Comparing Indian and Chinese progress on financial sector reforms

There is a broad consensus that India has done better than China at setting up the financial system. Indian banks are less bankrupt; the Indian equity market works better; the financial sector acts as more of a check in India in choosing which firms obtain access to capital, rewarding performance and good corporate governance. While these statements are broadly on track, in recent years, the Chinese have actually made remarkable and far-reaching progress, much more than they are generally given credit for. The Chinese have gone ahead and done things that are considered heresy in India, particularly in the eyes of the communists. In recent weeks Mythili Bhusnurmath and Ila Patnaik have written a pair of excellent articles on this theme.

One feature which plays in China's favour is the liberalisation of finance that was agreed to when China was admitted into the WTO. Even though a five-year window of time governs the full implications, the promises which have been made surely guide and influence public policy which must plan a trajectory which is compatible with the dates and commitments. In India's case, there is no comparable hard budget constraint influencing liberalisation.

Another central bank gets a nose bloodied

All of us remember the famous speech at IGIDR by Y V Reddy on 12 January 2005 where he expressed interest in more capital controls [link to speech, the next day's front page comment by Ila Patnaik]. In India's case, this yearning ended at the speech stage.

A natural experiment in the introduction of such restrictions took place in Thailand last week. A Chilean-style unremunerative reserve requirement [link] was announced by Thailand's central bank on Monday (18th). The government backed away from this on 19th (Tuesday), after stock prices crashed by 15% [link, link].

I wrote an article Adventures of the Baht in Business Standard on this drama, after their announcement of the reserve requirement but before they backed away from it.

I think that the first best world is one with no capital controls. The second best world is one with no capital controls and this unremunerative reserve requirement; it is better than the intricate system of quantitative restrictions (QRs) which we have as a system of capital controls in India. The Thais may have made mistakes in exactly how they went about trying to do it. The bottom line in this episode is one more central bank with a bloodied nose.

Three interesting opinion pieces on finance & monetary economics

Mythili Bhusnurmath complains about RBI surprising the market; a Business Standard editorial on hedge funds; and another responding to recent SEBI proposals. Coincidentally, a great Foreign Affairs article on hedge funds just appeared by Sebastian Mallaby, and he wrote up a small version of this for Washington Post. And, Lars Nyberg, the deputy governer of the Swedish central bank, has a nice speech on hedge funds. I get really impressed by the speechwriters found in OECD countries.

Bureacrats as bankers: European view

In Financial Times, I saw an article by Wolfgang Munchau titled Get the state out of Europe's banking sector where he says:

When I recently asked a well-known Swedish economist about the lessons of Sweden's economic success for the rest of Europe, he answered: `Don't copy our social model. Have a financial crisis instead.' He was referring to the early 1990s, when Sweden experienced severe financial turmoil that precipitated deep structural changes in the banking industry and the economy at large.

...

My own priority for France and Germany would be ... the banking system. Follow the money. A Schumpeterian Swedish-style financial crisis might do the job but it is not going to happen. Back in the real world, reform is the best alternative.

Of course, the problems are not identical across European countries. In both France and Germany, the banking market is dominated by non-private financial institutions. The problem is perhaps most acute in Germany, where in 2005 commercial banks accounted for a mere 26.5 per cent of the assets of the entire banking system, a figure hardly changed since 1990. The biggest force in the German banking system is the public sector and co-operative banks. The result is a pathological co-existence between the public and private sectors, under which the private sector has been driven out of large parts of the retail market.

There are instructive parallels with Italy. A comparative study of the two systems by academics from the Bank of Italy, the Bundesbank and various European universities found that Italy is in some respects a role model. In 1990, Italy had a similar bank structure to Germany's. Between 1990 and 2005, the asset share of the public sector banks declined from 70 per cent to about 9 per cent. The research found that technological progress was the main cause of the increase in total factor productivity in both countries but in Italy, privatisation also contributed to the rise in TFP.

Why has Italy reformed, while Germany has not? The Italians realised they needed a modern banking sector in time for monetary union in the late 1990s. The Germans, by contrast, actually believed in their multi-pillar system. It served them well, especially in the period of postwar reconstruction. Attitudes are changing but only slowly. As a senior German official noted, the prevailing attitude today is more defensive: if it ain't broke, don't fix it.

Last week, the Bundesbank co-sponsored a conference on the future of public sector banking in Germany. The remarkable fact about this event is that it could not have taken place 10 years ago.

Academic research has consistently shown a negative relationship between the prevalence of public sector banking and a country's growth rate. This has been known for some time. Ross Levine, professor of finance at Brown University, argued that public sector banks are even unsuited to serving the goals they were originally set up to pursue: poverty reduction; financial development assistance; giving people access to capital they would otherwise not get; and overcoming the lack of credit history for small companies. The conclusion from the academic literature is that state-owned banks are mostly political banks that serve sectarian interests within society, but not society at large. To put it another way: they are tools of corruption.

A study of state-owned banks in India, for example, has shown that their credit volume is 5-10 per cent higher in an election year. A similar study in Japan concluded that prefectures represented by influential members of the governing Liberal Democratic party received more public-bank loans. The situation is not fundamentally different in Europe. In Germany, the public sector banking system was often used by politicians at all levels of the federal system to prop up companies that would otherwise not exist in a purely competitive environment. While bail-outs are politically popular, their long-term economic effect is negative. They impede structural change. If Germany had a purely commercial banking system, I would not be surprised if the share of manufacturing in the economy were smaller than it is today. The public-sector banking system is geared heavily towards the manufacturing sector.

So what are the chances of reform? A few years ago, after the collapse of the dotcom bubble, it looked for a while as though Germany might suffer a Swedish-style financial shock. But profit margins have since recovered. My prediction is that the combined force of European competition policy and further European financial integration will eventually lead to the long-overdue modernisation of the banking sector across the eurozone. It should be a priority for economic reformers to prepare the ground for change.

The research paper that he talks about is Productivity Change, Consolidation and Privatization in Italian and German Banking Markets, de Vincenzo et al, conference paper, November 2006.

When it comes to the question of public ownership of banks, the international consensus is that this is a bad idea. Giving elected representatives the power to meddle with loan decisions is a distraction from the core business of a State that focuses on public goods. In the best of times, running an opaque and highly leveraged financial firm is hard; things aren't helped by bureacrats being managers. Finance is about subtle forward-looking judgments about alternative firms: the rigid processes of the public sector aren't conducive to risk taking and jugdment. It is hard for banking regulation to have technical soundness when regulated entities are owned by the government.

The Indian discourse on this question is split between two camps. On one hand, there is the Left which thinks nationalisation of many things is a good idea. On the other hand, there are the folk who see that bank nationalisation was a big blunder, but just don't see how the politics will support privatisation.

Financial regulation of a third world country

In the best of times, financial regulation is hard. A lot of the time, in India, we get the financial regulation of a third world country. Business Standard has an editorial linking up three recent developments:

1. FMC banning advisory services by securities firms on the commodity futures markets,
2. New guidelines from RBI on derivatives and
3. SEBI granting BSE a monopoly corporate bond reporting platform.

The editorial says:

In recent days, three distinct announcements have come out, highlighting the low quality of financial sector policy in India. The first element was an announcement from the RBI about financial derivatives. For many years, the RBI has had profound flaws in the treatment of financial derivatives. Unfortunately, the new guidelines make no progress; they are old wine in an old bottle. Derivatives are the foundation of the new approach to risk in a mature market economy. Liquid and efficient derivatives markets change the functioning of every firm in the country, both through direct participation and indirectly through superior financing. Banks are key players in hedging, speculation and arbitrage, which enable the derivatives markets to function. This requires commensurate knowledge in the regulation and supervision of banks. The new RBI guidelines do not put India on the trajectory of becoming a mature market economy.

The second element was an announcement from the Securities and Exchange Board of India (Sebi) about a `corporate bond reporting platform', where a monopoly has been granted to the Bombay Stock Exchange (BSE). This is wrong at two levels. First, the hallmark of a mature market economy is competition, not monopoly. And, if Sebi felt that the right solution was a monopoly, the award of a concession requires a commensurate procurement procedure. Alternatives to the BSE need to be judged transparently based on technical and financial bids.

The third element was an announcement from the Forward Markets Commission (FMC), banning securities firms from offering clients portfolio advisory, portfolio management and other services in the commodity derivative markets. This move is in the wrong direction because the direction for progress consists of building up greater knowledge, greater sophistication and a bigger mass of capital which is able to trade in the commodity futures market and induce market efficiency. In every country, commodity trading has started out as the exclusive preserve of a small group of merchants. The transition to a mature market economy comes about by breaking the stranglehold of this small group of merchants, by broadening participation, by bringing in analytical thinking backed by capital. The FMC is doubtless responding to complaints from traditional merchant communities who find the modern development of commodity futures markets to be a threat. But the FMC has done wrong by giving in to these demands. The FMC announcement is, of course, completely futile because nobody can come in the way of an advisory relationship between person X and person Y. That advice will continue to be given. The only thing that will change is the mechanism through which the advice will be paid for. The FMC has only achieved a greater level of mis-representation in the accounts of both the buyer and the seller of advice. The FMC has lapsed into 1970s-style economic policy, where a ban drives a legitimate activity underground.

In certain aspects of the reforms process, the ruling United Progressive Alliance faces constraints owing to its inability to be tough with the Left parties. Such reasons explain the failure of the UPA government to pass the pension reform Bill. But no such reasons hold back the government when it comes to solving key bottlenecks in the financial sector. These policies of the RBI, Sebi and the FMC are not designed to help India move into the world of developed markets.

At present in India, too much power has been placed in the hands of these agencies without adequate mechanisms for transparency and accountability. When these agencies go wrong in this fashion (or in other ways), the system does not have an adequate homeostatic response.

What to do with $170 billion of reserves

Jaimini Bhagwati has a great article in today's Business Standard about the poor returns on India's foreign exchange reserves portfolio. In it, he says:

According to the Reserve Bank of India?s Annual Report for 2005-06, the nominal rupee (INR) denominated rates of return on India's foreign currency assets (FCA) for 2005-06 and 2004-05 were 3.9% and 3.1%, respectively. Foreign currency assets include foreign exchange reserves less gold holdings, special drawing rights and India's reserve position in the IMF. Inflation in India in the last one year has been about 5%. Therefore, the real rate of return on India's FCA for 2005-06 was around minus 1.1% (3.9-5).

The Reserve Bank of India (RBI) is currently responsible for managing the country's foreign exchange (FX) reserves. Since central banks hold gold as a last measure of protection against a balance of payments crisis, the discussion in this article is confined to FCA management. The real INR rate of return on India's FCA has been negligible to negative in the last two years. These low returns on India's FCA could be attributed to the RBI's cautious policies in which the guiding principles are to maintain mark-to-market value and liquidity by taking minimal credit and market risk. Effectively, the rate of return is a secondary concern and the RBI's options are accordingly limited to investing in short-dated triple-A rated government debt securities.

How should we measure the performance of the Indian FCA portfolio? For instance, should the numeraire currency be the dollar or INR? The currency in which the rate of return is measured should not matter in economic terms. It is the currency composition of the benchmark portfolio, against which the FCA portfolio's performance is measured, which needs to be calibrated carefully. Given the potential for disorderly US$ depreciation the benchmark portfolio may need to be tweaked frequently to take into account the exposure of the Indian current account to exchange rate risk.

A traditional yardstick to assess the sustainability of a sovereign's external borrowings is to compare the average cost of such borrowings with the GDP growth rate. By extension, India's FCA earnings should be comparable with the GDP growth rate. In the last one year, real growth has been 8% plus, making the GDP growth rate 9% [8 - (-1.1)] more than FCA earnings. Another construct, suggested by Dani Rodrik, is to compare FCA earnings with the cost of short-term external commercial borrowings (ECBs). At the margin, Indian FCA earnings would be about the same as the yield on 3-month US Treasury bills, currently about three-month LIBOR - 0.40%. The average cost of short-term ECBs for Indian firms is about 3-month LIBOR + 2.5%. That is, the opportunity cost of holding "excess" FCA would be at least about 3%.

Of the Asian countries which have accumulated significant volumes of FX reserves, Singapore has allocated the responsibility of managing reserves to maintain the stability of the Singapore dollar to the Monetary Authority of Singapore (MAS) and excess reserves have been assigned to the Government of Singapore Investment Corporation (GIC), which manages higher risk-return investment portfolios. More recently, South Korea has followed the same model and set up the Korean Investment Corporation.

Some questions about Indian FCA management need answers. Could the returns be increased significantly without undue risk to the country's ability to service its external debt and sustain current account deficits required for investment purposes? Is the allocation of Indian FCA management to the RBI conducive to a satisfactory rate of return? Further, if the mandate for FCA management is altered would that necessarily result in a higher rate of return?

Obviously, there are no definitive answers to these questions. In the context of adequacy of FX reserves, Guidotti-Greenspan have suggested that these should be at least equal to external debt maturing in the next one year. As of end March 2006, India's short-term external debt plus long-term debt maturing in a year was about $15 billion. On the same date, non-resident Indian (NRI) deposits amounted to approximately $35 billion and external commercial borrowings (ECBs) totalled about $26 billion. The market value of foreign institutional investors' (FII) portfolio investments in Indian equity markets is around $110 billion. That is, total external debt maturing in a year plus 50% of NRI deposits and ECBs and 25% of FII portfolio investments add up to about $70 billion.

How should the RBI maintain an adequate level of reserves for external debt servicing and other requirements while it manages excess FCA separately to maximise returns within acceptable credit and market risk limits? As of mid November 2006, Indian FX reserves amounted to about $170 billion. One option is for the RBI to manage a highly liquid, low-return portfolio of $70 billion as insurance against capital flight caused by unexpected market developments. The remaining $100 billion could also be managed by the RBI in separate portfolios with associated benchmarks which carry greater market risk and hence commensurately higher returns. This proposal for several portfolios with differing risk-return characteristics is not necessarily to take additional credit risk but diversified market risk. For instance, FCA managers could move up the yield curve and take some interest rate risk and invest in highly-rated municipal and asset-backed securities. They could also diversify out of fixed-income instruments into asset categories such as equity and real estate. Singapore and South Korea have set up separate investment corporations to manage their growing reserves because the skills required for managing investments in equities, asset-backed securities, and real estate are qualitatively different from those needed for managing portfolios consisting of short-maturity government-debt securities.

Lawrence Summers, speaking at an LK Jha memorial lecture in Mumbai on March 24, 2006, remarked that India could expect to earn about 6% in real terms on its FCA if these were invested in global capital markets. On balance, it appears that it should be possible to earn an additional 5%, compared to current FCA earnings by investing excess Indian FCA through a dedicated investment platform set up by the RBI/Ministry of Finance. An additional 5% return on $100 billion is $5 billion, which is about 0.6% of GDP. This number would be lower if the investment guidelines for the higher risk-return reserves portfolios were to be restrictive but it is still likely to be a significant figure. All things considered, it is time for the RBI and the Ministry of Finance to set up a separate investment firm or platform with appropriate performance benchmarks and incentives for the staff.

In my understanding, the quasi-fiscal costs of holding reserves in this fashion come in two parts. First, there is the well known opportunity cost of being invested in a low return asset (US government bonds or USD denominated bank accounts). As a country, India is paying higher rates for the equity/debt capital coming into the country, but earning low rates for the USD assets held by RBI - doesn't sound like a very good deal. More narrowly, if you focus on the consolidated government of India, there has been a gap between the high price at which GOI borrows on the bond market versus the low returns obtained on the reserves portfolio - this is a fiscal cost to GOI. This issue has been known in the literature for a while.

The second component, in my opinion, is more important: this is the losses that come about in the reserves portfolio when the currency adjusts. Suppose RBI tries to block an INR appreciation by purchasing USD, at a time when the exchange rate is Rs.46/$. This involves buying $100 for Rs.4600. Suppose you believe that you are in a situation where the central banks can only slow down the inevitable market process but not block it. So, if an appreciation was coming, it would come anyway - RBI is unable to prevent the inevitable, only delay it. In this case, after some period of time, you end up at Rs.43/$. Now the RBI portfolio is valued at Rs.4300. In other words, a loss has taken place from Rs.4600 to Rs.4300.

Some of this difficulty goes away by keeping score in USD. If RBI holds 25% of the reserves portfolio in EUR, and keeps score in USD, then the returns on the reserves portfolio as measured in USD looks great when the USD depreciates. I think this is illusory. I think it's safest to think in INR. In the Indian case, there are two manifestations of the fiscal costs of reserves. First, the `market stabilisation scheme' (MSS) was a very nice thing in converting some of the hidden cost of reserves into a line item in the budget. I think it's wrong to waste money on holding reserves, but if you must do so, I think it's better to be transparent about it. In addition, if you look at the time-series of the dividend paid by RBI to GOI over the years, expressed as percent of GDP, there's been a sharp drop. This drop has come about largely because of the growth of reserves.

Jaimini asks: Can we do better than RBI's management of the reserves portfolio? I'm sure we can. Jaimini is right in saying that the improved performance could amount to as much as 1% of GDP, which is a huge number.

I think it's equally important to ask: Do we need reserves beyond $70 billion? Does it make sense for any bureaucrat to hold a portfolio of 20% of GDP? I think it is preferable to not hold such assets in the public sector in the first place; it is better for the citizens of the country to hold globally diversified portfolios rather than placing these in the hands of a government agency, regardless of whether it's an RBI-style agency which earns low returns or an ADIA-style agency which does better. As an example, consider this Economic Times article titled Indian Temasek Challenger to be Launched (an inaccurate title). I think Indian politics does not mix well with such an entity. We are better off without it; we are better off with a government which just sticks to public goods and stays out of the management of the stock of assets of the citizens of the nation.

In 2003 and 2004, when India was building up reserves at a huge pace, Ila Patnaik wrote an excellent group of articles in Business Standard warning about these kinds of issues. In particular, see The USD quagmire, Dining with the devil and Feeding an elephant. This sequence of articles ended in March 2004 when India got off that tightly-pegged exchange rate. On the subject of `how much reserves is adequate', see her India's policy stance on reserves and the currency.

The only saving grace about the Indian story is that things are better here when compared with East Asia. The reserves managers in East Asia must feel terrible, holding gigantic USD assets that they dare not sell, while week after week they endure the agony of watching the USD drop.

It's been the best deal imaginable for the US: buy cheap Chinese goods through a distorted exchange rate, pay for them using IOUs, and then have those IOUs depreciate in value so they don't even have to be paid back in full. The Chinese get hurt twice: first when selling cheap goods, and second when suffering losses on the USD portfolio. The same double-whammy hurt India also, but on a much smaller scale.

Dubai: an international financial centre?

There is an article in The Economist about the effort at Dubai in becoming an international financial centre. On one hand, this is a success story of the speed and effectiveness of a dictatorship-doing-the-right-things. But as their next piece on the same subject says:

...

Yet it takes more than a dream and government largesse to succeed as a financial hub. Dubai and its imitators need to remember that the market is built not just on subsidies that attract foreigners, but markets that attract locals.

Dubai has done a lot right. Despite a tarnished past as a centre for money laundering, it has burnished its image so as to attract big investment banks and other financiers in the past year. Just a few weeks ago Carlyle, a large private-equity firm, announced that it would open shop there. Building on its transport links and a pleasant quality of life, Dubai has created a sparkling new financial centre that offers international-quality regulations enforced by imported regulators, a Western legal code, oodles of subsidies and refreshingly little red tape.

Yet in spite of this and the sea of petrodollars sloshing around the Middle East, Dubai is only halfway towards its ambition (see article). Its new stock exchange is struggling, with thin trading and few listings. The banks that blew in with the tide of global capital are impatiently muttering about embarking for the next port. Something is still missing.

To win a place in the top club of financial centres, Dubai must attract not just providers of capital but users, too. The bankers need companies that want to sell their shares and bonds in the region; fund managers want local companies to invest in; and private-equity partners need a pipeline of enticing ventures and the prospect of listing their companies after a few years. Dubai has sought to profit from the unprecedented mobility of markets, but without local demand for capital, that same mobility will start to count against it.

The trouble is that few local companies are ready for Dubai's capital markets. The Arab world includes plenty of sophisticated large investors but few modern companies. Long ago, the region's failure to develop joint-stock companies was one reason why it fell behind the West. Even today, financial transparency is weak and accounting is erratic. Most enterprises are family owned and, since they operate in protected markets, have no great need to raise capital, especially if it means exposing themselves to greater scrutiny.

This is not unique to the Gulf: the developing world is full of companies that are shielded from competitive marketsll that oil wealth, which means there is plenty of traditional bank credit for all sorts of Middle Eastern businesses. To make matters worse, local stockmarkets are still shaky after a crash earlier this year.

My reading, based on conversations with many people who have looked closely at DIFC, is that DIFC is creeping up into the ranks of a credible venue for placing certain mid-range financial functions. For the low-end BPO, India wins. For the high-end knowledge work, it's still London. There is a certain middle where Dubai is attractive. But as yet, it isn't a `financial ecosystem', where people meet and talk and do transactions on each other, where secondary market liquidity pulls in economic agents. A `big push' by a State, that tries to create an exchange or three by fiat, does not generate this liquidity. E.g. as of yet DGCX is doing perhaps 2,500 contracts per day... the case has yet to be made for trading at an exchange in Dubai when capital controls do not force business away from the great exchanges of the world. Perhaps you cannot will an international financial centre in a desert.

I like to apply a `bookshop test' in judging an international financial centre. I judge the quality of a financial centre by wandering the bookshops, which gives me a hint of the kinds of books the local financial elite is buying. Here London and New York clearly stand alone: their elite buys books on implementing finite difference schemes for Heath/Jarrow/Morton. Singapore is very, very impressive, with plenty of effort on learning stochastic calculus. Bombay is mediocre - with a big focus on get-rich-quick trader books. I haven't seen a bookshop inhabited by finance folk in Dubai - what is it like?

Moral hazard

The economists' way of thinking often leads to surprising results. One famous meme concerns the impact of seatbelts. At first blush, it appears obvious that wearing a seatbelt reduces the harm caused by an accident. The economist pipes up saying that it also increases the probability of an accident because the person feels safer; it probably increases the severity of the accident as well. While at an engineering level, seatbelts are of course wonderful, the overall effect is more cloudy than is commonly believed (link). You would need to study the data; it isn't obvious that seatbelts help. And if the adverse impact upon driving were bad enough, the economist would argue that a spear implanted in the steering wheel, pointing at the driver's heart, would probably do more for the health of the public than seat belts.

A similar debate surrounds the impact of motorcycle helmets. The biologist knows that a skull encased in a helmet does better when exposed to an accident. The economist worries that the probability of an accident goes up when the mind feels protected in a skull that's encased in a helmet. The two effects run in opposite directions; you'd need to study the evidence to know which one dominates.

Laymen often find `moral hazard' arguments to be downright bizarre. Do you believe that people actually take less care of their own health when covered by health insurance? Do you believe that people slack off in a job more when there is unemployment insurance or when it's hard for the employer to sack 'em? Do you believe that young people growing up in a welfare state invest less in human capital and have an inferior work ethic? Do you actually believe that the rise of the European welfare state had something to do with the breakdown of the family as an institution in Europe? These kinds of propositions almost sound morally repugnant. I think such behavioural changes do take place; people do respond to incentives much more than meets the eye.

Today I saw an amazing and new variation on this theme in the New York Times: cyclists who wear helmets are more likely to get hit by the traffic.

Regulatory anomalies: RBI edition

Everyone connected with finance in India has their own favourite stories about bizarre things being done in Indian finance as far as the system of policy-making, regulation and supervision is concerned. I recently wrote about the recent SEBI disgorgement order and about the separation between commodity futures and finance.

Today, in Business Standard, A. V. Rajwade has an excellent piece titled Regulatory anomalies which should really be called Regulatory anomalies: RBI edition. His checklist is:

1. The death of the interest rate futures contract:

Take, for example, the question of exchange-traded interest rate derivatives. In theory, a few contracts were introduced with much fanfare in the middle of 2003, but failed to take off. The principal reason was that commercial banks, which are by far the largest players in the bond market, were allowed to use exchange-traded derivatives only for hedging. Inasmuch as all the banks have long positions in government securities, they could have only sold the derivative contracts. With nobody on the opposite side, the market never took off. The irony of the regulatory regime is that, while banks cannot take trading positions in exchange-traded derivatives, they are free to do so in the OTC derivative market. This seems perverse, all the more so when exchange-traded derivatives are far safer than their OTC counterparts!

I agree. In addition to the above, there was one more catch: RBI wanted banks to hold greater capital backing an exposure on the exchange-traded contract when compared with the OTC contract. This was wrong because the exchange-traded contract is backed by the clearing corporation (a zero-leverage, specialised risk management shop holding only transparent assets) while the OTC contract is typically against another bank (a 20:1 leveraged financial firm holding opaque assets). This did not make sense either.

A lot has been made about the difficulties with cash-settled futures on a notional 10-year zero coupon bond. I agree with Rajwade in his emphhasis that the regulatory problems were the real difficulty. When you look at liquid bonds with a roughly 10-year maturity, there are correlations between the market price and the model price in excess of 0.8 - i.e. the contract tracked the (messy) spot market pretty well. The most important reason for the death of the contract was the regulatory treatment.

2. Mistakes in measuring the market risk of bond portfolios:

Consider another example. For measuring the market risk on bond portfolios, the central bank has prescribed the use of modified duration. The modified duration is used to estimate the price change in the value of a bond, arising from higher yields. Regulations require the price change to be calculated based on a 1 per cent yield change at the short end, but 0.6 per cent for longer maturities. This seems to be borrowed from western markets, where the yield volatility is more at the short end, and less at the long end. On the other hand, empirical evidence in India is exactly the opposite: yield volatility at the long end is more than at the short end. Surely we should not be borrowing western models and numbers without testing them empirically for conditions in the Indian market? (The same criticism is applicable to the decay factor of .94 used for calculating EWMA-based value at risk.)

(Aside: the ML estimate of the Risk Metrics lambda for Nifty works out to 0.96, so the difference there isn't economically significant). On the subject of risk measurement for interest rate risk, Jayanth Varma and I had done a fair bit of empirical work with Indian data on the time-series of the spot yield curve, leading up to the SEBI regs for interest rate futures. More generally, on the subject of the interest rate exposure of Indian banks, Ila Patnaik and I have done empirical work which finds that after complying with all RBI regulations, the banks have held huge interest rate anyway. This work was known from early 2002 onwards, but after that, it didn't seem to affect thinking on regulation. To say this in a technical way, after controlling for bank characteristics, the year-fixed-effect dummies are all insignificant. To say this in a non-technical way, even after RBI knew that the banks were carrying huge interest rate risk, nothing was done to solve the problem. [Links to material on these issues]

3. Mistakes in treatment of securitisation:

The securitisation market, which is so necessary for the growth of certain sectors like housing and infrastructure finance, has witnessed significantly reduced activity after the RBI came out with its guidelines on securitisation. While part of the reason could be a change in the interest rate scenario, surely the regulatory prescription that banks cannot account for profit on securitisation upfront, has also contributed to the death of the market. The restriction seems less than logical: on the one hand, the guidelines prescribe that there should be no recourse to the originator in the case of securitised assets; if so, why should the profit not be accounted upfront?

4. Capital controls which impede currency risk management:

Turning now to regulations about the foreign exchange market, recently the Reserve Bank allowed import duty payment (economic) exposures to be hedged in the forward market. On the other hand, it refuses to permit other economic exposures to be hedged. This too seems perverse: after all, import duty exposures are small, while every company in India, producing or consuming commodity kind of goods whose prices in the domestic market are governed by the import parity principle, is facing large economic exposures to the dollar: rupee exchange rate. These need to be managed, particularly when the rupee continues to manifest two-way movement. So what is not a pressing problem (exchange risk on import duty payment) is mitigated, but what is genuinely needed is disallowed! And this is despite both the Committees on capital account making recommendations on the issue.

5. Effectively killing foreign currency accounts:

Recently, the RBI allowed greater access to Indian companies to the maintenance of foreign currency accounts. If the idea is to facilitate such access, surely the stipulation that banks cannot pay any interest on such accounts, should simultaneously have been abolished? It is perverse that we continue with the ban on paying interest, which was introduced in an entirely different set of circumstances (i.e. when the rupee was under pressure), even when the environment has taken a U-turn for the last four years.

6. Complexity:

I also find some of the regulations unnecessarily complex, for the present stage of the market and the kind of business banks do. A few examples: capital adequacy (horizontal and vertical disallowances); derivatives accounting (the separation between below and above 90 days; the rigidity about portfolio hedges, etc.); the plethora of micro-level percentages on cancellation and rebookings of forward foreign exchange contracts.

And finally, his summing up:

Many other examples could be cited, but I suppose that the above list gives an idea of the kind of regulatory quirks, contradictions and irrationalities that exist. Is it that the central bank does not have adequate specialised staff for some of the newer areas of banking? Is it that the decision makers have drowned themselves so much in paper work that they have little time to think? Is it that, in the process, they miss the woods for the trees? Is it that there are too many steps in the decision-making ladder and that, if somebody expresses a negative opinion on a point, the system is reluctant to override it? Perhaps some introspection and review of the systems, quite apart from the specific points I have mentioned above, would be useful, and strengthen the central bank's reputation.

I think RBI staff have IQs which are as good as those found in other government agencies. It is hard to explain analytical and technical blunders such as those described above as deriving from ignorance or incompetence. I think the staff quality and their commitment to their job is just fine, though the RBI HR process leaves much to be desired. The biggest problems lie in the RBI Act and in the complex mandate that RBI is asked to discharge, one that is riddled with contradictions. I think the same staff would do much better in avoiding such mistakes if placed into more focused government agencies where such conflicts of interest were absent, and with improvements in HR procedures.

How to tackle informal sector pensions

When it comes to the question of pensions for the `organised sector', there is now a considerable consensus on how to proceed. The basic recipe consists of defined contributions; individual accounts; fund management based on the low prices of wholesale market with a big role for passive management (indexation); better returns through exposure to systematic risk factors; variation of risk exposure across the life cycle. These ideas are largely what drives the New Pension System (NPS) in India. I have an article on these issues, done for the inaugural India-and-China conference of the Lee Kuan Yew School of Public Policy (LKYSPP) at the National University of Singapore, titled A sustainable and scalable approach to Indian pension reform.

The key ingredients which make this a feasible recipe is the employer. Collection of contributions is made efficient because of the employer, and there is the rhythm of contributions coming in every month. Neither of these hold for the informal sector.

In the informal sector, the best you can do is to have people step forward to voluntarily contribute into a pension account. Given the high discount rates that most humans have, it is hard to elicit such participation. And, even if you can talk someone into stepping forward, preserving the flow of contributions across long decades is daunting.

I have started seeing glimmers of how this can be made to work. On this theme, I wrote an article How to tackle informal sector pensions in Business Standard yesterday.

The most remarkable success story of this nature is in Mexico, where the foundation was an NPS-style pension system for the organised sector. (In their case, this NPS replaced the EPFO, not the civil servants pension). Once this infrastructure was in place, they linked it up to the Conditional Cash Transfer system, through which transfers are made to poor mothers across the country. This enables the opening of pension accounts by poor people. The government co-contributes with them in order to incentivise participation.

US financial sector policy questions

I had earlier blogged about a great speech by Paulson which addresses the widely perceived sense that London has emerged as the world's #1 financial centre. On this subject, there is a report by the bipartisan `Committee on Capital Markets Regulation' which is of great interest. While the outside world sees a contest between the US-style rules-based framework versus the UK-style principles-based framework, the thinking end of the US system appears to be persuaded that emulating the UK is desirable.

Trickle down economics

Two pet hypotheses in India are as follows:

• That economic growth is not reaching "poor people"
• That government is central to improvements in education and health; conversely, that the only way to have educated and healthy people is to have a government spend more and/or spend it better.

Different people share these `pet theories' to different extents. Many liberals are skeptical about the usefulness of more spending by the government on education and health as long as spending consists of a mere intensification of existing programs. This is because there is now ample evidence that existing programs work pretty badly, as is borne out by evidence of absenteeism by health/education workers, the poor learning accomplishments associated with Sarva Shiksha Abhiyaan, etc. Many liberals would support a view that more government spending would help - or is essential for obtaining - better health and education outcomes, as long as fundamental surgery is made to the way in which programs work - e.g. shifting from teachers as civil servants to vouchers.

In recent weeks, fascinating new information about household level health and fertility has come out through NFHS-3. In terms of methodology, NFHS is the best household survey in India - it's the gold standard against which all surveys compare themselves. The first survey was conducted in 1992-93, the second in 1998-99 and the third in 2005-06. Every other survey aspires to NFHS quality resources and methodology. If you are one of those who loves to hate the NSS dataset, you needn't carry this skepticism on to the NFHS: it is the first world class household survey in India.

Kamla Gupta, Sulabha Parasuraman, P. Arokiasamy, S. K. Singh and H. Lhungdim have an article in the EPW of 21 October 2006 titled Preliminary Findings from the Third National Family Health Survey which shows some first findings from NFHS-III for five states (Chhattisgarh, Gujarat, Maharashtra, Orissa and Punjab) [pdf]. The quick summary is: the public health service delivery was terrible, but the health and fertility outcomes got tremendously better. Ila Patnaik has a great article in Indian Express summarising and interpreting their results. In this, she says:

The percentage of infants dying before they attain the age of one has dropped significantly in the last seven years in all five states. It has reduced in Punjab by 26 percent, in Gujarat by 21 percent, in Orissa by 20 percent. When compared to the data from NFHS-1 carried out in 1992-93, Orissa, one of the poorest states in India in terms of per capita income, has witnessed a decline in infant mortality by 40 percent.

For many years, the sense in India was that Kerala and Tamil Nadu had achieved replacement-level fertility (2 children per woman) but fertility in the rest of the country remained stubbornly high. The NFHS findings indicate that over the past 13 years, significant progress in fertility has taken place in all five states. Punjab and Maharashtra have achieved replacement fertility. Women in Orissa, Chattisgarh and Gujarat now average 2.5 children each. These trends in fertility indicate that India will reach replacement level fertility in 2010.

Preliminary evidence shows that the quality of public health services has been worsening. As NFHS data shows, immunisation, which is largely done by the government, has worsened in Gujarat, Punjab and Maharashtra in recent years. This data is in conformity with the data from the report on Reproductive and Child Health Program of the World Bank which found that out of 274 districts in the country, child immunisation declined in 197 districts.

Similarly, indicators of maternal health from the NFHS data show that while antenatal care is now universal in all five states, only 55-75 percent of women are getting the recommended three antenatal visits. Moreover, the report on Reproductive and Child Health Program found that the increase in in-hospital childbirth is caused by a rise in in-hospital births in private hospitals. There has been a decline in in-hospital births in public hospitals. The data on antenatal care and assisted deliveries showed that the pecentage of deliveries assisted by health workers went up from 39.6 percent in 1998-99 to 47.5 in 2002-03, the percentage of women delivering in public health facilities declined from 24 percent to 18.5 percent. The increase took place in deliveries in the private sector, where they rose steeply from 9.4 percent to 21.5 percent.

Moreover, women in richer states were seen to be using public health facilities less and turning to private health. In Andhra Pradesh, the percentage of women delivering in public institutions declined by 9.8 percent, in Kerala by 28.9 percent, in Karnataka by 10.2 percent, in Maharashtra by 9.1 percent and in Tamil Nadu by 15.3 percent. Further, the number of women who received post natal care by public health workers (ANM) through home visits within 2 weeks of delivery also declined from 14.1 percent to 12.7 percent. The Planning Commission's midterm appraisal of the 10th Plan observed that when people first seek treatment, an estimated 70-85 percent visit a private sector provider for their health care needs.

This result flies in the face of the two pet hypotheses cited above. If you believe that the lot of poor people is not improving, then this evidence is inconsistent with this position, because it suggests that poor people were a lot better off in 2005-06 when compared with 1998-99. If you believe that government spending and/or program design is important, then this evidence is inconsistent with this position: the NFHS (and other sources of evidence) show that the government system did badly, but that people got healthier and had fewer kids anyway.

What is going on? I think the main insight is that the health of the people reflects lots of things. It reflects nutrition, sanitation, knowledge, private purchases of health services and the outcomes delivered by the public health system. It is by no means controlled exclusively by the public health system; when people talk about improvements to the public health system as the only channel to having a healthier population, this is flat wrong. When people get richer, they buy better food, better sanitation and cleanliness, more knowledge (e.g. education within the family), and services of private doctors / hospitals. India has been experiencing powerful economic growth, which is trickling down to poor people. So even though the public health system is doing badly, health outcomes have improved, amongst poor people.

What I'm saying is not at all surprising when you think in terms of common sense. When people get richer, they have fewer children, buy more soap, buy more vegetables, are more likely to go to a private doctor when faced with a health problem, and are more likely to buy education services thus inducing more knowledge within the household. This makes them more healthy. But this common sense flies against the orthodoxy in India, which equates "the health of the public" with the spending on and the design of "public health programs", and assumes that poor people are not sharing in economic growth. NFHS-3 suggests that if you completely froze the spending on the Ministry of Health in nominal terms, and just had high GDP growth, you would most likely continue to get strong improvements in health outcomes.

Such an understanding - where health outcomes are not equated to the public health system - is consistent with the history of health in Europe, where a great deal of improvements in health took place owing to rising incomes feeding into nutrition, cleanliness and private purchases of health services. Such an understanding is also consistent with analysis of NFHS-1 and NFHS-2, where the basic story which emerges is that the presence of a Primary Health Centre does nothing for health.

India's trend GDP growth rate : 9% or 7%?

A short while ago, I wrote a BS article and blog posting about the remarkable GDP growth numbers that have been coming out. This was discussed on the Indian Economy Blog at the time and then again recently. The subject is particularly topical because of today's data release showing a fantastic 9.2% GDP growth (WOW!).

What is at stake is the distinction between trend and cycle. All market economies experience a business cycle. Even though Chinese data shows virtually no business cycle fluctuations to speak of, I'm pretty sure that a globalised market economy like China experiences a business cycle; it's just not being captured in the data properly.

How do you define trend and how do you define cycle? There are many ways of separating trend from cycle. I like a simple heuristic: I call the average growth over the latest 10 years to be the "trend growth rate". Ten years is a long enough period that it averages over ups and downs. The deviation from this trend is what I call "cycle". There are other ways, and in my judgment the answers don't differ by too much.

Going by this definition of trend, we find that from 1979 till 2006, trend GDP growth ticked up slowly from 3.5% to a shade below 7%. This is a very impressive achievement. But it highlights one important fact. All the wonderful things at work from 1979 to 2006 generated an improvement of 3.5 percentage points over an aeon (27 years). And there were a host of wonderful things at work in this period. The savings rate went up. The size of the workforce rose nicely (the so called `demographic dividend'). Many improvements in the economic policy framework took place - I think it's fair to say that the policy environment is completely transformed between 1979 and 2006. All these wonderful changes added up to a gain in the trend rate of 3.5 percentage points over a 27 year period.

I am optimistic about further improvements in the savings rate. I am optimistic about further improvements in the quantity and quality of labour. I am cautiously optimistic about the possibility that the economic policy might actually get a bit better. I expect the trend GDP growth in India will accelerate beyond 7%. (See these materials if you are curious about the past and future acceleration of trend GDP growth). But even the most adventurous optimism in these regards does not support an expectation of a sudden escalation of trend growth. These things only change slowly. GDP is a massive enterprise pumping out Rs.30 trillion per year. That is a lot of money; it is a vast enterprise of a great deal of producers. It does not change quickly. If we add 100 to 200 basis points to trend growth over a decade, I would say it's a grand achievement.

Further, I do not treat a further escalation of trend GDP growth as inevitable destiny. The world economy could have a nasty downturn. Indian economics and politics could go awfully wrong. Many countries have done very well in short spells and then run afoul of problems and thus faced growth decelerations. Think about it - what if the UPA does something on reservation which ignites blood in the streets like the Mandal Commission period? We in India have lived in a great period, where trend growth has accelerated for 27 years, and it's been a great ride. But we should not expect a further acceleration of trend growth as inevitable destiny.

Some ask whether it's fair to talk about trend growth at 7% when the latest quarter has shown 9.2%. Is an estimate of trend growth of 7% sensible, when we've got one quarter growth of a full 2.2 percentage points above it? My response lies in `procyclical policies' that India is following. The way India works, capital flows do well when things are good, RBI cuts real interest rates when capital flows come in, the government spends more when things are good. All this acts as a stimulant and exaggerates the good times. I say this with great sadness because all these aspects will exaggerate the bad times when they inevitably come. India has a poor macro policy framework. What Indian macro policy does is to magnify the cycle, to exaggerate the fluctuations. This is part of why we see a one-quarter result of 9.2% at a time when the trend is more likely to be ~ 7%.

Some say that I shouldn't worry about the gloomy outlook for world GDP growth when India and China are doing so well - these countries can power the world economy. The data doesn't support that. China is 5% of the world's GDP and India is 2%. The numbers just aren't big enough to counteract sluggishness in the US, Japan and Eurozone, all three of which are likely to turn in anemic numbers in the next 12 quarters.

Update (2006-12-13): Akash Prakash has a main piece in Business Standard today on these issues.

SEBI `disgorgement' order that isn't

SEBI has passed a `disgorgement' order against depositories and DPs in the `IPO scam'. For the background, my earlier blog entries on the `IPO scam' are here and here.

There are all kinds of slippery issues of language, on this issue, that require care. The IPO `scam' wasn't much of a scam, it was a mountain made out of a molehill caused by a wrong policy in the first place. And, this SEBI order fails to achieve `disgorgement' of unlawful gains - it merely inflicts fines upon parties who made no unlawful gains.

Jayanth Varma has an excellent blog entry on this order. An edit in Business Standard says:

However, several questions arise in the present case. First, the money to be paid to retail investors who lost out has to be taken from those who enjoyed unwarranted gains, i.e. those who `engorged' in the IPO scam. These are not the market intermediaries whom Sebi has focused on, namely the depositories and depository participants (DPs), who only got their regular fees and nothing more. These intermediaries may be guilty, as Sebi has already determined, of violating the `know your client' norms, but they are not the ones who `engorged' and who therefore should now be asked to disgorge. The `engorgement' was done by the dummy investors in whose names shares were allotted, and it should be possible to take those shares and sell them in the market, with the loss that has been calculated by retail investors being paid to them, and the balance returned to those who got the allotment. The logical flaw in Sebi's order is in mixing up a penalty for misconduct (which it can legitimately levy on market intermediaries who err) with disgorgement; both are a financial drain, but the logic of each is quite different.

The Rs 116-crore question is what happens to the disgorgement fund, since the money has been made payable to Sebi. In the US, the SEC set up the Fair Funds for Investors in 2002 to benefit investors who have lost money because of illegal practices of other investors or companies, and fair funds are now playing an increasing role in enforcement. But even in the US, the aggrieved parties have received little money despite a provision for the appointment of an administrator. The task of identifying the affected parties involves detailed work, but should not be shirked for that reason. The outcome to be avoided is Sebi pocketing the money - as the tax authorities do when they recover excise duties illegitimately collected from customers by companies. That would be very unjust engorgement.

The Economic Times editorial says:

Sebi’s final order on the case is still awaited. Its earlier order of April 27, 2006 is an interim one. Some respondents have gone on appeal against the findings and their appeals are pending at various stages. In such a scenario, to come down so heavily on intermediaries when they have not gained any monetary benefit defies logic.

Neither the depository nor the DPs have derived any ‘ill-gotten gains.’ That gain has been made by the scamsters. However, Sebi says, “it is expected the intermediaries will take prompt steps in their own interest to pursue other wrongdoers and perpetrators of the illegal actions and attempt to collect sums from such individuals/companies.” Given the nature of the legal system, that will be a Herculean task. Moreover, it is cumbersome to determine the identity of those who presumably lost out in the allotment process or to quantify the extent of loss.

Sebi’s order justifies its penalty by claiming that “each intermediary in the hierarchy of intermediaries contributed cumulatively to the market abuse”. But if CSDL and NSDL are guilty of failing to police the DPs, then Sebi as the regulator at the top of this hierarchy can also be accused of sleeping on the watch. Instead, it has chosen to gloss over its own culpability and that of the RBI, which as the banking regulator has constructive responsibility for the mistakes of bank DPs, and pinned the blame entirely on market intermediaries.

If disgorgement was the goal, careful detailed work is required in five steps:

1. Reconstructing the orders placed in the IPO auctions,
2. Identifying the people (the Roopalbens) who obtained unlawful gains,
3. Identifying the people who would have won allocations in the auction if these unlawful bids were removed;
4. Extracting money from the Roopalbens who obtained unlawful gains;
5. Transferring this to the people who would have won allocations.

Each one of these steps is hard work, but it is the hard work that a regulator has to do if it aspires to achieve disgorgement. SEBI has not done any one of these fives steps. It has hence failed to achieve disgorgement of unlawful gains. Plucking a number out of thin air - a fine of Rs.45 crore - and inflicting it upon a conveniently accessible NSDL - does not achieve disgorgement.

Update: There was an ET debate on this, with two good pieces by Rajiv Luthra and Somasekhar Sundaresan.

Big picture speech of financial sector policy reform by Paulson

In recent weeks, Bloomberg & Schumer have talked about the loss of competitiveness of New York as a financial centre. I have also felt the centre of gravity shifting from New York to London in the post-2001 period. On 20th, Paulson did a great speech on these issues. It makes the obligatory claims that New York is still a great financial centre, while talking about the reforms agenda in a statesmanlike fashion. The Ministry of Finance in India doesn't write speeches of this quality. In what follows ahead, I have extracted the most informative paragraphs of his speech. The boilerplate:

Our capital markets are the deepest, most efficient, and most transparent in the world. We are the world's leader and innovator in mergers and acquisitions advice, venture capital, private equity, hedge funds, derivatives, securitization skills, and Exchange Traded Funds. This expertise has made our leading financial institutions, many of them headquartered right here in New York, leaders in Asia, Europe, and Latin America. U.S. commercial and investment banks contribute greatly to economic success all around the globe.

The problem:

Despite our strong economy and stock market, IPO dollar volume in the U.S. is well below the historical trend and below the trend and activity level in a number of foreign markets.

Moreover, existing public companies in the U.S. are deciding to forgo their public status – with its attendant regulatory requirements – and go private. This is occurring in record numbers, at record volumes, and, as a percentage of overall public company M&A activity, is approaching levels we have not seen in almost 20 years. This development is being facilitated by ever-growing private pools of capital.

A checklist of what could be at work:

The development of markets outside the U.S., particularly in London and Hong Kong – and the ability of U.S. investors to participate in these offerings;

A legal system in the U.S. that exposes market participants to significant litigation risk;

A complex and confusing regulatory structure and enforcement environment;

And new accounting and governance rules which, while necessary, are being implemented in a way that may be creating unnecessary costs and introducing new risks to our economy.

I was intrigued by the fact that when discussing the development of markets outside the US, he touched upon IFRS as a piece of successful principles-based regulation:

A number of foreign markets have developed excellent standards and protocols. In some parts of the world, particularly Europe, public companies adhere to the International Financial Reporting Standards – an accounting system that differs from ours.

One important feature of the IFRS accounting system is that it is principles-based, rather than rules-based. By "principles-based," I mean that the system is organized around a relatively small number of ideas or concepts that provide a framework for thinking about specific issues. The advantage of a principles-based system is that it is flexible and sensible in dealing with new or special situations. A rules-based system typically gives more specific guidance than a principles-based system, but it can be too rigid and may lead to a "tick-the-box" approach. I will be talking about the difference between principles-based and rules-based systems in a number of contexts today.

International companies that list in the United States must reconcile their IFRS statements with U.S. Generally Accepted Accounting Principles, or GAAP. We should recognize that the time and cost that go into reconciling and restating IFRS statements may not be a worthwhile expense for a foreign company considering the U.S. market. Because of progress being made in converging accounting standards, the U.S. and EU have developed a "roadmap," with the goal of allowing listings in the U.S. market on the basis of statements prepared using IFRS, and likewise continuing to permit listings in the EU on the basis of statements prepared according to GAAP. These efforts are encouraging.

The usual conservative, sensible call for reforms of the tort system:

A sophisticated legal structure – with property rights, contract law, mechanisms to resolve disputes, and a system for compensating injured parties – is necessary to protect investors, businesses, and consumers. But our legal system has gone beyond protection. In 2004, U.S. tort costs reached a record quarter-trillion dollars, which is approximately 2.2 percent of our GDP. This is twice the relative cost in Germany and Japan, and three times the level in the UK. The consulting firm Towers-Perrin found that the tort system is highly inefficient, with only 42 cents of every tort dollar going to compensate injured plaintiffs. The balance goes to administration, attorney's fees, and defense costs. Inefficient tort costs are effectively a tax paid by shareholders, employees, and consumers. Simply put, the broken tort system is an Achilles heel for our economy. This is not a political issue, it is a competitiveness issue and it must be addressed in a bipartisan fashion.

From an Indian perspective, a very interesting rumination on a messy financial architecture:

Another issue to consider in assessing the competitiveness of our financial markets is regulation. Over the course of our nation's history, we have added multiple regulators to respond to the issues of the day. Our regulatory system has adapted to the changing market by expanding, but perhaps not always by focusing on the broader objective of regulatory efficiency.

For example, while the business of banking has converged over time, we still have four separate banking regulators. We have a similar dynamic with the securities and commodities markets, and their related self-regulatory structures. Each of these organizations has different statutory responsibilities and a number have different regulatory philosophies. We also have a dual federal-state regulatory system in the banking and securities markets – and the degree of federal preemption over state law in these areas varies greatly. Another large and important part of our financial sector, insurance, is regulated solely at the state level.

A consequence of our regulatory structure is an ever-expanding rulebook in which multiple regulators impose rule upon rule upon rule. Unless we carefully consider the cost/benefit tradeoff implicit in these rules, there is a danger of creating a thicket of regulation that impedes competitiveness.

A very UK-style advocacy of principles-based regulation instead of rules based regulation:

Our rules-based regulatory system is prescriptive, and leads to a greater focus on compliance with specific rules. We should move toward a structure that gives regulators more flexibility to work with entities on compliance within the spirit of regulatory principles.

Rules by themselves cannot eliminate fraud. Wrongdoers will seek out loopholes or ways to circumvent the rules. For instance, in the recent business scandals, management at some companies remained technically within the rules while offering deceptive financial statements.

Some rules developed in the past have proved to be deficient in today's dynamic marketplace and some that are developed today are likely to be sub-optimal in a few years unless they are rooted in principles which will stand the test of time.

The problems of multiple inspectors from multiple regulators going after the industry:

At times, our legal system and regulatory structure produce unintended consequences. Consider the area of enforcement. Over the last several years different regulators at the state and federal level have been focused on finding and prosecuting wrongdoing – a worthy, necessary, and successful effort. But when multiple jurisdictions and entities are involved, each with their own objectives and approaches, the enforcement environment can become inefficient and, to the regulated, can appear confusing and threatening.

On SOX, the Republicans don't seem to have an appetite for legislative solutions; they want to only improve the administration of the Act:

At this time, I do not believe we need new legislation to amend Sarbanes-Oxley. Instead, we need to implement the law in ways that better balance the benefits of the legislation with the very significant costs that it imposes, especially on small businesses.

By far the single biggest challenge with Sarbanes-Oxley is section 404, which requires management to assess the effectiveness of a company's internal controls and requires an auditor's attestation of that assessment. Companies should invest in strong internal controls and shareholders welcome this development because it is in their best interest. However, section 404 should be implemented in a more efficient and cost effective manner. It seems clear that a significant portion of the time, energy, and expense associated with implementing section 404 might have been better focused on direct business matters that create jobs and reward shareholders.

Businesses around the world are eager to see how we address this issue. The Chairman of the SEC, Chris Cox, recognizes the severity of this problem and is providing strong leadership to address it. He understands that it will take an aggressive forward-leaning approach to change the implementation of Section 404 and make it more efficient.

Mark Olson, the Chairman of the Public Company Accounting Oversight Board, shares Chris Cox's viewpoint. Collectively, they have responsibility for providing guidance on implementing Section 404. The SEC will soon seek comments on a new and much improved auditing standard aimed at ensuring that the internal control audit is top down, risk based, and focused on what truly matters to the integrity of a company's financial statements. This new guidance for both companies and their auditors should encourage common sense reliance on past work, and on the work of others. Moreover, the SEC and the PCAOB are going to provide tailored guidance for small companies that recognizes their specific characteristics and needs.

A paean on principles as opposed to rules; adhering to principles is harder than checkboxes on rules done by a clever compliance person!

We should remember that we cannot legislate or rule-make our way to ethical behavior, whether it be in the business world or any other endeavor. Proper corporate governance processes increase the likelihood that well-intentioned people will do the right thing. But they do not guarantee such an outcome – and they certainly do not guarantee that unethical people will do the right thing. In my judgment, we must rise above a rules-based mindset that asks, "Is this legal?" and adopt a more principles-based approach that asks, "Is this right?"

Several weeks ago, Warren Buffett offered a warning to his leadership team at Berkshire Hathaway when he wrote, "The five most dangerous words in business may be `Everybody else is doing it.'" As usual, Warren Buffett was right. The ability to avoid these pitfalls takes moral leadership, starting right at the top.

Concerns about accounting:

• Given the importance of accounting to our financial system, is there enough competition?

Will our reformed accounting system produce the high-quality audits and attract the talented auditors we need?

Do auditors seek detailed rules in order to focus on technical compliance rather than using professional judgment that could be second-guessed by the PCAOB or private litigants?

Importance of principles-based system for accounting:

A common theme in my remarks today is the desirability, where practical, of moving toward a principles-based system. Nowhere is this issue more relevant than in the accounting system. Added complexity and more rules are not the answer for a system that needs to provide accurate and timely information to investors in a world where best of class companies are continually readjusting their business models to remain competitive.

Last year, approximately 1,200 publicly listed companies in the United States restated their financials. As of September 30 of this year, the number is more than 1,000. Some of these companies were involved in the business scandals. Many others were well-intentioned companies struggling to cope with a redefinition of rules in a complex system. These restatements draw time and attention away from other value-enhancing activities – and they represent an added cost to shareholders. Businesses and auditors are searching for something that doesn't exist in today's constantly changing world – a rules-based safe haven that still provides investors with an accurate portrayal of a company's financial performance.

Auditors should be able to focus on one fundamental objective – ensuring the integrity and economic substance of management's financial statements. To get there, we must recognize that accounting is not a science. It is a profession, requiring judgments that cannot be prescribed in a one-size-fits-all manner that undermines the usefulness of financial statements to investors.

They seem to have an interesting "President's Working Group on Financial Markets". One feels so much safer when the head of Goldman Sachs has to make decisions about hedge funds:

And the President's Working Group on Financial Markets – comprised of the Treasury Secretary and the Chairmen of the Federal Reserve Board, the SEC, and the CFTC – continues to review and monitor markets, assess issues related to the performance of derivatives, and study the activities of hedge funds in three broad areas: investor protection, operational risk, and potential for systemic risk. We have begun a series of educational meetings with a broad array of participants in the hedge fund community to gain insight as we move forward with our deliberations.

Summary:

• First, it is necessary to take a global view. We don't operate in isolation, so it is very important to consider how changes we make affect the ability of our companies to compete globally and how these changes affect our interaction with markets and regulators around the world.
• Second, our regulatory structure should be more agile and responsive to changes in today's marketplace.
• Third, to stand the test of time, rules should be embedded in sound principles.
• Fourth, regulators should take a risk-based approach to regulation, weighing the cost to shareholders against the benefits.
• Fifth, our enforcement regime should punish and deter wrongdoing and encourage good behavior without hindering responsible risk-taking and innovation.
• And, lastly, the best way our business leaders can protect the integrity and competitiveness of our markets is to exert moral leadership, where the threshold question is, "Is this right?" not "Do the rules allow us to do this?"
• Our capital markets remain strong and competitive, but they face some significant challenges that do not lend themselves to easy answers or quick fixes. The Treasury Department plans to host a Conference on Capital Markets and Economic Competitiveness early next year. We will invite participants with a wide range of perspectives, particularly the investor perspective. The Conference will cover the three primary areas I have discussed today – our regulatory structure, our accounting system, and our legal system – all of which impact our capital markets and are critical to the overall economic competitiveness of our nation. Our objective will be to stimulate bipartisan discussion and to lay the groundwork for a long-term strategic examination of these issues.

Article by Mukul Asher on pension reforms

Mukul Asher has written a useful article in EPW about issues in Indian pension reform.

Global warming aspects of the Indo-US nuclear deal

The major focus about the Indian nuclear deal has been on proliferation issues. However, CO2 emissions is also an important dimension of the deal [link]. Ila Patnaik has two articles on nuclear energy [one, two] and one on global warming [link].

In the weeks leading up to the vote at the US Senate, David G. Victor of Stanford has done a document The India Nuclear Deal: Implications for Global Climate Change:Testimony before the U.S. Senate Committee on Energy and Natural Resources. The abstract reads:

The nuclear deal probably will lead India to emit substantially less CO2 than it would if the country were not able to build such a large commercial nuclear fleet. The annual reductions by the year 2020 alone will be on the scale of all of the European Union's efforts to meet its Kyoto Protocol commitments. In addition, if this arrangement is successful it will offer a model framework for a more effective way to engage developing countries in the global effort to manage the problem of climate change. No arrangement to manage climate change can be adequately successful without these countries' participation; to date the existing schemes for encouraging these countries to make an effort have failed; a better approach is urgently needed.

You can access the PDF file via `esocialsciences.com' (free registration required): link.

Article on the equity derivatives market in `Business World'

Mobis Philipose has written an interesting article in Business World on the equity derivatives market titled Needed: New wine, new bottle. It is related to, and adds value on, many of the issues on equity derivatives that have figured on this blog. It is on the web (free registration required), but the BW website does not give out permalinks. When that link stops working, use part 1, part 2.

How not to "control" inflation

India is a fascinating country on attitudes to inflation. On one hand, there is a deeply ingrained belief that inflation hurts the poor most, and politicians are hawkish about inflation. But concern about inflation has not manifested itself in good measurement of inflation. Inflation measurement is bad - and has been bad for the longest time without any effort at fixing it. And, in the short run, there is lassitude in doing anything about inflation. The `Taylor Principle' is not understood, and there is little by way of institutional mechanism or institutional commitment to control inflation.

When inflation does spike up, the first response in socialist India is to look for ways in which government can manipulate prices of a few products.

Suppose there are N commodities that go into an inflation measure. There are two sets of N numbers: the price rise p_i for all commodities and their weights in the index w_i. There will always be a distribution of different price rises; i.e. all values p_i will not be the same. So if you sort p_i you will always be able to identify 10 commodities with the highest price rise. And if you sort p_i*w_i, you will always be able to identify the 10 commodities which have `contributed the most to inflation'. Statements then get made of the form `there is no real problem of inflation; it's just that there are just 10 weird commodities which account for xx% of the overall inflation; we have to solve these localised problems and we're fine'.

In socialist India, the government would then go after these 10 commodities with price controls, imports, release of inventory from government warehouses, ban on futures trading, etc.

There is a need to completely shift away from this mentality. Data processing, as described above, delivers no insight into where inflation is coming from. It is just an arithmetic fact that some commodities will have higher price rises than others. The economy suffers greatly from distortions when the government goes after the top 10 commodities every now and then in this fashion.

Ila Patnaik had a great article in Indian Express on 11th November where she argues that in a market economy, inflation should be seen as a phenomenon of macroeconomics, requiring a response from macro policy; arguing that it is time for the government to get out of manipulating prices of individual commodities.

This is an important part of the case for an inflation targeting central bank in India. Monetary policy based on inflation targeting is good in its own right; it is monetary policy which stabilises the boom and bust of GDP growth. But in India, it will address the goal of politicians who like low inflation, and remove the pressures that come up from time to time for government to get hands-on with manipulation of prices of specific commodities.

Update (10 Feb 2007): Indian Express has an editorial on difficulties of inflation measurement.

Pension guarantees considered subtle

The negotiations about the PFRDA Bill, which are presently underway, are reportedly discussing guarantees gifted by the government to NPS participants.

Many years ago, when US-64 was fresh on our minds, I used to think that keeping government out of such obligations was a no-brainer. It is too easy for a political process to come up with a plausible-sounding guarantee, which is actually horribly expensive a few years down the line. The best example of this is the European DB pension systems.

In 2001 and 2002, when the early work on translating the Project OASIS report into the NPS was being done at DEA, Robert Palacios anticipated that discussions about pension guarantees would surely come up, and that a thorough analysis of guarantees needs to be done well ahead of time. He pushed me into thinking about the subject. I used this off-the-shelf knowledge to write an article titled Pension Guarantees are Subtle in Business Standard today.

The EPW article I talk about is: Investment risk in the Indian pension sector and the role for pension guarantees, EPW, 2003, pdf. In addition, I have worked further on the tools for analysing pension guarantees link.

Coincidentally, Gautam Bhardwaj is also in Business Standard today, in a debate about pension fund investment into the stock market. The other side is by a M. K. Pandhe, who seems to have the bulk of his facts wrong.

Separation between commodity futures and mainstream finance

One of the (many) strange things that India does in the financial sector is a separation between commodity derivatives and mainstream finance. Everywhere in the world, it is well understood that there is only one business called the securities industry, which involves organised trading of all manner of spot and derivatives products, including derivatives on physical commodities. But in India, we have a piece of legacy legislation dating back to the 1950s which places commodity futures with the Department of Consumer Affairs, and places regulatory functions with the Forward Markets Commission. Through this, the people who do consumer protection - e.g. issues like weights and measures - are tasked with thinking about safety + soundness of clearing corporations.

If commodity futures could be merged back into mainstream finance, there would be more rapid development, by tapping into the skills, regulations and legal structure which has been created for derivatives. In addition, in the existing situation, there is a loss of economies of scale, economies of scope and competition associated with cutting up finance into separate pieces.

When you wander in the streets of India, you see boards of firms saying "Member NSE, BSE, NCDEX, MCX", which reminds you every day of the de-facto convergence of the two worlds. The customers are the same; the brokerage firms are the same. The artificial separation is caused by a piece of legislation going back a half century, done at a time when none of this was understood.

Today two developments took place which illuminate these issues. First, SEBI seems to have removed the last barriers to the trading of Exchange Traded Funds on gold. This will be done by "financial" mutual funds, traded on "financial" exchanges, and regulated by SEBI. It serves to highlight the lack of a distance between commodities and finance.

In parallel, there were some newspaper stories about the possible use of the Securities Appellate Tribunal (which was created in the SEBI context) for handling appeals against the FMC. This also makes a lot of sense, and underlines the unity of commodity futures in mainstream finance.

By international standards, separating out commodity futures into a separate market is a fairly perverse thing to do. I have no doubt that at some point, some prime minister is going to sign off on the merger of these two worlds into a single competitive market.

The US is the only country where a somewhat wonky arrangement is in place (though not as wonky as what we have in India). In the US, the CFTC is a separate regulator for all derivatives markets. They do better than India in placing all derivatives together, i.e. commodity derivatives are not separated out. The CFTC is an old agency, and its continued separation from the SEC reflects complacence, and a lack of political will, in the US. When you are the world's biggest financial system in the world's biggest economy, it's easy to get complacent with what is in place (witness the sluggish movement towards electronic trading at exchanges in the US). But here also, international competition is bringing in a new level of stress; the UK integration of all financial regulation into the FSA is increasingly leading to a shift of business to the UK. A recent article in Forbes talks about some interest in convergence.

What google earth can do for illegal land development

Ubiquitous access to Google Earth has many interesting implications for the land market.

I have seen many signs where obscure little real estate brokers, by the road side, offer to show you properties through Google Earth.

Nancy Sajben sent me a pointer to a blog entry talking about how land acquisition for an SEZ was influenced by Google Earth: farmers were able to argue their position more clearly by utilising this information.

In cities like Bombay and Delhi, I sometimes think the resolution of Google Earth pictures are so high that one can even identify illegal construction where a house spills into the road. The puzzle is: who will do this?

I have long been highly conscious about illegal land development on the boundaries of national parks by developers who chip away, one acre at a time. I don't know the legal foundations surrounding Borivli National Park, but the amount of construction taking place at the edges of the park seems very, very suspicious to me. And this is Bombay - anywhere outside Bombay I'm sure the dangers of encroachment are much worse.

It would be wonderful if an environmental activist group would engage in the following steps:

1. Utilise the public records to make a .kmz file of the boundary of all the national parks in India,
2. Setup software which watches google earth, and throws up an alert when it looks like there is some habitation in what ought to be park land.

Update: I just noticed some work in South America which sounds like this.

A little off topic: Noticed a great photoblog on India.

Syed Rashed Ahmad runs a great blog "indianglory" where he puts out roughly two photographs a day. I find them stunning; a great reason to start using an RSS feed reader even if you don't do so already. Go look at the blog; Get his RSS feed. I just wish the pictures were bigger.

Reddy & Bernanke

I wrote an article Reddy & Bernanke in Business Standard today, in reaction to the RBI rate hike, and placing it in the context of developments outside India.

The outstanding fact of Indian macro in recent times is the acceleration of CPI inflation, which rose from 3% in late 2003 to between 6% and 7% today. Further, the inadequate response of monetary policy in this episode generates expectations on the part of households and firms that in the future, a rise in inflation will be persistent. Mature market economies have stable inflation and unstable exchange rates; in the third world it is upside down.

I argue that India continues to need tight monetary policy, so as to get CPI inflation back to the 3% which had been achieved in late 2003. The situation in the US is much more cloudy - if a recession sets in within a few months, the Fed might be cutting rates. This underlines the idea that India is a large economy which requires a monetary policy based on the domestic business cycle, and the use of US monetary policy (by running a pegged exchange rate) is not optimal for India.

Hmm, while on this note, it was interesting to then see Chidambaram using the phrase `inflationary expectations' in this speech. Maybe caring deeply about inflation persistence and the expectations of households & firms isn't a disease of economists only :-)