Five alternative frameworks in education policy

There has been much interest in scaling up programs like Sarva Shiksha Abhiyan and the midday-meal program. At the same time, the recent measurement of what children know, done by Pratham has shown a large-scale failure in what students actually know.

I wrote a column in Business Standard today where I describe five alternative frameworks of education policy:

1. Do Nothing,
2. Augment Purchase,
3. State Production But Do No Harm,
4. State Production While Damaging the Private Sector and
5. Ban Private Participation

With higher education, we are on the 5th (ban). With elementary education, we are now veering from the 3rd ("do no harm") to the 4th ("damaging the private sector") by new efforts at having State-enforced quotas in private schools.

I argue that internationally standardised test scores need to be made the foundation of education policy, as opposed to efforts like SSA which have concentrated on spending more money on public sector education. The choice of which of the five frameworks is best should be based on which appears to deliver adequate test scores in a cost-efficient manner.

Our loyalty needs to be with the interests of students instead of the interests of the existing producers of educational services. There is an innate conflict of interest in the control of education policy with incumbent educationists.

The Indian securities markets in 2005

As usual, Chapter 4 of the Economic Survey is on the securities markets. This was released today. It is a must-read for those interested in the field. Their website only gives you six PDF files for six sections. The Business Standard website is kindly offering a unified single-file of the whole chapter. One-way turnover on the equity spot and derivatives markets, put together, was Rs.60 trillion in calendar 2005. Wow. That's $1.35 trillion. Last year, it was slightly below a trillion dollars. I am not used to hearing `trillion dollars' in any Indian context. Out of the one-way turnover of Rs.120 trillion, a measly Rs.12.4 trillion were made by all institutional investors (domestic or foreign) put together. Particularly on the derivatives market, which is where price discovery takes place, all institutions are Rs.5.2 trillion out of a total of Rs.78.5 trillion. I suspect there isn't any other country with such a complete retail domination of price discovery.

Stock markets and the budget

Everyone is now curious about the budget. It is natural to think of an event study of index fluctuations surrounding budget day. Susan Thomas and I did this in an EPW article in 2002. The quick result, visible in the graph above, is: on average, a budget speech is worth a 10% rise in the index.

What is fascinating is that all this rise takes place before the date of the speech. We see this as some kind of strongform efficiency proposition. Informed traders seem to be quite aware of what is brewing inside the Ministry of Finance and are able to incorporate this into prices in the 40 trading days prior to budget date.

Ila Patnaik has an excellent article in Indian Express on the evolution of the budget speech as an institutional mechanism. There is much more to the budget speech than taxation and expenditure: it has shaped up as a tool for transparency and a commitment device in coalition politics. This is consistent with the idea that you got a +10% return on average associated with budget dates. This reflects the surprises on a broad swathe of economic policy embedded in the speech; not just decisions about taxation and expenditure.

Frontiers in systemic risk - computer security

Over the years, the materiality of computer security problems appears to have escalated. The game now seems to be of a person X writing a virus which infects a large number of Windows machines with software which listens to his instructions and performs actions as per the commands sent out by X to all the machines that he controls. This "large number of Windows machines" is called a "botnet". On 19 February, Washington Post has fascinating story where the reporter has managed to locate and photograph one young man who builds and controls botnets for a living. I have read of botnets which are as big as a million machines. Botnets are a whole new development, compared with the benign old days when viruses merely formatted your hard disk. Imagine the power of having a million machines standing ready and willing to do your bidding.

The two classes of uses of botnets appear to be advertising and blackmail. Advertising is where a captured machine is used to emit email promising to improve the sex life of everyone on the address book of users of that machine. Blackmail is where a `distributed denial of service' attack is mounted against a website, and then money is demanded from the owner of the website in order to desist.

These days, there are jobs in job advertisement classifieds in the "underground" portions of the Internet, for programmers. The employers are large organised crime syndicates, often with bases in East Europe. They are offering upto $100,000 a year for talented programmers to stay in Russia and work for them, developing spyware and keyloggers. Expressed as purchasing power parity wages, this is probably equivalent to $250,000 paid in the US.

An "off-the-shelf" program to exploit a Windows or IE vulnerability and install a piece of spyware is available typically for $60-$100. There are many programmers who sell such programs on the underground Websites of the Internet. These sites are also referred to as "hacker Websites" or "cracker sites". A more customised version of these programs is available for as little as $200.

As Shuvam Misra of Starcom Software says, I frankly think the entry of organised crime syndicates into this arena has made the picture far more alarming than we tend to believe. And there's a general consensus among such gangs that this is cleaner, easier money than drugs.

I think these developments have important ramifications for finance. At a policy level, I think it's time to start exploring the consequences of such vulnerabilities for systemic risk.

If you control a botnet within a stock exchange trading system, you could wreak havoc and profit from it. A dreadful recent story is about a Windows virus that brought down the Russian Stock Exchange. If a problem can bring down a stock exchange, I call it `systemic risk'.

I read recently about a freshly-discovered Windows vulnerability that may have been sold on the black market for a measly $4,000. At some point, a criminal could put the pieces together. Someone could buy a freshly pressed Windows vulnerability, adopt a long vol position, and bring down the exchange at 2 PM on futures expiration date. He will surely make much more than $4,000 out of this. (Full design details are left as an exercise for the reader).

One kind of mistaken response is to say `internet trading is dangerous and should be stopped'. The problem is not with Internet trading. I think the real problem is that Microsoft Windows is embedded inside a lot of Indian finance.

Rethinking the IMF (Mervyn King's lecture)

I attended a talk by Mervyn King, who is Governer of Bank of England, in Delhi. The talk, which was organised by ICRIER, was titled Reform of the IMF. The pdf file of appeared on the Bank of England website. It was fun. It was delightful hearing sharp and modern economics from an employee of a government! I admire the human capital that the UK is able to bring into economic policy. The Bank of England reform is amazing, and so are the humans of that story, such as Mervyn King, Charlie Bean, and Charles Goodhart.

As the old job of the IMF (to periodically bail out countries with a pegged exchange rate which get into trouble) has become redundant in a world with floating exchange rates and open capital accounts, many people have started pondering how to do an IMF differently.

One famous set of ideas on IMF reform has come from Charles Calomiris and Allan Meltzer. Mervyn King's ideas are more radical. He envisages an IMF that shifts into tasks of data, research and meetings. As he describes it, the only instruments that the reformed IMF should have should be the powers of analysis, persuasion and ``ruthless truth-telling''. I think it makes a lot of sense. Yesterday's Business Standard had an excellent editorial on this.

Resilient: Able to cope with big bankruptcies

For an economist, the goal of financial sector policy and regulation is: market efficiency. The normative benchmark is a market which is an unbiased and rapid processor of information, a market that is deep and liquid. For many a bureaucrat, the goal of policy and regulation degrades to "let's not have a crisis on my watch". A great deal of the follies of the real world flow from this difference.

One aspect of crisis is the failure of large finance companies. Bureaucrats working in finance regulators often have a horror of a big finance company defaulting. This makes all big finance companies "too big to fail", with it's own consequent moral hazard. But the safety net is not given out by the bureaucrat for free. The typical price that is demanded is great gobs of equity capital. The bureaucrat finds safety in seeing lots of zeros for the capital. It is mechanically assumed that an entity with Rs.100 crore of equity capital is safer than an entity with Rs.10 crore of capital.

This leads to two kinds of mistakes. One problem is in situations like securities brokerage or in asset management, where equity capital really doesn't do much, and the bureaucrat needlessly burdens the firm by demanding a lot of equity capital. This serves to merely introduce entry barriers, reduce competition, and place the burden of earning an equity rate of return for that capital upon the customers of the firms. Such a drift towards demanding more equity capital is supported by big finance companies, who are too happy to have less competition. The other kind of mistake is that of getting comfortable that firms with lots of capital are safe. The best example of these are banks.

In the context of the pension reforms, we get repeatedly asked: "What happens if a pension fund manager goes bust?". Remarkably enough, it's actually possible to handle this problem rather nicely. The customer assets are - anyway - never on the balance sheet of the fund manager. This is where agency fund management differs fundamentally from either banking or insurance, where customers are inextricably intertwined in the balance sheet of the firm. The pension fund manager is just a consultant, who is giving instructions for transactions using customer assets which are sitting with a custodian. If one pension fund manager goes bust, the regulator replaces him with another pension fund manager. Customer assets needn't be affected when bankruptcy hits a pension fund manager. This aspect underlines why substantial equity capital isn't required to be a pension fund manager.

In the context of risk management, safety comes from clever systems and procedures; not from equity capital. An incompetent bunch can mess up a big finance company with plenty of equity capital. Conversely, sound procedures and well thought out processes can correctly deliver sound outcomes even when there are very big positions and small equity capital. The futures clearing corporation is the best demonstration of how safety comes out of brainwork, not equity capital.

On this theme, Futures Industry magazine has a fascinating article on how the futures clearinghouse handled the recent disaster at Refco.

The disaster at Refco unfolded at a blinding pace. The story started on Monday morning (October 10) with a brief statement from the company. On Tuesday, the CEO was arrested. On Thursday, the shares of Refco had stopped trading and the company was forced to shut down one of it's unregulated units for want of liquidity. You don't get a crisis where the events move faster than this.

Refco was a big firm. In September 2005, it was the 4th biggest Futures Commission Merchant (FCM) measured by customer assets, which stood at $6.5 billion. Plenty of customers got spooked by seeing TV footage of the CEO being carried away in handcuffs. As the article says: According to CFTC data, the total amount of segregated funds held at Refco fell from $6.47 billion at the end of September to $2.53 billion at the end of October. In other words, somewhere in the neighborhood of $4 billion was transferred to other firms in the space of about 15 working days. In fact, I find it remarkable that all customer assets didn't leave.

The article tells the story in full detail, and I encourage you to read the intricate dance-of-death that comes about when such events arise. The bottom line is that the extremely sudden death of the 4th biggest FCM was handled perfectly by the system of futures exchanges + clearing corporations. That's what I call systemic stability. This comes about by building sound procedures and being smart; not by repressing innovation, or by requiring vast amounts of equity capital.

Imagine there's no `FII'

In India, all of us are used to the notion of `FII' as being the channel through which foreign investors access the Indian market. But looking forward, the future easing of capital controls in India will some day involve eliminating the concept of the FII, and opening up the equity spot and derivatives markets to anyone in the world. The FII is a piece of State-induced canalisation, and it will surely (someday) go the way of canalisation to favour the State Trading Corporation or import licence holders.

It is, hence, of interest to all of us to ponder what lies beyond. What is the institutional structure through which normal market economies engage in cross-border financial flows? I believe a key piece of the plumbing is the concept of an "Omnibus Account". This week, Futures Industry magazine has an excellent article describing this structure: Omnibus Accounts: The Portal to Cross-Border Trading, by Leslie Sutphen & Jeff Huang. This article is U.S. centric, but similar structures work for all normal market economies.

The picture that I'm getting is that if India is able to obtain the "Part 30.10 exemption" from CFTC, then it will pave the way for Indian brokers to directly sell to US customers. Else, the Omnibus Account is the only way. It will involve bilateral contracts between a U.S. brokerage firm and an Indian brokerage firm. The Indian firm will treat the orders coming from the U.S. brokerage firm as one big customer, except for the purpose of a `large trader reporting system' (which isn't yet in place in India) where the names of large positions are required.

The article says: Regulatory authorities in some countries have responded by banning omnibus accounts, but this leads to at least two problems. First, it becomes less efficient for global brokers and their customers to enter those markets, and in some cases legally impossible. Second, some market participants will resort to trading "look-alike" contracts with their broker on an over-the-counter basis. The broker then offsets these contracts by establishing an identical position on the exchange. This arrangement does allow these customers to trade these markets, but it provides the regulators with even less information on the ultimate customer. In any case, many institutional investors do not like the lack of price transparency of over-the-counter contracts, so they avoid these markets. This deprives new exchanges of liquidity.

In India, these "look-alike" contracts go by the name of Participatory Notes. :-)

I found it fascinating that in the same issue of Futures Industry magazine, there was an article on developments in Taiwan which is a country which is in the midst of this FII -> Ombinus Accounts transition. Taiwan is like India in having a very big direct retail participation in the securities markets. Roughly 10% of their population trades - in an Indian setting, that would translate to 100 million direct market participants. Taiwan is trying to move towards one thing which we have already done right: a merger between the spot stock exchange and the futures exchange. Right from the L. C. Gupta report onwards, India has been clearheaded on this, requiring no silly separation between the spot and the derivative. But the other frontiers which Taiwan is moving on are a jump ahead of us. They are removing their QFII system, and shifting to omnibus accounts. They are worrying about offering a range of traded products which are interesting to global market participants - such as gold futures and a dollar denominated Taiwanese stock market index - so as to make Taiwan a trading centre for market participants from all over the world. They are increasing the size of position limits. Taiwan is one of the unhappy countries which has taxation of financial transactions - a bad idea in public finance if there ever was one. They seem to be headed to drop the tax rate from 2.5 basis points to 1 basis point. Finally, you might find this article on Mexico interesting; they already have omnibus accounts.