Friday, December 19, 2014

Policy puzzles of the digital nirvana

by Arjun Rajagopal, Renuka Sane, Somasekhar Sundaresan.

It has been a bad week for Uber. The effect of its automated surge-pricing during the hostage crisis in Sydney and the reaction to this, have exacerbated the publicity surrounding the alleged rape of an Uber customer in Delhi by a driver who was listed on the company's app, and the litigation it faces in San Francisco over not conducting effective background checks on criminal records of drivers. In India, the outrage has been accompanied by bans in New Delhi and calls to ban or suspend Uber in other states.

This is not the first time, or the first geography in which Uber has run into trouble. It has been criticised over its sexism, ethics and bro culture and over its record on passenger safety. The app has been recently banned in Spain and Thailand and has run into trouble with authorities in several other countries, mostly for being at odds with the traditional, regulated taxi companies.

Uber does not have a taxi license in Delhi. It is not a radio taxi service. It does not own the cars or employ the drivers. Fine print on its website suggests that it disclaims the suitability, safety or ability of third-party providers. Uber claims to not be a transportation provider, and only connect riders to drivers through its app. Yet, it claims that its service is a safe and secure one, adopting standards that go way beyond local standards that regulatory authorities may prescribe.

These claims allow one to litigate against Uber with allegations of misleading customers with particular standards of safety when in fact there were none. This is the stuff class action suits are made of. Indian customers could potentially be creative and sue Uber in the US, where control over its operations is headquartered.

However, the furore also raises larger questions on what the appropriate legal or regulatory response should be to such aggregators, and where the liability lies when things go wrong.

Is more required? Liabilities for information aggregators

A defining feature of the early 21st century is businesses becoming powered by software and synonymous with services delivered online. Technology platforms, or aggregators, purely facilitate the sale between buyers and sellers. In this sense, they are neither originators of the product, nor distributors linked to specific manufacturers. Often touted as disruptive innovators, such businesses tread thin on requirements under the licensing and regulatory systems even while competing with similar services provided by the traditional licensed players. This regulatory arbitrage raises important questions on the obligations of such aggregators.

The fundamental question that governments need to ask themselves is what, if any, obligations should be placed on businesses such as Uber. Should a market aggregator be responsible for the quality, or safety of a product that is sold on its technology platform? There are well reasoned views on both sides.

The analogy with a financial exchange

We might make an analogy between Uber and an electronic stock exchange, in which case the exchange aggregates information and enables transactions. The quality of the product being sold (i.e. whether the shares represent a "good" investment) is not guaranteed by the exchange. The transaction is guaranteed. Under this analogy, Uber's job is simply to ensure that double booking of cabs never occurs, and that payment transfers occur reliably and seamlessly.

The analogy with a retailer

We might also make an analogy between Uber and the owner of a neighborhood mall. While a case may be made against regulatory intervention to make the mall owner responsible for quality of the goods and services, there would also be a case for the mall owner being obliged to ensure safety and security in the mall premises, and being liable for a customer injuring themselves on a broken step. Besides, if the mall owner knows that sale of some goods needs a license (for example, alcohol), and turns a blind eye, it would beg the question if the owner can effectively defend against a charge of aiding and abetting a violation of the licensing of sales.

The puzzle

Where does an aggregator fall, on the spectrum? This will determine what aspect of the customer interface the aggregator is held responsible for. For example, companies may make business decisions on where on the safety spectrum they lie, and charge a premium for it. Over time there may emerge expensive aggregator companies and cheap aggregator companies and customers take a call on how much they are willing to pay for what quality of service. Regulators could step in and prescribe minimum standards - in much the same way, product warranties across jurisdictions are spelt out. Rules about information disclosure could help consumers make better decisions.

At the point of entry into the cab, the consumer is held hostage to that cab, and must trust that certain minimum safety and service standards are met. In fact, such requirements were the reasons for entry regulations in the traditional cab industry. The onus for these then lie in the State capacity that gives commercial licenses, and does police verification checks. This requires the State machinery to work, and is independently an issue apart from that of requiring anything of a technology platform that merely brings together buyers and sellers.

Conclusion: Another kind of activism

The problem then, is two-fold. First, there is the tragedy of poor State capacity in preventing and prosecuting crime, which incentivises simply banning certain activities. This is a generic problem that bedevils the working of the Indian economy in numerous contexts. The solution to this issue can only be a long and hard one: of improving the functioning of our public institutions.

The other problem to address is the poor methods for shaping, regulating or nudging commercial conduct. While India is a common law country and action for tort indeed can shape commercial conduct, the problems in delivering timely justice under common law has led to regulators occupying the commercial space in many sectors. However, regulatory interventions with clarity of thought on what can and cannot be done by commercial parties, leaves much to be desired even in sectors that have been regulated for decades. When Uber began its coverage of India, no transport regulator raised as much of a whisper about the status of its regulatory compliance and whether at all intervention was warranted. Now, at the first sight of a crime, the same regulators are quick to consider imposing a complete ban.

Common law remedies coupled with penalties and damages offer recourse to the affected parties, and hit offenders where it hurts: on their balance sheets. Predictable regulations would not only make service providers answerable to society but also would make regulators answerable to the service providers. Is it a substitute for criminal prosecution of heinous crimes? Certainly not. But it is a useful complement. Regulatory activism is not just about ensuring effective prosecution, it also means bringing companies to book if they are lying about what they are providing.

There is an expectation that `software will eat the world', that lightweight businesses like Uber will come to dominate the whole world. Perhaps conditions of State capacity in India will prove to be a bottleneck, both in respect of problems such as obtaining law and order, and in terms of navigating the subtle questions of public economics and coming out with the right answers.

Sunday, December 07, 2014

Have Indian banks been underpricing corporate loans?

In the 1990s, we had large scale defaults on corporate loans, which felled IDBI and IFCI. For some time, we thought that we had learned our lessons, that micro-prudential regulation had improved, so that such failures would not recur. Has this happened? There is cause for concern.

  1. After these bailouts of slightly over a decade ago, we haven't had a big banking crisis with a collapse of banks such as IDBI or IFCI. But there is a worrisome scale of regular injections of capital into public sector banks by the Ministry of Finance. If government puts Rs.100,000 crore into an episode of bailing out banks, we say there is a banking crisis. This is not too different from putting Rs.10,000 crore every year for 10 years. Have we had a chronic sub-clinical banking crisis for a long time? Some will argue that all healthy banks raise equity capital as they grow. But there is an unmistakable element of bailout in the equity capital that has gone into PSU banks. On this subject, see Harsh Vardhan and me from October 2012, and this blog post from October 2011.
  2. India did not have a big financial crisis in 2008. All we have had was a business cycle downturn that's come after a big credit boom. Yet, we've now got a serious mess in banking on our hands.

These two difficulties suggest that micro-prudential regulation has not improved adequately.

When we open the black box of Indian banking, two problems are visible. Most banks have little skill in credit risk assessment. What passes for `risk management' in Indian banks, too often, is the mechanical adherence with RBI regulations -- regulations that micro-manage and are often wrong. There is low ability in the essence of credit analysis: to understand a firm, and make forward-looking forecasts about default. In addition, all banks suffer from high levels of loss given default owing to the lack of a bankruptcy code.

The objective of micro-prudential regulation of banks is to put down requirements through which the failure probability of banks stays at acceptable and low levels (though not zero). The heart of this is  ensuring that the accounting value of each loan is aligned with market value. This was not done. Banks have systematically failed to recognise and provide for bad loans. I feel a distressing deja vu when I hear stories today about what has gone wrong in Indian banking; we heard those exact same stories in 1999. We did not learn; the problems weren't fixed.

Given these weaknesses of micro-prudential regulation, banks have had a merry time, showing accounting profits while giving out loans at artificially low prices, and building up an ever larger inventory of loans where the book value is in excess of the market value. Better micro-prudential regulation would have created a set of rules through which bad loans were valued at market price. Better micro-prudential regulation would have hindered, and not helped, banks in covering up bad news.

Better micro-prudential regulation would have created incentives for banks to charge higher prices for corporate lending, with interest rates that better reflected their own weaknesses in corporate credit risk assessment, and the high values of loss given default. Mistakes in micro-prudential regulation gave us a systematic under-pricing of risk.

The great credit boom of 2004-2007 has traditionally been interpreted as mistakes of macro policy: This came from the pegged exchange rate. RBI bought dollars in order to prevent INR appreciation, with incomplete sterilisation, which gave low interest rates at a time of a boom in business cycle conditions. This gave us the biggest ever credit boom in India's history. I would add one more ingredient in our understanding of that credit boom: Mistakes in micro-prudential regulation of banks. Mistakes of macro and micro came together to give that party.

Looking forward, improving the thinking in micro-prudential regulation of banks is an important priority. It will take years for India to reverse public sector domination of banking, and the consequential weaknesses of credit risk evaluation. It will take years for India to reduce the loss given default, by enacting an Indian Bankruptcy Code. In the short term, these problems must be treated as given. For the coming two years, the agenda must be to break away from the failures of the last 20 years in banking regulation, while treating the presence of PSU banks and the lack of a bankruptcy code as a given. At present, the landscape of banking regulation is riddled with mistakes  [example, example]. The fair price of a bank loan to a corporation is probably much higher than what we've thought it should be.

Friday, December 05, 2014

Justice Srikrishna's speech at the ICSI/BSE show on FSLRC

Mr. Arun Jaitley, Honourable Union Minister of Finance, members of the Institute of Company Secretaries, ladies and gentlemen.

My thanks are due to the organisers of this seminar for giving me an opportunity to address this gathering of professionals and practitioners, who have come here today to meet and share knowledge regarding the Indian Financial Code recommended by the Financial Sector Legislative Reforms Commission (FSLRC) in its report submitted last March [report, law]. I am happy to be here today to speak to you about an important component of economic development that has engaged even the attention of the President of India, as reported on the front page of the Indian Express yesterday.

As all of you are aware by now that there are nine key components of the legal framework recommended by the Commission. These are:

  1. Consumer protection and competition,
  2. Micro Prudential Regulation,
  3. Resolution,
  4. Systemic Risk,
  5. Capital Controls,
  6. Development,
  7. Monetary Policy,
  8. Public Debt Management,
  9. Foundations of Contracts and Property.
I will not dwell on the nitty gritty details of the report of the Commission, or the draft Indian Financial Code recommended by it, since that will be sufficiently done in the technical sessions to follow. I shall try and put before you the flavour of the recommendations and what they seek to address.

The principle of consumer protection is an important determinant of the way governments and regulators think about their job. It is part of the invisible legal architecture that frames our choices, and shapes our lives. And yet, very few regulators have a precise understanding of what constitutes consumer protection. Some believe consumer protection is best served by holding financial literacy camps. Others believe consumer protection is best served by an ombudsman or by setting up an investor protection fund. While one cannot gainsay that these are important activities, consumer protection is much larger and requires an attitudinal change towards regulation.

Since there are no precise definitions of consumer protection in existing law, regulators claim the flexibility to do many things, some necessary and many not, under the garb of consumer protection and claim that the regulated should have a `healthy respect' towards them. Also, because consumer protection is not precisely defined, many regulations framed by regulators do not do enough to protect consumers. Moreover, in a developing country like ours, regulators often feel the need to develop the market, and in their enthusiasm inadvertently establish low thresholds of consumer protection. The need of the hour is for clearly identifying what constitutes consumer protection in the field of finance, and what tools regulators should develop to protect consumers.

As you know, I was fortunate enough to be associated with the Financial Sector Legislative Reforms Commission, as its Chairman, and its report is already in the public domain. The FSLRC and its members spent two years of intense research, consultations, deliberations and drafting, supported by a technical team of 30. In all, 146 people were involved in the Commission's work, including lawyers, economists and other domain experts from India and abroad, bringing with them decades of accumulated experience in finance, regulation and public administration. The aim of the Commission was to examine the foundations of the Indian financial system, raise fundamental questions unasked hitherto, attempt answers to them and recalibrate the financial system to align with the aspirations of a liberal democracy, namely that it should be open, transparent, and governed by the rule of law. The Commission's work involved asking difficult questions about the purpose of regulation, the role of the state, and the checks and balances required to make the system fair and accessible while being efficient and effective.

Though, the report of the Commission was released last year, along with the draft Indian Financial Code, the work started by it is far from over. Forums such as this are important opportunities to continue those debates in the public domain. Those are debates about democracy, fairness and justice just as much as they are about incentives, systems and signals. That is why it is so important for all of us to dispassionately participate in the debate so as to arrive at a consensus unhindered by the drag of status quo-ism.

There were a number of critical topics that were discussed during the writing of the FSLRC report, and consumer protection was an important one. All financial laws in the country are intended for the consumers, and regulators are the arms of the State to ensure that benefits reach the ultimate beneficiaries. The FSLRC report recommends a decisive move away from the old concept of 'caveat emptor,' or 'buyer beware,' towards a 'seller beware' regime. In such a regime, financial service providers must assume greater responsibility and care when recommending or selling products and services to consumers. This move is motivated by the realities of modern financial services, on the one hand, and the realities of an emerging market like India on the other. The deleterious consequences of the buyer beware approach is seen by us in real life today. When consumers are duped on a mass-scale by private entities within a buyer-beware attitude to regulation, there are few efficient mechanisms for recompense to the consumers. Consequently, there is an overreaction from government agencies who go into an overdrive to overkill by banning entire sectors of economic activity. We thus get caught in an adverse cycle of under-protection and over-reaction. We must surely ensure that the baby is not thrown away with the bath water!

As a general experience, financial service providers are in a position of massive bargaining power relative to all but their largest clients. Consumers are generally less informed about finance than financial firms, and typically not able to band together to defend their interests. India is an emerging economy: it cannot be taken for granted that all consumers are well-informed, or free to reject a contract they feel is unfair. The FLSRC therefore recommends a system-wide commitment to consumer protection, in which all regulators build relevant protections into their respective regulations. One critical priority is to mandate that financial service providers make clear, adequate and relevant disclosures to the consumer, and ensure that - based on the consumer's expressed needs - the product or service being offered is suitable for that consumer. Allow me to remind you all of the critical role you have to play, as you work to bolster development, in making that development more rule-bound and fair, and thus less fragile than if it were to come at the expense of the Indian consumer.

Let me turn for a moment to the broader debates I alluded to earlier about the fundamentals of a democratic system. Financial regulation, inasmuch as it is regulation - that is the application of the coercive power of the State to private parties - is not easy. As we pointed out in our report, and as any regulator would agree, regulation is technical work, requiring care, attention and expertise. It is precisely because of that complexity that we have created regulators in the first place: specialised bodies, who will accumulate knowledge and human capital, and will build institutional knowledge and physical infrastructure and information networks that allow them to rise to the challenges at hand. In order to be effective, regulators must have the legal mandate to formulate regulations, to allocate resources as they see fit, and to act decisively. All this contributes to an environment in which private parties can operate freely, and with clarity and confidence. I mentioned how we worked to strike a balance, and design a system that is fair and accessible while being efficient and effective. Striking this balance is complicated because many of the things we do to make regulators more effective, also diminish their accountability to Parliament, and to the people. After all, we cannot forget that regulators - like the State that they represent - are for the people and not vice versa.

The problem is that we have created regulators that function as 'mini-States.' In our larger Constitutional framework, we have separated the critical functions of the government - legislative, executive and judiciary - and placed them with separate bodies. This system of checks and balances is meant to prevent the government from acting outside the law. When we create a regulatory body, we often find it necessary to give that body the ability to write regulations, conduct investigations into the violation of those regulations, and adjudicate on the violation afterwards, which implies a lack of separation of powers. One partial solution to this is to at least separate out those functions within the regulator, and assign separate staff to carry out each function.

Let us take the case of adjudication: When the investigation staff of a regulator takes action against a regulated entity, they must provide it with an opportunity for a hearing before the regulator. When it appears before the regulator to represent its case, it should not before the investigation staff, but someone who will act as a neutral third party. This requires building a separate adjudicatory capability within the regulator, with dedicated staff - headed by an Administrative law member and staffed by lawyers. The person hearing the case should show no bias towards the investigation staff. He needs to be able to give a fair hearing, and, if necessary, decide against the investigatory staff. It is work to build this internal separation of powers, but it is absolutely critical to the rule of law. The game must not be rigged.

It has been argued that these internal safeguards are the only ones that are required to ensure that regulators remain within the bounds of the law, and that any interference beyond this will compromise their work. It is argued that the work of regulators is nuanced, esoteric and complicated, and that regulators need to preserve flexibility and freedom of action to respond decisively to events in the world. Under this view, there is a fear that judges will second-guess the actions of regulators, which is a short step from encroaching on the domain of policymaking. We disagree. We believe that in a democracy wedded to the rule of law, no one, not even a regulator, is above the law. Our response to the difficulty of building checks and balances in a specialised area of regulation, is to build a specialised mechanism - not to give up on checks and balances!

The proposed Financial Services Appellate Tribunal, would fulfill this role. It will be staffed by personnel with relevant domain knowledge, training and experience, and it is designed to adjudicate openly, efficiently and in an informed manner: the disputes between regulators and regulated entities. Yes, one can argue that a new tribunal will not have the institutional knowledge required to appreciate the subtlety of a regulator's action, and rule fairly. But the first thing to keep in mind is that the regulator must be able to explain its actions. If it can explain its actions to judges of the High Court or Supreme Court, neither of whom can claim expert knowledge, it can surely explain its actions to a Tribunal that can lay claims to such expertise. The second thing to keep in mind is that institutions evolve, and they evolve together through their interaction. Sometimes, that interaction may not be smooth, but may involve some tension. But that is the point of democracy, which is a system of checks and balances. A healthy tension between institutions is what makes a liberal democracy grow. In the years since the Securities Appellate Tribunal was set up, to hear appeals from SEBI orders, the quality of SEBI orders has increased. And so has the quality of SAT decisions. Regulators should take comfort in this fact.

Thankfully, the independent academic Dr. Rajan also disagrees with the RBI Governor Dr. Rajan on this aspect. In his 2009 report, A Hundred Small Steps, Dr. Rajan wrote, "Regulatory actions should be subject to appeal to the financial sector appellate tribunal." This is the thinking that guided the FSLRC's deliberations, and it is the position we still take today.

Allow me to share a few thoughts from the experience of the FSLRC: Those of you who have looked at the Commission's report will know that it has recommended re-organising India's financial regulatory architecture. Again, it is a topic that may easily get passed over by many people as esoteric, but all those who are connected with the financial field you would acknowledge that it will profoundly affect the Indian financial ecosystem. What is the logic behind this reconfiguration? The proposed regulatory architecture allows regulators to look beneath the surface of a product or service and unmask its essentials, be it termed a loan, an insurance scheme, or an investment, and regulate it according to the risk it poses to the system, and the probable risk that a firm may not fulfill its promise to a consumer. I fear that criticism of the proposed framework glosses over this critical argument, which is actually about more than just operational synergy. It is the result of soul-searching rethinking of the way we draw the lines around various kinds of financial activity and compartmentalise them, leading to avoidable turf wars. It is driven by a more agnostic view of risk management, both at the systemic level and at the level of individual firms. It is intended to underline the consumer as the focal point of the debate.

Finally, is this a leap into unknown territory? Hardly. This is the approach that many countries have implemented already. And yet, it is a bold move. But it is one that the Indian financial sector and the Indian consumers deserve. Our financial architecture has become unwieldy and unresponsive. Provisions that were intended be temporary (the RBI Act of 1934 is an example) have become permanent. Sometimes this is a result of inertia, rather than careful planning. Arrangements that were the best we could do at the time, are now considered to be the only way to do things. One fears that as a result, parts of our regulatory machinery have become brittle, fragile, or worse, completely irrelevant and utterly useless, if not downright harmful to our interests. It is this concern which motivated the proposed reforms. This is not change simply for the sake of change. And indeed what we proposed is far from cosmetic. This is fundamental re-engineering of a sector that desperately needs it. To push ahead with our current arrangements and simply hope for the best, would indeed be reckless, despite our known reliance on jugaad.. We must reform in anticipation of future crises, not only in response to past ones. Our preparedness for the future requires that our institutions and our systems be world class, when we expect our GDP to be in the region of about 20/30 trillion USD in about 15/20 years, and we entertain the ambition to be one of the leading leading players in the world's financial arena. Only legislation can drive institutional change to yield the high performance institutions that we need. Change is necessarily disruptive; hence people abhor it. Reform unsettles the powerful; hence it ruffles feathers. But it is necessary and it must be done now.

Thank you.

Saturday, November 29, 2014

Consequences of reversing the controls on gold imports

Impact on the Current Account Deficit?

Restrictions were put on gold imports as part of the currency defence of 2013. One important step towards removing these restrictions was taken yesterday. Some people are thinking "How much will the current account deficit go up by, now that more gold will be imported?"

For this to happen, you have to believe that the restrictions actually made a difference to gold imports. I feel that there was absolutely no decline in the gold purchases by Indian households when the restrictions came in. All that happened was that instead of going to a formal sector firm, the purchases were made from smugglers, which required a whole chain of `black money' transactions.

If you feel that the bulk of gold smuggling is paid for using hawala transactions i.e. misinvoicing, it seems that shifting between smuggling and legal imports makes no difference to the current account deficit. Ergo, removing the restriction will make no difference to the current account deficit.

Scarcity value

I suspect that when we made it difficult to buy gold, there was a greater perception of scarcity, and people became even more keen to stock up on gold. It takes years of sustained good behaviour by the government, for people to get comfortable. One slip, and you unleash the psychology of scarcity all over again.

With gold, I think that after the liberalisation of the early 1990s, it took 5-10 years for people to get used to the idea that the government was not going to interfere with their gold purchases. These gains were lost in the 2013 rupee defence.

A similar story holds with outbound capital flows. Capital account restrictions came in 1942 and turned into a rigorous system of control in the 1950s. From that point onwards, Indian households have believed that there is value in holding assets outside the country. One big advance took place in the mid 1990s, when it became easy to travel abroad and use an Indian credit card. This solved the problem of needing hard currency to travel. But portfolio diversification remained a problem.

When the liberalisation of outbound flows began, this sense of scarcity started easing. Then came the capital controls on outbound flows as part of the currency defence of 2013. These controls have still not been reversed. This sent out the message that you cannot trust the Indian government, so it's wise to hold assets outside India as much as possible. The attraction of gold went up: buying gold in India is actually a capital outflow. The value of gold is safe from Indian monetary policy or capital controls.

After the actions of the currency defence of 2013 are undone, it will take years before people get back to the pre-2013 modes of behaviour. MOF might probably manage to get rid of the restrictions by 2014 or 2015, and perhaps by 2020 people will start shedding the scarcity value.

Wednesday, November 19, 2014

Reducing the cost of doing business in India: One example (ADR/GDR regulations)

by Pratik Datta and Ajay Shah.

Last week, the Ministry of Finance notified the Depository Receipts Scheme, 2014 (`2014 Scheme'). This replaces the 1993 Scheme with respect to depository receipts. The key materials on this subject are:
The 2014 Scheme improves upon the 1993 Scheme in two dimensions: economic thinking and legal drafting quality.

Improved economic thinking

The 1993 Scheme was a haphazard set of interventions by the government in the working of the economy, without a clear rationale. The 2014 Scheme is logical and clear in the role of the government. Every policy intervention is viewed from the standpoint of market failures. If there are demonstrable concerns about consumer protection, micro-prudential regulation, systemic risk or resolution, they motivate interventions. Where there are no market failures, there is no case for intervention by the government.

As an example of the improved economic thinking underlying the 2014 Scheme: the 1993 Scheme embeds industrial policy with names of many industries. The 2014 Scheme eschews industrial policy.

Improved drafting of law

Everyone interested in law and finance should print the 1993 Scheme and the 2014 Scheme and compare them, side-by-side.

Occam's razor can be adapted to the field of law with the idea that when there are multiple ways of drafting a particular policy choice into the law, the simplest should be preferred. The most sophisticated law is that which is the simplest. Simplicity, clarity and reduced legal risk have been achieved in the 2014 Scheme through many strands of thought.

Word count. The first test of simplicity is the word count. The 1993 Scheme (paragraphs 1 to 11) had 2984 words, while the new 2014 Scheme (paragraphs 1 to 11) has 1659 words - a reduction of 44.4% in usage of words. However, this difference is overstated as the previous Scheme dealt with FCCBs also while the new Scheme does not.

Readability. When we apply the Flesch-Kincaid readability test, the 2014 Scheme wins clearly, with a score of 30 when compared with the 1993 Scheme, which stands at 21.5.

Structured document. For a given word limit, a well structured document is more comprehensible. The 2014 Scheme follows the logical sequence of a depository receipt transaction. The 1993 Scheme was a haphazard mess.

Use of examples. When drafting the Indian Penal Code, Thomas Babington Macaulay intentionally included many terse, exemplary cases to illustrate the application of a provision. The Justinian Code and writings of Roman jurists persuaded him to make clear the legislative intent: `they are cases decided not by the judges but by the legislature, by those who make the law, and who must know more certainly than any judge can know what the law is which they mean to make'. This unusual innovative feature of the Code earned the praise of John Stuart Mill, who wrote: `besides the greater certainty and distinctness given to the legislator's meaning, [it] solves the difficult problem of making the body of the laws a popular book, at once intelligible and interesting to the general reader'. The 2014 Scheme includes examples which clarify the law.

Minimal set of defined terms. The 2014 Scheme uses a standardised set of defined terms. For example, it strictly uses a defined term - `international exchange' - on listing institutions. In contrast, the 1993 Scheme used three different terms to explain listing institutions on which depository receipts could be listed - `overseas stock exchanges', `over the counter exchanges' and `book entry transfer systems'. None of them were defined. This created legal risk.

Principles-based definitions. With the rapid development of technology, the concept of an `exchange' itself has evolved substantially. To make the law neutral to such evolution, the 2014 Scheme is technology-neutral and principles-based in its definition of `international exchange'.

Rationale statement. Finally, there is the backdrop of the drafting intent and rationale of the Scheme. The 1993 Scheme was not backed by a document articulating what was sought to be done. The 2014 Scheme is accompanied by the Sahoo Committee Report which performs this function. When faced with litigation in the future, practitioners and judges will be able to use this document to reduce legal risk.

You will recognise the IFC way here. Also see Umakanth Varottil on the 2014 Scheme.

Clearing the thicket of India's capital controls

The Indian system of capital controls comprises the FEM Act, regulations under FEMA, RBI circulars, etc. The 1993 Scheme is representative of the mess that is the Indian system of capital controls. The cost of doing business in India is being greatly raised by the badly thought out and badly implemented capital controls that are all over the landscape.

Capital controls on ADR/GDR issuance by Indian companies is the only element, out of the overall system of capital controls, where the Ministry of Finance is able to initiate reforms. In all other areas, RBI has veto power, and has blocked all progress.

As the years go by, it is increasingly difficult to justify these failures. RBI needs to find the intellectual capabilities to clean up the mess. There is a lot to learn from the clarity of thinking, and the implementation strategies used, in fixing the capital controls on ADR/GDRs.

Sunday, November 16, 2014

The imprecision of volatility indexes

by Rohini Grover and Ajay Shah.

A remarkable feature of options trading is that it reveals a forward-looking measure of the market's view of future volatility. This was first done by CBOE in 1993 with the S&P 500 index options, with an information product named `VIX' which reveals the market's view of future volatility of the US stock market index. CBOE computes and disseminates VIX every 15 seconds. VIX is often termed a `fear index' as it conveys the fears of the market. It has found numerous applications:

  1. Time-series econometrics processes historical data to help us make statements about the future. VIX brings a unique forward-looking perspective into time-series analysis.
  2. VIX measures uncertainty in the economy e.g. when examining the effect of macroeconomic shocks (Bloom, 2009).
  3. The international finance literature has emphasised the role of VIX in shaping capital flows to emerging markets [example]. E.g. it is interesting to look at what happened in India on the days in which a very large rise or fall of the VIX took place.
  4. Trading strategies can be constructed which employ VIX as a tool for making decisions for switching between positions.
  5. VIX based derivatives offer methods to directly trade on VIX. In the US, CBOE introduced VIX futures and options on March 26, 2004 and February 24, 2006 respectively. In 2012, the open interest for these contracts was at 326,066 contracts and 6.3 million respectively. In India, futures on VIX have been launched at NSE, but the contract has not taken off.

All of us treat VIX as a hard number -- we talk about a value of VIX such as 24.53 as if it is known precisely. But VIX is computed from a set of option prices. These option prices suffer from microstructure noise and from the limits of arbitrage. Each option price is only an imprecise reflection of the thinking of the market. This raises concerns about the extent to which imprecision in option prices spills over into imprecision of VIX.

In a recent paper, The imprecision of volatility indexes we offer a method for measuring the imprecision of VIX, and find that the measurement noise is economically significant.

VIX is a statistical estimator working on a dataset of option prices. Different estimators exist (e.g. the old VIX vs. the new VIX). Regardless of what estimator is used, the foundation — the option price — suffers from microstructure noise and is shaped by limits of arbitrage. Noise in option prices will induce noise in VIX. The only question is that of understanding how imprecise is the VIX.

For an analogy, consider estimation of LIBOR. Each dealer reports a reading of LIBOR. We recognise that each value obtained is a noisy estimator of the true LIBOR. This is aggregated using a simple robust statistics procedure to obtain an estimate of LIBOR. Bootstrap inference is used to obtain a confidence interval about how imprecise our esitmator of LIBOR is. [Cita and Lien, 1992, Berkowitz, 1999, Shah, 2000].

A similar strategy is relevant for VIX. Each option should be seen as a noisy estimator of the implied volatility. Bootstrap inference can then be used to create a distribution of the vega-weighted VIX (VVIX). This yields a confidence interval for VVIX.

As an example, for a sample of end-of-day S&P 500 options, on 17th September, 2010, the at-the-money (ATM) options with 29 days to expiry show significant variation and take values between 15% and 21%. Our methods yield a distribution of the estimated VVIX:

As the graph above shows, the point estimate for the VVIX is 21.53% and this is what all of us are used to talking about. But the noise in option prices has induced an economically significant imprecision in our estimated VVIX. The 95% confidence band, which runs from 20.8% to 22.32%, is 1.5 percentage points wide. This is an economically significant number, since the one-day change in VVIX is smaller than 1.5 percentage points on 62% of the days. This suggests that on 62% of the days, we know little about whether VVIX went up or down when compared with the previous day.

To conclude, we got a huge step forward when options trading improved our knowledge of the universe by giving us a forward looking estimator of future uncertainty. However, market microstructure noise and the limits of arbitrage hamper our ability to know about the future: VIX is not a hard number. There is significant uncertainty in what we know about VIX. This insight may make a difference to many applications of VIX.

Monday, October 27, 2014

Rethinking the policy framework in coal

by Suyash Rai and Ajay Shah.

India needs more coal

Coal is the dirtiest of all modern fuels, whether measured by habitat destruction in mining areas, or CO2, SPM and SOx emissions, or radioactivity. However, there is no alternative to coal in India's energy strategy, as coal makes up half of India's energy consumption today, and as India is blessed with strong natural resources.

Despite the strategic importance of coal in India's energy strategy, domestic production growth has been slow, with an average compound growth of 3.65% per year between 1990-91 and 2013-14 (from 247.56 million tonnes to 565 million tonnes). Over that same period, coal imports went up from 5.56 million tonnes in 1990-91 to 171 million tonnes in 2013-14, a compound growth rate of 16.06%. Coal imports have become nearly 1% of GDP. India has become the world's third largest coal importer -- despite having the world's fifth largest reserves (with about 67 billion tonnes of proven reserves). It is reasonable for a country with abundance of a fuel to import that fuel for strategic reasons, but India is forced to import due to inefficiencies of the domestic coal sector.

These inefficiencies do not have to be. Reforms can rapidly increase productivity. As an example, Australia got a gain in the raw coal output per man-shift for open-cast mines from 20 tonnes in 1966 to 54 tonnes in 1974 -- almost a tripling in 8 years. In underground mines also, technological change can give massive improvements in productivity. The puzzle is that of improving the efficiency and environmental soundness of extraction, and improving the infrastructure of transportation. This requires a fundamental rethink of the policy framework that has been adopted.

As with most problems in India, the poor outcomes are coming from deeper problems of institutions. While we periodically try quick fixes, there is no running away from solving those deeper problems.

On this much, it is fair to say that there is a broad consensus. Everybody agrees on this much. What is not widely understood is the way forward.

The elephant in the coal mine: Coal India

Coal India is the public sector monopoly that produces, processes and sells coal. It produces 80% of the country's coal. It does so with much lower productivity (measured in terms of output/man-shift or OMS) than that in many developed countries. For example, in 2012-13, Coal India's OMS for open-cast mines was 11.48 tonnes, while the same for Australia was 75.04 tonnes back in 2005. The situation with OMS for underground mines is much worse: Coal India was at 0.77 tonnes in 2012-13, while Australia was 50 times bigger. Coal India has improved its productivity, but the rate of change is not adequate for solving India's problem. Drastic improvements in technology and management are required, but Coal India has been persistently unable to muster the requisite change capacity.

There could be many reasons for this. Some of them are generic to the public sector, some of them are generic to monopolies, and some may be specific to Coal India. Public sector enterprises face constraints of procurement, and human resource management, which private sector enterprises do not face. A monopoly does not face the competitive pressure that punishes inefficiency. This is particularly the case for public sector monopolies where the consequences are borne by tax payers. Not all public sector companies suffer from a productivity gap on the scale of Coal India -- as an example, NTPC fares pretty well on efficiency despite being a public sector company.

The relationship with labour in Coal India appears to be lopsided, even by the standards of public sector firms. Junior staff at Coal India are paid rather well when compared with other employment with the similar skill and hardship. This may be attributed to powerful trade unions. The strength of trade unions may explain the low productivity at Coal India.

We could discuss the problems of Coal India and how to solve these. However, it is important to not hold India hostage while waiting for those problems to be solved. As an example, India was held hostage by DOT/BSNL/MTNL in telecom, but the 1999 telecom reforms broke past that barrier. While DOT/BSNL/MTNL are an important part of Indian telecom, India's progress is no longer hostage to them. Similarly, there are fervent discussions about the problems of Air India, however policy thinking about civil aviation in India is focused on the interests of India and is not held hostage by the interests of Air India. In the field of coal, the objectives are clear: We need to increase output of coal by bringing in modern management so as to achieve high productivity and high standards of environment protection.

The previous legal framework

The Coal Mines (Nationalisation) Act, 1973 curtails private participation in coal mining. It limits allocation of coal mines to firms that will use the coal only for producing power, iron, steel, coal washing or any such government-specified use. Trading by private firms is forbidden: They were not allowed to sell the coal that they extract to other firms even for specified purposes. Since 1993, governments have allocated 218 coal blocks to public and private enterprises for specified purposes, under the provisions of this Act. More than two-third of these were allocated between 2005 and 2010, under the UPA government.

Allocations were done through a screening committee process, without competitive bidding. In 2010, an amendment to the Mines and Minerals (Development and Regulation) Act (MMDR Act), 1957 provided for auctions of coal blocks. But the Comptroller and Auditor General, in a 2012 report, asserted that the government had the power to conduct auctions even before this amendment. The report also asserted that the failure to conduct auctions led to a large revenue loss for the government and corresponding windfall gains for the allocatees. The government contested these claims. The matter went to the Supreme Court through writ petitions. In September 2014, the Supreme Court cancelled 214 of the 218 coal block allocations made since 1993, and imposed fines on the operational mines among them. The grounds for cancellation are primarily the failure to follow principles of due process.

For the 42 operational mines, the Supreme Court order takes effect in six months. These blocks were expected to produce 10% of India's coal production this year. Some of these users will resort to imports. Some of them will not be able to solve the logistics problems associated with imports, and hence the downstream economic activity (e.g. an electricity generation plant) will close down.

The recent reforms by the NDA government

On October 21, the government issued an Ordinance, which amends the Coal Mines (Nationalisation) Act, 1973 and the MMDR Act, 1957 to, give effect to certain coal sector reforms. It will run auctions to allocate coal mines. For some of the mines (74 mines), only actual users of coal in the cement, steel and power sectors will be allowed to bid, while for others (204 mines), the auction pool may include those who will produce and sell coal. While auctions had to be held after the CAG's and Supreme Court's interventions, opening of the sector to private firms for production and sale is a new step. This opens the window for giving mine leases to firms that are not in the business of producing power, steel, etc, but specialise in extracting and selling coal. It is important to note that the Ordinance also allows the government to continue with direct allocation of coal mines to public sector enterprises.

This Ordinance is a step forward in institutional reform. But it is an incomplete step. Looking forward, there are five areas of concern:

  • The elephant in the coal mine needs reform. Allocating coal mines to private sector for extraction and sale will reduce dependence on Coal India, but this does not solve the problem of low productivity at Coal India.
  • The role of the State in the field of coal. The Ordinance is focused on addressing the gap that has been created by the Supreme Court order. However, what is required is a more encompassing treatment of the tasks of the State in contracting, regulating, and supervising private players. Such a law needs to be written and this will correspondingly require creating State capacity for enforcing it. For an analogy, setting up financial economic policy is not a mere matter of auctioning some licenses to run a bank here or an insurance company there; it requires the full blown sophistication of the Indian Financial Code.
  • Why have captive mines at all? There is no case for limiting trading in coal, between private players, by forcing captive mining. India will gain when some specialise in mining, and sell to others who specialise in downstream applications of coal.
  • Why a dual system? Why is it necessary to directly allocate mines to government enterprises, and create a dual system in which some mines for auctioned and others are just allocated?
  • Who knows how to run a coal mine in India? Private sector participation in extraction and sale is a step forward, but after decades of public sector domination, do any domestic firms posses expertise on achieving high productivity and avoiding environmental degradation in the process?

We cannot ignore reforms of Coal India in reforming coal

Following the Ordinance, the government will give more mines to private sector for extraction and sale. But Coal India has preferential treatment with easy allocation of mines. This is not fair. Coal India must participate in open auctions on an equal footing with other bidders.

Even after this is done, private firms will find it difficult to compete with a huge government-backed firm with deep pockets. As an example, private airlines complain that the presence of a government-owned airline, which is able to bear huge losses, has had a negative impact on them.

It would make sense to break Coal India into several independent entities that actively compete with each other and with private firms, for the business of coal extraction and sale. This could set the stage for gradual privatisation of the baby Coal Indias.

As with the opening of civil aviation or telecom, the reforms will be opposed by trade union members of Coal India. Coal India should exist to maximise the interests of the people of India (about 1.3 billion) and not the interests of the 350,000 employees.

Building State capacity for the role of the State in coal

Government must build capacity to do efficient regulation, contracting and contract monitoring of private participation in the coal sector. Given the complex contracting problems and environmental consequences, government-private sector interface in coal sector must be backed by a sophisticated government that is capable of understanding difficult trade-offs and make the right choices. Government should draft a comprehensive coal sector law that encompasses various aspects of the government's role in the sector.

In addition to the problem of running auctions and writing contracts, the law needs to envision market failures, give the executive the minimum required powers to address them, and setup accountability mechanisms. Ultimately, the law should setup feedback loops through which the executive and the industry move forward towards world class capabilities.

In parallel, government should build human resources and other organisational capabilities to enforce the law in this sector.

A competitive market for production and sale of coal is required

Since mines will be auctioned, the immediate question is: who will be eligible to bid? For auctions of the coal blocks affected by the Supreme Court verdict, the government is allowing only the current users of coal for specified purposes. Perhaps, that is required as an expedient measure for the 20% of cancelled blocks that were already being used. But for the remaining and subsequent allocations, it is important to hold open auctions. The expertise of coal extraction and sale is different from the expertise of producing power, cement, steel, etc. The government should decouple the two, and unbundle the two markets of extraction and trading/sale.

It is particularly important to not directly allocate mines to government enterprises. If such enterprises fail to win the auctions, they can go ahead and purchase coal from successful bidders. NTPC is good at producing power, but it need not own coal mines for that. It could very well purchase it from firms specialising in production and sale of coal. This is not to say that there should be zero direct allocations. In some contexts, especially where a downstream plant has been set up with an assumption of access to nearby mine, it might be uneconomical to auction the mines. But the principle should be that direct allocations should be done in the rarest of cases, and the government should do a formal cost-benefit analysis before direct allocation decisions.

We need foreign players

As is evident from their superior productivity, firms in some other countries have substantially better expertise in coal extraction. If we continue to limit participation of foreign firms, we will also constrain investment and innovation. The government should open the auction to foreign firms, and enable introduction of productivity-enhancing technologies and management systems. If, for strategic reasons, the government wants to restrict the purposes of coal use, and/or place constraints on coal exports, it can do so. The key point to focus upon is to bring in the best expertise in the problem of extracting, value enhancing, transporting and selling coal.


The recent Ordinance is a step forward, but it is a tiny attack on the larger problem of coal sector reforms. We must reform Coal India; We must build State capacity on contracting, regulation and supervision of private players; We must setup separate and competitive markets for extraction and trading of coal; We must bring foreign players who have the requisite skills.

Saturday, October 25, 2014

The logjam in infrastructure investment

Quarter-on-quarter growth
of the non-seasonally adjusted value of
infrastructure projects that are classified as being `Under Implementation'
in the CMIE Capex database.

In the standard narrative, the first wave of infrastructure investment in India (2003-2010) choked owing to the ground-level difficulties of investment, including land acquisition, corruption scandals, contract disputes, etc. By this logic, if we solve these problems, we will have set the stage for the second wave of infrastructure investment. This is the sort of idea that motivated the `Cabinet Committee on Investment' in the late days of the UPA.

There is, however, another logjam which needs to be solved, that of infrastructure financing. In today's Indian Express, I worry about the short-term measures which were taken during the first wave. Each of them felt expedient at the time, but with the benefit of hindsight, they were mistakes. Instead of looking for more short-term expedient solutions, we need to solve the deeper problems of the financial system in order to break this logjam.

The second wave of infrastructure financing, that we now require, needs work on both tracks: fixing the foundations of the financial system so that well-incentivised developers try to invest, and fixing the ground level difficulties so that this investment actually turns into smoothly working operating assets.

Acknowledgements : My thinking on these questions has been greatly aided by Josh Felman (IMF), Gopal Sarma (Bain Consulting) and Suyash Rai (NIPFP). The phrase `the long run has caught up with us' is by K. P. Krishnan.

Monday, October 20, 2014

Ebola and India

The biggest-ever Ebola epidemic is taking place is West Africa. Through travellers, this could spread elsewhere. Carriers are asymptomatic for 2-21 days, and hence border screening does not block transmission.

Ebola is very virulent. That is, the Pr(death|infection) is high. However, it is not a complicated pathogen for a public health system to deal with. It has no method of jumping to new victims other than direct contact with body fluids. This is unlike (say) a virulent airborne influenza where there is no easy strategy for blocking transmission. The simple strategy of tracing, diagnosing and isolating cases suffices to block Ebola in its tracks.

Ebola is easy if and only if there is a capable public health system through which tracing, diagnosing and isolating cases is easy. It's a disaster for the countries that don't have such a capability.

Do the public health authorities in India have this organisational capability? We in India will be sorely tested, for we do not have a focus on public goods in our health system.

Our health system is a socialist mish-mash of a government that produces and gifts out private goods. We try to run primary health centres, we try to run hospitals, and such like. We don't do the things that a public health system does -- such as the analysis and control of epidemics. We lack the intellectual clarity that the public health system is not about the health of the public; it is about public goods in the problem of health. This could prove to be a costly mistake in coming weeks and months, if Ebola spreads well beyond West Africa.

The fact that most people in India cremate the dead, and that we don't have rituals which involve touching the victim, will help. Cremation procedures will need to be modified to address the biohazard.