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THE INVESTOR VOLUME 5 ISSUE 4 April 2012

Algorithmic, high frequency and

flash trading, Pg. 08

The africa cup: advantage scapering

dragon or loitering elephant, pg. 19

Who won and Who lost?


2/28Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bearsno responsibility whatsoever.

F R O M E D I T O R S D E S K

NiveshakVolume V

ISSUE IV

April 2012

Faculty Mentor

Prof. N. Sivasankaran

Editorial Team

Akanksha Behl

Akhil Tandon

Chandan Gupta

Harshali Damle

Kailash V. Madan

Nilkesh Patra

Rakesh Agarwal

Creative TeamAnuroop Bhanu

Venkata Abhiram M.

All images, design and artwork

are copyright of

IIM Shillong Finance Club

Finance Club

Indian Institute of ManagementShillong

www.iims-niveshak.com

THE TEAM

Dear Niveshaks,

It is the budget season in the count and all the newspapers across the nation areabuzz with analyses of to of the most imporant budgets, the Railway Budget and the

Union Budget.

The Railway Budget was seen as a golden oppornit for Trinamool Congess nomi-nated Dinesh Trivedi to make a mark in Union Politics. However, with an increase in pricesranging om 2 paise to 30 paise per kilometer, across dierent sections of the Railways, Mr.Trivedi did his reputation no good. The budget will be remembered more for the politicaldrama that unfolded beteen him and Ms. Mamta Banerjee. With stong demands to roll-back the fare hike, Mr. Trivedi had no option but to resig leaving the TMC to nominateMr. Mukul Roy as his successor.

The Union Budget rolled out no such surrises, with Mr. Pranab Mukherjee, nowa veteran at presenting budgets, presenting a satisfactor blueprint for the nex nan-cial year. The crx of the budget was aimed at maintaining the delicate balance beteen

gowth (curently at 6.9%, but pegged to reach levels of 7.6%), ination (which has seena continued decline) and the burgeoning scal decit (curently at 5.9%, but pegged tolower down to 5.1%).

For the individual investor, an increase in the income tax slab to Rs.2 lakh bringsmuch cheer. However, the provident fnd rate reduced by 125 basis points to 8.25% tooset some of the benets. The auto indust is likely to take a hit, with an increase in

prices highly likely. This is mainly due to an increase in excise dut to 12% om the cur-rent 10% levels. The retail sector saw some cheer with the FM commiing to allow FDI inMulti-brand retail in the near ftre and also seing augst as the deadline to implementGoods and Serices Tax.

Overall, the budget was in line with the exectations of many and did not dish outtoo many surrises. The cover stor this edition, featres a detailed analysis of the UnionBudget, what it means for a company and to the individual.

The last scal seems to have overcome some of the gloominess that existed in themarket, with top CEOs pocketing handsome salaries. Indra Nooyi, the Indian bor CEOof PepsiCo pocketed a he $17 million in compensation, while the Indian bor CEO ofCitigoup Inc., Vikram Pandit pocketed a handsome $14.5 million.

Protest-hit Marti Suzuki has decided to invest Rs.900 crore more at its upcomingR&D cente at Rohtak. This comes in the backdrop of a stong shi in customer focus om

petol cars to diesel ones. The Rs.900 crore investent is over and above the Rs.1700 croreinvestent in the plant in Gurgaon, which is set to be operational by mid-2013.

This months issue brings to you an insight into the Union Budget of Indian Gov -erment 2012-2013. The aricle of the month exlains the legal aspects of algorithmic, high

equency and ash tading. The issue also featres interesting reads on the investentstategies of India and China in Aican continent, scenario of weather based insuranceindex in India and the concept of sovereig credit ratings. This months classroom sectionexlains to you the concept of Quantitative Easing.

With summer placements about to begin for most of our readers, we, at Niveshakwish you all the ver best in your respective intership stints.

We would also like to thank our readers for mailing their wonderfl aricles andappreciation e-mails. It is your constant encouragement and enthusiasm that keeps us

going.

Kindly send in your suggestions and feedback to [email protected] and asalways, Stay Invested.

Team Niveshak


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C O N T E N T S

Niveshak Times

04The Month That Was

Article of the month

08 Algorithmic, High Frequen-cy and Flash Trading

Cover Story

11 Union Budget 2012-13-Who Won and Who Lost ?

Perspective

16 The Africa Cup:AdvantageScampering Dragon or LoiteringElephant

Finsight

19Weather Based Crop Insur-ance in India

Fingyaan

22Sovereign Credit Ratings:An Analysis of The Ratings

Downgrades in The US and EuroZone

CLASSROOM

25 Quantitative Easing


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Threat of ying license of Kingsher Air-

lines being cancelled

KingfisherAirlines lacks aircrafts as well as reserves forits day-to-day processes. They have not onlycaused inconvenience to passengers by notmeeting their flight schedule but have also failedto pay salaries to their employees for over fourmonths. This resulted in the prospects of its fly-ing license being cancelled. Also, the airline hasdecided to limit its overseas flights operationsto avoid more losses and also return its leasedaircraft. An explanation, for the same, needs tobe presented to the Directorate General of CivilAviation (DGCA) by Vijay Mallya. However, CivilAviation Minister Ajit Singh said that as per rules

the licenses of an airline cannot be cancelledas long as it has five planes and certain equityto run the business. Hence, shutting down ofoperations is call that Vijay Mallya would haveto take.

India to continue being an importer ofcrude oil from Iran

Oil Minister S Jaipal Reddy announced that Indiawill continue to import crude oil from Iran aslong as the International law is not violated de-spite financial sanctions made by the US againstcountries which do not cut Iranian oil purchases.The countrys purchases of crude oil, accountingfor about one tenth of its total crude imports,have been hampered due to banking difficultiesas most of the international banks are followingthe sanctions imposed by US and Europe andhence are not ready to route Indian paymentsfor Iranian oil. As a result, the two countries areconsidering making payment for oil partly in In-dian rupees and the remaining through export

of various commodities and services from India.The country is however, looking forward to diver-sifying its sources of crude imports to reduce therisks of dependence on any particular region. Asmentioned by the Foreign Minister S.M Krishna,

India would not be directed by authorizationsunless they are made obligatory by the UnitedNations.

US nominee to lead the World Bank an

expert in global health

Overturning a seven-decade tradition of havingofficials with experience in finance or diplomacy,as the president of the World Bank, President

Obama nominated Jim Yong Kim, president ofDartmouth College in New Hampshire and formerdirector of the Department of HIV/AIDS at theWorld Health Organization. Dr. Kim is a Korean-American known for his work in fighting diseasein impoverished countries. The choice came as asurprise as Washingtons past picks for the posthave had more standingin political circles. Mr.Obama also broke thepractice of selecting po-

litically connected indi-viduals for this post. Thedecision to nominate Dr.Kim was taken in part tocounterweight disparage-ment from developing na-tions about the U.S. lockon the job. He has demonstrated a leadershipstyle and charisma that would serve him well atthe bank. He is nearly certain to succeed Rob-ert Zoellick as Washington has the largest single

voting share at the World Bank and is likely toget the support of the banks second-largest vot-ing member, European nations and Japan.

Citigroup fails Fed Stress Test

A stress test conducted by the Federal Reserveon 19 banks proved that Citigroup was amongstthe four banks, others being Ally Financial Inc.,MetLife Inc. and SunTrust Banks Inc., which failedto pass the test designed to assess the neces-sity of reserves to endure another catastrophe

like the credit crisis of 2008. The test showedthat these four banks had less than 5% of capitalset aside under Tier 1 capital ratio, thereby fail-ing to meet the adequacy standards. This deci-sion was a disappointment to Citi, which had

The Niveshak Times


IIM, Shillong

Team NIVESHAK

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assured to increase its dividend above a notional1 cent a share for the first time since its neardownfall during the financial crisis. The groupclaimed that it failed only because of its plannedcapital-return plan.

Mahindra Satyam to merge with Tech

Mahindra

Tech Mahindra and Mahindra Satyam have decid-ed to merge into a combined entity which wouldrun under the aegis of C.P Gurnani, current Chief

executive of-ficer of Ma-hindra Saty-am. The $2.4billion entityis all set to

become a major player in the competitive Indiansoftware industry. The Board of Directors of thetwo companies fixed the swap ratio for the merg-er at 17 shares of Mahindra Satyam for every 2shares of Tech Mahindra. The combined entity

is Indias sixth largest IT service provider, witha market value of over $3billion and revenuesin excess of $2.4billion. The roots of the mergercan be dated back to 2009, when Tech Mahindraacquired the scam-struck Satyam computers, thethen fourth largest IT service provider of India.The news was well accepted by the bourses, asthe shares of both the companies closed at a 5%high on the day of announcement.

Norms for gold loan NBFCs revised

Citing concerns over the heavy borrowing andsale of bonds by Gold finance NBFCs, the reservebank of India has tightened rules for lendingagainst gold by finance companies, saying therapid growth in such loans in the past few yearshad increased risks to the banking system andretail investors. The NBFCs having atleast 50% oftheir assets in gold have been directed to main-tain a 12% Tier 1 capital from April 2014. In addi-tion to this, the companies have been instructednot to lend more than 60% of the value of their

gold jewelry. Of late, these NBFCs have borrowedin huge numbers from the banks and the public.Since these companies use Gold as collateral, itmakes the entire system vulnerable to gold pricemovements. The central bank fears that a fall in

the price of gold, might lead to a collapse of theentire system. RBI has also banned companiesfrom lending against bullion, primary gold andgold coins, leaving just jewelry.

BRIC nations eye multilateral develop-

ment bank

In wake of thefaltering glob-al economy,the BRIC na-

tions of Bra-zil, Russia, In-dia and Chinaare consider-ing creationof a multilateral development bank which wouldfacilitate financing of projects in these countriesas well as abroad. As per the statements doingrounds in the public domain, Brazil seems to beenthusiastic about the prospects of the deal. Theleaders from the respective countries are sched-

uled to meet in India soon, where they are ex-pected to sign a memorandum of understandingfor the same.

SBI to be more customer focussed

In another effort to become more customerfriendly, State Bank of India announced that itwill permit loan borrowers to switch to a lowerinterest rate. The decision is likely to affect amajor chunk of its 17 lakh loan borrowers, anda gain of approximately Rs 6000 a month on a20 year mortgage of Rs 50,00,000 can be ascer-tained. Recently, the bank also waived off pre-payment penalty on loans. In another valiant ef-fort SBI has cut its processing fee, and the feenow stands at 10.75% for home loans up to Rs 30lakh, 11% for loans between Rs 30 lakh and Rs 75lakh, and 11.25% for upward of Rs 75 lakh. Thebank is setting strong standards in the highlycompetitive banking industry, which will be dif-ficult for others to ape.

The Niveshak Times

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FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG


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MARKET CAP (IN RS. CR)BSE Mkt. Cap 60,81,408

Index Full Mkt. Cap 28,61,366

Index Free Float Mkt. Cap 14,35,450

CURRENCY RATESINR / 1 USD 50.92

INR / 1 Euro 67.85

INR / 100 Jap. YEN 61.52

INR / 1 Pound Sterling 81.21

POLICY RATESBank Rate 9.50%

Repo rate 8.50%

Reverse Repo rate 7.50%

Market Snapshot


RESERVE RATIOSCRR 4.75%

SLR 24%

LENDING / DEPOSIT RATESBase rate 10%-10.75%

Deposit rate 8.5% - 9.25%

Source: www.bseindia.comwww.nseindia.com

Source: www.bseindia.com

Source: www.bseindia.com13th March to 28th March 2012

Data as on 28th March 2012

MarketSnapshot

CURRENCY MOVEMENTS


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MarketSnapshot

BSEIndex Open Close % ChangeSensex 17,772 17,122 -3.66%

MIDCAP 6,375 6,191 -2.89%

Smallcap 6,787 6,451 -4.95%

AUTO 10,030 9,844 -1.85%

BANKEX 12,260 11,476 -6.39%

CD 6,751 6,283 -6.93%

CG 10,341 9,995 -3.35%

FMCG 4,151 4,473 7.76%

Healthcare 6,455 6,446 -0.14%

IT 6,151 6,021 -2.11%

METAL 11,629 11,017 -5.26%

OIL&GAS 8,383 7,850 -6.36%

POWER 2,234 2,057 -7.92%

PSU 7,656 7,138 -6.77%

REALTY 1,839 1,726 -6.14%

TECK 3,611 3,528 -2.30%


Market Snapshot


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Trading has been traditionally carried out in thestock exchanges, where traders negotiate onthe bid-ask prices and make profit on the dif-ference in spread or by using price differencesof the same security in different exchanges (ar-bitrage). In the last decade, with competitionbecoming much intensive, traders began usingfast computer systems to execute trades close

to the speed of light. These computer systemsused High frequency algorithms to take advan-tage of miniscule spreads for ephemeral peri-ods, which is impossible to be performed byhuman traders. High Frequency Trading systemsuse algorithms which track miniscule changes inprices, ephemeral price arbitrages and executetrades with extremely low latency. With emer-gence of advanced technology new methodslike co-location, flash trading and dark pools be-gan to be used in the markets. High frequencytrading systems can be simply viewed as a largegroup of market makers providing liquidity inthe markets. But there are also shades of greyassociated as some investors feels that thesesystems make money from the pockets of otherinvestors by bypassing trades and acting as ar-tificial pseudo- middlemen. This negative senti-ment has been accentuated by events like the

Flash Crash of May 6, 2010.

This article attempts to analyse the differentforms of HFT systems and their regulatory ambitwith respect to the SEC and SEBI and whetherthe fears of some investors about unfair advan-tage to certain favoured traders using HFT sys-tems is indeed true.

Co-location

Co-location is a practice where exchanges builddata centres and rent out racks of computingspace to HFT traders for a fee and thus allowtraders to position their computers as close aspossible to the exchanges servers to cut downa few microseconds off trading times. Co-loca-tion has become a controversial issue in recenttimes with a lot of question raised about its fair-ness and even legality in terms of offering equalopportunity for all market participants. If a bro-

ker hits the enter key faster than a HFT firm,then the broker should get the stock and notthe HFT firm that paid co-location rent to placeits server closer to the exchange. But currentlywith co-location that is not the case. Here, theissue is a market structure which threatens tothwart competition. Regulators including the USSecurities and Exchange Commission and SEBIare concerned that whether this practice holds

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IIM CalCuttaCharan Kumar U

High Frequency Trading systems use algorithms which track miniscule changes in prices, ephem-

eral price arbitrages and execute trades with extremely low latency. With emergence of ad-

vanced technology, new methods like co-location, ash trading and dark pools began to be used

in the markets.

Algorithmic, High Frequency andFlash Trading

Are they anti-competitive?What is the regulatory view

point?



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everyone on an equal footing.

The SEA (1934) requires that the terms of co-location services must not be unfairly discrimi-natory, and the fees must be equitably allocatedand reasonable Exchanges must obtain approv-al of the SEC for offering co-location services to

their customers. By approving the co-locationservices of NASDAQ, however, the SEC seemed toimply that this practice, by itself, is not unfairlydiscriminatory.

With respect to India, NSE has already enteredinto contracts with 60 members for the co-loca-tion facility. The members can place their trad-ing servers close to that of the exchange forRs. 22.5 lakhs. The available space is offered ona first-come-first served policy. The broker withthe trading server next to the exchange enginehas his price feed updated every 3 to 4 mil-liseconds as compared to a broker at a remoteplace whose feed gets updated once in 30 to 40milliseconds. In an attempt to not leave asideanyone, NSE has developed a computer cloudmodel where in the IT infrastructure is sharedwith small brokers who cannot afford the high-end servers used for HFT. This would mean notdifferentiating anyone with their capacity to in-vest. But is this enough? Does SEBI feel that it

offers an equal ground for every market partici-pant? This remains the much debated question.

Flash Orders

Flashing is the process of disclosing specific or-ders/ quotes to only a special class of inves-tors for a fee. It helps the exchange concernedto convert the unmatched trades into matchedones by providing an incentive (commission) totraders willing to take additional risk by execut-ing such trades. It creates a scenario where both

the flash participants and the flashing exchangeare mutually benefitted.

Anti-competition vs Efficiency of markets - FlashTraders defend this practise by citing the gen-eral principles of competition applying to all in-dustries where advantage due to technologicaladvancement or inn patents is legal and valid.While this competition among the Flash traderscan be deemed fair, the practise of paying a fee

to obtain information which can make the dif-ference between competitors miles apart doesnot seem to be fair. This practise creates a two-tiered market and even multi-tiered market de-pending on the resources of the traders. Thisis exactly the reason why SEC proposed to ban

Flash Trading in 2009 stating the following rea-sons:

SEC states that flash trading could destroyfair competition and efficiency if flash trad-ing were to expand to greater trading vol-ume11.

SEC states that banning flash orders couldlead market participants to display more oftheir trading interest, thus providing addi-tional price transparency.

Under Regulation NMS, a registered exchange oran ATS is prohibited from imposing unfairly dis-criminatory terms that would prevent or inhibitany person from obtaining efficient access tothe trading centres displayed quotations at thebest prices. An exchange will violate this rule ifit charges access fee more than the limit set bythe Regulation NMS. But the issue in Flash Trad-ing is about the very practise of charging accessfee to view data.

Presently, flash orders are permitted as an ex-ception to Rule 602 of Regulation NMS under theSecurities Act of 1934. However, the proposedban has still not taken effect as lot of HFT lob-byists and industry executives are emphasisingthe fact that how flash orders benefit retail in-vestors by lowering costs and even if a ban isinitiated, it should not be a blanket ban andshould exclude a few markets like the equitymarket.

From a legal viewpoint, Flash trading & HFT are

primarily not used with the intention to defraudinvestors. The mechanism of HFTs like quotestuffing might create mispricing in course ofaction, but such instances have been rare. Butsuch misrepresentation is in violation of sec 12A (a), SEBI Act 1992.

Flash traders are disclosed quotes millisecondsbefore others see them and they disclose their

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Flash trading allows a section of traders to view proprietary data feed and execute trades, but

it does not create articial rise or fall in prices of securities. Also the intent is to affect a tradefor the trader himself rather than to induce purchase or sale by another trader. Though ashing

involves dissemination of information, there is no evidence of articial rise or fall of prices of

securities.


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executions only after trades are completed. Theposition of SEBI regarding this practise is un-clear.

Defenders of Flash trading argue that there isno clear definition of fairness in trading fair-ness-based arguments are difficult to employ in

support of compelling disclosure of private in-formation by large liquidity traders, particularlyas regards transaction information and futuretransactions4. They also cite references fromsection 9 a(3), SEA Act (1934) implying an am-biguous position on Flash Trading -

circulation or dissemination in the ordinary

course of business of information to the effect

that the price of any such security will or is

likely to rise or fall because of market opera-

tions of any 1 or more persons conducted forthe purpose of raising or depressing the price of

such security

Flash trading allows a section of traders to viewproprietary data feed and execute trades, butit does not create artificial rise or fall in pricesof securities. Also the intent is to effect a tradefor the trader himself rather than to induce pur-chase or sale by another trader. Though Flash-ing involves dissemination of information, thereis no evidence of artificial rise or fall of pricesof securities.

The market regulators need to evaluate the trad-eoffs and take a hard line here as the stakes aretoo high, especially after the flash crash of May6 2010 which erased $862 billion in value fromthe markets.

Fat FingerTrade/ Freak Trade

Freak trade arises in a situation when a largevolume order on a specific stock/derivative is

wrongly entered on some other stock/derivativeby the traders mistake. The Indian flash crashon June 1, 2010, similar to the US flash crash onMay 6, 2010, is attributed to a freak trade orderentered by a trader causing a quick sell off inthe market. The alleged cause for the crash isa freak order entered by an unidentified traderfor 500,000 Reliance shares at Rs. 840 insteadof putting the same for ICICI Bank stock that

was trading at Rs. 846. Immediately, Relianceshares came crashing down from Rs. 1028.60 toRs. 840.55, a fall of 18% in a moment. Becauseof the high weight of Reliance in the Sensex, theindex also fell by 442 points, a fall of 3%, with-in a minute. According to Bloomberg data, this

caused a panic in the market and about 2.12lakh Reliance shares exchanged hands within aminute. This unusually high number was almost40% of the traded volume of the Reliance scripthe previous day. All in a minute!

Soon after this incident, SEBI is working onframing a policy for the stock exchanges to gothrough a stress test so as to better preparethem in facing flash-crash like situations in thefuture. Issues like across-the-board panic saledue to a steep fall in some stock (either due to

a freak trade or due to stock-related bad newssuch as scams) and crashes due to large marketorders interacting with a thin order book arekeeping the regulator on its toes.

Dark Pools

Dark pools, in simple terms, are trading plat-forms / exchanges that match buy and sell or-ders of large institutional investors with hugeblocks of securities, in the process bypassingthe central exchanges and carrying out off-mar-

ket deals in a completely anonymous manner.There are no stock quotes published all the timelike in public exchanges. An electronic system isused for order-matching, prices fixed betweenthe counterparties and transactions completed.Dark pools raise the issue of equality of oppor-tunity for all market participants. Dark pools canturn disadvantageous to the retail investors inthe market as they are totally left out from thesystem and cant participate in these trades.

To better understand why investors participatein a dark pool, let us consider an institutionalinvestor like a large pension fund wanting tosell a huge block of a particular stock, say GE, inthe market. Suppose the pension fund managergoes to a public exchange like NYSE with the bigchunk of GE shares, every move of his is beingclosely watched by the market since these in-stitutional investors act as the bellwether in the

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SEBI started working on framing a policy for the stock exchanges to go through a stress test so as

to better prepare them in facing ash-crash like situations in the future. Issues like across-the-board panic sale due to a steep fall in some stock (either due to a freak trade or due to stock-

related bad news such as scams) and crashes due to large market orders interacting with a thin

order book are keeping the regulator on its toes.



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market. Since all the bid and offer are shownpublicly in NYSE, due to the weight of the mul-tiple blocks sold and the technical pressure, thelast block of GE share sold by the pension fundmight be much lower thanthe first block. Dark pools,

in contrast, guarantee ab-solute anonymity. It cutsaway the opportunity ofmarket reacting before thetransaction is made as nodisclosure is to be manda-torily made to the public bythe dark pool and any dis-closure made is only donepost-trade.

Stub Quotes

A stub quote is an offerto buy or sell a securityat a price that is far awayfrom the prevailing marketprice, say a bid at 1 centand an offer at $100,000,that if executed could leadto freak movements in theprice of the security andunnecessary market panic.

Stub quotes, cited to bethe main villain of the May2010 flash crash in the US,is a tool that market mak-ers use to meet their obli-gation of maintaining two-way quotes continually inthe market but in actualityare unwilling to provide li-quidity. For example, if aninvestor has put in a sell

at market price order anda stub quote of bid 1 centis the only order in themarket, the stock falls from its current marketprice to 1 cent in no time. The same happenedwith a few stocks during the flash crash. Therewere no safeguards in the US markets to pre-vent this until recently. The SEC, with effect from

Dec 6, 2010, realized this and imposed a ban onstub quotes. Apart from this, the SEC has alsoinitiated a circuit breaker pilot program. Underthis, trading would be stopped if certain equity

prices moved more than10% in 5 minutes.

From a legal viewpoint,section 9. 2(A) of the SEAAct (1934) prohibits anytrade practice with intentto create price manipula-tion or deceive the mar-kets by creating a sce-nario of artificial pricing.By using HFT systems toperform quote stuffing,which is making random

non-executable ordersto glean market inter-est in an order, the HFTsmight be in violation ofthe above regulation. Butsince the probability of acrash due to stub quotesis very low until nowand the traders try tooutsmart law by using aloophole in the same sec-tion 9.2(a) by saying thatthere was no maliciousintent while using thepractice of quote stuffing.

Naked / Unltered /Sponsored Access

Naked or unfiltered ac-cess is a practice that al-lows HFT traders of vari-ous firms to send ordersdirectly (and anonymous-ly) to stock exchanges us-ing a sponsoring brokers

ID. Exchanges might not get to know the identityof the firms using naked access as the only wayto know the same is the computer identifica-tion code. Naked access allows a reckless HFTtrader to put in thousands of erroneous trade

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Stub quotes, cited to be the main villain of the May 2010 ash crash in the US, is a tool thatmarket makers use to meet their obligation of maintaining two-way quotes continually in the

market but in actuality are unwilling to provide liquidity.

The issue of a trade-off that exists betweenpromoting efficiency &competition among ex-changes and the conse-quent impartiality showntowards normal investorshas to be highlighted. Thewhole issue of whetherto effect an outright ban

on HFT, Flash trading ornot has been hanging inbalance for about 3 yearsnow mainly because ofthe trade-off describedabove. Numerous litiga-tions about the proposedban, especially in the US,have failed chiefly due tothe argument of tradersabout the consequentcost of banning algorith-mic trading outweighingthe benefits to smallermarket participants. Thismakes it difficult for law-makers to pass conclusivejudgements on the issuemaking it a matter of con-tention and debate thatsgoing on even as this ar-

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within the two minute period it might take tocorrect a market glitch. In November 2010, SECapproved a rule to curb the practice of nakedaccess and prevent brokers from handing overtheir IDs to trading firms. According to MarySchapiro, SEC chairman, Unfiltered access is

similar to giving your car keys to a friend whodoesnt have a licence and letting him drive un-accompanied. This proposal would require thatif a broker-dealer is going to loan his keys, hemust not only remain in the car, but he mustalso maintain control of it so that the persondriving observes the rules before the car is everput into drive. HFT firms, though, have raisedobjections citing that addition of identifiers andpre-trade risk management practices will slowdown their trading speeds.

On a concluding note, the issue of a trade-offthat exists between promoting efficiency & com-petition among exchanges and and the conse-quent impartiality shown towards normal inves-tors has to be highlighted. The whole issue ofwhether to effect an outright ban on HFT, Flashtrading or not has been hanging on a balancefor about 3 years now mainly because of thetrade-off described above. Numerous litigationsabout the proposed ban, especially in the US,have failed chiefly due to the argument of trad-ers about the consequent cost of banning al-gorithmic trading outweighing the benefits tosmaller market participants. This makes it dif-ficult for lawmakers to pass conclusive judge-ments on the issue making it a matter of con-tention and debate thats going on even as thisarticle is being written.

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FIN-Q Solutions

March 2012

1. SEBI, U. K. Sinha

2. Nakahara Prize, Jap-anese Economic Association

3. Bank for Internation-al Settlements

4. Help-Wanted Index HWI

5. Corporate Dossier

6. Commissioner vs.Mary Archer W. MorrisTrust, Reverse Morris Trust

7. Buon Ma Thuot CoffeeExchange Center, Vietnam

8. Walt Disney

9. National Rural Em-ployment Guarantee Act,2005

10. Seagull Leafin



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Agriculturegrowthprojectedat2.5%in2011-12

Industrialgrowthpeggedat4-5%inFY12

Inflationarypressuresfadebytheyearendas

food prices fall

WPIfoodinflationslumpsfrom20.2%inFeb10

to 1.6% in Jan 12

Fiscal consolidation could spur Savings and

Capital formation

Impact on Common Man

The Union Budget could not meet the expec-tations of common men because of rising in-flation. They had an expectation that this timethey will get some major benefits from taxation.They got some benefits from this budget butthose cannot be categorized as major. There arechanges in the tax slabs. Tax exemption limit isincreased from 1.8lacs to 2lacs and the 20% tax

slab is now from 5lacs to 10lacs. There will beno implementation of Direct Tax Code this year.Because government did not have enough timeas there were issues related to Anna Hazare,Food security bill and lot more. There is a newdeduction called preventive health checkupincluded under Section 80D, where a person caninclude health checkup cost up to 5,000. Now

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teaM NIveshakHarshali Damle & Nilkesh Patra

This years Union Budget came amidst tons ofexpectations not only from our countrymenbut also the entire global community. This ar-ticle provides an analysis of the budget and themajor take-aways for the common man. At thestart, the finance minister stated five objectivesof which focus on demand driven growth, ex-panding private sector investment and address-ing supply side bottlenecks were considered tobe high priority. The focus of this Budget wasclearly on infrastructure and fiscal consolida-tion.

Economic Survey Summary

The Union budget was preceded by the Econom-ic Survey tabled by finance minister, Mr. PranabMukherjee. This document is useful for policy-makers, economists, policy analysts, businesspractitioners, government agencies, students,

researchers, the media, and all those interestedin the development in the Indian economy. Themajor highlights of the survey are:

IndianEconomyestimatedtogrowby6.9%in

2011-12

FY13 and FY14 growth estimates pegged at

7.6% and 8.6% respectively

Union BUdget

2012-13Who won andwho lost ?

The Union Budget could not meetthe expectations of common men

because of rising ination.


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infrastructure bonds apart from 80C, which wasintroduced two years back, is not extended this

year. So, there is no tax ex-emption on these bonds.

Impact on Industry

The Union Budget 2012 was

not that severe on the indus-try, which is contrary to theexpectation of people, be-cause currently the focus ofthe government should beto increase revenue and de-crease expenses to achievethe target of lower fiscaldeficit. Total planned outlayin the agriculture sector hasbeen increased by 18% from

Rs171bn in FY12 to Rs202bn inFY13. Agriculture estimated togrow at 2.5% in FY12. Amend-ments are introduced to theFRBM Act as part of FinanceBill 2012, the medium-termexpenditure framework to laydown a three-year rolling tar-get for expenditure indicators.Endeavour to limit central

subsidies under 2% of GDP inFY13; to be further broughtdown to 1.75% of GDP overnext 3 years.

This budget has tried to sim-plify the process of IPOs by re-ducing their expenditure andhelping companies to reachmore retail investors. Thereis a proposal to make it man-datory for companies to is-sue IPOs of Rs100mn and thatshould be in electronic formthrough countrywide brokernetwork of stock exchanges.

The corporate tax rate remainsthe same. The charge of Mini-mum Alternate Tax (MAT) has

been extended to all persons other than compa-

people dont have to pay tax on saving bank inter-est income up to 10,000.

Another new tax deductionis introduced for equity in-vestments, which is calledas Rajiv Gandhi Equity Sav-ing Scheme. In this schemean investor can claim 50%of his investments in directequity up to the maximuminvestment limit of 50,000.But the investment has tobe locked for 3 years. Thisscheme is only available topeople with taxable incomebelow 10lacs. STT transac-tion tax has to be paid by

the investors, wheneverthey make equity transac-tions. This tax was previ-ously 0.125%, but now it isreduced to 0.1%.

There are some announce-ments, which can makenegative impact on public.The interest rate on EPF isnow reduced from 9.5% to8.25% and this will be ap-

plicable from next year. Asthe service tax is increasedfrom 10% to 12%, peoplehave to pay more on thebill amount like telephone& internet bills, hotel & res-taurant bills, flight chargesand several other services.The manufacturers pay atax called excise duty on

any kind of goods produc-tion. The excise duty is in-creased from 10% to 12%,which means that manufac-turers have to pay more taxnow and they will put ad-ditional burden on consum-ers by making the goodscostly. The benefit of tax saving up to 20,000 on

The Union Budget 2012 was not that severe on the industry, which is contrary to the expectation ofpeople, because currently the focus of the government should be to increase revenue and decrease

expenses to achieve the target of less scal decit.

The budget can beconsidered to be a con-

servative one with nobig-ticket announce-ments. The budgetis high on credibilitycompared to previous

years. The numbershave been computedon realistic expecta-tions and projections

and deviations at year-end would be minimalunlike the situation inthe current year. Realis-ing that developmentof infrastructure is cru-cial for the projectedhigh future growth, aslew of measures have

been taken to channelfunds from public andforeign sources to thissector. Also, from thegeneral public pointof view some positivescoming from the bud-get were introductionof Rajiv Gandhi EquityScheme and hike inpersonal tax exemptionlimit that will give themmuch needed higher

disposable income



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Measures to curb inflation

Increase in Agricultural Spending by 18%

Reduction in Subsidies - Neutral

Final Verdict- Neutral

Market Reaction

The flat markets showed what the investorsthought of the Budget. Markets were expectingsome comment on issues such as foreign directinvestment in retail and aviation sector, but thesewere not touched upon. Another mildly positivestep was the reduction in securities transaction

tax (STT) for cash delivery-based transactions by20% to 0.1%. Bond markets reacted negatively tothe increased borrowing program that was an-nounced. The Bond yields signaled thumbs downfrom the bond markets. The actual response andimplementations of the proposals will have an ef-fect on the market in the coming days. Also theinvestors are eying the RBI for acting on interestrates in April.

Conclusion

The budget presented a realistic assessment ofthe current political and economic situation. Tar-geting fiscal deficit at 5.1% and 4.5% of GDP for thenext two years, along with subsidy at 2% of GDP,are reassuring for optimists. However, there is aneed for a balancing act in the midst of high fiscaldeficit. There is a need to adopt strict measures toensure the implementation of the proposals andplans to reach the planned fiscal deficit for thecoming year.

nies claiming profit linked deductions. The defini-tion of income deemed to arise in India has beenwidened with retrospective effect from April 1,1962. This is significant considering the SupremeCourt judgment in the Vodafone Case. Dividendfrom foreign subsidiary is permitted at a lower

tax rate of 15% against the full tax rate to be per-mitted for a further one year i.e. up to March 31,2013. In the multi-tier corporate structure, there isa proposal to remove the falling effect of DividendDistribution Tax. This benefit was currently avail-able only in a two tier corporate structure. Theweighted deduction of 200% is available for invest-ment in research and development in an in-housefacility, which will be available for a further fiveyears beyond March 31, 2012. There is a raise inthe turnover limit from Rs6mn to Rs10mn for SMEs

for compulsory tax audit. Weighted deduction atthe rate of 150% on expenditure incurred on skilldevelopment in manufacturing sector would beavailable as per prescribed guidelines. Peak Cus-toms Duty rate is kept unchanged at 10%. Howev-er, relief is provided for specific sector, especiallythose under stress. Full exemption is provided forcoal mining project imports, reduction for mineralprospecting machineries, aircrafts & equipmentimported for third-party maintenance, repair &overhaul. Relief is proposed to steel (import duty

on flat products hiked to 7.5%). However, customduty on Gold has been doubled (to 4% for stan-dard gold, 10% for non-standard gold and 2% forgold ore and concentrate) to check the trend ofrise in gold imports.

Major Takeaways

Rise in Excise Duty and Service Tax

No change in Corporate Taxation

Implementation of GST

Lack of major Direct Tax changes w.r.t deductionsand slabs

Increase in Infrastructure spending

The budget presented a realistic

assessment of the current political

and economic situation.


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Perspective

ness with Africa while the Indians have adopted thesoft version.

INDIA:The ongoing relationship between Africa and thecompeting Asian duo has evolved over time andis currently dominated by competing interests intrade, investment, economic cooperation and thequest for influence. Trade between Africa and Chinahas grown from $20 billion in 2001 to $122.3 billionin the first three quarters of 2011 while over thesame period Indias engagement with Africa has ris-en from $8.5 billion to $49.1 billion with a target to

The last one-and-a-half decade has seen China andIndia, the worlds most populous and economi-cally fastest growing countries emerge as Africasmost important economic partners. It all startedin the last decade of the twentieth century, when

first China and later India, after breaking off fromthe socio-economic shackles of centuries of colo-nialism started on a path of modernization andeconomic development and lately results startedto pay off in the form of sustained economic andmilitary growth. This ever-burgeoning growth hasled both the countries to look further for resourcesto fuel their robust march onto the status of glob-al superpower. And Africa, lagging behind underthe constrained economic aid of the West was theideal ground to launch their initiatives. Though

both China and India are South Asian behemothsand have a cultural heritage dating back to theancient yore, their paths to investment in Africacouldnt have been any more different. China, themanufacturing hub of the new economic orderhas centered on a no-political-strings attachedpolicy of pouring money into the African continentand its foray has been led by the State-ownedcompanies fully supported by the deep pocketsof the Chinese government. On the other end ofthe spectrum, India has been a cautious player,

less risk-seeking in its investment strategy andthe Indian contingent has been led by the privatesector and only recently has the Indian govern-ment entered the fray. The timelines in figures 1 &2 highlight the difference in attitudes and actionstaken by the respective governments to shore uptheir countries stocks in the continent.

CHINA:

While China has had clear-cut objectives in mindvis--vis its African sojourn, India has approached

on a multi-pronged plan which is versatile enoughto accommodate humanitarian aid but not ro-bust enough to successfully face-off and thwartthe relentless Chinese highlight. In summary, theChinese have gone the hard way of doing busi-

The Africa Cup :

Fig. 1: Roadmap for Chinas African involvement: Focus on Oil& Mining, Construction, Agriculture and Capital Equipment

Fig. 2: Roadmap for Indias African involvement: Focus on Agri-

culture, Power, Pharmaceutical, Information& Telecommunica-tion sectors, Small & Medium scaleEnterprises

Advantage Scampering Dragon orLoitering Elephant

IIM RohtakMohit Mathur & Soumya Sarthak Mishra



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Perspective

reach $75 billion by 2015. China has outmaneu-vered not only India but also erstwhile largestbusiness partners of Africa viz. Europe and USA.

The figure 3 depicts the African nations wherethe Indians and theChinese have madetheir presence felt

with a plethora ofwide-ranging in-vestments. Whatis interesting tonote in the figure isthat while the Chi-nese have reachedout to the mostinterior and reclu-sive regions of theDark Continent,

the same cant besaid of the Indianmodus operandi.Speaking of themacro -economicramifications, themind-boggling rateof expansion ofChina-Africa andIndia-Africa tradehas brought the

Western and East-ern interests andeconomic clout to a face off and the consequentdynamics are bound to affect the developmentof African countries and their international rela-tions and place in the new pecking order.

In the current scenario, the Chinese economicbandwagon is viewed to be cantering away andout of reach of its Indian counterpart. The Chi-nese government, in its African Policy Paper, is-sued in January 2006, declared its commitmentto a new and strategic long-term partnershipwith Africa based on the five principles of:

1. Peaceful co-existence

2. Respect for African countries independentchoice of development path

3. Mutual benefit and reciprocity

4. Interaction based on equality

5. Consultation and co-operation in global af-fairs

This proclaimed humanistic approach coupledwith the massive amount of economic capi-tal being poured in by the Chinese has helpedthem rake up massive investment projects in

every nook and cranny of Africa as highlightedin the following fig 4.

A crucial plank behind the success of these Asiannations is the role played by the state in guid-

ing them a r k e tand thes t a t e sw i l l i n g -ness tointerveneand ex-perimentwith het-e r o d o xpo l i c i e sto re-

vive theeconomy,competein globalmarketsand re-d u c epo ve r t yin thep r o c e s sof mov-

ing in afree-mar-ket direction. The hallmark of Indian entry intoAfrica has been heavy investment in infrastruc-ture, education, research and developmentcomplemented with versatile policies designedto enhance the competitiveness of local produc-ers through technological retooling and workersretraining. Opposed to this, the Chinese haverelied on bringing in their cheap, indigenousChinese labor and this has created disquiet

amongst the local populace.The deepening competition and the policies ofChina have led India to cast the former as a fair-weather friend while presenting itself as an all-weather friend of Africa. Chinese investment hasbeen more aggressive, with the Chinese state-owned enterprises enjoying both political andfinancial support to undercut other competitorsin general and Indian in particular. On the otherhand, Indias relations with Africa include rela-tively modest but highly valued aid, economic

cooperation and technical assistance programs.Energy security is writ large in the strategic in-terests of both China and India as they continueto expand in Africa. Chinas two-pronged strat-

Fig. 3: Chinese vs Indian investments in Africa


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egy of engagingthe major Afri-can oil produc-ers (Nigeria, An-gola and Sudan)by offering themintegrated pack-

ages of aid andlow interest/in-terest free loansand simultane-ously targetingthe less visibleAfrican oil pro-ducers (Gabon,Equatorial Guin-ea) has helpedit score high on

the success lad-der over Indiain gaining ac-cess to Africasoil. The Chi-nese state-runoil companiesChina National Petroleum Corporation, Sinopec,China Gas, Chinese National Overseas Oil Cor-poration et al have outmaneuvered their Indiancounterpart Oil and Natural Gas Corporation time

and again. However, despite these setbacks, In-dia has continued to look for niches where itcan maximize its comparative advantage andslowly but steadily converting its toehold in Af-

rica to a rm foothold.

Indicators Present(2010)

Projected(2050)

CHINA INDIA CHINA INDIA

GDP $ 4667bn. $ 1256bn. $ 70710bn. $ 37668bn.

GDP percapita

$ 3,463 $ 817 $ 49,650 $ 20,836

Population 1.347 bn. 1.21 bn. 1.303 bn. 1.656 bn.

% Popula-tion in

15 - 45 agegroup

47 41 28 46

Table 1: Present and projected strategic developmental indica-tors for China and India

From an African perspective, the emergence of

China and India as important development part-

ners will be able to address the prevalent critical

infrastructure gap cheaply, less bureaucraticallyand in a shorter timeframe. The Asian giants

engagement with Africa is growing by leaps

and bounds, which simultaneously presents

both opportunities and challenges for the Afri-

can continent and

critical interven-

tions by the Afri-

can governments

in order to negoti-

ate with the Asian

superpowers is the

need of the hour.

The question that

now faces Africa

is whether there

exists a coherent

African strategy

for harnessing the

potential devel-

opment spin-offs

that could accrue

from increasedinvestments, trade

and aid from the

belligerents and if

one does not ex-

ist, what should be

done to create one.

A look at the crucial socio-economic indicators

shows China being way ahead of India on all

fronts and it is not predicted to change by the

forecasts of 2050 but a closer look reveals thedemographic advantage will swing decisively in

Indias favor.

Further, India may, in the medium to long term,

gain considerable comparative advantage over

China due to its closer proximity to Africa, its

historical ties, the sharing of English as a com-

mon language, the special niches to promote

its friendship and its excellent educational and

training opportunities and democratic systems.

However, all this will depend on a tectonic shiftin Indias foreign policy, bureaucracy and the

capacity to adapt its low-cost high efciency

business model to the African ground realities

and the corresponding response of the African

countries.

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Fig. 4: Quantum of Chinese FDI in Africa



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ble growth and upliftment

In this article we will focus on Agriculture Insuranceproduct innovations, analysing the product design,implementation insights, benefit analysis and the

open issues. We will focus on the products offeredby two major private players in this area: ICICI Lom-bard & IFFCO Tokio.

Agriculture Insurance in India

Agriculture insurance addresses goal no. 2 identi-

fied above. Crop yields are variable which leads tovariability of income for farmers. The goal is to re-duce this variability through insurance products andthereby promote a steady income.

There have been innovations in the recent past and

both government and private sector products arein the offering. Based on the insurance basis used,these products can be classified into two broad cat-

egories: Weather Based and Yield Based.This article focusses on weather based products and

innovations.

Weather Based Insurance Overview

To a farmer, weather represents a risk. 89 % of thehouseholds surveyed as part of a study by Cole etal. in 2009 reported rainfall variation as the most im-portant risk faced by them. In principle, we shouldbe able to manage this risk. Weather uncertaintiesfaced by a farmer have hardly any correlation withstock exchange movements. This means the riskshould be largely diversifiable.

There have been significant developments in thearena of weather based crop insurance products asvisible from the data for 2004-11.

1. Total Sum Insured crossed USD 3 billion in 2010-11,a 200% increase over the previous year

2. A rapid volume growth in past 7 years with totalnumber of farmers insured reaching close to 1 Crore

Finsight

XlRI, JaMshedpuRPrashant Kulbhushan Sahni & Shivendra Sharma

In recent years, there has been a growing interestin use of finance as a means of promoting devel-opment and economic growth. Within this context,

terms like inclusive finance, rural finance and mi-crofinance refer to the use of the innovative tools offinance which promote a more even distribution ofincome and poverty alleviation via inclusive growth.

But what does finance really mean for the rural citi-zens?

We have identified three aspects: Savings, Credit &Insurance. These tools are a hygiene factor for theurban; hence we may, at times, underestimate their

importance. But in absence of a formal access tothese, the lower income group has to face:

1. The vicious circle of high cost local debt

2. Severing of treatable medical emergencies

3. High impact of income variability and uncertainty

4. Exhausting of current resources leading to con-strained future opportunities

In fact a World Bank 2006 study indicated that rural

people do borrow, but in absence of a formal system

they rely on alternatives which are either very high

in terms of cost or negatively impact their long term

well-being. Specifically for insurance products, the

study indicated that rural demand far exceeds the

supply.

The primary benefits that the financial system can

extend to the rural and the lower income groups are:1. Capital provision for rural entrepreneurs - and

promotion of income generation through credit

2. Reducing the impact of income variability - through

affordable credit and agriculture insurance

3. Improving healthcare - through tools like commu-

nity health insurance and healthcare financing

4. Enabling a steady living standard promoting sta-

WEATHER BASED CROP INSURANCEIN INDIA

Table 1: Weather and Crop insurance differences


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3. Claims as a percentage of premiums have been

as high as 76%

(a) High liquidity requirement for Insurers

(b) A market for reinsurers

4. Low value of premium per farmer served com-bined with difficulty in reaching out to rural custom-

ers(a) Need to minimize administrative and transaction

costs

(b) Issue of financial viability

(c) Need for channel partners NGOs, commercialpartners which can reach out to customer at lowcost

(d) Space for technology innovations to reducetransaction costs

Delivery Mechanism

We saw in the overview section that there is a placefor re-insurers in this arena given the high liquid-ity requirement of the weather insurance products.We also realized the need for channel partners and

technology innovations to reduce transaction andadministration costs.

But the product design principles discussed abovealso imply that:

1. The design of the contract depends upon actuarialestimates of weather parameters

2. The pay-out depends on the actual values of theseparameters

3. These parameters , cumulative rainfall in our case,vary locally

These implications create the role of a delivery part-ner that can help reduce the transaction costs and

act as an interface between local customers and theinsurance provider. The above insights can help usunderstand the rationale behind general deliverystructure and implementation innovations utilized.

The general delivery model is given in fig 1.

Distribution channels have been the key in the scale-up of these projects. The private insurance provid-ers have joined with partners such as companiesinvolved in contract farming or agricultural input

supply in order to take advantage of their existing

links with farmers.

1. IFCCO-Tokio, for example, sells the bulk of its poli-cies through the extensive cooperative network ofits parent company, IFFCO Fertilizers

2. ICICI Lombard has worked with ITC, taking advan-tage of ITCs Internet kiosks

3. ICICI Lombard is also working with contract farm-

ing operations such as that of PepsiCo for potatoes

Apart from NGOs and microfinance institutions, spe-cialized technology and delivery partners are alsoemerging which will help in reaching out to the cus-

tomers and also lowering the transaction and ad-ministration costs.

1. ICICI Lombard BASIX set up is an example in thisarea

2. FINO has emerged as a specialized transaction

provider for banking services

Contract Implementation Statistics

Analysis

It can be seen from statistics in tables 2 and 3 thatIFFCO Tokio contracts were designed to cater more tocases of extreme rainfall shortage.

1. Hence IFFCO Tokio contracts have lower premiumdue to lower expected actuarial pay-out.

2. ICICI contracts were offered in two different cate-gories of premiums Low & High. Combined with the

three phased system, they present greater flexibility.

3. ICICI contracts have greater pay-out possibilitieshence greater premium.

Most Importantly: How will the farmer understandthese contract differences and make an appropriatechoice?

This is an open issue that we have listed down inthe issues section.

A study that statistically analysed the rainfall insur-ance pay-outs indicated that even the ICICI policy:

1. Was expected to make actual pay-outs in only 11%of the cases

2. 95th percentile of the pay-out occurred at aroundRs 200

Fig. 1: General delivery model



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Finsight

3. Only in 1% of the cases the maximum pay-outwas made

Though the actual benefits accrued cannot be as-

sessed with great accuracy, but we may still see thatan ideal policy design would require extensive fo-cussed analysis and critiquing, and we are still far

from the target.

Open Issues

There are many open issues but here we focus onthe ones most relevant to weather based insurance.The biggest of all is the Basis Risk.

1. Basis Risk Index insurance is vulnerable to basisrisk. Simply put, basis risk is when insurance pay-

outs do not match actual losses either there arelosses but no pay-out, or a pay-out is triggered eventhough there are no losses. Obviously, if either of

the basis risk situations occurs too frequently, theinsurance scheme will not be viable, and may evendamage livelihoods.

2. Literacy Financial and even general literacy of therural customer is an ever persisting problem while

providing financial products and insurance is no ex-ception. In many cases, the rural customer does notunderstand paying for a product which does not paya guaranteed return.

Recent innovations in this area offer insurance cou-

pled with credit or other similar products or con-tracts to overcome this problem to some extent.

3. Reliable and Extensive weather data The currentgrowth of weather station network in India is largely

haphazard and devoid of a coordinated approachand integrated planning.

(a) In order to attain the objective of an integrateddata system for India, Public-Private Partnerships(PPP) and integrated planning at the National level

should be taken up.

(b) These centralized efforts have to be followed up

by decentralized implementation in identified loca-tions across the country.

4. As the distance of the rainfall recording station

from the farms increases, the chance of getting a

meaningful insurance cover decreases.

5. Premiums for private contracts were not subsi-dized and were therefore higher than for NAIS con-

tracts (614% of the sum insured versus 23.5%)

In 2007, a few state governments began subsidizing

index insurance products offered by private insur-ance companies, paying 4050% of the premium.

Possibilities & Improvements

Based on the discussion above, and related re-

search, we have compiled a list of areas where in-novation may be focussed going forward. These aregiven below:

1. Build partnerships with several insurance com-panies to overcome the underwriting limitations in-

curred by reliance on a single company

2. Intensification of investment (both private andpublic) in the network of weather stations through-out the country, particularly in rural areas

3. Improve product design for better correlation be-

tween indices and crop losses

4. Ensure products remain simple enough to be un-derstood by farmers and other stakeholders

5. Financial literacy training for stakeholders

6. Exploring innovations such as money-back in caseof no pay out

7. Insurance product combination offered could in-clude both an early payment (based on a weather

index) and a final payment (based on an area yieldindex).

This will help to avoid the problem of the insuranceclaim payment made to a policyholder not always

reflecting the true loss incurred by that policyholder.

Table 2: ICICI Policies Gujarat 2006

Table 3: IFFCO Tokio Poilicies Gujarat 2007. Rs. payout as a function of rainfall decit from normal rain


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F

inGyaan

Credit ratings reflect thefinancial health of aneconomy. Major creditratings agencies likeS&P, Moodys and Fitchperiodically come outwith such ratings basedon the performance andfinancial environmentin different economies.

Though the ratings areonly indicative, it cov-ers exhaustively a hostof factors and henceany downgrade leadsto financial implica-tions across the globeand hence the threat ofa domino effect loomslarge.

negative outlook in April 2011, and hadsaid that it might lower the rating unlessthe government approves a $4 trillion

deficit cut in the next ten years.

Even though there was dodgy analysis in-volved in the downgrade, which resultedin artificial inflation of the US debt by 8%

by 2021, there were some solid reasonsbehind the credit downgrade.

Mounting Public Debt

In contrast to other AAA rated countrieslike Germany & Britain who have activelytaken steps to stabilise and lower their

debt to GDP ratio, Americas debt hasbeen rising unsustainably as a share ofits GDP. There have also been criticisms

that plan to slash government expen-diture by $2.4 trillion over the next tenyears, which accompanied by the debt

ceiling rise, are just not acceptable.

2011 may very well be remembered asthe year of sovereign credit downgrades.Apart from the historic credit downgrade

of the United States from AAA to AA+ byStandard & Poors (S&P), there was aslew of other high profile credit down-

grades. The credit rating agency, Moodysdowngraded Italian & Spanish govern-ment bonds by two & three notches re-

spectively. Thirteen days into 2012, S&Pdowngraded the credit rating of nineEurozone sovereigns, including that ofFrance from AAA to AA+. All throughout,

Greeces sovereign credit rating took abeating and is currently rated as junkstatus.

So what triggered these credit ratingsand what are their implications?

United States Credit Downgrade

On 5th August 2011, S&P downgraded thecredit rating of the United States gov-ernment from AAA (Prime Grade) to AA+(High grade). The downgrade took place

three days after the US congress raisedthe debt ceiling by $2.1 trillion from $14.3trillion. However, the downgrade was notunexpected. S&P had put US debt on a

MdI, GuRGaoNPragati Sangal & Raghav Pandey

Fig. 1: Soverign credit rating : Feb, 2012

Fig. 2: U.S. GDP Growth rate in % change

So v er eig n Cr ed it Ra t in g s :An Analysis of the ratings

downgrades in the US and Euro Zone



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an

Slowdown in Recovery

The global and US economic recovery has dragged

on for the past 2 years at a slow pace. Given thebackdrop of the Eurozone Crisis, several economistshave lowered the estimated growth rate of the US

GDP from 3% to 2%. Fiscal tightening & the Eurozonecrisis have been a drain on the growth. The unem-

ployment statistics are still grim, though they haveimproved over the last 6 months.

Lack of Political WillThere have also been concerns about the lack of

political will to take the necessary steps to curb themounting fiscal deficit. American policymaking andpolitical institutions have weakened at a time of on-

going fiscal and economic challenges. It is unclearif the US government will end the Bush era tax cutsor tackle entitlements. This anaemic policy makingand brinksmanship was the cause behind the US

debt crisis which resulted in the increase in the debtceiling. S&P has said that the US is likely to face a

further rating downgrade if the government contin-ues to extend the Bush tax cuts for the wealthiest

Americans.

Implications

Following the downgrade, US Treasury bond yieldsactually fell. Thanks to the combination of Americasstatus as a safe haven and the on-going crisis in

the Eurozone, the US dollars special place as theworlds reserve currency reinforced this movement.However, on an average, lower credit rating has ledto higher bond yields and this may very well be the

case with the US, over a long period of time.

Fig. 4: U.S. Govt Bond 10 year - Implied Yield

Gold prices also shot up, following the downgrade,

as investors fled equity and other risky assets andlooked for safe picks. However, since then, spot gold

prices have somewhat moderated.

However, there are deeper implications for this his-toric downgrade. It is the latest and the biggest blow

that the US economy has taken from the huge ramp

up in housing and other debt that lead to the finan-cial crisis. As the US population ages, healthcare &other social welfare costs are expected to rise fur-ther. In the long run, the US government may find

that it will have to offer higher interest rates to findtakers for its bonds. This is going to exasperate the

growth problem in America, as corporations and thegovernment find it harder to take loans and expand.

European Credit Downgrades

The Eurozone crisis resulted in financial instabilityin the continent owing to large government debt in

Greece and other countries. In January 2012, S&Pdowngraded nine European Nations including France,Austria, Malta, Slovenia, the Slovak Republic, Spain,

Italy, Portugal and Cyprus. However, Belgium, Fin-land, Ireland, Luxembourg, The Netherlands and Ger-many were exempted from any downgrading which

indicates relative confidence in their economies.With the current trend, UK and Germany, currentlyenjoying the top notch status in the ratings also facea threat of a similar downgrade, as the outlook hasbeen changed to watch and negative status.

The unstable economic and political environment inthe Eurozone has led to a spate of ratings down-grades in the last year. The credit rating agencieshave highlighted the following concerns:

Tightening Credit Conditions

It is essential to ensure that easy credit is not avail-

able across the European countries that are alreadydebt laden. With already soaring debt to GDP levels

in various nations, easy access to credit facility must

be tightened. Downgrading of credit ratings ensures

that the interest rates for borrowing for these na-

tions increase. On the other hand, expensive bor-

rowing raises the risk of these nations to default,

thus making the European Central Bank all the more

responsible for a possible bail out option to ensure

the consolidation of Euro. The fig 6 shows the mag-

nitude of debts raised by European nations and ex-

plains why tightening of credit is essential.

Disagreements among European policy makers

Euro zone members failed to tackle the immediate

crisis at hand and were unable to define measures

Fig. 3: U.S. Debt to GDP in % of GDP

Fig. 5: Spot gold price in USD


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25/28FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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Sir, yesterday while having dinner, Iheard three of my seniors discussing theterm quantitative easing. I tried to get in-volved in the discussion, but it all went

over my head. Can you explain me whatexactly is quantitative easing?

Hmmmm Its good that you arekeeping your ears and eyes open 24*7.Anyways listen. Quantitative easing is oneof the monetary tools used by the centralbanks to augment the money supply in the

economy. Usually, the central bank uses the indirectway of moderating economic activity, i.e. by varyingthe interest rates. However, in the case of quantita-tive easing, it influences the market in a direct way by

buying government and corporate bonds directly fromthe banks. The intention is to ease pressure off themarket by pumping in more quantity of money.

All right sir. But when does the cen-tral bank do so?

Quantitative easing is used wheneconomy is in a deflationary mode. Banksare reluctant to lend funds to businessesas they fear a default. They find it betterto invest in government treasury, which is

safe and also provides a healthy return. This deprivesbusiness houses of funds, which results in a decelera-tion in investment activities, and gradually leads to afurther fall in growth.

But central banks can also influencemoney supply by changing the interestrates. What is the need of quantitative eas-ing?

The central banks generally use quan-titative easing when reducing the interest

rates does not give them the desired suc-cess in curbing deflation. Quantitative eas-ing might be termed as the central banks

last resort to bring the economy back on the path ofgrowth.

Sir, why are central banks so wor-ried when economy is experiencing de-flation? Isnt a fall in price good for thepeople, as it will help them in buyingmore?

No, not really. When people expectfalling prices, they become less willingto spend, and in particular less willing toborrow. In such a scenario, just sitting oncash becomes productive for the inves-

tors, as the effective purchasing power of rupeeheld is on the rise. Business houses to shy awayfrom borrowing, as the loan will have to be repaid inrupees which are worth more than the rupees theyborrowed.

Also, when the prices are falling, people tendto postpone their demand for goods in anticipationof a further reduction in price. As more and moreconsumers think on these lines, the entire economyis engulfed in a slowdown.

Oh! I always used to think that

lower prices are good. Anyways sir, howdoes the Central Bank go about execut-ing Quantitative easing?

The central banks buy corporateand government bonds from commercialbanks. In return, it just credits the com-mercial banks account with an equivalentamount, and thus artificially injects mon-

ey into the system. This has a two-way effect on theeconomy.

Firstly, by buying the bonds held by banks, it

pumps in money, which improves the banks lendingcapacity.

Secondly, as the central bank purchases bonds,its demand increases. With an increase in demand,the yield on bonds falls, thereby making it less at-tractive for the banks to invest in them. The invest-ment proposals of business houses now appearsmore productive to them, and they readily extendcredit to them. With the multiplier in operation, thisgives a huge impetus to growth, and pulls the econ-omy out of that deflationary spiral.

However, if too much money is created, it mightlead to rampant inflation, which is again detrimentalfor the economy.

CLASSROOM

FinFundaof theMonth

QUANTITATIVE EASING

NIVESHAK 25

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IIM ShillongAkhil tandon


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F I N - Q1. What are we referring to?

2. Name the type of auction in which the price on an item is lowered until it gets abid.

3. This currency was called Royal before adoption of the current name. Name thecurrency.

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5. Among all the currencies with distinctive identities, what is the unique featureof the pound sterling?

6. The first budget of independent India was presented by ________________.

7. This defense strategy (coined by Bruce Wasserstein) prevented hostile takeoverof Martin Marietta by Bendix Corporation in 1982. Identify the term.

8. What term became popular after the newspaper report of Watergate Scandal inthe year 1973?

9. The annual shareholder meeting for which organization is held in the Qwest Cen-ter in Omaha.

10. Which word connected to stock exchange has its origin from Latin for moneybag?

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