It's the currency, stupid

What is the impact of changing the policy rate?

The `monetary policy transmission' is about changes in the short-term policy rate reaching out and influencing the economy through changes in all interest rates. But this requires a well functioning Bond-Currency-Derivatives Nexus. By preventing the Bond-Currency-Derivatives Nexus from coming about, RBI has rendered itself ineffectual. The impact of changes in policy rates upon the borrowing and lending rates of banks, and on the corporate bond market, is small. The impact on the economy is rather small given that banking and the bond market are pretty small when compared with GDP (as a consequence of policy mistakes).

Absent the BCD Nexus, changes to the short-term policy rate don't do much to affect the economy. So even if the right thinking was put into place for setting the short rate, this wouldn't do much to shake the economy. The short rate is more usefully seen in the context of interest rate differentials and exchange rate pegging; it isn't much of a tool for influencing aggregate demand in the economy.

To say this in more technical terms, if you try to do the standard models looking for a monetary transmission, you don't see much happening in the economy when the short rate is changed. Recall the draconian interest rates that were required in the mid 1990s to squeeze inflation out. The extreme measures that were required convey the extent to which the tools that RBI controls are relatively feeble. In a mature market economy, with a properly setup monetary policy framework, modest changes to interest rates would get the same job done. We had to resort to draconian things in the mid 1990s in order to combat inflation because small changes just didn't get the job done.

What can RBI do to tame inflation?

Given that the Bond-Currency-Derivatives Nexus isn't in place, and that changing the short rate can't easily influence inflation, the only effective instrument that RBI has to reduce inflation is a rupee appreciation.

So what is the credit policy announcement and what is the monetary policy?

Given that India runs a pegged exchange rate with increasing de facto convertibility, what really matters in defining monetary policy is currency trading. Monetary policy is effectively now played out every day, under a shroud of non-transparency, in RBI's trading on the currency market.

There is no publicly visible policy document about what is done there and why. No data is released on a daily basis about what was done there. FIIs tell us more about their actions than RBI does.

The very public credit policy announcement is a show that emulates central banks in mature market economies. It distracts attention away from the true story which is currency trading. It does not illuminate what is going on in monetary policy. If no show took place, your information set would not be substantially altered. Despite the show, RBI is one of the most opaque central banks in the world.

Journalists are blindly imitating what they see in the US and the UK in covering it. But we in India do not have the monetary policy framework that is found in a mature market economy, and it would help if we all took this show less seriously.

Some useful reading material

With these health and safety warnings out of the way, here are some materials that are useful for parsing the credit policy announcement:

• A four part `Reading Reddy' series in Financial Express: I. Ila Patnaik, II. Indranil Pan, III. Dominique Dwor-Frecaut, IV. Rohini Malkani, Summing up
• The case for a rate cut
• Four concerns for central bank by Anup Roy, in Mint.
• An editorial in Indian Express.

We are not alone

For all of us in India, the depths of dysfunctionality of financial policy and regulatory structure seem to be uniquely Indian. A key feature of the Percy Mistry and Raghuram Rajan reports, on the future of Indian finance, is the emphasis on reforming the role and function of government agencies such as RBI, SEBI, FMC, etc. These agencies owe their role and function to accidents of lawmaking in previous decades, at a time when conditions in India and the state of knowledge were very different when compared with what we see today.

While the Chinese have a head start on us by having done one big task of reforms (taking out banking supervision from the central bank), I just read a story about difficulties in China which sounded like it was straight out of India.

While these sorts of problems were acceptable circa 1998, they are a serious handicap for growth and stability today. Such dysfunctional behaviour did not matter so much in a largely closed $0.5 trillion economy with a 20% savings rate, but it is increasingly dangerous as we have come into a world of multi-trillion dollar economies with massive savings that need to be intermediated in an environment of substantial de facto convertibility.

Futures on carbon credits

Mobis Philipose has an interesting article in Mint on the emerging market of futures trading on carbon credits.

Critical appointments watch

Position	Date	Outcome
Chairman, Finance Commission	November 2007	Vijay Kelkar, 14 November 2007
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 24 January	February 2008	C. B. Bhave, but do see this, 14 February 2008.
Two members of SEBI
Chairman, IRDA. link	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.

Crony socialism

I read a story about a firm in China, by Henny Sender in the Financial Times of 27 April, which made me wonder about India.

Morgan Stanley scored a coup in 1995 with the creation of a firm "CICC", a joint venture with China Construction Bank (CCB) and some other investors. This new firm was capitalised at $100 million, and Morgan Stanley paid $35 million for 35%. What were they paying for? CICC 'had a virtual monopoly on bringing Chinese companies to local stock markets'. As an example, they were the first firm to get a QDII license, and they were the first to launch a foreign product.

CICC is headed by Levin Zhu, a Ph.D. in Meterology, and a son of Zhu Rongji, the former prime minister. Zhu got his first finance job in 1996, joined CICC in 1998 and gradually gained effective control of the management by 2000, becoming CEO in 2003 (i.e. with 7 years experience in finance after getting a Ph.D. in Meterology). The business model revolved around utilising communist party contacts to obtain business; he was a key player of this team. Mr. Zhu brought value to the business, and got paid well: with numbers like $10 million and $17 million, which look very big by the standards of Indian CEOs.

When Morgan Stanley needed cash in recent months, they wanted to sell shares in CICC. Zhu Rongji retired in 2003, which seems to have adversely affected the business model. In addition, with something like the erstwhile Indian `Press Note 18', Chinese regulators would block all other activities of Morgan Stanley until they were fully divested of CICC. But their efforts at selling shares have done badly because the management team feels it should obtain a bigger stake in the company. The management team is indispensable to the business owing to links to the communist party, and if they do not cooperate, a buyer is likely to be reluctant to step in. The FT article suggests that Morgan Stanley will endup getting a 3x return for their investment, or 9% per year, which is pretty bad. All in all, it's a sad story of the children of the communist party recapturing the pre-1949 wealth of the KMT and their cronies.

How bad is this, by Indian standards? (I think it's time for Sunil Jain to write a book about all the awful things done by Indian regulators). Could it happen in India? Could a foreign firm get a sweetheart deal where they get some exclusive market access, and then the business is run by the son of the prime minister, who uses political connections to gain business in a messy industry, gets paid very well, and then goes on to achieve a substantial stake in the business owing to unfair rules like `Press Note 18', thus leaving the foreign partner with little to show when the time comes to leave?

What is the undistorted rupee-dollar rate?

Writing in Business Standard today, Abheek Barua notices that the INR appreciation of 2007, in the end, didn't do much to exports growth despite a sharply slowing world economy. The five observations from October 2007 onwards show an average value for year-on-year growth of merchandise exports of 30%, and India always does better on services exports than we do with merchandise exports. This is clearly inconsistent with the doom and gloom about rupee appreciation and exports growth. And, the evidence does suggest that rupee appreciation could help contain this inflationary spiral.

But he wonders whether conditions on the currency market have changed so that a more hands-off approach by the RBI would actually result in appreciation. As he says:

I think the question that needs to be answered carefully at this stage (and that this debate has skirted) is whether the rupee will actually appreciate much if the RBI were to let it move freely. As someone who watches the forex market closely, my sense is that it won't. Capital inflows have dwindled quite palpably and with commodity prices at record highs, the current account deficit is unlikely to narrow. Going forward, I won't be surprised if the rupee depreciates a bit if the central bank allows free play of market forces.

Here's data for reserves accumulation per month in the recent period:

2007-02	14.1
2007-03	4.7
2007-04	4.9
2007-05	3.7
2007-06	5.4
2007-07	13.6
2007-08	1.7
2007-09	18.4
2007-10	16.4
2007-11	8.2
2007-12	1.8
2008-01	17.0
2008-02	7.6
2008-03	7.8

As a thumb-rule, 80% of reserves accumulation is currency trading by RBI. These are all massive numbers; in my reckoning, anything bigger than $1 billion a month leads to unacceptable monetary policy distortions. And, the true size of the market manipulation is bigger than this when one takes into account the purchases on the forward market.

This data runs till March. Suppose there has actually been a palpable change in currency market conditions in April, and that easing up on market manipulation doesn't affect the rupee-dollar exchange rate. What, then, would policy makers do? The first answer is: Reverse the capital controls of 2007 against ECB and against PNs, so as to get back to the status quo ante as of April 2007 on India's capital controls.

The second answer is: Sell reserves. It makes no sense for India to hold so much reserves. We are suffering visible fiscal costs (MSS payments) and invisible fiscal costs (losses on the reserves portfolio) owing to these reserves. Every opportunity should be used to shed reserves and thus reduce these costs.

Electronic trading for tea auctions

The New York Times has a story on the use of electronics in tea auctions. In it, they say:

In 2005, the Tea Board mandated that all tea auctions be conducted electronically, but the trading platform the board purchased from I.B.M. was plagued by software failures and within a year the entire system was abandoned. I.B.M. did not return calls seeking comment over several weeks.

An Internet start-up called teauction.com also tried to offer online auctions earlier this decade, but it never gained much trading volume and shut down.

Indian authorities say this time will be different. The latest exchange is being designed by NSE-IT, a branch of India’s national stock exchange that specializes in designing trading platforms. The Tea Board plans to roll out the system in Calcutta, where the first Indian tea auctions began, by December, with the software being introduced to other auction centers over the following three months.

Has inflation targeting stood the test of time?

Ilian Mihov, Andrew K. Rose (2008). Is Old Money Better than New? Duration and Monetary Regimes. Economics: The Open-Access, Open-Assessment E-Journal, Vol. 2, 2008-13. http://www.economics-ejournal.org/economics/journalarticles/2008-13. [pdf] To excerpt from their conclusion:

Inflation targeting seems like it would be a monetary regime that would compare poorly using the filter of time. After all, IT is a relatively new monetary regime. Nevertheless, we have found that IT seems already to have withstood the test of time; the duration of IT regimes is already as long as or significantly longer than alternatives like fixed exchange rates. Unlike all other monetary frameworks, no country has yet been forced to abandon a regime of inflation targeting in crisis. And this duration matters, since more durable monetary regime are systematically associated with better inflationary outcomes, meaning inflation within a band of (0, 4%). While having an exchange rate fix is better than having no clear quantitative target for monetary policy, inflation targeting is more likely to be associated with good inflationary outcomes. Any extrapolation of the heretofore successful record of inflation targeting remains exactly that: an extrapolation. Still, IT seems to work in both theory and practice, and is spreading quickly. Most importantly, inflation targeting is developing a reputation for durability, something that cannot be said of many alternative monetary regimes. Perhaps the monetary mishaps of the past will soon be seen as the byproduct of antiquated monetary regimes.

The transformation of Chinese higher education

China had unusually bad initial conditions with the decimation of universities and intellectual life under communism and particularly the cultural revolution. They have made remarkable progress in getting back in the game. Yao Li, John Whalley, Shunming Zhang, and Xilang Zhao have an article in voxeu which is linked to an NBER wp. In these, they talk about the transformation of Chinese higher education over the 1999-2008 period. While the whole article is worth reading, one element there caught my eye:

A shift from quantity to quality

These higher educational changes have been accompanied by a shift in focus from quantity flow in the pre-1999 period to an elevated emphasis on quality post-1999. Educational attainment in China is now subject to quantity indicators designed to drive continued improvement of educational quality by participating institutions: funding is no longer simply awarded in response to increasing the numbers of students enrolled. Chinese higher education institutions are now subject to extraordinary pressures to upgrade themselves in terms of objective rankings. High priority is placed on international rankings, taken as publications in international journals, citations, and international cooperation. These measures of attainment are directly linked to institutions funding. Some of this focus on improved educational attainment in China seems to be spontaneous and accelerated by the policy process that exerts the pressure. Indicators of educational attainments in terms of international rankings across countries, publications of papers, and citations feed directly into annual performance indicators for Chinese faculty in an ongoing process that goes substantially beyond the tenure-for-life system outside China. It is not uncommon for an annual target of three international publications to be set for faculty members, and failure means termination of employment.

These efforts are a striking contrast with what is sought to be done in India, which is all about quantity with no interest in quality. Certainly, there is no link between quality measures and the funding of institutions or job security of faculty.

Towards the end, they say:

China may thus be the first case of a lower income country using major tertiary (rather than primary or secondary) transformation in educational delivery as a development strategy.

I have generally felt that India is better described as a country where the growth takeoff was critically enabled by decades of investment into higher education. So, if anything, making mistakes on higher education is more damaging for the Indian trajectory of skill intensive growth as compared with the Chinese trajectory of cheap-labour intensive growth.

Google trends, markets, economy

Viral Shah pointed me to this example of google trends being useful in thinking about price fluctuations. So that got me thinking about what interesting things one could do with it.

In the muddled monetary policy framework that we have in India today, we ricochet between the three corners of the impossible trinity. When inflation gets uncomfortable, we do exchange rate flexibility. When exchange rate flexibility gets uncomfortable, we summon capital controls. When financial markets plummet in response to capital controls, we do inflation. Some people call it a "multiple objectives framework"; I call it shock therapy. But once in this monetary policy framework, what prompts a shift from one corner to another? In a democracy, how does one choose the dates when you switch gears? I think there's an element of avoiding the corner of the impossible trinity that is the most unpleasant, based on how a large number of households and firms are screaming.

To focus on the contemporary debate of inflation versus rupee appreciation, here's what google trends shows:

Click on the picture to see it more clearly. The red line on the upper graph is the number of google searches for "appreciation". The blue line represents the number of google searches for "inflation". The story seems to be that from roughly May till December 2007, both were roughly neck to neck. From end-2007 onwards, inflation has far and away been of much more interest to the people searching on google. This is in terms of what people are searching for. In terms of these words occuring in the news (the lower graph), inflation wins hands down and has always been much more important than appreciation.

Understanding the financial disturbances of 2007 and 2008

A few days ago, I wrote a blog post where I tried to collect together the outpouring of intellectual effort in understanding the financial disturbances of 2007 and 2008. Jayanth Varma also has an interesting blog post where he offers his original and very insightful ideas on this. While I am mostly derivative; he is mostly original.

In Business Standard today, I wrote a compact 1000 word summary sketching the key big questions and big ideas that are in play. It is useful as a compact executive summary. The above two blog posts are useful in giving you links to all the underlying source material.

The cartoonist for Business Standard took off from my last paragraph where I say:

For us in India, while these discussions are intellectually interesting, there is little by way of implications for domestic policy debates. We in India are still at the level of being tribesmen in the Kalahari desert reading stories about plane crashes in faraway continents. The first order issues that need to be addressed in India remain those of breaking down a repressive license-permit raj, and setting up a consistent monetary policy framework.

He came up with this:

A gentle introduction to exchange rate regimes

Read this article by Mark Stone, Harald Anderson, and Romain Veyrune from the latest Finance & Development. And after that, if you're curious about what is going on in India, see this EPW article by Ila Patnaik.

Empirical evidence on the impact of INR/USD changes on the WPI

Surjit Bhalla has written an article in Business Standard questioning the empirical evidence on the link between INR/USD appreciation and the WPI. Here's the empirical evidence, and the steps required to replicate the numerical results:

1. The mechanism of exchange-rate pass-through (ERPT) critically depends on low trade barriers. There was less ERPT in the older data, given the bigger quantitative restrictions and tariff barriers which were in place. Hence, let's focus on the latest 10 years, i.e. 120 observations of monthly data. Define the reading for each month as the average of the month (i.e. the default notion of `monthly' data in CMIE's Business Beacon database). Owing to lags of data release, this works out to the time period from Dec-1997 to Dec-2007.
2. Start with the differences of logs of series, and do seasonal adjustment. Think of this as the time-series of point-on-point percentage changes in the series, but seasonally adjusted. The seasonal adjustment is not essential to the result, but it's logically sound, and helps to improve the statistical significance.
3. We're going to do a two-variable vector autoregression. Four different criteria for selection of the lag length of the VAR (AIC, HQ, SC, FPE) all agree that the right lag order is 1. Estimate the VAR.
4. Testing for granger causality shows one-way causality from INR/USD changes to WPI changes. H0: INR/USD does not cause WPI has a prob value of 0.005954, i.e. you can be pretty sure that's a null you would reject. This is one-way causality - on the other direction the prob value is 0.5514.
5. Compute the impulse response function, orthogonalised, cumulative, using bootstrap inference. The dashed lines are the 95% confidence interval.

Click on the picture to see it more clearly. What does it say? (a) Over a horizon of roughly 4 months, a 1% shock to the INR/USD yields a 0.2% change in the WPI, and (b) The 95% confidence interval is all above 0; you can reject the null of no-effect at a 95% level of significance.

This same result comes out nicer when using weekly data.

This is a quick take on the problem. For a more thorough attack on it, and a review of the literature and international evidence on ERPT, look at this paper on exchange rate passthrough by Rudrani Bhattacharya, Ila Patnaik and myself [paper] [slideshow], a draft of which was presented at the 2nd Research Meeting of the NIPFP-DEA Research Program on Capital Flows and their Consequences.

The global financial disturbance of 2007 and 2008

Broad events

In the graph above, the blue line is the VIX, the implied volatility of the S&P 500 as read off the options market. It is a good measure of US and global economic uncertainty. The horizonal yellow line is the long-run average value of VIX. It helps us place recent values of VIX in perspective.

The black line is the S&P 500. However, instead of the conventional index levels, I use the US Major Currencies Index (produced by the US Federal Reserve) to adjust for the decline of the US dollar. The black line can thus be seen as a measure of the S&P 500 as seen by someone who keeps score in a floating currency.

The VIX shows four peaks in the last one year, with the fourth peak being particularly high - this is the day Bear Stearns died. The black line shows a sharp drop across these events -- a 19% fall in all -- reflecting a combination of a poor showing by the S&P 500 and by the US dollar.

The key questions

Ever since the financial disturbances of last year began, there has been fresh interest in understanding how they came about and perhaps in then figuring out ways in which such disturbances can be avoided. Here's my attempt at organising the thinking which has been taking place on both diagnoses and remedies, which is also a linkfest so you get all the underlying materials.

It is easy to blame (say) the flawed models at credit rating agencies for securitisation paper as the root cause of the problem. But to focus exclusively on that would miss out on the tremendous demand for this paper which was present from institutional investors. Dodgy practices amongst originators and ratings agencies were a response to a surge in demand for this paper. I think it is useful to structure the discussion around a few big questions:

1. Why was there such a surge in demand for a yield pickup? This leads to explanations emphasising monetary policy and the impact of interest rates on risk taking.
2. Why did dodgy practices with home loans and their securitisation process flourish? This leads to explanations emphasising the difficulties in regulation. The brunt of this story seems to be in the US, since the bulk of sub-prime loans happened there. As an example, there isn't much sub-prime housing debt in the UK.
3. When difficulties arose, why did liquidity collapse in key markets? Why did we get a run on Northern Rock - despite its excellent portfolio? Why did we get a run on non-bank players like Northern Rock and Bear Stearns? How can the role of monetary policy be changed so that key markets stay resolutely liquid in the future?

There are a few other questions out there which, in my mind, are better understood. Why did a modest rate of default in a relatively small part of finance lead to such a crisis? (My answer: There was a lot of leverage out there). Did the Fed do right in rescuing Bear Stearns? (In my opinion, Yes). Why has the impact on the real economy of these events been relatively modest? (My answer: There is little leverage amongst the firms, and firm profitability has been pretty good, so there hasn't yet been a wave of layoffs). I feel these things are relatively better understood. So I will focus on the big three questions that are the puzzle.

Q1: Why was there a surge in demand for a yield pickup

One element of the story is the USD pegs run by many countries. This led to a massive scale of purchase of US government bonds by foreign governments, thus depressing yields of US government bonds. On one hand, this led to a lack of market discipline from the bond market upon the expenditure patterns of US government and households. On the other hand, it gave many institutional investors acutely low interest rates on their traditional fixed income portfolios, and led to a quest for non-traditional products that would achieve a yield pickup.

John Taylor points out that Greenspan diverged substantially from a reasonable notion of what the Taylor rule should do, in keeping interest rates too low, too long.

How might government-induced interest rate distortions lead to trouble in Finance? Raghuram Rajan had a great speech from June 2006 sketching channels of influence from low interest rates to risk taking.

Q2: Why did dodgy practices on home loan origination and securitisation flourish?

Raghuram Rajan wrote an article in FT emphasising the mismatch in time horizons between compensation and portfolio performance that afflicts senior employees of banks. This falls in the larger context of the deeper difficulties of banking as a business from the viewpoint of public policy. However, as the story of Bear Stearns shows, employees do have a lot to lose if the firm goes wrong. It isn't asif they walk away scot free. With hedge funds, there is absolutely no difficulty of this nature. (Gary Becker is not convinced that compensation policies are flawed; he points out that many hedge funds and PE funds - where compensation practices are perfect in terms of aligning the interests of staff - also suffered large losses).

The reforms proposal from the US treasury is focused on problems of US financial regulation, on why a byzantine system of regulation failed to see difficulties and resolve them [backdrop]. See the press release, fact sheet, full report, main web page. Here's an analysis of the Paulson proposal by Howard Davies. Sebastian Mallaby reviews the experience of hedge funds in these months.

Jayanth Varma thinks this is the end of the beginning of housing finance, that when we pick up the pieces and do it again, we could do it right. In all these difficulties, it is fair to point out that Basle-II (with a fresh think on some issues such as the role for credit rating agencies) would help.

Q3: Why did liquidity collapse in key markets thus doing damage to Finance?

Act 1: Northern Rock. A few months ago, I think a fair consensus built up around the ideas that the ECB's more relaxed rules of collateral have worked better, and that the UK's effort at having less deposit insurance didn't work. Jayanth Varma is not happy about the FSA review of the supervision of Northern Rock. Also see his review of evidence and diagnoses of the Northern Rock espiode.

Act 2: Bear Stearns. The hearings of US Senate Committee on Banking are a great resource on the story of Bear Stearns. In particular, see Ben Bernanke Christopher Cox Robert Steel Timothy Geithner Jamie Dimon Alan Schwartz.

Why bank risk models failed by Avinash Persaud reminds us of an argument that he made a few years ago, about too many Ph.D.s armed with the same mental infrastructure, analysing the same data, come up with correlated trading strategies. We have not adequately taken into account the implications for asset pricing and liquidity at large, of a large number of traders behaving in optimising fashion in the small when armed with correlated micro models. Persaud suggests that this world suffers from a heightened risk of `liquidity black holes' when too much money wants to buy or sell en masse and the counterparties aren't to be found. Of course, some of these Ph.D.s will see this reversion in the data and become contrarian. Persaud's argument, is that we're at the first flush of the quantification of trading and money management and we're still learning how the game shapes up.

Jayanth Varma points to the great work that the researchers are rapidly coming out with in this field. On 12th December, the US Fed announced the Term Auction Facility (TAF). Stephen Cecchetti summarises the new efforts of the US Fed in overcoming the difficulties of traditional methods for implementing monetary policy. In April 2008, John Taylor and John Williams had a paper out titled A black swan in the money market modelling the collapse in liquidity and measuring the impact of the TAF (they say there isn't much of an impact).

In my mind, recent events emphasise the benefits of both exchange-traded derivatives and the clearing corporation [link]. A lot more can be done using exchange-traded products than is presently the case, but some regulators have an inexplicable bias against exchange traded. See this article in The Economist on this issue also.

Big picture responses

Alan Greenspan has an interesting response to these diagnoses. His pithy ending: We have tried regulation ranging from heavy to central planning. None meaningfully worked. Do we wish to retest the evidence?

In his article Percy Mistry interprets the sources of difficulty. Richard Katz compares the US today against Japan in its difficult years.

Howard Davies did a great speech on 15 January titled The future of financial regulation.

Also see Options paper from Financial Safety Forum.

The Economist does not see much of an opportunity for progress. As they say:

It would be convenient to blame the regulators for all that, but the system is stacked against them. They are paid less than those they oversee. They know less, they may be less able, they think like the financial herd, and they are shackled by politics. In an open economy, business can escape a regulatory squeeze in one country by skipping offshore.

...

The notion that the world can just regulate its way out of crises is thus an illusion. Rather, crisis is the price of innovation, so governments face a choice. They can embrace new financial ideas by keeping markets open. Regulation will be light, but there will be busts. The state will sometimes have to clear up and regulation must be about cure as well as prevention. Or governments can aim for safety and opt for dumbed-down financial systems that hobble their economies and deprive their people of the benefits of faster growth. And even then a crisis may strike.

And, see Robert Shiller on innovation.

A careful look at the most recent events

The figure shows the movement of VIX and the S&P 500 (once again, adjusted for fluctuations of the USD) in the most-recent episode. The vertical yellow line is 17th of March. We see a sharp outburst of fear and then it subsided. See an article that I wrote on 18th afternoon in Indian time (i.e. early morning of 18th in the US). Also see the associated blog entry.

Murmur about currency futures

See this story in Mint by Sanjiv Shankaran.

The impact of the capital controls of 2007

In 2007, India experimented with capital controls against external commercial borrowing (ECB) and participatory notes (PNs). This was a controversial move at the time; there were two views in the country on whether such controls are worth doing. Some early evidence on the impact of these decisions is now visible in the BOP data, and is interpreted by Ila Patnaik in Indian Express here.

Investment is destiny

Geographical patterns in investment planned out today are the geographical patterns in per capita GDP of coming years. Ila Patnaik reviews what the CMIE Capex data says about investment in the big states of India. The surprise, for me, was the poor showing of states that one traditionally expects will do well: Tamil Nadu, Karnataka, Andhra Pradesh and Maharashtra (they're at ranks 7-10). At the same time, this is an encouraging phenomenon in that investment isn't all going to rich and successful states.

Raghuram Rajan's Committee

• A draft report. Update (21 December): Here is the final report. Also see my India bookshelf.
• A hundred small steps by Raghu in Business Standard.
• An opinion piece by Raghu and Eswar Prasad in Wall Street Journal
• An editorial in Wall Street Journal
• An opinion piece by Mythili Bhusnurmath in Economic Times
• Andy Mukherjee on Bloomberg.
• Ila Patnaik in Financial Express
• An editorial in Business Standard
• Shankar Acharya in Business Standard
• Rajesh Chakrabarti in Mint
• An opinion piece in The Economist
• R. Ravimohan in Business Standard
• An editorial in The Telegraph
• An interview with Raghu in Economic Times by Gayatri Nayak
• Eswar Prasad writing in Economic Times
• An interview with Raghu, and an editorial about the report.

Never send a man to do a machine's job

Chapter 5 of the MIFC report talks about algorithmic trading and the potential for India to achieve a role in international finance here. Direct market access was prohibited by SEBI and hence this kind of development could not take place. Algorithmic trading also figures on page 152 of this report on the policy aspects of OTC vs. exchange-traded paths to organised financial trading.

SEBI has removed this constraint, and shifted to the conventional stance of securities regulators worldwide on this question. Here is the SEBI circular, and here is good reportage in Mint by Mobis Philipose, Rachna Monga and Khusbhoo Narayan.

With this, we get one more tick on the checklist of activities on implementation of the MIFC report. An edit in Business Standard says:

The Securities and Exchange Board of India (Sebi) has removed the regulatory impediments that prevented securities firms and their clients from directly connecting their computers to the stock exchanges and automating trading strategies. India has already evolved a highly computer-intensive stock market. Order placement, order matching, risk management, payment and settlement are all fully computerised. The Luddite rule which prevented a role for computers in the actual trading process, was an incongruity. Removing it made sense.

The automation of trading strategies, termed algorithmic trading or AT, helps increase the efficiency of a large number of mundane processes of the financial markets. When a security trades at multiple venues, such as NSE vs BSE, or spot vs. futures, there must naturally be a very tight link between prices at these multiple venues. At present, this link is established by virtue of human arbitrageurs, who watch two screens and look for arbitrage opportunities. Computers excel at patiently watching for these, making no mistakes in calculations or order placement. Further, dedicating one or two employees to watch a related group of securities is expensive and tends to be done only for the biggest securities, such as Nifty shares. With computerisation, it becomes possible to monitor smaller stocks, thus permeating greater liquidity and pricing efficiency for a bigger range of stocks. Once the algorithms start flourishing, it would increase Mumbai's attraction for listings from firms outside the country.

Interest rates and currencies are natural areas where AT can play a big role, given the simple formulas that are involved in yield curve or currency arbitrage. However, deriving these benefits requires first shifting the bond market and the currency market to electronic exchanges.

Outside India, tens of thousands of capable finance professionals are engaged in the development and implementation of such trading strategies. This process has not begun in India because such computerisation was banned. Hence, Indian financial firms are inexperienced and will need to rapidly catch up. Goldman Sachs and J. P. Morgan have in-house knowledge on AT, which can be applied to Indian exchanges. Indian financial firms such as ICICI Bank, HDFC and UTI need to set up R&D teams which set about matching global expertise in this.

The report on Mumbai as an International Financial Centre has emphasised that the field of AT unlike many other elements of finance is one in which India can make its mark. It requires brainpower and not human relationships. Individuals of Indian origin are already prominent in such work at global financial firms, while being located in London or New York. An R&D team sitting in Mumbai is well equipped to compete with one placed in London or New York. Hence, Mumbai could become a centre of AT activity, with thousands of individuals developing the specialised knowledge of computer engineering, statistics and financial economics that is required to build these systems. Building such systems for deployment with Indian exchanges is the natural stepping stone through which these individuals and teams will graduate to doing such work for the international market.

Ranked by the number of transactions, the top two exchanges of the world are Nasdaq and NYSE. India's premier exchanges, NSE and BSE, are ranked third and fifth, respectively. AT is estimated to account for as much as half the business of Nasdaq and NYSE. Sebi's move could, thus, pave the way for NSE and BSE to gain in the global league table.

Materials of the 2nd research meeting of the NIPFP-DEA Research Program on Capital Flows and their Consequences

The papers, slideshows, and some photographs from the 2nd research meeting (27,28 March) are up on the website.

Inflation scare

Watch me talk about this on CNBC yesterday.

How to control inflation

WPI inflation is up to 6.68% and the government is ready to do battle.

I wrote an article in Business Standard titled How to combat inflation where I suggest that the way to bring monetary policy back to balance is a 10% rupee appreciation coupled with a 300 bps drop in the short-term interest rate.

In this reasoming, I think the drop in the US dollar is important in understanding the global rise in commodity prices. As Ashok Gulati and Kanupriya Gupta say in Hindu Business line:

Our humble submission is that before any policy prescription is offered; let us get the diagnosis right. While most of the factors that these studies talk about are right and appropriate, many of them compare 2007 prices with those in 2000, and that too in current dollars, to arrive at their conclusion of gloom.

This, we opine, is not appropriate, if not misleading. The reason is simple: anyone dealing with agricultural prices knows that agricultural prices in 2000 were at their rock bottom resulting primarily from the East Asian crisis. No one expected those prices to stay at those levels, as East Asian economies started to recover. Maybe the pendulum has now swung a little on the other side.

Another reason is that 2007-08 prices need to be put in a long-term perspective, say at least from 1990 to 2007. And when one does that, the minimum one needs to do is to take the prices in constant US dollars. One can take the base year as 1990, or 1995, or even 2005, for converting the price series into constant US dollars, but not the year 2000, for the reasons explained above.

However, in a situation when US dollar is fast losing its strength in the international exchange market, it may be more appropriate to look at prices in constant euros (with base year of 1990, or 1995 or 2005).

We have done this exercise for the major agricultural commodities such as wheat, rice, palm oil, and sugar, at constant 1995 US dollars as well as at constant 1995 euros. And the results are revealing (see Graphs).

The upshot of these results is: the 2007 global prices of agricultural products are not very much out of line with what they were in say 1996, just before the East Asian crisis. These prices started rolling down in 1997 due to East Asian crisis, touched a rock bottom in 1999-2000, and then recovered over time. Today, they are a little on the other side of the swing.