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NIVESHAK

THE INVESTOR VOLUME 3 ISSUE 4 April 2010

FIN-Q PG.24 The Gold, oil and US dollar relationship Pg.18


FROM EDITOR’S DESK
Dear Niveshaks
It was January 2008 when our sensex touched its peak of 21000. Then came
Niveshak the scary October 2008 when it slid to 8000 mark. And now, again, it has swiftly
taken a big leap to pat the 18000 mark. What a roller coaster ride it has been.
Volume III One of the important pulling factors behind this upside swing has been the drastic
ISSUE 4 monetary steps such as slashing CRR by 300 basis points taken at that point of time
April 2010 which infused confidence as well as liquidity in the market. However, looking at it in
a short frame of time, I see that the things are a bit unusual. In an ever-volatile stock
market, I find it tough to recall the last time, when the broad based indices — Nifty
Faculty Mentor and Sensex — remained stagnant for the past six months. But this has been the case
Prof. S.S Sarkar with Indian stock market since October last year. It has been lurking roughly in the
same range of 17000 to 18000.Another food for thought for many Niveshaks is the
fact that Sensex is not really far from its all time high. And at the same time, many
EDITORIAL TEAM stocks especially in the information technology, banking and pharmaceutical indus-
tries have already reached their all time highs. That leaves investors and people like
us confounded to the future course of the market.
Editor The euphoria is not restricted to India only. World stocks are also slowly inch-
Bhavit Sharma ing close to their respective 18 months’ high on signs of improving global growth
but the Europe remains on the backseat due to prevailing worries about Greece’s
debt problems. The recently released strong U.S. data from jobs to manufacturing
Sub-Editors has spurted hopes that the world’s biggest economy will come out of woods soon.
Durgesh Nandini Mohanty In addition to this, the present dynamics of global oil price movement and curren-
Hitesh Gulati cies’ exchange rate is expected to have a lasting impact on the global economy.
Sumit Kedia Strengthening U.S. dollar has brought some correction in the oil price which had
Tanvi Arora reached its 18 month high of 87 dollars a barrel. Rising rupee against dollar will also
give import based Indian companies an advantage but it may come in the way of
Upasna Agarwal
RBI’s monetary policy tightening if it chooses to slow down this rise. All of these
factors along with the recently released strong IIP numbers and annual reports by
Indian firms make us believe that the Bull Run is here to stay.
Designers
Bhavya Aggarwal In continuation with our sustained endeavour to get the latest insights from
the corporate, we welcome Ms Deepali Bhargava, Economist for ING Vysya
Swarnabha Mukherjee
Bank as the guest of this issue of Niveshak. An illustrious economist - Deepali has to
her credit, consistent & accurate directional calls on inflation, interest rates and INR.
In a special session with her, she has talked about the Indian economy’s recovery
path, recent RBI’s monetary policy and some issues related to exchange rate poli-
cies.
This issue of Niveshak brings to you some more interesting and insightful top-
ics. In the contemporary fierce competition in markets and race for showing higher
All images, design and artwork profits and growth, many companies manipulate their financial position and results
are copyright of to hide the true picture of their financial health. The repercussions of this are in
IIM Shillong Finance Club front of us. We saw numerous accounting scandals resulting in bankruptcies and
fall of some major firms like Enron, WorldCom etc in the recent past. But the ques-
tion arises as to what are the different means of manipulating financial statements.
©Finance Club So our cover story addresses this question by elaborating various ways of fudging
Indian Institute of Management financial accounts and statements and means to detect such abnormalities. Hope
Shillong you find this issue an interesting read.
Stay invested with us!!
www.iims-niveshak.com
Bhavit Sharma
(Editor-Niveshak)

Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears
no responsibility whatsoever.
CONTENTS
Niveshak Times
04 The Month That Was
SHe Speaketh
09 Ms. Deepali Bhargava

Cover Story Finsight


18 The Gold, Oil and US
11 Window Dressing the Dollar Relationship
Financial Statements

Fingyaan
15 Catastrophe Bond Market

Article of the month


06 Banking The Unbanked
PERSPECTIVE
21 Nivesh In Indian Population
finlounge
14 FinToon
24 Fin-Q
Niveshak Times www.iims-niveshak.com

The Month That Was


Durgesh Mohanty & Tanvi Arora trials of exploration of some US companies began
Team Niveshak exploration nearly two decades ago, they did not
taste success due to lack of technology and inter-
Lobbying for FDI in multi brand retail est form big energy companies. Given the stagnant
The government has launched discussions be- reserves, many oil companies now see shale gas as
tween ministries about opening multi-brand retail a major source for the future.
to foreign direct investment (FDI), stepping gingerly Bharti gets its share of the Zain deal for
into an issue that has been demanding a lot of at- $10.7 bn
tention for the last few years in the national sce-
Bharti Airtel, India’s leading telecom service
nario. The Indian government allows up to 51% for-
provider has finally taken the huge leap to fulfill
eign investment presently in single-brand retail, but
its global ambitions. It sealed a deal on Tuesday to
has been reluctant to allow any foriegn investment
acquire most of the African assets of Kuwait’s Zain
in multi-brand retail. The rules allow foreign multi-
Telecom. The $10.7-billion deal, including $1.7 billion
brand retailers only through franchise agreements
of Zain’s debt, was signed in Amsterdam, the base
with local players. Large players in the Retail Indus-
of Zain’s African unit. With Zain Africa’s 42 million
try such as US-based Wal-Mart and Germany’s Metro
customers, Bharti Airtel will have 179 million sub-
AG that operate in the so-called cash-and-carry ven-
scribers, making it the world’s fifth-largest mobile
tures in India have long been clamouring for opening
phone operator.
up front-end retail.
The retail industry deserves a lot of importance Standard Chartered drafts red herring for
today as it is the second largest employer in the listing by IDRs
country. For a change, in the last few months, the This is one of the most significant develop-
government has been airing its views on opening up ments in the recent financial history as this is the
retail, dwelling on its benefits, possibly to deflect first issue of IDRs, the Indian counterpart of global
the storm of protests it could set off. The govern- depository receipts and American depository re-
ment has said in various forums that FDI in multi- ceipts, by an overseas company after guidelines
brand retail will enhance supply-chain efficiencies, were framed in 2004. Secondly, these depository re-
give farmers better earnings and reduce wastage. ceipts represent equity shares of Standard Chartered
— held by an overseas custodian based on which
RIL to buy out 40% in Atlas shale gas
an Indian depository issues rupee-denominated re-
Reliance Industries (RIL), the country’s larg- ceipts or IDRs to Indian investors — Indian IDR hold-
est company has agreed to buy a 40% stake in a ers will, in effect, own equity shares of a foreign
US shale gas venture of Atlas Energy for a whop- bank and also be able to trade in them as the re-
ping $1.7 billion, giving serious competition to Exxon ceipts will be listed on our stock exchanges. IDRs
Mobil and France’s Total in the race for a fuel that provide foreign companies a platform to directly
may change the global energy economics. It will raise capital in India but had not, for a variety of
invest $340 million in cash for the stake and pay reasons, including somewhat restrictive regulations
Atlas’ drilling expenses of up to $1.36 billion over compared to American or global depository receipts,
the next five-and-a-half years. The deal values per found favour with overseas companies so far. The
acre of shale at $14,167, compared with $14,000 an IDR listing of StanChart is a first in this direction.
acre paid by Japan’s Mitsui & Co in a similar deal.
The importane of Shale gas is increasing by the day Greece deficit worse than anticipated
as it represents a growing source of energy and is Greece’s budget gap last year was worse than
expected to constitute 20% of the overall gas pro- feared. This news triggered a fresh slide of asset
duction in the US over the next 10 years.Gas locked prices in Greece and other debt-choked European
in shale formations is expected to account for 50% countries. The news hurt financial markets’ waning
of US supply by 2035, up from 20%.Despite the early hopes for Greece to bring its swelling national debt

4 NIVESHAK VOLUME 3 ISSUE 4 April 2010


Niveshak Times www.iims-niveshak.com

The Month That Was


under control, and increased pressure on Athens to The postal life insurance has over 15 million
seek billions of euros of emergency loans from the policy holders. It offers two life insurance schemes,
EU and the International Monetary Fund. Postal Life Insurance and Rural Postal life Insurance
The Greek government posted a budget deficit with a corpus fund of Rs 14,000 crore and Rs 4,000
of € 32.34 billion or 13.6% of gross domestic prod- crore, respectively as on March 2009. All insurance
uct in 2009, not the 12.7% which it had reported ear- products offered by the DoP are not covered by IR-
lier. The deficit might be revised again, by between DA’s rules and regulations.
0.3 and 0.5 percentage points of GDP, because of Under the Insurance Act 1938, Section 118 (C),
uncertainty about the quality of Greece’s data and life insurance schemes run by several state govern-
accounting procedures. ments for their employees and the Postal Life Insur-
The incoming socialist government said ance Scheme of the central government don’t come
Greece’s 2009 budget deficit would be twice as big as under the IRDA purview. The insurance regulator is
the previous estimates — and four times EU ceiling. looking to extend its reach.

RBI reviews monetary policy yet again IRDA-SEBI war takes new turn

The RBI raised the two key policy rates—re- Last year, life insurance companies, including
verse repo and repo—by 25 basis points each, and LIC, were served show-cause notices by SEBI, ques-
left banks with Rs 12,500 crore less to lend with a tioning them on sale of Ulips without obtaining the
25 bps increase in the cash reserve ratio (CRR). This market regulator’s approval. The insurance regula-
rate hike is seen as moderate by any standard in tor responded broadly saying SEBI did not have the
the current circumstances. Therefore, most bankers remit or the jurisdiction to regulate Ulips. The turf
think RBI will have to raise rates as well as increase war took a fresh twist when on April 9 Sebi issued
the CRR in small doses during the year. orders to 14 life insurance companies, banning them
from selling new policies or renewing existing ones.
Banks borrow from RBI at the repo rate while
The market regulator said these companies have to
parking (or lending) surplus funds at the reverse
register with SEBI for marketing and servicing such
repo rate. After the increase, the repo and reverse
products. SEBI’s order may compel investors to sur-
repo rates are 5.25% and 3.75%, respectively. The
render their policies prematurely, leading to a sig-
CRR, which is like a tax on lenders, is the slice of
nificant loss to both investors and insurers.
customer deposit that banks have to set aside as
cash with RBI. After the 25 bps CRR hike, from 5.75% The issue came to a boil over IRDA telling insur-
to 6%, banks will have Rs 12,500 crore less to lend ance firms to continue selling Ulips, a day after capi-
from the fortnight beginning April 24. tal market watchdog Sebi barred 14 insurers from
selling these products without its approval.
RBI began tightening in January when it raised
the CRR by 50 bps in two stages. This was followed What makes the issue complicated is the fact
by the 25 bps increase in repo and reverse repo in that both the regulators have armed themselves
March. While RBI has been slower than its counter- with legal opinions supporting their case to regulate
parts in Australia and Israel in raising rates, it has Ulips. Following the meeting between the chiefs of
been quicker in reversing the cycle than the Chinese Sebi and Irda and senior finance ministry officials,
central bank and monetary authorities in many ad- both the regulators have decided to restore status
vanced economies. quo and keep in abeyance the orders issued by both
during the weekend.
IRDA tells postal dept to fall in line This means that the insurance industry will not
The insurance regulator has demanded that be staggering for now from selling Ulips. But the pre-
the country’s postal department adhere to its norms vailing uncertainty might put off new investors.
while selling insurance products, triggering a poten-
tially damaging row between the two and forcing the
finance ministry’s intervention.
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 5
B NKING THE UNBANKED
Abhishek Sarkar & Sreejit Gopinathan
Welingkar Institute of Management

Financial Inclusion The Indian financial system es-


pecially the banking has weathered
cannot and should the storm of the recessionary wave
not be just seen as that swept across the world thanks
a buzz word but two pillars firmly fixed in its culture:
exposure to risk & ethics. Having
should replicate had a firm footing the time has come
an effort to make that the benefits of the same reach
AoM

mainstream financial out to all strata’s of society and cor-


services accessible ners of the country. A person cannot North East, Eastern and Central re-
stand on its own without personal gions contain most of the financially
to all sections of the and financial security. excluded population. A stable and
population. It is a Even after 60 years of Indian healthy financial service sector cre-
conscious attempt at independence, 1/3 of our population ates trust among the people about
the economy and only with this trust
trying to bring the is still illiterate (let alone financially
literate) and at least 26% of the pop- (which has legal validity) could a
un-banked people strong, stable and an inclusive econ-
ulation still lives under the poverty
into banking. Finan- line. Financial inclusion would re- omy be created.
cial Inclusion does sult in all round economic develop-
not merely mean ac- ment of our nation. Nationalization
of banks in 1969 was an effort to
cess to credit for the channelize to funds to industrial and
poor, but also other business units which were starved
financial services of funds, even though the govern-
such as Insurance. ment policy was to encourage small,
tiny and cottage and village indus-
tries. Further consolidation of banks
and liberalisation of economy start-
Reasons for Banking Exclusion
ed in the early 1990’s saw people
getting exposed to various financial The low coverage of banking &
products. At the same time, a large financial services is due to following
chunk of people have still remained reasons:
immune to basic banking facilities • Lack of awareness, low in-
either due to insufficient earnings comes, social exclusion, illiteracy act
or to easy credit facility available as barriers for the masses.
to money lenders. Around 41% of • Too many formalities, branch
Indian population is unbanked and distance, unsuitable products, lan-
coverage of basic financial services guage & the attitude of the staff to-
in rural areas is 39% against 60% in wards people.
urban areas.
• Lack of proper Infrastructure
The financially excluded sec- due to inaccessibility & location of
tions largely comprise marginal the rural habitats.
farmers, landless labourers, oral
lessees, self employed and unorga- Strategies to Reach Banking to
nized sector enterprises, urban slum the Bottom of the pyramid
dwellers, migrants, ethnic minorities Challenges are many and these
and socially excluded groups, senior are being tackled but there is long
citizens and women. While there are way to go before we achieve all
pockets of large excluded popula- round financial inclusion and provid-
tion in all parts of the country, the

6 NIVESHAK VOLUME 3 ISSUE 4 April 2010


ing banking services is just one amongst them. a platter to the rurals. To begin with banks can tie up
with telcos and ask them to provide mobile phones
Financial Awareness to masses enabled desired services to people from the villages
Most of the people in this segment are scepti- who are well versed with the device and ask them
cal to open a bank account because of their non to serve as an intermediator in facilitating the finan-
financial background. cial transactions. These intermediators can provided
Hence, we should begin by spreading finan- with some commission for the same. Slowly, when
cial literacy & awareness among them. Teaching the villagers are becoming familiar with it they can
should be done in simple languages (preferably re- also be given training for the same. This will not
gional language) using various audio-video teaching only save operational cost & infrastructure cost for
aids. This education should begin from school level the banks but also increase the reach of the banks.
& can be clubbed with Sarva Shikhan Abhiyan of It will also make the banking operations conve-
the government. Since, people trust on those who nient, safe, reliable and transparent. The pilot proj-
ects of smart cards for opening bank accounts us-

AoM
ing biometric identification implemented in Andhra
Pradesh should encouraged further. Also, the same
channel can be used for providing other financial
services such as insurance.For this we need to scale
up our IT & telecom infrastructure as traffic of finan-
cial transactions is going to increase in tandem with
coverage of more & more villages. However the pace
at which the technology is being is used to provide
such facilities needs to be at a faster rate or else the
dream of complete financial inclusion will remain
mere on paper.

Star Network Model of Distribution


teach their children. Stories, Pictures, Cartoon strips,
Jig Saw puzzles can be used to imbibe the impor- The star network distribution model which is
tance of banking in the people. Local semiliterate a common computer network topology can used to
or educated people can help us in this initiative. We target the masses. For instance, when adopted by a
should keep them regularly updated through Gram bank, the various marketing functions will be per-
Panchayat Meets & help them realise their needs formed by the branches i.e. Leaf Nodes whereas the
rather than expanding the business of banking as processing is done at the central office i.e. the Cen-
envisaged by commercial banking sector. tral Node. That means the task of reaching out to the
masses will be done by the Leaf nodes. It is easier
IT Technology & Mobile banking to adopt as it gels well with the existing distribu-
Technology has reduced the distance between tion networks. This model provides a multichannel
nations & people and the same can be leveraged reach to banks. The following diagram depicts vari-
to deliver banking services to the un-banked. Mo- ous distribution channels which helps us in tapping
bile technology has its presence pan India and the BOP easily.
can be used as a tool in providing access to vari- • CO-OPERATIVE/COMMERCIAL BANKS: These are
ous facilities at their fingertip. The mobile market the ones which have their local presence in the vil-
in India has witnessed an increas- lages. Urban banks can have refer-
ing no of subscriber base from rural ral tie-ups with them can pass their
India, largely due to the declining products to masses through them.
mobile tariffs & availability of low • SELF HELP GROUPS (SHGs)/
cost handsets in the country. People NGOS: SHGs & NGOs can also prove
who are not comfortable with bank- an effective medium of credit dis-
ing are more comfortable using their tribution to the masses. Currently,
mobile phones. So, mobile banking most of micro-credit activity hap-
can be used as medium to make pens under the banking model
them banked. The Basic credit trans- through NABARD’s linkage with the
actions (debit /credit) can be done SHG’s. Currently, there are about 2.3
using mobiles as done in Africa. To- million SHG’s covering 35 million
day with 3G and Wimax coming into people from the BOP. The Grameen
picture the telecom operators can bank model of BanglaDesh is be-
provide all the banking functions in

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 7


ing followed here. We can take the example of SHG Offering Simple Products & Processes
movement Kudumbasree in Kerala which helped it Banks need to offer simplified products revolv-
attain 100% financial inclusion. This was possible by ing around the needs of BOP. To comply with Know
bringing together the agricultural department, the Your Customer Norms banks can use the existing UID
Revenue departments, the Panchayats (Local Self- project or biometric cards. They need to minimise
Governance), the D.R.D.A and the State Poverty Erad- their formal approach of banking & bring an infor-
ication Mission. mal touch in the whole banking experience. Banks
should start by offering Zero balance & No Frills Ac-
count to these BOP people. Also, ensure that the ac-
counts are not dormant. For this they can come up
with schemes such as offering low interests & pre-
cedence in getting loans to those who are having at
least one transaction per month. This will encourage
them to open account & carry out transactions. In-
AoM

dia is a country with diverse demographics where in


the languages changes every 5o kms. So, Banks can
customise & offer community-wise or region-wise
products which will be more easily accepted. Banks
need to connect with the emotions of these people
& understand the reasons for their borrowings such
buying crops, house, marriage, start new shop, etc.
The credit cycle should be aligned with crop cycle for
farmers. The mahajans or the money lenders are the
biggest competition to the banks. We need to under-
• MICRO FINANCE INSTITUTES (MFI): Microfinance stand the differences in them. The money lenders
is a gift to us by Bangladeshi economist Muham- provide easy & any time cash, also they don’t ask
mad Yunus. MFIs are basically sitting at the core of for any collateral. They treat poor people as users
the matter. They have helped people to help them- & not customers. To reduce the competition banks
selves. They have brought paradigm shift in peo- should make these mahajans as BC’s and offer them
ple’s outlook that poor people are worthy of being commissions. Also, they can be treated as HNIs & be
banked. Also, the rate of defaults is very less in spite given other incentives.
of having higher rate of interests.
Conclusion
• POST OFFICES: Post offices have a very wide
coverage all over the country. They can be used as The obvious question which might come to our
distribution partner for easy credit. Moreover, peo- mind is why we need to bank the BOP which may
ple are more familiar with the environment & staff not be profitable. The simple answer is low profits
which reduces their apprehensions. Post Offices can in high proportion can become a gold mine. More so
issue a “POST Office Card Account” as started in UK it’s about empowering the people because a country
which can be substitute for bank accounts. can be accurately judged not just by GDP numbers
and growth rate but more so by the well being of
• BUSINESS CORRESPONDENTS (BCs): Business
its people. Poverty alleviation can achieved through
Correspondents form the face of the banks or fi-
financial inclusion.
nancial institutes to masses. They can be the route
through which the importance of banking can com- With globalisation taking a big leap, the gap
municated at the grass root level. Retired Bank Of- between various nations are bridged, banking to ru-
ficers, Government servants, Sarpanch (Chief), Local ral masses can link up the gap within India under
Teachers & Other key important who are from the the umbrella of financial inclusion.
BOP should be made BCs. They can easily convince
the people in opening the bank accounts & increase
network using their familiarity & quality of trust.
With globalisation, the gap
between various nations are
bridged, banking to rural
masses can link up the gap
within India under the um-
brella of financial inclusion

8 NIVESHAK VOLUME 3 ISSUE 4 April 2010


Deepali Bhargava
Economist, ING Vysya Bank
Deepali Bhargava joined ING in August 2008, and is India Economist for ING Vysya
Bank. Deepali has to her credit, consistently accurate directional calls on inflation, interest rates
and INR.
Prior to ING, Deepali was an economist with the treasury of ICICI Bank for 3 years with
focus on India research. She has a Masters in Economics from The Delhi School of Economics.

Niveshak: There are talks that the Ms. Bhargava: RBI recently raised its
Global and Indian economy are key rates – repo, reverse repo and Deepali Bhargava,
on the recovery path. What do CRR – by 25 bps to each to 5.25%, in this interview
you have to say about it? How 3.75%, 6.00% respectively. Though with, Team Nive-
do you see the Indian macroeco- the recent rhetoric by RBI may have
nomic scenario panning out in hinted at a policy shift towards con- shak opines about
the next couple of years? taining inflation, the April policy the state of the

She Speaketh
report seems to be more balanced economy at present
Ms. Bhargava: Indian economy is well with a focus on risks to growth. RBI
sustaining the growth momentum is not in a hurry to move ahead of and the trajectory it
entering in to 2010-11. Leading in- the curve in the wake of uncertain- is expected to tra-
dicators are hinting at continued ties both on the inflation and growth
recovery. Services sector is likely to
verse. In light of the
front RBI sees monsoons as a key
catch up with the industry sector uncertainty as both inflation soften- RBI annual policy
in 2010-11 when we expect it to re- ing and growth pick-up are contin- attempting to deli-
cord over 9% growth. The big boost gent on a normal monsoon.
is likely to come from 1) enablers
cately balance the
like the arrival of 3-G facilitating A low rate hike now also gives RBI rising inflation and
telecommunication growth 2) strong more time to evaluate the growth growth recovery, a
emphasis on infrastructure reviving situation and impact of earlier rate
hikes. Upside risks to inflation are
peek in the dynam-
construction 3) higher tourist arriv-
als and 4) deleveraged bank balance likely to sustain for long, in the ics of the Indian and
sheets pulling up bank profitability. presence of rising global commodity world economy is
prices and demand –side pressures
Revival in domestic demand is likely building up. Outlook for growth, at
what this interview
to be complemented by a pick-up on 8% for FY11, is expected to be fi- has to offer.
exports. IMF has projected an expan- nanced by 20% growth in credit and
sion of 5.8% in world trade volume 17% growth in money supply - levels
in 2010 vs. a contraction of 12.3% in that are not consistent with an over-
2009, which is a positive for India heated economy. Hence, we stick to
trade. But, among other factors, the our call of gradual and consistent
competitiveness will be determined rate hikes in the current rate hike
by the extent, if any, of CNY revalu- cycle. We expect a cumulative 125
ation and also RBI’s comfort with bps of Repo and Reverse Repo hike
the pace of INR appreciation. Taking in FY11
these factors into account, we fac-
Niveshak: India has witnessed
tor in a 10% growth in exports. Bank
strong FII inflows in the capi-
credit is likely to play a key role in
tal markets for quite some time
financing growth. We, hence, pencil
in 8.2% GDP growth for FY11. now. FIIs have been consistent-
ly building up their portfolio in
Niveshak: What do you have to the top BSE and NSE companies.
say about the RBI annual policy? Where do you see the FII and FDI
Is it in accordance with the gen- investments heading in the com-
eral market sentiments? ing quarters?

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 9


Ms. Bhargava: Continuity of foreign inflows in the have and what factors will impact it in next
current year will be contingent upon inter-country quarter?
growth differentiation, interest rate differential,
growth expectations in the FDI sensitive sectors, and Ms. Bhargava: Though the broad growth number has
global liquidity. India, with expectations of 8% plus moderated, 3-month seasonally adjusted annualized
growth, will likely be one of the top contenders for growth rate for IIP recovered to 23% in both Jan and
flows going by the first two reasons. Services’ driven Feb 2010, reflecting strong momentum in IIP in these
growth will be a positive, as services have been the months. Going forward, a moderation in y-o-y IIP
primary driver of FDI inflows since 2000, account- growth is likely on negative base effect.
ing for 22% of total FDI inflows from Apr’00-Dec’09.
The key drivers - consumer durables and capital
The likely facilitators for FDI in 2010-11 will be: 1)
goods - continued to record stellar growth at 30%
3G auction and higher FDI approvals in telecom 2)
YoY and 44.4% YoY respectively. Consumer non-
Increase in FDI deals between emerging markets 3)
durables continued to be a laggard. Going forward,
Government mulling FDI hike in defense production
a possible reduction in automobile sales, following
4) government considering allowing foreign invest-
withdrawal of fiscal stimuli, may impact consumer
ment in LLP.
durables growth negatively.
The other factor – global liquidity –has been a prima-
But we assess that the trend is upwards as eco-
ry determinant of foreign inflows. With 65% positive
nomic recovery gains a firmer ground
correlation between global liquidity (calculated at
an aggregated index of money supply for the major Consumer non-durables, on the other hand, aver-
economies) and FII flows in the last two years, the aged a meager growth of 1.3% YoY Dec’09-Feb’10 on
She Speaketh

going will likely continue to be good as the major high food prices. Recovery in this segment will be
economies recover and with a build-up in positive hugely contingent upon the performance of mon-
risk environment. On the other hand, as G-3 starts soons. A normal monsoon and higher rural incomes
withdrawing excess liquidity, flows in FY11 (ING es- are likely to be positive for both consumer durable
timates: USD 20 bn) will turn more volatile and will and non-durables.
likely end-up aggregating lower vis-à-vis FY10 (USD
30 bn). But an increase in short-term trade credit Niveshak: What do you think about the ren-
(with a revival in trade) and ECB (as recovery gains minbi (Chinese yuan) exchange rate policy and
momentum) will likely fill the gap. Hence, we expect what will be impacts of the changes if any?
capital account surplus to increase to USD 68 bn in
FY11 vs. USD 62 bn (estimated) for FY10. The pain Ms. Bhargava: The US’s interest in China’s co-opera-
point will be a widening in current account as oil tion on Iran and China’s interest in adopting a more
prices go higher and non-oil imports stage a recov- market-based exchange rate mechanism suggest
ery. With export growth likely to fall short of import compromises are possible. We remain of the view
growth, current account deficit is likely to widen to that Beijing will align the renminbi-dollar trading
2.7% of GDP in FY11 (from 2.5% in FY10) assuming band, now +/- 0.5%, with the bands for the non-dol-
average oil price of USD 90/bbl. lar cross rates, +/- 3% by the end of June. We expect
this will produce a one-off 3% appreciation in the
Thus, from the balance of payments point of view renminbi to the strong end of the trading band. We
though appreciation pressure will exist due to a bal- think other Asian currencies will appreciate by up to
ance of payments surplus, it may not be very ag- the amount the renminbi appreciates. Renminbi ap-
gressive. Greater RBI intervention may further stem preciation is a monetary tightening, which is nega-
the appreciation pressure. Risk of surge in oil prices tive for global growth. We think increased growth
and hence local inflation will likely imply greater angst would cause the dollar to appreciate.
volatility for INR in FY11. We target 42.8 on USD/INR
by fiscal-end.
Niveshak: The IIP numbers were released re-
cently. According to you what impact will it

“RBI sees monsoons as a key


uncertainty as both inflation
softening and growth pick-up
are contingent on a normal
monsoon.”

10 NIVESHAK VOLUME 3 ISSUE 4 April 2010


Cover Story
Financial reporting refers to the manner in which
the companies show their financial position to inves-
tors, creditors and other interested parties by preparing
financial statements. Financial statements data is used
to evaluate a company’s past performance and current
financial position in order to form opinions about the abil-
ity of the company to earn profits in the future. Recent
Window
years have seen numerous accounting scandals resulting
in bankruptcies and demise of some major firms. Looking
back we see that these scandals have occurred whenever Dressing
the managers have felt the pressure to meet market ex-
pectations. Accounting practices have improved over the
years, but companies still find ways and means to get
around the stated rule to tweak their financial results.
The
The challenge for the financial analyst is to look not only
at the malpractices of reporting but also at the quality of
reporting.
Financial
In general accounting parlance, high financial report-
ing quality is defined as reporting which results in a fair
presentation of the company’s operations and financial
Statements
position. The article is an attempt to show how compa-
nies utilize creative accounting to overstate their financial
position and performance. Companies that manipulate
their financial position often try to increase their earn-
Hitesh Gulati
ings power in the current or future peri- Team Niveshak
ods to create the appearance of a strong
financial condition or performance. This
makes it easier for them to obtain lines
of credit at low interest rates, as well as
issue debt financing on better terms. The
management might also be motivated to
overstate assets or understate liabilities
to make the company appear more liquid
and solvent. The balance sheet can even
be used to “store earnings” for future
periods. The results can be a misleading
gauge of earnings power and financial
condition.
Generally Accepted Accounting Prin-
ciples (GAAP) can be exploited by the
firms to achieve a specific outcome while
meeting the letter, but not the spirit of
the accounting standards.
Low quality earnings can be a result
of:
1) Use of acceptable accounting
practices that misrepresent the econom-
ics of a transaction.
2) Restructuring transactions to
achieve a desired outcome.
...painting a rosy picture
3) Exploitation of the intent of the
Accounting Principle

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 11


Misrepresentation Lower Working Capital Higher Working Capital
LIFO Method of Inventory Reporting Higher Cash flows (less Lower Cash flows (more
taxes paid) taxes paid)
Inventory calculations and reporting are a ma-
Cover Story

LIFO method of reporting inventory is not per-


jor factor involved in the analysis of merchandis-
mitted under the IFRS. However companies reporting
ing and manufacturing companies. Such companies
according to the US GAAP can use the LIFO method
generate their sales and profits mainly through in-
of reporting inventory provided that they use the
ventory transactions. An important consideration in
method for tax reporting as well as accounting pur-
determining profits for these companies is measur-
pose. The companies that use the LIFO method
ing the cost of goods sold when the inventories are
are required to disclose in their financial notes the
sold. Inventory costs typically change from period to
amount of LIFO reserve.
period and the choice of inventory cost flow method
affects the firm’s income statement, balance sheet Phantom Profits
and several other financial ratios. Additionally, the
LIFO liquidation occurs when a firm’s inventory
cost flow method can affect the income taxes of the
quantities are declining. In this situation, the older
firm and hence affects the cash flow position of the
lower costs are included in the Cost of Goods sold.
firm.
This results in reporting a higher profit margin under
The various methods of reporting inventory are LIFO. However the higher profit margin is not sus-
the weighted average, specific observation, FIFO and tainable and is hence known as “Phantom profits”.
the LIFO method of accounting. Among these the Hence the firm cannot liquidate its inventory infi-
method which is of interest here is the LIFO meth- nitely as it well eventually run out of goods to sell.
od. The method assumes significance because of its
ability to significantly lower taxable income. The LIFO Depreciation Methods
method assumes that the companies sell their most Depreciation is the systematic allocation of the
recently purchased inventory units first. The ending assets cost over time. Depreciation may be reported
inventory under this method thus consists of those using the straight line, accelerated or units of pro-
units that have been held the longest and valued at duction method. Typically companies use the straight
their historic costs. Conditions favoring use of LIFO line method for financial reporting and an acceler-
method arise when the unit costs of inventory rise ated depreciation method for reporting taxes. In the
over time and the inventory quantities are generally accelerated methods of depreciation, more deprecia-
constant or increasing. tion expense is recognized in the early years of an
The consequences of LIFO method are that the asset’s life as compared to straight line depreciation.
Cost of goods sold reported under LIFO is higher This results in lower net income in early years under
when unit prices of inventory rise over time. This the accelerated methods as compared to the straight
leads to a lower reported net income and hence line method. Companies might also use longer use-
saves Income Tax for the firm. Lower income tax ful lives period for the purpose of depreciation and
expense under LIFO means that the operating cash amortization than their economic life to show lower
flows for the period are higher. The reported inven- expenses on the income statement.
tory value under FIFO is higher than under LIFO and
hence the creation of a “LIFO reserve” which is the Re- Structuring transactions
difference between the FIFO inventory value and the Capitalization vs. Expensing of Expenditures
LIFO inventory value.
When a firm makes an expenditure, then it can
LIFO results in FIFO results in either capitalize the cost as an asset on the balance
Higher COGS Lower COGS sheet or expense the cost in the income statement
Lower Net Income Higher Net Income for the period. Expenditures related to long-lived as-
Lower taxes Higher taxes sets are included as part of the recorded value of
Lower Inventory balances Higher Inventory balances
assets on the balance sheet if they are expected
to provide economic benefits for a period of time

Companies that manipulate


their financial position try to
create the appearance of a
strong financial condition or
performance.

12 NIVESHAK VOLUME 3 ISSUE 4 April 2010


greater than one year and are hence said to be capi- compared to an identical company which reports the
talized. Alternatively expenditures are treated as an lease as a financial lease.

Cover Story
expense if they are not expected to provide benefits F i n a n c i a l Operating
in future period. Lease Lease
Capitalized expenditure is treated as an invest- Total Assets Higher Lower
ment cash outflow. However an expenditure that is Liabilities Higher Lower
expensed appears as operating cash outflow in the
Net Income ( early year ) Lower Higher
period it is made. Expensing thus reduces the net
Net Income ( subsequent
income in the period it is made as compared to capi- Higher Lower
years )
talizing which results in greater reported profitability
Cash flow from operations Higher Lower
in the year of reporting.
Cash flow from financing Lower Higher
Capitalizing Expensing
Debt Ratios Higher Lower
Total Assets Higher Lower
Shareholders’ Equity Higher Lower Exploitation of the Intent of the Account-
Income Variability Lower Higher ing Principle
Net Income (1st year) Higher Lower
Use of market value method
Net Income (subsequent
Lower Higher Mark to market method of accounting requires
years)
a company to report accounts on the balance sheet
Cash flow from operations Higher Lower
at their fair market values rather than at historical
Cash flow from investing Lower Higher cost. Under the mark to market method of account-
Debt Ratios Lower Higher ing forwards, swaps, options, energy transportation
Interest Coverage ratio (1st contracts are allowed to be shown at their fair val-
Higher Lower
year) ues. However the use of mark to market method of
Interest Coverage ratio (sub- accounting for other types of contracts is somewhat
Lower Higher
sequent years) unusual and presents ample opportunities to distort
revenues and income as the management desires.
Operating vs. Financial Lease
Mark to market method has also been criti-
Certain companies structure
cized in the case of derivatives as outlandish
leases in the form of operating
assumptions, projections and account-
leases in such a way so as to achieve desirable
ing can result in both parties re-
financial ratios (low debt ratios and high return on
porting substantial profits for long
assets). Because a financial lease is economically
periods. According to Warren Buf-
similar to borrowing money to purchase an as-
fet, the practice of reporting “mark to
set, the lessee company (borrower of the asset)
market” leads to “mark to myth” in the
records the leased asset and the related debt on
case of derivatives.
the balance sheet. The income statement in case
of a financial lease reports the interest expense Equity Method of Accounting
along with depreciation expense. Companies can account for the investments
An operating lease however is similar to rent- in a separate business or entity under the consoli-
ing an asset. In an operating lease, only an income dation method or the equity method depending on
expense is recorded on the income statement while control on the subsidiary. Unfortunately, this leaves
no asset or liability is recorded on the balance sheet. the door open to companies that want to conceal
Debt on the balance sheet and expenses on the in- and manipulate the true performance of their sub-
come statement are thus higher in the early years sidiaries or joint ventures.
of a financial lease. Hence firms often prefer to re- Under the equity method, the investment is
port leases as operating leases as it results in higher recorded at cost and is subsequently adjusted to
profit and better solvency position in early years as

The challenge for the financial


analyst is to look not only at
the malpractices of report-
ing but also at the quality of
reporting.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 13


reflect the share of net profit or loss and dividends distinct competitive advantage that a firm possess-
received. The method limits the information avail- es, it is quite likely that it could be a case of abnor-
able for investors. For example, a company could mal accounting practices being followed by the firm.
overstate interest coverage in order to change the
Cover Story

leverage ratios of the subsidiary. Operating Cash flow out of line with re-
ported earnings: If a company reports positive
Classification of Recurring items earnings but negative operating cash flows, then
Certain companies try to move “Gains” up the this could be a signal of some wrong doing on the
income statement and report them as revenues part of the management.
and report expenses as “Losses”. Only those items
Fourth Quarter Surprises: Unusually high rev-
should be reported as income and expenses that are
enues or low expenses in the fourth quarter of a
expected to recur over subsequent years.
year should be scrutinized with detail as well.
Conclusion:
Companies can manipulate their financial
statements in many different ways. However, inves-
tors can detect these practices by simply reading
the financial statements a little more closely. Some
of the means to detect abnormalities that should be
looked at include:

Abnormally high growth compared to peers:


Although high growth of a firm could be a result of a

According to Warren Buffet,


the practice of reporting “mark
to market” leads to “mark to
myth” in the case of
derivatives.

14 NIVESHAK VOLUME 3 ISSUE 4 April 2010


CATASTROPHE BOND MARKET
DEBDIPTA MAJUMDAR
BIM TRICHY
WHAT DOES CATASTROPHE market or economic conditions and
BOND – CAT MEAN? offer significant attractions to inves- Natural disasters
It is a high-yield debt instru- tors. For example, for the same level would no longer be
ment that is usually insurance linked of risk, investors can usually obtain able to take a death-
a higher yield with CAT bonds rela-
and meant to raise money in case of
tive to alternative investments. An-
ly toll on Insurance
a catastrophe such as a hurricane companies with the
or earthquake. It has a special con- other benefit is that the insurance
dition that states that if the issuer risk securitization of CATs shows no arrival of Catastroph-
(insurance or Reinsurance Company) correlation with equities or corpo- ic Bonds or CAT
rate bonds, meaning they’d provide
suffers a loss from a particular pre-
a good diversification of risks.
bonds. This article
defined catastrophe, then the issu-
runs through the de-
er’s obligation to pay interest and/or WHY INVEST IN CAT?
repay the principal is either deferred tails about the issue
Investors choose to invest in
or completely forgiven. For example, and the circumstanc-
catastrophe bonds because their
if an insurer has built up a portfo- es of triggering of
return is largely uncorrelated with
lio of risks by insuring properties
in Bangladesh, then it might wish
the return on other investments in a CAT bond. It also
fixed income or in equities, so cat explains in detail
to pass some of this risk on so that
bonds help investors achieve diver-
it can remain solvent after a large
sification. Investors also buy these
their rating and their
hurricane. It could simply purchase significance in an
securities because they generally
traditional catastrophe reinsurance,
which would pass the risk on to re-
pay higher interest rates (in terms emerging economy
of spreads over funding rates) than like India.
insurers. Or it could sponsor a cat
comparably rated corporate instru-
bond, which would pass the risk on

FinGyaan
ments, as long as they are not trig-
to investors. In consultation with an
gered.
investment bank, it would create a
special purpose entity that would Key categories of investors
issue the cat bond. Investors would who participate in this market in-
buy the bond, which might pay them clude hedge funds, specialized ca-
a coupon of LIBOR plus a spread, tastrophe-oriented funds, and asset
generally (but not always) between managers. Life insurers, reinsurers,
3 and 20%. If no hurricane hits Ban- banks, pension funds, and other in-
gladesh, then the investors would vestors have also participated in of-
make a healthy return on their in- ferings.
vestment. But if a hurricane were to
HOW IS IT RATED?
hit Bangladesh and trigger the cat
bond, then the principal initially paid Cat bonds are often rated by an
by the investors would be forgiven, agency such as Standard & Poor’s,
and instead used by the sponsor to Moody’s, or Fitch Ratings. A typical
pay its claims to policyholders Ad- corporate bond is rated based on
vantages of CAT bonds are that they its probability of default due to the
are not closely linked with the stock issuer going into bankruptcy. A ca-

Special condition: if the issuer


suffers a loss from a catas-
trophe, then its obligation to
pay interest and/or repay the
principal is either deferred or
completely forgiven.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 15


tastrophe bond is rated based on its probability of dexed to the natural hazard caused by nature. So the
default due to an earthquake or hurricane triggering parameter would be the wind speed (for a hurricane
loss of principal. This probability is determined with bond), the ground acceleration (for an earthquake
the use of catastrophe models. Most catastrophe bond), or whatever is appropriate for the peril. Data
bonds are rated below investment grade (BB and for this parameter is collected at multiple reporting
B category ratings), and the various rating agencies stations and then entered into specified formulae.
have recently moved toward a view that securities For example, if a typhoon generates wind speeds
must require multiple events before occurrence of a greater than X meters per second at 50 of the 150
loss in order to be rated investment grade. weather observation stations of the Japanese Meteo-
rological Agency, the cat bond is triggered.
HOW ARE THEY TRIGGERED?
Parametric Index: Many firms are uncomfort-
The sponsor and investment bank who struc- able with pure parametric bonds due to the lack of
ture the cat bond must choose how the principal correlation with actual loss. For instance, a bond may
impairment is triggered. Cat bonds can be catego- pay out based on the wind speed at 50 of the 150
rized into four basic trigger types. The trigger types stations mentioned above, but the insurer loses very
listed first are more correlated to the actual losses little money because a majority of their exposure
of the insurer sponsoring the cat bond. The trigger is concentrated in other locations. Models can give
types listed farther down the list are not as highly an approximation of loss as a function of the speed
correlated to the insurer’s actual losses, so the cat at differing locations, which are then used to give
bond has to be structured carefully and properly cal- a payout function for the bond. These function as
ibrated, but investors would not have to worry about hybrid Parametric / Modelled loss bonds, and have
the insurer’s claims adjustment practices. lowered basis risk as well as more transparency.
Indemnity: triggered by the issuer’s actual
losses, so the sponsor is indemnified, as if they had LET THE ‘CAT’ OUT OF THE BAG
purchased traditional catastrophe reinsurance. If the The Economic Survey 2009-10 has suggested
layer specified in the cat bond is $100 million excess the introduction of catastrophe bonds in the Indian
of $500 million, and the total claims add up to more market, to transfer insurance risk arising out of nat-
than $500 million, then the bond is triggered. ural calamities such as earthquakes, hurricanes and
Modelled loss: instead of dealing with the floods, to the capital markets. The survey said:
company’s actual claims, an exposure portfolio is Popular abroad
constructed for use with catastrophe modelling Cat bonds are popular in some of the markets
FinGyaan

software, and then when there is a large event, the abroad, especially in the United States and Europe.
event parameters are run against the exposure da-
Insurance or reinsurance companies can issue
tabase in the cat model. If the modelled losses are
these bonds and place them with various investors.
above a specified threshold, the bond is triggered.
This helps them transfer a part of the risks to the
Indexed to industry loss: instead of adding investors.
up the insurer’s claims, the cat bond is triggered
The insurance company can further invest the
when the insurance industry loss from a certain peril
money generated from selling the bonds.
reaches a specified threshold, say $30 billion. The
cat bond will specify who determines the industry “Cat bonds can be issued by the Government
loss; typically it is a recognized agency like PCS. or financial institutions. Investors can get a slightly
“Modified index” linked securities customize the in- higher return when compared to other securities
dex to a company’s own book of business by weight- and it also offers them an opportunity to diversify
ing the index results for various territories and lines their investments. But if the catastrophe is of huge
of business. proportions, then investors can lose the capital.
Parametric: instead of being based on any The insurance company then uses the amount
claims (the insurer’s actual claims, the modelled raised against Cat bonds to pay policy holders’
claims, or the industry’s claims), the trigger is in- claims,” said Mr K. G. Krishnamoorthy Rao, Chief Ex-

Advantages of CAT bonds


are that they are not closely
linked with the stock market
or economic conditions and
offer significant attractions to
investors.

16 NIVESHAK VOLUME 3 ISSUE 4 April 2010


ecutive Officer, Future Generali India Insurance Com- servative enough to realize that innovation aimed at
pany. diversifying risk can end up increasing it, may not
Alternative to reinsurance warm up to it immediately. But just as they have
slowly but surely allowed interest rate futures or cur-
Insurers can use this tool as an alternative to
rency swaps, catastrophe bonds could pass muster.
reinsurance. However, according to insurance indus-
try officials, neither the capital markets nor the In- All of this points to a long time horizon. Which,
dian insurance industry is developed enough for the given the risks of overnight financial liberalization,
introduction of these types of bonds. is surely a relief.
“This is a risky instrument. Who knows what
will happen when insurance companies move away
from core insurance practices,” said an insurance
company official.

WHY IT’S IMPORTANT FOR INDIA?


There was a recent earthquake in Chile – the FIN-Q Solutions
5th most powerful in the last century – lucky it didn’t
exact a higher toll. Insurance companies aren’t: They March 2010
are on the line for losses up to $8 billion, making this
the second costliest earthquake for them in history.
Insurers in the West have been trying to mute the
1. General electric
risk of such Black Swans—events that almost no one
predicts but that everyone suffers from—for some 2. 1862
time. In the late 1990s, they developed a new prod-
uct called a catastrophe or “cat” bond. After hurri-
cane Katrina in 2005, activity in this market on Wall 3. Swaps
Street jumped from near zero to $14 billion. Now, the
office of India’s chief economic adviser has noticed 4. X is Mad Money; Y is Cramer
it, too. The Economic Survey notes that “there is
scope for introducing (this instrument) in countries Bounce
like India”. There are grounds for scepticism here,

FinGyaan
but it’s worthwhile for regulators to at least examine 5. Rebalancing
this bond.
The first is that of India’s immature capital
markets. It’s true that the low level of financial liter-
6. Small Order Execution
acy dampens much financial activity; however, this System (SOES)
bond caters to a sophisticated investor set, offering
a security unlinked to the usual market volatility. So 7. Royal sun alliance& Sundram
regardless of the weak bond market, this bond can
thrive, depending on insurance. alliance
Though, second, the current state of the insur-
ance market isn’t promising either. According to a 8. Sir John Templeton
paper last year by Crisil and Assocham, India’s insur-
ance business commands 0.6% of its output, against
the world average of 2.14%. Still, as incomes rise
and as more employers offer benefits, this market
has only room to expand.
Third, India’s regulators, who have been con-

A catastrophe bond is rated


based on its probability of
default due to an earthquake
or hurricane triggering loss of
principal.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 17


THE GOLD, OIL AND US RELATIONSHIP
Kaustubh Kolhar
JBIMS
Of the various vulnerabili- century, and this is one of the prime
The price of oil is
ties traditional financial assets are factors behind the unprecedented
poised to rise steadi- exposed to, a rising oil price is of prosperity of its economy in the 20th
ly as the supply/ particular concern. In 2004, oil hit century. While the US accounts for
demand imbalance an all-time high of $56 per barrel, only 4.5% of the world’s population,
up 366 percent from the $12 low of it consumes 20.25% of the world’s
increases and the 1998, and up 75 percent since Janu- fossil fuel-based energy. It imports
dollar declines. As ary 2004. about 70% of its oil, but produces
this happens, the Generally, an increasing oil only 10.7% and consumes 25.9% of
price of precious price results in increasing infla- the world consumption. Because of
tion, negatively impact the global this dependency on both oil and for-
metals will climb eign suppliers, any increase in price
economy, particularly oil-dependent
until they eventu- economies such as the US. Apart or supply disruptions will negatively
ally catch up to their from increased transportation, heat- impact the US economy to a greater
degree than any other nation.
historic ratios. If the ing and utility costs, higher oil prices
are eventually reflected in virtually
oil producers start Hubbert Curve:
every finished product, as well as
demanding Euros, food and commodities in general. In the early 1950s, M. King
dinars or precious Furthermore, there is evidence thatHubbert, one of the leading geo-
physicists of the time, developed a
global oil production is peaking and
metals in payment predictive model showing that all
the flow will soon be in permanent
for their product, decline. oil reserves follow a pattern called
the decline in the US Hubbert’s Curve, which runs from
The majority of oil reserves are
discovery through to depletion. In
dollar will accelerate located in politically unstable re-
any given oil field, as more wells
while the price of gions, with tensions in the Middle
are drilled and as newer and better
precious metals will East, Venezuela and Nigeria likely to
technology is installed, production
intensify rather than to abate. Be-
explode. initially increases. Eventually, how-
cause of frequent terrorist attacks,
ever, regardless of new wells and
Iraqi oil production is subject to dis-
new technology, a peak output is
ruption, while the risk of political
reached. After this peak is reached,
problems in Saudi Arabia grows. The
oil production not only begins to
timing for these risks is uncertain
decline, but also becomes less cost
and hard to quantify, but the impli-
effective. In fact, at some point in
cations of Peak Oil are predictable
FinSight

this decline, the energy it takes to


and quantifiable, and the effects will
extract, transport and refine a barrel
be more far-reaching than simply a
of oil exceeds the energy contained
rising oil price.
in that barrel of oil. When that point
Oil - A major contributor to is reached, extraction of oil is no lon-
US prosperity: ger feasible and the reserve is aban-
doned. In the early years of the 20th
The US has enjoyed inexpen-
century, in the largest oil fields, it
sive oil-based energy for nearly a

While the US accounts for


only 4.5% of the world’s popu-
lation, it consumes 20.25% of
the world’s fossil fuel-based
energy.

18 NIVESHAK VOLUME 3 ISSUE 4 April 2010


was possible to recover 50 barrels of oil for each bar- dollar, as a medium of exchange. There is growing
rel used in the extraction, transportation and refin- dissention among religious fundamentalists in Saudi
ing process. That ratio of 50-to-1 ratio has declined Arabia regarding the exchange of oil for US dollars.
to 5-to-1 or less. And it continues to decline. Oil, gold and commodities have all been priced
in US dollars since 1975 when OPEC officially agreed
to sell its oil exclusively for US dollars. From 1944
until 1971, US dollars were convertible into gold by
central banks in order to adjust for any trade imbal-
ances between countries. Up to that point, the price
of gold was fixed at US$35 per ounce, and the price
of oil was relatively stable at about US$3.00 per bar-
rel. Once the US ceased gold convertibility in 1971,
OPEC producers were forced to convert their excess
US dollars by purchasing gold in the marketplace.
This resulted in price increases for both oil and gold,
until eventually oil reached US$40 per barrel and
Using analytic techniques based on Hubbert’s gold reached US$850 per ounce.
work, oil and gas experts now project that world oil Today, apart from geopolitical threats in oil-
production will peak sometime in the latter half of producing regions, supply/demand imbalances from
this decade. We are now depleting global reserves Peak Oil and increasing demand from developing
at an annual rate of 6%, while demand is growing countries, the price of both gold and oil can be ex-
at an annual rate of 2% (and that growth rate is ex- pected to increase as the US dollar declines. With
pected to triple over the next 20 years). This means an ever-increasing US money supply, growing triple
we must increase world reserves by 8% per annum deficits and mounting debt at all levels, the US dollar
simply to maintain the status quo, and we are no- is likely to continue the decline that began in 2001.
where near achieving that S i n c e then, foreign holders of US dollar
goal. In fact, we are so assets have already lost 33% of
far from it that, accord- their investment.
ing to Dr. Colin Campbell, There have been discus-
one of the world’s leading sions among Arab nations
geologists, the world con- about pricing oil in Islamic
sumes four barrels of oil gold and silver dinars. If
for each one it discovers. this happens, other produc-
ers may follow suit and opt
Oil and other met- out of accepting US dollars
als: for oil. Demand for the cur-
There are numer- rency will plummet, send-
ous social, economic and ing the dollar into a freefall
political implications related to world while demand for Euros, gold
oil production peaking in the next few years, and silver soars.
FinSight
but our concern here is to examine how a rising
oil price is linked to precious metals. The answer Gold during the recession period:
to that question begins with the historical desire of During the recession period, as the financial
Arab producers to receive gold in exchange for their markets tried to find a bottom while banks went
oil. This dates back to 1933 when King Ibn Saud de- bankrupt and more and more investment scandals
manded payment in gold for the original oil conces- continued to pop up on the radar destroying inves-
sion in Saudi Arabia. In addition, Islamic law forbids tor’s life savings literally over night, the FED contin-
the use of a promise of payment, such as the US ued to pour billions of USD’s into the system. The

According to Dr. Colin Camp-


bell, one of the world’s leading
geologists, the world consumes
four barrels of oil for each one
it discovers.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 19


USD has been consistently stronger, even though the of precious metals. Precious metals may be consid-
FED continued to dilute the world with more dollars ered to be a hedge against geopolitical tensions or
on a monthly basis. Gold has also been increasing severe crises.
in value, reaching $1000, as foreign currencies de- • T h e r e is an inverse relationship be-
clined. tween the Commodity Pre-
In addition, Middle Eastern oil producers would cious Metal Price Index
be forced to diversify their vast US dollar holdings and the US Dollar Index.
into precious metals and other currencies to protect This relationship is also
themselves from further losses. As losses mount, substantiated by the em-
other large, non-oil producing, US dollar holders pirical findings of the World Gold
such as Japan, China, Korea, India and Taiwan would Council which shows that there is a neg-
seek to diversify out of US dollars. Eventually, this ative relationship between the price of gold
could result in a dollar sell-off and a correspond- and the US dollar.
ing increase in oil and gold prices. • During recessions the US
dollar typically appreciates in value
Oil and Gold Correlation:
and the price of silver, platinum and pal-
Over the last 50 years or ladium decline, keeping true to the inverse re-
so, gold and oil have generally lationship mentioned above.
moved together in terms of price,
• During recessionary periods the price of gold
with a positive price correlation of
and the US dollar appreciate together, failing the in-
around 80 percent. During this time, the price
verse relationship in the short-run. In the long-term,
of oil in gold ounces has averaged about 15 barrels
the inverse trend between gold and the US dollar
per ounce. However, with recent soaring oil prices,
holds, just not during recessions.
the relationship has strayed far from this average.
The gold-oil ratio reached a 10-year high of 25 as The above suggests that gold is a long-term
the global recession erodes demand for energy com- hedge against inflation and a short-term hedge
modities and investors abandon monetary assets against crises.
in favour of the safe haven metal. While oil prices
recently set an all-time high of $56 per barrel, gold
prices have not kept pace and the oil:gold ratio fell
to an all-time low of 7.5:1.
The size disparity between oil and gold mar-
kets must also be considered. While annual gold
production is approximately US$35 billion, annual
oil production is US$1.5 trillion, by far the largest-
trading world commodity. As oil prices increase and
demand for US dollar diversification increases, there
will be an ever-expanding number of petro dollars
and other offshore dollar holders chasing a relatively
small amount of bullion ounces.
FinSight

Gold: The Saviour


• Gold is considered to be a long-term hedge
against inflation. That has been empirically justified
by research conducted by the World Gold Council
(June 2006).
• In the short-run, the geopolitical tensions or
periods of uncertainty spark an uptrend in the price

Over the last 50 years, gold


and oil have generally moved
together in terms of price, with
a positive price correlation of
around 80 percent.

20 NIVESHAK VOLUME 3 ISSUE 4 April 2010


Nivesh in Indian Population
Rahul Goyal
NITIE, Mumbai
Most of the Indians plan to in- Countries Pop. Den- GDP per
vest in mutual funds, gold, property, The article targets
sity (per capita $

Sparsely Populated Countries


IPOs or stocks but have you ever giv- km2) the behavioural
en a thought of investing in human UAE 55.012 28611.84 aspect of the In-
population? If not, then why?
Australia 2.886 37433.85 dian economy and

Rich
The Indian population clock
has already clocked 1,151,068,507
Canada 3.405 38439.78 the investments be
USA 30.71 44155.00
and is still ticking fast enough to ing made overall.
Mozam- 24.21 377.69
question if this ever growing popu- The general feeling

Poor
bique
lation is generating poverty or eco-
nomic prosperity. At first sight, it Ethiopia 71.739 183.13 amongst the masses
appears that this huge population is Table 2 Source: www.nationmaster.com is that growing pop
a curse to our economy. It is also a The above statistics evidently ulation is a curse
liability for the nation. More people acquits population from the charge but the article does

Perspective
meaning more mouths to be fed that it causes poverty. Highly pop-
that ultimately makes the nation ulated states can both be rich and bring it is as a po-
suffer from poverty, corruption and poor. Singapore with the highest tential bless ing for
ill governance. Many of us even be- population density (per sq. km) of the economy only if
lieve that a growing population will 6386.29 generates 40 times the In-
simply guttle the planet, and lead to dia’s GDP per capita. Similar is the
proper investment is
famine, disease and death of civili- observation for sparsely populated made in the “human
sation as we know it. nations. Hence population growth is beings”.
But a serious thought and re- not the factor that causes poverty or
search would counter the above ar- miseries. So does that mean popula-
gument. Infact there is no correlation tion growth causes economic pros-
between the growing population and perity? Let us try to find that out by
a falling economic and social pros- analysing the statistics below.
perity. The statistics below would India’s Population
vouch for that non-correlation: Year Pop. LEB IMR FGP FGP/
(m) (yrs) (mt) per-
Countries Pop. Den- GDP per
son
sity (per capita $
Table 3 Source: www.censusindia.gov.in

km2) 1901 238 23 210 _ _


Densely Populated Countries

1911 252 21 204 _ _


China 136.12 2033.90
1921 251 27 219 _ _
Poor

India 328.29 816.60


1931 271 31 174 _ _
Japan 337.23 34022.94
1941 319 32 161 _ _
Germany 230.89 35270.36
1951 361 42 146 52 14.4
Rich

Singapore 6386.29 30082.46


1961 439 46 129 83 18.91
Belgium 339.71 37384.34
1971 548 51 129 105 19.16
UK 246.88 38849.97 1981 684 54 110 133 19.44
Hongkong 6348.61 27071.62 1991 846 58 92 168 19.86
Table 1 Source: www.nationmaster.com/ 2000 1000 62 72 200 20

Human population tripled in


the 20th century, but during
the same period the world per
capita output quadrupled thus
improving the quality of life
for everyone.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 21


Legend: hence greater would be the prosperity.
LEB: Life Expectancy at Birth To support the above argument let us analyse
IMR: Infant Mortality Rate per 1000 live births statistics given in Table 5: The table gives the most
FGP: Food Grain Production populous cities of India with their State GDP’s. The
It can be seen that with the rising population Top 5 most populous cities of India also happen to
India has actually done better in terms of food grain have their state’s GDP in the Top 5 slots barring Del-
production and availability. Life expectancy has in- hi. The most populous State of India, which is Uttar
creased and mortality rate has come down. With ris- Pradesh (which is not shown in the table) ranks 2nd
ing population India has become self sufficient and in GSDP.
has indeed prospered.
Rank:
At this point somebody may put forward an ar- Rank City
Pop.
State/UT
Rank:
Cities
gument that with rising population India is running (2010) GSDP
GDP
out of resources. But the fact is: India is not and 1 Mumbai 13,830,884 Maharashtra 1 1
neither would any other country. Let us go through 2 Delhi 12,565,901 Delhi - 3
another piece of statistics to prove that: 3 Bangalore 5,438,065 Karnataka - 4
Percentage 4 Kolkata 5,138,208 West Bengal 4 2
Metal 1980 1990
Change 5 Chennai 4,616,639 Tamil Nadu - 5
Copper 6 Hyderabad 4,068,611 Andhra 3 6
$200 $163 -18.5%
(195.56 lbs.) Pradesh
Chrome 7 Ahmedabad 3,959,432 Gujarat 5 7
$200 $120 -40%
(51.28 lbs.) 8 Pune 3,446,330 Maharashtra - 8
Nickel
Perspective

9 Surat 3,344,135 Gujarat - 9


$200 $193 -3.5%
(63.52 lbs.) Table 5 Source: “India: largest cities and towns and sta-
Tin tistics of their population”. World Gazetteer. http://www.
$200 $56 -72% world-gazetteer.com
(229.1 lbs.)
Tungsten The inference that can be drawn from these
$200 $86 -57% statistics is that despite of being highly populated,
(13.64 lbs.)
Table 4 Source: London Metal Exchange these states have been doing extremely well. Even if
It can be seen that the cost of various metals we take the GDP per capita of these states or cities
(resources) has decreased over a decade despite the the Top 10 would more or less remain the same. Be-
population increase. It also means that natural re- cause of the sincere efforts put by people of various
sources will progressively become less scarce, hence specialisations like politicians, academicians, stu-
less costly, and will constitute a smaller proportion dents, doctors, engineers, architects, street vendors,
of our expenses in future years. dhobis, barbers, labourers etc rapid urbanisation of
Nearly every datum from life expectancy and these states happened. Wherever the concentration
infant mortality rate to health indicator, to price of was thick, there was greater prosperity simply be-
natural resource and consumption good like food cause there was greater division of labour.
item, to environmental quality, things have bettered. Human beings have the ultimate resource with
Human population tripled in the 20th century, but them i.e. their minds and the ability to comprehend.
during the same period the world per capita output These resources when invested in along with proper
quadrupled thus improving the quality of life for ev- training, development and skills building initiatives,
eryone. would give the highest ROI compared to other avail-
People are actually wealth creators. They create able “risky” investment options in market. With this
wealth because they are inherently non self-suffi- statement, I, out rightly, want to make two things
cient. They need the services of other humans for clear. Firstly I didn’t advocate for investing in human
which they need to have wealth. People specialize beings just to make them doctors, engineers, politi-
and create staggering volume of services and prod- cians, managers only. Even Street vendors qualify
ucts. They drive innovation. Hence more the popu- to be the people whom we can invest heavily in.
lation, greater the division of labour would be and Secondly for prosperity, human beings need not be

Statistics tells us that Street vendors and hawkers form a major part of over 90% of India’s
workforce which earns its livelihood in the informal sector. As a matter of fact this sector ac-
counts for 63% of the country’s GDP.

22 NIVESHAK VOLUME 3 ISSUE 4 April 2010


educated at all. we have been fed into our minds that without edu-
Both the statements may have surprised you. cation we will be nothing. But the fact of life is that
But let us try to understand the reasoning: Statis- we humans are everything.
tics tells us that street vendors and hawkers form It brings us to the conclusion that all human
a major part of over 90% of India’s workforce which beings are potential contributors. They all must
earns its livelihood in the informal sector. As a mat- get equal opportunities to grow and prosper. There
ter of fact this sector accounts for 63% of the should not be any bias towards educated
country’s GDP. and uneducated, poor and rich
For a wide array of or men and women. Each
products - from one of us has some
fruits and veg- or the other role
etables, to to play in the
garments, economic
toys, and system.
maga- With this
zines c on fi -
- street dence, hu-
vendors man be-
provide ings with
an effec- their mind
tive distri- and ability

Perspective
bution chan- to trade will
nel, on which generate numer-
both producers and ous wealth by doing
consumers rely. Street what they can do best
vendors not only create em- in a free market economy. It will
ployment for themselves through their also enable them to look upon themselves and
own entrepreneurial skills, but also help generate their brethren as a huge asset. Surely, investing in
employment in agriculture as well as small-scale in- human beings is one Nivesh that will reap the ben-
dustry. Hence we can say that street vendors are a efits for hundreds of years to come.
vital and vibrant part of the Indian economy (Source: There are jobs
www.petitiononline.com). a-plenty there—
So street vendors turns out to be a potential I’ll be a watchman,
where we must heavily invest. They must be given waiter, doctor
vending licenses and, on lines of SEZs’ Hawing zones Even a politician—
must be created to let them operate freely. But the if I dare!
sad part is that we are investing blindly in setting up I am there where millions live
of mammoth buildings, malls, multiplexes etc which And a million dreams come true.
don’t even hold a respectful contribution in nation’s I am not a liability I am an asset to accrue.
GDP.
From the above example it is clear that dho-
bis, street vendors, hawkers, and autowalas are all
potential entities to invest in and it is primarily be-
cause they have minds, skills and ability.
Evidently the above example explains the sec-
ond point too, that, for a nation to prosper, it is not
mandatory for each and every one to be educated.
What they must have are skills. The argument may
seem unintelligent because right from the beginning

People specialize and create


staggering volume of services
and products. They drive
innovation.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 23


FIN-Q
1. In a recent decision by RBI, the infrastructure finance companies (IFC) have also been
included in the NBFCs. What has been kept the minimum capital adequacy ratio for these
newly included NBFCs?

2. What is the world’s largest gold exchange traded fund and silver exchange traded fund?

3. In which of the following countries is prevalent the Pay as you earn (PAYE), a
withholding tax system?
(A) USA
(B) UK
(C) Australia
(D) Germany
(E) China

4. What term became popular after the newspaper report of Watergate Scandal in the year
1973?

5. Which is the first Indian bank to commence operations in Singapore?

6. Which bank is promoted by 20th Century Finance Corporation and Keppel Tatlee Bank of
Singapore in India?

7. He is the pioneer in mutual fund industry and often referred as the Father of Index
Fund investing. He created the first S&P 500 Index fund. Identify this famous person?

8. Which financial services giant is referred as the “Thundering Herd”?


FinLounge

9. Which country’s currency is known as Drachma, which in Greek means ‘to grasp’?
FinSight

10. By how many basis points were CRR and reverse repo rates hiked by RBI in the latest
credit policy released on 20th April?

All entries should be mailed at niveshak.iims@gmail.com by 10th May, 2010 23:59 hours
One lucky winner will receive cash prize of Rs. 500/--

24 NIVESHAK VOLUME 3 ISSUE 4 April 2010


ANNOUNCEMENTS
ARTICLE OF THE MONTH
The article of the month winners for April 2010 are
Abhishek sarkar and Sreejit Gopinathan
of Welingkar Institute of Management
They receive a cash prize of Rs.1000/-

FINQ WINNER
The FinQ Winner for the month March 2010 is
Harshil Suvarnkar
of JBIMS
He receives a cash prize of Rs.500/-
CONGRATULATIONS!!

ALL ARE INVITED


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for original articles related to finance & economics. Students can also contrib-
ute puzzles and jokes related to finance & economics. References should be
cited wherever necessary. The best article will be featured as the “Article of the
Month.” and would be awarded cash prize of Rs.1000/-

Instructions
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