## Thursday, August 30, 2007

### New paper on the Indian IPO market

Radha Gopalan and Todd A. Gormley have a new paper The Going Public Decision and the Role of Public Equity Markets in Emerging Economies which has the abstract:

We highlight the role of public equity markets in firm financing by studying firms' going public decision in India. The availability of detailed firm-level data for a large sample of private and public firms combined with the liberalization of the IPO market in 1992 and its subsequent collapse in 1997 make India an ideal setting to analyze the role of public equity markets. We find that firms going public after liberalization are smaller, younger, from industries with greater investment opportunities, and less likely to be affiliated with a business group then other private firms. The firms also exhibit significant increases in capital expenditure and sales around the time of their IPO. Highlighting a lack of alternate sources of capital, the equity market collapse in 1997 adversely affects the performance of private firms with characteristics similar to pre-1997 IPO firms. The firms that go public during 1992-1996 also exhibit sharp declines in sales growth rates, profitability and increases in leverage and bankruptcy rates beginning in 1997. Reflecting a lack of continued equity financing, the fall in sales growth is more severe for firms from industries with greater dependence on external finance and for firms with lower asset tangibility. Overall, the evidence suggests that public equity markets play a significant role in expanding access to finance for small, young firms in emerging markets.

Look at this search on google scholar for India IPO.

## Tuesday, August 28, 2007

### The holding company structure for financial firms

An RBI Discussion Paper on Holding Companies in Banking Groups' has brought questions about the structure of financial firms to prominence.

I think that competition policy is a core principle, and that government should not prevent a firm that makes trucks from embarking upon making cars. In my opinion, achieving efficient and world-class financial firms critically requires breaking down the walls that have been artificially created within Indian finance. Such efforts in financial sector reforms would help achieve multi-product firms where competition, innovation and efficiency considerations determine what a financial firm does. For the forseeable future, in India, we're going to have atleast four financial regulators covering banking, securities, insurance and pensions. The clean holding company structure involves an unregulated mother company - which might typically be listed - which works as a corporate headquarters which has four subsidiaries. Each subsidiary might deal with one regulator, and each subsidiary would operate like a division of a multiproduct firm.

Government agencies might point out that, given their present organisation, this configuration makes life difficult for the regulator. However, it is only fair to propose that government must be restructured to fit the needs of an efficient and competitive industry, and not the other way around.

On this subject, I would like to point you to Section 2.1, titled The holding company structure' in Chatper 11 Reforming financial regime governance' of the MIFC report.

### The wonderful world of algorithmic trading

A pair of articles by Will Acworth and Bennett Voyles in Futures Industry Magazine take you to the edge of the wonderful new world of algorithmic trading. A few remarkable things that I found:

• CME gives you co-location facilities for $6,000 per connection (not counting co-location facility charges), so that you can place your servers closer to the exchange and reduce latency. • Eurex's co-location gets you a round-trip of below 10 milliseconds, when compared with 29 milliseconds for a connection in London and 128 milliseconds for a connection from Chicago. • ICE is worrying about a new notion of quality of service: no more than 0.1% of the messages should get processed in worse than 50 milliseconds, once a new trading engine is in place. • Acworth says: In the old days, a trader might be watching four screens at the same time, commented one speaker. Now its two rows of four, with one row displaying the markets and the other row displaying network conditions. • People like the fact that in C++ you get to control when garbage collection is done, so as to avoid unpredictable glitches in performance. (Ugh!) • The average order size on the E-mini has dropped to 2 contracts. • The biggest systems are nearing a million messages a second. • Some firms have started moving functions from software to FPGA in the quest for speed. A million messages a second is a lot! I remember in the late 1990s, when I worked on the PRISM system (which does the realtime VaR at NSE), our goal was to be able to handle 100 trades/s, which is 200 VaR calculations a second. We were thrilled because the system evolved into exceeding 1000 trades a second. For those interested in algorithmic trading, you may like to see Chapter 5 of the MIFC report. ## Monday, August 27, 2007 ### Combating the costs of fund management At a wholesale level, fund management can be very cheap, with customers being charged as little as one basis point out of assets under management a year. At a fee of one basis point, a fund manager who runs Rs.100,000 of your money earns Rs.10 a year out of it. This is the price achieved by bulk fund management abroad and in India. These low prices are just not visible to the end customer in India. EPFO is expensive. Most mutual funds are very expensive. The fund management products sold by insurance companies are outrageously expensive. The key problem with mutual funds and insurance companies appears to be the distributor-centric business model. Achieving lower fees requires (a) Modifying the implementation of that model or (b) Starting over with a new business model. SEBI has recently floated a new proposal to remove loads on direct applicants for mutual funds, who would then have a choice to achieve a lower cost channel by doing it on their own, when compared with the high costs associated with a distributor. See reports by Rachna Monga in Mint and George Mathew and Sandeep Singh in Indian Express. For particularly informed commentary on this proposal, see Ajit Dayal in Indian Express, and Gautam Chikermane, also in Indian Express. I am sympathetic to this line of thought. What SEBI is proposing is a step forward. However, I worry that it represents a small move which does not challenge the fundamental agent-driven business model. What the agents could lose in this might easily be made up in other ways. These recent events have brought a fresh focus upon ways to achieve low cost fund management. Four elements come to mind: Avoid fund management products sold by insurance companies The worst excesses in terms of fees and expenses seem to be emanating from insurance companies. On this subject, see this piece by Deepti Bhaskaran in Express Money. When your friendly neighbourhood accountant comes to you, suggesting that you sign up for an insurance product so as to save taxes, it would help to think thrice about it. Quantum Mutual Fund Ajit Dayal's outfit is a rare mutual fund which is trying to break with the distributors. If active management is your thing, then this is a good way to go. But unlike (say) Vanguard, quantum is not single-mindedly fighting to bring down fees and expenses - a thought process that inevitably takes you to index funds. Index funds and ETFs The cheapest fund management products in India today are the index funds, particularly the ETFs. Benchmark's Nifty fund charges an AUM fee of 45 basis points. As an aside, Benchmark staff informally says that if there is a 10x increase in the AUM, this price can come down to 20 bps and if there is a 100x increase in the AUM, the price can come down to 7 bps. A key insight of the ETF path is that the customer gets his work done through the extremely competitive, transparent and efficient stock broking industry. A customer who goes to his stock broker seeking to buy an ETF gets a low price with no hidden catches - unlike the customer who deals with an agent and tries to buy a conventional mutual fund product or insurance product. The New Pension System (NPS) The best eye-popping numbers for saving money in fund management come from the New Pension System. These are early days and it is not yet clear how small these numbers will be. Stay tuned, for the NPS reflects a full-blown thought process of fully redesigning a fund management mechanism so as to achieve a good deal for the customer. Update: Business Standard has an editorial on these issues: A simple idea that is well appreciated worldwide is the importance of fighting fees and expenses in fund management. Good returns in fund management are a possibility, but the fees and expenses paid are a certainty. The international evidence suggests that paying more for fund management generates reduced returns. A remarkable twist to this tale in India lies in the “distributors”, or agents, who sell fund management products. Fund managers have resorted to making very large payments to these agents, to the point where the profits of the agent sometimes exceed the profits of the financial firm. The chief executives of financial firms privately gripe about this state of affairs, but have not been willing to break with the existing system. As a consequence, customers of mutual funds, and particularly those of insurance companies, are getting a poor deal. All too often, customers of insurance companies are blindly placing money in schemes with the intention of saving taxes, and ending up fuelling the profits of the agent who is selling them the scheme. The non-transparency and high charges that are in place with most mutual funds, and particularly with insurance companies, fuel the discomfort of critics of modern finance, who see “professional fund management” as a way to channel the money of ordinary citizens to financial fat cats. Exchange traded funds (ETFs) are a promising way out, because the customer is able to go to a stock broker to get invested, and stock broking is a transparent, competitive and efficient industry with very low charges. The lowest-cost fund management accessible to an individual in India is the ETF. Only one active management vehicle — Quantum Mutual Fund — has broken with the agent system, and has so far experienced limited success. The Securities and Exchange Board of India (Sebi) has now proposed that customers be given a zero-cost alternative whereby they are able to use the Internet and get their money to the mutual fund while bypassing the agent. This is a sound initiative. The insurance regulator, by way of contrast, has offered no positive proposal for addressing the egregious practices of insurance companies. However, the essence of the problem lies not in tweaking the agent system but fundamentally re-shaping the fund management industry. The New Pension System (NPS) represents an effort at using public policy in order to address the market failures of the fund management industry. In the NPS, the selection of fund managers is done on the basis of an auction where the sum total of fees and expenses is stated up front by the fund manager. This ensures that customers get low prices. Centralisation of record-keeping at the “Central Recordkeeping Agency” (CRA) and an unbundling of customer front-ending to Points of Presence (POPs) help to reduce dramatically the costs of bulk fund management. In a recent auction conducted by the Coal Miners Provident Fund, the winning bid was as low as one basis point of assets per annum. Many details remain to be worked out — how the CRA will operate, what the charges of the CRA and the PFMs will be, how POPs will be incentivised in a way that avoids the flaws of mutual funds and insurance companies, and how every detail of operation will be structured so as to constantly put pressure in favour of obtaining low fees and expenses. The onus is upon the ministry of finance and the pension regulator to translate the promise of the NPS into reality. ## Friday, August 24, 2007 ### Day one in the implementation of the New Pension System On 10 April this year, I wrote a blog entry: Day zero of implementation of the New Pension System. From 10 April till 24 August, SEBI tried to prevent NSDL from becoming the Central Recordkeeping Agency for the New Pension System (NPS). This explicit ban ended yesterday. So, 136 days later, we are now at day one of implementation of the New Pension System, though encumbered by strictures imposed on NSDL by SEBI. Okay, 135 days later, now we get going on building the New Pension System. I think it's going to be a very exciting time from here on. In parallel, it looks like there may be some movement on new recruits into PSU banks being placed into the NPS. ### Competition policy perspective on banking There is a news item in FE saying that the Competition Commission of India has started waking up to the anti-competitive policies in banking [link]. The MIFC report has written extensively about the importance of a competition policy perspective on Indian finance. ## Thursday, August 23, 2007 ### Reforming the role of credit rating agencies Business Standard has an editorial on rating agencies: Each crisis leads to incremental improvement of the institutional structure of the global financial system. The “sub-prime crisis” may generate important reforms in the role and functioning of credit rating agencies, which have come under attack for overly generous ratings that misled the market. On the one hand, it is always easy for investors to complain about losing trades. However, genuine mistakes do appear to have been made by credit rating agencies, who under-estimated the correlations between defaults by households, under-estimated the effect of higher interest rates on defaults, and under-estimated the consequences of default upon home prices and thus further defaults. Such genuine mistakes can be understood when they come from an impartial analyst. But they look particularly shocking in the context of the close nexus implicit in the rating agencies working jointly with financial firms in structuring products, and getting paid handsomely for this work. When the sub-prime market grew from$120 billion in 2001 to $600 billion in 2006, the rating agencies profited handsomely. The behaviour of a paid analyst who is a party to the launch of a product is inherently different from the behaviour of an impartial analyst who is a bystander. The European Union says it plans to examine the agencies’ roles, and investigate possible conflicts of interest between the agencies and the issuers of mortgage bonds. In Washington, Representative Barney Frank, the chairman of the House financial services committee, is planning hearings in October to examine the same issue. The first key reform that is now being discussed is to roll back to the pre-1970 situation, when credit rating agencies performed the job of being independent research companies who sold subscription services based on their true merits, and never took payments from the firms that they rated. The second key reform that is being proposed is the removal of credit rating agencies from the regulatory treatment of institutional investors. The appeal of these proposals is that they would convert credit rating agencies into genuine information and research companies, working at a healthy distance from financial transactions. A rating agency would rate a bond in the hope that investors would like to pay for the subscription service. Institutional investors would judge credit rating agencies alongside other information and research vendors, all of which offer comparable information and research services. In such a world, credit rating agencies would have to pass the market test, instead of being government-supported gatekeepers. These reforms are particularly pertinent in India, where it is now practically impossible to do a primary issue of a bond without the involvement of a credit rating agency. Fees to credit rating agencies have become akin to a tax. Infosys has zero debt, and its first Rs 1,000 crore bond issue should surely face a good market in a rational world without any credit rating. It is better to trust the processes of the competitive and speculative market, rather than trying to install a set of government-supported profit-making gatekeepers. Recent Sebi proposals involve mission-creep, from bond issuance to equity issuance. It is proposed that initial public offers (IPOs) should be “graded”. All these criticisms apply equally here. If a credit rating agency (or any research firm) has something useful to say about an upcoming IPO, it should pass the market test of being able to sell a subscription service to investors. While on this subject, you may like to see this blog entry; We need a better way to judge risk in FT by Charles Calomiris and Joseph Mason; Overrated in portfolio by Jesse Eisinger. Update: The CEO of Standard & Poors resigned, possibly as a consequence of difficulties with ratings of securitisation products. I would always argue that what matters is not individuals but incentives. Witchhunts don't help; our goal should be to reshape the incentives surrounding the bright and well-motivated people who work at credit rating agencies. Update: Business Standard carries a debate between Susan Thomas and Roopa Kudva on a related theme: Susan Thomas: Concerns about credit rating agencies (CRAs) have been gathering weight in the world of finance for a while now. Starting from the problems of highly rated companies like Enron which proved to be insolvent, to countries like Argentina, to the more recent problems of the default of sub-prime loans, the reputation of CRAs have been taking a beating over the last two decades. In response, new ways of thinking about credit risk have proliferated. One of the most important alternatives for thinking about the default risk of a corporate bond is the “KMV model” which utilises the stock price to produce continuously updated measurement of the default probability of a firm. Financial practitioners have already de-emphasised the role of CRAs. In a competitive market, CRAs would have faded away, or reinvented themselves. The distortion in the role of the CRA comes from the responsibilities vested by the government — when regulators of different financial intermediaries mandated that credit ratings be obtained before these intermediaries could invest in the bonds of firms. This paved the path for firms to pay CRAs to get their bonds rated, in order to get investments from banks or insurance companies. But once the firms started paying for their ratings, the incentive structure for the CRA to do a trustworthy job became bent towards more favourable ratings. This perverse incentive reached a pinnacle with the role of the CRA in helping to structure securitised products such as mortgage loans or sub-prime credit products. Given that there would tend to be a larger fraction of poor credit to good credit in any economy, sub-prime loans was a volumes business that earned the CRAs large profits. By definition, the sub-prime loans business was also greater risk, which showed up as large losses with the increase in high market volatility of the last six months or so. CRAs are facing the responsibility of what they reaped such rich profits from: as they reaped, so they are sowing. In a competitive market, there would not have been the regulatory mandate the CRAs have benefitted from. In a competitive market, existing CRAs would lose market share to more sophisticated alternatives. India is specially worrisome when it comes to the regulatory responsibility of credit ratings. Listed firms have to mandatorily get credit ratings for bonds; non-government pension funds and gratuity funds can invest only in investment grade bonds with two credit ratings; commercial banks can invest only in rated non-SLR bonds; and the latest peculiarity, a Sebi mandate that IPOs must be “graded”. If these regulatory responsibilities persist in the role of the Indian CRA, then we will indeed have to get serious about “rating the raters”. Instead, if the credit information business can be fundamentally re-engineered so that CRAs pass the market test and compete to obtain subscription revenues from investors, without payments from firms for credit information sent by government agencies, we won’t have to worry about it. Roopa Kudva: Absolutely yes. And indeed rating agencies are constantly subject to scrutiny, evaluation and questioning by investors, media and regulators. Since ratings are opinions, it is important that markets are convinced about their robustness before acting on them. Rating agencies therefore publish extensive data on rating default and transition statistics, and metrics on predictive capability of ratings vis-à-vis macro-economic and corporate performance. CRISIL regularly holds investor discussion forums where its methodologies and views are hotly debated by about 100 analysts present at each such event. How should raters be evaluated? Firstly, through a long-term record demonstrating that higher ratings are consistently more stable and have a lower probability of default than lower ones. Adherence to clearly stated and widely disseminated criteria is another parameter. The governance and business practices are critical in evaluating their independence. Some of these include: multi-layer decision-making processes, dedicated criteria and quality assurance teams, prohibition of analysts’ involvement in fee decisions, and analyst compensation not linked to assigned ratings. India’s rating industry scores well on these counts. There is a two-decade history of credible and robust default statistics. Since credibility is its bedrock, the rating industry has proactively and suo motu provided its report card to the market. The issuer-pays model is much debated, but would investors paying work? When a rating is assigned, the investor is generally not known. Issuers have to commission ratings and provide them to a range of potential investors who then decide whether to invest. And if investors paid, only paying investors would get access to ratings. Markets should not underestimate the huge benefits of the public disclosure of ratings — today all ratings and rating changes are available to the entire market free of charge, as they are widely disseminated. Rating agencies are the most independent providers of credit opinions compared to other potential opinion providers — borrowers, lenders, investment bankers or brokers. Ratings have a vital role to play in India’s credit markets. The Indian rating agencies proactively alerted the market to the impending risks in the NBFC sector in the 1990s, well before the crisis precipitated. The contingent liabilities of state government guarantees as a risk factor were first highlighted by CRISIL. The potential problem in the collective investment plantation schemes was nipped in the bud by rating agency alerts. The recent actions by CRISIL highlighting the heightened risks associated with leverage in corporate balance sheets to fund their global expansion were keenly appreciated by the market. Not surprisingly, Indian investors’ acceptance of ratings preceded regulatory recognition. Even today, investors demand ratings in areas which go well beyond those where regulations make them mandatory. ### Should IST be broken up into two? Should India do DST? Evaluating two timezones and Daylight Saving Time for India, by Viral Shah & Vikram Aggarwal, August 2007. On a related subject, you might like to see this blog entry. Update: Pierre Mario Fitter has an article in Business World on this question. ## Tuesday, August 14, 2007 ### Separation between market and state I wrote an article Concerns about sovereign funds in Business Standard today where I worry about placing shares - and thus a say in corporate governance - in the hands of governments, particularly those which lack domestic political accountability. It is related to the problems of civil servants managing large reserves portfolios. Here's a useful collection of readings on the subject of sovereign wealth funds (SWFs) [wikipedia], organised in chronological fashion. I was dimly aware of the problem for quite a while; Larry Summers, Jeffrey Garten and William Pesek woke me up. The recent fracas about China talking about selling US government bonds is an illuminating episode: it tell us something about what can happen with SWFs in the days to come, and it tells us that the reserves portfolio is not that different from a SWF when it comes to such strategic behaviour. On the issues of both the reserves portfolio and SWFs, I'm reminded about the difficulties of quasi-nationalisation' that arise in the context of government-controlled pension funds getting invested in equities (see this paper, particularly page 34, for the index fund response to that issue). ### Lessons to not draw from the sub prime crisis' Percy Mistry has an article in Economic Times on the lessons that India's policy makers might draw from the sub-prime crisis'. Also see Ila Patnaik (Indian Express) and Niranjan Rajadhyaksha (Mint) on the same subject. Do look at The credit crunch quandary by David Hale in Financial Times. I also enjoyed reading Subprime ‘crisis’: observations on the emerging debate by Charles Wyplosz where at the end, he says: The deeper moral is simple. Financial markets exist to do risky things. The more risk they take, the higher the (expected) returns. You can use regulation to squeeze risk out of a segment of the market, say banks, but you don’t eliminate the risk, you just move it elsewhere. New segments, say hedge funds, emerge to take over the risk and the high (expected) returns that go with it. The problem is that little is known of the new segment and its players, so the armies of regulators and supervisors that protect us look in the wrong direction because they don’t know where to look. There has been much talk about regulating the hedge funds; it might happen, so the game will move elsewhere. The only way to eliminate financial crises is to fully eliminate risk. Kim Jung Il knows how; eliminate financial institutions. But that means no (expected) returns. I would say it only slightly differently. ## Friday, August 10, 2007 ### Universities in India and China In Indian Express today, Ila Patnaik describes how Indian and Chinese universities fare in the Times Higher Education Supplement (THES) measurement of the top 200 universities of the world. The Indian Express website is clunky; you have to click on the "image" on the right hand bottom to get the table which is the heart of the article. The underlying information is on the THES website. Meanwhile in India, the UPA continues to focus on quota politics instead of structural reforms -- Laveesh Bhandari has an article (also in today's Indian Express) on the present situation. ## Thursday, August 09, 2007 ### Mumbai as an IFC, by Percy Mistry ### Shankar Acharya and Nirvikar Singh on monetary policy Shankar Acharya thinks the UPA government's approach to monetary policy is deeply wrong. Nirvikar Singh reminds us about the first principles of modern open economy macro. ## Wednesday, August 08, 2007 ### Disclosure-based approach to government's role in higher education Business Standard has an editorial on a disclosure-based approach to government involvement in higher education: The All-India Council of Technical Education (AICTE) has decided to approach state governments and ask them to close roughly 150 unapproved institutions. Some of these institutions are undoubtedly dubious (as are many that have received AICTE certification); on the other hand, one of the institutions in the gunsights of the AICTE is the Indian School of Business in Hyderabad, which is arguably India’s best business school. The crude approach of the AICTE brings basic questions about public policy on higher education to the fore. What is the appropriate role for government in higher education? A major question animating law-makers is the fear of “fly by night” firms who will “run away” with the money of students or short-change them. This is reminiscent of the problems seen in the securities markets, where there are concerns about similar “fly by night” firms who sell securities to “hapless investors” and run away. In the securities markets, the country has seen a shift away from the Controller of Capital Issues—who gave out discretionary permissions to any firm seeking to sell securities—to the modern disclosure-based framework. In this disclosure-based framework, the government only emphasises the importance of accurate information being available to the investor when a decision is made to invest in a security. A similar approach would work very well in education. In a disclosure-based framework, the focus of the government would be on disclosure. For the rest, the decision about what university a person chooses to go to is best made by that person—and not by the government. The key insight here is that—as with investors—students are not eager to waste money on earning low-quality diplomas. Students are self-interested and work hard on trying to identify good programmes. Their efforts at making a choice can be supported by the government, if it runs a disclosure programme whereby accurate and salient information is made available to prospective students. The great advantage of such a disclosure-based approach lies in the fact that it would eliminate entry barriers in higher education, and make possible a surge of supply through which shortages would ease. Reputed global brands would come into the country to offer educational services. The market for education would shift from the present framework of scarcity and low quality to one with competition and choice. A healthy debate can take place on exactly what information universities and institutes should be required to disclose. The key decision that the UPA government faces is that of breaking with the established mentality of the ministry of human resource development, which is running a licence-permit raj with steep entry barriers into education, coupled with extensive meddling in the activities of universities. The task of the UPA now is to end the involvement of government in both the licensing of universities and their actual operation, and refashioning the HRD ministry so that it focuses on disclosure by universities in a way that supports the task of students faced with choice. On the securities markets, a small number of investors are cheated every year: they fail to understand the disclosures and make mistakes. In similar fashion, the error rate under a disclosure-based regime in higher education will not be zero. The rationale for a disclosure-based regime is not that it is perfect. The rationale for such a reform lies in observing that it will be much better than the present disaster in Indian higher education. ### Rajwade on trade credit A key insight of modern international economics is that once a country has a large current account, capital controls become relatively ineffective. When the currency regime leaves money on the table in terms of one-way-bets, it becomes harder and harder to prevent this from inducing unstable capital flows. A V Rajwade has an article in Business Standard about this phenomenon. ## Tuesday, August 07, 2007 ### Capital controls on external commercial borrowing At 6:49 PM today, there was a MoF press release with capital controls against external commercial borrowing (ECB). Here's a spreadsheet with facts about ECB. Will these capital controls substantially change the situation on the currency market? Are these initiatives a good idea? I think not, for a few reasons: 1. How big is the benefit for a central bank seeking to manipulate the currency market? ECB is not that big when compared with the overall size of the problem of market manipulation of the currency market. As the spreadsheet mentioned above shows, of the incremental gross inflows into the country in 2006-07, only 5% were on account of incremental ECB inflows. The daily trading volume on the currency market is$38 billion a day. Manipulating such a market is hard - and the change in ECB caused by today's announcement is small. Recall that RBI purchased $12 billion in February alone - while the net ECB in the full year of 2006-07 was$16 billion.
2. The reduction in ECB through this may be pretty small. ECB above $20 million has to be used outside the country for specified purposes' such as the purchase of equipment. This needn't change the situation on the currency market: pretty much the same outcome on the currency market could come about, while only changing the identity of the firms doing ECB. Consider a firm that was ordinarily going to import equipment anyway. Ordinarily, this firm might have purchased USD on the INR-USD market in order to buy imported capital goods. Instead, this firm will do ECB. It will now be the beneficiary of low cost borrowing and possibly a one-way bet on the rupee. Its orders will now fail to come into the INR-USD market. To the extent that such substitution takes place, the impact of the rule change will be smaller than meets the eye. 3. Capital controls on debt are easy to evade using repos and using put-call parity. It's not hard to disguise offshore borrowing once equity flows are open. See my pre-31st' text in this blog posting, and this blog posting on the general theme of dodging restrictions against debt. There is a widespread belief in India that equity flows are "good" and that debt flows are "bad" and that the levers of policy should be used to block the latter. But once equity flows are open, no "Maxwell's demon" can favour equity flows and block debt flows, since market participants will just do put-call parity and spot-futures "arbitrage" (i.e. repo) positions so as to achieve debt-style payoffs while using equity-style instruments. 4. Offshore arms of Indian firms will do the borrowing. Many Indian firms are becoming multinationals. When firm X in India owns firm Y outside the country, now, firm Y will do borrowing. The intra-firm trade between X and Y will do transfer pricing so as to move cash to Y. Y will then repay the debt. Once you have a large current account with globalised firms, capital controls lose effectiveness. 5. Loss of credibility and respect for the policy process. These four difficulties raise questions about the policy process that led up to this decision and lead to a loss of credibility. We're still in a stage of denial about an inconsistent monetary policy regime; we're not confronting the fundamental mistakes that lie beneath; we're still looking for palliatives (and we're trying palliatives that won't even work). 6. Capital controls on debt today; where can this go next? Reversing some reforms undermines the credibility of all reforms. When this won't work, where would you go next? A tobin tax' on FII flows? 7. Poor development strategy. Suppose I am wrong; suppose these capital controls are effective. The deeper question remains: Why do such restrictions? This boils down to industrial policy where a garment exporter is good' and must be supported with an undervalued exchange rate, while (say) a power plant that wanted to do ECB is bad' and must finance this subsidy. It is hard for a government to have the information processing required to make such calls correctly. Is there much to gain from export-led growth' when that growth is based on subsidies? Garment exporters will, of course, export more if they are given free electricity - is this a good way for India to achieve export led growth'? (This Business Standard article talks about fake exports'). Update (9 August): The editorial in Business Standard says: However, it must be emphasised that this is only a “breathing space” measure, giving policy-makers some time to grapple with the longer-term implications of a persistently appreciating rupee. While it is true that an under-valued currency itself stimulates capital flows—foreign investors need not worry about currency depreciation diluting their returns—there is also little question that capital inflows into the country are significantly motivated by the more fundamental factor of sustained growth. These flows are likely to persist regardless of the currency regime. Whether they come in as debt or as equity investments is secondary. Given the widely held view among global investors that the Indian growth story is enduring, a balance of payments surplus induced by large capital inflows is a structural phenomenon. To the extent that it complicates domestic macro-economic management, it requires a structural response. One of these is to simply let the currency float. In fact, this is an eventuality which will emerge along with full convertibility, for which there is a roadmap with four years remaining. Perhaps that process can be hastened, but it is constrained by the state of preparedness of the financial sector. The real question is how the regime should transit from a managed exchange rate to a largely market-determined one. Too rapid a transition can be disruptive, as has already been seen in the performance of exports, many of which are relatively employment-intensive. On the other hand, too slow a movement intensifies the problem of large capital inflows, while exacerbating the risks of a drastic response to domestic or external shocks. It is this transition which needs to be rigorously but quickly considered in the current scenario. Recent upheavals in global equity markets should heighten the sense of urgency. Of course, part of the adjustment required has already taken place with the recent appreciation of the rupee. It is now, clearly, much closer to its true market value, whatever that may be. By imposing the cap on ECBs, the government appears to be signalling that it now wants to hold course for a while and let the various players impacted by the appreciation adjust to it. Under the circumstances, stopping for a breather is all very well, but the opportunity it provides will go to waste if the requirements for a currency regime more appropriate to the state of the economy and its future course are not decided and acted upon. The editorial in Mint says: Sadly, the numbers won’t stack up. The current financial year till 20 July saw accretions to foreign currency reserves worth$22.9 billion—double that witnessed in the same period in 2006-07. While this pace may not be sustained for the rest of the year, especially with global financial markets beginning to see volatility, it is also not likely to see a sharp reversal. Either way, the curbs announced on Tuesday will not have the desired effect of a dramatic slowdown in foreign currency inflows.

Worse, the move sends the wrong signal to the markets.

For one, it is probably the first time that India has regressed on its measures for external sector reforms. After effecting a shift in the mindset by allowing Indian companies to borrow in dollars to spend in rupees domestically, it is now forcing a reversal. Second, North Block has conveyed a sense of panic. The fact that foreign currency inflows are posing a macro-economic problem has never been in doubt. By undertaking a measure, which on the face of it will achieve little, the authorities have conveyed to the market that RBI is short on options.

Market players now realize that there is not much that the government can do at this stage. Any further measures to sterilize inflows are not possible, unless the Union government is willing to absorb the fiscal costs. Unless something dramatic occurs, the pressure on the rupee to appreciate will resume. In other words, the authorities would have failed to restore a two-way movement of the rupee. This could be disastrous for the shortterm, as foreign currency speculators will be emboldened to take riskier bets—making it even tougher for RBI to manage inflows.

If there is any lesson here, it is that there is no simple solution. The way forward is for the government to allow greater flexibility to the market, calibrated to account for real-world situations. The market estimates that if RBI stopped all interventions, then the rupee would settle to Rs37 to a dollar, with undoubtedly catastrophic effects on exports. The first step is to develop a vibrant market for foreign currency derivatives that can provide a foreign currency hedge. The Percy Mistry report, submitted earlier this year, has set out the blueprint. But due to internal resistance, matters have begun to drag. It is for the leadership to manage the conflicts among policy wonks within government.

The editorial in Financial Express says:

There are no two ways about this. The Indian government’s clampdown on external commercial borrowings (ECBs) for domestic use, to prevent rupee appreciation, is simply bad economic policy. Even if, for the moment, we do not question the policy of tying the rupee down to boost exports, the question to ask is whether these new impositions can be effective. Maybe they will work for a few days. But the size of ECB inflows, both as a proportion of gross dollar inflows (4.5%) and incremental gross dollar inflows last year (5%), is so small, and the size of the currency market so big, that this measure cannot really work. The new restrictions could make a marginal difference to net inflows, but on the whole, they will do little to ease the pressure on the rupee. In any case, it isn’t the ECB surge that has pressured the currency up. Rather, it is India’s irresistibility as an investment destination. Therefore, the argument that net ECB flows doubled last year and so this is what needs to be brought under control is flawed. Take a closer look. BoP data shows that gross ECB inflows went up from $14.5 billion in 2005-06 to$21.9 billion in 2006-07, nearly touching the raised annual cap. But net flows, first-year repayments being negligible, rocketed from $2.7 billion to$16 billion. This may have alarmed policymakers, but it was not a runaway figure. Assuming gross flows of the maximum permissible $22 billion next year, net flows would be lower on account of larger repayments. Meanwhile, most foreign capital flowing into India is via other channels. By an AV Rajwade estimate, nearly$70 billion may be flowing in as trade credit for imports, and this does not even show up in the BoP data. Similarly, there are instruments by which debt flows in through equity markets. A foreign investor could buy shares of a company and have a fixed-price buyback on a future date—thus making it as good as debt. So, instead of resorting to clumsy controls that cramp the operational freedom of enterprises and send out all the wrong signals, it would be better if the government let market processes play themselves out in the external sector. The more we muddle things up, the worse will be the turbulence when market forces eventually start disentangling them, as they will.

Update: Jamal Mecklai has written an article about the restrictions on ECB.

## Monday, August 06, 2007

### Two articles on monetary policy and the rupee

Ila Patnaik points out, in Indian Express, that government must set up a sound monetary policy framework in the sense of clearly writing down what RBI must do. And, Kalpana Kocchar & Andre Richter Hume have an article in Business Standard about the linkages from rupee appreciation to exports growth.

## Friday, August 03, 2007

### Fumbling on currency futures

Nirvikar Singh has an excellent article in Financial Express on how India should play the currency futures question. Unfortunately, the early indications are that this will go badly wrong.

## Thursday, August 02, 2007

### Why the turbulence in global financial markets?

My starting point is Jim Hamilton's treatment of the July news in US housing. But how did the difficulties of loans inappropriately given to poor credits in the US turn into global financial market fluctuations? Matthew Goldstein and David Henry have written The pain moves beyond subprime in Business Week, which helps in understanding some of the linkages at work.

If you had any doubt about the spreading problems in the US economy, Jim Hamilton points out that the July automobile sales data - 14% down compared with last year and 17% down compared with July 2004 - were not just another bad sales month. One opinion poll shows that two-thirds of individuals in the US are decidedly gloomy about the economy.

The VIX rose from roughly 12 to roughly 24 over the last 3 months [link]: a dramatic increased in the ex-ante uncertainty about US equities.

Willem Buiter has a thoughtful blog entry putting these elements together in a coherent framework from which I'd like to quote at length:

The normalisation of the two global asset market anomalies of the period from 2003 to QI 2007 - very low long-term risk-free real interest rates and astonishingly low credit risk spreads across the board - is proceeding apace. Long-term risk-free real rates are no more than about 50 bps from their long-term historical average - certainly if we filter out the transitory flight to quality that has temporarily boosted government bond prices for the past few weeks. Default risk premia on corporate debt, and on the debt of any institution exposed to the US subprime mortgage market are almost back to normal. Credit spreads further removed from the subprime debacle are still low, including emerging market debt of countries that don't have foreign exchange reserves coming out of their ears (there are some!).

What is interesting is that global stock markets have gone through a non-trivial, albeit still modest, downward adjustment in the last couple of weeks, and especially at the end of last week. Such a correction is quite consistent with the often-heard view that, compared to debt and credit default risk , that is, given then prevailing long-term interest rates and credit risk spreads, equity was not overpriced during the asset anomaly period. All that statement means, after all, is that the price of equity seemed reasonable, in that it could be explained in terms of the three key fundamentals: projected future earnings, risk-free discount rates and a reasonable guess at the equity risk premium. There was no need to rationalise equity valuations as the result of a bubble in the stock market. However, even if there was no bubble in the stock market, equity could have been the beneficiary of a bubble in the bond markets, and even of the credit risk market anomaly, if the equity risk premium responded to the same force(s) that kept the default risk premium artificially low.

A fall in the stock market is, in fact, quite easily rationalised as a result of the fundamental shocks that caused weakening of the two asset market anomalies. Even if the anticipated future path of earnings were unchanged, the bursting of the bond market bubble that, in my view, caused almost of the increase in longer-term risk-free discount rates, would have a negative impact on equity values through an increase in the risk-free component of the equity earnings discount rate.

It is true that higher default risk premia caused by a sudden reduction in risk tolerance (an exogenous shift towards fear on the greed - fear spectrum) does not necessarily imply a higher equity risk premium. It is, however, not difficult to come up with quite plausible stories that would have credit risk premia and the equity risk premium going up in tandem; for instance, an increase in risk aversion, holding constant the covariance between consumption growth and the return on equity, would do the job. Finally, expected future earnings growth could have been revised downwards, either independently of the shocks causing the two asset market anomaly corrections or (partly) as a result of these same shocks. There is, however, no evidence, either aggregate or at the level of individual corporate earnings reports, of any unexpected weakness in corporate earnings.

Three key global asset market now have flashing amber lights. Does this mean we are about to see the end of the five golden years that saw global real GDP growth never far below 5 percent per annum? Possibly but not likely. The fourth (set of) key global asset price(s), exchange rates, are continuing to play a stabilising role. The US dollar is tanking, as it must. The yen is finally strengthening, as it ought to. The euro and sterling are strong as a DDR body builder on steroids (there is some redundancy in this simile), but there seems to be remarkably little pain.

While we may seem some weakening of real economic activity in the remainder of 2007 and in 2008 relative to what was expected earlier (pace the IMF which just revised its forecasts for 2007 and 2008 upward), I believe it more likely that we will continue to see a lot of Sturm und Drang in global financial markets, especially in the overdeveloped world, but rather little noticeable weakening of real economic activity. The financial superstructure appears increasingly to exist in a world of its own, cocooned off from the rest of the world. Fortunes are won and lost, but except for those immediately affected, it really does not impact much on anything real, that is, on anything that matters.

On the subject of this remarkable financial superstructure, you might like to see this blog entry.

Business Standard has an editorial on 7 August where they say:

A few months ago, the long-standing problems of “global imbalances” appeared to be abating, with a soft landing involving a dropping dollar and slow US GDP growth. Now, fears about global macro-economic worries are back on the front pages. Three major things have changed in recent weeks. The trouble in US housing has turned out to be much worse than was earlier felt to be the case. Many financial firms have failed—in the US and elsewhere. Credit spreads have risen sharply and risk perceptions have been revised upwards.

Stock prices fared very well in the last year, with the Nifty gaining 35 per cent and the S&P 500 gaining 12 per cent. Now fears about the world economy have led to lower stock prices. Home construction is the worst-performing industry in the US; shares of companies in the field have lost 60 per cent over the last two years. In addition, the projections embedded in option prices show an upsurge of volatility. The S&P 500’s implied volatility has surged to 25 per cent, the highest in three years. In India, so far, the implied volatility is at 27 per cent, which is modest for India’s markets. The relative numbers suggest that India’s markets have some ground to lose before they stabilise.

An opinion poll conducted by the Wall Street Journal shows that as many as 66 per cent of the respondents believe the US will now have a recession. This conveys the gloom in the US. Will the US Federal Reserve mount a rescue by swiftly cutting interest rates? It is unlikely. The Fed is a de facto inflation-targeting central bank. The expected inflation embedded in the prices of inflation-indexed bonds in the US is at 2.3 per cent, which is above the 2 per cent target. Until future inflation softens perceptibly, the US Fed is unlikely to cut rates. At present, the derivatives markets are showing a 20 per cent probability of a rate cut by the Fed by September and a 40 per cent probability of a rate cut by October. In India, all these financial markets are missing, and the central bank’s objectives are not clearly specified, hence it is not possible to anticipate what the RBI will do.

How would India be affected in an unhappy scenario? A recession in the US would lead to soft prices of tradeable goods worldwide, particularly given the massive investment boom in China focused on producing these tradeables. Hence, profits rates of Indian firms producing tradeables would be adversely affected. This would apply not just for companies exporting goods, but also for a company producing goods for the domestic market which are priced by import-parity pricing. The net profits of Indian companies have grown remarkably from 2002. The unhappy scenario would dent this profit growth. It would also diminish optimism, and thus investment demand.

A feature of recent weeks has been the robustness of global financial capitalism. A few hedge funds have gone bust, with losses of billions of dollars. A few very rich customers of the hedge funds have suffered big losses. Barring that, nobody seems to have got hurt. Hedge funds are, thus, shaping up as an important new shock absorber in global capitalism. In India, this shock absorber is lacking, through longstanding efforts by policymakers at preventing a hedge fund industry from coming about. The key tool for confronting future events, then, remains price flexibility. If there is bad news, the government should not prevent stock prices and the rupee from losing ground. These are the essential equilibriating responses of the system of financial markets.