Thursday, June 28, 2007
I wrote an article titled Mumbai as an international financial centre: Implications for the securities industry for `BSENSEX', the new magazine launched by the BSE.
Thursday, June 21, 2007
Business Standard has an edit on the turf battles affecting currency futures:
A tussle involving turf may be developing between the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (Sebi), about the currency futures market. By definition, a currency futures is an exchange-traded product. An RBI-regulated currency futures market, then, involves the RBI building a separate pool of exchanges. There are four arguments against such a move. The first issue is that of economies of scope and economies of scale. If India is to achieve an international financial centre, then this will require charges for trading on exchanges which are competitive against the top five exchanges of the world. The National Stock Exchange and Bombay Stock Exchange are the third- and fifth-biggest exchanges in the world, by number of transactions. They have the economies of scale through which additional transactions for currency futures trading could be woven into the existing IT facilities at low cost. One or more brand new exchanges would involve much higher cost.
The purpose of creating a currency futures market lies in the fact that the existing currency forward market is opaque, is centred on 20 banks in South Bombay, and has high charges. Currency risk is spread all over the country, including many firms and individuals who have no apparent trade exposure. If the currency futures market is to make a dent in this currency risk that is spread all across the country, it must harness the 75,000 trading screens of the NSE and BSE. These screens, coupled with Internet trading, constitute the most effective distribution capability through which transparent market access at a low cost reaches every corner of the country. The RBI vision, in contrast, involves a market which is a club, with entry controlled through 100 banks, with capital controls, with non-transparency, and high profits for banks.
The international experience shows that currency futures trading is squarely the job of the securities regulator, which deals with all derivatives markets: equities, commodities, interest rates, currencies, etc. In mature market economies, central banks have no role in policy, regulation or supervision of currency futures markets. India needs to be moving towards focusing the RBI on inflation and interest rates. Adding currency futures to the responsibilities of the RBI, which is already burdened with conflicting functions, would be moving in the wrong direction.
Perhaps most important is the issue of credibility and track record. From the scam of 1991 onwards, the RBI has tried to set up a debt market and a currency market. In both cases, the conditions were highly supportive. The debt market should have grown dramatically on the strength of sustained large fiscal deficits. The currency market should have grown dramatically on the strength of Indias remarkable globalisation. However, in both areas, a liquid and efficient market has been elusive. This suggests that there are some gaps between the RBI's approach and skills, when compared with the requirements of building liquid financial markets. Over the same period, policy decisions at Sebi have succeeded in creating India's most important financial market, the equity market, which is now a highly efficient and liquid market. Pragmatism demands that more work should be placed on the shoulders of those who have achieved success on related work in the past. The Sebi approach has delivered results on the equity market, while the RBI approach has failed to deliver results on the debt market and on the currency market. Hence, the task of regulating and supervising the currency futures market should be placed with Sebi.
Wednesday, June 20, 2007
There is a chorus of protest amongst employers in the country about the high price of skilled labour and high staff turnover. Some people think that India's deep public policy mistakes on higher education will greatly hinder GDP growth. I like to point out that over the twenty year period 1987-2007, the higher education got worse (since salaries in universities fell behind those in the private sector), but GDP tripled all the same. There is clearly much more going on in achieving skilled labour than good universities. I wrote an article in Business Standard today titled Crisis on skilled labour? on this subject, where I offer an optimistic view about how the present crisis on skilled labour might play out.
Monday, June 18, 2007
Ten years after the Asian crisis, is Asia safe? On one hand, it looks like there has been a huge buildup of foreign currency reserves. But that could be a case of fighting the last war. The areas of concern are now (a) the fragility of Chinese banks and (b) the Chinese investment boom. Barry Eichengreen has an article The Asian Crisis after Ten Years where he compares China against another fast-growing poorly regulated country: late 19th century United States.
I agree with Eichengreen in worrying about the mixture of Chinese banks and Chinese investment. But unlike him, I think that when that mixture goes sour, it will have global repercussions. It is not like late 19th century US, where the world economy did not care that much about the boom and bust of US output. Today, we are in a situation where a disturbance in Chinese investment or exports could propagate into US interest rates and thus world GDP growth.
If the critical piece of the puzzle is the Chinese investment boom, then the outlook depends on continued profitability of the export-oriented firms. Andy Mukherjee has a wake up call about difficulties in pricing of exports from Asian companies (though not yet Chinese firms), which should surely adversely affect profitability of these firms and thus the investment outlook.
On a related theme, William Pesek has an article about Brazil diversifying its China exposure by playing the India card.
Saturday, June 16, 2007
Sanjeev Sanyal of Deutsche Bank has written a good paper on Mumbai as an International Financial Centre (MIFC). He emphasises the opportunity of building a world class city on the Eastern waterfront of Bombay as a Canary Wharf.
Thursday, June 14, 2007
Monday, June 11, 2007
Financial Express has an editorial on the currency futures question where they say:
Mounting an effective response to the rupee currency futures trading that has begun in Dubai is a national priority. So far, all that the government has been able to muster is a group of RBI employees who are to form a working group on the suggestion of a local currency futures market to keep the business from flying overseas. The formation of committees or working groups by the RBI should be viewed with scepticism. In a famous episode recently, when the Prime Minister reopened the issue of capital account convertibility, the RBI swiftly cobbled together the Tarapore II Committee. And what did this Committee do? It did the expected. It presented a report that nothing should be done about it, thus effectively laying to waste the bold initiative of the Prime Minister. A few years ago, the RBI ensured that interest rate futures trading would not succeed on Sebi-regulated exchanges. This was done by blocking the participation of banks in this market.
Expect similar issues to arise with currency futures. By definition, currency futures trade on stock exchanges, and therefore, ought to involve Sebi regulation. The RBI, however, is loath to see any currency-related matter slip out of its control, and will surprise nobody if it uses all its power to thwart any currency futures market in India. Blocking banks from taking part, throwing in capital controlsthese are old familiar devices. Given such intransigence, what the government needs to do is distance the RBI from all securities markets, as has been recommended in the Mumbai International Financial Centre report. This means transferring several of its current functions to Sebi, which is well equipped to oversee a currency futures market. The RBI abounds with conflicts of interest, being saddled with multiple contradictory functions. Sebi has no such conflicts of interest. Specifically, Sebi does not run either an exchange or a depository. If a currency market in India matches the market design and regulatory framework of the Nifty futures, then India has a chance to be a player in this crucial market. If the RBI manages to exert itself on the prospects of an onshore currency futures market, then it could end up as a failure, and the Dubai Gold and Commodities Exchange will be very happy. The government must decide what is in the countrys best interests.
Also see this previous editorial on June 5 on this subject in Financial Express, which is quoted in this Reuters story about the issue. And Economic Times also has an editorial on the same issue, which also sees the question in the context of the MIFC report, where they say:
The rising rupee is beginning to present considerable challenges and opportunities to policy makers. As reported by ET (June 7) the RBI has formed a committee to examine the details of introducing trading in currency futures on exchanges.
This would enable investors to hedge currency risks. The RBIs hand may have been forced by the fact that Dubai is allowing rupee-dollar contracts to be traded. According to reports, trading in rupee futures on the Dubai Gold and Commodity exchange crossed $23 million on Friday. The lure of the rising rupee has led to some overseas investors opting for rupee denominated debt instruments (ET, 8 June). This means that holder of the instrument needs to pay back the dollar equivalent of, say, Rs 1,000 crore. If the rupee rises, the lender gains.
These transactions have nothing to do with India. The point about all this is that markets are ahead of the authorities. It is faintly embarrassing that Indian rupee risks should be hedged on an overseas exchange. The RBI needs to move fast so that these transactions can take place on Indian exchanges.
The opportunity is that Indian authorities can now harness what is already happening naturally in order to expedite the conversion of Mumbai into an international finance centre. If that were to happen, the fund raising and subsequent trading in rupee-denominated instruments could take place on Indian exchanges, with considerable value addition for the domestic economy.
The high powered expert committee set up by the government estimated that purchase of international financial services by Indian clients was $13 billion in 2005. It projects this rising to $48 billion by 2015. Currently, these financial services are provided by markets such as Singapore and London. The committee lays out a road map of what needs to be done, but a core element of their recommendation is the creation of markets in bonds, currencies and derivatives (BCD). Certain parts of this package, such as currency derivatives, interest rate derivatives and the creation of a corporate bond market, all of which are in the works, should be carried out on a war footing. This should be followed by fully liberalising foreign investment in GoI and corporate bonds.
Sunday, June 10, 2007
Business World has an editorial titled Reservations as cancer where they say that reservations were always unjust -- now they create only misery and jealousy all round without political advantage to any party:
It is an historical accident that Meenas were included amongst scheduled tribes and Gujjars were not. There was a time when Meenas were like any other Rajput clan. They built Amber fort, which commands the approaches to Jaipur. In the 16th century, Baharmull Kuchhwaha, a Rajput king, transferred his allegiance to Akbar, and with his help, destroyed the Meena kingdom of Naed. The feud continued for four centuries. When the British came, Rajput kings allied themselves with them to defeat Meenas, who lost their kingdoms and turned to robbery. That is how they ended up in the list of criminal tribes. Later, when the British ceded power to nationalists, the label, “tribe”, proved a godsend. It brought Meenas reservations in the civil service and education, and proved to be their entry ticket to the lucky Indian middle class. Today, Meenas are well represented in the civil service, and are turning to business.
Gujjars have a less distinguished history. They were originally nomads spread across the dry tracts of western India and Pakistan from Kashmir to Karnataka; it is possible that they came from Central Asia, perhaps Georgia. There are two subcastes of Gujjars: dodhi and bakarwal, or buffalo-keepers and goat-herds. When India was sparsely populated, they used to take their animals up to the Himalayan foothills in summer and descend back into the plains of Punjab and Uttar Pradesh in winter. Now that settled population has grown and grazing grounds have shrunk, they are being forced to take to more sedentary occupations. But not being a landed community like the Meenas, they do not have steady incomes or family support and have not invested as much in education. As a result, they have found it difficult to climb up the social ladder.
When the mutiny broke out in 1857, Gujjars were amongst the most energetic rebels; as a result, they had their share of hangings and dispossession, and earned their place in the 1871 list of criminal tribes. But somehow the curse of the British did not turn into a blessing of the Congress on the advent of independence; Gujjars were not included amongst scheduled tribes.
It is thus an accident of history that Meenas are a scheduled tribe and Gujjars are not. Meenas did the right crimes in the 19th century to earn their place in the fortunate category of tribes; Gujjars somehow fell through the cracks of history. This is no justice; it is sheer chance.
This government does not believe in justice; it is prepared to take a chance. Its resolve to shower favours upon Other Backward Castes (OBCs) is a perfect example. OBCs are so close in their social parameters to the main population that if they deserve reservations, so does almost everyone. They are backward only in name; if they are backward, there are no forward castes, except politicians. But they are a big vote bank; reservations are the way the Congress hopes to get their votes. Hence, the government’s opportunistic move. Mayawati came to power by giving sops to the most forward caste; the Congress does not want to be left behind in opportunism.
But here too, Gujjars are unlucky. They are not numerous enough for the government to bother. There are many groups and castes related to Gujjars — after all, Gujarat calls itself the land of Gurjars — but they would rather hide their kinship to the poor Gujjars.
The looming civil wars of India are not over class as the Prime Minister claims. The working class may have fought bloodthirsty capitalists in the textbooks he once read; but in the India he rules, it is castes that are fighting over the right to undeserved jobs and places in educational institutions. The way to douse their wars is to leave caste behind, and to abolish reservations. Reservations were originally introduced for an opportunistic reason: the Congress wanted to wean away Untouchables from Ambedkar, and to persuade them not to convert themselves to Islam and Buddhism. So it gave them reservations — but only if they were Hindus. There are Muslim Meenas, called Meos; they were excluded from the reservations.
For reasons of political advantage, the Congress divided the people by caste and religion. But now those divisions it created are causing bloodshed and havoc. There is no more political mileage in them; instead, there is only trouble. Even sectarian political parties must see that the time for favouring vote banks has passed.
No politician likes to take a radical decision, least of all the Prime Minister. It may be beyond him to abolish reservations. But he should at least begin to reduce the reservation percentages. If he wants to profit politically, he can replace them at the margin by reservation for the meritorious poor. Let him practise inclusive growth.
Update: Arvind Subramanian wrote in Wall Street Journal Asia suggesting that the State shift from quotas to targeted education vouchers.
Saturday, June 09, 2007
There is a certain tension in designing a bankruptcy code, where both extremes - of killing a firm too soon or too late - are bad, and the trick seems to be to find the right middle. In India, discussions about creditors rights are clouded by a bias in favour of being soft on an incumbent firm. There is a certain bleeding heart sentiment which comes into play, where the State tries to help a weak firm claw back to life, where it is felt that the death of firms is a bad thing.
Tom Chang and Antoniette Schoar have an important paper The effect of judicial bias on Chapter 11 reorganisation where they obtain new insights on these questions.
First, using US data they are able to watch judges repeatedly processing bankruptcy cases, and are able to identify some judges who are more lenient than others. This is, in itself, a fascinating case of the value of bringing economic reasoning to bear on legal thinking. Ideally, judges are not supposed to display such differences in behaviour, but bankruptcy proceedings constitute an opportunity to watch the same judge perform on many homogeneous cases and thus identify judge characteristics.
They go on to look at what happens to the firms which benefited from dealing with a lenient judge at the bankruptcy proceeding. These firms don't bounce back, they don't do well.
Wednesday, June 06, 2007
One recurring theme in international economics is how households & firms evade restrictions on trade and capital controls. In a curious twist, policy hostility against debt flows is reminiscent of "Islamic finance" where straight debt is considered bad. So interesting ideas on rerouting business past proscriptions against Islamic finance are relevant when thinking about what the private sector will do when faced with rules against debt flows. You may also be interested in an earlier blog post on synthetic corporate bonds.
The paper referenced above is:
The Ancient Roots of Modern Financial Innovation: The Early History of Regulatory Arbitrage by Michael Knoll [direct link]. The abstract reads: Recent years have seen an explosion of financial innovation. Much of this innovation seeks to exploit inconsistencies in the regulatory environment, and one of the most popular techniques for doing so uses put-call parity. Nonetheless, regulatory arbitrage using put-call parity is not a new phenomenon, as is frequently suggested. This Essay traces the use of put-call parity to avoid the usury prohibition back to Ancient Israel. It also describes the important role that put-call parity played in developing the equity of redemption, the defining characteristic of a modern mortgage, in Medieval England. In addition, this Essay describes how Muslims living in the West are using mortgage substitutes based on put-call parity to avoid Islam's prohibition on paying interest.
The rupee appreciation, of roughly 10% from 15 March to 6 April, has triggered a nice decline in WPI inflation. I have an article Combating inflation in Business Standard on understanding the inflation situation. Seldom in economics does reality throw up such an uncluttered demonstration of an idea.
The discussion on this blog entry offers many objections to my story:
- It was a `base effect'
- Prices did not go down - only rates of year on year growth of the WPI went down; therefore my explanation is wrong
- Maybe the supply side interventions of the government are getting through; maybe it is these which managed to bring inflation under control.
Let me start with the supply side interventions of the government - what I term `1970s economics' in the article. These have been going strong for a long time, before the rupee appreciation of 15 March. The documents released by the Ministry of Finance in February 2007 have a long catalog of things that were done in the previous year, in trying to attack one market after another: all these interventions were well in place before the INR appreciation. The graph in the BS article shows that none of this worked; it was the inappropriate use of policies that worked in an old India that are out of touch with an India which is a trillion dollar market economy.
As for the distinction between prices and yoy inflation, we know that in all countries, inflation has persistence. Once the inflationary fires are burning, they have a momentum of their own, since inflation creeps into the expectations of economic agents. So the default setting is that high yoy inflation is followed by high yoy inflation. The INR appreciation affected the prices of those goods which are priced by import parity pricing. For those goods, there has been an impact on prices, and I would imagine that for some of those goods there has even been a decline in prices in sympathy with a 10% change in the rupee. But these goods only account for a part of the WPI basket. Putting things together, we see continued inflation, though at a lower rate.
It's the only thing you could have expected. Nowhere in the world does inflation, which is rooted in the expectations of economic agents, stop suddenly and turn into deflation.
Finally, to `base effects', which seem to be popular amongst the folks in securities firms writing analyst reports about India. I'm a skeptic on ascribing an important role to `base effects'. They are a cop-out of economic analysis, for you say nothing when you say "there is a base effect". What is really interesting about the rupee appreciation is that it gave a turning point on the WPI series, exactly as predicted by the logic of import parity pricing. `Base effect' reasoning is devoid of such strength; it wouldn't give you an insight into turning points. The only situation where a base effect is important is where there is a big change in an administered price. That would kick up the WPI in a certain week in one year but might be relatively benign in the same week of the next year. There is no reason for expecting a base effect with WPI manufacturing. And, the effect I am describing in the BS article (that INR appreciation broke the inflation spiral) is stronger, not weaker, with WPI manufacturing.
Let's look at the evidence for WPI overall (my case is even stronger with WPI manufacturing).
The graph superposes the latest 52 points of yoy WPI inflation (overall) and the previous 52 points - i.e. the identical weeks of the previous year. The latest year happens to be the upper curve. Look at the features:
- Early in the previous year, there was a powerful and sudden rise of the WPI from week 15 to week 20 by 150 bps. There was no "base effect" in the next year - WPI just kept accelerating without regard for the previous year.
- Similarly, the drop in WPI from week 0 to week 15 in the previous year didn't generate a rise in this year.
- If the claim of the "base effects" people is that the fluctuations of one year are undone in the next, then the two curves should be mirror images. They are not.
- Then we move forward to the first vertical red line, which is 15 March, the date from which the INR appreciation began until the next vertical line where there was a sharp inflation acceleration in the previous year. In the period in between the two red lines, there was no base effect. Last year's inflation was flat at 4%, and in the current year, inflation dropped by 100 bps.
- That leaves the last 50 bps of the drop in inflation this year, where it's possible to say that there was an opposing (bigger) change last year. Say so if you like, but it still buys you no insight.