Wednesday, February 25, 2015

Become a public policy thinker in three easy steps

Step 1: What's the market failure?


Each of us tends to get unhappy at some feature of the world or the other. As an example, I don't like rap music. But value judgements of this nature do not justify the use of State power - either to ban rap music or to encourage classical music. That is just abuse of power.

When should the State intervene? The technically sound answer is: When you are certain there is a market failure, and when you are confident you know how to setup the correct State capacity for the intervention.

Market failures come in four kinds: 1. Asymmetric information,   2. externalities,   3. market power and 4. public goods. These are technical terms in microeconomics and each needs to be carefully understood.

The first hurdle that must be crossed in policy thinking is: "Is there a market failure?"  Every proposal to do something in public policy faces this test.

A good way to smell market failures is the prices being wrong. In a well functioning economy, the price should be close to marginal cost or to the Ramsey price. When the observed price diverges from these normative ideals, a market failure may be afoot. But while the price being wrong is the diagnostic that alerts you to a problem, direct intervention in the price (i.e. a government that imposes a price control) is seldom the right answer.

Most of what the government does in India is not about market failures. Using the coercive power of the State to meddle in the voluntary decisions of consenting adults is almost always a bad idea. The Indian State suffers from rampant central planning, license-permit raj, and shameless value judgments.

Step 2: What's the proposed intervention?


Once we agree there is a market failure, we have to figure out what we'd like to do about it. Here, it's important to understand the anatomy of the market failure, and solve it at its root cause.

If there is a causal chain x -> y -> z, and there is a problem with the outcome z, don't use the power of the State to change y or z. Understand the root cause, and solve it there.

Example: Investors are not buying infrastructure bonds. Don't propose tax exemption as the solution.

Example: Micro-finance companies in Andhra Pradesh are mistreating their consumers. Don't propose micro-prudential regulation of micro-finance companies as an answer.

Example: OTC derivatives are not enforceable. Don't propose changing the financial regulatory architecture as the answer.

Government agencies in India are known to do a bait-and-switch. A problem is shown, outrage is created, and then a completely unrelated solution is pushed forward which will increase power and reduce accountability. We need to be skeptical and thorough and ask the question: Does your claimed intervention address your claimed market failure?

Complicated microeconomic interventions which require volumes of law are almost always abuses of power, and will not deliver on the original objective. At a heuristic level, the main reason the Indian capital controls don't work is that the FEMA handbook weighs 3.5 kilos.

Occam's Razor in Public Policy: Many different interventions could possibly change the world in the direction that you like. The least intrusive intervention that gets the job done is the right one. In order to find this least-intrusive intervention, you have to understand the market failure deeply. Sound thinking in public policy requires understanding the anatomy of the market failure, and coming up with the minimum use of the coercive power of the State in addressing that market failure and in minimally disturbing the rest of the landscape.

Corollary: Macroeconomic problems require macroeconomic policy tools. It's almost always wrong to use microeconomic interventions to pursue macroeconomic goals.

Step 3: The hurdle of public administration


Okay, you are all dressed up and ready to go, with a demonstrated market failure, and a minimal intervention which solves it. Now the question arises: Can you design a feasible solution with real world public administration?

Pressure groups will hijack well meaning policy frameworks to favour small groups at the expense of the diffused populace. Government agencies like to be lazy and corrupt. Politicians and officials work for themselves and not for the citizenry. Can we envision the accountability mechanisms through which the Principal (the citizen) is able to coerce the Agent (the government) to deliver results? An enormous machinery of checks and balances has to be designed, including transparency, reporting, rule of law, due process, etc.

As a thumb rule, government should almost never be in the position of determining a price. Prices must fluctuate every day, based on changes out there in the world. It is impossible for government agencies to figure out what the right price should be. Similarly, a government should not be in the business of determining business plans or business models. That's a tell tale sign of central planning.

We have to be careful about mission creep. Market power is the job of the Competition Commission and not the IRDA. Enforcing IPC is the job of the police and not of FMC. SEBI should not be forcing listed companies to have women directors; RBI should not be subsidising ATM placement in Assam, and so on.

Libertarianism of necessity vs. libertarianism of choice


Many times, even after we know there is a market failure and we're able to envision a surgically limited intervention, we have to fall back on doing nothing, as the market failure is not very large or significant, and it's not easy to design the public administration machinery through which we can make a government deliver the desired outcomes. When there is low State capacity, this happens more often. We do more subtle interventions in Sweden, we do more laissez faire in India.

Conclusion


Decades of Indian socialism have starved us of capabilities in economics. Everyone interested in the field of public policy should limber up with these three steps: (a) What's the market failure? (b) What's the minimal intervention that precisely addresses the root cause of the market failure? (c) How do we construct mechanisms through which government agencies in the real world will deliver the desired outcome, even though their first instinct is to favour laziness and corruption?

This is hard work. The outcomes of this process of thinking resist classification into prefabricated belief systems. I sometimes meet people who say "As I'm a Keynesian, I propose policy X". That's a great economy of thought; by reading a few books by Keynes, you have figured out the world. It's  better to start from first principles, and analyse each problem on its merits, and engage with the gritty reality out there in figuring things out.

Going from strong as in scary to strong as in capable

by Suyash Rai and Ajay Shah.

The central question in India's journey, today, is that of constructing State capacity. How should laws, agencies, processes and accountability be designed, to engender high performance? In a recent speech titled Democracy, inclusion and prosperity, Raghuram Rajan talks about the joint process of evolution of economics, politics and the State. Rajan provides a brief summary of the framework articulated in the first of Francis Fukuyama's two volumes on political development. Fukuyama uses three pillars to trace political development globally: State-building, rule of law, and accountable government.

Late in the speech, he asserts that India is unique in having built democratic accountability and rule of law before building a strong government. He argues that there is a conflict between government accountability and government capacity, and since checks and balances make it difficult for the government to do its job, we should focus more on State-building and less on accountability. In other words, we have plenty of accountability but little capacity, and should therefore focus on the latter. The key text is:
An important difference from the historical experience of other countries is that elsewhere typically strong government has emerged there first, and it is then restrained by rule of law and democratic accountability. In India, we have the opposite situation today, with strong institutions like the judiciary, opposition parties, the free press, and NGOs, whose aim is to check government excess. However, necessary government function is sometimes hard to distinguish from excess. We will have to strengthen government (and regulatory) capability resisting the temptation to implant layers and layers of checks and balances even before capacity has taken root. We must choose a happy medium between giving the administration unchecked power and creating complete paralysis, recognizing that our task is different from the one that confronted the West when it developed, or even the task faced by other Asian economies.

For instance, a business approval process that mandates numerous government surveys in remote areas should also consider our administrative capacity to do those surveys well and on time. If it does not provide for that capacity, it ensures there will be no movement forward. Similarly, if we create a multiple appellate process against government or regulatory action that is slow and undiscriminating, we contain government excess but also risk halting necessary government actions. If the government or regulator is less effective in preparing its case than private parties, we ensure that the appellate process largely biases justice towards those who have the resources to use it, rather than rectifying a miscarriage of justice. So in thinking through reforms, we may want to move from the theoretical ideal of how a system might work in a country with enormous administrative capacity, to how it would work in the actual Indian situation. Let me emphasize, we need "checks and balance", but we should ensure a balance of checks. We cannot have escaped from the License Permit Raj only to end up in the Appellate Raj!
In this article, we disagree with this argument. We analyse RBI in some detail as an example of what is going wrong in the Indian State. We see the argument above as a restatement of the present mores of the Indian State. This way of thinking is integral to the poor outcomes that we see in India today, and yields low State capacity and abuses of power. The essence of making progress on the construction of liberal democracy in India, and of building State capacity, is to break with this position.

The three big phrases in this debate


State-building. Fukuyama uses the term `State' in the sense that Max Weber used it: An organisation deploying a legitimate monopoly of violence over a defined territory. He also borrows the definition of a modern state: A state that is subject to a rational division of labor, based on technical specialisation and expertise, and impersonal both with regard to recruitment and their authority over citizens. State-building essentially amounts to successfully extending the state's legitimate monopoly on force over the territory it governs, and modernising the use of this force by division of labor, technical expertise, and impersonal recruitment and authority. The state may use its force for benign ends, but it has the power to do the opposite. This monopoly is necessary but it is also dangerous, and therefore it must be constrained. That is why democratic accountability and rule of law become important.

Rule of law. For many people in India, the phrase rule of law means `obeying all laws'. However, it means much more than this; it is about a deeper constitutionalism that pervades the working of the State. The essence of this complex and multi-faceted concept is the restriction of arbitrary use of power. When the power of the State is given to an individual, that individual is expected to use it in good faith for the precise purpose for which it was given, without undue intrusion into the people's lives. However, trust in good faith is not enough. If men were angels, no government would be necessary. Hence, the rule of law must be enshrined in procedures and policies. All use of power must be subordinated to established laws, and not based only on volition. The rule of law is strengthened when laws limit the use of power, and prescribe due process for use of power. Under the rule of law, the law is known, State behaviour is predictable and aggrieved persons have efficacious mechanisms for appeal.

Accountable government: In Fukuyama's words, accountable government means that the rulers believe that they are responsible to the people they govern and put the people's interests above their own. This moral concept of accountable government has formal manifestations. One major way in which this manifests itself in democratic societies is through the Constitution and parliamentary laws. The government is mandated to put the public interest above its own interest. If the government fails to meet the objectives satisfactorily or if it uses its powers for some other ends, the electorate would hold it accountable at the elections. Alongside this, well drafted laws create an array of additional accountability mechanism, which constantly keep government agencies and their employees under check.

Ordering or interdependence?


While many countries developed strong governments before they strengthened government accountability and rule of law, there are important examples of countries where this was not the case. The US and UK saw the emergence of democratic accountability and rule of law alongside the rise of strong governments. Democratic accountability and rule of law helped decide what kind of strong and capable government the country needed. That is what protected the populace from a rapacious state. Even James Madison who wrote about enabling the government to control the governed, and then obliging it to control itself, helped build accountability and rule of law in the US Constitution from day 1, which helped shape the nature and extent of strengths of the US government (see Federalist 47-51 by James Madison).

There is a deep dialectical relationship between government capacity and government accountability, and not some simple ordering. Accountability may shape State capacity, and the opposite could also happen. As Tocqueville demonstrated in his book on the French Revolution, The Old Regime and the Revolution, the French monarchy unintentionally paved way for a democratic revolution by creating a rational, centralised state that weakened the feudal order and placed most citizens on equal footing, thus laying the foundations of democratic society.

Education in India shows us an opposite story: if so many people in the country had not exercised the "exit" option by taking their kids to private schools, and instead "voiced" their dissatisfaction with government schools, we would have seen much better performance from the government schools.

It is more risky to have the State build capacity in a vacuum as it is all too easy to misuse coercive power. State capacity must be built within the contestations and pressures of democratic accountability and it must operate within the bounds of rule of law.

Strong as in scary vs. strong as in capable


At first blush, it seems that India has a `weak State' and has rushed ahead on greater democratic accountability and rule of law. However, the precise sense of `strong' or `weak' needs to be carefully understood. There are two aspects of the 'strength' of a State.

  1. One feature of a `strong' State is having coercive power over citizens, the ability to force them to do certain things, and the ability to hurt them. By this definition, large parts of the Indian State qualify. Many regulators in the financial and infrastructure sectors are fairly strong in terms of their ability to make their regulated sectors follow their commands. The tax bureaucracy in India is very powerful, to the point where the phrase `tax terrorism' has entered the lexicon. If we think of the word `strong' as `scary', then a lot of the Indian State meets the test.
  2. Another feature of a `strong' State is one that delivers the desired results. A `strong' criminal justice system is one that delivers law and order. If we think of `strong' as `capable', most of the Indian State apparatus is faulty.
Rajan says that asking for more accountability and the rule of law will hold back the emergence of a strong State. At present, all too often, the Indian State is strong as in scary but not strong as in capable. A great deal of coercive power has been given to the government and its agents, but they do not build sufficient capacity to do their jobs. At the same time, they use the power as they wish.

How to map power into the desired outcomes? This is substantially about accountability and the rule of law. If results are not delivered, it is very likely because there is not enough accountability and the rule of law. The journey from a scary State (which has the coercive power over citizens) to a capable State (one that delivers on governance outcomes) runs through the bridge of accountability mechanisms and the rule of law.

'Leave it to the experts' or 'give them power and hold them accountable'?


Rajan says that since it is difficult to distinguish necessary government function from excess, the government should get a long rope. But it is precisely because government function is hard to distinguish from excess, that government and regulators can amass illegitimate power and use it excessively. Only when we build adequate checks and balances will the temptation for excess be curtailed.

To place Rajan's comments in context, in a recent debate [link, response, response, response, response], he opposed judicial review of regulations. Is such review an example of "excessive checks and balances"? In the working of liberal democracy, nobody has the ability to write law without checks and balances. As an example, a committee report led by Professor Rajan in 2009 strongly and repeatedly recommends the idea of an appellate system for all financial regulators. Now, Governor Rajan opposes the idea.

Looking at the RBI through this framework


It is well and good to talk about high principles, the big picture and the long march of history. However, specific actions, real institutions and the current context also matter. When talking of the entire system, one is vulnerable to commit a fallacy of division, i.e. assuming that what is true of the whole must also be true of the parts. What is true of the overall Indian government may not actually be true of all its parts. Rajan is on a three-year term as the Governor of RBI. He has completed about half of the term. This is hence a good time to look at how issues of State capacity, accountability and rule of law are working at RBI.

Regulators such as RBI subsume within them legislative, executive and judicial powers. They make regulations, implement them and adjudicate over those they claim have breached the regulations. This devolution of authority from the Parliament is justified because of technical expertise required, and because there is a need for independence from day-to-day political intervention. However, if such power is not checked, it is a recipe for tyranny.

Is the grand narrative of the Indian state - high on accountability and rule of law, and low on capacity and strength - true of the RBI? RBI is strong as in scary. It lords over banking, payments, capital flows, etc with such strength that it is almost unimaginable that a regulated entity would do anything against RBI's wishes. Most employees of financial firms privately excoriate the RBI but are scared enough to praise it in public. There is a level of fear, and self-censorship, that is seldom found in argumentative India.

While India has high democratic accountability overall, this is not true of RBI. RBI is a set of unelected bureaucrats who are, in effect, largely unaccountable. Although it is supposed to be held accountable by the Parliament, one cannot see how such accountability can be enforced. At present, RBI pursues multiple, conflicting objectives, which give endless opportunities of offering alibis for non-performance. It is a central bank, manager of government debt, redistributor (e.g. priority sector requirements), regulator of banks, non-banking financial companies, payments and capital flows. It runs exchange and payments infrastructure. When failing on beating inflation, it can say it was keeping interest rates low on government debt. When failing on safety and soundness regulation, it can argue that it was busy ensuring banks lend to priority sectors where they incurred losses. Multiple objectives, and conflicts of interest, has given a loss of accountability.

What about the rule of law at RBI? RBI has taken undue advantage of what Rajan calls "the difficulty of distinguishing between necessary government function and excess".

Example: RBI has arbitrarily arrogated to itself the power to restrict competition in banking by giving only 2 licenses a decade, and there is no effective mechanism to question this power. This is partly because the RBI Act and the Banking Regulation Act do not impose sufficient procedural restrictions on such misuse of powers. If, for example, the RBI was mandated to conduct a cost-benefit analysis of its regulations, we would learn about the economic consequences of the restrictions it imposes, but no such mandate exists.

Example: RBI's actions on exchange-trade currency derivatives, which damaged the liquidity in the market, and increased currency volatility. These mistakes would have been less likely if there were better checks and balances.

Example: Under Rajan, RBI's intervention of the Rupee has grown manifold compared to that in the previous Governor's tenure:


This major shift in the actions of monetary policy has not been announced or explained to the public. This change in course is an exercise of arbitrary power conducted under opacity.

Example: In a recent case involving Docomo, RBI arbitrarily announced that one particular transaction was allowed to violate its own regulations. This violates the rule of law. See: Good sense on Docomo vs. the rule of law by Bhargavi Zaveri and Pratik Datta.

Example: RBI's notion of `wilful default' is inconsistent with the rule of law.

Example: RBI repeatedly puts out orders which are arbitrary exercises of power.


RBI has almost completely unchecked powers. Judicial review would be a valuable check. The judiciary will not rewrite regulations or order, but it may strike down regulations and orders that are found violating the Constitution, some laws or regulations. This helps improve the quality of regulations and orders.

Rajan seems to be arguing that because RBI is low on capacity, the accountability mechanisms should be reduced. We have one interesting counter-example in the Indian experience. SEBI was weak, and issuing a stream of low quality orders. The application of constitutional principles led to the introduction of appeals against SEBI orders, in 1997, at the Securities Appellate Tribunal. In the years since the SAT was set up, to hear appeals from SEBI orders, the quality of SEBI orders has improved, and indeed, the quality of investigations and enforcement at SEBI has been pushed up.

In similar fashion, the highway to a superior RBI runs through subjecting RBI actions to judicial review. State capacity at RBI is 18 years behind the capacity which has come up at SEBI as a consequence of the pressure that SEBI faced in the form of appeals at SAT. We have `Governor Raj'. If we add some `Appellate Raj', we might get a good mix.

Accountability and rule of law are not just about judicial review. The rule of law is violated when RBI makes a regulation without proper cost-benefit analysis, without a two-way public consultation, without detailed reasoning for the regulation. This is arbitrary use of power. This happens, among other things, because the idea of rule of law is not properly embedded in the institutional framework of the RBI.

Take the example of payment regulation. At present, the RBI does not allow customers to waive the two-factor authentication requirement even for small value transactions [link, link]. So, if I want to be able to transact upto Rs. 1000 transactions every day without a second factor of authentication, I am not allowed to do that, even though it is my own money. We have the same level of security for Rs. 10 lakh transaction as for Rs. 100 transaction. This imposes undue transaction costs on small value transactions and makes many businesses difficult to do. If the RBI followed due process in making regulations (cost-benefit analysis, consultations, etc), it may have, in the process, modernised its regulatory approach and liberalised the sector.

Greater accountability and rule of law would help RBI build the right kind of capacity and to use it to regulate free markets optimally, and not to constrain the markets unnecessarily. Will more due process and judicial review slow down RBI? In fact, RBI will have to speed up its game. It will not be able to centrally plan the sectors it regulates, and therefore it will have to build systems to actually regulate the fast-moving innovations of the financial system, rather than slowing down innovations to make its own life easy. It is only in a police state that a policeman's job is easy. Our thinking on public policy should not cater to the convenience of an RBI official.

The RBI has recently allowed two more types of banks - payment banks and small banks. However, the basic framework of central planning by RBI, and the License-Permit Raj, is intact. RBI continues to decide what innovation the market will do, and market participants bend over backwards to modify their business models to accommodate RBI's notions of innovation. Once in a decade or so, a committee is set up to tell the market what kinds of business models it can pursue. Now that RBI has released two new types of business models that it was preventing from getting out, we are happy and thankful. Institutional reform would be to change this system of "innovation by committees". More pressures of accountability mechanisms is required, to break the edifice of central planning. We have not escaped from License-Permit Raj; more Appellate Raj will help break down License-Permit Raj.

Four strands of thinking


There are four strands of thinking in India on the project of building the Republic:
  1. At one end is the Left, which just wants an intensification of the socialist republic of India.
  2. A second group wants to do direct democracy - get citizens to devote a large amount of their time to participate in governance in pursuit of the common good, just like ancient Athens. This group also wants to hand over arbitrary power to a watchdog agency - Lok Pal.
  3. A third group wistfully looks back at the power concentrated in Nehru and Indira Gandhi and thinks "Gee, what would I do with that power!" This is not about the rule of law, it is not about the rule of men, it is the craving for the "rule of me".
  4. A fourth group wants to construct a liberal democracy, where performance is obtained out of potent accountability mechanisms and checks-and-balances.
In India, some in the elite pay lip service to words like liberal democracy, rule of law, and free markets. At the same time, there is limited commitment to enlightenment values, and limited understanding of how a complex State works. For some in the elite, arbitrary power for the State means increasing their own power. We need to do more in terms of improving knowledge and the quality of the debate.

As Fareed Zakaria has emphasised, holding elections is not the essence of liberal democracy. The real story of liberal democracy lies in the internal machinery of checks and balances, of the intricate systems of rule of law, judicial review, separation of powers, freedom of speech and myriad accountability mechanisms. The main story of India should be about making these institutions work [example].

Sunday, February 22, 2015

How to make courts work?

by Pratik Datta, Ajay Shah.

We in India are proud of the way elections are conducted. We are ashamed of the way our courts work. The problem of judicial delays in Indian courts is well-known. Delays are a significant contributor to India ranking 186th in "Enforcing Contracts" in the Doing Business Report. Studies have shown that court efficiency has a bearing on economic activity, making our record on delays a serious cause for concern.

There are many initiatives presently underway, which seek to do `court modernisation' using computer technology. We argue that most present initiatives are poorly designed. Simply computerising the existing processes of courts will not give us better functioning courts.

A recent example: Computerisation of court records


One example of superficial application of technology to courts is the Supreme Court's e-filing process. This has a few problems.

The Advocate-on-Record (AoR) doing the e-filing is notified online of the defects. He is supposed to rectify the defects and ultimately submit a hard copy. The requirement of a physical document defeats the very purpose of e-filing.

Physical filings cost less than electronic filings. This should be reversed.

Most important, the e-filing system merely injected some computers into existing court processes without fundamentally rethinking the design of the existing processes. This yields low, zero or negative gains.

Business process engineering


A court is an organisation made up of various components: judges, advocates, registry, IT team, accounts department and so on. Each component interacts with the other in a consistent pattern: each gets an input from another, processes it and delivers an output. Failure of one component to deliver the right output results in delay. For example, when a matter is filed, the advocate provides an input in the form of a petition. The registry processes the petition, reviews it and fills a checklist and delivers an output - often a checklist of filing defects. From this perspective, a court is just like any other firm. The experiences of firms in business process re-engineering from the world of firms are relevant to the objective of building better courts.

There is enormous global experience with business process re-engineering in firms. Three main lessons can be identified:

  1. The superficial sprinkling of technology on top of legacy processes yields low, zero or negative gains.
  2. What is required is comprehensive redesign of processes, utilising the possibilities of contemporary technology.
  3. Rolling out such comprehensive transformation is difficult. It will be resisted by erstwhile staff who are set in their ways. These initiatives have to be owned and championed by the top leadership.

Business process re-engineering of Indian courts should start with time and motion studies, to look at how air time of courts is used, and abused. This should then lead to a brand-new design of how the court room functions. There are many global initiatives which can give ideas in this regard. Indian IT and consulting teams have done a lot of overseas work, and have global state of the art expertise in process engineering. We should tap into this talent pool for building world class courts in India.

In the mind of a BPR person, the foundations of the thinking are the work load (how many customers show up per month) and the capacity which is required to serve them. This is simple division: How many man-hours of a court room does it take to serve one customer, and hence how many court rooms do we need? This also leads to the question: How can the man-hours used by one customer be reduced? These elementary sizing calculations do not take place in the judiciary today. Courts are built with no regard for the anticipated case load, nobody knows how many cases will show up, and all that happens when queues build up is hand-wringing. No Indian IT/consulting professional would accept such lassitude, but the legal fraternity has become used to treating delays like death and taxes.

Integral to the new system should be an instrumentation mechanism, through which fine grained data is made available about the working of the new processes. This can then be used to kick off a continuous spiral of process improvement. In other words, a brand new process should not be seen as a one time reform. Integral to the one time reform should be a process of continual measurement and refinement.

This kind of thinking has been used with courts before, elsewhere in the world. Here are some examples. The National Center for State Courts in the US has done extensive research on this. Software have been developed to manage court business processes across jurisdictions (some examples are here and here).

Why do our courts work badly?


Expert committees have played an important role in policy making in India. However, in the past, court automation committees have usually comprise of judges, lawyers and registrars. All these persons (a) Lack knowledge on business process engineering (example: the composition of the Supreme Court e-committee) and (b) Are invested in the present ways. They have succeeded and risen to the top of the profession under the present arrangements, and tend to treat the present system as broadly sound.

Contrast this with an example of a successful re-engineering of business processes in another wing of the government - the Income Tax department. In his 2006 Budget Speech, the then Finance Minister declared that the IT department will undergo process re-engineering. Accordingly, a global tender was floated and a management consultant firm was appointed as external consultant for the project. It is because of this extensive project that today income tax returns can be easily filed online.

Projects must start with the mandate of building a world class court, not a mandate of computerising the court. Computerisation committees are typically not given the mandate of redrafting the procedural rules of the courts. For example, the terms of reference of the Supreme Court's e-committee does not clearly specify that it should produce new draft procedural rules. However, the Supreme Court e-committee itself in its Policy and Action Plan Document (2014) instructed all High Courts to take up process re-engineering. Accordingly, some High Courts set up their own process re-engineering committees (see here, here). Reportedly, the High Courts have submitted these reports to the Supreme Court and these have been forwarded to the Law Commission for identifying the best practices. It is unclear whether the result of this exercise will be a fresh set of procedural rules. Moreover, this approach is inefficient as it requires every High Court to reinvent the wheel and leads to the possibility of a differential response from High Courts.

The way forward


We think three ingredients are essential:

  1. The dominant flavour of new projects should be to do fundamental, ground-up process re-engineering, drawing on the tremendous talent pool found in India in the consulting and IT industries. The flavour of the teams should be consulting and IT, and not legal practitioners.
  2. Since we have started out at the bottom of the world, too often, our aspirations are too low. International experiences should be used much more than is presently the case. E.g. consider the example of Dubai. The attitude should be to jump to the top 10 in the world, not go up from rank 186 to rank 166.
  3. We should build scalable systems and institutional arrangements which, once proven in one or two courts, can be rapidly re-applied all across the country.

Some important developments are now taking place in building better courts:

  1. Justice Srikrishna's Financial Sector Legislative Reforms Commission has drafted primary law governing the `Financial Sector Appellate Tribunal' with strong provisions forcing world class functioning.
  2. The Ministry of Finance has setup a `Task Force' to build this Financial Sector Appellate Tribunal.
  3. We may be at the early stages of important new developments in finance with the rise of `Finance SEZs'. The NIPFP concept note on this subject recommends that the agency design for FSAT be applied to commercial courts which would do dispute resolution between firms.

Conclusion


As Fareed Zakaria says:

...when we think about democracy, we should really think about not simply the electoral process but the inner stuffing of democracy, which is the institutions that produce liberty, separation of powers, the rule of law, courts and constitutions and that that inner stuffing is in many ways more important than elections.

The Constitution requires elections. We would be outraged if elections were marred by delays, corrupt staff, etc. The Constitution also requires courts. We should bring that same level of outrage to the failures of courts in India. The organisational capabilities which are used to run elections properly need to be brought into the field of running courts properly. As with free and fair elections, there is no contradiction between efficient management and fairness. All that is required is obtaining a quantum jump in processes. India has made this jump with the working of elections; now we need to do this with the working of courts.

Wednesday, February 18, 2015

Policy framework for Finance SEZs

There is a lot of interest in India today, on setting up an international financial services centre (IFSC) in an enclave, i.e. a Special Economic Zone. Possibilities include GIFT City near Ahmedabad and a MIFC in Bombay.

A concept note of ours on this subject has been released for public comment by the Ministry of Finance.

Many decades ago, free trade zones like Kandla or SEEPZ, played a role in improving India's engagement with globalisation at a time when there were many restrictions on the current account. There is a possibility that Finance SEZs could play a similar role in improving India's engagement with globalisation.

In 2007, the Percy Mistry Committee on Mumbai as an International Financial Centre (MIFC) had rejected the strategy of building an enclave, and had emphasised the importance of solving the problems of the mainland. From 2007 till 2015, the main work process of financial sector policy has been to fix the mainland. It is only in the context of that larger strategy that it makes sense, today, to additionally explore an enclave strategy. The raw materials available at hand today, owing to that larger strategy, are what make now the enclave strategy feasible. The enclave strategy is now only a small detour and is now advisable.

The Percy Mistry Committee used the acronym `IFC' for `International Financial Centre'. This has become confusing as the acronym also stands for `Indian Financial Code'. The folks at GIFT shifted to the phrase `International Financial Services Centre' (IFSC) which is unambiguous and we should all just switch.

Thursday, February 12, 2015

For GDP growth to revive, we must win back households into financial savings

The decline in private corporate investment in India, in recent years, has been widely noticed. What deserves equal attention is the dismal state of household financial savings. If corporate investment is to revive, firms will require external capital, and the problem of household financial savings will become an important bottleneck. I have a column in the Economic Times today on this.

Saturday, February 07, 2015

What's required in the budget speech of February 2015 in fiscal, financial and monetary institution building

There are high expectations for the February 2015 budget. The budget speech is a statement of the workplan of the government for the coming year. The BJP aspires to lay the foundations for India as a mature market economy. A key component of this is setting up fiscal, financial and monetary institutions.

At the Public finance conference in December 2014, I did a talk titled `Fiscal, financial and monetary institution building'. The video is on the NIPFPMF youtube channel:

Thursday, February 05, 2015

Expert committee reports in Indian finance

Expert committees play an important role in the evolution of financial economic policy in India. Committees can be a way to merely delay action. But as Isher Ahluwalia says: "Nothing ever got done by writing it in a committee report, but nothing ever got done without writing it in committee reports". In the hands of sensible people in the world of policy, the committee process is an important tool.

Committees sift through debates, analyse rival viewpoints, draft consensus statements, bring heretical ideas into the mainstream, work out nuts and bolts of implementation particularly when there is a need for inter-agency cooperation, and sometimes draft legal instruments such as regulations or laws. I generally find that the highest quality drafting of reglations and laws is done in India through the committee process.

What follows here is a collation of what seem to be, with the benefit of hindsight, some of the more interesting and important reports in Indian finance. I was quite excited about many others at various points in time, but in the end, they turned out to be dead ends.


Full name: Report of the committee to suggest steps for fulfilling the objectives of price discovery and risk management of commodity derivatives markets, Department of Economic Affairs, Ministry of Finance, April 2014. Chairman: D. S. Kolamkar.
Short name: Kolamkar committee report.
Claim to fame: First clean thinking on the role of commodity futures.
Downstream: This will shape the evolution of commodity futures regulation.
Factoid: This was the first fruit of shifting commodity futures to DEA, which took place on 6 September 2013.


Full name: Report of the Committee to Review the FCCBs and Ordinary Shares (Through Depository Receipt Mechanism) Scheme, 1993. Ministry of Finance, November 2013. Chairman: M. S. Sahoo. Blog post.
Short name: Sahoo Committee report, or to the cognoscenti, the Sahoo 1 report.
Claim to fame: Drafted the new capital control regulation for Indian firms issuing ADR/GDRs. The cleanest and best drafted financial regulation as of November 2013.
Downstream: The regulation was issued.
Factoid:  The first report which was accompanied by a video.
Lag:  0.94 years. The shortest gap in Indian history between the committee report and its complete implementation.


Full name: Report of the Financial Sector Legislative Reforms Commission. Ministry of Finance, 22 March 2013. Chairman: B. N. Srikrishna. Blog post.
Short name: FSLRC or Srikrishna Commission report.
Claim to fame: Drafted the Indian Financial Code (IFC).
Downstream: Handbook, MIS on Handbook implementation, and task forces.
Factoid: The biggest ever team in Indian public policy for the purpose of drafting one bill. While the Commission is termed FSLRC or the Srikrishna Commission, the main output of the Commission was the IFC.


Full name: Report of the Working Group on Foreign Investment, Department of Economic Affairs, Ministry of Finance, 30 July 2010. Chairman: U. K. Sinha.
Short name: U. K. Sinha Report, or WGFI report.
Claim to fame: First talked about the rule of law as applied to capital controls, invented the single window QFI system (ht: C. B. Bhave).
Downstream: The thinking on rule of law which began here ultimately laid the foundation for FSLRC. Hopefully this report may yield a single QFI framework one day. The QFI idea is in the IFC.
Factoid:  Embarassing fumbles in the alphabet soup of FPI, QFI, etc., where the implementers seem to have not understood the report. An element of that journey.


Full Name: Financial Well-Being: Report of the Committee on Investor Awareness and Protection, Ministry of Finance. Order Issued 17 March 2009. Report submitted December 2009. Report made public 22 May 2014. Chairman: D. Swarup.
Short name: Swarup Committee Report on Consumer Protection.
Claim to fame: Built an argument for moving to a full trail model instead of the high up-front commission retail model followed by the financial sector. Triggered a public turf conflict between regulators. Also triggered the ordinance issued by the Government of India to decide the turf war in favour of the insurance regulator [blog post].
Downstream: Mutual funds went no load in 1 August 2009, even before the committee submitted its report. Ulip cost structures were reduced to be compatible with mutual funds. The traditional insurance policies continue with a 40% front commission. The knowledge and perspective produced in this committee fed into the idea that consumer protection must be at the heart of the IFC.
Amusing: For many years, the report was buried; it was probably inconsistent with the MoF decision to do the ordinance. Insurance agents burnt effigies of committee chair protesting the recommendation that the industry move to a no-load incentive structure. Links. Images.


Full name: A hundred small steps: Report of the Committee on Financial Sector Reforms, 2009. Chairman: Raghuram Rajan.
Short name: CFSR report, Raghuram Rajan Report.
Claim to fame: Raghuram Rajan's views when he was an independent economist. Chapter 7, titled "Creating a robust infrastructure for credit".
Downstream: Fed into FSLRC.
Factoid: The chairman signed the report, but recanted in 2014. Response #1, Response #2, Response #3, Response #4.


Full name: Report of the Internal Working Group on Debt Management, Department of Economic Affairs, Ministry of Finance, 31 October 2008, Chairman: Jahangir Aziz. Blog post.
Short name: Jahangir Aziz Report, or WG DMO report.
Claim to fame: This drafted a DMO Bill.
Downstream: This got subsumed into the draft Indian Financial Code that was drafted by FSLRC. The IFC extended this to place cash management for the government also at the DMO.
Factoid: The agency was named `National Treasury Management Agency' in this report. This turns out to be the name of the Irish DMO. FSLRC shifted to the name `Public Debt Management Agency'.


Full name: Report of the High Powered Expert Committee on Making Mumbai an International Financial Centre, Department of Economic Affairs, Ministry of Finance, 10 February 2007. Chairman: Percy S. Mistry. Buy. Blog post.
Short name: MIFC report, Percy Mistry committee report.
Claim to fame: The first committee report in India's history which thought on the scale of the entire financial system. In 2008, Jayanth Varma described this as the only honest committee report in Indian finance. A lot of the things that are considered obvious today first appeared here. E.g. this is the first official document which talks inflation targeting. These were heretical ideas then.
Downstream: Fed into FSLRC.
Factoid: The chairman did not sign the report, but stands by it.


Full name: Report of High Level Expert Committee on Corporate Bonds and Securitisation, Department of Economic Affairs, Ministry of Finance, 23 December 2005. Chairman: R. H. Patil.
Short name: R. H. Patil committee report.
Claim to fame: First focus on the corporate bond market.
Downstream: Corporate bonds went demat. All trades are now reported at NSE, BSE or FIMMDA.
Factoid: In early 2004, Rakesh Mohan as Secretary (DEA) chaired a meeting which simultaneously setup the Percy Mistry Committee and the R. H. Patil Committee; the two reports were (put together) to show the light for the next phase of Indian financial sector reforms.


Full name: Report of the inter-ministerial task force on convergence of securities and commodity derivative markets, 2003. Chairman: Wajahat Habibullah.
Short name: Habibullah committee report, Convergence committee report.
Claim to fame: The first step towards unification of all organised financial trading.
Downstream: On 6 September 2013, the allocation of business rules were modified to place commodity futures into DEA.
Factoid:  A remarkable high minded report, where the Secretary of a department (Habibullah was then Secretary of the Department of Consumer Affairs) supported doing the right thing even when it reduced the turf of his department.
Lag: 10.3 years from report date to the change in allocation of business rules.


Full name: The Project OASIS report. Ministry of Social Justice and Empowerment, 11 January 2000. Chairman: Surendra A. Dave.
Short name: OASIS report or Dave Committee report.
Claim to fame: Designed the New Pension System. Anticipated the consumer protection crises of later years. Anticipated the computer and telcommunications technology that was going to become ubiquitous, but was considered space-age then.
Downstream: In December 2002, the Union Cabinet decided to create the NPS and make it mandatory for all new recruits from 1/1/2004 onwards, and to create PFRDA.
Factoid: Within the committee, it was Dave's insight that the only way to make a pension system work for poor people was to ratchet up to the frontiers of technology.
Lag:  2.93 years from the report date to the decision, and 10.75 years from the decision to the PFRDA Act.


Full name: Report of the committee on derivatives, SEBI, March 1998. Chairman: L. C. Gupta.
Short name: L. C. Gupta committee report.
Claim to fame: Laid the foundations for the start of exchange-traded derivatives in India, along with a pair of Jayanth Varma committee reports which worked out the risk management.
Downstream: Equity derivatives trading started in June 2000.
Factoid: Was the slowest committee process for a report of this complexity. It took 1.3 years from committee creation (November 1996) to the report.
Lag: 3.57 years from the creation of the committee to the start of trading.

Understanding one-rank-one-pension

This is a post that should have been written a long time ago. It seems impossible to reverse one-rank-one-pension in India now, and it seems hopeless to fix the military pension. However, it's worth understanding what the issues are, and the mess that we've landed in.

Nominal annuities in a zero growth environment


Let's start with a country with no GDP growth. So a worker earns some income all his life. We want him to tuck some money away every year into a pension account that will buy an annuity at the age of retirement. He builds up this pension wealth, and at age 60, he buys an annuity. It's common to target a "50% benefit rate", i.e. the magnitude of the annuity should be half his last wage.

To fix intuition, let's assume the number A is the price of an annuity which yields a flow of income of Rs.1 per month. In this case, the pension wealth to get to half the last wage is Aw/2.

This is the challenge of the ordinary pensions discussion. If you want an unfunded, i.e. a `defined benefit' pension, then you want the taxpayer to pay Aw/2 for each person. There is no other difference; the basic story is the same.

In India today, A is roughly Rs.133. That is, if you buy an annuity at age 60 which pays Rs.1 per month until death, the price is Rs.133.

So far, we have asked the annuity provider a simple question: We have said: I want a fixed cash flow of Rs.1 per month until I die. What would you charge for this? The annuity market says: I will charge A for this contract. This is the lowest price of an annuity; this is a simple unindexed nominal annuity.

Now we can modify the terms of this annuity in many ways.

Real annuities in a zero growth environment


You could say: Instead of giving me a nominal Rs.1 per month, give me an inflation indexed Rs.1 per month. This is an inflation indexed annuity. This will of course cost a lot more than A. To produce a nominal annuity, the annuity provider invests in nominal bonds which produce a stream of cash. But to produce a real annuity, the annuity provider has to invest in inflation-indexed bonds, which yield a lower stream of cash. Hence, it needs much more than A to produce an inflation indexed stream of Rs.1 per month. Suppose the price is B, and we know B >> A.

A government that promises an unfunded inflation-indexed annuity is placing an expense on the tax payer of Bw/2.

The problem of GDP growth


Into this environment, let's inject high GDP growth. Let's go to the higher side by assuming per capita GDP growth of 7%, which means that per capita GDP doubles every decade.

When a person is 60, he was at half the wage of persons who are 59. But when he reaches 70, his pension has stood still, but the persons who are at age 59 have (roughly) got a doubling of their wage. The pensioner has lost ground compared with the worker.

That pensioners lose ground when compared with workers is a fact of life of all pension systems. In the West, where pensions were invented, this was not a big deal, as they have had a slow growth environment. But when there is high GDP growth, this can yield glaring gaps. A pensioner who is at the 90th percentile of the Indian income distribution at age 60 will endup at perhaps the 70th percentile of the Indian income distribution at age 70.

This is just a fact of life and you can't do anything about it. Anyone who builds up wealth in India over the working years 1980 to 2020 will seem prosperous in relative terms in 2021 but will seem less prosperous in relative terms in 2031 and in 2041. That's the inexorable logic of high GDP growth.

Suppose we go to the annuity provider and say: Sell me an annuity which is not just inflation indexed, but wage indexed. The payment per month will go up to reflect the average wage growth of the economy. This is a pension which will keep up with the Joneses.

In my knowledge, there is no private insurance company which will produce such an annuity. It's a very expensive annuity to produce. Let's use the symbol C for the price of this annuity. C >> B >> A.

A government that promises someone a wage indexed pension is asking the taxpayer to put up Cw/2 which is much bigger than Bw/2 or Aw/2.

That's one-rank-one-pension


This is the costliest pension imaginable. The Indian government seems to be on the trajectory of offering this for all military personnel. It is a dramatic escalation of the implicit pension debt for the government on account of military personnel.

Once this entitlement is in place, it will be hard for the government to go through with the NPS reform, where the second stage was supposed to be integrating uniformed personnel into the NPS.

It is a disappointment that we did not have adequate thinking on these issues in time. The delays and sloppiness of implementing the NPS have been extremely costly for India.