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Monday, December 28, 2009

Protectionism, recession, recovery: looking back and looking forward

In thinking of protectionism, the Great Depression, the Great Recession, and what might come next, here are two interesting angles.

Governments with their backs against the wall


Ideally, stabilisation using monetary and fiscal policy, alongside actions by the private sector, should restrain the decline in consumption, and yield conditions which are not too harsh for households. At the time of the Great Depression, much less was known of economics. Pegging the currency to gold meant giving up monetary policy autonomy; the US Fed succumbed to contractionary monetary policy once you take into account the closure of banks; the fiscal policy response at the time was miniscule.

It has been argued that the the Smoot-Hawley Tariff Act came about in the US in June 1930, at a point in time where the politicians were coming under enormous pressure to do something. After seven months of inaction by macro policy, with mounting difficulties in the economy, the politicians succumbed to protectionism. This appears to have been of decisive importance in sending the world down the destructive path of competitive trade barriers and cometitive devaluation. In the graph made famous by Barry Eichengreen and Kevin H. O'Rourke, at month 7 there was almost no decline in world trade. Douglas A. Irwin is worth reading on this.

Protectionism adversely impacts the recovery


Greg Mankiw and Scott Sumner point out one more channel through which Smoot-Hawley damaged prospects for the recovery was through the impact of protectionism on confidence.

The private sector saw protectionism as symbolising government backing away from responsible thinking in economics, and responded with a weakening of investment demand. This served to exacerbate the downturn.

Will this time be different?


The bulk of world GDP is now endowed with inflation targeting central banks. This ensures that monetary policy will be counter-cyclical: under bad business cycle conditions, inflation forecasts will drop below targets, and central banks will use every trick in their book to push inflation back up to target.

Fiscal policy has responded well this time around, thanks to better understanding of business cycles when compared with 1929. But there is little headroom to go further.

The world has as little ability to rein in some players engaging in competitive devaluation (e.g. China) today, as was the case in 1930. But with the bulk of world GDP being placed with inflation targeting central banks, the extent to which such tactics will be used will be relatively limited.

So far, we have had an upsurge of protectionism, but nothing on the scale of that seen from 1930 onwards. This could partly reflect the dramatic actions which governments have undertaken through monetary and fiscal policy, through which politicians have been able to reduce the domestic political difficulties that go along with business cycle downturns. But if, in coming months, the world economy remains mired in recession, then we could get fresh pressure to do something. In a recent voxEU post, Jeffrey Frieden points out that the path of adjustment of macroeconomic imbalances and currency distortions will involve political pain along the way, which could spillover into protectionism.

Some protectionist decisions could reflect bargaining tactics aimed at getting China to reduce or end their market manipulation of the currency market. But if there is an upsurge of protectionism beyond this, it will further damage the recovery by hurting investment, giving a spiral of bad economy -> protectionism -> reduced investment demand -> worse economy.

Saturday, December 26, 2009

Five questions on asset prices and monetary policy

Howard Davies was a deputy governor of the Bank of England, and the first head of the UK FSA. He is one of the world's leading thinkers on financial regulation and monetary policy, and one of the people who combines skills in both finance and monetary economics. In a recent article, he focuses on the five interesting questions about central banks and asset prices. Everyone interested in monetary policy today needs to ask themselves these five questions.

Q1: Should central banks target asset prices?


Davies points out that the consensus view is that central banks should remain focused on inflation targeting and not target asset prices.

However, pretty much everyone would agree that information from the world around us, about asset prices, is useful for forecasting inflation and output, and should be used in figuring out what values for output and inflation we put into our Taylor rules (whatever they might be).

So it seems that on this question, there is consensus: Asset prices are (and have always been) useful inputs in monetary policy formulation, but monetary policy should continue to do inflation targeting and not asset price targeting.


Q2: Should the measure of inflation targeted include an element of asset price, and particularly house price inflation?

Any reasonable CPI must have house rent in it, and through this, a boom in house prices and thus rents will get reflected in the CPI. This would give one more channel through which asset prices would directly influence a traditional inflation-targeting central bank.


Q3: Is it possible to identify serious asset price misalignments, and are they of legitimate concern to monetary policy-makers?

This is controversial territory. Some economists believe it is possible to ask central banks to make a call on when asset prices are misaligned.

I am personally skeptical about the extent to which this is possible. It is always easy to look back, ex-post, and say that it was obvious that US house prices were way off in 2006. But how many of the people who say this today were shorting US housing then?

Making a call about asset price fluctuations is hard even for a well motivated hedge fund manager. It is doubly hard in the public sector given the peculiar combination of skills and incentives that are found within central banks. The people with real skill in these things are unlikely to choose to work in a central bank; years spent in a central bank do not hone skills at market timing; the public will be very irritated if a central bank calls wrong.

So overall, I'm skeptical about the extent to which central banks (past or future) can usefully make calls about when asset prices are out of whack.


Q4: Even if we can identify misalignments, and believe that some price adjustment is bound to occur, is it right to use interest rates to try to moderate the expansion?

Even if you knew that asset prices were grossly wrong, interest rates seem to be a very blunt tool, which inflict collateral damage all around the economy. Davies quotes Mervyn King who said two months ago: Diverting monetary policy from its goal of price stability risks making the economy less stable and the financial system no more so.


Q5: Should we try to find and use mechanisms other than interest rates to moderate extravagant credit expansion and associated asset price bubbles?

I think there is a good case for building some kinds of counter-cyclicality into financial regulation. But operationalising this is hard.

It should be feasible for financial regulators to have three manuals which govern boom times, normal times, and recessions. Full public disclosure of these three manuals is, of course essential, to avoid the usual issues of transparency and consistency. The question is: When would you flip from one manual to another?

Doing this based on asset prices runs into the difficulties articulated above. How is a civil servant to know when asset prices are in a boom or a bust?

Doing it based on business cycle conditions is more objective and feasible. It should be possible to setup indicators like Eurocoin which give low latency information about a coincident indicator. This could be used to drive rules about when we go into each of the three manuals. I personally think this would be useful.

Such efforts can be rationalised on the narrow ground that we seek to reduce the extent to which finance is a source of pro-cyclicality in the economy. If this is done right, it would reduce the amount of heavy lifting that monetary and fiscal policy have to do by way of stabilisation.

You don't have to have a `financial markets are irrational' view to support this. All you have to believe is that the existing structures of financial regulation are a source of pro-cyclicality. If that much is agreed, then there is a case for changing the framework of financial regulation so as to reduce the extent to which this is the case.

Wednesday, December 23, 2009

Interesting readings

Tuesday, December 22, 2009

Building the perfect GST

The 13th finance commission has released the report of the task force on the GST. Here are some responses:
There are three huge and complex projects which are afoot in India today, each of which is of critical importance in transforming the landscape. They are: the Goods and Services Tax (GST), the New Pension System (NPS) and the Unique Identification (UID).

A lot of what I know about pension economics comes from David Lindeman, and he often quoted Larry Thompson in saying that such reforms involve three dimensions of effort : policy, politics and administration. Each of the three has to work out right in order to obtain success. If any one of the three goes wrong, then the overall outcome is attenuated.

With the NPS, we have made enormous progress on the politics and policy, but are weak on implementation. The GST faces political difficulties and it is not clear that the policy thinking will be done right. But the moment these early stages are crossed, the brunt of the problem will become administration. With the UID, there seems to be political support (so far), and the challenges are of making the right moves on policy and administration.

Bringing Nandan Nilekani to run UIDAI is an important step forward because it shows a recognition that the administrative challenges of these systems are unlike business-as-usual in government. These are complex IT systems, and require a new kind of execution punch in terms of rolling out complex nationwide IT systems. Similar thinking needs to be brought to bear for NPS and GST also.

Till date, the best success of a large complex system of this nature is the TIN. That was a problem which was all administration - it did not involve complex problems of politics and policy. However, it has proved a certain model of how to get this done (by contracting-out to NSDL using a certain kind of contract structure).

On large complex IT systems and their impact on India, you might like to see: Improving governance using IT systems, page 122-148 in Documenting reforms: Case studies from India, edited by S. Narayan, Macmillan India, 2006.

Update (February 2011): IT strategy for GST.

Monday, December 21, 2009

How bad was industrial production in October?

by Radhika Pandey and Rudrani Bhattacharya.

This appeared in Financial Express today.

In India, many people look at year-on-year changes to track the state of the economy. This indicator has important weaknesses. It is the moving average of the change seen in the latest twelve months and is hence a sluggish indicator of the changes in the economy. In order to monitor current developments in the economy, it is preferable to look at month-on-month changes.

However, month on month changes are distorted by seasonal fluctuation. The solution lies in seasonal adjustment. The seasonally adjusted month on month changes provide more timely information about the state of the economy. Internationally, the standard procedure for examining and monitoring economic series uses seasonal adjustment.

The figure shows the familiar time-series of year-on-year growth of IIP. This shows that output in October 2009 was 10.3% bigger than the level of October 2008. This seems reassuring.

Far more informative is the time-series of month-on-month changes. Each of these values is the annualised month-on-month change in the seasonally adjusted IIP. The term applied is `SAAR change' which stands for the Seasonally Adjusted Annualised Rate of change. This shows an unhappy value of -5.12% for October 2009 (when compared with September 2009). The key strength of this approach is that we are discussing the change from September 2009 to October 2009, instead of the 12 changes from October 2008 till October 2009.

Is the picture so dismal? To answer this, we need to look into the non-economic factors which might influence this number. October 2009 was a month of festivities with fewer working day but enhanced purchases prior to Diwali. At the same time, Diwali does not occur in a fixed month every year. Hence, the simplest seasonal adjustment procedures will not remove these effects.

In the jargon of seasonal adjustment, Diwali is a `moving holiday'. It requires special care in seasonal adjustment. Hence, in our work on seasonal adjustment, we test for the impact of moving holidays such as Diwali and Id, and when these effects are statistically significant, we adjust for them. Through this procedure, we find that SAAR for IIP for October 2009 works out to +0.12%. In other words, correcting for Diwali yields a change from an estimate of -5.12% SAAR for October 2009 to an estimate of +0.12% SAAR.

The figure superposes the two time-series of SAAR IIP (without adjusting for Diwali) and SAAR IIP (with adjustment for Diwali). In most months, the two series are obviously identical. But in some months, the interpretation of the IIP data strongly requires care in treatment of Diwali as a moving holiday.

Many analysts warned about reading too much into the weak October 2009 IIP performance, on the grounds of a Diwali effect. We go from this broad but unspecific caution to a precise estimate of what happened to overall IIP and IIP-consumer goods in October 2009 when compared with September 2009, after adjusting for seasonality and Diwali. The result is a gloomy value of 0.12% SAAR for IIP in October 2009.

The biggest impact is visible on the IIP-consumer goods (figure above) which shows a pleasant value of 7.01% SAAR after the Diwali adjustment, while without this adjustment, there is a worrisome SAAR value of -25.07%.

The calculations reported here are updated every Monday at on the world wide web. For all series, Diwali effect testing is done, and wherever the impact is statistically significant, it is adjusted for. It proves to be significant for IIP, IIP (Manufacturing) and IIP (Consumer goods).

Sunday, December 20, 2009

The trading hours controversy

Shifting away from central planning


Traditionally, Indian socialism has involved government control of all aspects of financial products or processes. As an example, government specified the time of day at which trading starts and the time of day where it stops. The RBI committee process on currency futures and interest rate futures specified that trading must start at 9 AM and stop at 5 PM.

In most areas of the Indian economy, goverment no longer controls the economy in such fashion. The government does not specify what time a shop opens or closes. There was a time when the Indian government did not permit the use of aluminium for making cans of soft drinks. A large fraction of such meddling in the economy has been dismantled (though not in finance).

A few weeks ago, SEBI came out with a liberalised policy: Exchanges could open anytime afer 9 AM and stop trading anytime before 5 PM. If NSE or BSE opt for longer hours, securities firms will face the decision about the time at which the shop opens for business and the time at which it closes. Staying open longer will involve somewhat higher costs and in return will yield somewhat higher revenues. Each shop will make its own decision about choosing a starting and a closing time.


What do we gain?


If Indian markets to be open from 9 AM to 9 PM, there are two benefits. First, consumers should have maximal choice on when they can achieve their trading needs. Recall that internationally, many grocery stores choose to stay open for 24 hours a day.

Second, in the late evening in India, the ADR market opens in the US, and it is important to link up the closing Indian prices to the opening US prices.


How will exchanges and their members cope?


If securities firms have to stay open for 12 hours a day, this will require process modification, including multiple shifts for certain employees.

These changes might seem burdensome. But similar changes have taken place before. With floor trading at the BSE, trading only lasted for two hours a day; but when NSE came along, trading moved up to 5.5 hours a day. Members doing commodity trading are already running to almost midnight.

Securities firms and exchanges will need to change their process design to achieve longer hours. If a securities firm has to trade from 9 to 9, this will require two shifts. The first shift will probably come to work at 8 AM, and stay till 3 PM, while a second shift will probably come to work at 3 PM and stay till 10 PM. Some firms will find that this does not make sense for them and they will choose to only keep their shop open for shorter hours.

The operation of securities markets in India is held back by infirmities of the payment system. A shift to longer trading hours will encounter frictions owing to problems with payments.

At first, clumsy solutions will be found because of problems of the payments system. But at the same time, when the industry demands more from the payments system, we set ourselves on the course for deeper surgery of the payments system. In this 21st century, we can and should have a payments system which processes 100,000 messages per second and runs for 24 hours a day. When the industry complains enough about the infirmities of what is in place, the existing payments system will be questioned, which could ultimately lead to improvements in the payments infrastructure.


A messy situation?

NSE and BSE have gone through a series of announcements. First, BSE said they would start at 9:45. Then NSE said they would start at 9 AM. Then both said they would think about this after the holidays.

These activities seem messy and confusing in the public eye. These tactical details are an inherent part of the market economy. When government control is withdrawn, and a license-permit raj is scaled down, we go from a tranquil and stable environment -- the silence of a graveyard -- to a dynamic environment where firms are thinking and reacting. This should be welcome.


Doing more on moving away from central planning


SEBI needs to move forward on many fronts in terms of getting away from government control of product features. There is no reason to restrict exchanges to the zone from 9 to 5. Similarly, many other product features on the derivatives market need to be decontrolled: what underlyings to use, whether cash settlement or physical settlement, the expiry dates, the contract sizes, etc. Government control of these product features is as legitimate as government control over the design of a bicycle.

There is a difference between regulation and control. The role of government is to specify pollution standards for cars and to require seat belts or airbags. It is not to design cars.

An upsurge in inflation?

There is a lot of concern about inflation. Most of it is based on perusing the following numbers of the year-on-year changes in price indexes:

WPI Food
WPI fruits,vegs
True inflation in India is somewhere between the CPI-IW (which overstates the importance of food) and the WPI (which overstates the importance of tradeables and thus the exchange rate). YOY CPI changes are stubbornly above 10\%, and the yoy WPI inflation seems to have risen in each of the above three changes.

However, the year-on-year growth is the summation of the changes of the last 12 months. To get a sense of what is going on in the recent period, and to not be confused by ancient information, it is essential to look at month-on-month changes. This requires seasonal adjustment.

At, we have a program of regular release of this data, which includes month-on-month changes expressed as `seasonally adjusted annualised rates' (SAAR). This shows:

WPI Food
WPI fruits,vegs

This shows a rather different picture. We have food inflation, particularly with fruits and vegetables, given that we've just had a bad monsoon. But the overall WPI Food inflation contained one big jump in July and has slowed down after that.

The CPI(IW) gives a lot of weight to food. Hence, it showed a big value in July. After that, it has reported softer values.

The WPI itself was showing values around 10% in July and August, but gave values near 5% in September and October.

This, then, seems to be a relatively benign inflationary environment to me, particularly from the viewpoint of monetary policy. Monetary policy should not take interest in food prices in connection with a monsoon failure, because the time horizon over which monetary policy acts is long - perhaps between 9 and 18 months. By this time, conditions in WPI Food will have been reshaped by many new harvests.

Friday, December 18, 2009

Difficult times in Andhra Pradesh

Andhra Pradesh was once seen as a state with good governance by Indian standards. In recent years, the problems seen with Satyam, attempts to harass Nimesh Kampani, etc. have led many to question the quality of governance in Andhra Pradesh. Today, John Elliott has an important article in the Financial Times on the difficulties of Andhra Pradesh.

I took a look at the CMIE data on investment projects outstanding to measure the share in the investment projects at hand in India. I found that the action was strongest in state-wise data for projects which were `Announced' (and not `under implementation'). The two states with the biggest decline in the share in India were West Bengal and Andhra Pradesh:

Andhra Pradesh West Bengal
Jun '08 7.46 8.00
Sep '08 6.43 7.31
Dec '08 7.15 8.19
Mar '09 6.20 6.48
Jun '09 6.29 5.71
Sep '09 5.43 5.56

For Andhra Pradesh, the decline over this period was 2.03 percentage points and for West Bengal, the decline was 2.44 percentage points. These are the two biggest declines across all the states in this period.

All these values are a far cry from the biggest share of Andhra Pradesh ever seen -- which was 18.53% in December 2001, when Chandrababu Naidu was chief minister. For a comparison, the peak share seen for West Bengal was 8.25%, which was in March 2008, when the CPI(M) was still a part of the UPA; we can vividly see the decline from that point to 5.56% in the latest data. The full time-series for all states are here.

Tuesday, December 15, 2009

Getting to a liberal trade regime

I wrote two columns on trade liberalisation in Financial Express:
Also see:

Monday, December 14, 2009

Consequences of exposure to violence

Marginal Revolution pointed me to a paper by Edward Miguel, Sebastian Saiegh, and Shanker Satyanath (of UCB, UCSD, NYU) titled Civil war exposure and violence. Their key result is: Football players from countries which have experienced civil wars are more violent on the field (after controlling for a host of things). This supports the idea that exposure to violence coarsens human sensibilities.

The authors mention the World Values Survey, and I dug out a small table out of this about responses to the proposition: Using violence for political goals is not justified. Here is what we see for 1995:

Strongly agree
I picked Russia because they have suffered terrible violence through the combination of World War II and Communism. We see a difference in "Strongly agree" but not much of a difference in "do not agree" (i.e. the residual category).

I have often wondered about these issues in the context of India's story. In the period after the fall of the Mughal empire, many parts of India experienced extreme violence. But the last big war that was fought in India was 1858. After this, there have only been wars at the border; these wars have not brought violence and barbarism to civilians. We were incredibly lucky to have been the lab for Gandhiji's revolutionary idea, of political change without violence. So we have had 151 years without war. But the roots of India's sustained peace today lie not just in Gandhiji and the nature of the freedom movement, but deeper in history to the peace that has reigned from 1858 onwards. If anything, the puzzle in India is about how badly law and order has fared, given such benign initial conditions.

Going by the argument of Miguel et al, this sustained peace would have helped shift mores towards reduced violence. I feel that when peace is established, and for many generations the incentives guide young men towards participating in the market economy, this exerts a civilising force.

The great bursts of violence that we have had have been like Partition (1947), Delhi (1984), Punjab (1984-1990) and Gujarat (2002). (I'm curious: What other big episodes would you classify alongside these?) Each of these would scar an entire generation near that location. Time heals, but the clock takes 25 years after one such episode of large-scale violence. Part of what has worked better for South India is that there has been less violence there all the way from 1858 onwards.

This perspective tells us something about places like Iraq or Afghanistan or Pakistan. It is not enough to bring about peace; what is of critical importance is to have sustained decades under conditions of peace. This would yield the incidence of non-violent behaviour and trust capital which might help in graduating to the double helix of capitalism and freedom.

Tuesday, December 01, 2009

Interesting readings

  • T. N. Ninan in Business Standard on the decline of Bombay. I think of the establishment of ISB in Hyderabad as an important lost opportunity, and a prominent contribution of the Shiv Sena to India's backwardness. ISB near Hyderabad is an impressive achievement, but it's a shadow of what it would be if it were on the outskirts of Bombay.
  • G. N. Bajpai, Mr. Bhave's predecessor's predecessor, argues in favour of legislation that defines the role of HLCC and makes it more effective. (This was an opinion piece in the Economic Times).
  • Replace EPFO with NPS by Dhirendra Kumar.
  • Writing in Financial Express, Ramkishen Rajan worries about the analytical foundations of the supposed hierarchy of desirability of various types of capital flows.
  • Viral Acharya in Financial Express.
  • In India, the phrase `industrial policy' is considered acceptable in polite company, while in the international discourse, people get embarassed when they propose it. Michael Boskin has a column on the return of industrial policy from its grave.
  • Roger Bate, writing in The American is skeptical about the possibilities for the Indian drugs industry.
  • A 1000 word precis summarising what we know about economic development, by Daren Acemoglu. Also see this piece by Lisa Chauvet and Paul Collier on voxEU.
  • A paean to Timothy Geithner, by David Brooks, in the New York Times.
  • The open source approach to maps: See this and this. You might like to see my blog post and FE article on the subject of map databases in India.
  • David Edmonds has a great story about Levon Aronian, the man who aspires to unseat Vishwanathan Anand from the world #1 slot, and the remarkable place of chess in Armenia.

Monday, November 30, 2009

New sources of financing for microfinance assets

by Nachiket Mor.

The problem

The main source of funding for microfinance in India has been through banks, primarily through the forced `priority sector lending'. Over the years, the demand for funds in the microfinance industry has outpaced the growth in investment by banks. In addition, banks are not the ideal place for these assets, given the nature of cashflows and maturity of micro loans. Hence, even though MFI assets are part of priority sector lending, the excessive focus on bank capital has effectively raised the cost of capital for MFIs.

The upstream funding for microfinance needs to be diversified to harness a diverse array of borrowers, so as to avoid the constraints and unique compulsions of any one source. However, at present in India, MFIs are not permitted to mobilise deposits, or borrow from international lenders, or from MIVs (Microfinance Investment Vehicles).

The role for securitisation

The ideal financing channel for them, in this environment, is securitisation. Through securitisation, a pool of loans across many borrowers (and ideally across many MFIs) would be turned into a tradeable securities that are targets of investment by a diverse array of investors, with different beliefs and compulsions.

A recent transaction

One step towards this goal came about last week, when IFMR Capital announced the completion of a micro-loan securitisation through which mutual fund investment into microfinance takes place. The Rs.480 million ($10.4 million) transaction is backed by over 55,000 micro-loans originated by Equitas Micro Finance, a Chennai-based microfinance institution (MFI) with approximately 700,000 low-income clients.

The bulk of the securities issued were purchased by ICICI Prudential AMC, the country's third largest mutual fund. The entry of a mutual fund investor into the micro-loan backed securities (MLBS) market, as well as the treasury desks of major Indian banks, has given Equitas a new investor base and lower cost of financing. This should enable lower cost borrowing for the households that Equitas lends to.

Deeper implications

Going beyond the direct issue of access to a large volume of funds at a low cost, capital market financing is beneficial to microfinance firms by bringing about new pressures on transparency, accountability and thus oversight of MFIs.

IFMR Capital has previously done a MLBS transaction, but there it was the sole investor in the BBB rated (subordinated) tranche. In the Equitas transaction, there was investor interest in all tranches; a majority of the BBB tranche was purchased by a private bank. This is relatively new for the Indian corporate bond market, which has hitherto been wary of BBB securities. These developments are thus synergistic for both the growth and development of microfinance and for the corporate bond market.

The ultimate goal is an ecosystem where securitisation paper is constructed using loans made by multiple MFIs, sold to a diverse array of domestic and foreign investors, actively traded on the secondary market, with trading that is supported by high quality disclosure of data about the underlying loans on a daily basis. IFMR Capital will work in all aspects of this ecosystem, including facilitating listing and engaging in market making.

Looking beyond the vision of MFIs funding themselves through securitisation, there is also a role for (say) 1000 small banks (as argued in Raghuram Rajan's report). A key ingredient of making this work is bringing in market discipline, by having regulations which require them to finance (say) a quarter of their assets using subordinated debt, and using this BBB bond market to exercise market discipline on them. The task of bank supervisors would be simplified when the BBB bond market, the CDS market and the stock market jointly serve up a list of the 50 weakest banks on each trading day. The stock market is in place in India; what is now missing is the BBB bond market and the CDS market.

Further reading

At the IFMR website.

Saturday, November 28, 2009

Dubai's great crash

Sheikh Makhtoum won't go to debtor's prison, but short of that, Dubai's all-but-sovereign default is an epochal event in its story. I wrote a column in Financial Express titled Dubai's great crash where I draw on this episode to think more clearly about (a) International financial centres and (b) Puffery. On this subject, also see Reality catches up with the Gulf's model global city by Roula Khalaf in the Financial Times, and 'The Sheikh's New Clothes?' Dubai's Desert Dream Ends by Stanley Reed in Business Week.

One hears talk about Dubai giving up crown jewels, like the airline, in exchange for a bailout. I think the time for that bailout was six months ago. Today, with a funding gap of $80 billion, the crown jewels are not big enough. But six months ago, it was possible to think of a deal where ADIA bought up the crown jewels for (say) $40 billion and Dubai would have tided over the storm. Or maybe this is big, and runs beyond just the crown jewels: see Enough glitzy debt: time for regime change by Jo Tatchell in The Times.

This episode is an opportunity to think about exchange rate regimes. What if Dubai had used a floating rate instead of a fixed rate? This would have worked in two ways. First, it would have been a stabiliser. When bad times came, capital would have started leaving Dubai, the exchange rate would have depreciated, thus making real estate or hotel rooms in Dubai cheaper in the eyes of foreign customers. (Conversely, in good times, the exchange rate would have appreciated, thus reducing the attraction of going to Dubai). The key intuition (RBI speechwriters please note) is that exchange rate fluctuations stabilise the economy. Without a flexible exchange rate, adjustment in Dubai was forced on to the labour market, the real estate market, etc., which are all places where adjustment is more disruptive and is resisted more.

The second interesting feature of this thought experiment is linked to borrowing. A fixed exchange rate encourages and even subsidises dollar denominated borrowing. For society, the low cost of borrowing (the USD interest rate) is paid for by the loss of monetary policy autonomy. If a flexible exchange rate were used. Mr. Makhtoum would have been more careful and would have borrowed less.

Friday, November 27, 2009

The rise of private sector education service producers in India

In India, in the fields of health and education, an impressive rise of a private ecosystem has come about. In these fields, the State has tried hard to get back in the game, particularly after the UPA won power in 2004. But the unwillingness of the State to undertake deeper reforms has meant that ultimately, government facilities generally work badly. CPI(M) ideologues send their children to private schools.

The CMIE Consumer Pyramids data shows the fraction of household expenditure on school/college fees. Households that spend nothing are those that have no children, or those that are fully served by government schools/colleges. The CMIE data separates out expenditures on stationery, books, private tuitions, etc., so what is observed here is just the pure payment to the school/college. It shows:

Income class
Fraction of expenditure
Rich 1
Rich 2
Higher Middle Income 1
Higher Middle Income 2
Higher Middle Income 3
Middle Income 1
Middle Income 2
Lower Middle Income 1
Lower Middle Income 2
Poor 1
Poor 2

The overall average expenditure per household in the survey is Rs.86,228, so 2.82% of this is Rs.2400 a year or Rs.200 a month. This, of course, reflects a split between some households who use government facilities (who spend nothing) and others who use private facilities (who spend more than Rs.200 a month).

An incipient academic literature shows that learning outcomes from the weakest private schools broadly replicate learning outcomes from government schools even though the resource outlay of government schools is 3x to 10x bigger. If this evidence was correct, private schools would not have gained market share. Poor people have been spurning government schools with zero tuition fees and free meals, and choosing private schools where significant payments have to be made. There are two possible explanations: either the parents are not understanding how best to take care of their interests, or the econometricians are not understanding what parents are thinking. I am biased in favour of the latter explanation.

Like all incumbents, public sector producers of educational services resent competition, and particularly competition that is gaining market share. With the Right to Education Act, the government has armed itself with new powers to force `unrecognised schools' to close down. This is similar to the Department of Posts trying to prevent private firms from carrying letters. This is going to shape up as one of the most important battlegrounds in Indian education. So far, the broad story was that the government floundered and spent ever larger sums of money, but did not prevent `unrecognised' schools from coming up. Now it is shifting gears from category 3 ("State Production But Do No Harm") to category 4 ("State Production While Damaging the Private Sector").

As Lant Pritchett has emphasised, countries like Chile which have a fully competitive framework, where parents choose between public and private schools, have a bigger market share of public schools as compared with India, where the main approach of the State is to pretend that private schools don't exist, or to try to force them out. This ought to trigger off fundamental rethinking about what we are doing in the government. This rethinking has not begun, and the customers are quietly voting with their feet, switching their children to private schools. Despite the huge increase in funding to public schools, the market share of private schools is rising every year.

In this setting, it is worth attending the School Choice National Conference 2009 which will be held in Delhi on 16 December. And, do read The Beautiful Tree by James Tooley.

Wednesday, November 25, 2009

When a currency futures market dominates a currency forward market

by Gurnain Kaur Pasricha

In recent months, a sense has emerged that the exchange-traded currency futures market in India is more liquid than the corresponding contract traded OTC (i.e. the forward market). As an example, we examine a dataset from NSE of 28,797 observations of data - one observation per second - from 3 November 2009, for the November expiry. The effective spread for a transaction of $1 million (i.e. 1000 contracts) is calculated, in the units of paisa. This dataset has the following summary statistics:


In other words, 95% of the time, the spread on NSE for a $1 million rupee-dollar futures transaction was below 2.344 paisa. The median spread, for a $1 million transaction, was 1 paisa. This spread dropped below 0.5 paisa with only a 5% probability.

These numbers are significantly superior to those found on the OTC forward market, where, as a thumb rule, dealers feel that a $1 million transaction typically involves a spread of 2 paisa. This suggests that the liquidity at NSE is roughly 2x superior to the OTC market. The superiority of the execution at NSE is likely to be greater than 2x when we consider the opacity and execution risk of the OTC market. To the extent that order flow has shifted away from the forward market to the futures market, there could be a dynamic story here of the futures spread getting tighter at the expense of the forward spread.

This situation is unexpected. In the international experience, the currency forward markets is more liquid than its exchange-traded counterpart. This is despite the fact that futures markets has desirable features including near-zero counterparty risk, transparency, contracts standardisation and open public participation. The key reason for the domination of the OTC market appears to be historical. The OTC market came first, had entrenched liquidity, and the network externalities of liquidity hold the users in place.

In thinking about India's currency futures market, it would be useful to compare and contrast with Brazil's experience. Brazil is an interesting peer to India for reasons of a large GDP, democracy, rule of law, institutional quality, etc. It is also the only country of the world, prior to India, where the currency futures market became more liquid than the currency forward market.

In Brazil, currency futures trading began in 1991 - a seventeen year head start when compared with India. While Brazilian macroeconomics is now remarkably healthy, Brazil has had a turbulent history with many crises, high and volatile interest rates and inflation. The futures market, with daily marking to market, and therefore lower collateral requirements, offered a cheaper way to take positions in the currency. Nevertheless, there is reason to believe that several (sometimes unrelated) regulations contributed to tipping the balance in favor of futures contracts, so much so that today there is essentially no OTC market to speak of. The dealers on the forward market now provide OTC contracts to their customers but unwind their positions in the futures market (See Note 2). The regulatory pressures which moved liquidity from the OTC market to the futures market were:
  1. Access to spot markets was limited for several decades as a tool to control capital flight. Both domestic and foreign residents had easier access to futures markets than to spot markets. This led to greater number of players, and more liquidity in futures markets. Access to spot markets in Brazil is still far from free, for both domestic and foreign residents. India is in the same boat, with a futures market that is accessible to citizens but a spot market which is not.
  2. Until 2005, banks were subject to unremunerated reserve requirements on foreign exchange exposures exceeding pre-specified limits. These reserve ratios did not apply to futures positions, thus driving trading to futures markets.
  3. Until December 2007, Brazil imposed a financial transactions tax, called CPMF, on all debits on bank accounts. This levy applied to profit and loss payments on exchange traded contracts, not to their notional amounts, thus pushing activity to exchanges.
  4. OTC derivatives contracts are not netted, whereas contracts with the exchange or clearing house are netted by the latter. This means that the tax on cash flows, PIS-COFINS (See Note 3), de-facto taxes OTC transactions at a higher rate than exchange traded derivatives.
  5. Brazil has reporting requirements for OTC transactions - all transactions with domestic counterparties must be reported to regulators, in order for them to be considered enforceable. This levels the playing field in terms of the reporting burden of exchange traded versus OTC transactions. India has not yet done this.
  6. Pension funds are required to use only standardized derivatives contracts.
  7. The central bank, Banco Central Do Brasil, uses the futures market for doing currency intervention. This gives liquidity to the futures market, and also ensures that the OTC community has to look very carefully at the price on the screen so as to capture current information. India has not yet done this.
While some of these rules were removed in the 2000's, after being in place for several years, their consequences have outlasted them. There is a path-dependence in market liquidity. These kinds of market rules matter in getting liquidity on the exchange off the ground. Once the exchange becomes liquid, the network externality of market liquidity sucks in further order flow and preserves the domination of the exchange even after these rules are removed.


1 The author is a senior analyst at the Bank of Canada. The views expressed here are personal. No responsibility for them should be attributed to the Bank of Canada.
2 The material in this note is a summary of information provided by Brazilian economists as well as that contained in Dodd and Griffith-Jones (2007), Brazil's derivatives markets: hedging, central bank interevention and regulation, and Kolb and Overdahl (2006), Understanding futures markets, sixth edition, Blackwell Publishing.
3 The PIS and COFINS are federal taxes on revenues, charged on a monthly basis.

Working group on foreign investment in India

MOF has setup a working group on foreign investment:
To review the existing policy on foreign inflows, other than Foreign Direct Investment (FDI), such as foreign portfolio investments by Foreign institutional investors (FIIs)/ Non Resident Indians (NRIs) and other foreign investments like Foreign Venture Capital Investor (FVCI) and Private equity entities and suggesting rationalisation of the same with a view to encourage foreign investment and reducing policy hurdles in this regard while maintaining the Know Your Customer (KYC) requirements. 
To identify challenges in meeting the financing needs of the lndian economy through the foreign investment. Foreign investment for this purpose to be understood broadly and can include investment in listed and unlisted equity, derivatives and debt including the markets for government bonds, corporate bonds and external commercial borrowings. 
To study the arrangements relating to the use of Participatory Notes and suggest any change in the policy if required from KYC and other point of view. 
To reexamine the rationale of taxation of transactions through the STT and stamp duty. 
To review the legal and regulatory framework of foreign investment in order to identify specific bottlenecks impeding the servicing of these financing needs. 
To suggest specific short, medium and long term legal, regulatory and other policy change; in respect to foreign investment keeping in view of the suggestions expert committee reports such as the Committee on Fuller Capital Account Convertibility, the Committee on Financial Sector Reforms and the High Powered Expert Committee on Making Mumbai an lnternational Financial Centre.

Tuesday, November 24, 2009

Outsized capital inflows?

A lot of people are getting anxious about a scenario with outsized capital inflows hitting India. The historical time-series is illuminating:

Billion USD
Percent to GDP

In the latest quarterly data (Apr/May/June 2009), net capital inflows worked out to $6.7 billion or 2.7% of GDP. These are not big numbers.

What are big numbers? 10% of GDP is a big number, which was breached for six months in this history. At the time, this corresponded to above $30 billion a quarter of net capital inflow. In future quarters, the physical magnitude will depend on how big GDP is at the time. My rough sense of 10% of GDP in the Oct-Nov-Dec 2009 quarter is that it will be $30 billion. To get to these numbers, we'd need to get back to an environment like Jul-Dec 2007 in terms of optimism about emerging markets in general and India in particular. So far, this doesn't seem to be what is in place.

Saturday, November 21, 2009

Interesting readings

  • Tackling systemic risk is no job for the status quo by William Donaldson and Arthur Levitt, in the Financial Times.
  • Short-Selling Bans around the World: Evidence from the 2007-09 Crisis by Alessandro Beber and Marco Pagano. The abstract reads: Most stock exchange regulators around the world reacted to the financial crisis of 2007-2009 by imposing bans or regulatory constraints on short-selling by market participants. We use the large amount of evidence generated by these regime changes to investigate their effects on liquidity, price discovery and stock returns. Since bans were enacted and lifted at different dates in different countries, and in some countries applied to financial stocks only, we identify their effects with panel data techniques, and find that bans (i) were detrimental for liquidity, especially for stocks with small market capitalization and high volatility; (ii) slowed down price discovery, especially in bear market phases, and (iii) failed to support stock prices..
  • A story on regulatory impact assessments.
  • Mahesh Vyas on improving disclosure.
  • Let bidding begin in the market by Rajesh Chakrabarti, in Financial Express.
  • Ashok Desai in Business World on the scandal that is ULIPs.
  • Sanjeev Sanyal in Business Standard on making Bombay work.
  • At 250 kph, the Bombay-Delhi distance of 1200 km is covered in 5 hours. At 376 kph (which the Chinese are implementing today), it's roughly 3 hours. If that sounds exciting, read Bullet trains for America? by Mark Reutter.
  • A pair of articles from The Economist on India and capital controls: A world apart, and Raining on India's parade.
  • Anita Bhoir in Mint on the proposed Standard Chartered IDR.
  • Looking back at Indira Gandhi: Ila Patnaik in Financial Express, and Shekhar Gupta in Indian Express.
  • A great collection of pictures about the Berlin Wall. Do not miss the symbolism of #34, where Lech Walesa starts the toppling of the dominos.
  • New York Times blogs on weight loss and exercise; you might like to also see my page on this which has a framework within which the NYT blog post can be placed.
  • India's dirty role in Sri Lankan war by Brahma Chellaney in [covert].
  • Terror in Mumbai, a documentary on HBO on 19 November.

Thursday, November 19, 2009

The problems of big banks

I wrote an article in Financial Express titled The problem of big banks. On this subject, also see:
  1. In the world of banks, bigger can be better, Charles Calomiris in the Wall Street Journal.
  2. A three-way split is the most logical, by John Gapper in the Financial Times.
  3. Narrow banking is not the answer to systemic fragility by Charles Goodhart.
  4. See the section titled Regulatory and legislative reaction and the foreign exchange market in Lessons for the foreign exchange market from the global financial crisis by Michael Melvin and Mark P. Taylor on voxEU.


Count Sergei Witte was an important figure in czarist Russia in the early 20th century. In October 1905, he wrote a memorandum to the Tsar summarising his view of the political unrest in the aftermath of the Japanese war. In it, he said:
The idea of civil freedom will triumph, if not by way of reform then by way of revolution. But in the latter event it will come to life on a thousand years of destroyed history. The Russian rebellion, mindless and pitiless, will sweep everything, turn everything to dust. What kind of Russia will emerge from this unprecedented trial exceeds human imagination: the horrors of the Russian rebellion may surpass everything known to history. A possible foreign intervention will tear the country apart. Attempts to put into practice the ideals of theoretical socialism -- they will fail but they will be made, no doubt about that -- will destroy the family, the display of religious faith, property, all the foundations of law.
How many other paragraphs can you think of, where someone peers into the unknowable, and largely sees the next 100 years right?

I saw this in Nicholas 2 Signs the October Manifesto by Richard Pipes, in I wish I'd been there, edited by Byron Hollinshead and Theodore K. Rabb, Pan Books, 2008.

Sunday, November 08, 2009

Mobile phones and economic development

The CMIE Consumer Pyramids data shows that in all their income categories, more than 50% of households have a mobile phone. It is only in their bottom category `Lower Middle Income - II' that only 37.5% of households have mobile phones. From `Higher Middle Income - III' upwards, the incidence is above 80%. If you had asked anyone in 1999 or 1989 whether this could be done by 2009, the answer would have been in the negative.

With broadband Internet, in contrast, India has not got such breakthroughs.

The September 2009 issue of Finance & Development has a story on the impact of mobile phones for development. In India, there is a lot of merit in using new technologies and players to break with the comfortable stagnation that's enveloped finance.

The Economist has a beautiful section on mobile phones and development: on Chinese progress on network hardware, broadband, on the impact on development, a retrospective, looking forward, and an enthralling piece on the cost reductions by firms in developing countries. Now all we need is for Indian finance to go the way of Indian telecom (and airlines).

Anand Giridharadas, writing in New York Times, describes new developments in distance education. India is the place in the world which would be the biggest beneficiary from distance education, given the combination of lots of young people and a dismal education system. This does require broadband to go the way mobile phones have. I often joke that the task of an economics undergraduate education in India should be to get a person to the point where he or she can read my blog :-) (and cynics respond saying that most of the teachers of economics in India can't parse my blog).

Anne Eisenberg has an article in New York Times about researchers at UCLA trying to use cell phones to do medical diagnosis. Given the ubiquity of cell phones in India, these could be useful lines of attack for us.

Saturday, November 07, 2009

East Europe after 1989

I have an article in Financial Express where I look back economic development in Eastern Europe in the last 20 years, and compare and contrast with India.

In recent weeks, a lot of very interesting writing, looking back at 1989, has come out. My suggestions for further reading follow. Readers of age 40 and below should try particularly hard to read these and other materials so as to comprehend these earth-shaking events. These events matter because they have had a huge influence on the world that we see today. And, they matter because they help us think more effectively about the drama that will come about in China in coming years.
  1. 1989! by Timothy Garton Ash in The New York Review of Books. Am eagerly waiting for part 2 of this. Also by him in The Guardian: This tale of two revolutions and two anniversaries may yet have a twist (May 2008) and 1989 changed the world. But where now for Europe? (now). 
  2. A great story of the big day by Alison Smale. Also see Serge Schmemann.
  3. The unknown war by Matt Welch on We feel this intuitively, but the statistics are stunning:

    In 1988, according to the global liberty watchdog Freedom House, just 36 percent of the world's 167 independent countries were `free,' 23 percent were 1partly free,' and 41 percent were `not free.' By 2008, not only were there 26 additional countries (including such new `free' entities as Croatia, Estonia, Latvia, Lithuania, Serbia, Slovakia, and Slovenia), but the ratios had reversed: 46 percent were `free,' 32 percent were `partly free,' and just 22 percent were `not free.' There were only 69 electoral democracies in 1989; by 2008 their ranks had swelled to 119.

  4. A beautiful section from The Economist:
    Walls in the mind;
    So much gained, so much to lose;
    The man who trusted his eyes;
    A globe redrawn;
    Less welcome;
    Keep calm and carry on;
    Wall stories;
    Down in the dumps
  5. The peaceful revolution of 1989 by Adam Roberts in The Independent.
  6. Brain drain in reverse behind fallen Berlin Wall by Carter Dougherty, in the New York Times.
  7. A slideshow by Erik Berglof which summarises the Transition in crisis? report released by the European Bank of Reconstruction and Development.
  8. My take on the new dangers that we face today.

Thursday, November 05, 2009

Governments taking over banks

Jerry Caprio and Ila Patnaik, at two ends of the world, on the same subject.

The UK Special Resolution Regime has excellent documentation on the web.

There is a lot of talk in India about financial stability, where basic ideas are distorted to defend the status quo. Financial stability is, sadly, not interesting to the establishment when achieving it requires undertaking economic reform. One example of this is the problems of closing down failed banks or other financial firms: few things are more important to financial stability than the machinery of the bankruptcy process for financial firms. The best thinking on how to build deposit insurance is found in Chapter 6 of Raghuram Rajan's report. In the mid 1990s I was member of an RBI committee on reforming deposit insurance. There hasn't been any movement on this in decades.

Wednesday, November 04, 2009

Recent RBI moves in finance

On 30 October, I had written a response, in Financial Express to recent RBI moves on financial reform. Here are a few other responses:

Sunday, November 01, 2009

Interesting readings

Friday, October 30, 2009

Recent RBI moves in financial reform

I have an article in Financial Express today where I try to interpret recent RBI announcements in financial reforms.

Looking back at Indira Gandhi

Writing in Indian Express, Pratap Bhanu Mehta looks back at Indira Gandhi. He offers five lessons for today's Congress:
  1. Leaders are more effective when they work through institutions rather than attempting to subvert them.
  2. Sound economic policies are not a matter of simply projecting good intentions; they require a concerted understanding of the causal conditions that make for successful intervention.
  3. Being personally secular is neither here nor there. The important thing is to fish in the treacherous waters of communal identification, from wherever it comes.
  4. As the Punjab crisis demonstrated, when the state does not act impartially and in time, it sows the seeds of greater violence in the future.
  5. Democracy is not just about the practice of popular authorisation. It is about a whole gamut of constitutional values that have to be zealously guarded.
India had a bad period from 1962 to 1977, of which the worst part was the Emergency. This period preceded Pakistan's worst years (Zia ul Haq's period, 1978-1988). Kamal A. Munir has an article in Financial Express about Pakistan where we see the sustained impact of those years.

India seems to have come out better from the dark period, partly because that period ended a long time ago and there has been more time for healing. In addition, in Pakistan's case, the Afghan wars and islamisation which began in Zia ul Haq's period have not yet ended. In some sense, Pakistan is not yet into the post-authoritarian post-conflict period of reconstruction of institutions, which began in India in 1977.

Monday, October 26, 2009

Sunday, October 25, 2009

How evil is insider trading?

I have long been a skeptic about State action against insider trading, which is believed to be widely prevalent in India. Writing in the Wall Street Journal yesterday, Donald J. Boudreaux has a nice scheme which can replace the existing policy framework.

Tuesday, October 20, 2009

New thinking on financial stability

I have an article in Financial Express today, where I discuss RBI's take on financial stability, which sums up to the rejection of all recent thinking in India on monetary and financial reform, in the light of recent thinking on this subject at the US Fed and the ECB.

Saturday, October 17, 2009

Movement on corporate bonds

Shilpy Sinha and Swapnil Mayekar have a story in Business Standard offering some optimism about the corporate bond market. They point out that in the six months from April to September 2009, corporate bond turnover was Rs.1.6 trillion, when compared with Rs.0.5 trillion in the same period of the previous year.

SEBI has decided to force many market participants to do netting by novation at a clearing corporation when trading on the corporate bond market. From 1 December 2009 onwards, there will be two possibilities for a trading mechanism:
  1. OTC trade, reported on one of the three trade-reporting systems, run by BSE, NSE and FIMMDA, or
  2. Order book trade, run by BSE or NSE.
But regardless of how trading takes place, counterparty risk will be eliminated, and netting efficiency obtained, through the clearing corporations. This will be a big win compared with the awful settlement mechanism that's used today. It should reduce transaction costs on this market.

The deeper problems of corporate bonds remain:
  1. The lack of a liquid GOI yield curve along with interest rate derivatives, so as to be able to layoff interest rate risk when holding a corporate bond portfolio,
  2. The low values for loss-given-default, given the lack of a bankruptcy code and
  3. The ban on credit derivatives.
The workaround for #2 is: to stick to trading in short dated bonds from issuers where the failure probability is very low. A workaround for #3 is: to utilise information about credit risk embedded in the stock price.

The right way to think about the corporate bond market is in the context of the Bond-Currency-Derivatives Nexus, which emphasises the interlinkages between the government bond market, interest rate derivatives, corporate bonds, credit derivatives, the currency spot and currency derivatives. All these markets have to achieve liquidity with active arbitrage. The key ingredient for getting there is unifying the regulation and supervision at SEBI. This should address the bulk of the problems of corporate bonds -- other than the problem of loss-given-default.

Tuesday, October 13, 2009

Interesting readings

Monday, October 12, 2009

Did we get a good IIP number today? No.

It seems that we got a good IIP number today? Here's what the year-on-year growth of IIP Manufacturing says:

Mar 2009
Apr 2009
May 2009
Jun 2009
Jul 2009
Aug 2009

So it looks like a recovery is gaining traction, with yoy growth going up in each month from March 2009 till August 2009, other than a slight decline in July 2009?


The year-on-year growth is, unfortunately, a highly misleading measure. Here's what we get when we look at the seasonally adjusted levels and the annualised growth of these:

Mar 2009
Apr 2009
May 2009
Jun 2009
Jul 2009
Aug 2009

This shows a very different picture. It shows one big month -- June 2009 -- where seasonally adjusted IIP jumped from 299.09 to 319.78. This was an annualised growth rate of 80.32%. This was the month in which the recovery kicked in, where we jumped back from the low state to a better state.

After that, growth has dropped back to anaemic levels, with annualised growth of 3.84% in July and 4.98% in August. So today's data release was actually not so hot - it was just 4.98% growth (annualised) of seasonally adjusted IIP manufacturing.

Each value of the year-on-year growth rate is the moving average of the latest 12 values of the month-on-month growth. So this one big value of 80.32% is going to elevate each reading of yoy growth up, all the way until we calculate the yoy growth from May 2009 till May 2010. After that, we'll get to the yoy growth from June 2009 till June 2010 and this jump will go away.

You only get the true picture by looking at point-on-point changes of seasonally adjusted data.