The program is up.
Sunday, November 30, 2014
Saturday, November 29, 2014
Consequences of reversing the controls on gold imports
Impact on the Current Account Deficit?
Restrictions were put on gold imports as part of the currency defence of 2013. One important step towards removing these restrictions was taken yesterday. Some people are thinking "How much will the current account deficit go up by, now that more gold will be imported?"
For this to happen, you have to believe that the restrictions actually made a difference to gold imports. I feel that there was absolutely no decline in the gold purchases by Indian households when the restrictions came in. All that happened was that instead of going to a formal sector firm, the purchases were made from smugglers, which required a whole chain of `black money' transactions.
If you feel that the bulk of gold smuggling is paid for using hawala transactions i.e. misinvoicing, it seems that shifting between smuggling and legal imports makes no difference to the current account deficit. Ergo, removing the restriction will make no difference to the current account deficit.
Scarcity value
I suspect that when we made it difficult to buy gold, there was a greater perception of scarcity, and people became even more keen to stock up on gold. It takes years of sustained good behaviour by the government, for people to get comfortable. One slip, and you unleash the psychology of scarcity all over again.
With gold, I think that after the liberalisation of the early 1990s, it took 5-10 years for people to get used to the idea that the government was not going to interfere with their gold purchases. These gains were lost in the 2013 rupee defence.
A similar story holds with outbound capital flows. Capital account restrictions came in 1942 and turned into a rigorous system of control in the 1950s. From that point onwards, Indian households have believed that there is value in holding assets outside the country. One big advance took place in the mid 1990s, when it became easy to travel abroad and use an Indian credit card. This solved the problem of needing hard currency to travel. But portfolio diversification remained a problem.
When the liberalisation of outbound flows began, this sense of scarcity started easing. Then came the capital controls on outbound flows as part of the currency defence of 2013. These controls have still not been reversed. This sent out the message that you cannot trust the Indian government, so it's wise to hold assets outside India as much as possible. The attraction of gold went up: buying gold in India is actually a capital outflow. The value of gold is safe from Indian monetary policy or capital controls.
After the actions of the currency defence of 2013 are undone, it will take years before people get back to the pre-2013 modes of behaviour. MOF might probably manage to get rid of the restrictions by 2014 or 2015, and perhaps by 2020 people will start shedding the scarcity value.
Wednesday, November 19, 2014
Reducing the cost of doing business in India: One example (ADR/GDR regulations)
by Pratik Datta and Ajay Shah.
Last week, the Ministry of Finance notified the Depository Receipts Scheme, 2014 (`2014 Scheme'). This replaces the 1993 Scheme with respect to depository receipts. The key materials on this subject are:
The 1993 Scheme was a haphazard set of interventions by the government in the working of the economy, without a clear rationale. The 2014 Scheme is logical and clear in the role of the government. Every policy intervention is viewed from the standpoint of market failures. If there are demonstrable concerns about consumer protection, micro-prudential regulation, systemic risk or resolution, they motivate interventions. Where there are no market failures, there is no case for intervention by the government.
As an example of the improved economic thinking underlying the 2014 Scheme: the 1993 Scheme embeds industrial policy with names of many industries. The 2014 Scheme eschews industrial policy.
Everyone interested in law and finance should print the 1993 Scheme and the 2014 Scheme and compare them, side-by-side.
Occam's razor can be adapted to the field of law with the idea that when there are multiple ways of drafting a particular policy choice into the law, the simplest should be preferred. The most sophisticated law is that which is the simplest. Simplicity, clarity and reduced legal risk have been achieved in the 2014 Scheme through many strands of thought.
Word count. The first test of simplicity is the word count. The 1993 Scheme (paragraphs 1 to 11) had 2984 words, while the new 2014 Scheme (paragraphs 1 to 11) has 1659 words - a reduction of 44.4% in usage of words. However, this difference is overstated as the previous Scheme dealt with FCCBs also while the new Scheme does not.
Readability. When we apply the Flesch-Kincaid readability test, the 2014 Scheme wins clearly, with a score of 30 when compared with the 1993 Scheme, which stands at 21.5.
Structured document. For a given word limit, a well structured document is more comprehensible. The 2014 Scheme follows the logical sequence of a depository receipt transaction. The 1993 Scheme was a haphazard mess.
Use of examples. When drafting the Indian Penal Code, Thomas Babington Macaulay intentionally included many terse, exemplary cases to illustrate the application of a provision. The Justinian Code and writings of Roman jurists persuaded him to make clear the legislative intent: `they are cases decided not by the judges but by the legislature, by those who make the law, and who must know more certainly than any judge can know what the law is which they mean to make'. This unusual innovative feature of the Code earned the praise of John Stuart Mill, who wrote: `besides the greater certainty and distinctness given to the legislator's meaning, [it] solves the difficult problem of making the body of the laws a popular book, at once intelligible and interesting to the general reader'. The 2014 Scheme includes examples which clarify the law.
Minimal set of defined terms. The 2014 Scheme uses a standardised set of defined terms. For example, it strictly uses a defined term - `international exchange' - on listing institutions. In contrast, the 1993 Scheme used three different terms to explain listing institutions on which depository receipts could be listed - `overseas stock exchanges', `over the counter exchanges' and `book entry transfer systems'. None of them were defined. This created legal risk.
Principles-based definitions. With the rapid development of technology, the concept of an `exchange' itself has evolved substantially. To make the law neutral to such evolution, the 2014 Scheme is technology-neutral and principles-based in its definition of `international exchange'.
Rationale statement. Finally, there is the backdrop of the drafting intent and rationale of the Scheme. The 1993 Scheme was not backed by a document articulating what was sought to be done. The 2014 Scheme is accompanied by the Sahoo Committee Report which performs this function. When faced with litigation in the future, practitioners and judges will be able to use this document to reduce legal risk.
You will recognise the IFC way here. Also see Umakanth Varottil on the 2014 Scheme.
The Indian system of capital controls comprises the FEM Act, regulations under FEMA, RBI circulars, etc. The 1993 Scheme is representative of the mess that is the Indian system of capital controls. The cost of doing business in India is being greatly raised by the badly thought out and badly implemented capital controls that are all over the landscape.
Capital controls on ADR/GDR issuance by Indian companies is the only element, out of the overall system of capital controls, where the Ministry of Finance is able to initiate reforms. In all other areas, RBI has veto power, and has blocked all progress.
As the years go by, it is increasingly difficult to justify these failures. RBI needs to find the intellectual capabilities to clean up the mess. There is a lot to learn from the clarity of thinking, and the implementation strategies used, in fixing the capital controls on ADR/GDRs.
Last week, the Ministry of Finance notified the Depository Receipts Scheme, 2014 (`2014 Scheme'). This replaces the 1993 Scheme with respect to depository receipts. The key materials on this subject are:
- The Sahoo Committee Report, which provided the intelletual framework, and drafted the 2014 Scheme.
- An article about this Report
- A brief video summarising the Report.
Improved economic thinking
The 1993 Scheme was a haphazard set of interventions by the government in the working of the economy, without a clear rationale. The 2014 Scheme is logical and clear in the role of the government. Every policy intervention is viewed from the standpoint of market failures. If there are demonstrable concerns about consumer protection, micro-prudential regulation, systemic risk or resolution, they motivate interventions. Where there are no market failures, there is no case for intervention by the government.
As an example of the improved economic thinking underlying the 2014 Scheme: the 1993 Scheme embeds industrial policy with names of many industries. The 2014 Scheme eschews industrial policy.
Improved drafting of law
Everyone interested in law and finance should print the 1993 Scheme and the 2014 Scheme and compare them, side-by-side.
Occam's razor can be adapted to the field of law with the idea that when there are multiple ways of drafting a particular policy choice into the law, the simplest should be preferred. The most sophisticated law is that which is the simplest. Simplicity, clarity and reduced legal risk have been achieved in the 2014 Scheme through many strands of thought.
Word count. The first test of simplicity is the word count. The 1993 Scheme (paragraphs 1 to 11) had 2984 words, while the new 2014 Scheme (paragraphs 1 to 11) has 1659 words - a reduction of 44.4% in usage of words. However, this difference is overstated as the previous Scheme dealt with FCCBs also while the new Scheme does not.
Readability. When we apply the Flesch-Kincaid readability test, the 2014 Scheme wins clearly, with a score of 30 when compared with the 1993 Scheme, which stands at 21.5.
Structured document. For a given word limit, a well structured document is more comprehensible. The 2014 Scheme follows the logical sequence of a depository receipt transaction. The 1993 Scheme was a haphazard mess.
Use of examples. When drafting the Indian Penal Code, Thomas Babington Macaulay intentionally included many terse, exemplary cases to illustrate the application of a provision. The Justinian Code and writings of Roman jurists persuaded him to make clear the legislative intent: `they are cases decided not by the judges but by the legislature, by those who make the law, and who must know more certainly than any judge can know what the law is which they mean to make'. This unusual innovative feature of the Code earned the praise of John Stuart Mill, who wrote: `besides the greater certainty and distinctness given to the legislator's meaning, [it] solves the difficult problem of making the body of the laws a popular book, at once intelligible and interesting to the general reader'. The 2014 Scheme includes examples which clarify the law.
Minimal set of defined terms. The 2014 Scheme uses a standardised set of defined terms. For example, it strictly uses a defined term - `international exchange' - on listing institutions. In contrast, the 1993 Scheme used three different terms to explain listing institutions on which depository receipts could be listed - `overseas stock exchanges', `over the counter exchanges' and `book entry transfer systems'. None of them were defined. This created legal risk.
Principles-based definitions. With the rapid development of technology, the concept of an `exchange' itself has evolved substantially. To make the law neutral to such evolution, the 2014 Scheme is technology-neutral and principles-based in its definition of `international exchange'.
Rationale statement. Finally, there is the backdrop of the drafting intent and rationale of the Scheme. The 1993 Scheme was not backed by a document articulating what was sought to be done. The 2014 Scheme is accompanied by the Sahoo Committee Report which performs this function. When faced with litigation in the future, practitioners and judges will be able to use this document to reduce legal risk.
You will recognise the IFC way here. Also see Umakanth Varottil on the 2014 Scheme.
Clearing the thicket of India's capital controls
The Indian system of capital controls comprises the FEM Act, regulations under FEMA, RBI circulars, etc. The 1993 Scheme is representative of the mess that is the Indian system of capital controls. The cost of doing business in India is being greatly raised by the badly thought out and badly implemented capital controls that are all over the landscape.
Capital controls on ADR/GDR issuance by Indian companies is the only element, out of the overall system of capital controls, where the Ministry of Finance is able to initiate reforms. In all other areas, RBI has veto power, and has blocked all progress.
As the years go by, it is increasingly difficult to justify these failures. RBI needs to find the intellectual capabilities to clean up the mess. There is a lot to learn from the clarity of thinking, and the implementation strategies used, in fixing the capital controls on ADR/GDRs.
Sunday, November 16, 2014
The imprecision of volatility indexes
by Rohini Grover and Ajay Shah.
A remarkable feature of options trading is that it reveals a forward-looking measure of the market's view of future volatility. This was first done by CBOE in 1993 with the S&P 500 index options, with an information product named `VIX' which reveals the market's view of future volatility of the US stock market index. CBOE computes and disseminates VIX every 15 seconds. VIX is often termed a `fear index' as it conveys the fears of the market. It has found numerous applications:
In this field, we treat VIX as a hard number -- we talk about a value of VIX such as 24.53 as if it is known precisely. But VIX is computed from a set of option prices. These option prices suffer from microstructure noise and from the limits of arbitrage. Each option price is only an imprecise reflection of the thinking of the market. This raises concerns about the extent to which imprecision in option prices spills over into imprecision of VIX.
In a recent paper, The imprecision of volatility indexes we offer a method for measuring the imprecision of VIX, and find that the measurement noise is economically significant.
VIX is a statistical estimator working on a dataset of option prices. Different estimators exist (e.g. the old VIX vs. the new VIX). Regardless of what estimator is used, the foundation — the option price — suffers from microstructure noise and is shaped by limits of arbitrage. Noise in option prices will induce noise in VIX. The only question is that of understanding how imprecise is the VIX.
For an analogy, consider estimation of LIBOR. Each dealer reports a reading of LIBOR. We recognise that each value obtained is a noisy estimator of the true LIBOR. This is aggregated using a simple robust statistics procedure to obtain an estimate of LIBOR. Bootstrap inference is used to obtain a confidence interval about how imprecise our estimator of LIBOR is. [Cita and Lien, 1992, Berkowitz, 1999, Shah, 2000].
A similar strategy can be applied to the measurement of VIX. Each option should be seen as a noisy estimator of the implied volatility. Bootstrap inference can then be used to create a distribution of the vega-weighted VIX (VVIX). This yields a confidence interval for VVIX.
As an example, for a sample of end-of-day S&P 500 options, on 17th September, 2010, the at-the-money (ATM) options with 29 days to expiry show significant variation and take values between 15% and 21%. Our methods yield a distribution of the estimated VVIX:
As the graph above shows, the point estimate for the VVIX is 21.53% and this is what all of us are used to talking about. But the noise in option prices has induced an economically significant imprecision in our estimated VVIX. The 95% confidence band, which runs from 20.8% to 22.32%, is 1.5 percentage points wide. This turns out to be an economically significant number: the one-day change in VVIX is smaller than 1.5 percentage points on 62% of the days. This suggests that on 62% of the days, we know little about whether VVIX went up or down when compared with the previous day.
To conclude, we got a huge step forward when options trading improved our knowledge of the universe by giving us a forward looking estimator of future uncertainty: a quantitative peek into the structure of expectations of traders. However, market microstructure noise and the limits of arbitrage hamper this. VIX is not a hard number; there is economically significant imprecision in our observation of VIX. This insight may make a difference to many applications of VIX.
Once we start using the term `estimation' about VIX, we must pursue improvements in the estimation of VIX in order to address these issues of microstructure noise and the limits of arbitrage. One first step in this direction is Grover & Thomas, Journal of Futures Markets, 2012.
A remarkable feature of options trading is that it reveals a forward-looking measure of the market's view of future volatility. This was first done by CBOE in 1993 with the S&P 500 index options, with an information product named `VIX' which reveals the market's view of future volatility of the US stock market index. CBOE computes and disseminates VIX every 15 seconds. VIX is often termed a `fear index' as it conveys the fears of the market. It has found numerous applications:
- Time-series econometrics processes historical data to help us make statements about the future. VIX brings a unique forward-looking perspective into time-series analysis.
- VIX measures uncertainty in the economy e.g. when examining the effect of macroeconomic shocks (Bloom, 2009).
- The international finance literature has emphasised the role of VIX in shaping capital flows to emerging markets [example]. E.g. it is interesting to look at what happened in India on the days in which a very large rise or fall of the VIX took place.
- Trading strategies can be constructed which employ VIX as a tool for making decisions for switching between positions.
- VIX based derivatives offer methods to directly trade on VIX. In the US, CBOE introduced VIX futures and options on March 26, 2004 and February 24, 2006 respectively. In 2012, the open interest for these contracts was at 326,066 contracts and 6.3 million respectively. In India, futures on VIX have been launched at NSE, but the contract has not taken off.
In this field, we treat VIX as a hard number -- we talk about a value of VIX such as 24.53 as if it is known precisely. But VIX is computed from a set of option prices. These option prices suffer from microstructure noise and from the limits of arbitrage. Each option price is only an imprecise reflection of the thinking of the market. This raises concerns about the extent to which imprecision in option prices spills over into imprecision of VIX.
In a recent paper, The imprecision of volatility indexes we offer a method for measuring the imprecision of VIX, and find that the measurement noise is economically significant.
VIX is a statistical estimator working on a dataset of option prices. Different estimators exist (e.g. the old VIX vs. the new VIX). Regardless of what estimator is used, the foundation — the option price — suffers from microstructure noise and is shaped by limits of arbitrage. Noise in option prices will induce noise in VIX. The only question is that of understanding how imprecise is the VIX.
For an analogy, consider estimation of LIBOR. Each dealer reports a reading of LIBOR. We recognise that each value obtained is a noisy estimator of the true LIBOR. This is aggregated using a simple robust statistics procedure to obtain an estimate of LIBOR. Bootstrap inference is used to obtain a confidence interval about how imprecise our estimator of LIBOR is. [Cita and Lien, 1992, Berkowitz, 1999, Shah, 2000].
A similar strategy can be applied to the measurement of VIX. Each option should be seen as a noisy estimator of the implied volatility. Bootstrap inference can then be used to create a distribution of the vega-weighted VIX (VVIX). This yields a confidence interval for VVIX.
As an example, for a sample of end-of-day S&P 500 options, on 17th September, 2010, the at-the-money (ATM) options with 29 days to expiry show significant variation and take values between 15% and 21%. Our methods yield a distribution of the estimated VVIX:
As the graph above shows, the point estimate for the VVIX is 21.53% and this is what all of us are used to talking about. But the noise in option prices has induced an economically significant imprecision in our estimated VVIX. The 95% confidence band, which runs from 20.8% to 22.32%, is 1.5 percentage points wide. This turns out to be an economically significant number: the one-day change in VVIX is smaller than 1.5 percentage points on 62% of the days. This suggests that on 62% of the days, we know little about whether VVIX went up or down when compared with the previous day.
To conclude, we got a huge step forward when options trading improved our knowledge of the universe by giving us a forward looking estimator of future uncertainty: a quantitative peek into the structure of expectations of traders. However, market microstructure noise and the limits of arbitrage hamper this. VIX is not a hard number; there is economically significant imprecision in our observation of VIX. This insight may make a difference to many applications of VIX.
Once we start using the term `estimation' about VIX, we must pursue improvements in the estimation of VIX in order to address these issues of microstructure noise and the limits of arbitrage. One first step in this direction is Grover & Thomas, Journal of Futures Markets, 2012.
Monday, October 27, 2014
Rethinking the policy framework in coal
by Suyash Rai and Ajay Shah.
Coal is the dirtiest of all modern fuels, whether measured by habitat destruction in mining areas, or CO2, SPM and SOx emissions, or radioactivity. However, there is no alternative to coal in India's energy strategy, as coal makes up half of India's energy consumption today, and as India is blessed with strong natural resources.
Despite the strategic importance of coal in India's energy strategy, domestic production growth has been slow, with an average compound growth of 3.65% per year between 1990-91 and 2013-14 (from 247.56 million tonnes to 565 million tonnes). Over that same period, coal imports went up from 5.56 million tonnes in 1990-91 to 171 million tonnes in 2013-14, a compound growth rate of 16.06%. Coal imports have become nearly 1% of GDP. India has become the world's third largest coal importer -- despite having the world's fifth largest reserves (with about 67 billion tonnes of proven reserves). It is reasonable for a country with abundance of a fuel to import that fuel for strategic reasons, but India is forced to import due to inefficiencies of the domestic coal sector.
These inefficiencies do not have to be. Reforms can rapidly increase productivity. As an example, Australia got a gain in the raw coal output per man-shift for open-cast mines from 20 tonnes in 1966 to 54 tonnes in 1974 -- almost a tripling in 8 years. In underground mines also, technological change can give massive improvements in productivity. The puzzle is that of improving the efficiency and environmental soundness of extraction, and improving the infrastructure of transportation. This requires a fundamental rethink of the policy framework that has been adopted.
As with most problems in India, the poor outcomes are coming from deeper problems of institutions. While we periodically try quick fixes, there is no running away from solving those deeper problems.
On this much, it is fair to say that there is a broad consensus. Everybody agrees on this much. What is not widely understood is the way forward.
Coal India is the public sector monopoly that produces, processes and sells coal. It produces 80% of the country's coal. It does so with much lower productivity (measured in terms of output/man-shift or OMS) than that in many developed countries. For example, in 2012-13, Coal India's OMS for open-cast mines was 11.48 tonnes, while the same for Australia was 75.04 tonnes back in 2005. The situation with OMS for underground mines is much worse: Coal India was at 0.77 tonnes in 2012-13, while Australia was 50 times bigger. Coal India has improved its productivity, but the rate of change is not adequate for solving India's problem. Drastic improvements in technology and management are required, but Coal India has been persistently unable to muster the requisite change capacity.
There could be many reasons for this. Some of them are generic to the public sector, some of them are generic to monopolies, and some may be specific to Coal India. Public sector enterprises face constraints of procurement, and human resource management, which private sector enterprises do not face. A monopoly does not face the competitive pressure that punishes inefficiency. This is particularly the case for public sector monopolies where the consequences are borne by tax payers. Not all public sector companies suffer from a productivity gap on the scale of Coal India -- as an example, NTPC fares pretty well on efficiency despite being a public sector company.
The relationship with labour in Coal India appears to be lopsided, even by the standards of public sector firms. Junior staff at Coal India are paid rather well when compared with other employment with the similar skill and hardship. This may be attributed to powerful trade unions. The strength of trade unions may explain the low productivity at Coal India.
We could discuss the problems of Coal India and how to solve these. However, it is important to not hold India hostage while waiting for those problems to be solved. As an example, India was held hostage by DOT/BSNL/MTNL in telecom, but the 1999 telecom reforms broke past that barrier. While DOT/BSNL/MTNL are an important part of Indian telecom, India's progress is no longer hostage to them. Similarly, there are fervent discussions about the problems of Air India, however policy thinking about civil aviation in India is focused on the interests of India and is not held hostage by the interests of Air India. In the field of coal, the objectives are clear: We need to increase output of coal by bringing in modern management so as to achieve high productivity and high standards of environment protection.
The Coal Mines (Nationalisation) Act, 1973 curtails private participation in coal mining. It limits allocation of coal mines to firms that will use the coal only for producing power, iron, steel, coal washing or any such government-specified use. Trading by private firms is forbidden: They were not allowed to sell the coal that they extract to other firms even for specified purposes. Since 1993, governments have allocated 218 coal blocks to public and private enterprises for specified purposes, under the provisions of this Act. More than two-third of these were allocated between 2005 and 2010, under the UPA government.
Allocations were done through a screening committee process, without competitive bidding. In 2010, an amendment to the Mines and Minerals (Development and Regulation) Act (MMDR Act), 1957 provided for auctions of coal blocks. But the Comptroller and Auditor General, in a 2012 report, asserted that the government had the power to conduct auctions even before this amendment. The report also asserted that the failure to conduct auctions led to a large revenue loss for the government and corresponding windfall gains for the allocatees. The government contested these claims. The matter went to the Supreme Court through writ petitions. In September 2014, the Supreme Court cancelled 214 of the 218 coal block allocations made since 1993, and imposed fines on the operational mines among them. The grounds for cancellation are primarily the failure to follow principles of due process.
For the 42 operational mines, the Supreme Court order takes effect in six months. These blocks were expected to produce 10% of India's coal production this year. Some of these users will resort to imports. Some of them will not be able to solve the logistics problems associated with imports, and hence the downstream economic activity (e.g. an electricity generation plant) will close down.
On October 21, the government issued an Ordinance, which amends the Coal Mines (Nationalisation) Act, 1973 and the MMDR Act, 1957 to, give effect to certain coal sector reforms. It will run auctions to allocate coal mines. For some of the mines (74 mines), only actual users of coal in the cement, steel and power sectors will be allowed to bid, while for others (204 mines), the auction pool may include those who will produce and sell coal. While auctions had to be held after the CAG's and Supreme Court's interventions, opening of the sector to private firms for production and sale is a new step. This opens the window for giving mine leases to firms that are not in the business of producing power, steel, etc, but specialise in extracting and selling coal. It is important to note that the Ordinance also allows the government to continue with direct allocation of coal mines to public sector enterprises.
This Ordinance is a step forward in institutional reform. But it is an incomplete step. Looking forward, there are five areas of concern:
Following the Ordinance, the government will give more mines to private sector for extraction and sale. But Coal India has preferential treatment with easy allocation of mines. This is not fair. Coal India must participate in open auctions on an equal footing with other bidders.
Even after this is done, private firms will find it difficult to compete with a huge government-backed firm with deep pockets. As an example, private airlines complain that the presence of a government-owned airline, which is able to bear huge losses, has had a negative impact on them.
It would make sense to break Coal India into several independent entities that actively compete with each other and with private firms, for the business of coal extraction and sale. This could set the stage for gradual privatisation of the baby Coal Indias.
As with the opening of civil aviation or telecom, the reforms will be opposed by trade union members of Coal India. Coal India should exist to maximise the interests of the people of India (about 1.3 billion) and not the interests of the 350,000 employees.
Government must build capacity to do efficient regulation, contracting and contract monitoring of private participation in the coal sector. Given the complex contracting problems and environmental consequences, government-private sector interface in coal sector must be backed by a sophisticated government that is capable of understanding difficult trade-offs and make the right choices. Government should draft a comprehensive coal sector law that encompasses various aspects of the government's role in the sector.
In addition to the problem of running auctions and writing contracts, the law needs to envision market failures, give the executive the minimum required powers to address them, and setup accountability mechanisms. Ultimately, the law should setup feedback loops through which the executive and the industry move forward towards world class capabilities.
In parallel, government should build human resources and other organisational capabilities to enforce the law in this sector.
Since mines will be auctioned, the immediate question is: who will be eligible to bid? For auctions of the coal blocks affected by the Supreme Court verdict, the government is allowing only the current users of coal for specified purposes. Perhaps, that is required as an expedient measure for the 20% of cancelled blocks that were already being used. But for the remaining and subsequent allocations, it is important to hold open auctions. The expertise of coal extraction and sale is different from the expertise of producing power, cement, steel, etc. The government should decouple the two, and unbundle the two markets of extraction and trading/sale.
It is particularly important to not directly allocate mines to government enterprises. If such enterprises fail to win the auctions, they can go ahead and purchase coal from successful bidders. NTPC is good at producing power, but it need not own coal mines for that. It could very well purchase it from firms specialising in production and sale of coal. This is not to say that there should be zero direct allocations. In some contexts, especially where a downstream plant has been set up with an assumption of access to nearby mine, it might be uneconomical to auction the mines. But the principle should be that direct allocations should be done in the rarest of cases, and the government should do a formal cost-benefit analysis before direct allocation decisions.
As is evident from their superior productivity, firms in some other countries have substantially better expertise in coal extraction. If we continue to limit participation of foreign firms, we will also constrain investment and innovation. The government should open the auction to foreign firms, and enable introduction of productivity-enhancing technologies and management systems. If, for strategic reasons, the government wants to restrict the purposes of coal use, and/or place constraints on coal exports, it can do so. The key point to focus upon is to bring in the best expertise in the problem of extracting, value enhancing, transporting and selling coal.
The recent Ordinance is a step forward, but it is a tiny attack on the larger problem of coal sector reforms. We must reform Coal India; We must build State capacity on contracting, regulation and supervision of private players; We must setup separate and competitive markets for extraction and trading of coal; We must bring foreign players who have the requisite skills.
India needs more coal
Coal is the dirtiest of all modern fuels, whether measured by habitat destruction in mining areas, or CO2, SPM and SOx emissions, or radioactivity. However, there is no alternative to coal in India's energy strategy, as coal makes up half of India's energy consumption today, and as India is blessed with strong natural resources.
Despite the strategic importance of coal in India's energy strategy, domestic production growth has been slow, with an average compound growth of 3.65% per year between 1990-91 and 2013-14 (from 247.56 million tonnes to 565 million tonnes). Over that same period, coal imports went up from 5.56 million tonnes in 1990-91 to 171 million tonnes in 2013-14, a compound growth rate of 16.06%. Coal imports have become nearly 1% of GDP. India has become the world's third largest coal importer -- despite having the world's fifth largest reserves (with about 67 billion tonnes of proven reserves). It is reasonable for a country with abundance of a fuel to import that fuel for strategic reasons, but India is forced to import due to inefficiencies of the domestic coal sector.
These inefficiencies do not have to be. Reforms can rapidly increase productivity. As an example, Australia got a gain in the raw coal output per man-shift for open-cast mines from 20 tonnes in 1966 to 54 tonnes in 1974 -- almost a tripling in 8 years. In underground mines also, technological change can give massive improvements in productivity. The puzzle is that of improving the efficiency and environmental soundness of extraction, and improving the infrastructure of transportation. This requires a fundamental rethink of the policy framework that has been adopted.
As with most problems in India, the poor outcomes are coming from deeper problems of institutions. While we periodically try quick fixes, there is no running away from solving those deeper problems.
On this much, it is fair to say that there is a broad consensus. Everybody agrees on this much. What is not widely understood is the way forward.
The elephant in the coal mine: Coal India
Coal India is the public sector monopoly that produces, processes and sells coal. It produces 80% of the country's coal. It does so with much lower productivity (measured in terms of output/man-shift or OMS) than that in many developed countries. For example, in 2012-13, Coal India's OMS for open-cast mines was 11.48 tonnes, while the same for Australia was 75.04 tonnes back in 2005. The situation with OMS for underground mines is much worse: Coal India was at 0.77 tonnes in 2012-13, while Australia was 50 times bigger. Coal India has improved its productivity, but the rate of change is not adequate for solving India's problem. Drastic improvements in technology and management are required, but Coal India has been persistently unable to muster the requisite change capacity.
There could be many reasons for this. Some of them are generic to the public sector, some of them are generic to monopolies, and some may be specific to Coal India. Public sector enterprises face constraints of procurement, and human resource management, which private sector enterprises do not face. A monopoly does not face the competitive pressure that punishes inefficiency. This is particularly the case for public sector monopolies where the consequences are borne by tax payers. Not all public sector companies suffer from a productivity gap on the scale of Coal India -- as an example, NTPC fares pretty well on efficiency despite being a public sector company.
The relationship with labour in Coal India appears to be lopsided, even by the standards of public sector firms. Junior staff at Coal India are paid rather well when compared with other employment with the similar skill and hardship. This may be attributed to powerful trade unions. The strength of trade unions may explain the low productivity at Coal India.
We could discuss the problems of Coal India and how to solve these. However, it is important to not hold India hostage while waiting for those problems to be solved. As an example, India was held hostage by DOT/BSNL/MTNL in telecom, but the 1999 telecom reforms broke past that barrier. While DOT/BSNL/MTNL are an important part of Indian telecom, India's progress is no longer hostage to them. Similarly, there are fervent discussions about the problems of Air India, however policy thinking about civil aviation in India is focused on the interests of India and is not held hostage by the interests of Air India. In the field of coal, the objectives are clear: We need to increase output of coal by bringing in modern management so as to achieve high productivity and high standards of environment protection.
The previous legal framework
The Coal Mines (Nationalisation) Act, 1973 curtails private participation in coal mining. It limits allocation of coal mines to firms that will use the coal only for producing power, iron, steel, coal washing or any such government-specified use. Trading by private firms is forbidden: They were not allowed to sell the coal that they extract to other firms even for specified purposes. Since 1993, governments have allocated 218 coal blocks to public and private enterprises for specified purposes, under the provisions of this Act. More than two-third of these were allocated between 2005 and 2010, under the UPA government.
Allocations were done through a screening committee process, without competitive bidding. In 2010, an amendment to the Mines and Minerals (Development and Regulation) Act (MMDR Act), 1957 provided for auctions of coal blocks. But the Comptroller and Auditor General, in a 2012 report, asserted that the government had the power to conduct auctions even before this amendment. The report also asserted that the failure to conduct auctions led to a large revenue loss for the government and corresponding windfall gains for the allocatees. The government contested these claims. The matter went to the Supreme Court through writ petitions. In September 2014, the Supreme Court cancelled 214 of the 218 coal block allocations made since 1993, and imposed fines on the operational mines among them. The grounds for cancellation are primarily the failure to follow principles of due process.
For the 42 operational mines, the Supreme Court order takes effect in six months. These blocks were expected to produce 10% of India's coal production this year. Some of these users will resort to imports. Some of them will not be able to solve the logistics problems associated with imports, and hence the downstream economic activity (e.g. an electricity generation plant) will close down.
The recent reforms by the NDA government
On October 21, the government issued an Ordinance, which amends the Coal Mines (Nationalisation) Act, 1973 and the MMDR Act, 1957 to, give effect to certain coal sector reforms. It will run auctions to allocate coal mines. For some of the mines (74 mines), only actual users of coal in the cement, steel and power sectors will be allowed to bid, while for others (204 mines), the auction pool may include those who will produce and sell coal. While auctions had to be held after the CAG's and Supreme Court's interventions, opening of the sector to private firms for production and sale is a new step. This opens the window for giving mine leases to firms that are not in the business of producing power, steel, etc, but specialise in extracting and selling coal. It is important to note that the Ordinance also allows the government to continue with direct allocation of coal mines to public sector enterprises.
This Ordinance is a step forward in institutional reform. But it is an incomplete step. Looking forward, there are five areas of concern:
- The elephant in the coal mine needs reform. Allocating coal mines to private sector for extraction and sale will reduce dependence on Coal India, but this does not solve the problem of low productivity at Coal India.
- The role of the State in the field of coal. The Ordinance is focused on addressing the gap that has been created by the Supreme Court order. However, what is required is a more encompassing treatment of the tasks of the State in contracting, regulating, and supervising private players. Such a law needs to be written and this will correspondingly require creating State capacity for enforcing it. For an analogy, setting up financial economic policy is not a mere matter of auctioning some licenses to run a bank here or an insurance company there; it requires the full blown sophistication of the Indian Financial Code.
- Why have captive mines at all? There is no case for limiting trading in coal, between private players, by forcing captive mining. India will gain when some specialise in mining, and sell to others who specialise in downstream applications of coal.
- Why a dual system? Why is it necessary to directly allocate mines to government enterprises, and create a dual system in which some mines for auctioned and others are just allocated?
- Who knows how to run a coal mine in India? Private sector participation in extraction and sale is a step forward, but after decades of public sector domination, do any domestic firms posses expertise on achieving high productivity and avoiding environmental degradation in the process?
We cannot ignore reforms of Coal India in reforming coal
Following the Ordinance, the government will give more mines to private sector for extraction and sale. But Coal India has preferential treatment with easy allocation of mines. This is not fair. Coal India must participate in open auctions on an equal footing with other bidders.
Even after this is done, private firms will find it difficult to compete with a huge government-backed firm with deep pockets. As an example, private airlines complain that the presence of a government-owned airline, which is able to bear huge losses, has had a negative impact on them.
It would make sense to break Coal India into several independent entities that actively compete with each other and with private firms, for the business of coal extraction and sale. This could set the stage for gradual privatisation of the baby Coal Indias.
As with the opening of civil aviation or telecom, the reforms will be opposed by trade union members of Coal India. Coal India should exist to maximise the interests of the people of India (about 1.3 billion) and not the interests of the 350,000 employees.
Building State capacity for the role of the State in coal
Government must build capacity to do efficient regulation, contracting and contract monitoring of private participation in the coal sector. Given the complex contracting problems and environmental consequences, government-private sector interface in coal sector must be backed by a sophisticated government that is capable of understanding difficult trade-offs and make the right choices. Government should draft a comprehensive coal sector law that encompasses various aspects of the government's role in the sector.
In addition to the problem of running auctions and writing contracts, the law needs to envision market failures, give the executive the minimum required powers to address them, and setup accountability mechanisms. Ultimately, the law should setup feedback loops through which the executive and the industry move forward towards world class capabilities.
In parallel, government should build human resources and other organisational capabilities to enforce the law in this sector.
A competitive market for production and sale of coal is required
Since mines will be auctioned, the immediate question is: who will be eligible to bid? For auctions of the coal blocks affected by the Supreme Court verdict, the government is allowing only the current users of coal for specified purposes. Perhaps, that is required as an expedient measure for the 20% of cancelled blocks that were already being used. But for the remaining and subsequent allocations, it is important to hold open auctions. The expertise of coal extraction and sale is different from the expertise of producing power, cement, steel, etc. The government should decouple the two, and unbundle the two markets of extraction and trading/sale.
It is particularly important to not directly allocate mines to government enterprises. If such enterprises fail to win the auctions, they can go ahead and purchase coal from successful bidders. NTPC is good at producing power, but it need not own coal mines for that. It could very well purchase it from firms specialising in production and sale of coal. This is not to say that there should be zero direct allocations. In some contexts, especially where a downstream plant has been set up with an assumption of access to nearby mine, it might be uneconomical to auction the mines. But the principle should be that direct allocations should be done in the rarest of cases, and the government should do a formal cost-benefit analysis before direct allocation decisions.
We need foreign players
As is evident from their superior productivity, firms in some other countries have substantially better expertise in coal extraction. If we continue to limit participation of foreign firms, we will also constrain investment and innovation. The government should open the auction to foreign firms, and enable introduction of productivity-enhancing technologies and management systems. If, for strategic reasons, the government wants to restrict the purposes of coal use, and/or place constraints on coal exports, it can do so. The key point to focus upon is to bring in the best expertise in the problem of extracting, value enhancing, transporting and selling coal.
Conclusion
The recent Ordinance is a step forward, but it is a tiny attack on the larger problem of coal sector reforms. We must reform Coal India; We must build State capacity on contracting, regulation and supervision of private players; We must setup separate and competitive markets for extraction and trading of coal; We must bring foreign players who have the requisite skills.
Saturday, October 25, 2014
The logjam in infrastructure investment
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| Quarter-on-quarter growth of the non-seasonally adjusted value of infrastructure projects that are classified as being `Under Implementation' in the CMIE Capex database. |
In the standard narrative, the first wave of infrastructure investment in India (2003-2010) choked owing to the ground-level difficulties of investment, including land acquisition, corruption scandals, contract disputes, etc. By this logic, if we solve these problems, we will have set the stage for the second wave of infrastructure investment. This is the sort of idea that motivated the `Cabinet Committee on Investment' in the late days of the UPA.
There is, however, another logjam which needs to be solved, that of infrastructure financing. In today's Indian Express, I worry about the short-term measures which were taken during the first wave. Each of them felt expedient at the time, but with the benefit of hindsight, they were mistakes. Instead of looking for more short-term expedient solutions, we need to solve the deeper problems of the financial system in order to break this logjam.
The second wave of infrastructure financing, that we now require, needs work on both tracks: fixing the foundations of the financial system so that well-incentivised developers try to invest, and fixing the ground level difficulties so that this investment actually turns into smoothly working operating assets.
Acknowledgements : My thinking on these questions has been greatly aided by Josh Felman (IMF), Gopal Sarma (Bain Consulting) and Suyash Rai (NIPFP). The phrase `the long run has caught up with us' is by K. P. Krishnan.
Monday, October 20, 2014
Ebola and India
The biggest-ever Ebola epidemic is taking place is West Africa. Through travellers, this could spread elsewhere. Carriers are asymptomatic for 2-21 days, and hence border screening does not block transmission.
Ebola is very virulent. That is, the Pr(death|infection) is high. However, it is not a complicated pathogen for a public health system to deal with. It has no method of jumping to new victims other than direct contact with body fluids. This is unlike (say) a virulent airborne influenza where there is no easy strategy for blocking transmission. The simple strategy of tracing, diagnosing and isolating cases suffices to block Ebola in its tracks.
Ebola is easy if and only if there is a capable public health system through which tracing, diagnosing and isolating cases is easy. It's a disaster for the countries that don't have such a capability.
Do the public health authorities in India have this organisational capability? We in India will be sorely tested, for we do not have a focus on public goods in our health system.
Our health system is a socialist mish-mash of a government that produces and gifts out private goods. We try to run primary health centres, we try to run hospitals, and such like. We don't do the things that a public health system does -- such as the analysis and control of epidemics. We lack the intellectual clarity that the public health system is not about the health of the public; it is about public goods in the problem of health. This could prove to be a costly mistake in coming weeks and months, if Ebola spreads well beyond West Africa.
The fact that most people in India cremate the dead, and that we don't have rituals which involve touching the victim, will help. Cremation procedures will need to be modified to address the biohazard.
Ebola is very virulent. That is, the Pr(death|infection) is high. However, it is not a complicated pathogen for a public health system to deal with. It has no method of jumping to new victims other than direct contact with body fluids. This is unlike (say) a virulent airborne influenza where there is no easy strategy for blocking transmission. The simple strategy of tracing, diagnosing and isolating cases suffices to block Ebola in its tracks.
Ebola is easy if and only if there is a capable public health system through which tracing, diagnosing and isolating cases is easy. It's a disaster for the countries that don't have such a capability.
Do the public health authorities in India have this organisational capability? We in India will be sorely tested, for we do not have a focus on public goods in our health system.
Our health system is a socialist mish-mash of a government that produces and gifts out private goods. We try to run primary health centres, we try to run hospitals, and such like. We don't do the things that a public health system does -- such as the analysis and control of epidemics. We lack the intellectual clarity that the public health system is not about the health of the public; it is about public goods in the problem of health. This could prove to be a costly mistake in coming weeks and months, if Ebola spreads well beyond West Africa.
The fact that most people in India cremate the dead, and that we don't have rituals which involve touching the victim, will help. Cremation procedures will need to be modified to address the biohazard.
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