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Saturday, December 24, 2011

Uncomfortable times in real estate in store?

Patrick Chovanec has a fascinating article in Foreign Affairs, titled China's Real Estate Bubble May Have Just Popped. This is interesting and important from two points of view.

First, bad news for China is bad news for the world economy. We are already in a bleak environment, with difficulties in Europe, Japan, the US, and India. It will not be pretty if China runs into trouble as well. I am reminded of the feeling of carefully watching real estate in the United States in 2006, with a sense that the future of the world economy was going to turn on how it turned out.

Second, it made me think about real estate in India. As with China, one often sees buyers of real estate in India have the notion that this is a safe financial asset. This is a questionable proposition. Real estate is perhaps not an asset class with a positive expected return in the first place; and it is certainly not a convenient asset class with features like liquidity, transparency, diversification and easy formation of low-volatility diversified portfolios. I find it hard to explain the prominence of real estate in the portfolios of even educated people in India.

In the article, Chovanec says:

For more than a decade, they have bet on longer-term demand trends by buying up multiple units -- often dozens at a time -- which they then leave empty with the belief that prices will rise. Estimates of such idle holdings range anywhere from 10 million to 65 million homes; no one really knows the exact number, but the visual impression created by vast `ghost' districts, filled with row upon row of uninhabited villas and apartment complexes, leaves one with a sense of investments with, literally, nothing inside.

This has not happened in India. So in this sense, the situation in India is not as dire. But his second key message seems uncomfortably close:

As 2011 progressed, developers scrambled for new lines of financing to keep their overstocked inventories. They first relied on bank loans (until they were cut off), then high-yield bonds in Hong Kong (until the market soured), then private investment vehicles (sponsored by banks as an end run around lending constraints), and finally, in some cases, loan sharks. By the end of last summer, many Chinese developers had run out of options and were forced to begin liquidating inventory. Hence, the price slashing: 30, 40, and even 50 percent discounts.

Part of this looks familiar. There is a lot of leverage in Indian real estate development and speculation. Real estate speculators and developers are finding themselves in a bit of a scramble hunting for credit. One hears about very high interest rates being paid by developers. Other sources of financing are also weak. This reminds me of the dark days before the global crisis, when borrowing by real estate companies was the canary in the coal mine.

If business cycle conditions and financial conditions worsen, the problems of borrowing by real estate developers and speculators will get worse. How might this turn out? Perhaps the borrowers will merely get uncomfortable. Or, a few firms could really get into trouble, and start liquidating inventory. That would have substantial repercussions.

Suppose there is a situation where there are many people who have speculative positions in real estate, but significant selling of inventory has not yet begun. The longs would then be nervously looking at each other, wondering who would be the first one to sell, to take a better price and exit his position. The ones who sell late would get an inferior price. In such a situation, conditions could change sharply in a short time.

On a longer horizon, I would, of course, be delighted if real estate prices are lower. This would help shift the supply function of labour, reduce the cost of setting up new businesses, etc. But that's more about the long-term policy changes, which would remove barriers for converting land into built-up housing, while rising vertically into the sky with FSI in Indian cities ranging from 5 to 25.

Thursday, December 15, 2011

RBI reaches for capital controls

By and large, I have felt that RBI has done a pretty good job of the exchange rate. They doubled currency flexibility twice, in 2004 and 2007. In 2009, they shifted to a floating rate. There were two problems:

  1. They continue to sometimes do tiny blocks of trading on the currency market. In a market of $70 billion a day, a small scale of trading (e.g. $1 billion a month) is irrelevant, so why bother doing it? This has been pointless, but it has done no damage.
  2. They have failed to correctly communicate to the market that the exchange rate is now a float. I cannot recall an RBI governor who used the phase "floating exchange rate". Many economic agents seem to have got the following message: You're on your own for small fluctuations, but if there are big movements, RBI will block them. This was mis-communication. The people who hedged against small movements but not against large ones, as a consequence of RBI, have now got burned. This is going to further increase the cost of RBI to gain credibility in the years to come, to come to a point where its words are respected.
Barring these two issues, I have felt that RBI has done a pretty good job of the exchange rate. Until now.

RBI has just announced a batch of capital controls against the currency market. This is a mistake:
  1. When there is turbulence on the currency market, you want greater activity on the currency derivatives market - which is where people protect themselves from currency risk - not less. Recall how the Greek default really damaged the Italians because on that day, the owner of an Italian government bond was told that maybe his CDS would malfunction if an Italian default came about. It was not good for Italy for economic agents to have a reduced ability to manage this risk.
  2. This will merely shift business to alternative venues - the offshore market and the onshore currency futures market. To the extent that shifting to these venues is tedious or infeasible (e.g. FIIs are banned from the onshore currency futures market and don't have that choice), economic agents will be averse to holding India risk. This is bad for asset prices in India at a particularly difficult time.
  3. In a climate of pessimism about economic policy, it is important to send out a message, through action and non-action every day, that RBI (and more generally the Indian economic policy establishment) possesses top quality knowledge and decision-capabilities in economics and finance. This action of RBI reinforces the gloom about economic policy capabilities in India.
In April, Ila Patnaik and I released a paper titled Did the Indian capital controls work as a tool of macroeconomic policy? Our answer was largely in the negative. RBI's actions of today are likely to shape up as yet another episode of this larger theme. It might make things worse for the rupee, for Nifty, etc.; to this extent these decisions would not be irrelevant.

Financial regulation should be focused on the problems of consumer protection, micro-prudential regulation, market integrity and systemic risk. It should not be used as a tool for short-term macroeconomic policy. If this is done, it damages market liquidity and yields a less capable financial market. This further damages the limited monetary policy transmission that RBI possesses.

Tuesday, December 13, 2011

Be skeptical. Be very skeptical.

Mistake upon mistake


In recent months, we've had a few slip-ups by the official statistical system in India:
  • Yesterday's IIP release was preceded by a mistake. Mint says: On Monday, the government was guilty of a similar error in its factory output data. Till it corrected the number pertaining to capital goods output, analysts were left scrambling for explanations as to how this had grown 25.5% while overall factory growth had shrunk 5.1%. (The answer: it hadn’t, and had actually shrunk by 25.5%).
  • On 9 December, we discovered there were important mistakes in the exports data.
  • In December 2010, RBI modified the numbers that it releases about its trading on the currency market.
  • In September 2010, there was a mistake in the quarterly GDP data released by CSO.

What is going wrong?


These examples are part of a larger theme, of problems of the official statistical system. The Indian statistical system is afflicted by three levels of problems:
  1. The first level is conceptual problems and analytical errors. As an example, the weights of the WPI basket are wrong; the estimation methods used in the IIP are likely to be wrong, etc. Quarterly GDP measurement does not have a demand side (which requires a quarterly household survey, which the government does not know how to do).
  2. The second level is the lack of rugged IT systems. The production of statistics requires high quality enterprise IT systems. The government does not have the ability or incentive to roll these out. As an example, the September 2010 mistake in quarterly GDP data seems to have come about because quarterly GDP data is produced in a spreadsheet. As with all usage of spreadsheets, this is highly error prone. The hallmark of a reliably executed process is the absence of spreadsheets.
  3. The third level is the problems of truant front-line staff. In a country which is not able to get civil servants to show up at school to teach, it is not surprising that front-line staff of statistical agencies are untrustworthy in going out into the field and filling out survey forms. More generally, the statistical system is a set of public goods produced by civil servants, who are unresponsive about the needs of users, or the unhappiness of users, either on flaws about what is done or about the gaps in what is not done.
The rash of mistakes that we're seeing, lately, are merely a reflection of #2 (the lack of rugged enterprise IT systems). But there is much more going on which holds back the usefulness of official statistics.

How to make progress?


Government officials in this field have pinned a lot of hope on the implementation of the report of the statistical commission (headed by C. Rangarajan, 2001). I am personally not optimistic about this. The report seems to emphasise an incremental agenda of building the statistical system, emphasising the interests of the incumbents. In any case, it's been a decade after 2001, and it's important to ask fresh questions about what is going wrong and why.

What is required is a ground-up rethink about the statistical system, from first principles, so as to address the three difficulties above. As an example, most of the civil servants processing data in a labour-intensive manner are not required if a good quality enterprise IT system is put into place (and it is hence not surprising that the incumbents are un-enthusiastic about business process transformation). The revolution of computers and telecommunications needs to be brought into this field, just as it has done in so many others. This does not require large sums of money; it requires superior public administration.

What should users of data do?


Turning to the users of official statistics, most economists attach enormous prestige to phrases like GDP, IIP, CPI, etc. But in India, we cannot unthinkingly use some numbers just because they come with the label `GDP' from some government agency. We have to always skeptically ask first principles questions about how the data is generated. All too often, the standard Indian government data is useless.

Global financial firms who now operate in India have brought a certain cookie-cutter mentality. They produce a major report about each release of quarterly GDP for all countries that they write research reports about. Hence, once they started having such analyst coverage of India, they have started writing a report about quarterly GDP. Such a mechanical approach is a waste of resources. The quarterly GDP data is mostly uninformative.

In the class of government data that I know of, I feel the CPI is reasonably okay. The WPI is a fairly useful database about prices but useless as a price index. The quarterly GDP data, IIP, NSSO, ASI are untrustworthy.

Decision makers in government and in the private sector need to struggle with these issues, carefully thinking about what statistics are allowed to influence their decision processes.

Academic users of data need to be much more careful about avoiding garbage-in-garbage-out (GIGO).  With a large number of academic papers that work with Indian data, I stop reading the paper after I have read the data description; I know the data is rubbish, so the paper will not change my mind, so I should not bother reading it. A good referee blocks papers which are GIGO. But even if the referee in a faraway place thinks that quarterly GDP in India is well measured, the researcher should ponder whether there are better uses of his time - are there projects which can be more meaningful and genuinely answer important questions, over and beyond merely getting past a referee?

Finding out more


For more on this subject, you might like to look at the label `statistical system' on this blog.

Monday, December 12, 2011

Interesting readings

China's Pakistan Conundrum by Evan A. Feigenbaum, in Foreign Affairs.

The most important task of government is the public goods of law and order: laws, courts and judiciary. The first step towards strengthening these lies in sound measurement. Writing in Pragati, Sushant K. Singh has an excellent article on the problems of measurement of crime in India.

An independent judiciary by Ruma Pal.

Devesh Kapur, in the Business Standard, on the HR crisis in the Indian State.

Shyam Saran in the Business Standard on a more sensible approach that we should bring to intra-South-Asia logistics.

The lack of freedom of speech in India: Karan Singh Tyagi in the Hindu.

Amit Rai writes in the Times of India about the mistakes of the legal actions following the AMRI fire.



Mobis Philipose in Mint on how charges by exchanges have made a difference to the currency futures market.

Every advocate of a big spending Indian government should ponder this article about Greece by Landon Thomas in the New York Times.

Dreze and Sen on what India does right and wrong. We may not agree with most of this, but they are smart people and it's worth reading.

Hard times at UTI: Anirudh Laskar and Vyas Mohan in Mint, and Niladri Bhattacharya and N. Sundaresha Subramanian in Business Standard.

Air India and Maharashtra PSUs remind us, in interesting ways, about why government should not be in business.


Martin Feldstein explains what went wrong with the Euro.

Look at profiles of Mario Monti, who will try to fix Italy, and Loukas Papadimos, who will try to fix Greece. I guess that every now and then, the professional politicians foul up big time, and then bring in the economists to clean up. It reminds me of a perspective by C. B Bhave on urban governance in India: when things are going well, the politicians want an accomodating civil servant; when the city goes to hell, they want a tough competent one. Also see Greece and Italy Seek a Solution From Technocrats by Rachel Donadio in the New York Times.


Charles Moore looks back at the story of Maggie Thatcher, who ended Britain's long decline in the 20th century.

Read Larry Summers in the Financial Times on the problem of inequality and three things that need to be done about it.

Two important platforms for modern web development were Flash and HTML5. It now looks like Flash is dying. Looks like Steve Jobs was right on one more thing.

Saturday, December 10, 2011

Business cycle conditions in India: It's mostly cycle, not trend

There is a lot of gloom in India today about the broad-based failure of the UPA strategy of combining left-of-centre populism, fiscal profligacy, theft, and a lack of interest in the foundations of India's growth. We learn from history that we learn nothing from history; India has clearly learned very little from its escape from the Hindu rate of growth. The moment we got a little bit of growth, the old style socialism and theft reared up again. In one of the many pessimistic articles of this theme, Shekhar Gupta in the Indian Express says:
What is the Hindu Rate of Growth two decades after reform? It certainly can’t be the 2-3 per cent of India’s socialist Brezhnev decades. The new Hindu Rate of Growth is 6 per cent, and on all evidence, from macroeconomic data to the empty billboards of Mumbai, we are headed there next year.
In thinking about GDP growth, it's always useful to think about both growth and fluctuations. Growth is about the underlying trend growth rate.  In the olden days, this was all you needed to worry about. The economy trundled along at roughly the trend growth rate (the Hindu rate of growth of 3.5 per cent), being kicked up or down by good or bad monsoons. In that period, macroeconomics in India required thinking in completely different ways, when compared with standard Western textbooks.

But from the early 1990s onwards, India changed. The market-oriented reforms, which began with the Janata Party in 1977 and gathered momentum in the 1980s, had started creating a market economy. And every market economy in the world experiences business cycle fluctuations. So, in addition to the trend, we got a cycle about the trend. There were good periods and bad periods, and the story running in there was much like that found in mainstream Western textbooks, with a prominent role being played by profitability, inventories and investment by firms.

From this viewpoint, it's useful to decompose two elements of what we are seeing after 2009. On one hand, trend growth has been influenced by decisions of the UPA. Any perceptive observer also tends to rage at the lost opportunities, of policy decisions that should have been taken, which would have accelerated trend growth. But the second big story is that of fluctuations. Corporate investment is a major driver of business cycle fluctuations in India, and there has been a certain deceleration in this. This may have set off a downturn.

The bulk of the drama that we're now seeing, and what will play out in 2012, is business cycle fluctuations. This is about fluctuations, not the trend. When trend growth is 7 per cent, the fluctuations make GDP growth range from 4 per cent to 10 per cent. Even if trend growth does not change by even a bit, business cycle fluctuations can take us from a high of 10 per cent to a low of 4 per cent, which is a huge swing of 6 percentage points.

Many elements of economic policy are pro-cyclical: when times are good, they make things better and when times are bad, they make things worse. The financial system tends to suffer from pro-cyclicality: when times are good, bankers lend exuberantly (thus expanding the boom) and when times are bad, bankers tend to be cautious (thus accentuating the bust). It is important to look for a framework for stabilisation, of tools that will counteract business cycle fluctuations. India has crossed one major milestone, in getting to a floating exchange rate. The floating exchange rate is stabilising, in and of itself. In addition, it opens up the possibility of stabilising monetary policy.

As of today, by and large, I think of both fiscal policy and monetary policy as being part of the problem and not part of the solution. While floating the exchange rate (decisions from 2007 to 2009) opened up the possibility of sound monetary policy, the logical next step did not materialise. As of yet, we do not have a sound monetary policy regime. We're going to require far-reaching surgery to laws and institutions, in order to craft frameworks for fiscal policy and monetary policy that do stabilisation. Until these changes are made, Indian GDP growth will have the high volatility that is characteristically found in countries with weak institutions.

A lot of our work in the Macro/Finance group at NIPFP is rooted in this conceptual framework. In particular, you might like to see two relatively non-technical articles: New issues in macroeconomic policy and Stabilising the Indian business cycle.

Friday, December 02, 2011

Thursday, December 01, 2011

The rupee: Frequently asked questions

q: How big is the market for the rupee?

The rupee is now a big market. Summing across both spot and derivatives, perhaps \$30 billion a day of onshore trading and \$40 billion of offshore trading takes place. Both these markets are tightly linked by arbitrage. In other words, for all practical purposes, it's like NSE and BSE which are a single market unified by arbitrage. If you place a small order to buy 100 shares on either NSE or BSE, you get essentially the same price, and arbitrageurs are constantly at work equalising the price across both markets. It is a similar state of affairs between the onshore and the offshore rupee. Both markets are tightly integrated by arbitrage.

The offshore market for the rupee, and a large part of the onshore market, is OTC trading. Hence, the efficiencies of algorithmic trading and algorithmic arbitrage cannot be brought to bear on onshore/offshore arbitrage. So the arbitrage is done by manual labour. Still, it gets done. Both markets are tightly linked and show the same price. We should think of them as one market. It's one big market, it is one of the big currencies of the world, it's roughly \$70 billion a day.


q: How might RBI do manipulation of this market?

If RBI wants to hit the market with orders big enough to make a difference, they have to be ready to do fairly big orders and to be able to do it on a sustained basis. As a rough thumb-rule, I might say that in order to make a material difference to a market with daily volume of \$70 billion, they have to be in the market with atleast \$2 to \$3 billion a day.


q: What would go wrong if they tried this?

Three things would go wrong.

First, foreign exchange reserves are \$275 billion. If RBI sells off \$2.75 billion a day, the reserves would be quickly gone.

Second, when RBI sells dollars and buys rupees, this sucks liquidity out of the market. The side effect of selling dollars would be a sharp rise in domestic interest rates. In other words, monetary policy would get hijacked by currency policy. This would not be wise. Monetary policy should be focused on delivering low and stable inflation: it should have no ulterior motives. We have to make a choice: Do we want to use up the power of monetary policy to achieve domestic goals, or do we want to use up the power of monetary policy to achieve currency policy goals?

Third, suppose you and I saw a market price of Rs.45 per dollar, which is created by RBI and not a market reality. We would know that in time, the truth will out, that the price will go back to Rs.52 a dollar. The rational trading strategy for each of us would be: To sell any and every domestic asset, and shift money out of the country. This would trigger off an asset price collapse in India. We would take the money out, and wait for the distortion of the currency market to end. At that point (perhaps Rs.52 a dollar, perhaps worse) we would bring the money back to India and buy back our assets. We might make two returns here: first, on the move of the INR/USD from 45 to 52 (or worse) and the second, on the gain from the drop in asset prices.


q: Isn't it hard to take money out of India in this fashion?

It's easier than we think. Remember September 2008? The mythology in our heads was: we in India are crouching safely behind a wall of capital controls. In truth, the wall wasn't there.


q: But until recently, RBI used to give us a pegged INR/USD exchange rate! What changed?

In late 2003, RBI ran out of bonds for sterilisation. Associated with that, there was a first structural break in the rupee exchange rate regime, with a doubling of volatility. A short while later, in March 2007, there was another structural break, with another doubling of volatility. From April 2009 onwards, RBI's trading in the market has gone to roughly zero. RBI stopped managing the exchange rate a while ago.

The exchange rate is the most important price of the economy. The decontrol of this exchange rate is the biggest achievement of the UPA in economic reforms. The credit for this goes to Y. V. Reddy and Rakesh Mohan (who took the first two steps of doubling exchange rate flexibility twice) and to Dr. Subbarao (who got out of trading on the currency market, which did remarkably little to INR/USD volatility).


q: Why did nobody tell me that something changed in the exchange rate regime?

RBI should be talking more transparently about what is going on. But they are not transparent about what they do. Even though hundreds of millions of people are affected by their trading on the currency market (or the lack thereof), the manual which governs their currency trading at any point in time (i.e., the documentation of the prevailing exchange rate regime) is not transparently disclosed to the people of India. We have to decipher what is going on by statistically analysing exchange rate data.

The dates of structural break of the exchange rate regime are extremely important dates in thinking about what was going on in macroeconomics and international finance. Any time one is using data about exchange rates, interest rates, etc., it is important to work within one segment of the prevailing exchange rate regime at a time. It is wrong to pool data across many years. All users of data need to be careful in this regard.


q: So what might happen to the rupee next? Is there a `law of gravity' which will pull it back to erstwhile values of Rs.45 or Rs.50?

When you don't manipulate a financial market, the price time-series comes out to something close to a random walk. In the ideal random walk, all changes are permanent. The random walk never forgets; there is no law of gravity which takes it back to recent values. Your best estimator of what it will be tomorrow is: what you see today.

In order to get a sense of what will come next, go through the following steps. First, go to INR/USD options trading at NSE, and pluck out the implied volatility for the four at-the-money options. I just did that, and the values are: 10.43, 10.32, 10.33 and 10.08. Calculate the average of these four numbers. With the above four values, the average is: 10.3. (This is a quick and dirty method; here is one which is much better).

This tells a very important thing: The options market believes that in the future, the volatility of the INR/USD rate will be 10.3 per cent per year.

In order to re-express this as uncertainty per month, we divide by sqrt(12). This gives the volatility for a month as : 3% per month.

Roughly speaking, the 95% confidence interval for what might happen over a month, then, runs from -6% to +6% (this is twice the standard deviation, which we just worked out was 3% per month).

The INR/USD is now Rs.51.62. By the above calculation, we can be 95% certain that one month from today, it will lie somewhere between 48.5 and 54.7.

These trivial calculations have been done by equity market participants for the longest time. It is a standard and trivial idea: To read the implied volatility off the Nifty options market, and to do such calculations to get a sense of what might come next with Nifty. But on the currency market, this is relatively novel. Only recently have we got a nice currency options market, and only recently have we got to a genuine market. Now these skills can be brought to bear on the currency market. It's a brave new world, one in which the operations of financial derivatives markets (Nifty options, INR/USD options) produces forward-looking and timely information about the economy (implied volatility).


q: What changed in imports and exports which gave us the big recent move of the rupee?

The current account (goods, services, and then some) adds up to a mere buying and selling of \$4 billion a day. The bulk of currency trading is about the capital account. The currency is a financial object; the exchange rate is defined by financial considerations and not by current account considerations.


q: What happens to the Indian economy when the rupee depreciates?

This has been the source of a great deal of confusion and it's important to think straight about this. There are three important effects in play:
  1. Some people had borrowed in dollars, and left it unhedged since they were speculating that the INR would appreciate. They have got burned. That's okay - in a market economy, many people place bets about future fluctuations of financial prices, and half the time the speculator loses money. (If the rupee had not depreciated sharply, these speculators would have been truly joyous).
  2. When the rupee depreciates, imports become costlier and India's exports become more competitive. So exports (X) gradually start going up and imports (M) gradually start going down. The net gain in X-M is increased demand in the local economy. In this fashion, INR depreciation is good for aggregate demand (and conversely INR appreciation pulls back demand). However, we have to bear in mind that these effects are small and take place with long lags.
  3. Many things in India are tradeable. It is important to focus on the things that are tradeable and not just on the things that are imported. As an example, there are many transactions between a domestic producer of steel and a domestic buyer of steel. The buyer and seller are both in India. But the price at which they transact is the world price of steel (which is quoted in dollars) multiplied by the INR/USD exchange rate. This situation is called `import parity pricing'. Through this, the domestic prices of tradeables goes up when the rupee depreciates.

q: What is the impact of costlier tradeables for RBI?

RBI's job is to fight inflation. RBI must work to deliver year-on-year CPI inflation (a.k.a. `headline inflation') of four to five per cent. When tradeables become costlier, domestic CPI inflation goes up. So the rupee depreciation has made RBI's job harder. RBI will have to respond by hiking interest rates. (Note that one impact of higher interest rates will be that more capital will come into India, which will tend to yield a rupee appreciation; import parity pricing has created a new channel through which RBI rate hikes combat inflation).


q: What is the impact of costlier tradeables for business cycle conditions in India?

As the example above about steel suggests, the price realisation of all tradeables companies goes up when the rupee depreciates. Costs change by less by revenues (since many costs are not tradeables), and profitability goes up.

Firm profitability has dropped sharply in 2011. My prediction is that firms producing tradeables will show better profitability in Oct-Nov-Dec 2011 when compared with the previous quarter, thanks to the rupee depreciation.

This is great news for business cycle conditions. Profitability goes up, which yields more cash for investment by financially constrained firms. And, when profitability is higher, more investment projects look viable.


q: In the bottom line, what is the link between the rupee and India's business cycle stabilisation?

If RBI tried to peg the exchange rate, the lever of monetary policy would get used up to deliver the target exchange rate. By not trading on the currency market, the lever of monetary policy is now available. A pretty good use for this lever is to deliver low and stable CPI inflation. If this is done, then an RBI focused on inflation would help stabilise the economy by cutting rates when CPI inflation drops below 4% and hiking rates when CPI inflation goes above 5%.

But floating the exchange rate also yields stabilisation purely in and of itself. In bad times, capital leaves India, the rupee depreciates. This gives higher profitability in tradeables firms and bolsters investment. Conversely, when times are good, more capital comes into India, the INR appreciates, which crimps profitability of tradeables firms. The floating exchange rate exerts a stabilising influence upon the economy: purely by doing nothing on the currency market, RBI has unleashed this new force of stabilisation which will help India.


q: What should RBI do next?

RBI should do as they have done, i.e. avoided trading on the currency market.

RBI should keep driving up the short-term interest rate until point-on-point seasonally adjusted CPI inflation shows a decline and goes into the target zone of 4-5 per cent. After this hangs in there for a year, `headline inflation' (y-o-y growth of CPI) will be in the target zone.


q: What do other countries do?

When we look at countries with good governance, the mainstream strategy seen worldwide is an open capital account and a central bank that delivers on an inflation target. By and large, this goes with a floating exchange rate. Trading on the currency market interferes with achieving price stability and has hence been dispensed with, by most good countries. Japan and Switzerland come to mind as exceptions to this broad regularity.

Friday, November 25, 2011

Taxing investors to pay NGOs

In India, NGOs are fashionable. It is almost never wrong, in the Indian discourse, to give more money and more functions to NGOs.

Many people have worried about the extent to which NGOs are being used to supplant failing State machinery. This may seem expedient, but no country every became a developed country on the back of NGOs. There is no alternative to fixing the core mechanisms of the State.

In recent days, two pro-NGO policy elements seem to be in the pipeline:
  1. A new Companies Bill seems to require that 2% of profit be spent on corporate social responsibility (CSR).
  2. SEBI decided to force listed companies, starting with the top 100 firms, to describe measures taken by them along the key principles enunciated in the ‘National voluntary guidelines on social, environmental and economic responsibilities of business,' framed by the Ministry of Corporate Affairs (MCA).
When the government grabs 2% of the profit of a company, and hands it out to any purpose (no matter how good or bad), that is called expropriation. The fact that it satisfies some bleeding hearts does not change the fact that it is expropriation. In a good country, property rights would be fundamental, and the Supreme Court would block such expropriation.

The job of a corporation is to efficiently organise production, and send dividends back to shareholders. It is the individual, the shareholder, who has to then make a call about whether he would like to give money to charitable causes or not. We do wrong by expropriating this money even before it reaches the individual.

For an analogy, it is Bill Gates' birthright to gift away his own money, in his capacity as an individual. And I really admire the intelligence with which the Bill and Melinda Gates Foundation works. But Bill Gates (or the government or anyone else) has no right to expropriate money belonging to shareholders, through charitable initiatives by Microsoft.

We do wrong by placing the burden of charitable works upon the corporation. Corporations should not be organised to be do-gooders. They should be organised to obey laws, have high ethical standards and then power India's way out of poverty by efficiently organising production. Anything that corporations do, other than focusing on efficient production, is a distraction from the main trajectory of India's growth and development.

When a country is run by bleeding hearts, things start going wrong. If such a tax is enacted, it reduces the post-tax return on capital that Indian firms generate. Foreign investors and domestic investors have choices about where to invest. They will demand that firms only invest in a smaller set of high-return projects, which are competitive on the rate of return by global standards, even after being taxed. In other words, many projects will not be undertaken. This can't be good for India.

To make progress in India, we need to be hard headed. We should not let the urge to do good crowd out intelligence and analysis. We are falling into this trap too often.

One key element that I blame is the Indian college education. We fail to teach political science, we have   too many people who have not read The Republic, so we get trouble like Anna Hazare. We fail to teach economics, so we get Sarva Shiksha Abhiyaan and the education cess. Given the absence of a positive strategy for what India should be doing, in the mainstream, we are willing to turn away from the hard work of fixing the State, and feel satisfied by funding some do-gooding NGOs.

Intellectuals are the yeast that make a society rise. India is a big mighty youthful stagnant dough, waiting for a pinch of yeast.

Thursday, November 17, 2011

Guide to the Eurozone crisis

by Percy S. Mistry.

How did it happen?

The worst financial crisis in the western world for nearly 80 years broke in September 2008.

It required banking/financial systems to be supported and recapitalised by governments across the EU and in the US.

In June 2009 it became apparent that the peripheral countries of the Eurozone (Greece, Portugal, Spain and Ireland) were grossly over-indebted.

Yet in some instances (Spain) their public debt to GDP ratios happened to be lower than those of the US, France, the UK and Germany.

The continued viability of their public finances depended entirely on markets being willing to refinance them with cheap money.

But, when markets scrutinised the sustainability of their fiscal positions, they baulked from refinancing except at punitive rates.

CDS spreads (against Germany as a benchmark) of peripheral Eurozone countries (PIGS or Club Med) debt began widening relentlessly.

Global financial markets began to price in an escalating risk of partial/full voluntary/involuntary default on PIGS bonds since December 2009.

Contrary to first impressions, except for Ireland, that was a result not just of the financial crisis and bank recapitalisation demands on the fiscus.

It became apparent instead that bank recapitalisation demands on public finance were only the last straws that broke the camel's back.

Greece, Portugal, Spain and Italy, as a direct consequence of joining the Eurozone, had been running up unsustainable fiscal deficits since 2000.

Ireland had not. It suffered because the bailout of its disproportionately large banking system caused its public debt to rise astronomically.

PIGS became over-indebted despite the supposed self-imposed discipline adopted by the Eurozone of prohibiting fiscal deficits >3% of GDP.

That discipline was violated by almost all Eurozone members, beginning with France and Germany, but more egregiously by the PIGS.

To make matters worse, however, the PIGS were also running increasingly large current account deficits (with Germany, France, China).

Though countries like France (and to a lesser extent) Germany were fiscal sinners, they were at least running current account surpluses.

PIGS had access to excessively cheap public and private money available on terms totally inappropriate to their economic circumstances.

Given their inherent risks, which markets mispriced completely, their borrowing costs should have been 300-500 bp higher than Germany's.

Instead, they were virtually the same for nearly a decade. That relieved market-induced pressure on PIGS' governments to behave responsibly.

Consequently, their public expenditures after 2000 ballooned out of all proportion to their intrinsic capacity to fund them from tax revenues.

Such expenditures became almost wholly dependent on access to increasing amounts of cheap public borrowing from capital markets.

In response to access to excessively cheap money, wages in the PIGS rose across the board as did growth in public sector employment.

With the financial crisis triggering bank recapitalisation needs, on top of this unsustainable structure, the edifice began to crumble.

The first early warning signals became apparent in December 2009 but the dam broke in mid-2010 with the first Greek bailout.

How has the Eurozone crisis been handled?

Extremely ineptly; indeed very foolishly, by sophisticated Eurozone authorities (political, fiscal and monetary) that should have known better.

Eurozone leaders learned nothing from the preceding debt crises in Latin America (1982-87, 1994-95) and Asia (1997-2000).

They went through avoidable phases of serial denial that there was a structural debt (solvency) crisis that could spread via contagion.

They treated it as a liquidity crisis that could be dealt with by temporary patch-ups of additional money combined with fiscal restraint.

They reiterated their commitment to ensuring there would be no default - partial or full, voluntary or involuntary - by any Eurozone member.

They believed that their remedial measures would stop the crisis from ballooning beyond the first bailout package for Greece.

They were totally wrong. That package did nothing to convince markets that Eurozone leaders understood the nature/severity of the problem.

In fact, the inadequacy of that first bailout package -- which did not provide enough money for sufficiently long - became quickly apparent.

Eurozone leaders were fixated on debt-affected PIGS being forced to live within their means through indefinite austerity without end.

Debt recovery/sustainability models did not provide sufficient new money, or permit debt restructuring, in ways that would restore stability.

Least of all were bailout packages designed to restore growth in a conscionable period of time that would be socially/politically acceptable.

Without financial system (and borrowing cost) stability, and absent growth, debt problems can never become better. They can only worsen.

Instead, as a result of poor design, all the bailouts did (except for Ireland) was to add new debt to bad debt and reduce growth prospects.

To exemplify: In mid-2009 the debt/GDP ratio for Greece was 115% of GDP and the debt service ratio about 11% of GDP.

But, by October 2011 the debt/GDP ratio for Greece was 161% of GDP and the debt service ratio nearly 20% of GDP.

It is projected with the third bailout to rise to 185% of GDP (although debt service will be lowered to 16%) before it comes down again.

In the meantime, over the last 32 months, the Greek economy has shrunk in size by almost 17% in nominal terms. It will be 1/5 th less in 2012.

Such inane 'remedies' do not solve debt problems. They only aggravate and exacerbate them.

While behaving in this absurd fashion Eurozone leaders repeatedly asserted for two years that they would do everything in their power to:

  • Maintain the credibility of the Euro while ensuring that every member stayed in the Eurozone
  • Not allow any default of publicly issued bonds to occur; and
  • Do everything possible to avoid contagion spreading beyond PIGS (even as it became clear that markets were worried about Italy.

Instead they achieved the exact opposite of all three objectives through their inability to understand the implications of what they were doing.

Though now contrite and claiming to have learnt a few lessons from their serial bungling over 30 months Eurozone leaders have no solution.

The EFSF facility they created is woefully underfunded. It can barely deal with financing the third Greek bailout.

The idea of leveraging it or using it as a partial guarantee facility is absurd since it would add to risk and uncertainty not resolve them.

Yet over-indebted governments (including France and Germany) would have to issue more public debt in order to fund the EFSF properly.

That would simply mean requiring their fragile, near-bankrupt, banking systems (or the ECB) or global markets to buy more Eurozone debt.

Except for Germany (and even that will be in doubt soon) the market has no appetite for taking on more Eurozone debt given its risks.

Contagion has spread from the periphery and now lodges at the core of the Eurozone economy in which Italy is the third largest member.

What could have been resolved with about 300 billion euro in additional financing in mid-2010 is now a problem that may require 2 trillion euro.

Where are we now?

Over 35 EU/Eurozone summits in 30 months have resolved nothing. They have made matters worse; despite Herculean exertions!

Right now Greece is in 'effective' default; though markets are overlooking that because of the implications of CDS contracts being triggered.

Its borrowing costs for refinancing its debt would exceed 30% if it had any access to private markets; which it does not.

Any refinancing of, or addition to, Greek debt can now only be financed by the ECB; which the Germans will not permit the ECB to do.

Meanwhile the Greek banking system is bankrupt. Indeed the entire Eurozone banking system's credibility/stability/solvency is in doubt.

Today an outstanding portfolio of about 11-12 trillion euro in Eurozone debt - of which about 80% is held by EU firms - is souring relentlessly.

About 7 trillion euro of that portfolio is sufficiently affected by contagion to require provisioning (France and Belgium may soon be added).

About 5 trillion euro of Eurozone high-risk-debt is currently held by EU banks, insurance companies, pension funds and individuals.

That sovereign debt, which is supposed to constitute the 'safest' component of any asset portfolio, now constitutes perhaps the riskiest element.

That reality inverts the whole basis of banking/financial system soundness and stability across Europe (including the UK).

It compounds the problem of calculating capital adequacy requirements for these banking systems and puts regulators in a quandary.

Ireland's bailout programme is working but could be derailed by what is happening in the rest of Europe.

Portugal's programme is not working as intended. But nobody is talking about it because it pales in comparison with Italy and Greece.

Italy's outstanding public debt will soon cross 2 trillion euro (120% of GDP) and its debt service payments amount to around 300 billion euro per year.

That is made up of about 120 billion euro in interest payments and 180 billion euro in principal repayments. Average duration is 5 years.

Public debt service in Italy now amounts to around 17% of GDP and will rise to 20% unless Italy's debt is dramatically restructured.

Italy now needs to borrow about 40 billion a month euro (gross) and about 28 billion euro a month net in private markets to refinance its debt.

The world is holding its breath with every auction of Italian public debt (3-8 billion euro per week) any of which could trigger accidental default.

The cost of refinancing Italy's public debt has risen from around 4% a year ago to around 7% now. That adds 20 billion euro a year to its debt.

Meantime the Italian economy is flat-lining and its capacity to service additional debt is diminishing despite its running a primary balance.

Banks around the world are dumping their holdings of Italian public debt but there is no buyer other than the ECB because of the risk.

The ECB's capacity to refinance Greek, Italian and Portuguese debt is limited and constrained by Germany's unwillingness to consider that.

Contagion from Italy is now beginning to affect Spain and France which is supposed to be a bulwark for the EFSF's borrowing capacity.

The resulting gridlock is pushing the entire Eurozone system toward a catastrophic denouement with a binary outcome. Either:

  1. Crisis-induced progress toward fiscal union with national sovereign bonds being replaced by a single Eurozone bond with a joint/several guarantee, or
  2. Sudden disorderly collapse of the Eurozone with unimaginable fallout and consequences that would trigger a global double-dip recession.

Such a recession would last for a minimum of 2-3 years and would probably be quickly followed by a similar debt crisis in the US.

The resulting fallout of disorderly Eurozone break-up could trigger a break-up or restructuring of the larger EU as well.

So where do we go from here?

With the foregoing in mind it seems absurd that the world is waiting with bated breath to see what the new technocratic governments in Greece (Papademos) and Italy (Monti) will actually achieve by way of structural reform and increased debt servicing capability in coming months.

These technocratic governments inject new credibility but lack political and social legitimacy. They have been appointed not elected.

It remains to be seen how long their technocratic legitimacy holds out without the backing of gradually earned political/social legitimacy.

The risk is that if the ministrations of these technocratic governments (which their societies believe have been imposed on them from the EU above) do not work and bear fruit relatively soon (the probability is that they won't), public patience with them will melt.

Will they be able to convince electorates to accept the inevitability of austerity without growth for the indefinite future?

The next Greek crisis is perhaps 10-12 weeks away.

The next Italian crisis could be triggered by any one of the upcoming weekly auctions of Italian government debt.

Despite these rather obvious realities, global markets deem to be reacting in dream-like hope and optimism that all will be well.

There is of course a solution at hand; and the only one that will work because all the other options seem to have been exhausted.

That option requires Germany to reconsider its refusal to bear its large share of the fiscal burden that will come with Eurozone fiscal union.

It requires political/social willingness on the part of rich northern Eurozone members to finance fiscal transfers to poorer southern members through an exponential expansion of structural funds, currently applied to help develop more rapidly the poorer regions of the EU.

Reciprocally, it requires other Eurozone countries to relinquish fiscal, and a great deal of political, sovereignty immediately; in order to assure global markets of their commitment to structural reform, restoration of competitiveness, and relentless pursuit of fiscal/monetary discipline.

It requires all unwanted national sovereign bonds of Eurozone members to be replaced by a single Eurobond that is jointly and severally guaranteed and underpinned by the weight and ability of the ECB behind it to print money if necessary to ensure that such bonds are honoured.

This solution would resolve both the over-indebtness problem of the Eurozone and the problem of banking system collapse at a single stroke.

If it were adopted the need to provide for risky Eurozone debt and recapitalise (yet again) the EU banking system would disappear.

Yet, this is the one solution that keeps being discarded because of legitimate German constitutional, judicial and political constraints.

They inhibit movement in such a direction regardless of the consequences for the Eurozone, the EU, and mostly Germany itself.

It is like witnessing a repeat of 1939; not of conquest but of mindless destruction. But, this time with money rather than tanks being involved.

If that only workable solution continues to be discarded, the other possibility that will manifest itself is the disorderly break-up of the Eurozone; simply because its orderly break-up defies contemplation and imagination.

Talk of Greece being ejected from the Eurozone, or of Germany departing from it voluntarily, is fanciful simply because neither can afford to bear the costs of the consequences that will follow, regardless of what their populations and political leaders may believe or think (though 'thought' seems to be conspicuously absent from the process just now). Neither can their neighbours, regardless of what they may think.

Yet it is not unimaginable that a break-up will be forced on Eurozone members by global markets if the only workable solution continues to be ruled out as it seems to be repeatedly by the German Chancellor. But she has changed her mind so often the hope is she will yet again.

A disorderly break-up may result in a reversion to national currencies; which would be better than members trying to retain some semblance of the Euro through separate residual monetary unions of more compatible economies.

That would probably require four different Euros (for the super-efficient Northern economies a Baltic Euro, for the relatively efficient middling economies a Franco-Euro; for the newly acceding countries an Eastern-Euro and for the inefficient, uncompetitive Club-Med economies, a PIGS-Euro). Other than the first, none of the others would be credible for holding as reserves, or for trading significantly in global currency markets.

Finally, bear in mind that we have spoken of only the public debt problem in the Eurozone.

Should the unthinkable (but increasingly likely) disorderly break-up happen, the public debt problem will be accompanied by an unresolved private debt problem throughout the Eurozone of equally monumental proportions! That really will break the system and the banks!

Wednesday, November 09, 2011

Interesting readings

A pioneering conference of the academic community in the field of international relations in India.



Pramit Bhattacharya in Mint on the impact of transaction charges on the currency futures/options markets.

In continuation of my blog post on Pakistan, India, MFN, read Bibek Debroy on the subject.

Watch me talk about risk aggregation in the Indian economy, presenting joint work with Sucharita Mukherjee. This is from a fascinating conference organised by IFMR. From this same conference, also see the most excellent opening talk by Nachiket Mor.


The ally from hell by Jeffrey Goldberg and Marc Ambinder in the Atlantic magazine. Things aren't going well in Pakistan. What can India do to help? Mani Shankar Aiyar says, and I fully agree: One, return to the Musharraf/Manmohan Singh proposal to create a borderless Kashmir - where the LOC is rendered irrelevant - as a precursor to a borderless subcontinent. Two, agree to maintain uninterrupted and uninterruptable dialogue, that will remain unbroken and regular, irrespective of terrorist attacks or any other calamity. Three, introduce a visa regime similar to Nepal and remove all restrictions of pilgrimages. The fourth remedy is to ensure a full and free media exchange, including and not limited to movies, TV channels and newspapers. Five, an open investment regime without any barriers to trade. Six and seven involve standing together on the international stage to push for the expansion of the UN Security Council and launch a joint initiative for global nuclear disarmament.

David E. Sanger in the New York Times about how things aren't going well in Iran.


Adam Satariano and Peter Burrows have a fascinating story about how, in addition to innovation and design, Apple has a great third weapon: Operations.

In continuation to my post about Dennis Ritchie and Steve Jobs, read M. Douglas McIlroy on Dennis Ritchie, written on 19 May 2011.

Paolo Pesenti takes us back to 20 years ago, when Europe went through another economic crisis. It is useful knowledge about economic history, and it gives us some insights into the Eurozone crisis of today.

How to decontrol the price of oil

We know a lot about price controls from the field of exchange rates. Here's an argument from way back, in 1998:
When change comes to a stabilised currency, as it must, that change is painful. Change in the long term is inevitable. The random walk doles out a little change every day, which is less painful than sudden large changes. 
...
Currencies which are random walks yield a deeper sort of stability. The steady pace of small changes every day generates realistic expectations about currency risk and continual realignment in production processes in the economy. It avoids sudden changes, and keeps the currency out of the domain of politics. The random walk regime is sustainable without incurring serious distortions in the economy.
In the field of exchange rates, India understood these arguments, and moved to a floating exchange rate. In March 2007, the INR/USD volatility moved up to roughly 9% and from early 2009 onwards, RBI stopped trading in the currency market. This was the biggest achievement of the UPA in economic reforms: In the 2007-2009 period, we got to a market determined rate on the most important price of the economy.

These same ideas are useful in thinking about the price of petrol. A large jump of Rs.1.8 per litre attracts attention. It is far better to let the price fluctuate every day. Ultimately, the price has to adjust. We suffer a lower political cost by letting it adjust every day (through the depoliticised market process). If we bottle up the small changes, then we have to make large changes. These are a bad use of political capital.

Monday, November 07, 2011

Are the inflationary fires subsiding?


On 25 October, Dr. Subbarao announced a 25 basis point hike in the policy rate. Alongside this, he made statements that were widely interpreted as being dovish:
Keeping in view the domestic demand-supply balance, the global trends in commodity prices and the likely demand scenario, the baseline projection for WPI inflation for March 2012 is kept unchanged at 7 per cent. Elevated inflationary pressures are expected to ease from December 2011, though uncertainties about sudden adverse developments remain.
 ...
Inflation is broad-based and above the comfort level of the Reserve Bank. Further, these levels are expected to persist for two more months. ... However, reassuringly, momentum indicators, particularly the de-seasonalised quarter-on-quarter headline and core inflation measures indicate moderation, consistent with the projection that inflation will begin to decline beginning December 2011.
... 
The projected inflation trajectory indicates that the inflation rate will begin falling in December 2011 (January 2012 release) and then continue down a steady path to 7 per cent by March 2012. It is expected to moderate further in the first half of 2012-13. This reflects a combination of commodity price movements and the cumulative impact of monetary tightening. Further, moderating inflation rates are likely to impact expectations favourably. These expected outcomes provide some room for monetary policy to address growth risks in the short run. With this in mind, notwithstanding current rates of inflation persisting till November (December release), the likelihood of a rate action in the December mid-quarter review is relatively low. Beyond that, if the inflation trajectory conforms to projections, further rate hikes may not be warranted.
WPI inflation is not interesting in thinking about monetary policy. The WPI basket is not consumed by any household. The right measure of inflation that all of us should focus on is the CPI.

We just released an updated batch of seasonally adjusted data, and the news for inflation, for September 2011, is bad. CPI-IW grew at an annualised (seasonally adjusted) rate of 20.15% in September 2011. As a consequence, the 3-month moving average inflation went up from 8% in August to 11.77% in September.  If we compute the policy rate as the halfway mark (8%) and subtract out this latest value of the 3-month moving average inflation rate (11.77%), the policy rate expressed in real terms is -377 basis points.

Here's the picture of what's been going on with point-on-point seasonally adjusted CPI-IW inflation:

The key fact about India's inflation crisis is: "Headline inflation", which I would define as the year-on-year rise of CPI-IW, has been outside the target range of 4-5 percent in every single month from February 2006 onwards. High inflationary expectations have now set in. Given what is happening on prices of both tradeables and non-tradeables, I find myself skeptical about the sanguine picture on inflation that was painted on 25 October.

The bottom line: Headline inflation (year-on-year rise of CPI-IW) went up from 8.99% in August to 10.06% in September. This is inconsistent with a sanguine analysis of inflation on 25 October.

Or perhaps the econometricians at RBI have some aces up their sleeves. Will point-on-point seasonally adjusted inflation, under the benign influence of a strongly negative real rate, veer back into the 4-5 per cent range by December 2011? Stay tuned. So far, the score is: September 2011, 20.15%.

Piped natural gas (PNG) in India: Not priced to displace electricity

In continuation of my previous post on piped natural gas, I found that Mahanagar Gas charges Rs.33/m^3 for natural gas. The energy content is 8500 kcal/m^3 or 35.56 MJ/m^3. This corresponds to 10 kwhr i.e. 10 units. In the units of electricity pricing, then, this gas is priced at Rs.3.3 per unit (i.e. $0.066 per unit). This is slightly cheaper than electricity but not by much. I'd have expected gas to be cheaper than this. This isn't a pricepoint at which one can obtain a big shift from electricity to NG. It is more convenient than shipping bottles around, but that's about it.

For a comparison, in Los Angeles, the price of gas works out to $0.036 per kwhr while the price of electricity is $0.132 per kwhr. That is, piped electricity is 3.667 times costlier than piped gas. It makes you wonder about what we're doing wrong with natural gas in India.

Sunday, November 06, 2011

Residential water heating and the rise of the gas-fired economy

When electricity distribution networks fall into place, people start using electricity for everything. Heating, air conditioning, cooking, etc.: electricity is the supple path to all applications. Electricity is conveniently accessed at home, but at a system level, there are problems. Electricity is typically made in big facilities, primarily by burning coal or gas. It is then inefficiently transported to the home. Coal has the worst carbon footprint. Given the domination of coal in Indian electricity production, electricity consumption in India is highly carbon intensive.

Gas delivered to the home is a superior alternative, but this requires gas distribution to the home. A brand-new distribution infrastructure needs to be built, for delivering gas to the home. Once gas is at the home, it can be used for cooking and for heating. To the extent that this is done, it reduces the carbon footprint of residential energy consumption. And, given the way the world is going, gas delivered to the home is likely to be significantly cheaper (per joule) when compared with electricity, even without a carbon tax. (Question: Does someone know the price per joule for residential electricity versus piped gas in India?)

When we think about global warming in India, the dominant impulse is to say to the rich countries "this is not our problem; you guys loaded up the atmosphere with CO2, you guys fix it". While this approach has strengths, it is also important for India to find low-carbon paths to development. We have a problem in having a highly coal-fired economy. We also have the malleability in having the bulk of our energy system of 2050 having not yet been built out: this gives us choices about what should be done. In contrast, most rich countries have less room to maneuver. Policy decisions in India will determine whether cities develop energy-efficient mass transportation systems (such as the Delhi Metro) or not; in contrast, there is no possibility of Los Angeles or the Bay Area developing a good transportation system.

I suspect that gas is likely to be India's low-carbon bridge to renewables and nuclear, exactly as it will be for the rest of the world. From this perspective, we need to start looking for market-based channels to do more on building the gas ecosystem. One interesting litmus test that we can use is the number of households where one sees gas-fired water heating. 

This requires distribution networks for gas, and then households have to switch from electric ovens, water heaters, stoves to gas-fired equivalents. In India, a few cities are now starting to have gas distribution to the home. In time, households should increasingly build up the capital stock of gas-fired appliances, motivated by the superior pricing of gas.

And this gives us an illustration of India's malleability. The CMIE household survey shows that at present, 5.5% of households in India today have one or more geysers (this is for the quarter ended June 2011). For these 5.5% of households, there is the question of junking the existing capital stock and shifting over to a gas-fired appliance. Presumably the differential pricing of electricity versus gas will justify such a shift for the household, but for India, it is a waste when there is such destruction of capital stock. Far more interesting are the remaining 94.5% of households. We should be doing things today, so that over the next 25 years, when 94.5% of India's households will buy a geyser, they will go towards a gas-fired heater rather than an electric one.

From this perspective, I was surprised to see a sales flyer of a small company -- P. K. L. Ltd. -- talking about a gas-fired water header:


This was news, atleast to me. I have never seen a gas-fired water heater being sold to a household before in India. I walked over to the Croma website and they don't have one. Similarly, all the water heaters at ezone are electric. Amusingly enough, the P. K. L. Ltd. website also does not talk about a gas-fired water heater. So either this is vapourware or their website is not updated. Do you know any firm selling gas-fired water heating for homes in India, and do you know any home that has one?

Thursday, November 03, 2011

Pakistan, India, MFN: What are the implications?

For once, I am pleased at how India played it: India gave Pakistan MFN status way back, in 1996, without getting into the silliness of reciprocity. A hallmark of professional competence in international trade is the idea of unilateral liberalisation: Even if another country is silly enough to have barriers against us, we should not have trade barriers against them. Removing barriers against India's globalisation is a favour to us, regardless of what it does to anyone else. India often gets into cul de sacs by obsessing on reciprocity - e.g. we won't open up to imports of agricultural products because the Europeans won't. We won't allow foreign banks to operate in India because some other countries have barriers against the operations of Indian banks. And so on. But for once, in this case, our guys seem to have played it right (and way back in 1996, too!).

And now, we have a nice next step: Pakistan will give India MFN status. What might happen next? Here are some conjectures:
  1. At present, there is significant Indo-Pak trade; it merely gets routed through Dubai. Once Pakistan gives India MFN status, the entrepot trade that was going Bombay -> Dubai -> Karachi will go Bombay -> Karachi. This is bad news for Dubai and for individuals and firms which are invested in the future of Dubai as an entrepot centre. Trade data should show a fairly sharp decline in India's exports to UAE and a fairly sharp rise in India's exports to Pakistan.
  2. There will be a boom in shipping, communication and trade serving the direct Bombay -> Karachi route. Similarly, the ports of Gujarat will do a lot of business directly to Karachi.
  3. At first blush, little changes: the goods that used to go via Dubai would now go directly to Karachi. Another dimension is the cost of the middleman in Dubai, which would be eliminated. To a reasonable man, these changes add up to small numbers. But a recurring theme in economics is the extent to which apparently small frictions loom large. The removal of fairly modest frictions matters a lot for business activity. So when the cost of shipping goes down by roughly 3x, even though the cost of shipping may be small in absolute terms, this would have a big impact on trade. 
  4. Important dynamics will now set in amidst firms in Pakistan. Firms that compete with exports from India will suffer. Firms that consume imported inputs from India will thrive. Creative destruction will take place; resources will shift from one group of firms to another. Exporters will be better able to export to India, both because of access to cheaper labour and capital that's freed up by firms that die owing to import competition, and because of improved competitiveness that comes from cheaper raw materials. Exports from Pakistan to India will go up significantly through this movement on import liberalisation.
  5. Large Indian and Pakistani corporations will look much more seriously at the opportunities that lie just beyond the national border. Over time, human capacities and human networks will build up on both sides, supporting cross-border operations. This will take time to ripen, but when it does, the effects will be large. A good fraction of global trade is intra-firm trade, so it's very important to have large firms of both countries having operations in both countries, in order to get growth of trade. But for this, both sides have to do more on capital account liberalisation through which firms will expand operations across the border.
  6. The biggest gains in India will be in Gujarat, given the myriad ports in Gujarat which are a short distance away from Pakistan. But in the future, if road and rail links open up, then there are big opportunities in Punjab also. Wouldn't it be nice to have a NHAI style road running from Ahmedabad to Karachi, and from Amritsar to Lahore?
To the extent that we're merely rerouting trade, bypassing Dubai, this will impose no new stress on ports and airports in Pakistan. But to the extent that new trade is created - as I expect it will (and as argued above) - then new work will be required in Pakistan on enhancing the capacity of ports and airports. I would personally be surprised if the effects are not large. In other words, this initiative will need to be followed through by new work on infrastructure in Pakistan.

In the intuition of economists, there is a gravity model in the affairs of men. Proximity and low transactions costs are incredibly important. The natural opportunity for India to grow international integration on all dimensions (goods, services, people, ideas, capital) lies in our immediate neighbourhood. India's connections into the region are shockingly below those seen for all other large countries. Doing better on connections with Pakistan would be a nice step forward.

Consider a product like cement, which is ordinarily considered a non-tradeable. Transportation of cement is so hard, there isn't a unified national market even within India. There are a series of regional markets. But even in this, modifications of transportation have mattered greatly. E.g. when Gujarat Ambuja came up with the innovation (back in the mid 1990s) of sending cement from Saurashtra to Bombay, by sea, this was a very big deal. By that same logic, cement from the coast of Saurashtra can go to Pakistan (or vice versa, depending on who produces at a lower price).

We should not see trade in goods in isolation. All dimensions of globalisation are intimately connected to each other. It is not possible to have mode of internationalisation (trade in goods) without having the others. To do more trade in goods and services, we need more movement of people. Ergo, the silly visa restrictions that both countries impose on each other need to be eased. Finance follows trade: So where trade in goods and services leads the way, bigger financial integration will follow with trade financing, cross-border banking, payments, purchases of information, operations of multinationals and FDI, INR/PKR currency risk management, and investment flows. More will need to be done on investment guarantees, export/import trade financing, etc. Conversely, if all those elements are blockaded, then trade in goods and services will not blossom.

Wednesday, November 02, 2011

`The Quest' by Daniel Yergin: A great job but we need more

I recently read Daniel Yergin's fascinating book The Quest. It's a panoramic view of the global energy industry. For me personally, many parts were familiar territory. But many parts were new to me, and the overall integration of the story was valuable. I encourage every non-specialist (like me) who is curious about energy to read the book.

But I was left thirsty for two more books.

The first book would be a more technical treatment of the same material.

I repeatedly found myself wanting more technical detail. The pollution from cars has come down by 99% between 1970 and 2010. How was this done!? New nuclear reactor designs are fundamentally safer than the reactors that got into trouble at Chernobyl or Fukushima. What are these designs and why are they fundamentally safer!? Hybrid cars give you much higher mileage than ordinary cars. What are the key innovations which make this possible and how much did each of these new ideas contribute? The oil industry is doing incredible things digging deep into the sea. What are these engineering challenges and how are they being overcome?

And so on. The Quest is a good book but the The Quest for Geeks would be a great book.

The second direction in which I was curious and unsatisfied was India. The book has roughly nothing about India. It talks a bit about about Suzlon and has some political stories about India's views in global climate negotiations. For the rest, there is nothing about India's energy industry. It would be great if a comparable panoramic treatment was done, focusing on India. Perhaps Girish Sant and/or Rangan Banerjee should embark on such a project.

Monday, October 24, 2011

Project Tanzanite: Obtaining fundamental progress in the macroeconomics of developing countries

I was at a meeting in London recently, organised by the IGC, on the subject of the research agenda in macroeconomics for developing countries. This made me think about how to make progress.

The US as the shared dataset for mainstream macroeconomics

All existing knowledge on macroeconomics is rooted in data about the US economy. The US is seen as a canonical developed country. Economists all over the world have treated it as a common object of study, when building macroeconomics. It is a shared dataset. Researchers and Ph.D. students routinely pull out a paper from the literature, and replicate the results, as a first stage of offering innovations: all this is rendered convenient by using the US as a shared dataset. New work is generally obliged to demonstrate value-add in the context of the US dataset.

The US works as a shared dataset because it has high quality data. Good quality data starts right after 1945, because there was no destruction within the country, hence the early post-war years are not distorted by unusual reconstruction. There was a steady shift away from dirigisme from 1945 onwards, but for the rest there has been no regime change: events like the breakdown of communism or the rise of the European Union or the Euro have not taken place.

In the US, a high quality statistical system has produced good aggregative data. Organisations like NBER have processed this data nicely to create datasets about the business cycle. High quality datasets are available about households, firms and financial markets. Household- and firm-level data has been nicely utilised to obtain numerical values for parameters in macroeconomic models: why estimate something using macro data when you know it using gigantic and well trusted micro datasets? Finally, the major question for macro today is the fusion with finance, and the US has nice data for the financial system.

As a consequence, facts about the US are the shared dataset used in all mainstream macro research across the world.

The insights developed in this literature, which has examined the US economy, have been transported with fair success, into other developed countries. Thus, this emphasis on the US as a common dataset has delivered good results. As an example, the revolution in monetary policy which was thought through by Friedman, Lucas, etc. was created using US data. It has usefully reshaped central banks worldwide. US data was essential for inventing inflation targeting, but inflation targeting has worked well outside the US.

The major obstacle on building a macroeconomics for developing countries

The major obstacle that interferes with doing macroeconomics in developing countries is data.

India is a good example of what goes wrong. The standard GDP data is in bad shape. The annual GDP data is deplorable, and the quarterly GDP data that is so essential for doing macroeconomics is worse. The IIP is untrustworthy. Put these together, and we don't have an output series, really.

The BOP data is measured fairly well. Some plausible inflation data is now starting to come together. The statistical system run by the government does not produce seasonally adjusted data [succor]. Given the absence of the Bond-Currency-Derivatives Nexus, the bulk of data about interest rates that is required is missing; policy makers are flying blind. The standard household survey (NSSO) is in bad shape: it does not produce panel data, surveys are only conducted once in a few years, and there are incentive issues about the front-line staff who interact with households.

The large firms are observed using the CMIE database; the small firms are not observed using the ASI dataset. The CMIE household survey is starting to generate knowledge about households, but this only got started a few years ago. While the CMIE datasets (on firms and households) can be aggregated up to create many interesting macro series, so far this process has only begun in a small way.

Faced with these problems, it is not surprising that little is known, at present, about macroeconomics in India. We know numerous important questions, and we know that we don't know the answers. The roadmap to progress is often, though not always, blockaded by data constraints.

Many such problems bedevil the statistical system in other developing countries also.

Economists have complained about bad data in developing countries for decades, and that hasn't changed things. And there is a uniquely perverse problem. Incremental progress with a gradually improving statistical system does not get the job done for us: By the time a country gets to good institutions and thus a good statistical system (e.g. Taiwan, South Korea, Israel, Chile), the country is not a developing country anymore and is thus not a useful dataset for studying the macroeconomics of developing countries. Chile has world class databases on households and firms, but you can't extract microeconomic facts using these datasets and use them in calibration if your object of inquiry is the canonical developing country.

A proposal

How can we make progress? I feel the first idea that we need to agree on is that we do not need many developing countries to build a great literature. We need a shared dataset, a lingua franca, a replication platform, using which we will build a literature. We need a country that will play the role, for the macroeconomics of developing countries, that has been played by the United States in conventional macroeconomics.

The second idea is that we should be a little more ambitious. We should not merely sit around hand-wringing, complaining about a problem that isn't going to solve itself. When scientists in other disciplines identify questions that call for evidence, they write funding proposals (sometimes running to billions of dollars) and organise themselves to create those datasets. Could we do similarly?

Specifically, imagine that we pick one canonical developing country. It's got to be a typical developing country in most respects. And, it should not be a conflict zone, it should have the basics of law and order and physical safety so that operations can be mounted in it. Christopher Adam of Oxford suggests that Tanzania is a good choice.

Imagine that, the system of interest (a developing country) keeps running, but it gets instrumented up to world class. In essence, we try to place first world instrumentation into a third world country. (To the extent that this data improves decision making in the country, we would suffer from `Heisenberg' effects).

This will call for financial resources and, more importantly, organisational capability. The physicists know how to organise themselves to build the Large Hadron Collider. Most of the time, economists do not organise themselves as laboratories or teams doing complex projects. This will be a bridge that we will have to cross.

As with the Large Hadron Collider, this is not a short-term project. It is a project that needs to run for 25 years, in order to generate a strong dataset.

At first, the project will generate useful facts for calibration, drawing on household survey and firm databases. Gradually, as the span of the time-series builds up, the full picture will start becoming clear.

If this works, it can ignite a literature where researchers from all across the world do replicable work off a common dataset. Perhaps Tanzania could then play a role, for the macroeconomics of developing countries, that is comparable with the role played by the United States in mainstream macroeconomics.

Sunday, October 23, 2011

Fighting back inflation is cheaper when there is credibility: A numerical example

A few days ago, I wrote a blog post about India's inflation crisis. For five years now, in every single month, the y-o-y CPI inflation has exceeded 5%. Under these conditions, economic agents have little confidence that RBI cares about inflation. They are now reporting double digit inflationary expectations. Under these conditions, inflation will be persistent. By itself, inflation is not going to go back to the target range of 4 to 5 per cent. This blog post made certain qualitative claims about fighting inflation under two scenarios: when the central bank has credibility and when it does not.

I recently came across a fascinating paper which is about a similar situation: it is about the problems faced in Ghana recently, in fighting back an inflation. It gives numerical values which are interesting for us. Their inflation was a bit worse than ours - they were at 20%. But for the rest, this analysis illuminates what we face in India today. The paper is : A model for full-fledged inflation targeting and application to Ghana, by Ali Alichi, Kevin Clinton, Jihad Dagher, Ondra Kamenik, Douglas Laxton and Marshall Mills, IMF Working Paper, 2010.

Here is the main story. First, look at the projected trajectory for what happens to the short term interest rate and inflation under conditions of weak credibility of the central bank:

The nominal rate is required to go all the way out to 26%. Inflation responds slowly. It is projected to get to the target (with some overshooting at first) by 2016. The cumulative damage to GDP growth, in this process of exorcising inflation, works out to roughly 20 per cent of GDP. (This is the sum total of the output cost over all the years taken in wrestling this inflation down).

Compare this against the picture obtained when the central bank has high credibility:

This is much nicer story. The nominal interest rate starts out high (18%) but inflation responds rapidly and the interest rate can also come down rapidly. By 2013, inflation is at the target. The cumulative damage to GDP growth, in this process of exorcising inflation, works out to only 4% of GDP.

This difference is striking. Lacking credibility, the central bank has to force a total output loss of 20% of GDP, and they get to target inflation by 2016. With credibility, the job gets done three years sooner, and at a cost of only 4% of GDP of output loss.

This is an essential insight into our inflation crisis today. In the end, raising rates will get the job done. No matter how bad is the monetary policy transmission, no matter how deeply ingrained inflationary expectations have become, raising rates will ultimately deliver price control. The choice that we face is between being bloody-minded about it, or simultaneously undertaking RBI reforms which involve zero output loss, and improve RBI's credibility.