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Monday, November 30, 2009

New sources of financing for microfinance assets

by Nachiket Mor.

The problem

The main source of funding for microfinance in India has been through banks, primarily through the forced `priority sector lending'. Over the years, the demand for funds in the microfinance industry has outpaced the growth in investment by banks. In addition, banks are not the ideal place for these assets, given the nature of cashflows and maturity of micro loans. Hence, even though MFI assets are part of priority sector lending, the excessive focus on bank capital has effectively raised the cost of capital for MFIs.

The upstream funding for microfinance needs to be diversified to harness a diverse array of borrowers, so as to avoid the constraints and unique compulsions of any one source. However, at present in India, MFIs are not permitted to mobilise deposits, or borrow from international lenders, or from MIVs (Microfinance Investment Vehicles).

The role for securitisation

The ideal financing channel for them, in this environment, is securitisation. Through securitisation, a pool of loans across many borrowers (and ideally across many MFIs) would be turned into a tradeable securities that are targets of investment by a diverse array of investors, with different beliefs and compulsions.

A recent transaction

One step towards this goal came about last week, when IFMR Capital announced the completion of a micro-loan securitisation through which mutual fund investment into microfinance takes place. The Rs.480 million ($10.4 million) transaction is backed by over 55,000 micro-loans originated by Equitas Micro Finance, a Chennai-based microfinance institution (MFI) with approximately 700,000 low-income clients.

The bulk of the securities issued were purchased by ICICI Prudential AMC, the country's third largest mutual fund. The entry of a mutual fund investor into the micro-loan backed securities (MLBS) market, as well as the treasury desks of major Indian banks, has given Equitas a new investor base and lower cost of financing. This should enable lower cost borrowing for the households that Equitas lends to.

Deeper implications

Going beyond the direct issue of access to a large volume of funds at a low cost, capital market financing is beneficial to microfinance firms by bringing about new pressures on transparency, accountability and thus oversight of MFIs.

IFMR Capital has previously done a MLBS transaction, but there it was the sole investor in the BBB rated (subordinated) tranche. In the Equitas transaction, there was investor interest in all tranches; a majority of the BBB tranche was purchased by a private bank. This is relatively new for the Indian corporate bond market, which has hitherto been wary of BBB securities. These developments are thus synergistic for both the growth and development of microfinance and for the corporate bond market.

The ultimate goal is an ecosystem where securitisation paper is constructed using loans made by multiple MFIs, sold to a diverse array of domestic and foreign investors, actively traded on the secondary market, with trading that is supported by high quality disclosure of data about the underlying loans on a daily basis. IFMR Capital will work in all aspects of this ecosystem, including facilitating listing and engaging in market making.

Looking beyond the vision of MFIs funding themselves through securitisation, there is also a role for (say) 1000 small banks (as argued in Raghuram Rajan's report). A key ingredient of making this work is bringing in market discipline, by having regulations which require them to finance (say) a quarter of their assets using subordinated debt, and using this BBB bond market to exercise market discipline on them. The task of bank supervisors would be simplified when the BBB bond market, the CDS market and the stock market jointly serve up a list of the 50 weakest banks on each trading day. The stock market is in place in India; what is now missing is the BBB bond market and the CDS market.

Further reading

At the IFMR website.

Saturday, November 28, 2009

Dubai's great crash

Sheikh Makhtoum won't go to debtor's prison, but short of that, Dubai's all-but-sovereign default is an epochal event in its story. I wrote a column in Financial Express titled Dubai's great crash where I draw on this episode to think more clearly about (a) International financial centres and (b) Puffery. On this subject, also see Reality catches up with the Gulf's model global city by Roula Khalaf in the Financial Times, and 'The Sheikh's New Clothes?' Dubai's Desert Dream Ends by Stanley Reed in Business Week.

One hears talk about Dubai giving up crown jewels, like the airline, in exchange for a bailout. I think the time for that bailout was six months ago. Today, with a funding gap of $80 billion, the crown jewels are not big enough. But six months ago, it was possible to think of a deal where ADIA bought up the crown jewels for (say) $40 billion and Dubai would have tided over the storm. Or maybe this is big, and runs beyond just the crown jewels: see Enough glitzy debt: time for regime change by Jo Tatchell in The Times.

This episode is an opportunity to think about exchange rate regimes. What if Dubai had used a floating rate instead of a fixed rate? This would have worked in two ways. First, it would have been a stabiliser. When bad times came, capital would have started leaving Dubai, the exchange rate would have depreciated, thus making real estate or hotel rooms in Dubai cheaper in the eyes of foreign customers. (Conversely, in good times, the exchange rate would have appreciated, thus reducing the attraction of going to Dubai). The key intuition (RBI speechwriters please note) is that exchange rate fluctuations stabilise the economy. Without a flexible exchange rate, adjustment in Dubai was forced on to the labour market, the real estate market, etc., which are all places where adjustment is more disruptive and is resisted more.

The second interesting feature of this thought experiment is linked to borrowing. A fixed exchange rate encourages and even subsidises dollar denominated borrowing. For society, the low cost of borrowing (the USD interest rate) is paid for by the loss of monetary policy autonomy. If a flexible exchange rate were used. Mr. Makhtoum would have been more careful and would have borrowed less.

Friday, November 27, 2009

The rise of private sector education service producers in India

In India, in the fields of health and education, an impressive rise of a private ecosystem has come about. In these fields, the State has tried hard to get back in the game, particularly after the UPA won power in 2004. But the unwillingness of the State to undertake deeper reforms has meant that ultimately, government facilities generally work badly. CPI(M) ideologues send their children to private schools.

The CMIE Consumer Pyramids data shows the fraction of household expenditure on school/college fees. Households that spend nothing are those that have no children, or those that are fully served by government schools/colleges. The CMIE data separates out expenditures on stationery, books, private tuitions, etc., so what is observed here is just the pure payment to the school/college. It shows:

Income class
Fraction of expenditure
Rich 1
Rich 2
Higher Middle Income 1
Higher Middle Income 2
Higher Middle Income 3
Middle Income 1
Middle Income 2
Lower Middle Income 1
Lower Middle Income 2
Poor 1
Poor 2

The overall average expenditure per household in the survey is Rs.86,228, so 2.82% of this is Rs.2400 a year or Rs.200 a month. This, of course, reflects a split between some households who use government facilities (who spend nothing) and others who use private facilities (who spend more than Rs.200 a month).

An incipient academic literature shows that learning outcomes from the weakest private schools broadly replicate learning outcomes from government schools even though the resource outlay of government schools is 3x to 10x bigger. If this evidence was correct, private schools would not have gained market share. Poor people have been spurning government schools with zero tuition fees and free meals, and choosing private schools where significant payments have to be made. There are two possible explanations: either the parents are not understanding how best to take care of their interests, or the econometricians are not understanding what parents are thinking. I am biased in favour of the latter explanation.

Like all incumbents, public sector producers of educational services resent competition, and particularly competition that is gaining market share. With the Right to Education Act, the government has armed itself with new powers to force `unrecognised schools' to close down. This is similar to the Department of Posts trying to prevent private firms from carrying letters. This is going to shape up as one of the most important battlegrounds in Indian education. So far, the broad story was that the government floundered and spent ever larger sums of money, but did not prevent `unrecognised' schools from coming up. Now it is shifting gears from category 3 ("State Production But Do No Harm") to category 4 ("State Production While Damaging the Private Sector").

As Lant Pritchett has emphasised, countries like Chile which have a fully competitive framework, where parents choose between public and private schools, have a bigger market share of public schools as compared with India, where the main approach of the State is to pretend that private schools don't exist, or to try to force them out. This ought to trigger off fundamental rethinking about what we are doing in the government. This rethinking has not begun, and the customers are quietly voting with their feet, switching their children to private schools. Despite the huge increase in funding to public schools, the market share of private schools is rising every year.

In this setting, it is worth attending the School Choice National Conference 2009 which will be held in Delhi on 16 December. And, do read The Beautiful Tree by James Tooley.

Wednesday, November 25, 2009

When a currency futures market dominates a currency forward market

by Gurnain Kaur Pasricha

In recent months, a sense has emerged that the exchange-traded currency futures market in India is more liquid than the corresponding contract traded OTC (i.e. the forward market). As an example, we examine a dataset from NSE of 28,797 observations of data - one observation per second - from 3 November 2009, for the November expiry. The effective spread for a transaction of $1 million (i.e. 1000 contracts) is calculated, in the units of paisa. This dataset has the following summary statistics:


In other words, 95% of the time, the spread on NSE for a $1 million rupee-dollar futures transaction was below 2.344 paisa. The median spread, for a $1 million transaction, was 1 paisa. This spread dropped below 0.5 paisa with only a 5% probability.

These numbers are significantly superior to those found on the OTC forward market, where, as a thumb rule, dealers feel that a $1 million transaction typically involves a spread of 2 paisa. This suggests that the liquidity at NSE is roughly 2x superior to the OTC market. The superiority of the execution at NSE is likely to be greater than 2x when we consider the opacity and execution risk of the OTC market. To the extent that order flow has shifted away from the forward market to the futures market, there could be a dynamic story here of the futures spread getting tighter at the expense of the forward spread.

This situation is unexpected. In the international experience, the currency forward markets is more liquid than its exchange-traded counterpart. This is despite the fact that futures markets has desirable features including near-zero counterparty risk, transparency, contracts standardisation and open public participation. The key reason for the domination of the OTC market appears to be historical. The OTC market came first, had entrenched liquidity, and the network externalities of liquidity hold the users in place.

In thinking about India's currency futures market, it would be useful to compare and contrast with Brazil's experience. Brazil is an interesting peer to India for reasons of a large GDP, democracy, rule of law, institutional quality, etc. It is also the only country of the world, prior to India, where the currency futures market became more liquid than the currency forward market.

In Brazil, currency futures trading began in 1991 - a seventeen year head start when compared with India. While Brazilian macroeconomics is now remarkably healthy, Brazil has had a turbulent history with many crises, high and volatile interest rates and inflation. The futures market, with daily marking to market, and therefore lower collateral requirements, offered a cheaper way to take positions in the currency. Nevertheless, there is reason to believe that several (sometimes unrelated) regulations contributed to tipping the balance in favor of futures contracts, so much so that today there is essentially no OTC market to speak of. The dealers on the forward market now provide OTC contracts to their customers but unwind their positions in the futures market (See Note 2). The regulatory pressures which moved liquidity from the OTC market to the futures market were:
  1. Access to spot markets was limited for several decades as a tool to control capital flight. Both domestic and foreign residents had easier access to futures markets than to spot markets. This led to greater number of players, and more liquidity in futures markets. Access to spot markets in Brazil is still far from free, for both domestic and foreign residents. India is in the same boat, with a futures market that is accessible to citizens but a spot market which is not.
  2. Until 2005, banks were subject to unremunerated reserve requirements on foreign exchange exposures exceeding pre-specified limits. These reserve ratios did not apply to futures positions, thus driving trading to futures markets.
  3. Until December 2007, Brazil imposed a financial transactions tax, called CPMF, on all debits on bank accounts. This levy applied to profit and loss payments on exchange traded contracts, not to their notional amounts, thus pushing activity to exchanges.
  4. OTC derivatives contracts are not netted, whereas contracts with the exchange or clearing house are netted by the latter. This means that the tax on cash flows, PIS-COFINS (See Note 3), de-facto taxes OTC transactions at a higher rate than exchange traded derivatives.
  5. Brazil has reporting requirements for OTC transactions - all transactions with domestic counterparties must be reported to regulators, in order for them to be considered enforceable. This levels the playing field in terms of the reporting burden of exchange traded versus OTC transactions. India has not yet done this.
  6. Pension funds are required to use only standardized derivatives contracts.
  7. The central bank, Banco Central Do Brasil, uses the futures market for doing currency intervention. This gives liquidity to the futures market, and also ensures that the OTC community has to look very carefully at the price on the screen so as to capture current information. India has not yet done this.
While some of these rules were removed in the 2000's, after being in place for several years, their consequences have outlasted them. There is a path-dependence in market liquidity. These kinds of market rules matter in getting liquidity on the exchange off the ground. Once the exchange becomes liquid, the network externality of market liquidity sucks in further order flow and preserves the domination of the exchange even after these rules are removed.


1 The author is a senior analyst at the Bank of Canada. The views expressed here are personal. No responsibility for them should be attributed to the Bank of Canada.
2 The material in this note is a summary of information provided by Brazilian economists as well as that contained in Dodd and Griffith-Jones (2007), Brazil's derivatives markets: hedging, central bank interevention and regulation, and Kolb and Overdahl (2006), Understanding futures markets, sixth edition, Blackwell Publishing.
3 The PIS and COFINS are federal taxes on revenues, charged on a monthly basis.

Working group on foreign investment in India

MOF has setup a working group on foreign investment:
To review the existing policy on foreign inflows, other than Foreign Direct Investment (FDI), such as foreign portfolio investments by Foreign institutional investors (FIIs)/ Non Resident Indians (NRIs) and other foreign investments like Foreign Venture Capital Investor (FVCI) and Private equity entities and suggesting rationalisation of the same with a view to encourage foreign investment and reducing policy hurdles in this regard while maintaining the Know Your Customer (KYC) requirements. 
To identify challenges in meeting the financing needs of the lndian economy through the foreign investment. Foreign investment for this purpose to be understood broadly and can include investment in listed and unlisted equity, derivatives and debt including the markets for government bonds, corporate bonds and external commercial borrowings. 
To study the arrangements relating to the use of Participatory Notes and suggest any change in the policy if required from KYC and other point of view. 
To reexamine the rationale of taxation of transactions through the STT and stamp duty. 
To review the legal and regulatory framework of foreign investment in order to identify specific bottlenecks impeding the servicing of these financing needs. 
To suggest specific short, medium and long term legal, regulatory and other policy change; in respect to foreign investment keeping in view of the suggestions expert committee reports such as the Committee on Fuller Capital Account Convertibility, the Committee on Financial Sector Reforms and the High Powered Expert Committee on Making Mumbai an lnternational Financial Centre.

Tuesday, November 24, 2009

Outsized capital inflows?

A lot of people are getting anxious about a scenario with outsized capital inflows hitting India. The historical time-series is illuminating:

Billion USD
Percent to GDP

In the latest quarterly data (Apr/May/June 2009), net capital inflows worked out to $6.7 billion or 2.7% of GDP. These are not big numbers.

What are big numbers? 10% of GDP is a big number, which was breached for six months in this history. At the time, this corresponded to above $30 billion a quarter of net capital inflow. In future quarters, the physical magnitude will depend on how big GDP is at the time. My rough sense of 10% of GDP in the Oct-Nov-Dec 2009 quarter is that it will be $30 billion. To get to these numbers, we'd need to get back to an environment like Jul-Dec 2007 in terms of optimism about emerging markets in general and India in particular. So far, this doesn't seem to be what is in place.

Saturday, November 21, 2009

Interesting readings

  • Tackling systemic risk is no job for the status quo by William Donaldson and Arthur Levitt, in the Financial Times.
  • Short-Selling Bans around the World: Evidence from the 2007-09 Crisis by Alessandro Beber and Marco Pagano. The abstract reads: Most stock exchange regulators around the world reacted to the financial crisis of 2007-2009 by imposing bans or regulatory constraints on short-selling by market participants. We use the large amount of evidence generated by these regime changes to investigate their effects on liquidity, price discovery and stock returns. Since bans were enacted and lifted at different dates in different countries, and in some countries applied to financial stocks only, we identify their effects with panel data techniques, and find that bans (i) were detrimental for liquidity, especially for stocks with small market capitalization and high volatility; (ii) slowed down price discovery, especially in bear market phases, and (iii) failed to support stock prices..
  • A story on regulatory impact assessments.
  • Mahesh Vyas on improving disclosure.
  • Let bidding begin in the market by Rajesh Chakrabarti, in Financial Express.
  • Ashok Desai in Business World on the scandal that is ULIPs.
  • Sanjeev Sanyal in Business Standard on making Bombay work.
  • At 250 kph, the Bombay-Delhi distance of 1200 km is covered in 5 hours. At 376 kph (which the Chinese are implementing today), it's roughly 3 hours. If that sounds exciting, read Bullet trains for America? by Mark Reutter.
  • A pair of articles from The Economist on India and capital controls: A world apart, and Raining on India's parade.
  • Anita Bhoir in Mint on the proposed Standard Chartered IDR.
  • Looking back at Indira Gandhi: Ila Patnaik in Financial Express, and Shekhar Gupta in Indian Express.
  • A great collection of pictures about the Berlin Wall. Do not miss the symbolism of #34, where Lech Walesa starts the toppling of the dominos.
  • New York Times blogs on weight loss and exercise; you might like to also see my page on this which has a framework within which the NYT blog post can be placed.
  • India's dirty role in Sri Lankan war by Brahma Chellaney in [covert].
  • Terror in Mumbai, a documentary on HBO on 19 November.

Thursday, November 19, 2009

The problems of big banks

I wrote an article in Financial Express titled The problem of big banks. On this subject, also see:
  1. In the world of banks, bigger can be better, Charles Calomiris in the Wall Street Journal.
  2. A three-way split is the most logical, by John Gapper in the Financial Times.
  3. Narrow banking is not the answer to systemic fragility by Charles Goodhart.
  4. See the section titled Regulatory and legislative reaction and the foreign exchange market in Lessons for the foreign exchange market from the global financial crisis by Michael Melvin and Mark P. Taylor on voxEU.


Count Sergei Witte was an important figure in czarist Russia in the early 20th century. In October 1905, he wrote a memorandum to the Tsar summarising his view of the political unrest in the aftermath of the Japanese war. In it, he said:
The idea of civil freedom will triumph, if not by way of reform then by way of revolution. But in the latter event it will come to life on a thousand years of destroyed history. The Russian rebellion, mindless and pitiless, will sweep everything, turn everything to dust. What kind of Russia will emerge from this unprecedented trial exceeds human imagination: the horrors of the Russian rebellion may surpass everything known to history. A possible foreign intervention will tear the country apart. Attempts to put into practice the ideals of theoretical socialism -- they will fail but they will be made, no doubt about that -- will destroy the family, the display of religious faith, property, all the foundations of law.
How many other paragraphs can you think of, where someone peers into the unknowable, and largely sees the next 100 years right?

I saw this in Nicholas 2 Signs the October Manifesto by Richard Pipes, in I wish I'd been there, edited by Byron Hollinshead and Theodore K. Rabb, Pan Books, 2008.

Sunday, November 08, 2009

Mobile phones and economic development

The CMIE Consumer Pyramids data shows that in all their income categories, more than 50% of households have a mobile phone. It is only in their bottom category `Lower Middle Income - II' that only 37.5% of households have mobile phones. From `Higher Middle Income - III' upwards, the incidence is above 80%. If you had asked anyone in 1999 or 1989 whether this could be done by 2009, the answer would have been in the negative.

With broadband Internet, in contrast, India has not got such breakthroughs.

The September 2009 issue of Finance & Development has a story on the impact of mobile phones for development. In India, there is a lot of merit in using new technologies and players to break with the comfortable stagnation that's enveloped finance.

The Economist has a beautiful section on mobile phones and development: on Chinese progress on network hardware, broadband, on the impact on development, a retrospective, looking forward, and an enthralling piece on the cost reductions by firms in developing countries. Now all we need is for Indian finance to go the way of Indian telecom (and airlines).

Anand Giridharadas, writing in New York Times, describes new developments in distance education. India is the place in the world which would be the biggest beneficiary from distance education, given the combination of lots of young people and a dismal education system. This does require broadband to go the way mobile phones have. I often joke that the task of an economics undergraduate education in India should be to get a person to the point where he or she can read my blog :-) (and cynics respond saying that most of the teachers of economics in India can't parse my blog).

Anne Eisenberg has an article in New York Times about researchers at UCLA trying to use cell phones to do medical diagnosis. Given the ubiquity of cell phones in India, these could be useful lines of attack for us.

Saturday, November 07, 2009

East Europe after 1989

I have an article in Financial Express where I look back economic development in Eastern Europe in the last 20 years, and compare and contrast with India.

In recent weeks, a lot of very interesting writing, looking back at 1989, has come out. My suggestions for further reading follow. Readers of age 40 and below should try particularly hard to read these and other materials so as to comprehend these earth-shaking events. These events matter because they have had a huge influence on the world that we see today. And, they matter because they help us think more effectively about the drama that will come about in China in coming years.
  1. 1989! by Timothy Garton Ash in The New York Review of Books. Am eagerly waiting for part 2 of this. Also by him in The Guardian: This tale of two revolutions and two anniversaries may yet have a twist (May 2008) and 1989 changed the world. But where now for Europe? (now). 
  2. A great story of the big day by Alison Smale. Also see Serge Schmemann.
  3. The unknown war by Matt Welch on We feel this intuitively, but the statistics are stunning:

    In 1988, according to the global liberty watchdog Freedom House, just 36 percent of the world's 167 independent countries were `free,' 23 percent were 1partly free,' and 41 percent were `not free.' By 2008, not only were there 26 additional countries (including such new `free' entities as Croatia, Estonia, Latvia, Lithuania, Serbia, Slovakia, and Slovenia), but the ratios had reversed: 46 percent were `free,' 32 percent were `partly free,' and just 22 percent were `not free.' There were only 69 electoral democracies in 1989; by 2008 their ranks had swelled to 119.

  4. A beautiful section from The Economist:
    Walls in the mind;
    So much gained, so much to lose;
    The man who trusted his eyes;
    A globe redrawn;
    Less welcome;
    Keep calm and carry on;
    Wall stories;
    Down in the dumps
  5. The peaceful revolution of 1989 by Adam Roberts in The Independent.
  6. Brain drain in reverse behind fallen Berlin Wall by Carter Dougherty, in the New York Times.
  7. A slideshow by Erik Berglof which summarises the Transition in crisis? report released by the European Bank of Reconstruction and Development.
  8. My take on the new dangers that we face today.

Thursday, November 05, 2009

Governments taking over banks

Jerry Caprio and Ila Patnaik, at two ends of the world, on the same subject.

The UK Special Resolution Regime has excellent documentation on the web.

There is a lot of talk in India about financial stability, where basic ideas are distorted to defend the status quo. Financial stability is, sadly, not interesting to the establishment when achieving it requires undertaking economic reform. One example of this is the problems of closing down failed banks or other financial firms: few things are more important to financial stability than the machinery of the bankruptcy process for financial firms. The best thinking on how to build deposit insurance is found in Chapter 6 of Raghuram Rajan's report. In the mid 1990s I was member of an RBI committee on reforming deposit insurance. There hasn't been any movement on this in decades.

Wednesday, November 04, 2009

Recent RBI moves in finance

On 30 October, I had written a response, in Financial Express to recent RBI moves on financial reform. Here are a few other responses:

Sunday, November 01, 2009

Interesting readings