Wednesday, October 31, 2007

Capital controls against participatory notes

I have been surprised at how well the public has digested SEBI's recent moves on PNs. As an example, see M. K. Venu in ET and a debate in Business Standard.

In most parts of the economic policy debate in India, the people are deeply cynical about the motives and the competence of government, and deregulation is viewed as a good thing. The transformation of India - going from 3.5% growth in 1979 to 7.5% growth in 2007 - was critically about getting government out of a deep engagement with the economy. But in finance, there is not - as yet - a widespread appreciation of the difficulties of the license-permit raj that is in operation (though Jamal Mecklai gets it). Regulation is uncritically viewed as a good thing; audiences applaud when more restrictions and more controls are announced.

Part of the problem, of course, is that regulated firms are afraid of criticising regulators. Another part of the problem is that domestic lawyers & accountants are beneficiaries of the existing FII framework and would not be happy if India moved forward to ending the FII framework.

Amongst the sensible material that has come out is this debate between K. N. Vaidyanathan, Susan Thomas and Rashesh Shah in ET; an editorial in Indian Express; and this article in ET by Shishir Prasad.

The monetary policy announcement

Indian Express has nice commentary -- Ila Patnaik before the announcement and Bibek Debroy after.

Tuesday, October 30, 2007

Slideshow on India and convertibility

I did a slideshow on India and capital account convertibility at a Euromoney conference on derivatives. In it, I used some interesting results from a new paper by Gurnain Pasricha, which was written up by Nirvikar Singh in Financial Express.

Friday, October 26, 2007

The `slowdown' in IIP consumer durables

In Financial Express today, Ila Patnaik examines the `IIP consumer durables slowdown' and finds it's mostly about bad data.

Wednesday, October 24, 2007

The moribund government bond market

India is a land of extremes. Right alongside the remarkable success of a reforms effort on the equity market, we got a remarkable failure of a reforms effort on the bond market. Manish Sabharwal & Digant Bhansali have a fascinating article in Economic Times on the slow death of the government bond market in India. This table is in the article:

Feature 03-0404-0505-0606-0707-08
Number of gilts traded > 4 times/week 27 14 9 6
Number of gilts that addup to 90% of volume 26 33 15 11 11
Volume of top traded security (%) 11 23 18 33 36
Share of NDS in volume (%) 0 0 53 79 84
Equity turnover (billion USD) 933 1051 1802 2564
Gilts turnover (billion USD) 365 216 164 221

It's astonishing to notice that from 2003-04 to 2006-07, a time of remarkable GDP growth in India coupled with a massive scale of government bond issuance owing to large deficits, government bond turnover dropped from $365 billion to $221 billion. Over this same period, equities turnover went up from $933 billion to $2564 billion.

The state of the market is visible in the turnover of the biggest single bond - this went up from 11% of the market in 2003-04 to 36% in 2007-08.

This is the period over which RBI implemented the Negotiated Dealing System, their vision for how the bond market should be transformed.

Modernising the monetary policy regime

Glenn Stevens has a great speech from 2006 telling the story about how Australia evolved out of the pegged exchange rate. Reading it is useful for thinking about India's policy questions about the monetary policy regime. As is typical with central banks from the first world, the writing quality of the speech is excellent. I was amused to see this story from the pre-1983 period:

The exchange rate management committee also sought to add a random element to the daily movements in the exchange rate, around the general trend appreciation, to reduce the predictability in the movements in the exchange rate and thwart the speculation.

It struck me that the thinking at RBI circa 2007 was not that different from the thinking of RBA pre-1983, i.e. over a quarter century ago.

Saturday, October 20, 2007

Gloomy perceptions about PSUs and their consequences

Business Standard has a very insightful editorial on the oil industry:

Global oil prices are nearly $90 per barrel; the Indian crude basket is more than $80/barrel. The Indian consumer scarcely knows this, though, since domestic oil product prices remain firmly fixed, and by the look of it will remain fixed till the next Parliamentary elections are over. Petroleum Minister Murli Deora has managed to deliver this state of nirvana by getting the Cabinet to approve the issue of Rs 23,458 crore worth of oil bonds and by forcing the state-owned oil enterprises to absorb the rest of the expected shortfall of Rs 54,935 crore during the financial year. Given the 14 per cent share of fuel, power, light and lubricants in the wholesale price index (its 5.5 percentage points for LPG, petrol, kerosene and diesel), it is obvious that Mr Deora's role in keeping prices down has been an important one, because what is called under-recoveries on petrol now total as much as a tenth of its retail price, while for diesel it is even higher at one-fifth. The under-recovery gets still worse for cooking gas (40 per cent), and for kerosene (65 per cent).

This is price distortion of the worst kind, and is not without costs even if these are not immediately obvious. Consider the non-consumer side of the picture. The private sector Reliance Industries, which had been grabbing market share from state-owned oil firms, has virtually given up trying to sell its refined products in the domestic market (it does not get the subsidy that the government gives the state-owned firms) and has become instead the country's biggest exporter of petroleum products -- the share of oil product exports in total exports has risen as a result from 8.4 per cent in 2004-05 to 14.7 per cent in 2006-07, and may have climbed further to 18 per cent this year.

The state-owned oil companies, for their part, do not have the luxury of escaping into export markets and must suffer the vagaries of government policy, which has affected their bottom line as well as their investment plans. To take the figures for the current year, the firms will jointly incur a loss of over Rs 30,000 crore a fact that is not lost on investors. The result is that Indian Oil's share price now commands a price-earning multiple of barely 6.5 (about a quarter of the average Sensex stock), while in the case of Bharat Petroleum and Hindustan Petroleum, the P:E ratios are about 4.5 and 4.8. On a combined market capitalisation for the three firms of Rs 75,000 crore, they are valued at less than what just one of them should be worth and also less than the value of Reliance Petroleum, which is a new refining company that is still to start business but which is already valued in excess of Rs 80,000 crore!

This is a pointer to how much punishment the government is taking on the stock market. And since companies finance fresh investments by floating new shares and thus capitalising on their share valuation, what the government has done is to make sure that the hopelessly under-priced state-owned oil firms will not be able to play this game. So the oil-refining business will increasingly have only private sector investors who being unable to sell in the domestic market will be busy exporting their product while domestic demand is met by imports through the state-owned companies.

This bizarre denouement is what Mr Deora has achieved. Meanwhile, even as Mr Chidambaram counts the extra tax revenue being delivered to him by a buoyant economy, he should consider whether as much and more has been lost on the stock market because of the oil-pricing policy. If the government had an annual balance sheet wherein it had to assess the value of its assets (and liabilities) each year, instead of the outdated financial system that it calls its Budget, the disastrous trade-off would be obvious to everyone. Indeed, in today's accounting system, even the oil bonds that are being issued do not show up in the definition of what is the fiscal deficit. It is no wonder that most people are completely unaware of the cost of today's oil-pricing policy.

A similar phenomenon is taking place in banking. In banking, given the way capital requirements are structured, equity capital through a combination of retained earnings and external share issuance is critical for enabling deposit growth. Let's focus on some of the bigger banks [full list]:

BankNet profitP/E
Jun-07 Quarter
(Rs. crore)
Allahabad 200 6
Bank of Baroda 331 10
Bank of India 315 11
Canara 241 8
Corporation Bank 202 9
Indian Bank 212 9
IOB 268 8
Oriental Bk. Commerce 200 8
Punjab National Bank 732 9
Syndicate 221 7
Union Bank 225 9
SBI 1426 20
Axis 175 38
HDFC Bank 321 41
ICICI Bank 775 36

(The net profits is for the June 2007 quarter since all the results aren't out for the September 2007 quarter. All banks with more than Rs.200 crore of profit in that quarter are in the table. The P/E is for September 2007.)

The same phenomenon that the BS edit describes, with oil companies, is visible here also. There's a striking pattern where `ordinary' PSU banks have a P/E of roughly 10; SBI is a PSU bank with a P/E of roughly 20; the three large private banks are at a P/E of 40.

Friday, October 19, 2007

Chidambaram on MIFC

Mr. Chidambaram said:

Given the current exchange rate, India is a trillion dollar economy. Outflows and inflows together account for nearly 106 per cent of the GDP. As the economy becomes more open and trade intensity increases, giant financial flows will be intermediated in India. India is a purchaser of international financial services. A recent report has estimated the value of these services at US$ 13 billion a year and has concluded that this will rise to US$ 48 billion by the year 2015. While India will continue to be a purchaser of financial services, we believe that there is an opportunity for India to become a provider of financial services as well. It is, therefore, our intention to make Mumbai an International Financial Centre. We commissioned a report for this purpose. The report is in the public domain and we are in the process of building a consensus on the key recommendations. It is our intention to make financial services the next growth engine for India.

Tuesday, October 16, 2007

The middle muddle

I have an article in Business Standard titled The middle muddle, about India's attempts at running an inconsistent monetary policy regime.

The backdrop to this is recent statements from RBI, SEBI's plans about restrictions on participatory notes and S. S. Tarapore.

Watch me talk about these events on CNBC on Wednesday morning.

Thursday (18th morning), and here's more of fun and games:

  • I have a piece in Business Standard talking about how the overseas OTC derivatives industry on Indian equity underlyings works. There is quite a gulf between the rhythm of this business and the SEBI proposal.
  • Surjit Bhalla says in Business Standard that the need of the hour is to get past the very `FII' framework.
  • Akash Prakash says in Business Standard that in the short-term these proposed restrictions will bind.
  • Ila Patnaik, writing in Indian Express, links up these events to larger questions of India's strategy on harnessing globalisation.
  • Jayanth Varma, writing in Business Standard.
  • This clarification from SEBI was useful, though ideally the drafting of their document should have been clear enough that it was not required. I'm curious - what time did this come out? In this age of realtime information flows and analysis, all documents should be timestamped! :-)
  • What comes next in terms of capital controls, by Anindita Dey in Business Standard.
  • An editorial, and an article by Eswar Prasad, in Economic Times.
  • See this article by Ila Patnaik in Indian Express which points out how small PN-based inflows are, when compared with the scale of RBI's trading on the currency market. When the drumbeat was built up about the need for restrictions on PNs, a glance at the data would have helped keep things in perspective. But this wasn't done either in the case of PNs or in the case of ECB. What is needed is a shift away from this strategy of having no strategy, of only fire-fighting using ineffectual capital controls.

The Business Standard editorial is skeptical about what happened:

After a rambunctious day on the stock market, it is not clear how much of their objective the government and the market regulator have achieved with their late evening announcement of Tuesday. A de facto limit is proposed to be placed on the issuance of derivative participatory notes, which foreign institutional investors (FIIs) have been resorting to far more than in the past. This has created and will continue to create some selling pressure because of the unwinding of positions. And to the extent that these instruments were non-transparent (the actual investor could hide behind layers of intermediaries), the government may also achieve to a limited extent its goal of trying to stop the round-tripping of domestic money (which is believed to have been going into some active stocks).

The short-term liquidity pressures will fade, however. So while the stock market has been shaken out of its bull-market euphoria (which is welcome), and forced some overseas investors to also re-assess the level of regulatory risk (not so welcome), it is far from clear that anything longer-term has been achieved. If portfolio investment wants to come into India because — as the finance minister emphasised on Wednesday morning —nothing about the India story has changed, then all that the proposed step will do is to re-route the money through other windows, most of which remain open. That might explain why, after the initial crash, the market recouped most of its losses fairly quickly. The net drop in the stock index at the end of the day is less than 2 per cent, which makes it little more than an ordinary day in the office.

But the stock market was only the government’s subsidiary target, as became clear on Wednesday. The real objective was to slow down the inflow of money through the capital account (running at between 5 per cent and 6 per cent of GDP) and thereby to ease the upward pressure on the rupee — which has gained more against the dollar than almost all other currencies over the past year. This in turn had begun to slow export growth, and caused job losses in vulnerable sectors like textiles and leather goods. The government has tried to neutralise the inflow by sterilising the money coming in so that it does not impact domestic money supply, but has been only partially successful. The situation is still that if India continues to offer a rapidly growing economy and an attractive market that enthuses foreign investors, the money will continue to come in, especially when world markets are still awash with liquidity. The larger macro-economic management challenge therefore remains, and has not gone away simply because there has been a mini-crackdown on P-notes.

Sebi has said that it will ease the process of getting registered as an FII and thereby getting the regulator’s approval to operate in the Indian market. The question to ask is why such a licensing restriction should be there at all. Banks, which are required to follow the rules about knowing who is their customer, are perfectly capable of being the gate-keepers when it comes to funny money, and certainly no less capable than Sebi, which is manifestly unable to find out who is behind the P-notes. Once the Indian market is thrown open, the entire business of foreign portfolio investment should become more transparent, and the limits on foreign ownership in sectors and individual companies will operate as the fencing. Those who want to hide their identities may continue to operate through new tools thought up by the financial community, but that will leave the government and Sebi no worse off than today. Just as the foreign exchange crisis of 1991 was used to usher in overdue economic reforms, the P-note issue should be used to open up the capital market. The side-benefit of opening up will be that the capital market activity that now takes place offshore will mostly come onshore —which can only be to the country’s benefit and to the goal of developing Mumbai as a financial centre.

The final point which needs to be made is that the only long-term solution to the current challenges on financial flows is to improve the productivity and efficiency of the economy, so that producers and exporters neutralise through these gains the pressures that get transmitted through a more expensive rupee. This has to be accompanied by further opening up on imports, to absorb the capital flows which are coming in and which by all accounts will continue to pour in. This translates into action on a broad range of fronts, all of which are well known and have been stated often enough. The tragedy is that the government seems unable to do what is required, for a variety of political and administrative reasons, and is therefore trying to resolve systemic issues with Band-Aid kind of solutions, that most people realise, will not work.

Monday, October 15, 2007

Watching markets work

At 10 PM last night (Sunday night), news came out of a bomb blast at a movie theatre named `Shringar' at Ludhiana. Google news now has 32 news items about this. Some of these articles, and some of the television coverage, blurred the lines between this movie theatre and the listed firm named `Shringar Cinemas'. Many a viewer/reader might have felt that an outlet owned by Shringar Cinemas was bombed.

The CMIE website shows a clarification from BSE at 9:55 and from NSE at 10:26. Here are the underlying materials from NSE and from BSE.

Since trading starts at 9:55 AM, and the information in these announcements might not be common knowledge amongst all speculators, this made me wonder: Was there a false drop in the prices of Shringar in the early minutes of trading? Or, was there excessive turnover where some people made mistakes but smart speculators / arbitrageurs were able to catch this?

At first blush, based on this data from Yahoo finance, this does not appear to be the case; the market worked quite fine. In order to get a sense of what was going on, I compare Shringar against their peer PVR using the Yahoo finance website. Click on the picture to get a better look.

Correcting the good-news-about-stocks bias of the media

Jayanth Varma has long emphasised the importance of the short seller in upholding market efficiency. He points to many episodes where speculators have ferreted out misdeeds of firms, taken up short positions, and then brought the bad news to light in order to profit from it. Short selling, then, generates incentives for external parties to place constraints upon firms who are falsifying information and obtaining an exaggerated valuation.

Writing in Business Standard, Devangshu Datta led me on to a fascinating website called This operates on a very interesting business model:

  • There is a trader named Mark Cuban. He funds Chris Carey, who runs the website.
  • Carey discovers firms doing bad things.
  • First, Mark Cuban gets an opportunity to short sell the stock.
  • Then, Carey goes public with the facts that he has unearthed.
  • If Carey is right, the stock prices drops in response to his revelations, and Cuban makes money.

We need a few of these in India. At present, there is too much of a long-only bias in the media. The media has always had to worry about making advertisers unhappy. In addition, an extremely unhappy development in recent years has been the systematic equity investments in certain firms by one massive media house, which then goes on to shamelessly trumpet the virtues of these firms.

The decoupling hypothesis

Many people believe that China and India have decoupled from the US economy, so a slowdown in the US (which appears to be on its way) will not affect growth in China and India. Writing in Indian Express, Ila Patnaik looks at the facts about the trade linkages between India and the US.

Sunday, October 14, 2007

Measurement of quality of service of electricity distribution

What you measure is what you can manage. In thinking about public goods in India, achieving a sound public policy framework in India, and appropriate checks and balances for providers, critically requires sound measurement of outcomes.

In the area of telecom, TRAI has started working on measurement of quality of service (QOS). As an example, look at the PDF file that they are putting out. I find it interesting, but not yet designed in a way that facilitates customer choice. When you're picking a mobile phone vendor in Delhi or Bombay, it is hard to read this file and understand which vendors are strong on QOS. In the area of electricity, a think tank named Prayas has embarked on measurement of the quality of service at a few locations in Pune. They have setup a few data loggers which generate realtime data for the mains voltage, and measure supply interruptions. They have released documentation, and a lovely google maps mashup which locates their data loggers and gives access to the information being captured (click on any of the balloons). Their email says:

For the first time in India, the ESMI captures supply interruptions data as well as voltage levels at the ordinary consumer location.

Poor supply quality (i.e. frequent supply interruptions and low voltage levels), is the most common complaint by electricity consumers and often results in consumers unwillingness to pay. Poor supply quality forces consumers to either invest in back-up devices such as stabilisers, inverters and generators or they suffer loss of productivity and inconvenience. Though recently efforts are being made to capture supply quality parameters, (e.g. CEA compilation of interruptions at 11 kV feeders in urban areas) there is still a long way to go for availability of reliable and comprehensive indicators of supply quality.

The Electricity Supply Monitoring Initiative (ESMI), by Prayas, is developed as a complement to such ongoing efforts to monitor electricity supply quality. This is a tool for consumers and regulators to get an idea of the ground reality and to increase the accountability of electricity utilities. For example, this will allow consumers to verify if load shedding is being carried out as per the regulatory commission's directive. Similarly ESMI data could be used to assess the impact of large capital expenditure (under projects such as APDRP or MSEDCL's infrastructure plan) on supply quality.

Currently data loggers are installed at three locations in Pune, and supply interruptions and voltage profile of these locations is available at This site will be updated periodically and many more locations will be added in the next few weeks.

As an example, their Pune results reveal interesting and new facts:

Pune does not face any scheduled load shedding due to implementation of `Pune Model'. Under this arrangement local industries give the required relief to the grid by generating power through their captive power plants (using liquid fuel such as diesel). In spite of this as shown in the tables, Pune consumers fact ten to twenty sustained interruptions (i.e. interruptions of 4 minutes and more) every month and do not have supply for about eleven hours every month. As per Maharashtra Electricity Regulatory Commission (MERC) regulations, voltage for low-tension consumers should be between 225 volts to 255 volts. But as shown in the following tables, voltage levels in Pune are significantly below MERC norms. For example, even in central Pune (Deccan Gymkhana) voltage is often below MERC norms and for about 7% to 9% of the time is very low (i.e. below 195 Volts). This indicates that, apart from sufficient availability of power, proper maintenance and strengthening of local distribution network is essential to ensure good quality of supply. The electricity supply quality in rural areas is expected to be still worse. In the next few weeks ESMI will focus on capturing status of electricity supply quality in rural areas.

I'm a great believer in the importance of information in closing the loop and enabling superior public goods. What is not easy to figure out is the incentive structure for this information. This information has public goods characteristics, so what would work best is for a government agency to contract-out its production and public dissemination with tight integration between the public goods outcomes data and google earth. However, this would require sensible decision making and procurement on the part of the government agency. There is a bit of a chicken-and-egg problem here. A dysfunctional and non-responsive government agency would not even make this first step correctly - it might do nothing, or it might muck up the contract, or the contract might get awarded to the wrong team. Without a feedback loop from outcomes to citizens to policy, these mistakes might not get corrected.

Friday, October 12, 2007

New thinking on currency trading

Joydeep Mukherji pointed me to an article in Mint which points out that India's share in the global currency market has risen from 0.3% in 2004 to 0.9% in 2007. This is based on some interesting BIS data.

This is consistent with India's remarkably rapid globalisation in recent years. Of course, this number of 0.9 still lags India's GDP share. The MIFC Report has argued (Table 4.11, page 64) that for India to be considered a minimal IFC player, 5% of the world's currency trading has to be here. So the share of currency trading in India needs to grow by five to six times in achieving a minimal role in the global financial market.

The denominator - global currency trading - is pretty big. The global market runs at $3.2 trillion a day. BIS places India at $34 billion a day in 2007. If India were at a 5% market share, this would be $160 billion a day. As an aside, any wise and experienced market manipulator will tell you that it's pretty hard to manipulate a market which does turnover of $34 billion a day. So it's not surprising that the RBI is finding the going difficult.

The big weak link in Indian finance today is the lack of a properly functioning Bond-Currency-Derivatives nexus, the integrated system of spot and derivatives market (both exchange-traded and OTC) on currencies, bonds and credit risk. All these building blocks need to have liquidity based on speculative price discovery, and all of them need to be tightly integrated by arbitrage.

From the late 1990s onwards, a lot of people in India understood the universal applicability of the market design of the equity market, which uses a centralised limit order book with computerised order matching, open access for financial firms and for customers, and the elimination of counterparty credit risk at the clearing corporation.

For historical reasons, this is not how the global bond market and currency market functions. London has 30% of the world's currency trading, and initial conditions matter greatly. But in India, starting from scratch, there is less of a burden of history, and it behooves us to think from first principles. Indeed, the only path to achieving competitiveness and breaking into the established world of international finance might be through innovation.

I have always thought that if the order book market works for equities, it would work even better for bonds and currencies. The reason for this lies in the fact that the latter are a small number of macro underlyings. Order book markets are extremely good at aggregating large order flows on problems where there is low asymmetric information. Hence, if the equity market design works pretty well for 1000 equities, I think it'd work even better for 10 currencies and 50 government bonds (which is all that is needed with a well run DMO). The limit order book market doesn't work so well with a large number of small products with a lot of asymmetric information - but the government bond yield curve and currencies are just not like that.

These issues were kicking around in the Indian debate from the late 1990s onwards, by which time the success of the equity market design was starkly visible. The viability of the equity market design was accentuated in the last five years by the rise of algorithmic trading. Covered interest parity arbitrage, currency triplets, yield curve arbitrage: all these are highly automatable strategies. The algorithmic traders will blow away the human dealers, and deliver very a high quality of market efficiency in the BCD Nexus once the key markets are on the exchange platform. These, and other, arguments in favour of the exchange platform are summarised at page 152 of the MIFC Report.

With this backdrop, I saw a fascinating article Foreign Exchange Trading: New Trading Platforms Reshape Forex Marketplace by Will Acworth in Futures Industry magazine. It talks about new exchange-style trading platforms in the currency market. I find it particularly fascinating that Reuters - which has long milked the OTC currency market for all it's worth - is one of the pioneers in taking currency trading on exchange.

Early on, he says:

the FXMarket- Space platform represents the first attempt to bring a central counterparty into spot foreign exchange trading

This is incorrect. The first effort to do the central counterparty for a currency market - albeit an OTC market - was the Clearing Corporation of India Ltd. (CCIL). This was in 2002. CCIL was a great success story of Indian innovation - the idea of the clearing corporation was taken up from exchanges and applied to counterparty credit risk management on the OTC market. Unfortunately, India wasn't able to follow through on the achievement of setting up CCIL to harnessing the full benefits of CCIL, owing to deeper dysfunctionality in the BCD Nexus (see page 126 of the MIFC Report).

Currency trading with CCIL as the central counterparty harnesses all the wonderful benefits of netting, reduced operational costs, etc. CCIL complies with the `Lamfalussy Standards' where it is accepted that when one person fails, after collateral is exhausted, some losses can fall on his counterparties. While these standards are well accepted, I'd much rather see the full blown risk management that's found in clearing corporations such as the National Securities Clearing Corporation (NSCC), where the clearing corporation is good to the last drop, where customers only face losses after the clearing corporation has gone bankrupt.

Thursday, October 11, 2007

Coping with capital inflows

The IMF's World Economic Outlook has a chapter on capital inflows which is highly relevant for contemporary Indian debates on macro policy. They have done interesting empirical work in the form of examining a database of episodes of high capital inflows.

I hate to give you a sound bite when you should read the full chapter, but if there's a quick summary it is this. The wrong thing to do in response to a capital surge is: capital controls and sterilised intervention. In other words, the bulk of the Indian monetary policy response is wrong. The right thing to do in response to a capital surge according to the WEO is: fiscal consolidation.

Menzie Chinn has written a nice blog entry about it, and Andy Mukherjee links it to recent developments in Asia.

Wednesday, October 10, 2007

Using the Internet to improve liquidity on the Indian labour market

Economists have long been aware of the difficulties of job search, of properly matching up buyers and sellers in the highly non-standardised widget called labour. If the matching problem were solved better, the natural rate of unemployment would go down, and output would be higher. The frictions of this market, equally, imply that there are opportunities for innovations which help people achieve better outcomes at lower cost. The more inefficient a market, the bigger the business opportunity for someone who's able to make a contribution to fixing it. In May 2007, there was an NBER conference on the subject of `labour market intermediation' which touches on many aspects of this problem.

Anand Giridhardas has a fascinating article Internet revolution reaches India's poor in the International Herald Tribune which describes attempts by a few computer engineers at building two new systems -- babajob and babalife - which utilise computer technology to improve on the age-old Indian mechanisms of job hunting, based on a `circle of trust'. The driver that you recruit in India is almost always recommended by someone you trust. The question is: Can these trust mechanisms be made more efficient using the Internet? Can they thus reduce the frictions of the labour market? I believe these entrepreneurs are onto a very good thing.

I am reminded of TeamLease, which is also an innovative startup animated by the inefficiencies of the Indian labour market. I'm not sure about the exact facts, but teamlease is either the biggest or the second-biggest employer in India today. I find it interesting that both these projects are relatively recent startups. On the subject of temp jobs, see Do temporary jobs improve workers long-term labour market performance? by Fredrik Andersson, Harry J. Holzer, and Julia Lane, and see the NBER conference mentioned above.

I recall having a discussion about the Internet and entrepreneurship a few months ago with Viral Shah and Vikram Aggarwal. It's relatively easy to take a known business model like and try to transplant it into India, using relatively minor innovations like running a system of warehouses spread over India so as to avoid the irritating difficulties of buying from and delivering to an address in India. Sometimes, this might make money - ebay might like to buy an Indian auction company that's built up a head start. But at a deeper level, this doesn't make too much sense, because the global firms are all very focused on India as an important market, and they have the economies of scale. What would be really interesting, in contrast, is to do business models in India which utilise the Internet as a tool but come up with innovations in meeting the needs of customers in the Indian institutional setting and reflecting the very different prices of alternative production technologies that are seen in India. The babajob and babalife examples involve understanding the informal sector and contributing to making it more efficient.

On the issue of cost function, the single big difference about India is low prices of labour. Manual labour in urban India runs at $0.5 to $1 an hour. This has far reaching implications for the products and processes that one can imagine; what's optimal when faced with Indian labour costs might often not be optimal anywhere else in the world. My favourite example of this issue is travel sites. Of course, it's nice and convenient and useful to be able to buy plane tickets on the web - is an outstanding example of a graceful and well done implementation of that. But labour in India is unusually cheap. This means that a travel website should be able to affix the name of a support person and a telephone number onto the e-ticket. The customer should be able to call this person on the fly and make changes to the reservation. This kind of personalised customer-support is infeasible in the West, given high prices of labour. Hence, the big travel websites in the West don't think like this. But solving problems under Indian conditions needs to analyse such business processes which are figured out from first principles.

Sunday, October 07, 2007

Review of the equity derivatives market

Rajesh Gajra reviews the Indian onshore equity derivatives market in Business World.

Exchange traded vs. OTC

The MIFC book has argued (page 152-153) that there is a case for a policy bias in favour of exchange-trading over the OTC market.

On 5 October, Stephen Cecchetti argues in a similar vein in the Financial Times:

In September 2006 Amaranth Advisors, a US-based hedge fund specialising in trading energy futures, lost roughly $6bn (4bn) of the $9bn it was managing and was liquidated. With the exception of its shareholders, most people watched with detached amusement. Eight years earlier, reaction to the impending collapse of Long-Term Capital Management was very different: people were horrified and the financial community sprang into action. One big difference is that Amaranth was engaged in trading natural gas futures contracts on an organised exchange, while LTCM's exposures were concentrated in thousands of interest-rate swaps.


The difference between futures and swaps is that futures are standardised and exchange-traded through a clearing house. This distinction explains why Amaranth's failure provoked a yawn, while LTCM's triggered a crisis. It suggests that regulators, finance ministries and central bankers should be pushing as many securities on to clearing house-based exchanges as possible. This should be the standard structure in financial markets.

A critical part of any financial arrangement is the assurance that the two parties to it meet their obligations. In organised exchanges, the clearing house insures that both sides of the contract will perform as promised. Instead of a bilateral arrangement, both buyers and sellers of a security make a contract with the clearing house. Beyond reducing counterparty risk, the clearing house has other functions. The most important are to maintain margin requirements and "mark to market"gains and losses. To reduce its risk, the clearing house requires parties to contracts to maintain deposits whose size depends on the contracts. At the end of each day, the clearing house posts gains and losses on each contract to the parties involved: positions are marked to market.

Since margin accounts act as buffers against potential losses, they serve the role that capital requirements play for banks. Marking to market offers a way to monitor continuously the level of each market participant's capital.

Finally, exchange-traded securities are standardised, creating transparency: buyers and sellers know what they are buying and selling.

Returning to the comparison of Amaranth and LTCM, we can see why the former did not provoke concerns of a systemic crisis. Amaranth was required to hold margin to maintain its position in futures markets. When it started to sustain losses, the clearing house forced the sale of the positions into a liquid market; counterparties sat calmly, knowing their interests were protected. By contrast, the swaps LTCM held were with specific institutions. Since interest-rate swaps are not exchange-traded, selling them was not feasible. The collapse of LTCM would have led to defaults on the contracts and put other financial firms at risk.

This brings us to the present crisis. The defining feature is that there are securities out there no one knows how to value. We discovered this when poten- tial investors refused to accept certain mortgage-backed securities as collateral in the issuance of commercial pap-er. A failure of investors to monitor the originators of these securities had led to the creation of complex and non-transparent securities. If these were ex-change-traded through a clearing house, these problems would largely disappear.

There are many ways to encourage people to move trading into clearing houses. Are there tax and regulatory incentives that are doing the opposite? Are banks, insurance companies and pension funds being rewarded for holding difficult-to-value securities that are not exchange-traded?

The goal is to structure financial markets in a way that minimises -system-wide risk. Yet we also need to remember that there are gains to asset-backed securitisation. When the system works, it turns illiquid bank loans into readily marketable securities. This should reduce the overall riskiness of the financial system. Shifting these securities to exchanges with clearing houses would help ensure that these benefits materialise.

Friday, October 05, 2007

Does urban India favour liberal economics?

There is a broad stereotype in the world, where it is felt that liberal views about economic policy and globalisation are held the most in the US and the UK. It is often felt that mainstream middle class urban India has a fairly socialist approach to many questions.

The Pew Institute has been running a large scale survey effort across the world. In their latest 2007 survey, their sample is roughly 45,000 people worldwide. In India, they have roughly 2,000 people, with an urban bias.

They have three key questions that measure economic liberalism, covering attitudes towards international trade, attitudes towards foreign companies and attitudes towards free markets. The results contain many surprises. As an example, in urban India, they find 89% are supportive of international trade, 73% are supportive of foreign companies and 75% are supportive of free markets.

The fraction of the sample that is supportive on these three dimensions, in 46 countries, is as follows:

Free trade Foreign firms Free markets
US 59 45 70
Canada 82 48 71
Argentina 68 39 43
Bolivia 80 49 53
Brazil 72 70 65
Chile 88 63 60
Mexico 77 65 55
Peru 81 61 47
Venezuela 79 74 72
UK 78 49 72
France 78 44 56
Germany 85 47 65
Italy 68 38 73
Spain 82 56 67
Sweden 85 53 71
Bulgaria 88 52 42
Czech Republic 80 63 59
Poland 77 60 68
Russia 82 46 53
Slovakia 83 72 53
Ukraine 91 47 66
Egypt 61 68 50
Jordan 72 59 47
Kuwait 91 68 65
Lebanon 81 64 74
Morocco 70 72 66
Palestinian Territory 69 43 66
Israel 90 69 72
Pakistan 82 39 60
Bangladesh 90 75 81
Indonesia 71 62 45
Malayasia 91 80 71
China 91 64 75
India 89 73 76
Japan 72 54 49
S. Korea 86 54 72
Ethiopia 86 70 47
Ghana 89 89 75
Ivory Coast 94 80 80
Kenya 93 82 78
Mali 86 79 76
Nigeria 85 82 79
Senegal 95 87 63
S. Africa 87 77 74
Tanzania 82 45 61
Uganda 81 73 67

I think all three measures are driven by an underlying value system that I term `the liberal worldview'. A summary statistic could be made by averaging the three. I did a principal components analysis and find that the weights on the first principal component are not that unequal - they are 0.59 for trade, 0.59 for foreign firms and 0.55 for free markets. The first principal component accounts for 61% of the variance. Using this principal components analysis, one gets this table of countries sorted by the prevalence of liberal views on economic policy:

Liberal worldview
Ivory Coast 2.42
Kenya 2.33
Ghana 2.20
Bangladesh 1.98
Senegal 1.93
Nigeria 1.83
Malayasia 1.76
Mali 1.62
India 1.58
S. Africa 1.51
China 1.29
Israel 1.28
Kuwait 0.96
Venezuela 0.73
Uganda 0.58
Lebanon 0.55
S. Korea 0.38
Chile 0.29
Sweden 0.21
Ukraine 0.13
Slovakia -0.03
Spain -0.07
Poland -0.19
Canada -0.20
Ethiopia -0.21
Brazil -0.27
Morocco -0.27
Czech Republic -0.31
Germany -0.34
UK -0.38
Mexico -0.64
Tanzania -0.83
Peru -0.93
Bulgaria -1.08
Pakistan -1.13
Russia -1.19
Bolivia -1.20
France -1.40
Italy -1.48
Palestinian Territory -1.56
Jordan -1.63
Indonesia -1.68
Japan -1.74
Egypt -1.87
US -1.96
Argentina -2.95

This does not fit well with the stereotype of liberal Anglo-Saxon economics being prevalent in the US and the UK and nowhere else. If anything, poor countries have even more liberal values when compared with rich countries.

Urban India is at rank 9 out of 46 countries. China is at rank 11. I guess both countries have seen socialism first hand and support for liberal economics is strong.

The report also shows sharp changes over the last five years. On page 16, they show support for foreign companies in India went up from 61% in 2002 to 73% in 2007, a gain of 12 percentage points. On the question People are better off in free markets, support went up from 62% in 2002 to 76% in 2007, a gain of 14 percentage points. Most interesting is page 20, where the fraction that believes that government has too much control has risen from 52% in 2002 to 71% in 2007 - a rise of 19%.

If you looked at the rhetoric of political parties in India, you wouldn't think that this was the way the people think. Of course, this is not quite how voters think. The Pew Institute's sampling in India has a 79% urban weightage.