Uncomfortable times in real estate in store?

Patrick Chovanec has a fascinating article in Foreign
Affairs, titled href="http://www.foreignaffairs.com/articles/136963/patrick-chovanec/chinas-real-estate-bubble-may-have-just-popped?page=show">China's
Real Estate Bubble May Have Just Popped. This is interesting
and important from two points of view.

First, bad news for China is bad news for the world economy. We are
already in a bleak environment, with difficulties in Europe, Japan,
the US, and India. It will not be pretty if China runs into trouble as
well. I am reminded of the feeling of carefully watching href="http://www.mayin.org/ajayshah/MEDIA/2006/gloom_US_housing.html">real
estate in the United States in 2006, with a sense that the future
of the world economy was going to turn on how it turned out.

Second, it made me think about real estate in India. As with China,
one often sees buyers of real estate in India have the notion that
this is a safe financial asset. This
is a
questionable proposition. Real estate is perhaps not an asset
class with a positive expected return in the first place; and it is
certainly not a convenient asset class with features like liquidity,
transparency, diversification and easy formation of low-volatility
diversified portfolios. I find it hard to explain the prominence of
real estate in the portfolios of even educated people in India.

In the article, Chovanec says:

For more than a decade, they have bet on longer-term demand trends by
buying up multiple units -- often dozens at a time -- which they then
leave empty with the belief that prices will rise. Estimates of such
idle holdings range anywhere from 10 million to 65 million homes; no
one really knows the exact number, but the visual impression created
by vast `ghost' districts, filled with row upon row of uninhabited
villas and apartment complexes, leaves one with a sense of investments
with, literally, nothing inside.

This has not happened in India. So in this sense, the situation in
India is not as dire. But his second key message seems uncomfortably
close:

As 2011 progressed, developers scrambled for new lines of financing to
keep their overstocked inventories. They first relied on bank loans
(until they were cut off), then high-yield bonds in Hong Kong (until
the market soured), then private investment vehicles (sponsored by
banks as an end run around lending constraints), and finally, in some
cases, loan sharks. By the end of last summer, many Chinese developers
had run out of options and were forced to begin liquidating
inventory. Hence, the price slashing: 30, 40, and even 50 percent
discounts.

Part of this looks familiar. There is a lot of leverage in Indian
real estate development and speculation. Real estate speculators and
developers are finding themselves in a bit of a scramble hunting for
credit. One hears about very high interest rates being paid by
developers. Other sources of financing href="http://www.hindustantimes.com/business-news/Markets/Market-blues-hit-real-estate-public-issues/Article1-785813.aspx">are
also weak. This reminds me of href="http://ajayshahblog.blogspot.com/2008/10/cash-crunch-at-real-estate-companies.html">the
dark days before the global crisis, when borrowing by real estate
companies was the canary in the coal mine.

If business cycle conditions and financial conditions worsen, the
problems of borrowing by real estate developers and speculators will
get worse. How might this turn out? Perhaps the borrowers will merely
get uncomfortable. Or, a few firms could really get into trouble,
and start liquidating inventory. That would have substantial
repercussions.

Suppose there is a situation where there are many people who have
speculative positions in real estate, but significant selling of
inventory has not yet begun. The longs would then be nervously looking
at each other, wondering who would be the first one to sell, to take a
better price and exit his position. The ones who sell late would get
an inferior price. In such a situation, conditions could change
sharply in a short time.

On a longer horizon, I would, of course, be delighted if real
estate prices are lower. This would help shift the supply function of
labour, reduce the cost of setting up new businesses, etc. But that's
more about the long-term policy changes, which would remove barriers
for converting land into built-up housing, while rising vertically
into the sky with FSI in Indian cities ranging from 5 to 25.

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The most-read posts on this blog

Google started maintaining data about blogs from May 2009 onwards. In this data, I find the most read posts were:

1. The Right to Education Act: A critique, by Parth Shah


2. What in the world is happening to the rupee?


3. The rupee: Frequently asked questions


4. When and where do great feats of architecture come about?


5. Guide to the Eurozone crisis, by Percy Mistry


6. The US sells chopsticks to China, by Jim Hanson


7. Household financial choice of the hapless households of India


8. Don't like the SKS valuation? Compete, don't complain, by Bindu Ananth and Nachiket Mor.

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RBI reaches for capital controls

By and large, I have felt that RBI has done a pretty good job of the exchange rate. They doubled currency flexibility twice, in 2004 and 2007. In 2009, they shifted to a floating rate. There were two problems:

1. They continue to sometimes do tiny blocks of trading on the currency market. In a market of $70 billion a day, a small scale of trading (e.g. $1 billion a month) is irrelevant, so why bother doing it? This has been pointless, but it has done no damage.


2. They have failed to correctly communicate to the market that the exchange rate is now a float. I cannot recall an RBI governor who used the phase "floating exchange rate". Many economic agents seem to have got the following message: You're on your own for small fluctuations, but if there are big movements, RBI will block them. This was mis-communication. The people who hedged against small movements but not against large ones, as a consequence of RBI, have now got burned. This is going to further increase the cost of RBI to gain credibility in the years to come, to come to a point where its words are respected.

Barring these two issues, I have felt that RBI has done a pretty good job of the exchange rate. Until now.

RBI has just announced a batch of capital controls against the currency market. This is a mistake:

1. When there is turbulence on the currency market, you want greater activity on the currency derivatives market - which is where people protect themselves from currency risk - not less. Recall how the Greek default really damaged the Italians because on that day, the owner of an Italian government bond was told that maybe his CDS would malfunction if an Italian default came about. It was not good for Italy for economic agents to have a reduced ability to manage this risk.


2. This will merely shift business to alternative venues - the offshore market and the onshore currency futures market. To the extent that shifting to these venues is tedious or infeasible (e.g. FIIs are banned from the onshore currency futures market and don't have that choice), economic agents will be averse to holding India risk. This is bad for asset prices in India at a particularly difficult time.


3. In a climate of pessimism about economic policy, it is important to send out a message, through action and non-action every day, that RBI (and more generally the Indian economic policy establishment) possesses top quality knowledge and decision-capabilities in economics and finance. This action of RBI reinforces the gloom about economic policy capabilities in India.

In April, Ila Patnaik and I released a paper titled Did the Indian capital controls work as a tool of macroeconomic policy? Our answer was largely in the negative. RBI's actions of today are likely to shape up as yet another episode of this larger theme. It might make things worse for the rupee, for Nifty, etc.; to this extent these decisions would not be irrelevant.

Financial regulation should be focused on the problems of consumer protection, micro-prudential regulation, market integrity and systemic risk. It should not be used as a tool for short-term macroeconomic policy. If this is done, it damages market liquidity and yields a less capable financial market. This further damages the limited monetary policy transmission that RBI possesses.

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Be skeptical. Be very skeptical.

Mistake upon mistake

In recent months, we've had a few slip-ups by the official statistical system in India:

• Yesterday's IIP release was preceded by a mistake. Mint says: On Monday, the government was guilty of a similar error in its factory output data. Till it corrected the number pertaining to capital goods output, analysts were left scrambling for explanations as to how this had grown 25.5% while overall factory growth had shrunk 5.1%. (The answer: it hadn’t, and had actually shrunk by 25.5%).


• On 9 December, we discovered there were important mistakes in the exports data.


• In December 2010, RBI modified the numbers that it releases about its trading on the currency market.


• In September 2010, there was a mistake in the quarterly GDP data released by CSO.

What is going wrong?

These examples are part of a larger theme, of problems of the official statistical system. The Indian statistical system is afflicted by three levels of problems:

1. The first level is conceptual problems and analytical errors. As an example, the weights of the WPI basket are wrong; the estimation methods used in the IIP are likely to be wrong, etc. Quarterly GDP measurement does not have a demand side (which requires a quarterly household survey, which the government does not know how to do).


2. The second level is the lack of rugged IT systems. The production of statistics requires high quality enterprise IT systems. The government does not have the ability or incentive to roll these out. As an example, the September 2010 mistake in quarterly GDP data seems to have come about because quarterly GDP data is produced in a spreadsheet. As with all usage of spreadsheets, this is highly error prone. The hallmark of a reliably executed process is the absence of spreadsheets.


3. The third level is the problems of truant front-line staff. In a country which is not able to get civil servants to show up at school to teach, it is not surprising that front-line staff of statistical agencies are untrustworthy in going out into the field and filling out survey forms. More generally, the statistical system is a set of public goods produced by civil servants, who are unresponsive about the needs of users, or the unhappiness of users, either on flaws about what is done or about the gaps in what is not done.

The rash of mistakes that we're seeing, lately, are merely a reflection of #2 (the lack of rugged enterprise IT systems). But there is much more going on which holds back the usefulness of official statistics.

How to make progress?

Government officials in this field have pinned a lot of hope on the implementation of the report of the statistical commission (headed by C. Rangarajan, 2001). I am personally not optimistic about this. The report seems to emphasise an incremental agenda of building the statistical system, emphasising the interests of the incumbents. In any case, it's been a decade after 2001, and it's important to ask fresh questions about what is going wrong and why.



What is required is a ground-up rethink about the statistical system, from first principles, so as to address the three difficulties above. As an example, most of the civil servants processing data in a labour-intensive manner are not required if a good quality enterprise IT system is put into place (and it is hence not surprising that the incumbents are un-enthusiastic about business process transformation). The revolution of computers and telecommunications needs to be brought into this field, just as it has done in so many others. This does not require large sums of money; it requires superior public administration.

What should users of data do?

Turning to the users of official statistics, most economists attach enormous prestige to phrases like GDP, IIP, CPI, etc. But in India, we cannot unthinkingly use some numbers just because they come with the label `GDP' from some government agency. We have to always skeptically ask first principles questions about how the data is generated. All too often, the standard Indian government data is useless.



Global financial firms who now operate in India have brought a certain cookie-cutter mentality. They produce a major report about each release of quarterly GDP for all countries that they write research reports about. Hence, once they started having such analyst coverage of India, they have started writing a report about quarterly GDP. Such a mechanical approach is a waste of resources. The quarterly GDP data is mostly uninformative.



In the class of government data that I know of, I feel the CPI is reasonably okay. The WPI is a fairly useful database about prices but useless as a price index. The quarterly GDP data, IIP, NSSO, ASI are untrustworthy.



Decision makers in government and in the private sector need to struggle with these issues, carefully thinking about what statistics are allowed to influence their decision processes.



Academic users of data need to be much more careful about avoiding garbage-in-garbage-out (GIGO).  With a large number of academic papers that work with Indian data, I stop reading the paper after I have read the data description; I know the data is rubbish, so the paper will not change my mind, so I should not bother reading it. A good referee blocks papers which are GIGO. But even if the referee in a faraway place thinks that quarterly GDP in India is well measured, the researcher should ponder whether there are better uses of his time - are there projects which can be more meaningful and genuinely answer important questions, over and beyond merely getting past a referee?

Finding out more

For more on this subject, you might like to look at the label `statistical system' on this blog.

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Interesting readings

China's
Pakistan Conundrum by Evan A. Feigenbaum, in Foreign Affairs.

The most important task of government is the public goods of law
and order: laws, courts and judiciary. The first step towards
strengthening these lies in sound measurement. Writing
in Pragati, Sushant
K. Singh has an excellent article on the problems of measurement
of crime in India.

An
independent judiciary by Ruma Pal.

Devesh
Kapur, in the Business Standard, on the HR crisis in
the Indian State.

Shyam
Saran in the Business Standard on a more sensible
approach that we should bring to intra-South-Asia logistics.

The lack of freedom of speech in
India: Karan
Singh Tyagi in the Hindu.

Amit
Rai writes in the Times of India about the mistakes of
the legal actions following the AMRI fire.

Mobis
Philipose in Mint on how charges by exchanges have made
a difference to the currency futures market.

Every advocate of a big spending Indian government should ponder
this
article about Greece by Landon Thomas in the New York
Times.

Dreze and
Sen on what India does right and wrong. We may not agree with
most of this, but they are smart people and it's worth reading.

Hard times at
UTI: Anirudh
Laskar and Vyas Mohan in Mint,
and Niladri
Bhattacharya and N. Sundaresha Subramanian in Business Standard.

Air
India
and Maharashtra
PSUs remind us, in interesting ways, about why government
should not be in business.

Martin
Feldstein explains what went wrong with the Euro.

Look at profiles
of Mario
Monti, who will try to fix Italy,
and Loukas
Papadimos, who will try to fix Greece. I guess that every now
and then, the professional politicians foul up big time, and then
bring in the economists to clean up. It reminds me of a perspective
by C. B Bhave on urban governance in India: when things are going
well, the politicians want an accomodating civil servant; when the
city goes to hell, they want a tough competent one. Also
see Greece
and Italy Seek a Solution From Technocrats by Rachel
Donadio in the New York Times.

Charles
Moore looks back at the story of Maggie Thatcher, who ended
Britain's long decline in the 20th century.

Read Larry
Summers in the Financial Times on the problem of
inequality and three things that need to be done about it.

Two important platforms for modern web development were Flash and
HTML5. It
now looks
like Flash
is dying. Looks
like Steve
Jobs was right on one more thing.

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Business cycle conditions in India: It's mostly cycle, not trend

There is a lot of gloom in India today about the broad-based failure of the UPA strategy of combining left-of-centre populism, fiscal profligacy, theft, and a lack of interest in the foundations of India's growth. We learn from history that we learn nothing from history; India has clearly learned very little from its escape from the Hindu rate of growth. The moment we got a little bit of growth, the old style socialism and theft reared up again. In one of the many pessimistic articles of this theme, Shekhar Gupta in the Indian Express says:

What is the Hindu Rate of Growth two decades after reform? It certainly can’t be the 2-3 per cent of India’s socialist Brezhnev decades. The new Hindu Rate of Growth is 6 per cent, and on all evidence, from macroeconomic data to the empty billboards of Mumbai, we are headed there next year.

In thinking about GDP growth, it's always useful to think about both growth and fluctuations. Growth is about the underlying trend growth rate.  In the olden days, this was all you needed to worry about. The economy trundled along at roughly the trend growth rate (the Hindu rate of growth of 3.5 per cent), being kicked up or down by good or bad monsoons. In that period, macroeconomics in India required thinking in completely different ways, when compared with standard Western textbooks.



But from the early 1990s onwards, India changed. The market-oriented reforms, which began with the Janata Party in 1977 and gathered momentum in the 1980s, had started creating a market economy. And every market economy in the world experiences business cycle fluctuations. So, in addition to the trend, we got a cycle about the trend. There were good periods and bad periods, and the story running in there was much like that found in mainstream Western textbooks, with a prominent role being played by profitability, inventories and investment by firms.



From this viewpoint, it's useful to decompose two elements of what we are seeing after 2009. On one hand, trend growth has been influenced by decisions of the UPA. Any perceptive observer also tends to rage at the lost opportunities, of policy decisions that should have been taken, which would have accelerated trend growth. But the second big story is that of fluctuations. Corporate investment is a major driver of business cycle fluctuations in India, and there has been a certain deceleration in this. This may have set off a downturn.



The bulk of the drama that we're now seeing, and what will play out in 2012, is business cycle fluctuations. This is about fluctuations, not the trend. When trend growth is 7 per cent, the fluctuations make GDP growth range from 4 per cent to 10 per cent. Even if trend growth does not change by even a bit, business cycle fluctuations can take us from a high of 10 per cent to a low of 4 per cent, which is a huge swing of 6 percentage points.



Many elements of economic policy are pro-cyclical: when times are good, they make things better and when times are bad, they make things worse. The financial system tends to suffer from pro-cyclicality: when times are good, bankers lend exuberantly (thus expanding the boom) and when times are bad, bankers tend to be cautious (thus accentuating the bust). It is important to look for a framework for stabilisation, of tools that will counteract business cycle fluctuations. India has crossed one major milestone, in getting to a floating exchange rate. The floating exchange rate is stabilising, in and of itself. In addition, it opens up the possibility of stabilising monetary policy.



As of today, by and large, I think of both fiscal policy and monetary policy as being part of the problem and not part of the solution. While floating the exchange rate (decisions from 2007 to 2009) opened up the possibility of sound monetary policy, the logical next step did not materialise. As of yet, we do not have a sound monetary policy regime. We're going to require far-reaching surgery to laws and institutions, in order to craft frameworks for fiscal policy and monetary policy that do stabilisation. Until these changes are made, Indian GDP growth will have the high volatility that is characteristically found in countries with weak institutions.



A lot of our work in the Macro/Finance group at NIPFP is rooted in this conceptual framework. In particular, you might like to see two relatively non-technical articles: New issues in macroeconomic policy and Stabilising the Indian business cycle.

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Talk by Thomas Laubach on inflation expectations, inflation targeting, monetary policy

Thomas Laubach will do a talk
titled Inflation:
Expectations, Targets and the Institutional Framework for Monetary
Policy at the NIPFP auditorium at 3:30 PM on December 9
(Friday). He is Professor at Goethe University in Germany. All are
welcome.

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The rupee: Frequently asked questions

q: How big is the market for the rupee?




The rupee is now a big market. Summing across both spot and derivatives, perhaps $30 billion a day of onshore trading and $40 billion of offshore trading takes place. Both these markets are tightly linked by arbitrage. In other words, for all practical purposes, it's like NSE and BSE which are a single market unified by arbitrage. If you place a small order to buy 100 shares on either NSE or BSE, you get essentially the same price, and arbitrageurs are constantly at work equalising the price across both markets. It is a similar state of affairs between the onshore and the offshore rupee. Both markets are tightly integrated by arbitrage.



The offshore market for the rupee, and a large part of the onshore market, is OTC trading. Hence, the efficiencies of algorithmic trading and algorithmic arbitrage cannot be brought to bear on onshore/offshore arbitrage. So the arbitrage is done by manual labour. Still, it gets done. Both markets are tightly linked and show the same price. We should think of them as one market. It's one big market, it is one of the big currencies of the world, it's roughly $70 billion a day.






q: How might RBI do manipulation of this market?



If RBI wants to hit the market with orders big enough to make a difference, they have to be ready to do fairly big orders and to be able to do it on a sustained basis. As a rough thumb-rule, I might say that in order to make a material difference to a market with daily volume of $70 billion, they have to be in the market with atleast $2 to $3 billion a day.






q: What would go wrong if they tried this?



Three things would go wrong.



First, foreign exchange reserves are $275 billion. If RBI sells off $2.75 billion a day, the reserves would be quickly gone.



Second, when RBI sells dollars and buys rupees, this sucks liquidity out of the market. The side effect of selling dollars would be a sharp rise in domestic interest rates. In other words, monetary policy would get hijacked by currency policy. This would not be wise. Monetary policy should be focused on delivering low and stable inflation: it should have no ulterior motives. We have to make a choice: Do we want to use up the power of monetary policy to achieve domestic goals, or do we want to use up the power of monetary policy to achieve currency policy goals?



Third, suppose you and I saw a market price of Rs.45 per dollar, which is created by RBI and not a market reality. We would know that in time, the truth will out, that the price will go back to Rs.52 a dollar. The rational trading strategy for each of us would be: To sell any and every domestic asset, and shift money out of the country. This would trigger off an asset price collapse in India. We would take the money out, and wait for the distortion of the currency market to end. At that point (perhaps Rs.52 a dollar, perhaps worse) we would bring the money back to India and buy back our assets. We might make two returns here: first, on the move of the INR/USD from 45 to 52 (or worse) and the second, on the gain from the drop in asset prices.






q: Isn't it hard to take money out of India in this fashion?



It's easier than we think. Remember September 2008? The mythology in our heads was: we in India are crouching safely behind a wall of capital controls. In truth, the wall wasn't there.






q: But until recently, RBI used to give us a pegged INR/USD exchange rate! What changed?



In late 2003, RBI ran out of bonds for sterilisation. Associated with that, there was a first structural break in the rupee exchange rate regime, with a doubling of volatility. A short while later, in March 2007, there was another structural break, with another doubling of volatility. From April 2009 onwards, RBI's trading in the market has gone to roughly zero. RBI stopped managing the exchange rate a while ago.



The exchange rate is the most important price of the economy. The decontrol of this exchange rate is the biggest achievement of the UPA in economic reforms. The credit for this goes to Y. V. Reddy and Rakesh Mohan (who took the first two steps of doubling exchange rate flexibility twice) and to Dr. Subbarao (who got out of trading on the currency market, which did remarkably little to INR/USD volatility).





q: Why did nobody tell me that something changed in the exchange rate regime?



RBI should be talking more transparently about what is going on. But they are not transparent about what they do. Even though hundreds of millions of people are affected by their trading on the currency market (or the lack thereof), the manual which governs their currency trading at any point in time (i.e., the documentation of the prevailing exchange rate regime) is not transparently disclosed to the people of India. We have to decipher what is going on by statistically analysing exchange rate data.



The dates of structural break of the exchange rate regime are extremely important dates in thinking about what was going on in macroeconomics and international finance. Any time one is using data about exchange rates, interest rates, etc., it is important to work within one segment of the prevailing exchange rate regime at a time. It is wrong to pool data across many years. All users of data need to be careful in this regard.





q: So what might happen to the rupee next? Is there a `law of gravity' which will pull it back to erstwhile values of Rs.45 or Rs.50?



When you don't manipulate a financial market, the price time-series comes out to something close to a random walk. In the ideal random walk, all changes are permanent. The random walk never forgets; there is no law of gravity which takes it back to recent values. Your best estimator of what it will be tomorrow is: what you see today.



In order to get a sense of what will come next, go through the following steps. First, go to INR/USD options trading at NSE, and pluck out the implied volatility for the four at-the-money options. I just did that, and the values are: 10.43, 10.32, 10.33 and 10.08. Calculate the average of these four numbers. With the above four values, the average is: 10.3. (This is a quick and dirty method; here is one which is much better).



This tells a very important thing: The options market believes that in the future, the volatility of the INR/USD rate will be 10.3 per cent per year.



In order to re-express this as uncertainty per month, we divide by sqrt(12). This gives the volatility for a month as : 3% per month.



Roughly speaking, the 95% confidence interval for what might happen over a month, then, runs from -6% to +6% (this is twice the standard deviation, which we just worked out was 3% per month).



The INR/USD is now Rs.51.62. By the above calculation, we can be 95% certain that one month from today, it will lie somewhere between 48.5 and 54.7.



These trivial calculations have been done by equity market participants for the longest time. It is a standard and trivial idea: To read the implied volatility off the Nifty options market, and to do such calculations to get a sense of what might come next with Nifty. But on the currency market, this is relatively novel. Only recently have we got a nice currency options market, and only recently have we got to a genuine market. Now these skills can be brought to bear on the currency market. It's a brave new world, one in which the operations of financial derivatives markets (Nifty options, INR/USD options) produces forward-looking and timely information about the economy (implied volatility).





q: What changed in imports and exports which gave us the big recent move of the rupee?



The current account (goods, services, and then some) adds up to a mere buying and selling of $4 billion a day. The bulk of currency trading is about the capital account. The currency is a financial object; the exchange rate is defined by financial considerations and not by current account considerations.






q: What happens to the Indian economy when the rupee depreciates?



This has been the source of a great deal of confusion and it's important to think straight about this. There are three important effects in play:

1. Some people had borrowed in dollars, and left it unhedged since they were speculating that the INR would appreciate. They have got burned. That's okay - in a market economy, many people place bets about future fluctuations of financial prices, and half the time the speculator loses money. (If the rupee had not depreciated sharply, these speculators would have been truly joyous).


2. When the rupee depreciates, imports become costlier and India's exports become more competitive. So exports (X) gradually start going up and imports (M) gradually start going down. The net gain in X-M is increased demand in the local economy. In this fashion, INR depreciation is good for aggregate demand (and conversely INR appreciation pulls back demand). However, we have to bear in mind that these effects are small and take place with long lags.


3. Many things in India are tradeable. It is important to focus on the things that are tradeable and not just on the things that are imported. As an example, there are many transactions between a domestic producer of steel and a domestic buyer of steel. The buyer and seller are both in India. But the price at which they transact is the world price of steel (which is quoted in dollars) multiplied by the INR/USD exchange rate. This situation is called `import parity pricing'. Through this, the domestic prices of tradeables goes up when the rupee depreciates.

q: What is the impact of costlier tradeables for RBI?

RBI's job is to fight inflation. RBI must work to deliver year-on-year CPI inflation (a.k.a. `headline inflation') of four to five per cent. When tradeables become costlier, domestic CPI inflation goes up. So the rupee depreciation has made RBI's job harder. RBI will have to respond by hiking interest rates. (Note that one impact of higher interest rates will be that more capital will come into India, which will tend to yield a rupee appreciation; import parity pricing has created a new channel through which RBI rate hikes combat inflation).

q: What is the impact of costlier tradeables for business cycle conditions in India?

As the example above about steel suggests, the price realisation of all tradeables companies goes up when the rupee depreciates. Costs change by less by revenues (since many costs are not tradeables), and profitability goes up.

Firm profitability has dropped sharply in 2011. My prediction is that firms producing tradeables will show better profitability in Oct-Nov-Dec 2011 when compared with the previous quarter, thanks to the rupee depreciation.

This is great news for business cycle conditions. Profitability goes up, which yields more cash for investment by financially constrained firms. And, when profitability is higher, more investment projects look viable.

q: In the bottom line, what is the link between the rupee and India's business cycle stabilisation?

If RBI tried to peg the exchange rate, the lever of monetary policy would get used up to deliver the target exchange rate. By not trading on the currency market, the lever of monetary policy is now available. A pretty good use for this lever is to deliver low and stable CPI inflation. If this is done, then an RBI focused on inflation would help stabilise the economy by cutting rates when CPI inflation drops below 4% and hiking rates when CPI inflation goes above 5%.

But floating the exchange rate also yields stabilisation purely in and of itself. In bad times, capital leaves India, the rupee depreciates. This gives higher profitability in tradeables firms and bolsters investment. Conversely, when times are good, more capital comes into India, the INR appreciates, which crimps profitability of tradeables firms. The floating exchange rate exerts a stabilising influence upon the economy: purely by doing nothing on the currency market, RBI has unleashed this new force of stabilisation which will help India.

q: What should RBI do next?

RBI should do as they have done, i.e. avoided trading on the currency market.

RBI should keep driving up the short-term interest rate until point-on-point seasonally adjusted CPI inflation shows a decline and goes into the target zone of 4-5 per cent. After this hangs in there for a year, `headline inflation' (y-o-y growth of CPI) will be in the target zone.

q: What do other countries do?



When we look at countries with good governance, the mainstream strategy seen worldwide is an open capital account and a central bank that delivers on an inflation target. By and large, this goes with a floating exchange rate. Trading on the currency market interferes with achieving price stability and has hence been dispensed with, by most good countries. Japan and Switzerland come to mind as exceptions to this broad regularity.

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IGIDR Emerging Markets Finance conference

Link.

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Taxing investors to pay NGOs

In India, NGOs are fashionable. It is almost never wrong, in the Indian discourse, to give more money and more functions to NGOs.



Many people have worried about the extent to which NGOs are being used to supplant failing State machinery. This may seem expedient, but no country every became a developed country on the back of NGOs. There is no alternative to fixing the core mechanisms of the State.



In recent days, two pro-NGO policy elements seem to be in the pipeline:

1. A new Companies Bill seems to require that 2% of profit be spent on corporate social responsibility (CSR).


2. SEBI decided to force listed companies, starting with the top 100 firms, to describe measures taken by them along the key principles enunciated in the ‘National voluntary guidelines on social, environmental and economic responsibilities of business,' framed by the Ministry of Corporate Affairs (MCA).

When the government grabs 2% of the profit of a company, and hands it out to any purpose (no matter how good or bad), that is called expropriation. The fact that it satisfies some bleeding hearts does not change the fact that it is expropriation. In a good country, property rights would be fundamental, and the Supreme Court would block such expropriation.

The job of a corporation is to efficiently organise production, and send dividends back to shareholders. It is the individual, the shareholder, who has to then make a call about whether he would like to give money to charitable causes or not. We do wrong by expropriating this money even before it reaches the individual.



For an analogy, it is Bill Gates' birthright to gift away his own money, in his capacity as an individual. And I really admire the intelligence with which the Bill and Melinda Gates Foundation works. But Bill Gates (or the government or anyone else) has no right to expropriate money belonging to shareholders, through charitable initiatives by Microsoft.

We do wrong by placing the burden of charitable works upon the corporation. Corporations should not be organised to be do-gooders. They should be organised to obey laws, have high ethical standards and then power India's way out of poverty by efficiently organising production. Anything that corporations do, other than focusing on efficient production, is a distraction from the main trajectory of India's growth and development.

When a country is run by bleeding hearts, things start going wrong. If such a tax is enacted, it reduces the post-tax return on capital that Indian firms generate. Foreign investors and domestic investors have choices about where to invest. They will demand that firms only invest in a smaller set of high-return projects, which are competitive on the rate of return by global standards, even after being taxed. In other words, many projects will not be undertaken. This can't be good for India.

To make progress in India, we need to be hard headed. We should not let the urge to do good crowd out intelligence and analysis. We are falling into this trap too often.

One key element that I blame is the Indian college education. We fail to teach political science, we have   too many people who have not read The Republic, so we get trouble like Anna Hazare. We fail to teach economics, so we get Sarva Shiksha Abhiyaan and the education cess. Given the absence of a positive strategy for what India should be doing, in the mainstream, we are willing to turn away from the hard work of fixing the State, and feel satisfied by funding some do-gooding NGOs.



Intellectuals are the yeast that make a society rise. India is a big mighty youthful stagnant dough, waiting for a pinch of yeast.

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Guide to the Eurozone crisis

by Percy S. Mistry.

How did it happen?

The worst financial crisis in the western world for nearly 80 years
broke in September 2008.

It required banking/financial systems to be supported and
recapitalised by governments across the EU and in the US.

In June 2009 it became apparent that the peripheral countries of
the Eurozone (Greece, Portugal, Spain and Ireland) were grossly
over-indebted.

Yet in some instances (Spain) their public debt to GDP ratios
happened to be lower than those of the US, France, the UK and
Germany.

The continued viability of their public finances depended entirely
on markets being willing to refinance them with cheap money.

But, when markets scrutinised the sustainability of their fiscal
positions, they baulked from refinancing except at punitive rates.

CDS spreads (against Germany as a benchmark) of peripheral Eurozone
countries (PIGS or Club Med) debt began widening relentlessly.

Global financial markets began to price in an escalating risk of
partial/full voluntary/involuntary default on PIGS bonds since
December 2009.

Contrary to first impressions, except for Ireland, that was a
result not just of the financial crisis and bank recapitalisation
demands on the fiscus.

It became apparent instead that bank recapitalisation demands on
public finance were only the last straws that broke the camel's
back.

Greece, Portugal, Spain and Italy, as a direct consequence of
joining the Eurozone, had been running up unsustainable fiscal
deficits since 2000.

Ireland had not. It suffered because the bailout of its
disproportionately large banking system caused its public debt to rise
astronomically.

PIGS became over-indebted despite the supposed self-imposed
discipline adopted by the Eurozone of prohibiting fiscal deficits >3%
of GDP.

That discipline was violated by almost all Eurozone members,
beginning with France and Germany, but more egregiously by the
PIGS.

To make matters worse, however, the PIGS were also running
increasingly large current account deficits (with Germany, France,
China).

Though countries like France (and to a lesser extent) Germany were
fiscal sinners, they were at least running current account
surpluses.

PIGS had access to excessively cheap public and private money
available on terms totally inappropriate to their economic
circumstances.

Given their inherent risks, which markets mispriced completely,
their borrowing costs should have been 300-500 bp higher than
Germany's.

Instead, they were virtually the same for nearly a decade. That
relieved market-induced pressure on PIGS' governments to behave
responsibly.

Consequently, their public expenditures after 2000 ballooned out of
all proportion to their intrinsic capacity to fund them from tax
revenues.

Such expenditures became almost wholly dependent on access to
increasing amounts of cheap public borrowing from capital markets.

In response to access to excessively cheap money, wages in the PIGS
rose across the board as did growth in public sector employment.

With the financial crisis triggering bank recapitalisation needs,
on top of this unsustainable structure, the edifice began to
crumble.

The first early warning signals became apparent in December 2009
but the dam broke in mid-2010 with the first Greek bailout.

How has the Eurozone crisis been handled?

Extremely ineptly; indeed very foolishly, by sophisticated Eurozone
authorities (political, fiscal and monetary) that should have known
better.

Eurozone leaders learned nothing from the preceding debt crises in
Latin America (1982-87, 1994-95) and Asia (1997-2000).

They went through avoidable phases of serial denial that there was
a structural debt (solvency) crisis that could spread via
contagion.

They treated it as a liquidity crisis that could be dealt with by
temporary patch-ups of additional money combined with fiscal
restraint.

They reiterated their commitment to ensuring there would be no
default - partial or full, voluntary or involuntary - by any Eurozone
member.

They believed that their remedial measures would stop the crisis
from ballooning beyond the first bailout package for Greece.

They were totally wrong. That package did nothing to convince
markets that Eurozone leaders understood the nature/severity of the
problem.

In fact, the inadequacy of that first bailout package -- which did
not provide enough money for sufficiently long - became quickly
apparent.

Eurozone leaders were fixated on debt-affected PIGS being forced to
live within their means through indefinite austerity without end.

Debt recovery/sustainability models did not provide sufficient new
money, or permit debt restructuring, in ways that would restore
stability.

Least of all were bailout packages designed to restore growth in a
conscionable period of time that would be socially/politically
acceptable.

Without financial system (and borrowing cost) stability, and absent
growth, debt problems can never become better. They can only
worsen.

Instead, as a result of poor design, all the bailouts did (except
for Ireland) was to add new debt to bad debt and reduce growth
prospects.

To exemplify: In mid-2009 the debt/GDP ratio for Greece was 115% of
GDP and the debt service ratio about 11% of GDP.

But, by October 2011 the debt/GDP ratio for Greece was 161% of GDP
and the debt service ratio nearly 20% of GDP.

It is projected with the third bailout to rise to 185% of GDP
(although debt service will be lowered to 16%) before it comes down
again.

In the meantime, over the last 32 months, the Greek economy has
shrunk in size by almost 17% in nominal terms. It will be 1/5 th less
in 2012.

Such inane 'remedies' do not solve debt problems. They only
aggravate and exacerbate them.

While behaving in this absurd fashion Eurozone leaders repeatedly
asserted for two years that they would do everything in their power
to:

• Maintain the credibility of the Euro while ensuring that every
  member stayed in the Eurozone
  
• Not allow any default of publicly issued bonds to occur; and
  
• Do everything possible to avoid contagion spreading beyond PIGS (even
  as it became clear that markets were worried about Italy.
  

Instead they achieved the exact opposite of all three objectives
through their inability to understand the implications of what they
were doing.

Though now contrite and claiming to have learnt a few lessons from
their serial bungling over 30 months Eurozone leaders have no
solution.

The EFSF facility they created is woefully underfunded. It can
barely deal with financing the third Greek bailout.

The idea of leveraging it or using it as a partial guarantee
facility is absurd since it would add to risk and uncertainty not
resolve them.

Yet over-indebted governments (including France and Germany) would
have to issue more public debt in order to fund the EFSF properly.

That would simply mean requiring their fragile, near-bankrupt,
banking systems (or the ECB) or global markets to buy more Eurozone
debt.

Except for Germany (and even that will be in doubt soon) the market
has no appetite for taking on more Eurozone debt given its risks.

Contagion has spread from the periphery and now lodges at the core
of the Eurozone economy in which Italy is the third largest member.

What could have been resolved with about 300 billion euro in
additional financing in mid-2010 is now a problem that may require 2
trillion euro.

Where are we now?

Over 35 EU/Eurozone summits in 30 months have resolved
nothing. They have made matters worse; despite Herculean
exertions!

Right now Greece is in 'effective' default; though markets are
overlooking that because of the implications of CDS contracts being
triggered.

Its borrowing costs for refinancing its debt would exceed 30% if it
had any access to private markets; which it does not.

Any refinancing of, or addition to, Greek debt can now only be
financed by the ECB; which the Germans will not permit the ECB to
do.

Meanwhile the Greek banking system is bankrupt. Indeed the entire
Eurozone banking system's credibility/stability/solvency is in
doubt.

Today an outstanding portfolio of about 11-12 trillion euro in
Eurozone debt - of which about 80% is held by EU firms - is souring
relentlessly.

About 7 trillion euro of that portfolio is sufficiently affected by
contagion to require provisioning (France and Belgium may soon be
added).

About 5 trillion euro of Eurozone high-risk-debt is currently held
by EU banks, insurance companies, pension funds and individuals.

That sovereign debt, which is supposed to constitute the 'safest'
component of any asset portfolio, now constitutes perhaps the riskiest
element.

That reality inverts the whole basis of banking/financial system
soundness and stability across Europe (including the UK).

It compounds the problem of calculating capital adequacy
requirements for these banking systems and puts regulators in a
quandary.

Ireland's bailout programme is working but could be derailed by
what is happening in the rest of Europe.

Portugal's programme is not working as intended. But nobody is
talking about it because it pales in comparison with Italy and
Greece.

Italy's outstanding public debt will soon cross 2 trillion euro
(120% of GDP) and its debt service payments amount to around 300
billion euro per year.

That is made up of about 120 billion euro in interest payments and
180 billion euro in principal repayments. Average duration is 5
years.

Public debt service in Italy now amounts to around 17% of GDP and
will rise to 20% unless Italy's debt is dramatically restructured.

Italy now needs to borrow about 40 billion a month euro (gross) and
about 28 billion euro a month net in private markets to refinance its
debt.

The world is holding its breath with every auction of Italian
public debt (3-8 billion euro per week) any of which could trigger
accidental default.

The cost of refinancing Italy's public debt has risen from around
4% a year ago to around 7% now. That adds 20 billion euro a year to
its debt.

Meantime the Italian economy is flat-lining and its capacity to
service additional debt is diminishing despite its running a primary
balance.

Banks around the world are dumping their holdings of Italian public
debt but there is no buyer other than the ECB because of the risk.

The ECB's capacity to refinance Greek, Italian and Portuguese debt
is limited and constrained by Germany's unwillingness to consider
that.

Contagion from Italy is now beginning to affect Spain and France
which is supposed to be a bulwark for the EFSF's borrowing
capacity.

The resulting gridlock is pushing the entire Eurozone system toward
a catastrophic denouement with a binary outcome. Either:

1. Crisis-induced progress toward fiscal union with
   national sovereign bonds being replaced by a single Eurozone
   bond with a joint/several guarantee, or
   
2. Sudden disorderly collapse of the Eurozone with unimaginable
   fallout and consequences that would trigger a global double-dip
   recession.
   

Such a recession would last for a minimum of 2-3 years and would
probably be quickly followed by a similar debt crisis in the US.

The resulting fallout of disorderly Eurozone break-up could trigger
a break-up or restructuring of the larger EU as well.

So where do we go from here?

With the foregoing in mind it seems absurd that the world is
waiting with bated breath to see what the new technocratic governments
in Greece (Papademos) and Italy (Monti) will actually achieve by way
of structural reform and increased debt servicing capability in coming
months.

These technocratic governments inject new credibility but lack
political and social legitimacy. They have been appointed not
elected.

It remains to be seen how long their technocratic legitimacy holds
out without the backing of gradually earned political/social
legitimacy.

The risk is that if the ministrations of these technocratic
governments (which their societies believe have been imposed on them
from the EU above) do not work and bear fruit relatively soon (the
probability is that they won't), public patience with them will
melt.

Will they be able to convince electorates to accept the
inevitability of austerity without growth for the indefinite
future?

The next Greek crisis is perhaps 10-12 weeks away.

The next Italian crisis could be triggered by any one of the
upcoming weekly auctions of Italian government debt.

Despite these rather obvious realities, global markets deem to be
reacting in dream-like hope and optimism that all will be well.

There is of course a solution at hand; and the only one that will
work because all the other options seem to have been exhausted.

That option requires Germany to reconsider its refusal to bear its
large share of the fiscal burden that will come with Eurozone fiscal
union.

It requires political/social willingness on the part of rich
northern Eurozone members to finance fiscal transfers to poorer
southern members through an exponential expansion of structural funds,
currently applied to help develop more rapidly the poorer regions of
the EU.

Reciprocally, it requires other Eurozone countries to relinquish
fiscal, and a great deal of political, sovereignty immediately; in
order to assure global markets of their commitment to structural
reform, restoration of competitiveness, and relentless pursuit of
fiscal/monetary discipline.

It requires all unwanted national sovereign bonds of Eurozone
members to be replaced by a single Eurobond that is jointly and
severally guaranteed and underpinned by the weight and ability of the
ECB behind it to print money if necessary to ensure that such bonds
are honoured.

This solution would resolve both the over-indebtness problem of the
Eurozone and the problem of banking system collapse at a single
stroke.

If it were adopted the need to provide for risky Eurozone debt and
recapitalise (yet again) the EU banking system would disappear.

Yet, this is the one solution that keeps being discarded because of
legitimate German constitutional, judicial and political
constraints.

They inhibit movement in such a direction regardless of the
consequences for the Eurozone, the EU, and mostly Germany itself.

It is like witnessing a repeat of 1939; not of conquest but of
mindless destruction. But, this time with money rather than tanks
being involved.

If that only workable solution continues to be discarded, the other
possibility that will manifest itself is the disorderly break-up of
the Eurozone; simply because its orderly break-up defies contemplation
and imagination.

Talk of Greece being ejected from the Eurozone, or of Germany
departing from it voluntarily, is fanciful simply because neither can
afford to bear the costs of the consequences that will follow,
regardless of what their populations and political leaders may believe
or think (though 'thought' seems to be conspicuously absent from the
process just now). Neither can their neighbours, regardless of what
they may think.

Yet it is not unimaginable that a break-up will be forced on
Eurozone members by global markets if the only workable solution
continues to be ruled out as it seems to be repeatedly by the German
Chancellor. But she has changed her mind so often the hope is she will
yet again.

A disorderly break-up may result in a reversion to national
currencies; which would be better than members trying to retain some
semblance of the Euro through separate residual monetary unions of
more compatible economies.

That would probably require four different Euros (for the
super-efficient Northern economies a Baltic Euro, for the relatively
efficient middling economies a Franco-Euro; for the newly acceding
countries an Eastern-Euro and for the inefficient, uncompetitive
Club-Med economies, a PIGS-Euro). Other than the first, none of the
others would be credible for holding as reserves, or for trading
significantly in global currency markets.

Finally, bear in mind that we have spoken of only the public debt
problem in the Eurozone.

Should the unthinkable (but increasingly likely) disorderly break-up happen, the public debt
problem will be accompanied by an unresolved private debt problem
throughout the Eurozone of equally monumental proportions! That
really will break the system and the banks!

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Interesting readings

A pioneering
conference of the academic community in the field of
international relations in India.

Pramit
Bhattacharya in Mint on the impact of transaction
charges on the currency futures/options markets.

In continuation
of my
blog post on Pakistan, India, MFN, read
Bibek
Debroy on the subject.

Watch
me talk
about risk aggregation in the Indian economy, presenting joint
work with Sucharita Mukherjee. This is from a
fascinating conference
organised by IFMR. From this same conference, also see
the most
excellent opening talk by Nachiket Mor.

The
ally from hell by Jeffrey Goldberg and Marc Ambinder in
the Atlantic magazine. Things aren't going well in
Pakistan. What can India do to
help? Mani
Shankar Aiyar says, and I fully agree: One, return to the
Musharraf/Manmohan Singh proposal to create a borderless Kashmir
- where the LOC is rendered irrelevant - as a precursor to a
borderless subcontinent. Two, agree to maintain uninterrupted
and uninterruptable dialogue, that will remain unbroken and
regular, irrespective of terrorist attacks or any other
calamity. Three, introduce a visa regime similar to Nepal and
remove all restrictions of pilgrimages. The fourth remedy is to
ensure a full and free media exchange, including and not limited
to movies, TV channels and newspapers. Five, an open investment
regime without any barriers to trade. Six and seven involve
standing together on the international stage to push for the
expansion of the UN Security Council and launch a joint
initiative for global nuclear disarmament.

David
E. Sanger in the New York Times about how things aren't
going well in Iran.

Adam
Satariano and Peter Burrows have a fascinating story about
how, in addition to innovation and design, Apple has a great third
weapon: Operations.

In continuation to my post
about Dennis
Ritchie and Steve Jobs,
read M. Douglas
McIlroy on Dennis Ritchie, written on 19 May 2011.

Paolo
Pesenti takes us back to 20 years ago, when Europe went
through another economic crisis. It is useful knowledge about
economic history, and it gives us some insights into the Eurozone
crisis of today.

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How to decontrol the price of oil

We know a lot about price controls from the field of exchange rates. Here's an argument from way back, in 1998:

When change comes to a stabilised currency, as it must, that change is painful. Change in the long term is inevitable. The random walk doles out a little change every day, which is less painful than sudden large changes. 

...

Currencies which are random walks yield a deeper sort of stability. The steady pace of small changes every day generates realistic expectations about currency risk and continual realignment in production processes in the economy. It avoids sudden changes, and keeps the currency out of the domain of politics. The random walk regime is sustainable without incurring serious distortions in the economy.

In the field of exchange rates, India understood these arguments, and moved to a floating exchange rate. In March 2007, the INR/USD volatility moved up to roughly 9% and from early 2009 onwards, RBI stopped trading in the currency market. This was the biggest achievement of the UPA in economic reforms: In the 2007-2009 period, we got to a market determined rate on the most important price of the economy.



These same ideas are useful in thinking about the price of petrol. A large jump of Rs.1.8 per litre attracts attention. It is far better to let the price fluctuate every day. Ultimately, the price has to adjust. We suffer a lower political cost by letting it adjust every day (through the depoliticised market process). If we bottle up the small changes, then we have to make large changes. These are a bad use of political capital.

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Are the inflationary fires subsiding?

On 25 October, Dr. Subbarao announced a 25 basis point hike in the policy rate. Alongside this, he made statements that were widely interpreted as being dovish:

Keeping in view the domestic demand-supply balance, the global trends in commodity prices and the likely demand scenario, the baseline projection for WPI inflation for March 2012 is kept unchanged at 7 per cent. Elevated inflationary pressures are expected to ease from December 2011, though uncertainties about sudden adverse developments remain.

 ...

Inflation is broad-based and above the comfort level of the Reserve Bank. Further, these levels are expected to persist for two more months. ... However, reassuringly, momentum indicators, particularly the de-seasonalised quarter-on-quarter headline and core inflation measures indicate moderation, consistent with the projection that inflation will begin to decline beginning December 2011.

... 

The projected inflation trajectory indicates that the inflation rate will begin falling in December 2011 (January 2012 release) and then continue down a steady path to 7 per cent by March 2012. It is expected to moderate further in the first half of 2012-13. This reflects a combination of commodity price movements and the cumulative impact of monetary tightening. Further, moderating inflation rates are likely to impact expectations favourably. These expected outcomes provide some room for monetary policy to address growth risks in the short run. With this in mind, notwithstanding current rates of inflation persisting till November (December release), the likelihood of a rate action in the December mid-quarter review is relatively low. Beyond that, if the inflation trajectory conforms to projections, further rate hikes may not be warranted.

WPI inflation is not interesting in thinking about monetary policy. The WPI basket is not consumed by any household. The right measure of inflation that all of us should focus on is the CPI.



We just released an updated batch of seasonally adjusted data, and the news for inflation, for September 2011, is bad. CPI-IW grew at an annualised (seasonally adjusted) rate of 20.15% in September 2011. As a consequence, the 3-month moving average inflation went up from 8% in August to 11.77% in September.  If we compute the policy rate as the halfway mark (8%) and subtract out this latest value of the 3-month moving average inflation rate (11.77%), the policy rate expressed in real terms is -377 basis points.



Here's the picture of what's been going on with point-on-point seasonally adjusted CPI-IW inflation:

The key fact about India's inflation crisis is: "Headline inflation", which I would define as the year-on-year rise of CPI-IW, has been outside the target range of 4-5 percent in every single month from February 2006 onwards. High inflationary expectations have now set in. Given what is happening on prices of both tradeables and non-tradeables, I find myself skeptical about the sanguine picture on inflation that was painted on 25 October.



The bottom line: Headline inflation (year-on-year rise of CPI-IW) went up from 8.99% in August to 10.06% in September. This is inconsistent with a sanguine analysis of inflation on 25 October.



Or perhaps the econometricians at RBI have some aces up their sleeves. Will point-on-point seasonally adjusted inflation, under the benign influence of a strongly negative real rate, veer back into the 4-5 per cent range by December 2011? Stay tuned. So far, the score is: September 2011, 20.15%.

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Piped natural gas (PNG) in India: Not priced to displace electricity

In continuation of my previous post on piped natural gas, I found that Mahanagar Gas charges Rs.33/m^3 for natural gas. The energy content is 8500 kcal/m^3 or 35.56 MJ/m^3. This corresponds to 10 kwhr i.e. 10 units. In the units of electricity pricing, then, this gas is priced at Rs.3.3 per unit (i.e. $0.066 per unit). This is slightly cheaper than electricity but not by much. I'd have expected gas to be cheaper than this. This isn't a pricepoint at which one can obtain a big shift from electricity to NG. It is more convenient than shipping bottles around, but that's about it.



For a comparison, in Los Angeles, the price of gas works out to $0.036 per kwhr while the price of electricity is $0.132 per kwhr. That is, piped electricity is 3.667 times costlier than piped gas. It makes you wonder about what we're doing wrong with natural gas in India.

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Residential water heating and the rise of the gas-fired economy

When electricity distribution networks fall into place, people start using electricity for everything. Heating, air conditioning, cooking, etc.: electricity is the supple path to all applications. Electricity is conveniently accessed at home, but at a system level, there are problems. Electricity is typically made in big facilities, primarily by burning coal or gas. It is then inefficiently transported to the home. Coal has the worst carbon footprint. Given the domination of coal in Indian electricity production, electricity consumption in India is highly carbon intensive.

Gas delivered to the home is a superior alternative, but this requires gas distribution to the home. A brand-new distribution infrastructure needs to be built, for delivering gas to the home. Once gas is at the home, it can be used for cooking and for heating. To the extent that this is done, it reduces the carbon footprint of residential energy consumption. And, given the way the world is going, gas delivered to the home is likely to be significantly cheaper (per joule) when compared with electricity, even without a carbon tax. (Question: Does someone know the price per joule for residential electricity versus piped gas in India?)

When we think about global warming in India, the dominant impulse is to say to the rich countries "this is not our problem; you guys loaded up the atmosphere with CO2, you guys fix it". While this approach has strengths, it is also important for India to find low-carbon paths to development. We have a problem in having a highly coal-fired economy. We also have the malleability in having the bulk of our energy system of 2050 having not yet been built out: this gives us choices about what should be done. In contrast, most rich countries have less room to maneuver. Policy decisions in India will determine whether cities develop energy-efficient mass transportation systems (such as the Delhi Metro) or not; in contrast, there is no possibility of Los Angeles or the Bay Area developing a good transportation system.

I suspect that gas is likely to be India's low-carbon bridge to renewables and nuclear, exactly as it will be for the rest of the world. From this perspective, we need to start looking for market-based channels to do more on building the gas ecosystem. One interesting litmus test that we can use is the number of households where one sees gas-fired water heating. 

This requires distribution networks for gas, and then households have to switch from electric ovens, water heaters, stoves to gas-fired equivalents. In India, a few cities are now starting to have gas distribution to the home. In time, households should increasingly build up the capital stock of gas-fired appliances, motivated by the superior pricing of gas.

And this gives us an illustration of India's malleability. The CMIE household survey shows that at present, 5.5% of households in India today have one or more geysers (this is for the quarter ended June 2011). For these 5.5% of households, there is the question of junking the existing capital stock and shifting over to a gas-fired appliance. Presumably the differential pricing of electricity versus gas will justify such a shift for the household, but for India, it is a waste when there is such destruction of capital stock. Far more interesting are the remaining 94.5% of households. We should be doing things today, so that over the next 25 years, when 94.5% of India's households will buy a geyser, they will go towards a gas-fired heater rather than an electric one.

From this perspective, I was surprised to see a sales flyer of a small company -- P. K. L. Ltd. -- talking about a gas-fired water header:

This was news, atleast to me. I have never seen a gas-fired water heater being sold to a household before in India. I walked over to the Croma website and they don't have one. Similarly, all the water heaters at ezone are electric. Amusingly enough, the P. K. L. Ltd. website also does not talk about a gas-fired water heater. So either this is vapourware or their website is not updated. Do you know any firm selling gas-fired water heating for homes in India, and do you know any home that has one?

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Pakistan, India, MFN: What are the implications?

For once, I am pleased at how India played it: India gave Pakistan MFN status way back, in 1996, without getting into the silliness of reciprocity. A hallmark of professional competence in international trade is the idea of unilateral liberalisation: Even if another country is silly enough to have barriers against us, we should not have trade barriers against them. Removing barriers against India's globalisation is a favour to us, regardless of what it does to anyone else. India often gets into cul de sacs by obsessing on reciprocity - e.g. we won't open up to imports of agricultural products because the Europeans won't. We won't allow foreign banks to operate in India because some other countries have barriers against the operations of Indian banks. And so on. But for once, in this case, our guys seem to have played it right (and way back in 1996, too!).



And now, we have a nice next step: Pakistan will give India MFN status. What might happen next? Here are some conjectures:

1. At present, there is significant Indo-Pak trade; it merely gets routed through Dubai. Once Pakistan gives India MFN status, the entrepot trade that was going Bombay -> Dubai -> Karachi will go Bombay -> Karachi. This is bad news for Dubai and for individuals and firms which are invested in the future of Dubai as an entrepot centre. Trade data should show a fairly sharp decline in India's exports to UAE and a fairly sharp rise in India's exports to Pakistan.


2. There will be a boom in shipping, communication and trade serving the direct Bombay -> Karachi route. Similarly, the ports of Gujarat will do a lot of business directly to Karachi.


3. At first blush, little changes: the goods that used to go via Dubai would now go directly to Karachi. Another dimension is the cost of the middleman in Dubai, which would be eliminated. To a reasonable man, these changes add up to small numbers. But a recurring theme in economics is the extent to which apparently small frictions loom large. The removal of fairly modest frictions matters a lot for business activity. So when the cost of shipping goes down by roughly 3x, even though the cost of shipping may be small in absolute terms, this would have a big impact on trade. 


4. Important dynamics will now set in amidst firms in Pakistan. Firms that compete with exports from India will suffer. Firms that consume imported inputs from India will thrive. Creative destruction will take place; resources will shift from one group of firms to another. Exporters will be better able to export to India, both because of access to cheaper labour and capital that's freed up by firms that die owing to import competition, and because of improved competitiveness that comes from cheaper raw materials. Exports from Pakistan to India will go up significantly through this movement on import liberalisation.


5. Large Indian and Pakistani corporations will look much more seriously at the opportunities that lie just beyond the national border. Over time, human capacities and human networks will build up on both sides, supporting cross-border operations. This will take time to ripen, but when it does, the effects will be large. A good fraction of global trade is intra-firm trade, so it's very important to have large firms of both countries having operations in both countries, in order to get growth of trade. But for this, both sides have to do more on capital account liberalisation through which firms will expand operations across the border.


6. The biggest gains in India will be in Gujarat, given the myriad ports in Gujarat which are a short distance away from Pakistan. But in the future, if road and rail links open up, then there are big opportunities in Punjab also. Wouldn't it be nice to have a NHAI style road running from Ahmedabad to Karachi, and from Amritsar to Lahore?

To the extent that we're merely rerouting trade, bypassing Dubai, this will impose no new stress on ports and airports in Pakistan. But to the extent that new trade is created - as I expect it will (and as argued above) - then new work will be required in Pakistan on enhancing the capacity of ports and airports. I would personally be surprised if the effects are not large. In other words, this initiative will need to be followed through by new work on infrastructure in Pakistan.

In the intuition of economists, there is a gravity model in the affairs of men. Proximity and low transactions costs are incredibly important. The natural opportunity for India to grow international integration on all dimensions (goods, services, people, ideas, capital) lies in our immediate neighbourhood. India's connections into the region are shockingly below those seen for all other large countries. Doing better on connections with Pakistan would be a nice step forward.

Consider a product like cement, which is ordinarily considered a non-tradeable. Transportation of cement is so hard, there isn't a unified national market even within India. There are a series of regional markets. But even in this, modifications of transportation have mattered greatly. E.g. when Gujarat Ambuja came up with the innovation (back in the mid 1990s) of sending cement from Saurashtra to Bombay, by sea, this was a very big deal. By that same logic, cement from the coast of Saurashtra can go to Pakistan (or vice versa, depending on who produces at a lower price).

We should not see trade in goods in isolation. All dimensions of globalisation are intimately connected to each other. It is not possible to have mode of internationalisation (trade in goods) without having the others. To do more trade in goods and services, we need more movement of people. Ergo, the silly visa restrictions that both countries impose on each other need to be eased. Finance follows trade: So where trade in goods and services leads the way, bigger financial integration will follow with trade financing, cross-border banking, payments, purchases of information, operations of multinationals and FDI, INR/PKR currency risk management, and investment flows. More will need to be done on investment guarantees, export/import trade financing, etc. Conversely, if all those elements are blockaded, then trade in goods and services will not blossom.

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`The Quest' by Daniel Yergin: A great job but we need more

I recently read Daniel Yergin's fascinating book The Quest. It's a panoramic view of the global energy industry. For me personally, many parts were familiar territory. But many parts were new to me, and the overall integration of the story was valuable. I encourage every non-specialist (like me) who is curious about energy to read the book.



But I was left thirsty for two more books.



The first book would be a more technical treatment of the same material.



I repeatedly found myself wanting more technical detail. The pollution from cars has come down by 99% between 1970 and 2010. How was this done!? New nuclear reactor designs are fundamentally safer than the reactors that got into trouble at Chernobyl or Fukushima. What are these designs and why are they fundamentally safer!? Hybrid cars give you much higher mileage than ordinary cars. What are the key innovations which make this possible and how much did each of these new ideas contribute? The oil industry is doing incredible things digging deep into the sea. What are these engineering challenges and how are they being overcome?



And so on. The Quest is a good book but the The Quest for Geeks would be a great book.



The second direction in which I was curious and unsatisfied was India. The book has roughly nothing about India. It talks a bit about about Suzlon and has some political stories about India's views in global climate negotiations. For the rest, there is nothing about India's energy industry. It would be great if a comparable panoramic treatment was done, focusing on India. Perhaps Girish Sant and/or Rangan Banerjee should embark on such a project.

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Project Tanzanite: Obtaining fundamental progress in the macroeconomics of developing countries

I was at a meeting in London recently, organised by href="http://www.theigc.org/">the IGC, on the subject of the
research agenda in macroeconomics for developing countries. This made
me think about how to make progress.

The US as the shared dataset for mainstream macroeconomics

All existing knowledge on macroeconomics is rooted in data about
the US economy. The US is seen as a canonical developed
country. Economists all over the world have treated it as a common
object of study, when building macroeconomics. It is a shared
dataset. Researchers and Ph.D. students routinely pull out a paper
from the literature, and replicate the results, as a first stage of
offering innovations: all this is rendered convenient by using the US
as a shared dataset. New work is generally obliged to demonstrate
value-add in the context of the US dataset.

The US works as a shared dataset because it has high quality
data. Good quality data starts right after 1945, because there was no
destruction within the country, hence the early post-war years are not
distorted by unusual reconstruction. There was a steady shift away
from dirigisme from 1945 onwards, but for the rest there has
been no regime change: events like the breakdown of communism or the
rise of the European Union or the Euro have not taken place.

In the US, a high quality statistical system has produced good
aggregative data. Organisations like NBER have processed this data
nicely to create datasets about the business cycle. High quality
datasets are available about households, firms and financial
markets. Household- and firm-level data has been nicely utilised to
obtain numerical values for parameters in macroeconomic models: why
estimate something using macro data when you know it using
gigantic and well trusted micro datasets? Finally, the major question
for macro today is the fusion with finance, and the US has nice data
for the financial system.

As a consequence, facts about the US are the shared dataset used in
all mainstream macro research across the world.

The insights developed in this literature, which has examined the
US economy, have been transported with fair success, into other
developed countries. Thus, this emphasis on the US as a common dataset
has delivered good results. As an example, the revolution in monetary
policy which was thought through by Friedman, Lucas, etc. was created
using US data. It has usefully reshaped central banks worldwide. US
data was essential for inventing inflation targeting, but inflation
targeting has worked well outside the US.

The major obstacle on building a macroeconomics for developing
countries

The major obstacle that interferes with doing macroeconomics in
developing countries is data.

India is a good example of what goes wrong. The standard GDP data
is in bad shape. The annual GDP data is deplorable, and the quarterly
GDP data that is so essential for doing macroeconomics is worse. The
IIP is untrustworthy. Put these together, and we don't have an output
series, really.

The BOP data is measured fairly well. Some href="http://nipfp.blogspot.com/2011/02/how-to-measure-inflation-in-india.html">plausible
inflation data is now starting to come together. The statistical
system run by the government does not produce seasonally adjusted
data [succor]. Given the
absence of the Bond-Currency-Derivatives Nexus, the bulk of data
about interest rates that is required is missing; policy makers are
href="http://ajayshahblog.blogspot.com/2006/08/flying-blind.html">flying
blind. The standard household survey (NSSO) is in bad shape: it
does not produce panel data, surveys are only conducted once in a few
years, and there are incentive issues about the front-line staff who
interact with households.

The large firms are observed using the CMIE database; the small
firms are not observed using the ASI dataset. The CMIE household
survey is starting to generate knowledge about households, but this
only got started a few years ago. While the CMIE datasets (on firms
and households) can be aggregated up to create many interesting macro
series, so far this process has only begun in a small way.

Faced with these problems, it is not surprising that little is
known, at present, about macroeconomics in India. We know numerous
important questions, and we know that we don't know the answers. The
roadmap to progress is often, though not always, blockaded by data
constraints.

Many such problems bedevil the statistical system in other
developing countries also.

Economists have complained about bad data in developing countries
for decades, and that hasn't changed things. And there is a uniquely
perverse problem. Incremental progress with a gradually improving
statistical system does not get the job done for us: By the
time a country gets to good institutions and thus a good statistical
system (e.g. Taiwan, South Korea, Israel, Chile), the country is not a
developing country anymore and is thus not a useful dataset for
studying the macroeconomics of developing countries. Chile has world
class databases on households and firms, but you can't extract
microeconomic facts using these datasets and use them in
calibration if your object of inquiry is the canonical developing
country.

A proposal

How can we make progress? I feel the first idea that we need to
agree on is that we do not need many developing countries to build a
great literature. We need a shared dataset, a lingua franca, a
replication platform, using which we will build a literature. We need
a country that will play the role, for the macroeconomics of
developing countries, that has been played by the United States in
conventional macroeconomics.

The second idea is that we should be a little more ambitious. We
should not merely sit around hand-wringing, complaining about a
problem that isn't going to solve itself. When scientists in other
disciplines identify questions that call for evidence, they write
funding proposals (sometimes running to billions of dollars) and
organise themselves to create those datasets. Could we do
similarly?

Specifically, imagine that we pick one canonical developing
country. It's got to be a typical developing country in most
respects. And, it should not be a conflict zone, it should have the
basics of law and order and physical safety so that operations can be
mounted in it. Christopher Adam of Oxford suggests that Tanzania is a
good choice.

Imagine that, the system of interest (a developing country) keeps
running, but it gets instrumented up to world class. In essence, we
try to place first world instrumentation into a third world
country. (To the extent that this data improves decision making in the
country, we would suffer from `Heisenberg' effects).

This will call for financial resources and, more importantly,
organisational capability. The physicists know how to organise
themselves to build the Large Hadron Collider. Most of the time,
economists do not organise themselves as laboratories or teams doing
complex projects. This will be a bridge that we will have to
cross.

As with the Large Hadron Collider, this is not a short-term
project. It is a project that needs to run for 25 years, in order to
generate a strong dataset.

At first, the project will generate useful facts for calibration,
drawing on household survey and firm databases. Gradually, as the span
of the time-series builds up, the full picture will start becoming
clear.

If this works, it can ignite a literature where researchers from
all across the world do replicable work off a common dataset. Perhaps
Tanzania could then play a role, for the macroeconomics of developing
countries, that is comparable with the role played by the United
States in mainstream macroeconomics.

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