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Wednesday, February 28, 2007

We live in interesting times

Just when you thought financial markets had become boring, things got interesting again.
  • First, the Chinese market dropped 9% [picture]. That wouldn't, by itself, worry me so much. The stock market isn't that important to China's economy. It isn't a particularly well done stock market either, so I don't worry so much about the information content of this drop in prices. You might find this book review to be mildly interesting. William Pesek has a good column on Bloomberg, and this IHT story describes recent events.
  • The big news is that last night, while we were sleeping in Indian Standard Time, the S&P 500 dropped 3.47% [picture]. Menzie Chinn has a great blog post diagnosing what happened, Caroline Baum has a good column on Bloomberg about the US housing market, and this NYT story uses the R word. This one-day drop of 3.47% is a fairly big move for the S&P 500 which has a daily sigma of 1%. If I look at the post-1990 period, on 99% of the days, the one-day returns were milder than -2.6%. They seem to get three days in each four years, on average, with a move of worse than -3.47%, and the last four years have been unusually benign.
  • Most world indexes have also dropped [link]. I think this is mostly in response to the drop in the S&P 500 and its changed vol, and not so much in response to events in China.
  • For many months now, the volatility of the S&P 500, as forecasted by the index options market, has been slumbering at remarkably low levels. It has jumped back dramatically [picture], going from near 10% annualised vol on Tuesday to roughly 18% last night. I wrote about the eerie low volatility a few weeks ago, and many commentators have been worried about the extent to which assets are `priced to perfection'.
  • Turning to India, Business Standard has an excellent edit showing you the political context of this budget speech.
It's now 9:40 and at 11 the budget speech will start. This is, by itself, a big dose of vol for the Indian equity market. There could not have been a more dramatic setting for the speech. In the past few days, Nifty's been a bit volatile, so margin levels are already much higher than they were just ten days ago.

Saturday, February 24, 2007

Milestone in the internationalisation of the INR

With burgeoning flows on the current account and the capital account - with gross flows that exceed 90% of GDP and are growing much faster than GDP - the internationalisation of the INR is inevitable. I have previously written about how wrong India's approach on capital controls is, with rules that limit INR denominated borrowing but encourage foreign currency borrowing. It reminds me of pre-crisis South Korea, which encouraged short-dated debt flows but blocked equity flows.

A remarkable development has taken place for the INR: The first INR denominated offshore bond has come about, far from the clutches of local capital controls. This sets a new frontier for what you can do with the INR NDF market. Inter-American Development Bank has raised Rs.1 billion ($23 million) with an INR-denominated bond. The most interesting feature of the situation is what RBI proposes to do about this -- introduce more capital controls (see text which is not in italics). This text is from IFRAsia ($$) on 3 February 2007:

Non-deliverable forwards drive first offshore rupee bonds International investors recently had their first opportunity to gain exposure to the Indian rupee fixed-income market without having to register with the Reserve Bank of India thanks to the first ever non-deliverable Indian rupee-denominated bond.

The February 2010 bond, which was arranged by TD Securities, might have been small - it raised Rs1bn (US$23m) for the Inter-American Development Bank (IADB) - but it seems likely to be a taste of things to come.

"Through this structure, we are providing non-Indian entities access to rupee bond issuance and offshore investors a way to express a position in Indian rupees," said Greg Moore, a director with TD Securities in London. "The deal was small in size to start with but as investor confidence grows, we expect it to be upsized."

Though the deal was the first of its kind in rupees, TD has also arranged similar transactions for other issuers in Brazilian real or Indonesian rupiah.

The bonds, which are listed in London, pay an annualised coupon of 7.25% which is inside where Indian government bonds trade - possibly one of the motivations for the trade. Though denominated in rupees, the IADB deal is settled in US dollars. Seven investors based in Belgium, Canada, Germany, Switzerland and the UK bought the bonds.

Foreign investor interest towards rupee debt has been rising over the past few years but restrictive local regulations mean that it is difficult for most investors to access the market. The Indian rupee is convertible on the current account but not fully on the capital account which means that offshore investors looking to take rupee exposure cannot do so offshore and have to register as foreign institutional investors and then invest in India.

The total amount of foreign investment in rupee bonds is, however, tightly controlled and many investors don't bother to register as they will struggle to get access to enough rupee paper to make it worth their while.

Taken together, foreigners are now allowed to hold US$2.6bn in government bonds, with that limit due to rise to US$3.2bn by the end of March. The limit for corporate debt is US$1.5bn.

Regulators have been wary of inviting large-scale foreign investment in debt (unlike in equities) amid worries that this would encourage large speculative flows that could pose a systemic risk. But it is clear that the lack of foreign participation is one reason for the domestic market's lack of depth.

The IADB transaction skirts these issues by using non-deliverable forwards which, while based on rupees, don't directly interact with the onshore market. The NDF market gives offshore players a synthetic exposure to the currency and trade settlement is in foreign currencies based on the movement in the rupee versus foreign currencies.

However, the RBI is even looking to curb the progress of this market. In November, the central bank issued draft guidelines on the use of derivatives in India which will supersede all existing guidelines when they are confirmed.

One proposed rule states that market-makers and users should "not undertake any derivative transaction involving the rupee that partially or fully offsets a similar but opposite risk position undertaken by their subsidiaries/branches/group entities at offshore location(s)". In other words, the RBI is attempting to stop banks offering offshore-based rupee product from offsetting risk in the onshore market. If it is able to do that - a big "if" given that enforcement would be very difficult - such transactions would become considerably less efficient for the banks arranging them.

Either way, bankers think that there is very little the RBI can do to stop deals like the one from the IADB. News last week that S&P has also upgraded the Indian sovereign to investment grade is likely to add to the demand for such deals and make it worthwhile for banks to put in the work needed to construct such transactions.

"The biggest challenge of doing such deals is piecing the various inputs inherent to this type of trade together. But given the strong interest evidenced by investors, we expect more such deals in the future," said Moore.

Update: Jayanth Varma has written about this on his blog.

Pondering the GST (with a tailpiece about FBT)

Business Standard has an edit on the GST, and has an article on it by Sukumar Mukhopadhyay, where he emphasises the differences between alternative formulations of the GST. My sense is that the positions of Kelkar and Bagchi are actually 99% the same. And, I think Mukhopadhyay gives inadequate weightage to the remarkable implications of the 88th amendment of the Constitution.

There was an interesting edit in Financial Express, which I will discuss in reverse order. First, the part that I agree with, on the GST:

Exemptions made for one or the other industry only make space for lobbying and pressures that result in even more distortions in the future. If Indian business has to become globally competitive, then the finance ministry needs to institute a tax system that reduces friction and costs. That the country has begun to absorb the principle of value-added taxation (VAT) is encouraging. But beyond that, taxation policy must focus on converging the current system of multiple varied taxes towards an efficient, VAT-based, nationwide goods and services tax (GST) that removes all barriers within the country, gives the tax code cohesion, reduces the innumerable contact points between tax administration and industry and lowers cost of compliance. The finance minister must turn his attention towards a clear roadmap for this, and adhere to it. An increase in service tax to 14% and a reduction in central excise from 16 to 14% is only a first step in this direction. This should be done in the forthcoming Budget.

Compare the performance of Indian manufacturing with that of China, and one crucial fact that is often forgotten is that Chinese manufacturing was given a GST in the early 1990s. A better taxation system gave the Chinese no less an edge over Indian industry than did China’s superior infrastructure. Prime Minister Manmohan Singh and finance minister P Chidambaram have both made promises that India will see a GST. But the difficulty is that while other tax reforms—such as rationalisation of customs, removal of exemptions, changes in tax rates/items—can be done at the stroke of a pen, implementing any VAT-based system is difficult in many ways. It is administratively complicated, involves the consensus of states and requires changes in mindset all through the value chain, which is never easy in a country such as India. To be sure, there has been progress. The Union Budget for 2004-05 brought services into the VAT framework and integrated the credit on Cenvat and services taxes. Another step was the implementation of state VAT from April 2005. Now, for India to move towards a countrywide GST involving both the centre and states, the central government must provide clear leadership in setting up a well-functioning central GST system with the requisite administrative capacity. In doing this, its own revenues will go up and its dependence on direct taxes will go down.

As for other taxes, central excise deserves a closer look for possible problems of non-compliance. With some extra effort, however, such problems can be a thing of the past. Greater computerisation, for example, could help to quite a degree. The finance minister could make full use of the latest information technology enablers to merge databases and re-order data on transactions to make the entire taxation framework amenable to desktop overview on a consolidated basis. In fact, a vast central tax database should serve as the centrepiece of how VAT credits and refunds take place, and the treatment of VAT on imports and exports should be linked to it as well. Such a system, integrated electronically with the current tax information network (TIN) system that was up and running in eight months, can be easily initiated in the next fiscal year. The number of establishments involved would be smaller than the number that have already been plugged into TIN. This will help eliminate fraud in central excise and service taxes. And, when the centre demonstrates, by example, to the states that there are gains to be made by joining this system, the path towards an all-India GST will open up.

For those interested in the GST, there is more on GST in this blog. And then, the early part of the edit that I don't agree with:
Collections from the Fringe Benefit Tax (FBT) in the period April 1, 2006 to January 31, 2007 stood at Rs 3,984 crore, a tiny part of the Rs 1,56,429 crore collected as direct taxes during this period. The distortionary impact of the tax is, no doubt, much larger—so large that even larger collections would not justify them. The FBT is a presumptive tax that poses enormous headaches for employers who have genuine business expenses that are burdened by it. ‘Fringe benefits’ are deemed to have been provided when the employer incurs any expenses on account of maintenance of guest house, conferences, sales promotion including publicity, conveyance, tour and travel, hotel stay, boarding and lodging. These are routine business expenses for most enterprises, but a specified percentage of these are taxed. Which means that these expenses are effectively treated as profits. This goes against the basic principles of taxation.

Perks, or fringe benefits provided by an employer to his employees, in addition to the cash salary or wages paid, are often a way of paying a part of the salary in a manner such that the employee has to pay no tax on it. In other countries such fringe benefits are subject to varying tax treatment. These benefits are either taxed in the hands of the employees themselves or subject to a 'fringe benefit tax' in the hands of the employer. The rationale for levying a fringe benefit tax lies in the inherent difficulty in isolating the 'personal element' where there is collective enjoyment of such benefits and attributing the same to the employee. Many times the expense may be incurred for the purpose of business but,like in the case of entertainment, have benefits of a personal nature. The problem lies in being able to correctly identify the true business expense from a cash component of salary.

The real contribution of the FBT lies in the way that it has encouraged employers to move towards more transparent pay packages where the full cost-to-company is seen as total taxable income. The success or failure of the FBT should not be judged by the tiny direct collection of the FBT.

The FBT attempts to bring on par employees of private companies that offer a part of the salary as a tax free component with that of those with fully taxable salaries. Yet, there are difficulties in the tax for the employers who have genunine business expenses which get hit by the FBT. For example, fringe benefits are deemed to have been provided when the employer has incurred any expenses on account of maintenance of guest house, conference, sales promotion including publicity, conveyance, tour and travel, hotel, boarding and lodging. These are genuine expenses for most business enterprises but a specified percentage of these expenses are taxed. This distorts the behaviour of firms.

Four outstanding recent books

  1. The Oxford Companion to Economics in India, edited by Kaushik Basu. As I flipped the pages, I felt like sitting down and thoroughly reading roughly one third of the entries. [Link] [Link on Amazon] [Speech by Manmohan Singh about it].
  2. Scribner's Encyclopedia of India, edited by Stanley Wolpert (November 2005).
  3. Managing Globalisation: Lessons from India and China, edited by David Kelly, Ramkishen Rajan and Gillian Goh (November 2006). An edited set of papers from the inaugural conference of the Lee Kuan Yew School of Public Policy at the National University of Singapore [Link on Amazon].
  4. Documenting Reforms, edited by S. Narayan, Macmillan India, 2006 [link to an article by him about this].

Thursday, February 22, 2007

How to solve the problem of Uttar Pradesh

Pratap Bhanu Mehta has a article in Indian Express where he says that the way forward, to break the gridlock of UP politics, is to break UP up into three small states. I think there is merit in this approach. In parallel, enlarging the state of Delhi to include NOIDA and Gurgaon would improve urban planning. NOIDA and Gurgaon are already suburbs of Delhi; it is time for this to be recognised in administrative arrangements. In a similar vein, a way to improve electricity distribution in Maharashtra is to enlarge the size of the footprint of BSES, and thus reduce the economic impact of MSEB. This idea works for the other two private distribution companies - Ahmedabad and Calcutta - also. To the extent that territory responds to performance, and is not a jagirdari, this would induce greater pressures to perform.

Wednesday, February 21, 2007

Resource curse - comparing India and Russia

The development literature has long been aware of the `resource curse' where countries with weak institutions are actually hurt, and not helped, by lucrative natural resources. One can't help wonder how the post-1945 history of the Middle East would have shaped up differently if there had been no oil there. On Bloomberg today, there's a nice article by Amity Shlaes comparing the evolution of India as opposed to Russia in the light of the lack of natural resources in India.

The health of the Indian people as opposed to the Indian public health system

In a comment on my posting on `trickle-down economics', Suchi said:

Ajay, It's really very pleasing to see the improvement in health indicators in the third round of the NFHS. It's even more gratifying to be able to attribute the improvement to the high levels of economic growth in India. However, having said that I would also like to point out the lesson that's stored in this correlation for the Ministry of Health and Family Welfare. That is, the urgent need for the MOHFW to strengthen its public health programs.

I thought the lesson that flows from this evidence is the exact opposite.

I think it's important to distinguish between health-system and non-health-system factors that affect health outcomes. Economic growth helps people buy better food, more cleanliness and more education. These non-health-system factors have a huge impact on health outcomes. I think that many people who are in the field of health underestimate the importance of these mundane factors.

Next, we turn to health-system factors. These should be broken up into two groups: inputs purchased from the private sector and inputs obtained from the public sector. There is extensive evidence in India that people who have the choice of going to public sector health facilities choose to pay for private health services instead. The latter, once again, relies on economic growth.

So you have three pieces in the puzzle:

  • Growth gives people the ability to buy food, cleanliness, education;
  • Growth gives people the ability buy private health services;
  • And then there is the public health system, with its own issues in a weak mapping from expenditures to services delivered.

Hence, I become uncomfortable when there is an identity between "the health of the public" and "expenditures on public health systems". Too many people, in my opinion, jump from the view that "it's nice to be healthy" to the view that "the government should spend more on a public sector health system". Similarly, in my opinion, too many people jump from a fact like "the maternal mortality rate went down" to the view "therefore the public health system is performing better". These leaps are not logically sound.

The trickle down effect of India's growth is certainly making it more possible for families to get better health care but, having said that, I would also like to direct our attention towards the millions of people whose health still depends on the effective functioning of the government's public health system.

You say ...our attention towards the millions of people whose health still depends on the effective functioning of the government's public health system. Okay, then let me understand: are you saying that for 85% of India's population, spending on public health programs as presently setup is irrelevant for health outcomes, and the public health system is only important for the 15% poor? That would be a more sound position, but then it again begs the question: are there better ways to spend public money in improving the health of poor people, than running a public sector health system? Maybe the best intervention to improve the health of poor people would be to give them vouchers to buy lunch every day. Maybe the best intervention is to setup a cash transfer system where poor people are paid Rs.X per month by the State and then left free to choose how they want to spread that between food / education / health / clothes / shelter - it may well be that such a strategy will do more for health than the present path.

I work for an organization that has just finished conducting a detailed analysis of maternal and childcare issues in the ten of the least developed districts of India. The data just started rolling in and it only substantiates my point about the pressing need for a better public health system. This is because, we found that while there are now a number of people that have the facilities to get better health services, there are many others that are either not as well informed, or lack the resources to get them. This results in many people turning up at the local government health centers and unless those centers become our first and most effective line of defense, we will not be able to achieve significant improvements in the health sector.

We will be very happy to read your data and the inferences thereof. My sense of the evidence is that there is a continual process of people defecting from public facilities to private facilities - both in education and in health. And when we see poor people showing up at public health facilities, maybe the best answer is 10% GDP growth so that they will soon be able to afford private health facilities. The best thing to do may well be to take Rs.10,000 crore out of the health budget and use it to build roads - this pays for 10,000 km of good quality two lane roads every year, which would surely do more for the health of the population than the existing public health system.

Once again, my main point is that we need to be hard-headed and meticulously rational in arguing our case. Given the poor effectiveness of public health provision in India, given the many forces at work which shape health, we need much more care with the logic and evidence so as to think straight. Speaking for me, the present state of logic and evidence backing the status quo on health in India simply does not persuade.

You say: unless those centers become our first and most effective line of defense, we will not be able to achieve significant improvements in the health sector. But look at the evidence. For the last 40 years atleast, government health centres and hospitals have gotten worse and worse. But in this period, significant improvements have come about in health outcomes. This clearly falsifies the `unless' proposition.

I get very worried when you use the phrase "improvements in the health sector". Are you focused on prosperous health workers or a healthy population? If it's the latter, then you should be saying "improvements in the health of the population" and not "improvements in the health sector".

A few days ago I saw a public sector 10th-standard-pass ANM worker in a village in Rajsamand district in Rajasthan. She is paid Rs.11,000 a month - a bonanza for someone who has only passed the 10th. She has tenure and no incentive whatsoever to do any work since she can never be sacked, and gets her salary regardless of how few patients come to her. She is worse than the quacks that dot the countryside. The quacks are also 10th standard pass, but they don't have tenure and an above-market wage.

Additionally, we will need time to achieve the high levels of economic growth that can usher in a sea change in the health of our population, given our current issues with infrastructure and such. Like you mentioned in your article, people will first have to become rich, and then hopefully, they can get better medical attention. This can take a substantial amount of time to happen. However, the government currently has the resources to bring about a large-scale change in health indicators. Thus, it's important that the Government of India understands the urgency of the issue and makes appropriate amendments to its current public health practices. Your example of the European countries and the improvement in the health of their populations spurred by the high levels of growth in those nations is certainly useful in furthering the cause of greater economic growth in India, but we must realize that their governments have also put in place a strong and more effective public health system. In sum, we should and must appreciate the impact that economic growth is having on the health of our population, but that does not mean that the government can shy away from its responsibility of building a robust public health system.

The European public sector health systems came after high per capita GDP, not before. And, all over Europe, payments to `public sector' health practitioners follow the patients. If customers choose to not come to a certain doctor, the government payments to this doctor do not take place. The European public sector health worker has better incentives to work than the Indian civil-servant health worker. When you advocate a European-style health system, you should be careful to advocate the full package-deal. A close examination of the European public health system is known to induce heightened skepticism in the Indian public health system.

You assert that government has a responsibility to build a robust public health system. Is this an axiom, a political belief? Or is it backed by adequate reasoning? Is a `robust public health system' the means or the end? I think the end should be `a healthy population' and not a `robust public health system'. If we set course for a healthy population, a public health system may play a role, or it may not, and the public health system that actually caters to improved health of the population will surely look very different from the one that we presently have.

I'm all for public expenditures on public goods: which induce benefits which are diffused across the population - like programs on communicable disease. Or, it may be possible for a government to address a market failure in health services - but then the case needs to be made about what is that market failure, why a stated government intervention solves it, why this is the most cost-effective path for the government to proceed, and how it is incentive-compatible. So far, in India, such careful thinking hasn't particularly taken place. I'm very sceptical about the government producing the private goods of perambulatory care as in the WHO PHC framework, and particularly about the inept public health systems that don't translate money into outcomes, and are being abandoned by any citizen who can afford to.

You are asserting that `a robust public health system' is of essence to improving Indian health outcomes. This assertion has not been proven. Maybe we are better off without MOFHW, with lower tax rates, and higher GDP growth. Maybe we are better off without MOFHW, with this spending shifted to building roads, with unchanged tax rates and higher GDP growth. These questions need hard-headed analytical reasoning by health economists. I have not yet seen papers and reports showing such hard-headed analytical foundations supporting what is being done in the public sector in health in India today.

You should be loyal to the health of the people and not to the existing public health system, and demand rigorous logic and evidence: I believe such a path would lead you to very different positions.

Guest book

This is space for comments of a general nature.

Commodity futures are not evil

My column in Business Standard today is about recent calls for a ban on commodity futures trading.

Tuesday, February 13, 2007

Firms losing their national identity; firms in a flurry of M&A

Business Standard has an edit on the evolution of the `firm' as becoming increasingly distinct from nationality:

In the good old days, the identification between a firm and a country was obvious. IBM was an American company through ownership, management team, value added and source of profits, and Sony was Japanese. One of the remarkable features of globalisation is the emergence of a new breed of firms where the one-to-one link between a firm and a country has become increasingly tenuous. The front page of this newspaper yesterday was dominated by stories which reflected this transition.

Does ownership define firm nationality? If so, firms like ICICI Bank and HDFC are not Indian any more. When Reserve Bank policies discriminate against Citibank and favour ICICI Bank, it is worth reminding the RBI that the ownership structures of the two firms are not very different. By the yardstick of ownership, Samsung is not a Korean company and Corus is neither British nor Dutch. The modern multinational corporation has a globally diversified shareholding structure, with owners spread all over the world, and is often listed at multiple locations in different countries. It is not meaningful to link a company to a country through ownership patterns.

Does the location of value added or profit define the firm? In a few years, it is likely that more than half of the profits of Suzuki would be in India, through Maruti, and it would sell more cars in India than it does in Japan—indeed, that may already be the case. Would Suzuki, then, be an Indian company? A series of Indian firms are shifting the focus of their investment overseas, partly in order to exploit the gains of globalisation, and partly to avoid policy difficulties in India such as labour law. If things go right for Tata Steel, the bulk of its business would come from outside India. Would that make Tata Steel a non-Indian firm? The modern MNC produces and sells all over the world; it is not meaningful to link a company to a country through either value added or profit.

That leaves the management team. Intuitively, Samsung is thought of as a Korean company because of a management team—in culture, ethos and style—that is primarily Korean. ICICI Bank is an Indian bank because it has a management team which is primarily Indian. By this yardstick, a lot of companies in the world are turning Indian, because even though they have ownership, value added or profits from all over the world, many of their top managers are of Indian origin. Arun Sarin, CEO of Vodafone, is of Indian origin, as is Indra Nooyi at Pepsi. In all the top 20 global financial firms, key second-level managers are already Indian. In a few years, there will be more Indian CEOs of global financial firms. Conversely, Indian firms are beginning to recruit foreigners—especially the new airlines and some of the hotel companies. In a few years, the top management team of ICICI Bank may not look very different from that of, say, JP Morgan, when it comes to nationality.

The last vestige of the national identity of a firm, today, is the culture, ethos, style and nationality of its management team. One could argue that a German company is very different from an Australian one. By this yardstick, Samsung is a visibly Korean company. But looking forward, this vestige may also be erased. India needs to gear up for this world by supporting a much bigger expatriate presence in the workforce of firms operating in India, and by shedding a sense that “Indian” firms are somehow different. Indian firms are going global; they must now think global.

Update: On 19th February, BS has another interesting edit on the nature of the firm, this time with a focus on corporate control transactions:

The newspapers are filled with tales of acquisitions. Firms, it seems, are spending more time buying businesses than building them. This is great for investment bankers, but is it right for India? In a more placid period, firms were generally controlled by families, and the family visualised running the firm forever. Even if a family was not particularly good at converting the capital and labour of a company into profits, its members tended to hang on. Many times, an acquisition comes about when someone talks sense into the family, that it is better to sell a business when the offered price is bigger than the net present value of the cash flows that might be obtained by keeping it in the family. Such acquisitions are good because they shift productive assets from less competent hands to more competent ones.

A feature of these transactions is the interplay with rupee convertibility. On display now is the full range of transactions—foreign companies buying Indian companies; Indian companies buying foreign companies; control of an Indian company changing hands outside India. These productivity gains through mergers and acquisitions (M&A) would not have been possible if India had not embarked on dismantling capital controls. More needs to be done in terms of removing policy and procedural bottlenecks caused by capital controls.

Also relevant in this context are the remnants of the licence-permit raj: government permission or support is still required for entry into too many areas. Global retailers can’t come into India through the front door, which encourages less qualified teams in India to go into retailing, knowing that in a few years, when the policy environment changes, they will be able to sell to the global firms. Similarly, the RBI does not allow foreign banks enough leeway to do business in India, which generates incentives for them to buy weak Indian banks. The land market in India is so distorted that the best way to be a hotel company in India is to buy a few hotels or an existing hotel company.

Virtually every large global firm faces a choice in India between building and buying. When building is hard—given the entry barriers in India—there is a bias in favour of buying. Such transactions enhance efficiency—it is surely better for India to have a good bank (foreign or Indian) buy up a less well-managed Indian bank. The flow of control transactions steadily erases history: a productive asset may have a certain incompetent owner for historical reasons, but this gets handed over to a more efficient management team. These transactions are healthy for India: they generate GDP growth out of thin air, and ratchet up competitive pressure in one industry after another. As the licence-permit raj breaks down, and entry barriers are removed in sector after sector, such transactions will diminish. Internationally, entry barriers are those created by the market, not by governments, and the make-versus-buy decision tends to be less distorted. Logically, no one should be surprised if there is a bigger M&A/GDP ratio in India than is found in the UK or the US.

`Industrial policy' in action

Modern thinking on economic policy emphasises the dangers of `industrial policy', where a government picks winners, trying to identify industries or firms which will do well. Will the government be able to correctly identify winners? Will the political economy go all wrong, and the government ends up fostering the wrong firms / industries? In recent decades, a pragmatic sense, that has become the consensus view, is that there is no role for `industrial policy'; that a government must just stick to doing public goods.

A while ago, I had written about these issues in the context of a semiconductor fab, where I had criticised many features of the proposed government involvement for SemIndia. Yesterday Business Standard had an editorial that points out that even if you wanted to do industrial policy, the right place to target is IC design and not the fab:

India may be getting excited about domestic semiconductor manufacturing, but there are two analyst reports—from J P Morgan and Gartner—in the last one week which state that the country should not go ahead with chip manufacturing since it’s not economically feasible without a large subsidy from the government. The subsidy that is actually on offer (expected to be 22-25 per cent of project cost) falls short of industry expectations. China, for instance, gave newly-built semiconductor players a 100 per cent tax break for the first five years, and then a 50 per cent discount for the next five years. To get into the business of making chips, India needs to compete with China, Ireland, Israel and Malaysia in this regard.

Why, then, is SemIndia gung-ho about the $3 billion (Rs 13,200 crore) Fab City project? The answer, as has long been argued, is that setting up a semiconductor plant will create a semiconductor “eco-system”, which in turn will help Indian companies move up the global value chain. India’s consumption of electronic equipment is expected to touch $363 billion by 2015, up from $28.2 billion in 2005, at a compound annual growth rate (CAGR) of 30 per cent. Of this, the market for the semiconductor industry is expected to be around $36.3 billion.

But why should any company come to India for manufacturing chips when Taiwan can execute the same work at a fraction of the price? Besides, foundry revenue has slowed the world over due to price competition from new entrants like China. The growth of the “fab-less” industry (comprising companies that do not manufacture silicon wafers, and concentrate instead on the design and development of semiconductor chips) too has slowed. Taiwan captures 65 per cent of worldwide foundry revenue. One daunting point is that the gestation period for a chip-manufacturing plant is around one and a half years, by which time the technology involved could change, something that could leave a new entrant stranded.

Rather, India’s current play with integrated chip (IC) assembly (labelled AMTP to denote assembly, mark, test and package) makes more sense. This requires much lower investment—in the range of $250-400 million. India can also become a powerhouse in chip design. It already has a large and growing pool of experienced IC design engineers, and hundreds of expat engineers are returning to India every year (as happened with Taiwan in the 1980s). India also scores over China in this regard with more engineers, a greater English-speaking workforce and better protection laws for intellectual property. It already has around 125 companies doing design. In 2005, J P Morgan reveals, multinationals like Texas Instrument, Intel, Cypress, Infineon and STMicroelectronics comprised around 70 per cent of the semiconductor design industry in India. The industry’s turnover was $3.2 billion in 2005, with an engineering workforce of around 75,000. Those numbers are expected to reach $43 billion and 780,000 engineers by 2015. This would therefore seem to be the bigger apple to shoot for.

Friday, February 09, 2007

How many people in India are well out of deprivation?

One way to think about poverty and deprivation in India is to focus on the poverty line, and to try to count the people who don't get 2200 calories/day (or $1/day). One problem here is that measurement of poverty is weak. And, even if a lot of people get past this low threshold, it's a hardly satisfactory destination for the Indian development project. Such abysmal consumption is unacceptable in absolute terms, given the technological knowledge possessed in the world today. "Upper middle class" India is poor when placed in the context of the global income distribution.

Another way of thinking of the progress of the Indian development is to turn this upside down, and count the people who have achieved a good quality of life by world standards. I find ownership of a telephone to be an interesting proxy of income and wealth. (a) A person is not going to get a phone if basics like food and clothing are out of reach. Anyone who buys a phone costing Rs.2000 is a potential customer for anything at a price point of Rs.200 or below. (b) Measurement of the number of telephones is a lot better than measurement of poverty from NSS data.

I'm going to do a bit of hand-waving here. Do tell me where you disagree.

  1. Today, we have a data release showing there are now 150 million mobile phones.
  2. The land lines are a bit more than 40 million.
  3. This adds up to 190 million telephones.
  4. Some phones are surely in offices are shouldn't be attributed to households. But these are generally likely to be land lines, of which there are only 40 million. I'm going to assume that half the land lines are at home. Then we have 170 million telephones with households.
  5. Assume there are 5 persons per household.
  6. Assume that among phone-owners, there are 1.5 phones per household.
  7. In this case, there are 566 million people in India who are in a household which has at least one phone.

Hmm, that's interesting - roughly 53% of the population is in a household that is out of deprivation enough to have a phone. So the Indian development project is a bit more than halfway through. If you agree with this approach, then we're making meteoric progress, because the number of phones is simply exploding. There are two effects at work every year: the pdf of income is shifting right, and the vertical line (the price of a phone) is shifting left.

I found it amusing to look back at a piece written by me in 2000 based on a similar idea. The numbers were all picayune then. At the time, there used to be a debate between two views on the Indian income/wealth distribution. There were those who felt that there was a small cream - the top decile - of India which was affluent, and once cellular phones achieved ubiquity in this group, then after that growth would collapse. I was in the other position, where it was felt that as phones got cheaper and incomes rose, there was an enormous upside for telephony - well beyond 10% of the population. In the event, this view pretty much worked out correctly.

These are not just idle discussions about the Indian development project; these perspectives affect planning in the real world also. Imagine if you were a mobile phone company in India when there were 5 million phones out there. Would you have done strategic planning where you were envisioning a market size of 10 million phones in few years? Or would you have understood that in five years the world's biggest GSM tender would happen in India?

Martin Wolf on `enlightenment infrastructure'

Earlier, I had blogged about Will Hutton's important book The Writing on the Wall and a recent development in terms of enlightenment infrastructure taking root in India -- the Supreme Court judgment on the Ninth Schedule of the Constitution. I saw a fascinating review of this book by Martin Wolf in the Financial Times, where he says:

"Will Hutton's ability to articulate contemporary anxieties borders on genius." This remark, cited on the dust-cover of his latest book must be true: I wrote it. The Writing on the Wall is a superb demonstration of my thesis. In writing about the interaction between a rising China and the West, Hutton takes on the most important political and economic story of our time. He has also produced a thought-provoking, wide-ranging and largely correct analysis.

The book advances five fundamental and, in my view, fundamentally correct propositions.

First, for all its manifest achievements, the Chinese attempt to marry a communist party-state with the market is unsustainable. Hutton does not deny the economic achievements of the past three decades. But he stresses that the result has been "not free-market capitalism but Leninist corporatism". This is not a viable new model, but an ultimately dysfunctional hybrid.

The inevitable consequences include rampant corruption, an absence of globally competitive Chinese companies, chronic waste of resources, rampant environmental degradation and soaring inequality. Above all, the monopoly over power of an ideologically bankrupt communist party is inconsistent with the pluralism of opinion, security of property and vibrant competition on which a dynamic economy depends. As a result, Chinese development remains parasitic on know-how and institutions developed elsewhere.

Second, "the Chinese economy and the Chinese Communist Party are in an unstable halfway house." The latter is "a post-revolutionary party running a post-revolutionary society and an economy in transition to a form of capitalism". Sooner rather than later, the party's monopoly of power must end. Indeed, "all that stands between [the party] and its own demise is its capacity to deliver economic growth and its control of the army and the police."

If the party does not accept reform voluntarily, economic trouble is inevitable. Should the economy indeed falter, a politically unstable or, worse, assertively nationalistic China might emerge, which would pose grave dangers to the world. But political transition is itself risky, as the Chinese instability of the 20th century proves. China has a tiger by the tail: that tiger, of course, is itself.

Third, coping with China's evolution and encouraging it in an internationally co-operative and domestically pluralistic direction will be a huge challenge for western statesmanship. Hitherto, happily, the US has not merely accommodated China's rise but encouraged it, with successful consequences for both sides.

Unfortunately, adverse economic, political and ideological changes are undermining the willingness of the US to persist with these wise policies. Rising inequality and a growing sense of economic insecurity are reinforcing long-standing protectionist attitudes, the Democratic party now being almost entirely in that camp. Meanwhile, the rise of the religious right, of strident nationalism and of assertive unilateralism are leading to more confrontational attitudes towards a country that is not merely a potential rival, but is also ideologically alien.

Fourth, "it is," as Hutton remarks, "a truth universally acknowledged that a great power will never voluntarily surrender pride of place to a challenger." Yet that fundamental source of friction, described almost two and a half millennia ago by the Athenian historian Thucydides, is far from the only one. Objective sources of conflict also exist.

China's mercantilism or, more neutrally, its vast current account surplus and soaring foreign currency reserves is among these. Competition for valuable resources, above all oil, is a second. Taiwan is a third. China's search for supremacy in east Asia and influence in the rest of the world is a fourth. The combination of a more nationalist China with an assertive US could well lead to a breakdown in international order as dangerous as that of the first half of the 20th century.

Finally, argues Hutton, only if China and the US appreciate the enlightenment values of reason, pluralism, freedom and equality can these dangers be managed both domestically and through international co-operation. In the 20th century China succumbed to the west's bastard intellectual child, Marxism. It is impossible, however, to create a modern society that does not recognise the enlightenment's greatest truths: the case for a variety of competing institutions, for freedom of thought and expression, and for a legal system that curbs the executive. Somehow, China must graft these shoots on to its native Confucian stock.

Taiwan and Korea are two great role models for China : they are countries which started out with pretty gruesome authoritarian governments, but managed to make the transition into freedom and democracy. By the 1980s, these two countries were in the virtuous cycle of `enlightnment infrastructure' feeding economic growth and vice versa, and they add up to a great success story of the `Capitalism and Freedom' thesis. There was a huge welfare cost for the generations which lived with brutality, but in a generation or two, these two countries got out of it. But then, neither of these countries had the equivalent of a Chinese Communist Party, and the depth of its demand for perpetual political control of the country. In this respect, the CCP has been in charge from 1949-2007 and as yet shows no signs of fading away.

Hard work in store on tax exemptions

The Indian tax system has made enormous progress. Rate dispersion has come down; peak rates have come down; distortionary taxation has diminished. The political economy of businessmen pleading for tweaking the tax code in ways that suit one firm or the other is diminished. All these good things are true when you think of the big picture: things have improved dramatically. But in absolute terms, we are still far away from a rational tax system. The normative goal involves three things: (a) a single rate for all goods and services, (b) a single rate customs tariff for all goods and services and (c) the single rate of customs should be zero. Sukumar Mukhopadyay has recently done a great job of reminding us how much work is in store to get to this happy destination.

Wednesday, February 07, 2007

Pension provisions for the unorganised sector

Mukul Asher has an article in DNA on `micro-pensions', and Gautam Bhardwaj debates K. P. Kannan on the proposed `Unorganised Sector Social Security Bill' in Business Standard. I think the space that ought to have been filled by the New Pension System will get taken up by various wonky ideas, such as this `Unorganised Sector Social Security Bill', if there are continued delays on NPS implementation.

Inflation control

My column in Business Standard today is titled Inflation control. It is on the themes of why low inflation matters; what are the tradeoffs between GDP growth and inflation growth; the ban-milk-exports style of inflation control; monetary policy as the right path to achieving low and predictable inflation.

I am fascinated by the commitment of the Indian political system to low inflation. A de jure inflation targeting system can only, in the final analysis, be successful when it has such political foundations of support: when there are already glimmers of a de facto inflation target. Inflation has got to be important enough that politicians choose to give up other possible uses of monetary policy; my sense is that India does have this kind of passion about low inflation.

Monday, February 05, 2007

Banning commodity futures trading

Mobis Philipose and Pooja Meswani have an excellent article in Business World (link, but use this permalink) on the banning of futures trading on urad and tur (announced on 23 Jan and effective from 24 Jan). Ila Patnaik wrote about this in Indian Express a short while ago. For a sense of how one politician sees it, there was a fascinating piece in Business Standard by Deepender Singh Hooda (a Congress MP), where he takes support from Steve Levitt and the World Bank in saying there should be a ban on commodity futures trading:

Steven D Levitt's Freakonomics establishes an unconventional premise: if morality represents how we would like the world to work, then economics represents how it actually works. The crusade to promote futures trading in the name of the farmers interest began in India after the 1993 Kabra committees cautious recommendations, and gained momentum in 1998 with a World Bank-funded grant directed at reforming exchanges. Later, all the caution was thrown to the winds in the NDA budget of 2002-03, when the then FM announced expansion of futures and forward trading to cover all agricultural commodities.

Since 2002-03 we've seen unrestricted entry of speculative capital in futures trade in agricultural commodities. The total value of commodities futures traded in 2002-03 was Rs 100,000 crore, which increased to about Rs 22,00,000 crore in 2005-06. The farmers haven't gained through this, consumers have had to pay a lot more. Only middlemen and traders have benefitted.

Theoretically, such markets provide farmers, traders and processors a mechanism for hedging their risks and improving price discovery in their forward planning decisions. The classic application helps a farmer who is planting in November to know the price at which his produce will be sold at Baisakhi so that he may incur appropriate farming input costs.

While this agro-liberal utopia would work if we had a "perfectly free market" for our agro-products, that is neither true at the moment nor desirable. A free market would have: (1) No government intervention in setting procurement price floors (we have a strong MSP regime); (2) No or little governmental procurement at a pre-determined fixed prices (we have a substantial PDS); (3) Physical spot markets should not lag much behind the futures markets; (4) Government interventions should not restrict the normal flow of commodities (like between states), and so on.

Indeed, even a World Bank and UNCTAD study (Managing Price Risks in India's Liberalised Agriculture: Can Futures Markets Help?) had concluded that futures trading for commodities such as sugar, non-basmati rice and wheat are "non-viable" in India unless some of the market ground rules are changed.

Take the case of maize in Andhra where the MSP was announced at Rs 540 last season. The maximum reported price that farmers could secure was about Rs 600 whereas the futures trade was at around Rs 850. The early announcement of MSP here had increased the expectations of farmers who were happy to pre-sell their produce at a marginally higher price than the MSP to the middlemen who built their stocks under a pre-fabricated illusion of a negative supply-demand gap, which in turn led to higher prices for reselling and for consumers. The story on wheat is all too well known. Last year we saw big private companies cornering huge wheat stockpiles in the name of helping farmers get good prices (slightly above the MSP), and then prices hitting the end consumers hard (much above the MSP), and finally we ended up paying foreign traders up to Rs 400 more per quintal than what we paid to Indian farmers. The Haryana chief minister recently apprised the prime minister of an expected record-high wheat production this Baisakhi. Our farmers have responded astoundingly well to the demand pressures through their grit and toil. But even as you read this, the Cargills of the world are again securing their wheat stockpiles on account of forward trading while the Food Corporation of India's PDS stocks are awaiting the spring spot market MSP procurement. The bumper crop expectation should point to mild inflation for our consumers in the months ahead. But I'm afraid we should expect the opposite this summer, as the futures of our farmers and consumers have been forward traded already!

The "freakonomical" moral of the story: lets get rid of the current futures trading model for the essential commodities that have a propensity for undesirable exploitation in the current restricted agro-market reality and think of another model of forward trading thats suitable to the Indian MSP-PDS agro-regime that actually helps our farmer.

Steve Levitt should be proud that he has mind share amongst MPs in India!

Business Standard did an editorial today refuting Mr. Hooda:

Deepender Singh Hooda recently argued in a Business Standard debate that a genuine free market for the underlying commodity is a pre-condition for futures trading. He argues that since such a genuine free market is neither desirable nor prevalent, commodity futures trading should be banned. He is wrong, and this can be shown in two ways.

Proof by existence: crude oil. There is a powerful cartel (the Organisation of Petroleum Exporting Countries) which exerts the mighty energies of many governments in manipulating crude oil prices. Opec interferes with the global crude oil market far more effectively than the Government of India is able to do with most commodities. Yet, that has not changed even slightly the case for futures trading in crude oil. Energy futures trading at NYMEX (in New York) and IPE (in London) is highly successful. Every Indian firm which buys or sells crude oil suffers from risk owing to fluctuations of global crude oil prices, and it ought to be doing futures and options trading on NYMEX or IPE in order to manage this risk.

If someone plans to buy wheat at a future date, he suffers from price risk because the price of wheat is not certain. This fact holds regardless of why the price of wheat might change. It might respond to genuine market forces, or it might be responding to the manipulation of a government. The reasons do not matter; the fact remains that if a buyer of wheat is unsure of the wheat price next month, he is better off obtaining a locked-in price for a wheat purchase next month. This holds regardless of whether the wheat spot market is a genuine free market or not. It might be argued that someone operating in a futures market could exploit control of an imperfect or thin spot market, but that would be a fit case for the market regulator to get into.

Similarly, a speculator forecasts the price of wheat or crude oil next month. Whether the spot market is a vibrant free market, or it is vibrantly manipulated by a government, the fact remains that if a speculator predicts that the price will go up and adopts a buy position, and then the price does go up, the speculator makes a profit. The arithmetic of futures trading works whether the spot market is genuine or manipulated by a government.

The deeper reason why futures trading is extremely important lies in a strategic sense of Indian agriculture. Where is India going on the terrible distortions of the agricultural sector? Is India ever going to move away from the knee-jerk responses of hurting milk farmers one day by banning milk export, and then trying to set up a minimum support price for milk because milk farmers are unhappy? If India is going to make progress towards a well-functioning agricultural sector, then there is no question that futures trading belongs in it. Futures trading is as much a part of modern agriculture as fertilisers, drip irrigation and bio-technology.

Mr Hooda is not alone in his views. The political and bureaucratic establishment that deals with agriculture is deeply steeped in the mindset of a government that prevents agricultural markets from functioning. For this reason -- if not for any other -- the regulation of commodity futures trading needs to be moved to the Ministry of Finance, merging it with all organised financial trading, as is the case with all other mature market economies.

Friday, February 02, 2007

Who pays for inflation control?

Hapless milk farmers

Inflation has accelerated sharply and the UPA now truly wants to get a grip on it. Today I saw this news item:

The government on Thursday banned exports of milk products until the end of September, the country's finance minister said.

"Considering the milk situation the cabinet has decided to ban export of milk products till September 30, 2007," Palaniappan Chidambaram told reporters.

Prices of milk products have been rising due to supply shortages. Rising inflation has forced the government to adopt a variety of measures in recent weeks targetting widely consumed items.

I am very happy when a government gets anxious about inflation. I have always been disappointed by RBI statements that (WPI) inflation of 5 to 5.5 percent is acceptable. This is a very high inflation rate, in my book.

But one does have to think carefully about how low inflation might be achieved. I find it useful to think of this situation in terms of the question: Who pays for slowing down inflation?. If low and predictable inflation is a public good, and everyone benefits from lower inflation, it appears unfair that milk producers should have to bear a disproportionate part of the cost of inflation reduction. If someone outside the country is willing to buy milk powder at a price higher than the local price of milk powder, it is not fair for a government to interfere in the transaction and prevent a higher revenue stream reaching the milk powder producer.

Inflation control through monetary policy vs. inflation control through interference in commodity markets

This links up to the debate about how to control inflation. The nicest way to get a grip of inflation is to use monetary policy. Raising interest rates, gently by 25 bps at a time, touches the pockets of borrowers all across the country, pulls in aggregate demand, and gets inflation under control. We need to do more in terms of placing the full and exclusive responsibility for inflation upon a Monetary Authority. It needs to be independent in pursuing an inflation target, and be held accountable for achieving this target.

The incidence of inflation control efforts should be dispersed all across the economy. It is unfair if there is a disproportionate incidence on a few households. Inflation control through monetary policy achieves the former, while inflation control by going after supply side issues - the old Indian way of dealing with inflation - involves the latter.

Should we be skeptical about inflation measures which include food?

It is often argued that food prices should be viewed differently when it comes to inflation and monetary policy, for two reasons: (1) Food prices are inherently volatile and should (in any case) be removed from an overall inflation measure in computing `core inflation'; (2) Food prices are highly distorted by the government. This is one criticism of the CPI - that it has a significant weight of food, while the WPI does not.

On the issue of price volatility, I respect the idea of core inflation, but I would not lose sight of the fact that ultimately inflation is about the GDP deflator, and in a country where food is a big part of the consumption basket, we should tread cautiously in removing food from an inflation measure. The price of food is important in affecting the value of the rupee in the eyes of a lot of households. There is no wishing away that problem.

On the issue of government distortions, I quite agree that on things like wheat, the government is prominent in price formation, and hence these commodities should be removed in thinking about inflation. As an aside, I may add that when there is a hint of inflation in the air, the government does all it can to avoid raising these prices, so removing them from inflation measurement at a time like this will probably yield a higher measured inflation.

My basic point is that the market for milk is actually quite a nice and normal free market. There are millions of atomic producers and millions of atomic buyers, none of whom possess market power. Milk is a sensible part of the market economy (as long as the government doesn't get into banning exports). I see no reason why the ordinary processes of the market economy do not apply for milk where there is little or no government involvement and prices are formed on a competitive market. It may sound cruel, but homeowners with floating rate loans do buy less rasmalai when interest rates drive up their EMI, and that's a perfectly sensible mechanism for monetary transmission from higher interest rates to lowered milk prices.

For an increasing part of the food that's purchased by households, there is little or no government manipulation of the price. This includes milk, eggs, meat, vegetables, fruit, some grain, some oilseeds, etc. These prices are coming out of a nice Walrasian market. When these prices go up, we should interpret this as inflation, and use monetary policy to combat it.

Thursday, February 01, 2007

Maharashtra vs. Gujarat on cotton and farmer suicide

I have written earlier about the problem of farmer suicide. Today, Sanjeev Nayyar has a fascinating piece in Business Standard comparing and contrasting Gujarat and Maharashtra on cotton. There appears to be a significant incidence of suicide amongst cotton farmers in Maharashtra, but not in Gujarat. Why?

Both states accounted for roughly the same proportion of the country's production in 1991-92 (Gujarat was 12.7 per cent and Maharashtra was 10.5 per cent). While Maharashtra's share has increased only marginally in the period since, to 14.8 per cent in 2005-06, Gujarat's share is up three times, to 36.5 per cent; Maharashtra's area under cotton has grown just marginally, Gujarat's has nearly doubled; and Gujarat's yield is more than three times that of Maharashtra.

What went wrong is a classic story of how sops do little but bankrupt the exchequer and, at the same time, make the beneficiary so weak, he/she becomes uncompetitive. In 1971, when nationalisation was the flavour, Maharashtra launched the Cotton Monopoly Scheme (CMS) with the avowed aim to capture the whole economic value for the farmer, from growing cotton to selling finished cloth. It proposed to do this by helping farmers get a fair price for their produce, make available unadulterated cotton to consumers at reasonable prices, produce textiles and distribute bonus (profit on operations) to farmers. Therefore, the CMS allowed politicians to control the states cotton industry.


Under the scheme, cotton could be procured only by the state-owned Maharashtra State Co-operative Cotton Growers Marketing Federation Ltd (MSC). Farmers were to be given a bonus for the cotton they sold, but cotton produced in the state had to be pressed within the state only. On the face of it a good thing, this had four consequences.

One, since each cotton procurement area was managed by a grader, this functionary became a big power centre, extracting bribes from farmers according to one ex-MSC official, graders commanded the highest dowry in their villages! Second, since the state had to procure the cotton, and bribes had to be paid to the grader, there was no real incentive to produce better cotton. Third, as the state had financial difficulties sustaining over-payments to farmers, the payments were delayed and, a few years ago, just stopped. Four, since till 1999-00, private sector units had to obtain a license to set up ginning and processing, entrepreneurs began setting up units in border towns in adjoining states, such as Burhanpur in Madhya Pradesh cotton began to be sent out of the state illegally and value addition took place outside the state.


In neighbouring Gujarat, in contrast, a combination of factors ensured production increased. First, unlike Maharashtra, Gujarat didn't waste money on monopoly procurement and chose to invest it in creating irrigation. Over 40 per cent of cultivable land in Gujarat is irrigated as compared to just 3 per cent in Maharashtra. Also water levels across the state have gone up due to large-scale rain water harvesting by the construction of thousands of check dams. Instead of the Rs 6,000 crore or so that were wasted on CMS, the Maharashtra government could instead have constructed 100 Kolhapur-type Bandhara dam (medium type dam) at a cost of Rs 60 crore each this would have irrigated 25 lakh acres or 33 per cent of area under cotton cultivation. Indeed, in 1999-2000, both NABARD and the ministry of agriculture contributed Rs 100 crore each to create a Watershed Development Fund across the country of the corpus of Rs 579 crore, only Rs 30 crore has been disbursed.

Gujarat also created its own brand, Shanker6, and entrepreneurial farmers took faster to using Bt cotton to reduce costs. While around 40 per cent of Maharashtra's cotton farmers use Bt seeds, according to industry sources, around 80 per cent of the area cultivated in Gujarat is with Bt cotton. According to an IIM Ahmedabad study, this increases yields in irrigated areas by 35 per cent in Gujarat (48 per cent in Maharashtra) and profits by as much as 75 per cent in Gujarat (58 per cent in Maharashtra) Gujarati farmers sell a better variety of Bt cotton and are able to realise a higher price as well. The same study took a sample across Maharashtra, Gujarat and Andhra and found a 24 per cent reduction in pesticide cost. It found that the Gujarati farmer spends Rs 4,649 per hectare on fertilizer versus Rs 7,116 in Maharashtra (with respect to Bt cotton).

There are other critical areas like rural credit where the government needs to act since it is clear the current system is not working (the accumulated losses of all co-operative banks till 2002-03 was Rs 9,277 crore). The state would do well to take lessons from the Cotton Corporation of India (CCI), which is the equivalent of Maharashtras MSC.

CCI administers the Cotton Technology Mission. As part of the mission it provides ginning and processing units a subsidy of 25 per cent of their modernisation cost (upto a maximum of Rs 12.5 lakh). It also conducts demonstrations on production technology whereby it demonstrates to farmers how cotton should be cultivated on one acre plots and holds farmer field schools and kisan melas. It has started contract farming in Vidharbha. An informal association of farmers represented by select farmers sign a tripartite MoU with CCI and the textile mill. While various structures exist, the general model is that the mill provides farmers with inputs, conducts demonstrations and agrees to buy produce at a premium of 5-10 per cent of prevailing market price. This way the farmer focuses on production and quality, and the mill is assured of pure unmixed cotton.

Book review of Privatising China by Walter and Howie

Privatising China by Carl Walter and Fraser Howie: A review. This appeared in Business Standard on 31 January.

One of the many mysteries about China is the dichotomy between a booming economy and a malperforming stock market. Walter and Howie have written a fascinating book which helps us understand what is going on inside China's stock markets.

The first piece of the puzzle lies in the distinction between the Chinese economy and Chinese firms. China has done three key things right: they have good infrastructure, they have a proper national VAT and they have good labour law. Through this, China is an ideal destination for global corporations seeking to place factories. In China, this global economy is booming. This MNC activity has nothing to do with the Chinese stock market.

The second important distinction is between the onshore and offshore markets. The existence of Hong Kong has given China a quantum leap forward in the construction of a modern market economy. Hong Kong was immune to Chinese socialism, and governed by British law all along. To make an analogy, suppose Surat was ruled by the British after 1947. Through this, suppose Surat had escaped the ravages of socialism, had capital account convertibility, lacked a license-permit raj in finance, etc. Then Surat today would have been an international financial centre with top quality markets and knowledge. That is what China has in Hong Kong. China does not really need to create exchanges that trade the spot and derivatives markets because it already has them in Hong Kong. The entire story of Shanghai and Shenzen summarises to only one thing: that these exchanges do not hold a candle to Hong Kong.

If China has a world class financial centre in Hong Kong, then what is the problem with the Chinese stock market? The problem lies in the legal entity called "the corporation". Under socialism, there was no such thing as a firm; everything was a part of the State. To make an Indian analogy, recall the Department of Telecommunications. All Chinese production was organised like that. In India's case, when the time came to corporatise and privatise DOT, it was possible to shift the operations of DOT into the legal entities called limited liability corporations - MTNL, BSNL and VSNL. This was possible because India always had company law and now has centuries of experience with the idea of a firm. This idea is not yet clear in Chinese law.

What the Chinese have done is to carve up something like DOT into multiple sets of assets and liabilities. This has resulted in multiple classes of shares which trade separately. The legal rights of these distinct classes have not been adequately clarified, and they trade separately at very different prices. Because they are distinct legal rights, they are not fungible and these distinct prices cannot be arbitraged. It is not like Indian firms listed on NSE/BSE/NYSE where the securities are essentially identical.

In India, we also have problems associated with the notion of the firm. We have a good situation on the basic notion of equity; we have difficulties on corporate governance and we have a bad situation on the concept of debt. In China's case, the problems are much more acute and basic. The very foundation of a firm as a single financial unit does not exist.

The overall flavour of the Chinese equity market is one where the State has obtained some financing by doing a little disinvestment in a SOEs. Roughly 75% of the listed firms are such partly disinvested SOEs.

From the viewpoint of a foreign investor, the Chinese market is a forbidding one, with these deep problems afflicting the notion of a firm, difficulties with exchanges, trading and regulation, and a overbearing role of the State.

Walter and Howie have done an excellent job of painting a picture of what is going on in China. From an Indian perspective, it is a call to arms to focus on the core business of becoming a mature market economy: that of establishing sound legal and institutional frameworks. In the case of firms, the biggest piece lacking in India today is a bankruptcy code. What happens when a firm fails to repay a bond or a loan in a mature market economy? A swift procedure ensures full legal clarity on the next steps: the firm is taken over by a court-appointed receiver and auctioned off; using the proceeds, the bondholders are paid and finally if there is anything left over it goes to the shareholders. The whole thing ought to take less than six months. India has as much of a mess on this question as the Chinese have a mess on the notion of firm equity.