The Wise Investor May 2010 Sundaram BNP Paribas Asset Management

8/9/2019 The Wise Investor May 2010 Sundaram BNP Paribas Asset Management

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Sundaram BNP Paribas Asset ManagementSundaram BNP Paribas Asset Management: Investment Manager for Sundaram BNP Paribas Mutual Fund / Portfolio Management Services: Sundaram BNP Paribas Portfolio Managers

Shifts in market profile

Vol 4 - Issue 2 | May 2010 | Rs.3.50

sprinkling of what could be genuinely described as large-cap stocks.

The most important takeaway for investors should be for asset allocation

purposes.

Today the top 50 stocks account for about 62% of the market cap on the

NSE and the top100 stocks account for about 77%.This profile of the means

It is important to have an allocation of between 65% 80% in the large-cap

space.

Let us not forget that this part of the cap curve is less risky, more liquid, and

less volatile, suffers to a lower degree in downward phases and is made up

of more established and vis ible names with several possess ing robust

financials.

The mid-cap space can, however, no longer be ignored. Even if we ignore

stocks below the 300th by market-cap on the NSE (there are several

decent names in the sub-300 category, too), there is today room for

dedicated mid-cap and small-cap portfolios.

As we move from the top 50 to the entire market, there is an increase of

3.5 percentage points in compounded annual return over a 10-year plus

period. I f you want to perform in l ine with the broad market, you cannot

ignore a part of the cap curve that is almost 25% of the market.

An investor should have exposures to this segment;the level will depend onrisk appetite.

Risks in this part of the market are higher, but across market cycles over the

long term, returns should adequately compensate.This is clear even over the

period covered in this analysis, which had at least four different cycles.

The numbers presented here are relevant for the equity par t of an

investors portfolio and not the complete portfolio, which must have a

sizeable fixed-income component.

First 50 Stocks 420667 3755582 26.7 79.8 62.1 -17.7

Next 50 Stocks 50542 901369 36.5 9.6 14.9 5.3

Top 100 471209 4656951 28.1 89.4 77.0 -12.4

Next 100 (# 101 - # 200) Stocks 31902 636904 38.2 6.1 10.5 4.5

Next 100 (# 201 - # 300) Stocks 12027 305420 41.9 2.3 5.0 2.8

Rest of the stocks (# 301 onwards) 11942 448846 48.0 2.3 7.4 5.2

Total 527081 6048121 30.2 100 100

Stock group by market cap

Market-Cap on the NSE Share in NSE Market Cap

Dec-00

Rs Crore

Mar-10

Rs Crore

CARG

%

Dec-00

%

Mar-10

%

Change

% Points

Major shift over the past decade-more depth across the cap curve except at the top end of the Indian market

Source: Bloomberg,Analysis: Sundaram BNP Paribas Asset Management

The share of the top 50 stocks on the National Stock Exchange has declined

by a massive 17.7 percentage points since December 2000.There has been

an enhancement at every subsequent bucket of 50 and 100 stocks. The

accompanying table provides a snapshot of what has happened between

December 2000 and March 2010 on the NSE;a more detailed year-by-year

analysis is available on page 27 of this publication.

These shifts have important implications for investors.

There has been a signi ficant enhancement in market depth and breadthacross the cap curve.

In December 2000 we were still unwinding from the tech/media/telecom

boom that had a global footprint it would have been a challenge to even

think of a sizeable mid-cap allocation in a large-cap oriented portfolio.This

is no longer the case.

To have 100 large-cap stocks is an additional source of comfor t for

investors. This was not the case in 2000. Even the top 50 had only a


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Sundaram BNP Paribas Asset Management TheWise InvestorMay 20102

Granthams Probability Tree

World 47123 49722 31901 60880 100.0 100.0 100.0 100.0 -5.2 55.9 -47.6 -22.6

United States 14482 13748 10455 17660 30.7 27.7 32.8 29.0 5.3 31.5 -40.8 -18.0

Canada 1777 1609 992 1749 3.8 3.2 3.1 2.9 10.5 62.2 -43.3 1.6

Brazil 1270 1326 565 1273 2.7 2.7 1.8 2.1 -4.2 134.7 -55.6

Mexico 389 363 247 398 0.8 0.7 0.8 0.7 7.3 46.8 -37.9 -2.3

Chile 245 229 130 208 0.5 0.5 0.4 0.3 7.1 76.0 -37.5 17.8

United Kingdom 2994 2975 1981 4051 6.4 6.0 6.2 6.7 0.6 50.2 -51.1 -26.1

France 1758 1900 1480 2736 3.7 3.8 4.6 4.5 -7.5 28.4 -45.9 -35.7

Germany 1319 1371 1075 2208 2.8 2.8 3.4 3.6 -3.8 27.5 -51.3 -40.3Switzerland 1062 1076 848 1217 2.3 2.2 2.7 2.0 -1.3 26.8 -30.3 -12.7

Japan 3760 3488 3268 4545 8.0 7.0 10.2 7.5 7.8 6.7 -28.1 -17.3

Honk Kong 2262 2268 1312 2655 4.8 4.6 4.1 4.4 -0.3 72.9 -50.6 -14.8

India 1412 1294 640 1813 3.0 2.6 2.0 3.0 9.1 102.3 -64.7 -22.1

Australia 1280 1253 652 1415 2.7 2.5 2.0 2.3 2.2 92.1 -53.9 -9.5

China + Others 13113 16823 8256 18952 27.8 33.8 25.9 31.1 -22.1 103.8 -56.4 -30.8

Data Source: Bloomberg;The last available figures for each year have been taken; Analysis: Sundaram BNP Paribas Asset Management. End December 2007 figures have been reckoned as a proxy for the peak as different countries reached the point on different dates.

Region/CountryMarket Cap ( $ Billion) Share in World Market Cap (%) Returns (%) Distance

from Peak

(%)EndApr

20102009 2008 2007 End Apr 2009 2008 2007

2010YTD

2009 2008

A comparison in 2007 (close to peak),2008 (close to bottom) & the present

Economy has a strong and sustained recovery, rates rise,

market falls, but basically all is wellEconomybum

psalong,rates

staylow

No real market shocks, speculation and market prices rise

to October 2011 to dangerous levels, then soon break withsevere consequences

Pooreconomicdata

orcrisisin

nextfew

months

bre

aksanimalspirits,m

arketfalls,

avoiding

longer-termmajorbubbles

0.3

0.7

0.7

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0.49

0.21

Global Market Snapshot

Chart of the Month

This exhibit, used with permission, is taken from Jeremy Grantham's 1Q 2010 quarterly letter. The letter can be read in full at www.gmo.com.

The views presented by the author (s) do not necessarily represent that of Sundaram BNP Paribas Asset Management.The article / posts have been reproducedwith permission or from reports available in the public domain in order to provide readers access to a diverse range of views on the economy and asset markets.

The Line of Least Resistance


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Sundaram BNP Paribas Asset Management The Wise InvestorMay 20103

India View Equity

Indian markets put up an uninspiring performance last month, and

underperformed US markets as we had suggested it might as a near-term

trend. That trend is expected to continue for some more time, as the

earnings recovery in the US and improved economic data are yet to be

factored in fully by markets. India continues to outperform China and Brazil.

This is primarily because of lower levels of concern as compared to China

and Brazil, whose economies are highly correlated on account of the

Chinese commodity demand from Brazil. There is also the larger questionof Europes smaller countries enmeshed in debt traps for which solutions

seem difficult.

Indian markets out-performance of peers in the emerging markets space

has been on account of strong FII inflows as well as concerns about Chinese

momentum swell. Further, local institutions have also bought into stocks on

account of lower exposure to equities. This has kept market momentum

going.

Inflation in India remains high and is an area of concern, but there are

indications that the monsoons this year will be better resulting in a higher

crop output and lower prices. We are witnessing this trend in wheat and

sugar already and may see this play out in other crops as well.

India will remain short on edible oil and pulses and hence movements in

currencies or changes in output of oil seeds will impact the price levels.There is an ongoing discussion that the level of subsidies for fuels needs to

be limited implying that prices will have to be increased sharply by as much

as 15-20%.

Whether the government has the resolve remains to be seen. Should this

take place then inflation will remain higher for a longer period of time, but

government borrowing costs could drop quickly, enabling banks to

outperform on account of their large portfolio of government bonds.

The wheels-within-wheels suggest that the market will not perform on

account of several contradictory factors

Large foreign inflows could reduce inflation but could also cap market

earnings growth as commodity companies and technology earnings

suffer

Lower foreign inflows would on the other hand imply that inflation and

fiscal deficit concerns would outweigh

There are similarly, several other contradictory forces in the market which

imply that there is a lack of clarity in any trend emerging.

Further, Indias infrastructure project is not picking up as much as expected

and performance in railways and highways leave much to be desired. The

silver lining is that power projects in the private sector are gathering steam

and there seems to be a higher degree of visibility in this segment. An ear ly

resolution of KG-D6 gas pricing would also pave the way for some morepower output to come on stream.

We are nowhere close to potential infrastructure spend or build out, as

clearances still take time and the regulatory process complex.

Consequently, we have seen delays in road projects. We could also witness

higher foreign competition in infrastructure projects.

As regards the European debt crisis, a risk of default still exists, as there are

too many countries on the brink. There is a belief in the market that IMF

can resolve this issue, but a default and a hair cut in debt would perhaps be

the final resolution. Many of these countries have high borrowings with low

earnings and high unemployment implying a resolution of this crisis in not a

short one but could prolong for a sustained period of time.

The silver lining, if there were one, is that this problem is within Europe, and

is in a way a set off between the richer and poorer countries.The European crisis, should serve as a reminder that the spend and get out

of the slowdown policy may boomerang for a variety of reasons, and that

there is no substitute for fiscal prudence. The current government strategy

to spend and subsidize could invoke a sharp uptick in borrowing costs

impeding growth. These events occur suddenly and can impact market

sentiments sharply.

As of now, the Governments plans to raise capital from 3G auctions and

divestment are proceeding smoothly indicating that interest rates in the

system will be under check. With overall government debt above 80% of

GDP, there will be issues from time to time that the government needs to

resolve.

Consumption in India ended FY2010 on a strong note with record sales of

cars, televisions, phones, bicycles on the back of a confluence of factors-higher farm incomes, lower interest costs, and pent up demand due to delay

in purchases. Benefits of the Sixth Pay commission and other government

schemes have resulted in this high growth. Will this sustain?

Historically, our studies suggest that growth is sustainable albeit on a lower

level. This is a year of some achievements for the first time, two wheeler

sales crossed bicycle sales. Penetration levels remain low for most

consumer durables, as electricity is not available in most areas. With

electricity becoming accessible, it would be reasonable to assume that the

next consumption boom is shaping up.

Lacklustre trends

Satish RamanathanHead-Equity

Sundaram BNP Paribas Asset Management


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Market Outlook: There is an overwhelming consensus that markets will

continue to head higher. Mid-caps continue to outperform large caps.

Clearly, the signs of high liquidity are visible, in assets such as real estate, but

inflows into equity from domestic investors is subdued. The expectation is

that investors are sitting on the fringes and will be sucked in once markets

move sharply upwards.

Appealing as the logic may be, we remain concerned on the earnings

outlook for Corporate India. Corporate India is currently operating at one

of the highest margins on account of lower competition and trade

restrictions. But margins can compress quickly as seen in the case of

telecom. Capacities are coming up across many industries and could

become operational when demand is actually cooling off. This is especially

true in the auto industry.

Similarly, a lot of competition is coming in the private unlisted space, where

the pressure for short-term profits is low. Indias corporate profitability and

ROEs are among the best in the region on account of large supply

constraints. Once this eases, profitability gets eroded for a long period of

time. Hence, our concern is that volumes can keep going up for the industry

as per capita consumption increases, but company profits may remain

stagnant.

The same holds true for refining and petrochemicals as well, as capacity

additions were stalled on account of the credit crisis and are now nearing

completion. This will have a more lasting effect of weak margins. To counter

this trend of weaker margins, a number of mergers and acquisitions are

being announced, especially in the commodities space. We will have to wait

and watch if this indeed translates to superior pricing power when fresh

capacities come along.

We also remain worried on the amount of equity issuances that will take

place globally as companies try to repair their balance sheets. China and

India will continue to remain capital hungry markets and any change in risk

perception could dent market sentiments sharply.

On a medium-term perspective, we are more optimistic. We think India is

becoming a more favoured destination, as money moves from some of the

mature markets to India.

Infrastructure development, although slow, will continue to become a larger

theme in the private sector. We are also positive on the consumption

theme which will play an integral role in economic development as better

infrastructure is rolled out. While markets are expensive on a short term

basis, they are not, when adjusted for the growth potential.

We therefore recommend that investors continue to increase their equity

exposure during this period of consolidation. Thanks to the slow rate of

development in India, the potential for growth is bigger for longer. That is

an opportunity for investors, as corporate profitability will be more secular

and remain so longer rather than it getting competed away.

From a portfolio perspective, we are now looking at growth stocks with

sustainable cash flows rather than focus on companies where growth would

entail equity raising.

10 False Lessons from 2008 & 2009

Seth Klarman is the President of The Baupost Group, a Boston-based private

investment partnership. The firm has achieved investment returns of 20%

compounded annually over 25-plus years. He is also the author of Margin of Safety-

Risk Averse Investing Strategies for the Thoughtful Investor. In his latest annual letter,

Klarman describes 10 false lessons investors appear to have learned as of late 2009.

1. There are no long-term lessons ever.

2. Bad things happen, but really bad things do not. Do buy the dips, especially the

lowest quality securities when they come under pressure, because declines will

quickly be reversed.

3. There is no amount of bad news that the markets cannot see past.

4. If youve just stared into the abyss, quickly forget it: - the lessons of history can

only hold you back.

5. Excess capacity in people, machines, or property will be quickly absorbed.

6. Markets need not be in sync with one another. Simultaneously, the bond market

can be priced for sustained tough times, the equity market for a strong recovery,

and gold for high inflation. Such an apparent disconnect is indefinitely sustainable.

7. In a crisis, stocks of financial companies are great investments, because the tide is

bound to turn. Massive losses on bad loans and soured investments are irrelevant

to value; improving trends and future prospects are what matter, regardless of

whether profits will have to be used to cover loan losses and equity shortfalls for

years to come.

8. The government can reasonably rely on debt ratings when it forms programs to

lend money to buyers of otherwise unattractive debt instruments.

9. The government can indefinitely control both short-term and long-term interest

rates.

10. The government can always rescue the markets or interfere with contract law

whenever it deems convenient with little or no apparent cost. (Investors believe

this now and, worse still, the government believes it as well. We are probably

doomed to a lasting legacy of government tampering with financial markets and

the economy, which is likely to create the mother of all moral hazards. The

government is blissfully unaware of the wisdom of Friedrich Hayek: The curious

task of economics is to demonstrate to men how little they really know about

what they imagine they can design.)

Klarmans Message to Investors: To not only learn but also effectively implement

investment lessons requires a disciplined, often contrary, and long-term-oriented

investment approach, a resolute focus on risk aversion rather than maximizing

immediate returns, as well as an understanding of history, a sense of financial market

cycles, and, at times, extraordinary patience.

Source:www.zerohedge.com (http://bit.ly/aAjdxN)

Distilled WisdomIndia View Equity

The views presented by the author (s) do not necessarily represent that ofSundaram BNP Paribas Asset Management. The article / posts have beenreproduced with permission or from reports available in the public domain inorder to provide readers access to a diverse range of views on the economyand asset markets.
http://www.zerohedge.com/http://www.zerohedge.com/http://bit.ly/b4rfBUhttp://bit.ly/b4rfBUhttp://bit.ly/b4rfBUhttp://www.zerohedge.com/http://bit.ly/b4rfBU


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India View Bonds

Calibrated tightening likely

K RamkumarHead Fixed Income


The Reserve Bank of India appears

increasingly confident of growth per se and

the overriding fear is that of inflation

unbridled eating into growth. Inflation levels

though elevated for over five months now

were initially driven by food prices. Food

prices are now receding and are expected to

decline further, post the Rabi crop.

Yet another bad monsoon year would be

detrimental to inflation as well as the fiscal

deficit. Expenditure estimates in the budget

for FY 2011 are fairly optimistic and factors in

flat food subsidies. As far as core inflation is

concerned, though the absolute levels are not

alarming as yet, the trajectory is that of a

sharp upward move and prospects of further

rise are increasing with excise duty hike, metal

prices and oil prices.

Also, there are considerable lags between the

uptrend in international and domestic prices

in the case of oil, steel etc, which may keep

inflation elevated for a longer period. The end-

year target of 5.5% however looks achievable,

with the high base effect kicking in by then.

INR has witnessed sharp appreciation in real

terms and there is a degree of apprehension

that the current trend may persist given the

capital inflows and high interest rate

differentials. The RBI has mentioned it as a

growing source of worry, given that exportgrowth is still nascent.

Among recent developments, the Bank has

announced MSS ceiling of Rs 50,000 crore for

FY 2011. The RBI REER has now risen above

the one standard deviation band of its 10-year

average. Against this backdrop, there might be

a few attempts on the part of the RBI to slow

the pace of rupee appreciation.

Clearly the RBI has launched itself onto a path

of calibrated tightening; while policy rate

hikes may be gradual and spaced out through

the year, RBI may not go too aggressive on the

process in order to not jeopardize growth.

The central bank has assumed an 18% growth

in deposits for the full year. Assuming the same

and given the borrowing overhang, the system

can support a credit growth of about 17-

17.5% comfortably. The indicative credit

growth target is, however, higher at 20%.

This would make CRR hikes undesirable in

the second half of FY11 and may mean an

upward trend in deposit rates in a bid to ramp

up mobilization.

Market participants were expecting a 25 basis

points (a basis point is 0.01 per cent) hike in

reverse repo, repo and CRR with a few

anticipating a 50 bps hike in either one of

them. This led to participants approaching the

market with lot of caution. The 25 basis points

uniform rate hike was thus received well by

the market and led to a relief rally.

The current 10-year benchmark was

technically waiting to rally ever since a floating

rate security was announced in the recent

auction, with the policy action being the only

hurdle. The comfort from the monetary policy

announcement triggered and enhanced the

upward movement in prices.

Looking forward, the relief rally may short-

lived. The demand-supply mismatches, deft

management of the borrowing programme

by the RBI and the sword of calibrated rate

action (best case) will be back in focus and

shall determine the levels at which the

benchmark securities move. We expect the

10-year benchmark to move to a range of

8.25%-8.50% over the next couple of months.

Stance of Monetary Policy

Anchor inflation expectations, while

being prepared to respond

appropriately, swiftly and effectively to

further build-up of inflationary

pressures.

Actively manage liquidity to ensure that

the growth in demand for credit by

both the private and public sectors is

satisfied in a non-disrupt ive way.

Maintain an interest rate regime

consistent with price, output andfinancial stability.

The expected outcomes of the actions are:

Inflation will be contained and

inflationary expectations will be

anchored

The recovery process will be sustained.

Government borrowing requirements

and the private credit demand will be

met.

Policy instruments will be further

aligned in a manner consistent with the

evolving state of the economy.

Growth: Assuming normal monsoons and robust trendsin the industry and services sectors, RBI pencils in 8% GDP

growth in FY11, with an upward bias. Under risks to growth,the Bank lists a fresh dip in global growth as the first one. In

this context RBI also mentions the possibility of buoyant

capital inflows given the rising interest rate differential as a

challenge. Robust inflows has already led to 15%

appreciation of the Rupee in real terms in FY10 and is now

a growing concern for exporters, whose fortunes are only

beginning to turn, RBI warns. Other risks are in terms of a

steep rise in global commodity prices, another bad

monsoon-the latter would put fresh upward pressure on

food prices, dent the rural consumption significantly and

upset the delicate fiscal arithmetic, RBI cautions.

Inflation: The central bank appears worried about thelevel as well as the shifting composition of inflation, with

non-food manufactured products inflation accelerating from0.7% in Dec 2009 to 4.7% in March 2010. More disturbingly,

the upside risks to inflation are on the rise, the RBI states.

Despite the recently observed seasonal softening in food

inflation, the bank suspects that structural shortages in

certain commodities may limit the fall in prices.

Secondly the RBI is apprehensive on the upward in global

commodity prices as well as the return of corporate pricing

power. Monsoon, oil prices as well as domestic demand

pressures will be crucial to the inflation outlook, the Bank

concludes. The year-end estimate for WPI inflation is placed

at 5.5%.

RBI View on Growth & Inflation


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The outside view

Infrastructure +

EM Positive

In GREED & fears view the most exciting thing about the

Indian macro and micro story right now is the growing

likelihood that the next few years will see real progress

made in reducing supply bottlenecks in terms of the build

out of infrastructure, most particularly in the area of

power and roads, via a combination of private and public

sector financing.

In this context the present Indian Five Year Plan calls for

US$500bn of infrastructure investment through to March

2012. It appears that US$300-350bn of investment will

happen during this period, implying a success rate well

above the 50% norm during many past Plan periods. Mostof the action is likely to be in power, roads and telecom

where a 3G build-up will soon be under way.

The incentive for the private sector is that with supply so

limited in infrastructure, if execution can be achieved the

returns on such projects can be very attractive if not

enormous; particularly for those with first-mover

advantage to use ghastly business school jargon.

Christopher Wood, Managing Director & Strategist of

CLSA Asia-Pacific, an independent research outfit and

author of the weekly report GREED & Fear.

Within my personal portfolio, I have a stronger preference

for the already overpriced emerging market equities thando my colleagues at GMO, and actually more than I should

have as a dedicated value manager. This is because I believe

they will end up with a P/E premium of 25% to 50% in a

few years, as outlined two years ago in The Emerging

Emerging Bubble (Letters to the Investment Committee

XIV, April 2008).

The appeal of emerging markets higher GDP growth

compared with the slow growth of U.S. and other

developed countries is proving as compelling as I

suspected, and I would hate to miss some modest

participation in my one and only bubble prediction.

It is hard, though, for value managers like us to ever

overweight an overpriced asset, so we struggle on the

margin to find kosher ways to own a little more emerging

in order to give them the benefit of the doubt. I

recommend that readers do the same. The urge to weasel

and own a little more emerging is a direct result of the lack

of clearly cheap investment alternatives.

Jeremy Grantham, Co-Founder and Chief Investment

Strategist of GMO, in his latest quarterly report to

investors published in the last week of April.

Perspective

Baby Steps in Accountability

The most surprising and annoying aspect of

the global financial crisis, which has now

officially rumbled on for almost three years,

has been complete lack of accountability. The

Federal Reserve Bank of New York (led by

Timothy Geithner till he became Treasury

Secretary) appears to have played a vital role

in propping institutions, which is now under

scrutiny.

We have had the spectacle of governments

and central banks across the developed

world providing guarantees with gay abandon

and with no concern as to costs for

taxpayers. We have the U.S Federal Reserve

now sitting on $1 trillion-plus of mortgage-

backed securities, which if marked-to-market,

will carry punishing losses for taxpayers.

There was no semblance of even aninvestigation. Encouragingly, this has now

started to change. Over the past month, the

Securities and Exchange Commission has

pressed charges against Goldman Sachs.

Criminal investigations have also started

against the firm. Others have also filed law

suits seeking compensation for dubious

transactions. The net appears to be widening

to cover other institutions as well.

What will come out of all these efforts is as

yet unclear. Even if these are politically driven

the U S Congress is debating financial

reform they mark a much needed

beginning. The financial reform under

discussion is not completely of the required

kind (for instance, the too-big-to-fail

instructions will almost stay intact). Yet even

this process is facing stiff resistance from Wall

Street firms.

The ground appears to have been set for a

plethora of legal actions. Such moves and

their consequences are likely to play out for

years.

The one part of the U.S government that has

been relentless in its efforts from 2008 to

objectively look into the causes for the

financial problems - Special Inspector General

for the Troubled Asset Relief Program

(SIGTARP www.sigtarp.gov) headed by

Elizabeth Warren has threatened to pursuethe course of law against the New York Fed

and men who were its leaders.

In fact, Treasury Secretary Geithner tried in

vain to get reporting jurisdiction over this

body and was eventually forced to withdraw

his application to the court on this issue

following a robust defence by the SIGTARP

Chief. SIGTARPs efforts, too, could now have

a deeper impact, as it is now accompanied by

baby steps in action by multiple parts of the

U S government.

Only with accountability will any effort at

financial reform have a semblance of meaning.

Progress towards this end is important for

the global economy and investors in India,

too. We live in an inter-connected wor ld and

we escaped the consequences of the financial

crisis only due to stellar work by the Reserve

Bank of India. We may not always be so lucky.

S.Vaidya NathanThe Products Team

http://www.sigtarp.gov/http://www.sigtarp.gov/http://www.sigtarp.gov/


7/36


By Invitation

default data going back only to 1980, when the

underlying cycles can be half centuries and more, not

just thirty years.

Serial defaults & banking crisis: Exploiting the multi-

century span of the data, we study role of repeated

extended debt cycles in explaining the observed

patterns of serial default and banking crises that

characterize the economic history of so many

countriesadvanced and emerging alike.

Serial default refers to countries which experience

multiple sovereign defaults (on external or domestic

public or publicly-guaranteed debtor both). These

defaults may occur five or fifty years apar t; these may

be wholesale default (or repudiation) or a partial

default through rescheduling.

Debt intolerance: This manifests itself in the extreme

duress many emerging markets experience at debt

levels that would seem quite manageable by

advanced country standards.

Safe debt thresholds for highly debt intolerant

emerging markets turn out to be surprisingly low,

perhaps as low as fifteen to twenty percent in many

cases, and these thresholds depend heavily on a

countrys record of default and inflation.

Debt intolerance likely owes to weak institutional

structures and a problematic political system thatmakes external borrowing a useful device for

developing country governments to avoid hard

decisions about spending and taxing and global

investors rightly suspicious about the governments

motives.

Simply put, the upper limit to market access is lower

when governments suffer from an intolerance to

repayment but not to borrowing.

Hidden Debt: Our results here, as well a plethora of

vivid examples from the accompanying chart book

suggest that more attention needs to be paid to

hidden debt and liabilities. In a crisis, government

debt burdens often come pouring of out the

woodwork, exposing solvency issues about which the

public seemed blissfully unaware.

One important example is the way governments

routinely guarantee the debt of quasi-government

agencies that may be taking on a great deal of risk,

From Financial Crash To Debt Crisis

most notably as was the case of the mortgage giants

Fannie Mae and Freddie Mac in the United States.

Indeed, in many economies, the range of implicit

government guarantees is breathtaking. Many

governments find in a crisis that they are forced to

deal not only with their external debts (owed to

foreigners) but those of private domestic borrowers

as well.

Famously, Thailand (1997), just prior to its financial

crisis, hid its massive forward exchange market

interventions, which ultimately led to huge losses.

Hidden debt has loomed large in many sovereign

defaults over history. At the time of this writing oneonly has to read the debacle in the financial press

concerning Greeces hidden debts conveniently

facilitated by its underwriter Goldman Sachs.

In principle, of course, lenders should realize the huge

temptation for borrowers to hide the true nature of

their balance sheet. Private information on debt can,

in principle, be incorporated into models. The many

different margins on which governments can cheat

are a significant complicating factor.

Default & back to bad practices quickly: Another

noteworthy insight from the panoramic view is that

the median duration of default spells in the post

World War II period is one-half the length of what it

was during 18001945 (3 years versus 6 years). The

duration of a default spell is the number of years from

the year of default to the year of resolution, be it

through restructuring, repayment, or debt forgiveness.

A charitable interpretation is that crisis resolution

mechanisms have improved since the bygone days of

gun-boat diplomacy. After all, Newfoundland lost

nothing less than her sovereignty when it defaulted

on its external debts in 1936 and ultimately became

a Canadian province; Egypt, among others, became a

British protectorate following its 1876 default.

A more cynical explanation points to the possibility

that, when bail-outs are facilitated by the likes of the

International Monetary Fund, creditors are willing to

cut more slack to their serial-defaulting clients.

The fact remains the number of years separating

default episodes in the more recent period is much

lower. Once debt is restructured, countries are quick

to re-emerge.

In the wake of the excess debt problems surrounding

Greece immediately in the past couple of months,

imminently facing more of the PIIGS group (Portugal,

Ireland, Italy, Greece and Spain) in the next few years

and also staring the likes of U.S and U.K in the face,

we present edited extracts from a March 2010

report by Carmen M Reinhart & Kenneth S Rogoff-

the authors of the renowned bookThis Time IsDifferent Eight Centuries of Financial Folly.

This time is different The essence of the This time is

different syndrome is simple. It is rooted in the firmly-

held belief that financial crises are something that

happen to other people in other countries at other

times; crises do not happen here and now to us. We

are doing things better, we are smarter, we have

learned from the past mistakes. The old rules of

valuation no longer apply. The current boom, unlike

the many previous booms that preceded catastrophic

collapses (even in our country-U.S) is built on sound

fundamentals, structural reforms, technological

innovation, and good policy. Or so the story.

The economics profession has an unfortunate

tendency to view recent experience in the narrow

window provided by standard datasets. It is

particularly distressing that so many cross-country

analysis of financial crisis are based on debt and

Carmen M. Reinhart

Kenneth S. Rogoff

The views presented by the author (s) do not necessarily represent that of Sundaram BNP Paribas Asset Management. The article / posts have been reproducedwith permission or from reports available in the public domain in order to provide readers access to a diverse range of views on the economy and asset markets.

Source: From Financial Crash To Debt Crisis by Carmen M. Reinhart and Kenneth S. Rogoff, National Bureau of Economic Researchhttp://www.nber.org/papers/w15795. Sub-titles have

been provided by the Editor of this publication to provide context, as the extracts are from a detailed 48-page report. The report is also recommended for insightful and quality charts .
http://www.nber.org/papers/w15795http://www.nber.org/papers/w15795http://www.nber.org/papers/w15795http://www.nber.org/papers/w15795


8/36


pollutant. Systemic risk is a noxious by-product. Banking benefits those producing

and consuming financial services the private

benefits for bank employees, depositors,

borrowers and investors.

But it also risks endangering innocent

bystanders within the wider economy the

social costs to the general public from

banking crises.

Public policy has long-recognised the costs of

systemic risk. They have been tackled through

a combination of regulation and, at times,

prohibition. Recently, a debate has begun on

direct restrictions on some banking activities- in other words, prohibition. This is

recognition of the social costs of systemic risk.

Bankers are in uproar.

This paper examines the costs of banking

pollution and the role of regulation and

restrictions in tackling it. In light of the crisis,

this is the $100 billion question. The last time

such a debate was had in earnest followed

the Great Depression. Evidence from then,

from past crises and from other industries

helps define the contours of todays debate.

This debate is still in its infancy.

While it would be premature to be reaching

policy conclusions, it is not too early to begin

sifting the evidence. What does it suggest?

Counting the Systemic Cost: Animportant dimension of the debate concerns

the social costs of systemic risk. Determining

the scale of these social costs provides a

measure of the task ahead. It helps calibrate

the intervention necessary to tackle systemic

risk, whether through regulation or

restrictions. So how big a pollutant is banking?

There is a large literature measur ing the costs

of past financial crises. This is typically done by

evaluating either the fiscal or the foregone

output costs of crisis. On either measure, the

costs of past financial crises appear to be

large and long-lived, often in excess of 10% of

pre-crisis GDP. What about the present crisis?

The narrowest fiscal interpretation of the

cost of crisis would be given by the wealth

transfer from the government to the banks as

a result of the bailout. Plainly, there is a large

degree of uncertainty about the eventual loss

governments may face. But in the US, this is

currently estimated to be around $100 billion,

or less than 1% of US GDP.

For US taxpayers, these losses are (almost

Focus Topic

The $ 100 Billion Question

exactly) a $100 billion question. In the UK, the

direct cost may be less than 20 billion, or

little more than 1% of GDP.

Assuming a systemic crisis occurs every 20

years, recouping these costs from banks

would not place an unbearable strain on their

finances. The tax charge on US banks wouldbe less than $5 billion per year, on UK banks

less than 1 billion per year.2 Total pre-tax

profits earned by US and UK banks in 2009

alone were around $60 billion and 23 billion

respectively.

But these direct fiscal costs are almost

certainly an underestimate of the damage to

the wider economy which has resulted from

the crisis the true social costs of crisis.

World output in 2009 is expected to have

been around 6.5% lower than its

counterfactual path in the absence of crisis. In

the UK, the equivalent output loss is around

10%. In money terms, that translates into

output losses of $4 trillion and 140 billion

respectively. Moreover, some of these GDP

losses are expected to persist.

Evidence from past crises suggests that crisis-

induced output losses are permanent, or at

least persistent, in their impact on the level of

output if not its growth rate. If GDP losses

are permanent, the present value cost of

crisis will exceed significantly todays cost.

By way of illustration, Table 1 looks at the

present value of output losses for the world

and the UK assuming different fractions of the

2009 loss are permanent - 100%, 50% and

25%. It also assumes, somewhat arbitrarily,

that future GDP is discounted at a rate of 5%per year and that trend GDP growth is 3%.4

Present value losses are shown as a fraction

of output in 2009.

As Table 1 shows, these losses are multiples of

the static costs, lying anywhere between one

and five times annual GDP. Put in money

terms, that is an output loss equivalent to

between $60 trillion and $200 trillion for the

world economy and between 1.8 trillion

and 7.4 trillion for the UK.

What is the right size for banks? Do we need

the kind of monster-sized banks we have today

in the developed world the ones that pushed

the world to the brink, from which for now,

governments appear to have pulled us back by

risking trillions of dollars.

Andrew Haldane has been one of the rare

persons in central banking systems of the

developed world who has outlined the problems

as they are and the possible solutions; however

unpalatable they are to the banks and their

peers in the central banking system. In one such

speech last month, Haldane showcases the $

100 billion problem. We present the first part of

edited extracts from his speech:

The car industry is a pollutant. Exhaust fumes

are a noxious by-product. Motoring benefits

those producing and consuming car travel

services the private benefits of motoring.

But it also endangers innocent bystanders

within the wider community the social costs

of exhaust pollution. Public policy has

increasingly recognised the risks from car

pollution.

Historically, they have been tackled through a

combination of taxation and, at times,

prohibition. During this century, restrictions

have been placed on poisonous emissions

from cars - in others words, prohibition. This

is the recognition of the social costs of

exhaust pollution. Initially, car producers were

in uproar.

The banking industry is also a

Andrew HaldaneExecutive Director, Financial Stability

Bank of England

Put in money terms, that is an output loss

equivalent to between $60 trillion and

$200 trillion for the world economy and

between 1.8 trillion and 7.4 trillion for

the UK.


9/36


higher the discount rate and the lower the

trend growth rate, the smaller the losses.

Second, this ratings difference has increased

over the sample, averaging over one notch in

2007 but over three notches by 2009. In

other words, actions by government during

the crisis have increased the value of

government support to the banks. This

should come as no surpr ise, given the scale of

intervention. Indeed, there is evidence of an

up-only escalator of state support to banks

dating back over the past century.

Unsurprisingly, the average rating difference is

consistently higher for large than for small

banks. The average ratings difference for large

banks is up to 5 notches, for small banks up

to 3 notches. This is pretty tangible evidence

of a second recurring phenomenon in the

financial system the too big to fail

problem.

It is possible to go one step further and

translate these average ratings differences

into a monetary measure of the implied fiscal

subsidy to banks. This is done by mapping

from ratings to the yields paid on banks

bonds; and by then scaling the yield difference

by the value of each banks ratings-sensitive

liabilities.

The resulting money amount is an estimate of

the reduction in banks funding costs which

arises from the perceived government

subsidy.

For UK banks, the average annual subsidy for

the top five banks over these years (2007-

2009) was over 50 billion - roughly equal to

UK banks annual profits prior to the crisis. At

the height of the crisis, the subsidy was larger

still.

For the sample of global banks, the average

annual subsidy for the top five banks was just

less than $60 billion per year. These are not

small sums.

As might be expected, the large banksaccount for over 90% of the total implied

subsidy. On these metrics, the too-big-to-fail

problem results in a real and on-going cost to

the taxpayer and a real and on-going windfall

for the banks. If it were ever possible to mint

a coin big enough, these would be the two

sides of it.

These results are no more than illustrative

for example, they make no allowance for

subsidies

arising on retail deposits. Nonetheless, studies

using different methods have found similarly-sized subsidies. For example, Baker and

McArthur ask whether there is a difference in

funding

costs for US banks either side of the $100

billion asset threshold another $100 billion

question.8

They find a significant wedge in costs, which

has widened during the crisis. They calculate

an annual subsidy for the 18 largest US banks

of over $34 billion per year. Applying the

same method in the UK would give an annual

subsidy for the five largest banks of around

30 billion.

This evidence can provide only a rough guideto systemic scale and cost. But the qualitative

picture it paints is clear and consistent.

First, measures of the costs of crisis, or the

implicit subsidy from the state, suggest

banking pollution is a real and large social

problem.

Second, those entities perceived to be

too big to fail appear to account for the

lions share of this risk pollution. The public

policy question, then, is how best to tackle

these twin evils.

As with size, the effects of liberalisation on

banking concentration were immediate and

dramatic. The share of the top three largestUS banks in total assets rose fourfold, from

10% to 40% between 1990 and 2007 (Chart

2). (Editors note: It was about 60% at the

end of 2009)

A similar trend is discernible internationally:

the share of the top five largest global banks

in the assets of the largest 1000 banks has

risen from around 8% in 1998 to double that

in 2009.

This degree of concentration, combined with

the large size of the banking industry relative

to GDP, has produced a pattern which is not

mirrored in other industries. The largest

banking firms are far larger, and have grownfar faster, than the largest firms in other

industries. With the repeal of the McFadden

and Glass-Steagall Acts, the too-big-to-fail

problem has not just returned but flourished.

(To be concluded)

Table 1: Present Value of Output Losses (%

of 2009 GDP)

Region Fraction of initial

output loss

which is permanent

25% 50% 100%

UK 130 260 520World 90 170 350

Source: Bank Calculations

As Nobel-prize winning physicist Richard

Feynman observed, to call these numbers

astronomical would be to do astronomy a

disservice: there are only hundreds of billions

of stars in the galaxy. Economical might be a

better description. It is clear that banks would

not have deep enough pockets to foot this

bill.

Assuming that a crisis occurs every 20 years,

the systemic levy needed to recoup these

crisis costs would be in excess of $1.5 trillion

per year. The total market capitalisation of thelargest global banks is currently only around

$1.2 trillion. Fully internalising the output

costs of financial crises would risk putting

banks on the same trajectory as the

dinosaurs, with the levy playing the role of the

meteorite.

It could plausibly be argued that these output

costs are a significant over-statement of the

damage inflicted on the wider economy by

the banks. Others are certainly not blameless

for the crisis. For every reckless lender there

is likely to be a feckless borrower.

If a systemic tax is to be levied, a more

precise measure may be needed of banks

distinctive contribution to systemic risk. Onesuch measure is provided by the (often

implicit) fiscal subsidy provided to banks by

the state to safeguard stability. Those implicit

subsidies are easier to describe than measure.

But one particularly simple proxy is provided

by the rating agencies, a number of whom

provide both support and standalone

credit ratings for the banks. The difference in

these ratings encompasses the agencies

judgement of the expected government

support to banks.

Two features are striking.

First, standalone ratings are materially below

support ratings, by between 1.5 and 4

notches over the sample for UK and global

banks. In other words, rating agencies

explicitly factor in material government

support to banks. The results are plainly

sensitive to the choice of discount rate and

trend growth rate. Other things equal, the

Focus Topic

The systemic levy needed to recoup these

crisis costs would be in excess of $1.5

trillion per year. The total market

capitalisation of the largest global banks is

currently only around $1.2 trillion.


Source: Bank of England(www.bankofengland.co.uk)Speech link: http://bit.ly/cL4AKu
http://www.bankofengland.co.uk/http://bit.ly/b4rfBUhttp://www.bankofengland.co.uk/http://bit.ly/b4rfBU


10/36


Investing Environment

Asset Allocation

What are your investment objectives?

When do you need funds and how muchat each stage?

What is your r isk-taking ability?

Can you take losses, and, if so, to whatextent?

What is your family income (investor and

spouse) available for spending and saving? If you are self-employed, what are your

earnings, net worth and prospects for

your business?

At what age are you star ting to invest?

How many years do you have toretirement or stage when you wish you

to put your feet up?

What proportion of your income can youinvest?

Do you have an inheritance available forinvesting?

Do you have elderly parents to support?

What is time plan for education andmarriage of children?

What is time plan to own a home?

Have you optimized tax-relatedinvestments?

What proportion of current income willyou need in retirement to maintain

chosen life style?

At what age do you expect to complete

payment of home loans? Do you have a term insurance and

disability insurance?

Do you have knowledge & time for directequity investment?

What is your tax status?

Do you have a professional financialadvisor?

9

Asset Allocation

Individual investments selection

Market timing

Others

91.5%

4.6%

1.8%2.1%

Asset allocation determines about 92 per cent of your portfolio performance Ask & Answer

Financingeducation

of children

Managing

current

requirement

&

emergency

Leaving alegacy of

values andwealth

Owning a

home

Wealth

creation to

enhance

lifestyle

Acomfortable

life at

retirement

KEY

LIFETIME

GOALS

Generate

returns that

are

consistently

higher than

inflation

Lifetime goals demand financial planning

What is Asset Allocation?

Identifying investment options for deploying your funds to ensure suitablebalance between lifetime goals, returns, risk, liquidity and diversification.

Graph Source: Financial Analysts Journal*

1


11/36


India RBI-Speak

Key issues facing India

Duvvuri SubbaraoGovernor

Reserve Bank of India

11

India clocked average growth of 9 per cent per

annum in the five years to 2007/08. That

growth momentum was interrupted by the

financial crisis which impacted India too, more

than we had originally thought but less than it

did most other countr ies. Despite falling below

6 per cent for one quarter, the growth for the

full year 2008/09 was a resilient 6.7 per cent.

Current estimates are that the economy had

grown between 7.2 and 7.5 per cent for the

just ended fiscal year 2009/10 and that growth

for 2010/11 will be 8+ per cent. The quick turn

in sentiment following the uncertainty and

anxiety of the crisis period has seen the return

of the FAQ: When will India get on to double

digit growth? For policy makers, the FAQ

translates to three nuanced questions:

In the short term, how do we restore the

economy to its trend rate of growth while

maintaining price stability?

In the medium term, how do we raise the

trend rate of growth itself without

compromising financial stability? How do we ensure that growth is inclusive?

An over-analyzed country

India is such an over analyzed country that it

is difficult to be original. The answers to all the

three questions above are all out there in the

open, and they involve moving on with a host

of structural and governance reforms.

I want to use this platform provided by the

Peterson Institute to comment on a few issues

on the reform agenda that are relevant to the

Reserve Bank of India.

The final thought that I want to leave with you

as I finish is that the growth drivers that

powered Indias high growth in the years

before the crisis are all intact. The challenge for

the Government and the Reserve Bank is to

move on with reforms to steer the economy

to a higher growth path that is sustainable and

equitable.

Capital flows

Volatile capital flows have been a central issue

during the crisis, and continue to be so now as the crisis is ebbing. Emerging market

economies (EMEs) saw a sudden stop and

reversal of capital flows during the crisis as a

consequence of global deleveraging.

Now the trend has reversed once again, and

many EMEs are seeing net inflows - a

consequence of a global system awash with

liquidity, the assurance of low interest rates in

advanced economies over an extended period

and the prospects of robust growth in EMEs.

The familiar question of how EMEs can

maximize the benefits and minimize the costs

of volatile capital flows has returned to haunt

the policy agenda.

One little known aspect of capital flows, what

could perhaps be called the law of capital

flows, is that they never come in at the

precise time or in the exact quantity you

want them. Managing these flows, especially if

they are volatile, is going to test the

effectiveness of central bank policies of semi-

open EMEs.

If central banks do not intervene in the foreign

exchange market, they incur the cost of

currency appreciation unrelated to

fundamentals. If they intervene in the forex

market to prevent appreciation, they will have

additional systemic liquidity and potential

inflationary pressures to contend with. If theysterilize the resultant liquidity, they will run the

risk of pushing up interest rates which will hurt

the growth prospects.

Capital flows can also potentially impair

financial stability. How EMEs manage the

impossible trinity the impossibility of having

an open capital account, a fixed exchange rate

and independent monetary policy - is going to

have an impact on their prospects for growth,

price stability and financial stability.

Indias approach to capital flows

India has followed a consistent policy on capital

account convertibility in general and on capital

account management in particular. Our

position is that capital account convertibility is

not a standalone objective but a means for

higher and stable growth.

We believe our economy should traverse

towards capital convertibility along a gradual

path - the path itself being recalibrated on a

dynamic basis in response to domestic and

global developments. Post-crisis, that continues

to be our policy. We will continue to move

towards liberalizing our capital account, but we

will revisit the road map to reflect lessons of

the crisis.

Indias approach to managing capital flows too

has been pragmatic, transparent and

contestable. We prefer long term flows to

short-term flows and non-debt flows to debt

flows. The logic for that is self-evident. Our

policy on equity flows has been quite liberal,

and in sharp contrast to other EMEs which

liberalized and then reversed the liberalization

when flows became volatile, our policy has

been quite stable.

Historically, we have used policy levers on the

debt side of the flows to manage volatility. Thishas been our anchor when we had to deal

with flows largely in excess of the economys

absorption capacity in the years before the

crisis. This has been our policy when we saw

large outflows during the crisis. And I believe

this will continue to be our policy on the way

forward.

Tobin Tax

The surge in capital flows into some EMEs

even as the crisis is not yet fully behind us has

seen the return of the familiar question - the

advisability of imposing a Tobin type tax on

capital flows. Both before and after the crisis,

there are examples of countries, notably Chile,

Colombia, Brazil and Malaysia, which have

experimented with a Tobin tax or its variant.

Even as there are some lessons to be drawn

from the country experience, on the aggregate,

it does not constitute a sufficient body of

knowledge for drawing definitive conclusions.

Critics of Tobin tax contend that the tax is

ineffective, is difficult to implement, easy to

evade and that its costs far exceed the

potential benefits, and all this because financial


12/36


Not just an inflation fighter

The Reserve Bank is not a pure inflation

targetter. Some people have suggested that the

economy will be better served if the Reserve

Bank becomes a pure inflation targetter. The

argument is that inflation hurts much more in

a country like India with hundreds of millions ofpoor people and that the Reserve Bank will be

more effective at combating inflation if it is not

burdened with other objectives. This argument

is contestable.

Inflation targeting, characterized by a single

target (price stability) and a single instrument

(short term policy interest rate), has

respectable academic credentials. An exclusive

commitment to inflation enhances operational

effectiveness and enforces accountability. The

success of several developed economy central

banks in maintaining price stability in the years

before the crisis has also given it intellectual

credibility.

The unravelling of the Great Moderationduring the crisis has however diluted, if not

dissolved, the consensus around the minimalist

formula of inflation targeting. The crisis has

shown that price stability does not

necessarily ensure financial stability. Indeed

there is an even stronger assertion - that there

is a trade-off between price stability and

financial stability, and that the more successful

a central bank is with price stability, the more

likely it is to jeopardize financial stability.

Inflation targeting is neither desirable nor

practical in India for a variety of reasons: First,

it is inconceivable that in an emerging

economy like India, the central bank can drive

a single goal oblivious of the largerdevelopment context.The Reserve Bank must

be guided simultaneously by the objectives of

price stability, financial stability and growth.

Governments fiscal consolidation

Fiscal consolidation is important for a number

of other weighty reasons apart from the

inflation dimension. The Government has

initiated action on the recommendations of

the Thirteenth Finance Commission (TFC) on

the revised road map for fiscal responsibility. In

drilling down the road map, the Government

should also keep in view two relevant

objectives:

First, fiscal consolidation should shift fromexclusive reliance on increasing revenues to

focus on restructuring expenditures. The

consolidation effort should target slashing

recurring expenditures rather than one-off

items.

Second, it is important, even as targeting

quantitative indicators, to pay equal

attention to the quality of fiscal adjustment.

Improving Policy Effectiveness

The effectiveness of monetary transmission, the

process by which the central banks policy

signals influence the financial markets, is afunction of both tangible and intangible factors

It depends on the depth and efficiency of the

financial markets. It also depends on the overall

confidence and sentiment in the financial

system.

Typically, monetary transmission in emerging

economies tends to be slower, reflecting

shallow financial markets and inefficient

information systems. The monetary

transmission mechanism in India has been

improving but is yet to fully mature. There are

several factors inhibiting the transmission

process.

First, India has a government sponsoredsmall savings programme characterized by

administered interest rates and tax

concessions. Operating through a huge

network of post offices and field agents, the

small savings scheme has an enormous and

impressive reach deep into the hinterland.

Banks are typically circumspect about

reducing deposit rates in response to the

central banks policy rate signals for fear of

losing their deposit base to small savings. The

government too has not adjusted the rates

on small savings on a regular basis to offset

their competitive edge.

Second, depositors enjoy an asymmetriccontractual relationship with banks. When

interest rates are rising, depositors have the

option of withdrawing their deposits

prematurely and redepositing at the going

higher rate. On the contrary, when deposit

rates are falling, banks do not have the

option of repricing deposits at the lower

rate because of the asymmetry of the

contract. This structural rigidity clogs

monetary transmission. Banks are typically

unable to adjust their lending rates swiftly in

response to policy signals until they are able

to adjust on the

cost side by repricing the deposits in the

next cycle.

Third, and importantly, monetary

transmission is also impeded because o

large government borrowings and illiquid

bond markets.

markets always outsmart policy makers.

Supporters of the tax argue that if designed

and implemented well, the tax can be effective

in smoothing flows and that evading controls is

not such a straight forward option as efforts to

evade require incurring additional costs to

move funds in and out of a country which isprecisely what the tax aims to achieve.

In India, given the overall thrust of policy, we

are quite agnostic on the choice of different

instruments. The stereotype view is that we

have an express preference for quantity based

controls over price based controls.

A critical examination of our policy will show

that this view is mistaken. For example, on

bonds we impose both a limit on the amount

foreigners can invest as well as a withholding

tax. Similarly, our policy on external

commercial borrowing employs both price and

quantity variables. We have not so far imposed

a Tobin type tax nor are we contemplating

one but it needs reiterating that no policyinstrument is clearly off the table and our

choice of instruments will be determined by

the context.

Worldview changes on capital controls

The recent crisis has clearly been a turning

point in the world view on capital controls.

The Asian crisis of the mid-90s demonstrated

the risk of instability inherent in a fully open

capital account. Even so, the intellectual

orthodoxy continued to denounce controls on

capital flows as being inefficient and ineffective.

The recent crisis saw, across emerging

economies, a rough correlation between the

extent of openness of the capital account and the extent of adverse impact of the crisis.

Surely, this should not be read as a

denouncement of open capital account, but a

powerful demonstration of the tenet that

premature opening hurts more than it helps.

Notably, the IMF published a policy note in

February 20102 that reversed its long held

orthodoxy. The note has referred to certain

circumstances in which capital controls can be

a legitimate component of the policy response

to surges in capital flows.

Now that there is agreement that controls

can be desirable and effective in managing

capital flows in select circumstances,the IMFand other international bodies must pursue

research on studying what type of controls are

appropriate and under what circumstances so

that emerging economies have useful

guidelines to inform policy formulation.

India RBI-Speak


Source:http://bit.ly/dkjVbM Edited comments from the speech titled India and the Global Financial Crisis-Transcending from Recovery to Growth by

Dr. D. Subbarao, Governor, Reserve Bank of India at the Peterson Institute for International Economics, Washington DC, April 26, 2010.
http://bit.ly/b4rfBUhttp://bit.ly/b4rfBUhttp://bit.ly/b4rfBUhttp://bit.ly/b4rfBUhttp://bit.ly/b4rfBU


13/36


Separate traditional banking and investmentbanks. I want my commercial banks to be boring.

You know, traditional lending to customers,

services, that type of thing.

CDS Threaten the System:What happened in the last credit crisis was that interlocking credit

default swaps among so many banks made the

ENTIRE system too big to fail.

AIG basically sold naked options in the form of

credit default swaps to all and sundry (in a unit

basically created after Elliott Spitzer forced Hank

Greenberg out, which allowed the unit to get outof control, yet another reason to not l ike Spitzer).

And nothing has changed. We again have creditdefault swaps (CDS) growing, and no one knows

who could be overextended. Once again,

everyone could be dependent on everybody

else, and we have no idea if there is a Bear,

Lehman, or AIG in these woods.

As I have been pounding the table about for

years, we need to put CDS on an exchange.

ASAP. I am not against CDS, per se. CDS are

good things, just like futures. But they must go to

a transparent exchange.

There need to be position limits, just as there infutures and commodities. There needs to be very

transparent pricing and commissions. And

someone needs to monitor who owns them and

what risks they are taking.

Why hasn't this been done? In a word, money.Banks make huge commissions selling CDS, as

much as 2-3%, I am told. If they were on an

exchange the commissions would be $10 a

round turn. An enormous profit center would get

blown up. So, the banks hire lobbyists to persuadeCongress not to regulate CDS. Dodd's bill

basically says we will deal with them later.

The good news is that there is some effort toregulate these derivatives in Congress. It shouldhave been done a year ago, but the sooner thebetter. This shouldn't be all that partisan. It iscommon sense.

Time for reform we can believe in: CaseyStengel, manager of the hapless 1962 New York

Mets, once famously asked, after an especially

dismal outing, "Can't anybody here play this

game?" This week I ask, after months of worsethan no progress, "Can't anybody here even spell

financial reform, let alone get it done?"

We are in danger of experiencing another credit

crisis, but one that could be even worse, as the

tools to fight it may be lacking when we need

them. With attacks on the independence of the

Fed, no regulation of derivatives, and allowing

banks to be too big to fail, we risk a repeat of the

credit crisis.

Thoughts From The Frontline

Scanning the financial system

The bank lobbyists are winning and it's time for

those of us in the cheap seats to get outraged.

(And while this letter focuses on the US and

financial reform, the principles are the same in

Europe and elsewhere, as I will note at the end.

We are risking way too much in the name of

allowing large private profits.) And with no "but

first," let's jump right in.

Last Monday I had lunch with Richard Fisher,

president of the Federal Reserve Bank of Dallas.

Mr. Fisher is a remarkably nice guy and is very

clear about where he stands on the issues. My

pressing question was whether the Fed would

actually accommodate the federal government if

it continued to run massive deficits and turn onthe printing press.

Fisher was clear that such a move would be a

mistake, and he thought there would be little

sentiment among the various branch presidents

to become the enabler of a dysfunctiona

Congress. But that brought up a topic that he was

quite passionate about, and that is what he sees

as an attack on the independence of the Fed.

The Fed must be independent: There are bills inCongress that would take away or threaten the

current independence of the Fed.

I recognize that the Fed is not completely

independent.

Even Greenspan said so this past week: "There's

a presumption that the Federal Reserve's an

independent agency, and it is up to a point, but we

are a creature of the Congress and if ... we had

said we're running into a bubble and we need to

retrench, the Congress would say 'We haven't a

clue what you're talking about.'"

Long-time readers know I do not have much time

for Senator Chris Dodd. He has threatened theviability of the Fed by holding up appointments,

actually risking the ability of the Fed to get an

emergency quorum if the need arose.

His current proposal to give the President the

ability to appoint the president of the New York

Fed is likewise a wrong-headed political power

grab. He has openly proposed to have the

presidents of the local districts appointed by the

board of governors. These presidents are the only

real check on the board.

Too Big To Fail Must Go:We have large banksthat take massive risks, which allow them to pay

huge bonuses to management and traders; and

then if they have problems the taxpayer has to

take the losses. I can see why the banks like it. I

don't get this business model from a taxpayer's

point of view.

First, let me say that I thought, along with most of

the world, that repealing Glass-Steagall was agood thing. OK, we tried that experiment and it

didn't work out so well. Where is the movement

to separate commercial banks from investment

banks?

And I must admit, Glass-Steagall is not really the

problem. It is just a part of the problem. The

problem is that parts of these large banks are

essentially hedge funds, working with cheap

commercial deposit money and putting the entire

bank at risk.

I make a lot of my income helping investors find

hedge funds and alternative investments. I like

trading and traders, and we have a lot of client

money with them. There is good money to be

made there, if you are riding the right horse.But we don't put money with big investment

banks, just private funds, and there is the

difference. If our funds go bad, taxpayers don't

bail us out.

When I put on my taxpayer hat, I don't want tobe taking the risk so some big bank can have atrading desk and make large profits that onlybenefit their shareholders and management, andI have to pick up the pieces with my tax dollarswhen they fail.

John MauldinBest-Selling Author, Recognized Financial Expert

and Editor of Thoughts From The Frontline

Separate traditional banking and investment

banks. I want my commercial banks to be

boring. You know, traditional lending to

customers, services, that type of thing.


14/36

How did that work out? Monetary policy is notsomething you roll the dice on.

The key here is that any attempt to politicizethe Fed any more than it already is must beresisted. (That does not mean, however, thatthey should not be more transparent, along thelines of my friend Ron Paul's bill. Sunshine is a

good thing.)And This Thing About Leverage:The problem of too big to fail is ultimately one of leverage. If asmall bank fails, no one really notices. If a giantbank fails and puts the system at risk, it costs us a

lot. I have a simple proposal to mitigate theproblem.

Why not reduce the allowable leverage the largera bank gets? This would clearly reduce their risk

and encourage them to only make prudent bets(otherwise known as loans), as their risk capitalwould be limited. If they wanted to make more

loans, then they could raise more capital or retainmore earnings.

Would that hurt earnings and shareholders andlimit share prices? Yes. And I don't care. If I'm not

getting the dividends, then I don't want to bemade to pick up the tab if there is a crisis. Theworld of privatizing the gains and socializing therisks must become a thing of the past.

What Happens If We Do Nothing?: Whathappens when we have the next credit crisis,when a major sovereign government defaults, as I

think will happen? It will be a body blow to manybanks, especially in Europe.

Once again, we could have banks worried aboutlending to each other or taking letters of credit,which would be a disaster for world trade and

the recovery we are now in.

That we (and Europe and Britain) have taken so

long to enact real reform has the potential toreally put the world at risk. In the next crisis, wewill not have the tools available to stem the tide

that we did the last time. Rates are already low.

Do you think we could pass another TARP? The

Fed's balance sheet is already bloated. It could getmuch worse unless we get financial reforms that

have some bite.

All this debating about a consumer protectionagency and where it should be and all the othertrivia is wasting time. Fix the big things. Creditdefault swaps. Too big to fail. Leverage. Thenworry about the details. And leave the Fedalone.

Quick Thoughts on GoldmanGoldman Sachs is all over the news afterbeing charged with fraud. The way I see it,this is essentially a charge that there wasnot full disclosure. And it appears to me that that is true. It also is true that

Goldman will argue (or I think they will)that only very sophisticated investors whosigned very lengthy offering documentswere involved, and they should haveknown better. They were also reaching foryield.But this is just the tip of the iceberg. I waswriting about these "CDOs Squared" inlate 2006, and many of these were donein 2007. It was obvious to me (andothers) that they were going to blow up. Ioften wondered who was buying theequity tranches of these synthetic CDOs.Last week I read a very interesting reportfrom propublic.org about a hedge fundcalled Magnetar, which basically did thesame trade as in the Goldman deal. And

they did those deals with nine banks. Youcan read the whole article athttp://www.propublica.org/feature/the-magnetar-trade-how-one-hedge-fund-helped-keep-the-housing-bubble-going .The financial institutions are once againsoaring on new profits, with almost 30%of total corporate profits and a hugeproportion of the growth in profitscoming in the last 12 months.Side bet: Goldman and at least 8 otherbanks are going to have serious litigationcosts, if they don't actually have to eat thelosses of the investors in these syntheticCDOs.Understand, these were not

securitizations of actual mortgages. Theywere securitizations of derivatives thatacted like these mortgages, and the worsttranches of them to boot. On top of theirloan losses, there could be tens of billionsof losses to investors in the CDOs theysold.This will play out over years.As ProPublica noted, the hedge funds didnothing illegal. If the housing market hadcontinued to go up another year or two,most of them would have imploded whilewaiting for the market to break. More than a few funds did. It can be a difficultthing to bet on the end of the world andthen have to wait.The issue is disclosure. I wonder if the

ratings agencies knew. Would that havechanged their views?I hope someone writes an in-depthinvestigative book about this. I'll buy it..

John Mauldin

Let's do a brief recap. There are seven FederalReserve governors, including a chairman and vice-

chairman. There are twelve bank districts withindependent boards that choose their districtpresident. The Federal Open Market Committeeoversees monetary policy and is composed of the seven governors and five of the district

presidents.The president of the New York district is alwaysone of the five, and the other four are rotatedamong the remaining eleven. Note that the sevengovernors are appointed by the President andmust be approved by the Senate. Further, theboard of governors appoints three members to

each of the nine-member boards of directors ofthe local districts.

Dodd wants to give the President the right toappoint the president of the New York District.My response is "Not no, but hell no!" The

President (from whichever party) gets to appointa majority as it is. I prefer a small token ofindependence. And while the selection of adistrict president is of course political, it is at least

now local and not national politics.Further, when a local board narrows its choicesfor district president to a few candidates, itsubmits those choices to the national board ofgovernors for comments, which are of course taken seriously. (There has been at least oneoccasion when a board submitted only one nameand the governors asked for alternatives, and the

local board reasserted that this was their onlychoice. The governors backed down.)

A Fed governor is supposed to serve for 14 years,and the terms are staggered. That way, noPresident gets to appoint more than a few

governors and cannot stack the board in favourof certain policies. That has changed with Obama.Dodd held up two nominations by Bush for

several years, and with the resignation of Vice-Chairman Kohn, President Obama now gets toappoint four governors, and he has almost threeyears left in his term.

Let me be clear. There are a lot of things not tolike about the Federal Reserve System. I think itwas Milton Friedman who said we would bebetter off with a computer determiningmonetary policy. In the next crisis, we will not

have the tools available to stem the tide that wedid the last time. Rates are already low.

We are stuck with this system. But what would befar, far worse is a system that was directlycontrolled by Congress or the President, whether

Republican or Democrat. Politicians think in veryshort election cycles.

I do not want the same people who gave usFreddie and Fannie and now $400 billion in taxpayer losses, who pass entitlement bills thatwe cannot pay for, to have the power of the

printing press. "Roll the dice," said Barney Frank,on Freddie and Fannie and low-income loans.


Thoughts From The Frontline

In the next crisis, we will not have the tools

available to stem the tide that we did the last

time. Rates are already low.


[email protected] Copyright 2009 John Mauldin. All Rights Reserved John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts

From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to:http://www.frontlinethoughts.com/learnmore
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15/36


Perspective Global

The Greek debt situation has been an

interesting case study for students of the

sovereign bond markets. If there's a lesson to

be learned from Greece's experience thus far

it's that sovereign bailouts are far more

complicated than bank bailouts.

They require more sophisticated negotiations

and proposals and involve an extra layer of

diplomacy that makes them especially difficult

to accomplish. As we write this, the European

Union has recently announced new lending

terms to support the Greek government,

with great efforts made to assure the markets

that these new terms do not constitute a

'bailout'.

The problem with the Greek situation is that

an actual bailout would involve an almost

impossible coordination among all the major

powers within the EU. It would require the

unanimous pre-approval of all the EU heads

of state.

It would involve the European Commission,

the European Central Bank and the

International Monetary Fund (IMF) all visiting

Greece to perform financial assessments. And

finally, it would involve at least seven EU

countries affirming support through

parliamentary votes - all of this before a single

Documents

The Wise Investor May 2010 Sundaram BNP Paribas Asset Management