SBI vs. ICICI Bank

Business World has an opinion piece comparing State Bank of India against ICICI. It argues that the unflattering comparison shows the power of privatisation.

The official and the illegal currency market

A Nigerian diplomat was recently found converting Rs.100 million in cash into USD in New Delhi. This hints at the existence of a substantial INR/USD market outside the reach of capital controls.

I think there are two factors shaping this black market. The first is the capital controls - rapidly globalising India is increasing chafing at the bit. The second is the incredibly bad market design of the currency market.

In India, the equity market sets the benchmark for transparency of financial transactions. There is pre-trade transparency (order books are visible in realtime) and post-trade transparency (exact transaction information is put out in realtime). In addition, equity market intermediaries separately reveal (a) the price at which a transaction was executed on the market as opposed to (b) the brokerage fees charged by the intermediary. On the equity market, liquidity resides in the public, nationwide market, and the broker is only a transactional pathway to the market.

In contrast, the Indian currency market fares poorly on all three counts. It is highly non-transparent from the viewpoint of customers, lacking post-trade and pre-trade transparency. This makes it difficult for customers to ensure that they are getting best-price execution. Banks do not unbundle the price on the currency market as opposed to their intermediation fees.

To look back into the history of the equity market, in the early 1990s, all these features were absent. When BSE brokers were first asked to separately show brokerage fees as opposed to the price at which a transaction was executed, they went on strike. In the early 1990s, BSE brokers would routinely lie to customers, claiming that a purchase was executed at a higher price than it really was. Lacking transparency, customers were not able to cross-verify these claims. These very abuses are found on the currency market today: customers are not able to cross-check prices owing to the lack of pre-trade or post-trade transparency, and customers are not told what they are being charged for financial intermediation services as opposed to market prices. The people who work on policy issues of the currency market have not adequately learned from the success story of the equity market.

Owing to the deficiencies of the market design, currency trading is extremely profitable for banks. Customers pay high prices for buying and get low prices when selling. If a bank gets a buy and a sell order which it is able to serve internally, it earns the full spread (that is shown to customers). Only the net imbalance at a bank reaches the interbank market.

The excessive intermediation charges imposed by banks on the currency market reach all the way to retail transactions. A traveller who seeks to buy or sell on the rupee-dollar market faces a bid/offer spread of roughly Rs.1.50 (3.67%). As a consequence, an extensive black market has sprung up all over the country. This involves a network of dealers who do run a book on the rupee-dollar. Your friendly neighbourhood paanwala is often a currency trader. They offer a bid/offer spread of roughly Rs.0.15 (0.37%). This black market helps undercut the intermediation charges of the banks, and on avoiding the constraints which prevent competing trading systems from emerging.

The equity market is able to deliver a spread of Rs.0.1 on a base of Rs.4500 for the Nifty futures - this is like a spread of Rs.0.001 for a base of Rs.45 (roughly the INR/USD rate). Like the Nifty futures, currencies are also "macro" underlyings with little asymmetric information. Currency vol is lower than Nifty vol. Hence, if the market design is done right, currency spreads ought to be lower than the Nifty spread - in other words the spread should be lower than Rs.0.001. Such a tight spread directly saves money for market participants who trade - for the spread is the round-trip transactions cost faced by the customer. In addition, fine spreads improve market efficiency by reducing the overheads faced by speculators.

In short:

1. There is much more convertibility than meets the eye;
2. The currency spot market is one of the most important commanding heights of the economy, and it's a real shame that it has a 19th century market design, aimed at perpetuating entry barriers, profits for banks, non-transparency and high transactions costs for customers;
3. If policy makers want more of the currency market to come above the ground, then an exchange-traded currency spot market is required, where brokers clearly unbundle their brokerage charge from the price seen on the public limit order book.

As an aside, with commodity futures also, there is a substantial `number 2 market', which competes with the official regulated markets. These parallel currency and commodity futures markets reflect an exit from the mainstream regulated markets by some players. If wise policy making is able to unify all liquidity into the public markets - as has pretty much happened with the equity market - we will be able to reap substantially more liquidity than is presently the case.

Moving towards de facto convertibility

One of the most important phenomena which has been taking place in India in recent years is rapid integration into the world economy. In the case of merchandise trade, trade integration is commonly measured by summing exports and imports, and expressing these as percent of GDP. In similar fashion, I find it useful to focus on the sum of money coming in and going out, on the current account and capital account taken together, as a measure of globalisation. The data shows these gross flows have risen sharply:

Year	Trillion rupees	Percent to GDP
1999-00	9.16	51.28
2006-07	41.18	110.01

For such a structural parameter, going from 51.28% in 1999-00 to 110.01% in 2006-07 is a substantial change. When 110% of GDP is moving across the boundary, capital controls become increasingly ineffective.

Swaminathan S Anklesaria Aiyar has an article in Economic Times where he talks about big discrepancies in the BOP data. In my opinion, these discrepancies reflect the increasing use of the current account to effect capital flows. If a software company sends out a C program to a customer by email, and gets paid $1 million for it, what RBI inspector can verify what was the current account transaction that took place?

On a related note, Economic Times has an article on the growing internationalisation of the Indian rupee. The MIFC report has written about policy directions that India needs to embark upon, in order to make the INR one of the six key currencies of the world, a currency that would be used for bond issuance and complex financial transactions by issuers and investors all over the world.

On the scale of a trillion dollar GDP, with such large cross-border flows, the present discussions about bringing back capital controls on one small element (ECB) are missing a sense of scale about India's globalisation. Banning ECBs would have probably made a significant difference circa 1997. But not anymore. Instead of looking for ways to bring in more controls, it would make more sense to look forward to the time when India will be a $2 trillion GDP with $4 trillion in cross-border flows, and gear up for that world with the commensurate institutional maturity.

Harnessing solar energy

The New York Times has a set of three great articles on solar energy:

• Using the sun's heat, not light is about solar thermal energy. It mentions a facility which uses 400 acres of land to produce 64 Megawatts at a price of Rs.5.6 per KiloWattHour. That might make sense in many parts of India.
• Storing sunshine is about the problem of storing energy. A neat idea that I saw there was that of using off-peak low-priced electricity to construct a 2000 kg block of ice in the basement of a building, in order to reduce the purchase of peak-time expensive electricity for air conditioning in the daytime. The benefits from the system depend on how extreme the day vs. night temperature change is. It struck me that in a lot of India, there is a huge difference between the day and night temperatures. Such a system is, of course, only viable when there is a sensible time of day pricing scheme, one which also correctly penalises the capital cost induced by the peak load.
• Solar power wins enthusiasts but not money talks about the politics of government expenditures on alternative energy technologies.

While on this subject, see this fascinating article by R. K. Pachauri and Leena Srivastava in Indian Express on the energy efficiency implications of having two time zones in India. In that case, we'd have a GMT+5 west coast and a GMT+6 east coast instead of an awkward GMT+530 for the full country. And, there's a great article by Kevin Hassett on Bloomberg about the possibility of the government supplying put options on the price of alternative energy, to investors taking risks on alternative energy.

Comparing the Indian and Chinese governments

I wrote an article in today's Business Standard titled Comparing the Indian and Chinese governments.

Just in case you thought things were going well, Business Standard has an edit which is bang on:

One minister approves a massive order for new telecom equipment, placed by the country’s erstwhile telecom monopoly, but his successor comes along, raises a series of questions and the board of the company concerned dutifully does a re-think. Oil prices go through the roof, and the state-owned oil companies lose Rs 190 crore a day, but the petroleum minister will not reverse the product price cuts that he announced in February this year and November last year. The food minister cancels one wheat purchase contract, then approves another at a higher price. The minister for chemicals and fertiliser and steel and mines (yes, ministers do multi-task) announces arbitrary price controls for pharmaceuticals and won’t pay the fertiliser companies the subsidies that are their due. The finance minister summons the chiefs of state-owned banks every now and then and speaks his mind—don’t raise interest rates, lend more to agriculture, reduce interest rates for exporters… In each case, the gentleman concerned must think that he is doing national service (the food minister even declares in a rare rhetorical flourish that price is not a consideration when it comes to feeding the people—as though the alternative to defective import decisions is mass starvation).

Taken together, these and other examples point to a fundamental problem with economic management: the continuing dominance of the public sector, and in turn its continuing subjugation to ministerial whim. This is not just when it comes to board-level appointments, where it turns out that the most appropriate and best-qualified people who can be made non-executive directors just happen to be faithful members of the Congress party. After 16 years of economic reform, the hard fact is that more than half of India’s industrial sector is still government-owned (including the bulk of the banking, insurance, power, rail transport, oil and gas, and coal industries, and good chunks of aviation, telecommunications, shipping, steel…). In most of those sectors, ministerial whim prevails, irrespective of the presence of supposedly independent regulators armed with statutory powers. And large parts of private enterprise are subject to the same policy whims—if in doubt, ask Mukesh Ambani why he is being denied an oil subsidy that his public sector counterparts get.

If it were collective decision-making through a cabinet system, that would act as a brake on individual ministerial whim. But with an unassertive Prime Minister, and Cabinet ministers who owe their positions to their party bosses rather than to the Prime Minister (Mr Raja’s appointment as telecom minister was made, not by the President’s office in Rashtrapati Bhavan but in Chennai by the DMK chief, Mr Karunanidhi, who had also decided earlier on Mr Maran’s resignation), everyone feels free to pull in his or her own direction. In an effort to curb ministerial freelancing, the Prime Minister has set up dozens of “groups of ministers” and charged them to take a view on individual ministerial initiatives; but this not only slows down decision-making, it also overloads the two or three senior ministers who can be trusted to chair the GoMs and guide their deliberations so that aberrant policy does not result.

But only policy matters go to GoMs. What about all the executive decisions where ministers intervene, and where they can run amok without a “by your leave”? Privatisation of all non-vital state-owned enterprises would be a solution, but the UPA government and its Left allies will not hear of it, and even the previous NDA government was enthusiastic about it for only a brief while. A variety of stratagems have been worked out to try and give state-owned companies operational independence (formal agreements on performance benchmarks, “navratna” status, and so on), but nothing can stop a minister determined to wade into a purchase order.

Fixing the IPO process

Dinesh Narayanan has an excellent article in Business World on solving the problems of the IPO process.

The future of trading

Roughly speaking, NSE has 50,000 trading screens and BSE has 25,000 trading screens. Over and above this, a growing share of orders have been coming into NSE and BSE over the Internet. Recent data shows that the share of Internet trading went up from 3 per cent in 2003-04 to 16 per cent in 2006-07. Given that the broadband expansion in India started only very recently, the outlook for future growth of Internet trading is very good.

The sources of order flow coming into the market, then, are these 75,000 trading screens coupled with a large number of users sitting on their web browsers. All these people add up to a massive virtual trading floor. Their information gets pooled into the price that is revealed, and their disagreements are played out in the order matching process. Their diversity is a key source of liquidity and liquidity resilience [link].

To a significant extent, the same securities firms are playing the same role with commodity futures trading. So even though there is an FMC vs. SEBI separation, there has been de facto convergence. As you walk around India, you routinely see roadsigns of securities firms offering both NSE/BSE and commodity futures trading.

The big puzzle now lies in bringing the potential of this enormous virtual trading floor to infuse life into the moribund fixed income and currency markets.

Outside India, there have been fascinating developments in going beyond the vanilla Internet trading system. The game lies in enhancing the information set of the user while supporting `dumb' transaction services, and in doing better than the awful discussion boards that have proliferated. See link and link. (I had blogged about Zecco before). These sites rely on network externalities - the larger the number of people using them, the more attractive they become. So there may be a tipping point - perhaps 100,000 users? - beyond which they could just explode.

As seen in those two URLs, in the US, the price of brokerage services with some brokerage firms has dropped to zero. In India, that progression cannot be achieved because of the massive government charges which are layered on top of the basic transaction -- see Box 2.8, page 29 of the MIFC report.

These developments have interesting implications for exchanges also. An article in The Economist discusses some of these changes. It talks in hushed tones about an exchange that will sell transactions at a price of $1.2 per trade. In my mind, that's not a big deal; the technology exists today to do much better. The key thing to latch into is economies of scale - by the time you have a factory pumping out 10 million trades a day, the costs get dramatically lower than those seen with small exchanges. As a consequence, I believe that the pressures in favour of low prices paid by customers which will propagate to low prices charged by exchanges will generate a more oligopolistic situation where a few giant exchanges - like NSE and BSE - will dominate the world's trading.