FKCCI ARTICLE: JUNE/JULY 2008 ISSUE

GOLD WILL CONTINUE TO GLITTER

By Adhvith Muralidhar Dhuddu, Regular Columnist

There’s been much hullabaloo about investing in gold and gold related companies in the last few months. Although gold has historically been a low yielding investment in the long run, it has run up spectacularly and more than doubled in the last few years. With the stock markets in India, China and the USA in shambles right now and other asset classes drastically underperforming, investors are exploring safe havens like gold, silver (and other precious metals and commodities) to park their funds. But let’s look at some basic drivers of supply and demand for gold to see if it will continue to shine.

1. Inflation and Gold as a safe haven: Inflationary periods are detrimental to any economy and if high inflation persists for long, it consistently erodes the value of a country’s currency. Going back to the basics of money, we recognize that the primary function of money is: (a) to preserve value, (b) to be a medium of exchange and facilitate easy transactions, (c) to be a unit of account to help measure the value of an economy. The second and third function can be taken for granted as this is fulfilled irrespective of the type of currency or money used. But the most important function of money is to preserve and store value. If Rs.10 could buy you 5 tomatoes a few years ago, but can only buy you two tomatoes now, clearly the purchasing power of the currency has declined and it has failed to preserve value. Governments and central banks use politically appropriate verbiage and label this inflation.

When this phenomenon unfolds there is a rush to accrue assets that don’t decline in value and historically gold has been that safe haven. Gold is traditionally identified as a safe haven investment that preserves capital and increases in value gradually. But what is unfolding now is monumental because not only are emerging economies experiencing high inflation, slowly the US and the European economies will face inflationary problems. When this occurs, the rush to accumulate gold will drastically drive up the price with an increase in demand.

2. Gold investments via ETFs, ETN’s and increased access to retail investors: The only access individual investors had to invest in gold was jewelry and coins making it an illiquid and untradeable asset. But this is rapidly changing. Now, investors can buy, sell and trade gold with ease with the introduction of Exchange Traded Funds (ETF’s) and Exchange Traded Notes (ETN’s).

The boxed portion of the gold supply demand table below clearly reflects the rise in demand for gold by retail investors via ETF’s and other similar products. This is poised to increase tremendously as the demand to invest and trade gold continuously increases. The rise in popularity of these ETF’s and ETN’s is evident in the US markets and as other emerging countries’ financial markets mature to provide these instruments, the demand and popularity for them will increase. Another vital factor is that gold is considered a safe haven not just by US investors or households in India, but every individual, bank, and fund manager knows that gold is a safe haven investment and as access, liquidity and tradability increases, there will undoubtedly be more demand.

3. Role of Central Banks, Sovereign Wealth Funds and Foreign Exchange Reserves: As more wealth is created in third world and emerging economies and as foreign exchange reserves of export oriented countries continue to swell the demand for gold will continue to rise. The US Dollar’s recent decline has hurt the value of foreign exchange reserves forcing policymakers to identify another stable currency or any other form of capital preserving asset. And many central banks are slowly transitioning portions of their funds to gold, silver and other precious metals. Not only is gold turning out to be a safe haven for retail investors, even central banks and sovereign wealth funds want to park their funds in gold.

Nobel Prize economist Joseph Stiglitz clearly delineated in his book, “Making Globalization Work”, the flawed single currency reserve system. Many of the fears he outlined are slowly unfolding with the US dollar becoming a less favorable reserve currency. Allocators of forex reserves are prudently diversifying their funds by exploring other currency options like the Euro and Yen and safe haven commodities like gold and silver.

4. The Dollar Factor: The weakening of the US dollar has significantly affected the price of gold. Like crude oil, gold is a dollar denominated asset and its relative price has risen with the fall in the value of the US dollar. At least 15 to 20 percent of the price rise in gold can be attributed to the weakening of the US dollar.

Although the US Dollar/Indian Rupee relationship has been choppy, the overall strength of the US dollar (measured best using the US Dollar Index), which compiles the US Dollar exchange rates with the Yen, Euro, Pound, Swiss Franc and other major currencies has significantly declined. So the USD’s comprehensive weakness in the last few years helped inflate the price of gold, silver, steel, copper, crude oil, natural gas and many other US Dollar denominated commodities. Hence, going forward, the movements of the US Dollar will considerably impact the price of gold.

5. Universal demand and supply: Given below is a table outlining the worldwide supply and demand for gold in the last ten years. A comfortable balance can be observed in the supply less demand column which fails to explain why the price of gold has increased so much. What’s important now is not what the historical relationship was, but what will the supply demand relationship will look like going forward.

The increase in demand for gold going forward cannot be denied. Going forward, demand for gold to use in electronics, dentistry, and other industrial applications will only increase. But the supply picture for gold does not look very bright. Gold supply has increased at an average rate of 2-3 percent historically and this number is not about to change any time soon. One has to remember that the supply of gold is limited to how much gold is mined which limits the availability of this commodity.

6. Extreme Cases: Some economists have boldly predicted that the days of fiat currencies are numbered and the world will return to the gold standard. This could unfold if a major currency like the Dollar, Euro or Yen completely collapses or if inflation in developed economies like US reaches the stratosphere rendering paper money to be completely valueless. Although these are extreme cases nothing can be ruled out. In this case, the value of gold will also reach the stratosphere trading at eight to ten times of its current price.

Clearly, the current dire economic scenarios around the world, and other favorable factors outlined will send the price of gold higher. One should explore to see how they can diversify to include gold in their portfolio.

Federation of Karnataka Chamber of Commerce and Industry: April 2008 Issue
INFLATION’S LOOMING THREAT GOING FORWARD,
by Adhvith Dhuddu, Regular Columnist

The first four years of our Finance Minister’s term unfolded with buoyancy and resilient growth in most sectors. GDP grew handsomely, rising household incomes pleased the masses, corporate profits scaled new highs, the stock markets ventured into uncharted territory and prices across the board were relatively stable.

But the recent and sudden spike in prices exacerbated the looming inflationary threat and is creating jitters in the Finance Ministry, Commerce Ministry, RBI and more so at 7, Race Course Road, the PM’s Residence. Speculation about early elections is alive and well but even the regularly scheduled May 2009 elections could be marred with high inflation and outrageous price rises. This recent price rise is merely a preview of the agony faced by the electorate if appropriate measures are not taken to prevent further price rises and curtail inflation.

Recent measures taken during the damage-control mode seemed to have assuaged some pressures but pivotal factors which determine inflation (discussed below) are still at bay. Our FM, PM and RBI governor have vocally pledged that price stability

In a great nation like India, it is quite a pity when a starving family and has to make a choice between food and medicine when somewhere in the country food reserves in godowns are rotting.

is a high priority objective and are even willing to sacrifice growth to suppress inflation; a positive sign. But let’s examine what the FM has said before about inflation, price stability and monetary policy to measure him against his own benchmarks and analyze some root causes of inflation to tackle unfavorable price rises in the future.

Economist John Maynard Keynes said, “Inflation is a form of taxation which the public find hardest to evade and even the weakest government can enforce when it can enforce nothing else.” This invisible tax eats into the savings and incomes of the rich and poor alike, but impacts the lower rung more. In a developing economy like ours, the absence of a social security safety net and absence of income and employment insurance in the unorganized sector (which employs a significant portion of our population) severely aggravates the inflationary consequences for lower and lower-middle class families. The published inflation rate clouds the all important rate of increase in the price of basic food which affects the majority of our population. For example primary articles (which comprises 22 percent of the WPI and contains food articles) registered a growth of close to 9 percent at March end.

Many attribute the current spike in inflation to global externalities like widespread commodity price rise, supply shortages, demand increases, etc. This is true only to a certain extent as these trends have been in place for sometime (1-2 years). There are some reasons unique to India which is driving up inflation and needs to be tackled. Here are some of the fundamental macro issues causing inflation (and will continue to do so if they are not confronted).

1. Outrageous Money Supply: Going back the basics of inflation you learn that it is primarily caused by money supply issues. A continuous increase in money supply creates a situation where more and more money is chasing the same number of goods and services and this automatically drives up prices (irrespective of the supply-demand equation of the product). The importance of this characteristic cannot be stressed more because it has been the primary cause of high-inflation periods in recent economic history. USA (1973-1982), Germany

A continuous increase in money supply creates a situation where more and more money is chasing the same number of goods and services and this automatically drives up prices.

(during the 1970s) and Japan (1971-1980) experienced high inflation during the periods mentioned. All these were caused due to an increase in money supply and the central banks of all these economies had to drastically reduce money supply and increase interest rates to squeeze inflation out of the system.

Looking at the numbers from the recently released Annual Policy Statement 2008-09 from the RBI (abbreviated as RBI-APS-0809 for future references) proves the above point. According to the report, money supply (M3) increased by 20.7 percent in 2007-08, and 21.5 percent in 2006-07. Supply of money in the form of bank credit to the commercial sector increased 20.3 percent and 25.8 percent in the preceding two years respectively. All these increases are above the long term average rate of money supply growth in India. In fact later in the report RBI even acknowledges that, “money supply has risen above indicative projections,” and hence has decided to slow the printing presses. They plan to moderate monetary expansion (i.e. money supply) this time around only at 16.5-17 percent. The RBI deserves restrained applause because this is a step in the right direction and the problem is being tackled at its root. This is just the start and there should be a continued effort to control the supply of money, or we could see multi-year inflationary periods like the ones experienced by USA and Germany in the 1970s.

A common argument that is cited to support the increasing money supply numbers is the increase in net capital inflows. I will discuss this in detail later.

2. Inefficient Food Distribution Channels and Farming Techniques: Anyone blaming the supply-demand mismatch for recent price spurt in food articles needs to think twice before making that claim. The Ministry of Agriculture recently released numbers stating that, “total food grain production is expected to increase to an all-time high of 227.3 million tonnes in 2007-08 from 217.3 million tonnes in 2006-07.”

So, if the increasing disposable income of families is being reflected in the increased demand and supply of food is at record levels, why is it that food prices are going through the roof? It’s a simply because of horrendous and outright awful supply chain management and distribution techniques (or lack of them) that is driving up prices. The various middlemen coupled with rotting grains in the warehouse automatically decrease supply and increase the prices. No rain God, clearing of debts, increasing of fertilizers, giving free electricity or water, increasing/decreasing all sorts of taxes and duties, banning and placing limits, etc will solve this. It’s been tried repeatedly and has failed miserably. It’s pretty abysmal when our farmers are toiling hard in the fields only to see significant portions of their crop rot in godowns because of inefficient food and crop management.

In a great nation like India, it is quite a pity when a starving family and has to make a choice between food and medicine when somewhere in the country food reserves in godowns are rotting. We boast of churning out quality engineers, being home to IT behemoths and rich industrialists, but these are insignificant if we cannot feed our own people well. India’s food economy has to be strengthened and some basic steps like improving distribution channels, optimizing supply chains improving storage facilities must be undertaken. Knowing the unreliable nature of our government especially in the agricultural sector, the best way of doing this is to introduce competition. This should be a long term commitment and will eventually be undertaken when there is a crisis, like how the

Artificially keep the Indian Rupee (INR) undervalued vis-à-vis the USD by pumping in billions of dollars is analogous to pouring money into a bottomless pit for short term happiness. This flawed approach to undervalue the currency to improve growth is wrong and unsustainable in the long run.

foundations of our economy were reformed during a crisis. When a patient’s veins or arteries are clogged hampering the blood circulation, the doctor does not pump in oxygen, replace a leg or a hand, or improve the condition of the blood, he tries to open up the arteries first to improve blood flow and then tackle other issues. This is what needs to be done in the agricultural sector in India.

3. Misguided Currency Management: The misconception that a weak currency vis-à-vis the US dollar (USD) is good for Indian businesses because it serves as a backbone for export oriented businesses is widespread in India. The cheer leading from export oriented industries and export lobbies to artificially keep the Indian Rupee (INR) undervalued vis-à-vis the USD by pumping in billions of dollars is analogous to pouring money into a bottomless pit for short term happiness. This flawed approach to undervalue the currency to improve growth is wrong and unsustainable in the long run.

I agree that advocating an absolutely hands-off approach could be detrimental and make our currency extremely volatile creating ripples in the economy. Instead there should be a slow process of decontrolling currency valuation to allow the market forces to operate with relative freedom and enable price discovery. Another option is to allow the value of the INR vis-à-vis the USD to rise faster.

Besides helping the fight against inflation a strong local currency is beneficial in other ways. A stronger INR will automatically reduce food exports, keeping more food at home, hence increasing supply. Our strong currency will also increase imports

There should be a slow process of decontrolling currency valuation to allow the market forces to operate with relative freedom and enable price discovery.

of food because the same currency can now buy more hence increasing supply again. The government can then refrain from the ancient and unsuccessful policies of raising and lowering duties, banning and limiting stocks, etc. The increased purchasing power of the INR will be able to buy more products for the same amount of money. All this will automatically reduce inflation because of an immediate increase in supply and stronger currency being able to purchase more. There are some caveats associated with this technique but if executed with precision, it can work well.

Coming back to the argument that money supply should grow to support net capital inflows, we can see how a stronger currency can solve this too. According to RBI-APS-0809, “net capital inflows surged by 172 per cent to $81.9 billion during April-December 2007,” requiring the RBI to increase the supply of Indian Rupees. In lay man’s terms, over the last few years the demand for our currency has gone up but that strength is not reflected completely at the current price of our currency. Its common sense that demand for a certain product increases in the financial markets when the market perceives it to be undervalued and slowly reduces when the market thinks the price is fair.

But, in the case of the Indian Rupee, because the value of the currency has been artificially suppressed, the demand for it doesn’t seem to go away. The government ends up fighting a battle on two fronts: it has to continue to keep the Indian Rupee undervalued (to help exporters) by pumping money, but also try to decrease the demand for

Increasing the currency’s strength will mean less money needs to be printed to support net capital inflows, less money needs to be printed to support artificial currency valuation and less money needs to be printed as the purchasing power of our currency increases, eventually also helping tame inflation.

the currency so that market forces don’t overwhelm governmental force suppressing the price of the Indian Rupee. Finally the government has to continue printing more money to support the required payments to keep the INR undervalued. As capital inflows increase, as demand for local investment increases, and in general as the demand for INR increases it should be reflected in the currency, but it is not. So allowing the currency to strengthen will automatically relive the pressure to continue increasing money supply at high rates. Increasing the currency’s strength will mean less money needs to be printed to support net capital inflows, less money needs to be printed to support artificial currency valuation and less money needs to be printed as the purchasing power of our currency increases, eventually also helping tame inflation.

Consider this practical case: A year ago the central bank was making a valiant effort to keep the Rupee at 44-45 levels (vis-à-vis the USD), but eventually gave in when they were overwhelmed by market forces (and also the rising cost of suppressing the INR) and stepped back to allow a 10-15 percent appreciation of the Rupee to 39-40 levels. What about the approximately $120 billion pumped in to keep the Rupee at 44-45 level? It’s gone, wasted and will never come back (i.e. being held in USD denominated assets); in fact its value has now decreased because the US dollar has depreciated vis-à-vis the Rupee (imagine if this money could be used in more productive ways). History has shown repeatedly that as an economy strengthens, over the long run the value of its currency will rise. It is basically pointless to continue pumping money continuously to keep the currency at an artificial level. Think of the same situation two years from now when our government will again struggle to keep the Rupee at the 39-40 level by pumping in money and again give up to let it rise to the 35-36 level. With the democratization of finance and integration of financial markets over the globe it will become increasingly difficult and expensive to control currency values.

4. Flawed analysis that banning exports, tweaking import/export duties, fixing stocks levels, etc will solve the inflation problem: For some reason, our politicians and bureaucrats don’t seem to understand that these temporary tweaks will not solve inflationary issues in the long run. Generally, a complete scrap of import or export duties is good, but banning any kind of exports or imports, mandating stock levels, etc is unacceptable in a capitalistic and forward looking economy like India and is synonymous to going one step forward and two steps back.

On monetary policy, the FM said a few years ago that, “Unless we bring the fiscal deficit down to 3 per cent or below, we cannot gain mastery over inflation.” The finance ministry along with the RBI has worked diligently to achieve this number and have to be given credit for their efforts. On last count, the Gross Fiscal Deficit (GFD) for 2007-08 constituted 3.1 percent of GDP (from RBI’s Annual Policy Statement 2008-09). A significant assist from increased tax revenue cannot be denied and definitely contributed to this achievement.

There is another crucial reason that inflation needs to be brought under control. High inflation rates usually results in an ultra-low or negative net savings

But our Finance Minister certainly deserves credit for his ability to be able to balance the demands from the left and the right, the aam admi and the corporations, the public and the private sectors.

rate. According to our own Finance Minister, “High inflation and a negative return for depositors/savers make for an explosive combination, when key elections are round the corner.” (November 2^nd, 2003). Let’s see how our captain navigates this ship going forward.

It’s a relatively stress free job to analyze numbers, rely on theories and suggest remedies for the problems facing the economy right now. But our Finance Minister certainly deserves credit for his ability to be able to balance the demands from the left and the right, the aam admi and the corporations, the public and the private sectors and still manage to keep India’s growth intact and its flag fluttering proudly in the sky.

Money WhizDom: Demystifying the Bear Stearns fallout: The week that prevented global financial calamity.

By Adhvith Dhuddu, Regular Columnist

The US hasn’t been confronted by an economic tsunami of this proportion since the Great Depression. Although the downturn in the Indian stock markets was evident, the global repercussions could have intensified if the Fed’s antidote was considered insufficient. Many around the world failed to realize the gravity of the crisis because the Feds actions prevented a sudden and sharp downturn.

Never before has the US economy been confronted by so many issues that are affecting their fiscal and economic report cards, businesses, individuals and government. Its facing declining stock and real estate prices, increasing food, commodity and energy prices, weakening dollar, trade and fiscal deficits, increasing unemployment and inflation, decreasing investment, stagnant productivity levels, low confidence levels, decreasing consumption, low saving level, increasing cost of debt in a credit dependent economy, and to top it all off the failure the world’s fifth largest investment bank, Bear Stearns.

Many on Wall Street were aware of the pessimism surrounding Bear Stearns, but the severity of the fallout was what shocked investors and caught them by surprise. The implosion of Bear Stearns indicated a lot more than the dampened psychology on Wall Street. This fallout clearly showed how financial engineering and innovation outpaced the federal financial market regulators who were caught off guard, desperately trying to save face and avert a lock down of the financial system in the country (and around the world).

To understand what exactly happened at Bear Stearns, one has to put together a few pieces of the puzzle. The crisis that unfolded here was primarily driven by a liquidity crunch or in simple terms a lack of cash to meet day to day activities. Complex financial trades performed by investment banks require them to put up and receive large amounts of money (tens of billions) on a day to day basis, making them heavily cash dependent. The fluctuating values of its investments are why large sums of money flow in and out daily.

Investment banks are unique in their practice of using extremely high leverage to maximize their returns. A Lehman Brothers or a Goldman Sachs can approach a bank, put up $1 billion in assets as collateral to receive say $30 billion dollars to invest with, and this would be 1:30

This fallout clearly showed how financial engineering and innovation outpaced the federal financial market regulators who were caught off guard, desperately trying to save face and avert a lock down of the financial system in the country (and around the world)

leverage. Although it sounds outrageously risky, investment banks thrive on this luxury, something that banks and investment firms in India don’t completely indulge in. Bear Stearns in particular was highly leveraged, as high as 1:40 in some sections of its business.

The commercial banks like JP Morgan, Bank of America or Wachovia, who provide highly leveraged cash, can anytime call upon the investment bank to put up more collateral if they feel the investment bank has immersed itself in bad investments that are rapidly losing value.

Bear Stearns was whacked with a double whammy, when distressed investors started to pull out cash and some of their investments started to decline rapidly, the commercial banks demanded more collateral. Bear Stearns slowly drained their cash reserves to meet collateral demands, handicapping them on a daily basis. Their cash reserves declined from $17 billion to less than $2 billion in just four days, sparking a bank run. Having run out of cash they couldn’t clear trades on a daily basis, were unable to provide more collateral and couldn’t repay many investors.

This is when the Federal Reserve stepped in via JP Morgan to bail them out by providing emergency funds to continue daily activities, without which the complete financial system could have gone into a seizure.

It's important to distinguish an investment bank from a commercial bank to understand JP Morgan's involvement. Individuals park their savings in commercial banks which are insured in USA by the Federal Depository Insurance Corp (FDIC) for up to $100,000 per account. It’s common knowledge that the central bank of a country (in this case the Federal Reserve) is the

After starving off a bankruptcy at Bear Stearns and realizing the severity of the liquidity crisis surrounding investment banks, for the first time in 95 years (since its inception in 1913), the Federal Reserve opened the discount window to investment banks.

primary source of money and the lender of last resort, but only commercial banks have direct access to these funds via the discount window (i.e. rate at which they can borrow from the central bank). Commercial banks can borrow directly from the Federal Reserve, something an investment bank cannot do. Investment banks are not closely regulated by the government, which is why they cannot borrow directly from the central bank.

This is precisely why the Fed had to allow JP Morgan to borrow massively, who then turned around and lent to Bear Stearns just to keep the company alive. The Feds couldn’t have lent to Bear Stearns directly and had to lend via a commercial bank. One could ask why not Citigroup or Wachovia or Bank of America, as they are also commercial banks. Unfortunately, these banks were preoccupied with cleaning up their own sub-prime mess, and JP Morgan was the only unscathed banking still standing tall on Wall Street.

When JP Morgan acquires Bear, it will primarily be for Bear Stearns' highly successful prime brokerage and clearing businesses. The two other divisions: investment banking and investment advisory are of little value to JP Morgan as its own investment banking division is a world-class setup. There was a lot of clamoring when the takeover price of $2/share was announced (now increased to $10/share), saying the company has been tremendously undervalued. Many critics might be proved wrong because the amount of garbage on the balance sheets of Bear Stearns might actually mean the company is negatively valued at say negative $10-$15 billion affecting JP in the future. But because JP Morgan has a $30 billion backing from the Fed, it might siphon off all the bad investments onto the Fed and retain the good ones eventually having little to no affect on JP.

After starving off a bankruptcy at Bear Stearns and realizing the severity of the liquidity crisis surrounding investment banks, for the first time in 95 years (since its inception in 1913), the Federal Reserve opened the discount window to investment banks. This revolutionary move has so far warded off failures at other investment banks and also reflects enormity of the crisis. Clearly the Fed realized that desperate times call for desperate measures.

Regulating investment banks and hedge funds is extremely tricky. The quantitative and mathematical nature of their operation requires them to trade equities, bonds, debt, forex, futures and options in large quantities at lightning speed. The positions on their balance sheet change literally every day making the risky and highly leveraged nature of their positions complicated for regulation. Although the Federal Reserve knew of the threats posed by this due to their closely intertwined nature to the financial system, they never saw the need to regulate because of the high level of counterparty surveillance at investment banks and hedge funds. The

The most apparent global impact is the severe dent on the psyche of the investors from Wall Street to the Great Wall. Besides the increased cost of debt, the cost of insuring and securitizing debt has also gone up.

last time counterparty surveillance failed was the 1998 collapse of Long Term Capital Management hedge fund. Although the Bear Stearns collapse was primarily driven by a liquidity crisis, it can partly be blamed on failure of counterparty surveillance.

The impacts of this event have been widespread. The increased cost of capital has had a major blow on the investment banks forcing them to decrease their leverage significantly in the recent weeks. The most apparent global impact is the severe dent on the psyche of the investors from Wall Street to the Great Wall. Besides the increased cost of debt, the cost of insuring and securitizing debt has also gone up. Decreased liquidity in these markets is also a valid concern.

One disturbing parallel this crisis draws with the Great Depression is that in both cases banks caved in. The Great Depression saw widespread failures of commercial banks (this is when the FDIC was introduced) and this time an investment bank which specialized in advanced investment strategies like sub-prime mortgages and quantitative trading fell through. Despite their functionary difference, in both cases they perilously threatened to crumble the complete financial system and freeze liquidity. Note that the Great Depression witnessed widespread failures of banks; in this case, we have only seen one investment bank fail. Any more nasty surprises could cripple the already strained financial system, fueling speculation of a depression or a longer-than-anticipated recession.

History has proven that the US economy is one of the most resilient and nimble structures around the world. It has braved diverse problems from accounting scandals to bank failures and continued to roar forward. This is largely attributable to the strong foundations and competent regulatory institutions. Although this down phase is looking different one can be sure that when the bad times pass, investment opportunities will open up.

Money WhizDom: Demystifying, debunking recent Bear Stearns fall out

Adhvith Dhuddu, CT regular columnist

Wednesday, March 26; 12:00 AM

The U.S. hasn't been confronted by an economic tsunami of this proportion since the Great Depression. Our financial report card looks bleaker than ever with declining stock and real estate prices, increasing food and commodity prices, increasing unemployment and inflation, weakening dollar, decreasing investment, stagnant productivity levels and, to top it all off, the failure the world's fifth largest investment bank, Bear Stearns.

Many on Wall Street were aware of the pessimism surrounding Bear Stearns, but the severity of the fallout shocked investors and caught them by surprise. The implosion of Bear Stearns indicated a lot more than the dampened psychology on Wall Street. This fallout clearly showed how financial engineering and innovation outpaced the federal financial market regulators who were caught off guard, desperately trying to save face and avert a lockdown of the financial system in the country (and around the world).

To understand what exactly happened at Bear Stearns, one has to put together a few pieces of the puzzle. The crisis that unfolded here was primarily driven by a liquidity crunch or, in simple terms, a lack of cash to meet day-to-day activities. Complex financial trades performed by investment banks require them to put up and receive large amounts of money (tens of billions) on a day-to-day basis, making them heavily cash dependent. The fluctuating values of its investments are why large sums of money flow in and out daily.

Investment banks are unique in their practice of using extremely high leverage to maximize their returns. A Lehman Brothers or a Goldman Sachs can approach a bank, put up $1 billion in assets (cash, building, money in the bank, etc.) as collateral to receive say $30 billion dollars to invest with and this would be 1:30 leverage. Although it sounds outrageously risky, investment banks thrive on this luxury. Bear Stearns in particular was highly leveraged, as high as 1:40 in some sections of its business.

The commercial banks such as JP Morgan, Bank of America or Wachovia, which provide highly leveraged cash, can anytime call upon the investment bank to put up more collateral if they feel the investment bank has immersed itself in bad investments that are rapidly losing value.

Bear Stearns was whacked with a double whammy when distressed investors started to pull out cash and some of their investments started to decline rapidly, prompting the commercial banks to demand more collateral.

Bear Stearns slowly drained its cash reserves to meet collateral demands, handicapping them on a daily basis. Its cash reserves declined from $17 billion to less than $2 billion in just four days, sparking a bank run. Having run out of cash, it couldn't clear trades on a daily basis, was unable to provide more collateral and couldn't repay many investors. This is when the Feds stepped in via JP Morgan to bail them out by providing emergency funds to continue daily activities, without which the complete financial system could have gone into a seizure.

It's important to distinguish an investment bank from a commercial bank to understand JP Morgan's involvement. Individuals park their money in savings and checking accounts in commercial banks, which are insured by the Federal Depository Insurance Corporation for up to $100,000 per account. It's common knowledge that the Federal Reserve is the primary source of money, but only commercial banks have direct access to this money via the discount window. Commercial banks can borrow directly from the Feds, something an investment bank cannot do.

This is precisely why the Feds had to allow JP Morgan to borrow massively, which then turned around and lent to Bear Stearns just to keep the company afloat. The Feds couldn't have lent to Bear Stearns directly and had to lend via a commercial bank. One could ask, why not Citigroup or Wachovia or Bank of America, as they are also commercial banks? Unfortunately, these banks were preoccupied in cleaning up their own sub-prime mess, and JP Morgan was the only unscathed banking giant still standing tall on Wall Street.

If and when JP Morgan acquires Bear, it will primarily be for Bear Stearns' highly successful prime brokerage and clearing businesses. The other two divisions, investment banking and investment advisory, are of little value to JP, as its own investment banking division is a world-class setup.

One disturbing parallel this crisis draws with the Great Depression is that in both cases, banks caved in. The Great Depression saw widespread failures of commercial banks (this is when the FDIC was introduced), and this time, an investment bank that specialized in advanced investment strategies such as sub-prime mortgages and quantitative trading fell through. Despite their functionary difference, in both cases they perilously threatened to crumble the complete financial system and freeze liquidity.

Note that the Great Depression witnessed widespread failures of banks; in this case, we have only seen one investment bank fail. Any more nasty surprises could cripple our already strained financial system, fueling speculation of a depression or a longer-than-anticipated recession.

Online link to this arcticle: Click here

College students should know ABCs of credit score reports

Adhvith Dhuddu, CT regular columnist

Wednesday, March 19; 12:00 AM

Here's a startling statistic: In the economies of India, China and Russia, the ratio of people to credit cards appears healthy (ranges from 1 credit card for every 20 to 50 people), but in the U.S., the equation reverses, averaging 3 to 5 credit cards per person.This clearly shows how credit-dependent we are, but also reflects the requisite nature of credit cards in an increasingly cashless economy. With this in mind, the importance of maintaining, tackling and improving your credit history and credit scores cannot be more highly stressed.

Your credit score is a financial report card outlining how you have handled debt historically, helping corporations decide how creditworthy you are. Going forward, your credit score might be much more important than you think it is. When the Facebook generation steps into corporate America, unlike in the last century, when credit scores only mattered during credit card, home and car loan applications, in the future credit scores will determine everything from how your bills for water, electricity, cable and Internet are handled to your pay structure for televisions, laptops and other accessories.

The three broad aspects to focus on are obtaining your credit score, analyzing your credit score to report errors, corrections, and finally, outlining a plan to improve your credit score.

Credit reports are compiled by three companies: TransUnion, Equifax and Experian. The information in these reports is presented differently, and these organizations also calculate their own credit scores (Equifax has ScorePower, Experian has a PLUS score and TransUnion has its VantageScore). But it's your FICO score, compiled by the Fair Isaac Company, that is the all-important number. This score is derived from the information provided in the abovementioned reports and ranges from 300 to 850.

Taking the initiative to obtain your credit report is the first step. We are permitted to obtain one free credit report in a 12-month period from each of the three agencies or from FICO. The three agencies run a Web site, www.annualcreditreport.com, where anyone can request a report. This can also be done by calling 877-322-8228. Also, if you are rejected for a loan, denied a credit card, etc., you can ask for your latest credit report for free from one of the agencies (this has to be done within 30 days of rejection).

Close to 20 percent of all credit reports contain errors that might result in you paying a higher interest rate for a loan or rejection for a home or car loan. Sometimes the consequence can be devastating, such as losing a job. So it's important to go over and check for errors, misrepresentations and typos, and alert the credit reporting agencies. These agencies are obligated to fix errors when you point them out, and although the process is time-consuming and bureaucracy-oriented, it's worth it.

Finally, sketching out a plan to tackle the blemishes on your report and improve your credit score will be a drawn-out process requiring restraint, discipline and self-control. Here are some basic pointers to keep in mind when you are in the mall wanting to pull out your credit card to get your hands on those American Eagle jeans.

Your FICO score (or credit score) is derived from different aspects, such as handling of debt, number of credit cards, and credit limit to balance ratio, but without getting into the details, here are some things that might help or hurt your score.

Make sure you pay your bills on time; late payments tend to have a negative effect on your score. Your ratio of credit available versus outstanding balance is an important factor in your credit score. For example, if your credit limit is $2,000 and your outstanding balance is $500 with $1,500 credit remaining, your ratio is 25 percent. Lowering this number by clearing outstanding debts faster has a positive effect on credit scores.

The average age of your account is another determinant of your credit score. So, two things are important here: Try not to cancel your oldest card and don't unnecessarily apply for new credit cards. Refrain from applying for in-store cards such as the GAP cards and Wal-Mart cards, because this has a negative effect on your credit score.

Mastering the art of handling credit is not child's play and requires discipline, constant self-scrutiny and consistent follow up. It's a good habit to have, and starting in college is definitely beneficial. Countless books exploring credit scores have been published, and individuals have underpinned careers analyzing credit scores, so reading an article is only the first step.

But one book, the "Wall Street Journal Complete Personal Finance Guidebook" by Jeff Opdyke, is a comprehensive personal finance journal and also helps navigate aspects relating to credit.

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Federation of Karnataka Chamber or Commerce and Industry

URBANIZATION IN INDIA: MIGRATION OF A NEW KIND

Adhvith Dhuddu, Regular Columnist, JANUARY 2008 ISSUE

The turn of the century transformed Indian business, industry, government and people alike as modernization in the form of technology, internet and mobile phones seeped into the DNA of our country. While this was unfolding at a tremendous pace, it paved the way for another significant phenomenon for which we are now facing the consequences.

The mini revolution of mass migration to metropolitans and urban areas from the countryside caught many by surprise. Although a surge of people into cities was expected, the pace and magnitude is what created imbalances and debunked the inadequacies of large metros. The tech boom is what sparked this mass relocation, but now something else even more monumental might tip the balance to create mass hysteria in the metros.

This new episode, for which the seeds have already been sown, is the further migration from the rural areas to cities driven by the increase in productivity in agriculture and improved farming techniques. In India, 13.5 million hectares of arable agricultural land is cultivated by approximately 14 million farming families. As more efficient farming techniques emerge, as technology is introduced into farming, as private players and investors foray into agriculture, as supply chains become shorter and more efficient (elimination of APMCs, middlemen), as biotechnology and biochemistry percolate into our farms, as more efficient irrigation methods are adopted and as land tilled per farmer increases, the overall productivity of farmers will rise considerably.

As farming families become more productive, more members will have less to do and look to non-agricultural sources of income. This will attract them to teir one and teir two cities as rural areas lack diversity in income and business. Often, this is their only window of hope in their pursuit to increase non-agricultural income. A flow of this kind could be more devastating to cities (compared to the IT-migration) if proper planning and forecasting is not done. We must learn from the tech era that people do migrate to elevate their standard of living and quality of life. Then, we were drastically underprepared, under planned and only a crisis prompted action in many cases, but now we can plan, prepare and build for the future and avoid an unnecessary strain on capacities.

This differs from the IT-migration era because of the potential strain it can exert on the system. The agri-migration era will be slow and long (20-30 years) and this can either be a boon or a bane depending upon how well we recognize and confront this issue. Bangalore, Hyderabad, Mumbai and New Delhi (Guragaon) are ideal examples of this phenomenon. Civilizations tend to live and thrive in urbanized environments rather than rural ones.

Many solutions and reforms have been suggested for improving infrastructure, roads, etc. But this massive shift of population calls for basic structural reform and the respective governing bodies should be well equipped to assess, analyze and act. This macro issue calls for a multi-pronged solutions with multi-year reforms.

Union Minister of Panchayati Raj, Mr. Mani Shankar Aiyar, in the recent Economic Summit for Rural and Urban Development, suggested that one cure could be to initiate urbanization of rural India. But this, he said, starts with providing basic amenities like clean drinking water, proper sanitation, uninterrupted electricity, etc (often these are the reasons people migrate to cities). More importantly, he stressed on increasing sources of non-agricultural income and non-agricultural businesses in rural areas to stifle the future surge of people to cities. There was clearly a sense of urgency detected to remove the roadblocks for the development of rural India.

Empowerment at the local levels is a must (LSGs, district and city officials) and the mulishness of trying to centrally plan rural development for the entire country should be eliminated. This whole process should be participatory oriented and not bureaucracy oriented. Improving roads in villages is a crucial factor to increase rural affluence. This should be top priority for officials because this particular change can help villages in ways others cannot: it gives access to better education and schools, it gives access to better health care and hospitals, it inflates the size of rural markets giving rise to micro-businesses and will significantly increase nonfarm rural employment.

Individuals no doubt feel enriched by moving to a city, and in a democratic India where there are no restrictions on migration (unlike China, where there is a cap on migration to cities) and mobility is cheap and easy, metros will continue to inflate. So even with the control mechanisms in place, migration could slow down but will definitely not stop. Urban India is certainly poised to take on the world, but let us allow rural India and the, ‘aam admi,’ to enter the 21^st century with hope, optimism and confidence.

Online link to this article: FKCCI JANUARY 2008 ISSUE

Federation of Karnataka Chamber or Commerce and Industry

ARTICLE: COFFEE, COTTON AND THE CHANGING WORLD OF COMMODITIES

Adhvith Dhuddu, Regular Columnist, DECEMBER 2007 ISSUE

The commodity market boom coupled with inflation is taking more out of our pockets for everyday purchases of coffee, channa, chilli and crude oil (petrol, gas, and diesel) than ever before. These elevated prices are here to stay and it’s not too late to explore opportunities to put your money to work in the commodity arena. This extended Bull Run initiated at the turn of the millennium is expected to last at least another decade.

The explosion in commodity prices (i.e. raw materials, natural resources, precious metals, etc) closely resembles the buoyant stock markets the in the late nineties (in USA), the only difference being these lofty prices are sustainable over the long term. This is because of the tremendous imbalance in the supply demand relationship in the next few decades, attributable to the rise of South East Asian economies (more demand) and fast deteriorating supplies.

It's imperative to be well-informed about commodities as they — unlike stocks, bonds and real estate — are a part of our lives every day. Your breakfast includes corn and milk, your Coffee Day mocha contains sugar, cocoa, and coffee, your lunch and dinner include wheat, rice, beans and pulses; the car you drive is made up of steel, aluminum and rubber. Every day you touch and feel commodities that are traded on a 24 hour basis around the world, and every day the demand for these consumables is outpacing the supply.

Sugar for example has been experiencing a rise in prices for the last few years. An increasing number of sugar beet processing plants being shut down since the mid 90s in the US and higher demand for sugar from China (China has increased its sugar imports by 20 percent year-over-year for the past 6 years) are some reasons. Brazil’s (Brazil is one of the highest sugar producers) smarter use of its home grown sugar for local consumption and ethanol use have reduced its capacity to export also contributing to the price rise. Being one of the top producers, consumers and exporters of sugar, India has shown it is self sustaining but this resilience might soon fade away once Indian producers start to feel the pinch.

Lead is a metal with wide ranging applications in electric power systems, lead-acid batteries, ceramics, roofing, forklifts, television, computer monitors, etc, and its demand is expected to swell in the next two decades. With supply either constant or deteriorating, a price rise in lead is inevitable.

Global freight and shipping rates are at all time highs (check the Baltic Exchange Dry Index), and these outrageous prices affect commodity players. This automatically drives up the prices of steel, copper, aluminum etc, because either the producer or the supplier has the burden of paying shipping costs. This was an insignificant factor a few years ago, but increased sea traffic, insufficient ships and inadequate port capacities is driving freight rates to record levels and directly impacting commodity prices.

The Central Banks of any country have the power to warm up the printing presses and create more money out of thin air if there is a need. But it’s impossible to similarly create tangibles like foodstuffs, precious metals and raw materials. It will take time (10 to 15 years) to bring to market these highly demanded commodities to meet the supply.

It is cumbersome to invest directly in commodities like sugar, lead or coffee, but more direct methods like investing in a commodity index (tracks a bunch of commodities), or an ETF tracking a commodity index solves the problem. Some internationally acclaimed indices like the Rogers International Commodities Index and the Dow Jones AIG Commodity Index are up many-fold in the past few years.

Other alternatives include investing in companies that produce commodities. Behemoths like Arcelor-Mittal (produces steel), Alcoa (produces aluminum), Phelps Dodge (produces copper), Rio Tinto (mining giant), Vedanta Resources, etc, are sure to rope in record profits in the next decade and a half with rising commodity prices. In fact most of these stocks are up over 300 - 500 percent in the last few years and still appear undervalued. Locally, scrips like Amara Raja Batteries, Hindustal Zinc and Tata Steel have risen over the last few years. An economic slowdown in the US or the Asian subcontinent will drive commodity prices lower, but this only presents a buying opportunity for long term investors.

It is also very safe to invest in countries that produce commodities. Natural resource rich countries like Australia, New Zealand, Canada, Bolivia and Chile will experience good economic times in the next few years.

High net worth individuals (HNIs) can also invest directly in commodity exchanges. Multi Commodity Exchange of India (MCX India) and National Commodity and Derivatives Exchange (NCDEX) are two major commodity exchanges in India. As our economy expands, the volume of commodities traded locally will rise and the demand for membership to these exchanges will increase with it. This will translate into increased revenue and higher profits for commodity exchanges (the main source of revenue for commodity exchanges is trading fees and membership fees).Long term investors can thus obtain membership and watch its value rise, or simply purchase a stake in the exchange. Something very similar is unfolding in our stock exchanges, spurring a rat race for stakes in the National Stock Exchange of India (NSE) and Bombay Stock Exchange (BSE).

One spectacular book, “Hot Commodities,” written by legendary commodity investor Jim Rogers explains why the next decade and a half will see an unprecedented boom in prices of all types of commodities be it precious metals, energy, cereals or food. Being the first to foresee the commodity boom in 1998, he commands immense international respect.

Not surprisingly, the Canadian dollar was worth US $1.04 three decades ago during the late 1970s commodity bull market. It was exactly during this period that oil hit the record high of $101.30(inflation adjusted). The late 1970s was also when gold and silver hit record levels. This is exactly what has been happening in the recent past, and will continue to do so in the future. History might not repeat itself but it definitely rhymes with the past.

Online link to this article: FKCCI DECEMBER 2007 ISSUE

Money WhizDom: Entrepreneurship as a career choice

Adhvith Dhuddu, CT regular columnist

Monday, February 11; 12:00 AM

Peter Drucker famously said, “Entrepreneurship is neither a science nor an art. It is a practice."

Choosing entrepreneurship as a career choice not only requires courage and vision, but a deep desire to succeed and overcome at all costs. This career path is replete with unique obstacles and challenges that require more than just theoretical and practical knowledge to resolve. The DNA of a successful entrepreneur is coded with traits like effective communication skills, good networking abilities, mental resolve and grit, excellent theoretical and practical knowledge, hard worker, people skills like good listening ability, capability to motivate and drive individuals, respect for others, and above all a self starter who believes in the idea and his or her people.

Deciding to go solo might be an easy decision to make, but sticking to your guns in dire times requires persistence and doggedness. But once you make the initial move, leaving no stone unturned to attain prosperity should be the primary goal.

An ominous misconception is that inexperienced startups can lead to disasters. This is absolutely untrue if the entrepreneur believes in himself/herself and the idea. Experience definitely counts but if Mark Zuckerberg of Facebook, or Michael Dell waited to gain, “experience,” we wouldn’t be bombarding our friend’s walls and wasting two hours a day on Facebook. So never wait for the, “perfect time,” to start an enterprise because it might never come.

More often than not, the simplest ideas receive resounding and overwhelming success. Over analysis and excess scrutiny only lead to inaction and missed opportunities. Following a simple mantra of trying to identify a vacuum in the system and subsequently filling it with an uncomplicated product or service is sure to get credible recognition.

Another pivotal factor in your success as an entrepreneur is where you get your advice from. When you aspire to do something different and unique, the world is against you, the odds are against you and criticisms and denouncements will bestowed upon you with generosity. It’s essential to get your advice and guidance form an individual who is at a social, economic and financial position that you aspire to be in and not your friend or professor (people who have got practical not theoretical experience), because a drowning man is of no help to another drowning man.

The US is a capitalistic economy and the thriving free market system is conducive to entrepreneurs. Every entrepreneur dreams of selling his product or service in the US market. The environment in this country is encouraging to entrepreneurs and one should take help from the different sources. The US Small Business Administration website (www.sba.gov) contains a treasure trove of information on a number of aspect s like writing business plans, finding potential investors, getting tax help, sourcing raw materials for your product, etc.

Another excellent source of help and information is the Virginia Department of Business Assistance (www.dba.state.va.us) where specific information helpful to businesses in Virginia is well laid out. Issues like licensing and permits in the state, taxes and rebates applicable only to Virginia businesses, etc are explored in detail.

In Blacksburg, we have access to the world class Virginia Tech Corporate Research Center which is home to numerous startup companies. They too help in all aspects of business startups like idea incubation and improvement to venture capital funding. Another good source for ideas and networking is the ELITE club at the Pamplin College of Business. ELITE meets regularly with the common theme of entrepreneurship and encourages idea generation amongst students.

Approaching a profession lawyer for incorporation and other legal aspects early on could be a toll on the bank account. A cheap, easy and efficient way is to submit all legal documents for incorporation online at a one stop legal website called Legal Zoom (www.legalzoom.com). At Legal Zoom, you can incorporate as an individual, LLC, partnership and for any state, etc for a competitive price.

In the end, entrepreneurship cannot be mastered by reading books or attending lectures. Like flying a plane, irrespective of how much flight simulator one plays, getting your hands on the controls of a real jet is what matters. Similarly, diving in and putting your plans, ideas and thoughts into action is what counts. This is essentially what Drucker meant, that Entrepreneurship is not a science or an art, it is in fact a practice. So, think big, start small and act now!