Hollowing out of the Indian financial system

Business as usual, in India, is taking us to a destination where RBI & SEBI & company will preside over a minor and inconsequential financial system. The bulk of India-linked finance will take place overseas, and the overseas market will dominate price formation for India-related financial products.

Why might this happen?

Finance is the business of bits and bytes. Orders being sent to India can be easily switched to other venues. An array of other venues are now springing up:

1. Nifty futures trade in Singapore on the SGX
2. An array of sophisticated derivatives on Nifty trade on the OTC market offshore (also termed `the PN market').
3. Derivatives on the rupee trade overseas on the OTC market (linear contracts are termed `the NDF market').
4. Trading in individual stocks is taking place on the ADR and the GDR market.

Let's focus on Nifty - the most important financial product in India. (The arguments pretty much identically apply to everything else).

The success and survival of the onshore securities markets is fundamentally about NSE. NSE faces an array of problems rooted in domestic policy (example, example, example, example, etc). The overseas market faces no such problems. The CEO of SGX wakes up in the morning and thinks about competing with NSE. The CEO of NSE wakes up in the morning and thinks of an array of weird things.

And then, there is taxation. The fundamental principle worth using in this field is residence based taxation. We, as India, should not tax the activities of non-residents. For a global investor, sending orders to the Nifty futures on SGX is tax-efficient as Singapore follows a residence-based taxation system. Sending orders to India is inefficient today (owing to the STT and the stamp duty) and could get worse tomorrow (if GAAR is used to abrogate the Mauritius treaty).

We think we are comfortable, because India has capital controls, and residents don't have much of a choice on taking their custom elsewhere. Things aren't that simple. First, non-residents can pioneer sending order flow to overseas venues, and make them liquid. The next stage will be about Indian MNCs, who run global treasuries, who can easily patronise the overseas venues. The third stage will be HNI residents, who can take $200,000 per year per person outside India. In addition, the richest 1% of India would systematically shift money out of the country through various means fair and foul [example].

Put these factors together, and suddenly Nifty futures on SGX are a credible option. And this is exactly how things have worked out. Palak Shah in the Business Standard says:

As on date, the SGX Nifty OI is 27 per cent higher than that for Nifty futures on the National Stock Exchange (NSE). The figures are more alarming if one considers the OI in a single month in May as the built-up positions on the SGX are 70 per cent higher than on the NSE. In May, the SGX Nifty OI was worth over Rs 16,200 crore while that on the NSE stood at over Rs 9,250 crore. As far as three-month contracts go, the Nifty futures OI on the NSE is over Rs 12,750 crore.

In 2008, before these troubles had come together, SGX open interest was 59.78% of NSE. By 2012, where all these problems have come together, SGX open interest has come to 101.77% of NSE's. It is astonishing to see that for the biggest Indian product - Nifty - an overseas exchange has got superior open interest.

In the baseline scenario, Indian policy-making will meander on clueless and unconcerned. NSE will continue to lose ground. Why do we care? Is this mere protectionism - what is wrong if the entire India-linked equity index derivatives business takes place overseas?

• A rich and complex ecosystem of finance has developed surrounding the Nifty contracts. Hundreds of thousands of high skill workers are in this industry. A decisive loss of market share for India would endanger their livelihood.
• The tax revenues associated with all these activities, at present, come to the Indian authorities. The Indian tax man earns income tax (on wages and on corporate profit) and VAT (on an array of activities of the firms). All this will go away if the business shifts to Singapore.
• A sophisticated Indian financial system is required if monetary policy is to be effective. The demise of the onshore financial system will damage the onshore monetary policy transmission. It will further take us back towards a world where government is unable to play a role in business cycle stabilisation.
• Prospects of Bombay emerging as an international financial centre will subside. If we can't even hang on to market share for Nifty or the rupee, where is the question of competing against overseas financial firms or markets on things that aren't India-linked?
• Access to finance for firms will tend to split into a two-tier world: the big firms will go abroad to get their corporate finance done. The small firms will face greater constraints since they will not easily access finance abroad (there is a greater information distance between the typical Singapore investor and the typical Rs.1000 crore or Rs.100 crore Indian company), and the local financial system would be weak.

When India started trying to build a mature market economy in 1991, at first, it felt like a sophisticated financial system would emerge, which would both serve India and start competing for the global market. From 1993 to 2001, India achieved a remarkable revolution in the equity market. This increased optimism in the ability of India to understand problems, to achieve change, and to maintain high ethical standards.

It now seems that those hopes were premature. The more likely scenario is one where India-linked finance will happen offshore, while RBI/SEBI/CBDT/CCI/FMC/IRDA squabble over a minor and inconsequential onshore financial system that is riddled with ethics problems. In the short term, onshore Indian finance will suffer from one setback after another.

We are likely to go back to the conflicted arrangements that gave us the Harshad Mehta scandals of the early 1990s and the Ketan Parekh scandals one decade later. I used to think we were finished with those problems. But we are about to restart on that entire story; there is little institutional memory about how those things came about and how dangerous our present path is. Each future scandal, of this nature, will be greeted with joy by overseas financial providers, who will scoop up market share every time India falls into turmoil.

Many years from now, we may one day get to fundamentally superior governance arrangements in finance, and achieve high ethical standards in public life and securities infrastructure. If this happens, we would be able to come back to these questions. As an example, Japan lost the Nikkei 225 contract to Singapore in the mid-1980s and got back into this to a significant extent 15 years later. In the years or decades that will go by until domestic financial governance structures are corrected, a great deal of organisational capital in the onshore financial system will have been lost.

The revolution in the stock market used to be one of the best success stories of economic reforms in India [link, link]. It may well fall apart in coming months and years.

Evaluating responses to India's macroeconomic crisis

by Shubho Roy and Ajay Shah.

The macroeconomic setting

India's macroeconomic woes consist of high inflation, low GDP growth and a drop in asset prices. The loss of momentum is visible in the seasonally adjusted data:

Indicator	Early 2009	Latest
GDP growth (QoQ, saar)	9.83 Q2-2009	4.25 Q4-2011
Inflation (CPI-IW, pop, saar, 3mma)	7.5 Feb 2009	12.9 Mar 2012
INR/USD	48 Jan 2009	56 May 2012

The picture is not uniformly bleak. The most important asset price of the economy, Nifty, has not dropped across this period. On 1 January 2009, Nifty was at 3033. Today, it is at 4920, which is a good 62% higher. More generally, stock prices have held up rather well so far. The trailing P/E of the broad market index, the CMIE Cospi, stands at 17.3, while the median value across its full history (from 6/1990 to 4/2012) is 17.83. We may think that conditions in India are difficult, but the stock market is saying that they're roughly median conditions in terms of the outlook for earnings growth.

The current account deficit

In recent years, the fiscal condition of the government + PSUs has worsened. This has led to a large gap between savings and investment. The worsening in public finance has diminished savings. There is an accounting identity: The gap between savings and investment is the amount of capital that has to be imported. This is the current account deficit. We have a capital shortfall within India, so we are importing capital.

It is likely that in the coming year, we will have a current account deficit of 4% of GDP, or $80 billion a year, or Rs.1700 crore a day. This means that we have to worry about how foreign capital views India. Under these conditions, if there is even a short hiccup in capital inflows (as appears to have come about after the government proposed to modify the Mauritius route, and more generally with the problems of governance in India), it yields sharp rupee depreciation.

We import a lot of capital; government policy actions interrupt that flow of capital; the rupee depreciates. This is not mis-behaviour of the financial system. The system is not malfunctioning; it is behaving as it should.

What should the responses be?

There are five sensible paths for government to take, in this situation:

1. We need to see that at heart, this is a problem of macroeconomics. The root cause of the current account deficit is the fiscal deficit. If we want a lower CAD, we need a lower fiscal deficit.
2. To ensure the smooth flow of Rs.1700 crore a day into the country, we should not spook foreign investors. We should not interfere with the de facto residence-based taxation framework which India is giving foreign investors, as long as they come through Mauritius. This policy framework is, in fact, in India's best interests.
3. Deeper problems about the loss of confidence of foreign investors, owing to governance problems, need to be solved by strengthening governance. They are important (do not ignore them), but there is no quick fix other than improving governance.
4. In the face of these difficulties, it would make little sense for RBI to trade in the currency market, to try to block the rupee depreciation. There is good reason for rupee depreciation; the currency market is doing a pretty good job of translating the fundamentals into a price. And, in any case, even if RBI desired to do something about it, its weapons are puny when compared with the size of the currency market and the Indian economy.
5. It is an opportune time to continue with the liberalisation of the capital account. However, it is useful to think deeply about how to proceed with this. Some kinds of liberalisation can be dangerous. It is important to think about sequencing, and at all times, to worry about unhedged currency exposure. A good deal of expertise has built up on the subject, through the Raghuram Rajan Committee and the UK Sinha Working Group which worked out the medium-term and short-term sequencing of reform.

An evaluation of what has been done

There are three features of recent policy responses which appear to be on track:

1. By and large, RBI's trading on the currency market appears to be at a low scale, nearing zero in many recent months. This is wise. It increases respect for the brainpower at RBI.
2. The government raised the price of petrol, so as to cut the fiscal deficit. This increases respect for the brainpower and political capabilities of the government.
3. The government decided to defer the attack on the Mauritius treaty by a year (though not to shelve it altogether). In the absence of clear policy statements about the importance of residence-based taxation, this shelving does not increase respect for the government.

Apart from these three good moves, a slew of dubious ideas have been afoot.

A. Enlarging the scope for dollar-denominated borrowing by Indian firms

On 20^th April, 2012: external Commercial Borrowings regulations were amended to:

1. Increase the limit on power companies to refinance their borrowings in Rupees with foreign currency loans (also called External Commercial Borrowings or ECBs).
2. Allow companies to borrow in foreign exchange to make capital expenditure for maintenance and operations of toll systems (See here)
3. Companies were allowed to refinance their ECBs with subsequent ECBs at higher interest rates (See here).

Evaluation: Do we really want Indian firms to hold dollar denominated debt? In particular, firms in the field of infrastructure who have cashflows in rupees? Sensible firm should see the high ex ante currency volatility and stay away from borrowing in dollars without hedging; so the impact upon capital flows will be small at best. And firms that do borrow in dollars and keep it unhedged are probably not going to fare well.

B. Enlarging the scope for dollar-denominated borrowing by banks

On 4^th May, 2012: The maximum interest payable on forex deposits by NRIs in Indian banks was increased (See here):

1. For deposits between 1 to 3 years the increase was 75 basis points.
2. For deposits between 3 to 5 years the increase was 175 basis points.

Evaluation: Banks are disaster-prone 19th century institutions. Do we really want them to hold more unhedged foreign currency exposure? Of all places in the economy, this is the worst place to keep unhedged currency exposure. The wise ones will not borrow in this fashion, so the impact upon capital flows will be small at best. And the unwise ones, that borrow in dollars and keep it unhedged, are probably not going to fare well.

C. Reducing the economic freedom of exporters

On 10^th May, 2012: the right of exporters to hold foreign exchange was reduced by 50% (See here):

1. Exporters were allowed to keep their forex earnings in special accounts called EEFC accounts. They were not mandated to convert it into Rupees. This allowed them the ability to fund imports for their business without going through costly conversions.
2. Now only 50% of their export earning will be allowed to be kept in forex. The rest will be converted into Rupees against their wishes.

Evaluation: In the old India, FERA made ownership of foreign exchange an exotic and rare thing. Many businessmen in India engaged in import/export misinvoicing and tried to hold assets outside the country. In the early 1990s, C. Rangarajan's RBI embarked on a modern arrangement. Exporters were given greater economic freedom. We are now rolling the clock back by 20 years; we are tampering with current account liberalisation.

The number "50%" has not been justified in the RBI notification. Any exporter, with significant raw material import cost will now pay unnecessary transaction charges. In global trade, where every country takes the utmost effort to keep their exports competitive, any small distortion impacts on export competitiveness; this is pushing in the other direction - it is an attempt to reduce India's export competitiveness.

This is a new low in Indian economic policy. Every internationally oriented household in India will now be more keen to hold assets and liquid balances outside India, safe from the clutches of Indian capital controls. This measure will thus exacerbate capital flight and worsen the problems of the rupee. Success in the marketplace will tend to accrue to businessmen who break laws as opposed to the law-abiding ones.

D. Damaging the currency futures market

On 21^at May, 2012: restrictions were put on exchange-traded derivatives (See here):

1. The net overnight open positions that the banks hold shall not include positions in the exchanges.
2. The positions in exchanges cannot be used to offset positions in the OTC market for
3. The position of banks in currency exchanges shall be limited to $100 million or 15% of the market (whichever is lower)

Evaluation: The world over, there is a clear understanding that the exchange is a superior way to organise financial trading. When compared with the OTC market, the exchange has superior transparency and risk management. Policy makers need to continually modify policies so as to favour a migration of all standardised products away from the OTC market to the exchange-traded contracts. RBI's moves go in the wrong direction.

How do we ensure that the price on a financial market is driven by fundamentals? The answer : We must have a deep and liquid market, and a broad array of sophisticated speculators. RBI's actions are going in the exact opposite direction. They are trying to make the market illiquid. But it is in an illiquid market that we will get market inefficiencies and weird behaviour of the price. They are increasing the chance that something nutty happens on the rupee.

This circular is also a reminder about poor legal process at RBI. Every action by a regulator must articulate a rationale. Financial regulations are motivated by exactly two possibilities - consumer protection or micro-prudential regulation. The government agency that wields the power of financial regulation must show the clear rationale, describing what is the market failure that this regulation is seeking to address. The government agency must show the cost-benefit analysis, explaining why the costs of this action outweigh the benefits. As is typical of financial regulators in India today, RBI's documents show no rationale.

It is possible to conjure one conspiracy theory. The attempts at damaging the liquidity of the currency futures market should be seen in connection with previous work on damaging the liquidity of the OTC market. Perhaps there is a grand plan here. The scale of RBI's trading on the currency market is implausibly small when faced with the size of the Indian economy, with the size of India's cross-border interactions and the size of the currency market (both onshore and offshore). Perhaps these recent moves are designed to damage the liquidity of the market, so as to get to a point where RBI intervention can make an appreciable dent on the price. Perhaps the game plan is to gnaw away at the capability of the currency market through a series of moves, and then take off doing large scale manipulation of the market. If this is the game plan, it reflects very poorly on the economic policy capability at RBI. It would also generate massive profit opportunities for the speculators of the world, who would short the rupee when the large scale manipulation commences.

Rumours about other bad ideas abound. E.g. it is suggested that RBI will sell dollars to exporters directly. How is this different from selling dollars on the market?? It is suggested that the currency futures and the OTC markets should be completely cutoff by banning the arbitrage. How would this solve the macroeconomic problems which bedevil the rupee?

Microeconomic distortions are not a good way to address macroeconomic problems

What does one make of this spectacle? A simple principle worth reiterating is:

Problems rooted in macroeconomics must be addressed using macroeconomic instruments.

We got into this mess because of inappropriate fiscal and monetary policy. We need to solve these -- monetary policy must get back to the business of delivering low and stable inflation, we have to fight inflation until we see y-o-y headline inflation (i.e. CPI-IW inflation) going to the 4-to-5 per cent range. Alongside this, fiscal policy needs to correct itself. Each of these has a clear direction to move in, and movement on any one is valuable regardless of what the other does.

A big element in the picture is the loss of confidence, in the eyes of the private sector, on an array of issues ranging from ethical standards to the sophistication of fiscal, financial and monetary policy. This is an important problem and it needs to be addressed. The spectacle of a government flailing at the macro problems using micro instruments is worsening matters. Perhaps there is constant pressure to announce `new measures' to solve the problem. Deeper solutions are hard, and there is enthusiasm for `doing something' (large or small) [example].

We've seen this movie before. In the last decade, again and again, RBI tried to wield capital controls as a tool for macroeconomic policy. They failed. It is disappointing to see the lack of learning.

Some of the moves above have come out of the reflexive socialism that lurks within the Indian bureacracy. Perhaps, in a crisis environment, the ordinary immune system within each government agency, which keeps the sub-clinical socialism under check, is not working as well. This hurts from two points of view. It betrays the lack of capability of these government organisations; it reminds us that the Indian State is strewn with people who have a low knowledge of economics and a taste for dirigiste. It also reminds us of the policy risk: Precisely when the best capabilities are required (in a crisis), we seem to be slipping into the lowest quality policy initiatives.

Everyone who sees the government / RBI engaged in one ill thought out measure after another gets worried about India's future. How can a $2 trillion economy flourish while such immense powers are placed with individuals and institutions with such weak capabilities? This further damages confidence, which deepens the macroeconomic crisis.


Acknowledgements: We are grateful to Apoorva Ankur, Sumathi Chandrashekaran, Pratik Datta and Kaushalya Venkataraman for useful suggestions.

The costs in buying versus the costs in selling

by Ajay Shah.

All models are wrong, some models are useful. A model reduces complications that are true in return for tractability and insight. In finance, all too often, one complication which has been wished away is transactions costs. A great deal of what we see in the world around us is caused by the costs of transacting. Some of the most important finance is about analysing the causes and consequences of the costs of transacting.

The bid offer spread as a measure of transactions costs

The first flush of the literature draws on markets with market makers, and treats the bid-offer spread as the measure of the cost of transacting. On the NYSE, the specialist posts a bid price and an offer price. If you do two transactions in quick succession -- buy 100 shares and then sell them back -- you will be poorer by the bid-offer spread. The spread is like a tax on a speculator doing a round-trip for a small transaction.

There is no doubt that in that environment, the spread measures something important about transacting. Large databases about the spread are available. A whole literature arose which is rooted in the spread as the measure of the cost of transacting.

Limit order book markets are a whole new world in observability of liquidity

The world changed. Across countries and across asset classes, exchanges have been morphing into anonymous open limit order books. The market maker is not as important. On the open limit order book market, the full set of limit orders are observable, using which we can simulate a market order of any size, and calculate the exact cost that is paid. Suddenly, instead of just seeing a bid-offer spread, we see a whole new world which displays the full `liquidity supply schedule' (LSS) that has the impact cost (in per cent) associated with a single market order of all possible sizes.

An example of the `Liquidity Supply Schedule': The impact cost associated with all possible transaction sizes

When the bid/offer stands at 98/102, and the midpoint quote is 100, if a single market order to buy 1000 shares gets executed at an average price of 105, the buy impact cost for 1000 shares is 5%. This calculation, repeated for all possible transaction sizes, paints the full Liquidity Supply Schedule (the LSS).

Once the LSS is visible, and we start thinking about the world in new ways, and the spread feels like a highly unsatisfactory measure of the cost of transacting. At the NYSE, the market lot is 100 shares for all firms. A share price of \$5 means the spread refers to the cost of a transaction size of \$500. If the share price is \$200 instead, the spread pertains to a transaction of \$20,000. Hence, the spread is itself not comparable across securities. In contrast, the LSS can be a standardised calculation that is comparable across all firms, with standardised units on the $x$ axis either in rupees or basis points or market capitalisation.

For us in India who grew up with limit order book markets (NSE from 11/1994 onwards; BSE from 5/1995 onwards), the mainstream Western literature seems a little quaint, given their emphasis of the spread as the measure of transactions costs. We are seeing much more of the liquidity elephant through the LSS, while so many researchers are only seeing it's tail through the spread. In India, the construction of Nifty required the capture of multiple snapshots of the entire limit order book per day, and has generated information about the LSS going back to the mid 1990s.

Since exchanges worldwide have shifted over to an open electronic limit order book, the new focus of measuring liquidity in finance lies in understanding the LSS. What explains cross-sectional and time-series variation of the LSS? What are the consequences of various features of the LSS? These questions have only begun to be addressed in the literature. Rosu has a fascinating recent paper in the Review of Financial Studies, 2009, titled A Dynamic Model of the Limit Order Book that presents one of the first models which predicts the shape of the LSS in an open ELOB market.

Does the impact cost in buying differ from that faced when selling?

One interesting dimension which the LSS makes possible is to think afresh about buying versus selling. The bid-offer spread tells us the round-trip transactions cost. It does not differentiate between buying and selling. When you see that the bid and offer are 100/102, there is no sense in which the transactions cost in buying differs from the transactions cost in selling.

But with the full LSS, we see the impact cost of buying at all transaction sizes separately from the impact cost of selling at all transaction sizes. A first question to ask is: Is there symmetry in liquidity? In the example of the LSS graphed above, it's quite obvious that the impact cost when buying is superior (i.e. lower) than that faced when selling. But this is just one anecdote.

In a recent paper Measuring and explaining the asymmetry of liquidity, Rajat Tayal and Susan Thomas explore this question. With equity spot trading on the NSE, they find strong evidence in favour of asymmetry: impact cost is higher for large sell market order compared to large buy market orders.

Why might asymmetry arise?

What features about traders in the market generate differences between buying and selling? There is one candidate: how traders perceive sell market orders, particularly large sell orders that come despite constraints on borrowing shares, and restrictions on short-selling.

The speculator who makes a forecast that a share price will go down seldom owns the shares; selling requires borrowed shares. Particularly, in India, where formal mechanisms for borrowing shares are as yet quite small, a speculator who wants to sell physical shares has to mobilise borrowed shares on his own.

This may shape the thinking of the people placing limit orders. When I place limit buy orders (which will get hit by a speculative seller), the adverse selection runs against me. If the speculator was not confident about his forecast, he would not bother to borrow shares and sell short. Only when the speculator is really sure would he take the trouble of borrowing shares and doing a sell order. Hence, the person placing limit orders to buy would demand a bigger price of liquidity (i.e. the impact cost), since he runs a greater chance of losing money when giving liquidity to sellers.

The paper highlights a fascinating identification opportunity : at NSE, alongside the trading of the equity spot market, we also have trading in single stock futures. Everything about the two markets is identical: the same securities, the same trading system, the same participants, the same hours of day, etc. There are only two differences: stock futures trading is leveraged, and stock futures trading has cash settlement -- which removes the short-sales constraints. Cash settlement induces full symmetry between buying and selling.

If short sales were the reasons asymmetry in liquidity on the equity spot market, then the stock futures market should have no asymmetry between buy and sell orders. The paper uses the same measurement procedures and statistical tests to compare the asymmetry of liquidity on the spot market as well as for the stock futures market. They find that there is no asymmetry of liquidity on the stock futures market.

If their story is correct, it has many implications. In other market settings observed worldwide, cash settled derivatives should have symmetric liquidity. Physical settled derivatives should have asymmetry - which might get more accentuated as you come closer to expiry. Many natural experiments have taken place worldwide, where futures contracts have shifted from physical to cash settlement: these are all nice natural experiments where changes in asymmetry should become visible. On spot markets, asymmetry should vary with the ease of borrowing. Future research projects could explore these questions.



Financial economics benefits from the best datasets in all economics, and we are able to get sharp and clean papers which pretty decisively answer questions. In India, it has started becoming possible to do innovative work by drawing on data from the open ELOB equity exchanges, CMIE, etc.

The business of Indian politics

Raymond Fisman, Florian Schulz and Vikrant Vig have a fascinating new working paper: Private returns to public office, which gives us new insights into Indian politics.

We know that elections in India are typically rather close. There is something almost capricious about who wins and who doesn't. The random outcome of an election can, then, be interpreted as randomised allocation into control and treatment. One candidate gets elected, another candidate is very much like him but doesn't get elected.

We can then ask the question: what happened to the wealth of the bloke who got elected? The authors say that the rate of growth of the assets of the person who won grows by 300 to 600 bps per year when compared with the person who lost.

The strongest effects are observed for a person who makes it to being a minister: his asset returns are 1300 to 2900 bps higher than the person who did not win the election.

The paper reminds us of the conditions under which the most fruitful economic research happens today. It's got to be a live and interesting question. A high quality dataset has to be the engine; without good quality data, research is just garbage-in-garbage-out. It's got to persuade us that that the claimed answer is correct. Too often, we in the research profession are failing on these three tests.

Interesting readings

Mobis Philipose in Mint, Sunil Jain in the Financial Express: on the SEBI order (by Prashant Saran) on the Tayals. Also see coverage on firstpost.

The great debate about Pranab Mukherjee as President of India: read B. S. Raghavan in the Hindu Business Line; Inder Malhotra in the Indian Express.

Nick Robinson in the Business Standard on strengthening the rule-making process, i.e. the legal process for subordinate legislation, in India.

The next generation of reforms in India, a speech by Raghuram Rajan.

I just read Carnage and culture, by Victor Davis Hanson, and I recommend that everyone who thinks about India and international relations and military power should read it too.

As I read Karim Sadjadpour in Foreign Policy on prudishness in Iran, it made me think about Where boys and girls don't talk to each other in the Hindu.

M. Sahoo on SEBI's recent moves on opening up to conflicts of interest in exchanges.

Watch me talk about the current macroeconomic situation. Watch me talk on CNBC-TV18 on the day after RBI's surprising 50 bps rate cut.

I got many questions about seasonal adjustment of the CPI-IW. At our tracking page, we have a technical note on the seasonal adjustment procedure for each of the series. As an example, here is the technical note about seasonal adjustment of CPI-IW.

Financial regulation is particularly complex when the line between the government and the private sector are blurred, when the State contracts-out supervision to private parties, in the field of market infrastructure such as exchanges, clearing houses, depositories, credit rating agencies, etc. Credit rating agencies get paid by the firms that they rate; exchanges get paid by the members that they supervise. Panayotis Gavras has a good article in Finance and Development about the problems faced in the field of credit rating, and potential solutions.

Two new papers: A corporate governance index for large listed companies in India, by Jayati Sarkar, Subrata Sarkar and Kaustav Sen, and Do changes in distance-to-default anticipate changes in the credit rating by Nidhi Aggarwal, Manish Singh and Susan Thomas.

The Cabinet has cleared a Microfinance Institutions (Development and Regulation) Bill. The version of the draft Bill that has got greenlighted is not out in public domain. I hope the present version has fixed up the major flaws visible in the previous publicly visible draft Bill.

A great review by Timothy Snyder, of The Spanish Holocaust: Inquisition and Extermination in Twentieth-Century Spain by Paul Preston, in the New Republic.

John Pollock has a great story about Libya in Technology Review, which helps us to think about China's future in new ways.

Everyone interested in the world economy should read The true lessons of the recession: The West can't borrow and spend its way to recovery by Raghuram Rajan, in the Foregn Affairs.

Reviewing less -- progressing more, a great editorial in the RFS by Matthew Spiegel that gives us an insight into what is going wrong in academic refereeing.

One last thing: Scales.

Faulty tradeoffs in security

The new world of security in India

Only in a police state is the job of a policeman easy.

-- Orson Welles

The policemen of India say: It is only by using onerous and intrusive tracking procedures that we will be able to block the terrorism, the tax evasion, the money laundering. But society should be designed for the convenience of the median citizen and not for the convenience of the policeman. Yes, when citizens have liberty, it imposes more work upon the policeman. That is a tradeoff we should favour.

In every place in the world, I walk into a coffee shop, open my laptop, and go into free open wifi networks. Except in India. Open wifi networks are banned in India, because they make life difficult for policemen. This is a bad tradeoff : we have sacrificed the immense gains from ubiquitous open wifi networks, in return for reducing the work of policemen.

Terrorists and criminals use roads. Does that mean that we will only permit people with photo IDs to embark on roads? Terrorists and criminals drink water. Does this mean that we will only permit people with photo IDs to buy water? And so on.

Global norms on financial distribution, which have been pushed hard into the direction of more monitoring by the US Treasury, do not require a know-your-customer on every transaction. They only require `customer due diligence' (CDD), which means that the due diligence applied on a transaction should be appropriate (a big principles-based word) for the transaction at hand. We in India have translated this into a mechanistic rule "demand KYC for everything". This is incorrect. A greater push-back is required, from citizens.

In a civilised society, employees of government will have to work hard and work smart in blocking terrorism, obtaining tax revenues, etc. This is okay. We should not set out to make the life of these employees easy. Obtaining a high tax/GDP ratio requires careful, detailed hard work, and a lot of brainpower. In the absence of this, there is a temptation to resort to quick fixes, which should be avoided.

A civil liberties perspective

They who can give up essential liberty

 to obtain a little temporary safety,

deserve neither liberty nor safety

-- Benjamin Franklin

We get asked to prove identity to enter an airport, to do financial transactions, to get a mobile phone, etc. We have become used to the idea that this is essential in this world inhabited by too many terrorists.

I think anonymity and privacy are precious and valuable. We in India seem to have given up on protecting civil liberties from an encroaching State that wants to know a lot about us. Particularly given that we are a fragile democracy that works imperfectly, it is important for us to have less information in the hands of the State. One element of the imperfection of our democracy is the undersupply of criticism. We need to cherish and protect the critic, which will be assisted by having a government that knows less about us.

The best we're able to muster today, in the Indian discourse, is the hope that UIDAI will reduce our transactions costs of complying with the surveillance state. I think it's important to go deeper, to question this array of rules that monitor us. How much security do they buy us, in return for what costs to society?

What bang for the buck?

We should be more intelligent in weighing these tradeoffs between imposing costs upon society at large, and the extent to which they help us catch criminals. A great deal of what passes for security procedures today is quite silly when you pause to think about it.

We are obsessed with monitoring electronic payments. The bad guys will just use cash. The amount of money required for pulling off the WTC attacks is believed to be roughly \$100,000, which was wired to Mohammad Atta. It is not hard to move \$100,000 through non-electronic channels: this is the value of 11 bars of gold, each the size of a pack of cigarettes.

In fact, it is very convenient for the authorities when the bad guys use electronic channels, since greater tracing becomes feasible. We have a fair clue that this money came to Mohammad Atta from Pakistan's ISI because the money was wired; if the bad guys had moved money through cash or gold or diamonds or platinum, we would have not known this crucial fact. It is better for us if more bad guys ride on the electronic highways of the financial system. As long as cash is around in large quantities in India, it makes little sense to block people from coming into electronic payments on the grounds of KYC.

We are obsessed with physical IDs as a tool for security. But the bad guys will easily forge any physical IDs that you can propose. It is not clear what safety we're buying, in return for the enormous human resource and cost in time that is being expended today in checking IDs.

We in India are surprised to discover that in the US, you can buy a temporary one-month GSM SIM card at a storefront, without any know-your-customer or proof of identity. They do not even want to know your name. This is not to say that the security agencies in the US are not watching everyone keenly. The point is that they are doing this in ways that impose lower costs upon society; the security procedures are less of an eyesore.

A need to rethink where we're going

Many elements of the information before us, today, suggest things aren't going well:

• In the US, despite a fairly open and liberal system (e.g. freely selling GSM SIMs to anyone, without requiring even a name), law enforcement has been pretty effective: They haven't had a single successful terrorist attack after 2001, despite being the #1 target of myriad nutcases like OBL. In India, thousands of people have died in terrorist attacks, even though we have embarked on a barrage of security procedures.
• Every terrorist caught dead or alive in India has a cell phone. This suggests that our attempts at requiring a KYC for every mobile phone aren't so useful.

Failure should have consequences. We should rethink the way we work today, drawing on these blocks of evidence.

We need to ask three questions:

1. Tradeoffs between freedom and safety. How much of a violation of personal freedom are we willing to accept, in return for better enforcement of laws. We should be willing to sacrifice some safety in return for more freedom. E.g. Saudi Arabia has low crime, but do we want to be Saudi Arabia?
2. Tradeoffs between prosperity and safety. How much inferior GDP are we getting, as a consequence of the security procedures which are being put into place? We are willing to sacrifice some safety in return for more GDP. E.g. there would be fewer road accidents if the speed limit were 25 kph (and road accidents kill vastly more people than terrorists), but we're willing to live with the carnage on the roads in return for higher prosperity.
3. Does the claimed security procedure even work?? What is the bang for the buck, the effectiveness of these procedures? As many examples above have suggested, many of the security procedures used in India seem to be poorly thought out.

Drawing on my experiences in Indian public policy process, I can venture a guess about how the prevailing tools of security came about. A meeting was organised. Everybody in the room was an experienced security practitioner. The only viewpoint present was about how the world can be redesigned to make life easier for the employees of government. Everyone was indignant. We have to do something. A few security as theatre proposals came up. Everyone agreed. It felt like we were making progress; we certainly got plenty of showy security procedures to impress Parliamentarians and the media. Nobody asked second order questions; nobody analysed the data. This combination of factors (indignation, decision making dominated by the status quo, theatre to satisfy journalists and politicians, lack of a feedback loop through data capture and data analysis) is not conducive to problem solving.

We in India repeatedly find ourselves in a situation where law enforcement is placed under pressure to deliver. Whether it is a crime wave, or a terrorist attack, or a low tax/GDP ratio: officials are asked to do better. Such demands for performance are entirely appropriate. However, at such times, we should be careful to not accede to bargains where the enforcers promise results in exchange for arrangements that make life convenient for the enforcers, at the expense of the open society.

Insourcing vs. outsourcing government functions: A setback for public sector production of elementary education

A recurrent theme in the field of public administration is the appropriate separation, between things done within government qua government, versus the things that are best contracted out.

Example: A fascinating question in finance is the supervisory role of exchanges. Do we want exchanges to be rule makers and the front line of supervision, or do we want them to be mere profit-maximising IT companies who run trading systems, with all regulatory/supervisory functions being performed by SEBI? Is the exchange a public utility or a mere business?

In the field of education, the question is: Should government be the producer of education services (building schools, worrying about drinking water at the school, hiring teachers etc.) or should the actual production be done by private schools, with government giving money and decision making power to parents (through vouchers) and working on the public goods of education (measuring what children know, establishing curriculum, releasing information about each school into the public domain so as to assist the decision making of parents).

Our thinking on these boundaries is critically related to our views about the capabilities of government and the complexity of the problem.

How should we think about complexity? Problems that are hard, in the field of public administration, have three characteristics: large number of transactions, high discretion in the hands of the front-line civil servant, high stakes. (On the first two, see Pritchett & Woolcock, 2004). Under these conditions, production in government is hard.

How should we think about capability of government? When the government is fluently able to reorganise agencies, shift functions from one government agency to another, achieve cooperation between multiple government agencies, hire and fire civil servants, and pay market wages, then the government is going to be a capable one. A government that is weak on all these attributes is a low-capacity one.

Our views about the appropriate separation between in-sourcing and outsourcing would thus vary by problem and locale. For some problems, production in government is easy, and we'd be less emphatic that contracting-out should be done. E.g. monetary policy is easy, and there is no big problem with keeping it inside government. In some places, the government has high capacity - e.g. public schools work relatively well in Sweden. In other places, when the government has low capacity, we'd be more keen to contract things out.

Turning to the Indian setting, there are two huge problems that hold back the possibility of building high quality public schools. First, civil servant wages are set to 2x to 3x higher levels, when compared with market prices, thus inflating the cost of government schools. If you took the same money and gave it to parents, who chose a private school on their own, the private school would be recruiting much better teachers. Second, civil servants can't easily be fired, thus reducing the incentives of teachers to teach. Teaching is a transaction-intensive discretionary public service. When the front-line provider has no incentive to work, the quality of teaching will collapse, as has been seen with schools in India.

Some states in India had, appropriately, tried to fight these problems by going to the basics: by bringing in non-tenured staff at lower wages. By recruiting these "para-teachers", we improve production of education in the public sector. These two issues are of essence. By removing tenure, we increase the incentive of teachers to teach. By bringing wages in line with market conditions, we bring public sector production closer to the cost efficiency that can be obtained by the private sector.

This line of attack may now be torpedoed by the courts. The Gujarat High Court sees to have ordered the government to pay para-teachers full wages and give them tenure.

If this goes through, and if this creates a precedent for the rest of India, then this pretty much closes off these avenues for strengthening public sector production. It would, then, emphasise vouchers as the only way to go.

There is one important slip between cup and lip. The Right to Education (RTE) Act, one of the less impressive legislative achievements of the Indian Parliament, asks state governments to write rules about salaries paid by private schools. RTE was an attack by the public sector education providers against the private sector: so they wanted to kill off the ability of the private sector to pay market wages. Some states have written rules under the RTE which force private schools to pay civil servant wages. For these states, the gains from private production of education services will be smaller. Other states have been silent on this, and there is then a possibility of reaping the full superiority of private production.

I am grateful to Jishnu Das, Lant Pritchett, Parth Shah and Jeff Hammer for useful discussions on this.