BANKS woes have stolen the headlines this week.

But the real reason to worry about Europe is that policymakers are still flailing in their efforts to come up with a big plan, fast, to get to grips with the regions debt crisis. From how to deal with Greece to how to build a firewall around solvent but illiquid countries such as Italy, Europes progress is hampered by the usual mixture of public bickering and behind-the-scenes brinkmanship. The biggest confusion is over Greece, where European politicians are sowing short-term uncertainty by holding off on the disbursement of the next 8 billion ($10.7 billion) tranche of its first rescue package while jangling nerves with (another) public debate about whether the country needs a bigger debt restructuring. After initially promising to decide on October 3rd whether Athens would get its cash, European finance ministers this week put off a decision until November. In this section
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The reluctance to disburse this money is purely tactical, designed to push the Greek government into more reforms. Neither of Greeces two paymasters, the Europeans and the IMF, are considering withholding cash long enough to allow a chaotic default. But with no big bond payments due in the coming weeks, they see little risk in waiting a bit longer and wringing more action out of Athens. The bigger problem is what comes next. In July Greeces rescuers agreed that it would need a new bail-out plan to include a voluntary debt restructuring by private banks along with fresh dollops of official funds. The terms of this deal were always dubious: it did too little to reduce Greeces debt burden and was too generous to the banks. Given the price that Greek debt now trades at, the deal is widely regarded as obscenely sweet. Some officials from Germany and several other northern European countries want to start negotiating a more severe write-down of Greek debt with the banks. Others think a more modest tinkering would be enough: Jean-Claude Juncker, head of the Eurogroup of euro-zone finance ministers, said on October 4th that technical revisions were being discussed. Others

still, notably those from the euro zones more embattled economies, are appalled. No, no. I insist no, was the response of Spains finance minister to the prospect of a bigger Greek write-down. How deeply Greeces private debt is restructured will ultimately depend on how far the Germans push and how much the European Central Bank (ECB), which has long opposed any debt write-down, resists. The views of the ECB are also central to another, even more important component of any overall rescue planhow to build a firewall around Italy and Spain. The ECB is the obvious lender of last resort to governments but it is reluctant both to continue buying these countries bonds and to lend money to bolster the capacity of the European Financial Stability Facility (EFSF) to do so. I am not in favour of bail-out funds refinanced by the ECB, was the flat verdict of Jean-Claude Trichet, the ECBs outgoing president, in testimony to the European Parliament this week. With the ECB unwilling to help, Europes policymakers are scrambling for other ways to build the firewall. One widely discussed option is for the EFSF to guarantee the first 20% loss on any new bonds issued by countries under pressure. It would have enough money to do that without borrowing from the ECB, but not if it uses up lots of ammunition recapitalising banks. Another possibility being touted is for the EFSF to borrow money from public institutions that already have a banking licence (and so can get liquidity from the ECB), such as the European Investment Bank or individual countries development banks. A third possibility is to accelerate the creation of Europes permanent bail-out facility, the European Stability Mechanism, currently due to be set up in 2013. Since this institution would have paid-in capital of 80 billion, the theory is that the ECB might be more willing to lend to it. Other more exotic options are also in the hopper. On October 5th the IMFs European director hinted that the fund could create a special-purpose vehicle to buy sovereign bondsthough he quickly issued a clarification that nothing of that sort had been discussed with its members. Many of them would be appalled. The sheer ingenuity of some of these ideas is impressive. But no amount of financial engineering can hide a basic truth. In the short term the ECB is the only institution that can be an effective lender of last resort to the euro zones big, illiquid sovereigns. The more distance there is between the ECB and the firewall that is eventually constructed, the less useful it will be. This has been the week of silly proposals, says one observer. The question for the world is whether we will move on quickly to serious ones.

Sarcastic/Satirical This is a kind of tone where the author makes subtle mockery of a person or a system in the article. In order to help you understand better, Balakrishna mentions the cartoon strip published in Times of India, You Said It by R K Laxman. RK Laxmans satire is there for all to see-the manner in which he gently portrays the issues facing the common man and highlights the fallacy of statements made by politicians etc., he mentions. He exemplifies such tone by a sentence. Too often sports bodies in our country are in the hands of politicians. And you know how our politicians are. Do you notice the somewhat subtle attack on politicians in the statement? Balakrishna advises you to read certain sarcastic or satirical passages to understand the tone of the passage given in the Reading Comprehension. Such passages could be on any topic, whether it is politics, economics, sports,

social issues etc. What matters here is not the subject per se, but how the author writes about it and makes fun of the situation-not openly or in a blatant manner but subtly, says Balakrishna. Bemoaning/Regret/Lamenting This kind of tone, as the name suggests is that of grief or sadness. The passages with such tone depict some kind of loss. This tone is appropriate when the author wishes to express regret or sorrow about a particular issue. The author feels sorry for something, someone or about something, Balakrishna describes. He mentions the characteristic of such passages. The characteristic of this tone is therefore the presence of sentiments associated with loss and the author feeling sorry or sad about something. Balakrishna exemplifies the passages with the tone of Bemoan/Regret/Lament as, One could regret the loss of life in terrorist attacks or the presence of corruption etc. A traditionalist might lament the loss of traditions, cultural values etc. Types of passages with Bemoaning/Regret/Lamenting tone: A passage where the pain or anguish over the loss of something is expressed-could be a loss of lives, values etc A passage in which the author expresses his strong disapproval over something-could again be the loss of values, the prevalence of corruption etc Candid Candid literally means to be frank or open. Thus the word candid is appropriate as the tone for passages in which the author has admitted something, while being frank and open about his views, is how Balakrishna defined candid. He mentions the characteristic of the passage with such a tone are those of forthrightness, openness and being frank. Types of passages with Candid tone:

1. The CEO or a high-ranking official of a company admitting that there were problems in the company/
with a particular product etc

2. A scientist admitting that his experiments were a failure or a particular technology didnt work 3. Somebody writing that he admits that he was wrong etc.
Watch out for the second part of the article to know about the other two tones of Reading Comprehension passages. Descriptive or informative Balakrishna mentions that when a passage contains of lot of data, figures and facts, the tone of that passage is descriptive. The author purpose of writing the passage/ article was to increase the readers knowledge of the given issue or subject. Hence a lot of details are given, he says. Types of passages with Descriptive/informative tone: Passages dealing with events in history: giving details of some battle, dates, information about the rule of some civilization, king etc Passages dealing with some technology: providing details about some gadget, describing the features of some instrument etc Information about some building, landmark, historical place etc. For example, the passage may describe the Qutab Minar, giving information about when it was built, who built it, the material used for its construction etc. b) Judgmental

This is typically used for passages when the author expresses his views on some issues and takes a stand-is this person or issue right or wrong? Is this good or bad? Is someone intelligent or dumb? Balakrishna said. These tones mention the authors perception or views on a person, thing or issue.

Types of passages with judgmental tone: An expert giving his verdict on some issue-could be an automobile expert speaking about a car and providing his opinion on what is good or bad about the new vehicle, or a connoisseur of food providing his opinion about a dish, for example A follower or fan speaking about an issue close to his heart. For example, someone writing about a particular player c) Analytical

The characteristic of an analytical tone is the presence of reasons or logic/ justifications to support something, informs Balakrishna. According to him, the author tries to analyze an issue, presenting the pros and cons or compares two or more things and tells you why he feels something is better etc. Types of passages with Analytical tone: An author stating that he feels something could happen in the future and providing reasons to justify why he feels in that manner An analysis of some event in the past-reasons given to explain a certain event, action etc. For example, the author could analyze why India won the last cricket match etc. The author comparing two or more things and justifying why he feels something is better Passages in which the pros and cons of a certain action are weighed. For example, should Company A acquire Company B? The decision needs to be analyzed and reasons given both for and against the issue.

IFRS stands for International Financial Reporting Standards, which are drafted and issued by a body called the International Accounting Standards Board (IASB). Historically, European Union (EU) countries such as Germany, the UK, France and Spain had their own national GAAP (generally accepted accounting principles). When the EU was formed, its memberstates had to be brought under one financial reporting framework. That led to the birth of IFRS, which all EU countries adopted starting in 2005. Practically the whole world, other than the US, adopted or converged with IFRS over a period of time. Even the US allows IFRS in limited circumstances; foreign private insurers, for instance, are allowed to file IFRS financial statements rather than follow US GAAP standards. In 2011, the US will announce its position on IFRS adoption/convergence for local US filers. In a nutshell, IFRS is the biggest accounting change in a generation for many countries and companies around the world. GAAP differences can completely obscure comparisons. In 1993, under German GAAP, auto maker Daimler-Benz AG reported a profit of 168 million deutsche marks, but under US GAAP for the same period, the company reported a loss of nearly a billion deutsche marks. Such differences confuse investors. A uniform set of high-quality, globally accepted standards will facilitate comparison and reduce confusion. Thats why investors have been supporting uniform global financial reporting standards across the world. IFRS has numerous disclosure requirements and would provide a lot more information than Indian GAAP. Increased transparency can prompt managers to act more in the interests of shareholders. In particular, timely loss recognition in financial statements increases the incentive for managers to attend to existing loss-making investments and strategies more quickly, and to make fewer new investments with negative net present value (NPV).

There are numerous accounting differences between IFRS and Indian GAAP. For example, under Indian GAAP, in the case of foreign currency convertible bonds (FCCBs), the issuer company does not value the option to convert to shares the holder has, and redemption premium is generally charged to the securities premium account. Consequently, there is no charge to the income statement. Under IFRS, the accounting results in a significant impact on the income statement as the option is fairly valued in each reporting period and the redemption premium is considered at the market rate of interest. As India moves to IFRS, starting from 2011, companies will be impacted by such GAAP differences. The impact could range from minimal to significant. The follow-on question, therefore, is: will the IFRS adjustments impact the market valuation of a company. Many companies do not anticipate that IFRS compliance should/would alter investors opinions and beliefs, given that IFRS has no effect on their firms strategy, business performance or free cash flows. However, a study in the UK suggested that markets responded to IFRS adjustments. This response was mainly towards firms reporting lower earnings under IFRS compared with UK GAAP. The conservative nature of investors may be giving rise to this phenomenon. Positive earnings adjustment may signal opportunistic behaviour and, therefore, investors are reluctant to trade upon it. However, a negative adjustment is enough to trigger negative sentiment among investors. IFRS may provide new information about a company, positive or negative. For example, under Indian GAAP, structured entities were not consolidated or hedge losses were carried forward, and those are accounted under IFRS. This would have a bearing on the investors perception of the value of the company. In the past, the market value of companies that reported huge financial losses on account of their derivative portfolio took a significant beating. Companies reporting under IFRS for the first time should communicate the impact of IFRS conversion to investors much in advance so as to keep them prepared. Any last-minute negative news to an investor who is not prepared in advance will certainly trigger an adverse reaction. In Australia, companies prepared their investors months ahead of the formal reporting under IFRS. As a result, IFRS reporting did not have any significant impact on the market value of many Australian companies. In conclusion, the extent of market impact that will be caused by IFRS adjustments and the extensive disclosures therein would depend on the nature of the adjustment/disclosure and how value-sensitive it is. Nevertheless, it is always a good strategy for companies to keep their investors prepared by communicating early. Small investors may not have the skill sets or the ability to interpret IFRS financial statements when compared to a sophisticated investor. Such investors should seek high-level training in IFRS and become better informed. Companies should also ensure that their investors are appropriately trained in IFRS and generally have a better understanding of what is being reported under it.

As India converges with International Financial Reporting Standards (IFRS), there are certain matters that company directors should be aware of. First and foremost, India is converging with IFRS and not adopting IFRS. The Indian IFRS will be called Ind-AS, which would diverge from IFRS on some matters. The level of acceptability of Ind-AS financial statements outside of India will be somewhat discounted as those will not be in compliance with IFRS as issued by the International Accounting Standards Board (IASB). This aspect could be somewhat mitigated by a reconciliation statement between IFRS and Ind-AS in the Ind-AS financial statements. The impact of Ind-AS on financial statements could range from minimal to significant. For example, companies that have raised funds through foreign currency convertible bonds (FCCBs) typically did not have any charge in the Indian GAAP (generally accepted accounting principles) financial statements. However, under Ind-AS, there would be a significant charge on two counts. First, the market rate of interest would be charged to the income statement and second, the changes in the value of the convertibility option would be taken to the income statement. In some cases, the accounting could change a profit-making entity into a loss-making entity. Accounting of ESOPs (employee stock ownership plans) would impact the technology industry and financial instruments would affect the banking industry. Accounting of regulatory assets would impact the utility industry, completed contract accounting would affect the real estate industry and lease accounting would impact the manufacturing industry, and so on and so forth. The central role of the board of directors would be to ensure that Ind-AS financial statements are reliable. Therefore, the first and foremost obligation on board members is to educate themselves on Ind-AS so that they understand these high impact areas and ensure they are properly accounted for. Besides, the board of directors will have to institute a strong control system. For example, with regard to fair valuation of investment property, the oversight may require questioning the management on the valuation model applied, the competency of the valuer, the control on the inputs provided to the valuer and the review of the output of the valuer, including the assumptions. The board of directors should also keep an eye on future Ind-AS standards. For example, it is expected that in future all leases, irrespective of whether those are under finance lease or operating lease, will be on the balance sheet. This may significantly impact the balance sheet gearing and compliance with debt covenants. Keeping an eye on future standards serves as an important strategic input for current business decisions. Ind-AS would require extensive application of management judgement and estimates. Particularly, fair valuation can be an onerous and subjective exercise, providing numbers within a range rather than absolute numbers. In a research conducted by Ernst and Young, it was noticed that by making changes to the input variablesall within the allowable parameters of IFRSoption expense as a percentage of reported income was found to vary between 40% and 155%. In emerging economies such as India, markets may not be deep and, at times, there may be no markets to mark to market, which may pose additional problems and lend themselves to management indiscretion. The board of directors should ensure that they exercise judgement in good faith.

When Australia converted to IFRS, the Australian Securities Exchange did not miss a beat and market ratings of companies were not significantly impacted. Many attribute this to effective communication by Australian companies with stakeholders throughout the conversion process. The board of directors should ensure effective communication to various stakeholders of the Ind-AS conversion process, the significant differences between Ind-AS and Indian GAAP, and the impact on Ind-AS results on a regular basis. This will ensure that market ratings of Indian companies are protected. In India, we have not yet seen companies making any disclosures or preparing stakeholders on the impact of Ind-AS transition. It is important that Indian entities do not take the investors/analysts for granted. For companies that do not prepare analysts and investors for potential volatility or changes in reported numbers, the consequences could be dramatic. In fact this is a good opportunity for Indian entities to improve their overall communication and relationship with the investors/analysts. It is also true that analysts and investors in India do not have sufficient understanding of Ind-AS and its impact on financial reporting. Therefore, Ind-AS education of investors and analysts is imperative for a meaningful understanding of Ind-AS financial statements. The board of directors should not undermine the risks involved. Incorrect financial statements, or missing the deadline, or lack of communication with stakeholders, could cause embarrassment, regulatory action and a fall in the market valuation of an entity.

With Indian GAAP (generally accepted accounting principles) converging with the International Financial Reporting Standards (IFRS), most accounting areas will undergo a significant change. The impact on financial statements of some of the changes are outlined in this article. Business combinations Under Indian GAAP, acquisitions are accounted at book values of identifiable assets and liabilities of the acquiree, with the excess of consideration over the net book value recognized as goodwill. Under IFRS, accounting is done for all assets including hidden intangibles at fair value. As the assets are recognized at fair value, amortization of these assets will reduce future year profits under IFRS. IFRS requires expensing of acquisition-related costs, whereas the practice under Indian GAAP is to capitalize such expenses as cost of investment. Performance-related consideration paid to the acquiree, known as contingent consideration, is accounted at fair value under IFRS, with subsequent changes included in the profit and loss (P&L) account. Under Indian GAAP, the impact of contingent consideration is generally included in the cost of investment. Generally, it is expected that IFRS accounting of business combinations will have a negative impact on the future P&L account of Indian companies. Consolidation

Many Indian companies, for legal or operational reasons, operate through structured entities known as special purpose entities (SPEs). SPEs are common in securitization transaction, land acquisitions, outsourcing and sub-contracting arrangements. Many of these arrangements are not consolidated under Indian GAAP as they do not meet the definition of a subsidiary under the Companies Act. Under IFRS, many such SPEs may have to be consolidated as these entities are in substance controlled through an auto-pilot mechanism or through legal/contractual provisions determined at inception. The consolidation of SPEs under IFRS may have a substantial impact on the P&L account, net asset and gearing position, and also certain key ratios such as debt-equity. Employee stock ownership plans (ESOPs) Under IFRS, ESOPs are accounted using the fair value method, which results in a P&L charge. In contrast, Indian GAAP permits ESOPs to be accounted for using either the intrinsic value method or the fair value method, and most entities follow the intrinsic method. The intrinsic method does not result in a P&L charge unless the ESOPs are priced at a discount over the intrinsic price. Compared to Indian GAAP, IFRS will result in lower profits for companies that use ESOPs for remunerating employees. Financial instruments IFRS requires a financial instrument to be classified as a liability or equity in accordance with its substance. For example, mandatorily redeemable preference shares are treated as a liability and the preference dividend is recognized as interest cost. Under Indian GAAP, classification is normally based on form rather than substance. Thus, these shares are recorded as equity and the preference dividend as dividend rather than as interest cost. Compared to Indian GAAP, IFRS will show the firm as more geared and profits would be lower as a result of preference dividends being treated as interest. Many Indian companies use foreign currency convertible bonds (FCCBs) for their funding requirements. Under Indian GAAP, the redemption premium is charged to the securities premium, and the conversion option is not accounted for. Consequently, for many companies FCCBs result in minimal or no charge to the P&L account. Under IFRS, FCCBs are split into two componentsthe loan liability and the conversion option. The loan liability accretes interest at market rates and is also adjusted for exchange rate movements. Thus, the charge to profits under IFRS are higher than under Indian GAAP. The conversion option is marked to market at each reporting date, and the impact is recognized in the P&L account. This will have a significant impact on the volatility of profits under IFRS. If the fair value of the underlying shares rises, mark to market of the conversion option would lead to losses in the P&L and vice-versa. Derivatives Under Indian GAAP, companies may not have fair-valued derivatives and embedded derivatives on their books as there are no mandatory standards. Many that have fair-valued derivatives have not recognized losses as they claim those to be for hedging purposes. Under IFRS, all derivatives and embedded derivatives are fair-valued, and hedging is permitted only where stringent criteria relating to documentation and effectiveness are fulfilled. Therefore, in practice, many Indian companies may not be able to apply hedge accounting unless they

develop appropriate systems to be able to do so. Consequently, these companies are likely to experience significant volatility arising out of gains and losses on the derivative portfolio. Revenue recognition Under Indian GAAP, sales made on deferred payment terms are recognized at the nominal value of consideration. Under IFRS, they are accounted as a combination of financing and operating activity. The fair value of the revenue is recognized in the period of sale whereas the imputed interest amount is recognized as interest income over the credit term. Compared to Indian GAAP, revenue under IFRS will be lower, and earnings before interest, tax, depreciation and amortization will also be lower, as the financing component will be recognized as interest income. Presentation and disclosure IFRS will require companies to make significant new disclosures. The reviews of the 2005 financial statements of European companies indicate that financial disclosures under IFRS increased by more than 30%, compared with their previous disclosures. This is the third and final part of a Mint series on IFRS, with which India will begin converging in the quarter beginning April. The writer is a partner and national IFRS leader at consultancy firm Ernst and Young.

Greece's fiscal mess, all thanks to Goldman Sachs: YV Reddy

Despite hanging your boots from policy making, you are very much in the central banking and the policy making circuit. What is your understanding of the sovereign debt crisis in Europe? Do you think it gets resolved without an accident? A: At the onset I would say there is a bit of a mislabeling in that diagnosis. Its not entirely a sovereign debt crisis. Even the southern countries which are having a sovereign debt problem, it gives an impression that it was fiscal mismanagement. In the case of Greece, yes, but if you see in Ireland, fiscal management was very responsible but its the banking crisis which brought about a fiscal problem. So, not all countries which are facing fiscal problem are facing because of the fiscal mismanagement. Quite a lot of countries are facing a fiscal problem because of the sins of the financial sector. Secondly, how did these countries get to that position, because they are funded by the financial sector of Northern Europe? In a way if these countries had the option to restructure their debt then the irresponsible lending by the North European banks will come to light. So, yes, there is a sovereign debt problem but it is as much a financial sector problem.

Q: Is it in that sense an easier crisis to solve? A: No, it is not. A financial crisis is tough but ultimately that is how it comes on to the sovereign debt crisis. When you keep labeling that it is a sovereign debt crisis, people think that every country which is involved in this has indulged in fiscal mismanagement. There are only two countries where you can positively say that there was a fiscal management in particular Greece which had the benefit of advice of famous Goldman Sachs. Even there you can go back to the advice of the financial sector. In a way, the European problem is three fold. There are three legs on which the problem rests and therefore the solution will have to be on all three legs. One is the debt problem where the fiscal position is not comfortable either because of fiscal mismanagement or because of the problems of the financial sector which have come on to the fiscal situation, so there is a problem, particularly, a sovereign debt problem. The second leg is the financial sector problem in the sense the banks in Northern Europe are over exposed to toxic assets. This is on top of pretty low capital adequacies. So to start of they are not good enough and then they indulge in giving debt and it is inconceivable that they did not know the real fiscal position of the countries within the eurozone. It is inconceivable that if you are a reasonably good financial sector person you should have enough analysis. Obviously, there was not so responsible lending. The stress is on the balance sheets of the Northern European banks though there is some spillover into the US also. But, essentially, it is banks in Germany and France. The third leg is the institutional structures in Europe. The institutional structures when it was conceived in the eurozone are that there is a common currency and common monetary policy but multiple Fisc. So there is no central fiscal authority. Q: If they can't get the central fiscal authority does it mean the euro has to demise? A: How do you handle it? It is a very unique problem and therefore I would say you must think of unconventional measures. Why is this taking place? It is because it is not a technical solution. What we are looking at is burden sharing. Who bears how much burden? Those in the North would like to say that it is Southern Europes fiscal mismanagement. You tax your people and you come up with a plan where by you pay for your past sins of mismanagement is the view of Northern Europe. Q: But their banks you say are equal to blame? A: Southern Europe actually benefitted. You went from in terms of growth in your economy because there they are incurring expenditure without productivity whereas you are able to export. Germany and France could not have grown the way they have grown. The question now is how do you distribute the burden? There are three types of burdens which are to be distributed. As between different countries, as between the financial sector and the government and the third and most important thing is how do you institutionalise and you have to convince each government and for institutionalising therefore all this calls for enormous political management. It is not a technical economic problem but it is political management. In terms of political management,

most of those countries are heading towards elections next year. There is an underlying sociopolitical commitment to maintain Europe. Q: Do you mean break-up as a monetary union? A: Yes. The whole question is how do they keep negotiating and manage to get out of it? In a way it is easier to make people bear the burden when you are tire out some resistance. So, it is political management, its not that technical solutions are clear but the direction of technical solutions is clear. Some burden will have to be taken by Northern Europe and some recapitalisation will be required. If recapitalisation is not provided by the markets it has to be provided by the governments. As a euro zone they have the necessary economic wherewithal to do that. Q: The institution they have designed so far is the European Financial Stability Facility (EFSF) which is now been expanded to 440 billion euros. The latest suggestion is to leverage it. Do you think that will happen because that is not within the mandate of ECB? A: How exactly do you leverage? It is not easy to leverage. The limited point is simple. Essentially the facility is to give money and you yourself are virtually a sovereign city. Even if you borrow you are borrowing as a sovereign guarantee. When you are taking money directly or indirectly, leveraging may only indicate that like a SPV you are not showing it in your balance sheet has an immediate outgo, which is fair enough. In my view all measures will have to zonalise the national problem and the European commissioner is talking about some sort of a central fiscal authority. The central fiscal authority can come formally constitutionally and institutionally but that will take time. In effect this process of eurobonds, euro action etc is a surrogate. Q: Therefore, should I understand from you that you expect a euro bond or an EFSF bond to come in as the first step to an ultimate greater union? A: Yes. Ultimate greater union not partly fiscal but by itself will not help. It should be economic integrations also. There has to be trade integration and migration to significant extent. As far as sovereign debt is concerned, willy nilly they will have to increase taxation and perhaps selling of assets. Like in railways you sell assets and therefore reduce debt. So, there will be certain amount of taxation and selling of national and public sector assets to reduce debt and make it manageable. That is inevitable. Secondly, there has to be a combination of debt restructuring. Those who have lent money will have to accept some margins. Recapitalization of banks is required which has to come from public sector. Depending purely on private sector will not help. Thirdly, there has to be immediate innovative financial mechanisms which will be sort of a surrogate for fiscal integration to take care of immediate problems. They will also have to start looking at institutional arrangements. It is not impossible that there will be break down of the situational arrangements. But I would say that it is most unlikely from what I understood.

It is painful; there is a question of all nationalities involved. But gains they got from the integration and losses they will incur if there is disintegration by all, is so much that they will willy nilly have to work out. But I feel that, they will drag till most of the elections in 2012 are over. I expect first aid till next year and treatment after next year. Q: When Germany agreed to expand the EFSF when they vote a couple of weeks back and approved the expansion of the EFSF to 440 billion euros there was a lot of parliamentarians who made it very clear not a penny more now if you leverage the EFSF and create bonds, surrogate is an under writing of the SPV by the German and other governments do you think that will happen despite this opportunity? A: It can happen in the sense that politically, they should be able to explain the parliamentarians that the turnaround and benefits that are going to accrue are such that the guarantee is only to satisfy others. The likelihood of a liability arising out of guarantee is close to zero. Q: Should really India merit BBB minus just barely making it to investment grade and countries like Spain and Italy which are way more debt ridden at this point in time walking away with still A grades? A: Is there anything new about that? If I recall, we went in for rating in 1990 or 1991. It was the first time there was a sort of implicit sovereign rating by Standard and Poor. Dr Rangarajan from RBI and I from the ministry went to plead with them. From then on we have been closely monitoring. The rating agency has a standard methodology and that is definitely very much biased. But the most important consideration in this type of rating is our capacity to borrow in our own currency in the world. If the sovereign has a capacity to borrow in its own currency significantly then there is a comfort that they can borrow. In many cases like India our capacity to borrow till recent in our own currency is limited compared to Spain or whatever circumstance. I may call that as a technical justification for this particular difference. I am not saying it is justifiable but this is the technical point. In reality, there are two issues with the ratings agency. Any rating agency like an infrastructure facility has to have market discipline and sufficient rules to function efficiently and effectively in this type of situation. Particularly, when there are network effects and if you are rating agency for 20 then you become for 200. Unfortunately, in our case there have been only two and marginally third which is dominating the world. Therefore there is no market discipline. Use of credit rating by regulators is also an issue. Now you have a situation where with all this record most of the regulators all over the world use credit rating for regulatory purpose. That is an issue which has not been debated. If everybody knows that the credit rating has some informative then regulators should be able to insist on what they expect out of the regulatory. Why this is not been effectively done? Incidentally, I must share a personal secret with you. Soon after I retired, I explored a possibility of starting a credit rating agency. I got significant support from Asians including China informally, but then I suppose its not easy to get into that area. The entry barriers are heavy.

Q: What is your view on the deficit that we are running at the moment? A: The fiscal deficit is high when compared to standard parameters. There are redeeming as well as non redeeming factors in this. The redeeming factor is that our domestic household saving is pretty high. If there is some country in Latin America where the household savings are 5% and fiscal deficit is 3% whereas our financial savings are 12%, household savings are 25%. So this the first redeeming factor. The second redeeming factor is, most debt is held by residents and denominated in domestic currency so the vulnerability is less. Japan also was not that vulnerable because most of debt is held by resident. However another negative factor for India is that when the fiscal deficit is high when you are vulnerable then you do not have manoeuvrability. Q: I expected you to come with another dimension its contribution to inflation. In your time it was one lakh crore and as a percentage of GDP it was at 3% going towards 2.5% maybe not correctly counted. But now we are at Rs 4.5 lakh crore and even that is not correctly counted can perhaps go higher than that. Is it not creation of extra ordinary aggregate demand will you hold it as the main culprit for this systemic inflation? A: The policy manoeuvrability in the economy on several fronts is highly constrained with the fiscal position. Yes, I accept. Structurally, the fiscal position has deteriorated significantly in the last three years. I am just speaking factual and inference, I am not passing a judgment. Even when the stimulus was undertaken we started from a structural problem. It was not a stimulus in a sense because it couldnt be withdrawn. So in a way it was structural deterioration. Finally you find it is inevitable and also it is not for investment. In many other countries particularly in China it was for investment but here it was for consumption. Therefore we had a situation which I may call as an inevitable crowding out. Q: You have NREGS which is index to inflation because of the higher NREGS payments where MSP has gone up and because MSP pushes up the prices of food grains again NREGS payments go up. How do you break this vicious cycle? A: There I would say a lot more should be a determined effort at the supply management. Ultimately, especially, if you take the lessons of the crisis, if you are pumping in money in the hands of poor people there is a general impression that it is unproductive. No. In my view, particularly, in a country like India, if you take NREGS, dont think it is simply pushing up the labour cost. It is changing the bargaining power in the villages, in the rural societies. The agricultural labour is not entirely at the mercy of the landlords. Ultimately what is the purpose of policy? It is to increase the purchasing power of the poor people and if it is not being done indirectly it has to be done directly. The solution is not cutting down these programmes. The solution has to be found on the supply side. What is the most critical thing on the supply side? We have to actually declare that we are in a state of Agrarian crisis. We are in a state of Agrarian crisis and we better admit it that Indias biggest problem today is the Agrarian crisis. Q: What is the crisis and what is the solution?

A: Just one - you have to increase the output and everybody agrees that people want to eat more, want more diversified food, more proteins etc. That is not something which requires magic or highly superior space technology. Technologies are very well known. Therefore, you have to create an atmosphere both in terms of public investments and private incentives to produce the output. Here is one sector where there is a convergence of all the objectives. If we increase the output you are able to cater to the output of the economy, you are able to provide employment to a large section of the people which is required and you are moderating inflation. There is nothing on the downside but you are not doing it. Who is the production unit for agriculture? It is the farmer. Farmers are one part to the story. Have you heard about this area in Andhra Pradesh in particular district where they stopped cultivating in thousand of acres? Yes. They said we are loosing money every year so they said; we will not cultivate the lands, thousand of acres, yes. Q: Was MSP not enough? A: There are a number of issues. There are two issues. One is the cost of cultivation and second is the risk. Today for the farmer, he is not assured supply of water and there is no recourse if he doesnt get water from irrigation. There is no supply of power assured and the crops fail if the power does not come. There is no guarantee of the quality of the seed, there is no guarantee with regard to the quality of the pesticide, there is no quality control and there is no recourse so he is facing all these risks. How many people can withstand these risks? This has been building up. Public investment has come down and has been coming down for the last 10-15 years. If you just see the annual reports of the Reserve Bank of India for the last 10-15 years we are pointing out repeatedly inspite of the fact that it is not part of money in finance. If there is one national problem that has to be flagged, studied and determinately handled, it is the Agrarian crisis. I would say that there should be national consensus and I would even go to the extent of saying that it is time that there is a special meet with the National Development Council and see how to make agriculture the number one priority and everything else has to come down. In my view you must start with the production unit. If you are an exporter you will find 133 fellows going around and getting concessions to make it profitable. Are you sure that farming is profitable today? What are the studies to show that farming and the farmer as a unit of production is viable. Q: How would you analyse Indias inflation problem? It has been for the past 18 months it has not gone down below 8% and for the past nine months, it is almost at 10% would you blame this all or only the Agrarian crisis or is there something else which has to be handled? A: Essentially, it is a question of demand and supply. Hence, in case of demand and supply, the aggregate demand has increased significantly, due to the fiscal conditions and supply has been inelastic. Some people ascribe it to the global commodity prices but in the last three years the global commodity prices have not gone up.

We have seen some volatility in the last four-five years, so the contribution to the global commodity prices to our inflation is minimal. You cannot say that the global aggregate demand is very high with the type of economic conditions. As far as our inflation is concerned, it will be very difficult to find an external hand. Q: So, it is purely the supply side? A: Demand and supply both. And, particularly, from the fiscal side. Q: What would a monetary authority do? Where you clearly recognize that there is a supply issue? A: It is a question of how you handle the interface between the markets, so at some stage we should be able to convince people that I am determined. We are trying to control the inflation but normally they are not laggard effects. One way is to analyze and the actions taken so far will have a laggard effect in future. We should be able to say they will have laggard effect. The monetary authority has to convincingly explain to the nation that we have taken actions and it will come. They have to convince in a credible manner and that is one way of doing it. The second way is, to be able to do it sufficiently so that there is no more expectation if any thing more in some of these cases. Very often people talk of growth. The whole idea of growth and during the 5 years when I was the governor there was never was the interest rate increase but that did not affect growth nor did it affect inflation. It is a question of that side of a simple trade off at limited point. If you have gain inflation creditability then the growth will take care of itself. That is where I think creditability has to re-established. Q: Do you fear this sustained 24 month-30 month inflation is going to reverse the savings rate? A: I would say yes, I am a little afraid of that and we have to carefully watch the behaviour. There are two aspects a big problem in terms of macro, because of the fiscal situation and apart from affecting growth, there is second issue with regards to the savings. Ultimately, GDP growth at 10% will happen only if domestic savings are more than 30%. I agree with RBI governor Subbarao that more than 3% over the medium term on an average is what the rest of the world will give whatever you may say and therefore the Indian economic policy should be oriented towards strengthening the domestic saving above 30%. Therefore, 90% of attention of the economic policy should be with the domestic savers and domestic investment and only 10% should be devoted to foreign investment and foreign savings. Q: So, that itself is a very big reason why fight against inflation should continue? A: Yes, inflation in the medium term has grown but in the last three years it has almost grown 40% in essential commodities. Q: If you put all the events of the last 24 months - inflation, the huge political disruption, political movement, the capex drying up - are you getting a sense that may be this 8% plus growth that we had for the past 5-6 years is actually the aberration and

we are perhaps going to mellow down to something lower for the next several years, not just one year? A: Essentially, we have forgotten that we have to get a fix in potential output for the economy and that has been one of the biggest problems in the Indian management. The Indian management thought that macro economic in financial is enough but there have been inadequate attention, even by this callers and certainly by the policy makers about the potential output. We in RBI try to make some fairly large rates but I am happy to see RBI taking lot more interest now on potential output. It is very difficult to put a number at that point of time but I would say in the short spent the gut feeling that was potential output was closer to 8% rather than 9% when we are growing at 9% the judgment was, the range was 8-10%. Some people said only 7 to 10% but I feel we are taking from 9% on average for 5 years the potential output was perhaps between 8 and 8.5%. For the next 3 years whether it has gone up, gone down or stayed there, my judgement says it best stayed there and that is not good news at about 8%. Q: There have been virtual rise of capital expansion, capital investment by companies. Would you accrue that to higher interest rates or to lack of policy clarity? A: It is difficult but we have to examine whether the corporates are cash rich because there are two different things they may still be cash rich and may not be investing because of uncertainties. Globally that is the position now. You have got a serene situation globally and perhaps in India also if the corporates are cash rich and if the investment is not happening than you have to make your own inference. The impact of the interest rate on the actual investment irrespective of the intensions is not based on the interest rate today and most of the investments we require are medium to long term. Nobody is ready to take a decision on medium to long term and base the interest rates of the six months or one year. Therefore, the link between the interest rate and growth is not so close in regard to the longer term investments. Q: Is it actually likely to be lower? A: I wouldnt assert that, but I could more confidently say that there is no evidence that it has gone up. And especially what you say is that not much of investment is occurring now, due to which output will not go up in the immediate future also and thats not good news. Q: So what are the circumstances that are needed to take output to double digit, because there is no point growing at double digit when you dont have the enabling circumstances? A: Firstly, stop the fixation on double digit growth. We should start productivity growth savings and investment productivity. We should learn from Chinese, they are trying to reduce their GDP growth. Therefore, if you admit that this is the potential output, we should have the courage to be able to say that it should come down. So my first preference therefore is the issue should not be how we go into double digit growth, but how should we increase the productivity. Secondly, the productivity growth is

not with reference to what we were two years back, but where the world will be two years from now. We should look at how we are able to compete with the productivity growth in the rest of the world. Therefore, first we have to make an assessment of the way the rest of the growth productivity is increasing, then how to increase the productivity growth. You may require increasing productivity growth just to maintain a current potential output because the world is moving up. Q: Is the rupee a worry because we saw some degree of stability and then in the past eight weeks we had a 10% fall? A: Structurally, as the fiscal position has deteriorated, I would say external position has also deteriorated compared to three years back. See the net assets and liabilities position; public sector assets and reserves are more or less constant, but the short term borrowings have gone up. The FDA that we receive is substantially non-greenfield and the current account deficit has also gone up. So to that extent, yes the external sector is weaker. It is partly a reflection of the global developments and partly a reflection of our own. But having said that, what I am saying is it is not vulnerable. But, the situation requires to be monitored because of the global uncertainties and volatilities in the currency markets which appear inevitable. Q: Are we underserved with respect to banks? Is there a need for more banks? A: I would make a distinction between banks and banking. You can have 100 banks but not much of banking. Also, who is underserved by banks is another issue. We are underserved with regard to the traditional retail banking. On that segment we have deteriorated. There is a hollowness of banking. On one hand government is taking a significant amount of the money and other in the financial markets the whole financial market development is essentially dependent on the bank money. The people are not really prepared. If you just see the percentage of financial savings that goes to banks and non-banks in India, it is coming down constantly. The money in banks is being used lot more to fund the government, to fund mutual fund, to fund infrastructure corporation but not the retail banking, working capital etc and both on the customer side. If you take the rural bankin, the credit deposit ratio shows that the rural savings are still sucked into the urban areas. Hence, in my view banking services are underserved, not necessarily the banks. Q: Every time we speak about bank, new bank licences we have a committee going in and we periodically issue a bunch up set of licences. Why can't there be a standing set of guidelines that these are fit in proper for new bank licences and you issue them as and when why is this periodic? A: The reason is interest rates. Unfortunately, banking licence is not like a drivers licence where you know how to drive therefore you can go and drive because the difference is that here government is virtually allowing you to take money on trust, and so the licence. Therefore, it is not easy to simply say that here are the conditions you can keep.

Secondly, a variety of political economy is also a reason for the freezing of the legislative framework and the legislative framework has not been effective enough for regulation. Also the licences given to private sector banks in the past were given with a deficient regulatory regime. Regulatory habitual offender is been different from occasional offender or secondly they should be punished if the bank is not delivering something. Therefore, effective handling of the governance is legislation spending. There has been lack of clarity for both public and private banks. If things are in position then it become easier to handle the question of licences but there is no question of any country simply saying that automatically you will get licence if A,B, C, D satisfy the banking. Q: I am not saying automatic licence but what I am saying is that you apply for a licence on a regular basis? A: I agree that the door should be open and criteria should have basic framework and eligibility to apply and to be considered from time to time that is the situation and the proposed legislative framework which has been pending for almost five years provides. It shows spending and that also included reduction of SLR. The reduction of SLR was brought about through an ordinance. The existing markets are lot more interested in easing the possible burden than enhancing banking services but on the whole I would agree that there is need for clarity. There cannot be ad-hoc-ism. There should be basic framework but I would add that there would always be elements of discretion. The crisis is proved to be good because the legislation now passed it will be easier to understand the logic of the legislation. And, it should be a very transparent process of licensing.