Let's go metric

T. N. Ninan, writing in Business Standard, calls for a shift away from lakh and crore to thousand, million, billion and trillion. We agree! And we've moved our Indian Business Cycle page to metric.

Indian economics is easier in the metric system. GDP is Rs.55 trillion. The market capitalisation of Reliance is Rs.3.5 trillion. On a good day, Nifty as an underlying has derivatives turnover of Rs.1.5 trillion. A billion dollars is Rs.44 billion. When I was at the MoF, I had tried suggesting that the budget documents should be switched to metric, without success.

Interesting readings

C. Raja Mohan in Foreign Policy magazine on India's strategic future.

Vivek Kulkarni in the Hindu Business Line estimates the magnitude of corruption in Karnataka.

Ashish Nandy in Outlook magazine on India's proclivity towards censorship.

How to improve tax compliance in India: Thorsten Beck, Chen Lin and Yue Ma have an article where they say that financial development helps reduce tax evasion: when firms use more external financing, they have greater incentive to not `cook the books', which induces bigger tax payments.

Salil Tripathi in Caravan magazine on improving freedom of speech in the UK.

Robert F. Worth in the New York Times on the shift of the State in Saudi Arabian away from tolerating Islamic fundamentalism to fighting it.

Who was right: Aldous Huxley or George Orwell?

Nicholas Schmidle in The Atlantic with a story from Ghana about something we badly need in India: serious investigative journalism.

Anand Giridharadas in the New York Times, and Kimberly Brooks on the Huffington Post on alternatives to the handshake, particularly `Namaste'.

I just read this beautiful obituary for Milton Friedman, written by Larry Summers.

In continuation of the Indian debate on ownership and governance of critical financial infrastructure, see Jeremy Grant in the Financial Times.

India's liberal foundation

I just read The off-key notes of a Sena scion by Rahul Pandita in Open magazine. The quick summary: Aditya Thackeray is the son of Uddhav Thackeray and the grand-son of Bal Thackeray, both of whom are the most-feared politicians of Bombay. He is now being initiated into politics, and has led the charge by threatening violence against those who would read Rohington Mistry. But his resume up to here features all sorts of nice nineteenth century liberal values such as writing poetry, mostly in English, rap music, Urdu, wearing jeans, and a bit of French. The article correctly draws attention to the hypocrisy of those involved.

But in it, I see another dimension. An upbringing in the Thackeray family is as strong an indoctrination into the sectarian perspective as you could ask for. I find it quite striking that between a certain strong ideology being sold at home, and the broader liberal worldview that pervades India, young Aditya evolved into the culture of an open and inclusive India.

The idea of India is about a great coalition of people who differ in ethnicity, language, religion, skin colour, education, income etc., who have figured out how to live together with a mixture of tolerance and individualism, without getting trapped in hatred or envy. This liberal India was strong enough to be appealing to Aditya Thackeray, and this story tells us that we're in good shape.

Why does Bombay have abysmal governance?

The resource curse

For many years, economists have been puzzled at the way things have gone wrong in countries where natural resources were discovered. In 1993, the economist Richard M. Auty coined the phrase `Resource curse' to convey the extent to which natural resource finds are a curse and not a blessing. But the idea had been kicking around well before that. I suppose it was an obvious conjecture after watching the failures of the Middle East, where trillions of dollars of oil revenues were squandered by not one but many countries.

In the 1970s, when oil was discovered in Venezuela, former Oil Minister and OPEC co-founder Juan Pablo Perez Alfonzo said: "Ten years from now, 20 years from now, you will see, oil will bring us ruin." His phrase for oil was: "the devil's excrement."

Why are resources a curse? In a country blessed with no natural resources (think Japan), the only way forward for the ruling elite is the slow hard work of building public goods, so that GDP builds up, which then feeds back into the power and importance and utility of the ruling elite. When the ruling elite gets their wealth for free, without having to do the hard work of building public goods and thus GDP of the country, the rulers emphasise the wrong issues. That's how Venezuela ended up with Hugo Chavez.

On one hand, rulers get focused on finding ways to maximise their rent from the underlying resource flow, without developing the knowledge about how to build a State that delivers public goods. In parallel, competition between politicians becomes an unpleasant process of trying to grab the riches by means fair or foul, rather than a process of competing in doing better on public goods. If there are XX billion dollars to be grabbed by becoming head of state, fairly unpleasant tactics get used by rivals aiming for that job.

Bombay's resource curse

I just read Maharashtra's Audacious Chief Ministers by Ashok Malik and it is a chilling story. It made me think: Why did governance in Bombay go wrong so comprehensively?

Maybe the story runs like this. Winning elections in Maharashtra does not require serving the citizens of Bombay. A party can do various things in trying to win seats in the legislature across Maharashtra. Once this is done, the ruling party gets the rents that come from control of Bombay.

The wealth and prosperity of Bombay is like an oil well which is gushing out cash for the ruling party in Maharashtra. They did not earn it. The slow, long, hard work of learning how to run a State, of building public goods: these things do not matter for the ruling party in Maharashtra. They get a rental cashflow from Bombay for free.

In (say) Jaipur, the Chief Minister and his ilk do not have an oil well gushing cash at them. Their incentives are to worry about public goods, and grow the GDP of Rajasthan. The importance and rental cashflow of the leadership in Rajasthan are primarily about the GDP of Rajasthan. Their hard work in improving public goods in Rajasthan feeds back to them as a higher rental cashflow.

People often compare the problems with Bombay with the decline of Calcutta after the Left took charge. The two stories are similar in that parties which won rural votes got to run a great city into the ground. But the Left did not take rents from Calcutta on this scale. That was an age where the GDP of Calcutta, while impressive by Indian standards, was still small change. Bombay of the last 20 years is in a different league altogether. This connects with the middle income trap meme: when capitalism first bloomed in India, some governance problems got worse and not better.

Implications

I think this suggests that the right to govern a prosperous city should not be based on elections taking place somewhere else. If Bombay were a full fledged state, as Delhi is and as the four big cities of China are, then elections to control Bombay would require persuading voters in Bombay.

An option chain for INR/USD

We are all used to seeing the options chain for Nifty, but now you have one for INR/USD.

Also read Mobis Philipose in Mint on the unfinished business of derivatives trading in India.

Who will make the exchange-traded currency options market?

In a few minutes, NSE and USE will start trading in currency options. This will be the first exchange-traded options in India on a non-equity underlying.

Currency options are obviously useful as a risk-management tool. I feel that futures are nice simple linear contracts: they ask the person to make only one decision -- are you long or are you short. But once a futures position is entered into, the person needs the ability to manage the position since daily marking-to-market is done, and since there can be large losses for either the futures long or the futures short.

Compared with this, long positions on call or put options appeal to the kind of person that is willing to think carefully about a position at the outset, but after that it is fire and forget. This better describes the life of many firms exposed to currency risk, particularly those with relatively weak treasuries.

Currency options have, of course, been traded OTC for some time now. But there are real problems with this market. Customers have sometimes been ripped off by banks on pricing, given the lack of a liquid and transparent comparison point. While currency options are offered by banks to customers, there is not much by way of an inter-bank market.

As far as I know, there is relatively little by way of a build-up of human and systems capability in the banks for currency options trading (whether OTC or on exchange).

In contrast, there is a remarkable build-up of human and systems capability in the world of Nifty options trading. Options on Nifty have shaped up as one of the biggest options markets in the world. This involves end-users who think and trade options, staff working for securities firms who understand options (and understand issues about their credit risk when their customer has an options position), analytical software systems, and (most importantly) algorithmic trading systems. Options trading inevitably involves trading in a large number of underlyings. Strong computer systems which are able to think about, and place orders in, all the underlyings at one shot are of essence in achieving option liquidity. Such capabilities are now found in the world of Nifty options, and are absent in banks or in the OTC currency options market.

It is fairly easy for a person trading Nifty options to move to trading currency options. Hence, the brainpower and systems that have made Nifty options one of the world's top contracts will easily be able to move to currency options trading, and make it work. I expect that the securities firms who dominate Nifty options trading will now dominate currency options trading.

I think three kinds of stories will now kick in:

1. Liquidity in currency options will fuel liquidity in currency futures, and vice versa. Corporate hedgers will be more interested in either, given that the other is also a possibility.
2. Skills and systems from Nifty options will flow into currency options. Banks will be able to rapidly bulk up their options capabilities by recruiting from the world of Nifty options, and by purchasing the software systems that have sprung up in that space.
3. Conversely, trading in both currency options and Nifty options will generate an increased business size for people who build knowledge and systems for options; it will also improve knowledge of options trading through an understanding and comparison of the nuances of two different underlyings. The number of FRM and PRM certified people in India will go up.

Also see.

Of great interest will be the question of currency volatility. On one hand, the currency options market will generate an implied volatility for the currency, which will represent a market-based forecast for what future currency vol will be. This will be a big new piece of information which will inform macro policy and monetary policy, and thus diminish the extent to which we are flying blind in thinking about Indian macroeconomics.

In recent years, RBI has mostly stayed off from trading the currency market, so the volatility of the INR/USD is a true market volatility. If, in the future, RBI thinks that it wants to give subsidised currency risk management services to the private sector, one way in which it would be able to do that is to do `intervention' on the currency options market so as to force down the implied vol of the market. I.e., RBI would sell ATM calls and ATM puts and thus drive down that price, and thus give cheaper risk management services to the market. This would represent the first operational intervention strategy for RBI through which it can pursue the goal of reducing volatility without distorting the INR/USD exchange rate.

If RBI gets into actively trading the currency market again and trying to push the rupee into a de facto pegged exchange rate, we will see this clearly in the currency options market as a sharply reduced implied vol.

Better living through economics

The `lemons model' in milk procurement

One of the classic stories of India of old is that of Amul, which brought new technology into milk procurement. When the farmer brought his shipment of milk to the Amul front-end, a centrifuge was used to measure the characteristics of this shipment, and based on this payments were made. See this blog post by Alok Parekh, Naman Pugalia and Mihir Sheth. This eliminated the incentives for aduleration of milk by the farmer, which used to be done by adding in water or by skimming the cream.

We can think about this differently. Suppose the centrifuge was not there at the front end. Then the buyer of the milk faced asymmetric information about the characteristics of the milk that were being offered to him. Generally we expect that faced with this `lemons' problem, the buyer would bid low prices for the milk.

So to some extent, the ability of Amul to pay higher prices for milk is not about the greatness of cooperatives when compared with profit-oriented firms: it was about the injection of new technology which removed this asymmetric information.

The interesting puzzle is: in that age, why was Amul the pioneer in buying centrifuges? Why did no private firm buy centrifuges and create a winning business model around milk?

Penalty structure under incomplete detection

Another nice idea that we have understood is the relationship between the probability of getting caught and the penalty. Suppose the fee required for parking is Rs.10 and suppose the probability of getting caught when illegally parked (i.e. without paying the fee) is 10%. Then it's sensible to set the penalty for getting caught at Rs.100 so that even a risk-neutral person will prefer to play by the rules.

This can be applied in the problem of milk procurement. Suppose we say to the farmer: We'll trust you and accept your milk, but on a sampling basis, one in ten farmers will be tested.

Suppose a person added 2 litres of water to his shipment of milk and suppose the price of milk was Rs.10 a litre. In that case, he was trying to steal Rs.20 by palming off low quality milk. But there was only a 10% probability of getting caught, because only one in ten farmers is tested. So the penalty he should face should be Rs.200. If this is done, the risk-neutral farmer is agnostic between playing fair and cheating, even if only one in ten farmers is tested.

The advantage of this strategy is that for 90% of the farmers, the deadweight cost of putting a sample into the centrifuge is eliminated.

This idea is, of course, general:

• Sometimes, we are in situations (as in market manipulation in finance) where we know that even the best regulator in the world will only catch some of the crooks. So we should estimate what fraction of the crooks are getting caught, and then multiply up the size of theft that was attempted. That is, the right way to think of disgorgement is not that the bad guys should fork up the money that was stolen, but that the penalty imposed by the government should be equal to the size of theft divided by the probability of detection.
  
• Sometimes, while comprehensive checking is feasible, it's quite expensive, and it's efficient to deliberately only do checking on a sampling basis. A fairly modest scale of randomised checking (e.g. 5%) can do the trick, coupled with a 20x multiplication factor against the size of the theft that was attempted. This would yield a 95% reduction in the amount of checking that is required. This is the idea in the milk example above.