What's the Indian investor to do about global macroeconomic imbalances?

It is the best of times, it is the worst of times. On one hand, the Indian stock market is doing very well. The CMIE Cospi (2540 companies) is at a market capitalisation of Rs.24.7 trillion or roughly $550 billion. What is more, the Cospi P/E is up at 18.

At the same time, the world economy is plagued by important doubts - particularly about the US and the Chinese economies. Business Standard had an excellent editorial, a few days ago, exploring these themes.

What is doubly odd is that while many economists are truly worried about these `global macroeconomic imbalances' (e.g. Ken Rogoff, Martin Feldstein), the financial markets seem to be completely comfortable with what is going on! I use the implied volatility on the S&P 500 as a measure of expectations about future equity volatility. It is down to remarkably low levels like 11%. I can't help thinking it's a good idea to be long volatility.

What is someone invested in India to do? I think that India's exposure to a global business cycle downturn is greater than meets the eye. A lot of the Nifty stocks will take a beating if things go wrong between China and the US. Some Indian companies (e.g. Infosys) will suffer because they export a lot. Others (e.g. Tata Steel) will suffer because distressed Chinese companies will crash product prices.

And given how low the VIX is, it seems like a great idea to buy protection against the global business cycle by: Purchasing out-of-the-money put options on the S&P 500!

There is the small matter of RBI's capital controls, which prevent you or I from doing so. As Jayanth Varma says, the Indian capital account is open to all except the Honest Resident Indian (HRI). Can one use the limit of $20,000 per person per year of outbond capital in order to buy protection using the S&P 500 puts? Has anyone used this limit to do global diversification?

FBT & STT

It is budget season in India, and debates about taxation are once again in the air.

Everybody loves to hate the new treatment of `fringe benefits'. Firms are unanimous in being unhappy about the mechanics of the "fringe benefit tax" (FBT). From first principles, what one would like is a system which measures the complete income of all employees accurately, and applies the same tax schedule to all of them. In this cases, whether a person is paid Rs.50,000 per month as a flat salary or whether Rs.20,000 of that is delivered as a zero-rental apartment, the tax rate should be neutral. Critics of the FBT need to fully articulate a non-discretionary mechanism for solving this problem. To the extent that the FBT has pushed firms towards all-cash wage packets, that's a Good thing, and is partly a useful consequence of the FBT. Ila Patnaik has an interesting article on this in yesterday's Indian Express.

In my mind, the picture is very different with the `Securities Transactions Tax' (STT). Business Standard has an excellent editorial on this. This is a tax which is simply wrong. The job of a financial sector is to deliver low transactions costs for trading. Low transactions costs imply higher market efficiency, which is the end-goal of all finance.

The STT stands at 10 bps for cash (delivery) trades, 2 bps for cash (square off) trades and 1.33 bps for derivatives trading. These are huge numbers. Consider a vanilla spot-futures arbitrage for the Nifty futures. Normally, the transactions costs would be driven by the impact cost, which is typically 10 bps on the spot and 2 bps on the future. The STT then implies a huge jump in the frictions of trading - even for this simplest strategy (spot-futures arbitrage). If you tried to run an options book, based on a delta-neutral dynamic strategy, which ran up a lot of trading, the picture would be much worse.

The STT also does something deeply wrong by exempting many parts of finance (e.g. the bond market or the commodity futures market). Given the large size of the STT, this generates huge distortions of activity away from taxed sectors towards untaxed sectors. This is a bit like the customs problem. The best rate for customs duty is 0. But if you have to have a non-zero customs duty, the best system is to have a uniform rate for all markets.

The STT really taps into the deep intuition of a person vis-a-vis finance. Some people think that financial markets are to be mistrusted, that more trading is dangerous, that there is such a thing as markets that work too well. To this instinct, the STT is a good option, for it throws sand in the wheels of finance. To others, like me, the name of the game in financial sector policy is how to obtain more liquidity - not less. If we had wanted less liquidity, why did we bother trying to build modern markets?

Capital controls in operation: Tales from the front

We all very well remember the 1960s and 1970s, when we had a complex system of quantity controls and price controls. Three things were in place: There were many quantity controls, there were many price controls, and it added up to a complex system with thousands of levers.

We know what happened in that period. Firms got focused on how to earn profits by beating the system, rather than being efficient. People who had a permit earned a rent on that permit. It was easy money. They got addicted to it, and then started political lobbying to ensure that nobody else got the scarce permits. The functioning of companies, and the technology of production, got enormously distorted in ways which emphasised earning profits by learning and exploiting the system of controls rather than being smart or being efficient.

But we learn from history that we learn nothing from history. Hence, this movie is now being played in finance, where we have the same three pieces: there are many quantity controls, there are many price controls, and it adds up to a complex system with thousands of levers.

Today, the Hindu Business Line has an article by Rajesh Abraham telling a story about a `banking stock price index ETF' product by Benchmark which has been phenomenonally successful. Benchmark are good guys, and they are among the better purveyors of index funds in India, and I like index funds in general, but Rs.2,668.39 crore invested in a bank index ETF??

I read the piece, and it's the old 1960s and 1970s story being played again. FIIs are prohibited from buying bank stocks directly, so they flock to the bank ETF as a way of getting that exposure.

On a related note, U. R. Bhat has an opinion piece in Economic Times talking about participatory notes. PNs are OTC derivatives written outside India by a finance company. The article is not as blunt as it ought to be, in one respect: No regulator in India can know what PNs are written by what firm outside India to whom.

PNs can be described as OTC derivatives written outside India. Most of the time, the PN seller would want to hedge himself by taking an offsetting position in India. Ah, I see! This is just the old 1960s / 1970s story of earning a rent on a permit. Some FIIs in India have the permit, and they're getting a fee by renting it out to the poor folk who don't.

In addition, PNs are an elegant and desirable mechanism for avoiding the procedural frictions and transactions costs of doing business in India. The buyer of the PN is avoiding these hassles, and the seller of the PN is getting a fee for taking the trouble. As U. R. Bhat says: Quite often investors who are eligible to get a FII or FII sub-account registration do participate in the Indian market through PNs. This is the case because of the procedural issues relating to registration, establishing broker and custodian relationships, undertaking forex transactions and more importantly, dealing with tax certifications, filing of income-tax returns and getting tax assessments completed. In addition, there is the added uncertainty about the tax status of foreign investors with the revenue authorities interpreting the provisions of tax treaties differently on different occasions with issues like permanent establishment, classifying investment income as business income etc, being subject matters of frequent disputes. For an investor, PNs offer an elegant solution to procedural hassles and tax uncertainties, by transferring these risks to the main FII, albeit at a price, to enable the investor to focus attention on scouting for good investment opportunities.

The price of the PN reflects the size of these frictions, and the scarcity of FII permits.

What would the 1960s / 1970s response to these things be? More control and more policemen! FIIs are beating limits on bank stocks by buying the Bank ETF? Let's Ban FII investment in ETFs! FIIs are coming in through PNs? Let's Ban PNs! We already have RBI pushing the latter (couched in the vocabulary of `unclean capital flows', which would make a 1970s bureaucrat proud). I haven't seen anyone proposing the former, yet. But who can tell? Those who fail to learn from history are doomed to repeat it.

To read more on these issues in the context of capital controls, see Kristin Forbes' excellent survey article which is part of this forthcoming NBER book.

The pension reforms story goes on

Things are looking grim on pension reform. It's been 1.5 years of the UPA government, and they haven't yet got the PFRDA Bill to vote in Parliament. The left trade unions - who seem to have veto powers on this one - seem to have taken a tough stance of opposing reforms. There don't seem to be enough sane voices within the CPI or the CPI(M) to overcome the vested interests of the left trade unions. Things are just stuck.

My most-recent Business Standard column is titled What next on pensions. I argue that you don't need the PFRDA Act to build the New Pension System. We can proceed on building NPS right now, using alternative mechanisms for regulation, and do the PFRDA Act after the next elections, when the CPI(M) no longer has veto power over all legislation.

It's possible to sign a contract between government and the Central Recordkeeping Agency (CRA), and obtain enforceability through that contract. It's possible to have SEBI regulate pension fund managers. It's possible to have contracts with the banks and post offices who're the front-end of the new pension system. Through this three-pronged approach, it's possible to use contracts, and SEBI's powers on regulating fund management, to get the New Pension System up and running.

We've gone through some interesting flip-flops on this. Under the NDA government, Jaswant Singh and S. Narayan wanted to do NPS first, let it stabilise, and then do the law. When the UPA government came along, P. Chidambaram felt that it was feasible and important to do the legislation first. For a while, it looked like the legislation would go through (we got till an ordinance). But now things look gloomy i.t.o. the ability of the UPA to do economic policy, so I say, why not just go back to the previous strategy?

The very next day, Gautam Bhardwaj wrote an article, also in Business Standard, where he has a different take on the problem. He emphasises that the original goal of Project OASIS (1998-2000) was the great masses of the uncovered sector, and not civil servants. It was only later, in December 2002, that the Government of India chose to utilise the institutional mechanisms designed by Project OASIS for the purpose of solving the civil servants DC pension problem.

Now it looks like the baggage of the civil servants problem is slowing down the core task of a pensions regulator and a DC pension system. Gautam argues that what we ought to do is proceed on building PFRDA and NPS for the uncovered sector, while separately haggling with the left parties about what should be done for civil servants.

The third new piece on pension reforms is the briefing prepared by the new effort Parliamentary Research Service, which is located at the Centre for Policy Research in New Delhi. Their analysis of the PFRDA Bill, and associated briefing materials, seek to bring multiple perspectives to bear on pending legislation, and help Members of Parliament, and the public at large, become more effective in coping with pending legislation.

SEBI as the regulator of (all) securities markets

Business Standard has another editorial on a financial architecture question: on the organisation of commodity futures regulation. At first blush, it's an obvious problem - look around the world, and all the important exchanges of the world trade futures on all kinds of underlyings under a single roof. But in India, we're headed for a messy separation of the exchange-traded equity derivatives ecosystem from the exchange-traded commodity derivatives ecosystem.

If you are an exchange trading equity index futures, you won't be able to launch a gold futures product, and vice versa. If you are a securities firm, you will need to setup two distinct subsidiaries: one trading equity futures and another trading commodity futures. If you are a customer, you will need to have two trading accounts when one would have sufficed. This will induce three kinds of difficulties:

1. Costs will go up. India will fail to harness economies of scale and economies of scope.
2. There will be adverse effect on competition owing to walling off subsets of the industry from each other. In the best of times, it's hard to get active competition into the exchange industry, given the network effects associated with market liquidity. We make it worse by walling off exchanges from competing with each other.
3. It will take many years, and possibly many a disaster, before FMC replicates the learning that has already taken place at SEBI in terms of building an adequate regulatory capacity.

It looks like the UPA Cabinet has decided to support an amendment to the Forward Contracts (Regulation) Act. I haven't yet seen the amendment; it's unlikely to become public until it gets tabled in Parliament. Even if the amendment drafting is perfect, we'd get a bad policy (separation of commodity futures into a separate industry with a separate regulator).

In practice, it could easily get worse than that, if weak human capital is put into the drafting of the law. I have closely watched the evolution of SC(R)A and the SEBI Act over the last 15 years, and I know how hard it is to get the drafting right. There isn't much knowledge of finance in the Department of Consumer Affairs, where the drafting is being done, and I don't know that they are outsourcing the work to people who know. So we could easily get a flawed implementation of a bad idea.

Rational runs on cooperative banks

The weakest part of Indian finance is probably the cooperative banks. EPFO's Employee Pension Scheme (EPS) probably has a funding gap of 1% of GDP, but the cooperative banks are most-likely worse than this. Rediff has a fascinating collection of news items about fraud and crises in cooperative banks.

From a public policy perspective, it is generally thought that customers of cooperative banks are the worst off in being helpless, uninformed depositors - unable to understand the risk of banks and unable to take care of themselves. This motives all sorts of paternalism in terms of putting down government money to rescue failed cooperative banks, even beyond the ordinary processes of deposit insurance.

A big crisis in a cooperative bank took place in 2001, with Madhavpura Mercantile Cooperative Bank (MMCB). In a fascinating recent paper, Rajkamal Iyer and Jose-Luis Peydro have examined this episode. They seem to have obtained some unique data from RBI, which isn't easily available normally.

The special feature of MMCB that they focus on is a unique mechanism for interbank contagion: many other cooperative banks had held deposits with MMCB (!). Hence, when MMCB went down, there were fears about other cooperative banks also failing. As is well known, cooperative banks have negligible equity capital, and are hence unable to absorb even the smallest adverse shocks. So if a cooperative bank had even 1% of it's assets with MMCB, this would be enough to induce insolvency.

At the time, there was a run on many a cooperative bank in Gujarat. What Iyer & Peydro find is that there was more rationality in these runs than meets the eye. They find that the contagion was significantly related to exposure-to-MMCB. Banks which had a greater exposure to MMCB experienced higher depositor flight. Banks which were more sound experienced smaller withdrawals. Depositors didn't panic irrationally.

I see this as some kind of `strong form efficiency': depositors seem to have been able to obtain information about cooperative banks which is not in the public domain, and then make judgments about which banks were sound and which weren't.

This evidence contradicts the popularly held notion in India that depositors - particularly depositors in cooperative banks - are helpless, are ignorant and require paternalistic support from the government in the form of various kinds of risk-management subsidies for their transactions with banks.

The paper is here in pdf format. An easily-read version of the same ideas appeared in the H. T. Parekh column in EPW.

India's story with cooperative banks is far from finished - as the Rediff index page above clearly suggests. A recent, and excellent piece on this subject, by Tamal Bandopadhyay appeared in Business Standard.

MAPIN is back; so let's get the privacy right

MAPIN is a database about individuals, which uses fingerprints to ensure that one individual cannot have multiple accounts. This makes possible interesting applications in the financial sector. For example, if a person is debarred from working in the securities industry for X years by the regulator, the database makes it possible to prevent him from resurfacing under a new identity. SEBI has begun by making MAPIN mandatory for a few people (board of directors), but the long-term goal is to have a large number of people in the system.

Many pillars of society have complained about being treated like common criminals, and having to supply fingerprints. There are also concerns about the safety and privacy of the data.

For a while, SEBI seemed to want to kill the MAPIN system, but they have changed their mind now and seem to be headed to restart MAPIN. Business Standard has an interesting editorial on the MAPIN database. They say that the system is required, in dealing with problems like insider trading and market manipulation. They show a host of questions that the citizen should worry about on questions of safety and privacy of data, and argue that while MAPIN is needed a concerted policy focus on privacy.

The questions they pose are:

• If a private investigator could tap Amar Singh's Reliance telephone, what is to ensure privacy of the information with MAPIN?
• Can computer-scanned thumbprints, obtained from MAPIN, be used to frame a person at a crime scene?
• The Amar Singh case involved attack by a private individual. But very often, in India, the worst perpetrators in terms of violation of privacy are employees of the government. Is all MAPIN data available to the IT department?
• Can the police query one record? Can the police run a search on the full database?

My understanding of the treatment of thumbprints is that scanned images of fingerprints are put through a feature-detection algorithm, and a compact vector of characteristics is stored in the system. Testing that two fingerprints are identical is then synonymous with testing whether the two vectors are close to each other. The actual scanned fingerprint is not stored. (And, it a person can be tricked to hold a glass of water, his fingerprints can be extracted from it).

The attacks on privacy can occur in two ways: based on policy and based on violations of policy.

Violation of policy would involve attacking NSDL computer systems, unethical employees at NSDL, etc. NSDL needs to comprehensively persuade the country that it is doing a good job of blocking attacks which are based on violations of policy.

Policy-based attacks can be where a policeman walks up to NSDL and asks for information. NSDL is only the agent of SEBI. So when a policeman walks up to NSDL and asks for information from MAPIN, NSDL needs an instruction in writing from SEBI to release the information. So the question of policy-based attacks goes one deeper: SEBI needs to write down a privacy policy for the securities settlement database and MAPIN; the Income Tax Department needs to write down a privacy policy for TIN, and so on.