Blindly sending money down leaky pipes

Proposals to spend more on government programs in India are generally criticised on the grounds that this is sending more money down a leaky pipe. In addition to the problem that the pipes leak, there is an equally big problem that we have no idea about what happens at the other end.



In order to build and refine a system, the first foundation that has to be laid is that of measurement. What you measure is what you can manage. In India, all too often, government agencies and programs start out with lofty ambitions, and embark on spending money to get there. But there is little measurement about the extent to which those objectives have been achieved. Under these conditions, there is little chance of programs being designed properly, and of wastage and theft being checked.



I was reminded of this as I read As Dengue fever sweeps India, a slow response stirs experts' fears by Gardiner Harris in the New York Times. There may be an epidemic of Dengue out there. Or there might not be one. The point is, we just don't know. The statistical system simply does not measure this.

A public goods perspective

What should government do, and what should government not do? The government should work on the provision of public goods and stay out of private goods. In the field of health, what are the public goods and what are the private goods?



When I have a toothache, and I go to a dentist, and I get better, this is a private good. Yet, most government spending is oriented towards building `primary health centres' and hospitals and such like. Even if these worked well -- i.e. even if they were not characterised by theft and incompetence -- they are a bad use of public money as they deliver private goods and not public goods.



A public good is something that is `non-rival' (my consumption of that good does not reduce your access to it) and `non-excludable' (it is not possible to exclude me from benefiting from this good). The best example is clean air. My breathing in clean air does not diminish the amount of clean air available for you. When one more child is born, it is not possible to exclude him from benefiting from clean air.



What are the public goods in health? A few examples that come to mind:

• Statistics. Measurement of what is going on about health in India.


• Epidemiology. Tracking down and eradicating Smallpox. Mounting a response to fresh strains of the common cold.


• Running public systems that measure and ensure that medicines are not counterfeited, are properly stored in a cold chain.


• Running certification systems. Enforcing against quacks that practice medicine.


• Getting research done on diseases that matter on India, and releasing the findings into the public domain (i.e. unencumbered by patents).

We in India have this essentially upside down. Health policy in India is unfortunately shaped by the views of doctors, and is low on skills in public economics. We like to focus on Primary Health Centres that are run by the government, and we cut corners on all the five critical public goods listed above.

It is fashionable to say that India should spend more on health. I would advocate spending less on the things that the Indian government does in health. Until the pipes are fixed, we should be closing the taps.

An objectives-and-accountability perspective

The Indian State is in a crisis. The two key factors at work are mission creep and a lack of accountability.



Mission creep has set in because in India, almost any do-gooding is seen as the responsibility of the State. We need to narrow the mission statement of the State to a tangible set of public goods. Clarity of mission, and a controlled and narrow mission, is of essence to obtaining performance.



Consider the principal-agent relationship between you and your contractor. If the contractor is failing to deliver, you would narrow down the specifications given to him, and monitor him tightly to make sure the work gets done. That is precisely what we need to do, in the principal-agent relationship between citizens and the State. The State has failed on a sprawling mission. We need to narrow down the tasks given to the State, and tightly monitor the delivery of results.



Government and government agencies will work well when they have narrowly defined functions and strong accountability mechanisms. In the field of health, absent measurement of health outcomes, there is no accountability.

Conclusion

Is there a Dengue epidemic in India? We don't know.



An information system about the health of the people of India is a public good. It should achieve pride of place in the responsibilities of the State. However, health expenditures in India are squandered on private goods. To add insult to injury, there is theft and incompetence, so even these attempts at delivering private goods do not work so well. But the main point is that running PHCs and hospitals should not be done, even if the Indian State had the ability to run these things well.



In order to reconstruct the Indian State, we need to push on the combination of narrowing the mandate (focusing on a few core public goods) and strong accountability mechanisms.

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Finding the right path in consumer protection

by Anand Sahasranaman.

The recent approach paper of the Financial Services Legislative Reforms Commission has brought a fresh focus on consumer protection. What are the possible frameworks for financial consumer protection in India, and what would be the core elements of an ideal framework? This is the question that the IFMR Financial Systems Design Conference 2012 sought to answer. The Conference titled Envisioning the Future of Financial Consumer Protection in India was held at IFMR Trust, Chennai, on 31st August and 1st September 2012.

The Conference was designed to take a first principles look at financial consumer protection, deliberately setting aside constraints that reflect the current realities of the Indian context of consumer protection. The conference was organised to carry out deliberations around three stylised approaches to consumer protection, namely: an Emphasis on Disclosure, an Emphasis on Eliminating Conflicts of Interest, and an Emphasis on Suitability. In reality, any consumer protection framework would include elements from all three approaches, and the objective in setting up the conference as a debate between approaches was meant to sharply identify the way in which these approaches would fit into an overarching framework for India.

Keeping in mind the two-fold agenda of creating a framework for solving the current failings of the Indian market and providing a meaningful long-term solution for consumer protection in view of the future of Indian finance, Suitability emerged as the paradigm of choice to be placed at the heart of the consumer protection framework for India. The Suitability framework shifts the onus of consumer protection from the buyer to the seller of financial services through legal liability on the latter. However, it was also felt that very important aspects of Disclosure and Eliminating Conflicts of Interest would need to be built around this foundation of Suitability.

A Suitability Framework

Suitability is defined to be a process that pervades all functions within financial services manufacturers, intermediaries, and their representatives, such that at all points of time, the provider acts in the best interests of the consumer. The power of the Suitability framework will derive from the imposition of legal liability on financial services providers to act in the best interest of consumers, and thus decisively shift the onus of consumer protection from the buyer to the seller.

Suitability will not take away the right of the consumer to choose. The final decision, on whether to accept the financial advice or buy the product recommended by the seller must always lie with the consumer. What Suitability is meant to ensure is that the consumer gets expert unbiased recommendations that are in her best interest.

For Suitability to be realised, every citizen must have the right to be provided suitable advice or recommended suitable products. The principle of Suitability needs to be enshrined in mother regulation and the interpretation of suitable behaviour would be best determined by the build-up of case law precedents over time, thus ensuring that our understanding of Suitability comes from the realities of the financial marketplace and its evolution over time

Role of Disclosure in Suitability Framework

India has so far relied on caveat emptor, or a disclosure based framework of consumer protection. Participants however noted the fact that increased disclosure has resulted in information-overload for consumers and, along with behavioural biases, led them to make sub-optimal decisions resulting in bad financial outcomes. Despite this, it was felt that there were aspects of Disclosure that would be essential in a Suitability framework. Within the Suitability framework, it was felt that disclosure of real time transaction level data that could be meaningfully analysed be analysed by neutral third parties - industry analysts, financial advisors, market aggregators, media - or "wholesale" consumers could be useful in developing comprehensible welfare enhancing consumer-level outputs. Other aspects of Disclosure such as the need for comparators and benchmarks for products, and the need to make some financial terms commonly understood were also deemed important.

Eliminating Conflict of Interest in the Suitability Framework

Regulatory regimes all over the world have used a variety of approaches to eliminate conflicts of interest that exist within providers of financial services. The most common approach is to disclose the existence of such a conflict to consumers and let the consumers decide for themselves. Within the Suitability paradigm, however, eliminating conflicts of interest is naturally built through the legal liability channel. Even in scenarios where is it is not possible to separate out advice from sale, given the legal liability in the form of a fiduciary responsibility on the provider, the provider is obligated to ensure that they act in the best interests of the consumer, ahead of their own self-interest.

The conference also raised a number of questions for research on the Suitability framework related to its implementation, legal framework, regulatory and institutional costs as well as lessons from international experiences.

The detailed conference proceeds can be found here.

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Modified dates for financial law seminar

In consideration of a number of requests for extension of the last date for paper submission for Financial Law & Policy: An Inter-disciplinary Approach, the dates for submission of paper and intimation of shortlisted papers have been extended which are as follows:

Crucial Dates

• The last date for submission of the completed paper: November 12, 2012 (23.59 hrs)
• Intimation of shortlisted papers: November 20, 2012
• Date of the seminar: December 01, 2012

Other details about the seminar are as provided in my earlier post.

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Rethinking the Statutory Liquidity Ratio (SLR) in Indian banking

by Harsh Vardhan.




The CEO of a leading bank recently caused a flutter in the banking
community by demanding the abolition of the Cash Reserve Ratio (CRR).
RBI has promptly appointed a committee to look at this issue. The reserve
ratios, CRR and SLR (Statutory Liquidity Reserve), are an important
feature of Indian banking regulation. Alongside the debate about CRR,
and new thinking about how monetary policy should be conducted, we
should also review the SLR. SLR is a much
bigger burden on the banking system and has no role in monetary
policy.

What is SLR?

SLR is the requirement imposed by the regulator on commercial banks
that compels them to invest a percentage (currently 24%) of their Net
Time and Demand Liabilities (NDTL) in approved government securities.
Through this, today, 24% all the resources - deposits and
borrowings - mobilised by commercial banks are invested in
government securities. Currently bank deposits and borrowings are Rs.7
trillion which means that SLR places Rs.1.8 trillion
into purchases of government securities.
SLR creates a significant captive
source of financing its borrowing program. This has three important
implications:

1. SLR reduces the resources available for commercial lending by
   banks. Every rupee deployed in SLR is a rupee not invested in a private
   enterprise that needs capital. There is no free lunch: when capital
   given to the government, it comes at the cost of capital available to
   the private sector. Any reduction in the SLR (as in the CRR) will
   yield more capital for the Indian private sector. It is hence
   important to critically analyse both.
   


2. By creating a large captive source of deficit financing,
   SLR effectively subsidises government at the cost of
   savers and commercial borrowers. When a government has to borrow at
   a competitive rate in the market, the market exerts
   a check on irresponsible fiscal behavior of the
   government. When there is a large captive source of borrowing, the
   government is shielded from the pressures of the bond market and
   is more likely to engage in fiscal imprudence.
   


3. Such a large scale preemption of savings by the government through SLR
   fundamentally distorts the interest rate structure in the economy by
   artificially depressing the yield curve. This complicates the pricing of all assets in the economy.

If we want to "right-size" SLR we have to ask some important
questions:

1. What is the rationale for imposing SLR?
   


2. What
   is the right level of SLR, that is consistent with this rationale and
   does not result in preemption of resources from the banking
   system?
   


3. Are there other conditions that need to be imposed on SLR so
   that it achieves the objectives?
   

The rationale for SLR

What is the conceptual foundation for
the regulator to impose SLR? The answer is: prudence. Banks raise
public deposits with a promise to redeem them at par or more. To reduce the risk of the portfolio of the bank, the regulator ensures
through SLR that at least some part is deployed in the safest assets
available. But if prudence is the reason, what is the right level of
such reserves that will ensure adequate prudence? Could it be that
imposing a requirement as high as 24% is beyond prudence, and is
actually a means for the government to preempt savings in the economy?
It is hence important to ask the next question: What SLR do we need?

 

What is the right level of the SLR?

Banks are in the business
of taking risk. These risks are taken by deploying public
deposits. The most potent weapon that the regulators have used against
excessive risk taking is "risk capital" which the equity capital
committed by the banks owners. In fact, the entire edifice of modern
day bank regulation is based on provision of risk capital as a buffer
against risk taking by banks. If we believe, as do most
regulators, in risk capital as the buffer against risks, then it makes
eminent sense for banks to hold this capital safely. This would
logically lead us to conclude that prudence should demand that the
bank's risk capital be held in very safe assets. In India, the risk
capital requirement is 9% of risk assets which translates roughly to
6.5% of NDTL (given that the risk assets are typically 70% of
NDTL). Therefore, the policy prescription should be: Banks must
hold their entire risk capital in safe assets which should include
both CRR and SLR.



Even if we assume the CRR is zero, this means
that the theoretically right level of SLR would be around 6.5% of
NDTL. If we scan the international landscape, this is the sort of
number that we see in most countries. It is reasonable to argue that
an SLR value above 6.5% of NDTL is motivated by pre-emption and not
prudence. When the regulator prescribes a level of 24% for SLR, 6.5
percentage points are for prudence and the remaining 17.5 percentage
points is really preemption by the government.

The composition of
SLR

The next important question about SLR is about its
composition - what investments should qualify as SLR investments?
Currently securities issued by the sovereign (Central and State
Government bonds) are the only ones that are allowed as SLR
investments. But if we accept prudence as the logic for
SLR, then the regulation must make sure that these investments are as
safe as they can be. This raises concerns about the rating threshold
and of concentration risk. If Indian government securities are rated
BBB and that of New Zealand government are AAA, it makes sense for banks to hold SLR in New Zealand Govt
securities. Also, there should be limits on any individual issuer of
securities, reflecting the standard risk management practice followed
by any portfolio manager.

The ideal SLR

Putting all the
arguments above provides us an ideal construct of SLR as follows:

• SLR is imposed for the purpose of prudence and hence the
  operative principle is that banks should hold all the regulatory
  required risk capital in SLR


• The level of SLR should be consistent
  with the objective of prudence and anything over such a prudential
  level should be considered as preemption, which should be gradually
  eliminated.


• SLR should be invested in top rated
  securities available globally; furthermore there should be
  concentration limits on single security and issuer

Dual limits structure for SLR

In the short term, it would be hard
to come close to the ideal SLR outlined above. But there are
some incremental changes that can be made without fundamentally altering the
current framework that could provide banks with much greater
flexibility.
The regulator could prescribe 2 separate limits as
follows:

• L1: is the minimum level of SLR that a bank would
  normally maintain


• L2: "core" SLR - a minimum below L1 that the
  banks can go down on SLR as long as the difference is only through
  repo arrangement on SLR with another bank

What does this mean?
Let us assume that L1 is pegged at the currently prescribed level of
24%. We then define another limit, L2, which is closer to the
prudential requirement of 6.5%. For simplicity, let us assume that L2 is
set at 10%. This policy would demand that all banks maintain SLR at 24%
but could go down this level upto 10% if and only if they enter into a
repurchase agreement (repo) with another bank. Such a policy will
mean that the banking system as a whole will continue to hold 24% SLR
and so the government will continue to have access to this captive
source of funding deficit. However, individual banks would be able to go down to
lower levels if they have commercially viable opportunities to do
so. Without diluting the overall investment by the banking system in government
securities, it would provide significant flexibility to individual
banks on commercial lending. In this respect, it is analogous to the
idea of tradeable certificates for priority sector lending.

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One tangible pathway to fighting corruption: Increasing the disclosure by firms and politicans

While many researchers have started studying corruption, as of yet, the field is remarkably bereft of tangible policy choices that would yield reduced corruption. As I read The other side of reforms by A. K. Bhattacharya in the Business Standard, and Obtaining financial records in China by David Barboza in the New York Times (which describes the modus operandi of the New York Times' remarkable expose of corruption in China at the level of the Prime Minister, also by David Barboza), I thought there is one tangible policy lever through which we can combat corruption: Increase the transparency of companies and increase the transparency of politicians.

Transparency by firms

It is useful to think at two levels: Transparency about the activities of companies created by politicians, and transparency about the activities of the big companies that pay bribes. I am reminded of the Extractive Industries Transparency Initiative. One element of this is an attempt to change the behaviour of repressive regimes (e.g. Russia) by forcing the companies that deal with them (e.g. BP) to behave differently. Even if the politicians are irredeemably bad, we can change things by modifying the incentives of the firms that pay bribes.



In a recent post, Indian capitalism is not doomed, I argued that the markets for labour and capital are exerting pressure on firms, pushing them towards higher ethical standards even under conditions of medium grade enforcement by the State. To the extent that the firms are more transparent, their misdeeds are more likely to be exposed, and then these kinds of pressures will work more effectively.



At present, the MCA-21 database is clumsy and painful, but it's a step forward in one respect: It does yield some information about many companies. This has been of value in tracing the activities of the companies controlled by politicians and their business partners. This process needs to be carried forward in many dimensions:

• At present, the P&L statement of "public" companies is publicly visible in MCA-21. This definition needs to be widened so that the P&L statement for many more companies become publicly visible.


• The disclosure environment for listed companies in India is quite good. There is no quarterly balance sheet; the shareholding pattern statement is misleading; there are a few other blemishes. But the information access for listed companies is vastly greater when compared with what's in MCA-21. Many features of the disclosure regime for listed companies (where the work is led by SEBI) need to go into the disclosure regime for all companies (were the work is done by the Department of Company Affairs).

If private limited companies become more transparent, politicians will try to use trusts and limited liability partnerships for their activities. Improvements in transparency should extend to LLPs, trusts and partnership companies also.

Transparency by politicians

Alongside a push for greater transparency by firms (both the big listed companies and the firms created by politicians), we should be pushing towards greater transparency by politicians. This push towards transparency has begun, and has started yielding some results. It needs to be carried forward. The comprehensive financial lives of MPs, MLAs, and their next of kin should be in the public domain. The transparency regime should kick in when a person wins an election, and should stay in place for atleast 10 years from that starting date. Any company or LLP with shareholding of more than 1% by an MP or an MLA or their next of kin should have to comply with the comprehensive disclosure manual of SEBI for listed companies. Any trust when an MP or an MLA or their next-of-kin is a trustee should have to similarly fall into a high quality disclosure framework.

Privacy is precious

There is a tradeoff between privacy of citizens and corruption control. There is value in protecting the privacy of the business dealings of individuals. Perhaps, at the early stages in the formation of the Republic, where we're grappling with basics of governance, there is a case for violating the privacy of individuals in the quest for improved cleanliness in public life. Over the years, as the State falls into place, a greater push for privacy would be desirable.

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Interesting readings

A. K. Bhattacharya
in the Business Standard on how the UPA is faring well
without Pranab Mukherjee.

As we ponder the fundamental challenges that India faces, it is
interesting to
read Boss
Rail by Evan Osnos in New Yorker magazine.

India's
new approach lets individual states take the lead on
development by Simon Denyer in the Washington Post.

Madhavi
Goradia Divan in the Indian Express on defamation law.

Towards
better financial regulation
and What
is regulation for, by Ila Patnaik, on the big
picture of the FSLRC approach paper.

One
head is better than many by Ila Patnaik. Let's not
repeat the mistake of the RBI Amendment Act of 2006, she
says.

In
the mood for reform by Ila Patnaik in the Indian
Express, on the fresh push by the UPA government.

The
Evolution of India's UID Program: Lessons Learned and
Implications for Other Developing Countries by Frances
Zelazny.

Great post-mortems of the Sahara
case: Tony
Munroe and Devidutta Tripathy on Reuters,
and Tamal
Bandhyopadhyay in Mint. These stories helped form my
arguments in the recent blog
post Indian
capitalism is not doomed.

Most of us take a certain degree of Internet access in India for
granted. But not so long ago, getting to the net in India was
nightmarishly
hard. A story
on FirstPost tells us about the early days, with an appropriate
accent on Ernet, the pioneer which made all this possible.

Don't bring your cell phone to
meetings in China, you might get hacked by James
McGregor on Quartz.

The difference
between reality and fiction is that reality doesn't have to be
plausible. I was quite gloomy about what might happen with
Iran's nuclear program, but for the second time in history, it
is starting to look like sanctions might work.

Quants
aren't really like regular people by Izabella Kaminska in
the Financial Times.

Charles
Duhigg and Steve Lohr tell us, in the New York Times
that In the smartphone industry alone, according to a Stanford
University analysis, as much as $20 billion was spent on patent
litigation and patent purchases in the last two years - an amount
equal to eight Mars rover missions. Last year, for the first time,
spending by Apple and Google on patent lawsuits and unusually
big-dollar patent purchases exceeded spending on research and
development of new products, according to public filings.

Two great stories about Barack Obama in Vanity
Fair: The
Hunt for `Geronimo' by Mark Bowden,
and Obama's
way by Michael Lewis. While on this subject, see Time
magazine
on Robert
Gates. These three articles give us a sense of the gap that we
face between governance in India today and that seen in a
sophisticated country.

David
Quammen has a great story about zoonoses. In it, I learned
that we now know that one animal reservoir of Marburg is the
Egyptian fruit bat.

Nineteen
seventy three, a story by Alan Bellows that takes us
back to how the world looked in the early 1970s.

Offtopic: Here
is a fabulous example (best viewed on a 30" monitor)
of Google Art
Project.

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India's inflation crisis, and what this means for monetary policy

The graph above shows headline inflation in India, i.e. year-on-year CPI-IW inflation. The informal target zone for policy makers in India is to have year-on-year CPI-IW inflation between four and five per cent. This is shown on the graph as blue dashed lines.



From February 2006 onwards, inflation breached the upper bound of five per cent. It has never come back below five per cent. The red line shows the overall average inflation from 1999 to today: it is well beyond the upper bound of five per cent. If our informal goal was to get inflation between four and five per cent, we have failed to do this as measured by average inflation from 1999 onwards (averaging across both good periods and bad).



Our loss of price stability is a major weakness of macroeconomic policy. It has far reaching consequences and hampers the extent to which the economy is able to get back onto a stable growth trajectory.



That's the big picture. Now let's look at current inflationary pressures. For this, we must look at the month-on-month annualised changes in the seasonally adjusted CPI-IW. This data shows difficulties in 2012:

Jan	8.68
Feb	13.22
Mar	17.88
Apr	20.22
May	8.62
Jun	7.78
Jul	7.18
Aug	13.06

The target -- year on year CPI-IW inflation -- is the moving average of the latest 12 values of month-on-month inflation. If we hope to get y-o-y CPI-IW inflation below 5 per cent sometime in the coming six months, then the latest six months should contain good news. But there isn't a single month of data in 2012 where the month-on-month CPI-IW inflation was within the target zone of four to five per cent. It is, hence, likely that we're atleast a year away (if not more) for y-o-y CPI-IW inflation to drop below 5 per cent.



Inflationary expectations are in excess of 10 per cent; the policy rate expressed in real terms is negative. Under these conditions, I fail to see how many people are thinking it's time for RBI to cut rates.



As India becomes a middle income economy, and experiences business cycle fluctuations, we're going to require a quantum leap in the institutional and human foundations of macroeconomic stabilisation. One key component of this is an institutional commitment at RBI to deliver low and stable inflation.



Some argue that private sector confidence, and stock prices, will be boosted by a rate cut. Will it? Will the private sector be impressed by a display of low institutional capacity? Will lower rates foster investment? I'm curious to see how this will work out.

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