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Cover Article: Inflation Targeting as a Monetary PolicyChina Shadow Banking, Bond swap trading – is it blind arbitrage?“VIX” De-mystified..……Major Economies of the World covered

Special Edition 2014

Dear Reader,

Welcome to the Special edition of Blue Chip, the quarterly magazine of Monetrix

– The Finance and Economics Club of MDI Gurgaon.

This edition is special in so many regards for us. First, we have completely

changed the way in which we function and have decided to make this magazine

global serving you with economics and finance news from all the major

economies of the world.

Keeping this edition in front of you makes us all nervous and excited at the same

time. We are nervous about your reaction to this change of functioning and

excited because this may drastically alter the way students at MDI pursue

knowledge of economics and finance.

With the above changes we have articles about China shadow banking, VIX

along with the cover article on “Inflation Targeting as a Monetary Policy”.

For any feedback or suggestions, feel free to reach us on Facebook or mail us at

monetrix@mandevian.com.

Till then, Happy Reading!

~ Editors for Blue Chip

Country Team

Kumar Nittin India

Rishabh Duggar Brazil

Suneel Palukuri UK

Prerna Thakur Japan

Ankit Gupta US

Shubham SE Asia

Shreyans Gangwal SE Asia

Avneet Sikka China

S. Prashanth Russia

Ravikiran Eurozone

Ishan Gupta Eurozone

Other Asset class

Darshan Gandhi Fixed income

Aaditya Mulani Oil

Editorial team

Ankita

Himanshu Kashyap

Manu Mehrotra

Satyajit Tripathy

Adit Agrawal

Blue Chip

2

TABLE OF CONTENTS

INDIA 4

CHINA 8

EUROZONE 11

INFLATION TARGETING AS A MONETARY POLICY 16

BRAZIL 19

CHINA SHADOW BANKING 22

JAPAN 24

OIL 26

BOND SWAP TRADING 29

UNITED STATES 31

UNITED KINGDOM 33

VIX 35

MARKET UPDATES 36

3

INDIA

M ajo r Hi gh l igh t s

Point of Interest:

India saw declining GDP growth

rate as well as a declining EPS

growth rate for BSE companies

in the last 5 years but still the

return on Sensex seems to be

too high. The correlation be-

tween GDP growth and Sensex

as well as EPS growth of com-

panies and Sensex seem to be

absent but EPS growth rate

seems to be more correlated to

Sensex return than GDP growth.

It is due to the changing pro-

files of the companies which

draw a greater part of their

profit from outside India or is it

due to long term faith in the

economy imposed by long term

investors.

After opening up of the Indian economy in

1991, India became one of the major econo-

mies of the world with its GDP becoming

highly susceptible to external fluctuations.

The main issues addressed at that time were

the abolishment of license raj, making tax

simpler and opening up of economy to global

competition by removing trade barriers. This

has been continued for the 23 years that

have followed.

Let us concentrate on the period from 2004

to 2013. The Indian economy was in a good

shape when NDA left the baton of command

in the hands of Congress. The FRBM act was

introduced which was meant to restrict the

centre and state’s fiscal deficit limit to 3% by

2007 but due to the global financial crisis,

the deadline for implementation was initially

postponed and subsequently suspended in

2009. There was a current account surplus

along with lot of focus given by the govern-

ment on Infrastructure. After 2004, due to

the good shape of fiscal and monetary posi-

tions of government which continued till

2007, there was a high growth of approxi-

mately 9% witnessed because of easy money

flowing into the Indian economy and the

continued stress on infrastructure creation.

Then came the financial crisis in 2008 for

which the government provided a huge sti-

stimulus. The economy rebounded initially

but post 2011 saw a declining trend. The

main reasons for this can be attributed to

several wrong government policies: The fiscal

stimulus led to consumption led growth ra-

ther than investment led growth which

caused an inflation buildup in the economy. It

also caused the fiscal deficit to slip as well as

CAD, which is very much correlated with the

global economy, inflation and fiscal deficit,

started to increase. The inflation eroded the

export competitiveness of the economy. Ulti-

mately inflation as well as some wrong poli-

cies of the government like retrospective tax-

ation caused the rupee to depreciate. In order

to control the exchange rate depreciation and

inflation, the central bank increased the inter-

est rate 13 times. Further in 2013 after an

announcement by Fed with respect to quanti-

tative tapering, the rupee again started de-

clining which was controlled initially by inter-

est rate hike and then by other policies like

FCNR-B and swap windows for oil companies.

Steps taken by government to restore

growth:

1. Fiscal deficit targeting: This is a very im-

portant step that the government has taken.

After 2012, there has been a roadmap made

by the government for fiscal deficit target and

this has been extended till 2017 to bring the

fiscal deficit to 3%. The government has been

able to meet the fiscal deficit target of 2013

as well as 2014 which instills a sense of confi-

dence in investors, both domestic as well as

external. This is a very important step as con-

trolling fiscal deficit leads to a gradual de-

crease in inflation which in turn causes other

macroeconomic factors to become stable like

interest rate.

NOMINAL GDP:

$ 1.84 trillion

GDP RANKING:

10

FOREX RESERVES

$ 295 billion

DEBT/GDP Ratio

67.57%

FISCAL DEFICIT (% of GDP):

4.6%

CAD (% of GDP)

2.44%

4

2. Gradually going towards price discovery and decrease of

subsidies: The government has taken a number of steps to

control subsidies. It has been increasing the price of diesel by

50P every month whereby the government intends to orient

the diesel price to market price. Also, it has put a cap on

number of subsidized cylinders. These are clear signals that

the government might decontrol and remove subsidies from

these items in the near future. Also, it has hiked the price of

gas which will encourage the investors to invest in this sector

which needs huge funding. Moreover, it has recently decon-

trolled sugar by removing controls on the quota of sugar

produced as well as removing the cap on sugar price.

3. Cabinet Committee on Investments: Although India’s in-

vestment rate is still 35% of GDP as shown in the figure

which implies that the GDP growth rate should be 3.5-4%, it

is seen that GDP has declined to 4.5-5%. This implies that the

incremental capital output ratio has declined which might be

due to the slow off-take of projects. The CCI was established

in order to give clearance to projects above 1000 crore and

remove the bureaucratic hurdles. It has cleared projects

worth Rs 6.6 lakh crore till January 2014.

4. FDI relaxation: The government recently relaxed FDI limit

in a number of sectors like pharma, civil aviation, power

trading exchanges and multi-brand retail.

5. Monetary Policy: According to IMF, an increase of 1% flow

in portfolio investment translates into a rise of 0.5% in pri-

vate consumption and a further 1.5% point rise in invest-

ment. Hence it is very important that central bank takes the

right decisions and the twin deficits are brought under con-

trol.

Certain monetary policies that are intended to be taken

by RBI are as flows:

1. Urjit Patel Committee report: This report highlights

that inflation targeting should become one of the major

objectives of RBI and that too CPI inflation. Till now WPI

used to be the targeting inflation index but since CPI is

the actual measure of retail inflation it is better to target

CPI. This is because it has been seen in recent times,

especially since 2003, that even if there is food inflation

and no hike in interest rate, the food inflation alone gets

translated into other types of inflation like wage infla-

tion and core inflation. There is a high correlation be-

tween different kinds of inflation, implying that one in-

flation leads to another and hence until inflation comes

to normal condition for a sufficient amount of time, RBI

should not loosen the monetary policy. Even a small

supply shock can lead to high inflation as India is a 100%

capacity utilized economy. Moreover, when the in-

vesttors see that RBI follows this policy the inflation ex-

pectation would go down. In 2008, aggregate WPI de-

clined to 1% from 8% in 2007, the Pure Inflation Gauges

(PIG) remained at 3% which was way above RBI comfort

zone. Urjit Patel committee says that CPI inflation should

be between 2% and 6%. For this it has recommended a

5

number of measures like fiscal deficit control by govern-

ment, no abrupt rise of MSP price, no OMO to facilitate gov-

ernment borrowing et al. It has also been found that food

inflation has mainly been due to MGNREGA and increase in

MSP price. Some disadvantages of Inflation are: low savings,

high interest rates, real exchange rate appreciation which

makes the export less competitive and depreciation of do-

mestic currency which further causes inflation leading to an

investment dry-up. This is one of the major challenges being

faced by India. All the relations between different variables

are shown in figure above. Also, it has recommended term

repo of different tenures, a kind of forward guidance.

2. Mor Committee report: This report envisages for innova-

tive ways to do financial inclusion. It recommended a new

set of banks, called payment banks to widen payment ser-

vices and deposit products to small businesses and low-

income households. India still has 40% unbanked people.

3. Reform India’s banking system: RBI said that soon banks

will be allowed to open branches without RBI permission.

Also, foreign banks will be given the option to set up shop as

local companies rather than as branch of a foreign parent.

This will allow it to take decisions without permission from

RBI. Also, the wholly owned subsidiaries of foreign banks will

be given national treatment.

4. Liberalizing Indian Markets: RBI said that it intends to

deepen the currency derivatives, money market, corporate

debt market, government debt market as the country needs

about $1 trillion in the 12th five-year plan to develop its in-

frastructure for which it will need foreign financing. For this

the central bank is thinking of entering the global bond indi-

ces like JP Morgan Government Bond Index-Emerging

Markets abroad. Although India has entered this index,

it has got no bond indexed to this global index. The rea-

son is that India has capital control and allows only $30

bn of FIIs into government debt although India has a

government debt market of $550 bn. Moreover, pres-

ently the government debt market is skewed in the

hands of a few investors. By entering these indices,

there will be access to more money which might reduce

the cost of debt as well as corporate debt cost will de-

crease. Moreover, the fluctuation in the bond market

will decrease as was seen in May 2013 as these indices

mostly include long term investors. CAD will reduce as

there will be dollar inflows by long term investors. This is

like moving to complete capital account convertibility

but as suggested by Tarapore Committee, before enter-

ing into CAC the gross fiscal deficit should be 3% of GDP,

inflation (3-5%), gross NPAs(5%), CAD(3% of GDP) and

Import to Forex reserves (>6 months).

5. Dealing with financial distress: RBI has recently come

out with stricter rules for banks to track assets which

seem to get converted into NPAs. It has given incentives

for banks in the form of provisioning for early recogni-

tion of bad assets and immediately sell it to Asset Recon-

struction companies or to increase equity participation

in the company or to go for leveraged buyout.

6. Natural resource Allocation: More transparent meth-

ods of allocating natural resources has been made into

laws. Moreover easier M&A rules has been made into

law by parliament in order to reduce the very stiff com-

petition in telecom industry.

7. Fuel Supply agreements: Fuel supply agreements has

been signed for 78000 Mw. The government has also

allowed public-private partnership in coal production

along with CIL. The government should allow price dis-

covery for coal in order to encourage investment in this

sector which is greatly needed.

Challenges for India

India needs to address various issues to solve its chal-

lenges:

Labor laws: India has one of the most stringent labor

laws in the world. This causes several distortions in the

labor market. The smaller companies which worldwide

6

-wide create the maximum number of employment hires

lesser people as it is impossible to fire people in an organi-

zation having more than 100 people. Larger firms have to

suffer the harassment or pay bribes. These add direct and

indirect cost making the industries less competitive. An IFC

report says that due to these laws, intermediate-sized firms

are missing in India. Moreover, these laws reduces the la-

bor productivity which causes GDP per capita not to in-

crease. It has been observed for all OECD countries that as

labor productivity increases, GDP per capita increases. This

labor productivity only can prevent a country from entering

middle-income trap. This increase in labor productivity also

increases capital productivity.

Taxes: India’s tax system is too complicated. According to a

certain report, India’s 30 companies of BSE had a tax litiga-

tion of $7 bn in 2011-12 compared to $5.5 bn in the previ-

ous year. India still has an inefficient indirect tax system due

to cascading effect of multiple taxes on goods and services.

India needs to quickly adopt GST which seems to increase

GDP growth by 2%. In fact easier tax rules is like a fiscal

devaluation against other countries making the domestic

economy competitive.

Infrastructure and skill development: Although India is pay-

ing attention to infrastructure, it is very urgent to do it

quickly by reducing red tape. The main point with infra-

structure building is that it makes the products very com-

petitive by reducing the cost. It was estimated in 2005 that

due to golden Quadrilateral, India at that time was saving

2.5Bn$ per annum. Also, there is a need to have skill devel-

opment. NSDC proposes to create 500 Mn people by 2022

in order to provide a labour surplus market.

it quickly by reducing red tape. The main point with in-

frastructure building is that it makes the products very

competitive by reducing the cost. It was estimated in

2005 that due to golden Quadrilateral, India at that time

was saving $2.5 bn per annum.

Crony Capitalism: It is very important to make laws very

transparent. India’s GDP decline in the last 3-4 years has

been due to corruption scandals. India must develop

stable, predictable and market-based transparent laws

so that crony capitalism does not develop which has

been the cause of demise of economies like Russia.

Does India future look bright?

On every macroeconomic parameter, India seems to be

performing poorly compared to 2004 and 2009. But, in

the last 2 years it is being seen that certain indicators

like inflation, fiscal deficit and CAD have improved which

reflects that India is recovering slowly. As we know that

economy is based more on perception and psychology, it

is said that there is every chance that NDA government

led by an able administrator will come to power which

will surely lift the spirits of India. India has the a great

demographic dividend and there is growing expectations

among investors from the next government which is

shown by the improving MSCI India premium over MSCI

emerging markets.

In chart below: Although India is growing economy G-Sec

yield is high, this might be due to inflation

Observe the less diversified exports. Exports/GDP= 44%

7

CHINA

M ajo r Hi gh l igh t s

Special point of inter-

est

Personal Computing Industry

Center (PCIC) of the University

of California, Irvine took apart

an iPad and worked out its

value chain. After stripping

out Apple’s 30 percent profit,

amounts paid to suppliers from

Taiwan, Japan and other non-

China suppliers of batteries

and touchscreens, only about

$10 is paid to Chinese workers

to assemble the product in

China. While each unit sold in

the United States adds from

$229 to $275 to the trade defi-

cit between the United States

and China, only a tiny portion

of that amount is retained in

China’s economy.

If we look back into the history of China, the

economy of the country has seen a lot of

upswings and downswings. The late Ming

period saw an increasing trade between re-

gions which was followed by the Qing dynas-

ty (1644-1912) holding key positions in Asian

diplomatic ties. By 1820, China was contrib-

uting one third of the total global output

with its strategic location aiding to its

growth.

The industrial revolution however changed

the entire scenario with the improvement in

productivity of Europe and North America

ultimately leading to the relative erosion of

Chinese economy.

It was then the initiation of economic re-

forms and liberalization in 1979 which ush-

ered a new era for China. Before that, the

Chinese Communist party was following so-

cial economist policies under the leadership

of Mao Zedong. The death of Zedong led to

the end of Cultural Revolution. The Chinese

leaders realized that there was an urgent

need for change and that change was

brought in through experimentation.

The first set of reforms was directed towards

the agricultural sector wherein there was a

shift from collective farming to private farm-

ing. The next focus was on price control and

thus a two-tier price system was implement-

ed. This was largely done to give a boost to

the industry sector.

Thirdly, the central planning mechanism was

replaced by a macro-control framework of

monetary and fiscal policies which ultimately

led to the banking reforms.

The most important reform was the open

door policy which brought in a sea of change

in the trade history of the country. From be-

ing a trade deficit nation in 1970s and 1980s,

China went on to become a trade surplus

economy in the 1990s. Non state sectors of

the economy were suddenly the prime area

for development and China started paying

attention towards revamping of institutional

infrastructure. Education as well as the legal

system in the country has also greatly im-

proved over the years.

If we look into the steps taken by the govern-

ment, the free market reforms and opening

up to foreign trade particularly have resulted

in China becoming the world’s fastest growing

economy. It is currently the world’s second

NOMINAL GDP:

$ 9.3 trillion

GDP RANKING:

2

FOREX RESERVES

$ 3.82 trillion

DEBT/GDP Ratio

230%

FISCAL DEFICIT (% of GDP)

1.86%

CAS (% of GDP)

2.03%

China – is it really the end of an era?

8

largest economy and the largest holder of foreign exchange

reserves. Economists believe that if China maintains the

same growth rate, it will overtake the US to become the larg-

est economy within few years.

But the story doesn’t end here. Lately, the situation in China

has not been that promising. The biggest concern for the

country is the unfolding debt crisis which is like a sword of

Damocles hanging on the head. History teaches us that there

have been only five developing countries which have had a

similar credit boom as being witnessed by China and all of

them eventually dealt with severe financial crisis.

Trusted aides and supporters of the country’s policy still sug-

gest that the huge forex reserves and current account sur-

plus will shield the country from a BOP or currency crisis.

Although, they do forget that the country has no defense

mechanism in place for the domestic credit crisis which is

inching closer towards them. Taiwan proves to be an apt

example for their current situation. The country had huge

forex reserves accounting for 45% of the GDP but it could

not elude the credit crisis.

Shadow banking poses another problem for China. It is be-

lieved that excessive regulation on formal banking system by

the government has led to this unregulated financial indus-

try. This high yield lending banking mechanism provides

credit to the borrowers who do not meet the bank criteria

and as the name suggests, this alternate channel is obscure

as a result of the inability to measure the size as well as dis-

closure of accounts. The private debt has been largely in-

-creasing due to the same reason and there is an inad-

vertently high risk of failure with such form of lending

because the money borrowed is invested in risky pro-

jects.

It has often been seen that economies which have had a

rapid growth have ultimately ran out of steam and land-

ed in the middle income trap. China is also expected to

encounter the same phenomenon, more so because of

its highly undervalued exchange rate. Other reasons

which support this view are the inability of the country

to bring underemployed people into the economy and a

reducing contribution from utilizing foreign technology.

The current economic framework of China is believed to

be the root cause of the major problems being faced by

the economy. The country has seen an over dependence

on exports and fixed investments to leverage its growth

and the income inequality is also growing at a rapid

pace. There has been an incomplete transition of the

country to a free market economy and that has led to

structural imbalance.

The month of February saw an unusual depreciation of

9

Renminbi which raised an alarm all over the world. This drop

against dollar could be viewed as a result of the Federal Re-

serve tapering but with Renmimnbi being a heavily managed

currency and tapering having no adverse impact in previous

months, this reason appears to be fallacious.

One of the possibilities that economists consider is that a

weaker Renminbi might be a strategy on the part of china to

stimulate wider international use and it is also expected that

PBOC might soon widen the currency’s trading band. The

weakening of currency would also perk up the exports. If the

fluctuation continues for a longer period, it may suggest

their intention of internationalizing the currency.

China is trying hard to get its business model back on track

by developing its modern market sector and removing regu-

lations requiring state council approvals, but it is for the

world to see in the time to come, whether these reforms

would help it sustain its growth rates.

10

Eurozone

M ajo r Hi gh l igh t s

Points of Interest-

As the Eurozone continues

to face challenges, Lativia

a Baltic country of just 2

million people became the

bloc’s 18th member.

All euro coins have a com-

mon side showing the de-

nomination (value) and a

national side showing an

image specifically chosen

by the country such as a

monarch or a national

symbol.

NOMINAL GDP:

€ 2136.8 billion

GDP RANKING:

2 ( combined)

FOREX RESERVES

$ 337926 million

DEBT/GDP Ratio

92.7%

FISCAL DEFICIT (% of GDP)

3.38%

Current Account Balance(% of

GDP)

3.53%

Introduction to Eurozone

The Eurozone officially called the euro area, is an economic and monetary union (EMU) of 18 European Union (EU) member states that have adopted the euro (€) as their common curren-cy. The Euro came into existence on 1 January 1999 when 11 participating nations who had met the Euro convergence criteria adopted the Euro as their official currency. The other EU (a union of 28 nations) states except Denmark and United Kingdom are obliged to join once they meet the criteria to do so. The European Central Bank is in charge issuing banknotes and setting monetary policy for the Eurozone. The Maastricht Treaty laid out the five main criteria countries must meet to join the Eurozone.

Maastricht criteria

The raison d'être of the EU has always been some form of common market. The introduction of a common currency further facilitated trade and exchange.

Advantages of Euro

1) It ensures low, stable inflation and low interest rates. It eliminates currency exchange costs and fluctuations between the member nations.

2) It facilitates easier travel and trade between states.

3) It increases price transparency, consumers can more easily compare prices across borders

4) A single regional currency gives EU greater weight on world stage and better protects against external economic shocks like oil price rises or upheaval in currency markets.

5) It attracts foreign investment and trade to the Eurozone

Disadvantages of Euro

1) Differences in economic performance make it hard to implement one-size fits all policies.

For example, the inflation level set by the ECB may not work well for all Eurozone coun-

ties which means that weaker economies can pull down stronger economies.

2) Deficit limits restrict what fiscal tools governments can use to combat recession, unem-

ployment and other economic problems that may be specific to their situation.

Inflation Should be less than 1.5 % points above the inflation of the three EU states with lowest inflation in the previous year.

Budget deficit

National budget deficits must be at or below three per cent of GDP.

Public debt

National public debt must not exceed 60% of GDP or must be falling stead-ily

Interest rates

Must not vary by more than 2% points from the average interest rates of the three EU member states with the lowest inflation in the previous year

Exchange rates

Exchange rates must remain within the accepted margin of fluctuation laid out in the Exchange Rate Mechanism (ERM) for two years prior to entry.

11

3) Adhering to the strict deficit and inflation caps can force countries to deflate their economies.

In the period 1999 – 2008, The Eurozone economy prospered. Bolstered by low interest rates and decreased costs for trade and

exchange, economies like Greece, Portugal which were associated with large structural deficit benefited with the introduction of

common currency and the availability of cheap money. The ballooning tax revenue from real estate bubble accommodated in-

creased government spending. However the governments did not administer the structural problems or introduced any major re-

forms to make their economy competitive. Greece whose main industries were shipping and tourism was hit really hard after the

recession in 2008 and the government started spending heavily to keep its economy functioning. Thus Greece accumulated a lot of

debt and violated the Maastricht Treaty without disclosing the full extent of its debts. Ireland and Spain were particularly hit by the

asset bubble and their government went into large debts to bailout their banks. Portugal and Greece too were affected by the slip-

page in state managed public works which was characterized by inflated bonuses and wages and redundant employees thus lead-

ing to huge spending for the government. However Germany which had made its economy competitive by imposing controls and

on wages and prices was much less affected. Cyprus the most recent country to come out of the closet in 2012 has a large offshore

banking industry. It had exposed itself to large amounts of Greek debt and subsequent haircuts on Greek debt led to trouble for its

two major banks. The troubled nations were subsequently offered bailout packages to revive their economies. However bailout

packages came in with a strict lot of austerity measures and were regulated by the TROIKA which limited the ability of the nations

to revive their economy through fiscal spending. .In 2012 fears of Euro breakup were evident, as there were concerns that Greece

might have to leave the Eurozone. However ECB chairman Mario Draghi introduced a host of measures to allay the fears and his

statement that the ECB will do whatever it takes to save the Euro pacified the markets. The introduction of Long Term Refinancing

Operations and the establishment of the ESM helped in lowering bond yields of troubled nations. Under LTROs money at very low

interest rates was lent to the various national banks using the sovereign bonds as collateral for loans which helped in reducing their

yield and also providing money to central banks to revive demand and boost their economy. Draghi extended the period of repay-

ment to three years. Outright Monetary Transactions (OMTs) were also undertaken in secondary bond markets to reduce bond

yields at the longer end of curve. However the concept of full sterilization was applied meaning that unlike QE excess liquidity in-

jected was reabsorbed. Inflation was targeted and the rise of Euro was checked.

Present State of Euro Zone

Euro zone has emerged out of recession in the Q3’13. Yet, the world is

cautious before celebrating the success. The policy makers and the

world bankers aren’t sure if the growth achieved is sustainable. The aus-

terity measures imposed on several peripheral countries have con-

strained their budgets. This has virtually taken the fiscal policy out of

their hands when they have already renounced their monetary control.

Austerity measures imposed on the peripheral countries have restricted

the countries to not exceed more than 3% of fiscal deficit. None of the

peripheral country has succeeded from austerity measures. In fact, it has

further shrunk the economies in the name of fiscal consolidation. Reduc-

ing fiscal deficit by controlling the necessary expenses has hurt their po-

tential growth. With the cut on healthcare expenditure and increasing

unemployment, the infant mortality rates and deaths due to HIV, cancer

have increased inviting protests from public. Growth in Germany has

been the major reason for the apparent end of recession and with ade-

quate measures not taken it may be matter of time before the Eurozone

fall into recession again.

12

Rising Euro

The rising exchange rate is a major concern for the Euro zone. Even as the peripheral countries trying to shake up their economies

using exports, the exchange rate may act as a dampener not just the debtor countries but to Germany as well. The aging popula-

tion, dwindling domestic demand have made the economies depend on exports to fuel the growth but the increasing Euro is mak-

ing the exports uncompetitive.

Inflation and Interest Rates

The alarmingly falling inflation is at 0.7% , an evidence of the falling de-

mand. Draghi has maintained a target inflation of 2%. Already, the Main

Refinancing rate been adjusted to 0.25% and the deposit rate is at 0%.

Negative Interest Rates have been discussed. The Euro zone is risking of

going into liquidity trap by trying to stimulate growth with monetary poli-

cies as continued efforts have failed to increase inflation.

Fiscal Stimulus

It’s not a bad idea for the countries to stimulate the failing economies by

fiscal stimulus packages. As, the ECB is against printing currency, the

countries have to try fiscal policy to come out of the hole they dug for

themselves.

Unemployment rate and General characteristics

The unemployment rate is hovering around 12% for the Euro zone. The

job market of PIIGS countries hasn’t seen any improvement after the

2008 crisis. The business confidence which was over 1% in the pre crisis

era is just over 0.37 in Q’14. The industrial production seems to have

jumped a few points to just over 2% in 2013 which was at 5% in 2008.

After years of contraction in services, PMI for services has grown over 50

in 2013. The personal disposable income is one parameter that has

shown tremendous increase in the past two years.

Rising Current Account Balance

Germany’s internal devaluation, wage and price control, has made it com-

petitive in the Euro zone. Over the last few years the Euro was under val-

ued owing to the deficits in the current account of other Euro zone coun-

tries. These factors have aided Germany in balancing the current account

deficits of many other small economies in the Euro zone. This has serious

implications on the 17 (total 18 countries now) other countries which are

sharing Euro with Germany. The deflationary pressure created by the in-

creased exports will never allow the peripheral Euro countries to come

out of their slumber in the near future. A constant appreciation of Euro

will create more deflationary pressure unless ECB maintains a fixed ex-

change rate.

13

What’s up with PIIGS?

Greece

Greece, which has seen its economy decline by 25% in five years, is now running a primary budget surplus, excluding interest pay-

ments. Greece is months behind in negotiations with its creditors and a third bailout is likely. Borrowing costs for the most vulnera-

ble countries have fallen to levels not seen since 2010. There is a funding gap this year of probably 4bn euros. This might be begin-

ning before Greece misses its fiscal and structural targets.

Negotiations with its creditors are months behind schedule. A third bailout is likely. IMF predicts that growth will only emerge if a

major chunk of its debt is written off. Greece is unfinished business.

Italy

Italy's two-year borrowing costs have fallen to their lowest level since the launch of the euro. Tremors in the emerging markets

have scarcely ruffled Europe - so far. It is spluttering its way out of recession. Its economy has not really grown since the middle of

2011. It has now embarked on a privatization drive which is expected to raise 12 bn euros over the next two years. These sales are

driven by the need to reduce Italy's public debt. It is forecasted to reach 133% of GDP this year.

Spain

Early in the crisis it enthusiastically embraced structural reforms, making it easier to hire and fire workers. Productivity has im-

proved strongly. Its labor costs have fallen and its exports have surged. However, house prices are still falling; bad loans are still

rising, as is public debt. There are signs that unemployment is beginning to fall, but even if Spain achieves growth of 1% it will have

little impact on the 5.9 million people out of work. Future growth will have to depend on exports and investment but not on do-

mestic demand.

Ireland

The Republic of Ireland, having almost been bankrupted by its banks, has felt strong enough to leave the safety of the bailout pro-

gramme. Portugal may soon follow.

Euro zone might be out of emergency room but certainly not discharged yet.

Road Ahead for Euro Zone

Given the hole the Euro Zone economies are in it will take systematic and long sighted reforms to bail out the peripheral countries.

One of the Novel ideas that could be tested in the troubled times is, “Sharing the excess premium cost of bonds of core Euro coun-

tries with the debt laden peripheral countries”

The Euro-rates idea could be operated as follows:

At the end of each year, the average bond yield of the bonds issued that year is calculated. The variance would be transferred to

countries with high costs from countries with low costs. The transfer would only cut but not eliminate the divergence between

different countries’ borrowing costs. The amount of money that low-interest countries, like Germany and France, contribute to the

group is a function of volume of bonds and the difference of yield of the bonds and the average yield. Conversely, the amount of

cash that high-interest countries, like Italy and Spain, are likely to receive would depend on how expensively they borrowed, as

well as their bond issuance.

Every year, the accumulated value of the rates will be used as the reference. In this way as the time progresses, the stakes of each

of the countries, irrespective of their status as net donor or net borrower, will be too costly to ignore. Potential benefits can be:

The transfer will not give an exposure to the other countries debt. This will save the net donor countries from the ill effects of

investing in risk debt of peripheral countries.

14

Since the accrued value increases with time, the drive for the peripheral countries to keep up with the over haul of their econ-

omies would grow with time as the net donor countries always have the incentive to withdraw the package.

Countries in the periphery would have a dual benefit. Not only would they receive money the core Euro countries each year,

but can also borrow money at lower rates from the investors as they would have signed contracts with the core countries to

overhaul their economies.

The final advantage is that euro-rates be range bound as long as governments agreed to have a predefined gap in interest

rates that countries paid.

That would balance the solidarity with the market discipline. A program of this nature would only need to run for 6-7 years for it to

show the desired results. It would augment the peripheral countries to borrow debt at least 50 bps lower than their present costs.

Advantages:

The package is similar to a bailout fund but with necessary clauses that can motivate the net receiver countries to abide by the

guidelines

The solution will not visibly fuel further systemic problems that are as potential as a adopting a single currency. If anything it

will strengthen the peripheral nation

In case any country goes against the agreed principles, the net donor countries have the right to discontinue the scheme

Disadvantages:

The package gives free capital to peripheral countries. Although, the core Euro zone countries have their own benefits tied up

to the health of other economies, the initial inertia to agree to join the board is too much to overcome

When austerity measures are not yielding results, fiscal stimulus seems to be the only obvious answer. However, without a

consensus on the policy, countries like Germany and France wouldn’t be willing to join the treaty

Fiscal Devaluation

The major problem with Euro zone nation facing crisis is their inability to affect the exchange rates. Normally countries in times of

crisis can devalue their currencies to make exports more competitive and revive growth. However this is not the case with Euro-

zone countries and in fact they have been facing a rising Euro as Germany’s current account surplus is increasing, thus compound-

ing their problems. A novel way for countries facing such problem is fiscal devaluation. The idea of fiscal devaluation originates

with John Maynard Keynes By increasing value-added taxes while cutting payroll taxes, a government can affect gross domestic

product, consumption, employment, and inflation much as a currency devaluation would.

The higher VAT raises the price of imported goods as foreign companies pay the levy on the products and services they export to

that country. The lower payroll tax helps offset the extra sales tax for domestic companies, reducing the need for them to raise

prices. Since exports are VAT-exempt, the payroll cost saving allows producers to sell goods more cheaply overseas, simulating the

effect of a weaker currency. Thus imports and exports are affected in the same way as they would be by a devalued currency. The

policy also can help on the fiscal front, as increased competitiveness can lead to higher tax revenue.

France has already started implementing this novel concept. As part of France’s fiscal devaluation, Hollande has offered French

companies a €20 bn ($27 bn) tax cut on some salaries as he attempts to turn around an economy that has barely grown in more

than a year. He’ll also lift the two highest VAT rates.

15

Inflation Targeting as a

monetary policy

Inflation Targeting (IT) is an economic policy in which the

central bank makes public a target rate of inflation and then

uses monetary tools to achieve the target inflation rate.

Design and implementation of IT is based on the following:

Inflation in India

India has been a high inflation economy for the past few

years. Although current account deficit has reduced, due to

several reasons including import curbs on gold and CPI has

Provide nominal anchor for the economy

Reduce uncertainty and incidence and severity of boom-bust cycles

Makes the task of monetary policy easier and more credible

Lags in monetary transmission mechanism makes it tough to keep inflation exactly

on target and hence in practice it becomes inflation-forecast targeting

Central Bankers must possess clear objectives and inde-

pendence from political processes. Effective monitoring and

accountability mechanisms are necessary to ensure policies

are consistent with objectives.

Need for Inflation Targeting

Developing countries have been seeing high inflation rates

in the past few years. As long as high inflation is coupled

with high economic growth and rising wages, there may be

less public opposition. Inflation is beneficial to the economy

as long as it is within its limits.

reduced, core inflation has not seen a similar decline. Central

banks in developed nations have an inflation target of 2%.

Inflation target in high growth emerging markets should be 2

percentage points more than that of developed nations and

as suggested by Sukhamoy Chakravarty committee on mone-

tary policy in 1985, inflation should be less than 4%. The Urjit

Patel committee has recommended a target of 8% by January

2015. India is now close to the target with CPI inflation falling

to 8.1% in February from 8.8% in January, 2014 especially

because of easing of vegetable prices. Hence it is now im-

portant to sustain these levels.

Source: IMF Source: IMF

16

Costs of High inflation

There may be unrealistic assumptions regarding the continu-

ation of high rates of inflation on asset prices which may

lead to bubbles in the asset prices, i.e., investors may pur-

chase real estate at prices that may end up being overval-

ued. For example, in Japan, excessively optimistic expecta-

tions regarding the asset prices due to inflation in the 1980s

led to the bursting of the bubble.

Inflation is usually characterized by volatile rates. In such a

scenario, if a company funds projects through long term

debt, then it is exposed to risk of loss in case of an unex-

pected disinflation and short term debt is exposed to fund-

ing risk.

Inflation also indirectly affects the collection of taxes. Tax

codes are based on the assumption of price stability, i.e., the

impact of inflation is not taken into account. Depreciation,

based on original cost of assets, and historical costs of goods

that were sold in the current period but manufactured in

earlier periods overstate the profits and corporate taxes.

High volatile inflation leads to output and unemployment

volatility. Typically, upsurges in inflation are followed by

sharp downturn in economy as distortions in price caused

by inflation initially leads to bouts of overinvestment fol-

lowed by bouts of underinvestment.

Central Banks rely on a nominal anchor to base their mone-

tary policy in pursuit of low inflation. Nominal anchor in-

volves fixing a nominal variable in an economy as a means of

reducing inflation. It is useful to the central bank in formu-

lating monetary policy and clarifying the objective both

within the bank as well as the general public. Earlier coun-

tries used monetary aggregates and fixed exchange rate as a

nominal anchor but they failed due to lack of stability in the

demand for money and hence the need for Inflation Tar-

geting arose.

Inflation Targeting Framework of New Zea-

land

Reserve Bank of New Zealand (RBNZ) was the first central

bank with legislated Inflation Targeting. Its inflation has av-

eraged around 2.7% since 2000 and 2.4% in the 1990s.

Inflation Measure

New Zealand used the Consumer Price Index (CPI) in order to

restrict inflation within a target range of 0 and 3 percent be-

cause of its familiarity with the public although it can be

affected by relative price movements that do not constitute

ongoing inflation.

Numerical value of the target

The initial target for inflation was set at 0 to 2%. The central

aiming point was consistent with price stability at 1%. How-

ever a small positive inflation is beneficial to the economy.

Hence the inflation target has been changed to a range be-

tween 1 and 3%.

Point target or range

A range provides clear outer bounds within which inflation

could vary without evoking a reaction. Without such bounds

the Reserve Bank would have to take evasive action whenev-

er the inflation rate reached was not near its target. Ranges

also have certain issues associated with them. They can be

too narrow and may lead to frequent inflation rates outside

the range and frequent changes in monetary policy to mini-

mize the frequency of breaches.

Forward looking

The Reserve Bank has to choose to react to current inflation

or forecast inflation even though monetary policy affects

inflation with a lag. Aggressiveness of the monetary policy

depends on the degree to which the policy looks forward.

RBNZ focused on inflation 12 months ahead in the initial

Source: Reserve Bank of New Zealand

17

years of inflation targeting since the effect of monetary poli-

cy takes at least a year to materialize. Now, it looks ahead

by one or two years since it also has a bearing on the policy

transmission channels emphasized. Real exchange rates and

interest rate channels are emphasized relative to direct ex-

change rates.

Transparency

Since RBNZ implements forward looking inflation targeting,

it publishes inflation forecasts (projected inflation based on

the assumption of no policy change) so that observers can

easily relate policy decisions to forecasts and anticipate poli-

cy changes.

Conclusion

Inflation Targeting demands a few pre-conditions for its suc-

cessful implementation like independence of central banks,

well developed financial markets, flexible exchange rates,

etc. But, adoption of IT has been beneficial to several coun-

tries in reducing their inflation rates. It has also helped in

increasing the transparency and credibility of the central

bank to carry out its monetary policy effectively. In addition

to this, it has provided a nominal anchor, stabilized inflation-

ary expectations in an uncertain future and reduced ex-

change rate volatility.

18

Brazil

M ajo r Hi gh l igh t s

Points of Interest:

Brazil shrank by 0.5% in

the third quarter of 2013

Infrastructure spend is on-

ly 1.5% of GDP compared

to global average of 3.8%

Brazil contributes 38.5% of

Latin America’s GDP

Brazil fell to 126th rank

from 120th in the Ease of

Doing Business Index

Brazil: Boom to Bust

Introduction:

Brazil is one of the BRICS nations which was

growing at a very fast rate in the 2000s. The

economy, having stabilised under Fernando

Henrique Cardoso in the mid-1990s, acceler-

ated under Luiz Inácio Lula da Silva in the

early 2000s. It barely stumbled after the Leh-

man collapse in 2008 and in 2010 grew by

7.5%, its strongest performance in a quarter-

century. To add to the magic, Brazil was

awarded both next year’s football World Cup

and the summer 2016 Olympics. On the

strength of all that, Lula persuaded voters in

the same year to choose as president his

technocratic protégée, Dilma Rousseff.

Since then the country has come back down

to earth with a bump. In 2012 the economy

grew by 0.9%. Hundreds of thousands took

to the streets in June in the biggest protests

for a generation, complaining of high living

costs, poor public services and the greed and

corruption of politicians. Many have now lost

faith in the idea that their country was head-

ed for orbit and diagnosed just another voo

de galinha (chicken flight), as they dubbed

previous short-lived economic spurts. The

issue of where the burden of economic ad-

justment falls is particularly relevant in Bra-

zil, a country where the poorest 40% of the

population share an 8% slice of the national

income cake and the

wealthy 10% consume 48%.

Brazil, as the seventh largest economy in the

world, is regularly mentioned in the world's

financial press, but since capital started pour-

ing out of the country in August 1998, hardly

a day passes without articles referring to its

crisis and the international repercussions.

What was seen as a promising emerging mar-

ket, in the hands of a safe economic team,

has become one more global problem. The

summer drain on reserves, in which $30 bil-

lion winged their way out of the country, was

followed by an autumn international support

operation led by the IMF. Careful timing

helped avoid impediments to President Car-

doso's electoral victory in October over Lula,

his left-wing challenger. Three weeks later,

the government announced a $22.5 billion

package of spending cuts and tax hikes. The

New Year came, and the markets looked anx-

iously at the slow progress in shrinking the

public sector deficit. The IMF's $41.6 billion

cushion seemed threadbare, capital took

flight once more and the currency crisis ex-

ploded. The government attempted a con-

trolled devaluation on 13 January and threw

in the towel two days later. By the end of the

month, the real hero of the victory over hyper

-inflation in 1994, had fallen from 1.21 per US

dollar to 2.05. Forecasters revised their guess-

es about the depth of the 1999 recession

down to 5-6% negative growth - and the IMF

negotiators flew back to Brasilia to redo their

sums.

NOMINAL GDP:

$2.435 trillion

GDP RANKING:

7th

FOREX RESERVES

$362.69 Billion

DEBT/GDP Ratio

65.10%

FISCAL DEFICIT (% of GDP)

1.9%

CAD (% of GDP)

3.66%

19

Reasons for Slowdown:

There are excuses for the deceleration. All emerging econo-

mies have slowed. Some of the impulses behind Brazil’s pre-

vious boom—the pay-off from ending runaway inflation and

opening up to trade, commodity price rises, big increases in

credit and consumption—have played themselves out.

But Brazil has done far too little to reform its government in

the boom years. It is not alone in this: India had a similar

chance, and missed it. But Brazil’s public sector imposes a

particularly heavy burden on its private sector. Companies

face the world’s most burdensome tax code, payroll taxes

add 58% to salaries and the government has got its spending

priorities upside down.

Compare pensions and infrastructure. The former are ab-

surdly generous. The average Brazilian can look forward to a

pension of 70% of final pay at 54. Despite being a young

country, Brazil spends as big a share of national income on

pensions as southern Europe, where the proportion of old

people is three times as big. By contrast, despite the coun-

try’s continental dimensions and lousy transport links, its

spending on infrastructure is as skimpy as a string bikini. It

spends just 1.5% of GDP on infrastructure, compared with a

global average of 3.8%, even though its stock of infrastruc-

ture is valued at just 16% of GDP, compared with 71% in oth-

er big economies. Rotten infrastructure loads unnecessary

costs on businesses. In Mato, Grosso a soyabean farmer

spends 25% of the value of his product getting it to a port;

the proportion in Iowa is 9%.

These problems have accumulated over generations. But

Ms Rousseff has been unwilling or unable to tackle

them, and has created new problems by interfering far

more than the pragmatic Lula. She has scared investors

away from infrastructure projects and undermined

Brazil’s hard-won reputation for macroeconomic recti-

tude by publicly chivvying the Central Bank chief into

slashing interest rates. As a result, rates are now having

to rise more than they otherwise might to curb persis-

tent inflation. Rather than admit to missing its fiscal tar-

gets, the government has resorted to creative ac-

counting. Gross public debt has climbed to 60-70% of

GDP, depending on the definition—and the markets do

not trust Ms Rousseff.

Way Forward:

Fortunately, Brazil has great strengths. Thanks to its effi-

cient and entrepreneurial farmers, it is the world’s third-

biggest food exporter. Even if the government has made

the process slower and costlier than it needed to be,

Brazil will be a big oil exporter by 2020. It has several

manufacturing jewels, and is developing a world-class

research base in biotechnology, genetic sciences and

deep-sea oil and gas technology. The consumer brands

that have grown along with the country’s expanding

middle class are ready to go abroad. Despite the recent

protests, it does not have the social or ethnic divisions

that blight other emerging economies, such as India or

Turkey.

If Brazil is to recover its vim, it needs to rediscover an

appetite for reform. With taxes already taking 36% of

GDP—the biggest proportion in the emerging world

alongside Cristina Fernández’s chaotic Argentina—the

government cannot look to taxpayers for the extra mon-

ey it must spend on health care, schools and transport

to satisfy the protesters. On paper, the solution is easy:

a threshold for seats in Congress and other changes to

make legislators shape public spending, especially pen-

sions. It must also make Brazilian business more com-

petitive and encourage it to invest. Also, Brazil

20

urgently needs political reform. The proliferation of parties,

whose only interest is pork and patronage, builds in huge

waste at every level of government. One result is a cabinet

with 39 ministries more accountable to voters. But getting

those who benefit from the current system to agree to

change it requires more political skill than Ms Rousseff has

shown.

In a year’s time Ms Rousseff faces an election in which she

will seek a second four-year term. On her record so far,

Brazil’s voters have little reason to give her one. But she has

time to make a start on the reforms needed, by trimming red

tape, merging ministries and curbing public spending. Brazil

is not doomed to flop: if Ms Rousseff puts her hand on the

throttle there is still a chance that it could take off again.

21

CHINA– SHADOW BANKING

The Credit in China has increased at a rapid pace as com-

pared to any other country in the world, having increased

from 125% of GDP in 2008 to over 215% of GDP in 2012.

Local government debt has shot up by 70% since 2009

reaching over $3 trillion last year. This has raised concerns

about the level of risk existing in the Chinese banking sys-

tem and maybe another banking crisis in the making.

The situation becomes more complex because of the exist-

ence of an unregulated banking sector – famously known as

shadow banking. These credits are not regulated at the

same standards as conventional bank loans. The term

“shadow banking” gained prominence during the subprime

mortgage crisis in the United States to account for non-bank

assets in the capital market, such as money-market funds,

asset-backed securities, and leveraged derivative products,

usually funded by investment banks and large institutional

investors. In 2007, the volume of shadow-banking transac-

tions in the US exceeded that of conventional banking.

Therefore, not only the non-bank financial institutions start-ed to fill in the gap (trust company products, security compa-ny products, etc), but the formal banks tried to facilitate those demands in a way that regulators can hardly control.

As per the Chinese Banking watchdog, the credit through shadow banking increased from ¥800 billion ($130 billion) in 2008 to ¥7.6 trillion in 2012 (roughly 14.6% of GDP). In addition to this, total off-balance-sheet financing in China is estimated to be around ¥17 trillion in 2012, roughly one-third of GDP

The Origin

Deposit rates in China have been artificially low and real

deposit rate was negative in half of the last decade whereas

annual GDP growth was above 10% on average since 2000.

This made depositors, seek higher return from somewhere

options. At the same time, lending rates were too low as

well and it boosted endless credit demand together with

other pro-investment institutions. To avoid inflation and

credit bubbles, the banking regulators set loan quota every

year for the banking system (but it failed several times in

controlling inflation and it never succeeded in curbing prop-

erty prices). Since 2010, property developers were specially

restricted to get access to bank loans as a measure to curb

the property market. However, the property prices only

dipped for a short while. Loan quota and specific restriction

on property loans made some borrowers, especially proper-

ty developers, seek financing from non-bank channel. Con-

sequently, from both the borrowers' and the depositors'

sides, there was tremendous need for a "banking system"

that is not as strictly regulated as the formal one.

The Surge - Post 2009 era

Negative real interest rates and lending quota have existed in

China for many years before 2009, but the "shadow banking"

referred to during that time was largely lending of pawn

houses or lending between individuals. Large financial institu-

tions were not involved that much. It was only after 2009

when trust companies and banks' WMP (wealth management

product) business surged.

The answer lies in the credit boom in 2009. While actual

credit growth went beyond the target in most of years after

2000, it was usually within an acceptable range. But it more

than doubled the target in 2009, which was unprecedented.

In order to boost economic growth, the banking watchdogs

tolerated a much higher credit growth than they planned in

late 2008 and it almost went out of control in the beginning

of 2009. New credit was as much as 4.58 trillion in the first

quarter of 2009, almost equal to the total new loans in 2008.

The banking regulators realized that credit growth in 2009

was too exceptional and it would create problems. It did and

22

it led to severe inflation and asset price bubble in 2010 and

2011. To counter inflation, the People’s Bank of China

(PBOC) reiterated the importance of credit target and urged

the commercial banks to lend within the limit in 2010. Bor-

rowers became much more addicted to credits and many

investment projects simply needed more credits to sustain.

Facing obstacles getting official bank loans, they went to

seek credits from other channels and non-bank financial

institutions led by trust companies were well prepared to

welcome their new customers

Drivers of Shadow Banking - Demands & Attached Risks

Shadow banking in China is dominated by lending to higher-

risk borrowers, such as local governments, property devel-

opers and SME’s.

SME’s are the most important growth engine of the Chinese

economy. Unable to acquire sufficient funding through the

formal banking channel, they have been forced to resort to

the informal channel. As SME’s are traditionally high risk

borrowers and are borrowing mainly through informal chan-

nels, facing a high rate of interest of over 10 per cent, the

risk in the Chinese banking system has grown exponentially.

The result was a 43% increase in shadow-banking credit in

2013, accounting for 29% of China’s total credit. Real estate

developers unable to acquire financing through the formal

banking channels also resorted to the informal channels.

They started taking massive loans at unsustainably high inter-

est rates. But in most cases the supply was not met by a

growth in housing demand, again transmitting the risk to the

entire financial sector.

Way Forward - Regulatory Measures

Chinese policymakers should view the shadow-banking scare

as a market-driven opportunity to transform the banking sys-

tem into an efficient, balanced, inclusive, and productive en-

gine of growth. They should begin by reforming the property-

rights regime to enable market forces to balance the supply

and demand of savings and investments in a manner that

maintains credit discipline and transparency .

For this, reducing local-government financing vehicles expo-

sures is essential. China needs to build its municipal bond

market to generate more sustainable funding for infrastruc-

ture projects. Local governments could then privatize the

massive assets that they have accumulated during years of

rapid growth, using the proceeds to pay down their debt.

Reform efforts should be supported by measures – such as

strict enforcement of balance-sheet transparency require-

ments – to improve risk management. In fact, the existing

shadow-banking risks are manageable, given relatively robust

GDP growth and strong macroeconomic fundamentals

Chinese policymakers must focus on curbing the shadow-

banking sector’s growth, while ensuring that all current and

future risks stemming from the system are laid bare. The in-

troduction of measures to cool the property market, and new

direct regulatory controls over shadow-banking credit, repre-

sent a step in the right direction

Perhaps the biggest challenges facing China are raising real

returns on financial liabilities (deposits and wealth-

management products) and promoting more balanced lend-

ing. Increased costs for investment in real assets would help

to rein in property prices and reduce over-capacity in infra-

structure and manufacturing.

Ultimately, addressing shadow banking in China will require

mechanisms that clearly define, allocate, and adjudicate fi-

nancial risks among the key players. This includes ensuring

that borrowers are accountable and that their liabilities are

transparent; deleveraging municipal debt through asset sales

and more transparent financing; and shifting the burden of

resolving property-rights disputes from regulators to arbitra-

tors and, eventually, to the judiciary. Such institutional re-

forms would go a long way toward eliminating default (or

bailout) risk and creating a market-oriented financial system

of balanced incentives that supports growth and innovation.

23

JAPAN

M ajo r Hi gh l igh t s

Japan is the third largest economy in the

world by nominal GDP, after US and China.

Japan has become a topic of discussion ever

since Shinzo Abe took the Prime Ministerial

Office in December 2012. Japan is mired with

a host of problems which is why policies un-

dertaken by Shinzo Abe to tackle them are

under constant scrutiny.

It all began in the late 1980s with the burst

of the Japanese asset price bubble which led

to the 1990s being known as the “lost dec-

ade”. Before that, the Japanese economy

had been undergoing a phase which was

called the “miracle” where their economy

had recovered from the post war effects and

was growing at a rate of over 10% in the

1960s and around 5% in early 1980s. The

bubble burst was preceded by rising asset

prices, credit expansion and uncontrolled

money supply. Bank of Japan recognised that

an unstable bubble was developing and thus

raised interest rates sharply to reduce liquid-

ity but it led to a stock market crash and

bursting of the bubble.

When the economic bubble burst in 1991,

the banks faced losses due to increasing bad

debts and falling real estate prices which

were kept as collateral. Also, Bank for Inter-

national Settlements introduced capital ade-

quacy norms to control excessive loans

which were prevalent in the 1986-91 period.

This made banks conservative in lending

funds.

The Japanese businesses had an excess of

machinery, employment and debt. They fo-

cussed more on expanding business and

maintaining employability rather than en-

hancing profitability. These inefficiencies in

the business created problems after and

during the recession.

The impact of the recession on Japanese

people was limited due to their inherent

nature of frugality and emphasis on savings.

Thus their standard of living did not deterio-

rate much though their consumption of lux-

-ury items did decrease and never reached

the same levels again.

Today, Japan is facing five problems - defla-

tion, debt, deregulation, deficit and demogra-

phy - five "Ds"1. With falling prices and falling

demand, GDP growth rate has been either

negative or dismally low. Increasing bad debts

was a heavy blow to banks which has led to a

credit crunch in the economy. The ties be-

tween the state and industry in Japan have

been termed an iron triangle of politicians,

industrialists and bureaucracy. Japanese

economy, a combination of regulation and

protection, will remain a handicap in a world

based on globalisation without deregulation.

The numerous stimulus packages so far have

benefitted little but greatly fuelled the fiscal

deficit. Also, the demography is such that the

population between 15 years to 65 years is

contracting at a 6% rate which is hampering

growth further.

This is where Abenomics comes to the rescue.

Abenomics basically refers to the collective

policies that Shinzo Abe supports in order to

bring Japan out of its decades long deflation-

ary trap. It aims to boost the annual growth

rate of GDP from its current level of 2.4%, and

raise inflation to 2% via short-term stimulus

spending, monetary easing, and reforms that

will boost domestic labour markets and in-

crease trade partnerships.

Abe’s aggressive revival plan follows a three

pronged approach, called the “three arrows”:

aggressive monetary easing (monetary poli-

cy), expansion of public investment (fiscal

policy) and structural reform (growth policy).

NOMINAL GDP:

$5.960 trillion

GDP RANKING:

3

FOREX RESERVES

$1288.2 billion

DEBT/GDP Ratio

227.2%

FISCAL DEFICIT (% of GDP)

9%

CAD (% of GDP)

2.02%

%

24

The hope is of creating a virtuous cycle. Monetary expansion

will spur depreciation of the yen, increase inflation, boosting

exports and increasing investment and employment which

will create a wealth effect, hence increasing private con-

sumption and boosting stock prices.

To stimulate the economy, the government will spend a

hefty amount of 20.2 trillion yen of which an expenditure of

10.3 trillion yen will focus on infrastructure projects like

building bridges, tunnels and earthquake resistant roads.

The package includes Bank of Japan’s bond buying program

which will depreciate yen but has raised concerns about the

emergence of a “currency war”. This is because depreciating

yen will make Japan more competitive in the export market

where countries like China are on the forefront and they

might see it as a direct threat. Already, Japan and China have

been on cold terms on quite a few issues with the recent one

being the Senkaku/Diayu Islands. Abe's structural reform

plans includes his decision to join the Trans-Pacific Partner-

ship (TPP), a proposed regional free trade agreement being

negotiated between the United States and eleven other

countries in Asia and the Americas. However, it has been

opposed by the agriculture industry and other interest

groups due to the protective measures given to them. Also,

some say that focussing on exports is increasing dependence

on demand from other economies leading to increased vul-

nerability.

Despite the risks, Abenomics has become the hope for Ja-

pan. Though stimulus packages have been issued before but

what distinguishes this from others is the sheer magnitude

and the collection of the right reforms. However,

how successful this is will only unveil in the time to

come.

25

The Shale Revolution

Until Twitter went public in November; 2013’s hottest Amer-

ican IPO was of shares in Antero Resources, whose wells in

the Appalachians are expected to increase the company’s

output by 76% in 2014 and 47% the year after. Now exactly

what wells are we talking about here?

It has commonly been touted for some time now that the

biggest innovation in energy so far this century has been the

development of shale gas and the associated resource

known as “tight oil.” And it is being said of the late George

Mitchell, a pioneer of the technique of hydraulic fracturing

to tap “unconventional” reserves of oil and gas, that “his

impact eventually might even approach that of Henry Ford

and Alexander Graham Bell.”

This “unconventional revolution” in oil and gas did not come

quickly. Hydraulic fracturing – known as “fracking” – has

been around since 1947, and initial efforts to adapt it to

dense shale began in Texas in the early 1980’s. However, it

was not until the late 1990’s and early 2000’s that the spe-

cific type of fracturing for shale, combined with horizontal

drilling, was perfected. Moreover, it was not until 2008 that

its impact especially on the US energy supply became nota-

ble.

Five years ago, it was expected that the US would be im-

porting large volumes of liquefied natural gas to make up for

an anticipated shortfall in domestic production. However,

since late 2008, the industry has developed fast, with shale

gas currently accounting for 44% of total US natural-gas pro-

duction. Given abundant supply, US gas prices have fallen to

a third of those in Europe, while Asia pays five times as

much. Tight oil, produced with the same technology as shale

gas, is boosting US oil production as well, with output up

56% since 2008 – an increase that, in absolute terms, is larg-

er than the total output of each of eight of the 12 OPEC

countries. Indeed, the International Energy Agency predicts

that in the next few years the US will overtake Saudi Arabia

and Russia to become the world’s largest oil producer.

If we look at it from a particular angle, US shale oil covers up

a recent decline of crude oil production of 1.5 mb/d (i.e.

million barrels per day) in the rest of world. This means that

without US shale oil the world would be in a deep oil crisis

similar to the decline phase 2006/07 when oil prices went

up. The decline comes from many countries. A detailed

schematic below shows us how the picture of global oil is

changing quite dynamically across geographies.

Countries, which had substantial changes in production, ap-

pear as large areas in the graph. Russia supplied – quite relia-

bly – the largest increment and the North Sea (UK and Nor-

way) had the largest losses. Countries, which feature promi-

nently, are Venezuela (low production in Jan 2003 due to a

strike), Iraq (low production in April 2003 during the Iraq

war), Libya (war in 2011), Iran (sanctions) and Saudi Arabia

(production increase since 2002 and swing role). Notably, US

shale oil has not brought down oil prices substantially and

definitely, the US does not act as a swing producer.

The world without shale oil declined after a recent peak in

February 2012, to an average of 73.4 mb/d in 2013, inci-

dentally the same average seen for the whole period since

2005 when crude production was 73.6 mb/d. One can see

that Saudi Arabia declined in 2006/07 (prices up), pumped

more in the oil peak year of 2008, (but not enough and prices

skyrocketed), served as a (negative) swing producer during

the financial crisis year of 2009 and stepped in (belatedly)

when the war in Libya started and continued pumping at rec-

ord levels when sanctions on Iran started. Saudi Arabia ap-

parently tries to compensate for Libyan and Iranian produc-

tion losses but does not seem to reduce crude production to

offset US shale oil. Iraq will have to return to OPEC’s quota

system. Decline in Syria and Yemen was offset by increases in

Kuwait, UEA and Qatar. Iraq could not offset Iran’s produc-

tion drops.

Russia, producing now at 10 mb/d, is still growing at around

100 kb/d but this growth rate is down from 2010 and 2012

years. FSU countries (i.e. Former Soviet Union) of Azerbaijan

declined at 50 kb/d after its peak in 2010. Kazakhstan is flat

since 2010. Oil production in Russia is approaching the record

levels of the Soviet era, but maintaining this trend will be

difficult, given the need to combat declines at the giant west-

ern Siberian fields that currently produce the bulk of the

country’s oil.

In Latin America, Brazil seems to have peaked while Colombia

slowly increased heavy oil production. Venezuela’s data ap-

pear sustained, as they have not been updated since Jan

2011. In Africa, irrespective of what has happened in Libya,

the rest of the continent’s countries seem to have peaked.

Overall, since end of 2010, the group of still growing coun-

tries (+1.2 mb/d) cannot offset decline elsewhere (-2.4 mb/

d), giving a resulting decline of 1.2 mb/d or 400 kb/d p.a.

26

This is mainly a geologically determined decline in oil. OPEC,

which is usually called upon to provide for the difference

between demand and non-OPEC production, has got its own

problems (geopolitical feedback loops caused by peaking oil

production) and was not able to fill that gap. Total global

crude oil without US shale oil would have declined by 1.5

mb/d since its most recent peak in Feb 2012.

At this juncture, it would be interesting to note the impact

of US Shale apart from the obvious one of mitigating global

supply woes.

With the US market cordoned off by cheap domestic gas,

some of that LNG is going to Europe, introducing unex-

pected competition for traditional suppliers Russia and Nor-

way. For Japan, the lack of US demand for LNG proved fortu-

nate in the aftermath of the disaster at the Fukushima

Daiichi nuclear-power plant in 2011. Much of that LNG could

go to Japan to generate electricity, replacing the electricity

lost from the total shutdown of nuclear power. Throughout

Europe, industrial leaders are becoming increasingly

alarmed by enterprises’ loss of competitiveness to factories

that use low-cost natural gas and the consequent shift of

manufacturing from Europe to the US. This is particularly

worrying in Germany, which relies on exports for half of its

GDP, and where energy costs remain on a stubbornly up-

ward trajectory. These high costs mean that German indus-

try will lose global market share.

European industry pays around three times as much for its

gas as its American counterpart, and Japanese firms pay

more than four times as much. A report by the International

Energy Agency, a think-tank backed by energy-consuming

rich countries, predicts that by 2015 America’s energy-

intensive firms will have a cost advantage of 5-25% over rivals

in other developed countries.

There are many who believe that as long as gas prices remain

at historic lows in America, it will remain unattractive to in-

vest in wells that produce only gas—as opposed to ones that

produce oil or a mix of gas and “natural-gas liquids” (NGLs)

such as butane and propane. As new gas has flooded onto

the American market since 2008, its price has fallen by two-

thirds to less than $4 per million British thermal units (BTU).

The average price needed to cover all the costs over a well’s

life cycle is around $6. These levels are expected to stay for

another three to five years. Roughly speaking, fracking for oil

and NGLs is profitable when oil is trading on American ex-

changes at above $80 a barrel, as it has mostly done for the

past four years. As long as energy firms expect this to contin-

ue, there will be lots of drilling, and thus lots of gas as well as

oil and NGLs. Most forecasts are bullish on the issue of prices;

“I can’t see any scenario, other than a widespread ban on

drilling, that would push prices higher than $6,” says Scott

Nyquist, one of the authors of a report by the McKinsey Glob-

al Institute.

Page No 2

27

Roughly, $200 billion are being saved by America currently

due to non imports of LNG coupled with reduction in oil

imports. Jobs in energy have nearly doubled since 2005;

since the end of the recent recession, they have grown at a

faster rate than in any other big industry. North Dakota,

which sits on the huge Bakken oil and gas field, now boasts

an unemployment rate of just 3%, the lowest among all the

states. The McKinsey report reckons that between now and

2020, shale gas and oil will add $380 billion-690 billion, or

two to four percentage points, to America’s annual GDP,

creating 1.7m permanent jobs in the process. A recent re-

port by IHS, another research outfit, talks of a manufactur-

ing Renaissance and predicts a $533 billion boost to GDP by

2025, creating around 3.9m jobs.

This is the first of a two part write up series on The Shale Revolu-

tion.

- Aaditya Mulani

Ref—Project Syndicate, The Economist, The Resilience Organiza-

tion and International Energy Agency.

Page No 2

28

BOND-SWAP TRADING-IS IT A BLIND ARBITRAGE?

Fixed Income, considered to be a relatively safe investment/

trading option, provides traders with a variety of products

which can be used in order to generate payoffs consistent

with the risk appetite of the trader. One such trading strate-

gy is Bond-Swap trading.

In India, the Fixed Income market is still in a nascent stage.

The Indian Bond Market is majorly dominated by Central

Government securities wherein the volumes exceed far be-

yond any other category. If we were to analyze the risk in

holding a Bond, we would say that even though we will re-

ceive x% returns (Bond’s Interest Rate) every year till ma-

turity, the mark to market fluctuations (by pricing the bond

to current market price) will determine the value of our in-

vestment at that point in time, even though we will receive

the entire Face Value at maturity.

So now post having a basic overview of Bonds and Swaps, let

us now focus on trading positions involving these two finan-

cial instruments.

Fixed Income traders generally enter into a bond-swap trad-

ing strategy so as to hedge floating interest rate risks and/or

to realize perceived arbitrage profits. But then how effective

this strategy can be is something that we wish to share with

you all.

Say on 15th May 2013, a Fixed Income trader entered into

the following trade:

Purchase a 5 year Indian Government Bond of Face Value

INR 100 crores which gives a yield of 7.27%1. So, over a

period of 5 years, the trader receives a return of 7.27%

on an annualised basis. The trader pledges the same on

the CBLO2 platform at a marginal haircut (say 5%) and

Fixed Income Market in India is in a nascent stage and is majorly dominated by Central

Government securities

In normal markets, a Bond-Swap strategy is highly effective and provides almost a zero

risk profit. However, the same position can be devastating when markets turn volatile

Another Fixed Income product common in India is called

Interest Rate Swap. The Interest Rate Swap in India is called

Overnight Index Swap. Swaps are highly liquid in US markets

and the Indian market though behind, is trying to catch up.

Interest Rate swaps call for exchanging the interest rate

cash flows between two parties, say a fixed rate for a

floating rate or vice versa.

If we were to think that Interest Rates may fall in future

then we may want to exchange our fixed rate liability for a

floating rate liability on the premise that our total payments

will reduce. Similarly, if we were to think that the rates will

rise then we may want to do the opposite - exchanging the

floating rate liability for a fixed rate liability and on the

premise that our overall payments will reduce. So, this is

where estimation of future Interest Rates comes into pic-

ture and so does the related risk of the estimation being

incorrect and thereby we making a loss.

obtains a funding on a daily basis at the CBLO Rate which

trades very close to the one day MIBOR3. For example –

if our bond value is INR 100 crores then we can deposit

the same in the CBLO market and obtain a loan of INR 95

crores (post haircut of 5%) and our interest will be calcu-

lated on a daily basis which will be linked to the daily

CBLO rate.

Enter into a 5 year Pay Fixed Overnight Index Swap

(Indian Interest Rate Swap) position (maturity same as

the bond) with a notional value of INR 100 crores at a

rate of 6.77%4. This means that the trader will pay to the

counterparty 6.77% of the notional trade amount every

year for 5 years and in return will receive a floating pay-

ment which is linked to one day MIBOR.

Effectively, the floating rate positions more or less nullify

each other (MIBOR and CBLO Rate trade very closely). So

majorly, the trader is left with an annualized receive

29

fixed position of 7.27% (Bond) and pay fixed position of

6.77% (swap). This is the trade that many fixed income

players exploit and bet on a spread which is more or

less certain to receive.

But then if we were to think that if this leveraged trade

promises such a good arbitrage opportunity then shouldn’t

the trader be putting in all of the firm’s money into this. This

is where the risks of the trade come into picture and was

something that the market realized very well during the

recent interest rate movements, majorly driven by macro

imbalances in the economy, and liquidity crisis in the past

few months.

The risks associated with this trade can be understood as

follows:

Mark-to-market hits on the bond and swap positions

can be severe in a volatile market. The trade economics

may be hit badly in case the bond-swap spread widens

further or the value of the bond falls and so less funds

become available from CBLO (overall position funding

cost increases).

Exit from the trade can come at a high impact cost if

the bond position becomes off-the-run (and so poor

liquidity). Liquidity crunch in the swap market will also

have a hit on exit as bid-ask spreads generally become

too wide. So, larger the trade size, larger is the risk.

The spreads between the CBLO Rate and MIBOR can wid-

en and on a net basis the trader may end up paying

more.

A large position size may make borrowing through the

CBLO window expensive, moreover when there is a li-

quidity crunch in the market and not many players are

willing to lend.

Even though someone may say that the profits outweigh the

risks, but calling it a blind arbitrage strategy will only make

one more susceptible to crisis in this extremely exciting but

complicated fixed income market space.

We feel, with time new trading products will evolve in the

market. Having a sound understanding of the risks of a prod-

uct has been and will continue to be the key in differentiating

a wise trader from the rest.

1Bloomberg 2Collateralized Borrowing and Lending Obligation 3Mumbai Inter Bank Offer Rate 4Bloomberg

Source: Bloomberg

30

U.S.A

M ajo r Hi gh l igh t s

Point of Interest:

Coming out of one of the

worst recessions in 80

years

The growth recovery has

been slow and intermittent

QE will be tapered in the

current fiscal, with increase

in interest rates, spillover

effect will need to be con-

tained

The economy of US has probably seen the

greatest number of business cycles in the

World. Not only that they seem to have navi-

gated through them successfully but rather

thrived on them. The economic recession of

2009-10, however was a near death experi-

ence for the US Economy and it will be wiser

for them to learn from it. The roots of this

recession lay in the terrorist attacks of Sep-

tember, 2001.

Supply Side Economics:

2001-2009 In early 2001, George W. Bush was elected

the President of United States; he was a

staunch Republican with a bent towards free

market and lesser government intervention.

The economy was coming out of a Dot-Com

bubble and the terrorist attack couldn’t have

come at a worse time for the US. It impacted

the confidence of the Industry as a whole

and threatened to send the US economy into

a second recession.

The US government acted in the only way it

could, to shore up confidence of its Inves-

tors, by announcing Tax cuts for the upper

echelons of the society, reducing interest

rates and going for lesser government over-

sight in the financial and manufacturing. This

was a perfect example of Supply side eco-

nomics, where a government provided in-

centives for the rich to invest heavily into the

economy.

The government got the desired results, the

economy boomed from 2001-2009, but then

what went wrong? Actually two things went

wrong. One was the extended wars in Iraq

and Afghanistan that bloated the Balance

sheet of the US government. Second was the

profligacy of the American banks, based on

the lower Interest rates and lower Tax rates,

it made sense for the lenders to lend more

and for the borrowers to spend more. The

more they lent, the larger their balance

sheets were and larger the balance sheet fast-

er the economy grew.

One of the prime examples of this is the Bush

Administration supported “Housing for All”

campaign. In this campaign, two semi-Federal

agencies, Fannie Mae and Freddie Mac were

asked to provide housing loans to economi-

cally weaker sections of the society, even

when their probability of returning the loans

was less (sub-prime). We all know how that

ended.

As to how the war contributed to the reces-

sion; think of the fact that the war was fund-

ed entirely through debt. About 20% of all the

National debt from 2001-2012 for the United

States went to the war. This amounts to

$260billion paid as interest for Financial Year

2013 and mounting. The total cost of war for

the US is expected to be $6Trillion, according

to a study by Harvard University

The problem is Supply side economics works

perfectly, when the fruits of the increased

production and greater liquidity are made

available to the masses. This is also known as

the Trickle-Down effect. However in this case

the money was funneled into the war-effort

and inflating a Real Estate and Stock market

bubble, instead of reaching the bottom of the

pyramid.

The immediate response of the US govern-

ment in the aftermath of the fall of Lehmann

Brothers and the beginning of the recession

was Bailout Package. This was a new form of

Keynesian Economics or Demand Side Eco-

nomics.

Demand Side Economics:

2009-Present Demand Side economics works in the com-

pletely opposite manner, instead of less gov-

ernment intervention; it stands for more gov-

ernment intervention. In demand side eco-

nomics, the government spends more money

NOMINAL GDP:

15.68 trillion USD

GDP RANKING:

1

FOREX RESERVES

145 billion USD

DEBT/GDP Ratio

106.52%

FISCAL DEFICIT (% of GDP)

2.8%

CAD (% of GDP)

2.3%

31

usually in Infrastructure development. This spending is fi-

nanced through Corporate and other Taxes. The US had its

first cycle of Keynesian Economics, just after the Great De-

pression. The government went into spending overdrive,

financing large scale infrastructure projects (the New Deal)

such as the Hoover Dam. At one point the Fiscal Deficit

reached 5% of the GDP. By the 1970 the Keynesian model

had began to falter as the power of Unions increased and

Productivity stagnated.

However this time the dynamics of the Keynesian model are

different and that is why we call it new Keynesian Model.

The major critique of the Keynesian model had been that the

government is highly inefficient in delivering services/capital

to the public. Hence this time the government spending was

not in Infrastructure projects, rather in doling out Bailout

packages. First to the Banks and then to the Auto Industry.

The rationale being, that Banks are too big to fail, hence

must be saved and are much more efficient in delivering

capital where it is required. Though if the past few years are

any reflection, that is hard to accept. (Part of the bailout has

gone to Infrastructure development)

So now almost 5 years after the recession, the US govern-

ment must reap what they had sowed. The expectation was

that increasing liquidity in the system through Banks will

help increase consumer confidence and increased invest-

ment in the Economy. This increased activity will improve

employment and hence push up consumption. However the

road back to growth has been slow and steep. As seen from

the graph:

32

United Kingdom

M ajo r Hi gh l igh t s

Special points of in-

terest:

Service sector shall re-

main the main engine of

UK growth with regards

to both output and em-

ployment

After a period of disap-

pointing growth in 2011

and 2012, UK economy

has showed signs of re-

covery in 2013

Reshoring has a poten-

tial to bring back

100,000 to 200,000 jobs

back to UK by 2020

Housing prices are on

rise since early 2013

The United Kingdom is the 6th largest

economy in the world with a Nominal

GDP of $2.47 trillion. After a couple of

years of sluggish growth, UK economy

has shown signs of recovery in 2013

with a growth of 0.8% in Q3 of FY13

and 0.7% in FY14. Growth has been

primarily driven by service sector over

the last four years but there has been a

clear uptrend in the manufacturing and

construction sector as well which are

indicative of good signs for the econo-

my. The other positive signs are the

rise in business investment and con-

sumer spending in 2013 even though

they haven’t reached the pre-crisis lev-

el yet. In fact, the growth has been

largely driven by consumer spending,

fueled by soaring house prices and

funded by a sharp fall in the savings

rate The other key feature of the re-

covery is that even though the jobs

(employment rate) have risen to the

pre-crisis level, the productivity has

been relatively poorer. The net exports

are currently negative and it is ex-

pected to remain the same because of

difficulties in Eurozone as well as slow-

down in emerging markets.

With Regards to the monetary

policy of Bank of England, interest rates

have been kept constant for a consider-

able period of time now at 0.5% and it is

expected to continue until late 2014 as

per the indications from Monetary Poli-

cy Committee. Nevertheless, it could be

influenced by other factors like how

growth and inflation evolve in the

months to come. In addition, the asset

purchase programme has been kept

constant at 375 billion pounds (total

since 2009) by the central bank.

One worrying feature of the

economy is its CAD which has been con-

stantly rising since 2008. In fact UK is

one of the only eight countries whose

CAD has widened since 2008 and its

CAD has widened the most. The export

performance has been worrying despite

a 20% devaluation of its currency in con-

trast to other European economies like

Germany, Spain and Portugal which

have seen strong export growth. The

key matter of concern is that the deficit

was fuelled by consumption and not by

NOMINAL GDP:

$ 2.47 trillion (2012)

GDP RANKING:

6

INTERNATIONAL RESERVES

$ 134 billion (2014)

DEBT/GDP Ratio

88.7% (2012)

FISCAL DEFICIT (% of GDP)

6.1% (2012)

CAD (% of GDP)

3.7% (2012)

33

would aid a rise in consumer spending. But the wor-

rying factor is that even though the unemployment

has reduced, the overall productivity has not im-

proved considerably.

Finally, UK’s trade deficit has increased to

2.56 billion pounds in Jan’14 in comparison to 1.45

billion pounds a year ago owing to lower sales of

aircrafts and chemicals. Shipments to EU declined

primarily due to chemicals while non-EU shipments

declined mainly due to aircrafts. On the other hand

net imports have increased by 1.92% in comparison

to last year and by 2.26% since December’13. Im-

ports from EU countries remained the same while

imports from Non-EU countries, mainly ships, air-

crafts, precious stones and silver increased by 7.5%

in comparison to December’13. Overall the outlook

for the next two years is that exports are expected

to grow accompanied by a strong growth in im-

ports, meaning net trade is not expected to add to

the economic growth over the next 2 years.

investment and it is accompanied by large fiscal deficit

which would eventually lead to slower growth and cur-

rency devaluation.

Another worrying factor for the economy is its

high debt to GDP ratio which even though is compara-

ble to US and France but is very high in comparison to

other European economies like Germany and Spain. In

fact UK borrows around 100b pounds a year and

spends half of it servicing existing debt. In order to ad-

dress the same, spending cuts worth $41 bn have been

announced in Jan’2014 which shall be spread over a

period of 2 years amounting to around 2% of the gov-

ernment spending.

Unemployment has been reducing reflecting

signs of recovery in the economy. The unemployment

rate as on January 2014 stands at 7.2% but the decline

has been mostly because of the increase in the num-

ber of self-employed people. The unemployment lev-

els in the 16-24 years age group has been the lowest

since 2011 levels. This falling unemployment com-

bined with rising income levels and falling inflation

rates show prospects for real income growth which

34

VIX

The VIX is a widely used measure of market risk and is often

referred to as the "investor fear gauge." VIX stands for Vola-

tility Index. It is the ticker symbol for the Chicago Board Op-

tions Exchange Market Volatility Index. It measures the im-

plied volatility of S&P 500 index options. Implied volatility is

a measure of the market’s best estimate of the volatility of

the price of the underlying asset. It is a useful gauge of the

market’s perception of risk, and it can experience very large,

rapid changes in, for example, a financial crisis or market

downturn. It is meant to be forward looking and is calculat-

ed from both calls and puts.

There are three variations of volatility indexes: the VIX

tracks the S&P 500, the VXN tracks the Nasdaq 100 and the

VXD tracks the Dow Jones Industrial Average, Nasdaq 100

and the VXD tracks the Dow Jones Industrial Average.

The first VIX, introduced by the CBOE in 1993, was a

weighted measure of the implied volatility of eight S&P 100

at the money put and call options. Ten years later, it expand-

ed to use options based on a broader index, the S&P 500,

which allows for a more accurate view of investors' expecta-

tions on future market volatility. VIX values greater than 30

are generally associated with a large amount of volatility as a

result of investor fear or uncertainty, while values below 20

generally correspond to less stressful, even complacent, times

in the markets.

The idea of a volatility index, and financial instruments based

on such an index, was first developed and described by Prof.

Menachem Brenner and Prof. Dan Galai in 1986. Professors

Brenner and Galai published their research in the academic

article "New Financial Instruments for Hedging Changes in

Volatility," which appeared in the July/August 1989 issue of

Financial Analysts Journal.

In a subsequent paper, Professors Brenner and Galai pro-

posed a formula to compute the volatility index.

VIX is often referred to as the fear index or the “fear gauge” It represents one measure of the market's expectation of stock market volatility over the next 30 day

period, which is then annualised.

It is quoted in percentage points.

Professors Brenner and Galai wrote "Our volatility index, to

be named Sigma Index, would be updated frequently and

used as the underlying asset for futures and options... A

volatility index would play the same role as the market index

play for options and futures on the index."

In 1992, the CBOE retained Prof. Robert Whaley to create a

tradable stock market volatility index based on index option

prices. In a January 1993 news conference, Prof. Whaley

reported his findings. Subsequently, the CBOE has computed

VIX on a real-time basis.

35

Market Updates

India has done pretty well overall the first 5 months of 2014. But the year did not start all that well. For the first one and a half

months or so, stock market indices fell overall and rupee mostly depreciated. The RBI monetrary policy review came on Jan 28

in which it increased the repo and the reverse repo rate by 25 bps, while leaving the CRR unchanged. Subsequently, the inter-

im budget was declared on February 17, which came up with a host of changes. After this phase, the market began to do well

with the influx of FIIs and also the CAD coming down to only 2% of GDP as a result of a considerable dip in imports of gold.

The FIIs pumped in a total 6 Billion during this phase in a space of one week. On March 10 the Sensex hit an all-time high

crossing the 22,000 mark and on the same day the Rupee also reached a year high of 60.85. The Nifty followed the Sensex and

itself reached an all time high thenext day. The Inflation rate in mid-march reached a nine month low of 4.68.

With the inflation, fiscal deficit and CAD coming down and Modi reaching at the helm of the government, markets started

rising steadily. Few days before election results i.e. 16th May, markets clearly facored in the BJP government. After 16th May,

when BJP alone was able to garner full majority, bullish sentiments were rekindled in the markets taking it to fresh all time

high i.e. above 25k.

RBI Current Interest Rates (As on 14th June 2014)

[Last RBI Policy Review: 1th June 2014]

BSE Sensex (Dec 16 to June 14)

Repo rate 8 %

Reverse Repo rate 7 %

MSF 9 %

CRR 4 %

SLR 22.5 %

36

Inflation rate (CPI)

Movement of the Rupee (Jan-June 2014)

Market News:

Jan 02: IPO Fund raising via IPOs hit lowest level in 12 yrs during 2013

Indian companies mopped-up Rs 1,619 cr in 2013 through IPO, the lowest level in 12 yrs.

Jan 04: Sluggish start to 2014, BSE Sensex slumps to 2-week low

Sensex is expected to remain cautious over political developments leading up to general elections.

Jan 13: Indian rupee hits over 1-month high, gains in shares aid

The Indian rupee rose to its highest level in over a month on Monday, boosted by hefty gains in domestic shares and after

weaker-than-expected U.S. jobs data eased worries about an aggressive reduction in the Federal Reserve's stimulus.

Jan 15: Inflation declines to 5-month low at 6.16 pc, RBI may ease interest rates to prop up growth

Wholesale inflation declined to a five-month low of 6.16 per cent in December, providing space to the Reserve Bank to

ease interest rates and prop up growth.

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BSE based Indices (16 Dec – 14 June)

Global Indices (Dec 16 – June 14)

Jan 15: NSE Nifty ends one-month high, closes above 6,300

The 50-share Nifty hovered between a high of 6,325.20 and a low of 6,265.30 before settling at 6,320.90.

Jan 17: RBI to infuse Rs 10k cr liquidity into market on Wed via OMO

The Reserve Bank of India (RBI) will pump Rs 10,000 crore in the market on Wednesday by buying government securities to ease the liquidity situation. RBI said the liquidity conditions are undergoing some stress in the recent period, primarily due to build-up of cash balances on the government.

Jan 19: FIIs invest over Rs 16,000 cr in debt market

Overseas investors have pumped in over Rs 16,000 crore (USD 2.6 billion) in the Indian debt market in the new year so far, after being net sellers of bonds in 2013.

INDEX

16th December

14th June

Return (%)

S&P BSE Sensex

20659

25228

22.21

S&P BSE Midcap

6321

8935

41.35

S&P BSE Smallcap

6152

9674

57.24

S&P BSE 500

7572

9606

26.86

S&P BSE Auto

11949

15195

27.16

S&P BSE Bankex

12962

17309

33.5

S&P BSE FMCG

6369

6868

7.83

S&P BSE IT

8690

8895

2.35

Country Index Dec 16, 2013 June 14, 2014 Return (%)

UK FTSE 6522 6758 3.61

Japan Nikkei 15152 14430 - 4.76

Germany DAX 9163 9829 7.26

USA S&P 500 1786 1927 7.89

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Jan 20: MCX-SX exchange kicks off interest rate futures

The IRF contract traded is the 7.16 per cent 2023 bonds on Monday. Cash-settled interest rate futures started trading in In-dia's MCX Stock Exchange Ltd (MCX-SX).

Jan 22: GDP growth in India to slip to 4.8 pct in FY'14; to improve next year: Crisil

India's GDP growth rate in the current fiscal is expected to slide to 4.8 per cent and the prospects for 2014-15, which currently appear to be bright, hinge on the stability of the new government.

Jan 28: RBI policy review: 'Worried' Raghuram Rajan pulls surprise, raises repo rate 25 bps, CRR left unchanged

The Reserve Bank of India in its policy review unexpectedly raised its policy interest rate on Tuesday by 25 basis points but said that if consumer price inflation eases as projected it does not foresee further near-term tightening - Governor Raghuram Rajan leaves cash reserve ratio (CRR) unchanged at 4 pct (read highlights below). Having raised repo rate, RBI Governor Raghuram Rajan said slowdown in economy getting 'increasingly worrisome'.

Jan 28: Indian bonds fall after surprise RBI repo rate hike; outlook supportive

Jan 30: Investment limit for foreign investors raised to $10 billion

In a move to attract more long-term dollars into government bonds, the Reserve Bank of India (RBI) has hiked the investment limit for foreign investors, such as sovereign wealth funds, pension funds and foreign central banks, to $10 billion from $5 billion.

Feb 01: Forex reserves up marginally as RBI refrains from selling dollars

Forex reserves, as on January 24, were $292.24 billion, down $3.5 billion from a year ago, data from the RBI showed.

Feb 03: RBI raises FII limit in Power Grid to 30% RBI raised Foreign Institutional Investors' investment limit in Power Grid Corporation to 30 per cent.

Feb 04: NSE Nifty recovers from multi-month lows; holds on to 6,000 mark After hitting multi-month lows in early trade, the NSE Nifty smartly recovered the lost ground.

Feb 08: RBI removes 26% cap on MFI interest rates Feb 08: Last bond auction for FY14 ends on bright note RBI sold three bonds, including the benchmark 10-year bond, for a total of Rs 10,000 crores.

Feb 09: Bitcoin gang inches towards 100-member mark, hits $13-bn value Enhanced regulatory oversight in India and other countries seems to be having little impact on spread of bitcoins and other virtual currencies, whose number is fast moving towards a century with a total valuation of close to USD 13 billion.

Feb 17: Budget 2014 Government to borrow 25p for every rupee in its kitty. Cars, two-wheelers, soaps set to be cheaper. P. Chidambaram plans to

boost financial markets, revamp ADR, GDR scheme. Government cuts Plan spending by Rs 79,000 crores for current fiscal.

Feb 11: India FY15 GDP to improve to 5.3% from 4.7% in FY14: Standard chartered bank

Feb 17: Govt to infuse Rs 11,200 cr in PSU banks in 2014-15

The government today said public sector banks should raise capital on their own in future.

Feb 17: Indian rupee rises to nearly 1-month high of 61.84, up nine paise vs US dollar

Feb 18 : NSE to launch India VIX futures contracts from Feb 26

The NVIX contracts will be available in the existing futures and options segment on the NSE.

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Feb 22: CAD to come down to 2 pct of GDP this fiscal: C. Rangarajan

Exports have picked up. Imports have come down not only in relation to gold but also in relation to oil.

Feb 23: Indian govt approves eight FDI proposals worth Rs 1,024 crore

Feb 28: India's April-January fiscal deficit touches $86 bn, 101.6 per cent of full year target

Mar 01: Q3 GDP at 4.7 pct, need 5.7 pct in Q4 to meet full year target of 4.9 pct. Infrastructure sector slows to 1.6 pct in Jan

Mar 05: Current account deficit narrows sharply to $4.2 bn in Q3 Current account deficit had reached $5.2 bn, or 1.2 pct of GDP in July-Sept quarter last year.

Mar 07: Indian Rupee rallies to 3-month high, goes from worst performer to rising star

The worst-performing currency among emerging markets less than a year ago, the rupee has staged an impressive comeback to become a much sought-after asset for foreign investors. The Indian currency closed at a three-month high of 61.12 against the dollar, gaining 1.5% in just three sessions. Mar 07: RBI raises FII purchase limit in Manappuram Finance to 49 pct Mar 09: FIIs infuse Rs 3,000 crore in Indian equities in past week

Overseas investors pumped in over Rs 3,000 crore in the Indian stock market in the past week mainly on hopes of a strong mandate for the government to be elected in polls starting next month.

Mar 10: Indian rupee ends at 7-month high of 60.85 vs US dollar on robust FII inflows

The Indian rupee appreciated 22 paise against the US dollar to end at an over seven-month high level. FIIs have pumped in 6

Billion in a period of one week.

Mar 10: BSE Sensex hits all-time high of over 22,000 intra-day; HDFC Bank, L&T shares soar

BSE Sensex hits lifetime high of 22,024 pts and closed at yet another record of 21,935 pts

Mar 11: Emerging market funds see outflows of nearly $30 billion in 2014

Emerging market (EM) funds witnessed another $3.8 billion of outflows for the week ended March 5, extending the outflow

streak to 19 weeks and taking the aggregate outflows for this year to $29.4 billion.

Mar 11: NSE Nifty hits lifetime high of 6,562.85, BSE Sensex trading over 22,000-mark

NSE Nifty shot up by 0.39 per cent, to trade at an all-time high of 6,562.85

Mar 13: Banks feel NPA pinch: For every Indian rupee lent, 13 paise go bad

Mar 14: Inflation eases to 9-month low, RBI interest rates seen on hold for now

Mar 21: Govt raises over Rs 5,550 cr from Axis Bank stake sale

Mar 24: FIIs pumped in Rs. 4,280 crore into Indian equities to take Sensex to record high 22055

Mar 27: Bombay Stock Exchange (BSE) 30-share sensitive index (Sensex) closed at 22214

Mar 31: Sensex, Nifty hit new lifetime highs in opening trade

Apr 1: RBI kept the indicative policy rate (repo) unchanged at 8 per cent while taking measures to provide longer term li-

quidity in the system

Apr 2: RBI adopted the new Consumer Price Index (CPI) (combined) as the key measure of inflation

Apr 8: India’s growth likely to recover to 5.4 % in 2014: IMF 40

Apr 11: Exports dip 3.15 per cent in March

Apr14: Gold regains 30,000 level on strong global cues

Apr 17: Sensex surges 351 points on value buying

Apr 22: Sensex touched a record high of 22,853.03 points

Apr 28: New Foreign Trade Policy to focus on ways to boost exports

May 07: Sensex tanks 184 points as IT, banking stocks decline

May 12: April retail inflation rises to 3-month high of 8.59%, March industrial output shrinks 0.5 %

May 16: Bulls greet BJP show, Sensex soars over 25k , Rupee at 11-month high as BJP sweeps election

May 23: S&P BSE Sensex, after hitting an intra-day high of 24746, closed at 24693, Rupee rose by another 10 paise to trade

at a fresh 11-month high of 58.37

May 26: Current account deficit narrows to 1.7 % of GDP

May 30: India’s growth remains subdued at 4.7% in 2013-14

June02: Sensex surges 467 points as funds pick banking, oil stocks ahead of RBI monetary policy review meeting

June 05:Sensex ends above 25,000 for the first time, closes at 25019

June 13: El Niño to keep inflation elevated: BoFA-ML

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