Opportunities in the Macro/Finance Group at NIPFP

The Macro/Finance Group
at NIPFP offers opportunities for interesting and important
policy work which is connected with the ground realities of India's
economic reform. One of the important projects being undertaken, at
present, is research support for the Financial Sector Legislative
Reforms Commission.

Policy work is highly inter-disciplinary. The policy group at NIPFP
is particularly looking for people with a knowledge of financial
regulation and law. Deep practitioner knowledge, about the ground
realities of law and regulation are important. Equally important is
the instinct of looking beyond the present and envisioning the future,
drawing on strong foundations of public economics and international
experience. We welcome interest in these positions by people with
strong capabilities in at least one of these areas, and curiosity
about the other. The ideal candidates would have read the Percy Mistry
and Raghuram Rajan reports, and have familiarity with the things being
talked about in this blog.

The Macro/Finance Group at NIPFP is a conducive research
environment including a modern office. Compensation is generally
superior to that seen in government academic institutions. There is
joint work and spillovers of knowledge with the quantitative research
team within the Macro/Finance Group.

If this interests you, please contact Anurodh Sharma (anurodh54 at
gmail.com) with your resume by 22 June 2012, where you clearly
identify where your interests and capabilities lie.

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Is building and running the IIT JEE a public goods problem?

What should government do?

In the question "What should government do?", economists have one big answer "do the public goods". A public good is something that is non-rival (the consumption by one does not come at the cost of consumption by another) and non-excludable (it is not possible to exclude someone from benefiting from the public good).



The regulation of air pollution is the favourite example which illustrates a public good. Clean air is non-rival (if you breathe clean air, it does not diminish my supply of clean air) and non-excludable (if the air is cleaned up, nobody can prevent me from breathing it in). Indeed, nothing that one person can do can make a difference to air pollution. Only the government can regulate pollution and this deliver clean air.



Similar issues arise with defence, police, judiciary, monetary policy, financial regulation, public health (though not the health of the public), biodiversity, etc., all of which add up to the economists' vision of what government should be doing.

What should government do in the field of education?

Education is substantially a private good. I study, I benefit. There are spillovers ("externalities") to others, and so there is a case for a government subsidy. But barring that, this is a field where the incentives are well aligned for each person to be the main one in charge of his own education.



Public funding solves the problem of externalities. At the level of elementary education, vouchers are a nice way to deliver public funding that is large enough to pay for the externalities. At the level of higher education, public policy can focus on economies of agglomeration alongside some public funding, nudging the outcome in India so that there are 100 high quality broad-based universities.



As I read The delicate technology of creating excellence by Pradip Ghosh in the Telegraph, I was reminded of the public goods character of testing and curriculum development. As he says:

in this very large country with a multitude of school boards and their non-uniform curricula and examination standards, it would be inappropriate to go by board grades because that would yield unreliable, undesirable results — we would not get the best students. And, such a course, therefore, would be unfair both to the aspiring students and to the institutions they would be entering. A single post-high school examination with a well-defined syllabus and a centrally administered paper-setting and grading system was thought to be the best alternative

The production of education services is a private good problem, to be sorted out between one student and one education provider. However, the problems of curriculum and testing have a public goods character. Let's run the tests of a public good, for a nationwide system for standardisation of curriculum and testing.



Is it non-rival? Does the consumption of the services of this system by one person diminish the amount of this system available for another? With computerised testing, there should be full scalability (though Pradip Ghosh argues, in the article above, that there are problems with this).



Is it non-excludable? High quality curriculum is non-excludable in that once curriculum documents are on a website, everyone can download them. Testing is excludable if you want to be cussed about it, but for the rest it should not be possible to exclude anyone from taking a nationwide test.



This argument guides us in thinking about what government should be doing in the field of education:

1. Funding (calibrated to overcome the externalities)


2. Curriculum development


3. Testing


4. Information infrastructure about education service providers (i.e. schools but also all sorts of new ways of organising education service delivery) so as to assist choice by parents and students.

The entire focus of management time, and the entire resources available for the task, should be devoted to these 4 problems.

Central government or local government?

Once we know that testing and curriculum are public goods, we have to ask who should do it.



If an important outcome (getting into the IITs) was linked to regional board examinations, that is a recipe for grade inflation. This is a reason for doing this at the central government.



There are economies of scale. A curriculum only needs to be developed once. This is a reason for doing this at the central government.

In conclusion, the IIT JEE has many problems, but the building and running of high quality examinations is an important task of the central government and should not be diluted or abandoned. The fraction of management time, and resources, that are devoted to curriculum and testing need to go up.

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Uptake of systems like Amazon's `Mechanical Turk' in India

I have long been aware of Amazon's `Mechanical Turk', a mechanism through which tasks are farmed out to a large bank of humans. Each human worker has full flexibility on how many hours are worked and when. From the customer's point of view, Amazon supplies an API and access to a very large pool of humans who can perform small tasks. The median wage is $1.4 or Rs.80 per hour. In effect, Amazon has created a large market through which workers can find work, and firms can find workers to perform well defined tasks.



In a recent issue of The Economist, I was surprised to discover (a) that Amazon's Mechanical Turk has 0.5 million workers and (b) that roughly a third are from India. That's roughly 150,000 persons in India who are plugged into Amazon's Mechanical Turk. We don't know how many hours/week are spent in doing labour supply, but it's still a lot.



There are a few other such systems also. Here are links for exploration: oDesk, CrowdFlower, Elance, Amazon's Mechanical Turk.



These mechanisms add up to a whole new world for the functioning of the labour market. For first world customers who would like to connect up to cheap labour in India, our traditional view was that there had to be a man in the middle - a Datamatics or a TCS or an IBM. What these new systems seem to suggest is that for a certain class of tasks, it is possible to disintermediate the Datamatics or TCS or IBM.



For many individuals in India, the flexibility of working from home without rigidity about how many hours are supplied, and when, these systems could be a big win. At present, many households do not have computers and broadband connections, which is an important impediment. But this is also a constraint that is being rapidly eased through 3G, LTE, etc. These developments, put together, could become a whole new chapter in the story of India's connecting up to globalisation.

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Hollowing out of the Indian financial system

Business as usual, in India, is taking us to a destination where RBI & SEBI & company will preside over a minor and inconsequential financial system. The bulk of India-linked finance will take place overseas, and the overseas market will dominate price formation for India-related financial products.



Why might this happen?



Finance is the business of bits and bytes. Orders being sent to India can be easily switched to other venues. An array of other venues are now springing up:

1. Nifty futures trade in Singapore on the SGX


2. An array of sophisticated derivatives on Nifty trade on the OTC market offshore (also termed `the PN market').


3. Derivatives on the rupee trade overseas on the OTC market (linear contracts are termed `the NDF market').


4. Trading in individual stocks is taking place on the ADR and the GDR market.

Let's focus on Nifty - the most important financial product in India. (The arguments pretty much identically apply to everything else).

The success and survival of the onshore securities markets is fundamentally about NSE. NSE faces an array of problems rooted in domestic policy (example, example, example, example, etc). The overseas market faces no such problems. The CEO of SGX wakes up in the morning and thinks about competing with NSE. The CEO of NSE wakes up in the morning and thinks of an array of weird things.

And then, there is taxation. The fundamental principle worth using in this field is residence based taxation. We, as India, should not tax the activities of non-residents. For a global investor, sending orders to the Nifty futures on SGX is tax-efficient as Singapore follows a residence-based taxation system. Sending orders to India is inefficient today (owing to the STT and the stamp duty) and could get worse tomorrow (if GAAR is used to abrogate the Mauritius treaty).

We think we are comfortable, because India has capital controls, and residents don't have much of a choice on taking their custom elsewhere. Things aren't that simple. First, non-residents can pioneer sending order flow to overseas venues, and make them liquid. The next stage will be about Indian MNCs, who run global treasuries, who can easily patronise the overseas venues. The third stage will be HNI residents, who can take $200,000 per year per person outside India. In addition, the richest 1% of India would systematically shift money out of the country through various means fair and foul [example].

Put these factors together, and suddenly Nifty futures on SGX are a credible option. And this is exactly how things have worked out. Palak Shah in the Business Standard says:

As on date, the SGX Nifty OI is 27 per cent higher than that for Nifty futures on the National Stock Exchange (NSE). The figures are more alarming if one considers the OI in a single month in May as the built-up positions on the SGX are 70 per cent higher than on the NSE. In May, the SGX Nifty OI was worth over Rs 16,200 crore while that on the NSE stood at over Rs 9,250 crore. As far as three-month contracts go, the Nifty futures OI on the NSE is over Rs 12,750 crore.

In 2008, before these troubles had come together, SGX open interest was 59.78% of NSE. By 2012, where all these problems have come together, SGX open interest has come to 101.77% of NSE's. It is astonishing to see that for the biggest Indian product - Nifty - an overseas exchange has got superior open interest.



In the baseline scenario, Indian policy-making will meander on clueless and unconcerned. NSE will continue to lose ground. Why do we care? Is this mere protectionism - what is wrong if the entire India-linked equity index derivatives business takes place overseas?

• A rich and complex ecosystem of finance has developed surrounding the Nifty contracts. Hundreds of thousands of high skill workers are in this industry. A decisive loss of market share for India would endanger their livelihood.


• The tax revenues associated with all these activities, at present, come to the Indian authorities. The Indian tax man earns income tax (on wages and on corporate profit) and VAT (on an array of activities of the firms). All this will go away if the business shifts to Singapore.


• A sophisticated Indian financial system is required if monetary policy is to be effective. The demise of the onshore financial system will damage the onshore monetary policy transmission. It will further take us back towards a world where government is unable to play a role in business cycle stabilisation.


• Prospects of Bombay emerging as an international financial centre will subside. If we can't even hang on to market share for Nifty or the rupee, where is the question of competing against overseas financial firms or markets on things that aren't India-linked?


• Access to finance for firms will tend to split into a two-tier world: the big firms will go abroad to get their corporate finance done. The small firms will face greater constraints since they will not easily access finance abroad (there is a greater information distance between the typical Singapore investor and the typical Rs.1000 crore or Rs.100 crore Indian company), and the local financial system would be weak.

When India started trying to build a mature market economy in 1991, at first, it felt like a sophisticated financial system would emerge, which would both serve India and start competing for the global market. From 1993 to 2001, India achieved a remarkable revolution in the equity market. This increased optimism in the ability of India to understand problems, to achieve change, and to maintain high ethical standards.

It now seems that those hopes were premature. The more likely scenario is one where India-linked finance will happen offshore, while RBI/SEBI/CBDT/CCI/FMC/IRDA squabble over a minor and inconsequential onshore financial system that is riddled with ethics problems. In the short term, onshore Indian finance will suffer from one setback after another.

We are likely to go back to the conflicted arrangements that gave us the Harshad Mehta scandals of the early 1990s and the Ketan Parekh scandals one decade later. I used to think we were finished with those problems. But we are about to restart on that entire story; there is little institutional memory about how those things came about and how dangerous our present path is. Each future scandal, of this nature, will be greeted with joy by overseas financial providers, who will scoop up market share every time India falls into turmoil.

Many years from now, we may one day get to fundamentally superior governance arrangements in finance, and achieve high ethical standards in public life and securities infrastructure. If this happens, we would be able to come back to these questions. As an example, Japan lost the Nikkei 225 contract to Singapore in the mid-1980s and got back into this to a significant extent 15 years later. In the years or decades that will go by until domestic financial governance structures are corrected, a great deal of organisational capital in the onshore financial system will have been lost.

The revolution in the stock market used to be one of the best success stories of economic reforms in India [link, link]. It may well fall apart in coming months and years.

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Evaluating responses to India's macroeconomic crisis

by Shubho
Roy and Ajay Shah.

The macroeconomic setting

India's macroeconomic
woes consist of high inflation, low GDP growth and a drop in
asset prices. The loss of momentum is visible in the seasonally
adjusted data:

Indicator	Early 2009	Latest
GDP growth (QoQ, saar)	9.83 Q2-2009	4.25 Q4-2011
Inflation (CPI-IW, pop, saar, 3mma)	7.5 Feb 2009	12.9 Mar 2012
INR/USD	48 Jan 2009	56 May 2012

The picture is not uniformly bleak. The most important asset price
of the economy, Nifty, has not dropped across this period. On 1
January 2009, Nifty was at 3033. Today, it is at 4920, which is a
good 62% higher. More generally, stock prices have held up rather
well so far. The trailing P/E
of the broad market index, the CMIE Cospi, stands at 17.3, while
the median value across its full history (from 6/1990 to 4/2012) is
17.83. We may think that conditions in India are difficult, but the
stock market is saying that they're roughly median conditions in
terms of the outlook for earnings growth.

The current account deficit

In recent years, the fiscal condition of the government + PSUs has
worsened. This has led to a large gap between savings and investment. The worsening in public finance has diminished savings. There is an
accounting identity: The gap between savings and investment is
the amount of capital that has to be imported. This is the current
account deficit. We have a capital shortfall within India, so we are
importing capital.



It is likely that in the coming year, we will have a current
account deficit of 4% of GDP, or $80 billion a year, or Rs.1700 crore
a day. This means that we have to worry about how foreign capital
views India. Under these conditions, if there is even a short hiccup
in capital inflows (as appears to have come about after the government
proposed to modify the Mauritius route, and more generally with the
problems of governance in India), it yields sharp rupee
depreciation.



We import a lot of capital; government policy actions interrupt
that flow of capital; the rupee depreciates. This is not
mis-behaviour of the financial system. The system is not
malfunctioning; it is behaving as it should.

What should the responses be?

There are five sensible paths for government to take, in this
situation:

1. We need to see that at heart, this is a problem of
   macroeconomics. The root cause of the current account deficit is the
   fiscal deficit. If we want a lower CAD, we need a lower fiscal
   deficit.
   
   


2. To ensure the smooth flow of Rs.1700 crore a day into the
   country, we should not spook foreign investors. We should not interfere with the
   de facto residence-based taxation framework which India is
   giving foreign investors, as long as they come through
   Mauritius. This policy framework is, in fact, in
   India's best interests.
   
   


3. Deeper problems about the loss of confidence of foreign investors,
   owing to governance problems, need to be solved by strengthening
   governance. They are important (do not ignore them), but there is no quick fix other than improving governance.


4. In the face of these difficulties, it would make little sense
   for RBI to trade in the currency market, to try to block the rupee
   depreciation. There is good reason for rupee depreciation; the
   currency market is doing a pretty good job of translating the
   fundamentals into a price. And, in any case, even if RBI desired to
   do something about it, its weapons are puny when compared with the
   size of the currency market and the Indian economy.
   
   


5. It is an opportune time to continue with the liberalisation of
   the capital account. However, it is useful to think deeply about how
   to proceed with this. Some kinds of liberalisation can be
   dangerous. It is important to think about sequencing, and at all
   times, to worry about unhedged currency exposure. A good deal of
   expertise has built up on the subject, through the Raghuram Rajan Committee and the UK Sinha Working
   Group which worked out the medium-term and short-term sequencing of reform.

An evaluation of what has been done

There are three features of recent policy responses which
appear to be on track:

1. By and large, RBI's trading on the currency market appears to
   be at a low scale, nearing zero in many recent months. This is
   wise. It increases respect for the brainpower at RBI.
   


2. The government raised the price of petrol, so as to cut the
   fiscal deficit. This increases respect for the brainpower and
   political capabilities of the government.
   


3. The government decided to defer the attack on the Mauritius
   treaty by a year (though not to shelve it altogether). In the
   absence of clear policy statements about the importance of
   residence-based taxation, this shelving does not increase respect
   for the government.
   

Apart from these three good moves, a slew of dubious ideas have
been afoot.

A. Enlarging the scope for dollar-denominated borrowing by Indian firms

On 20^th April, 2012: external Commercial Borrowings
regulations were amended to:

1. Increase the limit on power companies to refinance their borrowings in Rupees
   with foreign currency loans (also called External Commercial
   Borrowings or ECBs).


2. Allow companies to borrow in foreign exchange to make capital
   expenditure for maintenance and operations of toll systems
   (See here)


3. Companies were allowed to refinance their ECBs
   with subsequent ECBs at higher interest rates
   (See here).

Evaluation: Do we really want Indian firms to hold dollar
denominated debt? In particular, firms in the field of
infrastructure who have cashflows in rupees? Sensible
firm should see the high ex ante currency volatility and
stay away from borrowing in dollars without hedging; so the
impact upon capital flows will be small at best. And firms that
do borrow in dollars and keep it unhedged are probably
not going to fare well.

B. Enlarging the scope for dollar-denominated borrowing by banks

On 4^th May, 2012: The maximum interest payable on
forex deposits by NRIs in Indian banks was increased (See here):

1. For deposits between 1 to 3 years the increase was 75 basis points.
   


2. For deposits between 3 to 5 years the increase was 175 basis
   points.
   

Evaluation: Banks are disaster-prone 19th century
institutions. Do we really want them to hold more unhedged foreign
currency exposure? Of all places in the economy, this is the worst
place to keep unhedged currency exposure. The wise ones will not
borrow in this fashion, so the impact upon capital flows will be
small at best. And the unwise ones, that borrow in dollars and
keep it unhedged, are probably not going to fare well.

C. Reducing the economic freedom of exporters

On 10^th May, 2012: the right of exporters to hold foreign exchange was
reduced by 50% (See here):

1. Exporters were allowed to keep their forex earnings in
   special accounts called EEFC accounts. They were not mandated to
   convert it into Rupees. This allowed them the ability to fund
   imports for their business without going through costly conversions.
   
   


2. Now only 50% of their export earning will be allowed to be kept
   in forex. The rest will be converted into Rupees against their
   wishes.
   

Evaluation: In the old India, FERA made ownership of
foreign exchange an exotic and rare thing. Many businessmen in
India engaged
in import/export misinvoicing and tried to hold assets outside
the country. In the early 1990s, C. Rangarajan's RBI embarked on a
modern arrangement. Exporters were given greater economic
freedom. We are now rolling the clock back by 20 years; we are
tampering with current account liberalisation.



The number "50%" has not been justified in the RBI
notification. Any exporter, with significant raw material import
cost will now pay unnecessary transaction charges. In global
trade, where every country takes the utmost effort to keep their
exports competitive, any small distortion impacts on export
competitiveness; this is pushing in the other direction - it is an
attempt to reduce India's export competitiveness.



This is a new low in Indian economic policy. Every internationally
oriented household in India will now be more keen to hold assets
and liquid balances outside India, safe from the clutches of
Indian capital controls. This measure will thus exacerbate
capital flight and worsen the problems of the rupee. Success in
the marketplace will tend to accrue to businessmen who break laws
as opposed to the law-abiding ones.

D. Damaging the currency futures market

On 21^at May, 2012: restrictions were put on
exchange-traded derivatives (See here):

1. The net overnight open positions that the banks hold shall
   not include positions in the exchanges.
   
   


2. The positions in exchanges cannot be used to offset
   positions in the OTC market for
   
   


3. The position of banks in currency exchanges shall be
   limited to $100 million or 15% of the market (whichever is
   lower)
   

Evaluation: The world over, there is a clear understanding
that the exchange is a superior way to organise financial
trading. When compared with the OTC market, the exchange has
superior transparency and risk management. Policy makers need to
continually modify policies so as to favour a migration of all
standardised products away from the OTC market to the
exchange-traded contracts. RBI's moves go in the wrong direction.



How do we ensure that the price on a financial market is driven by
fundamentals? The answer : We must have a deep and liquid market, and a
broad array of sophisticated speculators. RBI's actions are going
in the exact opposite direction. They are trying to make the
market illiquid. But it is in an illiquid market that we will get
market inefficiencies and weird behaviour of the price. They are
increasing the chance that something nutty happens on the rupee.



This circular is also a reminder about poor legal process at
RBI. Every action by a regulator must articulate a
rationale. Financial regulations are motivated by exactly two
possibilities - consumer protection or micro-prudential
regulation. The government agency that wields the power of
financial regulation must show the clear rationale, describing
what is the market failure that this regulation is seeking to
address. The government agency must show the cost-benefit
analysis, explaining why the costs of this action outweigh the
benefits. As is typical of financial regulators in India today,
RBI's documents show no rationale.



It is possible to conjure one conspiracy theory. The attempts at
damaging the liquidity of the currency futures market should be
seen in connection with previous
work on damaging the liquidity of the OTC market. Perhaps
there is a grand plan here. The scale of RBI's trading on the
currency market is implausibly small when faced with the size of
the Indian economy, with the size of India's cross-border
interactions and the size of the currency market (both onshore and
offshore). Perhaps these recent moves are designed to damage the
liquidity of the market, so as to get to a point where RBI
intervention can make an appreciable dent on the
price. Perhaps the game plan is to gnaw away at the capability of
the currency market through a series of moves, and then take off
doing large scale manipulation of the market. If this is the game
plan, it reflects very poorly on the economic policy capability at
RBI. It would also generate massive profit
opportunities for the speculators of the world, who would short
the rupee when the large scale manipulation commences.

Rumours about other bad ideas abound. E.g. it is suggested that RBI
will sell dollars to exporters directly. How is this different from
selling dollars on the market?? It is suggested that the currency
futures and the OTC markets should be completely cutoff by banning the
arbitrage. How would this solve the macroeconomic problems which
bedevil the rupee?

Microeconomic distortions are not a good way to address
macroeconomic problems

What does one make of this spectacle? A simple principle worth
reiterating is:

Problems rooted in
macroeconomics must be addressed using macroeconomic
instruments.

We got into this mess because of inappropriate fiscal and monetary
policy. We need to solve these -- monetary policy must get back to the
business of delivering low and stable inflation, we have to fight
inflation until we see y-o-y headline inflation (i.e. CPI-IW
inflation) going to the 4-to-5 per cent range. Alongside this, fiscal
policy needs to correct itself. Each of these has a clear direction to
move in, and movement on any one is valuable regardless of what the
other does.



A big element in the picture is the loss of confidence, in the eyes
of the private sector, on an array of issues ranging from ethical
standards to the sophistication of fiscal, financial and monetary
policy. This is an important problem and it needs to be addressed. The
spectacle of a government flailing at the macro problems using micro
instruments is worsening matters. Perhaps there is constant pressure
to announce `new measures' to solve the problem. Deeper solutions are
hard, and there is enthusiasm for `doing something' (large or small)
[example].



We've seen this movie before. In the last decade, again and again,
RBI tried to wield capital controls as a tool for macroeconomic
policy. They
failed. It is disappointing to see the lack of learning.



Some of the moves above have come out of the reflexive socialism
that lurks within the Indian bureacracy. Perhaps, in a crisis
environment, the ordinary immune system within each government agency,
which keeps the sub-clinical socialism under check, is not working as
well. This hurts from two points of view. It betrays the lack of
capability of these government organisations; it reminds us that the
Indian State is strewn with people who have a low knowledge of
economics and a taste for dirigiste. It also reminds us of the
policy risk: Precisely when the best capabilities are required (in a
crisis), we seem to be slipping into the lowest quality policy
initiatives.



Everyone who sees the government / RBI engaged in one ill thought
out measure after another gets worried about India's future. How can a
$2 trillion economy flourish while such immense powers are placed with
individuals and institutions with such weak capabilities? This further
damages confidence, which deepens the macroeconomic crisis.





Acknowledgements: We are grateful to Apoorva Ankur, Sumathi
Chandrashekaran, Pratik Datta and Kaushalya Venkataraman for useful
suggestions.

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The costs in buying versus the costs in selling

All models are wrong, some models are useful. A model reduces complications that are true in return for tractability and insight. In finance, all too often, one complication which has been wished away is transactions costs. A great deal of what we see in the world around us is caused by the costs of transacting. Some of the most important finance is about analysing the causes and consequences of the costs of transacting.

The bid offer spread as a measure of transactions costs

The first flush of the literature draws on markets with market makers, and treats the bid-offer spread as the measure of the cost of transacting. On the NYSE, the specialist posts a bid price and an offer price. If you do two transactions in quick succession -- buy 100 shares and then sell them back -- you will be poorer by the bid-offer spread. The spread is like a tax on a speculator doing a round-trip for a small transaction.



There is no doubt that in that environment, the spread measures something important about transacting. Large databases about the spread are available. A whole literature arose which is rooted in the spread as the measure of the cost of transacting.

Limit order book markets are a whole new world in observability of liquidity

The world changed. Across countries and across asset classes, exchanges have been morphing into anonymous open limit order books. The market maker is not as important. On the open limit order book market, the full set of limit orders are observable, using which we can simulate a market order of any size, and calculate the exact cost that is paid. Suddenly, instead of just seeing a bid-offer spread, we see a whole new world which displays the full `liquidity supply schedule' (LSS) that has the impact cost (in per cent) associated with a single market order of all possible sizes.

An example of the `Liquidity Supply Schedule': The impact cost associated with all possible transaction sizes

When the bid/offer stands at 98/102, and the midpoint quote is 100, if a single market order to buy 1000 shares gets executed at an average price of 105, the buy impact cost for 1000 shares is 5%. This calculation, repeated for all possible transaction sizes, paints the full Liquidity Supply Schedule (the LSS).



Once the LSS is visible, and we start thinking about the world in new ways, and the spread feels like a highly unsatisfactory measure of the cost of transacting. At the NYSE, the market lot is 100 shares for all firms. A share price of $5 means the spread refers to the cost of a transaction size of $500. If the share price is $200 instead, the spread pertains to a transaction of $20,000. Hence, the spread is itself not comparable across securities. In contrast, the LSS can be a standardised calculation that is comparable across all firms, with standardised units on the x axis either in rupees or basis points or market capitalisation.



For us in India who grew up with limit order book markets (NSE from 11/1994 onwards; BSE from 5/1995 onwards), the mainstream Western literature seems a little quaint, given their emphasis of the spread as the measure of transactions costs. We are seeing much more of the liquidity elephant through the LSS, while so many researchers are only seeing it's tail through the spread. In India, the construction of Nifty required the capture of multiple snapshots of the entire limit order book per day, and has generated information about the LSS going back to the mid 1990s.



Since exchanges worldwide have shifted over to an open electronic limit order book, the new focus of measuring liquidity in finance lies in understanding the LSS. What explains cross-sectional and time-series variation of the LSS? What are the consequences of various features of the LSS? These questions have only begun to be addressed in the literature. Rosu has a fascinating recent paper in the Review of Financial Studies, 2009, titled A Dynamic Model of the Limit Order Book that presents one of the first models which predicts the shape of the LSS in an open ELOB market.

Does the impact cost in buying differ from that faced when selling?

One interesting dimension which the LSS makes possible is to think afresh about buying versus selling. The bid-offer spread tells us the round-trip transactions cost. It does not differentiate between buying and selling. When you see that the bid and offer are 100/102, there is no sense in which the transactions cost in buying differs from the transactions cost in selling.



But with the full LSS, we see the impact cost of buying at all transaction sizes separately from the impact cost of selling at all transaction sizes. A first question to ask is: Is there symmetry in liquidity? In the example of the LSS graphed above, it's quite obvious that the impact cost when buying is superior (i.e. lower) than that faced when selling. But this is just one anecdote.



In a recent paper Measuring and explaining the asymmetry of liquidity, Rajat Tayal and Susan Thomas explore this question. With equity spot trading on the NSE, they find strong evidence in favour of asymmetry: impact cost is higher for large sell market order compared to large buy market orders.

Why might asymmetry arise?

What features about traders in the market generate differences between buying and selling? There is one candidate: how traders perceive sell market orders, particularly large sell orders that come despite constraints on borrowing shares, and restrictions on short-selling.



The speculator who makes a forecast that a share price will go down seldom owns the shares; selling requires borrowed shares. Particularly, in India, where formal mechanisms for borrowing shares are as yet quite small, a speculator who wants to sell physical shares has to mobilise borrowed shares on his own.



This may shape the thinking of the people placing limit orders. When I place limit buy orders (which will get hit by a speculative seller), the adverse selection runs against me. If the speculator was not confident about his forecast, he would not bother to borrow shares and sell short. Only when the speculator is really sure would he take the trouble of borrowing shares and doing a sell order. Hence, the person placing limit orders to buy would demand a bigger price of liquidity (i.e. the impact cost), since he runs a greater chance of losing money when giving liquidity to sellers.



The paper highlights a fascinating identification opportunity : at NSE, alongside the trading of the equity spot market, we also have trading in single stock futures. Everything about the two markets is identical: the same securities, the same trading system, the same participants, the same hours of day, etc. There are only two differences: stock futures trading is leveraged, and stock futures trading has cash settlement -- which removes the short-sales constraints. Cash settlement induces full symmetry between buying and selling.



If short sales were the reasons asymmetry in liquidity on the equity spot market, then the stock futures market should have no asymmetry between buy and sell orders. The paper uses the same measurement procedures and statistical tests to compare the asymmetry of liquidity on the spot market as well as for the stock futures market. They find that there is no asymmetry of liquidity on the stock futures market.



If their story is correct, it has many implications. In other market settings observed worldwide, cash settled derivatives should have symmetric liquidity. Physical settled derivatives should have asymmetry - which might get more accentuated as you come closer to expiry. Many natural experiments have taken place worldwide, where futures contracts have shifted from physical to cash settlement: these are all nice natural experiments where changes in asymmetry should become visible. On spot markets, asymmetry should vary with the ease of borrowing. Future research projects could explore these questions.







Financial economics benefits from the best datasets in all economics, and we are able to get sharp and clean papers which pretty decisively answer questions. In India, it has started becoming possible to do innovative work by drawing on data from the open ELOB equity exchanges, CMIE, etc.

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The business of Indian politics

Raymond Fisman, Florian Schulz and Vikrant Vig have a fascinating new working paper: Private returns to public office, which gives us new insights into Indian politics.



We know that elections in India are typically rather close. There is something almost capricious about who wins and who doesn't. The random outcome of an election can, then, be interpreted as randomised allocation into control and treatment. One candidate gets elected, another candidate is very much like him but doesn't get elected.



We can then ask the question: what happened to the wealth of the bloke who got elected? The authors say that the rate of growth of the assets of the person who won grows by 300 to 600 bps per year when compared with the person who lost.



The strongest effects are observed for a person who makes it to being a minister: his asset returns are 1300 to 2900 bps higher than the person who did not win the election.



The paper reminds us of the conditions under which the most fruitful economic research happens today. It's got to be a live and interesting question. A high quality dataset has to be the engine; without good quality data, research is just garbage-in-garbage-out. It's got to persuade us that that the claimed answer is correct. Too often, we in the research profession are failing on these three tests.

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