Niveshak September 2009

8/14/2019 Niveshak September 2009

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FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 1

CoverS

tory

AoM

Perspective

FinGyaan

FinSight

Build america bonds PG. 22 spread betting and cricket pg. 06

THE INVESTOR VOLUME 2 ISSUE 8 September 2009

Is It A Real Concern?


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 II

ISSUE 8

September 2009

Faculty Mentor

Prof. S.S Sarkar

Editor

Biswadeep Parida

Sub-Editors

Amit Choudhary

Nilesh Bhaiya

Sareet Mishra

Sujal Kumar

FinToonistDilpreet S. Gandhi

Saurav K. Bagchi

Design Team

Bhavya Aggarwal

Sarvesh Chowdhury

Swarnabha Mukherjee

Tripurari Prasad

All images, design and

artwork are copyright of

IIM Shillong Finance Club

Finance Club

Indian Institute

of Management, Shillong

www.iims-niveshak.com

Dear Readers,

The global financial system is reminiscing the fall of Lehman Brothers, the

event of September 15, 2008, that shook the world economy and sparked theworst financial crisis in generations. A year after, world is slowly but surely com-

ing out of its tremor. The markets across the globe are continuously scaling new

heights every week, backed with strong fundamentals from all the sectors. Hence

with some level of confidence we can say the financial systems around the world

have stabilized and the economy recovery is on its way. Whether this has been

possible due to the resilience of economies and financial markets or the prudence

of policymakers who responded to the crisis with massive macroeconomic stimulus

and other measures to prop up their domestic financial system is already a burning

topic of discussion.

The Asian and European market is on upward trend which has been termed

as Cautiously Bullish, is now waiting for the second quarter results of the corpo-

rate. The market sentiments and expectation across the globe has been positive for

last three months, with almost all markets giving positive returns. The revival of US

market and numerous signs recovery like positive home sales for the first time since

2007 and the growing of order book of manufacturing sectors have brought some

cheers to the Wall Street. But the glaring fact which needs to be pointed is that the

world is still looking up to US to pull the global economy from the crisis. China on

the other hand is showing signs of recovering from the present crisis with the fund-

ing from government and bank lending. Today, China is one of the fastest growing

economy of the world. We have covered this question whether China is the next

economic superpower of the world and will overtake US is highlighted in this issue.

Indias GDP growth for the first quarter of 2009 stood at 6.1%. This exceeds

the consensus estimates and an improvement from the last quarter growth whichwas 5.8%. Hence given the global downturn these figures have brought some

cheers to the investors in the Dalal Street and also to the policymakers of the coun-

try. But the fiscal deficit at 6.8% of GDP is hot topic of discussion among policymak-

ers and economist. Its not that only India is facing its worst fiscal deficit in past

decade, most of the countries across the globe are facing the problem of huge

fiscal deficit. US fiscal deficit stood 12.3% of its GDP. Our cover story is in line with

these issues and gives a perspective whether to worry about fiscal deficit and what

implication it will have on the recovery from the current crisis.

We have also covered the topic of rising prices and falling inflation which

have been making news every week. The basic of inflation calculation in India and

the comparison of CPI and WPI method have been outlined. This issue also features

the prospects of credit default swaps in India. An inside look into the Build America

bonds have also been covered in this issue.

I am glad to mention that this is the beginning of second year of Niveshak

journey and would thank all our well wishers for their support for making the An-

niversary issue a huge success. We will constantly try to scale new heights. Now in

the outset of the recovery of the world economy its even more important to track

the global cues and be informed. Economists and experts across the global have

already stated that it may be V or W or even square root shape recovery. So its

the time to keep a watch on the Bull and Bear fight in the global market and sup-

port the Bull to win the race. In the last we would like to thank Mr. Geert Linnebank,

ex- Editor in Chief of the Reuters group for inaugurating our anniversary issue on

24th August.Stay Invested for the good times ahead.

Biswadeep Parida

(Editor-Niveshak)

THE TEAM


3/26

Niveshak Times

04The Month That Was

C O N T E N T S

PERSPECTIVE06 Spread Betting And Cricket

08 Is China The New America?

3 2 Cover StoryFiscal Decit: is it a real

concern?

finsight

22 Build America Bonds

fingyaan14Rising Prices And Infation:The Illusion

article of the month

18 Credit Deault Swap: InIndia???

finlounge

17FinToon

24Fin-Q


4/26NIVESHAK VOLUME 2 ISSUE 8 September 2009

Market Watch

Stock markets across the globe hit multi-monthhighs last week (September 7 - 11). In India, the

benchmark indices Sensex and Nifty extended theirgains to a sixth straight session last Friday and closedat 15-month highs. It was an interesting week to saythe least. Monday, the markets opened with a gap

lower, and there was a sharp follow-through loweron Tuesday. Once again the markets threatened tobegin a larger correction, but by the end of the week

they had regained the majority of their losses. Theend result was a fairly balanced last month (17 Au-gust - 11 September).

The news on the monsoon front turned out tobe somewhat encouraging and FIIs, for their part, re-mained bullish and kept buying stocks almost right

through the week. The past one month saw the mar-ket slip below 15000 mark due to monsoon worriesand global concerns about the economic recovery.The first week, both Sensex and NSE Nifty closed

with a loss of 1%. The next week saw the markets

gaining steadily by adding around 4.5% on both theindices. The third week began with a negative note

but rise in vehicle sales led to the auto market up-surge. The weekend of the third week saw an in-crease of 1.46% in Sensex and 1.1% rise in Nifty. Theindices moved in almost the same trading band as

that in the preceding week.

Jets Mayhem

Jet Airways had last month terminated the ser-

vices of two of its senior-most pilots, saying theirservices were not required. Later the two pilots,

along with others, formed a trade pilots union bodyin the company, National Aviators Guild (NAG), andheld a strike to protest their dismissal. The unionhas termed the sacking an act of vendetta and de-

manded their reinstatement. The deadlock betweenthe two sides was resolved after hours of talks inMumbai on Saturday, 12 September.

The five-day strike by hundreds of pilots ofJet Airways ended late on Saturday night with the

private airline agreeing to unconditionally take backfour pilots it had sacked for forming a trade unionand the pilots agreeing to resume flying at the earli-est. The rapprochement means most Jet flights will

begin to operate normally from 13 September, end-

ing one of the worst airline disruptions in the coun-try in recent years.

Proposed Models of Dual GST

Budget 2009-10 has indicated that there will bedual GST - a Central GST and a state GST. There aretwo ways of making it - one advocated by Finance

Commission and one by the Empowered Committee.

One Model envisions Central GST as an incorpo-ration of Central Excise, additional excise duties, ser-vice tax and all cess and surcharges. Whereas, thestate GST will combine VAT and various other service

taxes as well as all state cess and surcharges.

Second Model combines Central Excise (alongwith additional excise duty, etc.), service tax, salestax (VAT) and all other state taxes together andmakes a common base. Thereafter a certain percent-

age say is charged by the Centre and some part bythe states.

Alarming New MAT Provisions

It comes as a shock for over 250 companies asthe government announces the new MAT provision.Large, capital-intensive companies in infrastructure,

oil and gas, telecom, pharmaceuticals, real estateetc. will have to pay over Rs. 11,500 crore as ad-ditional tax in 2010-11 if the government enacts theproposed Direct Taxes Code in its present form.

In a big blow for such firms, the draft code

says companies will have to pay the higher of a 25per cent corporation tax and a minimum alternatetax (MAT) of 2 per cent on their gross assets. Second,the basis for computing MAT has changed from book

profits (15 per cent of the book profits at present)to gross assets. Third, MAT will have to be paid ineven loss-making years, with no set-off against fu-ture profits. MAT is being sought as an additional

burden, which would make sustainability difficult,especially in recessionary periods.

NTPC and DVC Gets Approval

To aim at the power shortage in the countrythe government has approved an order of Rs. 40,000

Niveshak Times

The MonTh ThaT Was


IIM, Shillong

Tanvi Arora


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

crore for power equipment for the upcoming thermal

power plants of NTPC and Damodar Valley Corpora-tion. The proposals were made for induction of su-percritical technology through bulk ordering for 11units of 660 MW each by NTPC and DVC. After the

governments approval, power producer NTPC plansto float tenders for procuring the equipment forthese 11 units within 45 days.

RBI Surplus Shoots by Rs. 10,000 crore

The Reserve Bank of Indias (RBIs) transfer-able surplus to the Government of India for 2008-09

jumped 66.6 per cent to Rs. 25,009 crore from Rs.15,011 crore in the previous year. This is primarilydue to the domestic investments on account of anincrease in Interest on Domestic Securities and LAF

operations and Interest on Loans and Advances.The surplus thus included Rs. 1,436 crore towardsthe interest differential on special securities convert-ed into marketable securities for compensating the

government for the difference in interest expendi-ture, which the government had to bear consequenton conversion of such special securities.

TATA - Different Strokes

Auto major Tata Motors today reported Rs. 329crore consolidated net loss for the first quarter of

this fiscal as compared to a net profit of Rs. 719.69crore in the same quarter last fiscal. Although themanagement at Tata Motors says that the results

are not comparable with the previous fiscal as theresults for the quarter ended June 30, 2009 includethe operations of JLR businesses, acquired on June 2.

In the same week, Tata Power Company said itsconsolidated net profit jumped nearly three-fold toRs. 572.65 crore in the first quarter ended June 30,

2009. Total income rose to Rs. 4,713.16 crore for thequarter ended June, against Rs. 4,069.34 crore in thesame quarter corresponding year.

Hyundai Mobis Wins Order from ChryslerHyundai Mobis Co, in South Korea, has won a

$2 billion order from Chrysler for chassis modules to

be used for Jeep Grand Cherokee and Dodge Duran-go models. Mobis plans to begin pilot production of

the front- and rear-chassis modules at new facilitiesfrom February. The facilities will be built adjacent tothe Chrysler plant. They had been supplying Chrys-

ler with chassis modules since 2006. This had sendHyundais shares up by more than 7 percent againsta decline of 0.5% in the wider market.

IOC Revamps

Government-owned Indian Oil Corporation

(IOC) strategize to invest around Rs. 60,000 crore incapacity-building in next five years and in turn, isaspiring to have 15 per cent of its revenue from pet-rochemicals in the next three years.

There are various expansion plans in each re-spective sector. A new plant worth Rs. 14,000 crore

is under construction at Panipat for propylene. Also,they intend to convert Paradip plant into a petro-chemical complex. The company is also eyeing ac-

quisitions of oil producing assets in Africa and SouthEast Asia. The company also signs a joint venturewith NPCIL with the aim of entering energy sector.The IOC also plans to expand its retail sector by add-

ing 200 outlets each year.

Idea Demerges from Passive Infra

Idea Cellular telecom operator got an approval

from Gujarat high court for demerging its passive in-frastructure to its wholly-owned subsidiary Idea Cel-lular Towers Infrastructure. Also, the company looks

forward to its financial restructuring to adjust theamount of non-compete fee paid to the erstwhilepromoters of Spice communications pending fromthe acquisition deal between the 2 companies. Thisnews affected the shares of Idea cellular as it moved

up by 0.80 percent whereas, Spice com shares raisedby 17.5 percent.

Niveshak Times

The MonTh ThaT Was




p

IIM ShillongMOHIT KHEMKA

Spread Betting & Cr icket

Spread Betting as a FinancialInstrument:

Spread betting refers to a typeof speculation that involves takinga bet on the price movement of asecurity. A spread betting companyquotes two prices, the bid and offerprice (also called the spread), andinvestors bet whether the price ofthe underlying stock will be lowerthan the bid or higher than the of-fer. The investor does not own theunderlying stock in spread betting,they simply speculate on the pricemovement of the stock. Financialspread betting is a leveraged toolthat gives investors the opportunityto trade the financial markets with-out ever taking physical ownershipof the underlying instrument.

For Example: A Betting companyquotes the bid price of a stock as Rs.500 and the offer price as Rs. 505.

If the investor feels that the priceof the stock will move up above Rs.505, he can gamble and bet Rs. 10on every rupee above Rs. 505 in aparticular time frame. Suppose theprice goes up to Rs. 520, the inves-tor gains 15 x 10 = Rs. 150 as theprofit; on the other hand, if the pricegoes down to Rs. Rs. 495, the inves-tor loses 10 x 10 = Rs. 100.

Many people think that finan-cial spread betting is too risky. Sub-

consciously, they feel that invest-ing in shares is ethically acceptablewhereas betting has down marketconnotations and morally reprehen-sible. That is a pity, because thetruth is quite different. You buy ashare because you believe that theprice will rise and you will make aprofit. You bet on a share price forexactly the same reason. The onlypractical difference between buyinga share and betting on the move-

ment of the share price is that youneed much more ready cash to buythe share. The costs of buying ashare are much greater than placinga bet.

There are many attractions at-tached to financial spread betting.One of the key advantages of spreadbetting is Leverage. Very littlecapital is needed although a lot ofmoney can be made from bettingsuccessfully. One can trade with alot more than the deposit amount.So with Rs. 20,000 as deposit, an ex-posure to nearly Rs. 200,000 can beobtained if required.

Spread Betting in Sports...In UK, Spread betting is legal

and regulated by the Financial Ser-vices Authority. In the United King-dom spread betting has come to re-semble the futures market. It is sopopular among the investors that ithas spread to Sports betting too. Thebets are usually on the outcome ofsporting events or indeed on finan-cial instruments, but the firms oftenoffer bets on more arbitrary events

- such as the number of cornersduring a football match or the totalnumber of points a team will get ina Football league.

Unlike fixed odds betting theamount won or lost can be verylarge, as there is no single stake tolimit the maximum losses. However,it is usually possible to place a stoploss with the bookmaker, automati-cally closing your bet if the valueof the spread moves against you

by a specified amount. Stop winsare the opposite -- closing your betwhen the spread moves in your fa-vour by a specified amount.

Consider this example: In a 50overs cricket match between Indiaand Australia, assume the spreadfor runs scored in 1st innings is 200-250, the betting firm believes therewill be 200 to 250 runs scored in to-tal during the 1st innings. A bettor

approaches the firm with the beliefthat there will be more than 250 runsscored by the team that plays first,the bettor buys at Rs. 100 a run at250. If the final total of the 1st team

...What A Combination



Perspective

The ghost of match-xing

started haunting the WorldCricket community in a bigway after the famous India-South Africa series in 2000

is 275, the bettor has won, receiving (275-250) x 100= Rs. 2500. If the final total turns out to be 200, thebettor loses (250-200) x 100 = Rs. 5000.

A sell transaction is similar except that it ismade against the bottom value of the spread. Forexample: a bettor sells at Rs. 50 per run at 200runs. If the team scores 250, the bettor loses 50 x 50

= Rs. 2500. Often there is live pricing, which changesthe spread during the course of an event allowing aprofit to be increased or a loss minimized.

The use of a point spread evens out themarket towards an equal number of participants oneach side of the spread. This allows a bookmakerto make a market by accepting bets on both sidesof the spread. The bookmaker charges a commis-sion and acts as the counter party for each partici-pant. As long as the size of wagers on each side isroughly equal, the bookmaker is unconcerned withthe actual outcome; profits instead come from thecommissions.

Cricket Betting in India... Must be legalized!

In cricket, one can bet on the outcome of thematch (win, loss or draw/tie), the toss, top scorer inthe match or each team, top bowler in the match oreach team; batting order, the manner of the dismiss-al of a batsman, total innings score, runs that willbe conceded in the next over (odd, even, or more orless than the previous over) and so on.

Since, huge amounts are at stake in betting,

the bookies, especially the ones who operate ille-gally, may sometimes approach players or officialsconcerned to fix the outcome of what is bettedon. Fixing the outcome of a match involves a vastnetwork of connections. On-field actions, such as,which bowler would open the attack, the manner ofdismissal and runs conceded in a certain over, canbe easily fixed by the players or officials involved.

The ghost of match-fixing started haunting theWorld Cricket community in a big way after the fa-mous India-South Africa series in 2000. The lid of thegames biggest scandal ever was blown off, when

former South African captain Hansie Cronje & thethen Indian skipper Md. Azharuddin were exposedin an embarrassing manner.

Since then there have been numerous effortsby the International Cricket Council & the Cricketboards of respective countries to find a solutionto such corrupt practices. But the efforts have notyielded any substantial results as yet. As it is rightly

said that Prevention is better than cure, the onlysolution that remains feasible to prevent this ghostfrom ruining the game is to legalize its existence!

Now, who stands to benefit if this happens? Itis estimated that about US$ 2 billion rides illegallyon every international cricket match that is playedin India. India has emerged as the financial capital

of the Cricket world. Any kind of cricket betting iscurrently a criminal offence as per the laws of thisland. It is high time that the Indian Government gaveup its ostrich-like approach to betting and openedits eyed to the stark realities. If this activity is legal-ized, the amount of money that will be at stake isjust unimaginable.

Legalizing Sports betting has got many advan-tages. Firstly, it would help to remove any kind ofunfair results in a match. If matches can be legallybetted upon, curtailing match-fixing will not be adifficult thing to do for the cricket authorities andregulators. The whole betting activity would thenbecome more transparent. Match-fixing could bedetected in cases when the betting odds are abnor-mally lop-sided.

Secondly, If Sports betting in India (Cricket inparticular) is legalized and regulated by the Govern-ment through instruments like Spread Betting, thepotential revenue for the Government from enter-tainment and other forms of Taxes is going to bemagnificent. Earning thousands of crores just fromCricket betting would not be impossible for Indian

Government.And it is not incorrect to legalize an activity in

such a way that it is a Win-Win situation for all thestakeholders involved the Government, the play-ers, the Cricket Boards, the spectators and most im-portantly, the future of the great game itself!

IPL can be taken up as Pilot project:

The celebrated Indian Premiere League hassuccessfully corporatized cricket in India. There isinvolvement of large number of Business housesin IPL, which means that it is serious business for

them. The Indian Government in conjunction withBCCI can think of legalizing betting in India by takingup IPL as a pilot project to see if the potential ben-efits can actually be materialized. It is high time thatthe Government initiates measures to regulate thiscurrently illegal activity, and seizes the opportunitiesthat galore in legalized betting!



p

The question that

remains to be an-

swered is, WillChina be able to

do its job of eco-

nomic superpower

as well as America

did? Is China actu-

ally becoming the

new America? Does

it actually have all

that is required tobecome the most

powerful country of

the world?

History often has a way of sur-prising us and repeating itself, put-ting us back in the same situationsas were there years ago, again not

leaving us prepared to expect them.Roles are reversed and players havechanged so fast that countries arenot able to properly play their part.

The situation after the WorldWars is very similar to the situationof the world economy now. Britain,exhausted after the world wars,paved the way for United States;which then emerged as the econom-ic superpower of the world. U.S. was

the net creditor of the world, thusthe leadership was easy to passfrom the Debtor Economy (U.K.) tothe Creditor Economy (U.S.). Thesame situation exists now exceptthat the exhausted debtor economyrole is being played by U.S. now andChina has emerged as the creditoreconomy sitting on reserves worthalmost 2 trillion dollars. China hasthe same power that U.S. had at

that time. Applying the same histori-cal principles of the period after theWorld wars, China would become thenew U.S., inspired with the drive tomanufacture more and more, be-coming richer and richer, growinglike crazy to overthrow the currentreigning superpower.

Post the economic reforms in1979 till now, Chinas GDP has beengrowing at a rate of around 10% per

annum. The Chinese economy hasgrown 14 fold in real terms and itsreal GDP has also grown more than10 folds. China has also transformed

into a major trading power. Chineseexports rose from $14 billion in 1979to $1,429 billion in 2008, while im-ports over this period grew from $16

billion to $1,132 billion. However, to-wards the later part of 2008, Chinatoo suffered some ripple down ef-fects from the financial crisis andthere was a reduction in demand forits products.

China is producing many ITgraduates year after year. Manyeconomists say that the new IT hubwill move to China and that its nota question of if this will happen

but when will it happen. Historyproves that authoritarian regimesyield high growth rates. This hashappened in the case of Germanyin 1930s, Soviet Union in the 1950sand now China in the 1990s.

At this moment, China is one ofthe fastest growing economies of theworld. Being in such a situation, itwas expected from China that Chinashould come and save the rest of

the world from drowning in the fi-nancial turmoil created. China, in itsdefence, did try to rescue the restof the world. In the initial stage ofthe financial crisis, sovereign wealthfunds from many countries espe-cially China were pumped into Eu-ropean and American institutions.After pumping a lot of money Chinarealised that the great deal of uncer-tainty in the world economy might

make it lose millions, the risk whichChina was not prepared to take.

China, though it has the finan-cial backing to become the new US,

Kanika NayarNMIMS, Mumbai

is china.. .

. . .the new america?



Perspective

Will the Yuan be able to save

the rest of the world fromdrowning in the mounting US

debt? Will the Yuan be thenew Dollar for us?

is still in nascent stages in some parts of its econo-my. The Chinese banking system, its aging problem,growing pollution, over reliance on exports, are justa few factors hindering the growth of China as thenew superpower. China has a large treasure chestbut lacks in a well developed financial system. It stillhas many people living below the poverty line, with

wide income inequalities.

The Chinese currency, Yuan, is in a strong posi-tion to become the global currency of the world andtake the weakening dollar off the shelves.

China holds 2 trillion dollars in assets, accu-mulated over a number of years. If dollar goes onweakening and America is not able to reduce themountain of its debt, the big losers from this wouldbe China.

The world was sceptical whether Yuan would

be made a convertible currency with its prices de-termined freely by the market. This would requireChina to reduce trade barriers and regulations whichthe world was sure that China would never agreeto do. However, recently China has made big stepstowards making Yuan freely convertible with othercurrencies, declaring open war to the U.S. that itscurrency is ready to be the reserve currency of theworld. Though, China has not openly declared thatits currency is ready to be the reserve currency of theworld, they believe that it may be time for someone

to step in and replace the dollar. There are thoughsome road blocks stopping Yuan and thus providinga safe haven for dollar despite its continuous weak-ening. Absence of a derivative market for Yuan, ab-sence of large market for Yuan denominated bonds,issues with encouraging banks to hold large sums ofYuan, are some of those hurdles.

In the past few months China has signed cur-rency swap agreements worth more than 95 milliondollars with Argentina, Malaysia, South Korea, Indo-nesia and many other nations who are happy to be

as far away from the shaky dollar as possible.In April, China announced that the Yuan can

be used in overseas trade settlement in five cities- Shanghai, Guangzhou, Shenzhen, Zhuhai and Dong-guan. China has also signed an MOA with neighbour-ing countries and Latin American countries as a firststep of making the Yuan freely convertible.

Chinese trade surplus in 2007 was 130 billionpounds and is continuing to increase steadily. It

is being said by many finance experts all over theworld that the label Made in China will soon be re-placed by Owned by China. China also surpassedAmerica as the greatest driver of global economicdemand. China has slowly become an importantinternational player and is the league for the nextsuperpower though all are not sure whether it was

Chinas primary intention to do so.

In 2008, while the rest of the world was suf-fering because of the recessionary conditions, Chinawas not. It was preparing itself for the 20 billionpound Olympics in Beijing and watching its domesticconsumption go to levels higher than ever expected.The Olympics in Beijing has helped China in risingup further and may have proven to be a major factorhelping China to become more powerful.

The goal of the Yuan though, should be to elim-inate exchange risk fluctuation, a necessity of theworld at this point of time. If the Yuan becomes theglobal reserve currency then China will find itselfin more pressure. It will be forced to develop itseconomy even more as its economic climate will af-fect countries all over the world.

China though, may not be willing to open itselfto such degrees of globalisation. What will China getin rescuing the world economy? This is a questionChina needs to ask itself before we can fully decidewhether China is the new America. If China does

replace America and the Yuan does replace the dol-lar, this is a change that will not happen overnightand will take the world a long time to digest and getused to. Is the world ready for such a big change? Isthe dollar ready to give up? Its too soon to answerthose questions as China is not ready yet. But whenChina is ready, we will be able to witness whetherthe U.S. is stronger or China and watch the emer-gence of our superpower. Either the U.S. will emergestronger than before or China will take its place or isthere a possibility that another country becomes thesuperpower? Most economists are placing their beton China and I too agree with that opinion placingmy money on China.


10/260 NIVESHAK VOLUME 2 ISSUE 8 September 2009

v

y

banks. While deficits are good in thesense that they help an economy getout of recession, there negative ef-fects can be seen when it comes tofinancing these deficits. Because ofdeficit financing, the money stock in-creases in the economy which leadsto Inflation (however it is argued

that since the output also increasesas a result of fiscal expansion alongwith the money stock, there mightnot actually be inflation). Greaterdeficits raise the accumulated debtand thus also raise the interest rateburden. Deficits can be reduced byincreasing the revenue receipts (thishas not been done in India till now)or by reducing expenditure, or disin-vestment.

Overall Fiscal TrendsFiscal performance is con-

tingent on the performance of theeconomy. The economic downturn

took a serious toll on governmentrevenues in 2008-09. The gross rev-enue of the central governmentgrew by a mere 2.8 percent in 2008-09 compared to over 25.0 percentin the preceding year. Income taxand corporation tax growth fell to7.2 and 10.8 percent, respectively,

from close to 35 percent in 2007-08.The worst performers were indirecttaxes, which shrank by 8.4 percentin 2008-09. Manufacturing sector isthe key contributor to corporationtax and excise duties. With growth inmanufacturing slipping to an anemic2.5 percent, the poor performance ofexcise and corporation tax does notcome as a surprise.

The graph (next page) shows

the trends in Indias fiscal deficit inthe last decade

As seen from the previousgraph, India was able to comply withthe Fiscal Responsibility and Budget

Abhinav Chugh & Nidhi KaickerFMS, Delhi

...is it a real concern?

The recent (2009-10) Union Bud-get of India was presented againstthe backdrop of extremely challeng-ing economic conditions worldwide.Indias growth rate has slipped fromthe highs of 9.0% to 6.7% in 2008-09. The fall in the growth might havebeen sharper had it not been for the

fiscal stimulus of the government.While fiscal expansion is necessaryto bring back growth to its previouslevels, it is the increasing deficitsthat are becoming a cause of con-cern.

What are Fiscal Decits?

Fiscal Deficit arises when thegovernments total expenditures(current & capital expenditure) ex-ceeds the revenue receipts (i.e. total

receipts of the government minusborrowings). A fiscal deficit can befinanced by borrowing from the RBI(Deficit Financing) or borrowing from



CoverS

tory

Higher scal decit and anapparent lack of road map forreforms in Pranab MukherjeesBudget pulled down the Sensex

via autonomous private-sector spending. So, ifthe trend rate of growth proves to be more mod-est than in the past, then the governments planto reduce its debt load primarily through thenormal process of economic recovery may be

difficult to achieve. And that leaves three othersolutions: deeper spending cuts, higher taxationor inflation.

Rising concern of the Fiscal Decit post

Budget

Higher fiscal deficit and an apparent lackof road map for reforms in Pranab MukherjeesBudget pulled down the Sensex, Indias mosttracked equity index, by 5.83% or 869 points,the sharpest-ever decline on any Budget day.

The recent Union Budget Speech mentioned theneed to amend the FRBM to accommodate thebusiness cycles. With several social and infra-structure initiatives announced, the governmentexpenditure is projected to expand by 15%,though relief is expected under the subsidieshead. On the revenue front, the tax receipts areexpected to be lower and only a moderate in-crease in revenue can be expected from disin-vestment and auctioning of 3G spectrum. This

will keep the deficit under pressure and it is nothard to believe that 6.8% is not a very conserva-tive estimate.

With states also allowed to borrow frommarkets even if their fiscal deficit increases to 4per cent of their GDP against the current limit of3.5 per cent, the combined fiscal deficit of Indiawill easily touch the double-digit mark.

Management Act (FRBM) laid in FY04 to bring fiscaldiscipline into the economy up to FY08. In fact, inthe last five years, fiscal deficit has always beenlower than the budgeted estimate owing to highGDP growth and compression in expenditure. Thereversal in 2008-09 (6.2% deficit instead of the pro-

jected 2.8%) is due to expenditures which were notbudgeted and revenues hit by lower growth. BothIncome tax and Indirect taxes shrunk, the dent inmanufacturing led to lower corporation and exciseduties, and the external sector contributed lesserthan expected customs duty. There was a moderaterelief from service tax. Expenditure increased, alongwith NREGA, sixth pay commission and farm loanwaiver, on two fronts: increased oil, food and fertil-izer subsidies due to the global commodity prices;and fiscal stimulus required to restore growth rates

in the wake of the global financial crisis.

Fiscal Decit in United States

The sharp deceleration of the US economyin 2008, under the weight of a significant hous-ing correction and a banking crisis opened upthe possibility of a severe recession borderingon a depression. As a result Government spend-ing expanded enormously to stimulate the econ-omy and compensate for the shortfall in othercomponents of aggregate demand, particularly

consumer expenditures. Above mentioned stepsresulted in increase in fiscal deficit as a percent-age of GDP to worrying heights - $1.75 trillion(12.3% of the GDP).

One way that the US government can re-duce its fiscal deficit and eventually pay downits debt is by the resumption of robust growth


12/26



CoverS

tory

2009-10 will be the seventh

consecutive year of the agri-cultural sector not seeing a

decline, and the fth consecu-tive year with positive increase

doing better than it ever did in the past, whichis amazing, because theres hardly been any in-vestment in agriculture in 30 years.

Drought could hold negative ramificationsfor the economy, but fortunately, more area un-der irrigation, making our vulnerability to the

monsoon decline. The problem is, the reservoirlevels are quite low. And that low reservoir lev-els can lead to low hydra-power creation, whichwill have a negative effect on the southernstates. I see the Deccan Belt being the most af-fected area if the rains are insufficient. I findthat to be a bit of a problem. Agricultural sectorwill not grow as well as it could have, if rainswere normal.

As per discussion of CMIEs projections for

the commission of investments, Based on ourestimations, we are seeing Rs 5.5 lakh crore (Rs5.5 trillion) of investments to get commissionedin 2009-10. Im not talking about new proposalsand outstanding numbers. Its not about com-missioning of new projects. Compare this to theRs 2.2 lakh crore (Rs 2.2 trillion) that was com-missioned last year, its easy to see how theindustrial sector will benefit. These (projects)are big steel mills, big farm projects, big powerprojects and a host of other investments. Whathappens is that when a plant is commissioned,it starts employing people, it creates demandfor services, transport increases and (newly em-ployed people) start spending; so overall youget a higher level of activity. The multiplier ef-fect on the economy will very, very substantial.

And thats the reason that I am not onlyoptimistic about the industrial sector in 2009-10,I am fairly optimistic about the industrial sec-tor going ahead. So even if investment activitybegins to go down, which I expect due to fiscaldeficit, industrial will continue to grow.

deficit and inflation, measured any way, or in-terest rates, measured any way and they foundno relationship, that relationship is absent inthe data for the last twenty years. So what arethese economists saying?

The reason is not that the theory is wrong;

it is just that the range of the gross fiscal deficitis still not bad enough to have an impact oninflation and interest rates. Which means thata 10% fiscal deficit -- Centre and state included-- is not something to get too worried about. Thegood thing is: we do worry about it. Therefore,were not testing the limits of the theory. So itsgood to be cautious.

There is a good likelihood that in 2009-10,India will turn out to be the fastest growing rel-

evant economy in the world, at about 6.6 percent, which is similar to what we saw in 2008-09. But this growth Im talking about for 2009-10 is not actually the whole story, because be-hind this sits a very substantial increase in thegrowth of industrial production, which is what Ithink matters the most.

And if there is going to be something thatspoils the story, its going to be the servicesexport sector. And our services sector is likely

to suffer because our exports are not going todo very well. If the world economy is going toshrink by 3 per cent, and if world trade shrinksby about 10 per cent, it will take a toll on ourimports and exports, which will impact our GDP.It will affect both trade and transport measure-ments. Still, the economy is doing reasonablywell. Industrial growth rate should double thisyear.

2009-10 will be the seventh consecutive

year of the agricultural sector not seeing a de-cline, and the fifth consecutive year with posi-tive increase. Now thats never been seen inIndia. That is a phenomenal thing to have. Andthat shows up in consumer domestic demand.And consumer domestic demand is our saviour,is the reason why the Indian economy is not asstressed as other economies are. Agriculture is



FinGyaan

Indias annual rate of ination was minus 0.21 percent for the week ended on Aug 22, up from mi-nus 0.95 percent the week before. The rate turned negative for the week ended on June 6 for the rsttime since the new wholesale price index (WPI) series started in 1995. The ination rate had last

turned negative in 1977

If you like to talk about num-bers for inflation, allow us to giveyou a news article Indias annualrate of inflation was minus 0.21 per-cent for the week ended on August22, up from minus 0.95 percent theweek before. The rate turned nega-tive for the week ended on June 6 forthe first time since the new whole-

sale price index (WPI) series startedin 1995. The inflation rate had lastturned negative in 1977. Now thatbaffles you.

Negative inflation implies tothe layman that the price level waslower during a given week, than itwas over in an earlier period. Foodprices have been rising for the pastfew months, yet our beloved minis-ters claim of negative inflation. That

anyways is also unhealthy, but whyis the discrepancy? When reality andstatistics go in different directions,we have to accept that something isseriously wrong somewhere. Let usattempt to dig into the reality of In-flation.

Ination and its Importance:

Inflation is the rate at whichprices of goods and services in-crease in an economy. Undoubtedlyit is one of the most vital economicparameters today. Widely trackedby the media, inflation is alwaysin news. So, what exactly makes itsuch a big shot? Inflation is a sign

that the economy is growing. On theother hand, hyperinflation i.e. infla-tion gone out-of-control in whichmoney loses its value very rapidly(otherwise called debasement of cur-rency) is considered detrimental forthe economy. At the other extreme,an economy with no inflation has es-sentially stagnated. Consequently,the maintenance of an optimum lev-el of inflation which is somewhere

in between the extremes is what isrequired. Economists opine that in-flation is considered to be a seriousproblem at over 10%. Anything over100% could lead to hyper inflationand serious destabilization. Inflationbetween 2-4% is considered healthy.

Inflation is one of the most

Falling Infation

Durgesh Nandini MohantyIIM Shillong

Lot of talks is going

around regarding

the discrepancy be-

tween the inflation

and rising prices of

food articles. In this

article we will try

to understand whyfood prices are surg-

ing when we had

inflation in red.

Rising Prices

&

...the Illusion



FinGyaan

closely watched national economic statistics. Thereasons for this are many. Firstly, the rate of inflationis referred to while formulating major governmentpolicies. It is used to index wages, salaries, pen-sions, and regulated or contracted prices. Secondly,a high and volatile level of inflation leads to shakypredictions about prices in the future. This creates

an air of suspicion, hence leading to reduced inwardinvestments in the country. And ultimately the eco-nomic growth of the country is seriously hampered.Last but not the least, inflation directly affects theliving standards of the people because as the rate ofinflation increases, the cost of all commodities alsoincreases.

In a country the responsibility of sustaining astable inflation rate is assigned to the central banksi.e. the RBI in our case. They act like regulatory bod-ies and control the size of money supply primarily

through the setting of interest rates, through openmarket operations, and through the setting of bank-ing reserve requirements, hence controlling the in-flation.

Calculation of Ination:

To get an exact measure of inflation, theoreti-cally, the average increase in prices of all the goodsand services available should be taken into account.But this is far from feasible. Hence certain conces-sions are allowed and a basket of goods and servic-

es that are indicative of the consumption patterns ofthe entire economy is considered. Mathematically,inflation rate is calculated as the percentage rate ofchange of a certain price index. A price index is anormalized average or a weighted average of pricesfor a given class of goods or services in a given re-gion, during a given interval of time. In India wehave adopted the WPI (Wholesale Price Index) forthis purpose. In countries like the USA, UK, Japanand China CPI (Consumer Price Index) is followed forcalculating inflation.

For calculating the WPI, a set of 435 commod-ities and their price changes are used for the cal-culation. The selected commodities are supposedto represent various strata of the economy and aresupposed to give a comprehensive WPI value for theeconomy. On a broader level, the 435 commoditiesare grouped into Primary Articles; Fuel, Power, Light& Lubricants and Manufactured Products. PrimaryArticles consist of food grains, fruits and vegetables,milk, eggs, meats and fishes, condiments and spic-es, fibers, oil seeds and minerals. Fuel, Power, Light& Lubricants consist of coal and petroleum relatedproducts, lubricants, electricity etc. ManufacturedProducts consist of dairy products, flour, biscuits,edible oils, liquors, cloth, toothpaste, batteries, au-tomobiles etc. As WPI is a weighted average of the

commodities, the weights are derived based on thevalue of quantities traded in the domestic market.The corresponding group weights are

Primary Articles 22.02525%

Fuel, Power, Light & Lubricants 14.22624%

Manufactured Products 63.74851%

The fiscal year 1993-94 is considered the baseyear and the WPI is assumed to be 100 for the same.

Flaws in the System:

After reaching a 13 year high of 11.05% in June2008, inflation dipped to -1.74%, a 33 year low, inAugust 2009. This raised serious questions over thecredibility of the method that is adhered to whilecalculating inflation. This is because the ground con-ditions in India are far from being reflected in theinflation rate. It is the international price of crude

petroleum that single-handedly dictates our infla-tion rate, unnecessarily overshadowing the pricesof the basic commodities that are required in thelife of the aam aadmi in India. For instance, evenwhen the inflation rate is low, the prices of cereals,pulses and vegetables continue to rise. The pricesof other products like fertilizers and pesticides thatare very crucial to a primarily agrarian economy alsodefy the plummeting inflation and continue to swell.The price of crude petroleum which is given a highweight in the WPI pulls down the inflation rate andgives us a totally skewed picture, very different fromthe actual prevailing conditions. The list will only getlonger if we state the injustice that a heavily biasedWPI and hence the rate of inflation inflict on thepeople of the country.

The facts say that out of the 14.22624% of theweight allotted to Fuel, Power, Light & Lubricants inthe WPI, the largest chunk of 6.98963% i.e. half of itis assigned to Mineral Oils consisting of LPG,Petrol, Aviation fuel, Diesel,Kerosene etc.



FinGyaan

Either the WPI should be

amended. Or shifting fromthe WPI to the CPI should be

given a serious thought.

The following two graphs show that inflation ratein India is largely dependent on the fluctuations inprices of crude petroleum as crude petroleum formsone of the major imports of the country. This glaringinclination towards Petroleum is better witnessedwhen we notice the weights conferred on the Pri-mary Articles. For instance the weight of Food Grains

(Cereals and Pulses) is merely 5.009% and that ofFruits and Vegetables is an ignominious 2.916%. In acountry where approximately 25% of the populationis wallowing Below Poverty Level and is struggling tofulfill the basic needs of life, the current split-up ofthe WPI cannot be justified.

Price of Crude Petroleum per barrel

The WPI has many other shortcomings besidesthe above mentioned one. In the WPI more than 100out of 435 commodities have abstained to be im-portant from consumption point of view. Secondlythe WPI measures the general level of price changeseither at level of wholesaler or at the producer and

does not take into account the retail margins. Andfinally services like health and education which con-stitute major expenditures of the people today arenot included in the WPI.

Therefore a change is inevitable. The sooner itis brought about the better. Either the WPI should beamended. Or shifting from the WPI to the CPI shouldbe given a serious thought. Most of the developedcountries had replaced WPI with CPI in the 1970s.

Advantages of the CPI:

The benefits of the CPI over the WPI are numer-ous.

Firstly, the CPI changes in the US correspondto the changes in the prices of around 80,000 items(in contrast to the 435 items in the WPI).They areincluded under more than 200 categories arrangedinto the following eight major groups:

Food and Beverages Housing Apparel Transportation Medical Care Recreation Education and Communication Other goods and services

This represents a cross-section of goods andservices purchased by urban households which rep-resent almost 87% of the US population. Hence the

method of calculation of CPI is much more inclusiveof the entire population and the products, in con-trast to Indias WPI.

Secondly, the CPI includes sales taxes andhence unlike the WPI takes the retail level into ac-count. Therefore it reflects more accurately the waythe price changes affect the end-user, the commonman.

Thirdly the data collection is done in a moreproficient manner. It is carried out by the Bureauof Labor Statistics (BLS) which makes sure that the

products included are relevant to the consumersand the prices the latest.

Fourthly the WPI is calculated every weekwhereas CPI is calculated every month. This way theCPI gets us a better picture of the more sustainedprice changes, discarding the minor day to day fluc-tuations. Hence the government can rely on the in-flation rate for formulating long term policies for the



FinGyaan

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

country.

Fifthly the BLS calculates the CPI for two popu-lation groups, one consisting only of wage earnersand clerical workers (CPI-W) and the other consist-ing of all urban consumers (CPI-U). The wage earnerand clerical worker population consists of consum-er units with clerical workers, sales workers, craftworkers, operative, service workers, or laborers. Theurban consumers consist of professional, manage-rial, and technical workers who constitute the upperstrata of the society. This classification indicates theprice variations with respect to the different eco-nomic classes in the society. Hence no class getsovershadowed by the other and the needs of eachcan be specifically looked after by the government.

Also the CPI takes the price of services likeeducation, health and recreation into account, un-like the WPI.

Most importantly, the CPI is not a slave of theups and downs in the international price of crudepetroleum. There are two measures of the inflationaccording to the CPI, Core and Non-core inflation.The Core CPI index excludes products like energywith high price volatility. The non-core CPI indexincludes everything. Core CPI is important because

this is what the Federal Reserve (the central bankof the US that regulates inflation) looks at to decidewhether or not to raise the Fed Funds rate. TheFed uses the Core CPI because the price of en-ergy, specifically gasoline, is volatile and swingsto the moods of the OPEC and the Feds tools tocounter inflation are comparatively slower to act.

It can take 6 - 18 months before the effect of arate change can trickle down into the economy.Therefore, inflation could be high if gas prices haveincreased dramatically, but the Fed would not reactuntil those increases have trickled through to theprices of other goods and services. Hence the infla-tion in this case is not solely dependant on theprice of petroleum.

Conclusion:

After considering the advantages of the CPI,

the necessity of a change in our system for mea-surement of inflation is more than evident. Pres-ently, India is the only major country that uses WPIto measure inflation. The shift from WPI to CPI wouldmake inflation a more exact indicator of where oureconomy is headed and hence it would not remainan illusion anymore.



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The rst CDS contract wasintroduced by JP Morgan in

1997 and by middle of 2007the value of the market had

ballooned to an estimated $45trillion.

Simply put, a credit defaultswap (CDS) is a kind of insuranceagainst credit risk. Credit default

swaps (CDS) are the most widelyused type of credit derivative andare a powerful force in the world fi-nancial markets. The first CDS con-tract was introduced by JP Morganin 1997 and by middle of 2007 thevalue of the market (in terms of thetotal notional of CDS outstanding)had ballooned to an estimated $45trillion, according to the Internation-al Swaps and Derivatives Association(ISDA), which interestingly is morethan twice the size of the U.S. equitymarket. The current notional of theall CDS contracts is assumed to bearound $ 62 trillion by the ISDA.

CDS contracts are in the centreof a major controversy after the re-cent financial crisis unravelled itself(especially with the bailout of AIGdue to huge CDS exposure), receiv-ing a lot of flak from regulators andcommon investors alike. Before weget into the details of the reasonsfor the existence of a huge CDS mar-ket and the purpose it serves, wewould have a look at the basics of acredit default swap and its featuresand nuances. We would then look atthe ways at which CDS can be usedto speculate, and how these simple

looking credit insurance can poten-tially destabilise the financial sys-tem itself. A brief look at the state

of Indian corporate debt marketis also required to understand thewhether there exists a need for cred-it default swaps in India. Finally, wehave a look at the current regulatorystance on CDS in India and how hasit evolved in the past, and we con-clude on the decision to introduceCDS in India.

Credit Default Swap Basics

A credit default swap is a pri-vately negotiated bilateral contract.The buyer of protection pays a fixedfee or premium to the seller of pro-tection for a period of time (mostliquid contracts are for 5 years)and if certain pre-specified creditevents occur the protection sellerpays compensation to the protec-tion buyer. The premium paid by theprotection buyer to the seller, oftencalled spread, is quoted in basis

points per annum of the contractsnotional value and is usually paidquarterly. Periodic premium pay-ments allow the protection buyerto deliver the defaulted bond atpar or to receive the difference ofpar and the bonds recovery value.Therefore, a CDS is like a put option

Shuvabrata NandiIIM Ahmedabad

Satans financial tool

of choice Credit

default Swaps arein the center of

controversies after

the recent financial

crisis. In this article

we will try to touch

upon the basics of

CDS, its features and

nuances. We will

also try to look, ifIndian debt market

is ready for such a

complex financial

instrument which

is being blamed for

its role in the global

meltdown

CREDIT DEFAULT

SWAP

...In India???



AoM

The 2003 ISDA Credit Deriva-tives Denition provide for six

kinds of credit events

written on a corporate bond. Like a put option, theprotection buyer is protected from losses incurredby a decline in the value of the bond as a resultof a credit event. Accordingly, the CDS spread canbe viewed as a premium on the put option, wherepayment of the premium is spread over the termof the contract. It is important to note that the CDS

contract is not actually tied to a bond, but insteadreferences it. For this reason, the bond involved inthe transaction is called the reference entity. Acontract can reference a single credit, or multiplecredits. (Nomura CDS Primer)

The 2003 ISDA Credit Derivatives Definition pro-vide for six kinds of credit events - Bankruptcy,Failure to pay, Repudiation / Moratorium, ObligationAcceleration, Obligation Default, and Restructuring.

However, for market participants, bankruptcy,failure to pay and restructuring are the most signifi-

cant credit events. It is also important to note thata written admission of a companys inability to payits debt must be made in a judicial, regulatory oradministrative filing. ISDA master agreement for CDSincludes four different ways to treat restructuringas well No Restructuring (NR), Full Restructuring,Modified Restructuring and Modified Restructuring.(ISDA Credit Derivative Definitions, 2003)

So, once a credit event happens, the buyeror the seller delivers a Credit Event Notice. Then,compensation is to be paid by the protection seller

to the buyer via either1. Physical settlement - the protection seller buys

the distressed loan or bond from the protection buy-er at par. Here the bond is called the deliverableobligation,

2. Cash settlement - the payment is determinedas the difference between the notional of the CDSand the final value of the reference obligation forthe same notional.

Evolution of Global CDS Market

The CDS market is an important market thathas grown dramatically over a short period of time.The market originally started as an inter-bank mar-ket to exchange credit risk without selling the un-derlying loans but now involves financial institutionsfrom insurance companies to hedge funds. The Brit-ish Bankers Association (BBA) and the InternationalSwaps and Derivatives Association (ISDA) estimate

that the market has grown from $180 billion in no-tional amount in 1997 to $5 trillion by 2004 and anastronomical $62 trillion by end of 2007. This rapidgrowth was spurred by the ISDA creating a set ofstandardized documentation. This standardized in-dustry standards and benchmarks which greatlylowered the transactions costs to trading CDS.

This rapid growth got halted for the first timein 2008 at the wake of the global financial crisis.The notional amount outstanding of credit defaultswaps (CDS) was $38.6 trillion at year-end, down 29percent from $54.6 trillion at mid-year 2008. Notionaloutstanding, for the whole of 2008, was down 38percent from $62.2 trillion at year-end of 2007. The$38.6 trillion notional amount was approximatelyevenly divided between bought and sold protection:bought protection notional amount was $19.5 trillionand sold protection was $19.1 trillion, with a net

bought notional amount of $400 billion.

Why CDS is Used

Now, let us look at the reasons as to why creditdefault swaps, touted as Satans financial tool ofchoice by the popular press, exist.

Hedging (Bidirectional Trading in Credit):

A CDS contract is used as a hedge or insur-ance policy against the default of a bond or loan.An individual or company that is exposed to a lotof credit risk can shift some of that risk by buying

protection in a CDS contract. This may be preferableto selling the security outright if the investor wantsto reduce exposure and not eliminate it, avoid takinga tax hit, or just eliminate exposure for a certain pe-riod of time. Please note that, such contracts donteliminate risk, and they dont increase it. They justtransfer the risk from one party to the other. Butthis enables those who bear a risk to protect them-selves against it, and considering the huge volumeof risk-taking that occurs daily in financial markets,the ability to redistribute risk has to be seen as very

useful.A competitive market in credit default swaps

contributes to the transparency of price-setting andthus to the efficiency of the whole process. This low-ers the cost of financial risk management in general.

Speculation:

Credit default swaps allow speculators toplace their bets about the credit quality of a par-



oM

ticular reference entity. With the value of the CDSmarket larger than the bonds and loans that thecontracts reference, it is obvious that speculationhas grown to be the most common function for aCDS contract. CDS provide a very efficient way totake a view on the credit of a reference entity. Aninvestor with a positive view on the credit quality of

a company can sell protection and collect the pay-ments that go along with it rather than spend a lotof money to load up on the companys bonds. An in-vestor with a negative view of the companys creditcan buy protection for a relatively small periodic feeand receive a big payoff if the company defaults onits bonds or has some other credit event. Hence CDSsolves the following issues faced by an active cashcredit portfolio manager:

- A manager who wants to take a long positioncannot find enough of the bond to buy in the sec-

ondary market, receives insufficient allocationsin the primary market, or else finds himself con-strained by his own risk limits.

- CDS allows an active manager to invest in for-eign credits without currency risk

At the same time there are some unique ad-vantages of credit default swaps, which are brieflydiscussed below:

a. Unfunded Instruments: As a general matter,credit default swaps are un-funded. That is, the pro-

tection seller does not post the notional amount ofthe contract into an account for the benefit of theprotection buyer. This allows the protection sellerto invest that amount elsewhere, earning a return.Thus, credit default swaps allow for unfunded expo-sure to credit risk, which facilitates a return that ishigher than the underlying bond.

b. Simplified Documentation: Credit default swapsalso offer the advantage of simplified and standard-

ized documentation, which allows market partici-pants to precisely tailor the credit risks to whichthey are exposed. ISDA does a great job in providingtemplates of master agreements to the market par-ticipants.

c. Advantage of a Contract: Credit default swapsare contracts, and so the rights and obligations ofeach party can be whatever the parties agree to.This allows for the creation of essentially infinitevariations on the basic credit default swap theme from sovereign, to single name to basket products.(Derivative Dribble Blog on CDS)

Corporate Debt Market in India

At this juncture, it is imperative to look at thecorporate debt market in India, which is essentiallyclosely linked to the introduction of CDS in the coun-try. Compared to very well developed equity and

equity derivatives markets, corporate debt marketin India is primitive at best, with daily turnover ofaround Rs. 1,000 Crores compared to a turnover ofRs. 100,000 Crores in equity markets.

In comparison, in most matured economiesdebt market is three times the size of the equitymarket. Investment in equity being riskier, certainclass of investors choose to invest in debt, basedon their risk appetite and liquidity requirements.In fact, most investors like to spread their invest-ments into equity, debt and other classes of assets

for reasons of optimal combination of return, liquid-ity and safety. A vibrant debt market therefore en-ables investors to shuffle, reshuffle their portfoliodepending upon the expected changes. Debt mar-ket, in particular, provides financial resources for thedevelopment of infrastructure. Due to this lack ofdepth in the domestic debt market, many large In-dian corporate prefer FCCBs and Yankee Bond routefor debt placement.

Looking forward, Prime Minister ManmohanSingh says the country will need as much as $475

billion over the next five years to upgrade the coun-trys crumbling infrastructure and Indian companiesmay need to raise as much as $200 billion, accordingto estimates by Moodys Investors Service. (Bloom-berg.com)

Hence, the question of credit risk becomeseven bigger. Effective management of credit risk is,therefore, a critical factor in banks risk manage-ment processes and is essential for the long-term fi-nancial health of banks. Credit risk management en-compasses identification, measurement, monitoring

and control of the credit risk exposures. AlthoughIndian banks are in a position to identify measureand monitor credit risk, they have no instrument tocontrol or hedge their credit risk exposure. In theprocess of financial sector deregulation, interest rate



AoM

ICICI, RIL, Tata Motors and

SBI are among the 50 most-active USD-denominated

credit default swaps contractsin Asia

risks and foreign currency risks are now effectivelymanaged by derivatives, and the lack of credit de-rivatives is a spot of concern for the banking com-munity as well as the corporate in the country.

Current State of Regulation in India

Currently, CDS contracts are available on debt

raised by Indian companies overseas. ICICI BankLtd., Reliance Industries Ltd., Tata Motors Ltd. andState Bank of India are among the 50 most-activeUSD-denominated credit default swaps contracts inAsia, excluding Japan, according to a dealer surveyconducted by the International Index Co. in Frank-furt. Bank of India, ICICI Bank, IDBI Bank, RelianceIndustries and State Bank of India each have a 2%weight in the 50 member Markit iTraxx Asia ex-JapanInvestment Grade 5-Year CDS Index (quoting at 125basis points as on July 31st 2009), whereas Reliance

Communications, Tata Motors and Vedanta Resourc-es each have a 5% weight in the 20 member MarkitiTraxx Asia ex-Japan High Yield 5-Year CDS Index(quoting at 600 basis points as on July 31st 2009).So, there exists a vibrant CDS market for Indian enti-ties already.

In response to this as well as the Percy MistryCommittee report on Making Mumbai an Interna-tional Financial Centre, Reserve Bank of India (RBI)has come out with draft guidelines on Credit DefaultSwap (CDS) per notification dated May 2007. In the

wake of the financial crisis, there has been no fur-ther progress on the same, but according to recentnews (July 24th 2009) the possibility of introducingCDS on exchanges as a part of measures to reformthe debt market in India would be placed on theagenda of the meeting of the high-level co-ordina-tion committee on capital markets next month asreported by business daily The Mint.

According to ISDA, guidelines proposed by RBIfor trading credit-default swaps exclude a signifi-cant part of the domestic debt market and may limit

growth in bank lending. Indian lenders have to ownthe underlying notes in order to buy default protec-tion and the securities must carry a public creditrating, according to the guidelines. (RBI Draft Guide-lines on CDS) Indias loan market is as much as sixtimes larger than the amount of Indian corporatebonds in existence, according to Bloomberg calcula-tions based on central bank data, and most loansdont have a published rating. That significantly re-

duces the effectiveness of such a CDS contract to betraded on exchanges and denominated in INR.

Conclusion

Based on the discussion above and the prosand cons of CDS as an instrument to hedge credit ex-posure or to take a view on credit exposure, I think

its time that INR denominated CDS be introduced inIndian Markets. For emerging markets like India thefollowing points need to be stressed upon:

Being an efficient tool of pricing the risk ofcredit default by the reference entity, the CDS mar-ket provides the most objective tool for pricing ofcredit risk. This synthetic market is not affected byany of the inflexibilities and limitations of the cashbond market lack of availability, regulatory restric-tions, etc and hence CDS market can potentially be-come more liquid than the cash bond market in time

to come, which is already the case globally. Over time both single name and portfolio de-

fault swaps are going to get developed in the coun-try. Portfolio default swaps are particularly impor-tant from the viewpoint of a bank transferring therisks of a portfolio such as the SME loans portfolio,through credit linked notes, which will allow muchneeded capital flow in the SME sector of India.

Hence, keeping in mind all the benefits andpotential troubles, here are the recommendations:

Exchange traded CDS contracts of 5 year ma-turity should be allowed in India with single namereference entity (only of Indian origin) as well asbaskets formed through a CDS index. Cash settle-ment is preferred rather than delivery based settle-ment. This will be more transparent than traditionalOTC CDS contracts.

Market participants should be allowed to tradein instruments tied to reference entities where theydont have a credit exposure. This will potentiallyincrease the depth of the market and thereby allowa more efficient price discovery.

Considering that the loan portfolio is muchas six times bigger than cash bond portfolio, loansshould be allowed to be referenced as well, whichagain allows for broader participation

Thus an efficient market of credit pricing andexposure can be started in India.



FinSight

There are two types of the

Build America Bonds rst oneis tax credit and the secondone is direct payment bonds

The entire world is facing themost severe financial crisis in gen-erations. Budgets are being scaled

back, government jobs are beingcut, and services are being curtailed.These cuts contribute to a deeperrecession, while restricting access

to services at a time when the needfor them is greatest. Turning thingsaround requires innovative think-ing. Extraordinary challenges require

extraordinary action by the govern-ment to ensure the economy getsback on track and that millions ofpeople get back to work. Creating

the conditions for an economic re-covery also requires addressing thechallenges facing state and localgovernments in the midst of the cur-

rent economic climate.

US Government has takenmany initiatives to tackle the pre-

vailing recession and to re-establishthe confidence of investors and con-sumers. These initiatives includethe lowering of interest rates toease raising funds and reduce the

cost of capital. But these initiativescould not achieve success becauseof the cyclic nature of the business

and delay that happens because ofthe very nature of these monetary

policies. One of the initiatives fromUS government is the Build AmericaBond program under the AmericanRecovery and Reinvestment Act of

2009. These types of bonds are madeavailable through government espe-cially in the period of downturn. Letus understand more about them.

What They Promise To Do?

These bonds have been intro-

duced by the US government to pro-vide much-needed funding for stateand local governments at lower bor-rowing costs. This will enable them

to pursue necessary capital projects,such as work on public buildings,courthouses, schools, roads, trans-portation infrastructure, government

hospitals, public safety facilities and

equipment, water and sewer proj-ects, environmental projects, energy

projects, governmental housing proj-ects and public utilities.

Traditionally, tax-exempt bondsprovide a critical source of capital forstate and local governments, but the

recession has sharply reduced their

BUILD AMERICA BONDS

Seema SharmaIIM Shillong

In order to over-

come extraordinary

challenges faced by

USA due to financial

crisis American govt

is taking extraordi-

nary steps, one such

step is The Ameri-

can Recovery andReinvestment Act of

2009 and implemen-

tation of build Amer-

ica bond program

under this act. In this

article we will try to

find out the details

of BAB and its impli-

cations



FinSight

Direct payment bonds provides a Federal subsidy through a refundable tax credit paid to state orlocal governmental issuers by the Treasury Department and the Internal Revenue Service (IRS) in an

amount equal to 35 percent of the total coupon interest payable to investors in these taxable bonds

ability to finance new projects. Supplementing this

existing market, the Build America Bond program isdesigned to provide a federal subsidy for a largerportion of the borrowing costs of state and localgovernments than traditional tax-exempt bonds in

order to stimulate the economy and encourage in-vestments in capital projects in 2009 and 2010.

How Do They Work?

Build America Bonds are a new financing toolfor state and local governments. The bonds, whichallow a new direct federal payment subsidy, are tax-

able bonds issued by state and local governmentsthat will give them access to the conventional cor-porate debt markets. At the election of the state andlocal governments, the Treasury Department will

make a direct payment to the state or local govern-mental issuer in an amount equal to 35 percent of

the interest payment on the Build America Bonds.

As a result of this federal subsidy payment,state and local governments will have lower net bor-

rowing costs and be able to reach more sources ofborrowing than with more traditional tax-exemptor tax credit bonds. For example, if a state or lo-cal government were to issue Build America Bonds

at a 10 percent taxable interest rate, the TreasuryDepartment would make a payment directly to thegovernment of 3.5 percent of that interest, and thegovernments net borrowing cost would thus be only

6.5 percent on a bond that actually pays 10 percentinterest.

This feature makes Build America Bonds attrac-tive to a broader group of investors, and thereforecreates a larger market than typically invest in more

traditional state and local tax-exempt bonds, whereinterest rates, due to the federal tax exemption,have historically been about 20 percent lower thantaxable interest rates. They are attractive to inves-

tors without regard to their tax status or income tax

bracket (e.g., pension funds and other tax-exemptinvestors, investors in low tax brackets, and foreign

investors).

Two types of the Build America Bonds are thetax credit and the direct payment bonds. The firsttype of Build America Bond i.e. tax credit provides aFederal subsidy through Federal tax credits to inves-

tors in the bonds in an amount equal to 35 percent

of the total coupon interest payable by the issuer ontaxable governmental bonds (net of the tax credit),

which represents a Federal subsidy to the state orlocal governmental issuer equal to approximately 25percent of the total return to the investor (includ-ing the coupon interest paid by the issuer and the

tax credit). The second type of Build America Bond

i.e. direct payment bonds provides a Federal sub-sidy through a refundable tax credit paid to state orlocal governmental issuers by the Treasury Depart-

ment and the Internal Revenue Service (IRS) inan amount equal to 35 percent of the total couponinterest payable to investors in these taxable bonds.

Are They Better Than Traditional Ways?

Let us compare this initiative of governmentwith the existing ones. One of the important mon-

etary policies in the recession period is the lowering

of interest rates to maintain the investor confidenceby ensuring easy availability of money. The prob-lem lies in the delay involved in the process. At the

same time the central bank has the responsibility ofcontrolling inflation along with increasing the moneysupply. One more issue is that the decision of bankto reduce interest rates actually works against the

government bonds because it leads to increase inthe bond price and therefore reduces the demandfor government bonds. On the contrary, the BAB con-cept is increasing the demand for government bonds

and therefore is meant to help government projects.Another benefit with these bonds is the facilitiesgiven with these bonds can be withdrawn as soon

as the need is felt, therefore there is no possibilityof time lag.

Though the BAB looks very promising primafacie but the actual performance is yet to be seen.The success of these bonds in America will actually

trigger this kind of initiatives to tackle recession inother part of the world as well.


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T E A M N I V E S H A KARTICLE OF THE MONTH

The article of the month winner for September 2009 isShuvabrata Nandiof IIM Ahmedabad

He receive a cash prize of Rs.1000/-

Fin-Q WinnerThe Fin-Q Winner for the month July 2009 is

Mohit Khemkaof IIM Shillong

He recieves 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 the

Month. and would be awarded cash prize of Rs.1000/-

Instructions Please send your articles before 5th October 2009 to

[email protected]. Do mention your name, institute name and batch with your article. Format: Font:- Times New Roman, Size:- 12, Length


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Finance ClubIndian Institute of Management, Shillong

Mayurbhanj Complex,NongthymmaiShillong- 793014

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