We live in interesting times

Just when you thought financial markets had become boring, things got interesting again.

• First, the Chinese market dropped 9% [picture]. That wouldn't, by itself, worry me so much. The stock market isn't that important to China's economy. It isn't a particularly well done stock market either, so I don't worry so much about the information content of this drop in prices. You might find this book review to be mildly interesting. William Pesek has a good column on Bloomberg, and this IHT story describes recent events.
• The big news is that last night, while we were sleeping in Indian Standard Time, the S&P 500 dropped 3.47% [picture]. Menzie Chinn has a great blog post diagnosing what happened, Caroline Baum has a good column on Bloomberg about the US housing market, and this NYT story uses the R word. This one-day drop of 3.47% is a fairly big move for the S&P 500 which has a daily sigma of 1%. If I look at the post-1990 period, on 99% of the days, the one-day returns were milder than -2.6%. They seem to get three days in each four years, on average, with a move of worse than -3.47%, and the last four years have been unusually benign.
• Most world indexes have also dropped [link]. I think this is mostly in response to the drop in the S&P 500 and its changed vol, and not so much in response to events in China.
• For many months now, the volatility of the S&P 500, as forecasted by the index options market, has been slumbering at remarkably low levels. It has jumped back dramatically [picture], going from near 10% annualised vol on Tuesday to roughly 18% last night. I wrote about the eerie low volatility a few weeks ago, and many commentators have been worried about the extent to which assets are `priced to perfection'.
• Turning to India, Business Standard has an excellent edit showing you the political context of this budget speech.

It's now 9:40 and at 11 the budget speech will start. This is, by itself, a big dose of vol for the Indian equity market. There could not have been a more dramatic setting for the speech. In the past few days, Nifty's been a bit volatile, so margin levels are already much higher than they were just ten days ago.

Milestone in the internationalisation of the INR

With burgeoning flows on the current account and the capital account - with gross flows that exceed 90% of GDP and are growing much faster than GDP - the internationalisation of the INR is inevitable. I have previously written about how wrong India's approach on capital controls is, with rules that limit INR denominated borrowing but encourage foreign currency borrowing. It reminds me of pre-crisis South Korea, which encouraged short-dated debt flows but blocked equity flows.

A remarkable development has taken place for the INR: The first INR denominated offshore bond has come about, far from the clutches of local capital controls. This sets a new frontier for what you can do with the INR NDF market. Inter-American Development Bank has raised Rs.1 billion ($23 million) with an INR-denominated bond. The most interesting feature of the situation is what RBI proposes to do about this -- introduce more capital controls (see text which is not in italics). This text is from IFRAsia ($$) on 3 February 2007:

Non-deliverable forwards drive first offshore rupee bonds International investors recently had their first opportunity to gain exposure to the Indian rupee fixed-income market without having to register with the Reserve Bank of India thanks to the first ever non-deliverable Indian rupee-denominated bond.

The February 2010 bond, which was arranged by TD Securities, might have been small - it raised Rs1bn (US$23m) for the Inter-American Development Bank (IADB) - but it seems likely to be a taste of things to come.

"Through this structure, we are providing non-Indian entities access to rupee bond issuance and offshore investors a way to express a position in Indian rupees," said Greg Moore, a director with TD Securities in London. "The deal was small in size to start with but as investor confidence grows, we expect it to be upsized."

Though the deal was the first of its kind in rupees, TD has also arranged similar transactions for other issuers in Brazilian real or Indonesian rupiah.

The bonds, which are listed in London, pay an annualised coupon of 7.25% which is inside where Indian government bonds trade - possibly one of the motivations for the trade. Though denominated in rupees, the IADB deal is settled in US dollars. Seven investors based in Belgium, Canada, Germany, Switzerland and the UK bought the bonds.

Foreign investor interest towards rupee debt has been rising over the past few years but restrictive local regulations mean that it is difficult for most investors to access the market. The Indian rupee is convertible on the current account but not fully on the capital account which means that offshore investors looking to take rupee exposure cannot do so offshore and have to register as foreign institutional investors and then invest in India.

The total amount of foreign investment in rupee bonds is, however, tightly controlled and many investors don't bother to register as they will struggle to get access to enough rupee paper to make it worth their while.

Taken together, foreigners are now allowed to hold US$2.6bn in government bonds, with that limit due to rise to US$3.2bn by the end of March. The limit for corporate debt is US$1.5bn.

Regulators have been wary of inviting large-scale foreign investment in debt (unlike in equities) amid worries that this would encourage large speculative flows that could pose a systemic risk. But it is clear that the lack of foreign participation is one reason for the domestic market's lack of depth.

The IADB transaction skirts these issues by using non-deliverable forwards which, while based on rupees, don't directly interact with the onshore market. The NDF market gives offshore players a synthetic exposure to the currency and trade settlement is in foreign currencies based on the movement in the rupee versus foreign currencies.

However, the RBI is even looking to curb the progress of this market. In November, the central bank issued draft guidelines on the use of derivatives in India which will supersede all existing guidelines when they are confirmed.

One proposed rule states that market-makers and users should "not undertake any derivative transaction involving the rupee that partially or fully offsets a similar but opposite risk position undertaken by their subsidiaries/branches/group entities at offshore location(s)". In other words, the RBI is attempting to stop banks offering offshore-based rupee product from offsetting risk in the onshore market. If it is able to do that - a big "if" given that enforcement would be very difficult - such transactions would become considerably less efficient for the banks arranging them.

Either way, bankers think that there is very little the RBI can do to stop deals like the one from the IADB. News last week that S&P has also upgraded the Indian sovereign to investment grade is likely to add to the demand for such deals and make it worthwhile for banks to put in the work needed to construct such transactions.

"The biggest challenge of doing such deals is piecing the various inputs inherent to this type of trade together. But given the strong interest evidenced by investors, we expect more such deals in the future," said Moore.

Update: Jayanth Varma has written about this on his blog.

Pondering the GST (with a tailpiece about FBT)

Business Standard has an edit on the GST, and has an article on it by Sukumar Mukhopadhyay, where he emphasises the differences between alternative formulations of the GST. My sense is that the positions of Kelkar and Bagchi are actually 99% the same. And, I think Mukhopadhyay gives inadequate weightage to the remarkable implications of the 88th amendment of the Constitution.

There was an interesting edit in Financial Express, which I will discuss in reverse order. First, the part that I agree with, on the GST:

Exemptions made for one or the other industry only make space for lobbying and pressures that result in even more distortions in the future. If Indian business has to become globally competitive, then the finance ministry needs to institute a tax system that reduces friction and costs. That the country has begun to absorb the principle of value-added taxation (VAT) is encouraging. But beyond that, taxation policy must focus on converging the current system of multiple varied taxes towards an efficient, VAT-based, nationwide goods and services tax (GST) that removes all barriers within the country, gives the tax code cohesion, reduces the innumerable contact points between tax administration and industry and lowers cost of compliance. The finance minister must turn his attention towards a clear roadmap for this, and adhere to it. An increase in service tax to 14% and a reduction in central excise from 16 to 14% is only a first step in this direction. This should be done in the forthcoming Budget.

Compare the performance of Indian manufacturing with that of China, and one crucial fact that is often forgotten is that Chinese manufacturing was given a GST in the early 1990s. A better taxation system gave the Chinese no less an edge over Indian industry than did China’s superior infrastructure. Prime Minister Manmohan Singh and finance minister P Chidambaram have both made promises that India will see a GST. But the difficulty is that while other tax reforms—such as rationalisation of customs, removal of exemptions, changes in tax rates/items—can be done at the stroke of a pen, implementing any VAT-based system is difficult in many ways. It is administratively complicated, involves the consensus of states and requires changes in mindset all through the value chain, which is never easy in a country such as India. To be sure, there has been progress. The Union Budget for 2004-05 brought services into the VAT framework and integrated the credit on Cenvat and services taxes. Another step was the implementation of state VAT from April 2005. Now, for India to move towards a countrywide GST involving both the centre and states, the central government must provide clear leadership in setting up a well-functioning central GST system with the requisite administrative capacity. In doing this, its own revenues will go up and its dependence on direct taxes will go down.

As for other taxes, central excise deserves a closer look for possible problems of non-compliance. With some extra effort, however, such problems can be a thing of the past. Greater computerisation, for example, could help to quite a degree. The finance minister could make full use of the latest information technology enablers to merge databases and re-order data on transactions to make the entire taxation framework amenable to desktop overview on a consolidated basis. In fact, a vast central tax database should serve as the centrepiece of how VAT credits and refunds take place, and the treatment of VAT on imports and exports should be linked to it as well. Such a system, integrated electronically with the current tax information network (TIN) system that was up and running in eight months, can be easily initiated in the next fiscal year. The number of establishments involved would be smaller than the number that have already been plugged into TIN. This will help eliminate fraud in central excise and service taxes. And, when the centre demonstrates, by example, to the states that there are gains to be made by joining this system, the path towards an all-India GST will open up.

For those interested in the GST, there is more on GST in this blog. And then, the early part of the edit that I don't agree with:

Collections from the Fringe Benefit Tax (FBT) in the period April 1, 2006 to January 31, 2007 stood at Rs 3,984 crore, a tiny part of the Rs 1,56,429 crore collected as direct taxes during this period. The distortionary impact of the tax is, no doubt, much larger—so large that even larger collections would not justify them. The FBT is a presumptive tax that poses enormous headaches for employers who have genuine business expenses that are burdened by it. ‘Fringe benefits’ are deemed to have been provided when the employer incurs any expenses on account of maintenance of guest house, conferences, sales promotion including publicity, conveyance, tour and travel, hotel stay, boarding and lodging. These are routine business expenses for most enterprises, but a specified percentage of these are taxed. Which means that these expenses are effectively treated as profits. This goes against the basic principles of taxation.

Perks, or fringe benefits provided by an employer to his employees, in addition to the cash salary or wages paid, are often a way of paying a part of the salary in a manner such that the employee has to pay no tax on it. In other countries such fringe benefits are subject to varying tax treatment. These benefits are either taxed in the hands of the employees themselves or subject to a 'fringe benefit tax' in the hands of the employer. The rationale for levying a fringe benefit tax lies in the inherent difficulty in isolating the 'personal element' where there is collective enjoyment of such benefits and attributing the same to the employee. Many times the expense may be incurred for the purpose of business but,like in the case of entertainment, have benefits of a personal nature. The problem lies in being able to correctly identify the true business expense from a cash component of salary.

The real contribution of the FBT lies in the way that it has encouraged employers to move towards more transparent pay packages where the full cost-to-company is seen as total taxable income. The success or failure of the FBT should not be judged by the tiny direct collection of the FBT.

The FBT attempts to bring on par employees of private companies that offer a part of the salary as a tax free component with that of those with fully taxable salaries. Yet, there are difficulties in the tax for the employers who have genunine business expenses which get hit by the FBT. For example, fringe benefits are deemed to have been provided when the employer has incurred any expenses on account of maintenance of guest house, conference, sales promotion including publicity, conveyance, tour and travel, hotel, boarding and lodging. These are genuine expenses for most business enterprises but a specified percentage of these expenses are taxed. This distorts the behaviour of firms.

Four outstanding recent books

1. The Oxford Companion to Economics in India, edited by Kaushik Basu. As I flipped the pages, I felt like sitting down and thoroughly reading roughly one third of the entries. [Link] [Link on Amazon] [Speech by Manmohan Singh about it].
2. Scribner's Encyclopedia of India, edited by Stanley Wolpert (November 2005).
3. Managing Globalisation: Lessons from India and China, edited by David Kelly, Ramkishen Rajan and Gillian Goh (November 2006). An edited set of papers from the inaugural conference of the Lee Kuan Yew School of Public Policy at the National University of Singapore [Link on Amazon].
4. Documenting Reforms, edited by S. Narayan, Macmillan India, 2006 [link to an article by him about this].

How to solve the problem of Uttar Pradesh

Pratap Bhanu Mehta has a article in Indian Express where he says that the way forward, to break the gridlock of UP politics, is to break UP up into three small states. I think there is merit in this approach. In parallel, enlarging the state of Delhi to include NOIDA and Gurgaon would improve urban planning. NOIDA and Gurgaon are already suburbs of Delhi; it is time for this to be recognised in administrative arrangements. In a similar vein, a way to improve electricity distribution in Maharashtra is to enlarge the size of the footprint of BSES, and thus reduce the economic impact of MSEB. This idea works for the other two private distribution companies - Ahmedabad and Calcutta - also. To the extent that territory responds to performance, and is not a jagirdari, this would induce greater pressures to perform.

Resource curse - comparing India and Russia

The development literature has long been aware of the `resource curse' where countries with weak institutions are actually hurt, and not helped, by lucrative natural resources. One can't help wonder how the post-1945 history of the Middle East would have shaped up differently if there had been no oil there. On Bloomberg today, there's a nice article by Amity Shlaes comparing the evolution of India as opposed to Russia in the light of the lack of natural resources in India.

The health of the Indian people as opposed to the Indian public health system

In a comment on my posting on `trickle-down economics', Suchi said:

Ajay, It's really very pleasing to see the improvement in health indicators in the third round of the NFHS. It's even more gratifying to be able to attribute the improvement to the high levels of economic growth in India. However, having said that I would also like to point out the lesson that's stored in this correlation for the Ministry of Health and Family Welfare. That is, the urgent need for the MOHFW to strengthen its public health programs.

I thought the lesson that flows from this evidence is the exact opposite.

I think it's important to distinguish between health-system and non-health-system factors that affect health outcomes. Economic growth helps people buy better food, more cleanliness and more education. These non-health-system factors have a huge impact on health outcomes. I think that many people who are in the field of health underestimate the importance of these mundane factors.

Next, we turn to health-system factors. These should be broken up into two groups: inputs purchased from the private sector and inputs obtained from the public sector. There is extensive evidence in India that people who have the choice of going to public sector health facilities choose to pay for private health services instead. The latter, once again, relies on economic growth.

So you have three pieces in the puzzle:

• Growth gives people the ability to buy food, cleanliness, education;
• Growth gives people the ability buy private health services;
• And then there is the public health system, with its own issues in a weak mapping from expenditures to services delivered.

Hence, I become uncomfortable when there is an identity between "the health of the public" and "expenditures on public health systems". Too many people, in my opinion, jump from the view that "it's nice to be healthy" to the view that "the government should spend more on a public sector health system". Similarly, in my opinion, too many people jump from a fact like "the maternal mortality rate went down" to the view "therefore the public health system is performing better". These leaps are not logically sound.

The trickle down effect of India's growth is certainly making it more possible for families to get better health care but, having said that, I would also like to direct our attention towards the millions of people whose health still depends on the effective functioning of the government's public health system.

You say ...our attention towards the millions of people whose health still depends on the effective functioning of the government's public health system. Okay, then let me understand: are you saying that for 85% of India's population, spending on public health programs as presently setup is irrelevant for health outcomes, and the public health system is only important for the 15% poor? That would be a more sound position, but then it again begs the question: are there better ways to spend public money in improving the health of poor people, than running a public sector health system? Maybe the best intervention to improve the health of poor people would be to give them vouchers to buy lunch every day. Maybe the best intervention is to setup a cash transfer system where poor people are paid Rs.X per month by the State and then left free to choose how they want to spread that between food / education / health / clothes / shelter - it may well be that such a strategy will do more for health than the present path.

I work for an organization that has just finished conducting a detailed analysis of maternal and childcare issues in the ten of the least developed districts of India. The data just started rolling in and it only substantiates my point about the pressing need for a better public health system. This is because, we found that while there are now a number of people that have the facilities to get better health services, there are many others that are either not as well informed, or lack the resources to get them. This results in many people turning up at the local government health centers and unless those centers become our first and most effective line of defense, we will not be able to achieve significant improvements in the health sector.

We will be very happy to read your data and the inferences thereof. My sense of the evidence is that there is a continual process of people defecting from public facilities to private facilities - both in education and in health. And when we see poor people showing up at public health facilities, maybe the best answer is 10% GDP growth so that they will soon be able to afford private health facilities. The best thing to do may well be to take Rs.10,000 crore out of the health budget and use it to build roads - this pays for 10,000 km of good quality two lane roads every year, which would surely do more for the health of the population than the existing public health system.

Once again, my main point is that we need to be hard-headed and meticulously rational in arguing our case. Given the poor effectiveness of public health provision in India, given the many forces at work which shape health, we need much more care with the logic and evidence so as to think straight. Speaking for me, the present state of logic and evidence backing the status quo on health in India simply does not persuade.

You say: unless those centers become our first and most effective line of defense, we will not be able to achieve significant improvements in the health sector. But look at the evidence. For the last 40 years atleast, government health centres and hospitals have gotten worse and worse. But in this period, significant improvements have come about in health outcomes. This clearly falsifies the `unless' proposition.

I get very worried when you use the phrase "improvements in the health sector". Are you focused on prosperous health workers or a healthy population? If it's the latter, then you should be saying "improvements in the health of the population" and not "improvements in the health sector".

A few days ago I saw a public sector 10th-standard-pass ANM worker in a village in Rajsamand district in Rajasthan. She is paid Rs.11,000 a month - a bonanza for someone who has only passed the 10th. She has tenure and no incentive whatsoever to do any work since she can never be sacked, and gets her salary regardless of how few patients come to her. She is worse than the quacks that dot the countryside. The quacks are also 10th standard pass, but they don't have tenure and an above-market wage.

Additionally, we will need time to achieve the high levels of economic growth that can usher in a sea change in the health of our population, given our current issues with infrastructure and such. Like you mentioned in your article, people will first have to become rich, and then hopefully, they can get better medical attention. This can take a substantial amount of time to happen. However, the government currently has the resources to bring about a large-scale change in health indicators. Thus, it's important that the Government of India understands the urgency of the issue and makes appropriate amendments to its current public health practices. Your example of the European countries and the improvement in the health of their populations spurred by the high levels of growth in those nations is certainly useful in furthering the cause of greater economic growth in India, but we must realize that their governments have also put in place a strong and more effective public health system. In sum, we should and must appreciate the impact that economic growth is having on the health of our population, but that does not mean that the government can shy away from its responsibility of building a robust public health system.

The European public sector health systems came after high per capita GDP, not before. And, all over Europe, payments to `public sector' health practitioners follow the patients. If customers choose to not come to a certain doctor, the government payments to this doctor do not take place. The European public sector health worker has better incentives to work than the Indian civil-servant health worker. When you advocate a European-style health system, you should be careful to advocate the full package-deal. A close examination of the European public health system is known to induce heightened skepticism in the Indian public health system.

You assert that government has a responsibility to build a robust public health system. Is this an axiom, a political belief? Or is it backed by adequate reasoning? Is a `robust public health system' the means or the end? I think the end should be `a healthy population' and not a `robust public health system'. If we set course for a healthy population, a public health system may play a role, or it may not, and the public health system that actually caters to improved health of the population will surely look very different from the one that we presently have.

I'm all for public expenditures on public goods: which induce benefits which are diffused across the population - like programs on communicable disease. Or, it may be possible for a government to address a market failure in health services - but then the case needs to be made about what is that market failure, why a stated government intervention solves it, why this is the most cost-effective path for the government to proceed, and how it is incentive-compatible. So far, in India, such careful thinking hasn't particularly taken place. I'm very sceptical about the government producing the private goods of perambulatory care as in the WHO PHC framework, and particularly about the inept public health systems that don't translate money into outcomes, and are being abandoned by any citizen who can afford to.

You are asserting that `a robust public health system' is of essence to improving Indian health outcomes. This assertion has not been proven. Maybe we are better off without MOFHW, with lower tax rates, and higher GDP growth. Maybe we are better off without MOFHW, with this spending shifted to building roads, with unchanged tax rates and higher GDP growth. These questions need hard-headed analytical reasoning by health economists. I have not yet seen papers and reports showing such hard-headed analytical foundations supporting what is being done in the public sector in health in India today.

You should be loyal to the health of the people and not to the existing public health system, and demand rigorous logic and evidence: I believe such a path would lead you to very different positions.