Thursday, March 29, 2012

FSLRC has a website

The Financial Sector Legislative Reforms Commission is one of the important elements of economic reforms in India. It now has a website.

Justice Srikrishna and Chirag Anand at the inaugural

NIPFP-DEA Research Program: third MOU going out till 2014

From August 2007 onwards, the Department of Economic Affairs (DEA) of the Ministry of Finance (MoF) has collaborated with NIPFP on a new kind of research arrangement titled the `NIPFP-DEA Research Program'. This institutional innovation induces capacity building in the fields of macroeconomics and finance at the Macro/Finance Group of NIPFP, original academic and policy papers in these fields which are released into the public domain, and policy advice in these fields for DEA.

Earlier this month, the third MOU was signed for the NIPFP DEA Research Program, thus carrying this working arrangement forward till March 2014.

R. Gopalan, Thomas Mathew, M. Govinda Rao and Manoj Govil at the signing ceremony

Sunday, March 25, 2012

Interesting readings

The new Indian journalism: Vinod K. Jose in Caravan magazine profiles Narendra Modi.

Bibek Debroy on the prospects for the CPI(M) in West Bengal.

Ronald U. Mendoza has an article on voxEU which should ideally trigger off similar research by political scientists in India, about politics as a family business.

A caucasus wedding, by an unnamed US foreign service person. This is fascinating reading from two points of view. First, I'd love to get the Wikileaks report about the same wedding filed by the corresponding Indian diplomat. I fear our guys are just not in the same league in terms of the quality of despatches. And, there was something eerie in this story: it reminded me of the socially backward subset of India.

Trampling on the individual in India: A response by Suw Charman-Anderson, on Firstpost, to Kapil Sibal's dreams of tracking the location of every resident of India. A country where the government knows less about citizens is likely to be a country with greater de facto freedom of speech
Learning how to argue, an interview with Ran Yunfei by Ian Johnson in the New York Review of Books. It's an interesting glimpse into China. It's also relevant for India as we face a series of attacks upon freedom of speech.

Haseeb Drabu in Mint worries about the record 25 amendments found in the Finance Bill that apply with retrospective effect.

Mobis Philipose on SEBI's concerns about algorithmic trading.

The Kingfisher bankruptcy is helping us think more clearly about the problems of failure of firms. I read a remarkable blog post about it. And, see a debate between Vikas Bajaj and Heather Timmons on the New York Times blogs.

Open DataCamp 2012, in Bangalore on 24 March.

The public and its problems by Raghuram Rajan, in Mint.

How to help the Syrians by Hugo Dixon. He talks about Why civil resistance works by Erica Chenoweth and Maria Stephan. This is a paper and a book. Put together, these give you fresh insights into India's path to independance.

Glowing pork, exploding watermelons by Thomas N. Thompson, in Foreign Affairs, on the problems of food safety in China. I wonder how we are faring on these questions.

I have wondered why my interest in watching TED talks had dwindled away. Benjamin Wallace, in New York magazine, helps understand what happened there.

Saturday, March 24, 2012

Why Ngozi Okonjo-Iweala should be the next head of the World Bank

by Lant Pritchett.

The US had a chance to lead. It abdicated that chance, to play domestic politics and put forward a US nominee who is manifestly less qualified to be head of the World Bank, than the alternative candidate nominated by African countries: Ngozi Okonjo-Iweala.

The World Bank is a full-service development institution that provides loans, grants and development advice to promote development, which is the transformation of countries towards prosperous economies that support broad based improvements in material well-being, democratic polities that respect citizen rights and respond to citizen demands, and capable administrations that allow governments to carry out their core functions: law and order, education, macro-economic management, health, infrastructure, regulation, security.

Therefore an ideal candidate should have:
  • Some experience in government and the process of policy-making (as the World Bank's clients are all governments);
  • Some acquaintance with economic policy and policy making: including the tough choices like allocation of resources across uses;
  • Some knowledge of finance (it is, after all, a bank that makes income from lending money);
  • Perhaps some management experience in a multilateral organization;
  • Exposure to the breadth of development issues.
Experience in Government.
Ngozi has been the Minister of Finance of Nigeria, twice. If one had to name a tough job in the world, I think that would be it. She did it first from 2003 to 2006 and by all accounts handled a very tough situation -- including tackling entrenched corruption -- in an admirable way. Jim (to be fair we'll use first names for both) has no experience in government. He has been engaged in development as an academic and through NGOs.
Advantage Ngozi.
Acquaintance with Economic Policy.
Ngozi has had training in economic development from MIT. Jim has been trained as doctor and anthropologist. Ngozi has been a Minister of Finance making budget allocations and dealt with the entire array of economic policies to promote growth and prosperity. Jim has worked exclusively on health issues (rightly, as he is a physician) and never been in position of responsibility about economic policy. Health was just one of many sectors for which Ngozi had to allocate budgets and promote performance.
Advantage Ngozi.
Knowledge of Finance.
Ngozi has been a Minister of Finance as such, among other things, she led the Paris Club negotiations that led to billions of dollars debt relief for Nigeria. Jim has no demonstrable experience in finance, banking, the private sector.
Advantage Ngozi.
Management Experience.
From 2007 to 2011 Ngozi was a Managing Director of the World Bank. She therefore has in-depth experience running a large and complex multi-lateral organization. Jim was director of WHO's HIV/AIDS department, from 2004 to 2006, and so has some experience in a multilateral organization. Jim has also, for two years, been president of an American university. But while Ngozi was near the top of a large organization dealing with all development issues Jim was responsible for one disease in an organization that does only health.
Advantage Ngozi.
Breadth of exposure.
There is a massive difference between doing development policy, and doing charity work to mitigate the consequences of the lack of development. Ngozi has done development policy in many settings and in many positions both in Nigeria and within the World Bank. Jim deserves praise for having devoted his time, attention and expertise in medicine to improve the health care for people in the developing world -- which is certainly one component of development -- but his development experience is limited.
Advantage Ngozi.
Jim holds an American passport. Ngozi is a Nigerian woman.
Advantage Jim.
In this day and age, is that still really all it takes?

Sunday, March 11, 2012

Movement at SEBI towards principles-based regulation

by Shubho Roy and Ajay Shah.

A milestone for SEBI in its rule-making function

SEBI is a modern financial regulator in that it issues `subordinate legislation' (i.e. regulations) which constitute law. These laws embed intricate domain knowledge where Parliament does not have the capacity for detail. This separation -- where Parliament sets up SEBI and gives it the power to write subordinate legislation -- is the hallmark of modern regulatory arrangements. This needs to be accompanied by sophisticated arrangements through which such regulatory agencies are independent, accountable and free of conflicts of interest. While SEBI has many problems, it is the most sophisticated arrangement of this nature found in India today.

From 1996 onwards, SEBI has issued regulations for mutual funds. On 21 February, they published regulations ("SEBI (Mutual Funds) (Amendment) Regulations, 2012") that govern advertisements of mutual funds, and the methods by which the mutual funds value their assets and consequently the units that they issue.

These regulations are a major milestone in the evolution of Indian financial regulation, in the shift away from rules to principles.

Rules versus principles

The two major approaches to regulation are 'rules based' and 'principles based or outcome based regulations'. Rules based regulation sets out the processes which a regulated entity is supposed to comply with, and is not directly concerned with the consequent outcome. Firms then try to find clever ways to comply with the letter of the law, but defeat the purpose of the rules.

As an example, consider statutory warnings on cigarette boxes. The rules require that the font in which the statutory warning is printed should have a minimum 'height'. Firms get around this by printing the warning in the required height, but reducing the width of the characters to a ridiculously low size, so that it is very difficult for readers to decipher. Thereby, they are able to comply with the directive for statutory warnings, yet defeat the purpose of warning buyers.

Recently, the rules asked that cigarette packets must contain a picture of a pair of lungs with cancerous growth. In response, firms forced down the resolution of the pictures so that they look like two blotches of ink to a normal viewer. These blurry pictures cannot be interpreted by anyone lacking in good knowledge about human anatomy. The person must not only know what a pair of lungs looks like; he must also know that the light blotch in the dark blotch represents a potentially fatal cancerous growth.

Rules based regulation draws regulators into an endless arms race, where the industry will always tend to invent ways to circumvent the rules. It creates an unhealthy tension in the relationship between regulators and the industry. In addition, rules tend to rapidly become obsolete with the constant evolution of technology and processes. Government has to keep modifying the rules, catching up with new thinking in the industry. If this is not done, Government holds back progress by preventing such evolution.

The alternative to rules-based regulation is principles-based regulation. Law based on principles is not new. A large number of our older laws have been based on principles. These laws do not specify a method or process that an entity must approach but lay down the guiding principle that it must follow. A beautiful example of this is the Indian Contract Act, which was written in the late 19th century. It is principles-based law that has stood the test of time.

As an example, the Contract Act defines acceptance of a contract to be complete when information of acceptance reaches the person who offered the contract. This definition in no way requires a specific mechanism for acceptance. When the Contract Act was written, telephones or email had not been imagined. However, the principles-based text of the Contract Act has withstood 150 years of technological change.

An expert body, like SEBI, which studies the market and issues subordinate legislation, yields greater malleability: regulations can be repeatedly changed, unlike laws drafted by Parliament which are very hard to change. However, the full benefits in terms of heightened malleability are obtained when the very subordinate legislation is principles-based. Rigidity is the greatest with rules-based law, it is reduced with rules-based subordinate legislation accompanied by a high quality rule-making expert body, and it is minimised when both laws and regulations are principles-based.

Principles-based law is integral to common law and is part of our legal heritage. In recent decades, when India became socialist and when staff quality in government agencies declined, there was an insiduous shift to detailed, prescriptive, micro-management. Principles-based regulation and laws was put back on the financial policy agenda by the Percy Mistry report in 2007.

The new principles-based SEBI regulations

The new SEBI regulations on advertisement reveal a shift towards principles-based regulation. For example a regulation reads:

In audio-visual media based advertisements, the standard warning in visual and accompanying voice over reiteration shall be audible in a clear and understandable manner. For example, in standard warning both the visual and the voice over reiteration containing 14 words running for at least 5 seconds may be considered as clear and understandable. (emphasis added).

Instead of mandating that the warning should be at least 5 seconds long, as would have been done with rules-based regulation, it is stated that that it must be audible, clear, understandable. The 14 words in 5 seconds is now not a legal requirement: it is only an illustration of how the principle can be satisfied.

On valuation, the new regulations say:

The valuation of investments shall be based on the principles of fair valuation i.e. valuation shall be reflective of the realizable value of the securities/assets. The valuation shall be done in good faith and in true and fair manner through appropriate valuation policies and procedures.

This regulation recognises that there are many different types of assets a mutual fund may acquire, stocks, securitisation papers, derivatives, bonds, etc. Each of them may have different forms of valuation. More importantly the list of assets mutual funds may buy is not exhaustive: MFs in India are going to buy an array of new instruments in India and abroad. The principle however, will hold true for different assets and valuation methods. The objective of the regulation is to ensure that the investors get a fair picture of the assets that their fund holds.


We do not know what forms of media the mutual funds of the future will use: billboards will go 3D, holograms will be used, mobile phones will carry rich targeted advertising. Mutual funds will also invest in new financial instruments in global markets. As long as they provide warnings in a clear and understandable manner and value their assets in a fair and truthful system, they will be compliant with SEBI regulations and can innovate freely.

Principles based regulations have two major advantages over a rules based system:

  1. The regulations require the regulated to strive towards an outcome and not mechanistic compliance.
  2. The regulations allow for innovation to be absorbed quickly by the industry as long as they meet the objective of the regulation. Imagine if the Contract Act had specified that all acceptance of contracts should be done by letters. All the innovation of e-commerce, mobile telephony based commerce, telephonic negotiation and trading would have been illegal till the statute was amended. This would have required Indian law-makers to constantly update the Contract Act.

Moving to a principles based system is a crucial step forward, away from the command and control mindset that many regulators suffer from. Instead of prohibiting malpractices, all too often, laws in India micro-manage the regulated business. This is a recipe for stagnation.

However, principles based financial regulation also has costs. Rules are black and white - there is legal certainty. With principles based regulation, the precise nature of a government response to a new idea by the private sector is less predictable.

More complex behaviours are, then, required of the regulator. More litigation will arise. This will impose a greater burden on staff in regulators, courts and law firms. They will need to understand principles (and their underlying drafting intent), alongside practical knowledge about how the real world works, so as to be able to intelligently apply the principles. This requires a great deal of understanding of technology, business and regulatory objectives. Moving towards a principles based system requires commensurate strengthening of organisational and staff capabilities at SEBI, the Securities Appellate Tribunal (SAT), and the Supreme Court.

Thursday, March 08, 2012

IEDs in Diwali and Toxic chemicals in Holi

When I was young, resounding explosions and other fireworks were an integral part of Diwali. It was not possible to conceive of Diwali any other way. If you extrapolated into the future, and envisioned the next doubling of GDP, you'd have forecast that there would be much more than 2x the explosions and other glittering displays, assuming that social mores stayed unchanged.

There was a dark side to such Diwali celebrations: the inevitable trickle of people engaging with explosives who got hurt, extreme discomfort for all forms of life other than humans, and air pollution. Many years ago, it seemed like all these problems were real, but there wasn't any other way. It was hard to conceive of a world where Diwali was celebrated differently.

I used to think there was a common goods problem: Each individual gained utility out of igniting fireworks, despite imposing externalities on other creatures (of various species) in terms of noise or pollution. It isn't easy to get humans to be concerned about externalities imposed upon others.

I have been astonished at how these three messages (accidents, animal rights, pollution) have gone through to the young, and Diwali now involves much less of the fireworks than used to be the case. After we factor in the GDP growth, the change is simply amazing. By rights, such a social transformation should have been very hard. But it happened. I wonder how this happened. (There is some data on this phenomenon at Central Pollution Control Board, but the work is of poor quality and the website is terrible, so it's hard to compare 2002 against 2011).

Fast forward to Holi. Holi seems deeply entrenched, particularly in North India. There is a dark side to Holi celebrations: toxic chemicals, sexual harassment, substance abuse. All these problems are real, but there doesn't seem to be any other way. Unlike the problems of Diwali, two out of these three (toxic chemicals and substance abuse) are about private goods: the individuals who engage in certain practices are the direct losers as a consequence. So there isn't a common goods problem here; this should be easier to solve. But it's hard to conceive of a world where Holi is celebrated differently.

Or should we be so pessimistic? I saw a story on NDTV: Nearly 175 hospitalised for colour poisoning. As information about these problems spreads, will behaviour change? In an ideal world, we should have the public goods of Health/Safety/Environment regulation, ensuring that the dyes used are safe. In an ideal world with high quality police and courts, the sexual harassment and Holiganism will be checked. But it will be many years before India has such governance capacity; at present the main focus of politicians is not upon public goods. For a few decades, the only way forward is for a lot of people to step away from the present social mores. It happened with Diwali; could it happen to Holi?

Could it happen to Ganpati Visarjan in Bombay?