Materials from the 4th Research Meeting of the NIPFP DEA Research Program

All the slideshows and papers are up on the web.

Of broader interest within this collection is the presentation India in the Great Recession.

Contours of finance after the crisis

I have a piece in Financial Express today titled Contours of finance after the crisis where I look at the first glimmers of how financial regulation is going to be modified in response to the crisis. This is based on the Turner report (in the UK) and the Geithner proposal (in the US), both of which were released this month.

Also see:

• A quest for other ways by David Pilling and Ralph Atkins, in Financial Times, 15 March.
• Do not let the `cure' destroy capitalism by Gary Becker and Kevin Murphy, in Financial Times, 19 March.
• Liberalise now! - The only chance for emerging economies to become a major player by Andreas Freytag and Sebastian Voll, on voxEU, 25 March.
• Do we really want to regulate everything that moves? by Jon Danielsson, on voxEU, 25 March. Prof. Danielsson, if you'd like to see a country where this is done, I can help you setup a visit.

Currency exposure of Indian firms

Under a floating exchange rate, firms have a correct estimate of how risky it is to have unhedged foreign currency exposure. When a central bank artificially distorts currency volatility downwards, as RBI has often done, this gives out the wrong incentives to take on foreign currency risk. Now firms in India are lobbying that they be permitted to delay marking to market of exchange rate losses in the aftermath of a surprising rupee depreciation. Mahesh Vyas has facts on Indian firms and currency exposure, in the immediate context of the debate on fudging AS 11 disclosures. Also see editorials in Financial Express and Business Standard.

Netbooks and operating systems

by Naman Pugalia.

Recently, this blog (1,2) discussed the netbook revolution.

My experience with the Eee PC

I purchased the Asus Eee PC and upgraded the RAM. This allowed me to run 2 operating systems, as I was originally wary about working with Linux only. In the event, I used Windows once : to install Ubuntu. I thought it would be a travel gadget, but I have used it as my primary machine for 3 months now.

Weighing 2.2 kilograms, it is lighter than most books and with a 4 hour battery life, it is made for the on-the-go user. The built-in mic, speakers and camera work well with chat programs like Skype. The 7-inch screen is a fine compromise between a smartphone (in fact, Dell is banking on netbooks and not smartphones to ride the 3G wave) and a laptop. The lack of a CD/DVD drive does not bother me as I use flash drives for backup, and software for Ubuntu is easily installed over the network so reading CDs or DVDs isn't required.

OpenOffice, the open source competitor to Microsoft's office suite, runs smoothly and recognizes most formats used by Windows users, thus giving inter-operability with others. The pre-installed Transmission BitTorrent Client, GIMP Image Editor and VLC Media Player fulfill other basic needs. The Eeebuntu forum and the Eeeuser forum offer elaborate tech support.

Larger implications of what is going on

Netbooks are important for India as they can revolutionize the way the economy works due to the mobile-phone-like multiplier effects. Barring Apple, most manufacturers have released such a smaller, lighter and cheaper laptop. Considering the critical mass this product category has acquired, Apple is probably working on a prototype. Most netbooks come with a low cost CPU such as the Intel Atom processor, designed specifically for this new breed of notebooks.

Netbooks are a new battleground for operating systems. Given the open source code, and long experience in coping with underpowered hardware, the Linux kernel has easily adapted to netbook conditions. Linux usability is assisted by the availability of free applications software such as Firefox (a web browser), Thunderbird (an email program), Openoffice (a word processor, spreadsheet, etc) and programs that play music and video. The Taiwanese hardware vendors such as Asus, who are some of the top sellers of netbooks, have got closely involved with Linux device drivers and distributions in ensuring that their netbooks work well with Linux.

Microsoft's Windows 7, expected to ship later this year, will come with a Starter Edition which will be light enough to run on netbooks. It will permit the user to run a maximum of three applications at once. Users will have to choose between this, and a Linux environment where there are no artificial constraints.

In rich countries, netbooks are used as secondary gadgets which help in executing basic tasks such as e-mailing, browsing and blogging. Many users in low income markets will, in contrast, embrace netbooks as a primary computing device. Therefore, a light OS with free software is more likely to succeed in emerging markets characterized by customers with small budgets. For the price sensitive Indian consumer, Ubuntu Linux is a natural choice for an OS for a netbook.

Looking into the future, there are two interesting dimensions to what is taking place with netbooks. For Microsoft, the price points that Windows 7 can support are limited by (a) The low price of netbooks and (b) The availability of a credible competitor at a price of zero. This will force Microsoft to fundamentally modify its business model.

The second interesting dimension is the new embrace, by hardware vendors, of Unix (i.e., OS X and Linux family including Google's `Android'). Whether it is Ubuntu Linux, Google's `Android', or other Linux variants, the Taiwanese / Japanese / Korean producers of netbooks and mobile phones are now much more tuned towards finding ways to put flexible and free operating systems on their hardware while enjoying healthier profit margins. This will have many interesting long-term implications for the future of computer devices and hardware.

Serious numbers

In the currency volatility of yesterday, the NSE currency futures got turnover of $714 million off 25,518 trades.

At the heart of the problem is the task of fixing the financial architecture

Hank Paulson has an article in the Financial Times where he emphasises that a key part of fixing financial regulation in the US is the task of changing the architecture of financial regulation. This is essential for avoiding problems like AIG being regulated by the State of New York. As he says:

Creating a fundamentally different regulatory system is complex and will take months, if not years. But policymakers can achieve significant near-term regulatory reforms that represent progress towards the ideal. These include giving the Fed expanded powers to regulate market stability, combining the Office of Thrift Supervision and the Office of the Comptroller of the Currency to strengthen regulation by reducing duplication, centralising the scrutiny of mortgage origination, creating an optional federal insurance charter, beginning the process of integrating the Securities and Exchange Commission and Commodity Futures Trading Commission and continuing to improve arrangements for clearing and settling over-the-counter derivatives, including development of well regulated and prudently managed central clearing counterparties for OTC trades.

For some of the background, see this speech, and see here.

Like many democracies, the US is very bad at solving such problems under normal times. The SEC vs. CFTC separation was a silly thing to have, but for decades, it has lingered on. Now, in the aftermath of this crisis, there's a good chance that it will get fixed. I hope the merged agency draws its organisational culture more from the CFTC than from the SEC.

In the UK, the architecture was fixed in the late 1990s: regulation of all financial firms was placed at the FSA; investment banking for the government was placed at the DMO; the Bank of England was given independence in return for (a) transparency (b) accountability and (c) a narrow mandate to only do monetary policy. The gap in that framework was the lack of a deposit insurance mechanism akin to the US FDIC; this is now being fixed. In the new framework, FSA regulates banks; when FSA makes a decision that a bank is in a bad way, the bank gets handed to the Bank of England which chooses whether to give liquidity support or to shut it down. For the rest, the basic structure of agencies and laws is fine, unlike what's seen in the US.

In India also, the deeper problems of Indian finance are critically about the accidents of history, which have given us a warped financial architecture. The RBI Act, the FC(R) Act, SC(R) Act, etc., were all done decades ago when knowledge of finance in India was absent. That task before us is that of now replacing all these badly drafted laws by sensible ones.

In the UPA period, we have understood these problems and done a lot of the technical work that lays the groundwork for what comes next. The task for the next goverment is to implement this technical work. The regulation and supervision of all organised financial trading needs to be placed at SEBI (thus merging functions that are presently at FMC and RBI); banking needs to come out into a BRDA; the regulation of all pension activities (and not just the NPS) needs to be placed in PFRDA; the investment banking for the government that's presently done at RBI needs to go out into a professional and independent Debt Management Office (which is termed NTMA). At the end of this, we would be holding four regulators (SEBI, BRDA, IRDA, PFRDA), one investment banker (NTMA) and one independent central bank.

Indian finance readings of the day

Read Mahesh Vyas in Financial Express on SEBI's new initiative on transparency requirements for people selling mutual fund products. For background reading, see: link, link. I have two comments here:

• The debate about transparency in the relationship between the customer and the mutual fund agent reminds me about the debate which took place a long time ago on the transparency in the relationship between the customer and the BSE broker. In the bad old days, when you purchased shares, the BSE broker gave you a consolidated bill for the consideration which you had to pay. You were not supposed to ask what was the actual execution price at which shares were bought and what was the markup charged by the broker. It was as bad as buying a currency forward from a bank.
  Thanks to SEBI's pushing, transparency came into the contract note of the BSE broker: today the contract note clearly shows the price at which the share was bought on the market and the markup charged by the broker. The same can and should be done with mutual funds.
• The second dimension is the extent to which the mutual fund agent is conflicted. I feel the mutual fund agent must be required to first show the customer a tariff card containing the fee earned by him on all the various products that he sells. This will help the customer have an better perspective on what advice is being given out.

And, Mobis Philipose has an article on the unique governance challenges of financial exchanges. I have long argued that profit-oriented and valuation-focused exchanges present difficult problems, particularly given the weaknesses of the legal system and regulation in India. See: link, link.

From young turk to defender of the status quo

I have often noticed how many individuals who were unconventional in their thinking about Indian economic policy in the 1970s and 1980s, and got influential out of being correct then, are apologists for or defenders of the status quo today. This seems to happen often enough that it can't be mere accident; there must be a mechanism which generates reversion to the mean.

Today, Tyler Cowen takes a stab at this (in a broader setting) on his blog:

Do influential people develop more conventional opinions?

1. People "sell out" to become more influential.
2. As people become more influential, they are less interested in offending their new status quo-oriented friends.
3. As people become more influential, their opinion of the status quo rises, because they see it rewarding them and thus meritorious.
4. The status quo is good at spotting interesting, unusual people who will evolve (sell out?) and elevating them to positions of influence.
5. Oddballs who are influential arrive first at where the status quo is later headed, and eventually they end up looking conventional.
6. Influential people are asked to write increasingly on general interest topics ("How to Be Nice to Dogs") and thus they find it harder to be truly unconventional. They cultivate skills of conventionality because that is what they are paid for or allowed to express.

Larry Summers is one person who's done well in not losing his intellectual edge as he has gained influence, and he made treasury secretary (the equivalent of finance minister) at the tender age of 45. It's hard to think of the Indian political process recruiting such a person as finance minister (at any age). Another example of a personality type that Indian politics is not friendly to is Ed Balls, who had a huge influential on the macroeconomic policy framework of the UK.

Implementation of the QR on investments by foreigners into INR debt

One of the least sensible things that India does is to put restrictions on foreigners buying rupee-denominated bonds, despite their being one of the best possible channels through which India can get engaged into globalisation. In this area, policy makers in India are clearly out of touch with present knowledge. (Here is background, and for the conceptual picture, see : link, link, link).

Once this quantitative restriction (QR) is in place, there is an allocative question: Which firms are going to get these limits? SEBI has just released the names of the firms who have won allocations in an auction. While there was space of Rs.41,000 crore on offer, the bids seem to have only added up to Rs.29,000 crore. Does this mean there is no charge for these bidders? Still, this sets the stage for Rs.29,000 crore of investments in the corporate bond market over the next 1.5 months.

4th meeting of NIPFP DEA Research Program

See the program. This is 24 and 25 March, at India Habitat Centre, in New Delhi.

G-20 meeting

Here's C. Fred Bergsten (Testimony at the US House of Representatives) on what deal the G-20 countries should shoot for. The early indicators are that what's likely to come about is a small step in this broad direction. Ila Patnaik (in Indian Express) has an Indian perspective on the G-20 meeting.

Two wise men try to comprehend Narendra Modi

Read Ashok Desai and Robert Kaplan on Narendra Modi. Kaplan has some priceless quotes:

I could see how he moves crowds, or takes over boardrooms. I have met Jimmy Carter, Bill Clinton, and both Bushes. At close range, Modi beats them all in charisma. Whenever he opened his mouth, he suddenly had real, mesmerizing presence.

and

...the churches and bastions in Diu are ruins not because they represent an idea that failed but because they represent no idea at all, whereas India has been an idea since Gandhi’s Salt March in 1930. Either Modi will fit his managerial genius to the service of that idea, or he will stay where he is. Hindus elsewhere in India are less communal-minded than those in Gujarat, and that will be his dilemma.

Tax havens

Governments running large welfare states have long resented tax havens, which reduce their tax take. In recent weeks, some people have managed to sell the idea that in response to the global financial crisis, governments need to crack down on tax havens. I, for one, don't see any link between tax havens and the problems of the global financial system.

Writing in Financial Express a few weeks ago, Avinash Persaud had an eloquent argument about the critical role that tax havens play in enabling multinational corporations and thus globalisation. His description of the tax haven as a tax-efficient `junction box' for a multinational corporation reminded me of the role of securitisation SPVs as junction boxes for financial contracts.

Responding to the global crisis

In recent weeks, Percy Mistry wrote four pieces in Financial Express analysing present and potential responses to the global crisis. These are best read as an integrated piece.

Watch the policy rate in real terms, but worry about how little it matters

I have an article in Financial Express titled Watch the policy rate in real terms, but worry about how little it matters where I discuss monetary policy in India's slowdown.

A key flaw that is being made in the public discussion of inflation is the use of year-on-year measurement of inflation. While the yoy WPI inflation stands at 5.25% in January, the WPI has dropped from a level of 241.5 in September 2008 to 229.6 in January 2009. What we have today is a period of deflation but the use of yoy inflation measures - which represent a moving average of the latest 12 monthly shocks - yields a misleading input into economic analysis.

In similar fashion, CPI-IW inflation shows 10.45% on a yoy basis in January, but the level of the CPI IW has been flat from October 2008 to January 2009. To use yoy inflation as a measure is to get a very wrong picture of the inflationary pressures in the economy.

On the subject of better early warnings of inflation, and how this sheds light on monetary policy in the past, see this paper.

Revenues accrued and booked, but never realized

by Ravi Purohit

What happened

Lok Housing & Constructions made the following disclosure during the just concluded Dec'08 quarter:

The global economy in general and the real estate industry in particular is passing through recessionary scenario, which has resulted in to financial melt down of un-precedential scale. From time to time the Company had entered several agreements for sale of plots, properties, development rights and constructed units held by it as stock in trade. In accordance with the consistently followed accounting policy of the Company, sales revenue and profit thereon were recognised at the time of entering in to such agreements to sell. Due to the financial meltdown and Severe economic recession, some of the parties with whom the Company had entered in to agreement to sell have failed to meet their commitments and considering the overall interest of the Company, the agreement for sale entered in to in the past financial years and in respect of which revenues already recognized have been mutually terminated / cancelled. The Company has been legally advised that though the agreements for cancellation of sales have been entered in to during this quarter (being October to December 2008), but since cancellation of sales pertains to sales recognised earlier, the financial statements of the period during which sales and profits were recognised needs re-construction / amendment, on the doctrine of "Relation back". The Company shall amend the financial statements of earlier years and get the same approved in the next general body meeting. Accordingly no effect in respect of cancellation of sale agreements has been given in the financial statements of this quarter. During the quarter under review the Company has entered in to 53 agreements for cancellation of sales made in the earlier financial years, the sale value of which is Rs 282.14 crores and the resulting loss / reversal of profit recognized earlier being Rs 225.01 crores"

How big is this restatement, compared with the size of the firm?

It is huge. In the last three years (FY06, '07, & '08), Lok Housing Constructions reported cumulative revenues of Rs.578 crore and cumulative net profit of Rs.226.4 crore. The revenues were taken in the income statement based on the Company signing sales agreement with potential buyers (as mentioned in the explanation provided by the Company).

Now they say those contracts have been mutually terminated/cancelled, which means it will have to restate earlier numbers, ie. sales by Rs.282 crore (50% of total sales of the last three years) and net profit by Rs.225 crore (almost 100% of all profits earned during the last three years). Prior to FY2006, the company did not even make profits.

Using the CMIE standardised definition of PAT net of P&E, the profits ever made by the company are: Rs.14.55 crore ('06), Rs.79.07 crore ('07) and Rs.109.78 crore ('08). Compared with these more modest values, a restatement of Rs.226.4 crore is even more massive.

How did this happen?

In its accounting policies section of the Annual Report for FY07 and FY08, the Company states the following:

1. The Company follows completed contract method of accounting in respect of its construction activity. Under this method profit in respect of units sold is recognized only when the work in respect of the relevant units are completed or substantially completed, which is determined on technical estimates.
2. The construction and development cost for completion relating to the sold units, which are considered for profit are estimated on the basis of technical evaluation.
3. Revenue recognition in respect of property sale transactions is on the basis of agreement to sale and are subject to execution of conveyance and compliance of applicable legal formalities.

The first and second statement is clearly not in sync with what the Company describes in its Note to Accounts for the Dec'08 quarter. Thus, it has to be the third point which states that it recognizes sales in respect of property sale transactions on the basis of "agreement to sale". However, according to Accounting Standard 9, the Company can book revenues only if the following two are fulfilled:

• The seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership; and
• No significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods.

This means, revenues can be booked only upon delivery of the said property, which clearly was not the case for Lok Housing, else it would not have to restate sales and profits. So how is Lok Housing able to book revenues and profits and yet not deliver the property to the purchaser with whom it has an agreement to sale in place for more than 2-3 years?

Could it be because of the following Guidance note by the ICAI on Recognition of Revenue by Real Estate Developers?

Revenue in case of real estate sales should be recognized when all the following conditions are satisfied:

1. The seller has transferred to the buyer all significant risks and rewards of ownership and the seller retains no effective control of the real estate to a degree usually associated with ownership;
2. no significant uncertainty exists regarding the amount of the consideration that will be derived from the real estate sales; and
3. it is not unreasonable to expect ultimate collection.

7. The determination of point of time when all significant risks and rewards of ownership are transferred depends on the facts and circumstances of each case considering the terms and conditions of the agreement. In case of real estate sales, all significant risks and rewards of ownership are normally considered to be transferred when legal title passes to the buyer (e.g., at the time of the registration, with the relevant authorities, of the real estate in the name of the buyer) or when the seller enters into an agreement for sale and gives possession of the real estate to the buyer under the agreement. All significant risks and rewards of ownership are also considered to be transferred, if the seller has entered into a legally enforceable agreement for sale with the buyer and all the following conditions are satisfied even though the legal title is not passed or the possession of the real estate is not given to the buyer:

1. The significant risks related to real estate have been transferred to the buyer. In case of real estate, price risk is generally considered to be one of the most significant risks.
2. The buyer has a legal right to sell or transfer his interest in the property, without any condition or subject to only such conditions which do not materially affect his right to benefits in the property.

8. When the seller has transferred to the buyer all significant risks and rewards of ownership, it would be appropriate to recognize revenue at that stage subject to fulfillment of other conditions specified in paragraph 6 above, provided the seller has no further substantial acts to complete under the contract. However, in case the seller is obliged to perform any substantial acts after the transfer of all significant risks and rewards of ownership, revenue should be recognized on proportionate basis as the acts are performed, i.e., by applying the percentage of completion method in the manner explained in Accounting Standard (AS) 7, Construction Contracts. An example is a building or other facility on which construction has not been completed though all significant risks and rewards of ownership have been transferred pursuant to the fulfillment of conditions stated in paragraph 7 above. Another example is of a land which is yet to be developed though the seller has transferred all significant risks and rewards of ownership of the land to the buyer through an agreement for sale as per paragraph 7 above."

I think this means that having once sold the rights to the buyer, the seller is merely a contractor and can therefore start booking revenues based on the work completed, i.e. even if a building is still under construction, the builder can start booking revenues and profits on it.

I am no expert on the accounting standards that are practiced by real estate companies in India, and after looking at the Notes to Accounting Policies in the Annual Report and in the most recent quarterly result for Lok Housing, my doubts have only increased. However, there have been some insightful articles in the press in recent times, which touch upon this topic:

1. An article in the Hindu Business Line by Dolphy D'Souza of E&Y [link].
2. An article in the Business Standard [link]

An unsatisfactory situation

This raises two questions:

• How can a Company be allowed to book sales and profits for transactions never completed and allowed to carry it for 2-3 years? Surprisingly, there are no provisions for bad debts in any of the years during 2006-08, the maximum sundry debtors (outstanding for more than six months that the Company reported by Rs.147 crore in FY08, half of what was due to Lok Housing and that they belonged to previous years?
• Even if our Accounting Standards do allow companies to book sales and profits without delivering the underlying consideration because there is an 'agreement to sale' in place, why is Lok Housing mutually terminating/cancelling these contracts and not going to the Court of Law and make those involved pay for the agreements entered into? How can a company benignly view cancellation of the agreements that are supposed to have earned it all the profits it reported in the last three years?

Disclosure: I have no shares of any Indian real estate company, and never have. I may never even invest in them in future too, unless there is more transparency in the way they operate, report their financials and the way the entire real estate market in India operates.

What can we do better?

I think the government would do well to:

• Make it compulsory for all the local municipalities (such as the BMC) across India to provide all information pertaining to real estate projects (the clearances/objections, blue prints of plans applied for by developers and thereafter approved by the municipal authorities, and other related and important documents), on the Internet.
• Ask every builder to a) Create a website, b) Make the entire plan as approved by the local authorities, the various clearances (CC, OC, etc.), and the flats/offices (including the ones currently on sale/already sold) available on the site with daily updates.
• Clarify guidelines on financial reporting, or else more episodes like Lok Housing will come about, particularly given the softness in real estate prices.

FMC vs. NCDEX, continued

Mobis Philipose has a good piece in Mint on FMC's order on NCDEX [background].

Diagnosing the global financial crisis, and reforming financial regulation in response: core readings

Even if you're overloaded with too many things being written about the global financial crisis, do look at these four most-useful readings (in my view):

• Road to the London summit, 26 February 2009: a competent summary of what has taken place and the questions that we face.
• Reforming financial regulation, supervision, and oversight: What to do and who should do it by Morris Goldstein, 24 February 2009.
• The Fundamental Principles of Financial Regulation, January 2009, by Markus Brunnermeier, Andrew Crocket, Charles Goodhart, Avinash D. Persaud and Hyun Shin.
• The financial crisis and the future of financial regulation by Adair Turner, 21 January 2009.

Given the G-20 summit which is now just a month away, it will be useful to place this documents into your working set.