The impact of the capital controls of 2007

In 2007, India experimented with capital controls against external commercial borrowing (ECB) and participatory notes (PNs). This was a controversial move at the time; there were two views in the country on whether such controls are worth doing. Some early evidence on the impact of these decisions is now visible in the BOP data, and is interpreted by Ila Patnaik in Indian Express here.

Investment is destiny

Geographical patterns in investment planned out today are the geographical patterns in per capita GDP of coming years. Ila Patnaik reviews what the CMIE Capex data says about investment in the big states of India. The surprise, for me, was the poor showing of states that one traditionally expects will do well: Tamil Nadu, Karnataka, Andhra Pradesh and Maharashtra (they're at ranks 7-10). At the same time, this is an encouraging phenomenon in that investment isn't all going to rich and successful states.

Raghuram Rajan's Committee

• A draft report. Update (21 December): Here is the final report. Also see my India bookshelf.
• A hundred small steps by Raghu in Business Standard.
• An opinion piece by Raghu and Eswar Prasad in Wall Street Journal
• An editorial in Wall Street Journal
• An opinion piece by Mythili Bhusnurmath in Economic Times
• Andy Mukherjee on Bloomberg.
• Ila Patnaik in Financial Express
• An editorial in Business Standard
• Shankar Acharya in Business Standard
• Rajesh Chakrabarti in Mint
• An opinion piece in The Economist
• R. Ravimohan in Business Standard
• An editorial in The Telegraph
• An interview with Raghu in Economic Times by Gayatri Nayak
• Eswar Prasad writing in Economic Times
• An interview with Raghu, and an editorial about the report.

Never send a man to do a machine's job

Chapter 5 of the MIFC report talks about algorithmic trading and the potential for India to achieve a role in international finance here. Direct market access was prohibited by SEBI and hence this kind of development could not take place. Algorithmic trading also figures on page 152 of this report on the policy aspects of OTC vs. exchange-traded paths to organised financial trading.

SEBI has removed this constraint, and shifted to the conventional stance of securities regulators worldwide on this question. Here is the SEBI circular, and here is good reportage in Mint by Mobis Philipose, Rachna Monga and Khusbhoo Narayan.

With this, we get one more tick on the checklist of activities on implementation of the MIFC report. An edit in Business Standard says:

The Securities and Exchange Board of India (Sebi) has removed the regulatory impediments that prevented securities firms and their clients from directly connecting their computers to the stock exchanges and automating trading strategies. India has already evolved a highly computer-intensive stock market. Order placement, order matching, risk management, payment and settlement are all fully computerised. The Luddite rule which prevented a role for computers in the actual trading process, was an incongruity. Removing it made sense.

The automation of trading strategies, termed algorithmic trading or AT, helps increase the efficiency of a large number of mundane processes of the financial markets. When a security trades at multiple venues, such as NSE vs BSE, or spot vs. futures, there must naturally be a very tight link between prices at these multiple venues. At present, this link is established by virtue of human arbitrageurs, who watch two screens and look for arbitrage opportunities. Computers excel at patiently watching for these, making no mistakes in calculations or order placement. Further, dedicating one or two employees to watch a related group of securities is expensive and tends to be done only for the biggest securities, such as Nifty shares. With computerisation, it becomes possible to monitor smaller stocks, thus permeating greater liquidity and pricing efficiency for a bigger range of stocks. Once the algorithms start flourishing, it would increase Mumbai's attraction for listings from firms outside the country.

Interest rates and currencies are natural areas where AT can play a big role, given the simple formulas that are involved in yield curve or currency arbitrage. However, deriving these benefits requires first shifting the bond market and the currency market to electronic exchanges.

Outside India, tens of thousands of capable finance professionals are engaged in the development and implementation of such trading strategies. This process has not begun in India because such computerisation was banned. Hence, Indian financial firms are inexperienced and will need to rapidly catch up. Goldman Sachs and J. P. Morgan have in-house knowledge on AT, which can be applied to Indian exchanges. Indian financial firms such as ICICI Bank, HDFC and UTI need to set up R&D teams which set about matching global expertise in this.

The report on Mumbai as an International Financial Centre has emphasised that the field of AT unlike many other elements of finance is one in which India can make its mark. It requires brainpower and not human relationships. Individuals of Indian origin are already prominent in such work at global financial firms, while being located in London or New York. An R&D team sitting in Mumbai is well equipped to compete with one placed in London or New York. Hence, Mumbai could become a centre of AT activity, with thousands of individuals developing the specialised knowledge of computer engineering, statistics and financial economics that is required to build these systems. Building such systems for deployment with Indian exchanges is the natural stepping stone through which these individuals and teams will graduate to doing such work for the international market.

Ranked by the number of transactions, the top two exchanges of the world are Nasdaq and NYSE. India's premier exchanges, NSE and BSE, are ranked third and fifth, respectively. AT is estimated to account for as much as half the business of Nasdaq and NYSE. Sebi's move could, thus, pave the way for NSE and BSE to gain in the global league table.

Materials of the 2nd research meeting of the NIPFP-DEA Research Program on Capital Flows and their Consequences

The papers, slideshows, and some photographs from the 2nd research meeting (27,28 March) are up on the website.

Inflation scare

Watch me talk about this on CNBC yesterday.

How to control inflation

WPI inflation is up to 6.68% and the government is ready to do battle.

I wrote an article in Business Standard titled How to combat inflation where I suggest that the way to bring monetary policy back to balance is a 10% rupee appreciation coupled with a 300 bps drop in the short-term interest rate.

In this reasoming, I think the drop in the US dollar is important in understanding the global rise in commodity prices. As Ashok Gulati and Kanupriya Gupta say in Hindu Business line:

Our humble submission is that before any policy prescription is offered; let us get the diagnosis right. While most of the factors that these studies talk about are right and appropriate, many of them compare 2007 prices with those in 2000, and that too in current dollars, to arrive at their conclusion of gloom.

This, we opine, is not appropriate, if not misleading. The reason is simple: anyone dealing with agricultural prices knows that agricultural prices in 2000 were at their rock bottom resulting primarily from the East Asian crisis. No one expected those prices to stay at those levels, as East Asian economies started to recover. Maybe the pendulum has now swung a little on the other side.

Another reason is that 2007-08 prices need to be put in a long-term perspective, say at least from 1990 to 2007. And when one does that, the minimum one needs to do is to take the prices in constant US dollars. One can take the base year as 1990, or 1995, or even 2005, for converting the price series into constant US dollars, but not the year 2000, for the reasons explained above.

However, in a situation when US dollar is fast losing its strength in the international exchange market, it may be more appropriate to look at prices in constant euros (with base year of 1990, or 1995 or 2005).

We have done this exercise for the major agricultural commodities such as wheat, rice, palm oil, and sugar, at constant 1995 US dollars as well as at constant 1995 euros. And the results are revealing (see Graphs).

The upshot of these results is: the 2007 global prices of agricultural products are not very much out of line with what they were in say 1996, just before the East Asian crisis. These prices started rolling down in 1997 due to East Asian crisis, touched a rock bottom in 1999-2000, and then recovered over time. Today, they are a little on the other side of the swing.