finly july 15

FINLY July 2015

chimerica : the vicious circle

Issue No. 43

TEAM

Dear Readers,

The month of July saw Greece-the first developed nation to default on The month of July saw Greece-the first developed nation to default on sovereign debt which later received credit aid of 7.16 billion Euros through European Financial Stabilization Mechanism (EFSM)in order to remain financially floating. After receiving strong majority of referendum from the Greeks who rejected the austerity measures, a strong Greek conviction seems to have come up of keeping Greece in the European union which was also lately backed by other leaders including Germany. including Germany.

The article of the month subsequently talks about the MUDRA bank and how this initiative of the government will solve the issues which the MSME sector is facing for raising their capital.

Cover story for this month is on CHIMERICA which is about the Cover story for this month is on CHIMERICA which is about the Chinese strategic business policies with The United States that has trapped China in its own dollar game. While engaging it's valuable foreign exchange reserves in funding the US markets by buying the US treasury bonds to support its export, China has created a mess of its policy. The accumulated reserves are proving to be of little use to either resolve a domestic financial crisis or to pressurize The United States. Thus the accumulated reserves are now proving to be a demon States. Thus the accumulated reserves are now proving to be a demon for china itself.

It's the China's stock market crash to almost 30% that has worried the investors across the globe considering the magnitude of its contagion effect. Driven by80% of retail investors, the Chinese stock markets were highly inflated creating the bubble which burst and wiped out the $3 billion from the markets.

Finally we'll have some insights from our seniors sharing their experience in the corporate culture and what career opportunities one possesses in the field of finance.

I would like to thank all our readers for their immense support and encouragement. You remain our prime motivation factor that keeps our spirits high and give us the vigor to keep trying and working hard.

- Abhimanyu Singh Chauhan

Our education section covers the sovereign defaults, the various scenarios under which the sovereign debt crisis may occur, the implications it has on the countries sovereign ratings and the overall macro-economic parameters.

03Editor’s Desk

04Article of the Month

10Educational Section

Trivia

12Alumni Section

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16

17

Faculty Section

News Buzz

Contents

Mercantilism and mei jin:Mercantilism theory argued that a country should export more and import less and receive in exchange gold (the deficit in gold). China had followed mercantilist policies and have amazed large reserves of ‘mei jin’ which liter-ally means ‘American Gold’ (read American dollars).

China exported more than it imported to US (Figure 1), creating large foreign reserves that by 2015 totaled over $3.73 trillion (Figure 2).

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Article of the Month

Gaurhari Pal

Chimerica: The Vicious Circle

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this leads to low Chinese household consumption. Insufficient pension and social secu-rity system further adds to the lower consumption.

Further, the harsh realities that bought many Asian countries on their knees in 1997-98 Asian Financial crisis too have compelled China to build large foreign exchange reserves.

Domestic savings coupled with huge foreign exchange reserves, helped China to boost consumption across the world especially in US.

But, how these ‘mei jin’ turned into ‘iron pyrite’ or ‘fool’s gold’ is what we will explore in this article.

Fool’s gold:

The People’s Bank of China (PBOC) buys dollars earned by Chinese exporters to keep renminibi weak by mandating a high reserve ratio that is required to be maintained by Chinese Banks.


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The ownership of foreign assets as a percentage of monthly average M1 money supply is in between 82-90% during years 2009 to 2014 (Figure 3). This indicate that the M1 money supply was primarily used to buy foreign assets.

Each year, as the reserves continued to grow, China increasingly bought US treasury bonds and other dollar-denominated assets. Chinese dollar infusion helped United States to finance its trade and budget deficits.

Each year, as the reserves continued to grow, China increasingly bought US treasury Each year, as the reserves continued to grow, China increasingly bought US treasury bonds and other dollar-denominated assets. Chinese dollar infusion helped United States to finance its trade and budget deficits.

Spend it Like Beckham:

Chinese dollar infusion helped keep American interest rates low, encouraging increasing levels of borrowing, especially among consumers. Cheap credit enabled US consumer to purchase more Chinese goods.

What “essentials” do the boomers invested all the borrowed money every year?What “essentials” do the boomers invested all the borrowed money every year?US Census bureau provides a breakup on what the Americans are spending the bor-rowed money on:

• $200 billion on furniture, appliances ($1,900 per household annually)• $400 billion on vehicle purchases ($3,800 per household annually)• $425 billion at restaurants ($4,000 per household annually)


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• $9 billion at Starbucks ($85 per household annually)• $250 billion on clothing ($2,400 per household annually)• $100 billion on electron-ics ($950 per household annually)• $60 billion on lottery tickets ($600 per household annually)• $100 billion at gambling casinos ($950 per household annually)• $60 billion on alcohol ($600 per household annually)• $40 billion on smoking ($400 per household annually)• $32 billion on spectator sports ($300 per household annually)• $150 billion on entertainment ($1,400 per household annually)• $100 billion on education ($950 per household annually)• $300 billion to charity ($2,900 per household annually)

Marc Faber of The Gloom, Bloom and Doom summarized the problem of “producMarc Faber of The Gloom, Bloom and Doom summarized the problem of “produc-tion bubble” in Asian countries and how Americans are little to gain by this spending spree, aptly in his June 2008 newsletter with below lines:

"The federal government is sending each of us a $600 rebate. If we spend that money at Wal-Mart, the money goes to China. If we spend it on gasoline it goes to the Arabs. If we buy a computer it will go to India. If we purchase fruit and vegetables it will go to Mexico, Honduras and Guatemala. If we purchase a good car it will go to Germany. If we purchase useless crap it will go to Taiwan and none of it will help the American economy. The only way to keep that money here at home is to spend it on prostitutes and beer, since these are the only products still produced in US. I've been doing my part."been doing my part."

Further, as the market value of the real estate rose, US home owners borrowed on their home-equity this led to the increased imports of Chinese goods and created more outflows of dollars and further increased trade deficit.

Thus, US economic order have become increasingly dependent on dollars flowing from countries like China, Japan etc. This has led to a vicious circle which threatens the foundation of US economy because of the inter-dependence between China and USA - China on spending of US consumers to keep its factories running and US on dollar flows to finance its trade and budget deficit.


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The recent downgrade of US government’s debt rating by S & P further added fuel to the fire by reducing the value of US Treasury bond and the currency held by China.This led people to dub the inscription on dollar bill- ‘In God we Trust’ as ‘I hope my redeemer liveth’, highlighting the prospects that loans might never be repaid.

The Vicious circle:

Curse of export led growth:China’s huge dollar reserves requires a destination which has well developed financial China’s huge dollar reserves requires a destination which has well developed financial markets. To attract them, a country had to be willing to spend much more than its own producers could supply, and a strong financial system capable of attracting the inflows and reassuring the exporters that their savings would be safe, safer than the developing countries had been. The obvious candidate was United States.

Forty years ago, John Connally then the US treasury secretary, accurately identified Forty years ago, John Connally then the US treasury secretary, accurately identified China’s problem: ‘It may be our currency, but it’s your problem.’ China happens to learn this the hardest way possible.

If China tries to pull funds from United States government debt and bring the fund to China then it will have severe effects on exports.

If China were to diversify, say if China were to buy UK’s debt, it would bring down If China were to diversify, say if China were to buy UK’s debt, it would bring down UK’s bond yields. Then UK’s investors would move to United States as the bond yields there would have increased due to China’s moving from US government debt markets. Thus ultimately Chinese funds will land in United States only. For China diversifying to UK or any other developing country would only mean an increase in risk.Further, if China tries to diversify by purchasing resources like iron ore mines, oil fields Further, if China tries to diversify by purchasing resources like iron ore mines, oil fields etc., as it has done in Africa, Australia and in Latin America, there too it has to face risks. As the demand for commodities is mainly driven by the Chinese economy, slow-down in Chinese economy will drive commodities prices down and will thus decrease the value of Chinese investment in resources.


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There is a saying that ‘If I owe you a pound, I have a problem; but if I owe you a mil-lion, the problem is yours.’ China has now understood what vicious circle it has now got into.

Chinese curse’s effects on United States:

If China were to withdraw from US government debt, it will raise the bond yields and ultimately raise the borrowing cost for US consumers. If Federal Reserve increases money supply to bring interest rate down, this may lead to inflation.Though, China’s withdrawal from US government debt market may lead reduction in import from China, however low cost countries (LCC) like India, Vietnam, Cambodia and others may take China’s position in this case and it is less likely that labor intensive jobs will shift to US shores.

Summary and Conclusion:

China seems to be trapped in its own dollar game. The accumulated reserves China seems to be trapped in its own dollar game. The accumulated reserves are proving to be of little use to either resolve a domestic financial crisis or to pressurize United States.Thus its investment of reserves and savings in dollars, has proved to be a demon. If China continues to feed demon, demon only grows stronger (China gets trapped further in the dollar game) and if China stops feeding him, the demon may eat the master (the value of its existing reserve will fall).Export led growth strategy of China has only made both China and Unites Export led growth strategy of China has only made both China and Unites States more vulnerable, as United States need to create demand for the goods produced by China. Further as US politicians took the path of least resistance to tackle growing inequality in United States and favored debt financed consumption, it had only led to heart break as seen in the recent financial crisis which affected both Unites States and China.


With the Greece becoming the first developed nation to default, the international investors are much worried about the risk prevailing in the global economies regarding rising debt levels in the financial crisis leading to sovereign defaults.

So what exactly is a sovereign default and on what parameters is it being quantified?

A sovereign default is the failure or refusal of the government of a sovereign state to A sovereign default is the failure or refusal of the government of a sovereign state to pay back its debt in full. A sovereign default is different from the credit risk default in the sense that the creditors can't repossess the sovereign state's assets the way they can in case of a company. Over the years countries with weak fundamental and economic framework tend to restructure their debt rather than going default. Restructuring of debt may include partial payment of the debt amount which are called 'haircuts' or extension of the time limit to pay. Countries often tend to escape the real burden of debt by inflating the markets or by devaluing their currency by printing more currency debt by inflating the markets or by devaluing their currency by printing more currency or by converting it to the foreign currency or keeping it equivalent to the rates of pre-cious metals, this is how it becomes harder for the investors to quantify the interest or capital default.

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Educational Section

Abhimanyu Singh Chauhan

Sovereign Default

If potential lenders or bond purchasers begin to suspect that a government may fail to pay back its debt, they may demand a high interest rate in compensation for the risk of default. A dramatic rise in the interest rate faced by a government due to fear that it will fail to honor its debt is sometimes called a sovereign debt crisis. Governments may be especially vulnerable to a sovereign debt crisis when they rely on financing through short-term bonds, since this creates a situation of maturity mismatch between their short-term bond financing and the long-term asset value of their tax base. They may also be vulnerable to a sovereign debt crisis due to currency mismatch: if few may also be vulnerable to a sovereign debt crisis due to currency mismatch: if few bonds in their own currency are accepted abroad, and so the country issues mainly foreign-denominated bonds, decrease in the value of their own currency can make it prohibitively expensive to pay back their foreign-denominated bonds.

Since a sovereign government, by definition, controls its own affairs, it cannot be obliged to pay back its debt. But the government comes under international and do-mestic pressure to repay it’s obligations. The implications of debt crisis severely affects the economic scenario of the state, and the government is pressurized to follow some austerity measures which curbs the government spending which affects the GDP growth. Poor output levels raises the current count deficit which affects the credit rating agencies’ abilities to keep an eye on various instruments. Downgrading of the rating as an investment destination makes the nation extremely difficult to raise of the rating as an investment destination makes the nation extremely difficult to raise capital in order to revive the economic system, followed by the domestic pressure. Domestic savers and investors, anticipating a fall in the value of the local currency, will scramble to withdraw their money from bank accounts and move it out of the country. To avoid bank-runs and precipitous currency depreciation, the government may shut down banks and impose capital controls. As punishment for default, capital markets will either impose punitive borrowing rates or refuse to lend at all.

Currently, there is no international law or courts for settling the sovereign defaults, which explains the reason of default cases to be so varied in length and severity. The need of the hour is to come up with a framework which allows to quantify the risk beforehand by keeping the hard view on how the source of funds is being utilized jus as the way it is done by international financial bodies like IMF for developing nations same procedure has to be followed for the developed and industrial nations, which are more likely to default in order to save the interest of the investors.

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Educational Section

“An investment in knowledge pays the best interest.” - Benjamin Franklin

It gives meimmense pleasure to write for FINly again. I would like to share It gives meimmense pleasure to write for FINly again. I would like to share with our readers some of my experiences and make few suggestions for the corporate life in the field of finance.I have been placed at ICRA Limited as a Senior Associate Analyst. My work includes analysing the financials and un-derstanding the overall business of a companyin order to assess their credit risk and rate them accordingly. The most important thing which I learnt in the first week of my professional world was to understand the application of our classroom learning in real life scenarios. I realised that some of theoretical classroom learning in real life scenarios. I realised that some of theoretical concepts of finance like ratio and peer group analysis can be better under-stood, only when you actually apply them. I have workedfor only two months at ICRA Ltd., but the learning has been immense and the scope still remains wide. The financial domain is very wide, so don’t be disappointed if you don’t get to do what you feel is worthwhile in the beginning because as long as you are learning, you are growing in the in the professional ladder. I would also like to suggest to my readers that high salary packages should not be a priority to those who are looking for a good profile in the financial domain because you may have to make a compromise between the two. I chose a good profile and the satisfaction of the work exceeds all other factors for me.

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Alumni SectionIrina Goel

Coming to preparations for placements, it would be redundant to point out that a lot of reading and a sound understanding of basic financial concepts is required. Also, Economics and Finance have a lot of synergies between the two and an understanding of one subject would require an understand-ing of the other as well. Therefore, it is important to keep yourself updated on the news and be aware of the impact of macro-economic changes and policies on business environment. Companies hiring for finance profiles usually take written tests, which are not tough to crack if your finance and usually take written tests, which are not tough to crack if your finance and economics basics are strong.

Finally, I would like to say that even though the transition from college life to corporate life is a little tough because of more responsibility and lesser freedom to work like you want, you can make the best of the initial few years of your new career to learn, make new contacts, new friends, add new memories and new experiences.

I wish all our readers and finance aspirants all the very best for their future career and I hope that all of you enjoy your work as much as I do when you enter the corporate life.

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Alumni Section

Finance Minister of India while presenting the Union Budget 2016 announced to start up MUDRA bank. MUDRA stands for “Micro Units Developments & Refinance Agency”. It is an institution specially set up by Government of India for refinancing and development of Micro, Small and Medium Enterprises (MSMEs) in India. MSME sector in India is playing very important role for development. Nearly 45 % of our manufacturing output and 40 % of our exports is contributed by MSME sector. Growth of this sector is critical for our GDP. The biggest problem this sector is facing today is access to financial support by organised financial sector like banks and today is access to financial support by organised financial sector like banks and NBFCs. With a view to encourage the banks and other financial institutions to provide financial support to MSME sector, MUDRA bank is created. MUDRA will refinance to the lenders like Commercial Banks, Regional Rural Banks, Cooperative Societies, and Small Banks etc. who are in to MSME lending.

MUDRA is ready with the schemes through which it is targeting micro and small busi-ness entities that are into manufacturing, trading and service activities. The scheme of lending by MUDRA is signifying the stage of development and funding needs of the borrowers and also its growth to the next level of operations.

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Faculty Section

Dr. Pankaj TrivediProf. and Area Chair Person Finance, SIMSR

Mudra Bank

MUDRA has named the lending scheme as follows.(a) Shishu; Loan up to Rs.50,000(b) Kishore: Loan from Rs. 50,000 to 500,000(c) Tarun: Loan from Rs.500,000 to 10,00,000

MUDRA is a good beginning for refinancing the lenders lending to MUDRA is a good beginning for refinancing the lenders lending to MSME. Apart from refinancing, MUDRA will also come out with policy guidelines for MSME financing business. MUDRA is proposed to design policy relating to ratings of Micro Finance Institutions, client protection, recovery methods, and technology issues faced by MSME lenders.

MUDRA to be effective, need to look at better risk management practices MUDRA to be effective, need to look at better risk management practices like any other banks, considering the unique features of lending to MSME sector. Also MUDRA needs to come out with innovative financial prod-ucts at rational price.

In the family of refinancing agency in India, we already have three mem-bers, NABARD, SIDBI and NHB. Welcome to the forth member MUDRA.

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Faculty Section

Greece no longer in default on its loans- IMFIMF declared Greece to be longer in default on its loans after it remitted about 2 billion euros ($A2.93 billion) to make up for missed debt pay-ments. Athens has also initiated repayment of overdue loans to the Euro-pean Central Bank and is also paying back a 500 million-euro loan to its own central bank. Greece owes 3.5 billion euros to the ECB and national central banks in the euro area for government bonds that have matured, including 0.7 billion euros in interest. The credit worth 7.16 billion euros that it received last week from the European Financial Stabilization Mecha-nism (EFSM) has been serving as a bridge loan to keep Greece financially afloat until a new aid package is agreed by eurozone member countries.

Maurice Obstfeld becomes the new Blanchard

White House economic adviser Maurice Obstfeld is to become the Interna-tional Monetary Fund’s new chief economist, succeeding Olivier Blanchard who is retiring.

Bharti Airtel enters into exclusive talks for sale of 4 African units to Orange

French telecom group Orange SA is in talks to buy four of Bharti Airtel Ltd’s African businesses as the French phone company looks at ways to push expansion in one of its fastest-growing markets. Orange is discussing the possible acquisition of Bharti’s Airtel units in Burkina Faso, Chad, Re-public of Congo and Sierra Leone.

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NEW S BUZZ

Sebi, RBI working for smooth e-IPO rollout:

Market regulator Sebi is working with the Reserve Bank of India (RBI) for Market regulator Sebi is working with the Reserve Bank of India (RBI) for a smooth rollout of the proposed e-IPO process. This will reduce paper-work in public offerings to nearly zero, halve the timeline for listing of a company to just six days and also reduce costs of listing substantially. Sev-eral banks are currently working to roll out the ASBA (Applications Sup-ported by Blocked Amount) system through all the branches, which is cru-cial for launching the e-IPO process. Sebi has set January 1, 2016 as the date for launch of this paperless public offering system.

Banks seek RBI nod to spread Q1 bond losses over four quarters:

Yields on government securities (g-secs), which were on a declining path Yields on government securities (g-secs), which were on a declining path since early October last year, reversed their trajectory after RBI announced a hawkish stance in itsbimonthly policy review in June. The yield on the 10-year benchmark government bond, for example, has moved up 18 basis points (bps) since the policy was announced. Worried over mounting losses in their bond portfolio in the April-June quarter, banks have re-quested the Reserve Bank of India (RBI) to allow them to amortise mark-to -market losses (writing down assets at current values) over the next four quarters.

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NEW S BUZZ

Finstreet, Finance Committee of [email protected]

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