Public policy research in India

In a country like the US or the UK, there is a lively `marketplace of ideas' in public policy, where alternative visions about the State are debated. On 30 August 2006, Guy de Jonquières wrote a piece in FT titled Asia needs a more active market in ideas where he says:

One of the most surprising discoveries on moving to Asia is how little intellectual curiosity there is in the region about the dynamics of its dizzying rise and where it is leading. In spite of Asia’s growing global weight, much of the most illuminating research into its affairs, whether economics, business, social policy or international relations, still originates elsewhere, mainly in the west.

Asia has no shortage of brainpower, or of self-styled think-tanks. But most produce pedestrian work that often fails to grapple with – still less answer – the hard questions. Many simply churn out official propaganda, and few look far beyond their own backyard. In the words of Jean-Pierre Lehmann, a Swiss business school professor who knows Asia well, there is a lot of tank, but not much think.

Many western think-tanks, of course, are also little more than mouthpieces for their financial backers. But the best ones dig for facts, sift them rigorously, question established policies and seek to chart new directions. Occasionally, like those that shaped the thinking of Britain’s Baroness Thatcher, they can seed a revolution.

Asia has no such marketplace for ideas. Stunning though China’s growth is, it is impressive as a daring feat of execution, not because it is based on startlingly original development thinking. When “Asian values” were hawked around the region a decade or so ago as some kind of distinctive philosophy, they turned out to be just a self-serving attempt to justify autocracies.

Novel ideas, by contrast, are stimulated by intellectual contention and reasoned dissent. It is no accident that they tend to flow freely in countries such as the US and Britain that not only tolerate but encourage those activities as socially beneficial. In Asia, only India, home to some notably independent-minded research institutes, has a comparable tradition.

In continuation of this discussion, Suman Bery has a column in Business Standard today about policy research in India.

In my experience, once we get to a narrow and specialised subject, there are very few experts in the country. This hurts because there is reduced discussion and competition. The flow of good quality papers is very thin, and there are very few good conferences. As any journal editor and any conference organiser knows, it is hard to find interesting papers, and once you have them, it's hard to find good discussants or referees.

A few people in Western universities are writing empirical papers with Indian data which are appearing in Western journals, but there are two recurring problems: I have often seen a lack of common sense on data, and the choice of questions and research strategy is driven by the needs of publication rather than a sense of the important questions and issues in India.

I find it remarkable that the Indian State expends thousands of crore on research into fields like nuclear energy, where the payoff for India has been remarkably slim, while not putting resources behind public policy research on the main tasks of the State - issues such as judiciary, law & order, international relations, defence, elections, and economic policy. On one hand, this has improved independence and criticism of entrenced policies and powerful government agencies. On the other hand, there is a secular lack of resources which is generating an inadequate number of manyears of time on the questions of the age.

If "government" and "think tank / university" are two pieces in the map of ideas, a key institution which India has been utilising is "the expert committee". A. K. Bhattacharya has an article on this institution in today's BS. There are some intruiging differences between India and other countries in the "committee" institution. As an example, today in the New York Times, there is news about a committee which seems to have been setup, suo moto, by a bunch of people and not appointed by the government. Friends who live outside the country have suggested such things to me in the past - that on a certain problem, a top quality bunch of 5 people can set themselves up to write a report and they do get accepted in the policy making mechanisms of the US or UK, despite no role of the government in appointing the committee.

Update (2006-12-19): Ajay Shukla has an excellent article on the weaknesses of think tanks, in Business Standard.

Entry barriers in banking reflected in UWB episode

The typical bank has Rs.5 in equity capital and Rs.100 of assets. If things go wrong, losses exceed Rs.5 and the bank is bankrupt. Generally, when a bank goes bad, the managers are in a scramble searching for cash for the months prior to failure. So from the viewpoint of a buyer, a bankrupt bank is a troublesome entity to get into in terms of ownership. It likely has weak processes; the staff is demoralised; there is possibly corruption; the recovery value of the bad loans is hard to ascertain.

When UWB went bust in India recently, there has been a surprising phenomenon of a raft of buyers lining up to grab control! This is entirely unexpected. A Business Standard editorial correctly says that this remarkable phenomenon is caused by entry barriers in banking. It is hard to start a bank. It is hard to get permission to start a branch of a bank. So under these conditions, what does the rational entrepreneur do? Buy a dead bank, for the license value.

Resilience of liquidity of the Indian equity and bond markets

One key aspect of market liquidity is the resilience of liquidity. This is not a word that has been sharply defined in the literature; it has a few dimensions. One aspect is the time in which a limit order book restores to having the low impact cost prior to the placement of a large trade. If one could measure this in an experimental setting for a given security, suppose a large order is placed at t=0. Measuring resilience is about obtaining a graph with transaction size on the x axis and the time taken for impact cost to "substantially" revert to conditions that were prevalent at t=0.

Another dimension of liquidity is the ability of market liquidity to handle bad news or negative returns. I don't really understand why, but it often seems that market liquidity is diminished after negative news. One part of this is just a measurement issue : dollar turnover is higher after prices have gone up and lower after prices have gone down. But even if one is using measures of liquidity which are not affected by this problem, the hallmark of a successful financial market is resilience in the sense of being able to handle sharp movements, particularly sharp negative movements, and continue to deliver a continual supply of liquidity. Participants face greater liquidity when this is not the case.

Susan Thomas has an EPW article on the resilience of liquidity on the Indian equity and debt markets. The main finding is that the equity market has considerable resilience while the debt market does not. I think this is related to RBI's belief that the bond market should have no speculators compared with SEBI's belief that speculators are a legitimate part of the equity market.

Fiscal consolidation now?

As the academic literature has long pointed out, India has a serious problem with a growing debt/GDP ratio. The decline in interest rates in the last six years has masked the problem, but the situation remains difficult.

For a while, it looked like India was winning on a dramatic fiscal turnaround. The Fiscal Responsibility and Budgetary Management (FRBM) FRBM Act was a nice piece of work and some of the numbers have improved well.

Are the FRBM targets adequate for solving India's fiscal problem?

The rough targets appear to be shaping up as a 3% deficit for the centre and a 3% deficit for the states (link). One problem is that these numbers are not enshrined in the law itself and can easily be changed by a future government. In addition, the Act has defined no penalties which come into play when the targets are breached.

And, from an international perspective, a 6% deficit would still be one of the biggest in the world! A few comparisons from the IMF World Economic Outlook (WEO):

	Advanced economies	Other emerging markets and developing countries	India
Central government fiscal balance	-2.4	-0.9	-4.2
General government fiscal balance	-3.1

This suggests that our central government fiscal deficit, of -4.2%, is big when compared with advanced countries (who are at -2.4%) and even bigger when compared with our peer group (who are at -0.9%). The WEO does not have comparable data for all three cases, but for industrial countries, they show that the general government balance, at -3.1%, is only slightly worse than the central government balance. We in India seem to think that it's okay to do much worse.

So I think of hitting the FRBM targets as a bare minimum modicum of fiscal responsibility. It is possible to paint plausible scenarios under which the Debt/GDP ratio is not stabilised even if the FRBM targets are adhered to: it is not a sufficient condition.

The importance of tax buoyancy

The FRBM Act was followed up by a careful game plan called the "FRBM Task Force report" for achieving the targets. The politically easiest strategy for achieving FRBM targets is based on high tax buoyancy. When nominal GDP grows by 10%, tax revenues should grow by 15% to 20% -- i.e. tax buoyancies of 1.5 to 2. In this case, the sheer growth of India leads to a closing of the gap. Roughly speaking, this was the game plan of the Kelkar FRBM Task Force report:

1. Tax reforms which change buoyancy but don't immediately pinch the pocket of the tax payer are most politically feasible;
2. So reform tax policy and tax administration so as to get up to high buoyancy;
3. Don't do new damage in terms of spending money;
4. and let GDP growth take care of the rest.

At first, things seemed to be working. Tax administration (particularly income tax) has been pumping out high growth rates of tax revenues. From 2001-02 to 2004-05, the investment rate went up from 23% to 30% - a huge gain of seven percent! Of this seven percentage point swing, 4 percentage points occured because of an improvement in the fiscal situation (link).

Now the situation is looking more difficult. Tax revenues might not do as well as hoped owing to the Special Economic Zones (SEZs). Expenditures might be higher than expected owing to welfare programs like the National Rural Employment Guarantee (NREG) program, and the 6th pay commission. The most remarkable recent development on India's journey to the FRBM targets is that Montek Ahluwalia thinks the targets should be breached.

The SEZ problem

The rationale for SEZs is supposed to be that there are huge infrastructure and institutional problems with India, so in order to win on exports growth, the way out is to create enclaves with good infrastructure (particularly urban infrastructure) and generous tax treatment. The government seems to be ready with generous tax concessions, but no relaxations to labour law are proposed.

Does it make sense to undertake distortionary policies which artificially prop up exports, e.g. by tools such as export subsidies, tax breaks, or manipulation of exchange rates? Economic growth is accentuated by openness, not by faking exports. (See two articles by Ila Patnaik [link, link], and this recent piece by Adam S. Posen). So I am not enthusiastic about doing SEZs "in order to boost exports". We need a sound, well-run country, which will (by the way) import a lot and export a lot.

What about the fiscal implications? The generous tax treatment of SEZs constitutes a threat to the high tax buoyancies that we have been seeing. If a lot of SEZs come up, and if they succeed, we could see two possibilities. On one hand, existing output could relocate from the taxed zone to the untaxed zone. This would be very bad news. Or, a more mild scenario, a lot of incremental output could take place in SEZs. This sounds nicer from a fiscal perspective, but it isn't. In this case, we will see a decline in the tax buoyancy. I have crunched the data, and it is not clear to me how FRBM targets will be met if tax buoyancies drop below 1.25. Or if I may say this differently, if tax buoyancies drop below 1.25, then a new level of political pain will be required, in cutting discretionary expenditures, in order to get back to FRBM targets.

A short while ago, Ila Patnaik had an article worrying about the tax exemptions for SEZs and other fiscal largesse.

Welfare programs

A daunting feature of a program like the NREG -- which guarantees some mandays of employment for every household at the choice of the household -- is that it is hard to budget for how big the outlays will be. Some preliminary budget numbers look weak, and I don't know whether the NREG is yet playing a role there. Business Standard had a good editorial on the unfolding difficulties showing up in fiscal data, despite remarkable tax buoyancy. The NREG is not alone; the UPA has had a penchant for big expenditure programs. And, there remains the risk that the UPA will implement the Arjun Sengupta proposals for a giant welfare program for employees of the unorganised sector (link).

The 6th Pay Commission, and the New Pension Scheme (NPS)

Then there is the 6th Pay Commission. The HR framework for the civil service is awful, and there is a crying need for change. It is not, as yet, clear that the 6th Pay Commission will be constituted in a way that will make progress on these problems. If one extrapolates from the experience of the 5th Pay Commission, the 6th Pay Commission could induce acute fiscal stress from 2009 onwards. Subir Gokarn has a good article on this issue.

A short while ago, Ila Patnaik pointed out in an article titled First payoff to structural pension reform that with the 6th Pay Commission, we are seeing the first payoff to the long-term structural reform that the New Pension Scheme (NPS) represents. The `grandfathering' approach to phasing in the NPS means that for one generation, the government is paying contributions to recent recruits while paying pensions to old ones. But from 2004 onwards, new recruits who are in the NPS have a pension which is decoupled from pay commissions. That changes the way we think about pay commissions. In an NPS world, the employer-employee relationship reduces to a decision about the contribution rate into the NPS.

Planning Commission vs. FRBM Act

I have previously written about the approach paper for the 11th plan, emphasising the good things that it says about reforming the mechanisms for production of public goods. In my earlier scanning of this document, I did not pay enough attention to the fiscal aspects.

Financial Express recently reproduced extracts of a letter from P. Chidambaram to Montek Ahluwalia on fiscal issues. (See story). For what it's worth, Arjun Singh agrees with Montek, which suggests that old Congress may be pushing for violating the FRBM. A piece with a response from Montek Ahluwalia underlines the gap between what is sought and the FRBM.

Just in case we lost sight of the Things That Matter, Dr. S. Narayan reminds us that what we really need to be doing is closing down the Planning Commission. There ought to be no contest between an Act of Parliament and a non-constitutional body like the Planning Commission. Nirvikar Singh has an article in Financial Express on a related theme.

Montek Ahluwalia carries a lot of credibility, and his willingness to take the FRBM Act lightly opens the floodgates for a lot of people who have always wanted less fiscal discipline. Ila Patnaik wrote two pieces on the importance of fiscal discipline (link, link). I recently wrote in a debate in Business Standard on it. The Martin Feldstein lecture that I refer to is here.

Putting the pieces together

How do we put these pieces together? Ila Patnaik evaluates the pros and cons of violating the FRBM (also see this review of two years of the UPA). Paromita Shastri has an article in Outlook on the "hole in the bucket" perspective. In the Business Standard of 22 July, T. Ninan has an excellent article worrying about the fiscal outlook.

I feel we should be cognisant of the 2009 dimension. A host of difficulties will come together by 2009: the next elections, the FRBM targets, the fiscal impact of the 6th pay commission, UPA welfare programs at full steam, and a possible global downturn. Fiscal stress could spill over into bad economics and bad politics in unpleasant ways.

Given India's unique demographic situation, the most wonderful thing would have been if the revenue deficit vanished by 2008-09, and stayed that way, and the fiscal deficit was capped at 3%. This is not the best fiscal rule - as I argue above, this is probably not a deficit level which will stabilise debt/GDP - but it's a minimum first step. This would free up savings for investment at the perfect time for India to be able to generate astonishing growth (see article by Ronald Lee and Andrew Mason on the demographic dividend). If the FRBM Act is violated by the UPA, it will be do long-term damage to India's development project, by contaminating growth in what could be the most important 10-15 years of India's history.

The first sound attempt at doing a good university in India

I have written several times about higher education: December 2005, May 2006, June 2006, August 2006.

On one hand, it is possible to bemoan the things that government does wrong on higher education. But it is perhaps more important to make progress on building good universities - regardless of the constraints. In my opinion, the most important effort at starting a serious university in India is the Indian School of Business. ISB is the first incentive compatible campus on India, where the faculty members get appropriate incentives and resources to perform.

I have heard from some employers that ISB MBAs are superior to IIM MBAs (which is not surprising given their pre-MBA work experience, and the quality of the faculty). The ISB experiment is far from complete. It is only a good MBA program so far. It is not yet clear that it will take root as a genuine research university, going well beyond an MBA to play a role in the intellectual life of the nation. But in a bleak situation with dismal public sector universities, and a State that won't solve long-standing policy mistakes, ISB is the most important experiment in what could happen with universities in India.

In my view, the biggest weakness about ISB is the location. There is no reason for most people to visit Hyderabad :-). In the US, the argument is made that good universities are found in obscure places, so location does not matter that much. But the institutional setting where we are is more like US higher education in 1858 (when MIT was started). At that time, in order to attract the best faculty, the university had to be on the East Coast - that was no time to setup a university in an obscure location like Chicago - the founding date for the University of Chicago was only 1890 or 30 years later.

In similar fashion, I feel that in the India of today, Bombay, Delhi and Bangalore are the natural locations for universities in India, in order to attract the best faculty members and in order to have a meaningful engagement with India.

What comes next in the global business cycle

In recent weeks, disturbing news has been emanating out of the US in terms of difficulties on the housing market. In today's Business Standard I try to describe what is going on, and speculate about implications for India.

Coincidentally, today's BS also has me offering one side of a debate on fiscal consolidation with T. C. A. Srinivasa Raghavan on the other side (link to full debate on BS website).

CAC-2 report has been released

I think Jamal Mecklai embarassed RBI :-). The elusive report of the Tarapore-2 committee has been released (you might find my blog entry on the creation of this committee to be of some interest). I haven't read it yet, but a first skim shows some oddities -- their idea of liberalising the capital account involves banning participatory notes, and they don't get the impossible trinity of open economy macroeconomics. Tarapore-II has two dissent notes, by Surjit Bhalla and A. V. Rajwade. RBI has chosen to not implement anything right away (i.e. between July 31 and 1 September), but has setup one more internal group to work on the subject.

Excellent commentary on the report, and on the larger issues of moving towards "fuller capital account convertibility" has come out in the press.

• Economic Times had a front page piece by Shaji Vikraman and M. K. Venu with unnamed Ministry of Finance staff saying that there wasn't going to be a ban on participatory notes. (See this blog entry on participatory notes and moving forward from the Indian FII framework to omnibus accounts).
• See an edit in Indian Express and a main column there by Ila Patnaik.
• An edit in Business Standard, a main piece there by Abheek Barua and another by Subir Gokarn.
• Jayanth Varma has written a blog entry and another one today.
• The other edit in Business Standard helps you place this in the context of the prevailing climate of faulty economic policy making in India.
• Andy Mukherjee gets the impossible trinity in an exuberant piece titled Indian Currency Panel Wants Rupee to Risk Ruin.
• Somasekhar Sundaresan has an article on the PN debate.
• And, Sucheta Dalal argues the RBI position on participatory notes.
• There is an ET debate with 3 people on the subject: Omkar Goswami, Susan Thomas and Soumya Kanti Ghosh.
• Ila Patnaik offers a sketch of what the chapter on banking in the report should have been.
• A response on the report from Jamal Mecklai.

Watching RBI and the removal of capital controls, I'm reminded of SEBI and the onset of equity derivatives trading:

14 December 1995	NSE asked SEBI for permission to trade index futures.
18 November 1996	SEBI setup L. C. Gupta Committee to draft a policy framework for index futures.
11 May 1998	L. C. Gupta Committee submitted report.
24 May 2000	SIMEX chose Nifty for trading futures and options on an Indian index.
25 May 2000	SEBI gave permission to NSE and BSE to do index futures trading.
9 June 2000	Trading of BSE Sensex futures commenced at BSE.
12 June 2000	Trading of Nifty futures commenced at NSE.
25 September 2000	Nifty futures trading commenced at SGX.