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Tuesday, February 28, 2006

Five alternative frameworks in education policy

There has been much interest in scaling up programs like Sarva Shiksha Abhiyan and the midday-meal program. At the same time, the recent measurement of what children know, done by Pratham has shown a large-scale failure in what students actually know.

I wrote a column in Business Standard today where I describe five alternative frameworks of education policy:

  1. Do Nothing,
  2. Augment Purchase,
  3. State Production But Do No Harm,
  4. State Production While Damaging the Private Sector and
  5. Ban Private Participation

With higher education, we are on the 5th (ban). With elementary education, we are now veering from the 3rd ("do no harm") to the 4th ("damaging the private sector") by new efforts at having State-enforced quotas in private schools.

I argue that internationally standardised test scores need to be made the foundation of education policy, as opposed to efforts like SSA which have concentrated on spending more money on public sector education. The choice of which of the five frameworks is best should be based on which appears to deliver adequate test scores in a cost-efficient manner.

Our loyalty needs to be with the interests of students instead of the interests of the existing producers of educational services. There is an innate conflict of interest in the control of education policy with incumbent educationists.

Monday, February 27, 2006

The Indian securities markets in 2005

As usual, Chapter 4 of the Economic Survey is on the securities markets. This was released today. It is a must-read for those interested in the field. Their website only gives you six PDF files for six sections. The Business Standard website is kindly offering a unified single-file of the whole chapter. One-way turnover on the equity spot and derivatives markets, put together, was Rs.60 trillion in calendar 2005. Wow. That's $1.35 trillion. Last year, it was slightly below a trillion dollars. I am not used to hearing `trillion dollars' in any Indian context. Out of the one-way turnover of Rs.120 trillion, a measly Rs.12.4 trillion were made by all institutional investors (domestic or foreign) put together. Particularly on the derivatives market, which is where price discovery takes place, all institutions are Rs.5.2 trillion out of a total of Rs.78.5 trillion. I suspect there isn't any other country with such a complete retail domination of price discovery.

Stock markets and the budget

Everyone is now curious about the budget. It is natural to think of an event study of index fluctuations surrounding budget day. Susan Thomas and I did this in an EPW article in 2002. The quick result, visible in the graph above, is: on average, a budget speech is worth a 10% rise in the index.

What is fascinating is that all this rise takes place before the date of the speech. We see this as some kind of strongform efficiency proposition. Informed traders seem to be quite aware of what is brewing inside the Ministry of Finance and are able to incorporate this into prices in the 40 trading days prior to budget date.

Ila Patnaik has an excellent article in Indian Express on the evolution of the budget speech as an institutional mechanism. There is much more to the budget speech than taxation and expenditure: it has shaped up as a tool for transparency and a commitment device in coalition politics. This is consistent with the idea that you got a +10% return on average associated with budget dates. This reflects the surprises on a broad swathe of economic policy embedded in the speech; not just decisions about taxation and expenditure.

Frontiers in systemic risk - computer security

Over the years, the materiality of computer security problems appears to have escalated. The game now seems to be of a person X writing a virus which infects a large number of Windows machines with software which listens to his instructions and performs actions as per the commands sent out by X to all the machines that he controls. This "large number of Windows machines" is called a "botnet". On 19 February, Washington Post has fascinating story where the reporter has managed to locate and photograph one young man who builds and controls botnets for a living. I have read of botnets which are as big as a million machines. Botnets are a whole new development, compared with the benign old days when viruses merely formatted your hard disk. Imagine the power of having a million machines standing ready and willing to do your bidding.

The two classes of uses of botnets appear to be advertising and blackmail. Advertising is where a captured machine is used to emit email promising to improve the sex life of everyone on the address book of users of that machine. Blackmail is where a `distributed denial of service' attack is mounted against a website, and then money is demanded from the owner of the website in order to desist.

These days, there are jobs in job advertisement classifieds in the "underground" portions of the Internet, for programmers. The employers are large organised crime syndicates, often with bases in East Europe. They are offering upto $100,000 a year for talented programmers to stay in Russia and work for them, developing spyware and keyloggers. Expressed as purchasing power parity wages, this is probably equivalent to $250,000 paid in the US.

An "off-the-shelf" program to exploit a Windows or IE vulnerability and install a piece of spyware is available typically for $60-$100. There are many programmers who sell such programs on the underground Websites of the Internet. These sites are also referred to as "hacker Websites" or "cracker sites". A more customised version of these programs is available for as little as $200.

As Shuvam Misra of Starcom Software says, I frankly think the entry of organised crime syndicates into this arena has made the picture far more alarming than we tend to believe. And there's a general consensus among such gangs that this is cleaner, easier money than drugs.

I think these developments have important ramifications for finance. At a policy level, I think it's time to start exploring the consequences of such vulnerabilities for systemic risk.

If you control a botnet within a stock exchange trading system, you could wreak havoc and profit from it. A dreadful recent story is about a Windows virus that brought down the Russian Stock Exchange. If a problem can bring down a stock exchange, I call it `systemic risk'.

I read recently about a freshly-discovered Windows vulnerability that may have been sold on the black market for a measly $4,000. At some point, a criminal could put the pieces together. Someone could buy a freshly pressed Windows vulnerability, adopt a long vol position, and bring down the exchange at 2 PM on futures expiration date. He will surely make much more than $4,000 out of this. (Full design details are left as an exercise for the reader).

One kind of mistaken response is to say `internet trading is dangerous and should be stopped'. The problem is not with Internet trading. I think the real problem is that Microsoft Windows is embedded inside a lot of Indian finance.

Saturday, February 25, 2006

Rethinking the IMF (Mervyn King's lecture)

I attended a talk by Mervyn King, who is Governer of Bank of England, in Delhi. The talk, which was organised by ICRIER, was titled Reform of the IMF. The pdf file of appeared on the Bank of England website. It was fun. It was delightful hearing sharp and modern economics from an employee of a government! I admire the human capital that the UK is able to bring into economic policy. The Bank of England reform is amazing, and so are the humans of that story, such as Mervyn King, Charlie Bean, and Charles Goodhart.

As the old job of the IMF (to periodically bail out countries with a pegged exchange rate which get into trouble) has become redundant in a world with floating exchange rates and open capital accounts, many people have started pondering how to do an IMF differently.

One famous set of ideas on IMF reform has come from Charles Calomiris and Allan Meltzer. Mervyn King's ideas are more radical. He envisages an IMF that shifts into tasks of data, research and meetings. As he describes it, the only instruments that the reformed IMF should have should be the powers of analysis, persuasion and ``ruthless truth-telling''. I think it makes a lot of sense. Yesterday's Business Standard had an excellent editorial on this.

Monday, February 20, 2006

Resilient: Able to cope with big bankruptcies

For an economist, the goal of financial sector policy and regulation is: market efficiency. The normative benchmark is a market which is an unbiased and rapid processor of information, a market that is deep and liquid. For many a bureaucrat, the goal of policy and regulation degrades to "let's not have a crisis on my watch". A great deal of the follies of the real world flow from this difference.

One aspect of crisis is the failure of large finance companies. Bureaucrats working in finance regulators often have a horror of a big finance company defaulting. This makes all big finance companies "too big to fail", with it's own consequent moral hazard. But the safety net is not given out by the bureaucrat for free. The typical price that is demanded is great gobs of equity capital. The bureaucrat finds safety in seeing lots of zeros for the capital. It is mechanically assumed that an entity with Rs.100 crore of equity capital is safer than an entity with Rs.10 crore of capital.

This leads to two kinds of mistakes. One problem is in situations like securities brokerage or in asset management, where equity capital really doesn't do much, and the bureaucrat needlessly burdens the firm by demanding a lot of equity capital. This serves to merely introduce entry barriers, reduce competition, and place the burden of earning an equity rate of return for that capital upon the customers of the firms. Such a drift towards demanding more equity capital is supported by big finance companies, who are too happy to have less competition. The other kind of mistake is that of getting comfortable that firms with lots of capital are safe. The best example of these are banks.

In the context of the pension reforms, we get repeatedly asked: "What happens if a pension fund manager goes bust?". Remarkably enough, it's actually possible to handle this problem rather nicely. The customer assets are - anyway - never on the balance sheet of the fund manager. This is where agency fund management differs fundamentally from either banking or insurance, where customers are inextricably intertwined in the balance sheet of the firm. The pension fund manager is just a consultant, who is giving instructions for transactions using customer assets which are sitting with a custodian. If one pension fund manager goes bust, the regulator replaces him with another pension fund manager. Customer assets needn't be affected when bankruptcy hits a pension fund manager. This aspect underlines why substantial equity capital isn't required to be a pension fund manager.

In the context of risk management, safety comes from clever systems and procedures; not from equity capital. An incompetent bunch can mess up a big finance company with plenty of equity capital. Conversely, sound procedures and well thought out processes can correctly deliver sound outcomes even when there are very big positions and small equity capital. The futures clearing corporation is the best demonstration of how safety comes out of brainwork, not equity capital.

On this theme, Futures Industry magazine has a fascinating article on how the futures clearinghouse handled the recent disaster at Refco.

The disaster at Refco unfolded at a blinding pace. The story started on Monday morning (October 10) with a brief statement from the company. On Tuesday, the CEO was arrested. On Thursday, the shares of Refco had stopped trading and the company was forced to shut down one of it's unregulated units for want of liquidity. You don't get a crisis where the events move faster than this.

Refco was a big firm. In September 2005, it was the 4th biggest Futures Commission Merchant (FCM) measured by customer assets, which stood at $6.5 billion. Plenty of customers got spooked by seeing TV footage of the CEO being carried away in handcuffs. As the article says: According to CFTC data, the total amount of segregated funds held at Refco fell from $6.47 billion at the end of September to $2.53 billion at the end of October. In other words, somewhere in the neighborhood of $4 billion was transferred to other firms in the space of about 15 working days. In fact, I find it remarkable that all customer assets didn't leave.

The article tells the story in full detail, and I encourage you to read the intricate dance-of-death that comes about when such events arise. The bottom line is that the extremely sudden death of the 4th biggest FCM was handled perfectly by the system of futures exchanges + clearing corporations. That's what I call systemic stability. This comes about by building sound procedures and being smart; not by repressing innovation, or by requiring vast amounts of equity capital.

Sunday, February 19, 2006

Imagine there's no `FII'

In India, all of us are used to the notion of `FII' as being the channel through which foreign investors access the Indian market. But looking forward, the future easing of capital controls in India will some day involve eliminating the concept of the FII, and opening up the equity spot and derivatives markets to anyone in the world. The FII is a piece of State-induced canalisation, and it will surely (someday) go the way of canalisation to favour the State Trading Corporation or import licence holders.

It is, hence, of interest to all of us to ponder what lies beyond. What is the institutional structure through which normal market economies engage in cross-border financial flows? I believe a key piece of the plumbing is the concept of an "Omnibus Account". This week, Futures Industry magazine has an excellent article describing this structure: Omnibus Accounts: The Portal to Cross-Border Trading, by Leslie Sutphen & Jeff Huang. This article is U.S. centric, but similar structures work for all normal market economies.

The picture that I'm getting is that if India is able to obtain the "Part 30.10 exemption" from CFTC, then it will pave the way for Indian brokers to directly sell to US customers. Else, the Omnibus Account is the only way. It will involve bilateral contracts between a U.S. brokerage firm and an Indian brokerage firm. The Indian firm will treat the orders coming from the U.S. brokerage firm as one big customer, except for the purpose of a `large trader reporting system' (which isn't yet in place in India) where the names of large positions are required.

The article says: Regulatory authorities in some countries have responded by banning omnibus accounts, but this leads to at least two problems. First, it becomes less efficient for global brokers and their customers to enter those markets, and in some cases legally impossible. Second, some market participants will resort to trading "look-alike" contracts with their broker on an over-the-counter basis. The broker then offsets these contracts by establishing an identical position on the exchange. This arrangement does allow these customers to trade these markets, but it provides the regulators with even less information on the ultimate customer. In any case, many institutional investors do not like the lack of price transparency of over-the-counter contracts, so they avoid these markets. This deprives new exchanges of liquidity.

In India, these "look-alike" contracts go by the name of Participatory Notes. :-)

I found it fascinating that in the same issue of Futures Industry magazine, there was an article on developments in Taiwan which is a country which is in the midst of this FII -> Ombinus Accounts transition. Taiwan is like India in having a very big direct retail participation in the securities markets. Roughly 10% of their population trades - in an Indian setting, that would translate to 100 million direct market participants. Taiwan is trying to move towards one thing which we have already done right: a merger between the spot stock exchange and the futures exchange. Right from the L. C. Gupta report onwards, India has been clearheaded on this, requiring no silly separation between the spot and the derivative. But the other frontiers which Taiwan is moving on are a jump ahead of us. They are removing their QFII system, and shifting to omnibus accounts. They are worrying about offering a range of traded products which are interesting to global market participants - such as gold futures and a dollar denominated Taiwanese stock market index - so as to make Taiwan a trading centre for market participants from all over the world. They are increasing the size of position limits. Taiwan is one of the unhappy countries which has taxation of financial transactions - a bad idea in public finance if there ever was one. They seem to be headed to drop the tax rate from 2.5 basis points to 1 basis point. Finally, you might find this article on Mexico interesting; they already have omnibus accounts.

Friday, February 17, 2006

Sarva Shiksha Abhiyan and it's discontents

The `Sarva Shiksha Abhiyan' (SSA) in India is supposed to be a fantastic program which has driven up enrollment rates to near 100%. As an example, here is an article by the World Bank staff that has lent money to the project. But simultaneously, we see data streaming out about teacher absenteeism and - most important - poor educational outcomes. I see a big gulf between education professionals, who are keen to get customers into schools, and economists, who worry about what children learn.

Education vouchers seem to increasingly loom large as the way out of the present problems. On 16 February, Economic Times had an edit on this theme.

The second problem with SSA is that a lot of children are getting past the first few years of school, but then the capacity of existing schools breakdown. The very success of SSA in getting kids enrolled, and the demographic patterns of India, induces a surge in demand for schooling for middle school. Ila Patnaik has a fascinating article in Indian Express proposing `scholarships' (vouchers conditional on performance in standardised tests) as a way to address the gap in education for slightly older children.

Wednesday, February 15, 2006

Caution, dangerous curves ahead

I wrote a column in Business Standard today titled Caution, dangerous curves ahead. I argue that while the Indian economy appears to be in extremely good shape, there are some important concerns about the period leading up to 2009:

  • The resolution of global imbalances - which don't seem to be gently subsiding - and a potential reduction in the global GDP growth rate.
  • The expenditure impact of the UPA's spending programs.
  • The impending general elections of 2009.
  • The FRBM deadline of 2008-09.

In the worst case, these problems could come together giving a `perfect storm' in 2008-09.

Hence, I argue that greater caution is called for, in fiscal policy and in economic reform. This perspective suggests that the bulk of the FRBM requirements should be fulfilled in 2006-07 and 2007-08 itself. I argue that fiscal policy will not stabilise, which emphasises the importance of stabilising monetary policy. This requires shifting away from the pegged exchange rate in order to obtain monetary policy autonomy. Finally, the present good times should be utilised to buy out pockets of discontent, and forge ahead with reforms, so as to build a strong economy, and be ready for hard times.

Monday, February 13, 2006

Buy high P/E stocks in India

I noticed an fascinating article Growth beats value on the Bombay Stock Exchange by Satneet K. Sabharwal and Timothy Falcon Crack, December 2005 [link to it on SSRN]. It looks at data for a sample of stocks on the BSE from 1990 till 2004. There are few other papers in the field of Indian equity + asset pricing theory, so it is really interesting to read a well implemented and pioneering paper.

I am surely a non-specialist, for I don't read papers in asset pricing theory. But I felt uncomfortable about two things about this one.

Difficulties with sampling: They use panel data (the 203 firms with atleast 173 readings of returns over 175 months). But there was a huge phenomenon in India of birth and death of firms over this period. Their results pertain to: the few old firms who survived. This amounts to a nonrandom selection of low-risk firms, since the high-risk firms are likely to have died. I don't know how that changes things, but this worries me. I suspect you get an upward bias by looking at a few low-risk firms that managed to survive. Also, cross-sectionally, across these firms, there may be a low variation of risk thus adversely affecting the experimental design.

Liquidity premium: I think that over 1994-2001, there was a huge change in liquidity owing to the reforms of the stock market. This improvement in liquidity gave a liquidity premium. The gain in liquidity was concentrated amongst large stocks. So it looks like big stocks got strong returns - but what might have been going on was a liquidity premium story. At first, there was a spike in liquidity of the biggest stocks (Nifty). Later, that has been percolating into other stocks. E.g. the gap between the liquidity of Nifty and Nifty junior has declined in recent years (accompanied by powerful returns to Nifty Junior). But all this is about one-time changes in response to a modified market design. It isn't about a timeless relationship between risk and return.

Can liquidity premia explain the large differences in return across the portfolios formed in a paper like this? I believe they can. As an example, the diagram of excess returns on A group stocks when badla was banned (in the JFE article by Eleswarapu & Berkman) shows huge effects. And the improvements in liquidity that came through the reforms were even bigger than the widening of the bid-offer spread that came from the ban on badla.

The dataset is now building up to do these kinds of papers - the CMIE firm level data is mature from 1989-90 (i.e. year ended 31 March 1990) onwards, and the CMIE returns data starts from 1/1/1990. So I hope there will be more work of this nature - we are all ears.

While I'm on this subject, data sizes in India are becoming quite cool. My data for daily Nifty returns goes from 3/7/1990 till 7/2/2006 and is 3,680 points of a fairly homogeneous methodology. The daily returns time-series for the BSE Sensex goes from 3/4/1979 till 7/2/2006 and is 5,888 points (!). Unfortunately, they messed up along the way (shifted to float-weighted index), so they've lost out both on consistent methodology across a long series and on having a sensible methodology.

Friday, February 10, 2006

Global warming and the Indian nuclear deal

Kirit Parikh headed a group which has produced a report presenting an integrated view on Indian energy policy, looking out into the next 25 years.

There has been considerable debate on the "Nuclear Deal" where India separates out civilian from military nuclear facilities, and gets access to imports of reactors and Uranium. Generally, discussions about this subject are rooted in questions of India's choice of retaining the right to build nuclear weapons. Business Standard has an editorial today which looks at the energy dimensions of this problem. They worry about the gigantic scale of CO2 emissions that will come about as India moves forward with a primarily coal-fired energy system. As they say:

Nuclear energy is the only scalable source of energy which avoids CO2 emissions. The Parikh plan is based on the views of the Department of Atomic Energy (DAE). Over the 1947-2030 period, the DAE is supposed to have figured out how to use our plentiful Thorium to generate essentially infinite nuclear energy. But along the way, the DAE plans insignificant nuclear generation. Nuclear energy is too important to be left to the nuclear establishment. Prime Minister Manmohan Singh's nuclear deal with the US has thrown up the opportunity to get to a sound integrated energy policy. Indias best path today is to import world-class reactors of perhaps 100,000 Mw over the next decade. These should become the mainstay of the emerging private electricity generation industry. In global negotiations on CO2 emissions, India should insist on a per capita cap, which will generate huge revenues for Indian citizens from selling excess permits. Energy security can be obtained by holding a 5-10 year inventory of fuel.

Any OECD lawmaker who tries to interfere with Indian import of nuclear reactors and fuel should be given a copy of the Parikh plan, so that the consequences of India staying on the DAE trajectory can be seen. The whole world has a stake in Indian nuclear energy policy being freed from the DAE.

Elizabeth Kolbert had a marvellous three-part article in New Yorker a while ago, on global warming. It's a bit hard to find through google, so here's a text file with the content.

Update: Shekhar Gupta has an excellent big-picture piece in the Indian Express, about India's evolution on the nuclear question.

Tuesday, February 07, 2006

RBI's yearning for more capital controls

The National Common Minimum Program (NCMP) of the UPA government had promised to encourage foreign equity flows into India, while "checking speculation". In order to translate this wish into policies, the Ashok Lahiri committee was setup in the Department of Economic Affairs [link to pdf]. The most fascinating thing about the report is actually a dissent note by RBI (page 59), which spells out the capital controls that RBI wants. In summary:

  1. They think the "origin and source" of investment funds matters greatly.
  2. They want a committee to study measures to curb volatility of portfolio flows.
  3. They want to continue to have restrictions through the separate enforcement of FDI and FII limits.
  4. They want to ban participatory notes.
  5. They want to remove any hedge funds which are FIIs today, and block future registration of hedge funds.
  6. If entity X is eligible to come into India as a subaccount, but not as an FII, and is not presently in India, they want to block it.
  7. They want to continue with the existing ceiling on the stock of FII ownership of debt securities, rather than shifting to a ceiling on the flow of debt investments per year.

Today's Business Standard has an excellent edit which disagrees with RBI's position on the direction of the evolution of India's capital controls. The edit says: Rather than keeping certain types of investors out, the policy objective with respect to foreign investment should be to keep most, if not all, in. That means making it easier for foreign investors to buy stocks in India, to the point where they should not have to come in through the conduit of registered FIIs.

Update: Andy Mukherjee has an excellent column titled Hedge Funds Bring Capital, Anxiety to India on Bloomberg, where he links up the issues of capital controls and the impossible trinity.

Sunday, February 05, 2006

Banks, CDOs, leverage

Jayanth Varma has an extremely funny blog entry which responds to an article in The Economist. The article is a gloomy piece about Collateralised Debt Obligations (CDOs), which the journo portrays as dark and dangerous instruments. JRV points out that everything the journo says could equally be said about bank loans, but then, the moment someone utters the magic word `bank', all skepticism is suspended. The journo has the usual `financial innovation is dangerous' worldview - e.g. cash settlement is bad, and so on.

I have an extension on his theme, this is about leverage. When we look at any normal company or business plan, we are extremely conscious about leverage. Every sensible person knows to watch out for the leverage. People who don't like derivatives talk about the enormous leverage of derivatives positions - e.g. in India, the Nifty futures give you roughly 6:1 leverage. By putting down cash of only Rs.15, you can get a position of notional value Rs.100.

How does this enormous leverage work out okay in the derivatives field? The main answer is: good financial and computer engineering. This is the entire edifice of VaR, initial margin, daily mark-to-market margin, novation at the clearing corporation, etc. A sophisticated synchronised dance is pulled off, and it works out well.

In contrast, ponder the leverage of banks. The average leverage of banks in India is 20:1! Banks - supposedly the bastion of safety and the backbone of civilisation - have a great deal more leverage than the supposedly wild derivatives market.

And the banks do a terrible job of handling it. The financial and computer engineering that has gone into exchange-traded derivatives is infeasible with banks. Banks don't do daily mark-to-market. There is no VaR, there is no novation at the clearing corporation, etc. A bank is just one big opaque leveraged position.

ps: Sometimes people think the "capital adequacy ratio" of the Basle Capital Accord (1988) shows the amount of equity in the bank. That is not so - the CAR is just a formula invented by Basle. A bank may say it has a CAR of 12%, but it may have 20:1 leverage all the same. I like to compute the simple number - Total Assets divided by Equity Capital - as a simple metric of leverage. Leverage is about asking: How big is your position? And, how much equity do you have in it?

Update: a response by Jayanth Varma.

Thursday, February 02, 2006

What you pay for fund management in India

Modern finance, based on securities markets, is a great enterprise when compared with the old banking-oriented finance. As Merton Miller says, banking is a disaster-prone 19th century industry. Emphasising the securities markets avoids the periodic disasters with banks that seem to afflict most countries, particularly the countries which are unable to close down a weak bank before it's insolvent.

From this framework, there is much to like about mutual funds and `defined contribution' pensions: there is no leverage, all assets are marked to market every day, if a money manager goes bust it's easy to replace him with a new manager since customer assets are not comingled onto the money manager's balance sheet, and all losses are borne directly on the balance sheets of households.

The one bad thing with this happy picture is: the fees and expenses that customers suffer. I am unable to fully comprehend why, but customers simply do not seem to understand how damaging the fees and expenses of their fund manager are. For a normal product such as a refrigerator, paying more generally gets you a better product. But that isn't true for fund management, and customers just don't seem to see that.

Cellphone calling plans are plagued with an attempt to obfuscate customers and make it difficult to understand where you will get socked with charges. But atleast in the end, the customer of the cellphone clearly understands two things: He understands the call quality and he understands the number that he writes on a cheque every month. With fund management, these two things don't happen! The customer doesn't understand what "call quality" he is getting. And the customer doesn't know what number is on the cheque he is writing every month to the fund manager.

I believe there is a serious market failure taking place here. In India, the commission model has come to dominate, where agents sell fund products to customers and collect a fee. There is competition between finance companies and competition between insurance versus mutual funds, each trying to gain market share by giving the agent a bigger discount. One foreign bank has an internal target of obtaining 12% of the wealth out of each customer of theirs per year. This, in a country where the expected return on the equity index is probably 13%. The worst excesses of this kind are by the insurance companies. Of the Rs.60,000 crore that went into insurance companies in 2004, Rs.6,000 crore (or 10%) turned around and went back as kickback to agents! But the mutual funds are now determined to match the insurance companies in this racket. Recently, SBI Mutual Fund reached a new low by paying 7% to the agent. So when the customer puts in Rs.100, only Rs.93 gets invested.

Monika Halan has a good article on this problem in today's Indian Express. What can you do different at a personal level? One big thing that comes to mind is: Buy Exchange Traded Funds (ETFs) on the exchange screen. The only direct fee that you pay is brokerage, which is a competitive market and really cheap. You do need a tight bid-offer spread on the screen, but that's often available.

In the long run, will the situation get sorted out? Competition between agents could drive down their fees. Customers could wise up, start looking at fees and expenses, understand that when they write a check for Rs.10,000, the agent is getting Rs.700, and favour index funds sold over the net without commissions in the picture. But all this could take many decades. Can we do better? The design features of the New Pension System are focused on addressing some of these problems with the market for fund management products. You might find my paper on the Indian pension reforms useful.

Wednesday, February 01, 2006

The distorted taxation of Indian telecom

Indian telecom is burdened with a strange menagerie of taxes. I wrote a column in Business Standard today, where I argue that this is bad tax policy, for no industry or sector should face higher or lower taxes than any other. I make no argument that telecom is somehow a good thing and requires favoured treatment. I argue that telecom should be treated on a level playing field, like any other good or service in the country, and be placed into a single flat rate VAT. Simultaneously, all other taxes/charges being imposed upon the telecom sector should be removed. The only exception is the problem of allocating spectrum, where there is a case for an auction, while having a significant role for technologies like 802.11 where clever devices are used to render spectrum non-rival.

This approach would eliminate distortionary taxation of telecom, and thus lower telecom prices. It would make it possible for TRAI to move further in reducing telecom to much more of `an ordinary industry' and less of an area where there is rigidity about licenses/permits from the State that define what this or that vendor can do.

A lot of innovation in the future of telecom involves intra-sectoral trade between specialised telecom firms. There is a role for more firms who buy and sell telecom services to each other - e.g. a customer-facing VoIP firm could be buying bandwidth from upstream suppliers. Such an industrial organisation of the telecom sector is impeded by the present framework of licensing and taxation. Value added will be placed efficiently between competing firms if the tax treatment is a VAT.

Finally, spectrum allocation based on an auction would depoliticise spectrum allocation, and allow markets to shape the vendors and technologies who utilise the scarce spectrum.