I have an article in Financial Express today titled Political problems of governments intervening in financial firms. Also see:
The Pyramid Saimira order is a landmark in SEBI's history. It seems to be grounded in high quality investigative work and if it survives appeal, it will put a new level of fear in the minds of the bad guys. On this, read : Palak Shah in Business Standard, and Vivek Law and Priyal Guliani in Mint.
Writing in Business Standard, Mahesh Vyas disagrees with the gloomy scenario for corporate investment, drawing on the information in the CMIE Capex database.
Writing in Business Standard, Sunil Jain reviews the fracas about Indians holding money in Switzerland. For recent research on capital movements through trade misinvoicing, see this work by Abhijit Sen Gupta, Ila Patnaik and me: slideshow, paper. While on this subject, see Somasekhar Sundaresan in Business Standard on the messy legal foundations of India's capital controls. The system of control that seeks to tie down India's capital flows is grossly out of touch with the realities of India's openness today.
Forbes has a fascinating article by Laurence J. Kotlikoff and Edward Leamer, with fundamental thinking about banks.
They trace the problems of banks to the fundamental contradictions of having a highly leveraged financial firm, with assured returns and full liquidity for depositors, and opaque + illiquid assets. I agree with this gloomy prognosis. A more fleshed out argument is in this pair of articles -- link and link -- which were opinion pieces in 1999.
I stopped chasing those lines of thought because it seemed dishearteningly hard, trying to sell a world without banks as we know 'em. But if you are persuaded by these arguments, then you will like a world where we do more finance through securities markets, through `defined contribution and NAV-based' financial firms (i.e. direct household participation in financial markets, mutual funds and DC pensions), and less through `assured returns' financial firms such as banks, DB pensions and insurance companies.
In a perverse way, India's prodigous mistakes of policy on banking have helped steer the country into a more market-dominated financial system, which has helped build a better financial system.
Since we're unlikely to reconstruct the economy in radical ways, we have to confront the problems of banks. I feel the most important element of safe and sound banking is: a proper deposit insurance mechanism. Chapter 6 of Raghuram Rajan's report is the best blueprint out there about setting up a deposit insurance corporation, and other dimensions of improving systemic risk (see `V. Preventing Crisis and Dealing with Failure').
You might like to also see this picture on banking reforms.
On 14 October 2008, Jahangir Aziz, Ila Patnaik and I released a short note on what was going on. It was titled The current liquidity crunch in India: Diagnosis and policy response.
On Monday (20th April 2009), Ila Patnaik has an article in Indian Express with one more piece of evidence that the APS story was basically on the right track.
Today, when we look back at the APS paper, it seems mild. But I distinctly remember at the time, the world was much more confusing. Lehman died on 15 September. After that, there was a `fog of war' problem: a lot was going on, there was information overload in many ways, lots of critical information from within RBI is not released into the public domain in a timely manner or is not released at all, and the statistical system has such long lags that on 10 October, when we started writing, almost nothing was known about the period immediately after 15 September.
Speaking for me personally, I had the right starting conditions in terms of being oriented towards the themes of de facto convertibility, Indian multinationals, etc. I should have got the story quickly after 15 September. But still, it took me a long time to understand what was happening.
Similar problems -- on an immensely magnified scale -- have afflicted crisis responses everywhere in both the private sector and governments. Whether it was Northern Rock, Bear Stearns, or Lehman: analysts and decision makers have been ambushed by difficult questions, very little time within which to make calls, and bad information at the time. With the benefit of hindsight, it's easy to criticise what was done, but this stuff is hard.
Economists are very clear that the interest rate that matters is one that is expressed in real terms. If I borrow Rs.100, and am obligated to pay back Rs.110 a year from now, the true cost of borrowing that weighs in my mind is not 10%; it is lower to the extent that I expect the rupee will be worth less owing to inflation, a year from now. Hence, what matters is the real rate: the difference between the nominal interest rate, and expected inflation over that identical horizon. This perspective matters greatly for thinking about monetary policy. What matters is not the short-term interest rate which we apparently see on the money market; what matters is this rate after subtracting out expected inflation over the same time horizon
In good countries, inflation has become boring, owing to the success of inflation targeting central banks, and the distinction between the real rate and the nominal rate has become less prominent. But in India, inflation volatility is immense, and it is particularly important to look at the policy rate in real terms.
In the recent article India in the Great Recession, which appeared in Financial Express on 15 April, of particular interest to a lot of people was the graph of the time-series of the policy rate, expressed in real terms. (This is inside section VII of the article). Lots of people asked for details about how this was done. Here goes:
This time-series (click on the picture to see it more clearly) shows some signs of procyclicality:
While on this subject, do read about the Taylor Principle which gives a simple conceptual framework for thinking about how the real rate should respond to changes in expected inflation. Now all this is vulnerable to the difficulties of measurement that bedevil the WPI. So it's worth doing this by the CPI (IW) also. Here's the graph that it yields (click on the picture to see it more clearly):
How good is this estimator of the real rate? Only as good as the inflation forecast.
What would be great is to have a liquid market for inflation indexed bonds and a liquid market for nominal bonds; the difference between these would be a market-based estimator of expected inflation. This would take into account myriad factors that affect inflation. In contrast, forecasting inflation using ARMA models is quite lame. It only uses the time-series structure of inflation and fails to take into account all the other factors that affect inflation. This can and should be done better by going to a multivariate setting.
However, I do think that this is a useful first cut, and it's more useful to look at this rendition of the real rate as compared with only looking at the policy rate expressed in nominal terms, as is currently done in India.
