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Saturday, March 31, 2007

Procurement of fund managers through auctions

Ashish Aggarwal of Invest India Economic Foundation has a great story in Business Standard about how fund management under Indian conditions can be remarkably cheap [link], reporting on recent developments that validate the design decisions of the New Pension System:

How much does pension fund management have to cost? The mutual fund industry has been emphasising fees ranging from one to 1.5 percent of assets under management (AUM) per year. The insurance industry is used to even bigger numbers.

In 1999, the OASIS Committee set up by the Ministry of Social Justice and Empowerment had talked about numbers of 0.2 percent and below for the New Pension System (NPS), which could be obtained using an auction for procurement and using index funds. These numbers have been roundly criticised by mutual funds and insurance companies as being completely unrealistic and lacking in common sense.

A remarkable recent development shows the possibilities for low cost fund management under Indian conditions. The Coal Mines Provident Fund Organisation (CMPFO) recently conducted an auction to pick fund managers for assets of Rs 20,000 crore ($4.6 billion). ICICI Securities and SBI quoted the lowest price of 0.01 per cent, in a competitive field containing HDFC Bank, UTI Bank, SBI Mutual Fund, IDBI Bank, IDBI Capital and Franklin Templeton. The CMPFO obtained a five-fold reduction in fees for fund management owing to this auction.

The result of this auction validates the approach of the NPS in targeting very low prices for fund management, through procurement by auction. Under Indian conditions, the cost of fund management which involves skilled labour is lower than the numbers found in the West. For a benchmark, the US civil servants pension, the Thrift Savings Plan (TSP), also uses an auction for recruitment of the fund manager for a fund of $186 billion. The winning bids in the most recent selection were from Barclays Global, for fees ranging from 0.02 per cent to 0.08 per cent of AUM per year depending on the asset class. The experiences of the US civil servants pension are, thus, quite meaningful in thinking about the New Pension System in India, even though the size of NPS assets are tiny when compared to $186 billion.

CMPFO is a legislated fund under the Ministry of Coal. This highlights the fact that it is not just private sector treasuries which can drive such deals. The Employee Provident Fund Organisation (EPFO) which pays SBI less than 0.02 per cent is another example of competitive fees in a public sector setting.

Why are fees much lower with the US TSP, or the Indian CMPFO or EPFO, when compared with the gigantic charges of Indian mutual funds and insurance companies? The essential point is that bulk fund management is highly cost efficient. Mutual funds and life insurers pay large commissions to agents to get customers and then spend even larger amounts in trying to retain them through their marketing and advertisement budgets. They also have to spend a significant amount in servicing retail customers. Fund managers fees are drastically lower when the burden of an expensive distribution model and a large number of retail customers is taken out of the picture.

... As with the NPS, the TSP achieves dramatically low costs through the centralisation of record keeping and the elimination of the conventional sales practices of fund managers.

Retail mutual funds in India, on the other hand, incur an annual expense ratio of 2-2.5 per cent. Then there is the entry and exit load over and above this. Recent offer documents filed by the mutual funds indicate that about half of the 2.5 per cent fee is for fund management. The highest costs for fund management in India are found with insurance companies: they levy upto 50-60 per cent of the first year contribution in unit linked pension plan as charges. Only after the third year, do the charges recede below double digits. The high fee does not result in any special fund management services as it is largely paid out to the sales agents.

Such high prices are not in the interests of consumers. In policy discussions about pensions, it is emphasised that on a 30-year horizon, a 1 percentage point improvement in the rate of return generates a 30 per cent improvement in the terminal pension wealth. Equally, a 1 percentage point increase in the fees and expenses charged to the customer generates a 30 per cent reduction in the terminal pension wealth. Good policy making in pensions is as much about the shift to equity and corporate bonds so as to increase the rate of return as about the organisational ideas of the NPS which would drive down the fees and expenses paid by the participants.

These expenditures reflect an inefficient organisation of the industry, and are eliminated by the NPS. The cost function for a fund manager under an NPS-like situation is very different. For example, the fund manager does not have to invest in fund collection infrastructure. He would get the investment funds daily through a single cheque from an agency to be called the Central Record keeping Agency (CRA) and would be required to invest the funds as per the specified investment pattern under each of the available schemes. Further, there is no complicated stock picking to be done as the fund manager would largely track benchmark equity indices.

Further, the fund manager under the NPS would not be required to service the customers as that would be taken care of by the Point of Service (POS). In case of civil servants, the POS is the government itself. Once private sector POSs are envisaged, they would be working on behalf of the customers and not on behalf of the fund managers. This could reduce the practice of distributors churning customers from one fund to another simply to get higher commissions. The fund manager would only be managing funds and even that would not require complex investment decisions as largely only passive investing in equity is contemplated.

Passive equity investment is the reason that even retail oriented Index or Exchange Traded Funds (ETFs) which track specific indices have a relatively low expense ratio compared to other equity mutual funds. For instance, UTIs Sundar ETF has an expense ratio of 0.5 per cent. Benchmark AMC charges an expense of about 0.41 per cent of the assets for its ETF Nifty BeES.

The charges could have been even lower if the fund AUM was larger than the Rs 140 crore ($35.25 million) that is managed under BeES.

The current commission costs for mutual funds agents are high because of structural problems in the distribution model of the mutual fund industry. In their case, the high commissions are paid not to grow the market and get new customers but to steal customers from other mutual funds or insurance companies. The NPS attempts to align the interests of the POPs to the customers.

The NPS represents a fundamental business process reengineering of the fund management industry, one that eliminates the huge payments being made to mutual fund agents and insurance agents. The CMPFO experience proves that an auction-based procurement for fund management for NPS will be able to deliver extremely low prices of 0.1 per cent or below in order to do bulk fund management.

Wednesday, March 28, 2007

Reforming the `universal services obligation' in Indian telecom

For many decades, telecom policy in India was distorted based on two excuses: the need to utilise this lever of power to "help poor people" and the need to "protect national security". What was really going on was the capture of an area of the Indian economy by the Department of Telecommunications, which was policy maker, regulator and service provider, all rolled into one. If you wanted to start a mobile telephone company, you had to come to DOT for permission, and they would say no. Extravagrant claims were made about systemic stability and the interests of poor people, in order to defend an entrenched status quo.

One of the singular achievements of the late 1990s was the political capital that was deployed at taking on DOT and breaking this monopoly. I don't think anything has happened to national security, and the results were miraculous for poor people. Decontrol, competition and the entry of private + foreign companies has done more for the interests of poor people than decades of socialism did.

That left the `Universal Services Obligation', a tax which has to be paid by all telephone companies in order to support telephony for poor people. I have previously argued that such taxation is unfair: if the government wants to run such a program, it must do so on-budget and not by charging an excise on just one sector. The income tax and the GST are the most efficient taxes; it is distortionary to have any other tax which penalises any one industry.

Earlier, USO was a cost-plus scheme where telephone companies were reimbursed absurdly high "costs" associated with placing a telephone in a village. Today Business Standard has a great edit about the benefits of shifting USO to an auction based and technology-neutral system:

Less than five months after the government amended the law to allow the Universal Service Obligation (USO) Fund to be used for subsidising even mobile phones and broadband services in the rural areas, the results are there for all to see. Mobile phone firms have come up with bids that ask for a subsidy that is a fraction of the benchmark price. In the case of Cluster 1, for instance, a benchmark price of Rs 394,967 had been set as the cost of building a mobile phone tower from which rural mobiles would be serviced; against that, the winning bid from GTL Infrastructure is for Rs 197,484. In the case of Cluster 10, to take another example, the benchmark price was Rs 423,860 while BSNL has won the bid by asking for a subsidy of just Rs 80,222. As for the other part of the subsidy (required for the electronics on the tower), most bidders have said they dont want itthat is, with the cost of the physical towers having been met, they are confident that they have a business model that can provide phones to rural India at costs low enough to bring in sufficient demand. Admittedly, this does not mean that the rural telephony model is robust enough to do away with subsidies altogether, but the heartening point is that the level of subsidy required has come down dramatically. It is reasonable, therefore, to expect a surge in rural telephony, with the attendant gains in connectivity and productivity that can be expected to follow when this happens.

Contrast this with the earlier situation in which the USO Fund was available only for fixed-line phones. This was exorbitantly costlythe Telecom Regulatory Authority of India (Trai) had estimated in 2005 that this model would need nothing less than Rs 30,457 crore by 2010 to set up all of 28 million rural phones, thereby reaching the rural tele-density target of a modest 4 per cent. Those numbers were forbidding, and that is when Trai came up with the model of subsidising the tower, which would service more users at a fraction of the cost. The other negative aspect of the earlier model was that, since fixed lines require physical digging and laying individual lines, progress was slow. Of the Rs 14,000-odd crore that will be collected by month-end through the five-year-old USO levy on phone services, just Rs 4,500 crore is expected to be spent! Since setting up mobile phones is faster, such backlogs can now be tackled.

The lesson this holds with regard to government subsidies in general should be obvious, namely that it is unwise to get married to particular technologies or policy prescriptionsif a new or different technology or method provides the same result, it should be adopted. To extend the logic to the education sector, for instance, if privately-run schools can ensure the same or a high quality of education as compared to government-run schools, channelling subsidies to private schools is clearly a good idea. The other lesson is that it pays to try and work through the market. Instead of fixing a subsidy based on normative cost, potential service providers should be asked to do a reverse-bid on what they require to provide the same servicethis is the only way to bring into play those efficiencies that are normally associated with free markets.

Developments in the world economy and in the Indian economy

The world economy

Larry Summers has a piece on the 25 March titled As America falters, policymakers must look ahead in the Financial Times [link + excellent discussion] where he says:

Three months ago I was able to write in this space that in economics the main thing we have to fear is the lack of fear itself. This is no longer true today. With clear evidence of a crisis in the subprime US housing sector, risks of its spread to other credit markets, sharp increases in market volatility, reminders of the fragility of global carry trades and signs of slowing economic growth, there is enough apprehension to go around.

While it would be premature to predict a US recession, there are now strong grounds for predicting that the US economy will slow down very significantly in 2007. Whether in retrospect 2007 will prove to have been a pause that refreshed a nearly decade-long expansion like the growth slowdowns in 1986 and 1995 or whether it will see the end of the expansion is not yet clear.

It is clear though that the global economy has been relying on the US as an importer of last resort; that the US economy has been relying on the consumer for its primary impetus; and that until now consumers have been encouraged to spend their incomes fully or more than fully by being able to access the wealth in their homes.

This growth syllogism has appeared fragile for some time, but has continued longer than many observers expected as US consumers have kept spending even after it was clear that the housing market had peaked and foreigners particularly those in the official sector in Asia and the Middle East have been willing to continue financing, on very attractive terms, the US in importing nearly 70 per cent more than it exports.

But the growth syllogism is now in doubt. Recent developments in the subprime sector exacerbate housings brake on US economic growth. Foreclosures will bloat the supply overhang of houses. At the same time reductions in capital in the housing finance sector and more rigorous credit standards will reduce the demand for new homes. Even as these developments reduce housing prices and the construction of new houses, housing finance problems are likely to magnify wealth effects on consumption as consumers face upward resets on their mortgage rates and are unable to refinance as they had planned, and as home equity, car and credit card lending conditions tighten.

If consumer spending declines and interest rates fall or appear likely to fall, there is the real possibility that the foreign lending to the US that has financed imports far in excess of exports will start to dry up, leading to a combination of higher long-term interest rates and a weaker dollar. This would tend to raise inflationary pressures, transmit US weakness to the rest of the world and could, by discouraging foreign demand for US assets, lead to further downward pressure on investment in plant, equipment and commercial real estate.

How should economic policy respond to a potential fall-off in US demand? The great irony is that just as the worst investment decisions are made by those who do today what they wish they had done yesterday buying assets that have already risen and selling those that have just lost their value so also the worst economic policy decisions are made by policymakers who, instead of responding to current circumstances, seek to rectify past mistakes.

It would have been desirable if policymakers had done more to restrain imprudent subprime lending to households with dubious credit in recent years. But with the sector littered with bankruptcies, this is not todays problem. The problem is the opposite: to avoid a vicious cycle of foreclosures, declining property values, reduced consumption demand, rising unemployment, more delinquencies and more foreclosures.

Some argue that the Federal Reserve should have started tightening monetary policy earlier in the current cycle and avoided what they see as liquidity-driven bubbles. Regardless of the merits of this position, the theory that this constitutes a reason to avoid easing monetary policy, come what may, hardly follows. If, as may prove the case, the dominant economic concern becomes a shortage of demand, it is incumbent on the Fed to provide stimulus so as to maintain conditions for growth and financial stability.

Those in the rest of the world who have been insisting on the global imperative of increased US saving and a reduced US current account deficit should fear getting what they want too quickly. So also should those US observers who have insisted that foreign countries stop artificially holding their currencies down by purchasing dollar assets. While US current account adjustment is a medium-term imperative, an effort to bring it about rapidly in the face of an already declining economy could turn a soft landing into a hard one.

Similar principles can be extended to almost every macroeconomic policy area from fiscal policy to financial regulation. Good economic policies operate counter-cyclically, slowing booms and mitigating downturns. It follows that when the dominant risk changes from complacency and overheating to risk aversion and economic slowdown, the orientation of policy must change as well.

Economic policymakers who seek to correct past errors by doing today what they wished they had done yesterday actually compound their errors. They are in their way as dangerous as generals fighting the last war. We do not yet know how much economic conditions will change or whether current concerns will prove transitory. But if recent developments mark a genuine change, let us hope that policymakers look forwards rather than backwards.

To respond to the first paragraph, I think that while implied volatility of the S&P 500 has reared up from roughly 10% to roughly 14% in recent weeks, it remains at historically low levels when compared with the longer experience, and when compared against the daunting challenges faced by the world economy today.

I think what he's saying to Bernanke & co is "be open minded about a rate cut". This is not the mainstream view. The situation on US inflation is not pretty, with expected inflation embedded in the market for inflation indexed bonds running above 2.2%. My view is that the Chinese appreciation has helped accelerate manufacturing inflation worldwide. The UK CPI is under pressure. Reflecting these fears, and reflecting a very high respect for the importance that the Fed attaches to keeping inflation under control, the market does not expect a Fed rate cut anytime soon. Price data on the options on fed funds futures market can be used to back out the probability of a rate cut, and right now the values are roughly 8% by May, 20% by June and 20% by August.

Stephen Roach has an interview on Foreign Policy which has a grim picture of the difficulties of the world economy. He is away from the mainstream in blaming inflation-targeting. He says:

FOREIGN POLICY: Observers have suggested a number of different reasons for last weeks stock market stumble. What do you think was the main cause?

Stephen Roach: The correction in the Chinese stock market was a very important development. There were new doubts that surfaced with respect to the outlook for the U.S. economy. Those were the two dominant factors. There were other causes: the yen carry trade, or investors simply being caught complacent on a number of risky assets. Those were all facets. But the fundamental story from my point of view was a real one. This was not a trading accident, and it was made in China and America.


FP: What lessons should policymakers take away from what happened?

SR: [Prior to last week], we had seen a dangerous build-up of complacency around the world by investors, by policymakers, and by politicians. And markets were pretty much ripping on their own. The trading action that I thought was most disconcerting was in what has traditionally been the riskiest of assets: high-yield corporate credit in the United States or in Europe, emerging-market debt, and emerging-market equities, where spreads in debt markets had gotten down to levels wed last seen in the late 1990s.

Policymakers, by targeting inflation in the narrow sense, whether its the consumer price index (CPI) or some type of consumption deflator, were ignoring an important responsibility in managing risk and financial market stability. Its very important for central banks, in particular, to have a broad perspective on their mandate, and not ignore the excesses that can build from time to time in asset markets.


FP: Your viewpoint is pretty bearish relative to those of other observers and commentators. What is it, either from your experience or your insights, that leads you to a more pessimistic conclusion than others?

SR: Well, Ive been examined by leading physicians and geneticists, and so far they havent determined anything terribly abnormal in my physical makeup. But I am very suspicious of the view that market fundamentals are sound. The standard response [to last weeks drop] is to say that this was just a market event, its a blip, the fundamentals are sound, and nothing has impacted the underlying strength of the global economy. In many respects, those statements are made by political figures or policymakers who have strong political leanings, or by sell-side analysts who want markets to just rebound and resume their sharp upward assent.

In China, I do see some legitimate reasons for a marked slowdown. In the United States, this post-housing bubble shakeout is going to end up being a lot more serious than most people think. When we woke up last Tuesday, not only did we get news of a huge drop in the Chinese stock market, but earlier in the day in the United States we also got a hugely disappointing report on capital goods orders. It was the fourth disappointment in the last five months. This was one of the sectors that was supposed to be resilient and underscore the case that the U.S. economy had this amazing knack for walling off problems. As the capital expenditures outlook darkens, that [belief] will be drawn into serious question. The one sector thats hanging in there is the consumer, and my guess is thatll be the next shoe to drop. But right now thats a guess, and so far it looks like Im wrong.

Linkages between the world economy and India

Turning to India, see Growth story in volatile times by Ila Patnaik on 9th March for an exposition of how these developments in the world economy matter for us. There was a significant slowdown of exports from all over Asia starting from the middle of 2006. The poor merchandise exports growth seen in India in January 2007 (5.37%) was perhaps, to some extent, driven by this wider phenomenon.

Macro policy and outcomes in India

Much more interesting is her piece A fresh mandate for RBI (20th March) which, I think, makes an important and new point. In a nutshell, the argument is this. Inflation in India is a serious problem, in the worldview of both economists and politicians. In the short run, you can't do anything about the aggregate supply function, so what has to be pulled back is aggregate demand. Aggregate demand is the sum of domestic demand and foreign demand. Raising interest rates hits domestic demand, while an INR appreciation hits foreign demand.

What RBI was doing until a short while ago was remarkable: they were preventing an INR appreciation (which would, normally, have reined in foreign demand by itself). As a consequence, there was ample liquidity in the domestic economy. This led RBI to do things like rate hikes and CRR hikes in combating inflation. These inflicted some pain, though not enough to rein in inflation (we still have a policy rate of roughly 0 in real terms).

What we were left with was a strange combination of a monetary policy which was willing to allow local inflation, and inflict pain on local households and firms, but treated the INR-USD pegged exchange rate as the non-negotiable core. I felt that this strategy is not in India's interests and waited for the politics to work itself out.

Did RBI budge?

It may be the case that some of this criticism of the INR/USD peg is getting through, because we are seeing some give on the part of the RBI:

One problem with the Indian currency regime is that there is no transparency. One never knows what RBI is doing and why. But looking at the INR/USD exchange time-series it looks like RBI did budge. Given the lack of a transparently understood monetary policy regime, one does not know what could come next. Will they now defend Rs.43 per dollar? Or will further appreciation take place?

The dates on this graph are interesting. On 14th March they were at Rs.44.25 and today they're near Rs.43. (My graph is drawn from the US Fed data, and stops at Rs.43.2 on 26 March).

This reminds me of another episode - in March/April 2004 - where the RBI similarly came under acute pressure on upholding the INR/USD peg, and budged:

There are long lags in the data, but it my sense is that there has been a slowdown in world output and particularly exports from August 2006 onwards. We have got a one rupee INR appreciation, and my view is that more ought to be in the pipeline. Put together, selling with an appreciating currency into a slowing world economy should give a significant slowdown in exports, and thus help to rein in inflation.

This picture is complicated a bit by the fact that the Chinese appreciation has been stronger than ours:

The red line is the CNY and the blue line is the INR; the graph covers two years since the relationship between the exchange rate and trade runs over roughly two years. This CNY dimension cuts in two ways: it helps Indian exports but helps sustain Indian inflation.

The next few weeks are full of imponderables. How badly will the world economy slow down? How will inflation in India react? To what extent will the politics override the RBI operating manual, thus giving an INR appreciation, and a higher short rate? What is the lag structure with which an INR appreciation and higher short rates feed back into inflation? My sense is that the bulk of these uncertainties should get resolved over May and June.

Tuesday, March 27, 2007

Finance materials in the Economic Times

Today, there is an ET debate on hedge funds, with three pieces by Samir Barua, Rashesh Shah and S. V. Prasad. And, Shaji Vikraman has an article on Bombay as an international financial centre.

Monday, March 26, 2007

Two decisions of the SEBI board

A recent SEBI board meeting appears to have made two important decisions: To have mandatory `grading' of IPOs by a credit rating agency [link, link], and to permit institutional investors to do short selling [link]. Financial Express had an edit on the former, see an edit in Economic Times, and today Business Standard has an edit on both issues:

The Sebi board has made progress on capital market regulation by permitting institutional investors to engage in short selling. The fundamental principle of financial markets is that diverse speculative views come together to generate price discovery. Some people believe a security will do well: they are able to borrow money and buy shares. If they are right, they will be able to sell the shares at a future date, repay the loan, and be left holding a profit. Such borrowing permits the expression of positive views on a security. In an exactly symmetric way, the financial markets must permit the expression of a negative view on a security. If a person believes a security will do badly, he should be able to borrow securities and sell them off. If he is right, he will be able to buy back the securities at a future date, repay the loan, and be left holding a profit. Such symmetric expression of views by optimists and pessimists is usually good for market efficiency. For liquid stocks, the presence of derivatives trading on individual stocks has already addressed the problem of giving a pessimist the means to express his views. But even here, stock lending is a fundamental requirement for achieving market efficiency on the derivatives market, by supporting arbitrage.

The important next step should be the construction of an effective system through which access to borrowed shares is ubiquitously available as supporting infrastructure for the stock market, while avoiding the difficulties of the badla system. It is to be presumed that the onus of this will now lie with the two main stock exchanges, the NSE and BSE. Sebi and the exchanges need to build common scalable infrastructure which works for all securities; it should be possible for users to borrow shares, government bonds, corporate bonds, gold ETFs, dematerialised warehouse receipts, etcall through a single scalable borrowing mechanism. This would harness economies of scale, and deliver the benefits of short selling on all these markets.

While the decision about short selling by institutions is on the right track, the Sebi board has made a mistake in introducing mandatory IPO grading by credit-rating agencies. In mature market economies, the credit ratings of bonds are optional in the hands of the issuer and grading IPOs is non-existent. In India, credit-rating agencies have been delivered a bonanza by the government by making both mandatory. In the case of credit rating, at least, a rating agency can work for a decade or two, and then there can be accountability in the eyes of the market because rating decisions can be compared against the default experience. In the case of IPO grading, this slow and remote accountability is absent. Fluctuations in stock prices take place for all kinds of reasons, and no rating agency can be held accountable if some companies do well and others do badly. More importantly, it is impossible to hold the rating agency accountable for the IPOs that it blocked. Sound thinking in financial sector policy requires the elimination of IPO grading, the elimination of mandatory credit ratings for bonds, and a requirement that each rating agency report quarterly statements about the performance of its credit ratings of the last five and ten years.

Sunday, March 25, 2007

Interpreting and contemplating the European growth experience

Barry Eichengreen has a new book titled The European Economy since 1945. Sheri Berman has written a great book review in the New York Times. Greg Mankiw points to Chapter 1 of the book on the NYT website.

It is a fascinating story. After World War II, Europe bounced back on a foundation of great human capital, institutional mechanisms and State capacity. In the first three decades, the story was one of pouring capital into a near-ideal setting, which gave very high GDP growth. Eichengreen says that European institutions comprising trade unions, employer organisations, and corporatist arrangements evolved to support this phase of `extensive' growth where the information processing required in deploying capital was relatively easy, and the game was primarily about quickly getting the top quality labour force up to the production possibility frontier.

I believe there was one more reason why European institutions evolved the way they did in the post-war years: Appeasement. In the early 20th century, communism was a genuine alternative to democracy both at the level of ideas and in terms of realpolitik. My sense is that for wise people like Keynes, who knew and loved the ideals of classical liberalism, a pragmatic path of buying off the `working class' was taken, so that there would be no fertile ground for a communist revolution. We know today that communism was hopelessly broken, that there was never any threat; the perceived fertile ground would have rapidly evaporated the moment workers in the West learned more about the plight of workers in the USSR. But at the time this was not obvious.

My sense is that people like Keynes, with a heavy heart, supported the rise of a big State thinking that it was the only way to stave off the takeover of totalitarian ideas as had happened in Russia in 1917 and Germany in 1933. The thinkers of that age, who knew and loved individualism and freedom the best, thought that it is better to have a big State, and hang on to an attenuated form of personal freedom, rather than collapse into brutality as Germany and Russia did. This rationale, founded on appeasement, lost relevance after the collapse of the USSR. This may have set the stage for dismantling the European welfare state, which has now outlived its original purpose of staving off totalitarianism.

Extensive growth is an important part of development economics also. Some countries, like China, have done very well by marshalling a vast pool of labour and capital, and obtaining growth by deploying these factors of production. Paul Krugman famously reminded all of us over a decade ago that East Asian growth was quite `unmiraculous' in that it mostly reflected a boring accumulation of labour and capital into the production process, often with poor technology and productivity.

In Eichengreen's story, by roughly 1975, the potential for `extensive' growth in Europe was exhausted, and from that point onwards, the `European model' has looked bad. Margaret Thatcher and Ronald Reagan helped to radically turn the US and the UK away towards the Anglo-Saxon model. This experiment has been running for a while, and continental policy regimes like Germany and France have inferior growth and worse unemployment when compared with the US and the UK.

In the post 1975 period, what Europe - at the frontiers - needed was "flexible and mobile work relationships, technological novelty and the financing of risky ventures" (as Eichengreen puts it). The UK and the US economic policy framework worked much better with a flexible labour market, market-oriented finance, and powerful incentives for hard work, risk-taking, innovation and entrepreneurship.

What does this say for economic development in the third world? Sometimes the argument is made for more Statist growth in the early decades of catch-up, as was done in the first 30 years in Europe. In my view, there is a fundamental difference between post-war Europe and the typical third-world context: this lies in institutional sophistication and State capacity. The competence and lack of corruption of the State in Germany is something which we just do not possess in India. The Indian State tried to lead, particularly over 1966-1976, and we saw how bad that was. There is no one road to serfdom, but in places with weaker political and institutional capacity, a large State is more vulnerable to cancer.

In India, we don't seem to be walking down a phase of State-led extensive growth which is then followed by a withering away of the State. India is walking on a sui generis path, where we seem to be jumping out of poverty into a world of "flexible and mobile work relationships, technological novelty and the financing of risky ventures". We seem to be developing what Vijay Kelkar's October 2005 Gadgil Memorial Lecture calls a new model of `Indo-Saxon Capitalism', where the primitive accumulation is taking place alongside the huge technological catch-up.

The private sector, which is driving growth, is working within a market-oriented financial system which is able to supply risk capital. However, my sense is that this `extensive' growth is not simple-minded. Highly novel mechanisms are often required for plugging India into globalisation, which require creativity, intelligence, risk-taking and entrepreneurship. The private sector operates in a framework of flexible and mobile work relationships. I believe this path is scalable for many decades, and involves a virtuous cycle between widening personal freedom and high economic growth.

How poor countries subsidise rich countries

Tina Rosenberg has a nice article in New York Times today where she has the following checklist of the ways in which poor countries help rich countries:

  1. Reserves.
  2. The application of first world IPR rules, which convert the public goods of knowledge into excludable things that you can earn a toll off.
  3. Fiscal subsidies for foreign investment.
  4. The brain drain
  5. First world policies which make it difficult for the third world to export agriculture
  6. Global warming - which everyone will pay for.

In the case of reserves: India holds roughly $200 billion of reserves, all of which are invested in low-yield first-world securities. From an `insurance' perspective, what India needs is roughly $50 billion. The opportunity cost of reduced returns works out to perhaps five percentage points. Applying 5 percentage points on $150 billion is an annual cost of $7.5 billion or roughly 1% of GDP.

In the case of #3 and #4, I believe that the basic problem is the self-harming policies in the 3rd world which are hostile to investment and hostile to smart people. Once these policies are in place, fiscal subsidies for investment appear inescapable. But it would be far better to instead have a climate of policy which is supportive towards investment and towards smart people.

The Indian currency regime and its consequences

India's currency regime and its consequences, Ila Patnaik, Economic and Political Weekly, 17 March 2007. A short article which summarises the situation on the Indian currency regime, and its consequences for monetary policy and business cycles.

Wednesday, March 21, 2007

Monetary policy difficulties

Two weeks ago I had written about Monetary policy at a crossroads. Today, the front page headlines in the business press were about short-term inter-bank rates going up to very high annualised rates. I think these symptoms are consistent with the picture of an inconsistent monetary policy regime, one where the old operating framework is increasingly problematic. Update: Andy Mukherjee has a Bloomberg column on this.

Competition policy and privatisation policy

My column in Business Standard today is titled Competition policy > privatisation policy. I argue that while privatisation is the first best strategy, in a time when there are political constraints impeding privatisation, it is very important to not cut corners on competition policy. The most powerful tool for making progress on economic policy is bringing in the maximal domestic and foreign competition. There is a lot to do on competition policy which is politically feasible today, without waiting for the next general elections.

I think it is useful to put together a nuanced picture combining privatisation and competition. In the backdrop, privatisation is about obtaining GDP growth through improved productivity of labour and capital [link]. But more importantly, privatisation is a valuable means to heightened competition insofar as it helps us attain a government which is not conflicted [link] in achieving sound competition policy. But going beyond privatisation, it is also possible for men and agencies to rise above these conflicts of interest and push the competition agenda - as has happened with the best of policy makers in India in the last 20 years.

I highlight the Indian experience with mutual funds, telecom and airlines - each of which has benefited from the best of policy makers. In each of these areas, the single most important event was removal of entry barriers. In the case of international long distance, the removal of entry barriers was supported and enabled by the privatisation of VSNL. Today, the privatisation of UTI, MTNL, BSNL and the merged airline would be excellent achievements, but these privatisation events are no longer the key milestones for progress. The genie of competition and growth is out of the bottle, and this was achieved by competition policy, not privatisation policy.

The most disappointing thing about Indian banking is not the lack of privatisation. This is a decision made by Parliament, and until enough MPs are persuaded, there will be no progress on that score. In contrast, competition policy in banking is something that RBI controls, and there is no political bias in favour of impeding competition. The present state of affairs, with high entry barriers, branch licensing, and a near-ban on branch expansion by foreign banks: this adds up to a dismal state of affairs in terms of competition.

Monday, March 19, 2007

Carbon tax questions

Greg Mankiw criticises David Friedman who is worried about what politicians will do with the gigantic tax revenues that come out of a carbon tax.

I think there is a way out which can satisfy all parties: this is Martin Feldstein's idea of having tradeable carbon vouchers. In brief, the idea is that the government should only setup an enforcement machinery, and every citizen should get a voucher entitling X amount of carbon emissions a year. After that, the rich will buy vouchers from the poor, thus achieving a new distribution of the emission rights, in a way that avoids having this money flow into the exchequer [link, link]. This is the ideal solution for the carbon problem: a target level of emission is achieved, using the most efficient solution in terms of modified technology and consumption, while avoiding the political economy problems of a large tax/GDP ratio.

Saturday, March 17, 2007

`The mystery of capital' by Hernando de Soto

I must be the last guy in the world to read the famous book `The mystery of capital: Why capitalism triumphs in the West and fails everywhere else' by Hernando de Soto.

He says that the institutional and legal infrastructure surrounding the ownership of land and property makes possible a great deal of sophisticated things, far beyond the apparently mundane question of being clear on who owns what land. It becomes possible to borrow against land/property. I would go far beyond him in emphasising the vast sophistication of spot and derivative financial markets that can be built, which are ultimately founded on clarity of title and ease of transactions. Without clarity on title, and frictionless transactions, the great wealth that land ownership constitutes is frozen; transactions only happen with neighbours and family. Further, friction in transactions inhibits speculation and thus market efficiency.

I was witness to a similar transformation in India - the shift from share certificates printed on physical paper to ownership information maintained in a computer database. This eliminated the counterfeiting and theft, and made possible a superstructure of sophisticated finance. I am very much in tune with this first point of the book, that of emphasising the importance of clarity of property ownership and frictionless transactions. The task of maintaining these databases and ensuring frictionless transactions is a core State function, right up there alongside the police and judiciary.

I was recently in Ahmedabad and asked about the frictions of purchasing flats. Apparently they are used to paying 5-7% to a lawyer who does a `title check' and a bribe of roughly 2% in order to get the government to register the ownership in the name of the new buyer. These payments add up to 7-9%!!! Such a barrier to transactions and speculation is sure to yield a horribly inefficient market. Since land is one of the biggest asset classes, such inefficiency is costly.

The book then goes off into a fascinating ramble, which was fun to read. He asks the question: Where did the intricate systems of property ownership in the West come from? The practitioners of today have no idea about the rationale that led up to present institutions, and the compulsions that shaped present practice. I agree with this notion completely. As Lant Pritchett says, to ask a first world practitioner who operates a certain institutional infrastructure to then go on to design institutions is like asking a New York cab driver to design a car. To understand where first world institutions come from, one has to go delve in history, and think about incentives from first principles. Talking with contemporary practitioners is useful for obtaining a description of the present institutional structures, but not much beyond that.

There is a very interesting chapter about the history of land and the US. The basic story of the US appears to be one where settlers took what land they could, and the State later legitimised the facts on the ground as property rights. The book projects this experience as carrying important lessons for third world countries, who (the book suggests) should do as the US did when it was a developing country. Yes, this is certainly how the US evolved - but that is a very singular story in human history. It was perhaps like that in Canada and Australia also, where a tiny group of settlers faced quasi-infinite land and where State capacity was negligible. In a third world country there is no empty land to expand into. All land is owned by someone. I simply don't see how it is possible to make this analogy: squatters were legitimised in the early history of the US, hence there is a case for a benign treatment of squatters in the third world today.

If anything, there's a strong contradiction between the previous point (clarity of title) and this one (giving squatters rights). I personally do not dream of buying land in (say) Kanpur, since I'm not there in the neighbourhood to watch over it and ensure that squatting does not take place. The squatting equilibrium ensures that a national market does not develop, that a complex financial superstructure does not develop on the land market. With squatting, each person only thinks of owning land in an epsilon neighbourhood or in the epsilon neighbourhood of trusted family.

A side battle taken up in the book is the history of guilds and the `extra legal sector'. We all know the broad story - that the development of capitalism led to the breakdown of the guilds, which were anti-competitive. The book paints this as part of the saga of heroic squatters taking on entrenched wealth. I am quite unpersuaded. Yes, taking on the guilds was very important, but it is just a question of competition policy. (As an example, see this recent edit in Business Standard about allowing an `extra legal sector' of heroic small telecom companies to take on the guild of Indian telecom companies). Yes, I perfectly agree that at every possible turn in policy thinking, we must enshrine competition. But I don't see how singing paeans to the gritty entrepreneurs in the informal sector is consistent with supporting land grab.

The book draws on examples from a few countries like Egypt and Haiti and argues that Capitalism has failed. It ignores the history of country after country in Asia where Capitalism has worked. First Japan, then Korea and Taiwan, then China and now India are achieving a takeoff based on market-oriented economics, and many small countries have also done splendidly. The book may perhaps be excessively influenced by information from a few countries where Capitalism did fail. But the lessons are less general than meet the eye.

He makes much of the `bell jar' analogy, of a modern sector of a poor country inside a bell jar with the great unwashed masses outside clamouring to get in. His belief is that this bell jar will not grow by itself. Well, the data shows that in countries like Japan, Korea, Taiwan, China and India, the bell jar has grown wonderfully. A modern sector takes root in the country, plugs into globalisation, and then reshapes it's surroundings: we have seen this over and over, and have pretty much understood this process ever since Adam Smith, David Ricardo and Karl Marx.

We admire the grit, determination, and innovation of small entrepreneurs, but we should be wary in judging their economic significance. A lot is made of the size of the informal sector, but when you look at the data, SMEs just don't add up to much. In India, the mere 100 big firms (the firms in Nifty and Nifty junior, which have good stock market liquidity) account for a full 10% of GDP. And this is just the value added within the firms - given Indian labour law, these firms contract-out a large amount of production so as to steer clear of this law. The true economic footprint of these biggest 100 firms, then, well exceeds 10% of GDP. And I've only counted the biggest 100 firms. By the time you get to the top 10,000 firms, which (with the government) inhabit the bell jar, you get to a huge and growing slice of India.

Capitalism has not failed `everywhere else'. The bell jar is big; the bell jar is growing. I do not share the message offered by the book that the bell jar is stagnant; the bell jar has failed; that the only way to build a vibrant capitalism is to go outside the bell jar and enshrine the reality of the extralegal sector into the legal system.

The book claims that when law diverges from universal social practice, the law must inevitably give way. What about the campaign against sati? There was a time in India when after a husband died, the widow was urged, encouraged and pushed into the funeral pyre by immediate family. The prevalence of sati was the `facts on the ground'. The creation of a modern India critically relied on the Law saying that such practices were unacceptable.

I remember how, ten years ago, there were many fatalists who believed that counterfeiting and theft of physical share certificates was the inescapable reality of India. It was solved by a top-down reformative policy push, not by a process of law accepting theft, or giving partial ownership rights to the counterfeiter. The only way towards making progress on building a mature market economy is to go after these kinds of problems with passion and zeal. In similar fashion, squatting is the norm in India today, and no land is safe, but still there is absolutely no case for benign support towards squatting or `encoding the facts on the ground in law'. The success of the Indian development project critically requires achieving frictionless land transactions.

Nice reading

HIV in India - A complex epidemic by Robert Steinbrook in the New England Journal of Medicine of 15 March 2007.

What next for the left? Defining Buddha moment by Shekhar Gupta in today's Indian Express and The Bengal Paradox by Vir Sanghvi in Hindustan Times. Also see an edit in BS on a related theme.

Responding to inflation: Suman Bery in Business Standard. And, an edit on RBI currency trading in Financial Express.

RBI's concerns about inter-bank exposures : an edit in Business Standard on 13th.

Decision making in a modern democracy: an edit in Business Standard today. I would add one more key piece of what helps faster and better decisions: the financial markets. If May 17, 2004 hadn't happened, you might have had a very different UPA cabinet. We now have markets that think and react in realtime.

More from Business Standard: The fine print of Budget 2007, by Sukumar Mukhopadhyay. A. K. Bhattacharya about transparency and the response of the economy to the budget.

Susan Thomas on Indian stock market volatility.

Vivek Ranadive does monetary policy.

Friday, March 09, 2007

Paper on Indian ADRs

A Study of International Listing By Firms of Indian Origin, by Sudipa Majumdar [link]. The abstract reads: A growing number of companies from emerging economies are crosslisting their shares on international exchanges in their effort to access the developed stock markets. This paper tries to look into the inter-sectoral and inter-temporal characteristics in prices of such stocks of Indian origin that are being dually traded on the American and Indian stock exchanges. The trend up to August 2006 shows the existence of positive premia levels of the American Depository Receipts (ADRs) over the underlying domestic securities. In an effort to realign ADR prices and bring down premia levels, the Reserve Bank of India introduced two-way fungibility in February 2002. However, ADR premia levels continued to increase during the period 2002 to 2004, with a decline only from 2005 - this downward trend seems to be unrelated to the fungibility criterion since the two-way conversion did not open up arbitrage opportunities. We find that legislative changes in India had an impact on decisions of Indian companies to go in for international listings. However, once listed, the trading in ADRs by foreign investors was guided by movements in the US stock market rather than capital market activities in India. We do not find any increases in domestic stock prices across firms after their foreign listings, but the domestic stocks show an increase in trading volumes (liquidity gains) after their international listings.

Wednesday, March 07, 2007

Monetary policy at a crossroads

My column in Business Standard today is titled Monetary policy at a crossroads. It describes nine maladies afflicting monetary policy today, and argues that the problem won't be solved by incremental intensification of the familiar `operating manual' that has been in use at RBI for many decades. One of the maladies concerns the fluctuations of the call money rate away from the corridor - here's the data and a picture. Update (17/3): Suman Bery wrote in BS on the same subject on the 14th.

Tuesday, March 06, 2007

India must breed more policy wonks

Mukul Asher has a fascinating article in Far Eastern Economic Review in March 2007 titled India must breed more policy wonks [pdf]. This is partly about public policy research in India, and primarily about formal educational programs in public policy. In some ways, folks in the IAS do a Masters in Public Administration at Mussoorie. But there is a big gap between what they get and a modern MPA/MPP program. In addition, it's better to decouple the education from the recruitment. Indeed, the signals thrown up in the educational process improve the decision making of recruiters.

Monday, March 05, 2007

Para 173 of the budget speech is 100% wrong

This year, the budget speech has a proposal in para 173: ``Venture capital funds are a useful source of risk capital, especially for start-up ventures in the knowledge-intensive sectors. Since such funds enjoy a pass-through status, it is necessary to limit the tax benefit to investments made in truly deserving sectors. Accordingly, I propose to grant pass-through status to venture capital funds only in respect of investments in venture capital undertakings in biotechnology; information technology relating to hardware and software development; nanotechnology; seed research and development; research and development of new chemical entities in the pharmaceutical sector; dairy industry; poultry industry; and production of bio-fuels. In order to promote business tourism, I also propose to allow this benefit to venture capital funds that invest in hotel-cum-convention centres of a certain description and size.''

This is profoundly wrong, at three levels:

  1. A tax pass-through status of all fund managers is a core principle of sound tax policy. If you hire me as a fund manager, I'm your agent. Your funds pass through me into investments and back to you. The only taxable unit is the customer of the fund manager. If the fund management vehicle were taxed, this would amount to double taxation, and it would kill all professionalisation of fund management. To retreat from a tax pass-through status for any fund management is profoundly wrong. The pass-through status of fund managers is not a privilege, it is a foundation of sound tax policy.
  2. By making the tax pass-through status conditional on investments in certain industries, the government is playing god on which industries should receive investment. What is special about `hotel-cum-convention centres of a certain description and size' or `nanotechnology' which makes investment in these fields `desirable'? No government has the information processing capacity to decide where investment must take place. Such sentences show the Indian State going back to the archaic reflexes of industrial policy. Conversely, if investments into all industries are double-taxed but these few privileged industries receive single-taxation, then this corresponds to a fiscal subsidy for investors in these industries. That is bad economics.
  3. The ground reality in the Indian private equity business is that the PE funds are incubators for business. They are inciting entrepreneurship amongst people who are not traditional business families. It is to India's benefit, because the best entrepreneurial minds do not have to be born into business families. A good chunk of the PE investments in India are in old economy industries such as cinemas or retailing or readymix concrete. And there is nothing wrong with that: for India to go from a per capita GDP of $800 to $8,000, 99% of the job lies in good quality investments in traditional businesses. The real role of private equity lies in supporting entrepreneurship and in fostering first-generation entrepreneurs; not in fostering investments in nanotechnology.

A great deal of money has been contracted by the existing private equity industry where the customer expected a tax pass-through and expected the PE fund to engage in a certain investment strategy (most of which was not in fields like nanotechnology or seed research). If the government goes through with the above paragraph, then it would make India look foolish in the eyes of the investors. I would expect that the bulk of commitments would be withdrawn, and the Indian private equity industry would shrink dramatically in size and significance.

One would dearly hope that this paragraph gets deleted in the Finance Bill that will get voted upon. Update (28/3/2007): M. P. Chitale & Associates have a thoughtful piece on this subject.

Sunday, March 04, 2007

How to make email to blogger work

One of the neat features of blogspot used to be submission of blog postings by email. Email->blogger is highly convenient for me, particularly because I write most of my blog postings when offline. When I moved to the the new software release in January 2007, this feature stopped working. The interactive authoring component that blogspot has is inconvenient and buggy.

With a little help from my friends, I figured out how to do email to blogger. To the best of my knowledge, this information isn't yet on the net, so here goes.

The key insight is that the email that must be submitted to blogger must have content type text/html and must have only one object in it (the HTML content). There must be no attachments or anything else.

Generic receipe using sendmail

This works as long as you have a machine with a working MTA. Regardless of what your MTA is, generally there is an executable named "sendmail" where many flags of sendmail are respected.

First make a file named `posting' as follows:

To: myblogemailaddress
Subject: Title of posting
Content-Type: text/html

Content of posting.

Send this off by saying:

 $ cat posting | sendmail -i -t 

Incantations specific to one MUA - mutt

Make an HTML file posting.html starting with until . Bring it into the text of the email using mutt by saying:

 $ mutt -i posting.html myblogemailaddress 

This puts you into an interactive editor screen. Fill in the title of the post under `Subject:' and exit the editor.

Now you will face the mutt menu screen. There is no attachment, there is only an email that you've been writing `by hand'. Say Ctrl-T to change from text/plain to text/html and send.


I haven't figured out how to place labels into the HTML that's submitted. As a consequence, I go into the blogspot interactive screen to tag the posting with labels. That's tedious, and further, blogspot emits one more entry into the RSS feed when the labels are added or modified.

Thursday, March 01, 2007

Views on Budget 2007

As usual, the Indian media has excellent budget commentary, e.g. Suman Bery, S. Narayan, Ila Patnaik, M. Govinda Rao. A spreadsheet with some minor value added on the budget-at-a-glance is useful in thinking about what happened. In it, I have removed the SBI transaction of Rs.40,000 crore which is just accounting entries between MOF and RBI. I like to use the `best available estimates' in comparing the three recent years, which involves using actuals for 2005-06, revised estimates for 2006-07 and budget estimates for 2007-08.

Political backdrop

Feb 2007 is a bad time for economic policy. The UPA is worried about its political future, thanks to high inflation and two lost state elections. This stress is generating an interest in going back to the economic thinking of the garibi hatao days in the minds of many MPs of many parties. Business Standard had an excellent editorial setting this stage on the 28th morning.

My Business Standard piece says:

The most depressing feature of the budget speech was right at the outset. The speech began by punching the viewer in the nose in para 8A (a last minute insertion) with a ban on futures trading on wheat and rice. It was a jarring reminder that India may be an IT superpower with a $1 trillion GDP, but there are many people at the top who are still thinking in the 1970s mentality of blaming futures traders, hoarders, profiteers and speculators for an economy-wide mismatch between supply and demand.

For more on banning commodity futures trading, see link, link.

Progress on the deficit

The situation on the (central) fiscal deficit is:

Unit 2005-06 (A) 2006-07 (R) 2007-08 (B)
Rs. crore 146,435 152,328 150,948
Percent to GDP 4.11 3.68 3.23

In 2007-08, bond issuance of Rs.150,948 crore is proposed. This involves a low growth in nominal terms when compared with 2005-06. If this target is met, it would imply that the central government has expenditures of 3.23% of GDP which are not covered by revenues. When bond issuance is flat in nominal terms, the growth of GDP and the growth of the savings rate gives increased space for private investment and thus an opportunity for accelerating Indian GDP growth. This is good news for achieving high GDP growth.

If the existing FRBM Act and Rules are treated as a given, and if a deficit of 3.23% of GDP is achieved, we're pretty much done on the job of getting the central GFD down to the target of 3% of GDP. Hence, the gains which were obtained in recent years, of a sharply dropping fiscal deficit, will not be repeated in the future.

There were two reasons to shoot for a fiscal deficit of roughly 2% this year:

  1. From a business cycle perspective, these are the best of times. A fiscal stance that is roughly achieving the FRBM target of 3% in these best-of-times involves acute fiscal stress when there is a business cycle downturn. A fiscal deficit of 2% for 2007-08 would have meant a fiscal stance that was basically FRBM-compatible.
  2. Rapid deficit reduction could have been a contractionary device to help check inflation [link].

But this policy option, of getting down to a 2% fiscal deficit, was not taken. Good times were used, instead, to sharply grow `plan' expenditure. Roughly speaking, a percent of GDP is Rs.40,000 crore. Instead of devoting that last Rs.40,000 crore to deficit reduction, it has been tossed into `plan' expenditure.

Tax reforms

The peak customs rate and many other customs rates were dropped a bit. This will reduce local prices; improve the competitiveness of exports; increase the trade/GDP ratio; improve resource allocation locally; induce GDP growth. I should remind the reader that the "peak" customs rate is not the peak: many, many products are above it. It's probably more like "the rate we'll use if we don't have any special thoughts on our minds".

Apart from this, there was no progress on tax reforms. E.g. on the GST, there was just a pious phrase, but not the kind of brick-and-stone implementation that is required. I have blogged separately on a mistake that has been made on the tax treatment of venture capital. In my mind, UPA politics does not particularly impede such areas of progress, so the daunting political backdrop does not explain the lack of progress [see article by Bibek Debroy].

Size of the State

The situation on growth of the State is as follows (all numbers as percent of GDP):

Element 2005-06 (A) 2006-07 (R) 2007-08 (B)
Non-plan non-interest 5.48 5.21 4.81
Interest 3.723.533.40
Plan 3.95 4.17 4.39
Total 14.21 14.03 13.72

Interest payments reflect a combination of the debt/GDP ratio and the cost of financing public debt. They have dropped slowly, primarily responding to lower interest rates on incremental debt issuance.

`Plan' expenditure is money spent on major programs such as the National Rural Health Mission or Sarva Shiksha Abhiyan. This is where the UPA has dramatically increased outlays, going from 3.95% of GDP to 4.39% of GDP over a two year period.

`Non-plan' expenditure is the remaining expenditure of government. In my understanding, all the expenditure on genuine public goods, such as judges and policemen lies here. It has been shrinking.

The overall picture adds up to a central expenditure/GDP that dropped slightly from 14.21% to 14.03% to 13.72% of GDP.

There is a lot to be dissatisfied about about this game plan. One could have argued for a bigger reorientation in favour of expenditures on public goods. One could have argued in favour of using the fiscal space of a business cycle upturn to achieve deficit reduction. But broadly, despite these difficulties, it is not an alarming situation where the expenditure/GDP is growing. At worst, if projections go wrong, we might endup with an expenditure/GDP for 2007-08 which is flat at 14.03; if things go right, we will endup at 13.72. The numbers are not as dangerous as the welfare-program rhetoric.

Mechanisms for provision of public goods

The main game plan of the UPA for winning the coming elections seems to be: exuberant spending on the `flagship schemes' such as NRHM, SSA, NREG, etc. There is limited evidence that these schemes work well. The right area to focus on would have been to look for more bang for the buck. The UPA seems to be content with just more buck.

There are some signs of fresh thinking in education. On one hand, FM announced an excellent `scholarship' program (para 20) where 100k children will be given Rs.6,000 a year in class 9,10,11,12. The entry of 100k children every year means that within four years, there will be nearly half a million children in this program.

There will be an exam that filters entry into this. But it won't be like many other ridiculous Indian competitive examinations, like (say) the NTS which in my time was awarded to 250 students in the country. A full 100,000 children all over the country will get through, and then get a decent scholarship of Rs.6,000 per year which is big enough to be attractive to most families. Assuming roughly everyone who finishes class 7 will take this exam, it will also throw up wonderful data on learning attainments at class 8.

I think this is an excellent strategy for addressing the bulge of children coming out at class 8. For more on this subject, see this article from February 2006. While this effort is very, very good, it remains vulnerable to the weaknesses of curriculum and examinations of CBSE and other 12th standard level coursework in India.

The speech has a host of other scholarship programs - for SC/ST/minorities. It makes a lot of sense for the State to provide such politically targeted scholarships, rather than fundamentally distort the educational system through quotas or other interference in the mechanisms of how schools and colleges work. The big picture should be one where if there is a political reason to gift someone some cash, that is okay, but this should be done without contaminating the overall resource allocation and growth.

Finally, the speech has a plan for shifting 1396 ITIs into public-private-partnership. The devil is in the details, but if (in principle), 1396 ITIs could be transformed, that would be pretty cool.

So my broad sense about Budget 2007 is that primarily it's the UPA trying to throw money at their `flagship schemes' in the hope that some of this will generate votes, with a small layer of clever thinking layered on top of it.

Structural reforms

The establishment of the Debt Management Office (DMO) is, in my opinion, a truly big deal. It links up to larger questions of RBI reform [link]. But even viewed in isolation, I think it's the biggest milestone in Indian monetary reform after the 1997 ways and means agreement. Economic Times has an edit on this, and I say in my piece in Business Standard:

Perhaps the most important announcement of the budget speech, in terms of long-term structural economic reforms, concerns the establishment of an independent debt management office (DMO). For all these years, India has burdened the RBI with the task of being the investment banker for the government. This is an onerous burden for the RBI, for there is a severe conflict of interest between setting the short interest rate (i.e. the task of monetary policy) and selling bonds for the government. If RBI tries to do a good job of discharging the responsibility of selling bonds, this involves selling bonds at high prices, i.e. keeping interest rates low. This leads to an inflationary bias in monetary policy.

An additional conflict of interest is caused by RBI being the regulator of banks also. If RBI tries to do a good job of discharging its responsibility of selling bonds, it has a bias in favour of forcing banks to buy government bonds. This generates a bias in favour of flawed banking regulation and supervision, so as to induce banks to buy government bonds and particularly long-dated government bonds. This has hurt the safety and soundness of banks in India.

In addition to these core problems of conflicts of interest, Indian debt management has many other weaknesses. There is no one place in the country where there is a full database of all the liabilities of GOI. This information is, hence, not used for risk management and optimisation of the financial burden of GOI. There is a big gap between the way mature market economies apply sophisticated financial economics for the purpose of devising optimal strategies for debt management, and the state of play in India.

As far as the mechanics of implementation are concerned, the budget speech says `in the first phase, a Middle Office will be setup'. A mid-office would constitute a single comprehensive database about all liabilities and guarantees of GOI, and a risk management overlay which improves the risk profile of the overall portfolio. It is the logical starting point for the construction of DMO. If MOF is able to get key staffpersons with experience in state-of-the-art debt management in public sector settings, it is possible to setup the mid office in 9 months, and have the DMO fully running in 18 months.

In 1997, RBI and MOF signed the `ways and means agreement', which was the first milestone in modernising Indian monetary policy. The separation of government's investment banking function from monetary policy, ten years later, marks the second important milestone in Indian monetary reform.