Interesting readings

Since most of us in India can talk about little else other than corruption, do read this article by Nauro F. Campos and Ralitza Dimova on voxEU which is an interesting meta-analysis about papers which analyse the impact of corruption on growth. I have long heard about meta-analyses, but this one made me sit up and notice.

Anand Giridharadas in the New York Times on Arthur Bunder Road in Bombay.

Roger Bate and Tom Woods, in The American, point to a new dimension in India's crisis of fake medicines.

I I Sc will now use the IIT JEE as their entrance examination for the new Bachelor in Science course. Given that the IIT JEE is a well managed and difficult examination, it would make sense to have more and more schools plugging into it in order to filter their intake. But as you move away from the top .01% of the distribution, the statistical precision of the score on a very difficult exam as a measure of student capability tends to decline. The managers of the IIT JEE will need to shift towards adaptive testing, where the questions are dynamically modified based on student characteristics, in order to retain efficiency across the distribution. Once this is done, the IIT JEE would be useful for sifting through millions of students, and exert a beneficial effect of all of them facing a more demanding high-stakes examination.

Shobhana Subramanian in the Financial Express on C. B. Bhave.

A fascinating article by Nicolai Ourussoff in the New York Times about the attempt to reinvent Saudi Arabia.

Sadness about Europe by Orhan Pamuk in the New York Review of Books, and a tragic perspective on Istanbul by Claire Berlinski in City Journal.

A dystopian future for the world: a story of ageing and depopulation from Amakusa in Japan.

Liu Xiaobo's beautiful acceptance speech for the Nobel Prize for Peace. A lot of countries of the world, including India, have much to do in order to achieve freedom.

Philippines?

Tourism in Afghanistan by Damon Tabor.

Steven Johnson in the Financial Times on the future of linking to information sources on the web.

With 75% of world GDP in service, trade liberalisation in agriculture or manufacturing is not that important. The really big story is trade liberalisation in services, and there the picture is quite bad. Read this article on voxEU by Bernard Hoekman and Aaditya Matoo on how to obtain progress.

Understanding the rise in currency turnover by Michael R. King and Dagfinn Rime on voxEU.

Anders Aslund, on Project Syndicate, on the remarkable story of the global crisis as it played out in East Europe. Also see this story in The Economist on the same subject, which is a bit less optimistic. The recovery in East Europe matters for recovery in Europe and elsewhere. It also illuminates our thinking on some of the grand policy questions.

David Alexander points out how Australia is the role model for the world.

Barry Eichengreen, Daniel Gros and Ila Patnaik on the resolution of Europe's problems.

Devin Friedman in GQ on the strange world of social networking.

Discussions on 'Mythbusting: Current account deficit edition'

Many interesting comments appeared on my previous blog post, Mythbusting: Current account deficit edition, and I thought it made sense to respond to all of them in this post.

Ambarish: I don't think there has been a sudden rise in rupee trading outside India. It was always there; we weren't seeing it. As Jayanth Varma has emphasised, we used to think the NDF market was in Singapore. But the BIS data on rupee trading shows significant rupee trading at many places worldwide, not just in Singapore. Overall, the picture is roughly one with \$20 billion of onshore trading a day and another \$20 billion of offshore trading, giving an overall market size of \$40 billion a day.

One can think of many good reasons for domestic and overseas economic agents to do INR trading outside India. E.g. foreigners are, presently, not permitted to trade on the onshore currency futures. Given that gross flows across the Indian border, on the BOP, are now at \$1.3 trillion a year, it is not surprising that there is a lot of rupee trading going on. Until big changes to the capital controls take place, I believe there will be an increasing shift of INR trading away from India.

Neeraj: I agree with you that capital controls can potentially change the situation significantly. So one can think at two levels. First, for a given set of capital controls, a central bank can float as in not trading. That gives you a float, but yes, the price that comes out of this is distorted because there are capital controls. As an example, the government can have non-interference in the domestic market for DRAM chips, but the domestic price can itself be distorted through quantitative restrictions or customs duties on DRAM chips. So even though the government is not manipulating the domestic price by directly trading in the market (as it does with foodgrain or currency) the observed price is a distorted one. Then comes the second level where you have full convertibility. Once again, here the central bank could choose to trade in the market or it could choose to not trade in the market. Only when there are no capital controls + no trading by the central bank do you get to the true floating rate and the market's price.

Durga: Modulo the issue raised by Neeraj and touched upon above, I think we're a fairly flexible rate today. If INR trading globally is \$40 billion, then RBI trading of anything less than \$2 billion per day would have a negligible impact on the price. RBI has to either hit the market with very big trades (over \$2 billion a day, i.e. over \$40 billion a month, i.e. Chinese style currency manipulation) or RBI has to sit back and accept the price. Small trades are pointless, and actually make you wonder what the strategy there is.

That said, the rupee is still a small currency. India is a GDP of only \$1.25 trillion and there are a lot of restrictions on cross-border commerce. So there is a long way to go before the INR becomes a serious international currency. It does not, hence, surprise me to see that the spreads on the INR are much worse than those seen for the big international currencies.

However, what I talked about in the blog post -- that when a central bank stops trading on the currency market, the CAD = capital flows -- is not an equilibrium condition. It is an accounting
identity. It requires nothing about market microstructure on the currency market, or about the capital controls, in order to hold. As long as RBI trading on the currency market is zero, CAD will be exactly equal to capital flows.

Finally, Anonymous, you ask: Is there a point where the CAD becomes so big that it becomes dangerous? We should think in two parts.

First, in a place like the US, there has been a lot of concern that the imbalance (= the very large CAD) is too big in the sense that under reasonable assumptions, the US is not going to be able to service all the capital coming into the country. After all, all the equity / debt capital that comes into (say) India today inexorably requires that at future dates, dividends and coupon payments and debt repayment have to happen in dollars, which will require purchases of foreign exchange by residents. In order to service the borrowing of the US today, substantial exports growth will be required, which is unlikely. Hence, when this borrowing of today is to be repaid in the future, a huge dollar depreciation will have to take place.

As long as there is an environment of high growth in exports of goods and services, there is no problem. If, hypothetically, you see a country with a big CAD but you also have a WEAK pace of exports growth then you know that at future dates, there will be pressure on the currency which will give sharp depreciations. Odds are, the financial system will see that and these fears will translate into a depreciation right away! Conversely, if you see capital inflows going into investments which will bolster growth of exports of goods and services, then you feel comfortable that there is no problem.

I believe that's a fair description of the present Indian situation. Over the last 15 years, the gross inflows on the current account into India (which can be roughly interpreted as the total revenues from exporting goods and services) grew by 8.1 times, from \$42 billion in 1994-95 to \$343 billion in 2009-10. This was an average annual growth rate of 15%. This is a huge pace of growth, and gives me confidence that the CAD coming in today will be serviced tomorrow without large currency depreciation. If, hypothetically, you disagree with my optimism about future growth in exports of goods and services, then you would think that this large CAD today increases the odds of INR depreciation in the future, and you would go short the rupee.

For smaller emerging markets, there is a risk of sudden changes in international financing conditions, which is rooted in the lack of information in the hands of foreign investors about the country. Then a large CAD could mean that if something goes wrong and a lot of capital leaves the country, then it could yield a large currency depreciation. I believe this is less and less an issue for the large emerging markets like India, where problems of asymmetric information and lack-of-attention in the global community are not a problem.

Mythbusting: Current account deficit edition

The question

In recent months, the current account deficit has risen. The latest data shows:

Sep 2009	-3.03
Dec 2009	-3.64
Mar 2010	-3.68
Jun 2010	-3.84

This has started making many people worried. Is such a `large' current account deficit a cause for concern?

The right answer

How long should a man's legs be? Long enough to touch the ground.

The old intuition

Under a fixed exchange rate, where the central bank holds the rate fixed by trading on the market:

• Net capital inflow is an autonomous variable
  
• All the capital that comes into the country is bought by the central bank (and vice versa), and this has consequences for sterilisation or monetary distortions.
  
• You can then ask yourself whether the amount of capital coming into the country is "too much" or "too little".

The new intuition

But all this changes under a floating exchange rate!

As the graph above shows, RBI's trading on the currency market has been at near-zero values in recent months: we have something that is essentially a floating exchange rate. The rupee is now a fairly big market, and small scale trading by RBI has zero impact on the price: i.e. what we're seeing is a true market price. Under a floating exchange rate:

• Net capital inflows = Current account deficit, as an accounting identity
  
• If there is a sudden increase in capital inflows, this yields a rupee appreciation, which tends to increase the current account deficit. Conversely, if there is a sudden capital outflow, this yields a rupee depreciation, which tends to decrease the current account deficit. Through this, there are constant equilibriating forces which bring the two together.

With a floating exchange rate, you curiously look at the current account deficit and wonder that if there is some sudden international crisis (e.g. Lehman's death) whether there would be a short-run dislocation. For the rest, there is no policy involvement in either the current account deficit or in net capital inflows, both of which are purely market phenomena.

A new angle

In the very short run (e.g. a day), changes in the exchange rate can have little impact upon imports or exports. So if \$10 billion suddenly leaves the country in a day, when the rupee depreciates, there can't be a response from import or exports immediately. The only response that can come about immediately is: from capital flows.

When \$10 billion leaves the country, the rupee depreciates, and some investors think that they will score some nice returns by buying short-dated rupee securities. They step in in the breach, thus yielding an equilibrium.

So I will conjecture: A country that has capital controls against short-dated debt flows will have more volatility on the currency market.

Also see

Viewing the current account deficit as a capital inflow by Matthew Higgins and Thomas Klitgaard, FRBNY, December 1998.

Previous editions of `Mythbusting'

Mythbusting: Reserves edition, 18 October 2008.

Talk on US financial regulatory reform, by Viral Acharya

Viral Acharya will do a talk Recent developments in financial regulatory policy in the United States: Review and Critique at NIPFP (1st floor conference room) at 4:30 PM on Monday the 20th of December. All are invited. The talk will be followed by snacks on the lawns of NIPFP.

This will draw upon the work of many scholars at the NYU Stern School of Business, which has given two books: Restoring financial stability: How to repair a failed system (Viral V. Acharya, Matthew Richardson, 2009) and Regulating Wall Street: The Dodd-Frank Act and the new architecture of global finance (Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, Ingo Walter, 2010).

Appropriate regulatory structure for development

A. D. Shroff Annual Public Lecture, by C. B. Bhave.

It is a great honour to be invited to deliver the A. D. Shroff Annual Public Lecture. Mr. A. D. Shroff was an outstanding financial thinker and a practioner who took great interest in organisational and ideological issues. He was known to express his views in a candid manner and without any fear of the consequences of such expression. Regulators have a reputation of not speaking much and if they do speak then not saying much. I will try to strike a balance between Mr. Shroff's forthrightness and regulatory reticence.

Costs and benefits of regulation

The world has gone through very troubled times in the last three years. Unbridled growth and development in the financial markets is no longer an accepted article of faith. Deregulation in developed markets resulted in excessive leverage being built by large institutions, and financial innovation being used more to hide risk than create real value. This inevitably led to a crisis and the cost of repair is being borne by the tax payer and the economies in general.

Those who are bearing the costs are, in a substantial measure, not those who reaped the benefits of unchecked growth. In the event, there is no support for development without regulation. For orderly development, regulation is a sine qua non. Notwithstanding the fact that regulation is a must for orderly development, we still need to enquire and debate what constitutes an appropriate regulatory structure. We need to debate issues around this especially in the Indian context.

At the very basic level, regulation means restraint and restraint is a hindrance. Thus any business subject to regulation does pay a price whether the regulation is voluntary or imposed. The question is not whether regulation will come in the way of development but whether the price we pay by accepting regulation is worthwhile or not.

Three kinds of regulation

If we look at various sources of regulation one can roughly say that there are three reasons why business entities agree to regulate their behaviour even though it does make them pay a price for such regulation or restraint:

• The first source of regulation arises from the fact that the commercial entity interacts with the outside world, suppliers, customers, financers, shareholders and so on. There are certain norms by which the entity decides to bind itself irrespective of whether there are formal rules and regulations or deterrent punishment for deviation from norms exists or not. No trader can repeatedly violate his contract even if oral, with either his customer or with his supplier. It will simply render his business impossible. One can call this self regulation at its most basic level with the source of discipline being the market place. The market place simply does not deal with you if your behaviour is substantially out of line with basic norms and we don't need the force of law here to enforce such norms.
• As a second source of demand for regulation one can look at situations where entities engaged in a particular business activity may decide to come together and conclude that certain norms of behaviour are not adequately discouraged if the entire thing is left to the individual entities. Yet, the group feels that such norms need to be in place for the overall development of their business. Since such voluntary groupings of entities do not enjoy the force of law they may decide that any behaviour against the agreed rules of behaviour will be punished by making the concerned entity lose the membership of that group. Trade Guilds, clubs, the early form of stock exchanges are examples of this. This form of regulation is commonly known as self regulation. This self regulation is not regulation of activities by the entity by itself but is the regulation of the entity by a common interest group of which that entity has agreed to be a member. For such a grouping to succeed, individual members must be able to see the benefits of membership. The price of being expelled from membership should be high enough to ensure behaviour as per the commonly agreed norms by the group itself. Our experience in India has not been entirely satisfactory in this area. Nevertheless, we need to continue our efforts at establishing credible self-regulation.
• That brings us to the third category of regulation which is regulation enforced by law. The argument in such cases appears to be that the activity of entities in a particular area of operation affects the lives of more than just the member entities. In other words the society has a stake in ensuring that the entities conduct their operation in a manner that is acceptable not just to those entities but to the society at large as well. The discontentment with financial meltdown is very aptly captured by the expression `privatisation of gains and nationalisation of losses'. This sentiment is also a reflection of the fact that there are stakeholders outside the universe of finance who suffer if finance is not regulated.

The interplay between self regulation and regulation by the authority of law has been a subject of interesting discussion not only in the area of capital markets but in other fields as well. Self regulation is generally considered desirable since it is made by the entities themselves and therefore,it is considered more business friendly. Equally there are arguments that there are not sufficient incentives in self regulation to put the interest of other stakeholders before the interests of the participating entities. In addition self regulation lacks the ability to enforce its rules beyond depriving the member concerned the membership of the group. If a significant group decides to violate norms the self regulatory structure can become unsustainable and only the backing of law can sustain such activity.

In different jurisdictions, efforts have been made to make the deterrent actions of self regulatory organisations stronger by granting such organisations `recognition'. However, difficulties arise if more than one organisation wants to be recognised as a self regulatory organisation for entities in the same area or business. In other words if the entities split and form multiple organisations, all of which seek recognition as self-regulatory organisations, the situation is not amenable to an easy resolution. Notwithstanding the various forms of self regulatory organisations and the different degrees of strength and their deterrent actions, it is commonly accepted around the world that self regulation alone is not sufficient and an apex regulatory body is necessary.

The functions of the regulator

Regulation with the backing of legislation is administered either by the Government itself or their autonomous statutory regulatory organisations. While the model of Government being a regulator itself has been tried in the past,the modern consensus is to have independent and autonomous statutory regulatory bodies. In the wake of the reforms undertaken by the Government in 1991, SEBI legislation was passed by the Parliament in April 1992. SEBI has been created as an independent statutory body.

What are regulators expected to do? Regulators set rules for conduct of market entities, the manner of conducting business, and even the tariff to be charged in certain cases. Regulators may also lay down norms for entry as well as continuity of business for entities. It is thus apparent that regulators can enjoy powers in the area of rule making for entry / exit regulation, conduct regulation, tariff regulation, and risk containment regulation.

Regulators not only set rules but are also required to keep an eye on the compliance of these rules. They therefore, end up setting up an elaborate mechanism for ensuring compliance. If despite this, the rules are breached then the regulators are charged with the duty of carrying out necessary investigation and enforcing these rules by adjudication.

The question of autonomy of the regulator

The list of responsibilities is fairly onerous and since the regulators combine in themselves the roles of rule making (legislative role), administration of rules and investigation if breach of rules occur (administrative function) and adjudication (judicial function), it is necessary to pay careful attention to the governance issues of regulators. It is an accepted principle that regulators need to be autonomous in discharging the duties laid down by law. A regulator, subordinate to or dependent on the executive wing of the Government will not be in a position to do proper justice to its duties.

Autonomy is not only a matter of creating appropriate structures and legal provisions but also a matter of perception. Regulatory structures in India are in different stages of evolution and therefore the thinking on autonomy and the perception of autonomy has not yet fully crystallised.

The Reserve Bank of India as a regulator has been in existence for more than 75 years and therefore, the relationship between the executive branch of the Government and the RBI is far more evolved compared to the relationship of regulators which are of more recent origin. SEBI is in its 19th year and stands somewhere in the middle of regulatory evolution: it is more evolved compared to the regulators that have been set up in this century but has lesser history when compared to the Central Bank.

The first Chairman of statutory SEBI, Mr. G. V. Ramakrishna, once famously remarked in the early days that brokers of BSE should know that the route from Dalal Street (BSE) to Mittal Court (the location of the SEBI head office, then) is not via the North Block (Finance Ministry, Delhi). The brokers at that time had not got used to the idea of a regulatory body having been formed which would independently set regulations. Capital market regulation was part of the Ministry of Finance functions till the formation of SEBI. They therefore had a tendency to run to the Government for every little problem.

The tension between the executive branch of the Government and the regulatory bodies is not a phenomenon only during the early stages of regulation nor is it peculiar to India alone. Both the regulators and the executive need to nurture this relationship in a manner that reinforces regulatory autonomy. It is not easy for the executive to deal with this especially when the very powers that were exercised by the executive are transferred to the regulator. It is imperative in this context to make sure that there are adequate supportive provisions in law and the rules to support the autonomous character of the institutions.

To maintain the autonomous character of the institutions and its independence from the executive one needs to start at the process of the appointment and the terms of removal of the Members of the regulatory apparatus. Interestingly, the framers of the Indian Constitution saw the importance of this aspect in institutions such as the Election Commission, the Higher Judiciary namely High Courts and Supreme Courts and the Comptroller and Auditor General of India. The Constitution makers were very careful in providing for the conditions for removal of persons at the helm of these bodies even while recognising that the appointments will be made by the executive. These autonomous institutions have served India well. The prolonged tension between the Election Commission and the other organs of the Government is an example of how constitutional protection delivered a powerful and autonomous Election Commission which admirably served the cause of democracy.

The regulators do not enjoy protection in terms of the conditions under which their services can be dispensed with by the executive. In fact the regulators are at the other end of the spectrum in terms of provisions for their removal. In SEBI, the Members and the Chairman are appointed for a tenure of certain number of years or until further orders whichever is earlier.

A tradition has been established that regulators are not removed from their jobs as easily as the functionaries in the executive itself. There is no known example of the executive having resorted to the clause `until further orders whichever is earlier' to remove the functionaries of the regulatory organisations. Whether it is sufficient to rely on tradition or whether we need a better legal mechanism with checks and balances needs to be debated, so that this important aspect of governance is not ignored.

A vital component of autonomy is financial autonomy. In case of SEBI and some other regulators such as IRDA this autonomy was built into the legislation by way of providing that such authorities will establish a separate fund into which the fees paid by the market intermediaries will be credited. Such funds are to be used by the authorities for discharging the functions entrusted to them by law.

Currently there is a line of thought - as you must have all read in the media - that the regulatory authorities should not be allowed to have funds of their own but these funds should be merged with the Consolidated Fund of India. If the Government finally accepts this line of thinking, substantial damage will be done to the autonomy of regulatory institutions. If the regulators have to depend on the executive for release of funds the question of independent behaviour by the regulators would be jeopardised. It is necessary to carefully consider the pros and cons of taking away financial autonomy from regulators.

The function of investigation in case of breach of rules is an area that hinges in a vital manner on autonomy from the executive wing. Regulators by the definition of their responsibility have investigative wings. This function has come under increasing judicial scrutiny and the movement of the last 15 to 20 years has been to free the investigation function from the possibilities of influence by the executive.

The CBI is a case in point. Under the direction of the Supreme Court the supervision of this institution is with the Chief Vigilance Commission which in itself is an independent statutory authority. I would therefore, argue that regulatory autonomy vis a vis the executive wing of the Government is not only necessary but is essential.

The question of accountability

Any governance structure based on autonomy must also look into the question of accountability. Since regulators have multiple roles, part legislative, part administrative and part adjudicatory, the accountability in the three areas is handled in different ways. Regulators are creatures of law and the ultimate supervisory authority of the Parliament to assess whether the regulators are discharging the functions assigned to them is supreme.

The Comptroller and Auditor General of India is empowered under the regulatory provisions to audit accounts of the regulators and submit reports to the Parliament to help the legislative in its assessment. In addition the regulators are required to prepare an annual report on their activities and lay it on the table of both Houses of Parliament.

The adjudicatory function of the regulators has been treated differently and by its nature has to be a subject matter of supervision by judicial bodies. A mechanism in the form of Securities Appellate Tribunal headed by a retired High Court Judge and an appeal provision to the Supreme Court of India forms an integral part of SEBI legislation.

The rule making powers of SEBI are supervised by the Parliament in order to ensure that the rule making is confined to the powers granted by the Parliament to the regulators. If a regulator exercises power beyond the permissible limit of legislation, the rules can also be challenged in the courts of law.

In the rule making function the regulators do interact with the executive branch of the Government. The executive wing of the Government will have legitimate imputs into the rule making process and a fine balance is required between the need for autonomy and the need for harmonisation. This is achieved through the presence of Government representatives in the Board of SEBI.

Conclusion

In conclusion, it is quite clear that attempts at unregulated development not only in a particular sector but even in small sub-sections of sectors have failed. The failure is mainly because such development ultimately leads to crisis. The cost of resolving such crisis is high and the burden of the cost is borne not just by those who benefited from the development but a large portion is borne by those who were not part of the recipients of the benefits. Clearly the collateral damage is very high.

The question is, therefore, not so much as to whether development and regulation are in conflict as the quality of regulation that will enable us to find a balance between the needs of development and the need to keep the risk-reward relationship appropriate. It is necessary to carefully think and design proper regulatory structures, ensure regulatory autonomy and make sure that there are checks and balances in the system to address the concerns of accountability as well.

Thank you.

Emerging markets finance conference at IGIDR

link

A puzzling data revision

Ordinarily, official statistics get revised because at first, provisional estimates are released, and when the full data filings come in, then improved estimates are put out.

In the case of RBI's data about RBI's trading on the currency market, such data revisions should ordinarily not arise.

But yesterday, data released by RBI modified the previous information that had been put out about RBI's trading on the currency market. Earlier, trading in June had been claimed to be 0. Now it shows purchase of $370 million and sale of $260 million. Earlier, trading in September had been claimed to be 0. Now it shows a purchase of $260 million. I wonder why this data revision took place.

The newest data - for October - shows a purchase of $450 million on the spot and $450 million on the forwards. At a time when rupee trading is estimated at above $40 billion a day (worldwide), it is hard to see how such a small scale of trading can generate a significant impact upon the price; so I wonder what is going on in terms of the rationale and the thought process.

Interesting readings

One of the big impediments to India's integration into the world economy is xenophobic visa rules. There is some progress in the pipeline: visa on arrival has been working from Jan 2010 onwards for visitors from Finland, Japan, Luxembourg, New Zealand and Singapore. A nice touch here is that India did not get stuck on issues of reciprocity; this is unilateral liberalisation.

Watch this talk by Steve Coll.

Mature treatments of the Niira Radia wiretaps : Sail Tripathi in the Mint, Pratap Bhanu Mehta in the Indian Express.

Anil Padmanabhan in Mint on the question of corruption, and Sevanti Ninan on the media response to the tapes.

In search of America's liberty and India's dharma by Gurcharan Das in the Times of India.

A rumination by Vikram Doctor, on the need to shift focus in Bombay from the West to the East.

Sam Geall on the problems of Chinese science. Some of these problems are found in India also.

With corruption scandals galore, what India needs most is competent and clean government. SEBI continues to soldier on: see the recent order on bond issues by Sahara. Or if you don't have appetite for the full text, here is a precis by V. Umakanth. Everyone interested in Indian finance should read a few orders of Bhave's SEBI every year: they give you fresh insights into how the interplay between law and regulation works.

Tamal Bandyopadhyay in Mint with his sense about the extent of corruption in Indian banking.

How do foreign capital flows behave around elections, on voxEU by Emmanuel Frot and Javier Santiso.

Currency warriors should consider India by Sebastian Mallaby in the Financial Times.

A. K. Bhattacharya writes in the Business Standard about fresh thinking on Indian Railways from an unexpected source.

Huang Yiping on voxEU has a story from China which is similar to what we often see in India: the use of microeconomic tools to go after macroeconomic problems.

In the footsteps of Gandhi, Mandela and Havel, by Ma Jian, on Project Syndicate. Unveiling hidden China by Christian Caryl in the New York Review of Books.

Good-bye to Dubai by Joshua Hammer in the New York Review of Books.

Robert Messenger looks back at Dien Bien Phu.

Richard Boudreaux in the Wall Street Journal about Russia's Parliament accepting Stalin's responsibility for the Katyn massacre.

Kenneth Rogoff on the Euro.

A tale from the frontiers of public administration. The Australian government has announced a competition to forecast the behaviour of traffic on Sydney's M4 freeway. This illustrates three themes. The first is that of better living through science: the attempt at using statistical analysis to shape public administration. The second is the unique value of public domain databases. The third is the importance of harnessing brainpower out there in innovative ways: through openness of data and through the competition.

Trailhead by E. O. Wilson. As I read it, I was astonished at the way in which knowledge gleaned from hundreds of research papers has been stitched into a compelling story.

A club of 19

What binds this club of 19 countries: China, Russia, Kazakhstan, Colombia, Tunisia, Saudi Arabia, Pakistan, Serbia, Iraq, Iran, Vietnam, Afghanistan, Venezuela, the Philippines, Egypt, Sudan, Ukraine, Cuba and Morocco? Answer. Am I glad India is not in this club!

Alternative stock market indexes

I saw this interesting article about the mind-share of Nifty as opposed to the BSE Sensex. It is by Samie Modak and Muthukumar K. in the Financial Express.

The NSE data for June 2010 shows that Nifty futures have peaked at Rs.0.36 trillion of notional turnover in a day (27 Jan 2010) and Nifty options have peaked at Rs.0.89 trillion of notional turnover in a day (24 June 2010). Nifty has shaped up as one of the big contracts by world standards. It is interesting to go back and read the original paper. Those were interesting times. Looking back, it seems obvious that Nifty would dominate the derivatives market, but at the time, the outcome was far from clear.

This made me look at data on risk and reward of the alternative indexes. I start from the first data for Nifty Junior, which takes me back to 21 February 1997, thus giving data for 13.7 years.

	Mean	Volatility	Ratio
Nifty	12.99	26.37	0.4926
BSE Sensex	12.68	26.92	0.4711
Nifty Jr.	18.16	32.38	0.5608
CMIE Cospi	17.40	27.23	0.6391

Nifty and the BSE Sensex are a lot like each other.

The real surprise is Nifty Junior: Merely moving down from rank 1-50 to ranks 51-100 has given an enormous juice in the return and in the reward-to-risk ratio. But the volatility of Nifty Junior is also higher.

The CMIE Cospi index has roughly 2800 stocks today, and represents the broad market. It includes the Nifty Junior stocks and a host of other smaller stocks. But unfortunately, these numbers are not comprabale with the other three in that it includes dividends while the other three do not. With this combination of high diversification (giving a low volatility), small-cap stocks (which helps returns) and inclusion of dividends (which helps returns), it is not surprising that it scores the best reward-to-risk ratio.

In my mind, most of the claims of out-performance by active managers in India are purely about being invested in the non-Nifty space. Nifty Junior ETFs are easily accessible and I get surprised that more people aren't putting this into their investment strategy.

A more efficient piece of code

CMIE's firm databases use a fine-grained product code to identify each product. Each firm is also allocated to a product code based on its predominant activities. I like to reconstruct a coarse classification out of this that suits my tastes. I do this using this R function:

cmie.14.industries <- function(s) {
  values.8 <- c("Food","Textiles",
                 "Chemicals","NonMetalMin",
                "Metals","Machinery",
                 "TransportEq","MiscManuf",
                "Diversified","Serv.IT")
  names(values.8) <- c("01010101", "01010102",
                       "01010103", "01010104",
                       "01010105", "01010106",
                       "01010107", "01010108",
                       "01010109","01010408")
  values.6 <- c("Serv.Construction","Serv.Other",
                 "Mining","Electricity")
  names(values.6) <- c("010106","010104","010102",
                       "010103")

  if (is.na(s)) {return(NA)}

  leading8 <- substr(s, 1, 8)
  attempt <- values.8[leading8]
  if (!is.na(attempt)) {return(attempt)}

  leading6 <- substr(s, 1, 6)
  attempt <- values.6[leading6]
  if (!is.na(attempt)) {return(attempt)}

  leading4 <- substr(s, 1, 4)
  if (leading4 == "0102") {return("Serv.Finance")}

  return("MISTAKE")
}

This maps each firm into one of 14 coarse categories. Here are some examples of this in action:

> cmie.14.industries("0102090000000000")
"Serv.Finance"
> cmie.14.industries("0101041502000000")
"Serv.Other" 
> cmie.14.industries("0101010601010000")
"Machinery"

So in short, the function cmie.14.industries() maps a string like "0101010601010000" into a set of 14 broad industry names such as "Machinery".

Faced with a file with roughly 48,000 firm-years, at first blush, it seems that this function has to be run 48,000 times. For a given firm, this classification could change over time, so it isn't just a matter of doing this once for each firm. Here is one simple way to do it:

badway <- function(task) {
  result <- rep("", length(task))
  for (i in 1:length(task)) {
    result[i] <- cmie.14.industries(task[i])
  }
  result
}

This is just a loop that runs over everything in the supplied vector and calls cmie.14.industries() for each element. The only concession to efficiency is that the empty vector `result' is allocated ahead of time.

This proves to be quite slow. None of the standard R vectorisation ideas offer much relief.

The key idea for obtaining a leap in performance was that while I had to run through 48,000 firm-years, the industry codes actually attain only a modest list of possibilities. This makes possible a table lookup:

goodway <- function(task) {
  possibilities <- unique(task)
  values <- rep("", length(possibilities))
  for (i in 1:length(possibilities)) {
    values[i] <- cmie.14.industries(possibilities[i])
  }
  names(values) <- possibilities
  values[task]
}

For a problem of size 1000, this works out to be 13.5 times faster:

> load("task.rda")
> length(task)
[1] 1000
> system.time(res1 <- badway(task))
   user  system elapsed 
  0.030   0.000   0.031 
> system.time(res2 <- goodway(task))
   user  system elapsed 
  0.002   0.000   0.002 

This is just a demo with a 1000-sized task. In my production situation, the performance difference is even greater, since badway() calls cmie.14.industries() 48,000 times while goodway() only calls it a few hundred times.

Ownership & governance of critical financial infrastructure

SEBI has released the Bimal Jalan committee report about the ownership and governance of critical financial infrastructure. We're going to need a similar report on the questions about entry into banking also.

Governments riding in to rescue firms

What is a government to do when a company faces a near-death situation? In almost all cases, the right answer is to let the company go under: It is not the job of a government to prevent companies from dying. Indeed, creative destruction is central to the proper functioning of capitalism. Capitalism without failure is socialism for the rich.

But sometimes, the cost-benefit ratios can look startling. Sometimes, the disruption to the economy that comes from the death of a company can be rather large. Let's look at three stories.

Three examples

GM

In July 2009, the US government chose to put $50 billion into the auto maker General Motors (GM) as part of complex rescue, which included wiping out the existing shareholders and embarking on a complex restructuring of the firm. The old GM died there.
GM got back to profitability this year. Seventeen months later, in 17 November, GM got back on its feet with an IPO which raised $23.1 billion. How impressive! See this story by Michael J. de la Merced and Bill Vlasic in the New York Times. This IPO was at $33. With this IPO, the US Treasury got down from 61% ownership to 26% ownership, so this IPO was the re-privatisation of GM. From here, if the US Treasury is able to sell its remaining 0.5 billion shares at $53 a share in the future, it will fully recoup the $50 billion that went into the rescue (ignoring time value of money).

Satyam

On 7 January 2009, Satyam announced that a lot of money was missing from their balance sheet. In the aftermath of this crisis, the government put Deepak Parekh, Kiran Karnik, Tarun Das, and three others in charge. Read this interview of Deepak Parekh with Tamal Bandyopadhyay in Mint, and this blog post by John Elliott.
The new board put the firm up for sale. It was bought by Tech Mahindra. A collapse of the firm was averted; the employees and customers largely stayed in place.

UTI

When UTI got into trouble, I was opposed to government intervention. But by and large, I think the intervention worked well. US-64 unitholders did suffer losses: half of the gap between the NAV and market value was paid by the unitholders and half by the government. And the follow-through was excellent. The staff quality that MoF was able to muster on the problem was outstanding. The UTI Act was repealed, and UTI was turned into an ordinary company. `Bad UTI' was separated out by `Good UTI'. The ownership was modified including the recent work of bringing in T. Rowe Price as a shareholder. All in all, the exchequer did well when selling off the shares in SUUTI. Privatisation hasn't yet come about, but where we are is progress.

When is it right for a government to go in?

Should the US government have gone into GM? There was a fair amount of criticism of the Obama administration for the decision. There was concern that they were doing this owing to pressure from trade unions. But the outcomes have been quite nice, so (at least ex post) it looks like a good call.

In the case of Satyam, the existing shareholders were not expropriated. It can be argued that the failure of the firm was not their fault. But by that argument, many firm failures in India in the future will justify government intervention since most public shareholders are fairly powerless when the inside shareholders have over 50% shares. In his interview, Deepak Parekh says Had it happened to a consumer finance company or a small, or even big, manufacturing company, the government would not have come out and superseded the board. The normal procedures for bankruptcy and liquidation would have taken place.. I am not sure how the future will work out.

The problem of execution capability

Satyam, GM and UTI are success stories in that the government packed a mean punch in the execution. In particular, in Satyam's case, I had simply not expected that such a nice outcome could be achieved by the government. We should really admire the teams that worked on these problems.

But can we count on such high quality execution on such problems in the future? Our success in the Satyam or UTI stories should not be generalised to the view that in the future such high quality execution will always come about.

The exit strategy

The really amazing feature of the GM story is the clarity and commitment of the government in getting out of `Government Motors' by doing a privatisation just 17 months after going in. All too often, government interventions turn into nationalisation and then you're stuck with a public sector company for a long time, with all the usual politics of the privatisation.

In the deep past, numerous weak companies have been nationalised in the decades of Indian socialism (e.g. National Textile Company) and generally the outcomes have been bad.

A particularly attractive feature of the Satyam story is that no government money was involved. The presence of government money makes things much harder. In India, all too often, it's easy to ask for government money and it's easy to get it. And if the government had got shares in Satyam, it's not easy to see how they would have got out of it.

Similarly, a nice feature of the UTI story is that in the end, the UTI Act was repealed, and UTI is on course for turning into a normal financial firm. Government intervention in the rescue did not yield an ossified PSU.

At the same time, while Satyam and UTI are good stories in terms of the exit path, we cannot generalise too much from this given the fact that GOI is at a standstill on privatisation. In general, we have to assume that what is purchased is never sold, which puts a crimp on a vast array of situations where government intervention might be evaluated.

To summarise

When most firms approach death, the decent thing to do is to let the firm die. We must rejoice in the extent to which Indian capitalism is able to bring about a steady pace of firm death. Building a good quality bankruptcy mechanism will increase the class of firms where resolution is handled in a routine and humdrum way, without the possibility of a special intervention. (Note that going through the bankruptcy process was an integral part of the GM story).

When a potential intervention situation arises, six questions need to be asked:

1. Are the negative externalities of firm death really that onerous?
2. Can government intervention be envisaged without requiring money?
3. Are the Union ministers involved in the problem known for being smart and clean?
4. Can a top quality team be put together which will work on a time-bound project starting from intervention until exit? Does this team combine competence with cleanness?
5. Do we see an exit strategy through which, within a short time, the firm will be fully out of government hands?
6. Are we very sure that in the end, we will endup imposing no costs upon the government?

Ex post, these questions worked out well for GM, UTI and Satyam.

Let's go metric

T. N. Ninan, writing in Business Standard, calls for a shift away from lakh and crore to thousand, million, billion and trillion. We agree! And we've moved our Indian Business Cycle page to metric.

Indian economics is easier in the metric system. GDP is Rs.55 trillion. The market capitalisation of Reliance is Rs.3.5 trillion. On a good day, Nifty as an underlying has derivatives turnover of Rs.1.5 trillion. A billion dollars is Rs.44 billion. When I was at the MoF, I had tried suggesting that the budget documents should be switched to metric, without success.

Interesting readings

C. Raja Mohan in Foreign Policy magazine on India's strategic future.

Vivek Kulkarni in the Hindu Business Line estimates the magnitude of corruption in Karnataka.

Ashish Nandy in Outlook magazine on India's proclivity towards censorship.

How to improve tax compliance in India: Thorsten Beck, Chen Lin and Yue Ma have an article where they say that financial development helps reduce tax evasion: when firms use more external financing, they have greater incentive to not `cook the books', which induces bigger tax payments.

Salil Tripathi in Caravan magazine on improving freedom of speech in the UK.

Robert F. Worth in the New York Times on the shift of the State in Saudi Arabian away from tolerating Islamic fundamentalism to fighting it.

Who was right: Aldous Huxley or George Orwell?

Nicholas Schmidle in The Atlantic with a story from Ghana about something we badly need in India: serious investigative journalism.

Anand Giridharadas in the New York Times, and Kimberly Brooks on the Huffington Post on alternatives to the handshake, particularly `Namaste'.

I just read this beautiful obituary for Milton Friedman, written by Larry Summers.

In continuation of the Indian debate on ownership and governance of critical financial infrastructure, see Jeremy Grant in the Financial Times.

India's liberal foundation

I just read The off-key notes of a Sena scion by Rahul Pandita in Open magazine. The quick summary: Aditya Thackeray is the son of Uddhav Thackeray and the grand-son of Bal Thackeray, both of whom are the most-feared politicians of Bombay. He is now being initiated into politics, and has led the charge by threatening violence against those who would read Rohington Mistry. But his resume up to here features all sorts of nice nineteenth century liberal values such as writing poetry, mostly in English, rap music, Urdu, wearing jeans, and a bit of French. The article correctly draws attention to the hypocrisy of those involved.

But in it, I see another dimension. An upbringing in the Thackeray family is as strong an indoctrination into the sectarian perspective as you could ask for. I find it quite striking that between a certain strong ideology being sold at home, and the broader liberal worldview that pervades India, young Aditya evolved into the culture of an open and inclusive India.

The idea of India is about a great coalition of people who differ in ethnicity, language, religion, skin colour, education, income etc., who have figured out how to live together with a mixture of tolerance and individualism, without getting trapped in hatred or envy. This liberal India was strong enough to be appealing to Aditya Thackeray, and this story tells us that we're in good shape.

Why does Bombay have abysmal governance?

The resource curse

For many years, economists have been puzzled at the way things have gone wrong in countries where natural resources were discovered. In 1993, the economist Richard M. Auty coined the phrase `Resource curse' to convey the extent to which natural resource finds are a curse and not a blessing. But the idea had been kicking around well before that. I suppose it was an obvious conjecture after watching the failures of the Middle East, where trillions of dollars of oil revenues were squandered by not one but many countries.

In the 1970s, when oil was discovered in Venezuela, former Oil Minister and OPEC co-founder Juan Pablo Perez Alfonzo said: "Ten years from now, 20 years from now, you will see, oil will bring us ruin." His phrase for oil was: "the devil's excrement."

Why are resources a curse? In a country blessed with no natural resources (think Japan), the only way forward for the ruling elite is the slow hard work of building public goods, so that GDP builds up, which then feeds back into the power and importance and utility of the ruling elite. When the ruling elite gets their wealth for free, without having to do the hard work of building public goods and thus GDP of the country, the rulers emphasise the wrong issues. That's how Venezuela ended up with Hugo Chavez.

On one hand, rulers get focused on finding ways to maximise their rent from the underlying resource flow, without developing the knowledge about how to build a State that delivers public goods. In parallel, competition between politicians becomes an unpleasant process of trying to grab the riches by means fair or foul, rather than a process of competing in doing better on public goods. If there are XX billion dollars to be grabbed by becoming head of state, fairly unpleasant tactics get used by rivals aiming for that job.

Bombay's resource curse

I just read Maharashtra's Audacious Chief Ministers by Ashok Malik and it is a chilling story. It made me think: Why did governance in Bombay go wrong so comprehensively?

Maybe the story runs like this. Winning elections in Maharashtra does not require serving the citizens of Bombay. A party can do various things in trying to win seats in the legislature across Maharashtra. Once this is done, the ruling party gets the rents that come from control of Bombay.

The wealth and prosperity of Bombay is like an oil well which is gushing out cash for the ruling party in Maharashtra. They did not earn it. The slow, long, hard work of learning how to run a State, of building public goods: these things do not matter for the ruling party in Maharashtra. They get a rental cashflow from Bombay for free.

In (say) Jaipur, the Chief Minister and his ilk do not have an oil well gushing cash at them. Their incentives are to worry about public goods, and grow the GDP of Rajasthan. The importance and rental cashflow of the leadership in Rajasthan are primarily about the GDP of Rajasthan. Their hard work in improving public goods in Rajasthan feeds back to them as a higher rental cashflow.

People often compare the problems with Bombay with the decline of Calcutta after the Left took charge. The two stories are similar in that parties which won rural votes got to run a great city into the ground. But the Left did not take rents from Calcutta on this scale. That was an age where the GDP of Calcutta, while impressive by Indian standards, was still small change. Bombay of the last 20 years is in a different league altogether. This connects with the middle income trap meme: when capitalism first bloomed in India, some governance problems got worse and not better.

Implications

I think this suggests that the right to govern a prosperous city should not be based on elections taking place somewhere else. If Bombay were a full fledged state, as Delhi is and as the four big cities of China are, then elections to control Bombay would require persuading voters in Bombay.

An option chain for INR/USD

We are all used to seeing the options chain for Nifty, but now you have one for INR/USD.

Also read Mobis Philipose in Mint on the unfinished business of derivatives trading in India.

Who will make the exchange-traded currency options market?

In a few minutes, NSE and USE will start trading in currency options. This will be the first exchange-traded options in India on a non-equity underlying.

Currency options are obviously useful as a risk-management tool. I feel that futures are nice simple linear contracts: they ask the person to make only one decision -- are you long or are you short. But once a futures position is entered into, the person needs the ability to manage the position since daily marking-to-market is done, and since there can be large losses for either the futures long or the futures short.

Compared with this, long positions on call or put options appeal to the kind of person that is willing to think carefully about a position at the outset, but after that it is fire and forget. This better describes the life of many firms exposed to currency risk, particularly those with relatively weak treasuries.

Currency options have, of course, been traded OTC for some time now. But there are real problems with this market. Customers have sometimes been ripped off by banks on pricing, given the lack of a liquid and transparent comparison point. While currency options are offered by banks to customers, there is not much by way of an inter-bank market.

As far as I know, there is relatively little by way of a build-up of human and systems capability in the banks for currency options trading (whether OTC or on exchange).

In contrast, there is a remarkable build-up of human and systems capability in the world of Nifty options trading. Options on Nifty have shaped up as one of the biggest options markets in the world. This involves end-users who think and trade options, staff working for securities firms who understand options (and understand issues about their credit risk when their customer has an options position), analytical software systems, and (most importantly) algorithmic trading systems. Options trading inevitably involves trading in a large number of underlyings. Strong computer systems which are able to think about, and place orders in, all the underlyings at one shot are of essence in achieving option liquidity. Such capabilities are now found in the world of Nifty options, and are absent in banks or in the OTC currency options market.

It is fairly easy for a person trading Nifty options to move to trading currency options. Hence, the brainpower and systems that have made Nifty options one of the world's top contracts will easily be able to move to currency options trading, and make it work. I expect that the securities firms who dominate Nifty options trading will now dominate currency options trading.

I think three kinds of stories will now kick in:

1. Liquidity in currency options will fuel liquidity in currency futures, and vice versa. Corporate hedgers will be more interested in either, given that the other is also a possibility.
2. Skills and systems from Nifty options will flow into currency options. Banks will be able to rapidly bulk up their options capabilities by recruiting from the world of Nifty options, and by purchasing the software systems that have sprung up in that space.
3. Conversely, trading in both currency options and Nifty options will generate an increased business size for people who build knowledge and systems for options; it will also improve knowledge of options trading through an understanding and comparison of the nuances of two different underlyings. The number of FRM and PRM certified people in India will go up.

Also see.

Of great interest will be the question of currency volatility. On one hand, the currency options market will generate an implied volatility for the currency, which will represent a market-based forecast for what future currency vol will be. This will be a big new piece of information which will inform macro policy and monetary policy, and thus diminish the extent to which we are flying blind in thinking about Indian macroeconomics.

In recent years, RBI has mostly stayed off from trading the currency market, so the volatility of the INR/USD is a true market volatility. If, in the future, RBI thinks that it wants to give subsidised currency risk management services to the private sector, one way in which it would be able to do that is to do `intervention' on the currency options market so as to force down the implied vol of the market. I.e., RBI would sell ATM calls and ATM puts and thus drive down that price, and thus give cheaper risk management services to the market. This would represent the first operational intervention strategy for RBI through which it can pursue the goal of reducing volatility without distorting the INR/USD exchange rate.

If RBI gets into actively trading the currency market again and trying to push the rupee into a de facto pegged exchange rate, we will see this clearly in the currency options market as a sharply reduced implied vol.

Better living through economics

The `lemons model' in milk procurement

One of the classic stories of India of old is that of Amul, which brought new technology into milk procurement. When the farmer brought his shipment of milk to the Amul front-end, a centrifuge was used to measure the characteristics of this shipment, and based on this payments were made. See this blog post by Alok Parekh, Naman Pugalia and Mihir Sheth. This eliminated the incentives for aduleration of milk by the farmer, which used to be done by adding in water or by skimming the cream.

We can think about this differently. Suppose the centrifuge was not there at the front end. Then the buyer of the milk faced asymmetric information about the characteristics of the milk that were being offered to him. Generally we expect that faced with this `lemons' problem, the buyer would bid low prices for the milk.

So to some extent, the ability of Amul to pay higher prices for milk is not about the greatness of cooperatives when compared with profit-oriented firms: it was about the injection of new technology which removed this asymmetric information.

The interesting puzzle is: in that age, why was Amul the pioneer in buying centrifuges? Why did no private firm buy centrifuges and create a winning business model around milk?

Penalty structure under incomplete detection

Another nice idea that we have understood is the relationship between the probability of getting caught and the penalty. Suppose the fee required for parking is Rs.10 and suppose the probability of getting caught when illegally parked (i.e. without paying the fee) is 10%. Then it's sensible to set the penalty for getting caught at Rs.100 so that even a risk-neutral person will prefer to play by the rules.

This can be applied in the problem of milk procurement. Suppose we say to the farmer: We'll trust you and accept your milk, but on a sampling basis, one in ten farmers will be tested.

Suppose a person added 2 litres of water to his shipment of milk and suppose the price of milk was Rs.10 a litre. In that case, he was trying to steal Rs.20 by palming off low quality milk. But there was only a 10% probability of getting caught, because only one in ten farmers is tested. So the penalty he should face should be Rs.200. If this is done, the risk-neutral farmer is agnostic between playing fair and cheating, even if only one in ten farmers is tested.

The advantage of this strategy is that for 90% of the farmers, the deadweight cost of putting a sample into the centrifuge is eliminated.

This idea is, of course, general:

• Sometimes, we are in situations (as in market manipulation in finance) where we know that even the best regulator in the world will only catch some of the crooks. So we should estimate what fraction of the crooks are getting caught, and then multiply up the size of theft that was attempted. That is, the right way to think of disgorgement is not that the bad guys should fork up the money that was stolen, but that the penalty imposed by the government should be equal to the size of theft divided by the probability of detection.
  
• Sometimes, while comprehensive checking is feasible, it's quite expensive, and it's efficient to deliberately only do checking on a sampling basis. A fairly modest scale of randomised checking (e.g. 5%) can do the trick, coupled with a 20x multiplication factor against the size of the theft that was attempted. This would yield a 95% reduction in the amount of checking that is required. This is the idea in the milk example above.

A cross-country comparison of charges of exchanges

In reading this article in the Wall Street Journal by By Rebecca Thurlow, Alison Tudor And P. R. Venkat about the potential merger of SGX with ASX, I saw this interesting cross-country comparison of exchange charges (in basis points):

Country	Trading and clearing	Taxes
Singapore	4.75	0
Hong Kong	1.1	20
Taiwan	0.75	30
Korea	0.54	30
Australia	0.53	0
India	0.35	27
Japan	0.24	0

It is quite a striking set of facts.

First, we see that in terms of the core trading and clearing -- the charges of the exchange -- India is the 2nd lowest in this pile, with a value of 0.35 basis points. This is slightly worse than Japan (0.24 basis points) and superior to all the others. This partly derives from the immense economies of scale at NSE and BSE, which are ranked at 3 and 5 in the world by number of transactions. This is also about the cost-efficiency of the human part of running an exchange: small exchanges like SGX cannot match the price points which NSE and BSE can reach. In this field, as in finance more broadly, India is pretty good at reaching up to world class at below the world price. This was the basic logic, if you recall, of Percy Mistry's Mumbai as an International Financial Centre report.

Secondly, we see the huge problem that transactions taxes present in all these countries other than Singapore, Australia and Japan. The Indian charge of 0.35 basis points is just swamped by the taxation of 27 basis points. Even if NSE cut charges by half, and got down to 0.175 basis points, this would do nothing for the end-customer who is paying 27.35 today and ends up paying 27.175 across the price cut. Conversely, Singapore, with the least efficient exchange (4.75 basis points) ends up being a nice place for the customer because there is no tax upon transactions there: only Australia and Japan are better than Singapore.

Economists are very clear that all taxation of transactions is distortionary. It's puzzling why so many countries (four out of these seven) continue to indulge in something which is an elementary mistake in public policy.

Currency conflicts come to prominence again

From the mid 1990s onwards, the US trade balance has steadily become bigger. This is a centrepiece of the problem of `global imbalances'. Starting from values of roughly zero, this got all the way to values like $70 billion a month, where the US was importing over $2 billion a day of capital to pay for the trade deficit. Here's the picture:

The US trade balance (goods+services, per month, seasonally adjusted)

This was termed as the `Bretton Woods II' configuration, where exporting countries like China gave loans to the US, in a form of suppliers' credit, and the US bought Chinese goods. This magnitude of capital import was un-sustainable for the US. Something had to give.

Warning for Indian readers: In India, the term `trade balance' pertains only to merchandise trade. In the US, the monthly trade data covers both goods and services. So it is a meaningful measure of what is going on in international trade, unlike the corresponding Indian data.

Bretton Woods II first broke down in the financial crisis. In the downturn, the mighty American consumer purchased fewer 50" television sets. The US trade deficit dropped nicely all the way to $25 billion per month. Alongside a rise in the US savings rate, this looked like a world which was rebalancing.

In recent months, this movement reversed itself and the US trade deficit once again started getting worse.   A deterioration of $20 billion per month is visible; i.e. a deterioration of $240 billion a year. Suddenly, the story of global imbalances righting themselves came under question. The present US run rate is around $40 billion a month or $0.5 trillion a year.

Alongside this, we have news that the Chinese reserves rose by $194 billion in Q3 2010. The Chinese seem to have also passed on some of their problems of exchange rate pegging upon their neighbours by purchasing Japanese, South Korean and Indonesian assets. I am not aware of such behaviour having been observed prior to this in human history. Japan, South Korea and Indonesia have taken unkindly to this behaviour. Given the opacity of the Chinese regime, one can't help wonder if similar things are going on through less visible channels - e.g. a Chinese sovereign wealth fund buys $10 billion of OTC derivatives on Nifty.

So we seem to be headed for quite some escalation of conflict over the Chinese exchange rate regime. Here are some interesting readings on the subject:

• What happens if the RMB is forced to revalue? by Michael Pettis on his blog.
• Why America is going to win the global currency battle, by Martin Wolf in the Financial Times.
• The final end of Bretton Woods 2? on Tim Duy's Fed Watch (the source of the above graph).
• The effect of RMB appreciation on the US-China trade balance, by William Thorbecke on voxEU.
• An interview with Raghuram Rajan on der Spiegel.
• Evolution of the exchange rate regime in Asia.
• How to avoid trade war: A reciprocity requirement, by Daniel Gros on voxEU, which makes a lot of sense to me as one of the least troublesome policy avenues to go down.

Movement on FSDC

MoF press release on FSDC.

For the background on FSDC, see: the budget announcement of Feb 2010, a newspaper column of mine on 16 March, and a collection of responses in the media on 20 March.

Does the FSDC amount to clipping RBI's wings?

The FSDC is only a committee. It is not backed by law. So nothing changes about RBI's role and function.

RBI staff have done speeches saying that financial stability is their job.

The RBI Act does not contain the word `financial stability'. So while some in RBI might aspire to such a function, the present role and function of the RBI does not include financial stability.

The FSDC is not a new law, it's merely a committee, so what changes? We already had the HLCC. What changes with the FSDC?

The FSDC is intended to have a full-time technical secretariat which will work on the problems of financial stability and development. This is something the HLCC lacked. And, the HLCC was chaired by the RBI Governor. He was unable to resolve three classes of situations: (a) Differences between two financial agencies such as the ULIPs question, (b) Differences between two financial agencies when one of them was RBI and (c) Problems of financial stability which require system thinking, which no one Indian agency is good at understanding, given the silo system that is in place. The FSDC should fare better on all three fronts by virtue of being chaired by the finance minister (and backed by a strong secretariat).

So will the FSDC help matters?

It all depends on the staff quality that DEA is able to put into it. The "strong secretariat" is only an aspiration at the present moment.

What is the right role for autonomy for an agency external to MoF?

There are two clear areas where autonomy is required. The first is about specific transactions. As examples, what entities get bank licenses or exchange licenses? Or, when RBI/SEBI investigate Bank of Rajasthan or MCX-SX. It is highly desirable for MoF to be completely hands-off on these kinds of activities of agencies external to MoF. The second is about monetary policy, i.e. the setting of the short-term interest rate. For these two areas, there is a strong and clear case for de-politicisation and autonomy. In other questions, the case for autonomy is not clear-cut.

So is it okay for MoF to meddle in the decisions of an external financial agency on subjects like the policy framework for exchange ownership, or the rules about private bank entry?

The staff quality that DEA is able to put into these functions is supremely important. It is possible to do this right.

Is FSDC opening a Pandora's box by asking too much of DEA staff quality?

I think it is an attempt in the right direction. Largely speaking, it is converting the existing de facto arrangements into de jure with greater formal structure. If FSDC builds up top quality staff, then it will make progress. Else, it will be irrelevant and the present will continue mostly unchanged.
There will of course be ups and downs, but when I look back at the brainpower at DEA from 1993 onwards I feel optimistic about the expected value of FSDC.
The attempt at building a team which works on financial stability and development is an important and a good one. Success on putting together a top quality team cannot be taken for granted. But at the same time, if MoF had not tried this, there would have been a certainty that such a team would not have come together. It is possible to spin this in a gloomy way, but an oversupply of cynicism can crowd out attempts at progress.

Interesting readings

C. J. Chivers has a story in the New York Times from Uzbekistan which links up to an idea that I have often thought would be a great step forward for India: the interior of every police station in the country should be blanketed with video cameras giving feeds out to the Net. As Robert Kaplan says, underdevelopment is where the police are more dangerous than the criminals. If we think surveillance cameras are important in public places, they are triply important to watch the interiors of police stations. On a related note, see this harrowing story about a journalist in Pakistan. Do we do similarly?

A fascinating fact about insurgencies: while a diverse array of weapons can be in fray, ammunition is quite well standardised. Writing about the guns used by the Taliban, C. J. Chivers points out on the New York Times blog, `for the 24 rifles and machine guns in the locker, produced in multiple nations over many decades, only three types of cartridges are required to feed them'.


Shobhana Subramanian in the Financial Express on C. B. Bhave. And, Sandeep Singh has a story in the Hindustan Times about Mr. Bhave coming through fine on one attack on him.

Ashok Desai reviews a book in Business World. Also see.

Auditor and Audit Committee Independence in India by Jayati Sarkar and Subrata Sarkar.

Developments on MCX:
    - John J. Lothian is a respected observer of the global securities business. He has written a piece about Financial Technologies Group titled You gotta earn it.
    - Mobis Philipose in Mint.
    - Deepshikha Sikarwar in the Economic Times.
    - A story by Deepika D. Thapliyal on NDTV.

An editorial in Business World on the MoF Working Group on Foreign Investment.

Learn R in Bombay.

Gautam Bhardwaj in the Indian Express on using the NPS to solve the problems of EPFO.

Sunil Jain on the difficulties of the data reported by the Indian statistical system.

An editorial in the Business Standard about developments on private container train companies, which reminds me of the conflicts between DoT and private telecom companies in the early 1990s.

Mobis Philipose worries about the apparent turnover numbers that we're seeing.

An editorial in the Mint on the latest attempt to keep FMC separate from mainstream financial regulation.

Jan Sjunnesson Rao in Education World on the damage that the Right to Education Act is causing.

The Economics of Foodgrain Management in India by Kaushik Basu, DEA Working Paper, September 2010.


A recent paper by Guido Heineck and Bernd Sussmuth finds that the blight of communism runs deep: Using data from the German Socio-Economic Panel, we find that despite twenty years of reunification East Germans are still characterized by a persistent level of social distrust. In comparison to West Germans, they are also less inclined to see others as fair or helpful..

A great interview with Condoleezza Rice on Spiegel Online about the halcyon days of 1989.

The last practical connection with World War I just died away. The legacy of that war, of course, remains with us; everything that came after was attenuated.

David Sanger in the New York Times; Jaswant Singh and Jeffrey N. Wasserstrom on Project Syndicate, on Engaging China. Also see these threats being made against Norway.

Mick Meenan in the New York Times about kabbadi going places.

A great story about the innovative logistics of the Italian army in Ethiopia in 1938.


Greg Mankiw on the high marginal tax rates which are hobbling labour supply in many countries.

China's Charter 08 is a brilliant and well-crafted document, worthy of a Nobel Peace Prize.

Norman MacLean wrote a great article in Lapham's Quarterly about his 1928 experiences with violinist, watercolorist, chess player, and physicist: Albert Michelson. They don't make men like that these days.

Randall Stross in the New York Times on the making of Steve Jobs.

Brad DeLong on Who can replace Larry Summers?.

A great article by Michael Heilemann on binarybonsai: George Lucas Stole Chewbacca, But It's Okay, which made me think about how copyright, patents and `intellectual property' fit uneasily into the creative process. As he says: Chewbacca didn't spring to life out of nowhere, fully formed when Lucas saw his dog in the passenger seat of his car. That's the soundbite. A single step. The reality is complex and human. From vague names floating around, the kernel of an idea, changing purposes and roles of characters, major restructuring, the design hopping from person to person, scrapping the existing concept and going down a different path, seeing existing things in a different light and having to conform a range of ideas to complement and enrich one another.. Everything is a remix.

At the frontiers of computing is `cloud computing', where users rent equipment, e.g. by the hour. Amazon's tariff card for such rental is bad news for developers who built knowledge on Microsoft technologies.

John Taylor has a story about Japanese currency manipulation. Recent research shows that the role of the Yen in global currency arrangements has been waning, and this episode of currency trading by the BoJ will exacerbate this trend.

Interesting ideas in trade

by Ajay Shah. 

Akbar's transport of ice

In the ferocious height of the Delhi summer, Akbar setup a mechanism whereby horses started out with ice in Kashmir and rode south. The ice was handed from one horse to another, keeping it constantly on the move. In the end, what reached him was a few kilos of ice.

(I'm unable to recollect where I read this, and google doesn't seem to have heard about it. Please do tell me if you know something about this.)

The Indian ice trade

In 1833, merchants figured out that it was profitable to transport ice from the US to India. The existing technical skills enabled the production of low-grade ice in Calcutta for six weeks of the year at a price of 4p per pound. Transport by sea made possible perfect Boston ice, available round the year, at a price of 3p per pound. Ships would start out with 150 tons of ice and reach Calcutta with 2 tons of ice.

`Ice houses' were built to store ice. The ice houses in Bombay and Calcutta no longer exist, but the ice house in Madras, built in 1841, still exists [location].

In 1878, manufacturing of ice began with the formation of the Bengal Ice Company, and this transport of ice from America dwindled away. By 1882 -- a short four years later -- it had ended. In 1904, there was an ice plant in Peshawar.

Sources: Better than Hooghly slush by Jayakrishnan Nair, in Pragati, June 2010.

The world's largest refinery on the coast of Jamnagar

India's biggest company, Reliance Industries, runs the world's largest refinery off the coast of Jamnagar. Crude oil is imported here, products are made, and re-exported. Here's my interpretation of what's going on. The natural place to put a refinery is in the Persian Gulf, but the political risk in that region is too great, given that the fixed assets in question amount to Rs.2.3 trillion.

What's the most efficient way out? To transport crude oil on the shortest possible hop from the Middle East to a place with political stability. That takes you to the coast of Gujarat.

A new trade: Alaskan water

I just read a story by Sambit Saha in the Telegraph about a new frontier in trade. A firm named True Alaska Bottling has obtained rights to transport 11.34 billion litres of water (i.e. 11.34 million tonnes) out of a lake in Sitka, Alaska. This will be transported to a plant near Bombay, which will be run by a firm named S2C Global, thus yielding bottled water to be sold in India and in the Middle East.

This seems to me to reflect an extension of the themes above. If you want to deliver product into the Middle East, it is better to build a factory in India given political stability and low labour cost. In this sense, it's a bit like Reliance. And, it reminds me of the old ice trade; except that this time we're transporting water.