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Tuesday, August 29, 2006

Nifty rules (but why?)

I just looked at the July 2006 `Derivatives Update' from NSE. It shows an astonishing success with index derivatives trading. In the late 1990s, we used to think that the badla community would easily switch to stock futures and stock options, and that trading the index required new ways of thinking, which are always hard. But look at the data for July 2006:

  • Of all futures traded at NSE, Nifty made up 47% of the turnover. The biggest stock futures (Reliance) was at 6%.
  • The biggest traded product in July, unsurprisingly, was the July expiration Nifty (Rs.1531 billion). What was second? Nifty August expiration (Rs.330 billion). The July Reliance contract came in 3rd with Rs.232 billion.
  • Turning to the options, Nifty was 80% of the turnover. Reliance was 2nd with 6%.
  • The top 5 option products were all Nifty contracts with July expiration. The order was: 3100 call, 3100 put, 3000 put, 3000 call, 3200 call.

In a famous paper, Morck Yeung and Yu (JFE 2000) find that in emerging markets, market model R2 is bigger; the index plays a bigger role in the life of a stock. In the case of India, generally, market model R2 values are small by world standards - this suggests more price discovery about each stock in its own right. But when we look at the derivatives trading, it looks like there is a huge role for the index.

Another perspective is the distinction between macro underlyings and individual firms. The microstructure literature has argued that with macro underlyings -- indexes, currencies, interest rates -- there is intrinsically less asymmetric information, so bid-offer spreads are fine. But by that same yardstick, low asymmetric information ought to induce lower trading volume, since volume comes about when people disagree on a valuation. I don't understand this.

Monday, August 28, 2006

The Naina Lal Kidwai problem

Andy Mukherjee wrote about this, and A. V. Rajwade has an article in Business Standard linking up the recent episode of RBI & Naina Lal Kidwai to the larger theme of rules-based regulation versus principles-based regulation. I have previously made the analogy of this debate as being akin to the choice between common law and civil law. The principles-based approach, or the common law approach, seems to be extremely desirable in finance: but this comes at the price of placing greater discretion in the hands of government employees. This requires changing the HR process of government (hiring, firing, performance evaluation, salaries) and in having immense transparency, public scrutiny and accountability bearing upon financial regulators. I think the UK has got this right: the Bank of England has been tied down by having accountability for meeting an inflation target, and the FSA is tied down by (a) having an outward oriented financial sector and (b) recourse for the financial industry to the treasury for disputes with the FSA.

Rajwade also notices how RBI is in no position to talk about conflicts of interest, given the conflicts of interest that are at its core. Ila Patnaik had written about this a few days ago.

Saturday, August 26, 2006

Why firms should not run DB pension programs

In the context of Indian pension reform, sometimes discussions about pension programs run by the employer come up. I have generally advocated not going down that route, because on the sweep of 70 years (from starting to work at age 21 to death at age 91), the firm is but an ephemeral and temporary coalition of a few people and some capital. Firms come and firms go; what makes sense is a portable individual account that stays with the person across job changes.

Today I saw a fascinating article titled The Risk Pool by Malcolm Gladwell, in The New Yorker magazine. This sheds light on three interesting issues. The first is the problems of an employer-centric DB pension program. The second is the debate about India's "demographic dividend". The third is the woes of large US manufacturing companies such as Ford or GM. These difficulties are sometimes attributed to the innately poor competitiveness of trying to do manufacturing at US wages. But as the author argues, is (to a large extent) merely caused by a bad (DB, firm level) pension program.

The article suggests that one way to solve the problems of GM or Ford would be to take them into bankruptcy, thus getting away from existing pension promises, and then selling off the good parts to a private equity firm which would be able to rebuild these firms as sound businesses; that once the flawed pension plan is out of the way, GM or Ford are actually viable firms. Perhaps Tata Motors should wait in the wings, for the time when GM or Ford go belly up.

I am sometimes accused of being obsessed about financial planning for old age, but I do think that small mistakes on pension policy have far-reaching consequences, and thinking this through requires complex reasoning that spans across many fields. Gladwell's article nicely highlights how an apparently small mistake made by CEOs of these firms, a few decades ago, was big enough to destroy these firms. The same applies for countries, in more ways than is widely understood.

Monday, August 21, 2006

Indian monetary reform

I have previously written about RBI in connection with capital controls, the lack of a countercyclical monetary policy, the issue of transparency, and the difficulties of trying to do monetary policy while not having a market for interest rates or currencies.

Today Ila Patnaik has an article in Indian Express titled How to solve the RBI problem about putting Indian monetary policy on a sound footing by having a small central bank which only sets the short rate, which is independent of the Ministry of Finance, but is accountable for hitting a publicly visible inflation target and is required to be transparent.

Wednesday, August 16, 2006

Global diversification is not a side show

Capital controls have been in India since 1955, and have deep roots at the level of ideology, rent seeking and the interests of existing agencies. Take 1 on outbound investments from India came to naught through the introduction of a clause that Indian mutual funds could only buy shares of companies abroad which had FDI in India. So, for example, an Indian mutual fund could not buy index funds outside the country, since most global index components have no FDI in India.

SEBI recently put out guidelines on international investment by Indian mutual funds [pdf] which have solved this problem. The spirit of these guidelines appears to be one where mutual funds will do a little international investment, with a raft of QRs: no more than 10% per fund, no more than $100 million per fund, no more than $2 billion overall per year (or roughly 5% of mutual fund assets under management, or roughly 0.3% of GDP). And they say that if you want to run an exchange traded fund (ETF) on an offshore index, you can only do this if you have prior experience with overseas investment (which, of course, is a rarity in India given the elaborate system of capital controls which has been in place). As a consequence, the firm with 90% market share in ETFs (Benchmark) won't be able to launch an ETF on offshore assets. As Jayanth Varma points out, the political economy which could be at work here is: Conventional actively managed funds have an incentive to block the growth of ETFs since they represent dangerous low-price competition.

Sigh. Small pieces of progress on economic policy in India seem to take a long time.

I wrote an article Global diversification is core to fund management in Business Standard arguing that global diversification is not a sideshow in fund management. I show sample calculations of computing efficient portfolios based on the historical covariance matrix of weekly returns, across 4 indexes, over the last 16 years. I know, estimation of covariance matrices is hard, but I think the results illustrate the basic point. And I do have 837 weeks of data with only 4 indexes.

Diversification is a free lunch. When a portfolio is spread across the globe, the reward/risk ratio unambiguously improves. This issue goes to the core of portfolio formation, it is not a side show. Efficient porfolios involve a much bigger role for offshore assets when compared with the tiny numbers that RBI and SEBI are talking about. As an example, Israel has a rough balance between capital inflows of 9% of GDP and outbound investment by local households and portfolio managers of the same amount.

Economic logic thus suggests that every portfolio in India should be unabashedly globally diversified, with large fractions of offshore assets. If some portfolios manage to have more globalised portfolios, their Sharpe's ratio will beat that of autarkic portfolios, and they will gain market share.

I am reminded of the broader issue of home bias. The home bias literature points out that industrial country portfolios underdiversify into the third world, they keep too much at home. Home bias seems to be the consequence of capital controls in the third world, and mistrust of third world institutions in the eyes of first world investors, which is assisted by asymmetric information.

Now we are seeing this problem in reverse. In autarkic India today, we have extreme home bias: capital controls have prevented agents from diversifying globally (other than the hawala route). The incentive to globalise assets is probably a bit higher in India, since the Indian investor respects UK institutions (say) more than the UK investor respects Indian institutions. On the other hand, I sometimes meet people here who are dazzled at the high rates of return on Indian equities and don't quite understand why they should diversify into low-yield assets such as the S&P 500. My BS article seeks to show the benefits of global diversification to such a person.

The rise of hundreds of Indian multinational firms, with subsidiaries across the world against which transfer pricing can be done, along with the enormous growth of the current account, has thrown up a wealth of opportunities for shifting capital across the boundary. It is common knowledge that many hundreds of billions of dollars of assets are outside India, controlled by Indian households, based on evasion of capital controls. I think this reflects the enormous benefits from global diversification: so economic agents have strong incentives to achieve global diversification by evading capital controls and building portfolios out of reach of RBI inspectors implementing capital controls. Until decontrol takes place, this will remain the main strategy which agents will adopt. The present approach, of having a host of highly restrictive QRs, will not make a dent on this phenomenon.

Paradoxically, the system of capital controls increases the incentive to hold assets outside the country, since in addition to considerations of risk and return, there is the greater flexibility of utilising those assets. By holding money outside India, you have the option value of doing what you want with it, without interference from the Indian State. Holding assets outside the country eliminates the the risk of future evolution of capital controls in the years to come. That option value is out of the picture when decontrol takes place, after which normal considerations of risk and return should come to prominence.

Chet Currier has a column on Bloomberg which points out that US home bias has made progress - a full 25% of equity funds are now placed outside the country. Of course, this is only progress and not a resolution of the problem; most economists would argue that the US investor should hold much more than 25% of his equities outside the US. And, I think Chet Currier gets it wrong when he thinks about the forces at work. Global integration means that global diversification is less attractive - the more correlated is the GDP growth of various countries, the less is the benefit from diversification across countries.

I recently saw a web site offering offshore securities trading to Indian customers. Does this work well?

Update: Watch me talk about this. (It was a while ago, right after the BS article came out).

Tuesday, August 15, 2006

Do events in Lebanon matter for India?

In the good old days, if there was a war around Israel, it didn't particularly matter for India. But the times, they are a changing; part of India's growth and globalisation is a more complex network of interests. Ajai Shukla has an excellent piece in Business Standard -- In the arms of Israel about the new role that Israel is playing in Indian military purchases, and they have an editorial about India's interests in the conflict in Lebanon.

Economic aspects of nation building

Happy 59th birthday to all of us!

The idea of India is the notion that the shared spirit of a nation, founded on the liberal notions of freedom of individuals, can hold together the world's greatest diversity of language, religion, ethnicity, caste and skin colour. We in India live this project: we tend to be aware that the idea has not been seen to fruition in full measure, but it has worked very substantially. We tend to sometimes lose sight of how hard the task is. Today, I saw an article in New York Times which revisits the traditional wisdom that ethnic diversity leads to ethnic warfare; this made me think once again about what are the forces at work in India.

In a famous book India: the most dangerous decades published in 1960, Selig Harisson argued that the Republic of India would come apart, leaving a situation more like Africa or East Europe. This was not an extremist position. Particularly after the rise of the Shiv Sena and the breakup of the Bombay Presidency, in the 1960s and 1970s, my father used to think this was a scenario worth taking seriously.

Matters were made worse by socialist economic policy, which (a) gave a low-growth environment, and (b) converted the political process into a game where groups of citizens organised themselves to grab a bigger slice of the pie through the aegis of a tax-and-transfer State. It was a natural development for these coalitions to get organised around language, religion, caste or ethnicity, each trying to grab a bigger slice of the resources taken by the State from citizens through taxation, the inflation tax and seignorage.

For many years, things used to look bleak. As an example, see this note by Shyam Kamath which was written in 1991.

What changed after that? I think three factors have been at work:

  1. Greater competition in many sectors of the economy has helped shift focus away from sectarian considerations towards meritocracy. As Gary Becker observed in 1971, in a competitive environment, the firm comes under pressure to hire the best man for the job, or to contract with the lowest-cost supplier. Considerations like caste or ethnic origins are luxuries which matter less when there is fierce competition. Discrimination against Harijans is not an upper-caste conspiracy to keep Harijans down; rather it's a luxury that upper caste can allow themselves when competition is weak. The increase in levels of competition after 1991, both in product markets and in removing the role of the government in finance, has taken us closer to a meritocratic society. In areas with competition, and areas where firms compete to obtain resource access from a private sector financial sector, what matters is the output of a person or a firm. Considerations like religion or ethnicity fade away in decision making. In India today, religion or caste or ethnicity are a bigger issue in the public sector than in the private sector, since the revenue stream there is not under competitive pressure. This gives the decision maker the luxury of bringing religion or ethnic origins into decision making. I find it interesting to see that with a public sector that is unremitingly sectarian and a private sector that is meritocratic (in the areas with competition), the Indian nation building project is assisted by a small State. Right now, public sector employment in India is small (roughly 3 crore workers in all), so the outlook for meritocracy and for the Republic of India is good. However, this perspective reiterates the importance of public policy effort on maintaining a small State, on competition and the financial sector.
  2. The second factor is the cost/benefit analysis for a faction to be in the Republic of India. The Indian nation-building project - whether it is about highways or about stock market trading - has grown deep roots across the land, particularly with the greater resources and greater sophistication that has come about in the last 20 years. Improvements in infrastructure are delivering `internal gains from trade' [link] [link] and weave the national economy together, though a lot of work is still needed on the impediments against India as a single market. A person sitting in Srinagar or Guwahati benefits by participating in Indian national systems such as computerised railway reservation, HDFC Bank branches, NSDL depository participant outlets or NSE brokerage firms. If a faction chose to break away from the republic, they'd have to do all this hard work by themselves. Last year, when I worked on the paper Improving governance using IT systems which has appeared in S. Narayan's edited book Documenting reforms: Case studies from India (not yet at Amazon), the phrase which repeatedly came to my mind was "nation building".
  3. Finally, the system of fiscal transfers is sending huge money back into state capitals. Indian GDP growth, coupled with a flat tax/GDP ratio, means that the resources that go into the Finance Commission sharing formulas are growing by leaps and bounds. This mechanism for sending resources into the provinces delivers rents to the local elite, and removes the incentive for them to to break away from the union. The best talent in each province gets tempted to think "make PWD roads, not war", and gets drawn away from separatist movements into collaborating with the Indian nation-building project. I recall a one-kilometre stretch of road at Dehra Dun, which used to be an open-air retail market for Basmati rice under the old boundaries of Uttar Pradesh. After Dehra Dun became capital of Uttaranchal, that stretch of road has become a market for cars, ranging from small cars all the way up to the best cars available in India. I can't help thinking that the fiscal transfers which used to be captured by the Lucknow elite have now shifted to the Dehra Dun elite. High Indian GDP growth plus the system of fiscal transfers gives people with intelligence and organisation skills the incentives to become CPI(M) (i.e., to seek to control provincial expenditures) instead of CPI(ML) (i.e. to rail against the Republic of India).

Punjab has been the biggest success story for the project of Indian nation-building, where a province that went to the brink in the early 1980s has come back whole-heartedly into the Indian mainstream. Now the problem areas are J&K and the North-East states. Apart from that, there are numerous districts where the lumpen engages in banditry, but there is no organised effort at establishing an alternative nation-state. My view is that the banditry will be successfully overcome by the growing resources of the State which can go back into law & order, and the growing appeal of participation in the economy owing to improvements in infrastructure. This does require a State that is more interested in law & order, and less oriented towards tax-and-transfer.

Friday, August 11, 2006

Rethinking higher education

My recent blog post on Israel reiterates the deep impact of strong universities on the task of winning at high-end knowledge functions in the global economy. Even in the lower-quality BPO jobs that India excels at, meaningful higher education matters critically in giving young people the ability to rapidly reshape their skills in response to the evolving needs of the global labour market.

One useful thing Arjun Singh has done is to help bring a greater focus upon the long-standing crisis in Indian higher education. There has been a bunch of interesting readings on the subject:

A short while ago, I had written about entry barriers in Indian higher education. China has made enormous progress when compared with India, particularly in freeing up foreign and private entry. A recent article in The Economist looks at their problems: China: Chaos in the classrooms; An education policy torn between the market and the state.

A simple litmus test of the situation with universities in India is: How often do you see work done in an Indian university get noticed and have impact globally? I can only think of a handful of situations. One that leaps to mind is the work done at IIT Kanpur in number theory a few years ago. Another recent episode is a paper written by a group of people at the Central Salt & Marine Chemicals Research Institute, Bhavnagar, Gujarat and the Hindustan Lever Research Centre, Bangalore about how to make salt flow smoothly, which got mentioned as one of the great ideas of 2006 by the New York Times Magazine By and large, such episodes appear to be woefully rare.

Tuesday, August 08, 2006

Flat price tariff structures for financial transactions

One fascinating debate in finance is that between ad-valorem and transaction-based tariff structures. In an IT system, the cost of processing a transaction is not sensitive to the value of the transaction. When there is a flat fee per transaction, competitive pressure operating upon the CEO turns into pressure on trying to harness the explosive progress in IT and turn it into lower per-trade tariffs.

When there is ad valorem pricing, large transactions get charged more. So it's essentially a cross-subsidy program where large transactions subsidise small transactions. It is not clear why such a subsidy is worth implementing.

The pioneer in switching to a flat tariff was NSDL. Most of Indian finance does not, at present, use a per-transaction price. An interesting recent development is an announcement at Kotak Securities, that they will offer a flat price of Rs.20 per trade or Rs.9 per trade (with many caveats). Also see the Business Standard story on this. As with the NSDL tariff structure, by the time India gets going on doing things right, the prices that are seen are really low by world standards.

The securities transaction tax is, of course, ad valorem, and Kotak Securities has to add this into your contract note even after they have shifted to flat pricing. Update: Rachna Monga has done a story in Business World on this (unfortunately, is not a permalink, and requires a registration).

How good can high-end knowledge work in India get?

India has been faring surprisingly well in building high-end capacity in science and technology. A host of global corporations now have labs in India who are now producing seriously important work. There is a large number of patent filings. One small recent example: Google finance was developed in Bangalore.

What is the upside? How good can it get for India? How far can India go in the task of bulking up on top end knowledge, given the constraints of being far away from knowledge hubs in the US, Europe, Japan and Taiwan? Apart from the US and UK, Indian knowledge workers have a language gap also, apart from the gaps of physical distance and time zones.

I think the best answer to this question is : Israel. Israel has all these same strikes against them (and a few strikes which don't apply in the Indian case). Yet, what Israel has got going in terms of top end human capital is breathtaking. As is well known in the finance field, Israel is the 2nd biggest country represented in NASDAQ listings (71 firms as of November 2005). A large chunk of these companies do contract research, or pure mind-work.

I believe Israel shows the way for the kind of role in the global economy could come about in India, in addition to the classic labour-intensive applications which are taking place in India.

CNET News has an excellent feature on high-end knowledge in Israel. Interestingly enough, a while ago, they had done one on India. Their website is a bit hard to use, so you might find the two PDF files to be useful: Israel, India.

Monday, August 07, 2006

Easing credit constraints

In an ideal world, individuals should be able to smooth consumption across time through a variety of financial devices such as debt. Given the high risk aversion of most households, there is quite a bit of welfare that can be gained by better smoothing of consumption. In India, a large number of households are "credit constrained" - they are unable to have significant debt. This is not necessarily bad - e.g. some of the problem of farmers killing themselves has surely got to do with inappropriate debt-equity ratios.

Every country goes through a transition where the overall borrowing of households goes from roughly nothing, and ends up with a significant amount of leverage. Robert Samuelson has a very nice story about how the US went from household debt of 22% of disposable income in 1946 to 126% in 2006. (I suppose he means PFCE when he says "disposable income"?) William Pesek had a nice article in 2005 on the crisis with household credit in South Korea. It's a great period for the macroeconomy, with high consumption growth, while households are adding leverage. It is a transition that comes only once in the life of a country.

A while ago, I had written about new approaches to solving credit constraints in the form of loans against securities and credit cards. All over the world, when the credit card business works, it effectively serves as small-business financing.

Loans against securities are now quite mainstream thanks to the mass of dematerialised shares that are now in existence. The NSDL data shows they have Rs.18 trillion of equity and roughly Rs.3.5 trillion of debt securities amongst their 7.7 million accounts. The CDSL data shows another Rs.2.1 trillion of demat assets.

What is new about demat securities is that they constitute top quality collateral. The collateral is frictionless for the lender, mark to market is easy, liquidation is easy. This makes it easy to give a loan against such high quality collateral. In contrast, real estate or cars are bad collateral.

One new kind of high quality collateral that is falling into place is dematerialised warehouse receipts which are claims on standardised physical commodities. These aren't quite as good as securities on the issues of valuation and liquidation, but it's another big step forward for easing credit constraints. Today's Indian Express has a story by Suresh P. Iyengar on this.

In my opinion, another frontier on easing credit constraints is obtaining a loan using the accumulated balance in your DC pension account as collateral. The size of credit required to tide over small problems like health or unemployment are small compared with the size of pension wealth that needs to be built up over life, so for most decades of the working life, it is possible to solve the consumption smoothing required owing to ill-health and unemployment by having access to loans against the DC pension account. I have talked about this a bit in my submission to PRS about the PFRDA Bill.

Saturday, August 05, 2006

Farmer suicide continued

A short while ago, I had written about the farmer suicide problem. Now Business World has an excellent editorial on the farmer suicide problem:

Four weeks ago, the Prime Minister visited villages in Vidarbha where farmers had committed suicide. After hearing the stories of their distress from those that were left behind, he announced a relief package amounting to Rs 3750 crore : Rs 712 crore in interest to be written off, Rs 1275 crore in fresh credit, and the rest to fund irrigation, water harvesting and seed improvement. This practice of throwing money at problems is so common amongst politicians that it hardly attracts comment. They buy votes with taxpayer's money. Politicians all over the world do it; if they do it somewhat more egregiously in India, that is what Indian democracy is about. But when it is adopted by a Prime Minister who once was a renowned economist, it evokes questions about which turban he is wearing. For he cannot be unaware of the incentive effects of his actions. If some farmers are forgiven their interest liabilities, they will ask why it should not happen again. Others will ask why they do not deserve the same bounty. Many borrowers will stop paying interest, hoping that when they are asked to pay, they will make up some hard-luck story and get by. Giving fresh loans to defaulters has similar incentive effects. Having been rewarded once for defaulting, they will expect further rewards. And borrowers with an impeccable record will ask themselves why they should pay when others do not. The cost is initially borne by banks, and when they cannot bear it any more, the central government pumps taxpayer's money into them. To a soft-hearted politician, the above considerations will seem devoid of pity. How can one just stand by and watch when farmers are committing suicide? For every suicide there are a hundred farmers going through unbearable financial distress. Such crises are what politics is supposed to address. The press is a spoilt, hypercritical brat. It will criticize any meritorious act. But its attention span is short; soon something else will catch its attention, and it will forget the farmers. What is sad and surprising in this affair, is that although the Prime Minister himself once wrote theses and papers analysing economic problems, he has no interest in analyses of the problems he has to deal with. The problem is not confined to Vidarbha, but is endemic in the Deccan trap, consisting of inland Maharashtra, Andhra and Karnataka. The rainfall in this region is insufficient for rice or sugar cane. So farmers in these areas are confined to dry crops. Amongst these crops, the dry foodgrain crops lost out over the years when cheap (some would say subsidized) wheat and rice came to be sold all over the country; today, jowar, bajra and ragi are largely forgotten. When these crops became uneconomic, the farmers of the Deccan Trap turned to cotton. Cotton is subject to the triple risk of rainfall, pests and prices. Pests can be tackled, but pesticides are expensive; and more recently, expensive high-yield seeds have become available. Both require investment. It should ideally come as risk capital. But farmers cannot set up companies or raise equity. So the capital has come as fixed-interest loans. Banks have from time to time been forced to lend; but they do not like lending to cotton farmers on account of the risk; so the lending business has been largely in the hands of private money-lenders. There are laws going back to late nineteenth century against exploiting farmers. But the returns are high enough to cover the risk, so moneylending has continued to flourish. The Maharashtra government has tried to protect farmers against price fluctuations by guaranteed purchases. But it did not want a situation in which it had to buy all the cotton that was offered in years when prices were low, and get none when prices were high. So it has instituted monopoly procurement - with the result that Maharashtra farmers miss out on price booms. Its monopoly procurement scheme is extremely unpopular, not least because of delayed payments and corruption; farmers routinely smuggle cotton out of Maharashtra. Manmohan Singh may be a master of economics, but he is a prisoner of politics. He can do nothing to dismantle Maharashtra's monopoly procurement scheme. He cannot force the Maharashtra government to act against politically powerful moneylenders; an MLA from Buldana is reputed to be Vidarbha's most prominent agricultural moneylender. And the Prime Minister is too conscientious to abandon his job as long as he thinks he has a chance of doing something good for his country - or at any rate of preventing another politician from doing harm. So the only option he sees is to throw money at problems, knowing full well that money nourishes and multiplies problems.

Friday, August 04, 2006

25 big ideas in Indian economic reform

The new newspaper of Bombay, DNA, asked 25 people what's the one big thing they would in terms of economic reforms in their field. You can view the 25 responses here : page 1 and page 2. You have to click on "zoom" (the magnifying glass icon) a few times to make it readable.

Thursday, August 03, 2006

Flying blind

While futures and forwards are merely priced by arbitrage, options trading is fascinating in that it throws up new information in the form of the implied volatility, which is the market's view about future volatility. This is something which is not visible before we have options trading but is visible after options trading commences.

In addition to revealing what private agents believe, it is also an excellent free forecasting tool. By now, there is a rich literature which tells us that such market-based measures are forward looking, and are very good forecasters.

In several other situations, financial markets are shaping up as new sources of forward-looking information for the statistical system: this includes market-based measures of inflation expectations, market-based measures of the probability distribution of the decisions of the US Fed in the next two meetings, etc.

Traditionally, it is felt that the Indian license-permit raj in finance induces real costs by virtue of supressing information about the yield curve and the exchange rate. In an article in Business Standard today, I argue that our approach of financial repression induces costs which go beyond the lack of a trusted yield curve and the lack of a trusted exchange rate. The host of information sources which are based on derivatives markets are also lost when policy makers block the development of financial markets. These information sources play a marvellous role in the decision making of private agents and of public policy in mature market economies, but we don't have them in India.

I worry about the illusion of control that goes along with flying blind. In the present situation, we don't observe a market exchange rate or a market yield curve, we don't observe market-based estimates of future inflation and inflation volatility, we don't observe market-based estimates of future currency volatility, and so on. I think that in a developing country, where the economists and the econometric models are weak, the benefits from having market-based forecasts is even stronger than is the case in industrial countries. (Of course, this goes over and beyond the minor matter of not having a decent measure of inflation).

Update: Jayanth Varma has a nice post on the delicious exchange-traded binary option on the Fed Funds rate that's gaining momentum at CBOT.

Coincidentally, today's Business Standard also carried a debate between Bibek Debroy and myself on the subject of capital account convertibility.

Frictions at ports

For anyone interested in the economic benefits from globalisation, transactions costs that impede trade or invisibles or capital flows are a big issue. Brad De Long had a nice recent piece on the remarkable impact of containerisation upon the global movement of non-perishable non-fragile goods. Business Standard had a fascinating story about high port charges in India, which was followed up by an edit on the subject.

A topic which has been making waves is the security concerns that come about when a Chinese company runs an Indian port or airport. Business Standard had an interesting edit on this subject.

I have long been fascinated by the potential for using sea routes to reduce the transactions costs of shipping within India. The engineering efficiency of railways (steel-on-steel rolling friction!) matches that of shipment on the high seas, but India will likely achieve more competition in shipping than with railways, so the engineering opportunity of railways is less likely to get translated into low costs. I recently read that a significant chunk of the global sales of the giant "Panamax-size ships" is going into intra-China coastal trade.

Problems of land acquisition by the State

Land is the most distorted factor market in India. The State is deeply involved in all aspects of the functioning of the land market. Particularly in a place like Delhi, one sees acre after acre of land which has been politically allocated to cronies of the State at some point in the past. In addition, the market features high transactions taxes and acute illiquidity.

The State routinely engages in forcible land acquisition, where traditional rural populations are displaced. This land finds its way into the hands of modern developers at below-market prices, with rents flowing into the State machinery. This is obviously unfair. Ila Patnaik has an article in Indian Express where she shows an argument by Shubhashis Gangopadhyay on how this problem can be solved.

Tuesday, August 01, 2006

Dabba trading on currencies

The issue of "dabba trading" springs up from time to time in India. The way this works is roughly like this. Suppose there is a pre-existing market like NSE, NYSE, or whatever - let us call this "the main market". The dabba trading shop has screens for the main market. It then acts like a market maker which matches the bid/offer quotes seen on the main market. Customers are then able to buy/sell at these stated bid / offer quotes as seen on the main market.

The house earns the bid/offer spread on a large number of transactions, which can be quite profitable. There has been a great deal of discussion about "quote matching" by people like Bernard L. Madoff in the NYSE context; so I think that "dabba trading" isn't new to India.

What is the incentive in favour of dabba trading? In the domestic case, this involves not posting margin, not paying NSE its charges, not paying MoF the securities transaction tax, and not paying SEBI its transaction tax. To the extent that transaction taxes are bigger, the incentive for dabba trading is bigger. In the international case, dabba trading is a way to bypass either capital controls or local financial repression: the order flow that ought to have gone to a global exchange or to a local exchange ends up at the local dabba trading shop.

Dabba trading involves two-way credit risk. If a client makes a big loss, he can default, and the shop operator has to struggle to recover money. This isn't that different from an ordinary "full fledged" brokerage firm, which also faces such risk: the key difference is that the "full fledged" brokerage firm imposes bigger collateral requirements and thus faces lower credit risk.

On the reverse side, a client faces bigger credit risk because it can happen that a client has made a big profit but the shop is now bankrupt. The "full fledged" brokerage firms are a bit better capitalised, are less likely to suddenly vanish, and the client has recourse to the investor protection fund run by the exchanges.

In my opinion, some of the commodity futures trading taking place in India is much like "dabba trading" in that there really isn't much of local price discovery. This is particularly the case in the "evening session" where local orders are placed with one eye on the bid/offer quotes found on global exchanges. What is taking place is really local participants taking positions on a global price time-series. Capital controls hold back the local participants from placing orders on the global trading venue.

A recent Economic Times has a fascinating story about "dabba trading" taking place on currencies. I found it particularly interesting that they don't trade the INR/USD - since India has a de facto pegged exchange rate, there isn't much vol in the INR/USD. But the INR/GBP, INR/EUR, INR/JPY etc. are floating rates with a great deal of vol.