Seminars by Sanjay Banerji (today) and Tarun Ramadorai (Thursday).
Monday, 26 September 2011
Friday, 23 September 2011
What in the world is happening to the rupee?
Posted on 00:22 by Unknown
The INR/USD rate is now nudging Rs.50 to the dollar. This is a big
move over a short period: a depreciation of 12.1 per cent over the 84
days from 1 July till 23 September.
What fluctuations of the INR/USD can we reasonably expect?
After the rupee became a float, so
far, it has had average volatility of roughly 9 per cent
annualised. Roughly speaking, this means that over a one year horizon,
the movement over a year would range between -18 per cent and +18
percent, with a 95 per cent probability. More extreme movements would
happen with a 5 per cent probability.
Over a period of 84 days, roughly speaking, we'd have expected this
95 per cent range to run from -8.6 per cent to +8.6 per cent. Compared
with that, a 12.1 per cent move is a bit unusual.
It's only a bit unusual because the historical volatility of the
INR/USD, in the period of the float, was rather low. The USD/EUR rate,
which is perhaps the world's most liquid market, has had an annualised
volatility from January 1999 onwards of 10.3 per cent. The INR/USD has
got to surely be more volatile than this, given the inferior liquidity
of the INR and given the greater macroeconomic volatility in
India. Hence, I think we should consider the 9 per cent vol, that was
seen in the early days of the float, as relatively unusual. The future
will most likely hold bigger values for this vol.
The implied volatility of the INR/USD
the NSE has reared up to values like 14 per cent annualised. That
sounds more sensible to me.
What about other currencies?
We tend to do wrong by focusing too much on the bilateral INR/USD
rate. In the recent days of distress, as fear has resurged, people
have taken money out of everything under the sun and put it into US
Treasury bills. This has given a strong dollar at the expense of
essentially every other currency. Here's the picture for the INR,
against the four major currencies of the world, from 1 July till 22
September:
| 1 July | 22 Sep. | Depreciation | |
| (per cent) | |||
| USD | 44.585 | 48.821 | 9.50 |
| EUR | 64.804 | 66.103 | 2.00 |
| JPY | 0.553 | 0.636 | 15.01 |
| GBP | 71.720 | 75.481 | 5.24 |
The picture of the rupee is much more complex than that implied by
simply watching the bilateral rupee/dollar rate.
Can RBI block such a large depreciation?
Let's think through the steps which would follow if RBI tried to
sell dollars in trying to prop up the INR:
- Global trading in the INR stands at roughly $75
billion a day. If you want to manipulate this market, you need a
big stick. Small trades will do nothing. If preventing INR
depreciation is the goal, RBI has to go into this with trades of $2
to $5 billion a day, with the willingness to stick it out for the
long run. With reserves of $281 billion, there is not much hope
here. Specifically, if RBI sells $80 billion in reserves, the market
will see that. They will know that further rupee defence is now
going to be hard (since $200 billion of reserves is starting to look
like a small hoard), and speculators across the world will start
betting that RBI's defence of the rupee will fail.
- Reserve money is only $275 billion. For each $27.5 billion that
RBI sells, reserve money drops by 10%. At a difficult time like
this, a sharp and sudden monetary tightening will be an unpleasant
side effect of defending the rupee. (This trading can be sterilised,
but that has its own problems. I just want to emphasise that selling
reserves is not easy and is not a free lunch).
- The rational speculator knows that the exchange rate will
eventually find its level. When RBI prevents a large INR
depreciation today, they are giving a free lunch to the speculator,
who would take a bet that INR would depreciate in the
future. Specifically, it would be efficient for domestic and foreign
investors to dump assets in India, take money out at (say) Rs.45 to
the dollar which is the artificial price, wait for the gradual
depreciation to Rs.50 to the dollar, and come back into India to buy
back the same assets. This trade generates 11% returns over a short
period and is thus very attractive. In other words, a defence of the
rupee would trigger off an asset price collapse in India.
Meddling in the affairs of the currency market is thus highly
ill-advised for a central bank.
Should RBI try to block INR depreciation, even if they could?
Let us play a thought experiment where RBI had $2810 billion,
i.e. 10x larger than what's with us today. In that case, RBI could
play in the currency market, selling $2 to $5 billion a day for a year
without serious distress. Is this a good idea?
I would argue that this is not a good idea. When times are bad, the
rupee should depreciate. This drives up the profit rates of all
Indian tradeables firms and thus bolsters the economy.
Under a floating rate, in good times, the INR appreciates (which
pulls back the exuberance of tradeables) and in bad times, the INR
depreciates (which fuels profits and thus the physical investment in
tradeables). This is arguably the only element of
in Indian macroeconomic policy.
RBI is playing this mostly right
From early 2007 onwards, the INR has been quite flexible. In
particular, after early 2009, RBI's trading on the market has tailed
off. There have been a few months with minor amounts of trading by
RBI. This trading has mystified me, since these small trades can do
nothing to influence the price. In practice, the INR has been a
float.
A floating exchange rate is exactly the right stance for difficult
times like this. In bad times, the best thing that can happen for
India is a big INR depreciation, thus bolstering the tradeables
sector.
Let's evaluate an alternative policy platform: To peg the INR in
normal times but to let go in difficult times. Is this feasible?
Yes. But this is very disruptive: if economic agents have been given
an implicit promise that the INR will not move, then the large move
(which will surely come) would cause pain. It is far better to stay
out of the market all the time, and create a trustworthy structure of
expectations in the minds of economic agents about what the future
holds.
We had a large depreciation in the crisis of 2008, and that served
India well. In similar fashion, we should welcome the INR depreciation
that is accompanying global gloom.
The only element of RBI policy where I have a major disagreement is
communication. RBI has never used the words floating exchange
rate. RBI needs to clearly communicate to the economy that the
rupee is now a market determined exchange rate, and RBI is no longer
in the business of trading in this market. There is greater clarity of
thought at RBI as compared with the quality of communciation; the
speech writing still suffers from twinges of 1960s economics.
What is the collateral damage of a large INR depreciation?
There are three things that go wrong alongside a big INR
depreciation:
- Firms who have unhedged foreign currency borrowing get hurt,
because they have to pay back more than anticipated. A person who
borrowed Rs.100 (in unhedged USD) has to pay back Rs.110, owing to
the 10 per cent INR depreciation. The stock market is doing a fine
job of identifying these firms and beating down their stock prices.
Of crucial importance is the fact that from early 2009 onwards, the
INR had already moved to a float with a 9 per cent annualised
vol. So CEOs and CFOs knew that the INR/USD rate was going to
fluctuate. They were not lulled into complacence thinking that the
exchange rate was going to be stable. By avoiding this moral hazard
associated with pegged exchange rates, RBI's decision to float
in early 2009 laid a good foundation for the structure of firm
borrowing as of July 2011.
When a country has a pegged exchange rate, you tend to see a big
buildup of unhedged currency exposure on corporate balance
sheets. When the big depreciation comes, the big businessmen then
queue up to the central bank begging for defence of the
LCY. Prevention is better than cure: It is far better to have high
exchange rate volatility all along, so that firms do not undertake
such risks, and the toxic political economy does not come into
play.
- With an INR depreciation, tradeables become costlier. On
one hand, this bolsters the profitability of tradeables firms, and
thus their investment plans. But at the same time, this feeds into
inflation. In recent months, tradeables inflation has been sleeping
while non-tradeables have contributed to the high CPI-IW
inflation. We will now see a resurgence of tradeables
inflation. This will exacerbate the inflation crisis. RBI will need
to stay on the project of raising rates in order to combat this
inflation.
- The government's subsidy program with petroleum products and
fertilisers gets costlier when the INR depreciates. So India's
fiscal crisis gets a bit worse when the INR depreciates.
This logic is rooted in high levels of de facto capital
account openness. Sometimes, policy analysts think that you can have
your cake and eat it too, and try to dodge these arguments by
utilising capital controls.
has not worked in India, and the levels of de facto
openness have only grown through the years.
In summary, what should RBI be doing?
RBI should be focused on using the short-term interest rate as a
tool to bring CPI-IW inflation under control, without distortions of
interest rate policy caused by trying to meddle in the currency
market. This should be accompanied by liberalisation of the
Bond-Currency-Derivatives Nexus so as to achieve an effective monetary
policy transmission. These are the two things that RBI needs to focus
on.
India shifted away from government interference in the currency
market, from 2007 onwards but particularly after 2009. This is one of
the biggest achievements in India's economic liberalisation. This is a
bigger issue in economic liberalisation than (say) decontrol of
petroleum product prices. The INR is now a market. Nifty and INR are
the two most important markets in the economy. It is time for all of
us to analyse the INR as we analyse Nifty: as the outcome of a market
process.
Is RBI back to trading the INR?
We don't know. The data only comes out at monthly resolution, with
a two month lag. But early signs that would show up would be unusual
jumps in the weekly data about reserves, reserve money, etc. Greater
transparency from their side would help greatly.
Posted in business cycle, capital controls, currency regime, monetary policy, reserves, socialism
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Tuesday, 20 September 2011
Seminar: "Contagion in international financial markets"
Posted on 20:22 by Unknown
Monday, 19 September 2011
Interesting readings
Posted on 06:15 by Unknown
nice story about UIDAI, by Lydia Polgreen, in the New York
Times.
A new insight into India's north-east states:
are part of a region provisionally named Zomia. An interesting
article in the Chronicle of Higher Education by Ruth
Hammond. The book.
On 21 April 1956, Jawaharlal Nehru did
the first
convocation address at IIT, Kharagpur. It's a good read, and
it's surprising how much of it makes sense in 2011. E.g.: in the
larger context of history, and looking at it in this way it seems to
me that at the present moment there is no more exciting place to
live in than India. Mind you, I use the word exciting. I did not use
the word comfortable or any other soothing word, because India is
going to be a hard place to live in. Let there be no mistake about
it; there is no room for soft living in India, not much room for
leisure, although leisure, occasional leisure is good. But there is
any amount of room in India for living the hard, exciting, creative
adventure of life. In case you have not yet seen the
commencement speech, it is worth watching.
civilised: Literature festivals in India, by Abhilasha Ojha in Mint.
A
story from rural India about the differences between boys and
girls on mathematics, by Maia Szalavitz in Time magazine.
to blame for India's inflation and
Inflation Is a Lesson for Fast-Growing Economies by Alex
Frangos in the Wall Street Journal.
do stock futures dominate price discovery? by Nidhi Aggarwal
and Susan Thomas, IGIDR working paper, has some surprising results.
Chandrasekaran and Vidya Padmanabhan, in Mint, on Indian
ventures into farming in Ethiopia.
Dayal in the Business Standard on the huge opportunities in
better India-Bangladesh relations.
Mobis
Philipose in Mint, on recent developments in SEBI and
on currency derivatives trading.
need a Hazare in the financial sector by Tamal Bandyopadhyay
in Mint.
Subramanian in the Business Standard.
member to PM: ID leaked, family at grave risk by
P. Vaidyanathan Iyer in the Indian Express.
to Fin Min: Probe both sides' complaints by Ritu Sarin in
the Financial Express. And,
in India Today.
between Abraham, SEBI, finance ministry gets murkier by Appu
Esthose Suresh in Mint.
Court wants petition on SEBI refiled by Nikhil Kanekal and
Appu Esthose Suresh in Mint.
first and then
second article on these issues, by R. Jagannathan, on
FirstPost. An
in the Business Standard.
Bhattacharjee in the Financial Express.
on post offices as banks (on firstpost). And, you might like this
document.
China's A. Q. Khan problem: an article by
Wines in the New York Times.
great story by Anthony Shadid in the New York Times about
being on the run in Syria.
A
article by Paul Berman, in the New Republic, about
Islamism.
is it so hard to find a suicide bomber these days by Charles
Kurzman, in Foreign Policy.
Love and war, by Janine di Giovanni, in the
New York Times.
What's next for
the dollar? by Martin Feldstein.
Craig has a great profile, in the New York Times, of how
Howard W. Lutnick brought Cantor Fitzgerald back to life after the
firm was savaged in the 9/11 attacks.
Sunday, 18 September 2011
Paying for liquidity provision on exchanges
Posted on 09:44 by Unknown
Market making versus the electronic limit order book
Exchanges in India all operate as electronic limit order book
markets. There are no `market makers'; there is just a publicly
visible limit order book. Anyone is free to supply liquidity, by
placing limit orders. The person who places market orders is the
consumer of liquidity: he pays market impact cost. [
the jargon].
Prior to the rise of the anonymous limit order book, there used to
be a great deal of effort on thinking about the market maker. Market
makers played a big role in many old markets. E.g. at the NYSE, the
`specialist' was obliged to provide liquidity. RBI established
`primary dealers' thinking that they would provide liquidity.
These market structures involved complicated problems of measuring
the liquidity provision by market makers, correctly compensating them,
avoiding monopoly power in the hands of the market market, and
enforcing against market manipulation by the market maker. The rise of
the open electronic order book cut through this Gordian knot.
For many years, there used to be a debate about whether the
anonymous open limit order book market (where anyone can provide
liquidity) is better or worse than a market maker market (where limit
orders can only be placed by one or more market makers). That debate
died down in the 1990s with the success of the electronic limit order
book.
Market making on the electronic limit order book
But even on a limit order book, does it make sense to pay one or
more market makers to provide liquidity? The public would be free to
place limit orders, but one or more market makers would be paid to
place limit orders.
The positive argument runs like this. In the life of every
contract, at first there is a lack of liquidity as various market
participants are reluctant to take the plunge and trade on an illiquid
contract. This leads to a chicken and egg problem. Illiquidity
inhibits participation, and the lack of participation is
illiquidity.
From a regulatory perspectives, exchanges might try to make
payments for liquidity provision (or outright turnover) by various
underhand means. If that is going to happen, then it is better to have
this come out into the open.
But there are also important problems that can come out by going
down this route. The resources that an exchange puts into portraying
tight spreads or high turnover could potentially be used to improve
services for customers. Market participants would make wrong decisions
about an investment decision when they see a product as looking liquid
on screen, whereas this liquidity is actually artificial: the screen
would be falsely portraying liquidity. When exchanges compete on
payments to market makers, this can degenerate into a slugfest where
the deepest pockets win.
The artificial liquidity pushed by mercenary market makers would
tend to lull the exchange into complacence. In the absence of market
making, the exchange would run harder to solve problems of market
mechanisms and contract design, and to get the word out about the
contract.
Recent developments in India
On 2 June 2011, SEBI chose to move ahead with the specification of
a `
Enhancement Scheme' (LES).
By these rules, LES is applicable for individual stocks where the trading volume on
the last 60 days is below 0.1 per cent of the market
capitalisation. (How would this be scaled to derivatives such as
currency futures, where market capitalisation cannot be defined?) I
think this makes sense. The LES would be used to kickstart liquidity
when it is abysmal. The moment a small amount of liquidity comes
about, the LES would step aside.
Based on these rules,
announced a program for market making on the derivatives products
recently launched at the exchange: on the S&P 500 and the Down
Jones Industrial Average (launched in partnership with the Chicago
Mercantile Exchange). These incentives are over and above the absence
of charges by the exchange. I was disappointed to see a payment
based on mere turnover. This would give the market maker an
incentive to do circular trading and thus show a lot of trades. But
turnover is not liquidity.
This program came into effect on 15 September. It may matter more
in the coming week, given that new contract series start trading from
tomorrow.
Will it matter? How will we know that it mattered?
Derivatives on the S&P 500 and the Dow Jones indexes have
gotten off to a surprisingly good start, even though there was no such
program. This has perhaps been helped by unusual levels of volatility
in the US after the launch of these contracts.
The early days of a contract can be a rollicking ride and even
after these time-series fall into place, it will not be easy to tell
whether LES was useful in the history of these contracts or not.
Similar thinking is taking place at BSE also: See
BSE's biggest initiative work? by Mobis Philipose in
Mint. The text there -- obligations such as providing
two-way continuous quotes within specified parameters for quote size
and spread -- sounds good, but here also there are payments per
crore of turnover. By and large, the payments being made at BSE look
much bigger than those at NSE.
In the case of BSE, if LES is able to lift BSE out of zero market
share in derivatives trading, even after the six month period has
expired, then it would be a clear proof that the LES helped. So this
experiment is unlike that of NSE where it will be hard to evaluate
whether or not the LES mattered.
Tuesday, 6 September 2011
The reversal of reforms on the New Pension System?
Posted on 23:11 by Unknown
In December 2002, the NDA made a very big move in pension reforms. They decided that from 1/1/2004 onwards, all new staff recruited into the government would be switched out of the traditional defined-benefit pension and instead placed into a new individual-account defined contribution pension system. This was one of the major achievements of the economic reforms of that period. For a conceptual picture of the New Pension System (NPS), see this article, and for a story of that period, see this article.
An essential feature of the NPS was that it was a defined contribution system. India has a long history with getting into trouble with guaranteed returns. UTI's assured return schemes turned into a problem for the exchequer. EPS, run by EPFO, is bankrupt. When pension promises are made, they require peering into many decades into the future and arriving at estimates of longevity and asset returns. In the best of times, it is hard to make such estimates; honest mistakes are possible. In addition, when governance is weak, there are political pressures to make extravagant promises, which will look popular right now but generate staggering costs for the government in the future. As an example, rough calculations show that the implicit pension debt on account of the traditional civil servants pension in India (the one which was replaced by the NPS) stand at roughly 70% of GDP. This is a very big price to pay, for a tiny sliver of the workforce.
The NDA did the unpopular work of switching new recruits out of the defined benefit pensions. But the UPA did not follow through appropriately. At first, many years were lost in hoping that the CPI(M) would come on board the reform. After that, the legal engineering was put into place in order to get an NPS up and running without requiring the legislation. This process was slower than what one might have desired, but it has been making inexorable progress.
But now, a new existential threat seems to have come up : the Parliamentary Standing Committee on Finance seems to be saying that the fundamental idea of the NPS -- defined contributions -- should be scrapped. This would amount to a major reversal of India's economic reforms.
On this subject, see:
- Reportage in the Hindustan Times.
- How PFRDA Bill proposals change NPS structure, by Deepti Bhaskaran, in Mint.
- Editorial in Mint.
Monday, 29 August 2011
Vijay Kelkar
Posted on 03:24 by Unknown
Financial Express recently did a special feature about 20
interesting people in India's economic reforms. In that, I wrote
this profile of Vijay Kelkar.
Vijay Kelkar's is a fascinating story in Indian public policy. He
started out as an economics Ph.D. and turned himself into a consummate
policymaker. While he did many interesting things in the field of oil
and gas, and as executive director of the IMF, I worked with him in
his fiscal phase.
This involved carrying forward the tax reform agenda of the 1990s,
translating the intent of the FRBM Act into a concrete workplan,
leading the transformation of income tax administration through
innovative institutional arrangements in the form of the Tax
Information Network (where the implementation was contracted out to
NSDL), analysing and championing the Goods and Services Tax (GST) and
leading the 13th Finance Commission.
For most people, the idea of the fiscal reform is exhausting. Fiscal
systems have many moving parts, and suffer from the political economy
problem of entrenched beneficiaries. I used to get astonished at the
way Kelkar, who is 20 years older than me, consistently found the
energy and morale to go back into the fray again and again, chipping
away at solving long-standing problems. This also taught me that while
weary cynicism is a more fashionable pose, progress is only achieved
through the dint of boundless optimism.
Practical people are often dismissive of the world of ideas, but that
is not the Kelkar that I have known. For one thing, he made a point of
reading the current global research in economics on an astonishing
scale. I have been frequently humbled in finding that his knowledge of
the current literature was better than mine. I suspect his years at
the IMF were very useful in tooling him up in modern open economy
macroeconomics, which is often a gap in the knowledge of those who
experienced a closed India in their formative years. Kelkar has always
encouraged me, saying that in an open society, ideas matter, so it was
important to build good ideas, and to push important messages out in
the public domain, even when this makes many people uncomfortable.
After decades of engagement, Kelkar is no longer active in the public
policy work of the New Delhi community. However, he has begun a stint
as chairman of the National Stock Exchange (NSE). Given the immense
importance of the equity market in the Indian economy, and the immense
complexity of ownership and governance of stock exchanges, it is
indeed valuable that a person of his wisdom is performing this public
service.
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