Article on the equity derivatives market in `Business World'

Mobis Philipose has written an interesting article in Business World on the equity derivatives market titled Needed: New wine, new bottle. It is related to, and adds value on, many of the issues on equity derivatives that have figured on this blog. It is on the web (free registration required), but the BW website does not give out permalinks. When that link stops working, use part 1, part 2.

How not to "control" inflation

India is a fascinating country on attitudes to inflation. On one hand, there is a deeply ingrained belief that inflation hurts the poor most, and politicians are hawkish about inflation. But concern about inflation has not manifested itself in good measurement of inflation. Inflation measurement is bad - and has been bad for the longest time without any effort at fixing it. And, in the short run, there is lassitude in doing anything about inflation. The `Taylor Principle' is not understood, and there is little by way of institutional mechanism or institutional commitment to control inflation.

When inflation does spike up, the first response in socialist India is to look for ways in which government can manipulate prices of a few products.

Suppose there are N commodities that go into an inflation measure. There are two sets of N numbers: the price rise p_i for all commodities and their weights in the index w_i. There will always be a distribution of different price rises; i.e. all values p_i will not be the same. So if you sort p_i you will always be able to identify 10 commodities with the highest price rise. And if you sort p_i*w_i, you will always be able to identify the 10 commodities which have `contributed the most to inflation'. Statements then get made of the form `there is no real problem of inflation; it's just that there are just 10 weird commodities which account for xx% of the overall inflation; we have to solve these localised problems and we're fine'.

In socialist India, the government would then go after these 10 commodities with price controls, imports, release of inventory from government warehouses, ban on futures trading, etc.

There is a need to completely shift away from this mentality. Data processing, as described above, delivers no insight into where inflation is coming from. It is just an arithmetic fact that some commodities will have higher price rises than others. The economy suffers greatly from distortions when the government goes after the top 10 commodities every now and then in this fashion.

Ila Patnaik had a great article in Indian Express on 11th November where she argues that in a market economy, inflation should be seen as a phenomenon of macroeconomics, requiring a response from macro policy; arguing that it is time for the government to get out of manipulating prices of individual commodities.

This is an important part of the case for an inflation targeting central bank in India. Monetary policy based on inflation targeting is good in its own right; it is monetary policy which stabilises the boom and bust of GDP growth. But in India, it will address the goal of politicians who like low inflation, and remove the pressures that come up from time to time for government to get hands-on with manipulation of prices of specific commodities.

Update (10 Feb 2007): Indian Express has an editorial on difficulties of inflation measurement.

Pension guarantees considered subtle

The negotiations about the PFRDA Bill, which are presently underway, are reportedly discussing guarantees gifted by the government to NPS participants.

Many years ago, when US-64 was fresh on our minds, I used to think that keeping government out of such obligations was a no-brainer. It is too easy for a political process to come up with a plausible-sounding guarantee, which is actually horribly expensive a few years down the line. The best example of this is the European DB pension systems.

In 2001 and 2002, when the early work on translating the Project OASIS report into the NPS was being done at DEA, Robert Palacios anticipated that discussions about pension guarantees would surely come up, and that a thorough analysis of guarantees needs to be done well ahead of time. He pushed me into thinking about the subject. I used this off-the-shelf knowledge to write an article titled Pension Guarantees are Subtle in Business Standard today.

The EPW article I talk about is: Investment risk in the Indian pension sector and the role for pension guarantees, EPW, 2003, pdf. In addition, I have worked further on the tools for analysing pension guarantees link.

Coincidentally, Gautam Bhardwaj is also in Business Standard today, in a debate about pension fund investment into the stock market. The other side is by a M. K. Pandhe, who seems to have the bulk of his facts wrong.

Separation between commodity futures and mainstream finance

One of the (many) strange things that India does in the financial sector is a separation between commodity derivatives and mainstream finance. Everywhere in the world, it is well understood that there is only one business called the securities industry, which involves organised trading of all manner of spot and derivatives products, including derivatives on physical commodities. But in India, we have a piece of legacy legislation dating back to the 1950s which places commodity futures with the Department of Consumer Affairs, and places regulatory functions with the Forward Markets Commission. Through this, the people who do consumer protection - e.g. issues like weights and measures - are tasked with thinking about safety + soundness of clearing corporations.

If commodity futures could be merged back into mainstream finance, there would be more rapid development, by tapping into the skills, regulations and legal structure which has been created for derivatives. In addition, in the existing situation, there is a loss of economies of scale, economies of scope and competition associated with cutting up finance into separate pieces.

When you wander in the streets of India, you see boards of firms saying "Member NSE, BSE, NCDEX, MCX", which reminds you every day of the de-facto convergence of the two worlds. The customers are the same; the brokerage firms are the same. The artificial separation is caused by a piece of legislation going back a half century, done at a time when none of this was understood.

Today two developments took place which illuminate these issues. First, SEBI seems to have removed the last barriers to the trading of Exchange Traded Funds on gold. This will be done by "financial" mutual funds, traded on "financial" exchanges, and regulated by SEBI. It serves to highlight the lack of a distance between commodities and finance.

In parallel, there were some newspaper stories about the possible use of the Securities Appellate Tribunal (which was created in the SEBI context) for handling appeals against the FMC. This also makes a lot of sense, and underlines the unity of commodity futures in mainstream finance.

By international standards, separating out commodity futures into a separate market is a fairly perverse thing to do. I have no doubt that at some point, some prime minister is going to sign off on the merger of these two worlds into a single competitive market.

The US is the only country where a somewhat wonky arrangement is in place (though not as wonky as what we have in India). In the US, the CFTC is a separate regulator for all derivatives markets. They do better than India in placing all derivatives together, i.e. commodity derivatives are not separated out. The CFTC is an old agency, and its continued separation from the SEC reflects complacence, and a lack of political will, in the US. When you are the world's biggest financial system in the world's biggest economy, it's easy to get complacent with what is in place (witness the sluggish movement towards electronic trading at exchanges in the US). But here also, international competition is bringing in a new level of stress; the UK integration of all financial regulation into the FSA is increasingly leading to a shift of business to the UK. A recent article in Forbes talks about some interest in convergence.

What google earth can do for illegal land development

Ubiquitous access to Google Earth has many interesting implications for the land market.

I have seen many signs where obscure little real estate brokers, by the road side, offer to show you properties through Google Earth.

Nancy Sajben sent me a pointer to a blog entry talking about how land acquisition for an SEZ was influenced by Google Earth: farmers were able to argue their position more clearly by utilising this information.

In cities like Bombay and Delhi, I sometimes think the resolution of Google Earth pictures are so high that one can even identify illegal construction where a house spills into the road. The puzzle is: who will do this?

I have long been highly conscious about illegal land development on the boundaries of national parks by developers who chip away, one acre at a time. I don't know the legal foundations surrounding Borivli National Park, but the amount of construction taking place at the edges of the park seems very, very suspicious to me. And this is Bombay - anywhere outside Bombay I'm sure the dangers of encroachment are much worse.

It would be wonderful if an environmental activist group would engage in the following steps:

1. Utilise the public records to make a .kmz file of the boundary of all the national parks in India,
2. Setup software which watches google earth, and throws up an alert when it looks like there is some habitation in what ought to be park land.

Update: I just noticed some work in South America which sounds like this.

A little off topic: Noticed a great photoblog on India.

Syed Rashed Ahmad runs a great blog "indianglory" where he puts out roughly two photographs a day. I find them stunning; a great reason to start using an RSS feed reader even if you don't do so already. Go look at the blog; Get his RSS feed. I just wish the pictures were bigger.

Reddy & Bernanke

I wrote an article Reddy & Bernanke in Business Standard today, in reaction to the RBI rate hike, and placing it in the context of developments outside India.

The outstanding fact of Indian macro in recent times is the acceleration of CPI inflation, which rose from 3% in late 2003 to between 6% and 7% today. Further, the inadequate response of monetary policy in this episode generates expectations on the part of households and firms that in the future, a rise in inflation will be persistent. Mature market economies have stable inflation and unstable exchange rates; in the third world it is upside down.

I argue that India continues to need tight monetary policy, so as to get CPI inflation back to the 3% which had been achieved in late 2003. The situation in the US is much more cloudy - if a recession sets in within a few months, the Fed might be cutting rates. This underlines the idea that India is a large economy which requires a monetary policy based on the domestic business cycle, and the use of US monetary policy (by running a pegged exchange rate) is not optimal for India.

Hmm, while on this note, it was interesting to then see Chidambaram using the phrase `inflationary expectations' in this speech. Maybe caring deeply about inflation persistence and the expectations of households & firms isn't a disease of economists only :-)