Saturday, May 31, 2008

Globalisation and the nation state

Much of the present narrative tends to treat nation states that throw up high walls as the default setting. A new idea called globalisation is seen as being about breaking down barriers imposed by the nation state against the freedoms of individuals on the movement of ideas, goods, services, capital and labour. Barriers are normal, globalisation is novel. This perspective is based on looking at the post-war experience.

Nikolaus Wolf has an article European economic integration: Undoing 1914-1945 on voxeu where he looks at `the division of labour in Europe'. His main story is about the German economy, where natural economic forces produced integration with Europe (i.e. globalisation) and not within Germany. It took quite a prodigous effort for the nation state to force Germany to trade within Germany. In a larger historical perspective, globalisation is the natural state, and nation states that throw up barriers against it the temporary aberration.

The day Bear Stearns died

A great three-part story in Wall Street Journal of the death spiral of Bear Stearns: part one, part two, part three.

I'm reminded of LTCM's death spiral, the story of which is best told in Nicholas Dunbar's book. In both cases, a firm holding large positions got hit by something like a speculative attack where every counterparty in the world had an incentive to bet against it.

No credit rating agency could have possibly comprehended with the complexity of information, and the pace of events, that unfolded in the endgame. Bear Stearns was a publicly listed firm, so the stock price generated a daily estimate of the default probability (as did the CDS). Both these market-based indicators of distress worked very well. A curious little difference between Bear Stearns and LTCM: Neither of these two realtime indicators existed for LTCM.

For older material on the death of Bear Stearns, do see this blog post. While we dodged a bullet here, the world bounced back quite nicely.

"Rearrange the world to fit my constraints"

Vijay Mahajan of BASIX [link] has an article in Financial Express inspired by RBI's efforts at preventing business correspondents (BCs) from taking banking services to people who are not within 15 km of an existing bank branch. (If people are already near a bank branch, they don't need BCs!) In it, he says:

Regulatory reputation and supervisory convenience is more important to RBI than financial inclusion.

This reminded me of a sentence from the Percy Mistry report (para 20, page 195, from the recommendations chapter):

In the view of the HPEC, regulatory arrangements and architecture should be rearranged to meet the market's needs; rather than having the market rearranged in order to meet the demands of regulatory convenience.

Wednesday, May 28, 2008

New aspects of capital controls

The `Indian Corporate Law' blog links to a story in the Economic Times which says that one factor why the Bharti/MTN transaction fell apart was: India's 75% restriction on foreign ownership of telecom companies. That fits in the larger theme of India's 21st century firms hitting limitations owing to 20th century controls.

They also have a story on a possible first Indian Depository Receipt (IDR) from Standard Chartered Bank. If it comes through, that would be cool. But that's going to take quite a few changes by SEBI and RBI to the existing policy framework for IDRs (which have helped ensure zero foreign listings in India).

Tuesday, May 27, 2008

The impact of recent government measures on the edible oil industry

by Malay Makkar.

Recent events

India is one of the world's largest importers of edible oil. Soybean and palm oil account for a major share of Indian imports. India's oil consumption is roughly about 120 lakh metric tonnes (MT) of which about 70 lakh MT is imported. Of the oils imported by India, Soyabean and palm form the primary constituents, since these are produced in sufficient quantities to be exported by the US and Malaysia and hence, are relatively cheaper. Futures contracts on NCDEX and MCX had daily turnover of roughly Rs.400 crore a day and Rs.100 crore a day, respectively.

In early May 2008, soyabean oil prices were 30% higher than the level of the previous year. The government believes that futures trading has helped induce this price rise. Hence, on 7 May 2008, futures trading was suspended for soyabean oil for four months (along with this, futures on potato, chana and rubber were also banned). All existing futures contracts were liquidated at the closing price as on that date on the respective exchanges. Owing to fears that such a move was imminent, the open interest on NCDEX, MCX and NBOT in soyabean oil had already halved to 0.15 million MT. For a comparison, monthly consumption is roughly a million MT.

Using powers under the Essential Commodities Act, 1955, various state governments have imposed stock limits on the edible oil traders in their states. On 10 May, the UP government imposed an inventory ceiling of 25 MT for any trader of edible oil. Large traders who normally carried stock in excess of 250 MT are now forced to live within a tiny limit of 25 MT. Similar stock limits were also imposed by the Maharashtra Government the same week. The central government has also advised state governments to strengthen their enforcement machinery to act against `hoarding' edible oil.

How much risk does an oil importer carry?

The task of importing Soyabean and palm oil exposes the edible oil trade to fluctuations in prices occurring internationally. A fall in price of the commodity has a severe impact, since it leads to losses and lower valuations of even the existing inventory. Oil refiners in India quote a daily selling price for the oils based on the international trends. The benchmark exchanges for trade in these two oils are the Chicago Board of Trade for soya oil and the Malaysian Derivatives Exchange for palm oil. In order to derisk or hedge their future risks, importers short-sell futures contracts. Selling futures helps in assuring a constant return to the importer and removes the uncertainty that he might have faced without a similar contract.

A standard oil tanker usually ferries 30,000 MT of oil. For one such shipment, the value at risk for the importer is large. From January 2008 onwards, the standard deviation of change in daily prices of soy oil has been $44.2 per tonne of oil. In other words an importers shipment could vary in value everyday by about $1.33 million dollars a day. No importer is willing to take that big a risk; since the return on investments (if the company is lucky) is only about 1% (around $0.36 million). Thus it becomes essential for any businessman who imports edible oil to be able to lock in his future selling prices and hence assure himself of the returns. But by banning the futures products, the government has taken away this risk mitigation tool from importers. Bereft of hedging using futures, importers impose bigger markups upon the local economy, thus exacerbating inflation.

Impact of the ban

In absence of an avenue for price discovery, the entire trade channel consisting of distributors, wholesalers and retailers has lost a price signaling method. They are unable to observe market estimates of future prices. Due to this confusion, there is less long-term planning (through forward contracts) and there is more short-term cash trading. This in turn poses new problems for the business. Firstly, it increases the possibilities of stock outs occurring and forces the suppliers to frequently replenish the shelves of the retailers. Secondly, the oil refining companies are losing out since higher stocks have to be maintained in their own godowns for frequent replenishment requirements of the retailers and lesser stocks can be pushed down the supply chain. Additionally, increased transportation costs associated with repetitive distribution of small quantities of goods is expensive for the companies and reduces energy efficiency of the economy.

There are indirect effects also. Higher uncertainty has made firms involved in this trade more risky and reduced their access to borrowing. Firms are using their own capital for holding inventories which is adversely affecting new investment.

The importers are now forced to hedge their risks on foreign exchanges like Chicago and Malaysian derivatives exchanges. While this should work well in theory, in practice, there are many impediments against doing this correctly and fully owing to the system of capital controls that India has against use of offshore derivatives markets.

Indian finance professionals stand to lose since companies are reluctant to hire new traders and maintain on their rolls, since the ban has been imposed. This adversely affects the building-up of derivatives competence in India.

Due to lack of a pan India benchmark price, inter-regional arbitrage opportunities have appeared. The prices in spot markets have jumped and traders are making a killing by exploiting these informational asymmetries. Moreover, small time traders who cannot be out of business for a long time will now resort to forwards contracts (the `number 2' market that survives even though futures trading has been banned) and hence the risks in the whole system will be magnified as counter party risks will also appear. Finally, the prices will now align themselves completely to international markets. When our local crops are harvested price discovery will be difficult as the price discovery mechanism will take its signals from international exchanges.

Impact of imposition of stock limits

A short term effect will be that people will be forced to reduce their existing inventories of oil. This will please the policy makers who think hoarding is bad. But holding large inventories is essential to a well functioning trade. With lower stocks the overall business will go down and shortages will appear in a few months. Lower business volumes also imply loss in income for all the people involved in the process - the refiners, brokers, distributors (and lower tax revenues for the government). In order to circumvent the state wise stock limits oil companies will be forced to open oil depots in states which do not have stock limits. And then oil will be routed to other states through them.

Another way to circumvent the system is by opening a large number of firms by the same individual. For example a distributor earlier maintaining stocks of about 250 Tons on any given day will now open 10 firms in his name thereby fulfilling the condition of 25 Tons per firms stock limit also but maintaining his usual oil stock also. All this will simply lead to more corruption in the system; it constitutes a bias in favour of less ethical companies.

Government import of edible oils

The government has floated tenders for import of oil about 12 lakh MT of oil in the coming 12 months. By this action, the government, in one step, has replaced the private sector and emerged as the single largest importer of oil into India. This is inconsistent with the efforts in other industries in India, where the government has retreated from business into the core tasks of public goods. The decision of the government to move into this business reduces the incentives of firms to invest and build businesses.

Moreover, the imported oil will be available only to poor people through the public distribution channel but the remaining market (read the middle class) has to deal with the troubled private trade. Companies who were selling to poor people would lose market share.

It is possible that in order to lower the oil prices, the government may also release this imported oil in the markets by floating tenders in the Indian markets. In absence of clarity about the government's future policies, importers will remain unwilling to import oil. This could lead to acute difficulties in coming months.

Understanding food prices

I wrote an article in Business Standard titled Understanding food prices.

Sunday, May 25, 2008

An additional consideration in thinking about optimal currency areas

Traditionally, when we think about currency pegging, we think that if two countries are exposed to highly correlated shocks, then pegging is not a bad idea. E.g. if Austria and Germany have the same business cycle, it is not a bad idea for Austria to adopt German monetary policy. By this logic, it is a bad idea for Qatar to adopt US monetary policy.

Now suppose there are two countries which have common shocks but dissimilar per capita income and thus different CPI consumption baskets. This leads to poor correlation between the two CPI measures. Example: one is a poor country and has a high weight for food and fuel while the other is a rich country where this is not the case.

Now suppose the poor country runs a pegged exchange rate to the rich country. Even though the two countries have common shocks, the inflation process in the poor country will be different when compared with the rich country. A monetary policy that delivers low and stable inflation in the rich country will fail to do this for the poor country even if the two countries have common macroeconomic shocks. The rich country will achieve the frontier in terms of low output gaps with a low and stable inflation rate, but the same would not be the case with the poor country.

By this logic, if Canada and Mexico have similar correlations with the US business cycle, it's less sensible for Mexico to adopt US monetary policy. By this logic, there are two strikes against India adopting US monetary policy by running a pegged rupee-dollar rate: Neither are the shocks common nor are the CPI baskets alike.

Differences in CPI baskets have another interesting implication. If one measures competitiveness by using the REER, but with CPIs that have very different weights, one could come to potentially odd conclusions. Even if PPP holds perfectly, CPIs with different weights can diverge. One country will show a loss of competitiveness, even though by definition competitiveness hasn't changed at all.

Saturday, May 24, 2008

What 3G protocols in India?

A few days ago, I wrote a blog post A new low in Indian telecom policy on the lack of 3G services in India. It looks like this is perhaps a few months away. The question of standards remains [link]. Will the 3G services envisaged in India speak HSPA and `Evolved HSPA'?

Dhiraj Nayyar has a good article in Financial Express on satisfying both sides of the 3G debate.

Right now, I'm in Colombo, Sri Lanka, and a telecom vendor (Dialog) is advertising global roaming with "3.5G" HSPA with peak speed of 14.4 Mb/s!

Understanding the inflation in emerging markets

A lot is said about inflation being a global problem today. But when you glance at the front page of the Bank of England website, they report CPI inflation of 3% as compared with an inflation target of 2%. This is not so bad when compared with the 8% inflation that we see in India and China. The Economist has a good article interpreting the bad inflation that has sprung up in third world countries. Their main argument is that these countries are making the same mistakes in monetary policy formulation which gave high inflation in industrial countries in the 1970s. Economists in industrial countries, and then central banks in industrial countries, digested the lessons of these experiences, but this learning did not happen in (say) India.

One simple way to see how monetary policy has gone wrong is the `Taylor principle'. When there is a 100 bps rise in inflationary expectations, if the policy rate does not rise by atleast 100 bps, then the real rate goes down. Under such a monetary policy regime, positive inflation shocks are expansionary (and vice versa). Monetary policy is destabilising. This is a key channel through which a central bank which is not primarily focused on inflation ends up exacerbating the business cycle.

To review the recent Indian experience, yoy CPI inflation was 5.5% and WPI inflation was 4% in late 2007. Both have accelerated by 200-300 bps. But the short rate has not budged. In other words, the real rate has gone down by 200-300 bps. This violates the Taylor principle: when combating inflation, you surely do not want the real rate to drop sharply.

You might like to read this on the Taylor Principle.

Friday, May 23, 2008

Paper: "Managing capital flows: The case of India"

From 2007 onwards, ADB Institute has been running a project titled Managing Capital Flows: Search for a Framework. They have a website on which there are all the papers. Ila Patnaik and I did the India paper in this project, which is here.

Wednesday, May 21, 2008

A new low for Indian telecom policy

It looks like the 3G iPhone will be launched in a few weeks. But if you live in India, you won't be able to get an unlocked version, since there is no 3G in India. Is there enough clarity on standards that a 3G iPhone will work with service providers all over the world? Or do we have the potential difficulty that there will be incompatibilities across countries?

Big, fast and unstable

A few weeks ago, I wrote an opinion piece in The Australian titled Big, fast and unstable, describing the problems of stabilising the business cycle in India and China. While on this subject, you might like to read this article.

Tuesday, May 20, 2008

For young people in India seeking good knowledge of finance

If you're a young person in India, and desire to genuinely know finance, and the NSE NCFM F&O exam was too easy, you should do the GARP FRM examination. Studying for this exam, and winning at it, gets you close to a good finance education.

Sunday, May 18, 2008

What now, finance?

Now that the global financial disturbances of 2007 and 2008 seem to be subsiding, it's interesting to take stock of where we stand, what we have learned, and where we go from here. I was personally unimpressed by many writers in the Financial Times who, I feel, lost their heads in 2007 and 2008. The Economist has a section in the latest issue which impressed me with interesting insights and clear thinking. There is a main piece, and then there are these nice articles in it:

While on this subject, see Short-Run Pain, Long-Run Gain: Financial Liberalization and Stock Market Cycles by Graciela Kaminsky and Sergio Schmukler; their abstract says: The views on financial liberalization are quite conflictive. Many argue that it triggers financial bubbles and crises. Others claim that financial liberalization allows markets to function properly and capital to move to its most profitable destination. The empirical evidence on these effects is not robust. This paper constructs a new comprehensive chronology of financial liberalization and shows that a key reason for the inconclusive evidence is that the effects of liberalization are time-varying. Financial liberalization is followed by large booms and busts only in the short run. In the long run institutions improve and financial markets tend to stabilize.

Measurement of LIBOR

The problem

In recent months, concerns have been expressed about LIBOR. Jayanth Varma's blog post on the subject reports on these issues. On 16 April, the British Bankers Association (BBA) announced that banks giving bad quotations will be banned from participation in the calculation of LIBOR. Immediately after that, LIBOR rose by 18 basis points.

BBA is believed to be reviewing the LIBOR methodology and is expected to come out with a report later this month. ICAP is believed to be launching a New York Funding Rate, as a response to the difficulties of LIBOR.

The statistical methodology that is employed for LIBOR could be a source of trouble.

Suppose there are N observations. There are two polar extremes in obtaining a location estimator: to compute the sample mean and to compute the sample median. The mean is statistically efficient, but vulnerable to outliers. The median is robust, but statistically inefficient.

For the longest time, LIBOR has used the strategy of deleting the two most extreme observations. Think of this as being mostly like the mean, with some safety thrown in. (Recall that if you deleted N/2 extreme observations, you'd be at the median).

This method has doubtless worked well for a long time. But the tradeoffs that determine how many observations should be deleted are not static. They depend on market conditions.

In an illiquid and volatile market, the dispersion of quotes is high and everyone is uncertain about what the true price is. (For an example: think of a typical illiquid product in India). For years and years, the strategy of deleting 2 for LIBOR worked well - under normal market conditions. That same strategy is unlikely to be optimal under stressed market conditions. The mistrust of LIBOR under stressed market conditions, that I am seeing out there, sounds a lot like the mistrust that I have seen with such polling-based reference rates in illiquid and volatile markets in India.

One element of a solution

Roughly a decade ago, J. Cita and D. Lien proposed that instead of fixed trimming procedures, `adaptive' trimming could be done. In a nutshell, their idea was: Use bootstrap inference to know the standard deviation of the estimated location estimator for a few alternative trimming schemes. Then pick the `best' trimming by examining these standard deviations.

The neat thing about this scheme is that when the market is liquid and tranquil, trimming can go down, but more trimming will kick in when market conditions change.

This strategy has been used in India for NSE's `MIBOR' reference rate, and for the commodity spot prices polled by CMIE for NCDEX. All these markets are much more troublesome than the situation faced for LIBOR for a long time - but perhaps more like the situation seen with LIBOR under stressed markets.

At this page is (a) a paper, (b) a frequently asked questions and (c) full R source code.

Gyntelberg & Woolridge, 2008

Jayanth Varma points to the paper Interbank rate fixings during the recent turmoil by Jacob Gyntelberg and Philip Woolridge of BIS. In it, they say:

To test the robustness of trimming procedures, we re-estimated the mean of the US dollar, euro and yen Libor panels using a bootstrap technique. This technique minimises the influence of non-random observations and outliers on the mean without disregarding any quotes (Efron and Tibshirani (1994)). The bootstrapped mean is not significantly different from Libor for any of the panels considered.

This I do not understand. We use bootstrap inference to compute the distribution of an estimator of interest (e.g. a mean, a median, a fixed trimmed mean, or an adaptive trimmed mean). Bootstrapping is not an alternative strategy for constructing estimators.

Gyntelberg & Woolridge feel that estimation procedures are not an important issue, and they may well be right. Estimation procedures may well not be of importance in the recent criticisms of LIBOR. However, the above text makes me feel the adaptive trimmed mean was probably not evaluated. If all they have done is bootstrap inference of the fixed-trim-by-2 procedure, that is not the core issue. The core issue is to question trimming by 2 as a fixed rule that is appropriate for all kinds of market environments.

As argued above, a fixed-trim-by-2 procedure that works well for many years of tranquil times might not be such a good engineering approximation in the unique market stress which was observed lately. It's an empirical question, and one that would be settled by applying the adaptive trimmed mean to the BBA database in recent times.

A small correction for them: On page 62, in the table showing reference rates in various countries, the Indian Mibor is not just a `trimmed mean', it is an `adaptive trimmed mean'.

Larger links to physical settlement and cash settlement

This discussion is linked to the efforts that product designers make in choosing cash settled vs. physically settled derivatives. Some documents written by government agencies in India say fanciful things about cash settlement. They reflect a lack of knowledge of derivatives. The correct arguments are as follows.

Whenever good quality measurement of a reference rate is possible, cash settlement is always superior. A small reason for this is that settlement of money is cheaper than settlement of the underlying. The deeper reason is that physical settlement is much more vulnerable to short squeezes, so position limits for physically settled contracts tend to be lower there, which imposes a cost on society of a missing market when the position limits are reached.

When the underlying is traded on an electronic exchange, there is no difficulty in obtaining a top quality reference rate, for the best buy and best sell prices in the entire market are visible off the limit order book. But when the underlying is an OTC market, you are down to polling in making a reference rate. For these underlyings, it boils down to the question : How bad is the problem of a short squeeze and a small cap on the open interest? versus How bad is the problem of measurement of the spot price? In most Indian settings, I have felt that it's cheaper to put time and money into improving measurement on the spot market, rather than running afoul of a short squeeze or reducing the limits on open positions sharply.

Saturday, May 17, 2008

Trivia question: What central bank speech is this from?

Which central bank staffperson said:

1.15 As Monetary Authorities, we have been humbled and have taken heart in the realization that some leading Central Banks, including those in the USA and the UK, are now not just talking of, but also actually implementing flexible and pragmatic central bank support programmes where these are deemed necessary in their National interests.

1.16 That is precisely the path that we began over 4 years ago in pursuit of our own national interest and we have not wavered on that critical path despite the untold misunderstanding, ...

1.17 Yet there are telling examples of the path we have taken from key economies around the world. For instance, when the USA economy was recently confronted by the devastating effects of Hurricanes Katrina and Rita, as well as the Iraq war, their Central Bank stepped in and injected life-boat schemes in the form of billions of dollars that were printed and pumped into the American economy.

1.18 A few months ago, the USA economy confronted a severe mortgage crisis, which threatened to spark an economy-wide recession.

1.19 The USA Central Bank again responded by injecting over US $160 billion between December, 2007 and March, 2008, to provide impetus to the American economy and prevent a worse crisis from happening....

... we had our near-bank failures a few years ago and we responded by providing the affected Banks with (funds)... for which we were heavily criticized even by some multi-lateral institutions who today are silent when the Central Banks of UK and USA are going the same way and doing the same thing under very similar circumstances...

1.26 As Monetary Authorities, we commend those of our peers, the world over, who have now seen the light on the need for the adoption of flexible and practical interventions and support to key sectors of the economy when faced with unusual circumstances.

When I first read it, I scratched my head and thought : this writing is too clear for it to be an RBI speech. Here's the answer.

Paying the price of ignorance

by Percy Mistry. This appeared in Business Standard today.

Reading India's pink papers suggests incontrovertibly that the country is paying a high price for pervasive ignorance: i.e. the innate beliefs/prejudices of: (a) its political and administrative class; as well as (b) an uninformed public brought up on a diet of propagandised falsehoods for over six decades. Those beliefs are a deadweight drag on continuing with reform. What are these beliefs? What are their practical implications? There are far too many of both to adumbrate exhaustively here. But lets stick to the topical and illustrative.

Typical False Beliefs: A mixed economy with large-scale state intervention is in the interests (for growth and equity) of as ethnically diverse, poor and inequitable a country as India. Nehruvian socialism rather than a free-market economy is the right model to follow. Prices are guided better by bureaucrats than by markets. Price subsidies are quintessential to make basic commodities affordable for the common man. Government has a natural duty to control prices because markets get them wrong. Consumers in India have a basic right to be protected against the laws of global supply/demand and against droughts/floods and climate change. State intervention in the economy works in the interests of the dispossessed; it ensures greater access, equality and opportunity. [If so, why has it not delivered for 60 years?]

Markets (proven to work better than any other model all over the world) are suspect for India. They work to private not public advantage and that of the rich. Sophisticated market instruments are also suspect. They increase systemic risk. Sarcastically condemning bright young people, who know far more than former CEAs do, averts systemic risk!! Closing the capital account will enable us to deal with India's openness and integration with the world economy! STT and CTT will make securities and commodities markets less volatile, work better and more fairly. Manipulating exchange rates through RBI fiat will help us control better our internal and external account imbalances. It will enable us to grow our exports, contain imports and manage inflation more efficiently than letting markets work!

Price subsidies and controls in a distorted domestic market will relieve global food/oil commodity shortages. It will enable better management of demand, supply and market equilibration. State intervention is the answer to questions no has asked, and to market failure. State failure -- which we now have over 60 rich years experience of -- is not worth examining forensically. Politicians are the right self-appointed guardians of our culture and morality (though we did not elect them to do that; instead we elected them to do things that they are busy avoiding -- like governing properly!)

Their Implications: Too large an embedded role for the state in the economy as an enterprise owner and manager, as well as regulator/referee. This leads to profound conflicts of interest, structural inbuilt inefficiencies, and an economy riddled with perverse incentives. The result: chronic and endemic fiscal incontinence at every level of government. Yet central and state governments are unable to undertake basic asset/liability management (i.e. sell public assets and reduce public liabilities) appropriately in the public interest. The present government acts like the proverbial rat trapped in a maze of its own construction from which it cannot exit by application of reason! Bureaucrats (like former chief economic advisers) have thus become prescient, omniscient and totally knowledge proof. Obviously, they managed the past so well that no one else is capable of managing the present and future; they are particularly allergic to analysts who strip their arguments bare and show them to be absurd.

Too large a public debt and debt-servicing burden at all levels of government. That pre-empts government from acting in the interests of the poor. A runaway price subsidy budget (for energy, food, fertiliser etc.) which is financed off-budget (through things like oil bonds) that favours the rich and middle classes but penalises the poor. A GoI-RBI dominated financial system pivoting around state-owned banks (ostensibly to protect the deposits of the poor) that is deliberately retarded and kept primitive. Apparently, primitivism protects India from financial crises. Hence proper insurance, risk management, and derivatives markets are not allowed to develop. Banning futures markets is believed to reduce commodity prices! That is like the Aztec belief that daily blood sacrifice is necessary for the sun to rise every morning! Banning P-Notes and closing the capital account will safeguard India's financial integrity!!

The perverse reasoning applied by our `leaders' has prevented India from having: proper overall economic and financial management, proper internal and external account management, public debt and asset/liability management, proper sovereign, sub-sovereign and corporate debt markets, derivative markets, micro-finance markets, commodity markets as well as simple instruments like interest rate and currency futures for the last 20 years! Instead we have a continuing legacy of belief in state ownership that palpably does not work (and we use terms like navratnas to justify it) when we have more than enough post-1992 reform evidence to confirm that what the state really ought to do is get out of the way, and stick to improving competition through more privatisation and better regulation.

The belief prevails that attempting to manage risk will exacerbate it because the tools involved are double-edged. To be sure a sharp knife can be used to murder people. So should it be banned? We could always cut onions with our fingers, toes or teeth! That is the practical equivalent of what we are doing now in the world of Indian finance. If the thermometer gives you a reading you don't like (like prices being signalled by futures markets) then break or discard it! Adhering to counterproductive beliefs in pervasive state ownership and intervention, as we try to transit to a market-based economy, is like shooting ourselves in both feet as we prepare to run the middle third of our national marathon toward developed economy status. But our leaders and former functionnaires think otherwise.

They believe in a unique Indian heterodoxy for its own sake, confident in the knowledge that India is so different from any other country that general principles that apply everywhere else do not apply in India. Everywhere (including China) is different! Our policy-makers believe that using the prefix `development' converts bad economics into good. They cannot see that the post-independence formula of `meddle-and-muddle' -- e.g. with fiscal, monetary, inflation and exchange rate mismanagement -- is disabling India from progressing further, faster. They cannot see that India will not achieve its aspirations nor cross the thresholds it confronts -- from mediocrity to greatness, from low to middle-income, from backward to progressive, from poverty-ridden to poverty-free, etc. -- if it keeps indulging in the contradictions of the past.

The dilemma boils down to a chronic inability on the part of India's leaders, indoctrinated in socialism, to understand the contours of the present, accept markets, and gird for the future. Goaded by commentaries of retired CEAs and RBI executives also living in the past, but unfamiliar with the problems of today (or of how similar problems are addressed elsewhere) the counterproductive beliefs of our ignorant leaders is bolstered. There seems to be a fundamental reluctance to accept a self-evident (inconvenient?) truth in 21st century India: i.e. that the socialist mixed-economy paradigm they have grown up with is bankrupt. It does not work. It never did; not at macro, meso or micro levels. It was rooted in bad theory and good intention -- the same combination and dynamic that paved the road to hell.

With India's inexorable move to a market economy, that old paradigm is dysfunctional. Its inherent intellectual contradictions need to be openly recognised and decisively discarded. It does nothing for the poor except impoverish them more. It does little for the middle class but block it from making faster progress. It may do something for the very rich. They can still buy and manipulate the political class to serve their own ends and share the ill-gotten gains of unfairly achieved mutual enrichment; as is now happening in India's property markets. What the present system does is empower those who should be disempowered; i.e. leaders who control large swathes of the economy through public ownership. That arabesque makes it possible for damaging opacity and economic inefficiency/malpractice to continue unabated.

The agenda that India confronts for continued reform is so deep, so wide and so urgent that we cannot afford to keep going round in lazy circles wasting time with useless argument that gets us nowhere. We cannot keep using the excuse that our democracy perforce requires us to waste time in this fashion. India needs much deeper structural reform of: its economy, its financial system, its political system (which respects democracy more in form than in substance) and its judicial system (which has no respect for the concept of justice at all). Indeed the latter two systems are now acutely embarrassing to a country of India's growing stature. Six months before the next elections it should be obvious to everyone that we need to cut through the crap and get on with reality. That's what elections should be about. But we are unlikely to focus on reality or on a proper agenda for elections unless we discard our false beliefs, relieve our self-inflicted ignorance, take our blinkers off, and realise that we have to run a race in competition with the rest of the world -- much of which is not handicapped by the same dangerously dysfunctional ignorance that we seem to so enjoy revelling in.

The crowded Indian print media business

Knowledge @ Wharton has a good article on the Indian print media industry. Here is CMIE data on the firms and the industry for the `Media - print' industry - this has things like the `market shares' statement. I found it fascinating that there are now six listed companies out there in this field, with industry market capitalisation of roughly Rs.100 billion, of which three firms are above $0.5 billion of market capitalisation (Deccan Chronicle, HT, Jagran Prakashan). This suggests there are now clear `listed peers' in place, which should help focus entry strategies for newcomers and the going-public decision for incumbents. While the Knowledge @ Wharton article depicts a spate of entry taking place, the (trailing 4-q) industry P/E is 18.2, suggesting that the market's outlook for earnings growth is not particularly high by Indian standards. Then why is so much entry taking place? Update: On 20 May, the New York Times carried a story Newspapers on upswing in developing markets by Heather Timmons.

Thursday, May 15, 2008

The pitfalls of an Indian Sovereign Wealth Fund

For the people manning the existing monetary policy regime, a Sovereign Wealth Fund is attractive because it alleviates one criticism: the cost of holding gigantic reserves. It helps RBI to delay RBI reform; to perpetuate the monetary policy regime of a pegged exchange rate for a wee bit longer. While this perspective is convenient for RBI, it ignores the difficulties of actually running a Sovereign Wealth Fund in India.

In Economic Times today, there is a story:

The government on Thursday wished the country's top mobile operator Bharti Airtel success in its pursuit to acquire South African telecom company MTN, while assuring other private companies of extending a helping hand in overseas buyouts.

Making it clear that there is no need to involve the government when private companies pursue deals among themselves, Minister of State for IT and Telecom Jyotiraditya Scindia said, "If the need arises and the companies ask for help, then the government can consider helping companies".

Scindia was replying to query if the government would back Bharti's move to acquire South African operator MTN, which has operations in 20 countries.

Earlier, the government had provided support to India- born businessmen L N Mittal during his company's takeover of Luxembourg-based steel maker Arcelor. The Indian government had lobbied with French authorities during the takeover.

This made me quite concerned. If an Indian SWF existed, would this mean that the Indian State would support overseas takeover attempts by Indian firms? How would the State pick which firms should be supported and which should not? Is there a possibility that there could be a variety of murky deals that are worked out in smoke filled rooms where politicians ask for a quid pro quo? And, is this all not a huge distraction for the incredibly overstretched Indian State from the core business of delivering public goods? A Sovereign Wealth Fund might be convenient for RBI but it is a bad idea when juxtaposed against the low standards of governance in India.

While on the subject of Sovereign Wealth Funds, see this.

A tale of two countries

Marian Tupy has an article telling the story of Botswana and Zimbabwe. Both countries started out similar.

Botswana went from $700 to $10,000 of per capita GDP over 40 years. This was done through a strategy of `a limited government and one of the freest economies in Africa. (In its 2007 Economic Freedom of the World report, Canada’s Fraser Institute ranked Botswana’s economic freedom on par with that of Belgium and Portugal).'

Zimbabwe pulled off the first hyperinflation of the 21st century, getting to an exchange rate of 1 USD to 200 million Zimbabwean dollars. They just launched a 500 million dollar bill (I wasn't able to find an image of this - please email me a good scan of one if you have one!).

Let's hope more countries do policies more like Botswana and less like Zimbabwe. On this subject, you might like to see The return of the idiot.

Sunday, May 11, 2008


The US FRED system has monthly data for imports by the US from China. The graph above shows year-on-year growth rates. NBER-defined recessions are superposed as shaded bars. Click on the graph to see it more clearly; here's the original source.

In all the three past recessions, one sees a substantial slowdown of imports by the US from China.

We don't yet know whether NBER will call this episode a recession, but the year-on-year growth of US imports from China has already gone to zero. Further, over this one year, the USD dropped by 10% (as measured by the US major currencies index). So effectively, there was a 10% drop in Chinese exports to the US over the last one year. Ouch! Another critical question is the depth and severity of this recession (in the event that it proves to be one). It could well be worse than the last two recessions.

I wonder what is happening to US imports from India. In China's case, the bulk of US imports from China are merchandise, so customs-based information works. In India's case, while data for merchandise exports to the US is available, this is an incomplete picture because a good chunk of India's exports to the US are services.

What happened to global food prices?

Before we get to the arguments, here's a picture with the key facts from Martin Wolf's recent FT column on the subject:

Explanations that don't persuade

Hypothesis: The spike in world food prices is caused by increased demand in China and India, particularly the shift towards consumption of meat as people get richer. My problem with this explanation is that it doesn't explain why the price index for major food crops was stable at 100 from 1990 till 2005, and spiked thereafter. China and India had a massive transformation of incomes and the structure of the food basket from 1990 to 2005.

Hypothesis: It's the evil speculators. Speculators who anticipated higher prices would have held more inventory. But the graph shows that inventories have dropped from 2000 onwards. There was less hoarding, not more. [Ken Rogoff]

The bulk of trading on futures markets is speculative: but for every buyer on a futures market there's an equal and opposite seller (by definition). A bigger futures open interest has no net effect on prices.

More generally, futures markets have been around for over a century and grown steadily over the 1990-2008 period: it's hard to blame them for the spike in prices starting in 2005.

Yes, there's a new phenomenon of commodity funds and hedge funds trading in commodities. But these numbers are just tiny when compared with the global agricultural trade. And if they had held a lot of inventory, it would have shown up in the inventory series above - but total global inventories went down and not up.

Hypothesis: As the world gets richer, price volatility of non-storable agricultural products gets bigger

Here's one phenomenon which could play a role in deciphering what happened. Suppose, for a moment, that a commodity is not storable. And, we know that given the lags between sowing and harvest, in the short term, a price innovation can induce no supply response. When an imbalance between supply and demand arises, prices move to clear the imbalance. How far do prices have to move? Prices have to move as much as is needed for demand to get crimped, so as to equalise supply and demand.

Now consider a product such as wheat. When there is an upward shock to the price of wheat, rich people just do not reduce their consumption. A naan or a baguette that weighs 0.1 kg has an embedded cost of wheat of USD 0.04 or Rs.1.6 (assuming wheat is at $400/MT). When an affluent person buys or makes a baguette or a naan, a very large change in the price of wheat generates no change in consumption. A 50% change in the price of wheat sounds like a lot: but it drives up the embedded wheat cost in the baguette/naan by USD 0.02 or Rs.0.8 - this would be insignificant for affluent people. Their demand is inelastic.

When demand is bigger than supply for a nonstorable commodity with zero short-term supply elasticity, prices would rise as much as is needed to close the gap. Demand can only shrink when some people get pinched and ease up on consumption. These are the poor. Poor people are the shock absorber that stabilise prices for non-storable agricultural commodities.

When potato prices went up in an Irish famine, poor people consumed more not less, because the income effect dominated. Could that happen with poor people and wheat? It is useful to think of three levels of affluence:

  • The first would akin to 19th century Ireland, with poor people primarily eating wheat, and we can get odd effects. We could get such behaviour today with the really poor. In 1985, I happened to be an honoured guest at a hamlet in Western Maharashtra. The lunch they served me was: flat bread made of coarse grain. That's it. There was nothing else, just powdered red chili for flavour.
  • The second case is a person who's rich enough to eat some meat, but would cut back on meat when it got expensive. This kind of person generates high price elasticity of demand for grain because of the 2:1 or 8:1 ratios between meat and grain, which imply that for each 1 kg of meat that he backs away from, 2 or 8 kg of grain is freed up. Hence, in the early stages of food-feed conflict, when people have started dabbling with meat but aren't yet price insensitive about it, the price elasticity of wheat demand goes up sharply.
  • The third case is a person who is rich enough to eat meat and is price insensitive about it. A buildup of more people in this third case reduces price elasticity of demand.

My story is about a world where there are very few people in the 1st case, and an increasing transition from the 2nd case to the 3rd case. GDP growth yields fewer poor people who respond to higher wheat prices by purchasing less meat or wheat, i.e. we have less of a shock absorber. That generates a reduced elasticity of demand of wheat. So prices have to rise by more in order to clear a supply-demand imbalance than was required in the past when there were more poor people who would adjust.

In the bad old days, people in China and India supplied the world with a large shock absorber, a large mass of poor people who tightened their belts when prices rose. This gave higher global demand elasticity and reduced price volatility. From the late 1970s, economic reforms in China and India have given greater affluence and thus diminished this shock absorber.

Here's a picture of the moving-window volatility (calculated using four-year windows off weekly returns) for wheat:

This does seem to show a longer term phenomenon of increasing vol.


Now let's bring in speculators and storage. Suppose commodity volatility went up in this fashion when affluence increased. This should generate increased profitability for the speculative strategy of holding inventories of food and opportunistically waiting for the next great price flare-up. Call this hoarding or call it buffer stocks: the bottom line is that large inventories stabilise prices.

The cost of holding in recent years was unusually low given the low interest rates. (As an aside, the direction of effects here runs opposite to what Jeffrey Frankel has been talking about). But the data shows that hoarding didn't go up; on the contrary inventories have dropped from 2000 onwards.

The puzzle is : why is there so little speculation? Why did speculators in 2000-2005 do so little hoarding? Hoarding would have smoothed out prices: purchases in 2000-2005 would have given higher prices then and sale in 2008 would have given lower prices today.

To buy 10 million tonnes of wheat in 2005 and hold requires a bit of capital. At USD 300/MT, this would require putting down $3 billion plus a flow of storage costs. Who were the kinds of players who were setup to evaluate such a trade? What kinds of leverage was available to them, to juice up their return on equity? I don't know enough about the field: was there an abundance of such players and did they have enough leverage?

Were we hitting limits of arbitrage? Was insufficient capital being put into these speculative strategies for some reasons that are linked up to the institutional structures of finance? I am reminded of the difficulties of uncovered interest parity (UIP) on the currency markets. The `carry trade' is an equilibriating response; it would tend to make UIP work. Perhaps too little capital is put into the carry trade relative to the massive size of the currency market, thus generating violations of UIP.

Is a similar phenomenon going on here? Perhaps the massive pools of financial capital that are able to hold large inventories (a.k.a. buffer stocks) weren't being deployed into commodities on a scale required to have inventories that are large enough to stabilise the global food market. If so, the solution would involve more capital with commodity funds and hedge funds that trade in commodities.

Putting together

Perhaps what happened was like this. There was a string of supply shocks - things like ten consecutive droughts in Australia, a small switch towards biofuels.

If these shocks were anticipated in 2000-2005, then this points to institutional failures where the financial / commodity firms were not able to galvanise themselves to do enough hoarding. Alternatively, if these shocks were not anticipated in 2000-2005, then the future outlook had to be benign, which led to a rational drawdown of inventory, i.e. low buffer stocks, in the hands of the speculators.

Prosperity had risen over the years, giving unusually inelastic demand -- the consumers of China and India who have long contributed to elasticity of global demand by tightening their belts were less poor and less willing to tighten their belts. With fewer people willing to adjust, prices had to move a lot to clear supply and demand.

What comes next

I am optimistic about what the future holds.

High prices have a way of inducing far-reaching supply responses on the medium term and long term. We have been surprised, again and again in the past, at the cleverness with which producers responded to higher prices by producing more. When the Hunt brothers tried to corner the world market for silver, they were astounded at the quantities of silver that were brought into the market by way of a response to higher prices. High prices of petroleum products increases the use of camels in transportation.

In similar fashion, high wheat prices can even make Afghan poppy farmers switch to growing wheat! Vast tracts of land in Russia and India have low yields: High prices will give incentives to entrepreneurs to find ways to use this land better. Over the coming two years, a large supply response could come about. Something big might already be afoot: an 8.2% rise in world wheat output is projected for 2008-09, and surely some of it has to do with the incentives put out by high prices.

These events seem to have helped reduce the informational and institutional gap between finance and commodities. A greater convergence between the financial world and the commodities world, through new structures such as commodity funds or hedge funds that deal in commodities, would bring resources commensurate with the size of these markets into play. You choose whether you want to call this stabilisation, hoarding, speculation or buffer stocks.

Friday, May 09, 2008

Bharti Airtel proposes purchase of MTN

Bharti Airtel Ltd. is trying to buy MTN, the biggest mobile phone company in Africa. If the transaction works, at $19 billion, it would be the biggest transaction in outbound FDI from India so far. Bharti's market capitalisation on 9th was Rs.1.6 trillion or $40 billion. News of 8th, 9th. In 2006-07, Bharti Airtel had foreign assets which were just 0.07% of total assets. If this transaction comes through, it would be a huge jump into being a multinational firm. As with other large transactions such as the Tata Steel - Corus buyout, a great deal of international financial services are required for such events, and Indian financial firms are prohibited from producing these.

See the story in The Economist. The two papers mentioned in the story were both in the Internationalisation of firms session at the 2nd Research Meeting of the NIPFP-DEA Research Program on Capital Flows and their Consequences.

In the analytical framework employed in Graduating to globalisation by Dilek Demirbas, Ila Patnaik and myself [paper] [slideshow], telecom services are not tradeable and hence the progression from first learning to export (termed "DX") and then learning to do exporting and outbound FDI (termed "DXI") can't come about. (In 2006-07, Bharti Airtel shows exports of Rs.1335 crore. That's the net settlement between Airtel customers calling outside the country vs. foreigners calling Airtel customers. Apart from this, telecom is a non-tradeable: it's not possible for a telecom company in India to offer telecom services in Africa).

If a firm has high productivity, it can jump from being purely domestic (termed "D") to doing outbound FDI (termed "DI"). A firm which is unable to export but jumps to outbound FDI is a high productivity firm that knows how to rearrange labour and capital - in faraway countries - to produce cheaper than local firms there. That sounds like a good description of good Indian telecom companies.

The story that Ashok Jhunjhunwala tells is as follows. Roughly a decade ago, the standard engineering solutions that came from international telecom vendors induced prices for mobile telephony like USD 0.1 per minute. In India, there was a unique bulge of customers who were only available at lower prices. This market reality, coupled with competitive pressure, prompted Indian mobile phone vendors to resort to an array of hardware and software innovations which have induced the lowest cost of mobile telephony in the world.

These skills are transportable: a firm like Bharti Airtel which knows how to produce at very low prices in India can rearrange labour and capital in faraway countries to produce better than local firms there. The biggest telecom firm in Africa - also a place with a bulge of consumers who are very sensitive to prices - sounds like a good place to make such a play.

While Bharti Airtel isn't a particularly internationalised firm in terms of exporting, it has highly internationalised liabilities. The ownership pattern in March 2008 shows 20.57% in the hands of foreign `promoters' (i.e. insiders) and 25% in the hands of FIIs. Thus, 46% of the ownership of the firm is by foreigners. As with the typical large Indian firm, debt financing is not important: total borrowings are just Rs.5,310 crore compared with market capitalisation of Rs.160,000 crore. The internationalisation of liabilities is concentrated in equity financing.

Services-led growth in India

Many economists bemoan India's strength in producing services and weaknesses in producing goods. It is argued that the only trajectory of development is one where a country graduates from agriculture to industry to services.

Stephen Broadberry and Bishnupriya Gupta of the University of Warwick have a fascinating piece on voxeu on this, where they point out that India's strengths in services production go back to the late 19th century. Based on an analysis of data over 1870-2000, they say:

Only in services has there been an improvement in comparative India/UK labour productivity, from around 15% in the late nineteenth century to around 30% by the end of the twentieth century. Services have thus played a positive role in Indias productivity performance throughout the period, limiting Indian relative decline before 1870 and leading the process of catching-up from the 1970s.


...Indias service-led development may be a strength rather than a weakness. The emphasis on manufacturing as the key sector for growth and the neglect of services has now largely disappeared in the analysis of economic performance in the developed world, but continues to hold sway in the analysis of developing countries.

If India had some innate advantages in services production to start with, then it was the greatest windfall imaginable for India when, in the 1990s, many services went from being non-tradeable to being tradeable. This then gave a growth acceleration, a shift in resource allocation towards producing these services and hence away from some other sectors, a real appreciation of the exchange rate, etc.

I see the `goods illusion' as only one of the many holy cows that the Indian economic discourse clings to, which have largely disappeared in the economic performance in the developed world, but continue to hold sway in the analysis of developing countries.

Thursday, May 08, 2008

Watching markets work: tender coconuts

Rajesh Gajra has an article in Business World about the business of growing, transporting and selling tender coconuts across a supply chain that spans more than 1000 kilometers and contains no large firms. One fascinating element of this is the markup from roughly Rs.3.5 per coconut at the farm gate to Rs.15 per coconut in the hands of the customer.

1970s vintage inflation control

Yesterday, I wrote about 1970s vintage monetary economics breeding 1970s vintage inflation control. Today I read that FMC has banned futures trading in four products for four months.

Wednesday, May 07, 2008

Losing the plot on inflation

Another credit policy announcement, another reminder of how badly this is being done. As Ila Patnaik says:

On a broader note, the RBI continues to disappoint as usual, in failing to make any progress on improving transparency or communication with the market. A 2 to 4 page concise and clear policy statement that cuts down on excessive detail and focusses on the challanges and difficulties before the RBI, the options it had and the choices it made, would have been very welcome. Instead, what one got was a massive 79 page long winded excessively detailed report that misses the woods for the trees. Now, even after the credit policy announcement, the market is still left guessing and is no wiser about what the RBI wishes to do next.

In its 79 page long policy statement Governor Reddy fails to clearly point out the conflicting objectives on inflation, growth and rupee management and instead, appears to suggest that all these are being effectively dealt with by the RBI. The huge increase in liquidity that has resulted from RBI's interevention in forex markets in its attempt to peg the rupee to a weakening dollar are hidden away in terms like "sizable accretions" to the Reserve Bank's foreign exchange assets. The report does not discuss why the net issuance during the year of MSS bonds of Rs.1,05,691 crore during 2007-08 has proved to be inadequate to contain liquidity growth. It fails to clearly articulate why, instead of more open market operations the RBI has chosen to hike the CRR. While there is a lot of discussion about global liqudity conditions, there is no clarity on the impact it has had on interest differentials with India, on RBI's responses in terms of capital controls, on the effectiveness of capital controls and ECB and PN restrictions. In other words, there is excessive details on things that do not matter, and little clear discussion on those that do. This is consistent with RBI's past policy of not being transparent or giving clear signals to the market to allow their expectations to be shaped. It is consistent with the RBI's belief that monetary policy is effective when the central bank surprises the market.


For almost five years the RBI appears to be hoping that the problem would go away on its own. That is, the pressure on the rupee to appreciate would go away and RBI would be left to be the monetary policy authority and the banking supervisor in peace. The policy of sterilised intervention that it has followed for more than five years now suggests that it sees capital inflows as a short term phenomenon which are addressed by a short term solution. This policy is now showing cracks but unfortunately this credit policy too was a lost opportunity when this issue could have been addressed transparently and decisively.

I wrote a piece in today's Business Standard on deciphering the bad inflationary spiral that we find ourselves in, and the worse actions that the government is taking in trying to do something about it. This is the price we pay for inaction on monetary policy reform.

Anders Aslund has an article Ukraine's dollar addiction on Project Syndicate. I was quite surprised at how much of this story resonated for us in India. Writing in Indian Express yesterday, Ila Patnaik points out that right from the early 1990s, exchange rate pegging has given bad monetary policy. On that subject, see this.

Confidence is back

The figure shows the movement of VIX and the S&P 500 (adjusted for fluctuations of the USD) in recent weeks. The vertical yellow line is 17th of March. Click on the figure to see it more clearly. We see a sharp outburst of fear and then it rapidly subsided. I'm feeling fairly pleased with myself about an article that I wrote on 18th afternoon in Indian time (i.e. early morning of 18th in the US); a "long S&P + long dollar + short VIX" position from that date would have worked quite nicely. Also see the associated blog entry, and this synthesis of analysis of the disturbances of 2007 and 2008.

Using a dataset from 1/1990 till yesterday, the overall average value for VIX is 19.07. We are now at 18.21. So I guess we're pretty much back to the unconditional mean.

Sunday, May 04, 2008

What value does a university add?

In judging what a university does to a student, a key problem lies in distinguishing differences in raw material vs. differences in training. Do IIT graduates do well because they were smart to start with, or because they learned something at IIT? The resources being expended by society on universities are misplaced if the universities aren't adding value. Michael Spence showed us the value of signaling in the labour market in 1973: it may be rational to employ IIT grads even if the university teaches them nothing.

It's possible to get stuck in an equilibrium where employers value a university because it attracts bright entrants, and the university attracts smart people because this is a good signal on the labour market. The university can then be a prodigal waste of resources, that doesn't add value to students, but the situation can be an equilibrium.

How does one break out of these situations? If there was a strong signalling value to getting through the CAT, but ISB taught me more than IIM, then I could put my CAT rank on my resume, and go on to study at ISB instead. This gives me the best of both worlds: the signalling value of the CAT coupled with the education of ISB.

David Friedman has a blog post in which he shows a situation where a small change in policy design can possibly obtain a big impact on the way the world works. His setting is law schools in the US. The innate ability of students is measured using the LSAT examination, and then they try to go to various law schools. But all this is a means to an end: The end is winning at the bar examination.

One proposal to measure the value of the school, which is at a proposal stage, is to require the school to disclose bar passage rates. Think of this as asking coaching classes to reveal the fraction of their kids that get into IIT.

David Friedman rightly points out that bar passage rates depend on a combination of the raw ability of students and characteristics of the school. This problem is easily solved: ask schools to disclose bar passage rates as a function of LSAT scores. This way, if I have a given LSAT score, I can shop amongst schools that give me the maximum bang for the buck in terms of bar passage rates at my LSAT score.

This is a rare situation which affords such a neat solution. In most situations, it is much harder to disentangle the raw ability of the student and the contribution (or lack thereof) of the school. I wonder if there are other such situations where clear measurement is possible.

More generally, I think that the conventional university (e.g. MIT or IIT) reflects a bundle of services that may have been appropriate in a different age. It is important to rethink this bundle from first principles, reflecting the way new technologies are making it possible to rearrange information and incentives. As an example, I'm fairly convinced that we should shift away from each university having its own lectures, just as we have shifted away from each teacher having his own lecture notes.

Saturday, May 03, 2008

Cost of holding excessive reserves in India

Abhijit Sen Gupta has a paper with this abstract: Most of the existing literature has used single reserve adequacy measures to evaluate the volume of excess reserves. In this paper, we employ empirical methods to generate a comprehensive reserve adequacy measure, incorporating the various objectives of holding reserves, and compare the actual reserve accumulation experience of various emerging markets with the prediction of our empirical model. Using this comprehensive reserve adequacy measure, we calculate the cost of holding excess reserves for India by looking at three different alternative uses of resources. We find that India is foregoing as much as 2% of its GDP by accumulating reserves instead of employing resources in alternative uses.