Niveshak September 2011

8/4/2019 Niveshak September 2011

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THE INVESTOR VOLUME 4 ISSUE 9 September 2011

Who is bearing

the burden..?


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 IV

ISSUE IX

September 2011

Faculty Mentor

Prof. N. Sivasankaran

Editor

Rajat Sethia

Sub-Editors

Alok Agrawal

Deep Mehta

Jayant Kejriwal

Mrityunjay Choudhary

Sawan Singamsetty

Shashank Jain

Tejas Vijay Pradhan

Creative Team

Vishal Goel

Vivek Priyadarshi

All images, design and artworkare copyright of

IIM Shillong Finance Club

Finance Club

Indian Institute of Management

Shillong

www.iims-niveshak.com

THE TEAM

Dear Niveshaks,

The world economy has been in a bad shape since some months now. TheFeds announcement of $400 billion Operation tist to stimulate the US econ-omy sent global markets on a ee fall. The earlier monetar easing by Fed QE2

failed to revive the US economy and the market seems to have lost faith that thenew avatar of monetar easing is going to help either. The Indian markets fellby more than 4% on announcement of monetar easing by Fed, its highest fallin a single day since 2009. The volatilit in all markets have increased to an un-

precedented levels and the possibilit of a double dip has increased frher. FearIndex VIX, which is based on volatilit has increased by 22% for Indian marketsin September and has reached high levels for most markets. Adding to the woesis the Euro crisis which has been worsening ever passing day. The possibilit of

a Greek default is now ver real. The Euro crisis which was bor out of scal prof-ligacy and mispricing of credit risk has now aained a massive scale threateningthe disintegation of Euro itself and no Euro zone count seems to be knowingthe solution to the crisis.

Meanwhile, the gowth of Indian economy has stalled, thanks to RBI, whichhas been on an interest hike spree for quite some time now. However, all the

measures by RBI have failed to contain the ination and the hawkish tone of RBIGoveror is scar and an indication that interest rates can be increased frher.Unlike the Americans, Indians do not live by credit, and hence a credit squeezeto contain demand may really not be eective in India. When ination is drivenby high prices of food and other basic necessities, a credit squeeze can hardlyhelp, as Indians are unlikely to buy food on credit. This is not to arge that eco -

nomic gowth is the only priorit and ination does not maer, but it is simplyunacceptable that economic gowth is hur while ination remains unchecked.The fact is that the Goverment can do lile to check ination in an open econ-omy. As a corollar, if commodit prices were to fall in the event of a double-diprecession, the goverment can hardly claim credit for bringing prices under con-tol. When it is already known that the curent ination is largely driven by high

food and raw material prices, squeezing credit to agicultre and allied activitiescan only make ination more persistent. But ination is a political issue and the

goverment must show that it is taking eors to check ination. Hence theserounds of interest rate hikes.

This issue brings to you some more interesting and insightfl topics. Thecover stor this month focuses on the outlook of the world economy and whetherthe ghosts of 2008 will retr to haunt us. The issue also featres an aricle onthe genesis of Euro Crisis and the way forard for it. Other aricle focus on down-

gade of US, Indias scal decit and whether dollar can replaced as the reserecurency in the coming years as the US economy is losing steam. The Classroomthis month exlains the topic of Curency wars. Last month, we celebrated ourthird anniversar with a special issue on Sector Repors. The Anniversar issue

was a huge success with more than 100 enties for Sector Repors. We would liketo thank all those who contibuted the Sector Repors and made our anniversarissue such a success.

Rajat Sethia(Editor - Niveshak)


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C O N T E N T S

Niveshak Times04The Month That Was

Article of the month

13 Indias Fiscal Defcit A ticking time bomb...

Cover Story

06The Greek Debt Crisis Who is bearing the burden?

Perspective

10World Economy Outlook

Stressed & Downgraded

16 Replacement o Dollar asGlobal currency

Reality or Illusion

Finsight

20 Euro Debt Crisis

The next looming danger

CLASSROOM

21 Currency Wars


4/26September 2011

DEPB scheme closure scheduled on

October 1

The central government has decided to put an end

to Duty Entitlement Passbook Scheme (DEPB), effec-

tive October 1, a move that reflects governments

resoluteness towards tightening of fiscal policies.

This move will adversely impact exporters in engi-

neering sectors like auto components, chemicals,

pharma, textile and marine. The revenue benefit re-

ceived by exporters on account of DEPB was around

INR 8700 crore for previous year. The finance min-

istry has however assured the exporter community

that the duty drawback items list upon which the

exporters can claim benefit has been expanded to

4000 items to ensure that their revenues would not

be affected by termination of this export promotion

scheme. The expansion in the list of duty back items

may be attributed to the addition of 2130 items in

the soon to expire DEPB scheme. The termination

of DEPB scheme has been perceived by some in ex-porter community as a signal of the beginning of

withdrawal of export promotion schemes and other

impetuses.

12th successive policy rate hike by RBI

RBI maintained its hawkish stance on interest rates

with a 25 basis point increase in key interest rates

to rein in on rising inflation. After this hike by the

central bank the short term lending repo and bor-

rowing reverse repo rate stand at 8.25%

and 7.25% respec ti ve ly.

This interest rate in-crease has allowed RBI

to cover some of its

losses in- curred on

investment in foreign

curr enci es and gold.

Meanwh i l e the increase

in petrol prices by INR 3.14 is ex-

pected to push up the WPI inflation by 7 basis

points. The high food inflation despite normal mon-

soon has led RBI to point out structural demand

supply imbalances as the cause behind the high

food inflation.

Telenor-Unitech JV to raise INR 8000 crore

Norway based telecom behemoth, Telenor has initi-

ated a process to raise INR 8k crore in its Indian JV

with real estate giant Unitech. BNP Pari-

bas has been roped in by the JV, Uni-

tech Wireless to explore the fund-

raising options which

may be availed by the

company. Rights

and debt issue arethe two sources o f

fundraising identi- fied so

far. Unitech is keen on raising funds

through debt issue while Telenor is

bullish about the rights issue. Telenor which has a

controlling 67.5% stake in JV is also considering the

option of inducting a second Indian partner in rights

issue in case Unitech decides not to participate in

the equity issue. The stay on the initial fund raising

process has been lifted by the Punjab and Haryana

high court that was held up due to Unitechs opposi-

tion to the proposed rights issue.

Blackstone-Carlyles joint bid for Reliance

Infratel on the cards:

Seasoned private equity players, Blackstone and

Carlyle group are keen on putting forward a joint bid

for Reliance Infratel, the tower business of Reliance

Communications. The bid values Reliance Infratel at

$4 billion against R Coms expectation of $5 billion.

R Com is looking to sell its entire 95% stake in its

tower division. A likely competition for this joint bidmay come from another private equity consortium

comprising of Apax Partners and Advent Internation-

al. Investment bankers in charge of this deal had

earlier approached strategic buyers like American

Tower Company and Crown Castle who are inter-

ested in buying tower business in India.

Fortis Healthcare to acquire group company

Fortis Healthcare India (FHI) is ready to acquire its

international arm, Fortis Healthcare International

Pte Ltd. in an all cash deal from its promoters Mal-vinder Mohan Singh and Shivinder Mohan Singh,

whose joint stake in Fortis Healthcare Internation-

al is 100%. The promoter brothers also hold 80%

The Niveshak Times

www.iims-niveshak.com

IIM, Shillong

Team NIVESHAK

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stake in FHI. The combined entity resulting from thisacquisition will have consolidated revenues of $1

billion with equal contribution from both the com-

panies. The deal will enable FHI to enter into in-

ternational markets like Hong Kong, Australia, New

Zealand, Sri Lanka, Singapore, Vietnam and UAE. The

size of the deal is estimated to be around $1.5 bil-

lion. Given the all cash nature andsize of the deal,

the huge payout to be made by FHI for acquisition

may limit the international expansion plan of the

domestic healthcare giant.

Softbank makes $200 million investment

into InMobi

Bangalore based mobile advertisement company;

InMobi has received a $200 million investment from

Japanese internet company, Softbank. The proposed

investment will be made in two equal tranches - an

immediate influx of $100 million in September fol-

lowed by remaining $100 million in April next year.

The deal which is touted to be one of the largest in

mobile advertising space has an estimated value of

around $1 billion. Estimates by Crunchbase, a da-tabase of technology companies has placed Inmobi

at second position in global mobile advertisement

network behind market leaders Google. InMobi has

the network to reach out to 340 million customers in

165 countries with more than 47 billion ad impres-

sions on a monthly basis.

Google acquires Motorola Mobility in a

$12.5 billion deal

The $12.5 billion acquisition of Motorola Mobility

by Google is the largest acquisition by the search

engine company till date. The deal is an all cash

deal as a part of which Google has agreed to pay

$40 per share of Motorola Mobility. The statement

about the deal posted on the investor relations pageof Googles website mentions The acquisition of

Motorola Mobility, a dedicated Android partner, will

enable Google to supercharge the Android ecosys-

tem and will enhance competition in mobile com-puting. Motorola Mobility will remain a licensee of

Android and Android will remain open. Google will

run Motorola Mobility as a separate business. The

acquisition is considered by industry analysts as an

attempt by Google to build a strong patent port-

folio that represents a formidable defense against

competitive threats from Microsoft, Apple, etc. The

company holds approximately 14,600 granted pat-

ents and 6,700 pending patent applications, world-

wide, as of January 2011.

S&Ps unexpected downgrade of Italys credit

rating

Standard and Poor downgraded Italys credit rat-

ing by one notch to A/A-1 citing concerns over poor

growth prospect and political instability plaguing the

country and maintained

a negative outlook on

the country. The Italian

government reacted on

expected lines dismissing concerns raised by S&P

by saying that such concerns were misleading andfar removed from reality. The government assured

the Euro lenders community that it is taking suf-

ficient measures within its capacity to keep debt

crisis under control and referred to the 59.8 billion

euro austerity plan in the Italian parliament. The

downgrade came as a surprise to market that ex-

pected Moody to come up with the downgrade first.

ICBC ventures into India

Industrial and Commercial bank of China (ICBC), the

worlds largest bank with a market capitalization of

$234 billion has set up its first branch in Bandra-

Kurla business region in Central Mumbai in India.

Sun Xiang has been appointed as the CEO of ICBC

operations in India. The Chinese banking behemoth

will make an initial investment of $100 million and

will primarily deal with corporate clients in sectors

like power, telecom and infrastructure in which Chi-

nese companies have a presence in India. ICBC is

also the worlds largest bank in terms of profits and

market capitalization. The start of ICBCs branch op-

erations in India is a part of the long term plan ofthe bank to increase its share of international busi-

ness (as a percentage of total business) to 10%.

The Niveshak Times

www.iims-niveshak.com 5NIVESHAK

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FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG


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Team NiveshakTejas Pradhan & Vivek Priyadarshi

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The CRUX of the CRISIS

It started just before the 2009 Greece electionswhen the Government confessed that the fiscal deficitwhich was claimed as 2% till now was actually 6%. Aninquiry by the European statistical institute found it tobe a whopping 15%. Unnecessary government spend-ing, low lending rates and lack of proper reforms hadpulled the rug from under Greeces feet after the globaleconomic recession of 2009. It did not have the moneyto fund its own debt. The EU and the IMF stepped in tobail out Greece with a loan of Euro 110 billion at a stagewhen debt to GDP ratio was above 112% (in 2009) and

the fiscal deficit was at 12%.

It was May 2010, when problems in Greece weretaken seriously by the international community andGreece was offered a bailout of Euro 110 billion by theEU and the IMF. In the same month Greece Debt Cri-sis was the cover story of Niveshak. Our editors Sumitand Upasna analysed the current situation then andprovided possible future implications. Most of theirviews, like just by implementing austerity measuresGreece would not come out of the crisis, combined ac-tion by all EU members (not just France and Germany)

would actually help Greece and the weakening of Eurovs the Dollar, have come to be true.

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which does not show the intention to revive its econ-omy, with the hard earned money of its citizens. This

practice of bail out if continued in future would lead topolitical unrest in France and Germany.

EU DOES NOT BAIL OUT GREECE

This seems to be a remote possibility. If EU doesnot bail out Greece it will default on its debt whichwould send ripples not only through the EU but throughthe global economy. The other major economy the Unit-ed States is still suffering from its own problems. Ger-many and France together hold roughly Euro 40 billionof the previous bail out in the form of Greek bonds. IfGreece defaults then German and French banks would

come down to its knees, leading to the failure of twobiggest economies of the Eurozone.

THE FUTURE OF EURO

One of the reasons of formation of the Eurozoneand the common currency Euro was to reduce domi-nance of the US dollar as Eurozone ($16.2 trillion GDP in2010) was the only economy that was ahead of the US($14.5 trillion GDP in 2010). But because of the failingeconomies in Europe investors are slowly losing faithon the Euro. The Euro fell 9.7% from 4th May 2011 to23rd September 2011, a span of five months. The fail-ure of Euro has led to investors holding hard cash inUS dollars. As US came close to defaulting on its debt,investors are preferring hard cash than governmentbonds as the currency of a country is the promiseto pay the bearer a certain denomination of money.With investors round the globe hoarding USDs as a safehaven, the value of USD has appreciated compared tomost of the global currencies. Euro has also sufferedfrom the same.

Going forward, if the Eurozone still suffers fromailing economies PIIGS (Portugal, Ireland, Italy, Greece

and Spain), Euro would never be able to challenge thedominance of the USD. Moreover the well to do econo-mies of the Euro zone would not trust the Euro. Mean-while the laggards would still continue to enjoy thebenefits of a strong currency, Euro, which they could

Consequences for the EU

GREECE REMOVED FROM THE EU

This would be an extreme measure to save theEuro and the EU the reason being that EU would thenhave to consider severing ties with the other PIIGS (Por-tugal, Ireland, Italy and Spain) who are in a situationsimilar to Greece. The removal of these five memberswould then threaten the existence of EU and the Eu-roZone as the purpose of its formation was to makethe region function as a single entity having commoncurrency, ease of movement of people among otherthings. With these five nations not in the group therewould be no meaning of other members staying to-

gether.

THE EU AGAIN BAILS OUT GREECE

The EU can be held equally responsible for Greecescondition today. A point that EU has failed to under-stand right from the time of its inception is that thoughlogically it might be a single economy but structurally itis a group of countries which have different economicand financial strength and hence different aspirations.France and Germany, the two biggest economies of theEurozone have modelled the Eurozone economy basedon the developed economy model of their own country.This can be found out from the fact that Greece waslending money at very low interest rates, a phenom-ena common to developed economies like France andGermany. Greece being nowhere close to the might ofFrance and Germany was funding social security of itspeople which amounted to 50% of its GDP. For everythree Euros spent in the Greece economy, one Euro wascoming from the EU, instead it should have come fromGreece itself.

It is because of the above reasons that the EUagain bails out Greece. The biggest hurdle in this pro-

cess is the unwillingness of France and Germany tofund the bail out. Both these countries had fundedmore than a third of the previous bail out of Euro 110billion. They do not want to make this as a habit wherethey have to fund the bail out of another country,


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tively factored in the pricing of government debt. Thiswould have significant impact on the borrowing costsof countries such as Japan which have a very high debtto GDP ratio. Moreover the cost of private borrowingwould increase as it is calculated on the basis of a riskpremium to the countrys bond rates. However the im-pact of these risks is not very high as the financial mar-

kets realise that the higher growth potential of thesecountries and that most of their debt is denominatedin their local currencies.

The EU is the second largest export market for theAsia Pacific economies accounting for 15% of the totalexports, just behind the United States. The devaluationof the euro would make Asian goods costlier in thesemarkets and this coupled with the weakness of theseeconomies, the exports of the Asia Pacific region wouldtake a hit. Having said this, the peripheral regionswhich are affected by the crisis currently constitute a

lesser portion of the market compared to the nationsof Germany and France. Moreover the uncertainty sur-rounding the US adds to the possible impact on tradeif the crisis spills over.

Most of the banks in the Asia Pacific region donot have any significant European bond holdings hencethe risk of losses for these banks is limited. There aremany who fear a possible seizure of the interbanklending similar to that which occurred in the 2008 cri-sis. However the two scenarios are different as in thelast crisis, most of the banks did not know the actual

amount of exposures to the subprime lending differentbanks had and hence there was a collective reluctanceto lend to each other. In the current scenario, banks areaware of the exact amount of exposures each of themhas. Additionally this not being a sudden event theyhave already planned for different scenarios whichcould occur which was not the case in 2008. Hencethe risk of financial contagion to regions outside theEurozone is limited.

Consequences for India

Indias exposure to the affected Eurozone coun-

tries (PIIGS) is minimal. These countries together ac-count for just 4.4% of the total exports and just 1% ofthe FDI inflows. However the global risk aversion whichwill set in after the crisis would see large amount ofFII outflows which would lead to significant downtrendon the stock markets. Sectors such as IT which are sig-nificantly exposed to global markets such as US wouldbe impacted while the domestic demand would remainlargely unscathed. Thus there would be a short termslowdown in the growth of the economy but the longterm growth prospects would remain to be driven bydomestic factors.

What now?

Considering the grave implication to the worldeconomy in the event the crisis spreads to largercountries such as Italy and France, this contagion

not have afforded had they not been a part of theunion. In the future if the EU wishes to make Euro asstrong as the USD it should first aim at strengtheningthe economies that constitute it. There should a largenumber of strong economies and lesser number ofweak ones so that the strong can support the weak intimes of need. With just two big economies, France and

Germany, holding the debt ridden economies, it wouldnever develop a Eurozone which can be sustained fora long time. It should also ensure by the means ofchecks and balances that all the members are workinghard to make the Eurozone strong and that nobody isa free-rider.

Consequences for the Global Economy

There are three ways in which the euro zone cri-sis could spill over to the Asia Pacific economies whichhave otherwise been on a robust recovery path fromthe 2008 recession. These are cost of sovereign debt fi-

nancing, impact on trade due to moderation in demandand the possibility of increase in the cost of credit dueto its impact on the banking sector. We study the pos-sible impact of the debt crisis on the world economythrough these three channels.

Consequences for the United States

Standalone the economic crisis in the Eurozoneshould not affect the US but in a scenario where theUS economy is already in a precarious position, nega-tive news from the euro zone may just nudge it into adouble dip recession.

US accounts for almost 10% of the total exportsof the Eurozone. Thus a flagging demand from the eurozone would add to the gloomy economic outlook forthe US. From a banking perspective, U.S. banks are ex-posed to the euro area for US$2.7 trillion, largely re-flecting claims towards France (US$643 billion) and Ger-many (US$623 billion). These claims account for 29%of total US foreign exposure. Exposure to France andGermany accounts for 14% of total foreign exposure.Exposure to the peripheral economies under stress ismodestclaims on Greece, Ireland, and Portugal ac-

count for 3% of total foreign exposure.Thus the US exposure to the euro zone is limited

to the relatively stable countries like Germany, Franceand to a lesser extent to Italy. Hence US would be hitonly if the crisis becomes systemic and spreads toother countries in the Euro zone. However the impactcould be severe if the crisis spreads to the countriessuch as France as can be seen from the amount ofexposures US has to countries such as France and to asmaller extent Italy.

Consequences for Asia Pacifc

Before the euro zone crisis the financial mar-ket considered the sovereign debt of most developednations as relatively risk free. This notion has beenchanged and the possibility of default has been ac-


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economist intelligence unit, the effective interest ratefor Greece on such a rollover is as high as 11% which isunsustainable in the long run.

Another idea which is being looked upon is thatof Eurobonds. The idea of a Eurobond is to combinethe borrowing of all the countries of the euro area byissuing common bonds for the entire euro zone. Thiswould result in greater liquidity and lower default riskas it would average it out over all the countries. Themain benefit of these bonds is that it would be less se-vere on the outliers who find that their borrowing costsincrease astronomically in the event of a crisis forminga kind of self-fulfilling prophecy. Thus this would be astep on the path of a greater fiscal union than what is

present currently.

Lastly, the Eurozone needs to realise that they need towin back the the confidence of the market to enticebusiness and investments. The current lack of it canbe seen in the bond yield spread and the rates of creditdefault swaps which indicate the return an investor re-quires in providing loan to a particular country. The big-gest challenge would thus be to drive austerity mea-sures and investment growth hand in hand which bytheir very nature are contradictory and hence require adetailed and structured execution plan.

Conclusion

Most of the measures suggested above call for apolitical handling of the challenge more than a finan-cial one as it would involve convincing various stake-holders to pay in some measure for the financial indis-cretions of the southern countries. In the long term theroots of the crisis which include unchecked spendingcoupled with a dysfunctional monetary union need tobe addressed. Unless there is a greater fiscal union forthe EU countries there is a risk that the same dramawould play itself again. The mistakes committed in the

past may be repeated again in absence of a lastingsolution to the crisis from EU countries.

should be avoided with the utmost urgency. For thisit is necessary that the size of the bailout fund (EFSF)be increased. Currently the EFSF cannot support Italywere it to default. Only when the EFSF is strengthened

enough to pay significant amount of PIIGS debt wouldthe financial markets be calmed. The United States hasasked that the fund be leveraged to improve its capac-ity. Many feel that a large contribution for this mustcome from Germany as it is in its best interests to keepthe euro afloat. The euro is cheaper than a standaloneGerman currency because of the weaker peripheraleconomies comprising the EU. This aids Germany asit can export more easily and exports are the primereason why the German economy is the strongest inthe region.

In addition to these short term measures, fixes tothe crisis are being deliberated. One such idea is of avoluntary debt rollover. Under this plan, as the GreekBonds mature over the next three years, 30% of thematurity value would be paid back in cash to holdersand the remaining would be voluntarily reinvested bymost banks in new 30 year zero coupon Greek Bonds.This rollover would be under the condition that 30% ofthe rollover amount is parked with a SPV which investsin AAA rated bonds with similar maturities which canpay back the principal to banks in case Greece defaultson payments on the 30 year bonds. Thus the technical

classification of a default is avoided while Greece isrequired to pay just half of its amount due. Howeverthis plan is criticised by many as one which just de-lays the inevitable. According to the calculations by the


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Ankit Srivastav

iiFT, Delhi

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September 2011

Wild could get wilder, that is whatthe world witnessed in the 2nd weekof August11 when the Swiss interestrates plunged into negative territory.It meant that if one wanted to lend

Swiss francs or make a deposit in thenext year, then he would have to payfor that privilege. It was not that simi-lar situations had not been witnessedin the past not just the short termrates but the future markets had alsopredicted negative rates until 2013.In a world fraught with spill overs, itonly signalled the ominous and notso surprisingly US and Europe occu-pied the centre-stage.

Back in March11, European bankingauthority (EBA), haunted by the ghostof the recessionary past, penned evenadverse a scenario for the stress test.Stress test was initially formulatedto serve as a supervisory tool to as-sess the resilience of banks to hypo-thetical external shocks. The resultof the test for European banks waspublished in July11 and eight banks

reportedly failed. These included fivebanks in Spain, two in Greece andone in Austria. 16 other banks, asshown in the exhibit, just managedto scrap through the test with a mar-gin of less than 1%. Consequently,what makes matters worse in Europetoday is the thinning patience of Ger-man tax-payer. They were reluctant

Stressed & Downgraded

about bailing out Greece, but agreedeventually, showed even greater adiscomfort over Ireland and Portugal,but stepped up. Now that Europesdebt crisis is threatening economic gi-

ants like Italy, Spain and most recentlyFrance, German public needs to takestock of how much can they take fromtheir less-disciplined neighbours.

Around the same time, US Fed alsoannounced its stress test results. Therosy picture shared suggested signifi-cant improvements in both economicconditions and the capital positionsof US financial institutions. The worldbreathed a sigh of relief but it lasted

only till the regulators had not spot-ted an anomaly in the deployed 10year Treasury bond yield which at 2.26was far lower than 2.79 as was sug-gested in the scenario. To makes mat-ters worse now, the banks ability togenerate earning growth would comeunder further pressure with the centralbanks decision to keep the rates ultra-low until at least the end of 2013.

Rating FiascoPost 2008, US had taken prudent mea-sures to push consumption and growthback on track; however the statisticsstill showed 11.1% projected unem-ployment for the year 2012. Despitethat investors and agencies alike, re-vered US as a safe investment of funds.

The global economy iscurrently in doldrumsmarred by weakeningUS economy, Euro debtcrisis and a loss of con-fidence among businessand investors. The cur-rent article explores thevarious facets of global

economy and the wayforward for it.


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But their judgement got questioned on August6th 2011, when the entire world stood shocked tolearn that Standard & Poors had downgraded the

U.S.s AAA credit rating. S&Ps downgrade woulddefinitely hurt even as strong an economy as USand despite continuous efforts to keep interestslow it is bound to result in increased cost of mort-gages, auto loans and other types of lending overthe long term as they are all tied to the interestrates paid on Trea-suries.

S&P had already putthe U.S. governmenton notice on April 18stating that it riskedlosing the AAA ratingunless the lawmak-ers agreed on a planby 2013 to reducebudget deficits andthe national debt.It had indicated $4trillion as the preferred reduction in spending.In response to that the US lawmakers on Aug 2

put in place a plan to enforce only $2.4 trillionin spending reductions over the next 10 years inaddition to agreeing to raise the nations $14.3trillion debt ceiling. What followed next was anexpulsion of US from Triple-A debt club leavingonly 15 countries (and the very small Isle of Man)intact in it. The downgrade, more broadly, reflectsthat the effectiveness, stability, and predictabilityof American policymaking and political institu-

tions have weakened at a time of ongoing fis-cal and economic challenges. The US economy isbound to enter a negative feedback loop, with ev-

ery drop in stock prices deteriorating the investorconfidence further. In the light of fresh evidencesthat the U.S. home sales and manufacturing areweakening, the risk of a recession is now aboutone in three, according to Bank of America andMorgan Stanley.

Recession threatsfor Europe arelooming equallylarge and the cor-nerstone for whichhad been conceivedat the same time asUSs. In the wake ofLehman crash itselfEuropean bankswere far more high-ly leveraged and farmore dependent on

short-term wholesale funding. Half of Americaslethal sub-prime assets had been bought by insti-

tutions in Europe only. And the offspring are nowemerging with a visible slowdown in the growthrate of Germans and Frances economy to 0.1 per-cent and zero percent respectively in the April-June quarter. The industrial production for the 17nation Euro countries also has fallen 0.7% in Junecompared to May.

The problem is on both sides of the Atlantic andthe root is simple: too much debt, and too little


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political will to deal with the consequences. Theexhibit enclosed points to this problem. Sluggisheconomic growth and unfavourable debt to GDPbalance have set the stage for a series of pro-spective rating downgrades in the form of Ger-many, France and UK. Japan, however, despite thehighest Debt/GDP ratio, has only recently been onthe radar for a downgrade. This was due to itsintervention in foreign exchange markets to stopthe rise of the yen post the earthquake that an-nihilated its economy.

Threats of a Double Dip Recession

Even prior to the rating downgrade there hadbeen fears of US dollar slipping from the status ofworlds reserve currency. And a downgrade awayfrom AAA is like a small step towards credit riskbrewing in the economy, something which any

country would ike to avoid. The US economy, theworlds largest by market price and the purchas-ing power parity was never imagined to succumb,and thus the threats of double dip recession seemmore real.

Double dip recession means when gross domes-tic product (GDP) growth slides back to nega-tive after a quarter or two of positive growth. Adouble dip recession study carried out by econo-mists from Deutsche Bank AG, who reviewed US

economic history all the way back to the 1850s,revealed that double dip recessions were exceed-ingly rare and the current situation is not akin toone. It stated that out of 33 recessions that hadtaken place since 1854 two of the three doubledips happened in the years prior to World WarII in 1913, and in 1920. The third and the morerelevant double dip recession took place in early1980s, where the underlying cause was inflation.With deflation just as likely as inflation in the cur-rent scenario, a repeat of the 1980s is unlikely

and rock bottom interest rates are a testimonyto that.

Disaster Management

In case of Europe, Germany does not have theoption to break away from the Euro zone. Theproposition could create further trade imbalancesand slowdown its growth. Instead Angela Merkel

by agreeing to triple or quadruple the current$625-billion bailout fund can push for a commonfinance ministry with sweeping powers to settaxes, limit debt and control deficits of Euro zonecountries. This closer fiscal integration could thenpave way for a smooth introduction of collectiveEurobonds to replace government bonds issuedby individual countries.

US, on the other hand, can take heart from thefact that the world has still not turned a blind eyeto it. Even in the face of a downgrade the yieldsof Treasuries are low because there is nowhereelse for the people to go. Amid concerns thatglobal growth is slowing and Europes sovereigndebt crisis is spreading, investors still view dol-lar assets as amongst the safest. Post downgradedecline in fuel prices has also played in USs fa-

vour by lowering commodities prices. This wouldin turn also lower energy and food costs, freeingup consumer purchasing power and slowing infla-tion. A show of strength by sectors such as retailin US and a consistent level of job growth are allfavourable signs.

It is common fact now that QE2 was a failure andthe world already anticipates negative resultsfrom QE3. US must take into cognizance that itsproblem is more fiscal in nature and that they

have failed to cut spending and raise revenueenough to reduce budget deficit. Thus, cuttingentitlement programs such as Social Security andMedicare would be steps in the right direction.However, under the threat of default, an agree-ment on raising the debt ceiling is akin to com-promising the spending ability of future genera-tions to come. In financial trouble, US faces thechallenge to reconcile deficit control with mea-sures to stimulate its economy and create jobs.In the end, a concerted effort would be required

from both US and Europe to safely steer the worldthrough another economic downturn.

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that barring a onetime revenue stream from the 3G

auction and divestment the figure would have stoodat 6.1% of the GDP. The current numbers for Q1 FY12 are 4 times of the corresponding FY 11 numbersand represent 40% of the budgeted estimate (BE) forFY 12 signalling an ominous situation on this front.The macro environment since the budget was an-nounced has witnessed tectonic shifts with the USdowngrade and spread of the European sovereigndebt contagion and we analyse the expected fiscaldeficit for FY 12 as follows.

Tax Collections

The BE growth of 9% seems unrealistic now with like-ly softening in exports and high inflation. Consensusestimates peg it in the vicinity of 7.5%. Lower growthwill lead to lower tax receipts (direct tax buoyancy1.94 and indirect tax buoyancy at 0.84). Thus the fallin direct tax will be 0.154 lakh crore while that inindirect taxes is 0.055 lakh crore (BE at 5.32 and 3.92lakh crore respectively).

Subsidies

Indian crude basket for FY 11 hovered at $ 80/bbl re-sulting in a Rs 78000 crores under-recoveries to the

OMCs (Oil Marketing Companies) of which the gov-ernment tab stood at Rs 21000 crores. The revisedsubsidy burden under the assumption of averagecrude basket of $110/bbl is computed below:

If the sharing pattern suggested by the Kirit ParikhCommittee report were to be followed, the upstreamcompanies can be expected to shoulder to 38.5%of the tab (based on FY11 burden sharing) leav-ing a minimum of Rs 1105.67 Billion to be footedby government. As the government wants to tameinflation (which rules out passing the burden onto

the consumer) and exercise fiscal rectitude one canconclude that the maximum possible amount willbe foisted on the OMCs. A fundamental analysis ofthe key financials of the OMCs on a target debt to

The Indian growth story over the past decade has

turned heads across the globe to take notice of aneconomic super power in the making. However,cracks are now beginning to appear partly as a re-sult of global scenario and in part due to neglectof fundamental aspects. High inflation, surging cur-rent account deficit, widening fiscal deficit are justa few of the macroeconomic indicators that portenda shaky outlook.

Fiscal deficit and current account deficit (twin defi-cits as they are referred to commonly) are an unwel-come proposition for any economy. A yawning fiscal

deficit forces the government to borrow to meetsits expenses, crowds out private investment, hurtsinterest rate sensitive sectors such as infrastructureand above all eats into economic growth. A lowergrowth with an increased deficit further inhibits thecountry ability to meet its obligations leading to afall in credit ratings and a consequent rise in bor-rowing costs essentially asphyxiating the country ina debt trap. This debt trap inhibits the governmentsability to spend on welfare schemes in the future.

This combination of deficits makes the economy ex-

tremely susceptible to any shock as was witnessedduring the 1991 crisis as the economy needs bothdomestic and foreign borrowing to nullify the defi-cits. US, Spain and Greece are few countries thatface the same peril and their current state is anexcellent indication of this fact.

This article makes an attempt at exploring Indiasfiscal deficit situation by challenging the viability ofthe underlying assumptions and estimating the ca-pacity of the current system to finance it.

Fiscal Defcit Estimation

It is defined as government expenses less revenuesand stood at 3.69 lakh crore (4.7% of the GDP) forFY11. While a y-o-y trend suggest a sharp plummetfrom 6.3% in FY 10, reading the fine print shows

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cash flow ratio of 6 indicates a maximum additional

debt capacity of Rs 240 billion. Thus, governmentwill have to foot Rs 865.67 billion (Rs 86,500 crore)towards petrol subsidies this year versus BE of Rs23,600 crore in the absence of price hikes.

Fertilizer Subsidy

In 1992 prices of all fertilizers except urea were de-controlled leading to a sharp increase in use of urea.To fix this anomaly government proposed the intro-duction of Nutrient Based Subsidy scheme whereinsubsidy will be provided based on nutrient contentsof fertilizers. Currently the fertilizer subsidy can be

classified into three categories:

a) Imported Urea: This component of fertil-izer subsidy is very volatile because internationalurea prices movement. Subsidy on imported ureaincreased 66% from 2007-08 to 2008-09 (Rs 6606Crto Rs 10891Cr). The budget estimates for the year2011-12 stands at Rs 6983Cr but any upward move-ment in international prices can inflate this figuresubstantially.

b) Indigenous Urea: This subsidy is intendedto protect urea manufacturers. The quantum of thissubsidy is also increasing because of increasing in-put prices, increasing production and stable sellingprice of urea (just an increase of 10% in 10 years; Rs4600/ton in 1999-2000 to Rs 5070/ton currently). Thebudget estimates for the year 2011-12 stands at Rs13308Cr and represents 27% of the fertilizer subsidybill.

c) Decontrolled fertilizers: Government sells P,K based fertilizers to farmers at concession price.Current budget estimate for the year 2011-12 is Rs29707Cr and it forms 60% of the total fertilizer subsi-dies.

Government revised their budget estimates for fertil-izer subsidy from Rs 49997Cr to Rs 63000Cr on March4, 2011

Food Subsidy

Food subsidy is currently provided in form of dis-tribution food grains through Public Distribution

System (PDS). Agricultural produce is procured from

farmers at minimum support prices to replenish thebuffer stocks (held by Food Corporation of India) aswell as for distribution to through PDS. Hence, partof the government subsidy goes towards the carry-ing cost of buffer stocks. The budget estimates forfood subsidy given by government for 2011-12 wereRs 60573Cr.

The budget estimate needs to be revised due totwo factors. Firstly, India has consistently witnessedfood inflation close to 9% during most of year 2011and it is expected to hover around that figure till at

least October 2011. The minimum support price ofpaddy was increased by Rs 80/quintal (increase of8%) in June 2011. Secondly, National Advisory Coun-cils (NAC) recommendations on Food Security Billpropose to provide 35kg of food grains per month toabout 75% of the population at a price not more thanhalf the MSP. This leads to an estimated increase infood subsidy by Rs 23000Cr according to NAC. But

according to Rangarajan Committee report, if invest-ment on additional storage capacity and higher MSP

are taken into consideration, the estimated increasein food subsidy will be Rs 35000Cr. This pegs thetotal food subsidy figure for 2011-12 at Rs 99570Cr ifFood Security Bill is implemented in its current form.

The estimate of revised fiscal deficit as a % of GDPuses the FY 12 GDP as Rs 84.38 lakh crore (7.5% y-o-y growth). Clearly the figure is alarming by anymeasure and financing it becomes our next concern.

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Financing the revised fscal defcit

The government may finance the deficit internallyor externally. Internal financing is preferred as iteliminates exchange rate risk and provides a lastditch option of printing currency to meet commit-ments. This is reflected in the historical GoI borrow-ing trends with the 3 year average external borrow-ing at 3.3% of GFD.

On the internal financing front, banks through the

SLR route, mutual fund and life insurance compa-nies drive government market borrowings. The BE ofgross market borrowing stood at Rs 4.17 lakh crorefor FY 12. The broad money supply (M3) is expectedto increase by 15% in FY 12 from Rs 65lakh crore toRs 75lakh crore. The additional Rs 10lakh crore willcontribute to SLR deposits of banks to the tune ofRs 2.4lakh crore (24% SLR). Given the current risk-averseness in the markets an additional Rs 1.77lakhcrore of market borrowing to meet the BE seemsdicey. Even if we add Rs 0.175lakh crore of externalborrowings, the unbridged deficit works out to be Rs0.945lakh crore.

This brings us to the options the government has tomeet its expenses:

a) Increase the M3 further: This is a sure shotrecipe for higher demand side inflation. Given thecurrent fight against a 9% + WPI number, it is defi-nitely not an option worth exercising.

b) Borrow Additional Funds from market: Sucha move will drive up interest rates, suck out liquid-ity and dent investment retarding future growth as a

result. Moreover to get the borrowings in the currentenvironment a high interest rate needs to be offeredwhich drives up the borrowings costs and disturbsfuture fiscal balance.

c) Foreign Borrowings: These will be hard tocome by given the flight to quality and risk-aversionin the global capital markets.

d) Divestment: The most likely option that willbe exercised to sugarcoat a worrying fiscal deficit.While this is a viable one time option its no pana-cea to the fundamental deficit problem India faces.

This income may still not be sufficient and increasedmarket borrowings are highly likely.

Recommendations & Conclusion

It is high time we plugged the deficit gap that has

been often forgotten in the India Shining story. Thiscalls for strong leadership and aggressive reforms.GST & DTC are potent tools to widen the tax basewithout burdening the middle class with high taxes.This model has proven to be successful as has beenwitnessed by the steady decrease in tax rate along-side an upbeat tax revenue collection on account ofa widening tax net.

On the expenditure front, the concept of subsidiesin India is out dated and backward looking. Whilea food subsidy is justified on account of the hugebelow poverty line population (BPL), an efficienttransmission of the same through the UID system isnecessary to eliminate pilferage. Petroleum productsubsidies are a sham as the government taxes theseproducts on one hand and gives a subsidy to theOMCs on the other. The Kirit Parikh Committee Re-port reflects that the government earns net positiverevenue on these products by this mechanism. Thecomplex muddle of the current oil pricing mecha-nism should be done away with and abnormal taxes

on these products be slashed. This should reduceinflation and set in the virtuous growth cycle whichin turn will bring higher tax collections for the gov-ernment.

Cleansing the oil sector will attract private partici-pation. This is necessary to reduce our import de-pendence and decouple the economy from oil priceshocks capable of paralysing the economy. With 30%of the imports being petroleum products, such aninitiative will help narrow down the second of ourtwin deficits also namely the trade deficit.

These fundamental measures should go a long wayin checking the runaway fiscal deficit and add manymore golden years to the Indian growth fable.

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Perspective

A high fiscal deficitand not-so-good situ-ation prevailing in theUS economy has raisedcertain questions andconcerns over US dollaras the reserve currency.This article discusses thevarious factors respon-sible for dollar being thereserve currency, wheth-er they still hold true,and the alternatives tothis system.

How the Dollar became global

currency

Before questioning the status of dol-lar as reserve currency, we have tofirst understand the factors that wereresponsible for giving dollar a globalstatus and if those factors still pre-vail in the present scenario. Only thencan we infer whether we should think

about the possibility of replacing dol-lar or not.

A. Bretton Woods System

Bretton Woods System was a fully ne-gotiated monetary order among theworlds major industrial countries inthe mid-20th century to govern mon-etary relations among each other.The planners at Bretton Woods es-tablished the International Monetary

Fund (IMF) with the duty of monitor-ing and supervising the system andthe International Bank for Reconstruc-tion and Development (IBRD), whichtoday is part of the World Bank Group,was charged initially with role of as-sisting the reconstruction of Europesdevastated economies.

It was this era in which US dollar be-came a global currency and this forc-

es us to analyse the dominant factorsthat were responsible to make US dol-lar a global currency. Harry Dexter theUS economist, negotiated for Bretton

From oil to gold, coffee to coal,the global price of all commoditiesis quoted in dollars, making it themost sought after currency in theworld. The US Dollar got the status ofglobal currency in 1944 near the endof World War II and the dominancecontinues till date. There have beennumerous reserve currencies overthe centuries, but none were morewidely accepted than the US dollarsince 1944. While the US dollar hasfluctuated widely in value over the65 years since its designation as thereserve currency, its credibility hascome under the most intense scruti-ny ever in the last few years. The USdollar peaked in value in 2000-2001and has been suffering a significantdecline ever since.

With a proposed record $1.56 tril-lion deficit, there are uncertain-ties about the reserve status of thedollar. As a result, there are talksaround the world to end the dollarsstatus as the worlds reserve cur-rency and replace it with a betteralternative. The question is, replaceit with what? The US dollar is by farthe largest reserve currency in the

world; many commodities aroundthe world are priced in dollars; andmost international transactions aresettled in dollars.

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Woods System and infused dollar as a globalreserve currency. He was able to negotiate ingood terms, because all the conditions favouredUS at that time.

Goldreserves:-In1945,theUSauthori-ties held approximately 70% of the worlds gold

reserves. This was the major factor that influ-enced countries to peg their currency againstdollar and each currency was allowed to fluctu-ate by plus or minus 1% either side of the par-ity. This is because dollar itself was fixed to theprice of gold at $35 per ounce. The idea of fixingthe dollar to the price of gold was to provideconfidence in the system. It was reasoned thatthe foreign central banks would be more willingto hold dollars in their reserves if they knew

that it could be converted to gold. Biggestconsumer:-AfterworldwarII,

the US proved to be the biggest consumer. Ac-cording to the economist Robert Triffin - The Bret-ton Woods system works, only if US maintainsa trade deficit and other countries maintain asurplus, then other countries would be able tomaintain a dollar reserve and thereby wouldbe able to prevent their currency from appre-ciating. And if a currency appreciates, then thedollar would depreciate and dollar had peggeditself to gold i.e. $35 = 1 ounce of gold. So a de-preciated dollar would either have to shed moregold when asked by an appreciated currency orelse dollar has to devalue itself against gold.Thus, dollar has no other option under the Bret-ton Woods but to keep on importing goods andthereby allowing other countries to maintaindollar reserve through trade surplus.

The above mentioned reasons were key influ-encers for dollar to become a reserve currency.

Present Scenario

The factors that prevailed in the past that en-abled US dollar to become a global reserve cur-rency may or may not exist in the present sce-nario. One has to analyse whether those factorsprevail today or not and if they dont, then re-placement of dollar can be thought of.

Huge Debt: - In the past, countries

pegged to dollar because it was strong enoughto help countries to grow, but with the subprimecrises and then recession, US has landed intohuge debt of $12.311 trillion and now it requiresrebuilding.

Nolongerapromisingconsumer:-Acon-sumer who is at the verge of insolvency cant bepromising. In case of United States, even thoughit may recover but, it is facing a deflation i.e. in2009 its annual inflation was -0.4%.

Alternatives to dollar

The dollar can be replaced by any of the threealternatives:-

Replacing dollar by another currency

It can be easily inferred that after dollar, it isthe euro which covers maximum portion ofthe global reserve. Also with its past ten yearsgrowth rate in the global reserve euro tends tobe the undisputed winner against the other twoalternative currencies (yen and pound sterling),when it comes to the confidence - level.

The best way to infuse euro in the global systemis by legalizing oil trades in euro. Once oil tradeis mandatory in euro all countries will be forcedto keep euro as their key reserve currency. How-

ever, with the reserve currency status, euro willhave to shoulder responsibilities too. All thecountries in the euro-zone will have to be majorimporters of goods and services and only thenthe rest of the world would accept euro as areserve currency. If the countries in the euro-zone have a trade surplus, then the rest of thecountries wont have sufficient euro reserve tocarry on their international trade with membercountries and as a result all the member coun-

tries would resort to other currency reserves.But, by taking euro as a global currency, chanc-es are that after some time the world economywould be at the same position as it is right now.This is because replacing one currency by someanother currency wont help much in solving thesituation; the world economy would be again

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dependent on just a single currency.

Abolishing the concept of currency as a global

reserve

Special Drawing Rights (SDRs) can be thought ofas an option to the current problem of depend-ing on just a single currency. The SDR is linked

to a basket of currencies with a weight of 44%for the dollar, 34% for the euro, and 11% eachfor the yen and pound sterling. If India wantsto use its SDRs, it will typically ask the IMF fordollars in exchange. The IMF will debit IndiasSDR account, credit Americas SDR account, askthe US for the corresponding dollars, and handthese to India. In case of SDRs, the risk of de-pending on just a single currency would get dis-tributed in four different currencies. However,

when it comes to implementing SDRs, there arevarious issues that surface up. Firstly, beforebecoming a separate international currency, theSDR will remain a derivative of the dollar and afew other major national currencies. As a resultof which any change in the constituting curren-cies economies would bring in a change in SDRsvalue. Thus, SDRs are anchored in four existingcurrencies, and do not constitute an indepen-dent new currency. Also, since dollar holding a44% share in SDR and if SDR is made a globalcurrency, then any turmoil in US economy willhave an adverse effect on SDR and thereby onthe world economy.

Introducing a new global currency

This alternative may seem ambiguous, but atthe UNs Bretton Woods conference in 1944,John Maynard Keynes put forward this idea. Andtill date, it seems logical enough and can bethought of. One of the reasons for financial cri-

ses is the imbalance of trade between nations.Countries accumulate debt partly as a result ofsustaining a trade deficit. They can easily be-come trapped in a vicious spiral: the bigger theirdebt, the harder it is to generate a trade sur-plus. International debt wrecks peoples devel-opment trashes the environment and threatensthe global system with periodic crises.

As Keynes recognised, there is not much thedebtor nations can do. Only the countries thatmaintain a trade surplus have real agency, so itis they who must be obliged to change their pol-icies. His solution was an ingenious system forpersuading the creditor nations to spend their

surplus money back into the economies of thedebtor nations.

He proposed a global bank, which he called theInternational Clearing Union. The bank would is-sue its own currency - the bancor - which wasexchangeable with national currencies at fixedrates of exchange. The bancor would become theunit of account between nations, which meansit would be used to measure a countrys tradedeficit or trade surplus. Every country would

have an overdraft facility in its bancor accountat the International Clearing Union, equivalentto half the average value of its trade over afive-year period. To make the system work, themembers of the union would need a powerfulincentive to clear their bancor accounts by theend of the year: to end up with neither a tradedeficit nor a trade surplus. But what would theincentive be?

Keynes proposed that any country racking up alarge trade deficit (equating to more than halfof its bancor overdraft allowance) would becharged interest on its account. It would also beobliged to reduce the value of its currency andto prevent the export of capital. But - and thiswas the key to his system - he insisted that thenations with a trade surplus would be subjectto similar pressures. Any country with a bancorcredit balance that was more than half the sizeof its overdraft facility would be charged inter-est, at a rate of 10%. It would also be obliged to

increase the value of its currency and to permitthe export of capital. If, by the end of the year,its credit balance exceeded the total value ofits permitted overdraft, the surplus would beconfiscated. The nations with a surplus wouldhave a powerful incentive to get rid of it. Indoing so, they would automatically clear othernations deficits.

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Replacement of dollar reality or illusion

Before drawing out a conclusion as to whetherdollar would get replaced or not, two notableimplications should be considered which wouldprove to be hindrance to the replacement ofdollar.

ReservesAny alternative which is implemented againstdollar should be in a position to absorb dol-lar from the economies. If the alternatives arenot in a position to absorb dollar, then membercountries would resort to US or the monetary au-thority concerned to convert dollar reserves intothe new alternative reserve currency (i.e. euroor SDRs or bancor). If the concerned authority isnot in a position to convert dollar reserves, then

the world economy would be at stake.Dominance of US as a business entity

Strength of the Economy

United States is the largest domestic economyin the world. Its GDP is estimated to be around$14.2 trillion in 2009, which is 3 times theworlds second largest economy, Japan. In thepast as well, it has maintained a very high levelof output per person and keeps on doing thatin the present. Also American labour market has

attracted immigrants from all over the worldand has one of the worlds highest immigrationrates. It has been ranked 2nd, down from 1stdue to economic crisis, according to Global com-petitiveness report. It has worlds largest andmost influential financial market

Stable and flexible political system

The US political system is highly stable and levelof corruption is quite low as it is evident fromthe corruption perception index by Forbes in

which US is rated from 7 7.9 out of 10 andranked 19th. Also the US economy is highly flex-ible in its approach in tackling economic situa-tions which is visible in the present scenario,where in spite of being a capitalist economy,understanding the present down turn, it shifteditself to a socialist economy by giving bailoutpackages and nationalizing the private enti-

ties. This kind of shift in approach is mostlyseen by corporate houses but not by countriesas a whole. Also, US is considered as an openeconomy and have always promoted the same,but when presently its interest is at stake, itchanged its open economy policy. History hasalways challenged US yet it has always been a

superpower. This is just because of its flexiblepolicy - attitude towards downturns and its sayin all the decisions pertaining to world econom-ic policies.

Conclusion

In this article, we discussed the various factorsthat were responsible for the dollar to attainglobal currency status. We validated that wheth-er those factors are still prevailing in the pres-ent scenario and also checked the confidencelevel in global reserve through trend analysis.The comparison and analysis proved that thefactors no longer exist, so we can think of re-placing dollar. Then we analysed the alternativesavailable against dollar and the mechanism asto how they would function. We also uncoverthe negative impacts of replacing dollar on theglobal economy and as to how US still tends tomaintain a dominating position over the worldeconomy.

We conclude that since dollar is deeply infusedin the global financial system it would not loseits dominance in the global reserve in the nexttwo decade. Also, if replacement of dollar isconsidered, then world economy would go foreuro, which is the next best alternative. Logi-cally the world economy should go for a newcurrency as suggested by Keynes, but since it isagainst the interest of developed nations so itwont get implemented.

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CoverStory EURO DEBT CRISIS

THE NEXT LOOMING DANGER

Nmims, mumbai

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eled an asset price bubble in real estate, drawingresources away from productive activities, inflatingbank loan books and exposing them to sector-specificshocks. Fiscal profligacy by peripheral governments,hot capital inflows, rapid economic growth, and surg-ing imports coupled with rising wages [Exhibit 2] ledto declining competitiveness, mounting public debtsand current account deficits. [Exhibit 3]. The 2008 fi-nancial crisis only acted as a trigger to this perilousposition waiting to explode.

Why the international community needs tosit up and take notice?

Today Europe accounts for around one third of globalGDP, of which 90% is generated by the EU, the worlds

Current scenario on the Euro Debt crisisand policy view

Ensnared in the ensuing debt crisis, western worldis confronted with pressing problems, viz. - rescuingembattled financial system, restoring investor con-fidence, halting the contagion, and effecting timely,

complementary, sustainable and effective fiscal andmonetary policy responses.

The crisis which had its genesis in a) fiscal profli-gacy, b) lack of deeper macro-economic integration,c) private sector excesses, d) availability of cheapcredit, e) mis-pricing of the creditrisk, and f) stop-gap policy making is compounded by coupled mar-kets & socio-political issues. The EU & IMF policiesviewed it as a liquidity issue and failed to addresspossibility of insolvency, systemic inter-dependencebetween banking and sovereign crisis, and concerns

of growth and structural reforms.Historic origin of the crisis [Exhibit 1]

Post EMU formation 1999, with the deepening ofan integrated EU market, diminishing country riskpremia, narrowing sovereign bond spreads therewas a sharp fall in real interest rates, especially inperipheral countries. This led to rapid expansion ofcredit demand, which in part created and nourishedfinancial and economic imbalances which were un-sustainable.

For e.g., institutional and psychological factors fu-

% Real GDPGrowth

EmploymentGrowth

Real PrivateConsumptionGrowth

Real PublicConsump-tion Growth

Real Gross FixedCapital FormationGrowth

ExportVolumeGrowth

ImportVolumeGrowth

Greece 4.1 1.3 3.8 4.1 6.3 6.4 6.0

Ireland 6.5 3.7 5.9 6.1 6.7 8.4 8.2

Portugal 1.8 0.7 2.3 2.2 0.1 4.9 4.1

Spain 3.7 4.3 3.9 4.9 6.1 5.3 8.3

Italy 1.5 1.5 1.2 1.9 2.6 2.9 3.8

France 2.2 1.0 2.7 1.6 4.1 3.8 5.7

Germany 1.6 0.6 0.9 0.8 1.3 8.0 6.1

Euro Area 2.2 1.4 2.0 2.0 3.0 - -

US 2.8 1.2 3.4 2.1 3.1 4.6 6.2

Exhibit 1: Main Macro Variables revealing increased consumption activity in PIGS in the period.

Source: OECD Economic Outlook No 88 & OECD Stat - Average over period 1999-2007

Exhibit 2 : Slower growth of services sector in Europe than in

the United States. Source: McKinsey Global Institute European

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largest economic area. Presently, European Bankshave US$ 2.16 trillion debt exposure to PIIGS. A col-lapse of financial systems in some euro membernations could have a domino effect in other mem-bers & non-euro countries carrying a significantexposure to euro sovereign bonds and privatedebt. About a quarter of Chinas record foreigncurrency reserves of more than $3 trillion are heldin euro assets. Developing Countries [DC] contrib-ute 58.3% [ 869 billion 2010 source: Eurostat]of EUs imports. A significant decline in real de-mand will have a far-reaching impact on economyof these DCs.

Analysis of previous policy attempts to

tackle similar crisis and the way forwardSovereign borrowing via govt. bonds, increasescomplexity due to the increased number of credi-tors. The most common methods employed toaddress a debt crisis include Debt Rescheduling,Debt Restructuring, Provide new credit to easeliquidity situation & facilitate imports for futureimport substitution & export promotion as short-term measures. The long term measures includepolicies for prevention of a spiraling liquidity andbanking crisis and providing a conducive econom-

ic climate that enable the sovereign to operatecompetitively in international credit markets.

Initially problems were viewed as short-term li-quidity issues, focusing on immediate debt re-lief. Subsequently, policies such as the BradyPlan recognised the need for development poli-cies apart from the existing debt strategy. It tiedup contributions from the IMF and World Bank,thereby increasing the accountability of debtor na-tions to the creditors. It involved explicit quotasfor interest support (40%) as well as standby loanfacility (25%). It also recognised the need for re-laxation of legal, taxation, regulatory and account-ing constraints, in order to remove disincentivesor incentivise debt reduction.

However, certain debt restructuring issues faced

by debtors still remained viz.: (a) exorbitant debtservicing requirements, (b) reliance on one or twoexport-oriented commodities, (c) significant weak-ness in terms of trade of commodities, and (d)entrance of rogue vulture hedge funds. To addressthese concerns, policies such as export credit fa-cility, ensuring NPV terms with other options, eco-nomic program to set on the path to recovery, set-ting up of a centralized authority to monitor debtand negotiate debt restructuring terms, SDRM,CAC and the Chapter 9 bankruptcy proposal. These

moves ensured the interests of majority of thecreditors and didnt aim at unanimous decisions.

A decade of wars, tax exemptions, US Govt. sub-prime crisis response fiscal loosening, QE 1 &2, TARP program increased public debt and ne-cessitated raising of debt ceiling. Nonetheless, USfundamentals are strong and ratings downgradereflects political gridlock and policy making inepti-tude.

Eurozone specifc measure and the gap to

be plugged

The Eurozone has put in place a specialised mech-anism of EFSF & EFSM to safeguard financial stabil-ity under supervision of the EC. Its primary func-tions involve raising funds in capital markets andsemi-annual review of the economic condition of

Exhibit 3: Bourgeoning Public Debt. Source: McKinsey Global

Institute: Beyond Austerity: A path to economic growth &

renewal in Europe

Exhibit 4: Sovereign Spreads to German Bunds projectingreturn to pre-euro level. Source: Nomura Global Economics

Report: Europe Will Work, March 2011 Note: Data represent-

ed here is the simple average of Austrian, Irish, Belgium,

Netherlands, Italy, Spain and France 10yr government bond

spreads to 10yr Bunds

Exhibit 5: Financial Repression as a way out. Source: BCG:

Collateral Damage Stop Kicking the Can Down the Road


22/26september 2011

22 NIVESHAK

CoverStory

22

Finsight

the member nations. Although lessons from thepast have helped shape relief packages and poli-cies, some issues are yet to be addressed

The Eurozone members are subject to varied eco-nomic risks; however this aspect is not factoredinto the yields.

For example, The Greek bonds had a risk premiumof 1796 bps over the German Bund, in spite of asignificantly riskier economic environment. Withcheap availability of overseas funds, Greece bitmore than it could chew resulting in a drasticupward shift in yields upon the revelation of itseconomic vulnerability. [Refer to Exhibit 4]

Proposed Strategic policy making [Referto exhibit 5]

The suggested policy would primarily aim at the

following 3 objectives-(A) Plan to restore banking-sector soundness

Exchange offers, negotiated in private between Eu-rozone Bank Committee and the sovereign debtor,wherein the latter would offer medium to longterm, replacement bonds or credit agreements forthe existing bonds. This would entail creation ofspecial accounting, tax and regulatory treatmentfor the restructured Eurozone debt by the EU.

Urgent recapitalisation of systemically impor-

tant banks using public funds and the EFSF. Register EFSF as a bank to borrow from the

ECB, with sovereign bonds it buys as collat-eral. This arms-length arrangement would bemuch better than having the ECB buy bondsitself.

Encourage banks consolidation to cut [opera-tional] costs and improve capital ratios.

Minimise stock flow adjustment and diminishthe snow ball effect .

ECB should ensure a loose monetary policy bynot increasing short term interest rates, espe-cially in times of fiscal austerity

(B) Revising EU assistance mechanism and

restructuring of public debt where required

Haircut realized over several year time horizonthat allows EU banks (a) to control the magni-tude of the losses; (b) to distribute the lossesover the life of the new instruments; and (c)strengthen their balance sheets with a newcredit in part guaranteed by the EFSF/EFSM

Value recovery by effecting GDP warrants. Issuance of Euro joint bonds, reducing bor-

rowing costs for the profligate and overcomingissue of mis-pricing of credit risk associated

with sovereigns. [Red Euro-Bonds above Debt/

GDP of 60%, Blue Euro-Bonds below this limit] Debt-for-equity, education, environment and

poverty swaps

(C) Enhancing Domestic Reforms, Growth,

and Competitiveness

Ensure labour market flexibility (reforms inwelfare and pension policy and employmentprotection legislation), focus on education andtechnical skills and boosting product marketcompetitiveness (remove high barriers to en-trepreneurship & restrictive product market

practices). [Refer to exhibit 6]

Debt burdened nations need a well-designedprivatization scheme instead of a fire-sale toraise cash

Structural, supply-side measures Improvegrowth prospects in prudent and profligatecountries alike by investing in core business-es.

Not only the size, but also the form, of thefiscal retrenchment is important. Fiscal con-

solidations that cut expenditure, rather thanraise taxes should pave the future sustainablegrowth path

Incentivise the debtor nations to invest in ca-pacity creation for import substitution and ex-port promotion measures by providing a creditline facility thereby facilitating the economicrecovery

Although the recovery is expected to be fragileand sluggish, these policies have a better chanceof avoiding debt contagion, recession and stagna-tion.

Exhibit 6: Relative Unit Labour Costs, 1999-2007. Source: No-

mura Global Economics Report: Europe Will Work, March

2011


23/26FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

23

CoverS

tory

NIVESHAK 23

Sir, recently there has been a lot oftalk about the currency wars between USand China. What exactly do we mean bycurrency wars?

Well, currency war is nothing but thecompetitive devaluation of currency. De-valuation is the decrease in the value of acountrys currency relative to that of foreign

countries to attain a lower exchange rate.

But why would a country want to de-valuate its currency? I always thought astronger currency is a positive indicator!

This is a general misconception. Thestrategy a country adopts to deal with itscurrency depends on various factors. De-valuation of currency has its own advan-tages. As the value of the local currency

decreases, it makes the exports cheaper. This makesthem more competitive in the foreign markets, therebyincreasing the revenue for the parent country. It alsohelps in boosting employment, as there is a demandfor more products in the foreign market. So, depending

on the situation, countries go for devaluation of theircurrency. These strategies are often adopted during re-cession.

Yes sir, now it all fits in. But there hasto be some downside to this, right?

Absolutely, there are always limitationsto every phenomenon. What we need to un-derstand is that while on one hand exportsbecome cheaper, on the other, our ability to

buy foreign goods decreases because the imports arenow expensive. Also the local firms would not reducethe costs of the products as they rely on devaluation,which will anyway increase their competitiveness in

the market. These factors can ultimately lead to in-flation, and therefore affecting the entire economy.The impact of the inflation can vary, depending onthe pervasiveness of the currency. For Example, in-flation in the USA is bad news to the entire worldeconomy because the US Dollar is widely used bymost the countries.

Sir, all this is very interesting. Buthow actually can a country devaluate itscurrency?

Countries adopt many ways to de-valuate their currency. One of those is byinfusing more money in local currency intothe market. This will automatically result

in its devaluation. Another way is by selling its owncurrency to buy the currencies of other countries,which will lead to the reduction of its value.

Okay, this should mean that each

country would want the other countryto have a stronger currency.

No, not exactly. A country wouldwant the other countries to have a stron-ger currency only if it has a positive bal-ance of trade, i.e. if it has higher exports

than imports.

Oh! I see. Then what exactly is the

problem between China and US?

It is a similar scenario between USand China. China is complaining that de-valuation of US dollar has resulted in in-flation while US wants China to appreci-

ate the Yuan, so as to make Chinese products moreexpensive in the US market. It is very important foryou to understand this as this war has aggravated in

the current scenario and might pose a threat to theworld economy.

Thank you sir. The articles on cur-rency wars will definitely make moresense from now on.

CLASSROOM

FinFundaof theMonth

CURRENCY

WARS

IIM ShillongPochineni Shalini

Classroom


24/26September 2011

2424

F I N - Q

1. Governments should automatically reduce taxes during economic slumps andincrease taxes during economic boom are an example of activist strategy of mon-etary and Fiscal policy. (true or False)

2. A bond is paying 6,5% coupon rate/annum, semiannually,FV 100,what will bethe effective annualized yield ?

3. Which types of risk is involved while trading Government bond?

4. In options trading, market risk for buyer is. but for seller it is..

5. You bought 100 shares of M&M at 1000. The current market price is 1050. Atwhat price must you place a stop loss order to prevent losses beyond Rs.5000 ?

6. Book Building is a auction while a normal public issue is a .. auctionin India

7. The interest rate of a bond quoted in the secondary market is calledthe..

8. What is LEAPS? Define it.

9. A trader who is willing to quote both bid and offer prices for assets iscalled.

10. You buy an option to sell 100 shares of EIL at 2400. The premium is Rs.10per share. The price of EIL goes up to 2500 on maturity. What is your profit or loss onthe option?

All entries should be mailed at [email protected] by 15th October, 2011 23:59 hrs

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


25/26

Article of the Month

Prize - INR 1000/-Aashish Chhachhi & Ankit Kesri

XLRI, Jamshedpur

W I N N E R S

A N N O U N C E M E N T S

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

Instructions

Please email your article with the file name and the subject as __ by 15 October 2011. Article must be sent in Microsoft Word Document (doc/docx), Font: Times New

Roman, Font Size: 12, Line spacing: 1.5 Please ensure that the entire document has a wordcount between 1200 - 1500 The cover page of the article should only contain the Title of the Article, theAuthors Name and the Institutes Name Mention your e-mail id/ blog if you want the readers to contact you for furtherdiscussion

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