Saturday, December 29, 2007

Daily data from electronic payments systems: a new treasurehouse of data on the economy

John W. Galbraith and Greg Tkacz have a paper which, to me, implies that RBI should initiate release of daily data on traffic on payments networks such as credit cards, debit cards, etc.

Thursday, December 27, 2007

Monday, December 24, 2007

SEBI's move on short selling

SEBI has moved on short selling and securities lending. See the two PDF files at the bottom of this page. For the motivation, about why this is important, and the political economy of the constraints, see this blog post by Jayanth Varma. A quick summary of where we stand on this question:

  • Instititional investors are prohibited from selling a security they do not own, but some of them (mutual funds, FIIs) have fairly good flexibility on using single-stock futures where shorting is easy and convenient.
  • Non-institutional investors - who make up the bulk of the market - are able to go short, but lack a mechanism for borrowing shares. Once again, shorting is easy and convenient using the single-stock futures. In addition, many day traders short-sell within the day but are forced to buy back within the same day since borrowing shares is infeasible.

My sense of the situation is that India does not suffer from a significant problem in the ability to express negative views about stocks, given the strength of the individual stock futures market. However:

  • Reverse cash and carry arbitrage requires access to borrowed shares.
  • Many securities lack individual stock futures. Obtaining market efficiency on these critically requires that speculators have a mechanism for selling borrowed shares.

SEBI's announcement envisages short selling for the same stocks where individual stock futures are available. The impact there will, then, be limited to enabling the activities of arbitrageurs. While that is beneficial, much more remains to be done.

The really important issue is the mechanism for borrowing shares. Will this work frictionlessly? In my intuition, demand for borrowing is small and the supply (with institutional investors) is quasi-infinite, so access to borrowed shares should become possible at very low prices. I wonder what the charges for borrowing securities are in the UK and the US.

As emphasised in the MIFC report, the need of the hour is an integrated securities lending mechanism covering shares, corporate bonds and government bonds, so that short selling can flourish on all three markets. SEBI needs to urgently solve the problems of the borrowing mechanism, so as to then move forward on implementing this larger agenda. Short selling is more urgently needed on the bond market, where the minimum semblance of market efficiency is presently lacking.

Mobis Philipose has a good article in Mint reviewing the SEBI announcements and their consequences, and Business Standard had a good editorial on this subject today:

Economic liberalisation is, ultimately, about the idea that resource allocation driven by markets works better than that driven by a Planning Commission. This requires markets that work well. This calls for ample information disclosure, checks against market power, and a free play of both optimistic and pessimistic views. Short selling - expressing a negative view about a stock that one does not own - is thus an integral part of any well-functioning financial system. Sebi's recent moves on short selling are, hence, based on the correct vision for financial sector policy.

When derivatives trading on individual stocks began, a "technology" for expressing speculative views about individual stocks became available. An optimist can buy futures or call options, or sell put options. A pessimist can sell futures or call options, or buy put options. Thus, with derivatives trading, a level playing field between positive and negative views is assured; short selling is no longer a big issue. Unfortunately, Sebi says that short selling will only be available for these stocks. Sebi would do well to permit derivatives trading and short selling on more stocks. Short selling for stocks on the derivatives list matters only insofar as it supports reverse cash and carry arbitrage. When the futures price is `too low', arbitrageurs borrow shares, sell them, and buy the futures. The impact of this announcement will, then, be indirect: it will help cure the persistent underpricing of futures that has been found in India.

Some features of Sebi's announcements are unfortunate. Institutional investors are prohibited from squaring off positions within the day. They are required to disclose that an order is a short sale at the time the order is placed. Retail investors are being asked to make the same disclosure at the end of day. Brokers have to supply this data to exchanges who will then release these to the public. These notions are not grounded in serious policy analysis. For the spot market, short selling is invisible: on T+2, when deliveries have to be made, the short seller supplies shares just like any other seller. A thorough policy analysis effort on Sebi's part would have led to the simple removal of all restrictions on short selling.

The real challenge is not in short selling but in effecting borrowing of shares. Sebi proposes to set up an exchange-traded mechanism for borrowing shares. This involves one key rigidity that will hamper its success: borrowing and lending can be done only for seven days. This is inconsistent with the needs of futures arbitrage. When an arbitrage opportunity surfaces (say) three days from futures expiration, the futures arbitrageur needs a way to borrow shares immediately for a maturity of three days. While an exchange traded mechanism sounds sophisticated, the mainstream solution found internationally - that of merely borrowing securities OTC from institutional investors - appears to be a superior solution.

Update: Andy Mukherjee disagrees, saying that India might well be onto something very important by emphasising an anonymous order-matching mechanism for borrowing shares.

Friday, December 21, 2007

Paper on PNs

Manmohan Singh has written a good IMF working paper on participatory notes in India. I have checked and I'm sure this URL works.

Who needs weather derivatives?

Once I was chatting with a kabab vendor on the streetside. I asked him "What problems do you face?". He said that it was Id that day, and he faces a massive risk. If the crescent moon is sighted, he gets flooded with business, and runs out of chicken. If it's cloudy, and the moon is not sighted, then he is holding too much inventory of chicken and it gets wasted. I thought to myself: Wouldn't it be neat if he could get a contract that pays if it's cloudy.

The New York Times has a fascinating story on a new place where weather derivatives are useful. They describe applications in the apparel industry :

And the manufacturer Weatherproof, which supplies coats to major department stores, has bought what amounts to a $10 million insurance policy against unusually warm weather, apparently a first in the clothing business.

Fredric Stollmack, the president of Weatherproof, said that unseasonable weather, once a widely mocked excuse for poor performance in the industry, is the new norm, forcing companies to make sweeping changes in how they manufacture and sell clothing.

...

For Weatherproof, forecasts and climatologists are not enough. The majority of the companys business is done in November and December and if the weather is unusually warm, as it was during those months last year, sales plunge. (The last several months were not much better, with August, September and October combined the warmest ever recorded for six states, according to Planalytics, a weather research firm.)

So in a closely watched experiment, Weatherproof signed a contract that guarantees it would be paid as much as $10 million if daily temperatures in New York City are warmer than the historical average for December, 37 degrees. The higher the temperature this month, the more money Weatherproof will be paid.

Weatherproof bought its coverage from a 1-year-old company called Storm Exchange, which also sells such contracts to oil and electricity companies.

The Internet changes the music business

This blog entry is written jointly with Kaushik Krishnan.

The crisis of the old music business

With computer technology, music has gone from LPs and CDs into computer files. Crashing prices of networks and storage has meant that transferring music files from one friend to another is effortless. Through these changes, music has acquired characteristics of a public good: it is non-rival (my consumption of music doesn't come in the way of yours) and non-excludable (it has become impossible to stop piracy in anything but a police state). Hence, the traditional business model of the music industry is in deep trouble. As an example of the difficulties that music companies are facing, see Robert Sandall writing in Prospect magazine. David Byrne has also written a very nice piece in Wired magazine. (You might also want to look at a conversation between Thom Yorke and him on the future of music.) He shows that there has been a drop in music sales in general and a steady increase in the sales of music electronically:

Many experiments are afoot on rethinking business models in this age of the Internet. The essential opportunity lies in utilising the very computer technology - which has obsoleted the record / CD business - by linking up the ultimate artist to the ultimate consumer, so as to eliminate the overhead of various middlemen. Byrne writes that a large portion of the cost of a CD is in overheads; the payments by the buyer of the CD mostly don't reach the artist:

The sarodist Suresh Vyas pointed out to us that the 15% of the overhead that's spent on marketing/promotion is in the interest of the artist, insofar as it is about raising publicity and awareness. And yet, a key change of the electronic world is that friends pass on music to friends, giving a powerful word-of-mouth phenomenon through which awareness can be increased. It is different from the marketing blitzkrieg of pop music of old, but that doesn't mean it's non-existent.

The Apple Music Store does not solve many of these problems

The leader of the pack, in terms of revenues, is Apple Music Store. However, I would personally never buy a single minute of music from Apple Music Store, given their closed standards: you can only use their music files on Apple hardware. Even though I have an ipod and my main machine is an Apple Macbook Pro, I wouldn't dream of being tied down to them like this. In addition, they have digital rights management (DRM) of a sort that I find offensive. Electronic distribution should help by lowering overheads. As yet, the situation is one where Apple makes money, but the musicians still get very little (as shown in the above diagram).

Today, I saw magnatune, an alternative way of organising the music business, that I think has a bright future. Magnatude has been around since sometime in 2003. Here is how it works:

  1. For starters, experimentation in their catalogue is convenient and free. They have pages sorted by genre, such as this page of `world music', which work as a free radio station. This helps you to sample their material.
  2. They make it easy to shift from listening to the radio to buying. While something is playing, the album cover is displayed. Click on it and you are looking at the material produced by this artist. Here is an example.
  3. When you click to `buy', it gives you a choice between download or physical disc.
  4. When you go to the download page (here is an example), you are asked to pick a number for what you will like to pay - between $5 (Rs.200) and $18 (Rs.720).
  5. They make it very convenient - all you have to do is type in a credit card number and the CVV.
  6. This takes you to a download page (here's an example) which offers various file formats. All the files are free of Digital Rights Management (DRM), and both low-res and high-res files are on offer.

The download password works for 60 days, so if something goes wrong in the download, it's easy to restart it. Every time you buy an album, they give you three gift coupons using which three of your friends can download the same album for free.

I find it to be quite a transformation when compared with the traditional music business - whether it's the old record companies or the Apple Music Store -

  1. It is easy to evaluate material on the website without paying for it.
  2. Customers have flexibility to pay between $5 and $18 for an album;
  3. Half the revenues goes to the musician, which is a lot better than the traditional business;
  4. Downloading files is, of course, nicer than buying CDs;
  5. Yet, this is done without bringing any DRM into the picture;
  6. High-resolution FLAC or WAV files are on offer, as are low-res files for those who prefer them;
  7. Non-commercial use of the purchased material is free.
  8. The website is extremely well thought out and easy to use.

I think they will go far, and are a far more impressive model for what the music business can be in the Internet age when compared with the market leader, Apple Music Store. Here are some links:

Other efforts

Magnatune is very impressive, but it's only one of a new breed of `open source record labels'. One example worth examining is onclassical.com.

Some other music sites worth exploring are pandora which is the offspring of the Music Genome Project. Pandora used to be available everywhere but it is now restricted to US users only due to legal issues. Suresh Vyas pointed us to http://www.underscorerecords.com which pays 70% to the artist.

Ruminating on what is happening

If I may ruminate on what is going on, the free software movement has shown the way in shifting from products to services. In this world, products have public goods characteristics (non-rival and non-excludable) and are free. Associated services are not public goods (they are rival and excludable) and are not free. So it is possible to earn money from consulting, configuring, adapting and modifying free software - but not from selling it. A good programmer will never starve, but in this world there is no possibility of scoring another Bill Gates.

In similar fashion, when music has acquired public goods characteristics, musicians will have to shift from revenues based on products (sale of CDs) to revenues based on services (concerts, custom compositions / performances, etc). The Byrne article shown above lists six strategies that musicians can use in this changing environment to still chalk out a living for themselves. A good musician will never starve, but revenues like those obtained by music companies of old are not feasible in this world. Open source record labels fit well into this emerging ecosystem, while many traditional firms do not.

Rajappa Iyer asks a deeper question. The `old deal' offered to musicians was: With a low probability, you will get Led Zeppelin payoffs. This helped attract a certain kind of person, with low risk aversion, to take the plunge into the tens of thousands of hours of effort that is required to try to become a good musician. Most didn't make it, but a tiny few became fabulously rich. In the new world, where this low-probability massive-payoff is not in the picture, will there be a reduction of supply of individuals who are willing to undergo such penance? My first answer would be that the risk aversion of people who choose to make music will be higher than that found in the old world. :-) But that is surely only a part of the story.

Watching markets work - IFCI

There was an announcement on 19th that the IFCI control transaction would not go through. The CMIE website shows this at 6:11 PM, so this would be after the market closed at 3:30. The stock price graph from Friday (14th) to Thursday (20th), from Yahoo Finance, is fascinating (click on it to see it more clearly). At the close of business on 17th, IFCI and Nifty were together. A gap showed up on 18th morning and widened slightly by 19th. On 20th morning, there was a massive gap and the opening price was over 30% below that found on Friday.

But then, IFCI is defunct. The only reason to buy IFCI is to get a license to be an Indian financial firm - a reflection of the entry barriers in Indian finance. The 20th closing price (Rs.76.75) is still a hefty P/E of 7.89 and a P/B of 2.81.

I often meet people who are repelled by sharp price fluctuations. Episodes like this are a vivid demonstration of markets in action, and of the importance of sharp movements of the price when there is a sharp change in the situation. The valuation of IFCI on Friday was conditional on the sense that a management transformation was around the corner. On Tuesday and Wednesday it was clear there were problems, and on Wednesday evening the announcement came out that the deal was not going through as envisaged. It is an efficient market that responds swiftly and clearly.

Look closely at the intra-day chart for 20th (Thursday) only. I was fascinated to see how the opening price of Thursday morning was roughly true - there was no significant undershooting or overshooting. (Once again, click on the above graph to see it more clearly). There was a lot of turnover, but right in the first few minutes, the market basically got the closing price right. This IFCI story is a clean experiment because the firm is defunct; it has no expectations of cashflows that vibrate intra-day owing to news about the economy and the firm. The only news affecting the firm is the impending transaction (or lack thereof).

Through all this, the IFCI stock futures market was quite resilient. (As an aside, once a stock has futures trading on it, there are no price limits, which was essential to allowing these large price movements to take place unhindered). At closing time, the `market by price' of IFCI futures at NSE was:

I worked out the `liquidity supply schedule' (LSS) that's implied by this MBP:

The LSS shows the impact cost associated with all possible transactions. Negative values on the x axis pertain to selling while positive values pertain to buying. It looks quite liquid. At the touch, the spread is ~ 0.26%. The one-way impact cost for buying Rs.5.6 million is 0.23% and the one-way impact cost for selling Rs.6.2 million is 0.26%. The `market-by-price' display (of the top five prices) alone gets you to buying/selling over Rs.10 million, where impact cost of a tad beyond 0.3% is seen. All in all, it's a good display of market resiliency - a big price move took place, but the futures market was not spooked, atleast by NSE closing time. On the subject of resilience, you might like to see this.

Thursday, December 20, 2007

Impact of rupee appreciation on margins of software companies

To continue the discussion on the impact of rupee appreciation that was begun by Swaminathan Aiyar a few days ago, the software industry is an interesting test case of the questions of interest. This is because the domestic firms are primarily export oriented. Hence, firm financial data is directly relevant for understanding changing export conditions and their consequences. The software industry is expected to have been hurt both by the slowdown in the US, and by the appreciating rupee.

The CMIE Internet system has interesting data about the aggregated quarterly results of software companies:

ParameterJul-Sep 2006Jul-Sep 2007
Operating profit margin (%)29.9828.46
Net profit margin (%)23.4921.58

While sales growth has dropped, margins have not yet dropped much. An operating profit margin of 28.46% is still a very large one by any standard - it is roughly ten percentage points bigger than the operating profit margin for non-financial firms as a whole. A glance at this table does not suggest that the INR/USD appreciation of 13.6% from Sep 2006 to Sep 2007 has greatly damaged the situation of these firms.

In understanding what is going on, a key aspect is the role of the exchange rate appreciation as an equilibriating mechanism. With INR/USD at Rs.46 a dollar, the economy was overheating. The INR appreciation has helped deliver more normal conditions on the labour market, in the investment of firms, etc. As an example, see this excellent article by Mobis Philipose in Mint about the responses at Infosys. The appreciation is not a shock which is demanding corresponding adjustments of the economy; it is the mechanism through which the economy adjusts. A distorted exchange rate - like distorted petroleum product prices - yields distorted behaviour on the part of a lot of firms and households. When the government comes in the way of the market exchange rate, it hinders the adjustment process on the part of millions of households and firms.

Wednesday, December 19, 2007

Futility of capital controls?

I read a fascinating story by N. S. Vageesh in Hindu Business Line titled Overseas borrowings continue to grow, about the October data on ECB.

I had heard stories about RBI trying to have capital controls against ECB, through bureaucratic tactics, which exceed the restrictions in the stated policy on ECBs. On this subject, Vageesh says: "Subsequently, there were reports that the RBI was keeping a number of applications for borrowing pending in view of the unprecedented inflows of forex during this period."

It's striking to notice that despite these efforts, there has been no easing up of the difficulty of preventing INR appreciation above Rs.39 in September and October. I put together my thoughts on this in an article titled Futility of capital controls? in Business Standard today.

Similar stories are being acted out elsewhere in the world. The Economist had a fascinating story about the leakiness of Chinese capital controls.

Large-scale job loss owing to rupee appreciation?

Swaminathan S Anklesaria Aiyar has an interesting piece in Economic Times today where he questions the claims of job loss owing to the rupee appreciation that are being bandied about:

Hundreds of columns have been written on the exchange rate policy of the Reserve Bank of India, and its decision to let the rupee appreciate sharply this spring. However, what was earlier a debate mainly between technocrats has suddenly assumed populist, alarmist tones.

In Parliament, commerce minister Kamal Nath has said the appreciating rupee has hit labour-intensive exports such as textiles, leather goods and gems & jewellery, and that one to two million workers may have lost their jobs. Following up, industrialist and Rajya Sabha member Rahul Bajaj has written in this newspaper suggesting that 2.8 million people have lost their jobs.

The numbers are so huge that, if they were anywhere near the truth, we would have a major human tragedy on our hands. In fact, we have only tall stories and data inflation aimed at scaring people rather than informing them.

I toured Gujarat in the run-up to the state election, and talked to a wide range of people about the many issues that might determine the outcome. Not a single person mentioned worker distress in export industries as an election issue. Nor did I see this mentioned in the innumerable TV discussions of the Gujarat elections.

Now, at election time opposition parties are given to exaggerating rather than hiding distress issues. Narendra Modi was fighting principally on an economic development platform, and Congress speakers were looking desperately for flaws in his platform. Gujarat is a major centre for exporting both textiles and gems. If indeed workers were being thrown out of work by a strong rupee, this would have been a huge election issue. In fact, it was a non-issue.

I myself toured Ahmedabad and Saurashtra. I can state categorically that the garment and textile areas there were not hit by mass unemployment. Indeed, at least one textile magnate, Vinod Arora of Aarvee Denims, was positively gung-ho about the future of his industry.

I did not visit the diamond-cutting areas around Surat. But my Economic Times colleagues went there, and found no unemployment arising out of a strong rupee. They found signs of declining foreign orders, but this had not translated into fears of job losses among diamond cutters. The electoral impact was negligible. In which case the economic impact must be close to zero too. Proponents of a weak rupee are altogether more agitated than the people on whose behalf they claim to be agitating.

Now, ET correspondents have reported job losses running into thousands in Tiruppur. Clearly, there is some distress in some areas. But it is not an all-India calamity. There is a world of difference between losing a few thousand jobs and two million. Some job losses are inevitable, indeed desirable, in a market economy, and constitute transitional pains, not human disaster. Those who claim that a strong rupee is costing millions of jobs are talking through their hats. We need to shout this from the rooftops, since many media folk are falling for false propaganda on this score.

Indeed, the notion that modest changes in the exchange rate can produce such huge swings in employment is obviously false. If a modest rise in the rupee can kill two million jobs, a corresponding fall in the rupee should create a similar number of jobs. Alas, that did not happen when India had big currency declines in the past. Nor will it happen if the rupee now falls by 13%.

Export growth in April-September was 26.9% in dollar terms, and provisional data suggest 35.6% growth in October. Even allowing for rupee appreciation of 13%, this constitutes solid export growth. Exporters may be under somewhat more pressure than before, but are not throwing millions out of work.

A rupee appreciation is exactly like a reduction in all customs rates -- imported raw materials become cheaper and all tradeable finished goods become cheaper. I find it unsurprising that the advocates of autarky such as Rahul Bajaj, who fought for many years against lowering of customs duties, are similarly offended by rupee appreciation.

I would also encourage two kinds of skepticism about job loss in India. First, the massive unorganised sector - where there is no labour law and the market clears - acts as a stabilising force when employment in the organised sector fluctuates. Through this, India actually has substantial flexibility in the labour market, unlike the situation in industrial countries other than the US and the UK. Second, with an overall workforce of roughly 500 million, fluctuations of 1 million or roughly 0.2% are lost in the imprecision of most statistical systems. So even though the word `million' sounds like a lot, on an Indian scale, it isn't.

Swami also talks about the relative fluctuations of the rupee and the Chinese RMB. To help think about what's going on, here's a graph of the INR/CNY rate. Think of it like the usual INR/USD graph - bigger values are a rupee depreciation, and vice versa. The broad picture that I get is of a little movement since 2000, and a lack of a time trend. Which is hardly surprising, considering that both countries essentially peg to the USD.

Tuesday, December 18, 2007

What is required in Asian financial sector policy

Dominic Barton has an interesting article Taking stock: Ten years after the Asian financial crisis in The McKinsey Quarterly which is worth reading. His checklist of what needs to be done in Asian financial sector policy is:

  1. Embed and deepen risk-management processes, capabilities, and culture in financial institutions.
  2. Ensure that top management, both in the private sector and in regulatory bodies, conducts annual scenario- and contingency-planning exercises.
  3. Shift the major banks emphasis in corporate governance from hardware to software.
  4. Focus on developing talent.
  5. Increase and intensify the formal cooperation and interaction among government bodies with economic responsibilities.
  6. Formalize and greatly increase the interaction among regulators and supervisors across Asia.
  7. In each Asian country, launch master plans, developed cooperatively by both the public and the private sectors, for the financial system.

I think the combination of the international-finance-focused MIFC report and the (work-in-progress) domestic-finance-focused Raghuram Rajan report will add up to an excellent master plan for India to pursue.

Critical appointments over the next year

PositionDateOutcome
Comptroller and Auditor-General January 2008 Vinod Rai, 17 December 2007
Secretary, Dept. Financial Services, MOF December 2007
Chairman, SEBI February 2008
Two members of SEBI
Chairman, IRDA May 2008
Governor, RBI September 2008
Chairman and members of Competition Commission

Sunday, December 16, 2007

Never saw a club that I liked

In my experience in doing finance in the period after the IT revolution, one thumb-rule that has reliably worked for me is this: anytime you see a small club that was created through government fiat, there's merit in asking first principles questions about why that club exists.

An example is the `primary dealer' institution as it existed in the US. When California was very far away, it made sense for the treasury to sell bonds to primary dealers on East Coast, who would then farm them out to customers all over the country. But in this electronic age, we only introduce frictions by introducing one more layer of intermediaries. A better market design would involve direct auctions open to the world at large.

On 12th December, the US Fed announced a new animal called the Term Auction Facility (TAF). Stephen Cecchetti has an excellent summary of the efforts that are presently underway, in resolving the difficulties of monetary plumbing.

The quick summary is this. Temporary liquidity injections by the US Fed were done through repos against the 20-odd primary dealers. This broke down because these 20 banks are in the eye of the storm themselves. In response, as Cecchetti says: the Fed announced that they are going to auction off reserves for terms of up to 35 days, allowing all banks to participate and accept the same collateral that is accepted in discount lending. This is different from open market operations because it involves all 7000+ banks, not just the 20 primary dealers.

Now, in this computer age, an auction with 7000 or 7 million players is not hard to organise. What I found really funny is footnote 9 of the article, which points out that the US Fed will not use computer systems for any of this! The 7000+ banks are going to bid by phone!

Well before this crisis erupted, my policy instincts would have been to break open clubs. The right way to sell securities is through the massive distribution networks of the securities industry, where auctions can reach millions of screens worldwide. There is no need to have select clubs like primary dealers or investment bankers in this modern IT-enabled world. At best, enshrining a club introduces frictions. At worst, it could lead to serious policy difficulties when the select club is in trouble, as has happened in the US.

As an aside, India was a pioneer in using NSE/BSE screens to sell IPOs. This was done well before google made it famous. See World's biggest democracy can show Google how to conduct an online IPO by Francesco Guerrera in Financial Times, 31 Jul 2004. However, the present state of the IPO process in India is highly unsatisfactory; it is far, far from a state where securities are auctioned off, with bids emanating from every NSE/BSE screen, at a market-determined price, without an investment banker. The SMILE report had walked in the right direction, but after that there was no follow through. The full transformation of the primary market should be on the agenda for the next SEBI chairman, and when it's done, this would be the vehicle of choice for the Debt Management Office in selling securities, and the central bank for conducting monetary policy.

Friday, December 14, 2007

Finally, good airports

T. N. Ninan has good news from the airport that's being constructed at Delhi. Right now, Delhi is probably the worst airport in the world (e.g. see a list of the world's worst airports in Foreign Policy). It will be an interesting contrast to see the existing mess being replaced by a new airport. The glass is half full on infrastructure, given the transformation of policies - politics - administration that has taken place with telecom, roads, ports and aviation. With electricity, railways and urban infrastructure, we continue to be mired in an unreconstructed and dysfunctional institutional framework.

Fiscal discipline at the state level

A few days ago, I had posted a blog entry pointing to my paper New issues in Indian macro policy which is forthcoming in T. N. Ninan's edited book. In that paper, I suggest that the glass is half full on fiscal consolidation. India has made important institutional changes (e.g. tied down fiscal policy with the FRBM Act) and administrative changes (e.g. the Tax Information Network) which have given significant progress on public finance. In connection with that, I noticed an RBI document which looks at state budget data for 2007-08. The press release summarises the important achievement: "The consolidated fiscal position of State Governments in 2007-08 indicates that the States have budgeted to achieve revenue surplus (0.3 per cent of GDP) during 2007-08 after a gap of two decades. As a consequence of the budgeted revenue surplus, the GFD is budgeted to decline to 2.3 per cent of GDP in 2007-08."

Do IIT grads lack a conscience?

The renowned academic Martha Nussbaum gave an interview in Tehelka magazine two weeks ago, in which she said: "This IIT mentality - become technically competent engineers, forget about human values - is very dangerous, particularly for a country like India." In response, Salil Tripathi wrote an interesting piece, which appears in Tehelka today. As Salil says, "No, I didn't go to the IIT, but some of my friends are IITans :-)".

What should you do when you're stuck with a pegged exchange rate

On 12th, SBI cut deposit rates by 25 bps. Many newspapers thought this was partly a response to the liquidity conditions that have shaped up after the rate cuts of the US Fed. When asked by reporters, Y. V. Reddy said that he does have monetary policy autonomy. An edit in Financial Express titled Rewrite the RBI Act interprets SBI's decisions as reflecting a loss of monetary policy autonomy in India.

In an excellent article in Indian Express today, Ila Patnaik makes an argument that runs roughly like this:

  1. In the short term, the reforms to financial and monetary policy institutions that are required `to do the right thing' are not forthcoming. The present RBI leadership has repeatedly articulated a lack of interest in reform. In any case, even if there was an interest in reform, it would take time to do the institutional transformation of finance and monetary economics as described in the MIFC report.
  2. In the short term, the political situation is unfavourable for exchange rate flexibility, particularly given the difficulties that exporters will face selling into a slowing world economy.
  3. Hence, in the short term, we are stuck with a pegged exchange rate.
  4. That leaves two choices: capital controls or loss of monetary policy autonomy.
  5. Capital controls are ineffective; India has gone too far along the route of modernising the external sector, and the political appetite for draconian controls (that are required in order to be effective) is absent. In addition, capital controls represent a step backwards compared with where India has to go. When financial firms and markets are damaged by controls, it will take time and effort to rebuild these things to get back to where we were.
  6. Hence, the best path forward in this trap that we are in is: To give up monetary policy autonomy, and cut rates.
  7. That might not be such a bad idea given the growing gloom in the global economy; lower interest rates would boost consumption and investment, and thus offset some of the impact of slowing exports [link].

Also see this review of the difficulties of India's pegged exchange rate regime in The Economist.

Wednesday, December 12, 2007

Outsourcing and the backlash against it

A. J. Jacobs has a really funny and interesting article My Outsourced Life (in Esquire Magazine in 2005) about his experiences with using support staff in India while living and working in America. While on this subject, you might like to glance at the frontiers of outsourcing (hat tip).

While on this subject, S. G. Badrinath had pointed me to an interesting article The establishment rethinks globalisation by William Greider, in The Nation about people who are skeptical about the benefits to the US of the way telecom has made many things that were formerly non-tradeable into things that are tradeable.

I feel this is no different from all the previous stories about gains from trade. New technologies spring up; the purveyors of old technology get hurt; there's nothing surprising in it (to me) while there are benefits in the large. When cheap computer hardware started coming into India because of the lowering of trade barriers, it was very painful for thousands of workers employed in those sectors. Their human capital was obsoleted; they were mostly forced to shift into new sectors; their lifetime wage trajectory was pushed down to a lower level. In similar fashion, there is nothing new, in my eyes, when there are parts of the US economy which are hurt when one more new kind of trade a.k.a. technology springs up.

I am also optimistic when it comes to fears of protectionism. I am skeptical about whether the industrial countries will really go back to tariff or non-tariff barriers when it comes to goods. With goods, it's possible to have barriers, even though it would be really unwise to have them. In contrast, with services, I think it is not even possible for a State to come in the way without seriously interfering with personal freedoms and open telecom systems. Even if the worst politicians get their act together, and whip up a lynch mob, I don't see how they can block outsourcing of services jobs.

Formalising education in public policy

Writing in DNA, Mukul Asher says that India needs schools of public policy.

Tuesday, December 11, 2007

Dating exchange rate regimes; the currency exposure of firms

I wrote an article in Business Standard today titled How frail are the firms? about changing currency volatility of a pegged exchange rate and its implications for the currency risk management of Indian firms.

Sunday, December 09, 2007

Interview with C. B. Bhave about the recent SAT ruling

There is an interview with C. B. Bhave in Mint where he says:

q: SAT has set aside the Sebi order. So, are you relieved?

a: We are naturally relieved because SAT has ruled in our favour. However, at one level, I am feeling very sad that we had to move SAT. As an institution, NSDL, would be reluctant to take any legal recourse against the regulator, but unfortunately, we were left with no option in this matter.

q: How do you react to the ruling that sets aside the disgorgement order?

a: As I have clarified, we would rather have these matters sorted out with Sebi directly. But if the regulator refuses to hear us and passes an ex-parte order, what do we do? We were pushed into a corner and had no choice.

q: Why is NSDL constantly in litigation with Sebi?

a: You are not fair in your assessment. In this case, very strangely, NSDL along with other entities were asked to pay Rs115 crore without even being heard. It is not possible for any entity to accept such a decision. NSDL was not alone. In fact, all the affected entities moved SAT.

q: Are you suggesting that you were asked to pay Rs45 crore without even being heard?

a: Yes, unfortunately that was the case.

q: Why did Sebi do this? You seem to have lost credibility with the regulator.

a: Frankly, we are surprised that principles of natural justice were violated. In fact, in this country, no authority has the right to violate the basic principle of hearing a party before ruling anything adverse to that party. You must be aware that recently even Parliament on a sensitive issue of contempt heard the concerned party before reaching any conclusion.

q: What do you mean? Cant the regulator ask any entity to disgorge?

a: My reading of the SAT order is that the appellate authority has not ruled on Sebis power to disgorge. SAT has stated that disgorgement can occur if the concerned entity is guilty of violation of law. It should have derived profits out of such violation and should have been given an opportunity of being heard before any disgorgement can occur. In this case, these norms were not followed.

q: What about the order to your promoters to revamp management? I believe your appeal was dismissed?

a: The appeal was dismissed as infructuous. The reason being that Sebi contended that its directives to the promoters were not mandatory. The regulator also contended that the directives in the April 2006 order were only observations in aid of the show cause notice (issued last year). Since the contention was that there was no order against NSDL, we had nothing to appeal against.

q: Can a direction of a regulator be non-mandatory?

a: You have to ask this question to Sebi.

q: How do you plan to celebrate the victory?

a: I dont think there are victories against regulators. I would prefer to look at this matter in a more constructive manner. The SAT has laid down some very valuable ground rules and these would serve the capital market well in future. All market intermediaries, including NSDL, should learn from the episode of IPO allotment scam and correct their systems to ensure similar things do not occur again.

Worsening the PSU banking problem

Privatisation of PSU banks is difficult because 51% of MPs won't support the requisite amendment of the Bank Nationalisation Act. While progress is hard, it would be useful to atleast not make things worse. Further equity infusions into PSU banks by the Ministry of Finance make things worse. As an example, MOF is about to put Rs.16,742 crore into SBI. They didn't need to do that.

Going beyond new money going into PSU banks is the issue of dividend payouts. The average dividend payout for 2006-07 of non-financial firms was 18%. PSU banks paid out 14%. I would argue that far from putting more money into PSU banks, what MOF needs to do is get the payout ratio of PSU banks up. Simultaneously, given the poor HR, risk management and corporate governance of PSU banks, capital requirements for them need to be higher.

Internationalisation of the rupee

Sanjiv Shankaran wrote a two-part article on the internationalisation of the rupee in Mint : Part 1, Part 2. While on this subject, you might like to see this blog posting.

Capital controls impeding trade

Matt Nesvisky wrote (in the December 2007 NBER Reporter) about an NBER paper: Exchange controls and international trade by Shang-Jin Wei and Zhiwei Zhang. This fits into the Indian debate on the costs and benefits of capital controls. This paper figured in this `Capital controls' slideshow done at MOF in July 2007. The quick summary of this paper is: "The experience of the emerging market economies during the late 1990s suggests that controls on capital transactions that are intended to regulate capital flows also tend to harm trade substantially." Nesvisky's text says:

Some years ago, NBER Research Associate and Columbia University Professor Shang-Jin Wei and IMF economist Zhiwei Zhang learned from a top finance official of a certain country that it was common for both companies and individuals to try to circumvent that country's capital account restrictions. A common practice, the source allowed, was mis-invoicing imports, exports, or both. The government naturally reacted by stepping up inspections of goods passing through the customs to make sure that they are not mis-reported to evade capital controls. From this, the economists concluded that attempts to enforce exchange controls most likely raised the cost to firms of engaging in importing and exporting. Just how costly this might be is reported in their study, Collateral Damage: Exchange Controls and International Trade (NBER Working Paper No. 13020).

For their study, Wei and Zhang use data on capital account restrictions collected by the International Monetary Fund (IMF) since 1996 on 184 countries. The IMF's Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER) uses up to 192 indicators to track exchange controls for individual member countries. From this database, Wei and Zhang are able to construct three broad categories of indicators for 1) controls on proceeds from exports and payments for imports, 2) controls on capital transactions, and 3) controls on foreign exchange (FX) transactions and other items not specific to trade or capital transactions.

Wei and Zhang find that countries tend to have more controls on capital transactions and foreign exchange transactions than on trade payments. At the same time, countries with more controls in one category are also likely to have more controls in the other categories. Broadly speaking, the researchers observe that all three indices showed a moderate decline during the years 1996-2005 for countries instituting multiple controls.

There are substantial differences across countries as well as variation over time for many countries. Wei and Zhang illustrate this point with a close examination of the patterns for three developing countries -- Brazil, Chile, and Malaysia -- and one OECD country, Greece. Each of these countries experienced substantial changes in its controls during the sample period.

The researchers conclude that economically and statistically significant evidence exists to confirm their suspicions about the "collateral damage" to international trade brought on by exchange controls. They report that an increase by a single standard deviation in the controls on foreign exchange transactions reduces trade by the same amount as an increase in the tariff rate of 11 percentage points. A comparable increase in the controls on trade payments has the same negative effect on trade as an increase in the tariff rate of 14 percentage points. The experience of the emerging market economies during the late 1990s suggests that controls on capital transactions that are intended to regulate capital flows also tend to harm trade substantially. According to these researchers, the collateral damage of exchange controls should therefore be part of any assessment of the desirability of capital account liberalization.

Wei and Zhang caution that their study is only a first step towards understanding the effects of exchange controls on trade. It is possible, they note, that the effects are non-linear; that is, the same measure in an already restrictive exchange control regime may do more harm than in a less restrictive regime. Moreover, the effects may vary by sectors: exchange controls may raise the cost of trading in more differentiated products more than the cost of trading in homogeneous products; as differentiated products have a greater variance in their unit values over different varieties, it may be more difficult for traders to convince bureaucrats that a particular transaction is not mis-invoiced to evade exchange controls. In such a case, exchange controls imply one more distortion by affecting a country's pattern of specialization.

The effects may also interact with other features of the economy; the same exchange controls may do either more or less damage in a governance-challenged economy, depending on whether corruption primarily weakens the exchange controls or exacerbates the burden of complying with the controls. Such questions, Wei and Zhang suggest, are worthy of further research.

Thursday, December 06, 2007

A paper: `New issues in Indian macro policy'

I have a working paper version up on the web, of an article titled New issues in Indian macro policy. This is forthcoming in a book edited by T. N. Ninan that will be published by Business Standard Books in 2008. In this paper, I first highlight the aspects where the Indian economy has changed substantially when compared with a decade ago. I then try to think about what fiscal policy and monetary policy in today's India should be doing, and propose directions for institutional reform. I hope this paper should be interesting to anyone thinking about Indian macroeconomics.