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Sunday, April 24, 2016

Author: Ashish Aggarwal

Ashish Aggarwal is a researcher at the National Institute for Public Finance and Policy.

On this blog:

Regulatory mistakes on the treatment of investment products sold by insurance companies

by Ashish Aggarwal.

There are cost and commission differences in what are essentially investment products across insurance, mutual funds and pension. These tilt the market towards products with higher commissions. In insurance, the commissions are both high and front loaded. This causes serious problems, particularly in conjunction with poor persistency (high percentage of customers discontinuing their policies midway), which is often an outcome of mis-selling. Let us examine the evidence about these problems and the regulatory failures.

The large scale mis-selling in ULIPs was prompted by high front loaded commissions, helped by high costs and poor disclosures. Research shows that investors lost more than a trillion rupees on account of these mis-sales. Similar problems continue to plague the traditional insurance products, whose sales shot up after regulation of ULIPs was improved.

The Sumit Bose Committee on curbing mis-selling and rationalising distribution incentives had in August 2015, recommended:
  1. Investment products and investment components of bundled products should have no upfront commissions.

  2. All investment products and investment portions of bundled products should move to Asset Under Management (AUM) based trail fee.
Eight months later, IRDAI has not made progress in these directions. Even as SEBI has improved consumer protection, IRDAI has weakened consumer protection. Regulatory arbitrage between similar products is getting worse (Sebi tightens disclosure norms, versus IRDAI plans to increase commissions, and IRDAI removes persistency norms for distributors, specified in 2011).

High Costs

Life insurers are allowed to charge 90 percent of the first year and 15 percent of the renewal premium as cost for policies of over eleven years (Rule 17D prescribed by the Central Government under the Insurance Rules, 1939). Section 40B and 40C of the recently enacted Insurance laws (Amendment) Act, 2015 have made the above cost caps defunct and allowed IRDAI to regulate the same. Why did the government persist with such high cost structures for over 75 years? This continued even after IRDAI was established in 1999.

IRDAI's proposed reform as outlined in the draft on Expenses of management of Insurers transacting the business of life was released in December 2015. This suggests reducing the cap to 70 percent in the first year and 12 percent thereafter. The analysis that we present ahead shows that these numerical values are unjustifiable.

All insurance, other than protection (called term plans), are basically investment products with about 5 percent of the premium going towards protection. Consider a traditional plan with an annual premium of Rs 1 lakh and protection of Rs 10 lakhs. A standalone protection plan of same amount is priced between Rs 3,000-4,000 per annum (for 15 years, for a 40 year old). In other words, about Rs 96,000 of the premium is available for investment. No other product allows its manufacturer to charge upto 90/70 percent of this as cost in the first year.

High costs impact returns. This is amplified in case of traditional plans where the portfolio design is low risk. As shown by the table in Bose Committee report, the nominal returns on maturity can be very low. They can turn negative, even in nominal terms, if the policy is discontinued/ surrendered, after being held for many years!

Traditional Plan (Non Linked Participating)
This table shows the net yield on premiums (net of mortality costs) in case of premature exit for a 35 year tenure policy with an annual premium of Rs 2,881 and a sum assured of Rs 100,000. The customer age on joining is 30 years. For example, based on the above scenario, in case of surrender after 25 years, a customer would have earned a net negative yield of -0.1 percent on investment
Years At 4% returns At
8% returns
5 -27.2% -23.5%
10 -9.7% -6.3%
15 -4.8% -2.6%
20 -2.5% -0.9%
25 -1.3% -0.1%
30 -0.4% 0.6%
35 2.4% 5.3%


High front loaded commissions

A life insurance product is usually for 15-25 years. In a 15 year traditional plan, the distributors could get 33 percent of the total commissions over 15 years in first year itself. In a ULIP, this could be 17 percent. On an NPV basis, they could earn 62 percent and 48 percent of the total commissions in the respective plans, in the initial three years. See:

UlIP/ Traditional Plans: Front loading of commissions
Particulars Year 1Year 2Year 3Year
Annual Premium 100,000 100,000100,000100,000
ULIP Commission 15% 7.5%5%5%
Yearly Commissions 15,000 7,5005,0005,000
Cumulative Commission (A) 15,000 22,50027,50087,500
Cumulative Commission on an NPV basis
(discount rate of 10%) (B)
15,000 21,81825,95054,106
Cumulative Commission as a % of total commissions (A)/87,500 17.1%25.7%31.4%100%
Cumulative Commission (NPV) as a % of total
commissions (NPV) (B)/54,106
27.7% 40.3%48%100%
Traditional Plan Commission 35% 7.5%5%5%
Yearly Commissions 35,000 7,5005,0005,000
Cumulative Commission (A) 35,000 42,50047,500107,500
Cumulative Commission on an NPV basis
(discount rate of 10%) (B)
35,000 41,81845,95074,106
Cumulative Commission as a % of total commissions (A)/107,500 32.6%39.5%44.2%100%
Cumulative Commission (NPV) as a % of total
commissions (NPV) (B)/74,106
Commissions: ULIPs - Y1 15%, Y2 7.5% and Y3 onwards 5%
Commissions: Traditional Plans - Y1 35%, Y2 7.5% and Y3 onwards 5%

While front loaded commissions drive sales, they leave distributors with little incentive to worry about investors staying put. For a long term product, this can be a recipe for mis-selling. In insurance, this usually means pushing low-return high-cost products. The front loading also incentivises churn, i.e. encourage customers to drop-off from the plan and then sell them a new policy, to make high commissions in the initial years, all over again.

Consumers interested in higher returns, could easily buy a term plan for protection, and mutual funds for investment. Clearly, most consumers do not understand this option. Even with online purchase removing the need for a distributor, the term segment constitutes less than 10 per cent of the insurance industry business. A pan India survey sponsored by IRDAI shows that only 38.23 percent of household replied felt that they were reducing risk by purchasing insurance products. The same survey reported that majority of insured perceived insurance as a bundle of savings and protection (see table).

Perception of Insurance
Perception Insured HouseholdsUninsured Households
Rural UrbanTotalRural UrbanTotal
Savings tool10.5 9.39.910.0 10.010.0
Protection tool 20.5 20.820.715.6 17.616.8
Both 49.7 15.651.626.5 26.026.2
None 19.3 16.417.848.0 46.447.1
All 100.0 100.0 100.0 100.0 100.0 100.0
Total number of households 11,301 10,86622,1673,237 4,7748,011
Source: IRDAI sponsored Pre-launch Survey Report of Insurance Awareness Campaign,
NCAER, 2011

In a term plan, distributors earn about 25 percent commission in year one and five percent thereafter. In rupee value and in comparison to investment plans, this offers them no motivation. A Rs 10 lakh term plan, as described earlier, would earn Rs 750-1,000 in the first year. As against this, a traditional plan/ ULIP with an annual premium of Rs 1 lakh could earn Rs 35,000/ 15,000 in the first year.

The argument that customers make informed purchases does not tie up with the high discontinuance. The persistency is at just 65 percent at first year, meaning, 35 percent of the customers drop off within the first year. At the end of five years, 63 percent drop off. The Bose committee noted that, in the case of LIC, the 61st month persistency in 2013-14 was just 44 percent.

Source: McKinsey & Company, India Insurance Vision 2025, Prepared for Confederation of Indian Industry, 2015

Problem of partial fixes

IRDAI has since 2010, improved the regulation of ULIPs. These improvements include mandating charges to be evenly distributed during the lock-in, to reduce the high front end expenses. IRDAI also imposed cost cap as a percentage of the yield on the product. This resulted in the following trend in sales:

Shift in sales from ULIPS to traditional plans. Source:Bose Committee report

Sales of ULIP declined dramatically. The distributors shifted to sell the more toxic (expensive - no cap on reduction in yield; and opaque - customer is not explicitly disclosed costs or the the net return on investment) traditional products which were left out of the clean up. This phenomenon is also reflected through an audit study of insurance agents carried out by Anagol, Cole, and Sarkar (2012).

Problem of sectoral arbitrage

Mutual funds too faced similar problem, albiet on a smaller scale. Over the years, SEBI cleaned this up (removed initial issue expenses in 2008, banned upfront loads in 2009, required funds to offer direct plans in 2012). AMFI, the industry body, followed this up in 2015 and capped upfront commissions to one percent and banned payment of advance commissions. Anecdotal evidence suggests that some distributors are moving to an advisory or online sales model. The remainder have either exited the business or have shiftd to selling insurance plans. In less than four years of SEBI directions, retail investments in mutual funds from direct purchase (without any intermediary) have grown to 13 percent of the total.

However, with IRDAI not keeping keeping pace, the disclosure and product structure norms do not allow consumers to compare basic features like costs and returns with mutual funds and NPS. This further helps distributors to push insurance as the preferred long term investment instead of mutual funds (where the commissions are backloaded) or NPS (where the commissions are low and evenly spread).

Sectoral arbitrage: Front loading of commissions
First year commission as a percentage of total commissions
payable (Nominal basis)
Tenure Mutual Funds ULIPS Traditional Plans
30 yrs 0.35% 9%19%
25 yrs 0.54% 11%22%
20 yrs 0.91% 13%26%
15 yrs 1.70%17%33%
The AUM based trail fee for mutual funds is assumed
at one percent in the first year and 0.4 percent thereafter.

The point in the table above is not that the commissions in mutual funds are overall less than insurance. Since the commissions are back loaded, mutual funds would deliver higher commissions only if a consumer is persistent and the corpus grows over 20-25 years. When this happens, the incentive of the distributor are aligned with that of the consumer.


IRDAI needs to review the cost and commissions in investment oriented plans, specially the traditional plans, with the objective of making the products less expensive and more transparent. It needs to reduce the regulatory arbitrage by adopting SEBI's norms on costs and distribution incentives for investment portion of its bundled products.

The Bose Committee had representation from insurance and was a unanimous report. It is awaiting implementation.

We must ask deeper questions. IRDA is composed of intelligent people. Why has IRDA made mistakes in regulation of products sold by insurance companies, for decades? There are two factors at work. The first is the problem of the underlying legislations, which do not enshrine consumer protection as the central objective. The second is the problem of sectoral regulation, where persons in the organisation tend to get co-opted into the profit motive of the industry that they deal with. Both these problems are solved by the Indian Financial Code.

Ashish Aggarwal is a researcher at the National Institute for Public Finance and Policy.

Sunday, April 17, 2016

Interesting readings

Commodity futures: Waiting for the gains by Ajay Shah in the Business Standard, 18 April.

Caring about personal insolvency by Renuka Sane in the Business Standard, 16 April.

How technology helps creditors control debtors by Sarah Jeong in the Atlantic, 15 April. Also see.

M. R. Madhavan in the Indian Express on Aadhaar as a money bill, 15 April.

Superbugs are on track to kill 10 million people by 2050 if things don't change --fast by David Cox on

Ila Patnaik in the Indian Express, 9 April, on the implications of the Panama information leak. Also read Tyler Cowen on this.

Crackdown in China: Worse and Worse by Orville Schell in the The New York Review of Books, 21 April.

How a Cashless Society Could Embolden Big Brother; When money becomes information, it can inform on you. by Sarah Jeong in the Atlantic, 8 April.

Becca Cudmore in Audobon (21 January), on a great project in Kerala on mapping the birds. This takes us to eBird India.

I noticed two private forests: link link

Saturday, April 16, 2016

Subsidies are the last refuge of a failed policy maker

by Ajay Shah.

The government wants to subsidise your use of energy efficient household appliances. RBI wants to subsidise merchants who accept cards. Many people want to increase Internet access by using subsidies, e.g. the money disbursed through the `USOF'. Are all these subsidies appropriate?

Market failures versus your pet peeve

My pet peeve about the world is that there isn't enough classical music. Does this justify State intervention? The careful answer of an economist is: No, the scope of interference must be limited to `market failures'. Market failures are situations where the free market gets the resource allocation wrong. These are also generally situations where the free market gets the price wrong.

A useful four-part classification of market failures helps us look for them. The four categories are: market power (e.g. a monopoly that jacks up the price and cuts the quantity produced), asymmetric information (e.g. you buy medicines at a shop but you don't know whether they're adulterated), public goods (e.g. law and order, where the private sector will always under-produce), and externalities (e.g. your smoking gives me cancer).

The absence of an opportunity to trade widget $x$ at time $t$ is not, in general, a market failure. It may be a perfectly rational outcome for the retailing industry to not sell woolens in the desert. It may be a perfectly rational financial market where limit orders of a certain kind are absent. We may want more prosperity, more development, through which these markets would be more active, but the absence of trading in widget $x$ at time $t$ is not, in general, a market failure. In India, often times, we find that abnormally low trading is caused by government failures where the government is banning or interfering with various kinds of economic activity.

Similarly, when we see person $p$, and we dearly wish that he could buy butter, but he is too poor to buy butter, this is not a market failure. It's poverty.

When we see something that is going wrong in the world, the first hygiene check should be: Is this just my value judgement, or is this actually a market failure? Just because I like classical music, this does not mean that the slow death of classical music is a market failure.

Addressing market failures

When faced with a market failure, we may try to come up with a State intervention which would address this market failure. This is a dark art which involves the following considerations:

  1. The smallest use of force is the best. The best intervention that gets the job done is the one which uses the least coercive power of the State.  Spending money is grounded in taxation, which is a high use of the coercive power of the State. Each rupee of money spent by the government probably imposes a cost of Rs.3 upon society. We should be cautious before going there. In general, the engineering question -- the search for tools which address a market failure using the least force -- requires scientific knowledge in the form of a good understanding of the market failure. As an example, a careful analysis of the problems of energy efficiency leads to solutions very different from subsidising energy-efficient equipment.
  2. Taking implementation constraints seriously. Some interventions are infeasible in the light of the constraints of State capacity. Sometimes, the incentives of politicians and officials are impossible to correct, and while we can conceive of a nice tool for addressing a market failure, this may prove to be administratively infeasible. When implementation constraints are unsurmountable, we should just walk away leaving the market failure untouched. The lower the State capacity in a country, the more we should push towards laissez faire. Addressing a large class of market failures through State intervention is the luxury of people who possess State capacity. There is libertarianism of necessity and there is libertarianism of choice; we in India have to often engage in the former.
  3. Subsidies are the tool of choice when faced with one kind of market failure: externalities of the positive kind. Consider education. When person $p$ gets more educated, he captures certain gains, but there are also gains to society at large which are not captured by him. These positive externalities are not valued by person $p$, who would tend to under-invest in education. This under-investment is a market failure: the free market outcome is the wrong resource allocation. We can correct this market failure by having a subsidy. While this logic is true some of the time, not all positive externalities can be addressed using subsidies. Here's an example : of market failure in the undersupply of criticism.
  4. How big should the subsidy be? This requires two pieces of measurement. We should measure the positive externalities. The magnitude of the subsidy should be set to the point where the marginal gains to society from the last unit of subsidy is equal to the marginal social cost of funds. At present, in India, we have little empirical economics ability on measuring either. When we don't measure these things, caution requires a bias in the downward direction: push towards low or zero subsidies.

Addressing the `digital divide' using subsidies? 

Consider recent debates about the `digital divide'. Facebook and others proposed net non-neutrality as a way to increase their profit rates, and claimed that this would address access problems to the Internet. Proponents of net neutrality said that if access was a concern, this could be achieved by issuing bandwidth vouchers through which the government pays for (say) the first Rs.50 of data consumption per month by each citizen of India. Yes, this can be done. But should it be done?

Suppose most consumers use data comm to watch cat videos. In this case, why should the violence of the State (taxation) be brought to bear on increasing the consumption of cat videos? Before we propose a subsidy that would increase consumption of data communications, we should have measures of the spillovers, the positive externalities.

Ordinarily, a subsidy is funded by general tax revenues. In this case, people often rush to proposing the use of the `Universal Services Obligation Fund' (USOF). This is a less efficient means of raising public resources as it is a tax on one sector. The marginal social cost of USOF money is higher than the marginal social cost of funds. Intuitively, if the marginal social cost of funds is 3, I suspect the marginal social cost of USOF funds is 6. A subsidy funded through USOF would thus have to be significantly lower than a subsidy funded through general tax revenues.

Aadhaar and the Indian debate on subsidies

Nandan Nilekani and his team were very controlled in their arguments. They said: We have no opinion on whether the purchase of LPG should be subsidised, but assuming you want to do this, here's a way to better implement this subsidy. The re-engineering of many subsidy programs using Aadhaar has occupied public attention and absorbed management capacity in government.

But this does not change the basic question: Why should we have the LPG subsidy in the first place? Now that the Aadhaar system is built, we should go back to asking deeper  questions. Do we really want to have a fertiliser subsidy?

The rampant use of subsidies

We can't get our policies on ATMs right, so let's just subsidise ATM placement in northeast states. This sort of policy reflex is found all over the Indian policy landscape.

We failed to get our policy framework on payments right. Now we see a point of pain: acceptance infrastructure is lacking. The solution: subsidies in the form of an `Acceptance Development Fund'.

We failed to get prices right and interest rates right. Hence, households have incentives to buy energy inefficient equipment. The solution: subsidies.

We failed to make the Bond-Currency-Derivatives Nexus work. The solution: create a specialised class of financial firms named `primary dealers' and subsidise credit to them.

We failed to make infrastructure financing and the Bond-Currency-Derivatives Nexus work. Infrastructure projects are unable to sell corporate bonds. The solution: subsidies in the form of tax exemption for these bonds.

A conjecture about the rampant use of subsidies

Why are subsidies rampantly used in India? Why are policy makers so quick to reach into their toolbox of diverse possible interventions and pick on the subsidy?

Perhaps there are many market failures out there. Perhaps there are pervasive failures of policy analysis, misbehaviour by politicians and officials, and a shortage of State capacity. Hence, many market failures are not addressed. Solving these problems at the root cause is hard. The easy way out is a subsidy.

From a political point of view, sound policy work on addressing market failures involves using the coercive power of the State in order to force certain persons to behave differently. This is always unpleasant and makes some people unhappy. Spending money, on the other hand, is always popular. The unhappiness is concentrated against the Ministry of Finance which has to use State violence in collecting taxes. Once taxes are collected, every department of government, and every government agency, is too happy spending money. This is the soft option, compared with actually addressing market failures.

Actually fixing policy institutions is hard work. The leadership of most policy institutions lacks the ability to achieve State capacity. Subsidies are a tempting alternative for an `action-oriented government'.  Samuel Johnson said `patriotism is the last refuge of a scoundrel'. In similar fashion, subsidies are the last refuge of a failed policy maker.


If you believed that income inequality was a problem, the subsidy which addresses that is a transfer of Rs.1000 per person, every month, to the bottom decile of society. There is no need to interfere with the working of the market economy, for the purpose of reducing inequality.


Many times in India, subsidies are being used to express sheer value judgments; they are just the faddish thinking of one bunch of hausfraus running policy versus another. At other times, a market failure is indeed present. But instead of more subtle interventions and the minimum use of force -- based on a sound scientific understanding of the anatomy of the market failure -- we tend to rush to the excessive use of force that is a subsidy. Every subsidy is grounded in the monopoly of violence of the State that is required for tax collection. We should be far more circumspect before doling out subsidies. Subsidies are the last refuge of a failed policy maker.

Monday, April 11, 2016

How to achieve fiscal responsibility in India

by Ajay Shah.

The FRBM Act has not delivered in reining in Leviathan. India continues to suffer from chronic fiscal problems. Recently, Montek Ahluwalia and Rathin Roy have written about the new thinking that must go into fiscal responsibility legislation.

Laws that protect against fiscal irresponsibility

It's hard to restrain Leviathan by using a fiscal responsibility legislation. In recent years, we have a procession of Finance Bills that disregarded the FRBM Act. The FRBM Act is a mere Act of Parliament, and can be amended each time a Finance Act is enacted.

There are a few success stories of very strong legal protections against fiscal irresponsibility, such as the `Debt Brake' constitutional amendment that was done in Germany and a few other places. Short of this, it's hard for Parliamentary legislation to make a significant difference. We in India are unlikely to summon the political capacity to do this.

The role of the bond market

It's also interesting to see that most countries have achieved superior fiscal responsibility than India, without a Debt Brake style constitutional amendment.  The key thing to focus on is financial repression. When the government faces a captive bond market, it feels it can get away with fiscal irresponsibility.

What has really mattered to advanced countries achieving fiscal discipline is not fiscal responsibility legislation but the pressure of the bond market. E.g. look back at how in recent years, the bond market stopped European governments in their tracks. The famous quotation by James Carville, sourced from the Wall Street Journal, 25 February 1993, says: I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.

In the present Indian arrangement, we don't do public debt management in a serious sense of the term; we just force financial firms to buy government bonds. This is a tax on formal finance, which has far reaching adverse implications for the financial system and for the economy. It yields easy sale of bonds till the numbers associated with financial repression are exhausted, and an exceedingly difficult time beyond.

Exacerbating the marginal social cost of funds

It is useful to link up financial repression with the concept of Marginal Cost of Public Funds. In OECD countries, this is generally thought to be 1.7: the cost to society of Rs.1 of government expenditure is ~ 1.7. In India, this needs to be adjusted upwards twice: first, for a badly designed and badly administered tax system, and second for financial repression. This demands a very high bar on what is a useful government expenditure: the gains to society for Rs.1 of government spending may have to be as large as Rs.3 for the expenditure to make sense.

The way forward

Hence, the first step in our fiscal journey is the establishment of the Public Debt Management Agency (PDMA), and getting bond market regulation out of RBI. We need to replace the forcible conscription of savings from institutional investors by sound debt management which knows how to sell bonds to voluntary buyers, into a liquid and well regulated market where the bond market regulation is arms length from either debt management or monetary policy or banking regulation.

Micro-prudential regulation should be technically sound. This involves ensuring that banks do not go bankrupt, as they have in India. It should not support and enable financial repression, as has been done. The European crisis has taught us the extreme dangers that come from hitching bank fragility to sovereign fragility. If we wanted banks to not take risk, and we were willing to use intrusive rules about portfolio composition, technically sound micro-prudential regulation should ask of them to hold short maturity bonds issued by high rated countries. Similar considerations apply with micro-prudential regulation of insurance and pensions.

The full picture of macro and finance policy

Israel is an inspiring story of a country that built modern macro and finance institutions, and was bountifully rewarded by the bond market. But it's useful for us to remember that even at the starting point of their reforms, they were never as bad as us; in other words, the gains to us of doing the orthodox macro and finance reforms are even greater than what was seen in Israel.

There are strong linkages between bond market development, price stability and debt management. Hence, we must see the overall strategy for fiscal, financial and monetary reform in a unified way. As an example, see the inter-relations between the three components which were begun in February 2015, of which two were shot down. The debates of March and April 2015 displayed a low appreciation of these inter-relationships, which led to the rollback of two out of the three components. We have begun with one piece, inflation targeting, but haven't done the rest of it. This is the heart of the question of fiscal prudence.

Tuesday, April 05, 2016

Motivations for capital controls and their effectiveness

by Radhika Pandey, Gurnain K. Pasricha, Ila Patnaik, Ajay Shah.

The global financial crisis has re-opened the debate on the place of capital controls in the policy toolkit of emerging-market economies (EMEs). The volatility of capital flows during and after the global financial crisis, and the use of capital controls in major EMEs spawned a vigorous debate among policy-makers on the legitimacy and usefulness of capital controls.

In order to aid the development of best practices in capital controls policy, the literature needs to address four questions:

  1. Under what circumstances do policy makers utilise capital controls? Do policy-makers use capital controls as macroprudential tools, as envisioned in the recent literature?

  2. What impact do different capital controls have?

  3. Do the benefits outweigh the costs?

  4. How should real world institutional arrangements be constructed, to utilise these tools appropriately?

In a recent paper (Pandey et. al, 2016) we offer new evidence on the first and second of these questions.

A rich literature has sprung up in recent years, which has re-engaged with these questions. A number of recent studies examine effectiveness of controls in a single country (Brazil or Chile) or a multi-country setting. See for example, Alfaro et al, 2015; Fernandez et al., 2015; Forbes and Klein, 2015; Pasricha et al., 2015. A full list of references is in our paper. In this literature, several researchers have argued that capital controls may be particularly effective in a country like India with the legal and administrative machinery to implement controls (Habermeier et. al., 2011; Klein, 2012).

Indian policy makers have modified the capital control framework frequently to address concerns about the exchange rate, country risk perception and other issues. For example page 15 of RBI's 2014 Annual Report states that RBI's response to the developments following the US Fed's indication that it would taper its large-scale asset purchase program ``aimed at containing exchange rate volatility, compressing the current account deficit (CAD) and rebuilding buffers.'' This response included use of capital controls, foreign exchange intervention as well as interest rate changes. India is thus a good laboratory for studying the motivations and consequences of capital controls.

Credible research designs in this field require precise measurement of capital controls or capital control actions (CCAs). There are many concerns about the measurement obtained through conventional multi-country databases. We comprehensively analyse primary legal documents from 2004 to 2013, in order to construct a new instrument-level dataset about every capital control action for one asset class (foreign borrowing by firms) for one country (India).

In constructing this database, we differentiate between capital control announcements and capital control instruments (e.g., controls on minimum maturity of loans, controls on eligible borrowers, interest rate ceilings, etc.). In India, several instruments can be changed in the same announcement, and we count each instrument separately. We compare our approach with other recent work that compiles datasets on capital control actions (e.g. : Pasricha et al 2015; Pasricha 2012; Forbes et al. 2015) in our paper.

Q1: Under what circumstances do policy-makers utilise capital controls?

We use event studies to ask whether EME policy-makers use capital controls as macroprudential tools, as envisioned in the recent literature. Specifically, do EME policy-makers use capital controls to pursue macroprudential objectives or to achieve exchange rate objectives? A large literature since 2008 envisions capital controls as prudential tools, that can help mitigate systemic financial sector risk, and therefore views them in a more benign light than controls aimed at managing the exchange rate (See Korinek, 2011; Jeanne and Korinek, 2010; Bianchi, 2011, among others).

Factually assessing the motivations for past EME CCAs can help inform the debate on capital controls, as well as the resulting international consensus on the rules of governance for their use. On the one hand, if it can be discerned in the data that emerging markets have, in fact, been using capital controls to target systemic risk, this bolsters the legitimacy of the EME case for continued use of these instruments. On the other hand, if the data suggest that CCAs have been used for currency manipulation, this bolsters the case of those who argue that further international discussions on the rules of the game are needed to address multilateral concerns.

Figure 1: Exchange rate change prior to a easing CCA. Positive values denote depreciation.

Figure 2: Exchange rate change prior to a tightening CCA. Positive values denote depreciation.

The key result is in the two figures above. In the five weeks prior to an easing action, USD/INR depreciated by 3% on average. In the five weeks prior to a tightening action, USD/INR appreciated by 5% on average. Not only was the average trend prior to easing of inflow controls that of a depreciation of the currency, this also held true for the broad majority of events in sample: 42 out of the 68 instances of easing in our sample were preceded by exchange rate depreciation.

For the easing events which were preceded by an appreciation, the extent of the appreciation was small compared with that seen with events preceded by depreciation: the largest 5-week appreciation prior to an easing was 1.3%, compared to 9.2% for depreciation. The average appreciation prior to an easing was only 0.5%, compared to an average depreciation prior to easings of 5%.

None of the variables that measure the build-up of systemic risk show a similar strong pattern in the 6 months prior to the event date (see Figures 5-8 and Table 5 in the paper). The prime motivation for CCAs in India appears to be exchange rate policy and not macroprudential policy. This shows a certain gap between capital controls in the ideal world and capital controls as they operate in the field.

Q2: What impact do different capital controls have?

Next, we measure the impact of capital control actions. In order to obtain a credible estimation strategy, we utilise propensity score matching to identify time points which are counterfactual. This yields a quasi-experimental design where the treatment effect can be measured. Specifically, for each week in which a capital control action was taken, we identify a week in which macro / financial stress was similar, but no capital control action was taken.

Table 1: Causal impact of CCAs on various indicators
Impact uponCoefficientStd. Errort-statistic
Credit growth-0.441.7-0.46
Stock prices1.173.550.49
Frankel-Wei Residual-0.230.92-0.25
Net foreign inflow-0.040.03-1.33

Our results suggest that there was no significant impact of the capital control actions, either on the exchange rate or on measures connected with systemic risk (Table 1). Table 1 above shows the coefficient for the period 4 weeks after the capital control action. Similar values are found for all other time horizons. There is no statistically significant impact upon any of the outcomes at horizons from 1 to 4 weeks.

Broader implications of our results

These results have many implications for the global debate about capital controls. In many countries, the capital controls system was fully dismantled. In such an environment, it may be particularly easy to evade capital controls, for example through financial engineering. The best opportunity to obtain effectiveness of capital controls may be in countries like China or India, where large bureaucracies implement capital controls, and the detailed system of specifying rules about every asset class and every type of economic agent was never dismantled. For this reason, India is an ideal laboratory to study capital controls. If capital controls are found to be useful in India, the case could potentially be made that other EMEs, which dismantled the overall capital controls system, should reverse these reforms.

Our results show that Indian authorities seem to be using capital controls as a tool for exchange rate policy and not for systemic risk mitigation, and their actions seem to be ineffective. These results are also consistent with many papers in the recent literature which are skeptical about the usefulness of capital controls (Chamon and Garcia, 2015; Fernandez et. al, 2015; Forbes and Klein, 2015; Forbes et. al., 2015; Hutchison et. al, 2012; Klein, 2012; Patnaik and Shah, 2012; Pasricha, 2015; Warnock, 2011).

The strength of the research presented here is that it provides credible estimates about one locale, India. A fruitful line of inquiry would be to apply such strategies to multiple countries, and build up a literature with careful assessment of country experience, one country at a time, about the ways in which capital controls are used, in the field, and about their treatment effects. A much more expansive strategy would seek to undertake such thorough instrument-level analysis on a multi-country scale in order to construct a consistent database about capital control actions on the scale of all EMEs or the whole world.

Even when capital controls do yield a desired treatment effect, the important question of cost-benefit analysis remains. A body of research is required which would assess the costs and the benefits of utilising these tools. On the cost-assessment side, a wide body of research on capital controls focuses on microeconomic distortions from capital controls (Alfaro et al, 2015; Forbes, 2007). On the benefits side, the evidence is mixed regarding the extent to which capital controls are able to deliver on the objectives of macroeconomic policy. While capital controls seem to be able to change the composition of flows toward more long-term debt, it is not clear to what extent this represents a mislabelling of flows (Magud et al., 2011; Carvalho and Garcia, 2008). Pasricha et al. (2015) find that capital control actions were not useful in allowing major emerging markets to change their trilemma configurations and Patnaik and Shah (2012) find that the Indian capital controls are not an effective tool for macroeconomic policy.

Further research is required on the institutional arrangements for capital controls. As an analogy, monetary policy was long viewed as being effective, but it was only in the 1980s that clarity was obtained around the institutional structure of independent central banks with inflation targets and monetary policy committees. In similar fashion, if capital controls have to graduate into the macroprudential policy toolkit, normative research is required in designing the optimal institutional arrangements for systemic risk regulation with mechanism design, akin to a monetary policy committee, and accountability, similar to an inflation target.


Laura Alfaro, Anusha Chari and Fabio Kanczuk. The real effects of capital controls: Financial constraints, exporters and firm investment NBER Working Paper 20726, Dec 2014.

Marcos Chamon and Marcio Garcia. Capital controls in Brazil: Effective? Journal of International Money and Finance, 2016 (Forthcoming).

Bernardo S. de M. Carvalho and Marcio G. P. Garcia. Ineffective controls on capital inflows under sophisticated financial markets: Brazil in the nineties In Sebastian Edwards and Marco G. P. Garcia (Eds.), Financial markets volatility and performance in emerging markets, pp. 29-96. University of Chicago Press.

Andres Fernandez, Alessandro Rebucci, and Martin Uribe. Are capital controls countercyclical? Journal of Monetary Economics, 76:1--14, 2015.

Anton Korinek. The new economics of capital controls imposed for prudential reasons. IMF Working Paper, Dec 2011.

Javier Bianchi. Overborrowing and systemic externalities in the business cycle. American Economic Review: Vol. 101 No. 7, Dec 2011.

Kristin J. Forbes. One cost of the Chilean capital controls: Increased financial constraints for smaller traded firms. Journal of International Economics 71(2): 294-323, Apr 2007.

Kristin J. Forbes and Michael W. Klein. Pick your poison: The choices and consequences of policy responses to crises. IMF Economic Review, 63(1):197--237, Apr 2015. ISSN 2041-4161.

Kristin J. Forbes, Marcel Fratzscher, and Roland Straub. Capital-flow management measures: What are they good for? Journal of International Economics, 96, Supplement 1:S76 -- S97, 2015. ISSN 0022-1996. 37th Annual NBER International Seminar on Macroeconomics.

K. F. Habermeier, C. Baba, and A. Kokenyne. The effectiveness of capital controls and prudential policies in managing large inflows. IMF Staff Discussion Note SDN/11/14, International Monetary Fund, 2011.

Nicolas E. Magud, Carmen M. Reinhart and Kenneth S. Rogoff. Capital controls: Myth and reality - A portfolio balance approach. NBER Working Paper No. 16805, Feb, 2011

Michael M. Hutchison, Gurnain Kaur Pasricha, and Nirvikar Singh. Effectiveness of capital controls in India: Evidence from the offshore NDF market. IMF Economic Review, 60(3): 395--438, 2012.

Michael W. Klein. Capital controls: Gates versus walls. Brookings Papers on Economic Activity, 45(2 (Fall)):317--367, 2012.

Olivier Jeanne and Anton Korinek. Excessive Volatility in Capital Flows: A Pigouvian Taxation Approach. American Economic Review, 100(2), May 2010.

Radhika Pandey, Gurnain Kaur Pasricha, Ila Patnaik, Ajay Shah. Motivations for capital controls and their effectiveness. Working paper, 2016.

Gurnain Kaur Pasricha. Recent trends in measures to manage capital flows in emerging economies. The North American Journal of Economics and Finance 23 (3), 286-309.

Gurnain Kaur Pasricha, Matteo Falagiarda, Martin Bijsterbosch and Joshua Aizenman. Domestic and multilateral effects of capital controls in emerging markets. NBER Working Paper No. 20822.

Ila Patnaik and Ajay Shah. Did the Indian capital controls work as a tool of macroeconomic policy. IMF Economic Review, 60(3):439--464, 2012.

Frank E. Warnock. Doubts about capital controls. Working Paper 14, Council on Foreign Relations, 2011.

Gurnain Pasricha is at the Bank of Canada, and the other three authors are at the National Institute for Public Finance and Policy, New Delhi. The views expressed in this post are those of the authors. No responsibility for them should be attributed to the Bank of Canada or NIPFP.

Monday, April 04, 2016

Interesting readings

Doing everything wrong on foreign borrowing by Ajay Shah in the Business Standard, 4 April.

New stories about Otto Skorzeny! by The Forward and Dan Raviv And Yossi Melman in the Haaretz, 4 April.

How bankruptcy code will save lenders by Anjali Sharma and Susan Thomas in Mint, 1 April.

An Act that hinders competition by Avirup Bose and Pratik Datta, in the Business Standard, 31 March.

Montek Ahluwalia in Mint (30 March) and Rathin Roy in Business Standard (1 April) on a new Fiscal Responsibility framework.

The Bharat Mata pivot by Ashutosh Varshney in the Indian Express, 30 March.

Middle class or insecure juveniles? by Salil Desai in the Tribune, 28 March.

Matt Honan on Sundar Pichai on Buzzfeed, 28 March.

Christopher Balding on China, 28 March.

Financial sector development needs a boost with an independent debt office by Jaideep Mishra in the Economic Times, 22 March.

Pratap Bhanu Mehta on the Aadhaar Bill in the Indian Express, 26 March.

Does engineering education breed terrorists by Dan Berrett in the Chronicle of Higher Education, 23 March. I see a hint of this lack of humanities knowledge in Indian extremism also.

The burden of proof by Mukul Kesavan in the Telegraph, 21 March.

The Norwegian TV series that's enraged the Kremlin by James Kirchick in Politico, 20 March. Also read about Ten Years in the Guardian, 4 April.

Vikram Doctor on the RSS choice of uniform, in the Times of India, 19 March.

Now There's Proof: Docs Who Get Company Cash Tend to Prescribe More Brand-Name Meds by Charles Ornstein, Ryann Grochowski Jones and Mike Tigas on ProPublica, March 17. There are remarkable similarities between the market failures in finance and those in health care. I wonder how far consumer protection from IFC 1.1 would go in addressing these market failures in health care.

Sunday, April 03, 2016

Foreign Currency Borrowing by Indian Firms: Towards a New Policy Framework

by Ila Patnaik, Ajay Shah, Nirvikar Singh.

A well established concept in the field of international capital flows is the problem of `original sin': where governments or firms have currency mismatches with foreign borrowing that is typically in dollars. When such exposures exist, there is the possibility of substantial balance sheet effects in the event of a large depreciation. In India, foreign currency borrowing has grown seven-fold, from \$20 billion in 2004 to \$140 billion in 2014. This has generated concerns about systemic risk. We have a paper which is forthcoming in India Policy Forum on these questions. Key ideas from this are presented here.

Rational firms are conscious about the destruction of wealth that comes with a large depreciation and unhedged exposure, and are likely to avoid currency mismatches. The moral hazard hypothesis suggests that firms choose to have unhedged foreign currency borrowing because governments and central banks communicate their intent to manage the exchange rate when faced with large depreciations. Concerns about unhedged foreign currency borrowing by firms are a greater issue in emerging markets where the monetary policy regime targets the exchange rate, as compared with mature market economies with floating exchange rates.

Capital controls are proposed as a way of avoiding moral hazard associated with foreign currency borrowing under pegged exchange rates. The puzzle lies in designing a capital controls system which interferes with unhedged foreign currency borrowing but not with foreign borrowing by firms with hedges. For firms who have natural hedges, unhedged foreign currency borrowing is a valuable source of low cost capital. These firms include not just net exporters, but net producers of tradeables where domestic output prices are set by import parity pricing.

What is a policy framework where hedged firms are able to obtain the economic benefits of unhedged foreign currency borrowing, while avoiding unhedged foreign currency borrowing? One strategy is to combat the moral hazard at the root cause: the monetary policy framework. A monetary policy framework which enshrines inflation as the target, and not the exchange rate, would remove the moral hazard. Inflation targeting central banks are, in general, associated with greater exchange rate flexibility.

The second element of the policy question is the capital controls regime. The Indian strategy for capital controls on foreign currency borrowing presently involves many kinds of restrictions. The dominant form of currency borrowing is ``External Commercial Borrowing'' (ECB) by companies. Rules restrict who can borrow, who can lend, how much can be borrowed, at what price, what end-use the borrowed resources can be applied for, who can offer a credit guarantee, when borrowed proceeds must be brought into India, when loans can be prepaid, when loans can be refinanced, procedural rules for all these activities, and rules for banks to force all borrowers to hedge currency exposure. Further, loans above a certain amount require approval.

The present policy framework is highly complex, uncertain, and, as has been suggested by the Sahoo Committee that was set up by the government to review the existing framework, fails to address some of the concerns of policy makers. For example, policy makers are concerned about the level of unhedged foreign currency exposure in the economy, issues of discretion and transparency, and policy uncertainty in the framework. Further, the recent focus on modern regulation making processes and rule of law has raised questions about the appropriateness of the existing policy framework. We compare the present distribution of foreign currency borrowing among firms against a normative ideal (foreign borrowing by naturally hedged firms), and find large deviations.

In recognition of these problems, in recent times, some policy changes have been introduced in the capital controls that may help reduce currency mismatch. These include allowing firms to undertake rupee-denominated ECB, an increase in the caps on FII investment in rupee-denominated corporate bonds (the cap has increased slowly to USD 51 billion in 2015), monitoring of the hedge ratio for ECB by requiring firms to report these, requiring infrastructure firms to fully hedge their ECB and prudential requirements for banks when lending to companies with unhedged foreign currency exposure.

For Indian firms, markets for derivatives are illiquid and costly owing to restrictive regulations, making it unattractive to hedge explicitly through these markets. On the other hand, while some borrowers may have natural hedges, the policy framework for ECB does not take this into account. This helps explain why firms with natural hedges, such as domestic makers of tradeables, are not strongly present in foreign currency borrowing.

The current restrictions on ECBs raise concerns about engaging in ill-defined or poorly justified industrial policy, about the scale of economic knowledge required to write down the detailed prescriptive regulations, the impact upon the cost of business and about rule of law. Recent research suggests that the large number of changes in the capital controls governing ECB are motivated by exchange rate policy and not systemic risk regulation. This raises questions about the process through which regulations are being made.

In the international discourse, there is renewed interest in capital controls, in particular in order to address the systemic risk associated with large scale unhedged foreign currency borrowing by firms in countries with pegged exchange rates. For those who are willing to intrude on economic freedom with capital controls, India is a poster child, with a great willingness to do central planning on what happens with cross-border activities. The careful examination of the Indian capital controls on foreign currency borrowing suggests that the Indian framework has not been effective in permitting safe activities while reducing systemic risk.

Saturday, April 02, 2016

The gains from sound macro and finance policy

by Ajay Shah.

Israel went through a complete transformation of macro and finance policy. They started out pretty bad, and put in all the key machinery : inflation targeting, floating exchange rate, open capital account, modern financial regulation, public debt management, etc.

A graph of the nominal yield curve for government borrowing is quite revealing [source]. It superposes the yield curve prevalent at many dates:

The curve at the top is the yield curve in October 1996: it goes out to only 3 years, and features nominal rates of 16 to 17%.

Through the years, as the macro and finance reforms fell into place, nominal interest rates for borrowing went down, and the maturity went up. By January 2012, inflation had stabilised at the target of 2%, the short rate was 1.5%, and the 30 year rate was 5.51%.

Note that the 2012 situation is without financial repression and without capital controls. Private persons voluntarily choose to lend to the government, for a 30 year horizon, at 5.51%. There are no other distortions in the picture. This is the `fair and square' cost of borrowing for the government.

This shows the the direct gains to the fiscal authority from doing the orthodox approach to macro and finance policy. Similar large gains became available to the private sector, as corporate bonds and bank loans are expressed as credit spreads off the government bond interest rates. We in India will get these gains by enacting and enforcing the Indian Financial Code.