## Tuesday, December 28, 2010

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.

## Wednesday, December 22, 2010

### 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.

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. ## Thursday, December 09, 2010 ### 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. ## Wednesday, December 08, 2010 ### 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! ## Sunday, December 05, 2010 ### 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. ## Saturday, December 04, 2010 ### 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. ## Wednesday, November 24, 2010 ### 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. ## Friday, November 19, 2010 ### 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.

## Sunday, November 14, 2010

### 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.

## Monday, November 08, 2010

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.

## Saturday, November 06, 2010

### 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.

## Friday, October 29, 2010

### 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.

### 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.

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.

## Tuesday, October 26, 2010

### 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.

## Wednesday, October 13, 2010

### 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:

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:

### 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.

## Monday, October 11, 2010

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.

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.

## Sunday, October 10, 2010

### 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.

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.