ALL YOU NEED TO KNOW ABOUT THE PANAMA LEAKS

By Parth Parikh and Keerthana Raghavan

Edited by Anjana Bhatia

Introduction

At some point or the other, we must have come across this palindrome “A Man A Plan A Canal Panama”. Little did we realise then that this innocuous looking palindrome would be related to a place responsible for hiding wealth and properties to the tune of billions of dollars. So what is the Panama leak all about and how did such enormous amount of wealth go unnoticed for so many years? How did the leak happen and what is the impacts of such leak on the world economics going forward? Staying true to the anagram, there were “Men”, there was a “Plan” which was shelled out through a law firm based in Panama. We wish to delve deeper into the entire issue through a series of Q&A.

What are Panama Papers?

Panama papers are over 11.5 million documents leaked from the offices of Mossack Fonseca which is a law based firm in Panama. These documents contain the names of many rich people around the world who took help from the law firm Mossack Fonseca to create shell companies in offshore tax havens. The list includes the names of many current and former leaders like Hosni Mubarak, Muammar Gaddafi, Xi Jing Ping etc. There also 500 Indian names in the list including Amitabh Bachchan, Aishwarya Rai and Kushal Pal Singh.

How did the leak take place?

An anonymous source leaked encrypted internal papers from the Mossack Fonseca database to a German-based Newspaper named Sueddeutsche Zeitung who shared them with the International Consortium of Investigative Journalists which is a body of various media house like the Indian Express.

What is the rationale behind the incorporation of
shell companies?

Shell companies do not have any significant assets or operations. They exist only on paper to serve as a conduit for other business transactions. Incorporating shell companies can help in evading taxes and launder money. This is because shell companies provide anonymity and its ultimate ownership is difficult to trace. It has to be noted that all shell companies are not illegal in itself but they can be used for illegitimate business purposes. These companies are set up in offshore tax havens like Panama, Bahamas, Seychelles, British Virgin Islands etc. This is because tax havens have low or zero taxes on income generated and also provide banking secrecy.

What does an offshore law firm like Mossack Fonseca do?

An offshore law firm sells anonymous offshore companies around the world. They are shell companies which allow their promoters to hide their business deals. They have many offices all over the world. Their job is to start, sell and manage thousands of companies and thus making huge profits and helping others to make their black money into white and thus evade taxes. These companies make it easy for others to start companies, by selling its shell companies in cities across the world. They provide different facilities at the cheaper rate, from buying an anonymous company for as little as $1,000 (nearly Rs 66,290), to providing them with a fake director, to holding board meetings. And if the clients desire, it conceals the company’s true shareholding pattern. In short, the company is into the business of withholding the true identity of the offshore company’s owner.

What is the legal position on the creation of such offshore firms?

The remittance of money abroad has been tightly controlled by the RBI. Till 2004, all investments made abroad required prior permission from RBI. It was made easier in 2004 by the introduction of the Liberalized Remittance Scheme (LRS). As per the scheme, the amount of money that can be remitted without approval has been increased by 10 times to $250,000 from $25,000. Before 2004, Indians could not incorporate companies outside India because remittances to foreign countries were not allowed. In 2004, RBI introduced a scheme called Liberalized remittances scheme (LRS) which permitted individuals to remit up to $25000 per year outside India. It was increased to $250000 in phases. The remittances could be for various purposes like medical, gifting, buying shares etc. But, RBI did not allow individuals to specifically set up a company. There was a lot of confusion amongst the people. So, RBI came up with a notification in the year 2010 that though LRS allows for buying shares, it specifically prohibits setting up of companies abroad by individuals. But, chartered accountants took a technical view of this notice. That, though an individual cannot incorporate a new company, it can acquire/ take over an existing company. It meant that a company incorporated by Mossack Fonseca can be bought from them off the shelf. RBI came up with another notice in 2013, in which it allowed resident Indians to invest directly in Joint ventures and through the Overseas Direct Investment (ODI) route. So, setting up a company overseas by Indian can be considered legal only if it was done after the year 2013.

For what activities is remitting money allowed under LRS?

Under the LRS scheme, all resident individuals (including minors), can remit up to $250,000 for any permissible current account (such as medical treatment and education) or capital account transactions (like buying of property abroad and holding shares in an overseas company) in a financial year without prior RBI permission. According to the notice dated 15th June from the RBI, the permissible capital account transactions can include purchasing property abroad; making other investments abroad like setting up wholly owned subsidiaries and joint ventures. One can also extend loans to NRI relatives. However, money can’t be remitted for certain purposes under LRS. This includes buying overseas lottery tickets, sweep stakes and the purchase of foreign currency convertible bonds (FCCBs) issued by Indian firms abroad.

What are the gray areas about holding shares in an overseas company or setting up of a company abroad?

Buying shares of overseas companies are allowed since 2004 but there is a gray area if an Indian resident is allowed to set up a company. In the RBI notice on September 17, 2010, it is mentioned that LRS does not permit remittance by an individual for setting up a company overseas. Representations were made to the RBI after which the RBI’s issued a further notification on March 5, 2013, which clarified that an overseas company can be set up by an Indian resident. The notification also mentioned that joint venture or wholly owned subsidiary to be acquired or set up by an individual should be only an operating entity. This means the overseas company cannot further act as an investment company and acquire or setup another subsidiary. This leaves a gray area between the period 2010-2013 where the legality of setting up a company abroad is blurred.

Tax evasion or tax avoidance?

Although both terms look similar, there is a considerable difference between the two. Tax evasion is the difference between the amount of income that should be reported to the tax authorities and what is actually reported by us. Tax avoidance, on the other hand is somewhat legal and it implies the use of tax laws to reduce our tax burden.

Although both are seen as a means of dodging the taxes the legal definition of the difference between the two has been decreasing across the years. Hiding huge amounts of money is convenient for the rich to stay rich and by avoiding the taxes the ultimate loss is to the poor or the citizens of the country. There are many big firms that avoid tax legally, they have complicated tax structure which works to their advantage. Starbucks, for example, had sales of 400 m last year but was saved from paying corporation tax. What it did was to transfer some money to its sister company in royalty payments and bought coffee beans from Switzerland. So, in a nutshell, what corporates do is, move the money within the company, to its off-shore branches or subsidiary companies which are located in areas where taxes are less, which can reduce profits and hence you end up paying lesser taxes. This is what Starbucks also did, it also paid high interest rates to borrow from other parts of the business in addition to moving money to its Dutch subsidiary.

But many big firms do it and it is deemed legal. They call it tax planning and get away with it. Even though the wealth management would involve means and ways of helping ultra-high net worth individuals by helping them evade taxes, debts and legal judgments, Panama papers which feature some popular personalities is a clear cut case of tax evasion because many cases of political corruption has come to limelight. These include hidden assets of Vladimir Putin, David Cameron among other famous political personalities. Some Indians have set up offshore entities when it is clearly not legal and the laws did not allow them to do so.

So, is this a fraud case? (From an Indian perspective)

In a way, it is. It all depends when they have invested and also if they have informed the authorities about their assets/earnings in abroad in past. As discussed earlier, if a person has invested before 2004, then he is in violation of the law. And, as per RBI, those setting up or buying companies before 2013 are in ‘technical’ violation of the act. If individuals have kept the government informed of their investments/ earnings abroad through these companies, then there is a weak case. But if the authorities were not informed of the assets held abroad then there are various acts that are triggered, such as the money laundering act and foreign exchange management act (FEMA), among others & they should/ will be prosecuted.

How did the transfer of wealth take place?

For any money laundering case, it involves three stages –

1. Placement: Getting the black money or the surplus money into the financial system

2. Layering: Involves international movement of funds basically to separate the money from its source

3. Integration: The money comes back to the person and the money becomes legal having passed through a couple of transactions. In case of Panama, the transfer of wealth took place in a similar manner.

1.Clients :

The firm, Mossack fosenca, acts as an agent to about 2000000 companies. These companies were used to hold property and bank accounts.The Figure 1 below shows the companies that were its clients.

I3A3D2

2.The intermediaries:

The firm was in touch with an array of intermediaries such as lawyers, accountants and banks (who help avoid taxes) and act on their instructions. The Figure 2 below shows its intermediaries that are concentrated across the globe.

I3A3D3

3.Owners

The real owners hide their identity behind nominees and people with no real control. China and Russia top the list. Figure 3 highlights the major owners.

I3A3D4

Was the Indian Government not aware about these companies before?

They were aware. Indian Governments have approached Panama Government & Mossack Fonseca before to share information about those who have invested in their companies. Everyone knows about such firms/ companies, these are not difficult to track. But, these companies don’t share information about their clients, as their whole business is based on this and people invest in them because they have very strong policies to maintain secrecy. So, yes the Indian Government knew about them, just like they know about Swiss Bank, but couldn’t do anything for years due to the lack of a concrete proof.

Have tax disclosure norms been strengthened?

Yes. Since the financial year 2011-12, resident individuals now have show details of foreign assets for tax returns, which includes the details of bank accounts held in foreign countries and also for the purchase of immovable properties abroad. The disclosure details have been strengthened with the income-tax returns for the financial year 2014-15 asking for disclosures of foreign trusts. The punishments for incorrect disclosures include a penalty of up to Rs 10 lakh and imprisonment of up to seven years.

Conclusion

Panama leaks is touted to be one of the biggest leaks in the recent times. With around approximately 11.5 million documents, totaling 2.6 terabytes (TB) of data, the scale of this leak is higher than the combined data of the Wikileaks, Offshore Leaks and the Swiss Leaks.

In this backdrop, it is not surprising that there are two parallel financial systems running in this globalized world. One is for the majority taxpayers of the 7.3 billion people alive today and the other is for the rest who do not wish to share their riches (as taxes). The bottom line is if the persons accused in the Panama Papers prove themselves legal with a valid reason, they’ll get away. Others who don’t may be charged with a severe penalty.

References

•Tara Golshan (2016, April 4). The 8 most important things to read to under-
stand the Panama Papers document leak . Retrieved from: http://www.vox.com/2016/
4/4/11360290/panama-papers-findings-document-leak-explained
•Luke Harding (2016, April 5). What are the Panama Papers? A guide to
history’s biggest data leak Retrieved from : http://www.theguardian.com/news/2016/
apr/03/what-you-need-to-know-about-the-panama-papers
•Jason Silverstein (2016, April 4). What you need to know about the massive
offshore accounts leak . Retrieved from: http://www.nydailynews.com/news/world/
panama-papers-explained-article-1.2587774
•William Maulding (2016, April 5). AT A GLANCE – The ‘Panama Papers’
Scandal . Retrieved from: AT A GLANCE – The ‘Panama Papers’ Scandal


About authors:

ParthThe author is a student of PGDM finance of batch 2015-17 at TAPMI. He is an avid follower of financial markets and his core interests include studying about various buying opportunities in equity markets. His strengths lie in finding potential multi-bagger stocks in the mid-cap space. He also likes to read and write about current financial happenings across the globe. You can contact him at parikh.17@tapmi.edu.in

keerthana

The author is a student of PGDM finance of batch 2015-17 at TAPMI. She likes reading financial news and interested in the current happenings in the economy and the banking sector. She is also a follower of capital markets and hopes to become a financial consultant. You can contact her at keerthana.17@tapmi.edu.in

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WHAT DOES CHINESE SLOWDOWN MEAN FOR INDIA?

By Priyanka Modi

Edited by Sachit Modi

Executive Summary

The purpose of this paper is to analyze the impact of the slowdown in the economic growth of China on India. I will analyze the repercussions of Chinese economic crisis on the global economy. India being well-integrated with the global economy cannot be alienated from the effects of the slowdown. I will discuss both the benefits and the negative implications for the Indian economy. In the midst of this crisis, there is also an opportunity for India. I will consider the steps that can be taken by the Indian government to reduce the degree of the negative impacts of the weakening Chinese economy and leverage the opportunities at hand.

Ever since the economic growth of China, India’s largest trading partner in goods started slowing down, concerns have been raised over its possible impact on the Indian economy. The steep fall in value of the Chinese currency, Yuan, in recent times has once again emboldened the naysayers. While it will be erroneous to argue that India will not be impacted by the economic churning happening in China, it will be equally irresponsible to suggest that India will be completely doomed if China falters. In value terms, China accounts for approximately one-tenth of India’s merchandise trade, and bulk of it comes from imports of goods to India. India’s trade deficit with China stood at $51.86 billion, with a bilateral trade of $71.22 billion in 2015. During this period, India’s exports to China came in at $9.68 billion while imports stood at $61.54 billion. With respect to 12 major product groups largely manufactured by MSMEs, imports from China grew at a higher rate than respective imports from all other countries combined during the period negative impact of a Chinese slowdown as trade flows slow down. At the same time, it should also explore the positive side and leverage the opportunities it has.

Implications of Chinese slowdown on the Global Economy

China used to have the fastest growing economy with growth rates averaging 10% over the past 30 years, according to the International Monetary Fund. They account for close to half of the global consumption of copper, aluminium and steel, and more than 10% of the crude oil. China has driven global growth, which has averaged a paltry 3% a year since 2008. So, the Chinese economy slowdown would impact different regions of the world in different ways depending on their exposure. In countries like Australia, Brazil, Canada and Indonesia, which are dependent on the commodity exports, the slowdown could have a negative impact on their GDP. However, the inevitable fall in the commodity prices could be beneficial for the countries that consume the commodities, such as the United States. Either way, the slowdown will require some adjustment on the part of the global economy. As per IMF, the country was the single largest contributor to the global economic growth, contributing 31% on average between 2010 and 2014. In this scenario, slower Chinese GDP growth would definitely have global repercussions. A fall in exports to China will impact countries such as South Korea, Japan, Brazil and Australia as exports to China are ~20-30% of total exports for these countries. India too won’t be spared as the overall global growth falters.

Positive Impact on India

Lower commodity prices: The first and an overwhelmingly positive impact of a slowdown in China’s commodities demand on India would be through lower commodity prices. India imported $139 billion worth crude and petroleum products in the FY 2015, and as a rough rule of thumb, every $1 drop in crude prices results in a $1 billion drop in the country’s oil import bill.

Attract foreign capital: Though India cannot do much about the currency, the rupee is expected to remain strong as oil prices tumble and markets remain flush with foreign money. While the impact of China is negative for exports, it may provide a good opportunity for Indian debt and equity markets. The Chinese devaluation has scared foreign investors who may flock to India to look for better returns. A depreciated currency shrinks the dollar value of investments at the time of repatriation. Given that other large emerging markets such as Brazil, Russia and South Africa are going through their own economic issues, India currently is the best-placed country among the top developing nations to attract these flocking investors.

Lower cost of infrastructure: China is the world’s largest copper consumer, accounting for 40% of the global consumption. The Chinese slowdown has resulted in the fall in prices of the hard commodities, especially copper and aluminum. These commodities constitute the largest portion of the infrastructure bills. Thus, the fall in prices could be beneficial for India, whose major focus at this time is building a strong infrastructure network for the country. This fall would help India to reduce the cost of constructing new infrastructure and would act as a supporting element to initiatives such as the Smart City Mission.

Control deficit and inflation: Oil prices were already tumbling down because of the global slowdown and the possible US-Iran deal. The Chinese economic slowdown further plummeted the prices. Low oil prices help India to control its deficit and keeps inflation under check.

Higher profits for Indian corporates: Over the past few years, due to the depressed domestic demand, many of the Indian corporates had been struggling with their pricing power and were unable to pass on the increased cost to the end consumer. Cheap global crude and commodity prices mean lower input costs, translating into higher profit margins for them. This will act as a major respite for them.

Negative Impact on India

India’s export growth: India’s exporters will lose out on currency competitiveness in the segments where it competes directly with China, particularly textiles, apparels, chemicals and project exports. If the Chinese demand slows down, its raw material requirement will go down, and India’s exports to that country may decrease to such an extent that it may not be able to take advantage of the Yuan devaluation to earn more dollars. The fact that India’s exports to China declined 19.5 percent to $11.9 billion in 2014-15 from $14.8 billion a year ago illustrates this. India’s trade deficit with China has almost doubled from $25 billion in 2008-09 to $50 billion in 2014-15. And China’s share of India’s total trade deficit is up from just under 20% in 2009-10 to 35% in 2014-15. Thus, there is a chance that India may lose out in the race.

Indian metal producers: China accounts for nearly half of the world’s steel production and as construction and investment slows down, the decline in demand for commodities will hurt the Indian metal producers. Steel companies and Aluminium manufacturers may start facing losses. Hindalco and Balco, for instance, are increasingly relying on costlier captive coal. Steel manufacturers like JSW Steel and Tata Steel were forced to lower their prices and face the fear of dumping from across the border. Also, companies like Tata Steel and SAIL, which have their own mines, will suffer the most as they will not be able to benefit from the lower iron ore and coal prices. Metal producers like JSW, who buy coal and iron ore from the open market, would be the least affected.

Tyre industry: As demand slows down in their home market, Chinese tyre makers might start exporting tyres at very competitive rates to the rest of the world. A Chinese tyre is around 30-40 per cent cheaper as compared to the domestic prices. Thus, the commercial vehicle tyre segment will be negatively impacted as most of the consumers are more concerned about the value rather than the brand.

Automobile industry: China had the potential of becoming the fastest growing market for the automobile exporters and manufacturers. As the demand in their market goes down, companies like JLR, who were investing in that market, will have to look for alternate options.

How should India react?

India’s GDP has expanded by 7.3 percent in the last quarter of 2015 whereas China’s GDP slipped to 6.8 percent in the same period. India will be the fastest-growing major economy in 2016-17 growing at 7.5%, ahead of China, at a time when global growth is facing increasing downside risks, as per the World Economic Outlook released by the IMF in April 2016.

Since we are already growing, now is the right time to leverage the Chinese slowdown to our advantage. India can surely benefit from the opportunities it has by focusing on the following-

Make in India: With the government of India giving a lot of weight to the ‘Make in India’ campaign, this may be the time to provide impetus to manufacturing and invite Chinese companies to set up a manufacturing base in India.

Growth center to invest: A slowdown in the Chinese economy would also mean that the global finance and capital market would look for new growth centers to invest in. The government should invest in infrastructure like roads, railways etc. and introduce reforms to improve business conditions in India. By providing an attractive alternative to China, India can have a much bigger pie of the global capital, which in any case it needs to fund its huge infrastructure capital requirement.

I3A3D1

Stem the rupee’s fall: A bigger concern that arises from the Chinese devaluation is for the Reserve Bank. RBI governor, Raghuram Rajan, who had been giving warning against the “beggar thy neighbor” policies, may have to alter rate decisions in order to keep up with the global environment. The Reserve Bank of India could sell dollars in the market to increase the rupee’s value. There are several other measures possible that range from floating a sovereign bond to raise money from NRIs to making the import of luxury goods costlier by imposing duties on them.

Anti-dumping duty: The steel industry and the government, both are worried over dumping from China. So far, there have been 322 anti-dumping cases in 2015, of which 177 cases involve China. The Finance Ministry has imposed antidumping duties on the import of hot-rolled stainless steel (HR SS) flats of grade 304 originating from China, Malaysia and South Korea. The anti-dumping duties will be effective for a period of five years starting 2015. India consumes about 1 million ton of this type of stainless steel and more than 40 percent of that is imported, mainly from China. The anti-dumping duty can also be extended to the 200 grade stainless steel as it commands a market share of more than 50 percent in India.

Conclusion

The impact of China’s slowdown on India would depend on many factors such as lower input prices, intensity of competition from cheaper imports and the pace of global growth. The speed at which we go ahead with the reforms is very important. It is not a matter of global economy slowing down, but how India speeds up its reforms. India will have to come to grips with the fact that in an integrated world, much is beyond its control and it needs to focus on the things it can change – boosting investments and generating jobs.

References

http://www.crisil.com/pdf/research/CRISIL-Research-Opinion-China-Slow-
down-16Jul2015.pdf. (n.d.). Retrieved April, 2016, from http://www.crisil.com/pdf/research/CRISIL-Research-Opinion-China-Slowdown-16Jul2015.pdf

•How China’s Slowdown Is Having Ripple Effects All Over The World. (n.d.).
Retrieved May 17, 2016, from http://www.businessinsider.in/How-Chinas-Slowdown-Is-Having-Ripple-Effects-All-Over-The-World/articleshow/29918501.cms

•China economy slowdown: India should focus on mitigating impact. (2016,
January 11). Retrieved April 20, 2016, from http://www.hindustantimes.com/editorials/
china-economy-slowdown-india-should-focus-on-mitigating-impact/story vMRWd6CcBdkVFTr0whrGkL.html

•India imposes anti-dumping duty on some steel from China. (n.d.). Retrieved
April 22, 2016, from http://www.moneycontrol.com/news/current-affairs/india-imposes-anti-dumping-dutysome-steelchina_1401378.html

•How the Chinese Yuan devaluation will impact India? Read more at: Http://
http://www.vccircle.com/news/economy/2015/08/11/how-chinese-yuan-devaluation-will-
impact-india. (2015, August 11). Retrieved April 22, 2016, from http://www.vccircle.com/news/economy/2015/08/11/how-chinese-yuan-devaluation-will-impact-india

•Steel producers to benefit from import curb: India Rating. (2015, June 22). Retrieved April 23, 2016, from http://www.dnaindia.com/money/report-steel-produc-
ers-to-benefit-from-import-curb-india-rating-2097936

•The impact of a China slowdown. (2014, November 29). Retrieved from http://www.economist.com/news/economic-and-financial-indicators/21635039-impact-china-slowdown

• India Could Edge Out China From Top Growth Spot in 2016. (2016, January 13). Retrieved April, 2016, from http://www.bloomberg.com/news/articles/2016-01-
12/india-seen-edging-out-china-from-top-growth-spot-in-2016#media-4

•India’s trade deficit with China swells to $51.9 billion in 2015. (2016, March
14). Retrieved April, 2016, from http://articles.economictimes.indiatimes.com/2016-03-14/news/71509794_1_trade-deficit-trade-imbalance-chinese-exports


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About the author:

She is a PGDM finance student of batch 2015-17 at TAPMI. Her area of interest includes economic research and risk management. You can contact her at priyankam.17@tapmi.edu.in

THE ROLE OF INTEREST RATE IN INFLATING ASSET PRICE BUBBLE

By Astha Mehta & Nayan Saraf

Edited by Sachit Modi

Introduction

Since the inception of the financial market, the interest rate has had a significant impact on various financial assets. The direct impact can be seen on the bond prices, which have an inverse relation with the interest rates. It also affects the deposit and lending pattern in the sense that with the fall in interest rates, the deposits decreases while the lending increases and vice-versa.

However, the impact is not just limited to the change in the saving and investment behavior of the individuals and bonds, but also extends to the valuation of various financial assets like stock prices, currency, real estate etc. This can be explained using the Gordon’s Model. The modelasset1 explains the valuation of an enterprise by discounted cash flow method. For example, any firm giving regular dividends, say $100, will have different values for different interest rates. When the interest rate (r) is low, say 1%, the value of the firm is, 100/r, i.e. $10,000. But as the interest rate goes on increasing to 25%, the value of the firm exponentially declines to $400. This is one of the reasons why in the low-interest rate regimes, the price of assets are high and vice versa. This is shown in Figure 1.

Similarly, the currency value is also influenced by the interest rates. Although, there are various factors affecting exchange rate, like economic stability, domestic good’s demand etc., but interest rate has a significant effect on the appreciation and depreciation of the currency. A decrease in interest rate is unattractive for foreign investors resulting in shifting of foreign investments to other countries with relatively higher returns. This weakens the domestic currency. As currency loses value, investors look for other investment sources like gold and real estate. Thus, the effect percolates down to these assets also.

These changes in the value of the assets cause investors to modify their portfolio holdings. There have been instances throughout history where the change in the interest rate has driven investors to alter their portfolio in such a way that asset bubbles were created. Now let’s look at some of the major asset bubbles which stirred the global economy.

U.S. Housing Bubble

The U.S. housing bubble is a perfect example where the lower interest rate was one of the key reasons to inflate the housing prices. The lower interest rate had given the opportunity to the investor to buy the house when the money was virtually freeasset2. The common explanation for the lower interest rate goes back to the hypothesis of “Global Saving Glut” by Ben Bernanke, Ex Fed Chairman. According to Ben, prior to the housing bubble, there was an excessive saving generated in the emerging market which was channelized to the U.S. market, and subsequently lowered the long-term real interest rates. He argued that a shortage of safe assets could also have contributed to the problem.

This fact could have been evident from the yield of 10Y U.S. Government bond, where the lower real interest rate has reduced the bond  yield from a high of 8% in 1995 to as low as 4% before the housing bubble (Figure 2).

Now this lower bond yield had caused the investors to shift to other risky investments. And real estate seemed to be an ideal choice for the investors then. During the post dot-com bubble era, the effective Federal Fund Rate was reduced dramatically from 6.5% to just 1%. This long-term lower interest rate had resulted in the dramatic increase in the asset prices (Housing). By 2006, this interest rate was normalized from 1% to 5.25% and people started regretting the exorbitant prices they paid for the assets which were overvalued. It brought about lower demand and increased monthly payments for adjustable rate mortgages. Soon after that, a series of defaults started, resulting in the bursting of the bubble. Figure 3 explains the same.

asset3

However, it is not completely true that the lower interest rate was the only reason which created this bubble. As Raghuram Rajan argued in his book, “Fault Lines”, that if there are other factors that encourage investment in a single asset, then the impact is amplified to an extent that asset bubbles are created. 2 This phenomenon was clearly evident in the housing bubble of 2007 when not only interest rate but also government policies like home buyer’s credit, easy lending practices, Fed’s focus on job creation rather than output, inefficiency of credit agencies etc. were equally culpable for it.

Japan’s Real estate bubble

A similar scenario can be seen in Japan’s real estate bubble. The Japan asset bubble started when US dollar depreciated against the yen due to the signing of the Plaza Accord by the US with Germany, England, France and Japan. The dollar depreciation boosted US exports, but at the same time made investors shift investments from the US to Japan due to foreign exchange fluctuations.

The rising value of yen hindered business opportunities for Japanese exporters. To protect its export market, Bank of Japan resorted to monetary easing by lowering the interest rates from 5 percent in 1985 to 2.5 percent in the early 1987. The free lending by Japanese banks increased the real estate and stock purchases which inflated the value of land and stocks. During this period, Nikkei tripled to 39,000 and real estate prices reached a record high. It was even rumoured that during this phase the Tokyo Imperial Palace was worth more than the entire state of California. The price rise continued for four years, until 1989, when BOJ finally increased interest rates on account of inflationary pressures, and caused the asset bubble to burst.

The Nikkei plunged from 39,000 to 20,000 in 1990 and retail loans became NPAs which resulted in the Japanese government to take twenty years to recover back to the pre bubble economy which is now commonly referred as the lost two decades.

asset4
asset5
The Japan debt crisis was also a result of lower interest rates. Lower interest rates allow governments to fund its economic spending through cheap debt. A part of government’s revenue is used to pay interest on the debt taken. When interest rates are kept low for a long period, the government’s borrowing increases and so does the interest payments. Later on, if there is an increase in the interest rate, the interest payment shoots up consuming a large part of or sometimes whole of the government’s revenue. This creates a vicious debt trap.

Shale oil production bubble

Shale oil production is another case where the low-interest rate had fuelled the gas drilling bubble. Since the crisis of 2007, Fed had kept the interest rates constant, nearly zero, which resulted in loose money being poured into the capital intensive oil drilling process for years. When these investments became successful, there was an excess supply of oil in the world economy. Since, in just a period of one year, the price of oil plummeted from $120 a barrel to just $30 a barrel, the shale oil production (drilling industry) busted.

There are more than 50 shale oil production companies in the U.S. and more than half of them have already filed for bankruptcy due to the plunging oil prices. None of these oil companies are able to reach the break-even point. And the ones who haven’t filed for bankruptcy are running in huge losses.

Now, the Fed has again increased the interest rate by 0.25 basisasset6 points and it would have negative consequences for these oil companies. Firstly, it would lead to an additional debt cost in their balance sheets. Figure 6 clearly indicates there is an increase in debt due to cheap lending and also, the increase in debt to gross cash flow, due to lower generation of cash flow from the operations. Second, the higher interest rate will increase the cost of capital, which would mean that these stressed drill companies would lose access to finance. Third, the higher interest rate will result in the appreciation of the dollar, leading to downward pressure on oil prices, due to crude oil being priced in dollars.

Conclusion

Central Banks undertake monetary easing often by lowering interest rates, in order to stimulate the economy, but more often than not, end up in creating an asset bubble. The various historic events highlight the role that interest rates have played in the financial market and its effect on the asset prices.

Even though, these events indicate that various factors contributed to the loss of wealth due to bubble formation, investors sometimes ignore the risk and fall into the trap of increasing asset prices. It is also noteworthy that the dot-com bubble burst after the Fed had increased the interest rate by 1.91% in 1999-2000. More interestingly, the current US housing index shows that the US house prices have reached to new heights while the interest rates are nearly zero. So, are we heading for another bubble? Well, it is difficult to predict as of now, but it would be interesting to see what happens to the housing prices when Fed would further increase the interest rates.

References:


astha_tjef1About authors:

The author is a Banking and Financial Service student of batch 2015-17 at TAPMI. Her area of interest  includes economics, banking, data analysis and digitalisation. She is also a senior analyst at Samnidhy. You can contact her at astha.bkfs17@tapmi.edu.in

Nayan_tjef
The author is a Banking and Financial Service student of batch 2015-17 at TAPMI. His area of interest is mainly economics, banking, and risk management. He previously submitted his research paper on REGRESSIVE EXCHANGE RATE POLICY OF CHINA. He is on the editorial board of TJEF and also the member of Literary and Media Committee of TAPMI. You can contact him at nayan.bkfs17@tapmi.edu.in.

THE INTERNET OF MONEY – A DIGITAL REVOLUTION IN FINANCE

By Nikhita Kalibhat

Edited by Prof. Madhu Veeraraghavan

Introduction

Finance has evolved from usuries to being executed through established banking systems. Over the years, innovation in this space has enabled financial integration, economic growth and risk-sharing by diversification. Businesses now function among sophisticated investors, suppliers and customers who are well-equipped with accurate, real-time information. Mobile commerce platforms and online credit evaluation systems have changed the way financial transactions are managed. Finance education now includes exposure to technology such as Bloomberg. Wall Street aspirants learn how to access timely, accurate and relevant information. This digital revolution calls for a collaboration among practitioners, researchers, technologists, educators, and students, for innovations that might change the way we make, spend and save money.

1. Practice of Finance

Businesses today are spread across geographies and transact with clients across regions in various currencies. Technology architecture is designed to mimic the company’s organization structure and accommodate accounting and legal norms across the world. Technology innovations that impact financial services attempt to fix the existing gaps in accessibility, regulations and customer experience. There are six facets of financial relevance that have attracted disruptive innovation in technology (“Future of Financial Services 2015” World Economic Forum, 2015):

1.1 Capital Raising

We live in the era of innovative ideas, growth and excellence – the era of start-ups. The number of opportunities for investors has seen a marked increase. Small enterprises and start-ups need an increased exposure and access to investors. Alternative investments markets, such as GREX in India, act as exchanges creating an ecosystem of market participants thus providing opportunities for investors and visibility and accessibility for the companies. Smart contracts are used to secure financial transaction made on virtual exchanges, making digital avenues for raising capital simple and attractive.

In 2003, Brian Camelio launched ArtistShare where struggling artists could raise funds for their performances and production of their albums. Since then, the crowdfunding trend has grown exponentially resulting in collaborated software applications and products in the field of real estate, food and medicine. Crowdfunding platforms such as Indiegogo and EquityNet have created a community of angel investors, venture capitalists and business supporters who view business plans and projects, and reach out to entrepreneurs.

Alternative investments such as hedge funds, pension funds and private equity funds are now gaining prominence. Due to the high failure rate of hedge funds, investors not only consider fund performance but also focus on operational effectiveness. Post 2008, operational due diligence has become a standardized process (“Operational Due Diligence 3.0” Castle Hall Alternatives, Oct 2015). The advent of technology services such as Report Central by Great Lakes Fund. Solutions has facilitated better verification and scrutiny.

1.2 Investment Management

Information influences investments. Reliability, accuracy, timely access to news and data is of great significance to investors. Social trading platforms such as FXJunction connect traders of all experience levels across the globe to discuss strategies, analyze past performance and follow their trades.

Financial management information systems such as Bloomberg provide access to real-time, accurate, global data across all asset classes. Bloomberg allows investors, analysts and researchers to access news, download financial data, implement algorithms, build a professional network and execute trading strategies.

Brokerage houses are now collaborating with technology providers to enable algorithmic trading. Exchanges across the globe are competing to provide faster trade processing, higher consistency and risk mitigation.

Today’s world of integrated business brings together people, data and process with the help of technology. Enterprise Resource Planning has resulted in a seamless transfer of data across the value chain of a business. Cloud computing has revolutionized the way data is stored, accessed and shared. Companies are now restructuring into networks completely integrated with technology with increased accessibility of information to investors, suppliers and customers (“The Impact of Cloud” The Economic Intelligence Unit, June 2014).

1.3 Payments

According to a McKinsey report in November, transaction revenues are expected to grow at a CAGR of 7% by 2019 (Bansal Sukriti, Bruno Phil, Hou Grace, Istace Florent, and Niederkorn Marc, “How the Payments Industry is Being Disrupted” McKinsey and Company, November 2015). We are already beginning to see digitization of transaction banking, efficient international payment systems and infrastructure upgrades in banks and payment systems. Digital wallets are quite popular on e-commerce websites; with a better system for user authentication, and internet connectivity, this service can soon reach local retail shops in rural India. Globally, sophisticated smart contracts and blockchain technologies provide authentication, compliance checks and storage of electronic money.

Today, we have 46 Bitcoin exchanges, with a volume for more than 180,000 BTC in 24 hours. Cryptocurrencies are encrypted digital currencies that can be used worldwide, cannot be misused, does not need a bank account and can be traded on a virtual exchange (Greenberg Andy, “Crypto Currency” Forbes, April 2011). There is some ambiguity in the worth and validity of these currencies. Unfortunately, there is no way to monitor what is being purchased with these cryptocurrencies. This advancement calls for regulation by governments and central banks.

1.4 Insurance

A report by Bloomberg Intelligence states that auto, home and health insurance companies are heavily investing in Internet of Things (IoT) devices. Insurers are establishing strategic partnerships to develop home smart devices such as Nest,fitness trackers such as FitBit, smart glasses and vehicle crash avoidance systems (Greenough John, “From fitness trackers to drones, how the Internet of Things is transforming the insurance industry” Business Insider, July 2015). IoT is expected to disrupt the traditional insurance model to keep insurers and customers constantly connected.

The AirBnBs and Ubers of the world are creating grey areas for insurers –can they cover private property being used for commercial purposes? Insurance companies are forming alliances with sharing economy companies to develop solutions such as pooled insurance premiums.

1.5 Deposits and Lending

The most popular technology innovation is peer-to-peer lending platforms that bring borrowers and lenders together. In an exclusive report on online marketplace lending, PwC has stated that this industry could reach $150 billion by 2025 (“Peer Pressure” Pricewaterhouse Cooper, February 2015). US lending platforms have grown at 84% over the last 10 years and have ventured into other asset classes. These platforms cater to banks, institutional investors and individual investors pairing borrowers with interested lenders. There have been significant advances in the technology used on P2P lending platforms for underwriting and credit modelling. Online lending marketplaces such as Lendbox in India, are achieving a turnaround time of 2-5 days for loan applications, making them an attractive choice for borrowers and lenders.

2 Study of Finance

      Education was text-book based up until the early 90s. Since then, we have seen a gradual increase in the involvement of technology in learning. In finance education, we have transitioned from teaching portfolio theory to actually constructing mock portfolios, generating efficient frontiers and managing virtual investments. Top schools around the world are increasingly focussing on making their students industry ready. This involves a significant investment in infrastructure to procure licenses for software tools and building state of the art trading labs.

2.1 Financial Literacy

Financial education is now a necessity not just for investors but for any individual. Financial markets are becoming more aggressive and sophisticated. It has now become essential for every individual to learn how to manage wealth, choose interest rates for bank loans, select mutual funds and pension funds, weigh market risk and invest through the right financial instruments (“The Importance of Financial Education” Organization for Economic Co-operation and Development, July 2006).

Governments, banks and exchanges across nations are setting up websites, apps and portals to gain information on the basics of capital markets , credit and borrowing, personal finance and budgeting. Hands on Banking, a website sponsored by Wells Fargo Bank, offers online courses on financial management. JumpStart, a non-profit organization in Washington, has an online library to educate children on the importance of financial management right from pre-school through college. ClearPoint Credit Counseling Solutions has been providing their customers with online advice on debt, housing and budgeting for over 50 years. Financial literacy is aimed at achieving higher and sophisticated market participation in the coming years.

2.2 Pedagogy for Finance Education

Top schools around the world are increasingly using technology to explain finance concepts. Live market data, financial statements, economics data and historical performance data is being downloaded through various sources and used in classroom learning as well as in assignments.

Financial econometrics and portfolio management is taught exclusively on software tools such as Stata, EViews, R and Microsoft Excel. What used to take hours to calculate a few decades ago, can be displayed on-screen in almost no time. Normalized graphs, efficient frontiers, box plots, candle charts and Bollinger bands can be generated on various tools using real-time and historical data. This makes for an engaging classroom environment.

Among all the software tools and websites designed for finance education, Bloomberg and Thomson Reuters are the leading financial information management systems. Bloomberg provides real-time and historical data, news, in-built complex calculators and tools for analysis, communication network with industry experts and simulation trade execution. It becomes the perfect learning platform for aspiring analysts to pick and review stocks, create portfolios, manage risk and monitor market events.

2.3 Finance at TAPMI

The Bloomberg Championship Program at TAPMI is aimed at integrating Finance curriculum with Bloomberg through classroom teaching, assignments projects and simulation games. Almost 60-80% of the finance courses at TAPMI use Bloomberg to support course content. All Finance majors in the institute are Bloomberg certified and trained on various functionalities on Bloomberg Equity, Commodities, Foreign Exchange and Fixed Income. The Banking and Financial Services (BKFS) students undergo a special primer course dedicated to learning on Bloomberg. Students of finance at TAPMI are encouraged to use Bloomberg data for sector analysis, peer evaluation, technical analysis and portfolio management.

TAPMI Finance Lab is the largest Bloomberg lab in India with 16 terminals. The lab is home to the Finance Forum’s flagship event “Finomenal” – an annual finance conclave, TAPMI Bloomberg Olympiad – a battle among Bloomberg Champions on use and application of Bloomberg, and Samnidhy – a student managed investment fund consisting of more than 60 analysts investing in the equity market. TAPMI also runs a special course for a select group of high-performing students called the Student Managed Investment Course (SMIC). This 4 credit course requires students to form investment teams and manage real money in real markets. Bloomberg is extensively used for analysis, tracking market events and portfolio management.

TAPMI is innovating every day to achieve a complete integration of Finance with technology. Students’ familiarity with the functionalities and application of Bloomberg makes TAPMI the preferred destination for recruitment in the finance industry.
The continuously innovating world of technology is disrupting traditional finance practices. Banks, financial institutions, exchanges, regulators and businesses are evolving rapidly. The flow of information is becoming seamless and otherwise distinct functionalities are being integrated. Finance is indeed undergoing a revolution, backed by education, technology, policy and creativity.


Nikhita M Kalibhat

About the author:

Bloomberg at TAPMI, has shaped her philosophy regarding the importance of the technology into businesses making decision on the basis of data acquired through effective implementations of technology. Her familiarity with technology systems and frameworks and her passion for Finance inspires her to be a part of the Fin-Tech space. She is currently working as a Functional Finance Consultant at Deloitte Consulting. You can contact her at nikhita9@gmail.com.

REGRESSIVE EXCHANGE RATE POLICY OF CHINA

By Nayan Saraf

Edited by Shulin V K Satoskar

 Introduction

There have been many dramatic events in the history of the financial world which have subsequently changed the structure and practices across the world. These practices were mainly intended at getting ahead in the competitive world of trade. And when it comes to trade, all we can talk about is China. Perhaps, China is one of those countries which has tried every possible trade practice to be ahead of other countries. Some of these are unfair. These unfair practices are: Currency manipulation and currency devaluation. But before we go ahead and discuss the impacts of these unfair and regressive trade policies, we first need to understand currency manipulation.

What is Currency Manipulation?

Currency manipulation, also known as foreign exchange market intervention, or currency intervention, occurs when a government buys or sells foreign currency to push the exchange rate of its own currency away from equilibrium value or to prevent the exchange rate from moving towards its equilibrium value. This is basically an act of artificially inflating or deflating the fair value of the currency. In most cases, manipulation is illegal. Usually, the fair value is decided by the demand and supply of that currency in the market. But when a country manipulates its currency, the free market does not remain any free. In that case, the country with trade surplus doesn’t allow its currency to get appreciated, which in self-correcting phenomenon should do. Due to this process, the goods from that country would still cost less than those of other countries whose currencies would be wrongly inflated. This way, the country using currency manipulation attracts more exports and disturbs the free market.

How does China do Currency Manipulation?

      Now suppose, a trade occurs between a US importer A and a Chinese exporter B. After the trade, importer A would transfer its money to the account of Chinese exporter B in dollars. Now, after receiving money in dollars, exporter B would go exchange the dollars in local currency Yuan. But instead of exchanging from its reserves, People’s Bank of China (Central Bank) exchanges it with newly created Yuan. This is equivalent to printing money. The Central Bank thus supplies more Yuan in the market. The Central Bank constantly prints new currency and uses it to buy U.S. dollars and U.S. government debt, thereby flooding the market with Chinese currency and increasing demand for American dollar. This way the supply of Yuan would be more than its demand and would result in lower prices of Yuan. On the other hand, the demand for dollar would be more than its supply and would result in an inflated dollar value.

Proof of China’s Currency Manipulation

We can observe it from the Figure 1 that from 2005-14, China’s export has grown by more than 300% which is 30% growth annually (on average). The monetary value of exports from 2005-14 has grown from $500 billion to $2.3 trillion. But in the same decade yuan depreciated by only 25%, i.e. from 8.26 CNY to 6.37 CNY for a unit dollar.

I1A1D1

I1A1D2

How is it possible?

It is only possible by manipulating the currency. In the same decade, the Central Bank has increased its Forex Reserve by more than 600% i.e. from $500 billion to $3.7 trillion (Figure 3). This is a clear sign of manipulating yuan by buying more dollars and supplying more Yuan. Figure 4 clearly indicates the increased money supply of Yuan, which is more than 700% in the same decade.

I1A1D3

I1A1D4

Why is China Devaluing its Currency?

The question which everybody is asking: why did the Chinese government devalue its currency in 2015? The answer is an interplay of many reasons. First, the global economic slowdown in US and Eurozone: The U.S. is slowly recovering from the global financial crisis of 2007-08, but the Eurozone is still in the vicious circle of recession. The export of Chinese goods has reduced due to low demand in US and Eurozone. Inflation in the second quarter of 2015 remained at 2% in the U.S., and abysmally low at 0.2% in Eurozone.

Second, the declining growth rate in China: It also resulted in this devaluation. China has realized that the currency manipulation is not yielding benefits as it did five years back. The exports are declining, which is also resulting in lower demand in the domestic market.

Third, the adoption of quantitative easing by Eurozone: Since the adoption of QE in March 2015, Euro has drastically depreciated against dollar. Now, Chinese government is worried that if this depreciation continues, then their goods would be less desirable in the Eurozone.

At the same time, Japanese government also adopted QE, which resulted in depreciation of yen. The fear of losing this competitive advantage over other countries has forced China to get into this currency war.

Impact on Chinese economy

The recent devaluation resulted in a crash of the Chinese stock markets. Despite the massive stimulus the government unleashed to prop them up the situation remains unchanged. The Shanghai index has fallen by nearly 40% from its mid-June peak. So is this the hour of China’s crisis? Not so likely. Stocks and economic fundamentals have little in common. When share prices nearly tripled in the year till June, it was not a sign of stunning improvement for Chinese growth prospects. China’s growth has been slow for a while but their stock market kept rising.

Furthermore, the property market of China is far larger than the equity market. Housing land accounts for a major chunk of the financial system and thus plays a much bigger role in spurring growth. House prices have risen up nationwide but this crisis has stopped overvaluing the property market. This stabilization has reduced the risk of property market crash – an event equivalent to that of a stock market crash in America.

Conclusion

This is not the first time that any country has devalued its currency. In 2010, the Japanese government moved to depress the value of yen. South Korea also has a habit of intervening in the valuation of its currency. Switzerland pegged its franc to the euro in the beginning of 2011. But a lesson that these countries have not learnt is that the fluctuation in currencies have global impacts.

Earlier this year, when Swiss Central Bank had unpegged their currency, the currency rose from pegged level of 1.12 Euro to 0.82 Euro in just one day. This is the highest appreciation of a currency in the history of the financial world in one day. The corresponding impact was that the Swiss market went down by 12% the same day. Many big hedge funds went bankrupt. And now, when China has devalued its currency, again, there is a market crash. This market crash is far bigger than the Swiss market crash. It eroded nearly $1 trillion of wealth in just one day.

China has always used these unfair practices just to get ahead in the world. But now, it should realize that this world is interconnected, and any volatility would cause global crisis. When China last devalued its currency in 1994, there was a financial crisis in Asian economies just after 3 years. Now again, we are at the verge of another financial crisis as the RBI governor, Raghuram Rajan, predicts. And its consequences would be far more fatal than 2007-08 global financial crisis.

References:


Nayan_tjef

About the author:

The author is a Banking and Financial Service student at TAPMI. His area of interest is mainly economics, banking, and risk management. He is on the editorial board of TJEF and also the member of Literary and Media Committee of TAPMI. You can contact him at nayan.bkfs17@tapmi.edu.in