India's governance crisis: Tales from the battlefront

The Competition Commission of India (CCI) has written an order on NSE and MCX-SX in the currency derivatives market. Even if you do not take interest in financial markets, this is an interesting episode in Indian governance. It illuminates the larger problems of building regulatory agencies, and India's middle income trap.

In an impressive show of strength with the media, there was a flurry of editorial and other commentary praising CCI for this order - even before the order had been released. The files are now on the CCI website. Here is the main order and here is the dissent by two members of CCI.

Gautam Chikermane has written an excellent analysis of the order in the Hindustan Times. Unlike much of the other commentary on this order, he has actually read the two PDF files above. Also see this editorial and column by Mobis Philipose, in Mint, on 6 June.

The order has breathtaking ramifications. If this works as a precedent, it would impose huge complexities upon an array of industries where some products and services are given out free. This feature is particularly prevalent in the new economy, where systems such as google search are free and have been free for the longest time, and where a blizzard of new product launches (e.g. google plus) are free.

In India, regulatory organisations are still finding their feet. They have to gradually build up credibility and respect. When a regulatory body signs on a breathtakingly large penalty which will have huge implications for the economy, they have to be absolutely sure they are right. Otherwise, the institution loses credibility. I fear that with this order, CCI is now in a soup. If the appeals process is half decent, the order will be overturned, which will make CCI look bad. If the appeals process is not half decent, CCI will be seen as a source of trouble in the Indian regulatory landscape. In numerous industries, zero pricing will run into trouble. More generally, such muggings will be a new dimension of the political risk faced by firms operating in India.

India's crisis of governance is about the puzzle of building agencies like the Competition Commission of India, of taking these agencies closer to the competence and honesty seen at SEBI in recent years. How do we master the intricate recipe of public administration, so that such events don't happen? Until this is done, the structure of incentives encourages a certain kind of entrepreneur, and will damage the outlook for India.

How to damage market quality

The problem of measuring the price

In a liquid and transparent financial market, there is no doubt about the price. There is high pre-trade transparency, because orders are visible on the limit order book, and the best estimate of the true price is (bid+offer)/2. You glance at the screen and you know what is the price.

In a non-transparent market, it is hard to know the true price. Special schemes have to be constructed in order to measure the price. Price measurement does not happen `for free' as a minor side effect of the very trading process.

Why price measurement matters

As a thumb-rule, the best design for a derivatives contract is to use cash settlement, as long as you can be pretty certain about observing the price. If you can't measure the price, then physical settlement is better.

Cash settlement is a great technology. But it requires sound measurement of the price.

Measuring price on an OTC market

In an OTC market, information is not visible at a glance. It is dispersed. Many traders have private information about the price, but you do not. If you could setup an electronic order book, you would see bid and offer at a glance: these are the prices at which a small buy and a small sell transaction could be done. On an OTC market, the dealer has a sense about where the market is, but you don't. So a natural strategy is that of asking the dealer what he is seeing.

Dealers have positions on the market, so we have to worry about what they say. Standard schemes used involve removing extreme observations, and thus coming up with a more robust price measure. These schemes have been used in India with the NSE MIBOR (the dominant price measure on the interest rate swaps market), the CMIE measurement of commodity spot prices for NCDEX, etc.

RBI's measurement of the INR/USD exchange rate

In India, RBI is an information producer in reporting the INR/USD exchange rate at 12 noon. This `official RBI price' is widely used in computing the settlement price for cash-settled derivatives on the rupee. It is used for the official closing price on the NSE currency futures/options market, which in many ways is shaping up as the main market where the INR exchange rate is discovered. As an example, yesterday (an expiration day), the open interest closed at $7.2 billion, and turnover was $6.2 billion.

RBI has not had a formal methodology for how this price is computed and reported.

I have always been a bit uncomfortable with RBI producing this vital information, since RBI has many other goals which can conflict with the goal of producing high quality information. But for a while, this seemed to be working.

New methodology at RBI

On 1 July, their methodology will change to something new:

1. They will choose a random five-minute window from 10:30 to 12:30 (i.e. a two-hour window).
2. The reference rate will be computed using these five minutes.
3. It will be released at 13:00.

I cannot imagine the logic which led up to this, but I have to say that this is not a good idea.

A two hour window is a lot of time in the life of a market. The RBI reference rate is then no longer a reference rate of the market. It is a measure of the price at a randomly chosen time in that window. This makes it much less informative.

As an analogy, imagine if the official NSE closing price for Nifty was plucked out of a randomly chosen time from 2:30 PM to 3:30 PM. This would be a lot less informative as compared with the present methodology (value weighted average of all trades from 3 PM to 3:30 PM). It would be even better if NSE were to do a call auction from 3:15 PM to 3:30 PM and report that price as the official closing price. That would be sharp and interpretable.

All cash derivatives settling on the RBI reference rate will now suffer from a new source of uncertainty: the randomly chosen time at which the price is reported. The cash-and-carry arbitrageur needs to sell his spot position at the exact time at which the derivatives expire. In the case of the Nifty futures, there is a simple trading strategy which roughly approximates the Nifty closing price: In each of the last 30 minutes, do 1/30 of your required trade. This is typically automated, i.e. it requires algorithmic trading, but it's fully feasible.

With a randomly chosen timepoint over a two hour horizon, the arbitrageur does not know when to closeout. This will exert a negative impact on pricing efficiency and thus basis risk on the derivatives market.

If the INR/USD exchange rate is a random walk in trading time, then the 9% annualised volatility maps to a standard deviation of 28 basis points over a two hour horizon. On a base of Rs.45 a dollar, this is a standard deviation of 12.6 paisa. This is quite a bit for traders and arbitrageurs. These small issues have a disproportionate impact in contaminating market efficiency.

But wait. There are some people who know at what time the pricing is done: the banks who are polled! So suppose there is a fixed panel of banks who are asked by RBI. The moment the RBI phone call comes in, they closeout. These banks will find it profitable to do currency arbitrage while others are not. Such shifts in the currency arbitrage constitute a distortion induced by RBI's new method of price measurement.

Lessons

RBI needs to cultivate improved knowledge of finance amidst its staff.

This illustrates the importance of legal process in rule-making. If RBI had gone through a formal notice-and-comment process, then they could have heard from external experts and desisted from doing this. I wasn't able to find a document on the RBI website explaining the rationale for what is being done.

Information production should be done by specialised information organisations. If information is produced by people who have other conflicting interests, then such sub-optimal decisions are more likely to arise.

Alternative information producers, such as Reuters, should leap into this opportunity by producing a better INR/USD reference rate. FEDAI already has an alternative reference rate. We should all switch away from the RBI reference rate towards alternatives.

Unfortunately, many people in the trade are fearful of the RBI and would not evaluate alternatives rationally. This tells us two things. First, RBI needs to be enveloped in the rule of law so that there is no fear of RBI on the part of market participants. Second, RBI should not be a producer of information. As long as two private agencies are producing INR/USD reference rates, the decision in the derivatives trade about what information measure to use will be based on technical merits alone. If someone then tries to come up with a scheme where a randomly chosen time over a two hour window is used for the measurement, his market share will go to zero.

The impending cabinet reshuffle: A few interesting links

The UPA-2 seems to be trying to come back into the game with a new look cabinet:

• Annie Banerji on Reuters blogs.
• Anil Sharma in the DNA.
• T. C. A. Srinivasa Raghavan in the Hindu Business Line.
• The gossip in Delhi.
• Reportage in the Indian Express.
• Reportage in the Hindu.
• James Lamont in the Financial Times blogs.

Envisioning future scenarios for India and China

Suppose we go back to 1870 and envision future scenarios for four interesting and promising countries.

Britain: the incumbent, the pioneer of the industrial revolution, home of Newton and Darwin, with a head start on building institutions, with sound economic policy and deep integration with a global empire.

Germany: the rising power of Europe, rapidly catching up with the frontier (and ahead of Britain in some fields). More centralisation of power, which perhaps gave an edge in certain things.

The US: a vast country blessed with a great constitution, inhabited by a colourful cast of characters drawn from the mavericks, misfits, nutcases and adventurers of Europe.

Argentina: a vast country with boundless prospects, sound policies after 1852, and tightly integrated into globalisation on both trade and capital.

You're probably thinking: `Argentina?' But in the middle of the 19th century, there were many people who thought that Argentina had better prospects than the US. From 1850 to 1930, Argentina did astonishingly well. In particular, from 1880 to 1905, GDP growth averaged 8 per cent over 25 years, which was unheard of in those years.

With the benefit of hindsight, we know what happened. Argentina collapsed into illiberal populism (first into socialism/fascism (1930) and then into Peronism (1946)). Germany collapsed into nationalism and militarism. The US and the UK managed to build liberal democracies.

With this framing, let's ask about how India and China will work out in coming decades.

Will India make it to good institutions, like the UK or the US? Or will India collapse into illiberal populism, much like Argentina did? All too often, the Indian elite tends to take good outcomes in the deep future for granted. I am not so sure and it is worth worrying about the foundations of liberal democracy and a market economy. Given the weak foundations of liberal ideas in India, political freedom is not something to take for granted. Given the weak foundations of market economics in India, economic freedom is not something to take for granted. Argentina's binge of welfare programs and populism is uncomfortably close to the instincts of most Indian politicians.

Will China make it to good institutions, like the UK or the US? Or will China descend into nationalism and militarism, much like Germany did?

The story of Argentina and Germany, from 1870 to 1914, reminds us that what works in a country for a short time is often not enough to carry the country through to a happy ending. Germany did very well from 1870 to 1914 (a full 44 years). Argentina did very well from 1850 to 1930 (a full 80 years) of which 50 years had really high growth.

To many people, sustained success that we have seen in India has generated complacence. We have started trusting in our governance DNA, thinking that it has delivered results after 1979 and particularly after 1993. This complacence hinders the process of identifying incipient problems, criticising the status quo, and changing course. The fact that a economic/political recipe worked well for a few decades does not mean that this recipe will continue to deliver. For a country to work out in the long run, it has to constantly nurture the foundations of liberal democracy and the market economy, and repeatedly reinvent itself.

In the late 19th century, growth rates were low in absolute terms, other than outlandish episodes like Argentina (1880-1905). Germany was the star performer of Europe over 1870-1914, with GDP growth of 2.9 per cent. The UK did just 1.9 per cent in this period. At 2.9 per cent growth, GDP doubles each 24 years. In other words, the economy and the political system need to be reinvented in each generation.

At 7 per cent growth, in India, we are getting a doubling of GDP every decade. This requires a reinvention of the economy and the political system every decade. But India presents a stark contrast with what's required: we have grossly failed on modifying laws, government agencies, policy frameworks and world views at a rapid pace.

Great SEBI orders, continued

Today we get the privilege of reading another amazing SEBI order: on Sahara. You might like to see some of the other orders which have caught my eye.

It takes immense competence and integrity to go after the facts and write a top quality order like this. The individuals and institutions who add up to this capability are the essence of attacking India's problem of corruption.

Does someone know how much money will have to flow back from Sahara to the investors of India, as a consequence of this order? And how will Sahara do fund-raising to meet this obligation? Within how much time will this money flow back? Other than 45 days to appeal at SAT, what are the other delays which could arise?

Making sense of the Mauritius tax treaty

Since the Mauritius treaty is back on the front burner, do see some sophisticated thinking on how the tax system can be made compatible with globalisation:

• Page 29 (`Residence based taxation of finance') in Indian social democracy: The resource perspective by Vijay Kelkar and Ajay Shah, February 2011.
• Chapter 9 of the Ministry of Finance Working Group on Foreign Investment, 30 July 2010.
• The Mauritius Code by Ila Patnaik, in the Indian Express on 12 July 2010.
• An entry titled India's financial globalisation, in Encyclopedia of Financial Globalization, edited by Gerard Caprio, Elsevier, 2012; in this the problem of residence-based taxation is located in the larger setting of India's integration into the world economy.

Inflation targeting: What have we learned

Inflation targeting: What have we learned, a seminar by Spencer Dale, Chief Economist of the Bank of England, at NIPFP, 16 June.