Article by Joydeep Mukherji

Joydeep Mukherji has written a good article titled Economic growth and India's future. It is a balanced treatment which portrays the big picture of where he thinks India is going. Joydeep is unusually clear-headed and this is worth reading. His story may be summarised as saying that India will grow well but will not achieve the `miracle' growth like South Korea's sprint into OECD.

Political economy of removing capital controls

Ila Patnaik has an article in Indian Express today linking up three themes:

• The political economy of removing capital controls -- exactly as the Ministry of Industry hated the removal of industrial licensing, the RBI unsurprisingly advocates great caution on removing capital controls. Which incumbent agency operating a system of controls has ever been an impartial thinker when it came to liberalisation?
• Convertibility has to inevitably go with a floating exchange rate, because monetary policy autonomy is more precious than a pegged exchange rate. That will make a dent in another function that the RBI performs, that of manipulating the currency market and being the biggest portfolio manager in India. Ila likens this to a shift from a giant State-run portfolio to a million portfolios run by households.
• Larry Summers recently pointed out that the opportunity cost on India's excessive reserves are bigger than State expenditure on health. This problem will also go away when we switch from public sector reserves management to a million portfolios run by households, for each one will diversify across shares, real estate, corporate bonds, etc., while the RBI reserves portfolio only invests in short-dated government bonds of AAA countries.

All in all, a fascinating set of insights into convertibility. I will add one more element to it. Who stands to lose from the removal of controls? The existing permit-holders. Who are they? The big FIIs who sell PNs. If there's a mass of $50 billion of PNs out there, and if this is a revenue stream of 2% per year, then the revenue stream from renting out permits is a cool billion dollars a year.

In addition, FIIs and FDI investors surely like it when India expends over 1% of GDP on giving them free risk management on currency risk. This adds up to two reasons why existing license-holders are going to be unenthusiastic about convertibility, and why so many FII reports praise RBI's handling of capital controls and the currency regime :-)

The picture I'm getting of the political economy of convertibility is that RBI, FIIs and FDI investors stand to lose from removing capital controls, and everyone else benefits. Let's see who is stronger in the political landscape.

The RMB currency regime budged!

As readers of this blog may know, for almost six months now, Achim Zeileis, Ila Patnaik and myself have been sniffing at the Chinese currency regime. So far, our story was that there was miniscule currency flexibility and no evidence of structural change. This has changed! Look at our monitoring plot on that web page: For the first time now, we can reject the null of an unchanged currency regime when compared with the history period (August, September, October). We're hard at work on this... stay tuned. :-)

How did the 7 percentage point swing in investment/GDP ratio happen?

One of the most remarkable things about the recent Indian macroeconomic experience has been the rise in the investment rate from 23% in 2001-02 to 30% in 2004-05. This is a huge seven percentage points of GDP of a rise over a mere 3 year period.

Ila Patnaik has an article in FE about how this happened. The pieces appear to be:

• Net capital inflow into the country swung from -0.7% (a current account surplus) to +0.8% (a current account deficit) - a gain of 1.5 percentage points.
• The biggie was the consolidated public sector, which swung from -2% to +2.2% - a gain of 4.2 percentage points.
• Retained profits of the corporate sector went up from 3.6% to 4.8% - a gain of 1.2%.

These three pieces add up to a swing of 6.9% of GDP, and are the bulk of what happened.

As Ila emphasises, these changes are about the tactical evolution of economic policy coupled with the business cycle. They are not about the `demographic dividend', as has been claimed by many people.

A business cycle downturn will affect both the public sector (lower tax revenues, lower PSU profits) and the private sector (lower earnings). So a simple business cycle downturn could lead to a peeling of a lot of these gains. The UPA's exuberant spending programs could generate a deterioration of the public sector numbers.

The 1.5 percentage point swing in the current account surplus was primarily a gift caused by higher oil prices. The currency regime also did improve slightly, but that played second fiddle. RBI basically kept hanging on to the pegged exchange rate regime. It just so happened that an oil shock came along and at the old rate (which RBI was hanging on to) we flipped to a current account deficit. We haven't yet got a currency regime which can deliver a sustained current account deficit.

The 2006 Neemrana conference (NCAER/NBER)

A few days ago I had talked about the 7th Neemrana conference. I now have URL for the program, which has links to papers / slideshows.

Here, you will get Robert Jensen's talk about mobile phones in Kerala, and their impact on market efficiency of the fish market. My talk at Neemrana this year was titled Next steps in financial sector policy.

Indian exchange-traded derivatives in a global context

Futures Industry magazine has an annual feature tracking the growth of the global exchange-traded derivatives business [pdf]. It is fascinating in terms of tracking what is going on in the global derivatives business. And, India shows up in some of the tables.

When we keep score in terms of the number of transactions or number of derivative contracts traded, India looks good. While that means something in terms of conveying activity, it also exaggerates India's position since the contract size or mean trade size - measured in USD - are unusually small. In the Economic Survey chapter on the securities markets, there was FIBV data showing that NSE and BSE are ranked 3 and 5 in the world by number of transactions.

At page 18, we see the amazing achievement of the Korean KOSPI 200 contract - the biggest contract in the world. We have a long way to go with Nifty, which isn't even in the top 20 contracts. At page 22, Nifty futures show up as the 7th biggest gain of the year.

At page 26, NSE shows up at rank 7 in the biggest futures exchanges of the world. Not bad - rank 3 in the world by number of transactions on the spot market, and number 7 in the world by number of contracts on the futures market. But on the next page, when we look at the sum of futures and options, Korea again rocks. NSE shows up at rank 14. This reminds us that lacking Direct Market Access (DMA), India is very weak on options trading when compared with where we are on futures trading.

At page 18 they also show a modest revival for currency futures, which saw growth of 57% compared with overall growth of 12%. When I was in Chicago last year, Leo Melamed was telling stories about how the key device was to get the realtime terminals like Reuters to show the currency futures bid/offer spread alongside the bid/offer spread on the currency forward market. That was apparently the decisive thing which turned things around for currency futures. Customers could see the superior spreads on currency futures juxtaposed against those of the OTC market, and the 25-year slide of currency futures was reversed.

On a related note, you might like to read the latest NSE Derivatives Update (February 2006) which just came out.

What changed in Indian finance, and why

Few parts of India have changed as much in the last decade as finance. Susan Thomas has done a cool paper for S. Narayan's forthcoming edited book titled How the financial sector in India was reformed [pdf] Dr. Narayan's forthcoming book is titled Case studies in reforms. I have previously blogged about some other chapters. It's going to be a cool book.

Opening the capital account - II

In 1997, the Tarapore committee took on the convertibility question. For a glance at the zeitgeist of the time, see an article I wrote in ET at the time. The conventional wisdom is that the report was buried after the East Asian Crisis. I disagree. I think Bimal Jalan did an amazing job of chipping away at capital controls through his period as RBI governor, once the early problems of 1998 were put behind. At the level of rhetoric, the word "convertibility" was avoided, while steadily moving forward to de facto convertibility, and obtaining a steady increase in the size of the capital account when compared with GDP.

On 18th (Saturday), Manmohan Singh did a speech in Bombay where he said:

Today, globalization is changing many familiar things the way we think, act and perform. It is changing central banking too. Funds in large amounts move across borders with ease and speed. Maintaining financial stability in the face of such forces of globalization is a challenge. But globalization is an opportunity too as it makes it possible to harness global capital in search of investments for furthering national goals. The Reserve Bank has to remain ahead of the curve so as to minimize the costs and maximize the benefits of globalization for the country.

A proposal to make Mumbai a Regional Financial Centre is already under active consideration. Our economic reforms have accelerated growth, enhanced stability and strengthened both external and financial sectors. Our trade as well as financial sectors are already considerably integrated with the global economy and the trend is irreversible. Mumbai, with all its inherent advantages in terms of human capital and commercial acumen, can be positioned as a viable Regional Financial Centre. We need to work towards this objective.

Given the changes that have taken place over the last two decades, there is merit in moving towards fuller capital account convertibility within a transparent framework. This issue was first examined by the Tarapore Committee. Much water has flown down the Ganga since then. Our own position, internally and externally, has become far more comfortable. I will therefore request the Finance Minister and the Reserve Bank to revisit the subject and come out with a roadmap based on current realities. Progress in this regard will facilitate the transformation of Mumbai into not only a Regional but also a Global Financial Centre.

This was extensively reported in the media in India and abroad. It was a big front-page story in FT. A first round of editorial commentary (e.g. editorial in BS) was supportive.

On 20th (Monday), Chidambaram said some intruiging stuff. E.g., the story in BS says:

With Prime Minister Manmohan Singh favouring full float of the rupee, Finance Minister P Chidambaram today said the government and the Reserve Bank of India (RBI) would, in the next few days, announce steps on capital account convertibility of the Indian currency.

"Prime Minister has made a very definitive statement day before yesterday, and the RBI and the government would announce the next steps (on capital account convertibility) in a few days from now," he said at a CII function this morning.

Chidambaram said the finance ministry and RBI had discussions on capital account convertibility of the rupee, and the issue could have been part of Budget 2006. "It was pulled out of the Budget as it could have overshadowed other fiscal policy announcements," he said.

A few hours later, RBI moved, setting up a RBI-friendly committee that will write a report about where to go next. The committee consists of S. S. Tarapore, Surjit Bhalla, M G Bhide, A V Rajwade, R H Patil and Ajit Ranade. An interesting composition: three Ph.D.s, some macroeconomics (Surjit), some finance (Bhide, Rajwade, Patil). I tried to look up recent writings by Tarapore in FE, but he seems to have stopped writing in recent years.

The speed in setting up this committee is astonishing. E.g. the Percy Mistry committee on Bombay as an international financial centre took one year from budget speech to setting up the committee. In contrast, this was setup in a few hours.

The Tarapore-2 committee will start work on 1 May and submit on 31 July. This differs from announcing steps in the next few days as stated by the FM. It is about putting off steps till 31 July. :-)

In short, I don't understand what is going on. There is some chess game afoot that I'm only dimly comprehending. Why did Manmohan Singh and Chidambaram say what they said, in quick succession? Why did RBI rapidly create this committee? Why these names for the committee?

It took a few days, but top quality commentary has started appearing in the media:

• An editorial in BS argues that moving towards convertibility should leave banks out of the mainstream, and that it's time to fix the debt market and commodity futures regulation. It emphasises that there will be six great currencies in the years to come: the USD, Euro, JPY, GBP, CNY and INR. They say we have to build an INR yield curve which is a target for investment and issuance for the whole world. I will point out that of the six currencies, the institutional structures underpinning the Euro are not yet fully done. E.g. see this recent article by J. Bradford DeLong. And the CNY, of course has huge problems. So prospects for the INR may be a bit better than might otherwise have been the case.
• G. Ramachandran has an excellent piece in Hindu Business Line where he emphasises the link between greater openness and greater currency flexibility.
• Ila Patnaik has an excellent `Gained in Translation' on the subject.

This story started with a speech by the PM on the 18th of March and today is March 23. It's a fast moving game. These developments could also influence the Percy Mistry committee on Bombay in interesting ways.

Is something happening with the Chinese Renminbi?

A visual inspection of the USD-CNY rate suggests that in recent days, there has been a bit more volatility: (This picture is taken from Yahoo finance, where you can tinker with the parameters further). I just updated our `Monitoring the Chinese Currency Regime' page and find that while visually it looks like something has changed, one can't yet reject the null that nothing has changed: What is going on here is that the months of August, September and October are used as the history period. From 1 November onwards, the `monitoring period' starts. The red line shows the threshold for rejection and the black line shows the empirical test statistic. When the black line crosses the red line, we will be able to say that the Chinese currency regime has changed when compared with that prevalent in August 2005 - October 2005. So far, the situation seems to be one of running on the same regime. What I find particularly fascinating is that a three-month history period has shed light on the following five months (November 2005 till now). Perhaps this is a moving target, and the dates matter greatly. The Yahoo finance data goes till 20 March. The data we use for the paper, which is from the US Federal Reserve website, goes till 17 March.

Synthetic corporate bonds

India has many restrictions against debt flows, but is fairly open on equity flows. In particular, for registered FIIs, there are no limits in terms of buying or selling securities such as Infosys common stock and securities such as futures and options on Infosys common stock. Suppose there are foreign investors who seek to buy Indian corporate debt but are presently prohibited from doing so. Can a clever design overcome the situation?

As a general principle, we know that financial innovation renders capital controls porous. The Indian situation is a relatively unique logic puzzle where the foreign investor is given access to a liquid spot market, a liquid stock futures market, and a relatively illiquid stock options market. Can these raw materials be combined to produce payoffs that are similar to a corporate bond?

I feel that a key aspect of the situation is the dramatic extent to which the firms of India have become highly deleveraged. Equity financing now dominates. Many firms, such as Infosys, have gone down to zero debt. I feel there are some cool things that can be done using the common stock of zero-debt companies; that a key ingredient to toss into the pot is the assumption that the firm has no debt.

In short, the rules of the game are: you have access to spot and futures for a zero-debt company, and at a pinch, you have access to options too. How do you produce a synthetic corporate bond?

I can think of one interesting set of moves, to produce a low volatility cashflow while abiding by these rules:

1. Setup a SPV in a tax haven.
2. Buy $100 million of Infosys shares in India. These generate a stream of dividends in the future.
3. Issue a senior claim on the assets - which is "an Infosys bond". The residual (subordinated / junior) claim is then a "leveraged Infosys equity".

Just to fix ideas, the senior claim promises to pay cash of Rs.10 per year for five years and, in the end, pay Rs.100. So it looks like a five-year maturity, 10% coupon, corporate bond issued by Infosys. Every year, the SPV takes stock of the cash and shares available with it. The SPV first pays Rs.10 to the senior investors. If there is no cash in hand (i.e. the Infosys dividend dropped to 0), it sells shares to obtain Rs.10. If there is any cash in hand at the end of these steps, this is sent to the subordinated investors.

At the end of five years, the position is liquidated. The first Rs.100 obtained are paid out to the senior investors. After that, if there is residual cash, it is paid out to the subordinated investors.

The senior claim is akin to a "fixed income" instrument issued by Infosys. A Japanese insurance company or pension fund, that likes to buy corporate bonds, might like to buy these "Infosys corporate bonds". The subordinated claim - how about a name like "supercharged equity"? - will be bought by the usual risk-loving characters such as the hedge funds.

If India's capital controls are binding, and there is an unmet desire for corporate bonds on Infosys amongst overseas investors, then this set of trades can add value.

The senior claims are not corporate bonds in one key respect: the treatment of bankruptcy. When a corporate bond fails to pay a coupon, this is a default event, and the bondholder gets the company. In contrast, the senior investors of the SPV don't have recourse to a bankruptcy process where they takeover Infosys in the event of bankruptcy. While I respect this difference, I still feel that the senior claim does have risk/return characteristics that are a lot like a corporate bond, particularly since India doesn't have much by way of a bankruptcy process.

Another fly in this ointment is that the structure works best as long as Infosys preserves their zero-leverage structure of liabilities. If (say) next year, Infosys chooses to issue debt, then that muddies the waters. The investors in the senior claim on the SPV would be unhappy because now there is some other debt which is more senior than them, at the mother source. There could be a provision in the contracting - a "debt covenant"? - that the entire structure will unwind, at prices driven by formulas agreed-upon as of today, in the event that in the future, Infosys issues debt. In other words, if Infosys issues debt in the future, then the senior and the subordinated paper are both put back to the originator where they are extinguished, and the originator sells off his Infosys shareholding in India.

I don't know how to think clearly about tax efficiency. Does that dimension break the design?

Another path to synthetic corporate bonds is through stock options. Suppose the assets of the firm are V and equity (E) is a call option on V. The foreign investor has access to trading the call and trading the call on call. In the special case where the firm has no debt, E=V and the call options on E (which are accessible) are call options on V. It looks like one can work through put-call parity and construct a synthetic corporate bond.

The trouble with that route is that India doesn't allow investment in the riskless. In addition, the maximal maturity, liquidity and market efficiency of the stock options market is not that attractive. So maybe some years out, this will become possible. The senior/subordinated structure is feasible today.

I have arrived

I am in Beijing, and I find that the Great Firewall of China blocks this blog! I'm a real person now!!

It's not as sweet as writing a book that gets banned, or having a fatwa on one's head, but it feels nice to know that perhaps one picocent is being wasted in the Chinese monitoring system in blocking this content.

I wonder how the Great Firewall of China works. They allow rsync-over-ssh out so clearly one can move encrypted content in and out. It also seems costly to do realtime checking, for latency-sensitive applications. The videoconferencing at the World Bank's Beijing office was a lot worse than that in their Delhi office - perhaps this was the latency introduced by the checks?

-- Ajay Shah http://www.mayin.org/ajayshah ajayshah@mayin.org http://ajayshahblog.blogspot.com <*(:-? - wizard who doesn't know the answer.

Fab envy

I have watched the development of the `SemIndia' project with some curiosity. It looks like a situation where there is an `industrial policy' push in favour of one project (SemIndia) in one industry (semiconductor manufacturing). There is a raft of laudatory stories in the press, and various arms of government seem to be keen to dole out equity capital, `viability gap funding', land, etc. [Story 1] [Story 2] [Story 3]

I wrote a column for Business Standard arguing that there is no role for the State in this business. There is no public good being produced by State involvement. I argue that if the State does want to foster top end research and knowledge, then the best way to do it is through a system of defence contracts akin to that which was operated by DARPA in the US.

Getting a fab into India will be an occasion to celebrate, but it should be based on the true merits of India as an economy. Getting a "fake" fab in based on government subsidies is as silly as trying to get "fake" exports growth based on either export subsidies, or on a government-distorted exchange rate. We mix up means and ends when we start going after the goal of a fab, rather than seeing a fab as a litmus test of how well India is faring on the core public goods.

This debate is about `industrial policy', where the State picks winners. Sometimes, there is a view that India should attempt industrial policy, as has been done in South Korea [recent ambivalent NYT article on South Korean industrial policy]. I am willing to believe that there are countries where a big State-driven push into `good' industries and `good' companies can work. But in India today, I deeply believe that it can't work. The Indian governance puzzle is about keeping the State focused on public goods, when the political system would all the time love to goof off playing the patronage game with either industrial policy or social programs.

One facet of Semindia that is particularly disturbing is a political allocation of land - 1200 acres of it. I argue that this is way beyond the ordinary land requirements for a fab. This is part of the deeper problems of the land market in India. Of the four factors of production - land, labour, capital and enterprise - the State is still a very big player in the land market.

My views on these issues were greatly shaped by the late 1980s evolution of the global semiconductor business, and particularly the evolution of the last piece of industrial policy in the US, Sematech. Back in 1995, there was an excellent article by T. J. Rodgers titled Technology traps: Defunding the megaprograms on Sematech. Rodgers was CEO of Cypress, and stood to gain from public money being poured in his industry. That makes his logic all the more credible. You will also find this interview with him to be fascinating.

On the `mercatus' blog, I found an interesting pointer to a PDF file describing site selection for a fab at Intel. That links up to this discussion in the sense of answering `what would it take for Intel to voluntarily choose to build a fab in India?'.

The public goods of law and order

India's socialist experiment led to a great focus on politically controlled resource allocation, and a loss of focus on the core tasks of public goods. In my mind, the most important first task of the State is law and order, which comprises (a) police, (b) the body of law and (c) the judiciary.

Public goods versus private goods. In India today, there is a lot of focus on `service delivery' for health and education. I feel that this is misplaced. A lot of the issues in health and education are actually private goods. E.g. I have a toothache, I get cured, I get better: my consumption of health services is the consumption of a private good. The benefits are mine and my consumption of 20 minutes of service provider time comes at the price of somebody else accessing that provider for 20 minutes. Perambulatory curative health services - the kind doled out by WHO-vintage PHCs, are a pure private good.

In contrast, law and order is as non-rival and non-excludable as can be. I think that today, there is an imbalance in too much focus on health and education, and not enough focus on law and order. I think it is fair to say that the situation on this front has deteriorated today when compared with 1947. New York Times had an editorial on the Indian justice system, yesterday.

Economists are so tuned out of the law and order question, and so focused on the non-public goods of health and education, that in an otherwise excellent World Development Report 2004 on public goods, we don't find mention of law and order. To learn about this field, we have to use non-traditional sources like Amnesty International.

Police. Between the two service delivery systems of police and judiciary, the police is much harder. In the classification scheme of Pritchett & Woolcock, 2004, it's a transaction-intensive discretionary public good. It is very difficult to overcome agency problems: building a good police force is very, very hard. In India, the police appears to be uniformly bad. As Robert Kaplan said, "underdevelopment is when the police are more dangerous than the criminals".

The body of law. The police and judiciary can only perform in enforcing a body of law. Too often, in India, the legislation is in very bad shape. In personal law, there are problem like unequal treatment of men and women, or the punishments against homosexuality. In economics, the bulk of the pages of law out there were written a long time ago. They are steeped in socialism, and they are out of touch with contemporary institutional realities. Bibek Debroy is one of the rare scholars who has understood the enormous importance of these issues and done good work on the subject. He doesn't disseminate his work on the net as much as he should, so I have placed PDF files of two of his works in this field on my website: one and two. Update: Sanjeev Sanyal has an article on the legal system which is also of interest (free registration required).

Judiciary. We seem to be faring a bit better with judiciary as compared with the police. Process improvements based on IT at the supreme court have largely eliminated the case backlog, and these ideas are now creeping into high courts [Look at the existing efforts on process engineering using IT]. This assault on case backlog should have taken place much faster than it has, but atleast it's progress. Below the high courts, the situation is grim. There are huge gaps in the knowledge of judges and their physical facilities. Another aspect about the judiciary which is fundamentally different from the other two elements of law & order is that for commercial disputes, it's possible to use arbitration, and thus escape some of the infirmities of the public system. In contrast, there is no escaping bad laws and bad police. (Recruiting your own security guards is a coping mechanism, more like having an aquaguard because the tap water sux; it is not an alternative to having police).

On this subject, see this recent blog entry by Naveen Mandava which points to two recent working papers on the subject of India and judiciary. Another excellent piece on the subject is by Pratap Bhanu Mehta, it is a chapter in the recent edited book put together by Devesh Kapur and him. It tells a sad story of a judiciary that has played to the gallery; a judiciary that was unable to protect the individual against the State, even in areas where the drafting of the constitution was not faulty. This, once again, underlines the importance of the recruitment and training process for the judiciary. We need more of Richard Posner and H. R. Khanna and less of Ray, Beg, Chandrachud, and Bhagwati.

The agency problem between citizens and politicians. Citizens might like law and order, but this does not mean that politicians will maximise what is in their interest. How do incentives operate upon elected representatives to put in a focus on the hard work of public goods, as opposed to enjoying themselves dispensing patronage through welfare programs? I think the media has a powerful role to play in this process. The media is able to translate a specific incident - Jessica Lall's murder and the subsequent failure of prosecution - into pressure for broad-based reforms on the police and the judiciary On a related note is the recent events about Zaheera Shaikh, where also we're seeing a specific high-visibility event leading to strengthening the policy environment. Similarly, I was very happy to see the citizenry respond when a teenage girl was raped by a policeman in Bombay a few months ago.

We may be in a situation like 19th century England, or the wild west in the late 19th century in the US, where at first there is weak law and order. Then an emergent middle class starts exercising influence upon elected politicians, and forces them to walk the hard path of doing law and order right. In this sense, once modern economic growth is ignited, it can reshape the political environment around itself and keep the process going. Between 1979 and 2006, India seems to have successfully ignited a modern economic growth.

Revising the wages of civil servants

Gauri Mishra has an article on the front page of Business Standard today that I disagree strongly with.

The title is Boom sidesteps govt wages: Govt salaries remain pegged at 1996 levels. Her bottom line: The demand for a 6th Pay Commission to revise government salaries may not be totally out of place.

A more careful reading of the evidence is required. I think she has missed out the main story. The main story is simultaneously that while GOI employees at the top are incredibly underpaid - by market standards - the bulk of GOI employees (roughly 98% of them) are incredibly overpaid by market standards. Example: the full cost of a driver at the Ministry of Finance was estimated by me to be four times bigger than the cost of an unorganised sector driver. Not 4% higher, not 40% higher, but four times higher.

Going from anecdote to data, see Wage differentials between the public and private sector in India by Lokshin & Glinskaya, World Bank, 2005. The paper uses data for 1993-94 and 1999-00. They find on average, the public sector premium ranges between 62 percent and 102 percent over the private-formal sector, and between 164 percent and 259 percent over the informal-casual sector, depending on the choice of methodology... The wage differentials in India tend to be higher in rural as compared with urban areas, and are higher among women than among men.... There is considerable evidence of an increase in the wage differential between 1993-94 and 1999-2000.

The right principle to adopt is: At all levels, GOI should pay the lowest possible wage at which an adequate candidate can be hired. That's it. Wages should be high enough to get the right candidate for the job. The huge queues of unskilled labour clamouring for junior level government jobs proves that the wages there are too high. And at the top, the wages paid by GOI are 5x less than what they should be.

Sometimes I have heard the argument In the last 10 years, GDP has grown by 50%, so shouldn't GOI employees get a pay raise of 25%? This is using the wrong benchmark. It is not correct to compare the growth of GOI wages against the growth of private wages. What is required is to compare prices - at all levels - against prevailing market rates. GOI does this for everything else - GOI pays market prices for the steel that it buys or the paper that it buys. There is no reason why purchases of labour should be different.

Business Standard had a sensible edit on this on 3 February 2006.

The pension reforms saga

India has made remarkable progress on pension reforms. We are, of course, not out of the woods yet, but where we are is quite remarkable as compared with the way the policy process meanders in many other parts of the economy. It is hence interesting to ask: How did the pension reforms get done? Are there some more general lessons which can be drawn?

A draft of a paper by Surendra Dave on India's pension reforms saga tries to address these questions. In case you didn't know, Dr. Dave was founding chairman of SEBI, he was chairman of UTI, and he headed the OASIS project which was a key element of India's pension reforms story. (Today, he is Chairman of CMIE). This paper is from a forthcoming book Case studies in economic reform, edited by S. Narayan. In case you didn't know, Dr. Narayan was finance secretary at one of the most interesting times at the Ministry of Finance. I think it's going to be a really good book.

Budget speech 2006

The budget speech was a disappointing display of socialism and industrial policy. For many years, we have been used to thinking that a budget speech should offer a vision of important economic reform. This one does not. It makes some important progress on tax policy. There's nothing else, other than a mile-long list of subsidy programs of one kind or the other. Even in finance, where MoF's dealings with RBI and SEBI are immune to the CPI(M), there isn't much progress to show.

The budget speech is first of all a political statement. The FM has to make a connection with as many MPs in the room as possible. I find it a useful thumb rule to ignore any expenditure program of below 0.1% of GDP (Rs.3,000 crore). These little expenses are crumbs tossed to this constituency or that. Once you have stripped off this verbiage, you'll have the core of the speech in your hands. (See the article by Ila Patnaik on the institutional function of the budget speech).

At a numerical level, a quick summary picture is the `budget at a glance' statement. I put it into a spreadsheet and computed some useful numbers.

The UPA seems to be gunning for big expenses on their `flagship schemes' such as Sarva Shiksha Abhiyan (SSA). As the numbers in the spreadsheet show, roughly 1% of GDP was added into "plan revenue expenditure" to fund these schemes. Business Standard has an editorial questioning the efficacy of SSA as a tool for getting education done. You might find my earlier piece, on a five-fold classification of policy choices on education, useful.

Let me highlight some interesting comments and responses on the speech. For starters, see the front-page article in Indian Express by Ila Patnaik, Surjit Bhalla's response in Business Standard, and the double edit in Business Standard. All these big picture responses are happier about the budget than I am.

Shankar Acharya is often gloomier than the mainstream, but on this one, I agree with him 100%. The Securities Transaction Tax (STT) was raised by 25%. All of financial sector reforms are about trying to improve liquidity, i.e. reduce costs of transacting. The progress of reducing transactions costs of the last 8 years has been undone by the STT. The STT at 12.5 basis points is huge. As an example, a $100,000 basket purchase of Nifty now runs up an impact cost of 8 basis points. Compared with this, a 12.5 basis point tax is a very material addition to the costs of transacting. It is really depressing seeing these kinds of taxes, which fly in the face of elementary good sense in public finance.

On 22 Feb, Vijay Kelkar had a piece in Indian Express on the Goods and Services Tax [FRBM Task Force Report]. The FM has announced that we will set course for the GST with a 4/2010 deadline. Even though 4/2010 sounds far away (it's four years out, and after the next elections), this could be a development of the first order. Kelkar has a front-page piece in Indian Express today on translating this goal into reality.

One new development this year is a statement about the cost of the various tax exemptions out there [pdf from MoF website]. Saubhik Chakravarti has an article in Indian Express on this. The value reported in the budget document is roughly thrice the size seen in the recent NIPFP paper by Amaresh Bagchi et. al. I think that the disclosure of this statement by MoF is a major development. It's the beginning of the end of the exemption racket. Earlier, exemptions were a non-transparent way for politicians to get transfers into their favourite constituency. Now everyone knows who is getting what subsidy. Technical improvements are needed on methodology, but it's a great start.

As Andy Mukherjee recently emphasised, a big question facing India is the evolution of capital controls. Will India move forward - easing capital controls? Or will India move backward, reversing some of the opening the capital account that had been done by governers Rangarajan and Jalan? I wrote a short piece in Business Standard on the announcements on capital controls - which seem to avoid the danger of sliding back into controls. I also touch upon the announcements on development of the corporate bond market.