THE INVESTOR

VOLUME 2 ISSUE 11 DECEMBER 2009

decoupling: myth or reality? PG.11 Role of real estate in contemporary

Economical Scenario pg. 26
FROM EDITOR’S DESK
My Dear Fellow Niveshaks,
Niveshak
This is my last editorial for your magazine.
Volume II
ISSUE 11 As we are at the doorstep of a fresh new year which is supposed to provide
a break from all the downward slopes, let us take a look over our shoulders at what
December 2009
this year has been and try to find out how the next year is going to be like. We
woke up to the morning of 2009 with the nightmares of Sub-Prime still afresh in
Faculty Mentor our minds only to find an Indian parallel to Enron & WorldCom. An Indian compa-
Prof. S.S Sarkar ny Satyam had hogged the limelight for all wrong reasons. Then there have been
several ups and downs in the stock markets across the globe but steadily all of them
started on an upturn since March. Indian stock markets showed sudden spikes on
THE TEAM the day of declaration of general election results in May but showed negative re-
sponse to a much awaited budget in August. Corporate houses started showing
Editor
profits and commodity prices spiralled up as positive sentiments about sovereign
Biswadeep Parida
economies prevailed. Most of the worst affected financial institutions were among
big bucks, clearing their TARP debts and again jumping back to the dirty business
Sub-Editors
Amit Choudhary of paying hefty bonuses. When it seemed All izz well, stock markets around the
Nilesh Bhaiya world suffered a minor jolt by the so called bankruptcy declaration of Dubai World
Sareet Mishra in November. Towards the fag end of an eventful year, we had a fizzed-out Copen-
Sujal Kumar hagen conference on climate change in December. There were numerous other
interesting stories among several terrorist attacks. It has been quite an eventful year.
New Team But we will try to drag your attention to an altogether different story – the old Team
Bhavit Sharma Niveshak has chosen to make way for a new energetic team.
Durgesh Nandini Mohanty We started Niveshak in August of 2008 just as a Finance Club magazine of
Hitesh Gulati IIM Shillong. A very humble beginning indeed. Since then, 15 monthly issues have
Sumit Kedia come out successfully, more than 400 articles have been written for us from 39
Tanvi Arora institutes and our 15 issues have been circulated in more than 50 top B-Schools
Upasna Agarwal of India. Niveshak today has achieved the feat of being the only monthly B-School
finance magazine with the largest circulation base. A feat we had never dreamt
Design Team
of when we started. We had just assembled a few articles amongst ourselves and
Bhavya Aggarwal
shared in our batch as Niveshak, a platform to share our knowledge. For a few
Sarvesh Chowdhury
months we preferred to stay indoors in terms of articles and circulation. We were
Swarnabha Mukherjee
pampered a lot by our fellow students and faculty members during our infancy.
Tripurari Prasad
Niveshak will always remain indebted to some faculty members who encouraged
and appreciated us for feats we were yet to achieve. Soon, we realised it is high
All images, design and art- time to live up to the expectations of the institute and test ourselves in the hostile
work are copyright of IIM (we felt at that time) territories of other B-Schools. A few members joined and Nive-
Shillong Finance Club shak gained momentum in terms of content, quality & presentation. Amidst lots of
apprehensions and scepticism, we sent our November 2008 edition to all B-Schools
and invited them to write articles for us. The rest, as has been said several times, is
©Finance Club history.
Indian Institute We got numerous appreciation mails, articles and Fin-Q entries from other B-
of Management, Shillong Schools. We were overwhelmed by your response and there has been no looking
www.iims-niveshak.com back since then. We again felt we didn’t deserve the support and encouragement
that other B-Schoolers had showered on us. Every moment we felt we needed to

Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears
no responsibility whatsoever.
 FROM EDITOR’S DESK
Niveshak
improve. Soon we came up with our own website and current affairs stories among
Volume II
many other improvements. On each of our baby steps, we got huge appreciations
and response in terms of articles from our readers in esteemed B-Schools of India.
ISSUE 11
Today, if someone asks me on the reason for success (you may question this) of December 2009
Niveshak, undoubtedly it is the Finance Fraternity of all the 50 top Indian B-Schools
who have supported us throughout the journey. When we asked for your articles Our Contributors Include
for your magazine, you flooded our mail box. We salute your generosity.
It is because of the contributions of yours and your seniors that today Nive-
DoMS, IIT Delhi
DoMS, IIT Chennai
shak can be referred to as the Finance magazine of all B-Schools of India. We are
DoMS, IIT Roorkee
extremely thankful to all our article contributors across all B-Schools and to all our
FMS, Delhi
subscribers who en¬couraged us through their appreciation mails and by increas-
Great Lakes, Chennai
ing the count of our subscription. We are also thankful to Public Relations com-
IIFT, Delhi
mittees of all B-Schools of India who have circulated Niveshak among their partici-
IIM, Ahmedabad
pants. We are thankful to all our faculty members who inspired us during difficult IIM, Bangalore
times and whose support and encourage¬ment made us see this day. Most of IIM, Calcutta
all, we thank all the participants of IIM Shillong, without whom Niveshak would IIM, Indore
not have completed 15 glorious issues. On a more personal note, I was privileged IIM, Kozhikode
enough to get an opportunity to work with some of the brightest brains like Amit, IIM, Lucknow
Nilesh, Sareet, Sarvesh, Sujal & Tripurari as a part of Team Niveshak. They filled the IMNU, Ahmedabad
journey with passion, fun and learning. Niveshak would never have been the same IMT, Ghaziabad
without them. JBIMS, Mumbai
But as time passes by, we choose to pass the baton to more deserving people KJSOM, Mumbai
who can match your expectations better. We have selected a team comprising of MDI, Gurgaon
Bhavit, Bhavya, Durgesh Nandini, Hitesh, Sumit, Tanvi, Swarnabha & Upasna who MIB, Delhi
we think can serve you better than we did. I just wish that this new team is fortu- NITIE, Mumbai
nate enough to get the same love and support from you. Let us wake up to 2010
NMIMS, Mumbai
with the fresh new team, a fresh commitment and a hope to see the bull running
SCMHRD, Pune
SIBM , Pune
on the streets of world finance markets.
SIIB, Pune
This is your editor Biswadeep signing off for the last time. Merry Christmas and SIMS, Pune
a very Happy New Year. SIOM, Pune
SITM , Pune
Stay Invested with us! SJMSoM, Mumbai
Sydenham, Pune
Biswadeep Parida TISS, Mumbai
(Editor-Niveshak) VGSOM, Kharagpur
On behalf of the Outgoing Team
Wellingkar, Mumbai
XIM, Bhubaneshawar
XLRI, Jamshedpur

©Finance Club
Indian Institute
of Management, Shillong
www.iims-niveshak.com

Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears
no responsibility whatsoever.
CONTENTS
Niveshak Times
05 The Month That Was article of the month
07 Current Financial Crisis:
HE SPeaketh Another Lost Decade?
14 Mr. Kumar Sanjay Krishna

Perspective
17 Valuing Human Resources
31 Socialist Aptitude and
Capitalism
fingyaan
11 Decoupling: Myth Or
Reality?
26 Role Of Real Estate In
Contemporary Economical
Scenario: The Way Ahead

34 High Risk, High Reward: A

21 Cover Story
Review Of Changing
Market Efficiency In The Currents On Executive
Real World Compensation

Finsight
29 Hangover On Wall Street

Fin Lounge
30 FinToon
37 Nivesh
 Niveshak Times www.iims-niveshak.com

The Month That Was

Tanvi Arora
Team Niveshak

MARKET WATCH
or 2.33% over its preceding weekend’s close. The
It has been a turbulent one month with respect Nifty too slipped down by 129.60 points or 2.53% to
to the stock markets all over the globe. The current settle the week at 4,987.70 from its last weekend’s
trend in the stock markets is in an ambiguous state close.
and needs to get a clear direction to determine the
exact market conditions. As of now, it is difficult to
sustain any upside on the market due to these fluc- Bharti plans to buy 70% Warid Telecom
tuations. Bharti Airtel looks forward to extend its func-
Although the week beginning 22 November tioning and control overseas as it plans to buy a
started on a positive note and Sensex touched a major stake in Bangladesh’s fourth biggest mobile
high of 17,290, the fear of the Dubai debt meltdown phone operator, Warid Telecom. The move comes
and derivatives expiry resulted in the markets crash- just two months after its unsuccessful attempts to
ing to a low of 16,210. Finally the markets recovered merge with South Africa’s MTN. It is working on seek-
and closed at 16,632 points (down by 2.3 per cent ing permissions from the Bangladesh Telecommuni-
as compared to previous week’s closing, a fall of cations Regulatory Commission to buy a 70% stake
390 points). The affected stocks included majors like from the Abu Dhabi group, the owner of Warid. Bhar-
TCS, ICICI Bank, Reliance Communications and NTPC ti Airtel estimates the Warid group to be worth $318
by 3-5 per cent each.The another major index of In- million. These valuations include Warid Telecom’s
dia, Nifty soared up to a high of 5,138, and fell down operations in Uganda and the Republic of Congo.
to a low of 4,807 in the same week. The week saw
the Nifty settling at 4,942, at a loss of 111 points.
Industrial Output shows a rise of 10.3%
The strong GDP figures at the beginning of the
Industrial output grew by 10.3% in October as
week (29 November – 4 December) brought good
compared to the last year. This was lower than the
news for the market. Also, it helped to pacify the
market expectations and hence left the investors
investors troubled by the Dubai debt fiasco. Though
disappointed and speculating about the India’s eco-
the week had its own share of ups and downs at
nomic recovery. One of the three components of the
both the major indices, the markets closed with a
index of industrial production (IIP), manufacturing
gain of 2.8 percent on Sensex and 3.4 percent on
revived as the factory output increased by 11.1%.
Nifty .The BSE Sensex saw the highest intraday at
This increase in manufacturing still could not affect
17,361 in the past six weeks. It settled at 17,102, an
the industrial output satisfactorily. Not only this,
increase of 470 points as compared to the previous
even the automobile sales increased by 61% in No-
week. Meanwhile, the Nifty closed at 5,109 points,
vember. The IIP grew in the last three months at a
up by 167 points from last week.
rate of 11% in August, 9.1% in September and 0.1%
The market in the week from 7 December – 11 in October. Though the last month was almost flat,
December were majorly affected by lower than ex- still the markets had a lot of expectations.
pected industrial output and investors’ speculation
about rising inflation. The week ended at 17,119.03
on Sensex, an increase of 0.1% over the previous Exports grow by 18.3% in November
week. Nifty went up by 8.4 points to close at 5117.30. After a span of 13 months, exports finally
The turbulent market settled after two-weeks showed a positive growth of 18.3%. The exporters
of gains and the benchmark Sensex fell by nearly and policymakers though decided to be cautious
400 points during the week (14 December – 18 De- and not go haywire about the news. The major push
cember). This week Sensex touched a high of 17,275 in the exports was due to Christmas buying which
only to end at 16,719.83, a steep fall of 399.20 points resulted in exports reaching $13.2 billion. Among

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 5

 Niveshak Times www.iims-niveshak.com

The Month That Was

the reviving sectors were gems & jewellery, which FDIC would receive help of about $45 billion as the
moved up by 34% to $2.15 billion, and petroleum banks would prepay it the three years’ industrial
products, which grew 84% to $2.4 billion. The sectors assessment.
including basic chemicals, iron ore and leather also
saw an increase.
Debt-laden Dubai stirs world
This month Dubai stirred the entire world up as
GDP grows by 7.9% its debt problems raised concerns about corporate
The gross domestic product (GDP) for India exposure. It also stands at major risk of the repa-
grew by 7.9% in July-September 2009 as compared to triating funds by its foreign investors. Dubai’s eco-
6.1% of the previous quarter. Not only did this rise nomic growth depends largely on its Dubai world.
beat market expectation but also the anticipation Hence the creditors of Dubai world and Nakheel
of the Finance Minister who had envisaged it to be property group have been asked to consent on a
around 7% for this fiscal year. These figures are in debt standstill. India reacted as the gold lost its
line with the ones before the slow down and give an shine, stocks collapsed, rupee weakened and the re-
indication towards the revival of country’s economy. turns on bonds dropped. In this scenario of predica-
Although the agriculture sector saw a growth of less ment, Abu Dhabi has agreed to help Dubai come out
than 1% in its output, it was compensated by other of its debts, however it has clearly indicated that it
sectors like community services, mining and quarry- will not write-off their debts. Abu Dhabi has already
ing, boarding and lodging which had a considerably given $15 billion to Dubai indirectly through 2 private
large increase in the last quarter for FY 2009-10. The banks and UAE central bank.
financial analysts however speculate the third quar-
ter to be critical as the agricultural GDP is expected
to be negative. These improved growth figures will Satyam lies again
also increase the anxiety of the industry regarding The CBI claimed yet another incident of fraud
government’s future action regarding the stimulus at Satyam Computers on Tuesday, November 24, al-
packages. most two years after Raju, the founder of Stayam,
had admitted to fraud in his company. This time it
was a scam of around Rs 5000 crore. As per CBI,
US banks still feel the heat of loans people indicted for Satyam fraud case had pledged
The number of US banks that have closed down their share in the stock at an inflated price. Also,
has increased to 130 as 6 more banks were seized they forged the board resolutions to raise loans and
by the FDIC regulators last Friday. Though the gen- divested stocks at a higher value. These new fraud
eral economy is showing positive signs, the banking charges are different from the previous Rs 7000 crore
industry is slow to recover as FDIC speculates clos- fraud.
ing down of small banks for another year. The bank
failures in the state of Georgia numbered to 24 with
three more being unable to bear the burden of loans
last week. The other three were in Virginia, Illinois
and Ohio.
The AmTrust Bank of Cleveland, Ohio, had as-
sets worth $12 billion. The other 5 were holding as-
sets of even less than $1 billion. The major reason
of the failure of small banks is the fact that real
estate was one field where they were actually at
par with larger banks during the boom period. The

6 NIVESHAK VOLUME 2 ISSUE 11 december 2009

The current financial crisis
In the last 38 years (1970-
2008), there have been 124 banking
crises, an average of 3.4 every year.
Some have been minor, others very
serious and long-lasting, like the one
in Japan from 1991 to 2002. The most
recent is the financial crisis that
started in the US in July 2007 and
is playing out in front of us today.
Infact, the current financial crisis is
in many ways very similar to Japan’s
lost decade. This article attempts to
seek out the similarity and differ-
ences between the two. This could
possibly help us learn from the mis-
takes that were made in the past.
Although the current crisis de-
veloped much faster than Japan’s
crisis, the key mechanism is the
same- They both started with busted
stock-and- real-estate bubbles. With
both the United States and Japan,
the meltdowns were ignited by loose
credit policies, lack of oversight from
government regulators, market ana-
lysts or such private-sector sentinels
as credit-rating agencies, and were
finally fanned into a frenzied finan-
cial blaze by the promise of easy
profits.
Japan’s lost decade
Japanese “lost decade” of the
1990s led to over a decade of de-
flation and slow growth.At the end
of the 1980s, Japan was on the peak
of prosperity. Surging exports had
pumped up the economy and the
value of the yen. The stock market
had also climbed to dizzying heights.
Banks loaned money with only cur-
sory background checks. However,
Japan’s economy has been in a dis-
mal state since. Between 1990 and
2005, property and stock values col-
lapsed and economic growth slowed
to little more than 1 percent annu-
ally.
Japan’s financial deregulation
began in the late 1970s with reforms
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
Another L O S T decade?
Gayatri Kapur
SPJIMR, Mumbai
in the bond, foreign exchange, and
equity markets. This allowed Japa- The Japanese finan-
nese companies to raise capital cial crisis has been
cheaply from the capital markets,
especially in the foreign bond mar-
juxtaposed with the
ket. As a result, savers could invest Recession of 2008
in the equity markets, thereby erod- exposing some stark
AoM
ing the dominant position banks en- similarities. The de-
joyed in the financial system.
cade that the Land
Due to fierce competition and
declining margins banks were forced of Rising Sun lost
to look for alternative sources of had been very much
business and also to increase their like what the world
risk profile. As a result, they lent ag-
underwent recently,
gressively to the property market,
consumers, small-medium size en- marked by bubbles
terprises, and for share purchases. and indiscriminant
This coincided with a period lending by banks.
of high economic growth and low
inflation which boosted asset pric-
es to unprecedented levels. Banks
lent based on collateral rather than
cash flow. In the equity market, the
keiretsu system, where Japanese
banks and large corporations have
large cross-holdings of each other’s
shares, encouraged poor corporate
governance and lax lending practic-
es. The rise in equity prices boosted
Japanese banks’ capital and enabled
them to push out more loans. Be-
tween 1980 and 1996, loans to the
property and construction sector
nearly doubled from 11% to 19%;
loans to the financial sector tripled
from 3% to 10%; whereas loans to
the manufacturing sector dropped
from 32% to 15%.
The Nikkei stock index doubled
between 1980 and 1985 (7,116 to
13,113) and then tripled between
1985 and 1989 (13,113 to 38,916).
Likewise real estate prices as mea-
sured by the urban land price index
for six major cities quadrupled in 10
years from 68 in 1980 to 285 in 1991.
The fall in asset prices had an
enormous impact on banks. A de-
cline in the price of stocks held by
7
 banks eroded their capital base and forced a reduc-
tion in lending. In addition, a drop in land prices
reduced the collateral value for banks’ loans, in-
creased their non-performing assets, and necessitat-
ed a write-down of their loan value and a provision
for these losses. The graph below illustrates con-
siderable capital loss in land and shares combined
during the crisis period in Japan.
AoM
Non-performing loans (NPLs)
The NPLs problem erupted into a crisis in 1995
when Jusen companies were left with huge amounts
of non-performing housing loans. Jusen companies
are finance companies that provide consumer and
mortgage loans. In August 1995, the Ministry of Fi-
nance (MoF) estimated that Yen 9.6 trillion of jusen
assets (74%) were non-performing. The government
spent Yen 680 billion to bail out these jusen com-
panies.
Even though non-performing loans rose, banks
and policy makers were slow or reluctant to face the
problem, and did not take radical corrective actions.
For example, specific provision for loan losses by 21
big banks amounted only to Yen 4.3 trillion in March
1995. Policy makers mistook the slump for a short
business cycle correction and did not apply enough
fiscal stimuli to revive the economy.
The economy became worse and the problem
became a full-blown crisis by the end of 1997 with
the failure of Hokkaido Takushoku Bank, one of the
19 largest banks, and Yamaichi Securities, one of
the big four securities companies. A year later the
government rescued and nationalized another two
major banks - Long Term Credit Bank and Nippon
Credit Bank. The collapse of large financial institu-
Japan’s Nikkei was at 8,000
in October 2008 compared to
its height of 39,000 in 1989.
8 NIVESHAK VOLUME 2 ISSUE 11 december 2009
tions sent the ‘Japan premium’ soaring to 100 basis
points above Libor. By the fall of 1997, the MoF had
announced NPLs at Yen 77 trillion (16% of Japan’s to-
tal bank loans or 15% of GDP). In December 1997, the
government made available Yen 30 trillion to solve
the problem, of which Yen 13 trillion was to recapi-
talize banks, and Yen 17 trillion to protect depositors
in insolvent banks. Between 1992 and 1998, the top
21 Japanese banks wrote off Yen 42 trillion of bad
loans; this was significantly larger than their equity
base of Yen 22 trillion.
The collapse of the asset bubbles sent many
companies into defaults that in turn caused banks
to suffer huge losses from NPLs. The banking cri-
sis hence prolonged the economic stagnation of the
country. Between 1992 and 2002, Japan’s GDP grew
at an annual average of 1.1%, with negative growth
rates in the late 1990s. Faced with stagnation and de-
flation, many corporations defaulted on their loans;
this served to deepen the vicious cycle - banks’ NPLs
and losses mounted, forcing them to cut back on
lending. The credit crunch in turn caused a contrac-
tion in the real economy.
Despite the Bank of Japan dropping interest
rates to 0.5% (1995-2000) and to 0.1% (2001-2005),
and the government pump-priming sending govern-
ment debt to 160% of GDP, bank loans shrunk and
the economy continued to stagnate. Japan was suf-
fering from a liquidity trap where the central bank,
having dropped interest rates to near-zero, was un-
able to influence the real economy with its monetary
policies. Pumping more liquidity into the system
could not jump-start the economy.
Japan lost a decade of growth and did not get
out of stagnation until 2003. The stock and property
markets never really recovered. Japan’s Nikkei was
at 8,000 in October 2008 compared to its height of
39,000 in 1989, and the urban land price index at 79
in 2007 compared to its height of 285 in 1991.
The current financial crisis
The current financial crisis is in many ways
similar to the Japan’s financial crisis in the 1990s.
However, what is disturbing is that the meltdown
has shown global consequences. Contributors to this
downturn include high oil prices, high food prices,
and a credit crisis leading to the drastic bankruptcy
of large and well established investment banks as
well as commercial banks in many nations around
the world. This crisis has led to increased unemploy-
ment, and other signs of contemporaneous econom-
ic downturns in major economies of the world. In
fact, in December 2008, the NBER declared that the
United States had been in recession since December
2007.
The main causes of this unfortunate downturn
are similar to the ones seen in Japan, i.e. indiscrimi-
nant lending, creation of asset bubble due to excess
liquidity in the past. This has also been complicat-
ed by complex securities which have bad assets as
their base. Also, what is troubling is that both the
faster than Japan’s crisis, the key mechanism is the
same. Loose monetary policy and high savings levels
(by Japanese households in Japan’s case, China and
oil exporters in current crisis) created a large pool
of money looking for investments to buy. Moreover,
rising prices encouraged speculation in both real es-
tate and stocks. Inefficient underwriting standards
and willingness to lend against real estate as col-
lateral meant that banks made hundreds of billions
of dollars’ worth of loans that were sustained solely
by rising prices. When prices fell, those loans lost
most of their value, crippling banks’ ability to lend
to creditworthy borrowers and choking the economy.
Similarities can be illustrated by the following

AoM
government and the consumers in the US have lev-
eraged themselves to an unsustainable level. In the facts:
US, the personal savings rate was 12% in the early • Since 1991, average Japanese home prices have
1980’s and reached negative 1% during the Bush ad- fallen about 40 percent. Similarly, in some parts of
ministration. It has inched above 2% in the last few the United States, housing prices have dropped by
months. Consumers have utilized easy debt to main- more than 35 percent, and many economists expect
tain their desired lifestyle. The consumers have now average U.S. home prices to fall for at least another
begun to reduce spending, pay down the debt and year.
increase savings to resolve their problem of excess • The Bank of Japan had a lax monetary policy
debt. Now, with consumer spending accounting for for most of the 1980s. In the United States, the Fed-
72% of GDP in the US, the country is experiencing a eral Reserve did the same thing beginning in the late
serious recession due to the decrease in consumer 1990s. In both cases, easy money fueled liquidity
spending. The government and Federal Reserve have booms that led to major bubbles.
already committed $8 trillion of taxpayer funds to
bailing out insolvent banks. The US government is • The unwinding of excessive corporate indebt-
now expected to spend in excess of $1 trillion in an edness in Japan and a “keiretsu” culture of compa-
effort to stimulate the economy. nies buying one another’s equity shares put extraor-
dinary pressures on business spending. Similarly, in
The graph below illustrates increasing house- America, an excess of household indebtedness could
hold debt as a percentage of GDPs and decreasing put equally serious and lasting restrictions on con-
personal savings rate over the years. sumer spending.
• Looking at Japan, we know that the interplay
between financial and real economic bubbles causes
serious damage. An equally lethal interplay between
the bursting of housing and credit bubbles is now at
work in the United States and the rest of the world.
The dissimilarities
There are two major differences between the
current policy response and the response in Japan
in the 1990s.
• The U.S. government has moved much more
quickly to attempt to fix problems in the banking
sector. Banks have already taken close to $1 trillion
The similarities in write downs, although many write downs may
Although the current crisis developed much still be hidden in bank balance sheets. In addition,

The Bank of Japan had a lax

monetary policy for most of the
1980s. In the United States,
the Federal Reserve did the
same thing beginning in the
late 1990s

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 9

 interest rates have been dropped to 0.5% from 5.25%
in a matter of months and hundreds of billions of
dollars of liquidity have been pumped into the fi-
nancial system. So far this has prevented the finan-
cial system from collapse but has not had the effect
of arresting the credit crunch.
• The Fed has in just a few months acknowl-
edged that its main monetary instrument - the Fed
funds rate - is no longer useful, and has instead
hinted at a broader program of quantitative easing,
through some combination of printing money and
buying all sorts of assets to prop up prices and push
down yields. This was a major topic of Bernanke’s
famous 2002 speech on fighting deflation, which was
AoM
for the financial crisis due to the collapse of asset
prices. While Japan undertook huge fiscal stimulus
packages repeatedly in the 1990s, the government
did not pursue a serious policy effort to make banks
dispose of their nonperforming loans. As a result, a
huge amount of hidden nonperforming loans swelled
under implicit collusion between the government
and banks. The essential problem was the spread-
ing of payment uncertainty, and policies centered on
public works and tax cuts were not direct enough to
attack the problem, though they were temporarily
effective at mitigating the severity of the economic
downturn. Direct debt relief for mortgage borrowers
and distressed (but viable) firms, along with fiscal
assistance for the liquidation of nonviable firms, are

written with the Japanese experience in mind.

Learnings from Japan
• Debt restructuring is absolutely
necessary to prevent a vicious cy-
cle. Debt relief and rehabilitation
of viable but debt-ridden firms
and the liquidation of nonviable
firms are important to wipe out
the payment uncertainty from the
economy and restore market confi-
dence.
• Stringent and conservative
evaluation of the toxic assets should
be the premise behind bank-capital
injections and debt restructuring. Financial regula-
tors should establish a system for asset evaluation
and push financial institutions to recalculate their
asset values conservatively enough so that the mar-
ket can rely on their numbers.
• If bad assets are disposed of by distress selling
in the market, stringent asset evaluation will result
in a vicious cycle of debt deflation. This distress sell-
ing can cause asset prices to decline further, which
in turn can accelerate the distress selling of assets.
To stop this vicious cycle of debt deflation, the gov-
ernments should establish asset management com-
panies, public entities that purchase and hold the
bad assets. The purchase and freezing of toxic as-
sets is necessary to stop debt deflation. The public
entities should then restructure the bad assets and
sell them off gradually after the market stabilizes.
• One big lesson from Japan’s 1990s is that
Keynesian policy or fiscal stimulus did not work
straightforward, cost-effective fiscal policies much
more capable of wiping out the payment un-
certainty than standard
public works and tax
cuts.
• The development of huge
nonperforming loans in Japan was
made possible by the virtual non-
existence of mark-to-market ac-
counting for bank assets. Although
suspension of mark-to-market ac-
counting may temporarily calm the
panic, it may also enable bankers to
hide their toxic assets from regulators and market
participants.
In conclusion, we can’t be sure that we won’t
see a replay of 1990s Japan. The bailout packages
so far have been notable for their attention to the
interests of existing shareholders. Simply because
a broader arsenal of tools is being used than those
which were used in Japan it doesn’t mean these
tools will work. Japan managed to create its boom
and bust largely on its own, and when it did begin to
come out of its lost decade it was largely thanks to
exports to a booming world. This time, with more or
less the entire world slowing down in unison, there
is no external growth engine to bail us out. The lon-
ger this crisis drags on without improvements in
personal consumption and inflation, the more it will
come closer to Japan.

The longer the Global Reces-

sion drags on without improve-
ments in personal consumption
and inflation, the more it will
come closer to Japan.

10 NIVESHAK VOLUME 2 ISSUE 11 december 2009

DECOUPLING
Decoupling theory, as the
name suggests, decouple emerging
world markets from US markets. The
followers of this theory believe that
“because of the strong GDP growth
of many developing countries, espe-
cially of China and India, their mar-
kets will remain bullish even at the
time of US recession. They claim that
emerging economies have made sig-
nificant progress in achieving strong
domestic demand growth and reduc-
ing external vulnerabilities.
The decoupling is just opposite
of “coupling” which talk about the
integration and synchronisation of
two economies. The most significant
synchronisation is the Business Cy-
cle Synchronisation. The main points
of this theory are as follows:
• Increased trade implies de-
mand shocks in one country lead to
output shocks in another.
• Shocks such as commodity/
oil prices can affect all countries.
• Monetary policy shocks can
get transmitted.
• Increased financial integra-
tion implies financial shocks in one
country may lead to contagion.
Trade Integration
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
M Y T H OR REALITY??
Ankit Khetan
IIM Calcutta
The exports done by India have in-
creased consistently 2002 onwards. The decoupling
Exports account for around 22% of of the emerging
Indian GDP and major trading part- economies from the
ners are European Union, US and
China. Higher percentage of Export
developed econo-
in GDP indicates higher level of mies of the world
trade synchronisation and if there has been dealt with.
is demand shock by 1 major trading Today the emerg-
partner then it’s bound to affect the
Indian exports which will finally af- ing economies have
fect the GDP growth rate. It can be made significant
argued that this situation might be progress in achiev-
avoided by diversifying the exports
ing strong domestic
portfolio in coming years between
different economies. But it has to be demand growth and
taken in account that business cycle reducing external
of major trading partners of India is vulnerabilities.
highly synchronised. So, if there is
a demand shock from US economy
then there will be demand shock
from European Union also, although
this effect might be delayed.
A very handy way of looking
FinGyaan
at this synchronisation will be Index
of Industrial production (IIP) of In-
dia and how it has been affected by
the change in business cycle of US
(graph 1). It can be seen that during
recessionary periods of US economy
(indicated by the red line in the
graph 1), the industrial production
of India has gone down. It shows
that downturn in one economy and
decreased demand by it leads to de-
creased production in India as there
is a demand shock.
Graph 2 shows the IIP of India
versus the IIP of advanced economy.
After liberalisation of Indian econ-
omy it has integrated with other
developed economies of the world
Increased trade implies de-
mand shocks in one country
leading to output shocks in
another
11
 Graph 1: IIP of India over the years

Graph 2: IIP of India vs IIP of advanced economy

on an increasing basis. There is high correlation be-

FinGyaan

tween the IIP of India and advanced economy post

2000.
Financial Integration
Indian financial markets like stock markets are
more vulnerable to the risk emanating from else-
where in the world. This is because of dominant role
played by the Foreign Institutional Investors (FII) in
the market and huge amount of speculative money
present in the market.
This is because of diversified exposure that FIIs
have in various asset classes globally, like real es-
tate, the commodity market, bullion, the sub-prime
mortgage market, currency trading, exchange traded
funds (ETF), the bond market and equity markets,
among others. Any losses incurred by them in any
one of these asset classes will be compensated by
booking profits in some other asset class. And going
forward, emerging markets equities being the most
profitable asset class will continue to feel the pres-
sure more even if their economies are on a solid
growth path.
This can be clearly interpreted from the follow-
ing graph of BSE Sensex versus Dow Jones Industrial
Average (white line indicates Dow Jones) during 2007
and 2008 respectively.

12 NIVESHAK VOLUME 2 ISSUE 11 december 2009

 It can be seen that a bull rally started in US
stock markets from March 2007 and how In-
dian equity markets followed the trend. Then
Subprime Crisis began to surface in July 2007.
This led to a panic in markets but after the
steps taken by Fed it rallied back again and In- 2008
dian markets again followed. Post September on-
2007 US markets began to crash but Indian wards the GDP of
markets continued to rally as participa- US has declined
tion from Indian retail investors and and there is an
mutual funds had increased and impact on India’s
speculative money was pouring in. GDP also as this is
But as discussed earlier the the period of recession. This
l o s s indicates that if global economy is
slowing down then India cannot
b e a n exception and its growth is
bound to be affected. But it will only be
to a certain ex- tent as we have a develop-
in US ing domestic market which is becoming huge. This
market can be figured out from the fact that while in first
and the quarter of 2009 US GDP continues to decline on a
liquidity rapid pace, the Indian GDP growth rate stabilises in
crunch led the first quarter.
to the FIIs book-
ing profit in Indian
markets and in graph of
2008 we can see that a high-
er correlation between Dow Jones and BSE
Sensex.
The correlation factor between Dow Jones and
BSE Sensex in 2007 was 0.211 and it increased to

FinGyaan
0.352 in 2008 which shows that in time of recession
or economic crisis the Indian financial market are
more likely to follow US as there is higher level of
integration due to FIIs.
However, the fall in the equity prices didn’t
have any impact on other asset classes in India, es-
pecially the real estate sector, as expected by certain Conclusion
sections of the market. But a fall of this magnitude
Complete decoupling of Indian economy re-
in the equity market has definitely given an indica-
mains a farfetched idea as higher level of trade and
tion of the possible future events to unfold, i.e., the
financial integration exists with economies like US,
systemic risk associated with equity market where a
European Union and China. If one of these econ-
liquidity crunch could potentially spill over to other
omies goes in recession then it’s bound to affect
asset classes and that is what actually happened.
the growth rate of other. But if the domestic mar-
Growth ket is developed, then the adverse effect of demand
shocks and financial shocks will be limited.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 13

 Speaketh
Story

Kumar Sanjay Krishna

Joint Secretary, Department of Economic Affairs, Ministry Of Finance
Kumar Sanjay Krishna, Joint Secretary in the Department of Economic Affairs in Ministry of Fi-
Cover

nance, Government of India, is in charge of Bilateral Economic matters and India Aid Program. Before
joining in Ministry of Finance, he was Director in Prime Minster’s Office (2004-2006) and Director,
He

Tea Board in New York (2001-2004).

Krishna, who is an IAS officer of Assam cadre held posts (1985-2001) such as Managing Director,
Kumar Sanjay Assam Tea Corporation Ltd, Secretary to Government of Assam, Food and Civil Supplies Department,
Krishna in his Commissioner & Secretary, Education, Forest, Excise Departments, District Magistrate in Guwahati
and Tezpur.
interview with
Sanjay Krishna did his graduation from St. Stephen’s College, Delhi and post-graduation from Delhi
Biswadeep Parida University in Physics. He also attended programs in IIM, Banglore and JFK School of Government,
talks about the Harvard University.
growing economic Niveshak: Of late India has become an
power of India and important force in most of the multi-
lateral talks in the world. It has been
its implications in the
leading talks in the WTO ministerial
global power play. and has been a regular invitee at the
He also shares his G-8 talks along with China. Has the
world changed the way they have
knowledge about
been looking upon at India? How
the development does being a part of G-8 meeting help
on the G8 front and India?
the significance of Mr. Krishna: It is no doubt that India is
an emerging global economic power.
the decisions taken
Despite global economic recession, In-
by the often touted dia’s economic growth during 2008-09
superpowers of the remains 6.7% against average growth of
8.8% over five years from 2003-08. The
world. With bur-
World Bank projects that over the pe-
geoning RTAs and riod 2005-2020, India will grow at 5.5%
BTAs on the world’s a year. Even this conservative estimate
negotiation table, he implies an increase in the India’s share
of the world economy from 1.7% in
opines about the fu- 2004 to 2.4% in 2020. Goldman Sachs
ture of international BRIC Report suggests that India would
trade. The interview emerge as the third largest economy in
the world by 2035. According to the re-
wraps up with a port of Goldman Sachs, the Indian econ-
reflection on the role omy is poised to overtake Italy in 2015,
of India in providing France in 2020, Germany in 2025 and
Japan in 2035, when China will occupy
help to Africa. the second place and the U.S. the first.
Five years later in 2040, BRIC countries
will collectively overtake the economies
of G-6 nations – Britain, France, Germa-
ny, Italy, Japan and the United States.
Therefore, it is clear that India will be
economic power house in the medium
term and its growth has significant im-
pact on the world economy. Reflecting
these developments, India is playing a
very important role in the global gover-
nance and economy.
Owing to its growing importance in
the global economy, India has been
invited along with other emerging
countries for Outreach meeting with
the G-7 /G-8 since 2005. Most signifi-
cant outcome of the G-20 Pittsburgh
Leaders Summit in September, 2009
is the initiative taken by the USA to
make the G-20, a Premier Multilater-
al Forum for discussing international
economic issues. The expectation is
that G-20 would replace the G-7/G-8.
Expectations from the G-20 Forum are
growing especially since its interven-
tion is globally perceived to have pre-
vented the current global crisis esca-
lating into another great depression.
There is wide spread expectations
that given its spectacular track record
over a short period, the G-20 may
step to try and resolve tricky issues,
that have eluded global consensus,
as in the case of climate change and
international trade. However, much
of its success has been achieved in
crisis situation, where consensus is
much easier and it remains to be seen
whether it would be equally effective
in resolving contentious issues in nor-
mal times.
Niveshak: How committed is G-8
in helping developing countries in
fighting poverty, providing devel-
opment assistance to developing
world, issues relating to climate
change etc. Are issues like achieving
of MDGs and development of Africa
still important for developed world?
What are India’s views on Climate

14 NIVESHAK VOLUME 2 ISSUE 11 december 2009

change financing? are trying to divert their ODA to climate and environ-
Mr. Krishna: The year of 2005 was a year of develop- mental issues. The developing world believes that pov-

ment when the international community undertook a
number of initiatives including Paris High Level Forum
on Aid Effectiveness, G-8 Gleneagles Summit, United
Nations World Summit etc. These meetings produced
a number of declarations and initiatives intended to
advance the development agenda and to generate mo-
mentum towards achieving Millennium Development
Goals (MDG). At the Monterrey Conference on Finance
for development in 2002, over 50 Heads of State, Fi-
nance Ministers and Foreign Ministers called on de-
veloped countries to make concrete efforts towards
the target of 0.7% of Gross National Product (GNP) as
Official Development Assistance (ODA) to developing
countries. Only a handful of donor countries were on
track to meet these commitments till 2005. This failure
to translate international commitments into concrete
action points led to monitoring of the progress of the
commitment a part of the 2005 pledge.
Since 2002, G-8 leaders have also given importance on
development in Africa an agenda of global perspective.
In early part of first decade of 21st century, 40% of sub tiated responsibilities and respective capabilities. Vast
Saharan Africa, 600 million people live on less than
US $1 per day. Africa’s average per capita income is
lower than it was 20 years ago while human develop-
ment has declined in recent years. MDG No.8, which
aims to halve poverty by 2015, can be met globally
only if there is substantial poverty reduction in India
and China which together accounted for 60% of the
World’s poor in the base line year of 1990. Most African flows through carbon markets in developed countries
States will be hard pressed to achieve any of the MDGs
because of current trends both in Africa and among
donor countries.
One of the achievements of last few years have been
to focus on quantifiable targets in MDGs which have
helped put aid back on to the international agenda.
This helped encourage Governments to commit finan-
cial resources for development. In 60’s and 70’s devel-
opment was thought as implementing through huge
capital projects but development policy has evolved Mr. Krishna: Regional Trade Agreements (RTA) have be-
substantially since then and is very focussed now on come in recent years a very prominent feature of Mul-
social nature and human capital, macro and micro tilateral Trading System (MTS). The surge in RTAs has
economic policies and aid efficiency.
During the G-8 Summit in Okaya, Japan, a number of
organizations called upon G-8 nations to take urgent
and firm action to address worsening global poverty,
soaring food and oil prices, promote energy efficiency
as well as secure a reduction in carbon emissions. G-8
countries are serious about climate change issues and
He Speaketh
erty alleviation in developing countries should be the
first and foremost priority of the G-8 countries and the
commitment of the Monterrey should be achieved first
before diverting their ODA to climate issues in develop-
ing countries. However, it is now felt by most of the
countries that in addition to the historical responsibil-
ity of the industrialised countries, it is the responsibil-
ity of the all the countries to protect and preserve the
earth through the concept of common but differenti-
ated responsibilities.
India’s view on climate change is that no discussion
can be taken forward without underscoring the deep
inequity in the causes and impact of climate change.
The current global architecture for delivering and fi-
nancing mitigation and adaptation efforts is mandated
under the multilaterally negotiated UNFCC. This frame-
work provides for new, additional, adequate and pre-
dictable financing and transfer of relevant technology
by developed country Parties to developing country
Parties. It must be in principle of common but differen-
funds are required for financing climate change miti-
gation and adaptation. These would be best provided
through mandatory assessed contributions from devel-
oped countries, at least of the order of 0.5% of their
GDP to meet the incremental cost of combating climate
change in developing countries. This should be distinct
and additional to ODA. It is also felt that while private
and CDM are welcome, they cannot become the main
vehicle for climate change financing.
Niveshak: Are multi lateral cooperation or trade fo-
rums less successful compared to bilateral allianc-
es? WTO is at crossroads, most of the world trade is
being carried on bilateral agreements and handful
of multilateral agreements like Safta, Nafta, Asean
etc. What do you see as the future on international
trade?
continued unabated since the early 1990s. 421 RTAs
have been notified to the GATT/WTO up to December,
2008. RTAs can be used as a tool for material man-
agement, cheaper imports, domestic prices in control,
better quality products at competitive prices, better
market access, mutual recognition of standards and
laboratories, trade facilitation, harmony in customs

Mr. Krishna likes Tennis,

Photography, Music and he
never misses good cinema of
any language.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 15

 procedure etc. The main motivations for RTAs are to
maintain market access, attract foreign direct invest-
ment and counter balance other RTAs.
He Speaketh
Economies are divided over desirability of regional
trade agreements in a multilateral trade regime. The
threat to the multilateral trading system does not ap-
pear to be as large as is often reported. The debate
about whether RTAs are building blocks or stabilizing
blocks for global free trade, faded because whatever
the answer to the question, in practice RTAs have made
little difference either way. The impact of the global
trading regime of hundreds of RTAs notified to the
GATT/WTO as being in contravention of the MFN prin-
ciple has been trivial compared to the establishment of
multilateral trade law based on the non discrimination
principle. The dissemination of regionalism can con-
tract and distort non-discriminatory multilateralism.
There is still no consensus about this issue. However,
regionalism with its advantages and drawbacks is a
reality of the current global trade regime. The wave
of regionalism is likely to intensify in the near future.
If a very large proportion of global trade gets diversi-
fied through the regional route, WTO is bound to lose
some its relevance in the global trading system. In the
current state of distorted multilateralism, regionalism
has turned out to be one of more viable alternatives
for developing countries to expand their market ac-
cess. Regional Trade Agreements have been effective
for countries geographically close to each other, with
close economic exchange and interests.
Niveshak: The Department of Economic Affairs also
deals with extension of Lines of Credit to other de-
veloping countries which include support to NEPAD,
TEAM9, ASEAN and ECOWAS? How has this helped
India and what are its future implications?
Mr. Krishna: India has been a partner in development in
Africa for last 50 years. The Scheme of India’s Develop-
ment Economic Assistance (IDEAS) was introduced in
the year 2003-04 and has been a successful scheme
which has generated a lot of goodwill. The lines of
credit help project our growing economic strength as
well as our willingness to contribute to infrastructure
development and capacity building in the recipient de-
veloping countries. India went through the process of
planned development in last 50 years and has been
successful in many sectors such as agriculture. The
scheme gives an opportunity to show India’s expertise
in project planning, design and implementation as well
as high technical services in diverse areas for socio
economic development of developing countries. LoCs
help us to promote exports of projects, goods & ser-
vices from India to those developing countries where
exposures may have been limited because of high
commercial and political risks. Through these lines
of credit, it is intended to create political goodwill for
India in beneficiary countries.
The developed countries have been provided Official
Development Assistance (ODA) to developing countries
16 NIVESHAK VOLUME 2 ISSUE 11 december 2009
for many years. However, there have been also part-
nerships between developing countries where coun-
tries like India have been providing assistance to some
countries in Africa and Asia for many years thorough a
partnership of sharing knowledge and experience. Our
assistance to these countries is an important pillar of
South-South Cooperation.
Niveshak: Can we say that India’s dealings with
ASEAN have been a success? How can India play a
more important role in the South Asian region? Or
do we need to improve our bilateral ties and trade
with South East Asian nations?
Mr. Krishna: India’s trade with East Asia and ASEAN
countries and Australia, New Zealand stood at US $
48.83 billion during the year 2007-08 registering a
growth of 23.46% over the previous year. Exports to
the ASEAN region grew by 30.35% during the year 2007-
08 over the previous years and imports witnessed a
growth of 25.33% in the same period. India’s trade with
Australia and New Zealand showed robust growth in re-
cent years. Trade grew by 54.74% between 2005-06 and
2007-08. India and Australia had set up a Joint Feasibil-
ity Study for a free trade agreement between the two
countries in 2008. The Joint Study Group is expected to
submit its report shortly.
In order to address the economic content of the Look
East policy, a continuous dialogue is maintained with
ASEAN and the countries of the South East Asia. India
ASEAN trade in goods agreement was signed on 13th
August, 2009. Negotiations for service and investment
agreements are in progress. India and Malaysia Com-
prehensive Economic Cooperation Agreement Negotia-
tions have commenced in 2008. CECA would be negoti-
ated as a single undertaking including agreements on
trade in goods, services, investments and other areas
of cooperation. India and Indonesia Joint Study Group
is expected to submit its report shortly.
South East Asia occupies a very important place in
India for expanding its economic relations and to re-
alise the full potential. Expanding relations with South
Asia has its own limitations because of relationship
between countries in South Asia. However, there are
no such restrictions with respect to South East Asian
countries and we must go all out to expand and diver-
sify our relations.
 Valuing HUM
The quality, ability and charac-
ter of the people working in an orga-
nization are some of the most impor-
tant factors that determine whether
an organization is successful or not.
However, traditional accounting has
never had a provision to incorpo-
rate the value and record the value
of human resources in their reports.
Over the last few decades there has
been a definite shift at a global level
from manufacturing to service based
economies. The major difference be-
tween the two lies in the very nature
of their assets. In a manufacturing
firm, the physical assets like plant
and machinery are most important.
In contrast, knowledge of employ-
ees assumes utmost significance in
service based economies. In knowl-
edge –driven economies therefore,
it is imperative that the humans be
recognized as an integral part of the
total worth of an organization. How-
ever, in order to estimate and proj-
ect the worth of the human capital,
it is necessary that some method of
quantifying the worth of the knowl-
edge, motivation, skills, and contri-
bution of the human element as well
as that of the organizational pro-
cesses, like recruitment, selection,
training etc., which are used to build
and support these human aspects,
is developed.
A few years ago, behavioral
scientists criticized the conventional
accounting practice of not valuing
the human resources along with oth-
er material resources of an organiza-
tion. This led to an attempt made by
various finance professionals to val-
ue and record human resources in
the financial statements of an orga-
nization. Human Resource Account-
ing (HRA) is basically an information
system that tells management what
changes are occurring over time to
the human resources of the busi-
ness. HRA also involves accounting
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
N RESOURCES
Reju Mathew & Srinath Sridharan
XLRI, Jamshedpur
for investment in people and their
replacement costs, and also the eco- Human resources
nomic value of people in an organi- accounting is the art
zation. The current accounting sys- of valuing, recording
tem as discussed above is not able
to provide the actual value of em-
and presenting sys-
ployee capabilities and knowledge. tematically the worth
This indirectly affects future invest- of human resources
ments of a company, as each year in the financial state-
the cost on human resource devel-
opment and recruitment increases. ments of organiza-
Experts point out that the informa- tions An attempt
tion generated by HRA systems can to illustrate Human
be put to use for taking a variety of
resources accounting
Perspective
managerial decisions like recruit-
ment planning, turnover analysis, methods needed to
personnel advancement analysis quantify and record
and capital budgeting, which can the value of human
help companies save a lot of trouble
in the future. Once a company is able
resources of a com-
to assess the worth of an individual pany. By exemplifying
working for it, it helps it substantial- the merits and de-
ly in increasing its worth. Realising merits of each system,
this, many companies world-over
are making HRA as a necessary ele- the article puts things
ment on their balance sheets. One of in perspective about
the best examples is of the Denmark what will be the ideal
Government. The Danish Ministry of
tool for Human re-
Business and Industry has issued a
directive that with effect from 2005, source accounting.
all companies registered in Den-
mark will be required to include in
their Annual reports information on
human capital. A minimum of five
measures for each is required, and
comparison with the previous two
years is a must. As far as the statu-
tory requirements go in our country,
the Companies Act 1956 does not
demand furnishing of HRA related
information in the financial state-
ments of the company. The Institute
of Chartered Accountants of India
too, has not been able to bring any
definitive standard or measurement
in the reporting of human costs. The
Chairman of various organizations
has been able to make qualitative
pronouncements regarding the im-
portance of Human Resources. How-
17
 ever there is a distinct absence of any kind of quan-
titative
SAIL was one of the first companies that volun-
tarily disclosed the worth of their human resources
in their annual reports, since then many Indian cor-
porate houses notably Infosys have always volun-
tarily disclosed their human capital figures in their
Published Accounts. Other companies which have
implemented Human Resources Accounting are
BHEL, Reliance Industries. Although the regulatory
authorities across the globe have not yet taken the
bold step of advising the companies to disclose the
worth of their human resources as a mandatory dis-
closure requirement chiefly because of the amount
of subjectivity which is present in these suggested
models.
The Concept of Financial Treatment of Hu-
man Resources
In simple words, human resources accounting
is the art of valuing, recording and presenting sys-
tematically the worth of human resources in the fi-
Perspective
nancial statements of organizations. There are three
main aspects of human resources accounting which
are
• Valuation of human resources
• Recording the value of Human Resources in
the financial statements
• Supporting the same by adequate disclo-
sures for the benefit of readers and users of finan-
cial statements
In this paper we would discuss three popu-
lar ways of Valuing Human resources, their merits
and their corresponding demerits. The three ways of
valuing Human Resources are the following
• Historical Cost Approach
• Replacement Cost Approach
• Present Value Approach
Historical Cost Approach
This was the first attempt made towards em-
ployee valuation made by R.G. Barry Corporation of
Columbus, OHIO .According to this approach of valu-
ing human resources, the actual costs incurred on
recruiting, selecting, hiring, training and developing
human resources are capitalized and then amortized
over its useful life. Any further training and develop-
Despite valuation being dependant on a large number of abstract factors which are not measur-
able in precise monetary terms and that the valuation would lack in objectivity and preciseness
human resource accounting is an exercise that every firm would do well to incorporate
18 NIVESHAK VOLUME 2 ISSUE 11 december 2009
ment expenses which are expected to enhance the
skills of such human resources are also capitalized.
Sometimes, opportunity cost method, that is a cal-
culation of what would have been the returns if the
money spent on HR was spent on something else, is
also used in this method. However, this method is
seen to be not as objective as desired. Hence its use
is restricted to internal reporting and not external
reporting. The schedule of amortization is revised
periodically based on changes that has occurred to
the initial assumption on which such amortization
policy was originally based.
Merits of Historical Cost Approach method
This method is reasonably simple to under-
stand and operate and is primarily in agreement
with the fundamental principles of accountancy.
Demerits of Historical Cost Approach method
This method ignores the value of potential fu-
ture services that are derived by a company from its
pool of man power. The selection of an appropriate
amortization policy also creates some problem. As
per this method value of human resources goes on
decreasing every year due to amortization whereas
in most cases the value of human resources actu-
ally increases on account of employees gaining ex-
perience in the organization. This method measures
only the costs to the organization.
Replacement Cost Approach
This approach values the human resources at
their present replacement cost. In other words hu-
man resources are valued on the basis of the as-
sumption- what would be the cost to the firm if
the existing human resources are required to be re-
placed with others having equivalent talent as well
as experience. For instance, if an employee were
to leave today, several costs of recruiting, select-
ing, hiring, placement, orientation and on the job
training would have to be incurred. These costs have
two dimensions- positional replacement costs or the
costs incurred to replace the services rendered by an
employee only to a particular position; and personal
replacement cost or the cost incurred to replace all
the services expected to be rendered by the em-
ployee at the various positions that he might have
occupied during his work life at the organization.
Standard cost method is another costing meth-
od that can be used. In this method, the standard
costs associated with training, recruitment, hiring
per grade of employees are determined annually.
The total costs for all the personnel signify the worth
of the human resources in the organization.
Merits of Replacement Cost Approach
This method takes into account the current val-
ue of firm’s human resources and hence it portrays
a much more realistic picture than the historical cost
approach.
Demerits of Replacement Cost Approach
There are no objective methods of ascertain-
ing such replacement costs and hence, the entire
exercise depends largely on various subjective judg-
ments. However the relative subjectivity that is in-
volved in this exercise is much greater as compared
to the historical cost approach method. This practice
also goes against the conventional accounting prac-
tice.
Present Value approach (Law and Schwartz
Model)
According to this approach, the value of human
resources in an organization is determined on the
basis of present value of expected future benefits
that may be derived from such resources. The fol-
lowing steps are adopted to arrive at the value of
human resources as per this Present Value of Future
Earnings Model
• All employees are classified in specific
groups according to their age and skills
• Average annual earnings are determined for
various ranges of age and skills
• The total earnings which each group would
get up to retirement age are calculated
• The total earnings calculated above is ap-
propriately discounted to arrive at their PV
• The total value thus arrived at is regarded as
the value of the human resources
For example:
From the following details one would be able
to compute the value of human resources of an em-
ployee group with an average age of 58 years
Annual average earnings of an employee till
the retirement age - Rs 4 lakhs
Retirement age - 60 years
Appropriate Discounting factor - 10%
Total no. of employees in group - 10
Demerits of Present Value model
A person’s value to an organization is not en-
tirely determined by the salary paid to him. A per-
son may like to work at a salary which is less than
what he actually deserves( due to a number of other
considerations). Moreover, salary does not remain
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
constant over a period of time. Hence, it is pretty
difficult to predict such future expected earnings
with a reasonable degree of precision and accuracy.
The model ignores the possibility that an employee
may leave the organization before reaching his age
of retirement. Thus, in one way it overstates the em-
ployees expected service life and thereby his total
expected earnings as well. This model also ignores
other considerations like bargaining capacity, skill,
experience etc, which may result in paying higher or
lower salaries to employees. Thus, the salary actu-
ally paid to employees does not necessarily repre-
sent the employee’s true worth to the organization.
Despite these limitations, the Lav and Scwartz
model is perhaps regarded as the most popular
model of human resources valuation. The compa-
nies which voluntarily disclose the value of human
resources in their financial statements mostly use
this model for computational purposes.
Flamholtz’s model of determinants of Indi-
Perspective
vidual value to Formal Organizations
According to Flamholtz, the value of an indi-
vidual is the present worth of the services that he
is likely to render to the organization in the future.
As an individual climbs the organization ladder, the
services that he offers to the organization could dif-
fer radically in their value and in their nature. The
present cumulative value of all the possible services
that an individual is likely to render during his/her
association with the organization is regarded as the
net value of the individual.
Given the different career paths that are avail-
able in most of the organizations, this value is defi-
nitely uncertain and has two different dimensions.
The first is the expected conditional value of the
individual. This is the amount that the organization
could potentially realize from the services of an indi-
vidual during his/her productive years in the organi-
zation. This factor in turn is composed of three main
factors which include
19
 • Productivity or performance which is the set
of services that an individual is expected to provide
in his/her present position
• Transferability which concerns itself with
the set of services that an individual is expected to
provide if and when he/she is in different positions
at the same level.
• Promotability which includes the set of ser-
vices that an individual provides in higher level posi-
tions.
These factors are dependent on both the mo-
tivational levels and the ability of the individual as
well as the organizations capacity to provide oppor-
tunities to use these skills or roles that an individual
has the capacity to provide.
The second dimension of the individual value
is the expected realizable value. We live in an era
unlike those of our predecessors given the number
of job opportunities we have. The concept of a per-
son staying in one organization throughout his life
is becoming obsolete. Therefore the expected realiz-
Perspective
able value which is a function of the expected condi-
tional value, and the probability that the individual
will remain in the organization for the duration of
his/her productive service life becomes one of para-
mount importance.
The higher the job satisfaction in an organiza-
tion, the lower is the probability of employee turn-
over and hence higher is the expected realizable
value.
Merits and demerits of Flamholtz model of determi-
nants of Individual value
It is a difficult task to obtain reliable data for
determining the value derived by an organization
during the period a person occupies a particular po-
sition. The model also ignores the fact that individu-
als operating in a group may have a higher value for
the organization as compared to individuals work-
ing independently. It is an improvement over the
present value of future earnings model, given that
it takes into consideration the possibility or prob-
ability of an employee’s movement from one role to
another in his career and also of his leaving the firm
a little earlier.
Recording and Disclosing Human Resources
All the methods suggested above reveal ways
of calculating the human capital however they have
not dealt with the mode of recording and disclosing
such information in the financial statements of the
organizations. That had been left to the discretion of
various accounting bodies which are yet to develop
a generally accepted basis of treatment in the finan-
cial statements.
Prof N. Dasgupta suggested in his total cost ap-
20 NIVESHAK VOLUME 2 ISSUE 11 december 2009
proach the following mode for disclosure of human
resources in the balance sheet of an organization
According to him, the human resources valued
per this model should be shown both on the assets
as well as liabilities side of the balance sheet. On the
assets side, it should be shown after the fixed assets
as Human assets classified into two parts.
• Value of individuals
• Value of firms investment
On the liabilities side, it should be shown after
the capital as Human Assets capital by the amount
at which it has been shown on the asset side against
the value of individuals.
For example a firm had started its business
with a capital of Rs 1 crore as on 1st April 2009 .It
had fixed assets worth Rs 50 lakhs in cash, working
capital needs were met separately by an amount
to the tune of Rs 40 lakhs. The firm incurred Rs 10
lakhs on recruitment of a few employees for running
the show and the company had valued the human
capital resources using the Lav&Schwartz model. The
value of employees in the organization was Rs 80
lakhs.
Implementing Human Resources accounting to
this would result in the following balance sheet:
Liabilities Rs (in lakhs) Assets Rs
Capital 100 Fixed Assets 50
Human As- 80 Human Assets
sets Capital
(i)Individuals 80
value
(ii)Firms value 10
in terms of
investment
Current Assets 40
180 180
Conclusion
Despite common objections by finance profes-
sionals to human resource accounting owing to the
fact that valuation would depend on a large number
of abstract factors which are not measurable in pre-
cise monetary terms and that the valuation would
lack in objectivity and preciseness human resource
accounting is an exercise that every firm would do
well to incorporate. It is valuable both as an inter-
nal tool as well as an external tool. The various
measures that are available for human resources ac-
counting indicate that the question of how to com-
pute the value of human resources is as much a
question of philosophy as of technique.
 Cover Story
Hitesh gulati
Team Niveshak

Price discovery mechanism refers to absorb- tal analysis is however criticized on the ground that
ing new information and reflecting it into the stock all financial data and information of a given security
prices. Price discovery has been a serious issue for are already reflected in the market price.
debate for the traders, professionals, regulatory bod-
Efficient market hypothesis (EMH)
ies and the academicians. Three different schools of
thought: Technical Analysis, Fundamental Analysis Efficient Market Hypothesis is a backbreaker
and Efficient Market Hypothesis have emerged to for forecasters. In its crudest form it says that the
analyze and understand the reaction of stock prices returns from speculative assets cannot be forecast-
to new information. ed. The earliest form of this theory appeared as the
random walk theory given by Bachelier. One of the
Technical analysis famous definitions of EMH has been given by Jensen
Technical analysis implies that by observing who says “A market is efficient with respect to infor-
and studying the historical information about the mation set Øt if it is impossible to make economic
behaviour of a given stock, one can predict the fu- profits by trading on the basis of information set
ture price movements of the security. But the techni- Øt.”
cal analysis is not by itself, the road to the riches. It
Traditional Concept of Market Efficiency
is just a tool that should be used along with Funda-
mental analysis. Further Technical Analysis requires The concept of ‘efficient’ stock markets has
talent, intuition, commonsense, experience and been debated ever since Eugene Fama first intro-
most importantly – “luck” to be successful duced it around 40 years ago. Eugene Fama defined
Market Efficiency as the state where “security prices
Fundamental analysis: reflect all available information.” The primary role
In Fundamental analysis, the investment proj- of the capital market is to allocate the economy’s
ects are ranked by comparing factors like economic capital stock. Thus an ideal market is one where
influences, industry factors and relevant company prices provide accurate signals for resource alloca-
information such as demand, earnings and divi- tion, i.e. a market in which firms can make produc-
dends. Based upon all these factors, investors reach tive-investment decisions and investors can choose
upon an intrinsic value for the firm’s securities and among the securities that represent ownership of
by comparing these values with current prices of the firms’ activities.
security, investment decisions are taken. Fundamen- Thus, a security market is generally defined

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 21

 as efficient if:
(1) Price of the security traded in the market
act as though they fully reflect all available informa-
Cover Story
tion.
(2) Security prices react instantaneously and in
an unbiased way to new information.
The figure shown above explains the nature of
efficient markets. If the markets are efficient, then
stock prices would react almost instantaneously to
the news regarding the stock and reach the appro-
priate price levels (higher level in the figure reflects
good news regarding the firm). However if the mar-
kets are over enthusiastic, then the stock prices
would rise un-naturally to more than the optimum
levels leading to a bubble formation. In contrast, if
the markets are slow to react and respond to the
news only after a few days, then it leads to a de-
layed response. Both these scenarios of over and
under response are characteristics of inefficient mar-
kets.
Efficiency of equity markets has important im-
plications for investors. If the equity market is ef-
ficient, then researching to find miss-priced assets
is not needed. In an efficient market, prices of the
assets will reflect the markets’ best estimate for the
risk and expected return of the asset. Therefore,
there will be no undervalued or overvalued assets.
Hence, in an efficient market an optimal investment
strategy is to concentrate on risk and return charac-
teristics of the asset or portfolio.
In an efficient market, prices
of the assets will reflect the
markets’ best estimate for the
risk and expected return of the
asset.
22 NIVESHAK VOLUME 2 ISSUE 11 december 2009
According to Fama, three different levels of ef-
ficiency exist based on the nature of available infor-
mation – the weak, semi- strong, and strong forms.
i. Weak form efficiency – This form exists when
the stock prices reflect all the information contained
in the historical prices of the stock. Therefore, stock
returns are not predictable, and hence follow a ran-
dom walk. In simpler words, we can say that the
price of a stock already contains all the historical in-
formation available about it. Therefore as far as fore-
casting the future is concerned, there is no benefit
in examining the historical sequence of prices. In
an aggressive form, the theory concludes that there
is no value in technical analysis. Thus, the Random
Walk Theory is a direct repudiation of technical anal-
ysis. There have been four major methods to test
markets for Weak-form of market efficiency: serial
correlation test, filter rule test, cyclical tests, and
volatility test.
ii. Semi-strong form efficiency - Under semi-
strong form efficiency, security prices reflect all pub-
licly available information. Semi strong form main-
tains that the current stock prices instantaneously
and fully react to all the public information available
about the stock such as corporate reports, announce-
ments, dividend policies etc. Thus the efforts by
analysts and investors to acquire and analyze public
information will not yield superior returns. As soon
as the information becomes public, it will be ab-
sorbed and reflected in the stock prices. If any such
information does not lead to a change in security
prices, then according to the semi-strong form we
can infer that the news contains no relevant infor-
mation. Semi-strong form tests include the testing
of market reaction to accounting information, stock
split and block trading.
iii. Strong form efficiency - Under strong form
efficiency, all information, public as well as private is
incorporated in security prices and thus no investor
can earn excess profit by trading on public or pri-
vate information. This form states that not only the
public information but all information is worthless
for the investor. In other words, the current stock
prices instantaneously and fully reflect all known in-
formation about the securities including the private-
ly available information. The markets are so efficient
that not even someone with the most valuable piece
of inside information can trade profitably. As an ex-
ample, even the information about the forthcoming
announcement by a Company regarding a split in its
stock, cannot be used by an investor to his advan-
tage. The test for strong form efficiency is done by
testing the return that is earned by an insider.
Adaptive Market Efficiency
The traditional theory of market efficiency as-
sumes that all investors are “rational,” meaning they
make optimal decisions based on the information
available to them. In the field of asset pricing, this
means that the asset prices fully reflect all available
information, so there are no opportunities to earn
extraordinary returns. According to this view, inves-
tors no matter how savvy they may be cannot im-
prove on the performance of index portfolios. When
rational investors value a stock, they must combine
information from a number of different sources. They
must also combine new information with existing
information, and information they collect on their
own with information provided by others. Rational
investors would combine these different sources of
information by placing weights on different pieces
of information (proportional to the precision of each
source of information). Rationality as it appears in
the literature implies that individuals have an ability
to both observe and process information.
In reality, however, individuals have limited
processing ability, and hence use ad- hoc rules to
convert the information they receive from various
sources into firm valuations and will therefore make
mistakes (referred to as irrational investors). For
example, investors can’t really convert the news
about the proceedings against Satyam into concrete
views about the future competitiveness of the com-
pany and its cash flows. What they do is base their
analysis on “hunches” or “feelings,” which are influ-
enced by behavioural biases. However, these ad-hoc
rules should on average provide a good approxima-
tion if there is no systematic bias in the way they
make mistakes.
The recent finance literature however offers
The notion of efficient markets described in the literature is quite strong and probably unreal-
istic. Hence, we need to review the theory of efficient markets in favour of an alternative theory
which suggests that asset prices are influenced by investor overconfidence.
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
an alternative paradigm in which individuals make
systematic mistakes in the way that they process
Cover Story
information and such individuals are referred to as
irrational investors. The notion of efficient markets
described in the literature is quite strong and proba-
bly unrealistic. Hence, we need to review the theory
of efficient markets in favour of an alternative theo-
ry which suggests that asset prices are influenced by
investor overconfidence of certain investors. Over-
confidence has both a direct and indirect effect on
how individuals process information. The direct ef-
fect is that individuals place too much weight on in-
formation they collect themselves since they tend to
overestimate the precision of that information. The
indirect effect arises because investors filter infor-
mation in ways so as to allow them to maintain their
confidence. They tend to ignore information that
lowers their confidence. For example, investors may
be reluctant to sell their losers since this requires
that they in some sense admit to making a mistake.
A somewhat weaker and murkier definition of
efficiency that emerges from such biases is called
adaptive-efficiency. It recognizes the presence of
bias in most market investors (irrational) but also
assumes that there exist other rational investors
who can detect and profit from these behavioural
biases by examining past prices. The adaptive ef-
ficiency theory states that if a significant number of
investors exist, who can benefit from price anoma-
lies created by irrational investors then the profits
from such strategies would quickly dissipate and
markets would return back to efficiency. Econo-
mists in adaptive efficient markets believe that ir-
rational investors can only have a minor effect on
prices. Their argument is that, in competing to take
advantage of the profit opportunities created by the
trades of irrational investors, rational investors will
push prices to a level where the profit opportunities
virtually disappear. Thus, in the end, prices will be
determined in the market “as if” all investors are
rational and that the market was efficient. Thus in
a market that is adaptive-efficient, pricing anoma-
lies may be observed in historical data (as opposed
to the traditional concept of efficiency which states
that prices should neither be under or over-valued).
23
 However, if investors learn from the past price his-
tory, then these anomalies would disappear quickly
or we can say that the markets would adapt to the
inconsistencies.
Cover Story
bias of their irrational counterparts. Ironically, if
most rational investors believe that the market
is very efficient, and hence choose not to ex-

ploit such strategies, then the pricing anomaly

Thus a rational investor in the presence of a will continue to persist and the markets would
large number of irrational investors should tilt his remain inefficient. Alternatively, if the rational
portfolio towards strategies that have performed investors underestimate the number and aggres-
well in the past. If all the rational investors try to siveness of other rational investors (i.e. assume
exploit investment opportunities observed from his- the markets to be inefficient), they may go for
torical data, then they would push the prices to a strategies that cause the anomaly in prices to
level where the investment opportunities would dis- be reversed and this way markets correct them-
appear. Determining how much an investor should selves to become efficient.
tilt towards the higher performing strategies is not
very easy. An investor would want to have some
idea of the extent to which the other rational inves-
tors uncover these pricing anomalies to change their
portfolios. An investor who believes that he was
the only one doing this sort of an analysis would
strongly tilt his portfolio towards the strategies that
performed well in the past. On the other hand, an
investor who believes that inefficiencies are immedi-
ately corrected by other active investors may choose
FIN-Q Solutions
not to tilt it at all towards the better performing November 2009
strategies.

Conclusion 1. Poison Pill

Hypothesis of Market Efficiency is an impor-
tant concept for the investors who wish to hold in- 2. Walter Gresham
ternationally diversified portfolios. In the developed
economies like U.S.A. and U.K., markets are found to
be efficient but the reverse holds in the case of the 3. Alfred Winslow - Father of
emerging markets like India, Taiwan and Bangladesh. hedge fund industry
With increased movement of investments across in-
ternational boundaries owing to the integration of
world economies, the understanding of efficiency of
4. 75%
the emerging markets is also gaining greater impor-
tance. Though, neither the traditional nor the adap- 5. Muriel Sibert
tive form of efficiency exist in the real world markets
as found in literature, the concept of adaptive ef-
ficiency is closer to the real world market scenario. 6. Phantom of Bombay House
It assumes the possibility of the existence of irratio-
nal investors. It further states that the markets are
naturally inefficient and turn efficient only when the
rational investors take advantage of the anomalies
in the prices of stocks caused by the overconfidence

The adaptive efficiency theory states that if a significant number of investors exist, who can
benefit from price anomalies created by irrational investors then the profits from such strategies
would quickly dissipate and markets would return back to efficiency.

24 NIVESHAK VOLUME 2 ISSUE 11 december 2009

38
 Role of Real Estate In Contemporary Economical
Scenario
Peeyush Anand & Sushil Pasricha
The article analyzes
the contribution of
housing sector to
the GDP of India
along with its impact
on other sectors
through backward
and forward link-
ages.
FinGyaan
Almost five per cent of the country’s GDP is contributed by the housing sector. The real estate sec-
tor is also responsible for the development of over 250 ancillary industries such as cement, steel,
26 NIVESHAK VOLUME 2 ISSUE 11 December 2009
...the Way ahead
FMS, Delhi
Market Overview
The Indian real estate sector
plays a significant role in the coun-
try’s economy. The sector contrib-
utes heavily towards the gross do-
mestic product (GDP). Almost five
per cent of the country’s GDP is con-
tributed by the housing sector. The
real estate sector is also responsible
for the development of over 250 an-
cillary industries such as cement,
steel, paints etc.
But, in the last few months the
real estate market has undergone
major changes into business.
The real estate sector is sec-
ond only to agriculture in terms of
employment generation and con-
tributes heavily towards the gross
domestic product (GDP). In the next
five years, the contribution of 5% to
the GDP is expected to rise to 6 per
cent. It has also been suggested that
India’s property sector could begin
to improve from late 2009 and may
attract up to US$ 12.11 billion in real
estate investment over a five-year
period.
The global financial meltdown
and the slowdown in the Indian econ-
omy have adversely impacted India’s
retail sector which forms around 5%
of the real estate sector. This drop in
yield coupled with low leasing activ-
ity and high vacancy rates have all
led to individual investors staying
away from new retail real estate in-
vestments. Many first-time develop-
ers who were earlier planning mall
developments on sales model have
now either postponed or cancelled
paints etc.
their projects. This has further lim-
ited opportunities. The changes in
valuations brought about by the fi-
nancial crisis in major markets can
be seen below:
Lessons from the Real Estate
Bust of 1996
The Indian property market
witnessed a prolonged trough fol-
lowing a bust in 1996.
Residential real estate prices
which had seen an increase of on
average 70% cumulatively in the
three years preceding the 1996 bust,
fell 40% in the three years after 1996.
After the trough, prices witnessed a
prolonged slump of five years before
recovering.
• The property market bust was ac-
companied by a period of relatively
lower economic growth. GDP growth
which had averaged 6.8% in the
four years prior to the bust, fell to
5.4% on average in the four years
after it Although the causes of the
growth slowdown were myriad and
beyond the scope of this note, there
was some impact of the real estate
decline on consumption and invest-
ment demand.
• In the current context, we think the impact of a loan as a percentage of GDP was at ~6% as of FY07
property slowdown can potentially be stronger than versus ~4% in FY06. We believe that a sizeable op-
in post-1996. In the three years prior to 2008, resi- portunity exists for funding residential units in In-
dential prices had increased some 80% on average. dia, which in turn would propel further residential
There has also been a large increase in mortgages, demand. However, rising interest rates have reduced
albeit from a low base (see Exhibit 12), and more the attractiveness of home loans.
household wealth in absolute terms is in housing.
Growth in IT/ITES
Furthermore, the importance of construction in the
economy has progressively increased, from 5.6% of The IT/ITES sector grew at a phenomenal pace
GDP in 1997 to 7.3% of GDP in 2007. in the past decade, significantly impacting office real
estate in India. The sector comprises ~75-80% of the
• Housing busts generally have larger wealth ef-
current commercial demand. Bangalore is the tradi-
fects on consumption, deeper effects on the bank-
tional hub for IT/ITES space in India. At present, Tier
ing system, and a high degree of contagion to other
II cities offer more advantages to IT/ITES companies,
asset classes, compared with equity busts.
considering the lower real estate prices. Apart from
Market Drivers for Future IT/ITES, biosciences, insurance, banking and consult-
Favourable demographics ing sectors are also contributing to office space de-
mand.
The three demographic trends, i.e. high but
falling birth rate, increasing life expectancy and de-
clining infant mortality (due to improved living con-
ditions), are expected to persist in the coming years.
Growing urban population – India’s urban pop-
ulation has grown ~3% annually to 285mn in ’01
from 109mn in 1971. We expect the growth trend
to continue, with the urban population touching
~370mn by ’11E. Indian cities with >1mn population
grew from 12 in 1981 to 35 in ’01 and are expected
to reach 70 by ’25.
Rising Indian Middle class – The number of In-
dian middle class households with annual income Increasing demand in hotels and logistics

FinGyaan
between Rs0.2mn and Rs2mn has quadrupled in sectors
the past 10 years from 4.7mn households in 1996
to 17.5mn in ’06. The Indian middle and upper class The growth in tourism and business travel
together stand at ~100mn and are expected to grow and the emergence of low cost airlines have led to
15-16% annually in the next five years, which will increased demand for hotel rooms. Real estate de-
drive housing demand further. velopers have aggressively ventured into the hotel
business to capture unmet demand.
Young India – India’s median age was 24 in
’05 against China’s 33 years and Japan’s 43 years. Backward and Forward Linkages: Multi-
As per industry estimates, average age of a home plier Effect
buyer has decreased from 42 years to 31 years. The The construction sector in
younger generation is creating further demand for particular has strong linkages
residential units and the trend should continue as with the economy. By
the income generation capability of the Indian youth
improves.
Nuclearisation – Reduction in household
size has created additional demand in resi-
dential units. The size of an average urban
household decreased from 6.06 in ’01 to 5.5 at
present. Rising income, greater number of income
generators per household, especially working
women and the younger generation, and chang-
ing mindset are the primary reasons for reduction
in the household size.
Increasing funding options in India – Home

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 27

 • Positive Wealth Effects
• Higher Income Growth
• Decreasing Borrowing Costs
Impact of Boost in Real Estate on Investment De-
mand:
• Financial Accelerator
• Confidence Effects

using a commodity industry input-output matrix,

there are linkages that construction has with the
rest of the economy. Although the direct impact
of construction is 7.3% of GDP, the indirect impact
through backward linkages in terms of the sector’s
usage of iron, steel, cement etc we estimate to be
roughly 12% of GDP in FY08 .Of the inputs going into
the construction sector, industrial goods account for Way Ahead
some 64%, while services such as trade account for Going forward, Real Estate sector has huge
a further 34%. scope to grow in a developing country like India
Hence Real Estate forms very important part in and also needs to assume very important role in the
GDP. In coming 5 years Real Estate needs to play a overall growth of Economy. India should take lead
very mature role to pull India out of the Economic from Obama regime in USA and try to bring country
turmoil and back to 8%-9% sustainable GDP growth out of the economic turmoil by focussing on estab-
in coming future. lishing huge infrastructure projects, building roads,
building bridges etc. This will not only increase the
productivity but through multiplier effect will gener-
FinGyaan

ate employment and income and lead India towards

10% GDP growth.

Positive Impact on consumption will be felt

through:
Impact of Boost in Real Estate on Consumption De-
mand:

The real estate sector is second

only to agriculture in terms of
employment generation.

28 NIVESHAK VOLUME 2 ISSUE 11 december 2009

 Hangover
“There’s no question about it.
Wall Street got drunk -- that’s
one of the reasons I asked you
to turn off the TV cameras --
it got drunk and now it’s got
a hangover. “
--George W. Bush, speaking at a private
fundraiser, Houston, Texas, July 18, 2008
I start of this article with a
Bushism we all heard and enjoyed.
This statement was made by George
Bush at a fundraiser in Texas some-
time around July 2008 in response
to a question regarding the housing
crisis in America.
The housing crisis was like a
road roller devouring everything that
came in its way, large and small or-
ganisations, financial institutions
and investment banks. Its cascading
effects and repercussions were felt
throughout the world. But the perti-
nent question here is, “How did all
this happen and what are the con-
sequences?” As I attempt this ques-
tion, many thoughts go through my
mind as to how this bubble started
getting bigger and bigger, until one
fine day it just burst.
According to the Robert Shiller
graph of house prices the hous-
ing bubble was spotted sometime
around 2001 which was mainly be-
cause of the savings glut. In the USA
housing prices were at their peak,
sometime early 2005 and started
to decline sometime in 2006. The
sub-prime crisis started sometime
around 2006-2007 when foreclosure
rates were at their peak. Loans were
granted liberally, even to subprime
borrowers. Subprime borrowers were
The uncertainty still remains
and the spill over effect has
been felt in 2009 also
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
on Wa l l Street
Hufriya Kavarana
SPJIMR, Mumbai
those who were considered more
risky because of problems with their This article states the
credit history. After undergoing a causes of the sub
credit check, there is something prime crises and the
call a FICO score which is a number
which states the creditworthiness of
effects of it which
an individual based on factors like are being felt now
past payments of debts, amount in 2009. The banks
earned and amount of debt currently have not yet been
held by the individual.
able to recover the
In the years leading to the
subprime crisis, the Fed had cut loans and the mon-
interest rates to their lowest lows ey invested in other
and this basically resulted in heavy financial instru-
borrowing and increased spending.
ments.
As more money is borrowed, there
is an increase in the money sup-
ply and increased spending which
leads to growth in the economy but
conversely also leads to inflationary
trends due to the increased supply
of money. This led to a huge expan-
sion in the real estate market, since
the value for houses continued to
increase and it became easy to pay
up interest on loans. Now appears
the twist in the tale. The subprime
homeowners, looking at the rapid
increase in the price of their proper-
ties had taken huge loans that they
would not be able to afford, antici-
pating refinance at favorable rates.
The lender’s point of view
FinSight
The sole reason why this sub-
prime crisis blew out of proportion
was because of the exposure of
many financial firms to these sub-
prime loans and the chief culprit
was Securitization of mortgages
and the issue of CDO’s and MBS’s.
For this we need to understand the
The housing crisis was like a
road roller devouring every-
thing that came in its way,
large and small organisa-
tions, financial institutions
and investment banks
29
 concept of securitization. Securitization is a tool by
which all the subprime loans and mortgages (mainly
long term debts) are pooled together and sold in
the secondary market to another group of investors.
This helps in freeing up the capital of the company
and increased liquidity for the company since their
funds do not remain tied up. The Adjustable rate
mortgage loan has also played a very important part
in the subprime mortgage crisis. This kind of a loan
is one which starts off with very low interest rates
that appeal to borrowers but eventually settles at a
high rate.
The upside of subprime lending is the rise in
credit opportunities and increased home ownership
due to innovations in the prime and subprime mar-
kets. The downside though is the rise in the delin-
quency rates.
So far so good, but is there something more
to it?
By 2004, the US market was growing at a fast
clip and the Fed decided to raise interest rates. This
resulted in lesser borrowings and also payment of
interest on loans and mortgages became more dif-
FinSight
ficult, leading to foreclosures and delinquencies.
There were not many buyers in the real estate mar-
ket, which led to a fall in home prices. All this com-
pounded the problems for banks that granted the
loans since they could not recover the money and
also for institutions that had invested in the finan-
cial instruments issued on the basis of the underly-
ing loans and mortgages. More than 24000 job cuts
were announced by various institutions due to lower
profits because of the write downs.
When you drop a pebble into still water, it will
create a ripple and will continue travelling until it
meets resistance or reverse motion. This stands true
for the subprime crisis and its impact. The uncer-
tainty still remains and the spill over effect has been
felt in 2009 also. Billions of dollars in write downs
and stimulus packages are being used as an incen-
tive to prop up the economy; yet, the subprime de-
bacle echoes through the economy, hurting inves-
tors and overall growth alike.

The sole reason why this subprime crisis blew out of proportion was because of the exposure of many
financial firms to these subprime loans and the chief culprit was Securitization

30 NIVESHAK VOLUME 2 ISSUE 11 december 2009

Socialist aptitude and Capitalism
“The age of big government is
dead” signed off Mr. Bill Clinton as
he became the president of United
States, arguably the most successful
capitalist economy of the world.
Capitalism in its essence is all
about individual liberty. With the
economic and social fallacy of social-
ism exposed, capitalism took its toll
in various countries as it triumphed
in the debate on ideology and tech-
nology. Promising to lift countries
out of underdeveloped status, capi-
talism has come a long way in being
the dominant form of market system
in most of the economies today. The
idea that elected governments have
been overpowered by the market
forces of capitalism has become a
well worn cliché. This fact, however,
is far from being completely true and
the paper deals with aspects which
go to disprove the fact (with which
this paper starts).
Before that, let us look into
why socialism is self-defeating.
Since the government has to incur
costs to provide some public goods,
it has to receive money from the
public. Since it is too utopian to
expect voluntary contributions, the
government has to collect taxes. As
the range of services extend, the
tax net has to increase too. So far
so good if the capital and labor are
immobile. However if this condi-
tion is violated, and it is in the real
world, the skilled laborer looks for
the best tax havens and the capital
owners look for the highest returns
(i.e. low-tax regimes instead of high-
tax regimes). The governments in or-
der to attract these scarce resources
cut their spending as well as taxes.
The ‘race to the bottom’ ensues and
money power starts dominating
vote-power. Democracy is defeated
and hence the model itself. This is
not to say, however, that democracy
is the major factor behind sustaining
a country. In fact, for the most part,
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
ARUN SINGHAL
MDI, Gurgaon
democracy and individual freedom
are incompatible. Democracy works With the economic
against liberty. However, other forms and social fallacy of
of governments are more incompat-
ible with freedom. Authoritarianism
socialism exposed,
may appeal to be favorable in the capitalism took its
beginning but the growth of model toll in various coun-
itself depends on expanding at the tries as it triumphed
cost of mitigating the individual free-
dom.
in the debate on ide-
Having said that, capitalism is ology and technol-
no better than socialism in sustain- ogy. Promising to lift
ability. However, capitalism is much countries out of un-
more resilient a model than social-
derdeveloped status,
ism. Despite the private liberty and
capitalism has come
Perspective
high growth rates witnessed across
economies, capitalism has some in- a long way in being
herent factors which lead to the col- the dominant form
lapse of the model. As new heights
are reached, the vulnerability and
of market system in
the distance to fall increase. Every most of the econo-
economic adhering to neo-liberal mies today. The idea
economics assumes the rationality that elected govern-
of human beings. However, as his-
tory would prove, humans, at best, ments have been
can at best be called rationally irra- overpowered by the
tional. When the economy is at new market forces of cap-
highs, everyone believes the best is
italism has become
yet to come. Lessons from history
are seldom learnt. It can be said that a well worn cliché.
capitalism digs its own holes. This This fact, however,
is why governments exist. And not is far from being
only exist, and in contrast to com-
mon misconception, they are getting
completely true and
bigger. Just think of this, the govern- the paper deals with
ment share of national income, ar- aspects which go to
guably the best indicator of size of disprove the fac.
government in the economy, was
around 30% in the industrial econo-
mies (mostly capitalist nations). It
increased to 42.4% in 1980s and has
been on an increase ever since as
the economies face recessions and
the crisis spreads!! And not only dur-
ing the recession and the wars, the
government’s share increases dur-
ing peace conditions too. Let us now
compare these industrial economies
with the developing and under-de-
veloped ones:
As we can see, the share of
government expenditure (by eco-
31
 High-Income Middle-Income Low-Income All Countries
GDP Total Expen- GDP Total Ex- GDP Total Ex- GDP Total Expendi-
diture penditure penditure ture
Expenditure by eco-
31.4 100.0 26.6 100.0 21.6 100.0 30.4 100.0
nomic type
Current expenditure 29.1 92.9 20.9 79.0 14.0 64.7 27.5 90.5
Goods and services 8.4 26.9 8.8 33.3 5.4 25.1 8.3 27.4
Wages 3.7 11.9 5.5 21.2 2.5 11.5 3.9 12.8
Other goods and
4.7 15.0 3.2 12.2 2.9 13.6 4.5 14.6
services
Interest 3.6 11.5 5.0 18.6 3.0 14.0 3.8 12.4
Subsidies and trans-
17.1 54.5 7.2 27.1 5.5 25.2 15.4 50.7
fers
Capital expenditure 1.8 5.7 3.8 14.5 4.3 19.9 2.2 7.1
Lending minus
0.4 1.3 2.3 8.0 3.3 15.2 0.8 2.5
repayments
Expenditure by func-
30.9 100.0 24.3 100.0 18.4 100.0 29.5 100.0
tion
Defense 4.4 14.2 2.0 8.2 2.8 15.3 4.0 13.6
Education 1.6 5.0 2.8 11.4 1.0 5.4 1.7 5.7
Health 3.7 12.0 1.2 5.0 0.4 2.2 3.3 11.0
Perspective

Social security and

10.6 34.4 3.6 14.9 0.1 0.8 9.3 31.5
welfare
Housing 0.7 2.2 0.6 2.4 0.7 3.8 0.7 2.3
Economic services 2.8 8.9 4.8 19.6 4.6 25.0 3.1 10.5
Other government
3.8 12.2 4.4 18.1 5.7 30.8 3.9 13.2
services
Interest 3.4 11.1 5.0 20.2 3.0 16.3 3.6 12.2
Number of countries 26 26 36 36 18 18 80 80
Share of Central Government Expenditure in GDP and in Total Expenditure for 80 Countries, 1990
nomic type), increases with the level of income. middle class. This can be proved by a simple 3X3
Low income countries have a share of 21.6% while matrix:
high-income countries have a figure of 31.4% of the
A/B Poor Middle Rich
national income. If we look deeper, the biggest dif-
Poor 150,150 100,200 150,150
ference comes in the part of Transfers and Subsi-
dies. Ideally, we should expect governments to roll Middle 200,100 150,150 200,100
back their doles as the economies get richer. As the Rich 150,150 100,200 150,150
situation improves, more people work and are self- In the above matrix, A and B are the two politi-
dependent or family-dependent, and less dependent cal parties. It is clearly evident from the matrix that
on the government transfers. However, this is not choosing ‘middle’ is the strictly dominant strategy.
the case. Governments increase their role with in- ‘Middle’ is better if the other party chooses non-
come. This is the case even with health. Govern- middle i.e. rich or poor. And ‘Middle’ is better if the
ment’s health expenditures increase with income. other party chooses ‘middle’. Here, the numbers
We would poor economies to take care after its cash- represent the number of votes garnered in a total
ridden citizens much more than a rich economy like of 300.
U.S.A. It is imperative hence to probe deeper and
The rich may demand low involvement and the
answer the question: Why are Governments getting
poor may demand a very high involvement of the
bigger not only over the years but also as the coun-
government. But the political party chooses a ‘ra-
tries cover the path of development?
tionally’ optimum strategy i.e. ‘middle’. We see the
Probably the best reason seems to come from manifestation of this in the real world too. As we
the field of Game theory. Let us take a very realistic have already seen, as economies mature, with the
assumption that three economic classes exist: ultra- exception of Sweden and U.K., political parties have
rich, middle class and poor. With more than one po- targeted the middle class. The top 20 percentile re-
litical party in almost all the economies, as the case ceives much more than the share of bottom 20 per-
is, each political party will target the median voter. centile in both health and education. And the middle
The median voter along the economic lines is the class shares the maximum. Even in India, most poli-
32 NIVESHAK VOLUME 2 ISSUE 11 december 2009
cies are oriented to benefit the middle
class instead of the ‘targeted’ poor,
with the possible exception of
NREGA (which benefits the middle
too if you consider the funds si-
phoned off by the government of- fi-
cials). As the middle class grows,
the political campaign for a larg- er
share to cater to this expanding class.
It can be argued there is more to
socialist aptitude and attitude than gov-
ernment share in national income. B u t
just like GDP is insufficient yet the best in-dicator
of economic development, government share in na-
tional income can be said to be the best indicator of
socialist aptitude of the government.
Another reason why governments still play a
significant role can be viewed from the banking sec-
tor. Consider this: Banks are required to keep only a
low (say, 8) percentage of its total assets as capital.
Even in India, in one of the most regulated banking
sector, banks on average have 12.5% of its total as-
sets as its capital. This means, the banks on average
can play around with 8 rupees with only 1 rupee
as its own. We keep deposits as we do not want
whole of our ‘fixed commitment’ instrument as cur-
rency. We keep a fraction as deposits, the return of
which is guaranteed by Reserve Bank of India (to
prevent a bank run). We refrain from caring about
these deposits due to government liability. Hence,
the ex-post demand for liquidity is de-facto, much
less than ex-ante demand. Hence, the banks enjoy
an imbalance in the asset-liability risk, a clear sign
of moral hazard. Banks have an incentive to take
more risks than advised. This is essentially why cri-
ses happen. So, the government role doesn’t end at
guaranteeing the deposits. It has to regulate these
banks in its use of these deposits without effec-
tively hampering the operations. Crises happen in
countries where governments do not play this role
and crises do not happen where they do. Hence, the
clear implication is that with the private and govern-
ments as players, Government finds it optimum to
play the regulatory role even in the most capitalistic
nations of the world.
And not only is it competitively advantageous
to play a big role while competing with the political
rival within the country, it is the optimum decision
while competing with rival nations. Powerful govern-
ments can extract a larger share from international
transactions than smaller governments. For exam-
ple- one of the reasons China is given an increas-
ingly important role in the international arena is that
Chinese government is able to stick to its interna-
tional commitments, be it carbon emission reduc-
tion or trade deregulation. In contrast, the reason
why Pakistan has failed to be an important figure
in the international arena is the fact that Pakistan
government is unable to hold a dominant position
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
within its country. Its power is corroded by
the military and the terrorist figures.
Bigger governments possess more
bargaining power than small
ones. This is also one of the
rea- sons why Russia, formerly USSR,
is still a headache to America, despite
b e - ing defeated in the Cold War. In
i n - ternational trade, the power of big
gov- ernments to impose sanctions en-
ables them to force other countries to re-
cipro- cate by liberalizing the export-import
m a r k e t . Also, countries with bigger governments
are also more likely to enter into free-trade agree-
ments than small ones. Some of these facts seem
contrary to the common mind. After it is thought
that the raison de etre for big governments is to
enforce self-sustainability and to hamper integra-
tion with other countries. However, the reality is far
from this. Bigger governments do not necessarily go
with regulations and nationalizations. For- example
Congress in America plays a significant role and yet
Perspective
America is arguably among one of the most inte-
grated nations in the world. It is time we shed the
clichés and start realizing this. Here two things are
involved: First, big governments do not necessarily
mean closer economies. Second, we are moving to-
wards bigger governments instead of smaller ones
across economies, as is commonly thought.
Concluding with this is very difficult since the
cross-country experiences have been very different,
and there are exceptions to both the facts stated.
However, in general, if we are ever allowed to gen-
eralize, the countries including both capitalist and
socialist economies (and its conservative deviants)
have seen governments growing over the years.
There is a heated market-vs.-state debate going over
the years. It is often forgotten that there is not nec-
essarily a trade-off between the two. Markets can
flourish with the presence of powerful governments
and only with the presence of governments. There is
a thin line of difference between a socialist economy
and an economy with socialist aptitude. It’s the for-
mer that was defeated in the Cold War and the lat-
ter which is the dominant across both developing
and developed nations. The market-vs.-state debate
fails to take this into account. The pro-market ‘ex-
perts’ ignore the market failure, the savior of which
can only be the government. The efficient-market
hypothesis has been proved more than once and
the latest instance is the present times. The pro-gov-
ernment ‘experts’ or socialists, as famously called,
fail to understand that at the end of the day, gov-
ernments are run self-interested officials who care,
after all, for themselves. One of the sole purposes is
to increase their power. This may seem a far-fetched
argument, but the truth is not far from this. It is time
we shift to a different debate.
33
 High Risk, High Reward:
A Review of Changing Currents on Executive Compensation
Anand Goyal
IIM Calcutta
Financial institutions have re-
The article identifies
cently been recording enormous
concerns with the losses, yet those losses are barely
current and pro- reflected in employee compensa-
posed compensa- tion. For instance, AIG had intended
to pay out $165 million in bonuses
tion frameworks and and compensation having lost a re-
provides recommen- cord $62 billion in the fourth quarter
dation for a better of 2008. CEO Edward Liddy, however,
pay methodology to assumed some responsibility and
agreed to take a pay of $1. Accord-
disincentivize reck- ing to Raghuram Rajan1 the justifica-
less risk taking by tion was that many employees had
senior executives. a banner year, and their compensa-
tion should not be held hostage to
mistakes that were made in the sub-
prime market. Also, many of these
pay outs are claimed to be legally
binding. Clearly something is not
right here. Studies by BusinessWeek
and other publications show that
compensation for big company CEOs
was more than 400 times the pay for
average workers last year, up from a
42-to-1 ratio in 1980. If the minimum
FinGyaan
wage had gone up at the same rate,
it would have been more than $22
an hour in 2006 instead of $5.15.
Compensation and Firm Risk:
Theoretical Framework
Firm risk has been shown to
be strongly positively correlated to
both the incentive and non-incentive
compensation components2. If an
executive’s performance equals the
standard, then he earns his target
bonus. Bonus plans also often speci-
fy a minimum bonus (corresponding
to a threshold performance level)
and a maximum bonus, both usually
expressed as a percentage of the
executive’s target bonus. The pay-
for-performance relation is shown
by the “incentive zone” in Figure 1.
The probability that an executive re-
ceives a bonus greater than or equal
to his target bonus is independent of
the bonus the executive received in
the prior period. The theory underly-
ing the use of stock option compen-
34 NIVESHAK VOLUME 2 ISSUE 11 December 2009
sation derives from the financial and
economic assertion that stock op-
tions offer upside potential, but limit
downside risk. Specifically, building
on the fundamental assumption of
a positive relationship between risk
and return, increased stock price
volatility will increase stock option
value. In the US, options as mode
of compensation gained popularity
in the
1980s in response to sharehold-
er pressure to link pay more closely
to performance. But they only came
to dominate compensation packages
after 1993, when Clinton administra-
tion imposed a cap of $1 million on
cash payouts to be eligible for cor-
porate tax deductions, many firms
shifted compensation to guaranteed
bonuses, such as the controversial
AIG payouts.
A typical executive annual bonus plan
Researchers have generally
tested the correlation between in-
centive pay and risk preference
alignment by examining the extent
to which incentives increase ex-
ecutives’ risk taking. For example,
(Datta, Iskandar-Datta and Raman)
examined the influence of CEO stock
option compensation on acquisition
behaviour.
They found that option pay
(measured as the ratio of the Black-
Scholes value of options granted in
the year before the acquisition to
total compensation), was negatively
 associated with acquisition pre-
miums. They further found that
option pay positively influenced
the acquisition of high-growth
targets and was associated
with greater post-acquisition
firm risk. They concluded that
stock option pay encourages
CEOs to undertake riskier
investments. Similarly, in a study of
relationship between
stock options and risk tak-
ing in oil and gas firms, it was
examined whether stock options
encouraged CEO risk taking,
measured as the coefficient of
variation in expected future cash
flows from exploration. It was concluded
that stock options increased exploration, which is
viewed as riskier than exploitation.
Role in Financial Crisis
With top management compensa-
tion being tied to company’s stock
price, a booming stock market allows
executives to pocket huge, often unde-
served, profits. Management is incentivized
to boost share price by beating investor expec-
tations. One way is for management to surprise
the market by taking on more risks,
which often involves betting the farm. On the Wall
through leverage. Similarly, the management of
Northern Rock followed the oldest strategy in the
book of taking on tail risk, borrowing short and lend-
ing long, and praying that the unlikely event of a
liquidity shortage in financial markets never ma-
terialized. Also, there is the question of “internal
equity”- how the highest-paid executives’ pay com-
pares with that of everyone else in the organization.
A bias to focus only on the external market in recent
years has helped push executive compensation way
out of whack. Because of the yawning gap between
the leaders and the led, employee morale is suffer-
ing, talented performers’ loyalty is evaporating, and
strategy and execution are suffering at companies.
A smaller gap makes for greater solidarity, and, as
a result, better performance, throughout the work-
place. Executive compensation was at the forefront
of the concerns that G-20 leaders had when they
began thinking about restrictions that needed to be
imposed on the financial institutions. Since October
3, 2008, the date on which the Troubled Asset
Relief Program (TARP) was estab-
lished in the US, Congress and the Trea-
sury each have issued legislation and
guidelines regulating the timing,
form, and amount of compensation
that can be paid to executives em-
ployed by financial and other institutions
receiving government assistance under TARP.
Moreover, the White House appointed a special

FinGyaan
master for compensation who will be responsible for
Street, for example, focus on short term gains is per- establishing and monitoring the executive pay pack-
vasive. Misaligned risk-taking incentives for banks ages at the seven firms that received the most TARP
forced traders to make trades and carry spread bets. funds, e.g., AIG, Citigroup, and Bank of America.
Spread bets pay small amounts most of the time,
so traders book this “fake alpha” – masquerading Current Status: Concerns and Recommenda-
as outperformance – as profits, collect bonuses, and tion
cross their fingers hoping to avoid the inevitable With worldwide outcry over executive pay,
blowup. For instance, an investment manager who the G-20 seems to have decided to implement pay
bought AAA rated tranche of CDOs in the past got a curbs and reduce risk taking among executives
return of 50 to 60 basis points more than a similar through the use of “long term
AAA rated corporate bond. That “excess” return was measures that align com-
actually compensation for the “tail” risk the CDO pensation with sound risk
would default, no doubt perceived as small when the management and through
housing market was rollicking along, but not zero. If increased transparency
all that the manager disclosed was the high rating and shareholder control”.
of his investment portfolio, he would have looked The US has proposed pri-
like a genius, making money without additional risk, marily the use of “salary
even more so if he multiplied his “excess” return stocks” which are long term

The financial crisis has

exposed dangerous flaws in
even the most sophisticated
executive compensation prac-
tises based on the risk-reward
framework.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 35

 grants that cannot be exercised for at least 4 years.
However, this proposal has many shortcomings. For
start, it involves micromanagement of top executive
pay at more than 28 large banks and several regional
and other organizations to ensure compliance. More
importantly, any options based pay suffers from the
fundamental flaw that stock-option plans can also
demotivate management when options go under,
either because of stock market crashes, as in 2002
and 2008, or when a company reaches maturity and
its stock peaks. Holders of stock options are then
penalized regardless of their actual performance. Al-
though it is logically appealing to expect positive ac-
counting-based performance to increase investors’
firm valuations, and thus market performance, ac-
counting based measures reflect current (and recent
past) performance, whereas market-based measures
reflect investors’ perceptions of future value. Thus,
anticipated earnings are typically factored in to mar-
ket valuations. As a result, maturity reduces inves-
tor expectations about future growth and they value
firms accordingly. Thus, executive options lose their
value, no matter what the executives’ input. Alterna-
tives such as say-on-pay are reliant on activism by
institutional investors such as pension and hedge
funds. However, empirical studies have shown that
due to lack of block shareholding in majority of US
corporations, shareholders generally approve re-
spective board’s decision on executive pay or sell
the stock. Some PE funds have resorted to “claw-
backs” i.e. taking back some of the compensation
FinGyaan
the equity fraction remains above a certain thresh-
old; this threshold sensitivity is typically increasing
over time even in the absence of career concerns.
It includes post-retirement periods to mitigate risk
profligacy in immediately preceding period. This so-
lution is based on the principle that true alpha of
an investment can only be measured in the long
run and with the benefit of hindsight – in the same
way as the acumen of someone writing earthquake
insurance can only be measured over a period long
enough for earthquakes to have occurred. This solu-
tion is better than the common practice of rewarding
short term changes in share prices. Also, apart from
linking an executive’s compensation to the perfor-
mance of the firm over a longer horizon, this method
also takes into account changing conditions within
the firm, thus, making a firm better off in the long
run.
Conclusion
The failure of executive compensation to be
aligned with corporate performance was brought to
the public’s attention as part of the economic melt-
down of the financial services industry in 2008. The
resulting effects of this meltdown on the United
States and the world economies, such as the freez-
ing of the credit markets, the bankruptcy of Lehman
Brothers, and the near failure of AIG, have been un-
precedented in terms of their speed and breadth.
Indeed, compensation practices in the financial sec-
tor are deeply flawed, and contributed to the ongo-
ing crisis. More generally, unless we fix incentives

if the investments perform poorly. However, while

these systems are similar in spirit, Alex Edmans8
argues that claw backs are a less effective way to
deter manipulation than escrow accounts. He says,
“If you have paid out bonuses and the company
then tanks, trying to claw back the bonus seems like
shutting the barn door after the horse has bolted.”
Rather than paying out the bonus and then clawing
back, it is better to just don’t pay it out in the first
place. Edmans has also proposed a compensation
structure based on long-term escrow accounts. The
optimal contract takes a surprisingly simple form,
and can be implemented by a Dynamic Incentive Ac-
count. The executive’s expected pay is escrowed into
an account, a fraction of which is invested in the
firm’s stock and the remainder in cash. The account
features state-dependent rebalancing and time de-
pendent vesting. It is constantly rebalanced so that
in the financial system, we will get more risk than
we bargain for. The foregoing suggestions help align
executive compensation to long term performance
and discourage excessive risk-taking, providing in-
centives that ultimately improve the health of the
company. The recommended framework based on
escrow accounts will have a far-reaching effect and
will significantly impact the compensation paid to
the executives. Even though the recommendation is
for financial institutions, the relevance of this new
standard at some point may very well extend to
most public corporations.

Attempts to align pay with

corporate performance have
led to huge top executive pay
checks in good times and in
bad times, sparking public
outrage.

36 NIVESHAK VOLUME 2 ISSUE 11 december 2009

 All the budding Niveshaks can test there investing acumen in here. Nivesh is a simple yet interesting
game. You are given a total initial capital of Rs 1,00,00,000. This amount is to be invested amongst some or
all of the Stocks from the BSE SENSEX 30, Gold (India Price) and Currency i.e. US Dollar. You have to build a
portfolio so as to maximize your return and at the same time diversify your risks.
The investment options are as follows:
Investment Category Maximum Amount
Stocks Sensex 30 stocks Rs 20,00,000
Metal Gold ( in Lot of 10 grams- India price) Rs 40,00,000
Currency US Dollar Rs 40,00,000
Rules:

FinLounge
1. The purchase prices for the stocks, currencies and metals will be the closing prices as of December
31, 2009. For example the closing price of US Dollar on December 31 is 46.5 INR and you invest all your al-
located Rs 40, 00,000 in USD then you can buy 86021 USD.
2. Your portfolio will be evaluated according to the closing prices as on January 15, 2010.
3. Risk free return for unallocated capital is 7% per annum.
4. You need to mail us an excel sheet (the formal for which is stated below) containing the details of
your stock portfolio (no. of shares of the companies you choose from the BSE SENSEX-30), amount of gold
purchased in grams, and the amount of currencies you purchased in each category by 9:00 am January 4,
2010.
The format for the portfolio which you are supposed to send is as follows:
Investment Category Quantity Closing Price Total Amount Uninvested Target Price Stop Loss
(Q) as on Decem- invested in Rs. Capital (optional) (optional)
ber 31 2009(P) (QxP), I (Total Amount)
Stock 1 No. of
shares
Stock 2
Stocks
Stock 3
(and so
on)
Gold (India 10 grams
Metal
Price)
US Dollar No. of cur-
Currencies
rency
5. The results will be declared in the next issue of Niveshak.
6. It is not necessary to invest in all three i.e. stocks, metal and currencies. It is not necessary to
invest in all the SENSEX-30 companies or in both the currencies.
7. You can also give Target Price (for Buying) and Stop Loss (for Selling) for any particular stock, al-
though this is not mandatory.
8. For further queries in this regard you can mail Team Niveshak on niveshak.iims@gmail.com
Prize:
The Niveshak with the maximum return as on January 15, 2010 will be declared the winner and will
be awarded a cash prize of Rs 1000.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 37

TEAM NIVESHAK
ARTICLE OF THE MONTH
The article of the month winner for December 2009 is
Gayatri Kapur
of SPJIMR, Mumbai
She receives a cash prize of Rs.1000/-

Fin-Q Winner
The Fin-Q Winner for the month of November 2009 is
Gaurav Somani
of FMS, Delhi
He receives a cash prize of Rs.500/-
CONGRATULATIONS!!

CALL FOR ARTICLES

Team Niveshak invites article from B Schools all across India. We are looking
for original articles related to finance & economics. Students can also contrib-
ute puzzles and jokes related to finance & economics. References should be
cited wherever necessary. The best article will be featured as the “Article of the
Month.” and would be awarded cash prize of Rs.1000/-

Instructions
»» Please submit your article with the file name and the email subject as <Title of
the Article>_<Institute Name>_<Author’s name/Group’s name> by 10 January ‘10.
»» Article must be sent in Microsoft Word Document (doc/docx), Font: Times New
Roman, Font Size: 12, Line spacing: 1.5 and maximum of 5 pages.
»» The cover page of the article should only contain the Title of the Article, the
Author’s Name and the Institute’s Name
»» Mention your email id/ blog if you want the readers to contact you for further
discussion
»» Also, if certain entries which could not make the cut to the Niveshak will get
figured on our Blog in the ‘Specials’ section

SUBSCRIBE!!
Get YOUR OWN COPY DELIVERED TO INBOX
Drop a mail at niveshak.iims@gmail.com
Thanks
Team Niveshak
www.iims-niveshak.com
COMMENTS/FEEDBACK MAIL TO niveshak.iims@gmail.com
http://iims-niveshak.com
ALL RIGHTS RESERVED
Finance Club
Indian Institute of Management, Shillong
Mayurbhanj Complex,Nongthymmai
Shillong- 793014