Derivatives on Nifty Junior and CNX-100

When Nifty was done a long time ago [link], the key insight was that for an efficient futures market, it should be easy for arbitrageurs to force the futures towards fair price. This requires low impact cost (IC) when doing basket trades for the index. Low impact cost for doing basket trades for the index also helps other applications of an index, such as index funds.

Nifty futures were launched in mid-2000 and from 2001 onwards, the Nifty derivatives market did pretty well. The 9/11 attacks were of decisive importance in getting many stock market participants to shift their gaze away from individual stocks to the overall index.

Nifty Junior is the second tier: of stocks which don't make it into Nifty. For the rest, it's the identical methodology as that in Nifty. The methodology ensures that Nifty and Nifty junior have no common members. CNX-100 is the not-so-nifty name that's been given to the merged index of all 100 stocks. It's the index of the top 100 liquid stocks of India.

How Nifty Junior is different

The most interesting feature of Nifty Junior has been the remarkable returns over the last 10.57 years (the data starts from 4 November 1996). While Nifty returned 4.82 times (16.04% per year) over this period, Nifty Junior returned 8.1 times (21.89% per year) over the identical period. When many actively managed mutual funds talk about outperforming Nifty, it has to do with their loading up on Nifty Junior risk.

Over the last 10.57 years, you could have got a 21.89% return per year (not counting dividends) while paying 25 basis points to an index fund manager. Imagine that. If you use ETFs, you can replace the (big) cost of the mutual fund agent / distributor with the (small) brokerage fee.

Where did these wonderful returns come from? The CNX-100 (total return) index went from 1000 on 1-1-2003 to 4576.6 today, while the P/E went from 14.04 to 19.75. So there was a 1.4x gain owing to improved P/E, and a 3.25x gain in net profit, multiplying up to the overall 4.5766 times return. The bulk of the story was in the growth of net profit.

Current valuations for the three indexes are:

Feature	Nifty	Junior	CNX-100
P/E	20.11	17.78	19.75
P/B	5.59	4.02	5.30
Dividend yield (%)	1.1	1.06	1.1

Today, the market capitalisation of Nifty Junior is 3.52 trillion while Nifty is at 22.05 trillion. Put together, the CNX-100 has a market capitalisation of Rs.25.57 trillion or $630 billion. Out of this, Nifty Junior has a weight of 13.8%.

Nifty Junior is a bit more volatile than Nifty. Looking at the recent period, from 1-1-2003 onwards, Nifty had a daily volatility of 1.47% while Junior had 1.66%.

All three indexes have high correlations. The correlation between Nifty and Junior is 0.85 while that between Nifty and CNX-100 is 0.995%. The correlation between Junior and CNX-100 is 0.893.

Liquidity of the new indexes

NSE has been calculating the IC, off three or four snapshots of the limit order book every day, for both indexes for a while. The transaction sizes they are using for analysis are Rs.5 million for Nifty and Rs.2.5 million for Nifty Junior. These are plausible transaction sizes for index funds and generous sized transactions for arbitrageurs who are able to do smaller baskets.

How have these numbers been faring?

Year	Nifty	Junior
2001	0.20
2002	0.12
2003	0.10	0.24
2004	0.09	0.24
2005	0.08	0.16
2006	0.08	0.16
Jan-Apr 2007	0.08	0.14

In the case of Nifty, the IC at a Rs.5 million transaction, which used to be roughly 0.25% in 1996, had dropped to 0.2% in 2001 and has since dropped nicely to 0.08%. The IC for the Rs.2.5 million basket of Nifty Junior has dropped nicely from 0.24% in 2003 to 0.14% today.

The liquidity of Nifty Junior is thus roughly where Nifty was in 2001-2002. If Nifty futures succeeded in 2001-2002, then one precondition (adequate liquidity) is met by Nifty Junior today. These IC numbers appear to non-comparable because they pertain to different transaction sizes. While that's true, a Rs.2.5 million transaction size is ample from the viewpoint of an index arbitrageur seeking to achieve an accurate Nifty Junior program trade.

The bulk of the weight in CNX-100 is in Nifty stocks. So the IC of CNX-100 transactions will be a bit worse than that of Nifty : we might see an IC of 10 basis points for a basket of Rs.7.5 million. NSE says that a program trade for the 100-stock CNX-100 basket gets executed in under a second, so there is no practical impediment on doing direct spot-futures arbitrage for the CNX-100, if you wanted to.

Applications

Many interesting applications can be conjured for the new products:

• At the simplest, if you are an index fund investor, you can go beyond the front-line bluechip stocks and buy Nifty Junior index funds, so as to delve into less liquid and smaller stocks.
• CNX-100 is a more-diversified broad-Indian-index than Nifty. It would make a better proxy for broad market movements; it is likely to correlate better for most well-diversified portfolios. CNX-100 index funds would be better than Nifty index funds at catching the broad Indian market movements.
• Mid-cap stocks (Junior) have differing fluctuations when compared with the front-line stocks. Some people have an interest in that price discovery and would be able to trade on it. A position that's long Nifty Junior and short Nifty would be focused on the difference between the movements of Nifty and the movements of this second tier of stocks.
• Many stock speculators buy a stock and short the index in order to hedge against broad market movements. For many stocks, the correlations with Nifty Junior or CNX-100 are superior, so this application would work better by shifting away from Nifty. Sometimes, it may make sense to hedge a long position for a stock using positions on both Nifty and Nifty Junior futures. Here's a spreadsheet where, for many firms, we calculate the market model R2 for three cases: (a) Using Nifty alone, (b) using Nifty Junior alone and (c) using both. Here's an example from that file: Reliance Petroleum. Using Nifty alone, you have a beta of 0.58 and a market model R2 of 0.39. Using Junior only, you get to an R2 of 0.48 (with a beta of 0.52). You can do both: with a beta of 0.04 on Nifty and a beta of 0.49 on Nifty Junior, you get to a market model R2 of 0.48.
• 37 of the 50 stocks in Nifty Junior, which make up 87.3% of the market capitalisation, have stock futures trading. So it'd be possible to do futures-futures arbitrage between Nifty Junior futures and stock futures, for the bulk of Nifty Junior. For the remaining 13%, it would be necessary to use the spot market.
• With some cleverness, it should be possible to use a portfolio of Nifty futures, coupled with only a few stocks, in order to approximate Nifty Junior.
• It is, of course, easy to construct arbitrage positions between Nifty, Junior and CNX-100 because the latter is just a weighted average of the other two. I would imagine that the bulk of CNX-100 futures pricing would be done by arbitrage which combines Nifty futures and Nifty Junior futures.
• Index funds on both Nifty and Nifty Junior are available (JUNIORBEES, from Benchmark, is the ETF on the latter). They can be used for writing covered calls on both indexes. It is possible to put together a portfolio of the two, with a 13% weight on JUNIORBEES, and approximate CNX-100.

Candles of liquidity

Introducing a new product, and building liquidity in it, is like lighting a candle. We span new states, we obtain new information. But my intuition is that we jump from liquidity in one product to getting liquidity in a correlated product. It is difficult to light uncorrelated candles.

What we have in hand today is: Nifty futures plus 37 stock futures, and it is hoped that this will give liquidity in Nifty Junior. And if Nifty Junior becomes liquid, then CNX-100 will be just an easy arbitrage away. So these developments are a very interesting case of standing on the shoulders of some liquid products and pushing further into spanning new (yet not completely new) states. I had written something in 1997 about such a spiral of innovation which may interest you.

Today, in India, the indexation industry consists of:

1. BSE Sensex and it's index funds
2. Nifty and it's index funds
3. Nifty Junior and it's index funds
4. A bunch of ETFs on the above
5. Exchange-traded futures and options on the above
6. An OTC derivatives market on primarily Nifty outside the country.

If things go right, we will be able to add derivatives on Nifty Junior and on CNX-100 to this list.

While this will be a good situation in terms of the information produced through speculative price discovery, these markets are as yet inadequately liquid for the needs of the big portfolio hedgers. In an equity market with a market capitalisation of $1 trillion, a modest sized equity portfolio is $1 billion (such a portfolio manager owns 10 basis points of the broad market). Such a manager needs to be able to easily buy or sell $500 million (Rs. 2025 crore) of index futures, and occasionally be able to buy or sell $1 billion (Rs.4050 crore) of index futures. We're just not there yet. To get to this, index derivatives turnover would have to exceed a notional value of Rs.100,000 crore per day, at which point a person putting in a trade of Rs.2025 crore would account for 2% of the day's turnover.

WSJ on Indian capital controls and monetary policy

Eswar Prasad has an article Cracking open India's capital account in The Wall Street Journal Asia where he says:

Capital account liberalization is back on the table in India. In 1996, with spectacularly bad timing, the government-appointed Tarapore committee recommended rapid opening of the capital account. The Asian crisis that erupted in 1997 halted that policy dead in its tracks. In 2006, with the Asian crisis a distant memory, the Reserve Bank of India revived the Tarapore committee. This time, the group's report was more cautious, endorsing a gradual move towards a more open capital account. Another government committee's work, dubbed the "Mistry Committee" report, has ratcheted up the debate this year by arguing that to give Mumbai a fighting chance of becoming an international financial center, the capital account must be fully opened by the end of 2008.

Would India be putting the cart before the horse by plunging headlong into capital account liberalization? The financial system is still underdeveloped, the fiscal deficit remains high (around 7% of GDP) and the exchange rate is still managed (although in recent weeks the rupee has been allowed to appreciate significantly). Under such circumstances, when the economy is not equipped to handle a gusher of capital flowing in or out, unbridled capital account opening in some emerging market economies has ended in tears.

Despite the risks, capital account liberalization could indeed prove to be a boon for India, but for a completely different set of reasons than the traditional ones associated with pulling in capital inflows. And, notwithstanding the recent complications with managing inflows, it is important to keep the big picture in mind, and reforms moving forward.

The traditional view is that opening up to inflows allows capital-poor developing countries to import capital, increase domestic investment and grow faster. The problem for proponents of this view is that economists analyzing macroeconomic data have found it difficult to detect the direct growth-enhancing benefits of foreign capital.

But a new paradigm has recently emerged in the academic literature on this issue. The real benefits of financial globalization to an emerging market economy have less to do with the raw financing provided by foreign capital. Instead, the indirect "collateral" benefits associated with such capital are far more important. These indirect benefits may be crucial for India's development.

One of the key benefits is that openness to foreign capital catalyzes financial market development. Foreign investment in the financial sector tends to enhance competition, raise efficiency, improve corporate governance standards and stimulate the development of new financial products. For instance, in India, even the limited entry of foreign banks has already given domestic banks a much-needed kick in the rearside and forced them to improve their efficiency in order to compete and stay viable.

Liberalizing outflows has the salutary effect of giving domestic investors an opportunity to diversify their portfolios internationally. This means greater competition for domestic financial institutions but also an opportunity for them to cultivate the financial savvy to offer products that would help their customers invest abroad.

Other indirect benefits associated with foreign capital include transfers of expertise - technological and managerial - from more advanced economies. When supported by liberal trade policies, foreign investment can help boost export growth. Foreign-invested firms also tend to have spillover effects in generating efficiency gains among domestic firms.

Notwithstanding these potential benefits, there is strident opposition in India to capital account opening. Some of it is based just on ideological opposition to foreign involvement in the economy. Dig deeper, though, and it turns out that much of the opposition comes from entrenched interests that view foreign-financed competition as an unwelcome intrusion that erodes the protection and privileges they have enjoyed for many years. Indeed, a "shock" like capital account opening is just the tonic to shake up the system and thwart coalitions that try to block reforms in this and other dimensions.

So why the rush towards a fully open capital account? What is so special about the end-of-2008 date or, for that matter, any specific date? In short, nothing.

But deadlines do have a way of focusing the mind. A policy commitment to fully open the capital account in a couple of years would give domestic firms time to adjust to the new landscape but force them to get to work immediately on restructuring themselves. It would give less room for reactionary forces to coalesce and block the reforms. It would also force policy makers to push forward with reforms such as deficit reduction and increased currency flexibility. Moreover, the historically high level of foreign exchange reserves (about $200 billion) and the benign international environment provide a window of opportunity to undertake capital account liberalization with fewer risks.

For an emerging market economy, the process of opening the capital account comes down to a delicate balance between the benefits it affords and the risks of disruptions to growth if things go wrong. For the Indian economy, which has made great strides in recent years, the balance has shifted - the trisks are now smaller and well worth taking to embrace financial globalization and push growth higher.

Coincidentally, The Wall Street Journal Asia also had an editorial on Indian monetary policy:

Mercantilist monetary policies are popular in developing Asia, where central banks have plenty of money to intervene in foreign-exchange markets and keep their currencies cheap. But how long will the party last? At some point, intervention becomes too expensive and inflationary pressures too great.

That's the conundrum India is facing today, where waves of inbound foreign capital have led the central bank to abandon more than a decade's worth of heavy intervention in foreign-exchange markets to keep the rupee cheap. The rupee has risen by more than 8% since March, eliciting cries of pain from exporters and protests from the Commerce Ministry. But the move seems to have taken the edge off inflation, which has edged down to 5.4% at the beginning of this month, from a high of 6.5% in mid-March.

"We must learn to manage these inflows but we must not do anything that will restrict investment -- domestic and foreign, and private and public," Finance Minister Palaniappan Chidambaram told the Confederation of Indian Industry on Friday. That's exactly right -- though not always as easy a political matter.

Investment flows are an affirmation that foreigners judge India a good place to invest. They are a byproduct, too, of freer flows of trade and capital. India wouldn't be growing at 8 to 9% a year were it not for economic liberalization. But as the country opens up to trade and cracks open its capital account, it will be more exposed to global monetary policy.

Welcome to a world without stable exchange rates, in which central banks tussle with competing demands of keeping inflation under check while avoiding attacks on their currency. This year, the Reserve Bank of India found itself in a bind: It had to purchase the foreign currency to keep the rupee within its normal range, but it also had to sterilize those inflows' inflationary impact by issuing bonds. The costs of issuing the debt spiralled upwards, and in March, the RBI simply stepped back from the market, and the rupee shot up.

But will the RBI do what the Finance Minister suggests, and truly shed its old mercantilist ways? As soon as the rupee started to climb back toward its nine-year highs last week, the Reserve Bank started intervening again. Equally worrying, the central bank clamped down on real estate companies' ability to borrow abroad and repatriate the funds -- a major source of pressure on the rupee -- by setting limits on the bond yields they could offer.

Capital controls are distortionary, at best, and at worst, completely ineffective. Real estate companies aren't likely to stop raising money just because the RBI has discouraged them from selling bonds; they'll figure out other ways to do so. What's more, by capping the yields on bonds that real estate companies can raise, the RBI has tipped the scales in favor of larger companies at the expense of small and medium-size firms, which are the real drivers of India's economic growth.

New Delhi need only look to Thailand to see what broad capital controls can do to wreck a functioning economy. When the military-installed government -- pressured by the country's large exporting lobby -- clamped down on hard on incoming foreign-equity flows in December, the Bangkok Stock Exchange experienced a 15% one-day drop. In any case, the capital controls have done little to limit flows; the baht has continued to appreciate since December's action, and Bangkok has now lifted most of the controls.

India's exporters aren't happy with a rising rupee, but that's part of the price of doing business in an open economy. India could link its currency to the dollar, a la China, but that would mean abandoning its own monetary policy. It could, however, go on defense, and focus on what it can control: its domestic financial markets. It's past time India got serious about deregulating its banking sector, allowing futures and hedging markets to develop, and letting foreigners compete on an equal footing.

Unfortunately, those changes don't look likely under the current Congress-led government. There may be an economist in the Prime Minister's seat, but it's Sonia Gandhi, president of the Congress Party, who's pulling the strings, and she's no friend to free markets. The closest this administration has gotten to financial-sector reform has been to crack open the capital account a little bit to let Indian investors put more money abroad, and to issue a few reports on what else needs to be done. New Delhi can't control how much money the U.S. Federal Reserve Bank releases into the global financial system. But it can control how efficiently it receives and distributes that money. The RBI may not be able to guide the rupee in the way it used to, but there are plenty of things it can do to bolster India's competitiveness.

Looking beyond the FII framework

In India, we are so used to the idea that foreign portfolio flows are channeled through `FIIs' that we have stopped seeing that it is a licensing system designed to fit the India of 1991. The participatory note market is a daily reminder of the rents that derive from canalisation. Today, I saw a map in Wall Street Journal showing the parts of the world where individuals can open accounts and do stock market trading. India is in the company of the worst run economies of the world. You may want to see some of my other materials on this subject.

ICFAI + AICTE = blocking CFA

ICFAI is an Indian firm producing education and certification. The brand "CFA" is owned by a US company. The US company sued against use of the brand name "CFA" and Indian courts supported it. ICFAI harnessed the license-permit raj in education and got the CFA evicted. Bibek Debroy has a great article in today's Indian Express on this. You might like to read something that I wrote on a related theme a while ago. Update (31/5): Rajat Kathuria has a good article in Business Standard on AICTE.

In my opinion, ICFAI has made a mistake in their profit maximisation. Indian customers are now more likely, not less likely, to try to get the US CFA when they see ICFAI using the State to make sure they cannot access it. Long hotel stocks in Khatmandu.

Two interesting notebook computers

For a while, defection from the difficulties of Microsoft Windows involved broadly two choices - an Apple OS X notebook or taking the trouble to install linux yourself on a notebook. The latter was hard. Over the years, things got better with knoppix and then ubuntu, but it continues to be a hurdle. In my reckoning, once linux is installed and properly working on a notebook, it's roughly as good as OS X. But getting there is often daunting absent a friendly neighbourhood linux enthusiast.

A major development in this business is Dell offering a notebook with ubuntu pre-installed. This takes away the hurdle of knowing how to install linux. Here are links: Apple Macbook, and Dell ubuntu machines. In addition to the notebook, Dell has two desktops which have ubuntu pre-installed.

I configured a Dell notebook to be very close to the Apple (2 GHz dualcore processor, 1G of RAM, 80 G disk, etc) and it works out to $924. The Apple is $1100. So Apple seems to charge a premium of $175. There may be some differences: e.g. Apple says it has a 6 hour battery life while Dell is not obviously telling you what the battery life is; the Dell has a bigger screen (15.4" vs. 13"); linux is a bit ahead of OS X in terms of some pieces of technology (e.g. /proc) but a bit worse in others (e.g. USB). I have not been able to compare the mass of the two machines.

More interestingly, the entry level Dell notebook is at $600 and the entry-level desktop is at $400. That should attract many people, particularly in places like India. At Rs.40 per USD, $600 is just Rs.24,000 and $400 is Rs.16,000. The Dell India website does not yet have these machines but hopefully it soon will. Hmm, in a year or two, would we have a notebook at $500 and a INR/USD exchange rate of Rs.35 which multiplies to Rs.17,500? You could sell millions at this price.

So I think that for the first time, Apple has credible competition. You can now get another notebook - other than the Apple notebooks - with industrial-strength security, stability, flexibility, etc., where you open the box and start using it since the OS is pre-installed. As an aside, Dell has priced this notebook at $75 below the identical machine running Microsoft Windows, so the user saves money as well. All in all, very smart moves on the part of Dell.

Vikram Aggarwal points out that there have been difficulties with device support for linux. The Dell uses the Intel Integrated graphics, which has a full source code driver in the kernel and a driver written by Intel. As the open source ecosystem reaches commercial users, commercial motives will reshape the behaviour of many of the players.

Update: Vikram Aggarwal bought the new Dell notebook and has posted a review. He finds This is finally a Linux laptop that I can buy blindfolded.

Property rights, eminent domain, and the land market

At the heart of the SEZ and land acquisition debate are the difficulties of the land market. Shruti Rajagopalan has an article in Wall Street Journal (via Mint) telling the story of how we landed in the present situation. You may want to see a previous blog posting on a related subject.

Prediction markets & weather derivatives

My recent post on prediction markets elicited a fascinating set of comments.

Nitin said that publicgyan is a website trying to do a prediction market on Indian underlyings. But it, as yet, deals in funny money and that won't scale. Tarun said that maybe the way out is to shift over to a funny money which has some other uses on the net.

Kaushik seems to say that while the State won't enforce against someone who won't pay his gambling debts, gambling isn't itself illegal. (Am I understanding you correctly?) I am perfectly comfortable with the task of setting up a clearing corporation which works with little support from enforcement apparatus of the government. However, I have to ask : if gambling is not illegal, why does the government periodically go after people placing bets on (say) cricket matches?

One important `betting market' which falls within the rubric of derivatives trading but not the traditional set of four underlyings (equity, debt, currency, commodities) is weather derivatives. Long ago, I had read that in the 1970s, Richard Sandor (who was then at CBOT) had noted that of all countries in the world, the biggest imaginable weather derivative was a monsoon derivative product in India. Everywhere else, weather is local. Here, you have one big random variable which shakes the life of households and firms across the country. A futures product would be able to pool the trading interests of a very large number of firms and households, in contrast with existing weather derivatives elsewhere in the world, each of which taps into a small set of interested users. The liquidity that an Indian monsoon futures contract could get is, hence, gigantic.

I have heard descriptions of monsoon derivatives which had sprung up in Bombay in the 1950s. There used to be a standardised 500 ml milk bottle in Bombay, then. One such bottle would be placed on the terrace of a building and people would stand in the rain placing bets on how far the water would fill up.

When NCDEX started the guar contract, none of us understood that this was going to be the contract where NCDEX made it. Many people were surprised at the success of futures on Guar Seed at NCDEX. In my opinion, part of the reasoning lies in the fact that it is a rain-fed crop which is highly vulnerable to the monsoon. So it's a bit of a monsoon derivative. In addition, there is inelastic supply and vulnerable output, so you get big price fluctuations - that vol surely helps the futures product.

The need for a monsoon futures remains, and given that the formal financial sector is not offering a product, there is a big underground market. I saw a fascinating article by Rashmi Rajput titled Rs 3,000 crore riding on Mumbai monsoon in The Times of India where she says:

Want to make some money while you wait for the rains? Place your paisa on June 7. At least that's what punters across India have done. There is close to Rs 3,000 crore riding on the rains in Mumbai this year: Bookies have accepted bets worth Rs 3,000 crore on the date of the arrival of monsoon in Mumbai, the total rainfall the city will record this season, and even the monthly break-up of quantum of rainfall.

And this is what the consensus is: The city will experience its first shower on June 7. The season's total rainfall will between 1,700-2,000 mm, a good 500-800 mm less than the last year. And if the money being wagered is anything to go by, the rains will be evenly distributed between June, July and August with average 400-500 mm rainfall and the monsoon will rapidly lose its steam in September with just 200 mm rainfall (See charts for rates).

When we contacted meteorological director-general Dr C V V Bhadram he refused to hazard a guess if the bookies will lose or make money, familiar as he is no doubt with the whimsy of the monsoon. "The monsoon has two branches one extends from the Bay of Bengal and the other from the Arabian Sea. The west coast receives rains from the Arabian sea. It's only after the monsoon sets in Kerala that we can monitor its movement and tell when the rains will arrive in the city," he said, playing safe.

"Generally the monsoon sets in the Kerala in the first week of June and proceeds gradually upwards. I can't comment on what the bookies are saying. Our methods are scientific and proven," Bhadram added. Though of course the bookies will bet again, all in jest, on who will be more accurate they or the Met department. Confident with their date of June 7 punters are offering only 50 paise on every rupee bet on June 7. For June 8 it is 80 paise and 90 paise for June 10.

And mind you, they too have looked at weather charts, some of them possibly prepared by Bhadram's department, and sniffed the air in Kerala. "Looking at the climatic conditions predicted by the meteorology department, we don't foresee a good monsoon. An average rainfall of around 1,700 mm to 2,000 mm is expected this season," a bookie told this newspaper shying away from disclosing his identity.

Rains apart, the bookies are looking at a good season after the disappointment of World Cup. Last year's betting business during monsoon too was badly affected by the serial train blasts and bookies could mop up just over Rs 750 crore, sources said.

"This year we expect the business to be good. In fact, it is looking good already. We have already collected Rs 3,000 crore which is double of what we collected in the entire season last year. As the season progresses, more money will pour in," said the bookie. The punters outside Mumbai seem to be more interested. "Most of the bookies are from Jaipur, Udaipur, Ahmedabad, Pali, Guwahati, Indore and Bhopal," he said.

Mumbai as an International Financial Centre (MIFC): Additional materials

The Ministry of Finance website now has the full text of the report as PDF files and a bunch of interesting videos. In order to avoid fragmenting the materials, I have augmented the links on my old MIFC blog posting.

What to do with the World Bank, by Percy Mistry

It has long been clear that the World Bank is an institution lacking a clear business model. The present situation offers an opportunity for achieving fundamental change. Percy, who is one of the people who understands the World Bank the best, has ideas about what should best be done [pdf].

Pension reforms

Business World has a thoughtful editorial on pension reforms.

Righting the rupee

I wrote an article in Asian Wall Street Journal titled Righting the rupee.

Coincidentally, Jamal Mecklai wrote an opinion piece in Business Standard on roughly the same day with roughly the same ideas. Jamal's piece is, of course, much more fun to read than mine.

Adam Posen has a great oped on the issue of focus of the central bank. Also, see this by him.

In the AWSJ article, I mention Thailand as a reminder of what could happen if there is an effort to bring back capital controls. There also, reforms of monetary policy institutions appears to have taken place as a consequence of these problems: I believe that Bank of Thailand has been placed under the supervision of the Ministry of Finance (MoF) and the BoT governor will now serve for a fixed term.

The NBER paper on central bank transparency that I allude to is Dincer & Eichengreen, 2007.

Securitisation, innovation in finance, and the best use of the FM's and the PM's time

I wrote a piece in Business Standard titled Go to the root cause. I'm very happy that legislative changes are being made to support securitisation [link]. But what we really need to shoot for is a deeper change in financial law, so that innovations in products, market design and business processes do not require modifications to law or regulations. The latter idea is drawn from the MIFC book.

What holds back prediction markets

By now, all of us are familiar with `prediction markets', which are organised systems for placing bets on discrete outcomes - ranging from India's performance in world cup cricket to the date of the next general elections. Prediction markets have been proven to be rather effective at obtaining useful information about the future. As with the process of speculative price discovery in financial markets, the basic point seems to be that these markets give incentives to people who command remarkable knowledge to step forward and contribute their knowledge into a publicly visible form, to generate a public good of the price. As an example, I use this page to have a sense of when Apple is going to launch Macbook Pros with the Santa Rosa chipset.

New Economist has a blog post where an illustrious bunch of economists in the US appeal for a more liberal public policy framework which allows these markets to flourish. Their document is very well written and worth reading, as is Steve Levitt's blog post about why he did not sign it. Readers of this blog might recognise the name Michael Gorham. Also see When gambling is good by Robert Hahn and Paul Tetlock.

This got me thinking: Why don't we have prediction markets in India? A natural answer that might come back is: Because they'd be considered gambling and shut down.

I'm not a lawyer, but in my understanding, the legal framework [link] does not prohibit gambling: it only blocks the utilisation of the contract enforcement services of the State in collecting on gambling debt. So if a prediction market is properly collateralised, and if one never needs to resort to the State when an individual defaults, then the legislation should not be an impediment. (Or am I missing something essential? There is a scary provision in IPC where they promise to go after people who run lotteries.)

Another strategy, of course, is to setup a market outside the country and have Indian citizens submitting transactions into it using credit cards. One of the existing prediction market websites could easily come up with a bunch of India-related products, and sell them by advertising through the Internet.

Two articles on IPO grading

Prithvi Haldea is bang on about IPO grading. And, see Rajesh Kumar on this subject. You may like to see an earlier blog posting of mine on this.

Humility in making statements about equilibrium exchange rates

In discussions about the rupee, many people are offering views about overvaluation (or lack thereof). In a recent piece on the subject [link], I said :

The present state of economic science does not permit such confident statements. REER calculations are extremely imprecise and have little content in explaining key relationships - as the above example shows.

Menzie Chinn has a blog posting on this subject. I found it particularly amusing that the two numerical values about the Indian rupee on this page were +12.1 and -14.7. In other words, we just don't know.

A maze of twisty little capital controls

In the 1970s, India excelled in tweaking a gigantic system of controls on trade and industry. There were thousands of levers of power, and bureacrats + politicians utilised them on a day to day basis based on various needs. We are in that kind of world today with capital controls. On one day, RBI says that individuals can take $100,000 per year out of the country. On another day, fresh rules are introduced [pdf] to block one possible use of this money - posting margin for trading on futures markets. Andy Mukherjee has a great piece on Bloomberg about this flip-flop. The edit in Financial Express that he talks about is here.

Understanding inequality

There is a lot of concern that high GDP growth in recent years has been associated with higher inequality. Gary Becker and Kevin Murphy have a fascinating and different take on understanding higher income inequality. They say that the bulk of the phenomenon of recent increases in inequality are caused by bigger skill premia in the labour market. Also see this New York Times article by Tyler Cowen.

I'm faintly reminded of the argument by Montek Ahluwalia in the late 1990s on the subject of rising inequality between states of India. He pointed out that it was only after liberalisation that the opportunities became available for some better governed states to do better than the rest, so it's natural that in the early period of market-oriented policies, inequality should have gone up. The forces which reduce inequality - the `equalising differences' of the price system (see the comments on this post for more on `equalising differences'), and the feedback loop influencing governance through the political system - impact with a lag.

How to make a backup of all blog content?

I like to have a backup of my blog on my notebook, so that I can run searches in it when I am not connected.

Blogspot has nice URLs for each post - e.g.

http://ajayshahblog.blogspot.com/2007/03/how-to-make-email-to-blogger-work.html

is the URL for a post that I wrote on making email -> blogger (mostly) work. This suggests a file system where there are directories 2007, 2007/03 and then a file 2007/03/how-to-make-email-to-blogger-work.html, which would be a case of nice software engineering.

How would I make a personal file system which mirrors my blog which has this structure? I'm unable to do this. I tried to use wget with recursive get options and it gets lost. A key feature that I want is to be able to say wget -c so that modified posts are picked up (but all posts are not brought down).

Right now, I have a simple and dumb solution: I take one file per month, and I fetch the whole thing every time (which is wasteful of resources for google). I use this script:

#!/bin/sh

rm -f *.html *.text
for year in 2005 2006 2007 ; do
  for month in 01 02 03 04 05 06 07 08 09 10 11 12 ; do
   wget "http://ajayshahblog.blogspot.com/"$year"_"$month"_01_archive.html"
   links -dump "http://ajayshahblog.blogspot.com/"$year"_"$month"_01_archive.html" > $year$month.text
  done
done

This works, but it's not a nice solution: (a) I'm wasting bandwidth and google's resources - and the waste will grow as the years go by - and (b) It doesn't get me the clean well organised file system with nice file names that ought to be possible.

Why read blogs?

I was surprised to see a delay of 14 months for a story to get from a blog to The Economist.

Flaws in the monetary policy framework

Ila Patnaik has a response in Indian Express to calls for RBI to get back in the game to push the INR back to Rs.45 a dollar. As she emphasises, a key flaw today is the shroud of secrecy that surrounds monetary policy formulation and execution. This is not just about the generic issue of all government agencies doing better work when functioning with transparency and accountability. The lives of households and firms are greatly affected by "policy risk" of the fluctuations in RBI's currency policy. The work and planning of households and firms would be better enabled by improvements in transparency, where RBI would tell the country what is going on. E.g. how do you know they're not back in the currency market, defending 40.8?

PIMCO is long INR, and William Pesek agrees with what India has been doing, saying that this `madness' is the Right thing to do.

Other interesting pieces on monetary policy are by Nirvikar Singh and an editorial in Business World. Update (11/5): Kalpana Kochhar and Charles Kramer are bang-on with myths about inflation. Update (13/5): Vivek Moorthy talks about the linkages between inflation and a floating rate. Part of the impact comes from exchange rate pass through owing to appreciation, and part of the impact comes because of regaining autonomy of monetary policy.

What changed about the rupee: level vs. volatility effects

Business Standard has an editorial Rupee: level vs. volatility, which distinguishes between the two things that have happened on the Indian rupee: a shift in the level and a shift in the volatility:

The new currency regime that the RBI is following has led to new difficulties for individuals and firms. Two things have happened at once: The level of the rupee/US dollar has shifted from Rs 45 to Rs 41 per dollar, and the volatility of the exchange rate has gone up. The first effect inflicts pain on some (exporters) and pleasure for others (importers and the broad population). The second effect inflicts pain on importers, exporters and financial firms. The unhappiness about the shift in the exchange rate is not surprising. When diesel prices shift to their free market level, diesel consumers will obviously not be pleased. However, it is increasingly clear that it makes sense for monetary policy to focus on inflation control and not on targeting the exchange rate.

An entirely distinct story is the shift in volatility. The new currency regime represents a qualitative change from an RBI-controlled rate to a market determined exchange rate. The footprint of currency risk runs far beyond direct imports and exports. For, a large number of commodities are now priced by import parity pricing, where the local price is just the exchange rate multiplied by the world price, even if the producer and consumer are both Indian. Importers, exporters, financial firms and households are taken aback at this upsurge in volatility. This concern is legitimate.

The existing currency forward market does not pass muster, for numerous reasons. It is a non-transparent market, where substantial fees are transferred from users to financial firms. The non-transparency induces poor price discovery, something that India can ill afford at a time when well-functioning spot and derivatives markets on the currency are the need of the hour. The opacity of the existing forward market is a recipe for scandal, and this fear of scandal will continually generate a bias in the government to prevent this market from gaining adequate liquidity. Currency risk is present in every corner of the country, while the currency forward market takes place only in south Mumbai. There is a clear way out which addresses all these problems: that of establishing transparent, exchange-traded markets for both spot and derivatives on the currency, so as to match the market quality of the equity market.

In an ideal world, the finance ministry should have better planned the transition of the currency regime. First, the currency spot and derivatives market should have been built up, and only after these structures for trading and insurance were in place, currency volatility should have been permitted to go up. Such planning has, alas, not been done. It is, yet, not too late to urgently move on establishing new market structures through which individuals and firms can do better risk management. The Mumbai International Financial Centre report has proposed two key initiatives in strengthening the currency market: Establishment of a currency spot market, with a market lot of Rs 1 crore, accessible to all financial firms, and establishment of a rupee-settled currency futures market, accessible to all. The ministry needs to make up for lost time by rapidly executing on these two ideas, harnessing the strengths of Sebi, the NSE and the BSE. Rupee volatility like that seen in mature market economies must be accompanied by the tools found in mature market economies for coping with currency volatility.

I have previously written about currency futures, and there is a page on this blog about the MIFC report.

Understanding the INR

Arvind Subramanian has an opinion piece in Business Standard titled Action on the currency front inevitable. Update (15/5): Deepak Lal has a very clear-headed piece where he sorts out the confusion.

What happened to the REER?

In recent days, there has been a considerable focus on whether the recent INR appreciation leaves India with a badly overvalued exchange rate. I have argued that over the last five years, gross receipts on the current account tripled, and that exchange rate + inflation fluctuations have been swamped by other things that were going on which affect exports. Swaminathan S. Anklesaria Aiyer has an article in the Economic Times where he looks at what is going on with the real effective exchange rate and argues that there is no significant appreciation to speak of. I have long been concerned about difficulties in the methodology utilised by the RBI REER series, but am slowly getting convinced that the 36-country measure is done okay.

Three books on Afghanistan

In understanding the world today, it is important to understand the 9/11 attacks, and the geo-political risk that is derived from bin Laden and sympathisers. One of the most marvellous books that I found in this task, a few years ago, was Ghost Wars by Steve Coll [link on Amazon]. It is a gripping tale, spanning the US, the USSR, the Middle East, Pakistan and Afghanistan, running from 1979 till 11 September 2001 (but excluding the thought process and execution of the attacks).

The tale is of epic proportions, and Steve Coll does a marvellous job of cramming it in tight, unemotional pages. Again and again, you are transported by the breathtaking events, but the text just concentrates on telling the story in a terse, factual and authentic manner. The one character you notice out of the story is Ahmad Shah Masood.

I fervently hope that Steve Coll is hard at work writing a sequel to this book, which would pick up the tale from 9/11 onwards.

Steve Coll works at The New Yorker, a remarkable employer of people like David Remnick, Lawrence Wright, and Malcolm Gladwell. I think every journalist should aspire to write books like these four people have.

Ghost Wars is primarily played out at the level of high strategy. In a flurry of plane flights recently, I read a second book which takes you closer to the boots on the ground. This is First In by Gary Schroen [link on Amazon]. Schroen headed the first CIA team which setup a camp in Afghanistan in the days after 2001-09-11.

I always knew the big picture: Within weeks after 9/11, US Special Forces guided smart munitions in, and the Northern Alliance evicted the Taliban, marking the greatest achievement of special forces and the CIA ever. The book gave me a more fine grained understanding of how great powers work, of the actual detail about how these things got done. E.g. who'd have thought that Schroen and team would shop at REI to prepare for going into Afghanistan! :-) Some readers are turned off by the little details. I actually enjoyed every bit of it.

The story seems to be much more complex than meets the eye. Traditionally, US foreign policy was slanted in favour of the Pakistan / ISI view, which emphasised the importance of Pushtun tribes and the role of Pakistan as an indispensable interlocuter with them, and was skeptical about Ahmad Shah Masood and other northerners. Indeed, the term `Northern Alliance' was coined by the ISI in order to help denigrate the claim of Masood and others of being a broad-based political coalition which could lead Afghanistan.

As both books show, from 1979 onwards, Masood continuously talked with the US, but never got through. The US policy establishment seemed to have had profound blinkers on this problem. Masood eked out a meagre existence based on a little help from Iran and India, but with US and Arab resources backing the ISI, there was no question of his steadily losing ground in Afghanistan.

Then came 9/9/2001, when Masood was murdered by a pair of Arabs, and the attacks of 11/9/2001. I used to think that this swiftly demolished the Pakistan perspective in US policy making. (Steve Coll's book - which was my main source of knowledge - ends on 9/11/2001).

But the actual story was much more complex. Schroen was pulled back from retirement to lead a CIA team which went into Panjshir Valley to establish contact with Masood's team. This was the nucleus around which US Special Forces setup a boots-on-the-ground capability for guiding smart weapons at Taliban positions, which ultimately won the war in Afghanistan.

However, even after Schroen and a small team were in place, the US policy community was deeply divided on the extent to which they were going to go along with the ISI / Pakistan position. The ISI / Pakistan position was that it was dangerous for the US to have an engagement with the Northern Alliance. Schroen talks repeatedly about fruitless days spent in scanning target-rich territory, where Taliban assets were placed, but of being unable to obtain resources in terms of B-52 time to take out these assets.

Ghost Wars is at the level of high strategy, and First In is at the level of men of action. Both books are wonderful and complement each other. You can't help envy the amazing experiences that the people of First In went through, right from flying into Afghanistan in helicopters that are barely able to make it past 14,500 feet to the ultimate destination of building a rapport with the Northern Alliance and setting up for US air power to enable the victory in the ground war.

At one point, the story is told of a US Special Forces person who made a mistake, and supplied his own GPS coordinates to the B-52 instead of the geo-coordinates of the Taliban positions 1000 feet away. The 500 kg bomb swiftly came down on him, and almost killed Hamid Karzai. GPS-guided bombs endow a whole new meaning to the term `friendly fire'.

Another remarkable tale in this book is probably the last cavalry charge in human history, of 600 people riding horses across a few hundred metres of open ground at entrenched Taliban positions. This was at a point in time when US policy makers were not yet sure that they wanted to support the Northern Alliance. If air power were available, this would have been an easy attack, but at that time, US policy makers were as yet undecided about their activities in the north. So it was simply 600 people riding horses into guns without any support from the air. I suppose such a ride will ever happen again.

My next book in this sequence is by another person who works at New Yorker: Lawrence Wright's The Looming Tower. I read a few of his wonderful pieces in New Yorker when they came out, and look forward to the book. And of course, I hope Steve Coll will follow up with a Ghost Wars II.

I found it fascinating that two of these three books won the Pulitzer prize for general non-fiction. I was also surprised how many of the wonderful books that I cherish are on that list.

Mulling over government owned banks

The question of public ownership of banks has long been a political hot potato. However, the consensus of experts has steadily shifted towards discomfort with public ownership. As S. S. Tarapore points out (see the file by him on the MIFC web page), the Narasimham-2 report and the Tarapore-2 reports have endorsed a shift away from government ownership of banks. The MIFC report is also on that line of thought. This makes three prominent government committee reports which question PSU banking.

Today, the front page of Indian Express has a depressing story about career politicians being appointed on the board of directors of PSU banks (also see this). It is hard to see how such appointments are not consistent with rent seeking behaviour, and with a loss of competitive strength on the part of PSU banks. Update (8/5): See the edits on this in Business Standard and in Indian Express. These developments are perhaps not as significant as the Indian Express story makes them out to be, for they probably only convert the de facto into the de jure.

Poor management of PSU banks hurts the economy because of the important role that PSU banks play in Indian finance. The harmful effects of government ownership of banks would be much smaller if the market share of PSU banks was much smaller than 75%. As I have emphasised, the really damaging problem is the lack of competition in banking. A sound framework of banking regulation could yield an outcome like that which has been seen in mutual funds, airlines and telecom, where big privatisations did not take place (other than VSNL), but the privatisation issue has clearly faded in significance. In this sense, the real weakness lies in RBI's entry barriers, and not in Parliament's unwillingness to amend the Bank Nationalisation Act. If RBI were able to emulate SEBI on mutual funds, or TRAI in telecom, or the Ministry of Civil Aviation on airlines, and remove entry barriers faced by domestic and foreign banks, the bulk of this problem could be solved in under a decade. The MIFC report has many deep ideas which seek to address the difficulties of competition in banking.

If this story on the front page of Indian Express were not depressing enough, here's another: the Supreme Court thinks that freedom of speech is not fundamental.

Paper by Kaivan Munshi on the sociology of the diamond trade

I am fascinated by diamonds for two reasons. First, the part to part variation makes diamonds a place where standard techniques for organising markets and obtaining financial market liquidity don't apply. Second, diamonds was India's first experiment in globalisation: the trade barriers and the capital controls were eliminated, and Indian firms succeeded on a world scale. So I find it interesting to figure out what happened and why. You may like to see my earlier post on the diamond trade.

Kaivan Munshi has written a fascinating paper titled From Farming to International Business: The Social Auspices of Entrepreneurship in a Growing Economy [link].

The abstract reads: Entrepreneurship has been traditionally concentrated in the hands of a few small communities in most developing economies. As these economies restructure, it is evident that these communities will be unable to satisfy the increased demand for new entrepreneurs. The analysis in this paper suggests that new business networks will compensate for the weak family background of first-generation entrepreneurs under some circumstances, supporting occupational mobility even in industries with significant barriers to entry. Using new firm-level data on the Indian diamond industry, the empirical analysis documents the important role played by an underlying community network in the expansion from agriculture to international business in one historically disadvantaged community over the course of a single generation.

Not making progress on entry barriers faced by foreign universities

There are few parts of public policy in India which are in as much trouble as higher education. I have previously written about the entry barriers in higher education in India: if you're not a politician and if you're not the State, for all practical purposes, you can't start a university in India; and even if you manage to get through, the State fervently tries to interfere in your activities. As a response to these kinds of complaints, the UPA came up with the Foreign Educational Institutions Bill, the full text of which is not out in the public domain. Indian Express seems to have got a copy and they have written a useful editorial about it.

Article on the INR over the 1953-93 period

The relationship between the black market and official exchange rates: An examination of long-run dynamics in India by Jim Love and Ramesh Chandra, Scottish Journal of Political Economy, May 2007.

The abstract reads: This study is the first to use Johansen's cointegration approach for India in the analysis of the long-term dynamics between the black and official exchange rates for the period 19531993. The study also estimates the long-run elasticity of the official rate with respect to the black market rate. As monthly data over 40 years are used, and a more robust methodology is employed, the results are likely to be more reliable as compared with the earlier work on India. The results of our study suggest that while there is a long-term relationship between the two rates, the direction of causality is from the black rate to the official exchange rate. This is plausible in the Indian context where policy has generally lagged behind events in the black market. The hypothesis of a constant black market premium is rejected, implying that there is a mismatch between the percentage change in the official exchange rate and the percentage change in the black market rate. [link, $$]

Article on the Indian pension reform

Mukul Asher has an article India's innovative pension plan in the latest Far Eastern Economic Review.

Who's afraid of a strong rupee

RBI has been doing less trading on the currency market. Without these artificial forces in play, the INR has appreciated. Shankar Acharya wrote an eloquent article in Business Standard saying this is all wrong, that we should just go back to the happy days of the policy framework of the mid-1990s. He says that the INR is overvalued and that does fundamental damage to India's exports growth and ultimately India's GDP growth.

I disagree. My main point is that there is a lot going on in exports growth, and that the negative impact of INR appreciation and high local inflation has been swamped by other factors which have helped enable high export growth. The empirical evidence supports the claim that there is no simple and sharp negative impact flowing from INR appreciation to exports growth.

TCA Srinivasa Raghavan helped me to sharpen the argument. Let's start with an AR model for monthly yoy exports growth data, which just captures the time-series structure of the series. I use data from March 1992 onwards. This works out to an AR(14) model. With this in hand, suppose you introduce contemporaneous and past yoy changes of the INR/USD. There's absolutely nothing there. Going up to 6 lags (or beyond) gives nothing. Not a single coefficient is significant. This result holds whether you do the full dataset (from March 1992 onwards) or if you focus on the latest 100 points which is 8.33 years.

In other words, after controlling for the time-series structure of the exports growth series, yoy INR/USD fluctuations don't seem to matter in explaining the fluctuations of yoy exports growth.

Once again, my claim is not that prices don't matter. It's just that the explanatory power of currency fluctuations is small at best, and that the main story of exports growth is elsewhere. To say this differently, standard measures of REER are highly ineffective.

Confused about monetary policy

In recent weeks, monetary policy in India has faced many problems. Every plausible monetary policy regime ends up stabilising something - inflation, or interest rates, or exchange rates. You can disagree with what is being stabilised, but atleast something is. In recent weeks, India has suffered from huge volatility in all three. These suggest that the monetary policy regime is in distress. (See my blog entry from 7 March.)

In recent months, huge purchases of foreign currency were incompletely sterilised, fueling local inflation. These choices by RBI showed that the reaction function of RBI valued exchange rate policy over controlling inflation, even though the public rhetoric was full of talk about inflation. In mid-March, RBI appears to have stopped trading on the currency market. The INR appreciated sharply.

But there are numerous un-answered questions. Has the currency regime changed? What is the stance of monetary policy? Unfortunately, there are many uncertainties. The actions of RBI are the major risk factor that shapes future uncertainty. But it is not clear what RBI will do. The market does not know the monetary policy regime; it doesn't know the reaction function of RBI.

With this breakdown of the monetary policy framework, the recent credit policy statement would have been an ideal time for an introspective RBI to have displayed thought leadership, and offered a positive message of change. If such thinking is taking place, it is certainly not being communicated. RBI says that nothing was ever wrong and nothing needs to change. As an example:

q: Is there a need for the currency management policy to be changed as far as monetary management is concerned?

a: The exchange rate policy has served us very well in the last so many years and the exchange rate has been commended all around.

It has served the purpose of growth, stability, and external sector balance and there is no need to change any element of the exchange rate policy.

RBI believes that inflation targeting hasn't worked in the UK:

"Experience shows that inflation targeting has not worked in countries which had set formal inflation targets," Reserve Bank Governor YV Reddy said here.

Citing the example of the UK, he said that country had an open capital account, a pure monetary authority and an exchange rate which was virtually free, yet it had not succeeded in inflation targeting.

And, RBI seems to believe that an INR appreciation won't generate a negative impact on local prices:

Reserve Bank of India (RBI) governor Y V Reddy today disputed the notion that there is an inverse relation between the movement of the rupee and the direction of prices. The rupees rise to nine-year highs will not necessarily bring inflation down, he pointed out.

These unfortunate statements generate a loss of credibility and leave the market highly confused. Just in case you felt that RBI's retreat from currency trading in mid-March signified a change in the monetary policy regime, RBI is atleast saying this is not the case. Market manipulation of the currency market has gone down - does this mean we are headed for a more floating rate? But no, RBI recently bumped up the limit on MSS - so are we in for a bit more currency trading? (Isn't it time for MOF to question MSS?) Nobody knows what the next steps of monetary policy will be.

Business Standard had a fascinating edit titled Confusing signals on the subject on 30 April:

Has the Reserve Bank of India (RBI) changed its mind onand its attitude tocapital flows, currency management and how to cope with the problems caused by its established monetary policy? That would certainly seem to be the case, given the sharp rise of the rupee against the dollar in recent weeks. Perhaps the continuing strength of the capital inflow made it impossible for the RBI to continue with the old policy of trying to keep the rupee down by buying dollars and then sterilising the rupee funds that were generated by this action so that inflation did not get out of hand. Inflation was refusing to come under control, the dollar inflow was intensifying and monetary policy was coming unstuckwith higher interest rates causing their own problems. A change of tack may therefore have become inevitable.

From November 2006 to February 2007, the Reserve Bank of India spent Rs 88,000 crore to buy $19.7 billion on the currency market. These purchases are now worth about Rs 80,000 crore today, so the fall of the dollar has meant a substantial loss. An interest cost of 7 per cent, applied on Rs 80,000 crore worth of securities issued to sterilise rupee funds, would mean a further outflow of Rs 5,600 crore a year. Those are big numbers: Rs 14,000 crore would build a national highway from Delhi to Kanyakumari. But the true costs of the RBIs currency policy are even bigger. If dollar assets in November were $100 billion, a 10 per cent currency appreciation imposes a fiscal cost of 1 per cent of GDP. On top of that, there are costs owing to the poor returns on the reserves portfolio. The biggest cost of the policy, however, is not fiscal but political. Only a partial sterilisation of the dollar inflow was possible. As a result, in 2006-07, reserve money grew at 24 per cent, in contrast to 17 per cent in the previous year, resulting in higher inflation, which is politically unacceptable.

A higher external value for the rupee, which results from allowing the dollars to flow in and the RBI choosing not to intervene, is not without costs; the export slowdown that is already visible is one result. That is what has now made proponents of an activist currency policy unhappy, mindful as they are of what an export slowdown can mean to GDP growth and other macro-variables. The question is whether the RBI had a choice. Certainly, Y V Reddy, the RBI governor, seems to be singing a new tune after abandoning the erstwhile currency policy. With rising interest rates, inflation rates and money supply, the problems of monetary policy in India are visible to all. The question is whether a critical switch has been made in recent weeks, from the policies which worked fine in a closed economy, to a different policy matrix more in tune with an economy that is integrating with the rest of the world. The RBI does not make clear whether this is the case, and certainly its policy pronouncements should be different if it has indeed changed tack.

The centrepiece of a monetary policy statement is the central banks forecast of future inflation, which should guide interest rate setting today. Last weeks policy statement desires inflation of 4-4.5 per cent, but does not offer a path to that destination. While the stock market has been ecstatic because interest rates have not been jacked up again, the underlying problems remain. The government will want consumer price inflation to be no more than 3 per cent by 2008-09, so it is possible that the RBI may have to surprise markets again.

On the same day, Abheek Barua said:

Whatever the RBIs decision, it is imperative at this stage to communicate this to the markets if it is to put an end to the flux that currently prevails. If indeed, we are on the cusp of structural change in monetary management, the markets need to prepare for it. Second, if a less interventionist structure is indeed a short-term objective, the RBI has to recognise the imperfections and asymmetries in market structure that currently exist. These imperfections make a section of the banking system more vulnerable to the enhanced volatility that comes with a freer regime. Until the financial system moves to a new equilibrium, the central bank could perhaps provide these banks some succour.

What is to be done? The ideal thing is to have a consistent monetary policy regime. E.g. in the UK or the US, economic agents are not puzzled by the central bank; monetary policy decisions are not a source of risk. Even if a proper monetary policy regime is not in place, Ila Patnaik points out that a lot more transparency will help economic agents decipher what RBI is doing. Intuitively, think that economic agents, when armed with enough information, will run the right regressions and figure out what monetary policy is doing - regardless of what the central bank says.

I find that foreign banks or foreign financial firms often strongly advocate currency management by RBI. A pegged exchange rate, after all, is a gift of free risk management services for them. In addition, there are the great opportunities to make money from one-way bets, either speculative attacks or reverse speculative attacks. I find it fascinating to look back at how the people who saw the one-way bet on the INR a while ago have come out right.

Benn Steil and Robert Litan [book] have been preaching that third world countries lack the institutional capacity to do inflation targeting, and should just dollarise. At times like this, it's something to think of.