Why did RBI raise rates?

Many observers were surprised by RBI's recent rate hike. It appears to make no sense in terms of where the economy is going. As Ila Patnaik points out in an excellent piece in Indian Express today, it isn't hard to understand what RBI did, but you have to shift your mindset to a modern framework of open economy macroeconomics.

With a pegged exchange rate, and with a de facto open capital account, RBI doesn't actually have much autonomy to run a monetary policy that is crafted to suit India's interests. The weapon of monetary policy is getting used up to deliver low currency volatility, when it could instead be used to deliver low GDP volatility. So even though it just doesn't fit in the immediate context of Indian macro, RBI is responding to the interest rate hikes of the US Fed.

Some people think it's obvious that when the Fed raises rates, every country has to also do so. But as theory and evidence show, strong correlations of monetary policy across countries only happen when you peg or fix. Frankel, Schmukler and Serven have an excellent 2002 NBER paper on the loss of monetary policy autonomy for countries that fix/peg.

Open economy macro is a new field in India, and there isn't much out there. So here are some pointers to work in this field. What is India's exchange rate regime; why do we have such a huge reserves accumulation? Ila solved this in 2003. Does this hurt the implementation of monetary policy? I.e., is there `enough' openness on the capital account for a pegged exchange rate regime to come at the price of monetary policy autonomy? Ila did this in India's experience with a pegged exchange rate, which appeared in India Policy Forum (Brookings Institution & NCAER), Volume 1, 2005 (Here's a WP version). Finally, how can one interpret India's story with capital flows from this framework? Ila and I did a paper India's Experience with Capital Flows: The Elusive Quest for a Sustainable Current Account Deficit which is forthcoming in an NBER book.

A sharp rise in the VIX

Just last friday (14th January 2005), I wrote a blog entry saying that the VIX was very low, and it made a lot of sense to buy protection using put options on the S&P-500 at an implied volatility of 11%.

The VIX just rose and rose after that! [News story about VIX on Friday] The first opening price after that friday was at 12%. On Friday the 20th, it went up to 14.56%. Here's a table of the relevant data. While it's risen sharply, it's still at very low values by historical standards. I think all eyes will be on the VIX on Monday.

What happened!? Global equity markets have certainly become a lot more nervous. I could discern one potentially important piece of new bad news: that high US consumption based on home equity extraction could be coming to an end.

How free is India, supposedly the biggest democracy in the world?

The self-image of most of us in India is that we have freedom of speech and freedom of press. But in reality, things are much worse than meet the eye.

A simple litmus test is the scoring of `Freedom of Speech' in countries of the world, done by Freedom House. It gives India a score of 38 and a status of "Partly Free". We are a clear notch below the better-run countries of the world. We do better than China, but we're behind South Africa.

What is going wrong? A host of intrusions on freedom can be identified. The Freedom House URL above mentions:

• The Official Secrets Act as a tool for censorship,
• Intimidation of journalists including murder and physical violence,
• State actions to stop advertising in Kashmir Observer,
• The State monopoly on AM radio transmission,
• The ban on FM transmission of news,
• The very existence of Doordarshan,
• The political slants of a number of TV channels,
• The periodic bans upon books such as those that point out that Mr. Shivaji was more brigand than hero.

It adds up to quite a picture of infractions of freedom of speech. Is that a comprehensive list, or are there other violations? I can think of some others. The Indian government covered itself with shame in the episode where Yahoo Groups access within India was shut down because of one mailing list which disagreed with GOI. The State has a big role in the satellites through which TV broadcasting is done in India. The State has barriers against foreign newspapers.

Freedom is built out of a million small battles. One of these was acted out recently, when the State tried to place restrictions on the content that an Indian newspaper could carry, which was sourced from outside the country. This was challenged in the Delhi High Court, which struck down these restrictions as being incompatible with the freedom of speech enshrined in the Constitution.

That's great news! Does this mean someone can legally challenge the ban on FM stations broadcasting news?

Normally, we think that the proliferation of new technology makes it harder and harder to supress knowledge. But as China has demonstrated, electronic media are vulnerable to control, perhaps more so than physical paper was. Yahoo and Microsoft have both betrayed individuals in China, to curry favour with the State. Ila Patnaik had a nice article in Indian Express, on the freedom of speech issues associated with `Direct To Home' TV. As she says, in the case of newspapers, we know and rejoice in the fact that the State does not run newspapers, nor does it run printing presses. But in the electronic media, we accept Doordarshan, and the State has a near-monopoly on printing presses (satellites).

I find the widespread acceptance of Doordarshan and AIR -- government owned media -- to be really disappointing. Compare and contrast against the experience with the US `information' agencies, Voice of America and Worldnet Television. They are explicitly prohibited from broadcasting on US soil. As far back as 1948, lawmakers in the US clearly understood that control of a radio station in the hands of the existing administration distorts the next elections.

Things are bad in India on the related question of civil liberties also. The recent din and fury about phone tapping could hopefully take us to a state where phone tapping is made much harder. At present, violations of privacy are endemic. A friend of mine told me a story where there was a woman who suspected her husband was having an affair. She called the phone company and -- purely by talking with them on telephone -- got them to give all kinds of information about his phone records, and (worse) about his physical location on various dates. It could be that anyone armed with minor skills in social engineering, could call your telco on phone and discuss your movements and phone calls. Scary!! This links up to the civil liberties concerns abut Mapin. On a related note, Robert Cringely has an excellent article today about phone tapping in the US.

Update: Tapping phones might become slightly harder. And, my respect for The Times of India just went up a few notches when it appears that their Patna edition carried the famous cartoons. But this blogger claims that in India, this is illegal.

Another tax on transactions

Stamp duty has been on the burner of late. The `Telgi Scam' involved embezzlement of government tax revenues in the context of the "stamp duty". And the Maharashtra government tried to pull off some disastrous taxation of financial transactions, since most of the securities exchange infrastructure is located in Maharashtra.

Today there is news that the Maharashtra government has backed away from taxing bond market transactions. I don't know if that puts an end to this chapter, or if they will persist in trying to tax other markets such as equity, corporate bonds and commodity futures. There is also news about amending the relevant legislation.

Stamp duty is a tax on transactions. From first principles of public finance, we know that taxing transactions is wrong. Ila Patnaik has an excellent piece in Indian Express, where she says that it is the task of the State to maintain databases of land title, but this is a public good which should be delivered with atmost a user charge such as Rs.5 per transaction, which is roughly NSDL's price for one transaction. To tax this, or to have an ad-valorem charge, is wrong. Imagine how you would feel if when you went up to NSDL, asking him to change the ownership of some shares from Mr. X to Mr. Y, he asked for a fee -- not reflecting the cost of his work of maintaining the database of title -- but a 5% tax.

In the big picture, I see a role for bringing the entire real estate sector into the Goods and Services Tax, as had been proposed by the Kelkar FRBM Task Force, simultaneously with abolishing all taxes on real estate transactions.

A great new atlas of India is now available

Maps in India are generally terrible. There are two problems: Bad underlying survey data, and bad presentation in converting the map database into maps.

In my opinion, for many years, the best alternative was the Lonely Planet Atlas. For some mysterious reason, this was not available in India. But if you could get it, it was high quality cartographic display, on top of low quality underlying maps data. Which is a polite way of saying that the map is remarkably often flat wrong. The LP Atlas seems to have been done in 1995 and nothing has come up after that. The LP website doesn't have it.

A great new alternative has recently sprung up: the Eicher Atlas of India. It is just Rs.370 or so and worth getting. It combines top quality cartographic display with the same flawed underlying data. On the front cover is proudly flaunted a map of the Bombay region - which is a top quality map - but I could spot atleast two mistakes in it. But it's a huge step forward compared with everything else out there.

Maps are a nice problem which help in thinking about the separation between public goods and private goods. The public good is the creation of a map database by running around the country with theodolites and GPS handsets. Once this database is created and released into the public domain, it is a perfect public good (non-rival, non-excludable). After that, the State has no business to be in the map business. The State shouldn't print maps or interfere in what citizens do with maps.

In India, we do wrong on both counts:

• The Survey of India produces terrible maps data - riddled with mistakes, and hopelessly out of touch with the fast-changing bridges and roads. To add insult to injury, the tax-funded databases produced by the Survey of India are not released with no strings attached into the public domain.
• The State tries to produce maps, and tries to prevent citizens from having all kinds of maps.

It's a classic Indian public policy mess of not doing the public goods that matter properly, and adding insult to injury by meddling with what free agents in the country do.

I faintly recall a Central Asian city - in Azerbaijan? - where I have heard that there are no street signs, since the Russians wanted to make life difficult for an invasion (when it came). The invaders would be doing fine with GPS, and all the Russians acheived was terrible inconvenience. Update: Naveen Mandava has a pointer to a Rand Corporation study about the security issues of release of geospatial data.

We are like that. For a long time, the State prevented those nifty GPS-based route finding computers from being embedded in cars. I believe some of these legal impediments have been solved, so that these things are now available (Rs.60,000 was the price I heard for an in-car one-city setup). Does someone know more about this?

But the proscriptions against citizens accessing 1:250,000 or 1:50,000 topo sheets remain. Every terrorist wannabe or military type can buy these maps outside India; the only benefit of the license-permit raj is to prevent citizens from leading better lives based on maps.

Two big-picture lectures about India

I helped Vijay Kelkar in drafting of two lectures, which actually add up to an interesting integrated view of India:

1. The first was the Narayanan Oration (April 2004) at the Australian National University: India: On the growth turnpike.
2. The second was the Gadgil Memorial Lecture in October 2005: India's economic future: Moving beyond State Capitalism.

They add up to interesting reading. The first looks back and thinks of deeper forces, the second looks forward at what is to be done. A slightly related version of the key ideas of the first appeared in Indian Express on Diwali day of 2003. The latter has been written up a bit. Today Andy Mukherjee linked up to it in his column.

Fixing the IPO process

The financial establishment in India is in a tizzy about the "IPO Scam". This involves multiple applications in order to capture the shares reserved for "individual investors". As Jayanth Varma has pointed out, this problem is ultimately caused by mistakes in the design of the IPO.

I wrote a column for Business Standard titled Why track down Roopalben?, where I argue that the problem in the IPO process can best be solved by shifting the IPO market to a pure uniform-price auction, where there is no special treatment of individual investors, there is no `Syndicate', and only a trivial role for the merchant banker.

Oddly enough, I had written essentially the same idea in November 1999 in the context of the IPO of Hughes Software Systems. The basic issue is the same: Should India use some kind of messy computerised IPO process, or should there be a clean pure-auction that is run by computers?

The litmus test of the soundness of the IPO mechanism is the size of IPO underpricing, i.e. the returns from IPO date to listing date. As documented in my 1995 paper, in the bad old days, we had enormous underpricing. The screen-based bookbuilding has helped reduce the size of underpricing, but it is still very large. This suggests that there is a need to improve the IPO mechanism so as to acheive pricing efficiency. The tight "price band" that is set by the investment banker today violates the notion of price discovery by the auction and not by the investment banker, as was the case in the fixed-price offerings which used to take place in the bad old days.

The issue of multiple applications at the IPO by individual investors is sometimes linked up to the (lack of) the Mapin database which will allow a clarity of identifying each investor. I believe that whether or not Mapin is up and running, the only meaningful notion of finance is where every security has a single price, regardless of the identity of the buyer. Whether I'm an indvidual or a mutual fund, I pay the identical price for a Maruti car or a share on the secondary market. There is no reason why the IPO market should violate such a rule. (I believe we need the Mapin database for other reasons, but not for this one).