, and Baker Hughes have plunged in the last2 months.

Impact on Indian oil industry

With increasing demand of oil in India, Indianmajor operation companies like ONGC and Relianceare venturing further out and deeper down the seafor the search of hydrocarbons. After this BP oil spillincident, it didnt take long for Indian regulators totake a deep interest in safety standards for deep-water explorations. Reliance, Indias largest privateexploration and production operator, suspendeddrilling at a well in D3 field of KG basin citing someunresolved issues with blow out preventer of Deep-water Expedition, owned by Transocean which coin-cidently also owned the same rig which blew up inGulf of Mexico. With these stringent safety norms,the increased equipment requirements and higheroperating costs will result in a squeeze in margin foroperating companies in short and medium terms.

ConclusionThe efforts to stem the

leak and to settle initial claimshave certainly created a cashcrunch within BP and thusthe group is in dire need forextra financing. Therefore therecent willingness shown byBP to access both equity anddebt financing is quite justi-fied. Cut in the dividend and

capex, and the announcedasset sales (as per the agreement with US govern-ment) will initiate the process of recovery for BP. Butthe question remains how easy or difficult wouldit be for them given the recent happenings. BP isgoing to find it hard to access the capital marketsfor funding while the full cost of the oil leak re-mains unclear. In addition to this, Fitchs downgradecan make it more expensive for BP to borrow, espe-cially if the other ratings agencies follow its path.The company has around $5bn of cash reserves, and

has spent more than $1.6bn fighting the spill. Givingstrategic stake to sovereign wealth funds would bean easy way out but will make their current share-holders suffer because of dilution of their interests.The stand taken by BP in the coming 2 months willanswer our questions.


10/260

FinSight


Germany developed a surplus

within Europe at the expenseof growing decits in other

EMU nations.

The article seeks toexplore the current

precarious condi-

tion of PIIGS coun-

tries and its enor-

mous political and

economic conse-

quences, suggesting

alternative courses

of actions available

thereof.

SIBM, PuneAnkit Dhanuka & Kulin Shah

This topic may seem strange asEstonia has only recently announcedits intention of adopting the Euro asits currency from the 1st of January2011, and many others are waiting inthe queue.

We need to understand whythe European Economic & MonetaryUnion (EMU) member countries findthemselves in this crisis now, in or-der to envisage and understand pos-

sible scenarios of the future.

The Boom Period

After decades of perseverance,the Euro was adopted on 1st January1999 in the non-physical form andon 1st January 2002 in the Euro cur-rency form by the member states af-ter meeting the Convergence Crite-ria set out by the Maastricht Treaty.

Everything looked great for

the member states and the Euro inthe initial years. The Euro-zone wasalready a Free Trade Area and withno restrictions on the movement ofcapital and limited restrictions onmovement of labour. As there wasno longer a need to exchange cur-rencies, no exchange rate commis-sions and no need to insure againstcurrency fluctuations the transac-tion costs between member states

declined. Exchange rate stability as-sured lower interest rates as therewas no need for risk premiums. Priceinequalities of the same goods werereduced leading to a more efficientmarket. Prices and revenues be-came more stable leading to greatereconomic certainty. The loss of con-trol over monetary policy seemed

a small price to pay in comparisonfor the benefits. For once the worldthought that there was a currencythat had the potential to challengethe US Dollar as the global reservecurrency.

From Boom to Bust

The world economy in generaldid exceedingly well in the yearsupto 2007 and the Euro-zone was no

different. This was a period in whichhuge global imbalances were builtup leading to a structural problem.In this period of economic boommany countries ran high fiscal defi-cits which seemed sustainable dueto the high levels of growth. Somecountries like Greece fudged theirdebt figures in order to make theirdebt positions seem sustainable.The sub-prime crisis in the US andthe contagion effect across the globebrought these unsustainable modelsof growth crashing down.

Imbalances Leading to High

Fiscal Defcits

Germany, the strongest countryin the EMU, has benefited since theadoption of the Euro as the wageand cost levels in other countrieswith weaker currencies have goneup. Simultaneously Germany has

determinedly cut its own cost andwage levels in their endeavour tobecome more competitive. As a re-sult, Germany has taken away thedemand from other countries in theEMU such as Greece, Spain, Portugaland Italy. Thus Germany developeda surplus within Europe at the ex-



FinSight

A big fundamental defect inthe design of the EMU is that

while there is a single currencyand monetary policy, the scalpolicies of different countriesare completely uncoordinated.

pense of growing deficits in other EMU nations.

So now we have a situation where Greece hasa fiscal deficit of 13.6% of GDP. Its public debt/GDPratio is 115%, but may hit 140% by 2014 despiteausterity measures. Portugal has a fiscal deficit of9.4% GDP and public debt/GDP ratio is 77% while thecorresponding figures for Spain are 11.2% and 64%respectively. Thus Greek, Portuguese and Spanishbonds have been downgraded recently. Italy has ahigh public debt/GDP ratio of 116%, but is among theseven biggest economies in the world and so hopesto survive the crisis. But at the same time this alsomeans that if Italy fails it could have effects beyondimagination.

Defects in the EMU & Inappropriate Stimu-

lus Packages

A big fundamental defect inthe design of the EMU is that whilethere is a single currency and mon-etary policy, the fiscal policies ofdifferent countries are completelyuncoordinated. During the growthphase this was overlooked, but thisdefect surfaced in the post 2008period as different governmentsreacted differently in response tothe recession.

Another fact that these PI-IGS countries have realized is thatKeynesian stimulus is not the solution to all slow-downs. Keynes suggested that government spend-ing and tax cuts helped spur demand and hencegrowth. In an open economy the benefits of sucha stimulus can leak out to other countries whichare more competitive. The relatively uncompetitiveand low-productivity PIIGS economies have sufferedat the expense of more competitive economies likeGermany.

The Greek economy depends heavily on tour-ism and has an uncompetitive industry. Portugaland Spain also have uncompetitive industries. Be-ing a part of the EMU, these countries do not havethe option of devaluing their currencies to increasecompetitiveness and boost exports, as was the caseduring the Asian crisis of the late nineties.

A strong case for fiscal prudence can be made

with this crisis. Government policies should aim forlow fiscal deficits in good times in order to have acushion to offer a stimulus in bad times. The PIIGScountries are in trouble as they ran high fiscal defi-cits in good times, and went for even bigger deficitsto provide a stimulus. As a result, the stimulus pack-ages have increased government debt without really

achieving their aims.

The Bailout Package

Greece being in the most precarious situa-tion becomes the focal point in this situation. InApril 2010, Greece was bailed out by the IMF andthe European Union, led by Germany to the tune of$150-billion. This ensured that Greece was able tomeet its debt obligations without borrowing at high

rates which would have surelyput Greece in a debt trap.

Due to the size of the bail-out package, Greece will not needto borrow again from private fi-nancial markets for three years.But this means that Greece willhave to repay these loans backto the IMF, Germany and otherEU countries in due course. Strin-gent austerity measures havebeen put in place in order to getGreeces fiscal deficit back on

track. This means lower govern-ment spending and higher taxes. This will also meana compromise on growth and eventually lower taxrevenues for the Greek government. The fundamen-tal problem of having an uncompetitive industry isnot resolved and exchange rate devaluation is notpossible. The bailout has succeeded in avoiding theimmediate crunch but in the longer term, however,the numbers are still frightening. There is alreadya widespread public protest in lieu of the auster-ity measures and this could limit the options of the

government even further. Hence, it looks inevitablethat recovery in Greece will require a very largewrite-down of Greeces debts.

If Greece defaults there will be a contagion ef-fect with disastrous consequences. The exposure ofother EU banks to Greek debt, which according toBIS totals $193 billion, is significant. If you take intoaccount the risks of and exposures to other PIIGS


12/262

FinSight


The Euro is as much aboutpolitics as it is about

economics.

economies and bonds then there could be a Europe-wide banking crisis. Germany and France have a highexposure to European bonds and thus we can un-derstand the willingness of Germany and other EMUstates to bail out Greece. If this continues, there isonly one way for the Euro to go, and thats down.

Will countries leave the EMU?Recently there has been speculation that Ger-

many and Greece may exit the EMU and return totheir respective currencies. Here we discuss the pos-sibilities of such an eventuality.

Under the current laws, it is not possible toexpel a member nation. So we must mention at theoutset that unless the laws are changed, anymember nation leaving the EMU must bea voluntary action.

If Greece exits theEuro, then it willbe able to con-trol its monetarypolicy. In this casethey would be ableto ease their financ-ing problems substan-tially. The Greek centralbank could print moneyand purchase govern-ment debt, bypassing

the credit markets. Also,reintroducing its currencywould allow Greece to thendevalue it, which would stim- u l a t eexternal demand for Greek exports and spureconomic growth.

Besides the fact that investor confidence wouldbe at the lowest ebb, there are other practical prob-lems with such a solution. If Greece has to devalueits currency, first it must circulate it. Nobody wouldwant to hold a currency which is being reintroduced

to devalue it. Therefore, the only way to get the cur-rency circulating would be by force. Any such moveis likely to trigger more protests from an alreadyagitated public.

Another problem would be that Greeces debtis Euro denominated and a devaluation will make itsdebt repayments that much costlier. For an alreadyinsolvent nation this could be difficult to imagine

especially as the benefits of such a move would takeyears to surface.

At the other end of the spectrum is Germany.Germany is a capital rich and highly productive na-tion which might feel that the other EMU nations aredragging it down with them. Germany has for longbenefitted from this arrangement of having a singlecurrency. Other nations within the EMU are unableto undercut German exports with currency depre-ciation. Germanys share of exports has increasedin the Euro-zone as well as the global markets.

G e r - manys decision on wheth-er to abandon the Euro or not

will depend on the poten-tial liabilities that theywould be exposed to.Germany would there-fore not be leavingthe EMU to save itseconomy or extricateitself from its owndebts, but ratherto avoid the fi-nancial burdenof supportingthe other highly

indebted economies.

Greece is a relativelysmall economy and Germany bailed

it out despite strong public opinion againstit back home. Will Germany bail Greece out again if

the need arises? What if a much larger economy likeSpain defaults? The German policymakers must bewondering if this is all worth it. At some point theywill feel that its better to cut their losses rather thanputting in more money to save another economywith high degree of uncertainty about the outcome.

If Germany exits the Euro then the Euro willplummet, and all the EMU member nations alongwith Germany would be paying for it. In this case

many European banks are likely to default, andsince many German banks own much of this debtthey will also suffer.

Unlike Greece, Germany would be replacing aweaker and deteriorating currency with a strong andstable Deutschmark. Thus Germany is less likely toface a backlash. A significant portion of the Germanpopulation is already in favour of abandoning the



FinSight

Euro.

So what do we think is going to happen?

The Euro is as much about politics as it is abouteconomics. It helped different countries of Europeunite despite the acrimony between some memberstates. But demise of the Euro could spell doom for

the continent. If nations leave the Euro it would beto devalue their currency. There would be a run onthe banks and this crisis could well land up in adeep recession with highly indebted nations. Thiswould result in high levels of unemployment andsocial unrest for years to come.

For Greece the situation looks gloomy. Leav-ing the Euro isnt a realistic option unless it is awell designed and coordinated effort by the IMF, ECBand other EMU member nations. Only then will therevival of Greece be lasting and social fabric of the

country will be restored.

But at the same time the patience in Germanyis wearing thin. If there isnt a substantial econom-ic recovery across Europe, getting out of this messis going to be difficult. And the signs are not veryencouraging. So we feel that Germany will make asincere effort to revive the Euro, and probably theGreek bailout gives them time to contemplate theirnext course of action without sending shocks in theEuro-zone.

Germany could exit the Euro or stay onboarddepending on the recovery of other nations. If thingsget out of hand and Germany decides to abandonthe Euro-zone, then it would be due to the fact thatthe losses that it would suffer by exiting would bepale in comparison to the economic and politicalcosts of remaining within the Euro-zone and bailingout fiscally imprudent nations.

It looks unlikely that the EMU will survive inits current form. In the future we are likely to seea smaller EMU with more stringent regulations. Wehave seen that self regulation of fiscal policies doesnot always work and some sort of central controlover fiscal policies of member nations is also es-sential.

The debt situation in the US and UK is not com-forting, and in the event of their fallout the situationin the Euro-zone would look even more precarious.And in this eventuality no scenario can be ruled out.But hopefully these countries will manage to get outof the mess they are in, and we will see a morestable and sustainable Euro-zone. Hopefully.

FIN-Q Solutions

June 2010

1. Basis Swap

2. Rule 144A

3. New Zealand

4. China

5. Scalper

6. Speculative Company

7. C

8. Stagation

9. Harry Markowitz


14/264 NIVESHAK VOLUME 3 ISSUE 7 JUly 2010

pegged to the dollar at 6.83 yuan per dollar during theglobal financial crisis.

Devaluation: Why?

By keeping its currency cheap against the dol-lar, China has made its imports appear more attractivewhich has led to a massive trade surplus in China. Arebalancing of the yuan has been deemed necessary toprevent a further build-up of global imbalances. If theUS is still assumed to be both the consumer and im-porter of last resort and thus goes back to running largecurrent account deficits, then theres a risk that therecould be a repeat of the recent crisis.

President Obama had complained loudly about Chi-

nese currency manipulation during his 2008 presiden-tial campaign, but has since resisted labelling Beijing acurrency manipulator in the two semi-annual Treasuryreports issued during the peak of the global economiccrisis. As the world economy began to stabilize, U.S.complaints about Chinas exchange rate policies resur-faced. The Obama administration postponed its third re-view of Chinas currency practices, which was due April15 to give Beijing until the G20 leaders meeting to act.Bowing to international pressure, China has finally de-cided to de-peg its currency from the US dollar for thefirst time in almost two years. However, there will be no

one-off move; instead, there will be a gradual increasein dollar yuan daily fixings to around 10-20 basis pointsfrom the current 1-2 points. This way the exchange ratewould be made more flexible by determining the yuansvalue on a daily basis with reference to a basket of cur-rencies, allowing it to appreciate slowly and gradually

Exchange rate is defined as the number of unitsof one currency needed to acquire one unit of an-

other currency. A fixed exchange rate system is onewhere a countrys government or central bank tiesthe official exchange rate to another countrys cur-rency. The purpose of a fixed exchange rate systemis to maintain a countrys currency value within avery narrow band. It is also known as the peggedexchange rate. A fixed rate system provides greatercertainty for exporters and importers. This also helpsthe government maintain low inflation, which in thelong run keeps the interest rates down and stimu-lates trade and investment. In contrast to a fixed ex-change rate system is the floating rate system where

a countrys currency is set by the foreign-exchangemarket through supply and demand for that particu-lar currency relative to other currencies.

History of Yuan

The Renminbi is the official currency of thePeoples Republic of China, whose principal unit iscalled the Yuan (the distinction between yuan andrenminbi is that the yuan is the unit of account whilerenminbi is the actual currency). Since the beginningof the economic reform process in 1979, the yuanwas devalued on many occasions until 1994 whenthe two-tier foreign exchange system was ended byChina. From 1997 to 2005, the renminbi was peggedto the U.S. dollar by the Chinese government at about8.3 RMB per dollar. After years of speculation andhearsay, China finally revalued the RMB by 2.1% inJuly 2005.However, in July 2008, the yuan was again

v

y

Team NiveshakHitesh Gulati&

Bhavit Sharma



CoverS

tory

against the dollar. The currencys existing 0.5% dailytrading band has however been unchanged.

Some of the scenarios for how Beijing will man-age the exchange rate in the near future are:

Gradual Appreciation

China needs to allow the yuan to rise to prove

that it is serious in its commitment to make thecurrency more flexible. The strength of Chinas eco-nomic recovery gave policymakers the confidence toend the peg that had helped cushion the economyfrom the global financial crisis, but they remainworried that external demand is still not on a solidfooting, especially with European debt worries inthe background. It is most likely that the centralbank could use its setting of the yuans daily refer-ence rate to nudge the exchange rate up by modestamounts each day, for example from 6.8260 per dol-lar to 6.8250 per dollar

Two WayVolatility

For along time,China haswanted to in-troduce a twoway risk intothe exchangerate. In the-ory, traderswill no longer

be able to as-sume that theyuan can onlymove in one direction i.e. up. In the past, the yuanrarely fluctuated more than 0.1% in intraday trading,even though the trading band permitted a rise or fallof 0.5 % against the dollar each day. Beijing will bemore determined to increase volatility this time. Thisimplies that on days when the dollar is falling glob-ally, Beijing may push the yuan up slightly. However,when the dollar is strong, the Chinese currency maypare these gains.

Viewed abstractly, there is a strong rationalefor allowing a major appreciation of the yuan rightout of the starting blocks. But the government willbe loath to push the yuan up too aggressively. If Chi-nese leaders are risk-takers, then they might gamblethat words alone will be powerful enough. Keepingthe yuan locked at about 6.83 to the dollar wouldplease hard-liners at home who have accused Bei-jing of capitulating to foreign pressure. But continu-ing the peg would infuriate U.S. lawmakers and stripChina of any goodwill it has earned.

Implications for China

Exports make up nearly 25% of Chinas GDP.A big change of its exchange rate could cut downChinas growth rate to half. A revaluation of the yuanmakes Chinese exports relatively more expensiveand thereby decreases foreign demand for Chinese

goods. This in turn would negatively impact local pro-duction and would create a feedback loop throughto domestic employment and wages. Other adverseeconomic impact will include decrease in corporateprofitability, deflation in the agricultural sector, anincrease in unemployment, and less foreign directinvestment. According to the Chinese authorities,

the countrys foreign reserves are largely a result ofthe hot money, inflows of foreign capital hopingto instantaneously capitalize on a yuan revaluation,rather than long term foreign direct investment incapital projects. As a result, some additional poli-cies, such as an expansionary fiscal policy may needto be undertaken simultaneously to remove some ofthe adverse impacts of the yuan revaluation. Chinais still in the process of evolving and China cannotturn back years of a culture built on savers and un-der consumption overnight.

Yuans appreciation against the dollar will how-ever increase the purchasing power of the Chinese.

Even though theChinese export-ers, who havebenefited fromstrong demandin the past fewyears due to anartificially weakdomestic cur-rency, will nowfind it moredifficult to sell

abroad, othersectors of thecountrys econ-

omy stand to benefit from the move. Chinese bankswill see their yuan denominated assets appreciatein line with the rising currency, while shares in thecountrys top airlines are also expected to rise inthe short term, since their main operating costs areaircraft purchases overseas.

Implications for USA

Increased consumption in China would help

the US exports. As far as the U.S. markets go, theannouncement should fuel advances in equities asbulls argue that a stronger yuan should bode well forfuture growth for U.S. multinationals. Also, this couldlead interest rates to the higher end of the recentrange fuelled by future growth prospects and higherinflation expectations. Unfortunately, the benefitsto U.S. multinationals from yuan appreciation, as-suming China follows through and the appreciationis relatively small, will not be noticed in the shortterm. The fact remains that the U.S. stands on shakyground and the probability for a slowdown appearsreal for the second half, as evident by the recent

spate of weak economic data such as high initialjobless claims. Prospects for a shift in currency poli-cy by China cannot make the deep-rooted problemsof the developed economies suddenly disappear. Asa result, U.S. stocks and bond yields could resume


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its downward trend once euphoria wears off fromthe news from China.

Implications for the rest of the world

Even a gentle appreciation of the yuan isbound to be a powerful tonic for growth both inAsia and the rest of the world as the widespreadbelief among investors is that the yuan is still sub-stantially undervalued. However given the foreigninterests and investments in China, a dramatic yuanrevaluation that catapults China into recession couldresult in a global contagion effect. Supply chains areso interconnected around the globe that an upwardprice movement for intermediate and finished goodscoming out of China could have dire consequencesfor Western companies that rely on Chinese-sourcedgoods.

Implications for India

According to the Standard Chartered Bank, the

Indian rupee is expected to be one of the majorbeneficiaries of the Chinese move tode-peg the yuan. There maybe some short-termvolatility due tothe absence ofdetails on howChina plans toallow flexibility,however it neednot be a problem ifthe investors have

hedging tools suchas currency futures.The Reserve Bank ofIndias absence fromthe FX market may alsomake the INR particularly wellplaced to gain from the de-pegg ing.Appreciation of yuan will also help the Indian ex-porters compete better with their Chinese counter-parts in the global market, especially in areas liketextiles, leather and handicrafts.

The European Conundrum

Recent events in Greece and the Europe regionhave further compounded the issues surrounding therevaluation. The yuan has risen about 14.5 % againstthe euro during the last four months, which has in-creased cost pressure for Chinese exporters and hasalso had a negative impact on Chinas exports toEuropean countries which happen to be their largestmarket. Letting the renminbi rise against the dol-lar would mean a further increase in the renminbisvalue against the euro which would create furtherproblems for Chinese exports to Europe. Also, Chi-nese exporters rely very heavily on bank letters of

credit to finance their shipments. When banks havetrouble borrowing money themselves as has beenhappening as a result of worries about Europeanbanks possible losses from the regions sovereigndebt crisis, they tend to cut sharply the issuance of

letters of credit for trade finance.

Without net capital inflows, trade-deficit coun-tries in Europe such as Greece, Portugal and Spainare having difficulty financing themselves; thesecountries can no longer run current account short-falls. As Europes current-account surplus grows;there must be a trade adjustment elsewhere. Either

the current-account surplus of countries such asChina and Japan must contract by the same amountor the current-account deficits of countries such asthe US must grow (or some combination of both).

The truth of the matter is that China is reluc-tant to allow for a sizeable move in the yuan sinceit has already seen the currency appreciate withthe decline in the euro, limiting Chinese exports tothe region. Further declines in the euro due to thedeterioration of the European fiscal situation mayalter Chinas plan of allowing considerableapprecia- tion for the yuan.

ConclusionWe have

looked at 2 schoolsof thought in thearticle. One set ofeconomists arguethat the yuanis still under-valued by 25to 40% whichis giving theChinese com-

panies a hugeprice advantage in inter-

national trade. They believe thatunless the move is rapid and significant, Chi-

nas announcement can be termed as nothing morethan a cynical ploy ahead of the G20.

These thoughts emanate from the fact that wehave seen actions like this before from China and itis clear that China did not allow enough appreciationthe last time it adopted a policy like this one, from2005 to 2008. Also the U.S. politicians who wouldnot want to be seen as weak on China this time

around especially just before the Congress elections.However there is a second set of economists

who believe that the current economic scenario is alot different from the one that prevailed in 2005-08.They believe that although Chinas decision to ad-dress the yuan-dollar peg is probably the best out-come for the global economy; a sudden rise in thevalue of the yuan could come with painful near-termadjustments that could derail the currently fragileglobal recovery compounded by the European debtcrisis.



Perspective

The article elucidates

the controversy

revolving around

the devaluation of

yuan and the con-

sequences that will

follow. It seeks to

question the ratio-

nale behind such animportant economic

decision that seems

to be embroiled

in political contro-

versies. The power

balance between

the two countries

has impact on real

economy and needsto be dealt with deli-

cately.

Lancaster University Management School

Preeti Sindhu

America, for quite long, hascasted China as a mercantilist coun-try engaged in currency manipula-tions, illegal export subsidiaries andviolation of intellectual propertyrights. In spite of these accusationsChina is dogged in amassing exten-sive foreign-exchange reserves, highgrowth, building a strong militarybase and colonizing Africa andLatin America. In recent years Amer-

ica has become the biggest debtorand China its biggest creditor. Inter-locking of economies has put thetwo countries in a necessary evilrelationship. And for the world, Si-no-American diplomacy has becomecrucial for every global issue rangingfrom Climate Change to World peace.

America believes that by keep-ing its exchange rate artificially low,China is able to generate a substan-

tial export surplus, create jobs forthe Chinese at the expense of theAmerican and causing US to run intohuge trade deficit. This belief is in-herently flawed. Firstly, there is noevidence that yuan is undervalued.The trade surplus of China is a resultof the economic policies of Chinacentered on promoting low efficien-cy wages, low domestic demand andan export promotion. It is hard tounderstand how America can blameChina for loss of jobs in its country?Trade with China might alter the jobcomposition in America but it willnot have much effect on the overallemployment.

Surrounded by these falla-cies, the argument that revaluationof the yuan will help USA to reduceits trade deficit is fallacious and ex-aggerated. The real reason for thisdeficit is Americans are spend-

ing beyond their means. If strongeryuan does not encourage Americansto save more it will do little to re-duce the deficit. Another reason is

American goods cannot replaceChinese imports. A stronger yuan,will push up the price of goods suchas cloth, furniture, electronic devic-es. This will force the government toimpose taxes which will severely hitthe wallets of poor and middle classAmerican consumers.

China believes that a strongyuan will seriously harm its growth.However this is not true. A gradual

revaluation of yuan seems a goodsolution to cool down the sizzlingChinese economy. This will help thegovernment to shift its policy fromexports and investment to consump-tion which will boost consumerspurchasing power, allowing them tobuy more foreign goods. This willalso furnish more autonomy in mon-etary policy, inflation control and re-duce illegal capital inflows. Thus in

contrast to common belief, it is inUSAs own interest not to urge Chinato revaluate; and its foolish for Chi-na not to revaluate just because itdoes not want to be seen as yieldingto American demand.

America must take a step backand think why is it so upset withChina? Is China a mere scapegoatfor its failed policies? Why is Chinaaccumulating wealth when its peo-

ple lack proper public provisions ofhealth and education? Only whenAmerica has resolved its economicproblem will it be in a credible po-sition to question China. LikewiseChina can-not blame America for itspolicies when its own economy re-mains unbalanced. Nevertheless, itis depressing to see two superpow-ers being so adamant and ironicallyadvocating each others positions,causing costly and unnecessary

distractions and posing a potentialthreat to the financial stability of theworld.

ClashofTitans

Editor, LoudMouth


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FinGyaan


Due to increased access to money

and monetary lobbying clout,Chinese government will not beable to crack down on peopleagainst government practicesand hence wages will rise.

Frontier markets arethe new avenues of

investment for the

investors and a sub-

set of the emerging

market. They have

many advantages

like fewer correla-

tions with the other

markets, high return

opportunities etc.

Accessibility in these

markets is also now

a days not a big

problem, its just that

how can investor

cash in on the op-

portunity at the right

time.

IIM ShillongSaurabh Patawari

What if someone tells you notto invest in stock markets of India,China, USA or Japan but instead incountries like Sri Lanka, Vietnam oreven Nigeria? What will be your reac-tion? You may feel that the personis the biggest fool you have evermet in your life. Why you think sois because you are still living inthe old notion that BRIC countriesor some developing economies only

can give you good returns. But didyou ever think that what is the cor-relation between all these econo-mies, how if one market falls othersalso accompany them? Althoughthe effect of recession was not thatmuch in India as it was in US anda few other countries but still howcan we forget Sensex slipping downfrom 21000 to below 8000 levels andinvestors losing their life savings inone go. Is there any solution for this?Is there any place in the world whichis not correlated highly to such de-veloping or developed economies?Well, answer is not just yes but theample opportunities actually avail-able. We just need to open our eyes,and results are in front of us in formof Frontier Markets.

Frontier Markets

Frontier markets are the subset

of the emerging markets. Althoughthey have lower market capitaliza-tion and lower liquidity but inves-tors are pursuing these markets forhigh and long term returns, as thesemarkets have lower correlationswith other markets. For example, ona 90-day rolling basis, the correla-

tion between MSCI (Morgan Stan-ley Capital International) and HongKong stocks was 0.9. In comparisoncorrelation between MSCI and somefrontier markets like Sri Lanka or Ni-geria was as low as 0.05. CurrentlyMSCI has classified 25 countries likeBahrain, Bangladesh, Kenya etc. asFrontier markets. Argentina andPakistan were dropped from the listof emerging markets last year. The

difference between emerging andfrontier markets is in terms of thesize and how their regulatory systemworks because these are also someof the major concerns for the inves-tor.

Investment Rationale

Talking about the rationale ofinvesting in frontier market, it isbased on the modern portfolio the-ory which says that investors can

decrease the risk in their portfolioand increase their reward-to-risktrade-off through diversification.The benefits of diversification haveplayed a large part in the increasedinvestments in emerging markets.However, problem is that even if wetake the emerging economies intoconsideration, we find that theyhave also become correlated to oth-er economies and result of which we

saw at the time of recession whenall emerging markets also fell. Thisis where frontier economies are stillprotected a bit, if not fully, becausecorrelation is still very low with oth-er economies. Workers have alreadystarted to work out better workinghours, benefits etc. Hence in future

Frontier MarketsFrontier Markets



FinGyaan

Frontier markets are far moresecured due to the fact that

leveraging and lending eitherdoes not exist or is very muchrestricted due to the economic

reality.

there is more than a mere chance that productionhouse will be shifting to subsets of emerging econo-my, i.e. frontier markets, for low cost.

The second investment rationale for frontiermarkets is based on the strong returns enjoyed bythese markets over recent years. Frontier marketshave consistently outperformed both emerging anddeveloped markets since 1995. In particular, returnshave been extremely strong over the past four years,coinciding with the strong growth in size and liquid-ity of these markets over that time.

Another reason to consider investing in fron-tier market is that China has been the growth en-gine of the worldfor approximatelypast two decades,and hence wealthis also growing. Dueto increased accessto money and mon-etary lobbying cloutChinese governmentwill not be able tocrack down on peo-ple against govern-ment practices andhence wages willrise. Already work-ers have started to

work out better working hours, benefits etc. Hencein future there is more than a mere chance that pro-duction house will be shifting to subsets of emerg-ing economy, frontier markets for low cost.

Secondly, in frontier markets sensitivity to li-quidity issues is far less. In developed and emerg-ing economies debt explosion was felt which causedhavoc. But frontier markets are far more secureddue to the fact that leveraging and lending eitherdoes not exist or is very much restricted due to theeconomic reality.

Next point to ponder upon is accessibility. In-vesting in frontier markets has become increasinglyfeasible for the foreign investors and hence lumpsum amount of money can be invested now. Thereare several factors that determine if a market is ac-cessible, including if it has low foreign investmentrestrictions, allows for easy capital entry and exit,does not have pernicious tax levels and has ample

liquidity. There are eleven markets for which lo-cal listings are eligible for inclusion in the S&P NewFrontiers Index - Bahrain, Bulgaria, Colombia, Croa-tia, Jordan, Oman, Pakistan, Romania, Sri Lanka, theU.A.E. and Vietnam. These markets tend to havefew hurdles for foreign investors. All these countriesexcept Vietnam have relatively easy entry.

Risks and Returns

Now think of you as an investor- what do yousee when analyzing a fund? Risks and returns. Nowtake a look at this, the MSCI Barra Frontier Marketsindex which tracks equities of 25 countries, includingsix from the Middle East(accounting for 55% of the

indexs total marketcapitalization),year-to-date as of June21, the Frontier Mar-

kets index was up13.89% comparedwith a 4.19% gainby the BRIC coun-tries (Brazil, India,China, and Russia)in aggregate and a5.17% increase forthe emerging mar-kets overall.Whilemost of the worldindices are still re-

covering from recession and are trading below 2007levels, a handful has bucked the trend, six in num-ber, to be precise.To everyones surprise Tunisia hasbeen the best per forming stock market since 2007.Reason is simple- low correlation with world mar-kets.The Tunindex, a 12-year-old index of 45 stocks,is trading 80% above its high for that year, and is up16% for 2010. Sri Lanka is up 52% since 2007 and 38%this year. So is there any match for these returns?

The major reason for the growth in the frontiermarket is due to the GDP growth forecasts whichare around 3.5% in frontier market stocks comparedto 1.5% in more developed emerging economies.Further in terms of valuation frontier markets aretrading at 10 times the projected income for 2010 inMSCI frontier market index compared to emergingmarket, which is trading at 16 times the expectedearnings for 2010. Seeing the rally of gains spread byemerging markets in 2009, it is quite possible that


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FinGyaan


One of the pointers where an investor needs to be careful when investing is to see that he/she does notgo heavy on oil or gold; secondly, sensitivity of the fund to oil uctuation; thirdly the countrys break

down of the ETF and nally non-diversied fund status.

frontier markets which are still cheap compared todeveloped cousins will be benefited as the liquidityspreads. Of all the indices that make up MSCI fron-tier index Africa lead the way with year to date asof 21st June with gains of 24.9% compared to LatinAmerica with gains around 10.3%, 8% for central Eu-rope while nearly 5.9% for Asian index.

Currently Nigeria is the most attractive frontiermarket. Nigerian index is already up by around 34%this year. Oil rich Nigeria is projected to have growthrate of nearly 6.5%, its stocks are trading at 9times the expected earnings of 2010.Further as soon as wehere middleeast , thefirst thingto strike usis oil but the

funds concern-ing frontier mar-kets are ratherinvesting in compa-nies related to infra-structure , telecom andother such sectors otherthan oil and gold. Argen-tina is another hope forthe frontier market investorswhich itself is growing fast

and may again get back statusof emerging economy which wastaken back from it last year, so thetime is ripe to invest.

One of the pointers where an investor needsto be careful when investing is to see that he/shedoes not go heavy on oil or gold; secondly, sensitiv-ity of the fund to oil fluctuation; thirdly the countrysbreak down of the ETF and finally non-diversifiedfund status.

Drawbacks

While there are many arguments which arecompelling enough to force you into investing infrontier markets but still some drawbacks are there.Firstly, more than emerging markets, frontier mar-kets are more exposed to the political and macro-economic risks. Secondly, investing in the frontiermarkets fall in the domain of thematic investing, so

once the investor sentiments changes, investmentthemes are subjected to very high risk of sharp cor-rections. Further, economic growth may take longterm to reflect in the returns so it is necessary forthe investors to invest only that money for whichthey want return in the long run.

It would be naive for someone now to say thatthese funds wont succeed over the long term. Forexample ING Russias 10-year annualized return of

20.4% (through June 24), which trounc-es the MSCI EAFE Indexs 0.5% returnover that period and the diversi-fied emerging-markets categoryaverage of 9.9%, indicates thatinvesting in a costly fund thattargets a once-obscure mar-

ket wracked with politicalrisk could, in fact, pay off.

However, wheth-er an investor should

take the plunge intoa frontier-marketsfund, rather thansimply relying ona well-construct-ed portfolio ofproven, low-er-cost funds

with long-tenured man-

agers, is another question. Needlessto say, it takes not only hope, and in many

cases a blind eye to expenses, to believe in the pros-pects for these funds, but to benefit youd also needthe fortitude to hang on during some scary head-lines and nasty declines.

Conclusion

To conclude, broaden your horizon becauseit wont be long before India and similar emergingeconomies will also start giving returns like that of

USA and other developed nations, so try and cashonto the opportunities available in other markets,before it is too late or returns get dried up.



Perspective

There are many transactionswhich cannot be disclosed inthe balance sheet or even ifthey can be, then they can-

not be put down in monetaryterms.

This article gives a

detailed analysis of

all the factors that

need to be taken

care of so that the

corporate world can

be made more ethi-

cal and responsible

for its stakeholders.The government

should take these

new challenges into

consideration and

frame its policies ac-

cordingly.

SIBM PuneAnkit Gupta

GOVERNANCE CHALLENGESIN INDIAN BUSINESS ENTERPRISES

Governance concept is ap-plicable to all entities not limited

to business enterprises. Corporate

Governance is defined by many in

different ways. The essential pillars

include disclosures; fair, equitable

and transparent to stakeholders;

commitment to values and ethical

business framework, etc. In short it

is the key for economic and social

transformation.

Liberalisation, competition,

corruption, bankruptcies & cor-

porate scams like those of Enron,

WorldCom, Satyam, etc have brought

Corporate Governance into limelight.

In India, the concept is not new and

has been there since Ram Rajya.

Some of the latest developments

include KM Birla Committee 1999,

N Murthy Committee 2003, Amend-

ments in Clause 49 Dec2005, & Vol-

untary Guidelines issued by Ministry

of Corporate Affairs 2009.

All these events have made

stakeholders realize the importance

and urgency of good corporate gov-

ernance. People are concerned how

companies are being managed; after

all it is the public money which is at

stake in most of these companies.

Good corporate governance

makes for good business sense. It

increases the confidence of share-

holders in the company. This leads

to better stock prices. Research by A

Hasan, (2009) has shown that good

corporate governance brings down

the cost of capital for the company.Good disclosure practices lead to a

more liquid market for the compa-

ny. This lowers cost of debt for the

company. Thus for CEOs of today, it

has become quite essential to com-

ply with principles of good corporate

governance.

MAJOR CHALLENGES

Unlisted Corporate Not Covered

One of the major problems

with respect to applicability of regu-

lations & recommendations are that

they are restricted to listed entities

only. This makes small & mid size

companies to perform those activi-

ties which may be legal but are not

ethical.

Disclosure of Off Balance Sheet

TransactionsThere are many transactions

which cannot be disclosed in the

balance sheet or even if they can

be, then they cannot be put down in

monetary terms.

For instance by creating Special

Purpose Entities, companies transfer

financial assets involving transac-

tions that have off Balance Sheet im-

plications. Keeping certain financialassets off the balance sheet firms

can increase their liquidity and also

can obtain low-cost funding. As the

Accounting Standards AS-30, AS-31

and AS-32, relating to measurement

and disclosures of financial instru-

ments, are waiting to be mandatory,


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firms can easily structure transactions using Special

Purpose Entities.

Also some information like exposure to sub-

prime securities exact value cannot be ascertained.

It can just be indicated, but then again then it is just

indicative & not exact information.

Family Owned Enterprises

In India, majority of business enterprises are

family owned. Though it has advantages for family

members, it also has some limita- tions with re-

spect to minority shareholders.

First of all, there is mini-

mum or no dilution of power.

Ranging from Director to em-

ployees, one can notice the

presence of family mem-bers in all significant posi-

tions.

Secondly, quite

often, especially dur-

ing the early, start-up

stages of the fam-

ily business, the

company and fam-

ily relationships are not clearly

distinguished. This is particularly true withrespect to financial relations and accounts the

companys and familys assets are not legally sepa-

rated. This causes problems in distinguishing com-

pany-owned assets, and how company owned as-

sets can be used by the family as a shareholder.

Multiplicity of Regulations

In India, there are many regulatory bodies like

Companys Act 1956, Securities Exchange Board of

India (SEBI), Reserve Bank of India (RBI), Insurance

Regulatory Development Authority (IRDA), etc. Themain problem with all of them is that there is lack of

co-ordination or there is over regulation (E.g. SEBI &

IRDA dispute). Many a times there are two or more

treatments for a similar event/transaction. This du-

plicity gives companies opportunity to run away

from their mistakes & responsibilities.

Corporate Social Responsibility & Sustainability

Reporting

Triple Bottom Line is gaining importance butstill because of its Voluntary status, companies are

not adopting it. Many companies especially small &

mid sized ones cannot afford to do CSR from their

minute profits. But the main problem is not manda-

tory regulation, but the ethical aspects of activity;

which is difficult to report.

For example, a cigarette manufacturing com-

pany like ITC may carry out its social tasks through

e-Choupal but it is nothing if compared to the harm

caused by its core product, cigarette.

Commitment At All Levels

In a recent Supreme Court order, in case of the

bounce on cheque, Managing Director of a company

has to be held responsible. To a certain extent it is

justified but it should not be limited to Managing

Director. Each and every employee must be

made aware of his duties & held

responsible for the

said task. After

all it is not a one

man army.

Subjectivity

It is critical for

any company that the

people they recruit be-

lieve in the companys

values and imbibe those

values. Ideally, the in-

terview process should

be used to judge the can-d i - dates emphasis on values,

integrity, sincerity and transparency. But unfor-

tunately in Asian countries, nepotism plays crucial

role in recruitment. In majority cases the selection

of a candidate for a job is on the basis of reference

instead of his past performance & values.

Challenge of Existing Practices

Some existing practices of corporate gover-

nance are faulty in themselves. Some of the com-mon loopholes in the existing practices include:

a. Failure by Board of Directors to understand the

risk their firm is taking.

b. Conflict of interest and lack of independent (in-

dependently minded) Board members or senior ex-

ecutives.

c. Corporate culture which does not encourage to

raise questions

d. Problems in Whistle blowing Whistleblowers

may often be wrong in their accusations and theirmotives are not always pure. Their actions can dis-

rupt a workplace, and may cause serious harm to

individuals wrongly accused.



Perspective

There is no doubt that Cor-porate Governance, if imple-mented properly, has immensebenets for all stakeholders.

Impediments Due to Sectoral Nature

This can be explained with an example of pub-

lic sector, in which many countries are underper-

forming (Especially airlines-Air India, British Airlines,

China Air, etc). Of course its due to poor governance,

some of which include:

a. Political interference in the working man-agement & many a times in Board.

b. Government as a shareholder have different

risk, return appetite which are not same as retail or

institutional investors.

c. Last mentioned but most felt reason is cor-

ruption (Red Tapism).

Dependence on Indepen-

dent Directors

This has much to do withthe choice of directors and the

skills that they bring to the

board; the quality and quan-

tity of financial, operational

and strategic information sup-

plied by the management to

the board; managements ap-

petite for independent evalua-

tion and criticism of strategies

and performance. It dependson the extent to which pro-

moters and management truly want healthy debate

and independent oversight and of course, how much

a company is willing to pay for the experience and

skill sets of professional independent directors.

Independent directors should maintain objec-

tivity and stand firm on some issues, although it is

a difficult task. They should also have the will and

courage to say no when things are not moving in the

interest of the company and its stakeholders.CONCLUSION

There is no doubt that Corporate Governance, if

implemented properly, has immense benefits for all

stakeholders, majorly shareholders, management,

employees, customers, and community at large.

Some of the ways which might help to over-

come the challenges of governance in business en-

terprises are:

1) Compliance costs which in the initial phase

seem to be huge, can prove to be investment in long

run if appropriated at right time & suitable place. For

example online AGM voting.

2) Corporate Governance extends beyond cor-porate laws. Its objective is not mere fulfillment of

legal requirements but ensuring commitment on

managing transparency for maximizing shareholder

values.

3) Directors should have integrity and indepen-

dence of thought; the courage

to express their independent

thought; a grasp of the reali-

ties of business operations;

an understanding of thechanges taking place region-

ally, nationally and interna-

tionally; and an understand-

ing of business and financial

language.

4) Many a time pro-

moters play with investors

money, gain from market &

disappear from country. Reg-

ulators vigilance should bemade stricter and if anyone is

found guilty, he/she must be punished.

Quality of governance depends upon compe-

tence and integrity of Directors, who have to dili-

gently oversee the management while adhering to

impeachable ethical standards. Strengthened sys-

tems and enhanced transparency can only further

the ability. Implementing Corporate Governance

structures are Important but instilling the right cul-

ture work culture is the Most Essential. After all,well defined governance is just Artificial Legal En-

tity.


24/264 NIVESHAK VOLUME 3 ISSUE 7 JUly 2010

FinLounge

1. Identify this famous personality (Hint: Turf war over ULIPs)

2. What does ARM stand for in financial parlance?

3. Established on May 15, 1878, it is the second largest stock exchange in the world by

aggregate market capitalization of its listed companies, second only to the NYSE. Name

it.

4. Aditya Birla Minacs recently acquired a UK based financial services provider in March

in order to reach its target turnover of $1 billion. Name the company.

5. What is the deadline set by the Union Finance Ministry for the implementation of

GST?

6. Both Sharpe Ratio and Treynor Ratio give a measure of risk-adjusted return. What is

the difference between them?

7. An investor had originally purchased shares of XYZ for $27. Subsequently, she writes

a call for a premium of 1.50. If, during the expiry date, XYZ shares are trading at $32

and the investor still manages to break even on her strategy, what must have been the

exercise price on the calls involved?

8. Which was the last company to be added to the Dow Jones Industrial Average?

9. Two growing firms are identical except that firm A capitalizes whereas Firm B

expenses costs for long-lived resources over time. For these two firms, how is firm As

CFO and CFI affected as compared to firm B?

F I N Q

All entries should be mailed at [email protected] by 10th August 2010 23:59 hoursOne lucky winner will receive cash prize of Rs. 500/--


25/26

A N N O U N C E M E N T SARTICLE OF THE MONTHThe article of the month winner for July 2010 is

Ankit Nagar

of Schlumberger

He receives a cash prize of Rs.1000/-

FinQ WinnerThe FinQ Winner for the month June 2010 is

Akshay Suhag

of IIM Indore

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

ARTICLES INVITED

FOR ANNIVERSERY ISSUEEvery financial catastrophe has contributed to a better, stronger and a moreresilient financial system. As Niveshak trots into its third year of existence, wecelebrate the world of finance with all its failures and their learnings !! We are

inviting article on Milestones that shaped the world of Finance for the Anniver-sary edition of Niveshak. You can choose from one of the topics below.

The black Tuesday,The years of hyperinflationAcceptance of currency boardsThe broken Gold standard,Asian financial crisisThe lost decade,The collapse of Lehman brothers

You can also send articles on any topic of your choice.Win cash prizes worth Rs 10,000.Instructions Please submit your article with the file name and the email subject as __ by 10 August 2010. Article must be sent in Microsoft Word Document (doc/docx), Font: Times New

Roman, Font Size: 12, Line spacing: 1.5 to [email protected] 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

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