## Friday, February 24, 2012

### Doing better in our neighbourhood

A key intuition of modern thinking in international trade and international finance is that distance matters much more than we think.

We may like to believe that the world is becoming more flat. We may like to believe that for weightless things like services and financial flows, distance is irrelevant. But the research evidence is unambiguous: there is a `gravity model' in the affairs of men. The interactions between two countries tend to go up in proportion to the product of their GDP, and vary inversely with the squared distance between them.

Traditional trade theory would encourage us to think that India and Sri Lanka (say) have similar factor endowments, so the gains from trade might not be so great. But this is not borne out by the evidence: some of the most intense trade relationships are found between countries in Europe and between the US and Canada: between countries with very similar endowments.

In this region, we need to be much more mindful of the importance of intra-regional finance and trade activities. For India, this means a strong emphasis upon East Africa, the Middle East, Pakistan, Central Asia (by plane today, but someday we should get to road connectivity from the Indian ocean), the land route to China through Tibet, Nepal, Bangladesh, Burma, Singapore and Sri Lanka. India stands out, in international comparisons, for having unusually low economic engagement with its neighbours. This implies that there are opportunities for very large gains. In recent years, some Indian firms have emphasised these countries in their internationalisation strategy (both trade & investment), reflecting a greater role for natural conditions dictated by geography.

Some of these places are hobbled by political problems and abysmally low GDP. The product of the two GDPs matters, and bad political systems like to interfere with globalisation. The wise thing for us to do is to have a consistent and welcoming engagement strategy, waiting for the time that the country finds its feet in terms of establishing a healthy political system, waiting for the country to engage. A good example of India doing something right is the positive approach towards MFN status for Pakistan. We have to wait for Pakistan to understand that this is in their self-interest - and I do believe that in time, they will - but there is no reason for us to get stuck on reciprocity.

Of particular interest in recent months is Burma. Hamish McDonald has a beautiful piece titled Tractors may have replaced horses, but country is still decades behind.  If Burma comes out of its deep freeze, then the opportunities for trade and financial links with India are huge. We would go closer to the arrangements which were prevalent in the early 20th century, which reflect the natural opportunities.

With increased trade & financial linkages will come greater macroeconomic correlations a.k.a. shared interests. I saw a fascinating new IMF working paper by Ding Ding and Iyabo Masha titled India's growth spillovers to South Asia. This finds that after 1995, Indian growth has a significant impact in the region. If this is a robust finding, it is new; the idea that Indian business cycle fluctuations reach out and influence the region is not part of our intuition, particularly given the onerous trade barriers in place. Perhaps there is a lot more trade going on than meets the eye.

1. The IMF paper confuses correlation with causality -- it uses contemporaneous Indian growth to explain growth in South Asia!

1. I went back and read the paper more carefully and Yes, I'm not convinced they are handling common shocks.

One common shock is the monsoon which is likely to have similar features for all the countries. On the other hand (a) Even within India, we know that there can be a drought in Karnataka while things are fine in Tamil Nadu, hence it's possible that the shocks hitting Sri Lanka are not the same as those hitting the overall Indian macroeconomy; (b) In any case, agriculture is down to a mere 15% of Indian GDP, so the real story has got to be the remaining 85% of GDP which is not driven by agriculture.

A greater concern is global business cycle conditions. In 2009, Shruthi Jayaram, Ila Patnaik and I found (http://epw.in/epw/uploads/articles/14101.pdf) that Indian correlations against global business cycle conditions were going up through time. Global shocks would be a common shock hitting all countries in South Asia, and would generate correlations.

The IMF WP is well rooted in the literature and I hope that this literature has understood these things. It'd be good to get our heads straight on it.

2. Hi Ajay, We did some analysis where we find that the nature of cyclical shocks is similar across the South Asian Region. The results are similar whether we do ARMA type modeling (http://www.kluwerlawonline.com/document.php?id=TRAD2006023&mode=abstract),

Or, we do structural modeling (http://www.sciencedirect.com/science/article/pii/S1059056008000440).

So these economies, clearly exhibit a case for deeper economic integration (financial and otherwise). Unfortunately, problem arise because of lack of infrastructure: both hard (such as connectivity), and because of soft (such as issues related to customs at the border). This became evident while I was working on a recent project trying to understand the problem faced by exporters and importers.

I have summarized the finding in an editorial published at Hindu Businessline (Available at: http://www.thehindubusinessline.com/opinion/article2615480.ece?homepage=true).

Best, Nilanjan (IFMR).

2. Time to find a way to invest in Myanmar stocks: Investor Rogers Compares Myanmar Reforms to China’s Opening

This guy doesn't miss a beat. He also advocated buying Sri Lankan stocks at the end of the war there.

1. It's easy to talk about such strategies. Growth is bound to happen from a low-base for such countries. At least in the short-run, there will be a growth spurt and it might even spark a stock market rally. But how do execute it? Are foreigners allowed to buy stock or invest in these countries? How easy is it to exit these markets? How long will the stability last?

Burma might as well break up into several countries in a few years. Who knows?

2. Agree on all those counts. There are ETFs for Thailand, Malaysia, Indonesia but not for Myanmar. Sanctions limit access as well. Sri Lanka is the same in terms of lack of investment avenues, although a new ETF has been filed (but not started trading yet). Perhaps, the way to play it is to wait for a market to get hot and then short the newly announced ETF because it seems like new ETFs usually are released at the peak of performance! :-)

Kidding aside, perhaps one could look at Indian companies that evince interest in the region. Or, maybe proxy via the Bangladesh/Thailand/ASEAN ETFs if those countries happen to take greater advantage on a percentage basis.

And, sure, the investment may not work out and is very speculative but that is true of any investment. One isn't going to bet one's farm on Myanmar turning it around (even though Rogers says so), but the risk-reward makes it a call option.

3. Hi Ajay,

Would you please cover the fallout from the revelation that their own industry group is linking microfinance to suicides by poor people. You yourself had published a guest post by asking critics of Microfinance IPOs to compete better so to speak. This is not an attack on you. At that time, I and I am sure many others believed that microfinance was a good solution. Hindsight is 20/20. But to me, it looks like a failure and downright evil like so many other evils in our society.

1. Sorry, you'll have to explain yourself in greater detail. Could you tell us what you are seeing and how you interpret it?

2. Hi Ajay,

I was referring specifically to the new article about SKS and other such microfinance institutions. Here is the article (warning long article):

The articles describes the greed that drove the IPOs, which in turn has been directly linked to many suicides in their own report.

Microfinance is not going to work. It is a gimmick and a way to suck whatever little capital is left in these rural areas and pull them out for good. At least, the village lender was based out of the local economy and kept his capital there itself.

Two quotes that have defined my own thinking about the industry are these:

”Even if you lend at 0%, returns from agriculture would most likely be negative and micro-finance skirts agriculture and most of India’s poor are engaged in agriculture. So, micro-finance cannot and should not be expected to make a serious impact on poverty in India”- Ramesh Arunachalam

“In a static village economy, there is little scope to have too many petty traders. Two-thirds of the villagers directly live on non-cash-crop agriculture, and another 20% are small-time artisans. The cycle of economic activities for these people range from about six months to one year. None of them generate income to meet weekly repayments, and none of these activities generate a rate of return to afford interest rates of 20-40%.

And if they borrow — and many are compelled to borrow at such interest rates because banks have failed to provide them with credit that they deserve at affordable interest rates — they would never be able to rise from their levels of poverty, and very often just go back a few years in their economic status.” - Prakash Bakshi

The activities of microfinance in India reminds me of what Subprime lenders did in the US.

4. The WSJ piece on micro-finance is here:

http://online.wsj.com/article/SB10001424052970203918304577242602296683134.html?mod=WSJINDIA_hpp_MIDDLETopStories

While the misdeeds (if true) of one (or a few) organizations should never be reason enough to tarnish the entire sector, it does raise serious concerns about a) the role of incentives in the credit-business and b) the importance of the rule of law. At the end of the day, harassment by anyone (MFI or not) should be dealt with as a law and order problem.

1. Fleecing the poor (and retail investors) is not a misdeed (if true) but a crime (true). This case and others have to be thoroughly investigated. Yes, I know I can dream. It's definitely going to happen in this country!

Microfinance is the most hyped up useless exercise in poverty reduction. Even wealth transfer is not working as a recent study (albeit poorly done from whatever little I read) has shown that people are giving up productive work to take NREGA handouts rather than supplement their income from productive work. But still wealth transfer is better than sucking out capital from the poor and middle class towards the money centres of the world.

PS: Quoting WSJ on such issues is like quoting the Communist Manifesto on Marxism.

5. With decisions on Infrastructure investment held up in India, Indian firms can look across the borders for investments. Its not only the cross border infrastructure that is a bottleneck but within countries also. Last week Subroto Roy Sahara stated in an ET interview that they are building New Dhaka at an investment of Rs80,000crore.While that might be hyped up but there is no reason why GoI and Indian companies should not be building up Roads,Railways and Canals in Nepal,Bangladesh, Sri Lanka and Burma to benefit Indian economy.

6. Prof Pankaj Ghemawat's research shows a similar finding that the world is not flat-in fact he wrote an entire book on that showing that distance matters in social networks, trade and other things.

1. Yeah, even though Pankaj's World 3.0 is guilty of typical HBS spin, its way, way better than Thomas Friedman's which sets new lows in journalism & pop-econ.

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