## Friday, January 31, 2014

### Indian Financial Code: A big picture expository paper

Ila Patnaik and I have a gentle, big picture, expository paper (January 2014) which has been released by the Carnegie Endowment for International Peace.

This is a useful starting point before you go on to the key materials about the IFC:
1. The FSLRC report (March 2013)
2. The Indian Financial Code (March 2013). This file is now obsolete and deprecated.
3. The blog post on the Handbook (January 2014)
4. The Handbook (December 2013)
5. The blog post on the task forces (September 2014) and the blog post on setting up the FRA (June 2015).
6. The Indian Financial Code version 1.1 (July 2015). Please use this as the current version.

## Saturday, January 25, 2014

### Designing the Monetary Policy Committee

The establishment of a proper Monetary Policy Committee is central to a well functioning monetary policy process. There is a lot of interest in alternative designs of the Monetary Policy Committee. In this post I analyse a few designs. Before we get to that, let's think of the foundations.

#### One judge or a bench?

You are accused of a crime. The prosecution is going to make its case at a court and you're going to argue that you are innocent. What would make you more comfortable? One judge or a bench of judges?

Almost instinctively, our answer is: A bench of judges. We would feel more unsafe if there was just one judge. Why?

1. We might be unlucky and that one judge might be a bad one.
2. A well intentioned and sensible judge might just make a mistake.
3. The independent thinking of one judge might be compromised by other considerations. It is harder to contaminate the thinking of an entire bench.

For these three reasons, a bench always does better than a single judge.

#### Institutional capacity for monetary policy as opposed to individualistic monetary policy

In everything that we do in public life in India, we aspire for State structures to work in an impersonal way. Individuals come and go, but the institutional apparatus of the Indian State must exhibit consistency and predictability.

If monetary policy is controlled by the Governor, then it becomes personalised. Our job is to establish a framework through which the monetary policy strategy is consistent and predictable across 50 years.

When monetary policy is controlled by the Governor, every action is identified with him. This makes it  harder to do unpopular things. The Governor will have too much of a temptation to play to the gallery, or score political capital by doing the bidding of politically powerful people. If we want independent thinking, the rate setting should be done by the committee where the Governor is more important than other members, but not much more.

#### Combination of forecasts, or portfolio diversification

Ever since Bates & Granger, 1969, we have known this formally in the field of forecasting. A combination of forecasts is, in general, better than one forecast. The optimal combination gives a greater weight to a better forecaster. But even naive combinations are better than any one forecast.

The intuition is much like portfolio diversification. The diversified portfolio is always superior to an individual security. Each forecaster makes mistakes. As long as the forecasts are uncorrelated, the mistakes tend to cancel out, and the portfolio outperforms the individual security.

#### Design 1: The Governor makes monetary policy

This is a solution with one judge. This is a bad design for so many reasons:

• This is one forecaster making predictions.
• This is a portfolio with one security.
• We might be unlucky and have a bad Governor.
• A well intentioned and sensible Governor might be wrong.
• Under this arrangement, monetary policy is personal. Every time a new Governor shows up, there is a significant change in the nature of monetary policy. This generates policy risk. In contrast, a good MPC arrangement gives greater consistency and predictability.
• Politicians know this one person can deliver the desired outcome, so when elections are approaching, there will be extreme pressure on this one person to deliver a rate cut.
• The Governor is tempted to accede to these pressures, earn IOUs, and pursue his personal interests.

It's a bit worse than this in one setting:  the last 1 year before the date of retirement of the Governor. Monetary policy acts slowly. On a horizon like 1 year, the impact upon the economy, of a change in the policy rate, is small. Hence, when a Governor has a year to go before his term ends, accountability goes down sharply. A Governor can cut deals on the policy rate and not get caught out.

This arrangement is good for the Governor and bad for the country. This is today's RBI.

#### Design 2: An MPC with the Governor and two of his juniors

In this design, the MPC has three persons -- the Governor and two of his juniors.

Does this buy us a lot? The juniors are unlikely to challenge their boss.

For all practical purposes, this collapses into Design 1. We have not improved on Design 1.

This is the MPC you show the world, in order to claim we are on international best practice of having an MPC, but in truth, nothing has been done.

#### Design 3: The Governor appoints three independent experts to the MPC

In this design, the MPC is six people: two juniors of the Governor, and three independent experts appointed by the Governor.

The persons who are chosen by the Governor will feel they owe him something and will avoid disagreeing with him.

The persons who are chosen by the Governor are likely to have a shared view of the world with him. This will give correlated forecasts. The gains from combination of forecasts will be limited as all the six forecasts are much like each other.

The Governor has 3 votes in his pocket. For him to have his way, he has to only persuade one out of the three external members. All three are similar to him in worldview and all three owe him. In almost any situation, with almost any proposal, the Governor will be able to go down on bended knee and persuade one of the three external MPC members to go with him.

Hence, while this looks like the show of an MPC, it's actually just Design 1.

Similarly, giving the Governor a veto takes you to Design 1. There is no MPC in the world where the Governor has a veto.

#### Design 4: The Ministry of Finance appoints all the six members of the MPC

The Ministry of Finance, in any case, appoints the Governor and his juniors. Suppose we have an MPC where the three external members are also appointed by the Ministry of Finance.

The three external members will not owe their appointments to the Governor. This will generate greater independence in thinking and voting.

The three external members are likely to be less ingrained in the Governor's way of thinking. There will be less group-think; their forecasts will be less correlated with those of the Governor.

For any idea, the Governor still needs just one of the three external MPC members to side with him, and he's won the vote. But a few truly bad ideas will get shot down.

#### Design 5: Give the Governor only two votes out of six

In this design, only one of the juniors of the Governor is on the MPC. There are four external MPC members. All six are appointed by the Ministry of Finance.

The four external members do not owe their position to the Governor. And, they are not part of the group-think of the central bank.

In order to win a vote, the Governor needs 4 votes. He's got two in his pocket. He has to persuade at least 2 out of the 4 external members.

He will not be able to push through ideas where even half of the externals aren't persuaded. This sounds right.

The combination of forecasts will be best when the four external MPC members bring diverse thoughts to the table which are less correlated with those of the governor. One way to assist this is to have the four persons from the four regions of the country -- as is done in the US and in the ECB. Each one will bring a distinctive perspective about economic conditions all across India.

#### Odd numbers and ties

Assuming all members are in a meeting, it's simplest if the size of a bench is always an odd number so as to eliminate ties. When I use examples like six member committees above, this is faulty on this respect.

Even when an MPC has an odd number of members, if an odd number of persons is absent, we're left with an even number of persons present. This can be solved by giving the chairman a casting vote. But the same kind of reasoning (about power) should be conducted in those settings. E.g. consider an MPC with Governor + 1 internal + 2 externals + casting vote for the Governor. In this, the Governor can never lose, so it's just Design 1.

#### Feedback loops and the quality of external members

For external members, a considerable investment in time and trouble is required in being a good MPC member. This is related to the role that they play on the committee.

If the Governor has overwhelming power in the MPC meeting, this takes away the incentive for an MPC member to invest in figuring out stuff. Why bother, when your vote is irrelevant? For all members to go into a meeting with careful preparation, meetings have to have consequences, and every vote has to matter.

A well structured MPC creates feedback loops where external members build the knowledge and get better as they go. A badly structured MPC creates a low level equilibrium where external members tend to not acquire the requisite knowledge.

#### Conclusion

Many different designs of the MPC can be envisioned. This article shows how to think about the alternatives. The key questions to ask are:

1. How many of the externals does the Governor need to win the day?
2. How hard will it be for him to go down on bended knee and woo the externals? Do they owe him?
3. How uncorrelated is the thinking of the persons on the MPC? Are we successfully bringing in diverse perspectives?
4. How will monetary policy work when the Governor has only a year to go before he leaves, a period in which there is a sharp breakdown in accountability owing to the lags in monetary policy?
5. How to create an arrangement where there is stability in the thinking of the MPC, across personnel changes?

## Monday, January 20, 2014

### The problem of unhedged currency risk of corporate India: Comments on the recent RBI regulation' on the unhedged currency exposure of the customers of banks

#### How do firms get exposed to currency risk?

Many people think that a firm gets exposed to currency risk owing to imports, exports and foreign borrowing. This is an incomplete picture.

Suppose a firm switches from importing steel to buying imported steel from a domestic dealer. Does this change anything about its exposure to the world price of steel, expressed in rupees? The key insight is that things that can be traded across the border easily have import parity pricing': the Indian price is just the world price multiplied by the exchange rate. There is no Indian price of steel. There is only the London Metals Exchange (LME) price of steel, multiplied by the exchange rate. An Indian firm may buy or sell steel against a domestic counterparty, but it experiences currency exposure exactly as if it were importing or exporting steel.

For all products where cross-border goods arbitrage works well, i.e. for all tradeables', the Indian domestic price is close to the world price expressed in rupees. These product prices fluctuate with the exchange rate. These transactions are influenced by the exchange rate -- even if the buyer and seller are both domestic firms.

What is the currency exposure of the representative firm that processes tradeables? We can obtain intuition through a simplified calculation. Let's assume a firm consumes tradeable raw materials and makes a tradeable output. The typical values for an Indian non-financial firm in 2011-12 were:

 Total income 100 Raw materials purchased 58.45 Other operating expenses 27.66 Operating profit 13.88

I'm making the simplifying assumption that this is a firm like an engineering firm, which consumes tradeable raw materials and sells a tradeable like a ball bearing. Simplifying assumptions have been used above, such as merging the purchase of finished goods into the raw materials purchased', and treating all energy expenses as other operating expenses' even though some of this is tradeable.

By the logic of import parity pricing, for all practical purposes, this firm imports Rs.58.45 and exports 100. This is because there is no difference between selling Rs.100 of ball bearings on the domestic market vs. exporting ball bearings as the Indian price of ball bearings is the same as the world price of ball bearings (as ball bearings are tradeable and goods arbitrage is feasible). Similarly, for all practical purposes, this firm is an importer of Rs.58.45 of imported raw materials. That is, it's in the tradeables processing business; what it does is tantamount to importing raw materials, adding value, and re-exporting the output.

For all practical purposes, this firm has the currency exposure owing to its net exports, i.e. the exposure of someone who exports Rs.41.55. Suppose the INR/USD depreciated by 10%. The total income of the firm would go up to 110 and the raw materials purchased would go up to Rs.64.295. Other operating expenses are non-tradeable and would not budge, in partial equilibrium. Hence, the operating profit would become 110-64.295-27.66 or 18.045. This is an increase of Rs.4.16 which is the same as 10% of the net exposure of Rs.41.55. For all practical purposes, the firm is a plain and simple exporter with exports of Rs.41.55.

This gives us one useful insight: If all raw materials are tradeable and if all finished goods are tradeable, on average, the non-financial firms of India have the currency exposure of an exporter, and stand to gain from depreciation.

This analysis helps us think about measurement of currency exposure. To understand the currency exposure of a firm, you have to:

• Classify all outputs as tradeable vs. non-tradeable (this has nothing to do with their being exported by the firm or not).
• Classify all raw materials as tradeable vs. non-tradeable (this has nothing to do with their being imported by the firm or not).
• Work out projections for these.
• This gives the net unhedged exposure owing to the natural business of the firm.
• Layer on top of this the cashflows emanating from foreign currency denominated borrowing.
• This gives the overall picture for the exchange rate exposure of the firm.

#### Analysing what RBI said on 15 January

On 15 January, RBI put out a "regulation' titled Capital and provisioning requirements for exposures to entities with unhedged foreign currency exposure. In this, they ask banks to do greater provisioning and hold more capital when faced with a borrower who has unhedged currency exposure.

I have a few concerns with what has been done here.

1. This is unsound micro-prudential regulation. The risk faced by a lender is about only two numbers: Pr(default) and loss given default. That's it. Everything else is an input that goes into making these two numbers. If unhedged foreign currency exposure impacts upon the failure probability or upon the LGD, then it's correct to use it in internal models that generate a failure probability or the LGD. It is wrong to think of an additional layer of prudential regulation to address unhedged foreign currency exposure. For an analogy, greater leverage means that Pr(default) goes up. Does this mean that banks will now have enhanced provisioning or increased capital required to cope with the increased leverage? For another example, the volatility of cashflow impacts upon Pr(default). Does this mean that banks will now have enhanced provisioning or increased capital required to cope with firms that have more volatile cashflows? I could go on and on.
2. This is unsound measurement of unhedged currency exposure. The words import parity pricing' do not occur in the RBI document. They think in terms of direct exports and imports. Further, they say "export revenues (booked as receivable) may offset the exchange risk". For a firm like Infosys, it's perfectly safe to borrow in dollars for a 10 year horizon, knowing that for the next 10 years, export revenues are going to come along, even if this is from clients who are not known today.
3. This is unsound regulation-making process. If the due process in the Handbook had been followed, the quality of regulations would go up. In part, this is about the basic hygiene of the rule of law. As an example, under the Handbook, a regulation would not be a letter. In addition, the formal process of identifying the market failure, stating a clear objective, doing the cost benefit analysis and consultation would have caught the mistakes. The formal regulation-making process from the draft Indian Financial Code, and the Handbook, is the process design for a superior financial agency.

Suppose we believe that unhedged currency exposure is a problem for India, and not for banks, and that we're merely using the regulation of banks as a mechanism to attack that problem. This would stave off the first problem (this is unsound micro-prudential regulation of banks'): RBI could respond saying "we know this is unsound micro-prudential regulation, but this isn't micro-prudential regulation". But it would not solve the other two problems, and it raises two fresh concerns.

First, if there is a concern on the scale of India, and an intervention is undertaken in one part of the financial system (Banking), it will have little impact on the economy as a whole -- all that will happen is that the market share of banks in the credit market will go down. This shift in market share will be a distortion as it will constitute industrial policy in the form of RBI favouring one technology (non-bank lending) over another (bank lending).

Second, this raises concerns about accountability. The powers obtained by a financial agency for a specific purpose should not be misappropriated for other purposes. Once we start going down this slippery slope, we will get powers of micro-prudential regulation getting used to foster GDP growth in Himachal Pradesh. A few paragraphs down, I argue that the problem of unhedged currency exposure is rooted in inappropriate monetary policy (i.e. exchange rate management) and inappropriate regulation of organised financial trading. The problem of unhedged currency exposure was not born in mistakes of banking regulation and should not be addressed by modifying banking regulation.

#### How to combat unhedged currency exposure

I have been closely associated with enterprise hedging of certain firms and even to the management of the firm, it is not easy to precisely understand currency risk and hedge it. The true extent of exchange rate exposure for a non-financial firm is very hard to observe for an external observer such as a bank.

Unhedged currency exposure of firms is a real problem. Many countries have experienced serious problems with non-financial firms that got damaged as they had borrowed in foreign currency and hoped that the government would prevent depreciation. We should not ignore it. There are two channels to fighting this:

1. The problem of moral hazard. Firms will be careful about unhedged currency exposure when they know that the government will not manage it for them. As long as a government promises that extreme volatility of the INR will be prevented, it is advantageous for firms to leave tail risk unhedged. By doing this, the firm that has unhedged foreign exchange exposure free rides on RBI; its private gains from not doing risk management are offset against the costs to society of RBI having an exchange rate policy. The paper Does the currency regime shape unhedged currency exposure? by Ila Patnaik and Ajay Shah, Journal of International Money and Finance, 2010, finds there is this kind of moral hazard in India. To solve the problem of moral hazard, RBI should stop having a currency policy and should clearly say so in order to ensure that the firms of India know they are on their own, and have to do their own currency risk management.
2. The problem of incomplete markets and barriers to hedging. Even if a firm was sensible and wanted to hedge, RBI is working hard to prevent the firm from hedging. The rules about the use of the OTC market prevent correct measurement of enterprise-risk based on import parity pricing. The onshore market is illiquid, but Indian firms are prevented from getting their hedging work done on the superior NDF market. The exchange-traded currency futures market has been damaged by RBI, to make sure that it is not a viable venue for currency hedging. If Infosys tried to obtain a 3-year hedge from the private market, the prices are quite adverse.

This is a good example of the problems that come from mixing up multiple functions inside one agency. A financial agency which did micro-prudential regulation for banking would be technically sound and not make the mistakes identified above on provisioning and capital. A financial agency which dealt with organised financial trading would deliver a sound Bond-Currency-Derivatives Nexus without conflicts of interest, and the problem of incomplete markets and barriers to hedging would go away. If RBI had no role in banking regulation and no role in organised financial trading, the quality of monetary policy would go up. When each agency has clear objectives, each one will be accountable and more likely to deliver results without conflicts of interest.

#### Conclusion

The unhedged currency exposure of Indian firms is a big problem. It is an important concern for policy makers. But it makes no sense to go after it by asking banks to hold greater capital when lending to firms that are considered unhedged, based on an incorrect framework for thinking about the currency risk of firms.

We must address the root cause. If RBI had no currency policy -- and clearly said so -- the moral hazard would be removed. If RBI got out of the way, then the Bond-Currency-Derivatives Nexus would find its feet and firms would be able to hedge. The problem of unhedged currency exposure of firms is caused by inappropriate macro/finance policy at RBI, and the solutions lie there.

## Sunday, January 19, 2014

### The biggest exchanges in the world

There are two ways to measure turnover: dollar value and number of trades. By dollar value, advanced economies dominate the rankings. But the number of trades is more important than meets the eye. The number of trades is a measure of what's going on : 1000 trades/s is a lot more than 100 trades/s. And, as far as the IT complexity of an exchange is concerned, number of trades is all that matters. For the folks building and running exchanges, or consuming a feed from an exchange, the IT complexity is determined only by the number of trades.

Here's data from the World Federation of Exchanges for the top 10 exchanges by the number of transactions (measured in millions):

 Exchange 2012 transactions 2012 rank 2013 transactions 2013 rank Change (%) NSE India 1407 1 1449 1 3.04 NYSE Euronext 1375 2 1188 3 -13.59 NASDAQ OMX 1268 3 1151 5 -9.17 Korea Exchange 1219 4 1032 6 -15.38 Shenzen SE 936 5 1289 2 37.82 Shanghai SE 926 6 1153 4 24.61 BSE India 356 7 345 8 -3.07 Tokyo 350 8 599 7 71.39 London 222 9 211 10 -4.87 TMX Group 216 10 235 9 9.15

This shows that NSE was #1 in the world in both 2012 and 2013. With 1449 million transactions spread over roughly 250 days of roughly 20,000 seconds each, this is an average intensity of 290 trades per second. There is no other part of Indian finance where a win of this scale has come about. I used to be nervous about the vulnerability of these achievements, but now the danger has subsided. We have a good equity market and it's now unlikely to get messed up. As the Indian Financial Code gradually falls into place, the equity market will become much better.

The listing underlines the well known fact that the electronic limit order book won. There are no market maker exchanges of note any more. This is a serious problem for academic finance as a lot of our intuition is still rooted in the old world of market makers. I see a striking contrast between the importance of market makers in the finance literature and their irrelevance in the real world. The only game in town is the anonymous limit order book market, and academic finance is weak on it.

If you add up the two Chinese exchanges, there is more activity than the two Indian exchanges. In 2012, the two Chinese exchanges added up to 1861 million transactions, which went up sharply (by 31.25%) to 2442 million transactions in 2013. The two Indian exchanges, in contrast, added up to 1762 million transactions in 2012 but grew by only 1.81% to 1793 million transactions in 2013. In 2013, the two Chinese exchanges added up to a trading intensity that was 36% greater than India. If Shenzen and Shanghai keep up their blistering growth, and NSE stays at low growth, then by 2015 or so, NSE will be displaced from the #1 slot. The question mark for China lies in establishing something like the Indian Financial Code and the rule of law.

This ranking implies that NSE is a great lab for doing research. It is now a bigger exchange than the NYSE and NASDAQ by number of transactions. In addition, liquidity in the US is fragmented across numerous trading venues, which makes is much harder to understand what is going on. In contrast, the order flow for spot and derivatives is largely consolidated. If one can marshal data for NSE and BSE there is 100% coverage. There is no OTC trading and no dark pools. In fact, if a stock is not on the stock derivatives list, it is essentially impossible to take a leveraged position on it. This makes India a clean laboratory where the working of an equity market can be understood.

The US is the ideal lab for understanding what happens when liquidity is fragmented; research projects focusing on fragmentation of liquidity should be done using US data.

The heart of the action in modern exchanges is algorithmic trading. I see one world for the really big exchanges where on average there are over 200 trades/s with peaks of over 10,000 trades/s, and another world for all other exchanges. There is one cadre of finance and IT folks, spread all over the world, who are building these hairy systems around the top exchanges. If you setup a conversation on algorithmic trading between the folks in Bombay, New York, Korea and China, they'd have a lot to say to each other. A new world of financial firms is going to emerge, where a common set of finance & IT skills are deployed across the four locations.

A very large number of transactions yields economies of scale. It is not surprising that the charges in India are low by world standards. This is a competitive advantage in the production of transaction services. If India makes the right moves on the policy bottlenecks, a greater fraction of India-related activity will come to India, and India can be a platform for trading global products. The competitive advantage of NSE and the algorithmic firms surrounding NSE comes from a combination of world class transaction intensity but low revenues/trade. This forces exchanges and algorithmic firms in India to be more intelligent.

## Thursday, January 16, 2014

### Fixing MIBOR: Comments on the Draft Report of the RBI Committee on Financial Benchmarks

#### The problem

LIBOR is made by asking a few dealers what the price on the market is. The LIBOR scandal involves allegations that dealers in London made up the numbers. The dealers at twenty major global banks chose values that were convenient for the banks. This is considered terribly unfair.

#### Understanding the LIBOR scandal

The inter-bank money market is an OTC market. It is based on conversations between counterparties and when a position is taken, there is credit risk of the counterparty. At the height of the global crisis, this market broke down. In August 2007, HSBC and Citibank were not willing to take each others' credit risk in London. When HSBC and Citibank were not comfortable doing transactions on each other, they were also not willing to do inter-bank unsecured money market transactions. As a consequence, the underlying inter-bank unsecured money market became dramatically illiquid.

In an illiquid market, and particularly in an illiquid OTC market, the very participants in the market do not know what is the market price. Nobody knows what is going on.

Every morning, quotes had to be supplied by dealers to the BBA. There were two choices:

1. Admit that the unsecured money market had broken down. This would have generated a legal crisis for myriad contracts which are predicated on LIBOR. A large fraction of those would go into litigation. Many contracts would have deemed to be in auto-default in the absence of LIBOR. This would have amplified the market meltdown.
2. Or, make up some numbers and proceed. The dealer at HSBC felt that Citibank was bankrupt and was not willing to lend to Citibank. However, for the purpose of the polling, the dealer at HSBC could ask himself: If Citibank were solvent, at what price would I would be willing to lend to him? The rates reported were lower than those at which the fragile entities could borrow, as the credit risk was ignored.

The banks chose option 2. Government agencies were aware of this choice and complicit in it. They supported option 2 as they did not want one more spanner in the works of the global financial system. Many central banks privately talked with banks to help guide LIBOR rates since LIBOR has a big impact on the rate at which governments borrow. As an example, the Bank of England did this with major British banks operating in the LIBOR market.

I believe that the decisions of the banks and the financial agencies, to keep the boat aloft with invented LIBOR rates, were good for the world at large. Under any such messy arrangement, there are bound to be individual episodes of excesses, but at a strategic level, I think what was done was good for the world economy. I believe there is less criminality in the LIBOR scandal than is sometimes claimed.

#### Trade prices are not a panacea

Can such problems be avoided in the future? Suppose we switch from a reference rate made through polling, to the volume weighted average (VWA) of trades. This assumes that all the trades are observed in some trade reporting or trading or clearing system. This approach has three problems:

1. It does not solve the LIBOR crisis situation : What if there is no trading and the VWA makes no sense? For a contrast, the bid and offer price on an order book in an electronic exchange represent the market price even if there is no turnover.

2. The reference rate must be a rate that you can reliably attain in a trade. Suppose we make the VWA of all the trades of the day. This is an unambiguous number. The trouble is, this rate is not implementable for arbitrageurs. Suppose you are doing spot/futures arbitrage with a cash-settled futures. On the expiration date, the futures contract is worth the same as the spot, so you need to unwind your spot position alongside the termination of the futures contract. This requires a predictable time at which the spot unwinding is done. The VWA of the whole day is not replicable for a trader. Also see.

In contrast, a reference rate at 11:00 AM is replicable for a trader: he just does the unwind at 11:00 AM.

The Nifty reference rate is a very successful VWA, as it has been the foundation of one of the world's great index derivatives contracts. It is made as the average of 30 minutes of trading, from 3:00 PM to 3:30 PM. Why does this work well? The NSE spot market is an extremely liquid market. Hence, there is a feasible implementation algorithm through which an arbitrageur can attain this price: To split up each required trade into 100 trades that are placed once every 18 seconds. The average execution obtained over these 100 trades comes close to the Nifty spot that's computed as the VWA over 1800 seconds. This implementation strategy is hard for a human, but it can be done using algorithmic trading.

If Nifty was a less liquid market, then this uniform placement of orders (equal sized orders every 180 seconds) would not reliably yield VWA-execution so the reference rate would then be unattainable.

3. Market abuse. With a polling based MIBOR with 10 dealers (say), you'd need four of them to collude to have a significant impact upon the rate. For more on robust estimation with polled prices, see link and link. In an illiquid market, one person can do circular trading against himself, and dominate the VWA! The polling based MIBOR is vulnerable to market abuse but so is the VWA, particularly in an illiquid market. There is ample experience in India of bad people who paint the tape' doing circular trading through which apparent turnover is driven up, closing prices are faked, and so on. Our capabilities on enforcement against such market abuse are weak.

These three arguments show that while the VWA is a good technology under certain circumstances, it is not always superior. The VWA and polled rates are not the only choices for dealing with this question. There is an important third choice: Call auctions. Call auctions can be particularly useful when the market is relatively illiquid. Even with Nifty, I believe that we will do better on measurement of the Nifty close by using a call auction (as we do with the Nifty open).

In short, going from a polled reference rate to a VWA is not a free lunch. There are three alternative technologies: polled rates, VWA and call auctions. There is the need for judgement and experimentation in figuring out what works. For the VWA to work well, five conditions should be satisfied:

1. All trades on the market of interest should be observed in a central trade reporting system.
2. The window of time over which the VWA is computed must be small (e.g. Nifty uses 30 minutes; ideally it should be even shorter, more like 15 minutes).
3. The market must be very liquid so that one reliably gets execution within that short window of time, and market abuse through circular trading becomes difficult.
4. It should be easy to setup algorithmic trading to implement (say) 100 small trades over 15 minutes or 30 minutes so that it becomes possible to achieve execution at the reference rate.
5. There should be a regulatory capability that detects and enforces against market abuse aimed at falsifying the VWA.

Similarly, conditions can be articulated under which polled rates are optimal, and when call auctions are optimal. These are subtle questions of design of information series and financial products. Financial capitalism solves these problems through a process of crossing the river by feeling the stones. No one technology dominates under all circumstances.

#### Analysing a recent RBI committee report

RBI has a recent report on benchmarks. They say:
1. The ownership and control of MIBOR must shift from NSE to FIMMDA.
2. MIBOR must become a VWA from 9 AM to 10 AM.
3. The report suggests many other things such as: "Construction of the G-sec yield curve may use volume weighted average rate of the trades executed over longer time window in place of last traded yields" and "FEDAI may stop publishing spot fixings, if it is not used for any meaningful purpose by corporates and other clients".

1. If it ain't broke, don't fix it. There was no MIBOR scandal. The report has not demonstrated that there is a problem with MIBOR. (The statistical methods in MIBOR are a bit better than those in LIBOR).
2. Confusion of terminology. A VWA-based rate is different from MIBOR. It would reduce confusion all around if the new product did not use the name MIBOR. The name MIBOR is taken, and it means : a polling based reference rate. In fact, for contracts that are in flight (and MIBOR has dominant market share today), it would generate legal risk to make an in-flight change over from the polling-based MIBOR to a VWA-based MIBOR, a change that cannot be papered over by holding the name constant. The VWA-based rate can have some other name like VIBOR. For an analogy, a new method for measuring the stock market index, launched by NSE in 1996, was called Nifty and not Sensex.
3. Why choose one when you can have both. I don't see why we have to close down a polling based MIBOR. Why not do both? All that's required is to have a VWA-based rate competing with MIBOR, and the market can figure out which is better. The CCIL MIBOD/MIBOR is a VWA, has been around, and is competing for influence.
4. Expropriation alert. I do not see how the event of the LIBOR scandal leads to the recommendation that the coercive power of the State should be used to take MIBOR away from its present owner and give it to FIMMDA. Is this mere turf extension by RBI? Do the laws authorise RBI to expropriate, and even if they do, is such expropriation wise? For an analogy, the reformers of the equity market never proposed that BSE should be expropriated in its ownership of the BSE Sensex. Far from expropriation, there was no State coercion of any fashion in the emergence of Nifty.
5. The proposed solution has problems. There are five requirements to make a VWA work well (listed above), and the Indian money market does not satisfy them. The proposed window of 1 hour is too long. The spot market is not too liquid, and it is not an active electronic market where we can break up a trading problem into 200 trades, one each 18 seconds, implemented through algorithmic trading. The threats of market abuse will not go away. Shifting to a VWA will impose costs, in return for no visible gain. If the VWA-based CCIL MIBID/MIBOR were compelling, they would have passed the market test.
6. Cost-benefit analysis. Under the Handbook, page 39, RBI will need to do a cost-benefit analysis before undertaking interventions. It is not clear to me that the cost-benefit analysis of these interventions (expropriation, forcing VWA instead of a robust reference rate) is a win.
7. Strengthening the polling-based MIBOR. MIBOR construction should use data from a large number of dealers, and these dealers should be as diverse as possible. The problem of the monoculture of the Indian bond market, with domination by banks, implies that by default, we may end up with too many bank participants in the panel that's polled. We should work on obtaining a large and diverse panel, and on giving adequate incentive to dealers to bother to give sound information. A lot can be done on these lines, but I saw none of this in the report.
8. What about the third strategy? Call auctions may be better than the proposed VWA.
9. Central planning alert. A financial agency should not be a super-CEO of the financial system, determining who makes what information series and how. Financial agencies must not do industrial policy, picking winners among three rival technologies. Financial agencies should identify and solve market failures. There are difficulties with all three technologies, and the coercive power of the State should be devoted to solving market failures, with neutrality about technology. Policy interventions should be undertaken to make all three technologies function properly, so that private persons who develop markets and products have the full choice between VWA vs. polled rates vs. call auctions. It is not for a financial agency to (say) decide how statistical estimation of the yield curve should be done. The RBI report seeks to replace a self-organising system by the decisions of bureaucrats. Bureaucrats are likely to fare poorly in imagining and innovating on information measures. Private persons in the market economy cross the river by feeling the stones, and reverse themselves from numerous mistakes along the way; this method of nonlinear maximisation gives better outcomes when compared with intelligent design.
10. Reduced incentives for R&D. Information systems in India were developing on their own, based on the initiative of diverse persons on the market (e.g. Reuters, NSE, FEDAI, CCIL, etc). No bureaucrat would have thought of the innovations that went into information series like Nifty or MIBOR or PPI. When pioneers who create new measures are expropriated, there will be less incentive to think and invest in research and innovation in the future.
11. Rule of law. The report indulges in central planning without making clear the legal foundations of all the interventions that RBI will use to do these things. The report acts as if RBI has unlimited powers to give orders to a variety of organisations. Can the report be implemented through regulations that are made through the process spelled out in the Handbook and that would withstand judicial review? I doubt it. Many times, I fear, what may be envisaged is verbal instructions or intimidation by RBI. If this happens, it is inconsistent with the rule of law.
12. MIBOR is likely to matter greatly in the future. Looking into the future, a key objective for India is to build a Bond-Currency-Derivatives Nexus. This requires futures on the short interest rate, which has thus far been banned. A natural candidate for the underlying is MIBOR. There is a natural possibility of doing something like the CME Eurodollar Futures contract in India. Building towards something like the CME Eurodollar Futures contract should be high on our radar, in the project of constructing the Bond-Currency-Derivatives Nexus. We should be very careful before damaging MIBOR, which is a critical ingredient for this possibility.
13. FIMMDA as a custodian of MIBOR? Who has the best incentives to build towards something like a Eurodollar futures contract? A club of OTC dealers (mostly banks) has an incentive to pursue the rents that come from opacity and barriers to access to markets. From this point of view, an exchange is a better custodian of critical components of the Bond-Currency-Derivatives Nexus rather than FIMMDA. If anything, there is a greater possibility of extreme cooperation, that led to the LIBOR scandal, in a monoculture of bank dealers.
14. Think it possible that we may be mistaken. In the future, we may decide that a polling based rate was better after all. In this case, we would have lost a chunk of the MIBOR time-series when we closed down the polling-based MIBOR, and this gap can never be overcome. Future estimation of risk models for a polling-based MIBOR will forever be weaker with a gap in the time-series. Let's not do things that we may regret in the future.

## Friday, January 10, 2014

### The IFC: A bridge too far?

Transformative change of the Indian State takes place through big projects. We seem to combine stasis in government, with ground-up rethinking in big projects. Six big projects are now in the fray:

1. Goods and Services Tax (GST)
2. Direct Tax Code (DTC)
3. Indian Financial Code (IFC)
4. National Pension System (NPS)
5. Delhi Mumbai Industrial Corridor (DMIC)
6. Unique Identity Authority of India (UIDAI)

Everyone agrees these big projects should be done. The story of Indian State capacity and trend GDP growth is one of conceiving and executing a series of such ground-up redesigns of the State. With this shelf of 6 big projects, the bottleneck lies in execution. We cannot help but anxiously look back at the Companies Act. Could we have gone faster? Could we have achieved a better law when compared with the outcome we got there, the Companies Act of 2013? Similarly, while the NPS project has made great progress, there are important concerns about where the NPS has come. How should we work, in translating these big projects from ideas to action, and get to a pretty good thing at the end?

When the Financial Sector Legislative Reforms Commission (FSLRC) released the draft Indian Financial Code (IFC) in March 2013, many people were concerned that India lacked commensurate implementation capability. To some critics, it felt like an alien spaceship had landed, embedding knowledge that was too far ahead of the landscape. For a sense of the zeitgeist, see this blog post from 19 June 2013 which is roughly 3 months after the IFC. Reasonable men were asking: Was the IFC a bridge too far?

### T+7 months: A three-pronged strategy was visible

The first signs of implementation came from the Financial Stability and Development Council (FSDC), which consists of the Ministry of Finance and the five financial agencies (RBI, SEBI, FMC, PFRDA, IRDA). A press release reporting on the Eighth meeting of the FSDC on 24 October, seven months after the IFC, contained this text:

Based on the deliberations made today, it has been decided that all the financial sector regulators (including FMC) will finalise an action plan for implementation of all the FSLRC principles relating to regulatory governance, transparency and improved operational efficiency that do not require legislative action. As regards legislative recommendations, it was decided to analyze the public comments and feedback to further fine tune the draft Indian Financial Code. It was also decided that action should be taken for finalizing the roadmap for creation of new institutions such as Resolution Corporation, PDMA, FSAT and FDMC.
This suggests a three-pronged implementation strategy for the IFC: (a) An action plan of the things we can do now, (b) A consultative process that will lead to an improved IFC and (c) Creation of new institutions.

### T+9 months: the action plan' is a Handbook

Roughly two months after this meeting, and 9 months after the IFC, the Ministry of Finance has released the Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code. Here is the press release. The Handbook has four components:
• Chapters 2 and 3 are a good chunk of consumer protection from the IFC.
• Chapters 4 to 12 are a good subset of the regulatory governance process and the Rule of law from the IFC.
• Chapter 13 is on capacity building.
• Chapter 14 pulls together all the implementation activities that flow from Chapter 2 to Chapter 13.
With this in hand, we get a fair sense of the first prong of the implementation of the IFC, which is an action plan for right now. The three key documents connected with the IFC are now : The IFC itself, the report of the FSLRC and the Handbook.  They are collected together at http://macrofinance.nipfp.org.in/fslrc . Everyone interested in Indian economics should read all three documents.

### Next steps

The adoption of the IFC now runs on three tracks:

1. Implementation of the Handbook by FMC, IRDA, PFRDA, RBI, SEBI.
2. Consultative process leading to an improved IFC, led by MOF, and then the hazards of the legislative process after the next elections.
3. Construction of new institutions. We may assume some actions will get announced in coming weeks.

### Implications of the Handbook

How big is this? I have been in the field of financial regulation in India for 20 years and I think the adoption of the Handbook is the biggest event of this period. Trend GDP growth in India will go up when the members of FSDC implement the Handbook as they have resolved to implement it. Very crudely, and assuming technically sound follow through, I think this adds up to 66% of the consumer protection and 66% of the regulatory governance from the IFC. A properly implemented Handbook is perhaps 33% of the goodness of the IFC. While a lot remains in that 66%, to build 33% of the IFC is a big deal.

How much work will it take to implement this? I think the Handbook is a big deal because there is a big gap between what we see there, and present practices. All five financial agencies will require a significant scale of reorganisation, recruitment and reskilling in implementing the Handbook. SEBI is a bit ahead of the others, but for SEBI also, the changes required are substantial.

For people interested in public administration, and actually making the machinery of government work, this will be an exciting time. The people who built SEBI, NSE and NSDL over 1988-1996 had a disproportionate impact on the following twenty years. In similar fashion, the people who implement the Handbook, and build the new institutions of the IFC, will have a significant impact upon Indian finance of the next 50 years.

What is the impact of harmonisation on financial economic policy? At present, there are large differences between RBI, FMC, SEBI, IRDA and PFRDA. One achievement of the IFC is that it is one single law for the entire financial system. As a consequence, there is only one Handbook covering RBI, FMC, SEBI, IRDA and PFRDA. For the first time, we will be able to compare and contrast different agencies, and we will be able to carry good practices from one agency to others. We will achieve better outcomes with five agencies competing, with success stories getting transferred from one the others. On any question, a person in one agency will start by asking How do the other four agencies do this? What worked and what didn't?'. There will be greater scrutiny as finance practitioners and the media will be able to compare and question practices and events across all the five agencies.

What is the impact of harmonisation on individuals in finance? There is one IFC and one Handbook: this gives greater transferability of individuals across the entire Indian financial system -- whether in government or in financial firms or their surrounding support system such as legal firms, consultants, etc. Breaking down silos increases competition in the labour market. For the staff of government agencies, we will see the beginnings of an Indian financial regulatory cadre, with individuals across all five agencies (and MOF) thinking in consistent ways, sharing experiences, and feeding off each other's work. While SEBI has a head start, it is quite possible that agencies like RBI or FMC could outperform in coming months.

What will be the impact for financial firms? The Handbook is really Consumer protection and a group of improvements in governance that emphasise the rule of law. The consumer protection component of the Handbook implies that financial firms have to emphasise business plans that are good for their customers. For an analogy, when health standards make it harder to sell sugar water, this is good for the people selling water. Consumer protection from the Handbook will make life more difficult for the messy things that financial firms in India do (example), and improve the market share and profit rate of financial products and services that are good for consumers such as index funds, NPS, KGFS, Quantum Mutual Fund, direct sales (link), more sensible insurance (link, link). CEOs will lean away from toxic business plans towards things that are good for consumers -- not because they are nice guys but because of modified behaviour of financial agencies.

The governance-enhancing features of the Handbook imply that there will be less arbitrariness in the hands of financial agencies, and greater consistency across financial agencies and across time. This will reduce legal risk.

The greater portability of individuals and knowledge across all five regulatory agencies will make it easier for all financial firms to think about business strategy across the entire Indian financial system, instead of living within one silo at a time. More firms will be willing to span silos, which will increase competition in finance.

It will become easier to identify and solve mistakes by regulators, which will foster rationality, competition and innovation. But this will require capacity building among financial firms, who will have to construct public policy teams that will engage with financial agencies through the formal mechanisms of the IFC, and in associated academic institutions and law firms.

How does this change the outlook for the remaining 66% of the IFC? Implementing the Handbook front-loads much of the pain, of reorganisation, recruitment and re-skilling by existing financial agencies. Once these problems are out of the way, there will be less of a disruption when the law is passed by Parliament. This is a wise strategy that will reduce fear of the changes required for the IFC.

Implementation of the Handbook by existing financial agencies will generate knowledge that will assist the construction of new institutions required under the IFC such as the Resolution Corporation or the Public Debt Management Agency, all of which will run on regulatory governance of the IFC.

Implementing the Handbook will make gains from the IFC tangible. Many in Indian finance will see long-standing points-of-pain get addressed by implementation of the Handbook. Improved working of financial agencies, and of consumer protection, will become palpably visible, will increase confidence in the IFC, and help go forward to enactment of the law.

What are the implications for the Indian State more broadly? The Indian State is fraught with meddling, laziness, incompetence and corruption. We fail to be guided by market failures when thinking about the use of the coercive power of the State, and we fail to be guided by public choice theory in thinking about the organisation of the State. The State is lost in a haze of populist redistribution, and fails on the hard work of producing public goods.

The IFC constitutes a fully articulated solution of constructing a sensible State in one field with an extensive State interface, namely, Finance. The IFC limits the intervention of the State to market failures, and it is fully cognisant of public choice theory. Some of the ideas about how FSLRC was done, and some of the ideas from the IFC, could be usefully transplanted into other areas.

## Thursday, January 09, 2014

### Abolishing taxes

by Ajay Shah.

The BJP has started asking fundamental questions about fiscal policy. If we're willing to flirt with iconoclastic ideas, there are good foundations for two propositions:
1. It would be wise to cut total expenditure of the government to 12% of GDP.
2. There are only two sensible taxes -- income tax on individuals, and GST. All other taxes should be eliminated.
That leaves the problem of building sound tax policy and tax administration through which the income tax on individuals and the GST are setup, that yield revenue of 12% of GDP.

Let's start at expenditure. The golden age of the UK was from 1865 to 1914. In this period, the UK had price stability, the world's strongest army, good law and order, good courts, parks, clean water, a Metro system in London, and so on. They had world class public goods. Roughly speaking, the UK govenrment did all this while spending 10% of GDP. This gives us one objective benchmark: All you need, to deliver a comprehensive array of world class public goods, is 10% of GDP.

That leaves redistribution or subsidies. In the golden age of the UK, there were no subsidies. In India, we believe that we should help the poorest 20% of the population. This can be setup as a cash transfer costing 2% of GDP. If we are willing to spend 2% of GDP on delivering cash to 20% of the population, this pays for a subsidy of Rs.150 per household per day. This is an ample subsidy that will eliminate the extremities of poverty.

The government of India does a lot of things in the name of poor people. We would gain much by shutting all of them down, and replacing them by this cash transfer. The government of India does lots of things which are not public goods. We would gain much by shutting all of them down. That leaves a required expenditure outlay of 12% of GDP.

How do we obtain 12% of GDP? We need a tax system that would yield 12% of GDP. The puzzle lies in doing this at the lowest possible distortion of the economy. The distortion caused by a tax goes up sharply when the rate is raised, in proportion to the tax rate squared. An income tax rate of 20% is four times more distortionary when compared with an income tax rate of 10%. For this reason, it would make sense to have two taxes: the income tax on individuals and the GST. By having two taxes and not one, each rate can be lower.

All other taxes in India are mistakes; they impose terrible distortions and should go. These include customs duties, octroi, electricity duty, transaction taxes, stamp duty, etc. An important candidate for this bonfire of the taxes is taxation of corporations. All corporations are owned by individuals: If we just taxed individuals, we would tax all income once. The entire attempt at taxing corporations is conceptually a mistake and is worth eliminating.

We would gain a lot by getting rid of all these taxes and their commensurate tax administration capabilities. But we will need to build top quality tax policy and tax administration for the income tax for individuals and for the GST. Every individual would have to deal with exactly one tax man -- to pay income tax -- and it would be a low rate. Every firm would have to deal with exactly one tax man -- to pay the GST -- and it would be a low rate.

It is valuable to obtain income tax from a very large number of individuals in the country. This makes possible a lower tax rate. As the distortion associated with a tax goes up as the tax rate squared,
it is good to go down to a lower rate. In addition, when most adults in the country pay taxes, this improves the political economy: people who pay taxes are more careful in the expenditure programs that they ask for. In contrast, people who pay no taxes are likely to blindly support more profligacy as they are not paying for it.

For more on the tax system, see this paper by Vijay Kelkar and I.

If there is an appetite for first principles thinking, then, there is a lot of appeal in this platform: (a) A cash transfer where 2% of GDP is gifted to 20% of the population, (b) Create public goods by spending 10% of GDP, (c) Obtain 6% of GDP through a low income tax rate applied to 66% of adults, (d) Obtain 6% of GDP through a low GST rate, that is applied on 200,000 firms, (e) Remove all other taxes and (f) Remove all existing subsidies.

Every State requires tax resources. When a State has no tax base, it is down to exactly two sources of revenue: seignorage and the inflation tax. The inflation tax generates rapidly spiraling hyperinflation. When people mistrust the rupee and switch to gold or dollars or bitcoin, this hurts seignorage revenues. In history, every State that failed to build a tax capability has collapsed, and generated a social and political catastrophe.

It is easy to make fun of the BJP or AAP who are asking basic questions. There is value, however, in asking first principles questions, and in being willing to say that the emperor has no clothes. We will go far in public life in India if we are constantly willing to challenge the foundations of what is being done in public policy, for most of what is in place is based on bad thinking.