Tuesday, April 21, 2015

Friday, April 17, 2015

Solving market failures through information interventions

The standard approach in public economics

The standard approach of conventional public economics is to emphasise that the market economy generally works well, barring a group of market failures. The job of government is to try to address these market failures. The standard checklist of market failures is:

  1. Externalities -- e.g. a factory that pollutes.
  2. Asymmetric information -- e.g. safety in food or medicines.
  3. Market power -- e.g. firms that earn super-normal profit owing to weak competition, and
  4. Public goods -- e.g. law and order.

In the standard approach we weigh market failures against the problems of obtaining effective State intervention. The barrier is `public choice theory': the State is not benevolent. The citizen is the principal, the State is the agent, and there is a principal-agent problem. It is not easy to obtain performance when setting up real world arrangements that will sally forth, intervene in the working of the economy, and address market failures. This limits the class of situations where intervention may be appropriate. In a world with a perfect and benevolent State, we'd do a lot more in terms of going after market failures. In India, where State capacity is low, we are very selective and only do a few things.

The end of asymmetric information?

Alex Tabarrok and Tyler Cowen look at the proliferation of methods to create, store and transmit information, and say that there is an increased class of situations where asymmetric information has been conquered, thus reducing the extent of market failures.

Improved access to information also reduces the public choice problem. More information about the activities of politicians and bureaucrats is available to the citizen, which reduces the principal-agent problem.

It's a good article. I felt the case was a bit overstated. E.g. reputation measures on the Internet help people see more about you, and that's good in some settings (e.g. you know something about the Uber driver), but it's a small change in a vast gulf of lack of information. E.g. the authors say : Many public choice problems are really problems of asymmetric information. I don't agree. Yes, more information will help, but the principal-agent problem between citizen and State is vast and complicated. Merely monitoring some of the activities of civil servants better does not solve the public choice problem.

There is vast asymmetric information in the relationship between an employer and an employee in most complex work places, and nothing has changed which will make a dent to this. We can think of numerous other situations where the asymmetric information has not changed.

More or less government intervention?

The flavour of the article is that with less asymmetric information, you'd need less State. Yes, that is true, but it's also the case that with less of a public choice problem, you could use more State. In thinking about public policy, we are constantly watching the market failure that's worth addressing versus our ability to construct a State apparatus that would actually deliver the goods in trying to address this market failure. The new age of improved information cuts both ways: it reduces the places where we might want a State intervention, and it increases the class of places where we could pull off a successful State intervention.

A new kind of State intervention

In this new age of easy capture, storage and transmission of information, I have felt that there is a new kind of State intervention: one which rearranges the information set. The State can use its coercive power to force certain kind of information to be captured or released or transmitted. This is a beautiful intervention that directly addresses the root cause of the market failure, the lack of information.

As an example, in the old analysis of insurance, there were some good drivers and some bad drivers, but the insurance company did not know who fell into what category. There was adverse selection (bad drivers were more likely to sign up for insurance) which led to high prices of insurance and many good drivers got insurance which was not actuarially fair.

This is the standard description of the market failure, in the textbooks. We can now think of a new kind of State intervention: The government forces cars to be equipped with devices that measure how the person drives. This is an intervention that directly stabs at the asymmetric information.

Here is another example which nicely illustrates an information intervention. We have been working in the field of regulation of warehouses. There is an asymmetric information problem: I submit my goods for storage at the warehouse, but I don't know how much care will be exercised by the warehouseman. There are old style interventions which reduce this information asymmetry.

In some situations, we can directly attack the information asymmetry. As an example, consider frozen food. When you deposit 1000 kilograms of cheese into a cold storage, you worry that the warehouseman will not maintain the temperature at precisely 4 degrees. But now there are low cost devices that will measure the temperature every minute and thus tell you what your cheese experienced.

Now the customer and the warehouseman can enter into a private contract where the temperature of the cheese is monitored, and a set of payoffs calculated based on the extent to which the temperature of the cheese strays above 4 degrees. Good warehousemen would think: Why don't I release this information, so that prospective customers would trust me? The trouble is: this data could be tampered with, or data could be selectively released.

This suggests the design of a government intervention: The government could establish an inspection mechanism which ensures truthful release of comprehensive data about all transactions by the warehouse. This is a combination of the new age of devices (the data logger) plus a dose of State intervention (to ensure truthful and complete data release). We could also envision a valuable State intervention that standardises the XML files which are put out by all warehousemen, which would reduce the cost of processing this data for customers.

This is an example of what I call an `information intervention', which rearranges the structure of information, and thus combats the market failure that's rooted in asymmetric information.

How Finance SEZs can matter

I have a column in the Indian Express today on how Finance SEZs can matter.

Thursday, April 09, 2015

Brand names versus reality

Some people like a shirt if it's a good shirt. Some people are obsessed with the brand name on the shirt. To some extent, this could be rational: I know nothing about cars, but I've had good experiences with cars by Toyota in the past, so I have a bias in favour of cars by Toyota. And yet, why is it that in some places and some times, brand names matter more? The simplest idea seems to be one of exposure. If the stakes are very small, I'll go by a brand name, but if not, then it makes sense to see through the brand name to the underlying reality.

There is some evidence that consumers are more brand conscious in some places than in others. The Harris Poll, 2011, says that the following proportions of consumers believe that good brands translate to quality products (from Table 5):

CountryFraction that's brand conscious
Great Britain48

Similar problems are found in the academic version of the pursuit of brand names: connections with the top universities, and publications in the top journals. Research ought to be about following your curiosity, pursuing important questions, getting novel and persuasive answers, and doing research that matters. As I wrote in this post on Indian economics, the process of recruiting and promoting researchers in India has become centred on the filtering by North American editors and referees. This chase for external brand names is exerting a corrosive effect upon the Indian academic profession. Managers of research have absolved themselves of their responsibility to judge who is a good researcher. At too many places, it's turned into a stultifying chase for brand names.

A variation of the brand name problem is the `great man syndrome'. A person scores wins in field X, and starts talking about field Y, and is able to command credibility on field Y even though the actual knowledge on that field is low.

A person is a set of brand names (where have I studied, what organisations I have worked in, what journals I have published in), a set of capabilities (character, values, ethics, knowledge) and a set of outcomes (what have I done in life). While it appears obvious that the capabilities and outcomes should matter more, some people care more about the brand names. Why is it that in some places and some times, brand names matter more?

In an ideal world, we start at a young person of age 21 and we know little about the things that matter -- emotional endurance, values, ethics, knowledge, character. So we judge the person by the brand names: "She is an NTS scholar so she must be very smart".  (I am showing my age; I believe KVPY is now the most elite club in India). As the person grows up, we can increasingly switch gears from the brand names to the person. What matters in the 20s is the brand names; in the 30s it's personality, and after that it's character.

Why might brand names matter disproportionately in India?

Let's use the notation B for the brand name, D for the data that we observe, j for our judgement about a person. We start with a very flat prior P(j); we know very little. Now we get the minimal information packet -- the brand name. Under Bayesian learning, we should P(j | B) = P(B | j) P(j) / P(B). Here we seem to do a lot of learning; if we were good Bayesians, P(B|j)/P(B) is a big number. And then we observe facts about the person D. We update P(j | D) = P(D | j) P(j) / P(D). Here, we seem to do little learning; if we were good Bayesians, P(D|j)/P(D) seems to be a small number.

What is going on? Some conjectures follow:

  1. One could say: "This has nothing to do with India; this is just `confirmation bias', a well known bug in human decision making. We are not rational Bayesian updaters, we overweight the prior and do not attach enough weight to the data. Get used to it, this problem is everywhere."  There is something to this argument. However, there is something going on e.g. people in China seems to care more about the brand name on clothes; people in India seem to care more about the brand names on the resume. Maybe humans are the same everywhere, but are there some features of the stochastic environment which make things different across space and time?
  2. In the West, the environment is stable. Trend GDP growth is 2.5%, which yields a doubling every 27 years. From age 20 to age 60, a person experiences a change from 100 to 268. This is a relaxed pace of change where people get satisfied with doing a few small steps, and can comprehend what is going on. In India, we are in an environment of far more hectic change. Trend GDP growth is 6.5%, which yields a doubling every 11 years. From age 20 to age 60, a person experiences a change from 100 to 1241. This an environment of big decisions and big consequences; this is not a comfortable locale for the cautious climber of career ladders. It is far more difficult to figure out what is going on. This is a very noisy environment. Could this high volatility generate greater conservatism i.e. inadequate updating? E.g. in money management, great returns can be owing to dumb luck, and this can happen more in a high volatility environment. In a high volatility environment, a money manager who generated high returns is less likely to have intrinsic skill -- data about performance is less informative.
  3. Inequality of knowledge could also be an issue. If I know nothing about cars, I will just fall back on brand names. When journalists know less, they will fall back on brand names -- they will think that the IIT guy must be right. If the seniors in decision making roles (who judge young people for promotions or appointments) know very little, there is a greater temptation to fall back on brand names and hire the IIT guy. Critical thinking on the part of person i about person j requires a low gap in knowledge between the two. A greater use of brand names may be inevitable in an environment of high inequality of knowledge. By this logic, the use of brand names in the world of business should be lower as the results (profit, measured in rupees) are visible for all to see.
  4. Principal-Agent problems are at work. Nobody ever got fired for hiring the IIT guy. When faced with the prospect of failure, the Agent seeks deniability by purchasing the brand name.

What goes wrong in a brand-centric world

The IIT guy may feel he has arrived. He may work less hard. He may take less risk. He doesn't have to score wins; he just has to be good enough and make it into his next job.

In academics, the research trajectory of myriad researchers is distorted by chasing brand names. A lot of people would use their lives much better if only they would dig in and research reality. This misdirection of effort results in waste. Similar things can be said all across the labour market, but it's particularly bad in academics. In the non-academic part of the world, the brand names fade away more rapidly as the person grows up.

In the US, it seems that the price paid for a brand name education is hard to justify in terms of the improvements that flow in a causal sense from that education.

One bizarre thing that I often see is an exaggerated cynicism. It's claimed that we're all clueless and ignorant and wrong. This is elaborately packaged as humility -- let's be careful to not think that thinking helps. The hidden subtext is: "Thinking is pointless, so let's just leave it to the IIT guy". By deprecating logic, we hand it over to the brand name.

    Finding underpriced assets

    The pervasive obsession with brand names has left undiscovered assets for me. I take effort to see the person rather than the brand name, and find hidden geniuses who are shunned by a brand-conscious establishment. Many heroes of the Macro/Finance Group at NIPFP fit this description. In this `security selection' process, it is relatively easy to shrug aside the brand names, but it is harder to look beyond personality and peer into character.

    I find some of the most impressive people in leadership roles in India are those who got there without brand names. This may be similar to what's being conjectured about women CEOs: It is so hard for a woman to become a CEO, she's got to be really good.

    Monday, April 06, 2015

    Financial reforms -- a meeting at the BSE tomorrow

    Indian Merchants Chamber, BSE and NIPFP have organised a meeting at 4:30 PM tomorrow.

    Making monetary policy more potent

    Tamal Bandyopadhyay in Mint, and MC Govardhana Rangan in the Economic Times, worry about the lack of effectiveness of monetary policy.

    RBI officials have hinted at taking `tough actions' if banks do not respond to changes in the policy rate by RBI. This seems to be a bit odd to me. In a well functioning economy, changes in the policy rate should propagate out through a market process and not central planning. If that market process is not working out okay, this calls for reforms of the underlying problems and not more central planning.

    There are three components of the monetary policy transmission:

    1. The bond market: When the central bank changes the policy rate, the entire yield curve changes through yield curve arbitrage. This propagates all through the Bond-Currency-Derivatives Nexus. It impacts upon the exchange rate as currencies and bonds are tightly interlinked. It impacts upon the corporate bond market at all maturities as the corporate bond market is priced off the risk yield curve.
    2. The banking system: When the central bank changes the policy rate, competition between banks forces changes in lending and borrowing rates.
    3. The exchange rate: When the central bank changes the policy rate, this impacts upon capital flows and particularly debt flows. This changes the exchange rate. E.g. when we cut rates, less money comes in, which gives a rupee depreciation, which is expansionary.

    These three channels rely on a sensible financial system. The first requires a bond market embedded in the Bond-Currency-Derivatives Nexus. The second requires a banking system. The third requires openness to debt flows and a flexible exchange rate. In India today, we have difficulties on all four counts:

    • RBI has failed on bond market development for 25 years. This has damaged the monetary policy transmission through the Bond-Currency-Derivatives Nexus.
    • RBI gives out two banking licenses every decade, and blocks foreign banks, so there is a lack of competition in banking. This has damaged the monetary policy transmission through the banking system: changes in the policy rate do not impact upon the rates at which banks borrow and  lend.
    • RBI has blocked debt capital flows. This has damaged the monetary policy transmission through the exchange rate.
    • RBI has emphasised exchange rate objectives. This has damaged the monetary policy transmission through the exchange rate. Things have become much worse on this count after 2013.

    These four elements of RBI strategy have made RBI ineffective as a central bank. The journey to a strong and effective RBI lies in changing course on these four questions.

    These four elements of RBI strategy are the barriers to make inflation targeting work. It is one thing to sign a Monetary Policy Framework Agreement, it is another to actually succeed in delivering the goods. Until the quality of economic thinking at RBI improves, we will ricochet from failure to failure.

    It is important to see the triad of the recent reforms as tightly interconnected. Setting up the PDMA is important as it takes away a key conflict of interest, and leaves RBI free to focus on the inflation objective. Shifting bond market regulation to SEBI is important as it gives RBI the monetary policy transmission. These two moves are integral to inflation targeting. The people who argue against these reforms are those who are perpetuating a weak and ineffective RBI. The Ministry of Finance has been kind to RBI by doing three things, as opposed to only doing the Agreement.

    The RBI is now 80 years old and faces existential questions. All these years, RBI staff could mumble some mumbo jumbo, and get away with it, as most people could not understand the mistakes in thinking. Now RBI is accountable for delivering on CPI inflation, where the target and the performance are three simple numbers. This is a whole new game. If financial sector reforms are now not undertaken, failure will be visible in public.

    Saturday, March 28, 2015

    Opportunities in analytical and policy-oriented economics

    Analytical research

    At the Macro/Finance Group in NIPFP, we have an active research program with a flow of papers, conferences, etc. There are exciting opportunities here for people with a Ph.D. (economics, finance, statistics) or Masters (economics, finance or statistics). The key skills are macroeconomics and finance, modern quasi-experimental and time-series econometrics, working with large datasets and complex empirical research. We are at the frontiers of computation, and write and release R packages. The persons who fit these roles are those who want to get absorbed in doing research about how the world works, or learn how to do such research.

    Public policy `think tank'

    In our `think tank' role, we analyse the problems of existing policy frameworks and propose alternatives. This is multi-disciplinary work with a mix of economics, law, finance and public administration. As an example, we were the technical team which supported FSLRC. If this kind of work excites you, and you possess some of these skills, please get in touch. We welcome economists and lawyers, and also welcome persons from the field of public administration, including mid-career civil servants.

    Public policy `do tank'

    Our `do tank' role is about building high performance agencies in government. As an example, we are the technical team which supports the four task forces which have been setup by the Ministry of Finance. This is about setting up organisation structure, process manuals, IT systems, and checks and balances, through which world class organisations are built. This is a rare set of opportunities to grapple with the challenges of creating excellence in government. Here, we welcome economists, lawyers, and persons from the field of public administration, including mid-career civil servants. We also welcome persons with a private sector background in constructing high performance organisations, including skills in process engineering, consulting, and private equity.

    The workplace

    The Macro/Finance Group at NIPFP is a exciting workplace. You will be surrounded by high IQ people, and little politics, bureaucracy, hierarchy or paperwork. The team is driven by intellectualism and a public service culture.

    How to apply

    Please get in touch with Anurodh Sharma,   anurodh.sharma@nipfp.org.in   , by 15 April 2015 with a resume and a covering letter explaining how you fit into the Macro/Finance Group at NIPFP.

    Thursday, March 26, 2015

    The issue of authenticity in Indian economics

    Aatish Taseer wrote in the New York Times:

    In my own world — the world of English writing and publishing in India — the language has wrought neuroses of its own. India, over the past three decades, has produced many excellent writers in English, such as Salman Rushdie, Vikram Seth, Amitav Ghosh and Arundhati Roy. The problem is that none of these writers can credit India alone for their success; they all came to India via the West, via its publishing deals and prizes.


    This meant that it was not really possible for writers like myself to pursue a serious career in an Indian language. We were forced instead to make a roundabout journey back to India. We could write about our country, but we always had to keep an eye out for what worked in the West. It is a shameful experience; it produces feelings of irrelevance and inauthenticity. V. S. Naipaul called it “the riddle of the two civilizations.” He felt it stood in the way of “identity and strength and intellectual growth.”

    I feel similarly about Economics in India.

    Economics in India ought to be about looking at our backyard, understanding what is going on, and getting involved in fixing things. But, to paraphrase Taseer: We can write about our country, but we always have to keep an eye out for what worked in the West. It is a shameful experience; it produces feelings of irrelevance and inauthenticity.

    There is no problem of authenticity in (say) physics. A physics paper is a physics paper and it does not matter who you are and where you are. But as Werner Heisenberg said, every electron is the same but every love is different. There was a time, in Economics, when the datasets were few and far between. Economists then analysed imaginary worlds through theoretical models. At that time, the questions that academic economists talked about, the world over, were similar. Now, things have changed. There are thousands of datasets all over the world. Economics today is about diving into these datasets, and the reality that surrounds them, and figuring out what's going on. And each of these datasets is a world of its own. The intellectual imperialism of Economics, where a person in one corner of the world could pretend to know about all parts of the world, has subsided.

    In the peer review process, research is judged on two counts: "Is the question interesting?" and "Is the answer persuasive?". On both questions, authenticity is a key problem.

    What is an interesting and important question in the Western discourse is very different from what is an interesting and important question here in India. Economists in India, who work on India, have to struggle to distort their work, to package it in a way that it fits the interests of editors and referees outside India.

    On the issue of persuasiveness, all too often, editors and referees outside India do not know enough (about institutional arrangements and data) to judge the quality of a research design. This creates incentives to do shabby work and get by.

    In this world, a paper on India in the American Economic Review is generally not useful for those of us who want to understand India.

    The use of international journal publications in the academic HR process creates severe incentives for economists in India to ignore India and figure out how to succeed when judged in the eyes of editors and referees who do not know India. We should organise ourselves to do research in physics very differently from the way in which we do other fields. 

    On this theme, see a previous blog post. There is an interesting discussion on Quora about blogs vs. academic journals which is a bit related.

    Wednesday, March 25, 2015

    Improving warehousing in India through a grading mechanism

    by Smriti Sharma.

    A key sub-industry in modern agriculture is warehousing. Storage reduces price fluctuations. Trusted storage permits `dematerialisation', where warehouse receipts are traded or delivered, and is the key link between physical goods and finance. At present, the quantity and quality of warehouses in India are inadequate. This is a key bridge that has to be crossed for the modernisation of agriculture. Trusted mechanisms for warehousing of non-agricultural goods are also an important enabler of the market economy.

    Warehouses claim to take in goods and keep them safe. The customer of a warehouse does not know the probability with which the promise will be violated. There are a diverse array of warehouses in India, but customers do not know the failure rate of alternative warehouses. Currently, consumers do not have information to differentiate between one warehouse and the other. Most people make a choice with regard to a warehouse on the basis of word of mouth and local reputation. Sellers of warehousing service withhold privileged information about their warehousing service from the buyers. This leads to a situation of information asymmetry.

    Information asymmetry is one of the classic market failures. Market economies seek to establish State capacity that efficiently addresses market failures. As an example, customers of a restaurant do not know whether the kitchen is clean, and this calls for the State to undertake certain interventions which address this problem.

    Absent government involvement, users of warehousing services have devised their own solutions to address this problem. National Commodities Derivatives Exchange (NCDEX) operates a remarkable closed-user-group (CUG) that attempts to solve the problem of information asymmetry by creating its own inspection, audit and monitoring mechanism to ensure sanctity of the physical settlement of commodities traded on its exchange. Alongside this, many collateral management companies have come up which offer turn-key services of protection to users.

    As is well known in public economics, when faced with market failures, such private solutions are not as nice as having a well structured and efficiently implemented government-based solution.

    Grading of warehouses

    Warehousing Development Regulatory Authority (WDRA) is mandated by the Warehousing (Development and Regulation) Act, 2007 to regulate warehouses that issue negotiable warehousing receipts (NWRs). Currently, WDRA registered warehouses go through a process of accreditation. This process verifies whether entities who apply to register with WDRA comply with certain registration requirements. This intervention is inadequate in that it does not create a mechanism for watching the performance of a warehouse on an ongoing basis. In and of itself, the WDRA registration has generated limited trust on the part of market participants.

    A better intervention, which can be introduced by WDRA, is a mechanism for grading of warehouses, WDRA can provide more granular and complex information pertaining to warehouses and WSPs. This would require establishment of processes through which grades are awarded.

    Experiences with grading in related fields

    Is grading the right intervention for this market failure? Some analogies may be instructive:

    • Credit rating agencies assign grades to bonds.
    • In the real estate sector, grading helps by providing the real estate developers with the incentives to conform to fair trade practices and legal requirements.
    • The New York Health Department made it mandatory for the restaurants in its five boroughs to get themselves graded for their sanitary scores. The grades summarising the sanitary scores are then made public. Within 18 months of starting the grading programme, the share of restaurants without a trained food protection supervisor decreased from 13% to 7%. Prior to grading, 11% of the restaurants had inadequate hand washing facilities, which reduced to 5%. Also, a 10% drop was registered in restaurants that had signs of mice infestation.

    These areas -- bonds, real estate, restaurants -- have the same market failure as that found in warehouses, i.e. information asymmetry.

    Grading warehouses and warehouse service providers

    Warehousing is an amalgam of warehousing infrastructure including warehousing premises, equipment and manpower which is used to deliver a service. For purposes of grading warehouses, warehouses need to be compared to each other, and against some benchmarks that the market may find useful.

    A variety of public and private agencies internationally have formulated broad parameters, on the basis of which warehouses are classified and graded. For example, in Tanzania, warehouses are scored on parameters specified by Warehouse Receipts Regulations, 2006 and then graded accordingly. In UK, United Kingdom Warehousing Association issues an advisory for its members that lists broad headings like these, against which standards are set for warehouses.

    Real estate consultants like Knight Frank also have their own list of parameters for warehouses. The parameters devised by each of these agencies are customised for the needs of their clientele. There is no single check-list against which WDRA can require warehouses to be graded.

    A grade can capture information on the physical attributes of the warehouse (e.g. warehouse building and warehouse site), management of the warehouse (e.g. ownership, technical and managerial staff) and the warehousing processes and activities (e.g. storage and handling of goods, fire security, pest control, use of technology and book-keeping).

    There is no fixed recipe for grading. WDRA must allow expertise present in the market to innovate in designing better grading mechanisms, and for grading agencies to discover what information is relevant for the warehousing market. For an analogy, financial regulators have pushed the bond market towards the use of credit rating agencies, while not micro-managing how credit rating agencies analyse a bond.

    Re-imagining the role of accreditation agencies of WDRA

    Provisions in the WDR Act allow WDRA to facilitate grading of warehouses by specialised agencies. It would be useful for WDRA to develop such an environment for the warehousing industry.

    Rolling this out also presents complexities, which will need to be addressed:

    1. Financial regulation in India has encouraged a mindless notion on the part of investors, where the credit rating agency is the only determining factor about whether a bond can be the target for investment or not. A more subtle environment needs to be created, without black-and-white notions. As an example, a steady stream of information emanating from a warehouse, about failures in settlement, is valuable for users without being a black-and-white grade.
    2. The business of grading is frought with conflicts of interest. The "issuer-pays" model disincentivises grading agencies to be critical of their clients and award unfavourable ratings. The global experience with rating of bonds has exhibited such problems.
    3. The tools of coercion by the State can be applied at various levels, such as forcing warehouses to get graded, or forcing warehouses to always disclose what grade they got, etc. Careful analysis is required to use the minimal coercive power while maximally addressing the market failure.


    There is a market failure -- asymmetric information -- in the field of warehousing, which justifies government intervention. The intervention presently used at WDRA -- requirements applied at registration -- are not addressing the problem. The WDRA Act contains provisions which could be used to bring about a mechanism for grading warehouses. Done right, this could reduce the information asymmetry.

    Sunday, March 22, 2015

    What is interesting in Budget 2015: the package of fiscal, financial and monetary institution building

    After the dust has settled, the interesting feature of Budget 2015 is the package of fiscal, financial and monetary institution building:

    1. The signing of the Monetary Policy Framework Agreement, through which RBI now has an objective: That of delivering year-on-year CPI inflation of between two and six per cent.
    2. The establishment of a statutory Public Debt Management Agency.
    3. Shifting of the government bond market regulation from RBI to SEBI.

    There are other elements of institution building which are relatively disconnected from this triad. E.g. the merger of FMC into SEBI is also a step towards shifting all organised financial trading into SEBI
    regulation, but it is not interconnected with the above three.

    The three big reforms are interconnected; they require each other; they strengthen each other. This is why all three elements figure in all the expert committee reports.

    The interconnections

    Inter-relationships between the three elements of Budget 2015

    When RBI is given the responsibility of achieving low and stable inflation, this is a difficult problem for two reasons.

    At present, RBI has a conflict of interest: of doing investment banking for the government. This conflict of interest is removed by setting up PDMA. This is also a good thing for bond buyers as it's safer buying bonds from a person who does not know what the next interest rate decision will be.

    In addition, when RBI changes the policy rate, there is a low bang for the buck as the monetary policy transmission is weak. Low competition in banking implies that rate cuts by RBI do not propagate out into the economy. The weaknesses of the bond market mean that rate cuts by RBI do not propagate out into the economy. This makes RBI ineffective: very big rate hikes or rate hikes are required (e.g. as was done by Rangarajan in the 1990s) to stabilise inflation. Bond market reforms are required for RBI to get the tools for the task at hand.

    When the PDMA tries to sell government bonds, it requires a liquid bond market. Bond market reforms are required for PDMA to get the tools for the task at hand.

    Bond market reforms feed into the PDMA reform (by giving PDMA the tools for the job) and the Monetary Policy Framework Agreement (by giving RBI the tools for the job). In addition, bond market reforms improves the working of the corporate and infrastructure bond market, thus improving the investment climate for infrastructure investment and private corporate investment.

    For many years, each of these components was recommended by expert committees, got discussed in the run up to each budget, and not undertaken. This is partly because each of these components, if viewed in isolation, is more difficult. Budget 2015 was able to break the gridlock by doing all three in unison. The whole is greater than the sum of the parts.

    There are two more respects in which this package of reforms yields gains to the economy. When RBI was doing the investment banking for government, and also controlled banking regulation, they had an incentive to get their work done without undertaking much effort, by forcing banks to buy government bonds. Once the investment banking work shifts to PDMA, we may hope that RBI will reduce the Statutory Liquidity Ratio, and thus free up greater space for banks to lend to private enterprise. This will largely benefit small and medium enterprises as this is the segment which is most dependent upon bank borrowing.

    The second dimension concerns the corporate and infrastructure bond market. This market critically relies on the yield curve, that is discovered on the government bond market, and on hedging using interest rate derivatives which trade on the interest rates on the government bond market. The development of the government bond market will increase the viability of corporate and infrastructure bond markets. These gains will largely accrue to large firms, as this is the segment which dominates the corporate and infrastructure bond markets.

    All this will play out slowly. Inflation targeting, the setting up of the PDMA, the improvements for the bond market, and the playing out of the downstream consequences: all these will take place over years. This is slow, important work. Once begun, it will take many years to play out.

    The reform is incomplete in two respects. When, in the future, the full Bond-Currency-Derivatives Nexus is moved from RBI to SEBI, the effectiveness of monetary policy will be further enhanced, and RBI will become a full fledged central bank by world standards. When, in the future, the policy rate at RBI is set using a Monetary Policy Committee, this will improve upon the decisions of one person.

    Addressing the confusion

    MoF has done a poor job of explaining what has been done and why, which has given a lot of media misinformation. Here are some questions which have swirled in the discourse.

    q: Does this mean that SEBI will set the repo and reverse repo rate?
    a: No, RBI will set the repo and reverse repo rate.

    q: Does this mean that SEBI will control or regulate the market infrastructure through which RBI undertakes repo or reverse repo transactions, which are essential to the conduct of monetary policy?
    a: SC(R)A does not apply for RBI. RBI will design, build and operate the infrastructure through which RBI will do repo or reverse repo transactions in the conduct of monetary policy. SEBI will not have any say or power over these arrangements.

    q: Does this mean that SEBI is now the regulator of the money market?
    a: This means that SEBI is now the regulator of all government securities. This is true regardless of their maturity. Government securities with less than one year maturity would, previously, have been termed ``money market instruments''. RBI will continue to run its own repo / reverse repo operations in the course of doing monetary policy. RBI will continue to regulate the call money market.

    q: What will happen when two private parties enter into a repo transaction?
    a: That transaction will be regulated by SEBI as it is a securities lending transaction. SEBI will be the regulator of all aspects of the government securities market, which includes the activity of lending government securities.

    q: Why is SEBI the right regulator for government bonds?
    • All securities are alike. Whether a piece of paper is a share or a bond, it is a security.
    • Hence, there are economies of scope and economies of scale for both the private sector and the government in bringing together all work connected with securities.
    • There are three parallel systems for organised financial trading in India: one led by SEBI (the equity market), one led by RBI (the Bond-Currency-Derivatives Nexus) and one led by FMC (the commodity futures market). Of the three, the equity market has worked out the best. Hence, all expert committees have advised that the entire activity of organised financial trading be placed under SEBI regulation. The merger of FMC into SEBI is part of this progression.

    q: There are complex interlinkages between RBI's payment system (RTGS), the settlement system for government bonds and the working of RBI repo.
    a: At present, IT systems within RBI talk to the depository for government bonds (SGL) which is within RBI. In the future, these systems will have to talk to depositories for government bonds outside RBI. This will require IT system modifications.

    q: All these changes will be disruptive.
    a: The Finance Bill is written in a way that the changes do not get triggered immediately. They unfold in a phased manner, alongside the implementation work, which will take a few years.

    q: Has all this been thought through and analysed with a cool head?
    a: Yes, numerous expert committees have recommended precisely these actions. Every single expert committee which wrote on this subject has recommended these changes: Setup a debt management office, merge regulation of organised financial trading, give RBI clarity of purpose to stabilise inflation. Setting up the PDMA is in (1) RBI annual reports, (2) the Jahangir Aziz Working Group, (3) the M. Govinda Rao Working Group that was setup under FSLRC, (4) the Justice Srikrishna Commission, (5) the Percy Mistry Committee, (6) the Raghuram Rajan Committee and (7) the Vijay Kelkar Committee on MOF restructuring. Inflation targeting and the merger of organised financial trading at SEBI (or UFA) is in the Percy Mistry Committee, the Raghuram Rajan Committee and the Justice Srikrishna Commission.

    Not one expert committee has disagreed with any one of the three elements. The only critics are those motivated by self-interest.