MDI Monetrix BlueChip Issue3 October-December 2012

Dear reader,

Welcome to the third issue of Blue Chip!

The cover article this time is on the various aspects

that the RBI needs to work upon for the benefit of the

economy and the country. The country is going

through trying times such that even the Finance Min-

ister P Chidambram is conducting road shows abroad

to help the cause. One can only hope for a speedy

recovery for the Indian economy which seems to be

suffering from structural issues which may not be

readily alleviated by quick fixes such as rate changes

or import duties.

After covering the monetary aspect through the cover

article, we give a sneak peak into the fiscal side

through our interview with Mr. CS Mohapatra who is

Adviser, FSDC in the Department of Economic Af-

fairs of Finance Ministry. He talks about the meas-

ures taken by them for creating a better investment

environment in India for both foreign as well as do-

mestic investors. This interview would definitely be

very insightful for understanding the evolving regula-

tory system in India which would play a big role in

growth as well as the further development of India’s

economic landscape.

Keeping with the spirit of bringing exciting content

in every issue & our endeavour to always entice our

readers, we have taken a detour from the book review

to a fun movie review of Moneyball which released

in 2011.

The next issue would be special as it would be com-

ing to you in the fresh fiscal year brought to you by a

new editorial team. Wishing the graduating class of

MBAs across campuses ‘All the Best’ on their jour-

ney into the corporate world and beyond.

On this note, I would like to bid adieu to all the read-

ers of Blue Chip on behalf of the graduating team

and wish the incoming team all the best! A word of

advice in this placement season - take life as it

comes, don’t take yourself too seriously and remem-

ber that the answer to life, the universe & everything

is 42!

Signing off!

~Anupriya

Editor for Blue Chip

BLUE CHIP ISSUE 3

All images, artwork and design

are copyright of

Monetrix

Finance and

Economics club of

MDI, Gurgaon

The Team

Aneesha Chandra

Ashish Gupta

Rishabh Gupta

Rishi Maheshwari

Rohit Agarwal

Sankalp Raghuvanshi

Saurabh Saxena

Saurav Singh

Shaunak Laad

Stephen Thomas

Swapnil Sheth

Vipul Garg

Cover Page Chandrachuda Sharma

For any information or feedback,

please feel free to write in to us at

[email protected]

OR visit our Facebook page

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BlueChip.MDI

From the Editor’s Desk

Tutorial ( 12

Inflation

Current Account Deficit ( 22

India’s Achilles’ Heel

Business Quiz ( 39

Crossword

PPPs ( 36

Public Private Partnerships or

Paralysis ???

Market Update ( 42

Stock Market Update

In the News

Beginners’ Corner ( 19

Financial Risk Management

Facebook IPO ( 4

Through the eyes of

finance students

Dr. C.S. Mohapatra

In conversation with ( 27

Ministry Speak Ministry Speak Ministry Speak Ministry Speak

Cover Article ( 14

Reserve Bank of India

A bank in a need of 4 wheel drive

Movie Review ( 41

Moneyball 2G Auction ( 9

Auction Failure and Auction Pricing

CONTENTS

4

“If you've been playing poker for half an hour

and you still don't know who the patsy is, you're

the patsy.” - Warren Buffet

Retail investors (common investors like you and

us) lost $630 million from the plunge of Face-

book shares. Think that’s big, these numbers are

as of May 24th, 2012 when the stock was trading

at $33.03 which was down 13% since the IPO.

Fast forward to November 2nd, 2012, the stock

closed at $21.18 down 44 % since the IPO. Not

just retail investors with very low understanding

and knowledge about the stock markets but also

big institutional investors including big bank

have burnt their hands in the FB IPO. UBS was

hit with a loss of $356 million.

To understand how so many people, institutions

made fool out of themselves, we need to under-

stand the DNA of the game. We need to put

different spectacles to view the whole situation.

So here’s how the whole game unwounded.

Game

The game we are talking about here is “finding

the bigger fool”.

Players

Let’s introduce you all to the players of the game.

• The company – Facebook

• Insiders – Accel Partners, Goldman Sachs and

employees of Facebook

• The underwriters – Morgan Stanley, JPMC,

Goldman Sachs and the other 30 investment

banking firms

• NASDAQ – The index on which Facebook

got listed

• Homer Simpson – A common investor living

in Springfield

• Bart Simpson – Homer Simpson’s son and an

MBA in Finance from Ivey League college

• Ned Flanders – Homer Simpson’s next door

neighbour

• Ms. Albright - Sunday school teacher and who

believes that stock market is not for her

IPO Market

Before analyzing the game, we need to analyze the

IPO market as a whole. This market is very differ-

ent to the other market which is available for in-

vesting – secondary market. How is IPO market

different from secondary market? To answer this,

we need to need to look at the characteristics of

both the markets.

© Monetrix, Finance & Economics Club of MDI, Gurgaon

|FACEBOOK IPO|

FACEBOOK IPO: Through the eyes of Business

Finance students

PGPM 2011-13

Management Development Institute, Gurgaon

Prateek Dhingra Nikhil Sant

5

The above mentioned characteristics make IPO

market highly favourable for the seller and unfa-

vourable for the buyer. The table 2 reinstates the

point – IPOs make money for sellers and not buy-

ers.

Influence

The game we are analyzing here is not fair. It is

loaded at every stage and every player is playing

with the loaded dice. The force which influences

this game is “Incentive”. So let see what incen-

tive is with the respective players.

Facebook – It wants to raise capital at the lowest

possible cost. This would mean issuing shares at a

high price.

Morgan Stanley, JPMC, GS and other underwrit-

ers – they want the deal to be done. If they don’t

do the valuation which would be in accordance

with the expectations of the company, they would

lose the “big fee”. The lead underwriter gets to

have the largest chunk of the underwriting fee.

Rest of the underwriters small bites of the apple

pie. Hence, the race to become the lead under-

writer is very fierce and investment banking firms

cannot afford to lose such an opportunity.

|FACEBOOK IPO|

IPO Market Secondary Market

Many buyers and

handful of sellers

Many buyers and

many sellers

Information asym-

metry as sellers

being insiders

know more about

the company than

the buyers

Information asymme-

try is not much as not

many insiders are sell-

ers

Sellers can decide

when to sell the

shares

Price can be influ-

enced by even one

seller

Quantity can be

changed to get the

price the seller

wants

Scarcity of shares

cannot be created

easily

Country # of IPOs Issuing Years Total abnormal

return

Australia 266 1976-89 -46.5%

Austria 57 1965-93 -27.3%

Brazil 62 1980-90 -47.0%

Canada 216 1972-73 -17.9%

Chile 28 1982-90 -23.7%

Finland 79 1984-89 -21.1%

Germany 145 1970-90 -12.1%

Japan 172 1971-90 -27.0%

Korea 99 1985-88 +2.0%

Singapore 45 1976-84 -9.2%

Sweden 162 1980-90 +1.2%

UK 712 1980-88 -8.1%

US 4753 1970-90 -20.0%

Table 1: Trend in IPOs

Table 2: Primary & Secondary Market

OCTOBER—DECEMBER ‘12 | BLUE CHIP ISSUE 3

6

NASDAQ – Facebook IPO was one of the biggest

technology related IPO and biggest internet related

IPO. Both NYSE and NASDAQ wanted it to get

listed on them. NASDAQ securing the listing of

Facebook was a big feat as it was the smaller of the

two US indices and the listing would benefit it by

making it more attractive to the future IPOs.

Homer Simpson, Bart Homer and Ned Flanders –

they want to make money from the trade as they

think that Facebook is the stock to hold in the long

run which would enable them to spend rest of their

lives in peace. To them, Facebook is the next Ap-

ple or Google and they don’t want to be out of the

biggest stock market carnival in a decade. It’s what

all of them and hundreds of other Springfield citi-

zen and millions of US citizens have been dream-

ing about ever since they started investing – to get

a hand on such a catch.

How the game evolved?

Facebook was launched in 2004 in the dorm room

of Mark Zuckerberg its founder. After 8 years, the

firm decided to get listed and use the new equity

for further expansion. The firm had been infused

with equity thrice before the IPO.

• May, 2005: $12.7 million in funding led by ven-

ture capital firm Accel Partners

• October, 2007: Microsoft invested $240 million

• January, 2011: Goldman Sachs invested $1.5

billion giving Facebook a valuation of $50 bn.

On its 8th birth day, the company launched its

much anticipated IPO and approached the various

investment banks for valuation as well as under-

writing the issue. All the major firms

compete with each other to get the coveted role of

lead underwriter. So, they brought in the best of

their guys and after spending numerous nights in

the offices, they came up with the valuation of the

company at a humungous value of $104.2 billion.

Morgan Stanley was selected as the lead under-

writer with JPMC and GS as the other two major

underwriters and 30 other banks as a syndicate of

underwriters. The single most important reason for

Morgan Stanley getting the lead underwriter posi-

tion was years of work put in by its Managing Di-

rector and Co-Head of Global Technology Invest-

ment Banking, Michael Grimes. His relationship

and connections he made in the past decade espe-

cially after the dotcom bubble in 2000-2001 paid

off when he underwrote nearly every big IPO in

internet based companies, including LinkedIn,

Zynga, Groupon and Yandex. The reward for un-

derwriting FB IPO - $176 million which was about

1.1% of $16 billion Facebook raised in its IPO.

Trading of FB shares was supposed to start at

11:00 AM EDT on 18th May, 2012 but due to tech-

nical delay at NASDAQ, it began at 11:30 AM with

an opening price of $38/share. Around 82 million

shares traded in the first 30 seconds and seven

minutes after the opening, nearly 110 million

shares had traded. Total volume for FB shares on

the 1st day was 573,622,571 which was a new re-

cord beating General Motor’s record of 458 million

shares. The intraday for the share was $45 and the

stock closed at $38.23.

Since the listing, Facebook’s share has been down

on 64 trading days, up on 49 and unchanged on 3

days.

|FACEBOOK IPO|


7

How the Players Played the Game

In the days leading to the IPO, everyone wants

to be a part of it. All they see is the chance of

this becoming the next Google and possibility of

earning 700% percent returns! Now consider the

fact that the internet using population is around

2.4 billion out of which 1 billion is part of Face-

book. So even if Facebook manages to convert

the rest of the 1.4 billion people into users of

Facebook, that still results in a growth of 2.4

times. To grow anymore than that, Facebook

will have to turn to other species on earth like

cats and dogs. Certainly an over optimism bias!

So how do our players react to this IPO

process?

Bart, with all his finance knowledge and MBA

cockiness, is convinced that this is a great deal.

He forgets the basic Graham and Dodd princi-

ple of margin of safety. When the underwriters

raise the price from a range of $28-35 to $38, the

price becomes way out of range of any conserva-

tive estimate of intrinsic value. Can Facebook

sustain such high growth projections? If yes, for

how long? Will there be no competition? These

are the questions Bart needs to ask. But his sys-

tem 1 of the brain is firmly in control. System 1

of the brain, according to Kahneman, is the

automated decision making part of the brain as

opposed to the deliberating part of the brain

which is system 2. System 1 creates a coherent

view of the positives and aids in making a quick

decision. Scepticism often gets sidetracked when

system 1 is in control. As a result Bart goes

ahead and buys the overpriced Facebook shares,

and is very happy with it too. In spite of the

MBA in finance degree, Bart ultimately ends up

speculating.

In the meanwhile, the underwriters realise that

the public investors are all bullish on Facebook

and everyone wants to be a part of Facebook.

They realise that the 337 million shares that are

to be traded will not be sufficient to satisfy all

the bids. Thus, a scarcity has been created. Now,

since everyone is so eager to be a part of Face-

book, they are all scared to miss out on the

shares due to this scarcity. As a result they start

overbidding just to make sure they don’t miss

out. Right on cue, the underwriters take advan-

tage of this scarcity effect and raise the price of

the shares to $38. And the fear of missing out,

caused due to this scarcity effect, makes the in-

vestors go out and buy these overpriced shares.

Ned Flanders is an avid Facebook user. He has

all his friends and family on Facebook and so is

very fond of it. Facebook, to him is a way to

connect to his family and friends and hence has

a very special place in his mind. It’s a part of his

daily routine and he cannot imagine his life with-

out Facebook. He has all these positive feelings

associated with Facebook. As a result he does

not think of it as a business entity at all. Now

with the Facebook IPO on the horizon, due to

the emotional connect Ned feels that he has to

be a part of this. Owning a stock of something

that he is so familiar with and associated on a

daily basis is a natural thing to do according to

him. The day to day connect with Facebook

makes him feel that he knows all there is to

know about Facebook. In his eyes, since Face-

book is associated with positive feelings, it can

|FACEBOOK IPO|


8

do no wrong as a business. He does not mind pay-

ing a high price for the stock. In fact he doesn’t

even realise he is paying a much higher than neces-

sary price for the stock. The familiarity effect and

the emotional connect compel him to buy the

overpriced shares and he returns home happy and

content.

Homer is a happy go lucky person and a common

investor who dabbles a bit in stocks. He certainly

has no interest in Facebook and is not an active

user. When he reads about the IPO his interest is

not piqued and he ignores it. He carries on with his

day to day life and is happy with it.

One day Bart comes up to him and says, “Dad,

have u subscribed for the Facebook shares?” He

says that he is not interested and will not subscribe

to the shares. Bart reacts by saying that only a fool

would miss out on not buying these shares. He

goes on to say that he has done his analysis of the

stock using all his knowledge gained in his MBA

program and that it is just too good an opportunity

to miss out on. He then gives the example of

Google, which was listed at $85 in the IPO and

then went to be more than $650. “Oh, that’s a fan-

tastic return on investment!” says Homer. And

thus, an anchor has been laid in Homer’s mind.

While he is still pondering on what Bart said,

Homer comes across Ned, who is looking particu-

larly happy. He tells Homer that he has just gone

out and subscribed for a big amount of Facebook

shares. He advises Homer to do the same and tells

him that he will be missing a fantastic chance to

make money by not being part of the Facebook

IPO.

Now homer starts worrying about not being a part

of the IPO. “Everyone I know are going out and

subscribing for Facebook shares”, he thinks. He

feels that if he misses out on the deal and everyone

else makes a lot of money then he will look like a

big fool. “If everyone says it’s a big deal then it

must be a good investment!” he muses. Thus, the

herd mentality comes into play and Homer now

seriously ponders subscribing for the shares. This

combined with anchoring effect of the Google

IPO convinces him and to subscribe to shares of

Facebook.

The next day Homer meets Ms. Albright. He asks

her if she has subscribed to the shares of Face-

book. To which she says, “I am not too familiar

with the Facebook scenario. I am not aware of the

stock valuation and whether it’s under or overval-

ued. I am also not aware of the IPO process and

hence I am not sure if it is beneficial to the general

investors or the issuing company or the underwrit-

ers. In such a scenario I do not want to get into

something which I am unaware of and might get

my hands burnt in.” Homer mocked her for this

and said that she will regret her decision. But fast

forward to 6 months and Ms. Albright was the

only rational person amongst them all and is the

only person with a reason to smile.

The moral of the story being that one must always

conduct research with due diligence before invest-

ing and not get swayed by the biases. Finally it is

the base rates that matter the most. It is better to

miss out on one Google than get your hands burnt

in a 100 Facebooks.

|FACEBOOK IPO|


9

“2G auctions flop as 57% of spectrum remains

unsold, government gets less than a quarter of its

revenue target” is the headline of a popular

national newspaper. No need to burn midnight

oil to find out the reasons for the set back as it is

obvious from the high reserve price for 2G

spectrum set by EGoM. The government had set

the reserve price at whopping amount of

Rs14,000 crores for 5 MHz of pan-India 2G

spectrum. Even the government has itself

indicated recently that the culprit for the auction's

failure was the unrealistically high reserve price by

deciding to cut the reserve price for 2G

spectrum auctions by 30%. Even this move

appears inadequate to address the issue and not

anticipated to give the desired results.

So, what ails the 2G spectrum auction issue and

why telecom companies gave lukewarm response?

High reserve price for spectrum made it

unattractive for the companies to make a

profitable business case. With massive price war

going on between different operators and low

profit margins, such a high reserve price for

spectrum was simply economically unfeasible.

Compounded to this, the policy uncertainty in

India makes the scenario further worse,

consequently no operator is willing to take such a

huge risk. Therefore, telcos cleverly decided not

to bid for the expensive circles resulting in less

money generation for the government. It is amply

clear from Telenor bidding pattern as it did not

bid for the expensive Mumbai circle, apart from

Kolkata and West Bengal, even though it currently

has sizeable subscribers in these circles. If it had

done so, it would have had to pay a staggering

51.96 percent of the total base price to get into

circles which have 50.06 percent of the overall

telecom revenue. That would have been ill-

advised. As a result of this high price, Delhi,

Mumbai and Karnataka circles, which account

for 48 percent of the base price did not receive

any bids.

To put things in right perspective, the latest data

released by Ernst & Young on recent spectrum

auctions in six other nations (Table 1) is an eye

opener. Calculations show that the "per unit per

inhabitant price" of Indian spectrum in the 800

|2G AUCTION|

2G Auction Failure and Auction Pricing

PGDM (2012-14)

Goa Institute of Management Aditya Khajuria


“High reserve price for spectrum made it unattractive for the companies to make a profitable business case.

With massive price war going on between different operators and low profit margins, such a high reserve price for

spectrum was simply economically unfeasible. Compounded to this, the policy uncertainty in India makes the

scenario further worse, consequently no operator is willing to take such a huge risk. Therefore, telcos cleverly

decided not to bid for the expensive circles resulting in less money generation for the government.”

10

MHz band (post-ARPU adjustments for each

market) is nearly 5.3 times higher than

Germany's $0.95, 15 times higher than Sweden's

$0.54 and 13 times higher than France's $0.90.

Similarly, the 900 MHz bandwidth which is

considered the most efficient for 2G services is

27 times cheaper in Spain at $0.46 per unit per

inhabitant, compared with $12.49 in India.

Therefore, exorbitant spectrum reserve price in

India has clearly proved disastrous for 2G

successful auction.

From economics point of view, setting high

Reserve price for spectrum is also detrimental for

the economy of a nation. Such a high price is a

stumbling block for the entry of new operators

or small existing players, as they do not have the

large funds available with them for participation

in the high price auction. These small or new

companies might be having better business

model and technology, which can benefit

ultimately the customer. But the very high

reserve price deprived even the healthy

competition among bidders Thus, big players

had their own day as they had the required

money power to buy spectrum and ruled the

market in spite of the fact some of them may not

have the best business model. This result in

economic inefficiency in the market and the

popular economic concepts, like dead weight loss

to the consumer, becomes relevant.

By allowing companies with high marginal cost

to operate unopposed in the market, without the

challenge of facing new players, probability of

completely mopping of consumer surplus

increases. Thus, economic growth of the country

suffers as deserving and efficient players are not

allowed to operate freely. For example, if

Norway's Telenor had managed to get spectrum

for pan-India operations, then it might have

resulted in technology transfer to India leading to

better business model and improved services to

the customer. Worse apprehensions have come

true as three smaller operators - Etisalat, Videocon

and Swan Telecom - have already exited the

industry due to the prevailing scenario.

Let’s look the fate of the common man in middle

of all this chaos for whose benefit all this is

supposed to be done. Probable tariff rise is likely

to be more than even what has been projected by

TRAI. Increased spectrum fees will be passed on

to the consumer ultimately, thus increasing the

load on common man already staggering under

high inflation. Moreover, in this era of

communications it will be lethal to deprive poor

man for want of affordability and therefore it is

essential to have appropriate spectrum pricing in

order to maximize the socio-economic benefits of

wireless services. The situation is going to

adversely impact rural penetration as well, the

rural rollouts will become increasingly unviable

and unsustainable. It limits the capacity of telecom

operators to invest in networks, leading them to

prioritize urban areas and results in digital divide

|2G AUCTION|


Source: Ernst & Young

Table 1

11

|2G AUCTION|

between rural and urban areas.

To understand the adverse effect of high

spectrum pricing on the customer, take the case

of J&K circle where the author has worked in

Tata Teleservices Ltd and therefore can

understand the loss of the customers in this

militancy hit state. As per the recent TRAI report

for J&K circle, Bharti Airtel is the largest

operator as per the subscriber base, with

approximately 22 lakh customers. It is followed

by Aircel with nearly 18 lakh customers. Other

major players present are Reliance, Vodafone and

Idea. Tata Teleservices Ltd had close to 1.1 lakh

customers in this strategically important state

with Photon as its most popular product. Having

lost its licenses for J&K circle due to the famous

2nd February Supreme Court order cancelling 122

telecom licenses and spectrum allocations, only

option available for it was to bid for the spectrum

again. But the company decided not to pursue

the acquiring of spectrum in the auction as it did

not support the business case due to the high

current reserve prices of the spectrum. Earlier,

Uninor and Sistema had to exit the circle also.

All the above happenings has reduced the

competition in the J&K circle and low tariffs

which were anticipated due to the presence of

more number of operators now is a distant

dream. Additionally, the customers have been

deprived of some high tech services which are

expertise of these exiting companies. Just to

quote an example, wireless broadband service

offered by Tata Photon is considered best in the

industry and same will not be available in the

state from January 2013 when Tata Teleservices

ends its services in the state.

Looking ahead, 2G spectrum fiasco has added to

the negative economic sentiment prevailing in the

country. The 2012 outlook for most Indian

telecommunications companies is negative since

state owned and six private telcos will witness

operating losses according to Fitch Ratings in a

special report. Even county’s largest telecom

operator, Bharti Airtel, faces the risk due to the

new spectrum pricing, as they may be asked to

pay a one-time charge for excess spectrum

holding and any additional cash outflow would

have a negative effect on its rating. All telecom

operators remain exposed to significant

regulatory risks and National Telecom Policy

(NTP) and Spectrum Act 2012 needs to throw

light on the regulatory clarity in regard to the

issues of spectrum pricing. Unless, that happens

FDI flow in the sector will be adversely affected

as foreign players may not participate in fresh or

future auctions.

Thus, due to less Foreign Direct Investment

(FDI), Indian economy as a whole will be a loser

as it affects GDP growth in long as well as short

run directly. FDI in the Indian telecom sector

was $1.7 billion in FY 2011, which was down by

almost 35% as compared to the $6 billion in FY

2010. According to reports from COAI,

investments in the sector by leading operators are

down 50%. Moreover, banks and FIIs, including

domestic ones, have been shying away from

lending to telecom players owing to the policy

uncertainties. Already, the overall exposure of

Indian banks to the telecom sector (2G, 3G and

others) was $18 billion (910 billion) till

November 2011, making more funding almost

impossible in future. Current situation is already

ringing alarm bells for Indian telecom industry

and economic health of the country.

Therefore, accurate pricing policies and

regulations are the need of the hour and

government should take decisions in the right

direction urgently to salvage the situation. This is

crucial for the revitalization of the telecom sector

and the entire nation's economy. It should be

understood unambiguously that healthy auction is

the key to the price discovery. Moreover, pooling

of spectrum and letting operators dip in for a

slice as and when they need it is also a viable

option, as federal communications commission

of USA recognized recently. This will help to

promote new investment and competition.

Finally, government should remember golden

rule “There can be economy only where there is

efficiency” and let fair pricing policy prevail.


12

|TUTORIAL|

Understanding Inflation

“India Inflation Turns to Corner, Rupee to Benefit”;

“Inflation at Three-Year Low, Hopes of RBI Rate

Cut Rises”; “Inflation Still an Issue, So Is CAD: D.

Subbarao”.

These headings of some newspaper articles published

recently have some interesting underlying assump-

tions. It indicates that inflation is such an important

indicator that it can change the entire situation in the

foreign exchange market. Current account deficit,

which has the potential to bring about balance of

payments crisis if not kept in check, is ranked at the

same level with inflation. Also, the monetary policy

decisions are majorly influenced by inflation. Even

though Indian growth rate had been decreasing, RBI

decided to cut inflation after a long wait of nine-

months, and that also when inflation was at a low

level, clearly indicating that inflation gets priority

over economic growth. Further, many centrals banks

across the world like have adopted inflation targeting

i.e. the main aim of the monetary policy is to achieve

a targeted inflation rate.

But what exactly is inflation? What are the types of

inflation? It is one of the terms which everyone

knows but few understand. Inflation refers to a sus-

tained rise in the general price level i.e. prices of

goods and services over a period of time. Inflation

can be of various types depending upon which pa-

rameter is being compared.

On the Basis of the Cause:

This is the most commonly used classification of

inflation. According to it, inflation can be of four

types – demand-pull, cost-push, sectoral, and pricing

power inflation.

The basic economic principle is that whenever de-

mand exceeds the supply, the price of the good

would rise. This is the basic premise of demand-pull

inflation. When the demand for goods and services

exceeds the supply of the same, the resulting infla-

tion in the economy is known as demand-pull infla-

tion. This is the type of inflation which is generally

seen during war-times as the demand for war sup-

plies increases tremendously.

Production of any good/service requires the use of

the factors of production – land, labour, capital and

entrepreneur. When the price of these factors of pro-

duction rises, it leads to an increase in the overall cost

of production. Thus, to maintain profits, the prices of

the goods and services increase and this inflation is

known as cost-push inflation. One example of cost-

push inflation is the increase in prices because of

wage hikes.

Sectoral inflation is the situation in which rise in

prices of goods and services of any one or a few sec-

tors can lead to rise in price levels of all goods and

services in the economy. This generally happens

when some basic or raw material sector experiences

rise in prices.

Pricing power inflation a.k.a. administered inflation

and oligopolistic inflation is a type of inflation which

is generally seen during boom periods and never in

downturns. The firms and businesses sometimes in-

crease the price of their goods and services so as to

increase their profit margins. This rise in prices is

referred to as pricing power inflation.

On the Basis of Coverage:

Inflation can either be comprehensive or sporadic.

As the name suggests, comprehensive inflation refers

to a situation in which prices of most commodities

are rising in the entire economy. On the other hand,

sporadic inflation refers to a situation in which prices

of only a few goods and/or services is rising in some

parts of the economy.

On the Basis of Rate of Increase in Prices:

In this classification, inflation is characterized accord-

ing to the range in which the inflation rate lies.

Creeping Inflation refers to a situation in which the

prices are rising but at a low rate. Hence it also re-

ferred to as Low/Mild/Moderate Inflation. If the

rate is low and in single-digit (generally less than 3%),

it is called creeping inflation. Chronic/Secular Infla-

tion refers a situation in which an economy experi-

ences creeping inflation for a long period of time.

Walking Inflation is the next type of inflation in

which the prices of goods and services increases at a

rate higher than in the case of creeping inflation. The


13

|TUTORIAL|

range for walking inflation is generally accepted to be

between 3 to 10%. Creeping inflation and walking

inflation is together referred to as Moderate Inflation.

Thus, if the prices of goods and services rise at the

rate of less than 10%, it is called moderate inflation.

An economy experiences running inflation when the

inflation rate lies between 10 to 20%. Galloping/

Jumping Inflation refers to a situation in which the

economy is experiencing inflation in double or triple

digits. The range for the same is 20 to 1000%. The

maximum rate of increase in prices is referred to as

hyperinflation. Economies like Germany and Argen-

tina have experienced this in the past. The rate of

increase is higher than 1000%. Some economies saw

prices rising daily. The value of the currency was de-

stroyed which led to loss of confidence in the cur-

rency. People preferred to stock goods whose prices

were rising at an extremely high rate instead of hold-

ing the currency whose value was deteriorating con-

tinuously. The highest value of banknotes issued by

the different Central Banks were 100 trillion Mark in

Germany, 100 quintillion Pengo in Hungary, etc.

Impact of Inflation

The impact of inflation is the maximum on the

weaker sections of the society. Hence, inflation is said

to increase inequality in the economy. Further, as

inflation reduces the value of the currency, it acts as a

disincentive for saving. As people know that the pur-

chasing power of the currency would be lower in the

future, they would prefer to utilize the currency for

consumption instead of saving it for the future. As

the national savings of the economy would decline

because of inflation, it will reduce the funds available

for lending and hence can have a negative impact on

the capital formation in the economy. This further

will affect the growth and production potential of the

economy. Inflation also has a major impact on for-

eign exchange market. Rising prices make the domes-

tic goods more expensive and foreign goods relatively

cheaper. This leads to an increase in imports and a

fall in exports, which further leads to currency depre-

ciation.

Further, as an economy experiences sustained infla-

tion, it can lead to expectations of future inflation.

When inflation is anticipated, workers would demand

higher wages. This would increase the cost of pro-

duction for the firms and they would increase the

prices of their goods and services to maintain their

profits. However, this increase in prices would lead to

fulfilment of the expectations of the people and they

would expect the prices to rise in the future as well

hence demanding even higher wages and the process

would continue. This would lead to a vicious cycle

which is popularly known as wage-price spiral. Infla-

tion also reduces the lending-borrowing activity in

the economy. Generally, most loans involve a fixed

payment for a pre-decided specified number of years.

However, with inflation, the real value of the returns

to the lender increases. Hence, effectively, the debt-

ors pay a lower rate of return. This increases the de-

mand for loanable funds but reduces the supply of

the same leading to lower lending and borrowing. It

also leads to an increase in the interest rates in the

economy due to demand exceeding the supply which

further deters investment activity.

Inflation also leads to an increase in the shoe-leather

cost. When an economy is experiencing higher infla-

tion, it creates incentive for the people to keep their

money in banks so as to earn some interest. Thus,

whenever cash is required, people will have to make

more and more trips to the bank and the cost in-

volved in doing so is known as shoe-leather cost.

Another cost associated with inflation is the menu

cost. Changing prices is not a cost-less activity. It

involves printing new menus, making new packaging

which shows the higher price and so on. This cost is

called menu cost.

Inflation has some positive effects as well. As the

price of goods and services increase in the economy,

the producers have an incentive to increase their pro-

duction. This would lead to an increase in output,

employment and production leading to greater

growth in the economy. Another positive effect is

the Mundell-Tobin effect according to which due to

inflation people would prefer to decrease their cash

holdings and instead keep some amount in banks or

lend it out leading an increase in investment activity.

Further, deflation is not good for an economy too as

has been seen in Japan which went through a decade

long recession. Deflation leads to people postponing

their consumption to the future so as to get a better

deal i.e. lower price. This led Paul Krugman to con-

clude that some inflation might actually create an

incentive for the Japanese people to increase their

consumption which would provide the necessary

thrust for the economy to recover and growth to

pick up.


14

manages foreign exchange with an aim to fa-

cilitate external trade and payment and pro-

mote orderly development and maintenance of

foreign exchange market in India

►Issuer of currency: It issues and exchanges

or destroys currency and coins not fit for circu-

lation to give the public adequate quantity of

supplies of currency notes and coins and in

good quality

►Banker to the government: RBI performs

merchant banking function for the central and

the state governments

►Banker to banks: It maintains banking ac-

counts of all scheduled banks.

The reasons why Alice Rivlin was right

There are various external factors which make

RBI worry. The world economy is going

through an unconventional period and proba-

bly that is why conventional monetary tools

such as interest rate changes aren’t working

well. On one hand, RBI hiked interest rates 13

times in between Mar 2010 and Oct 2011 but

failed to arrest inflation and on the other hand

US Fed cut interest drastically to revive the

faltering economy but faced the same result.

Probably, unconventional times require uncon-

ventional measures.

RBI, unlike other Central Banks, faces a huge

task when it is about taking appropriate deci-

sions based on various macroeconomic data.

Government regularly revises economic data,

sometimes sharply, which makes RBI’s life dif-

INTRODUCTION

Alice Rivlin wasn’t wrong when she said that

the job of a central bank is to worry. No one

can appreciate her statement more than the

Governor of Reserve Bank of India. Faltering

growth, rising inflation, huge unbanked popu-

lation and extravagant government pose a

daunting task ahead of RBI policy makers.

The main function of RBI includes:

►Monetary Authority: RBI formulates, im-

plements and monitors the monetary policy

to maintain price stability and to ensure

proper availability of credit to productive sec-

tors

►Regulator and supervisor of the finan-

cial system: It prescribes broad parameters

of banking operations within which the coun-

try's banking and financial system functions

to maintain public confidence in the system,

protect depositors' interest and provide cost-

effective banking services to the public

►Manager of Foreign Exchange: RBI

RBI – A Bank in need of a 4 Wheel Drive

Cover Article

Monet r ix


15

rupee and forcing exporters to convert half of

their foreign earnings into rupee within two

weeks.

Some economists hold the view that RBI can’t

be fully transparent as it is not only monetary

policymaker but also government’s debt man-

ager.

With all the above mentioned external

and internal issues along with a few others and

a task to manage inflation, growth, rupee and

government of India’s borrowing programme,

RBI is facing a huge dilemma.

Growth

Both monetary and fiscal policy determines the

growth of the economy. Although RBI’s main

role is monetary, it still plays a huge role in

growth. Half of India’s workforce is employed

in agricultural sector and it constitutes 16% of

India’s GDP. A concern in 1968 regarding

growth in agriculture and small scale industries

led to RBI defining it as a Priority Sector. In

1972 it made it mandatory for state banks to

have a percentage (as high as 40% in 1985) of

its lending to priority sector to ensure growth.

Apart from that it plays a major role in driving

Investments in the economy. Depending on

the situation, RBI reduces interest rate for pro-

moting lending to banks and also to govern-

ment by lowering bond rates.

Currently the government is facing a deep fis-

cal deficit problem and it has chalked out the

following plan to bring it down to 3% by 2017.

India’s GDP growth has slowed down from

ficult. One of such events was Jan 2012 IIP

figure which reported a growth of 6.8% based

on a huge surge in sugar output and was

eventually revised to 1.1%. RBI governor D.

Subbarao called it “analytically bewildering”.

One of the most important internal factors

which is causing significant worries for RBI is

communication, an effective policy tool of

central banks. Few years back a U.S. based

economic think tank rated RBI as one of the

least transparent South Asian central bank

which was in sync with IMF findings. D. Sub-

barao took a few positive steps to break the

established image of RBI by introducing

greater transparency through more frequent

communications. He started mid-quarter pol-

icy meetings and began to release minutes of

its advisory meetings on interest rates. But

recently, RBI has failed to control over com-

munication and contradictory communication

making its own job more difficult. One in-

stance where RBI erred while communicating

was in June 2011 when RBI Deputy Gover-

nor, Subir Gokarn, suggested room for a rate

cut which ultimately didn’t come in June

monetary policy meeting. Another was when

RBI kept on saying that RBI doesn’t intend to

support rupee at a particular level and would

intervene only to arrest excessive volatility in

forex market. However, later on RBI took

extreme steps to support the currency by re-

ducing speculators’ ability to take a call on


|COVER ARTICLE|

Year Fiscal Deficit as % of GDP

2012 5.8

2013 5.3

2014 4.8

2017 3.0

Table 1: Plan for Fiscal Deficit

16

taken to curb it. Minister of Commerce and

Industry Anand Sharma said that around 40%

of fruits and vegetables do not reach the mar-

ket due to transportation delays and are

wasted. India faces structural problem due to

lack of adequate infrastructure which causes

supply side bottlenecks. However, govern-

ment is banking on the direct cash transfer

scheme which is soon going to be imple-

mented this year which will definitely reduce

the leakages and subsidy bill and have a posi-

tive impact in curbing inflation.

Interest Rate

Another tool in RBI’s repertoire is setting the

policy rates and Cash Reserve Ratio. RBI re-

duced the CRR, the minimum percentage of

total demand and time liabilities that banks

have to maintain as reserves with RBI, by 25

basis points to 4.25% on 30 October 2012, its

8.5%, 6.5% to 5.5% in the last 3 years, which

makes it a big concern for RBI.

Inflation

The acceptable level of Inflation according to

RBI is 5% and the current RBI governor D.

Subbarao has said it’s the highest priority

among the four. The

december figure of

WPI was 7.18%,

which was lowest in

3 years contradicted

by 3 month high

Consumer Price In-

dex of 10.56%. Also,

recently fuel retailers

were allowed to in-

crease diesel prices

by 45 paise per litre

every month have

put pressure on

prices of food, ce-

ment and other

products depending

on trucks for trans-

portation.

Inflation in India is

sticky. What that

means is that it stays

at high levels even

after measures are


|COVER ARTICLE|

Policy rates, Reserve ratios, lending, and

deposit rates as of 30th Jan, 2013

Bank Rate 8.75%

Repo Rate 7.75%

Reverse Repo Rate 6.75%

CRR 4.00%

SLR 23.0%

Base Rate 9.75%–10.50%

Deposit Rate 7.50%–9.00%

Table 2: Current Scenario

Figure 1: Exchange Rate fluctuation

Figure 2: Fluctuation of GDP growth rate

17

17

Exchange Rate

India has a Managed

float exchange rate sys-

tem where in the ex-

change rate is basically

determined by supply-

demand of currency,

mainly USD. However,

RBI has not set fixed

upper or lower limit and

intervenes in the for-

eign exchange rate mar-

ket only when the ex-

change rate is ‘too un-

comfortable’ on either

side. INR has depreci-

ated against the USD by

almost 23.8% from

44.06 in Jul 2011 to

54.7 in Jan 2013 which

has had an adverse ef-

fect on the economy

and the corporate sec-

tor, forcing RBI to in-

tervene.

RBI has sales dollars now and then to tame

sharp fall in the currency, with the latest sale

being $921 million in November 2012, up

from $95 million in October. However, dwin-

dling foreign exchange reserves and being a net

importing economy mean RBI can dip in the

reserves occasionally to defend the rupee. RBI

has also increased rates on Non-Resident De-

posits to attract more dollar deposits. Also,

interest rates have been maintained high for

nearly 3 years now to reduce sudden capital

outflows by the foreign investors.

When we look at the graphs of growth, interest

rate and inflation put together, we can see that

High Interest Rates have slowed down our

GDP growth from 8.5% to 5.5% within 3

years but inflation hasn’t reduced much.

This makes RBI’s job lot tougher to control

lowest level since 1974 and even further to

4% on 29th January 2013. A 25 bps reduction

in CRR is generally expected to inject around

INR 175 billion into the banking system and

provide adequate liquidity which will help the

industries get required credit.

In April 2012, RBI cut its policy repo rate, the

rate at which it lends money to commercial

banks, by 50 bps to 8% and the reverse repo

rate, the rate at which it borrows from com-

mercial banks to 7%. It was a first rate cut in

three years. This was expected to make auto

& home loans cheaper for public. However,

RBI was unhappy on the slow progress banks

have made in reducing lending rates. With

GDP growth stuttering to below 6% RBI

again reduced the Repo and Reverse Repo

rate by 25 bps each.


|COVER ARTICLE|

Figure 3: Interest rate trend in India

Figure 4: Fluctuation in Inflation rate

18

decision to not cut key policy rates, saying the

government would “walk alone” to face the

challenge of growth. In Jan 2013, RBI obliged

with rate cuts, which was necessary to revive

an economy that grew by below 6% for the

past three quarters. Further rate cuts are per-

haps necessary to further boost the economy

which is well on track to register, in this fiscal,

its slowest annual growth rate in a decade.

However, upside risks to inflation persist

which limits RBI’s scope to further reduce pol-

icy rates.

And then there is the sliding rupee. Increase in

policy rates help prevent sudden outflows of

foreign capital from the country and thus help

check the meltdown of the domestic currency.

It would not be a wise decision to increase

rates to address deprecation of rupee and put a

blow to the growth aspirations. On the other

hand, further decrease in the rates may lead to

further capital outflows.

Thus, every decision that RBI takes to achieve

one of it’s’ objectives, results in some adverse

effect on some of its other objectives. High

interest rates imply high borrowing costs which

result in reduced investment and thereby have

an adverse impact on industrial growth. High

rates create liquidity crunch in the market

which hampers growth. If it tries to control

inflation by increasing rates, growth is ham-

pered. If it tries to breathe life into the growth

by cutting rates, rupee depreciates and inflation

increases. If it raises policy rate to check rupee

meltdown, growth will lose momentum. No

wonder that the chariot is not able to move at

all!

It’s critical for the government and the RBI to

have a common goal, but independent working

and still managing to take actions which do not

have contradictory effect on the other’s ac-

tions. But for too long, inflation has been the

primary concern for RBI. It’s time for growth

to be as much a concern as inflation.

inflation and RBI generally is cautious in re-

ducing interest rates.

The Juggling Act

Imagine trying to run a chariot with

horses tied in 4 directions and each moving in

its own direction. RBI is running such a char-

iot whose four horses – inflation, growth,

currency and borrowing – are moving in 4

different directions.

There are an increasing number of analysts

who feel that RBI may have erred by focusing

too much on inflation. Their argument is

valid one: that RBI can have impact only on

the demand-side inflation and interest rates

are unlikely to have any impact on the supply-

side inflation. And the policy makers are well

aware of this. However, there is the ‘politics

of inflation’ which puts pressure on RBI’s

decisions.

With 2014 elections looming over the hori-

zon, it is difficult to see many things change.

Vote-bank politics would imply that govern-

ment would dig heavily in its coffers, irrespec-

tive of how much fiscal austerity inflation, all

time high current account deficit and fiscal

deficit would require.

In Dec 2012, the Finance Minister expressed

unhappiness over the Reserve Bank of India's


|COVER ARTICLE|

19

|BEGINNERS’ CORNER|

Liquidity Risk

The risk created by the inability to sell (liquidate)

an asset quickly or obtain required funds from its

sale. One of the reasons for this could be failure

to recognize changes in the market conditions and

respond in a timely manner.

Operational Risk

The risk of loss due to faulty internal processes,

people or systems that a company is exposed to

when it undertakes operations in a particular field

or industry. It can be thought of as an adverse

outcome which happens as a result of an organi-

zation’s activities.

There are broadly

three ways of deal-

ing with financial

risks, namely

diversification,

insurance and

hedging. Apart

from these, the central

banks of certain countries have resorted to

regulatory norms to safeguard banks from certain

types of financial risks. In India, the Reserve Bank

of India (RBI) fixes a Statutory Liquidity Ratio

(SLR) and Cash Reserve Ratio (CRR) for banks.

Diversification

The basic strategy in diversification is based on

the age old proverb “Don’t put all your eggs in

one basket”. It is a means of reducing risk by in-

vesting in a variety of asset classes so that the

positive performance of some will balance the

negative performance of others and thus the com-

bined portfolio would yield higher returns at

lower risk than the individual investments. The

assumption is that the value of all the component

assets will not move in the same direction at the

The objective of most firms is to create economic

value while managing the exposure to risk. The

various financial crises witnessed in the past have

reinforced the need for decision makers and inves-

tors to be well versed with the concepts of finan-

cial risk management. Let us first understand the

different types of financial risks before proceeding

to look at various techniques that can be used to

deal with them.

Credit Risk

The risk of loss due to the possibility of a bor-

rower defaulting on interest payments or principal

repayment. It is normal practice for a lender to

carry out a credit check on a prospec-

tive borrower prior to

issuing the funds. In

the case of corporate

or government

bonds, ratings

agencies analyze

and provide rat-

ings based on the credit

risk.

Market Risk

The risk to an investment arising from a phenome-

non or factors affecting the performance of the

financial markets as a whole. This phenomenon

could be natural such as a disaster or artificial such

as a recession. The four standard market risk fac-

tors include equity, interest rate, currency and com-

modity risk.

Regulatory Risk

The risk of regulatory changes impacting a busi-

ness, securities or the market in general can be

termed as regulatory risk. In the trading context it

can be defined as the risk exposure due to the


FINANCIAL RISK MANAGEMENT Team Blue Chip

20

same time. Diversification is only effective in deal-

ing with unsystematic risk which is the risk associated

with a single company. Although one can diversify

to any limit, in practice it is observed that the mar-

ginal benefits from diversification start decreasing

beyond a certain point.

Insurance

It is a transaction between two parties wherein the

insured pays the insurer a premium in exchange for

the surety that the insurer will compensate him in

the event of a financial loss. The premium is calcu-

lated based on several factors such as the frequency

and severity of the adverse event which in turn

would give an idea about the probability of its oc-

currence. The insurer ensures a profit by pooling

the funds from various insured entities with the

assumption that not all of them will incur losses.

Hedging

Hedging involves an investment intended to reduce/

cancel any potential losses in a related investment.

Financial instruments that can be used for hedging

include stocks as

well as derivative

products such as

Credit Default Swaps

and Futures Contracts.

Futures Contract

is an exchange traded forward contract or agree-

ment to transact an asset at a pre-determined price

and quantity on a pre-specified date in future. The

price is decided on the current future spot price.

Since this will fluctuate on a daily basis, the differ-

ence between the pre-determined price at which

the contract was entered into and the current fu-

tures price will be settled on a daily basis in a proc-

ess known as marking-to-market.

Credit Default Swap (CDS) is a financial instru-

ment or derivative wherein the seller agrees to

compensate the buyer in case of a default in ex-

change for regular payments (spread) from the

buyer. The spread depends on the risk of default,

higher the risk, higher the spread and vice-versa.

CDS is called a credit derivative as it is based on or

derived from some underlying loan or bond. In the

event of a default, the seller will take ownership of

the defaulted loan.

For example consider the following CDS.

In the case of a default, the following transactions

occur.

There is another variant of CDS known as ‘Naked

CDS’ wherein there is no bond or other financial

instrument. The buyer takes out a CDS agreement

without having ownership of any underlying as-

sets. This is primarily used for speculative pur-

poses by investors, say to bet against the solvency

of a particular company. Such CDSs on the debt

of nations have been banned by the European Par-


CDS Buyer

On 10 Lakh

bond

CDS Seller

Spread =

5%

Yearly pay-

ments 50,000

CDS Buyer

CDS Seller

Transfers

Bond

Pays 10 Lakh


Figure 1: A diversified Portfolio

21

liament since end 2011.

Statutory Liquidity Ratio (SLR)

SLR refers to the minimum proportion of demand

and time liabilities that a bank is required to main-

tain in the form of liquid assets such as cash, gold

or government approved bonds and shares at the

end of a business day. The current SLR is 23%.

Failure to maintain the minimum stipulated amount

leads to monetary penalties that need to be paid to

the Reserve Bank of India. The RBI uses SLR as a

tool to suck excess liquidity from the markets, man-

age liquidity risk of banks and thereby safeguard

customers’ money.

Other objectives of the SLR include ensuring sol-

vency of banks and promoting investment in gov-

ernment securities.

Cash Reserve Ratio (CRR)

CRR is the proportion of deposits to be maintained

in the form of cash with the RBI. The current CRR

is 4.25%. It is basically used to manipulate the

amount of funds available with banks to lend out or

invest and thereby secure their solvency. From an

investor’s point of view, it reduces the risk of de-

positing money in a bank.

Apart from the methods and regulations discussed

above, an important set of guidelines for financial

risk management is the Basel norms comprising of

Basel accords I, II and III. These were formulated

by a group of central banks known as Basel Com-

mittee on Banking Supervision (BCBS).

In plain and simple terms, the norms were devel-

oped to ensure that global banks maintain adequate

capital to withstand periods of economic crisis.

Basel Norms

Basel I

Basel I prescribed the minimum capital require-

ment of 8% and the structure of risk weights used

in determining the risk weighted assets (RWA) for

a bank. RWA is based on different weights as-

signed to different classes of assets based on their

risk profiles. For example, cash may be assigned a

risk weight of 0% whereas government approved

securities 2.5%. Basel I primarily dealt with credit

risk. It was introduced in 1988 and adopted by In-

dia in 1999.

Basel II

Basel II is concerned with maintenance of regula-

tory capital and development of risk management

techniques to deal with the three major types of

risk for a bank, namely credit, operational and mar-

ket risk. In addition it prescribed mandatory disclo-

sure by banks of their risk exposure to the central

bank. It was introduced in 2004 and implemented

by RBI in 2009.

Basel III

Basel III aims to strengthen the banking system

by turning the focus on banking factors capital,

leverage, funding and liquidity. It prescribes

tougher capital standards. It defines a Liquidity Cov-

erage Ratio (LCR), the amount of high-quality liquid

assets that can be easily converted into cash to

meet a banks needs during a 30-day c r e d i t

squeeze. Basel III was introduced in 2010 and mo-

tivated by the event of the 2008 financial crisis.

Banks are however concerned that Basel III will

impact their profitability as they have to make sig-

nificant changes to their systems in areas such as

stress testing, liquidity and capital management

infrastructure. Recently a compromise was reached

wherein the banks will have to meet only 60% of

their LCR requirements by 2015, the full rule being

implemented only by 2019. This comes as a relief

to certain parties at a time when the economic sce-

nario worldwide is not too positive and growth is

sluggish.



22

Introduction

A persistently negative current account deficit

is a cause of concern for any economy. When

a country runs a current account deficit, it

builds up liabilities to the rest of the world

that are financed by flows in the financial ac-

count. Large deficits and rising indebtedness

could also leave countries more vulnerable to

adverse external shocks.

Because India has a long history of sizeable

current account deficits, it makes for an inter-

esting case study. A closer look at figure one

clearly reveals India’s inability to maintain a

positive current account balance. We can see

that in only four years from the past two dec-

ades India has been able to claim a current

account surplus. The present levels of current

account deficit have clearly reached unsustain-

able levels, consistently rising for the past three

years. Will India be able to reduce present high

level of current account deficit that is such a

big cause of concern? What implications such

high levels of current account deficit have for

the Indian economy in 2013. Can we learn

something from other developing or developed

economies? This article explores answers to

these questions with a focus on analysing the

implications of high current account deficit on

the Indian economy in 2013 and possible

measures to bring down such high levels of

current account deficit.

Current Account Deficit (CAD)

Current Account Balance can be defined as the

net of export and import and if the import is in

excess to the export it is called a deficit. Al-

though CAD constitute of other factors like

|RISING CURRENT ACCOUNT DEFICIT|

Rising Current Account Deficit - India’s Achilles’ heel

PGPM 2012-14

Management Development Institute, Gurgaon

Ashish Khare Deependra Kumar


Figure 1: Current Account Deficit of India

23

factor income and transfer payment but major

constituent of Current account balance is the

trade balance (i.e. Export-Import).

Major Implications of High Current Ac-

count Deficit

High current account deficit is major concern

because it cannot be sustained for long as the

countries that 'lend' money (through the capi-

tal account surplus) will expect to get back

their money with interest at some point. If the

money is not seemed to be present in future,

the lending country may demand higher re-

turns or may take back their money. With no

one to lend, the country can’t import capital

goods to make own good or even import

consumer goods.

Reasons for high current account deficit

(CAD) - Indian Economy 2012-13

To put some numbers into perspective, cur-

rent account deficit widened to 5.4 % of

GDP in the Q2 2013. The current account

deficit was $22.3 billion in the three months

through September, or 5.4 percent of GDP,

compared with $16.6 billion in the June quar-

ter and $18.9 billion in the September quarter

of 2011.

The widening gap has been caused mainly by

the increasing trade deficit. The trade deficit

widened to 12.2% of GDP in Q3 from 9.7%

in Q2. While oil prices have risen, most of

this worsening is in the non-oil segment

(Nomura Report). Gold imports were the

major cause of the widening current account

deficit. India saw $60 billion worth of gold

imports in fiscal 2011-12 which contributed

to high CAD levels. Gold imports in the 2010

-11 were $40 billion. The increase of $20 bil-

lion can be attributed to high level of infla-

tion. While the imports were dominated by

higher demand for gold, the exports con-

tracted. In the April-November period, India's

total exports contracted by nearly 6 percent

from a year earlier, leaving a trade deficit of

nearly $130 billion.

Another possible cause has been the higher

demand or a supply shocks in the Indian Econ-

omy. In 2011-12 the growth in aggregate de-

mand categories like consumption and fixed

investment fell from about 8% to 5%. It has

been observed that the Indian CAD is counter-

cyclical, rising when output falls and not when

demand is rising. This suggests the dominance

of external supply shocks rather than the de-

mand factor. Current account deficit is going

to be as strained in Q3 2012-13 as it was in the

second quarter because of the lower GDP

growth.

The depreciating INR also contributed to for

the past one year and was the third worst per-

former in Asia in 2012. The rupee closed 2012

at 55.00 inflating the import bill and the cur-

rent account deficit.

Implications of the High Current Account

Deficit for the Indian Economy

The recent level of the Current account deficit

at 5.4 % of the GDP is above the sustainable

level. According to research report from RBI,

India can sustain a current account deficit of

2.5 % of GDP with a lower GDP growth. This

clearly is an alarming situation for the Indian

economy and has the capacity to impair India’s

financial stability.

This deficit will also cause the foreign ex-

change reserves to dry up if the inflows to

make the deficit do not materialize. It will have

direct bearing on the strength of INR. The de-



24

preciating INR has come under a lot of pres-

sure with the increasing current account defi-

cit. The Indian rupee has dropped more than

20% from its August 2011 peak against the

dollar. This sharp depreciation is mainly due

to India’s large current account deficit.

Action Taken by Indian Government and

RBI

Government of India is considering steps to

make gold imports costlier in order to reduce

the huge foreign exchange outgo on the yel-

low metal, which has pushed the current ac-

count deficit to a record high.

Government is also trying to create an inves-

tor friendly environment to increase invest-

ment from foreign investment in the form of

FDI and FII, the income from these foreign

investments positively contributes to current

account.

Current Account Deficit: Story of other

Developing Nations

While focusing on the current account deficit

problem of Indian economy it becomes in-

creasingly important to have a look at similar

developing nations to understand current ac-

count situation in these countries.

Brazil

Brazil is currently facing a big current account

deficit which is 2.11% of GDP at the end of

financial year 2011-12. Brazil has a current ac-

count deficit despite having a positive trade

balance on account of large service deficit. The

reason behind the positive trade balance is the

export-oriented Brazil economy heavily de-

pendent upon soybean, orange juice and iron.

Russia

Russia’s current account surplus is fuelled pri-

marily by high oil exports. Oil prices have risen

steadily over the past few years which have

increased their export prices. From 2000 on-

ward, the country started to record positive

trade surplus, taking the advantage of the de-

valued currency. Russia’s current surplus de-

creased sharply in `08-`09 due to the global

recession and decrease in demand for com-

modities. Increase in Russians income is set to

fuel demand for imports; this would lead to

narrowing of the current surplus.



Figure 2: Current Account Balance for BRICS Nations

25

China

China has had a consistent Current Account

Surplus which today is approximately $300

billion. The major reason for this surplus is

the competitiveness of Chinese products

which have gained a reputation in manufac-

turing sector and thus China has become the

supplier of goods for the whole world.

South Africa

The current account of South Africa has been

in the red lately. The weaker outlook for the

global economy in response to the interna-

tional financial crisis has already resulted in a

large-scale withdrawal of capital from South

Africa. The Rand has depreciated by approxi-

mately 30% against the American dollar dur-

ing this period. Trade balance is only quarter

of the current account deficit which makes it

difficult to reduce the latter simply by reduc-

ing imports.

Current Account Deficit of developed na-

tions: a case study on USA

1991-2006: The phase of rising Current Ac-

count Deficit

The U.S. current account deficit grew steadily

after 1991, hitting levels of 4.4% in 2000 and

steadily rose to a record high of 6.1% in 2005

and 2006. Much of the rise in the current ac-

count deficit over the period can be attributed

to two factors: accelerating U.S. productivity

and a surge in household wealth driven by the

stock market.

Due to the consumption boom, U.S. consum-

ers satisfied part of the increased demand for

goods and services with imports, purchasing

more and more goods from foreign sources

and increased current account deficit.

2007- Present: The decline of current ac-

count deficit (CAD)

CAD began falling in 2007, and reached 3% of

GDP in 2012. The decline may be attributed to

cyclical causes. As a result of the recession and

financial crisis, domestic savings became

higher, domestic private investment became

lower and so the need to borrow from abroad

diminished.



Figure 3: Current Account Deficit of United States

26

Conclusion

The need to contain current account deficit as

evident above is extremely urgent. Unfortu-

nately there is no magic wand that can bring

down Current Account (CAD) deficit in a go.

It needs to be achieved through the synergy

of a number of measures each aiming to

strike at the very root of reigning current ac-

count deficit. The widening deficit is attribut-

able to expensive oil, high gold imports and a

sharp drop in exports. There is, thus, a need

to reduce imports and boost merchandise

exports to bring the CAD to sustainable lev-

els. On the exports front, a lot depends on

the global economic situation. Our major

markets are the US, Euro Zone and China. If

these markets recover and do well we can

improve on the exports front, provided we

maintain our competitiveness. With the worst

of recession already behind us and United

States averting the fiscal cliff, the prospects

do look better.

The more dominant cause of worry is the im-

port bill. International commodity prices and

rupee exchange rate should be the focus areas

as the country imports many commodities it

needs. An important step would be to make

the gold imports expensive. The Indian gov-

ernment has taken right steps in this direction

by imposing tax on gold jewellery and increas-

ing the import duty for gold.

However, it will not be easy for Indian econ-

omy to correct current account in 2013, pre-

cisely because of strong domestic demand

and a weak external demand. Already envi-

ronment sensitive policies, land acquisition

issues and availability of quality infrastructure

have contributed to moderation in FDI in-

flows which are extremely important to fi-

nance the current account deficit. While the

subdued growth of receipts is cyclical in na-

ture and can be expected to improve with the

recovery in world economy, the rise in crude

oil prices and reasons for moderation in FDI

are more structural in nature. It is thus impor-

tant for the policymakers to make Indian econ-

omy more investor friendly in 2013 and elimi-

nate bottlenecks arising due to policy paralysis

at the centre.

What is the ideal way out for Indian govern-

ment then? Since India’s linkage with the world

economy, in terms of trade and finance, is

likely to grow, it is important that resilience in

its trade account is built up mainly by promot-

ing productivity-based export competitiveness

and improving the domestic fundamentals. The

persistent global uncertainty and capital flow

volatility demands increase in FDI to make the

capital account more resilient.

India should learn from other countries around

the world. The competitiveness of products of

China is something to look upon as India does-

n’t have resources like Russia or Brazil. India

should try to bring quality to its products simi-

lar to its services. One key thing to learn from

USA is that India cannot sustain its current

account deficit as can US because capital ac-

count in India is highly dependent upon the

conditions of rest of the world. Adjusting gov-

ernment spending to favour domestic suppliers

is another important step that needs considera-

tion.

Another important measure would be increas-

ing the remittances through lucrative savings

offer for Indian Diasporas all around the world

by offering higher interest rates and lesser

transaction charges. It is with the cumulative

effects of the above outlined measures and a

strong resolve to bring down the current ac-

count deficit that we can expect India to tame

this monster and safeguard the country’s finan-

cial health.



27

moting financial literacy and financial

inclusion is also an integral part of the

capital market development in a coun-

try like India.

Q 2: What according to you, are the

major achievements of Capital Markets

in recent times?

Capital Market in India has undergone a

considerable change over time in terms of

markets, instruments and institutions. Re-

forms in the capital market have always

been aimed at increasing competitive effi-

ciency in the operation of the system, in-

troduction of new markets/ instruments,

reduction in transaction cost improvement

in clearing, settlement and disclosure prac-

tices, greater participation of investor

classes and strengthening of regulatory/

institutional framework to safeguard the

interest of the investors as well as ensuring

orderly development of the market.

In recent times, a whole host of measures

have been taken with regard to capital mar-

Q 1: As an economist & bureaucrat,

please tell us about your experience

with Capital Markets and FSDC?

A: First of all, let me welcome you to

Ministry of Finance. I understand you are

doing good work and happy to learn

about your interest in the capital markets.

On completion of study leave for Ph.D.

at JNU, I joined the Capital Markets Divi-

sion of Department of Economic Affairs

in August 2007 and continued as Director

till I became Adviser FSDC in January

2012. Capital market is one of the most

important segments of financial system of

an economy; a well functioning capital

market is essential for efficient allocation

of resources and for channelizing them

for productive sectors to augment the

growth potential of the economy. Role of

capital market becomes more important

in a developing country like ours, where

resources need to be mobilized not only

for big corporates but also for small

firms including SMEs. Besides, pro-

Ministry Speak

|IN CONVERSATION WITH|


Dr. C S Mohapatra He is a senior Indian Economic Service officer of 1986 batch and is cur-

rently Adviser in Financial Stability and Development Council, Depart-

ment of Economic Affairs, Ministry of Finance. He is an MSc in Econom-

ics and has pursued Ph.D. He also has a Masters degree in Analytical &

Applied Economics and holds an M.Phil.

28 28

that the market is safe, competitive,

transparent and efficient and introduc-

ing reforms of international standard in

these dynamic markets. The idea was to

evolve responsible private, organizations

who will do the quasi-regulatory functions

of the state, which augers well from the

perspective of Govt being the facililater

rather than as a controller. In late 2007,

when Lehman Brothers crisis erupted,

followed by the global financial crisis,

India managed it very well. Government

at that time had a series of meetings to

assess the situation and took steps in con-

sultation with the stakeholders and han-

dled the crisis very well. However, at that

time, though the regulatory mechanisms

were in place; but the stability mecha-

nism was not. The Financial Stability &

Development Council, as an idea was de-

veloped in the Capital Markets Division

and it was finally notified in December

2010 under the chairmanship of Finance

Minister.

We need to be open in terms of attracting

foreign investment in desired areas while

practicing international practices with a

simple and transparent regulatory frame-

work. Keeping that in mind, we are intro-

ducing dynamic products, opening up vari-

ous sectors, enhancing limits of investment

for foreign investors, relaxing regulations

and trying to make the capital markets

more vibrant and deep.

Apart from SEBI as a regulator, the stock

ket reform, keeping in view the above

stated objectives.

Q 3: Could you give us your view of

how Capital Markets have evolved in

India over time?

When we talk about capital markets, every-

body thinks of Sensex or Nifty move-

ments. But these are only one of the indi-

cators of the market. More importantly,

the institutional mechanism the Govern-

ment put into place is as important as the

regulatory framework under which various

stakeholders operate. In distant past, there

used to be a lot of controls on capital mar-

kets. Government set up SEBI through a

statute in 1992. The Securities Contracts

(Regulation) Act, 1956 with its rules &

regulations have also undergone amend-

ments. The next generation reforms got a

boost with the Depositories Act of 1996.

We have a wide variety of rules and regula-

tions and a regulatory framework of inter-

national standards for capital markets.

Subsequent to this, the country had devel-

oped institutional framework for insurance

regulation as well as pension fund regula-

tion and development;, and as you know,

RBI is the regulator for the banking sector.

There is also a commodity market with

Forward Markets Commission as the regu-

lating body. The whole idea behind

regulating any market is not about

controlling the market, but about hav-

ing market surveillance to the extent



SEBI has also come back with the new

takeover code/regulations. We have revised

the delisting norms with a clear cut frame-

work for voluntary & compulsory delisting

procedures. We have introduced a new

category of Qualified Foreign Investors

(QFI). In all three important segments of

the securities market namely Mutual Funds,

Equity and Corporate bonds,. QFI schema

has been introduced to attract greater retail

participation of foreign investors to de-

velop depth for the market. We already

have an FII regime under which SEBI reg-

isters and regulate them.

Q.4 Do you think Rajiv Gandhi Equity

Savings Scheme (RGESS) would en-

hance the retail participation in the se-

curities market?

I am very hopeful about the success of

the Scheme. In the long run, it will fetch

enough investors especially young peo-

ple like you who would start their career

with the corporate sector, looking for an

alternative to save the tax.

All financial products which have

reached out substantially to the retail

investors (post office savings, life insur-

ance policies etc) have enjoyed these

tax benefits at one point or the other. So

the result of this tax break for direct in-

vestment in equity can’t be otherwise.

Q 5: What do you think are some of the

issues plaguing the markets?

exchanges, Clearing Corporations and De-

positories also have systemic role to play

and, therefore, these institutions cannot be

taken just as any other company. We have

two different depositories i.e. NSDL,

CDSL who are guided by Indian Deposi-

tory Act 1996. They are the record room

of all our shares. Today we have almost de

-matted the shares and now people don’t

generally possess shares physically. That is

a major improvement. Earlier, we used to

have an outcry system in share market.

Today we are doing on-screen trading.

These are the kind of developments

matching international standards. We have

been able to set up a robust institutional

mechanism for capital market in our coun-

try.

The minimum public shareholding re-

quirement has been increased for listed

companies so that the depth of the market

is increased. Today the market is mostly

guided by institutional investors and retail

market participation is less. We cannot

force people to invest but we can do many

things to encourage people to invest. Mu-

tual fund is one area where people pool in

the resources. Steps have been taken to

revive the mutual funds in our country.

More importantly, for the first time, gov-

ernment introduced a tax savings scheme

for equity investments by retail investors

called RGESS & gave it over & above the

Rs 1 lakh limit, individuals are enjoying at

present.



29

30 30

through many other measures. Measures

have also been taken to boost the Corpo-

rate Bond Market, which is in a nascent

stage.

Q 6: Sir, With regards to the proposed

amendment in the Banking Act, li-

censes will be given to NBFCs under

RBI’s supervision. The intent behind

this Act is to create larger banks. What

is your take on that?

A: A big organization has economies of

scale whereas small banks cater to various

diverse needs. With an adequate regula-

tory framework in place, I am sure,

Non -Banking Financial Companies

(NBFCs) and Micro-Finance Institu-

tions (MFIs) with their special charac-

teristic features will have a crucial role

to play, in the economy while further-

ing financial inclusion.

Q 7: What are your views on Financial

Inclusion with respect to current In-

dian situation?

A: Financial inclusion is a necessary ingre-

dient of inclusive growth. A lot needs to

be done to ensure wider participation. Fi-

nancial awareness and literacy should result

in bringing idle funds to financial market

through productive and diversified invest-

ment. Government, through the banks

and other financial market institutions, are

taking steps to spread financial literacy and

education. One important thing is that the

We should have a simplified and uniform

system of Know Your Customer (KYC)

norms across all the subsectors of financial

sector. An optimum level of investor

friendly regulatory regime is required to

provide further depth to the capital mar-

ket. Some investors have an apprehen-

sion that Indian regulations are com-

plex. We should have a very simplified

regime for QFIs which includes all

categories of foreign investors.

In order to facilitate the resource require-

ments of the private corporate sector, vari-

ous liberalization/rationalization measures

have been taken with respect to external

commercial borrowings (ECBs) policy to

enhance the availability of resources with

special focus on infrastructure develop-

ment in the country.

These days when we have global uncer-

tainty, we need to adopt a multipronged

approach to handle various issues like Cur-

rent Account Deficit, Fiscal Deficit, Infla-

tion and currency depreciation. We cannot

reduce imports or increase exports beyond

a point because on the export side demand

is sluggish because other economies are

not growing and the import side, demand

for petroleum products can’t be reduced

much in view of our developmental or

regular activities making petroleum prod-

ucts import demand inelastic. The other

most important item of import is Gold.

Government is trying to curb gold imports

by increasing the import duties and



31

development. Our Finance Minister is the

Chairman of this Council and all the finan-

cial sector regulators including the Gover-

nor, RBI, Chairman of SEBI, IRDA and

PFRDA are members apart from Finance

Secretary, Secretaries of DEA & DFS &

the Chief Economic Adviser, who are also

members. We also have a sub-committee

under FSDC headed by RBI Governor. All

other financial sector regulators are mem-

bers of the Sub-Committee. Under the ae-

gis of the Sub-Committee, there are various

working groups which work in various ar-

eas of financial stability such as monitoring

supervision of financial conglomerates, de-

veloping financial resolution regime, pro-

moting financial inclusion & literacy etc.

Promoting financial development is the

other major agenda of FSDC.

Q 9: We are dealing with lot of regula-

tors, when we are talking about FSDC,

so how do you manage, say dealing

with different regulators like RBI on

one hand and other regulators, i.e.

SEBI etc. And they have different tasks

like SEBI wants to open up the market

more, RBI wants to regulate. So how it

is being managed here? What is the ex-

act role of FSDC?

Ans: Precisely, that is role of FSDC, to be

able to manage all the regulators in a colle-

gial atmosphere through the process of

consultation, of discussion and delibera-

tions in a coordinated manner. Every regu-

investors should carry out a thorough

study of all investment documents before

making their investments and should un-

derstand them. The investor grievances

should be addressed by agencies sys-

tematically and properly. This will

build confidence of people in market.

The market distribution system has to

be transparent and efficient. There are

a number of stakeholders including

NGOs, CSR activities by corporate

houses, Ministry of Corporate Affairs,

SEBI etc. which are engaged in such

literacy efforts, directly or indirectly.

However, all this information should be

collected and used by some centralized

database or website for spreading knowl-

edge about financial education and devel-

opments that are taking place today. For

every regulation proposed, there

should be a Regulatory Impact Analy-

sis (RIA) which should tell about what

is the social cost and benefit from it.

Last but not the least, steps should be

taken to simplify the entire process and

regulations so that higher confidence

of investors in the financial markets is

instilled.

Q8: Could you tell us more about the

Financial Stability & Development

Council?

It is an initiative of the Government to

strengthen and institutionalize a mecha-

nism for maintaining financial stability and



32 32

to regulate them, stop them before failing

and resolve them if it collapses, inter-

regulatory coordination is imperative.

Q 10: Could you elaborate on Regula-

tory Arbitrage and how it might affect

the markets?

If one market is more regulated than

the other, business goes to less regu-

lated/streamlined sector at the cost of

other. We should discourage that.

There should not be any regulatory ar-

bitrage, but a level-playing field for mar-

ket players across all markets. We should

bring regulation at par and also should

have open and dynamic set of regula-

tions and market should be optimally

regulated with a robust institutional

framework.

Q 11: Is our Securities Market infra-

structure robust? What is your view?

Yes, we have a sound & robust institu-

tional framework & regulatory system in

the Securities market that is acknowledged

internationally. The rules/regulations to

support the structure are also amended

regularly in this dynamic setting. Last year,

on the basis of recommendations of the

Bimal Jalan Committee, a revised policy on

the ownership and governance structure of

the market infrastructure institutions i.e.

clearing corporations, stock exchanges and

Depository, have been put in place. Rele-

vant regulations have been amended ac-

lator has a specific role to play; in cases

where there are gaps or overlaps, the same

are brought up for discussion in national

interest; and all benefit from the process

of consultation. This forum functions

without prejudice to the autonomy of the

regulators. Areas are defined for every

regulator. SEBI manages the securities

market. RBI manages the banking sector,

IRDA manages the insurance sector and

PFRDA manages the pension sector and

the commodity sector is managed by

FMC.

The world has grown so much in terms

of financial management and financial

sector development that it has become

imperative to have greater coordination

amongst the regulators. Complex prod-

ucts & systemically important financial

conglomerates need to be handled in a

coordinated fashion.

We have to develop a comprehensive

financial resolution regime, which is

also a priority item of Financial Stabil-

ity Board, an international forum in

which India is a member. Managing

financial conglomerates and systemi-

cally important financial institutions is

also important. Unless all relevant

regulators of respective areas coordi-

nate amongst themselves & exchange

information, it will be difficult to un-

derstand the elephant called Financial

Conglomerate. To have a full view of a

financial conglomerate so that you are able



33

than banking & payments which is handled

by the Central Bank.

Q 14: What other major initiatives

would you like to highlight in the area

of Capital Market?

I must mention that a number of initiatives

have been taken recently. BSE & NSE

have set up SME platforms. We have given

access to Qualified Foreign Investors

(QFIs) to MF equity & then MF debt and

finally, to Corporate Bonds. FIIs limits

have been enhanced and other measures

taken to attract foreign investments, ECB

Policy have been liberalized. Steps have

been taken to reenergize the MF industry,

enhancing participation of retail investors

including through tax savings schemes, in-

creasing minimum public shareholding cri-

teria for listed companies etc. Besides, the

takeover code has been modified, and new

regulations for Alternative Investment

funds have been introduced by SEBI. . As

regards investment advice which was not

under a standardized regulatory framework,

the Regulators along with Govt. have

worked on this and SEBI has now finalized

the regulations for Investment Advisors.

Q 15: What types of developmental is-

sues are discussed in FSDC?

Any issues that are inter regulatory or in-

volves financial development and/or stabil-

ity are within the ambit of the Council. To

give an example, in FSDC meeting of No-

cordingly, to give effect.

Q 12: We have a wide array of laws and

sometimes, we hear there exist anoma-

lies in them; are we doing anything

about it?

One of the major initiatives as I have

told is setting up of the FSDC, the sec-

ond major one is notifying the Finan-

cial Sector Legislative Reforms Com-

mission. The Commission, with former

Supreme Court Justice Shri B.N. Sri

Krishna in Chair, has been set up to re-

view, rewrite and harmonize the financial

sector laws, rules & regulations to address

the contemporaneous requirement of fi-

nancial sector. The Commission is ex-

pected to give a report in a month or two

(March 2013). Their approach paper is

also out on their website.

Q 13: Is there a need for unifying the

regulators? Why should we have five

regulators?

All these issues and the Acts are being

looked at by the FSLRC. I understand

that the Commission is considering vari-

ous alternatives in terms of the best model

of financial regulatory architecture. As its

approach papers suggests, it gives a pivotal

role to the FSDC in the field of systemic

risk & development. Amongst other

ideas, it is also thinking in terms of a struc-

ture with an unified financial regulatory

agency, regulating financial fields other



34 34

the developed economies. To sustain at

above 9% which we did earlier is obviously

difficult. It is by choice that India has liber-

alized itself and coupled itself with the in-

ternational arena to reap the benefits of

globalization. Today, it is a fact that the

globe is a village and India is a part of that

village. We cannot grow in an isolated

manner boundlessly when the rest of the

globe is crashing. And you should admit,

as I told you earlier, that our Forex reserve

position is comfortable but simultaneously,

current account deficit is high due to vari-

ous factors. Decline in the rate of growth

of exports owes to reduced external de-

mand. Imports are also relatively inelastic

and more so, for a developing country.

Assuming that our imports cannot drasti-

cally reduce or exports cannot drastically

go up, we are vulnerable to the current

account deficit issue. Government is tak-

ing recess export promotion and import

containment measures. You are all aware

that Government have already taken many

steps for reducing gold and petroleum

products demand. To help finance Current

Account Deficit, we are also encouraging

foreign inflows. Country is looking up

with revived confidence and if you have

read today’s newspaper, it says that the

gloomy growth rate of 5%, takes into

account the information only up to No-

vember, 2012. Every day, the scenario

is changing globally. Let us see what

finally comes up. The revised growth

vember 2012, the Council discussed how

to further develop the corporate bond

market. The steps taken so far towards

developing the corporate bond market

were reviewed. The need for a roadmap

for a structural shift towards a diverse fi-

nancial system with an adequate emphasis

on corporate bond instruments was dis-

cussed. The Council also discussed a num-

ber of steps to be taken for rationalizing

the framework for regulation of corporate

debt with an aim to remove regulatory

constraints for issuers and protect inves-

tors, encourage participation of long term

investors, reduce cost of public issuance

and increase liquidity through improving

the market infrastructure. So, in a colle-

gial atmosphere we find that develop-

ing a system, developing infrastruc-

ture, developing a product, developing

composite regulation, it all becomes

that much easier, effective and faster.

Q 16: The India growth story has been

hit recently. We have seen that the

growth projections have been revised

recently to 5%. What is your take on

that? Also, how do we tackle this dual

problem of declining growth and high

inflation?

A: See there is no denying the fact that the

country has slowed down. But you should

see it in a context. In the global context,

you have negative growth in some coun-

tries and very slow growth rate of 1-2% in



35

Finally, a suggestion that has nothing to do

with finance is to remain committed to

what you are doing, to remain morally up-

right and dedicated to the cause of what-

ever you are pursuing. This is one of the

most important challenges for our youth.

Aim should be to learn management in a

way that you should best manage chal-

lenges that comes your way, with dedica-

tion. All my best wishes for you Ashish

and Vipul & your friends & the readers of

your magazine Blue Chip.

Finally, we would like to thank you

(Dr. Mohapatra) for giving us this

opportunity and finding time to inter-

view with us. Through this interview we

have gained an insight into the work-

ings and motivations of the Ministry

which have helped us in bettering our

understanding of the whole ecosystem

of the economy. Thank you once again!

- - - - - - - - - - - - - - - - - - -

Edited excerpts from the interview of

Dr. C S Mohapatra

As told to Ashish Gupta & Vipul Garg

from team Monetrix

rate, at the end of the year, I hope will

be greater than this. That is because af-

ter November, we saw a lot of good things

happening. A lot of measures have been

taken. It will pick up. We will get the re-

sult of the good work that has been done

in these last 6 months when you get a re-

vised estimate or may be next year. Gov-

ernment is very keen in driving the econ-

omy up as much as possible against the

adverse wind of the globe.

Q 17: Last question, any piece of ad-

vice for our readers and how students

can contribute to the growth of econ-

omy?

A: More & more of our young population

should get financially educated and edu-

cate others to make best use of financial

sector. Youngsters will make a difference

to the country.

Financial education does not come auto-

matically when you are qualified as an

MBA. A person in the village who does

not take money from money lender and

deposits his/her extra money with bank

can also be called financially literate. It is

your responsibility to educate your family

and people around you to take informed

financial decisions.

Today a very small fraction of household

saving comes to financial sector, therefore

educating more people will make the fi-

nancial base stronger and encourage finan-

cial inclusion & inclusive growth.



36

To cope up with the rapid population growth,

high lifestyle of people with increasing GDP per

capita income, and growing migration of people

of India within different regions, we people of

India expect and also deserve a better provision

of public services. But expectations never meet

reality and the reality is that we are not aware of

the budgetary constraints, limited technical

expertise, and insufficient bandwidth of resources

of our government.

In our 21st century India, we must recognise that

there is a huge supply-demand inconsistency and

this can only be improved if government

leverages full potential of private sector

consistently and constructively.

So, Public-Private Partnerships (PPPs) is a

need, not just an option for the sustained

progress of the modern India in:

►Infrastructure projects like roads, power, and water

►Healthcare facilities

►Education advancement

►Social security

Not to forget the usefulness of PPPs in effective

maintenance (like cleaning, security facilities) of

public assets like hospitals, schools and public

places.

Now the real question arises “How PPPs are

advantageous in improving the delivery of public services?”

The answer lies below, as it:

►Provides expertise and guidance for

successful completion of challenging public

projects

►Provides resources like manpower,

equipment and viable finance options

►Utilizes special expertise of a private entity

to obtain an objective viewpoint regarding

bottlenecks in on-hold projects

►Involves higher efficiency, optimum

utilization of available resources and

productivity by profit motivated private

entities

►Involves higher success rates, with faster

implementation of projects

►Provides huge potential of cost reductions

with increased competitiveness

Untapped Opportunities of PPPs in India

1. Maintenance/Restoration of tourist places

using private entities’ manpower capacity

2. Having water deficit states, there is a huge

opportunity for PPPs in water

management projects

3. Using private entities’ huge experience and

expertise in developing communication/

IT infrastructure in lagging areas

4. Set up of modern medical facilities,

educational institutions, affordable housing

schemes, waste management/sanitation

facilities on different PPP models in rural/

|PUBLIC PRIVATE PARTNERSHIPS|

Public Private Partnerships or Paralysis (PPPs) ???

Bharat Mattas MBA (2012-14)

Department of Management Studies (DoMS) – IIT Madras


36

37

semi-urban areas

5. Can also initiate PPPs in improving

productivity of agricultural produce

6. In recent years, encouragement by

government by investing in:

►Power sector under Rural Electrification

program

►Special Economic Zones (SEZs) for IT

sector

7. Also private entities can be encouraged to

partner in small scale industries like

handicrafts, jewellery and take the

country’s art to global platform.

Across India, there are numerous PPPs issues

(with root causes)

a. In recent times, there is a low participation

of private entities in PPPs, even in

conceptualization phase.

Root Causes: Low confidence of private

entities in partnering because of :-

►Uncertainty about state rules and

industry regulations

►Complicated procedures for entry/exit

of partnerships

►High cost structure/low margins due to

current global macroeconomic factors

b. Corruption and Irregularities observed in

private entities’ execution of projects

Root Cause:

►Awarding projects on the basis of lowest

bid, without giving equal importance to

quality and credibility of a private entity

in its sector

c. Several PPP projects cancelled, delayed and

terms renegotiated among participating

parties

Root Causes:

►Delay in obtaining necessary clearances,

state permits and acquisition of lands

►Flaw in agreements where risks and

responsibilities are not allocated

appropriately between state and private

entities

d. Agitations by people against involvement of

private sector ex. Hyderabad, Chennai

Airports

Root Causes:

►Job security concerns of public sector

employees. Fear of displacement of

people

►High profit motives of private entities

which lead to the fear of high tariffs for

usage

e. Low confidence of public and private

entities in each other’s way of working,



38


leading to continuous conflicts

Root Causes:

►Different organizational cultures of

public and private entities, with public

sector being more process focussed and

private sector focussing more on results

There are bad apples in any basket, but it doesn’t

mean that the whole orchid is bad. In recent

times, we have observed several issues in PPPs in

India, but the same can be improved by

providing a necessary shot in the arm.

Recommendations to address issues

▪ Encouragement by states by providing

conducive environment like allowing Special

purpose vehicles (SPVs) to fasten the

completion of necessary requirements of land

acquisition, environment clearances within

targeted timelines

▪ A single window mechanism for all

clearances and approvals from necessary

departments would encourage eager

participation of private entities

▪ Improving the investment climate by

♦Assuring certainty of state rules,

♦Providing economic incentives like tax

exemptions (SEZs), subsidies and viable

finance options

▪ Allocating risks to the partner who is better

placed to bear the cost of the same

▪ An independent and competitive regulator

should be appointed to look over the disputes,

delays, corruption and irregularities involved

in any project

▪ Compulsory training of state officials in key

areas like finance which will help to best

utilize available competencies in possible PPPs

▪ Hiring consultants in determining the

feasibility of a project before structuring and

conceptualizing the same. Also undertaking a

pilot project to justify the need of PPP in a

sector is also a promising option

▪ Before putting forward a project for bidding

process, all uncertainties like land acquisition,

compensation to displaced people should be

resolved strategically. A proactive decision is

better than a reactive one

▪ With exponential growth and complexity of

infrastructure projects, there is a need of

♦Mature decisions in awarding projects to

entities that have a systematic project

management and control abilities with an

appetite to mitigate risks involved. Lowest

bid should be one criteria, not the only

one

♦Performance based incentives to be

given to private entities for early

completion of a project and for improving

efficiency/quality

There is a requirement of a holistic approach, I

would say a “helicopter view” to analyse all these

issues, learn from others’ mistakes (Delhi-

Gurgaon Expressway, Hyderabad Metro), apply

best practices and come up with stringent

guidelines in coming periods, which fosters

environment of fairness, transparency and

accountability in PPPs. Also Will and

Synergies need to be created between public-

private entities, and then only true partnerships

will arise to sustain the path of India’s

development.


38

39

|BUSINESS QUIZ|


CROSSWORD

40

|BUSINESS QUIZ|


2. Name the stock market theory which holds that people don’t mind paying more for an investment be-

cause they believe that they can always find someone else who is willing to pay a higher price. (2 words)

4. Which famous tagline was once jokingly used by US President JF Kennedy when asked about his mar-

riage? (3 words)

5. X tried to enlist in army during world war I. however, he was denied due to his age. He joined the Red

Cross and drove an ambulance for it in support of allied troops. Later, X started a company called Laugh-

o-grams which went bankrupt. Give the surname of X.

7. X was initially launched in 1967 as “First National City Charge Service”. By what name is X known today?

9. Which automobile company’s logo features a circle with an arrow, which is a symbol for iron used by al-

chemists? The logo, representing a strong and powerful metal, combined with the company name signifies

the company’s brands that are known for their `rolling power’.

12. Neil Armstrong’s first words from moon were relayed by a transponder designed by company X. Name

X.

15. X was a big supporter of abstaining from alcohol and had once arranged a special train for those going to

a meeting to be held for temperance cause. Out of this act, was born his agency. X gave almost every

penny he made out of this agency to aid temperance cause. Who was X? (2 words)

16. On its first day of independent existence, X used American flag as its temporary logo. Name X.

18. During 1990s, this brand’s image in the US hit a low when Jay Leno, host of The Tonight Show compared

this brand with Yugos, communist era cars imported from Yugoslavia. Name the brand.

Across

1. X was started with an initial investment of Rs.295. X was also the first company east of the Suez Canal to

use imported gas ovens. During the World War II, government gave it the contract to supply “service

biscuits” to the armed forces. Name X.

3. The founder of this company started his career in the late 1800s by adopting the open road and the life of

a traveling salesman, peddling pianos, organs, and sewing machines off the back of a wagon. Later he sold

stock in the Northern New York State Building and Loan Association. Name him. (2 words)

6. Connect Alfred Nobel and Hindu newspaper.

7. Jay Leno, Shania Twain and Sharon Stone, what is common to all of them.

8. Started by son of a Paris watchmaker Pierre Samuel, name this company whose first product was an ex-

plosive.

10. X is the founder of Logistics Company 360. X is also the founder of an airline. X has contested election

unsuccessfully as BJP candidate. Give first name of X.

11. Which famous business family gets its name from a colloquial word in Gujrati that means peppery or not

tampered?

13. X launched online lottery SIXO and brought FTV in India. He was also the pan-India distributor for

ESPN. Give the full name of X. (2 words)

14. A famous landmark marking this place is a statue of George Washington which stands at the spot where

he stood to take oath as President. X has a river at one end and graveyard at the other. Which is the place

denoted by X? (2 words)

17. Celebrity endorsements begun in 19th century when Queen Victoria endorsed a product. The brand is

still in existence. Name the brand to which the product belonged.

19. The initial logo for X showed an eagle carrying a package in its talons. X is also known as “Big Brown”.

Which company does X refer to? (Give the acronym)

40

Down

Answers for the quiz would be shared in the next issue, but you can also follow our Facebook page

for the same: www.facebook.com/BlueChip.MDI

41

Movie Review: Moneyball Team Blue Chip

Moneyball is a

sports drama

film based on a

true story of a

baseball club ,

Oakland Ath-

letics called the

A’s. It is about

the General

Manager, Billy Beane, of Oakland Athletics who

under serious financial constraints prepares a win-

ning team with the help of a young Yale econom-

ics graduate. Billy Beane not only creates a win-

ning team but also sets an American League re-

cord of winning 20 games consecutively using

sophisticated sabermetric approach for scouting

and analyzing players.

Before telling about the plot of the movie in de-

tail, let’s discuss the technique used by Billy Beane

in the movie. As told earlier, approach used by

Billy Beane is Sabermetrics which is the special-

ized analysis of baseball through statistics that

measure in-game activity. Sabermetrics delves into

data and examines issues asking questions like,

how much difference does pitching coaches

make? Or, what is the best way to measure a hit-

ter’s value to a team? Sabermetrics focuses on

determining the value of a player or a team in the

future.

Plot: Movie tells the story of Billy Beane(Brad

Pitt) , the Oakland A’s General Manager , once

promising baseball player who uses Sabermetrics

to design a winning team. Initially it’s shown that

Oakland Athletics loose three of its star players

which forces Billy Beane to assemble a competi-

tive team from scratch under Oakland’s limited

payroll. During the process he meets Peter

Brand , a young Yale economics graduate who has

unusual ideas about how to assess players’ worth.

Beane tests Brand by asking him to convince

Beane that he should have taken Stanford scholar-

ship instead of trying his career in baseball league,

which he eventually does.

Sensing opportunity, Beane hires Brand as the Ath-

letics' assistant general manager and assembles team

on his recommendations based on Sabermetrics.

Assembled team of undervalued players was with

far more potential than the A's hamstrung finances

would otherwise allow. But Athletics’ staff, be it

chief scout or the manager, was not in favour of

Beane strategy. Despite vehement oppositions from

them, Beane hires and even exchanges his best

player in accordance with Brand’s theory which

leaves no option with Athletics’ staff except going

along with Beane’s strategy.

Early in the season, the Athletics performed poorly,

leading critics from outside as well as from inside

the team to dismiss the new method as utter failure.

But eventually team’s performance improves to

such an extent that they go on to create all Ameri-

can League record of winning 20 games consecu-

tively. Despite such a good performance Athletics’

lose in the first round of the postseason. But Beane

and Brand’s strategy came out successful and was

recognized by others as a result of which Beane was

approached by Boston Red Sox offering him as the

general manager post of the club with highest com-

pensation offered to any General Manager.

Analysis: As a sports movie lover, best thing I

liked about this movie was that, it doesn’t require

understanding anything of baseball to like this

movie. It is a rare sports movie which focused more

on the brains behind the game rather than last mo-

ment victory, kind of movies which have seen a lot

before. This movie not only deals with wins and

losses but also on the bold effort of a person to

revolutionize the game.

It is a fast paced movie in which constantly some-

thing new happens every moment. There's little

gimmickry here, just confident storytelling and a

script that tells out the dramatic arc in Beane's trail-

blazing approach and turns it into great material.

Crux of the whole thing is that it is a must watch

movie, which very efficiently depicts how econom-

ics can be used to solve problems from all strata of

the society.

|MOVIE REVIEW|


NSE’s index, Nifty surged at an annualized rate of

27% in the last six months with the peak of 6016

on 4th Jan, 2013 its highest in a year. This rise

came at a time when Indian Economy is going

through one of its toughest times since 2008. IIP

numbers along with other macro indicators going

in red many times in this year; Factory output

posted the growth of 0.1% in the month of No-

vember & manufacturing grew by mere 0.3% yoy.

Also inflation was out of comfortable zone for the

most part of this year. The only possible explana-

tion for the surge is the flow of FII funds at a re-

cord making pace $25 billion. Foreign investors

has shown lot of confidence in the emerging

economies indicating that worst is behind us in the

developed world. Last year the overall atmosphere

globally was extremely gloomy. We didn’t know

where Europe was going, we didn’t know the bond

yields were negative. The global liquidity; $ 10 tril-

lion have got printed in the world in last four

years. So, there was enormous liquidity in the mar-

ket. Amidst this global uncertainty, India seemed a

much better market to invest and hence it favoura-

bly acknowledged by the global players and it

started receiving funds in hordes.

Market soared in the backdrop of many uncertain-

ties which has started to clear away; moreover

there is good chance that Indian economy has bot-

tomed out. There were issues with US fiscal cliff (it

limits the amount of debt which US government

can take $16.394 trillion which would have led to

increase in taxes), Chinese economy decelerating

for the seven straight quarters, no major break-

throughs in results on Euro zone. However, now

the situation looks much better as most of these

issues if not resolved completely are in much

better shape.

In the short to medium term, there are two thing

that drive equities, earnings and liquidity. The

liquidity risk is perceived to be low as globally

most economies are in an easing cycle. However,

there is no writing in stone that foreign institu-

tional investor (FII) money will continue to flow.

The biggest risk is FII flows turning around, they

have been robust so far but if other markets start

to do well then money can shift.

During the entire rally where some stocks soared

by 100-150% with some sectors posting 50%

growth, there is zero earnings growth at the

broader level or near zero. Hence, it’s purely

multiple expansion on which it has happened.

Markets as such have been extremely calm dur-

ing this period which in turn is reflected in the

low volatility index worldwide, not only the stock

markets but in variety of sectors as well.

Most of the sectors grew more than 20% during

last six months, only some sectors like power

could not take off due to their inherent structural

problems. With Real estate garnering the major-

ity return of around annualised 60%, majorly on

the backdrop of optimism regarding the RBI’s

stance on liquidity which is largely expected to

relieve the rates more than once on the CY13.

42


STOCK MARKET UPDATE

|MARKET UPDATE|

43

Currency Rates

1 Dollar – Rs 54.83

1 Euro – Rs 72.48

1 Pound - Rs. 88.80

Policy Rates and Reserve Ratios

Repo Rate – 8.00 %

Reverse Repo – 7.00%

CRR – 4.25%

Bank Rate - 9%

SLR—23%

|MARKET UPDATE|

In the News

low base advantage had its contribution, a double

digit growth witnessed in the production of Coal,

Petroleum Refinery Products and Cement are

cited as consensus reason by analysts. The index

comprises of eight core industries which have a

combined weight of 37.90 per cent in the Index

of Industrial Production (IIP).

Banks to undertake proprietary transac-

tions in bond market

Nov 5, 2012; Business Standard

RBI has allowed banks to become members of

SEBI - approved stock exchanges to undertake

'proprietary transactions' in the corporate bond

market which, with a size of 11.8% of GDP, is

relatively less developed than government securi-

ties market in India. A well-developed corporate

bond market provides additional avenues to cor-

porates for raising funds in a cost effective man-

ner and reduces reliance of corporates on bank

finance.

Various stakeholders, including GOI, RBI, SEBI

and IRDA have made coordinated to help the

development of corporate bond market. RBI has

also taken measures to impart liquidity by permit-

ting repo transactions in corporate bonds and

increase transparency by capturing information

related to trading.

RBI issues guidelines on liquidity risk

management


According to RBI, banks should fix a lower limit

for their IBL (inter-bank liability) which should

not be more than 200% of its net worth as on

March 31 of the previous year. Further, banks

Nifty plunges 900 points on ‘flash crash’

Oct 5, 2012; Business Line

The market circuit filter got triggered due to entry

of 59 erroneous orders which resulted in multiple

trades for an aggregate value of over Rs. 650

crores. These orders were entered by a trading

member on behalf of an institutional client. These

market orders have been entered for an erroneous

quantity which resulted in executing trades at mul-

tiple price points across the entire order book

thereby causing the circuit filter to be triggered.

These orders have been identified to a specific

dealer terminal.

RBI cuts CRR by 25 bps

Oct 31, 2012; Economic Times

The Reserve Bank of India (RBI) reduced cash

reserve ratio (CRR), which is the part of deposits

bank have to park with RBI, by 25 bps to 4.25%

which reinforces that managing inflation remains

the primary focus of monetary policy. This is likely

to infuse additional liquidity of approximately Rs

17,500 crore into the monetary system. However

it kept the repo rate, reverse repo rate-at and inter-

est for the marginal standing facility (MSF) at 8%,

7% and 9% respectively.

RBI maintained that domestic growth risks has

been worsened by halted investment demand and

the current global environment poses challenges

to financing large current a/c deficit.

India's Core sector growth rises to 5.1


The core sector grew by a seven-month high of

5.1% in September which is more than 100% hike

of the 2.3% growth witnessed in August. While a


44

|MARKET UPDATE|

Rashtriya Ispat Nigam Ltd and SAIL.

FDI in retail clears parliament hurdle

Dec 7, 2012; Economic Times

The UPA government won the vote, albeit by

narrow margins, in the Lok Sabha and Rajya

Sabha on foreign direct investment (FDI) clear-

ing the way for foreign equity in multi-brand re-

tail. The government has maintained that FDI in

multi-brand retail will not render small traders

unemployed or hurt the interests of farmers.

Lok Sabha approves Companies Bill

Dec 19, 2012; Business Line

The Lok Sabha has passed the Companies Bill

2011 which is set to replace the existing Compa-

nies Act 1956, which was enacted 56 years ago. It

brings a slew of measures by making independent

directors more accountable, improving the cor-

porate governance practices and making corpo-

rate social responsibility mandatory for certain

companies.

It proposes that profit-making companies that

meet certain conditions will be required to set

aside 2 per cent of the net profit towards CSR.

The CSR condition will apply to firms that have a

net worth in excess of Rs 500 crore, or a turn-

over at least of Rs 1000 crore, or a net profit

more than Rs 5 crore. It also states that a direc-

tor’s remuneration should not exceed five per

cent of a company’s net profit.

Ratan Tata bids adieu as Cyrus Mistry

takes over

Dec 28, 2012; Financial Express

Ratan Tata handed over the reins of the group to

44 year old Cyrus Mistry, who was chosen his

successor last year and appointed Chairman in

early December, 2012. The group's revenues

grew manifold during Tata’s tenure totaling $100

billion in 2011-12. The number of listed compa-

nies in the group grew from 21 in 1992 to 29

presently including subsidiaries and associates of

key group companies such as Tata Steel, Tata

Motors, Tata Chemicals, Indian Hotels, Tata

Power and Tata Global Beverages, among others.

whose capital to risk-weighted assets ratio (CRAR)

was at least 11.25% (25% more than the minimum

CRAR of 9%) as on March 31 of the previous

year, can have a higher limit of up to 300% of net

worth for IBL.

RBI also allowed the limit on the call money bor-

rowings as prescribed by the central bank for call

money market operations to operate as a sub-limit

within the above IBL limits.

Direct Cash Transfer scheme to be

launched on January 1, 2013

Nov 24, 2012; Business Line

The government is set to launch the pay-out of

direct cash subsidy to people through the

‘Aadhaar’ based system in 51 districts in 16 states

of the country from January 1 with plans to com-

plete the rollout throughout the country by the

end of 2013. Both ‘Adhaar’ and Direct Cash

Transfer are the flagship schemes of UPA govern-

ment.

This will, among other things, facilitate the pay-

out of direct cash subsidy to the targeted benefici-

aries. The scheme is touted to bring efficiency into

the system as subsidies would be directly trans-

ferred as cash into the beneficiaries’ account. GOI

has identified 42 schemes under food, fertilizer

and LPG which could be brought the purview of

this ambitious scheme.

Government plans disinvestment in five

PSU’s

Dec 7, 2012; Business Standard

The government has plans to disinvest in five

more companies in the current financial year

(2012-2013) with a target to earn Rs 30,000 crore

through disinvestment of its part equity.

The first in pipeline with a planned 10% disinvest-

ment is National Mineral Development Corpora-

tion (NMDC). The issues of OIL and NTPC Ltd

are likely in January. While OIL is expected to

fetch around Rs 2,500 crore, a 9.5 per cent disin-

vestment in NTPC will garner Rs 12,000 crore.

Others that have been approved by Cabinet Com-

mittee on Economic Affairs (CCEA) are BHEL,


45


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MDI Monetrix BlueChip Issue3 October-December 2012

Documents

Transcript of MDI Monetrix BlueChip Issue3 October-December 2012