MONEY

THE

MANAGER
AN IIM-A, IIM-B,IIM-C INITIATIVE JANUARY 2011

MONTEK SINGH AHLUWALIA

SANJAY NAYAR
SHYAMALA GOPINATH
BRUCE TUCKMAN
JAHANGIR AZIZ
AMAR BHIDE
ARVIND SUBRAMANIAN
VIRAL ACHARYA
RITESH DUTTA
HAROLD KIM
RANODEB ROY
SWAMINATHAN ANKLESARIA AIYAR
STEVE YOUNG

THE NEW WORLD ORDER

THE NEW WORLD ORDER
the aftermaththe
of theaftermath
financial crisisof the financial crisis
 © UBS 2010. A
From the Money
Coordinator’s Desk Manager Team
— —
You’re 2010-11 has been a phenomenal academic year for Beta – The
Finance and Investments Club of IIMA. The team secured its high-
est ever corporate partnership with UBS emerging as a strong and
Editors-in-Chief
Tanu Singh

full of energy and ideas.

V M Avinass Kumar
patient patron for finance-related activities within IIMA. On behalf
of the IIMA community, I would like to thank UBS for its unflinch-
ing support. Managing Editor
Beta successfully kick-started the year with Finomena Anindya Dutta

And that’s just what

– a 3-day finance workshop and then followed it up with a mas-
sively successful flagship national event called Exchequer. In an Editorial Board
event which was slickly designed and organized with the smartest Anuj Dayal
future investors, traders and bankers locking horns, ISB Hyderabad Kunal Singal
was the eventual victors in the event which lasted a grueling two

we are looking for.

Gaurav Singhal
months. Apart from that, Beta strongly continued to support the Gautam Dhond
cause of promoting finance internally in IIMA through remedial Gourav Dhavale
sessions, mentor programs and guest lectures and the fruits of Pratik Gupta
its activities continue to bear fruit in the way a number of bulge- Sayali Kale
bracket banks and investment firms continue to repose their faith Sitaram Agarwal
Looking for a career where your ideas in hiring talent from IIMA. Soumyajit Mitra
could really make a difference? UBS’s One of the major successes for Beta has been its publi-
Graduate Programme and internships cation platform this year. Be it the Beta Budget series, Beta Daily
are a chance for you to experience for – our daily newsletter, Beta Pedia – our daily finance glossary di- Faculty Advisors
gest or Beta Times – a weekly finance newsletter, Beta continued Prof. Ajay Pandey
yourself what it’s like to be part of a
to deliver on its promise to emerge as thought leaders within the Prof. Joshy Jacob
global team that rewards your input Prof. Atanu Ghosh
student community.
and believes in succeeding together. Prof. Rakesh Basant
Further, this year Beta established a new one-stop on-
line shop (http://beta-iima.com/) for its activities which we hope
Wherever you are in your academic will emerge in coming years as a dominant forum for discussing Coordinating Committee
career, make your future a part of and debating finance- related global issues with IIMA taking the Anindya Dutta (IIMA)
ours by visiting ubs.com/graduates. lead in mentoring this effort. Priyank Patwari (IIMB)
It is in this context that Money Manager represents the Priyesh Jaipuriar (IIMC)
culmination of a year’s efforts to push the envelope at every stage.
Right from taking internationalizing the scope of Money Manager
to putting together views from 13 eminent personalities from the Design Coordinator
fields of finance and economics, Money Manager 9 has carved an Sandeep Dalmia
exclusive niche for itself, which we hope will continue to reflect in
the quality of future editions of Money Manager. Layout and Identity Designer
Lastly, I would like to thank the entire team of 23 ex- Prachi Chaudhari
tremely motivated Betans who made this year so successful for the
club and for each other.
Signing off… Coverpage Design
Kartik Krishnan
Anindya Dutta Junaid Hasan Hashmi
Coordinator, Beta
2 Money Manager / January 2011 Money Manager / January 2011 3
FROM THE
EDITORS DESK
“ “
When written in Chinese the It isn’t so much that
word “crisis” is composed of two hard times are coming; the
characters - one represents danger change observed is mostly
and the other represents soft times going
opportunity.”
”
Groucho Marx
John F. Kennedy
Finance as a business enabler found its biggest purchase in the
west with mounting business and consumer needs for invest-
ment destinations. With easy money, unfettered financial prod-
uct innovation and light-touch regulation, the financial markets
put money into everyone’s hands including that of those who
couldn’t afford the cost of using money. The levels of growth
were so gargantuan that it had to come to a halt or at least slow
down at some point. However, quite unexpectedly, it resulted
in a financial crisis which had just one parallel in history. The
post crisis world of 1929 resulted in a world war and the baton
of global economic domination passing to the United States of
America. The situation today is not too dissimilar. However, the
roles are reversed with the Asian Tigers, Brazil, Russia and the
Indian Elephant looking to occupy that spot.
If out of place quotes could so effortlessly morph
into relevance for the modern day, the quotes by Groucho Marx
and John F. Kennedy, men who had little to do with the world
of finance, take the cake. It is indeed the disappearance of soft
times for the western democracies. Here on things will move
but at the pace determined by the Emerging Markets. But things
are not going to be hunky-dory for the Emerging Markets either.
As Kennedy succinctly put it – it is danger when they tread the
greater heights, but it’s also opportunity that beckons. How
the emerging markets grab it and how the western democra-
cies battle it out to maintain their supremacy will indeed be a
fascinating contest. But one thing is clear at the moment – the
4 Money Manager / January 2011
CONTENTS
08 — COVER STORY
08 THE NEW WORLD ORDER-THE AFTERMATH OF THE FINANCIAL CRISIS
— GLOBAL CURRENCIES – A TECTONIC SHIFT OR A MUTED WHIMPER?
17
18 INTERVIEW WITH ARVIND SUBRAMANIAN
22 INTERVIEW WITH RITESH DUTTA
25
— FINANCIAL PRODUCTS – IS THE INNOVATION TREND TRULY OVER?
”
26 INTERVIEW WITH HAROLD KIM
29 INTERVIEW WITH BRUCE TUCKMAN
31 — REGULATORS –OMNIPOTENT WATCHDOGS OR LIBERAL BYSTANDERS?
32 INTERVIEW WITH SHYAMALA GOPINATH
36 INTERVIEW WITH STEVE YOUNG
39 INTERVIEW WITH VIRAL ACHARYA
power balance of global finance is not what it used to be and it
— EMERGING MARKETS – EPITOMES OF RESILIENCE OR TICKING TIME BOMBS?
may never revert in our times. This forms the core of our thought
process and led to the creation of the theme for the 9th edition 43
of Money Manager – “The New World Order of Finance”. 44 INTERVIEW WITH RANODEB ROY
This issue of Money Manager is punctuated with
47 INTERVIEW WITH SANJAY NAYAR
interviews of people from all walks in Finance - Bankers, Regu-
lators, Policymakers, Investment Managers and Academicians.
The student articles are exceptional in their focus, coverage,
quality of analysis and the insights they provide. We have tried
to accommodate opinions of every colour to give you a holistic
51 — THE DOMESTIC VIEWPOINT – IS INDIA POISED TO RULE AMIDST THE RUINS?
52 INTERVIEW WITH JAHANGIR AZIZ
perspective of the state of affairs in global finance and econom- 55 INTERVIEW WITH MONTEK S. AHLUWALIA
ics broadly categorized under Financial Products, Currencies,
— CHALLENGES – IS THE NEW WORLD ORDER PROGRESSIVE OR REGRESSIVE?
Regulatory Bodies, Emerging Markets, the Indian perspective
and Challenges to the evolving New World Order. 59
We would like to express our heartfelt gratitude to the illustri- 60 INTERVIEW WITH SWAMINATHAN AIYAR
ous people who have consented to provide their views and
63 INTERVIEW WITH AMAR BHIDE
thoughts on the topic, jury members who have adjudicated the
student entries and UBS who have sponsored Beta’s activities
this year. We hope this edition gives you a lot to think about and
even more to discuss and learn.
67 — STUDENT ARTICLES
68 GLOBAL CURRENCIES- A TECTONIC SHIFT OR A MUTED WHIMPER?
74 CHINA’S DOLLAR TRAP- A HISTORICAL PERSPECTIVE.
Please do send in your feedback to beta@iimahd.ernet.in 83 LIGHTING UP DARK POOLS
Tanu Singh 87 REGULATION IN INDIAN SECURITIZATION MARKET- PRUDENT OR PUNITIVE?
V M Avinass Kumar 90 DOLLAR CRISIS- REAL OR IMAGINARY
 OPINI ONS

ANALYSES VIEWS
6 Money Manager / January 2011 Money Manager / January 2011 7
COVER STORY
THE NEW
WORLD ORDER
the aftermath of the financial crisis
David Rockefeller speaking at the Business Council for the United Nations in
September 1994 mentioned, “We are on the verge of a global transformation. All we
need is the right major crisis and the nations will accept the New World Order.” 14 years
later, the world witnessed the worst financial crisis since the events that followed Black
Thursday in October 1929. The aftermath of the financial crisis has pointed to significant
shortcomings in the macroeconomic structure of large western democracies and the
susceptibility of their real economy to shocks in the financial economy.
8 Money Manager / January 2011
More importantly it has had a deep impact on the critical stakeholders in the
financial system. The hold of the Dollar over world trade is being questioned. Financial
product innovation has come under the scanner. The apparent failure of regulatory
mechanisms has sparked intense debates in the developed and developing world. The
Emerging economies in Asia (Ex-Japan) and the BRIC Economies have weathered this
storm much better than expected and have in fact come out stronger. But there are
enough cracks in the new world order that is indicative of a threat to this optimism for the
emerging giants.
Money Manager / January 2011 9
COVER STORY
global currencies
—
With the end of the Bretton Woods Agreement following the
Nixon shock in 1971, US dollar for all practical purposes replaced
gold as the benchmark standard and emerged as the dominant
currency and reserve of the world. This was caused by a vari-
ety of factors which included notably, the dominance of United
States as the major trade player of the world, the deep and flex-
ible financial systems of the US including an active secondary
market for dollar denominated instruments, the emergence of
petrodollars and the unparalleled political power of the US. The
US dollar had characteristics that favoured it to be used for all
the three purposes of money: as a medium of exchange, as a
unit of account and as a store of value. Although post 1971,
the developed world moved towards a flexible exchange rate
regime, holding foreign exchange reserves (primarily US dollars)
was seen vital to maintain financial stability and prevent tem-
porary exchange movements from interfering with broad fiscal
and monetary goals.
The last two years, particularly in the aftermath of
the global crisis, have seen growing concerns about the validity
of US dollar as the dominant currency. This has stemmed from a
host of reasons, chief amongst them being the weak fundamen-
tals of the United States as underscored by its huge federal debt
that touched 94% of the GDP in the fiscal year 2010, soaring
unemployment (9.8% in November 2010) and mammoth budget
deficit to the tune of $1.42 trillion in 2009. Adverse economic
impact caused by the United States’ military adventures and the
hoarding of dollar reserves by countries like China seeking to
increase export competitiveness through depreciated domestic
currencies.
This has led to protesting voices from several quar-
ters seeking an end to the dollar hegemony and a shift to an al-
ternative order anointed by other monetary units. Events which
have made this shift noteworthy include the purported talks by
OPEC to move to denominating oil in a basket of currencies com-
prising euro, yen, gold and a new currency unit for members of
the Gulf Co-operation Council; the tiptoed movements of China
and other countries to diversify their reserves away from the
US dollar; bilateral talks by China with countries such as Korea,
Russia and Malaysia to settle trade in renminbi and reduction in
the share of US dollar in global foreign exchange transactions.
However, the prevalence and velocity of US dollar
puts it in a different league altogether from its competitors,
atleast as of now. Its closest contender would be Euro which
has around half the share of US dollar in global foreign exchange
transactions. While the Euro area is larger than the United States
in economic terms and is integrating further with the growth of
its capital markets, it is far less liquid. Also the credit quality
of Euro bonds differs from country to country and questions are
being raised about the fiscal sustainability of a few members.
The yen suffers from the same problem as well and an ageing
10 Money Manager / January 2011
population raises question marks over the future credibility of the
Japanese economy. Further, neither the Euro-zone, nor countries
like Britain and Japan wield as much political power as the US.
This brings China into the picture. While the economic
and political clout of China is close to that of the US, Chinese sec-
ondary markets are woefully underdeveloped as compared to their
American peers and the depth of renminbi would have to increase
significantly, if it is to take the place of the US dollar. Moreover, the
renminbi is still not fully convertible and the political stability and
monetary policy of China is yet to command complete credibility
from the international community.
The Special Drawing Rights (SDR) suffers from none of
these drawbacks. It does not engender conflicts between short term
domestic and long term economic objectives (the Triffin dilemma).
Its implementation would not require a large scale overhaul as sys-
tems already in place can serve the function. It would also not lead
to a single country getting cheap credit from the rest of the world
and receiving seigniorage gains in the process. The composition of
the same which at present stands at 44.1% USD, 37.4% EUR, 9.4%
JPY, 11.3%GBP can be made flexible to include varying shares and
introduce new currencies of the emerging economies, making it
more stable than any single currency. The concept of SDR is cer-
tainly laudable and an effective long term solution. In particular,
its case as a unit of account seems very strong. However, its use
as the medium of exchange would imply the loss of considerable
sovereign authority which does not concur with popular sentiment
around the world. Further, the credit quality of SDR bonds would
be the credit quality of member country issuing them, the volume
of which would depend on global distribution of economic power
bringing us back to the credit quality of the Western world. Also,
a full blown implementation would imply creation of SDRs worth
more than $3 trillion as they currently stand at only 4% of the global
reserves. All these reasons militate against the immediate or short
term use of SDR as the store of value or medium of exchange.
“
The concept of SDR is cer-
tainly laudable and an effective
long term solution
”
COVER STORY
The outlook therefore, is not so radical in the short
term. The flexibility, innovation, depth and volumes of the US
financial system would ensure the continuance of dollar as the
dominant currency for some time now. The tipping point might
occur when measures such as the TARP cause the cost of dealing
in US dollars to exceed the benefits of doing the same. While an
abrupt shift seems unlikely, the movement of global trade and
reserve holdings from US dollar to other alternatives would con-
tinue as the US fiscal burden coupled with its near zero interest
rates makes investment in dollar a highly unprofitable venture.
financial products
—
The most significant trend in the financial sector, in the last two
decades, that has shaped the current structure of the banking
sector has been the advent of derivative products and securitized
products that provide higher yields to the banks and enhance
their margins particularly in an extremely competitive environ-
ment. As the wave of innovation through “securitization” and
“derivatization” spread throughout the industry creating an ex-
tremely opaque and complex financial product ecosystem, so did
the need for risk management practices and regulatory control
mechanisms. However, the vanguards of financial products in-
novation were always miles ahead of those wearing regulatory
shoes or those instituting the risk-management tools, methods.
Financial innovation has been on the rise since late
1980s. It was during this period that the US banking sector had
witnessed a tide of multi-billion mergers and acquisitions includ-
ing those of Citicorp and Travelers, J.P. Morgan and Banc One,
Chemical and Chase and many more. What was originally a frag-
mented banking sector turned into a highly consolidated one and
the incentive beyond operational efficiency was to enable cross
selling of products. This trend shepherded the products contrived
on Wall Street into the portfolios of risk-averse pension funds
and mutual funds.
Post 9/11, the Fed followed a regime of low interest
rates to boost the economy. With near zero interest rates, inves-
tors- individual as well as institutional, solicited products that
could enhance their yields. Structured products built over securi-
tized products - Collateralized Mortgage Obligations (CMOs) and
their credit counterparts- Collateralized Debt Obligations (CDOs)
flooded the markets. To achieve even higher yields, multiple lev-
els of CDOs were built over underlying CDOs and the investors
lost sight of the ultimate underlying asset.
Thus, the mushrooming market and increasing compe-
tition in the structured products space paved the way for products
with complexity that was unfathomable for the targeted investors
to understand their risk-return profile, for regulators to implement
effective capital requirements and for the credit rating agencies
to assess the credit quality. The bubble blew-up finally with Leh-
man Brothers & Bear Stern disappearing from face of Wall Street
and the outstanding trillions of dollars securities turning toxic.
In the aftermath of the crisis, financial innovation and
securitization has been labelled as evil and irrational exuberance.
However, most of the innovations arose out of the need of finan-
cial institutions and investors to hedge their risk exposures or to
meet the needs of market. Securitization has been denounced as
the nonpareil behemoth that propelled the banks and financial
institutions into making irresponsible loans and then selling them
off, with the help of good ratings from credit agencies, to unwary
investors seeking above normal returns.
This argument creates an abomination towards finan-
cial innovation as the root-cause of the iniquity that led to the
financial breakdown. However the fallacy here is probably not the
innovation, but the inability of credit agencies and regulators to
assess the risks, speculative activity superseding the core activi-
ties of banks, and the investors forgetting the old maxim- there is
no such thing as a free lunch.
As we stand at the cusp of a recovery – the future
of financial product innovation is very much in the balance with
more aware regulators and stringent norms. At present the va-
nilla products are dominating the street – mainly due to higher
spreads in markets which are relatively illiquid. There are three
primary factors behind this. One, the role of the exotic products
in exacerbating the recent crisis has made the investors uneasy
with such products. Secondly, at present the vanilla products are
offering high yielding investment opportunities. Banks are able to
achieve high yield by relatively risk free investments - borrowing
short term funds at near zero rates from Central Banks and invest-
ing in the rally in Treasury bonds fuelled by the Fed’s quantitative
easing. At the same time, the uncertainty in corporate bonds and
the European and emerging markets sovereign bonds are provid-
ing opportunities to make significant profits by second-guessing
policy action which has become predictable in the aftermath of
the Lehman debacle .
“
As we stand at the cusp of a
recovery- the future of financial
product innovation is very much
in the balance with more aware
regulators and stringent norms
”
Since 2008, the US banks have increased their holding of cash and
securities from 14% to 19% of the book, while the size of loans
have reduced from 58% in 2007 to close to 50% of the books. The
third factor is the new set of capital constraints being anticipated
with the BASEL III is making it imperative for banks to accumulate
more of Tier I securities, comprising primarily of vanilla products
including equity. The first factor- reluctance of investors suggests
that exotic financial products may not flood the markets again.
However, as imperfections created by the Fed’s policies recede
and the European uncertainty subsides, simple products would
Money Manager / January 2011 11
COVER STORY
start yielding nominal returns. At that point, it is highly likely
that the investors seeking higher yields would start picking up
the unconventional products again. It follows from Hyman Min-
sky’s theory that financial stability sets the stage for future cri-
sis, because the stability fuels high yield- high risk investments.
Although, the experience of the last recession would make a
case for rating agencies to be more vigilant towards these in-
novations, enough questions in that domain still remain.
The last factor curbing innovation at present is regu-
lations. Although it seems a strong factor, this is the least prob-
able factor to hinder financial innovation in future. Historically,
regulations have been backward looking and would probably
enforce constraints on financial institutions so that they cannot
get away with similar misrepresentations and negligence as last
time. However, the regulations, such as Dodd-Frank Bill and the
in process Basel III, target the banks primarily. Financial insti-
tutions like hedge funds and reinsurance firms provide mecha-
nisms for the banks to transfer risks out of the banking system
and regulations have still not adequately touched them. Thus,
with the new regulations coming into effect, financial institu-
tions, and not just banks, would carry on the innovation trend to
minimize the effect of new regulations on profitability.
Also, there are various avenues in the financial sec-
tor that need innovation. Loans and credit to small businesses
has dried up and Fed’s QE-II to incentivize banks to lend money
to them is not really working. Also, with the new Basel III re-
quirements of higher capital needs for loans to non-rated busi-
nesses, banks would be less willing to lend to these businesses.
Also, unlike the big corporations, they do not have access to
the Commercial Paper market. There is an irrefutable need for
innovation to design products that can provide incentives to the
banks to put their money to giving loans to the small businesses
and households.
Emergence of CDS exchanges is a positive move to-
wards addressing concerns raised by the OTC market having an
influence in exchange traded securities. However, the regulatory
system is yet to counter the parallel innovation of financial prod-
ucts in the OTC market. Many of the current innovations in secu-
ritization evolved from OTC products that were later brought into
the main fold. So the innovation has happened on those frontiers
were largely outside the purview of the regulators till they at-
tained macroeconomic significance. Innovation as we see it is
coming within the ambit of the exchange, but only after taking
roots elsewhere in the non-exchange segments of the financial
markets. Promoting value-additive innovation in the exchange
segment can, hence, be the perfect antidote to create a resilient
financial product market
To summarize, the innovation trend may not pick up
till there are concerns around recovery. But, with greater stabil-
ity, innovations in products would be imminent. The silver lining
is that the lessons from the last crisis may pave the way for a
more vigilant stand from the investors and the rating agencies,
and a more responsible set of financial innovations to meet the
need of the financial sector.
12 Money Manager / January 2011
regulatory
mechanisms and
responsibilities
—
The essence of free market capitalism has been the freedom as-
sociated with financial markets - the ability of private entities to
chart their growth path and more importantly the omnipotence of
the market in deciding who survives and who does not. The one
phrase that regulators all over the world have lost sleep over is
without a doubt “Too big to fail”. The Global Financial market has
evolved in such a way that some private players become systemi-
cally important giants.
Governments more often than not are caught between
saving some firms which turns out to be very costly and facing
failures that threaten to bring down the entire system. Govern-
ments have also had to contend with financial concentration
where the banks and financial institutions kept getting larger
through inorganic growth – this meant that failure of one insti-
tution will destroy nearly a tenth of the entire market – case in
point: AIG. Regulators have 2 key mechanisms in their reper-
toire to tackle this issue - they can deem certain institutions as
“too big” and fragment them with firewalls or increase capital
adequacy whereby winding down firms during bust a less pain-
ful process. The regulators have opted for improving capital ad-
equacy norms at present – however, with the “Volcker Rule” – a
combination of the two is expected to be adopted.
The Volcker Rule however is making the system more
complex as against fundamentally revamping it and is seen as
delaying the coup de grace that failing financial giants will go
through. But a key element of financial regulation – those of firms
that operate across borders has not been addressed. Lehman’s
responsibility that was spread across more than 3000 legal enti-
ties and the issue of an Icelandic Bank that has failed to pay back
nearly $6 Billion to creditors in Britain are critical examples of
how a mechanism for cross border regulation has still not been
strengthened.
This also raises the question of regulators straddling
the issue of taxpayers’ vs private creditors which has resulted
in a slightly philosophical issue of regulators’ responsibilities.
Regulators have also set a bad precedent previously with gen-
erous treatment of derivatives and the significant counter-party
risks they pose. So essentially the regulators need to revisit their
role as a watchdog of taxpayers’ money and examine the founda-
tions on which the current mechanisms of subjective handling of
systemically critical entities rests.
The Basel regulations in its avatar as Basel 3 are bleak
as they now replace the mantra of capital efficiency with robust-
ness. In the pre-crisis scenario banks could manage with common
equity as little as 2% of risk-weighted assets.
COVER STORY
However Basel 3 is expected to increase this to nearly 4.5%. Hy-
brids will be discouraged with the focus on core high-quality Tier-I
(iv) The market as an unbiased leveller – Risk taking comes with
the downside which is consequent on the entities actions and
capital. However the most important fundamental shift comes from inactions.
the rules being supplemented by a leverage ratio as against just
risk-weighted models. (v) The fundamental benefit of financial innovation, that is deliv-
“Procyclical” measures that allowed banks to store up ering value, will drive more innovation or curb it on the basis of
capital in boom times for lean period was originally seen as profit- market reaction.
smoothing, but this is now going to be the philosophical basis of the These have clearly not been the case and the regula-
tory bodies world over should examine the fundamental assump-
new regulations. Moving along after the crisis with banks starting
to repay the TARP funds and gaining on profitability, these measures tions of finance on which they have built the legal framework
of restrictions will surely face some opposition. With lesser govt. of securities and financial markets regulation. Clearly a new and
bold paradigm for regulatory function and responsibility needs
control, how the regulators handle the capital situation will be a key
to be established – and that needs to come from the regulators
parameter of their learning from the financial crisis.
themselves.
“
The regulators need to revisit the emerging markets
their role as a watchdog of taxpayers’
money and examine the foundations —
on which the current mechanisms of Ifstory,
the crisis raised questions about the Emerging Market (EM)
the post-crisis EM resurgence has laid them all to rest. Not
subjective handling of systemically only were the EM economies less affected by the crisis, they have
also been the first and the fastest off the block when the recovery
critical entities rests
”
set in. There are several reasons for this rapid recovery of the
emerging markets. Structural changes introduced in the after-
math of the South East Asian crisis, reduced reliance on Western
As much as microprudential regulations impact op-
exports due to growth in inter-EM trade, relatively under devel-
erational level aspects, the falling dominos impact of the financial
oped financial markets, higher reliance on domestic savings and
crisis can be attributed to poor macroprudential regulatory thought
prudent regulation have all contributed significantly to EMs faring
process. The biggest question lies in who should be doing this regu-
better during the crisis. Similarly, a timely and adequate policy
lation across borders, markets and global powers. Morgan Stanley’s
response through fiscal and monetary stimuli & strong domestic
ex-CEO John Mack, late last year, made a case for an uber-regulator
and inter-EM trade have helped in the post crisis EM revival.
– a global systemic risk manager. IMF has been suggested as a
Looking ahead, the growth in inter-EM trade such as
potential candidate – but experts, believe that IMF as a regulator
Asian commodity imports from Latin American countries, stronger
who can tell the SEC to buck up on certain regulations and norms is
inter-EM financial flows for example two-thirds of Chinese FDI
a pipe dream. Yes, the IMF can support troubled economies – the
is from other Asian EMs and the accumulation of forex reserve
Greece recovery plan lending testimony to that – but dictating global
buffers by EMs have helped reduce EM dependence on Western
monetary and regulation involves many principal-agent problems.
trade and capital. However, the EMs will continue to remain de-
Pricking bubbles again comes at an economic cost and
pendent on foreign investment to pursue their growth plans and
the responsibility here is not clearly divided between the Central
on Western demand for their exports. Consequently, the decou-
Banks and the Financial Services Authority. From a financial stand-
pling though in progress is far from complete as the transmittal of
point – some key points and assumptions that go into financial regu-
the crisis to EMs through trade and capital channels displayed.
lations are being questioned. They are:
Now that brings us to the following question: Is the
post crisis EM resurgence sustainable or is it a bubble? When
(i) Market prices truly build into them all information i.e. information
the sub-prime crisis first broke out, some optimists had gone to
asymmetry is assumed – the Efficient Capital Markets hypothesis.
the extent of calling EMs the new safe haven - especially after
fears of a U.S. recession made tens of billions of institutional
(ii) The positives of securitization – allowing people to take rational
money flee U.S. stocks for EM ones. Though the ‘safe haven’
risks and improving liquidity.
claim proved to be exaggerated, the EM’s thriving current ac-
count surpluses, underleveraged corporate balance-sheets, 50%
(iii) Mathematical and quantitative modelling and credit rating to
share of world GDP and 4% average growth during the crisis are
accurately measure risk.
strong reasons to believe that the EM growth story will continue
for quite some time. However, we need to remember that not all
Money Manager / January 2011 13
COVER STORY
characters in it are alike. A Korea or a Hungary is less reliant
on domestic consumption as compared to Asian powerhouses
China or India with their huge & growing domestic markets.
Badly hit by the crisis, East European EMs are worse off today
as compared to their Asian counterparts. Also, fortunes of cer-
tain EMs like Russia and certain Latin American countries are
strongly linked to commodity prices. Further, the EMs as a group
bears certain common risks. Shallow financial markets expose
EMs to asset price inflation due to foreign capital inflows as
the current episode of accommodative U.S. monetary policy
is showing. Nouriel Roubini and Robert Zoellick have warned
about a bubble forming in EM assets. Foreign exchange volatil-
ity remains a concern for investors affecting returns as well as
export competitiveness. Political and policy risk continue to be
pervasive factors be it the Khodorovsky verdict in Russia or the
Cairn–ONGC dispute in India.
To summarize, we believe that the EM growth story
remains robust albeit considering the aforementioned risks. The
growth story would be accompanied by growth in financial mar-
kets although such growth would definitely be characterized by
the conservatism that has worked for the EMs in the past. A
focus on domestic demand to reduce export dependence and
deepening of financial markets to reduce dependence on for-
eign capital are lessons of the crisis that are likely to be imple-
mented and create the platform for a shift in global power to
the Ems in the long term.
the indian viewpoint
—
The crisis and events in the last 2-3 years have uniquely posi-
tioned India in the global landscape. It is important, however, to
assess the impact of the crisis on India’s economic and financial
systems separately, particularly given the limited integration be-
tween these two systems in India. From an economic perspective,
the crisis and its far-reaching global impact has left India in a po-
sition of relative strength driven primarily by a burgeoning middle
class, favorable demographic trends and robust consumption. In
fact India has strongly rebounded in the last couple of years, with
growth having been recorded at 7.7% in FY2009 and expected to
clock in excess of 8.5% in FY2010. The two major reasons touted
for this economic resilience has been the strength of the Indian
banking system as demonstrated by strong credit growth even
during the peak of the crisis (24.1% credit growth in FY08 and
17.1% in FY09) as well as the relatively lesser dependence of the
economy on exports to the Western world. No doubt India came
through the crisis unscathed as a result of fundamentally strong
macroeconomic and policy management, both in terms of fiscal
and monetary policy formulation and implementation.
14 Money Manager / January 2011
As India now goes beyond crisis and recovery man-
agement and embarks on a path of high growth, several structural
deficiencies however remain. Supply side constraints created
by physical infrastructural quantity and quality deficits, skilled
workforce shortage due to inadequate spending on health and
education, spiralling inflation and issues related to governance
continue to limit India’s growth ambitions. It is in this context
of overcoming some of these constraints that the strengthen-
ing of the financial market ecosystem should be addressed by
policymakers. Financial market reform can create an environment
conducive for increased financial integration which will result in
the opening up of new, efficient and cost-effective methods of
financing, thus lowering intermediation costs.
“
The crisis and events in
the last two-three years have
uniquely positioned India in the
global landscape
”
This in turn will tremendously improve the productivity of capi-
tal and will have far-reaching consequences for several cash-
strapped sectors such as education, health and infrastructure
which are expected to be the backbone of Indian growth in coming
years. For example, the Indian physical infrastructure landscape
is suffering from a huge supply deficit, and innovative forms of
financing can help plug the supply-demand lag in this sector.
Further, broadening and deepening of financial markets can pro-
vide domestic savings access to a variety of financial products
as well as asset classes in the form of investment opportunities
and provide an additional thrust to improving domestic savings
(Already amongst one of the highest in the world with Gross Do-
mestic Savings amounting to over 37% of GDP in 2008-09). It is
in this context that the need to create a more robust corporate
debt market has been raised. An efficient corporate debt market
can create high yielding allocation opportunities for savings and
can concurrently meet the financing needs of businesses, thus
providing a fresh impetus to sustainable long-term rapid growth
in India.
Although the emergence of this new world order as
a result of the financial crisis has opened up several new op-
portunities for the Indian economy, there are also heightened
concerns regarding the sustainability of the Indian growth story.
These concerns are particularly pressing given the heightened
uncertainty regarding India’s ability to manage natural resource
requirements or its ability to initiate widespread governance-
related reform with the aim of securing domestic health, educa-
tion and infrastructure needs. In this context, the creation of a
sovereign wealth fund will allow India the much needed financial
COVER STORY
power to transfer excess foreign exchange reserves to meet
India’s infrastructural requirements on one hand, and also to challenges to the new
secure energy-related assets in what could be high-yielding
overseas investment opportunities.
Moreover, as the Indian economic clout grows in in-
world order
ternational circles, there is no doubt that savers and investors
will find themselves operating in an increasingly complicated
globalized world of risk and uncertainty in this new world order
developing in the aftermath of the global financial crisis. It is
—
The crisis that began with the fall of Lehman Brothers in Septem-
essential hence to create a vibrant risk management and hedg- ber 2008, has jolted the fundamentals of the economies and the
ing environment in order to sustain an environment of continued financial markets world over. From the fall of the biggest banks
savings and investments. It is in this context as well, that Indian in the United States to the debt crisis of the Euro zone, the world
policymakers need to encourage financial innovation such as of finance is no longer the same. But more than two years later,
the creation of a credit derivatives market, a structured prod- the world does seem to be a safer place and the markets have
ucts market and interest rate futures market which will help regained some shine. But the critics still point out to the dangers
financial intermediaries manage risks more efficiently.
There is no doubt that a sour taste has been left in
that are lurking in the economies.
The crisis brought with itself not just far reaching
the mouth by the global financial crisis which was fuelled by
unregulated financial innovation encouraged by benign poli-
changes in the regulatory structure of different countries but
also the fear of protectionism. There were indications that the
cymaking. However, to use the crisis as an excuse for putting
financial reforms on the backburner will continue to aggravate
advanced economies would resort to protectionist measures in
the future to boost employment and output in their respective
concerns regarding India’s ability to accelerate growth in the economies. Continued high unemployment (~10%) in the US
future. There is unquestionably a need for pro-active prudential raises concerns on these aspects particularly given heightened
regulation. However, the regulatory response cannot be ex- political pressure on US policymakers in this regard. Moreover,
tremely dovish or hawkish when it comes to addressing issues the Chinese government’s reluctance to appreciate the currency
related to financial reform and inclusion. Regulators will have on one hand and the increasing US current account deficit on the
to calibrate their responses so as to retain caution but not at other hand are creating an environment of major global imbal-
the cost of allowing the benefits of financial markets reform ances again posing a challenge to the stability of the world’s
from accruing to the real economy. financial system
The fact remains that despite a fundamentally strong
growth story, India stands on the cusp of a variety of opportuni-
ties waiting to be grabbed. All that is required is a little bit of
political boldness, rigorous macroeconomic management and
institutional activism to ensure that India can make the most
of what lies ahead. Whether policymakers have the appetite to
act with grit and gumption, still remains to be seen.
“
Another problem in the stability of the world economic system
would be the different pace at which the advanced economies and
the emerging economies are recovering
”
Though the advanced economies were recovering, the emerging
economies are racing ahead of the advanced economies. The
financial markets in the emerging economies are back to their
pre crisis level and countries like India have seen record inflows
in the past few months. Not only are the emerging markets a
preferred destination for investment but people are touting it as
a major shift in the financial hubs of the world. But critics are
questioning whether this growth is sustainable or not.
Central bankers have come up with new regulatory
measures such as the Dodd Frank Act, Basel III but these mea-
sures fail to deal with the problem of systemic risk in the financial
Money Manager / January 2011 15
COVER STORY

GLOBAL CURRENCIES
system or the risk posed by institutions which are “Too Big To
Fail”. The regulators are tightening the systems but would it put
an end to the “dangerous” innovations or would it hamper the fi-
nancial innovation in the coming future is a question that remains
unanswered. The crisis has definitely uncovered gaping holes in
our economies and the financial markets but the measures taken
so far do not seem to be enough to avoid the next big crisis.
It is without doubt, hence, that we are slowly graduat-
A TECTONIC SHIFT OR A MUTED WHIMPER?
ing to a new global economic and financial landscape, created
out of the ruins of the global financial crisis of 2008-09. How this
world will shape up remains to be seen, but there is no uncer-
tainty that global stability is still a distant dream and that this
new emerging world order will redefine the way we look at the
financial and economic world for decades to come...
-

Anindya Dutta
Gaurav Singhal
Gautam Dhond

“
Kunal Singal
Tanu Singh
V M Avinass Kumar

16 Money Manager / January 2011 Money Manager / January 2011 17

INTERVIEW WITH
ARVIND SUBRAMANIAN
Currencies that have dominated world trade have made an exit that has often been preced-
ed by a crisis and succeeded by the rise of a new economic superpower and its currency.
It is the same view that some experts hold with the USD right now, while some believe that
its sway is intact. Through this interview with Dr. Arvind Subramanian, a currency expert,
Money Manager captures his views on the evolution of the currency regime and the power
balance it will create.
Arvind Subramanian is senior fellow jointly at the Peterson Institute for International
Economics and the Center for Global Development and senior research professor at
the Johns Hopkins University. He obtained his undergraduate degree from St. Stephens
College, Delhi; his MBA from the Indian Institute of Management at Ahmedabad; and his
M.Phil and DPhil from the University of Oxford, UK.
18 Money Manager / January 2011
From 1987, when the dollar’s end as a global
currency for trade was sounded, the USD has
moved from strength to strength through a
number of crisis situations. How do you think
the credit crisis has affected this position and
are there any fundamental macro-economic
shifts that point towards the same?
—
In the post-war period, there have always been questions raised
about the dollar as a dominant currency. First the dollar’s role
was questioned in the late 60’s and the early 1970’s and as the
Bretton Woods system broke down, in part because the dollar
was very weak and so the American Policy makers felt that they
will not be able to sustain GDP growth and implement the do-
mestic policies when constrained by the Bretton Woods system.
This was followed by another crisis in the mid 80’s when in
fact the dollar became strong and in this recent crisis again, the
dominance of the American currency has been questioned and
for a number of reasons. This is because the United States being
has been the source of the crisis and mismanaged the financial
sector which has made people worry about good policy deci-
sions. As a result the US fiscal situation has deteriorated quite
rapidly and so there are questions about the ability of US to put
its public financing on a sound footing.
“
I don’t think the outside
world can bully or coerce
China into changing its currency
model
”
Unless the political system can absolve itself, the US public
debt can grow very enormously and that will again signal an
American weakness and therefore a weakness of the Dollar. The
irony of course is that even though the crisis originated in the
United States, in the initial phase of the crisis, the dollar actu-
ally strengthened, because people said “Oh my God! The world
is collapsing but the safest place in the world is United States”
and now, of course, the crisis in Europe is deepening and people
do think that, “Well certainly compared to Europe, the US still
remains a strong economy with a strong currency”. The huge
new development, however, that has been changing the stage
is the rise of China and the Chinese currency which I am writing
about in my next book. So the fundamental shift that has been
taking place is the emergence of the Chinese economy and the
Chinese currency.
Continuing on that note, Sovereign wealth funds
in the Middle East and China have consider-
able power in their ability to control the global
currency and bond market. What role do you
think they will play in determining the currency
regime in the future, especially in the light of
China pushing very strongly for SDRs.
—
So China’s strategy now is not to push for special drawing rights
although they did it to send a strong signal. It’s kind of implicit
that there is a plan to slowly but steadily promote the use of its
own currency and China has been doing a lot of things to en-
courage the use of its currency in terms of financial co-operation
with other countries, getting cheaper currencies denominated
in renminbi, agreements with a number of countries: Russia,
Brazil, Argentina and Middle-Eastern Countries. So the Chinese
strategy now, of course, is to make Shanghai an international
financial centre. China is going to gradually but steadily make
the renminbi stronger and insofar as they have both the eco-
nomic dominance and the reserves (two and half trillion dollars
of reserves) they would be in a strong position to make the
Renminbi strong.
With nearly two and a half trillion dollars of
reserves invested in US Dollar denominated
securities, how do you think China’s dollar trap
coupled with the Current real estate bubble will
play out in the near future?
—
I think the usage of the phrase “Dollar Trap” is a little too
strong. Fundamentally China will only change its currency policy
when it is confident it will not affect its long term growth. So
I don’t think the outside world can bully or coerce China into
changing its currency model and we have seen that over the last
one year, China has been absolutely adamant and stubborn in
not changing its policy. It has found that having an undervalued
exchange rate has helped its long run growth. So it’s going
to stick to its strategy until it feels it is in its own interest to
change the strategy and insofar as issues like overheating and
bubbles building up are concerned, it will use other instruments
like monetary policy and fiscal policy to cool down the economy.
It will not change its exchange rate policy very dramatically.
Coming to the dollar trap, I think that the calculations the
Chinese have made for the long run is that, yes, there would be
a huge capital loss on these reserves, but over the last twenty
thirty years, the higher growth and the higher exports that they
Money Manager / January 2011 19
have got from this exchange rate policy will outweigh those
costs that they will have to suffer. In the meantime they will try
and do everything to postpone that loss or to reduce that loss,
by diversifying into other currencies or promoting their own cur-
rate policy but now that’s not going to happen because China is not
going to allow it to happen. So the IMF authority, in a new Bretton-
Woods as a super regulator is going to be very limited because on
major policy issues like currency, monetary policy and regulation
So what policy measures do you think the major Regional trade agreements have played a
economies of the euro zone should take to ad- significant rule in countering the currency
dress the issue there? domination by the dollar. How do you think, the

rency. But at some point they have to take that loss- there is no
avoiding it. But the long run calculation is that it’s a price worth
paying for the higher exports and the higher growth that has
been caused over the last 25-30 years.
Prof. Roubini’s prediction of an impending cor-
rection is very much linked to the Chinese dol-
lar trap and the heating of the Chinese economy.
With QE2 and easy credit, do you think there
will be a medium term correction in the dollar
in the next couple of quarters?
of the financial sector, the big countries will not want to give away
the authority or the sovereignty to do so. China is not going to give
away the authority to determine its exchange rate policy to the IMF
as a super-regulator - No more than the US will be willing to give
away its monetary policy authority. So that’s not going to happen.
Therefore, as a super-regulator, I think the role is going to be much
more along the lines of what it has been doing will be limited and
relatively ineffective.
With the Greece crisis, the reputation of euro as
a chief trade currency has been severely af-
fected. What do you think will be the impact of the
stretched economies, like the PI(I)GS in the Euro
—
prevalence in growth of such regional trade
Well, first of all, many of these debts will have to be written
agreements and free trade agreements will
off. I don’t think Ireland, Greek, Spain & Portugal will pay off the decrease the impact of one single currency
debt that they have. So what Iceland did was to repudiate all its
foreign debt or most of it and Iceland bounced back. So first the
holding’s sway over the world trade?
debt would have to be brought down to a manageable level which
means that the Germans and the French will have to expect that
their banks which have lent to these countries will also have to —
take a hit. Second, these countries will have to find new sources
China is taking a number of policy initiatives to promote the
Renminbi - one of these initiatives is actually in regional trade
of growth. You can’t grow at 2 and 3 and 4 % and hope to be able
to repay your debt. Now for that the hurdle is that they will have
– to promote the Renminbi. So it’s not that China is promoting
to introduce structural reforms and countries like Germany will
regional trade agreements per se but the intensification of trade
links is being used by China to promote its currency. So part of
have also have to provide much more demand for these countries
in the short run. But, in fact, just the opposite has been happening
the strategy of China to make renminbi a world currency is by

— zone? What is lacking in the Euro to be the next making it a regional currency and then a world one.
- Germany has been running a huge current account surplus which
is the opposite of what these countries need.
Well, some of the correction is taking place through higher infla-
currency hegemon?
tion because remember what we care about is the appreciation
of the dollar in real terms. So even if they don’t change the
dollar and the renminbi rate, higher inflation in China means
—
Let me take it a step back: the next hegemon is going to be China
that some correction is taking place to some extent. But I do not - thats the big macro-shift thats taking place. China’s role in world
share the view that there would be a major correction over the GDP and in world trade is expanding rapidly. I think the euro as
next couple of quarters because the correction would be slow the next hegemon was a question that was very interesting in the
and gradual to minimize the political cost. Remember if the cur- early 2000s. It is less interesting now because after the Greek crisis
rency appreciates very rapidly, some sectors will become more people are even wondering now whether Euro currency as a zone
unprofitable than other sectors. There would be a lot of political can even stand together. They have this big problem between the
adjustment cost to that and hence the correction is not going to core countries which is Germany, France and to some extent Italy
be soon and it’s not going dramatic. It will be slow and gradual. which have actually not suffered the crisis, which are actually doing
quite well compared to the periphery countries which are not doing
very well at all.
When there was a call for SDR’s, Gordon Brown
mentioned about a second Bretton-Woods. What
is your take on this? What will be the avatar of
this institution? Is the IMF authority and attitude
as a regulator robust enough to take on this
mantle along with the World Bank – as some
kind of a super-regulator?

—
There are many aspects to this international monetary system
question. It’s true that the IMF has been strengthened but it’s
basically been strengthened to provide money to countries that
encounter a problem. There is no assurance at all that IMF will
be given the task to be a super regulator and that it will be ef-
fective in being the super regulator. One of the tasks that people
want to give it that it should determine what the currency
value should be between the different countries. For example,
it should have the power to tell China to change its exchange
20 Money Manager / January 2011
The troubles in these countries are far from over. Not only are they
far from over, people think that there’s no real light at the end of the
tunnel for these currencies. The only way to come back on a sound
footing is to make it grow and get rid of this huge amount of debt
that their governments have taken on. So unless some resolution is
sought for the problem of the peripheral countries, the whole fate of
the euro as a currency and the euro-zone, as a project of economic
integration, is in question. Unless, some drastic solution has been
found, I don’t think that’s going to change.
Money Manager / January 2011 21
INTERVIEW WITH
RITESH DUTTA
The Currency supremacy issue has swayed considerably over the last year – just when
the Euro looked strong enough to topple the dollar, the PIGS crisis happened to consid-
erably lessened its credibility. Add to this melting pot the Chinese inflexibility with the
Renminbi and we have a near deadlock on the “What’s after the dollar?” question. We
sat down with Ritesh Dutta of UBS to discuss the Sovereign Debt Crisis in Europe, China
and the G20. The excerpts follow.
Ritesh Dutta is Global co-Head of FICC Emerging Markets at UBS Investment Bank, based
in Zurich. Previously he worked in various roles for UBS across Rates, FX and Proprietory
trading in Mumbai, Singapore and London. He is a CFA charter holder and an alumnus of
IIM, Ahmedabad.
22 Money Manager / January 2011
Since the termination of Gold Standard, the USD
has been the base for international currencies.
However, with the US deficit increasing and also
QE raising concerns over the strength of US
Dollar, how do you think the role of US Dollar will
change?
—
The dollar remains the world’s pre-eminent reserve currency by
default rather by choice. At present, there are simply no other vi-
able alternatives. The long-term future of the Euro remains far from
certain and, in light of the sovereign crisis, the pool of investible
EUR-denominated reserve assets has declined materially. While
Special Drawing Rights (SDR) are increasingly viewed more favour-
ably, there is scant liquidity available. [The currency value of the
SDR is determined by summing the values in U.S. dollars, based on
market exchange rates, of a basket of major currencies (U.S. dollar,
Euro, Yen, and Sterling.] At the same time, the vast majority of
global reserves continue to be denominated in dollars and to allow
a rapid decline would damage many sovereign portfolios so it is in
nobody’s interest to rock the boat. After all, it was the intervention
of emerging markets to control the value of their currencies which
got themselves into this mess in the first place, so they should not
heap all the blame on the Fed and QE.
Prior to the crisis, there were increased specula-
tion of Euro assuming a prominent position as
an international currency and countries such as
China had started building reserves of Euro. Now
with the European Sovereign crisis in light and a
slight possibility of exclusion of some countries
from Euro Zone, how do you see the Euro evolving
in the near future?
—
It is too early to tell, but conditions in the Eurozone are likely to
deteriorate before they improve, and the governments in the region
know this. UBS is calling for fiscal guarantees, which we believe
to be the basic building blocks of fiscal union, to be in place by the
end of this year. Without movement towards fiscal convergence it’s
going to be very hard for the Euro to maintain credibility.
Prior to the European Crisis, south-east Asian
economies had been working towards estab-
lishing a single currency. As of now, the pro-
cess seems to have been halted. What would
be the advantages for these countries to move
ahead with this monetary integration, and do
you think after what we have seen in Europe,
they would move ahead?
—
There is little political support for such a project today, and the
Eurozone crisis has probably undermined the entire process. All
is compounded by the tendency for local governments/central
banks to see currency devaluation as a mechanism to increase
competitiveness. Of course, if you are a member of a currency
union you forgo this option - but never say never!
Despite the international pressure and increas-
ing US efforts, China has de facto maintained
its stand on keeping Yuan undervalued. Also,
China has over $1.5 trillion worth of US trea-
suries and has retained its position as a major
buyer during US Treasury auctions. With this
in mind, do you think that there is any possible
economic way that US can influence China to
appreciate its currency?
—
Notwithstanding any protestations from the Fed, the US has al-
ready exerted influence through quantitative easing - albeit that
the transmission mechanism is subtle. Soon after the launch
of QE2 (ostensibly to fight deflation), there was a sharp rise in
global inflationary expectations which, in turn, has lead to a
global jump in input costs. In China, the need to curb inflation is
a priority, but the authorities there will also be anxious to avoid
a collapse in asset prices. In light of this, we do not expect ag-
gressive interest rate hikes. This just leaves the CNY as a tool,
and it’s about time it was applied.
Money Manager / January 2011 23

In the last two years, G20 has increasingly
supported SDR as the international reserve
currency for the future. With concerns over
both USD and Euro, do you think a currency not
controlled by any single country, rather than
by a multilateral organization like IMF could
emerge as the preferred currency for interna-
tional transactions?
—
The SDR is not a transaction currency – it operates on a claims
basis and supply is determined by special allocation which
involves a high level of bureaucracy. Given that the US has a
blocking veto over any IMF decision, we doubt that it will be
considered a viable alternative. The IMF is not a settlement
bank. Simply put, the discourse has not advanced far enough for
people to consider alternative reserve/international currencies.
24 Money Manager / January 2011
FINANCIAL PRODUCTS
In the light of all the regulatory interventions
that are taking place (such as rate cuts, re-
serve enhancements etc.), do you believe there
should exist “Global guidelines” for capital flow
controls that every nation should adhere to, as IS THE INNOVATION TREND TRULY OVER?
suggested by the IMF recently?
—
Rules are routinely broken so it is futile for the IMF to impose
them in the first place. While there appears to be progress
towards reaching an agreement on current account targets, we
are only cautiously optimistic at this stage. It is about politics
as much as economics. Emerging market countries may be
warming towards current account targets but, as we saw at
“
the November G20, they managed to get the developed world
to agree to tolerate short-term capital controls as well. In par-
ticular, with the US still engaged in QE and other major central
banks exercising emergency policies, the scope for compromise
is limited. All remains a free-for-all.
“The views expressed in the interview are his own and do not
necessarily reflect those of UBS”
Money Manager / January 2011 25
INTERVIEW WITH
HAROLD KIM
The global economic crisis of 2007-08 has significantly affected the financial landscape in
terms of the nature of financial products which will be traded in the markets in the future.
As the markets continue to be uncertain about the nature of recovery, the Money Man-
ager team sits down with Dr. Harold Kim, to discuss how he sees the overall landscape
for investing in structured investment products shaping up.
Dr. Kim is currently the Managing Director and Head of the Cross Asset Group for Citigroup
Global Markets in Hong Kong, covering financial intermediary sales and investor structur-
ing for equity, fixed income and hybrid products. He originally started at Salomon Brothers
(a predecessor of Citigroup) in 1993, and has since served in a variety of capacities at
Salomon/Citigroup.
26 Money Manager / January 2011
Post crisis how has the attitude of clients
changed towards structured products? How has
Citi’s portfolio of products evolved in response
to this shift in attitude?
—
The onset of the financial crisis resulted in a decrease in activity
across all investment products, not just structured products, as
risk aversion increased and people looked to invest only in safe
assets. Once the markets started to settle down and risk aver-
sion decreased, we saw people broadening their range of in-
vestment products, understandably beginning with products that
they were familiar with. The crisis refocused people on making
investment decisions that they understand, which is good.
However, these new investments were not limited
to simple vanilla products. What was interesting about this
process was that, in some markets, we saw reacceptance of
products which are relatively exotic and structured to a reason-
able degree. Asia was not hit by the crisis as heavily as the
developed world, and by some measures the level of structured
investment activity has already recovered to pre-crisis levels.
For example, in Korea, in the equity-linked securities market
the volumes are close to pre-crisis highs. In India, the equity
markets are very strong, and we are seeing strong appetite for
structured products. In fact, we have a capacity constraint in
India where as soon as we have capacity to issue a product,
the product is taken up. So if you compare investment behavior
pre-crisis and what we are experiencing now, with the excep-
tion of some countries and client segments, it’s actually not that
different in Asia. For structured investment products in Asia, the
reacceptance of these products has been quite fast.
What has changed is that the product mix has
shifted towards what people view as the asset class with the
most favorable risk versus reward ratio. Immediately after the
crisis hit, the volume of equity products, which traditionally has
been the largest asset class segment, dropped in favor of fixed
income products. We saw a rapid increase in simple credit and
rate products. Now, with the equity market strengthening, that
shift has gone back towards equities, though the mix is not
as skewed as it was pre-crisis. I would estimate our pre-crisis
product mix to have been about 85% equities products and 15%
FICC products. If we look at our current product mix, it is roughly
60% equities and 40% FICC. Equity still represents the major
asset class, but credit and rates in particular and FX have gained
wider acceptance in terms of structured products.
“ With the equity market strengthening, that shift has gone
back towards equities, though the mix is not as skewed as it
was pre-crisis
”
Has Citi’s geographical focus changed in re-
sponse to the crisis?
—
Yes and no – Citi is still very committed to Asia as a whole, but
our focus within the region varies; the answer is country, product
and customer-dependent. In some countries, like Korea, the
volumes are reaching pre-crisis levels. In other countries, like
Taiwan where the regulatory response has been much stricter,
markets are still closed, and as a consequence our focus has
been reduced. In India, our volumes are down from 2007, but
this decrease is not due to a fall in investor demand, but due to a
decrease in our capacity to issue product.
Given investors’ preference for simpler prod-
ucts, going forward, do you see the financial
services industry continuing to be a hotbed of
innovation in product design?
—
There has been a lot of talk about the preference for simpler
products, but if you look at our business as it has evolved from
2007 to now, we actually have a large percentage of business
being done in what would be considered complex products. The
difference is that, these complex products are simple for the
customer to understand. I think this trend will continue.
For the last 30-40 years, the financial services
industry has been an industry focused on innovation, driven by a
variety of factors. Crisis and regulation breed opportunities for
innovation. Demographic trends breed opportunities for innova-
tion. If you think about Asia right now: where we stand in terms
of demographics, over the next several decades, Asia is going to
get older, it’s going to get richer and get more middle class. At
the same time we have very underdeveloped capital markets to
enable this increasingly wealthy middle class to invest and save
for retirement. As a result, we are going to see a real increase in
capital market innovation to satisfy this huge oncoming demand
for retirement products. The products will not be limited to
vanilla equity and mutual funds, but will include more complex
structured product solutions that will deliver good long term
investment value. We are at the cusp of another wave of very
productive innovation.
Money Manager / January 2011 27

There are some substantive changes in regula-
tions related to trading of financial products and
managing financial intermediaries. In the past
we have seen new structured products emerge
in response to regulatory changes. How do you
think changes in the regulatory framework will
affect financial innovation going forward?
—
That’s a hard question to answer right now, because the
regulatory environment is still changing. A good example is
what is going on in the US. The Dodd Frank bill has outlined the
intended guidelines for the new regulations, but the actual rules
have not been determined yet, so it’s very hard to say how the
industry will respond.
Do you feel that there would be a preference for
specific products given the Dodd Frank Bill or
products which can take better advantage of
the environment given those kinds
of conditions?
—
Again. it’s hard to say without seeing the actual regulations,
which are expected to be put in place over the next year. In fact,
the uncertainty around the changing regulations is one of the
biggest issues now facing product providers.
Thank You for agreeing to talk to us. Do you
have any additional comments?
—
First of all, thank you very much for the opportunity to speak
with you. Given your intended audience, there is one point that
I would like to leave you with. I talk to journalists quite a bit,
and they invariably ask similar types of questions. In general,
people are always looking for a simple solution to the problems
at hand. “Leverage is bad. We should get rid of it.” “Derivatives
are bad. We need to get rid of them.” But in fact, markets are
more complex than that, and simple solutions are not available.
As MBA students, you need to understand that complexity.
When you address the question of what caused the financial
crisis, “Was it derivatives? Was it the hedge funds?”, it is very
easy for the press and the public to assign blame and demon-
28 Money Manager / January 2011
INTERVIEW WITH
ize one or two instruments or actors as the simple cause of the
crisis. In fact, the crisis was caused by a combination of factors
-- regulatory guidelines got too loose, credit standards were too
lax, risk management fell apart, rates had been kept too low for
BRUCE TUCKMAN
too long, rating agencies did not do their jobs, etc. The financial
crisis was not caused by any one event or factor, but by the
interaction of all of these events and factors. There was a regu-
latory change in the US to encourage home ownership. Since it
was a political imperative, the banks got involved, the Fed kept
rates low, credit levels were not monitored correctly, the events
all cascaded into each other. Everybody had to play their part to Financial products follow a cycle in their innovation – in OTC markets where they grow
cause the problem, and unfortunately everybody did. The result
was the worst financial crisis since the 1930s.
As the markets recover, we are still looking for solu-
in size and impact macroeconomic trends then coming under the purview of the ex-
changes and then being standardized. When this trend is bucked some systemic risks
are wrought. Dr. Bruce Tuckman, an authority on financial products regulation, was at
tions for better ways to invest in general. The current economic IIMA this November for a brief lecture on ways to reduce systemic risk in OTC deriva-
environment is causing numerous challenges for investors. For
tives markets. The following are excerpts from an interview with Team BETA.
example, interest rates in Hong Kong are at or near 0%, and not
surprisingly people are looking for innovative investment ideas
that will give them some yield. In and of itself, this search for
yield is not a bad thing. The difficulties come when products
are misused and abused. Everything in life, even good things,
that are overused or misused can become harmful, including
derivatives and structured products, which are powerful tools
but sometimes easy to misuse.
“ The financial crisis was
not caused by any one event or
factor, but by the interaction of
various factors
”
Globally we have huge disparities in economic growth rates right
now between developed and emerging markets. We have lots of
liquidity being created. In Asia, we have a demographic problem
that will manifest itself over the next 20 to 30 years. As we
move forward and look at how to solve the financial problems
we are facing, it is innovation and derivatives and structured
products that will actually help us remedy these imbalances,
save for the future and allow inter-generational wealth transfer Dr. Tuckman, a Director at the Center for Financial Stability, is a world renowned author-
effectively and efficiently. If we didn’t have capital markets, the ity in fixed income markets. Along with being Managing Director and Global Head of
economies of the world would not have grown as fast as they Quantitative Research for Prime Services at Lehman and then Barclays, Dr. Tuckman has
have in the recent past, and looking forward, capital markets also held important teaching positions at Stern and Anderson (UCLA). He completed his
will only be an enabler of future growth. PhD from MIT in 1989.
Money Manager / January 2011 29
 REGULATORS
Bruce, to start off, could you give our readers a How do you envisage a possible clearinghouse
brief background of how OTC derivatives might structure for derivative instruments?
be in for a big change?
—
—
Well, Dodd-Frank gives regulators the authority to determine
There are three theoretically possible levels of clearing. The
first or most basic requires only 3rd party pricing and collateral OMNIPOTENT WATCHDOGS OR
LIBERAL BYSTANDERS?
management. The second level requires a central counterparty
which instruments have to be cleared and which will be exempt-
that stands between every trade. The third requires standardized
ed from clearing requirements. A big question facing regulators
products. I have made the argument that the first level goes a lot
is how wide they will cast the clearing mandate. If the span is
of the way to accomplishing the regulators’ goal of transparency.
too narrow, not much will be done with respect to their mandate
I and others have made the argument that central counterparties
to reduce systemic risk in these markets. If the span is too
can, for many reasons, become a source of systemic risk during a
broad, these instruments might be prevented from being used to
crisis. But the road lawmakers and policy makers are travelling is
carry out efficient economic transactions and systemic risk might
toward the central counterparty model.
increase as instruments not really appropriate for clearing are
forced into clearing houses.

Final thoughts on the current direction of regu-

“
Which do you believe would be the first deriva- lation and any suggestions?
tive instruments to be cleared?

— —
Here are my broad comments. The current path of regulation
Dealer-to-dealer, a lot of Credit Default Swaps and Interest Rate runs the danger of making the probability of a crisis less remote
Swaps have already moved to clearinghouses. With respect to but the severity of a crisis, when it hits, much worse. We have
customer transactions, the most likely to move are credit default to stop implicitly and explicitly encouraging leverage and the
swaps on corporate indexes and perhaps some well-known growth of financial institutions to behemoth proportions. We
individual names in addition to generic interest rate swaps. have to make sure that there is enough fear of losing money
However, this probably won’t do much with respect to the throughout the system so that there are many eyes on risk:
problems that led up to the financial crisis. Counterparty default regulators simply cannot do it on their own.
on these relatively simple and liquid instruments was manage-
able even at the worst times during the crisis. The problems
stemmed from more complex and illiquid securities. Should or
will the regulators push these securities into clearinghouses? I
think not. For example, setting prices and margin requirements
for CDS on illiquid mortgages is too hard a problem for market
participants to outsource sensibly to clearinghouses.

So if shifting derivatives to clearinghouses is

going to be so ineffective, why the huge interest
on the part of the regulators to make it happen?

—
During the crisis the regulators were shocked at how difficult
it was for them to get information about the exposures of large
financial institutions to each other. As a result they started to
push the industry to clear some of the more liquid products.
In the ensuing political discourse, however, all derivatives got
lumped together and Congress wanted to do something big.
This led to the potential for overkill with respect to pushing
derivatives into clearinghouses, but I don’t think the regulators
themselves will make this mistake. And, by the way, the market
for a lot of the structured products that played a part in the crisis
has, in the aftermath, dried up of its own accord.
30 Money Manager / January 2011 Money Manager / January 2011 31
INTERVIEW WITH
SHYAMALA GOPINATH
If the financial crisis has done anything, it has definitely brought into focus the role that
central banks and regulators play in ensuring the financial health of the economy. The RBI
has been at the forefront of laudable policy decisions that have kept the rupee in check as
also ensured that the financial markets have grown steadily. We take Smt. Shyamala Gopi-
nath’s views on the problems she foresees going ahead and on international collaboration
for financial markets regulation.
Smt. Shyamala Gopinath is the Deputy Governor of the Reserve Bank of India. Smt. Gopi-
nath has handled some of the critical portfolios in the Reserve Bank, such as, financial
markets, including regulation and management of government debt and exchange rate,
management of foreign exchange reserves, and banking regulation and supervision.
32 Money Manager / January 2011
In the backdrop of the global financial crisis,
has there been a significant change in the
overall approach to the regulatory framework
governing the financial services industry from
the RBI’s perspective?
—
The financial services industry in India operates in a very differ-
ent context compared to the developed markets, which were the
epicentre of the crisis. There is no doubt a fundamental shift in
the regulatory approach towards the financial sector globally
and the jurisdictions worst affected by the crisis have already
moved ahead in strengthening the regulatory framework. Many
of the issues are also getting discussed/pursued at various
multilateral fora such as G20, Financial Stability Board, Basel
Committee on Banking Supervision, International Accounting
Standards Board etc. in which India is a key member.
RBI’s regulatory approach in the near future would be
significantly conditioned by the guidance issued by these bodies
on a variety of issues such as capital adequacy, provisioning,
liquidity risk management, systemic risk regulation especially
the macro-prudential regulation, regulation of compensation
practices, regulation of securitisation activities, etc.
Quite apart from the global agenda, there are vari-
ous India-specific issues that will be addressed, particularly in
regard to strengthening the regulation of NBFCs and enhancing
transparency and mitigating risks in the OTC derivative markets.
What do you think will be the primary task
which regulators worldwide will seek to ad-
dress in the future as a sense of calm and
reason returns both to the financial markets as
well as the overall economy? How would you
contrast that to the nature of the regulatory role
played before the crisis?
—
The primary task for the financial sector regulators, and which is
already happening, is to reorient the regulatory and supervisory
frameworks and correcting the misaligned incentive structures
for the industry. The objective is twofold: one, reducing the
probability of occurrence of systemic crisis and two, containing
the impact of such a crisis, if and when it happens again.
The following initiatives have been initiated
internationally in this regard:
-Strengthening the Basel II capital adequacy framework and
introducing liquidity measurement standards.
-Instituting a macro-prudential approach to supervision and as-
signing a clear mandate to a systemic stability regulator.
-Expanding the perimeter of financial sector surveillance to
ensure that the systemic risks posed by unregulated or less
regulated financial sector segments are addressed.
-Ensuring that prudential regimes encourage incentives that sup-
port systemic stability and discourage regulatory arbitrage, and
assure effective enforcement of regulation.
-Improving the capacity of national authorities to respond to
systemic crises, including by establishing mechanisms for
coordination both within and across borders.
-Strengthening the OTC derivatives market and incentivizing
moving standardized products onto exchanges
In contrast, regulatory role played before the crisis was basically
minimalist in nature, focused largely on individual institutions,
segmented in scope, done in silos displaying undue faith in the
market discipline, devoid of any big-picture awareness on the
part of the regulators. The overall framework came to be known
as light-touch regulation focusing on individual banks and
institutions, disregarding the interconnectedness among these
entities and the systemic risk the interconnectedness could pose
to the financial stability. The potential adverse implications of
fallacy of composition were completely ignored.
Despite the crisis, several observers warn
that the nature of systemic risks in emerging
market economies is different from those of
the developed world. In fact there are already
whispers of the possibility of asset bubbles in
this part of the world given the global imbal-
ance of capital flows. How do you think regula-
tory policy should respond to such heightened
risk perceptions?
—
It is true that the nature of risks faced by emerging countries
is different from the developed countries. The RBI has recently
come out with its 2nd Financial Stability Report which brings
out the nature incipient risks. The Report notes that the tail
risks to financial stability are largely exogenous given increas-
ing correlation between global growth and growth in EMEs,
including that in India. The finance channel has assumed greater
importance increasing the pace and degree of contagion from
disturbances abroad. If recovery is derailed in the advanced
economies, it will be difficult to remain decoupled notwithstand-
Money Manager / January 2011 33
ing the domestic orientation of economic growth. Similarly, busi-
ness cycle synchronisation of the Indian economy with most of
the advanced economies and EMEs has increased.
The policy agenda in most EMEs in recent months has been
dominated by the management of capital flows. India’s dilemma
is somewhat contrarian to this. Our concern has been not so
much the quantum of flows, which we have been able to absorb
because of the widened current account deficit, but rather the
nature of these flows. Much of the capital has come in the form
of short term portfolio flows and debt flows which are signifi-
cantly prone to sudden stops and reversals. The external ratios
would need to be watched carefully.
On the asset price front, housing prices have risen sharply
especially in some pockets and the sector remains susceptible
to asset price bubbles driven by capital flows. Credit growth
remained healthy and alluring housing loan schemes continued
to be offered by the banking sector. Against this backdrop, the
Reserve Bank has tightened the prudential norms (LTV ratios and
risk weights) for housing credit.
As the world emerges from a crisis which has
been attributed primarily to shortcomings in
regulatory oversight, how do you see regula-
tory authorities’ worldwide respond and shape
policy going forward? Do you see greater
international collaboration amongst regulatory
agencies to respond to an increasingly global-
ized financial system?
—
Greater international collaboration is already happening as far
as etching out the regulatory agenda for the global financial
system is concerned. The proactive initiatives taken by the G20
in the immediate aftermath of the crisis laid the foundation for
developing a framework for repairing the financial system in a
globally coordinated manner. However, let me add that while
broader alignment with the international standards will be
imperative, the local jurisdictions will need to have the space to
frame policies and take suitable actions in their own context.
“
RBI’s approach has been to
encourage market development
keeping in consideration the over-
all macroeconomic stability
”
34 Money Manager / January 2011
At a time when the entire world is shying away Market observers have said that we need to
from the concept of securitization, given the develop robust secondary corporate bonds
legacy associated with it over the last two years, market and structured products market in order
you have advocated the idea of “sustainable to create a strong financial market ecosystem
securitization” in India. Can you explain how do in India. How would you respond to this demand
you see securitization as a concept pan out in the particularly in the light of the crisis?
coming years in India, and what would it mean for
the Indian financial markets in terms of innovation
—
Our approach has always been to encourage market development
in product design? keeping in consideration the overall macroeconomic stability.
—
In respect of all the markets mentioned by you, we have been
constantly endeavouring to develop viable frameworks. After
introduction of 10-year IRF, products for different maturities are
The principle and economic rationale of securitization is indeed
being considered including 92-day, 2-year and 5-years. The CDS
sound and it can rally help the banks in credit creation, which is a
is proposed to be allowed while trying to address the downsides.
fundamental requirement in a growing economy like India. However,
Various initiatives have been taken to further develop the corpo-
it needs to be sustainable. By sustainable I mean that the securitiza-
rate bond market. The intractable issues pertain to the structural
tion activity should grow and develop in such a manner that it does
elements relating to the lack of appetite for credit risk among
not promote risky models and complex product designs which are
difficult to understand and price. It also means that the activity
non-bank institutional investors, particularly insurance funds and
pension funds.I would just like to mention that development of
should not create misalignment of incentives among various players
new markets is gradual process and takes time.
in the securitization chain. If these pre-requisites are absent, the
securitization
Securitization framework in India is considered to be rea-
sonably prudent and not overregulated. RBI guidelines on Securitiza-
tion issued in February 2006 are applicable only to standard assets
which ensure that securitized assets are healthy and performing
at the time of securitisation. Besides, there are built in prudential
measures to contain risks.
-Firstly a prescribed stringent criterion for “True sale” of the asset
ensures total proper de-recognition thereof from the balance sheet
of the originator.
-Secondly, RBI consciously discouraged securitisation to be used as
mode of profit garnering by improper valuation. Thus, profit is not
allowed to be recognised upfront, but has to be amortised over the
period of securities.
-Thirdly in order to discourage originator to have further interest in
the securitised asset, stringent measures are prescribed for treat-
ment of credit enhancement when provided by the originator.
-Fourthly, adequate safeguards have been built in to ensure that
credit enhancement provided by originator is not camouflaged as
liquidity facility or any other service provided by originator.
Thus, banks in India did not have incentive to resort to unbridled
securitisation as observed in “originate-to-distribute” and “acquire
and arbitrage” models of securitisation in many other countries.
Recently, additional norms have been proposed requiring a mini-
mum lock-in-period and minimum retention criteria for securitising
the loans originated and purchased by banks. The final guidelines in
this regard will be issued shortly.
Money Manager / January 2011 35
FINANCIAL INSTITUTIONS
THE NEW ENVIRONMENT
additional regulation and opportunities
driving strategic changes
Everyone thinks about restrictions the moment you mention Basel III and Dodd-Frank. But
Steve Young sees it as an opportunity – an opportunity to define new growth paths and
develop new strategy. He argues, in his article for Money Manager, very cogently as to
how the current financial regulations are designed not to stifle financial services firms but
to help them carve their niche in the market. Read on to find out more.
Steve Young, a professor at Fisher School of Business, started his career in public ac-
counting and worked on Wall Street with Salomon Brothers. He has also worked with
Banc One Capital Markets, Stonehenge Partners and Century Surety Group. He holds a
bachelor’s degree in accounting from The Ohio State University and a master’s degree in
finance from the Harvard Business School
36 Money Manager / January 2011
the recent history
—
First, let’s take a brief look at the changes that have occurred
during the last 20 years that shaped the regulatory and competi-
tive environment prior to the financial crisis. One of the results
of the stock market crash and great depression of the 1930’s
was the passage of The Banking Act of 1933, a law that estab-
lished the Federal Deposit Insurance Corporation (FDIC) in the
United States and introduced banking reforms, some of which
were designed to control speculation. This act is most commonly
known as the Glass–Steagall Act, after its legislative sponsors,
Carter Glass and Henry B. Steagall.
One of the most important elements of this law
was to separate investment banking and commercial banking
functions in order to prevent speculative activities by financial
institutions. Some provisions of the Glass Steagall Act, such
as Regulation Q, which allowed the Federal Reserve to regulate
interest rates in savings accounts, were repealed by the Deposi-
tory Institutions Deregulation and Monetary Control Act of 1980.
Then, provisions that prohibited a bank holding company from
owning other financial companies were repealed on November
12, 1999, by the Gramm–Leach–Bliley Act. These changes along
with other deregulatory actions during the same time period
effectively allowed commercial banks, investment banks and
insurance companies to begin directly entering each other’s core
lines of business. In addition, during this same time, new entity
structures such as hedge funds and private equity firms emerged
and grew rapidly in a largely unregulated manner.
As a result, in the years leading up to and including
the financial crisis, the financial services sector was character-
ized by an almost “Wild West” strategic approach. Whatever
line of business was fast growing and seemingly profitable
quickly attracted new firms. Regional commercial banks merged
to become national money center banks. Larger commercial
banks acquired regional, well respected investment banking
firms and began underwriting new securities for their com-
mercial clients. Investment banks started private equity firms.
Junior partners at bulge bracket firms left and formed hedge
funds and raised billions of dollars almost overnight. Mortgage
brokers popped up on every city block and grew like weeds hid-
den within the shadow banking system fed by investors’ never
ending appetite for high yielding securitized investments. Large
insurance companies merged with large banks to offer all types
of financial services to Fortune 500 clients. Old line investment
banks transitioned from partnerships to public companies and
in doing so raised tremendous amounts of capital. In summary,
many financial service firms’ strategy was to be a “one stop
shop” for some targeted segment of the market as the industry
experienced a deregulatory and business friendly environment
buoyed by a steadily growing national economy.
new regulation
—
During the summer of 2010, Congress passed the most sweep-
ing changes in financial regulation since the great depression.
The act, whose common name is, “Dodd-Frank Wall Street
Reform and Consumer Protection Act” (H.R. 4173), provided
for a council to address risks posed to the economic stability
of the US by large interconnected financial institutions both in
and outside the financial markets, promote market discipline by
dissuading financial market stakeholders of the idea that the
federal government will protect institutions from losses, and
respond to emerging threats to the US’s financial stability.
One of the primary pieces of the Dodd-Frank regula-
tion was the increased reporting both by companies who were
already subject to a significant amount of reporting and those
who were exempt. Exempted organizations now required to
report range from hedge funds to bank holding companies and
could go as far as divisions of larger more complex institutions
like GE Capital. All those mentioned are subject to differing lev-
els of scrutiny based on business, interrelationships and amount
of risk posed to the greater system.
In addition, the recently passed financial overhaul
requires commercial banks to jettison any proprietary trading
they undertake with their own capital, including bets on com-
modities. Some large financial firms are already moving to close
down proprietary trading operations after more than five years
of rapid expansion. The bill gives banks nearly a decade to end
speculative derivatives trading to comply with the so-called
Volcker Rule, named after former Federal Reserve Chairman
Paul Volcker who first proposed it. The exits by J.P. Morgan
Chase & Co.’s and Goldman Sachs Group Inc. from proprietary
trading represent a quick strategic shift and sent a message that
Wall Street banks are moving quickly to comply with tough new
market regulations.
J.P. Morgan has already informed roughly 20
commodities traders on the bank’s proprietary desk that their
jobs are being eliminated, according to a person familiar with
the matter. Goldman Sachs has decided to close its principal
strategies unit, which does its proprietary trading, according
to someone familiar with the situation. However, a permanent
reduction in speculative activity isn’t in cards. Hedge funds and
other investment groups are expected to fill some of the void,
and analysts are hopeful that rules will still allow for banks to
serve clients. Regulators haven’t comprehensively defined what
constitutes “proprietary” trading, which is often intertwined
with deals done on behalf of clients, transactions still allowed
under Volcker Rule.
Money Manager / January 2011 37
new strategies
and opportunities
—
In this new regulatory and slow growth economic environment,
financial services firms will choose strategies that fit best with
their relative competitive position within the industry. Many
firms will focus on a “hedgehog” strategy and concentrate on
core competencies while divesting ancillary business units.
For example, commercial banks will return to their credit roots
with traditional lending activities. Also, high profile firms such
as Goldman Sachs are likely to return to strategies focusing on
core functions such as traditional investment banking services
like underwriting securities and mergers and acquisitions,
while jettisoning activities like proprietary trading in order to
comply with new regulations and repair their public images.
At the same time, firms like State Street and BONY Mellon
will continue with their laser like focus on fee based services
such as custody and wealth management which served them
well during the financial crisis. In addition, all strategies
adopted by financial services firms will need to provide for a
rebuilding of adequate regulatory capital levels and a repay-
ment of TARP funds where appropriate.
In contrast, hedge funds and private equity firms
will set strategies that seize on new market opportunities
created by the financial reform. For example, lines of business
that have fallen from the larger firms or the shadow banking
system, will likely end up with newly formed hedge funds that
find a way to remain lightly regulated. Furthermore, private
equity firms will invest substantial funds in troubled financial
38 Money Manager / January 2011
firms where they smell an opportunity to create value and make
money. For example, in early 2009, the Federal Deposit Insur-
ance Corp. reached a preliminary agreement to sell the remains INTERVIEW WITH
VIRAL V. ACHARYA
of IndyMac Bank one of the biggest bank failures in U.S. history
to a team of high-profile investors, suggesting there is private
money willing to invest in troubled banks if the government
agrees to shoulder heavy losses. The investment team, which
includes affiliates of private-equity chieftain Christopher Flow-
ers, hedge-fund investors George Soros and John Paulson, and
computer mogul Michael Dell, will contribute $1.3 billion in What do you think led to the financial crisis? “Banks passing on the credit risk of sub-
capital toward a purchase of IndyMac Federal Bank. prime mortgages …” Think again. This is what Prof. Viral Acharya had to say to Money
However, at the same time, make no mistake that Manager when he was in India to talk about the book he is co-editing - -“Regulating
many firms, like Goldman Sachs, have raised huge amounts of
Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance”. MM
capital and will not hesitate to enter new or re-enter old lines
quizzed him on what he thinks led to the financial crisis and global regulation of finan-
of business that prove profitable and can provide a sustain-
cial markets. Read on.
able competitive advantage. The shadow banking system is
temporarily dead on its feet, but do not be surprised if it comes
back to life as part of investment banks, hedge funds and other
financial firms’ strategies when the public outcry over the recent
financial crisis subsides as government officials move onto the
next national crisis and the seemingly always short memories of
investors quickly fade.
In summary, the future strategies of financial services
firms from commercial banks to hedge funds and everyone in
between will vary depending upon the ultimate outcome of the
new financial regulation and each firm’s relative position within
the financial services industry. For some larger firms, this will
mean a return to core operating strategies and historically profit-
able lines of business that will provide for a restoration of much
needed regulatory capital. However, for other smaller and more
nimble firms such as upstart hedge funds with immediate access
to vast amounts of capital, their strategies are likely to focus on
opportunistic niches that have been created by increased regula-
tion and the financial crisis itself.
Viral V. Acharya joined Stern School of Business as a Professor of Finance in September
2008. Prior to this, he was a Professor at the London Business School and an Academic
Advisor to the Bank of England. Professor Acharya earned a B.Tech in Computer Science
and Engineering from the Indian Institute of Technology, Mumbai, and a Ph.D. in Finance
from Stern School of Business.
Money Manager / January 2011 39
The dodd-frank act and the new architecture of
global finance
Prof. Viral Acharya was in India to give a talk on the new book
that he has co-edited -“ Regulating Wall Street: The Dodd-
Frank Act and the New Architecture of Global Finance”. The
talk focused on the regulatory structure being built in America
following one of the worst recessions which have hit the U.S
economy since the Great Depression. The recession, which was
mainly the result of the financial crisis which hit the banking
system has its roots in the subprime mortgage market which
crashed following large scale defaults by homeowners.
Talking about the roots of the financial crisis, he presented a
version different from the popular theories which float around
the press today. Regarding the most popular claim, that of banks
passing on the credit risk of subprime mortgages to the market.
What is your view on the reasons
behind the crisis?
—
China’s huge appetite for US Treasury bonds lead to a crowding
out of investment space for ‘safe assets’. Investors turned to
other sources, the prime among them being AAA rated products
created by banks which were higher yielding as well. This had
the direct effect of banks originating mortgages by the dozen
and repackaging them into MBS products, the AAA rated
tranches being sold to investors (the so called pension funds in
Norway etc). This however is the popular view. Data shows that
around 55% of those MBS tranches were held by banks, broker
dealers and government agencies themselves, which belie the
claim that foreign investors were driving up the demand for
subprime assets. Banks hence did not transfer the credit risk
to other investors who had the appetite for such ‘AAA’ rated
products. In our view, having a lesser capital requirement for
AAA assets allowing for higher leverage (c. 5 times) and lax
regulations which allowed Fannie Mae and Freddie Mac to
venture into the subprime space were the main drivers behind
the demand for subprime mortgages. These factors were one of
the major incentives for banks to create more of these structures
and trade it amongst themselves. Regulatory assessment of risk
was also not quite what it should have been. As the total no.
of assets held by banks grew at a phenomenal space, the risk
weighted assets grew at a very slow pace compared to that.
This indicates a lack of transparency more than anything else.
40 Money Manager / January 2011
Post the financial crisis, there are many new
regulations that have come up with the most sig-
nificant one being the Dodd Frank Act. What does
the Dodd Frank Act aim to regulate and how?
—
Post the Financial crisis, it was clear that allowing banks to go
bust was not the right way to contain risk and Systemically Impor-
tant Financial Institutions (SIFIs) have to be regulated in a better
manner. The Act deems institutions as SIFI, regulates them and
proposes and orderly liquidation procedures ruling out taxpayer
funded wind downs and requires that creditors and shareholders
bear all costs and if necessary ex post levies be imposed on other
surviving SIFIs. There is greater protection for the end users of
financial products with the Bureau of Consumer Financial Protec-
tion writing rules to govern such products & services offered by
banks & non-banks. The Volcker Rule reinstates a limited version
of the Glass Steagall Act with restrictions being placed on their
prop-trading activities. There are proposed rules for regulat-
ing Over The Counter products, increased transparency in the
positions of banks, separation of non-vanilla positions into well
capitalized subsidiaries.
According to you, what are the elements that are
still missing and have not been addresses
so far?
—
The Act addresses most of the key issues when the Systemic risk
posed by Too Big To Fail (TBTF) institutions. However, it ignores
the other element of Systemic risk, when too many small institu-
tions fail (akin to the scenario faced during the Savings & Loan
crisis of the 90s). The uninsured deposit sector has been left out.
As seen post Lehman bankruptcy, money market funds faced a
lot of redemption pressures which were even more aggravated in
the liquidity crunch being faced then. It could have also put a cap
on the $ amount the Fed can loan to ‘non-banks’. Also, as of now,
banks have a free put option, wherein they have a free line of
credit from the Fed when times turn bad without having to pay up
anything upfront. This creates a moral hazard for banks to not be
prudent about their risk taking behavior.
What in your view are the key elements of sys-
temic risk which still remain?
—
The U.S housing sector is far from perfect. No measures have
been taken yet to prop up the credit worthiness of home borrow-
ers, so we can still expect further defaults. So far, via the TARP
program only leverage has been reduced and recapitalization
has taken place to some extent, but it may not be enough. Some
pockets remain unaddressed like Fannie Mae & Freddie Mac. The
importance of small institutions still has not yet sunk in. The Repo
Market, the Money Market still pose a significant systemic risk to
the financial system as a whole. The balance sheet of banks still
look fragile and their assets need to be strengthened further.
Would a system of having ‘Full-recourse’ to the
assets of borrowers help in preventing or miti-
gating the effects of such crisis in the future?
—
A few states in America and a number of European countries, do
have such laws which allow full recourse to the assets of borrow-
ers in the event of a default. In the European countries at least,
there is anecdotal evidence of fewer mortgage defaults which can
be attributed to this law. It has several advantages as in providing
the ability to borrow more by pledging more assets. Homeowners
are also less speculative while mortgaging their homes or assets.
“
Recent regulations create
a moral hazard for banks to
not be prudent about their risk
taking behavior
”
What do you think would be the effect of the
Dodd-Frank Act on Emerging Markets?
—
There is no doubt that many Emerging Markets got thrashed
when the crisis broke out. It reinforced the view that markets are
now globally connected and the image of being insulated from
the global financial world remains largely a myth. It is now even
more obvious that a stable financial sector in the U.S would
benefit all economies in general and help stabilize the financial
world. In my view, the banking sector will be under duress in
the US once subjected to Basel 3 norms when they will be faced
with harsher capitalization requirements while the economy
continues to roil. This in my view is an excellent opportunity for
Emerging Markets banks with a strong capital base to enter the
US. A global M&A could be on the cards. However, all of this
needs to be vetted by the domestic regulators who should feel
comfortable with such a system.
What are your views on the financial innovation.
Do you think that the markets will continue to
come up with new products?
—
The first thing which needs to get right is the correct Cost
of Capital for the financial sector. Risk needs to be appropri-
ately priced and if the risk of collective failure becomes high,
restrictions need to be put in place. In such a background, if
innovations don’t have the effect of increasing correlations,
they are not a bad idea as such. The role of clearing houses
becomes even more important in fostering such innovations and
mitigating their ill effects by setting exposure limit and reducing
counterparty risk.
Money Manager / January 2011 41
 EMERGING MARKETS
And finally, your views on the Euro Bond being
floated around?

—
In my view the Euro Zone will act like a clearing house, should
the Euro bond ever actually take place. The ECB could issue joint
liability certificates and facilitate the liquidity of these bonds.
EPITOMES OF RESILIENCE OR
Currently, it deals with the countries on a case by case basis.
First it was Greece, then Ireland and now Spain or Portugal
could be next on the cards. In views of the current scenario,
TICKING TIME BOMBS?
ex-ante an arrangement with the member countries could have
reduced the overall burden on the Euro zone and the situation
may have been better.

“
42 Money Manager / January 2011 Money Manager / January 2011 43
INTERVIEW WITH
RANODEB ROY
Emerging Markets have been the buzz word for the last 5 years – be it hedge funds, PEs
or sovereign wealth funds – these markets have been the watched keenly by investors of
all colours. Investment Banks have also made strong inroads into capturing a part of the
value in the financial markets in emerging Economies. Money Manager sits down with
Ranodeb Roy to discuss Morgan Stanley’s take on how the emerging economies’ story
will shape up on key macroeconomic indicators.
Mr. Ranodeb Roy is the Managing Director, Head of Interest Rate Currency Credit, Asia
Pacific in Morgan Stanley. Prior to joining Morgan Stanley he worked at the FICC group
in Merrill Lynch in Hong Kong, New York and Tokyo. He has also worked at Barclays,
Peregrine and the Bank of America. An alumnus of IIM Ahmedabad, he has a degree in
Computer Science and Engineering from IIT Kanpur.
44 Money Manager / January 2011
Are we going to see a global power shift as sev-
eral emerging markets continue to outperform
their global peers financially and economically?
— the tensions which these currency skirmishes
Yes we believe so. Emerging Markets, especially the BRIC
Countries and in addition to that, Korea, South Africa, Indonesia,
Turkey will drive strategies for global growth and have already
been driving a power shift globally. China, India, Korea, Indonesia
and Australia to begin with will lead this power shift.
What kind of finer issues such as fiscal policy,
regulation of financial markets and firms, as
well as general governance standards will play a
crucial role in driving sustainable growth in
EM economies?
—
Apart from the ones mentioned above, there are also other factors
which will play an important role such as Monetary policy, Trans-
parency, Openness to capital and current account flows, Opening
currency to market forces, Controlling corruption, Controlling
Inflation, increasing labour and service sector productivity and
stability of government.
How far do you believe in the Asia decoupling
story with reference to its economic growth and
its markets? What are some of the broad macro-
economic factors which can upset the growth in
the coming years?
—
Asia (ex Japan) - AEJ is intertwined with the global economy. As
of now growth in AEJ cannot offset shrinkage of Europe and US,
but the linkages will be increasingly decoupled. Ability to control
inflation, prevention of over-heating in certain sectors of the
economy such as resources, construction and housing, run-away
over–lending, unfettered growth of consumer finance (keeping
it in line with income levels), environment and health care may
impact growth in emerging markets.
Do you see currencies in these markets con-
tinue to strengthen with respect to the USD in
the near and medium term and what are some of
would create?
—
Asian currencies are still undervalued compared to the USD.
Based on pure fundamentals, as well as trade surplus and capital
flow trends, AEJ currencies should appreciate against the USD.
This could lead to a lack of perceived export competitiveness,
and some central bank intervention to make the strengthen-
ing slower, but the general trend will be intact. However, it is
important to take the value of the EUR into context as often the
trade weighted index for AEJ currencies need to be taken into
account and EUR is an important trade partner. If EUR weakens
significantly against the USD, it automatically re-values Asian
currencies against the trade basket.
Will the shortcomings in innovations in struc-
tured financial products limit the financial
growth of the emerging markets? What are
some of the economic reforms which are neces-
sary for increasing the financial stability along
with deepening and integrating them?
—
Not in my opinion. Innovations in securitization are growing
hand in hand with development in EM. Microfinance is a good
example. Capital account convertibility, free float of currencies,
ability to use derivatives for hedging, broadening of the securiti-
zation market and development of a liquid corporate bond market
are some measures that will help in deepening and integrating
the financial markets in EMs.
How do you see the balance in banking and
markets in India evolving in the coming years?
—
I think both will increase, with markets gradually taking a bigger
role. Look at the growth of the mutual fund and insurance sectors
in India. It has totally transformed saving habits and grown with
the market.
Money Manager / January 2011 45

What are your views on the real estate bubbles
in emerging markets especially in specific
pockets of the AEJ region?
—
There is a huge demand-supply gap in quality housing in high
demographic countries such as India and China. As a result
potential bubbles may arise in certain areas, but the market
dynamics and timely intervention from regulators will by and
large control them in Asia.
46 Money Manager / January 2011
INTERVIEW WITH
China, Russia and India have recently started
adding gold to their reserve buckets. Do you
see any implications of the changing reserve
SANJAY NAYAR
portfolios in emerging markets? Is China’s State
directed lending and NPAs in their portfolio a
matter of concern?
—
These economies have added gold on account of lack of currency
Emerging Market dynamics is an altogether different ball game given their positive
recovery post crisis. But it’s not all hunky-dory as some have coloured it – they have
choices and seeing a massive monetary stimulus in the US
their own issue of depth of capital markets and inflation to cope with at present. We
caused central banks to worry about debasing their reserve cur-
discuss with Sanjay Nayar, Country Head of KKR & Co. his outlook for these markets
rency. This is a healthy trend. Other commodities such as oil may
be next. Speaking about China, when an economy grows fast,
and the reforms they need to put in place to ensure that their growth trajectory is
this kind of lending is important to jump start certain aspects of uninhibited.
public infra-structure spending. As long as Banks have pruden-
tial norms, and stay away from speculation, it could be under
control. Eventually when growth slows, it could lead to NPA in
certain sectors, but it is not an issue right now.
Mr. Sanjay Nayar is the CEO and Country head of Kohlberg Kravis Roberts & Co (KKR)
in India. Prior to joining KKR, Mr. Nayar was the CEO of Citigroup, India and South
Asia, and a member of Citigroup’s Asia Executive Operating Committee. He is a post-
graduate in management from the Indian Institute of Management, Ahmedabad, and a
bachelor in Mechanical Engineering from Delhi University.
Money Manager / January 2011 47
The recovery from the financial crisis seems
lop-sided in nature with most emerging mar-
kets returning to pre-crisis levels of growth as
opposed to the developed world. How do you
read this growth imbalance from the perspec-
tive of the emerging markets?
— of a very throbbing primary and secondary market. But frankly,
Yes, the crisis has been very lop-sided in its impact. The domes-
tic growth in the emerging markets is primarily being driven by
consumption because of shift in demographics especially in Lat-
in America and in Asia. The second thing is that these countries
have attracted a lot of capital and that has propelled growth
as well. Thirdly, almost all the emerging markets are partially
closed economies. They are not all open on the capital account
and therefore, they have not been as impacted by the crisis as
others except to the extent of capital flows that have gone out
of the equity markets. Secondly, if you are export oriented like
SE Asian economies, you got hurt. But other markets including
India have been pretty insulated from that. The recovery has,
therefore, been faster and given the demographic shift in local
consumption, it is bound to show up in robust growth numbers.
What are your views on the extent of develop-
ment of secondary market in emerging econo-
mies? Primary market for equities, in some
countries even debt, is reasonably well-devel-
oped. But without a strong secondary market
for securities - how will foreign investors and
PEs hedge investments?
—
I do not think any of the emerging markets have really well de-
veloped capital markets. Let’s talk about India. In India we have
a very broad based equity market but not very deep. Besides
being broad based in terms of the number of companies, it is
pretty shallow in terms of floating stock and the type of inves-
tors is quite limited. FIIs are a pretty significant contributor at
the margin, but the retail investment in India is no more than 6%
of the total household savings. Pension and insurance money is
not even worth talking about.
48 Money Manager / January 2011
So, I think the combination of lack of reforms and the
lack of an equity retail culture have really kept our markets rath-
er shallow. But they have pretty high velocity as against depth,
and, the velocity is high because of the nature of investors.
While you may have few classes of investors, they are pretty
trading oriented. And, of course, the FIIs which are coming on
the back of relatively inexpensive money tend to trade a little
more. So there is no doubt that there is a build-up of foreign
holding in India which is a good sign. It gives the impression
When you get down to looking at the breadth of investors, type
of investors and the size of the deal you can get done, they are
pretty small and if that is the backdrop it does make the private
equity or long only investors think very hard about how much
you want to put into a stock or a company because you have to
keep the exit in mind. Be it 5 years, 6 years or 10 years later.
Sustained periods of low interest rates in the
developed world have resulted in speculation-
driven surge in commodity prices in the last
quarter. How serious is the threat of inflation to
emerging markets?
—
My personal view is that easy money from the west does cre-
ate a relatively high degree of capital flows into the emerging
markets and all markets are tackling it differently. If there is
an absorption capacity in the economy, you can absorb these
capital flows as long as they are going into creating real assets.
So if somebody is raising money for a new factory, doing a
rights issue, doing a secondary offering, starting a new project
and as long as the money is finding its way into real assets after
the initial deleveraging is over, then I would say that you have a
pretty decent absorptive capacity. But if you don’t have absorp-
tive capacity which I believe is India’s case mainly due to lack of
reforms, (evidenced by a pretty low capital expenditure to GDP
and a low spend on physical infrastructure) - then it is an issue.
When that happens and the flows just keep coming in, they find
their way into commodities, real estate, currency and the stock
market. So, it begins to inflate asset values without creating real
assets. So I am not sure if it is a bubble or bubble magnitude
but there is no doubt that the valuation of assets, be it currency,
equity, commodities or real estate is obviously much more than
what it should be. China is absorbing these flows well because
they are creating a lot of assets. I think other markets have
some form of capital controls and taxes. But in India we have
not done any of that.
One of the central themes of 2010 was the
devaluation of the US dollar relative to several
emerging market currencies, raising concerns
on capital inflows spiking valuations as well as
hurting the competitiveness of export-oriented
industries. How do you see this playing out
ahead and what should be the role of the regu-
lators in this regard?
—
I think this is a question everybody is struggling with. We have
seen different regulatory responses from different countries. My
sense is that emerging markets have got an emerging problem
of how to tackle inflation. They are to an extent fighting inflation
by increasing rates. So if you take the system intervention route
by increasing rates, it should work the way theory would work,
which is - increasing rates would slow down the growth in these
economies and then the relative advantage would come down.
Increased rates can also attract increased flows! But everybody
is tackling it differently as every country has its own uniqueness.
The issue in India is however one of not having ad-
equate absorptive capacity. But we have a large current account
deficit which probably needs these flows. In a way we have a
financial imbalance with a large current account deficit. So, the
flows are helping us. My guess is that we have chosen to not
put any tax measures or gate keeping taxes but other markets
like Brazil are contemplating such a move. Thailand is going to
do something. Different markets are reacting differently.
The regulators should take a balanced view between
a few issues – what volatility can they live with, where are
the flows going – are they creating real assets or speculative
assets, and thirdly, do they have a strong enough financial
sector which can withstand a dramatic outflow. Finally, exports
are important but fortunately or unfortunately imports are also
critical for us. It depends upon the priorities of the government.
If you want to keep oil prices down in rupee terms, you are hap-
pier having an appreciating rupee but if you want to encourage
exports, you are happier having a depreciating rupee.
India’s GDP growth target of 9% for this decade
is heavily dependent on industrial growth and
infrastructure. Non-Govt equity investments in
India have been consistently low, what would
you attribute that to? What financial market
reforms are required to bring in more private
equity and foreign equity investments?
—
India is a market that has a heavy preponderance of local
savings (close to 35%) which is an excellent starting point. The
first reforms you would need are local capital markets reforms
to be able to tap local savings into the real sector. That should
be high-priority. Bond markets are pretty underdeveloped
for many reasons – one of the key being that we have a very
overbearing government deficit and a very heavy borrowing
programme so that takes away most of the liquidity and sav-
ings and leaves very little for the real sector. But if there was a
step wise reduction of the fiscal account and you open up the
insurance and pension sector, you would find a very meaningful
shift of savings into the real sector. But for that, you need to
create the right set of instruments - corporate bonds, municipal
bonds and infrastructure bonds. So there is a whole regime of
debt market reforms that needs to be created.
The second thing is that there are certain sectors
helping which will help improve financial services and those
are – the banking and the insurance sector. For whatever
reasons they have been kept shut for really long but they need
to get opened up because not only will this bring in high quality
long term capital but also excellent business practices and
better practices in risk management, innovation and it will drive
better risk allocation.
I think the third aspect is one of financial inclusion -
how do you extend banking, insurance wealth management to
a larger audience in India. For that you require reforms again.
This does not necessarily mean giving new bank licenses – we
need a paradigm shift in two aspects.
1- We do pre-empt a lot of banking liquidity into preferred
sectors like priority sector lending, agri-lending, exports and
government deficit. We have to cut that down and move the
burden away from the financial sector so that the money can be
made available to the real sector.
2- The second shift that we need to do is make some of India’s
banks bigger. You cannot have a small State Bank of India. By
any measure, compared to China or Singapore we have banks
that are small on all counts - be it asset size, market capitaliza-
tion, ATMs or branches. The biggest issue is that local savings
get pre-empted by large fiscal deficit, and a large population
remains unbanked.
Money Manager / January 2011 49
 DOMESTIC VIEWPOINT
Markets like Brazil and Mexico have done some very interest-
ing reforms. They made their banks bigger - whether by letting
foreigners buy in or just intra-country consolidation. SBI should
go and buy smaller banks. We need bigger banks in the begin-
ning of an economic cycle - banks with large balance sheets and
funding capabilities for large infrastructure projects.
IS INDIA POISED TO RULE
AMIDST THE RUINS?
The size reforms which are the consolidation reforms, and, the
whole change in the mindset on how to pre-empt liquidity and
deposits in the banking system are two major changes that we
need to encourage. These are real actions we need to take oth-
erwise we are going to be facing severe liquidity problems when
the capex cycle starts and the growth becomes real. When that
happens, you are going to find the banking system and financial
markets very inadequate compared to the need.

“
50 Money Manager / January 2011 Money Manager / January 2011 51
INTERVIEW WITH
JAHANGIR AZIZ
The ‘India Decoupled’ story on the face of it looks rosy and hints at the resilience of
India’s financial economy to global shocks. However, the impact on the real economy
has to be acknowledged, which in turn may have significant implications for the financial
economy as it evolves. Dr.Jahangir Aziz’s opinions in this interview shed insight into how
India should strengthen its macroeconomic fundamentals to evolve a complete financial
markets ecosystem.
Jahangir Aziz is the India Chief Economist for JP Morgan Chase. Before joining JP Mor-
gan, he was Principal Economic Advisor to the Indian Ministry of Finance. Jahangir has a
PhD from the University of Minnesota and spent 13 years at the IMF in the Research and
Asia Pacific departments. He was the head of the China division from 2004-08.
52 Money Manager / January 2011
Although the Indian financial markets have been
resilient to the financial crisis, there have been
several aftershocks in the last couple of years.
Could you please explain the structural fallacies
that have resulted in a critical impact on the
real economy? If this trend is to be maintained,
how will this affect the evolution of the credit
markets in India?
— —
Over the years, India’s policymakers have designed a financial
system that operates in silos. This was done in order to provide
stability to the financial system by ensuring that shocks in one
part of the system did not migrate to the rest of the sector. Such
a system works reasonably well when shocks are small. A mod-
est shock to an asset class is absorbed through a modest price
change in that asset class. However, when the shock is large -
like in October 2008-- because assets have limited substitutabil-
ity, the price changes in a particular asset class are much larger
than warranted. The only escape valve in the financial sector
is equity and to some extent the overnight interbank market.
That is where directly or indirectly all the participants in India’s
financial system meet to trade their asset positions. This too is
by design. But the end result is that we will continue to see large
(larger than needed) price fluctuations in the equity market and
in the call money rate. Such unwarranted price volatility raises
the cost of intermediation and with that the cost of credit.
You had mentioned in the NY Times that to
maintain the 8-9% pace of growth, India must
ensure low cost of capital and private invest-
ment in the future. With the structure of the
financial markets in India, to what extent will
the FIIs impact this growth trajectory?
—
The structure of India’s financial system, while, helpful in
preserving stability, intermediates savings and investment at a
high cost. Consequently, foreign funds, not just FII investments
but external borrowing by Indian corporates, will remain an
important source of affordable finance. It is not that India does
not have sufficient domestic savings. It does. It’s just that the
savings is intermediated at a very high cost to investors.
The critical factor in the boom in India has been
the supply constraint – the growth has been
demand led, which is affecting the prices and
the inflation has been up and down. How does
this portend for India in the next few years as
an emerging financial market as against China,
whose growth is pretty much supply driven?
This is a crucial difference between China and India. Because In-
dia is chronically short of supply, the lack of demand, especially
foreign demand, is not that much of a binding constraint. This
is a critical advantage when global demand is likely to remain
soft for some time. At the same time, India desperately needs
to ease these supply constraints failing which rising domestic
costs could crimp growth. This is why the reluctance of Indian
corporates to resume investment in earnest over the last two
years is a worry. Growth in India over 2003-08 has largely run
on investment and this engine has not fired at all outside the
infrastructure space since the October 2008 crisis.
To fuel growth, heavy investment is required in
infrastructure development and education. This
raises a key question about harvesting the sav-
ings which is close 35% of the GDP in India. To
what extent is financial deepening required in
India and how should this be better accessed?
—
I do not think that financial deepening will raise the level of
domestic savings that much. Some of those who are outside
the formal system will be brought into the system but that does
not increase the total quantum of savings. Those who choose
to remain outside the system for tax and regulatory purposes
will remain regardless of financial deepening. Indeed it is quite
possible that with financial deepening if access to credit also
expands then we could see a decline in household savings
rate. People will no longer need to save up to make durable
purchases or investments. They can get bank credit based
on future income stream. And this is a good thing. The key to
raising domestic savings is fiscal consolidation and reducing
the government pre-emptive capture of financial resources in
the guise of “prudential regulations.” Financial deepening is
required to allow better access to the formal financial system
and to reduce the cost of intermediation. I do not think overall
mobilization of resources will increase very much because of
financial deepening.
Money Manager / January 2011 53
You have stressed upon the need for financial Indian regulators have often been urged to

INTERVIEW WITH
sector reforms consistently. Steps have been develop a better atmosphere for a deeper debt
taken by the RBI to ease up financial enabling markets and facilities for securitization. From the
with more banking and micro-insurance viewpoint of an International Investment Bank,

licenses. How do you think this will impact the
financial sector development in the next few
years? What will be the effect in organizing
micro-investment and micro-credit from a
greater financial inclusion perspective?
MONTEK S AHLUWALIA
what do you think is the outlook for the Indian
Debt market? How do you expect regulations to
pan over the next 2 years?
— Post the financial crisis, experts across the world have mentioned it will be Advantage

—
The October crisis is a serious push back against any extensive India for the next decade. But for that to happen, the financial markets in India need to
deregulation of the debt market. The naysayers’ ultra cautious attract more equity and foreign investments to funnel the funds for the need of corpo-
position has now been significantly strengthened by the seeming rate India. Dr. Montek Singh Ahluwalia, who has been at the helm of policymaking in
Microfinance is a critical link in the overall financial system.
success of the Indian markets in the face of the global crisis. Even India, shares his views on Advantage India and financial markets regulation needed to
However, the process may not have been managed well. Banks
today there are hardly any noteworthy analyses of why the Indian strengthen the India growth story.
funded MFIs as a way of reducing their own cost of meeting
system survived relatively unscathed. It is pretty much presumed
the government’s priority lending requirements, not necessarily
that it was because of the invasive regulations and therefore
as a viable long-term business. This was one of the reasons
the regulations are good. While some liberalization will probably
behind the recent blow-up in the microfinance world. My guess
happen, it will require resurgence in private investment first. If the
is that the recent controversies will result in regulatory changes.
private investment cycle turns around sharply, then the financing
Hopefully they will be moderately invasive. And hopefully the
pressure on the government’s ambitious infrastructure program
reformed MFIs can go back doing the business they are good at-
will be severe. Once faced with a significant increase in financing
-reaching people that are beyond the reach and scope of banks.
costs for its infrastructure investments, the government will likely
More bank and MFI licenses are important to increase competi-
move towards opening up the debt market. As long as banks are
tion and it is encouraging that the RBI is looking to do so.
able to relatively cheaply finance infrastructure projects, which
so far has been possible because of lackluster private investment
demand, the pressure on doing anything meaningful to develop the
As a leading economic figure, you have con-
corporate bond market will be mild.
sistently stressed the need for financial market
integration in India. How do you propose this
financial market integration should happen?

—
The key is to recognize that by keeping asset classes closeted in
silos only ends up raising the volatility in prices and thus raises
the overall cost of credit. And this is on top of the relatively
smaller size of the Indian market compared to global flows. It
will be a long time before our markets reach a size that will
be able to withstand modest shifts in global portfolio alloca-
tions without going into a tizzy. In the meantime we can reduce
some of this unwarranted volatility by removing the invest-
ment restrictions imposed on our large financial institutions
like pension funds and life insurance companies. It would also
help if the corporate bond market is helped to be expanded.
All this again requires the government to reduce its borrowing
requirements, i.e., embark on serious fiscal consolidation. More
importantly, the regulatory framework needs to be streamlined
Dr. Montek Singh Ahluwalia is the Deputy Chairman of the Planning Commission of India.
and reoriented away from regulating asset classes to regulat-
He had previously served as Finance Secretary, Ministry of Finance; Secretary, Depart-
ing institutions, with institutions being allowed to trade across
ment of Economic Affairs; Special Secretary to the Prime Minister; and Economic Advi-
all asset classes. In this regard, we need to move to a qualified
foreign and domestic institutional investor framework away sor, Ministry of Finance. He earned his B.A. (Hons) degree in New Delhi and his M.A. and
from this ad hoc investor-specific and asset-specific framework M. Phil. degrees from Oxford University.
that we have at present.
Money Manager / January 2011 55
FII investments have been rushing into India,
with the country seeing record inflows over the
last few months. However, does the India growth
story have the necessary momentum to sustain
sufficient interest from the financial world going
ahead, or are the realities of structural deficien-
cies not being reflected in the optimism?
— —
Well, You know financial markets very often experience a kind of
irrational exuberance but they also experience a lot of irrational
panic. My feeling is that the basic judgement about the India’s
growth story being a strong and solid one is valid. But of course
you know financial markets like in other situations are likely
to show volatility around this basically strong forecast. But
that should not worry us because that is the nature of financial
markets. This will average out. They may get unduly optimistic at
some point they may become a little pessimistic at some point.
But I think we should be able to manage that kind of volatility.
I don’t think you can get away from the volatility in the financial
markets. You just have to concentrate on strengthening your own
growth story. And the more you do that, from experience, they
will in fact show less volatility. I think the key the key issue is not
that whether the financial markets are volatile but are they more
volatile in the Indian situation than for other countries. I don’t
think that is the case. They have shown much more volatility in
other countries than they have shown for India.
What are the implications of weakened devel-
oped markets for India? Does this impact the
As a policymaker, would the excess of the inflows way India will shape the path of its own eco-
worry you with regards to the long-term sustain- nomic growth in coming years? Will there be a
ability of the Indian growth story? Do you think major realignment in national policy in this new
that Indian financial markets are not as intimately world order which is emerging?
connected with the real economies as in the
western economies?
—
No, I think our financial markets are less integrated with global
markets. But financial markets are very important. So, if Indian
financial markets are seriously disrupted, it will certainly affect
Indian growth. But Indian financial markets are not that linked
to global financial markets but over time this linkage will only
increase. So, I think we need to be careful that this linkage is not
putting in a situation of undue volatility or vulnerability. But I don’t
think that at present it is.
56 Money Manager / January 2011
Since 2008, there have been structural changes
in the global economy which have heightened
concerns regarding inflation. How serious are
the concerns from the Indian perspective? How
does India respond to this situation where zero
interest rates over a long period of time in the
West is fuelling speculative action in
several commodities?
—
Well, I think there is a legitimate concern that if you have exces-
sive monetary quantitative easing in the industrialized countries,
it could fuel speculative asset bubbles and also speculative
commodity bubbles. But in our case, the Indian market is not that
open, so therefore the transmission effect directly to domestic
markets is less. However if it leads to commodity inflation in the
world, that will certainly affect us. I think in general around the
world, particularly in the emerging markets, there is a heightened
concern about inflation and we are also concerned about the
build up of inflation in India but fortunately for us the growth
story is very strong. And our growth rate has been a little higher
than what we originally thought it would be. But I think the infla-
tion is above our comfort level. It is not a big problem, inflation is
coming down but we will have to remain watchful.
— many to take leadership in this new world order?
Well, I think our national policy should be aimed really at
strengthening our own economy and the agenda for doing that
has been well established and we should concentrate on that.
Whether the international environment deteriorates a little bit, I
don’t think it alters what is the optimum policy for us, it may alter
the outcome of optimum policy. But I think we should be concen-
trating on taking care of the problems that we know are serious
at home and they need to be addressed. So I would not be too
distracted by the changes going on in the global situation. I think
we should remain focussed on the agenda we set for ourselves.
India’s growth is largely constrained by factors internal to India
not by global developments.
A lot has been said about the need for structural I think globally there is a lot of thinking going on about how
the financial markets should be regulated and how they
reform to develop a strong financial market
should be better supervised and we have to learn from
ecosystem in India. Do you think that in the long that too. The main learning that has come out really is that
financial markets have to be well capitalised and that in boom
term, in the backdrop of the global economic
years the inevitable tendency to give low quality lending i.e.
crisis, policymaking must be focused towards reduce the quality of lending should be regulated. Both the
regulatory and the supervisory systems should try to achieve
strengthening these markets for sustainable
that objective. Also there must be much more attention
economic growth? towards macro prudential regulations rather than micro pru-
dential regulations. Both are important but micro prudential
regulations are essentially the regulations that prevent an
No, it is certainly true that debt markets in the global situa-
tion are much stronger. An important reason for that in India,
individual firm from taking risky decisions in an otherwise
stable environment. Macro prudential regulations relate not to
the decisions that individual firms may take but to instability
of course, is that the fiscal deficit is quite high. The amount of
that may come into the system because of a general change
sovereign debt that is available at any given time is very high.
in the market conditions which will affect everybody. You can
The government has said that they will reduce the fiscal deficit.
have a situation where each individual entity looks as if it is
If they reduce the fiscal deficit, then the available savings will
stable as long as macro conditions remain okay but if macro
look around for other assets because the yield on sovereign debt
conditions change substantially, each one of them becomes
is likely to go down. As long as the government’s fiscal deficit is
instable. How do you avoid such a condition is the really the
huge, it is very difficult for savers to prefer corporate debt. They
great test.
may prefer corporate equity as there is a big upside but they
would not prefer corporate debt. So really reducing the fiscal
deficit is very crucial. I think another important thing is that we
do need some institutional changes - more competitive insurance
markets because these are the institutions that look for a high
“
yield long term debt. That is happening but it is happening a bit
more slowly than it should. But it will happen.
One thing which has been
The belief that the developed financial markets produced post crisis is a better
of the world were efficiently regulated was
appreciation of the relative
completely shattered after the financial crisis.
strengths of India
”
What do you think should be the role of regula-
tors in the wake of aftermath of the financial
crisis, particularly in India which is expected by
With respect to increasing accessibility to the
—
You know financial market regulation is important everywhere.
Indian financial markets, do you think there
I think it is true that in our case the financial system was fairly
should be a greater focus on encouraging
tightly controlled. But let me say that I would say that in our retail investments to increase the scope of
case, a lot of freedom that other market players had was simply
not available to our financial markets players. You know a good
financial inclusion?
—
regulation is not one where you simply tightly control the institu-
tions but rather the institutions have flexibility but they have a
regulatory and a supervisory framework which emphasises that I am not sure if I want to push retail investors to pick indi-
they do not take risks. In our case we did not allow them to take vidual stocks. As long as you have enough mutual funds being
risks anyways. Basically, we are transiting towards a more liberal made available to investors, you have institutions looking
structure of the financial system which will give people more after the interests of the retail investors and performing some
of a choice. As we do that we have to learn from the fact that kind of an averaging role. I think it will be a long time before
extreme liberalisation but no supervision is a very bad idea. our markets can have a large individual investor base.
Money Manager / January 2011 57
 CHALLENGES
Broadly, has the financial crisis been a blessing in Would it be fair to say that you see the balance
disguise for the Indian economy? of power in global policymaking shifting in
coming years?
— —
I would not call it a blessing but there is no doubt that it has
shown up a very significant weakness in the industrialized world. Well, that is not because of the financial crisis that is because of IS THE NEW WORLD ORDER
PROGRESSIVE OR REGRESSIVE?
And therefore when people look at the relative attractiveness of the underlying growth of the economic momentum– China, India and
investing in the emerging markets, they now appear to be a much other countries in Asia. Definitely, the centre of gravity is shifting
better bet in the terms of long term returns and I think India is slowly. But these should not be exaggerated. Looking 25 years
very well positioned in that context. That part is good. But maybe from now it definitely looks that the relative strength of Asia will be
that realization could have come without having a financial crisis. significantly higher than what it is now.
I would put it that the financial crisis has imposed quite a lot of And that is a good thing.
costs on the global economy not so much costs on us but some
costs on us as well. However, one thing it has produced post crisis
is a better appreciation of the relative strengths of India.

“
What are the advantages or the relative strengths
that you see and how can India reap benefits from
these?

—
The major benefit that India would reap is that investors would
perceive that the long term value of investing in India is higher
than what they otherwise thought. Earlier they thought that they
were getting fairly riskless returns in the United States and now
with the deleveraging that has taken place and it continues to
take place, such returns would not be possible. So, if people want
better returns they will have to accept little bit higher risk and that
will drive them to emerging markets and therefore to India.

58 Money Manager / January 2011 Money Manager / January 2011 59

INTERVIEW WITH
SWAMINATHAN AIYAR
The financial crisis has changed the global markets. Yes. But is this change going to last?
Are the changes sustainable enough to herald a new system entirely? Are there funda-
mental flaws that work against the creation of a global financial ecosystem? These are
some of the questions that will go through your mind when you think of challenges to the
new world order. Mr. Swaminathan Aiyar puts into perspective, in no uncertain terms, his
viewpoints regarding these issues. Read on.
Swaminathan Anklesaria Aiyar, Consulting Editor of The Economics Times, has been the
editor of two of India’s biggest economic dailies, Financial Express in 1988 and 90 and The
Economic Times in 1992 and 94. For two decades, he was also the India Correspondent of
The Economist, the British weekly. He is a graduate of St. Stephen’s College, Delhi, and
Magdalen College, Oxford.
60 Money Manager / January 2011
What are the elements of systemic risk, which
you think are still present in the international
financial system? How seriously do you think
are these concerns being treated by
regulators worldwide?
— gers to this new world order?
There have always been vulnerabilities in the financial system.
Fundamentally all financial systems are vulnerable. The bank-
ing system is fundamentally a con game since depositors are
guarantee freedom of withdrawal, which is possible since the
deposits are lent out to others. This makes it vulnerable when
trust is called into question. The financial and banking system is
so complex now that, in any government’s perspective, it is too
large to fail. The financial system is so interwoven and intercon-
nected that investment banks cannot be allowed to fail and they
have realized that the international community’s backing is there
and they are too big to fail. Even though the capital requirements
have been raised for the international banks after the crisis,
they have been given time till 2018 to cover these requirements,
which is very gradual. Even today there are questions about the
solvency of the western banks and they have been given consid-
erable time to build up their balance sheets. So to an extent the
vulnerabilities still exist, but the government guarantee is what
is making the difference.
Do you think the regulations being made right
now are making the system much more com-
plex than they were before?
— —
Well, to begin with, the system itself is becoming much more
complex than it was before. Complex derivative products did
not exist earlier, and financial innovation is happening at a rapid
pace. There is now a provision now that most derivatives will
be traded through exchanges. But with the pace of financial
innovation, there will be more products that will be created and
they will not be traded on exchanges to reduce counterparty risk.
Given that we are having more of innovation resulting in more
instruments and thus more of financial headaches, vulnerability
is very much there in the system. In my opinion, nothing that
has been done can prevent a future systemic risk from coming
in. Trying to keep pace with financial complexity has been hap-
pening for a hundred years. The complexity has increased, there
have been the occasional crises and we have had the cleaning
up act in the form of greater regulation and we have carried on.
So, in my opinion, the key issues of concern will be the relation-
ship governing commercial and investment banking and the
regulation of counterparty risk in securitized financial products.
Given that governments worldwide are involved
in fire fighting exercises in a bid to support
flagging financial and economic systems, do
you think there are concerns regarding govern-
ment introduced distortions posing new dan-
—
The issue is not in regulations, but the impact. The emerging
economies in Asia and Africa have exhibited considerable resil-
ience in surviving the impact of the financial crisis. Therefore the
outcome is that the emerging markets and BRICs have increased
their credibility as investment destinations. But the ultimate
power balance remains with the west and this has not been
affected by the financial crisis which affects economic growth
only marginally in the emerging economies. When it comes to
regulation in the western financial markets, the impact will be
aimed at improving the creditworthiness of the local market and
not against the emerging economies.
Are there any specific spill over effects which
you think emerging economies will face as a
result of corrective policy actions in the de-
veloped markets, particularly as a result of
specific global imbalances which we are seeing
currently in global trade and currency markets?
There will be some attempts at protectionism by the economies.
The war between the free-market lobby and protectionism will
always exist and both sides have won some victories in the
last 50-60 years. The real problem however is with the shift in
manufacturing capacities being handed over to the emerging
economies in the 1950s and 60s. This has moved abroad from
the developed countries and it is not moving back even if protec-
tive tariffs are brought in place. This will only raise domestic
prices without creating jobs or new investment, which, there-
fore, is not likely. Conventional tariffs may not be the case for
services. Off-shoring, which represents a very visible segment
of the imports of western economies, is a small part of total
imports, and any measures to curb this will be populist rhetoric.
Secondly, India & China can push for procurement and tendering
by moving the WTO and end up getting a favourable outcome.
Money Manager / January 2011 61

Do you think that globally tightened and strin-
gent regulatory measures will have drastic
consequences for financial innovations like
CDOs? Is that a serious concern in the financial
market ecosystem?
—
The point is there will be no end to financial innovation and it is
for the regulators to decide when and how to regulate as new
products keep coming up. But the whole point of innovation is
about overcoming the regulatory barriers. This is the struggle.
It is possible that regulators can pick up sufficient systemic and
economic risks in products, but not all. The regulators should
come up with disincentives to prevent risky innovation that
exposes vulnerabilities in the market
What are the disincentives do you think the
regulators should put in place?
—
There are a large number of tools at the disposal of the regula-
tors. Capital requirements for trading in specific securities
should be increased. Some securities can be altogether scored
off the sheet – like in India right now with some securities.
CDOs came into play only after the US passed regulations legal-
izing their trading. So the regulators will have to play their cards
carefully in harnessing the advantages and negate the ill-effects
of financial innovation.
How do you see the regulatory agencies per-
form the balancing act so that meaningful
innovation necessary to fund our future growth
does not get stunted? Microfinance for example
is an area where securitization of micro-loans
has great social implications. This is obviously
enabling better risk management and common
man’s access to credit.
—
Microfinance is an area where political sensitivity is high. You
also have govt. backed microfinance schemes and they are
competing with the private sector. The govt. will look to promote
its own business. In India, this assumes special significance,
as there is a political culture of encouraging default. Andhra
Pradesh which has been a pioneer in micro-finance has a repay-
ment rate of only around 90% in government-created self-help
62 Money Manager / January 2011
INTERVIEW WITH
groups, when private microfinance enjoys around 98% repay-
ment rates. If you have a situation where politicians constantly
want to waive loans and get votes, microfinance gets exposed
to a new risk. Securitization is ultimately a way of getting the
AMAR BHIDE
loans off the books of the microfinance institutions and into
those of the banks. This in principle is a great concept, but with
the political ramifications of this industry, in a culture where
default is encouraged for political gains – securitization can
become a problem.
Capitalist economies have been defined by one factor very strongly – freedom of the
John Mack of Morgan Stanley made a case Capital and currency markets. But the very same markets have now been subjected to
regulations which are amongst the most stringent in their history. Amar Bhide, ex-
for an “uber-regulator” in the backdrop of the
presses his unequivocal view points on the the loopholes in financial policymaking and
financial crisis. Do you see the movement for the dangers such regulations pose to the world economy.
unification of all regulatory agencies under one
umbrella as a distinct possibility? Do you see
a strong motivation for such uber-regulators
emerging in specific regional blocs like in the
case of the Euro zone?
—
The complexities are so great that a single regulator may not do.
On the one hand there is a problem of a unified coordinator to
monitor the activities of the regulatory agencies. Then there is a
problem of acquiring particular expertise in a function. However,
I have no over arching view on this. But within India, if we were
to have insurance companies regulated by each state and banks
regulated by each state, it would be very inefficient. So the
point lies in unifying the banking & insurance regulators in the
case. So ultimately it is about striking a balance in the function
performed and the coordination between regulatory bodies.
Amar Bhide is currently the Thomas Schmidheiny Professor at The Fletcher School
of Law and Diplomacy at the Tufts University. He is the author of A Call for Judgment:
Sensible Finance for a Dynamic Economy published in 2010. Prof. Bhide earned a DBA
(1988) and an MBA (1979) from Harvard. He received a B.Tech from the Indian Institute of
Technology in 1977.
Money Manager / January 2011 63
Over the last two years many of the western
economies which once extolled the principles of
free trade, had to resort to more regulation and
protectionism in order to boost their economies
and protect local industries. How do you see this
affecting the process of globalization and inte-
gration of financial markets around the world?
—
I think the globalization of financial markets is largely indepen-
dent of the globalization of real economies (which I think of as
the growth of trade and the flows of direct investment). The two
globalizations can advance strongly together or they can come to
a halt together but the factors that drive them are different.
Opposition to the integration of the real economies tends to
come, unsurprisingly, from owners of businesses in the real
economy and unionized workers employed in the real economy.
Business owners and workers usually know little about finance or
capital flows. It’s usually the central banks who worry about the
flows of capital and who try to restrict the flows of capital.
Of course if you had another financial collapse it would halt both
capital flows and trade flows so you could see both globalizations
stop due to a common cause.
One more thing that we have seen during the
financial crisis is the importance of the role of
regulators which you have mentioned in your
book- “A Call for Judgment” as well. We have
seen that regulators tend to follow the advance-
ments that happen in the industry rather than
trying to be more proactive and their policies are
never pre-emptive. Do you see the role played
by regulators across the world getting more dy-
namic in coming years and to move in line with
financial innovations and the way things happen
in the financial industry?
—
As I have argued in my book and as other people have argued as
well, regulators got seduced by claims for financial innovations
to a degree that made no sense, perhaps because regulators and
innovators were indoctrinated in the same ideology. They bought
into the theory of complete markets and a slew of other assump-
tions of modern finance. I do not think that, at least in the US, the
cast of characters and their mindset has changed much.
We now need much stricter regulation, but not in every
area of finance. I argue in my book that securities market regula-
tion is probably unnecessary or even counterproductive whereas
banking regulation is and always has been crucial. One can easily
imagine a securities market functioning more or less satisfac-
torily without much regulation. A stable banking system seems
inconceivable without fairly tough laws, however. But what we had
over last 30 years was securities regulation, which probably wasn’t
necessary to start with, becoming tighter and banking regulation,
which absolutely needs to be very tough, becoming looser. This
divergence may have been partly due to the differing mindsets of
regulators. Lawyers have pretty much dominated the enforcement
and formulation of securities laws. In banking, economists have
had much more influence as the Federal Reserve’s role in bank
regulation has grown.
So you are still concerned about misregulation?
—
I think the problem has become worse, if anything. The Dodd-Frank
Act is practically unenforceable because it places a mountain of
new responsibilities on regulators, a great many of which have
nothing to do with maintaining financial stability. I think regulators
are going to be overwhelmed and less capable of focusing on what
is really important.
Could you please illustrate some of the events
in 1990’s and 2000’s which connect to what you
have been saying from the regulation point of
view and that have enabled the finance industry to
make such innovations and deviate from how the
banking practices had been in the 70’s and 80’s.
— You have written -an article in WSJ- “Lets
My book traces back the unravelling of the banking system to the
70’s. To summarize the argument very briefly:
The Banking acts of 1933 and 1935 had created a pretty good
structure for bank regulation. This was the culmination of an
evolutionary process that had started in the early 1800’s.The acts
were deficient in one important aspect however as they preserved
a highly fragmented banking industry that was out of sync with
the real economy. After the first and second industrial revolutions,
the real economy became quite concentrated with the top 500
companies accounting for about half of real economic activity. And
big businesses needed big banks to extend credit. But because of
an ancient fear of the concentration of finance, banks weren’t al-
lowed to grow. They couldn’t open many branches and they could
not operate across state lines. So we had a mismatch between
industry, with big companies like General Motors and Boeing, and
small banks who could not satisfy their credit needs. If you put that
aside, bank regulation was well done.
Unfortunately, the inflation that started surging in the The Fed recently announced another round
early 1970’s made it impossible to sustain what had been an an
important piece of the banking acts, namely the regulation of
of quantitative easing and there is lot of hype
interest paid on deposits. about what Fed has been doing - whether it is
The rule back then was: 0% interest on demand de-
posits and interest on time deposits to be regulated by the Fed.
actually having the desired effect Fed wants
As long as the inflation rate was close to zero, people tolerated to achieve. Do you think Fed’s policies - trying
getting no interest on their demand deposits, but as inflation
jumped to 4-5%, a 0% interest rate on demand deposits became
to push medium and long term interest rates
untenable. Money market funds were established that bought down, like quantitative easing is working and at
risk free treasury bills that paid close to the inflation rate and
a larger level, do you think Fed is currently run-
shares in money market funds became a compelling substitute
for bank deposits. That was the beginning of the end. Money
markets funds stopped buying just treasury bills. They bought
ning out of monetary policy tools which it has in
higher risk instruments such as commercial paper that could
order to boost the economy?
—
give money market fund holders even higher rates of return.
And besides having the freedom to pay higher rates than banks,
money market funds did not have to pay salaries to lending offi-
I am sceptical of the role of government in managing business
cers or bear any other due diligence costs. They were pure free
cycles. I can’t prove that governments can’t control business
riders. At this point the banks could have made the argument to
regulators that this was ridiculous: money markets comprised an
unregulated and uninsured deposit taking system that regulated
cycles but I see no evidence that they can. The kind of evidences
that people produce to argue for doing this or the other to speed
the recovery seems unconvincing. To me, economies have quite
banks could not compete against. But banks did not do this,
a capacity for self healing and regulators have no reliable tools
because the ethos in ‘70s favoured deregulation and the freeing
to speed this process. Whether it is quantitative easing or
up of all markets. Rather banks lobbied to start their own money
stimulus packages, it all strikes me being not much better than
markets funds. The supposedly more progressive banks of the
black magic.
time also became enamoured with the business of securitizing
Think of medical devices designed with the best
credit and selling and speculating in derivatives instead of mak-
knowledge we have of human physiology and tested extensively
ing old fashioned loans and lobbied for more banking powers.
on animals. Yet they routinely fail when used in the human
By 1990, most of the restrictions on what banks could do, which
had been imposed by the 1933 and 1935 bank acts were gone
body because of complex interactions that no one can antici-
pate. I don’t think our knowledge of the economy is any better
all but in name. The actual repeal of the Glass-Steagall Act in
than our knowledge of human physiology so it is imperative that
1999 was to some degree almost a formality.
The particular manifestation that the 2008 crisis took
we proceed with extreme caution, avoiding treatments that may
or may not work in the short term but very likely could have huge
may have been the result of what happened in the previous five
long term consequences. Why risk the long term fiscal stability
or six years but the deep corrosion of the foundations of the
banking system had occurred well before 2000.
of the economy with measures backed by far less evidence than
we demand before allowing a new drug or medical device to be
put into use?
“
break up the Fed!” where you criticized the Fed
Whether it is quantitative and you advocate breaking it up. What struc-
easing or stimulus packages, it ture do you have in mind when you talk about
all strikes me being not much breaking up the Fed?
better than black magic —
”
At a minimum, the structure should be like that of the ECB. The
ECB is primarily responsible for monetary policy and has no bank
supervisory or oversight responsibilities. Let me also say that
getting that right structure is necessary but not sufficient. You
can have the right structure and regulators can still mess it up.
But if you have the wrong structure, you virtually mistakes.
Money Manager / January 2011 65

Absolutely. There has been a lot of hustle in
the currency markets of late, with the Chinese
issue and concerns around Euro rising again
with Ireland’s bankruptcy and other bailouts. It
seems that the currency markets are acting as
an impediment to the already weak recovery of
the world. So how do you see the impact of these
currency wars on the global recovery and can the
regulators or industry do something to curb this?
—
Currency markets are capricious. There is rarely much rhyme or
reason for why the Euro oscillates as it does for instance. I make a
STUDENT ARTICLES
The role of developing countries in the whole
recovery has kind of changed in last 2-3 years
and the impact of crisis was quite a bit limited in
these countries. How do you see these econo-
mies responding going ahead, and do you think
there will be some growth offset in the recovery
and some sort of response from the developed
economies to curb this growth offset?
—

“
little bit of money on it periodically, so I am not complaining loudly
(laughs). And from a policy point of view, what is the alternative?
The volatility of the currency markets is like the monsoons in India,
you wish they were more regular and predictable, but they are not.

The fact that Brazilian finance minister mentions

the term “currency wars” and then this entire
hype about this whole issue is a bit disconcerting
that over the last 6-7 months there has been so
Most economic policies in large countries tend to be based on
much talk about it. domestic factors; China is a bit of an outlier in this, it is the only

—
large economy that I can think of, that is highly dependent on
what happens outside and likewise the outside world has now
become incredibly dependent on what Chinese do and don’t do.
It may seem to the Brazilians that the Fed has embarked on a pro-
The Chinese are in some sense prisoners of their own success:
active policy to debase the dollar through quantitative easing. But
they have this fantastic manufacturing and export machine but in
I don’t think competitive devaluation is what the Fed has in mind.
the end it produces US treasury bills and the Chinese cannot eat
It’s just an unfortunate side effect, which is one more reason why
US treasury bills in the long run. And the more they accumulate
we should not have quantitative easing.
these T-bills, the harder it becomes to do anything about them.

66 Money Manager / January 2011

FIRST PRIZE FIRST PRIZE

GLOBAL CURRENCIES
Post the 1973 Middle East Oil crisis, US made unof-
ficial pacts with major oil producing nations to provide military
cover and political support in exchange for trading oil denomi-
nated only in US Dollars with all other countries. Hence, for a
country which did not have enough oil reserves (or did not want
events has occurred, with the impetus coming, not from OPEC,
but from an increasingly confident and assertive Russia. Putin
made his stand clear - a straight bargain chip with the EU and an
implicit threat to the United States (export oil in Euros). The “sole
superpower” cannot stop him, but must instead come up with

a tectonic shift or a muted whimper?

to utilize them because of strategic reasons), the only way of pro-
curing oil was to pay with dollars. Thus, with increasing demand
for oil across the globe, the demand for the dollar was artificially
inflated, thus making the dollar a globally circulated currency.
With the world seeing a crisis every half a decade, it looks quite imperative to hedge The deregulation of financial markets post Cold War
oneself against billions of dollars piled up in one’s Treasury. In the wake of the ‘Chinese further facilitated the flow of cross border funds routine. With
Suspicions’ we explore the reasons why Dollars was like an ‘Unparalleled Ruler’ in the the US government supporting the Dollar participation in inter-
1980’s who had no other opponents to challenge him in his prime, but now after almost two national markets and helping it become the reserve currency for
decades he has become weak and is susceptible to challenge by the new-age warriors most of the countries since two decades; Dollar currently stands
(Euro, Renminbi, etc). This article identifies the need to end the ‘Dollar Hegemony’ and as the most credit-worthy, most liquid and the deepest currency
in the world.
then explains the inability of Euro, Renminbi, SDR, WOCU, etc to replace the dollar. Thus in
The recent global turmoil and financial crisis in the
such times the best possible and most efficient solution is a set of norms imposed (possibly
U.S threatened to dethrone the dollar. Economists and analysts
by the IMF) on ‘Reserve Currencies Management’ that will be followed by each country.
around the world have not restrained themselves in pointing out
the weaknesses of the dollar. As Kenneth Rogoff, former IMF
chief economist puts it- There are “lots of reasons to be concerned
about the dollar. But a weaker dollar is a fantastic boost for the
United States, and it’s a problem for the rest of the world”.
terms that outweigh the benefits of Euro-shift. The Bush Pirate’s
quest for a global market subordinate to American fiat has failed.
This shift in the global relationship of forces should have been
expected when Bush declared war against world order. It is the
logical result of, and answer to, the president’s 2002 ultimatum,
“either you are with us, or against us.” The planet now prepares
to turn on its own axis. Henry C. K. Liu got it right in his far-
sighted Asia Times interview, “The War that may end the age of
superpower.”
Increasing US Debt
The U.S national public debt has reached around 67% of its GDP
in 2009 (much higher than historic level of 30%-50%) and the offi-
cial non-partisan Congressional Budget Office predicts it to cross
100% of GDP (by looking at the current policies) by the end of the
decade. It found that a 5% increase in the outstanding stock of
US treasury debt relative to Eurozone government bonds is asso-
ciated with an 8% depreciation of the dollar on average.
. THE NATIONAL DEBT AS A PERCENT

Source: Circles Phenomenon Research International (CPRI)

90% THROUGH
TRUMAN OF GROSS DOMESTIC PRODUCT
. SEPT 30 2008
80% [DATA FROM WHITE HOUSE.GOV]
.
70%
.

the authors
60%
.
50%

Source: MDI Library database

.
40%
.
30%

KENNEDY LBJ

NIXON FORD
.
20%

CLINTON

W.BUSH
.

CARTER
10%

IKE
.
0% . . . . . . .
Sumit Agarwal 1950 1960 1970 1980 1990 2000 2010

2nd Year student at MDI, Gurgaon

Pursuing dual degree in Finance and Marketing along with CA,
CFA, CAIA and FRM. He developed a strong foundation during his
graduation in Economics
Devi Prasad Biswal
2nd Year student at MDI, Gurgaon
Pursuing dual degree in Finance and Strategy along with CFA
He gained very strong analytical skills during Computer Science
Engineering
history of rise of the
‘dollar’ (usd)
— of concern with dollar
The Dollar supremacy story started with the establishment of the
Bretton Woods system in 1944. By the end of World War II, a
vacuum was created in the international financial system due to
the downfall of Pound Sterling. A requirement of a new global
some of the
Thus foreign governments worry that the US might consider re-
ducing the real value of debt by allowing for a higher inflation
rate and hence effectively reduce the real value of their invest-
prominent reasons
ments. China which is believed to be holding $ 1.2 trillion of its
reserves (out of around $ 2.6 trillion) in dollar assets would lose $
1.2 billion for every 1% weakening in the dollar
hegemony
Dollar’s diminishing role as a Reserve Currency
Even though the dollar still dominates the reserves held by most
of the major countries, a recent trend has been that of diversifica-

Aditya Narayan Jha

currency to rejuvenate the world economy got 44 allied nations to
gather in Bretton Woods where dollar took over the role played by
pound sterling/gold in previous international financial system.
2nd Year student at MDI, Gurgaon In 1971, when the Bretton Woods system was revoked by U.S,
Pursuing dual degree in Finance and Information Technology there was no currency which could challenge dollar to become the
along with FRM. He finds his interests in Psychoanalysis and Be- international currency. Thus, a free floating regime ensued with
havioral Finance dollar continuing as the dominant currency (dollar - fiat system).
68 Money Manager / January 2011
—
US: The Shrinking Superpower
It was assumed that, American military dominance in the Middle
East and a series of “regime changes” would eliminate the euro-
threat that dollar had while quoting oil. An opposite chain of
tion to other currency assets. China has recently made invest-
ments in yen assets (thus $ losing around 8% to the ¥), while
both Russia and Brazil have been net sellers of the US treasuries
in the past 12 months. “The real concern remains ongoing fall in
foreign demand for US treasuries as issuance is expected to rise
over the next several years on larger fiscal deficits,” says Michael
Woolfolk, senior currency strategist, The Bank of New York Mel-
Money Manager / January 2011 69
FIRST PRIZE
lon. Without greater foreign demand, domestic demand may not
keep pace, he points out. “If so, higher interest rates will be the
eventual outcome,” he says.
CURRENCY COMPOSITION OF FOREIGN EXCHANGE RESERVES (WORLD)
[IN USD MILLIONS] 2002 2003 2004 2005 2006 2007 2008 2009
ALLOCATED 1795994 2223203 2655173 2843625 3315575 4119398 4210072 4563579
RESERVES
CLAIMS IN USD 1204673 1465752 1751012 1902535 2171075 2641671 2698423 2837121
% CLAIM IN USD 0.670756 0.659297 0.659472 0.669053 0.654811 0.641276 0.640945 0.621688
‘Black Gold’ set to be quoted in
non-dollar Currencies
Middle Eastern nations and OPEC members are increasingly get-
ting inclined towards non US Dollar trading baskets. There have
been confirmed talks between Gulf Arab and Chinese representa-
tives in Hong Kong of oil trade in non-dollar denomination. Brazil
along with India has shown interest in collaborating in non-dollar
oil payments. Iran and Venezuela have taken the lead and have
proposed trading oil to a basket of currencies, but haven’t yet
garnered enough support from the OPEC nations, mainly Saudi
Arabia. Iran has increased the amount of its oil export earnings
in currencies other than U.S. dollars to about 70 percent. More-
over as previously mentioned the world second largest exporter,
Russia has even started trading oil in Euro terms. Putin did that
intentionally in order to remove US self – proclaimed supremacy
over the world. Putin had seen Bush beating the flesh out of the
Middle- East in its undercover of helping Saudi Arabia getting
independence from Saddam Hussain reign.
Decreasing share of dollars in
global forex market
The share of the USD in the global forex market has decreased
gradually albeit in small amounts over the past decade. This un-
derlines the fact that market players are gradually
“
‘WOCU’ could be the founda-
tion to a future unified currency
which would act a totally apolitical
instrument
”
increasing transactions in currencies other than dollars and
hence other currencies are set to gain significance importance in
the future. The share of major currencies in the foreign exchange
market as of April 2010 is shown in Figure 2.
70 Money Manager / January 2011
FIRST PRIZE
The Asian Region Currency Partnership
Japan, under the leadership of then Prime Minister, Yukio Hatoya-
seeming alternatives Renminbi
Currencies like Renminbi are likely to achieve international status
ma led the charge to form a regional currency partnership based
—
as it is issued by a large emerging country. However, Renminbi as a
on closer ties between it- replacement is a very long proposition. For this to happen not only
self, China and South Ko- the Chinese economy has to grow considerably bigger (which it very
rea. At the Association of likely in the near future) but also it must develop large financial
Southeast Asian Nations
Euro
markets, fully integrated in world exchanges, and the Chinese gov-
(ASEAN) discussions in ernment must issue top-rated public debt instruments. Currently,
The euro is often seen as the challenger. Its large denomination
late November, 2009, the renminbi is plagued by lack of full convertibility and the Chinese
banknotes have been instantly adopted around the world. Even
trilateral meeting unani- markets are not integrated and for various reasons, the financial
Source: International Monetary Fund
though the Eurozone is faced with similar challenges as the U.S,
mously concluded saying credibility of local authority is limited.
the outstanding stock of U.S treasuries grew at a double pace of
- “until now we have been too reliant on the United States” and
“we would like to develop policies that focus more on Asia”
that of Eurozone government bonds since the start of 2009.
Even with China’s increasing importance in the interna-
tional trade markets, it is not necessary that other countries use the
The Federal Reserve reckons that half of the dollar
Renminbi as the invoice currency as historically neither Yen (almost
bills ever printed circulate outside the United States, represent-
half of Japan’s exports are invoiced in dollars) nor Sterling (almost
ing an amount of $400 billion while, the European Central Bank
CURRENCY DISTRIBUTION OF quarter of Britain’s exports are invoiced in dollars) gained such
reports having shipped in just one decade about €100 billion
GLOBAL FORIEGN EXCHANGE MARKET TURNOVER prominence. Similarly for Renminbi to be a major reserve currency,
worth of banknotes outside the euro area. These are impressive
2002 2003 2004 2005 central banks around the world will have to divest from U.S. assets
numbers but they refer to just one aspect of what makes a cur-
US DOLLAR 89.9 88.9 85.6 84.9 and Treasury bonds causing USD prices to crash and Renminbi Pric-
rency international.
EURO 37.4 37.4 37.0 39.1 es to rise drastically, resulting in paper losses, which would cause
The foreign exchange reserves of central banks are
JAPANESE YEN 23.5 20.8 17.2 19.0 major loses to the Chinese reserve dollar assets.
held in interest-yielding public debt instruments, not cash. Obvi-
POUND STERLING 13.0 16.5 14.9 12.9
ously, these must be safe instruments, which would presumably
AUSTRALIAN DOLLAR 4.3 6.0 6.6 7.6
exclude a large number of Eurozone governments. The safest The Phoenix - I: SDR
euro-denominated instruments are issued by the German govern-
ment. Central banks want these instruments to be not just safe,
increasing risks with
Special Drawing Rights (SDRs) were created by the International
but quickly sellable in case of emergency. Unless the market is Monetary Fund in 1969 in an effort to stabilize the international
deep enough, emergency sales may resemble fire sales that en- foreign exchange system. Its value is based on a basket of four key
weakening dollar tail capital losses. The market for US Treasuries is the world’s
deepest. The total value of existing US public debt instruments is
nearing $9 trillion, of which $500 billion is traded on an average
international currencies – US Dollar, Euro, Yen and British Pound.
The exact amounts of currency making up SDRs are determined by
the IMF Executive Board in accordance with the relative importance
day. German debt instruments amount to about $1 trillion, with in international trade and finance every five years. The currency
— an average daily turnover of less than $30 billion. The situation
is similar for French debt instruments. The United States, thus
simply plays in a different league. Of course, things can change
composition of the SDR for the period 2006-2010 is 44% USD, 34%
EUR, 11% JPY and 11% GBP.
Credit Risks The IMF’s so-called Special Drawing Rights could be
over time. Turnover can increase but German government debt used as the basis for a new currency. Arguments against making
will remain small, unless it is multiplied several times over, in SDR the world’s reserve currency include the fact that the US dollar,
With decreasing footprint of United States as the military and eco-
which case it would be relegated to junk status. the Euro and the Pound – which make up the large majority of SDRs
nomic superpower and increasing US debt, serious credit issues on
Bank for International Settlements surveys also indi- – have all lost value since late 2007 when the recession began.
the US government abilities to defend its securities might crop up.
cate that euro turnover beyond Europe is only around 20% where
Additionally, considering the plethora of recessions that have been
as the Dollar is more evenly distributed all around. Although the
seen during the last decade the future decade promises the world
European Union has European Central Bank, there is no single
to be a cyclone. In such uncertain events, the US government will
definitely have a tough time ensuring its ability to be the world’s
European treasury. Instead, there are 27 European treasuries. COUNTRY WEIGHTINGS NOVEMBER 2009
INDONESIAN IOR
Investors cannot easily track or influence fiscal policy on the con- POLAND POZ
BELGIUM EUR
greatest creditor.
NETHERLANDS EUR
KOREAN KRW TURKEY YTL
tinent. Also the ECB does not have a goal of Internationalization AUSTRIAN EUR
MEXICO MXN
of the Euro. Similarly, Euro lacks depth and liquidity in capital- INDIAN INR
CANADA CAD
BRAZIL BRL
markets.UK is still not part of the Euro zone which leaves London,
Devaluation Risks SPAIN EUR
UNITED STATES USD
a major financial centre still without Euro monetary controls. RUSSIA RUD
ITALY EUR
The events of the Euro crisis of 2010 have also
The US government is coming up with expansionary fiscal and mon-
brought severe doubts to the credibility of the Euro and the exis- UK UBP
etary policies quite intermittently post 2008 crisis. Also incentives
tence of the Eurozone in the future. But, we believe that the Euro FRANCE EUR
of the US government to have slightly higher inflation back home
has overcome the challenge by providing the financial support
Source: www.wocu.com
GERMANY EUR
to reduce debt burden, have made the Chinese Treasury a bit sus-
to Greece (and implicit guarantees to other states in need) and CHINA CNY JAPAN JPY
picious about holding dollars. In its effort to slightly diversify its
hence has strengthened further.
holdings, it suffered huge losses on account of dollar devaluation.
The Chinese are riding a tiger without a way to get off it.
Money Manager / January 2011 71
FIRST PRIZE FIRST PRIZE

Why replace a falling dollar by an index which so heavily includes

the dollar? Also, SDRs do not contain participation from emerg- diversification 0.5
CURRENCY FORECASTS
EURO/USD
-Although China is gaining prominence in the
international stage and encouraging the inter-

argument:
0.5
ing markets, like the Chinese Renminbi, Indian Rupee, Australian national use of the Renminbi, there is a long
0.5
Dollar or Canadian Dollar, all of which are important benchmark way to go before it is an attractive vehicle for

way forward
0.5
or secondary global reserve currencies. international investments and holding reserves
0.5
However, even if the dollar is replaced by the SDR, A S O N D J F M A M J J A S O N D J F M A M J J due to its currency convertibility norms.
the IMF does not have the financial prowess to safeguard the ex- 0.5 2009 2010 2011 But the fact that each of these currencies has
change risk. SDRs would have to be delinked from other curren- 0.5
JAPAN YEN/USD underlying questions would mean that none of
cies and issued by an international organization with equivalent these currencies would singularly dominate

—
0.5
authority to a central bank in order to become liquid enough to and there would be a global market for all
0.5
be used as a reserve. To make SDR the principle reserve asset, three. Future may hold for us a ‘Currency War’.
0.5
close to $3 trillion in SDRs would have to be created (Currently, There are numerous factors which play in favor of the dollar includ- A S O N D J F M A M J J A S O N D J F M A M J J Such an idea would eliminate inefficiencies and
2009 2010 2011
it comprises 4% of world reserves). There is a need for a wider ing its size, liquidity, depth of US capital markets and stability of 0.5 would bring handsome opportunities for the in-
UK POUND/USD
basket of currencies in SDR in order to be accepted as a global the dollar asset markets, particularly the short term government 0.5 vestors!
currency. It would provide a more efficient, fairer and more sta- securities market where the central banks tend to be the most ac- 0.5
ble basis for our globalised economy. But however, this is not a tive. The foreign exchange reserves of central banks around the 0.5
quick or a short or easy decision and if at all it happens it would world are held in treasury bills. The total amount, $4.4 trillion, is 0.5
references
A S O N D J F M A M J J A S O N D J F M A M J J
be quite revolutionary. about ten times the value of greenbacks held outside the United
0.5 2009 2010 2011
States with the dollar’s share of foreign exchange reserves cur- SWITZERLAND FRANC/USD Articles in Journals
0.5
rently at 62 percent.
The Phoenix – II: World Currency Unit (WOCU) Another factor which favors the dollar is the natural 0.5
- IMF, 2010, “IMF Research Bulletin”, Vol 11,
Number 2, Pages 1-12
advantage of its incumbency. As one study (Goldberg and Tille, 0.5
The ‘WOCU’ is a synthetic currency, introduced by WDX organi- - Global Finance, 2009, “Dollar Secure in
2005) concludes: ‘The role of the dollar as a transaction currency in 0.5
zation & created from a balanced basket of the currencies of the A S O N D J F M A M J J A S O N D J F M A M J J
its Role as World’s Key Reserve Currency,
international trade has elements of industry herding and hystere- 2009 2010 2011
top 20 countries in the world ranked by GDP, weighted based 0.5
Analysts Say”, Sep, Pages – 1-4
sis’ that mitigate risks against rapid change. Thus, often ingrained CANADA CAD/USD
upon each country’s GDP as a proportion of the total GDP of 0.5
habits and institutional rigidities have favored the continued use - Ian Hillar Brook, 2009, “The World Currency
those top 20 countries. Hence WOCU being a balanced basket 0.5
of the dollar. But it might be possible for there to be a tipping point Unit: What does this mean for treasurers?”,
of 20 economies makes its structure much less volatile. ‘WOCU’ 0.5
when everyone starts migrating directly from the dollar to another, Feb, Pages 1-9
could be the foundation to a future unified currency which would 0.5
it is not necessary for only one international currency to exist. For A S O N D J F M A M J J A S O N D J F M A M J J - Cofer, 2010, “Currency Composition of Of
act a totally apolitical instrument, thus avoiding international
such a transition international bodies like the IMF can possible 0.5 2009 2010 2011
ficial Foreign Exchange Reserves”, Pages 1-8
disagreement over a particular currency becoming the global
come up with ‘Code for Reserve Currencies Management’ similar MEXICO MXN/USD
reserve currency. Compared to the SDR, the ‘WOCU’ is better 0.5 - Ronald Mckinnon, 2002, “The Euro versus
to Basel II norm for Bank Capital Management.
balanced and its constituent currencies are updated every six 0.5 the Dollar: Resolving a Historical Puzzle”
- Countries would seek to optimize the Markowitzian Risk-Return
months compared to 5 years in case of SDR. Since it has no po- 0.5 Feb, Pages 1-4
characteristics of their foreign exchange reserve portfolios by di-
litical interference, it is better suited to the conduct of global 0.5
versifying them. A S O N D J F M A M J J A S O N D J F M A M J J
trade in the 21st century. However problem like lack of financial 2009 2010 2011
- The sheer size of today’s global market means there is enough 0.5 Websites
muscle to safeguard exchange rate risk remain. The following

Source: Global Finance, 2009

BRAZIL/BRL/USD
room for liquid and deep markets in more than one currency. 0.5 - Retrieved Nov 3, 2010, from http://www.
graph shows the stability that ‘WOCU’ has as compared t o a
-The view of there being only one international currency is incon- 0.5 globalresearch.ca/articles/BLA310A.html
single currency – Euro.
sistent with history- there were three international currencies 0.5 - Retrieved Nov 3, 2010, from http://
before 1914 (British Pound, French Franc and German Marc), the 0.5
A S O N D J F M A M J J A S O N D J F M A M J J www.nytimes.com/2008/05/11/business/
Dollar and the Pound shared international primacy in the 1920’s
2009 2010 2011 worldbusiness/11iht-11goodman.12761804.
VOLATILITY FROM BASELINE- USD PRICE BASED and 1930’s and even today almost 38% of identified reserves are
1.800000- -FORECAST
in currencies other than dollars.
1.600000- Hence while the idea that there would be a sudden
1.400000- switch to another international currency seems a bit farfetched as - Retrieved Nov 3, 2010, from http://www.washingtonpost.com/wp-dyn/content/article/2009/03/23/AR2009032301782.html
EURO
1.200000-
of now, it is more likely that the Dollar, the Euro and the Renminbi - Retrieved Oct 28, 2010, from http://www.colinandrews.net/2012-Economy.html
would share the roles of invoicing, reserve and settlement curren- - Retrieved Oct 29, 2010, from http://www.wocu.com/wocu/the_charts.php#nov2009
1.000000-
cies in the years to come. Each of these currencies has its own
Source: Ian Hillar Brook (WOCU)

WOCU - Retrieved Oct 30, 2010, http://www.colinandrews.net/2012-Economy.html

0.800000- concerns:
0.600000- -America’s twin fiscal and external deficit may weaken the de-
Other Sources
0.400000-
mand for Dollars.
- Most traded currencies 2010 - Most popular currencies - What Are The Exotic Currencies
-Concerns about the European Union and its ability to hold to-
0.200000-
gether its members in the light of the Greece Debt crisis might And How It Affects The Foreign Exchange Markets.mht (MDI Library database)
2000-

2001-

2002-

2003-

2004-

2005-

2006-

2007-

2008-

2009-

undercut the Euro. - Factsheet -Special Drawing Rights (SDRs).mht (MDI Library database)

72 Money Manager / January 2011 Money Manager / January 2011 73

SECOND PRIZE
CHINA’S
DOLLAR TRAP
a historical perspective
the authors The Great Depression’s impact was accentuated in Europe by the
—
hammering of the chief currency of the region at that time – the
Pound-Sterling. The party to be majorly blamed in this regard –
The Bank of France which mismanaged its reserves of the Sterling
Aravind Vijayasarathy N in the late 1920s and early 1930s. This resulted in large scale
contraction of European economies that had a feedback effect on
a PGP2 student at IIMA and follows the financial markets with the US. The second crash of the world markets in 1933, post a na-
keen interest. He can be reached at 9aravindv@iimahd.ernet.in scent recovery period from 1929, can be in part attributed to this.
Fast-forward to the 21st century, a crisis of similar proportions is
unfolding, so is a recovery. Here too is a nation, China, an emerg-
S Harun Thilak ing superpower that has driven itself into a dollar trap and is on
tenterhooks as to how to manage its reserves. What China does
a PGP2 student at IIMA and interned with Nomura in Singapore.
from here will have implications for the recovery from this crisis
He can be reached at 9sharun@iimahd.ernet.in
and the future of the international monetary system. Through this
paper we seek to analyse factors that will influence China’s deci-
V M Avinass Kumar sion making and address 3 key questions. How China can react
to this situation and what will be its impact? What lessons can
a PGP2 student at IIMA and his areas of interest include M&A China learn from France’s debacle? and What significance it holds
and financial and economic history for the nascent recovery from the global financial crisis of 2007?
74 Money Manager / January 2011
SECOND PRIZE
france’s foreign reserve
management – 1930s
—
The period during the late 1920s and early 1930s was a period
where international cooperation was intertwined with conflict.
During this period, the global superpowers Great Britain, the
United States and France established a gold exchange stan-
dard. The re establishment of the gold exchange standard was
discussed vehemently in the Genoa Conference of 1922 and
it was taken by the above mentioned superpowers in the late
1920s. It enables central banks in these countries to hold for-
eign assets denominated in gold convertible currencies as part
of their foreign reserves. In each country, parity was constituted
between the prevailing currency and gold which was maintained
through coordinated action on exchange markets. The gold ex-
change standard found its backing from the superpowers in order
to prevent world deflation by reducing the risk of monetary gold
scarcity (BIS 1932, Hawtrey 1922)
france’s reserve policy
in the gold exchange sterling trap
standard
—
— From 1929 onwards, it became clear that France was trying to of-
The Bank of France was a private organization during this period
and its motives outlining its reserve policy can be attributed to
minimizing the risk of capital loss. Its foreign reserves were al-
located between the sterling, dollar and gold. After the franc was
stabilized in 1926, the French government mandated the Bank of
France to buy foreign exchange on the market, in order to avoid
excessive currency appreciation (Blancheton, 2001). Exhibit 1
shows the portfolio composition of the reserves held by the Bank
of France. In the late 1920s Bank of France held more than half
of the world’s volume of foreign reserves. However, there were
some pressing issues with the gold exchange standard. The cur-
rency parity with gold established during the stabilisation years
was a major cause for concern. It was believed that the sterling
which was stabilised at its pre-war gold parity was overvalued
compared to currencies like the franc and the reichsmark (Keynes,
1925). Moreover, France along with the United States were criti-
cised for hoarding gold.
Bank of France anticipating a sterling devaluation
started rebalancing its reserves portfolio by liquidating its ster-
ling holdings for the dollar and gold. Many theories have been
put across for this rebalancing. One clear aim of the rebalancing
CHINA’S CURRENCY RESERVES AS % WORLD GDP
100000-
80000-
60000-
source: bank of france archives
40000-
20000-
0-
1928-
1929-
1930-
1931-
1932-
1933-
1934-
1935-
1936-
GOLD OTHER DOLLAR
STERLING UNDOCUMENTED
was to limit the risk of capital loss on its sterling holdings on
the account of a highly probable sterling devaluation. Paul Einzig
(1932) believed that French monetary authorities were using their
reserves as a “fighting fund” in the financial war against Britain.
On the other hand, Bouvier (1989) believed that the accumulation
of large gold reserves were part of a holistic strategy employed
by France to make Paris as a major financial centre. However, the
Bank of France could not simply liquidate all its sterling holdings
in one-go as it was concerned that its actions would have brought
about widespread criticism as well as hastened the fall of the
sterling. It started converting its sterling holdings to dollar and
gold in the late 1920s at a temperate pace.
fload its sterling holdings in favour of the dollar and gold. Exhibit
1 shows the variation in the portfolio composition of the reserves
held by the Bank of France. Exhibit 2 shows decline in the Bank
of France’s sterling reserves during this period while Exhibit 3
shows the corresponding increase in the dollar reserves. The
liquidation of France’s sterling holdings expedited the fall of the
sterling leading to its eventual devaluation in 1931. The major
consequence of the sterling’s devaluation was a capital loss of
about 2.3 billion francs on the Bank of France’s sterling holdings.
This loss had a disastrous impact on the Bank of
France and it required the support from the French Treasury to
cover the losses (Moure, 1991). Furthermore, the Bank could no
longer have autonomy over its foreign reserves policy. One ques-
tion which is relevant and concerns us in this paper is – If the
Bank of France had expected a sterling devaluation, why did they
still have to suffer a huge capital loss? This is the quintessential
trap that a country which holds a large amount of foreign curren-
cies as part of its reserves finds itself in when the currency is on
the verge of devaluation. Any offloading of the currency holdings
would hasten the process of devaluation thereby leading to large
capital losses. In that scenario, what could a central bank do? Let
us examine what the Bank of France did in the 1930s.
Money Manager / January 2011 75
SECOND PRIZE SECOND PRIZE

BANK OF FRANCE’S STERLING BALANCES

(IN MILLIONS POUNDS) 50-
FRANCE’S GOLD RESERVES DURING
THE GREAT DEPRESSION chinese dollar trap and
impact on global trade
160
45-
UNITED STATES
30-
120
25-

—
20-

source: seeking alpha, 2009

source: bank of france archives
80
15- FRANCE
10-
20
5- UNITED KINGDOM Extent of China’s Dollar Reserves and rationale
0-

1913-

1923-

1924-

1925-

1926-

1927-

1928-

1929-

1930-

1931-

1932-
0
From the year 2003, China has been accumulating its reserve of
1928-

1929-

1930-

1931-

1932-

1933-

1934-

1935-

1936-
dollars by consistently devaluing the renminbi. Labour efficiency
in china makes it an attractive destination for FDI and Chinese
BANK OF FRANCE’S DOLLAR BALANCES (IN MILLIONS $) ond was a profit motive. The Bank of France’s gold policy during produce is price competitive thereby making it a highly export CHINESE EXPORT AND IMPORT $ BILLION, IMPORT
times of Gold exchange backed currency has played an equal part oriented economy with huge trade surpluses. This trade surplus ROLLING 12M SUMS EXPORT
700- 1600
in the monetary contraction of the great depression. The steriliza-

.
allowed China to accumulate dollar denominated reserves and
600- 1400
X
tion of these gold reserves without expanding money supply led thus buy more political and economic clout in the asian hotch-

.
X

1200
500- to a sharp upward rise in the price of gold. This fuelled a bubble potch. China’s total forex reserves stand $2.5 tn. which is by a

.
1000
400- that very literally burst on the face of Europe deflating the price of distance the largest in the world and more than 60% of this is
source: bank of france archives

.
800
the gold and also dragging down the value of the sterling with it. dollar denominated. China’s percentage of world reserves also

source: market oracle, 2010

300-

.
600
200- While these served the needs, in times of profit, a genuine value rose considerably to rech nearly 5% of the entire world forex 400

.
100- creation need during downturn was not understood. It is anybody’s reserve, putting it in a vantage position. The Exhibits 5,6,7,8 and 200

.
0
guess as to where the pound sterling may have headed post-the 9 succinctly sum up the situation of rising reserves, devaluation 0
1928-

1929-

1930-

1931-

1932-

1933-

1934-

1935-

1936-

Great Depression. But the untimely hammering of the Pound Ster-

1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
of the currency as well as the rise in gold prices. M12
ling by France not only resulted in loss of capital on its portfolio,
The Bank of France had started offloading its sterling holdings but also effectively transferred the effect of the declining dollar to
from the late 1920s as shown in Exhibit 2. However, it could not the pound and the great depression to the rest of Europe. CHINA’S FOREX RESERVES TREND GOLD PRICE TRENDS IN CHINA
go all-out in its off loading for the fear of completing destroying TONNES YUAN/OZ
4.5% 7.000 8.000

. . . .
the sterling, incurring massive losses and completely annihilating

what france could

4.0% 6.000 7.000
the international financial system. It had to be prudent in its of- 3.5%
5.000 6.000
floading of its sterling holdings. It was carrying out its offloading 3.0%

have done
4.000 5.000
in small measures and even had a change in attitude towards 2.5%

. . . .

source: seeking alpha, 2009

source: market oracle, 2010

2.0%
the sterling. As seen from Exhibit 2, between October 1930 and 3.000 4.000
1.5%
June 1931, it stopped offloading its sterling reserves and inter- 2.000 3.000

—
1.0%
vened in the exchange market in those early months to support 0.5% 1.000 2.000

.
the sterling. It also granted credit of 25 million pound-sterlings to 0.0% . . . . . . . . . . . . . . . 0 1.000

1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
the Bank of England in July 1931 (Moure, 1991). But all this was France could have obviously sought to reign in a control on the M12

1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
not done as a long term measure to prop up the sterling. Bank of franc by paring it against the pound and rallying. Gold reserves CUMULATIVE DEMAND(LHS) GOLD PRICE(RHS)
France wanted to minimise its risk exposure and began offloading should have been monetized to create money supply. However, CUMILATIVE SUPPY(LHS)

its sterling reserves as soon as the sterling strengthened. this would have fuelled inflation in the short run but would have
This temporary support for the sterling is clearly in helped France realize its goal of minimized capital loss in the ASSETS V US TRADE DEFICIT, $ BILLION,
CHINA’S PURCHASES OF US SECURITIES
line with what can be expected from a large player in the foreign forex reserves as well as an appreciation of its gold reserves. 2500 ROLLING 12M SUMS
900-
exchange market who possesses considerable sterling reserves. 800-
2000
The Bank of France officials have been quoted as saying that “(we) 700-

“
seized every chance to liquidate our sterling pound holdings but 600-

source: the asia-pacific journal, 2009

1500

In the foreseeable future

500-
circumstances were far from favouring full implementation of this
400-
policy”. The Bank further said that it did not want to “provoke the 1000

source: setser, 2009

300-
depreciation of a currency in which it had considerable holdings”.
These responses show that the Bank of France was well and truly
the replacement of the dollar as 500
200-
100-
caught in the sterling trap and the only option was prudent sup- a global currency seems highly 0-

2000-

2001-

2002-

2003-

2004-

2005-

2006-

2007-

2008-
0

M12
port of sterling and consequent offloading of sterling reserves in JAN 01 02 03 04 05 06 07 08 09

unlikely
”
CHINESE PURCHASES OF OFFICIAL PURCHASES OF US TRADE DEFICIT
order to limit the capital loss of its reserves. TREASURIES AND AGENCIES TREASURIES AND AGENCIES

The lack of cooperation between central banks of the

industrialized powers was one of the key triggers of the sterling
selloff by France. Central banks were driven by two motives – the
first was to minimize capital loss on their positions and the sec-
76 Money Manager / January 2011 Money Manager / January 2011 77
SECOND PRIZE
chinese dollar trap
— result, more new factories are being built to enhance China’s
In the early 2000’s, China followed an aggressive export-led
growth strategy. This was mainly a consequence of the increase
in consumption patterns in the US and other Western countries,
which led to the increasing demand for Chinese goods and ser-
vices. As a result, China began accumulating large trade sur-
pluses. This led to an increase in the inflow of foreign capital.
Since China’s Central Bank, the People’s Bank of China (PBOC)
decided to follow a fixed-exchange rate system and pegged the
Yuan against the dollar, China had to buy out the dollars that
were flowing in. This led to an accumulation in foreign exchange
reserves to the tune of $2 trillion (around 1/3rd of China’s GDP).
This “Dollar Trap” offers a risky proposition as the safety of in-
vesting in US Treasuries has decreased after the credit crisis.
Experts have suggested many ways to escape this dollar trap.
China is considering offloading its foreign exchange reserves, but
the inflow of such a large amount into the world economy might
lead to the devaluation of the dollar, which again would affect
China’s reserves. In order to avoid this, China is pushing for an
alternative form of reserve currency, namely, the SDR (Special
Drawing Rights) (Krugman, 2009)
impact on global trade global imbalances
created due to the
— dollar trap
China has been trying out various escape routes to this dollar trap.
This has resulted in a shift in the balance of worldwide trade and
is leading to the creation of various imbalances. World trade is
declining at a faster pace, with constantly declining demands for
exports. Wade quotes “As of May 2009, some 740 ships lie an-
chored in Singapore harbour, idle, unable to find cargo”. There is
a high risk of China dumping the dollar in the US. But, the US has
problems of its own in struggling to meet the demand for foreign
loans. As a result, the Fed might resort to printing dollars. This
would lead to devaluation of the dollar, impacting China adverse-
ly. (Wade, 2009)
The credit crisis has affected other large economies as
well. Increasing capital flows into China adversely affected trade
patterns in Japan, the world’s second largest economy. Japan’s
chief source of exports- the manufacturing industries, declined in
growth in December 2008. It was a third lower in December 2008
than in December 2007.
The Chinese Government responded to the crisis by
implementing a large stimulus package. Simultaneously, the PBOC
brought about an expansionary monetary policy. The government
introduced a stimulus package of 4 trillion yuan for 2009 and 2010.
Apart from this, provincial governments were also asked to imple-
78 Money Manager / January 2011
ment bailouts and packages of their own. Around 45% of this
investment is in infrastructure. This is primarily in fixed assets
and active promotion of public goods. But there is little incen-
tive for local governments to invest in public goods and as a
manufacturing capacity. This would only attract more foreign
investment into China and would not directly solve the dollar
trap problem at hand. (Yu, 2010)
The dollar trap has also severely impacted Taiwan,
as it faces further pressure to get incorporated with the Chinese
mainland. The Chinese government is pressurizing the US to aid
the incorporation of Taiwan in a deal which includes a promise
not to dump dollars into the US.
One of the strategies adopted to escape the dollar
trap has been promotion of outward FDI in developing countries.
China has become the largest source for outbound FDI and it has
been investing heavily in countries like Thailand and in Sub-Sa-
haran Africa. The creation of the China Investment Corporation,
a sovereign wealth fund to manage China’s foreign reserves is
seen as a positive step in this direction. Apart from this, do-
mestic Chinese industries continue to export large volumes of
services like shipping and insurance. Large Chinese firms are
actively taking part in Mergers and Acquisitions to strengthen
their foreign portfolio. An example of this is Lenovo’s acquisi-
tion of IBM’s computing arm. Lastly, Chinese enterprises are
seeking to move their factories to more labour intensive coun-
tries like Vietnam and Thailand. (Davies, 2009)
—
China’s investment of its foreign reserves in US Treasuries helped
finance the “twin deficits” faced by the US, i.e. trade and capital
deficits. Because of this, China became the largest creditor of the
US. As a result, the fortunes of China’s accumulating dollars and
that of the US are completely intertwined.
In the US, unemployment and house foreclosures continue to rise,
depressing the house prices further. As a result, the financial sys-
tem of the US still remains fragile and there is hope that China
would continue to buy US Treasuries, thus preventing the dollar
from crashing. But the situation in China is completely contrary,
with China looking to diversify its foreign reserves into other
stable currencies.
Also, China is investing majorly in countries which pro-
vide a stable environment for FDI and have stable currencies. The
sectors which it is investing are metal and energy. In the metals
sector, China has invested $19.5 billion in the Rio Tinto group, in
Australia. In the energy sector, it has signed a $25 million oil
SECOND PRIZE
pipeline deal with Russia and has provided loans to Russian oil
major Transneft. It has also signed a $10 billion agreement with
Kazakhstan. (Jiang, 2009)
One way to tackle this crisis was the calling of the G20 summit in
London in April 2009. The G20 summit arrived at a consensus on
the need for tax havens and transparency in hedge funds. Much
discussion took place on an alternate reserve currency, but noth-
ing concrete was proposed in this area. Meanwhile, the US bud-
get deficits continue to rise and China remains reluctant to fund
these deficits by buying US Treasuries. This could lead to a great
deal of discomfort between the US and China, especially if the US
is at the receiving end.
case for sdr as an
international reserve
currency
—
What is SDR?
SDRs or Special Drawing Rights are a form of international ac-
counting unit created by the IMF and allocated to member coun-
tries. SDRs were initially created in 1969 and were based on gold,
just as the dollar was based on gold back then. Currently, the SDR
consists of a basket of 4 major currencies – the dollar, the yen, the
Euro and the Pound. The SDR basked consists of 0.632 dollars, 0.41
euros, 18.4 yen and 0.0903 pounds. This unit of account is non-
tangible and hence, transactions can be carried out in SDRs if both
parties agree to it. (McCallum, 2009)
Each member country is allocated SDRs by the IMF.
It can convert its available SDRs to currencies of other member
countries at prevailing exchange rates. When it does so, it must
pay interest to the country from which it is borrowing currency. So
ideally, a lender would have SDR surplus while a frequent borrower
would have SDR deficits. Presently, the interest rate is around 0.5%
but it could vary depending on the financial conditions and interest
rate on short-term debt on all the four basket currencies.
China’s case for SDR as a reserve currency
In April 2009, Zhou Xiaochuan, Governor of the People’s Bank of
China issued an essay on “reformation of the International Mon-
etary System”. He basically called for the “establishment of a new
and widely accepted reserve currency with a stable valuation” to
replace the US dollar, the current reserve currency. The PBOC feels
that the deficiencies present in a credit-based system such as the
dollar would be solved using the SDR as it takes virtually no cost
to create or allocate an SDR, while the price to issue and borrow
international currency is high. (McCallum, 2009)
Governor Zhou also felt that the non-use of a particular coun-
try’s currency as a global measure would help the exchange rate
system of that particular country to adjust economic imbalances
within the country. Apart from this, China also wants an inter-
national settlement system to carry out trade in SDR, without
involving the concept of interest-rate payments, as these could
vary depending on the financial situation. It also wants the IMF
to actively promote SDR in trade and bookkeeping, essentially
making it an official form of transaction so that most member
countries will be pressured into following a similar pattern.
Lastly, it wants the valuation of SDR to be improved and man-
aged by the IMF. This could be done by expanding the existing
basket to include currencies of all major economies.
Why does the SDR present a strong case for an
international reserve currency?
In the present system, countries without foreign exchange re-
serves have to accumulate reserves and the adjustment lies in
the hands of the countries with a current account deficit. Devel-
oping countries would then borrow from developed countries
with stable currencies at a higher interest rate. This leads to
an increase in consumption in developed countries due to the
increase in capital inflow .The instability of the system can be
pointed out in the fact that the dollar can be devalued quickly
as a result of dumping of excess dollars by countries which have
them, like China. This rapid devaluation of the dollar could render
the reserves of many countries worthless. (Yu, 2010).
One of the most important advantages of the SDR is
the fact that it is low cost and doesn’t exist as a tangible unit.
Therefore, it would only require commitment from the Central
Banks of member countries to accept it as a global currency. As a
result, implementation of such a measure can be easily possible
without any transaction costs.
Secondly, this would prevent the accumulation of US
treasuries as the reserves of different countries. Developed coun-
tries would be spared the burden of having to accumulate US
Treasury securities for protection.
The fact that a reserve currency exists puts pressure
on countries to accumulate that currency. As a result, demand for
that currency increases and this impacts its exchange rate. Cur-
rently, most of the world’s trade is executed using the dollar and
its demotion from reserve status would reduce the demand for
the dollar drastically. As a result, this might impact the exchange
rate value of the dollar and devalue it, which would certainly af-
fect the US. (Smelt, 2009). Also, an international reserve system
based on SDRs would allow countries to convert its existing dol-
lar reserves into SDRs, in order to diversify exchange rate risks.
Lastly, in order for countries to place greater trust on SDR as a
currency, the basket must be expanded to accommodate curren-
cies of other large economies, in proportional weightage.
Money Manager / January 2011 79
SECOND PRIZE SECOND PRIZE

What are the factors that work against the SDR? If China is to go the route of France and resort to dumping its CHINA’S DEVELOPMENT OF STEEL CAPACITY –
dollar reserves – it will definitely precipitate the second dip as OVERCAPACITY PROBLEM

The SDR essentially is an accounting adjustment unit that allows during the great depression when in 1933 the markets crashed CHINESE STEEL OUTPUT
45-mil - - 11000
banks to readjust their forex portfolio. For the SDR to become again after a nascent recovery period from 1929. 47 MILLIONS JUNE 08
42-mil - - 10000
a vehicle of global investment and to function as a currency, a The chain of events post a dollar dumping by China
separate market must be created for the same. This requires the - 9000
may look like this: A dip in the value of US govt. securities fol- 39-mil -

source: yu yongding, third world network.

MONTHLY CHINESE STEEL
existing forex markets and banks to denominate trades in SDR lowed by a general loss in faith in the US govt. to repay its bor- PRODUCTION(TONS)
- 8000
36-mil -
and for the IMF to control it as a global currency issuing it in rowings. The chasm between debt issued and deficit will rein- - 7000
times of crisis, increase supply to manage liquidity problems – in force the same. This may prompt the US to lower the debt burden 33-mil -
- 6000
short function as a global central bank. To put such measures on by allowing inflation. Inflation will lead to higher cost of living 30-mil - - 5000
into place will take a better part of the decade. (Eichengreen, prompting cuts in consumption. This will lead to a general GDP
27-mil - - 4000
2009). If we are to take the SDR’s as a solution to the volatility in shrink and demand for imports. This will have a feedback effect BALTICDRY INDEX
- 3000
the dollar in the short run it will mean that nations apart from US on the Chinese economy which is highly dependent on trade to 24-mil -
- 2000
and China will have to assume losses in capital value by invest- fuel its growth. This will also be couple with loss of capital value 21-mil - CHINESE STEEL OUTPUT
21 MILLION MAY 04
ing in SDR and see the value of their dollar reserves dip. This in its current forex reserves. CHINA
- 1000
BALTICDRY
STEEL 2004 2005 2006 2007 2008
may not be an acceptable for players with large dollar reserves However, a nascent recovery has set in and liberal INDEX
– especially India and Brazil. (Yu, 2010) Therefore, at least in the monetary policy of the Fed has begun fuelling consumption
foreseeable future the replacement of the dollar as a global again. Although there is definitely a case for replacing the dollar THE “LOSS OF FAITH” POINT IN THE DOLLAR CREATED BY US DEFICIT
currency seems highly unlikely. with a more neutral and less volatile global monetary unit, the RISK TRIFFIN DILEMMA
PREMIUM
phasing out must be smooth. CURVE 1
RELATIONSHIP
China has already taken steps towards the same: BETWEEN DEBT/

source: yu yongding, third world network.

GDP AND COL-

lessons for china from

LAPSE OF DOLLAR
DUE TO CESSATION
1- China has already drastically reduced its purchase of newly OF INFLOWS
UNSUSTAINABLE

france’s debacle
issued US govt. securities. RATE OF
CURVE 2
RISK PREMIUM

2- Is pushing to strengthen the Renminbi as a medium of transac- BM2, NO TRIFFIN

tion in trade especially with Asian and African nations. DILEMMA
DEBT/GDP,TIME

—
The fundamental problem with the dollar trap lies in the fact that
the reputation of US as a quality supplier of financial assets has
been sullied and US looks to issue debt to the tune of $4tn. over
the next few years. These combined effects have weakened the
dollar as an investment destination.
The Bank of France, in the 1920s, without the cooper-
ating with the other Central Banks resorted to dumping pounds
in the international market in a stop-loss measure. China is in a
similar position but there are some critical differences which may
enable the Chinese to respond in a proactive fashion without dire
consequences for the world economy.
China’s trade forms close to 60% of its GDP and po-
litically, the ruling CPC derives its power from the control of both
trade and the currency – the weakening of either is detrimental to
its state. The PBOC is the financial voice of the government. The
PBOC has also signed significant swap deals especially with the
Asian tiger economies allowing it to hedge its reserves. China has
also realized its potential for expanding investment in strategic
reserves of resources like minerals and oil and has taken steps to
expand investment in developing nations in Africa.
In the case of France, this difference played a key role as the Bank
of France was not under govt. control. The Bank of France looked
only to hedge its capital loss and did not cooperate with other
central banks to gradually off-load its pound sterling reserves.
3- China is investing its dollar reserves in strategic resources
such as oil and minerals in Africa.
4- China is also pushing steadily for the SDR regime to come in –
this will find voice with emerging powers India and Brazil.
5- China has also entered into numerous “swap deals” with
Asian central banks to facilitate offloading US securities from its
large SAFE reserves.
China at the moment is highly unlikely to take the
route that France did during the 1920s and 1930s – thereby put-
ting to rest fears of a double-dip arising from the Chinese side of
the wall. A question to ponder for China will be the way Japan
went in the 1980s.
Japan was one of the largest trading nations with the
US at the time. US pressurized japan into appreciating the yen
so as to ease the concerns over the dollar valuation. Japanese
exports started falling. In order to control the appreciation Japa-
nese started a more liberal monetary policy by lowering interest
rates in the system. This brought the exports back up but fuelled
a property bubble, which then burst and resulted in the “lost de-
cades”. China already has a property bubble going and by not al-
lowing the currency to appreciate it is fuelling domestic inflation.
How this will pan out over the next 2-3 years will be crucial to the
world recovery from the financial crisis.
UNSUSTAINABLE UNSUSTAINABLE
POINT 1 POINT 2
references
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http://www.econ.ucdavis.edu/seminars/papers/472/4722.pdf
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http://csis.org/files/publication/091007_Murphy_IsChinaReady_Web.pdf

80 Money Manager / January 2011 Money Manager / January 2011 81

SECOND PRIZE THIRD PRIZE

- Bennett T. McCallum, April 21, 2009, “China, the U.S. Dollar, and SDRs”, CMU and NBER, July 25, 2010
http://www.shadowfed.org/wp-content/uploads/2010/03/benjamin_mccallum_042009.pdf
- Setser, Brad (January 13, 2009) “Secrets of SAFE : A sharp slowdown in reserve growth and large “hot” outflows” , Council on Foreign Rela LIGHTING UP
DARK POOLS
tions, August 16,
- http://blogs.cfr.org/setser/2009/01/13/secrets-of-safe-continued-slower-reserve-growth-bigger-trade-surplus-large-
%E2%80%9Chot%E2%80%9D-outflows-%E2%80%A6/
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August 16, 2010.
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“SDRs and the Global Reserve System” Action Aid Factsheet, 2010. As Main Street and Wall Street find ways to cohabitate symbiotically in the aftermath of
- http://www.actionaid.org/assets/pdf/ActionAid%20Factsheet-%20Special%20Drawing%20Rights%20%20the%20Global%20Reserve%20 the financial meltdown of 2008, capital markets are poised to witness a slew of changes
System.pdf with the passage of the Dodd-Frank Act into law and given the heightened regulatory
- Wade, Robert (2009) “From Global Imbalances to Global reorganizations”, Cambridge Journal of Economics 2009 33(4):539-562; doi:10.1093/ focus. This article aims to take a dekko at one of the sure shot targets of future regulation
cje/bep032 - dark pools of liquidity. We’ll discuss the electronic equities trading business, evolution of
- http://cje.oxfordjournals.org/cgi/content/full/33/4/539 these dark pools and their journey in Asia.
- Jiang, Wenran (29 April 2009) “China tries to wriggle out of the US Dollar Trap” , Yale Global Online, August 16, 2010.
- http://yaleglobal.yale.edu/content/china-wriggles-out
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tent_7607627.htm
- R Agarwala, April 3, 2009, “SDR should become the global currency”, The Economic Times, July 25,2010
- http://economictimes.indiatimes.com/ET-Debate/SDR-should-become-the-global-currency/articleshow/4352573.cms
- Simon Smelt, April 7,2009,”SDRs and Currency Reform”, Vox, July 25,2010 http://vox.cepr.org/index.php?q=node/3434
- Ambrose Evans-Pritchard, March 25, 2009,”US backing for world currency stuns markets”, Telegraph, July 25,2010 the author
- http://www.telegraph.co.uk/finance/economics/5050407/US-backing-for-world-currency-stuns-markets.html

—
2009, “SDR & the Global Reserve system”, Actionaid Factsheet, July 25, 2010
- http://www.actionaid.org/assets/pdf/ActionAid%20Factsheet-%20Special%20Drawing%20Rights%20%20the%20Global%20Reserve%20
System.pdf
- Owen F. Humpage, May 8,2009,”Will special drawing right supplant the dollar?”, Vox, July 25,2010 Dushyant Sahgal
http://www.voxeu.org/index.php?q=node/3538.
a first year MBA student at Olin Business School, Washington
- Olivier Accominotti, April 23,2009,”China’s syndrome: the “dollar trap” in historical perspective” Vox, July 25,2010 University in St. Louis. Prior to joining Olin, he was working at
http://voxeu.org/index.php?q=node/3490 Goldman Sachs in the Equities Technology division. He is reach-
- Menzie Chinn & Jeffrey Frankel, February 13,2008, “The Euro May Over the Next 15 Years Surpass the Dollar as Leading International Cur able via email at dsahgal@wustl.edu
rency”,
- International Finance, July 25,2010 http://www.hks.harvard.edu/fs/jfrankel/EuroVs$-IFdebateFeb2008.pdf
Zhou Xiaouchan, March 23, 2009, “Reform the international Monetary system”, People’s Bank of China, July 25, 2010 introduction
- http://www.pbc.gov.cn/english/detail.asp?col=6500&id=178

—
- Paul Krugman, April 2, 2009, “China’s Dollar Trap”, The New York times, July 25,2010
- http://www.nytimes.com/2009/04/03/opinion/03krugman.html?_r=3
- Ewe-Ghee Lim, “The Euro’s challenge to the Dollar: Different Views from Economists and evidence from COFER(Currency composition of
With the advent of computers and big money technology invest- in trading venues, evolution of Direct Market Access systems,
Foreign Exchange Reserves) and Other Data”, IMF, July 25, 2010
ment by broker-dealers and stock exchanges alike, especially complex trading strategies and a lot more. Somewhere along the
- http://www.imf.org/external/pubs/ft/wp/2006/wp06153.pdf
in the last decade, equity trading of the yore stands completely way, informal electronic trade matching and settlement systems,
Barry Eichengreen & Marc Flandreau, May 9, 2008, revolutionized. What was once a painstakingly manual and a called the ‘dark pools’ of today sprung up. Dark pools of liquidity
- “The Rise and Fall of the Dollar, or When did the Dollar Replace Sterling as the Leading Reserve Currency?” UC, Berkeley, July 25, 2010 relatively slow process involving open out-cry in trading pits has are alternate trading systems (ATS) maintained by broker-dealers
http://www.econ.berkeley.edu/~eichengr/rise_fall_dollar_temin.pdf transformed into a technology intensive process with computer that match buyers and sellers within their private system without
- Barry Eichengreen and Andrew Rose, June 2010, “Implications for China of abandoning its dollar peg”, 27 Up, August 20, 2010 systems matching trades electronically in a fraction of a second. displaying the quotations to the public.
- http://www.econ.berkeley.edu/~eichengr/27_up_6-22-10.pdf
- Barry Eichengreen, December 2009, “The Dollar dilemma”, Development Outreach, World Bank Institute, August 20, 2010
Online trading brought about much-desired transparency, as An Alternative Trading System (ATS) is a trading system
trading activities became visible through real-time price dis- that is not regulated as an exchange, but is a venue for
- http://siteresources.worldbank.org/WBI/Resources/213798-1259968479602/outreach_eichengreen_dec09.pdf
semination. The capital markets witnessed a massive increase matching the buy and sell orders of its subscribers.
82 Money Manager / January 2011 Money Manager / January 2011 83
THIRD PRIZE
a typical equities dark pools and smart
trade flow order routing
—
There are many ways in which an order might originate – either
—
Regulations like Reg NMS in US and MiFID in Europe led to
by a buy-side OMS/EMS, a sell side trader or an automated greater emphasis on smart order routing in order to meet the
algorithmic engine that forks orders based upon trading goals. requirement of best execution . To be smart, the order routing
When captured by the broker’s trading system, the order normally engine needs an active market data feed from the various trading
undergoes an array of enrichments, toxic checks and messaging venues it connects to. As best execution is not just capturing the
protocol conversions after which it enters the order routing en- best price, the broker has to factor in the trading costs, volume
gine. An order originating in Financial Information Exchange (FIX) available, likelihood of order fulfilment without significant market
protocol will need conversion into the in-house messaging proto- impact, trading limits imposed for that venue etc. Based upon
col that is compatible with the brokers trading system. the price and liquidity available at the trading venues, the order
router will split the parent order into one or more child orders
An Order Management System (OMS) is an electronic and route them to the destination which has the most favourable
system developed to execute securities orders in an quote available. As the process of seeking price and liquidity is
efficient and cost-effective manner. electronic, the impact on costs and order latency is reduced.
The order would then move to the order routing engine which Best Execution refers to the responsibility of brokers
oftentimes has the capability to connect to multiple dark pools of
to provide the most advantageous or best price, order
liquidity, stock exchanges and ECNs. This routing engine is load- execution for customers.
ed with a plethora of complex algorithms and trading logic that
enables it to work on the order based upon the trading strategy. With some dark pools, investors can signal their interest in buy-
Figure 1 below illustrates a generic equities order flow. ing or selling a stock but that indication of interest is communi-
cated only to a group of market participants. Smart routing also
GENERIC EQUITIES ORDER FLOW involves posting or shadow posting a child order to the dark pool
first as an Immediate or Cancel (IOC) order to seek favourable
BUY-SIDE SELL-SIDE ALGO
OMS/EMS TRADER ENGINE execution. If matching prospects are available, the order gets par-
tially or fully executed in the dark pool. Else, it gets cancelled. A
ORDER GATEWAY feedback loop into the trade flow ensures that the OMS/EMS is
PROTOCOL CONVERSION, ENRICHMENT, VALIDATION aware of the fate of the child order and does the trade manage-
ment accordingly.
SMART ORDER ROUTER MARKET DATA
the growth story
DARK POOL STOCK
EXCHANGE/ECNs
ORDER
MATCHED?
EXECUTION
ORDER CANCELLED
—
According to the Securities and Exchange Commission, the number
of active dark pools dealing in stocks on major US stock markets
trebled to 29 in 2009 from about 10 in 2002. Dark pools accounted
for 15% of all US equities executions in August 2010 . Given that
dark pools accounted for only 1% of the trading volume in 2003, the
industry has witnessed tremendous growth as far as the evolution
of dark pools goes.
There are at least two dozen brokers that operate dark
pools today. Figure 3 shows the major dark pools in the US and their
execution volume for August 2010. Each of these pools are open
to a mix of users, some are open only to institutional investment
managers whereas some cater to both the buy and the sell side.
84 Money Manager / January 2011
THIRD PRIZE
US EQUIY EXECUTION VENUE SPLIT AUG 2010 Dark pools aren’t without their detractors though.
Some market participants believe that when trades are execut-
15% DARK POOLS ed anonymously, the price listed on the exchange may become
skewed, leading to incorrect pricing and ultimately inefficient
markets. Participants contend that dark liquidity simply clouds
the marketplace and makes it harder for traders to tell what’s
happening. At times, users have to “ping” numerous pools with
small chunks of shares, which still can result in failing to make a
85% EXCHANGES/ECNs trade at all due to the increased fragmentation of the market.
As dark pool trade matching happens within the broker-dealers
private system, stock exchanges are beginning to lose substan-
tial transaction volume to dark pools. The London Stock Ex-
BROKER DARK POOL MATCHED SINGLE change has lost more than a quarter of the market to alternative
COUNTED(millions)
platforms, in particular Chi-X. In response, NYSE, LSE and many
151
CREDIT SUSSIE CROSSFINDER western exchanges have since set up their own dark pools to
GOLDMAN SACHS 112
SIGMA-X fend off competition.
KHIGHT 100
KNIGHT LINK
92
GETCO EXECUTION SERVICES
68
LEVEL LEVEL ATS
56
MORGAN STANLEY MS POOL
regulation and critique
BARCLAYS LX
46
INSTINET 34
INSTINET CROSSING
CITI CITI MATCH
28
24
LIQUIDNET LIQUIDNET
—
22
BIDS TRADING BIDS
MATCHED SINGLE ONE SHARE BOUGHT AND ONE SHARE Post the financial crisis triggered by the subprime crisis of 2008,
COUNTED SOLD EQUALS ONE M,ATCHED
the Securities and Exchange Commission has often expressed
displeasure at the “darkness” of dark pools and has called for
Some pools allow orders to rest for any amount of time till they increased regulation. According to the Securities and Exchange
find a match. A majority of large dark pools also operate in Eu- Commission, the characteristic lack of transparency in dark pools
rope and Asia, such as CrossFinder by Credit Sussise and SIGMA could create a two-tiered market that deprives the public of infor-
X operated by Goldman Sachs. mation about stock prices and liquidity.
On October 21 2009, the SEC put forth several propos-
who benefits and als for comment that would among other things, treat actionable
indications of interest (IOIs) as actual quotes and be therefore
who doesn’t
subject to the same market disclosure as public quotes. The SEC
also wants the dark pools to trade report real time and include the
name of the dark pool that handled a given stock trade. It believes
that Alternate Trading Systems should be subjected to the same
—
post-trade information disclosure requirements as exchanges by
amending existing rules to require real-time disclosure of the
Without dark pools, big institutional traders would have to route
their orders directly to the floor of the exchange, exposing their
intentions to the market and thereby causing considerable price
identity of a non-displayed venue that executed a trade.
Some industry participants believe that the modified
post trade reporting requirement might actually harm the invest-
impact. Traders seek the advantage of anonymity which allows ment management funds as they would get worse prices while
them to complete their transaction out of the public eye. Enter dark buying or selling large amounts of stock should dark pools be
pools. Institutional investors like hedge funds, pension funds and forced to identify themselves real time.
other investment management companies are extremely concerned The SEC hasn’t ruled on the matter yet. As it ploughs
about the impact cost of execution of large orders at the exchanges. through the massive workload of converting legislation into rule
For them, dark pools act as a preferred alternative trading venue making with the passage of the Dodd-Frank Act in July 2010, it
that addresses these concerns. While the clients of broker-dealers has also resolved to make progress on issues affecting equities
offering dark pools enjoy the benefits of having their execution out markets. The buy side and the sell side are not too enthusiastic
of the public gaze, the broker-dealers gain a two pronged advan- about releasing too much information too soon and as various
tage – collecting transaction fees from clients and simultaneously industry participants debate on this issue, time will only tell what
saving on exchange membership costs as the execution essentially compromise formula actually gets arrived at.
took place within the confines of the broker-dealer.
Money Manager / January 2011 85
THIRD PRIZE STUDENT ARTICLE

asia focus
— REGULATION IN
INDIAN SECURITIZATION
Dark pools, alternative trading systems, hidden liquidity etc are As the markets in Asia start seeing an expansion of
still relatively new to the emerging markets in Asia. As opposed the capital base pooled into the markets, new trading venues will
to the US and Europe, Asia is a market presenting unique chal- spring up to tap them. Goldman Sachs launched the SIGMA-X
lenges to dark pools operators. It has a large number of countries, dark pool in Hong Kong in March 2009 which allows for trading of

each operating its own set of exchanges and associated regula-
tory and clearance bodies. Each of these 12-13 countries has their
own currency, different set of rules and regulations. Moreover,
stock exchanges are perceived as national assets and change is
relatively more gradual. The depository and clearing bodies are
often owned by exchanges, implying that the dark pools opera-
tors can earn fees for matching trades but they wouldn’t be able
to make money from clearing and settling trades.
While broker-dealers operating dark pools acknowl-
edge that penetrating the Asian markets would be a challenge,
they are committed to expanding the footprint of dark liquidity in
the trading landscape here. At the moment, dark pools operators
command an approximate 1 to 3 percent share of equity execution
in Asia on the larger exchanges and close to zero on the smaller
ones. The Hong Kong and Japan market currently commands the
biggest slice of the pie in terms of dark pool presence.
MARKET
the stocks listed on the Hong Kong Stock Exchange. Chi-East, the
joint venture between Chi-X Global and the Singapore Exchange
(SGX), has recently received regulatory approval from the Mon-
etary Authority of Singapore (MAS) to operate a dark pool trading
platform.
Dark pools haven’t found home in India yet. At the
moment, brokers are not allowed to square trades within their
private network. It’s a market where Direct Market Access and
algorithmic trading itself were a relatively recent phenomenon
prudent or punitive?
and as these further develop and spread in the marketplace, the
Regulators – Omnipotent Watchdogs or Liberal Bystanders?
needs for dark pools will hopefully become apparent.
India and other Asian countries have a great opportunity to learn
from the experiences (both good and bad) of the US and Euro-
pean markets and work towards well thought of liberalization of
their capital markets as far as the expansion of alternate trad-
ing systems goes.Notwithstanding how the dark pools of tomor-
row shape up, dark pools of today – downright opaque or bright
enough? It is your call.

references
- Md Julfikar Rahaman,2009: Journal Article on Smart Order Routing: What it Brings to the Table

the authors
- Tabb Forum Liquidity Matrix August 2010
- http://www.tabbforum.com
- Jason Shough August 2010: Chicago investor groups and traders debate the benefit of ‘dark pools’
- Scott Patterson and Aaron Lucchetti, May 2008 WSJ: Dark Pools Drain Liquidity
- Kevin Lim and Adrian Bathgate: ANALYSIS-Regulation may dim growth of ‘dark pools’ in Asia -Financial Regulatory Forum August 2010
- Kevin Lim and Adrian Bathgate: ANALYSIS-Regulation may dim growth of ‘dark pools’ in Asia -Financial Regulatory Forum August 2010
- Securities and Exchange Commission: Statement on Dark Pool Regulation Oct 21 2009 http://www.sec.gov
—
Sharanjit Singh Abstract
- Matthew Samelson, Oct 2010 - Early thoughts on SEC Dark Pool Regulation: Advanced Trading http:// www.advancedtrading.com
- Peter Chapman, Sep 2010: Traders Magazine - Dodd-Frank Won’t Derail SEC’s Market Structure Work http://www.tradersmagazine.com The author is a second year student of Post Graduate Program in
- Kevin Lim and Adrian Bathgate: ANALYSIS-Regulation may dim growth of ‘dark pools’ in Asia -Financial Regulatory Forum August 2010 Following the global financial crisis, RBI has proposed quite a few
Management at Indian Institute of Management, Bangalore. He
significant changes in the Indian securitization framework. While
- Goldman Sachs Electronic Trading, March 2009 http://gset.gs.com can be reached at sharanjit.singh09@iimb.ernet.in
most of these changes are balanced and sensible reflection of
- Chi-East Press Release, Oct 4 2010: Chi-East Receives Regulatory Approval to Launch
important lessons learnt from the disaster, some of these might
- Independent, Pan-Asian, Non-Displayed Trading Venue http://www.chi-east.com Souvik Sen also choke the flow of funds in the economy. The proposal in its
- Other General References current form can potentially put an end to a few emerging asset
- http://www.investopedia.com The author is a second year student of Post Graduate Program in classes like microfinance loans. In this article, some of the major
http://www.marketswiki.com Management at Indian Institute of Management, Bangalore. He proposed changes and their impact in the Indian securitization
can be reached at souvik.sen09@iimb.ernet.in market have been highlighted.
86 Money Manager / January 2011 Money Manager / January 2011 87
STUDENT ARTICLE STUDENT ARTICLE

asset backed regulatory framework A blanket ban on the structure means even amortizing asset class
with shorter duration cannot be securitized. As long as the as-
to Distribute” model.1 Also, 5% of the portfolio should be held
on the book of the originator to ensure quality of the portfolio.

securitization in india set class is amortizing asset, payment irregularity does not exist While this move is a clear reflection of the lesson learnt from the

— even if the asset tenure is short term. Also, many of the other financial calamity, this will potentially put an end for securitiza-

—
issues can be resolved by ensuring frequent portfolio rating by tion of short term assets like microfinance loans. Therefore, this
In February 2006, RBI released its guidelines governing the asset the rating agencies, increasing credit enhancement requirement requirement in its current form will severely hit the securitization
securitization in India. The aim was to develop a vibrant and ro- etc. A blanket ban on the structure prevents institutions to raise market in India. The seasoning requirement should be different
Throughout the nineties auto loans have been the mainstay of
bust securitization market in India. Thereafter no change has been medium to long term capital when their asset is of shorter dura- for different asset classes depending on its tenure.
securitization in India. From 2000 onwards, growth of securitiza-
done in this guideline. However, post financial crisis, RBI took a tion. Therefore, even if the institution has good quality portfolio,
tion has been observed in Mortgage Backed Securities (MBS), the

monoline insurance
more conservative stand and proposed quite a few amendments this restriction will not allow them to raise funding.
infrastructure sector and other Asset Backed Securities (ABS).
in this guideline. While most of these changes are balanced and
However, the US housing bubble burst followed by the collapse
sensible reflection of important lessons learnt from the disaster,

re-securitization and
of global financial market severely hindered this growth.
some of these might also choke the flow of funds in the economy.

synthetic securitization —
Some of the significant changes are discussed here.
Globally, securitization has been attributed as one of the primary
causes of the financial disaster. However, the default rate in In-
Financial guaranty is one of the most popular forms of credit en-

revolving
dian securitization market has been significantly low, thanks to
hancements in the developed countries like USA, Australia. This
the conservative approach of RBI and the rating agencies.
is also popularly called monoline insurance. Recently, Tata Mo-
SECURITY ISSUANCE IN INDIA AS AT END
OF FY2009 securitization —
As per RBI definition “A re-securitisation exposure is a securiti-
tors came up with an innovative NCD structure guaranteed by SBI.
Following this transaction, RBI came up with a circular indicating
that banks cannot provide guaranty on bonds or any debt instru-

— sation exposure in which the risk associated with an underlying ments . Therefore, monoline insurance as a credit enhancement
Data Source: http://www.mof.go.jp/jouhou/kokkin/

pool of exposures is tranched and at least one of the underlying method does not exist in India. The monoline insurance industry
Revolving structure is an innovative way of securitizing asset exposures is a securitisation exposure. In addition, an exposure globally was severely hit by the recent credit crisis. Top global in-
classes with short term tenure. This structure is widely used in to one or more re-securitisation exposures is a re-securitisation surers like Ambac, MBIA, and CIFG are now in a suspended state
tyousa/ 0603indiabond_9.pdf

developed countries to securitize credit card receivables, trade exposure.” The draft guideline clarifies that resecuritization will of operations. Under these circumstances, RBI put the blanket
bills etc. The structure has two major cash flow periods. a) Re- not be allowed in India. This prohibits issuing collateralized debt ban on financial guaranty by the banks in India. As the financial
volving Period: During this period, only the interest component obligations where the underlying asset pool consists of asset institutions are not allowed to provide guaranty with a leveraged
of the payment from borrower is passed to the investors and the backed securities. position, this mitigates the risk for the investor to a great extent.
principal component is reinvested. b) Amortization Period: During While this restriction will hinder the growth of CDO market, it While this is a good step in preventing such disasters, it disallows
FYO2 FYO2 FYO2 FYO2 FYO2 FYO2 FYO2 FYO2
this period, the entire cash flow received from the borrowers is ensures that the investors of securitized PTCs know what they are small firm to take the benefit of securitization. Currently, the most
ASSET BACKED SECURITIES
passed to the investors. This transaction allows extending the buying. As the risk cannot later be transferred to another set of in- popular method of credit enhancement in India is cash collateral.
MORTAGE BACKED SECURITIES
tenure of the issued Passed Through Certificates (PTCs) when the vestors through re-securitization, the investor and the underwriter But, this increases the cost of capital and reduces the attractive-
COLLATERALIZED DEBT OBLIGATION
underlying asset has a short tenure. are incentivized to do proper due diligence of the portfolio. ness of securitization.
PARTIAL GUARANTEE
There are various risks associated with revolving structure. Credit derivatives and synthetic securitization are
OTHERS
- As the asset pool is replenished frequently with new assets, the deemed as complex and risky by RBI. Therefore, RBI does not al-
conclusion
While it is important to ensure a robust and institutional frame-

what hinders the

asset quality may change over a period of time. low these structures at the moment. RBI draft guideline dated
- Though it does not directly go against the “true-sale” criteria of 19th April, 2010, paragraph 7.2 clarifies this point. However, RBI work for securitization in India, it is also important to keep the se-
securitization, it requires a commitment from the originator to do indicated that the structure could be allowed in future if found curitization attractive. Otherwise, the economy could be starved

growth of abs in india? new “true-sale” later. appropriate. of capital and recovery imperilled. Though, the new guidelines
- In case the originator cannot generate new portfolio to replen- have been developed to ensure enhanced investor protection, the
same guideline for all asset classes may not be relevant and pre-

minimum holding
ish the asset pool, early amortization is kicked off. This involves

— reinvestment risk for the investor. vent the growth of many emerging asset classes. Lack of asset
RBI draft guideline dated 19th April, 2010, paragraph class diversification can severely impede the growth of a vibrant
Though, the stringent securitization guideline ensures a robust
system, it also reduces attractiveness of the same. Traditionally,
7.3 explicitly prohibits revolving structure in India1. But, this
clause lacks clarity. The point indicates that revolving structure is period and retention securitization market. Therefore, the new guideline requires fur-
ther elaboration and differential treatment for some of the emerg-

requirement
the activity in Indian securitization market has been low. The used for un-amortizing assets and this structure will not be per- ing asset classes.
total volume of securitization transaction in USA is almost 150 mitted. However, revolving structure can potentially be done also
times India’s market . Some of the reasons for this are for amortizing assets with short tenure like micro finance loans.
references
- Liquidity is substantially limited in the secondary market. Traditionally revolving structure is done for credit card - Source: http://www.mof.go.jp/jouhou/kokkin/ tyousa/ 0603in
- Number of participants is very low.
- Investor base is not large as NBFCs, PEs and VCs are not al-
lowed to invest in these securities.
receivables, trade receivables which are non-amortizing in na-
ture. It means the payoff to the investors may be highly irregular
during the tenure of the PTCs. For example, investors will be paid
—
Perhaps the most contentious change in the recent regulation is
diabond_9.pdf
- RBI Draft proposal for securitization, 19th April, 2010
- http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=402
- FIIs are not allowed to participate. only when the credit card borrower will pay the amount (which the minimum holding period and retention requirement. RBI has - RBI master circular on guarantees and co-acceptances dated
- Lack of investor appetite for long term and lower than AAA does not have any payment schedule). proposed to impose a seasoning requirement of 9 months for July 1, 2009 – paragraph 2.4.2.3.a.vii
rated papers. loans with tenure up to 24 months to discourage the “Originate
88 Money Manager / January 2011 Money Manager / January 2011 89
STUDENT ARTICLE STUDENT ARTICLE

DOLLAR CRISIS
reward-capital-poor countries to the low-risk-reward-capital-rich
countries. The trend seems to have become more prominent over
years. Studies show that the result holds even when controlling
for variables which reduces investors’ risk-adjusted returns, in
Costable (2007) points out that both “savings glut hypothesis”
and “profligacy argument” points to the same underlying phe-
nomenon of international monetary system- trade-off between
liquidity in the global monetary system and persistent current ac-

REAL OR IMAGINARY
developing countries like political instability, poor infrastructure, count deficits of central country.
corruption, etc. (Prasad et al.,2007) Clearly developing countries
seems to be paying premium for liquidity of dollar assets what
Keynes (1936) had referred to as “anti-social fetish of liquidity”. what is the distribution
But the buck does not stop here. Some part of that
capital invested into developed countries is ‘recycled back’ into of global current
account balances?
developing countries in the form of FDI and portfolio investment.
Sustainability of the global financial system has been questioned since its inception. Still the But these investments often don’t reflect investment priorities of
dollar is likely to survive because of lack of alternatives and ‘network externalities’ associ- developing countries and often cause volatility and distortion of
ated with it. Evidence suggest that China is trying to shift away from dollar and leading initia- relative prices.
tives for internalization of RMB in east Asia though ASEAN members are ‘hedging’ their
—
causes of current
position within existing power structures. Long term sustainability of system will require re-
investment of developing countrys’ savings back into their own country. “Insurance needs” East Asia as a whole accounts for more than 60 percent of world’s
of developing countries will have to be addressed through pooling of reserves. current account surpluses. (Wolf 2008 p 78) China alone accounts

global imbalances for around half of that. China is playing a unique dual role both
as a capital exporter and fastest growing emerging giant (played
by UK and US respectively in late 19th century.(Wolf 2008 p 81)
Oil countries surpluses accounted for 12 percent of their total

—
There are several competing theories to explain current global
imbalances. ‘Savings glut hypothesis’ states that the primary rea-
son for these imbalances is higher currency reserve accumulation
by developing countries either to promote exports-led growth or
as a “self insurance” against sudden flight of capital. Several
emerging countries have been doing systematic intervention in
exchange markets to keep value of their currency low. China’s
GDP. This was primarily due to rise in oil prices. But unlike 1970s
this time they have been cautious in spending their oil revenues.
These countries have been somewhat reluctant to park their sav-
ings into US dollars. European Union had more or less balanced
current account. Japan historically had large savings though due
to structural changes that is expected to come down in future.
Clearly all major blocs in the world are either generating current
account surpluses or are balanced.

comparison with
exchange rate policies have been severely criticized under the

the author format bracket.

— viations from purchasing power parity. (argument in favor of self
Nirmal Sharda
a second year student at IIM Ahmedabad. He has completed his
graduation in commerce from Shri Ram College of Commerce and
can be reached at 9nirmals@iimahd.ernet.in.
abstract
The recent financial crisis has again raised questions over funda-
mentals of present global monetary system. Triffin saw paradox
in current global system back in 1960s-creation of international li-
quidity through creation of debt over issuing country. Surprisingly
the same questions about the sustainability of global imbalances
are raised every time a crisis strikes but each time global finan-
cial system appears to be much more resilient. Nicholas Kaldor in
1971 predicted “… transforming a nation (US) of creative produc-
ers into a community of rentiers” with an observation by commen-
tator that the prediction looks equally true even 40 years after.
90 Money Manager / January 2011
Data prove that dollar is the pivot of the modern financial system.
Most global commodities– including oil and gold – are priced in
dollars. In 2008, 45% of international debt securities were de-
nominated in dollars, and only 32% in Euros. 66 countries used
dollar as an anchor against 27 who used Euro. (IMF April 2008).
Furthermore 86% of international transactions were invoiced in
dollars. (BIS 2007) This suggests that US is the center of the
world financial system.
At the same time, US is absorbing 70 percent of
world’s surplus savings. (wolf 2008 p. 76) . According to the bank
of international settlements two-thirds of reserves (excluding
China) were in Dollars-not too short against 70 percent reported
in 2001, despite a fall of Dollar against Euro and Pound-Sterling.
Standard economic theory suggests that surplus capital will
move towards capital-poor regions (where capital-to labor ratio is
relatively low) but globally, capital runs uphill: from the high-risk-
Aizenman and Lee (2005) report that insurance factors
like-openness and exposure to financial crisis-are better able to
explain rise in emerging countries’ reserves than exports and de-
insurance hypothesis). ” Self insurance theory” gains its material
empirical evidence from the fact that emerging countries had ma-
jor increases in their reserves during post East Asian and Mexi-
can crisis period. Dani Rodik mentions that prior to 2008, reserves
as percentage of GDP had risen to about 30 percent of GDP from
about 6-8 percent during 1970s and 1980s. The trend towards
excess self insurance is ubiquitous. African reserves grew to a
level of nine month of import equivalent (against benchmark 3
month). rent account deficit, movement of gold reserve can be avoided by
Another theory attributes cause of global imbalances
to US monetary excesses which resulted in lower interest rates
and substantial rise in consumer credit and consequently their
consumption and residential investment spending. This excess
spending spilled over abroad causing substantial rise in their
current account surpluses and consequently their reserves. But
considering monetary growth rate during this period, it looks un-
likely. Also inflation expectations were largely subdued during
this period.
gold-dollar standard
—
The equation that must hold true for reserve currency in the previ-
ous standard is: (X-M+R)=G+STC+LTC
Where X is exports, M denotes imports, R denotes balance in
the service account, G stands for gold, STC is short term bor-
rowings and LTC denotes long term borrowings. For a given cur-
central country only if short term debt (lent to central country) is
higher than long term investments (by central country) abroad
(STC>LTC). Chronic current account deficits will necessarily trig-
ger shortfall in short term borrowing of reserve currency coun-
try and hence cause movement of gold reserves outside central
country. But under present monetary system G ceases to exist
and all excesses of STC over LTC imply an increase in other coun-
try’s reserves. US don’t have to vary its interest rates to keep STC
and LTC in tandem-to attract gold. Also there are no restrictions
on its external account. (Serrano, 2003)
Money Manager / January 2011 91
STUDENT ARTICLE
the current scenario
—
In the aftermath of crisis there were several rumblings about the
inherent flaws in the present global financial system and need to
move away from it. Joseph Stiglitz proposed a new global reserve
system (UN Commission of Experts, 2009). Zhou, the Governor of
the People’s Bank of China, called for an international reserve
currency that delinked it from sovereign nations. During the same
year, John Lipsky, Director of IMF, assessed possibility of SDRs to
replace Dollar as reserve currency as “entirely conceivable”. Rus-
sian President Dmitry Medvedev, at the G8 meeting in Italy, pa-
raded a sample minted coin of a new world currency to the press.
UNCTAD’s Trade and Development Report 2009 also backed the
idea of using SDR as a form of liquidity against dollar.
whether dollar can
survive?
— —
Any impact of devaluation of dollar will also have to consider
‘valuation effect’. According to a Mckinsey report even with a
balanced current account, US would continue to run an overall
trade deficit in 2012. This would be composed of $720 billion defi-
cit in merchandise and $430 billion surplus in service account….
Its net foreign debt position would swing from a projected (-) $8.1
trillion to a positive $4.9 trillion. This is with an additional note
that this would be the biggest default in the history of the world
and might shift reserves away from dollar assets. This will be
primarily due to the valuation effect of dollar devaluation. When
dollar falls, US’s liabilities (which are also measured in dollar)
also fall. But at the same time its asset (which are denominated
in local currencies will rise in Dollar terms) Martin wolf calls this
“biggest default in the history”..
Dollar is likely to survive in the near future simply
because of lack of alternatives, its deep and liquid financial mar-
kets and inertia on the part of players. Flandreau et al suggest
that central banks persist to existing reserve currencies despite
decline of economic hegemon. Dollar did not become world cur-
rency until 1944 Bretton Woods Conference-approximately seven
decades aft.er US overtook UK in terms of GDP. Also strong
strategic ties of US with East Asia and Japan also provide it a
safety net. But position of the dollar is now more vulnerable than
before, particularly after the credibility of the US financial market
became highly questionable. Thus US now needs to make delib-
erate efforts to gain trust of global economic players. Dollar in
such condition can be called ‘Negotiated Currency’ –“currency
92 Money Manager / January 2011
that works as international currency only with support of other
major economies that are using it as the main reserve currency.”
Hicks states that even a chronic deficit-ridden dollar will continue
to hold its reserve currency position because of these reasons:
1) Approximately a third of US current account deficits is due to
exports by US corporations from abroad-a permanent source of
dollar demand. Also due to military superiority of US, developing
countries will continue to supply commodities to US and receive
payments in Dollars. Also Dollar is unlikely to be affected by a
unilateral action by a country. Rather that will only exacerbate
its own foreign position and can even trigger financial crisis. Also
other countries are likely to act against it. (Serrano, 2003)
But In the event of continued US current account deficit, market
could attempt to shift this balance from Dollar to other high in-
come countries’ assets causing major tensions in the Euro Bloc.
Maurice Obtsfeld et al show that real exchange rate of European
currencies will have to rise by over 50 percent if East Asian coun-
tries maintain their dollar peg as Europeans will have to adjust to
shrinkage in US deficit and substantial rise in East Asian surplus.
Deterioration of external balances due to appreciation of curren-
cies might cause Euro zone to fall apart.
china and east asia
In the aftermath of crisis, there are signs of major policy shifts
in China. It has more or less stopped buying US Treasuries. Also
Beijing sold $50-$100 billion of dollar assets every month since
late 2008, and invested in natural resources like minerals, energy
and European and Asian equity. China is also making loans to
oil companies in oil producing countries that will be repaid in oil.
(Wade 2009)
China accounts for 60 percent China has current ac-
count deficits against all major East Asian countries. Hence it
has a major interest in internationalization of RMB in the region.
China is making several steps in this direction: bilateral foreign
currency swap scheme with Korea, Hong Kong, Malaysia, Indone-
sia and Argentina. Also China is evaluating possibility of in cross
border trade settlements in RMB with Hong Kong, Yuman and
ASEAN.
But major hurdles in internationalization of RMB in-
clude lack of capital account convertibility, lack of floating cur-
rency (which prevents forward transactions and hence prevent
from hedging currency risks) and poor state of domestic finan-
cial markets, China has taken several steps in this direction. In
June 2010, the People’s Bank of China announced the return to
a managed floating exchange rate regime that allows for intra-
day movements of .5 percent from a central parity. Also there
have been several liberalization efforts in fixed income markets
including freeing up of rates on interbank transactions, central
STUDENT ARTICLE
bank papers and repo transactions. But China still employs non-
market measures to conduct monetary policy like ceilings on bank
Insurance to developing countries against sud-
den stoppage-
deposit rates and determination of quantity of bank lending.
Third-party insurance though efficient, this system has major
Monetary Union in East Asia don’t look feasible as
drawbacks in terms of :the absence of liquid markets, significant
compared with Europe, Asian countries have more marked dif-
upfront costs to underwriters for identifying risks and returns ad-
ferences in economic cycles and structures and they suffer from
equately, difficulty in pricing tail events such as financial crises,
significant conflicts in history, culture, religion and politics, which
inability to diversify sovereign risks etc. (Isabelle et al 2009)
makes currency and financial cooperation difficult.” (Grimes,
Pooling of reserves is a better alternative for self-insurance but
2009) Furthermore ASEAN members want to use initiatives like
for that IMF will have to lend relatively freely without policy di-
Chiang mai more to gain better bargaining position within the
rectives. Currently these countries do not trust IMF primarily be-
existing power structure rather than to bring drastic change into
cause of its role in previous crisis situations and its domination
it. (Drezner 2009)
by United States and Europe. Also IMF’s resources are too small
for the role. Regional reserve pooling arrangements like Chiang
Mai initiatives may provide practical solution in the short term.
Dollar block- (Martin Wolf 2008)
Consisting of countries using dollar as a currency or pegged to it-
accounted for three-quarters of total global reserves by the end of
2006. Internal recycling within the block can match net surpluses
and deficits within the block and hence no external funding is re-
Multi currency system-
Euro a possible alternative to dollar suffers from weaknesses like
quired. Within the block, peripheral members can hold up dollar.
high transaction costs, anti growth bias of European economy,
Any shifting of reserves from dollar to other floating currencies
will result in simultaneous depreciation of currencies of entire
no consolidated sovereign debt market and its fragile governance
structure. Also European continental financial markets cannot
‘dollar bloc resulting in deterioration in external account of the
match the dollar-based market in New York in its depth and ef-
shifting country itself
ficiency (Tadokoro 2010)
Even during the financial crisis, there was no substan-
tial shift in reserves towards Euro. Other high income countries
SDR as an alternative-
In the aftermath of crisis, both demand for SDR by BRIC coun-
tries and its increased supply from fund have increased global re-
like Australia UK are simply too small to absorb large financial
flows. The system will impose discipline on reserve currency
issuer as countries may shift to alternative reserve currencies.
serves held in SDR to 4 percent. (IMF Working Paper May 2009).
Also competing stores of value will cause higher exchange rate
But for SDRs will require deep and liquid markets to acquire re-
volatility if reserve holders manage their portfolios. Close policy
serve currency status. A critical mass of issuance and trading of
coordination among key reserve issuers would be necessary avoid
SDR denominated assets not just by IMF but by some member
exchange rate volatility. But problem is that in previous cases of
countries as well. Such attempts in 1970s failed primarily due to
multiple currencies, reserve holders tend to move towards a sin-
coordination problems. (IMF Working Paper May 2009)
gle currency for the “network effects” of money. (Tadokoro 2010)
Historically, composite currencies traded commercially
are not attractive for liquidity-return combination. For this to hap-
pen, someone would have to act as market maker and subsidize
the operation of the market until it acquired scale and liquidity. Creating a public investment fund-
The current export led model adopted by developing countries
cause capital to be “recycled back” by US back into their own
Domestic currency denominated bond markets country. But the investment does not reflect investment priorities
of that country. Also portfolio investment from these countries
in Developing countries- often distort relative prices and cause excessive volatility rather
There has been a substantial increase in the bond issuance of
than providing any long term financing. What is needed is(are)
emerging economies and amounted to $7.2 trillion. Approximately
closed ended fund(s) for making investments in the developing
84 percent was denominated in local currencies; issuance of local
countries. These funds would own assets in these countries
currency denominated bonds has been modest though increasing.
and simultaneously issue their liabilities in their local currency.
But a major chunk of the bonds is subscribed by domestic banks.
Multilateral nature of these funds would incentivize developing
(IMF Working Paper April 2010)
countries to invest their reserves with these funds. (Arista 2009)
Eichengreen et al suggest that international financial institutions
could encourage use of assets denominated in inflation-adjusted-
basket of emerging market economies by issuing debt denomi-
nated in basket of currencies and simultaneously purchasing
bonds in those currencies.
Money Manager / January 2011 93
STUDENT ARTICLE

LAST WORD
Reforming the international payment system
Current monetary system encourages non reserve countries to
keep their currency weak to gain competitive advantage and en-
hance exports. But for balance in the global system, every coun-
try will “have to use its own currency backed by wealth created
within its own borders, to participate in the global economy.”
Keynes idea of International Clearing Agency (ICA) would solve
this problem by clearing transactions in members’ home currency.
It would permit changes in exchange rates based upon changes
in reserve position. Variations could be introduced in the system
to authorize open market operations by an international agency.
ICA could govern liquidity by creating/extinguishing international The Money Manager was started with an aim to collect the views of students,
reserves. (Arista 2009) practitioners and academicians on the current developments and most relevant
issues in finance and bring to students perspectives on pressing issues in the
world of finance. Its stated objective was to provide a platform for management
students to express their views on all areas of finance from private equity to capi-
tal markets, corporate finance to insurance.
The Money Manager is not a “research journal”; rather, it is a collec-
tion of interesting and current ideas in finance. It is the first of its kind, a joint
endeavour of the finance clubs of IIM Ahmedabad, Bangalore and Calcutta. The
student articles are then screened for originality and then judged by an elite panel.
The winning articles are tested on originality, depth of analysis, relevance of topic
and presentation style.
Eight editions of the Money Manager have been published before this,
but this ninth edition of the Money Manager has broken several stereotypes which
Money Manager has become known for. Right from soliciting student entries from
international business schools, to expanding the scope of the guest articles, this
edition has been revolutionary in more ways than one. Moreover, student articles
were for the first time screened by an elite panel comprising both industry per-
sons and professors from IIMA. We hope you have enjoyed reading this edition
of Money Manager, and we promise that further editions of Money Manager will
continue to establish new ground-breaking norms delivering relevant and thought-
provoking articles to read for anyone who is interested in finance.
To enable the Money Manager to reach an even wider audience, it will
be available for download online. All current and past editions are available on
our websites, including http://stdwww.iimahd.ernet.in/beta, the website of Beta,
references the Finance Club of IIM Ahmedabad. These will be updated regularly, so do keep
checking in!

- Will currency follow the flag? Drezner Daniel W.,2009, Cambridge Journal of Economics 2009, 33, 633–652,
-The Finance Clubs of IIM - A,B & C
- Jane D’Arista, The evolving international monetary system, ,Cambridge Journal of Economics 2009, 33, 633–652
- Tadokoro Masayuki, After dollar?, International Relations of the Asia-Pacific, Volume 10 (2010) 415–440
- Wade Robert , From global imbalances to global Reorganizations, Cambridge Journal of Economics 2009, 33, 539–562
- Barry Eichengreen1, Out of the Box Thoughts about the International Financial Architecture, IMF Working Paper-Strategy, Policy, and
Review Department, , May 2009
- Shanaka J. Peiris ,IMF Foreign Participation in Emerging Markets’ Local Currency Bond Markets, ,IMF Working Paper-Monetary and
Capital Markets Department, ,April 2010
- Franklin Serrano, From ‘static’ gold to the floating dollar | Contrib. Pol. Economy | 2003-1122: | 87 - 102 |
- Martin Wolf, fixing global finance, Baltimore, Johns Hopkins, 2008
- Zhang Ming, China’s New International Financial Strategy amid the Global Financial Crisis, China & World Economy / 22 – 35, Vol. 17,
No. 5, 2009
- Gian Maria Milesi-Ferretti, Fundamentals at Odds? The U.S. Current Account Deficit and The Dollar
- Isabelle Mateos y Lago, Rupa Duttagupta, and Rishi Goyal, The Debate on the International Monetary System, Strategy, Policy, and
Review Department, International Monetary Fund, 2009

94 Money Manager / January 2011

BETA RECOMMENDS
Probably IIMA’s best known and most quoted econo-
mist post the crisis, Raghuram Rajan uses this 250-page book
to strongly drive home the point he infamously raised during the
Fed’s routine Jackson Hole retreat in 2005.
The book takes a reader through reasons why he
believes economists and politicians should take a greater blame
for the financial crisis than the average banker. While he does
acknowledge that certain institutions were too keen on making
the proverbial quick buck, he cautions against dismissing the
financial sector merely as a greedy industry serving to line the
pockets of its workers. While building upon the social useful-
ness of modern day banks, hedge funds and other financial
institutions, Rajan proposes some novel methods of regulation.
A very interesting distinction that he seeks to draw is between
institutions that are too big to fail (under which definition would
also fall PIMCO) and ones that are too intricately linked to fail
(like Bear Sterns).
Besides these chapters on finance and its regulations
which occupy the beginning and end of the book, the middle is
what I believe the book shall really be remembered for. In these
chapters Rajan carries out a detailed and refreshing analysis of
why he believes the problems facing the USA are too structural
to be resolved even when the financial markets come back to
life. From issues relating to a suddenly less flexible workforce
to decreasing average years of study and changing demograph-
ics, Mr. Rajan cautions that the current downturn might quite
become the norm if the American leadership does not take some
hard decisions very soon. Easy to understand with a very ambi-
tious scope, that it does full justice to, this book is a must for
any aspiring banker.
98 Money Manager / January 2011
Think
there’s a world of
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the rupee, dollar or pound is the fundamental link determines continue to stretch you long after
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99
BETA, THE FINANCE CLUB OF IIM AHMEDABAD
NETWORTH, THE FINANCE CLUB OF IIM BANGALORE
FINANCE & INVESTMENTS CLUB OF IIM CALCUTTA
BETA is the most prestigious club of IIM Ahmedabad
and has been an integral part of IIMA culture since
decades. BETA aims to generate and promote interest
in finance among IIMA students. Besides it has orga-
nized several national level competitions such as “Ex-
chequer”, trading games and workshops in the past.
It has also been associated with distinguished people
from academia and industry. Some of BETA’s regular
activities are organizing placement oriented sessions,
internships experience talks, contests and discus-
sions on current issues. Besides, BETA also releases
a plethora of publications, both daily and weekly. For
more on BETA, do visit http://beta-iima.com
Networth is ‘Everything Finance’ at IIM Bangalore. Its
primary driving force has been to establish a ‘connect’
with the world of finance and develop synergies
around the function, both within and outside the cam-
pus. Through its broad portfolio of activities, the club
encourages students to explore the realm of finance.
It conducts workshops and organizes talks wherein
students get exposed to the high priests of finance. It
also encourages participation from students
through its trading events, online quizzes and case
contests. At the same time it assists students in their
pursuit towards their dream careers in finance through
its popular gyaan sessions for placements.
Finance & Investments Club of IIM Calcutta,
popularly known as the Finclub is a student driven
initiative that collaborates with both the corporate
and academia from the financial sector to provide
a platform for students to improve their quantita-
tive and analytical thinking abilities. The club also
manages and maintains the IIM Calcutta Finance
Laboratory in collaboration with the Department of
Finance and Control. The club organizes industry
talks, workshops, stock trading and other finance
based simulated events.
Please send your feedback and queries to:
E-mail: beta@iimahd.ernet.in
Website: http://beta-iima.com/
Money Manager / January 2011 101