FROM THE EDITORS DESK

DEC 2011

MONEY MANAGER

From The Editors Desk

DearReader, The world today is going through a very turbulent phase. I say this not just because there is commotion in various parts of the world: sticky unemployment in the US, sovereign debt crisis in Europe, inflation in the emerging economies like India and China or the search for a suitable successorfortheKyotoprotocol.Isaythisbecause,weareseeingaworldthathasfallenvictimtoits ownbeliefsandpracticesandiscurrentlytryingtoreinventitselfinvariousways.Onecanviewthe worldtobeaskingitselfthequestionHasthehumanwelfarebeensidelinedinourquesttoachieve higherGDPgrowth? Theworldadecadeagowasonlyanticipatingtheriseofemergingnationsbuttodaytheirrole as the international engines of growth can never be overemphasized. Thanks to the growing influenceofthesecountriesintheinternationalarena,expertstodayaretryingtofindapractical, acceptableandasustainablepathaheadinthemidstofdiverginginterestsofamultitudeofsuper powers,ifImaysayso. ComingtoIndia,wearegoingthroughacrucialphaseinourdevelopmentasacountry.Itisa period which is marked by vulnerability to mounting international crises, awakening to fight corruptiontriggeredbyrecentscams,emphasisoninfrastructure,inflationconcernsandappropriate regulationoffinancialmarkets.PolicychangessuchasintroductionofCDS,FDIinmultibrandretail, regulationofMFIs,etcareeitherimplementedorwaitinginthewings.Itisnotanoverstatementto say that steps taken at this crucial juncture will define the future of India in the coming 15 to 20 years. ThiseditionofMoneyManagerhastriedtocoversomeofthecontemporaryissuesthathave takencentrestageintheworldscene.Ithankalltheauthorswhohavepenneddowntheirviews.I alsothankmyentireteamtohaveworkedhardtobringoutthisissue.Hopeyouenjoyreadingit. Thanks, SishirKolli EditorinChief PGDM2012 IIMCalcutta

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ACKNOWLEDGEMENTS

Acknowledgements
We, at The Finance & Investments Club, IIM Calcutta would like to sincerely thank all those who have been instrumental in helping us releasethiseditionofTheMoneyManager. TheMoneyManagerteamwouldliketoexpress its deepest gratitude to the leading luminaries from the industry and academia for their contributions through insightful articles and thoughtprovokinginterviews.Wewouldliketo thank Mr. Vaidyanathan, CEO, Quantum Phinanceforhisarticle,Prof.ParthaPratimPal andProf.SoumyenSikdarfortheirinterviews. We were quite overwhelmed by the phenomenal response from the student communitythebroadrangeoftopicscovered and analytical depth of the articles was extraordinary.Abigthankyoutoallthosewho sentinarticlesforthisissuewehopetohave yourcontinuedsupportinforthcomingeditions aswell. We would like to express our gratitude to all the members of The Finance and Investments Club,IIMCalcuttafortheirvaluableinputsand feedbacks. We would also like to thank Beta, IIM Ahmedabad and Networth, IIM Bangalore fortheirsupportinthisedition.Last,butbyno means least, we would like to thank you, our readers, whose unstinting support has helped the Money Manager grow to the national presence it enjoys today. We hope you will enjoy reading this edition as much as we enjoyedputtingittogether!

THE MONEY MANAGER

EditorinChief SishirKolli EditorialBoard A.S.ShoaibuddinAhmed AbhinavGupta SishirKolli CoordinatingCommittee AbhishekVerma AnuragMantry PiyushMaheshwari Design AnkurDalal NeeravVerma Feedback/Queries finclub@email.iimcal.ac.in http://www.iimcfinclub.com/

DEC 2011

MONEY MANAGER

Contents
Expert Opinions
9 Gettingitrightwithproperregulation Mr.K.Vaidyanathan,CEO,QuantumPhinance

46 InterviewwithProf.SoumyenSikdar 50 InterviewwithProf.ParthaPratimPal 05 20

Student Articles
5 ReductioninHumanWelfaredespiteproper functioningofCapitalMarkets 13 SEBI(AlternativeInvestmentFunds)regula tions 17 FurtherMonetarystimuluswillpushthere coveryoftheUSjobmarket 20 GreedinnotEvil 22 IsGreeceaconfirmationthatwearepre dictablyirrational? 25 IsIndianStockMarketreallyefficient? 27 ShouldIndiaallowStatesandLocalGovern ments/Municipalitiestoissuedebt? 30 TheGreekTragedyWhoisresponsible? 32 TheperilsofFiscalAusterity 36 InfrastructureinIndiaisgoingtowitnessa hugeboomandisthenextbigthing.Mere hypeorstatementwithsubstance? 40 Whyismicrofinancesuccessfulinsomere gionsbutnotinothers?IsIndiaanenviron mentconduciveformicrofinancetoflourish? 43 Growth,InflationandMonetaryPolicyThe IndianCase. 25 40 30

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Cover Article : Reduction in Human Welfare despite proper functioning of Capital Markets
Abstract: The article is based on a compilation of events dealing with market failures in the areaofessentialcommodities,wheretherehas been substantial reduction of human welfare even with state protected functioning capital markets in the areas where the overall growth storyhasbeenstupendous.Thisstudyismainly concentrated in emerging economies where new setups are emerging and the traditional setupsinpricingaregettingchallengedcreating uniquesituationssometimesdetrimentaltothe development of these countries. The cases of Brazil and Argentina have been considered to highlighttheseimportantaspectsandattempts havebeenmadetoanalyzethecausesofthese marketfailures. Introduction: The story commences with a very inter estingparadoxofeconomicsconcerningessen tial commodities. It is the paradox of the bumper harvest [1]. The concepts of price elas ticityofdemandandsupplycanbeusedtoillus tratethisparadox.Supposethatinaparticular year, every condition favors the farmer. The peststhatcoulddestroythecropsaredeaddue to a natural occurrence and other factors like landfertilityisalsogoodconsideringthatithad beenkeptfallowforthelastyear.Asfarasade quateamountofrainfallisconcerned,through out the crops growing phase, a consistent, timelyrainfallhasresultedgivingarecordhar vest.Becauseofthat,thefarmerexpectsarise inincomefortheyear.But,contrarytohisex pectations, when he calculates his actual in come,heisshockedtoseetheresults.Notonly has his income reduced, but also that of the other farmers who had a similar bumper har vest. This paradox might be puzzling. The an swer to it lies in the concept of price elasticity of demand. For essential commodities like wheatandcorn,thepriceelasticityofdemand tends to be very low which implies that the relative change in consumption in response to price is quite small. Vice versa, the change in priceinresponsetoasmallchangeinsupplyis

quitehigh.Thus,whentheharvestisgood,the totalsupplyincreasesandcausesalargedropin selling price of the good. Since the total con sumptionisalmostthesame,eachfarmersells approximately the same amount of that good, butatafarlowerprice.Thus,farmersreceivea lotlesstotalrevenuewhentheharvestisgood thanwhenitisbad.

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EmergingMarketsCase: Capitalmarketscatertoaggregatedemandand supply and react almost instantaneously to changing demand and supply but these signals fromthemarketsincaseofessentialcommodi tiesdoesnotnecessarilyindicatethetruemar ketdemandandsupply.Someofthedemandis based merely on speculation and some on ex traneous factors. Rising income disparities makesignalingdistortedinthemarkets. Ifweanalyzethequestionofrisingessen tial commodity prices in emerging markets in Asia, which have efficient functioning capital markets many new factors come up of which some of them are export curbs, speculative pricingandaninordinatelygrowingdemand.If we were to quote Geoffrey York, Globe and Mailmagazine,Withonlyabout30millionton nesofricetradedannually,governmentsupply curbs,suchasthosefromNewDelhiandHanoi, havespookedimporters,suchasthePhilippines and Bangladesh, at a time when global stocks havehalvedsincehittingarecordhighin2001. Similarexportcurbsattimesofbumperproduc tion in onions contributes to the continued wrongsignalinginmarkets. If we consider the idea of speculations drivingpricesofcommodities,financialspecula torsintheChicagoBoardofTrade,haveraised prices of certain commodities by over 80 per cent while looking for quick gains in a large commodity play. To a certain degree, hoarding by consumers has also fed the rise by spurring importers to seek supplies sooner. In poor na tionsriceconsumptionhasbeenrising,butthis is partly offset by falling percapita consump tioninlargecountriessuchasChina.Datafrom the U.S. Department of Agriculture shows that consumption in China which accounts for 30 per cent of world consumption has fallen by 3.9percentoverthepastfiveyears.Butglobal consumptionhasrisenby2.7percentoverthe

same period. All the factors make sure that evenwithefficientfunctioningcapitalmarkets, correct signaling to producers and consumers doesnotresultandifweconsiderthequestion of including the depreciation of environmental capital and rising pollution costs in the emerg ingeconomiesamoregloomypictureemerges withsubstantialreductioninhumanwelfare. ThecaseofBrazil: Overthelastfewyears,onaccountofitssteady growth and relatively stable financial system, Brazil, one of the 4 BRIC countries, has caught

the worlds attention. Investors worldwide are looking at this country for quick and assured returns. Large capital inflows in Brazil have led to its currency, the Real becoming the worlds most overvalued currency. This has led to high rates of inflation, implying spiraling production costsandcommodityprices.Oflate,taxifares, moviesetc.costmoreinSaoPaulothaninNew York rendering a huge spurt in daily expenses. Similarly, office space rents in Sao Paulo have shotpastthoseinManhattan. With major problems continuing in

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EuropeandtheU.S.,atideoffundsisexpected to flow into Brazils economy. Because of the associated rise in prices, manufacturing ex penses are expected to soar and Brazils labor and raw materials could soon have first world pricetags.Becauseoftheincreasingproduction costs, factories are finding it difficult to com pete in overseas markets. From May to June this year, Brazilian industrial production has fallenby1.6%,thehighestdropsincethe2008 financialcrisis. China, another BRIC country with great growthinthelastdecade,hasalsoexperienced similar problems with heightened investment flows contributing to food inflation leading to potential social unrest. Capital flows have sig nificantly exacerbated domestic problems like bubbles and inflation that could potentially throw emerging economies off their growth paths and produce social instability, Cornell University economist Eswar Prasad stated. The cash flows have affected the Chinese real estate market as well. Cashrich builders have bidupthepricesoflandinbigcities,causinga massiveriseinhomerates. This situation clearly demonstrates how the proper functioning of capital markets in Brazilhasledtoincreaseinforeigninterestfol lowed by massive capital inflows which are causing havoc in the markets now. This is a clear demonstration of a reduction in human welfareinBrazilfollowingeffectivecapitalmar ketfunctioning. TheArgentineanCase: IfweconsiderArgentinascaseinthe1910s,its economic status was at par with that of the United States of America. Both countries had efficientlyfunctioningcapitalmarketsbutwhat Argentina lacked was credible political institu tions to back them. There was no stability and no legal mechanisms to make sure that large

scale investors do not dominate the market. These factors along with concernsover its cur rency issues led to a path that arrested the growth of the country.In the 1920s, Argentina developed a system of protections to institu tionalize investments in the country but it lacked the backing of the government which kept changing and engaging in populist meas ures without a firm taxation policy in place. In case of an economy with diverse externalities (positive and negative), according to Coases Theorem, effective property rights protection must be in place. But legal moves by a politi cizedSupremeCourtallowedfurtherregulation of rents, putting the property rights protection onaslipperyslope.Thisledtoloomingoffiscal crisis culminating in the great crisis of the 1990s,whereafterthecountryhadcomeoutof alongslumphavingexperiencedstagnationfor around 50 years because of the lack of a reli ablecurrency,thelocalcurrency,thePeso,was peggedtotheAmericandollarbyMr.Domingo Cavallo,thethenFinanceMinister. Thisdefinitelyledtobetterfunctioningof the capital markets. But the functioning of the capitalmarketsdealinginitscurrencyhadsev eral problems. One problem emerged with President Menem undertaking populist meas uresandprofligatespending.Thisledtospecu lationsabouttheArgentinean currencyleading toafallinitsvalue.Theotherproblemwasthat larger export and import bills continued to be tradedindollars.Internationalbanksandother creditorsgaveloansquotedindollars,creating a parallel economy all in the name of efficient capital markets. What resulted was runaway inflation and unemployment. Simultaneously government sources of revenue were also re duced and then arbitrarily President Menem decided to devalue the currency and delink it fromthedollar.Thispleaseddomesticinvestors astheirtotaldebtreducedbutforeigninvestors lost large portions of their investments leading

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to a complete backlash in the country and fi nallyacollapseofthecurrency.Whatisappar ent from the case is that the capital markets alone cannot ensure stability and human wel fareandotherfactorsneedtobeconsideredto haveastablefunctioningoftheEconomy. Alongwiththecapitalmarkets,otherpo litical and external factors like environmental degradation and social costs should be taken intoaccount.Twocountriesinsimilarsituations with efficient capital markets can yield com pletelydifferentresultsasfarashumanwelfare andeconomicstabilityisconcernedashasbeen clearly demonstrated by Argentina and the UnitedStatesofAmerica.

Conclusion: Efficient capital markets fail to take into ac count many external factors including environ ment, social disparities and displacement costs and time lag in essential commodities produc tion. It also fails to account for the constant change in demographics, political and social concerns that are intertwined deeply in the questionsconcerningoverallhumanwelfare.So theassumptionthatonceefficientcapitalmar kets are functioning, human welfare is auto matically ensured is a misnomer. Other factors havetocontributeandneeddueconsideration inanyanalysisconcerningwelfarepolicies.

References: [1]http://www.blurtit.com/q222935.html [2]http://online.wsj.com/article/SB10001424053111904716604576544722103262938.html

DebanjanMunshi DebanjanMunsiisafirstyearPGDMstudentofIIMCalcutta.Hecanbereachedat debajanm2013@email.iimcal.ac.in SagarSambrani SagarSambraniisafirstyearPGDCMstudentofIIMCalcutta.Hecanbereachedat sagars2013@email.iimcal.ac.in.

EXPERT OPINION

DEC 2011

MONEY MANAGER

Getting it right with proper regulation

The Reserve Bank of India has issued guidelines on introduction of Credit Default Swaps (CDS) for Corporate Bonds. The guide lineswouldbecomeeffectivefromOctober24, 2011aspartofRBIseffortofdevelopingbond marketinfrastructure. The RBI has been considering introduc ing credit derivatives since 2003 so as to pro vide market participants with an effective tool to manage credit risk. It issued the first draft guidelinein2003.However,consideringtherisk management practices in domestic banks way backin2003,itdecidedtodefertheissuanceof thefinalguidelinestoalaterdate.Then,while it was deliberating on launching credit deriva tivesagainin2007,thesubprimecrisishadset in motion. The subprime crisis was, in part, at tributedtothisassetclassbecauselendersand credit risk takers could be segregated using credit derivatives, which caused lending to get laxandreckless.RBIhadtoplacetheintroduc tionofcreditderivativesonthebackburner,till suchtimeitwasnotclearif,andinwhatmeas ure,didcreditderivativescontributetothecri sis. Even if the economic benefits of this asset class were compelling and the domestic banks werereadytoembraceacomplexproductlike creditderivatives,thepoliticalcoststothecen tralbankwouldhavebeenfartoohigh.Oflate, there is a reassuring consensus that credit de rivativespersewerenotatfault,butthelackof regulation around credit derivatives, was the realculprit.Basedonbetterinsightsonhowthe product can be valuable if regulation is sound, China introduced credit derivatives in Novem ber 2010. The central bank, Peoples Bank of China, did not worry about the high political costs of introducing the product. It seems RBI too is convinced about the welfare benefits of theproductandisconfidentthatifregulationis proper, the asset class is immensely valuable, and is therefore initiating the process of intro 9 ducing the most basic credit derivative instru ment called the Credit Default Swap (CDS). If RBI had wanted to be politically correct, it would have deferred the introduction indefi nitely. The political cost is that if there is a credit crisis in the country in future, credit de rivatives would be blamed for it. It is probably not lost on the central bank that it would be answerable to the politicians and the media, whoprobablydonotunderstandtheassetclass well enough and would blame it for any deba cle,asithasbecomefashionabletodoso.Most journalistsdonotunderstandthatcreditderiva tiveperseisneithergoodnorbad,butitsuse forhedgingorspeculationiswhatmakesituse ful or harmful. The RBI would be condemned forintroducingcreditderivativesandnotlearn ingfromthelessonsofthedebacleofthesub prime crisis if indeed something goes wrong. However, it seems that the economic welfare benefitsoftheassetclassarequitecompelling fromtheperspectiveofthesetwoconservative central banks to make it worth incurring the possiblepoliticalrisk. CDSservesasimilarpurposelikethatof insurance.Oneofthereasonswhyinsuranceis usefulisbecauseithelpsanindividualoranor ganization, hedge against extensive loss. For instance, I do not mind spending on home in surance because if my house gets damaged, it wouldhaveasubstantialimpactonmyfinancial wellbeing. Moreover, buying insurance gives mepeaceofmindforacertaincostwhichIam happytopayeventhoughIwishthattheeven tuality when I receive anything back from the insurance company does not arise in the first place. CDS works similarly. Consider a mutual fundwhichhasasizeableamountofcorporate bonds in its portfolio. CDS allows the mutual fundtoinsureagainstpossibledefaultofcorpo rate bonds. Consequently, investors in mutual fundswouldnotlosemoneyifthosecorporate

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bonds actually default. Thus, a CDS could help inhedgingcreditrisk. An example of a typical CDS agreement would involve one firm, lets call it CDSbuyer with Rs. 100 crores invested in the bonds of a company called RiskeyLtd. The risk for the bondinvestoristhatRiskeyLtdmaydefault.An other company, say, CDSseller offers to sell CDSbuyer insurance protection against Ris keyLtdsdefault.PerhapsCDSbuyerwouldagree to pay 0.5% a year to insure its Rs. 100 crores investment in RiskeyLtd bonds. All that the CDSbuyer is doing is transferring his risk to CDSseller. The terms of the agreement would spell the circumstances under which CDSSeller would have to pay CDSBuyer and how much, but typically, payment is triggered by formal bankruptcy or failure to pay bond interest. In such a case, CDSSeller would buy the bonds fromCDSBuyeratparorpayCDSBuyerthedif ference between the bonds current market value and their par value. In a gist, the CDSBuyer is transferring his risk to CDSSeller. The origin of the credit risk is in the bonds is suedbyRiskeyLtdandnotintheCDS. Apart from insurance, another signifi cantbenefitofcreditdefaultswapsisthatthey free up capital for productive uses. Investors whowantstobuycorporatedebt,butarewary ofrisk,mightturninsteadtogovernmentbonds orlendthemoneyinthemoneymarket.Butby purchasingprotectionintheformofaCDS,in vestors can go ahead and buy corporate debt, without fear of losing their money. This would increase the supply of capital to corporate in theformofdebt,whichinturnwoulddecrease the cost of debt and cost of capital. If a com pany's cost of capital goes down, then it can invest more. This spurs investments and eco nomicgrowth. CDSletinvestorshedgerisk,resultingin lower cost of capital for firms in the economy.

Whatsmore,theyworktokeepthecreditmar ketshonestandexposenegligenceonthepart ofcreditratingfirms,atendencythatwehave seenintherecentpast.Forinstance,CDSmar ketsforewarnedaboutsovereigndefaultsmuch ahead of the rating agencies. Till December 2009, credit rating of Greece was A, three notches above the BBB rating of India. How ever,CDSmarketswerecorrectlyreflectingthe creditriskofGreece.TheGreeceSovereignCDS was trading way above 300 basis points which then corresponded to a rating lower than BB. Like in any information, there is an element of noisetoo.Butashrewdinvestororregulatoris normallyabletofilteroutthenoiseandextract usefulinformation. Analogously, there are many instances ofacompanybeingratedcreditworthybyrat ing agencies while the CDS trades at a high yield, indicating future credit troublesthe most infamous example being Blockbuster Inc, the movie rental giant which filed for bank ruptcy in September 2010. Enron, WorldCom and Tyco were other cases in point. Typically, marketscanbetterassessacompanysfinancial health than credit rating firms, as they have more collective ability and incentive to do so. Not having a CDS market, as some conserva tivesargue,maymerelyshieldunsoundcompa niesfromhavingtherealityoftheircreditcon ditionexposedtotheaverageinvestor. Inagroundbreakingarticle,OliverHart ofHarvardUniversity,andLuigiZingalesofthe University of Chicago argue that CDS is a valu able asset class as it can forewarn about crisis eventsmuchinadvance(Zingales&Hart,March 2009). One of the problematic aspects in deal ing with financial crisis is prima facie, to know that there is a crunch situation. If diagnosis is doneearlyenough,thereisagreaterlikelihood of limiting the damage due to crisis. Hart and Zingales argue that CDS can assist regulators forewarnaboutpossiblecreditlandminesmuch

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aheadoftimeandhencehelpwiththediagno sisofanimpendingcrisis. To understand the importance of credit derivatives in Indian markets, we need to un derstand the current credit risk management practices in local banks. At present in Indian Banks, credit risk is not actively managed. In fact,eveninleadingprivatesectorbanks,credit riskmanagementsofarhasbeenacaseofallo cating and adhering to a set of notional expo sures.Theseexposuresaresetbasedonindus try and sector limits. They do help in limiting concentration risk but do not help manage credit risk proactively. Presently, there isnt much of incentive for Indian Banks to manage credit risk handson. The accounting guidelines by ICAI are cost based rather than markto market based like IFRS or FAS. So a deteriora tionincreditriskdoesnottranslateintoaloss to the bank in the financial statement unless the loan is in default. So long as default rates arelow,activecreditriskmanagementdoesnt affecttheirquarterendearnings. Inthelastdecade,sincetheIndianecon omy has started to do well, the default rates too have been low. So banks have been quite aggressiveinlendingandhavebeenwarehous ingthecreditrisk.Between2001and2010,In dia's banking industry grew by a whopping 18 percent,from$250billionto$1.3trillion,ona cumulative basis (UNCTAD, 2010). However, if theeconomicenvironmentweretodeteriorate, thereisnoinstrumentavailablethroughwhich bankscanhedgetheircreditrisksincethesec ondary loan market is almost nonexistent. Giventhecontextandtiming,creditderivatives wouldbeanimportanttoolformanagingcredit riskforbanks. India needs a more vibrant corporate bond market so that companies have enough flexibilitytoraisemoneywhenneeded.Oneof

the requirements for creating a vibrant corpo ratebondmarketisavailabilityofriskmanage mentsolutionsthatcanhedgecreditriskofcor poratebonds.Astheeconomyexpands,Indian companieswouldneedfundsfortheexpansion for capital expenditure and new projects. Therefore, a welldeveloped corporate bond marketwouldmakeiteasierforIndiancompa nies to raise financing. So there are pretty strong factors driving the supply of debt mar kets and hence the need for hedging solutions likeCDS. On the demandside, major investors in corporate bonds are mutual funds and insur ancecompanieswhoareflushwithfunds.Cur rently the only way to hedge default risk is to layofftherisk.Butthenagain,thereisntaliq uid secondary corporate bond market and it is unlikelythattherewouldbealiquidsecondary market for corporate bonds in the foreseeable futureinIndia.Socreditderivativeswouldpro videausefultoolforhedgingcreditriskofbond portfoliosformutualfundsandinsurancecom panies.Thisshouldgiveafilliptothecorporate bondmarket. The initiative by RBI to introduce CDS would allow insurance companies, housing fi nancecompanies,providentfunds,listedcorpo rates and foreign institutional investors to hedge their exposures on listed corporate bonds.TheRBIhasalsoallowedCDStobewrit ten on unlisted but rated bonds of infrastruc ture companies. Besides, unlisted or unrated bondsissuedbytheSPVs(SpecialPurposeVehi cles) set up by infrastructure companies are alsoeligibleasreferenceobligationonCDS.So, the centralbank has tried to address the need forhedginglongdatedcreditriskofinfrastruc turecompaniesthesectorthatperhapsneeds the largest amount of investment in the coun try. Given the long gestation periods of public services projects in India, infrastructure bonds

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are typically long dated. Investors shy away from investing in infrastructure bonds because of their long maturity and the uncertainty re garding default due to frequent costoverruns. These concerns and risks can now be hedged withRBIallowingCDSoninfrastructurecompa niesandtheirSPVs.Exante,substantialbenefit should accrue to the infrastructure industry given RBIs effort in specially allowing hedging ofcreditriskinthissector. WhileCDSisausefulhedgingtool,how ever, if not properly regulated, it can become an instrument for unbridled speculation. Ac cording to the International Swaps and Deriva tivesAssociation(ISDA),theamountofCDSout standingasofthebeginningof2011was$30.4 trillion. Compared to this, the US Treasuries market is $4.4 trillion and its corporate bond market is $3.6 trillion. The worlds richest per sonhasapersonalnetworthof$53billionand one of the most cash rich corporations in the world, Apple Inc has a cash pile of $46 billion. For sure, there isnt $30,400 billion of money out there that needs to be hedged, which is what the current size of CDS market is. Quite evidently, a loosely regulated credit derivative market had allowed market participants to in dulgeinrampantspeculation. If inadequately regulated, CDS may not be as benign as insurance. For instance, insur anceisregulatedinsuchawaythatIcaninsure for my own house, but I cannot buy insurance onmyneighbourshouse,becauseIdontown that asset. Moreover, I cannot sell insurance

unlessIsatisfyaspecifiedsetofstringentcrite ria. However, the way CDS market is currently regulatedglobally,makesitpossibleforalarge number of market participants to speculate by being able to buy or sell CDS contracts. For in stance,ahedgefundcanagreetoprovidepro tectionagainstcreditriskbypostingasmallcol lateral.IfitindeedhadtopayupontheCDSin caseofadefault,thereisaprettyhighchance that it wont be able to make good the pay ment.AIG,whenitwasbailedoutinSeptember 2008,washoldingCDSpositionworth$441bil lion, which is quite high compared to the kind of cash corporations normally hold. If AIG had not been bailed out, all the entities which bought protection on the CDS from AIG would have been left high and dry. Loosely regulated creditderivativesmarketcanallowmarketpar ticipants to become overly levered as in the case of AIG. To get the valuable benefits from this asset class, it needs to be regulated effec tively. Introducing CDS is a praiseworthy move by the RBI because the easier option would have been to do nothing. We ought to give credit to the central bank where due, for not shirking on the mandate to develop the debt market microstructure despite the potential peril of high political cost. CDS were wrongly accusedofbeingpartoftheprobleminthere cent financial crisis. It is only fair that they are nowseenaspartofthesolution.

References: [1]UNCTAD,U.N.(2010).GlobalTrendsinFDI.WorldInvestmentReport. [2]Zingales,L.,&Hart,O.(March2009).ToRegulateFinance,TrytheMarket.ForeignPolicy.

K.Vaidyanathan HeistheCEO,QuantumPhinanceandisaVisitingFacultyatIIMCalcuttaandSPJIMRSingapore, Sydney&Dubai.HeisaB.Tech(IITKanpur),PGDM(IIMAhmedabad),CFA(CFAInstitute,Char lottesville)andaformerInvestmentBankerwithJPMorganChase,Singapore.HisbookonCredit Derivativesisduetobeoutsoon. 12

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SEBI (Alternative Investment Funds) Regulations

Abstract:OnAugust1,2011,theSecuritiesand Exchange Board of India (SEBI) released a con ceptpaperontheproposedregulationofAlter nativeInvestmentFunds(AIFs)inIndia.Thepa per was accompanied by a draft set of regula tions,whichwereopentopubliccommentstill August 30, 2011. As mentioned in the concept paper,SEBIsmainobjectiveistobuildaregula tory framework that reflects the broad spec trum of AIF investment strategies in the mar ketplace,setoutcertainconditionswhichapply toallAIFsand,inaddition,aspecificregimefor each identified investment strategy. While the newAIFregulationsaremuchneededandarea step in the right direction, there are certain clauseswhichneedmoredebate.Inthispaper, we review the salient features of the concept paperanddraftregulations.Wealsodiscussthe merits and demerits of the various rules and regulationsproposedbySEBI. I. Introduction SEBI (Venture Capital Funds) Regulations were framedbySEBIin1996inordertoboostinvest ments in earlystage companies. However, we observethattheseVCFsarebeingusedasave hicle for different categories of funds like pri vate equity (PE), private investment in public equity(PIPE),realestatefundsetc.SEBIrecog nizes that there is an economic rationale for existence of these funds. However, as a result, theoriginalobjectiveofboostinginvestmentsin startups or earlystage companies has been neglected.Also,SEBIisnotabletoprovidespe cial concession to those funds which want to invest in earlystage companies. At the same time, the regulations created for VCFs may be restrictive and inappropriate for PE and PIPE funds. Thus, SEBI recognizes that the private investingspaceinIndiahasbecomemuchmore sophisticatedthanitwasin1996andthereisa needofanewsetofregulationswhichcandeal 13 withthecomplexecosystemofprivateinvest II. SEBIs draft regulations for Alternative In vestmentFunds Letusdiscussthefewimportantsectionsofthe draftregulationsandstudytheirmeritsandde merits. 1. Section 2(1): Definitions (Categories of AIFs) Regulation: SEBIhasdefinedninedistinctcategoriesofAIFs: (i)VentureCapitalFund,(ii)PIPEFunds,(iii)Pri vateEquityFund,(iv)DebtFunds,(v)Infrastruc tureEquityFund,(vi)RealEstateFund,(vii)SME Fund, (viii) Social Venture Funds and (ix) Strat egyFund(ResidualCategory,includingallvarie ties of funds such as hedge funds, if any). In chapterIVofthedraftregulations,ithasmen tionedinvestmentconditionsforeachofthese ninecategories. Opinion: The nine categories formed by SEBI are funda mentallyincoherent.Inthiscategorization,SEBI has mixed up two different characteristics of funds: (i) Stage: According to the stage of in vestments(i.e.earlystage,growth,preIPO),we cancategorizefundsintoVCfunds,SMEfunds, PEfunds,PIPEfundsetc.(ii)Industry:According totheindustryofinterest,fundscanbecatego rized into Real Estate funds, Infrastructure funds etc. If SEBIs categorization is imple mented, PE funds would have to go through complicated structures to make their invest mentstrategiesflexible.Forexample,agrowth equityfundinIndiawouldalsowanttoinvestin infrastructurecompaniessinceinfrastructureis aboomingsector.Intheregimerecommended bySEBI,thePEfundwouldneedtoregistertwo separate funds: one Private Equity fund and

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one Infrastructure Equity fund, in order to strategy.Thiscausesanunnecessaryincreasein thecostofcomplianceforPEfunds. Ontheotherhand,itmayhappenthatall multistrategy funds would register under the residualcategoryi.e.Strategyfunds.Ifthishap pens, the regulation brought in by SEBI would be ineffective in providing targeted benefits since most funds in India are multistrategy funds. TheobjectiveofSEBItoprovidetargeted benefits can be easily achieved by defining benefits in the context of types of investments instead of types of funds. For example, investments in social sector, infra structure, early stage companies and SPVs can be specifically provided the desired benefits whilenotrestrictingthefundstofitintooneof theninecategories. 2. Chapter IV (1525): Investment conditions inrespectofdifferentcategoriesoffunds In chapter IV of the draft regulations, SEBI has mentioned investment conditions which each categoryoffundsneedstofollow. A. Regulation: Section 16(2): The total investment in the ven turecapitalfundshallnotbemorethanRs.250 crores.Section16(3):VCFshallnotinvestinany companythatispromoted,directlyorindirectly byanyofthetop500listedcompaniesbymar ketcapitalizationorbytheirpromoters. Opinion: The restriction of Rs. 250 crores on the fund sizeofaVCFishighlyrestrictive.Theamountof Rs.250croresislowascomparedtotheoppor tunitiescurrentlyexistingintheIndianmarket. Also,therestrictionofnotbeingabletoinvest in any company promoted by top 500 listed

companies will create substantial problems in fund raising and deployment. Thus, both these recommendationsneedtobeworkedonasitis unclearwhatSEBIintendstoachievebyputting theserestrictions. B. Regulation: Section17(1) PIPEfundshallinvestinshares of small sized listed companies which are not partofanymarketindicesinexchangeshaving nationwideterminals. Section 17(4)(i): Access to nonpublic informa tion is given only for the purpose of carrying duediligenceforPIPEtransactionsunderacon fidentiality agreement. Section 17(4)(ii): The PIPE fund shall be prohibited from selling or dealing in securities of investee company for a periodoffiveyears. Opinion: ItisextremelyrestrictivetosaythatPIPEfunds caninvestonlyincompaniesthatdontforma partofanyofthestockexchangeindices.Listed companies of all shapes and sizes require growth/expansion capital as much as smaller companies do, and such a restriction will se verely cramp the avenues for funding for large companies, which can only be detrimental to our economy. It will also make the universe of listed company investment opportunities in In diaverylimitedandunappealingtoprivateeq uityfunds. Section 17(4)(i) is a regulation which will bewelcomedbyallPIPEfunds.ItwillallowPIPE funds to freely conduct duediligence under a confidentiality agreement, while being pro tected from Insider Trading restrictions. How ever, section 17(4)(ii) says that any PIPE fund which invests on the basis of nonpublic infor mation cannot deal in the securities of the in vesteecompany for aperiod of five years. The basic logic behind this is: SEBI wants to allow time for the nonpublic information to be

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come public so that there is no information asymmetrybetweenthePIPEfundandtherest of the public market investors. However, the period of five years seems too long for this. GiventheefficiencylevelsoftheIndianmarket, a period of six months to one year should be enough for dissemination of the nonpublic information. 3. Section(3):Scope Regulation: All Alternative Investment Funds in securities market, irrespective of their legal domicile whichcollectsitsfundfrominstitutionalorhigh net worth investors in India or the manager of such fund who manages the fund for invest mentsinIndia,shallbeboundbytheseregula tions and be subject to registration and over sightoftheBoard. Opinion: As we see, the scope of the AIF regulations is very wide and includes funds which invest in andraisecapitalfromIndia.Eventhoughthere isaneedtoregulateallsuchfunds,thereneeds to be a different approach to regulate the dif ferent types. The fund could be divided into three types: (i) Funds which raise capital from andinvestinIndia,(ii)Fundswhichonlyinvest in India and (iii) Funds which only raise capital fromIndia. Categories(ii)and(iii)ofthesefundscan bedealtwithseparately(withalighterversion ofthesameregulations)sothatitdoesnotdis courage foreign funds from investing in and raisingcapitalfromIndia. 4. ChapterIII:InvestmentConditionsandRe strictions Regulation: Section 10: The sponsor of the Fund (if in the

formofatrust)ortheDesignatedPartner(ifin the form LLP), or directors (if in the form of a company) shall contribute from their own ac count an amount of investment equal to at least5%oftheFundandthisshallbelockedin tilltheredemptionbylastinvestorinthefund. Section 11(1): The funds shall be close ended andthedurationoffundshallbedeterminedat thetimeofregistration. Section 11(5): If any of the investments remainunliquidatedattheendoftenureofthe fund,thesponsor,managerordesignatedpart nershallbeliabletotakeupsuchinvestments. Opinion: AccordingtoSEBI,thepurposeof section10is to solve the conflict of interest problem be tween investors and the sponsor of the fund. Themarketpositioninternationallyisinthere gionof12%ofcapitalcommitments.5%isvery high and will make eligibility difficult for non institutional and firsttime sponsors in particu lar.Thiswillleadtoalossoftalentedsponsors fortheinvestingindustry.Thus,SEBIshouldnot specify the amount of personal capital which the sponsor will put into the fund and let the investors in the fund make that decision. The clauseinsection10relatedtolockinofinvest ment is also problematic. Ideally, the lockin requirement should be subject to a proration clause. The sponsor should be entitled to a re turnofcapitalalongwiththeinvestorsprorata foreverydistribution.Otherwise,itdoesnotfit conceptuallywiththemarketpracticefordistri butionwaterfalls. Withrespecttosection11(1),thereisno rationale given by SEBI to ban open ended fundsinIndia.Thus,therestrictionofallfunds beingcloseendedshouldberemoved. If section 11(5) was implemented, i.e. sponsors were forced to acquire unliquidated

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portfoliooftheAIF,itwouldbecounterproduc tive. It will pressurize the sponsor to exit at valuations less than fair valuation. This could severely impact the returns that the fund can maketotheinvestors. Permittingthemanager todistributetheassetsofthefundtotheinves torswouldensurethatthemanagerwouldnot make a distress sale. The distribution of assets to investors is in line with the current market practice which gives greater flexibility to the managerinliquidatingthefund. III. Conclusion:Openquestions Afterreadingthedraftregulations,someques tionsremainunansweredandsomenewques tionsareraised.Forexample,thedraftregula tions propose that the current Venture Capital

Regulations (1996) will be repealed, but that existinginvestmentsmadeundertheVCFRegu lationswillcontinueunderthesaidVCFRegula tions. However, it does not mention anything abouttheexistingForeignVentureCapitalInsti tutions (FVCIs) and their investments. It is also unclearwhatSEBIintendstodowiththeexist ing Foreign Institutional Investors (FIIs). Is the intention of the SEBI proposal to completely replace the FII and FVCI regimes with the AIF regime?Also,severalexistingFIIswillbecaught underoneofthecategoriesoftheproposedAIF regime. How will this conflict be addressed? Thesequestionsneedtobeclarified. Thus, all in all, the new AIF regulation by SEBI is a step in the right direction; however, the details need to be worked out in detail so that the desired objectives are achieved while allowing private investments to flow into and boosttheIndianeconomy.

RohanChinchwadkar RohanChinchwadkarisaPhD(Finance)studentatIndianInstituteofManagementCalcuttaanda BachelorofTechnology(Electronics)fromV.J.T.I.,Mumbai.Hisresearchinterestsincludecorpo ratefinancetheory,corporategovernance,privateequity,behavioralfinanceandsocialnetworks. HehasreceivedjoboffersfromprestigiousfirmslikeMcKinsey&Co.andJ.P.MorganChase.Ro hanhasbeenpassionateaboutentrepreneurshipafterhisstintasLeadDesignEngineerwithBio senseTechnologies,amedicaldevicestartupwhichwasincubatedatIIMAhmedabad.

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Further monetary stimulus will push the re covery of the US job market
The US economy could add just over 15,000 jobs in June 2011, which was lowest in nine months. Data for May was revised downward. The unemployment rate stayed at 9.1 percent for August. Since the federal fund rateswereclosetozeroforthelasttwoyears, theUShadtriedtopacetherecoverybymeans ofuntraditionalmonetarypolicy,chieflywhatis now popularly known as Quantitative Easing (QE). Subsequently, they infused money (QE2) in the economy in August 2010. Does it really favored the US or the Fed? If one looks at the unemploymentrate(table1)sincetheQE2,itis evidentthatithasnotmadeamajorimpactas far as the issue of creating jobs or containing unemploymentrateisconcerned.Thisindicates that the effects of the massive fiscal and monetary stimulus packages are dissipating while unemployment rates are still high whereas other global economies have been technicallyoutofrecession.Thisbringsseveral questions for the developed economy government like the US i.e. what are the measures available to check the high employmentrateandgettingbackonthetrack of the recovery. Is it possible to maintain
Year 2007 2008 2009 2010 2011 Jan 4.6 5.0 7.8 9.7 9.0 Feb 4.5 4.8 8.2 9.7 8.9 Mar 4.4 5.1 8.6 9.7 8.8 Apr 4.5 4.9 8.9 9.8 9.0 May 4.4 5.4 9.4 9.6 9.1 Jun 4.6 5.6 9.5 9.5 9.2

sustained fiscal burden without dampening with recovery? What are the steps require curbingthehighunemploymentrate? Before looking into the measures required for higher growth rate and increasing employment, one needs to understand the reasonsbehindtheslowgrowthintheUS.The dismal state of growth in the developed economies comes from two sources: low consumption and low investment (high savings). On the one front, households are saving instead of investing or consuming because of a renewed conservative approach after the subprime crisis; on the other front, the financial system is still tightly rationing credit to businesses. The downside risks for a slower recovery in 2011 relative to 2010 are realasthedifferentstimuluspackageinitiatives arewearingoffwhichcanbeobservedwiththe new employment figure added in last two months visvis four months before . At the sametime,theneedforstabilizingthebudgets of US in the medium term due to aggressively running overaccommodating fiscal policies in thepasttwoandahalfyearsisnecessary.How
Jul 4.7 5.8 9.5 9.5 9.1 Aug 4.6 6.1 9.7 9.6 Sep 4.7 6.2 9.8 9.6 9.0 Oct 4.7 6.6 10.1 9.7 Nov 4.7 6.8 9.9 9.8 Dec 5.0 7.3 9.9 9.4 Annual 4.6 5.8 9.3 9.6

9.1 9.1

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can a country service their public debt with millions of workers unemployed and the demographic shift to an aging population? In the United States, the market for sovereign debt is not closed and the country can borrow at zero percent short term and around 2 percentinthelongterm,sothereisanoption for US to continue to stimulate the economy. The danger for the United States would be to hamper its economys potential by keeping its labor force idle too long. An exaggerated time of idle labor can significantly lower the potential labor force as disillusioned workers will give up and their skills will become obsolete, particularly in highly skilled tech industries. One probable and feasible option availabletotheUSFedistoinfusethirdround of quantitative easing QE3 which Federal Reserve chairman, Ben Bernanke had announced in July 2011 in a press conference. This is necessary if the economy fails to gain momentum in the second half of the current year. Without a stimulus, demand will remain weak and the damagecould be extensive. This is the view of President Obamas economic team. Their policy recommendation is to not frontload the deficit reduction while keeping an eye on the consolidation of the longterm debt. But they could not avoid debt ceiling of $14.3trillionwhichresultedindowngradingof bonds from AAA to AA+ by S&P. In a recent pressrelease,BernankesaidathirdroundofQE might become warranted if necessary to boost a U.S. economy challenged by unemployment and financial turmoil. The Fed may choose to purchasetoxicmortgagebackedsecuritiesfrom the banks in QE3. The Fed has already purchased $2.3 trillion of debt to bolster the economy in first two rounds of quantitative easing. Earlier Fed chairman refused to act in

favorofQE3asQE1&QE2didnotfullyserveits purpose of stimulating the economy though it helped in containing the unemployment level close to 9 percent, which might have crossed 10%intheabsenceofanystimulus. Bernanke said the central bank is prepared to provide additional stimulus if the current US economic slump persisted. He mentionedthattemporaryfactors,suchashigh food and petrol prices, had slowed the economy,andthatgrowthshouldpickupwhen thosefactorseasetowardstheendoftheyear. Ifthatforecastproved wrong,hesaid,theFed waspreparedtodomore. TheneedofthehouristheUSeconomy typically needs to add 125,000 jobs per month justtokeepupwithpopulationgrowth.Andat leasttwicethatmanyjobsareneededtobring downtheunemploymentrateunlikethecasein MayJune 2011. Hence it has become a desperate need for US to infuse monetary stimulus to provide more money in the banks whichwilllendmoretothecitizensandthereby increasing the demand and the spending of households.Thereducedinterestrateforbanks and corporate will provide a push to the recovery and investment activity thereby generating the required employment. If these stepsarenottakenrightnowthenUSeconomy wouldbeheadingtowardsdoublediprecession which will again take years to recover from. Global impact of US economy cannot be ignored,whichmightrepeatthestoryof2007 2008 crisis. It is evident from the last stimulus infusedintheUSeconomywhichaccountedfor highjobopportunitiesforlast1year.Butsince the effect of stimulus has gone and the recovery is not yet sustained to take care of creating employment which left the Fed only with the option of infusing money in the system.

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Everyactionhastheflipsideassociated with it; here it is the burden that this kind of stimuluswillbringontheUSfinance.ThisQE3 wouldresultintheworseningofthesituation thegrowingdebtonthenationbeingtheissue of primary concern. Also the dollar will depreciate with respect to other international currency which might again lead to further downgradingofUSlongtermdebt.Besides,the decision of rolling out QE3 is likely to impact the world economy given the already existing negativeoutlookduetotheEurozonecrisisbut delayinrollingoutstimuluswilltendtoimpact the worsening state more severely. Already rates for basic commodities like petrol, foods etcarehigh.

Will this stimulus impact inflation? The answer is yes. This is again a critical problem which will reduce the real effect of stimulus. However, one cannot do about it just yet as investment in infrastructure, education and healthisessentialforstimulatingtheeconomy, addingmorejobsintheprocess.HenceQE3or any other monetary stimulus is of utmost importance in the scenario existing in todays US labor market; QE3 can be delayed but it cannot be avoided for pacing up the recovery. The whole world is watching the US monetary policy closelythis is a decision which has far reachingconsequencesevenasMr.Bernanke gearsuptoannouncethenextcourseofaction thatwillbetaken.

References: [1]http://www.msnbc.msn.com/id/43729201/ns/businessstocks_and_economy/t/fedgrowingmore worriedaboutweakeconomy/ [2]http://data.bls.gov/timeseries/LNS14000000 [3]http://www.ibrc.indiana.edu/ibr/2010/outlook/international.html [4]http://www.guardian.co.uk/business/2011/jul/13/bernankereadyformorequantitativeeasing

KuldeepPrasadNigam KuldeepisafirstyearPGDMstudentatIIMCalcutta.Hecanbereachedat kuldeepn2013@email.iimcal.ac.in

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Greed in not evil..

MahatmaGandhioncefamouslyquoted Theearthhasenoughformansneedbutnot for mans greed. The problem with greed is that it is deeply embedded in our systems. Greed is right. Greed is good. Greed cuts through and captures the essence of the evolutionary spirit. Movie fans would be familiar with this statement from the protagonist Gordon Gekko in the 1987 movie Wall Street. Though it signifies a sense of arrogance,thegreedIamreferringtoshouldbe clearly demarcated from complacency and dissoluteness.Greediswhatdrivesus,itiswhat we strive for and it is a part of our daily functioning. Ingrained in our psyche is the inherentneedtowantwhatwedonthave,the needtopushtheboundariesfurther. Benjamin Friedman, as a result of an examination of the economic and social histories of the United States, Britain, France, Germany and a number of developing economies that he describes in his book The Moral Consequences of Economic Growth, believes that growth does translate into a globaleconomy. Heassertsthateconomicgrowthfostersa moral society characterized by openness of opportunity, tolerance, economic and social mobility, fairness and democracy. Similarly, economies that fail to grow run the risk of encountering the reverse effects. His analysis suggests that major events occurring in responsetoperiodsofgrowthfosteropenness, tolerance, mobility, fairness and democracy. Thereverseisalsotrue.Butontheotherside, 20 our environment is beset with problems, from climatechangetodeforestationtospeciesloss, which are driven by the unsustainable habits otherwisetermedasgreed. This opens up a Pandora s Box. How much growth is too much? Lets examine this with an economic principle of rival and non rival goods. A rival good is one where if one consumes it, it prevents the other from consuming it and viceversa. Nature is a rival because it is a scarce commodity and similarly water is a rival too. Some resources, such as wood, are rival generationally, since within a generation there is only a limited supply, but canbenonrivalinthelongtermonlyandonly if exploited at levels of sustainable yield. Propheticasthesewordsmayseemitisalmost redundant today because who is to define the level of sustainable yield because there is no saturationleveltomansgreed.

The only solution to this is the capand tradesystemotherwiseknownasthesystemof

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tradingcarboncredits.Foreveryeconomy,rival resources such as polluting rights would be capped at an ecologically sustainable level and thentradedonamarketwhereinifaneconomy doesmanagetousetheresourcesjudiciouslyit earns certain carbon credits. This provides economieswithanimpetustobecautiouswith haphazard growth. Finally, the decision of wheretoplacethecaponthescaleoftheuse of a resource must be a social and ecological decision. Morally,itisacoalvs.coraldebateforthe

simplereasonthatthissortofgrowthmightnot be sustainable in the long run. Your guess is probably as good as mine but to put a tab on growthwouldbetocurbthenaturalinstinctsof humans. In saying so, selfdiscipline as an attitudeshouldideallybetheanswer.Themore importantfoodforthoughtisIsselfdiscipline and austerity the only answer or are the only words meant to remain in the realm of the spoken but not in the realm of things that are done.

AnjithMathur AnjitMathurisafirstyearPGDMstudentatIIMCalcutta.Hecanbereachedat anjitm2013@email.iimcal.ac.in

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Is Greece a confirmation that we are Predictably Irrational?

"The habit of reading is the only enjoyment in which there is no alloy; it lasts when all other pleasures fade.", so said the English novelist Anthony Trollope. I am sure it does not hold good for reading the newspaper these days which is indeed a traumatising experience. Speculationsonwheretheeconomyisheading, how the markets are going to be tomorrow, storiesonhowthepremiersofdifferentnations arehavingatoughtimetryingtoconvincetheir subjects about their plans, articles on which could be the next country to default on its sovereign debt and when, coverage of leaders meetingtodecideifacountryshouldbebailed out or not, estimates of the future value of different currencies, job cuts garnished with pay cuts, new theories being propounded to explain how we managed to reach the present state of affairs most of which many do not understandandtothosewhounderstanditjust addstotheanxietyandmisery. ThestoryoftheGreekdefaultandtheincidents that led to it has indeed superseded similar happeningsinotherEuropeancountries.Ithas reachedcelebritystatus,afterbeingcoveredin every possible angle by most news agencies worldoverindifferentmediaandhasprobably madeittotheheadlinesmostnumberoftimes with pictures of protests outside the Greek parliament splashed several times on leading dailies.Neverthelessletmestilldothehonours ofstatingitinmystyle.TheGreekgovernment borrowed indiscriminately from the capital market to fund its budget deficit and current account deficit. In 2009, Greece had a budget deficitof12.7%ofGDPandpublicdebtgreater than120%ofGDP.Theproblemwasfuelledby internal factors like tax evasion amounting to around $20b a year, corruption and the government not really keeping a tab on its 22 expenditure, and external factors like the introduction of the Euro and availability of fundsatalowinterestrateforborrowing.Soon investors began to doubt if Greece would be able to repay. Credit ratings were downgraded to reflect this loss of faith with Greece being ratedatthelowestpossiblerungofCCCbyS&P. Thereafterthecontagioneffectoccurredwhen other larger countries like Portugal, Italy and Ireland too lost credibility leading to a crisis in theregion. Some of the consequences of the Greek government's attempts to reduce its public debt are worth taking a look. Foremost is the freezing and cutting of public sector pay, bonuses and perks as well. Employers have been given greater freedom in terminating the services of employees and the young generation taking up employment can be paid less than the minimum wages. A pension reformwasalsopassedinprincipleredefininga lot of clauses in that regard including cuts in socialsecurity.Ablanketingmeasureincreases in several types of taxes was imposed. Special levies to be made on those belonging to high income brackets. Even education has not been spared and the expenses for the same have beenreduced.Privatisationandcutsindefence expenses and healthcare are other consequences. The only good that can be spotted is the increase in excise taxes on fuel, cigarettesandalcoholprobablyagoodtimeto go green and enhance the longevity of the planet and the lives of the citizens provided they survive the havoc wreaked otherwise by the economic crisis. These austerity measures clearly bring out what a strong hold the past has on the present and the future. Given that education,employment,oldagecareandsocial security are in jeopardy it is bound to cause a

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bigdentonhumanresourcedevelopment.Such announcements have been met with demonstrations, clashes and strikes and have ledtoAthenswitnessingviolenceandevenloss of life at times. In fact experts have expressed views that further austerity measures could lead to violation of basic human rights. These measures are aimed at saving 30b over three yearsandbringdownthedeficittolessthan3% ofGDPby2014. The world is not new to the phenomenon of sovereigndefault.AccordingtoanMITstudyon such incidents the first ever default on record datesbacktothefourthcenturyBCwhenmany of the Greek municipalities defaulted on their loans from the Delos Temple. The coincidence of it being the Greek then as well is striking indeed. However between this archaic Greek myththatwasrealityandthelatestonerocking the frail world economy, history has been dottedwithplentyofsimilaroccurrences.Many studies have brought out the fact that when economies make their transition towards becomingadevelopedeconomy,serialdefaults are bound to happen. But Greece does not qualify as one. So it is not just once but on several occasions that countries have been allowed to borrow indiscriminately and build huge deficits followed by a realisation of their inabilitytopaybacktriggeringacrisis.Whyhave investors repeated the same mistake over and again? Why werent lenders careful and strict while lending to these countries? Instead they areallowingthemtobuildtheircurrentaccount deficits as in 2010 when Greece revised its targetforitsdeficitto9.4%from7.8%ofGDP. Have they been that short sighted and lent withoutevaluatingmeansofpayback?Itcanbe appreciatedthatunfortunatelytwoofthemost important industries in Greece, tourism and shipping were indeed hit by the recession but wheredidtheconceptofcontingencyplanning vanish? Then havent hasty decisions been made by lending without evaluating all factors

orhasthemarketwhichhasnowrealisedthat Greecewillnotbeabletopaybackitsdebt,not been efficient enough to capture this early enough? On the other hand why hasnt the borrowing country ever feared that it will be unable to bear the burden of the debt? Are rules there to follow or break? All this has happened in spite of the ceiling that the European Monetary Union stipulates for its

membernationswhichisabudgetdeficitofless than 3% of GDP and a public debt of less than 60%ofGDP.Yetanotherpainfulaspectisthatit is not just one country that has done this but manymore. Ifsomuchdebtcouldbepiledupbeforeitwas realisedthatGreecewoulddefaultthenarewe lackingmonitoringmechanisms?Areourcredit ratingmechanismsfaulty?Itisbelievedthatin October 2009, the Greek government notified thatthedeficitfor2008wasrevisedfrom5.0% to7.7%ofGDPandthetargetfor2009wentup from 3.7% to 12.5% of GDP. Following this in the end of 2009 Greek debt was downgraded fromAtoBBBbyFitchwhichseemsmorelike areactiontotheannouncementratherthanan independent evaluation by any of the credit rating agencies. In a way isnt this Euro zone crisis similar to the subprime mortgage crisis except that the defaulters there were individuals while it is nation states today. Probably the latter came on the heels of the

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former that we did not find enough time to learnourlessons. Thewaythingshaveprogressedonecannotbut concur with the views Dan Ariely expresses in hisbookonbehaviouraleconomics'Predictably Irrational'. He illustrates how we make simple mistakeseverydayandwetendtorepeatthem several times. Probably a good illustration of thiswouldbethefactthattheGreekbondissue of 5b in January 2010 was in fact oversubscribed given that people had sensed trouble with Greece by the end of 2009. However it looks like what we are going through is the consequence of such repetitive cumulative mistakes committed by numerous people. He also discusses how our first impressions serve as anchors in our minds and everythingelsethatfollowsisbasedonthem.Is itbecauseweareusingtheexcruciatingcrisisof 20082009asananchorthatwhatfollowsdoes notseemtoscareus? Science and technology have time and again proved how the world has shrunk and how connectivityhasimproved,butitlookslikethe financial crisis best brings out how interconnected and interdependent we are. Banks in the other European countries majorly Germany, France and the United States have exposure to Greece and the other troubled nations.Intheeventofthesebanksandnations beingintroubleitwillnodoubthaveabearing References

ontheothereconomiesintheEasttoo.Growth inEuropehasbeencurbed,thanksagaintothe crisis which needs to be contained. Special purposevehiclesandentitiesliketheEuropean Financial Stability Facility (EFSF) have been establishedandhavebeenhandingoutbailouts only to reach a stage where it might not be possible to do this to everyone in future. Debt begetsdebtandcountrieswhichlentmoneyto thesetroublednationsareforcedtohelpthem with the bail outs as well. Germany, in an attempt to save its banks that are highly exposed to Greece, has had to bear the lions share of 22.4m of the bailout amount of 110mgivenoutearlierthisyear.Inspiteofthe injectionofthesefundsGreecehasnotrevived andislookingforwardtofurtherassistanceonly to be threatened by Germany that the next round of aid might not happen. Germany furtheropinesthatthereisanecessitytobuild a fund to provide bridge loans to financially troublednationsandbanksinthefuture. Ethical working of governments, continuous andfirmmonitoring,carefuldecisionmakingby investors are required in the future to avoid such incidents from repeating so that the generationstocomedonothavetogothrough the hardship the world has witnessed, for the impactsofthislongdrawncrisishavebeentruly global.

1. Greeces Debt Crisis: Overview, Policy Responses, and Implications by Rebecca M. Nelson, Paul Belkin and Derek E. Mix 2.http://www.ft.com/intl/cms/s/0/f77790d0-27c2-11df-863d-00144feabdc0.html#axzz1dmZO7z7Y 3. http://www.guardian.co.uk/world/2010/apr/11/eu-greece-bailout-terms 4. http://www.ocolly.com/opinion/greek-mess-has-american-implications-1.2688771 5. http://online.wsj.com/article/SB10001424052748704182004575055473233674214.html 6. http://en.wikipedia.org/wiki/2010%E2%80%932011_Greek_protests 7. http://www.piie.com/publications/papers/kirkegaard-20100212-rt-fig.pdf-Datastream; European Commission COM2010 (1).

ManasaMadhavan Manasa Madhavan, a second year student PGDM student in IIM Calcutta, graduated from Anna UniversitymajoringinIT.SheisspecializinginFinanceandisinterestedintheareasofcorporate financeanddealmaking.Shecanbereachedatmanasam2012@email.iimcal.acin 24

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Is Indian stock market really efficient?

How far is the Indian stock market from being efficient? I have tried to findthe answer throughsomestatisticaltestsaswellasmarket trends.Thetestresultsarebasedonreturnon adjusted closing prices of Nifty from 12 Aug 2002to22September2011. Stochasticreturns Onethingthatwecanbecertainaboutis the daily returns are not auto correlated with previousdaysreturn.DarwinWatsonstatistic forS&PCNXNiftyis1.99(closeto2meansnon autocorrelated).Ifweextendthelaggingnum berofdaysfrom1to10,theregressionresults againshowsthattodaysreturnisnotrelatedto any of the past 10 days return assuming 99% confidence level. Day of the week effect also doesnotexistforNifty.Thiswillgivesolaceto the retail investors that stock price movement is random. If other public and private non market information is not taken into account, with the past data we can say, the FII, DII and Retailinvestorsareinequalpositiontoreapthe benefits(maybesufferlosstoo!). Lawofoneprice Arbitrageworksverywellforstockslisted on both BSE and NSE. The price difference of anystockinthesetwomarketsisnegligibleand hence,Lawofonepriceholds. But,thisdoesnotimplythedailyreturns are perfectly normally distributed. While the distributionexhibitsmuchtallerpeak(Kurtosis: 9.33) than a normal distribution, the tails are thinner(Skewness:0.23)thanusual. Inefficiencyinthemarket 25 Mutual Fund: Mutual fund advertise ments always claim to outperform the bench mark(NiftyandSensexforEquityMF).Accord ingtoValueResearchdata,except2008,inthe years from 20022011, the average number of mutual funds outperforming Sensex is stagger ing81%withminimumof76%.In2008,thecor respondingnumberwas7%. Theprobablerea son could be expertise of mutual fund manag ersorincorrectbenchmarkintheformofNifty orSensex.IfwelookatUSmarket,percentage ofEquityMFsoutperformingtheirbenchmarkis low. So, inefficiency of Indian market could be another possible reason for the discrepancy. The mutual fund managers have access to pri vate information which helps them making in vestment decisions and subsequently reap the benefits. Unfortunately, the information is not availabletoretailinvestorsintherighttime. ParticipationofRetailinvestors As India is growing at 78% rate in the pastdecade,themarketcapitalizationofIndian companies have improved from USD 165 bn in 2001toUSD1.3tnin2010,whichisanapproxi mate increase of almost 8 times. But market developmentandpenetrationhasnotincreased proportionally. Number of active stock ex changes has reduced from 23 in 2001 to 4 in 2008. The market for derivative products like interestrateisstillnotmatureenoughinIndia. Equityandequityderivativescontribute67%of tradedactivitiesinBSEandNSEisalsowaybe lowthepeerexchangesinChina,Taiwan,Korea andUSA.Lowervelocityindicateslowerliquid ityinthesystem.Again,penetrationwise,more

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than 80% of the turnover comes from 5 cities with Mumbai (55%) and Delhi (15%) contribut ingthemostwhilenationalincomepercentage of these two cities are 24%, a stark contrast. NumberofDemataccountperpopulation(1.4) forIndiaiswaybelowthedevelopedcountries likeUSA(17.7)andalsootherBRICcountries. Awarenesslevelsarealsoverylowamong Indian investors including Institutional inves tors. According to a recent survey by MCX, morethan50%ofthepeoplesurveyeddidnot have ideas on how to invest in stock market. While market regulator SEBI is encouraging more retail participation to improve efficiency of the system, the Direct Tax Code gives the provisiontoaddthecapitalgainstoincomeof theinvestorandhencetaxaccordingly.Thein dividuals in lower income group will get the benefit as the tax rate on short term capital gainiscurrently15%. OverpricedIPOs DuringApril2010toMarch2011,70%of the55firmsraisingcapitalviaIPOweretrading below their offer price. Moreover, the firms traded at premium on their listing days, but prices fell rapidly on subsequent trading days. ThisisamajorissueintheIndiancapitalmarket now.Retailinvestorsusuallyinvestinthestock market with short to medium time frame. The overpricing of the IPOs is dissuading them to refrain from investing. SEBI needs to discuss

this issue with the merchant bankers and the companies to not cash in on the investor un awareness. Usefulnessof an efficient capital market for a nationsgrowth Central Public Sector Enterprises in India constitute22.11%and22.58%ofthetotalmar ketcapitalisationofcompanieslistedatBSEand NSE respectively (as on 30 August 2011) with highestmarketcapitalisationbeingofCoalIndia Ltd.atRs.2,36,832crore(BSE)andRs.2,37,243 crore (NSE). The divestment process will add market discipline and accountability to the functioning of public sector enterprises. The proceeds from the sale of minority shares are channelizedintoNationalIncomeFund.75%of the annual income of the Fund will be used to finance selected social sector schemes, which promoteeducation,healthandemployment. An efficient securities market is essential forgrowthofaneconomyasitchannelizessav ings into investment. It facilitates transfer of securities,internationalizationoftheeconomy. It also allows an investor to reap the benefits forgoodresultofanenterprise.Thecorporate can raise capital from securities market rather thanbeingdependentonlyonloansfromFIsor Banks.Hence,itisimperativethatadeveloping economy like India should have a highly effi cientandmaturedsecuritiesmarket.

AnkurNandi AnkurisasecondyearPGDMstudentatIIMCalcutta.Hecanbereachedat ankurn2012@email.iimcal.ac.in

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Should India allow States and local governments/ municipalities to issue debt?
Indiaisaverycomplexanddiversecoun trywithlargeamountofnaturalresourcesand an equivalently large population dependent upon these resources. The central government is responsible for the overall development of thecountry.Itimplementsimportantpolicyde cisions with assistance of state governments. Thestategovernmentsfurtherassistlocalgov ernmentssuchasgrampanchayatsandmunici pal governments, for execution of various de velopmentalplans. The centre collects taxes and this serves asamajorsourceofrevenues.Amajorityofthe states rely heavily upon loans and grants from the centre to meet their expenses. As funds available with central government are limited and demand for them is invariably high, the centralgovernmenthastobejudiciousinuseof these funds. However, this is seldom the case, aspoliticalaffiliationsalwayscauseunfairdistri butionoffunds.Apartfromtaxes,thecentre can also raise money by issuing long term and short term bonds in capital markets. These bondsaresafe,asthesearebackedbyGovern mentofIndia,andinvestorsareassuredoftheir investments and adequate returns. Unfortu nately,raisingdebtfromprimaryandsecondary marketsisnotthateasyforthestateandlocal governments.Letusanalyzetheimportanceof developing efficient money markets for raising debtforstateandlocalgovernments. Eventhestatesdeemedtobeprosperous once, are suffering from huge financial crisis 27 due to increase in population, limited avenues of revenue generation, and faulty government policies. For instance, Punjab is currently run ning a debt of Rs 73,000 Cr; majority of this is causedduetosubsidiesinelectricityandfertil izers given to farmers. Instead of looking for other revenue generating channels, states find it easier to extend their hand for grants from centralgovernment.Centralgovernmenthasto make a tough call of allocating limited funds amongthestates,andneedlesstosay,thismay notbefairforallthestakeholders.Forinstance certainstatesreceivelessascomparedtotheir contributiontowardsnationalrevenuebecause more funds are directed towards under devel opedstates. Local governments such as gram pancha yats and municipal corporations, also depend uponfundsprovidedbythestateandcentreto ensure their smooth functioning. We have ex amples of big Municipal corporations such as thatofAhmedabadandBangalore,whichhave raised good amount of money through issuing bonds but this activity is largely restricted to a handfulofmetrosandTier2cities.Butstillthe Indian municipal bond market is miniscule as comparedtothe$2.9 tnmunicipalbondmar ket of the U.S. Municipal corporations have to increasetheirfundraisingcapabilitiesifthecur rent level of rapid urbanization is to be sus tained As 70% of population in India is in rural areas, it is essential to make the agencies in

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volved in rural sector development self sufficient. In the initial stages, the finances for gram panchayats can be contributed by the stateandcentre,butafteracertainamountof time, these institutions will have to look for ways to finance their debts and become sus tainable.Thiscanbedonebyexecutingefficient development projects and generating profits fromsuchprojects. Inlightoftheaboveargumentsaboutthe need of allowing sub national governments to raisedebt,letusseethefactorsthatshouldbe considered by them while raising debt. There are states that can benefit immensely if they have initial capital to invest in quality projects. Ifnationalgovernmentfeelsconstrainedinallo cating funds to states, then such states should beallowedtoborrowfromfinancialmarketsfor satisfyingtheirdemands.Thesedebtsneednot be guaranteed by the national government. There are states which currently suffer from high levels of debt but have the necessary in dustrialandresourcebasetodevelopprofitable ventures. For instance, states with high debts likeMaharashtra(Rs208,000Cr),Karnataka(Rs 66,000) have strong industrial base and these debts can be seen as a transitional phenome non which is likely to pass in the coming years provided efficient projects are launched in these states. Then there are states which have incurredhugeamountsofdebtbecauseofcom placency,badpoliticaldecisions,andlackofac countability.Insuchcases,untilandunlessthe hand holding from central government is not stopped, the things are unlikely to change. In absence of alternative avenues of revenue, stateslikeWestBengalandUttarPradeshwith adebtofRs192,000Cr,andRs221,000Cr,re 28

spectively, seem to beheading towards a debt trap.Itisessentialforsuchstatestoreducefis caldeficitsbyimprovingtheirefficiencyandac countability. This is where markets come into picture. States which are consistently doing goodworkwillhavetheirbondsratedbetterby a central rating agency as compared to states whichhaveabadperformancerecord.Thecen tres interference in terms of issuing grants, etc., should be kept to minimum. The investor sentimentwilldecidethefutureoffinancialsta bilityofstategovernments. Needlesstosaytherearecertaincaveats in this approach, which cant be ignored. Cer tainlandlockedstateslikeNorthEasternstates are likely to perform bad in comparison with states like Gujarat because of availability of moreresourcesinlatterstates.Suchstatescan begivenmoreassistanceinformofgrantsfrom the central government. But for rest of the states, efficient administration and good politi caldecisionsisthekeyforsuccess. Let us analyze the factors that can in crease the participation of retail investors to developthedomesticsubnationalbondmarket The reason that most of the state sponsored initiativesofraisingdebtaregivenalukewarm responsefromretailinvestorsisduetotherisk associated with such bonds. The unstable tax structure at state levels such as the interstate octroi and sales tax (inter state sales tax), meansthatahugeamountofrevenuesearned byastatefromsuchtaxesisvariableandsuch sourcesofincomeareconsideredriskybymost of the retail investors. Add to this, a bad track recordofdeliverybystatesponsoredinfrastruc ture projects is also a major cause of concern.

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TheintroductionofuniformGoodsandservices tax (GST) may lead to reduction in uncertainty associatedwithtaxstructureinstates.Thesec ondissuecanbetackled,ifstates adoptalim ited obligation debt option in paying off its debts. In such an option, one pays through revenues earned from a particular project for whichdebtswereraisedinthefirstplace.These projects can be executed in a Public Private Partnership model to further increase the chancesofsuccessfulimplementation.Thecur rent practice in this regard is of General Gov ernment Obligation debt, where government pays debt through the taxes and nontax reve nues that it collects. The added advantage in choosingtheformerapproachisthat,theinves torscanchecktheviabilityofindividualprojects beforehand and make up their minds before investing, this leads to better loan agreements and less chances of bad debts as both parties have done their proper homework before tak ingtheplunge. One very important role that cannot be ignored is the role played by national govern mentinstrengtheningthedebtmarketforsub national governments. There is always an im plicitguaranteethatinanyscenario,Indiacant allowindividualstatestodefaultontheirloans asthereisnoprovisionforbankruptcylawsfor individualstatesinIndia,asisthecaseinsome other countries like Hungary. So it becomes veryimportanttomaintainaregulatoryframe

workinplace,soastoputacheckonthestates and local governments wishing to raise debt. Thisgivescertainautonomytothecentralgov ernment to decide over financing issues of a state, keeping in mind the bigger national pic ture. Theabovestepsareonlypartofthesolu tion to enable easy financing opportunities for state and local governments. It goes without saying that adopting a completely capitalistic modelindealingwithfinancingissuesofstates is not possible primarily because of the varied structure in terms of resource availability, in come distribution, infrastructure development, andcertainotherpeculiaritiesoftheIndiansub continentandthesocialisticidealsofourcon stitution, but initial steps can be taken in the directiontoequipthegovernmentswithbetter toolsforresourceallocationanddeliveringbet ter performance. The task of putting India on the forefront of prosperity and selfsufficiency has to be shared by both the government as wellasthecitizen.

ShubhkarmanSingh He is a first year PGDM student in IIM Calcutta. He also follows Indian as well as global markets regularlyandactivelytradeinequities. Hecanbereachedatshubhkarmans2013@email.iimcal.ac.in

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The Greek Tragedy Who is responsible?

The Greek fiscal crisis has been in the headlines for quite some time now. Greece is expected to take down the Euro along with it. Attempts to bail Greece out have, so far, been unsuccessful and debt restructuring seems im minent. This is also creating tension among strongermembersintheEuropeanUnion,such as Germany, Netherlands and France, as their taxpayers have to bear additional risk to sup portabailoutforGreece.Therearealsodiffer ences in opinion among the members of the European Union as to how to go about solving thisproblem.WithothercountrieslikeItalyand Portugal following suit, the condition is ex pected to worsen increasing fears of a double diprecession. Intryingtofigureoutwhattherootcause ofthisentireproblemis,everyoneisplayingthe blamegametheGreekGovernment,ECB,and evenspeculatorsarebeingheldresponsiblefor this financial fiasco. So what did each of them dotowarrantthiscriticism? TheGreekGovernment Greek policy makers have made several blundersthathaveaccumulatedovertheyears to culminate in todays crisis. Greeces public debt has been significant and growing since 1974,whenitbecameademocracy.Itisalleged that the Greek government wasted all the moneyinsteadofinvestingprofitablytostimu late growth. The government also did not do muchtostimulaterealemploymentopportuni tiesforitspeople. In the 1990s, Greece started taking mod 30 erateausteritymeasurestoreducethisnational debtinordertobecomeapartoftheEuropean Union.However,afterjoiningtheEuropeanUn ion, the government no longer made any con crete efforts to contain debt. Subsidies ob tained from the ECB created a moral hazard, and the government had little incentive to re duce debt or curtail unnecessary spending. Moreover, these trends were not being hon estlyreportedinthenationalstatisticsandde rivativeswereusedtodownplaydebtanddefi cit to keep Greece in the European Union. Greece was badly hit during the subprime re cession of 200809, as it had not strengthened itsfinancialpositionduringthegoodtimes. Greecesconditionwasnotfavorablyseen by the world. The intrinsic weaknesses of the economy came forth and led to credit down gradesofGreeknationaldebttojunkstatusby credit rating agencies like Moodys and Stan dard&Poors.Thisledtopanicandflightofin vestors from Greece, because of loss in confi denceinthegovernmentsabilitytoserviceits debt.Thus,theGreekFiscalPolicyhasplayeda veryimportantpartintodaysfinancialturmoil. EuropeanCentralBank(ECB) Many people also blame the ECB for Greecessituationtoday.Thedecisiontoincor porateGreeceintotheEuropeanUnionispartly to blame for this unfolding fiasco. Greece was neverfinanciallystrongenoughto jointheUn ion. This brought spreads on Greek sovereign debt on par with debts of Germany and other strong members, allowing Greece to borrow more at significantly lower cost, thereby

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encouraging moral hazard. The use of a single monetary unit the Euro was also not very wise as different members of the Union had differentfiscalpoliciesanddebtstructures. Duringtherecession,theEuroprevented the Greek government to ease inflation and promotegrowthduringtherecessionbydepre ciating its currency, and the appreciating Euro made things even more difficult by making in vestments costly. The ECB should have sent Greece to the International Monetary fund to solveitsdebtissues.Instead,itmodifieditsNo BailOut clause, and provided stimulus to Greece and forced the government to imple mentausteritymeasures.Howevertheproblem kept escalating, as these austerity measures wereinadequateandnotwellimplemented. So, ECBs leniency towards Greece and theweaknessesoftheEurocontributedsignifi cantlytoexistingcrisis. Speculators Leaders all around the world are also blamingspeculatorsforGreeksstateofaffairs.

Theyallegethathedgefundsandotherspecula tivetradersboughtCreditDefaultSwaps(CDSs) against Eurozone countries, especially Greece, without any underlying exposure to them with the sole intention of making short term profits by manipulating the market sentiments. The leaders have also sought to implement strin gent regulation of CDSs in order to protect Greece (and other EuroZone countries) from speculation. The question that arises is can specula tionbesolelyresponsiblefortheGreekcrisis?I would say no. The grave fiscal and policy mis stepstakenbytheGreekgovernmentcannotbe ignored.Thespeculatorsinquestioncameinto picture only after the condition of Greece had deterioratedseverely.WouldregulationofCDSs solve current problems? Again, the answer is no. The regulations may disable people with real exposures to Greece from hedging their positions thereby discouraging new invest mentsintoGreece.So,policymakersandother interested players should focus on solving the moredeeprootedmacroeconomicproblemsin Greeceinsteadofplayingtheblamegame.

VaniGopalan VaniisafirstyearPGDCMstudentatIIMCalcutta.Shecanbereachedat vanig2013@email.iimcal.ac.in

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The Perils of Fiscal Austerity

Doctorsusedtobelievethatbydraining a patients blood they could purge the evil humoursthatwerethoughttocausedisease. In reality, of course, all their bloodletting did was make the patient weaker, and more likely to succumb. Economic bloodletting isnt just inflicting vast pain; its starting to undermine ourlongrungrowthprospects.PaulKrugman TheIMFhassuggestedthatgovernments inmajoreconomiesshouldlookatcurbingfiscal austerity to boost growth, warning that the globaleconomyfacesa''threateningdownward spiral''.TheBritisheconomyhasfaced9months of almost zero growth. Yet, there seem to be littlesignsofdeviationfromthepathofpublic sector cutbacks. The IMF has also significantly revised downward its growth forecast for the US economy for 2011 and 2012, yet there are cutbacks in the budgets of the state and local governments and a lack of political consensus onPresidentObamasjobboostingplan.These twocountriesarefacingveryhighlevelsofun employment. DemandforAusterity A number of European countries, includ ingGreeceandthenationspopularlyknownas PIIGS, are facing difficulties with regard to the repayment of their large levels of public debt. Thepricethattheyhavetopayforsecuringres cueloansfromtheEurozonescorecountriesis largecutsintheirbudgets,alsoknownasfiscal austerity. For instance, the European Commercial BankrequiredItalytoadoptstringentausterity 32 measures before undertaking to buy Italian bonds.PrimeMinisterSilvioBerlusconipasseda 54bnausteritypackageinSeptembertomeet the requirements. Similarly, Greece is being threatened with nonissue of the next tranche ofrefinancingunlessitmeetscertainfiscaltar gets.TheECBsdepartingchiefeconomistJuer genStarksaidthatIrelandsgovernmentshould cut public sector pay again to get its budget deficit under control. Austerity, indeed, is lookeduponbymanytobetheuniversalpana ceafortidingoversituations ofhighdebtobli gations. ArgumentforAusterity Itisarguedthatthesolutiontofiscalprof ligacyleadingtounmanageablelevelsofdebtis austerity, as such measures restore investor confidence and spur the economy along the path of longrun sustainable economic growth, evenifthereispainintheshortterm. Before2008andAfter In the years prior to the recession of 2008, there were significant improvements in the fiscal balances of a number of countries. SpainandIrelandhadlowgovernmentdebt;in facttheywereactuallyrunningsmallsurpluses in2006and2007.Italy,ontheotherhand,had a long but reasonably stable level of public debt.However,theirfinancialpositionwassev erallyimpactedbyfinancialmeltdownfollowed by the economic recession. Italy had a long al beitreasonablystablepublicdebt. ThecaseofGreece,however,isdifferent. Greece has traditionally maintained high levels

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ofdeficitanddebtforanumberofyearsnow. In fact, debt as a percentage of GDP has re mained around 100 since 1993. According to the Economist, The symptoms of the crisis werefirstseeninGreece,andGreecesmessis indeedlargelythankstoitsspendthriftgovern mentanditscitizensrefusaltopaytheirtaxes. This was despite the high levels of growth ex periencedinthe20002007period.Theeaseof convertibilityofgovernmentbondsfromacross the Eurozone to cash at the ECB tended to weaken fiscal discipline, as seen in countries suchasGreece. Thereisanargumentwhichstatesthatit is important to draw a distinction between countriessuchasGreecewhicharefacingimmi nentdefaultandthosesuchasItalyandSpain, whicharesolventbutaresufferingfromshort age of liquidity. The policy implication of such an argument is that there should be a restruc turingoftheGreekdebtandatthesametime the latter group of countries must be given credible and complete financial support. This recommendation strongly attacks the blanket policy of financial support being contingent upon the degree of fiscal austerity measures. AccordingtotheEconomist,ItalyandSpainare under attack not because their finances have suddenly deteriorated, but because investors fretthattheymaybeforcedtodefault. The implication of the financial crisis was alargeincreaseingovernmentexpenditureand asubstantialdeclineingovernmentrevenuesin 2008and2009inallregions.Further,therewas an across the board easing of monetary policy to avoid financial collapse. However, according to the Trade and Development Report, 2011 33

published by the Unctad, such policies could notrevivecreditandrestoreglobaldemand,as amassiveprivatedeleveragingprocesswasun der way. Fiscal stimulus was therefore even more critical to counterbalance the shrinking demandoftheprivatesector. TheArgumentagainstFiscalAusterity Firstly,theeffectoffiscalausteritymeas ures has been a sharp reduction in output in countriessuchasGreeceandPortugal.Theim mediate effect of this is a rise in the cost of debt, as there is a direct reduction in tax re ceipts. Again, if we look at budget deficit as a percent of GDP, one way of reducing the per centage is by increasing output without raising deficitproportionately.If,however,acutinthe budget leads to a greater than oneonone de creaseinoutputduetomultipliereffects,then the purpose of budget austerity may get de feated. The Unctad report states An expan sionary fiscal policy can have strong effects on demand, increase privatesector incomes and generate higher fiscal revenues. The economic impact of fiscal policies can be extended by changingthecompositionofpublicexpenditure orstructuringpublicrevenuestomaximizetheir multipliereffects. Secondly, these shortterm effects can haveseverelongtermramifications.Lowerout putovertheshorttomediumtermcanleadto reducedlevelsofinvestment,stagnantlevelsof the manufacturing base, capacity constraints and higher risk of inflation that an economy might face when the growth rates eventually pick up. The slowdown in the manufacturing sectorcanalsospreadtoothersectors,thereby makingrecoveryevenmoredifficult. Thirdly, many developed nations, includ

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ingtheU.S.A.,arefacingpersistentlyhighlevels ofunemploymentcombinedwithverylowrates of growth. Private investment does not seem forthcoming in such a scenario of low demand andslumpineconomicactivity.Suchasituation seemsanidealoneforthegovernmenttostep inwithKeynesianexpansionarypoliciesinorder toboostthelevelsofeffectivedemandandre duce unemployment, with the caveat that the expansionary measures must be those with large multiplier effects, unlike, for example, largetaxcuts,whichwouldcontributetolower revenues but would not be very effective in a situation where people are not looking to spend.Unemploymentdependsverymuchon demand.Ifyouhavenodemand,thenyouneed governmenttostepinwithahugeprogramfor stimulating the economy, said Heiner Flass beck, a former deputy finance minister in Ger many and the chief of globalization and trade strategiesforUnctad. Such a policy would also impart greater confidence to the private sector to invest. Eric Schmidt,theformerCEOandcurrentexecutive chairman of Google, made the following re marks regarding the U.S. economy in an inter viewTheeconomyistodaystuckbehindthe power curve. It needs a lot of encourage ment. It needs not just something like the jobs bill,butalsosignificantgovernmentstimulation in terms of buying power and invest ment. Otherwise we're set up for years of ex traordinarilylowgrowthintheeconomyandno real solution to the jobless problem. The cur rent strategy is ludicrous. You have a situation where the private sector sees essentially no growth in demand. The classic solution is to have the government step in, and with short term initiatives help stimulate that demand. If 34

they do it right, they'll invest in income and growth producing things, like highways and bridgesandschools. Fourthly,thecounterargumenttoauster ity cites the poor results achieved so far over thelastcoupleofyearsasevidenceofthisbe ing a cure attributable to misdiagnosis of the disease. The austerity drive does not seem to be solving the problem of high debt and low confidence in economies such as Italy and Spain. At the same time, lower growth levels, downward revisions in growth forecasts, high levelsofunemploymentandgrowingfearsofa doublediprecessionaredentinginvestorconfi dence. Krugman states that the pain caucus keepstellingusthatausterityisthewaytore storeconfidence;andconfidencekeepsnotbe ingrestored.Hegoesontocitetheexampleof Irelandasacountrythathasundertakensavage fiscal cuts but the interest rate on its 10 year bonds remains significantly higher (about 4%) than on those of Germany. He feels that fears havealsorisenaboutBelgiumandFrance. Fifthly,thereisanargumentwhichstates thatthesolutionofausterityseemsmisdirected anddoesnottakecognizanceoftheturmoilin the financial world in 200708, which was the chief cause of such levels of debt in several countries. Hence, the solution should be to regulate the financial system in order to pre ventarepeatofsuchacrisisandtoboosteco nomicactivityusingawelltargetedmixoffiscal andmonetarymeasures.However,thecontrary seems to be happening. The Trade and Devel opment Report, 2011, published by the UNC TAD, saysInstead of new regulation of the financial system to address the problems that helped bring on the recession in 20078, gov ernments in the United States and Europe are

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tryingtowootheveryspeculatorswhohelped causetheproblem.TheEconomiststatesthat the current obsession with fiscal tightening in manycountriesismisguided,asitriskstackling thesymptomsoftheproblemwhileleavingthe basiccausesunchanged. The austerity measures are advocated as essentialforthelongrunwellbeingofanecon omy.Atthispoint,itisfoodforthoughttorec ollectKeynesfamousquoteInthelongrun, weallaredead.Thepaincausedbysuchmeas ures can last for a long time and affect a wide spectrum of people. Greece is witnessing a se ries of regular protests against the austerity drive of the government, which is directly af
References: [1]krugman.blogs.nytimes.com [2]TheEconomist [3]Unctad.org

fecting several civil servants and the education sector. When the brunt of the cuts in public spending fall on a sector like education, these austeritydrivesappeartoreducesocialwelfare. Thereisastrongargumentforusingfiscal policiestobailoutaneconomyfromcrisisand to improve its debtserving abilities when the crisisisnotcausedbyfiscalrecklessnessinthe firstplace.ReducingthedebttoGDPratiosbe comesaveryarduoustaskinasituationofstag nant GDP levels. In the opinion of Nobel Prize winnerJosephStiglitz,austeritycutbacksarean economic 'disaster'. Keynes must be spinning inhisgrave,saysKrugman.

AnuragMantry AnuragisafirstyearPGDMstudentatIIMCalcutta.Hecanbereachedat anuragm2013@email.iimcal.ac.in

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Infrastructure in India is going to witness a huge boom and is the next big thing.
Oxford Dictionary defines infrastructure as the basic physical and organizational structures and facilities (e.g. buildings, roads, power supplies) needed for the operation of a society or enterprise1. Infrastructure is the prerequisite for a society to progress and de velop.Theformerusuallyprecedesthelatter. Indiahasgrownrapidlyintherecentpast. Indianeconomyhadwitnesseda9%growthfor four years in a row before the global financial crisis in 2008 after which it slid to 6.7% and 7.4% in the past two years2. Gross Domestic Product(GDP)trendspaintasimilarpicture.

Figure1.IndiaGDPfrom1990to2009(Source:Google)

Ascanbeseenfromfigure1,IndianGDP hasrisensharplyinthelastdecade.ButtheIn dianstorywouldnotbecompletewithoutmen tioningthelackofinfrastructureinthecountry. As Steve Hamm said in Business Week, Indian economicboomisbuiltontheshakiestoffoun dations3. Lack of basic support structures viz.

roads,power,airports,rail,portsetc.hasbeen amajorobstacleinIndiasgrowthtrajectory. Recently, India has shifted its focus and increased expenditure on infrastructure. Through this article, I intend to convey that therearesignificantpointerswhichsuggestthat theinfrastructuresectorinIndiawillwitnessan economicboomanditisnotameremyth. FiveYearPlans The Planning Commission, instituted by the Government of India in 1950, is charged withtheresponsibilityofmakingassessmentof all resources of the country, augmenting defi cientresources,formulatingplansforthemost effective and balanced utilization of resources and determining priorities. The Planning Com mission releases FiveYearPlans which set the directioninwhichIndiawouldinvestandgrow duringthesubsequent5years. ForthefirsteightPlans,theemphasiswas on growing public sector with massive invest ments in basic and heavy industries. However, sincethelaunchoftheNinthPlanin1997,the emphasisonthepublicsectorhasbecomeless pronounced. It was the 10th fiveyear plan (2002 2007) which first talked about setting upofastateoftheartinfrastructureforallthe existing industries in India. The 11th fiveyear plan(20072012)ascertainsPlanningCommis sions commitment towards further developing Indias infrastructure and set a target of USD 500billionapproximately(INR22.5lakhcrores) tobeinvestedinthesame.AccordingtoMon 36

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tekSinghAhluwalia,DeputyChairman,Planning Commission; Indias actual investment in infra structurewouldbeinthevicinityofthesettar get13.Thisamountiscloseto38%oftheIndias currentGDP(USD1.3trillion12). For the next FiveYearPlan i.e. 2012 2017, Pranab Mukherjee, Union Minister of Fi nance, estimates investment of close to USD 1 trillion6(INR44.1lakhcrores)ininfrastructure, doubletheamountfromthepreviousFiveYear Plan:50% wouldbebygovernment6and50% wouldbebyprivatesector. Planning Commission, thus, has clearly envisagedinfrastructureasoneofthesectorsin whichIndiawouldinvestheavilyinthecoming years. Roads Roadsareanimportantconstituentofthe infrastructureacountryrequires.Especiallyina vast and geographically rich country like India, where all regions are not linked via rail or air, roads provide the only means of transport. In dustrialexpansioninaregionishighlydepend ent on the road network surrounding it. Also, under BOT (Build, Operate and Transfer) sys tem, Government is able to attract private in vestment in construction of roads. The central Government,inthepastfewyears,hasinvested

inroadsthoughagenciesandplanslikeNational HighwayAuthorityofIndia(NHAI)andPradhan Mantri Gram Sadak Yojana. Currently India has aroadnetworkapproximately33lakh7kilome ters long which includes Expressways, National HighwaysandStateHighways. Under National Highway Development Program(NHDP),MinistryofRoadTransport& Highways(MRTH)hasconstructed2010kilome ters and awarded contracts / concessions of 2610kilometersofNationalHighwaysin2009 20108. Going forward, MRTH plans to add an other 2500 kilometers and award contracts / concessions of another 9000 kilometers of Na tional Highways in 2010 20118. Kamal Nath, Union Minister of Road Transport and High ways, has announced that the Government would award road construction projects worth INR15,000croresbyMarch20119.Further,the Government targets 35, 000 kilometers of Na tional Highways during next 5 years which wouldrequireaninvestmentofUSD60billion9 (INR 2.7 lakh crores), out of which USD 40 bil lion (INR 1.8 lakh crores) is expected from the privatesector. With the above facts, it is apparent that

Figure2.Indianroadnetwork(Source:NHAI)

Figure3.Sourcesofpower(Source:MinistryofPower)

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theGovernmentisinvestingsignificantamount inroadsinyearstocome. Power Along with roads, power is another pre requisite for industrial growth. Currently, India produces1.67lakhMWs10ofelectricityoutof which53.3%isfromcoalbasedthermalpower plants. Under the 11th FiveYearPlan (2007 2012), Government has targeted generation of 62,000MWofelectricityrequiringUSD230bil lion (INR 10 lakh crores) for power generation, transmission and distribution10. Even though theMinistryisbehindschedule(asrevealedby thereviewdonebythePlanningCommissionin August 2010), there has been considerable im provementcomparedtoearlieryears. Sushil Kumar Shinde, Union Minister of Power,hadstatedthatscopeforinvestmentin power sector over the next few years is well over USD 300 billion10 (INR 13.5 lakh crores). Hefurtherhighlightedthatcreationofa20,000 MW solarbased power station is in pipeline and would be ready by the year 2020 under JawaharlalNehruNationalSolarMission. Therefore, as is the case with roads, power is expecting substantial investment by theGovernment.Heavyinvestmentssupported by both the Planning Commission and Govern ment initiatives clearly suggest that the infra structurewillwitnessahugeboom.Slightlyoff the topic but still relevant, is answer to the question Why should India develop its infra structure? Answer to this question should throwsomelightonthereasonsbehindtheno 38

table amount on money being spent and ex pectedtobespentoninfrastructure. Corelation between infrastructure develop mentandeconomicgrowth Intuitively, correlation between infra structure and economic growth is not hard to explain. Infrastructure is the framework, or as Hamm put it, foundation, upon which a coun trysindustry,agricultureandsocietyasawhole thrive,sustainanddevelop.Letstakeexample of an Integrated Steel Plant (ISP). Without power, it would be impossible to fire up the blast furnace and other heavyduty equipment

Figure4:EconomicgrowthvsInfrastructure(Source:WorldBank)12

deployedattheISP.Withoutroads,itwouldbe impossible to transport raw material and fin ishedgoods.Inshort,withoutinfrastructureitis impossibletorunanindustryandthisexample can be extended to agriculture and society as well. Hence, it can be concluded that without infrastructure,economicgrowthisdifficult. Withaboveinmind,Icollateddatatosta tisticallyobservethecorrelationbetweeninfra structure and economic growth (presented in figure4).Infigure4,economicgrowthisrepre sentedbythepercapitaGDPandinfrastructure

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is represented by electricity usage per capita, air travelers per capita and Internet users per capita. Other than Internet users per capita, other infrastructure parameters exhibit a slightly looser correlation. This is so because factorsotherthaneconomicgrowthareatplay. For example, in electricity usage per capita parameter,theclimateofthecountryshouldbe considered.But,figure4stilltellsusclearlythat in countries with higher GDP i.e. USA, UK, FranceandAustralia,infrastructurefacilitiesper capitaarebetterthantheoneswithlowerGDP i.e.SouthAfrica,ChinaandIndia. TheobviousnextquestionisWhichhap pened first? the famous chicken and egg cau sality dilemma. I do not have data to support any of the two possibilities; but, we can con clude that economic growth and infrastructure developmentarecomplementary;bothofthem

feedoffeachother. Summary Government has increased its spending on in frastructureanditcanbesafelyconcludedthat goingforward,thespendingwouldescalateand accelerate. The FiveYearPlans and initiatives bytheMinistriesofFinance,RoadTransport& Highways and Power are indicative of further investment in infrastructure. This coupled with the fact that economic growth and infrastruc turedevelopmentarecomplementary,India,in its endeavor to become a developed country, has to evolve and augment the current infra structure.Largescaleinvestmentwouldtrigger aboomandinfrastructurebeingtermedasthe nextbigthingisastatementofsubstance.

References http://oxforddictionaries.com http://timesofindia.indiatimes.com/business/indiabusiness/Growthmayreturnto9nextfiscal/ articleshow/7160575.cms http://www.businessweek.com/magazine/content/07_12/b4026001.htm http://planningcommission.gov.in http://www.economywatch.com/fiveyearplans/ http://marketcrawl.com/privatesectorcontributing500bforinfrastructure/10457 http://www.nhai.org http://morth.nic.in/ http://www.steelguru.com/indian_news/ India_to_award_INR_15000_crore_mega_road_projects_by_March/178425.html

BrijBhushanGarg BrijBhushanGargis2ndyearPGDMstudentatIIMCalcutta.Hecanbereachedat gargb2012@email.iimcal.ac.in

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Why is microfinance successful in some regions but not in others? Is India an environment condu cive for microfinance to flourish?
AboutMicrofinance: Microfinance was born approximately 30 years ago when Professor Mohammad Yunus foundedtheGrameenBankinBangladesh.Mi crofinanceistheprovisionoffinancialservices and products of very small amounts to low in come individuals, with the goal of creating so cial value. Over the years, the microfinance movementhasgrownatarapidpaceacrossthe world,andintheprocesshasimpactedthelives ofmillionsofpoorpositively. Microfinanceimpactstudieshavedemon stratedthat 1. Microfinancehelpsinprovidingconsump tion credit to the poor households for meetingtheirbasicneeds. 2. Financial services used by lowincome households helps in increasing the stabil ityandgrowthofsmallmicroenterprises. 3. Byencouragingeconomicparticipationof women, it promotes gender equality and improveshouseholdwellbeing. 4. The level of impact relates to the length oftime,theclientshavehadaccesstofi nancialservices. Scattered research suggests that more than half of the microloans are used primarily for a range of household cash management needs like stabilization of consumption, educa tion, medical expenses, weddings and funerals etc.SomeMFIsalsoprovidenonfinancialprod 40 ucts in the form of business development or healthservices. MicrofinanceinIndia: InIndia,microfinancestartedintheearly 1980s,withtheformationofinformalselfhelp groups (SHG) which provided access to credit services. This sector has grown a lot over the pastfewyearswiththeevolutionofmanykinds of microfinance institution organizations (MFOs). Other microfinance experiments like those done in Bangladesh, Indonesia, Thailand, andBolivia,havealsoinfluencedthedeliveryof microfinancialservicesinIndia.Todayonecan alsofindnationalbodieslikeSIDBIandNABARD which devote significant time and financial re sourcestomicrofinance. TheNeedinIndia In terms of demand for microcredit or microfinance in India, there are three seg ments,whichdemandfunds. Manual labourers require funds for con sumption credit during the months when they have no work. Funds are also re quired for purchasing small assets like livestock, which can be used to get addi tionalincome. Small farmers, rural artisans, people self employed in the urban sector like hawk ers, vendors, and workers in house hold

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microenterprises generally require funds for working capital. Credit is also used partially for consumption purposes and for purchasing other productive assets like pump sets, livestock, looms, machin eryetc. Fundsarealsorequiredbysmallandme dium farmers involved in dairying, poul try, fishery and cultivation of commercial crops. People living in villages and slums whoareinvolvedinmanufacturingactivi tiesorworkinworkshops,teashops,pro visionstoresetcalsoneedcreditservices. Thesepeoplearenotalwayspoor,though theylivebarelyabovethepovertylineandalso sufferfrominadequateaccesstoformalcredit. TheTop5MicrofinanceInstitutionsinIndiaby LoanAmountOutstandingfor2010. (Source:http://
www.mixmarket.org/mfi/country/India/ balance_sheet_usd.gross_loan_portfolio/)

mation and development by banks and government.

Methods used for loan recovery: Inhu man methods of loan recovery such as intimidating, abusing and harassing the borrowers have become common. The borrowersarealwaysunderthepressure torepaytheloan(onaweeklybasis)ata heavy compound interest for petty loans theytake. High interest rates:Anotherargumentis thatMFIslendmoneyatexorbitantinter estrateswhichrangefrom20percentto 40percent. Lack of SHG quality and leadership:The performance of SHGs to a great extent dependsupontheirqualityofgovernance and management. Available evidence clearly suggests that the quality of SHGs has suffered due to their fast growth. In AndhraPradeshwhichisoneofthelead ingstatesinSHGformation,itwasfound thataboutonethirdofSHGswereofun satisfactory quality with regard to their organizational and financial management abilities.ItisalsofoundthatasSHGsgrow oldertheirqualityfurtherdeteriorates.In many cases SHGs even break down or windup their operations. The major rea sons attributed for the poor quality of SHGsaretargetbasedpromotionofSHGs, inadequate training and capacity building andwidespreadilliteracyofthemembers. Continued and specialized trainings can help develop the abilities of SHGs in ma turingfully.

1. SpandanaSphoortyFinancialLtd(SSFL) 2. SKSMicrofinanceLtd(SKSMPL) 3. BandhanSociety 4. ShareMicrofinLimited(SML) 5. AsmithaMicrofinLtd(AML) CHALLENGESININDIA In our country micro finance is facing someglaringchallenges Problem of SHG outreach:TheSHGpro grammes are largely concentrated in southern region of the country. It is es sential for the microfinance programmes to spread more evenly so that the bene fits are available especially in regions where the need is more accurate. This callsforincreasedinvestmentinSHGfor 41

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Apartfromtheabove,high cost of deliv ery, low level of grants to micro finance, fear of increasing NPAs with micro finance, an un favourable policy environment, substantial traditional banking infrastructure aresomeof theotherpersistentproblems. CONCLUSION Microfinanceisnotyetatthecentrestage of the Indian financial sector. The knowledge, capital and technology to address these chal lenges however now exist in India, although

theyarenotyetfullyaligned.Withamoreena bling environment and surge in economic growth,thenextfewyearspromisetobeexcit ingforthedeliveryoffinancialservicestopoor people in India. Development of SmallScale Enterprises through microfinance will not only increasetheoutreachbutwillalsohelpthegen eration of more employment and income for the poor. It is expected that in the following years there will be considerable deepening of microfinanceinthisdirectionalongwithsimul taneous drives to reach and serve the poorest ofthepoor.

REFERENCES http://www.mixmarket.org/mfi/country/India http://articles.economictimes.indiatimes.com/20101019/news/27581212_1_poorborrowersmfis microfinanceinstitutions http://www.youthkiawaaz.com/2011/03/microfinanceinindiaproblems/ http://www.youthkiawaaz.com/2010/11/dynamicsofmicrofinanceinindiatheroadtowardsrural development/ http://www.iimahd.ernet.in/~mssriram/jmf.pdf http://www.scribd.com/doc/11946430/ReportonMicroFinance http://www.bwtp.org/arcm/mfdm/Web%20Resources/General%20MF%20Resources/ micro_finance_in_india.pdf

SumitSinha HeafirstyearstudentatIIMCalcutta.Hecanbereachedat sumits2013@email.iimcal.ac.in

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Growth, inflation and monetary policy The Indian case

The chief concerns for the Indian econ omy are currently the high level of interest ratesandinflation.Thecentralbankhasraised policy rates 13 times by as much as 375 basis points since March 2010. Elevated levels of in terest rates are impeding investments and slowingdowntheeconomy.HencetheGrowth inflationdebatehastakenpolicycentrestagein theyear2011.Moreoverthereisaclearindica tionofshiftintheemphasisofmonetarypolicy from avoiding growth disruptive normaliza tion in 2010 to containing inflation and an choring inflation expectations in 2011. Given the uncertain global environment, there is a seriousconcernthattheseriesofhikesinpolicy rates would hamper growth. In this context, GrowthvsInflationandshorttermvslongterm tations will further lead to low willingness to producebysupplierswhichwilllowerthelevels ofwagesandsalariesofworkers.Thesecyclical changesadverselyaffectaggregatedemandand supply,andtherebygrowth. The growthinflation tradeoff starts with the idea of threshold inflation. As noted by Montek Singh Ahluwalia, Inflation beyond the tolerablelevel,usuallyputat5to6percentby thegovernmentand4to5percentbytheRBIis regressive and also distortionary, damaging both inclusion and growth. Given that both inclusive growth and high growth are af fectedbyinflation,ensuringaninflationregime thatdoesnotyieldhigherthanthresholdinfla tionbecomesanimportantpolicyobjective.On the contrary a very low level of inflation leads to sacrifice in growth which may again impact the progress of inclusion. Thus there is a need to strike balance between high growth on one handwithinclusionontheother. It is important to understand the differ ence between inflation target and threshold inflation.Inflationtargetistheconstructofcen tral bank, in which the monetary policy strives toachievethattarget. Ontheotherhandthresholdinflationisa pointofinflexionforthegrowthinflationtrade off. The idea behind threshold inflation begins fromthetheoryofPhillipscurve,whichexplains the relation between inflation and unemploy mentrates.Supposethepolicymakerswereto use monetary policy or fiscal policy to expand aggregate demand, it would lead to a point of

effects of inflation on growth became the cor nerstoneforseriesofdeliberations. RBIsinterestratehike: Averylowlevelofinflationwouldleadto lowexpectationsinpricerise.Thefallinexpec

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higher output and higher price level along the shortrunaggregatesupplycurve.Higheroutput meanslowerunemploymentbecausefirmsem ploymoreworkerswhentheyproducemore.A higher price level, given the previous years price level, would mean higher inflation. Thus when policy makers move the economy up along the shortrun aggregate supply curve,

they reduce the unemployment rate and raise inflation rate. Conversely, when they contract

aggregate demand and move the economy down the aggregate supply curve, unemploy ment rises and inflation falls. This tradeoff be tween inflation and unemployment is defined bythePhillipscurve. 44

Aggregate demand and Aggregate Supply Curve: Backward Bending Phillips Curve: Many corollaries to Phillips curve were derived to make the model fit to different economies in the world. Recently a modified version of Phillips curve which is backward bendinghasbeensuggestedbyPalley.Itisnow realized that the Phillips curve relationship is more complex, with the likelihood of relation ship changing from low inflation to high infla tion.InthemodelsuggestedbyPalley,inflation expectations are a positive function of actual inflation. Phillips curve is negatively sloped at lower levels of inflation, positively sloped at higher levels of inflation and turns vertical if inflation expectations converge to actual infla tion. Thus there exists a threshold inflation at P*, which is the point of inflexion, acting as a guidepost for monetary policy when it has to justfocusoncontaininginflationatthecostof sacrificing growth. At inflation lower than P*, relyingonshortruntradeoffcouldmakesense. Themainreasonfortheexistenceofsuch threshold inflation is the speedand magnitude with which the inflation rate feeds into the in flationaryexpectations.AboveP*,workersand producersareworriedthathighinflationwould rapidly erode their living standards and profit ability, so they raise their wage and price de mandsveryoften.Thisinturnadverselyaffects aggregatedemandandsupply,andleadtorisks inmediumandlongtermgrowthprospects.By contrast, below the threshold level, workers andproducersdonotraisetheirwageandprice demandsveryoften. In India, the threshold level of inflation (WPI),aspervariousstudies,isestimatedtobe

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at 6 percent (Pattanaik and Nadhnael). Above this threshold level, inflation may start to hurt growth and there would be no tradeoff be tweengrowthandinflation.Theonlysolutionat higher level of inflation will be to control it, without actually worrying about growth. If we look at the reports of RBI, the intention of RBI wastoavoiddisruptionsingrowthmomentum inthefirsteighthikesinpolicyrateswhichwere till March 2011. Last five subsequent increases in May, June, July, September and October 2011, however communicate the risk of me diumgrowthfrominflation.ThusRBIseemsto compromiseonthegrowthatleastintheshort term to control the much dreaded problem of inflation. Besidesthelevelofinflation,variabilityin inflationcouldalsoadverselyimpactgrowth.It was found that for developing countries when the rate of inflation exceeds 10 percent, infla tion variability adversely impacts growth when thecoefficientofvariationofinflationislow.If the central bank maintains stable inflation, when the inflation is already high, an increase in inflation may result in reduction in growth, because people would think that central bank wantstoraisethe(stable)levelofinflation.Cor

respondingly, if inflation is unstable, then peo ple will not be clear whether this increase is temporary or permanent and the increase in inflationwillhavenoimpactongrowth. Thus we see that there are two factors whichaffectgrowth,levelofinflationandinfla

tion variability. For India, WPI inflation was at 9.78 percent in August 2011, the highest in 13 months.AlookattheWPIinflationratesforthe past one year shows that, inflation was above its threshold value, and hence subscribing to monetary policy which controls inflation and anchors inflation expectations would make sense.RBIsdidexactlythesamebyraisingthe repoandreversereporatesbyasmuch375ba sispointsfromMarch2010toOctober2011to controlinflation.

References: WhyPersistentHighInflationImpedesGrowth?Anempiricalassessmentofthresholdlevelofinflationfor IndiaRBIWorkingPaper(WPS:17/2011)`byPattanaikandNadhanael UnderstandingInflationandcontrollingitKaushikBasu,ChiefeconomicAdviser,GoI. SpeedofAdjustmentandInflationUnemploymenttradeoffindevelopingcountriesCaseofIndia;IIMA WorkingPaper(W.P.No.20110701July20110byRavindraHDholakiaandAmeyA.Sapre

SaikumarRathod SaikumarisasecondyearPGDMstudentatIIMCalcutta.Hecanbereachedat saikumarr2012@email.iimcal.ac.in KiranSGopan KiranisasecondyearPGDMstudentatIIMCalcutta.Hecanbereachedat kirang2012@email.iimcal.ac.in 45

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Interview with Professor Soumyen Sikdar

Interview of Prof. Soumyen Sikdar by Anurag Mantry ThePlanningCommissionhasmootedtheidea ofasovereignwealthfundof$10billion.What arethepossibleusesofsuchanSWF? Additionally, do you think forex reserves shouldbeusedforinfrastructuredevelopment inIndia,giventhecurrentaccountdeficit? Theideaof aSovereignWealthFundhas beencreatedtomakeuseoftheenormousfor eign exchange reserves some countries have piled on, particularly China and India. The cen tral banks of both these countries manage the exchangerate.Theydontallowafreefloatand intervene to buy and sell the dollar to reduce fluctuationsintheexchangerate.Now,consis tently over the past 1015 years, China and In diahavenotbeenallowingtheexchangerateto appreciate. Demand for Chinese Yuan and In dian Rupee is continuously growing up, mostly becausetheforeignerswanttopurchaseassets inthetwocountries.Thereiscontinuouspres sure on the currencies to appreciate, but the CentralBankswillnotwantthattohappen.So theyengageinbuyingupdollarsfromthemar ket.Theirstockofdollarshasbeengrowingata very rapid rate. Chinas reserves reached around 3000 billion in 2010, while Indias re serves were about 300 billion. However, if you keepthereservesidle,youarenotgettingany return on them. At the same time, there is a needtokeepliquidfundstobeabletoselldol lars when needed. They put most of the re serves in U.S. treasury bills. These are very liq uidbutofferlowreturns.TheSWFisanideato put the forex reserves into assets yielding higherreturns.Itisadevicetoreducethecost 46 of holding enormous forex reserves. Mainland Chinaalreadyhas3suchSWFsandHongKong has one. Many other countries have also started investing in assets that are relatively liquid,thoughnotasmuchastreasurybills,but offerhigherreturns.TheRBIisalsothinkingof doing the same. There exists a tradeoff in termsofobtaininghigherreturnsbutsacrificing liquiditytosomeextent.Thereisnothingwrong in the proposal provided the Reserve Bank keepsaclosewatchonthetypeofforeignasset investedin.Duringthesubprimefinancialcrisis in the United States, many SWFs lost a lot of money because they had purchased financial assets in some of the big investment banks, manyofwhichhadincurredlosses. The main objective of holding a large stock of forex reserves is to establish a buffer againstfutureflightoutoftherupee.So,using thereservesforinfrastructuredevelopmentwill lower the buffer. However, it is an idea that shouldbeexplored. WhatshouldbethepolicyoftheRBIregarding currency, given the large depreciation wit nessedrecently? The RBIs extent of intervention in the forex market has gone down recently, espe cially under the present government. It allows theexchangeratetobemarketdeterminedto agreatextent,unlikebefore.Itdoesnotinter veneatasbigascaleasbefore.Itstargetisto contain volatility in the exchange rate. So far, theproblemhasgenerallybeentopreventap preciationintheexchangerate,asitadversely impacts exports and the value remittances to India. The currency has depreciated at a fast

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rate recently, as the demand for dollars has sharplyrisenduetofearsofrecession.Thisisa paradoxical result, as there is higher demand for the same currency whose economy might face recession. The dollar is considered as the safestasset.Ordinarily,thereshouldnotbetoo much concern regarding the depreciation. Be sides, it is benefitting exporters and increasing the rupee value of remittances. However, the causeofconcernisthatforeignerstryingtobuy Indianassetsarediscouragedduetolowerpo tentialreturnoninvestment.Hence,ifthecapi tal inflow goes down, it can poseproblems for financingthecurrentaccountdeficit. Whatdoyouthinkwillbetheconsequencesof allowingFDIinorganizedmultibrandretail? FDIisalwaysbetterthanFPI.Theentryof FDI in the retail sector will probably make the supply chain more efficient. Middlemen, who take a large cut of profits, can be eliminated if theentiresupplychainismanagedbyonecom pany. The original farmers might be better off. The negative aspect is that roadside corner shopsmaybewipedout.However,ifthesupply chain deficiencies are reduced and the invest mentiscarriedoutinanorganizedway,newer opportunitiesmightopenupforthelocaltrad ersandsmallproducers,whoarerunningatlow profits and who might have to close down as their profitability would be further reduced, to becomeapartofthesupplychain.Thepossibil ity set can be widened through new activities and distribution networks. However, I believe that FDI should be encouraged in production and in setting up plants and factories, rather thaninthesupplychain,asthereexistgreater employment generating and factor income boostingopportunitiesintheformer. 47

The FDI flows wereonly $19.4 billion in FY11. For a country like India faced with infrastruc tural bottlenecks, what are the flaws in the currentFDIpolicyandwhatcanbedonetoat tractmoreinvestment? IthinkitisdifficulttoattractFDIininfra structure projects, as returns in those projects cannot be captured quickly. Hence, India will have to provide infrastructural facilities inter nally. India attracts lesser FDI as compared to Chinaandsomeothercountriesduetolowlev elsofdisciplineofworkers,poorinfrastructure and redtapism. Recently, there was a 2 day conferencein IIM Calcutta on the West Bengal economy. A gentleman who was on the board ofanMNCwasaskedwhytheydidnotinvestin West Bengal. The MNC is already present in China. He answered that discipline is better in China in the sense that suppose 8 things need to be done to set up an industry or to expand anexistingindustry,theconditionsaresatisfied veryquickly.InIndia,however,thereexistsalot ofbureaucracy,andBengalwasnotevenbeing consideredintheirplans.However,Imustpoint out that in China, though labour may be more productive than an average Indian laborer due tohigherlevelsofeducation,thelabouriseas ilyexploitable,unlikeinademocracylikeIndia. We do not need to replicate the harsh Chinesemeasures.Somethingsthatneedtobe done to attract FDI are reducing corruption, cuttingdownredtapism,improvingbasicinfra structure such as power supply, ports, roads, etc. Good telecommunication system is some thing that is very important and that has been providedbyIndia.

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Thestandingcommitteeonfinancehasrecom mended a 26% cap onFDI in the pension sec tor.Willthispolicybebeneficial?Additionally, asimilarceilingexistsintheinsurancesector. However, mutual funds are allowed 100% FDI and the new bank licensing norms allow for 49%FDI.Whatisthereasonbehindthediffer enceintreatment? Pensionfunds,whichprovidepostretire ment income, and the insurance sectors are very sensitive areas. The presence of foreign playersinthesetwosectors,personally,makes me feel uncomfortable, as they are more ex posed to risk. If you look at LIC, its portfolio is limitedandnotverygloballydiversified.Itmay be earning average to lower returns, but the volatility is lower and so is the risk of sudden andbiglosses.IwouldpreferFDIinnonlifein surance and national companies in sensitive areaslikelifeinsuranceandpension. When the Marxist political parties had some power at the centre, they were against openingupthesensitivesectorstoforeignplay ers.Itisaftertheirexitthatthegovernmenthas been looking into possible raises of the upper ceiling. I personally believe that a distinction should be made between pension and insur ancesectorsandothersectors. Whatisyourtakeontheargumentadvocating fullconvertibilityoftheRupee? Fullconvertibilityoftherupeeisapartof thebiggerprogrammeofeliminatingallbarriers to capital inflows and outflows. It will take us veryclosetowithdrawalofallcontrols.Ifmost of the capital inflow is FDI, which does not comeorgoeasily,thenthechancesofvolatility being transferred to the exchange rate leading 48

to currency crisis and financial crisis is low. However,inIndia,mostoftheinflowsconsistof FPI, wanting quick capital gains, and which are very volatile. There is a low inflow of FDI for reasons we have already discussed. If portfolio investorssuddenlydecidetodepartfromIndia ortocometoIndiainarush,thenwithafully convertiblerupee,thepossibilityofvolatilityin the exchange rate and reserves and a financial crisis becomes higher. Many economists share this view. We should be moving towards full convertibility, but under certain preconditions, such as stronger supervision in banking, more stable macro environment in general and a change in the composition of flows from pri marily FPI to FDI. The move should be gradual andcautious,nothurried. Thereisafresheffortbythedevelopedecono mies to push for greater concessions by the larger emerging economies to salvage the WTOs Doha talks. What should be Indias re sponse? The case of the Doha rounds, started in 2001, is very clear. At present it is limping along, which is bad for the world as a whole. ThesinglemostimportantreasonfortheDoha crisis is the refusal of developed countries, es pecially Japan and the USA, to liberalize their trade in major agricultural products. Japan is concerned about rice and the USA about rice andcotton.Infact,themainobjectiveoftheUS delegation was to ensure that their cotton farmers do not suffer, while at the same time 10millioncottongrowersinWesternAfricaand other countries suffered due to the refusal of the USA to coordinate. The EU also refused to cooperatebycuttingdownfarmsubsidies.The developing countries argue that they will not

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liberalize their trade unless the developed na tionsdothesame. India, along with other developing coun tries,shouldputpressureonthedevelopedna tions.Meanwhile,sincetheWTOisnotingood

shape,Indiashouldexploreotheropportunities, suchasregionaltradeagreements.Thereisno need to rely on the US. On the contrary, India shouldlooktodiversify.

Prof.SoumyenSikdar He is a Professor in the Economics Group of IIM Calcutta. His faculty profile can be accessed at http://facultylive.iimcal.ac.in/users/ssikdar.Hecanbereachedatssikdar@iimcal.ac.in.

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Interview With Professor Partha Pratim Pal

Interview of Prof. Partha Pratim Pal (Prof) by PiyushMaheshwari(PM)andSishirKolli(SK) PMWhatdoyouthinkwillbetheimpactof the impending "currency bill" by US govern ment ProfUSwouldnotbeabletopushthisbilluni laterally.Thisbilllooksmorelikeapoliticalgim mickastheelectionsareduein1year.Itwould beverydifficultforUStodosobecauseitisnot dependent on China only on trade basis. Their economies are linked otherwise as well with China providing funds to cover the US budget deficit. PMSo,ifUScannotpushthisbillunilaterally, what action do you expect? Because they wouldhavetotakesomehelpmaybefrom IMF/WTO? Prof The basic problem is that US is facing elections and it would be difficult to sell to US populationthattheUScannotdothisunilater ally.Itisapopulistmeasuretogainthesupport oftheUSpeopleandIexpectUStokeeppush ing it till at least the elections. But I dont ex pect either IMF or WTO to do anything com pletelyagainsttheiragendabecauseremember thatIMFcurrentlyhasaEuropeanchiefandex change rate management has never been part of WTO. WTO thought that once flexible ex changeratehadbeenintroduced,management of exchange rate would be done by IMF and it was not thought of at that time that exchange rate would be used as a trade policy measure bycountries.So,WTOdoesnothaveanyclause to manage the exchange rates. WTO is a more democratic organization than IMF and every 50 country has to agree to the new rule if they want to introduce a new rule not majority, but consensus. In WTO so far, no decision has been taken without consensus so even one country can block any new WTO rule if that countryisstrongenoughtostanditsground.In caseofIMF,increasinglythepowerofUSisde creasing;USstillisaformidablepowerthough. In IMF, the concept is not a one country one vote, number of votes available to a country dependsontheamountofmoneythatcountry givestoIMFsoUSstillhasfirmpower,butit is unlikely that it will be able to push through sucharuleinthiseconomicclimate. PM In my opinion, the proposed currency rule is against the trade rules. What is your opinionaboutthat? ProfInmostcases,theIMFdoesnotimpose thetraderules;theyareimposedbyWTO.The IMFtriestoensurethatthereisglobalfinancial stability,andiftheUSdoesimplementthatrule that would mean there is global financial in stability; so that would be against the IMF agenda as well. I dont see US being able to pushthisrulethrough.Itisjustapopulistmeas ure. PMLetustalkforabitaboutthesituationof Greece.ApartfromoutrightdefaultbyGreece, whatotheroptionsdoyousee? Prof One thing that is being talked about is that lenders should also take some loss the banks who have given loans to Greece despite knowing that the situation is not very well shouldtakesomelossaswell;soalosssharing

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kind of talk is being talked these days. I dont knowhowitisgoingtoworkorwhatwouldbe theimplication. SK Sir, but it has been agreed that 50% loss wouldbetakenbyinvestors ProfYes,ithasbeenagreednow,butyousee that can create a situation where the money flow to other countries is more difficult. Now thebankswouldbesuperconsciousaboutgiv inganymoneytoanycountry,andtheywould want strong collateral; even the sovereign bondswouldbebackedbysomecollateralnow. OneofthecountriessuggestedthatGreecesell someoftheirassetssothatGreececanpayoff itsdebt.Butitwouldbedifficulttoimplement this kind of thing. This kind of thing is called haircut a haircut has been agreed but it will bedifficulttoimplementforallcountriesitis abitofafluidsituation. SKRightnow,Italyssituationhasbecomeas bad as Greeces, right? Despite the fact that one is in the core and the other is in the pe riphery.Whatisyouropiniononthis? Prof There is a distinct difference between mainland Europe and Italy. Italy is more like a developing country. Between North Italy and South Italy, there is a major variation. South Italy is more like a developing country rather than a developed country. There is a develop ment mismatch between the 2 parts of Italy. I am not really surprised that Italy is also facing thiskindofproblem. The biggest problem is that these coun trieshaveamonetaryUnionbutnotafiscalun 51

ionso,monetarilytheyaredependentonthe centralbank(ECB)butthefiscalmeasureshave to be taken independently. Now, what hap pened after the financial crisis was that every country tried to overcome the demand short age(whichhappenedduetothecrisis)byfiscal measures and the countries which have a less reputation in the market are facing a bigger problem because the rate at which they bor rowedmoneyfromthemarketwashigherthan theotherssothatisbecomingaproblem.For other countries like India and US, that is not that big a problem because they can print money and give it to the guy who they owe moneytoforthesecountries,thatisnotpos sible. If you go to the market and the market thinksthatyourfinancialconditionisnotgood, theywillkeepchargingyouhigherrateofinter est.ThiskindofsnowballingledtothisEurocri sis. SKTheproblemwithinvestorstakingahitis that if banks of such major stature take a hit, then they would have to be recapitalized. It would bring us back to the same agenda of protectingthebanks. Prof The problem with the system is risk in the financial system. If a bank is going under loss, there are a number of institutions at tachedwiththebankandtheywillalsobefac ingproblems.Exactlythesamethinghappened when the property prices crashed; the banks lost a significant amount of assets. Here also the banks are losing significant amount of as setsandsospiralingwouldbethere.

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PM Talking about US, their deficit this fiscal was1.3trillionUSD,thesecondhighestdeficit intheirhistory.CouldUSgotheGreeceway? ProfThatseemsunlikelybecause1)Dollaris still the dominating currency, 2) US can print money, and 3) US has sources of getting funds fromabroad.Aslongaspeopleareparkingre servesinUStreasuries,thereisaplaceforsell ing those bonds and getting dollars out. So US wouldnotgotheGreeceway.Therewillbedif ferentkindsofproblemsforUSbuttheproblem GreeceisfacingisnotbeingfacedbyUS. PMAsyousaid,UShasdifferentwaysofget ting money from abroad as well. One of the primary ways is China, of course. China holds significant amount of US debt. With this new currency rule, US is alienating China as well., isntit? Prof That would not be possible for US. Be causethereareotherchainsaswellnotonly trade, they are dependent on other countries for capital. There are allegations that Chinese sovereign funds control significant amount of New York Stock Exchange. It is not a unipolar worldanymore.Maybe,instrategy,itisauni polar world, but there is emergence of other powers. So, it would not be possible for US to pushthroughthecurrencybill. PM What if China decides to take a more proactiverole?ChinahasseenthatUShaspro posed this new role. What if just to threaten US, China stops this currency flow and sud denlyUSfindsitselfcashstrapped?

ProfWhatisUStradedeficit?UStradedeficit is happening because US is buying more trade goodsfromChina.HenceChinaisalsodepend entonUSforitsmarketshare.So,itisakindof mutual symbiotic relationship. Each needs the other to survive and grow. If China does want to, China can because increasingly China has been taking a hostile role visvis US. You see thattherearesatelliteshacking,etcwhichChi nesemilitaryhasdone.So,thereisanudgeand push going on b/w US and China but I am not verysurehowfartheywilltakeit.Becausethe amount of Chinese exports which go to US is significant.IfUSthinksthatitcantakealoss,its countrymencantakea loss,andtheycanshift toamoreexpensivesupplier,thentheycanac tually push higher tariffs on China; they would have to flout WTO rules, but they can do it if theyarepushedtoacorner.Thereissomething called Super301 where US can unilaterally im pose duties on product from other countries; thatisnotWTOconsistentbutUShasdonethat in the past. So, it is possible. There are legisla tions inside US which allow them to impose countryspecificrestrictions.WhatcanWTOdo against that? They can say that China can also imposetraderestrictionsagainstUS.Soitisbe tweenChinaandUSAthen.Thisistheproblem when a big and a small country have a trade dispute.Forexample,evenifNigeriaisallowed to impose trade restriction on US, what good wouldthatdotoNigeria? PMUnemploymentinUSisstillinthehigh9 9.5range,theretailisgrowingslowly(itisnot significant), and the manufacturing index is also not up significantly. Taking such condi tionsintoaccount,whatcanbesaidaboutthe future of US economy? There was a period in 52

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200910 when it looked like the US economy might come back to normal by 201213 but nowitlooksasiftheremightbeadoubledip recession, or US economy might spend some majortimeinthisveryslowgrowthregion. Prof If you look at the recent publications which have come out in IMF, World Tech, or otherinstitutions,themainconcernisthetwo paced growth we are seeing. The developing countries have more or less recovered but the developed countries have not recovered. Now itisnotfeasibleforthedevelopingcountriesto keep growing without the developed countries growing;andifthegrowthratesforthedevel oped countries dont recover soon there is a possibility of a double dip. At least the G20 is aware of the condition and they are trying to bring out coordinated policies. So there is a possibility for double dip but the good part is that the countries are aware of this and they aretryingtodoasmuchastheycantoprevent that. PMIthasbeensaidthattheprobabilityofa recessionissignificantlycorrelatedwithunem ployment. For the current recession, the em ployment figures have fallen the most (from thepeakvalue)andtheyhavetakenthelong esttoevenslightlyrecoverthatistosay,in steadofhavingaVshapedgraphforemploy ment(plottedagainsttime),weseemtohave a Ushaped curve. So, it seems that it would takeatleast78years(fromthetimewhenit hadpeakvalue)fortheemploymentnumbers toreachitspreviouslevels.Ifthatistrue,the economic conditions would not improve sig nificantlyinthenearfuture.

Prof This is about fiscal stimulus coming into play. Some people are saying that the fiscal stimulus should be removed because it in creases the deficits. On the other hand, there are people like Krugman who are saying that more stimuli should be given because unless you give stimulus, you are not going to come out of recession. Fiscal stimulus, even if it pushesfiscaldeficitup,canbegoodinthelong runbecauseonecanuseittopushemployment figures up. But there is a consensus problem with respect to the stimulus. What we have seen till now is that the stimulus worked for a while and it was starting to push employment up but still the rate of employment increase is not very fast, it is painfully slow. The problem withUSunemploymentisthatonceyougointo this kind of a phase, the business confidence becomes very important to hire more people. Since you can make the existing people work for a little while longer and pay them more if you are not sure about the future prospects, andthecompanieswouldnothirepeople.Now since the future prospects are not very bright, employment is not increasing fast despite the GDP growth being better than before. So the confidence factor becomes important. Unless thegovernmentcaninstillconfidenceviasome means, it will be very difficult to push employ mentup. SKDoyouthinkthattheconceptofcapital ismthatUShasbeenpursuingforquitesome timehaslostrelevancerightnow?Asin,abso lute capitalism is not a valued proposition. Alsoatthispointoftime,withoutgovernment intervention wouldnt capitalism correcting itselfbepainfullyslow?

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Prof One feature of capitalism with all its negative connotations is that it has been sur prisingly resilient, and surprisingly flexible to come out in new forms and avatars. Many times the demise of capitalism has been sug gested but somehow it has managed to come outofthisthing.PeoplearesayingthatUScan gooutofthisthroughNewTechnologies.There is a business cycle. You can shift the business cycle through innovations and new technology (Nanotechnology / green technology, etc), and UShasdonethisovertheyears.WheneverUS gets into trouble, it does something and shifts thetechnologycurveoutside/rightsideandit gets more employment. Because the US is strong in R&D and in technology, it gets the maximumbenefitoutofthat.So,iftechnology comes to the rescue of US (I am talking more about US than capitalism because there would notbemanycountriesintheworldwhichprac tice perfect capitalism most European coun tries are a mix of socialism and capitalism; Within US also, one cannot explain the kind of subsidies people get using capitalism alone). The US has come out of this problem many a times. What is interesting these days is that Keynesian view is becoming more popular and ifyoulookatIMFwebsite,thereisafeatureon Keynesiantheory.Thisissurprising/refreshing becauseKeynesianviewhadbeenrelegatedto oldschooleconomics.So,increasinglyKeynesis becoming more relevant these days and in Keynesiantheory,statesplayamajorrole.So,a state driven economy which is a capitalist so cialist mix would be what is required to come out of this recession (in my opinion). That wouldnotbeademiseofcapitalismbutevolu tionofcapitalism.

PMItlookstomeasifthishasalreadyhap pened. Whatever progress the US has made since the financial crisis would not have been possible but for the significant government intervention. ProfThesystemisflexibleenoughtoincorpo ratethisstuff.AsyouseefromWallStreetOc cupiersandothers,theinequalityhasgoneup significantly and that is the problem which is probablygoingtoaffecttheworldforthenext coupleofdecadesbecausethisisonenegative aspect of capitalist driven growth that US has followedoverthefewyears.Unlessthatiscor rected,problemwillremain.Capitalismisresil ient because it reinvents itself and it comes back.Letusseeandlooktothepossibilityasto how it will do this this time. The most likely pathsareincreasedstateinterventionsandim proved technology, but let us see if something elsecomesup. SK Talking about Keynes, one of the key propositions about Keynes was that the state interventions is necessary to increase the spendingthatwillleadtoapositivespiraland hence our way out of this situation. In that light, how do we look at the fiscal austerity measuresthatEuropeistryingtoimpose? ProfThatispreciselytheoppositeofKeynes. Keynes said that in time of crisis Forget about inflation, just push governments spend ing,increasejobs,buildcapital,buildproductive capacity so that investment grows and so that thisgrowsintokindofavirtuouscycle.Andif whiledoingthatyouincursomeinflationissues, that is no problem at all that might be taken careofinlongrun.Butthiswilltakecareofthe 54

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unemploymentproblemandeconomieswillget out of recession faster. Inflation is a pain for people,butunemploymentisabiggerpain. SKWhataboutthefiscalausteritymeasures thattheEuropeancountriesaredoing? ProfThesemeasureswillonlycomplicatethe matter. As per Krugman and Stiglitz, too much ofausteritymeasureswillcreateproblems.But intheEuropeancontext,ifyoudontgoforaus terityrightnow,theproblemisthatyoucannot borrowfromthemarket.So,therealsolutionis tobeverycarefulwhendoingamonetaryunion and not a fiscal union. California for example facesthesameproblemasGreeceSignificant problems with revenues, etc. But the Califor nian people know that the US government wouldcomeandbailthemout.Thatisnotpos siblefortheEuropeancountries.ECBisnotthe lender of last resort for them. Monetary union without a fiscal union can create problems. HenceitisuptothebiggerEuropeancountries to come and bail these countries out, if they wantto. SKOneofthebiggestcriticismsforEuropeis that the political leadership doesnt have a strongstanceonhowitwantstogoaheadinto thefuture.Inlightofthis,howdoyouseethe futureforthismonetaryunionwithoutthefis calunion?

ProfIcannotprobablysaywhetheritwilllast ornot.ButIwillsaythatifitdoesnotlast,then itwillbeverypainfulprocess,especiallyforthe smaller Eurozone countries. For France and Germany, it would not be a very big issue. But forsmallerEuropeancountries,itisgoingtobe aproblem. SK For Germany, with its currency being se verely overvalued once this monetary union breaks up, and it being export driven econ omy,willitnotcreateproblems? Prof It will create problems but it would not be like that their existence would be at stake. For the smaller countries, it would be much more painful. I hope that Eurozone does not disintegrate and it somehow comes out of this crisis.Butitwillbeverypainful,evenmorethan the Greek crisis if the Eurozone were to break up.Onethingtorememberisthatthepolitical system in each of these countries is different. France is a much more socialist country than the others, so their spending patterns and the waytheyworkisalsoverydifferent.100years agothesecountrieswerefightingeachother,so toaskcountryAtobailoutcountryBandCand letyourowncountrymenbearsomeofthebur denisnotpoliticallythateasytosell.However, they must do it. Otherwise it will be difficult. And these are all ramifications of US crisis, we must remember that. That event basically shook the financial foundations of the smaller Europeancountries.

Prof.ParthaPratimPal HeisanAssociateProfessorintheEconomicsGroupofIIMCalcutta.Hisfacultyprofilecanbe accessedathttp://facultylive.iimcal.ac.in/users/parthapal.Hecanbereachedat parthapal@iimcal.ac.in. 55

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Across 1.ThisSalomonBrotherspartnerfoundedthe
behemothintheworldoffinancialdataafterhis name. 5.Borrowcheap&lendexpensive 7.TheJapanesecharacternamesakeisexpected totakeRomansoutofcrisis. 11.Mistaketrade. 13.Kryptonitetospeculativeinvestments. 14.Theglobalhubofcommoditymarkets. 15.LettheBuyerBeware! 17.CauseofJapaneseRecession. 20.Thistradingstrategywasinspiredbythe1983 movie"TradingPlaces" 21.ThecrisismanagersforEU. 22.CreatedoutofSevenSpanishBanks

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2.The11thheadelectedtobeatthehelmof financialworld. 3.NewYorkFinancierwhorestoredorderamidthe panicof1907 4.HomeofthelargeststockexchangeinEurope. 6.ThetemporarybailoutfundofEU. 8.Forcestheyieldstogoup. 9.RogueDesk! 10.ToutedastheBearStearnsof2011 12.Optimaltimetoexerciseyouroptions! 16.USTreasuryusedthistermfromChubby Checkershitsong. 18.PriceSensitivities 19.Bondsdenominatedincurrencyofthelandof KungFu

Apurva HeisafirstyearPGDMstudentofIIMCalcutta.Hecanbereachedat apurva2013@email.iimcal.ac.in 56