Budget 2008

Rs.60,000 crore of debt waiver

This is a dubious idea at so many levels.

Periodic debt waivers set up incentives for farmers to be irresponsible in borrowing, knowing that they will get a waiver at a future date. The bad farmer (who had no intention to repay) benefits, while the good farmer (who thought carefully about leverage) feels stupid. The bad bank (which has a bad credit processes) gets away scot free; the good bank (that spent money on building sound credit process) feels stupid. Expect vol of bank stock prices as the speculators calculate out who gains and who loses how much by the financing strategy that's put out by the government in coming days.

I think this is the exactly wrong way to shoot for financial inclusion: it contaminates the opportunity to build a genuine financial ecosystem surrounding farmers, which can cope with the risks and requirements of these users. This decision will help to bring out the worst behaviour amongst farmers and financial firms in the future.

If the intent is to help `poor people', then landholders are the wrong target audience; poor people are those who don't have land. While 80% of holdings are covered in the debt waiver plan, the government has gone on to offer a 25% writeoff even to the top 20% of holdings. You would have got a lot more bang for the buck for agriculture by spending Rs.60,000 crore on (say) roads.

What do I think is going on? I think the UPA got started with one big idea: to do a massive expansion of welfare programs. The spending is underway, but it hasn't been delivering results. The `flagship programs of the UPA' aren't working too well, and the UPA isn't winning elections. Desperate measures suggest desperate times. This debt waiver program is a desperate effort at trying to somehow get State money to some voters. They are unwilling to question the holy cows of how education, health or poverty programs work. So they're down to this. I think it suggests elections in October 2008.

I was truly depressed watching the MPs responding to these sentences of the speech. Why on earth would they be so thrilled at something that is so patently wrong, something that can't possibly be in the interests of the people of India? On the best of days, democracy is only the least bad form of government. On a day like this, it looked truly gloomy.

This is the sort of behaviour which leads me to have a bias in favour of a market-dominated financial system. Banks are too juicy a target for politicians. A bank-dominated financial system is inherently unsafe for a country with weak institutions. With such depredations in the fray, it is safer for India to have less resources going through banking.

In addition, a culture of not repaying on debt is bad for debt-style financial contracts. As a consequence, India is turning into not just a market-dominated financial system but an equity market dominated financial system. By the latest numbers, the end-Jan market capitalisation of the CMIE Cospi index is Rs.59 trillion, which is well above 2x bigger than the 15-Feb value for non-food credit of all banks which is Rs.21.7 trillion.

Fiscal outlook

At first blush, it's an impressive fiscal consolidation - we're down to a fiscal deficit of 2.5% of GDP (budget estimates). You might like to see this spreadsheet representation of `budget at a glance'. The picture is good; it is better than what you would think if you only read the budget speech. (T. N. Ninan has more on this on 8 March).

Then you layer in the off-balance sheet items of food, fertiliser and oil subsidies. This is perhaps 1% of GDP or a bit worse than that. Then you're up to atleast 3.5% of GDP which is not so good.

In the speech, the finance minister says he initiated presentation of these facts in `budget at a glance'. I couldn't find it there. What is the calculation that needs to take place and be transparently disclosed? The size of the fertilise subsidy for 2009-09 should be defined as the money owed irrevocably owed to fertiliser companies owing to the operation of the existing subsidy regime over 2008-09, under reasonable projections for the market price of fertiliser and the subsidised price that will be administered. Some of this, unfortunately, doesn't show up in the apparent size of fertiliser bonds; the government often dumps the cost on fertiliser companies and does not issue fertiliser bonds on time. In this case, what ought to be bonds issued by the government as fiscal deficit show up as bonds issued by fertiliser companies. Hence, merely counting the size of fertiliser bonds issued does not correctly measure the true deficit implications of the fertiliser subsidy regime. In similar fashion, a correct calculation about the correct entry which should be in the budget as a consequence of the oil subsidy involves making assumptions about how much petroleum product prices will be revised in 2008-09 and how much the world price of the Indian basket will turn out to be.

Then I started hunting through the budget papers looking for a bulky entry of Rs.60,000 crore for the debt waiver. This is 1.1% of GDP. It isn't there. So there's another 1.1% of GDP that's off balance sheet. Why isn't it there? I suspect it was a last minute addition to the budget speech.

We're then in the worst of all worlds. If these calculations are correct, we're down to a central gross fiscal deficit of 4.6%. In other words, we failed to harness the great business cycle upturn of the recent years to do the fiscal consolidation in these good times. And, we did this in the worst possible way: by setting up a new level of mistrust of Indian public finance data.

Sound institutional arrangements involve a government that comes to Parliament with a clear statement of what it will spend and how this will be financed. A gap between the stated deficit and the true deficit of 2% of GDP (or worse) is an unprecedented breakdown of fiscal accounting in India.

The only saving grace here is the promise made by the FM that he'll request the 13th Finance Commission to regroup and take stock on how the fiscal consolidation should now proceed.

The flagship schemes of the UPA

Over the UPA period, plan expenditure has risen to 4.5% of GDP. The first task of the next government should be to evaluate how well these flagship schemes are doing, and close down schemes that have a poor bang for the buck. There is a good case for more money going down to the third tier, by reducing the size of plan expenditure.

Failing to cut the customs rate

In my opinion, this was a mistake. The claim was made that owing to INR appreciation, local firms are having difficulties competing with imported goods. This claim does not square with the buoyant profits and rising profitability of Indian firms. There is a loss of credibility here, when compared with the clock through which customs duties only went down every year. Now, Indian industry knows this fight is up for grabs.

There are the usual pro-export noises that are made. But India never exported by having tariff barriers. Exporting only took off when tariffs were cut, thus reducing the prices of raw materials in India and exposing Indian firms to heightened competition. Not cutting tariffs was an important mistake.

The Bond-Currency-Derivatives Nexus

This was pretty neat. An article of mine about this appears in Business Standard. Also, recall that the removal of double-taxation of dividends was one of the things that the MIFC Report had brought up, as an impediment that hurts holding company structures which are required for finance. See Section 2.1, titled `The holding company structure' in Chatper 11 `Reforming financial regime governance' of the MIFC report.

Commentary in the media

• Suman Bery in Business Standard
• An editorial in Business Standard
• An editorial in Indian Express.
• M. Govinda Rao in Business Standard.
• Andy Mukherjee has the best analysis of the debt waiver on Bloomberg.
• Farm loan waiver triggers state wars by Raja Awasthi and Dheeraj Tiwari in Economic Times.

Parsing Budget 2008

Business Standard has a nice editorial on how to evaluate the budget speech:

Any Budget can be evaluated on a number of criteria. Here, briefly, is a check-list of benchmarks by which today's pronouncements can be scored. First, from the perspective of the finance ministry's own domain, we need to look at what it does on the fiscal front. Mr Chidambaram has shown complete commitment to the mandate of the Fiscal Responsibility and Budget Management (FRBM) Act, to cap the fiscal deficit while eliminating the revenue deficit. The latter is the greater challenge and his convergence towards the zero-deficit target will be a significant yardstick. Beyond the aggregate numbers, he has also indicated his commitment to taking the country to a full-fledged Goods and Services Tax (GST), which will involve a series of rate rationalisations and re-balancing as far as indirect taxes are concerned. These should be watched out for.

Second, broadening the scope of evaluation to macro-economic performance, the Budget must be seen in terms of what it does to sustain rapid economic growth, especially in the context of the global as well as Indian slowdown that has set in. To deal with the cyclical effects, he needs to pump money into programmes that will quickly spend it, thus achieving pump-priming. Critical to longer-term growth is the stepping up of investment in infrastructure, not just in terms of financial commitments but also in creating effective vehicles for implementation in the public and private sectors. Even with all the good intentions of the government in play, the infrastructure gap is not narrowing.

Third, the ruling coalitions emphasis on inclusive growth is beyond being a political slogan; inclusiveness is a critical component of a sustainable growth path. This needs to be tackled at several levels. Transfer payments to provide households a secure and minimum level of subsistence need to be combined with longer-term programmes that build capabilities and earning capacity. The Economic Survey has shown that, despite doubling social sector spending over the past four years, the country's position vis-a-vis the Human Development Index does not show much change. The budget needs to reinforce successful programmes and streamline the entire delivery system, including providing strong incentives to state governments. Fourth, the budget should be evaluated on its anticipation and provision for several threats looming on both the fiscal and macro-economic fronts. In the former category, apart from the impact of several off-budget items oil bonds, fertiliser bonds and the like, there is the impact of the recommendations of the Sixth Pay Commission on public finances to consider. On the latter, the global food supply and price situation is looking increasingly ominous and may well precipitate into widespread domestic distress in the event of a weak monsoon this year.

Finally, in a year before the scheduled general elections, whatever else the informed and lay observer may think about the budget, the sharpest reactions will come from Mr Chidambarams political colleagues. His party's and his allies sorrow will be the opposition's joy. He clearly cannot do anything that, even while being applauded by professional analysts, is condemned by politicians gauging their prospects for re-election. Some populist grand-standing is therefore to be expected, and it should be evaluated on how much damage it does to the fisc. The big danger to watch out for is a string of giveaways, including a write-off of banks loans. Serious damage here could undo much of the good work that Mr Chidambaram has done over the past four years.

Also see this editorial: No new social sector program, please in Economic Times. Ila Patnaik writes about the fiscal challenge in this main piece in Indian Express, and takes on two holy cows (public sector capital expenditure and `plan' expenditure) in Financial Express.

Awful universities

Another ranking of universities worldwide, another dismal showing from India's universities. Let's set our sights low, so we're only thinking of universities in Asia. What there is from India in this: IITB (39th), IISc (48th), IITM (Rank 99). We are reaping the fruits today of high GDP growth owing to good thinking on higher education in the 1950s and 1960s. Countries like China are doing the right things on higher education today, while India is playing it exactly wrong.

Pitfalls of the Indian middle path

Percy Mistry is very useful in taking us out of our comfort zone.

How much progress on the fiscal deficit?

Ila Patnaik puts together the facts on deficit reduction, and off-balance sheet items.

You might like to see the recent IMF document, and an article of mine that (among other things) takes stock of India's progress towards fiscal stability. I emphasise three key tests of fiscal stability:

1. The debt/GDP ratio should drop in all years, barring rare calamities;
2. Government bonds should be voluntarily purchased by well motivated actors (i.e. not force-fed through financial repression or to PSU financial firms) and
3. Measurement of deficits and debt should be correct.

At present, India fails on all three counts.

FII registration process seems to be improving

Capital controls against `participatory notes' were introduced in October 2007 [link, link]. At the same time, progress does seem to be taking place on easing restrictions against various kinds of foreign financial firms stepping forward and becoming `registered' FIIs.

Today, Business Standard has a story about a series of hedge funds, including Renaissance, obtaining a SEBI FII registration. Ganesh Mani pointed me to this Bloomberg story which gives the fascinating background story about this remarkable firm. Also see useful material on VC Circle.

I think the convertibility which has been given to FIIs has been one important element of the revolutionary progress that was achieved on the Indian equity market in the 1990s. Conversely, holding back foreign financial firms from other parts of the financial system involves an opportunity cost.

Blogger needs a better way to deal with spammers

I just wasted effort deleting eight spam comments left by `sharegyan'. Blogger urgently needs to improve their support for deterring spam:

• When new comments come up, the blog author(s) should get a single page showing all recent comments where it's easy to checkbox a few and punch a single button "delete". This would eliminate the need to separately navigate for deletion of each of the eight comments.
• It should be possible to blacklist a particular author of comments, so that one never has to deal with that source of spam again.

I'm zealous about deleting all spam comments. I hope that if I put out a credible deterrent, the rational spammer should find it efficient to not waste time spamming this blog. Sharegyan, you need to hire more rational staff.

Better football through science

A fascinating story about a paper by Michael Bar-Eli et. al., on the usefulness of data analysis:

Want to know how to stop a penalty kick? Don't ask the goalkeepers; ask the academics. A group of Israeli economists studied 286 penalty kicks and found that most goalkeepers decide to jump right or left before they can really see where the ball is going. Based on the distribution of kicks, the researchers concluded that the smartest choice would be to remain in the middle of the goal.

You don't have to be a hen to know about eggs. But you may need to be an economist to know about football.

In this `bias for action' (i.e. jump right or left before you know it's optimal), I am reminded of active fund management. The motto of index fund management is: Don't just do something, sit there. Index funds are a very good investment strategy. But there is a strong bias in the real world in favour of earning high fees in return for perceived action.

Also see the next page, where there's a paper by Divya Mathur on marriage in India.

Sovereign Wealth Funds and India

Shivnath Thukral hosted a debate on NDTV profit on Sovereign Wealth Funds, which dealt with two points of view. Should India worry about domestic assets being purchased by SWFs? And, should India setup a SWF? The show featured A. V. Rajwade, R. H. Patil, Somasekhar Sundaresan, Jayanth Varma and myself. Here's the video: part 1, part 2, part 3. You might like to also see this.

RBI does forwards

I wrote an article in Business Standard today, pointing out that RBI has started doing currency transactions on the forward market on a pretty large scale, and that this isn't such a good idea.

SEBI's tasks

You might like to see this video by Skoch from 2006, that featured C. B. Bhave. And, Business Standard had an editorial on 15th about the tasks at SEBI:

Among the different economic regulators, the job of the chairman of the Securities and Exchange Board of India (Sebi) is of more than ordinary importance. The roughly 3,000 firms that are traded have a market value of Rs 57 lakh crore: more than twice the non-food credit of the entire banking system. Taking corporate bonds into account, the market has a value of roughly Rs 65 lakh crore, and the total turnover exceeds Rs.1 lakh crore per day on most days. This market has become the foundation of financing for India's corporations and is thus central to India's growth prospect.

The first task for the new chairman, when he assumes office next week, will be to focus on improving the processes of investigation and enforcement. Sebi's staff needs to be trained on understanding terms like `manipulation' and `disgorgement'. Good-quality investigations should be followed by drafting sound legal documents. An internal quasi-judicial proceeding needs to take place, where some Sebi staff argues the case of the prosecution, the accused are given the opportunity to defend themselves, and an internal bench awards a penalty if it is proved that there is guilt. Such discipline will greatly improve Sebi's quasi-judicial functions.

Recent stock market volatility has brought a fresh focus on the issue of stock market liquidity, which can appear to abruptly vanish. The new Sebi chairman needs to examine the issues of price limits and circuit breakers, the role for a pre-opening call auction, the rules about margins, short-selling based on borrowed shares, derivatives, and algorithmic trading, so as to identify aspects of the market design in India which need to be improved in order to obtain a more resilient market.

Strengthening these processes will have deeper implications for Indias GDP growth. A better-functioning system of financial markets will induce liquidity, not just in the big products like Nifty or Infosys but in smaller products, such as corporate bonds and small companies. Even if a market design is fairly bad, it is not hard to make Nifty futures liquid. But a great deal of sophistication is required in order to make a liquid market in a product with a market capitalisation of Rs 100 crore.

The new Sebi chairman will have to work hard in institution building. This involves attracting high-quality people (who might often be young by government standards), putting them in a meritocratic workplace with open discussion, and establishing transparency and accountability structures so that Sebi becomes not a one-man shop but a genuine institution that will be a key player in India's GDP growth. Committees have recommended merging the Forward Markets Commission into Sebi, for instance. The new chairman needs to build Sebi with an eye to this future.

As was emphasised by the committee that prepared the report on Mumbai as an International Financial Centre, a key story that is now unfolding is India's integration into the world of global finance. The looming challenge for Sebi consists of the global options to Indian financial markets. Many Indian firms are listing offshore; a Nifty futures market at Singapore is gaining ground compared with the National Stock Exchange, and so on. Such competition is, of course, good for improving quality and reducing cost in India exactly as has been seen with Indian manufacturing. Sebi needs to be very mindful of this dimension. It is not enough for Indian markets to look good by domestic or self-set standards; they have to become competitive by global standards.

Fiscal distress ahead

We know that things are going badly on the fiscal front [link, link]. On 13th, Indian Express carried a story about Congress politicians requesting an abandonment of FRBM targets given the coming elections. (See this edit also). And, the politicians haven't even brought up the 6th pay commission.

When I was at MOF, Vijay Kelkar used to endlessly evangelise on the need to `fix the roof while the sun is shining'. While India has made progress on the fiscal crisis, this progress is disappointingly small considering that we have had an unprecedented business cycle upturn over the 2002-2008 period. It will be so much harder to achieve fiscal progress under more challenging macroeconomic circumstances.

In these difficult times, a professional Debt Management Office will help.

How much capital is coming into India?

In continuation of the recent focus on interest rate differentials and their consequences for upholding a pegged exchange rate, Ila Patnaik has an interesting article which makes two points:

1. Remittance inflows seem to be roughly of the same range of values as net capital flows. It is well known that a lot of remittances are actually capital flows: a person working abroad sends money to India to his relatives who get invested here.
2. Eyeballing the time-series seems to show a strong relationship between remittances and the interest rate differential.

This considerably enlarges our sense of how much capital is or can come into India in response to one-way bets. Conversely, if we set out to capital controls, then these will have to extend to remittances also. Else, money that is blocked as capital inflows will merely show up as remittances. Hmm, and if capital controls are placed against remittances, then passangers will need to be frisked at airports, because a kilogram of gold is roughly the size of a box of cigarettes. X-ray machines will detect a kilogram of gold? A cigarette-box filled with one-carat diamonds is worth roughly 2 million dollars.

Here's an amusing aside on Indian monetary policy. At a meeting at the Planning Commission, the policy debate on Indian monetary policy was reduced to the three corners of the impossible trinity:

• Some people favour closing down the capital account, so as to have pegged exchange rate + monetary policy autonomy (e.g. Shankar Acharya)
• Some people favour pegging the exchange rate with an open capital account, saying that the loss of monetary policy autonomy is harmless (e.g. Surjit Bhalla)
• Some people favour an open capital account with a floating exchange rate, which buys monetary policy autonomy (e.g. Suman Bery, Ila).

A remarkable feature of the present situation is: People at all three corners agree on one thing: RBI should cut rates now! :-)

Critical appointments watch

Position	Date	Outcome
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, Video on 24th Feb	February 2008	C. B. Bhave, but do see this, 14 February 2008.
Two members of SEBI
Chairman, IRDA	May 2008
Governor, RBI. link	September 2008
Chairman and members of Competition Commission. link

Also see:

• Who will fill the hot seats by Tamal Bandyopadhyay in Mint. 4 January, and the associated Experts speak on regulators.

Law and order, the most important public good

Gautam Chikermane reflects on the recent difficulties of law and order in Bombay.

Improving competition in the exchange industry

One of the many clever things that were done in the equity market reforms of the 1990s was a pro-competitive framework for depositories. The depositories legislation explicitly plans for multiple competing depositories. Further, there is an elegant decoupling between the decision of a customer about which exchange to use vs. which depository to use. E.g. it's perfectly feasible for a customer of NSE to use BSE's depository (or vice versa).

I believe competition policy is a very important element of sound government in the area of finance, and such thinking is essential to reshaping the competitive landscape. All too often, such care is not exercised in the formative phase, and we endup being stuck with a monopoly and/or conflicts of interest.

Jayanth Varma alerts us to a proposal of the US Department of Justice which has major implications for competition between exchanges. The document written by DOJ is of top quality - I really admire the human capital they are able to bring into these things - and is well worth reading.

At the essence, it is a proposal to unbundle an exchange business from a clearing corporation business. This would yield orthogonality (as above) where the choice of a exchange and the choice of clearing corporation are made independently. As he points out, this must surely be a good idea for competition, for the CME stock price dropped by 15%:

(Click on the picture to see it more clearly, or click here to see current data from Yahoo Finance.)

The logic here runs well beyond the simple idea of ensuring competitive conditions hold in both sub-industries. The DOJ's reasoning is essentially this:

If exchanges did not control clearing, an appropriately regulated clearinghouse could treat contracts with identical terms from different exchanges as interchangeable, i.e., fungible. The incentives of such a clearinghouse would be to maximize its own profits, and it thus likely would treat identical contracts as fungible. In a world of fungible financial futures contracts, multiple exchanges could simultaneously attract liquidity in the same or similar futures contract, facilitating sustained head-to-head competition. A trader could open a position on one exchange and close it on another. In such a world, a trader could execute against the best price wherever offered without fear of being unable to exit the position because there is insufficient trading interest (or of being forced to exit at a poor price) on the new entrant trading venue when a trader chooses to exit.

In addition, if exchanges did not control clearing, an appropriately regulated clearinghouse could reduce member margin obligations by recognizing offsetting positions in correlated financial futures contracts traded on different exchanges. The ability to offset correlated positions in a futures clearinghouse can significantly reduce the capital required to trade.

Here is a response from CME.

Two interesting documents from the IMF

The IMF released two documents on 4 February: India: 2007 Article IV Consultation, and India: Selected Issues.

Selected Issues

While a quick search on the IMF website shows many `Selected Issues' documents, I had not noticed this product type earlier. It turns out to be a small edited book containing seven papers about India:

1. Competitiveness and Exchange Rate Policy by Hiroko Oura, Petia Topalova, Andrea Richter-Hume, and Charles Kramer;
2. Challenges to Monetary Policy from Financial Globalization: The Case of India by Charles F. Kramer, Helene K. Poirson and A. Prasad;
3. Monetary Policy Communication and Transparency by Helene K. Poirson;
4. Financial Development and Growth in India: A Growing Tiger in a Cage? by Hiroko Oura and Renu Kohli;
5. Developing the Foreign Exchange Derivatives Market by Andreas Jobst;
6. Inclusive Growth by Petia Topalova;
7. India's Social Protection Framework by Andrea Richter Hume.

Of these, three stood out for me.

It has been previously noted that the RBI fares very badly in international comparisons of central bank transparency. Further, while central banks worldwide have improved over the last decade, RBI has stagnated. The paper by Helene K. Poirson is an outstanding how-to manual on how RBI's transparency can be improved. It is sensible, well written and immediately actionable. It reviews the recent difficulties of monetary policy from the viewpoint of communication strategy, and draws on these episodes to propose solutions. I hope RBI is able to implement all this right away. Everyone interested in Indian monetary economics should read this article.

The paper by Hiroko Oura and Renu Kohli was also most interesting to me. There is a vast literature based on the CMIE firm-level database; this one stands out as obtaining interesting answers to interesting questions. Specifically, it sheds light on the areas where the Indian financial sector does or does not deliver the goods in terms of financing of firms.

The paper by Jobst on currency derivatives is an excellent policy paper, one that is particularly timely given that RBI is presently engaged in trying to ensure that a currency futures market does not succeed.

Article IV Consultation document

I am generally cynical about Article IV documents. Too often, they are suffused with bureaucratic triumphalism, with sentences of the form ``Under the steady guidance of the great leader, the peasants and workers reaped a glorious harvest''. The IMF is forced to praise India's deft handling of macroeconomic policy in every alternate paragraph. If your tastes run to `ruthless truth-telling', the result of the Article IV process is often not interesting.

However, this time, the document is well worth reading, particularly if you're able to ignore the platitudes. It gives the reader a good grip of the overall macroeconomic situation, and a sound perspective on the difficulties of both fiscal and monetary policy. It struck me that there isn't an Indian effort of this genre out there.

The city is central to India's future

Writing in Indian Express, Pratap Bhanu Mehta reminds us that the city is central to India's future.

We know that urbanisation taking place at a fairly good pace (though not as fast as it would be if the cities worked well). How might the importance of cities bubble through into the political discourse? One element of this could be redistricting: As the mass of people in cities goes up, the number of MPs and MLAs from urban constituencies would go up. I wonder whether India is well placed in terms of the algorithms for redistricting. And, I wonder whether these processes correctly take into account the large numbers of people who live in the urban sprawl that extends for many kilometres outside all cities, outside the old administrative boundaries of the city.

Some key new infrastructure projects are inadequate

From 1997 till 2002, India had a business cycle downturn. In addition, there was considerable uncertainty about the political / regulatory risk that infrastructure projects would involve. As a consequence, many of the projects which were conceived at the time involved very conservative assumptions about traffic growth. The projects of that vintage are now approaching completion, and in many cases, it looks like the traffic today already exceeds capacity. In addition, many of these older projects involved inexperienced teams on the part of both government and the infrastructure vendor. So there are quite a few blunders coming to light as these things come out the front door.

• Here's a story by K. P. Narayana Kumar and Rahul Chandran on the difficulties of the Delhi-Gurgaon expressway, and here's Sunil Jain looking under the hood. Also see this edit in Business Standard.
• Ramesh Ramanathan on the shiny new airport for Bangalore... which won't deliver the goods.
• The new airport for Hyderabad will also be commissioned this year... but the road that links it to the city will immediately choke, and a new elevated road which will solve this is over a year away. See this story by Anjuli Bhargava in Business Standard, and this piece by Sunil Jain there.

It is easy to criticise all involved. But when we look back at the 1997-2002 period, when a lot of these projects were put together, there was genuine skepticism about Indian GDP growth, and fears that traffic growth would be weak (along with unspoken fears about the extent to which politicians would exempt certain classes of traffic from paying user charges). Today, it seems easy to criticise the thought process that went in there, but how many people were buying Nifty at 930 in April 2003?

This same story will be played in reverse also, when optimistic traffic projections made around 2005-2008 will prove to be over-estimates of traffic in the next business cycle downturn.

In thinking about this, it's important to see that the whiplash of GDP growth is a problem of macro policy and not infrastructure policy. India is a third world country where neither fiscal policy nor monetary policy are working to stabilise the business cycle. As a consequence, it is entirely to be expected that there will be a sharp boom-and-bust of GDP growth, such as the recent experience where we went from 3.84% in 2002-03 to 9.62% in 2006-07.

While it is frustrating looking at the blunders underlying shiny new infrastructure that's coming online, in my opinion, an excessive focus on this trickle of old projects that are now coming to fruition would be misplaced. In my opinion, the really important thing is: How quickly and effectively are lessons drawn from these blunders, and fed back into better contracting for the massive scale of infrastructure contracting and construction that is presently underway?

Real estate - an asset class?

Many people are increasingly comfortable treating real estate as `an asset class'. It is argued that land isn't being produced, that as the population grows, demand for real estate only goes up. Astronomical prices of real estate in India encourage holding real estate assets in the hope of obtaining high profits in the future.

This proposition is debatable. There is actually ample land out there. A calculation shows that even if all of India's population had a dwelling of 1000 square feet per family of 4, this requires only 0.76% of India's land area, assuming a low FSI of 1.

In the case of equities, we know that in all countries, a diversified portfolio of equities earns a few percent per year in real terms over long time periods. Some papers show that this is not the case with real estate (!).

If land isn't scarce, then the cost of built-up housing isn't much, it's just the cost of steel and bricks. To think of it as an asset class is as odd as treating (say) a car as a financial asset. The only challenge is one of overcoming government zoning restrictions, and building enough property, so that prices can then crash.

This is part of the story of the US housing market in recent years. Thanks to sound urban policies, there are no real entry barriers to building houses in the US. Zoning rules are sensible, and the policy framework supports easy extension of urban areas into outlying barren land. When houses could be sold for more than the price of cement and steel required to make them, this kicked off a massive supply response. This kicked up GDP growth for a few years. It took a little time, but this killed off the phase of rising prices. For some time now, house prices in the US will be low because of this overhang of supply.

There are legitimate concerns about bank exposures to real estate, since the market is non-transparent and marking to market is difficult. I think it is easy to build a risk management system governing loans against shares or bonds, but I'd worry about loans against houses or cars.

There are strong concerns about foreign capital coming into the real estate sector of a country like India. It is claimed that foreign speculators will drive up prices and thus make housing unaffordable. This needs to be questioned, for foreign capital that goes into development (directly or indirectly) ultimately drives up supply and thus solves the problem (see above link).

Transforming the real estate sector requires a sustained push in terms of financial capital in development, professional management teams that will build millions of square feet instead of thousands of square feet, and a big jump in the FSI. Once these initiatives are in place, real estate prices will drop, households and businesses will find space to be much more affordable, and it will not look so good as an asset class.

Some of these pieces are now coming together. A new breed of firms are now accessing public markets to obtain capital on a scale that was previously unimaginable, and bringing modern professional organisations to bear on the task of rapidly building properties. Foreign capital and foreign firms are increasingly coming into this area, though much slower than would be the case thanks to capital controls.

The CMIE executive summary for this sector shows a growth in total assets from Rs.22,156 crore in 2004-05 to Rs.53,522 crore in 2006-07. The market capitalisation of listed firms on NSE in this sector is Rs.3,13,981 crore, and the P/E of 37.3 will attract entry. Of the 80 firms in this sector, CMIE finds that 54 have adequate liquidity to make it into the price index for this sector. These are all still small numbers compared with the size of India, but it looks like serious firms are finally coming together, that might ultimately be able to pull off a massive supply response.

In this context, I was intruiged by this story by Raghavendra Kamath in Business Standard, describing incremental supply of ~ 15 million square feet in Bombay in a year. That sounds nice, it represents the kind of dent that is required on the part of supply to make a serious difference to prices.

Wrong call by RBI

I wrote an article in Business Standard today titled Wrong call by RBI on the subject of exchange rate pegging, interest rate differentials and the recent monetary policy (non) announcement by RBI.

In recent quarters, roughly 10-15% of GDP has come in by way of net capital flows. The true capital flows into the country are larger than this, owing to capital flows that are implemented over the current account. Hence, it's reasonable to think that RBI will be forced to add $100 billion to reserves (which is less than 10% of GDP) if the present policy framework continues. My rough calculations (in the article) suggest that this involves gifting Rs.20,000 crore to the private sector. This is money that is being paid for by the common man, since the fiscal costs of sterilisation are being placed on the exchequer. This seems like an inappropriate thing to do.

My main point is that there's a huge arbitrage opportunity out there. Hence, a tonne of money will come in. Hence, monetary policy distortions will build up with a pegged exchange rate. Hence, RBI will be forced to either break the peg, or lower rates, or both.

• Why can countries like the UK or Israel hold rates while the US has cut rates? They don't run pegged exchange rates, and are hence blessed with a central bank that can think about what is right for them.
• Isn't inflation a concern, justifying high interest rates? Whether inflation is too high or too low, we are powerless to use monetary policy to deal with it once we have pegged the exchange rate.
• Doesn't this arbitrage fizzle out once RBI permits an INR appreciation and/or cuts rates? Yes, it does, but note that the long-INR + long-bond position gets an exit bonus when RBI does move. If RBI does nothing, there is a one way bet. But the profits to the position are accentuated to the extent that the INR appreciates and/or interest rates go down.
• Shouldn't we focus on the rate at which corporations can borrow and lend, rather than interest rates on government bonds, when discussing the interest rate differential? Yes, the true size of the arbitrage opportunity is the difference between the borrowing rates abroad for USD-denominated borrowing by an Indian firm against the returns available by deploying that money in India. That differential happens to be bigger than 5.3 percentage points - so this actually strengthens my case. However, from the viewpoint of monetary policy, what RBI can control is only the policy rate; it doesn't control credit spreads. Hence, the discussion is couched in terms of the policy rate.
• Isn't the Indian business cycle different from that in the US, meriting a different stance of monetary policy when compared with the US? Even if it is, once we peg the exchange rate, we have given away the ability to do monetary policy based on domestic considerations.
• Why do you say that the interest rate differential needs to be no worse than 2 percentage points? Where is that number `2' coming from? India has been rapidly opening up to the world; openness is higher than ever before. And, we're right now running a tight INR/USD pegged rate with the price moving between Rs.39 and Rs.40. With high openness (by historical standards) and low currency flexibility (by historical standards), the interest rate differential must be low (by historical standards). Look at the graph, and the number of 2 suggests itself. If India were fully open, then running a pegged rate would require an interest rate differential of zero.
• Is it wise for India to peg the exchange rate? No, it isn't, but now that we are running a pegged exchange rate regime, we have to deal with the consequences. It seems nice to peg the rate when focusing on the interests of exporters. But in the process, the larger interests of the economy get hurt.

For the backdrop to this, see the recent credit policy statement, in particular their call for capital controls:

95. In the context of a more open capital account and the size of inflows currently, public policy preference for a hierarchy of capital flows with a priority for more stable components could necessitate a more holistic approach, combining sectoral regulations with broader measures to enhance the quality of flows and make the source of flows transparent. In this context, it is critical for public policy to effectively, demonstrably and convincingly indicate commitment to managing capital flows consistent with macro fundamentals through appropriate and decisive policy actions.

And, in an interview, Y. V. Reddy said:

The US rate cut is a relevant input for monetary policy, but domestic issues predominate. Moreover, when you talk of an interest rate differential, which is the currency where you measure the difference. Since maximum carry trade was in the Japanese Yen the argument has to be in respect of Japanese Yen where there has been no change in rates. For us, domestic policy considerations dominate. In the US they are facing a slowdown but we are only seeing moderation from 8% to 8.5%. US is pumping liquidity into the markets, we are absorbing liquidity. For leading institutions in the US, profitability is under question, here banking profitability is good. We can have a convergence of a solution only when there is a convergence of the problem. I will be surprised if there is a uni-directional movement in policy rates across all countries.

If you go back and look at history, there have been occasions when we had a huge interest rate differential and we had outflows instead of inflows. US rate changes are an important but not a determining factor. It is also exchange rate expectations, view on fundamentals and there are several other factors operating. On one hand, we have to give weightage to that rate of interest that offers an optimum balance between savings and investment.

On the other hand, there is the interest rate differential. For which should you give more weight? At this point, I would repeat domestic considerations have to dominate to maintain a balance between savings and investment in India.

Finally, see these materials by Ila Patnaik: link, link and link. Update: Ila offers a big picture on the difficulties that motivate RBI reform.

Watching markets work - Was Microsoft's offer to buy Yahoo value-destroying for Microsoft shareholders?

A few days ago, I had written about Microsoft's bid for Yahoo, suggesting that this wasn't such a bright idea for shareholders of Microsoft. Maybe it was better for the board of directors of Microsoft to block such empire-building and just pay out the cash to shareholders. The graph above of intra-day stock prices over the last few days (taken from Yahoo finance; click here for the latest data) shows a striking story. (Click on the graph above to see it more clearly). The Microsoft stock price dropped by ~ 10% in response to the takeover bid while the Yahoo stock price went up by ~ 55%.

Broad books on Indian economics

My suggestions for the three good broad books on Indian economics:

1. India: The Emerging Giant by Arvind Panagariya, Oxford, 2008.
2. The Oxford Companion to Economics in India, edited by Kaushik Basu, Oxford, 2007.
3. Documenting reforms: Case studies from India, edited by S. Narayan, Macmillan and Observer Research Foundation, 2006.

See my India bookshelf.

Mulling over Microsoft's bid for Yahoo

A lot of people are dazzled when Microsoft is ready to put down $44.6 billion to buy Yahoo. In New York Times, Joe Nocera has written an article A giant bid that shows how tired the giant is that offers an unusually clear-headed interpretation.

In modern thinking, a good financial system is one where investment is based on prospects, not cashflows.

Firms with cashflow but not prospects

Some firms - like Microsoft - are producing a lot of cash, and don't have good prospects. Such firms should be paying out dividends. CEOs and managers derive private benefits from size, and always have a bias in favour of more investment. The critical task of the board of directors, in such companies, is to say to the management team: "Please don't try to use your shareholders money on projects that aren't exciting. Just pay it out to the shareholders, who will buy securities of companies with good prospects." Good corporate governance is about forcing firms with below-median prospects to pay out high dividend rates and not allow their managers to use shareholder's money suboptimally.
I'm puzzled about how the board of directors of Microsoft sees this. Could this purchase be value-destroying, because a Yahoo that's managed by Microsoft might actually be worth less? E.g. many people who like Yahoo finance and yahoo messenger today, owing to their clean software foundations, might stop using them if they are turned into Microsoft-style products. Might it be better for shareholders of Microsoft if they were paid $44.6 billion in a dividend, and then they (i.e. the shareholders) choose how to do their own diversification - which could include buying shares of Yahoo?

Firms with prospects but not cashflow

When a firm has poor cashflow (or lacks tangible assets) but has high NPV projects, a good financial system is one which is able to process information, make forecasts, understand the good projects in the hands of this firm, and get debt and equity capital to this firm.

In a bad financial system, investment follows cashflow or tangible assets, dividend payout ratios are stable across time and across firms. A good financial system is one which breaks this link; investment is also found in firms with bad cashflows (or firms that lack tangible assets), dividend payout ratios are unstable through time and dividend payout ratios are non-uniform across firms.

I have the privilege of serving on the board of directors of one company where the projects aren't good. I have tried hard to persuade the board of directors to pay out bigger dividends. It is hard.