Don't sweat the quant stuff

We generally think that workers in India are good at the quant stuff. But is this just stereotype, or is it real? On one hand, 12th standard CBSE mathematics - which the ordinary Indian worker has generally mastered - exceeds what high school students in the US know. India has a significant edge here against the US, though not against Europe. On the other hand, college education in India is pretty awful, and this has generated skepticism about the potential upside for BPO in India. Very bright MBAs in India tend to be underskilled in probability, statistics, optimisation, financial economics; they tend to use spreadsheets too much. Their counterparts - the best MBAs from top schools in the US - seem to be better trained in these four critical blocks of knowledge. (I am comparing like to like: MBAs from the 3 best IIMs and ISB against MBAs from the top 10 schools in the US).

Thanks to Tirthankar Patnaik, I saw mention of an intruiging study by Ravi Aron of Wharton (link):

Questions abound about job functions that are likely to gravitate to places like India sooner than others. Some insights into this can be had from the concept of a "mechanism for complexity arbitrage" that Aron and colleagues worked on in a recent research project funded by the Mack Center at Wharton. The project involved collecting data covering three years from several companies about various processes and the places where they were performed across the globe. Managers at these companies overseeing those processes where then asked to rate each of them on a complexity scale of one to seven, with seven being the most complex.

The researchers found a striking polarization in the way managers assessed the complexity levels in their processes. Those in the U.S. and the U.K. formed one group, while their counterparts in India, China and Singapore made up the other. "Whenever work involved number crunching, quantitative analysis, mathematical formulation, statistical data analysis and numerical calculations, managers in India, Singapore and China would say this is low complexity work," says Aron. "They could find the people to do those jobs and deliver quality on scale, month after month, year after year. But wherever work involves persuasion, communication, context-sensitive responses, interpretation, subjective judgment and cultural sensitivity, managers in the U.K and the U.S. will tell you that is low complexity work."

Are there natural limits to the kind of work that can be offshored? Of course, says Aron, but he adds that Indian service providers will not encounter them "as long as they do not breach the complexity divide." He says certain job functions are a natural fit for the U.S. and the U.K. and not easily outsourced, because they require customer interactions and persuasion. These are activities that are "embedded in the context of the market and they need context-sensitive communication," he says. "The Indian market is nowhere as sophisticated as that in the U.S.; it does not have the range of derivatives like in the U.S. market, and futures and options are just beginning to catch on.

Also see here, another demo of the external perception of Indian quant prowess. How fascinating. Managers in India, Singapore and China think that the quant stuff is "low complexity". :-) I believe similar things are happening in Silicon Valley: many startups are organising themselves as a marketing front-end in the Bay Area, and the engineering team in India. If these effects are real, global capitalism will reshape the geographical allocation of production: activities involving the quant stuff are going to increasingly move to India, Singapore and China. This bodes well for MIFC. If you have the MIFC book handy, see page 172-176 on human capital which offers a gloomy perspective on this, and Chapter 5 on BPO. Both segments of the MIFC book paint a relatively gloomy picture: but maybe (in the light of the above) things are actually a bit better than portrayed there.

Once such a process gets going, it will be self-reinforcing, and it will induce effects that are reminiscent of the specialisation seen in evolutionary biology, where small mutations are accentuated by natural selection, and species separate themselves out in plying different trades. In the decision-making of the global firm, tasks that involve quant skills would be more likely to get sent to India/Singapore/China, while tasks that involve more cultural context are more likely to get done in an industrial-country setting. In the decision-making of the individual, people with quant predilections are more likely to move to India and people in India face a higher marginal product of investing in quant skills. Both these effects (at the firm and at the individual) would reinforce each other.

How will human capital build up in the context of terrible colleges & universities? I think learning-by-doing is the key. The last paragraph of the above quotation rings true to me. With weak colleges and universities, learning is dominated by on-the-job accumulation of skills. I would advise every victim of the terrible higher education system in India to intern, intern, intern and build up on-the-job skills, accompanied by a higher intellectualisation based on a self-study program of reading the best books and textbooks so as to not become a narrowly-specialised technician [link].

Index futures trading is active in India, so there is now plentiful talent that knows how to do index arbitrage. Interest rate futures trading in India is effectively banned, so naturally nobody knows anything about interest rate futures arbitrage. As the local financial system bulks up to higher levels of complexity, this feeds into the range of skills where there can be a global role for Indian professionals. There is thus a three-way synergy between (a) the BPO, (b) the local financial system and (c) the MIFC agenda: each feeds into the other. Conversely, a strategy of financial repression, where products and activities are banned in the domestic economy, has bigger costs than meets the eye: it hurts not just domestic finance but also the BPO and the prospect of MIFC.

The return of the idiot

Alvaro Vargas Llosa has a fascinating article in Foreign Policy, about Latin America, titled The Return of the Idiot. I know, Latin America is fundamentally different from India in culture and political dynamics. But one can't help feel uncomfortable at the echoes of this article which ring true, here.

Learning how monetary policy ought to work

Financial Express has an editorial remarking on the letter that the Bank of England had to write to the Chancellor of the Exchequer since inflation crossed 3%, and ruminating on Indian monetary policy questions in this light. The letter is remarkably well written, and is well worth reading for all who are interested in monetary policy. It is free of central bank mumbo-jumbo; it is written as clearly as a `Frequently Asked Questions' on the net.

Why does the Bank of England eschew central bank mumbo jumbo while RBI is steeped in it? I think there are two forces at work. The first is the sheer need for transparency to make monetary policy effective: Bank of England lives within a full set of financial markets where monetary policy transmission critically relies on finance knowing the monetary policy rule. RBI's strategy is to stifle the financial markets, and in such a strategy, it is felt there is no need to communicate honestly with financial markets. But equally, I think the clarification of the objectives of the Bank of England was essential for them to graduate to such clear and logical speech. With RBI, the burden of multiple conflicting roles makes it difficult for the RBI to be clear about what it is trying to do and why. Transparency is then jettisoned because if the reader fully knew what was being done, that would expose the full scale of difficulties. Each episode of stress is dealt with by hiding problems under the carpet, and repeated episodes of stress generate an institutional bias in favour of opacity.

Currency futures now

There has been an upsurge in currency volatility in India. Many firms, who were lulled into complacence by the pegged exchange rate, are unhappy at being taken by surprise by this upsurge in currency volatility. I wrote a piece in today's Business Standard titled Currency futures now saying that the most important policy issue in the present situation is to start an INR cash-settled futures and options market, where citizens and firms can do their own currency trading, and thus obtain private solutions to their own risk management problems. Achieving a strong currency derivatives market is a critical ingredient of the `BCD Nexus' which has been emphasised in the MIFC report, so starting a currency futures market today dovetails into the MIFC agenda.

There are actually two balls up in the air right now. The first is the rise in currency volatility. The second is the rapid developments on internationalisation of the INR. A. V. Rajwade had a piece in Business Standard yesterday on this theme. Aside: Earlier I had talked about the `first' INR denominated bond issue outside India. Rajwade points out that I was wrong; it was the 2nd such issue.

In continuation of his article, Business Standard has a good edit today:

Capital controls were introduced in India many decades ago; so for almost everyone living today, a life in India has been one where the government has had an intrusive system of controls affecting the Indian rupee. There is, hence, a high degree of surprise and novelty in seeing a blossoming of India-related trading, particularly involving the Indian rupee, taking place outside the country. The non-deliverable forward (NDF) market is a cash-settled OTC forward market on the rupee-dollar rate. On some days, and for some transaction sizes, the liquidity of the NDF market has come to exceed the liquidity of the Indian rupee-dollar forward market. The recent Mumbai International Financial Centre (MIFC) report has highlighted the trading on Indian underlyings taking place outside the country. It estimates that there is a turnover of $1 billion a day of derivatives trading on the Indian currency and Indian interest rates. In the case of interest rates and credit risk, it appears that the bulk of innovation and market development is taking place outside India. There is no OTC derivatives market on Indian equity in India, but there is a vibrant market of this nature in Hong Kong. As A V Rajwade's article in Business Standard on Monday emphasised, there is a remarkable appetite globally for rupee-denominated bonds. The Inter American Development Bank (IADB) - which does no business in India - has issued a rupee-denominated bond in response to this interest on the part of customers. FT/MCX will soon have an INR/USD currency futures market running in Dubai, at a safe distance from the system of controls that smothers Indian finance.

Owing to the new phenomenon of outbound FDI, every significant Indian company now has arms operating elsewhere in the world. It is now easy for those foreign arms to place orders on these currency/interest rate/credit risk markets, on Indian underlyings, which are taking place outside India. Hence, the international financial services business, which could have been transacted in India, is being transacted outside the country. Instead of India achieving export revenue from selling the international financial services to foreigners, what is happening is that the Indian licence-permit raj in finance is pushing domestic business out of the country into the hands of finance practitioners in Hong Kong, Singapore, Dubai and London.

Indian financial regulators have excelled in banning products and business activities. Every time the staff has been threatened by the intellectual complexity and hard work required in supporting and enabling financial innovation, the government response has been to ban it. What these developments highlight is that by running a licence-permit raj within India, the ministry of finance and its clutch of agencies are presiding over a shrinking component of Indian finance. Indian companies will increasingly get their equity issuance, bond issuance, risk management, etc. done from overseas providers, who benefit from world-class regulators as is found in London or Singapore.

The global game of international finance is, to a significant extent, competition between regulators. There is no alternative for the ministry of finance but to build up the staff quality of the RBI to match the Bank of England in doing monetary economics; to build up the staff quality of Sebi to match the Financial Services Authority in dealing with policy and regulatory questions on currency options or interest rate futures.

Movement on implementation of the New Pension System

In response to the recent developments on implementation of the New Pension System, I wrote an opinion piece in the Wall Street Journal.

INR trading outside India

INR-USD futures trading will start in two months in Dubai. I'm reminded of the Nifty futures, which first started trading at SGX, an event which probably had something to do with SEBI giving out permissions to NSE to trade Nifty futures.

If you have the MIFC book handy, I'd like to point you to (a) Page 127 which has the chronology of the license-permit raj in the story of Nifty futures trading; (b) Page 56 which has a full page box about Indian underlyings trading outside the country; (c) Page 46 which has a treatment of Dubai; (d) Page 152 on exchange vs. OTC trading; (e) Recommendation 45 (page 200) talks about rupee-settled currency futures.

MoF and RBI face the choice between having MCX/FT run an INR/USD currency futures market with DIFC regulation, or having an INR/USD currency futures market in India with SEBI regulation. With the huge growth of outbound FDI, a lot of Indian companies have global operations, and can place important risk management activities outside the countries. If the status quo - of currency futures trading being banned - continues, liquidity will increasingly shift to the INR NDF market or to this new currency futures product.

The edit in Financial Express says:

It had to happen. The Indian economy is becoming a powerhouse. So, too, the rupee. Ergo, the world becomes interested in the currency, and lo and behold, a world market for it emerges. How does such a market work? Suppose someone has an export contract payable in rupees two months from today. He can hedge the transaction against the payment going down in value against other currencies, by entering into a futures contract. It does not take an expert to tell us that such a market is critical for banks, traders and for anyone who deals in the Indian rupee. That tribe is growing pretty fast on the back of a rapidly globalising economy, with exports rising frenetically. Such transactions are critical to global financial markets, recording a daily turnover of about $270 billion. The scope of fee-based income for banks participating in these markets can be easily imagined. Yet, such a market is not permitted in India. So, it is hardly surprising that a foreign financial centre—in this case Dubai—has decided to plug the gap. Mumbai should have been the natural market for such contracts. According to reports, MCX has tied up with the Dubai Gold and Commodities Exchange to launch futures contracts on the Indian rupee to be operational from mid-June. Under RBI rules, such contracts may not be legal. But in this case, the RBI can hardly do anything, as contracts will be settled in US dollars.

With the rising profile of the Indian rupee, there has already been sporadic forward trading in derivatives with the rupee as the underlying tradeable unit in markets across the world (mostly non-deliverable, inter-bank deals). But since a futures contract is exchange traded, it is a superior financial product, and a transparent one, too. What’s more, as the RBI builds up a large defensive position on the rupee, the scope for hedging through a futures market in rupees has shot up dramatically. The biggest beneficiary of the new market will be Indian corporates, who are now increasingly exposed to global currency fluctuations. But, and this bears repetition, which financial centre should have led this move towards rupee trading sophistication? Mumbai, surely.

Today (17/4), there's an interesting story on this by Sanjiv Shankaran in Mint, where he says:

The government is considering introducing trading in rupee futures contracts on stock exchanges, a move that will bring the country a step closer to full convertibility of the rupee on the capital account of balance of payments.

Accordingly, the finance ministry will be asking the Reserve Bank of India (RBI) to explore the possibility of putting this in place at the earliest. Futures contracts are a commitment between two parties to effect transactions at a preset price and date.

The move is expected to usher in unprecedented transparency and liquidity in the country’s foreign currency market. At present, Indian corporates and banks hedge their foreign exchange positions through forward contracts in an over-the-counter (OTC) market, which are decentralized markets, unlike stock exchanges where all orders are matched electronically and in a transparent manner.

The finance ministry has decided to revisit the idea after the Dubai Gold & Commodities Exchange (DGCX) last week announced it would list rupee futures contracts in June, the first time a rupee futures contract will be traded on an exchange.

Allowing similar trades on an Indian stock exchange requires just an executive notification and no legislative changes, said a senior official of the finance ministry, who did not want to be named.

Indian stock exchanges can offer futures contracts, which can be settled at the time of expiry in rupees, the official added. Unlike DGCX’s rupee futures contracts, which are to be settled in US dollars.

The finance ministry wanted to make a broad policy announcement on the introduction of rupee futures contracts in stock exchanges during the course of the finance minister’s budget speech in 2006, said the official. The announcement did not take place as RBI felt the market was not yet ready to trade in rupee futures.

The DGCX move is a sign that RBI needs to loosen controls as forces beyond its control would begin to influence India, said Jamal Mecklai, CEO of Mecklai Financial, a forex advisory. “You cannot control markets when they start doing things outside what you are permitting,” he said. “It (DGCX’s move) is a loud sign that you need to accelerate your deregulation several notches; if you don’t, you will not only lose business to other centers but, far more important, you will have bouts of unmanageable volatility in your domestic market which will make it progressively more difficult for Indian companies to manage risk.”

There has been a historical precedent where external developments have prompted the government to fast-track its policy. In 1995, the National Stock Exchange (NSE) asked the capital market regulator, Sebi, for permission to start trading in stock index futures. Permission did not come through quickly and on 24 May 2000, Singapore’s SIMEX chose the Nifty, the exchange’s benchmark index of 50 stocks, for derivatives trading on an Indian index. Sebi then allowed NSE and the Bombay Stock Exchange to trade in index futures the next day.

...

The global currency futures market, though small when compared to a currency forward markets, is still very significant. Despite forward markets accounting for the maximum trade volumes, some studies show that 85% of price discovery in forex markets are on account of futures markets, said the recent report of the high powered expert committee which looked at ways to transform Mumbai into an international financial centre.

What RBI wanted

Monetary policy transparency in India is very poor. It's only today - 12th April - that we find out the truth about what the monetary policy was in the month of February. We find that RBI purchased a HUGE $11.9 billion on the currency market - roughly Rs.52,000 crore. That's what I call pouring fuel into the inflationary fire. The implementation of the pegged exchange rate in February, with very little currency flexibility, came at the cost of an inflationary monetary policy. A few weeks ago, when I had written a piece titled `What RBI wants', there was an element of reconstruction of what was going on from fragmentary data. Now the data is out and we know just how bad it was.

Monetary policy regimes break down when the political costs of upholding the regime become unacceptable. In India's case, the INR appreciated from 44.2 to 42.8. Did the people who care more than RBI about inflation pick up the phone? How will things play out from here? In a non-transparent monetary policy regime, one does not know what is going on, or why. Monetary policy is one more stochastic process that economic agents have to cope with.