Journal of Finance Vol 23

8/9/2019 Journal of Finance Vol 23

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Volume 23 / November 2008

FINANCIAL ADVISOR

PPPRRRAAACCCTTTIIICCCEEE JJJOOOUUURRRNNNAAALLLJOURNAL OF THE SECURITY ACEDEMY AND FACULTY OF e-EDUCATION

SAFE PDATES KEEP INFORMEDThe Securities Academy and Faculty of e-Education

Editor: CA Lalit Mohan Agrawal


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Editorial Preamble: Europe First, Asia Later1.1 EUROPE FIRST, ASIA LATER

Its Far Superior!

Since August, Europeans have delighted in what Germans call schandenfreude pleasure you get out ofsomebody elses difficulties. Watching the US financial collapse, Frances President Nicolas Sarkozy andother Europeans have pilloried the Anglo-Saxon free-market model, claiming that the European model,

with much heavier government regulation, is far superior. But the financial crisis has now hit Europe sohard that claims of European superiority sound hollow. Despite extensive regulations, and no investment-banks like Lehman Brothers and Bear Sterns, European financial markets are freezing up like Americanones. Governments have to rescue banks and mortgage lenders from collapse.

Dexia, a European bank reputed to be the worlds biggest lender to local governments, has been rescuedfor 6.4 billion. Fortis, another European bank, has been nationalised in bits and pieces by Holland,Belgium and Luxembourg. The Irish government has guaranteed all banks depositors to stem panic.Iceland has suspended trading in its top six banks and nationalised one of them. Germany has rescuedmortgage lender Hypo Real Estate. Britain has nationalised Northern Rock, a major bank, and Bradfordand Bingley, a top mortgage lender. No longer is it anAnglo-Saxon exception in Europe.

Forget the old notion that some banks are too big to fail (and so must be rescued). Analysts claim thatsome European Banks are too big to be saved. As many as 14 banks have loans/assets exceeding the GDPof their respective countries. When such banks are rescued by governments, the creditworthiness of thegovernments themselves may be tainted. European banks use the risk weighting of the Basel norms, and justify their high leverage by pointing to the high quality of their assets. Clearly, European claims togood, prudent regulation in supposed contrast with the US are highly suspect. Investment banks likeLehman Brothers had leverage ratios of up to 30:1, and this was widely condemned as casino capitalism.But august European banks appear to have leverage up to 50:1.

Recent events carry three serious lessons: First, the highest-rated assets, even government debt, can gettainted in a crisis. Second, in a panic, not even the biggest financial institutions are safe. Third, many practices such as mark-to-market accounting and capital adequacy norms can worsen deadlydownward in a downturn. Higher regulation has not crisis-proofed Europe.

In some ways, Europe has deeper problems than the US. European banks like Fortis typically haveoperations in several countries, and this complicates rescues. Fortis rescue entailed uncoordinated, partialnationalisation by three different governments. In the US and Britain, the government and monetaryauthority belong to same nation. But, in the Eurozone, the European Monetary Authority is anindependent institution, whereas the rescuers of banks are national governments. In the US, Fed governorBernanke and treasury secretary Paulson can get together on rescues. In Europe this is not possible, and soadds to the risks there. Besides, many analysts say the problem started with the US housing bubble. Yethouse prices rose much faster in many European countries, such as Britain, Ireland and Spain.

Many Indians are gleeful, that United State and European financiers, who lectured us during the Asianfinancial crisis on the virtues of western financial systems, now stand exposed as dummies themselves.For all its shortcomings, the financial system looks safer today in India than in the US and Europe. Butdont celebrate. India has simply proved that if a financial system is bound hand and foot, it will not haveenough rope to hang itself. But, a global recession has started and may continue for a year. This will hitIndian exporters, production, interest payments, job expansion, and stock markets. Forget talk ofdecoupling; India is going to slide down along with the west. Even though our financial system isrelatively insulated, our trade and economic systems are now integrated with the rest of the world. Afterthe US, Europe in the next falling domino, Asia and India will soon follow.


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Dominoes: Europe First, Asia LaterMarkets down-and-out

The flames of the financial wildfire in global markets are now licking Indian markets, sooner than whatmost market watchers had anticipated. The bellwether Sensex dipped to the four-digit level led by a selloff in banking, realty and metal shares as corporates continued to borrow at exorbitant rates as banks andNBFCs tightened their purse strings, and panicky investors pulled out money from fixed-income schemes

of mutual funds, thus, worsening the liquidity squeeze in the system.

So severe has been the run on the liquid funds of some mutual funds that the NAV of those schemes havefallen below par a rare occurrence for a security considered safe next to only gilts. Likewise in the USmarkets, the crisis of liquidity is rapidly degenerating into a crisis of solvency, forcing the RBI to slashthe CRR rate for banks. But with global financial markets still in a state of flux, the RBIs move failed tocalm players in both money markets as well as stock markets. Both Sensex and Nifty are now fell wellbelow to their psychological levels of 10k and 3k respectively.

The bull market from 2003 till 2008 was unprecedented, and indications so far are that the ongoing bearphase too promises to be one as signs of pain in the real economy are becoming evident. The talk is nolonger about showing in corporate earnings; the biggest fear now is corporate defaults, which will then hitthe banks that have lent to them. The benchmark indices are off 60% from their peaks seen 10 monthsago. The carnage was not restricted to Dalal Street alone. Among the other prominent losers, Japan, HongKong and South Korea were down-and-out.

The global financial crisis has been constantly spreading and worsening creating a severe shock to globaleconomic growth. Britains economy shrunk 0.5% in the third quarter, the first contraction in 16 years,after registering no growth in the second. The economy is now teetering on the edge of its first recessionin nearly 16 years. Crude prices slumped even as the Opec announced a production cut. The Japanese yenclimbed to a 13-year high against the dollar, as investors continued to pare their carry trades.

Poor economic data around the world and another international barrage of corporate profit warnings andjob cut announcement intensified fears of deep global recession. 79-years to the day after the 1929 crashthat led into Great Depression, currencies experienced almost unprecedented volatility, oil and othercommodities tumbled on fears of plummeting demand that would accompany a slowdown, and stockmarkets dropped from Tokyo to New York.

The October Purchasing Managers Indexes show services sector contracting at its fastest pace sincecollapsing after September 11, 2001 attacks. Factory output was contracting at its fastest pace in at least adecade. We are clearly into recession, said an economist at Bank of America. A range of corporatesgiants reeled too, not just the banks who were hit first and hardest by the financial crisis that began with aUS housing collapse and now threatens recession across much of the globe.

Bank of England policymaker Andrew Sentance said the risk of severe recession in Britain had risen.Hopefully we can avoid that sort of situation in the current circumstances, but the risks of that haveincreased. Compounding the gloom, a survey of companies showed the euro zone private sector economyon track for its worst performance since the recession of the early 1990s. The report of the euro zones private economy shrinking this month at the fastest pace since monetary union and a much deeper-expected contraction in Britains economy in the third quarter led many analysts to declare recession.Its not limited to the developed world. They added: You can run but cant hide anywhere.


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1.2 SECURITY MARKETIs This Really A Panic?

In the past century, the world has seen countless financial crisis, economic downturns and market crashes.But the last major event to be called panic was the Panic of 1907. If ever it were appropriate to revivethe term panic, this is the time. Call it, the Panic of 2008. The day-after-day declines in the stockmarket are unprecedented. Normally, even falling stock markets take a break from time to time, as the

vultures swoop in to pick up stocks at bargain prices. But at times, when the markets psychology isanything but normal - there are tonnes of sellers everywhere. People just want out.

A panic is a situation in which people do things that contradict rationality. By definition, is this really apanic? Paolo Pasquariello, a professor at the University of Michigans Ross School of Business says:Its difficult to say people are selling because they are panicking. Selling isnt necessarily irrational.There are plenty of goods reasons to move from riskier to safer investments at a time when the financialsystem has stopped working and serious economic slowdowns looks imminent to many economies.

But many analysts believe that the markets are behaving irrationally. Its not as if weve had a nuclear warand real assets were destroyed. Rather, problems are in the financial sector, not the real activity in therest of the economy. The real, non-financial base of the economy is still fairly strong far stronger thanduring, for example, the Great Depression. They point out, eventually, investors will realise: Eitherwere going into a Great Depression, or some of these assets are trading at very attractive prices.

Many market participants feel the wave of stock selling is being pushed by hedge funds and otherinstitutions that must sell assets to raise cash. Often, these assets from stocks in solid companies tomunicipal bonds are being sold without regard to their inherent value. But, before jumping back in themarket, You wait for the forced selling to run its course. The market ultimately reaches a bottom.

Beginning of October 08 Sensex fell below 13k

Daily review 28/09/08 29/09/08 30/09/08 30/09/08 01/10/08 03/10/08Sensex 13,102.18 (506.43) 264.68 12,860.43 195.24 (529.35)

Nifty 3,985.25 (135.20) 71.15 3,921.20 29.55 (132.45)

Weekly review 30/09/08 03/10/08 Points Percentage

Sensex 12,860.43 12,526.32 (334.11) (2.60%)

Nifty 3,921.20 3,818.30 (102.90) (2.62%)

1st week of October 08 Sensex fell below 12k and than 11k

Daily review 03/10/08 06/10/08 07/10/08 08/10/08 09/10/08 10/10/08Sensex 12,526.32 (724.62) (106.46) (366.88) (800.51)Nifty 3,818.30 (215.95) 4.25 (92.95) (233.70)


Sensex 12,526.32 10,527.85 (1998.47) (15.95%)

Nifty 3,818.30 3,279.95 (538.35) (14.10%)

Market see worst weekly slide in two decades Bourses saw a virtual meltdown in one of the worstweek in two decades, as the Indian indices plunged by 10 to 26 per cent amid wild rumours about globalrecession led to panic sales across the globe. .


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Security Market

2nd week of October 08 Sensex falls off 10,000 peak

Daily review 10/10/08 13/10/08 14/10/08 15/10/08 16/10/08 17/10/08Sensex 10,527.85 781.24 174.31 (674.28) (227.63) (606.14)Nifty 3,279.95 210.75 27.95 (180.25) (69.10) (194.95)


Sensex 10,527.85 9,975.35 (552,50) (5.25%)

Nifty 3,279.95 3,074.35 (205.60) (6.27%)

Benchmark index ends below psychological mark for the first time in 28 months In the past, anysustained downturn in the market was blamed on over leveraged bull operators and their coterie ofunscrupulous brokers. The speculation now is about how many corporates are likely to default, asopposed to how many broking firms. The finger of blame is being pointed at over-leveraged promoters.While the fall has been broad-based, brokers claim that it has been steepest in the case of those stockswhere promoters had borrowed money by pledging their shares. With these promoters unable to meet

margin calls, the stocks are being offloaded by the finance companies anxious to recover their money.

3rd week of October 08 Sensex fell below 9k

Daily review 17/10/08 20/10/08 21/10/08 22/10/08 23/10/08 24/10/08Sensex 9,975.35 247.74 460.30 (513.94) (398.20) (1070.63)

Nifty 3,074.35 48.45 112.10 (169.75) (122.00) (359.15)


Sensex 9,975.35 8,701.07 (1,274.28) (12.77%)

Nifty 3,074.35 2,584.00 (490.35) (15.95%)

Sensex hits 3-yr low The stock markets almost hit their bottom, falling to nearly three-year low at theweekend as the recession worries continued to haunt investors across the world even as the salvageoperations undertaken by various governments fell short of expectations. Analysts said the marketsituation seems grim with all the global markets under pressure due to an imminent economic recessionand spreading financial markets crisis beyond the banking sector. On the BSE, there was a single gainer inthe Sensex pack with half of them showing one of the biggest losses at the weekend.

4th week of October 08 Sensex fell below 8k intra-day

Daily review 24/10/08 27/10/08 28/10/08 29/10/08 30/10/08 31/10/08Sensex 8,701.07 (191.51) 498.52 36.43 743.55Nifty 2,584.00 (59.80) 160.40 12.45 Holiday 188.55

Sensex hits sub-8k on Diwali eveOn Monday, the sensex plunged to a three-year low 7,697.39, beforebouncing to 8,509.56 at close. Bears were clearly unruffled by reports that the regulator was analysingdata to check for attempts to hammer down prices.


Sensex 8,701.07 9,788.06 1,086.99 12.49%

Nifty 2,584.00 2,885.60 301.60 11.67%


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Security Market

Monthly review

Month March 08 April 08 May 08 June 08 July 08 August 08 Sept. 08 Oct. 08

Date 31.03.08 30.04.08 30.05.08 30.06.08 31/07//08 29/08//08 30/09//08 31/10//08

Sensex 15,644.44 17,287.31 16,415.57 13,461.60 14,355.75 14,564.53 12,860.43 9,788.06

Points Base 1,642.87 (871.74) (2,953.97) 894.15 208.78 (1704.10) (3,072.37)

% Base 10.50% (5.04%) (18.00%) 6.23% 1.45% (11.70%) (23.89%)

Tsunami and Ripple Effect

The stock market has fallen about 60% from its peak level in January 08, as the FIIs who hold 35% ($71billion) of Indian stocks are in a flight-to-safety mode. Although the market crash is not unique to India,there are key difference between India and other markets which have declined. In the US and most of theWest, there is a problem in the real sector. The economies are slowing, the financial sector is in a messbecause of bad loans and the financial sector crisis has passed on the stock markets.

In India, it is other way round. The economy is the second-fastest growing among all reasonably-sizedmarkets and bank balances sheets are sound, but stock markets have collapsed because of the flight offoreign funds to perceived safer havens. But even this flight to capital has not thrown the economy out ofkilter. RBI has over $280 billion of forex in liquid assets. Bankers say that more money will go out andpoint to the $89 billion of short-term debt to be repaid. But nearly half of the debt is non-resident deposits,which in all likelihood will stay. The only problem is the $40 billion short-term debt that may be tooexpensive too renew. But the economy seems to be in a position to absorb the impact of these outflows.

There are mixed opinion on the extent to which the US slowdown would hurt service exports the growthdriver and the largest forex earners for the country. But given the weakening of the rupee, it is almostwidely expected that the West would continue to depend on India for IT and ITES. However, it would befoolhardy to assume that a 60% crash in the markets would not have an impact on the real sector.

In the last two months, two sources of funds foreign borrowings and capital markets have completelydried up. According to bankers, the first casualty will be projects in the pipeline. Some promoters havepledged shares with lenders when prices were high. Now that prices have fallen, either the promoter hasto top it up with more securities or the lenders will be forced to sell shares.

Also, banks may put further lending on hold, affecting the project.

However, the central bank, which has its ear to the ground as far as the performance of corporate India isconcerned, is quite optimistic. RBI governor D Subbarao had said: This is not like the 1990s for India. Ithas changed. In the 1990s, our growth resilience arose from debt-financed growth. Today, it is privatesector-driven productivity-financed growth and there is resilience.


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2.1 INDIAN ECONOMYIndia Vulnerable To Global Financial Crisis

1. India is vulnerable among emerging markets; IMF

As the international economy grapples with the worst credit crisis in recorded economic history,multilateral agency International Monetary Fund (IMF) has identified India as vulnerable among the

many other emerging markets around the world to the fast spreading economic cataclysm. At the sametime, the fund has also formally buried the popular decoupling theory, which had convinced optimiststhat India would remain impervious to the global turmoil.

According to the Global Financial Stability Report, released by the Fund, the immunity of most emergingmarkets to financial and economic shocks emanating from the developed economies will be under severetest in the coming days and months. The multilateral agency has drawn up an acid test assessing thesusceptibility of emerging markets. This is based on 7- macro, economic and financial indicators

1. Commodity price sensitivity,2. Current account balance,3. Gross reserves to short term external debt,4. Net external position of reporting banks,5. Growth in credit to private sector,6. Inflation, and7. Real policy rates.

India is considered vulnerable in four out of these seven parameters - commodity price sensitivity, growth

in credit to the private sector, inflation, and real policy rates. Indias commodity price sensitivity clocksin at 0.5, against the IMFs threshold level of 1. The sharp escalation in crude oil prices must have playedhavoc with this ratio. The IMF has also expressed concern over the high rate of inflation growth and thenegative real policy rate at minus 3%.

The report added: Desperate deleveraging by global financial institutions has led to a credit drought aswell as a sharp rise in the cost of credit, reducing the availability of external financing options for banksand companies from emerging markets. This has been compounded by decreasing risk appetite; therebyfurther reducing demand for emerging market paper.

2. India could be more vulnerable among emerging markets; RBI deputy governorRBI deputy governor Rakesh Mohan said: India could be more vulnerable than the other emergingmarket economies because of its current account liabilities. Moreover, with corporates looking back atthe domestic markets for funds, there could be a pressure on interest rates back home. In the speech at theIMF-Financial Stability Forum in Washington DC, Mr Mohan said: The major emerging marketeconomies (EMEs) in Asia have been recording surpluses on the current account in recent years, with theexception of Korea and India. It is in this context the foreign exchange markets in India and Korea haveexperienced greater pressure in recent times.


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Indian Economy

3. Indias short-term outlook cloudy,Medium-term positive; Prime Minister

Prime Minister Manmohan Singh said: The short-term outlook for Indian economy looks cloudy in theface of the global financial meltdown and steps are required to prevent the credit crunch from turning intoa crisis of confidence. India has unleashed a host of measures, including a cut in key rates by its central

bank, to increase credit flow in and the government has also announced that more steps would be taken tostimulate the economy, which is expected to post near 8 per cent growth despite the global slowdown.The Prime Minister added: The great turbulence in the world economy has chocked credit flows andpredictably spilled over to the stock market.

He said that the global nature of the crisis calls for a coordinated global response. Developing economieslike India are affected by the crisis and have to be part of the solution. We hope to build on Indias manystrengths as an emerging market economy that is now ready for rapid growth. Over the past four years, wehave averaged nine per cent GDP growth per year. It will slow down in the current year because ofconditions in the global economy. Once normalcy returns, we can regain the 9% trajectory.

Mr Singh said confidently, assuring foreign investors about the stability of India. Even the mostpessimistic estimates have placed the growth rate at not less than 7%. Measures taken by RBI and thegovernment this month are aimed at kickstarting industrial activity which would feed economic growth.The fundamentals of our economy have been and continue to be strong. Our banking system is wellcapitalised. The RBI stands ready to respond swiftly to address the needs of the economy.

Delhi Declaration

The three nations grouping called IBSA (India, Brazil and South Africa), have called for strict actionagainst those responsible for the crisis and the lack of credible regulation. Delhi Declaration, which wasadopted at the end of the IBSA summit said: The explosion of new financial instruments,

unaccompanied by credible and systemic regulation, has resulted amongst others in a major crisis ofconfidence for which those responsible should be held accountable and liable. IBSA pushed for reformsof the International financial systems and warned that palliative measures would not be enough toaddress the core issues at the heart of the financial crisis.

The Delhi Declaration acknowledged that developing countries were not immune to the financial crisisand that there is a need for a new international initiative to bring about reform in the internationalfinancial system. The new initiative must take into account the fact that ethics must also apply to theeconomy; that the crisis would not be overcome with palliative measures and that the solution adoptedmust be global and ensure the full participation of developing countries.

There has been criticism among many economies that the bailout packages announced by US andEuropean countries were just treating the symptoms and not the root cause of the problem. South AfricaPresident Kgalema Motlanthe said: The ill-conceived decisions of the few have brought the internationalfinancial system on the brink of collapse. Brazilian President Luiz Inacio Lula da Silva was lesscharitable towards the US and European countries blaming the rich countries and irresponsiblespeculators for changing the world into a gigantic casino.


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2.2 INDIA AND THE GLOBAL FINANCIAL CRISISA Consequence of the Overconfidence

A year ago, people were questioning if the subprime crisis that began in the summer of 2007 in the UnitedStates would spread to India. It was pointed out that India has not been a major investor in US subprimemortgages. Moreover, the Reserve Bank of India did not follow the policy of the Federal Reserve in theUS of cutting interest rates to near zero levels, at the height of real estate boom.

In the US, The Federal Reserve kept policy so loose that short-term real (that is, inflation-corrected)

interest rates were in negative territory for roughly three years, from late 2002 to well into 2005, the veryheight of the real estate boom in the US. In India, the Reserve Bank did no such thing, and Indian real

three-month rates generally stayed in the (positive) 1% to 4% range for almost all the period since 2002.

So, it might well seem that the situation in India is completely different.

Now, a year later, after September 2008, India has been hit by the crisis originated in the US. Even thoughthe commonly-identified causes of the crisis in the US, the subprime mortgage and the extremely loosemonetary policy, were not in evidence in India, India is still seeing some of the same outcomes. Thesensex has had a correction, is down about 60% from its peak. The markets for residential houses (homes)in major cities which were booming in the summer of 2006 are now clearly in distress.

Should we be surprised? Actually, the similarity of market behaviour across countries is evidence thatsomething else, deeper than the causes that are usually given for the subprime crisis in the US, is at work.

The most fundamental problem if found in the swings of overconfidence that was seen in many countriessince the 1990s; overconfidence shared by millions, billions of people; and this confidence has been verystrong until recently. A strange idea that has grown dramatically after 2000 and is sign of our recent timesin much of the world has been that investing in homes would yield spectacular capital gains on into theindefinite future. In simple words, the idea that home prices can only go up become firmly entrenched,and has influenced the great masses of small investors all over the world.

When people expect good performance from their investment in assets, they tend to bid up their prices.That is what was happening in many places around the world in the years leading up to the current crisis,until markets collapsed. The most important single factor that has driven so many economies around theworld over the last decade or more has been the changes in confidence in the economy and investments,including stocks, real estate, as well as energy and agriculture.

The subprime crisis in the US is only a symptom of this fundamental problem. It is, in substantialmeasure, a consequence of the overconfidence. Mortgage lending standards deteriorated because peoplethought that home prices can only go up, and also lenders thought there is little risk in writing mortgagewith few protections. Even the loose Fed monetary policy in the US is, in a way, derived from theoverconfidence. The Fed was willing to have such loose monetary policy because, under Alan Greenspan,

it was so unaware of the bubble in home prices, and thought it was just another sign of spectaculareconomic growth, and so felt no concern about it.

India is part of world culture and is not invulnerable to changing patterns of thinking about investment.Much of what happens in speculative markets in India is just the same as in other countries.


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2.3 INDIA INCThe Credit Crunch Spreads to Business

The financial crisis is pinching corporate wallets, though India Incs chief number crunchers busy doingthe money math say they arent badly hit just yet. But suppliers are bawling from the bite and many aredemanding some financial buffer from their bigger client companies. The issue is liquidity.

Across industry segments, from steel to non-ferrous metals, engineering to auto components, paper tocement and other infrastructure sectors, the story is pretty much the same.

Companies are unsure of realising some of their receivables, as India Inc faces the heat from the globalliquidity crisis. CFOs are taking capex caution as the liquidity crisis starts to hurt India Inc. Greenfieldprojects and capacity expansion plans could be benched as equipment delivery from capital goods playersget stuck due to restricted lending by banks.

Most CFOs admit: Although we are all right, the issue will come back to us if our suppliers face financeproblems. We have sufficient working capital, but the same cannot be said of our suppliers.

Companies like motorcycle major Hero Honda have already kicked off some corrective measures tohelp out both vendors and dealers. Anticipating that the credit squeeze would hit vendors and dealers first,the company issued Rs 425 crore short-term credit limit for its dealers. Hero Honda CFO Ravi Sud says,We were apprehensive about it (the credit problem) and decided to help out our dealers as well as ourvendors. As a company with surplus cash, we helped our dealers by raising the cash credit limit for theminternally and also allowed faster payments for our vendors. Instead of the 45-days cycle, we are nowfollowing a 15-day payment cycle for all suppliers.

But not all companies have reserves to dole out similar sweeteners. While those that have alreadycompleted their expansion project are having a sigh of relief, those stuck in first or second gear arewondering whether to cut their losses and get out or stick around to ride out the storm. And if the data isanything to go by, India Inc has some very good reasons to sweat. Large investments worth over Rs40,000 crore accounted for 18% of the total capex plans announced in the first six months of the currentfiscal. This means a fifth of India Incs ongoing projects are hugely capital-hungry and so possiblyvulnerable. Some amount of conservatism will come into the capex plans of companies mainly because ofthe problems in funding. To that extent we could also see a fall in demand.

1. Top-up shares for Lock Box arrangement

Private Indian banks and foreign lenders, who financed listed Indian companies based on share comfortagreements, have started asking for top-up shares in the wake of the stock market crash. Theseagreements come by various names across different banks like Lock BoxArrangement in the case ofBarclays and other foreign banks lending in south East Asian markets.

As against a stock pledge, a share comfort agreement assumes a certain threshold pricing of the stock.The lending agreements allow lenders to ask for additional shares to maintain adequate loan cover if theshare price falls below the threshold level. These agreements are complex, and do not involve an outrightshare pledge. RBI clearance is required for any Indian company that wishes to raise overseas funding bypledging local shares. Such regulatory approvals can be time consuming. By share comfort agreements,the companies give a non-disposal undertaking coupled with a power of attorney in favour of an agentnominated by the bank.


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The Credit Crunch Spreads to Business

2. Job loss pain, suddenly more real

The financial crisis has finally invaded middle-class drawing rooms in India. With the sacking of JetAirways staff, the pain is suddenly more real. Job loss figures are no longer mere statistics, but have takenhuman form; a son, a daughter, a nephew, a niece who has lost a job; overnight! While the public furorand political fallout, has reportedly compelled airlines to rescind their decision, the episode must trigger

some collective introspection. Remember, who lost their jobs in export industries in Tirupur, Moradabadand Surat when the rupee appreciated last year and, going forward, are likely to lose their jobs if theglobal slowdown continues. At the macro level therefore, the layoffs dont mean very much. Its just thatwhen it happens to people like us, part of the urban middle class, it seems so much more real, unlike whenit happens in some remote dusty town.

DSP Merrill Lynch joins the firing line: DSP Merrill Lynch has started retrenchment people inbusinesses as Merrill Lynch gets ready for a global merger with Bank of America. Sources said that DSPMerrill Lynch has retrenched employees across various departments, including structured finance,derivatives, fixed income, currency and commodities and strategic risk group, which is the companysproprietary trading desk. The firm has around 500 employees in the country.

Kingfisher grounds 50 trainee co-pilots: Kingfisher Airlines has benched 50 trainee co-pilots, askingthem to say at home till further orders. The company has offered them a monthly stipend of Rs 20,000against their take home salary of up to Rs 1 lakh. This decision has put the co-pilots in a fix as most ofthem had borrowed funds from banks to pay for the commercial pilot licence course fees and wereplanning to repay the loan from their salaries.

Middle class spends 25% of pay on EMI:On the whole, even while the total household debt in India(from the formal sector) amounts to just Rs 5.58 lakh crore (about 10% of GDP) compared to over 100%of the US GDP for American households. These national averages some what underplay the financialvulnerability of the metros middle-class households during the current economic slowdown. Middle-

class households across Delhi, Mumbai, Kolkata, Chennai and Bangalore spend around a fourth of theirmonthly take-home income on loan EMIs housing, auto, durable and personal loans.

3. Dream turns into nightmare

Global financial crisis has worst affected the graduating students in engineering or management colleges.Words like No idea!, Indefinitely-postponed!, Scrapped and regret letters have suddenly becomea part of the latest lingo that can be heard often in all college campuses. The diffidence is ruling thesentiments of students, as they are now even questioning the career choice that they made.

Knowing that their seniors have got starting packages of say Rs 6 lakh per annum, they expected to get a

job with similar package. But, now companies are not visiting the campus. Even off-campus recruitmentoffers about Rs 2.5 - 3 lakh per annum, leaving them no option, but to accept it. However, students withoffer letters in hand are apprehensive for waiting for too long and are looking for alternatives albeit atmuch lower packages. The offer letters they have hot hold no value. They are switching to other profilesas being a lecturer, taking up call center jobs, which anybody else can do.

Assocham reports that India has over 3,500 engineering and over 1,600 B-schools registered with AICTE.Over 450,000 engineers students and 75,000 MBA students graduate every year. Out of these almost 80-85% is placed annually. This year most institutes are not sure of their placements.


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2.4 INTERNATIONALThe Bursting of a Debt Bubble

That whole make money in any marketthing isnt working out to the advantage of the money managers;since a forced deleveraging and potential global recession mean the whole range of alternativeinvestments, including real estate and commodities, are very vulnerable and should do substantially worsethan plain-vanilla stocks and bonds.

The growth of alternative investment has been phenomenal in recent years, and highly correlated with theoverall growth of debt in the global economy. It has produced some outsized returns for investors.According to JP Morgan estimates More than $5.6 trillion is committed to alternative strategies, a growthof more than 50% in a little over two years. But this is now coming unstuck. The bursting of a debt bubblehas had three important consequences for alternatives:

First, borrowing is hard to do and more expensive. The more you need it, the worse off you will be. Second, everyone is trying to sell assets at the same time. This drives prices down and murders forced

sellers.

Third, the real economy is taking the strain. That is hurting demand for commodities, real estate andthe things and services provided by companies owned by fund and private equity (money managers).It might be a little nave to expect the financial crisis will blow over and the real economy will escapeunscathed. That cant be. The loss of incomes, the fall in value of investment and the credit squeeze hasalready served to dampen consumer sentiments. Housing sector, one of the key drivers of growth, isunlikely to recover soon. The combined effect of these factors would further slow down demand.Countries that benefited from the commodity boom could suffer the most, as commodity prices softenamidst concerns of sharp deceleration of the global economy.

Interventions by regulators can at best provide limited respite in the face of the massacre in the globalstock markets. The meltdown, after the Wall Street crisis has spread to Europe, and has wiped out nearlythree years of gains for Indian investors, with the Sensex plummeting almost 60% from its peak so far.Markets such as Brazil that seemed relatively less vulnerable to the gyration in the global market are nowexperiencing the steeper decline. The Russian markets in single day plunged 19% on 6/10/08. Andinvestors across the globe are more concerned about the return of their money than returns on money.

The Emergency Economic Stabilization Act of 2008 (EESA)

The EESA has become the law in the US. Before the legislation was passed, speaker after speaker in theHouse of Representatives and the Senate spoke about the dire need of $ 700-billion package to stabilisethe US economy. But this package could fail to achieve the purpose for simple reasons. The chief is thedenial to recognise the nature and extent of the problem, its geographies and the number of entities

affected by the crisis. There is an urgent need to recognise the depth of the problem.

Homeowners cash-flows are under pressure and therefore the relief has to reach to them, so that theeconomy might pick up. Troubled assets should be structured keeping in view the cashflows of thehomeowners. The timeframe for complete resolution of the troubled assets would be anywhere betweenthree and seven years and certainly not two years as envisaged in EESA. This kind of approach can reallynot only become HOPE for Homeowners, but also for the US economy.


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3.1 MUTUAL FUND INDUSTRY

1. Dividends from MIPs begin to dry up

The situation is not looking good. 20 of the 35 odd Monthly Income Plans (MIPs) have failed to pay anymonthly dividend on more than one occasion since the beginning of this year. Many investors, especiallypensioners, depend on MIPs for a regular source of income. The situation is only likely to get worse if the

current woes experienced by the Sensex continue.

For investors who are wondering how funds can do this, the answer lies in the fine print. Every mutualfund schemes has a disclaimer that says read the offer document. The relevant part of the fine print inthis case for investors is the bit where it says monthly income is not assured and is subject to theavailability of distributable surpluses. In a bull run many investors never bothered about the fine print andnor did their distributors tell them about it. They are now discovering it in the hard way.

Distributable surplus is the return that the funds generate through their investments in various equity anddebt instruments. While MIPs are generally debt-oriented schemes, they do have a small componentinvested in equities. Depending upon the aggressiveness of the fund, the equity component can rangefrom about 5% to 25%. Given that the equity component of the fund is so limited ideally MIPs shouldhave not taken the same beating that pure equity funds have experienced. But, why is it that these fundsare unable to generate surpluses to pay at least some dividend to their investors?

The answer is quite simple the losses on account of equities have been greater than the gains on accountof debt investments. Given the kind of fall that the markets have seen since the beginning of the year, aMIP with say, Rs 100 crore of assets under management (AUM) and about 15% exposure in equities islikely to have lost about Rs 8 crore. At the same time, the 85% debt composition of the portfolio is likelyto have earned the fund about Rs 9 crore, if the average returns from debt are construed at about 9.5%-10%. Thus the net gain for the fund stands at about Rs 1 crore. Now, if the fund provides for the annualexpenses, say at 2% of the total assets of Rs 100 crore, then the net gain of Rs 1 crore gets erodedcompletely leaving nothing that can be distributed among the investors.

The funds say the way markets have fallen this year, even a small exposure in equities has eroded thelittle they get from debt. They also say that even with the current meltdown in stock prices they cannotcompletely get out of stocks because of their mandate. Most funds are mandated to invest in equities, andtherefore all they can do is to reduce the exposure in equities from say 15% to at best about 10%.

2. Redemptions in FMPs begin to hurt fund houses

An assessment of Fixed Maturity Plans (FMPs) has noticed a mismatch in asset-liability management atsome fund houses. Although FMPs are short-term funds, fund managers have taken long-term positions insecurities (maturity of one year or more), as they get a higher interest. An early exit by large institutional

investors can put fund managers in trouble as meeting redemption requirements at short notice is tough.As FMPs are short term funds, they are ought to be invested in short-term instruments like T-bills. Themost common FMPs vary in maturities between 3 and 13 months.

Besides, an assessment of mutual fund portfolio shows funds have 15-16% exposure to the real estatesector and nearly 5% to NBFCs through pass-through certificates. Both big and small funds have investedin these two sectors. Some fund houses, especially, a few smaller ones, were hit badly when largecorporate investors existed in the wake of concerns relating to the quality of papers issued by some realestate companies. The MFs had invested in such paper on hopes of higher yield.


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Mutual Fund Industry

3. Indian funds investing globally lose shine

As financial crisis steals the glitter from all globally connected financial instruments, even the India-basedglobal funds have succumbed and lost their shine.

Almost all fund houses that have global funds as a product have seen the AUM of their global fundsfalling by over 15% from June 2008 to September 2008.

In the last six months, a number of asset management company (AMCs) launched feeder funds. Theywere getting very encouraging response for them and they had also been providing some excellentreturns. However the virus that has hit the financial facet of the globe has also taken a toll on the assetsunder management (AUM) of the global funds or feeder funds.

A feeder fund invests solely in another fund primarily a foreign fund, known as master fund with aview of investing in global equities.

Waqar Naqvi, CEO, Taurus AMC says: There will certainly be a slowdown in the pace with which theAMCs were coming out with feeder funds. In fact the current crisis will cause fund houses to defer theirplans of launching feeder funds as people would hesitate from investing in them.

Some AMCs believe that it has become a bit of a challenge to raise funds even for domestic equity fundsand hence expecting a decent corpus for feeder funds is actually being over optimistic.

JP Morgan AMCs CEO Krishnamurthy Vijayan says, We have received approvals to launch four feederfunds. Although we are not expecting much of a response for our funds but we have no plans to deferlaunches, as there are no corpus constraints in case of feeder funds. Even if we gather Rs 1-2 crore wewill feed it into the master fund abroad.

There are various reasons contemplated by industry experts for the spurt in the growth of global funds thathad cropped up sometime back. Fund houses had already gauged that people had decent exposure todomestic equity funds and therefore new themes would add diversification to their portfolios.

Moreover, innovation and differentiation has always been a prop up for the AMCs to catch investorsattention. However, the response to new launches was not great even though fund houses are pushing onthemes involving exposure to international markets, gold, commodities and real estate.


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3.2 COMMODITY MARKRTWhy Smart Traders Went Short?

Although money supply has turned overnight from a gushing Nile to dry Sahara, it isnt the only reasonwhy commodity prices are crashing. Current price slides were inevitable even without the financialmeltdown because supply was poised to overshoot demand. Thats why smart traders went short.

Rapid changes in demand and supply are shredding costs cards around the world. Watching a market fallis such a gory yet hypnotic experience that one is apt to forget other influences such as harvest size,weather, and inventory levels. But these factors dont vanish when we lose interest.

Take again; Wheat is cheaper because global production may jump 10% and ending stocks are expectedto rise 18%. In India a crash in wheat prices was inevitable because the government the single biggest buyer from farmers at some point had to sell its grain in the open market. We didnt need a globalmarket meltdown to predict this one.

Rice is cheaper because from China to India, Asian countries are harvesting large crops.

Corn fell partly because the USDA predicted a 14% drop in demand for corn as feed.

Robusta coffee became cheaper because the market is expecting record crops in Vietnam and Brazil soon.

Sugar prices crashed for the same reason. When crude oil hits $80, who wants ethanol? Or indeed has themoney to buy fancy flex-fuel cars. Biofuel subsidies will also be chopped as governments find other usesfor their cash, such as propping up wilting banks. At the same time, global supplies are expected to risesharply, led by a 15% increase in Brazilian sugar cane production.

Soyabean meal and oil have dropped globally because demand from China the largest importer isslower while global production is up. India itself reaped a record crop. Global demand for soya oil inbiodiesel will hit a hump now that crude oil is cheaper.

Palm oil is down more than a third since June because biodiesel demand has evaporated. Indonesia haschopped its palm oil export tax. Coconut oil and palm Kernal oil (close substitute) are cheaper due tolarger than expected palm kernel oil production, with stocks reaching historic highs.

Even though metals are more closely entwined with global financial markets than agri-commodities,demand-supply factors are kicking in here as well. China is the worlds largest consumer of industrialmetals including copper. If the Chinese economy doesnt grow as fast as anticipated, a lot of metal willhave nowhere to go.

Copper saw the biggest plunge mainly because global demand is weak at a time when mines are in

overdrive. Aluminium dropped because demand is slow, stocks are rising fast, and China is rapidlyincreasing production and exports. Tin has fallen because demand is slowing even though stocks haveremained relatively low on continued supply constraints. Crude oil itself has fallen below $70 a barrelbecause demand has dropped in the US, which consumes about a quarter of the worlds oil. Natural gashas become cheaper because demand is lower, inventories are higher and US is producing more shale gas.One could argue that crudes decline was unforeseen and blame it for the consequent mayhem. But weknow many traders who read supply trends correctly and went short months ago.


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3.3 CURRENCY MARKETRupee under Pressure

When the rupee was appreciating last year, it was widely believed that the upturn was here to stay.Foreign investments came rushing to India, lured by its strong economic growth and low inflation. So,when the tide turned, it was rude awakening for India Inc. Today, India is more integrated with the worldcompared to a decade ago and the exchange rate has a huge bearing on India Incs growth prospects.Besides, depreciation in the rupee reduces the financial returns of foreign investors, reducing the relativeattractiveness of India as an investment destination. The most obvious reason for rupee under pressure isthe global financial crisis and the ensuing massive unwinding of foreign portfolio investors to fund theirdomestic liquidity requirements. However, there have been subtle changes in the economy over the pastfew months that have been hinting at a weak rupee:

Inflation Indias inflation spurted to double digits in June 08 higher than the rate of economicgrowth on the back of high crude oil and commodity prices. At the same time, the governmentsdecisions to raise subsidies rather than pass on the high global prices of crude oil and fertilisers havedramatically increased the fiscal deficit.

Fiscal deficit Indian government has to make provisions for waiving agricultural loans, handing outthe Sixth Pay Commission awards and other welfare schemes launched in the recent past. Accordingto various estimates, these measures are expected to push Indias fiscal deficit to nearly 8% of thegross domestic product (GDP) the highest ever in nearly a decade. A bigger fiscal deficit translatesinto an equally huge trade deficit, which puts downward pressure on the rupee.

RBIs limited ability RBI, which overseas the domestic money supply, also monitors the supply offorex in India, so as to smoothen out the erratic movements by keeping the markets well supplied andliquid. However, RBIs ability to intervene in market is limited. And, forex reserves have to be usedcarefully because they play a key role in maintaining the general confidence in the currency.

Foreign branches of Indian banks are suddenly finding it difficult to roll over short-term loans takenfrom local banks. In such cases, they are left with no other option, but to raise the necessary forex inthe domestic market by selling rupees, which adds to depreciation in the rupee.

Hot money During FY08 alone, nearly $48.8 billion of hot money flowed into India, representing43.3% of Indias net capital inflows of $108 billion. Since hot money can be easily pulled out at shortnotice, its large presence in the economy increases the risks of a sudden exodus of foreign capital.

The Indian economy is not in good shape. Growth in IIP has slowed, while inflation has soared.During the five months of FY09, fiscal deficit has already crossed 87% of Indias full-year forecast.The spurt in global crude prices has single-handedly increased Indias trade deficit. Indias export

growth is falling short of the growth in imports.

The recent fall in the rupee, led by withdrawal of foreign portfolio investors from India, may not berectified till stability returns. The global scenario is uncertain. India is also needs to fight its own woes high inflation, widening current account and fiscal deficit and slowing economic growth besidesabsorbing repercussions of the global turmoil.

The Indian economys ability to re-emerge as an attractive investment destination will determine therupees upward movement. Till then, the rupee is likely to remain under pressure.


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4.0 FINANCIAL SECTOR: TRANSFORMING TOMORROW

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In a joint news conference in Paris, on 4 th of October 2008 (Saturday), Frances PresidentNicolasSarkozy, German Chancellor Angela Merkel, British PMGordon Brown, and Italian PMSilvioBerlusconi said: We jointly commit to ensure the soundness and stability of our banking and financial

system and will take all the necessary measures to achieve this objective.

French President Nicolas Sarkozy, who called the Paris summit in hope that a show of unity would helprestore confidence in the banking sector and an economy on the brink of recession across the developedworld; said governments needed to act in a coordinated manner. We have taken a solemn undertaking asheads of states and government to support the banks and financial institutions in the face of this crisis.

British Prime Minister Gordon Brown said No sound bank would be allowed to fail for lack of liquidity.We will continue to do what ever is necessary. The summit follows approval on Friday by the USCongress of a $700-billion bank bailout plan to tackle a crisis sparked by a housing market collapse and asurge in bad mortgage debt. Washington, a White House spokesman said: We welcome and appreciatethe continued attention to the situation affecting the global financial system.

4.1 FINANCIAL ADVISORS:Weigh impact on investors

Co-ordinated action

In Washington, the finance ministers of the worlds richest countries the G-7 promised co-ordinatedaction to unclog the arteries of the worlds money and credit markets. There were no specifics, butincreasingly the consensus seems to be veering towards direct injection of capital by government intosuffering banks. The G-7 pledged to avoid systemically important financial institutions from failing, to do

whatever was possible to ease the credit crunch.

The G-20, which includes emerging markets such as India, China and Brazil, later, issued a similarstatement promising to work together.

The British prime minister strongly argued in favour of extending sovereign guarantees for interbanklending, to begin with. This was seen as critical to bring back trust among banks. Further, Britain hasrecommended that government must capitalise banks, which in turn will be accountable for dealing withtoxic assets. As a strategy, this is different what the American had chosen to do. The US governmentcreated a SPV to take over toxic assets of various banks. The British feel that banks must be left to dealwith these assets under strict regulation.

However, a consensus appears to be evolving in favour of following a combination of direct bankcapitalisation as well as using SPV to take over bad assets. Essentially, there is now an understanding thatthe global asset bubbles across various market segments real estate, oil, equities or commodities willbe managed jointly by the combined might of all the economies. The global markets are relieved that suchmassive government intervention will at least ensure that the asset bubble does not burst and thedeleveraging happens in an orderly fashion.

One can hope that things will only get better from here.


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4.2 WEALTH MANAGERSMap out the details to translate into benefits

Giving shape to a new world

On Tuesday (14th October, 2008), the United States ushered in a new era in banking with plans to takeequity stakes worth up to $ 250 billion in financial institutions, an incursion into the private sector that USofficials called a regrettable last resort. The US followed European powers that agreed to recapitalise theirbanks a day earlier. President George Bush said, US treasury secretary Henry Paulson said: This is anessential short-term measure to ensure the viability of Americas banking system. Government owing astake in any private US company is objectionable to most Americans, me included. Yet the alternative ofleaving businesses and consumers without access to financing is totally unacceptable.

4.3 CREDIT COUNSELORSResolve convertibility and recompensation issue

Too big to fail

Among other things, the events during last month (September 08) have erased one phrase from thelexicon of financial markets: too big to fail. As the high and mighty among financial services giantscontinued to tumble and central banks stepped up their rescue efforts.

Financial markets have become so treacherous that one is not surprised to hear of a hunter becoming thehunted. Leading US commercial bank Wachovia Corp, which was looking to acquire investment bankMorgan Stanley till few days back, has now ended up being swallowed by Citigroup Inc.

But this may well have been a sideshow in comparison to the events earlier on 29 th September, 2008 thatrattled the already nervous investors afresh. It was the turn of European governments to play firemen, asthey tried to shield their financial services majors from the inferno rapidly spreading towards them fromthe other side of the Atlantic. European governments steeped in to rescue Fortis, Bradford & Bingley Plc,and Hypo Real Estate Holding AG as tremors from the US credit crisis reverberated around the world.

The UK Treasury seized the liquidity-starved Bradford & Bingley - Britains biggest lender to landlords,

while government in Belgium, the Netherlands and Luxembourg agreed to cough up e11.2 billion ($ 16.3billion) to save Belgium-based banking major Fortis from going under. Hypo Real Estate - Germanys

second-biggest commercial-property lender - received e35 billion loan guarantee from the German

government to fend off insolvency.

These developments have shifted the focus away from the $700-billion bailout package for troubled USfinancial firms that were expected to stabilise credit markets. And investors now seem to have run into aperfect storm, with no asset class offering a safe harbour. Prices of commodities fell, led by oil, copperand lead, on worries that the US bail out package will not be able to avert a slowdown in the worldslargest economy. US President George W. Bush said in a radio address: My administration will move asquickly as possible, but the benefits of $700-billion bailout package will not all be felt immediately. The bail-out is earmarked to buy up assets that turned toxic when the US housing market and sub-primemortgage market collapsed, triggering a crisis that has paralysed wholesale money markets, caused hugevolatility on stock markets and changed the banking landscape in a matter of weeks.


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4.4 FINANCIAL PLANNERSValue unlocking for all stakeholders

Britains bailout package to banking system

Britain pumped 50-billion ($87 billion) of taxpayers money into its banks on 8 th October, 2008(Wednesday), seeking to revive Europes top financial centre and help allay an economic stormthreatening industry and jobs around the world. Prime Minister Gordon Brown said: We have led theworld today with a proposal to restructure our banking system.

The talks followed a day of dramatic falls on Tuesday in the shares of British Banks, threatened by aglobal collapse in confidence between banks that has led to a freezing up of lending, the lifeblood of theeconomy at large. Some British banks have lost nearly half their value of the stock market amid investorfears they could collapse if they were not handed a massive liquidity lifeline.

In all, seven British Banks including Abbey, Barclays, Lloyds TSB, Standard Chartered and the countryslargest building society Nationwide, have committed to increase their total Tier 1 capital by 25-billion intotal as part of the governments scheme. As part of the latest plan, the government will also issueguarantees of short and medium-term debt to banks who commit to raising their Tier 1 capital. Tier 1capital is the main measure of a banks financial strength.

The government said it would make 25-billion available to these institutions as preference share capitalor permanent interest-bearing shares, which offer a more guaranteed form of income for the holder, andwas also willing to help raise ordinary equity if required to do so. In addition to this, the Governmentstands ready to provide an incremental minimum of 25-billion of further support for all eligibleinstitutions. In return the government will require banks to meet certain terms and conditions that willinclude banks making commitments to support small businesses and home buyers and to deal with whatmany see as unfair pay deals for bank executives.

Besides, in an effort to get banks lending to one another again, the Bank of England will make at least200-billion available under its Special Liquidity Scheme and conduct three-month sterling and one-weekdollar auctions for three months against a wider range of collateral until market stabilise. The Bank ofEnglands Special Liquidity Scheme, set up in April in what was then the British authorities biggestresponse to the credit crisis, allows banks to exchange illiquid assets, including mortgages, forgovernment bills, helping free up their balance sheet.

4.5 INCLUSIVE CEOs

Innovative responses to problems

S Koreas bailout package to avert meltdown

Asias fourth-largest economy has looked one of the regions most vulnerable to the credit crunch with itsbanks struggling to find the dollars they need to pay debt and as frightened investors hammered down thewon to its lowest over a decade. The won has lost about a third of its value against the dollar so far thisyear to hit its lowest level since the Asian financial crisis 11 years ago and foreign investors have sold offa record 30 trillion won of local shares.


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On Sunday (19/10/08), South Korea announced a package worth over $ 130 billion to rescue its marketsdragged down in the global financial crisis offering a state guarantee on foreign debt and promising torecapitalise financial firms. The countrys top three economic planners told in a joint news conferencethat on top of the guarantees worth $100 billion, they would also inject $ 30 billion to banks. They also

said they would announce a separate set of measures to help construction industry, among the hardest hitsectors as the global turmoil is seen pushing domestic economic growth to its slowest in over a decade.

4.6 RISK MANAGEMENT CONSULTANTSEducate Engineer and Enforce

Asia, EU seek confidence booster

On Saturday (25/10/08), Asia and European leaders gathered in Beijing for the second day of a 43-nationsummit with the Herculean task of propping up the confidence of panic-stricken markets fearful of aworldwide recession. The financial crisis has injected urgency into Asia-Europe Meeting (ASEM) of 27

EU member states and 16 Asian countries.

Leaders queued up to pledge cooperation to tackle the turbulence by taking what a statement called firm,decisive and effective measures in a responsible and timely manner. Through such concerted efforts,leaders expressed full confidence that the crisis could be overcome.

Indian Prime Minister Dr Singh was spot on when he suggested the existing multilateral agencies likeIMF and World Bank must get substantially higher contribution from member countries to be able to lendto many emerging economies that are on the verge of going bust because of massive deleveraging by WallStreet banks which are selling equities across the board. The currencies of many small Asian and EastEuropean countries are in a free fall as their dollar reserves are fast vanishing because of deleveraging by

Wall Street banks, whose collective asset holding could be as much as Asias GDP.

Europes main goal in Beijing is to rally Asian support for a united front at a financial crisis summit onNovember 15 that US President George W Bush will convene in Washington. President Nicolas Sarkozyof France (which currently holds the rotating EU presidency) said: Europe would like Asia to supportour efforts, and we would like to make sure that in Washington Summit, we can face the world togetherand say that the causes of this unprecedented crisis will never be allowed to happen again. Sarkozy toldChinese President Hu Jintao that he wanted concrete decisions from the Washington talks. And that theG-20 Washington summit makes clear that all financial institutions in the future should be subject to strictscrutiny. Since, the behaviour of hedge funds was a scandal, while rating agencies were rubbish.

4.7 TECH SAVVY PROFESSIONALSTake first step to ensure efficient and reliable system

Set tasks for G-20 Washington summit

The government is in the process of formulating its response for the upcoming G-20 Washington summit,which will discuss the impact of the ongoing global financial crisis on emerging economies. The summit,to be held on November 15, will seek to urgently address the problems faced by many emergingeconomies due to massive sale of equity assets by the US and European investment banks.


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Recent weeks have seen severe pressure on many emerging market currencies, which depreciated by 20-30%. The forex reserves of these countries have depleted rapidly as Wall Street banks have kept uprelentless pressure by pulling out billions of dollars worth assets in equities and debt across emergingmarkets. A lot of outstanding short-term debt may also get pulled out of the emerging markets, going

forward. For instance, Russias forex reserves have more than halved from the robust level of $600 billionin the past two months. The larger issue that the G-20 economies will address at the Washington summitis whether a cooperative mechanism, in close consultation with the US, EU and Japan, can be put in placeto mitigate to stress being caused to emerging economies due to the precipitous deleveraging by thewestern financial system. This requires some creative thinking.

Finance Minister P Chidambaram has held one meeting with the current and ex-RBI governors to comeup with some ideas. The prime minister has said existing multilateral institutions could increase theircorpus substantially to help out emerging economies. We feel the US government, which is closelyworking with the stressed Wall Street banks, can impress upon them to sell their assets across emergingmarkets in a more gradual manner. This will help in a more orderly return to normalcy in the globaleconomy. It is in US interest to ensure that G-20 economies, which may contribute 100% of theincremental world GDP growth in 2009, do not get derailed by volatile capital flows.

4.8 MICRO-FINANCE PROFESSIONALSDeveloping alternative credit delivery models

Cut target rates to avert recession

As expected, and for second time in just three weeks, the US Federal Reserve cut its benchmark interestrate half a percentage point. The Fed fund rate (or target rate of overnight inter-bank lending) is now 1%,a level last seen in 2003. With inflation less of a worry, especially now that commodity prices have fallen

considerably from their earlier peak, it would seem policymakers have shifted their focus to growth.

Wednesday (29/10/08)s rate cut is of a piece with the spate of actions taken by US authorities to preventthe recession from turning into longer and deeper depression.

But if the reaction of the Dow Jones Industrial Average is any indication, fear runs too deep and marketsare not prepared to unfreeze. After reacting positively, the index fell to finally end the day 74 pointslower. Asian markets, however, seemed more upbeat. Most of them ended higher on Thursday, perhapsenthused by the Fed rate cut and the 27 basis points reduction effected by the Peoples Bank of China, itsthird in six weeks. China and US are not alone. The Bank of Japan is expected to cut interest rates,followed, perhaps, by Bank of England and the ECB.

The flurry of cuts will doubtless put pressure on the RBI to cut rates as well. But our situation is entirelydifferent credit growth is strong, these is no crisis of confidence and even the most pessimistic estimatesput growth at about 7%. The RBI and finance ministry have already addressed some of the short-termliquidity issues. The bank will do well not to rush into action on the interest rate front as it has alreadytaken a number of steps to ease liquidity.

It can always take more action, provided the situation warrants it.


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4.9 ONE-STOP-SHOPSDedicated to offer related services under a roof

Invest at home rather than abroad

Sovereign wealth funds, once feared as the lions of global finance, are looking more like lambs. Investingat home rather than abroad is a big shift for these state-run agencies that control trillions of dollars. Onething is clear that the sudden domestic focus indicates how perilous the financial landscape has becomefor emerging market countries, which boast some of the top sovereign wealth funds. As access to creditworldwide has dried up, investors have fled from emerging market equities and debt. Thats put pressureon local currencies, increasing the vulnerability of domestic banks with large foreign exchange liabilities.

Russia cleared it sovereign wealth fund to invest $ 6.7 billion in the domestic stock market, which hasfallen more than 70% since May peak. Funds in Qatar and Kuwait have also started buying shares oflisted banks to boost confidence, while the China Investment Corporation has pumped cash into statecommercial banks. The strategy makes good sense, said Stephen Jen, global head of currency researchat Morgan Stanley in London. By investing at home, they do three things: they support their own assetprices, they keep trophy assets in domestic hands and when they convert dollar holdings to buy domesticassets, theyre intervening and supporting their currencies.

4.10 CONTINUING LEARNING CENTRESTake informed decisions

12 Murderer of the financial system

Leftists claim that the global financial crisis was caused by reckless deregulation and greed. Rightists

blame half-backed financial regulations and perverse incentives. Actually, the financial sector is deeplyregulated, with major roles for both the state and markets. It was not one or the other that failed but thecombination. There are 12 murderers of the US financial system

1. Fed Governors:

Alan Greenspan, Fed Governor in 1987-2006, was once called as a genius for keeping the US booming,but is now called a serial bubble-maker. He presided over bubbles in housing, credit, and stock markets.He said it was difficult to identify asset bubbles in advance, so anti-bubble policies might be anti-growth.It was better to let bubbles build, and sweep up after they burst.

Bernanke, like Greenspan, ignored the US housing bubble till it burst.

2. US politicians:

Envisioning a home for every American, regardless of income, they provided excess implicit and explicithousing subsidies. One law forced banks to lend to subprime poor borrowers. Legislators created FannieMae & Freddie Mac, government-sponsored entities that bought or underwrote 80% of all US mortgages,and enjoyed exemption from normal regulations. Politicians ignored Greenspans warning that such adominant role for two unregulated giants posed a huge financial risk.


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3. Fannie Mae and Freddie Mac:

They resisted regulation, and lobbying legislators against any tightening of rules. As mortgagers of lastresort they should have been especially prudent. But they bought stacks of toxic mortgage paper Collateralised debt obligations (CDOs) seeking short-term profits that ultimately led to bankruptcy.

4. Financial innovation:

Their ideas provided cheap, easy credit, and helped stoke the global economic boom of 2003-08.Securitisation of mortgages provided an avalanche of capital for banks and mortgage companies to lendafresh. Unfortunately the new instruments were so complex that not even bankers realised their full risks.CDOs smuggled BBB mortgages into AAA securities, leaving investors with huge quantities of down-rated paper when the housing bubble burst. Financial innovators created credit default swaps (CDSs),which insured bonds against default. CDS issues swelled to a mind-boggling $60 trillion. When marketsfell and defaults widened, those holding CDSs faced disaster.

5. Regulators:

All major countries had regulators for banking, insurance and financial/stock markets. These were asleepat the wheel. No insurance regulator sought to check the runaway growth of the CDS market, or imposenormal regulatory checks like capital adequacy. No financial regulator saw or checked the inherent risksin complex derivatives. Leftists today demand more regulations, but these will not thwart the next crisis ifregulators stay asleep.

6. Bank and mortgage lenders:

Instead of keeping mortgages on their own books, lenders packaged these securities and sold them. So,they no longer had incentives to check the creditworthiness of borrowers. Lending norms were constantlyeased. Ultimately, banks were giving loans to people with no verification of income, jobs or assets.

7. Investment Bank:

Once, these institutions provided financial services such as underwriting, wealth management, andassistance to IPOs and mergers and acquisition. But more recently they began using borrowed money with leverage of up to 30 times to trade on their own account. Deservedly, all five top investment bankshave disappeared. Lehman Brothers is bust, Bear Sterns and Merrill Lynch have been acquired by banks,and Morgan Stanley and Goldman Sachs have been converted into regular banks.

8. Rating agencies:

Moodys and Standard and Poors were not tough or alert enough to spot the rise in risk as leverageskyrocketed. They allowed BBB mortgages to be launched into AAA mortgages through CDOs.

9. The Basel rules for banks: These international negotiated norms provided harmonised regulatory checkson financial excesses across countries. The first set of norms, Basel-I, was widely criticised as too rigidand blunt. So countries agreed on Basel-II, which allowed banks to use credit ratings and models based onhistorical record to lower the risk-rating of many securities. This dilution of norms led to excesseseverywhere. Icelands banks went bust holding loans/securities totaling 10 times its GDP. The dilution ofrisk-rating in Basel-II helped inflate the financial bubble.


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10. US consumers:

Their savings used to be 6% of disposable income some time ago, but more recently has been zero oreven negative. They have gone on a huge borrowing spree to spend far more than they earn. This excess isreflected in huge, unsustainable US trade deficits.

11. Asian and OPEC countries:

They undervalued their currencies to stimulate exports and create large trade surpluses with the US. Theyaccumulated trillions of forex reserves, and put these mostly into dollar securities. This depressed USinterest rates, and further fuelled borrowing there.

12. Everybody:

Consumers, corporations, banks, politicians, the media indeed everybody were happy when housingprices boomed, stock markets boomed, and credit became cheap and easily available. Bubbles in all theseareas grew in full public view. They were highlighted by analysts, but nobody wanted to stop the lovelyparty. Everybody liked easy money and rising asset prices. This trumped prudence across countries.

So, forget the Left-versus-Right or regulations-versus-markets debate on the financial crisis. States,institutions, markets and everybody else was guilty. These actors will for some time don sackcloth andashes, adopt stiffer regulations, and listen to lectures on the virtues of prudence and restraint. But aftertwo-to three years of the next business upswing, we predict that we will once again have a new generationof bubbles, evading whatever new checks have been put in place. When everybody loves bubbles, theyare both irresistible and inevitable.

4.11 GLOBAL OUTLOOK

Global pathways

Credit-default swaps

Finance needs regulation. It has always been prone to panics, crashes and bubbles. Because the economycannot work without it, governments have always heavily involved. Without doubt, modern finance hasbeen found seriously wanting. Some banks seemed to assume that markets would be constantly liquid.Risky behaviour garnered huge rewards; caution was punished. Even the best bankers took crazy risks.The financial innovation in derivatives spared ahead of the rule-setters. Somehow, the world ended upwith $60 trillion-worth of credit-default swaps (CDS), none of them traded on exchanges. Not even themost liberal libertarian could imagine that was sensible.

The crisis has brought complex structured financial products out of deep obscurity and exposed theirweaknesses. In particular, credit derivatives which allow investors to make bets on the creditworthinessof baskets of corporate debt stand accused as an accomplice in the meltdown. Bad mortgage debt was atthe heart of the credit crunch but in the eyes of many observers, banks inability to quantify their exposurethrough CDSs, aggravated crisis, and swings in the CDS market exacerbated the plunge in bank stocks.While CDSs have been hugely profitable for financial institutions, the lack of regulation and opacity hasproved to be the markets Achilles heel. The absence of a central clearer has made CDSs risky becausethere is no guarantee that parties will pay out.


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4.12 ISSUES OF THE PRESENTFreedom to get & fail in the system of free enterprise

Years of speculative excess

Sir Isaac Newton is said to have lost his lifes savings during the South Sea bubble. We think to ourselves,A smart guy like that should have known better.

It cant possibly be that in the sophisticated, computerised 21st century, we find ourselves experiencingthe same kind of financial panic, the same kind of financial insanity; really that has dogged mankind atleast since the Dutch tulip mania of the 1630s.

We look at those other eras Dutch tulips and South Sea bubbles, the panic of 1825 and 1907, the crashof 1929 and they seem so predictable in retrospect. They were marked by years of speculative excess, by financial innovation that got out of control and by mammoth asset bubbles that seem incrediblyoblivious in hindsight. There had to be a crash, it was all so unsustainable!

People keep on stepping on the same rakes because money, like romance, is only partly an intellectualexperience. In finance, the process is cyclical. Some people learn from their ancestors, but mostly theyrepeat the same mistakes. Thus, it has always been and it will always be.

It is not just the analytical part or our brain that deals with money; it is also the instinctive, emotional partwhat we like to think of as our gut. A lot of the time, our gut gets it wrong.

And that is as true of high powered investment bankers as it is of mom-and-pop investors.

Robert Shiller, the Yale economist, said, One thing we know about human behaviour is that ourmemory is influenced by recent events. Thus, when we are living through a housing bubble, it is hard notto get caught up, emotionally, in the idea that prices can only go up even though our analytical brainknows that acting on such impulses defies logic. But in the moment, a kind of unshakeable euphoriatakes over, and we just cant imagine its ever ending.

Similarly, when times are bad, fear and loathing capture our imagination, and we find it equallyimpossible to see a glimmer of hope. We take action to protect ourselves like banks refusing to lend toother banks, even though these individual actions result in a cumulative panic. That is where we are now.

I can calculate the motions of heavily bodies, but not the madness of people.-- Sir Isaac Newton, 1721, after the South See bubble bust.


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5.0 BANKING SECTOR

1. Cheaper money cant be an instant solution

Where do you go from here? The worlds top central banks have put their cards on the table. In a dramaticjoint action on 8th October 2008 (Wednesday), the US Federal Reserve Bank, Bank of England, EuropeanCentral Bank and monetary authorities of Sweden, Switzerland, Canada and United Arab Emirates havecut interest rates by 0.5 percentage point to revive the comatose lone market. The Chinese central bank

also announced a 0.27 percentage point cut in rates and 0.5 percentage point cut in reserve requirementsfor commercial banks. It was the strongest signal they could have sent to turbulent financial markets,which, after the subprime fiasco, is now haunted by a spectre of global recession.

But the impact was limited. Overnight lending rates softened a little, but the cost of long term borrowingwas still expensive. US and European shares were in red. It was evident that cheaper money cannot be aninstant solution in a nervous market rattled by defaults, collapse and mistrust. Given the massive crisisthat is playing out, policy makers across the world are being forced to think on their feet: Will this beenough for a banking system which is getting starved of short term liquidity?

The freeze in global credit markets slowly working it ways into India as well. Many small and medium

enterprises are said to be struggling to fund their working capital requirements due to tight liquidity in thesystem. Finance Minister P Chidambaram said the government would inject more liquidity into thesystem, if needed, to fire up economic activity. He added: Everybody in the world is doing it. We are notaffected to that extent. To the extent liquidity is needed, we will provide. RBI governor is already onrecord, if necessary he will take further measures to infuse liquidity.

Repo cut: (Monday 20/10/08) After CRR cuts, RBI paved the way for cheaper loan rates by slashing itskey short-term lending rate (repo) by 100 bps. The cut in repo, the first since 2004, would allow banks toimmediately borrow short-term funds from the apex bank at a cheaper 8% as against 9% till now. Earlierthe central bank cut the CRR by 250 basis points after five years, along with other measures to inject atotal of Rs 1,45,000 crore into the system.

RBIs Mid-year review: At his maiden monetary policy announcement on Friday (24/10/08), interestrates and reserve requirements were kept unchanged. If the RBI mid-year review of its annual policy,2008-09, seems a bit of a damp squib it is only because the central bank was so hyper-active most of thismonth. Given the flurry of activity, starting with the CRR cut in first week, followed in quick successionby two more reductions, going on to the 100-basis points repo rate cut last Monday. The RBI has optedto wait and watch how its recent moves will impact the still-unfolding situation before it acts again.

2. Meltdown halted loans to poor by MFIs

Financing for the poor is getting more frugal now, with the micro-finance institutions (MFIs) facing the

heat of the global financial meltdown. There has been a virtual halt in fresh disbursements to MFIs bybanks and financial institutions coupled with over 200 basis points hike in interest rates. Banks are alsoasking for personal guarantees of directors of MFIs.

A few banks have hiked security margins from 10% to 25% over the loan amount sanctioned to MFIs. Asa result, MFIs are unable to use even sanctioned funds. The total disbursement to MFIs aggregate toaround Rs 1 lakh crore and the South is the hub of micro-finance activity in India. At present the situationis alarming in India for MFIs. It will affect the credibility of MFIs. Further, it strains the relationship oftrust built with clients and may result to clients not making timely repayments.


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Banking Sector

3. Credit card cos lose sleep over rise in transaction

Credit card transactions in the country went up by as much as 25% in September 08 compared to theprevious month. Usually, this brings cheers to credit card companies. But this time, its worrying them.

Credit card companies fear that significant growth in plastic money usage may eventually result in higher

defaults. Because, this years growth in credit card usage is being attributed to rising inflation and interestrates which have left lower disposable incomes in the hands of consumers.

According to industry players, there is uncertainty all around. So people perhaps do not want to part withcash immediately even for their general shopping. But every user of credit card has to finally pay the bill.And credit card companies fear current circumstances may throw up more defaults, as stock marketcontinues to slide down and Indian firms cut jobs and salaries. It is important to constantly monitorspends and take appropriate action to prevent defaults. The default rate in the industry currently stands at9-12%, according to a data by Credit Card Management Consultancy (CCMC).

Citigroup loses $1.4 bin Citigroup Inc lost $1.4 billion from packaging credit card loans into bonds in

the third quarter of 2008. The loss reflects in part the worsening performance of credit card loans as theUS economy deteriorates. In the third quarter of 2007 Citigroup earned $ 169 million from packing creditloans into bonds. Credit card holders are broadly expected to suffer higher credit losses as risingunemployment makes it increasingly difficult for some borrowers to pay their bills.


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6.1 TAX UPDATES

1. Tax relief unlikely for derivative losers

In a double whammy of sorts, companies hit by mark-to-market (MTM) losses due to their exposure toforex derivatives are unlikely to get the income tax department to treat these losses as deduction.

The reason, according to department sources, is there are no specific provisions in the Income Tax Actdealing with this issue. There are also no precedents or case laws that clearly define treatment of suchlosses incurred by companies. As a result, these companies might not be allowed to set off such lossesagainst profits to reduce their tax liability.

But tax experts have a different view; There are no specific provisions under the Income Tax Act, 1961or direct judicial procedures dealing with treatment of losses or gains resulting from derivative contracts.

Hence, the issue would need to be examined on the basis of general principles relating to deductibility oflosses or taxability of gains. As a general rule, items that are revenue in nature are taxable or deductibleand items those capitals in nature are not taxable or deductible.

Logically MTM losses should be allowed as a normal business loss. The only relief that may come theway of these firms that a case-to-case basis approaches may be taken.

2. Tax evaders may be probed for company law violation

This could even spell double trouble for tax-evading companies. The ministry of corporate affairs (MCA)has sought details from income-tax department of companies against whom tax-evasion charges havebeen framed. The ministry feels that scanning those records could unearth cases of violation of companylaw. While tax evasion can be settled through payment of penalty, many offences under company law arepunishable as imprisonment for top managers.

A proposal to establish a system wherein the ministry is kept updated on corporate I-T defaults is underconsideration. Officials say the move will require setting up an information-sharing network between thetwo departments. The idea is to leverage on the I-T departments data to identify defaulting companiesand examine if they have breached company law provisions.

Experts find logic in the move as evasion of taxes often results in distortion of numbers in the companysfinancial results, an activity which constitutes an offence under the company law. Many companies, on being caught evading taxes, pay the penalty to the authorities and then shift the burden of it to theirshareholders by fudging their financial records.

A recent instance in the case of Mumbai-based Elder Pharma; where the ministry procured details from

the I-T department to initiate action against the company. The company, which is now being probed bythe ministrys Serious Fraud Investigation Office (SFIO) for altering its financial records, was earliercaught evading taxes. Officials feel the proposal, if effectively implemented, could reduce

Documents

Journal of Finance Vol 23