$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
Dear Reader,
Welcome to the Special edition of Blue Chip, the quarterly magazine of Monetrix
The Finance and Economics Club of MDI Gurgaon.
This edition is special in so many regards for us. First, we have completely
changed the way in which we function and have decided to make this magazine
global serving you with economics and finance news from all the major
economies of the world.
Keeping this edition in front of you makes us all nervous and excited at the same
time. We are nervous about your reaction to this change of functioning and
excited because this may drastically alter the way students at MDI pursue
knowledge of economics and finance.
With the above changes we have articles about China shadow banking, VIX
along with the cover article on Inflation Targeting as a Monetary Policy.
For any feedback or suggestions, feel free to reach us on Facebook or mail us at
monetrix@mandevian.com.
Till then, Happy Reading!
~ Editors for Blue Chip








Country Team
Kumar Nittin India
Rishabh Duggar Brazil
Suneel Palukuri UK
Prerna Thakur Japan
Ankit Gupta US
Shubham SE Asia
Shreyans Gangwal SE Asia
Avneet Sikka China
S. Prashanth Russia
Ravikiran Eurozone
Ishan Gupta Eurozone
Other Asset class
Darshan Gandhi Fixed income
Aaditya Mulani Oil
Editorial team
Ankita
Himanshu Kashyap
Manu Mehrotra
Satyajit Tripathy
Adit Agrawal
2
TABLE OF CONTENTS
INDIA 4
CHINA 8
EUROZONE 11
INFLATION TARGETING AS A MONETARY POLICY 16
BRAZIL 19
CHINA SHADOW BANKING 22
JAPAN 24
OIL 26
BOND SWAP TRADING 29
UNITED STATES 31
UNITED KINGDOM 33
VIX 35
MARKET UPDATES 36
3
INDIA
Maj or Hi ghl i ght s
Point of Interest:
India saw declining GDP growth
rate as well as a declining EPS
growth rate for BSE companies
in the last 5 years but still the
return on Sensex seems to be
too high. The correlation be-
tween GDP growth and Sensex
as well as EPS growth of com-
panies and Sensex seem to be
absent but EPS growth rate
seems to be more correlated to
Sensex return than GDP growth.
It is due to the changing pro-
files of the companies which
draw a greater part of their
profit from outside India or is it
due to long term faith in the
economy imposed by long term
investors.
Afer opening up of the Indian economy in
1991, India became one of the major econo-
mies of the world with its GDP becoming
highly susceptble to external fuctuatons.
The main issues addressed at that tme were
the abolishment of license raj, making tax
simpler and opening up of economy to global
competton by removing trade barriers. This
has been contnued for the 23 years that
have followed.
Let us concentrate on the period from 2004
to 2013. The Indian economy was in a good
shape when NDA lef the baton of command
in the hands of Congress. The FRBM act was
introduced which was meant to restrict the
centre and states fscal defcit limit to 3% by
2007 but due to the global fnancial crisis,
the deadline for implementaton was initally
postponed and subsequently suspended in
2009. There was a current account surplus
along with lot of focus given by the govern-
ment on Infrastructure. Afer 2004, due to
the good shape of fscal and monetary posi-
tons of government which contnued tll
2007, there was a high growth of approxi-
mately 9% witnessed because of easy money
fowing into the Indian economy and the
contnued stress on infrastructure creaton.
Then came the fnancial crisis in 2008 for
which the government provided a huge st-
stmulus. The economy rebounded initally
but post 2011 saw a declining trend. The
main reasons for this can be atributed to
several wrong government policies: The fscal
stmulus led to consumpton led growth ra-
ther than investment led growth which
caused an infaton buildup in the economy. It
also caused the fscal defcit to slip as well as
CAD, which is very much correlated with the
global economy, infaton and fscal defcit,
started to increase. The infaton eroded the
export compettveness of the economy. Ult-
mately infaton as well as some wrong poli-
cies of the government like retrospectve tax-
aton caused the rupee to depreciate. In order
to control the exchange rate depreciaton and
infaton, the central bank increased the inter-
est rate 13 tmes. Further in 2013 afer an
announcement by Fed with respect to quant-
tatve tapering, the rupee again started de-
clining which was controlled initally by inter-
est rate hike and then by other policies like
FCNR-B and swap windows for oil companies.
Steps taken by government to restore
growth:
1. Fiscal defcit targetng: This is a very im-
portant step that the government has taken.
Afer 2012, there has been a roadmap made
by the government for fscal defcit target and
this has been extended tll 2017 to bring the
fscal defcit to 3%. The government has been
able to meet the fscal defcit target of 2013
as well as 2014 which instlls a sense of conf-
dence in investors, both domestc as well as
external. This is a very important step as con-
trolling fscal defcit leads to a gradual de-
crease in infaton which in turn causes other
macroeconomic factors to become stable like
interest rate.
NOMINAL GDP:
$ 1.84 trillion
GDP RANKING:
10
FOREX RESERVES
$ 295 billion
DEBT/GDP Ratio
67.57%
FISCAL DEFICIT (% of GDP):
4.6%
CAD (% of GDP)
2.44%
4
2. Gradually going towards price discovery and decrease of
subsidies: The government has taken a number of steps to
control subsidies. It has been increasing the price of diesel by
50P every month whereby the government intends to orient
the diesel price to market price. Also, it has put a cap on
number of subsidized cylinders. These are clear signals that
the government might decontrol and remove subsidies from
these items in the near future. Also, it has hiked the price of
gas which will encourage the investors to invest in this sector
which needs huge funding. Moreover, it has recently decon-
trolled sugar by removing controls on the quota of sugar
produced as well as removing the cap on sugar price.
3. Cabinet Commitee on Investments: Although Indias in-
vestment rate is stll 35% of GDP as shown in the fgure
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 rato has declined which might be
due to the slow of-take of projects. The CCI was established
in order to give clearance to projects above 1000 crore and
remove the bureaucratc hurdles. It has cleared projects
worth Rs 6.6 lakh crore tll January 2014.
4. FDI relaxaton: The government recently relaxed FDI limit
in a number of sectors like pharma, civil aviaton, power
trading exchanges and mult-brand retail.
5. Monetary Policy: According to IMF, an increase of 1% fow
in portolio investment translates into a rise of 0.5% in pri-
vate consumpton 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 defcits are brought under con-
trol.
Certain monetary policies that are intended to be taken
by RBI are as fows:
1. Urjit Patel Commitee report: This report highlights
that infaton targetng should become one of the major
objectves of RBI and that too CPI infaton. Till now WPI
used to be the targetng infaton index but since CPI is
the actual measure of retail infaton it is beter to target
CPI. This is because it has been seen in recent tmes,
especially since 2003, that even if there is food infaton
and no hike in interest rate, the food infaton alone gets
translated into other types of infaton like wage infa-
ton and core infaton. There is a high correlaton be-
tween diferent kinds of infaton, implying that one in-
faton leads to another and hence untl infaton comes
to normal conditon for a sufcient amount of tme, RBI
should not loosen the monetary policy. Even a small
supply shock can lead to high infaton as India is a 100%
capacity utlized economy. Moreover, when the in-
vestors see that RBI follows this policy the infaton ex-
pectaton would go down. In 2008, aggregate WPI de-
clined to 1% from 8% in 2007, the Pure Infaton Gauges
(PIG) remained at 3% which was way above RBI comfort
zone. Urjit Patel commitee says that CPI infaton should
be between 2% and 6%. For this it has recommended a
5
number of measures like fscal defcit 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
infaton has mainly been due to MGNREGA and increase in
MSP price. Some disadvantages of Infaton are: low savings,
high interest rates, real exchange rate appreciaton which
makes the export less compettve and depreciaton of do-
mestc currency which further causes infaton leading to an
investment dry-up. This is one of the major challenges being
faced by India. All the relatons between diferent variables
are shown in fgure above. Also, it has recommended term
repo of diferent tenures, a kind of forward guidance.
2. Mor Commitee report: This report envisages for innova-
tve ways to do fnancial 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 stll has 40% unbanked people.
3. Reform Indias banking system: RBI said that soon banks
will be allowed to open branches without RBI permission.
Also, foreign banks will be given the opton 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 natonal treatment.
4. Liberalizing Indian Markets: RBI said that it intends to
deepen the currency derivatves, money market, corporate
debt market, government debt market as the country needs
about $1 trillion in the 12th fve-year plan to develop its in-
frastructure for which it will need foreign fnancing. 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 fuctuaton 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 infows by long term investors. This is
like moving to complete capital account convertbility
but as suggested by Tarapore Commitee, before enter-
ing into CAC the gross fscal defcit should be 3% of GDP,
infaton (3-5%), gross NPAs(5%), CAD(3% of GDP) and
Import to Forex reserves (>6 months).
5. Dealing with fnancial distress: RBI has recently come
out with stricter rules for banks to track assets which
seem to get converted into NPAs. It has given incentves
for banks in the form of provisioning for early recogni-
ton of bad assets and immediately sell it to Asset Recon-
structon companies or to increase equity partcipaton
in the company or to go for leveraged buyout.
6. Natural resource Allocaton: More transparent meth-
ods of allocatng 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 stf com-
petton 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 producton
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 distortons 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 fre people in an organi-
zaton having more than 100 people. Larger frms have to
sufer the harassment or pay bribes. These add direct and
indirect cost making the industries less compettve. An IFC
report says that due to these laws, intermediate-sized frms
are missing in India. Moreover, these laws reduces the la-
bor productvity which causes GDP per capita not to in-
crease. It has been observed for all OECD countries that as
labor productvity increases, GDP per capita increases. This
labor productvity only can prevent a country from entering
middle-income trap. This increase in labor productvity also
increases capital productvity.
Taxes: Indias tax system is too complicated. According to a
certain report, Indias 30 companies of BSE had a tax litga-
ton of $7 bn in 2011-12 compared to $5.5 bn in the previ-
ous year. India stll has an inefcient indirect tax system due
to cascading efect of multple taxes on goods and services.
India needs to quickly adopt GST which seems to increase
GDP growth by 2%. In fact easier tax rules is like a fscal
devaluaton against other countries making the domestc
economy compettve.
Infrastructure and skill development: Although India is pay-
ing atenton to infrastructure, it is very urgent to do it
quickly by reducing red tape. The main point with infra-
structure building is that it makes the products very com-
pettve by reducing the cost. It was estmated in 2005 that
due to golden Quadrilateral, India at that tme was saving
2.5Bn$ 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
compettve by reducing the cost. It was estmated in
2005 that due to golden Quadrilateral, India at that tme
was saving $2.5 bn per annum.
Crony Capitalism: It is very important to make laws very
transparent. Indias GDP decline in the last 3-4 years has
been due to corrupton 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 infaton, fscal defcit and CAD have improved which
refects that India is recovering slowly. As we know that
economy is based more on percepton 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 lif the spirits of India. India has the a great
demographic dividend and there is growing expectatons
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
Maj or Hi ghl i ght 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 Apples 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
Chinas 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 positons in Asian
diplomatc tes. By 1820, China was contrib-
utng one third of the total global output
with its strategic locaton aiding to its
growth.
The industrial revoluton however changed
the entre scenario with the improvement in
productvity of Europe and North America
ultmately leading to the relatve erosion of
Chinese economy.
It was then the initaton of economic re-
forms and liberalizaton 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 Revoluton. The Chinese
leaders realized that there was an urgent
need for change and that change was
brought in through experimentaton.
The frst set of reforms was directed towards
the agricultural sector wherein there was a
shif from collectve farming to private farm-
ing. The next focus was on price control and
thus a two-ter 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 fscal policies which ultmately
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 defcit naton 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
atenton towards revamping of insttutonal
infrastructure. Educaton 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 partcularly have resulted
in China becoming the worlds fastest growing
economy. It is currently the worlds 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 doesnt end here. Lately, the situaton 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 fve developing countries which have had a
similar credit boom as being witnessed by China and all of
them eventually dealt with severe fnancial crisis.
Trusted aides and supporters of the countrys policy stll 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 domestc credit crisis which is
inching closer towards them. Taiwan proves to be an apt
example for their current situaton. The country had huge
forex reserves accountng 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 regulaton on formal banking system by
the government has led to this unregulated fnancial 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 ofen been seen that economies which have had a
rapid growth have ultmately 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 contributon from utlizing 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 fxed investments to leverage its growth
and the income inequality is also growing at a rapid
pace. There has been an incomplete transiton of the
country to a free market economy and that has led to
structural imbalance.
The month of February saw an unusual depreciaton 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 possibilites that economists consider is that a
weaker Renminbi might be a strategy on the part of china to
stmulate wider internatonal use and it is also expected that
PBOC might soon widen the currencys trading band. The
weakening of currency would also perk up the exports. If the
fuctuaton contnues for a longer period, it may suggest
their intenton of internatonalizing the currency.
China is trying hard to get its business model back on track
by developing its modern market sector and removing regu-
latons requiring state council approvals, but it is for the
world to see in the tme to come, whether these reforms
would help it sustain its growth rates.

10


Eurozone
Maj or Hi ghl i ght s
Points of Interest-
As the Eurozone continues
to face challenges, Lativia
a Baltic country of just 2
million people became the
blocs 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%


Introducton to Eurozone
The Eurozone ofcially 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 partcipatng natons who had
met the Euro convergence criteria adopted the Euro as their ofcial currency. The other EU (a
union of 28 natons) 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
setng monetary policy for the Eurozone. The Maastricht Treaty laid out the fve main criteria
countries must meet to join the Eurozone.
Maastricht criteria

The raison d'tre of the EU has always been some form of common market. The introducton
of a common currency further facilitated trade and exchange.
Advantages of Euro
1) It ensures low, stable infaton and low interest rates. It eliminates currency exchange
costs and fuctuatons between the member natons.
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 beter protects
against external economic shocks like oil price rises or upheaval in currency markets.
5) It atracts foreign investment and trade to the Eurozone
Disadvantages of Euro
1) Diferences in economic performance make it hard to implement one-size fts all policies.
For example, the infaton level set by the ECB may not work well for all Eurozone coun-
tes which means that weaker economies can pull down stronger economies.
2) Defcit limits restrict what fscal tools governments can use to combat recession, unem-
ployment and other economic problems that may be specifc to their situaton.
Infaton Should be less than 1.5 % points above the infaton of the three EU states
with lowest infaton in the previous year.
Budget
defcit
Natonal budget defcits must be at or below three per cent of GDP.
Public
debt
Natonal 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 infaton in the previous year
Exchange
rates
Exchange rates must remain within the accepted margin of fuctuaton laid
out in the Exchange Rate Mechanism (ERM) for two years prior to entry.
11
3) Adhering to the strict defcit and infaton caps can force countries to defate their economies.
In the period 1999 2008, The Eurozone economy prospered. Bolstered by low interest rates and decreased costs for trade and
exchange, economies like Greece, Portugal which were associated with large structural defcit benefted with the introducton of
common currency and the availability of cheap money. The ballooning tax revenue from real estate bubble accommodated in-
creased government spending. However the governments did not administer the structural problems or introduced any major re-
forms to make their economy compettve. Greece whose main industries were shipping and tourism was hit really hard afer the
recession in 2008 and the government started spending heavily to keep its economy functoning. Thus Greece accumulated a lot of
debt and violated the Maastricht Treaty without disclosing the full extent of its debts. Ireland and Spain were partcularly hit by the
asset bubble and their government went into large debts to bailout their banks. Portugal and Greece too were afected by the slip-
page in state managed public works which was characterized by infated bonuses and wages and redundant employees thus lead-
ing to huge spending for the government. However Germany which had made its economy compettve by imposing controls and
on wages and prices was much less afected. Cyprus the most recent country to come out of the closet in 2012 has a large ofshore
banking industry. It had exposed itself to large amounts of Greek debt and subsequent haircuts on Greek debt led to trouble for its
two major banks. The troubled natons were subsequently ofered bailout packages to revive their economies. However bailout
packages came in with a strict lot of austerity measures and were regulated by the TROIKA which limited the ability of the natons
to revive their economy through fscal spending. .In 2012 fears of Euro breakup were evident, as there were concerns that Greece
might have to leave the Eurozone. However ECB chairman Mario Draghi introduced a host of measures to allay the fears and his
statement that the ECB will do whatever it takes to save the Euro pacifed the markets. The introducton of Long Term Refnancing
Operatons and the establishment of the ESM helped in lowering bond yields of troubled natons. Under LTROs money at very low
interest rates was lent to the various natonal banks using the sovereign bonds as collateral for loans which helped in reducing their
yield and also providing money to central banks to revive demand and boost their economy. Draghi extended the period of repay-
ment to three years. Outright Monetary Transactons (OMTs) were also undertaken in secondary bond markets to reduce bond
yields at the longer end of curve. However the concept of full sterilizaton was applied meaning that unlike QE excess liquidity in-
jected was reabsorbed. Infaton was targeted and the rise of Euro was checked.
Present State of Euro Zone
Euro zone has emerged out of recession in the Q313. Yet, the world is
cautous before celebratng the success. The policy makers and the
world bankers arent sure if the growth achieved is sustainable. The aus-
terity measures imposed on several peripheral countries have con-
strained their budgets. This has virtually taken the fscal policy out of
their hands when they have already renounced their monetary control.
Austerity measures imposed on the peripheral countries have restricted
the countries to not exceed more than 3% of fscal defcit. None of the
peripheral country has succeeded from austerity measures. In fact, it has
further shrunk the economies in the name of fscal consolidaton. Reduc-
ing fscal defcit by controlling the necessary expenses has hurt their po-
tental growth. With the cut on healthcare expenditure and increasing
unemployment, the infant mortality rates and deaths due to HIV, cancer
have increased invitng protests from public. Growth in Germany has
been the major reason for the apparent end of recession and with ade-
quate measures not taken it may be mater of tme before the Eurozone
fall into recession again.


12
Rising Euro
The rising exchange rate is a major concern for the Euro zone. Even as the peripheral countries trying to shake up their economies
using exports, the exchange rate may act as a dampener not just the debtor countries but to Germany as well. The aging popula-
ton, dwindling domestc demand have made the economies depend on exports to fuel the growth but the increasing Euro is mak-
ing the exports uncompettve.
Infaton and Interest Rates
The alarmingly falling infaton is at 0.7% , an evidence of the falling de-
mand. Draghi has maintained a target infaton of 2%. Already, the Main
Refnancing rate been adjusted to 0.25% and the deposit rate is at 0%.
Negatve Interest Rates have been discussed. The Euro zone is risking of
going into liquidity trap by trying to stmulate growth with monetary poli-
cies as contnued eforts have failed to increase infaton.
Fiscal Stmulus
Its not a bad idea for the countries to stmulate the failing economies by
fscal stmulus packages. As, the ECB is against printng currency, the
countries have to try fscal policy to come out of the hole they dug for
themselves.
Unemployment rate and General characteristcs
The unemployment rate is hovering around 12% for the Euro zone. The
job market of PIIGS countries hasnt seen any improvement afer the
2008 crisis. The business confdence which was over 1% in the pre crisis
era is just over 0.37 in Q14. The industrial producton seems to have
jumped a few points to just over 2% in 2013 which was at 5% in 2008.
Afer years of contracton in services, PMI for services has grown over 50
in 2013. The personal disposable income is one parameter that has
shown tremendous increase in the past two years.
Rising Current Account Balance
Germanys internal devaluaton, wage and price control, has made it com-
pettve in the Euro zone. Over the last few years the Euro was under val-
ued owing to the defcits in the current account of other Euro zone coun-
tries. These factors have aided Germany in balancing the current account
defcits of many other small economies in the Euro zone. This has serious
implicatons on the 17 (total 18 countries now) other countries which are
sharing Euro with Germany. The defatonary pressure created by the in-
creased exports will never allow the peripheral Euro countries to come
out of their slumber in the near future. A constant appreciaton of Euro
will create more defatonary pressure unless ECB maintains a fxed ex-
change rate.

13
Whats up with PIIGS?
Greece
Greece, which has seen its economy decline by 25% in fve years, is now running a primary budget surplus, excluding interest pay-
ments. Greece is months behind in negotatons with its creditors and a third bailout is likely. Borrowing costs for the most vulnera-
ble countries have fallen to levels not seen since 2010. There is a funding gap this year of probably 4bn euros. This might be begin-
ning before Greece misses its fscal and structural targets.
Negotatons with its creditors are months behind schedule. A third bailout is likely. IMF predicts that growth will only emerge if a
major chunk of its debt is writen of. Greece is unfnished business.
Italy
Italy's two-year borrowing costs have fallen to their lowest level since the launch of the euro. Tremors in the emerging markets
have scarcely rufed Europe - so far. It is splutering its way out of recession. Its economy has not really grown since the middle of
2011. It has now embarked on a privatzaton drive which is expected to raise 12 bn euros over the next two years. These sal es are
driven by the need to reduce Italy's public debt. It is forecasted to reach 133% of GDP this year.
Spain
Early in the crisis it enthusiastcally embraced structural reforms, making it easier to hire and fre workers. Productvity has im-
proved strongly. Its labor costs have fallen and its exports have surged. However, house prices are stll falling; bad loans are stll
rising, as is public debt. There are signs that unemployment is beginning to fall, but even if Spain achieves growth of 1% it will have
litle impact on the 5.9 million people out of work. Future growth will have to depend on exports and investment but not on do-
mestc demand.
Ireland
The Republic of Ireland, having almost been bankrupted by its banks, has felt strong enough to leave the safety of the bailout pro-
gramme. Portugal may soon follow.
Euro zone might be out of emergency room but certainly not discharged yet.
Road Ahead for Euro Zone
Given the hole the Euro Zone economies are in it will take systematc and long sighted reforms to bail out the peripheral countries.
One of the Novel ideas that could be tested in the troubled tmes is, Sharing the excess premium cost of bonds of core Euro coun-
tries with the debt laden peripheral countries
The Euro-rates idea could be operated as follows:
At the end of each year, the average bond yield of the bonds issued that year is calculated. The variance would be transferred to
countries with high costs from countries with low costs. The transfer would only cut but not eliminate the divergence between
diferent countries borrowing costs. The amount of money that low-interest countries, like Germany and France, contribute to the
group is a functon of volume of bonds and the diference of yield of the bonds and the average yield. Conversely, the amount of
cash that high-interest countries, like Italy and Spain, are likely to receive would depend on how expensively they borrowed, as
well as their bond issuance.
Every year, the accumulated value of the rates will be used as the reference. In this way as the tme progresses, the stakes of each
of the countries, irrespectve of their status as net donor or net borrower, will be too costly to ignore. Potental benefts can be:
The transfer will not give an exposure to the other countries debt. This will save the net donor countries from the ill efects of
investng in risk debt of peripheral countries.
14
Since the accrued value increases with tme, the drive for the peripheral countries to keep up with the over haul of their econ-
omies would grow with tme as the net donor countries always have the incentve to withdraw the package.
Countries in the periphery would have a dual beneft. Not only would they receive money the core Euro countries each year,
but can also borrow money at lower rates from the investors as they would have signed contracts with the core countries to
overhaul their economies.
The fnal advantage is that euro-rates be range bound as long as governments agreed to have a predefned gap in interest
rates that countries paid.
That would balance the solidarity with the market discipline. A program of this nature would only need to run for 6-7 years for it to
show the desired results. It would augment the peripheral countries to borrow debt at least 50 bps lower than their present costs.
Advantages:
The package is similar to a bailout fund but with necessary clauses that can motvate the net receiver countries to abide by the
guidelines
The soluton will not visibly fuel further systemic problems that are as potental as a adoptng a single currency. If anything it
will strengthen the peripheral naton
In case any country goes against the agreed principles, the net donor countries have the right to discontnue the scheme
Disadvantages:
The package gives free capital to peripheral countries. Although, the core Euro zone countries have their own benefts ted up
to the health of other economies, the inital inerta to agree to join the board is too much to overcome
When austerity measures are not yielding results, fscal stmulus seems to be the only obvious answer. However, without a
consensus on the policy, countries like Germany and France wouldnt be willing to join the treaty
Fiscal Devaluaton
The major problem with Euro zone naton facing crisis is their inability to afect the exchange rates. Normally countries in tmes of
crisis can devalue their currencies to make exports more compettve and revive growth. However this is not the case with Euro-
zone countries and in fact they have been facing a rising Euro as Germanys current account surplus is increasing, thus compound-
ing their problems. A novel way for countries facing such problem is fscal devaluaton. The idea of fscal devaluaton originates
with John Maynard Keynes By increasing value-added taxes while cutng payroll taxes, a government can afect gross domestc
product, consumpton, employment, and infaton much as a currency devaluaton would.
The higher VAT raises the price of imported goods as foreign companies pay the levy on the products and services they export to
that country. The lower payroll tax helps ofset the extra sales tax for domestc companies, reducing the need for them to raise
prices. Since exports are VAT-exempt, the payroll cost saving allows producers to sell goods more cheaply overseas, simulatng the
efect of a weaker currency. Thus imports and exports are afected in the same way as they would be by a devalued currency. The
policy also can help on the fscal front, as increased compettveness can lead to higher tax revenue.
France has already started implementng this novel concept. As part of Frances fscal devaluaton, Hollande has ofered French
companies a 20 bn ($27 bn) tax cut on some salaries as he atempts to turn around an economy that has barely grown in more
than a year. Hell also lif the two highest VAT rates.
15
Inflation Targeting as a
monetary policy
Infaton Targetng (IT) is an economic policy in which the
central bank makes public a target rate of infaton and then
uses monetary tools to achieve the target infaton rate.
Design and implementaton of IT is based on the following:
Inflation in India
India has been a high infaton economy for the past few
years. Although current account defcit has reduced, due to
several reasons including import curbs on gold and CPI has
Provide nominal anchor for the economy
Reduce uncertainty and incidence and severity of boom-bust cycles
Makes the task of monetary policy easier and more credible
Lags in monetary transmission mechanism makes it tough to keep infaton exactly
on target and hence in practce it becomes infaton-forecast targetng
Central Bankers must possess clear objectves and inde-
pendence from politcal processes. Efectve monitoring and
accountability mechanisms are necessary to ensure policies
are consistent with objectves.
Need for Inflation Targeting
Developing countries have been seeing high infaton rates
in the past few years. As long as high infaton is coupled
with high economic growth and rising wages, there may be
less public oppositon. Infaton is benefcial to the economy
as long as it is within its limits.
reduced, core infaton has not seen a similar decline. Central
banks in developed natons have an infaton target of 2%.
Infaton target in high growth emerging markets should be 2
percentage points more than that of developed natons and
as suggested by Sukhamoy Chakravarty commitee on mone-
tary policy in 1985, infaton should be less than 4%. The Urjit
Patel commitee has recommended a target of 8% by January
2015. India is now close to the target with CPI infaton falling
to 8.1% in February from 8.8% in January, 2014 especially
because of easing of vegetable prices. Hence it is now im-
portant to sustain these levels.

Source: IMF Source: IMF
16
Costs of High inflation
There may be unrealistc assumptons regarding the contnu-
aton of high rates of infaton on asset prices which may
lead to bubbles in the asset prices, i.e., investors may pur-
chase real estate at prices that may end up being overval-
ued. For example, in Japan, excessively optmistc expecta-
tons regarding the asset prices due to infaton in the 1980s
led to the burstng of the bubble.
Infaton is usually characterized by volatle rates. In such a
scenario, if a company funds projects through long term
debt, then it is exposed to risk of loss in case of an unex-
pected disinfaton and short term debt is exposed to fund-
ing risk.
Infaton also indirectly afects the collecton of taxes. Tax
codes are based on the assumpton of price stability, i.e., the
impact of infaton is not taken into account. Depreciaton,
based on original cost of assets, and historical costs of goods
that were sold in the current period but manufactured in
earlier periods overstate the profts and corporate taxes.
High volatle infaton leads to output and unemployment
volatlity. Typically, upsurges in infaton are followed by
sharp downturn in economy as distortons in price caused
by infaton initally leads to bouts of overinvestment fol-
lowed by bouts of underinvestment.
Central Banks rely on a nominal anchor to base their mone-
tary policy in pursuit of low infaton. Nominal anchor in-
volves fxing a nominal variable in an economy as a means of
reducing infaton. It is useful to the central bank in formu-
latng monetary policy and clarifying the objectve both
within the bank as well as the general public. Earlier coun-
tries used monetary aggregates and fxed exchange rate as a
nominal anchor but they failed due to lack of stability in the
demand for money and hence the need for Infaton Tar-
getng arose.
Inflation Targeting Framework of New Zea-
land
Reserve Bank of New Zealand (RBNZ) was the frst central
bank with legislated Infaton Targetng. Its infaton has av-
eraged around 2.7% since 2000 and 2.4% in the 1990s.
Inflation Measure
New Zealand used the Consumer Price Index (CPI) in order to
restrict infaton within a target range of 0 and 3 percent be-
cause of its familiarity with the public although it can be
afected by relatve price movements that do not consttute
ongoing infaton.
Numerical value of the target
The inital target for infaton was set at 0 to 2%. The central
aiming point was consistent with price stability at 1%. How-
ever a small positve infaton is benefcial to the economy.
Hence the infaton target has been changed to a range be-
tween 1 and 3%.
Point target or range
A range provides clear outer bounds within which infaton
could vary without evoking a reacton. Without such bounds
the Reserve Bank would have to take evasive acton whenev-
er the infaton rate reached was not near its target. Ranges
also have certain issues associated with them. They can be
too narrow and may lead to frequent infaton rates outside
the range and frequent changes in monetary policy to mini-
mize the frequency of breaches.
Forward looking
The Reserve Bank has to choose to react to current infaton
or forecast infaton even though monetary policy afects
infaton with a lag. Aggressiveness of the monetary policy
depends on the degree to which the policy looks forward.
RBNZ focused on infaton 12 months ahead in the inital
Source: Reserve Bank of New Zealand
17
years of infaton targetng since the efect of monetary poli-
cy takes at least a year to materialize. Now, it looks ahead
by one or two years since it also has a bearing on the policy
transmission channels emphasized. Real exchange rates and
interest rate channels are emphasized relatve to direct ex-
change rates.
Transparency
Since RBNZ implements forward looking infaton targetng,
it publishes infaton forecasts (projected infaton based on
the assumpton of no policy change) so that observers can
easily relate policy decisions to forecasts and antcipate poli-
cy changes.
Conclusion
Infaton Targetng demands a few pre-conditons for its suc-
cessful implementaton like independence of central banks,
well developed fnancial markets, fexible exchange rates,
etc. But, adopton of IT has been benefcial to several coun-
tries in reducing their infaton rates. It has also helped in
increasing the transparency and credibility of the central
bank to carry out its monetary policy efectvely. In additon
to this, it has provided a nominal anchor, stabilized infaton-
ary expectatons in an uncertain future and reduced ex-
change rate volatlity.
18

Brazil
Maj or Hi ghl i ght s
Points of Interest:
Brazil shrank by 0.5% in
the third quarter of 2013
Infrastructure spend is on-
ly 1.5% of GDP compared
to global average of 3.8%
Brazil contributes 38.5% of
Latin Americas GDP
Brazil fell to 126th rank
from 120th in the Ease of
Doing Business Index
Brazil: Boom to Bust
Introducton:
Brazil is one of the BRICS natons which was
growing at a very fast rate in the 2000s. The
economy, having stabilised under Fernando
Henrique Cardoso in the mid-1990s, acceler-
ated under Luiz Incio Lula da Silva in the
early 2000s. It barely stumbled afer the Leh-
man collapse in 2008 and in 2010 grew by
7.5%, its strongest performance in a quarter-
century. To add to the magic, Brazil was
awarded both next years football World Cup
and the summer 2016 Olympics. On the
strength of all that, Lula persuaded voters in
the same year to choose as president his
technocratc protge, Dilma Roussef.
Since then the country has come back down
to earth with a bump. In 2012 the economy
grew by 0.9%. Hundreds of thousands took
to the streets in June in the biggest protests
for a generaton, complaining of high living
costs, poor public services and the greed and
corrupton of politcians. Many have now lost
faith in the idea that their country was head-
ed for orbit and diagnosed just another voo
de galinha (chicken fight), as they dubbed
previous short-lived economic spurts. The
issue of where the burden of economic ad-
justment falls is partcularly relevant in Bra-
zil, a country where the poorest 40% of the
populaton share an 8% slice of the natonal
income cake and the
wealthy 10% consume 48%.
Brazil, as the seventh largest economy in the
world, is regularly mentoned in the world's
fnancial press, but since capital started pour-
ing out of the country in August 1998, hardly
a day passes without artcles referring to its
crisis and the internatonal repercussions.
What was seen as a promising emerging mar-
ket, in the hands of a safe economic team,
has become one more global problem. The
summer drain on reserves, in which $30 bil-
lion winged their way out of the country, was
followed by an autumn internatonal support
operaton led by the IMF. Careful tming
helped avoid impediments to President Car-
doso's electoral victory in October over Lula,
his lef-wing challenger. Three weeks later,
the government announced a $22.5 billion
package of spending cuts and tax hikes.

The
New Year came, and the markets looked anx-
iously at the slow progress in shrinking the
public sector defcit. The IMF's $41.6 billion
cushion seemed threadbare, capital took
fight once more and the currency crisis ex-
ploded. The government atempted a con-
trolled devaluaton on 13 January and threw
in the towel two days later. By the end of the
month, the real hero of the victory over hyper
-infaton in 1994, had fallen from 1.21 per US
dollar to 2.05. Forecasters revised their guess-
es about the depth of the 1999 recession
down to 5-6% negatve growth - and the IMF
negotators few back to Brasilia to redo their
sums.
NOMINAL GDP:
$2.435 trillion
GDP RANKING:
7th
FOREX RESERVES
$362.69 Billion
DEBT/GDP Ratio
65.10%
FISCAL DEFICIT (% of GDP)
1.9%
CAD (% of GDP)
3.66%


19
Reasons for Slowdown:
There are excuses for the deceleraton. All emerging econo-
mies have slowed. Some of the impulses behind Brazils pre-
vious boomthe pay-of from ending runaway infaton and
opening up to trade, commodity price rises, big increases in
credit and consumptonhave played themselves out.
But Brazil has done far too litle to reform its government in
the boom years. It is not alone in this: India had a similar
chance, and missed it. But Brazils public sector imposes a
partcularly heavy burden on its private sector. Companies
face the worlds most burdensome tax code, payroll taxes
add 58% to salaries and the government has got its spending
priorites upside down.
Compare pensions and infrastructure. The former are ab-
surdly generous. The average Brazilian can look forward to a
pension of 70% of fnal pay at 54. Despite being a young
country, Brazil spends as big a share of natonal income on
pensions as southern Europe, where the proporton of old
people is three tmes as big. By contrast, despite the coun-
trys contnental dimensions and lousy transport links, its
spending on infrastructure is as skimpy as a string bikini. It
spends just 1.5% of GDP on infrastructure, compared with a
global average of 3.8%, even though its stock of infrastruc-
ture is valued at just 16% of GDP, compared with 71% in oth-
er big economies. Roten infrastructure loads unnecessary
costs on businesses. In Mato, Grosso a soyabean farmer
spends 25% of the value of his product getng it to a port;
the proporton in Iowa is 9%.
These problems have accumulated over generatons. But
Ms Roussef has been unwilling or unable to tackle
them, and has created new problems by interfering far
more than the pragmatc Lula. She has scared investors
away from infrastructure projects and undermined
Brazils hard-won reputaton for macroeconomic rect-
tude by publicly chivvying the Central Bank chief into
slashing interest rates. As a result, rates are now having
to rise more than they otherwise might to curb persis-
tent infaton. Rather than admit to missing its fscal tar-
gets, the government has resorted to creatve ac-
countng. Gross public debt has climbed to 60-70% of
GDP, depending on the defnitonand the markets do
not trust Ms Roussef.
Way Forward:
Fortunately, Brazil has great strengths. Thanks to its ef-
cient and entrepreneurial farmers, it is the worlds third-
biggest food exporter. Even if the government has made
the process slower and costlier than it needed to be,
Brazil will be a big oil exporter by 2020. It has several
manufacturing jewels, and is developing a world-class
research base in biotechnology, genetc sciences and
deep-sea oil and gas technology. The consumer brands
that have grown along with the countrys expanding
middle class are ready to go abroad. Despite the recent
protests, it does not have the social or ethnic divisions
that blight other emerging economies, such as India or
Turkey.
If Brazil is to recover its vim, it needs to rediscover an
appette for reform. With taxes already taking 36% of
GDPthe biggest proporton in the emerging world
alongside Cristna Fernndezs chaotc Argentnathe
government cannot look to taxpayers for the extra mon-
ey it must spend on health care, schools and transport
to satsfy the protesters. On paper, the soluton 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-
pettve and encourage it to invest. Also, Brazil
20
urgently needs politcal reform. The proliferaton of partes,
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 getng
those who beneft from the current system to agree to
change it requires more politcal skill than Ms Roussef has
shown.
In a years tme Ms Roussef faces an electon in which she
will seek a second four-year term. On her record so far,
Brazils voters have litle reason to give her one. But she has
tme to make a start on the reforms needed, by trimming red
tape, merging ministries and curbing public spending. Brazil
is not doomed to fop: if Ms Roussef puts her hand on the
throtle there is stll a chance that it could take of 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 existng in the Chinese banking sys-
tem and maybe another banking crisis in the making.
The situaton 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 conventonal 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 securites, and leveraged derivatve products,
usually funded by investment banks and large insttutonal
investors. In 2007, the volume of shadow-banking transac-
tons in the US exceeded that of conventonal banking.
Therefore, not only the non-bank fnancial insttutons start-
ed to fll 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 artfcially low and real
deposit rate was negatve 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
optons. At the same tme, lending rates were too low as
well and it boosted endless credit demand together with
other pro-investment insttutons. To avoid infaton and
credit bubbles, the banking regulators set loan quota every
year for the banking system (but it failed several tmes in
controlling infaton 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 specifc restricton
on property loans made some borrowers, especially proper-
ty developers, seek fnancing 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
Negatve real interest rates and lending quota have existed in
China for many years before 2009, but the "shadow banking"
referred to during that tme was largely lending of pawn
houses or lending between individuals. Large fnancial insttu-
tons were not involved that much. It was only afer 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 afer
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 frst
quarter of 2009, almost equal to the total new loans in 2008.
The banking regulators realized that credit growth in 2009
was too exceptonal and it would create problems. It did and
22
it led to severe infaton and asset price bubble in 2010 and
2011. To counter infaton, the Peoples 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 getng ofcial bank loans, they went to
seek credits from other channels and non-bank fnancial
insttutons led by trust companies were well prepared to
welcome their new customers
Drivers of Shadow Banking - Demands & Atached Risks
Shadow banking in China is dominated by lending to higher-
risk borrowers, such as local governments, property devel-
opers and SMEs.
SMEs are the most important growth engine of the Chinese
economy. Unable to acquire sufcient funding through the
formal banking channel, they have been forced to resort to
the informal channel. As SMEs are traditonally 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 exponentally.
The result was a 43% increase in shadow-banking credit in
2013, accountng for 29% of Chinas total credit. Real estate
developers unable to acquire fnancing 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 transmitng the risk to the
entre fnancial 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 efcient, balanced, inclusive, and productve 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 fnancing vehicles expo-
sures is essental. China needs to build its municipal bond
market to generate more sustainable funding for infrastruc-
ture projects. Local governments could then privatze the
massive assets that they have accumulated during years of
rapid growth, using the proceeds to pay down their debt.
Reform eforts should be supported by measures such as
strict enforcement of balance-sheet transparency require-
ments to improve risk management. In fact, the existng
shadow-banking risks are manageable, given relatvely robust
GDP growth and strong macroeconomic fundamentals
Chinese policymakers must focus on curbing the shadow-
banking sectors growth, while ensuring that all current and
future risks stemming from the system are laid bare. The in-
troducton of measures to cool the property market, and new
direct regulatory controls over shadow-banking credit, repre-
sent a step in the right directon
Perhaps the biggest challenges facing China are raising real
returns on fnancial liabilites (deposits and wealth-
management products) and promotng 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.
Ultmately, addressing shadow banking in China will require
mechanisms that clearly defne, allocate, and adjudicate f-
nancial risks among the key players. This includes ensuring
that borrowers are accountable and that their liabilites are
transparent; deleveraging municipal debt through asset sales
and more transparent fnancing; and shifing the burden of
resolving property-rights disputes from regulators to arbitra-
tors and, eventually, to the judiciary. Such insttutonal re-
forms would go a long way toward eliminatng default (or
bailout) risk and creatng a market-oriented fnancial system
of balanced incentves that supports growth and innovaton.
23
JAPAN
Maj or Hi ghl i ght s
Japan is the third largest economy in the
world by nominal GDP, afer US and China.
Japan has become a topic of discussion ever
since Shinzo Abe took the Prime Ministerial
Ofce 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 scrutny.
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 efects 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
burstng 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-
natonal Setlements introduced capital ade-
quacy norms to control excessive loans
which were prevalent in the 1986-91 period.
This made banks conservatve 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 proftability. These inefciencies in
the business created problems afer 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 consumpton of lux-
-ury items did decrease and never reached
the same levels again.
Today, Japan is facing fve problems - defa-
ton, debt, deregulaton, defcit and demogra-
phy - fve "Ds"
1
. With falling prices and falling
demand, GDP growth rate has been either
negatve or dismally low. Increasing bad debts
was a heavy blow to banks which has led to a
credit crunch in the economy. The tes be-
tween the state and industry in Japan have
been termed an iron triangle of politcians,
industrialists and bureaucracy. Japanese
economy, a combinaton of regulaton and
protecton, will remain a handicap in a world
based on globalisaton without deregulaton.
The numerous stmulus packages so far have
benefted litle but greatly fuelled the fscal
defcit. Also, the demography is such that the
populaton between 15 years to 65 years is
contractng at a 6% rate which is hampering
growth further.
This is where Abenomics comes to the rescue.
Abenomics basically refers to the collectve
policies that Shinzo Abe supports in order to
bring Japan out of its decades long defaton-
ary trap. It aims to boost the annual growth
rate of GDP from its current level of 2.4%, and
raise infaton to 2% via short-term stmulus
spending, monetary easing, and reforms that
will boost domestc labour markets and in-
crease trade partnerships.
Abes aggressive revival plan follows a three
pronged approach, called the three arrows:
aggressive monetary easing (monetary poli-
cy), expansion of public investment (fscal
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 creatng a virtuous cycle. Monetary expansion
will spur depreciaton of the yen, increase infaton, boostng
exports and increasing investment and employment which
will create a wealth efect, hence increasing private con-
sumpton and boostng stock prices.
To stmulate the economy, the government will spend a
hefy 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 Japans bond buying program
which will depreciate yen but has raised concerns about the
emergence of a currency war. This is because depreciatng
yen will make Japan more compettve 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-Pacifc Partner-
ship (TPP), a proposed regional free trade agreement being
negotated 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 protectve 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 stmulus packages have been issued before but
what distnguishes this from others is the sheer magnitude
and the collecton of the right reforms. However,
how successful this is will only unveil in the tme to
come.
25
The Shale Revolution
Untl Twiter went public in November; 2013s hotest Amer-
ican IPO was of shares in Antero Resources, whose wells in
the Appalachians are expected to increase the companys
output by 76% in 2014 and 47% the year afer. Now exactly
what wells are we talking about here?
It has commonly been touted for some tme now that the
biggest innovaton in energy so far this century has been the
development of shale gas and the associated resource
known as tght oil. And it is being said of the late George
Mitchell, a pioneer of the technique of hydraulic fracturing
to tap unconventonal reserves of oil and gas, that his
impact eventually might even approach that of Henry Ford
and Alexander Graham Bell.
This unconventonal revoluton in oil and gas did not come
quickly. Hydraulic fracturing known as fracking has
been around since 1947, and inital eforts to adapt it to
dense shale began in Texas in the early 1980s. However, it
was not untl the late 1990s and early 2000s that the spe-
cifc type of fracturing for shale, combined with horizontal
drilling, was perfected. Moreover, it was not untl 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-
portng large volumes of liquefed natural gas to make up for
an antcipated shortall in domestc producton. However,
since late 2008, the industry has developed fast, with shale
gas currently accountng for 44% of total US natural-gas pro-
ducton. Given abundant supply, US gas prices have fallen to
a third of those in Europe, while Asia pays fve tmes as
much. Tight oil, produced with the same technology as shale
gas, is boostng US oil producton 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 Internatonal Energy Agency predicts
that in the next few years the US will overtake Saudi Arabia
and Russia to become the worlds largest oil producer.
If we look at it from a partcular angle, US shale oil covers up
a recent decline of crude oil producton 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
schematc below shows us how the picture of global oil is
changing quite dynamically across geographies.
Countries, which had substantal changes in producton, 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 producton in Jan 2003 due to a
strike), Iraq (low producton in April 2003 during the Iraq
war), Libya (war in 2011), Iran (sanctons) and Saudi Arabia
(producton increase since 2002 and swing role). Notably, US
shale oil has not brought down oil prices substantally and
defnitely, the US does not act as a swing producer.
The world without shale oil declined afer 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 producton 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 (negatve) swing producer during
the fnancial crisis year of 2009 and stepped in (belatedly)
when the war in Libya started and contnued pumping at rec-
ord levels when sanctons on Iran started. Saudi Arabia ap-
parently tries to compensate for Libyan and Iranian produc-
ton losses but does not seem to reduce crude producton to
ofset US shale oil. Iraq will have to return to OPECs quota
system. Decline in Syria and Yemen was ofset by increases in
Kuwait, UEA and Qatar. Iraq could not ofset Irans produc-
ton drops.
Russia, producing now at 10 mb/d, is stll 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 afer its peak in 2010. Kazakhstan is fat
since 2010. Oil producton in Russia is approaching the record
levels of the Soviet era, but maintaining this trend will be
difcult, given the need to combat declines at the giant west-
ern Siberian felds that currently produce the bulk of the
countrys oil.
In Latn America, Brazil seems to have peaked while Colombia
slowly increased heavy oil producton. Venezuelas data ap-
pear sustained, as they have not been updated since Jan
2011. In Africa, irrespectve of what has happened in Libya,
the rest of the contnents countries seem to have peaked.
Overall, since end of 2010, the group of stll growing coun-
tries (+1.2 mb/d) cannot ofset decline elsewhere (-2.4 mb/
d), giving a resultng 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 diference
between demand and non-OPEC producton, has got its own
problems (geopolitcal feedback loops caused by peaking oil
producton) and was not able to fll 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 interestng to note the impact
of US Shale apart from the obvious one of mitgatng global
supply woes.
With the US market cordoned of by cheap domestc gas,
some of that LNG is going to Europe, introducing unex-
pected competton for traditonal suppliers Russia and Nor-
way. For Japan, the lack of US demand for LNG proved fortu-
nate in the afermath 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 compettveness to factories
that use low-cost natural gas and the consequent shif of
manufacturing from Europe to the US. This is partcularly
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 tmes as much for its
gas as its American counterpart, and Japanese frms pay
more than four tmes as much. A report by the Internatonal
Energy Agency, a think-tank backed by energy-consuming
rich countries, predicts that by 2015 Americas energy-
intensive frms 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 unatractve to in-
vest in wells that produce only gasas 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 fooded onto
the American market since 2008, its price has fallen by two-
thirds to less than $4 per million Britsh thermal units (BTU).
The average price needed to cover all the costs over a wells
life cycle is around $6. These levels are expected to stay for
another three to fve years. Roughly speaking, fracking for oil
and NGLs is proftable 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 frms expect this to contn-
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 cant see any scenario, other than a widespread ban on
drilling, that would push prices higher than $6, says Scot
Nyquist, one of the authors of a report by the McKinsey Glob-
al Insttute.

Page No 2
27
Roughly, $200 billion are being saved by America currently
due to non imports of LNG coupled with reducton 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 feld, 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 Americas annual GDP,
creatng 1.7m permanent jobs in the process. A recent re-
port by IHS, another research outit, talks of a manufactur-
ing Renaissance and predicts a $533 billion boost to GDP by
2025, creatng around 3.9m jobs.

This is the frst of a two part write up series on The Shale Revolu-
ton.
- Aaditya Mulani
RefProject Syndicate, The Economist, The Resilience Organiza-
ton and Internatonal Energy Agency.
Page No 2
28
BOND-SWAP TRADING-IS IT A BLIND ARBITRAGE?
Fixed Income, considered to be a relatvely safe investment/
trading opton, provides traders with a variety of products
which can be used in order to generate payofs consistent
with the risk appette of the trader. One such trading strate-
gy is Bond-Swap trading.
In India, the Fixed Income market is stll in a nascent stage.
The Indian Bond Market is majorly dominated by Central
Government securites 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 (Bonds Interest Rate) every year tll ma-
turity, the mark to market fuctuatons (by pricing the bond
to current market price) will determine the value of our in-
vestment at that point in tme, even though we will receive
the entre Face Value at maturity.
So now post having a basic overview of Bonds and Swaps, let
us now focus on trading positons involving these two fnan-
cial instruments.
Fixed Income traders generally enter into a bond-swap trad-
ing strategy so as to hedge foatng interest rate risks and/or
to realize perceived arbitrage profts. But then how efectve
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 CBLO
2
platorm at a marginal haircut (say 5%) and
Fixed Income Market in India is in a nascent stage and is majorly dominated by Central
Government securites
In normal markets, a Bond-Swap strategy is highly efectve and provides almost a zero
risk proft. However, the same positon can be devastatng when markets turn volatle
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 fows between two partes, say a fxed rate for a
foatng rate or vice versa.
If we were to think that Interest Rates may fall in future
then we may want to exchange our fxed rate liability for a
foatng 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
foatng rate liability for a fxed rate liability and on the
premise that our overall payments will reduce. So, this is
where estmaton of future Interest Rates comes into pic-
ture and so does the related risk of the estmaton 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 MIBOR
3
. 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) positon (maturity same as
the bond) with a notonal 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 notonal trade amount every
year for 5 years and in return will receive a foatng pay-
ment which is linked to one day MIBOR.
Efectvely, the foatng rate positons more or less nullify
each other (MIBOR and CBLO Rate trade very closely). So
majorly, the trader is lef with an annualized receive
29
fxed positon of 7.27% (Bond) and pay fxed positon of
6.77% (swap). This is the trade that many fxed 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 shouldnt
the trader be putng in all of the frms 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 positons
can be severe in a volatle 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 positon funding
cost increases).
Exit from the trade can come at a high impact cost if
the bond positon becomes of-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 positon 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 profts outweigh the
risks, but calling it a blind arbitrage strategy will only make
one more susceptble to crisis in this extremely excitng but
complicated fxed income market space.
We feel, with tme new trading products will evolve in the
market. Having a sound understanding of the risks of a prod-
uct has been and will contnue to be the key in diferentatng
a wise trader from the rest.
1
Bloomberg
2
Collateralized Borrowing and Lending Obligaton
3
Mumbai Inter Bank Ofer Rate
4
Bloomberg


Source: Bloomberg
30
U.S.A
Maj or Hi ghl i ght 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 atacks 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 interventon.
The economy was coming out of a Dot-Com
bubble and the terrorist atack couldnt have
come at a worse tme for the US. It impacted
the confdence 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 confdence 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 fnancial and manufacturing. This
was a perfect example of Supply side eco-
nomics, where a government provided in-
centves 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
profigacy 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
Administraton 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 sectons 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 entrely through debt. About 20% of all the
Natonal debt from 2001-2012 for the United
States went to the war. This amounts to
$260billion paid as interest for Financial Year
2013 and mountng. 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
producton and greater liquidity are made
available to the masses. This is also known as
the Trickle-Down efect. However in this case
the money was funneled into the war-efort
and infatng a Real Estate and Stock market
bubble, instead of reaching the botom of the
pyramid.
The immediate response of the US govern-
ment in the afermath 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 interventon; it stands for more gov-
ernment interventon. 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 f-
nanced through Corporate and other Taxes. The US had its
frst cycle of Keynesian Economics, just afer the Great De-
pression. The government went into spending overdrive,
fnancing large scale infrastructure projects (the New Deal)
such as the Hoover Dam. At one point the Fiscal Defcit
reached 5% of the GDP. By the 1970 the Keynesian model
had began to falter as the power of Unions increased and
Productvity stagnated.
However this tme the dynamics of the Keynesian model are
diferent and that is why we call it new Keynesian Model.
The major critque of the Keynesian model had been that the
government is highly inefcient in delivering services/capital
to the public. Hence this tme 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 ratonale being, that Banks are too big to fail, hence
must be saved and are much more efcient in delivering
capital where it is required. Though if the past few years are
any refecton, that is hard to accept. (Part of the bailout has
gone to Infrastructure development)
So now almost 5 years afer the recession, the US govern-
ment must reap what they had sowed. The expectaton was
that increasing liquidity in the system through Banks will
help increase consumer confdence and increased invest-
ment in the Economy. This increased actvity will improve
employment and hence push up consumpton. However the
road back to growth has been slow and steep. As seen from
the graph:
32
United Kingdom
Maj or Hi ghl i ght 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. Afer 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
constructon sector as well which are
indicatve of good signs for the econo-
my. The other positve signs are the
rise in business investment and con-
sumer spending in 2013 even though
they havent 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 productvity has
been relatvely poorer. The net exports
are currently negatve and it is ex-
pected to remain the same because of
difcultes 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 tme now at 0.5% and it is
expected to contnue untl late 2014 as
per the indicatons from Monetary Poli-
cy Commitee. Nevertheless, it could be
infuenced by other factors like how
growth and infaton evolve in the
months to come. In additon, 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% devaluaton of its currency in con-
trast to other European economies like
Germany, Spain and Portugal which
have seen strong export growth. The
key mater of concern is that the defcit
was fuelled by consumpton 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 productvity has not im-
proved considerably.
Finally, UKs trade defcit has increased to
2.56 billion pounds in Jan14 in comparison to 1.45
billion pounds a year ago owing to lower sales of
aircrafs and chemicals. Shipments to EU declined
primarily due to chemicals while non-EU shipments
declined mainly due to aircrafs. On the other hand
net imports have increased by 1.92% in comparison
to last year and by 2.26% since December13. Im-
ports from EU countries remained the same while
imports from Non-EU countries, mainly ships, air-
crafs, precious stones and silver increased by 7.5%
in comparison to December13. 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 fscal defcit
which would eventually lead to slower growth and cur-
rency devaluaton.
Another worrying factor for the economy is its
high debt to GDP rato 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 existng debt. In order to ad-
dress the same, spending cuts worth $41 bn have been
announced in Jan2014 which shall be spread over a
period of 2 years amountng to around 2% of the gov-
ernment spending.
Unemployment has been reducing refectng
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 infaton
rates show prospects for real income growth which
34
VIX
The VIX is a widely used measure of market risk and is ofen
referred to as the "investor fear gauge." VIX stands for Vola-
tlity Index. It is the tcker symbol for the Chicago Board Op-
tons Exchange Market Volatlity Index. It measures the im-
plied volatlity of S&P 500 index optons. Implied volatlity is
a measure of the markets best estmate of the volatlity of
the price of the underlying asset. It is a useful gauge of the
markets percepton of risk, and it can experience very large,
rapid changes in, for example, a fnancial crisis or market
downturn. It is meant to be forward looking and is calculat-
ed from both calls and puts.
There are three variatons of volatlity 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 frst VIX, introduced by the CBOE in 1993, was a
weighted measure of the implied volatlity of eight S&P 100
at the money put and call optons. Ten years later, it expand-
ed to use optons based on a broader index, the S&P 500,
which allows for a more accurate view of investors' expecta-
tons on future market volatlity. VIX values greater than 30
are generally associated with a large amount of volatlity as a
result of investor fear or uncertainty, while values below 20
generally correspond to less stressful, even complacent, tmes
in the markets.
The idea of a volatlity index, and fnancial instruments based
on such an index, was frst developed and described by Prof.
Menachem Brenner and Prof. Dan Galai in 1986. Professors
Brenner and Galai published their research in the academic
artcle "New Financial Instruments for Hedging Changes in
Volatlity," 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 volatlity 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 volatlity index, to
be named Sigma Index, would be updated frequently and
used as the underlying asset for futures and optons... A
volatlity index would play the same role as the market index
play for optons and futures on the index."
In 1992, the CBOE retained Prof. Robert Whaley to create a
tradable stock market volatlity index based on index opton
prices. In a January 1993 news conference, Prof. Whaley
reported his fndings. Subsequently, the CBOE has computed
VIX on a real-tme basis.
35
Market Updates
India has done prety well overall the frst 5 months of 2014. But the year did not start all that well. For the frst 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. Afer this phase, the market began to do well
with the infux 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-tme high
crossing the 22,000 mark and on the same day the Rupee also reached a year high of 60.85. The Nify followed the Sensex and
itself reached an all tme high thenext day. The Infaton rate in mid-march reached a nine month low of 4.68.
With the infaton, fscal defcit and CAD coming down and Modi reaching at the helm of the government, markets started
rising steadily. Few days before electon results i.e. 16
th
May, markets clearly facored in the BJP government. Afer 16
th
May,
when BJP alone was able to garner full majority, bullish sentments were rekindled in the markets taking it to fresh all tme
high i.e. above 25k.
RBI Current Interest Rates (As on 14
th
June 2014)
[Last RBI Policy Review: 1
th
June 2014]
BSE Sensex (Dec 16 to June 14)
Repo rate 8 %
Reverse Repo rate 7 %
MSF 9 %
CRR 4 %
SLR 22.5 %
36
Infaton 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 cautous over politcal developments leading up to general electons.
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 hefy gains in domestc shares and afer
weaker-than-expected U.S. jobs data eased worries about an aggressive reducton in the Federal Reserve's stmulus.
Jan 15: Infaton declines to 5-month low at 6.16 pc, RBI may ease interest rates to prop up growth
Wholesale infaton declined to a fve-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 Nify ends one-month high, closes above 6,300
The 50-share Nify hovered between a high of 6,325.20 and a low of 6,265.30 before setling 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 securites to
ease the liquidity situaton. RBI said the liquidity conditons 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,
afer being net sellers of bonds in 2013.

INDEX

16
th
December

14
th
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
38
Jan 20: MCX-SX exchange kicks of interest rate futures
The IRF contract traded is the 7.16 per cent 2023 bonds on Monday. Cash-setled 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 fscal 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 lef 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 infaton eases as projected it does not foresee further near-term tghtening - Governor Raghuram
Rajan leaves cash reserve rato (CRR) unchanged at 4 pct (read highlights below). Having raised repo rate, RBI Governor
Raghuram Rajan said slowdown in economy getng 'increasingly worrisome'.
Jan 28: Indian bonds fall afer surprise RBI repo rate hike; outlook supportve
Jan 30: Investment limit for foreign investors raised to $10 billion
In a move to atract 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 Insttutonal Investors' investment limit in Power Grid Corporaton to 30 per cent.
Feb 04: NSE Nify recovers from mult-month lows; holds on to 6,000 mark
Afer hitng mult-month lows in early trade, the NSE Nify smartly recovered the lost ground.
Feb 08: RBI removes 26% cap on MFI interest rates

Feb 08: Last bond aucton 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 litle impact on spread of bitcoins and other
virtual currencies, whose number is fast moving towards a century with a total valuaton of close to USD 13 billion.
Feb 17: Budget 2014
Government to borrow 25p for every rupee in its kity. Cars, two-wheelers, soaps set to be cheaper. P. Chidambaram plans to
boost fnancial markets, revamp ADR, GDR scheme. Government cuts Plan spending by Rs 79,000 crores for current fscal.
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 existng futures and optons segment on the NSE.
39
Feb 22: CAD to come down to 2 pct of GDP this fscal: C. Rangarajan
Exports have picked up. Imports have come down not only in relaton to gold but also in relaton to oil.
Feb 23: Indian govt approves eight FDI proposals worth Rs 1,024 crore
Feb 28: India's April-January fscal defcit 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 defcit narrows sharply to $4.2 bn in Q3
Current account defcit 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-afer 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 equites 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 startng next month.

Mar 10: Indian rupee ends at 7-month high of 60.85 vs US dollar on robust FII infows
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-tme high of over 22,000 intra-day; HDFC Bank, L&T shares soar
BSE Sensex hits lifetme high of 22,024 pts and closed at yet another record of 21,935 pts
Mar 11: Emerging market funds see outlows of nearly $30 billion in 2014
Emerging market (EM) funds witnessed another $3.8 billion of outlows for the week ended March 5, extending the outlow
streak to 19 weeks and taking the aggregate outlows for this year to $29.4 billion.
Mar 11: NSE Nify hits lifetme high of 6,562.85, BSE Sensex trading over 22,000-mark
NSE Nify shot up by 0.39 per cent, to trade at an all-tme high of 6,562.85
Mar 13: Banks feel NPA pinch: For every Indian rupee lent, 13 paise go bad
Mar 14: Infaton 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 equites to take Sensex to record high 22055
Mar 27: Bombay Stock Exchange (BSE) 30-share sensitve index (Sensex) closed at 22214
Mar 31: Sensex, Nify hit new lifetme highs in opening trade
Apr 1: RBI kept the indicatve 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 infaton
Apr 8: Indias growth likely to recover to 5.4 % in 2014: IMF
40
Apr 11: Exports dip 3.15 per cent in March
Apr14: Gold regains 30,000 level on strong global cues
Apr 17: Sensex surges 351 points on value buying
Apr 22: Sensex touched a record high of 22,853.03 points
Apr 28: New Foreign Trade Policy to focus on ways to boost exports
May 07: Sensex tanks 184 points as IT, banking stocks decline
May 12: April retail infaton rises to 3-month high of 8.59%, March industrial output shrinks 0.5 %
May 16: Bulls greet BJP show, Sensex soars over 25k , Rupee at 11-month high as BJP sweeps electon
May 23: S&P BSE Sensex, afer hitng an intra-day high of 24746, closed at 24693, Rupee rose by another 10 paise to trade
at a fresh 11-month high of 58.37
May 26: Current account defcit narrows to 1.7 % of GDP
May 30: Indias growth remains subdued at 4.7% in 2013-14
June02: Sensex surges 467 points as funds pick banking, oil stocks ahead of RBI monetary policy review meetng
June 05:Sensex ends above 25,000 for the frst tme, closes at 25019
June 13: El Nio to keep infaton elevated: BoFA-ML
41