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Monday, September 25, 2006

Five predictions about India and China by Larry Summers

Ila Patnaik has written about five predictions made by Larry Summers in a talk about the evolution of the international financial integration of India and China:

  1. Capital account convertibility: Regardless of what policy makers in these countries want, there will be a deepening financial integration, owing to growing trade, investment and capital flows.
  2. Reserves accumulation: The increasing financial integration would not be accompanied by the current pace of foreign exchange reserves accumulation in terms of the reserves to GDP ratio. Why? At some point, the US government will not want to be massively indebted to the governments of India and China.
  3. INR and CNY appreciation:The next decade would witness an appreciation of the real exchange rates of the two countries.
  4. INR and CNY volatility: Exchange rates in India and China will be more flexible than they are today because of the difficulties of managing domestic monetary policy when exchange rates are being manipulated.
  5. Current account deficits: India and China would move from current account surpluses to structural current account deficits, reflecting the superior marginal product of capital in these countries.

At present, RBI seeks the other direction on all five counts. It fears convertibility, accumulates reserves in implementing a de facto pegged exchange rate, prevents a real appreciation, lacks a exit path towards a flexible exchange rate, and lacks a game plan for a sustainable current account deficit. So all five predictions are contrary to what RBI is trying. But Larry Summers is offering predictions, not policy recommendations. He feels that these outcomes will emerge regardless of what policy makers seek to achieve.

I see the unfolding story in the same way: these changes are inevitable. As I have written on the subject on convertibility, our choice is between handling these changes in a graceful and choreographed way, or in an inept and bumbling fashion.

Sunday, September 24, 2006

Crashing IT prices make interesting things possible; but Indian broadband prices are out of line

Crashing prices of IT systems

Everyone has heard of "Moore's Law", which asserts that CPUs double in roughly every 18 months. Similar phenomena are at work with memory, flash memory, disks, etc. I recently bought a pair of 400G USB disks for Rs.9,000 each - that's Rs.22.5 per G or $0.5 per G. I'm sure that some years from now, this blog entry will look incredibly dated, when hard disk capacity goes at Rs.2.25 per G! I vividly remember how roughly 12 years ago, when I was at CMIE, early design work for terabyte storage was being done and it looked most daunting. Now a terabyte is just 3 disks of Rs.9,000 each.

The growth of performance of a single-CPU has not kept up with Moore's law. But two things have taken place in spectacular measure. First, holding an old level of performance fixed, the cost of a CPU which achieves that level of performance has been crashing nicely. It's easy to put a decent 32-bit CPU into just about any low-price device today. The second phenomenon has been parallel computation. The name of the game now seems to be about harnessing a large number of CPUs to get your work done. For a large class of problems, that appears to be feasible.

Commercial software prices - like Oracle or Microsoft Windows - have held up remarkably well in real terms. So if one tries to configure a system today, the stable software costs loom large when compared with crashing hardware costs. But free software is creeping up into a larger and larger class of problems. It's possible to build a very powerful data centre with Linux, Apache, MySQL, and a free J2EE implementation. Such a data centre would be able to deliver transactions at mere hardware cost.

Crashing prices of IT systems make interesting things possible

Backing up your audio CDs. The `flac' file format permits lossless compression of audio CDs. So when you buy a CD, you can rip the .wav files and convert them to .flac files. As a thumb-rule, one audio CD reduces to 250 Meg or 0.25 G of .flac files. When storage costs Rs.22.5 per G, this means that for a price of Rs.8 of hard disk space, you get to keep a backup of your audio CD. When your audio CD gets scratched or broken, you would uncompress the .flac files to get back to the .wav files which can be burned into an audio CD. Imagine that.

The biggest data centre in the world, through ad revenues. A few years ago, if someone had asked me whether it was possible run a million-CPU data centre supported only by advertising, I would have said that it's not possible to run a million-CPU data centre. But today, we know that Google is extremely profitable running the most complex data centre in the world, and practically all their revenues are from advertising.

Other small data centres based on ad revenues? Turning to the territory more familiar to the readers of this blog, think of a brokerage firm. A brokerage firm is basically a data center interfacing between customer and exchange. If done right, using free software, it ought to be possible to do this data centre at hardware cost. If so, the cost per transaction of the brokerage firm ought to drop dramatically (see my earlier post on flat-price transactions in the brokerage industry). At some point, it'd become possible to have a brokerage firm which offers free transactions, supported only by advertising. It isn't obvious that it works, but it's worth trying. The first attempt at doing this has begun: link, link, link.

Free wifi in a city. When prices of IT hardware are sufficiently low, it may be possible to have free wifi in a city. I am sure that it is possible to have free wifi within a city for low bandwidth applications like email or reading the web. I don't know how the cost of infrastructure will go up if everyone is swapping videos using bit torrent. What might happen is that when city-wide networks are built, the video-related traffic will become so great that the network becomes effectively unusable, that some kind of congestion-pricing is central to making it work correctly. This might be the case; I don't know whether this is just an unhappy scenario or a likely outcome.

Easing nation-building in poor countries. I have previously written about the role of IT systems in delivering national public goods in India [link to paper]. The uniquely Indian challenge is : high volume + low transaction size. Being able to pull this off critically relies on building IT systems which deliver very low cost per transaction. A key litmus test shaping up of these questions is on the implementation of the New Pension System [link to paper].

Indian broadband prices are out of line

In this happy environment of dropping prices of hardware and software, prices of broadband in India stick out. By now, mobile telephony in India has acceptable prices by world standards. But broadband is still way out of line.

A recent blog entry says that the price of a megabit connection per month in the US has dropped to $6 (Rs.300). He quotes "Harvey's theorem": Divide your monthly bill by the speed being touted by your broadband provider" as the path to these calculations. In an Indian setting, that would be between Rs.1,000 and Rs.2,000 a month for a 512k connection from MTNL? That's between 2000-4000 INR (or $25 to $50) per megabit per month. This is between 5x to 10x costlier than in the US. I don't understand why this has to be.

China has 123 million Internet users, of which 77 million are broadband subscribers. A corresponding Indian number seems to be 25 million; broadband usage in India is as yet pitiful. I'm sure both numbers are artificially inflated - perhaps both numbers are wrong by an equal magnitude? I wonder how much of this is caused by lower Indian per capita GDP, and how much of this is caused by high prices of broadband in India.

Thursday, September 21, 2006

IMF and World Bank : Where do India's interests lie?

A lot of people have been thinking about the evolution of the IMF and the World Bank. I wrote an article Fund and Bank: Where do India's interests lie? in Business Standard yesterday offering an Indian perspective on the question.

An Indian perspective on the IMF

Many in India view the Fund as a potential source of assistance in the event of a future currency crisis, as was the case in 1981 and 1991. This thought process leads to concerns about a better relationship with the Fund in a future crisis scenario.

I think that India's globalisation has gone so far that it will not be easy to mount a 'rescue' in the event of a currency crisis. In four years time, we will be a $1 trillion GDP with much more than $1 trillion moving in and out of the country every year. The IMF lacks the resources to cope with a currency crisis for a country of this size.

More importantly, the tools are at hand for largely eliminating the risk of a currency crisis. If we embrace a policy framework comprising a floating exchange rate, convertibility, and a narrow inflation-targeting central bank, then the contest between currency speculators and central banks (for which the IMF was designed) does not arise. It is better for India to walk down this path, where there will be no need for an IMF program in the future. Once we start thinking like a mature market economy, we lose interest in issues of who controls the IMF.

An Indian perspective on the World Bank

As far as the World Bank is concerned, there is a consensus on two issues. Gross capital formation in India is slightly below $200 billion a year. In this, $1 to $3 billion from the World Bank is just not a big deal, even after the problem of India's current account surplus is firmly out of the way. More generally, the market-oriented economics that has transformed India's growth opportunities and thus poverty reduction is now sustained by a domestic process of policy reform, where the World Bank is not an actor. The core business of Indian GDP growth, leading to poverty alleviation, seems to be driven entirely by private capital and the domestic political economy that sustains liberal economic policies.

That leaves the argument about knowledge riding alongside a World Bank loan. (See notes from Singapore by Ila Patnaik).

I am a skeptic on the knowledge inputs that the World Bank is able to bring when it comes to day to day reality. When we look at a program like Sarva Shiksha Abhiyan (SSA), where the World Bank was involved, it seems to look more like a traditional Indian government program - riddled with design problems - rather than a program that has been embellished with state of the art microeconomics of information and incentives. (Bibek Debroy's recent article Scrap the SSA is of interest in this regard).

Can the World Bank help by improving monitoring and evaluation? I didn't see that happening with SSA. It was Pratham - and not the World Bank - which discovered (at a tiny cost) that the kids getting enrolled through SSA aren't learning much. The bureacratic incentives of the World Bank are probably as unfriendly to discovering bad news as are those within the GOI.

Another perspective is that of incentives. Compare private sector financing versus World Bank financing in an infrastructure setting. Suppose a expressway project is packaged by Goldman Sachs and has private sources of equity and debt. Compare this against a traditional World Bank financed expressway project. I think the private sector version is superior for two reasons. First, there is generally less leverage with greater private sector involvement, which leads to more healthy project structure. Second, the private owners have an incentive to fight on all aspects of project success, from effective execution to O&M to revenues. In contrast, a World Bank bureaucrat is more likely to lose interest in a project once it is signed. It is better for India to have private financing rather than World Bank financing.

Finally, I instinctively dislike bundling. It is hard to think rationally about either knowledge services or cost of capital when the two are bundled together. I think unbundling of finance and knowledge leads to better procurement of both. The Indian project would be better off separately procuring the best knowledge services, and then procuring the lowest cost equity and debt capital. Mixing them up hinders clear thinking.

Hence, I'm unable to see an important role for the World Bank in a country like India or China, where high growth rates have already been ignited. High GDP growth, and thus poverty reduction, now rides on the domestic political problems of economic policy in these countries.

On the other hand, there are much more daunting problems with "failed states" which could merit a focused effort on institution building through an agency like the World Bank. These are big threats to global prosperity, in this post 9/11 age. If we think of WMD scenarios like a nuclear bomb on Manhattan island or an antiobiotic resistant smallpox virus that is let loose into the world, then the failed states count as major threats to global prosperity. I know, the World Bank's mandate prohibits involvement in political issues. But there is plenty of low-intensity work to be done in building a State, that I call "nation-building", which is not inconsistent with the World Bank's charter.

All around us, India has countries in dire need of nation building: Pakistan, Afghanistan, Central Asia, Nepal, Bangladesh, Burma, Sri Lanka. It is in India's best interest if these countries are able to achieve sound institutions and ignite high GDP growth. From a selfish Indian perspective, that's a great role for the World Bank - to give us a safer neighbourhood and enormous trade growth in our immediate neighbourhood.

That leaves the problem of a funding model. At present, the World Bank needs customers like India and China to make ends meet. If the Bank reorients itself to focus on nation building, it needs new sources of financing. In resolving this problem, I think it helps to see that nation-building in Afghanistan or Sudan is about producing global public goods. Everyone benefits when these countries are set on track. Placing the brunt of financing of these global public goods upon India and China does not sound like a fair arrangement. A reasonable solution could be to pass the hat around to the 25 biggest countries of the world, and ask for contributions in proportion to GDP.

Wednesday, September 20, 2006

Three articles in Futures Industry magazine on derivatives in India

Michael Gorham has written three articles in Futures Industry magazine about the Indian derivatives business: in June/July 2000, in May/June 2005 and now a piece titled Incredible India - Formidable Futures in the September/October 2006 issue. Mike first came to India to help in the launch of the equity derivatives market in roughly 1996, and has keenly followed the field in the following decade. These three articles add up to excellent knowledge for anyone interested in derivatives in India.

While I am on this subject, I should also point to the full text of the book Derivatives Markets in India edited by Susan Thomas, Invest India Tata McGraw Hill, 2003, which is now available for download.

Monday, September 18, 2006

Dancing with Giants: China, India and the Global Economy

The World Bank has produced a draft volume Dancing with Giants: China, India and the global economy, edited by L. Alan Winters and Shahid Yusuf. Six areas are covered: global industrial geography, competing with giants, international financial integration, energy and emissions, regional variations in growth within the giants, and governance.

Groundwork towards this was done in the form of 21 background papers. Drafts of the book, and the 21 background papers, have been placed on the web. It is good work.

Saturday, September 16, 2006

A government that gifts television sets to households?

What should the State do? The ideal State is one that obtains revenue from an efficient consumption tax (e.g. VAT or an income tax with correct treatment of income on capital) and then spends it to produce public goods. Public goods are areas like police, judiciary, defence and financial regulation: non-rival and non-excludable (link, link). The preferences of the population should determine how much taxes are collected and to determine what public goods are produced. Efficient production technologies should be used to produce public goods.

Okay, we don't live in that world. We have a State that obtains a certain tax/GDP ratio, and the bulk of this isn't spent on public goods, it goes into subsidy programs. In that case, what would you hope for? The inefficient thing for the State to do is to try to run programs like PDS or NREG where a little money reaches the population and the bulk of it gets captured by the political system. A clever thing to do would be to have a negative income tax program.

Making a negative income tax work is very hard. If one had to be simple & stupid, an efficient thing to do would be to have a helicopter drop of money where each citizen gets a fixed payment. I am thinking of a very simple, administratively feasible scheme: a direct transfer from the Department of Expenditure into a bank account for every citizen of the country. That would achieve efficient redistribution with minimum frictions. Many middle income countries have built `conditional cash transfer' (CCT) programs accompanied by `electronic benefit delivery' (EBT) with considerable success. They work much better than PDS or NREG. But at present in India, the administrative capacity for doing either CCT or EBT does not exist (though it can be built in a few years if there is an interest in doing this).

Let's spin some numbers. Suppose you wanted to blindly deliver Rs.1000 per person per year. For a family of five, this is a transfer of Rs.5,000 per year or Rs.400 per month. (As an aside, the "poverty line" in year 2000 was a monthly consumption of Rs.211 per person (rural) or Rs.454 per person (urban), so a transfer of Rs.400/person today is quite a lot.). For a billion people, this is an expense of Rs.1 trillion or 3% of 2006 GDP. If the State would restrict itself to this one redistributive program - and do nothing else by way of distorting the economy - I would warmly applaud. This one program would achieve the task of redistribution, and the rest of economic policy can simply focus on growth.

Now suppose you didn't have the infrastructure for delivering Rs.5,000 per year into the household. How else would you do it?

You could gift a television set to every household. If a TV costs Rs.20,000, a gift of a TV set to a household is roughly the same as four year's worth of payments per household. The administrative challenge is that of ensuring that every household gets exactly one TV.

A TV set is something that is visible and monitorable. Every household can verify that it gets one TV set and that everyone around them gets exactly one TV set. Once the TV set has been obtained, everyone would turn around and sell off the TV set into the secondary market and turn it into cash. So it's fair to think of a TV-set-gifting program as being a way of implementing a helicopter drop of cash in a way that supports transparency, monitoring and enforcement.

Viewed in this perspective, what Karunanidhi is doing with TV sets is not that off the mark, even though it has been widely ridiculed and surely links up to their business interests in television states. But if you are cynical enough to believe the State can just not be persuaded to produce public goods, then this is a decent way of returning taxes back to the populace in a broad-based redistributive way. It is easier for voters to verify that television sets are given to all households -- as opposed to complicated welfare programs where goodies are delivered to favoured subsets of the population in non-transparent ways. Gifting TVs to all is better than most welfare programs that we know today, where the bulk of money gets captured by a few households in the political system.

If this issue interests you, T. Ninan had also done an editorial in Business Standard a while ago.

Friday, September 15, 2006

Evolution in China of financial architecture, capital controls, and monetary policy

I noticed two aspects of what is going on in China which struck me as being quite different from what is going on in India. Financial Times has a story filed from Beijing titled Financial watchdog considered for China where he says:

China is debating the establishment of a new "super regulator" for its finance and banking industries to improve co-ordination in a sector in which reform has been increasingly hamstrung by infighting and inertia.

The establishment of an institution is likely to be on the agenda of a closed-door meeting later this year of senior leaders and finance industry officials, according to government advisers and scholars.


The so-called Finance Work Committee meeting, to be chaired by Wen Jiabao, the prime minister, has only been held twice before and both times has been followed by major policy changes.


Topics under discussion ahead of the meeting include the introduction of a form of monetary or inflation targeting, instead of the present emphasis on tracking money supply as a benchmark for the macroeconomy.


With the major decisions largely behind the government on the reform of the state banks, a key focus for reform remains the capital markets, where development has badly lagged growth in the real economy.

Elements of the capital markets and brokerages are governed by separate banking, insurance and securities regulators, as well the People's Bank of China, the central bank. Local governments also have significant shareholdings in brokerages, making them difficult to sell off.

This sounds like a discussion about financial architecture of the type one has not yet seen in a meaningful way in India. In India, we have all sorts of problems with financial architecture, but in the period after the half-creation of PFRDA in 2002/2003, no progress has been made on resolving problems. The debate on regulation of commodity futures is an example of a failure (so far) in doing the right thing.

The second piece I noticed was a story about a Chinese attempt at doing a "trial" of greater convertibility in one geographically restricted area. This is in keeping with many other Chinese "experiments" with reform which have been first initiated in a small way in a part of the country.

This is also much ahead of the Indian convertibility discussion. My sense is that barring the Indian FII framework, which is superior to the Chinese QFII framework, the Chinese have greater de facto convertibility than what is in place in India. To say this differently, when the INR offered a one-way bet, the size of buying by RBI on the market was smaller than what China has had to do in a similar situation.

Is this a reflection of a greater commitment to liberal economics in China? Or is this a mere set of press releases which are well timed given the Singapore meetings? China is very non-transparent, and no outsider really knows.

Wednesday, September 13, 2006

Keeping our word

Business Standard has some remarkably good writers who seem to want to not reveal their identity. The two names that come to mind are "V V" and "A P". I have guesses based on expanding initials, and I once asked Ninan who they were and he said he was honour bound to not tell. :-)

"A P" seems to be a person who has a remarkable grip of the new world of international finance. He is not a mere data analyser; he operates in that world. But unlike many practitioners, he has top quality knowledge of modern analytical financial economics. When I read his stuff, I don't worry about him making the elementary mistakes about how markets work which one sees so often with people in realworld finance. I take his writings in BS very seriously.

Today "A P" has an article titled Keeping your word where he worries about situations where the Indian State appears to be reneging on prior commitments. The three examples he has are:

First of all, the government's refusal to sell the remaining stake in Balco, which, if my facts are correct, it was bound to do. Second is the refusal by the Reserve bank of India to recognise the CECA treaty, under which the GIC and Temasek are explicitly guaranteed treatment as separate and distinct organisations. Third is the decision by the IT department to challenge a ruling given by the AAR in the case of Morgan Stanley and all for BPOs in general.

He says that the one thing India has going for it, when compared with China, is rule of law. This must be protected, and we need to keep our word. GOI needs to either keep its word, or rapidly come out with clarifications in public which are sufficiently persuasive in the eyes of a sophisticated observer like "A P".

Tuesday, September 12, 2006

Public policy research in India

In a country like the US or the UK, there is a lively `marketplace of ideas' in public policy, where alternative visions about the State are debated. On 30 August 2006, Guy de Jonquières wrote a piece in FT titled Asia needs a more active market in ideas where he says:

One of the most surprising discoveries on moving to Asia is how little intellectual curiosity there is in the region about the dynamics of its dizzying rise and where it is leading. In spite of Asia’s growing global weight, much of the most illuminating research into its affairs, whether economics, business, social policy or international relations, still originates elsewhere, mainly in the west.

Asia has no shortage of brainpower, or of self-styled think-tanks. But most produce pedestrian work that often fails to grapple with – still less answer – the hard questions. Many simply churn out official propaganda, and few look far beyond their own backyard. In the words of Jean-Pierre Lehmann, a Swiss business school professor who knows Asia well, there is a lot of tank, but not much think.

Many western think-tanks, of course, are also little more than mouthpieces for their financial backers. But the best ones dig for facts, sift them rigorously, question established policies and seek to chart new directions. Occasionally, like those that shaped the thinking of Britain’s Baroness Thatcher, they can seed a revolution.

Asia has no such marketplace for ideas. Stunning though China’s growth is, it is impressive as a daring feat of execution, not because it is based on startlingly original development thinking. When “Asian values” were hawked around the region a decade or so ago as some kind of distinctive philosophy, they turned out to be just a self-serving attempt to justify autocracies.

Novel ideas, by contrast, are stimulated by intellectual contention and reasoned dissent. It is no accident that they tend to flow freely in countries such as the US and Britain that not only tolerate but encourage those activities as socially beneficial. In Asia, only India, home to some notably independent-minded research institutes, has a comparable tradition.

In continuation of this discussion, Suman Bery has a column in Business Standard today about policy research in India.

In my experience, once we get to a narrow and specialised subject, there are very few experts in the country. This hurts because there is reduced discussion and competition. The flow of good quality papers is very thin, and there are very few good conferences. As any journal editor and any conference organiser knows, it is hard to find interesting papers, and once you have them, it's hard to find good discussants or referees.

A few people in Western universities are writing empirical papers with Indian data which are appearing in Western journals, but there are two recurring problems: I have often seen a lack of common sense on data, and the choice of questions and research strategy is driven by the needs of publication rather than a sense of the important questions and issues in India.

I find it remarkable that the Indian State expends thousands of crore on research into fields like nuclear energy, where the payoff for India has been remarkably slim, while not putting resources behind public policy research on the main tasks of the State - issues such as judiciary, law & order, international relations, defence, elections, and economic policy. On one hand, this has improved independence and criticism of entrenced policies and powerful government agencies. On the other hand, there is a secular lack of resources which is generating an inadequate number of manyears of time on the questions of the age.

If "government" and "think tank / university" are two pieces in the map of ideas, a key institution which India has been utilising is "the expert committee". A. K. Bhattacharya has an article on this institution in today's BS. There are some intruiging differences between India and other countries in the "committee" institution. As an example, today in the New York Times, there is news about a committee which seems to have been setup, suo moto, by a bunch of people and not appointed by the government. Friends who live outside the country have suggested such things to me in the past - that on a certain problem, a top quality bunch of 5 people can set themselves up to write a report and they do get accepted in the policy making mechanisms of the US or UK, despite no role of the government in appointing the committee.

Update (2006-12-19): Ajay Shukla has an excellent article on the weaknesses of think tanks, in Business Standard.

Entry barriers in banking reflected in UWB episode

The typical bank has Rs.5 in equity capital and Rs.100 of assets. If things go wrong, losses exceed Rs.5 and the bank is bankrupt. Generally, when a bank goes bad, the managers are in a scramble searching for cash for the months prior to failure. So from the viewpoint of a buyer, a bankrupt bank is a troublesome entity to get into in terms of ownership. It likely has weak processes; the staff is demoralised; there is possibly corruption; the recovery value of the bad loans is hard to ascertain.

When UWB went bust in India recently, there has been a surprising phenomenon of a raft of buyers lining up to grab control! This is entirely unexpected. A Business Standard editorial correctly says that this remarkable phenomenon is caused by entry barriers in banking. It is hard to start a bank. It is hard to get permission to start a branch of a bank. So under these conditions, what does the rational entrepreneur do? Buy a dead bank, for the license value.

Resilience of liquidity of the Indian equity and bond markets

One key aspect of market liquidity is the resilience of liquidity. This is not a word that has been sharply defined in the literature; it has a few dimensions. One aspect is the time in which a limit order book restores to having the low impact cost prior to the placement of a large trade. If one could measure this in an experimental setting for a given security, suppose a large order is placed at t=0. Measuring resilience is about obtaining a graph with transaction size on the x axis and the time taken for impact cost to "substantially" revert to conditions that were prevalent at t=0.

Another dimension of liquidity is the ability of market liquidity to handle bad news or negative returns. I don't really understand why, but it often seems that market liquidity is diminished after negative news. One part of this is just a measurement issue : dollar turnover is higher after prices have gone up and lower after prices have gone down. But even if one is using measures of liquidity which are not affected by this problem, the hallmark of a successful financial market is resilience in the sense of being able to handle sharp movements, particularly sharp negative movements, and continue to deliver a continual supply of liquidity. Participants face greater liquidity when this is not the case.

Susan Thomas has an EPW article on the resilience of liquidity on the Indian equity and debt markets. The main finding is that the equity market has considerable resilience while the debt market does not. I think this is related to RBI's belief that the bond market should have no speculators compared with SEBI's belief that speculators are a legitimate part of the equity market.

Sunday, September 10, 2006

Fiscal consolidation now?

As the academic literature has long pointed out, India has a serious problem with a growing debt/GDP ratio. The decline in interest rates in the last six years has masked the problem, but the situation remains difficult.

For a while, it looked like India was winning on a dramatic fiscal turnaround. The Fiscal Responsibility and Budgetary Management (FRBM) FRBM Act was a nice piece of work and some of the numbers have improved well.

Are the FRBM targets adequate for solving India's fiscal problem?

The rough targets appear to be shaping up as a 3% deficit for the centre and a 3% deficit for the states (link). One problem is that these numbers are not enshrined in the law itself and can easily be changed by a future government. In addition, the Act has defined no penalties which come into play when the targets are breached.

And, from an international perspective, a 6% deficit would still be one of the biggest in the world! A few comparisons from the IMF World Economic Outlook (WEO):

Advanced economies Other emerging markets and developing countries India
Central government fiscal balance -2.4 -0.9 -4.2
General government fiscal balance -3.1

This suggests that our central government fiscal deficit, of -4.2%, is big when compared with advanced countries (who are at -2.4%) and even bigger when compared with our peer group (who are at -0.9%). The WEO does not have comparable data for all three cases, but for industrial countries, they show that the general government balance, at -3.1%, is only slightly worse than the central government balance. We in India seem to think that it's okay to do much worse.

So I think of hitting the FRBM targets as a bare minimum modicum of fiscal responsibility. It is possible to paint plausible scenarios under which the Debt/GDP ratio is not stabilised even if the FRBM targets are adhered to: it is not a sufficient condition.

The importance of tax buoyancy

The FRBM Act was followed up by a careful game plan called the "FRBM Task Force report" for achieving the targets. The politically easiest strategy for achieving FRBM targets is based on high tax buoyancy. When nominal GDP grows by 10%, tax revenues should grow by 15% to 20% -- i.e. tax buoyancies of 1.5 to 2. In this case, the sheer growth of India leads to a closing of the gap. Roughly speaking, this was the game plan of the Kelkar FRBM Task Force report:

  1. Tax reforms which change buoyancy but don't immediately pinch the pocket of the tax payer are most politically feasible;
  2. So reform tax policy and tax administration so as to get up to high buoyancy;
  3. Don't do new damage in terms of spending money;
  4. and let GDP growth take care of the rest.

At first, things seemed to be working. Tax administration (particularly income tax) has been pumping out high growth rates of tax revenues. From 2001-02 to 2004-05, the investment rate went up from 23% to 30% - a huge gain of seven percent! Of this seven percentage point swing, 4 percentage points occured because of an improvement in the fiscal situation (link).

Now the situation is looking more difficult. Tax revenues might not do as well as hoped owing to the Special Economic Zones (SEZs). Expenditures might be higher than expected owing to welfare programs like the National Rural Employment Guarantee (NREG) program, and the 6th pay commission. The most remarkable recent development on India's journey to the FRBM targets is that Montek Ahluwalia thinks the targets should be breached.

The SEZ problem

The rationale for SEZs is supposed to be that there are huge infrastructure and institutional problems with India, so in order to win on exports growth, the way out is to create enclaves with good infrastructure (particularly urban infrastructure) and generous tax treatment. The government seems to be ready with generous tax concessions, but no relaxations to labour law are proposed.

Does it make sense to undertake distortionary policies which artificially prop up exports, e.g. by tools such as export subsidies, tax breaks, or manipulation of exchange rates? Economic growth is accentuated by openness, not by faking exports. (See two articles by Ila Patnaik [link, link], and this recent piece by Adam S. Posen). So I am not enthusiastic about doing SEZs "in order to boost exports". We need a sound, well-run country, which will (by the way) import a lot and export a lot.

What about the fiscal implications? The generous tax treatment of SEZs constitutes a threat to the high tax buoyancies that we have been seeing. If a lot of SEZs come up, and if they succeed, we could see two possibilities. On one hand, existing output could relocate from the taxed zone to the untaxed zone. This would be very bad news. Or, a more mild scenario, a lot of incremental output could take place in SEZs. This sounds nicer from a fiscal perspective, but it isn't. In this case, we will see a decline in the tax buoyancy. I have crunched the data, and it is not clear to me how FRBM targets will be met if tax buoyancies drop below 1.25. Or if I may say this differently, if tax buoyancies drop below 1.25, then a new level of political pain will be required, in cutting discretionary expenditures, in order to get back to FRBM targets.

A short while ago, Ila Patnaik had an article worrying about the tax exemptions for SEZs and other fiscal largesse.

Welfare programs

A daunting feature of a program like the NREG -- which guarantees some mandays of employment for every household at the choice of the household -- is that it is hard to budget for how big the outlays will be. Some preliminary budget numbers look weak, and I don't know whether the NREG is yet playing a role there. Business Standard had a good editorial on the unfolding difficulties showing up in fiscal data, despite remarkable tax buoyancy. The NREG is not alone; the UPA has had a penchant for big expenditure programs. And, there remains the risk that the UPA will implement the Arjun Sengupta proposals for a giant welfare program for employees of the unorganised sector (link).

The 6th Pay Commission, and the New Pension Scheme (NPS)

Then there is the 6th Pay Commission. The HR framework for the civil service is awful, and there is a crying need for change. It is not, as yet, clear that the 6th Pay Commission will be constituted in a way that will make progress on these problems. If one extrapolates from the experience of the 5th Pay Commission, the 6th Pay Commission could induce acute fiscal stress from 2009 onwards. Subir Gokarn has a good article on this issue.

A short while ago, Ila Patnaik pointed out in an article titled First payoff to structural pension reform that with the 6th Pay Commission, we are seeing the first payoff to the long-term structural reform that the New Pension Scheme (NPS) represents. The `grandfathering' approach to phasing in the NPS means that for one generation, the government is paying contributions to recent recruits while paying pensions to old ones. But from 2004 onwards, new recruits who are in the NPS have a pension which is decoupled from pay commissions. That changes the way we think about pay commissions. In an NPS world, the employer-employee relationship reduces to a decision about the contribution rate into the NPS.

Planning Commission vs. FRBM Act

I have previously written about the approach paper for the 11th plan, emphasising the good things that it says about reforming the mechanisms for production of public goods. In my earlier scanning of this document, I did not pay enough attention to the fiscal aspects.

Financial Express recently reproduced extracts of a letter from P. Chidambaram to Montek Ahluwalia on fiscal issues. (See story). For what it's worth, Arjun Singh agrees with Montek, which suggests that old Congress may be pushing for violating the FRBM. A piece with a response from Montek Ahluwalia underlines the gap between what is sought and the FRBM.

Just in case we lost sight of the Things That Matter, Dr. S. Narayan reminds us that what we really need to be doing is closing down the Planning Commission. There ought to be no contest between an Act of Parliament and a non-constitutional body like the Planning Commission. Nirvikar Singh has an article in Financial Express on a related theme.

Montek Ahluwalia carries a lot of credibility, and his willingness to take the FRBM Act lightly opens the floodgates for a lot of people who have always wanted less fiscal discipline. Ila Patnaik wrote two pieces on the importance of fiscal discipline (link, link). I recently wrote in a debate in Business Standard on it. The Martin Feldstein lecture that I refer to is here.

Putting the pieces together

How do we put these pieces together? Ila Patnaik evaluates the pros and cons of violating the FRBM (also see this review of two years of the UPA). Paromita Shastri has an article in Outlook on the "hole in the bucket" perspective. In the Business Standard of 22 July, T. Ninan has an excellent article worrying about the fiscal outlook.

I feel we should be cognisant of the 2009 dimension. A host of difficulties will come together by 2009: the next elections, the FRBM targets, the fiscal impact of the 6th pay commission, UPA welfare programs at full steam, and a possible global downturn. Fiscal stress could spill over into bad economics and bad politics in unpleasant ways.

Given India's unique demographic situation, the most wonderful thing would have been if the revenue deficit vanished by 2008-09, and stayed that way, and the fiscal deficit was capped at 3%. This is not the best fiscal rule - as I argue above, this is probably not a deficit level which will stabilise debt/GDP - but it's a minimum first step. This would free up savings for investment at the perfect time for India to be able to generate astonishing growth (see article by Ronald Lee and Andrew Mason on the demographic dividend). If the FRBM Act is violated by the UPA, it will be do long-term damage to India's development project, by contaminating growth in what could be the most important 10-15 years of India's history.

The first sound attempt at doing a good university in India

I have written several times about higher education: December 2005, May 2006, June 2006, August 2006.

On one hand, it is possible to bemoan the things that government does wrong on higher education. But it is perhaps more important to make progress on building good universities - regardless of the constraints. In my opinion, the most important effort at starting a serious university in India is the Indian School of Business. ISB is the first incentive compatible campus on India, where the faculty members get appropriate incentives and resources to perform.

I have heard from some employers that ISB MBAs are superior to IIM MBAs (which is not surprising given their pre-MBA work experience, and the quality of the faculty). The ISB experiment is far from complete. It is only a good MBA program so far. It is not yet clear that it will take root as a genuine research university, going well beyond an MBA to play a role in the intellectual life of the nation. But in a bleak situation with dismal public sector universities, and a State that won't solve long-standing policy mistakes, ISB is the most important experiment in what could happen with universities in India.

In my view, the biggest weakness about ISB is the location. There is no reason for most people to visit Hyderabad :-). In the US, the argument is made that good universities are found in obscure places, so location does not matter that much. But the institutional setting where we are is more like US higher education in 1858 (when MIT was started). At that time, in order to attract the best faculty, the university had to be on the East Coast - that was no time to setup a university in an obscure location like Chicago - the founding date for the University of Chicago was only 1890 or 30 years later.

In similar fashion, I feel that in the India of today, Bombay, Delhi and Bangalore are the natural locations for universities in India, in order to attract the best faculty members and in order to have a meaningful engagement with India.

Wednesday, September 06, 2006

What comes next in the global business cycle

In recent weeks, disturbing news has been emanating out of the US in terms of difficulties on the housing market. In today's Business Standard I try to describe what is going on, and speculate about implications for India.

Coincidentally, today's BS also has me offering one side of a debate on fiscal consolidation with T. C. A. Srinivasa Raghavan on the other side (link to full debate on BS website).

Friday, September 01, 2006

CAC-2 report has been released

I think Jamal Mecklai embarassed RBI :-). The elusive report of the Tarapore-2 committee has been released (you might find my blog entry on the creation of this committee to be of some interest). I haven't read it yet, but a first skim shows some oddities -- their idea of liberalising the capital account involves banning participatory notes, and they don't get the impossible trinity of open economy macroeconomics. Tarapore-II has two dissent notes, by Surjit Bhalla and A. V. Rajwade. RBI has chosen to not implement anything right away (i.e. between July 31 and 1 September), but has setup one more internal group to work on the subject.

Excellent commentary on the report, and on the larger issues of moving towards "fuller capital account convertibility" has come out in the press.

Watching RBI and the removal of capital controls, I'm reminded of SEBI and the onset of equity derivatives trading:

14 December 1995 NSE asked SEBI for permission to trade index futures.
18 November 1996 SEBI setup L. C. Gupta Committee to draft a policy framework for index futures.
11 May 1998 L. C. Gupta Committee submitted report.
24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian index.
25 May 2000 SEBI gave permission to NSE and BSE to do index futures trading.
9 June 2000 Trading of BSE Sensex futures commenced at BSE.
12 June 2000 Trading of Nifty futures commenced at NSE.
25 September 2000 Nifty futures trading commenced at SGX.