Ajay Shah's blog

Evaluating responses to India's macroeconomic crisis

2012-05-28T14:51:00.001+05:30

by Shubho Roy and Ajay Shah.

The macroeconomic setting

India's macroeconomic woes consist of a high inflation, low GDP growth and a drop in asset prices. The loss of momentum is visible in the seasonally adjusted data:

Indicator	Early 2009	Latest
GDP growth (QoQ, saar)	9.83 Q2-2009	4.25 Q4-2011
Inflation (CPI-IW, pop, saar, 3mma)	7.5 Feb 2009	12.9 Mar 2012
INR/USD	48 Jan 2009	56 May 2012

The picture is not uniformly bleak. The most important asset price of the economy, Nifty, has not dropped across this period. On 1 January 2009, Nifty was at 3033. Today, it is at 4920, which is a good 62% higher. More generally, stock prices have held up rather well so far. The trailing P/E of the broad market index, the CMIE Cospi, stands at 17.3, while the median value across its full history (from 6/1990 to 4/2012) is 17.83. We may think that conditions in India are difficult, but the stock market is saying that they're roughly median conditions in terms of the outlook for earnings growth.

The current account deficit

In recent years, the fiscal condition of the government + PSUs has worsened. This has led to a large gap between savings and investment (the worsening in public finance has diminished savings). There is an accounting identity: The gap between savings and investment is the amount of capital that has to be imported. This is the current account deficit. We have a capital shortfall within India, so we are importing capital.

It is likely that in the coming year, we will have a current account deficit of 4% of GDP, or $80 billion a year, or Rs.1700 crore a day. This means that we have to worry about how foreign capital views India. Under these conditions, if there is even a short hiccup in capital inflows (as appears to have come about after the government proposed to modify the Mauritius route, and more generally with the problems of governance in India), it yields sharp rupee depreciation.

We import a lot of capital; government policy actions interrupt that flow of capital; the rupee depreciates. This is not mis-behaviour of the financial system. The system is not malfunctioning; it is behaving as it should.

What should the responses be?

There are five sensible paths for government to take, in this situation:

We need to see that at heart, this is a problem of macroeconomics. The root cause of the current account deficit is the fiscal deficit. If we want a lower CAD, we need a lower fiscal deficit.
To ensure the smooth flow of Rs.1700 crore a day into the country, we should not spook foreign. We should not interfere with the de facto residence-based taxation framework which India is giving foreign investors, as long as they come through Mauritius. This policy framework is, in fact, in India's best interests.
Deeper problems about the loss of confidence of foreign investors, owing to governance problems, need to be solved by strengthening governance.
In the face of these difficulties, it would make little sense for RBI to trade in the currency market, to try to block the rupee depreciation. There is good reason for rupee depreciation; the currency market is doing a pretty good job of translating the fundamentals into a price. And, in any case, even if RBI desired to do something about it, its weapons are puny when compared with the size of the currency market and the Indian economy.
It is an opportune time to continue with the liberalisation of the capital account. However, it is useful to think deeply about how to proceed with this. Some kinds of liberalisation can be dangerous. It is important to think about sequencing, and at all times, to worry about unhedged currency exposure. A good deal of expertise has built up on the subject, through the Raghuram Rajan Committee and the UK Sinha Working Group.

An evaluation of what has been done

There are three features of recent policy responses which appear to be on track:

By and large, RBI's trading on the currency market appears to be at a low scale, nearing zero in many recent months. This is wise. It increases respect for the brainpower at RBI.
The government raised the price of petrol, so as to cut the fiscal deficit. This increases respect for the brainpower and political capabilities of the government.
The government decided to defer the attack on the Mauritius treaty by a year (though not to shelve it altogether). In the absence of clear policy statements about the importance of residence-based taxation, this shelving does not increase respect for the government.

Apart from these three good moves, a slew of dubious ideas have been afoot.

A. Enlarging the scope for dollar-denominated borrowing by Indian firms

On 20^th April, 2012: external Commercial Borrowings regulations were amended to:

Increase the limit on power companies to refinance their borrowings in Rupees with foreign currency loans (also called External Commercial Borrowings or ECBs).
Allow companies to borrow in foreign exchange to make capital expenditure for maintenance and operations of toll systems (See here)
Companies were allowed to refinance their ECBs with subsequent ECBs at higher interest rates (See here).

Evaluation: Do we really want Indian firms to hold dollar denominated debt? In particular, firms in the field of infrastructure who have cashflows in rupees? Sensible firm should see the high ex ante currency volatility and stay away from borrowing in dollars without hedging; so the impact upon capital flows will be small at best. And firms that do borrow in dollars and keep it unhedged are probably not going to fare well.

B. Enlarging the scope for dollar-denominated borrowing by banks

On 4^th May, 2012: The maximum interest payable on forex deposits by NRIs in Indian banks was increased (See here):

For deposits between 1 to 3 years the increase was 75 basis points.
For deposits between 3 to 5 years the increase was 175 basis points.

Evaluation: Banks are disaster-prone 19th century institutions. Do we really want them to hold more unhedged foreign currency exposure? Of all places in the economy, this is the worst place to keep unhedged currency exposure. The wise ones will not borrow in this fashion, so the impact upon capital flows will be small at best. And the unwise ones, that borrow in dollars and keep it unhedged, are probably not going to fare well.

C. Reducing the economic freedom of exporters

On 10^th May, 2012: the right of exporters to hold foreign exchange was reduced by 50% (See here):

Exporters were allowed to keep their forex earnings in special accounts called EEFC accounts. They were not mandated to convert it into Rupees. This allowed them the ability to fund imports for their business without going through costly conversions.
Now only 50% of their export earning will be allowed to be kept in forex. The rest will be converted into Rupees against their wishes.

Evaluation: In the old India, FERA made ownership of foreign exchange an exotic and rare thing. Many businessmen in India engaged in import/export misinvoicing and tried to hold assets outside the country. In the early 1990s, C. Rangarajan's RBI embarked on a modern arrangement. Exporters were given greater economic freedom. We are now rolling the clock back by 20 years; we are tampering with current account liberalisation.
The number "50%" has not been justified in the RBI notification. Any exporter, with significant raw material import cost will now pay unnecessary transaction charges. In global trade, where every country takes the utmost effort to keep their exports competitive, any small distortion impacts on export competitiveness; this is pushing in the other direction - it is an attempt to reduce India's export competitiveness.
This is a new low in Indian economic policy. Every internationally oriented household in India will now be more keen to hold assets and liquid balances outside India, safe from the clutches of Indian capital controls. This measure will thus exacerbate capital flight and worsen the problems of the rupee. Success in the marketplace will tend to accrue to businessmen who break laws as opposed to the law-abiding ones.

D. Damaging the currency futures market

On 21^at May, 2012: restrictions were put on exchange-traded derivatives (See here):

The net overnight open positions that the banks hold shall not include positions in the exchanges.
The positions in exchanges cannot be used to offset positions in the OTC market for
The position of banks in currency exchanges shall be limited to $100 million or 15% of the market (whichever is lower)

Evaluation: The world over, there is a clear understanding that the exchange is a superior way to organise financial trading. When compared with the OTC market, the exchange has superior transparency and risk management. Policy makers need to continually modify policies so as to favour a migration of all standardised products away from the OTC market to the exchange-traded contracts. RBI's moves go in the wrong direction.
How do we ensure that the price on a financial market is driven by fundamentals? The answer : We must have a deep and liquid market, and a broad array of sophisticated speculators. RBI's actions are going in the exact opposite direction. They are trying to make the market illiquid. But it is in an illiquid market that we will get market inefficiencies and weird behaviour of the price. They are increasing the chance that something nutty happens on the rupee.
This circular is also a reminder about poor legal process at RBI. Every action by a regulator must articulate a rationale. Financial regulations are motivated by exactly two possibilities - consumer protection or micro-prudential regulation. The government agency that wields the power of financial regulation must show the clear rationale, describing what is the market failure that this regulation is seeking to address. The government agency must show the cost-benefit analysis, explaining why the costs of this action outweigh the benefits. As is typical of financial regulators in India today, RBI's documents show no rationale.
It is possible to conjure one conspiracy theory. The attempts at damaging the liquidity of the currency futures market should be seen in connection with previous work on damaging the liquidity of the OTC market. Perhaps there is a grand plan here. The scale of RBI's trading on the currency market is implausibly small when faced with the size of the Indian economy, with the size of India's cross-border interactions and the size of the currency market (both onshore and offshore). Perhaps these recent moves are designed to damage the liquidity of the market, so as to get to a point where RBI intervention can make an appreciable dent on the price. Perhaps the game plan is to gnaw away at the capability of the currency market through a series of moves, and then take off doing large scale manipulation of the market. If this is the game plan, it reflects very poorly on the economic policy capability at RBI. It would also generate massive profit opportunities for the speculators of the world, who would short the rupee when the large scale manipulation commences.

Rumours about other bad ideas abound. E.g. it is suggested that RBI will sell dollars to exporters directly. How is this different from selling dollars on the market?? It is suggested that the currency futures and the OTC markets should be completely cutoff by banning the arbitrage. How would this solve the macroeconomic problems which bedevil the rupee?

Microeconomic distortions are not a good way to address macroeconomic problems

What does one make of this spectacle? A simple principle worth reiterating is:

Problems rooted in macroeconomics must be addressed using macroeconomic instruments.

We got into this mess because of inappropriate fiscal and monetary policy. We need to solve these -- monetary policy must get back to the business of delivering low and stable inflation, we have to fight inflation until we see y-o-y headline inflation (i.e. CPI-IW inflation) going to the 4-to-5 per cent range. Alongside this, fiscal policy needs to correct itself. Each of these has a clear direction to move in, and movement on any one is valuable regardless of what the other does.

A big element in the picture is the loss of confidence, in the eyes of the private sector, on an array of issues ranging from ethical standards to the sophistication of fiscal, financial and monetary policy. This is an important problem and it needs to be addressed. The spectacle of a government flailing at the macro problems using micro instruments is worsening matters. Perhaps there is constant pressure to announce `new measures' to solve the problem. Deeper solutions are hard, and there is enthusiasm for `doing something' (large or small) [example].

We've seen this movie before. In the last decade, again and again, RBI tried to wield capital controls as a tool for macroeconomic policy. They failed. It is disappointing to see the lack of learning.

Some of the moves above have come out of the reflexive socialism that lurks within the Indian bureacracy. Perhaps, in a crisis environment, the ordinary immune system within each government agency, which keeps the sub-clinical socialism under check, is not working as well. This hurts from two points of view. It betrays the lack of capability of these government organisations; it reminds us that the Indian State is strewn with people who have a low knowledge of economics and a taste for dirigiste. It also reminds us of the policy risk: Precisely when the best capabilities are required (in a crisis), we seem to be slipping into the lowest quality policy initiatives.

Everyone who sees the government / RBI engaged in one ill thought out measure after another gets worried about India's future. How can a $2 trillion economy flourish while such immense powers are placed with individuals and institutions with such weak capabilities? This further damages confidence, which deepens the macroeconomic crisis.

Acknowledgements: We are grateful to Apoorva Ankur, Sumathi Chandrashekaran, Pratik Datta and Kaushalya Venkataraman for useful suggestions.

The costs in buying versus the costs in selling

2012-05-26T02:18:00.001+05:30

All models are wrong, some models are useful. A model reduces complications that are true in return for tractability and insight. In finance, all too often, one complication which has been wished away is transactions costs. A great deal of what we see in the world around us is caused by the costs of transacting. Some of the most important finance is about analysing the causes and consequences of the costs of transacting.

The bid offer spread as a measure of transactions costs

The first flush of the literature draws on markets with market makers, and treats the bid-offer spread as the measure of the cost of transacting. On the NYSE, the specialist posts a bid price and an offer price. If you do two transactions in quick succession -- buy 100 shares and then sell them back -- you will be poorer by the bid-offer spread. The spread is like a tax on a speculator doing a round-trip for a small transaction.

There is no doubt that in that environment, the spread measures something important about transacting. Large databases about the spread are available. A whole literature arose which is rooted in the spread as the measure of the cost of transacting.

Limit order book markets are a whole new world in observability of liquidity

The world changed. Across countries and across asset classes, exchanges have been morphing into anonymous open limit order books. The market maker is not as important. On the open limit order book market, the full set of limit orders are observable, using which we can simulate a market order of any size, and calculate the exact cost that is paid. Suddenly, instead of just seeing a bid-offer spread, we see a whole new world which displays the full `liquidity supply schedule' (LSS) that has the impact cost (in per cent) associated with a single market order of all possible sizes.

An example of the `Liquidity Supply Schedule': The impact cost associated with all possible transaction sizes

When the bid/offer stands at 98/102, and the midpoint quote is 100, if a single market order to buy 1000 shares gets executed at an average price of 105, the buy impact cost for 1000 shares is 5%. This calculation, repeated for all possible transaction sizes, paints the full Liquidity Supply Schedule (the LSS).

Once the LSS is visible, and we start thinking about the world in new ways, and the spread feels like a highly unsatisfactory measure of the cost of transacting. At the NYSE, the market lot is 100 shares for all firms. A share price of $5 means the spread refers to the cost of a transaction size of $500. If the share price is $200 instead, the spread pertains to a transaction of $20,000. Hence, the spread is itself not comparable across securities. In contrast, the LSS can be a standardised calculation that is comparable across all firms, with standardised units on the x axis either in rupees or basis points or market capitalisation.

For us in India who grew up with limit order book markets (NSE from 11/1994 onwards; BSE from 5/1995 onwards), the mainstream Western literature seems a little quaint, given their emphasis of the spread as the measure of transactions costs. We are seeing much more of the liquidity elephant through the LSS, while so many researchers are only seeing it's tail through the spread. In India, the construction of Nifty required the capture of multiple snapshots of the entire limit order book per day, and has generated information about the LSS going back to the mid 1990s.

Since exchanges worldwide have shifted over to an open electronic limit order book, the new focus of measuring liquidity in finance lies in understanding the LSS. What explains cross-sectional and time-series variation of the LSS? What are the consequences of various features of the LSS? These questions have only begun to be addressed in the literature. Rosu has a fascinating recent paper in the Review of Financial Studies, 2009, titled A Dynamic Model of the Limit Order Book that presents one of the first models which predicts the shape of the LSS in an open ELOB market.

Does the impact cost in buying differ from that faced when selling?

One interesting dimension which the LSS makes possible is to think afresh about buying versus selling. The bid-offer spread tells us the round-trip transactions cost. It does not differentiate between buying and selling. When you see that the bid and offer are 100/102, there is no sense in which the transactions cost in buying differs from the transactions cost in selling.

But with the full LSS, we see the impact cost of buying at all transaction sizes separately from the impact cost of selling at all transaction sizes. A first question to ask is: Is there symmetry in liquidity? In the example of the LSS graphed above, it's quite obvious that the impact cost when buying is superior (i.e. lower) than that faced when selling. But this is just one anecdote.

In a recent paper Measuring and explaining the asymmetry of liquidity, Rajat Tayal and Susan Thomas explore this question. With equity spot trading on the NSE, they find strong evidence in favour of asymmetry: impact cost is higher for large sell market order compared to large buy market orders.

Why might asymmetry arise?

What features about traders in the market generate differences between buying and selling? There is one candidate: how traders perceive sell market orders, particularly large sell orders that come despite constraints on borrowing shares, and restrictions on short-selling.

The speculator who makes a forecast that a share price will go down seldom owns the shares; selling requires borrowed shares. Particularly, in India, where formal mechanisms for borrowing shares are as yet quite small, a speculator who wants to sell physical shares has to mobilise borrowed shares on his own.

This may shape the thinking of the people placing limit orders. When I place limit buy orders (which will get hit by a speculative seller), the adverse selection runs against me. If the speculator was not confident about his forecast, he would not bother to borrow shares and sell short. Only when the speculator is really sure would he take the trouble of borrowing shares and doing a sell order. Hence, the person placing limit orders to buy would demand a bigger price of liquidity (i.e. the impact cost), since he runs a greater chance of losing money when giving liquidity to sellers.

The paper highlights a fascinating identification opportunity : at NSE, alongside the trading of the equity spot market, we also have trading in single stock futures. Everything about the two markets is identical: the same securities, the same trading system, the same participants, the same hours of day, etc. There are only two differences: stock futures trading is leveraged, and stock futures trading has cash settlement -- which removes the short-sales constraints. Cash settlement induces full symmetry between buying and selling.

If short sales were the reasons asymmetry in liquidity on the equity spot market, then the stock futures market should have no asymmetry between buy and sell orders. The paper uses the same measurement procedures and statistical tests to compare the asymmetry of liquidity on the spot market as well as for the stock futures market. They find that there is no asymmetry of liquidity on the stock futures market.

If their story is correct, it has many implications. In other market settings observed worldwide, cash settled derivatives should have symmetric liquidity. Physical settled derivatives should have asymmetry - which might get more accentuated as you come closer to expiry. Many natural experiments have taken place worldwide, where futures contracts have shifted from physical to cash settlement: these are all nice natural experiments where changes in asymmetry should become visible. On spot markets, asymmetry should vary with the ease of borrowing. Future research projects could explore these questions.

Financial economics benefits from the best datasets in all economics, and we are able to get sharp and clean papers which pretty decisively answer questions. In India, it has started becoming possible to do innovative work by drawing on data from the open ELOB equity exchanges, CMIE, etc.

The business of Indian politics

2012-05-21T22:28:00.001+05:30

Raymond Fisman, Florian Schulz and Vikrant Vig have a fascinating new working paper: Private returns to public office, which gives us new insights into Indian politics.

We know that elections in India are typically rather close. There is something almost capricious about who wins and who doesn't. The random outcome of an election can, then, be interpreted as randomised allocation into control and treatment. One candidate gets elected, another candidate is very much like him but doesn't get elected.

We can then ask the question: what happened to the wealth of the bloke who got elected? The authors say that the rate of growth of the assets of the person who won grows by 300 to 600 bps per year when compared with the person who lost.

The strongest effects are observed for a person who makes it to being a minister: his asset returns are 1300 to 2900 bps higher than the person who did not win the election.

The paper reminds us of the conditions under which the most fruitful economic research happens today. It's got to be a live and interesting question. A high quality dataset has to be the engine; without good quality data, research is just garbage-in-garbage-out. It's got to persuade us that that the claimed answer is correct. Too often, we in the research profession are failing on these three tests.

Interesting readings

2012-05-15T18:03:00.001+05:30

Mobis Philipose in Mint, Sunil Jain in the Financial Express: on the SEBI order (by Prashant Saran) on the Tayals. Also see coverage on firstpost.

The great debate about Pranab Mukherjee as President of India: read B. S. Raghavan in the Hindu Business Line; Inder Malhotra in the Indian Express.

Nick Robinson in the Business Standard on strengthening the rule-making process, i.e. the legal process for subordinate legislation, in India.

The next generation of reforms in India, a speech by Raghuram Rajan.

I just read Carnage and culture, by Victor Davis Hanson, and I recommend that everyone who thinks about India and international relations and military power should read it too.

As I read Karim Sadjadpour in Foreign Policy on prudishness in Iran, it made me think about Where boys and girls don't talk to each other in the Hindu.

M. Sahoo on SEBI's recent moves on opening up to conflicts of interest in exchanges.

Watch me talk about the current macroeconomic situation. Watch me talk on CNBC-TV18 on the day after RBI's surprising 50 bps rate cut.

I got many questions about seasonal adjustment of the CPI-IW. At our tracking page, we have a technical note on the seasonal adjustment procedure for each of the series. As an example, here is the technical note about seasonal adjustment of CPI-IW.

Financial regulation is particularly complex when the line between the government and the private sector are blurred, when the State contracts-out supervision to private parties, in the field of market infrastructure such as exchanges, clearing houses, depositories, credit rating agencies, etc. Credit rating agencies get paid by the firms that they rate; exchanges get paid by the members that they supervise. Panayotis Gavras has a good article in Finance and Development about the problems faced in the field of credit rating, and potential solutions.

Two new papers: A corporate governance index for large listed companies in India, by Jayati Sarkar, Subrata Sarkar and Kaustav Sen, and Do changes in distance-to-default anticipate changes in the credit rating by Nidhi Aggarwal, Manish Singh and Susan Thomas.

The Cabinet has cleared a Microfinance Institutions (Development and Regulation) Bill. The version of the draft Bill that has got greenlighted is not out in public domain. I hope the present version has fixed up the major flaws visible in the previous publicly visible draft Bill.

A great review by Timothy Snyder, of The Spanish Holocaust: Inquisition and Extermination in Twentieth-Century Spain by Paul Preston, in the New Republic.

John Pollock has a great story about Libya in Technology Review, which helps us to think about China's future in new ways.

Everyone interested in the world economy should read The true lessons of the recession: The West can't borrow and spend its way to recovery by Raghuram Rajan, in the Foregn Affairs.

Reviewing less -- progressing more, a great editorial in the RFS by Matthew Spiegel that gives us an insight into what is going wrong in academic refereeing.

One last thing: Scales.

Faulty tradeoffs in security

2012-05-10T20:54:00.002+05:30

The new world of security in India

Only in a police state is the job of a policeman easy.

-- Orson Welles

The policemen of India say: It is only by using onerous and intrusive tracking procedures that we will be able to block the terrorism, the tax evasion, the money laundering. But society should be designed for the convenience of the median citizen and not for the convenience of the policeman. Yes, when citizens have liberty, it imposes more work upon the policeman. That is a tradeoff we should favour.

In every place in the world, I walk into a coffee shop, open my laptop, and go into free open wifi networks. Except in India. Open wifi networks are banned in India, because they make life difficult for policemen. This is a bad tradeoff : we have sacrificed the immense gains from ubiquitous open wifi networks, in return for reducing the work of policemen.

Terrorists and criminals use roads. Does that mean that we will only permit people with photo IDs to embark on roads? Terrorists and criminals drink water. Does this mean that we will only permit people with photo IDs to buy water? And so on.

Global norms on financial distribution, which have been pushed hard into the direction of more monitoring by the US Treasury, do not require a know-your-customer on every transaction. They only require `customer due diligence' (CDD), which means that the due diligence applied on a transaction should be appropriate (a big principles-based word) for the transaction at hand. We in India have translated this into a mechanistic rule "demand KYC for everything". This is incorrect. A greater push-back is required, from citizens.

In a civilised society, employees of government will have to work hard and work smart in blocking terrorism, obtaining tax revenues, etc. This is okay. We should not set out to make the life of these employees easy. Obtaining a high tax/GDP ratio requires careful, detailed hard work, and a lot of brainpower. In the absence of this, there is a temptation to resort to quick fixes, which should be avoided.

A civil liberties perspective

They who can give up essential liberty

to obtain a little temporary safety,

deserve neither liberty nor safety

-- Benjamin Franklin

We get asked to prove identity to enter an airport, to do financial transactions, to get a mobile phone, etc. We have become used to the idea that this is essential in this world inhabited by too many terrorists.

I think anonymity and privacy are precious and valuable. We in India seem to have given up on protecting civil liberties from an encroaching State that wants to know a lot about us. Particularly given that we are a fragile democracy that works imperfectly, it is important for us to have less information in the hands of the State. One element of the imperfection of our democracy is the undersupply of criticism. We need to cherish and protect the critic, which will be assisted by having a government that knows less about us.

The best we're able to muster today, in the Indian discourse, is the hope that UIDAI will reduce our transactions costs of complying with the surveillance state. I think it's important to go deeper, to question this array of rules that monitor us. How much security do they buy us, in return for what costs to society?

What bang for the buck?

We should be more intelligent in weighing these tradeoffs between imposing costs upon society at large, and the extent to which they help us catch criminals. A great deal of what passes for security procedures today is quite silly when you pause to think about it.

We are obsessed with monitoring electronic payments. The bad guys will just use cash. The amount of money required for pulling off the WTC attacks is believed to be roughly $100,000, which was wired to Mohammad Atta. It is not hard to move $100,000 through non-electronic channels: this is the value of 11 bars of gold, each the size of a pack of cigarettes.

In fact, it is very convenient for the authorities when the bad guys use electronic channels, since greater tracing becomes feasible. We have a fair clue that this money came to Mohammad Atta from Pakistan's ISI because the money was wired; if the bad guys had moved money through cash or gold or diamonds or platinum, we would have not known this crucial fact. It is better for us if more bad guys ride on the electronic highways of the financial system. As long as cash is around in large quantities in India, it makes little sense to block people from coming into electronic payments on the grounds of KYC.

We are obsessed with physical IDs as a tool for security. But the bad guys will easily forge any physical IDs that you can propose. It is not clear what safety we're buying, in return for the enormous human resource and cost in time that is being expended today in checking IDs.

We in India are surprised to discover that in the US, you can buy a temporary one-month GSM SIM card at a storefront, without any know-your-customer or proof of identity. They do not even want to know your name. This is not to say that the security agencies in the US are not watching everyone keenly. The point is that they are doing this in ways that impose lower costs upon society; the security procedures are less of an eyesore.

A need to rethink where we're going

Many elements of the information before us, today, suggest things aren't going well:

In the US, despite a fairly open and liberal system (e.g. freely selling GSM SIMs to anyone, without requiring even a name), law enforcement has been pretty effective: They haven't had a single successful terrorist attack after 2001, despite being the #1 target of myriad nutcases like OBL. In India, thousands of people have died in terrorist attacks, even though we have embarked on a barrage of security procedures.
Every terrorist caught dead or alive in India has a cell phone. This suggests that our attempts at requiring a KYC for every mobile phone aren't so useful.

Failure should have consequences. We should rethink the way we work today, drawing on these blocks of evidence.

We need to ask three questions:

Tradeoffs between freedom and safety. How much of a violation of personal freedom are we willing to accept, in return for better enforcement of laws. We should be willing to sacrifice some safety in return for more freedom. E.g. Saudi Arabia has low crime, but do we want to be Saudi Arabia?
Tradeoffs between prosperity and safety. How much inferior GDP are we getting, as a consequence of the security procedures which are being put into place? We are willing to sacrifice some safety in return for more GDP. E.g. there would be fewer road accidents if the speed limit were 25 kph (and road accidents kill vastly more people than terrorists), but we're willing to live with the carnage on the roads in return for higher prosperity.
Does the claimed security procedure even work?? What is the bang for the buck, the effectiveness of these procedures? As many examples above have suggested, many of the security procedures used in India seem to be poorly thought out.

Drawing on my experiences in Indian public policy process, I can venture a guess about how the prevailing tools of security came about. A meeting was organised. Everybody in the room was an experienced security practitioner. The only viewpoint present was about how the world can be redesigned to make life easier for the employees of government. Everyone was indignant. We have to do something. A few security as theatre proposals came up. Everyone agreed. It felt like we were making progress; we certainly got plenty of showy security procedures to impress Parliamentarians and the media. Nobody asked second order questions; nobody analysed the data. This combination of factors (indignation, decision making dominated by the status quo, theatre to satisfy journalists and politicians, lack of a feedback loop through data capture and data analysis) is not conducive to problem solving.

We in India repeatedly find ourselves in a situation where law enforcement is placed under pressure to deliver. Whether it is a crime wave, or a terrorist attack, or a low tax/GDP ratio: officials are asked to do better. Such demands for performance are entirely appropriate. However, at such times, we should be careful to not accede to bargains where the enforcers promise results in exchange for arrangements that make life convenient for the enforcers, at the expense of the open society.

Insourcing vs. outsourcing government functions: A setback for public sector production of elementary education

2012-05-06T17:47:00.001+05:30

A recurrent theme in the field of public administration is the appropriate separation, between things done within government qua government, versus the things that are best contracted out.

Example: A fascinating question in finance is the supervisory role of exchanges. Do we want exchanges to be rule makers and the front line of supervision, or do we want them to be mere profit-maximising IT companies who run trading systems, with all regulatory/supervisory functions being performed by SEBI? Is the exchange a public utility or a mere business?

In the field of education, the question is: Should government be the producer of education services (building schools, worrying about drinking water at the school, hiring teachers etc.) or should the actual production be done by private schools, with government giving money and decision making power to parents (through vouchers) and working on the public goods of education (measuring what children know, establishing curriculum, releasing information about each school into the public domain so as to assist the decision making of parents).

Our thinking on these boundaries is critically related to our views about the capabilities of government and the complexity of the problem.

How should we think about complexity? Problems that are hard, in the field of public administration, have three characteristics: large number of transactions, high discretion in the hands of the front-line civil servant, high stakes. (On the first two, see Pritchett & Woolcock, 2004). Under these conditions, production in government is hard.

How should we think about capability of government? When the government is fluently able to reorganise agencies, shift functions from one government agency to another, achieve cooperation between multiple government agencies, hire and fire civil servants, and pay market wages, then the government is going to be a capable one. A government that is weak on all these attributes is a low-capacity one.

Our views about the appropriate separation between in-sourcing and outsourcing would thus vary by problem and locale. For some problems, production in government is easy, and we'd be less emphatic that contracting-out should be done. E.g. monetary policy is easy, and there is no big problem with keeping it inside government. In some places, the government has high capacity - e.g. public schools work relatively well in Sweden. In other places, when the government has low capacity, we'd be more keen to contract things out.

Turning to the Indian setting, there are two huge problems that hold back the possibility of building high quality public schools. First, civil servant wages are set to 2x to 3x higher levels, when compared with market prices, thus inflating the cost of government schools. If you took the same money and gave it to parents, who chose a private school on their own, the private school would be recruiting much better teachers. Second, civil servants can't easily be fired, thus reducing the incentives of teachers to teach. Teaching is a transaction-intensive discretionary public service. When the front-line provider has no incentive to work, the quality of teaching will collapse, as has been seen with schools in India.

Some states in India had, appropriately, tried to fight these problems by going to the basics: by bringing in non-tenured staff at lower wages. By recruiting these "para-teachers", we improve production of education in the public sector. These two issues are of essence. By removing tenure, we increase the incentive of teachers to teach. By bringing wages in line with market conditions, we bring public sector production closer to the cost efficiency that can be obtained by the private sector.

This line of attack may now be torpedoed by the courts. The Gujarat High Court sees to have ordered the government to pay para-teachers full wages and give them tenure.

If this goes through, and if this creates a precedent for the rest of India, then this pretty much closes off these avenues for strengthening public sector production. It would, then, emphasise vouchers as the only way to go.

There is one important slip between cup and lip. The Right to Education (RTE) Act, one of the less impressive legislative achievements of the Indian Parliament, asks state governments to write rules about salaries paid by private schools. RTE was an attack by the public sector education providers against the private sector: so they wanted to kill off the ability of the private sector to pay market wages. Some states have written rules under the RTE which force private schools to pay civil servant wages. For these states, the gains from private production of education services will be smaller. Other states have been silent on this, and there is then a possibility of reaping the full superiority of private production.

I am grateful to Jishnu Das, Lant Pritchett, Parth Shah and Jeff Hammer for useful discussions on this.

Regulated cost of capital for airports

2012-04-25T10:18:00.001+05:30

Many elements of infrastructure have natural monopoly characteristics. Under these conditions, if the owner of the infrastructure is profit-maximising, he is likely to impose high user charges and extract a monopoly rent. As a consequence, in many infrastructure services in most countries, independent regulators are established which control the user charge.

The critical building block that goes into this is assessing the `fair' rate of return on equity capital. By and large, infrastructure projects have low betas; whether business cycle conditions are good or bad, they tend to generate stable cashflows. By this logic, the rate of return obtained by the developer should be relatively low.

India requires a trillion dollars of infrastructure investment in coming years. For this to come about properly, sound thinking on the appropriate rate of return is required. If this rate of return is set too low, then the required investments will not be forthcoming. If the rate of return is set too high, then developers will earn monopoly rents, and the economy will be hobbled with expensive infrastructure.

The regulated industry has strong incentive to lobby with the regulatory agency. Almost nobody else in the country has detailed technical knowledge about the activities within the regulated industry. This field is thus fraught with problems of governance, the capabilities of regulatory agencies, etc. High quality public discussion, and criticism of the activities of regulatory agencies, is thus critical to ensuring that the outcomes are sensible. Our puzzle in India is that of getting to an ecosystem comprised of well drafted laws that create independent regulators, high quality staff in regulators, high quality independent experts outside government, well educated journalists, freedom of press, etc.

In this setting, an important order has been released by the Airports Economic Regulatory Agency (AERA): tariff setting for the Delhi airport. This will be of great interest to people interested in the fields of infrastructure financing and corporate finance in India. In my knowledge, this is the first episode in the field of Indian infrastructure where high quality corporate finance knowledge has gone into tariff setting. The arguments and methods here will be relevant for other airports, and for other areas of infrastructure.

The genesis of India's 'basic structure' doctrine

2012-04-23T20:36:00.001+05:30

by Pratik Datta.

India and Pakistan are slowly reintegrating their economies, through trade and investment. Will we stop at sterile commercial transactions, or can there be more to the engagement of the two countries? Most of us in India think of Pakistan as a country with serious governance problems; we think that India has little to learn from Pakistan. A careful reading of history will surprise most of us.

One of the most important developments in the history of the Indian Constitution was the rise of the `basic structure' doctrine, which limits the extent to which a powerful political configuration can amend the Constitution. What is not widely known is the intellectual links that led up to this. A judge of the Supreme Court of India created what was possibly the first constructive jurisprudential connection between India and Pakistan: he imported the concept of basic structure into Indian jurisprudence from a decision of the Supreme Court of Pakistan. This is not to say that the basic structure doctrine was not discussed before by myriad scholars and applied in other countries, but merely to celebrate an old acquaintance that not too many of us recall today.

The authors of the Constitution of India saw the necessity of having a mechanism for amending the Constitution: Art. 368 of the Indian Constitution. However, one question that has time and again caught the attention of the Indian Supreme Court is the extent of this amending power. For example, can Parliament amend the Constitution and make India an autocracy? If not, then is there any implied restrictions to the power of amendment? And if such restictions do exist, what is the scope of judicial review of an amendment passed by a super majority of the elected representatives of the country?

There appear to be three critical milestones in India's path to the basic structure doctrine.

Justice Mudholkar in the case of Sajjan Singh (AIR 1965 SC 845), for the first time (para 63) used the phrase `basic feature' of the Constitution to argue that there are certain features of the Constitution that cannot be amended by the Parliament through its amending powers under Art. 368 of the Constitution. This judgment was a seperate concurrent opinion and not the majority view of the Court. Justice Mudholkar drew upon the Pakistan Supreme Court's decision in Fazlul Quader Chowdhry v. Mohd Abdul Haque, 1963 PLC 486, which had used the basic structure doctrine already.

The phrase `basic structure' or `basic feature' of the Indian Constitution has arisen in some decisions before Mudholkar, J. pointed it out in 1964. For example, in re: Beruberi Union case (AIR 1960 SC 845) and State of West Bengal v. Union Of India (AIR 1963 SC 1241) used the phrase but in a much looser sense and not squarely in the context of implied limitations to the amending power under Art. 368. It is, then, fair to say that Justice Mudholkar was the first important introduction of this concept into Indian jurisprudence.

The decision of Sajjan Singh came up for reconsideration by the Supreme Court in IC Golak Nath's case (AIR 1967 SC 1643). Justice Wanchoo after opining in para 113 that `the power to amend includes the power to add any provision to the Constitution, to alter any provision and substitute any other provision in its place and to delete any provision', went on to discuss in para 115 if there are any implied limitations on the power of amendment under Art. 368. In this context he referred to the doctrine of basic structure as was highlighted for the first time in India in the separate opinion of Justice Mudholkar. However, Justice Wanchoo ultimately opined that no limitations can be and should be implied upon the power of amendment under Art. 368 but did not go into the question as to whether Art. 368 can be used to repeal the present constitution and come up with a completely new one. Justice Wanchoo was however speaking only for himself and two other judges amongst the 11 who were on the bench. Finally, 6 judges held that Fundamental Rights cannot be taken away by an amendment while 5 judges held that Fundamental Rights can be taken away by an amendment. However, the line of argument taken up by Mudholkar and Wanchoo, that there are implied restrictions to the power to amendment under Art. 368, was still a fringe argument.

This implied restriction or basic structure argument gained prominence for the first time in Kesavananda's judgment (AIR 1973 SC 1461) where a 13 judge bench of the Supreme Court deliberated on this issue. In spite of the length and complexity of the judgment, the one ratio that emerges out of it is that the amending power under the constitution cannot be used in a manner so as to interfere with the basic structure of the Indian constitution. Reference to Mudholkar's views in Sajjan Singh (which in turn was the view of the Supreme Court of Pakistan) was made in para 681.

It is in this context, we should recognise the immense contribution of the Supreme Court of Pakistan to the constitutional jurisprudence of India. And Justice Mudholkar needs to be credited for at least trying to make possibly the first jurisprudential connection between the two neighbours back in 1964.

Developments on implementation of the GST

2012-04-23T18:25:00.001+05:30

by Viral Shah and Ajay Shah.

As with many other problems in Indian economic reform, getting to the right destination on the GST requires winning on policy, politics and administration. On the policy side, the basic design of the GST needs to be done right. Pulling this off will require great political skill - a coalition of beneficiaries from the GST will need to champion it in the Indian federal setting. Finally, assuming that the policy and the politics has been done well, it will require the right plumbing. In this blog post, we review progress on this third element.

Done right, the GST ought to replace all existing indirect taxes. This would remove barriers to inter-state commerce, and create an Indian common market. It should treat all goods and all services identically. It should be a single administrative system covering tax payments to both Centre and States thus eliminating the compliance cost that is associated with dealing with multiple tax authorities. It should be globalisation-compatible: goods and services sold to non-residents would be fully refunded the entire burden of indirect taxation that has been incurred at all stages of production. India would then follow the principle of not taxing non-residents. This would be fair for domestic producers who face foreign competition, and ensure competitiveness of domestic producers selling abroad.

These are powerful and important economic concepts. However, their translation into reality is critically about execution. In the case of the GST, as with the New Pension System, the problem of execution is substantially (though not entirely) a question about building large IT systems.

While much of the legal and policy framework around GST is still being worked on by the Central Government in consultation with States, some progress has been made on setting up the infrastructure for processing registration, returns, and payments in a standardised manner. A detailed note on the IT infrastructure for GST has been put up by the Ministry of Finance.

In terms of organisation structure, existing success stories include the Tax Information Network (TIN) and the New Pension System, both of which are being managed by NSDL. A more general concept of `National Information Utilities' (NIU) was proposed by the TAGUP Report. This report drew on the success of establishing market infrastructure institutions such as NSE and NSDL, and recommended that NIUs be such non-Government companies, with Central and State Governments as joint shareholders, dispersed shareholding among other institutions, avoiding shareholders that may have a conflict of interest, and avoiding listing on exchanges. In spirit, NIUs must have the efficiency of a private corporations, but be animated by a public purpose.

In the Budget Speech of 2012-13, the Finance Minister announced that a NIU for implementing the GST would be constructed. It would be called GSTN and would be fully operational by August 2012. The first steps towards constructing GSTN have now been taken, with a Cabinet approval for GSTN. The official press release on this says:

The Cabinet has approved a proposal to set up a Special Purpose Vehicle (SPV) namely Goods and Services Tax Network SPV (GSTN SPV) to create enabling environment for smooth introduction of Goods and Services Tax (GST). GSTN SPV will provide IT infrastructure and services to various stakeholders including the Centre and the States.

The GSTN SPV would be incorporated as a Section 25 (not-for-profit), non-Government, private limited company in which the Government will retain strategic control. It would have an equity capital of Rs. 10 crore, with the Centre and States having equal stakes of 24.5% each. Non Government institutions would hold 51% equity. No single institution would hold more that 10% equity, with the possibility of one private institution holding a maximum of 21% equity.

GTSN SPV would have a self-sustaining revenue model, based on levy of user charges on tax payers and tax authorities availing its services. While the SPV's services would be critical to actual rollout of GST at a future date, it is also expected to render valuable services to the Centre / State tax administrations prior to the GST implementation.

Welfare programs change behaviour

2012-04-21T18:26:00.000+05:30

Many people like to envision worlds where the State will tax the rich and help "the needy" - this ranges from free health care to unemployment insurance to disability insurance, etc.

There are many problems with these schemes. One of them is the fact that people respond to incentives. We are not bricks, we are not stones, but men, and being men, we will optimise. When unemployment insurance is offered, people will try less hard to find a job, to acquire skills that will get them a job, to migrate to a place where jobs are more easily found, etc. When health care is free, people are more inclined to be fat or smoke or otherwise take less care of themselves. And so on.

Among economists, it's considered obvious that people drive in a more rash manner when wearing a seat belt, but in the wider discourse, this raises hackles. When researchers found that drivers pass closer when overtaking cyclists wearing helmets as compared with overtaking bare-headed cyclists, economists were among the few who were not surprised. Laypersons generally recoil from the idea that the presence of a government giving out free open heart surgery increases obesity.

The first element of the behavioural change is lying and misrepresentation by citizens. When a government says it will give out disability insurance, people have an incentive to go to a civil servant and claim that they are disabled. I remember hearing a story from Holland, when a certain set of rules were constructed to give an early pension to the disabled, and policy makers had estimated that 1% of workers would be eligible for those benefits. In a few years, 10% of workers tried to claim these benefits, and front-line civil servants were placed in the difficult situation of having to identify the few genuinely disabled within the large pool that was claiming to be disabled.

The second layer is genuine changes in behaviour. Ljungqvist/Sargent have emphasised the damage caused by European-style welfare programs, which encourage or support withdrawal from the labour market. Some of these problems are now coming about with NREG. Migration out of villages is central to India's future, but NREG is reducing the incentives of people to engage with the urban labour market and ultimately to leave.

I just came across an example of behaviour distorted by incentives that veers on the fantastical: An unemployed Austrian man sawed his foot off, to avoid being found fit enough to go back to work. We find it incredible that Aron Lee Ralson cut off his right arm (to avoid certain death). But sawing your foot off to avoid going back to work?

This is a colourful story and only an anecdote. The man is most likely a nutcase. It is nobody's case that such extreme responses will come about on a large scale. The claim of the microeconomics literature is more limited: that on average, fairly significant behavioural changes come about in response to changes in the rules of the game. Through this, welfare programs have unintentional consequences that go far beyond those visible at the surface.

Politicians and bureaucrats in India like to roll out out more welfare progarms. It would be useful to bring alternative perspectives on these questions, which are mainstream worldwide but are considered cutting edge in India: about the limited governance capacity of the State, about the fiscal crisis that the State faces, and about the behavioural changes induced by welfare programs. In this field, you may like to see a paper by Vijay Kelkar and me.

RBI's rate cut

2012-04-19T10:05:00.002+05:30

Watch me talk about it on CNBC-TV18.

The inflation crisis has not ended

2012-04-12T13:55:00.000+05:30

The most important measure of inflation in India is the year-on-year change of the CPI-IW index. This time series, for 120 months, is shown above. From 2006 onwards, India slipped into a new phase of macroeconomic instability, where inflation has strayed far outside the informal target zone of inflation at four-to-five per cent.

Has inflation subsided?

In recent months, there has been a surge of optimism that the inflation crisis is coming to an end. However, a careful look at the seasonally adjusted data reveals that there is cause for concern.

Month	P-o-p SA	Y-o-y
Sep 2011	17.49	10.06
Oct 2011	2.01	9.39
Nov 2011	3.11	9.34
Dec 2011	-2.14	6.49
Jan 2012	8.22	5.32
Feb 2012	12.01	7.57

In September 2011, point-on-point seasonally adjusted (annualised) inflation was at 17.49 per cent. The year-on-year inflation was running at 10.06%.

We then had three good months: October, November and December, where the point-on-point seasonally adjusted (annualised) inflation dropped to 2.01, 3.11 and -2.14 per cent. This yielded a sharp decline in the year-on-year inflation to 6.49 per cent in December 2011 and further to 5.32 per cent in January 2012.

But after that, things haven't gone well. Point-on-point seasonally adjusted inflation, which is the thing to watch for in understanding what is happening every month, is back up to 8.22 per cent in January 2012 and 12.01 per cent in February 2012. Year-on-year inflation is back up to 7.57 per cent in February 2012.

A casual examination of the key graph (shown above) shows that the worst of double digit inflation seems to have ended. But we are not inside the target zone of 4 to 5 per cent, and neither are we likely to achieve this in the rest of this year. It would be unwise to declare victory over the inflation crisis, with this information set in hand.

Looking forward

Looking forward, there are two main problems worth worrying about. The first is the expectations of households. At the heart of India's inflation spiral is the problem that the man in the street has lost confidence that inflation will stay in the four-to-five per cent target zone. Survey evidence about household expectations has shown double digit values. This generates persistence of inflation; idiosyncratic shocks tend to not quickly die away. The mistrust of households is rooted in the lack of commitment to low and stable inflation at RBI, and this problem is not going to go away quickly. Despite all the problems faced in fighting inflation, RBI continues to communicate, through speeches and official documents, its lack of focus upon inflation.

The second problem is that of the exchange rate. Exchange rate depreciation feeds into tradeables inflation. With a large current account deficit, with policy impediments putting a cloud on capital inflows, rupee depreciation has taken place and may continue to take place. This would be inflationary. Indeed, if RBI chooses to cut rates on the 17th, there will be further weakening of the rupee (since the interest rate differential will go down thus deterring debt flows), which will further exacerbate tradeables inflation.

The media and financial commentators treat it as a given that on 17th, RBI will cut rates. However, the outlook on inflation is worrisome. India's inflation crisis, which began in 2006, has not ended. Year-on-year CPI-IW inflation has not yet got into the target zone of four-to-five per cent, nor is this likely to happen anytime soon.

Our thinking on this needs to factor in the general elections, which are looming at the horizon in May 2014. Given the salience of inflation in India for the poor, the ruling UPA coalition is likely to be quite concerned about getting inflation back to the informal target zone of four-to-five per cent, well ahead of elections. This also suggests that the time for hawkish monetary policy is now, so as to get inflation under control by mid-2013, well in time for elections in mid-2014.

A historical perspective

Inflation went out of control in 2006/2007 because RBI's pursuit of the exchange rate peg required very low interest rates at a time when the domestic economy was booming. (The capital controls that were then prevalent failed to deliver monetary policy autonomy; the only way to get towards exchange rate goals was through distortions of monetary policy). Given the lack of anchoring of household expectations, that inflation crisis has not yet gone away. Today, RBI is substantially finished with exchange rate pegging; we are mostly a floating exchange rate. In the future, inflationary expectations will not get unhinged owing to a pursuit of exchange rate policy by RBI. But while a pegged exchange rate pins down monetary policy, a floating exchange rate does not define monetary policy. RBI has yet to articulate what it wants to do with the lever of monetary policy. The first task for the lever of monetary policy should be the conquest of the inflation that is in our midst, owing to the monetary policy stance of 2006/2007.

In the early 1990s, unsterilised intervention in the pursuit of Rs.31.37 a dollar gave an inappropriate stance of monetary policy, which kicked off an inflation. Dr. Rangarajan wrestled it to the ground, even though the monetary policy transmission was weak then. In 2006, we ignited another inflation, once again owing to exceedingly low policy rates in the pursuit of exchange rate policy. Dr. Subbarao's challenge lies in wrestling this to the ground. His job is easier when compared with what Dr. Rangarajan faced, thanks to the progress which has taken place on financial reforms and capital account decontrol.

New insights into the events on the Indian stock market in the mid-1990s

2012-04-11T22:52:00.001+05:30

Liquidity matters

One of the most important features of a financial market is liquidity. In a well functioning market, a trader faces low costs of transacting and can confidently expect that at future dates, across many states of nature, the cost of transacting will prove to be low.

The immediate impact of a low cost of transacting is that it imposes a lower `tax' upon the speculator, who brings new information into prices, and the arbitrageur, who removes obvious mistakes in prices. The long-term impacts that are obtained when the trader can confidently expect that transactions will be inexpensive are in two parts. When investors expect to waste money in buying and then selling a certain security, they demand higher rates of return from it: i.e., the cost of capital for the issuer goes up. And, when traders are confident that high liquidity will persist into the future into a diverse array of states of nature, they will more confidently embark upon dynamic trading strategies which are required for producing useful securities such as options.

Measurement of liquidity

In an electronic limit order book market, a static concept of liquidity is eminently visible: you look at the order book and work out what is the impact cost faced when doing transactions of a desired size. E.g. it is easy to take order book data from NSE and work out the impact cost seen for doing a transaction of Rs.10,000 for all companies.

Impact cost accurately measures the instantaneous cost faced when placing an order of the stated size. It is a observed precisely in a modern exchange setting. There are two weaknesses. No large order is going to be placed as one single market order into the order book. Hence, the analysis of the NSE order books does not guide us in understanding liquidity when doing large sized transactions, e.g. Rs.1,000,000. The moment we think of orders that are spaced over a short time (e.g. I break up an order for Rs.1 million into 100 orders of Rs.10,000 each) or over a long time (e.g. dynamic hedging of an option book) I have to worry about the fluctuations of impact cost, or my liquidity risk.

The biggest problem lies in the fact that in numerous market situations, order book information is not observed. Two key areas are: the deep past, before order book data existed, and the OTC market, where there is no order book. E.g. the CMIE daily returns data for BSE starts from 1/1/1990. NSE equity trading began in 11/1994. But NSE's order book snapshots (thrice a day) only exist from 4/1996 onwards. For the period prior to 1996, there is no data on liquidity.

The power of range

The first flush of the financial economics focused on returns. It was amazing, the amount of interesting work that could be done once you had assembled a dataset with daily returns. This was first done at the Centre for Research on Security Prices (CRSP) at the University of Chicago, and it made possible an entire generation of financial economics.

As an example, the ARCH model is a very clever way to utilise pure returns information and construct a time-varying notion of volatility. Models of the ARCH family assumes that volatility is deterministic, and that it responds to realisations of returns.

A remarkably important fact looks beyond returns to the range between the day's high and the day's low price. When volatility is high, the range is higher. Range is a volatility proxy. This has been known for a while -- e.g. On the estimation of security price volatilities from historical data, M. B. Garman and M. J. Klass, page 67--78, Journal of Business, 1980.

In the late 1990s, people got back to looking at this in a new way. We understood that range is an enormously informative volatility proxy. There is much more information in the range of the day than is found in the squared returns of the day.

Another new volatility proxy is `realised volatility', where you difference intra-day returns to construct a time-series of returns within the day. As an example, in an 8-hour trading day, there are 480 minutes. So you could difference returns into 5-minute intervals, and you have 96 readings of returns on each day. The standard deviation of this is a good measure of the volatility of the day. As an example, the recent paper by Grover and Thomas, Journal of Futures Markets, August 2012, does performance evaluation for a VIX estimator by asking for better predictions of future realised volatility.

In the ARCH world, volatility of the day was not observed, and squared daily returns was a poor proxy for this. Realised volatility is a highly precise estimator of the volatility of the day, and range is also remarkably good.

Constructing a deep history of stock volatility

Using intra-day data, it is possible to construct a realised volatility for every security for every day. This is obviously infeasible for the period when intra-day data is not observed - e.g. in India before electronic trading came along, i.e. before November 1994.

But as long as the day's high and the day's low are observed, one can construct a range-based measure, and thus push deeper into history.

Constructing a deep history of stock liquidity

When trading is electronic, it is possible for the exchange to produce `snapshots' of the limit order book, as has been done by NSE from April 1996 onwards. Using these, it is easy to get precise estimates of the spread for all stocks. But what about the period before that?

I just read a fascinating paper: A Simple Way to Estimate Bid-Ask Spreads from Daily High and Low Prices by Shane A. Corwin and Paul Schultz, Journal of Finance, April 2012. Their key insight is that the day's high is almost always at the ask and the day's low is almost always at the bid. When the high/low is computed over two days, the variance is doubled but the spread component is intact. This generates a mechanism for extracting a spread estimator using only high-low data.

I liked the paper a lot. At its best, finance is close to data, the data has low measurement error, the work is careful and grounded in a detailed institutional understanding of reality, and the results open up new lines of inquiry.

Using these new ideas, it becomes possible to dig into history, using the CMIE data for BSE which goes back to 1/1/1990, and construct liquidity measures for that deep period.

The authors do precisely this:

They show a big and dramatic drop in the spread at the time when electronic trading came in. There are three key dates here: NSE started electronic trading on 3 November 1994, BSE started electronic trading on 14 March 1995 and in November 1995, NSE became the dominant exchange [link]. This is a valuable addition to our understanding of these events. I do worry about mistakes in measurement of the day's high and day's low, however, prior to the onset of electronic trading at NSE in November 1994.

I found it fascinating, how a 2012 paper has produced a better understanding of our history of the mid-1990s.

Understanding the badla episode

What is equally interesting, and what is not mentioned by the authors, is the dog that did not bark prior to the launch of NSE. This is the event where SEBI forced BSE to stop badla trading.

I had worked on this question at the time (in 1996). I had rigged up a matching scheme where each A group company (where badla trading used to take place) was matched against a partner from the B group (where there had never been badla trading). This allowed you to construct a hedged portfolio: long the A group companies and short the B group companies. The performance of this portfolio is:

This hedged portfolio has a most satisfying zero return in the days before SEBI's decision. This gives us confidence that the matching is done well. The two big dates of SEBI decisions -- 12 December 1993 and 12 March 1994 -- show big negative returns for A group companies. And from 4 November 1994, when trading at NSE began, we start seeing a recovery.

At the time, this was interpreted at the time as a liquidity premium. See Short-term traders and liquidity: A test using Bombay Stock Exchange data by Berkman and Eleswarapu, Journal of Financial Economics, 1998, who worked this out nicely.

But the new evidence for the deep history of spreads on the BSE, by Corwin and Schultz, suggests that there was no big change in liquidity in 1993 or 1994. This raises new questions about why such large price reactions were observed. I used to think this was a great liquidity premium story; now I'm not so sure. I'm pretty certain that A group companies had sharp negative returns in early 1994, but I am now less sure that we know why.

Path-breaking rules under the Right to Education Act, in Gujarat

2012-04-10T22:10:00.001+05:30

by Parth Shah.

One major initiative of the Indian government, in the field of education, was the Right to Education Act of 2009. This act has major problems, as has been argued by numerous observers and experts in the field. This Act focuses on the interests of incumbent public sector education providers, instead of focusing on the interests of children and parents. It is focused on inputs into the educational process, regardless of the outcomes which are coming out. It penalises private schools that have weaknesses on inputs, regardless of the fact that these schools often induce better learning outcomes when compared with public schools.

At the same time, the translation of the Act into benign or malign outcomes critically hinges on the Rules under the Act, which are notified by State governments. Thus, now that Parliament has chosen to enact the RTE Act, the critical frontier that matters is how state governments choose.

In recent weeks, Gujarat notified its Rules for the implementation of the Right to Education Act (RTE) 2009. It has introduced some of the most innovative ideas for recognition of existing private unaided schools. The Committee in charge of drafting the Rules in Gujarat, that was headed by the former Chief Secretary Mr.Sudhir Mankad, has broken new ground in understanding the policy issues faced in education in India today.

Instead of focusing only on input requirements specified in the Act like classroom size, playground, and teacher-student ratio, the Gujarat RTE Rules put greater emphasis on learning outcomes of students in the recognition norms. Appendix 1 of the Gujarat Rules is the one which has a path breaking formulation for recognition of a school: this will be a weighted average of four measures:

Student learning outcomes (absolute levels): weight 30%: Using standardised tests, student learning levels focussing on learning (not just rote) will be measured through an independent assessment.
Student learning outcomes (improvement compared to the school's past performance): weight 40%: This component is introduced to ensure that schools do not show a better result in (1) simply by not admitting weak students. The effect of school performance looking good simply because of students coming from well-to-do backgrounds is also automatically addressed by this measure. Only in the first year, this measure will not be available and the weightage should be distributed among the other parameters.
Inputs (including facilities, teacher qualifications): weight 15%
Student non-academic outcomes (co-curricular and sports, personality and values) and parent feedback: weight 15%: Student outcomes in non-academic areas as well as feedback from a random sample of parents should be used to determine this parameter. Standardised survey tools giving weightage to cultural activities, sports, art should be developed. The parent feedback should cover a random sample of at least 20 parents across classes and be compiled.

This is one of the first times in India's history that public policy has focused on children and parents, instead of focusing on the public sector producers of education services.

Furthermore, the Gujarat RTE Rules have taken a more nuanced and flexible approach in other areas too. For instance, both class size and teacher-student ratio have not been defined in absolute terms, but in relative terms. The required classroom size is 300 sq feet but in case classrooms are smaller, then instead of re-building them, the Rules allow for a way to accommodate that with a different teacher-student ratio. The formula is: Teacher Student ratio = (Area of the classroom in sq feet-60)/8. This approach not only allows smaller classrooms to exist but also gives schools a more efficient way to manage physical infrastructure.

If a private school is unable to meet recognition norms, then the RTE Act de-recognises the school and forces it to close down. This sudden forced closure would create serious problems for the students and parents who would have to find a new school in the neighbourhood. The Gujarat Rules allow for the State to takeover the school, or transfer management to a third party, and create a genuine possibility for the school to continue and meet the norms. This, once again, shows the focus of the Gujarat Rules upon the interests of students and parents.

This approach is significantly better to that of the other states where recognition norms are based solely on input requirements and that are also rigid (like playground, classroom size and teacher-student ratio). The Gujarat approach recognises the substantial contribution made by budget private schools in urban and semi-urban areas where land and buildings are very expensive. Actually many government schools themselves would not be able to meet the rigid input norms that RTE has mandated.

FSLRC has a website

2012-03-29T23:27:00.003+05:30

The Financial Sector Legislative Reforms Commission is one of the important elements of economic reforms in India. It now has a website.

Justice Srikrishna and Chirag Anand at the inaugural

NIPFP-DEA Research Program: third MOU going out till 2014

2012-03-29T01:47:00.000+05:30

From August 2007 onwards, the Department of Economic Affairs (DEA) of the Ministry of Finance (MoF) has collaborated with NIPFP on a new kind of research arrangement titled the `NIPFP-DEA Research Program'. This institutional innovation induces capacity building in the fields of macroeconomics and finance at the Macro/Finance Group of NIPFP, original academic and policy papers in these fields which are released into the public domain, and policy advice in these fields for DEA.

Earlier this month, the third MOU was signed for the NIPFP DEA Research Program, thus carrying this working arrangement forward till March 2014.

R. Gopalan, Thomas Mathew, M. Govinda Rao and Manoj Govil at the signing ceremony

Interesting readings

2012-03-25T11:28:00.001+05:30

The new Indian journalism: Vinod K. Jose in Caravan magazine profiles Narendra Modi.

Bibek Debroy on the prospects for the CPI(M) in West Bengal.

Ronald U. Mendoza has an article on voxEU which should ideally trigger off similar research by political scientists in India, about politics as a family business.

A caucasus wedding, by an unnamed US foreign service person. This is fascinating reading from two points of view. First, I'd love to get the Wikileaks report about the same wedding filed by the corresponding Indian diplomat. I fear our guys are just not in the same league in terms of the quality of despatches. And, there was something eerie in this story: it reminded me of the socially backward subset of India.

Trampling on the individual in India: A response by Suw Charman-Anderson, on Firstpost, to Kapil Sibal's dreams of tracking the location of every resident of India. A country where the government knows less about citizens is likely to be a country with greater de facto freedom of speech
Learning how to argue, an interview with Ran Yunfei by Ian Johnson in the New York Review of Books. It's an interesting glimpse into China. It's also relevant for India as we face a series of attacks upon freedom of speech.

Haseeb Drabu in Mint worries about the record 25 amendments found in the Finance Bill that apply with retrospective effect.

Mobis Philipose on SEBI's concerns about algorithmic trading.

The Kingfisher bankruptcy is helping us think more clearly about the problems of failure of firms. I read a remarkable blog post about it. And, see a debate between Vikas Bajaj and Heather Timmons on the New York Times blogs.

Open DataCamp 2012, in Bangalore on 24 March.

The public and its problems by Raghuram Rajan, in Mint.

How to help the Syrians by Hugo Dixon. He talks about Why civil resistance works by Erica Chenoweth and Maria Stephan. This is a paper and a book. Put together, these give you fresh insights into India's path to independance.

Glowing pork, exploding watermelons by Thomas N. Thompson, in Foreign Affairs, on the problems of food safety in China. I wonder how we are faring on these questions.

I have wondered why my interest in watching TED talks had dwindled away. Benjamin Wallace, in New York magazine, helps understand what happened there.

Why Ngozi Okonjo-Iweala should be the next head of the World Bank

2012-03-24T21:21:00.001+05:30

by Lant Pritchett.

The US had a chance to lead. It abdicated that chance, to play domestic politics and put forward a US nominee who is manifestly less qualified to be head of the World Bank, than the alternative candidate nominated by African countries: Ngozi Okonjo-Iweala.

The World Bank is a full-service development institution that provides loans, grants and development advice to promote development, which is the transformation of countries towards prosperous economies that support broad based improvements in material well-being, democratic polities that respect citizen rights and respond to citizen demands, and capable administrations that allow governments to carry out their core functions: law and order, education, macro-economic management, health, infrastructure, regulation, security.

Therefore an ideal candidate should have:

Some experience in government and the process of policy-making (as the World Bank's clients are all governments);
Some acquaintance with economic policy and policy making: including the tough choices like allocation of resources across uses;
Some knowledge of finance (it is, after all, a bank that makes income from lending money);
Perhaps some management experience in a multilateral organization;
Exposure to the breadth of development issues.

Experience in Government.: Ngozi has been the Minister of Finance of Nigeria, twice. If one had to name a tough job in the world, I think that would be it. She did it first from 2003 to 2006 and by all accounts handled a very tough situation -- including tackling entrenched corruption -- in an admirable way. Jim (to be fair we'll use first names for both) has no experience in government. He has been engaged in development as an academic and through NGOs.
Advantage Ngozi.
Acquaintance with Economic Policy.: Ngozi has had training in economic development from MIT. Jim has been trained as doctor and anthropologist. Ngozi has been a Minister of Finance making budget allocations and dealt with the entire array of economic policies to promote growth and prosperity. Jim has worked exclusively on health issues (rightly, as he is a physician) and never been in position of responsibility about economic policy. Health was just one of many sectors for which Ngozi had to allocate budgets and promote performance.
Advantage Ngozi.
Knowledge of Finance.: Ngozi has been a Minister of Finance as such, among other things, she led the Paris Club negotiations that led to billions of dollars debt relief for Nigeria. Jim has no demonstrable experience in finance, banking, the private sector.
Advantage Ngozi.
Management Experience.: From 2007 to 2011 Ngozi was a Managing Director of the World Bank. She therefore has in-depth experience running a large and complex multi-lateral organization. Jim was director of WHO's HIV/AIDS department, from 2004 to 2006, and so has some experience in a multilateral organization. Jim has also, for two years, been president of an American university. But while Ngozi was near the top of a large organization dealing with all development issues Jim was responsible for one disease in an organization that does only health.
Advantage Ngozi.
Breadth of exposure.: There is a massive difference between doing development policy, and doing charity work to mitigate the consequences of the lack of development. Ngozi has done development policy in many settings and in many positions both in Nigeria and within the World Bank. Jim deserves praise for having devoted his time, attention and expertise in medicine to improve the health care for people in the developing world -- which is certainly one component of development -- but his development experience is limited.
Advantage Ngozi.
Passport.: Jim holds an American passport. Ngozi is a Nigerian woman.
Advantage Jim.
In this day and age, is that still really all it takes?

Movement at SEBI towards principles-based regulation

2012-03-11T00:56:00.001+05:30

by Shubho Roy and Ajay Shah.

A milestone for SEBI in its rule-making function

SEBI is a modern financial regulator in that it issues `subordinate legislation' (i.e. regulations) which constitute law. These laws embed intricate domain knowledge where Parliament does not have the capacity for detail. This separation -- where Parliament sets up SEBI and gives it the power to write subordinate legislation -- is the hallmark of modern regulatory arrangements. This needs to be accompanied by sophisticated arrangements through which such regulatory agencies are independent, accountable and free of conflicts of interest. While SEBI has many problems, it is the most sophisticated arrangement of this nature found in India today.

From 1996 onwards, SEBI has issued regulations for mutual funds. On 21 February, they published regulations ("SEBI (Mutual Funds) (Amendment) Regulations, 2012") that govern advertisements of mutual funds, and the methods by which the mutual funds value their assets and consequently the units that they issue.

These regulations are a major milestone in the evolution of Indian financial regulation, in the shift away from rules to principles.

Rules versus principles

The two major approaches to regulation are 'rules based' and 'principles based or outcome based regulations'. Rules based regulation sets out the processes which a regulated entity is supposed to comply with, and is not directly concerned with the consequent outcome. Firms then try to find clever ways to comply with the letter of the law, but defeat the purpose of the rules.

As an example, consider statutory warnings on cigarette boxes. The rules require that the font in which the statutory warning is printed should have a minimum 'height'. Firms get around this by printing the warning in the required height, but reducing the width of the characters to a ridiculously low size, so that it is very difficult for readers to decipher. Thereby, they are able to comply with the directive for statutory warnings, yet defeat the purpose of warning buyers.

Recently, the rules asked that cigarette packets must contain a picture of a pair of lungs with cancerous growth. In response, firms forced down the resolution of the pictures so that they look like two blotches of ink to a normal viewer. These blurry pictures cannot be interpreted by anyone lacking in good knowledge about human anatomy. The person must not only know what a pair of lungs looks like; he must also know that the light blotch in the dark blotch represents a potentially fatal cancerous growth.

Rules based regulation draws regulators into an endless arms race, where the industry will always tend to invent ways to circumvent the rules. It creates an unhealthy tension in the relationship between regulators and the industry. In addition, rules tend to rapidly become obsolete with the constant evolution of technology and processes. Government has to keep modifying the rules, catching up with new thinking in the industry. If this is not done, Government holds back progress by preventing such evolution.

The alternative to rules-based regulation is principles-based regulation. Law based on principles is not new. A large number of our older laws have been based on principles. These laws do not specify a method or process that an entity must approach but lay down the guiding principle that it must follow. A beautiful example of this is the Indian Contract Act, which was written in the late 19th century. It is principles-based law that has stood the test of time.

As an example, the Contract Act defines acceptance of a contract to be complete when information of acceptance reaches the person who offered the contract. This definition in no way requires a specific mechanism for acceptance. When the Contract Act was written, telephones or email had not been imagined. However, the principles-based text of the Contract Act has withstood 150 years of technological change.

An expert body, like SEBI, which studies the market and issues subordinate legislation, yields greater malleability: regulations can be repeatedly changed, unlike laws drafted by Parliament which are very hard to change. However, the full benefits in terms of heightened malleability are obtained when the very subordinate legislation is principles-based. Rigidity is the greatest with rules-based law, it is reduced with rules-based subordinate legislation accompanied by a high quality rule-making expert body, and it is minimised when both laws and regulations are principles-based.

Principles-based law is integral to common law and is part of our legal heritage. In recent decades, when India became socialist and when staff quality in government agencies declined, there was an insiduous shift to detailed, prescriptive, micro-management. Principles-based regulation and laws was put back on the financial policy agenda by the Percy Mistry report in 2007.

The new principles-based SEBI regulations

The new SEBI regulations on advertisement reveal a shift towards principles-based regulation. For example a regulation reads:

In audio-visual media based advertisements, the standard warning in visual and accompanying voice over reiteration shall be audible in a clear and understandable manner. For example, in standard warning both the visual and the voice over reiteration containing 14 words running for at least 5 seconds may be considered as clear and understandable. (emphasis added).

Instead of mandating that the warning should be at least 5 seconds long, as would have been done with rules-based regulation, it is stated that that it must be audible, clear, understandable. The 14 words in 5 seconds is now not a legal requirement: it is only an illustration of how the principle can be satisfied.

On valuation, the new regulations say:

The valuation of investments shall be based on the principles of fair valuation i.e. valuation shall be reflective of the realizable value of the securities/assets. The valuation shall be done in good faith and in true and fair manner through appropriate valuation policies and procedures.

This regulation recognises that there are many different types of assets a mutual fund may acquire, stocks, securitisation papers, derivatives, bonds, etc. Each of them may have different forms of valuation. More importantly the list of assets mutual funds may buy is not exhaustive: MFs in India are going to buy an array of new instruments in India and abroad. The principle however, will hold true for different assets and valuation methods. The objective of the regulation is to ensure that the investors get a fair picture of the assets that their fund holds.

Assessment

We do not know what forms of media the mutual funds of the future will use: billboards will go 3D, holograms will be used, mobile phones will carry rich targeted advertising. Mutual funds will also invest in new financial instruments in global markets. As long as they provide warnings in a clear and understandable manner and value their assets in a fair and truthful system, they will be compliant with SEBI regulations and can innovate freely.

Principles based regulations have two major advantages over a rules based system:

The regulations require the regulated to strive towards an outcome and not mechanistic compliance.
The regulations allow for innovation to be absorbed quickly by the industry as long as they meet the objective of the regulation. Imagine if the Contract Act had specified that all acceptance of contracts should be done by letters. All the innovation of e-commerce, mobile telephony based commerce, telephonic negotiation and trading would have been illegal till the statute was amended. This would have required Indian law-makers to constantly update the Contract Act.

Moving to a principles based system is a crucial step forward, away from the command and control mindset that many regulators suffer from. Instead of prohibiting malpractices, all too often, laws in India micro-manage the regulated business. This is a recipe for stagnation.

However, principles based financial regulation also has costs. Rules are black and white - there is legal certainty. With principles based regulation, the precise nature of a government response to a new idea by the private sector is less predictable.

More complex behaviours are, then, required of the regulator. More litigation will arise. This will impose a greater burden on staff in regulators, courts and law firms. They will need to understand principles (and their underlying drafting intent), alongside practical knowledge about how the real world works, so as to be able to intelligently apply the principles. This requires a great deal of understanding of technology, business and regulatory objectives. Moving towards a principles based system requires commensurate strengthening of organisational and staff capabilities at SEBI, the Securities Appellate Tribunal (SAT), and the Supreme Court.

IEDs in Diwali and Toxic chemicals in Holi

2012-03-08T20:37:00.000+05:30

When I was young, resounding explosions and other fireworks were an integral part of Diwali. It was not possible to conceive of Diwali any other way. If you extrapolated into the future, and envisioned the next doubling of GDP, you'd have forecast that there would be much more than 2x the explosions and other glittering displays, assuming that social mores stayed unchanged.

There was a dark side to such Diwali celebrations: the inevitable trickle of people engaging with explosives who got hurt, extreme discomfort for all forms of life other than humans, and air pollution. Many years ago, it seemed like all these problems were real, but there wasn't any other way. It was hard to conceive of a world where Diwali was celebrated differently.

I used to think there was a common goods problem: Each individual gained utility out of igniting fireworks, despite imposing externalities on other creatures (of various species) in terms of noise or pollution. It isn't easy to get humans to be concerned about externalities imposed upon others.

I have been astonished at how these three messages (accidents, animal rights, pollution) have gone through to the young, and Diwali now involves much less of the fireworks than used to be the case. After we factor in the GDP growth, the change is simply amazing. By rights, such a social transformation should have been very hard. But it happened. I wonder how this happened. (There is some data on this phenomenon at Central Pollution Control Board, but the work is of poor quality and the website is terrible, so it's hard to compare 2002 against 2011).

Fast forward to Holi. Holi seems deeply entrenched, particularly in North India. There is a dark side to Holi celebrations: toxic chemicals, sexual harassment, substance abuse. All these problems are real, but there doesn't seem to be any other way. Unlike the problems of Diwali, two out of these three (toxic chemicals and substance abuse) are about private goods: the individuals who engage in certain practices are the direct losers as a consequence. So there isn't a common goods problem here; this should be easier to solve. But it's hard to conceive of a world where Holi is celebrated differently.

Or should we be so pessimistic? I saw a story on NDTV: Nearly 175 hospitalised for colour poisoning. As information about these problems spreads, will behaviour change? In an ideal world, we should have the public goods of Health/Safety/Environment regulation, ensuring that the dyes used are safe. In an ideal world with high quality police and courts, the sexual harassment and Holiganism will be checked. But it will be many years before India has such governance capacity; at present the main focus of politicians is not upon public goods. For a few decades, the only way forward is for a lot of people to step away from the present social mores. It happened with Diwali; could it happen to Holi?

Could it happen to Ganpati Visarjan in Bombay?

Doing better in our neighbourhood

2012-02-24T10:54:00.002+05:30

A key intuition of modern thinking in international trade and international finance is that distance matters much more than we think.

We may like to believe that the world is becoming more flat. We may like to believe that for weightless things like services and financial flows, distance is irrelevant. But the research evidence is unambiguous: there is a `gravity model' in the affairs of men. The interactions between two countries tend to go up in proportion to the product of their GDP, and vary inversely with the squared distance between them.

Traditional trade theory would encourage us to think that India and Sri Lanka (say) have similar factor endowments, so the gains from trade might not be so great. But this is not borne out by the evidence: some of the most intense trade relationships are found between countries in Europe and between the US and Canada: between countries with very similar endowments.

In this region, we need to be much more mindful of the importance of intra-regional finance and trade activities. For India, this means a strong emphasis upon East Africa, the Middle East, Pakistan, Central Asia (by plane today, but someday we should get to road connectivity from the Indian ocean), the land route to China through Tibet, Nepal, Bangladesh, Burma, Singapore and Sri Lanka. India stands out, in international comparisons, for having unusually low economic engagement with its neighbours. This implies that there are opportunities for very large gains. In recent years, some Indian firms have emphasised these countries in their internationalisation strategy (both trade & investment), reflecting a greater role for natural conditions dictated by geography.

Some of these places are hobbled by political problems and abysmally low GDP. The product of the two GDPs matters, and bad political systems like to interfere with globalisation. The wise thing for us to do is to have a consistent and welcoming engagement strategy, waiting for the time that the country finds its feet in terms of establishing a healthy political system, waiting for the country to engage. A good example of India doing something right is the positive approach towards MFN status for Pakistan. We have to wait for Pakistan to understand that this is in their self-interest - and I do believe that in time, they will - but there is no reason for us to get stuck on reciprocity.

Of particular interest in recent months is Burma. Hamish McDonald has a beautiful piece titled Tractors may have replaced horses, but country is still decades behind. If Burma comes out of its deep freeze, then the opportunities for trade and financial links with India are huge. We would go closer to the arrangements which were prevalent in the early 20th century, which reflect the natural opportunities.

With increased trade & financial linkages will come greater macroeconomic correlations a.k.a. shared interests. I saw a fascinating new IMF working paper by Ding Ding and Iyabo Masha titled India's growth spillovers to South Asia. This finds that after 1995, Indian growth has a significant impact in the region. If this is a robust finding, it is new; the idea that Indian business cycle fluctuations reach out and influence the region is not part of our intuition, particularly given the onerous trade barriers in place. Perhaps there is a lot more trade going on than meets the eye.

CNBC Awaaz symposium on India's education crisis

2012-02-21T14:59:00.001+05:30

India's education crisis is now high on our consciousness. In response to the recent developments, CNBC Awaaz did a four-hour symposium on national television (in Hindi/English) titled Kala Akshar: The Great Education Crisis. This brings together an interesting and diverse set of voices on the subject.

10:00 - 11:00 AM	1	2	3	4
11:00 - 12:00 PM	5	6	7	8
12:00 - 1:00 PM	9	10	11	12
1:00 - 2:00 PM	13	14	15	16

Interesting readings

2012-02-16T23:52:00.001+05:30

Great insights into India's breakdown of governance, from N. Sundaresha Subramanian in the Business Standard.

Jeff Glekin and Hugo Dixon have a great three-part rumination about India. Also see Jeff Glekin and Shaji Vikraman on the ruckus at UTI.

Cullen Murphy has a great article about the Inquisition. His story is a troubling one for us in India, where we are at the point of transition from persecution by thugs to persecution by competent organisations.

At the crossroads, an article on education by me in the February issue of Pragati. Also see here.

Pratap Bhanu Mehta and Ila Patnaik, in the Indian Express, on the UID controversy.

Do away with surfeit of financial regulators to make the financial sector better, in the Economic Times. (This was by Shaji Vikraman.)

Ila Patnaik on the best contribution that RBI can make for high Indian GDP growth. And by her, see: capital controls are no way to try to block rupee depreciation [link].

Ila Patnaik on the subject of how the Eurozone crisis changes our thinking about achieving bank safety by stuffing banks with government bonds.

SEBI turns heat on USE, by Palak Shah in the Business Standard. Equity licence: MCX-SX faces fresh hurdle by Pramit Bhattacharya in the Mint, which was followed by The question of motive by the editor, R. Sukumar, of Mint.

Sino-Americana by Perry Anderson, in the London Review of Books. You might like to also read The undersupply of criticism by me.

How your cat is making you crazy by Kathleen Mcauliffe in the Atlantic, and a great video of an interview with Robert Sapolsky.

Wikipedia has serious problems, an article in the Chronicle Review by Timothy Messer-Kruse. My experiences have also been similar; I've given up on fixing errors in Wikipedia because people generally undo the work later on.

An election rally in Amethi, Uttar Pradesh

2012-02-12T18:33:00.000+05:30

by Naman Pugalia, Viral Shah and Ajay Shah.

We decided to experience the spectacle of Indian democracy, by going to an election rally in the Uttar Pradesh (UP) assembly elections. Elections in Uttar Pradesh are unbelievably big - in 2007 there were 110,654 polling stations, which gathered up 471 votes each (on average) into electronic voting machines (EVMs), adding up to 52 million votes. (For a comparison, the US presidential election in 2008 had 132 million votes). In UP, the 2012 elections are going to be much bigger than what was seen in 2007.

A microcosm of Uttar Pradesh.

Deep inside the production function of the political campaign is the rally. From Gandhiji's public meetings to Nehru's memorable speeches, mass gatherings have been an integral element of political communication. Audiences pick up an array of subtle aspects of the voice, body language, and mannerisms of the speaker, through which a great deal is communicated other than the text of what is spoken.

On February 9th, we attended a rally organised by the Congress, where Priyanka Gandhi spoke. The meeting took place in Pari village in the Amethi district. This is a place so obscure that google maps does not know it.

A small rally, with a special platform for the media to mount cameras.

Perhaps 500 to 1000 people from Pari and neighbouring villages had assembled to hear Priyanka, who urged them to vote for their (incumbent) MLA from the Salon constituency, Balak Pasi. A strong media contingent was there, with both local and national media being represented. In 2007, this constituency was reserved for a scheduled caste (SC) candidate. Balak Pasi had won handily, with 45,078 votes compared with his rivals Asha Kishor of SP who got 31,969 votes and Dalbahadur of the BSP who got 26,588 votes.

As with a music concert, you have to warm up the crowd before the main act. Two local politicians kept the audience entertained before Priyanka arrived:

Local politicians, warming up the crowd before the main show.

Priyanka was fluent in Hindi, and was quite at ease. The well-rehearsed speech pitched Congress. There were two main planks of the speech: that UP had done badly with 22 years of non-Congress alternatives, and that Congress was doing good things for the people at the Centre but the failures of the BSP government had prevented these benefits from reaching them. It was a short, well-written speech: not a lengthy tiresome rant or ramble. The video you see ahead is from a different location, but the speech is essentially the same as what we heard.

Needs at least Flash Player Ver.9 to Play Download Here

The audience was not very engaged. We were told that audiences have not been too engaged with any political speaker after Gandhiji. After the speech, she stepped off the podium and walked towards the gathering to shake hands with a few awestruck attendees. In a few minutes, her convoy of SUVs, complete with SPG staff, sped off.

Everyone was comfortable.

UP has a bad reputation for law and order, but we were struck by the civility of the entire process. Everyone was comfortable. It was a day out for the family, and aided by the beautiful winter morning, people were smiling. There was no hint of violence, intimidation or fear.

If mass politics evolves in this direction, a lot more people would be comfortable getting involved in it. It was one more reminder of the importance of law and order as the foundation of democracy and civilisation: when politics involves violence, only the goons will participate in it. As Fareed Zakaria says, the courts are even more important than the elections.

In the olden days, politicians did a small number of speeches for big audiences. Meetings were announced many days in advance, and a large crowd took the trouble of going to the meeting venue. The world has changed. Small rallies are a much more intimate experience. They are also a security nightmare, owing to the very intimacy of the experience. At the same time, we felt that the security arrangements were non-intrusive.

With these small rallies, the politician comes to the audience. The speaker probably does 10 rallies a day, and thus touches perhaps 5000 people a day. Another feature of the new production function of political campaigns is television: A politician may do a speech for a small rally, but the omnipresent television cameras beam it all across Uttar Pradesh, to a vastly larger audience.

The rally was pretty nice, but at the same time, political parties in India are not professional organisations. There were numerous small issues where a relentless process engineering perspective could have added value. Politics in India is a bit like the way big companies used to be twenty years ago (and small companies are today). Big Indian firms have figured out how to graduate from mom and pop operations to professional organisations, how to write process manuals, setup instrumentation of the process in motion, and how to bring in high end brainpower to improve processes. That transformation of Indian politics -- from cottage industry to professional organisations -- has mostly not begun.

After the speech, the crowd peacefully dispersed.

The blog as a platform for conversation

2012-02-11T12:13:00.000+05:30

There are three ways in which a person can speak in today's Internet into the public domain: to write on twitter (140 bytes), to write a comment on a blog (~ 1000 bytes) or to write a blog post (~ 5000 bytes). The appetite of each person varies, reflecting a combination of having something to say and having the discipline of carefully constructing sentences and paragraphs. Each of these three choices comes with a different set of human factors which shapes who participates and how much.

This blog started out in end-2005, and quickly built up thousands of readers. It branched out from a single-author blog to having many people writing. There is a certain kind of person who reads this blog, where 20% of the words have three or more syllables, and hence there is a natural opportunity for intra-group conversation between us. But for a long time, there was relatively little going on by way of discussion on the blog through comments.

At first, comments were unmoderated, which is nice in that writing a comment gives instant gratification to the author of the comment. Google Blogger does not block spam in blog comments on the scale that Gmail does, and I was forced to shifted to moderated comments. This introduced an inevitable delay between writing a comment and seeing it come up on the page. The threshold readership required for significant discussion was further pushed up once comments were moderated. So one had to sit back and wait for readership to further build up before interaction-through-the-blog took off.

On the other side, Blogger recently released a nice new feature: the ability to pointedly respond to a comment with a comment. I think this has helped increase the attraction of comments.

In recent days, I've seen a significant increase in comment traffic. Here are a few recent posts, with the number of comments in brackets: Diluting the role of the IIT JEE (17), Girish Sant (10), The first PISA results for India: The end of the beginning (16), Uncomfortable times in real estate in store? (16), The rupee: Frequently asked questions (21), Taxing investors to pay NGOs (12), Residential water heating and the rise of the gas-fired economy (15), Envisioning future scenarios for India and China (13), Can we get back to track on corruption now? (12). Prior to 2011, there was seldom a post with over 10 comments. So it looks like we have crossed some threshold on participation which is leading to liquidity in comments.

Some interactions have been particularly noteworthy. At Diluting the role of the IIT JEE, AVI said "please give some references to support your assertion". I replied about my (lack of) verifiable evidence, and then Murli responded with verifiable evidence. This was blog-based interaction at its best.

Similarly, it was a comment by Anonymous (on an unrelated post) which got me going on the recent OECD PISA results. This led to posts by Lant Pritchett, Jeff Hammer, and me (link, link). This was blog-based interaction at its best (though it did start with an awkwardness, a comment on an unrelated post).