Interesting readings

Since most of us in India can talk about little else other than
corruption, do read href="http://www.voxeu.org/index.php?q=node/5971">this article by
Nauro F. Campos and Ralitza Dimova on voxEU which is an interesting
meta-analysis about papers which analyse the impact of corruption on
growth. I have long heard about meta-analyses, but this one made me
sit up and notice.

Anand
Giridharadas in the New York Times on Arthur Bunder
Road in Bombay.

Roger Bate and Tom Woods, in The American, point to href="http://www.american.com/archive/2010/december/made-in-india-faked-in-china">a
new dimension in India's crisis of fake medicines.

I
I Sc will now use the IIT JEE as their entrance examination
for the new Bachelor in Science course. Given that the IIT JEE is
a well managed and difficult examination, it would make sense to
have more and more schools plugging into it in order to filter
their intake. But as you move away from the top .01% of the
distribution, the statistical precision of the score on a very
difficult exam as a measure of student capability tends to
decline. The managers of the IIT JEE will need to shift towards
adaptive
testing, where the questions are dynamically modified based on
student characteristics, in order to retain efficiency across the
distribution. Once this is done, the IIT JEE would be useful for
sifting through millions of students, and exert a beneficial
effect of all of them facing a more demanding high-stakes
examination.

href="http://financialexpress.com/news/column-great-job-mr-bhave/724748/0">Shobhana
Subramanian in the Financial Express on C. B. Bhave.

href="http://www.nytimes.com/2010/12/13/arts/design/13desert.html?_r=2&pagewanted=all">A
fascinating article by Nicolai Ourussoff in the New York
Times about the attempt to reinvent Saudi Arabia.

href="http://www.nybooks.com/blogs/nyrblog/2010/dec/25/fading-dream-europe/">Sadness
about Europe by Orhan Pamuk in the New York Review of
Books, and href="http://www.city-journal.org/2010/20_4_weimar-city.html">a
tragic perspective on Istanbul by Claire Berlinski in City
Journal.

href="http://spikejapan.wordpress.com/2010/11/28/amakusa-islands-of-dread/">A
dystopian future for the world: a story of ageing and depopulation
from Amakusa in Japan.

Liu Xiaobo's
beautiful acceptance
speech for the Nobel Prize for Peace. A lot of countries of the
world, including India, have much to do in order to achieve freedom.

href="http://www.asiasentinel.com/index.php?option=com_content&task=view&id=2869&Itemid=187">Philippines?

href="http://outsideonline.com/travel/travel-pf-201012-taliban-sidwcmdev_153115.html">Tourism
in Afghanistan by Damon Tabor.

href="http://www.ft.com/cms/s/0/d1248de4-11f4-11e0-92d0-00144feabdc0.html?ftcamp=rss#axzz19PnDeQ2O">Steven
Johnson in the Financial Times on the future of linking to
information sources on the web.

With 75% of world GDP in service, trade liberalisation in
agriculture or manufacturing is not that important. The really big
story is trade liberalisation in services, and there the picture is
quite bad. Read href="http://www.voxeu.org/index.php?q=node/5969">this article on
voxEU by Bernard Hoekman and Aaditya Matoo on how to obtain progress.

Understanding
the rise in currency turnover by Michael R. King and Dagfinn Rime on voxEU.

Anders Aslund, on Project Syndicate, on the
remarkable story of the global crisis as it played out in East
Europe. Also
see this
story in The Economist on the same subject, which is a
bit less optimistic. The recovery in East Europe matters for
recovery in Europe and elsewhere. It also illuminates our thinking
on some of the grand policy questions.

href="http://www.cis.org.au/publications/policy-magazine/article/2291-feature-public-opinion-divided-on-population-immigration-and-asylum">David
Alexander points out how Australia is the role model for the world.

href="http://www.project-syndicate.org/commentary/eichengreen25/English">Barry
Eichengreen, href="http://www.voxeu.org/index.php?q=node/5892">Daniel Gros and href="http://openlib.org/home/ila/MEDIA/2010/us_euro.html">Ila
Patnaik on the resolution of Europe's problems.

href="http://www.gq.com/news-politics/big-issues/201012/viral-me-silicon-valley-social-networking-devin-friedman?printable=true">Devin
Friedman in GQ on the strange world of social networking.

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Discussions on 'Mythbusting: Current account deficit edition'

Many interesting comments appeared on my previous blog post, href="http://ajayshahblog.blogspot.com/2010/12/mythbusting-current-account-deficit.html">Mythbusting:
Current account deficit edition, and I thought it made sense
to respond to all of them in this post.

Ambarish: I don't think there has been a sudden rise in rupee
trading outside India. It was always there; we weren't seeing it. As
Jayanth Varma has emphasised, we used to think the NDF market was in
Singapore. But the BIS data on rupee trading shows significant rupee
trading at many places worldwide, not just in Singapore. Overall, the
picture is roughly one with $20 billion of onshore trading a day and
another $20 billion of offshore trading, giving an overall market size
of $40 billion a day.

One can think of many good reasons for domestic and overseas
economic agents to do INR trading outside India. E.g. foreigners are,
presently, not permitted to trade on the onshore currency futures.
Given that gross flows across the Indian border, on the BOP, are now
at $1.3 trillion a year, it is not surprising that there is a lot of
rupee trading going on. Until big changes to the capital controls take
place, I believe there will be an increasing shift of INR trading away
from India.

Neeraj: I agree with you that capital controls can potentially
change the situation significantly. So one can think at two
levels. First, for a given set of capital controls, a central bank can
float as in not trading. That gives you a float, but yes, the price
that comes out of this is distorted because there are capital
controls. As an example, the government can have non-interference in
the domestic market for DRAM chips, but the domestic price can itself
be distorted through quantitative restrictions or customs duties on
DRAM chips. So even though the government is not manipulating the
domestic price by directly trading in the market (as it does with
foodgrain or currency) the observed price is a distorted one. Then
comes the second level where you have full convertibility. Once again,
here the central bank could choose to trade in the market or it could
choose to not trade in the market. Only when there are no capital
controls + no trading by the central bank do you get to the true
floating rate and the market's price.

Durga: Modulo the issue raised by Neeraj and touched upon above, I
think we're a fairly flexible rate today. If INR trading globally is
$40 billion, then RBI trading of anything less than $2 billion per day
would have a negligible impact on the price. RBI has to either hit the
market with very big trades (over $2 billion a day, i.e. over $40
billion a month, i.e. Chinese style currency manipulation) or RBI has
to sit back and accept the price. Small trades are pointless, and
actually make you wonder what the strategy there is.

That said, the rupee is still a small currency. India is a GDP of
only $1.25 trillion and there are a lot of restrictions on
cross-border commerce. So there is a long way to go before the INR
becomes a serious international currency. It does not, hence, surprise
me to see that the spreads on the INR are much worse than those seen
for the big international currencies.

However, what I talked about in the blog post -- that when a
central bank stops trading on the currency market, the CAD = capital
flows -- is not an equilibrium condition. It is an accounting
identity. It requires nothing about market microstructure on the
currency market, or about the capital controls, in order to hold. As
long as RBI trading on the currency market is zero, CAD will be
exactly equal to capital flows.

Finally, Anonymous, you ask: Is there a point where the CAD becomes
so big that it becomes dangerous? We should think in two parts.

First, in a place like the US, there has been a lot of concern that
the imbalance (= the very large CAD) is too big in the sense that
under reasonable assumptions, the US is not going to be able to
service all the capital coming into the country. After all, all the
equity / debt capital that comes into (say) India today inexorably
requires that at future dates, dividends and coupon payments and debt
repayment have to happen in dollars, which will require purchases of
foreign exchange by residents. In order to service the borrowing of
the US today, substantial exports growth will be required, which is
unlikely. Hence, when this borrowing of today is to be repaid in the
future, a huge dollar depreciation will have to take place.

As long as there is an environment of high growth in exports of
goods and services, there is no problem. If, hypothetically, you see a
country with a big CAD but you also have a WEAK pace of exports growth
then you know that at future dates, there will be pressure on the
currency which will give sharp depreciations. Odds are, the financial
system will see that and these fears will translate into a
depreciation right away! Conversely, if you see capital inflows going
into investments which will bolster growth of exports of goods and
services, then you feel comfortable that there is no problem.

I believe that's a fair description of the present Indian
situation. Over the last 15 years, the gross inflows on the current
account into India (which can be roughly interpreted as the total
revenues from exporting goods and services) grew by 8.1 times, from
$42 billion in 1994-95 to $343 billion in 2009-10. This was an average
annual growth rate of 15%. This is a huge pace of growth, and gives me
confidence that the CAD coming in today will be serviced tomorrow
without large currency depreciation. If, hypothetically, you disagree
with my optimism about future growth in exports of goods and services,
then you would think that this large CAD today increases the odds of
INR depreciation in the future, and you would go short the rupee.

For smaller emerging markets, there is a risk of sudden changes in
international financing conditions, which is rooted in the lack of
information in the hands of foreign investors about the country. Then
a large CAD could mean that if something goes wrong and a lot of
capital leaves the country, then it could yield a large currency
depreciation. I believe this is less and less an issue for the large
emerging markets like India, where problems of asymmetric information
and lack-of-attention in the global community are not a problem.

Read More

Mythbusting: Current account deficit edition

The question

In recent months, the current account deficit has risen. The latest data shows:

Sep 2009	-3.03
Dec 2009	-3.64
Mar 2010	-3.68
Jun 2010	-3.84

This has started making many people worried. Is such a `large' current account deficit a cause for concern?

The right answer

How long should a man's legs be? Long enough to touch the ground.

The old intuition

Under a fixed exchange rate, where the central bank holds the rate fixed by trading on the market:

• Net capital inflow is an autonomous variable
  
  


• All the capital that comes into the country is bought by the central bank (and vice versa), and this has consequences for sterilisation or monetary distortions.
  
  


• You can then ask yourself whether the amount of capital coming into the country is "too much" or "too little".

The new intuition

But all this changes under a floating exchange rate!

As the graph above shows, RBI's trading on the currency market has been at near-zero values in recent months: we have something that is essentially a floating exchange rate. The rupee is now a fairly big market, and small scale trading by RBI has zero impact on the price: i.e. what we're seeing is a true market price. Under a floating exchange rate:

• Net capital inflows = Current account deficit, as an accounting identity
  
  


• If there is a sudden increase in capital inflows, this yields a rupee appreciation, which tends to increase the current account deficit. Conversely, if there is a sudden capital outflow, this yields a rupee depreciation, which tends to decrease the current account deficit. Through this, there are constant equilibriating forces which bring the two together.

With a floating exchange rate, you curiously look at the current account deficit and wonder that if there is some sudden international crisis (e.g. Lehman's death) whether there would be a short-run dislocation. For the rest, there is no policy involvement in either the current account deficit or in net capital inflows, both of which are purely market phenomena.

A new angle

In the very short run (e.g. a day), changes in the exchange rate can have little impact upon imports or exports. So if $10 billion suddenly leaves the country in a day, when the rupee depreciates, there can't be a response from import or exports immediately. The only response that can come about immediately is: from capital flows.



When $10 billion leaves the country, the rupee depreciates, and some investors think that they will score some nice returns by buying short-dated rupee securities. They step in in the breach, thus yielding an equilibrium.



So I will conjecture: A country that has capital controls against short-dated debt flows will have more volatility on the currency market.

Also see

Viewing the current account deficit as a capital inflow by Matthew Higgins and Thomas Klitgaard, FRBNY, December 1998.

Previous editions of `Mythbusting'

Mythbusting: Reserves edition, 18 October 2008.

Read More

Talk on US financial regulatory reform, by Viral Acharya

Viral Acharya will do a talk Recent developments in financial
regulatory policy in the United States: Review and Critique at
NIPFP
(1st floor conference room) at 4:30 PM on Monday the 20th of
December. All are invited. The talk will be followed by snacks on
the lawns of NIPFP.

This will draw upon the work of many scholars at the NYU Stern
School of Business, which has given two
books: Restoring
financial stability: How to repair a failed system (Viral
V. Acharya, Matthew Richardson, 2009)
and Regulating
Wall Street: The Dodd-Frank Act and the new architecture of global
finance (Viral V. Acharya, Thomas F. Cooley, Matthew
P. Richardson, Ingo Walter, 2010).

Read More

Appropriate regulatory structure for development

A. D. Shroff Annual Public Lecture, by C. B. Bhave.

It is a great honour to be invited to deliver the A. D. Shroff
Annual Public Lecture. Mr. A. D. Shroff was an outstanding
financial thinker and a practioner who took great interest in
organisational and ideological issues. He was known to express his
views in a candid manner and without any fear of the consequences of
such expression. Regulators have a reputation of not speaking much
and if they do speak then not saying much. I will try to strike a
balance between Mr. Shroff's forthrightness and regulatory
reticence.

Costs and benefits of regulation

The world has gone through very troubled times in the last three
years. Unbridled growth and development in the financial markets is no
longer an accepted article of faith. Deregulation in developed markets
resulted in excessive leverage being built by large institutions, and
financial innovation being used more to hide risk than create real
value. This inevitably led to a crisis and the cost of repair is
being borne by the tax payer and the economies in general.

Those who are bearing the costs are, in a substantial measure, not
those who reaped the benefits of unchecked growth. In the event, there
is no support for development without regulation. For orderly
development, regulation is a sine qua non. Notwithstanding the
fact that regulation is a must for orderly development, we still need
to enquire and debate what constitutes an appropriate regulatory
structure. We need to debate issues around this especially in the
Indian context.

At the very basic level, regulation means restraint and restraint
is a hindrance. Thus any business subject to regulation does pay a
price whether the regulation is voluntary or imposed. The question is
not whether regulation will come in the way of development but whether
the price we pay by accepting regulation is worthwhile or not.

Three kinds of regulation

If we look at various sources of regulation one can roughly say
that there are three reasons why business entities agree to regulate
their behaviour even though it does make them pay a price for such
regulation or restraint:

• The first source of regulation arises from the fact that the
  commercial entity interacts with the outside world, suppliers,
  customers, financers, shareholders and so on. There are certain
  norms by which the entity decides to bind itself irrespective of
  whether there are formal rules and regulations or deterrent
  punishment for deviation from norms exists or not. No trader can
  repeatedly violate his contract even if oral, with either his
  customer or with his supplier. It will simply render his business
  impossible. One can call this self regulation at its most basic
  level with the source of discipline being the market place. The
  market place simply does not deal with you if your behaviour is
  substantially out of line with basic norms and we don't need the
  force of law here to enforce such norms.
  
  
• As a second source of demand for regulation one can look at
  situations where entities engaged in a particular business activity
  may decide to come together and conclude that certain norms of
  behaviour are not adequately discouraged if the entire thing is left
  to the individual entities. Yet, the group feels that such norms
  need to be in place for the overall development of their
  business. Since such voluntary groupings of entities do not enjoy
  the force of law they may decide that any behaviour against the
  agreed rules of behaviour will be punished by making the concerned
  entity lose the membership of that group. Trade Guilds, clubs, the
  early form of stock exchanges are examples of this. This form of
  regulation is commonly known as self regulation. This self
  regulation is not regulation of activities by the entity by itself
  but is the regulation of the entity by a common interest group of
  which that entity has agreed to be a member. For such a grouping to
  succeed, individual members must be able to see the benefits of
  membership. The price of being expelled from membership should be
  high enough to ensure behaviour as per the commonly agreed norms by
  the group itself. Our experience in India has not been entirely
  satisfactory in this area. Nevertheless, we need to continue our
  efforts at establishing credible self-regulation.
  
  
• That brings us to the third category of regulation which is
  regulation enforced by law. The argument in such cases appears to be
  that the activity of entities in a particular area of operation
  affects the lives of more than just the member entities. In other
  words the society has a stake in ensuring that the entities conduct
  their operation in a manner that is acceptable not just to those
  entities but to the society at large as well. The discontentment with
  financial meltdown is very aptly captured by the expression
  `privatisation of gains and nationalisation of losses'. This sentiment
  is also a reflection of the fact that there are stakeholders outside
  the universe of finance who suffer if finance is not regulated.
  

The interplay between self regulation and regulation by the
authority of law has been a subject of interesting discussion not only
in the area of capital markets but in other fields as well. Self
regulation is generally considered desirable since it is made by the
entities themselves and therefore,it is considered more business
friendly. Equally there are arguments that there are not sufficient
incentives in self regulation to put the interest of other
stakeholders before the interests of the participating entities. In
addition self regulation lacks the ability to enforce its rules beyond
depriving the member concerned the membership of the group. If a
significant group decides to violate norms the self regulatory
structure can become unsustainable and only the backing of law can
sustain such activity.

In different jurisdictions, efforts have been made to make the
deterrent actions of self regulatory organisations stronger by
granting such organisations `recognition'. However, difficulties arise
if more than one organisation wants to be recognised as a self
regulatory organisation for entities in the same area or business. In
other words if the entities split and form multiple organisations, all
of which seek recognition as self-regulatory organisations, the
situation is not amenable to an easy resolution. Notwithstanding the
various forms of self regulatory organisations and the different
degrees of strength and their deterrent actions, it is commonly
accepted around the world that self regulation alone is not sufficient
and an apex regulatory body is necessary.

The functions of the regulator

Regulation with the backing of legislation is administered either
by the Government itself or their autonomous statutory regulatory
organisations. While the model of Government being a regulator itself
has been tried in the past,the modern consensus is to have independent
and autonomous statutory regulatory bodies. In the wake of the
reforms undertaken by the Government in 1991, SEBI legislation was
passed by the Parliament in April 1992. SEBI has been created as an
independent statutory body.

What are regulators expected to do? Regulators set rules for
conduct of market entities, the manner of conducting business, and
even the tariff to be charged in certain cases. Regulators may also
lay down norms for entry as well as continuity of business for
entities. It is thus apparent that regulators can enjoy powers in the
area of rule making for entry / exit regulation, conduct regulation,
tariff regulation, and risk containment regulation.

Regulators not only set rules but are also required to keep an eye
on the compliance of these rules. They therefore, end up setting up
an elaborate mechanism for ensuring compliance. If despite this, the
rules are breached then the regulators are charged with the duty of
carrying out necessary investigation and enforcing these rules by
adjudication.

The question of autonomy of the regulator

The list of responsibilities is fairly onerous and since the
regulators combine in themselves the roles of rule making (legislative
role), administration of rules and investigation if breach of rules
occur (administrative function) and adjudication (judicial function),
it is necessary to pay careful attention to the governance issues of
regulators. It is an accepted principle that regulators need to be
autonomous in discharging the duties laid down by law. A regulator,
subordinate to or dependent on the executive wing of the Government
will not be in a position to do proper justice to its duties.

Autonomy is not only a matter of creating appropriate structures
and legal provisions but also a matter of perception. Regulatory
structures in India are in different stages of evolution and therefore
the thinking on autonomy and the perception of autonomy has not yet
fully crystallised.

The Reserve Bank of India as a regulator has been in existence for
more than 75 years and therefore, the relationship between the
executive branch of the Government and the RBI is far more evolved
compared to the relationship of regulators which are of more recent
origin. SEBI is in its 19th year and stands somewhere in the middle of
regulatory evolution: it is more evolved compared to the regulators
that have been set up in this century but has lesser history when
compared to the Central Bank.

The first Chairman of statutory SEBI, Mr. G. V. Ramakrishna, once
famously remarked in the early days that brokers of BSE should know
that the route from Dalal Street (BSE) to Mittal Court (the location
of the SEBI head office, then) is not via the North Block (Finance
Ministry, Delhi). The brokers at that time had not got used to the
idea of a regulatory body having been formed which would independently
set regulations. Capital market regulation was part of the Ministry of
Finance functions till the formation of SEBI. They therefore had a
tendency to run to the Government for every little problem.

The tension between the executive branch of the Government and the
regulatory bodies is not a phenomenon only during the early stages of
regulation nor is it peculiar to India alone. Both the regulators and
the executive need to nurture this relationship in a manner that
reinforces regulatory autonomy. It is not easy for the executive to
deal with this especially when the very powers that were exercised by
the executive are transferred to the regulator. It is imperative in
this context to make sure that there are adequate supportive
provisions in law and the rules to support the autonomous character of
the institutions.

To maintain the autonomous character of the institutions and its
independence from the executive one needs to start at the process of
the appointment and the terms of removal of the Members of the
regulatory apparatus. Interestingly, the framers of the Indian
Constitution saw the importance of this aspect in institutions such as
the Election Commission, the Higher Judiciary namely High Courts and
Supreme Courts and the Comptroller and Auditor General of India. The
Constitution makers were very careful in providing for the conditions
for removal of persons at the helm of these bodies even while
recognising that the appointments will be made by the executive. These
autonomous institutions have served India well. The prolonged tension
between the Election Commission and the other organs of the Government
is an example of how constitutional protection delivered a powerful
and autonomous Election Commission which admirably served the cause of
democracy.

The regulators do not enjoy protection in terms of the
conditions under which their services can be dispensed with by the
executive. In fact the regulators are at the other end of the spectrum
in terms of provisions for their removal. In SEBI, the Members and
the Chairman are appointed for a tenure of certain number of years or
until further orders whichever is earlier.

A tradition has been established that regulators are not removed
from their jobs as easily as the functionaries in the executive
itself. There is no known example of the executive having resorted to
the clause `until further orders whichever is earlier' to remove the
functionaries of the regulatory organisations. Whether it is
sufficient to rely on tradition or whether we need a better legal
mechanism with checks and balances needs to be debated, so that this
important aspect of governance is not ignored.

A vital component of autonomy is financial autonomy. In case of
SEBI and some other regulators such as IRDA this autonomy was built
into the legislation by way of providing that such authorities will
establish a separate fund into which the fees paid by the market
intermediaries will be credited. Such funds are to be used by the
authorities for discharging the functions entrusted to them by
law.

Currently there is a line of thought - as you must have all read in
the media - that the regulatory authorities should not be allowed to
have funds of their own but these funds should be merged with the
Consolidated Fund of India. If the Government finally accepts this
line of thinking, substantial damage will be done to the autonomy of
regulatory institutions. If the regulators have to depend on the
executive for release of funds the question of independent behaviour
by the regulators would be jeopardised. It is necessary to carefully
consider the pros and cons of taking away financial autonomy from
regulators.

The function of investigation in case of breach of rules is an area
that hinges in a vital manner on autonomy from the executive wing.
Regulators by the definition of their responsibility have
investigative wings. This function has come under increasing judicial
scrutiny and the movement of the last 15 to 20 years has been to free
the investigation function from the possibilities of influence by the
executive.

The CBI is a case in point. Under the direction of the Supreme
Court the supervision of this institution is with the Chief Vigilance
Commission which in itself is an independent statutory authority. I
would therefore, argue that regulatory autonomy vis a vis the
executive wing of the Government is not only necessary but is
essential.

The question of accountability

Any governance structure based on autonomy must also look into the
question of accountability. Since regulators have multiple roles, part
legislative, part administrative and part adjudicatory, the
accountability in the three areas is handled in different ways.
Regulators are creatures of law and the ultimate supervisory authority
of the Parliament to assess whether the regulators are discharging the
functions assigned to them is supreme.

The Comptroller and Auditor General of India is empowered under the
regulatory provisions to audit accounts of the regulators and submit
reports to the Parliament to help the legislative in its
assessment. In addition the regulators are required to prepare an
annual report on their activities and lay it on the table of both
Houses of Parliament.

The adjudicatory function of the regulators has been treated
differently and by its nature has to be a subject matter of
supervision by judicial bodies. A mechanism in the form of Securities
Appellate Tribunal headed by a retired High Court Judge and an appeal
provision to the Supreme Court of India forms an integral part of SEBI
legislation.

The rule making powers of SEBI are supervised by the
Parliament in order to ensure that the rule making is confined to the
powers granted by the Parliament to the regulators. If a regulator
exercises power beyond the permissible limit of legislation, the rules
can also be challenged in the courts of law.

In the rule making function the regulators do interact with the
executive branch of the Government. The executive wing of the
Government will have legitimate imputs into the rule making process
and a fine balance is required between the need for autonomy and the
need for harmonisation. This is achieved through the presence of
Government representatives in the Board of SEBI.

Conclusion

In conclusion, it is quite clear that attempts at unregulated
development not only in a particular sector but even in small
sub-sections of sectors have failed. The failure is mainly because
such development ultimately leads to crisis. The cost of resolving
such crisis is high and the burden of the cost is borne not just by
those who benefited from the development but a large portion is borne
by those who were not part of the recipients of the benefits. Clearly
the collateral damage is very high.

The question is, therefore, not so much as to whether development
and regulation are in conflict as the quality of regulation that will
enable us to find a balance between the needs of development and the
need to keep the risk-reward relationship appropriate. It is
necessary to carefully think and design proper regulatory structures,
ensure regulatory autonomy and make sure that there are checks and
balances in the system to address the concerns of accountability as
well.

Thank you.

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Emerging markets finance conference at IGIDR

link

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A puzzling data revision

Ordinarily, official statistics get revised because at first, provisional estimates are released, and when the full data filings come in, then improved estimates are put out.



In the case of RBI's data about RBI's trading on the currency market, such data revisions should ordinarily not arise.



But yesterday, data released by RBI modified the previous information that had been put out about RBI's trading on the currency market. Earlier, trading in June had been claimed to be 0. Now it shows purchase of $370 million and sale of $260 million. Earlier, trading in September had been claimed to be 0. Now it shows a purchase of $260 million. I wonder why this data revision took place.



The newest data - for October - shows a purchase of $450 million on the spot and $450 million on the forwards. At a time when rupee trading is estimated at above $40 billion a day (worldwide), it is hard to see how such a small scale of trading can generate a significant impact upon the price; so I wonder what is going on in terms of the rationale and the thought process.

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Interesting readings

One of the big impediments to India's integration into the world
economy is xenophobic visa rules. There is some progress in the
pipeline: visa
on arrival has been working from Jan 2010 onwards for visitors
from Finland, Japan, Luxembourg, New Zealand and Singapore. A nice
touch here is that India did not get stuck on issues of reciprocity;
this is unilateral liberalisation.

Watch
this talk by
Steve Coll.

Mature treatments of the Niira Radia wiretaps
: Sail
Tripathi in
the Mint, Pratap
Bhanu Mehta in the Indian Express.

Anil
Padmanabhan in Mint on the question of corruption, and
Sevanti
Ninan on the media response to the tapes.

In
search of America's liberty and India's dharma by
Gurcharan Das in the Times of India.

A
rumination by Vikram Doctor, on the need to shift focus in
Bombay from the West to the East.

Sam
Geall on the problems of Chinese science. Some of these
problems are found in India also.

With corruption scandals galore, what India needs most is competent
and clean government. SEBI continues to soldier on:
see the
recent order on bond issues by Sahara. Or if you don't have
appetite for the full text, here is
a precis
by V. Umakanth. Everyone interested in Indian finance should read
a few orders of Bhave's SEBI every year: they give you fresh
insights into how the interplay between law and regulation
works.

Tamal
Bandyopadhyay in Mint with his sense about the extent
of corruption in Indian banking.

How do foreign
capital flows behave around elections, on voxEU by Emmanuel
Frot and Javier Santiso.

Currency
warriors should consider India
by Sebastian Mallaby
in the Financial Times.

A. K. Bhattacharya
writes in the Business Standard about fresh thinking on
Indian Railways from an unexpected source.

Huang
Yiping on voxEU has a story from China which is similar to
what we often see in India: the use of microeconomic tools to go
after macroeconomic problems.

href="http://www.project-syndicate.org/commentary/jian5/English">In
the footsteps of Gandhi, Mandela and Havel, by Ma Jian, on
Project Syndicate. href="http://www.nybooks.com/articles/archives/2010/dec/09/unveiling-hidden-china/?pagination=false">Unveiling
hidden China by Christian Caryl in the New York Review of Books.

Good-bye
to Dubai by Joshua Hammer in the New York Review of Books.

Robert
Messenger looks back at Dien Bien Phu.

Richard
Boudreaux in the Wall Street Journal about Russia's
Parliament accepting Stalin's responsibility for the Katyn massacre.

href="http://www.project-syndicate.org/commentary/rogoff75/English">Kenneth
Rogoff on the Euro.

A tale from the frontiers of public administration. The Australian
government has announced a
competition to forecast the behaviour of traffic on Sydney's M4
freeway. This illustrates three themes. The first is that of better
living through science: the attempt at using statistical analysis to
shape public administration. The second is the unique value of public
domain databases. The third is the importance of harnessing
brainpower out there in innovative ways: through openness of data
and through the competition.

Trailhead
by E. O. Wilson. As I read it, I was astonished at the way in which
knowledge gleaned from hundreds of research papers has been
stitched into a compelling story.

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A club of 19

What binds this club of 19 countries: China, Russia, Kazakhstan, Colombia, Tunisia, Saudi Arabia, Pakistan, Serbia, Iraq, Iran, Vietnam, Afghanistan, Venezuela, the Philippines, Egypt, Sudan, Ukraine, Cuba and Morocco? Answer. Am I glad India is not in this club!

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Alternative stock market indexes

I
saw this
interesting article about the mind-share of Nifty as opposed to
the BSE Sensex. It is by Samie Modak and Muthukumar K. in
the Financial Express.

The NSE
data for June 2010 shows that Nifty futures have peaked at
Rs.0.36 trillion of notional turnover in a day (27 Jan 2010) and
Nifty options have peaked at Rs.0.89 trillion of notional turnover
in a day (24 June 2010). Nifty has shaped up as one of the big
contracts by world standards. It is interesting to go back and
read the
original paper. Those were interesting times. Looking back, it
seems obvious that Nifty would dominate the derivatives market,
but at the time, the outcome was far from clear.

This made me look at data on risk and reward of the alternative
indexes. I start from the first data for Nifty Junior, which takes
me back to 21 February 1997, thus giving data for 13.7 years.

	Mean	Volatility	Ratio
Nifty	12.99	26.37	0.4926
BSE Sensex	12.68	26.92	0.4711
Nifty Jr.	18.16	32.38	0.5608
CMIE Cospi	17.40	27.23	0.6391

Nifty and the BSE Sensex are a lot like each other.

The real surprise is Nifty Junior: Merely moving down from rank
1-50 to ranks 51-100 has given an enormous juice in the return and in
the reward-to-risk ratio. But the volatility of Nifty Junior is also
higher.

The CMIE Cospi index has roughly 2800 stocks today, and represents
the broad market. It includes the Nifty Junior stocks and a host of
other smaller stocks. But unfortunately, these numbers are not
comprabale with the other three in that it includes dividends while
the other three do not. With this combination of high diversification
(giving a low volatility), small-cap stocks (which helps returns) and
inclusion of dividends (which helps returns), it is not surprising
that it scores the best reward-to-risk ratio.

In my mind, most of the claims of out-performance by active
managers in India are purely about being invested in the non-Nifty
space. Nifty Junior ETFs are easily accessible and I get surprised
that more people aren't putting this into their investment
strategy.

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A more efficient piece of code

CMIE's firm databases use a fine-grained product code to identify
each product. Each firm is also allocated to a product code based on
its predominant activities. I like to reconstruct a coarse
classification out of this that suits my tastes. I do this using
this R function:

cmie.14.industries <- function(s) {
  values.8 <- c("Food","Textiles",
                 "Chemicals","NonMetalMin",
                "Metals","Machinery",
                 "TransportEq","MiscManuf",
                "Diversified","Serv.IT")
  names(values.8) <- c("01010101", "01010102",
                       "01010103", "01010104",
                       "01010105", "01010106",
                       "01010107", "01010108",
                       "01010109","01010408")
  values.6 <- c("Serv.Construction","Serv.Other",
                 "Mining","Electricity")
  names(values.6) <- c("010106","010104","010102",
                       "010103")

  if (is.na(s)) {return(NA)}

  leading8 <- substr(s, 1, 8)
  attempt <- values.8[leading8]
  if (!is.na(attempt)) {return(attempt)}

  leading6 <- substr(s, 1, 6)
  attempt <- values.6[leading6]
  if (!is.na(attempt)) {return(attempt)}

  leading4 <- substr(s, 1, 4)
  if (leading4 == "0102") {return("Serv.Finance")}

  return("MISTAKE")
}

This maps each firm into one of 14 coarse categories. Here are some
examples of this in action:

> cmie.14.industries("0102090000000000")
"Serv.Finance"
> cmie.14.industries("0101041502000000")
"Serv.Other" 
> cmie.14.industries("0101010601010000")
"Machinery"

So in short, the function cmie.14.industries() maps a
string like "0101010601010000" into a set of 14 broad industry names
such as "Machinery".

Faced with a file with roughly 48,000 firm-years, at first blush,
it seems that this function has to be run 48,000 times. For a given
firm, this classification could change over time, so it isn't just a
matter of doing this once for each firm. Here is one simple way to do
it:

badway <- function(task) {
  result <- rep("", length(task))
  for (i in 1:length(task)) {
    result[i] <- cmie.14.industries(task[i])
  }
  result
}

This is just a loop that runs over everything in the supplied
vector and calls cmie.14.industries() for each
element. The only concession to efficiency is that the empty vector
`result' is allocated ahead of time.

This proves to be quite slow. None of the standard R vectorisation
ideas offer much relief.

The key idea for obtaining a leap in performance was that while I
had to run through 48,000 firm-years, the industry codes actually
attain only a modest list of possibilities. This makes possible a
table lookup:

goodway <- function(task) {
  possibilities <- unique(task)
  values <- rep("", length(possibilities))
  for (i in 1:length(possibilities)) {
    values[i] <- cmie.14.industries(possibilities[i])
  }
  names(values) <- possibilities
  values[task]
}

For a problem of size 1000, this works out to be 13.5 times
faster:

> load("task.rda")
> length(task)
[1] 1000
> system.time(res1 <- badway(task))
   user  system elapsed 
  0.030   0.000   0.031 
> system.time(res2 <- goodway(task))
   user  system elapsed 
  0.002   0.000   0.002 

This is just a demo with a 1000-sized task. In my production
situation, the performance difference is even greater,
since badway() calls cmie.14.industries()
48,000 times while goodway() only calls it a few hundred
times.

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Ownership & governance of critical financial infrastructure

SEBI has released the Bimal Jalan committee report about the ownership and governance of critical financial infrastructure. We're going to need a similar report on the questions about entry into banking also.

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Governments riding in to rescue firms

What is a government to do when a company faces a near-death
situation? In almost all cases, the right answer is to let the
company go under: It is not the job of a government to prevent
companies from dying. Indeed, creative destruction is central to the
proper functioning of capitalism. Capitalism without failure is
socialism for the rich.

But sometimes, the cost-benefit ratios can look
startling. Sometimes, the disruption to the economy that comes from
the death of a company can be rather large. Let's look at three
stories.

Three examples

GM

In July 2009, the US government chose to put $50 billion into the
auto maker General Motors (GM) as part
of complex
rescue, which included wiping out the existing shareholders and
embarking on a complex restructuring of the firm. The old GM died
there.

GM got back to profitability this year. Seventeen months later, in
17 November, GM got back on its feet with an IPO which raised $23.1
billion. How impressive! See this
story by Michael J. de la Merced and Bill Vlasic in
the New York Times. This IPO was at $33. With this IPO, the
US Treasury got down from 61% ownership to 26% ownership, so this
IPO was the re-privatisation of GM. From here, if the US Treasury is
able to sell its remaining 0.5 billion shares at $53 a share in the
future, it will fully recoup the $50 billion that went into the
rescue (ignoring time value of money).

Satyam

On 7 January 2009, Satyam announced that a lot of money was missing
from their balance sheet. In the aftermath of this crisis, the
government put Deepak Parekh, Kiran Karnik, Tarun Das, and three
others in charge. Read this href="http://www.livemint.com/2010/01/06212549/Deepak-Parekh--Satyam-was-res.html">interview
of Deepak Parekh with Tamal Bandyopadhyay in Mint, and this
href="http://ridingtheelephant.wordpress.com/2009/04/17/india%E2%80%99s-successful-satyam-rescue-is-the-way-to-go/">blog
post by John Elliott.

The new board put the firm up for sale. It was bought by Tech
Mahindra. A collapse of the firm was averted; the employees and
customers largely stayed in place.

UTI

When UTI got into trouble, I was opposed to
government intervention. But by and large, I think the intervention
worked well. US-64 unitholders did suffer losses: half of the
gap between the NAV and market value was paid by the unitholders and
half by the government. And the follow-through was excellent. The
staff quality that MoF was able to muster on the problem was
outstanding. The UTI Act was repealed, and UTI was turned into an
ordinary company. `Bad UTI' was separated out by `Good UTI'. The
ownership was modified including the recent work of bringing in
T. Rowe Price as a shareholder. All in all, the exchequer did well
when selling off the shares in SUUTI. Privatisation hasn't yet come
about, but where we are is progress.

When is it right for a government to go in?

Should the US government have gone into GM? There was a fair
amount of criticism of the Obama administration for the
decision. There was concern that they were doing this owing to
pressure from trade unions. But the outcomes have been quite nice,
so (at least ex post) it looks like a good call.

In the
case of Satyam, the existing shareholders were not
expropriated. It can be argued that the failure of the firm was
not their fault. But by that argument, many firm failures in India
in the future will justify government intervention since most
public shareholders are fairly powerless when the inside
shareholders have over 50% shares. In his interview, Deepak Parekh
says Had it happened to a consumer finance company or a small,
or even big, manufacturing company, the government would not have
come out and superseded the board. The normal procedures for
bankruptcy and liquidation would have taken place.. I am not
sure how the future will work out.

The problem of execution capability

Satyam, GM and UTI are success stories in that the government
packed a mean punch in the execution. In particular, in Satyam's
case, I had simply not expected that such a nice outcome could be
achieved by the government. We should really admire the teams that
worked on these problems.

But can we count on such high quality execution on such problems in
the future? Our success in the Satyam or UTI stories should not be
generalised to the view that in the future such high quality
execution will always come about.

The exit strategy

The really amazing feature of the GM story is the clarity and
commitment of the government in getting out of `Government Motors'
by doing a privatisation just 17 months after going in. All too
often, government interventions turn into nationalisation and then
you're stuck with a public sector company for a long time, with all
the usual politics of the privatisation.

In the deep past, numerous weak companies have been nationalised
in the decades of Indian socialism (e.g. National Textile Company)
and generally the outcomes have been bad.

A particularly attractive feature of the Satyam story is that no
government money was involved. The presence of government money
makes things much harder. In India, all too often, it's easy to ask
for government money and it's easy to get it. And if the government
had got shares in Satyam, it's not easy to see how they would have
got out of it.

Similarly, a nice feature of the UTI story is that in the end, the
UTI Act was repealed, and UTI is on course for turning into a
normal financial firm. Government intervention in the rescue did not
yield an ossified PSU.

At the same time, while Satyam and UTI are good stories in terms of
the exit path, we cannot generalise too much from this given the fact
that GOI is at a
standstill on privatisation. In general, we have to assume that
what is purchased is never sold, which puts a crimp on a vast array of
situations where government intervention might be evaluated.

To summarise

When most firms approach death, the decent thing to do is to let
the firm die. We must rejoice in the extent to which Indian capitalism
is able to bring about a steady pace of firm death. Building a good
quality bankruptcy mechanism will increase the class of firms where
resolution is handled in a routine and humdrum way, without the
possibility of a special intervention. (Note that going through the
bankruptcy process was an integral part of the GM story).

When a potential
intervention situation arises, six questions need to be asked:

1. Are the negative externalities of firm death really that
   onerous?
   
   
2. Can government intervention be envisaged without requiring
   money?
   
   
3. Are the Union ministers involved in the problem known for being
   smart and clean?
   
   
4. Can a top quality team be put together which will work on a
   time-bound project starting from intervention until exit? Does this
   team combine competence with cleanness?
   
   
5. Do we see an exit strategy through which, within a short time,
   the firm will be fully out of government hands?
   
   
6. Are we very sure that in the end, we will endup imposing no
   costs upon the government?
   

Ex post, these questions worked out well for GM, UTI and
Satyam.

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Let's go metric

T. N. Ninan, writing in Business Standard, calls for a shift away from lakh and crore to thousand, million, billion and trillion. We agree! And we've moved our Indian Business Cycle page to metric.



Indian economics is easier in the metric system. GDP is Rs.55 trillion. The market capitalisation of Reliance is Rs.3.5 trillion. On a good day, Nifty as an underlying has derivatives turnover of Rs.1.5 trillion. A billion dollars is Rs.44 billion. When I was at the MoF, I had tried suggesting that the budget documents should be switched to metric, without success.

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Interesting readings

C. Raja
Mohan in Foreign Policy magazine on India's strategic future.

Vivek
Kulkarni in the Hindu Business Line estimates the
magnitude of corruption in Karnataka.

Ashish
Nandy in Outlook magazine on India's proclivity towards censorship.

How to improve tax compliance in
India: Thorsten
Beck, Chen Lin and Yue Ma have an article where they say that
financial development helps reduce tax evasion: when firms use more
external financing, they have greater incentive to not `cook the
books', which induces bigger tax payments.

Salil
Tripathi in Caravan magazine on improving freedom of
speech in the UK.

Robert
F. Worth in the New York Times on the shift of the
State in Saudi Arabian away from tolerating Islamic fundamentalism
to fighting it.

Who was
right: Aldous
Huxley or George Orwell?

Nicholas
Schmidle in The Atlantic with a story from Ghana about
something we badly need in India: serious investigative
journalism.

Anand
Giridharadas in the New York Times,
and Kimberly
Brooks on the Huffington Post on alternatives to the
handshake, particularly `Namaste'.

I just
read this
beautiful obituary for Milton Friedman, written by Larry Summers.

In continuation of the Indian debate on ownership and governance of
critical financial infrastructure,
see Jeremy
Grant in the Financial Times.

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India's liberal foundation

I just read The off-key notes of a Sena scion by Rahul Pandita in Open magazine. The quick summary: Aditya Thackeray is the son of Uddhav Thackeray and the grand-son of Bal Thackeray, both of whom are the most-feared politicians of Bombay. He is now being initiated into politics, and has led the charge by threatening violence against those who would read Rohington Mistry. But his resume up to here features all sorts of nice nineteenth century liberal values such as writing poetry, mostly in English, rap music, Urdu, wearing jeans, and a bit of French. The article correctly draws attention to the hypocrisy of those involved.



But in it, I see another dimension. An upbringing in the Thackeray family is as strong an indoctrination into the sectarian perspective as you could ask for. I find it quite striking that between a certain strong ideology being sold at home, and the broader liberal worldview that pervades India, young Aditya evolved into the culture of an open and inclusive India.



The idea of India is about a great coalition of people who differ in ethnicity, language, religion, skin colour, education, income etc., who have figured out how to live together with a mixture of tolerance and individualism, without getting trapped in hatred or envy. This liberal India was strong enough to be appealing to Aditya Thackeray, and this story tells us that we're in good shape.

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Why does Bombay have abysmal governance?

The resource curse

For many years, economists have been puzzled at the way things have
gone wrong in countries where natural resources were discovered. In
1993, the economist Richard M. Auty coined the phrase `Resource
curse' to convey the extent to which natural resource finds are a
curse and not a blessing. But the idea had been kicking around well
before that. I suppose it was an obvious conjecture after watching
the failures of the Middle East, where trillions of dollars of oil
revenues were squandered by not one but many countries.

In the 1970s, when oil was discovered in Venezuela, former Oil
Minister and OPEC co-founder Juan Pablo Perez
Alfonzo said:
"Ten years from now, 20 years from now, you will see, oil will bring
us ruin." His phrase for oil was: "the devil's excrement."

Why are resources a curse? In a country blessed with no natural
resources (think Japan), the only way forward for the ruling elite
is the slow hard work of building public goods, so that GDP builds
up, which then feeds back into the power and importance and utility
of the ruling elite. When the ruling elite gets their wealth for
free, without having to do the hard work of building public goods
and thus GDP of the country, the rulers emphasise the wrong
issues. That's how Venezuela ended up with Hugo Chavez.

On one hand, rulers get focused on finding ways to maximise their
rent from the underlying resource flow, without developing the
knowledge about how to build a State that delivers public goods. In
parallel, competition between politicians becomes an unpleasant
process of trying to grab the riches by means fair or foul, rather
than a process of competing in doing better on public goods. If
there are XX billion dollars to be grabbed by becoming head of
state, fairly unpleasant tactics get used by rivals aiming for that
job.

Bombay's resource curse

I just
read Maharashtra's
Audacious Chief Ministers by Ashok Malik and it is a
chilling story. It made me think: Why did governance in Bombay go
wrong so comprehensively?

Maybe the story runs like this. Winning elections in Maharashtra
does not require serving the citizens of Bombay. A party can do
various things in trying to win seats in the legislature across
Maharashtra. Once this is done, the ruling party gets the rents
that come from control of Bombay.

The wealth and prosperity of Bombay is like an oil well which is
gushing out cash for the ruling party in Maharashtra. They did not
earn it. The slow, long, hard work of learning how to run a State,
of building public goods: these things do not matter for the ruling
party in Maharashtra. They get a rental cashflow from Bombay for
free.

In (say) Jaipur, the Chief Minister and his ilk do not have an oil
well gushing cash at them. Their incentives are to worry about
public goods, and grow the GDP of Rajasthan. The importance and
rental cashflow of the leadership in Rajasthan are primarily about
the GDP of Rajasthan. Their hard work in improving public goods in
Rajasthan feeds back to them as a higher rental cashflow.

People often compare the problems with Bombay with the decline of
Calcutta after the Left took charge. The two stories are similar in
that parties which won rural votes got to run a great city into the
ground. But the Left did not take rents from Calcutta on this
scale. That was an age where the GDP of Calcutta, while impressive
by Indian standards, was still small change. Bombay of the last 20
years is in a different league altogether. This connects with the
middle
income trap meme: when capitalism first bloomed in India, some
governance problems got worse and not better.

Implications

I think this suggests that the right to govern a prosperous city
should not be based on elections taking place somewhere else. If
Bombay were a full fledged state, as Delhi is and as
the four
big cities of China are, then elections to control Bombay would
require persuading voters in Bombay.

Read More

An option chain for INR/USD

We are all used to seeing the options chain for Nifty, but now you have one for INR/USD.



Also read Mobis Philipose in Mint on the unfinished business of derivatives trading in India.

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Who will make the exchange-traded currency options market?

In a few minutes, NSE and USE will start trading in currency options. This will be the first exchange-traded options in India on a non-equity underlying.



Currency options are obviously useful as a risk-management tool. I feel that futures are nice simple linear contracts: they ask the person to make only one decision -- are you long or are you short. But once a futures position is entered into, the person needs the ability to manage the position since daily marking-to-market is done, and since there can be large losses for either the futures long or the futures short.



Compared with this, long positions on call or put options appeal to the kind of person that is willing to think carefully about a position at the outset, but after that it is fire and forget. This better describes the life of many firms exposed to currency risk, particularly those with relatively weak treasuries.



Currency options have, of course, been traded OTC for some time now. But there are real problems with this market. Customers have sometimes been ripped off by banks on pricing, given the lack of a liquid and transparent comparison point. While currency options are offered by banks to customers, there is not much by way of an inter-bank market.



As far as I know, there is relatively little by way of a build-up of human and systems capability in the banks for currency options trading (whether OTC or on exchange).



In contrast, there is a remarkable build-up of human and systems capability in the world of Nifty options trading. Options on Nifty have shaped up as one of the biggest options markets in the world. This involves end-users who think and trade options, staff working for securities firms who understand options (and understand issues about their credit risk when their customer has an options position), analytical software systems, and (most importantly) algorithmic trading systems. Options trading inevitably involves trading in a large number of underlyings. Strong computer systems which are able to think about, and place orders in, all the underlyings at one shot are of essence in achieving option liquidity. Such capabilities are now found in the world of Nifty options, and are absent in banks or in the OTC currency options market.



It is fairly easy for a person trading Nifty options to move to trading currency options. Hence, the brainpower and systems that have made Nifty options one of the world's top contracts will easily be able to move to currency options trading, and make it work. I expect that the securities firms who dominate Nifty options trading will now dominate currency options trading.



I think three kinds of stories will now kick in:

1. Liquidity in currency options will fuel liquidity in currency futures, and vice versa. Corporate hedgers will be more interested in either, given that the other is also a possibility.


2. Skills and systems from Nifty options will flow into currency options. Banks will be able to rapidly bulk up their options capabilities by recruiting from the world of Nifty options, and by purchasing the software systems that have sprung up in that space.


3. Conversely, trading in both currency options and Nifty options will generate an increased business size for people who build knowledge and systems for options; it will also improve knowledge of options trading through an understanding and comparison of the nuances of two different underlyings. The number of FRM and PRM certified people in India will go up.

Also see.

Of great interest will be the question of currency volatility. On one hand, the currency options market will generate an implied volatility for the currency, which will represent a market-based forecast for what future currency vol will be. This will be a big new piece of information which will inform macro policy and monetary policy, and thus diminish the extent to which we are flying blind in thinking about Indian macroeconomics.

In recent years, RBI has mostly stayed off from trading the currency market, so the volatility of the INR/USD is a true market volatility. If, in the future, RBI thinks that it wants to give subsidised currency risk management services to the private sector, one way in which it would be able to do that is to do `intervention' on the currency options market so as to force down the implied vol of the market. I.e., RBI would sell ATM calls and ATM puts and thus drive down that price, and thus give cheaper risk management services to the market. This would represent the first operational intervention strategy for RBI through which it can pursue the goal of reducing volatility without distorting the INR/USD exchange rate.

If RBI gets into actively trading the currency market again and trying to push the rupee into a de facto pegged exchange rate, we will see this clearly in the currency options market as a sharply reduced implied vol.

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Better living through economics

The `lemons model' in milk procurement

One of the classic stories of India of old is that of Amul, which brought new technology into milk procurement. When the farmer brought his shipment of milk to the Amul front-end, a centrifuge was used to measure the characteristics of this shipment, and based on this payments were made. See this blog post by Alok Parekh, Naman Pugalia and Mihir Sheth. This eliminated the incentives for aduleration of milk by the farmer, which used to be done by adding in water or by skimming the cream.



We can think about this differently. Suppose the centrifuge was not there at the front end. Then the buyer of the milk faced asymmetric information about the characteristics of the milk that were being offered to him. Generally we expect that faced with this `lemons' problem, the buyer would bid low prices for the milk.



So to some extent, the ability of Amul to pay higher prices for milk is not about the greatness of cooperatives when compared with profit-oriented firms: it was about the injection of new technology which removed this asymmetric information.



The interesting puzzle is: in that age, why was Amul the pioneer in buying centrifuges? Why did no private firm buy centrifuges and create a winning business model around milk?

Penalty structure under incomplete detection

Another nice idea that we have understood is the relationship between the probability of getting caught and the penalty. Suppose the fee required for parking is Rs.10 and suppose the probability of getting caught when illegally parked (i.e. without paying the fee) is 10%. Then it's sensible to set the penalty for getting caught at Rs.100 so that even a risk-neutral person will prefer to play by the rules.



This can be applied in the problem of milk procurement. Suppose we say to the farmer: We'll trust you and accept your milk, but on a sampling basis, one in ten farmers will be tested.



Suppose a person added 2 litres of water to his shipment of milk and suppose the price of milk was Rs.10 a litre. In that case, he was trying to steal Rs.20 by palming off low quality milk. But there was only a 10% probability of getting caught, because only one in ten farmers is tested. So the penalty he should face should be Rs.200. If this is done, the risk-neutral farmer is agnostic between playing fair and cheating, even if only one in ten farmers is tested.



The advantage of this strategy is that for 90% of the farmers, the deadweight cost of putting a sample into the centrifuge is eliminated.



This idea is, of course, general:

• Sometimes, we are in situations (as in market manipulation in finance) where we know that even the best regulator in the world will only catch some of the crooks. So we should estimate what fraction of the crooks are getting caught, and then multiply up the size of theft that was attempted. That is, the right way to think of disgorgement is not that the bad guys should fork up the money that was stolen, but that the penalty imposed by the government should be equal to the size of theft divided by the probability of detection.
  
  


• Sometimes, while comprehensive checking is feasible, it's quite expensive, and it's efficient to deliberately only do checking on a sampling basis. A fairly modest scale of randomised checking (e.g. 5%) can do the trick, coupled with a 20x multiplication factor against the size of the theft that was attempted. This would yield a 95% reduction in the amount of checking that is required. This is the idea in the milk example above.

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A cross-country comparison of charges of exchanges

In reading this article in the Wall Street Journal by By Rebecca Thurlow, Alison Tudor And P. R. Venkat about the potential merger of SGX with ASX, I saw this interesting cross-country comparison of exchange charges (in basis points):

Country	Trading and clearing	Taxes
Singapore	4.75	0
Hong Kong	1.1	20
Taiwan	0.75	30
Korea	0.54	30
Australia	0.53	0
India	0.35	27
Japan	0.24	0

It is quite a striking set of facts.



First, we see that in terms of the core trading and clearing -- the charges of the exchange -- India is the 2nd lowest in this pile, with a value of 0.35 basis points. This is slightly worse than Japan (0.24 basis points) and superior to all the others. This partly derives from the immense economies of scale at NSE and BSE, which are ranked at 3 and 5 in the world by number of transactions. This is also about the cost-efficiency of the human part of running an exchange: small exchanges like SGX cannot match the price points which NSE and BSE can reach. In this field, as in finance more broadly, India is pretty good at reaching up to world class at below the world price. This was the basic logic, if you recall, of Percy Mistry's Mumbai as an International Financial Centre report.



Secondly, we see the huge problem that transactions taxes present in all these countries other than Singapore, Australia and Japan. The Indian charge of 0.35 basis points is just swamped by the taxation of 27 basis points. Even if NSE cut charges by half, and got down to 0.175 basis points, this would do nothing for the end-customer who is paying 27.35 today and ends up paying 27.175 across the price cut. Conversely, Singapore, with the least efficient exchange (4.75 basis points) ends up being a nice place for the customer because there is no tax upon transactions there: only Australia and Japan are better than Singapore.



Economists are very clear that all taxation of transactions is distortionary. It's puzzling why so many countries (four out of these seven) continue to indulge in something which is an elementary mistake in public policy.

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Currency conflicts come to prominence again

From the mid 1990s onwards, the US trade balance has steadily become bigger. This is a centrepiece of the problem of `global imbalances'. Starting from values of roughly zero, this got all the way to values like $70 billion a month, where the US was importing over $2 billion a day of capital to pay for the trade deficit. Here's the picture:

The US trade balance (goods+services, per month, seasonally adjusted)

This was termed as the `Bretton Woods II' configuration, where exporting countries like China gave loans to the US, in a form of suppliers' credit, and the US bought Chinese goods. This magnitude of capital import was un-sustainable for the US. Something had to give.

Warning for Indian readers: In India, the term `trade balance' pertains only to merchandise trade. In the US, the monthly trade data covers both goods and services. So it is a meaningful measure of what is going on in international trade, unlike the corresponding Indian data.

Bretton Woods II first broke down in the financial crisis. In the downturn, the mighty American consumer purchased fewer 50" television sets. The US trade deficit dropped nicely all the way to $25 billion per month. Alongside a rise in the US savings rate, this looked like a world which was rebalancing.

In recent months, this movement reversed itself and the US trade deficit once again started getting worse.   A deterioration of $20 billion per month is visible; i.e. a deterioration of $240 billion a year. Suddenly, the story of global imbalances righting themselves came under question. The present US run rate is around $40 billion a month or $0.5 trillion a year.

Alongside this, we have news that the Chinese reserves rose by $194 billion in Q3 2010. The Chinese seem to have also passed on some of their problems of exchange rate pegging upon their neighbours by purchasing Japanese, South Korean and Indonesian assets. I am not aware of such behaviour having been observed prior to this in human history. Japan, South Korea and Indonesia have taken unkindly to this behaviour. Given the opacity of the Chinese regime, one can't help wonder if similar things are going on through less visible channels - e.g. a Chinese sovereign wealth fund buys $10 billion of OTC derivatives on Nifty.

So we seem to be headed for quite some escalation of conflict over the Chinese exchange rate regime. Here are some interesting readings on the subject:

• What happens if the RMB is forced to revalue? by Michael Pettis on his blog.


• Why America is going to win the global currency battle, by Martin Wolf in the Financial Times.


• The final end of Bretton Woods 2? on Tim Duy's Fed Watch (the source of the above graph).


• The effect of RMB appreciation on the US-China trade balance, by William Thorbecke on voxEU.


• An interview with Raghuram Rajan on der Spiegel.


• Evolution of the exchange rate regime in Asia.


• How to avoid trade war: A reciprocity requirement, by Daniel Gros on voxEU, which makes a lot of sense to me as one of the least troublesome policy avenues to go down.

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Movement on FSDC

MoF press
release on FSDC.

For the background on FSDC, see: the budget
announcement of Feb
2010, a
newspaper column of mine on 16 March,
and a
collection of responses in the media on 20 March.

Does the FSDC amount to clipping RBI's wings?

The FSDC is only a committee. It is not backed by law. So nothing
changes about RBI's role and function.

RBI staff have done speeches saying that financial stability is
their job.

The RBI Act does not contain the word `financial stability'. So
while some in RBI might aspire to such a function, the present role
and function of the RBI does not include financial stability.

The FSDC is not a new law, it's merely a committee, so what
changes? We already had the HLCC. What changes with the FSDC?

The FSDC is intended to have a full-time technical
secretariat which will work on the problems of financial stability
and development. This is something the HLCC lacked. And, the HLCC
was chaired by the RBI Governor. He was unable to resolve three
classes of situations: (a) Differences between two financial
agencies such as the ULIPs question, (b) Differences between two
financial agencies when one of them was RBI and (c) Problems of
financial stability which require system thinking, which no one
Indian agency is good at understanding, given the silo system that
is in place. The FSDC should fare better on all three fronts by
virtue of being chaired by the finance minister (and backed by a
strong secretariat).

So will the FSDC help matters?

It all depends on the staff quality that DEA is able to put into
it. The "strong secretariat" is only an aspiration at the present
moment.

What is the right role for autonomy for an agency external to
MoF?

There are href="http://www.mayin.org/ajayshah/MEDIA/2010/autonomy.html">two
clear areas where autonomy is required. The first is about
specific transactions. As examples, what entities get bank licenses or
exchange licenses? Or, when RBI/SEBI investigate Bank of Rajasthan or
MCX-SX. It is highly desirable for MoF to be completely hands-off on
these kinds of activities of agencies external to MoF. The second is
about monetary policy, i.e. the setting of the short-term interest
rate. For these two areas, there is a strong and clear case for
de-politicisation and autonomy. In other questions, the case for
autonomy is not clear-cut.

So is it okay for MoF to meddle in the decisions of an external
financial agency on subjects like the policy framework for
exchange ownership, or the rules about private bank entry?

The staff quality that DEA is able to put into these functions
is supremely important. It is possible to do this right.

Is FSDC opening a Pandora's box by asking too much of DEA staff quality?

I think it is an attempt in the right direction. Largely speaking,
it is converting the existing de facto arrangements
into de jure with greater formal structure. If FSDC builds up
top quality staff, then it will make progress. Else, it will be
irrelevant and the present will continue mostly unchanged.

There will of course be ups and downs, but when I look back at the
brainpower at DEA from 1993 onwards
I feel optimistic about the expected value of FSDC.

The attempt at
building a team which works on financial stability and development
is an important and a good one. Success on putting together a top
quality team cannot be taken for granted. But at the same time, if
MoF had not tried this, there would have been a certainty that such
a team would not have come together. It is possible to spin this in
a gloomy way, but an oversupply of cynicism can crowd out attempts at
progress.

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Interesting readings

C. J. Chivers has a story in the New York Times from Uzbekistan which links up to an idea that I have often thought would be a great step forward for India: the interior of every police station in the country should be blanketed with video cameras giving feeds out to the Net. As Robert Kaplan says, underdevelopment is where the police are more dangerous than the criminals. If we think surveillance cameras are important in public places, they are triply important to watch the interiors of police stations. On a related note, see this harrowing story about a journalist in Pakistan. Do we do similarly?



A fascinating fact about insurgencies: while a diverse array of weapons can be in fray, ammunition is quite well standardised. Writing about the guns used by the Taliban, C. J. Chivers points out on the New York Times blog, `for the 24 rifles and machine guns in the locker, produced in multiple nations over many decades, only three types of cartridges are required to feed them'.





Shobhana Subramanian in the Financial Express on C. B. Bhave. And, Sandeep Singh has a story in the Hindustan Times about Mr. Bhave coming through fine on one attack on him.



Ashok Desai reviews a book in Business World. Also see.



Auditor and Audit Committee Independence in India by Jayati Sarkar and Subrata Sarkar.



Developments on MCX:

    - John J. Lothian is a respected observer of the global securities business. He has written a piece about Financial Technologies Group titled You gotta earn it.

    - Mobis Philipose in Mint.

    - Deepshikha Sikarwar in the Economic Times.

    - A story by Deepika D. Thapliyal on NDTV.



An editorial in Business World on the MoF Working Group on Foreign Investment.



Learn R in Bombay.



Gautam Bhardwaj in the Indian Express on using the NPS to solve the problems of EPFO.



Sunil Jain on the difficulties of the data reported by the Indian statistical system.



An editorial in the Business Standard about developments on private container train companies, which reminds me of the conflicts between DoT and private telecom companies in the early 1990s.



Mobis Philipose worries about the apparent turnover numbers that we're seeing.



An editorial in the Mint on the latest attempt to keep FMC separate from mainstream financial regulation.



Jan Sjunnesson Rao in Education World on the damage that the Right to Education Act is causing.



The Economics of Foodgrain Management in India by Kaushik Basu, DEA Working Paper, September 2010.





A recent paper by Guido Heineck and Bernd Sussmuth finds that the blight of communism runs deep: Using data from the German Socio-Economic Panel, we find that despite twenty years of reunification East Germans are still characterized by a persistent level of social distrust. In comparison to West Germans, they are also less inclined to see others as fair or helpful..



A great interview with Condoleezza Rice on Spiegel Online about the halcyon days of 1989.



The last practical connection with World War I just died away. The legacy of that war, of course, remains with us; everything that came after was attenuated.



David Sanger in the New York Times; Jaswant Singh and Jeffrey N. Wasserstrom on Project Syndicate, on Engaging China. Also see these threats being made against Norway.



Mick Meenan in the New York Times about kabbadi going places.



A great story about the innovative logistics of the Italian army in Ethiopia in 1938.





Greg Mankiw on the high marginal tax rates which are hobbling labour supply in many countries.



China's Charter 08 is a brilliant and well-crafted document, worthy of a Nobel Peace Prize.



Norman MacLean wrote a great article in Lapham's Quarterly about his 1928 experiences with violinist, watercolorist, chess player, and physicist: Albert Michelson. They don't make men like that these days.



Randall Stross in the New York Times on the making of Steve Jobs.



Brad DeLong on Who can replace Larry Summers?.



A great article by Michael Heilemann on binarybonsai: George Lucas Stole Chewbacca, But It's Okay, which made me think about how copyright, patents and `intellectual property' fit uneasily into the creative process. As he says: Chewbacca didn't spring to life out of nowhere, fully formed when Lucas saw his dog in the passenger seat of his car. That's the soundbite. A single step. The reality is complex and human. From vague names floating around, the kernel of an idea, changing purposes and roles of characters, major restructuring, the design hopping from person to person, scrapping the existing concept and going down a different path, seeing existing things in a different light and having to conform a range of ideas to complement and enrich one another.. Everything is a remix.



At the frontiers of computing is `cloud computing', where users rent equipment, e.g. by the hour. Amazon's tariff card for such rental is bad news for developers who built knowledge on Microsoft technologies.



John Taylor has a story about Japanese currency manipulation. Recent research shows that the role of the Yen in global currency arrangements has been waning, and this episode of currency trading by the BoJ will exacerbate this trend.

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