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Sunday, December 23, 2012

Law and order: How to go from outrage to action

There is fresh rage on the bad state of law and order in India today. That rage is entirely appropriate.

My father was born in 1926 and experienced British rule. One of the high points of his life was participation in the freedom movement. He used to say to me with great regret that under British rule, the Shiv Sena would have never arisen. What has happened in India is a disgrace.

The interesting and important question is: How can the problems be solved?

Moral outrage does not lend itself to good policy analysis. As with the problem of corruption, the problem of law and order requires sophisticated thinking. Just as the young people who got enamoured by Baba Ramdev and Baba Hazare got nothing done in terms of combating corruption, we should worry about what comes next on law and order. Anger and outrage, coupled with low knowledge of political science and public economics, is a sure path to poor policy analysis. What matters is shifting from anger to analysis to action.

As an example, if laws are modified to prescribe draconian penalties for rape, then rapists are more likely to kill the victim. What is required is better quality implementation of the existing law.

What would it take to make the police and courts work better? The three ingredients that are required are incentives for politicians, resources and feedback loops.

Incentives for politicans

The first issue is incentives for politicians. Politicians will deliver law and order if they think that this is what will get them re-elected. From Indira Gandhi's time onwards, politicians in India have felt that the way to win elections was to focus on welfare programs for the poor. As long as this is the case, the narrative that will dominate the Indian State is that of poverty, inequality, and welfare programs.

Economists distinguish between public goods and private goods. Public goods are defined to be those that are `non-rival' (your consumption of safety does not reduce my consumption of safety) and `non-excludable' (it is impossible to exclude a new born child from the environment of safety). The legitimate purpose of the State is to pursue public goods. All citizens gain from public goods, and all voters should respond to these benefits. The first and most important public good is safety, which requires building the army, the police and the courts.

The Indian State has, instead, gone off on the adventure of building welfare programs: of government giving private goods to marginal voters. The first priority of the Indian State is the themes of poverty, inequality and welfare programs. Politicians need to learn that this hurts. Sheila Dixit should realise that her top priority in Delhi is law and order.

There are undoubtedly problems in the leadership and management structure of the police. I believe that once politicians want law and order, this will drive them to recruit the leadership that is required, and undertake structural reforms, so as to get results. As an example, look at how the politicians broke with PWD and setup NHAI, or setup Delhi Metro. The question that matters is : Do politicians want law and order? From the 1960s onwards, the minds of politicians have been addled by welfare programs.

If Rs.X is spent as a gift on a few marginal voters, it makes a certain difference to winning elections. If that same money is spent on public goods -- e.g. better safety for all -- it should make a bigger difference to winning elections since more voters gain. The question is: Do politicans see this and act in response?


The second issue is resources. India needs much more staffing in the police and the courts. This includes both technical staff (e.g. constables and judges) and support staff (e.g. clerical staff, operators of computer systems, etc).

Courts and police stations need to be high quality workplaces with air conditioning, computer systems, modern office equipment, canteens, web interfaces to the citizenry, lighting, toilets, and such like.

Policemen need to live in high quality housing. If policemen live in high quality housing and work in high quality offices, they will be more civilised both in terms of the quality of intake and in terms of how their behaviour evolves on the job. This will cost a lot of money. The State in India has very little money. To improve the police and courts will require cutting back on welfare programs.

As Robert Kaplan says, underdevelopment is where the police are more dangerous than the criminals. One element of this is the biases in recruitment. As an example, the police in Bombay tends to be male Maharashtraian and relatively low skill. This needs to evolve into a more sophisticated workforce, with gender, ethnic and religious diversity that reflects the cosmopolitan structure of the populace.

At present, in India, spending on police and courts (which are core public goods) is classified as `non-plan expenditure' and is treated as a bad thing. Spending on private goods like welfare programs is classified as `plan expenditure' and grows lavishly year after year. In the UPA period, plan expenditure has gone up by four times in 10 years. These priorities need to be reversed.

The other critical resource, other than money, is top management time. The simple question that I would ask Sheila Dixit or Manmohan Singh is: What fraction of your time do you devote to public goods? My fear is that the bulk of their time is spent worrying about welfare programs. When the top management is not focused on law and order, safety will degrade.

The lack of safety is a regressive tax: it hits the poor more than the rich. The rich are able to insulate themselves at a lower cost. When a policeman faces me on the street, he immediately speaks to me in a certain way once he sees that I come from the elite. Poor people are mistreated by both criminals and the police. Through this, the number of votes that should be affected by improved law and order is large. The people who care deeply about the poor, and would like to focus the Indian State upon problems of inequality and poverty, should ponder the consequences of what they have wrought.

Feedback loops

In order to think about law and order, we need measurement. I used to think that the murder rate is high quality data. Over recent years, I have come to believe that in many parts of India, not all murder is reported to the police. In this case, we are at ground zero about the state of crime: we know nothing about how much crime is taking place out there.

What you measure is what you can manage. I had recently written a blog post about health, and the same issues apply here. Our first priority should be to setup crime victimisation surveys [link].

The most important outcome that I think matters is a question asked in a household survey of parents: Are you comfortable when your teenage daughter is out alone at 11 PM? That's it. That's the end goal. Civilisation is where parents are comfortable when their teenage daughters are out alone at 11 PM.

Once the CPI is measured, and measured well, RBI can be held accountable for delivering low and stable inflation. In similar fashion, the Bombay police can be held accountable once we get a graph updated every month about the crime rate in Bombay, supplemented by quarterly data from crime victimisation surveys. This would generate feedback loops whereby we can judge whether Sheila Dixit has improved law and order in Delhi on her watch.

When Sheila Dixit gets anxious about the lack of progress on publicly visible statistics about the state of law and order in Delhi, she will have the incentives to recruit high quality leadership for the Delhi police, and to resource them adequately, to get things done.

Why are these good things not getting done?

This is the hardest question. I have three opinions about what has been going wrong.

The first lies in the incentives of politicans. Why do politicians pursue private goods for a few when they can instead spend money on doing public goods that benefit all? Why does democracy not push Indian politicans towards the centre? I think one element of the answer lies in first-past-the-post elections.

Today in India, winning elections does not require pleasing all voters; it only requires a base of 30% of the voters. This gives politicans a greater incentive to dole out goodies for the 30% and not work on public goods that please all voters. This reduces the prioritisation for public goods.

The second issue is that of urban governance. The defining challenge for India today is to make the cities work. But our constitutional structure is confused on the location of cities versus states. The feedback loop from the voters in Bombay do not drive improvements in governance in Bombay.
Delhi is unique in this respect in that it's the first city of India where the basic structure is correct. Sheila Dixit is the Mayor of Delhi. She is held accountable for making voters in Delhi happy. Voters in Delhi bother to vote in the Delhi elections. Hence, I am far more optimistic about the future of Delhi than I am with Bombay.

The third issue lies in the intelligensia. Western NGOs, aid agencies and the World Bank are focused on inequality, poverty and welfare programs. This generates incentives for individuals to focus on inequality, poverty and welfare programs, owing to the funding stream and career paths associated with western NGOs, aid agencies and the World Bank. These large funding sources and career paths have generated a distorted perspective in the Indian intelligensia. We need more minds in India who think in terms of first principles economics and political science, without the distortions that come from the worldview of development economics.

We blame politicians in India for being focused on welfare programs. But to some extent, they are influenced by the intelligensia. It is the job of the intelligensia to hold their feet in the fire, and hold politicians accountable for public goods. The politicians were too happy when, from the 1960s, the intellecturals proposed welfare programs, poverty action, socialism, etc.


I am grateful to Pradnya and Nandu Saravade who helped me think about all this.

Friday, December 21, 2012

Next big development in the global market for the rupee

The next interesting development after ICE trading of rupee futures: CME will launch rupee futures soon also. See CME follows ICE into rupee futures by Tom Osborn on Financial News.

ICE and CME are the world's top exchanges and they are serious rivals for the global rupee market. These recent developments add up to a substantial change in the outlook for the rupee as an internationally traded currency. The rupee will become more prominent as a globally traded and liquid market. And, ICE and CME are likely to do well, thus accelerating the decline of the onshore market.

Thursday, December 20, 2012

Trade misinvoicing as a channel for capital account openness

A recent literature has explored the effectiveness of capital controls (Klein, 2012, Yothin, Noy and Zheng, 2012, Patnaik and Shah, 2012). In a recent paper on trade flows, we find that unofficial capital flows through the channel of trade misinvoicing are an additional mechanism through which the effectiveness of capital controls is eroded.

Trade misinvoicing

In the 1970s and 80s, when the literature first identified capital flight through trade misinvoicing, many countries had significant restrictions on trade. Aizenman (2004) showed that in countries that have capital account restrictions, greater trade integration creates greater opportunities to shift capital through trade misinvoicing.

In a recent paper (Patnaik, Sen Gupta and Shah, 2012), we find that de jure capital account restrictions are correlated with higher levels of trade misinvoicing. After controlling for factors such as macroeconomic stability, corruption, currency overvaluation, and political instability, the openness of the capital account influences trade misinvoicing. For each increase in the Chinn-Ito index of de jure capital controls by 0.1, export misinvoicing goes up by 0.8 to 1.3 percent of exports. On the landing page above, we have released the full dataset so as to facilitate replication and downstream research.

Based on this evidence, trade misinvoicing should be viewed as a channel for de facto capital account openness. Over the 1980--2005 period, the average extent of misinvoicing-induced capital flows in developing countries works out to roughly 7.6 percent of GDP. This is a substantial number when compared with the objectives of macroeconomic policy.

Traditional and new explanations

The traditional literature on trade misinvoicing has focused on two broad motivations for misinvoicing. First, it emphasised high customs duties. When firms face high rates of customs duties, or VAT on imports, they have an incentive to understate the true value of imports. Second, misinvoicing was viewed as a method for achieving capital flight, which was, in turn, motivated by fears of expropriation alongside unsound economic policy and political instability.

An overvalued exchange rate, and high inflation, gives expectations of depreciation in the near future and stimulates capital flight. Research on the determinants of the large outflows of capital from Latin American countries in 1980s and Asian economies in late 1990s has identified explanatory variables such as macroeconomic instability, large budget deficits, low growth rates and the spread between foreign and domestic interest rates. These factors, as well as others such as corruption, political freedom, and accountability were significant in explaining capital flight from sub Saharan Africa.

By the logic of this traditional literature, when countries like India and China achieved high GDP growth and cut customs duties sharply, the motivation for misinvoicing should have subsided. We find that by and large, such a decline in misinvoicing is not visible. Hence, we pursue a new explanation: that misinvoicing is a tool for evading capital controls.

Conventional estimates are likely to understate the phenomenon

The magnitude of trade misinvoicing is conventionally estimated by juxtaposing trade data from the importing and the exporting country. A firm interested in moving capital out of a country would underinvoice its exports, thus bringing reduced foreign exchange into the country. Similarly, overinvoicing of imports would allow the domestic importer to gain access to greater foreign exchange than required. Both these mechanisms leave domestic firms in control of hard currency assets overseas. Underinvoicing of imports, on the other hand, can result from an attempt to evade taxes on imports including customs duties and the Value Added Tax (VAT) on imports. These calculations are likely to understate the scale of misinvoicing on the current account for three reasons:

  1. The overall misinvoicing of imports that is computed using macroeconomic data reflects a certain cancelling out between some firms who are engaged in underinvoicing of imports and other firms who are engaged in overinvoicing of imports. Similar considerations apply with misinvoicing of exports. To the extent that firms have heterogeneous goals, the measured misinvoicing is likely to understate the true scale of gross capital flows being achieved through misinvoicing in an economy.
  2. Services trade offers substantial opportunities for misinvoicing given the lack of market benchmark prices for many services such as customised software. Many elements of services trade are not in conventional trade databases.
  3. Intra-MNC trade offers opportunities for misinvoicing that would not be captured in our methodology. When the importer and the exporter are one firm, there will be no discrepancy in the data, even if the value of a product is overstated or understated.

For these three reasons, conventional trade misinvoicing measures may understate the true extent of misinvoicing.

Conclusion and implications

The evidence on misinvoicing suggests that studies on the effectiveness of capital controls should also take into account unofficial flows through the trade account as these may be further eroding the effectiveness of capital controls. For example, there is interest in the extent of capital flight from China. While capital flight through official channels can be observed directly on the capital account of the balance of payments, significant capital flight might take place through the current account. Since the trade account for China is large, it provides a channel for capital movements. The discussion on whether there is capital flight from China cannot be settled without an analysis of its trade account.

It is sometimes argued that developing countries should open the trade account but not the capital account. This evidence suggests that once trade openness is achieved, a substantial element of de facto capital openness follows.

Tuesday, December 18, 2012

10th Conference of the NIPFP-DEA Research Program

As part of the NIPFP-DEA Research Program, we have been running a conference series in the fields of macroeconomics and finance. The 10th of these conferences was a joint effort with Journal of International Money and Finance: a subset of the papers will appear as a special issue on the Macroeconomic and financial policy challenges of China and India. The materials of the conference are up on the website.

Friday, December 14, 2012

Interesting readings

Ruminating over The Republic by Plato is the first step to thinking about politics and the State, and many angry young men that try to think about India do wrong by skimping on their intellectual foundations. Saugato Datta in Mint worries about similar problems in the domain of economics.

Ila Patnaik analyses the two kinds of criticisms of Aadhaar: (a) That a lot of money is being spent and this expenditure isn't justified and (b) That building Aadhaar will threaten civil liberties in India.

Trampling on the individual in India: Five ways Indian Internet users are fighting for free speech by Sruthi Gottipati on the India Ink blog on the New York Times website. Sec 66A: Curbs on free speech are part of Nehru family legacy by R. Vaidyanathan on FirstPost.

Emerging Markets Finance conference, 2012.

In thinking about Why is solving India's inflation crisis important?, see Does Inflation Harm Corporate Investment? Empirical Evidence from OECD Countries by Piotr Cizkowicz and Andrzej Rzonca.

Vivek Kaul has an excellent article in FirstPost about India's problems with ponzi schemes. Also see: Buying respectability. Ponzi schemes are one of the many consequences of the badly structured laws in Indian finance. We have created silos such as securities and banking, and existing agencies can wash their hands off what is going outside their jagirdari. The legal foundations must change in the ways proposed by FSLRC

In an interview with Akshai Jain on Tehelka, Arvind Panagariya says he isn't convinced the Indian child malnutrition data is horribly out of line.

Ila Patnaik on the role of FDI in non-tradeables as a essential element of competition policy, analogous to what trade does for tradeables.

Lant Pritchett and Shrayana Bhattacharya in the Indian Express on what cash transfers can do and what they cannot.

Evgeny Morozov has an amazingly well written article in the New Republic about new-age superficiality. Notes to self: One day I'm going to write such a hatchet job about a management guru or such like.

Joseph Sternberg has a great article on the things that went wrong when Bangladesh attempted industrial policy.

David Pogue of the New York Times is impressed at the new Samsung Chromebook . Hmm, $250 is Rs.13,000 for a laptop that's 1.1 kg, it is nice.

Tunisia, Libya, Egypt, Syria?, and after that Lebanon?.

Thursday, December 06, 2012

Tuesday, December 04, 2012

The problems of the economics profession

Ronald Coase has an interesting new piece titled Saving economics from the economics profession. You may like to see What is wrong with Economics on this blog.

Last week, in the US, I heard that the number of Ph.D. graduates coming out vastly exceeds the number of academic job openings. Most economics Ph.Ds. are going to end up in non-academic jobs. In fields like Physics, the basic arithmetic became clear early on. Each academic in a research university produces 12 Ph.D. students, on average, over his or her life. In steady state, 11 of them have to go into non-academic lives. For some time, in Economics, this phenomenon was masked by the rise of business schools and schools of government, which recruited a lot of economists. With that transition largely behind us, the simple logic of 1-in-12 comes back to hit us.

I feel the profession is not doing enough to prepare the 11-of-12 economics Ph.D. students for a life in the real world. I am a sunny optimist on the importance of economics in the real world. Whether it is Google or a hedge fund or a consulting firm: I think a good economist has a lot to say. But what we do to Ph.D. students is pretty bad. The skills required to succeed in academic economics seem to be precisely unlike the skills required to engage with the world. I feel that fairness to the students requires turning this upside down. We should be primarily training Ph.D. students to gear up to be useful in the real world, for only a tiny fraction of them will go back into academics.

Academic economics in India suffers from one additional layer of trouble: the legacy of development economics. India has moved on. Only 15% of Indian GDP is agriculture; the labour force is moving away from agriculture; only 20% of India is below the poverty line. This implies that development economics is of little use in thinking about India. Whether it is P. Chidambaram or Mukesh Ambani, the decision makers of India are not too interested in development economics.

The early days of physics shows us a nice three-step story. First, the datasets fell into place, with Tycho Brahe. Then came the empirical regularities, with Kepler. Once Kepler's laws were firmly established as hard facts of the data, you could curiously ask: Why might this be the case? And this gave us theory, in the hands of Newton. In economics, and particularly with economics in India, we are struggling with the first phase. We barely observe the economy.

When the physicists did not observe the world, the frontier lay in observation (Tycho Brahe), and not in the guys doing angels on pinheads. But in economics, in the early years, in the absence of data, the field got dominated by mathematicians analysing artificial worlds, the bulk of which was angels on pinheads exercises. Instead of looking at the world, we looked at blackboards and made up assumptions. Research papers got written by looking at other research papers, rather than looking at the world.

I am optimistic about where we will go from here, for the computer revolution is finally giving us datasets where there is high quality observation of the economy. E.g. retail stores are capturing scanner code data, financial exchanges see every order, massive databases of census or tax authorities are being prised open, google trends data is available, satellites measure illumination at night and give us estimates for the GDP of each square kilometre of the country every night, etc. The future of economics lies in data science. Just as astronomers are drowning in the data coming out of telescopes, we in economics will shake our heads in wonder, as we find our way around immense treasures of large datasets of high quality.

Yet, at present, most economists and economics Ph.D. students are focused on theory, or the old perspective where economics is seen as a part of axiomatic mathematics and not as an observational science. For most people in economics, there is a certain willingness to accept bad data and bad econometrics since all this is (in any case) just an excuse to get on with the thing that really matters, the model. Matters are made worse, in India, by the typical Western referee who does not ask questions about data quality. This gives the economist in India zero incentive to be careful about measurement, and gives us an equilibrium replete with garbage-in-garbage-out.

I don't want to overstate the problem. Things have changed enormously when compared with the 1970s and 1980s, when economics was almost entirely dominated by theory. Today, the most important work in the profession is applied. Applied papers get more citations. The ship is turning. But as Ronald Coase is saying, it's still far from where it needs to be.

Academic economics is a self-sustaining system, on the strength of the tuition fees paid by a large number of undergraduates who register for these course. There is relatively little pressure to change. The impetus for change will come from four directions:

  1. While wages for a small number of the superstars of the profession are sky high, most academic economists are not paid that well and are not experiencing real wage growth. This gives an incentive for some to engage with the world through consulting. Their work will matter.
  2. As Larry Summers has emphasised, a strength of the business school and the school of government (and the think tank) is that they engage with reality. They have incentives to look at the field with new eyes. The work done in these places will matter.
  3. The 11 of 12 freshly minted Ph.D.s who show up in the real world and puzzle over it matter a great deal. For the vast majority of them, the Economics Ph.D. will recede in their minds like a bad dream. A small fraction of them will do stuff that matters.
  4. The people with skills in data science will do unexpectedly cool things with the new datasets where we observe the economy. This stuff will matter.

Thursday, November 29, 2012

Rupee and Real futures at ICE

Intercontinental Exchange has announced cash-settled futures on the Indian Rupee and the Brazilian Real [press release] [Saabira Chaudhuri in the Wall Street Journal]. With this, ICE is the first serious global exchange to start trading in the rupee.

Vimal Balasubramaniam and I have pointed out that the global market for the Indian rupee is adding up to some fairly big numbers. I recently noticed that in 2010, even though China is a much bigger economy than India, rupee trading was 0.9 per cent of global currency trading while RMB trading was at 0.7 per cent. Similarly, it appears that the INR NDF is bigger than the RMB NDF, even though China is a much bigger economy. Something is going right in the growth of the rupee as a big currency by world standards. Rupee trading at ICE would strengthen that process.

The ICE announcement also connects to the issues of global competition for Indian underlyings. The two biggest financial markets in India are Nifty and the rupee. So far, NSE faced serious competition with Nifty futures trading at SGX and CME, but there was no significant rival with the rupee. With the arrival of ICE, the competitive dynamics for the rupee changes, which is a welcome development. NSE now faces genuinely difficult competition from three first-tier rivals: CME, ICE, SGX. At the same time, the outlook for rupee trading in India is hobbled by an array of constraints:

  • ICE can pitch for business from non-residents, while NSE cannot, since foreign participation in currency futures is banned. We seem to think that OTC trading of currency forwards requires encouragement from industrial policy operated by RBI.
  • ICE is able to start contracts any time it likes on (say) the Brazilian Real while NSE is forbidden from starting any new contracts.
  • India has mistakes on tax treatment, lacking residence based taxation, while the world has all this well sorted out.
  • India has an array of other policy and regulatory mistakes that hobble local players. The ICE transaction charge is zero. I wonder if litigation will now start at CCI to try to block this.
A process is afoot, at present, through which the Indian financial system is being hollowed out. If this process runs unchecked, RBI and SEBI will be left lording over nothing. There is a need to reverse this  policy framework of reverse protectionism.

Sunday, November 25, 2012

Interesting readings

A talk by Pratap Bhanu Mehta.

Governance 2.0 by Ila Patnaik, on the notions of autonomy and independence for agencies like the CVC.

Trampling on the individual in India:
Jim Yardley in the New York Times. An `Oppressive' Regime Limits Free Speech in India, Civil Liberties Expert Says in the New York Times. How two Mumbai girls changed the Thackeray conversation by G. Pramod Kumar on Firstpost.

Why are India's politicians scared of social media? by Mahima Kaul on UnCut. Conceived in haste, India's Internet law now targeted for change by Niharika Mandhana on the New York Times. It is not enough to solve the IT Act, we need to fix the IPC also.

Ila Patnaik on what ails the Indian economy today: Growing pains and Policy easing won't lift investment.

In the aftermath of the Emkay crash [link, link], Mobis Philipose in Mint worries about where SEBI is going.

A great piece by Devesh Kapur on how wrong Indian official thinking in higher education is.

Morten Jerven on economic measurement in Africa. Seems like a fair description of Indian official statistics to me.

Shareholder lessons: Stay away from Ponty Chadha-like businesses by Arjun Parthasarathy, is linked to a theme from Indian capitalism is not doomed.

One head is better than many: Ila Patnaik on the need for modifying the present Indian financial regulatory architecture.

The misery of a sixteen year old in 1984 in the USSR.

A great debate between Justice Scalia and Justice Breyer of the Supreme Court of the United States.

Marco Arment walks into a new Microsoft store. And, see Charlie Demerjian on the difficulties that they face. Jakob Nielsen, the expert on usability, analyses Windows 8 on the tablet and the computer. So far, the market is giving Microsoft a thumbs-down, with a -9% return over the last six months, net of macroeconomic fluctuations..

Tuesday, November 20, 2012

Did the Indian Capital Controls Work as a Tool of Macroeconomic Policy?

A recent article: Did the Indian capital controls work as a tool for macroeconomic policy, Ila Patnaik and Ajay Shah. IMF Economic Review, page 439--464, volume 60, 2012.

At the main page for this paper, you will find all the materials: a video presentation, PDF paper, link into the journal, a compact summary on voxEU.

Thursday, November 15, 2012

The IRR of UIDAI is over 50 per cent in real terms

We have released a cost-benefit analysis of the UID system. In one line, the result of the calculations, under fairly conservative assumptions, is that the IRR of building the system is 53% in real terms. Hence, building UIDAI is a pretty good use of public money.

Through this page, you can access a short and accessible explanation, a video presentation, and the full PDF paper. We have also released the spreadsheet used in our calculations, so that others can modify the assumptions or other numerical values, and obtain alternative answers.

This is true in the Indian case. Is it true in general? I feel the answer depends on (a) The scale of expenditure on subsidy programs and (b) The extent to which present implementation systems suffer from the kinds of leakages that UID readily addresses (multiple payments to one person, payments to ghosts). If a country has small welfare programs, that would undermine the case for UIDAI. If a country is doing a pretty good job of paying out subsidies through conventional procedures, that would undermine the case for UIDAI.

Monday, November 12, 2012

Land and property rights workshop at IRMA, Anand

Venue: Institute of Rural Management, Anand (Gujarat).

Dates: 04-06 December 2012.

In recent years, land related issues have emerged at the top of the social and political agenda. A three day workshop on theoretical aspects and practical implications of property rights for rural transformation is being organised at IRMA, jointly with ARCH, Gujarat, and Liberty Institute, New Delhi, with the support of Friedrich Naumann Foundation.

The workshop will deal with topics such as the political evolution of property rights, their constitutional significance, the changing nature of land conflicts, the significance of property for economic well being, political empowerment and democratic participation. The Forest Rights Act provides a practical illustration of the changing contours of the discourse. Both national and international legal instruments around property will be discussed. The objectives of the workshop are:

  1. To deliberate on the significance of property rights as a pro-poor instrument
  2. To create a network of scholars and practitioners around property and land rights
  3. To gain ground level understanding of the progress in forest rights implementation

Please visit, to get a glimpse of a new initiative which allows remote rural communities to document and map their own land. If you are interested, contact and see the details.

Sunday, November 11, 2012

Macroeconomics workshop at NIPFP on 12 November

Five papers in macroeconomics at NIPFP tomorrow. All are invited.

I should like to call you all by name

Friday, November 09, 2012

Blindly sending money down leaky pipes

Proposals to spend more on government programs in India are generally criticised on the grounds that this is sending more money down a leaky pipe. In addition to the problem that the pipes leak, there is an equally big problem that we have no idea about what happens at the other end.

In order to build and refine a system, the first foundation that has to be laid is that of measurement. What you measure is what you can manage. In India, all too often, government agencies and programs start out with lofty ambitions, and embark on spending money to get there. But there is little measurement about the extent to which those objectives have been achieved. Under these conditions, there is little chance of programs being designed properly, and of wastage and theft being checked.

I was reminded of this as I read As Dengue fever sweeps India, a slow response stirs experts' fears by Gardiner Harris in the New York Times. There may be an epidemic of Dengue out there. Or there might not be one. The point is, we just don't know. The statistical system simply does not measure this.

A public goods perspective

What should government do, and what should government not do? The government should work on the provision of public goods and stay out of private goods. In the field of health, what are the public goods and what are the private goods?

When I have a toothache, and I go to a dentist, and I get better, this is a private good. Yet, most government spending is oriented towards building `primary health centres' and hospitals and such like. Even if these worked well -- i.e. even if they were not characterised by theft and incompetence -- they are a bad use of public money as they deliver private goods and not public goods.

A public good is something that is `non-rival' (my consumption of that good does not reduce your access to it) and `non-excludable' (it is not possible to exclude me from benefiting from this good). The best example is clean air. My breathing in clean air does not diminish the amount of clean air available for you. When one more child is born, it is not possible to exclude him from benefiting from clean air.

What are the public goods in health? A few examples that come to mind:
  • Statistics. Measurement of what is going on about health in India.
  • Epidemiology. Tracking down and eradicating Smallpox. Mounting a response to fresh strains of the common cold.
  • Running public systems that measure and ensure that medicines are not counterfeited, are properly stored in a cold chain.
  • Running certification systems. Enforcing against quacks that practice medicine.
  • Getting research done on diseases that matter on India, and releasing the findings into the public domain (i.e. unencumbered by patents).
We in India have this essentially upside down. Health policy in India is unfortunately shaped by the views of doctors, and is low on skills in public economics. We like to focus on Primary Health Centres that are run by the government, and we cut corners on all the five critical public goods listed above.

It is fashionable to say that India should spend more on health. I would advocate spending less on the things that the Indian government does in health. Until the pipes are fixed, we should be closing the taps.

An objectives-and-accountability perspective

The Indian State is in a crisis. The two key factors at work are mission creep and a lack of accountability.

Mission creep has set in because in India, almost any do-gooding is seen as the responsibility of the State. We need to narrow the mission statement of the State to a tangible set of public goods. Clarity of mission, and a controlled and narrow mission, is of essence to obtaining performance.

Consider the principal-agent relationship between you and your contractor. If the contractor is failing to deliver, you would narrow down the specifications given to him, and monitor him tightly to make sure the work gets done. That is precisely what we need to do, in the principal-agent relationship between citizens and the State. The State has failed on a sprawling mission. We need to narrow down the tasks given to the State, and tightly monitor the delivery of results.

Government and government agencies will work well when they have narrowly defined functions and strong accountability mechanisms. In the field of health, absent measurement of health outcomes, there is no accountability.


Is there a Dengue epidemic in India? We don't know.

An information system about the health of the people of India is a public good. It should achieve pride of place in the responsibilities of the State. However, health expenditures in India are squandered on private goods. To add insult to injury, there is theft and incompetence, so even these attempts at delivering private goods do not work so well. But the main point is that running PHCs and hospitals should not be done, even if the Indian State had the ability to run these things well.

In order to reconstruct the Indian State, we need to push on the combination of narrowing the mandate (focusing on a few core public goods) and strong accountability mechanisms.

Finding the right path in consumer protection

by Anand Sahasranaman.

The recent approach paper of the Financial Services Legislative Reforms Commission has brought a fresh focus on consumer protection. What are the possible frameworks for financial consumer protection in India, and what would be the core elements of an ideal framework? This is the question that the IFMR Financial Systems Design Conference 2012 sought to answer. The Conference titled Envisioning the Future of Financial Consumer Protection in India was held at IFMR Trust, Chennai, on 31st August and 1st September 2012.

The Conference was designed to take a first principles look at financial consumer protection, deliberately setting aside constraints that reflect the current realities of the Indian context of consumer protection. The conference was organised to carry out deliberations around three stylised approaches to consumer protection, namely: an Emphasis on Disclosure, an Emphasis on Eliminating Conflicts of Interest, and an Emphasis on Suitability. In reality, any consumer protection framework would include elements from all three approaches, and the objective in setting up the conference as a debate between approaches was meant to sharply identify the way in which these approaches would fit into an overarching framework for India.

Keeping in mind the two-fold agenda of creating a framework for solving the current failings of the Indian market and providing a meaningful long-term solution for consumer protection in view of the future of Indian finance, Suitability emerged as the paradigm of choice to be placed at the heart of the consumer protection framework for India. The Suitability framework shifts the onus of consumer protection from the buyer to the seller of financial services through legal liability on the latter. However, it was also felt that very important aspects of Disclosure and Eliminating Conflicts of Interest would need to be built around this foundation of Suitability.

A Suitability Framework

Suitability is defined to be a process that pervades all functions within financial services manufacturers, intermediaries, and their representatives, such that at all points of time, the provider acts in the best interests of the consumer. The power of the Suitability framework will derive from the imposition of legal liability on financial services providers to act in the best interest of consumers, and thus decisively shift the onus of consumer protection from the buyer to the seller.

Suitability will not take away the right of the consumer to choose. The final decision, on whether to accept the financial advice or buy the product recommended by the seller must always lie with the consumer. What Suitability is meant to ensure is that the consumer gets expert unbiased recommendations that are in her best interest.

For Suitability to be realised, every citizen must have the right to be provided suitable advice or recommended suitable products. The principle of Suitability needs to be enshrined in mother regulation and the interpretation of suitable behaviour would be best determined by the build-up of case law precedents over time, thus ensuring that our understanding of Suitability comes from the realities of the financial marketplace and its evolution over time

Role of Disclosure in Suitability Framework

India has so far relied on caveat emptor, or a disclosure based framework of consumer protection. Participants however noted the fact that increased disclosure has resulted in information-overload for consumers and, along with behavioural biases, led them to make sub-optimal decisions resulting in bad financial outcomes. Despite this, it was felt that there were aspects of Disclosure that would be essential in a Suitability framework. Within the Suitability framework, it was felt that disclosure of real time transaction level data that could be meaningfully analysed be analysed by neutral third parties - industry analysts, financial advisors, market aggregators, media - or "wholesale" consumers could be useful in developing comprehensible welfare enhancing consumer-level outputs. Other aspects of Disclosure such as the need for comparators and benchmarks for products, and the need to make some financial terms commonly understood were also deemed important.

Eliminating Conflict of Interest in the Suitability Framework

Regulatory regimes all over the world have used a variety of approaches to eliminate conflicts of interest that exist within providers of financial services. The most common approach is to disclose the existence of such a conflict to consumers and let the consumers decide for themselves. Within the Suitability paradigm, however, eliminating conflicts of interest is naturally built through the legal liability channel. Even in scenarios where is it is not possible to separate out advice from sale, given the legal liability in the form of a fiduciary responsibility on the provider, the provider is obligated to ensure that they act in the best interests of the consumer, ahead of their own self-interest.

The conference also raised a number of questions for research on the Suitability framework related to its implementation, legal framework, regulatory and institutional costs as well as lessons from international experiences.

The detailed conference proceeds can be found here.

Tuesday, November 06, 2012

Modified dates for financial law seminar

In consideration of a number of requests for extension of the last date for paper submission for Financial Law & Policy: An Inter-disciplinary Approach, the dates for submission of paper and intimation of shortlisted papers have been extended which are as follows:

Crucial Dates

  • The last date for submission of the completed paper: November 12, 2012 (23.59 hrs)
  • Intimation of shortlisted papers: November 20, 2012
  • Date of the seminar: December 01, 2012

Other details about the seminar are as provided in my earlier post.

Monday, October 29, 2012

Rethinking the Statutory Liquidity Ratio (SLR) in Indian banking

by Harsh Vardhan.

The CEO of a leading bank recently caused a flutter in the banking community by demanding the abolition of the Cash Reserve Ratio (CRR). RBI has promptly appointed a committee to look at this issue. The reserve ratios, CRR and SLR (Statutory Liquidity Reserve), are an important feature of Indian banking regulation. Alongside the debate about CRR, and new thinking about how monetary policy should be conducted, we should also review the SLR. SLR is a much bigger burden on the banking system and has no role in monetary policy.

What is SLR?

SLR is the requirement imposed by the regulator on commercial banks that compels them to invest a percentage (currently 24%) of their Net Time and Demand Liabilities (NDTL) in approved government securities. Through this, today, 24% all the resources - deposits and borrowings - mobilised by commercial banks are invested in government securities. Currently bank deposits and borrowings are Rs.7 trillion which means that SLR places Rs.1.8 trillion into purchases of government securities. SLR creates a significant captive source of financing its borrowing program. This has three important implications:
  1. SLR reduces the resources available for commercial lending by banks. Every rupee deployed in SLR is a rupee not invested in a private enterprise that needs capital. There is no free lunch: when capital given to the government, it comes at the cost of capital available to the private sector. Any reduction in the SLR (as in the CRR) will yield more capital for the Indian private sector. It is hence important to critically analyse both.
  2. By creating a large captive source of deficit financing, SLR effectively subsidises government at the cost of savers and commercial borrowers. When a government has to borrow at a competitive rate in the market, the market exerts a check on irresponsible fiscal behavior of the government. When there is a large captive source of borrowing, the government is shielded from the pressures of the bond market and is more likely to engage in fiscal imprudence.
  3. Such a large scale preemption of savings by the government through SLR fundamentally distorts the interest rate structure in the economy by artificially depressing the yield curve. This complicates the pricing of all assets in the economy.
If we want to "right-size" SLR we have to ask some important questions:
  1. What is the rationale for imposing SLR?
  2. What is the right level of SLR, that is consistent with this rationale and does not result in preemption of resources from the banking system?
  3. Are there other conditions that need to be imposed on SLR so that it achieves the objectives?

The rationale for SLR

What is the conceptual foundation for the regulator to impose SLR? The answer is: prudence. Banks raise public deposits with a promise to redeem them at par or more. To reduce the risk of the portfolio of the bank, the regulator ensures through SLR that at least some part is deployed in the safest assets available. But if prudence is the reason, what is the right level of such reserves that will ensure adequate prudence? Could it be that imposing a requirement as high as 24% is beyond prudence, and is actually a means for the government to preempt savings in the economy? It is hence important to ask the next question: What SLR do we need?

What is the right level of the SLR?

Banks are in the business of taking risk. These risks are taken by deploying public deposits. The most potent weapon that the regulators have used against excessive risk taking is "risk capital" which the equity capital committed by the banks owners. In fact, the entire edifice of modern day bank regulation is based on provision of risk capital as a buffer against risk taking by banks. If we believe, as do most regulators, in risk capital as the buffer against risks, then it makes eminent sense for banks to hold this capital safely. This would logically lead us to conclude that prudence should demand that the bank's risk capital be held in very safe assets. In India, the risk capital requirement is 9% of risk assets which translates roughly to 6.5% of NDTL (given that the risk assets are typically 70% of NDTL). Therefore, the policy prescription should be: Banks must hold their entire risk capital in safe assets which should include both CRR and SLR.

Even if we assume the CRR is zero, this means that the theoretically right level of SLR would be around 6.5% of NDTL. If we scan the international landscape, this is the sort of number that we see in most countries. It is reasonable to argue that an SLR value above 6.5% of NDTL is motivated by pre-emption and not prudence. When the regulator prescribes a level of 24% for SLR, 6.5 percentage points are for prudence and the remaining 17.5 percentage points is really preemption by the government.

The composition of SLR

The next important question about SLR is about its composition - what investments should qualify as SLR investments? Currently securities issued by the sovereign (Central and State Government bonds) are the only ones that are allowed as SLR investments. But if we accept prudence as the logic for SLR, then the regulation must make sure that these investments are as safe as they can be. This raises concerns about the rating threshold and of concentration risk. If Indian government securities are rated BBB and that of New Zealand government are AAA, it makes sense for banks to hold SLR in New Zealand Govt securities. Also, there should be limits on any individual issuer of securities, reflecting the standard risk management practice followed by any portfolio manager.

The ideal SLR

Putting all the arguments above provides us an ideal construct of SLR as follows:
  • SLR is imposed for the purpose of prudence and hence the operative principle is that banks should hold all the regulatory required risk capital in SLR
  • The level of SLR should be consistent with the objective of prudence and anything over such a prudential level should be considered as preemption, which should be gradually eliminated.
  • SLR should be invested in top rated securities available globally; furthermore there should be concentration limits on single security and issuer

Dual limits structure for SLR

In the short term, it would be hard to come close to the ideal SLR outlined above. But there are some incremental changes that can be made without fundamentally altering the current framework that could provide banks with much greater flexibility. The regulator could prescribe 2 separate limits as follows:
  • L1: is the minimum level of SLR that a bank would normally maintain
  • L2: "core" SLR - a minimum below L1 that the banks can go down on SLR as long as the difference is only through repo arrangement on SLR with another bank
What does this mean? Let us assume that L1 is pegged at the currently prescribed level of 24%. We then define another limit, L2, which is closer to the prudential requirement of 6.5%. For simplicity, let us assume that L2 is set at 10%. This policy would demand that all banks maintain SLR at 24% but could go down this level upto 10% if and only if they enter into a repurchase agreement (repo) with another bank. Such a policy will mean that the banking system as a whole will continue to hold 24% SLR and so the government will continue to have access to this captive source of funding deficit. However, individual banks would be able to go down to lower levels if they have commercially viable opportunities to do so. Without diluting the overall investment by the banking system in government securities, it would provide significant flexibility to individual banks on commercial lending. In this respect, it is analogous to the idea of tradeable certificates for priority sector lending.

Saturday, October 27, 2012

One tangible pathway to fighting corruption: Increasing the disclosure by firms and politicans

While many researchers have started studying corruption, as of yet, the field is remarkably bereft of tangible policy choices that would yield reduced corruption. As I read The other side of reforms by A. K. Bhattacharya in the Business Standard, and Obtaining financial records in China by David Barboza in the New York Times (which describes the modus operandi of the New York Times' remarkable expose of corruption in China at the level of the Prime Minister, also by David Barboza), I thought there is one tangible policy lever through which we can combat corruption: Increase the transparency of companies and increase the transparency of politicians.

Transparency by firms

It is useful to think at two levels: Transparency about the activities of companies created by politicians, and transparency about the activities of the big companies that pay bribes. I am reminded of the Extractive Industries Transparency Initiative. One element of this is an attempt to change the behaviour of repressive regimes (e.g. Russia) by forcing the companies that deal with them (e.g. BP) to behave differently. Even if the politicians are irredeemably bad, we can change things by modifying the incentives of the firms that pay bribes.

In a recent post, Indian capitalism is not doomed, I argued that the markets for labour and capital are exerting pressure on firms, pushing them towards higher ethical standards even under conditions of medium grade enforcement by the State. To the extent that the firms are more transparent, their misdeeds are more likely to be exposed, and then these kinds of pressures will work more effectively.

At present, the MCA-21 database is clumsy and painful, but it's a step forward in one respect: It does yield some information about many companies. This has been of value in tracing the activities of the companies controlled by politicians and their business partners. This process needs to be carried forward in many dimensions:
  • At present, the P&L statement of "public" companies is publicly visible in MCA-21. This definition needs to be widened so that the P&L statement for many more companies become publicly visible.
  • The disclosure environment for listed companies in India is quite good. There is no quarterly balance sheet; the shareholding pattern statement is misleading; there are a few other blemishes. But the information access for listed companies is vastly greater when compared with what's in MCA-21. Many features of the disclosure regime for listed companies (where the work is led by SEBI) need to go into the disclosure regime for all companies (were the work is done by the Department of Company Affairs).
If private limited companies become more transparent, politicians will try to use trusts and limited liability partnerships for their activities. Improvements in transparency should extend to LLPs, trusts and partnership companies also.

Transparency by politicians

Alongside a push for greater transparency by firms (both the big listed companies and the firms created by politicians), we should be pushing towards greater transparency by politicians. This push towards transparency has begun, and has started yielding some results. It needs to be carried forward. The comprehensive financial lives of MPs, MLAs, and their next of kin should be in the public domain. The transparency regime should kick in when a person wins an election, and should stay in place for atleast 10 years from that starting date. Any company or LLP with shareholding of more than 1% by an MP or an MLA or their next of kin should have to comply with the comprehensive disclosure manual of SEBI for listed companies. Any trust when an MP or an MLA or their next-of-kin is a trustee should have to similarly fall into a high quality disclosure framework.

Privacy is precious

There is a tradeoff between privacy of citizens and corruption control. There is value in protecting the privacy of the business dealings of individuals. Perhaps, at the early stages in the formation of the Republic, where we're grappling with basics of governance, there is a case for violating the privacy of individuals in the quest for improved cleanliness in public life. Over the years, as the State falls into place, a greater push for privacy would be desirable.

Interesting readings

A. K. Bhattacharya in the Business Standard on how the UPA is faring well without Pranab Mukherjee.

As we ponder the fundamental challenges that India faces, it is interesting to read Boss Rail by Evan Osnos in New Yorker magazine.

India's new approach lets individual states take the lead on development by Simon Denyer in the Washington Post.

Madhavi Goradia Divan in the Indian Express on defamation law.

Towards better financial regulation and What is regulation for, by Ila Patnaik, on the big picture of the FSLRC approach paper.

One head is better than many by Ila Patnaik. Let's not repeat the mistake of the RBI Amendment Act of 2006, she says.

In the mood for reform by Ila Patnaik in the Indian Express, on the fresh push by the UPA government.

The Evolution of India's UID Program: Lessons Learned and Implications for Other Developing Countries by Frances Zelazny.

Great post-mortems of the Sahara case: Tony Munroe and Devidutta Tripathy on Reuters, and Tamal Bandhyopadhyay in Mint. These stories helped form my arguments in the recent blog post Indian capitalism is not doomed.

Most of us take a certain degree of Internet access in India for granted. But not so long ago, getting to the net in India was nightmarishly hard. A story on FirstPost tells us about the early days, with an appropriate accent on Ernet, the pioneer which made all this possible.

Don't bring your cell phone to meetings in China, you might get hacked by James McGregor on Quartz.

The difference between reality and fiction is that reality doesn't have to be plausible. I was quite gloomy about what might happen with Iran's nuclear program, but for the second time in history, it is starting to look like sanctions might work.

Quants aren't really like regular people by Izabella Kaminska in the Financial Times.

Charles Duhigg and Steve Lohr tell us, in the New York Times that In the smartphone industry alone, according to a Stanford University analysis, as much as $20 billion was spent on patent litigation and patent purchases in the last two years - an amount equal to eight Mars rover missions. Last year, for the first time, spending by Apple and Google on patent lawsuits and unusually big-dollar patent purchases exceeded spending on research and development of new products, according to public filings.

Two great stories about Barack Obama in Vanity Fair: The Hunt for `Geronimo' by Mark Bowden, and Obama's way by Michael Lewis. While on this subject, see Time magazine on Robert Gates. These three articles give us a sense of the gap that we face between governance in India today and that seen in a sophisticated country.

David Quammen has a great story about zoonoses. In it, I learned that we now know that one animal reservoir of Marburg is the Egyptian fruit bat.

Nineteen seventy three, a story by Alan Bellows that takes us back to how the world looked in the early 1970s.

Offtopic: Here is a fabulous example (best viewed on a 30" monitor) of Google Art Project.

India's inflation crisis, and what this means for monetary policy

The graph above shows headline inflation in India, i.e. year-on-year CPI-IW inflation. The informal target zone for policy makers in India is to have year-on-year CPI-IW inflation between four and five per cent. This is shown on the graph as blue dashed lines.

From February 2006 onwards, inflation breached the upper bound of five per cent. It has never come back below five per cent. The red line shows the overall average inflation from 1999 to today: it is well beyond the upper bound of five per cent. If our informal goal was to get inflation between four and five per cent, we have failed to do this as measured by average inflation from 1999 onwards (averaging across both good periods and bad).

Our loss of price stability is a major weakness of macroeconomic policy. It has far reaching consequences and hampers the extent to which the economy is able to get back onto a stable growth trajectory.

That's the big picture. Now let's look at current inflationary pressures. For this, we must look at the month-on-month annualised changes in the seasonally adjusted CPI-IW. This data shows difficulties in 2012:


The target -- year on year CPI-IW inflation -- is the moving average of the latest 12 values of month-on-month inflation. If we hope to get y-o-y CPI-IW inflation below 5 per cent sometime in the coming six months, then the latest six months should contain good news. But there isn't a single month of data in 2012 where the month-on-month CPI-IW inflation was within the target zone of four to five per cent. It is, hence, likely that we're atleast a year away (if not more) for y-o-y CPI-IW inflation to drop below 5 per cent.

Inflationary expectations are in excess of 10 per cent; the policy rate expressed in real terms is negative. Under these conditions, I fail to see how many people are thinking it's time for RBI to cut rates.

As India becomes a middle income economy, and experiences business cycle fluctuations, we're going to require a quantum leap in the institutional and human foundations of macroeconomic stabilisation. One key component of this is an institutional commitment at RBI to deliver low and stable inflation.

Some argue that private sector confidence, and stock prices, will be boosted by a rate cut. Will it? Will the private sector be impressed by a display of low institutional capacity? Will lower rates foster investment? I'm curious to see how this will work out.

Wednesday, October 24, 2012

The young are getting away from agriculture

Who does agriculture in India? Here's some fascinating evidence, from the CMIE Household Survey for the quarter Apr-May-June 2012. This is a survey of 700,000 individuals in 150,000 households all across India, both urban and rural. Let's look at the share of the working population, in each age group, that's engaged in agriculture:

Age 15-20 19.69
Age 20-25 21.22
Age 25-30 24.70
Age 30-35 28.22
Age 35-40 30.91
Age 40-45 32.76
Age 45-50 34.75
Age 50-55 36.96
Age 55-60 40.02
Overall 31.31

As we see, in the overall dataset, 31.31 per cent of the working population is in agriculture. CMIE shows three categories of this -- `Small farmer', `Organised farmer' and `Agricultural labourer'. I have added up these three categories to make the table above.

That 31.31 per cent of the Indian workforce is in agriculture is fairly well known. What I had not thought about, previously, is the age structure. Will agriculture have a bigger share of young or old workers? We can envisage two competing effects. On one hand, if a family has underemployed young ones who are engaged in agriculture by default, then we'd see a lot of young people in agriculture. On the other hand, if families try hard to get their kids off the farm, and the growth in industry and services in India is successfully absorbing this workforce, then we should see a smaller share with the young.

The evidence above favours the latter story. The share of the overall workforce which is engaged in agriculture is 31.31%. But amongst the old (age 55-60), the share is higher at 40.02%. This share steadily drops as you get to the young. In the class of the working young (i.e. age 15-20 but a part of the working population), just 19.69% are in agriculture.

Perhaps there is greater malleability of human capital with the young: the old may not be able to easily pick up the skills required to participate in the modern world of services and industry. When the shift of a worker into services or industry is accompanied by migration, it adds up to a powerful engine of social and economic modernisation. It is a powerful mega-trend that is reshaping India today.

The agricultural workforce is greying. There are many divides between the old India and the new one. This evidence suggests one more: the old world of agriculture is disproportionately one of the old, while the new worlds of industry and services are disproportionately manned by the young.

This data helps us understand India's demographic dividend. Many people worry that services and manufacturing in India will not absorb the great surge of young people in India. If that was the case, there would be a lot more people in agriculture. Instead, we see only 20% of the young depending on agriculture.

The application of sound economic principles in the field of agriculture will give us a situation where no more than 5% of the workforce is required there. At present, agriculture is using up 31% of the workforce. This gives us a headroom of an additional 25% of the workforce which can move out. This movement would give a one-time improvement in GDP because the per-worker output in industry or services is greater than that seen in agriculture. But these effects are diminished with the young, where the alteration that's feasible is smaller: from 20% to 5%.

For an interesting comparison against China, in 2007, roughly 10% of the workforce was in agriculture in the age group from 16 till 35. By the time you got to the age group of 41-50 (in 2007), roughly 45% were in agriculture.  By 2012, China has reached a point where there is relatively little upside for GDP growth by getting workers out of agriculture. The Indian evidence for 2012 looks similar to China of 2004, so India is perhaps 10 years away from this loss of upside in GDP growth.

Tuesday, October 16, 2012

Preventing shocks or becoming resilient to them?

My previous blog post, on not cancelling trades after a fat finger trade, elicited some interesting email conversations. In a nutshell, there are two views of the world. One camp argues that it is important to prevent fat finger trades and other such weird episodes. This requires building an array of preventive measures. The other side argues that the costs of prevention are high, and what's really important is to make a resilient market that is able to absorb shocks.

Prevention is difficult for two reasons:

  1. NSE and BSE are some of the biggest exchanges of the world. We should be pleased that India has two of the great factories of the world doing order matching. But as a side effect, NSE and BSE are at the limits of what today's CPUs can do. Many, many orders are placed, compared with the number of trades. Pre-trade checks are expensive because the number of orders is high. Fairly trivial notions of pre-trade checks can triple the hardware requirements or worse. We have to ask ourselves: Is it worth driving up the cost of transacting by 3x or 5x or 10x in order to do those checks? In addition, pre-trade checks introduce delays ("latency") which are not good for the trading process. When an order is placed, the person wants an instant confirmation that it was placed into the order book and ideally matched. More work in screening orders before the trade increases the latency suffered by traders. This, in turn, increases the risk faced by various trading strategies, which has adverse implications for market liquidity and market efficiency.
  2. What validation rules would you write, pre-trade? There is a danger of fighting the last war. New kinds of problems will inevitably surface in the future. Will we keep on increasing the burden of pre-trade computation, over the years, as the list of potential difficulties goes up through time?
There is a shades-of-gray dimension here. It appears obvious to us that if a computer program is buggy, and puts in a wrong order, this should be blocked. But what when a man-machine hybrid (the typical human trader that operates a computer) makes a mistake? What about a pure human trader that makes a mistake (e.g. saying on the phone "buy me 25 million shares of Infosys" when he meant "buy me 25 million rupees of Infosys")? Where do you draw the line?

It is better, instead, to see that mistakes are an inevitable part of financial markets. I would argue that pre-trade computation should be kept to the bare minimum, and that it is instead important to focus on deeper initiatives that will make the market more resilient. We need more eyeballs, more capital, more limit orders, more arbitrageurs, more algorithmic trading, more short selling. This is what will make the market resilient. A resilient market is one that is ready to accept a diverse array of unpredictable shocks in the future. Until a few weeks ago, we never imagined an order for 17 lakh nifties could be placed. The market did well in absorbing this completely unanticipated shock. The market should be a flexible, intelligent, resilient construct that is ready for all sorts of unexpected events of the future.

Some people say: "We should put in infinite expenses in order to screen orders". This reflects a lack of  economic thinking. The strategies of prevention and cure need to be evaluated from a cost/benefit perspective. Each features tradeoffs. Driving up the charges of an exchange by 3x to 10x, and increasing the latency suffered by every market participant, is a big cost. This should be weighed against the benefits.

I am reminded of a great story told by the Chilean economist Raimundo Soto at a NIPFP/DEA Conference in 2009. He started by describing a cautious 80-year old person, who is very careful about what he eats, who avoids stepping out of the house, and so on. He stays alive, but is perennially afraid that a small sickness will bring him down. And, indeed, when one small common cold comes along, it can have catastrophic consequences for him. Compare this with a 15-year old prancing around the world, tumbling in the dirt, taking risks, and living a great life. He is exposed to many illnesses, but rapidly bounces back from each of them.

Raimundo Soto said that the analysis of capital account convertibility should be rooted in the desire to become this 15 year old rather than this 80 year old. We should be asking: How can the system be made more resilient to shocks? We should not aspire for a Chinese Wall of capital controls that cuts India off from the global financial system; instead we should be doing the things that make India resilient to international shocks - such as develop a sophisticated Bond-Currency-Derivatives Nexus.

In similar fashion, too much of the conversation in India, after the Emkay fat finger trade, is about asking How can such shocks be prevented? I think we should aspire to be like the 15 year old and not like the 80 year old. The really important question is: How can the system be made more resilient to such shocks?

Saturday, October 13, 2012

Cancelling trades on an exchange: When is it a good idea?

When inexplicable things happen on an exchange, many people argue that those trades should be cancelled. I think it is useful to be clear about the test to apply for this.

The key question should be: Did something foul up in the order matching software? If order matching went wrong, or if there was a systematic breakdown of connectivity to the exchange, then there is a case for cancelling trades. We'd say that persons placed certain orders, but the exchange mis-handled the orders, hence the observed series of matched trades and prices is unfair.

If the exchange and its rules worked as advertised, this reason peels away. In fact, I would argue that particularly when there is a fat finger trade or something like the US `flash crash', it is important to not cancel trades, to cement faith in the trading process.

The recent events surrounding the fat finger trade by Emkay are a good example of this line of thought. Owing to a human error,  a basket trade to sell Rs.17 lakh of Nifty was instead placed as an order  to sell 17 lakh nifties (where one `nifty' is a basket of 50 shares adding up to the present level of the Nifty index expressed in rupees). If Nifty is at 5000, then an order for "100 nifties" is an order for Rs.500,000.

Through this human error, a very large sell order appeared on the market. At that instant, everyone looking at the market would have been taken aback. What was going on? Has a huge event unfolded which some informed speculator knows about, but I do not know about? It takes nerve in that moment to be on the other side of the order. We must reward the people who did not lose their head when everyone around them was losing theirs.

When the big Emkay order came in, many of the orders which were matched were limit orders which had been patiently waiting there. This does not, in any way, change the analysis. Waiting with `deep out of the money' limit orders is a hazardous business. As an example, consider the persons waiting with deep out of the money limit orders, standing ready to buy at very cheap prices (e.g. 10% below the current market price) when the Satyam scandal unfolded. They lost money big time because the informed speculators, who understood the Satyam announcement and placed massive market sell orders, knew more than them. Waiting patiently with limit buy orders, 10% away from the touch, is not free money. ("The touch" is finance parlance for the bid and the offer price). It is a risky trading strategy.

Two trading strategies matter most in stabilising a market when crazy things have happened. Traders  have to be there ahead of time, with limit buy orders far away from the touch. The limit order book should be thick with orders; i.e. the impact cost associated with a giant market order should be low. And there have to be traders who see that the market has crashed, are able to work the phone and gain confidence that this is an idiosyncratic shock, and come into the market and buy. The more the capital and intelligence behind such trading strategies, the more stable the market will be.

If trades are now cancelled, these two trading strategies will have suffered the risk and got nothing in return. In the future, they will be more circumspect about stabilising the market. Similar considerations apply on the other side. When there are strange and large upward moves of the market, we want rational speculators who short sell and bring the price back to fundamentals. The market must be designed in a way that supports and enables this. At present, it is not [link, link].

Fat finger trades will happen. There will occasionally be strange rumours and other odd things that will make markets fluctuate away from fair price. In those situations, what we want most is for clear-headed rational speculators to put large scale capital into making money by stabilising the market. The rules of the market should reward the people who perform these roles. Trades from their orders should not be cancelled.

The Emkay story has gone well for the Indian securities markets. The market design worked as it should have. A human error was made, there was a brief market-wide suspension on the equity spot market (but the futures market continued to work). A call auction took place to discover the price, and within minutes everything came back to normal. Emkay took full responsibility for their trades and came through with the money. We shouldn't stumble in the policy analysis that follows this story.

Thursday, October 11, 2012

Government equity infusions into PSU banks

Harsh Vardhan's excellent blog post on this subject made me think further about the questions.

Finance policy makers in India are often proud of the fact that India has avoided a large systemic crisis in which substantial fiscal resources have been put into rescuing financial firms. I think this optimism is overstated. If we look back into the last 20 years, there has been a steady process of government money going into financial firms. On one hand, we have big events like UTI or IFCI or Indian Bank where large sums of public money were put into financial firms. Equally important is the regular flow of government money into PS Banks.

India is in the midst of a business cycle slowdown. This has come after the biggest-ever credit boom in India's history: in 2007, year-on-year growth of non-food credit was nudging 35%. As we know well, a boom in credit is followed by a boom in NPAs when a downturn comes about. We may well be at the cusp of an upsurge of NPAs. In this case, the pressure on capital in PS banks is going to be acute. If government thoughtlessly continues on the path of putting public money into PS banks then it would involve large sums of money.

As Harsh remarks, the striking feature of this annual resource flow is the way it has become commonplace. Nobody even notices this any more. In a time where government does not put equity capital into any other PSUs, the scale at which this is taking place is quite remarkable.

When the government builds a highway, the cost-benefit analysis is straightforward. Do we want to spend Rs.5000 crore in order to get a 1000 kilometre highway? A tangible result -- the highway -- is the fruit of the fiscal labour. In contrast, capital infusions into PS banks are not animated by a clear goal. What are we doing? Why is this wise? What is the cost benefit analysis? Are there other mechanisms through which the same objectives can be obtained at a lower cost? As the approach paper of the FSLRC has emphasised, perhaps the most important element of the public policy process that we require in India is clarity on objectives, and a clear demonstration that the proposed policy initiative is the best way to achieve the objective. I would classify the annual fiscal transfers to PS banks as part of the larger problem, that the edifice of Indian financial economic policy has been grounded in inadequate analysis. I am almost certain that 1000 kilometres of highway is a better use of public money than putting it into the equity capital of a PSU.

Once objectives are articulated, it becomes possible to measure the extent to which those objectives are being achieved. Evidence can be brought to bear about the extent to which the claimed objectives are being pursued. As an example, Shawn Cole did a beautiful paper which demonstrates the extent to which PS banks are a tool for rigging elections in India [journal link, ungated pdf]. If this is what PS banks do, are we better off if PS bank assets would decline, as a fraction of GDP?

Harsh's calculations treat one key number -- 1.1% return on assets for Indian banks as a whole -- as a given. If this number is given, the average Indian bank is not generating enough retained earnings to support growth, and then there is an inexorable need for fresh equity capital. I would attenuate this discussion in two dimensions:

  • A key feature of a world where banks are required to have equity capital is that not all banks get this equity capital. Some banks do well, they build up their balance sheets, they have good prospects and are able to raise equity capital, and they are able to grow. Alongside them, weaker banks fail to grow. This is perfectly appropriate and a desirable feature of the system: a healthy banking system must be one where only some banks are able to grow. The fact that a bank with the average ROA requires capital for growth does not mean that we should be putting public money into all banks that require capital for growth. Many, many banks in India do not deserve to grow and hanging tough is the right way to deal with them. Growth is not a birthright: a bank must do well, and pass the market test, and thus earn the right to grow.
  • There are many elements of banking policy which are driving down the return on assets. Easing these constraints is a better path for policy rather than putting in public money.
Banks in India are facing a combination of swelling NPAs, and difficulties in finding capital to grow. It is not fair for private banks to face competition from PS banks that get equity capital for free. I am reminded of Kingfisher. As long as Kingfisher was around, with an artificially low cost of capital, this exerted downward pressure on air fares, and hurt all healthy airlines. The exit of Kingfisher was of essence in bringing the rest of the industry back to health. This is the story of Japan's `zombie firms': when failed firms were kept alive using public money for capital infusions, this infected healthy firms. Percy Mistry famously pointed out that Indian finance suffers from the presence of `zombie banks', who only walk the world on the life support of public money. This is a deeper consequence of easy access to capital for public sector companies that we in India should be worrying about.

Harsh is undoubtedly right in suggesting that government should be willing to accept a reduced shareholding in PS banks while retaining control under the Bank Nationalisation Acts. But this leaves the residual question: if PS banks have a low ROA, the share price that this can support is low, if investors see no possibility of true privatisation in the years to come. The amount of equity capital which will come by going down this route is limited. The real story has got to be to ask PS banks to demonstrate that their claim on public money is backed by a good possibility of using capital better than NHAI.

Suppose we suggest that the government should be stingy in giving equity capital to PS banks. In the short term, the partial equilibrium analysis suggests that this will hold back the growth of banks and thus the size of Indian banking. We should bring two different perspectives to this. First, the very absence of free capital for PS banks will increase the profitability and thus equity capital access for private and foreign banks. The overall impact for India will thus be attenuated. In addition, it's easy for government to have entry of 20 new private banks. Suppose each is asked to bring in Rs.500 crore as equity capital. Using the rough 20x leverage that's found in Indian banking, this gives us new bank assets of 2% of GDP or Rs.2 trillion.