## Wednesday, December 27, 2006

### Comparing Indian and Chinese progress on financial sector reforms

There is a broad consensus that India has done better than China at setting up the financial system. Indian banks are less bankrupt; the Indian equity market works better; the financial sector acts as more of a check in India in choosing which firms obtain access to capital, rewarding performance and good corporate governance. While these statements are broadly on track, in recent years, the Chinese have actually made remarkable and far-reaching progress, much more than they are generally given credit for. The Chinese have gone ahead and done things that are considered heresy in India, particularly in the eyes of the communists. In recent weeks Mythili Bhusnurmath and Ila Patnaik have written a pair of excellent articles on this theme.

One feature which plays in China's favour is the liberalisation of finance that was agreed to when China was admitted into the WTO. Even though a five-year window of time governs the full implications, the promises which have been made surely guide and influence public policy which must plan a trajectory which is compatible with the dates and commitments. In India's case, there is no comparable hard budget constraint influencing liberalisation.

## Thursday, December 21, 2006

### Another central bank gets a nose bloodied

All of us remember the famous speech at IGIDR by Y V Reddy on 12 January 2005 where he expressed interest in more capital controls [link to speech, the next day's front page comment by Ila Patnaik]. In India's case, this yearning ended at the speech stage.

A natural experiment in the introduction of such restrictions took place in Thailand last week. A Chilean-style unremunerative reserve requirement [link] was announced by Thailand's central bank on Monday (18th). The government backed away from this on 19th (Tuesday), after stock prices crashed by 15% [link, link].

I wrote an article Adventures of the Baht in Business Standard on this drama, after their announcement of the reserve requirement but before they backed away from it.

I think that the first best world is one with no capital controls. The second best world is one with no capital controls and this unremunerative reserve requirement; it is better than the intricate system of quantitative restrictions (QRs) which we have as a system of capital controls in India. The Thais may have made mistakes in exactly how they went about trying to do it. The bottom line in this episode is one more central bank with a bloodied nose.

## Monday, December 18, 2006

### Three interesting opinion pieces on finance & monetary economics

Mythili Bhusnurmath complains about RBI surprising the market; a Business Standard editorial on hedge funds; and another responding to recent SEBI proposals. Coincidentally, a great Foreign Affairs article on hedge funds just appeared by Sebastian Mallaby, and he wrote up a small version of this for Washington Post. And, Lars Nyberg, the deputy governer of the Swedish central bank, has a nice speech on hedge funds. I get really impressed by the speechwriters found in OECD countries.

## Saturday, December 16, 2006

### Bureacrats as bankers: European view

In Financial Times, I saw an article by Wolfgang Munchau titled Get the state out of Europe's banking sector where he says:

When I recently asked a well-known Swedish economist about the lessons of Sweden's economic success for the rest of Europe, he answered: Don't copy our social model. Have a financial crisis instead.' He was referring to the early 1990s, when Sweden experienced severe financial turmoil that precipitated deep structural changes in the banking industry and the economy at large.

...

My own priority for France and Germany would be ... the banking system. Follow the money. A Schumpeterian Swedish-style financial crisis might do the job but it is not going to happen. Back in the real world, reform is the best alternative.

Of course, the problems are not identical across European countries. In both France and Germany, the banking market is dominated by non-private financial institutions. The problem is perhaps most acute in Germany, where in 2005 commercial banks accounted for a mere 26.5 per cent of the assets of the entire banking system, a figure hardly changed since 1990. The biggest force in the German banking system is the public sector and co-operative banks. The result is a pathological co-existence between the public and private sectors, under which the private sector has been driven out of large parts of the retail market.

There are instructive parallels with Italy. A comparative study of the two systems by academics from the Bank of Italy, the Bundesbank and various European universities found that Italy is in some respects a role model. In 1990, Italy had a similar bank structure to Germany's. Between 1990 and 2005, the asset share of the public sector banks declined from 70 per cent to about 9 per cent. The research found that technological progress was the main cause of the increase in total factor productivity in both countries but in Italy, privatisation also contributed to the rise in TFP.

Why has Italy reformed, while Germany has not? The Italians realised they needed a modern banking sector in time for monetary union in the late 1990s. The Germans, by contrast, actually believed in their multi-pillar system. It served them well, especially in the period of postwar reconstruction. Attitudes are changing but only slowly. As a senior German official noted, the prevailing attitude today is more defensive: if it ain't broke, don't fix it.

Last week, the Bundesbank co-sponsored a conference on the future of public sector banking in Germany. The remarkable fact about this event is that it could not have taken place 10 years ago.

Academic research has consistently shown a negative relationship between the prevalence of public sector banking and a country's growth rate. This has been known for some time. Ross Levine, professor of finance at Brown University, argued that public sector banks are even unsuited to serving the goals they were originally set up to pursue: poverty reduction; financial development assistance; giving people access to capital they would otherwise not get; and overcoming the lack of credit history for small companies. The conclusion from the academic literature is that state-owned banks are mostly political banks that serve sectarian interests within society, but not society at large. To put it another way: they are tools of corruption.

A study of state-owned banks in India, for example, has shown that their credit volume is 5-10 per cent higher in an election year. A similar study in Japan concluded that prefectures represented by influential members of the governing Liberal Democratic party received more public-bank loans. The situation is not fundamentally different in Europe. In Germany, the public sector banking system was often used by politicians at all levels of the federal system to prop up companies that would otherwise not exist in a purely competitive environment. While bail-outs are politically popular, their long-term economic effect is negative. They impede structural change. If Germany had a purely commercial banking system, I would not be surprised if the share of manufacturing in the economy were smaller than it is today. The public-sector banking system is geared heavily towards the manufacturing sector.

So what are the chances of reform? A few years ago, after the collapse of the dotcom bubble, it looked for a while as though Germany might suffer a Swedish-style financial shock. But profit margins have since recovered. My prediction is that the combined force of European competition policy and further European financial integration will eventually lead to the long-overdue modernisation of the banking sector across the eurozone. It should be a priority for economic reformers to prepare the ground for change.

The research paper that he talks about is Productivity Change, Consolidation and Privatization in Italian and German Banking Markets, de Vincenzo et al, conference paper, November 2006.

When it comes to the question of public ownership of banks, the international consensus is that this is a bad idea. Giving elected representatives the power to meddle with loan decisions is a distraction from the core business of a State that focuses on public goods. In the best of times, running an opaque and highly leveraged financial firm is hard; things aren't helped by bureacrats being managers. Finance is about subtle forward-looking judgments about alternative firms: the rigid processes of the public sector aren't conducive to risk taking and jugdment. It is hard for banking regulation to have technical soundness when regulated entities are owned by the government.

The Indian discourse on this question is split between two camps. On one hand, there is the Left which thinks nationalisation of many things is a good idea. On the other hand, there are the folk who see that bank nationalisation was a big blunder, but just don't see how the politics will support privatisation.

## Friday, December 15, 2006

### Financial regulation of a third world country

In the best of times, financial regulation is hard. A lot of the time, in India, we get the financial regulation of a third world country. Business Standard has an editorial linking up three recent developments:

The editorial says:

In recent days, three distinct announcements have come out, highlighting the low quality of financial sector policy in India. The first element was an announcement from the RBI about financial derivatives. For many years, the RBI has had profound flaws in the treatment of financial derivatives. Unfortunately, the new guidelines make no progress; they are old wine in an old bottle. Derivatives are the foundation of the new approach to risk in a mature market economy. Liquid and efficient derivatives markets change the functioning of every firm in the country, both through direct participation and indirectly through superior financing. Banks are key players in hedging, speculation and arbitrage, which enable the derivatives markets to function. This requires commensurate knowledge in the regulation and supervision of banks. The new RBI guidelines do not put India on the trajectory of becoming a mature market economy.

The second element was an announcement from the Securities and Exchange Board of India (Sebi) about a corporate bond reporting platform', where a monopoly has been granted to the Bombay Stock Exchange (BSE). This is wrong at two levels. First, the hallmark of a mature market economy is competition, not monopoly. And, if Sebi felt that the right solution was a monopoly, the award of a concession requires a commensurate procurement procedure. Alternatives to the BSE need to be judged transparently based on technical and financial bids.

The third element was an announcement from the Forward Markets Commission (FMC), banning securities firms from offering clients portfolio advisory, portfolio management and other services in the commodity derivative markets. This move is in the wrong direction because the direction for progress consists of building up greater knowledge, greater sophistication and a bigger mass of capital which is able to trade in the commodity futures market and induce market efficiency. In every country, commodity trading has started out as the exclusive preserve of a small group of merchants. The transition to a mature market economy comes about by breaking the stranglehold of this small group of merchants, by broadening participation, by bringing in analytical thinking backed by capital. The FMC is doubtless responding to complaints from traditional merchant communities who find the modern development of commodity futures markets to be a threat. But the FMC has done wrong by giving in to these demands. The FMC announcement is, of course, completely futile because nobody can come in the way of an advisory relationship between person X and person Y. That advice will continue to be given. The only thing that will change is the mechanism through which the advice will be paid for. The FMC has only achieved a greater level of mis-representation in the accounts of both the buyer and the seller of advice. The FMC has lapsed into 1970s-style economic policy, where a ban drives a legitimate activity underground.

In certain aspects of the reforms process, the ruling United Progressive Alliance faces constraints owing to its inability to be tough with the Left parties. Such reasons explain the failure of the UPA government to pass the pension reform Bill. But no such reasons hold back the government when it comes to solving key bottlenecks in the financial sector. These policies of the RBI, Sebi and the FMC are not designed to help India move into the world of developed markets.

At present in India, too much power has been placed in the hands of these agencies without adequate mechanisms for transparency and accountability. When these agencies go wrong in this fashion (or in other ways), the system does not have an adequate homeostatic response.

## Thursday, December 14, 2006

### What to do with $170 billion of reserves Jaimini Bhagwati has a great article in today's Business Standard about the poor returns on India's foreign exchange reserves portfolio. In it, he says: According to the Reserve Bank of India?s Annual Report for 2005-06, the nominal rupee (INR) denominated rates of return on India's foreign currency assets (FCA) for 2005-06 and 2004-05 were 3.9% and 3.1%, respectively. Foreign currency assets include foreign exchange reserves less gold holdings, special drawing rights and India's reserve position in the IMF. Inflation in India in the last one year has been about 5%. Therefore, the real rate of return on India's FCA for 2005-06 was around minus 1.1% (3.9-5). The Reserve Bank of India (RBI) is currently responsible for managing the country's foreign exchange (FX) reserves. Since central banks hold gold as a last measure of protection against a balance of payments crisis, the discussion in this article is confined to FCA management. The real INR rate of return on India's FCA has been negligible to negative in the last two years. These low returns on India's FCA could be attributed to the RBI's cautious policies in which the guiding principles are to maintain mark-to-market value and liquidity by taking minimal credit and market risk. Effectively, the rate of return is a secondary concern and the RBI's options are accordingly limited to investing in short-dated triple-A rated government debt securities. How should we measure the performance of the Indian FCA portfolio? For instance, should the numeraire currency be the dollar or INR? The currency in which the rate of return is measured should not matter in economic terms. It is the currency composition of the benchmark portfolio, against which the FCA portfolio's performance is measured, which needs to be calibrated carefully. Given the potential for disorderly US$ depreciation the benchmark portfolio may need to be tweaked frequently to take into account the exposure of the Indian current account to exchange rate risk.

A traditional yardstick to assess the sustainability of a sovereign's external borrowings is to compare the average cost of such borrowings with the GDP growth rate. By extension, India's FCA earnings should be comparable with the GDP growth rate. In the last one year, real growth has been 8% plus, making the GDP growth rate 9% [8 - (-1.1)] more than FCA earnings. Another construct, suggested by Dani Rodrik, is to compare FCA earnings with the cost of short-term external commercial borrowings (ECBs). At the margin, Indian FCA earnings would be about the same as the yield on 3-month US Treasury bills, currently about three-month LIBOR - 0.40%. The average cost of short-term ECBs for Indian firms is about 3-month LIBOR + 2.5%. That is, the opportunity cost of holding "excess" FCA would be at least about 3%.

Of the Asian countries which have accumulated significant volumes of FX reserves, Singapore has allocated the responsibility of managing reserves to maintain the stability of the Singapore dollar to the Monetary Authority of Singapore (MAS) and excess reserves have been assigned to the Government of Singapore Investment Corporation (GIC), which manages higher risk-return investment portfolios. More recently, South Korea has followed the same model and set up the Korean Investment Corporation.

Some questions about Indian FCA management need answers. Could the returns be increased significantly without undue risk to the country's ability to service its external debt and sustain current account deficits required for investment purposes? Is the allocation of Indian FCA management to the RBI conducive to a satisfactory rate of return? Further, if the mandate for FCA management is altered would that necessarily result in a higher rate of return?

Obviously, there are no definitive answers to these questions. In the context of adequacy of FX reserves, Guidotti-Greenspan have suggested that these should be at least equal to external debt maturing in the next one year. As of end March 2006, India's short-term external debt plus long-term debt maturing in a year was about $15 billion. On the same date, non-resident Indian (NRI) deposits amounted to approximately$35 billion and external commercial borrowings (ECBs) totalled about $26 billion. The market value of foreign institutional investors' (FII) portfolio investments in Indian equity markets is around$110 billion. That is, total external debt maturing in a year plus 50% of NRI deposits and ECBs and 25% of FII portfolio investments add up to about $70 billion. How should the RBI maintain an adequate level of reserves for external debt servicing and other requirements while it manages excess FCA separately to maximise returns within acceptable credit and market risk limits? As of mid November 2006, Indian FX reserves amounted to about$170 billion. One option is for the RBI to manage a highly liquid, low-return portfolio of $70 billion as insurance against capital flight caused by unexpected market developments. The remaining$100 billion could also be managed by the RBI in separate portfolios with associated benchmarks which carry greater market risk and hence commensurately higher returns. This proposal for several portfolios with differing risk-return characteristics is not necessarily to take additional credit risk but diversified market risk. For instance, FCA managers could move up the yield curve and take some interest rate risk and invest in highly-rated municipal and asset-backed securities. They could also diversify out of fixed-income instruments into asset categories such as equity and real estate. Singapore and South Korea have set up separate investment corporations to manage their growing reserves because the skills required for managing investments in equities, asset-backed securities, and real estate are qualitatively different from those needed for managing portfolios consisting of short-maturity government-debt securities.

Lawrence Summers, speaking at an LK Jha memorial lecture in Mumbai on March 24, 2006, remarked that India could expect to earn about 6% in real terms on its FCA if these were invested in global capital markets. On balance, it appears that it should be possible to earn an additional 5%, compared to current FCA earnings by investing excess Indian FCA through a dedicated investment platform set up by the RBI/Ministry of Finance. An additional 5% return on $100 billion is$5 billion, which is about 0.6% of GDP. This number would be lower if the investment guidelines for the higher risk-return reserves portfolios were to be restrictive but it is still likely to be a significant figure. All things considered, it is time for the RBI and the Ministry of Finance to set up a separate investment firm or platform with appropriate performance benchmarks and incentives for the staff.

In my understanding, the quasi-fiscal costs of holding reserves in this fashion come in two parts. First, there is the well known opportunity cost of being invested in a low return asset (US government bonds or USD denominated bank accounts). As a country, India is paying higher rates for the equity/debt capital coming into the country, but earning low rates for the USD assets held by RBI - doesn't sound like a very good deal. More narrowly, if you focus on the consolidated government of India, there has been a gap between the high price at which GOI borrows on the bond market versus the low returns obtained on the reserves portfolio - this is a fiscal cost to GOI. This issue has been known in the literature for a while.

The second component, in my opinion, is more important: this is the losses that come about in the reserves portfolio when the currency adjusts. Suppose RBI tries to block an INR appreciation by purchasing USD, at a time when the exchange rate is Rs.46/$. This involves buying$100 for Rs.4600. Suppose you believe that you are in a situation where the central banks can only slow down the inevitable market process but not block it. So, if an appreciation was coming, it would come anyway - RBI is unable to prevent the inevitable, only delay it. In this case, after some period of time, you end up at Rs.43/$. Now the RBI portfolio is valued at Rs.4300. In other words, a loss has taken place from Rs.4600 to Rs.4300. Some of this difficulty goes away by keeping score in USD. If RBI holds 25% of the reserves portfolio in EUR, and keeps score in USD, then the returns on the reserves portfolio as measured in USD looks great when the USD depreciates. I think this is illusory. I think it's safest to think in INR. In the Indian case, there are two manifestations of the fiscal costs of reserves. First, the market stabilisation scheme' (MSS) was a very nice thing in converting some of the hidden cost of reserves into a line item in the budget. I think it's wrong to waste money on holding reserves, but if you must do so, I think it's better to be transparent about it. In addition, if you look at the time-series of the dividend paid by RBI to GOI over the years, expressed as percent of GDP, there's been a sharp drop. This drop has come about largely because of the growth of reserves. Jaimini asks: Can we do better than RBI's management of the reserves portfolio? I'm sure we can. Jaimini is right in saying that the improved performance could amount to as much as 1% of GDP, which is a huge number. I think it's equally important to ask: Do we need reserves beyond$70 billion? Does it make sense for any bureaucrat to hold a portfolio of 20% of GDP? I think it is preferable to not hold such assets in the public sector in the first place; it is better for the citizens of the country to hold globally diversified portfolios rather than placing these in the hands of a government agency, regardless of whether it's an RBI-style agency which earns low returns or an ADIA-style agency which does better. As an example, consider this Economic Times article titled Indian Temasek Challenger to be Launched (an inaccurate title). I think Indian politics does not mix well with such an entity. We are better off without it; we are better off with a government which just sticks to public goods and stays out of the management of the stock of assets of the citizens of the nation.

In 2003 and 2004, when India was building up reserves at a huge pace, Ila Patnaik wrote an excellent group of articles in Business Standard warning about these kinds of issues. In particular, see The USD quagmire, Dining with the devil and Feeding an elephant. This sequence of articles ended in March 2004 when India got off that tightly-pegged exchange rate. On the subject of how much reserves is adequate', see her India's policy stance on reserves and the currency.

The only saving grace about the Indian story is that things are better here when compared with East Asia. The reserves managers in East Asia must feel terrible, holding gigantic USD assets that they dare not sell, while week after week they endure the agony of watching the USD drop.

It's been the best deal imaginable for the US: buy cheap Chinese goods through a distorted exchange rate, pay for them using IOUs, and then have those IOUs depreciate in value so they don't even have to be paid back in full. The Chinese get hurt twice: first when selling cheap goods, and second when suffering losses on the USD portfolio. The same double-whammy hurt India also, but on a much smaller scale.

### Dubai: an international financial centre?

There is an article in The Economist about the effort at Dubai in becoming an international financial centre. On one hand, this is a success story of the speed and effectiveness of a dictatorship-doing-the-right-things. But as their next piece on the same subject says:

...

Yet it takes more than a dream and government largesse to succeed as a financial hub. Dubai and its imitators need to remember that the market is built not just on subsidies that attract foreigners, but markets that attract locals.

Dubai has done a lot right. Despite a tarnished past as a centre for money laundering, it has burnished its image so as to attract big investment banks and other financiers in the past year. Just a few weeks ago Carlyle, a large private-equity firm, announced that it would open shop there. Building on its transport links and a pleasant quality of life, Dubai has created a sparkling new financial centre that offers international-quality regulations enforced by imported regulators, a Western legal code, oodles of subsidies and refreshingly little red tape.

Yet in spite of this and the sea of petrodollars sloshing around the Middle East, Dubai is only halfway towards its ambition (see article). Its new stock exchange is struggling, with thin trading and few listings. The banks that blew in with the tide of global capital are impatiently muttering about embarking for the next port. Something is still missing.

To win a place in the top club of financial centres, Dubai must attract not just providers of capital but users, too. The bankers need companies that want to sell their shares and bonds in the region; fund managers want local companies to invest in; and private-equity partners need a pipeline of enticing ventures and the prospect of listing their companies after a few years. Dubai has sought to profit from the unprecedented mobility of markets, but without local demand for capital, that same mobility will start to count against it.

The trouble is that few local companies are ready for Dubai's capital markets. The Arab world includes plenty of sophisticated large investors but few modern companies. Long ago, the region's failure to develop joint-stock companies was one reason why it fell behind the West. Even today, financial transparency is weak and accounting is erratic. Most enterprises are family owned and, since they operate in protected markets, have no great need to raise capital, especially if it means exposing themselves to greater scrutiny.

This is not unique to the Gulf: the developing world is full of companies that are shielded from competitive marketsll that oil wealth, which means there is plenty of traditional bank credit for all sorts of Middle Eastern businesses. To make matters worse, local stockmarkets are still shaky after a crash earlier this year.

My reading, based on conversations with many people who have looked closely at DIFC, is that DIFC is creeping up into the ranks of a credible venue for placing certain mid-range financial functions. For the low-end BPO, India wins. For the high-end knowledge work, it's still London. There is a certain middle where Dubai is attractive. But as yet, it isn't a financial ecosystem', where people meet and talk and do transactions on each other, where secondary market liquidity pulls in economic agents. A big push' by a State, that tries to create an exchange or three by fiat, does not generate this liquidity. E.g. as of yet DGCX is doing perhaps 2,500 contracts per day... the case has yet to be made for trading at an exchange in Dubai when capital controls do not force business away from the great exchanges of the world. Perhaps you cannot will an international financial centre in a desert.

I like to apply a bookshop test' in judging an international financial centre. I judge the quality of a financial centre by wandering the bookshops, which gives me a hint of the kinds of books the local financial elite is buying. Here London and New York clearly stand alone: their elite buys books on implementing finite difference schemes for Heath/Jarrow/Morton. Singapore is very, very impressive, with plenty of effort on learning stochastic calculus. Bombay is mediocre - with a big focus on get-rich-quick trader books. I haven't seen a bookshop inhabited by finance folk in Dubai - what is it like?

## Sunday, December 10, 2006

### Moral hazard

The economists' way of thinking often leads to surprising results. One famous meme concerns the impact of seatbelts. At first blush, it appears obvious that wearing a seatbelt reduces the harm caused by an accident. The economist pipes up saying that it also increases the probability of an accident because the person feels safer; it probably increases the severity of the accident as well. While at an engineering level, seatbelts are of course wonderful, the overall effect is more cloudy than is commonly believed (link). You would need to study the data; it isn't obvious that seatbelts help. And if the adverse impact upon driving were bad enough, the economist would argue that a spear implanted in the steering wheel, pointing at the driver's heart, would probably do more for the health of the public than seat belts.

A similar debate surrounds the impact of motorcycle helmets. The biologist knows that a skull encased in a helmet does better when exposed to an accident. The economist worries that the probability of an accident goes up when the mind feels protected in a skull that's encased in a helmet. The two effects run in opposite directions; you'd need to study the evidence to know which one dominates.

Laymen often find moral hazard' arguments to be downright bizarre. Do you believe that people actually take less care of their own health when covered by health insurance? Do you believe that people slack off in a job more when there is unemployment insurance or when it's hard for the employer to sack 'em? Do you believe that young people growing up in a welfare state invest less in human capital and have an inferior work ethic? Do you actually believe that the rise of the European welfare state had something to do with the breakdown of the family as an institution in Europe? These kinds of propositions almost sound morally repugnant. I think such behavioural changes do take place; people do respond to incentives much more than meets the eye.

Today I saw an amazing and new variation on this theme in the New York Times: cyclists who wear helmets are more likely to get hit by the traffic.

## Friday, December 08, 2006

### Regulatory anomalies: RBI edition

Everyone connected with finance in India has their own favourite stories about bizarre things being done in Indian finance as far as the system of policy-making, regulation and supervision is concerned. I recently wrote about the recent SEBI disgorgement order and about the separation between commodity futures and finance.

Today, in Business Standard, A. V. Rajwade has an excellent piece titled Regulatory anomalies which should really be called Regulatory anomalies: RBI edition. His checklist is:

1. The death of the interest rate futures contract:

Take, for example, the question of exchange-traded interest rate derivatives. In theory, a few contracts were introduced with much fanfare in the middle of 2003, but failed to take off. The principal reason was that commercial banks, which are by far the largest players in the bond market, were allowed to use exchange-traded derivatives only for hedging. Inasmuch as all the banks have long positions in government securities, they could have only sold the derivative contracts. With nobody on the opposite side, the market never took off. The irony of the regulatory regime is that, while banks cannot take trading positions in exchange-traded derivatives, they are free to do so in the OTC derivative market. This seems perverse, all the more so when exchange-traded derivatives are far safer than their OTC counterparts!

I agree. In addition to the above, there was one more catch: RBI wanted banks to hold greater capital backing an exposure on the exchange-traded contract when compared with the OTC contract. This was wrong because the exchange-traded contract is backed by the clearing corporation (a zero-leverage, specialised risk management shop holding only transparent assets) while the OTC contract is typically against another bank (a 20:1 leveraged financial firm holding opaque assets). This did not make sense either.

A lot has been made about the difficulties with cash-settled futures on a notional 10-year zero coupon bond. I agree with Rajwade in his emphhasis that the regulatory problems were the real difficulty. When you look at liquid bonds with a roughly 10-year maturity, there are correlations between the market price and the model price in excess of 0.8 - i.e. the contract tracked the (messy) spot market pretty well. The most important reason for the death of the contract was the regulatory treatment.

2. Mistakes in measuring the market risk of bond portfolios:

Consider another example. For measuring the market risk on bond portfolios, the central bank has prescribed the use of modified duration. The modified duration is used to estimate the price change in the value of a bond, arising from higher yields. Regulations require the price change to be calculated based on a 1 per cent yield change at the short end, but 0.6 per cent for longer maturities. This seems to be borrowed from western markets, where the yield volatility is more at the short end, and less at the long end. On the other hand, empirical evidence in India is exactly the opposite: yield volatility at the long end is more than at the short end. Surely we should not be borrowing western models and numbers without testing them empirically for conditions in the Indian market? (The same criticism is applicable to the decay factor of .94 used for calculating EWMA-based value at risk.)

(Aside: the ML estimate of the Risk Metrics lambda for Nifty works out to 0.96, so the difference there isn't economically significant). On the subject of risk measurement for interest rate risk, Jayanth Varma and I had done a fair bit of empirical work with Indian data on the time-series of the spot yield curve, leading up to the SEBI regs for interest rate futures. More generally, on the subject of the interest rate exposure of Indian banks, Ila Patnaik and I have done empirical work which finds that after complying with all RBI regulations, the banks have held huge interest rate anyway. This work was known from early 2002 onwards, but after that, it didn't seem to affect thinking on regulation. To say this in a technical way, after controlling for bank characteristics, the year-fixed-effect dummies are all insignificant. To say this in a non-technical way, even after RBI knew that the banks were carrying huge interest rate risk, nothing was done to solve the problem. [Links to material on these issues]

3. Mistakes in treatment of securitisation:

The securitisation market, which is so necessary for the growth of certain sectors like housing and infrastructure finance, has witnessed significantly reduced activity after the RBI came out with its guidelines on securitisation. While part of the reason could be a change in the interest rate scenario, surely the regulatory prescription that banks cannot account for profit on securitisation upfront, has also contributed to the death of the market. The restriction seems less than logical: on the one hand, the guidelines prescribe that there should be no recourse to the originator in the case of securitised assets; if so, why should the profit not be accounted upfront?

4. Capital controls which impede currency risk management:

Turning now to regulations about the foreign exchange market, recently the Reserve Bank allowed import duty payment (economic) exposures to be hedged in the forward market. On the other hand, it refuses to permit other economic exposures to be hedged. This too seems perverse: after all, import duty exposures are small, while every company in India, producing or consuming commodity kind of goods whose prices in the domestic market are governed by the import parity principle, is facing large economic exposures to the dollar: rupee exchange rate. These need to be managed, particularly when the rupee continues to manifest two-way movement. So what is not a pressing problem (exchange risk on import duty payment) is mitigated, but what is genuinely needed is disallowed! And this is despite both the Committees on capital account making recommendations on the issue.

5. Effectively killing foreign currency accounts:

Recently, the RBI allowed greater access to Indian companies to the maintenance of foreign currency accounts. If the idea is to facilitate such access, surely the stipulation that banks cannot pay any interest on such accounts, should simultaneously have been abolished? It is perverse that we continue with the ban on paying interest, which was introduced in an entirely different set of circumstances (i.e. when the rupee was under pressure), even when the environment has taken a U-turn for the last four years.

6. Complexity:

I also find some of the regulations unnecessarily complex, for the present stage of the market and the kind of business banks do. A few examples: capital adequacy (horizontal and vertical disallowances); derivatives accounting (the separation between below and above 90 days; the rigidity about portfolio hedges, etc.); the plethora of micro-level percentages on cancellation and rebookings of forward foreign exchange contracts.

And finally, his summing up:

Many other examples could be cited, but I suppose that the above list gives an idea of the kind of regulatory quirks, contradictions and irrationalities that exist. Is it that the central bank does not have adequate specialised staff for some of the newer areas of banking? Is it that the decision makers have drowned themselves so much in paper work that they have little time to think? Is it that, in the process, they miss the woods for the trees? Is it that there are too many steps in the decision-making ladder and that, if somebody expresses a negative opinion on a point, the system is reluctant to override it? Perhaps some introspection and review of the systems, quite apart from the specific points I have mentioned above, would be useful, and strengthen the central bank's reputation.

I think RBI staff have IQs which are as good as those found in other government agencies. It is hard to explain analytical and technical blunders such as those described above as deriving from ignorance or incompetence. I think the staff quality and their commitment to their job is just fine, though the RBI HR process leaves much to be desired. The biggest problems lie in the RBI Act and in the complex mandate that RBI is asked to discharge, one that is riddled with contradictions. I think the same staff would do much better in avoiding such mistakes if placed into more focused government agencies where such conflicts of interest were absent, and with improvements in HR procedures.

## Thursday, December 07, 2006

### How to tackle informal sector pensions

When it comes to the question of pensions for the organised sector', there is now a considerable consensus on how to proceed. The basic recipe consists of defined contributions; individual accounts; fund management based on the low prices of wholesale market with a big role for passive management (indexation); better returns through exposure to systematic risk factors; variation of risk exposure across the life cycle. These ideas are largely what drives the New Pension System (NPS) in India. I have an article on these issues, done for the inaugural India-and-China conference of the Lee Kuan Yew School of Public Policy (LKYSPP) at the National University of Singapore, titled A sustainable and scalable approach to Indian pension reform.

The key ingredients which make this a feasible recipe is the employer. Collection of contributions is made efficient because of the employer, and there is the rhythm of contributions coming in every month. Neither of these hold for the informal sector.

In the informal sector, the best you can do is to have people step forward to voluntarily contribute into a pension account. Given the high discount rates that most humans have, it is hard to elicit such participation. And, even if you can talk someone into stepping forward, preserving the flow of contributions across long decades is daunting.

I have started seeing glimmers of how this can be made to work. On this theme, I wrote an article How to tackle informal sector pensions in Business Standard yesterday.

The most remarkable success story of this nature is in Mexico, where the foundation was an NPS-style pension system for the organised sector. (In their case, this NPS replaced the EPFO, not the civil servants pension). Once this infrastructure was in place, they linked it up to the Conditional Cash Transfer system, through which transfers are made to poor mothers across the country. This enables the opening of pension accounts by poor people. The government co-contributes with them in order to incentivise participation.

### US financial sector policy questions

I had earlier blogged about a great speech by Paulson which addresses the widely perceived sense that London has emerged as the world's #1 financial centre. On this subject, there is a report by the bipartisan Committee on Capital Markets Regulation' which is of great interest. While the outside world sees a contest between the US-style rules-based framework versus the UK-style principles-based framework, the thinking end of the US system appears to be persuaded that emulating the UK is desirable.

## Sunday, December 03, 2006

### Trickle down economics

Two pet hypotheses in India are as follows:

• That economic growth is not reaching "poor people"
• That government is central to improvements in education and health; conversely, that the only way to have educated and healthy people is to have a government spend more and/or spend it better.

Different people share these `pet theories' to different extents. Many liberals are skeptical about the usefulness of more spending by the government on education and health as long as spending consists of a mere intensification of existing programs. This is because there is now ample evidence that existing programs work pretty badly, as is borne out by evidence of absenteeism by health/education workers, the poor learning accomplishments associated with Sarva Shiksha Abhiyaan, etc. Many liberals would support a view that more government spending would help - or is essential for obtaining - better health and education outcomes, as long as fundamental surgery is made to the way in which programs work - e.g. shifting from teachers as civil servants to vouchers.

In recent weeks, fascinating new information about household level health and fertility has come out through NFHS-3. In terms of methodology, NFHS is the best household survey in India - it's the gold standard against which all surveys compare themselves. The first survey was conducted in 1992-93, the second in 1998-99 and the third in 2005-06. Every other survey aspires to NFHS quality resources and methodology. If you are one of those who loves to hate the NSS dataset, you needn't carry this skepticism on to the NFHS: it is the first world class household survey in India.

Kamla Gupta, Sulabha Parasuraman, P. Arokiasamy, S. K. Singh and H. Lhungdim have an article in the EPW of 21 October 2006 titled Preliminary Findings from the Third National Family Health Survey which shows some first findings from NFHS-III for five states (Chhattisgarh, Gujarat, Maharashtra, Orissa and Punjab) [pdf]. The quick summary is: the public health service delivery was terrible, but the health and fertility outcomes got tremendously better. Ila Patnaik has a great article in Indian Express summarising and interpreting their results. In this, she says:

The percentage of infants dying before they attain the age of one has dropped significantly in the last seven years in all five states. It has reduced in Punjab by 26 percent, in Gujarat by 21 percent, in Orissa by 20 percent. When compared to the data from NFHS-1 carried out in 1992-93, Orissa, one of the poorest states in India in terms of per capita income, has witnessed a decline in infant mortality by 40 percent.

For many years, the sense in India was that Kerala and Tamil Nadu had achieved replacement-level fertility (2 children per woman) but fertility in the rest of the country remained stubbornly high. The NFHS findings indicate that over the past 13 years, significant progress in fertility has taken place in all five states. Punjab and Maharashtra have achieved replacement fertility. Women in Orissa, Chattisgarh and Gujarat now average 2.5 children each. These trends in fertility indicate that India will reach replacement level fertility in 2010.

Preliminary evidence shows that the quality of public health services has been worsening. As NFHS data shows, immunisation, which is largely done by the government, has worsened in Gujarat, Punjab and Maharashtra in recent years. This data is in conformity with the data from the report on Reproductive and Child Health Program of the World Bank which found that out of 274 districts in the country, child immunisation declined in 197 districts.

Similarly, indicators of maternal health from the NFHS data show that while antenatal care is now universal in all five states, only 55-75 percent of women are getting the recommended three antenatal visits. Moreover, the report on Reproductive and Child Health Program found that the increase in in-hospital childbirth is caused by a rise in in-hospital births in private hospitals. There has been a decline in in-hospital births in public hospitals. The data on antenatal care and assisted deliveries showed that the pecentage of deliveries assisted by health workers went up from 39.6 percent in 1998-99 to 47.5 in 2002-03, the percentage of women delivering in public health facilities declined from 24 percent to 18.5 percent. The increase took place in deliveries in the private sector, where they rose steeply from 9.4 percent to 21.5 percent.

Moreover, women in richer states were seen to be using public health facilities less and turning to private health. In Andhra Pradesh, the percentage of women delivering in public institutions declined by 9.8 percent, in Kerala by 28.9 percent, in Karnataka by 10.2 percent, in Maharashtra by 9.1 percent and in Tamil Nadu by 15.3 percent. Further, the number of women who received post natal care by public health workers (ANM) through home visits within 2 weeks of delivery also declined from 14.1 percent to 12.7 percent. The Planning Commission's midterm appraisal of the 10th Plan observed that when people first seek treatment, an estimated 70-85 percent visit a private sector provider for their health care needs.

This result flies in the face of the two pet hypotheses cited above. If you believe that the lot of poor people is not improving, then this evidence is inconsistent with this position, because it suggests that poor people were a lot better off in 2005-06 when compared with 1998-99. If you believe that government spending and/or program design is important, then this evidence is inconsistent with this position: the NFHS (and other sources of evidence) show that the government system did badly, but that people got healthier and had fewer kids anyway.

What is going on? I think the main insight is that the health of the people reflects lots of things. It reflects nutrition, sanitation, knowledge, private purchases of health services and the outcomes delivered by the public health system. It is by no means controlled exclusively by the public health system; when people talk about improvements to the public health system as the only channel to having a healthier population, this is flat wrong. When people get richer, they buy better food, better sanitation and cleanliness, more knowledge (e.g. education within the family), and services of private doctors / hospitals. India has been experiencing powerful economic growth, which is trickling down to poor people. So even though the public health system is doing badly, health outcomes have improved, amongst poor people.

What I'm saying is not at all surprising when you think in terms of common sense. When people get richer, they have fewer children, buy more soap, buy more vegetables, are more likely to go to a private doctor when faced with a health problem, and are more likely to buy education services thus inducing more knowledge within the household. This makes them more healthy. But this common sense flies against the orthodoxy in India, which equates "the health of the public" with the spending on and the design of "public health programs", and assumes that poor people are not sharing in economic growth. NFHS-3 suggests that if you completely froze the spending on the Ministry of Health in nominal terms, and just had high GDP growth, you would most likely continue to get strong improvements in health outcomes.

Such an understanding - where health outcomes are not equated to the public health system - is consistent with the history of health in Europe, where a great deal of improvements in health took place owing to rising incomes feeding into nutrition, cleanliness and private purchases of health services. Such an understanding is also consistent with analysis of NFHS-1 and NFHS-2, where the basic story which emerges is that the presence of a Primary Health Centre does nothing for health.