Search interesting materials

Monday, January 28, 2008

Major achievement in higher education in India

The Financial Times ranking of global MBA programs places ISB at #20 in the world. I believe this is the first time an Indian MBA program has made it into a good rank by world standards. (There is no other Indian MBA program in the top 100). I also suspect this is the first time an Indian university has figured with a decent rank in any global ranking (is that correct?).

This achievement reminds us of how a radical break with the past - i.e. internal mechanisms which look more like international universities and less like Indian universities - can yield major success in six short years. I think ISB features very important institutional innovations that should be increasingly transplanted into other Indian universities.

Saturday, January 26, 2008

Debt management office; easing financial repression

An editorial in Business World reminds us of the importance of translating the budget announcement last year - about setting up a Debt Management Office - into reality. It also talks about easing financial repression and going further beyond the FRBM target to get to a fiscal deficit of zero. On the latter subject, you might like to read this.

Friday, January 25, 2008

Price limits for small IPOs?

Susan Thomas says, in Economic Times, that price limits do not help small IPOs. I think that many old-fashioned folk find price limits reassuring because it is felt that the government is in control of the price.

Should RBI cut rates?

In continuation of the discussion on RBI cutting rates, the situation has changed because the US Fed cut rates. One unexpectedly large rate cut of 75 bps has taken place. What is more, the derivatives market suggests that more rate cuts are in store. Look at these probabilities:

This influences monetary policy in India and China. In both cases, pegged exchange rates induce a loss of monetary policy autonomy. Upholding the exchange rate peg will require cutting rates. In India's case, there is a large interest rate differential that (in any case) needed narrowing. See an edit in Indian Express and Omkar Goswami in Business Standard. In the Chinese case, the game of sterilised intervention - which used to be profitable since local Chinese rates were lower than the return on US treasuries - is now starting to cost serious money.

So expect moves in monetary policy amongst the peggers (though not the floaters, who have monetary policy autonomy) in response to the decisions of the US Fed. News begets news and volatility clusters.

Thursday, January 24, 2008

Media and ethics continued

See People's media by Pratap Bhanu Mehta in Indian Express on 23 Jan, and the comment by Jayanth Varma on the previous post.

Monday, January 21, 2008

Murky ethics on the part of the media, and the firms they cover

Bennett Coleman, a very big media house, is onto difficult ethical terrain with a concept of `private treaties'. Here, they get invested in some companies, and then these companies get favourable media treatment. Their media outlets trumpet these stocks, hopefully a good IPO takes place, and Bennett Coleman makes a good return on their portfolio. The expectation of free advertising and glowing editorial treatment probably leads to their purchases of these stocks getting done at bargain basement prices.


Sucheta Dalal says:

MoneyLIFE has in its possession a document to prove that journalists are being designated as champions for PT clients to tailor editorial coverage to enhance the value of these companies and TOIs investment. An e-mail by The Economic Times editor, Rahul Joshi (dated 29 November 2007), says, At ET, we are carving out a separate team to look into the needs of Private Treaty clients. Every large centre will have a senior editorial person to interface with Treaty clients. In turn, the senior edit person will be responsible, along with the existing team, for edit delivery. This team will have regional champions along with one or two reporters for help - but more importantly, they will liaise with REs (Resident Editors) and help in integrating the content into the different sections of the paper. In this way, we will be able to incorporate PT into the editorial mainstream, rather than it looking like a series of press releases appearing in vanilla form in the paper. He then goes on to name the PT champions for each region, who will advise the regional editorial chief to carry stories about PT clients. He also designates trouble shooters in each region, probably to ensure that no PT client is offended with negative coverage.

It reflects poor ethical standards on the part of Bennett Coleman to do such a thing. First, a question of fact: Do good papers in the world, such as New York Times, have private equity portfolios where editorial coverage and advertising are bartered in return for shares? Compare and contrast against the soul-searching that the New York Times has institutionalised on far more subtle kinds of conflicts of interest. I am curious about the role that law can play here. If the New York Times embarked on such a thing, would it be outright illegal? If it was not outright illegal, what else might go wrong for New York Times if they did such a thing?

The only saving grace lies in the fact that Bennett Coleman has put up their hall of shame, of firms who are willing to cooperate with such a scheme, on the web. Some names in there make no sense - e.g. I can't see how they can get a fabulous return on an investment in ISB. But many are recognisable targets of laudatory coverage.

I have often felt that in order to become a well functioning market economy, there has to be a culture of high ethical standards, a sense that certain things are just not done. While ethical standards require legal foundations, there is something about ethics which goes well beyond law. A go-getting atmosphere, where all kinds of behaviour is welcome, is a highway to becoming a banana republic. You may like to see something that I wrote in 1997, about how an atmosphere of low ethical standards induces entry barriers and hampers competition.

While there are signs of progress on the economy as a whole, in recent years, the scale of corruption in India associated with real estate and natural resources appears to be straight out of your worst stereotypes of a banana republic. CEOs have an incentive to do bad things: e.g. the stock market likes electricity generation projects which have locked down coal supplies, which favours entrepreneurs with a gift for manipulating the government. Ministers are rumoured to have become like Bennett Coleman, asking for shares in return for unethical actions. With natural resources and land, we are experiencing the well known pathologies of the `resource curse'. The only saving grace for us is that by now, the real estate and natural resource related sectors are a small part of the economy.

I'm not one of the proponents of the view that blogging fundamentally changes mainstream media. But in this one respect, I can see that it helps. The rise of the Internet in general and blogs in particular has helped to reduce the mindshare of Bennett Coleman. Blogs have helped make such murky practices more visible.

Saturday, January 19, 2008

When a powerful urge to do good crowds out hard thinking

Stephen Dubner and Steve Levitt have an article in The New York Times that reminded me a lot about the pitfalls of public policy in India.

When a powerful urge to do good crowds out hard thinking, the results are often different from what might have been intended. Their article has two interesting examples:

  • The `Americans With Disabilities Act' in the US involves all kinds of privileges for disabled people. E.g. it allows a patient to place the costs of a sign-language interpreter on the doctor. A paper by Acemoglu and Angrist found that when the law was enacted in 1992, employment of disabled workers went down sharply. Employers were concerned that the law would limit their ability to discipline or sack disabled people who happened to be incompetent, and chose to avoid recruiting them in the first place.
  • The `Endangered Species Act' in the US allows the notification of `critical habitats' for endangered species. As a consequence, when a landowner feels that endangered species are possibly inhabiting his privately owned forest land, he often takes care to raze the trees to make sure that he is not expropriated. This leads to more habitat destruction, not less. They describe the cactus ferruginous pygmy owl, studied in a paper by List, Margolis and Osgood: landowners near Tucson, Arizona `rushed to clear their property for development rather than risk having it declared a safe haven for the owl'.

As Dubner and Levitt summarise:

So does this mean that every law designed to help endangered animals, poor people and the disabled is bound to fail? Of course not. But with a government that is regularly begged for relief these days, from mortgage woes, health-care costs and tax burdens and with every presidential hopeful making daily promises to address these woes, it might be worth encouraging the winning candidate to think twice (or even 8 or 10 times) before rushing off to do good.

Thursday, January 17, 2008

Cut rates now

Ila Patnaik says that if you have a pegged exchange rate, you shouldn't have illusions of monetary policy autonomy. The Indian short rate can't be higher than that in the US, and if the US is about to cut rates, then we have to do so too. In any case, the global economic situation is getting gloomy, which also supports lower rates.

Wednesday, January 16, 2008


Jayanth Varma has a blog entry about a recent SAT ruling on SEBI, that makes you worry about the quality of investigative work at SEBI.

Tuesday, January 15, 2008

Fix the distortions, in petroleum products and in the rupee, at once

Two major price distortions in the economy, where the government is directly involved in setting prices, are with petroleum products and the exchange rate. While the deeper economic policy reform that is required is to shift both to genuine markets, without government involvement in price-setting, the minimum work that is needed right now is to reset the controlled prices so as to eliminate the pent-up distortions.

In Business Standard today, I argue that there are merits to tackling the distortions that have built up on both these markets at once; rough estimates suggest that the net effect on WPI of a 10% rupee appreciation plus a 10% rise in WPI fuel might cancel out in roughly 10 weeks.

On the subject of administered prices of petroleum products, also see this by Ila Patnaik from Nov 2007, and this article from The Economist.

India - a `socialist secular democratic republic'?

This blog entry is joint work with Kaushik Krishnan.

A fascinating episode is taking place in, what I hope, is the unfolding improvement of the Indian constitution.


In 1951, the `Representation of the People Act' was enacted, which demands that any political party must state, in an affidavit, that they would adhere to the principles of the preamble to the constitution.

Then the Constitution was amended in 1976 by the Constitution (Forty-Second) Amendment to put the word `socialist' into the preamble. Combining these two facts implies that today in India, every political party is forced to adhere to the precepts of socialism. Barun Mitra tells this story in Mint, and you might like to read my earlier blog post on the Emergency of 1976.


(Image credit). What does the word `socialism' mean? Here are some definitions from and Merriam-Webster online: Unabridged
1. a theory or system of social organization that advocates the vesting of the ownership and control of the means of production and distribution, of capital, land, etc., in the community as a whole. 2. procedure or practice in accordance with this theory. 3.(in Marxist theory) the stage following capitalism in the transition of a society to communism, characterized by the imperfect implementation of collectivist principles.
American Heritage Dictionary
1. Any of various theories or systems of social organization in which the means of producing and distributing goods is owned collectively or by a centralized government that often plans and controls the economy. 2. The stage in Marxist-Leninist theory intermediate between capitalism and communism, in which collective ownership of the economy under the dictatorship of the proletariat has not yet been successfully achieved.
a political theory advocating state ownership of industry 2. an economic system based on state ownership of capital
American Heritage New Dictionary of Cultural Literacy
An economic system in which the production and distribution of goods are controlled substantially by the government rather than by private enterprise, and in which cooperation rather than competition guides economic activity. There are many varieties of socialism. Some socialists tolerate capitalism, as long as the government maintains the dominant influence over the economy; others insist on an abolition of private enterprise.
1: any of various economic and political theories advocating collective or governmental ownership and administration of the means of production and distribution of goods 2 a: a system of society or group living in which there is no private property b: a system or condition of society in which the means of production are owned and controlled by the state 3: a stage of society in Marxist theory transitional between capitalism and communism and distinguished by unequal distribution of goods and pay according to work done

None of this seems, to me, to be a part of the idea of India.

Challenge at the Supreme Court

The Supreme Court was recently asked to think about this situation by the `Good Governance India Foundation'. See:

Fali Nariman, arguing for the petitioners, said that changing a word in the preamble amounts to changing the basic structure of the constitution and requires scrutiny as with the `basic structure' doctrine. But this is going to be a tough argument to pull off since the Supreme Court has said that the objectives specified in the Preamble (socialism being one of them) contain the basic structure (Kesavananda Bharati v. Union of India, Excel Wear v. Union of India). Aparently some time ago, an attempt to revive the Swatantra Party was blocked by the election commission because this party was not willing to say that it adhered to socialism.

The bench, headed by Chief Justice K. G. Balakrishnan, refused, saying:

Why do you define socialism in the narrower sense as the communists do? ... Why don't you go by the broader definition which mandates the state to ensure social welfare measures for all the citizens as a facet of democracy?

I'm pretty clear that the word `democracy' and the words `social welfare' are very different and do not have to go together. The former is unquestionably the core idea of the modern State worldwide; the latter is a controversial vision of the State that originated in Europe and has been having a lot of trouble the world over. Perhaps our Chief Justice should consult a dictionary to know what `socialism' means. Did he just blow a chance to make it into the history books?

The story that seems to be at work is that the words in the Preamble are defined by the Supreme Court through its judgments; dictionary meanings do not matter. The Court seems to have always favored defining socialism in loose, vague and highly idealistic terms. ``Indian socialism'' is said to be about what the Constitution of India wants to have for the people of India. In the past the Supreme Court has said that socialism is about ending poverty, ignorance, disease and inequality of opportunity. This socialist concept ought to be implemented in the true spirit of the Constitution (G.B. Pant University of Agriculture and Technology v. State of Uttar Pradesh). The Court has also said that the basic framework of socialism is to provide a decent standard of life and security to the working people (D.S. Nakara v. Union of India). As recently as last year, it was held that socialism is one of the systematic and structural principles underlying the Constitution (M. Nagraj v. Union of India).

I find it very odd, that the Constitution of a country utilises a word that has a certain mainstream meaning in the dictionaries, but that word actually means something different - on the ground - as compared with what any citizen would think. What do we want every citizen of India to think about what the Constitution of India says? Should the Constitution - or atleast the preamble to it! - not be written in plain English?

There has been a recent trend in which the Supreme Court has, only slightly, been promoting liberal ideas (State of Punjab v. Modern Breweries, BALCO Employees Union v. Union of India). But in most of these cases, the Court cleverly skirts the issue of `socialism'.

Legal experts say the Court will never say that socialism should be deleted, for two reasons. The first, a reason that isn't as relevant today as it was during Mrs. Gandhi's rule, was the fear that judges who spoke out against State Policy would be transferred or superceded. The second reason is that the judiciary is not the organ of the State that can change the Constitution. At most, it can make sure that the Legislature creates law within the framework that the Constitution allows. But it cannot create law. More importantly it cannot delete law. But all hope is not yet lost, while the PIL that sought to remove socialism from the Constitution was dismissed, the PIL that seeks to remove the socialist ideology as a necessary requirement of all political parties has been admitted.

In the US, the original drafting of the Constitution was a brilliant one, and in 1791 the First Amendment was put into place which upholds freedom of speech. It was only in the 20th century that a series of judgments fashioned the full implications of the First Amendment into the defence of freedom of speech as we understand it today. This required courageous judges, who interpreted the (brilliant) text as meaning that the government cannot ban offensive speech, except to prevent a threat of serious and imminent harm. We can yearn for such judges. But the courts can only follow up on sound drafting by seeing it through to the full consequences. The drafting has to first be sound. In India's case, we have had a weak starting point to start with, and a history of faulty amendments.

Fixing the preamble vs. fixing the RPA

In the great two-part article by Shubhankar Dam mentioned above, he says:

Incidentally, a proposal to amend the RPA and delete the reference to socialism was introduced in the Parliament in 2005. In a remarkable speech in the Upper House of Parliament, MP Anantrao Joshi submitted eight arguments for amending the RPA and deleting the socialist pledge.

First, India's freedom struggle, Joshi said, did not have any significant connections with socialist ideology. Neither Gandhi nor Patel expressed any sympathies for socialism. Patel, on the contrary, he said, compared the socialist in India to a dog walking under the bullock cart, which thinks that it is driving the bullock cart. And while Nehru was personally committed to socialism, he acknowledged that the majority in the Congress party did not share his views.

And this opposition to socialism, he added, explains why the word was omitted from the Constitution in its original text. Socialism was inserted only in 1977 as an afterthought by some vested political interests.

Secondly, his opposition to socialism, Joshi said, was borne out of his belief in the right to dissent. I am not an anti-socialist, he declared. But it was only after visiting the erstwhile USSR that he came to realise the significance of his right to dissent, of protecting his right not to be a socialist. By necessarily requiring every political party to swear by socialism, the RPA, he said, did not allow space for disagreeing with socialism.

Thirdly, his opposition to socialism, he said, was borne out of personal experience. Based on his belief that state intervention in artificially controlling the prices of agricultural commodities was detrimental to the interests of farmers, he decided to form a political party to lobby for the interests of the farmers in India. But his application was rejected by the Election Commission because he refused to affirm his commitment to socialism. Swearing by socialism to gain the status of a political party would be rank dishonesty, he said, and he did not want to do that.

Fourthly, the RPA, he thought, promoted hypocrisy. There were many parties in India that did not believe in secularism. And similarly, there were many left-wing parties that did not believe in democracy. And yet the Election Commission was reluctant to act against them because they had, even if falsely, sworn to uphold secularism and democracy respectively. The law, he argued, should not reward (or tolerate) hypocrisy while penalising honesty.

Fifthly, a mere commitment to socialism meant nothing. The term, he thought, was incorrigibly vague and has been applied to a large spectrum of theories over the last two centuries. The term has been associated with a wide number of thinkers including Saint Simon, Robert Owen, GB Shaw, GDH Cole and John Keynes. However, when used without any qualifications, the term socialism, he added, is interpreted to refer to the system of thought propagated by Marx, Engels and supplemented by lesser prophets like Lenin, and Stalin.

And certain traits of mainstream theory of socialism, according to him, were clearly opposed, if not repugnant to the basic principles and structure of the Constitution of India: for example, class-contradiction, atheism, and dictatorship of the proletariat. In other words, socialism at best was too vague and at worst contradictory to the basic principles of the Indian Constitution.

Sixthly, the RPA, he argued, was violative of the right to equality. Individuals taking oath to hold public offices under the Constitution do not need to affirm their commitment to socialism: they merely affirm their true faith and allegiance to the Constitution. But political parties cannot be recognised unless they specifically affirm their commitment to socialism and this, he thought, was violative of the right to equality under Article 14.

Seventhly, the RPA, he argued was also discriminatory. Only parties had to affirm their belief in socialism. The RPA did not require individuals desiring to stand for elections to make any commitment to socialism. This differentiation, he thought, was wholly arbitrary and violative of the right to equality.

Finally, Joshi submitted that by tying all political parties to a particular economic ideology, the law denied the possibility of change by legal means. By appropriating the entire legal space for socialism, the RPA, he said, left no room for advocating change.

This meant that the RPA prevents committed and sincere non-socialists from agitating as an organised force and trying to get the Constitution modified in their favour by entering the Legislative State Assemblies as also the Parliament.

Not surprisingly, Joshi's arguments created a tumult in the Upper House: many staunchly opposed his amendment. EM Sudarsana and Jairam Ramesh reiterated the usual socialist banter about social and economic justice and riled against the exploitative nature of capitalism.

And with Anantrao Joshi refusing to withdraw the amendment, the proposal was put to vote. The motion was negatived: majority of the members voted against it (i.e., they voted in favour of retaining socialism in the RPA).

Why? As Indias foremost criminal lawyer, Ram Jethmalani, pointed out during the debates: To oppose socialism is a very unpopular thing. While in personal agreement with Joshi's argument, he advised his friend to withdraw the amendment: I want to tell my friend, he said he has no chance of getting this Bill through this Parliament.

But, he added, in the Supreme Court of India, [Joshi] is bound to succeed on the constitutionality of the provision. A conscientious NGO has finally brought the matter to the SC.

A new liberal philosophy?

While one gets these disappointing statements from the Supreme Court, there are also some very interesting things going on. As an example, see Requiem for a principle by M. J. Antony in Business Standard which describes how the Supreme Court has nicely buried the notion that the State should enforce the notion that two people should get the same pay for the same work:

Though the Constitution asserts that the Directive Principles of State Policy listed in Part IV are not enforceable and are guiding principles in making laws, a zealous Supreme Court once tried to elevate one of them to the status of a fundamental right. In 1982, the Supreme Court ruled in the case of a bus driver of Delhi, that though the principle of equal pay for equal work is a directive principle, it could be considered as a fundamental right of the workers (Randhir Singh vs Union of India). It was the first and last time that a directive principle was anointed with the sanctity of a fundamental right. The experiment has failed, as recent judgements of the Supreme Court show.

The latest judgement delivered in the case of a tractor driver of Punjab (State of Punjab vs Surinder Singh) diluted the principle so much that it has been emptied of all practical utility. The court summed up the position thus: The principle of equal pay for equal work has undergone a sea change. Earlier the view of the Supreme Court was that if two persons are discharging the same functions, they will be entitled to the same wages. Subsequently this view has been changed and now the view of this court is that there should be complete and total identity between the two persons similarly situated so as to grant equal pay for equal work.

The court began having second thoughts on the application of its own principle in the nineties. In State of Haryana vs Jasmer Singh (1997), it observed that the principle was not easy to apply. There are inherent difficulties in comparing and evaluating the work of different persons in different organisations. Persons doing the same work may have different degrees of responsibilities, reliabilities and confidentialities, and this would be sufficient for a valid differentiation, the judgement explained. The court, therefore, left the decision to the administrative wisdom and bonafides of the employers, though it would be a value judgement.

This year saw further assaults on the principle. In the Indian Drugs & Pharmaceuticals case, the Supreme Court stated that granting pay scales is a purely executive function and the court should not interfere with it. It may have a cascading effect, creating all kinds of problems for the government and employers. In SC Chandra vs State of Jharkand, involving the staff of schools run by Hindustan Copper Corporation and Bharat Coking Coal Ltd, the court openly said that the principle was creating havoc. All over the country, different groups were claiming parity in pay with other groups.

The Supreme Court went so far as to say that if the court enforced the principle, it would violate the principle of separation of powers enshrined in the Constitution. Citing Madison, it said that all power was of an encroaching nature and judicial power is not immune to this human weakness. It must also guard against encroaching beyond its proper bounds, and not the less so since the only restraint upon it is self-restraint.

The court, therefore, recommends that the judiciary should keep out of the field. The equation of posts and salary is a complex matter which should be left to an expert body, it said in State of Haryana vs Secretariat Personal Staff Assn. The courts must realise that the job is both difficult and time-consuming which even experts having the assistance of staff with requisite expertise have found difficult to undertake.

Another area where a recent judgment suggests some new ideas are in the air was about women working in bars.

Monday, January 14, 2008

Pension assets in the Indian securities market

Vikas Dhoot has a fascinating story in Indian Express about pension funds and the stock market:

Now, as many as 152 global pension funds from 18 countries are here and the number is growing fast46 registered in the last 12 months.

Pension funds now make up for almost 13 per cent of the 1,240-odd FIIs in the country. Last month, Microsoft registered its 401 (K) plan (the US pension system for private sector workers) with SEBI, following the whos who of the global corporate world who have registered in recent months like Citigroup, JP Morgan Chase, Cargill, Hewlett Packard and Xerox.

Following Calpers lead, other states, counties and cities in the US, Canada and UK have also joined the actionin 2007 alone, public employees pension funds were registered from Chicago, Florida, Ohio, New York, Strathclyde, Hartford city, Detroit, Utah, Ontario, Cheshire, Westminster, Colorado, Mississippi and Pennsylvania, among others.

Apart from regional school employees and teachers pension funds, even the top universities have registered Massachusetts Institute of Technology in March 2007 and Duke University as recently as on January 8.

Countries such as Malaysia, South Korea, Northern Ireland, Australia and New Zealand have, in fact, started investing their national pension funds as well as civil servants pension funds in India. And on May 18, 2007, the Pension fund for members of the European Parliament entered India.

As he points out, it's a fascinating contrast. Myriad pension funds worldwide are now participating in the Indian securities market. But this is not the case for Indian pension assets. Update: Indian Express has an editorial on this.

Wednesday, January 09, 2008

Has the strategy of bringing back capital controls worked?

The government has sallied forth with reversals of reforms, with capital controls against private equity in February 2007, external commercial borrowing (ECB) in August 2007, and participatory notes in October 2007. Does this work? Ila Patnaik looks at the recent BOP data and finds that the impact is limited. (I had written on a related issue last month).

In the international experience, when any one component of capital flows is targeted by a government, it is possible for sufficiently stringent action to drive down those numbers. But the real story lies in how other components then swell up.

The camel in the tent, of course, is the current account, which goes beyond the data on capital flows that she examines. Economic agents are able to move capital in and out of the country by misinvoicing on the burgeoning current account.

The bottom line is that the ground realities of the currency market are not altered by these kinds of capital controls; the scale of trading required in order to achieve the desired distortion of the exchange rate continues to be huge and induces unacceptable monetary policy distortions.

Massive and unprecedented currency purchases by RBI have taken place in recent months -- $12 billion in September and $12.5 billion in October. Data after October has not been released, but in November, reserves grew by $8.3 billion. These are all numbers that are incompatible with running a monetary policy framework that will rein in inflation.

If a pegged exchange rate is desired, and monetary policy autonomy is sought, then a much more draconian regime of capital controls - a la FERA - is required. Smaller scale efforts do not work.

Tuesday, January 08, 2008

Critical appointments watch

Comptroller and Auditor-General January 2008 Vinod Rai, 17 December 2007.
Secretary, Dept. Financial Services, MOF January 2008 Arun Ramanathan, 8 January 2008.
Chairman, SEBI. link February 2008
Two members of SEBI
Chairman, IRDA May 2008
Governor, RBI. link September 2008
Chairman and members of Competition Commission

Also see:

Monday, January 07, 2008

Combating fees and expenses in fund management

One of the important problems afflicting Indian finance is the phenomenon of high fees and expenses charged for fund management services by financial firms.

There is something paradoxical going on here which I don't fully understand. In some situations, Indian customers are incredibly price sensitive. But when it comes to fund management, customers seem to be willing to tolerate very high charges, and accept astonishing levels of non-transparency.

Progress at SEBI

The mutual fund industry has been afflicted by fairly perverse phenomena. There is the inherent conflict of interest where the distributor takes money from the manufacturer while advising the investor. The distributors have a tremendous stranglehold on customers; there is a race to the bottom taking place where the mutual funds which squander the most customer money on the distributor gain market share. One symptom of the idiocy of what is going on is the bias in favour of churning (customer switching from one scheme to another since the distributor earns a fee at every fresh investment) and the bias in favour of `new fund offerings' at which point distributors make a killing.

SEBI embarked on an important initiative, proposing to force mutual funds to give customers a choice of buying mutual fund products directly - e.g. through the Internet - without going through the fees and expenses associated with distributors. I had blogged about the SEBI proposal in August 2007.

The industry tried hard to lobby against these proposals. Two weasel clauses that were proposed were : (a) Having separate no-load funds, as opposed to having all products available for direct distribution, and (b) By having `variable loads' where customers would be able to negotiate prices with the distributor.

SEBI has come through fairly well on this one. See this story by Sandeep Singh in Indian Express, SEBI's press release and circular.

Ajit Dayal pointed out to me that the practical implication of this effort has been greatly undermined by the requirement that the physical PAN card has to be verified before an online transaction takes place. In other words, the canonical online transaction - the ability for a stranger to be able to come up to the website of a financial firm and put in money - is infeasible. SEBI strongly needs to switch the sequencing around: Require the physical verification of the PAN card after the online transaction and not before.

Progress at IRDA

Gautam Bhardwaj of Invest India pointed out to me that as a country, the impact of SEBI's move is limited because it will merely push the distributors away from selling mutual funds to selling insurance products, where the most toxic distribution strategies are to be found. An across-markets perspective is required on the part of policy makers. As long as distributors / advisors are paid for transactions, there will be a bias in favour of churning, a bias in favour of selling products from AMCs that pay the highest fees, etc. As Gautam Chikermane has emphasised, this is a strong argument in favour of unified regulation, atleast for the purpose of all financial products sold to retail customers. While on this subject, see the proposal of a `Financial Product Safety Commission' in the US by Elizabeth Warren of Harvard Law School - op-ed version.

IRDA has also been making progress; it has started asking for more disclosure about how much money is actually invested. There are going to be some red faces when it is revealed that out of Rs.100 paid by a customer, only Rs.40 will get invested in the first year. Monika Halan describes the IRDA initiative as going from 20% transparency to 60% transparency. She emphasises that the burden on customers is the sum of fees and expenses, and when there is transparency on fees, it's easy for financial firms to switch to administrative charges. As many readers will recall, this ease of portraying marketing expenditures as either fees or expenses is the reason why the design work of the New Pension System (NPS) has long emphasised selection of pension fund managers (PFMs) based on an auction focused on one number: the sum-total of fees and expenses.

What is a customer to do?

When I write blog entries like this, I get a fair supply of email asking what should the customer do. Here are my suggestions:

  • There is a small group of products that I am comfortable with: there are index funds (both open-ended funds and ETFs) and there is Quantum Mutual Fund. I like the Nifty and Nifty junior ETFs from Benchmark Mutual Fund, which are the lowest-cost index funds around.
  • I would encourage customers to avoid the fund management products sold by insurance companies: Buy pure insurance products from insurance companies if you really need insurance, and avoid the bundling of fund management with insurance.
  • In all cases, I would encourage the customer to avoid distributors, be very conscious about the grand total fees and expenses being inflicted on you, and pay as little as you possibly can to financial firms. Fund management is a rare field where paying more generally gives you lower quality products.
  • Avoid all `New Fund Offerings' (NFOs); do not churn.
  • Become a customer of the New Pension System, which is phenomenally low cost, when you get the opportunity. The NPS has no NFOs, no innovative product development, no distributors, just honest down-to-earth low cost fund management.

The agency business of securities firms is fine

While these difficulties afflict the fund management industry, as a rough approximation, I think the securities firms are carrying no fat. Entry barriers are low, competition is brutal, fees and expenses are fully transparent, there is no shades of gray in judging whether the firm performed its job, there is no illusion of performance.

In absolute terms, the charges are high. As an example, see this story. However, as diagnosed in Box 2.8 (page 29) of the MIFC report, the bulk of this story is the array of transaction taxes that have been imposed by MOF and SEBI that are driving up the charges. Once these are stripped out, charges in India are not out of line.

A glance at the brokerage firms in the CMIE database shows some interesting facts. I focus on the performance of the aggregate industry, and juxtapose a bad year (2002-03) against a good one (2005-06):

Parameter 2002-03 2005-06
PAT / Net worth 11.27 23.03
PAT / Total assets 3.93 8.97

These profit numbers are the `normalised' values reported by CMIE, where the bulk of earnings management is stripped out using procedures that are consistently applied across firms and across time. The values reported above are not that different from the evolution seen for the universe of non-financial firms, which I use as a benchmark of performance under fairly competitive conditions.

Fiscal policy to the rescue?

Writing in the Financial Times, Larry Summers says that the odds of a US recession have risen further in the last six weeks, and that there is a strong case for a fiscal stimulus of roughly $50 to $75 billion, delivered to poor people in the US.

What are the coefficients on your Taylor rule?

He says that a sharp easing of monetary policy is a done deal, and that the policy rate will go to roughly 3 percent. I don't see how it's easy for the US Fed to cut rates given how bad things are on inflation in the US. The latest data for TIPS-derived expected inflation in the US are showing values above 2.8%. This is not a pleasant environment in which cutting rates can be envisaged. To the extent that Larry Summers is effectively advocating a high weightage on the unemployment coefficient and a low weight on the inflation coefficient of the Taylor rule, this is a source for concern.

The US lacks a de jure inflation targeting framework for monetary policy. Trusting the Fed on inflation is, then, only a matter of the personalities of the people in charge. The Fed is mistrusted more than (say) the Bank of England where, since inflation targeting is written into the law, there is no question about the credibility with which the BOE will take on innovations in expected inflation. In this paradoxical way, writing down inflation targeting into the law actually gives more space to respond to events. In the US, the law does not tie down Ben Bernanke's monetary policy rule, so he has to worry about how the market sees the coefficients on his Taylor rule, and has to be concerned about the threat to his credibility if he eases rates and ignites inflation.

Can fiscal policy do stabilisation?

A few weeks ago, I wrote a paper titled New issues in Indian macro policy which is forthcoming in a book edited by T. N. Ninan. There, I argue that the right strategy for both monetary policy and fiscal policy in India consists of devoting these tools to the task of stabilising the business cycle. The question arises: Why not lock down fiscal policy into a relatively dumb rule (like the existing FRBM), and leave the entire job of stabilisation to an inflation-targeting monetary policy? I think the answer lies in two parts.

First, a dumb fiscal rule like the existing FRBM is not implementable. If we set out to achieve a 3% central fiscal deficit every year through a dumb fiscal rule, in a bad year, the outcome will be worse. In February 2008, little is known about business cycle conditions that will prevail over 2008-09, so the budgeting process will inevitably go wrong. This will adversely affect the credibility of the fiscal rule, and possibly induce fiscal instability with a non-decreasing debt/GDP ratio.

The second reason is that fiscal policy can, in an ideal world, help do good things for stabilisation. Larry Summers offers four elements of this logic:

The question is whether it is better for all the stimulus to come from discretionary monetary policy or for some of the stimulus to come from discretionary fiscal policy. A diversified policy approach seems clearly preferable in that (i) in a world where judging the impact of policy measures is difficult, the outcome is less uncertain with a diversified mix of stimulus measures; (ii) the proximate impact of fiscal policies is felt by the families bearing the brunt of recession, in contrast to monetary policies whose immediate impact is on financial institutions; (iii) use of fiscal policy reduces the amount by which interest rates have to be reduced, thereby reducing downward pressure on the dollar, which in turn contributes to upward pressure on US inflation and international instability; (iv) partial reliance on fiscal policy mitigates the various risks of bubble creation associated with excessively low interest rates.

He also offers a fifth reason: When there are difficulties in the financial sector, as in the present situation in the US, the effectiveness of monetary policy (as in cutting rates) as a tool for stabilisation is lowered.

These are all good reasons, though some of them are unique to the present situation in the US. I do think there is a case for building business cycle considerations into the fiscal rule. But this is hard; the experience of many decades, all over the world, has shown that fiscal policy is too slow and too politicised. All too often, fiscal policy flirts with the danger of a rising debt/GDP ratio and/or election cycles. The formulation that I offer in the paper mentioned above is one where government always budgets for a fiscal deficit of 1% of GDP, but slippage to 3% is considered acceptable if (and only if) business cycle conditions are adverse.

As Richard Clarida once explained to me, the 9/11 attacks were a singular moment in the history of macroeconomic policy, because on the morning of 12 September 2001, the day he started work at the US Treasury, there was full clarity that a downturn was coming. There was no difficulty of reading the tea leaves with old data; you knew for sure that a counter-cyclical response was needed. US fiscal policy and monetary policy worked very effectively in the aftermath of the attacks. We should treat that episode as being on the frontier of what is possible. Most of the time, what macroeconomic policy can deliver will be worse than that episode.

Saturday, January 05, 2008

A part of Indian history that most of us have forgotten

William Dalrymple (of City of Djinns fame) has a book review in The New York Times of a book named The Adventures of Amir Hamza. This book appears to be an epic that was transmitted and embellished in the muslim world, and particularly took root in India. I was surprised and embarassed that I had not heard of The Adventures of Amir Hamza before. Apparently I am not alone, the book seems to have died down in the public consciousness. This new translation as done by the Pakistani-Canadian scholar Musharraf Ali Farooqi, who has worked off Urdu editions from 1855 and 1871, and come up with a 948-page version. As Dalrymple says:

To read The Adventures of Amir Hamza is to come as close as is now possible to the world of the Mughal campfire those night gatherings of soldiers, sufis, musicians and hangers-on that one sees illustrated in Mughal miniatures, a storyteller beginning his tale in a clearing of a forest as the embers of the blaze glow red and the eager faces crowd around.

It sounds fascinating; it reminds me of the oral tradition that led up to the Mahabharata. Ashok Desai once said to me that the reason these epics are so much fun is a process of natural selection where the most quirky stories tend to survive across time. This is the opposite of the modern Internet where every dull paragraph is faithfully archived forever!

Got noticed

In the `BH Economics Blog Awards 2008', Bayesian Heresy thinks this is the best South Asian blog. Even if you have to be a genius to read it.

Friday, January 04, 2008

End of 2007 reading

  • Swaminathan S Anklesaria Aiyar on the rupee appreciation.
  • I completely agree with his focus on creative destruction. While on that subject, look at this piece on letter writers by Anand Giridharadas and this older piece by Ila Patnaik on the STD PCO.
  • I'm not too sympathetic on the difficulties of economic reforms. Leadership is all about pulling off fundamental reforms even when holding a weak hand of cards. Arvind Panagariya's article on the telecom reforms that have made all the difference is a reminder of how far-reaching transformative change - the "first-best reforms" that are generally dismissed by the wise and cynical - gets done by a good leadership even when the odds are against it.
  • In 1998, I had written an article about two great investment strategies. Here's another great investment strategy (irony alert) - an article by Dean P. Foster and H. Peyton Young. While on this subject, you might like to read this old speech by Raghuram Rajan.
  • Ila Patnaik reminds us that if you insist on pegging the exchange rate, the best strategy is to give up monetary policy autonomy.
  • The operating system that stole Christmas by Aaron Edlin of U C Berkeley.
  • Ashok Desai tries to understand Narendra Modi.
  • Ruchir Joshi's Manifesto of Freedom.
  • The Washington Post has a story by Glenn Kessler saying that India has stopped selling arms to Burma. The difficulty lies in the extent to which the Burmese army would then deepen their embrace of China.
  • Joschka Fischer has an article saying that NATO should take the Afghanistan problem head-on. Fischer was foreign minister and vice chancellor of Germany 1998-2005, and led the Green Party for 20 years.
  • Imagine no boundaries. In these gloomy days, let us all dream that South Asia can become like Europe in the withering away of boundaries.

Critical appointments watch

Comptroller and Auditor-General January 2008 Vinod Rai, 17 December 2007
Secretary, Dept. Financial Services, MOF January 2008
Chairman, SEBI. link February 2008
Two members of SEBI
Chairman, IRDA May 2008
Governor, RBI. link September 2008
Chairman and members of Competition Commission

Also see:

Thursday, January 03, 2008

Understanding the foreign institutional investor

For a country that was used to decades of autarky, where most people spent their formative years in a FERA mindset, a key hurdle in re-integrating with the world economy is the incomprehensibility of capital flows. Many people are hostile to capital flows on the grounds that foreign capital is capricious and ignorant. If you can't understand it, it must be a fad :-)

One of the nice things that has been happening in India's deepening engagement with the world is a buildup of data about the international finance aspects of the economy. It is now possible to look at a good monthly time-series with 140 observations with data for net FII inflows. And, it's now possible to look at data for the thousands of firms in the CMIE database and ponder which of them have foreign shareholding and why.

I wrote an article Understanding the FII in Business Standard today which conveys an executive summary of what one finds from these two lines of thought.

The first few paragraphs (looking at the time-series characteristics of net FII inflows) is unpublished work. The results using firm-level data are on the website of the NIPFP-DEA Research Program on Capital Flows and their Consequences (slideshow, paper).