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Tuesday, March 08, 2011
Monday, March 07, 2011
A big step forward on interest rate derivatives
For the backdrop, here are two key facts. First, the failures of policy in the field of interest rate derivatives have led to a peculiar situation where substantial trading on the INR yield curve now takes place outside India. Second, while RBI has permitted one exchange traded interest rate derivative product, there are a host of problems with this contract. The process of policy reform in this field has been a disappointing experience. RBI seems to have quaint notions that cash settlement is harmful, that derivatives trading on short-dated bonds could interfere with monetary policy, etc.
In this setting, here's a big move today: cash-settled futures on the 91-day treasury bill. In a nutshell, it will cash-settle to the price of the 91-day treasury bills (details yet to be announced).
In this setting, here's a big move today: cash-settled futures on the 91-day treasury bill. In a nutshell, it will cash-settle to the price of the 91-day treasury bills (details yet to be announced).
Sunday, March 06, 2011
Two unconventional ideas in breaking with bad governance
Jumpstart a city
Cities are the heart of civilisation and growth. A well functioning city is a great opportunity to obtain economic growth and social change. The best thing that we can hope for, in thinking about the lives of poor people or those facing discrimination in rural India, is for them to escape to a city. We in India don't have a single well functioning city. As an example, governance in Bombay is deeply broken.
How could a poor country kick start the emergence of one or more good cities? Paul Romer has an idea : To walk down the Hong Kong route, to create `charter cities'. See Two paths to good cities. Writing on CFR.org, Sebastian Mallaby reports some big events. Last year, Madagascar came close to signing onto a charter city, but it did not work out. And last month, Honduras approved a Constitutional Amendment which will make this possible. So Paul Romer's three-year crusade appears to be going from a wild idea to the zone of possibility. If it works, it'll score bigger impact than Romer, 1986, which is in Nobel Prize range.
I personally think it would be a much better use for aid money, to go down this route, instead of the conventional development economics that aid agencies emphasise. I feel these existing strategies range from useless to counterproductive. In contrast, it seems that under the right conditions, a charter city could work, and if it works, the upside is phenomenal. So even if 10 charter cities are attempted and one works, it'd be a huge contribution.
On a related theme, you might like to see: What if India had a Hong Kong?
Elect a foreigner
Raghuram Rajan has been talking about another line of attack. He has a recent paper titled Failed States, Vicious Cycles and a Proposal. The blurb reads:
...examines the problems of failed states, including the repeated return to power of former warlords, which he argues causes institutions to become weaker and people to get poorer. He notes that economic power through property holdings or human capital gives people the means to hold their leaders accountable. In the absence of such distributed power, dictators reign.
Rajan argues that in failed states, economic growth leading to empowered citizenry is more likely if a neutral party presides. He proposes a unique solution to allow the electorate to choose a foreigner, who would govern for a fixed term. Candidates could be proposed by the UN or retired leaders from other countries; they would campaign on a platform to build the basic foundations of government and create a sustainable distribution of power.
Rajan emphasizes that this is not a return to the colonial mode: the external candidate (like all the others) would be on a ballot and the electorate would choose whether he or she was their best chance to escape fragility.
Each country is unique and we have to ask ourselves what might work where. In India? Bangladesh? Sri Lanka? Pakistan? Afghanistan? Libya?
Tuesday, March 01, 2011
Interesting readings on the Indian budget
- Editorial in the Indian Express.
- Consolidation without pain! What am I missing? by Jahangir Aziz in the Business Standard.
- An anti-inflation budget by T. N. Ninan in the Business Standard.
- Sweet smell of radicalism by Surjit Bhalla in the Indian Express.
Monday, February 28, 2011
What is gained from cross-border exchange mergers?
by Ajay Shah.
Cross-border exchange mergers are in the news. See Indian exchanges must go regional and then global and Global mergers and Indian exchanges, by Jayanth Varma, who points us to LSE and TMX merge by Jeff Carter on Points and Figures. Also see Stock exchange mergers: the fight for global dominance in the Telegraph, and Big bourse mergers are back but hold the hyperbole by Benn Steil.
An article in the Economist, Back for more: Has the global exchange industry lost its marbles again?, is skeptical about various stories that are being told about exchange mergers, but holds forth the possibility that there might be cost savings:
In this article, I focus on the question: Is there a big opportunity for reducing cost through exchange mergers?
An exchange is an IT system that matches orders. The computational complexity of an exchange is all about taking in a lot of orders per second and computing a lot of trades per second. The output of the IT facility is purely measured by the number of orders that were produced. In the public domain, we see the number of trades, and not the number of orders. Hence, the number of trades is the best public domain source of the size of each exchange, from the viewpoint of cost.
To illustrate the magnitudes involved, last Friday, BSE got 34.1 million orders and did 1.94 million trades. This is an orders-to-trades ratio of 17.6:1 -- for each trade that BSE produces, they have to have the IT capacity to process 17 orders. The only way to get up to these kinds of values is by having a good deal of algorithmic trading.
The revenue per trade is, of course, very different across countries. In India, the average trade size on the equity spot market is \$500 and the tariff for the exchange is hence tiny: NSE or BSE earn Rs.0.65 or \$0.014 per trade. Using the above numbers, BSE's earning Rs.0.04 or \$0.000795 per order on average. These low low tariffs imply that the revenue, profit and valuation of an exchange in India is tiny when compared with what's seen abroad. But on the question of cost, there is direct comparability: it costs as much to produce a billion trades in India as it does anywhere else.
From this perspective, let's look at the biggest factories in the world that produce trades. This is data from the World Federation of Exchanges, for equity trades on the limit order book, in January 2011:
I do believe that in this business, there are economies of scale. To build a factory that produces twice the trades costs less than twice the money.
Does this mean that exchange mergers can create value? Not necessarily.
Let's take one plausible merger from the above. The London SE is a small exchange: they did 19.1 million trades in January. The BSE did 35.1 million trades.
Can one save money by producing 55 million trades in a single data centre? Yes.
Will a BSE+LSE merged entity drop down to one data centre? Of course not! The problem is the speed of light. Today, the conversations between securities firms and exchanges are reckoned in milliseconds. And in one millisecond, light only travels 300 km. So even without reckoning for switching overheads (which are huge!) it is not feasible to unify data centres apart from local mergers such as CME and CBOT.
Since light moves at a glacial pace, it is simply not feasible to beam orders from London to a data centre in Bombay. So even if BSE merged with London SE, there would be two data centres. This limits the cost saving. Until we find a way to speed up light, there is going to be no data centre consolidation in this business, other than within small geographical areas (e.g. within Chicago or within New York).
Okay, let's look further. Could there be cost saving by building one software system and deploying it twice? We'd still spend money to run two data centres, but we'd have only one expense of building software. Could this work?
It's much harder than it sounds. It is not often that one gets to fully transplant an exchange software system in a new location: all too often, the systems have to be significantly different. Regulatory differences, local preferences, history, what users prefer and are used to: all these shape immense diversity in exchange systems. There can actually be diseconomies of scale, with engineering and political problems of handling multiple versions.
Another key problem lies in the sizing of the software system. An exchange system that works for BSE will generally involve a different set of engineering tradeoffs when compared with the LSE setting. So ground-up implementations could be more efficient. By this logic, there may be a useful role for cooperation between similar-sized exchanges (e.g. NSE and Shanghai), but not across divergent sizes which are more than 2x apart.
When decision makers think `a system' can be readily transported across highly diverse order intensities, without regard for the inefficiencies introduced in this process, I think this has something to do with the lack of engineering backgrounds among these decision makers. On a related note, there isn't much of a role for exchange software as a software product, other than in the zone of tiny exchanges where an android phone will suffice for order matching. By the time you get to anything in the top 20 exchanges of the world, an efficient implementation will involve large amounts of ground-up development.
NYSE merged with Euronext. Did we see cost reductions? A lot was said about cost reduction at the time of the merger, but I haven't particularly seen evidence of this filtering out post-merger.
ASX-SGX: Will they drop down to one data centre? Of course not. Will they unify systems? What will be the cost of system unification? Does it make any sense to unify systems? It helps that both are similar-sized small exchanges, but the institutional settings are highly different.
NSE and NASDAQ produce a similar number of equity spot trades. In the latest year, NSE spends roughly \$150 million a year doing this, while NASDAQ spent \$850 million. (NSE produces derivatives trades also, and the NSE number includes the cost of the clearing corporation, so the cost-per-trade edge at NSE is probably of the order of 10x when compared with NASDAQ). The two exchanges are similar in size in terms of the trades per second. Yet, this is not an easy merger opportunity. There will certainly be no data centre unification. NSE's knowledge can be used to run the NASDAQ data centre more cheaply, but complex organisational dynamics would have to be navigated in achieving the transition, and this could take decades to pull off. It is hard to get management teams that are able to play for such long-term gains.
Also see Are exchange mergers always good? by Mobis Philipose in Mint.
There is one kind of exchange merger which I have become increasingly skeptical about: one in which a parent foists computer systems upon the recipient. I have started worrying that this is a bit of a con, a method to generate revenues from system sales under the garb of partnership or strategic alliances. This is done to some extent by firms that are primarily in the business of selling software and not in the business of running exchanges. Or, to the extent that high-cost exchanges are able to do this, the systems/software revenues are able to mask the deeper problem of a high cost structure.
I have watched the grand global deal-making between exchanges for a long time. In my reckoning, most of it has been a waste of time and money. As one specific example, in my observation in India, some foreign investments into Indian exchanges has been irrelevant, others have directly done damage. None has as yet helped improve product offerings or cost efficiency.
One contract that comes to my mind as one that really worked was Mutual Offset (MOS) between CME and SIMEX, which was done way back in 1984. This was one deal that really mattered and was a good idea. But it was useful in the age before capital account openness - such connections are less important today when capital flows freely anyway. And, remember that it was a mere contract, it involved no complications of ownership and management. So I do think there will be value if the Nifty futures on SGX, CME and NSE are all unified through a mutual offset system: but this does not require anything more complex than signing a contract.
Jayanth Varma says:
I disagree. The global exchange M&A story seems to be overrated, apart from the extent to which systems like MOS which can alleviate home bias (and only require contracts). There isn't much to gain there. On the other hand, the problem of sound regulation and supervision of exchanges in India is a GDP-scale issue. Indian experience and evidence does not support a complacent approach that the regulation and supervision will work out.
My thinking on this was improved through conversations with Ravi Apte and Ashish Chauhan.
Cross-border exchange mergers are in the news. See Indian exchanges must go regional and then global and Global mergers and Indian exchanges, by Jayanth Varma, who points us to LSE and TMX merge by Jeff Carter on Points and Figures. Also see Stock exchange mergers: the fight for global dominance in the Telegraph, and Big bourse mergers are back but hold the hyperbole by Benn Steil.
An article in the Economist, Back for more: Has the global exchange industry lost its marbles again?, is skeptical about various stories that are being told about exchange mergers, but holds forth the possibility that there might be cost savings:
Joining forces does not in itself realise revenue gains or alter this decline. But it may make it possible to combine the technology and back-office platforms being used by different exchanges, cutting costs. Efficiency savings are the one element of the last round of consolidation that did arrive as promised.
Cost savings are being emphasised again now. The Deutsche Borse and NYSE-Euronext combination should yield annual savings of \$412m, the two firms say, equivalent to about a fifth of the combined entity's pre-tax profits, while the LSE-TMX deal should produce savings of about 7%.
In this article, I focus on the question: Is there a big opportunity for reducing cost through exchange mergers?
Getting a sense of the magnitudes
An exchange is an IT system that matches orders. The computational complexity of an exchange is all about taking in a lot of orders per second and computing a lot of trades per second. The output of the IT facility is purely measured by the number of orders that were produced. In the public domain, we see the number of trades, and not the number of orders. Hence, the number of trades is the best public domain source of the size of each exchange, from the viewpoint of cost.
To illustrate the magnitudes involved, last Friday, BSE got 34.1 million orders and did 1.94 million trades. This is an orders-to-trades ratio of 17.6:1 -- for each trade that BSE produces, they have to have the IT capacity to process 17 orders. The only way to get up to these kinds of values is by having a good deal of algorithmic trading.
The revenue per trade is, of course, very different across countries. In India, the average trade size on the equity spot market is \$500 and the tariff for the exchange is hence tiny: NSE or BSE earn Rs.0.65 or \$0.014 per trade. Using the above numbers, BSE's earning Rs.0.04 or \$0.000795 per order on average. These low low tariffs imply that the revenue, profit and valuation of an exchange in India is tiny when compared with what's seen abroad. But on the question of cost, there is direct comparability: it costs as much to produce a billion trades in India as it does anywhere else.
From this perspective, let's look at the biggest factories in the world that produce trades. This is data from the World Federation of Exchanges, for equity trades on the limit order book, in January 2011:
| Rank | Exchange | '000 trades |
| 1 | NYSE Euronext | 1,52,922 |
| 2 | NSE | 1,18,200 |
| 3 | NASDAQ OMX | 1,13,753 |
| 4 | Shanghai SE | 1,04,965 |
| 5 | Korea Exchange | 1,00,221 |
| 6 | Shenzhen SE | 76,268 |
| 7 | BSE | 35,157 |
| 8 | Tokyo SE | 27,557 |
| 9 | Taiwan SE | 20,313 |
| 10 | London SE | 19,132 |
Saving money through unification of data centres?
I do believe that in this business, there are economies of scale. To build a factory that produces twice the trades costs less than twice the money.
Does this mean that exchange mergers can create value? Not necessarily.
Let's take one plausible merger from the above. The London SE is a small exchange: they did 19.1 million trades in January. The BSE did 35.1 million trades.
Can one save money by producing 55 million trades in a single data centre? Yes.
Will a BSE+LSE merged entity drop down to one data centre? Of course not! The problem is the speed of light. Today, the conversations between securities firms and exchanges are reckoned in milliseconds. And in one millisecond, light only travels 300 km. So even without reckoning for switching overheads (which are huge!) it is not feasible to unify data centres apart from local mergers such as CME and CBOT.
Since light moves at a glacial pace, it is simply not feasible to beam orders from London to a data centre in Bombay. So even if BSE merged with London SE, there would be two data centres. This limits the cost saving. Until we find a way to speed up light, there is going to be no data centre consolidation in this business, other than within small geographical areas (e.g. within Chicago or within New York).
Saving money on software development?
Okay, let's look further. Could there be cost saving by building one software system and deploying it twice? We'd still spend money to run two data centres, but we'd have only one expense of building software. Could this work?
It's much harder than it sounds. It is not often that one gets to fully transplant an exchange software system in a new location: all too often, the systems have to be significantly different. Regulatory differences, local preferences, history, what users prefer and are used to: all these shape immense diversity in exchange systems. There can actually be diseconomies of scale, with engineering and political problems of handling multiple versions.
Another key problem lies in the sizing of the software system. An exchange system that works for BSE will generally involve a different set of engineering tradeoffs when compared with the LSE setting. So ground-up implementations could be more efficient. By this logic, there may be a useful role for cooperation between similar-sized exchanges (e.g. NSE and Shanghai), but not across divergent sizes which are more than 2x apart.
When decision makers think `a system' can be readily transported across highly diverse order intensities, without regard for the inefficiencies introduced in this process, I think this has something to do with the lack of engineering backgrounds among these decision makers. On a related note, there isn't much of a role for exchange software as a software product, other than in the zone of tiny exchanges where an android phone will suffice for order matching. By the time you get to anything in the top 20 exchanges of the world, an efficient implementation will involve large amounts of ground-up development.
A skeptical perspective
NYSE merged with Euronext. Did we see cost reductions? A lot was said about cost reduction at the time of the merger, but I haven't particularly seen evidence of this filtering out post-merger.
ASX-SGX: Will they drop down to one data centre? Of course not. Will they unify systems? What will be the cost of system unification? Does it make any sense to unify systems? It helps that both are similar-sized small exchanges, but the institutional settings are highly different.
NSE and NASDAQ produce a similar number of equity spot trades. In the latest year, NSE spends roughly \$150 million a year doing this, while NASDAQ spent \$850 million. (NSE produces derivatives trades also, and the NSE number includes the cost of the clearing corporation, so the cost-per-trade edge at NSE is probably of the order of 10x when compared with NASDAQ). The two exchanges are similar in size in terms of the trades per second. Yet, this is not an easy merger opportunity. There will certainly be no data centre unification. NSE's knowledge can be used to run the NASDAQ data centre more cheaply, but complex organisational dynamics would have to be navigated in achieving the transition, and this could take decades to pull off. It is hard to get management teams that are able to play for such long-term gains.
Also see Are exchange mergers always good? by Mobis Philipose in Mint.
There is one kind of exchange merger which I have become increasingly skeptical about: one in which a parent foists computer systems upon the recipient. I have started worrying that this is a bit of a con, a method to generate revenues from system sales under the garb of partnership or strategic alliances. This is done to some extent by firms that are primarily in the business of selling software and not in the business of running exchanges. Or, to the extent that high-cost exchanges are able to do this, the systems/software revenues are able to mask the deeper problem of a high cost structure.
I have watched the grand global deal-making between exchanges for a long time. In my reckoning, most of it has been a waste of time and money. As one specific example, in my observation in India, some foreign investments into Indian exchanges has been irrelevant, others have directly done damage. None has as yet helped improve product offerings or cost efficiency.
One contract that comes to my mind as one that really worked was Mutual Offset (MOS) between CME and SIMEX, which was done way back in 1984. This was one deal that really mattered and was a good idea. But it was useful in the age before capital account openness - such connections are less important today when capital flows freely anyway. And, remember that it was a mere contract, it involved no complications of ownership and management. So I do think there will be value if the Nifty futures on SGX, CME and NSE are all unified through a mutual offset system: but this does not require anything more complex than signing a contract.
Jayanth Varma says:
It is tragic that at this point of great opportunities and strategic challenges, the energies of Indian exchanges and their regulators are entirely consumed by the debate about whether exchanges should be regulated like public utilities
I disagree. The global exchange M&A story seems to be overrated, apart from the extent to which systems like MOS which can alleviate home bias (and only require contracts). There isn't much to gain there. On the other hand, the problem of sound regulation and supervision of exchanges in India is a GDP-scale issue. Indian experience and evidence does not support a complacent approach that the regulation and supervision will work out.
Acknowledgements
My thinking on this was improved through conversations with Ravi Apte and Ashish Chauhan.
Thursday, February 24, 2011
Rapid buildup of currency options open interest
Today, on NSE, derivatives trading showed the following numbers:
This is really something: Rs.2.98 trillion notional rupees in a day. It's starting to sound like a real market.
This data shows an incredible domination of Nifty futures and options. It also shows the massive success of Nifty options.
One element of the options to futures ratio with equities lies in the securities transactions tax, which has distorted the market in favour of options. In the case of currencies, this distortion is absent. Hence, the ratio of options to futures that we see there should reflect the undistorted applications of the products by the market.
Now that the NSE trading community has skills on options, the question arises: Do these skills readily port over into currency options? I believe they should: every good Nifty options trader is a good INRUSD options trader. The same options knowledge should pretty much carry over from equity stock or equity index options to currency options. In fact, with small modifications, the algorithmic trading that is being done on the equity options should readily deploy into the currency options.
So what does the evidence show? Currency options trading (INR/USD only, says the RBI) started on 29 October 2010. I have 117 trading days of data for the open interest of INRUSD options. Let's compare the rise of open interest starting from contract launch:
The early days of currency futures trading was hard work: the open interest got up to $0.2 billion and stopped growing. In contrast, open interest with currency options has grown very fast in these 117 days. At each contract expiration, it has been much bigger than the previous one.
As a consequence, INRUSD options open interest is now bigger than INRUSD futures open interest, even though the latter has been a market that has been around for much longer:
This is consistent with the story that the Nifty options brainpower would yield a rapid establishment of the currency options market. This also tells us that not all of the domination of equity options is a distortion caused by the differential securities transaction tax.
This rise of the options and futures open interest has done a great deal for the viability of enterprise-scale economic risk management using the currency futures and options, given that the position limit is linked to the overall open interest. The limit is now looking big enough to be of interest to even the biggest Indian companies.
Some older materials that you might like to see:
| Product class | Turnover (Billion rupees) |
| Index futures | 353 |
| Index options | 1981 |
| Stock futures | 391 |
| Stock options | 48 |
| Currency futures | 178 |
| Currency options | 30 |
| Total | 2981 |
This is really something: Rs.2.98 trillion notional rupees in a day. It's starting to sound like a real market.
This data shows an incredible domination of Nifty futures and options. It also shows the massive success of Nifty options.
One element of the options to futures ratio with equities lies in the securities transactions tax, which has distorted the market in favour of options. In the case of currencies, this distortion is absent. Hence, the ratio of options to futures that we see there should reflect the undistorted applications of the products by the market.
Now that the NSE trading community has skills on options, the question arises: Do these skills readily port over into currency options? I believe they should: every good Nifty options trader is a good INRUSD options trader. The same options knowledge should pretty much carry over from equity stock or equity index options to currency options. In fact, with small modifications, the algorithmic trading that is being done on the equity options should readily deploy into the currency options.
So what does the evidence show? Currency options trading (INR/USD only, says the RBI) started on 29 October 2010. I have 117 trading days of data for the open interest of INRUSD options. Let's compare the rise of open interest starting from contract launch:
The early days of currency futures trading was hard work: the open interest got up to $0.2 billion and stopped growing. In contrast, open interest with currency options has grown very fast in these 117 days. At each contract expiration, it has been much bigger than the previous one.
As a consequence, INRUSD options open interest is now bigger than INRUSD futures open interest, even though the latter has been a market that has been around for much longer:
This is consistent with the story that the Nifty options brainpower would yield a rapid establishment of the currency options market. This also tells us that not all of the domination of equity options is a distortion caused by the differential securities transaction tax.
This rise of the options and futures open interest has done a great deal for the viability of enterprise-scale economic risk management using the currency futures and options, given that the position limit is linked to the overall open interest. The limit is now looking big enough to be of interest to even the biggest Indian companies.
Some older materials that you might like to see:
- Evolution of exchange traded derivatives, 1 June 2009.
- URLs for the two option chains.
- Who will make the exchange-traded currency options market, 5 December 2010.
- Currency futures: An example of how India changes, 22 April 2010.
- A book.
Jittery regimes fix prices
The puzzle
All of us are now curiously thinking about the abrupt phase transition that seems to sometimes occur in the endgame of an authoritarian regime. The traditional script was: The people rise up to rebel and the strongman murders them.
When the USSR collapsed, we thought it was special: it was a defunct regime that had just lost the will to live. But for the rest, the basic rulebook stood: the people get mowed down. And sure enough, that happened in Tiananmen Square.
But now, there are an increasing number of success stories with `velvet revolutions', and one has to think more carefully about what goes in an authoritarian regime.
Conflicts beneath the surface
What appears like a monolithic regime from the outside can actually often reflect a diverse array of interests tugging in different directions. In this beautiful article by Laurence Wright on Saudi Arabia, he says:
I had begun to look at Saudi society as a collection of opposing forces: the liberals against the religious conservatives, the royal family versus democratic reformers, the unemployed against the expats, the old against the young, men against women.On that same thread, Why do protests bring down regimes? A follow up by Graeme Robertson says:
I have also read others write similarly about China (but sadly, I do not have the reference): That in the absence of freedom of speech, the regime actually has no idea about where the problems lie, and is hence hypersensitive about criticism, and about solving the problems that it thinks do matter.
While the news media focus on "the dictator", almost all authoritarian regimes are really coalitions involving a range of players with different resources, including incumbent politicians but also other elites like businessmen, bureaucrats, leaders of mass organizations like labor unions and political parties, and, of course, specialists in coercion like the military or the security forces. These elites are pivotal in deciding the fate of the regime and as long as they continue to ally themselves with the incumbent leadership, the regime is likely to remain stable. By contrast, when these elites split and some defect and decide to throw in their lot with the opposition, then the incumbents are in danger.
So where do protests come in? The problem is that in authoritarian regimes there are few sources of reliable information that can help these pivotal elites decide whom to back. Restrictions on media freedom and civil and political rights limit the amount and quality of information that is available on both the incumbents and the opposition. Moreover, the powerful incentives to pay lip service to incumbent rulers make it hard to know what to make of what information there is.
The behaviour of a jittery regime
Democracy matters in two ways. First, the regime has legitimacy. It is not worrying about a sudden upheaval that will destroy the regime. And, freedom of speech carries a steady flow of information to the regime. The UPA leadership does live in a bubble, but even they know that 8% inflation is a serious problem.
When a regime lacks legitimacy, and does not know what is going on, it is constantly fearful. It does not know what is going wrong and it can go off into extremes in trying to stave off some problems that it believes are first order. One area where this shows up is inflexible prices. To an external observer, it may be obvious that allowing price flexibility is better, but the regime is terrified about what will happen, so the price stays fixed.
Three examples
- Egypt
- In a blog post titled Garam Masala: Bread And The Life Of Egypt, Vikram Doctor writes:
I first realised how different Egypt was when I saw the bread in the street in Cairo. It was piled on low charpoy-like tables, thick rounds of freshlybaked bread, slightly scorched from the oven, a bit like tandoori rotis, but heavier.... Someone would replenish them from the bakery close by, and collect the money that people left, but nothing seemed to stop them just taking it away... the other reason why no one took the bread free was that it was so ridiculously cheap that they might as well just leave the few coins needed (in fact, buying bread seemed to be pretty much all that the piastre coins were used for). I calculated that, at that time (over 12 years back), the cost of a round of bread converted to something like three paise : something I could not imagine anything costing in any large Indian city. But this was the point: the price was unreal because a massive bread subsidy was one of the basic ways the Mubarak regime stayed in place.
- Iran
- From The regime tightens its belt and its first, in the Economist:
From top ayatollahs to the IMF, everyone agrees that spending $100 billion each year to pin down petrol, gas and electricity prices, besides the cost of staples such as flour and cooking oil, is a bad way to dispose of Iran's hydrocarbon revenues, accounting for more than 10% of GDP and encouraging waste on an epic scale. The symptoms of the malaise are legion: tea kettles simmer all day; the streets clog with recreational drivers out for a spin; lights glare because no one can be bothered to turn them off. `We can do it because we have oil,' Iranians used to tell incredulous visitors.
- China
- The outstanding price inflexibility of China is that of the exchange rate. Consider the Chinese and the Indian exchange rates of recent years:
The exchange rate is the most important price in any economy. A country that can handle a floating exchange rate is a flexible economy, one in which firms are born and die, workers move across locations and industries, and prices fluctuate. Deep and liquid markets are shock absorbers. Firms have ample equity capital, i.e. low leverage, so that they are able to absorb shocks. There is a whole configuration of institutional arrangements which are conducive to price flexibility. By and large, India fares well on these counts, particularly in the vast informal sector where there is extreme flexibility. And most of all, when things do hurt, individuals are able to express their discontent through democratic politics.
If India did not have these long-standing strengths, Governors Reddy and Subbarao would not have been able to move to a flexible exchange rate. And this exchange rate flexibility, in turn, enables an array of other economic reforms in favour of a market-based system.
Also see: The message for China from Tahrir Square by Minxin Pei in the Financial Times and The Secret Politburo Meeting Behind China's New Democracy Crackdown by Perry Link, on the New York Review of Books Blog.
Stability that is illusory
The regime change of recent years should make us think afresh about the notion of `political stability'. Democracy is always messy: demonstrations, machinations of party politics out in the open, colourful and often intemperate figures on television, elections, change in the ruling arrangement. But at a deeper level, this can be a more stable arrangement; there is no revolution at the end of the tunnel.
Similar reasoning applies in economics. Economists have always known that when prices appear to be stable, they often mask real trouble underneath. It is far better to have a small fluctuation every day, i.e. a steady flow of vol. The alternative -- of clamping down on price movements on most ordinary days -- merely yields big price movements on some days, which are far more difficult to handle.
Economic agents are not fooled by this stability on the surface. As Mark Roe says on Project Syndicate:
Even if all of the rules for finance are right, few will part with their money if they fear that an unfavorable regime change might occur during the lifetime of their investment.
More importantly, the grim stability of the type displayed by Hosni Mubarak's Egypt is oftentimes insufficient for genuine financial development. Authoritarian regimes, especially those with severe income and wealth inequality, inherently create a risk of arbitrariness, unpredictability, and instability. They are themselves arbitrary. And everyone knows that beneath the stability of the moment lurk explosive forces that can change the regime and devalue huge investments. Because financiers and savers have limited confidence in the future, such regimes can't readily build and maintain strong foundations for financial development.
Implications
This is a `capitalism and freedom' style argument: that democracy and markets interact in the double helix of modern civilisation.
Price flexibility works best when there is price flexibility in a lot of markets. If all prices were fixed, and you only freed up one, then it could easily make things worse. It is hard, crossing the hump, and reaching over to the other side where all prices are flexible. And, price flexibility goes well with democracy. Flexible prices are constantly disruptive. Every day, there are a few pockets of the economy that are really getting hurt in the creative destruction. It requires a confident regime to take these fluctuations in its stride. A jittery and illegitimate regime may be more likely to clamp down on price fluctuations since it fears these could destabilise it.
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