Ajay Shah's blog

Dubai's great crash

2009-11-28T10:44:00.006+05:30

Sheikh Makhtoum won't go to debtor's prison, but short of that, Dubai's all-but-sovereign default is an epochal event in its story. I wrote a column in Financial Express titled Dubai's great crash where I draw on this episode to think more clearly about (a) International financial centres and (b) Puffery. On this subject, also see Reality catches up with the Gulf's model global city by Roula Khalaf in the Financial Times, and 'The Sheikh's New Clothes?' Dubai's Desert Dream Ends by Stanley Reed in Business Week.

One hears talk about Dubai giving up crown jewels, like the airline, in exchange for a bailout. I think the time for that bailout was six months ago. Today, with a funding gap of $80 billion, the crown jewels are not big enough. But six months ago, it was possible to think of a deal where ADIA bought up the crown jewels for (say) $40 billion and Dubai would have tided over the storm.

This episode is an opportunity to think about exchange rate regimes. What if Dubai had used a floating rate instead of a fixed rate? This would have worked in two ways. First, it would have been a stabiliser. When bad times came, capital would have started leaving Dubai, the exchange rate would have depreciated, thus making real estate or hotel rooms in Dubai cheaper in the eyes of foreign customers. (Conversely, in good times, the exchange rate would have appreciated, thus reducing the attraction of going to Dubai). The key intuition (RBI speechwriters please note) is that exchange rate fluctuations stabilise the economy. Without a flexible exchange rate, adjustment in Dubai was forced on to the labour market, the real estate market, etc., which are all places where adjustment is more disruptive and is resisted more.

The second interesting feature of this thought experiment is linked to borrowing. A fixed exchange rate encourages and even subsidises dollar denominated borrowing. For society, the low cost of borrowing (the USD interest rate) is paid for by the loss of monetary policy autonomy. If a flexible exchange rate were used. Mr. Makhtoum would have been more careful and would have borrowed less.

The rise of private sector education service producers in India

2009-11-27T10:40:00.002+05:30

In India, in the fields of health and education, an impressive rise of a private ecosystem has come about. In these fields, the State has tried hard to get back in the game, particularly after the UPA won power in 2004. But the unwillingness of the State to undertake deeper reforms has meant that ultimately, government facilities generally work badly. CPI(M) ideologues send their children to private schools.

The CMIE Consumer Pyramids data shows the fraction of household expenditure on school/college fees. Households that spend nothing are those that have no children, or those that are fully served by government schools/colleges. The CMIE data separates out expenditures on stationery, books, private tuitions, etc., so what is observed here is just the pure payment to the school/college. It shows:

Income class	Fraction of expenditure
Rich 1	2.88
Rich 2	3.25
Higher Middle Income 1	3.52
Higher Middle Income 2	4.16
Higher Middle Income 3	3.81
Middle Income 1	3.17
Middle Income 2	2.78
Lower Middle Income 1	2.43
Lower Middle Income 2	1.89
Poor 1	1.46
Poor 2	1.35
Overall	2.82

The overall average expenditure per household in the survey is Rs.86,228, so 2.82% of this is Rs.2400 a year or Rs.200 a month. This, of course, reflects a split between some households who use government facilities (who spend nothing) and others who use private facilities (who spend more than Rs.200 a month).

An incipient academic literature shows that learning outcomes from the weakest private schools broadly replicate learning outcomes from government schools even though the resource outlay of government schools is 3x to 10x bigger. If this evidence was correct, private schools would not have gained market share. Poor people have been spurning government schools with zero tuition fees and free meals, and choosing private schools where significant payments have to be made. There are two possible explanations: either the parents are not understanding how best to take care of their interests, or the econometricians are not understanding what parents are thinking. I am biased in favour of the latter explanation.

Like all incumbents, public sector producers of educational services resent competition, and particularly competition that is gaining market share. With the Right to Education Act, the government has armed itself with new powers to force `unrecognised schools' to close down. This is similar to the Department of Posts trying to prevent private firms from carrying letters. This is going to shape up as one of the most important battlegrounds in Indian education. So far, the broad story was that the government floundered and spent ever larger sums of money, but did not prevent `unrecognised' schools from coming up. Now it is shifting gears from category 3 ("State Production But Do No Harm") to category 4 ("State Production While Damaging the Private Sector").

As Lant Pritchett has emphasised, countries like Chile which have a fully competitive framework, where parents choose between public and private schools, have a bigger market share of public schools as compared with India, where the main approach of the State is to pretend that private schools don't exist, or to try to force them out. This ought to trigger off fundamental rethinking about what we are doing in the government. This rethinking has not begun, and the customers are quietly voting with their feet, switching their children to private schools. Despite the huge increase in funding to public schools, the market share of private schools is rising every year.

In this setting, it is worth attending the School Choice National Conference 2009 which will be held in Delhi on 16 December. And, do read The Beautiful Tree by James Tooley.

When a currency futures market dominates a currency forward market

2009-11-25T17:41:00.006+05:30

by Gurnain Kaur Pasricha

In recent months, a sense has emerged that the exchange-traded currency futures market in India is more liquid than the corresponding contract traded OTC (i.e. the forward market). As an example, we examine a dataset from NSE of 28,797 observations of data - one observation per second - from 3 November 2009, for the November expiry. The effective spread for a transaction of $1 million (i.e. 1000 contracts) is calculated, in the units of paisa. This dataset has the following summary statistics:

5%	25%	50%	75%	95%
0.519	0.763	1.000	1.380	2.344

In other words, 95% of the time, the spread on NSE for a $1 million rupee-dollar futures transaction was below 2.344 paisa. The median spread, for a $1 million transaction, was 1 paisa. This spread dropped below 0.5 paisa with only a 5% probability.

These numbers are significantly superior to those found on the OTC forward market, where, as a thumb rule, dealers feel that a $1 million transaction typically involves a spread of 2 paisa. This suggests that the liquidity at NSE is roughly 2x superior to the OTC market. The superiority of the execution at NSE is likely to be greater than 2x when we consider the opacity and execution risk of the OTC market. To the extent that order flow has shifted away from the forward market to the futures market, there could be a dynamic story here of the futures spread getting tighter at the expense of the forward spread.

This situation is unexpected. In the international experience, the currency forward markets is more liquid than its exchange-traded counterpart. This is despite the fact that futures markets has desirable features including near-zero counterparty risk, transparency, contracts standardisation and open public participation. The key reason for the domination of the OTC market appears to be historical. The OTC market came first, had entrenched liquidity, and the network externalities of liquidity hold the users in place.

In thinking about India's currency futures market, it would be useful to compare and contrast with Brazil's experience. Brazil is an interesting peer to India for reasons of a large GDP, democracy, rule of law, institutional quality, etc. It is also the only country of the world, prior to India, where the currency futures market became more liquid than the currency forward market.

In Brazil, currency futures trading began in 1991 - a seventeen year head start when compared with India. While Brazilian macroeconomics is now remarkably healthy, Brazil has had a turbulent history with many crises, high and volatile interest rates and inflation. The futures market, with daily marking to market, and therefore lower collateral requirements, offered a cheaper way to take positions in the currency. Nevertheless, there is reason to believe that several (sometimes unrelated) regulations contributed to tipping the balance in favor of futures contracts, so much so that today there is essentially no OTC market to speak of. The dealers on the forward market now provide OTC contracts to their customers but unwind their positions in the futures market (See Note 2). The regulatory pressures which moved liquidity from the OTC market to the futures market were:

Access to spot markets was limited for several decades as a tool to control capital flight. Both domestic and foreign residents had easier access to futures markets than to spot markets. This led to greater number of players, and more liquidity in futures markets. Access to spot markets in Brazil is still far from free, for both domestic and foreign residents. India is in the same boat, with a futures market that is accessible to citizens but a spot market which is not.
Until 2005, banks were subject to unremunerated reserve requirements on foreign exchange exposures exceeding pre-specified limits. These reserve ratios did not apply to futures positions, thus driving trading to futures markets.
Until December 2007, Brazil imposed a financial transactions tax, called CPMF, on all debits on bank accounts. This levy applied to profit and loss payments on exchange traded contracts, not to their notional amounts, thus pushing activity to exchanges.
OTC derivatives contracts are not netted, whereas contracts with the exchange or clearing house are netted by the latter. This means that the tax on cash flows, PIS-COFINS (See Note 3), de-facto taxes OTC transactions at a higher rate than exchange traded derivatives.
Brazil has reporting requirements for OTC transactions - all transactions with domestic counterparties must be reported to regulators, in order for them to be considered enforceable. This levels the playing field in terms of the reporting burden of exchange traded versus OTC transactions. India has not yet done this.
Pension funds are required to use only standardized derivatives contracts.
The central bank, Banco Central Do Brasil, uses the futures market for doing currency intervention. This gives liquidity to the futures market, and also ensures that the OTC community has to look very carefully at the price on the screen so as to capture current information. India has not yet done this.

While some of these rules were removed in the 2000's, after being in place for several years, their consequences have outlasted them. There is a path-dependence in market liquidity. These kinds of market rules matter in getting liquidity on the exchange off the ground. Once the exchange becomes liquid, the network externality of market liquidity sucks in further order flow and preserves the domination of the exchange even after these rules are removed.

Endnotes

¹ The author is a senior analyst at the Bank of Canada. The views expressed here are personal. No responsibility for them should be attributed to the Bank of Canada.
² The material in this note is a summary of information provided by Brazilian economists as well as that contained in Dodd and Griffith-Jones (2007), Brazil's derivatives markets: hedging, central bank interevention and regulation, and Kolb and Overdahl (2006), Understanding futures markets, sixth edition, Blackwell Publishing.
³ The PIS and COFINS are federal taxes on revenues, charged on a monthly basis.

Working group on foreign investment in India

2009-11-25T10:28:00.000+05:30

MOF has setup a working group on foreign investment:

To review the existing policy on foreign inflows, other than Foreign Direct Investment (FDI), such as foreign portfolio investments by Foreign institutional investors (FIIs)/ Non Resident Indians (NRIs) and other foreign investments like Foreign Venture Capital Investor (FVCI) and Private equity entities and suggesting rationalisation of the same with a view to encourage foreign investment and reducing policy hurdles in this regard while maintaining the Know Your Customer (KYC) requirements.

To identify challenges in meeting the financing needs of the lndian economy through the foreign investment. Foreign investment for this purpose to be understood broadly and can include investment in listed and unlisted equity, derivatives and debt including the markets for government bonds, corporate bonds and external commercial borrowings.

To study the arrangements relating to the use of Participatory Notes and suggest any change in the policy if required from KYC and other point of view.

To reexamine the rationale of taxation of transactions through the STT and stamp duty.

To review the legal and regulatory framework of foreign investment in order to identify specific bottlenecks impeding the servicing of these financing needs.

To suggest specific short, medium and long term legal, regulatory and other policy change; in respect to foreign investment keeping in view of the suggestions expert committee reports such as the Committee on Fuller Capital Account Convertibility, the Committee on Financial Sector Reforms and the High Powered Expert Committee on Making Mumbai an lnternational Financial Centre.

Outsized capital inflows?

2009-11-24T23:04:00.003+05:30

A lot of people are getting anxious about a scenario with outsized capital inflows hitting India. The historical time-series is illuminating:

Quarter	Billion USD	Percent to GDP
12/2004	12.6	7.4
03/2005	8.2	4.6
06/2005	5.8	3.4
09/2005	10.5	6.2
12/2005	0.8	0.4
03/2006	8.4	4.2
06/2006	10.7	5.7
09/2006	7.9	4.2
12/2006	10.8	4.8
03/2007	15.8	6.7
06/2007	17.8	7.4
09/2007	33.2	13.6
12/2007	31.0	10.7
03/2008	26.0	8.7
06/2008	11.1	4.0
09/2008	7.6	2.8
12/2008	-4.3	-1.6
03/2009	-5.3	-2.0
06/2009	6.7	2.7

In the latest quarterly data (Apr/May/June 2009), net capital inflows worked out to $6.7 billion or 2.7% of GDP. These are not big numbers.

What are big numbers? 10% of GDP is a big number, which was breached for six months in this history. At the time, this corresponded to above $30 billion a quarter of net capital inflow. In future quarters, the physical magnitude will depend on how big GDP is at the time. My rough sense of 10% of GDP in the Oct-Nov-Dec 2009 quarter is that it will be $30 billion. To get to these numbers, we'd need to get back to an environment like Jul-Dec 2007 in terms of optimism about emerging markets in general and India in particular. So far, this doesn't seem to be what is in place.

Interesting readings

2009-11-21T02:17:00.001+05:30

Tackling systemic risk is no job for the status quo by William Donaldson and Arthur Levitt, in the Financial Times.
Short-Selling Bans around the World: Evidence from the 2007-09 Crisis by Alessandro Beber and Marco Pagano. The abstract reads: Most stock exchange regulators around the world reacted to the financial crisis of 2007-2009 by imposing bans or regulatory constraints on short-selling by market participants. We use the large amount of evidence generated by these regime changes to investigate their effects on liquidity, price discovery and stock returns. Since bans were enacted and lifted at different dates in different countries, and in some countries applied to financial stocks only, we identify their effects with panel data techniques, and find that bans (i) were detrimental for liquidity, especially for stocks with small market capitalization and high volatility; (ii) slowed down price discovery, especially in bear market phases, and (iii) failed to support stock prices..
A story on regulatory impact assessments.
Mahesh Vyas on improving disclosure.
Let bidding begin in the market by Rajesh Chakrabarti, in Financial Express.
Ashok Desai in Business World on the scandal that is ULIPs.
Sanjeev Sanyal in Business Standard on making Bombay work.
At 250 kph, the Bombay-Delhi distance of 1200 km is covered in 5 hours. At 376 kph (which the Chinese are implementing today), it's roughly 3 hours. If that sounds exciting, read Bullet trains for America? by Mark Reutter.
A pair of articles from The Economist on India and capital controls: A world apart, and Raining on India's parade.
Anita Bhoir in Mint on the proposed Standard Chartered IDR.
Looking back at Indira Gandhi: Ila Patnaik in Financial Express, and Shekhar Gupta in Indian Express.
A great collection of pictures about the Berlin Wall. Do not miss the symbolism of #34, where Lech Walesa starts the toppling of the dominos.
New York Times blogs on weight loss and exercise; you might like to also see my page on this which has a framework within which the NYT blog post can be placed.
India's dirty role in Sri Lankan war by Brahma Chellaney in [covert].
Terror in Mumbai, a documentary on HBO on 19 November.

The problems of big banks

2009-11-19T00:43:00.002+05:30

I wrote an article in Financial Express titled The problem of big banks. On this subject, also see:

In the world of banks, bigger can be better, Charles Calomiris in the Wall Street Journal.
A three-way split is the most logical, by John Gapper in the Financial Times.
Narrow banking is not the answer to systemic fragility by Charles Goodhart.
See the section titled Regulatory and legislative reaction and the foreign exchange market in Lessons for the foreign exchange market from the global financial crisis by Michael Melvin and Mark P. Taylor on voxEU.

Prescience

2009-11-19T00:01:00.001+05:30

Count Sergei Witte was an important figure in czarist Russia in the early 20th century. In October 1905, he wrote a memorandum to the Tsar summarising his view of the political unrest in the aftermath of the Japanese war. In it, he said:

The idea of civil freedom will triumph, if not by way of reform then by way of revolution. But in the latter event it will come to life on a thousand years of destroyed history. The Russian rebellion, mindless and pitiless, will sweep everything, turn everything to dust. What kind of Russia will emerge from this unprecedented trial exceeds human imagination: the horrors of the Russian rebellion may surpass everything known to history. A possible foreign intervention will tear the country apart. Attempts to put into practice the ideals of theoretical socialism -- they will fail but they will be made, no doubt about that -- will destroy the family, the display of religious faith, property, all the foundations of law.

How many other paragraphs can you think of, where someone peers into the unknowable, and largely sees the next 100 years right?

I saw this in Nicholas 2 Signs the October Manifesto by Richard Pipes, in I wish I'd been there, edited by Byron Hollinshead and Theodore K. Rabb, Pan Books, 2008.

Mobile phones and economic development

2009-11-08T14:34:00.004+05:30

The CMIE Consumer Pyramids data shows that in all their income categories, more than 50% of households have a mobile phone. It is only in their bottom category `Lower Middle Income - II' that only 37.5% of households have mobile phones. From `Higher Middle Income - III' upwards, the incidence is above 80%. If you had asked anyone in 1999 or 1989 whether this could be done by 2009, the answer would have been in the negative.

With broadband Internet, in contrast, India has not got such breakthroughs.

The September 2009 issue of Finance & Development has a story on the impact of mobile phones for development. In India, there is a lot of merit in using new technologies and players to break with the comfortable stagnation that's enveloped finance.

The Economist has a beautiful section on mobile phones and development: on Chinese progress on network hardware, broadband, on the impact on development, a retrospective, looking forward, and an enthralling piece on the cost reductions by firms in developing countries. Now all we need is for Indian finance to go the way of Indian telecom (and airlines).

Anand Giridharadas, writing in New York Times, describes new developments in distance education. India is the place in the world which would be the biggest beneficiary from distance education, given the combination of lots of young people and a dismal education system. This does require broadband to go the way mobile phones have. I often joke that the task of an economics undergraduate education in India should be to get a person to the point where he or she can read my blog :-) (and cynics respond saying that most of the teachers of economics in India can't parse my blog).

Anne Eisenberg has an article in New York Times about researchers at UCLA trying to use cell phones to do medical diagnosis. Given the ubiquity of cell phones in India, these could be useful lines of attack for us.

East Europe after 1989

2009-11-07T09:09:00.005+05:30

I have an article in Financial Express where I look back economic development in Eastern Europe in the last 20 years, and compare and contrast with India.

In recent weeks, a lot of very interesting writing, looking back at 1989, has come out. My suggestions for further reading follow. Readers of age 40 and below should try particularly hard to read these and other materials so as to comprehend these earth-shaking events. These events matter because they have had a huge influence on the world that we see today. And, they matter because they help us think more effectively about the drama that will come about in China in coming years.

1989! by Timothy Garton Ash in The New York Review of Books. Am eagerly waiting for part 2 of this. Also by him in The Guardian: This tale of two revolutions and two anniversaries may yet have a twist (May 2008) and 1989 changed the world. But where now for Europe? (now).
A great story of the big day by Alison Smale. Also see Serge Schmemann.
The unknown war by Matt Welch on reason.com. We feel this intuitively, but the statistics are stunning:

In 1988, according to the global liberty watchdog Freedom House, just 36 percent of the world's 167 independent countries were `free,' 23 percent were 1partly free,' and 41 percent were `not free.' By 2008, not only were there 26 additional countries (including such new `free' entities as Croatia, Estonia, Latvia, Lithuania, Serbia, Slovakia, and Slovenia), but the ratios had reversed: 46 percent were `free,' 32 percent were `partly free,' and just 22 percent were `not free.' There were only 69 electoral democracies in 1989; by 2008 their ranks had swelled to 119.
A beautiful section from The Economist:
Walls in the mind;
So much gained, so much to lose;
The man who trusted his eyes;
A globe redrawn;
Less welcome;
Keep calm and carry on;
Wall stories;
Down in the dumps
The peaceful revolution of 1989 by Adam Roberts in The Independent.
Brain drain in reverse behind fallen Berlin Wall by Carter Dougherty, in the New York Times.
A slideshow by Erik Berglof which summarises the Transition in crisis? report released by the European Bank of Reconstruction and Development.
My take on the new dangers that we face today.

Governments taking over banks

2009-11-05T23:07:00.001+05:30

Jerry Caprio and Ila Patnaik, at two ends of the world, on the same subject.

The UK Special Resolution Regime has excellent documentation on the web.

There is a lot of talk in India about financial stability, where basic ideas are distorted to defend the status quo. Financial stability is, sadly, not interesting to the establishment when achieving it requires undertaking economic reform. One example of this is the problems of closing down failed banks or other financial firms: few things are more important to financial stability than the machinery of the bankruptcy process for financial firms. The best thinking on how to build deposit insurance is found in Chapter 6 of Raghuram Rajan's report. In the mid 1990s I was member of an RBI committee on reforming deposit insurance. There hasn't been any movement on this in decades.

Recent RBI moves in finance

2009-11-04T10:55:00.001+05:30

On 30 October, I had written a response, in Financial Express to recent RBI moves on financial reform. Here are a few other responses:

Anil Padmanabhan in Mint on the big picture.
An editorial in Business World, and Tamal Bandyopadhyay in Mint, on the PLR controversy.
An editorial in Financial Express, and a blog post by Bagdu, on freedom to open branches.

Interesting readings

2009-11-01T11:07:00.003+05:30

Sanjeev Sanyal in Business Standard : Building cities for 21st century India, Delhi (which leads you to delhinullahs.org), and Calcutta. Also see: The Sustainable Planet Institute.
Why investment banks were fated to be roadkill, in Financial Express by Viral Acharya.
On Mumbai's Streets, Cabbies Fight To Keep Passengers Uncomfortable by Eric Bellman in the Wall Street Journal. A simple emphasis on law and order would go a long way.
Green roots of recovery, by Ila Patnaik in Indian Express.
In Foreign Policy magazine, Steve Coll has a great article on how the US should think about its AfPak strategy. India has a lot at stake in ensuring that this works out right.
Brian Krebs is a columnist on computer security for The Washington Post. He has recommendations for customers -- and implicitly for banks -- on how to be safe when doing Internet banking.
Editorials in Financial Express on the confusion that arises in India owing to the pervasive use of year-on-year growth rates: 13 October and 14 October.
Andre Beteille, in the Telegraph, on The language of rights.
Rob Walker in the New York Times, on the frontiers of quantification of Indian music.
An editorial in the Telegraph on the disappointing perpetuation of censorship in various aspects of the Indian government.
In response to The museum of innocence by Orhan Pamuk: a review in the New York Times by Maureen Howard, review by Pico Iyer in The New York Review of Books, and Negar Azimi in the New York Times on the museum that goes with the book.
In the story of Microsoft vs. Unix, Windows 7 seems to have reached the point where, in David Pogue's words: ``Microsoft employees can show up in public without avoiding eye contact''. On another front, Microsoft seems to be losing the cell phone to the two Unixes playing in that space. See Daniel Lyons look back at Microsoft's last decade, and a great Bill Gates story by Joel Spolsky.
Baby you were born to run by Tara Parker-Pope, in the New York Times.

A conference on Indian pension reform

2009-10-31T18:32:00.003+05:30

IIEF Pension Policy and Business Conference, 2009.

Recent RBI moves in financial reform

2009-10-30T13:16:00.000+05:30

I have an article in Financial Express today where I try to interpret recent RBI announcements in financial reforms.

Looking back at Indira Gandhi

2009-10-30T11:29:00.002+05:30

Writing in Indian Express, Pratap Bhanu Mehta looks back at Indira Gandhi. He offers five lessons for today's Congress:

Leaders are more effective when they work through institutions rather than attempting to subvert them.
Sound economic policies are not a matter of simply projecting good intentions; they require a concerted understanding of the causal conditions that make for successful intervention.
Being personally secular is neither here nor there. The important thing is to fish in the treacherous waters of communal identification, from wherever it comes.
As the Punjab crisis demonstrated, when the state does not act impartially and in time, it sows the seeds of greater violence in the future.
Democracy is not just about the practice of popular authorisation. It is about a whole gamut of constitutional values that have to be zealously guarded.

India had a bad period from 1962 to 1977, of which the worst part was the Emergency. This period preceded Pakistan's worst years (Zia ul Haq's period, 1978-1988). Kamal A. Munir has an article in Financial Express about Pakistan where we see the sustained impact of those years.

India seems to have come out better from the dark period, partly because that period ended a long time ago and there has been more time for healing. In addition, in Pakistan's case, the Afghan wars and islamisation which began in Zia ul Haq's period have not yet ended. In some sense, Pakistan is not yet into the post-authoritarian post-conflict period of reconstruction of institutions, which began in India in 1977.

Regulation vs. micro-management

2009-10-26T13:17:00.001+05:30

Writing in Business Standard, Somasekhar Sundaresan reminds us that SEBI has greater powers than US SEC. I'm curious: Does the US SEC have the power (if it should so decide) to control what time trading should start and stop at all exchanges?

How evil is insider trading?

2009-10-25T16:48:00.000+05:30

I have long been a skeptic about State action against insider trading, which is believed to be widely prevalent in India. Writing in the Wall Street Journal yesterday, Donald J. Boudreaux has a nice scheme which can replace the existing policy framework.

New thinking on financial stability

2009-10-20T04:36:00.002+05:30

I have an article in Financial Express today, where I discuss RBI's take on financial stability, which sums up to the rejection of all recent thinking in India on monetary and financial reform, in the light of recent thinking on this subject at the US Fed and the ECB.

Movement on corporate bonds

2009-10-17T07:56:00.003+05:30

Shilpy Sinha and Swapnil Mayekar have a story in Business Standard offering some optimism about the corporate bond market. They point out that in the six months from April to September 2009, corporate bond turnover was Rs.1.6 trillion, when compared with Rs.0.5 trillion in the same period of the previous year.

SEBI has decided to force many market participants to do netting by novation at a clearing corporation when trading on the corporate bond market. From 1 December 2009 onwards, there will be two possibilities for a trading mechanism:

OTC trade, reported on one of the three trade-reporting systems, run by BSE, NSE and FIMMDA, or
Order book trade, run by BSE or NSE.

But regardless of how trading takes place, counterparty risk will be eliminated, and netting efficiency obtained, through the clearing corporations. This will be a big win compared with the awful settlement mechanism that's used today. It should reduce transaction costs on this market.

The deeper problems of corporate bonds remain:

The lack of a liquid GOI yield curve along with interest rate derivatives, so as to be able to layoff interest rate risk when holding a corporate bond portfolio,
The low values for loss-given-default, given the lack of a bankruptcy code and
The ban on credit derivatives.

The workaround for #2 is: to stick to trading in short dated bonds from issuers where the failure probability is very low. A workaround for #3 is: to utilise information about credit risk embedded in the stock price.

The right way to think about the corporate bond market is in the context of the Bond-Currency-Derivatives Nexus, which emphasises the interlinkages between the government bond market, interest rate derivatives, corporate bonds, credit derivatives, the currency spot and currency derivatives. All these markets have to achieve liquidity with active arbitrage. The key ingredient for getting there is unifying the regulation and supervision at SEBI. This should address the bulk of the problems of corporate bonds -- other than the problem of loss-given-default.

Interesting readings

2009-10-13T16:08:00.000+05:30

David Oakley reports on Brazil having made it to investment grade. This is their payoff to the immense progress that took place in the last decade in terms of fiscal, financial and monetary institution building. In many respects, India's starting conditions today are similar to where Brazil was before these reforms.
Robert Shiller, in Financial Times defends financial innovation, and Robert Cryan, in New York Times worries that Canadian banks missed opportunities in this crisis.
Chiraga Chakrabarty, in DNA, on the need for INR/EUR futures. Once INR/USD and INR/EUR futures are trading, futures on USD/EUR will close the currency triplet and ensure efficient pricing of all three.
Raghuram Rajan in Financial Times on the neat idea of requiring banks to hold debt capital that will convert into equity when two triggers are met.
Read about Larry Summers and the US economic policy process in New Yorker magazine.
Anil Padmanabhan has an important column in Mint on the mess that is shaping up on the Goods and Services Tax.
James Lamont describes the world's third largest producer of Gherkins: a firm named Global Green, out of Bangalore.
On TV, Vivek Law takes on the mess found in fund management products sold by Indian insurance companies.
Nell Minow in Financial Times with new thinking about corporate governance.
Ila Patnaik on RBI's next moves. Also see The good news, analysed better and This is no time for a rate hike.
Vimal B in Financial Express on the internationalisation of the Chinese yuan.
Jayanth Varma is scathing about the SEC's efforts at being motherly towards fat fingers.
India's New Capital Restrictions: What Are They, Why Were They Created, and Have They Been Effective? by Bryan J. Balin of The Johns Hopkins University School of Advanced International Studies (SAIS).
Alan Blinder thinks that we should all be long India.
Shubhashis Gangopadhyay pleads for the removal of capital controls against venture capital and private equity.
Counterfactual history, by Ramachandra Guha: Episode 1: What if Subhas Chandra Bose had returned home sometime after WW-II ended?.
How Sam Yin Chueh changed the world.
We have serious problems with freedom of press in India.

Did we get a good IIP number today? No.

2009-10-12T17:19:00.004+05:30

It seems that we got a good IIP number today? Here's what the year-on-year growth of IIP Manufacturing says:

Mar 2009	-0.30
Apr 2009	0.39
May 2009	1.84
Jun 2009	7.82
Jul 2009	7.41
Aug 2009	10.21

So it looks like a recovery is gaining traction, with yoy growth going up in each month from March 2009 till August 2009, other than a slight decline in July 2009?

No.

The year-on-year growth is, unfortunately, a highly misleading measure. Here's what we get when we look at the seasonally adjusted levels and the annualised growth of these:

	Seas.Adj.IIP	Ann.Growth
Mar 2009	296.64	1.62
Apr 2009	297.69	4.24
May 2009	299.08	5.59
Jun 2009	319.78	80.32
Jul 2009	320.81	3.84
Aug 2009	322.14	4.98

This shows a very different picture. It shows one big month -- June 2009 -- where seasonally adjusted IIP jumped from 299.09 to 319.78. This was an annualised growth rate of 80.32%. This was the month in which the recovery kicked in, where we jumped back from the low state to a better state.

After that, growth has dropped back to anaemic levels, with annualised growth of 3.84% in July and 4.98% in August. So today's data release was actually not so hot - it was just 4.98% growth (annualised) of seasonally adjusted IIP manufacturing.

Each value of the year-on-year growth rate is the moving average of the latest 12 values of the month-on-month growth. So this one big value of 80.32% is going to elevate each reading of yoy growth up, all the way until we calculate the yoy growth from May 2009 till May 2010. After that, we'll get to the yoy growth from June 2009 till June 2010 and this jump will go away.

You only get the true picture by looking at point-on-point changes of seasonally adjusted data.

Interpreting recent movements of the rupee-dollar rate

2009-10-12T02:16:00.000+05:30

In recent weeks, there has been a lot of focus on the appreciation of the rupee against the dollar. In an opinion piece in Financial Express today, I point out that the US dollar has fluctuated considerably in the period after September 2008, and interpret the recent events on the Indian currency market. At first, in the `flight to safety' into US government bonds that came about after the Lehman shock, the US dollar gained ground. As the global financial system has gained confidence, the reversal of this `flight to safety' has meant a concomitant decline in the US dollar.

These ups and downs of the US dollar have important implications for our intuition in India about the rupee-dollar rate. If we think the US dollar is roughly fixed, then the pursuit of an inflexible rupee-dollar rate can be interpreted as some kind of `stability'. But if the US dollar itself is a fluctuating yardstick, it is hard to justify efforts at RBI to obtain inflexibility of the rupee-dollar rate. When the dollar declines in value, an attempt at holding on to a rigid rupee-dollar rate is tantamount to forcing a rupee depreciation, and vice versa.

Greater flexibility in the rupee dollar rate will free up monetary policy to pursue the more important goal of stabilising the domestic business cycle. But along the way, for firms to learn to live with greater flexibility of the rupee dollar rate, well functioning currency derivatives markets are required. RBI needs to first step away from the present strategy of banning most of these markets, so as to be able to move forward to greater flexibility of the rupee.

On the macroeconomic arguments about the long-term decline of the US dollar, see Wolfgang Munchau in the Financial Times today.

2009 Economics Nobel Prize

2009-10-06T10:15:00.003+05:30

We'll soon get the announcement. Here are a few possibilities, computed by Thomson/Reuters, using citation analysis.

If I had to vote, it would be a Taylor/Woodford prize. For a sense of this work, see: link, link. While inflation targeting was invented in New Zealand based on the intuition of cleanliness in public administration, Taylor and Woodford had a lot to do with being able to think straight about it.

It's interesting to wonder how publicly visible citation data can be used to predict the Nobel prize outcome. One would want some kind of model which consumes citation data and comes up with an estimate of the Pr(Nobel prize). E.g. if one strong idea suffices (example: James Heckman) then it suggests certain people who will get through (example: Paul Romer). If they want you to build a broad literature (example: Robert Lucas) then that yields a different profile of those who will get through. Hmm, I can't come up with an example of another Robert Lucas. Such a modelling effort will yield insights on the usefulness of summary statistics of citation data such as the h-index and the g-index. As an example, it's easy to test which of the h index or the g index have superior predictive power in a model of predicting the Nobel prize.

For an analogy, it's easy to take firm data and fit an ordered probit model which predicts the credit rating. Once this is done, you're holding a black box which is able to look at firms, and come up with a real valued measure of credit risk. In similar fashion, once a model is estimated, which maps citation data and generates a real number from 0 to 1 (e.g. the probit latent variable), then it can be applied to a full database of all economists, and yield a measure of how Nobel-like each person is. This can be easily layered into Google scholar.

Most people in India think of Raghuram Rajan as being the first Indian-born economist who became the chief economist of the IMF. What is not widely appreciated is that in the class of economists of Indian origin who are younger than Amartya Sen, Raghu is the best set of papers, as measured by citations.

Bharti/MTN transaction, and India's problem of capital controls

2009-10-05T01:39:00.002+05:30

I have a piece in Financial Express today about the deeper linkages between the failed Bharti/MTN transaction and India's problem of capital controls.

The dual listing issue was, of course, not the only or even the main reason why the Bharti/MTN transaction failed. But it was an important impediment, and many interesting transaction structures could have been used if this constraint had been absent. And, the issues that I highlight in the article are applicable in a much broader range of situations. Unsigned reportage in Economic Times suggests that a few other people are also thinking similarly.

Also see reportage by Heather Timmons in the New York Times. Subhomoy Bhattacharjee in Financial Express has interesting views. Also see The legal aspects of dual listings, on the blog `Indian corporate law'.

For another story of Indian companies who are growing up, facing global competition, and hitting constraints of Indian public policy, see this story by Pallavi Aiyar about Jet Airways setting up their hub in Belgium.