Posts by AjayShah:
- Many government services are moving on to the internet. While India has only 18% internet penetration, around 39% of railway tickets are sold online.
- Even with poor systems, the internet is helping citizens deal with poor state interface through HOWTO documents, computerised services, etc.
- The knee-jerk reaction to defend their turf, fight to keep systems closed and inaccessible, try to increase the complexity of systems, and create and sustain non-transparent institutions.
- The enlightened response to focus on long-term survival by aligning itself with the interests of the consumer and industry they serve.
- make detailed codes of conduct;
- make these codes of conduct available to the public;
- make these codes of conduct readable and comprehensible, through plain English guidance notes, FAQ pages, etc.;
- provide information about how grievances can be addressed.
- ensure that the entrance exams it runs are performing their function correctly. This requires analysis of test results and periodic review of the design and content of the tests, to ensure that they are relevant and of an appropriate level of difficulty;
- engage in continuing professional education of its members, as opposed to voluntary and occasional seminars, and ensure that this continuing education reflects the rigour of the selection process for entry;
- ensure that complaints against the profession are taken seriously, and investigated, and that the investigations are time-bound, and that the complainants are informed about the status of the investigation.
- have an impartial and effective judiciary;
- have a fair system for addressing complaints;
- have a detailed procedure for adjudication;
- make rules allowing the complainant to participate;
- ensure that adjudication proceedings are time bound.
- What is the market failure that I have identified? Can I demonstrate that this is a market failure?
- Is solving this market failure within my objectives as stated in the law?
- What intervention am I proposing?
- Is this intervention within my powers?
- Will the proposed intervention hit at the claimed market failure? (All too often, financial regulators in India talk about a certain stated malady and then propose an intervention which does something unrelated).
- What costs will this proposed intervention impose upon society? Will these costs be larger than the benefits?
- Regulation making should be the power of the board and not of officials. It should go through a full formal regulation-making process. This one has not.
- The announcement by RBI came out with zero notice. It suddenly imposes negative consequences on MCX and Financial Technologies. This is not fair.
- The regulation really makes no sense. What is the economic objective that is being pursued? What is the cost that is being imposed? What do we gain as society from it? The document says nothing. It is a statement of arrogant power, that reminds me of the stories about China at the outset.
- The outcome – a high quality airport – is visible and measurable and monitorable. In other fields — e.g. criminal justice system — it is much harder to know where you stand, which reduces accountability.
- MPs and ministers use the airport. In contrast, with the criminal justice system, they have opted out of public systems. In a problem like corruption, many might actually want the status quo to continue.
- Airports are relatively cheap and easy: All you had to do was to offend the employees of AAI. The government wrote contracts with GMR/GVK, and the passengers are footing the bill in terms of paying user charges every time they fly. There was no tradeoff between pushing airports and pushing welfare programs.
From clubs to States: The future of self-regulating organisations
December 29th, 2013
By Ajay Shah, Arjun Rajgopal, Shubho Roy.
This post is based on talk at the 2013 National Convention of the Institute of Company Secretaries of India.
India’s governance environment is undergoing rapid changes, and this will drastically re-shape the role of Company Secretaries. As a professional body, ICSI needs to understand and anticipate these changes, in order to ensure that its members are equipped to fulfill their critical role. While the ideas here pertain to ICSI, they also apply more generally to other self-regulating organisations.
The citizen-government interface is changing
The development of the government-citizen interface of a country can be divided into two phases. In the first phase, the interface is characterised by poorly written regulations, wide variation in practice and very bad infrastructure. Each government office uses its own unique processes and practices, and requires physical filings on forms that are difficult to fill. Different branches of government collect the same information in different ways, the same function and form are widely different in different states. In such contexts, professionals invest time in learning to “work” the system, and create a valuable niche for themselves as indispensable intermediaries between citizens and the state. Twenty years ago filing a personal income tax return was challenging and often required professional help. This culture persists in many government offices: forms have `unique’ requirements which only `experienced’ persons know. This knowledge/experience comes from being a member of the professional organisation (the club) and the club prevents this knowledge from falling into the hands of non-members. As a result citizens and businesses are `forced’ to approach the club members to comply with laws.
The second phase of development occurs when the State-Citizen interface improves. This is occurring in India through computerisation and standardisation of processes and forms on the one hand, and increased empowerment of citizens on the other. The internet is changing the interface in two ways:
As a result, consumers of professional services begin to demand more of their service providers, and professionals are faced with an existential crisis.
The profession’s response
Professional organisations have two choices:
The knee jerk reaction causes frustration among customers and clients. This leaves the profession vulnerable to being side-lined by cost-driven innovations in the economy. An example of this is the rise of Legal Process Out-sourcing (LPO), which has allowed clients to access a broad range of legal services without hiring expensive lawyers. Worse, a profession can spiral into a vicious cycle of defensive and unethical behaviour, in which members to put the interests of the profession above those of their clients and customers, and in which standards of competence and conduct begin to suffer. In extreme cases, persistent self-interested or indisciplined conduct can invite a devastating response from the political establishment, as occurred when the Government took over management of the Medical Council of India in 2010.
By contrast, an enlightened response to a changing environment would try to preempt such crises and focus on the long-term survival of the profession. In the long-term, the profession will only survive if its interests are aligned with those of its clients, and if it provides a useful service to society at large. Strategically, it would make sense for the profession to focus on those roles in which it is truly irreplaceable, re-focussing its attention on its highest value services. And institutionally, the profession’s governing body should move from being a “club” to being a “state”.
The way forward
The state model recognises that modern professional organisations are like regulators, in that they incorporate the broad functions of the modern state: legislative, executive and judicial. As such, they ought to be designed with the same internal safeguards and processes as the modern state. These include, most critically, defining and separating out these functions. A good SRO will carry out its legislative functions by making codes of conduct and defining conditions of entry into the profession. It will carry out its executive functions by holding exams to restrict entry into the profession to qualified individuals, and by investigating complaints against its members. And it will carry out the judicial function of disciplining its members.
The record on performance of these functions in India is mixed. We have sometimes been successful in defining codes of conduct and entry conditions, sometimes not. In terms of executive functions, Indian SROs have paid extreme attention to maintaining entry barriers, often at the cost of efforts to investigate complaints against the profession. In terms of the judicial function, Indian SROs are highly averse to disciplining their members in public, fearing that this will be seen as a sign of failure of the SRO. It is possible to bolster each of these functions, and ensuring the long-term survival of the profession requires that this be done.
In order to exercise its legislative function effectively, a modern SRO must:
In order to exercise its executive functions effectively, a modern SRO must:
Too often in India, entrance tests are just a reflection of the person taking the exam and not the person who organised the exam. We do not bother to think whether the exam was fair. A recent data analysis of ICSE and ISC exams (high school exams) shows statistical evidence of poor exam design and manipulation of marks.
In a “club”, standards of conduct are enforced by norms, not rules. Those norms are flexible, and defaulters are treated kindly. Clubs work well for small groups of professionals, who must rely on each other in an uncertain and unpredictable environment, which itself must be managed with a high degree of flexibility and discretion. A club is thus an appropriate model for a SRO in an early stage of its development. But as the environment changes, as processes become technologised and standardised, and customers become empowered, the club model will have to give way to a “state” model, which is less discretionary, less cosy, and less forgiving to defaulters.
Regarding the judicial function of a modern SRO, the organisation must:
Achieving this requires three ingredients: The first is a law, which will clearly set the bounds within which the SRO will operate. This law should be “anti-professional” in that it must be designed to protect the interests of society rather than the interests of the profession. Punishments should not only be meted out but publicly shown to have been meted out. In 2012, the New York city Disciplinary Committee publicly disciplined 65 lawyers (See pg. 32) which include 13 disbarments. Many jurisdictions even go to individual practitioner level information about disciplinary actions. We rarely see any comparable level of disciplinary actions against professionals in India. The ones that do happen are usually after a big `scandal’ like the Satyam failure and soon die out of public memory. No comparable data is publicly available for Indian professional organisations. They seem to hide the data about disciplinary actions and therefore should be presumed to have not carried out much.
India is going through an interesting time. The nature of the state is changing. RTI, Lokpal, E-governance, etc., are just examples of a move to a more perfect republic. SRO’s have a choice, get in the way or join the change.
Who’s afraid of a big current account deficit?
October 23rd, 2013By Ajay Shah.
A big CAD is a bad thing — much like a big fiscal deficit.
A country is always better off with a small or zero CAD or ideally a surplus.
The CAD is a drag on growth.
The large CAD is a profound drag on India’s outlook.
If we managed to reduce the CAD, things would get better.
Statements like this are rife. They are wrong.
What is the CAD?
The CAD is three things, all of which are identical. It is the gap between revenues from selling goods and services versus the payments made for buying goods and services. This has to be exactly matched by the capital inflow into the country. This is exactly equal to the gap between investment and savings. These three relationships are accounting identities.
What if there was no capital account?
If there was no capital account, then the proceeds from selling goods and services would have to exactly match the payments for goods and services, in every minute. Every small mismatch between the two would generate extreme currency fluctuations (large enough to incite a current account response).
The capital account is what smooths these things out. Let us imagine the currency market for one minute in which someone is buying $1 billion in order to import something. In that very same minute, it is very unlikely that there will be a double coincidence of wants, in the form of an exporter who wishes to sell $1 billion. What fills the breach is the capital account. Some speculator comes in and supplies that $1 billion in the hope of scoring a short-term speculative profit. The real economy demands liquidity in the currency market and finance supplies this, through the capital account.
The CAD is exactly equal to the gap between savings and investment. A CAD of zero is tantamount to only investing what we have saved. In general, this is a bad idea. If the country is all set to invest 35% of GDP, and savings are only 30% of GDP, it is a good thing if capital flows of 5% of GDP show up, through which investment exceeds savings.
Should we bemoan the large Indian CAD?
Should you be unhappy that investment is bigger than domestic savings by 5 per cent of GDP? If we insisted that the CAD should be 0 (i.e. we had no capital account) then investment would have to be lower and savings would be higher (which in turn implies reduced consumption). This would give reduced GDP growth.
Financial autarky implies that we live within our means. With savings of 30% of GDP, investment is forced to 30% of GDP under autarky. Opening up to the world makes it possible for a country to import or export capital.
If a country has good prospects but low savings, running a CAD is a way to front-load the investment, and service the foreign capital through a stream of dividends, interest payments and debt repayments into the future. If a country has poor prospects, it is better off sending capital to good uses overseas, instead of investing it domestically. For these gains, we have to have an open capital account and run large and variable CADs.
(There are also gains from risk sharing from large gross capital flows, even if the CAD is 0, but that’s a separate topic of discussion).
A big CAD got us into trouble in 1991. Won’t that happen again?
In 1991, FERA (1973) was in force. Capital account transactions by private parties had been criminalised. The only mechanism that generated flows on the capital account was the government. The entire CAD had to be financed by government borrowing. When the government lost creditworthiness in the eyes of the world, we had a funding crisis on the capital account.
On a day to day basis, imports required dollars which came from the government. The Ministry of Finance monitored daily inflows and outflows of dollars, and controlled who could access foreign exchange.
When GOI lost credit-worthiness in the eyes of overseas lenders, this was a collapse in the flow of dollars. If you wanted to import penicillin, you needed to get dollars, and RBI had none. That’s where it came to crunch: when an importer is told that he cannot import as there are no dollars.
Nothing remotely like this can happen in the present environment. With capital account liberalisation, many channels have opened. There is FII investment in equity and debt, there is FDI, there is ECB, and so on. The money moving in these channels dwarfs the borrowing by the government. India is now well connected into financial globalisation. All these channels won’t choke.
Suppose there is some big mess abroad and all fixed income funds stop buying Indian bonds. Under these circumstances, capital inflow will come through the other channels. The more we open up to a diverse array of investors into a diverse array of asset classes, the safer the environment becomes, the lower the exchange rate volatility becomes.
Why won’t all channels choke all at once?
We require a capital inflow, on average, of Rs.20 billion per day. That’s the gap, on the currency market, which has to be filled. If foreign capital does not come in, there is a supply-demand mismatch on the currency market. This gives a currency depreciation.
Ex-post, supply always equals demand. On the market, this demand will be met. Every day, the CAD of the day will equal the capital inflow of the day. The only question is: At what price?
When bad news comes out in India, foreign capital becomes more circumspect. They require a more attractive exchange rate at which to get in. Or, to say it differently, suppose INR/USD is at Rs.65 to the dollar. Suppose bad news come out. The inflow of Rs.20 billion is not forthcoming. The market has a gap. The rupee starts falling. At Rs.70 to the dollar, some foreign investors think `Hmm, maybe at this price, it’s a good deal, and I should get in’.
How far does the depreciation go? Minute by minute, the rupee moves to elicit the net capital inflow (or outflow) required to clear the currency market. In response to bad news, the INR drops till a speculator feels that it might be a good idea to come into India, buy a 91 day treasury bill, and hope that the rupee will do well in a few minutes or few days. That’s how the current account deficit always gets financed under a floating exchange rate.
Rupee depreciation makes Indian assets more attractive. It would be nice if foreign capital found Indian assets attractive for other reasons. But when all else fails, rupee depreciation is what gets the job done.
What kinds of foreign investors respond the most to rupee depreciation?
Sharp spikes of the rupee are fertile ground for currency speculators. The more currency speculators that we have, who are operating on the rupee market, the smaller is the INR movement associated with an event.
Imagine an INR depreciation of 5% in one day. A currency speculator believes this is over done and wishes to come in. What does he do? He sells dollars, buys INR, and invests in short-dated government bonds. This would add up to a pure play on INR. Currency speculators are not comfortable holding Nifty in India. They want a pure exposure to INR.
Hence, the best way to obtain a deep and liquid currency market, where shocks will lead to small exchange rate fluctuations, is to remove capital controls on the rupee denominated debt market.
A big CAD increases the damage caused by a sudden stop in capital inflows. What should the country do to forestall this?
Sudden stops are ultimately about asymmetric information in the hands of foreign investors. If India has a deep engagement with financial globalisation, then the informational asymmetry will be removed.
Our policy goal should be to have thousands of global financial firms who are running business activities connected with India, who have large scale organisational and human capital that is devoted to understanding India. This deep engagement will deter problems such as home bias, sudden stops, etc.
The Indian capital controls are damaging this deep engagement. As an example, repeated stop-go policies frustrate the development of teams inside global financial firms that have deep knowledge about India. When these teams know less about India, there is a greater likelihood of encountering the pathologies of international finance.
When India does silly things like trying to `crush the speculators’ through various means fair and foul, this hinders a mature engagement with financial globalisation. When global capital feels that India operates on stable rules of the game and has mature policy makers, the resources committed for building organisational capital connected with India will be greater.
In order to avoid international finance pathologies such as sudden stops, our engagement with financial globalisation should be a deep engagement. While this issue becomes particularly salient when the CAD is large, but there is no short term solution. Over the years, we have to chip away at building a deep engagement with financial globalisation at all times, so as to reduce the risk when there is a large CAD.
This is like a rules versus discretion problem. When discretion is used at a time of a large CAD, it contaminates credibility at all times. A mature approach to public policy involves establishing capable institutions that implement stable rules of the game and not tactical dogfights.
What is the role of MOF or RBI in ensuring adequate capital comes into the country to match the CAD?
On a day to day basis — nothing. It’s a purely market process. The market does it. There are no gray men who look at the CAD and figure out how to finance it and then undertake actions through which it gets financed. The financing of the CAD is purely a market process.
The role for MOF and RBI is to get out of the way by removing capital controls, so as to reduce the magnitude of INR depreciation required when a certain negative event takes place.
Does this work differently for other countries?
A large CAD is dangerous when there is a managed exchange rate. Under a managed exchange rate, there is a propensity to borrow in foreign currency and leave it unhedged. These borrowers (whether corporations or governments) get into big trouble when there is a large exchange rate depreciation.
The central bank is much more likely to fail on exchange rate management when there is a large CAD.
The witches’ brew that adds up to trouble is a central bank that believes there should be exchange rate policy + borrowers who believe the central bank will pursue exchange rate policy + a large CAD.
While India has a de facto floating exchange rate, RBI has not yet stopped talking about dreams of exchange rate management. We are relatively safe because borrowers don’t believe RBI can do much about the exchange rate. Hence, there is no moral hazard and a large CAD poses no threat.
Why is a large CAD seen as a big problem?
With a large CAD, India is beholden to foreign capital inflows. If foreign investors are displeased, we get a big rupee depreciation. This generates accountability.
When India enacts capital controls, or the Food Security Bill, we get a rupee depreciation. This irritates policy makers, who feel that mirrors should reflect a little before throwing back images.
Nobody likes accountability. Hence, people in positions of power do not like a large CAD.
In a mature market economy, a key channel of accountability for the government is the bond market. When the government does bad things, their cost of financing goes up, and this directly hits the ability of politicians to spend on their pet projects. In India, the bond market has been muzzled by setting up a system of financial repression. The job of intimidating the authorities is then left to Nifty and the rupee. The voice of the latter is amplified when there is a large CAD.
If you look at the world from the viewpoint of the people who run the place, there is a desire to muzzle Nifty and the rupee (particularly when the latter is speaking loudly thanks to a large CAD). From that viewpoint, a large CAD is a bad thing. Because the establishment has a disproportionate impact upon the climate of ideas, we have started accepting their claim, that a large CAD is a bad thing.
If you care about India’s future, a large CAD is a good thing, as it enhances accountability. By this logic, other things being equal, the Indian policy process generates superior outcomes when there is a large CAD. If we had a small CAD, Mr. Mukherjee might have been finance minister today.
Conclusion
Financial globalisation is work in progress. Capital controls and source-based taxation hinder international capital mobility. Even if there are no restrictions, it is hard for investors in country i to properly utilise the investment opportunities in country j, for reasons of `information distance’. All too often, there is home bias (people in a country holding vastly greater domestic assets than is optimal from the viewpoint of diversification). There are international finance pathologies such as capital surges, sudden stops, investments by foreigners in wrong assets, and so on. These are the hurdles along the road.
In the destination state, there is no good reason why the investment opportunities in country i at time t should match the savings of country i at time t. We should judge the success of the project of financial integration by the extent to which we are able to achieve large and variable current accounts.
In addition, in a place like India, a big CAD generates greater accountability on the part of the government. One would predict better economic policy when there is a large CAD.
The widespread mistrust of a large CAD may reflect two things. Some don’t see the extent to which we’re not in 1991 anymore: there is much more of a deep engagement with financial globalisation, and the exchange rate floats enough that the borrowers are not unhedged. And, establishment figures resent accountability.
I am grateful to Josh Felman for illuminating discussions on these issues.
The case for differentiated bank licenses
August 24th, 2013Posted by Ajay Shah.
by Harsh Vardhan.
Then why is it that they want to jettison a specialisation built over years of effort, and merge into this undifferentiated, monolithic group called commercial banks? More importantly, will the financial system become weaker when these specialists become generalists?
Ask the applicants why they want to become a bank and the most common answer is access to low cost deposits. This is, at best, a half-truth. While, it is true that only licensed banks can access putative low cost deposits (CASA), the belief that they are actually `low cost’ is not supported, once we account for all the costs of getting them. New banks will have a hard battle on their hand getting a foothold into this intensely competitive business of CASA. It is not a coincidence that the only banks to have hiked savings account interest rates, post deregulation, are the newest and the smallest ones: Kotak Mahindra, Yes, and IndusInd.
But there are other important parts of financial services that are reserved for banks – access to payment systems is the most important one. Payments have seen enormous innovation across the world primarily driven by non-banking players. In India, we have lagged in this area. Non-banks cannot enter the payments business, and banks are laden with legacy technology and processes that make them slow to innovate and reluctant to cannibalise their existing cashflows.
RBI recognises only one type of bank. So, the moment an entity becomes a bank, it is subject to the same rules and regulations as every other bank. All large Indian banks look like each other, and they all look like mere enlarged versions of what they were 10 years ago. Bank regulation is a giant homogenising force that kicks in when a banking license is granted. If any of the currently specialist players get a license, they will undergo this transformation and begin to look like the 90-odd scheduled commercial banks.
As India grows and becomes more sophisticated, banks must keep pace with the sophistication of the real economy, where most firms do not look much like they were 10 years ago. An important feature of a sophisticated banking system is specialisation. How do we achieve specialisation and diversity in our banking system?
First, in the current round of licensing, I suggest that RBI not only recognises diversity but encourages it. It can do so by giving licenses to applicants with diverse and specialist business models that focus on specific customer segments, products, and technology and process platforms. More importantly, it needs to show flexibility in regulation, and not ask all banks to look the same in the short run. Financial regulation is about consumer protection and micro-prudential regulation, and not homogenisation.
Second, RBI needs to start thinking about differentiated banking licenses. Why should we have only one type of license? Why can’t we have a utility bank – one that provides only transaction services (e.g. security related services such as custodian, trade related services, etc) and does not lend or borrow (significantly)? Why can’t we have a payment specialist bank or a home loan banks (one that can take deposits but lend only in form of home loans, by far the safest lending for Indian banks)? Everyone talks about financial inclusion, so why can’t we have an inclusion bank – one that serves only the bottom of pyramid customers?
Such specialist banks will be expected to focus on their own individual niches and strengthen their capabilities in serving these niches as a bank – through access to payment systems, ability to raise deposits, regulatory oversight, etc. The presence of such banks will make the system less monolithic and hence better placed to face economic cycles. With differentiated banking licenses, we will have banks that do not face boom and bust at the same time. Reduced correlations between banks will give lower systemic risk.
Issuing differentiated licenses will require that RBI has to become more sophisticated in how regulations are drafted. RBI’s regulatory staff will need to understand each business model, and write regulations about consumer protection and micro-prudential regulation that cater to the unique features of that business model. These regulations will have to differentially use the main tools of micro-prudential regulation – capital adequacy and reserve requirements, regulatory audits, reporting and compliance — so as to achieve the desired failure probability, while recognising differences in business models. RBI will also have to ensure that there is no regulatory arbitrage that is created across different types of banks.
Structural transformation and stylized business cycle facts
May 31st, 2013
By Ajay Shah.
When we think about India, however, there is the question of structural transformation of the economy. There was an old Indian macroeconomics which worried about different things. In recent decades, the economy has changed in fundamental ways: the economy has become mostly open, the role of agriculture has subsided, a financial system has come about and private decisions of firms that are shaped by financial markets now dominate fluctuations of investment. On these themes, you may like to see my article New issues in Indian macro policy.
This raises the question: Does structural transformation change the stylised facts of the business cycle? It appears obvious that when we go from an agriculture-dominated economy to one where agriculture is 12% of GDP, the role of monsoon shocks in GDP should fade away, which should matter for the spectral properties of business cycle fluctuations. Other kinds of structural transformation may not change stylised facts too much. As an example, the IT revolution did not change the business cycle facts in the US. In some respects, things could go in reverse. Some researchers have found that going from a closed to a more open economy yields more consumption volatility, not less, which violates the neoclassical prediction that capital account openness enables better risk sharing.
A recent paper explores these questions: Has India emerged? Business cycle stylised facts from a transitioning economy, by Chetan Ghate, Radhika Pandey and Ila Patnaik, Structural Change and Economic Dynamics, volume 24, page 157–172, March 2013.
The findings of this paper are quite fascinating. Prior to 1991, the stylised facts of the Indian business cycle are quite different from those seen for advanced economies. A sharp change is visible after 1991, and the Indian business cycle becomes more like that of advanced economies. But in the post-1991 period, consumption volatility went up in both absolute and relative terms.
Why did these changes take place? The authors explore a few hypotheses. Was India just lucky in the post-1991 period — with lower volatility of productivity or monsoon shocks? No, that was not the case.
Did India figure out how to do business cycle stabilisation? No.
The three components which seem to have kicked in are: (a) The decline in the share of agriculture; (b) Investment / inventory cycles rooted in the behaviour of private firms and financial markets and (c) Capital account integration. The fading away of agriculture gave a reduction in the volatility of GDP. Investment and output are now positively correlated thanks to the new investment/inventory cycle that is rooted in the private sector. Pro-cyclicality of capital flows helps explain higher consumption volatility.
A great deal of knowledge in Indian economics was rendered obsolete when India changed from being a closed and poor country to being an open and middle-income economy. We now need to construct a new edifice of empirically grounded knowledge that will help us think about where we now are. This paper will be a key component of this reconstruction.
The arrogance of power
May 13th, 2013By Ajay Shah.
Several of these rules have since been revoked, but their wacky and arbitrary nature demonstrates the arrogance of power in China. One can imagine all too easily their creators — sitting in comfortable armchairs, drinking high-grade tea and smoking fine cigarettes — discussing the issues at hand as if they were purely intellectual abstractions, never considering how ordinary people might react. That people will be unhappy is no cause for concern because, for so long, the power of the state has trampled on individual rights. Only when rules are so onerous that they stir actual protest do higher-ups take notice: “You guys are just making a mess of things,” they’ll tell their bureaucrat underlings.
This is in China, where the law is a bit of a joke; they do not have a Constitution, an independent judiciary, and the rule of law. Sadly, I often feel similarly about regulation-making in India, where we have much more rule of law, and the law matters much more!
It is rare and unusual, in liberal democracy, for Parliament to contract-out the power to make law. We do this, with regulators. Regulators are bodies created by Parliament and given the power to issue law. The agencies, and unelected bureaucrats, that issue law should be possessed with thought and care in wielding this power. All too often, they are not. Regulation-making in finance, all too often, is devoid of reason.
The draft Indian Financial Code, drafted by FSLRC, features an elaborate regulation-making process — with details encoded into the law — that will check such abuses and help bring more sanity to the outcome. It requires that regulators walk through the following steps:
2. It has been observed that eligible Indian parties are using overseas direct investments (ODI) automatic route to set up certain structures facilitating trading in currencies, securities and commodities. It has come to the notice of the Reserve Bank that such structures having equity participation of Indian parties have also started offering financial products linked to Indian Rupee (e.g. non-deliverable trades involving foreign currency, rupee exchange rates, stock indices linked to Indian market, etc.). It is clarified that any overseas entity having equity participation directly / indirectly shall not offer such products without the specific approval of the Reserve Bank of India given that currently Indian Rupee is not fully convertible and such products could have implications for the exchange rate management of the country. Any incidence of such product facilitation would be treated as a contravention of the extant FEMA regulations and would consequently attract action under the relevant provisions of FEMA, 1999.
Activism and wonkery are the ying and yang of India
January 25th, 2013By Ajay Shah.
The first element of achieving change is a dissatisfied public that is able to speak up. In places like China, freedom of speech is circumscribed and it is not that easy to express dissatisfaction with the way things are going. In India also, freedom of speech is under attack, and particularly when it comes to our problems of crony capitalism, the threats that we face are dire. But in some other fields — e.g. the protests against the events in Delhi — there are no real barriers to speaking out.
When does democratic outrage genuinely change the republic?
Everyone is against rape. Shouldn’t our outrage about rape immediately yield a world where women are safe? Unfortunately, the safety of women comes from the functioning of the complex machinery of laws, police, lawyers, judges, courts. To fix the problem, we have to modify this machinery.
The workings of government are a vast clanking machinery with many moving parts. When you see something going wrong in the outcomes, it isn’t always easy to diagnose the problems of objectives, accountability, and organisation structure that are inducing the problem, and envisioning the change that is required in order to solve the problem. The protester is saying I’m mad because the car does not work. But it takes a skilled engineer to understand why the car does not work and how to fix it.
Sometimes, I see activists who are revulsed at the workings of the dark satanic mills; who emphasise the protesting and downplay the fixing. There is sometimes a mix of frustration and reverse snobbery in play. I think that at its best, democratic society needs both: the activism (that puts a searchlight on things going wrong in society) and the wonkery (that actually gets things done). I respect the work of activists: What is in the searchlight of the public debate is where we have a chance to break free from the tyranny of the status quo. But there is no escape from getting engaged in the plumbing, from figuring out how it works, and coming up with fully articulated blueprints for change.
In a blog post about Occupy Wall Street, Paul Krugman says:
It would probably be helpful if protesters could agree on at least a few main policy changes they would like to see enacted. But we shouldn’t make too much of the lack of specifics. It’s clear what kinds of things the Occupy Wall Street demonstrators want, and it’s really the job of policy intellectuals and politicians to fill in the details.
This emphasises a two-part process: a democratic process throws up an opportunity for change, after which the quality of the change that is obtained depends on the capabilities of the policy intellectuals and politicians.
While voice is a precondition, it is not enough. The Anna Hazare movement set out to conquer corruption and achieved nothing. A great deal of energy was expended, and it generated plenty of television footage, but it came to nought.
A related example: a while ago, there was a public outcry about insecticides in soft drinks. I think the activists got it wrong : the really important target should be the low quality of drinking water, and not corporations peddling soft drinks. We did not have the policy intellectuals and politicians who could think about reforming water and sanitation, who could harness the outrage and get a meaningful reform program going. Hence, that episode has failed to alleviate the insecticide in India’s drinking water.
Example: London’s Great Smog of 1952
The Great Smog of China by Clarissa Sebag-Montefiore in the New York Times tells a great story. In 1952, London was hit by a terrible bout of air pollution, termed `The Great Smog of 1952′. 4000 people died. As she says: Most Londoners who lived through the Great Smog thought it was simply an especially foggy period until the undertakers ran out of coffins and the florists sold out of funeral flowers. This led to a `Clean Air Act’ of 1956.
Look at the Clean Air Act of 1956. It takes a great deal of thinking to go from outrage at 4000 dead, to figuring out how to draft this. There are hundreds of decisions in the 15,389 words of the law, all of which have complex implications in terms of public administration, incentives for private households and firms, and so on. It isn’t about setting up a death penalty for emitting smoke: it is about finding the smallest possible intervention that will get the job done, and one that is feasible given the implementation constraints of government.
Example: India and airports
Circa 2002, the airports were a disgrace. There was a public outcry. The government reacted. Today Bombay and Delhi have decent airports. Why did this work so well?
Under these circumstances it was possible for the political leadership to achieve airports, and make some in the elite (and themselves) happy, at no cost to their conventional focus on welfare programs and at no cost to anyone other than a few unhappy employees of AAI (who did not even lose their jobs).
There was the difficult problem of building regulatory capacity at AERA. The leadership in AERA of the early years did things better than most infrastructure or financial regulation in some respects. My personal experiences with AERA in recent months have left me enormously impressed at the capabilities in the organisation. But at the same time, the problem that they face is a relatively simple one. To use Pratap Bhanu Mehta’s delicious phrase, building airports in Bombay and Delhi was not a wicked problem.
Example: London’s Big Stink of 1858
Going much further back into time, London went through the `Big Stink of 1858‘, where the Thames was clogged with human waste. In the summer of 1858, within 18 days, Parliament drafted and enacted legislation that, in time, made the Thames one of the cleanest rivers of the world.
That’s a remarkable story. As an illustration of the firepower amongst the policy intellectuals: they had Michael Faraday working on the problem! We don’t have a Michael Faraday in our midst; we have yet to match the capabilities of the UK circa 1858.
Some areas are harder than others
Drawing on work by Lant Pritchett and Michael Woolcock, we should apply three tests to understand when doing something in government is hard: (a) Does a public service have a large number of transactions? (b) Do front line workers have discretion? (c) Are the stakes high?
When these three problems come together, building sound public systems is extremely hard. As an example of this thinking, financial regulation is hard while monetary policy is easy. By these three tests, building a criminal justice system is truly hard.
How do good countries grapple with the problem of constructing a criminal justice system? As an example, the John Jay College of Criminal Justice, at the City University of New York, works in this field. It has over 1000 academics working on this one field! In this one field, they have placed more than 2x the number of academics across all fields at IIT Bombay.
There are thus two reasons why making progress on the criminal justice system is hard. Unlike the airports example, these are difficult areas: Large number of transactions, front line civil servants have discretion, and the stakes are high. And unlike the partial success of the equity market reforms, we in India have not laid the foundations in terms of analysis of problems, consensus-building, and construction of key individuals that can play leadership roles in the change.
Example: India’s stock market reforms
Financial regulation is a wickedly hard problem. There are a large number of transactions, front-line workers have discretion, and the stakes are sky-high. If all regulation and supervision were done in government, it would be truly hard to make things work, particularly in India.
Hence, there is a neat two-part separation of the work. The exchange is a unique private body that does regulation and supervision. In the bad old days, the exchanges in Bombay and Calcutta were riven with conflicts of interest and did not do a good job of supervision. This gave us stock market crises in 1992 and 2001, which had large-scale consequences for the country. Calcutta Stock Exchange was a small player in 2001, but the problems there were big enough to matter to everyone.
There was an outcry. This led to a dramatic program for change. A new governance model was put into place at NSE and BSE, where there is a three-way separation between shareholders, managers and trading members. The managers, who perform quasi-State functions in supervision, have no shareholding nor stock options. It worked.
Why did it work? It is important to look back into time. Right from the 1980s, ideas for reform had been tossed about. The G. S. Patel Committee, in 1984, had many of the key ideas of the following 20 years in its report. A little noticed feature of the G. S. Patel Committee report is in the preface, where the research support of a R. H. Patil from IDBI is acknowledged. Many of the names that figure in the story of the Indian stock market in the following 20 years were part of the G. S. Patel Committee; as an example R. H. Patil was the founding CEO of NSE.
As a consequence, in 1992, when the crisis came, there were people and ideas in the system that were ready to respond. The knowledge and consensus that was available then carried us half the way.
Through the 1990s, there was a process of analysis and thinking about policy alternatives. There was a view on how change should proceed, and the conservatives were able to stall it. In the listless years from 1996 to 2001, a lot of hard work got done on fully thinking through the next batch of reforms. When, in 2001, the next crisis came, the Ministry of Finance was able to access well-developed ideas and people that drove the next batch of change.
From the viewpoint of politicians, all change is risky. Fear of the unknown feeds into inertia: Why suffer a political cost for sure, offending the status quo, for a reform that might not work? We improve the probability of a reform being attempted when two properties hold: (a) We have a fully articulated blueprint for change, which is backed by high quality thinking and evidence, and (b) People who can staff the reform effort are available.
From 1980 to 2000, the committee process created a working consensus on what was needed to be done, took new ideas from heretical to mainstream, and built individuals who went on to play leadership roles in achieving the change.
That’s the good part. And yet, in some ways, this has started turning into a failure story of sorts. After 2001, when the big changes fell into place, the policy community stopped focusing on the stock market. It was felt this is a solved problem. There was a lack of institutional memory about what had gone wrong in 1992 and 2001. The three-way separation between shareholding, management and securities firms was not remembered, and has been undone. We are going back to dangerous times.
Why has the wonkery been so weak in India?
Why are the policy intellectuals and politicians of India so weak on the questions that matter for India’s future? There are two elements of an explanation. The first is money.
In India, we spend roughly 1% of GDP on research in four fields : defence, nuclear engineering, the space program and agriculture. But all these fields are of second order importance when compared with the main story of India’s future, which is at the intersection of politics, economics, law, ethics and philosophy. In these areas, we are spending 0.001% of GDP. This ratio of 1000:1 of expenditure between these areas is inappropriate. As a consequence, we are failing to grow the intellectuals and university departments in these fields.
This matters for the wonkery. It also matters for the activism. If we could do better on the education that millions of people get in college, we could have a much more thinking citizenry which could be much more effective in mass political action. Our failures on universities are limiting the feedback loop through which growth should feed higher education and should feed back into better politics.
The second problem is development economics. What little is there of the social sciences and humanities in India matters less than it should, owing to the development economics worldview. Everyone outraged about violence in India should ask why the policy wonks of India are so interested in health, education and welfare programs, and so disengaged with the most basic public good of all, law and order. Why have economists thought the private goods of primary health centres are more important than the public goods of policing and courts?
To some extent, the two problems are related. India has offered little by way of career paths in studying India, and getting engaged in the project of building the republic. The development economics establishment, in contrast, offers a full career path: with Western aid agencies, NGOs, the World Bank, academic development economics, and much nourishment from a socialist government. This gives strong incentives for people to focus on poverty, inequality and welfare programs. This has enfeebled the wonks, for the big questions that India now faces are not poverty, inequality or welfare programs.
Conclusion
As Sunil Khilnani says, the most important task for each of us in India is to get involved in politics, in the sense of taking interest in how the State functions and undertaking actions small and large that will prod it towards better functioning. We have traditionally felt that the greatest threat that we face is that of an apathetic citizenry.
It now appears that we have a more active and participatory demos and this is a great thing. We are seeing profound changes in the world of activism. New technologies are reducing the cost of mobilisation. Millions of people have joined the conversation. We find that they care about core public goods and corruption. The voice of the people is negating the socialist claim of all these years, that what people care most about isgaribi hatao and inequality. These are great developments.
But while this is a necessary element for a well functioning republic, it is not sufficient. The surge of policy involvement by citizenry is not getting translated into action on a commensurate scale. The constraint is the weakness of the elite. We lack the policy intellectuals and politicians who are able to pursue wicked problems, diagnose what is going wrong, and articulate a tangible program for change.
The policy intellectuals and politicians are missing in action on the questions that matter. The bulk of the existing policy establishment is focused on poverty, inequality and welfare programs. As Shekhar Gupta has emphasised, the ruling ideology among most politicians is ossified in the thought process of the 1970s. India has moved on, but our political ideologies haven’t.
Intellectuals are the yeast that make a society rise. Our under-development in intellectual capacity limits our ability to translate a moment — like the anti corruption movement — into change. In addition, there is a danger that an irate public that is weak on political philosophy will settle for cartoonish solutions like Lok Pal or Naxalism or a death penalty for rape.
The wonkery is intellectually bankrupt today. The policy intellectuals and politicians who are able to reshape themselves to fit the needs of India from 2013 to 2038 will matter. A greater conversation between the two cultures will also matter greatly, with each cross-fertilising the other. Activism and wonkery are the yin and yang that must work together to build the republic.
Cancelling trades on an exchange: When is it a good idea?
November 3rd, 2012By Ajay Shah.
When inexplicable things happen on an exchange, many people argue that those trades should be cancelled. I think it is useful to be clear about the test to apply for this.
The key question should be: Did something foul up in the order matching software? If order matching went wrong, or if there was a systematic breakdown of connectivity to the exchange, then there is a case for cancelling trades. We’d say that persons placed certain orders, but the exchange mis-handled the orders, hence the observed series of matched trades and prices is unfair.
If the exchange and its rules worked as advertised, this reason peels away. In fact, I would argue that particularly when there is a fat finger trade or something like the US `flash crash’, it is important to not cancel trades, to cement faith in the trading process.
The recent events surrounding the fat finger trade by Emkay are a good example of this line of thought. Owing to a human error, a basket trade to sell Rs.17 lakh of Nifty was instead placed as an order to sell 17 lakh nifties (where one `nifty’ is a basket of 50 shares adding up to the present level of the Nifty index expressed in rupees). If Nifty is at 5000, then an order for “100 nifties” is an order for Rs.500,000.
Through this human error, a very large sell order appeared on the market. At that instant, everyone looking at the market would have been taken aback. What was going on? Has a huge event unfolded which some informed speculator knows about, but I do not know about? It takes nerve in that moment to be on the other side of the order. We must reward the people who did not lose their head when everyone around them was losing theirs.
When the big Emkay order came in, many of the orders which were matched were limit orders which had been patiently waiting there. This does not, in any way, change the analysis. Waiting with `deep out of the money’ limit orders is a hazardous business. As an example, consider the persons waiting with deep out of the money limit orders, standing ready to buy at very cheap prices (e.g. 10% below the current market price) when the Satyam scandal unfolded. They lost money big time because the informed speculators, who understood the Satyam announcement and placed massive market sell orders, knew more than them. Waiting patiently with limit buy orders, 10% away from the touch, is not free money. (“The touch” is finance parlance for the bid and the offer price). It is a risky trading strategy.
Two trading strategies matter most in stabilising a market when crazy things have happened. Traders have to be there ahead of time, with limit buy orders far away from the touch. The limit order book should be thick with orders; i.e. the impact cost associated with a giant market order should be low. And there have to be traders who see that the market has crashed, are able to work the phone and gain confidence that this is an idiosyncratic shock, and come into the market and buy. The more the capital and intelligence behind such trading strategies, the more stable the market will be.
If trades are now cancelled, these two trading strategies will have suffered the risk and got nothing in return. In the future, they will be more circumspect about stabilising the market. Similar considerations apply on the other side. When there are strange and large upward moves of the market, we want rational speculators who short sell and bring the price back to fundamentals. The market must be designed in a way that supports and enables this. At present, it is not [link, link].
Fat finger trades will happen. There will occasionally be strange rumours and other odd things that will make markets fluctuate away from fair price. In those situations, what we want most is for clear-headed rational speculators to put large scale capital into making money by stabilising the market. The rules of the market should reward the people who perform these roles. Trades from their orders should not be cancelled.
The Emkay story has gone well for the Indian securities markets. The market design worked as it should have. A human error was made, there was a brief market-wide suspension on the equity spot market (but the futures market continued to work). A call auction took place to discover the price, and within minutes everything came back to normal. Emkay took full responsibility for their trades and came through with the money. We shouldn’t stumble in the policy analysis that follows this story.