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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
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 ( 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 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


When written in Chinese the It isn’t so much that 18 INTERVIEW WITH ARVIND SUBRAMANIAN
word “crisis” is composed of two hard times are coming; the 22 INTERVIEW WITH RITESH DUTTA

characters - one represents danger change observed is mostly

and the other represents soft times going



Groucho Marx
John F. Kennedy
Finance as a business enabler found its biggest purchase in the power balance of global finance is not what it used to be and it


west with mounting business and consumer needs for invest- may never revert in our times. This forms the core of our thought
ment destinations. With easy money, unfettered financial prod- process and led to the creation of the theme for the 9th edition 43
uct innovation and light-touch regulation, the financial markets of Money Manager – “The New World Order of Finance”. 44 INTERVIEW WITH RANODEB ROY
put money into everyone’s hands including that of those who This issue of Money Manager is punctuated with
couldn’t afford the cost of using money. The levels of growth interviews of people from all walks in Finance - Bankers, Regu-
were so gargantuan that it had to come to a halt or at least slow lators, Policymakers, Investment Managers and Academicians.
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
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
of global economic domination passing to the United States of perspective of the state of affairs in global finance and econom- 55 INTERVIEW WITH MONTEK S. AHLUWALIA
America. The situation today is not too dissimilar. However, the ics broadly categorized under Financial Products, Currencies,


roles are reversed with the Asian Tigers, Brazil, Russia and the Regulatory Bodies, Emerging Markets, the Indian perspective
Indian Elephant looking to occupy that spot. and Challenges to the evolving New World Order. 59
If out of place quotes could so effortlessly morph We would like to express our heartfelt gratitude to the illustri- 60 INTERVIEW WITH SWAMINATHAN AIYAR
into relevance for the modern day, the quotes by Groucho Marx ous people who have consented to provide their views and
and John F. Kennedy, men who had little to do with the world thoughts on the topic, jury members who have adjudicated the
of finance, take the cake. It is indeed the disappearance of soft student entries and UBS who have sponsored Beta’s activities
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.
this year. We hope this edition gives you a lot to think about and
even more to discuss and learn.
As Kennedy succinctly put it – it is danger when they tread the 74 CHINA’S DOLLAR TRAP- A HISTORICAL PERSPECTIVE.
greater heights, but it’s also opportunity that beckons. How Please do send in your feedback to 83 LIGHTING UP DARK POOLS
the emerging markets grab it and how the western democra-
cies battle it out to maintain their supremacy will indeed be a Tanu Singh 87 REGULATION IN INDIAN SECURITIZATION MARKET- PRUDENT OR PUNITIVE?
fascinating contest. But one thing is clear at the moment – the V M Avinass Kumar 90 DOLLAR CRISIS- REAL OR IMAGINARY
4 Money Manager / January 2011

6 Money Manager / January 2011 Money Manager / January 2011 7

the aftermath of the financial crisis

More importantly it has had a deep impact on the critical stakeholders in the
David Rockefeller speaking at the Business Council for the United Nations in financial system. The hold of the Dollar over world trade is being questioned. Financial
September 1994 mentioned, “We are on the verge of a global transformation. All we product innovation has come under the scanner. The apparent failure of regulatory
need is the right major crisis and the nations will accept the New World Order.” 14 years mechanisms has sparked intense debates in the developed and developing world. The
later, the world witnessed the worst financial crisis since the events that followed Black Emerging economies in Asia (Ex-Japan) and the BRIC Economies have weathered this
Thursday in October 1929. The aftermath of the financial crisis has pointed to significant storm much better than expected and have in fact come out stronger. But there are
shortcomings in the macroeconomic structure of large western democracies and the enough cracks in the new world order that is indicative of a threat to this optimism for the
susceptibility of their real economy to shocks in the financial economy. emerging giants.
8 Money Manager / January 2011 Money Manager / January 2011 9

global currencies The outlook therefore, is not so radical in the short

term. The flexibility, innovation, depth and volumes of the US
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-
financial system would ensure the continuance of dollar as the
dominant currency for some time now. The tipping point might cial institutions and investors to hedge their risk exposures or to

With the end of the Bretton Woods Agreement following the
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
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
population raises question marks over the future credibility of the
Nixon shock in 1971, US dollar for all practical purposes replaced Japanese economy. Further, neither the Euro-zone, nor countries reserve holdings from US dollar to other alternatives would con- off, with the help of good ratings from credit agencies, to unwary
gold as the benchmark standard and emerged as the dominant like Britain and Japan wield as much political power as the US. tinue as the US fiscal burden coupled with its near zero interest investors seeking above normal returns.
currency and reserve of the world. This was caused by a vari- This brings China into the picture. While the economic rates makes investment in dollar a highly unprofitable venture. This argument creates an abomination towards finan-
cial innovation as the root-cause of the iniquity that led to the

financial products
ety of factors which included notably, the dominance of United and political clout of China is close to that of the US, Chinese sec-
States as the major trade player of the world, the deep and flex- ondary markets are woefully underdeveloped as compared to their financial breakdown. However the fallacy here is probably not the
ible financial systems of the US including an active secondary American peers and the depth of renminbi would have to increase innovation, but the inability of credit agencies and regulators to
market for dollar denominated instruments, the emergence of significantly, if it is to take the place of the US dollar. Moreover, the assess the risks, speculative activity superseding the core activi-
petrodollars and the unparalleled political power of the US. The ties of banks, and the investors forgetting the old maxim- there is

renminbi is still not fully convertible and the political stability and
US dollar had characteristics that favoured it to be used for all monetary policy of China is yet to command complete credibility no such thing as a free lunch.
the three purposes of money: as a medium of exchange, as a from the international community. As we stand at the cusp of a recovery – the future
unit of account and as a store of value. Although post 1971, The Special Drawing Rights (SDR) suffers from none of The most significant trend in the financial sector, in the last two of financial product innovation is very much in the balance with
the developed world moved towards a flexible exchange rate these drawbacks. It does not engender conflicts between short term decades, that has shaped the current structure of the banking more aware regulators and stringent norms. At present the va-
regime, holding foreign exchange reserves (primarily US dollars) domestic and long term economic objectives (the Triffin dilemma). sector has been the advent of derivative products and securitized nilla products are dominating the street – mainly due to higher
was seen vital to maintain financial stability and prevent tem- Its implementation would not require a large scale overhaul as sys- products that provide higher yields to the banks and enhance spreads in markets which are relatively illiquid. There are three
porary exchange movements from interfering with broad fiscal tems already in place can serve the function. It would also not lead their margins particularly in an extremely competitive environ- primary factors behind this. One, the role of the exotic products
and monetary goals. to a single country getting cheap credit from the rest of the world ment. As the wave of innovation through “securitization” and in exacerbating the recent crisis has made the investors uneasy
The last two years, particularly in the aftermath of and receiving seigniorage gains in the process. The composition of “derivatization” spread throughout the industry creating an ex- with such products. Secondly, at present the vanilla products are
the global crisis, have seen growing concerns about the validity the same which at present stands at 44.1% USD, 37.4% EUR, 9.4% tremely opaque and complex financial product ecosystem, so did offering high yielding investment opportunities. Banks are able to
of US dollar as the dominant currency. This has stemmed from a JPY, 11.3%GBP can be made flexible to include varying shares and the need for risk management practices and regulatory control achieve high yield by relatively risk free investments - borrowing
host of reasons, chief amongst them being the weak fundamen- introduce new currencies of the emerging economies, making it mechanisms. However, the vanguards of financial products in- short term funds at near zero rates from Central Banks and invest-
tals of the United States as underscored by its huge federal debt more stable than any single currency. The concept of SDR is cer- novation were always miles ahead of those wearing regulatory ing in the rally in Treasury bonds fuelled by the Fed’s quantitative
that touched 94% of the GDP in the fiscal year 2010, soaring tainly laudable and an effective long term solution. In particular, shoes or those instituting the risk-management tools, methods. easing. At the same time, the uncertainty in corporate bonds and
unemployment (9.8% in November 2010) and mammoth budget its case as a unit of account seems very strong. However, its use Financial innovation has been on the rise since late the European and emerging markets sovereign bonds are provid-
deficit to the tune of $1.42 trillion in 2009. Adverse economic as the medium of exchange would imply the loss of considerable 1980s. It was during this period that the US banking sector had ing opportunities to make significant profits by second-guessing
impact caused by the United States’ military adventures and the sovereign authority which does not concur with popular sentiment witnessed a tide of multi-billion mergers and acquisitions includ- policy action which has become predictable in the aftermath of
hoarding of dollar reserves by countries like China seeking to around the world. Further, the credit quality of SDR bonds would ing those of Citicorp and Travelers, J.P. Morgan and Banc One, the Lehman debacle .
increase export competitiveness through depreciated domestic be the credit quality of member country issuing them, the volume Chemical and Chase and many more. What was originally a frag-

currencies. of which would depend on global distribution of economic power mented banking sector turned into a highly consolidated one and
This has led to protesting voices from several quar-
ters seeking an end to the dollar hegemony and a shift to an al-
bringing us back to the credit quality of the Western world. Also,
a full blown implementation would imply creation of SDRs worth
the incentive beyond operational efficiency was to enable cross
selling of products. This trend shepherded the products contrived As we stand at the cusp of a
ternative order anointed by other monetary units. Events which
have made this shift noteworthy include the purported talks by
more than $3 trillion as they currently stand at only 4% of the global
reserves. All these reasons militate against the immediate or short
on Wall Street into the portfolios of risk-averse pension funds
and mutual funds.
recovery- the future of financial
OPEC to move to denominating oil in a basket of currencies com-
prising euro, yen, gold and a new currency unit for members of
term use of SDR as the store of value or medium of exchange.

Post 9/11, the Fed followed a regime of low interest
rates to boost the economy. With near zero interest rates, inves-
product innovation is very much
the Gulf Co-operation Council; the tiptoed movements of China tors- individual as well as institutional, solicited products that
could enhance their yields. Structured products built over securi-
in the balance with more aware
and other countries to diversify their reserves away from the
regulators and stringent norms

US dollar; bilateral talks by China with countries such as Korea, tized products - Collateralized Mortgage Obligations (CMOs) and
Russia and Malaysia to settle trade in renminbi and reduction in their credit counterparts- Collateralized Debt Obligations (CDOs)

the share of US dollar in global foreign exchange transactions. flooded the markets. To achieve even higher yields, multiple lev-
However, the prevalence and velocity of US dollar els of CDOs were built over underlying CDOs and the investors Since 2008, the US banks have increased their holding of cash and
puts it in a different league altogether from its competitors, The concept of SDR is cer- lost sight of the ultimate underlying asset. 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
atleast as of now. Its closest contender would be Euro which
has around half the share of US dollar in global foreign exchange tainly laudable and an effective Thus, the mushrooming market and increasing compe-
tition in the structured products space paved the way for products third factor is the new set of capital constraints being anticipated
transactions. While the Euro area is larger than the United States
long term solution with complexity that was unfathomable for the targeted investors with the BASEL III is making it imperative for banks to accumulate

in economic terms and is integrating further with the growth of to understand their risk-return profile, for regulators to implement more of Tier I securities, comprising primarily of vanilla products
its capital markets, it is far less liquid. Also the credit quality effective capital requirements and for the credit rating agencies including equity. The first factor- reluctance of investors suggests
of Euro bonds differs from country to country and questions are to assess the credit quality. The bubble blew-up finally with Leh- that exotic financial products may not flood the markets again.
being raised about the fiscal sustainability of a few members. man Brothers & Bear Stern disappearing from face of Wall Street However, as imperfections created by the Fed’s policies recede
The yen suffers from the same problem as well and an ageing and the outstanding trillions of dollars securities turning toxic. and the European uncertainty subsides, simple products would
10 Money Manager / January 2011 Money Manager / January 2011 11

start yielding nominal returns. At that point, it is highly likely regulatory 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

mechanisms and
that the investors seeking higher yields would start picking up capital. However the most important fundamental shift comes from inactions.
the unconventional products again. It follows from Hyman Min- the rules being supplemented by a leverage ratio as against just
sky’s theory that financial stability sets the stage for future cri-

risk-weighted models. (v) The fundamental benefit of financial innovation, that is deliv-
sis, because the stability fuels high yield- high risk investments. “Procyclical” measures that allowed banks to store up ering value, will drive more innovation or curb it on the basis of
Although, the experience of the last recession would make a capital in boom times for lean period was originally seen as profit- market reaction.
case for rating agencies to be more vigilant towards these in- smoothing, but this is now going to be the philosophical basis of the These have clearly not been the case and the regula-
novations, enough questions in that domain still remain. tory bodies world over should examine the fundamental assump-

new regulations. Moving along after the crisis with banks starting
The last factor curbing innovation at present is regu- to repay the TARP funds and gaining on profitability, these measures tions of finance on which they have built the legal framework
lations. Although it seems a strong factor, this is the least prob- of restrictions will surely face some opposition. With lesser govt. of securities and financial markets regulation. Clearly a new and
able factor to hinder financial innovation in future. Historically, The essence of free market capitalism has been the freedom as- bold paradigm for regulatory function and responsibility needs
control, how the regulators handle the capital situation will be a key
regulations have been backward looking and would probably sociated with financial markets - the ability of private entities to to be established – and that needs to come from the regulators
parameter of their learning from the financial crisis.
enforce constraints on financial institutions so that they cannot chart their growth path and more importantly the omnipotence of themselves.

the market in deciding who survives and who does not. The one

get away with similar misrepresentations and negligence as last

The regulators need to revisit the emerging markets

time. However, the regulations, such as Dodd-Frank Bill and the phrase that regulators all over the world have lost sleep over is
in process Basel III, target the banks primarily. Financial insti- without a doubt “Too big to fail”. The Global Financial market has
tutions like hedge funds and reinsurance firms provide mecha- evolved in such a way that some private players become systemi-
nisms for the banks to transfer risks out of the banking system cally important giants. their role as a watchdog of taxpayers’
money and examine the foundations —
and regulations have still not adequately touched them. Thus, Governments more often than not are caught between
with the new regulations coming into effect, financial institu- saving some firms which turns out to be very costly and facing
failures that threaten to bring down the entire system. Govern-
tions, and not just banks, would carry on the innovation trend to
minimize the effect of new regulations on profitability. ments have also had to contend with financial concentration 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
Also, there are various avenues in the financial sec-
tor that need innovation. Loans and credit to small businesses
where the banks and financial institutions kept getting larger
through inorganic growth – this meant that failure of one insti- 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

has dried up and Fed’s QE-II to incentivize banks to lend money tution will destroy nearly a tenth of the entire market – case in
point: AIG. Regulators have 2 key mechanisms in their reper- set in. There are several reasons for this rapid recovery of the
to them is not really working. Also, with the new Basel III re-
toire to tackle this issue - they can deem certain institutions as emerging markets. Structural changes introduced in the after-
quirements of higher capital needs for loans to non-rated busi-
“too big” and fragment them with firewalls or increase capital math of the South East Asian crisis, reduced reliance on Western
nesses, banks would be less willing to lend to these businesses. As much as microprudential regulations impact op-
adequacy whereby winding down firms during bust a less pain- exports due to growth in inter-EM trade, relatively under devel-
Also, unlike the big corporations, they do not have access to erational level aspects, the falling dominos impact of the financial
ful process. The regulators have opted for improving capital ad- oped financial markets, higher reliance on domestic savings and
the Commercial Paper market. There is an irrefutable need for crisis can be attributed to poor macroprudential regulatory thought
equacy norms at present – however, with the “Volcker Rule” – a prudent regulation have all contributed significantly to EMs faring
innovation to design products that can provide incentives to the process. The biggest question lies in who should be doing this regu-
combination of the two is expected to be adopted. better during the crisis. Similarly, a timely and adequate policy
banks to put their money to giving loans to the small businesses lation across borders, markets and global powers. Morgan Stanley’s
The Volcker Rule however is making the system more response through fiscal and monetary stimuli & strong domestic
and households. ex-CEO John Mack, late last year, made a case for an uber-regulator
complex as against fundamentally revamping it and is seen as and inter-EM trade have helped in the post crisis EM revival.
Emergence of CDS exchanges is a positive move to- – a global systemic risk manager. IMF has been suggested as a
delaying the coup de grace that failing financial giants will go Looking ahead, the growth in inter-EM trade such as
wards addressing concerns raised by the OTC market having an potential candidate – but experts, believe that IMF as a regulator
through. But a key element of financial regulation – those of firms Asian commodity imports from Latin American countries, stronger
influence in exchange traded securities. However, the regulatory who can tell the SEC to buck up on certain regulations and norms is
that operate across borders has not been addressed. Lehman’s inter-EM financial flows for example two-thirds of Chinese FDI
system is yet to counter the parallel innovation of financial prod- a pipe dream. Yes, the IMF can support troubled economies – the
responsibility that was spread across more than 3000 legal enti- is from other Asian EMs and the accumulation of forex reserve
ucts in the OTC market. Many of the current innovations in secu- Greece recovery plan lending testimony to that – but dictating global
ties and the issue of an Icelandic Bank that has failed to pay back buffers by EMs have helped reduce EM dependence on Western
ritization evolved from OTC products that were later brought into monetary and regulation involves many principal-agent problems.
nearly $6 Billion to creditors in Britain are critical examples of trade and capital. However, the EMs will continue to remain de-
the main fold. So the innovation has happened on those frontiers Pricking bubbles again comes at an economic cost and
how a mechanism for cross border regulation has still not been pendent on foreign investment to pursue their growth plans and
were largely outside the purview of the regulators till they at- the responsibility here is not clearly divided between the Central
strengthened. on Western demand for their exports. Consequently, the decou-
tained macroeconomic significance. Innovation as we see it is Banks and the Financial Services Authority. From a financial stand-
This also raises the question of regulators straddling pling though in progress is far from complete as the transmittal of
coming within the ambit of the exchange, but only after taking point – some key points and assumptions that go into financial regu-
the issue of taxpayers’ vs private creditors which has resulted the crisis to EMs through trade and capital channels displayed.
roots elsewhere in the non-exchange segments of the financial lations are being questioned. They are:
in a slightly philosophical issue of regulators’ responsibilities. Now that brings us to the following question: Is the
markets. Promoting value-additive innovation in the exchange
Regulators have also set a bad precedent previously with gen- post crisis EM resurgence sustainable or is it a bubble? When
segment can, hence, be the perfect antidote to create a resilient (i) Market prices truly build into them all information i.e. information
erous treatment of derivatives and the significant counter-party the sub-prime crisis first broke out, some optimists had gone to
financial product market asymmetry is assumed – the Efficient Capital Markets hypothesis.
risks they pose. So essentially the regulators need to revisit their the extent of calling EMs the new safe haven - especially after
To summarize, the innovation trend may not pick up
role as a watchdog of taxpayers’ money and examine the founda- fears of a U.S. recession made tens of billions of institutional
till there are concerns around recovery. But, with greater stabil- (ii) The positives of securitization – allowing people to take rational
tions on which the current mechanisms of subjective handling of money flee U.S. stocks for EM ones. Though the ‘safe haven’
ity, innovations in products would be imminent. The silver lining risks and improving liquidity.
systemically critical entities rests. claim proved to be exaggerated, the EM’s thriving current ac-
is that the lessons from the last crisis may pave the way for a
The Basel regulations in its avatar as Basel 3 are bleak count surpluses, underleveraged corporate balance-sheets, 50%
more vigilant stand from the investors and the rating agencies, (iii) Mathematical and quantitative modelling and credit rating to
as they now replace the mantra of capital efficiency with robust- share of world GDP and 4% average growth during the crisis are
and a more responsible set of financial innovations to meet the accurately measure risk.
ness. In the pre-crisis scenario banks could manage with common strong reasons to believe that the EM growth story will continue
need of the financial sector.
equity as little as 2% of risk-weighted assets. for quite some time. However, we need to remember that not all

12 Money Manager / January 2011 Money Manager / January 2011 13


characters in it are alike. A Korea or a Hungary is less reliant

on domestic consumption as compared to Asian powerhouses
As India now goes beyond crisis and recovery man-
agement and embarks on a path of high growth, several structural
power to transfer excess foreign exchange reserves to meet
India’s infrastructural requirements on one hand, and also to challenges to the new
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-
deficiencies however remain. Supply side constraints created
by physical infrastructural quantity and quality deficits, skilled
workforce shortage due to inadequate spending on health and
secure energy-related assets in what could be high-yielding
overseas investment opportunities.
Moreover, as the Indian economic clout grows in in-
world order
tain EMs like Russia and certain Latin American countries are education, spiralling inflation and issues related to governance ternational circles, there is no doubt that savers and investors
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
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
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-
the current episode of accommodative U.S. monetary policy policymakers. Financial market reform can create an environment essential hence to create a vibrant risk management and hedg- ber 2008, has jolted the fundamentals of the economies and the
is showing. Nouriel Roubini and Robert Zoellick have warned conducive for increased financial integration which will result in ing environment in order to sustain an environment of continued financial markets world over. From the fall of the biggest banks
about a bubble forming in EM assets. Foreign exchange volatil- the opening up of new, efficient and cost-effective methods of 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
ity remains a concern for investors affecting returns as well as financing, thus lowering intermediation costs. policymakers need to encourage financial innovation such as of finance is no longer the same. But more than two years later,
export competitiveness. Political and policy risk continue to be the creation of a credit derivatives market, a structured prod- the world does seem to be a safer place and the markets have

pervasive factors be it the Khodorovsky verdict in Russia or the ucts market and interest rate futures market which will help regained some shine. But the critics still point out to the dangers
Cairn–ONGC dispute in India.
To summarize, we believe that the EM growth story
The crisis and events in 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
remains robust albeit considering the aforementioned risks. The
growth story would be accompanied by growth in financial mar-
the last two-three years have 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
kets although such growth would definitely be characterized by
the conservatism that has worked for the EMs in the past. A
uniquely positioned India in 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
global landscape

focus on domestic demand to reduce export dependence and concerns regarding India’s ability to accelerate growth in the economies. Continued high unemployment (~10%) in the US
deepening of financial markets to reduce dependence on for- future. There is unquestionably a need for pro-active prudential raises concerns on these aspects particularly given heightened
eign capital are lessons of the crisis that are likely to be imple- regulation. However, the regulatory response cannot be ex- political pressure on US policymakers in this regard. Moreover,
mented and create the platform for a shift in global power to tremely dovish or hawkish when it comes to addressing issues the Chinese government’s reluctance to appreciate the currency
This in turn will tremendously improve the productivity of capi-
the Ems in the long term. related to financial reform and inclusion. Regulators will have on one hand and the increasing US current account deficit on the
tal and will have far-reaching consequences for several cash-
to calibrate their responses so as to retain caution but not at other hand are creating an environment of major global imbal-
strapped sectors such as education, health and infrastructure

the indian viewpoint the cost of allowing the benefits of financial markets reform ances again posing a challenge to the stability of the world’s
which are expected to be the backbone of Indian growth in coming
from accruing to the real economy. financial system
years. For example, the Indian physical infrastructure landscape
The fact remains that despite a fundamentally strong
is suffering from a huge supply deficit, and innovative forms of
growth story, India stands on the cusp of a variety of opportuni-
financing can help plug the supply-demand lag in this sector.
ties waiting to be grabbed. All that is required is a little bit of
Further, broadening and deepening of financial markets can pro-

political boldness, rigorous macroeconomic management and
vide domestic savings access to a variety of financial products
institutional activism to ensure that India can make the most
as well as asset classes in the form of investment opportunities
of what lies ahead. Whether policymakers have the appetite to
The crisis and events in the last 2-3 years have uniquely posi- and provide an additional thrust to improving domestic savings
act with grit and gumption, still remains to be seen.
tioned India in the global landscape. It is important, however, to (Already amongst one of the highest in the world with Gross Do-

assess the impact of the crisis on India’s economic and financial mestic Savings amounting to over 37% of GDP in 2008-09). It is
systems separately, particularly given the limited integration be- in this context that the need to create a more robust corporate
tween these two systems in India. From an economic perspective, debt market has been raised. An efficient corporate debt market Another problem in the stability of the world economic system
the crisis and its far-reaching global impact has left India in a po-
sition of relative strength driven primarily by a burgeoning middle
can create high yielding allocation opportunities for savings and
can concurrently meet the financing needs of businesses, thus would be the different pace at which the advanced economies and
the emerging economies are recovering

class, favorable demographic trends and robust consumption. In providing a fresh impetus to sustainable long-term rapid growth
fact India has strongly rebounded in the last couple of years, with in India.
growth having been recorded at 7.7% in FY2009 and expected to Although the emergence of this new world order as
clock in excess of 8.5% in FY2010. The two major reasons touted a result of the financial crisis has opened up several new op-
Though the advanced economies were recovering, the emerging
for this economic resilience has been the strength of the Indian portunities for the Indian economy, there are also heightened
economies are racing ahead of the advanced economies. The
banking system as demonstrated by strong credit growth even concerns regarding the sustainability of the Indian growth story.
financial markets in the emerging economies are back to their
during the peak of the crisis (24.1% credit growth in FY08 and These concerns are particularly pressing given the heightened
pre crisis level and countries like India have seen record inflows
17.1% in FY09) as well as the relatively lesser dependence of the uncertainty regarding India’s ability to manage natural resource
in the past few months. Not only are the emerging markets a
economy on exports to the Western world. No doubt India came requirements or its ability to initiate widespread governance-
preferred destination for investment but people are touting it as
through the crisis unscathed as a result of fundamentally strong related reform with the aim of securing domestic health, educa-
a major shift in the financial hubs of the world. But critics are
macroeconomic and policy management, both in terms of fiscal tion and infrastructure needs. In this context, the creation of a
questioning whether this growth is sustainable or not.
and monetary policy formulation and implementation. sovereign wealth fund will allow India the much needed financial
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
14 Money Manager / January 2011 Money Manager / January 2011 15

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-
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 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
Continuing on that note, Sovereign wealth funds
in the Middle East and China have consider-
able power in their ability to control the global

number of crisis situations. How do you think currency and bond market. What role do you
the credit crisis has affected this position and think they will play in determining the currency
are there any fundamental macro-economic regime in the future, especially in the light of
Currencies that have dominated world trade have made an exit that has often been preced-
shifts that point towards the same? China pushing very strongly for SDRs.
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 —
In the post-war period, there have always been questions raised

So China’s strategy now is not to push for special drawing rights
its sway is intact. Through this interview with Dr. Arvind Subramanian, a currency expert,
about the dollar as a dominant currency. First the dollar’s role although they did it to send a strong signal. It’s kind of implicit
Money Manager captures his views on the evolution of the currency regime and the power
was questioned in the late 60’s and the early 1970’s and as the that there is a plan to slowly but steadily promote the use of its
balance it will create.
Bretton Woods system broke down, in part because the dollar own currency and China has been doing a lot of things to en-
was very weak and so the American Policy makers felt that they courage the use of its currency in terms of financial co-operation
will not be able to sustain GDP growth and implement the do- with other countries, getting cheaper currencies denominated
mestic policies when constrained by the Bretton Woods system. in renminbi, agreements with a number of countries: Russia,
This was followed by another crisis in the mid 80’s when in Brazil, Argentina and Middle-Eastern Countries. So the Chinese
fact the dollar became strong and in this recent crisis again, the strategy now, of course, is to make Shanghai an international
dominance of the American currency has been questioned and financial centre. China is going to gradually but steadily make
for a number of reasons. This is because the United States being the renminbi stronger and insofar as they have both the eco-
has been the source of the crisis and mismanaged the financial nomic dominance and the reserves (two and half trillion dollars
sector which has made people worry about good policy deci- of reserves) they would be in a strong position to make the
sions. As a result the US fiscal situation has deteriorated quite Renminbi strong.
rapidly and so there are questions about the ability of US to put
its public financing on a sound footing.
With nearly two and a half trillion dollars of

reserves invested in US Dollar denominated
I don’t think the outside securities, how do you think China’s dollar trap
world can bully or coerce coupled with the Current real estate bubble will
play out in the near future?
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
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
irony of course is that even though the crisis originated in the one year, China has been absolutely adamant and stubborn in
United States, in the initial phase of the crisis, the dollar actu- not changing its policy. It has found that having an undervalued
ally strengthened, because people said “Oh my God! The world exchange rate has helped its long run growth. So it’s going
is collapsing but the safest place in the world is United States” to stick to its strategy until it feels it is in its own interest to
and now, of course, the crisis in Europe is deepening and people change the strategy and insofar as issues like overheating and
do think that, “Well certainly compared to Europe, the US still bubbles building up are concerned, it will use other instruments
Arvind Subramanian is senior fellow jointly at the Peterson Institute for International remains a strong economy with a strong currency”. The huge like monetary policy and fiscal policy to cool down the economy.
Economics and the Center for Global Development and senior research professor at new development, however, that has been changing the stage It will not change its exchange rate policy very dramatically.
the Johns Hopkins University. He obtained his undergraduate degree from St. Stephens is the rise of China and the Chinese currency which I am writing Coming to the dollar trap, I think that the calculations the
College, Delhi; his MBA from the Indian Institute of Management at Ahmedabad; and his about in my next book. So the fundamental shift that has been Chinese have made for the long run is that, yes, there would be
M.Phil and DPhil from the University of Oxford, UK. taking place is the emergence of the Chinese economy and the a huge capital loss on these reserves, but over the last twenty
Chinese currency. thirty years, the higher growth and the higher exports that they
18 Money Manager / January 2011 Money Manager / January 2011 19
have got from this exchange rate policy will outweigh those rate policy but now that’s not going to happen because China is not So what policy measures do you think the major Regional trade agreements have played a
costs that they will have to suffer. In the meantime they will try going to allow it to happen. So the IMF authority, in a new Bretton-
economies of the euro zone should take to ad- significant rule in countering the currency
and do everything to postpone that loss or to reduce that loss, Woods as a super regulator is going to be very limited because on
by diversifying into other currencies or promoting their own cur- major policy issues like currency, monetary policy and regulation 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 of the financial sector, the big countries will not want to give away
prevalence in growth of such regional trade
avoiding it. But the long run calculation is that it’s a price worth the authority or the sovereignty to do so. China is not going to give
paying for the higher exports and the higher growth that has away the authority to determine its exchange rate policy to the IMF Well, first of all, many of these debts will have to be written
agreements and free trade agreements will
been caused over the last 25-30 years. as a super-regulator - No more than the US will be willing to give off. I don’t think Ireland, Greek, Spain & Portugal will pay off the decrease the impact of one single currency
away its monetary policy authority. So that’s not going to happen. debt that they have. So what Iceland did was to repudiate all its
Therefore, as a super-regulator, I think the role is going to be much foreign debt or most of it and Iceland bounced back. So first the
holding’s sway over the world trade?
Prof. Roubini’s prediction of an impending cor- more along the lines of what it has been doing will be limited and debt would have to be brought down to a manageable level which
rection is very much linked to the Chinese dol-
relatively ineffective. means that the Germans and the French will have to expect that
their banks which have lent to these countries will also have to —
lar trap and the heating of the Chinese economy. With the Greece crisis, the reputation of euro as 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
With QE2 and easy credit, do you think there a chief trade currency has been severely af- 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
will be a medium term correction in the dollar fected. What do you think will be the impact of the 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 next couple of quarters? stretched economies, like the PI(I)GS in the Euro 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 The troubles in these countries are far from over. Not only are they
question. It’s true that the IMF has been strengthened but it’s far from over, people think that there’s no real light at the end of the
basically been strengthened to provide money to countries that tunnel for these currencies. The only way to come back on a sound
encounter a problem. There is no assurance at all that IMF will footing is to make it grow and get rid of this huge amount of debt
be given the task to be a super regulator and that it will be ef- that their governments have taken on. So unless some resolution is
fective in being the super regulator. One of the tasks that people sought for the problem of the peripheral countries, the whole fate of
want to give it that it should determine what the currency the euro as a currency and the euro-zone, as a project of economic
value should be between the different countries. For example, integration, is in question. Unless, some drastic solution has been
it should have the power to tell China to change its exchange found, I don’t think that’s going to change.
20 Money Manager / January 2011 Money Manager / January 2011 21
Since the termination of Gold Standard, the USD Prior to the European Crisis, south-east Asian
has been the base for international currencies. economies had been working towards estab-
However, with the US deficit increasing and also lishing a single currency. As of now, the pro-

QE raising concerns over the strength of US cess seems to have been halted. What would
Dollar, how do you think the role of US Dollar will be the advantages for these countries to move
change? ahead with this monetary integration, and do

The Currency supremacy issue has swayed considerably over the last year – just when —
The dollar remains the world’s pre-eminent reserve currency by
you think after what we have seen in Europe,
they would move ahead?
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
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

There is little political support for such a project today, and the
sat down with Ritesh Dutta of UBS to discuss the Sovereign Debt Crisis in Europe, China
EUR-denominated reserve assets has declined materially. While Eurozone crisis has probably undermined the entire process. All
and the G20. The excerpts follow.
Special Drawing Rights (SDR) are increasingly viewed more favour- is compounded by the tendency for local governments/central
ably, there is scant liquidity available. [The currency value of the banks to see currency devaluation as a mechanism to increase
SDR is determined by summing the values in U.S. dollars, based on competitiveness. Of course, if you are a member of a currency
market exchange rates, of a basket of major currencies (U.S. dollar, union you forgo this option - but never say never!
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 Despite the international pressure and increas-
nobody’s interest to rock the boat. After all, it was the intervention
of emerging markets to control the value of their currencies which
ing US efforts, China has de facto maintained
got themselves into this mess in the first place, so they should not its stand on keeping Yuan undervalued. Also,
heap all the blame on the Fed and QE.
China has over $1.5 trillion worth of US trea-
suries and has retained its position as a major
Prior to the crisis, there were increased specula- buyer during US Treasury auctions. With this
tion of Euro assuming a prominent position as in mind, do you think that there is any possible
an international currency and countries such as economic way that US can influence China to
China had started building reserves of Euro. Now appreciate its currency?
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

Notwithstanding any protestations from the Fed, the US has al-
ready exerted influence through quantitative easing - albeit that
in the near future? the transmission mechanism is subtle. Soon after the launch

It is too early to tell, but conditions in the Eurozone are likely to
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
deteriorate before they improve, and the governments in the region a priority, but the authorities there will also be anxious to avoid
know this. UBS is calling for fiscal guarantees, which we believe a collapse in asset prices. In light of this, we do not expect ag-
to be the basic building blocks of fiscal union, to be in place by the gressive interest rate hikes. This just leaves the CNY as a tool,
end of this year. Without movement towards fiscal convergence it’s and it’s about time it was applied.
going to be very hard for the Euro to maintain credibility.

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 Money Manager / January 2011 23

In the last two years, G20 has increasingly In the light of all the regulatory interventions
supported SDR as the international reserve that are taking place (such as rate cuts, re-
currency for the future. With concerns over serve enhancements etc.), do you believe there
both USD and Euro, do you think a currency not
controlled by any single country, rather than
should exist “Global guidelines” for capital flow
controls that every nation should adhere to, as IS THE INNOVATION TREND TRULY OVER?
by a multilateral organization like IMF could suggested by the IMF recently?
emerge as the preferred currency for interna-
tional transactions? —

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
The SDR is not a transaction currency – it operates on a claims
are only cautiously optimistic at this stage. It is about politics
basis and supply is determined by special allocation which
as much as economics. Emerging market countries may be
involves a high level of bureaucracy. Given that the US has a
warming towards current account targets but, as we saw at
blocking veto over any IMF decision, we doubt that it will be

the November G20, they managed to get the developed world
considered a viable alternative. The IMF is not a settlement
to agree to tolerate short-term capital controls as well. In par-
bank. Simply put, the discourse has not advanced far enough for
ticular, with the US still engaged in QE and other major central
people to consider alternative reserve/international currencies.
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”

24 Money Manager / January 2011 Money Manager / January 2011 25

Post crisis how has the attitude of clients Has Citi’s geographical focus changed in re-
changed towards structured products? How has sponse to the crisis?
Citi’s portfolio of products evolved in response

to this shift in attitude? Yes and no – Citi is still very committed to Asia as a whole, but

The onset of the financial crisis resulted in a decrease in activity
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
across all investment products, not just structured products, as Taiwan where the regulatory response has been much stricter,
The global economic crisis of 2007-08 has significantly affected the financial landscape in risk aversion increased and people looked to invest only in safe markets are still closed, and as a consequence our focus has
terms of the nature of financial products which will be traded in the markets in the future. assets. Once the markets started to settle down and risk aver- been reduced. In India, our volumes are down from 2007, but
As the markets continue to be uncertain about the nature of recovery, the Money Man- sion decreased, we saw people broadening their range of in- this decrease is not due to a fall in investor demand, but due to a
ager team sits down with Dr. Harold Kim, to discuss how he sees the overall landscape vestment products, understandably beginning with products that decrease in our capacity to issue product.
for investing in structured investment products shaping up. 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 Given investors’ preference for simpler prod-
to simple vanilla products. What was interesting about this
process was that, in some markets, we saw reacceptance of
ucts, going forward, do you see the financial
products which are relatively exotic and structured to a reason- services industry continuing to be a hotbed of
able degree. Asia was not hit by the crisis as heavily as the
developed world, and by some measures the level of structured
innovation in product design?
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

There has been a lot of talk about the preference for simpler
markets are very strong, and we are seeing strong appetite for products, but if you look at our business as it has evolved from
structured products. In fact, we have a capacity constraint in 2007 to now, we actually have a large percentage of business
India where as soon as we have capacity to issue a product, being done in what would be considered complex products. The
the product is taken up. So if you compare investment behavior difference is that, these complex products are simple for the
pre-crisis and what we are experiencing now, with the excep- customer to understand. I think this trend will continue.
tion of some countries and client segments, it’s actually not that For the last 30-40 years, the financial services
different in Asia. For structured investment products in Asia, the industry has been an industry focused on innovation, driven by a
reacceptance of these products has been quite fast. variety of factors. Crisis and regulation breed opportunities for
What has changed is that the product mix has innovation. Demographic trends breed opportunities for innova-
shifted towards what people view as the asset class with the tion. If you think about Asia right now: where we stand in terms
most favorable risk versus reward ratio. Immediately after the of demographics, over the next several decades, Asia is going to
crisis hit, the volume of equity products, which traditionally has get older, it’s going to get richer and get more middle class. At
been the largest asset class segment, dropped in favor of fixed the same time we have very underdeveloped capital markets to
income products. We saw a rapid increase in simple credit and enable this increasingly wealthy middle class to invest and save
rate products. Now, with the equity market strengthening, that for retirement. As a result, we are going to see a real increase in
shift has gone back towards equities, though the mix is not capital market innovation to satisfy this huge oncoming demand
as skewed as it was pre-crisis. I would estimate our pre-crisis for retirement products. The products will not be limited to
product mix to have been about 85% equities products and 15% vanilla equity and mutual funds, but will include more complex
FICC products. If we look at our current product mix, it is roughly structured product solutions that will deliver good long term
60% equities and 40% FICC. Equity still represents the major investment value. We are at the cusp of another wave of very
asset class, but credit and rates in particular and FX have gained productive innovation.
wider acceptance in terms of structured products.

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
“ With the equity market strengthening, that shift has gone
back towards equities, though the mix is not as skewed as it
was pre-crisis

(a predecessor of Citigroup) in 1993, and has since served in a variety of capacities at

26 Money Manager / January 2011 Money Manager / January 2011 27

There are some substantive changes in regula- 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
tions related to trading of financial products and -- regulatory guidelines got too loose, credit standards were too
managing financial intermediaries. In the past lax, risk management fell apart, rates had been kept too low for

too long, rating agencies did not do their jobs, etc. The financial
we have seen new structured products emerge crisis was not caused by any one event or factor, but by the
in response to regulatory changes. How do you interaction of all of these events and factors. There was a regu-
latory change in the US to encourage home ownership. Since it
think changes in the regulatory framework will was a political imperative, the banks got involved, the Fed kept
affect financial innovation going forward? 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

That’s a hard question to answer right now, because the
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
regulatory environment is still changing. A good example is 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-
what is going on in the US. The Dodd Frank bill has outlined the environment is causing numerous challenges for investors. For
tives markets. The following are excerpts from an interview with Team BETA.
intended guidelines for the new regulations, but the actual rules example, interest rates in Hong Kong are at or near 0%, and not
have not been determined yet, so it’s very hard to say how the surprisingly people are looking for innovative investment ideas
industry will respond. 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,
Do you feel that there would be a preference for that are overused or misused can become harmful, including
derivatives and structured products, which are powerful tools
specific products given the Dodd Frank Bill or but sometimes easy to misuse.
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.
“ The financial crisis was
not caused by any one event or
factor, but by the interaction of
various factors

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 Globally we have huge disparities in economic growth rates right
with you. Given your intended audience, there is one point that now between developed and emerging markets. We have lots of
I would like to leave you with. I talk to journalists quite a bit, liquidity being created. In Asia, we have a demographic problem
and they invariably ask similar types of questions. In general, that will manifest itself over the next 20 to 30 years. As we
people are always looking for a simple solution to the problems move forward and look at how to solve the financial problems
at hand. “Leverage is bad. We should get rid of it.” “Derivatives we are facing, it is innovation and derivatives and structured
are bad. We need to get rid of them.” But in fact, markets are products that will actually help us remedy these imbalances,
more complex than that, and simple solutions are not available. 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-
As MBA students, you need to understand that complexity. 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
When you address the question of what caused the financial 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
crisis, “Was it derivatives? Was it the hedge funds?”, it is very have in the recent past, and looking forward, capital markets also held important teaching positions at Stern and Anderson (UCLA). He completed his
easy for the press and the public to assign blame and demon- will only be an enabler of future growth. PhD from MIT in 1989.

28 Money Manager / January 2011 Money Manager / January 2011 29

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
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
In the backdrop of the global financial crisis, -Instituting a macro-prudential approach to supervision and as-
signing a clear mandate to a systemic stability regulator.
has there been a significant change in the
overall approach to the regulatory framework -Expanding the perimeter of financial sector surveillance to

ensure that the systemic risks posed by unregulated or less
governing the financial services industry from
regulated financial sector segments are addressed.
the RBI’s perspective?
-Ensuring that prudential regimes encourage incentives that sup-

If the financial crisis has done anything, it has definitely brought into focus the role that

The financial services industry in India operates in a very differ-
port systemic stability and discourage regulatory arbitrage, and
assure effective enforcement of regulation.

central banks and regulators play in ensuring the financial health of the economy. The RBI ent context compared to the developed markets, which were the -Improving the capacity of national authorities to respond to
has been at the forefront of laudable policy decisions that have kept the rupee in check as epicentre of the crisis. There is no doubt a fundamental shift in systemic crises, including by establishing mechanisms for
also ensured that the financial markets have grown steadily. We take Smt. Shyamala Gopi- the regulatory approach towards the financial sector globally coordination both within and across borders.
nath’s views on the problems she foresees going ahead and on international collaboration and the jurisdictions worst affected by the crisis have already
moved ahead in strengthening the regulatory framework. Many -Strengthening the OTC derivatives market and incentivizing
for financial markets regulation.
of the issues are also getting discussed/pursued at various moving standardized products onto exchanges
multilateral fora such as G20, Financial Stability Board, Basel
Committee on Banking Supervision, International Accounting In contrast, regulatory role played before the crisis was basically
Standards Board etc. in which India is a key member. minimalist in nature, focused largely on individual institutions,
RBI’s regulatory approach in the near future would be segmented in scope, done in silos displaying undue faith in the
significantly conditioned by the guidance issued by these bodies market discipline, devoid of any big-picture awareness on the
on a variety of issues such as capital adequacy, provisioning, part of the regulators. The overall framework came to be known
liquidity risk management, systemic risk regulation especially as light-touch regulation focusing on individual banks and
the macro-prudential regulation, regulation of compensation institutions, disregarding the interconnectedness among these
practices, regulation of securitisation activities, etc. entities and the systemic risk the interconnectedness could pose
Quite apart from the global agenda, there are vari- to the financial stability. The potential adverse implications of
ous India-specific issues that will be addressed, particularly in fallacy of composition were completely ignored.
regard to strengthening the regulation of NBFCs and enhancing
transparency and mitigating risks in the OTC derivative markets.
Despite the crisis, several observers warn
What do you think will be the primary task that the nature of systemic risks in emerging
which regulators worldwide will seek to ad- market economies is different from those of
dress in the future as a sense of calm and the developed world. In fact there are already
reason returns both to the financial markets as whispers of the possibility of asset bubbles in
well as the overall economy? How would you this part of the world given the global imbal-
contrast that to the nature of the regulatory role ance of capital flows. How do you think regula-
played before the crisis? tory policy should respond to such heightened
risk perceptions?

The primary task for the financial sector regulators, and which is —
already happening, is to reorient the regulatory and supervisory It is true that the nature of risks faced by emerging countries
frameworks and correcting the misaligned incentive structures is different from the developed countries. The RBI has recently
for the industry. The objective is twofold: one, reducing the come out with its 2nd Financial Stability Report which brings
probability of occurrence of systemic crisis and two, containing out the nature incipient risks. The Report notes that the tail
the impact of such a crisis, if and when it happens again. risks to financial stability are largely exogenous given increas-
The following initiatives have been initiated ing correlation between global growth and growth in EMEs,
Smt. Shyamala Gopinath is the Deputy Governor of the Reserve Bank of India. Smt. Gopi-
internationally in this regard: including that in India. The finance channel has assumed greater
nath has handled some of the critical portfolios in the Reserve Bank, such as, financial
importance increasing the pace and degree of contagion from
markets, including regulation and management of government debt and exchange rate,
-Strengthening the Basel II capital adequacy framework and disturbances abroad. If recovery is derailed in the advanced
management of foreign exchange reserves, and banking regulation and supervision. economies, it will be difficult to remain decoupled notwithstand-
introducing liquidity measurement standards.

32 Money Manager / January 2011 Money Manager / January 2011 33

ing the domestic orientation of economic growth. Similarly, busi- At a time when the entire world is shying away Market observers have said that we need to
ness cycle synchronisation of the Indian economy with most of
the advanced economies and EMEs has increased.
from the concept of securitization, given the develop robust secondary corporate bonds
The policy agenda in most EMEs in recent months has been legacy associated with it over the last two years, market and structured products market in order
dominated by the management of capital flows. India’s dilemma
is somewhat contrarian to this. Our concern has been not so
you have advocated the idea of “sustainable to create a strong financial market ecosystem
much the quantum of flows, which we have been able to absorb securitization” in India. Can you explain how do in India. How would you respond to this demand
because of the widened current account deficit, but rather the
nature of these flows. Much of the capital has come in the form
you see securitization as a concept pan out in the particularly in the light of the crisis?
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.
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
On the asset price front, housing prices have risen sharply in product design? keeping in consideration the overall macroeconomic stability.

especially in some pockets and the sector remains susceptible In respect of all the markets mentioned by you, we have been
to asset price bubbles driven by capital flows. Credit growth constantly endeavouring to develop viable frameworks. After
remained healthy and alluring housing loan schemes continued introduction of 10-year IRF, products for different maturities are
The principle and economic rationale of securitization is indeed
to be offered by the banking sector. Against this backdrop, the 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
Reserve Bank has tightened the prudential norms (LTV ratios and is proposed to be allowed while trying to address the downsides.
fundamental requirement in a growing economy like India. However,
risk weights) for housing credit. 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
As the world emerges from a crisis which has 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
been attributed primarily to shortcomings in 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
regulatory oversight, how do you see regula- securitization
tory authorities’ worldwide respond and shape Securitization framework in India is considered to be rea-
sonably prudent and not overregulated. RBI guidelines on Securitiza-
policy going forward? Do you see greater tion issued in February 2006 are applicable only to standard assets
international collaboration amongst regulatory which ensure that securitized assets are healthy and performing
at the time of securitisation. Besides, there are built in prudential
agencies to respond to an increasingly global- measures to contain risks.
ized financial system?

-Firstly a prescribed stringent criterion for “True sale” of the asset
ensures total proper de-recognition thereof from the balance sheet
of the originator.
Greater international collaboration is already happening as far
as etching out the regulatory agenda for the global financial
-Secondly, RBI consciously discouraged securitisation to be used as
system is concerned. The proactive initiatives taken by the G20
mode of profit garnering by improper valuation. Thus, profit is not
in the immediate aftermath of the crisis laid the foundation for
allowed to be recognised upfront, but has to be amortised over the
developing a framework for repairing the financial system in a
period of securities.
globally coordinated manner. However, let me add that while
broader alignment with the international standards will be
-Thirdly in order to discourage originator to have further interest in
imperative, the local jurisdictions will need to have the space to
the securitised asset, stringent measures are prescribed for treat-
frame policies and take suitable actions in their own context.
ment of credit enhancement when provided by the originator.

-Fourthly, adequate safeguards have been built in to ensure that

RBI’s approach has been to credit enhancement provided by originator is not camouflaged as
liquidity facility or any other service provided by originator.

encourage market development Thus, banks in India did not have incentive to resort to unbridled
securitisation as observed in “originate-to-distribute” and “acquire
keeping in consideration the over- and arbitrage” models of securitisation in many other countries.
Recently, additional norms have been proposed requiring a mini-
all macroeconomic stability

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.

34 Money Manager / January 2011 Money Manager / January 2011 35


new regulation

THE NEW ENVIRONMENT 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
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

additional regulation and opportunities

was the passage of The Banking Act of 1933, a law that estab- for a council to address risks posed to the economic stability
lished the Federal Deposit Insurance Corporation (FDIC) in the of the US by large interconnected financial institutions both in
United States and introduced banking reforms, some of which and outside the financial markets, promote market discipline by

driving strategic changes were designed to control speculation. This act is most commonly
known as the Glass–Steagall Act, after its legislative sponsors,
dissuading financial market stakeholders of the idea that the
federal government will protect institutions from losses, and
Carter Glass and Henry B. Steagall. respond to emerging threats to the US’s financial stability.
Everyone thinks about restrictions the moment you mention Basel III and Dodd-Frank. But One of the most important elements of this law One of the primary pieces of the Dodd-Frank regula-
Steve Young sees it as an opportunity – an opportunity to define new growth paths and was to separate investment banking and commercial banking tion was the increased reporting both by companies who were
develop new strategy. He argues, in his article for Money Manager, very cogently as to functions in order to prevent speculative activities by financial already subject to a significant amount of reporting and those
how the current financial regulations are designed not to stifle financial services firms but institutions. Some provisions of the Glass Steagall Act, such who were exempt. Exempted organizations now required to
to help them carve their niche in the market. Read on to find out more. as Regulation Q, which allowed the Federal Reserve to regulate report range from hedge funds to bank holding companies and
interest rates in savings accounts, were repealed by the Deposi- could go as far as divisions of larger more complex institutions
tory Institutions Deregulation and Monetary Control Act of 1980. like GE Capital. All those mentioned are subject to differing lev-
Then, provisions that prohibited a bank holding company from els of scrutiny based on business, interrelationships and amount
owning other financial companies were repealed on November of risk posed to the greater system.
12, 1999, by the Gramm–Leach–Bliley Act. These changes along In addition, the recently passed financial overhaul
with other deregulatory actions during the same time period requires commercial banks to jettison any proprietary trading
effectively allowed commercial banks, investment banks and they undertake with their own capital, including bets on com-
insurance companies to begin directly entering each other’s core modities. Some large financial firms are already moving to close
lines of business. In addition, during this same time, new entity down proprietary trading operations after more than five years
structures such as hedge funds and private equity firms emerged of rapid expansion. The bill gives banks nearly a decade to end
and grew rapidly in a largely unregulated manner. speculative derivatives trading to comply with the so-called
As a result, in the years leading up to and including Volcker Rule, named after former Federal Reserve Chairman
the financial crisis, the financial services sector was character- Paul Volcker who first proposed it. The exits by J.P. Morgan
ized by an almost “Wild West” strategic approach. Whatever Chase & Co.’s and Goldman Sachs Group Inc. from proprietary
line of business was fast growing and seemingly profitable trading represent a quick strategic shift and sent a message that
quickly attracted new firms. Regional commercial banks merged Wall Street banks are moving quickly to comply with tough new
to become national money center banks. Larger commercial market regulations.
banks acquired regional, well respected investment banking J.P. Morgan has already informed roughly 20
firms and began underwriting new securities for their com- commodities traders on the bank’s proprietary desk that their
mercial clients. Investment banks started private equity firms. jobs are being eliminated, according to a person familiar with
Junior partners at bulge bracket firms left and formed hedge the matter. Goldman Sachs has decided to close its principal
funds and raised billions of dollars almost overnight. Mortgage strategies unit, which does its proprietary trading, according
brokers popped up on every city block and grew like weeds hid- to someone familiar with the situation. However, a permanent
den within the shadow banking system fed by investors’ never reduction in speculative activity isn’t in cards. Hedge funds and
ending appetite for high yielding securitized investments. Large other investment groups are expected to fill some of the void,
insurance companies merged with large banks to offer all types and analysts are hopeful that rules will still allow for banks to
of financial services to Fortune 500 clients. Old line investment serve clients. Regulators haven’t comprehensively defined what
banks transitioned from partnerships to public companies and constitutes “proprietary” trading, which is often intertwined
in doing so raised tremendous amounts of capital. In summary, with deals done on behalf of clients, transactions still allowed
Steve Young, a professor at Fisher School of Business, started his career in public ac- many financial service firms’ strategy was to be a “one stop under Volcker Rule.
counting and worked on Wall Street with Salomon Brothers. He has also worked with shop” for some targeted segment of the market as the industry
Banc One Capital Markets, Stonehenge Partners and Century Surety Group. He holds a experienced a deregulatory and business friendly environment
bachelor’s degree in accounting from The Ohio State University and a master’s degree in buoyed by a steadily growing national economy.
finance from the Harvard Business School

36 Money Manager / January 2011 Money Manager / January 2011 37

new strategies
and opportunities
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
of IndyMac Bank one of the biggest bank failures in U.S. history
to a team of high-profile investors, suggesting there is private

In this new regulatory and slow growth economic environment,
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-
financial services firms will choose strategies that fit best with ers, hedge-fund investors George Soros and John Paulson, and
their relative competitive position within the industry. Many 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-
firms will focus on a “hedgehog” strategy and concentrate on capital toward a purchase of IndyMac Federal Bank. prime mortgages …” Think again. This is what Prof. Viral Acharya had to say to Money
core competencies while divesting ancillary business units. 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
For example, commercial banks will return to their credit roots many firms, like Goldman Sachs, have raised huge amounts of
Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance”. MM
with traditional lending activities. Also, high profile firms such 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-
as Goldman Sachs are likely to return to strategies focusing on of business that prove profitable and can provide a sustain-
cial markets. Read on.
core functions such as traditional investment banking services able competitive advantage. The shadow banking system is
like underwriting securities and mergers and acquisitions, temporarily dead on its feet, but do not be surprised if it comes
while jettisoning activities like proprietary trading in order to back to life as part of investment banks, hedge funds and other
comply with new regulations and repair their public images. financial firms’ strategies when the public outcry over the recent
At the same time, firms like State Street and BONY Mellon financial crisis subsides as government officials move onto the
will continue with their laser like focus on fee based services next national crisis and the seemingly always short memories of
such as custody and wealth management which served them investors quickly fade.
well during the financial crisis. In addition, all strategies In summary, the future strategies of financial services
adopted by financial services firms will need to provide for a firms from commercial banks to hedge funds and everyone in
rebuilding of adequate regulatory capital levels and a repay- between will vary depending upon the ultimate outcome of the
ment of TARP funds where appropriate. new financial regulation and each firm’s relative position within
the financial services industry. For some larger firms, this will
In contrast, hedge funds and private equity firms mean a return to core operating strategies and historically profit-
will set strategies that seize on new market opportunities able lines of business that will provide for a restoration of much
created by the financial reform. For example, lines of business needed regulatory capital. However, for other smaller and more
that have fallen from the larger firms or the shadow banking nimble firms such as upstart hedge funds with immediate access
system, will likely end up with newly formed hedge funds that to vast amounts of capital, their strategies are likely to focus on
find a way to remain lightly regulated. Furthermore, private opportunistic niches that have been created by increased regula-
equity firms will invest substantial funds in troubled financial 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.

38 Money Manager / January 2011 Money Manager / January 2011 39

The dodd-frank act and the new architecture of Post the financial crisis, there are many new What in your view are the key elements of sys- What do you think would be the effect of the
global finance regulations that have come up with the most sig- temic risk which still remain? Dodd-Frank Act on Emerging Markets?
Prof. Viral Acharya was in India to give a talk on the new book
that he has co-edited -“ Regulating Wall Street: The Dodd-
nificant one being the Dodd Frank Act. What does
the Dodd Frank Act aim to regulate and how?

The U.S housing sector is far from perfect. No measures have

There is no doubt that many Emerging Markets got thrashed
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 —
Post the Financial crisis, it was clear that allowing banks to go
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
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
economy since the Great Depression. The recession, which was
bust was not the right way to contain risk and Systemically Impor- has taken place to some extent, but it may not be enough. Some more obvious that a stable financial sector in the U.S would
mainly the result of the financial crisis which hit the banking
tant Financial Institutions (SIFIs) have to be regulated in a better pockets remain unaddressed like Fannie Mae & Freddie Mac. The benefit all economies in general and help stabilize the financial
system has its roots in the subprime mortgage market which
manner. The Act deems institutions as SIFI, regulates them and importance of small institutions still has not yet sunk in. The Repo world. In my view, the banking sector will be under duress in
crashed following large scale defaults by homeowners.
proposes and orderly liquidation procedures ruling out taxpayer Market, the Money Market still pose a significant systemic risk to the US once subjected to Basel 3 norms when they will be faced
Talking about the roots of the financial crisis, he presented a
funded wind downs and requires that creditors and shareholders the financial system as a whole. The balance sheet of banks still with harsher capitalization requirements while the economy
version different from the popular theories which float around
bear all costs and if necessary ex post levies be imposed on other look fragile and their assets need to be strengthened further. continues to roil. This in my view is an excellent opportunity for
the press today. Regarding the most popular claim, that of banks
surviving SIFIs. There is greater protection for the end users of Emerging Markets banks with a strong capital base to enter the
passing on the credit risk of subprime mortgages to the market.
financial products with the Bureau of Consumer Financial Protec- US. A global M&A could be on the cards. However, all of this
tion writing rules to govern such products & services offered by
Would a system of having ‘Full-recourse’ to the needs to be vetted by the domestic regulators who should feel
banks & non-banks. The Volcker Rule reinstates a limited version assets of borrowers help in preventing or miti- comfortable with such a system.
of the Glass Steagall Act with restrictions being placed on their
prop-trading activities. There are proposed rules for regulat-
gating the effects of such crisis in the future?
What is your view on the reasons
behind the crisis?
ing Over The Counter products, increased transparency in the
positions of banks, separation of non-vanilla positions into well
capitalized subsidiaries.

A few states in America and a number of European countries, do
have such laws which allow full recourse to the assets of borrow-

China’s huge appetite for US Treasury bonds lead to a crowding According to you, what are the elements that are
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
out of investment space for ‘safe assets’. Investors turned to still missing and have not been addresses the ability to borrow more by pledging more assets. Homeowners
other sources, the prime among them being AAA rated products
created by banks which were higher yielding as well. This had so far? are also less speculative while mortgaging their homes or assets.

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 The Act addresses most of the key issues when the Systemic risk
Norway etc). This however is the popular view. Data shows that posed by Too Big To Fail (TBTF) institutions. However, it ignores
around 55% of those MBS tranches were held by banks, broker the other element of Systemic risk, when too many small institu-
dealers and government agencies themselves, which belie the tions fail (akin to the scenario faced during the Savings & Loan
claim that foreign investors were driving up the demand for

crisis of the 90s). The uninsured deposit sector has been left out.
subprime assets. Banks hence did not transfer the credit risk As seen post Lehman bankruptcy, money market funds faced a
to other investors who had the appetite for such ‘AAA’ rated
products. In our view, having a lesser capital requirement for
lot of redemption pressures which were even more aggravated in
the liquidity crunch being faced then. It could have also put a cap
Recent regulations create What are your views on the financial innovation.
AAA assets allowing for higher leverage (c. 5 times) and lax
regulations which allowed Fannie Mae and Freddie Mac to
on the $ amount the Fed can loan to ‘non-banks’. Also, as of now, a moral hazard for banks to Do you think that the markets will continue to
banks have a free put option, wherein they have a free line of come up with new products?
venture into the subprime space were the main drivers behind credit from the Fed when times turn bad without having to pay up not be prudent about their risk

the demand for subprime mortgages. These factors were one of anything upfront. This creates a moral hazard for banks to not be
taking behavior

the major incentives for banks to create more of these structures prudent about their risk taking behavior.
and trade it amongst themselves. Regulatory assessment of risk The first thing which needs to get right is the correct Cost
was also not quite what it should have been. As the total no. of Capital for the financial sector. Risk needs to be appropri-
of assets held by banks grew at a phenomenal space, the risk ately priced and if the risk of collective failure becomes high,
weighted assets grew at a very slow pace compared to that. restrictions need to be put in place. In such a background, if
This indicates a lack of transparency more than anything else. 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.
40 Money Manager / January 2011 Money Manager / January 2011 41
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.
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,
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
Are we going to see a global power shift as sev- Do you see currencies in these markets con-
eral emerging markets continue to outperform tinue to strengthen with respect to the USD in
their global peers financially and economically? the near and medium term and what are some of

RANODEB ROY — the tensions which these currency skirmishes

Yes we believe so. Emerging Markets, especially the BRIC
would create?
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

Asian currencies are still undervalued compared to the USD.
Emerging Markets have been the buzz word for the last 5 years – be it hedge funds, PEs and Australia to begin with will lead this power shift. Based on pure fundamentals, as well as trade surplus and capital
or sovereign wealth funds – these markets have been the watched keenly by investors of flow trends, AEJ currencies should appreciate against the USD.
all colours. Investment Banks have also made strong inroads into capturing a part of the This could lead to a lack of perceived export competitiveness,
value in the financial markets in emerging Economies. Money Manager sits down with What kind of finer issues such as fiscal policy, and some central bank intervention to make the strengthen-
Ranodeb Roy to discuss Morgan Stanley’s take on how the emerging economies’ story regulation of financial markets and firms, as ing slower, but the general trend will be intact. However, it is
will shape up on key macroeconomic indicators. important to take the value of the EUR into context as often the
well as general governance standards will play a trade weighted index for AEJ currencies need to be taken into
account and EUR is an important trade partner. If EUR weakens
crucial role in driving sustainable growth in significantly against the USD, it automatically re-values Asian
EM economies? currencies against the trade basket.

Apart from the ones mentioned above, there are also other factors
Will the shortcomings in innovations in struc-
which will play an important role such as Monetary policy, Trans- tured financial products limit the financial
parency, Openness to capital and current account flows, Opening
currency to market forces, Controlling corruption, Controlling
growth of the emerging markets? What are
Inflation, increasing labour and service sector productivity and some of the economic reforms which are neces-
stability of government.
sary for increasing the financial stability along
with deepening and integrating them?
How far do you believe in the Asia decoupling
story with reference to its economic growth and —
Not in my opinion. Innovations in securitization are growing
its markets? What are some of the broad macro- hand in hand with development in EM. Microfinance is a good
economic factors which can upset the growth in example. Capital account convertibility, free float of currencies,
ability to use derivatives for hedging, broadening of the securiti-
the coming years? zation market and development of a liquid corporate bond market

Asia (ex Japan) - AEJ is intertwined with the global economy. As
are some measures that will help in deepening and integrating
the financial markets in EMs.

of now growth in AEJ cannot offset shrinkage of Europe and US,

but the linkages will be increasingly decoupled. Ability to control How do you see the balance in banking and
inflation, prevention of over-heating in certain sectors of the
economy such as resources, construction and housing, run-away
markets in India evolving in the coming years?
over–lending, unfettered growth of consumer finance (keeping
it in line with income levels), environment and health care may
impact growth in emerging markets. —
I think both will increase, with markets gradually taking a bigger
role. Look at the growth of the mutual fund and insurance sectors
Mr. Ranodeb Roy is the Managing Director, Head of Interest Rate Currency Credit, Asia in India. It has totally transformed saving habits and grown with
Pacific in Morgan Stanley. Prior to joining Morgan Stanley he worked at the FICC group the market.
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 Money Manager / January 2011 45

What are your views on the real estate bubbles China, Russia and India have recently started
in emerging markets especially in specific adding gold to their reserve buckets. Do you
pockets of the AEJ region? see any implications of the changing reserve

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
There is a huge demand-supply gap in quality housing in high this kind of lending is important to jump start certain aspects of uninhibited.
demographic countries such as India and China. As a result public infra-structure spending. As long as Banks have pruden-
potential bubbles may arise in certain areas, but the market tial norms, and stay away from speculation, it could be under
dynamics and timely intervention from regulators will by and control. Eventually when growth slows, it could lead to NPA in
large control them in Asia. 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.

46 Money Manager / January 2011 Money Manager / January 2011 47

The recovery from the financial crisis seems So, I think the combination of lack of reforms and the One of the central themes of 2010 was the India’s GDP growth target of 9% for this decade
lack of an equity retail culture have really kept our markets rath-
lop-sided in nature with most emerging mar- er shallow. But they have pretty high velocity as against depth,
devaluation of the US dollar relative to several is heavily dependent on industrial growth and
kets returning to pre-crisis levels of growth as and, the velocity is high because of the nature of investors. emerging market currencies, raising concerns infrastructure. Non-Govt equity investments in
While you may have few classes of investors, they are pretty
opposed to the developed world. How do you trading oriented. And, of course, the FIIs which are coming on
on capital inflows spiking valuations as well as India have been consistently low, what would
read this growth imbalance from the perspec- the back of relatively inexpensive money tend to trade a little hurting the competitiveness of export-oriented you attribute that to? What financial market
more. So there is no doubt that there is a build-up of foreign
tive of the emerging markets? holding in India which is a good sign. It gives the impression
industries. How do you see this playing out reforms are required to bring in more private

— of a very throbbing primary and secondary market. But frankly, ahead and what should be the role of the regu- equity and foreign equity investments?

When you get down to looking at the breadth of investors, type
Yes, the crisis has been very lop-sided in its impact. The domes- of investors and the size of the deal you can get done, they are
lators in this regard?
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
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

I think this is a question everybody is struggling with. We have
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
have attracted a lot of capital and that has propelled growth keep the exit in mind. Be it 5 years, 6 years or 10 years later. seen different regulatory responses from different countries. My
to be able to tap local savings into the real sector. That should
as well. Thirdly, almost all the emerging markets are partially sense is that emerging markets have got an emerging problem
be high-priority. Bond markets are pretty underdeveloped
closed economies. They are not all open on the capital account of how to tackle inflation. They are to an extent fighting inflation
for many reasons – one of the key being that we have a very
and therefore, they have not been as impacted by the crisis as Sustained periods of low interest rates in the by increasing rates. So if you take the system intervention route
overbearing government deficit and a very heavy borrowing
others except to the extent of capital flows that have gone out by increasing rates, it should work the way theory would work,
of the equity markets. Secondly, if you are export oriented like
developed world have resulted in speculation- which is - increasing rates would slow down the growth in these
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
SE Asian economies, you got hurt. But other markets including driven surge in commodity prices in the last economies and then the relative advantage would come down.
step wise reduction of the fiscal account and you open up the
India have been pretty insulated from that. The recovery has, Increased rates can also attract increased flows! But everybody
therefore, been faster and given the demographic shift in local
quarter. How serious is the threat of inflation to is tackling it differently as every country has its own uniqueness.
insurance and pension sector, you would find a very meaningful
shift of savings into the real sector. But for that, you need to
consumption, it is bound to show up in robust growth numbers. emerging markets? The issue in India is however one of not having ad-
create the right set of instruments - corporate bonds, municipal

equate absorptive capacity. But we have a large current account
bonds and infrastructure bonds. So there is a whole regime of
deficit which probably needs these flows. In a way we have a
debt market reforms that needs to be created.
What are your views on the extent of develop- My personal view is that easy money from the west does cre-
financial imbalance with a large current account deficit. So, the
The second thing is that there are certain sectors
flows are helping us. My guess is that we have chosen to not
ment of secondary market in emerging econo- ate a relatively high degree of capital flows into the emerging
put any tax measures or gate keeping taxes but other markets
helping which will help improve financial services and those
markets and all markets are tackling it differently. If there is are – the banking and the insurance sector. For whatever
mies? Primary market for equities, in some an absorption capacity in the economy, you can absorb these
like Brazil are contemplating such a move. Thailand is going to
reasons they have been kept shut for really long but they need
do something. Different markets are reacting differently.
countries even debt, is reasonably well-devel- capital flows as long as they are going into creating real assets.
The regulators should take a balanced view between
to get opened up because not only will this bring in high quality
So if somebody is raising money for a new factory, doing a long term capital but also excellent business practices and
oped. But without a strong secondary market rights issue, doing a secondary offering, starting a new project
a few issues – what volatility can they live with, where are
better practices in risk management, innovation and it will drive
the flows going – are they creating real assets or speculative
for securities - how will foreign investors and and as long as the money is finding its way into real assets after
assets, and thirdly, do they have a strong enough financial
better risk allocation.
the initial deleveraging is over, then I would say that you have a I think the third aspect is one of financial inclusion -
PEs hedge investments? pretty decent absorptive capacity. But if you don’t have absorp-
sector which can withstand a dramatic outflow. Finally, exports
how do you extend banking, insurance wealth management to
are important but fortunately or unfortunately imports are also

tive capacity which I believe is India’s case mainly due to lack of a larger audience in India. For that you require reforms again.
critical for us. It depends upon the priorities of the government.
reforms, (evidenced by a pretty low capital expenditure to GDP This does not necessarily mean giving new bank licenses – we
If you want to keep oil prices down in rupee terms, you are hap-
and a low spend on physical infrastructure) - then it is an issue. need a paradigm shift in two aspects.
I do not think any of the emerging markets have really well de- pier having an appreciating rupee but if you want to encourage
When that happens and the flows just keep coming in, they find
veloped capital markets. Let’s talk about India. In India we have exports, you are happier having a depreciating rupee.
their way into commodities, real estate, currency and the stock 1- We do pre-empt a lot of banking liquidity into preferred
a very broad based equity market but not very deep. Besides
market. So, it begins to inflate asset values without creating real sectors like priority sector lending, agri-lending, exports and
being broad based in terms of the number of companies, it is
assets. So I am not sure if it is a bubble or bubble magnitude government deficit. We have to cut that down and move the
pretty shallow in terms of floating stock and the type of inves-
but there is no doubt that the valuation of assets, be it currency, burden away from the financial sector so that the money can be
tors is quite limited. FIIs are a pretty significant contributor at
equity, commodities or real estate is obviously much more than made available to the real sector.
the margin, but the retail investment in India is no more than 6%
what it should be. China is absorbing these flows well because
of the total household savings. Pension and insurance money is
they are creating a lot of assets. I think other markets have 2- The second shift that we need to do is make some of India’s
not even worth talking about.
some form of capital controls and taxes. But in India we have banks bigger. You cannot have a small State Bank of India. By
not done any of that. 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.

48 Money Manager / January 2011 Money Manager / January 2011 49

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.
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
Although the Indian financial markets have been The critical factor in the boom in India has been
resilient to the financial crisis, there have been the supply constraint – the growth has been
several aftershocks in the last couple of years. demand led, which is affecting the prices and

Could you please explain the structural fallacies the inflation has been up and down. How does
that have resulted in a critical impact on the this portend for India in the next few years as
real economy? If this trend is to be maintained, an emerging financial market as against China,
how will this affect the evolution of the credit whose growth is pretty much supply driven?
The ‘India Decoupled’ story on the face of it looks rosy and hints at the resilience of
markets in India?
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 — —
This is a crucial difference between China and India. Because In-
Over the years, India’s policymakers have designed a financial dia is chronically short of supply, the lack of demand, especially
India should strengthen its macroeconomic fundamentals to evolve a complete financial
system that operates in silos. This was done in order to provide foreign demand, is not that much of a binding constraint. This
markets ecosystem.
stability to the financial system by ensuring that shocks in one is a critical advantage when global demand is likely to remain
part of the system did not migrate to the rest of the sector. Such soft for some time. At the same time, India desperately needs
a system works reasonably well when shocks are small. A mod- to ease these supply constraints failing which rising domestic
est shock to an asset class is absorbed through a modest price costs could crimp growth. This is why the reluctance of Indian
change in that asset class. However, when the shock is large - corporates to resume investment in earnest over the last two
like in October 2008-- because assets have limited substitutabil- years is a worry. Growth in India over 2003-08 has largely run
ity, the price changes in a particular asset class are much larger on investment and this engine has not fired at all outside the
than warranted. The only escape valve in the financial sector infrastructure space since the October 2008 crisis.
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
To fuel growth, heavy investment is required in
(larger than needed) price fluctuations in the equity market and infrastructure development and education. This
in the call money rate. Such unwarranted price volatility raises
the cost of intermediation and with that the cost of credit.
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
You had mentioned in the NY Times that to India and how should this be better accessed?
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

I do not think that financial deepening will raise the level of
domestic savings that much. Some of those who are outside
financial markets in India, to what extent will the formal system will be brought into the system but that does
the FIIs impact this growth trajectory? not increase the total quantum of savings. Those who choose
to remain outside the system for tax and regulatory purposes

The structure of India’s financial system, while, helpful in
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
preserving stability, intermediates savings and investment at a rate. People will no longer need to save up to make durable
high cost. Consequently, foreign funds, not just FII investments purchases or investments. They can get bank credit based
but external borrowing by Indian corporates, will remain an on future income stream. And this is a good thing. The key to
important source of affordable finance. It is not that India does raising domestic savings is fiscal consolidation and reducing
not have sufficient domestic savings. It does. It’s just that the the government pre-emptive capture of financial resources in
Jahangir Aziz is the India Chief Economist for JP Morgan Chase. Before joining JP Mor- savings is intermediated at a very high cost to investors. the guise of “prudential regulations.” Financial deepening is
gan, he was Principal Economic Advisor to the Indian Ministry of Finance. Jahangir has a required to allow better access to the formal financial system
PhD from the University of Minnesota and spent 13 years at the IMF in the Research and and to reduce the cost of intermediation. I do not think overall
Asia Pacific departments. He was the head of the China division from 2004-08. mobilization of resources will increase very much because of
financial deepening.
52 Money Manager / January 2011 Money Manager / January 2011 53
You have stressed upon the need for financial Indian regulators have often been urged to

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 what do you think is the outlook for the Indian
financial sector development in the next few Debt market? How do you expect regulations to
years? What will be the effect in organizing pan over the next 2 years?
micro-investment and micro-credit from a
greater financial inclusion perspective? — 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, Since 2008, there have been structural changes 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
with the country seeing record inflows over the in the global economy which have heightened reform to develop a strong financial market
should be better supervised and we have to learn from
last few months. However, does the India growth concerns regarding inflation. How serious are 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
story have the necessary momentum to sustain the concerns from the Indian perspective? How term, in the backdrop of the global economic
years the inevitable tendency to give low quality lending i.e.
sufficient interest from the financial world going does India respond to this situation where zero 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
ahead, or are the realities of structural deficien- interest rates over a long period of time in the strengthening these markets for sustainable
that objective. Also there must be much more attention
cies not being reflected in the optimism? West is fuelling speculative action in economic growth? towards macro prudential regulations rather than micro pru-

— —
dential regulations. Both are important but micro prudential
several commodities? regulations are essentially the regulations that prevent an
Well, You know financial markets very often experience a kind of
irrational exuberance but they also experience a lot of irrational

Well, I think there is a legitimate concern that if you have exces-
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
panic. My feeling is that the basic judgement about the India’s of course, is that the fiscal deficit is quite high. The amount of
sive monetary quantitative easing in the industrialized countries, that may come into the system because of a general change
growth story being a strong and solid one is valid. But of course sovereign debt that is available at any given time is very high.
it could fuel speculative asset bubbles and also speculative in the market conditions which will affect everybody. You can
you know financial markets like in other situations are likely The government has said that they will reduce the fiscal deficit.
commodity bubbles. But in our case, the Indian market is not that have a situation where each individual entity looks as if it is
to show volatility around this basically strong forecast. But If they reduce the fiscal deficit, then the available savings will
open, so therefore the transmission effect directly to domestic stable as long as macro conditions remain okay but if macro
that should not worry us because that is the nature of financial look around for other assets because the yield on sovereign debt
markets is less. However if it leads to commodity inflation in the conditions change substantially, each one of them becomes
markets. This will average out. They may get unduly optimistic at is likely to go down. As long as the government’s fiscal deficit is
world, that will certainly affect us. I think in general around the instable. How do you avoid such a condition is the really the
some point they may become a little pessimistic at some point. huge, it is very difficult for savers to prefer corporate debt. They
world, particularly in the emerging markets, there is a heightened great test.
But I think we should be able to manage that kind of volatility. may prefer corporate equity as there is a big upside but they
concern about inflation and we are also concerned about the
I don’t think you can get away from the volatility in the financial would not prefer corporate debt. So really reducing the fiscal
build up of inflation in India but fortunately for us the growth
markets. You just have to concentrate on strengthening your own deficit is very crucial. I think another important thing is that we
story is very strong. And our growth rate has been a little higher
growth story. And the more you do that, from experience, they do need some institutional changes - more competitive insurance
than what we originally thought it would be. But I think the infla-
will in fact show less volatility. I think the key the key issue is not markets because these are the institutions that look for a high
tion is above our comfort level. It is not a big problem, inflation is

that whether the financial markets are volatile but are they more yield long term debt. That is happening but it is happening a bit
coming down but we will have to remain watchful.
volatile in the Indian situation than for other countries. I don’t more slowly than it should. But it will happen.
think that is the case. They have shown much more volatility in
other countries than they have shown for India.
One thing which has been
What are the implications of weakened devel- The belief that the developed financial markets produced post crisis is a better
oped markets for India? Does this impact the of the world were efficiently regulated was
As a policymaker, would the excess of the inflows way India will shape the path of its own eco- appreciation of the relative
completely shattered after the financial crisis.
strengths of India

worry you with regards to the long-term sustain- nomic growth in coming years? Will there be a
What do you think should be the role of regula-
ability of the Indian growth story? Do you think major realignment in national policy in this new tors in the wake of aftermath of the financial
that Indian financial markets are not as intimately world order which is emerging?
crisis, particularly in India which is expected by
connected with the real economies as in the
western economies? — many to take leadership in this new world order?
With respect to increasing accessibility to the

Well, I think our national policy should be aimed really at
strengthening our own economy and the agenda for doing that —
You know financial market regulation is important everywhere.
Indian financial markets, do you think there
No, I think our financial markets are less integrated with global
has been well established and we should concentrate on that.
I think it is true that in our case the financial system was fairly
should be a greater focus on encouraging
Whether the international environment deteriorates a little bit, I
markets. But financial markets are very important. So, if Indian
don’t think it alters what is the optimum policy for us, it may alter tightly controlled. But let me say that I would say that in our retail investments to increase the scope of
financial markets are seriously disrupted, it will certainly affect case, a lot of freedom that other market players had was simply
Indian growth. But Indian financial markets are not that linked
the outcome of optimum policy. But I think we should be concen-
not available to our financial markets players. You know a good
financial inclusion?

trating on taking care of the problems that we know are serious
to global financial markets but over time this linkage will only regulation is not one where you simply tightly control the institu-
at home and they need to be addressed. So I would not be too
increase. So, I think we need to be careful that this linkage is not tions but rather the institutions have flexibility but they have a
distracted by the changes going on in the global situation. I think
putting in a situation of undue volatility or vulnerability. But I don’t regulatory and a supervisory framework which emphasises that I am not sure if I want to push retail investors to pick indi-
we should remain focussed on the agenda we set for ourselves.
think that at present it is. 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
India’s growth is largely constrained by factors internal to India
risks anyways. Basically, we are transiting towards a more liberal made available to investors, you have institutions looking
not by global developments.
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.

56 Money Manager / January 2011 Money Manager / January 2011 57

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
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

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

What are the elements of systemic risk, which Given that governments worldwide are involved
you think are still present in the international in fire fighting exercises in a bid to support
financial system? How seriously do you think flagging financial and economic systems, do

are these concerns being treated by you think there are concerns regarding govern-
regulators worldwide? ment introduced distortions posing new dan-

— gers to this new world order?

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-
There have always been vulnerabilities in the financial system.
Fundamentally all financial systems are vulnerable. The bank-

The issue is not in regulations, but the impact. The emerging
ing system is fundamentally a con game since depositors are
mental flaws that work against the creation of a global financial ecosystem? These are economies in Asia and Africa have exhibited considerable resil-
guarantee freedom of withdrawal, which is possible since the
some of the questions that will go through your mind when you think of challenges to the ience in surviving the impact of the financial crisis. Therefore the
deposits are lent out to others. This makes it vulnerable when
new world order. Mr. Swaminathan Aiyar puts into perspective, in no uncertain terms, his outcome is that the emerging markets and BRICs have increased
trust is called into question. The financial and banking system is
viewpoints regarding these issues. Read on. their credibility as investment destinations. But the ultimate
so complex now that, in any government’s perspective, it is too
power balance remains with the west and this has not been
large to fail. The financial system is so interwoven and intercon-
affected by the financial crisis which affects economic growth
nected that investment banks cannot be allowed to fail and they
only marginally in the emerging economies. When it comes to
have realized that the international community’s backing is there
regulation in the western financial markets, the impact will be
and they are too big to fail. Even though the capital requirements
aimed at improving the creditworthiness of the local market and
have been raised for the international banks after the crisis,
not against the emerging economies.
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- Are there any specific spill over effects which
erable time to build up their balance sheets. So to an extent the
vulnerabilities still exist, but the government guarantee is what you think emerging economies will face as a
is making the difference. result of corrective policy actions in the de-
veloped markets, particularly as a result of
Do you think the regulations being made right specific global imbalances which we are seeing
now are making the system much more com- currently in global trade and currency markets?
plex than they were before?

— —
There will be some attempts at protectionism by the economies.
Well, to begin with, the system itself is becoming much more The war between the free-market lobby and protectionism will
complex than it was before. Complex derivative products did always exist and both sides have won some victories in the
not exist earlier, and financial innovation is happening at a rapid last 50-60 years. The real problem however is with the shift in
pace. There is now a provision now that most derivatives will manufacturing capacities being handed over to the emerging
be traded through exchanges. But with the pace of financial economies in the 1950s and 60s. This has moved abroad from
innovation, there will be more products that will be created and the developed countries and it is not moving back even if protec-
they will not be traded on exchanges to reduce counterparty risk. tive tariffs are brought in place. This will only raise domestic
Given that we are having more of innovation resulting in more prices without creating jobs or new investment, which, there-
instruments and thus more of financial headaches, vulnerability fore, is not likely. Conventional tariffs may not be the case for
is very much there in the system. In my opinion, nothing that services. Off-shoring, which represents a very visible segment
has been done can prevent a future systemic risk from coming of the imports of western economies, is a small part of total
in. Trying to keep pace with financial complexity has been hap- imports, and any measures to curb this will be populist rhetoric.
pening for a hundred years. The complexity has increased, there Secondly, India & China can push for procurement and tendering
have been the occasional crises and we have had the cleaning by moving the WTO and end up getting a favourable outcome.
Swaminathan Anklesaria Aiyar, Consulting Editor of The Economics Times, has been the up act in the form of greater regulation and we have carried on.
editor of two of India’s biggest economic dailies, Financial Express in 1988 and 90 and The So, in my opinion, the key issues of concern will be the relation-
Economic Times in 1992 and 94. For two decades, he was also the India Correspondent of ship governing commercial and investment banking and the
The Economist, the British weekly. He is a graduate of St. Stephen’s College, Delhi, and regulation of counterparty risk in securitized financial products.
Magdalen College, Oxford.

60 Money Manager / January 2011 Money Manager / January 2011 61

Do you think that globally tightened and strin- groups, when private microfinance enjoys around 98% repay-
ment rates. If you have a situation where politicians constantly
gent regulatory measures will have drastic want to waive loans and get votes, microfinance gets exposed
consequences for financial innovations like to a new risk. Securitization is ultimately a way of getting the

loans off the books of the microfinance institutions and into
CDOs? Is that a serious concern in the financial those of the banks. This in principle is a great concept, but with
market ecosystem? the political ramifications of this industry, in a culture where
default is encouraged for political gains – securitization can

The point is there will be no end to financial innovation and it is
become a problem.

Capitalist economies have been defined by one factor very strongly – freedom of the
for the regulators to decide when and how to regulate as new
products keep coming up. But the whole point of innovation is
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-
about overcoming the regulatory barriers. This is the struggle. for an “uber-regulator” in the backdrop of the
It is possible that regulators can pick up sufficient systemic and presses his unequivocal view points on the the loopholes in financial policymaking and
economic risks in products, but not all. The regulators should
financial crisis. Do you see the movement for the dangers such regulations pose to the world economy.
come up with disincentives to prevent risky innovation that unification of all regulatory agencies under one
exposes vulnerabilities in the market
umbrella as a distinct possibility? Do you see
a strong motivation for such uber-regulators
What are the disincentives do you think the emerging in specific regional blocs like in the
regulators should put in place? case of the Euro zone?

There are a large number of tools at the disposal of the regula-

The complexities are so great that a single regulator may not do.
tors. Capital requirements for trading in specific securities On the one hand there is a problem of a unified coordinator to
should be increased. Some securities can be altogether scored monitor the activities of the regulatory agencies. Then there is a
off the sheet – like in India right now with some securities. problem of acquiring particular expertise in a function. However,
CDOs came into play only after the US passed regulations legal- I have no over arching view on this. But within India, if we were
izing their trading. So the regulators will have to play their cards to have insurance companies regulated by each state and banks
carefully in harnessing the advantages and negate the ill-effects regulated by each state, it would be very inefficient. So the
of financial innovation. 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.
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 Amar Bhide is currently the Thomas Schmidheiny Professor at The Fletcher School
competing with the private sector. The govt. will look to promote of Law and Diplomacy at the Tufts University. He is the author of A Call for Judgment:
its own business. In India, this assumes special significance, Sensible Finance for a Dynamic Economy published in 2010. Prof. Bhide earned a DBA
as there is a political culture of encouraging default. Andhra (1988) and an MBA (1979) from Harvard. He received a B.Tech from the Indian Institute of
Pradesh which has been a pioneer in micro-finance has a repay-
Technology in 1977.
ment rate of only around 90% in government-created self-help
62 Money Manager / January 2011 Money Manager / January 2011 63
Over the last two years many of the western We now need much stricter regulation, but not in every Unfortunately, the inflation that started surging in the The Fed recently announced another round
area of finance. I argue in my book that securities market regula- early 1970’s made it impossible to sustain what had been an an
economies which once extolled the principles of tion is probably unnecessary or even counterproductive whereas important piece of the banking acts, namely the regulation of
of quantitative easing and there is lot of hype
free trade, had to resort to more regulation and banking regulation is and always has been crucial. One can easily interest paid on deposits. about what Fed has been doing - whether it is
imagine a securities market functioning more or less satisfac- The rule back then was: 0% interest on demand de-
protectionism in order to boost their economies torily without much regulation. A stable banking system seems posits and interest on time deposits to be regulated by the Fed.
actually having the desired effect Fed wants
and protect local industries. How do you see this inconceivable without fairly tough laws, however. But what we had As long as the inflation rate was close to zero, people tolerated to achieve. Do you think Fed’s policies - trying
over last 30 years was securities regulation, which probably wasn’t getting no interest on their demand deposits, but as inflation
affecting the process of globalization and inte- necessary to start with, becoming tighter and banking regulation, jumped to 4-5%, a 0% interest rate on demand deposits became
to push medium and long term interest rates
gration of financial markets around the world? which absolutely needs to be very tough, becoming looser. This untenable. Money market funds were established that bought down, like quantitative easing is working and at
divergence may have been partly due to the differing mindsets of risk free treasury bills that paid close to the inflation rate and
a larger level, do you think Fed is currently run-

I think the globalization of financial markets is largely indepen-
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
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
dent of the globalization of real economies (which I think of as regulation has grown. higher risk instruments such as commercial paper that could
order to boost the economy?

the growth of trade and the flows of direct investment). The two give money market fund holders even higher rates of return.
globalizations can advance strongly together or they can come to And besides having the freedom to pay higher rates than banks,
a halt together but the factors that drive them are different. So you are still concerned about misregulation? money market funds did not have to pay salaries to lending offi-
I am sceptical of the role of government in managing business
Opposition to the integration of the real economies tends to cers or bear any other due diligence costs. They were pure free
cycles. I can’t prove that governments can’t control business
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

I think the problem has become worse, if anything. The Dodd-Frank
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
capital flows. It’s usually the central banks who worry about the Act is practically unenforceable because it places a mountain of banks could not compete against. But banks did not do this,
a capacity for self healing and regulators have no reliable tools
flows of capital and who try to restrict the flows of capital. new responsibilities on regulators, a great many of which have because the ethos in ‘70s favoured deregulation and the freeing
to speed this process. Whether it is quantitative easing or
Of course if you had another financial collapse it would halt both nothing to do with maintaining financial stability. I think regulators up of all markets. Rather banks lobbied to start their own money
stimulus packages, it all strikes me being not much better than
capital flows and trade flows so you could see both globalizations are going to be overwhelmed and less capable of focusing on what markets funds. The supposedly more progressive banks of the
black magic.
stop due to a common cause. is really important. 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
Could you please illustrate some of the events By 1990, most of the restrictions on what banks could do, which
One more thing that we have seen during the had been imposed by the 1933 and 1935 bank acts were gone
body because of complex interactions that no one can antici-
in 1990’s and 2000’s which connect to what you pate. I don’t think our knowledge of the economy is any better
financial crisis is the importance of the role of all but in name. The actual repeal of the Glass-Steagall Act in
than our knowledge of human physiology so it is imperative that
have been saying from the regulation point of 1999 was to some degree almost a formality.
regulators which you have mentioned in your The particular manifestation that the 2008 crisis took
we proceed with extreme caution, avoiding treatments that may
view and that have enabled the finance industry to or may not work in the short term but very likely could have huge
book- “A Call for Judgment” as well. We have may have been the result of what happened in the previous five
long term consequences. Why risk the long term fiscal stability
make such innovations and deviate from how the or six years but the deep corrosion of the foundations of the
seen that regulators tend to follow the advance- banking system had occurred well before 2000.
of the economy with measures backed by far less evidence than
banking practices had been in the 70’s and 80’s. we demand before allowing a new drug or medical device to be
ments that happen in the industry rather than put into use?
trying to be more proactive and their policies are
never pre-emptive. Do you see the role played — You have written -an article in WSJ- “Lets

My book traces back the unravelling of the banking system to the
by regulators across the world getting more dy- 70’s. To summarize the argument very briefly: break up the Fed!” where you criticized the Fed
namic in coming years and to move in line with
The Banking acts of 1933 and 1935 had created a pretty good Whether it is quantitative and you advocate breaking it up. What struc-
structure for bank regulation. This was the culmination of an
financial innovations and the way things happen evolutionary process that had started in the early 1800’s.The acts easing or stimulus packages, it ture do you have in mind when you talk about
in the financial industry?
were deficient in one important aspect however as they preserved
a highly fragmented banking industry that was out of sync with all strikes me being not much breaking up the Fed?
the real economy. After the first and second industrial revolutions,
better than black magic —

the real economy became quite concentrated with the top 500
companies accounting for about half of real economic activity. And At a minimum, the structure should be like that of the ECB. The
As I have argued in my book and as other people have argued as big businesses needed big banks to extend credit. But because of ECB is primarily responsible for monetary policy and has no bank
well, regulators got seduced by claims for financial innovations an ancient fear of the concentration of finance, banks weren’t al- supervisory or oversight responsibilities. Let me also say that
to a degree that made no sense, perhaps because regulators and lowed to grow. They couldn’t open many branches and they could getting that right structure is necessary but not sufficient. You
innovators were indoctrinated in the same ideology. They bought not operate across state lines. So we had a mismatch between can have the right structure and regulators can still mess it up.
into the theory of complete markets and a slew of other assump- industry, with big companies like General Motors and Boeing, and But if you have the wrong structure, you virtually mistakes.
tions of modern finance. I do not think that, at least in the US, the small banks who could not satisfy their credit needs. If you put that
cast of characters and their mindset has changed much. aside, bank regulation was well done. Money Manager / January 2011 65
Absolutely. There has been a lot of hustle in The role of developing countries in the whole
the currency markets of late, with the Chinese recovery has kind of changed in last 2-3 years
issue and concerns around Euro rising again and the impact of crisis was quite a bit limited in
with Ireland’s bankruptcy and other bailouts. It these countries. How do you see these econo-
seems that the currency markets are acting as mies responding going ahead, and do you think
an impediment to the already weak recovery of there will be some growth offset in the recovery
the world. So how do you see the impact of these and some sort of response from the developed
currency wars on the global recovery and can the economies to curb this growth offset?
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

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


Post the 1973 Middle East Oil crisis, US made unof- events has occurred, with the impetus coming, not from OPEC,
ficial pacts with major oil producing nations to provide military but from an increasingly confident and assertive Russia. Putin
cover and political support in exchange for trading oil denomi- made his stand clear - a straight bargain chip with the EU and an
nated only in US Dollars with all other countries. Hence, for a implicit threat to the United States (export oil in Euros). The “sole
country which did not have enough oil reserves (or did not want 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- terms that outweigh the benefits of Euro-shift. The Bush Pirate’s
curing oil was to pay with dollars. Thus, with increasing demand quest for a global market subordinate to American fiat has failed.
for oil across the globe, the demand for the dollar was artificially This shift in the global relationship of forces should have been
inflated, thus making the dollar a globally circulated currency. expected when Bush declared war against world order. It is the
With the world seeing a crisis every half a decade, it looks quite imperative to hedge The deregulation of financial markets post Cold War logical result of, and answer to, the president’s 2002 ultimatum,
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 “either you are with us, or against us.” The planet now prepares
Suspicions’ we explore the reasons why Dollars was like an ‘Unparalleled Ruler’ in the the US government supporting the Dollar participation in inter- to turn on its own axis. Henry C. K. Liu got it right in his far-
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 sighted Asia Times interview, “The War that may end the age of
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 superpower.”
(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
Increasing US Debt
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. The U.S national public debt has reached around 67% of its GDP
around the world have not restrained themselves in pointing out
in 2009 (much higher than historic level of 30%-50%) and the offi-
the weaknesses of the dollar. As Kenneth Rogoff, former IMF
cial non-partisan Congressional Budget Office predicts it to cross
chief economist puts it- There are “lots of reasons to be concerned
100% of GDP (by looking at the current policies) by the end of the
about the dollar. But a weaker dollar is a fantastic boost for the
decade. It found that a 5% increase in the outstanding stock of
United States, and it’s a problem for the rest of the world”.
US treasury debt relative to Eurozone government bonds is asso-
ciated with an 8% depreciation of the dollar on average.

Source: Circles Phenomenon Research International (CPRI)

. SEPT 30 2008

the authors

Source: MDI Library database







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, history of rise of the 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-
CFA, CAIA and FRM. He developed a strong foundation during his
graduation in Economics ‘dollar’ (usd) 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
Devi Prasad Biswal
— of concern with dollar
2nd Year student at MDI, Gurgaon
Pursuing dual degree in Finance and Strategy along with CFA
The Dollar supremacy story started with the establishment of the Dollar’s diminishing role as a Reserve Currency
Bretton Woods system in 1944. By the end of World War II, a
He gained very strong analytical skills during Computer Science
vacuum was created in the international financial system due to Even though the dollar still dominates the reserves held by most
the downfall of Pound Sterling. A requirement of a new global 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.

US: The Shrinking Superpower
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
2nd Year student at MDI, Gurgaon In 1971, when the Bretton Woods system was revoked by U.S, in the past 12 months. “The real concern remains ongoing fall in
Pursuing dual degree in Finance and Information Technology there was no currency which could challenge dollar to become the It was assumed that, American military dominance in the Middle foreign demand for US treasuries as issuance is expected to rise
along with FRM. He finds his interests in Psychoanalysis and Be- international currency. Thus, a free floating regime ensued with East and a series of “regime changes” would eliminate the euro- over the next several years on larger fiscal deficits,” says Michael
havioral Finance dollar continuing as the dominant currency (dollar - fiat system). threat that dollar had while quoting oil. An opposite chain of Woolfolk, senior currency strategist, The Bank of New York Mel-
68 Money Manager / January 2011 Money Manager / January 2011 69

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.
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
CURRENCY COMPOSITION OF FOREIGN EXCHANGE RESERVES (WORLD) self, China and South Ko- the Chinese economy has to grow considerably bigger (which it very
[IN USD MILLIONS] 2002 2003 2004 2005 2006 2007 2008 2009 rea. At the Association of likely in the near future) but also it must develop large financial
ALLOCATED 1795994 2223203 2655173 2843625 3315575 4119398 4210072 4563579 Southeast Asian Nations
markets, fully integrated in world exchanges, and the Chinese gov-
RESERVES (ASEAN) discussions in ernment must issue top-rated public debt instruments. Currently,
CLAIMS IN USD 1204673 1465752 1751012 1902535 2171075 2641671 2698423 2837121 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
% CLAIM IN USD 0.670756 0.659297 0.659472 0.669053 0.654811 0.641276 0.640945 0.621688 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
‘Black Gold’ set to be quoted in “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
non-dollar Currencies 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
Middle Eastern nations and OPEC members are increasingly get- CURRENCY DISTRIBUTION OF quarter of Britain’s exports are invoiced in dollars) gained such
reports having shipped in just one decade about €100 billion
ting inclined towards non US Dollar trading baskets. There have 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
been confirmed talks between Gulf Arab and Chinese representa- 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-
tives in Hong Kong of oil trade in non-dollar denomination. Brazil US DOLLAR 89.9 88.9 85.6 84.9 and Treasury bonds causing USD prices to crash and Renminbi Pric-
rency international.
along with India has shown interest in collaborating in non-dollar 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
oil payments. Iran and Venezuela have taken the lead and have 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-
proposed trading oil to a basket of currencies, but haven’t yet POUND STERLING 13.0 16.5 14.9 12.9
ously, these must be safe instruments, which would presumably
garnered enough support from the OPEC nations, mainly Saudi
Arabia. Iran has increased the amount of its oil export earnings
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-
in currencies other than U.S. dollars to about 70 percent. More-
ment. Central banks want these instruments to be not just safe,

increasing risks with

over as previously mentioned the world second largest exporter, 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
Russia has even started trading oil in Euro terms. Putin did that
deep enough, emergency sales may resemble fire sales that en- foreign exchange system. Its value is based on a basket of four key
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 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
independence from Saddam Hussain reign.
day. German debt instruments amount to about $1 trillion, with in international trade and finance every five years. The currency

Decreasing share of dollars in — 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.
global forex market 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,
The share of the USD in the global forex market has decreased 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
gradually albeit in small amounts over the past decade. This un- 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.
derlines the fact that market players are gradually 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
‘WOCU’ could be the founda- 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

tion to a future unified currency

Investors cannot easily track or influence fiscal policy on the con- POLAND POZ

greatest creditor.

tinent. Also the ECB does not have a goal of Internationalization AUSTRIAN EUR

which would act a totally apolitical of the Euro. Similarly, Euro lacks depth and liquidity in capital- INDIAN INR

markets.UK is still not part of the Euro zone which leaves London,
Devaluation Risks SPAIN EUR


a major financial centre still without Euro monetary controls. RUSSIA RUD

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

increasing transactions in currencies other than dollars and of the US government to have slightly higher inflation back home
has overcome the challenge by providing the financial support


hence other currencies are set to gain significance importance in 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

the future. The share of major currencies in the foreign exchange picious about holding dollars. In its effort to slightly diversify its
hence has strengthened further.
market as of April 2010 is shown in Figure 2. holdings, it suffered huge losses on account of dollar devaluation.
The Chinese are riding a tiger without a way to get off it.
70 Money Manager / January 2011 Money Manager / January 2011 71

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
-Although China is gaining prominence in the
international stage and encouraging the inter-

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

way forward
or secondary global reserve currencies. international investments and holding reserves
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

authority to a central bank in order to become liquid enough to and there would be a global market for all
be used as a reserve. To make SDR the principle reserve asset, three. Future may hold for us a ‘Currency War’.
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-
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
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
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

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
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
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
of now, it is more likely that the Dollar, the Euro and the Renminbi - Retrieved Oct 28, 2010, from
would share the roles of invoicing, reserve and settlement curren- - Retrieved Oct 29, 2010, from
cies in the years to come. Each of these currencies has its own
Source: Ian Hillar Brook (WOCU)

WOCU - Retrieved Oct 30, 2010,

0.800000- concerns:
0.600000- -America’s twin fiscal and external deficit may weaken the de-
Other Sources
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-
gether its members in the light of the Greece Debt crisis might And How It Affects The Foreign Exchange Markets.mht (MDI Library database)










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

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


france’s foreign reserve


management – 1930s 80000-


source: bank of france archives


The period during the late 1920s and early 1930s was a period
where international cooperation was intertwined with conflict.









a historical perspective
During this period, the global superpowers Great Britain, the GOLD OTHER DOLLAR
United States and France established a gold exchange stan- STERLING UNDOCUMENTED

dard. The re establishment of the gold exchange standard was

discussed vehemently in the Genoa Conference of 1922 and was to limit the risk of capital loss on its sterling holdings on
it was taken by the above mentioned superpowers in the late the account of a highly probable sterling devaluation. Paul Einzig
1920s. It enables central banks in these countries to hold for- (1932) believed that French monetary authorities were using their
eign assets denominated in gold convertible currencies as part reserves as a “fighting fund” in the financial war against Britain.
of their foreign reserves. In each country, parity was constituted On the other hand, Bouvier (1989) believed that the accumulation
between the prevailing currency and gold which was maintained of large gold reserves were part of a holistic strategy employed
through coordinated action on exchange markets. The gold ex- by France to make Paris as a major financial centre. However, the
change standard found its backing from the superpowers in order Bank of France could not simply liquidate all its sterling holdings
to prevent world deflation by reducing the risk of monetary gold in one-go as it was concerned that its actions would have brought
scarcity (BIS 1932, Hawtrey 1922) about widespread criticism as well as hastened the fall of the
sterling. It started converting its sterling holdings to dollar and

france’s reserve policy gold in the late 1920s at a temperate pace.

in the gold exchange sterling trap


— From 1929 onwards, it became clear that France was trying to of-
fload its sterling holdings in favour of the dollar and gold. Exhibit

the authors The Great Depression’s impact was accentuated in Europe by the
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-
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

hammering of the chief currency of the region at that time – the located between the sterling, dollar and gold. After the franc was shows the corresponding increase in the dollar reserves. The
Pound-Sterling. The party to be majorly blamed in this regard – stabilized in 1926, the French government mandated the Bank of liquidation of France’s sterling holdings expedited the fall of the
The Bank of France which mismanaged its reserves of the Sterling France to buy foreign exchange on the market, in order to avoid sterling leading to its eventual devaluation in 1931. The major
Aravind Vijayasarathy N in the late 1920s and early 1930s. This resulted in large scale excessive currency appreciation (Blancheton, 2001). Exhibit 1 consequence of the sterling’s devaluation was a capital loss of
contraction of European economies that had a feedback effect on shows the portfolio composition of the reserves held by the Bank about 2.3 billion francs on the Bank of France’s sterling holdings.
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- of France. In the late 1920s Bank of France held more than half This loss had a disastrous impact on the Bank of
keen interest. He can be reached at scent recovery period from 1929, can be in part attributed to this. of the world’s volume of foreign reserves. However, there were France and it required the support from the French Treasury to
Fast-forward to the 21st century, a crisis of similar proportions is some pressing issues with the gold exchange standard. The cur- cover the losses (Moure, 1991). Furthermore, the Bank could no
unfolding, so is a recovery. Here too is a nation, China, an emerg- rency parity with gold established during the stabilisation years longer have autonomy over its foreign reserves policy. One ques-
S Harun Thilak ing superpower that has driven itself into a dollar trap and is on was a major cause for concern. It was believed that the sterling tion which is relevant and concerns us in this paper is – If the
tenterhooks as to how to manage its reserves. What China does which was stabilised at its pre-war gold parity was overvalued Bank of France had expected a sterling devaluation, why did they
a PGP2 student at IIMA and interned with Nomura in Singapore.
from here will have implications for the recovery from this crisis compared to currencies like the franc and the reichsmark (Keynes, still have to suffer a huge capital loss? This is the quintessential
He can be reached at
and the future of the international monetary system. Through this 1925). Moreover, France along with the United States were criti- trap that a country which holds a large amount of foreign curren-
paper we seek to analyse factors that will influence China’s deci- cised for hoarding gold. cies as part of its reserves finds itself in when the currency is on
V M Avinass Kumar sion making and address 3 key questions. How China can react Bank of France anticipating a sterling devaluation the verge of devaluation. Any offloading of the currency holdings
to this situation and what will be its impact? What lessons can started rebalancing its reserves portfolio by liquidating its ster- would hasten the process of devaluation thereby leading to large
a PGP2 student at IIMA and his areas of interest include M&A China learn from France’s debacle? and What significance it holds ling holdings for the dollar and gold. Many theories have been capital losses. In that scenario, what could a central bank do? Let
and financial and economic history for the nascent recovery from the global financial crisis of 2007? put across for this rebalancing. One clear aim of the rebalancing us examine what the Bank of France did in the 1930s.
74 Money Manager / January 2011 Money Manager / January 2011 75


THE GREAT DEPRESSION chinese dollar trap and
impact on global trade


source: seeking alpha, 2009

source: bank of france archives
5- UNITED KINGDOM Extent of China’s Dollar Reserves and rationale











From the year 2003, China has been accumulating its reserve of








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
tion of these gold reserves without expanding money supply led thus buy more political and economic clout in the asian hotch-


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

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

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


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

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









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

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

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

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

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

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,
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
exchange market who possesses considerable sterling reserves. 800-
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


In the foreseeable future

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

source: setser, 2009

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
caught in the sterling trap and the only option was prudent sup- a global currency seems highly 0-










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


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

chinese dollar trap ment bailouts and packages of their own. Around 45% of this
investment is in infrastructure. This is primarily in fixed assets
pipeline deal with Russia and has provided loans to Russian oil
major Transneft. It has also signed a $10 billion agreement with
international currency is high. (McCallum, 2009)
Governor Zhou also felt that the non-use of a particular coun-
and active promotion of public goods. But there is little incen- Kazakhstan. (Jiang, 2009) try’s currency as a global measure would help the exchange rate
tive for local governments to invest in public goods and as a One way to tackle this crisis was the calling of the G20 summit in system of that particular country to adjust economic imbalances

— result, more new factories are being built to enhance China’s

manufacturing capacity. This would only attract more foreign
London in April 2009. The G20 summit arrived at a consensus on
the need for tax havens and transparency in hedge funds. Much
within the country. Apart from this, China also wants an inter-
national settlement system to carry out trade in SDR, without
In the early 2000’s, China followed an aggressive export-led investment into China and would not directly solve the dollar discussion took place on an alternate reserve currency, but noth- involving the concept of interest-rate payments, as these could
growth strategy. This was mainly a consequence of the increase trap problem at hand. (Yu, 2010) ing concrete was proposed in this area. Meanwhile, the US bud- vary depending on the financial situation. It also wants the IMF
in consumption patterns in the US and other Western countries, The dollar trap has also severely impacted Taiwan, get deficits continue to rise and China remains reluctant to fund to actively promote SDR in trade and bookkeeping, essentially
which led to the increasing demand for Chinese goods and ser- as it faces further pressure to get incorporated with the Chinese these deficits by buying US Treasuries. This could lead to a great making it an official form of transaction so that most member
vices. As a result, China began accumulating large trade sur- mainland. The Chinese government is pressurizing the US to aid deal of discomfort between the US and China, especially if the US countries will be pressured into following a similar pattern.
pluses. This led to an increase in the inflow of foreign capital. the incorporation of Taiwan in a deal which includes a promise is at the receiving end. Lastly, it wants the valuation of SDR to be improved and man-
Since China’s Central Bank, the People’s Bank of China (PBOC) not to dump dollars into the US. aged by the IMF. This could be done by expanding the existing

case for sdr as an

decided to follow a fixed-exchange rate system and pegged the One of the strategies adopted to escape the dollar basket to include currencies of all major economies.
Yuan against the dollar, China had to buy out the dollars that trap has been promotion of outward FDI in developing countries.
were flowing in. This led to an accumulation in foreign exchange China has become the largest source for outbound FDI and it has
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-
been investing heavily in countries like Thailand and in Sub-Sa-
haran Africa. The creation of the China Investment Corporation, international reserve
vesting in US Treasuries has decreased after the credit crisis. a sovereign wealth fund to manage China’s foreign reserves is
Experts have suggested many ways to escape this dollar trap. seen as a positive step in this direction. Apart from this, do-
Why does the SDR present a strong case for an
China is considering offloading its foreign exchange reserves, but mestic Chinese industries continue to export large volumes of international reserve currency?
the inflow of such a large amount into the world economy might services like shipping and insurance. Large Chinese firms are

lead to the devaluation of the dollar, which again would affect actively taking part in Mergers and Acquisitions to strengthen In the present system, countries without foreign exchange re-
China’s reserves. In order to avoid this, China is pushing for an their foreign portfolio. An example of this is Lenovo’s acquisi- serves have to accumulate reserves and the adjustment lies in
alternative form of reserve currency, namely, the SDR (Special tion of IBM’s computing arm. Lastly, Chinese enterprises are the hands of the countries with a current account deficit. Devel-
Drawing Rights) (Krugman, 2009) seeking to move their factories to more labour intensive coun- What is SDR? oping countries would then borrow from developed countries
tries like Vietnam and Thailand. (Davies, 2009) with stable currencies at a higher interest rate. This leads to

impact on global trade global imbalances

SDRs or Special Drawing Rights are a form of international ac- an increase in consumption in developed countries due to the
counting unit created by the IMF and allocated to member coun- increase in capital inflow .The instability of the system can be
tries. SDRs were initially created in 1969 and were based on gold, pointed out in the fact that the dollar can be devalued quickly

created due to the 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
as a result of dumping of excess dollars by countries which have
them, like China. This rapid devaluation of the dollar could render

— dollar trap
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-
the reserves of many countries worthless. (Yu, 2010).
One of the most important advantages of the SDR is
China has been trying out various escape routes to this dollar trap. tangible and hence, transactions can be carried out in SDRs if both the fact that it is low cost and doesn’t exist as a tangible unit.
This has resulted in a shift in the balance of worldwide trade and parties agree to it. (McCallum, 2009) Therefore, it would only require commitment from the Central
is leading to the creation of various imbalances. World trade is Each member country is allocated SDRs by the IMF. Banks of member countries to accept it as a global currency. As a
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

China’s investment of its foreign reserves in US Treasuries helped
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
result, implementation of such a measure can be easily possible
without any transaction costs.
Secondly, this would prevent the accumulation of US
a high risk of China dumping the dollar in the US. But, the US has finance the “twin deficits” faced by the US, i.e. trade and capital ideally, a lender would have SDR surplus while a frequent borrower treasuries as the reserves of different countries. Developed coun-
problems of its own in struggling to meet the demand for foreign deficits. Because of this, China became the largest creditor of the would have SDR deficits. Presently, the interest rate is around 0.5% tries would be spared the burden of having to accumulate US
loans. As a result, the Fed might resort to printing dollars. This US. As a result, the fortunes of China’s accumulating dollars and but it could vary depending on the financial conditions and interest Treasury securities for protection.
would lead to devaluation of the dollar, impacting China adverse- that of the US are completely intertwined. rate on short-term debt on all the four basket currencies. The fact that a reserve currency exists puts pressure
ly. (Wade, 2009) In the US, unemployment and house foreclosures continue to rise, on countries to accumulate that currency. As a result, demand for
The credit crisis has affected other large economies as depressing the house prices further. As a result, the financial sys- that currency increases and this impacts its exchange rate. Cur-
well. Increasing capital flows into China adversely affected trade tem of the US still remains fragile and there is hope that China China’s case for SDR as a reserve currency rently, most of the world’s trade is executed using the dollar and
patterns in Japan, the world’s second largest economy. Japan’s would continue to buy US Treasuries, thus preventing the dollar its demotion from reserve status would reduce the demand for
chief source of exports- the manufacturing industries, declined in from crashing. But the situation in China is completely contrary, In April 2009, Zhou Xiaochuan, Governor of the People’s Bank of the dollar drastically. As a result, this might impact the exchange
growth in December 2008. It was a third lower in December 2008 with China looking to diversify its foreign reserves into other China issued an essay on “reformation of the International Mon- rate value of the dollar and devalue it, which would certainly af-
than in December 2007. stable currencies. etary System”. He basically called for the “establishment of a new fect the US. (Smelt, 2009). Also, an international reserve system
The Chinese Government responded to the crisis by Also, China is investing majorly in countries which pro- and widely accepted reserve currency with a stable valuation” to based on SDRs would allow countries to convert its existing dol-
implementing a large stimulus package. Simultaneously, the PBOC vide a stable environment for FDI and have stable currencies. The replace the US dollar, the current reserve currency. The PBOC feels lar reserves into SDRs, in order to diversify exchange rate risks.
brought about an expansionary monetary policy. The government sectors which it is investing are metal and energy. In the metals that the deficiencies present in a credit-based system such as the Lastly, in order for countries to place greater trust on SDR as a
introduced a stimulus package of 4 trillion yuan for 2009 and 2010. sector, China has invested $19.5 billion in the Rio Tinto group, in dollar would be solved using the SDR as it takes virtually no cost currency, the basket must be expanded to accommodate curren-
Apart from this, provincial governments were also asked to imple- Australia. In the energy sector, it has signed a $25 million oil to create or allocate an SDR, while the price to issue and borrow cies of other large economies, in proportional weightage.
78 Money Manager / January 2011 Money Manager / January 2011 79

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.

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
ing in SDR and see the value of their dollar reserves dip. This in its current forex reserves. CHINA
- 1000
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
phasing out must be smooth. CURVE 1
China has already taken steps towards the same: BETWEEN DEBT/

source: yu yongding, third world network.


lessons for china from

1- China has already drastically reduced its purchase of newly OF INFLOWS

france’s debacle
issued US govt. securities. RATE OF

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

3- China is investing its dollar reserves in strategic resources
such as oil and minerals in Africa.
The fundamental problem with the dollar trap lies in the fact that
the reputation of US as a quality supplier of financial assets has 4- China is also pushing steadily for the SDR regime to come in –
been sullied and US looks to issue debt to the tune of $4tn. over this will find voice with emerging powers India and Brazil.
the next few years. These combined effects have weakened the
dollar as an investment destination. 5- China has also entered into numerous “swap deals” with references
The Bank of France, in the 1920s, without the cooper- Asian central banks to facilitate offloading US securities from its
ating with the other Central Banks resorted to dumping pounds large SAFE reserves.
- Bouvier, J. (1989). A propos de la stratégie d’encaisse (or et devises) de la Banque de France de juin 1928 à l’été 1932. In J. Bouvier (Ed.), L’historien sur son
in the international market in a stop-loss measure. China is in a
similar position but there are some critical differences which may China at the moment is highly unlikely to take the métier. Paris: Editions des Archives Contemporaines.
enable the Chinese to respond in a proactive fashion without dire route that France did during the 1920s and 1930s – thereby put- - Blancheton, B. (2001). Le Pape et l’Empereur: la Banque de France, la Direction du Trésor et la politique monétaire de la France (1914-1928). Paris: Albin
consequences for the world economy. ting to rest fears of a double-dip arising from the Chinese side of Michel.
China’s trade forms close to 60% of its GDP and po- the wall. A question to ponder for China will be the way Japan - Bank for International Settlements. (1932). The Gold Exchange Standard. Unpublished document. 26 October 1932.
litically, the ruling CPC derives its power from the control of both went in the 1980s. - Hawtrey, R. G. (1932). The Art of Central Banking. London: Longmans, Green and co.
trade and the currency – the weakening of either is detrimental to Japan was one of the largest trading nations with the - Keynes, J. M. (1925). The Economic Consequences of Mr. Churchill. London: L. and G. Woolf.
its state. The PBOC is the financial voice of the government. The US at the time. US pressurized japan into appreciating the yen
- Einzig, P. (1932). Behind the scenes of international finance. London: Macmillan.
PBOC has also signed significant swap deals especially with the so as to ease the concerns over the dollar valuation. Japanese
- Mouré, K. J. (1991). Managing the Franc Poincaré: economic understanding and political constraint in French monetary policy, 1928-1936. Cambridge: Cam
Asian tiger economies allowing it to hedge its reserves. China has exports started falling. In order to control the appreciation Japa-
also realized its potential for expanding investment in strategic nese started a more liberal monetary policy by lowering interest bridge University Press.
reserves of resources like minerals and oil and has taken steps to rates in the system. This brought the exports back up but fuelled - Niall ferguson, “From Empire to Chimerica”, Pg 284 -341, The Ascent of Money, ISBN 978-01413580-2, Penguin Books, August 20, 2010
expand investment in developing nations in Africa. a property bubble, which then burst and resulted in the “lost de- - Olivier Accominotti, November, 2008, “The Sterling Trap: Foreign reserves management at the Bank of France, 1928 – 1936”, UC, Berkeley, July 25,2010
In the case of France, this difference played a key role as the Bank cades”. China already has a property bubble going and by not al-
of France was not under govt. control. The Bank of France looked lowing the currency to appreciate it is fuelling domestic inflation. - Douglas A. Irwin, July, 2010, “Did France cause the Great Depression?”, Dartmouth College & NBER, August 16, 2010
only to hedge its capital loss and did not cooperate with other How this will pan out over the next 2-3 years will be crucial to the
central banks to gradually off-load its pound sterling reserves. world recovery from the financial crisis.
- Melissa Murphy & Wen jin Yuan, October, 2009, “Is China ready to challenge the Dollar?”, CSIS Freeman chair in China Studies, CSIS, August 16, 2010

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


- Bennett T. McCallum, April 21, 2009, “China, the U.S. Dollar, and SDRs”, CMU and NBER, July 25, 2010
- Setser, Brad (January 13, 2009) “Secrets of SAFE : A sharp slowdown in reserve growth and large “hot” outflows” , Council on Foreign Rela LIGHTING UP
tions, August 16,
- Yongding, Yu (2010) “The Impact of the Global Financial Crisis on China’s Economy and China’s Policy responses” Third World Network,
August 16, 2010.
- Simon Smelt, April 7,2009,”SDRs and Currency Reform”, Vox, July 25,2010
“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
- 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
- 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.
- March 23, 2009, “China eyes SDR as global currency”, China Daily, July 25,2010
- R Agarwala, April 3, 2009, “SDR should become the global currency”, The Economic Times, July 25,2010
- Simon Smelt, April 7,2009,”SDRs and Currency Reform”, Vox, July 25,2010
- Ambrose Evans-Pritchard, March 25, 2009,”US backing for world currency stuns markets”, Telegraph, July 25,2010 the author

2009, “SDR & the Global Reserve system”, Actionaid Factsheet, July 25, 2010
- Owen F. Humpage, May 8,2009,”Will special drawing right supplant the dollar?”, Vox, July 25,2010 Dushyant Sahgal
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 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
- International Finance, July 25,2010$-IFdebateFeb2008.pdf
Zhou Xiaouchan, March 23, 2009, “Reform the international Monetary system”, People’s Bank of China, July 25, 2010 introduction

- Paul Krugman, April 2, 2009, “China’s Dollar Trap”, The New York times, July 25,2010
- 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
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 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.
- 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
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

a typical equities dark pools and smart US EQUIY EXECUTION VENUE SPLIT AUG 2010 Dark pools aren’t without their detractors though.
Some market participants believe that when trades are execut-

trade flow order routing 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

There are many ways in which an order might originate – either

Regulations like Reg NMS in US and MiFID in Europe led to
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
by a buy-side OMS/EMS, a sell side trader or an automated greater emphasis on smart order routing in order to meet the 85% EXCHANGES/ECNs trade at all due to the increased fragmentation of the market.
algorithmic engine that forks orders based upon trading goals. requirement of best execution . To be smart, the order routing As dark pool trade matching happens within the broker-dealers
When captured by the broker’s trading system, the order normally engine needs an active market data feed from the various trading private system, stock exchanges are beginning to lose substan-
undergoes an array of enrichments, toxic checks and messaging venues it connects to. As best execution is not just capturing the 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
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 platforms, in particular Chi-X. In response, NYSE, LSE and many
protocol will need conversion into the in-house messaging proto- impact, trading limits imposed for that venue etc. Based upon CREDIT SUSSIE CROSSFINDER western exchanges have since set up their own dark pools to
col that is compatible with the brokers trading system. the price and liquidity available at the trading venues, the order SIGMA-X fend off competition.
router will split the parent order into one or more child orders 92
An Order Management System (OMS) is an electronic and route them to the destination which has the most favourable 68
system developed to execute securities orders in an quote available. As the process of seeking price and liquidity is 56

regulation and critique

efficient and cost-effective manner. electronic, the impact on costs and order latency is reduced. BARCLAYS LX

The order would then move to the order routing engine which Best Execution refers to the responsibility of brokers CITI CITI MATCH
oftentimes has the capability to connect to multiple dark pools of 24
to provide the most advantageous or best price, order LIQUIDNET LIQUIDNET

liquidity, stock exchanges and ECNs. This routing engine is load- execution for customers. BIDS TRADING BIDS
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- MATCHED SINGLE ONE SHARE BOUGHT AND ONE SHARE Post the financial crisis triggered by the subprime crisis of 2008,
Figure 1 below illustrates a generic equities order flow. ing or selling a stock but that indication of interest is communi- the Securities and Exchange Commission has often expressed
cated only to a group of market participants. Smart routing also displeasure at the “darkness” of dark pools and has called for
GENERIC EQUITIES ORDER FLOW involves posting or shadow posting a child order to the dark pool Some pools allow orders to rest for any amount of time till they increased regulation. According to the Securities and Exchange
first as an Immediate or Cancel (IOC) order to seek favourable find a match. A majority of large dark pools also operate in Eu- Commission, the characteristic lack of transparency in dark pools
OMS/EMS TRADER ENGINE execution. If matching prospects are available, the order gets par- rope and Asia, such as CrossFinder by Credit Sussise and SIGMA could create a two-tiered market that deprives the public of infor-
tially or fully executed in the dark pool. Else, it gets cancelled. A X operated by Goldman Sachs. mation about stock prices and liquidity.
ORDER GATEWAY feedback loop into the trade flow ensures that the OMS/EMS is On October 21 2009, the SEC put forth several propos-
PROTOCOL CONVERSION, ENRICHMENT, VALIDATION aware of the fate of the child order and does the trade manage-
ment accordingly. 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
SMART ORDER ROUTER MARKET DATA subject to the same market disclosure as public quotes. The SEC
also wants the dark pools to trade report real time and include the

the growth story

name of the dark pool that handled a given stock trade. It believes
DARK POOL STOCK 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



According to the Securities and Exchange Commission, the number
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-
of active dark pools dealing in stocks on major US stock markets impact. Traders seek the advantage of anonymity which allows ment management funds as they would get worse prices while
trebled to 29 in 2009 from about 10 in 2002. Dark pools accounted them to complete their transaction out of the public eye. Enter dark buying or selling large amounts of stock should dark pools be
for 15% of all US equities executions in August 2010 . Given that pools. Institutional investors like hedge funds, pension funds and forced to identify themselves real time.
dark pools accounted for only 1% of the trading volume in 2003, the other investment management companies are extremely concerned The SEC hasn’t ruled on the matter yet. As it ploughs
industry has witnessed tremendous growth as far as the evolution about the impact cost of execution of large orders at the exchanges. through the massive workload of converting legislation into rule
of dark pools goes. For them, dark pools act as a preferred alternative trading venue making with the passage of the Dodd-Frank Act in July 2010, it
There are at least two dozen brokers that operate dark that addresses these concerns. While the clients of broker-dealers has also resolved to make progress on issues affecting equities
pools today. Figure 3 shows the major dark pools in the US and their offering dark pools enjoy the benefits of having their execution out markets. The buy side and the sell side are not too enthusiastic
execution volume for August 2010. Each of these pools are open of the public gaze, the broker-dealers gain a two pronged advan- about releasing too much information too soon and as various
to a mix of users, some are open only to institutional investment tage – collecting transaction fees from clients and simultaneously industry participants debate on this issue, time will only tell what
managers whereas some cater to both the buy and the sell side. saving on exchange membership costs as the execution essentially compromise formula actually gets arrived at.
took place within the confines of the broker-dealer.
84 Money Manager / January 2011 Money Manager / January 2011 85

asia focus
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- the stocks listed on the Hong Kong Stock Exchange. Chi-East, the
tory and clearance bodies. Each of these 12-13 countries has their joint venture between Chi-X Global and the Singapore Exchange
own currency, different set of rules and regulations. Moreover, (SGX), has recently received regulatory approval from the Mon-
stock exchanges are perceived as national assets and change is etary Authority of Singapore (MAS) to operate a dark pool trading
relatively more gradual. The depository and clearing bodies are platform.
often owned by exchanges, implying that the dark pools opera- Dark pools haven’t found home in India yet. At the
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-
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?
edge that penetrating the Asian markets would be a challenge, and as these further develop and spread in the marketplace, the
Regulators – Omnipotent Watchdogs or Liberal Bystanders?
they are committed to expanding the footprint of dark liquidity in needs for dark pools will hopefully become apparent.
the trading landscape here. At the moment, dark pools operators India and other Asian countries have a great opportunity to learn
command an approximate 1 to 3 percent share of equity execution from the experiences (both good and bad) of the US and Euro-
in Asia on the larger exchanges and close to zero on the smaller pean markets and work towards well thought of liberalization of
ones. The Hong Kong and Japan market currently commands the their capital markets as far as the expansion of alternate trad-
biggest slice of the pie in terms of dark pool presence. 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.

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

the authors
- Tabb Forum Liquidity Matrix August 2010
- 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

Sharanjit Singh Abstract
- Matthew Samelson, Oct 2010 - Early thoughts on SEC Dark Pool Regulation: Advanced Trading http://
- Peter Chapman, Sep 2010: Traders Magazine - Dodd-Frank Won’t Derail SEC’s Market Structure Work 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 can be reached at
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 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
- The author is a second year student of Post Graduate Program in classes like microfinance loans. In this article, some of the major Management at Indian Institute of Management, Bangalore. He proposed changes and their impact in the Indian securitization
can be reached at market have been highlighted.
86 Money Manager / January 2011 Money Manager / January 2011 87

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-

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-
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:

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
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
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.
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-
underlying asset has a short tenure. are incentivized to do proper due diligence of the portfolio. ness of securitization.
There are various risks associated with revolving structure. Credit derivatives and synthetic securitization are
- As the asset pool is replenished frequently with new assets, the deemed as complex and risky by RBI. Therefore, RBI does not al-
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-

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.
- Liquidity is substantially limited in the secondary market. Traditionally revolving structure is done for credit card - Source: 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
- RBI Draft proposal for securitization, 19th April, 2010
- 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
rated papers. loans with tenure up to 24 months to discourage the “Originate
88 Money Manager / January 2011 Money Manager / January 2011 89

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

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
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-
imbalances. ‘Savings glut hypothesis’ states that the primary rea- ings into US dollars. European Union had more or less balanced
son for these imbalances is higher currency reserve accumulation current account. Japan historically had large savings though due
by developing countries either to promote exports-led growth or to structural changes that is expected to come down in future.
as a “self insurance” against sudden flight of capital. Several Clearly all major blocs in the world are either generating current
emerging countries have been doing systematic intervention in account surpluses or are balanced.
exchange markets to keep value of their currency low. China’s

comparison with
exchange rate policies have been severely criticized under the

the author format bracket.

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- gold-dollar standard
— viations from purchasing power parity. (argument in favor of self
insurance hypothesis). ” Self insurance theory” gains its material
Nirmal Sharda
a second year student at IIM Ahmedabad. He has completed his Data prove that dollar is the pivot of the modern financial system.
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

The equation that must hold true for reserve currency in the previ-
graduation in commerce from Shri Ram College of Commerce and Most global commodities– including oil and gold – are priced in as percentage of GDP had risen to about 30 percent of GDP from ous standard is: (X-M+R)=G+STC+LTC
can be reached at dollars. In 2008, 45% of international debt securities were de- about 6-8 percent during 1970s and 1980s. The trend towards Where X is exports, M denotes imports, R denotes balance in
nominated in dollars, and only 32% in Euros. 66 countries used excess self insurance is ubiquitous. African reserves grew to a the service account, G stands for gold, STC is short term bor-
dollar as an anchor against 27 who used Euro. (IMF April 2008). level of nine month of import equivalent (against benchmark 3 rowings and LTC denotes long term borrowings. For a given cur-
abstract Furthermore 86% of international transactions were invoiced in month). rent account deficit, movement of gold reserve can be avoided by
The recent financial crisis has again raised questions over funda- dollars. (BIS 2007) This suggests that US is the center of the Another theory attributes cause of global imbalances central country only if short term debt (lent to central country) is
mentals of present global monetary system. Triffin saw paradox world financial system. to US monetary excesses which resulted in lower interest rates higher than long term investments (by central country) abroad
in current global system back in 1960s-creation of international li- At the same time, US is absorbing 70 percent of and substantial rise in consumer credit and consequently their (STC>LTC). Chronic current account deficits will necessarily trig-
quidity through creation of debt over issuing country. Surprisingly world’s surplus savings. (wolf 2008 p. 76) . According to the bank consumption and residential investment spending. This excess ger shortfall in short term borrowing of reserve currency coun-
the same questions about the sustainability of global imbalances of international settlements two-thirds of reserves (excluding spending spilled over abroad causing substantial rise in their try and hence cause movement of gold reserves outside central
are raised every time a crisis strikes but each time global finan- China) were in Dollars-not too short against 70 percent reported current account surpluses and consequently their reserves. But country. But under present monetary system G ceases to exist
cial system appears to be much more resilient. Nicholas Kaldor in in 2001, despite a fall of Dollar against Euro and Pound-Sterling. considering monetary growth rate during this period, it looks un- and all excesses of STC over LTC imply an increase in other coun-
1971 predicted “… transforming a nation (US) of creative produc- Standard economic theory suggests that surplus capital will likely. Also inflation expectations were largely subdued during try’s reserves. US don’t have to vary its interest rates to keep STC
ers into a community of rentiers” with an observation by commen- move towards capital-poor regions (where capital-to labor ratio is this period. and LTC in tandem-to attract gold. Also there are no restrictions
tator that the prediction looks equally true even 40 years after. relatively low) but globally, capital runs uphill: from the high-risk- on its external account. (Serrano, 2003)
90 Money Manager / January 2011 Money Manager / January 2011 91

the current scenario that works as international currency only with support of other
major economies that are using it as the main reserve currency.”
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-
Hicks states that even a chronic deficit-ridden dollar will continue deposit rates and determination of quantity of bank lending.
Third-party insurance though efficient, this system has major
to hold its reserve currency position because of these reasons: 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-
1) Approximately a third of US current account deficits is due to ferences in economic cycles and structures and they suffer from
equately, difficulty in pricing tail events such as financial crises,
In the aftermath of crisis there were several rumblings about the exports by US corporations from abroad-a permanent source of significant conflicts in history, culture, religion and politics, which
inability to diversify sovereign risks etc. (Isabelle et al 2009)
inherent flaws in the present global financial system and need to dollar demand. Also due to military superiority of US, developing makes currency and financial cooperation difficult.” (Grimes,
Pooling of reserves is a better alternative for self-insurance but
move away from it. Joseph Stiglitz proposed a new global reserve countries will continue to supply commodities to US and receive 2009) Furthermore ASEAN members want to use initiatives like
for that IMF will have to lend relatively freely without policy di-
system (UN Commission of Experts, 2009). Zhou, the Governor of payments in Dollars. Also Dollar is unlikely to be affected by a Chiang mai more to gain better bargaining position within the
rectives. Currently these countries do not trust IMF primarily be-
the People’s Bank of China, called for an international reserve unilateral action by a country. Rather that will only exacerbate existing power structure rather than to bring drastic change into
cause of its role in previous crisis situations and its domination
currency that delinked it from sovereign nations. During the same its own foreign position and can even trigger financial crisis. Also it. (Drezner 2009)
by United States and Europe. Also IMF’s resources are too small
year, John Lipsky, Director of IMF, assessed possibility of SDRs to other countries are likely to act against it. (Serrano, 2003)
for the role. Regional reserve pooling arrangements like Chiang
replace Dollar as reserve currency as “entirely conceivable”. Rus- But In the event of continued US current account deficit, market
Mai initiatives may provide practical solution in the short term.
sian President Dmitry Medvedev, at the G8 meeting in Italy, pa- could attempt to shift this balance from Dollar to other high in- Dollar block- (Martin Wolf 2008)
raded a sample minted coin of a new world currency to the press. come countries’ assets causing major tensions in the Euro Bloc. Consisting of countries using dollar as a currency or pegged to it-
UNCTAD’s Trade and Development Report 2009 also backed the Maurice Obtsfeld et al show that real exchange rate of European accounted for three-quarters of total global reserves by the end of
idea of using SDR as a form of liquidity against dollar. currencies will have to rise by over 50 percent if East Asian coun- 2006. Internal recycling within the block can match net surpluses
tries maintain their dollar peg as Europeans will have to adjust to 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
shrinkage in US deficit and substantial rise in East Asian surplus. quired. Within the block, peripheral members can hold up dollar.
high transaction costs, anti growth bias of European economy,

whether dollar can Deterioration of external balances due to appreciation of curren-

cies might cause Euro zone to fall apart.
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-

china and east asia

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.
Any impact of devaluation of dollar will also have to consider serves held in SDR to 4 percent. (IMF Working Paper May 2009).
Also competing stores of value will cause higher exchange rate
‘valuation effect’. According to a Mckinsey report even with a In the aftermath of crisis, there are signs of major policy shifts But for SDRs will require deep and liquid markets to acquire re-
volatility if reserve holders manage their portfolios. Close policy
balanced current account, US would continue to run an overall in China. It has more or less stopped buying US Treasuries. Also serve currency status. A critical mass of issuance and trading of
coordination among key reserve issuers would be necessary avoid
trade deficit in 2012. This would be composed of $720 billion defi- Beijing sold $50-$100 billion of dollar assets every month since SDR denominated assets not just by IMF but by some member
exchange rate volatility. But problem is that in previous cases of
cit in merchandise and $430 billion surplus in service account…. late 2008, and invested in natural resources like minerals, energy countries as well. Such attempts in 1970s failed primarily due to
multiple currencies, reserve holders tend to move towards a sin-
Its net foreign debt position would swing from a projected (-) $8.1 and European and Asian equity. China is also making loans to coordination problems. (IMF Working Paper May 2009)
gle currency for the “network effects” of money. (Tadokoro 2010)
trillion to a positive $4.9 trillion. This is with an additional note oil companies in oil producing countries that will be repaid in oil. Historically, composite currencies traded commercially
that this would be the biggest default in the history of the world (Wade 2009) are not attractive for liquidity-return combination. For this to hap-
and might shift reserves away from dollar assets. This will be China accounts for 60 percent China has current ac- pen, someone would have to act as market maker and subsidize
primarily due to the valuation effect of dollar devaluation. When count deficits against all major East Asian countries. Hence it the operation of the market until it acquired scale and liquidity. Creating a public investment fund-
dollar falls, US’s liabilities (which are also measured in dollar) has a major interest in internationalization of RMB in the region. The current export led model adopted by developing countries
also fall. But at the same time its asset (which are denominated China is making several steps in this direction: bilateral foreign cause capital to be “recycled back” by US back into their own
in local currencies will rise in Dollar terms) Martin wolf calls this currency swap scheme with Korea, Hong Kong, Malaysia, Indone- Domestic currency denominated bond markets country. But the investment does not reflect investment priorities
“biggest default in the history”.. sia and Argentina. Also China is evaluating possibility of in cross of that country. Also portfolio investment from these countries
Dollar is likely to survive in the near future simply border trade settlements in RMB with Hong Kong, Yuman and
in Developing countries- often distort relative prices and cause excessive volatility rather
There has been a substantial increase in the bond issuance of
because of lack of alternatives, its deep and liquid financial mar- ASEAN. than providing any long term financing. What is needed is(are)
emerging economies and amounted to $7.2 trillion. Approximately
kets and inertia on the part of players. Flandreau et al suggest But major hurdles in internationalization of RMB in- closed ended fund(s) for making investments in the developing
84 percent was denominated in local currencies; issuance of local
that central banks persist to existing reserve currencies despite clude lack of capital account convertibility, lack of floating cur- countries. These funds would own assets in these countries
currency denominated bonds has been modest though increasing.
decline of economic hegemon. Dollar did not become world cur- rency (which prevents forward transactions and hence prevent and simultaneously issue their liabilities in their local currency.
But a major chunk of the bonds is subscribed by domestic banks.
rency until 1944 Bretton Woods Conference-approximately seven from hedging currency risks) and poor state of domestic finan- Multilateral nature of these funds would incentivize developing
(IMF Working Paper April 2010)
decades US overtook UK in terms of GDP. Also strong cial markets, China has taken several steps in this direction. In countries to invest their reserves with these funds. (Arista 2009)
Eichengreen et al suggest that international financial institutions
strategic ties of US with East Asia and Japan also provide it a June 2010, the People’s Bank of China announced the return to
could encourage use of assets denominated in inflation-adjusted-
safety net. But position of the dollar is now more vulnerable than a managed floating exchange rate regime that allows for intra-
basket of emerging market economies by issuing debt denomi-
before, particularly after the credibility of the US financial market day movements of .5 percent from a central parity. Also there
nated in basket of currencies and simultaneously purchasing
became highly questionable. Thus US now needs to make delib- have been several liberalization efforts in fixed income markets
bonds in those currencies.
erate efforts to gain trust of global economic players. Dollar in including freeing up of rates on interbank transactions, central
such condition can be called ‘Negotiated Currency’ –“currency
92 Money Manager / January 2011 Money Manager / January 2011 93

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, 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

there’s a world of
opportunities out there?
We think you’re right.
Probably IIMA’s best known and most quoted econo- Niall Ferguson has exhaustively and succinctly
mist post the crisis, Raghuram Rajan uses this 250-page book covered the evolution of money from its humble origins as cocoa
to strongly drive home the point he infamously raised during the beans used to trade slaves in South America to the plastic
Fed’s routine Jackson Hole retreat in 2005. money of the present age. Money in its various avatars – be it If you’re looking for a career that’ll
The book takes a reader through reasons why he the rupee, dollar or pound is the fundamental link determines continue to stretch you long after
believes economists and politicians should take a greater blame the dynamics between the financial and real economy. In that
university, UBS is a great place to start.
for the financial crisis than the average banker. While he does sense a deeper study of its evolution sheds interesting insights
acknowledge that certain institutions were too keen on making into the state of the current monetary and financial systems Whatever you‘re studying now, from
the proverbial quick buck, he cautions against dismissing the and how they will evolve in the years to come. The book is a your first day at UBS you’ll continue to
financial sector merely as a greedy industry serving to line the lot more than just a timeline that traces the roots of money; it learn from the very best in their field.
pockets of its workers. While building upon the social useful- delves deep into the men and the society who were intimately
And you‘ll be realising your potential
ness of modern day banks, hedge funds and other financial involved in its creation. Be it the Medici family who gave us the
institutions, Rajan proposes some novel methods of regulation. double entry book keeping system or Nathan Mayer Rothschild as part of a great team that believes
A very interesting distinction that he seeks to draw is between who virtually detonated Napoleon through the bond market – in succeeding together. As well as our
institutions that are too big to fail (under which definition would the reason for evolution of the fancy stock markets and bond Graduate Program, we offer internships
also fall PIMCO) and ones that are too intricately linked to fail markets have had very little to do with the intent of creating
to students in all stages of their academic
(like Bear Sterns). an institution. They were intended to serve the money making
Besides these chapters on finance and its regulations ambitions of the holders of the baton of power. Men of power
career – so visit
which occupy the beginning and end of the book, the middle is have determined the course that currency and money have taken to explore a world of opportunities
what I believe the book shall really be remembered for. In these to reach the present stage. But Ferguson doesn’t stop there in and be part of our success.
chapters Rajan carries out a detailed and refreshing analysis of analysis – he takes it a step further by analysing the political un-
why he believes the problems facing the USA are too structural derpinnings that went into making money, mankind’s fascination
to be resolved even when the financial markets come back to for Gold and how it determined seigniorage. At this point of time
life. From issues relating to a suddenly less flexible workforce post a financial crisis that has worked economists and bankers
to decreasing average years of study and changing demograph- into overdrive, the author, a historian by profession, provides a
ics, Mr. Rajan cautions that the current downturn might quite refreshing and altogether different insight into the vagaries of
become the norm if the American leadership does not take some the financial markets, globalization and the geopolitical impact
hard decisions very soon. Easy to understand with a very ambi- on monetary practices. An interesting and absorbing read that
tious scope, that it does full justice to, this book is a must for deeply analyses from a business and societal stand point the
any aspiring banker. ascent and also possibly the descent of money.
98 Money Manager / January 2011 99
BETA, THE FINANCE CLUB OF IIM AHMEDABAD 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

NETWORTH, THE FINANCE CLUB OF IIM BANGALORE 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,

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:

Money Manager / January 2011 101