In the Independence Day special issue of Forbes magazine, I have an article titled Rightsizing the State. At a recent show organised by Dun & Bradstreet, I joked that the puzzle in India is that of finding the middle road, between Gotham City on one hand (a murky world of corruption and criminality) and Jurassic Park on the other (with socialist dinosaurs destroying the economy). Pessimists about India might say that if the goons won't get you, the dinosaurs will.
Wednesday, August 28, 2013
Sunday, August 25, 2013
Capital controls: what might sound nice at 40,000 feet is a big mess on the ground
Every now and then, some people get enamoured about capital controls as a tool for macroeconomic policy. The actual operation of capital controls on the ground is a mess.
As an example, consider the recent decision to hinder outbound capital flows by individuals and firms. At first it sounds fair and plausible. We are hindering outbound capital flows by households by interfering with their purchase of gold, and in similar fashion we should intefere with their outbound capital flows through other routes.
Vatsal Gaur and Sidharrth Shankar review this capital control in the Financial Express and everyone must read their analysis as a demo of what goes on in this field.
Their article shows that these capital controls are riddled with numerous microeconomic effects. As an example, Gaur & Shankar say: "Additionally, through a rather innocuous tweak to the July 1, 2013, master circular on Miscellaneous Remittances from India, RBI had effectively closed the LRS window for resident individuals looking to acquire securities of unlisted offshore companies."
Every time a government indulges in microeconomic meddling, this introduces distortions. The basic hygiene test of public policy is that detailed microeconomic interventions are only justified in order to address market failures (externalities; asymmetric information; market power) subject to two tests : (a) We are able to figure out a public administration strategy to overcome the principal-agent problem of citizens versus State and (b) We are able to do a cost-benefit analysis and demonstrate that the costs imposed by the intervention is exceeded by the benefit.
Every time a government meddles in the economy at a microeconomic level, this proposal must pass the following tests:
It is easy to slam RBI for what they have done, and to a significant extent they can do better. But the trouble is, almost everything in the field of capital controls suffers from these problems. Capital controls are detailed microeconomic meddling in the economy. They do not address market failures and hence they cannot be justified or analysed. It is not possible to clearly articulate objectives, or construct accountability mechanisms, for a public agency that would do capital controls. This generates the worst outcomes with a State apparatus that does not serve the interests of the principal.
In order to pursue the goals of macroeconomic policy, we need macroeconomic levers which affect the broad economy without introducing narrow microeconomic distortions by dealing with things like LRS windows and unlisted offshore companies. In monetary policy, the macroeconomic lever is the policy rate. Capital controls, in contrast, are microeconomic levers. Their use is always messy. People find other ways of getting their work done, so the desired macroeconomic outcome is not obtained. But along the way, GDP growth is adversely affected owing to the deadweight cost that people have to incur in getting past the restriction.
There is an extensive literature on the microeconomic distortions caused by capital controls. While they are effective in the sense of achieving distortions at a microeconomic level, they fail to deliver on the goals of macro policy. You may like to see Did the Indian capital controls work as a tool of macroeconomic policy?
As an example, consider the recent decision to hinder outbound capital flows by individuals and firms. At first it sounds fair and plausible. We are hindering outbound capital flows by households by interfering with their purchase of gold, and in similar fashion we should intefere with their outbound capital flows through other routes.
Vatsal Gaur and Sidharrth Shankar review this capital control in the Financial Express and everyone must read their analysis as a demo of what goes on in this field.
Their article shows that these capital controls are riddled with numerous microeconomic effects. As an example, Gaur & Shankar say: "Additionally, through a rather innocuous tweak to the July 1, 2013, master circular on Miscellaneous Remittances from India, RBI had effectively closed the LRS window for resident individuals looking to acquire securities of unlisted offshore companies."
Every time a government indulges in microeconomic meddling, this introduces distortions. The basic hygiene test of public policy is that detailed microeconomic interventions are only justified in order to address market failures (externalities; asymmetric information; market power) subject to two tests : (a) We are able to figure out a public administration strategy to overcome the principal-agent problem of citizens versus State and (b) We are able to do a cost-benefit analysis and demonstrate that the costs imposed by the intervention is exceeded by the benefit.
Every time a government meddles in the economy at a microeconomic level, this proposal must pass the following tests:
- What is the market failure? Can you demonstrate that what you are worrying about is a market failure?
- What's your proposed intervention?
- Does your proposed intervention address your market failure?
- What is the incentive structure through which policy formulation and enforcement is being done in the best interests of the people of India?
- Can we show that the costs are outweighed by the benefits?
It is easy to slam RBI for what they have done, and to a significant extent they can do better. But the trouble is, almost everything in the field of capital controls suffers from these problems. Capital controls are detailed microeconomic meddling in the economy. They do not address market failures and hence they cannot be justified or analysed. It is not possible to clearly articulate objectives, or construct accountability mechanisms, for a public agency that would do capital controls. This generates the worst outcomes with a State apparatus that does not serve the interests of the principal.
In order to pursue the goals of macroeconomic policy, we need macroeconomic levers which affect the broad economy without introducing narrow microeconomic distortions by dealing with things like LRS windows and unlisted offshore companies. In monetary policy, the macroeconomic lever is the policy rate. Capital controls, in contrast, are microeconomic levers. Their use is always messy. People find other ways of getting their work done, so the desired macroeconomic outcome is not obtained. But along the way, GDP growth is adversely affected owing to the deadweight cost that people have to incur in getting past the restriction.
There is an extensive literature on the microeconomic distortions caused by capital controls. While they are effective in the sense of achieving distortions at a microeconomic level, they fail to deliver on the goals of macro policy. You may like to see Did the Indian capital controls work as a tool of macroeconomic policy?
The talent pool in Macro and Finance
by Percy Mistry.
Dhiraj Nayyar, Director of the Think India Foundation, has just written an excellent, sympathetic piece about Dr. Subbarao's tenure as Governor of RBI.
It is full of pathos because Dr. Subbarao is a decent, dignified and extraordinarily intelligent, capable man with a powerful sense of politeness and decorum. These days: decency, decorum, dignity and politeness are virtues that, in modern political, bureaucratic and corporate India, seem conspicuous by their absence. So anyone who exhibits them, should score highly in anyone's book.
Dr. Subbarao's appointment as RBI Governor shows up, unfortunately, the bankruptcy of a bureaucratic career system that permits outstanding IAS officers like him -- an accomplished urban economist -- to be parachuted into a situation which requires a lifelong acquired feel for monetary policy and the numbers behind it.
From the many central bankers I have known around the world and in India (many of whom I had the privilege of working with, and others whom I came to know socially), and have observed closely over the years, I conclude that central banking is still more an art (that requires extraordinary prescience, instinct and judgement) than a precise econometric science. All top flight central bankers over the last 50 years have invariably ignored econometric evidence when it did not jibe with their instincts (something that a distinguished former Fed Chairman once told me he found essential to do, with all the econometricians around at the Fed!).
In India, our rare 'good' RBI Governors have had luck on their side and not fouled things up too much because of a lack of domain knowledge. Our 'bad' ones have had some bad luck but mostly a lack of comprehension about what they were doing. Most had good luck but still fouled it up without knowing they were doing that. None have had either domain knowledge or monetary policy expertise and experience on their side when they came into the job. They picked up what little they could as they went along.
Sadly, we have not learnt yet that, in the brave new globalised, open economy world we live in, specialised domain knowledge for the management of an open economy is a MUST for fiscal and monetary policy-makers and managers of the macroeconomy. There is no room anymore for relying on the peculiar British civil service tradition of using gifted (or, more likely, ungifted) amateurs, or all-rounders of the kind the IAS believes it still produces. It does produce exceptions like U. K. Sinha and K. P. Krishnan. But they are precisely that -- exceptions. They do not typify the IAS drone -- moderately clever, yet with dull, rigid, closed minds that are comfortably 'knowledge-proof'. I was once reliably informed that the minds of IAS were like powerful steel traps. Pity that they are rarely open.
It is amazing to me that almost none of the members of our top economic team in MoF, DEA, RBI, have much serious domain knowledge in their areas of control (except perhaps Raghuram Rajan and Montek Ahluwalia) or put any weight on its importance. Most of our economic heavyweights know more about managing a closed economy because that is how/when they were brought up as career officers during their formative years. Their instincts are still command-and-control, even when they haven't a clue about what they are doing, or its implications and consequences.
They have no idea how to deal with the challenges of an open (or in India's case partially open) economy and its weird reactions in times of stress/crisis when markets determine the extreme febrility of volatile outcomes. They still fly by the seat of their pants and talk about the 'fundamentals being sound'. That is disconcerting, because it only reinforces the view of the outside world that they do not know what they are talking about. It results in a collapse of confidence in India's economic managers and damages India even more. What exactly is it about any fundamental of the Indian economy that is sound right now -- the fiscal deficit? the current account deficit? capital flows? growth? inflation? the PMI? the food security bill -- which might be more appropriately called the Economic Insecurity Bill?
Dhiraj Nayyar, Director of the Think India Foundation, has just written an excellent, sympathetic piece about Dr. Subbarao's tenure as Governor of RBI.
It is full of pathos because Dr. Subbarao is a decent, dignified and extraordinarily intelligent, capable man with a powerful sense of politeness and decorum. These days: decency, decorum, dignity and politeness are virtues that, in modern political, bureaucratic and corporate India, seem conspicuous by their absence. So anyone who exhibits them, should score highly in anyone's book.
Dr. Subbarao's appointment as RBI Governor shows up, unfortunately, the bankruptcy of a bureaucratic career system that permits outstanding IAS officers like him -- an accomplished urban economist -- to be parachuted into a situation which requires a lifelong acquired feel for monetary policy and the numbers behind it.
From the many central bankers I have known around the world and in India (many of whom I had the privilege of working with, and others whom I came to know socially), and have observed closely over the years, I conclude that central banking is still more an art (that requires extraordinary prescience, instinct and judgement) than a precise econometric science. All top flight central bankers over the last 50 years have invariably ignored econometric evidence when it did not jibe with their instincts (something that a distinguished former Fed Chairman once told me he found essential to do, with all the econometricians around at the Fed!).
In India, our rare 'good' RBI Governors have had luck on their side and not fouled things up too much because of a lack of domain knowledge. Our 'bad' ones have had some bad luck but mostly a lack of comprehension about what they were doing. Most had good luck but still fouled it up without knowing they were doing that. None have had either domain knowledge or monetary policy expertise and experience on their side when they came into the job. They picked up what little they could as they went along.
Sadly, we have not learnt yet that, in the brave new globalised, open economy world we live in, specialised domain knowledge for the management of an open economy is a MUST for fiscal and monetary policy-makers and managers of the macroeconomy. There is no room anymore for relying on the peculiar British civil service tradition of using gifted (or, more likely, ungifted) amateurs, or all-rounders of the kind the IAS believes it still produces. It does produce exceptions like U. K. Sinha and K. P. Krishnan. But they are precisely that -- exceptions. They do not typify the IAS drone -- moderately clever, yet with dull, rigid, closed minds that are comfortably 'knowledge-proof'. I was once reliably informed that the minds of IAS were like powerful steel traps. Pity that they are rarely open.
It is amazing to me that almost none of the members of our top economic team in MoF, DEA, RBI, have much serious domain knowledge in their areas of control (except perhaps Raghuram Rajan and Montek Ahluwalia) or put any weight on its importance. Most of our economic heavyweights know more about managing a closed economy because that is how/when they were brought up as career officers during their formative years. Their instincts are still command-and-control, even when they haven't a clue about what they are doing, or its implications and consequences.
They have no idea how to deal with the challenges of an open (or in India's case partially open) economy and its weird reactions in times of stress/crisis when markets determine the extreme febrility of volatile outcomes. They still fly by the seat of their pants and talk about the 'fundamentals being sound'. That is disconcerting, because it only reinforces the view of the outside world that they do not know what they are talking about. It results in a collapse of confidence in India's economic managers and damages India even more. What exactly is it about any fundamental of the Indian economy that is sound right now -- the fiscal deficit? the current account deficit? capital flows? growth? inflation? the PMI? the food security bill -- which might be more appropriately called the Economic Insecurity Bill?
Saturday, August 24, 2013
Reverse Dutch disease from reverse resource curse
The problem
Shekhar Gupta and Swaminathan S. A. Aiyar have pointed out that our domestic policy logjam is leading to the import of natural resources which are amply present in mines in India. This is giving a bigger current account deficit and a weak rupee.
I feel this is not such a bad thing. Many countries have been afflicted by the resource curse and many countries have been afflicted by Dutch disease. We are blessed with reverse resource curse and reverse Dutch disease. Here's the argument.
Reverse resource curse
The idea of the resource curse runs like this:
For many years, economists have been puzzled at the way things have gone wrong in countries where natural resources were discovered. In 1993, the economist Richard M. Auty coined the phrase `Resource curse' to convey the extent to which natural resource finds are a curse and not a blessing. But the idea had been kicking around well before that. I suppose it was an obvious conjecture after watching the failures of the Middle East, where trillions of dollars of oil revenues were squandered by not one but many countries.Source: Why does Bombay have abysmal governance, 6 November 2010, on this blog.
In the 1970s, when oil was discovered in Venezuela, former Oil Minister and OPEC co-founder Juan Pablo Perez Alfonzo said: "Ten years from now, 20 years from now, you will see, oil will bring us ruin." His phrase for oil was: "the devil's excrement."
Why are resources a curse? In a country blessed with no natural resources (think Japan), the only way forward for the ruling elite is the slow hard work of building public goods, so that GDP builds up, which then feeds back into the power and importance and utility of the ruling elite. When the ruling elite gets their wealth for free, without having to do the hard work of building public goods and thus GDP of the country, the rulers emphasise the wrong issues. That's how Venezuela ended up with Hugo Chavez.
On one hand, rulers get focused on finding ways to maximise their rent from the underlying resource flow, without developing the knowledge about how to build a State that delivers public goods. In parallel, competition between politicians becomes an unpleasant process of trying to grab the riches by means fair or foul, rather than a process of competing in doing better on public goods. If there are XX billion dollars to be grabbed by becoming head of state, fairly unpleasant tactics get used by rivals aiming for that job.
And, you may like to also see: Resource curse - comparing India and Russia, 21 February 2007 and The resource curse of land ownership, 12 January 2012.
For many years, resources in India were a messy business. Now, we have started getting push back in terms of greater scrutiny and medium-grade enforcement. This has exerted a sharp negative impact on this business.
This is not such a bad thing. A country that lacks good institutions is better off without natural resources! If we hide the natural resources into the ground for 25 years, while we build good institutions, that is a good deal. It is far better to do this than to face the destruction of institutions which comes from natural resources impacting upon a badly constructed political system.
If we were advising a tin pot dictator who has just found oil, what's the best advice we could give? We would say: Burn all the documents about this oil find, and build the rule of law for the next 25 years. It is an achievement of Indian democracy and institutions that the reduced form outcome is one of restraint rather than exploitation of these natural resources. If this restraint had not come about, it would have distorted the trajectory of Indian politics, possibly with disastrous consequences for our future.
Reverse Dutch disease
At present, the exchange rate in Sri Lanka reflects a combination of competitiveness of the tradeables sector and financial considerations. Suppose there is a great oil find there. A surge of oil exports from Sri Lanka would then commence. This would exert pressure for the exchange rate to appreciate. This would damage the development of the tradeables sector which would not be able to compete at that distorted exchange rate. This has been termed `Dutch Disease' as it was first described in the context of the impact of North Sea oil.
We in India are getting the reverse. Excessive imports of natural resources, of even the things that are found under the ground in India, is exerting pressure on the exchange rate in favour of excessive depreciation. This will foster the tradeables sector. Reverse Dutch disease is not such a bad thing.
Conclusion
It is curious and remarkable that India is importing things that are found under the ground in India, owing the domestic institutional logjam. But we should resist calls to cut the Gordian knot and debottleneck the resources business in messy ways. It is much better for us to dig in and build good institutions, rather than find short cuts through which natural resource exploitation can hurriedly take place. This will surely take a long time. In the meantime, this will generate currency weakness. This is not such a bad thing.
Thursday, August 22, 2013
Too sensational: The defence of the rupee
Miss Prism: Cecily, you will
read your Political Economy
in my absence. The
chapter on the
Fall of the Rupee
you may omit.
read your Political Economy
in my absence. The
chapter on the
Fall of the Rupee
you may omit.
It is somewhat too sensational.
-- Oscar Wilde,
The Importance of Being Earnest,
1895.
The Importance of Being Earnest,
1895.
The graph above superposes the INR/USD exchange rate and Nifty, both reindexed to start at 100 on 15 May 2013. The graph runs till 21 August (i.e. yesterday). The rupee has depreciated by 17% and Nifty has dropped by 13.7%. I feel that the drop in Nifty is substantially about the reversal of reforms of this period. On the exchange rate, I think every short seller of the world got attracted watching the government trying to defend the rupee, which has given overshooting. This problem was exacerbated because RBI had damaged the liquidity of the currency market; when a flood of orders came, the price moved more because the market was shallow.
- Why did we bumble on the defence of the rupee?, Economic Times, 21 August.
- Crisis and complicity, Pratap Bhanu Mehta in the Indian Express, 21 August.
- A deadly defence, Surjit Bhalla in the Indian Express, 21 August.
- The RBI should end its stop-go policies, Lars Christensen in Mint, 21 August.
- Credibility crunch, Sanjaya Baru in the Indian Express, 20 August.
- Let the rupee sink, Andy Mukherjee in the Business Standard, 20 August.
- The needless battle, by Ila Patnaik in the Indian Express, 19 August.
- Editorial in the Business Standard, 18 August.
- Editorial in the Indian Express, 17 August.
- India Inc hedges its bets by Ila Patnaik in the Financial Express, 16 August.
- Editorial in the Business Standard, 15 August.
- Will the capital controls to defend the rupee work?, 14 August.
- Editorial in the Indian Express, 13 August.
- Govt, RBI fighting a losing battle on rupee, Tamal Bandyopadhyay in Mint, 13 August.
- We don't know much about what the exchange rate ought to be, 12 August.
- Should we have picked this battle?, Economic Times, 7 August.
- Don't hold the rupee, by Abheek Barua in the Business Standard, 6 August.
- The collateral damage to banks from RBI, Ravi Krishnan in Mint, 5 August.
- RBI norms on gold imports may deal a blow to domestic jewellers, Dinesh Unnikrishnan in Mint, 1 August.
- Editorial in the Indian Express, 31 July.
- Editorial in the Business Standard, 31 July.
- Rising collateral damage, Sonal Varma in Mint, 30 July.
- Does India need sovereign bonds?, by Ila Patnaik in the Financial Express, 24 July.
- Editorial in the Business Standard, 24 July.
- RBI's rupee rescue mission may hurt government, by Anup Roy, Manish Basu, Kayezad E. Adajania in Mint, 24 July.
- India moves closer to gold import quota to stifle demand, Siddesh Mayenkar and A. Ananthalakshmi in Mint, 24 July.
- Editorial in the Business Standard, 23 July.
- Offshore funds make a killing on betting of movement of interest rates in India, by Sugata Ghosh in the Economic Times, 22 July.
- There is no method to RBI's madness, by Tamal Bandyopadhyay in Mint, 22 Jul.
- Editorial in the Indian Express, 17 July.
- Government paper sales cancelled after investors demand high yields, Anup Roy in Mint, 17 July.
- Editorial in the Indian Express, 16 July.
- Step back into the ring, by Jahangir Aziz in the Indian Express, 16 July.
- RBI, SEBI attack currency speculator; but rupee stays intact, by Mobis Philipose in Mint, 15 July.
- The taming of the rupee, by Ila Patnaik in the Financial Express, 12 July.
- The attack on the market for the rupee is a mistake, Economic Times, 11 July.
- Editorial in the Indian Express, 11 July.
- Losing currency, by Ila Patnaik in the Indian Express, 10 July.
- Editorial in the Business Standard, 10 July.
- Hedging surge prompts RBI inquiry on rupee moves, Bloomberg content in Mint, 8 July.
- Editorial in the Business Standard, 8 July.
- RBI moves to curb rupee speculators, Rafael Nam and Suvashree Dey Choudhury in Mint, 2 July.
- Rupee at 60: the options before RBI, by Tamal Bandyopadhyay in Mint, 30 June.
- How to cap the CAD, by Ila Patnaik in the Financial Express, 28 June.
- Don't try to control the rupee, by Ila Patnaik in the Financial Express, 21 June.
- Do not mourn rupee fluctuations, Economic Times, 11 June.
- Rupee will need support in coming months, Renu Kohli in Mint, 28 May.
- The arrogance of power, 12 May.
- How do you prevent rupee trades?, by Ila Patnaik in the Financial Express, 10 May.
- The rupee: Frequently asked questions, 1 December 2011.
And, you may find it interesting to see an updated picture of the evolution of the Indian exchange rate regime [methodology]:
This graph shows a moving window of annualised volatility of the INR/USD exchange rate for the last 15 years, starting from 28 August 1998. Vertical lines show the two dates of structural change of the exchange rate regime. As we see, we had volatility of 1.84% for 4.74 years until 23 May 2003. Then we jumped up to 3.87% volatility for 3.84 years. This lasted till 23 March 2007. We are now in the longest single period under one single exchange rate regime: 6.42 years spent with an annualised volatility of 8.73%. Through this period, every debate on exchange rate policy ended up in favour of exchange rate flexibility. The floating exchange rate is the only stable long-term option for India.
Wednesday, August 21, 2013
Why did we bumble on the defence of the rupee?
I have a column in the Economic Times today on this subject.
Thursday, August 15, 2013
Author: Harsh Vardhan
- Beyond Syndication: Unlocking the Power of Single-Asset Securitisation, 2 February 2026.
- Who lends to the Indian state?, 24 August 2024.
- The place of short selling in the financial markets, 18 April 2023.
- How "Orderly" is the Evolution of the Indian Yield Curve?, 3 June 2022.
- A cooperative liquidity window for mutual funds: A debate, 10 January 2022.
- Sudden Rise of the Floaters, 9 August 2021.
- The Indian corporate bond market: From the IL&FS default to the pandemic, 7 August 2020.
- Are Indian banks systematically mispricing risk?, 2 January 2015.
- The case for differentiated bank licenses, 15 August 2013.
- Rethinking the Statutory Liquidity Ratio (SLR) in Indian banking, 29 October 2012.
- Should government capitalise public sector banks?, 9 October 2012.
- White label ATMs, 6 August 2012.
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