All the materials are up on the website.
Wednesday, 11 September 2013
Monday, 9 September 2013
Essentially everywhere in the world, we see unification of trading in all kinds of products -- spot or derivatives, equities or currencies or fixed income or commodities etc., OTC or exchange. It makes too much sense to reap economies of scale and economies of scope, both in the private sector and in the work of regulation and supervision. The arrangement in India, where the Forward Contracts Regulation Act (1952) envisages the Forward Markets Commission that is a part of the Department of Consumer Affairs, is a silly one.
Everything we have learned about how to run the equity market is valuable for commodity futures:
- The regulatory governance process at SEBI including authority to issue regulations, enforcement process, appeals at SAT, etc.
- Governance problems of Infrastructure Institutions with three-way separation between shareholders, managers and trading members.
- Netting by novation at the clearing corporation.
- Not having `badla' trading.
It is likely that the Ministry of Finance would not give an exemption to any exchange from regulation. A lot of what we saw in this field in the last decade would not have arisen if commodity futures had been placed with SEBI and MoF. But then, we have had dubious finance ministers and one should not be too confident. The price of sound governance is eternal vigilance.
Merging FMC into SEBI began as controversial ideas:
- One markets regulator or three? in the Business Standard, 1997.
- An interview in the Financial Express, 1998.
- Rethink financial intermediation in the Business Standard, 1998.
Then it turned into a government committee process:
- On 14 May 2003, a committee was setup headed by Wajahat Habibullah, who was secretary of the Department of Consumer Affairs. Key persons who shaped this work were S. Narayan, who was Secretary at the Department of Economic Affairs, and Ashok Lahiri, who was Chief Economic Advisor.
- Percy Mistry's committee said: Redraft the legal foundations for organised financial trading, so as to unify all organised financial trading under SEBI regulation. This would include currencies, equities, sovereign and corporate bonds, and commodity derivatives.
- Raghuram Rajan's report said: all organized financial trading, spanning currencies, fixed income, equities, commodity futures, exotics (such as weather and decision markets), and spanning all trading venues and forms of trading should come under a single regulator, the SEBI.
- The draft Indian Financial Code has a general and sector neutral treatment of financial regulation where all organised financial trading is the work of the Unified Financial Authority.
In 2003 and 2004, we were well on our way on getting this done. However, once the UPA government came to power in May 2004, and Sharad Pawar became the minister in charge of Consumer Affairs, it became infeasible to shrink his turf. By that time, substantial commercial interests had developed which wanted to preserve the existing arrangement, with regulatory capture of FMC.
More generally, one of the most harmful instincts of bureaucrats and citizens in India is the notion that the boundaries of government agencies are somehow sacred. There is much resistance to changing the role and function of a government agency. But every employee of government exists to serve the people of India, and we need to continually change the block diagram of government so as to best cater to the fast changing requirements of the economy.
Now we have a crisis on our hands, and policy makers have resurrected the project. While there is a news item, the details are not yet visible. The first step would be a small change in the allocation of business rules, through which the subject of commodity futures trading would shift from the Department of Consumer Affairs to the Ministry of Finance. The big step would be to repeal the FC(R)A and modify securities law appropriately; until this is done, the gains would be limited. The draft Indian Financial Code is a natural source of ideas on how this drafting should be done.
In the short term, the FMC would become a part of the Ministry of Finance. Important decisions at FMC would go up to the Ministry of Finance and ultimately the Minister of Finance for approval. The knowledge on organised financial trading at the Ministry of Finance will give us improved decisions under the existing law. We may expect considerable porting of regulations and public administration practice from SEBI into FMC.
This seems to be a season for old policy projects working out. First the Pensions Act, and now this. Nothing like adversity to make India deliver.
Thursday, 5 September 2013
An
editorial in the Business Standard on getting away from
gerontocracy.
An
editorial in the Indian Express on the next steps on
pensions and the next steps on legislation.
Anil
Padmanabhan in Mint about the people in India who would
like for India to remain focused on poverty. I would add one more
interest group in this: Development economics.
The
burqa joins the league of cape and cowl by Mahvesh
Murad.
N.
Sundaresha Subramanian in the Business Standard reports
on the parties of India which have the biggest criminal
footprint.
One of the first sensible things in the field of higher education
policy in
India: Building
the Links Between Funding and Quality in Higher Education:
India's Challenge by Lindsay Daugherty, Trey Miller, Rafiq
Dossani, Megan Clifford, Rand
Corporation. Also
see.
Trampling on the individual in India: Here's something for us in India to envy:
the response of the Polish Prime
Minister to proposals to censor the Internet: We shall not block
access to legal content regardless of whether or not it appeases us
aesthetically or ethically.
And here is another: a story
of a
dentist who tried to interfere with the online freedom of speech
of customers.
Compare and contrast with what our Supreme
Court just
said to mouthshut.
Ila
Patnaik: What
Raghuram Rajan needs to do
and Gearing
up for the slow withdrawal of QE.
Mihir
Sharma in the Business Standard on the consequences of
exchange rate depreciation.
The
trouble with our banks by Shankar Sharma and Devina Mehra in
the Business Standard.
Editorial
in the Indian Express.
Trouble
for treaties by N. Sundaresha Subramanian in the Business
Standard, about the kind of firms who showed up in the
Private Treaties portfolio.
Anusha
Soni in the Business Standard about capacity
constraints in the government that are hindering the field of infrastructure.
When
rent-seekers and startups collide by Steve Blank: A useful
set of insights into the field of payments in India.
Noah Smith on the Economics Ph.D.:
and
see:
set of concerns, and
beautiful books.
Those who fail to remember our past will be forced to relive
it. See this
post. I wrote
something a
while ago which draws on a similar idea.
Wednesday, 4 September 2013
In 1998, the Ministry of Social Justice and Empowerment setup `Project OASIS', led by Surendra Dave, to engage in deep thinking about pension reforms. The report, which was submitted on 11 January 2000, envisaged an individual account defined-contribution system with central recordkeeping, and recruitment of fund managers by an auction which asked for the lowest fees+expenses.
This was a futuristic vision at the time, as a lot of the surrounding infrastructure had not fallen into place. In socialist India, it was quite novel to propose that households would build their own assets to take care of themselves in old age. However, the idea rapidly got widespread acceptance. More and more people started looking at the maladies around them and said that if only we had the NPS, these problems would not arise.
NPS was ahead of its time in being mistrustful of mutual funds and insurance companies. The great scandals of mutual funds and ULIPs lay in the future. Issues of consumer protection were not widely understood in 1998. But the key calls made in the NPS have proved to be the right ones: of delivering a solution that is good for the lifetime financial planning of households while giving financial firms wafer-thin margins. Apart from index funds, the NPS is essentially the only piece of Indian finance that is accessible to the average household that I trust. Thinking on consumer protection has progressed enormously in the following years, first at IFMR and then in FSLRC. Yet, the NPS designed in 2000 fares well in satisfying the consumer protection principles of the draft Indian Financial Code of 2013.
In December 2002, NPS was adopted by the NDA government as the mandatory pension system for all new recruits after 1 January 2004. All this was re-opened by the UPA government when it took charge in May 2004, and they chose to stay on course.
From May 2004 to September 2013, we were unable to make progress on the proper legal foundations. But the NPS was built and executed through a network of contracts and rules, planned out by one of India's best lawyers (P. Chidambaram), which is legally sound. All civil servants recruited after 1/1/2004 have been placed into the NPS, and by now this is shaping up to be substantial numbers. NPS has also started gradually going into the unorganised sector, with the assistance of co-contribution.
The wheels grind slow, but they grind true. I wish all this had happened faster, but it is good that it happened. The key implication of this decision by Parliament is that the NPS cannot be shut down by a future administration. To find out more, I suggest :
- Concepts of the NPS and their rationale: Indian pension reform: A sustainable and scalable approach by Ajay Shah, Chapter 7 in `Managing globalisation: Lessons from China and India', edited by David A. Kelly, Ramkishen S. Rajan and Gillian H. L. Goh, World Scientific, 2006.
- A story of how the NPS came about: India's pension reforms: A case study in complex institutional change by Surendra Dave, page 149--170 in `Documenting reforms: Case studies from India', edited by S. Narayan, Macmillan India, 2006.
- A recent look at developments in implementing the civil service pension: Civil service and Military Pensions in India by Renuka Sane and Ajay Shah. Chapter 4 in `Reforming Pensions for Civil and Military Servants', edited by Noriyuki Takayama, Maruzen Publishing, 2011.
This story is interesting not just from the immensely important problem of ageing, but also as a case study in how we achieve far-reaching change in India. I disagree with the pessimists who limit their ambitions to minor tinkering changes. We in India must constantly question the foundations; almost everything about the Indian State is broken and needs to be redone from scratch.
There has been a sea change in thinking about financial law in India thanks to the work of the Financial Sector Legislative Reforms Commission. In 2001 and 2002 we did not know how to draft law. The PFRDA Act reflects the old ways of drafting law and will not look good to modern eyes.
Looking into the future, the story now runs on five tracks:
- Making the civil servants NPS work properly as originally envisaged. At present it does not.
- NPS has forked into two systems: one for the unorganised sector and another for civil servants. These need to be merged into one single system with full portability.
- Achieving large-scale participation and sustained contribution for the unorganised sector -- while not sacrificing the heart of the NPS which is wafer thin charges. All too often, we get an urge to do to the NPS what was done to mutual funds and insurance companies.
- Using this institutional capacity to solve the problems of EPFO.
- We will need to adapt the PFRDA Act and the draft Indian Financial Code so as to achieve the following framework: (a) NPS would become a pension system run at the instance of the government, (b) It would be regulated by the machinery of the Indian Financial Code, (c) PFRDA would get merged into the proposed Unified Financial Authority (UFA). It is more important to be correct than to be consistent.
Tuesday, 3 September 2013
One feature of each period of turbulence is that we get an upsurge of out of the box thinking. While it is always good to think out of the box, these innovative ideas must also make sense. If I were a teacher of economics, I would use these in class as demos of how not to do economics:
- Coordinated intervention by emerging markets. Andy Mukherjee nails this one.
- Devesh Kapur and Arvind Subramanian want an import tariff -- that they term a `third best measure' -- to do things that exchange rate depreciation does better.
- Veerappa Moily says we should close down petrol pumps at night so as to reduce consumption of petrol.
- Swaminathan S. Anklesaria Aiyar thinks there is a second Asian Financial Crisis in store. But Asia has substantially moved away from exchange rate rigidity. He says depreciation is recessionary. No, depreciations are expansionary. He implies that depreciation is a problem in India today as corporations have large unhedged foreign currency borrowing. The existing evidence does not support this.
- Jamal Mecklai on temple gold. It is satire.
Tuesday, 27 August 2013
In the Independence Day special issue of Forbes magazine, I have an article titled Rightsizing the State. At a recent show organised by Dun & Bradstreet, I joked that the puzzle in India is that of finding the middle road, between Gotham City on one hand (a murky world of corruption and criminality) and Jurassic Park on the other (with socialist dinosaurs destroying the economy). Pessimists about India might say that if the goons won't get you, the dinosaurs will.
Sunday, 25 August 2013
Every now and then, some people get enamoured about capital controls as a tool for macroeconomic policy. The actual operation of capital controls on the ground is a mess.
As an example, consider the recent decision to hinder outbound capital flows by individuals and firms. At first it sounds fair and plausible. We are hindering outbound capital flows by households by interfering with their purchase of gold, and in similar fashion we should intefere with their outbound capital flows through other routes.
Vatsal Gaur and Sidharrth Shankar review this capital control in the Financial Express and everyone must read their analysis as a demo of what goes on in this field.
Their article shows that these capital controls are riddled with numerous microeconomic effects. As an example, Gaur & Shankar say: "Additionally, through a rather innocuous tweak to the July 1, 2013, master circular on Miscellaneous Remittances from India, RBI had effectively closed the LRS window for resident individuals looking to acquire securities of unlisted offshore companies."
Every time a government indulges in microeconomic meddling, this introduces distortions. The basic hygiene test of public policy is that detailed microeconomic interventions are only justified in order to address market failures (externalities; asymmetric information; market power) subject to two tests : (a) We are able to figure out a public administration strategy to overcome the principal-agent problem of citizens versus State and (b) We are able to do a cost-benefit analysis and demonstrate that the costs imposed by the intervention is exceeded by the benefit.
Every time a government meddles in the economy at a microeconomic level, this proposal must pass the following tests:
- What is the market failure? Can you demonstrate that what you are worrying about is a market failure?
- What's your proposed intervention?
- Does your proposed intervention address your market failure?
- What is the incentive structure through which policy formulation and enforcement is being done in the best interests of the people of India?
- Can we show that the costs are outweighed by the benefits?
No such analysis is visible in RBI's action. There is no demonstration of market failure. There is no accountability mechanism that holds RBI in check when meddling like this. There is no cost-benefit analysis. Until analysts like Gaur and Shankar write about this in public domain, there is not even a thorough enumeration of all the microeconomic impacts of this regulation, which ensures that these five questions have not been answered for all these effects.
It is easy to slam RBI for what they have done, and to a significant extent they can do better. But the trouble is, almost everything in the field of capital controls suffers from these problems. Capital controls are detailed microeconomic meddling in the economy. They do not address market failures and hence they cannot be justified or analysed. It is not possible to clearly articulate objectives, or construct accountability mechanisms, for a public agency that would do capital controls. This generates the worst outcomes with a State apparatus that does not serve the interests of the principal.
In order to pursue the goals of macroeconomic policy, we need macroeconomic levers which affect the broad economy without introducing narrow microeconomic distortions by dealing with things like LRS windows and unlisted offshore companies. In monetary policy, the macroeconomic lever is the policy rate. Capital controls, in contrast, are microeconomic levers. Their use is always messy. People find other ways of getting their work done, so the desired macroeconomic outcome is not obtained. But along the way, GDP growth is adversely affected owing to the deadweight cost that people have to incur in getting past the restriction.
There is an extensive literature on the microeconomic distortions caused by capital controls. While they are effective in the sense of achieving distortions at a microeconomic level, they fail to deliver on the goals of macro policy. You may like to see Did the Indian capital controls work as a tool of macroeconomic policy?
Saturday, 24 August 2013
by Percy Mistry.
Dhiraj Nayyar, Director of the Think India Foundation, has just written an excellent, sympathetic piece about Dr. Subbarao's tenure as Governor of RBI.
It is full of pathos because Dr. Subbarao is a decent, dignified and extraordinarily intelligent, capable man with a powerful sense of politeness and decorum. These days: decency, decorum, dignity and politeness are virtues that, in modern political, bureaucratic and corporate India, seem conspicuous by their absence. So anyone who exhibits them, should score highly in anyone's book.
Dr. Subbarao's appointment as RBI Governor shows up, unfortunately, the bankruptcy of a bureaucratic career system that permits outstanding IAS officers like him -- an accomplished urban economist -- to be parachuted into a situation which requires a lifelong acquired feel for monetary policy and the numbers behind it.
From the many central bankers I have known around the world and in India (many of whom I had the privilege of working with, and others whom I came to know socially), and have observed closely over the years, I conclude that central banking is still more an art (that requires extraordinary prescience, instinct and judgement) than a precise econometric science. All top flight central bankers over the last 50 years have invariably ignored econometric evidence when it did not jibe with their instincts (something that a distinguished former Fed Chairman once told me he found essential to do, with all the econometricians around at the Fed!).
In India, our rare 'good' RBI Governors have had luck on their side and not fouled things up too much because of a lack of domain knowledge. Our 'bad' ones have had some bad luck but mostly a lack of comprehension about what they were doing. Most had good luck but still fouled it up without knowing they were doing that. None have had either domain knowledge or monetary policy expertise and experience on their side when they came into the job. They picked up what little they could as they went along.
Sadly, we have not learnt yet that, in the brave new globalised, open economy world we live in, specialised domain knowledge for the management of an open economy is a MUST for fiscal and monetary policy-makers and managers of the macroeconomy. There is no room anymore for relying on the peculiar British civil service tradition of using gifted (or, more likely, ungifted) amateurs, or all-rounders of the kind the IAS believes it still produces. It does produce exceptions like U. K. Sinha and K. P. Krishnan. But they are precisely that -- exceptions. They do not typify the IAS drone -- moderately clever, yet with dull, rigid, closed minds that are comfortably 'knowledge-proof'. I was once reliably informed that the minds of IAS were like powerful steel traps. Pity that they are rarely open.
It is amazing to me that almost none of the members of our top economic team in MoF, DEA, RBI, have much serious domain knowledge in their areas of control (except perhaps Raghuram Rajan and Montek Ahluwalia) or put any weight on its importance. Most of our economic heavyweights know more about managing a closed economy because that is how/when they were brought up as career officers during their formative years. Their instincts are still command-and-control, even when they haven't a clue about what they are doing, or its implications and consequences.
They have no idea how to deal with the challenges of an open (or in India's case partially open) economy and its weird reactions in times of stress/crisis when markets determine the extreme febrility of volatile outcomes. They still fly by the seat of their pants and talk about the 'fundamentals being sound'. That is disconcerting, because it only reinforces the view of the outside world that they do not know what they are talking about. It results in a collapse of confidence in India's economic managers and damages India even more. What exactly is it about any fundamental of the Indian economy that is sound right now -- the fiscal deficit? the current account deficit? capital flows? growth? inflation? the PMI? the food security bill -- which might be more appropriately called the Economic Insecurity Bill?
Friday, 23 August 2013
The problem
Shekhar Gupta and Swaminathan S. A. Aiyar have pointed out that our domestic policy logjam is leading to the import of natural resources which are amply present in mines in India. This is giving a bigger current account deficit and a weak rupee.
I feel this is not such a bad thing. Many countries have been afflicted by the resource curse and many countries have been afflicted by Dutch disease. We are blessed with reverse resource curse and reverse Dutch disease. Here's the argument.
Reverse resource curse
The idea of the resource curse runs like this:
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.
Source: Why does Bombay have abysmal governance, 6 November 2010, on this blog.
And, you may like to also see: Resource curse - comparing India and Russia, 21 February 2007 and The resource curse of land ownership, 12 January 2012.
For many years, resources in India were a messy business. Now, we have started getting push back in terms of greater scrutiny and medium-grade enforcement. This has exerted a sharp negative impact on this business.
This is not such a bad thing. A country that lacks good institutions is better off without natural resources! If we hide the natural resources into the ground for 25 years, while we build good institutions, that is a good deal. It is far better to do this than to face the destruction of institutions which comes from natural resources impacting upon a badly constructed political system.
If we were advising a tin pot dictator who has just found oil, what's the best advice we could give? We would say: Burn all the documents about this oil find, and build the rule of law for the next 25 years. It is an achievement of Indian democracy and institutions that the reduced form outcome is one of restraint rather than exploitation of these natural resources. If this restraint had not come about, it would have distorted the trajectory of Indian politics, possibly with disastrous consequences for our future.
Reverse Dutch disease
At present, the exchange rate in Sri Lanka reflects a combination of competitiveness of the tradeables sector and financial considerations. Suppose there is a great oil find there. A surge of oil exports from Sri Lanka would then commence. This would exert pressure for the exchange rate to appreciate. This would damage the development of the tradeables sector which would not be able to compete at that distorted exchange rate. This has been termed `Dutch Disease' as it was first described in the context of the impact of North Sea oil.
We in India are getting the reverse. Excessive imports of natural resources, of even the things that are found under the ground in India, is exerting pressure on the exchange rate in favour of excessive depreciation. This will foster the tradeables sector. Reverse Dutch disease is not such a bad thing.
Conclusion
It is curious and remarkable that India is importing things that are found under the ground in India, owing the domestic institutional logjam. But we should resist calls to cut the Gordian knot and debottleneck the resources business in messy ways. It is much better for us to dig in and build good institutions, rather than find short cuts through which natural resource exploitation can hurriedly take place. This will surely take a long time. In the meantime, this will generate currency weakness. This is not such a bad thing.
Thursday, 22 August 2013
Miss Prism: Cecily, you will
read your Political Economy
in my absence. The
chapter on the
Fall of the Rupee
you may omit.
It is somewhat too sensational.
-- Oscar Wilde,
The Importance of Being Earnest,
1895.
The graph above superposes the INR/USD exchange rate and Nifty, both reindexed to start at 100 on 15 May 2013. The graph runs till 21 August (i.e. yesterday). The rupee has depreciated by 17% and Nifty has dropped by 13.7%. I feel that the drop in Nifty is substantially about the reversal of reforms of this period. On the exchange rate, I think every short seller of the world got attracted watching the government trying to defend the rupee, which has given overshooting. This problem was exacerbated because RBI had damaged the liquidity of the currency market; when a flood of orders came, the price moved more because the market was shallow.
Here's a kit of readings. By now, almost everyone thinks that the Strong Rupee Policy was a mistake. It's interesting watching people switch positions through this time-line.
- Why did we bumble on the defence of the rupee?, Economic Times, 21 August.
- Crisis and complicity, Pratap Bhanu Mehta in the Indian Express, 21 August.
- A deadly defence, Surjit Bhalla in the Indian Express, 21 August.
- The RBI should end its stop-go policies, Lars Christensen in Mint, 21 August.
- Credibility crunch, Sanjaya Baru in the Indian Express, 20 August.
- Let the rupee sink, Andy Mukherjee in the Business Standard, 20 August.
- The needless battle, by Ila Patnaik in the Indian Express, 19 August.
- Editorial in the Business Standard, 18 August.
- Editorial in the Indian Express, 17 August.
- India Inc hedges its bets by Ila Patnaik in the Financial Express, 16 August.
- Editorial in the Business Standard, 15 August.
- Will the capital controls to defend the rupee work?, 14 August.
- Editorial in the Indian Express, 13 August.
- Govt, RBI fighting a losing battle on rupee, Tamal Bandyopadhyay in Mint, 13 August.
- We don't know much about what the exchange rate ought to be, 12 August.
- Should we have picked this battle?, Economic Times, 7 August.
- Don't hold the rupee, by Abheek Barua in the Business Standard, 6 August.
- The collateral damage to banks from RBI, Ravi Krishnan in Mint, 5 August.
- RBI norms on gold imports may deal a blow to domestic jewellers, Dinesh Unnikrishnan in Mint, 1 August.
- Editorial in the Indian Express, 31 July.
- Editorial in the Business Standard, 31 July.
- Rising collateral damage, Sonal Varma in Mint, 30 July.
- Does India need sovereign bonds?, by Ila Patnaik in the Financial Express, 24 July.
- Editorial in the Business Standard, 24 July.
- RBI's rupee rescue mission may hurt government, by Anup Roy, Manish Basu, Kayezad E. Adajania in Mint, 24 July.
- India moves closer to gold import quota to stifle demand, Siddesh Mayenkar and A. Ananthalakshmi in Mint, 24 July.
- Editorial in the Business Standard, 23 July.
- Offshore funds make a killing on betting of movement of interest rates in India, by Sugata Ghosh in the Economic Times, 22 July.
- There is no method to RBI's madness, by Tamal Bandyopadhyay in Mint, 22 Jul.
- Editorial in the Indian Express, 17 July.
- Government paper sales cancelled after investors demand high yields, Anup Roy in Mint, 17 July.
- Editorial in the Indian Express, 16 July.
- Step back into the ring, by Jahangir Aziz in the Indian Express, 16 July.
- RBI, SEBI attack currency speculator; but rupee stays intact, by Mobis Philipose in Mint, 15 July.
- The taming of the rupee, by Ila Patnaik in the Financial Express, 12 July.
- The attack on the market for the rupee is a mistake, Economic Times, 11 July.
- Editorial in the Indian Express, 11 July.
- Losing currency, by Ila Patnaik in the Indian Express, 10 July.
- Editorial in the Business Standard, 10 July.
- Hedging surge prompts RBI inquiry on rupee moves, Bloomberg content in Mint, 8 July.
- Editorial in the Business Standard, 8 July.
- RBI moves to curb rupee speculators, Rafael Nam and Suvashree Dey Choudhury in Mint, 2 July.
- Rupee at 60: the options before RBI, by Tamal Bandyopadhyay in Mint, 30 June.
- How to cap the CAD, by Ila Patnaik in the Financial Express, 28 June.
- Don't try to control the rupee, by Ila Patnaik in the Financial Express, 21 June.
- Do not mourn rupee fluctuations, Economic Times, 11 June.
- Rupee will need support in coming months, Renu Kohli in Mint, 28 May.
- The arrogance of power, 12 May.
- How do you prevent rupee trades?, by Ila Patnaik in the Financial Express, 10 May.
- The rupee: Frequently asked questions, 1 December 2011.
And, you may find it interesting to see an updated picture of the evolution of the Indian exchange rate regime [methodology]:
This graph shows a moving window of annualised volatility of the INR/USD exchange rate for the last 15 years, starting from 28 August 1998. Vertical lines show the two dates of structural change of the exchange rate regime. As we see, we had volatility of 1.84% for 4.74 years until 23 May 2003. Then we jumped up to 3.87% volatility for 3.84 years. This lasted till 23 March 2007. We are now in the longest single period under one single exchange rate regime: 6.42 years spent with an annualised volatility of 8.73%. Through this period, every debate on exchange rate policy ended up in favour of exchange rate flexibility. The floating exchange rate is the only stable long-term option for India.
Tuesday, 20 August 2013
I have a column in the Economic Times today on this subject.
Wednesday, 14 August 2013
- The case for differentiated bank licenses, 15 August 2013.
- Rethinking the Statutory Liquidity Ratio (SLR) in Indian banking, 29 October 2012.
- Should government capitalise public sector banks?, 9 October 2012.
- White label ATMs, 6 August 2012.
by Harsh Vardhan.
The much hyped applications for new bank licenses are in – all 26 of them. Now, RBI will evaluate these applications which will require scrutinising mountains of documents that have been presented.
A casual look at the applicants reveals remarkable diversity in their character. The applications include non-banking finance companies, micro-finance companies and brokerage firms. There are established and new firms. There are focused (i.e. single business oriented) and diversified firms. There are public and private firms. A number of applicants have well established niche businesses: gold loans, vehicle finance, micro lending, etc. They clearly have established capabilities and credibility in these businesses over years of operating them. Now they want to morph into a generic universal banking model, large parts of which they have no experience in. In effect, all these players transform from a specialised business to a more generic, undifferentiated business.
This is surprising. As any business evolves, we expect specialisation to develop. It is a natural response to innovation and deepening of capabilities. In response to competition, firms become specialists in some things and develop a competitive edge there. Many of the specialist players in Indian finance have done so over the last few decades – they have focused on serving specific needs (e.g. loans against gold), specific customer segments (e.g. semi-urban, self-employed), and specific geographies. Many of the aspirants of banking license today are very successful specialists in one sub-component of finance.
Then why is it that they want to jettison a specialisation built over years of effort, and merge into this undifferentiated, monolithic group called commercial banks? More importantly, will the financial system become weaker when these specialists become generalists?
Ask the applicants why they want to become a bank and the most common answer is access to low cost deposits. This is, at best, a half-truth. While, it is true that only licensed banks can access putative low cost deposits (CASA), the belief that they are actually `low cost' is not supported, once we account for all the costs of getting them. New banks will have a hard battle on their hand getting a foothold into this intensely competitive business of CASA. It is not a coincidence that the only banks to have hiked savings account interest rates, post deregulation, are the newest and the smallest ones: Kotak Mahindra, Yes, and IndusInd.
But there are other important parts of financial services that are reserved for banks – access to payment systems is the most important one. Payments have seen enormous innovation across the world primarily driven by non-banking players. In India, we have lagged in this area. Non-banks cannot enter the payments business, and banks are laden with legacy technology and processes that make them slow to innovate and reluctant to cannibalise their existing cashflows.
RBI recognises only one type of bank. So, the moment an entity becomes a bank, it is subject to the same rules and regulations as every other bank. All large Indian banks look like each other, and they all look like mere enlarged versions of what they were 10 years ago. Bank regulation is a giant homogenising force that kicks in when a banking license is granted. If any of the currently specialist players get a license, they will undergo this transformation and begin to look like the 90-odd scheduled commercial banks.
As India grows and becomes more sophisticated, banks must keep pace with the sophistication of the real economy, where most firms do not look much like they were 10 years ago. An important feature of a sophisticated banking system is specialisation. How do we achieve specialisation and diversity in our banking system?
First, in the current round of licensing, I suggest that RBI not only recognises diversity but encourages it. It can do so by giving licenses to applicants with diverse and specialist business models that focus on specific customer segments, products, and technology and process platforms. More importantly, it needs to show flexibility in regulation, and not ask all banks to look the same in the short run. Financial regulation is about consumer protection and micro-prudential regulation, and not homogenisation.
Second, RBI needs to start thinking about differentiated banking licenses. Why should we have only one type of license? Why can’t we have a utility bank – one that provides only transaction services (e.g. security related services such as custodian, trade related services, etc) and does not lend or borrow (significantly)? Why can’t we have a payment specialist bank or a home loan banks (one that can take deposits but lend only in form of home loans, by far the safest lending for Indian banks)? Everyone talks about financial inclusion, so why can’t we have an inclusion bank – one that serves only the bottom of pyramid customers?
Such specialist banks will be expected to focus on their own individual niches and strengthen their capabilities in serving these niches as a bank - through access to payment systems, ability to raise deposits, regulatory oversight, etc. The presence of such banks will make the system less monolithic and hence better placed to face economic cycles. With differentiated banking licenses, we will have banks that do not face boom and bust at the same time. Reduced correlations between banks will give lower systemic risk.
Issuing differentiated licenses will require that RBI has to become more sophisticated in how regulations are drafted. RBI's regulatory staff will need to understand each business model, and write regulations about consumer protection and micro-prudential regulation that cater to the unique features of that business model. These regulations will have to differentially use the main tools of micro-prudential regulation – capital adequacy and reserve requirements, regulatory audits, reporting and compliance -- so as to achieve the desired failure probability, while recognising differences in business models. RBI will also have to ensure that there is no regulatory arbitrage that is created across different types of banks.
We will wake up to the 66th anniversary of free India with reduced freedom. Today, new capital controls were announced. Once every decade, we have to trot out Did the Indian capital controls work as a tool for macroeconomic policy?
Tuesday, 13 August 2013
Road safety is a problem in India. The authorities are getting push back from the citizenry about the carnage on the roads. What is convenient for them is: to shut down roads.
Finding terrorists is difficult. Terrorists can use open wifi networks or trains. What is convenient for the authorities is to shut down open wifi networks or trains.
Achieving safety in public spaces late in the night is difficult. What is convenient for the authorities is to force all establishments to close down at 10 PM.
In similar fashion, I was disappointed to read Chanpreet Khurana in Mint write about how the Delhi Metro is trying to achieve safety of women: through gender segregation. This is profoundly wrong. Women must have complete flexibility to dress as they like, go where they like, and at any time they like. Anything less than that is a reduction of personal freedom of women. It is the job of the State to achieve extreme levels of safety while never interfering with the freedom of women. Gender segregation is a cop out. It will lead to a worsening of safety of women, by emphasising to the authorities that they actually don't have to figure out how to achieve a sound criminal justice system. The next time a woman gets attacked in a mixed-gender coach, she will be blamed for having been in the wrong place.
The rules of society must be designed to maximise the freedom of citizens. It is only in a police state that a policeman's job is easy. Decisions should not be taken which make life convenient for bureaucrats and politicians. Achieving a capable State is hard work! That is what politicians and bureaucrats must do, as opposed to finding easy ways to dodge the problem. We have to hold their feet in the fire, else they will readily wriggle out using these excuses which are bad for citizens, avoid the problem of building State capacity, and perpetuate an incompetent State. On a related note, see Faulty tradeoffs in security, on this blog.
It is very convenient for bureaucrats to ban things in Indian finance and cut Indian finance off from the world. This reduces their work. Why bother learning about credit default swaps when you can just ban them? Blocking a capable financial system is easier than restructuring regulatory organisations, enacting new laws, recruiting high quality staff, and setting up sound business processes. The strategy of blocking the emergence of a capable Indian financial system is self-serving and convenient; it avoids the difficult work of actually constructing capable financial regulators. As Percy Mistry says, in Indian finance, instead of regulators adapting themselves to the needs of the financial system, we have the financial system distorting itself to fit the needs of the regulators. In an accountable democracy, it must be the State that constantly adapts to achieve freedom for each citizen.
There is a principal-agent problem between citizens and State. The principal wants the agent to serve their goals, i.e. to produce public goods at the lowest possible cost, and to not abuse power by meddling in the lives of citizens. The agent wants to be lazy and inefficient, to steal, and to abuse power. We should be cautious: we should not hear the views of the agent on what the principal should do, and we should not accept solutions that are convenient for the agent such as gender-segregated coaches in Delhi metro.
Monday, 12 August 2013
Many people are confidently saying that the market's price of the rupee-dollar exchange rate is wrong. They think they know what the exchange rate should be. There are many pitfalls along this path.
The simplest international trade perspective
To fix intuition, let's think there are only two countries: India and the US. Suppose there was no capital account. Suppose there was only import and export of goods and services on the current account. In the absence of a capital account, in every time period, the current account would have to work out to zero. The currency market would clear to yield an appropriate exchange rate from the viewpoint of export competitiveness. We would find an exchange rate at which we earn enough export proceeds to be able to pay for for our imports (that are also a function of this exchange rate).
Suppose we had a base year in which things were square. Now, from that point onwards, one could look at inflation in the two countries and the exchange rate and get a sense about how export competitiveness was changing. As an example, inflation in India is 10% and inflation in the US is 2% so we might think that the exchange rate should depreciate steadily at 8% per year in order to keep the CAD at 0.
The Real Effective Exchange Rate (REER) goes one step further and implements this calculation while taking into account the fact that India trades with many countries. A note of caution: The best REER measure for India is that made by the BIS.
Problem 1: The export basket is different from the CPI
The CPI is, indeed, the best measure of inflation. But the things that we export and import are not the things that the average household consumes. Hence, this crude estimate -- that the rupee should depreciate by roughly 8 per cent per year on average -- is wrong.
There is really no way to solve this problem. In an ideal world, we would have price indexes that are specific to the import and export basket. But these indexes are essentially impossible to make. Think of all the goods and services that India imports or exports, and the problems of obtaining a sensible price for each of them.
Problem 2: Productivity is not constant
All this assumes that nothing else is changing. But productivity is changing, slowly in the US and dramatically in India. In our backyard, there are a million microeconomic mutinies, through which production is becoming more efficient. Individuals learn. Firms improve their processes. Indian firms get internationalised, and global firms start operating here, all of which drives a ferment of improving knowledge. Our indirect tax policy & administration has slowly gotten better. State of the art equipment gets brought in. We learn how to utilise better and more specialised raw materials (which are often imported). Infrastructure gets better, thus linking up productive capacity in difficult locations (e.g. 100 km away from Bombay, 1000 km away from Bombay, 4000 km away from Bombay) to global markets.
The pair of graphs here is blindingly obvious and yet revealing. From 1994 till 2010, the Indian REER fluctuated between 85 and 110. Over this period, merchandise exports grew from $2 billion a month to $15 billion a month. What was going on? Superior Indian productivity growth.
Qingyuan Du, Shang-Jin Wei and Peichu Xie have a fascinating new paper Roads and the real exchange rate, which finds that changes in transport infrastructure have important implications for the real exchange rate.
Problem 3: The exchange rate is actually mostly about finance and not trade
So far, we have played in the simplest world where there was no capital account, and all that was going on was imports and exports (of goods and services). That's not the world that we live in anymore. We have a mostly open capital account, which gives each country the convenience of not having to achieve a CAD of 0 in every time period. We obtain microeconomic gains from international capital flows.
In 2012-13, India had inflows on the current account of $452 billion and outflows of $583 billion. If this was all that was going on, on the currency market, we would have trading volume of $583 billion per year. The outflows would require buying $583 billion. On the other side would be exporters selling $452 billion and capital inflows filling the gap. This translates to (one way) turnover on the currency market of $2.3 billion per day. In truth, the currency market for the rupee trades between $40 billion and $70 billion every day. The overall activity on the currency market dwarfs the minor business of sorting out the current account. The currency is now a financial product.
Bottom line: Exchange rate assessment is a mugs game
We started out with a simple and intuitive world, but ran into three problems. We can't quite use CPI in India and in trading partners, as the CPI is the basket consumed by the household and not a reflection of prices of the goods and services that are traded. The big story is all about productivity growth in India, which we know little about. And, the exchange rate is a financial object and not driven in the short run or medium term by trade considerations.
Policy makers should be cautious when thinking there is something going wrong with the market's exchange rate
When so little is known about exchange rate assessment, we should be cautious before determining that something is wrong with the exchange rate that the currency market has made.
None of this is new (1997, 2007). But every few years, we seem to come up against a situation where policy makers have strong views on what the exchange rate ought to be. We may all have our own personal opinions about what the exchange rate ought to be. A Hippocratic oath should prevent us from undertaking interventions in the real world that have manifestly visible costs [link, link], until we are really sure that there are corresponding gains.
Tuesday, 6 August 2013
For the last month, financial and monetary policy has pursued the goal of preventing rupee depreciation. I have a column in the Economic Times today titled Should we have picked this battle?
Tuesday, 23 July 2013
One cool idea for improving the Indian police : video monitoring.
We always knew that gender-segregation of society, as is practised in most of traditional India, is deeply damaging. Writing in the New York Times, Adam Grant shows new insights on why men need women.
Are India's policy rates too low? by Niranjan Rajadhyaksha in Mint.
Atul Gawande in the New Yorker at his best: he has deep insights into how new ideas diffuse. In India, with GDP doubling every decade, we need for new ideas to come into every organisation at a hectic pace. The organisations which are more closed have become obsolete and have failed.
A public interest litigation to be imagined by Somasekhar Sundaresan in the Business Standard. Also see this post where I have an interesting comparison against the election commission.
The recent war on rupee depreciation has inflicted enormous damage. Read Devangshu Datta in the Business Standard, and Tamal Bandhyopadhyay in Mint and Sugata Ghosh in the Economic Times.
The Indian State suffers from basic blunders in the field of health: Too much spending on private goods and not enough spending on public goods. Gardiner Harris has a fascinating story in the New York Times about the detective stories in Indian epidemiology which require State attention. These are the public goods in the field of health.
Mobis Philipose on problems faced by exchanges.
Remya Nair reports on RBI and NBFCs. This should be seen in the context of the FSLRC recommendation on shifting NBFC regulation out of RBI.
When evil was a social system by Christopher Caldwell, in the New Republic.
While we have long heard skeptical views while China thundered ahead with high GDP growth, the problems today seem to be a bit worse than usual. See William Pesek, Paul Krugman and Brad Plumer interviewing Patrick Chovanec. In some sense, the market has known this for a long time. Over the last decade, Nifty has generated returns of 291% while the Dow Jones Shanghai Index gave only 62.6% despite faster Chinese GDP growth.
Take a glimpse into the life of Albert O. Hirschman and Christine Granville. They don't make people like this anymore.
Monday, 22 July 2013
I have a column in the Economic Times today on this subject.
Sunday, 21 July 2013
High GDP growth has led to structural transformation, with dramatic change in the composition of the labour force. The latest data from the CMIE Consumer Pyramids database pertains to December 2012, and shows the following occupation structure of the Indian workforce:
| Occupation | Share (Per cent) |
| Small farmer | 13.39 |
| Organised farmer | 8.69 |
| Agricultural labourer | 8.70 |
| Industrial worker | 7.92 |
| White collar worker | 8.44 |
| Manager / supervisor | 0.53 |
| Support staff | 6.93 |
| Businessman | 7.91 |
| Small trader / Hawker | 3.32 |
| Self-employed professional | 4.92 |
| Home-based worker | 1.50 |
| Wage labourer | 27.75 |
How might this influence political platforms?
The success and stagnation of the Left
The Left caters to the interests of tenured employees of manufacturing firms. They were very successful in influencing policies. To a great extent, the Congress stole the Left's thunder by pampering organised labour, and every political party in India treats them as holy cows.
This success undermined Left thinking as a political force. Left-influenced policies hobbled organised manufacturing, and we see only 7.92% of the workforce in `Industrial worker', which most closely fits the support base of the Left. It is ironic that the very success of the Left in shaping the Indian State has marginalised the Left as a political force. The price we pay for being a liberal democracy is the sacrifice of large-scale labour-intensive manufacturing.
The aristocracy of workers in organised manufacturing is grossly overpaid. What matters to their take now is not GDP growth or their marginal product, but their ability to use their privileged position to extract a rent out of the firms that have no choice but to deal with them. Hence, their interest in GDP growth is relatively low.
The role of agriculture
The farm lobby is not a monolithic bloc with unified interests. There are kulaks who seem to correspond to `Organised farmers' and are 8.69% of the workforce. And there are others (`Small farmers' at 13.39% and `Agricultural labourers' at 8.7%) who add up to 22.09% of the workforce. CMIE defines wage labourer as `Wage labourers are those who seek daily wages from non-agricultural sources. Typically, these are industrial workers who work in factories or companies but are not employed on a regular basis in these. Wage labourers also include construction site workers and those working in other non-agricultural activities. This includes a taxi driver who operates the owners' taxi' and hence this excludes agricultural labour. Policies that favour producers of agricultural products in broad terms would thus benefit 30.78% of the workforce (and hurt everyone else, who buys agricultural products). Policies that are more narrowly focused on the interests of kulaks, such as the old-school fertiliser subsidy, are good for 8.69% of voters and bad for everyone else.
India's structural transformation is giving a rapid decline in the share of the workforce in agriculture. While the CMIE data for December 2012 shows 30.78% of the workforce is in agriculture, the oldest available data, for December 2010, shows 32.68%. This is a decline of 1.9 percentage points in just two years. If we guess that on average, in each year, there is a decline of 0.75 to 1 percentage points, then in a decade, we will get to the range of 20.8 to 23.3 per cent of the workforce in agriculture.
Ordinarily, we would expect politics to favour the interests of buyers of food (69.22% of workers) trump the interests of producers (30.78%). Why is agriculture so prominent in Indian politics? I can conjecture three explanations:
- As with Industrial workers, the priorities of Indian politics reflect the failure of imagination of the gerontocracy.
- The redistricting process is slow and for a long time had stalled. This has given an exaggerated emphasis to constituencies where agriculture is important. That Indian politics is a gerontocracy despite rapid economic and demographic change may partly be a consequence of slow redistricting.
- As with Industrial workers, once unequal policies create a focused beneficiary of distortions, these beneficiaries have a focused interest in lobbying in favour of the status quo. The costs of these policies are dispersed across society and the others don't have an incentive to mobilise politically.
In this context, it is interesting to see that in places like the US, Japan and Europe, there are strong agricultural lobbies that have achieved highly distorted policies even though their vote share has dwindled away to almost nothing. Brad Plumer in the Washington Post has some insights on how this comes about, and suggests that it is a combination of sharp interests of agriculturists in marginal constituencies.
How might competitive democracy construct an interest-based politics
Indian politics has come up with two ideas that transcend caste and religion : catering to agriculture and catering to industrial workers. Both these interest groups are not that salient in today's India. It is interesting to look at the table and puzzle over what might work.
Congress is pursuing the goal of setting up big welfare programs that target agricultural labour (8.7%) and wage labourers (27.75%), adding up to 36.45%. While this is a big chunk of votes, it isn't big enough to close the deal, particularly as in fast-growing India, many individuals within these two interest groups actually want to escape from poverty and welfare programs. Many of them would be interested in a platform that shows a roadmap out of poverty, instead of offering dole while perpetuating it. If even a small fraction comes to mistrust the strategy of dole, it undermines the extent to which this platform will win elections.
I think there is more possibility in a platform of public goods + growth when compared with the conventional wisdom. By definition, public goods (e.g. law and order or the infrastructure of transportation and communications) benefit all. There is no need to split up the vote and pursue narrow constituencies in this. A pro-growth stance is directly good for many sub-components: Organised farmers (8.69%), White collar workers (8.44%), Managers (0.53%), Businessmen (7.91%), self-employed professionals (4.92%), adding up to 30.49% which is similar to the size of the old-fashioned agriculture lobby (at 30.78%). Looking forward, this group will grow while those interested in either agriculture or dole will shrink.
In addition, a large chunk of the remainder of the workforce -- which may have only a weak interest in a pro-growth platform today -- aspires for a better life, particularly the young. The wage labourer of today wants to be a small trader tomorrow, and the small trader of today wants to be a businessman tomorrow.
I would hazard the following guesses:
| Occupation | Share (Per cent) | Dole | Public goods | Growth |
| Small farmer | 13.39 | Weak | Yes | Weak |
| Organised farmer | 8.69 | No | Yes | Yes |
| Agricultural labourer | 8.70 | Yes | Yes | Weak |
| Industrial worker | 7.92 | No | Yes | Weak |
| White collar worker | 8.44 | No | Yes | Yes |
| Manager / supervisor | 0.53 | No | Yes | Yes |
| Support staff | 6.93 | No | Yes | Weak |
| Businessman | 7.91 | No | Yes | Yes |
| Small trader / Hawker | 3.32 | Weak | Yes | Weak |
| Self-employed professional | 4.92 | No | Yes | Yes |
| Home-based worker | 1.50 | Weak | Yes | Weak |
| Wage labourer | 27.75 | Yes | Yes | Weak |
| Total | 100.00 | 36.45 | 100.00 | 30.49 |
It seems to me that a public goods + growth platform would work better than most people in Indian politics think. Public goods are interesting to all, and the constituency that would strongly favour growth is 30.49% and growing. In contrast, a dole strategy is interesting to 36.45%, and is shrinking.
None of this is relevant if the question that is posed to the electorate is about religion, English, or social conservatism. It may well be the case that the 2014 elections will be fought purely on these questions. But in time, the competitive dynamics of democracy will favour platforms that reflect the interests of the populace, and then these kinds of considerations will matter more.
Saturday, 20 July 2013
by Akhil Dua, Pinaki Mukherjee, Radhika Pandey, Ila Patnaik, Pramod Sinha, Ajay Shah.
India's emergence as a market economy has been accompanied by the emergence of business cycle fluctuations that are similar to those seen in market economies [link, link]. In understanding business cycle conditions, and in crafting institutional arrangements for stabilisation, it is essential to properly measure output and prices.
The problem
India is in reasonably good shape on measurement of prices, with older CPI-IW data and now the new CPI. (Using WPI as a measure of prices is wrong, but you don't have to make this mistake; the statistical system does have CPI-IW and then CPI). Measurement of output, in contrast, has presented serious difficulties.
The index of industrial production is widely used as a measure of business cycle conditions. However, it reflects only manufacturing, which is a small part of the economy. In addition, it is riddled with serious difficulties of measurement.
The other key measure that has been widely used is quarterly GDP data. However, contrary to what textbooks teach us, in India, quarterly GDP data is constructed without information about the demand side. In addition, there are two important concerns about the quarterly GDP data from the viewpoint of business cycle analysis:
- Agriculture is included in the overall GDP data -- as it should -- but to a significant extent, fluctuations in agriculture reflect weather shocks and do not reflect underlying business cycle conditions.
- Spending by the government is counted as output in GDP data. However, it does not reflect underlying business cycle conditions. See Robert Higgs on this subject.
As a consequence, quarterly GDP data in India is not a good reflection of business cycle conditions.
Two steps towards measuring output
In order to address these issues, we have constructed two new series which, we feel, do a good job of measuring nominal output.
The first of these is GDP excluding agriculture and excluding government. This focuses upon the output of individuals, small firms and large firms, which is what the market economy and the business cycle is all about.
The second strategy consists of utilising firm data. Listed companies are required to release quarterly results. These results are pored over by accountants, auditors, senior managers, tax collectors, shareholders, etc. They are thus likely to have few mistakes of the sort which have plagued government statistics and survey-based information.
Finance companies have very different concepts underlying their accounting data, and are hence excluded. Oil companies sometimes experience very large jumps in their revenues owing to decisions by the government about administered prices. These fluctuations are not a feature of underlying business cycle conditions. Hence, oil companies are excluded. In short, we focus on all listed firms observed in the CMIE database other than finance and oil companies.
For each pair of quarters, we construct a panel of firms observed in both quarters, and work out the percentage change in the sum of net sales across all the firms. These percentage changes are used to construct a net sales index.
Non-agricultural and non-government GDP is the business cycle. It is made up of production by small firms (going down to one employee) and large firms doing both industry and services. This measure captures large firms in both industry and services and is thus a good proxy for what is going on in business cycle conditions.
 |
| Net sales of non-finance non-oil firms, and GDP ex-agriculture and ex-government. Nominal indexes, non-seasonally adjusted. |
The graph above shows these two time-series. The fact that the two series -- which are constructed from completely unrelated sources -- agree with each other across long periods of time is a source of increased confidence.
 |
| Net sales of non-finance non-oil firms, and GDP ex-agriculture and ex-government. Nominal indexes, seasonally adjusted. |
Our first step is to seasonally adjust both series. Once again, it is satisfying to see how well the two series agree with each other, even though they are quite unrelated on their underlying sources.
 |
| 2-Q moving average of growth of seasonally adjusted levels. Annualised per cent. |
Using this, we are able to compute nominal GDP growth. Once again, it is striking how well the two series agree with each other. Two major recessions are visible: 2001 and 2009.
This series shows much more macroeconomic volatility when compared with what we are used to with conventional data. This is perhaps unsurprising as government expenditure is a fairly stable series, and fluctuations of agriculture are noise. When these two are removed we see substantial macroeconomic volatility. This is not surprising, as India presently lacks the frameworks of stabilisation through either monetary or fiscal policy.
Conclusion
We feel that we now observe a good measure of output in India, with two different measures that are gratifyingly close to each other. These series are a valuable starting point for business cycle research.
The key flaw of this work is that it takes us till a nominal output index. The next big hurdle to cross is that of converting to real. The simplest strategy would be to just use the CPI-IW and then the new CPI.
Thursday, 18 July 2013
An entry level game console
A console with quirks, for tinkerers by David Pogue in the New York Times: a gaming computer which is a cube with a 3 inch side, at $100. It runs Android. It is an open design; you can hack the software and hardware.
Raspberry Pi
This is a complete computer for $35. You have to see it to believe it. Connect in an ordinary smartphone power supply, an Ethernet cable, a USB keyboard, a USB mouse and an HDMI screen, and you're up and running. It boots linux and runs a browser. [link] [link] [link]
A bit more money and a lot more compute
Arduino is going beyond the geeks to the artists.
Beaglebone Black is at the $45 pricepoint.
Utilite is a quad-core computer that consumes 3-8 watts. At $99.
Implications
In the West, these things are cute. But in developing countries, where individuals and firms are more resource-constrained, these new approaches can be valuable alternatives to conventional bloatware. These open up a new world of exploration and R&D in India, as a large number of tinkerers and researchers can afford these pricepoints. Many workplaces can shift away from conventional desktops and save money on hardware and on electricity.
Tuesday, 16 July 2013
by Suyash Rai.
What is the Equity Risk Premium and why it matters
The basic intuition in investing is that over and above the time value of money, the return on an investment must compensate for the risk it adds to the portfolio of an investor. In the Capital Asset Pricing Model (CAPM), this rate of return can be computed based on two variables: the risk premium of the market on the whole (ERP), and the sensitivity of an asset to the market (Beta). The asset must generate returns equaling the time value of money (a.k.a. the risk free rate) plus ERP*Beta. This tells us the required rate of return for an asset of systematic risk Beta.
The Equity Risk Premium (ERP) is a key variable in many decisions in corporate finance and asset pricing. The equity index is a diversified portfolio where the bulk of gain from (domestic) diversification has been accomplished. How much higher is the return on this portfolio, on average, when compared with taking zero risk by investing in government bonds? This value is termed the `equity premium' or the `equity risk premium':
The equity risk premium is at the heart of finance, shaping the behaviour of everyone buying, selling or regulating publicly traded assets. For example, monopoly regulators the world over use some version of the CAPM to decide how much return is fair for regulated monopolies. The ERP is an essential component of this decision. For example, the Airport Economic Regulatory Autority (AERA) uses the standard CAPM to determine the fair rate of return on capital for private airports in India. All these applications require arriving at a numerical estimate for the ERP.
A warning about the risk free rate
Estimating the ERP inherently requires taking a stand on what the risk-free rate is. For the risk free rate, the yield on a government of India bond can be used. For short-term decisions, treasury bills (maturity of under 1 year) can be used, but for most decisions with long term horizons, it makes sense to use yield on the 10-year government of India bonds. The 10-year bond has a deeper, more liquid market, and therefore provides a more reliable estimate of the risk free rate, compared to government bonds of other maturities.
We have to, however, keep in mind the problem that under the Indian system of financial repression (forced purchases of government bonds), the observed interest rates on all government bonds are understated: given the level of inflation, default risk and inflation risk in India, voluntary buyers would require a higher rate of return.
In the future, many things are likely to happen to the risk-free return in India. Progress on easing financial repression will remove the forced purchases of bonds and tend to push up the required rate of return for government bonds. On the other hand, access to the Indian bond market for foreign buyers of bonds will give lower interest rates. Finally, establishing a sound central bank, as envisaged under the draft Indian Financial Code, will give low and stable inflation which will give a lower cost of borrowing for the government.
Another problem is that prior to 2000, market data on the government bond market is highly spotty. Some analysts (for example, see this paper by Prof. Rajnish Mehra) use the bank deposit rate as the risk free rate in the pre-2000 period. However, this is also a rate that was distorted by regulation and did not reflect market forces.
Three alternative approaches for estimating the equity risk premium
Even though the ERP is extremely important, it is quite difficult to arrive at a good numerical estimate for it. There are three stylised approaches of estimating ERP, each with a few variations (for a detailed discussion on these approaches, see this review paper on ERP). They are:
- Asking around
- Utilising forward looking estimates
- Looking back
In this article I review these three approaches as a mechanism for estimating the ERP in India, and offer some views on what the most sensible estimates might be.
1. Asking around
If two alternative estimates are unbiased and imperfectly correlated, then a combination of these estimates is generally better than either of the two. Hence, we can survey investors, portfolio managers, and other people we consider relevant, and ask them about what they think is a reasonable spread of stock returns over time value of money. The average value will be a good estimate as long as each person has an unbiased estimate.
A recent survey (published on June 26, 2013) of 12 finance and economic professors, analysts and managers of companies in India found the average ERP to be around 8.5% (up from 8% in 2012).
This method is used by many practitioners, but its validity is quite suspect. There is a great degree of recency bias in ERP based on surveys, and given the voluntary nature of responses, we usually don't know how representative the surveys are. If the survey respondents are not using a sound basis for estimating the ERP, the survey cannot, in most cases, give an accurate estimate.
2. Looking into the future
One can compute the ERP implied in the present stock valuations and forecasted earnings for firms. The implied return is calculated based on the stock valuations and the forecasted earnings, and then the risk free rate is deducted.
This implied ERP can change quite rapidly, because it is based on the current stock valuations and expected cash flows. For example, in the US, implied ERP (based on Free Cash Flow to Equity or FCFE) was 2.05% in 1999, and doubled to 4.10% in 2002. Someone using the 1999 implied ERP to take a decision with, say, a ten year horizon, would have underestimated the risk premium. A variant of this method, which mitigates this problem, is to take the average implied ERP for the last few years.
To calculate the implied ERP, we require estimates of future cash flows, which, except for a few well-analysed firms, may not always be available. In India, we now have a number of analysts regularly putting out earnings estimates. For the biggest firms in India, there are 20-40 such analyst reports available at any point of time. But for most other firms, these estimates are hard to come by. Taking a handful of prominent firms as representative of the entire market may lead to an under-estimation of risk premium.
The strength of the implied ERP approach is that it yields a reasonably good estimate of the ERP over a short term (over the next few years). For June-end, 2013, one estimate of the implied ERP (by Pitabas Mohanty of XLRI) is 10%.
3. Looking back
The most commonly used method for estimating the ERP is the historical method. This method uses the difference between the average historical return on a stock market index and the returns on the riskless asset. It is a useful method in many contexts, because it yields a good estimate of the long term central tendency of the ERP. However, it has big problems in the Indian context. Two problems stand out: the problem of estimating risk-free rate, and the shortage of historical data on index returns.
We don't have a long span of equity market data available. Though the index returns (on BSE Sensex) are available from 1979 onwards, dividend data in CMIE Prowess only starts from 1990. So, we have reliable data on market returns for about 23 years only (1990-2013).
The full time-series for the BSE Sensex, from April 1979 onwards, has 8100 observations. However, estimating average returns depends only on the span and is not helped by frequency. And the span of only 23 years in the period where dividends are observed, leaves a lot to be desired. The average annual return on BSE Sensex (not including the dividend yield) during this period (July 06, 1990 to July 05, 2013) is about 19% and the annualised standard deviation of daily returns is 27.8%. As a consequence, the mean return is estimated quite imprecisely: the standard error of the mean works out to 5.8%. The 95% confidence interval runs from 7.4% to 30.6%.
A few more years of data is not going to solve this problem. Halving the standard error requires increasing the span by 4 times.
Let's apply the basic historical method of estimating ERP in India. As the risk free rate, I take the average yield from 2000-01 to 2012-13 on the 10-year government of India bond: 7.77%. The average total annual return on the Sensex (stock return+dividend yield) from 1990 to 2013 is 20.7%, but this is an arithmetic mean. For equity returns, geometric mean is a better measure of central tendency, because of the high level of serial correlation in the series of market returns. The geometric mean of total annual returns (stock returns+dividend yield) is 15.9%, which means that the historical ERP is 8.13%. This is an estimate, but not a reliable one.
3a. Looking back in a different way
To work around the problems in the historical method we need to use a variant of the historical method, which helps us make the most of the advantages of the method, while overcoming the measurement limitations we face in India. This can be done if we take the historical ERP for a mature market (or a group of mature markets) over a long span, and adjust it for the premium to be paid for India's country risk. In using this method, the best option is to take long run historical ERP from the US as the base. Stable and reliable equity market time series is available for a fairly long span in the US. Based on equity market returns from 1928 to 2012, the historical ERP for the United States is 4.2% (geometric mean). Adjusting for the country risk premium for India is a bit tricky. It can be done through a number of methods, each with its pros and cons:
- Based on sovereign rating: There is a default spread implied in India's sovereign rating. India's sovereign rating of Baa3 (Moody's) implies a default spread of 2%. Based on this the ERP in India is 4.2%+2% = 6.2%.
- Based on bond spreads or CDS spreads: Bond spreads and CDS spreads are often used, but the relevant information is not available for India. For bond spreads, we need a significant amount of sovereign debt denominated in US dollars, which is not there. There is negligible CDS activity on sovereign debt, mainly because very little sovereign debt is held by foreign investors.
- Relative standard deviation of the Indian and a benchmark equity market: Another method is to use the relative standard deviation of India's equity market with the US equity market over the last few years. The idea in this approach is that since the standard deviation of returns is a measure of the risk in a market, the relative standard deviation can be used to adjust the mature market ERP to get the ERP in India. In this approach, the relative standard deviation of equity markets in the two countries is multiplied into the ERP of US markets, to get the ERP in India.
Based on the relative standard deviation of equity returns from Feb 2011 to Feb 2013 (0.99), the ERP in India would be around 4.16. So, as per this estimate, the ERP in India is lower than that in the US. It is difficult to make the case that India is less risky than the US, and should have a negative spread vis-a-vis the US. - Relative standard deviation of domestic equity and bond markets: Another market-based approach is to use the relative standard deviation of the domestic equity and bond markets in India. The intuition in this method is that the default spread implied in the sovereign rating does not fully capture the risk of the equity market, and should therefore be adjusted to reflect the relative risk between the equity market and the debt market. The relative standard deviation is assumed to be a measure of this adjustment. In this approach, the relative standard deviation is multiplied into the default spread implied in the sovereign rating, and added to the mature market ERP.
Though in theory this is a good method, in application it gives strange results in some contexts. It is highly dependent on recent data on relative volatility. For example, right now in Greece, given the volatility in debt markets, this approach yields a very low ERP, lower than most developed markets. As of March 2013, India had the highest relative standard deviation of equity and bond markets in the world (4.91), more than many countries usually assumed to be riskier. This is based on two years of weekly returns. I think this high relative standard deviation is because of the relative inactivity in the bond market, which is largely dominated by sovereign bonds that are largely held by captive investors. Volatility in the market would increase if it becomes more vibrant. At present, this method yields an ERP of 4.2% + 4.91*2 = 14.02%.
Any historical method has two general problems: there is a certain degree of survivorship bias in the time series, and the ERP is obtained mainly on the basis of data from firms above a certain size. These biases need to be considered before using any version of the historical method of estimating the ERP.
Choosing a suitable approach
There is no perfect method for estimating the ERP in India, and there is a wide range of estimates (from 4.16% to 14.02%). While choosing the suitable approach for our purpose, we must be cognizant of the fact that in the Indian environment, too often, we are flying blind with weak information. We don't have access to a long span of reliable market data. We don't have reliable estimates of future cash flows for many firms. We don't have reliable sovereign bond and CDS spread information. We don't have good indicators of the risk free rate. But we must make do with what we have; we have to go to war with the data that we have got.
I am thinking mainly about the corporate finance decisions. In corporate finance, the main use of the ERP is to estimate the cost of capital or reasonable rate of return on investments. In such applications, the ERP estimation method one uses is shaped by the horizon. For estimating the long run ERP (say, for more than 5 years), all methods other than the historical method are rife with problems, especially given the data availability in India. The standard historical approach is not suitable, because we really need a much longer span of equity market data, and much better indicators of the risk free rate.
A variant of the historical method can be used: one that takes the ERP from a mature market and adjusts it for India's country risk. In my opinion, for estimating the long run ERP, it is best to take the historical ERP for US, and add to it the default spread implied in India's sovereign rating. This yields the ERP of 6.2%. The other methods of adjusting for country risk premium suffer from serious problems. As of now, the two methods based on relative standard deviations yield very strange estimates, and therefore must be set aside. The ERP in India yielded by one of these methods is lower than the ERP for the US, and the other method puts the ERP in India at a level higher than many economies that are known to be much worse than India. Having regularly observed the results of these methods over the last few years, I have seen them yield some really wonky estimates of the ERP for many countries. We should use these methods carefully. The implied default spread, on the other hand, is a bit too stable (ratings are revised infrequently), but it is not as prone to absurd results.
So, I would say that 6.2% is a reasonable estimate of the long run ERP in India. If the horizon of asset pricing decision is long, this should be a reasonable estimate of the ERP in India. Take the example of the Airport Economic Regulatory Authority (AERA) of India, which needed an estimate of the ERP over a long horizon (5 years). We at NIPFP worked with AERA to estimate a reasonable rate of return for the private airports, and after due consideration of the options, AERA decided to opt for this method of taking the ERP from the US and adding to it the default spread implied in India's sovereign rating (see this order on the tariff for the Mumbai International Airport).
If the horizon of the investment decision is shorter, one needs an estimate of short run central tendency. In such contexts, one can use survey-based or implied ERP. The ideal survey should have a large sample that is drawn randomly from the surveyed population so as to be representative of it, and for implied ERP, reasonably reliable data on expected cash flows for firms should be available. Since it forces us to do our own math and to think precisely, and because good data is now available for firms in India, I would say it is better to use the implied ERP than to use the survey-based ERP in India.
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