SEBI at 25

In a column in the Economic Times today, I look back at SEBI's journey of the last 25 years. In success and in failure, SEBI was the laboratory where we learned how to do financial economic policy.



You may find it interesting to look at my note about RBI at age 75 (in 2010).

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Structural transformation and stylised business cycle facts

The first step in the economics of business cycles is to establish `stylised facts' about the characteristics of business cycle fluctuations. Once these are know, alternative models can be judged on the extent they are able to predict these stylised facts. This is routine in mainstream macroeconomics, which is largely about the United States economy.



When we think about India, however, there is the question of structural transformation of the economy.  There was an old Indian macroeconomics which worried about different things. In recent decades, the economy has changed in fundamental ways: the economy has become mostly open, the role of agriculture has subsided, a financial system has come about and private decisions of firms that are shaped by financial markets now dominate fluctuations of investment. On these themes, you may like to see my article New issues in Indian macro policy.



This raises the question: Does structural transformation change the stylised facts of the business cycle? It appears obvious that when we go from an agriculture-dominated economy to one where agriculture is 12% of GDP, the role of monsoon shocks in GDP should fade away, which should matter for the spectral properties of business cycle fluctuations. Other kinds of structural transformation may not change stylised facts too much. As an example, the IT revolution did not change the business cycle facts in the US. In some respects, things could go in reverse. Some researchers have found that going from a closed to a more open economy yields more consumption volatility, not less, which violates the neoclassical prediction that capital account openness enables better risk sharing.



A recent paper explores these questions: Has India emerged? Business cycle stylised facts from a transitioning economy, by Chetan Ghate, Radhika Pandey and Ila Patnaik, Structural Change and Economic Dynamics, volume 24, page 157--172, March 2013.



The findings of this paper are quite fascinating. Prior to 1991, the stylised facts of the Indian business cycle are quite different from those seen for advanced economies. A sharp change is visible after 1991, and the Indian business cycle becomes more like that of advanced economies. But in the post-1991 period, consumption volatility went up in both absolute and relative terms.



Why did these changes take place? The authors explore a few hypotheses. Was India just lucky in the post-1991 period -- with lower volatility of productivity or monsoon shocks? No, that was not the case.



Did India figure out how to do business cycle stabilisation? No.



The three components which seem to have kicked in are: (a) The decline in the share of agriculture; (b)  Investment / inventory cycles rooted in the behaviour of private firms and financial markets and (c) Capital account integration. The fading away of agriculture gave a reduction in the volatility of GDP. Investment and output are now positively correlated thanks to the new investment/inventory cycle that is rooted in the private sector. Pro-cyclicality of capital flows helps explain higher consumption volatility.



A great deal of knowledge in Indian economics was rendered obsolete when India changed from being a closed and poor country to being an open and middle-income economy. We now need to construct a new edifice of empirically grounded knowledge that will help us think about where we now are. This paper will be a key component of this reconstruction.

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Autonomy for the CBI: Desirable but non-trivial

I wrote an article in the Economic Times today about autonomy for bodies such as the CBI. 

There are five areas where there is a role for autonomy. But this is a difficult puzzle in public administration and we should be wary of simplistic solutions. We know a bit about how to do autonomy correctly in three areas (monetary policy, financial regulation, infrastructure regulation). Comparable cogitation is required for the other two problems (criminal investigation, tax administration).

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The arrogance of power

Yu Hua has a great piece in the New York Times titled In China, Power is Arrogant where he says:

Several of these rules have since been revoked, but their wacky and arbitrary nature demonstrates the arrogance of power in China. One can imagine all too easily their creators — sitting in comfortable armchairs, drinking high-grade tea and smoking fine cigarettes — discussing the issues at hand as if they were purely intellectual abstractions, never considering how ordinary people might react. That people will be unhappy is no cause for concern because, for so long, the power of the state has trampled on individual rights. Only when rules are so onerous that they stir actual protest do higher-ups take notice: “You guys are just making a mess of things,” they’ll tell their bureaucrat underlings.

This is in China, where the law is a bit of a joke; they do not have a Constitution, an independent judiciary, and the rule of law. Sadly, I often feel similarly about regulation-making in India, where we have much more rule of law, and the law matters much more!



It is rare and unusual, in liberal democracy, for Parliament to contract-out the power to make law. We do this, with regulators. Regulators are bodies created by Parliament and given the power to issue law. The agencies, and unelected bureaucrats, that issue law should be possessed with thought and care in wielding this power. All too often, they are not. Regulation-making in finance, all too often, is devoid of reason.



The draft Indian Financial Code, drafted by FSLRC, features an elaborate regulation-making process -- with details encoded into the law -- that will check such abuses and help bring more sanity to the outcome. It requires that regulators walk through the following steps:

1. What is the market failure that I have identified? Can I demonstrate that this is a market failure?


2. Is solving this market failure within my objectives as stated in the law?


3. What intervention am I proposing?


4. Is this intervention within my powers?


5. Will the proposed intervention hit at the claimed market failure? (All too often, financial regulators in India talk about a certain stated malady and then propose an intervention which does something unrelated).


6. What costs will this proposed intervention impose upon society? Will these costs be larger than the benefits?

This six-step procedure will have to be followed by regulatory agencies, when the Indian Financial Code is enacted as law. This will force staff of regulators to think more and speak in the public domain about what they are thinking. Documentation answering these six questions will have to be released into the public domain. This will achieve two things: Market participants will not be caught by surprise, and criticism (if any) will be voiced by independent observers and stakeholders. The regulatory agency will then have to respond to criticism, also in the public domain. The board of the agency (no less) will take in all this documentation and decide whether to issue the regulation and in what form. The documentation tabled in Parliament will also reflect this full process; it will not merely be the text of the regulation.

Compare this idealised process against a recent episode: RBI regulation on Indian entities owning overseas trading facilities that trade on Indian underlyings. Here is the full text of the RBI `regulation':

2. It has been observed that eligible Indian parties are using overseas direct investments (ODI) automatic route to set up certain structures facilitating trading in currencies, securities and commodities. It has come to the notice of the Reserve Bank that such structures having equity participation of Indian parties have also started offering financial products linked to Indian Rupee (e.g. non-deliverable trades involving foreign currency, rupee exchange rates, stock indices linked to Indian market, etc.). It is clarified that any overseas entity having equity participation directly / indirectly shall not offer such products without the specific approval of the Reserve Bank of India given that currently Indian Rupee is not fully convertible and such products could have implications for the exchange rate management of the country. Any incidence of such product facilitation would be treated as a contravention of the extant FEMA regulations and would consequently attract action under the relevant provisions of FEMA, 1999.

and here is an opinion piece by Ila Patnaik about it.

RBI is perfectly within its powers in issuing this -- and that is the problem with the existing laws. However, this behaviour of RBI is riddled with problems:

• Regulation making should be the power of the board and not of officials. It should go through a full formal regulation-making process. This one has not.


• The announcement by RBI came out with zero notice. It suddenly imposes negative consequences on MCX and Financial Technologies. This is not fair.


• The regulation really makes no sense. What is the economic objective that is being pursued? What is the cost that is being imposed? What do we gain as society from it? The document says nothing. It is a statement of arrogant power, that reminds me of the stories about China at the outset.

Suppose the economic objective was blocking FEMA violations that might take place through such structures. If so, the intervention proposed should directly address these. Suppose the economic objective was blocking PMLA violations that might take place through such structures. If so, the intervention proposed should directly address these. In either event, it is important for RBI to fully articulate what is the problem they're trying to solve; under the present law they have no obligation to say what they are trying. The present law creates arrogance of the regulator.

This is just an example. I see this all the time with RBI, SEBI, FMC, etc. Regulations are issued in much the same mode as the Chinese story: `One can imagine all too easily their creators — sitting in comfortable armchairs, drinking high-grade tea and smoking fine cigarettes — discussing the issues at hand...'.

Under the rule of law, the power to write law is a sacred one, and should be exercised with commensurate care. The present structure of financial law in India is riddled with bad laws that feature inappropriate delegation of powers to semi-autonomous agencies that are not sufficiently careful about using this power, that are arrogant in their use of this power. The regulation-making process of the Indian Financial Code will put regulation-making on a sound foundation, and prevent episodes like this one.

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What ails the police?

by Pradnya Saravade and Renuka Sane.





The recent incidents of rape in Delhi have led to public outrage and calls for resignation of the Delhi Police Commissioner. The problems in police functioning and the unmet expectations of the people are not restricted to Delhi alone. There is a sense of distrust and dissatisfaction with police organisation and operations across the country. In a survey by Transparency International and the Centre for Media Studies, the police topped the list on both perception of corruption and actual experience with corruption. The challenge of police reforms looms large, and an inadequate response may prove to be very costly to not just economic growth, but overall social stability of the country.





It is important to think of three aspects of police operations:

• Manpower
  
  


• Competence
  
  


• Accountability

Manpower

The number of policemen per 100,000 people in India in 2011 was 137. This compares to about 217 in Australia, 393 in Hong Kong, 370 in Malaysia, 195 in South Korea, 307 in the UK and 256 in the USA.



The overall average masks remarkable variation within states in India. The first column (1) in the Table below on the four most populous states from the four regions in India sourced from the National Crime Records Bureau, shows that Bihar and Uttar Pradesh have only 65 and 94 policemen per 100,000 population, a very low number even by Indian standards. These statistics reflect a very low presence of police personnel on the streets and consequently a high work-load on those on duty.

	(1)	(2)
State	Per 100,000 population (2011)	Police expenditure (% of total expenditure) (2012-13)
Uttar Pradesh	94	5.2
Bihar	65	4.5
Maharashtra	163	4.8
Andhra Pradesh	106	3.1

Competence

The State may increase recruitment into the police force over the next few years. For policing to be effective, however, the policemen need to be competent to serve the population on local crimes: from murder and rape to kidnapping and burglary, handling mass agitations of an aggrieved public against the State in a sensitive manner, and also getting into action during terrorist strikes utilising a completely different skill set. The increasing demands on all of the above require that the police undergo continuous training and upgradation of skills, and be well equipped with the latest technology and weaponry.

It is, then, not just a matter of hiring more policemen but also a matter of devoting top management time to organising the police force well, and ensuring adequate inputs of equipment and training.



The second column (2) in the Table above, sourced from States of India, CMIE, shows that the expenditure on police in the four states is about 3-5% of total expenditure.

A large part of this expenditure is on the maintenance of the existing police machinery. There is little scope for the police to invest in training and upgradation of skills. This expenditure on policing is not enough to even cater to the basic needs of staff and equipment.

Accountability

The efficiency with which spending is converted into public goods outcomes depends on accountability mechanisms. Ultimately, the test of the effectiveness of the increase in police strength and expenditures is the resolution of crime, and satisfaction of the public on the service provided by the police machinery. There has been dissatisfaction on the evaluation system of police organisations, and a Supreme Court judgement required the setting up of state security commissions in every state. One of the mandates of these commissions is to develop a framework that measures performance through crime victimisation and police perception surveys. As yet, no state has done this. There was one randomised experiment which included a crime victimisation survey in Rajasthan. However, it has not been institutionalised as part of police policy to be followed up at regular intervals. Unless a well conceived survey based feedback loop is established, and becomes a periodic feature of the policy on policing, accountability on the desired outcomes cannot really be expected.

Conclusion

The personal safety of citizens is a public good. It satisfies the two tests for a public good: it is non-rival (your consumption of safety does not diminish my safety) and non-excludable (we cannot exclude a new born child from the blanket of safety).



The desire for safety is the most basic human impulse. To some extent, sectarian impulses amongst common people in India may be driven by the unmet requirement for safety in individuals who then resort to embracing kith and kin in the quest for safety. Without safety, the project of building prosperity through a market economy will stall, as the operations of complex firms break down when faced with criminality and the threat of expropriation dulls the incentive to work.



The republic needs to do more in terms of building a world class criminal justice system, and achieving safety for all. This requires improvements in laws, courts and police. For the police, this requires getting more policemen, transforming their training, equipment and management, and establishing accountability mechanisms.

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Interesting readings

In continuation
of Capacity
constraints in public
policy, India
will double the size of its diplomatic staff. And,
see Milan
Vaishnav in Foreign Affairs.

India
is Asia's dharamshala -- why not learn to love it? by
R. Jagannathan on Firstpost.

The
crisis in our community by Nilanjana S. Roy in
the Hindu.

How
to tell if your neighbour is a bombmaker by Scott Stewart
of Stratfor.

href="http://economictimes.indiatimes.com/opinion/comments-analysis/the-law-that-can-kill-ponzis-once-for-all/articleshow/19774738.cms">K. P. Krishnan,
Smriti Parsheera and Suyash Rai in the Economic Times on
Saradha and the IFC.

href="http://www.business-standard.com/article/economy-policy/learning-from-the-inflationary-mistakes-of-the-past-113042900447_1.html">Shanu
Athiparambath in the Business Standard on the objective of
monetary policy in India.

href="http://telegraphindia.com/1130416/jsp/opinion/story_16742473.jsp#.UXYB-r9ZJzo">An
unusual commission by Ashok V. Desai in the
Telegraph. href="http://www.livemint.com/Money/nkpAhAcZpmFuIBgc9hd8IO/Hurdles-to-new-financial-code.html">Hurdles
to new financial code by Monika Halan in Mint.

href="http://www.livemint.com/Money/Zd9W7iZSREdEexjiIEstCL/363-banking-costs-the-poor-money.html">Monika
Halan in Mint on lazy banking that costs the poor
money.

T. B. Kapali
in the Hindu Business Line worries about accountability of
financial regulators.

T. K. Arun
in the Economic Times on the root cause of the Saradha
scandal. Editorial
in the Indian Express about ponzi schemes raging in Indian
finance.

Smriti
Parsheera on mylaw.net about FSLRC.

Anuradha
Guru and Prachi Misra in the Financial Express on
systemic risk in the Code.

An
interview with Justice Srikrishna on barandbench.com.

In continuation
of Real
estate - an asset class?,
see Why
property is the biggest con-job on investors by
R. Jagannathan on Firstpost.

href="http://www.livemint.com/Money/xObjKkzAAHbilmQ3gTFTaK/Sebi-takes-a-good-first-step-in-reviewing-risk-management.html">SEBI
takes a good first step in reviewing risk management by Mobis
Philipose in Mint.

India's
poor crisis resolution regime by Radhika Pandey and
Sumathi Chandrashekaran in the Business Standard.

href="http://www.zdnet.com/windows-its-over-7000013964/">Windows:
it's over by Steven J. Vaughan-Nichols wonders about what
will happen to Microsoft Windows, now that both Windows and the PC
are in a slump.

href="http://www.businessweek.com/printer/articles/110848-multiplayer-game-eve-online-cultivates-a-most-devoted-following">Ashlee
Vance in BusinessWeek tells a story about `Eve' that I
found rather remarkable.

Seven
traits of highly creative people.

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Real estate in India is not a great asset class

Most people in India are convinced that investing in real estate is a great idea. In the Economic Times today, I have an article titled Real estate in India is not a great asset class.



Economic Times had carried this as a `poke me' feature, where reader comments are invited. There are 186 comments there as I write this, and they are broadly hostile to what I have written. I would get nervous about the price of any asset where a strong majority of market participants think there are great returns in store.

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