Five predictions about India and China by Larry Summers

Ila Patnaik has written about five predictions made by Larry Summers in a talk about the evolution of the international financial integration of India and China:

1. Capital account convertibility: Regardless of what policy makers in these countries want, there will be a deepening financial integration, owing to growing trade, investment and capital flows.
2. Reserves accumulation: The increasing financial integration would not be accompanied by the current pace of foreign exchange reserves accumulation in terms of the reserves to GDP ratio. Why? At some point, the US government will not want to be massively indebted to the governments of India and China.
3. INR and CNY appreciation:The next decade would witness an appreciation of the real exchange rates of the two countries.
4. INR and CNY volatility: Exchange rates in India and China will be more flexible than they are today because of the difficulties of managing domestic monetary policy when exchange rates are being manipulated.
5. Current account deficits: India and China would move from current account surpluses to structural current account deficits, reflecting the superior marginal product of capital in these countries.

At present, RBI seeks the other direction on all five counts. It fears convertibility, accumulates reserves in implementing a de facto pegged exchange rate, prevents a real appreciation, lacks a exit path towards a flexible exchange rate, and lacks a game plan for a sustainable current account deficit. So all five predictions are contrary to what RBI is trying. But Larry Summers is offering predictions, not policy recommendations. He feels that these outcomes will emerge regardless of what policy makers seek to achieve.

I see the unfolding story in the same way: these changes are inevitable. As I have written on the subject on convertibility, our choice is between handling these changes in a graceful and choreographed way, or in an inept and bumbling fashion.

Crashing IT prices make interesting things possible; but Indian broadband prices are out of line

Crashing prices of IT systems

Everyone has heard of "Moore's Law", which asserts that CPUs double in roughly every 18 months. Similar phenomena are at work with memory, flash memory, disks, etc. I recently bought a pair of 400G USB disks for Rs.9,000 each - that's Rs.22.5 per G or $0.5 per G. I'm sure that some years from now, this blog entry will look incredibly dated, when hard disk capacity goes at Rs.2.25 per G! I vividly remember how roughly 12 years ago, when I was at CMIE, early design work for terabyte storage was being done and it looked most daunting. Now a terabyte is just 3 disks of Rs.9,000 each.

The growth of performance of a single-CPU has not kept up with Moore's law. But two things have taken place in spectacular measure. First, holding an old level of performance fixed, the cost of a CPU which achieves that level of performance has been crashing nicely. It's easy to put a decent 32-bit CPU into just about any low-price device today. The second phenomenon has been parallel computation. The name of the game now seems to be about harnessing a large number of CPUs to get your work done. For a large class of problems, that appears to be feasible.

Commercial software prices - like Oracle or Microsoft Windows - have held up remarkably well in real terms. So if one tries to configure a system today, the stable software costs loom large when compared with crashing hardware costs. But free software is creeping up into a larger and larger class of problems. It's possible to build a very powerful data centre with Linux, Apache, MySQL, and a free J2EE implementation. Such a data centre would be able to deliver transactions at mere hardware cost.

Crashing prices of IT systems make interesting things possible

Backing up your audio CDs. The `flac' file format permits lossless compression of audio CDs. So when you buy a CD, you can rip the .wav files and convert them to .flac files. As a thumb-rule, one audio CD reduces to 250 Meg or 0.25 G of .flac files. When storage costs Rs.22.5 per G, this means that for a price of Rs.8 of hard disk space, you get to keep a backup of your audio CD. When your audio CD gets scratched or broken, you would uncompress the .flac files to get back to the .wav files which can be burned into an audio CD. Imagine that.

The biggest data centre in the world, through ad revenues. A few years ago, if someone had asked me whether it was possible run a million-CPU data centre supported only by advertising, I would have said that it's not possible to run a million-CPU data centre. But today, we know that Google is extremely profitable running the most complex data centre in the world, and practically all their revenues are from advertising.

Other small data centres based on ad revenues? Turning to the territory more familiar to the readers of this blog, think of a brokerage firm. A brokerage firm is basically a data center interfacing between customer and exchange. If done right, using free software, it ought to be possible to do this data centre at hardware cost. If so, the cost per transaction of the brokerage firm ought to drop dramatically (see my earlier post on flat-price transactions in the brokerage industry). At some point, it'd become possible to have a brokerage firm which offers free transactions, supported only by advertising. It isn't obvious that it works, but it's worth trying. The first attempt at doing this has begun: link, link, link.

Free wifi in a city. When prices of IT hardware are sufficiently low, it may be possible to have free wifi in a city. I am sure that it is possible to have free wifi within a city for low bandwidth applications like email or reading the web. I don't know how the cost of infrastructure will go up if everyone is swapping videos using bit torrent. What might happen is that when city-wide networks are built, the video-related traffic will become so great that the network becomes effectively unusable, that some kind of congestion-pricing is central to making it work correctly. This might be the case; I don't know whether this is just an unhappy scenario or a likely outcome.

Easing nation-building in poor countries. I have previously written about the role of IT systems in delivering national public goods in India [link to paper]. The uniquely Indian challenge is : high volume + low transaction size. Being able to pull this off critically relies on building IT systems which deliver very low cost per transaction. A key litmus test shaping up of these questions is on the implementation of the New Pension System [link to paper].

Indian broadband prices are out of line

In this happy environment of dropping prices of hardware and software, prices of broadband in India stick out. By now, mobile telephony in India has acceptable prices by world standards. But broadband is still way out of line.

A recent blog entry says that the price of a megabit connection per month in the US has dropped to $6 (Rs.300). He quotes "Harvey's theorem": Divide your monthly bill by the speed being touted by your broadband provider" as the path to these calculations. In an Indian setting, that would be between Rs.1,000 and Rs.2,000 a month for a 512k connection from MTNL? That's between 2000-4000 INR (or $25 to $50) per megabit per month. This is between 5x to 10x costlier than in the US. I don't understand why this has to be.

China has 123 million Internet users, of which 77 million are broadband subscribers. A corresponding Indian number seems to be 25 million; broadband usage in India is as yet pitiful. I'm sure both numbers are artificially inflated - perhaps both numbers are wrong by an equal magnitude? I wonder how much of this is caused by lower Indian per capita GDP, and how much of this is caused by high prices of broadband in India.

IMF and World Bank : Where do India's interests lie?

A lot of people have been thinking about the evolution of the IMF and the World Bank. I wrote an article Fund and Bank: Where do India's interests lie? in Business Standard yesterday offering an Indian perspective on the question.

An Indian perspective on the IMF

Many in India view the Fund as a potential source of assistance in the event of a future currency crisis, as was the case in 1981 and 1991. This thought process leads to concerns about a better relationship with the Fund in a future crisis scenario.

I think that India's globalisation has gone so far that it will not be easy to mount a 'rescue' in the event of a currency crisis. In four years time, we will be a $1 trillion GDP with much more than $1 trillion moving in and out of the country every year. The IMF lacks the resources to cope with a currency crisis for a country of this size.

More importantly, the tools are at hand for largely eliminating the risk of a currency crisis. If we embrace a policy framework comprising a floating exchange rate, convertibility, and a narrow inflation-targeting central bank, then the contest between currency speculators and central banks (for which the IMF was designed) does not arise. It is better for India to walk down this path, where there will be no need for an IMF program in the future. Once we start thinking like a mature market economy, we lose interest in issues of who controls the IMF.

An Indian perspective on the World Bank

As far as the World Bank is concerned, there is a consensus on two issues. Gross capital formation in India is slightly below $200 billion a year. In this, $1 to $3 billion from the World Bank is just not a big deal, even after the problem of India's current account surplus is firmly out of the way. More generally, the market-oriented economics that has transformed India's growth opportunities and thus poverty reduction is now sustained by a domestic process of policy reform, where the World Bank is not an actor. The core business of Indian GDP growth, leading to poverty alleviation, seems to be driven entirely by private capital and the domestic political economy that sustains liberal economic policies.

That leaves the argument about knowledge riding alongside a World Bank loan. (See notes from Singapore by Ila Patnaik).

I am a skeptic on the knowledge inputs that the World Bank is able to bring when it comes to day to day reality. When we look at a program like Sarva Shiksha Abhiyan (SSA), where the World Bank was involved, it seems to look more like a traditional Indian government program - riddled with design problems - rather than a program that has been embellished with state of the art microeconomics of information and incentives. (Bibek Debroy's recent article Scrap the SSA is of interest in this regard).

Can the World Bank help by improving monitoring and evaluation? I didn't see that happening with SSA. It was Pratham - and not the World Bank - which discovered (at a tiny cost) that the kids getting enrolled through SSA aren't learning much. The bureacratic incentives of the World Bank are probably as unfriendly to discovering bad news as are those within the GOI.

Another perspective is that of incentives. Compare private sector financing versus World Bank financing in an infrastructure setting. Suppose a expressway project is packaged by Goldman Sachs and has private sources of equity and debt. Compare this against a traditional World Bank financed expressway project. I think the private sector version is superior for two reasons. First, there is generally less leverage with greater private sector involvement, which leads to more healthy project structure. Second, the private owners have an incentive to fight on all aspects of project success, from effective execution to O&M to revenues. In contrast, a World Bank bureaucrat is more likely to lose interest in a project once it is signed. It is better for India to have private financing rather than World Bank financing.

Finally, I instinctively dislike bundling. It is hard to think rationally about either knowledge services or cost of capital when the two are bundled together. I think unbundling of finance and knowledge leads to better procurement of both. The Indian project would be better off separately procuring the best knowledge services, and then procuring the lowest cost equity and debt capital. Mixing them up hinders clear thinking.

Hence, I'm unable to see an important role for the World Bank in a country like India or China, where high growth rates have already been ignited. High GDP growth, and thus poverty reduction, now rides on the domestic political problems of economic policy in these countries.

On the other hand, there are much more daunting problems with "failed states" which could merit a focused effort on institution building through an agency like the World Bank. These are big threats to global prosperity, in this post 9/11 age. If we think of WMD scenarios like a nuclear bomb on Manhattan island or an antiobiotic resistant smallpox virus that is let loose into the world, then the failed states count as major threats to global prosperity. I know, the World Bank's mandate prohibits involvement in political issues. But there is plenty of low-intensity work to be done in building a State, that I call "nation-building", which is not inconsistent with the World Bank's charter.

All around us, India has countries in dire need of nation building: Pakistan, Afghanistan, Central Asia, Nepal, Bangladesh, Burma, Sri Lanka. It is in India's best interest if these countries are able to achieve sound institutions and ignite high GDP growth. From a selfish Indian perspective, that's a great role for the World Bank - to give us a safer neighbourhood and enormous trade growth in our immediate neighbourhood.

That leaves the problem of a funding model. At present, the World Bank needs customers like India and China to make ends meet. If the Bank reorients itself to focus on nation building, it needs new sources of financing. In resolving this problem, I think it helps to see that nation-building in Afghanistan or Sudan is about producing global public goods. Everyone benefits when these countries are set on track. Placing the brunt of financing of these global public goods upon India and China does not sound like a fair arrangement. A reasonable solution could be to pass the hat around to the 25 biggest countries of the world, and ask for contributions in proportion to GDP.

Three articles in Futures Industry magazine on derivatives in India

Michael Gorham has written three articles in Futures Industry magazine about the Indian derivatives business: in June/July 2000, in May/June 2005 and now a piece titled Incredible India - Formidable Futures in the September/October 2006 issue. Mike first came to India to help in the launch of the equity derivatives market in roughly 1996, and has keenly followed the field in the following decade. These three articles add up to excellent knowledge for anyone interested in derivatives in India.

While I am on this subject, I should also point to the full text of the book Derivatives Markets in India edited by Susan Thomas, Invest India Tata McGraw Hill, 2003, which is now available for download.

Dancing with Giants: China, India and the Global Economy

The World Bank has produced a draft volume Dancing with Giants: China, India and the global economy, edited by L. Alan Winters and Shahid Yusuf. Six areas are covered: global industrial geography, competing with giants, international financial integration, energy and emissions, regional variations in growth within the giants, and governance.

Groundwork towards this was done in the form of 21 background papers. Drafts of the book, and the 21 background papers, have been placed on the web. It is good work.

A government that gifts television sets to households?

What should the State do? The ideal State is one that obtains revenue from an efficient consumption tax (e.g. VAT or an income tax with correct treatment of income on capital) and then spends it to produce public goods. Public goods are areas like police, judiciary, defence and financial regulation: non-rival and non-excludable (link, link). The preferences of the population should determine how much taxes are collected and to determine what public goods are produced. Efficient production technologies should be used to produce public goods.

Okay, we don't live in that world. We have a State that obtains a certain tax/GDP ratio, and the bulk of this isn't spent on public goods, it goes into subsidy programs. In that case, what would you hope for? The inefficient thing for the State to do is to try to run programs like PDS or NREG where a little money reaches the population and the bulk of it gets captured by the political system. A clever thing to do would be to have a negative income tax program.

Making a negative income tax work is very hard. If one had to be simple & stupid, an efficient thing to do would be to have a helicopter drop of money where each citizen gets a fixed payment. I am thinking of a very simple, administratively feasible scheme: a direct transfer from the Department of Expenditure into a bank account for every citizen of the country. That would achieve efficient redistribution with minimum frictions. Many middle income countries have built `conditional cash transfer' (CCT) programs accompanied by `electronic benefit delivery' (EBT) with considerable success. They work much better than PDS or NREG. But at present in India, the administrative capacity for doing either CCT or EBT does not exist (though it can be built in a few years if there is an interest in doing this).

Let's spin some numbers. Suppose you wanted to blindly deliver Rs.1000 per person per year. For a family of five, this is a transfer of Rs.5,000 per year or Rs.400 per month. (As an aside, the "poverty line" in year 2000 was a monthly consumption of Rs.211 per person (rural) or Rs.454 per person (urban), so a transfer of Rs.400/person today is quite a lot.). For a billion people, this is an expense of Rs.1 trillion or 3% of 2006 GDP. If the State would restrict itself to this one redistributive program - and do nothing else by way of distorting the economy - I would warmly applaud. This one program would achieve the task of redistribution, and the rest of economic policy can simply focus on growth.

Now suppose you didn't have the infrastructure for delivering Rs.5,000 per year into the household. How else would you do it?

You could gift a television set to every household. If a TV costs Rs.20,000, a gift of a TV set to a household is roughly the same as four year's worth of payments per household. The administrative challenge is that of ensuring that every household gets exactly one TV.

A TV set is something that is visible and monitorable. Every household can verify that it gets one TV set and that everyone around them gets exactly one TV set. Once the TV set has been obtained, everyone would turn around and sell off the TV set into the secondary market and turn it into cash. So it's fair to think of a TV-set-gifting program as being a way of implementing a helicopter drop of cash in a way that supports transparency, monitoring and enforcement.

Viewed in this perspective, what Karunanidhi is doing with TV sets is not that off the mark, even though it has been widely ridiculed and surely links up to their business interests in television states. But if you are cynical enough to believe the State can just not be persuaded to produce public goods, then this is a decent way of returning taxes back to the populace in a broad-based redistributive way. It is easier for voters to verify that television sets are given to all households -- as opposed to complicated welfare programs where goodies are delivered to favoured subsets of the population in non-transparent ways. Gifting TVs to all is better than most welfare programs that we know today, where the bulk of money gets captured by a few households in the political system.

If this issue interests you, T. Ninan had also done an editorial in Business Standard a while ago.

Evolution in China of financial architecture, capital controls, and monetary policy

I noticed two aspects of what is going on in China which struck me as being quite different from what is going on in India. Financial Times has a story filed from Beijing titled Financial watchdog considered for China where he says:

China is debating the establishment of a new "super regulator" for its finance and banking industries to improve co-ordination in a sector in which reform has been increasingly hamstrung by infighting and inertia.

The establishment of an institution is likely to be on the agenda of a closed-door meeting later this year of senior leaders and finance industry officials, according to government advisers and scholars.

...

The so-called Finance Work Committee meeting, to be chaired by Wen Jiabao, the prime minister, has only been held twice before and both times has been followed by major policy changes.

...

Topics under discussion ahead of the meeting include the introduction of a form of monetary or inflation targeting, instead of the present emphasis on tracking money supply as a benchmark for the macroeconomy.

...

With the major decisions largely behind the government on the reform of the state banks, a key focus for reform remains the capital markets, where development has badly lagged growth in the real economy.

Elements of the capital markets and brokerages are governed by separate banking, insurance and securities regulators, as well the People's Bank of China, the central bank. Local governments also have significant shareholdings in brokerages, making them difficult to sell off.

This sounds like a discussion about financial architecture of the type one has not yet seen in a meaningful way in India. In India, we have all sorts of problems with financial architecture, but in the period after the half-creation of PFRDA in 2002/2003, no progress has been made on resolving problems. The debate on regulation of commodity futures is an example of a failure (so far) in doing the right thing.

The second piece I noticed was a story about a Chinese attempt at doing a "trial" of greater convertibility in one geographically restricted area. This is in keeping with many other Chinese "experiments" with reform which have been first initiated in a small way in a part of the country.

This is also much ahead of the Indian convertibility discussion. My sense is that barring the Indian FII framework, which is superior to the Chinese QFII framework, the Chinese have greater de facto convertibility than what is in place in India. To say this differently, when the INR offered a one-way bet, the size of buying by RBI on the market was smaller than what China has had to do in a similar situation.

Is this a reflection of a greater commitment to liberal economics in China? Or is this a mere set of press releases which are well timed given the Singapore meetings? China is very non-transparent, and no outsider really knows.