Blue Chip $2.4T $16.2T $8.2T $2T $2.2T $1.8T $5.9T $12.1T Cover Article: Inflation Targeting as a Monetary Policy China Shadow Banking, Bond swap trading – is it blind arbitrage? “VIX” De-mystified..…… Major Economies of the World covered Special Edition 2014
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Blue Chip
$2.4T
$16.2T
$8.2T
$2T
$2.2T
$1.8T
$5.9T
$12.1T
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
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.
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-
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
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.
37
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.
39
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