Men behind the money: Book Review in Financial Express 25th August, 2013

There has been a lot of interest in what goes on behind the appointment of heads of central banks, be it the Reserve Bank of India (RBI) or the Federal Reserve. There is always discussion on the independence of the central bank and the extent to which politics plays a role in determination of monetary policy. It is only more than timely and appropriate that these issues are taken up by Neil Irwin in his extremely engaging book, The Alchemists: Inside the Secret World of Central Bankers, where he traces the evolution of central banking and little-known facts of how decisions are taken by these so-called alchemists.
The name of the book is quite significant and interesting. Alchemists are people who turn base metal to gold. However, when you are a central banker, you turn metals, which were used in the earlier years as currency (copper) to paper money by fiat. That is how central banking began way back in 1656 in Sweden when Johan Palmstruch first brought in such money. The story also goes on to say that when things went wrong and money went missing in the vault, he was to be executed, unlike today, when bankers get away with just the critic’s censure when systems collapse. Times surely have changed. The role of alchemy is also played out when central banks go in for monetary easing when all else fails by printing more notes through the buyback of bonds and other financial instruments, which was done by the Fed, Bank of England and ECB, which is also like creating money from nothing. Irwin’s story is focused on the three honchos, Ben Bernanke, Jean-Claude Trichet and Mervyn King, who led their central banks with aplomb. An interesting anecdote here is that quantitative easing is not really a new thing and was introduced and pursued way back in 1866 in England when Overend and Gurney collapsed and there was a bank run. The Bank of England took on bills that were ‘otherwise good in normal times’ at a haircut to rescue banks. So the concept of rescue at a cost was there at that time too. The same did not quite work out in Germany when the Reichsbank printed money when the Treaty of Versailles put strain on the finances of the German economy, which Keynes had warned was not fair. The result was hyperinflation. Therefore, printing more money when all else fails is not always the right solution. In the US, just when the oil crisis had spread in 1971, the concern was on unemployment, growth and inflation. Nixon had wanted to bring the Fed under the executive so that the policies would be more positive. Therefore, politics cannot be separated from economics. Irwin explains the various pressures on the chairman of the Fed under these conditions when interest rates had to be raised, against the president’s wishes. Therefore, relentless pressure on central bankers to toe the line, especially during elections, is not really something new. Coming back to contemporary times, Irwin writes about how the three protagonists were of a different nature. Trichet, with his perfect manners, was persuasive and would ensure that the ECB took decisions and never left anything hanging. He would delay the lunch that was served until a decision was taken. Bernanke, surprisingly, even though being an academic, had to take training from a speaking coach and was consensus-driven, which was a challenge because he was dealing with 19 members. King, on the other side, was snobbish, loved sports and western classical music, and was disdainful of bankers who did not have training in economics. But he had a way with words, which was typically British. All three of them were for injecting liquidity and King did it to rescue Northern Rock Bank. In the US, it was tough considering that the investment banks were not really regulated by the Fed and hence in order to provide support, they had to invoke 13 (3) of the Federal Reserve Act, which allowed the Fed to lend to any individual or entity. Trichet had a tough time with opposition coming from Germany, which was against supporting Greece when the default happened. Under the Maastricht Treaty, such support was to be eschewed. Therefore, the idea was floated to create an SPV funded by the Euro members that would then take on these bonds and provide liquidity. Also interesting is the fact that the ECB was in general averse to aid coming from the IMF as there was a feeling that allowing such a thing to happen would mean showing some kind of subservience to the power of the US, which it is believed had supreme control over the institution. However, the interesting part is that the central bank always operates under guidance from the political leader in any territory. In the US, the appointment is political. Bernanke was not supposed to be an Obama man, as he was appointed by Bush, but his policies of being accommodative had worked and given assurance to Obama that he would be the right person to continue. At that point of time, Larry Summers, who is again today a candidate for the same position, was also in the running and supposedly closer to the democrats. However, Bernanke’s performance, as well as the fact that Summers was not a consensus person, worked against him. In fact, the entire rescue act, starting from AIG to money market mutual funds, such as Reserve Primary Fund, had the support of the government with Bernanke being backed by Tim Geithner. This had provided succor to both the funds and corporates. Again the wand of the alchemist had to be waved and Section 13 (3) invoked to transfer funds to an SPV, which, in turn, bought commercial paper offered by the funds. Quite clearly, innovative methods had to be used to resuscitate the system.Irwin also gets into the details of the Dodd formula where there was an attempt made to separate the monetary policy function from regulation and supervision. He did not quite manage to push through on this score in the Senate and went down 91-8. Banks naturally wanted the Fed, as the latter had rescued them in hard times. Meanwhile, we have had other versions of easing coming through, including Operations Twist, where the tenure of bonds was swapped to provide liquidity. On the same issue, the British experience was different. Bank of England, under King, wanted to wrest power from the FSA, which had power on regulation and King never missed a chance to have a swing at the deficit being run by the government, which gives us a sense of deja vu when one thinks of how Subbarao had also played this tune in the last couple of years. In fact, King was quite blunt when he likened central banks to the ‘nation’s economist-in-chief’ and said they should stay away from ‘politics’. The author moves adeptly between the three sets of nations and central banks to give the reader the pain and anguish that the bankers go through, even though they do appear to occupy celebrity status for the rest of the world. The decisions taken, which look as simple as lowering rates or using innovative methods, are not without opposition and severe criticism even within their own committees. Interestingly, while the Fed and Bank of England put up their minutes on their websites, the same does not hold for the ECB, where the agreement is that everything remains secret for 30 years! Therefore, we will never get to know who said what. Towards the end, and quite appropriately too, there is a chapter on how China does it. Things are very much easier when the entity conducting monetary policy, enforcing regulation, directing lending and formulating fiscal policy is the same person—the government. Things work smoothly when there can be fiscal stimulus, rates lowered, banks willingly lend and asset quality does not matter that much. That is how China got out from the possible mess.This book is easy to read with its stories. The historical backdrop is even more interesting as Bagehot had said during the crisis of 1866—Bank of England lent to merchants and banks and this man and that man to stop the run on the system. Surely, given the fragile nature of relationships between various entities in the financial system today and the domino effect of a failure, one does finally end up lending to this man and that man, almost always to avert a crisis. This tune has not quite changed over centuries now.

Lessons from the National Spot Exchange episode: Financial Express 22nd August 2013

The fissures in the National Spot Exchange model have quite expectedly been greeted with umbrage given the loss of money involved due to a failure of systems. The fact that the ministry of consumer affairs had warned of the inappropriate contracts much earlier did not lead to any action as the system was working just fine. The amount involved is quite large and it appears that the combination of the settlement guarantee fund as well as commodities stored in the warehouses cannot match the payments that are to be made. What are the implications or rather the lessons to be learnt from this story?
The idea of having an electronic spot exchange is to mimic what happens in a mandi in a transparent manner so that there is efficient price discovery and all parties are better off with counter-party risk guarantee being provided by the exchange. To make this work, systems of warehousing, assaying and weighing have to be in place, which improve the quality of infrastructure in the farm sector. This was the idea when these exchanges came on board, and the recent episode of what can go wrong is a lesson for all of us.The two immediate takeaways are that we require regulation at the top and adequate risk practices in place within the exchange so that there is orderly trade which results in delivery. The absence of regulation was the first lacunae because the way contracts were structured, it could be defined as being a spot or futures transaction. Also, given that players took advantage of the settlement cycles of 11 or more days, there was inherently interest arbitrage at the corner. This allows speculators or investors to buy and sell without having to take delivery of the commodity.Therefore, APMCs, FMC and probably a combination of RBI and Sebi would all be potential regulators as it involved spot sale, futures sale and financial investment. But the sector got away with no regulation. Ideally, all contracts should have been settled and delivery taken on the same day which would have been cumbersome but with less risk.Second, the exchange should have had its risk as well as surveillance systems in place. Typically, all contracts should result in delivery which was not the case here. Therefore, for this market to develop delivery should be mandatory. The surveillance systems were lax as it was assumed that nothing could go wrong as most transactions were by investors where the commodity was being traded multiple times. It was not expected that the ministry would ban these contracts as they overlapped with the futures market. Therefore, neither the physical commodity nor the positions taken really mattered. So, for a stock of, say, 100 tonnes, there could be 10,000 tonnes worth of contracts. The same is less likely to happen in a futures market as the regulatory systems are in place with margins, position limits and mark-to-market processes being in place.At a fundamental level it raises the question of whether or not commodities should be treated as financial products. This question takes the trail back to the Jalan committee which raised the issue of financial infrastructure companies being profit motivated. For an exchange to be profitable it has get volumes, and to enable this goal, it has to reach out to a vast community. We need to generate liquidity and a pure hedgers market will not do. Therefore, the spot or futures transaction in commodities has to resemble a financial product—just like, say, equity. The National Spot Exchange model was mimicking more the futures market rather than a mandi and was attractive on account of the assured returns that could be procured on the basis of a simultaneous buy and sell transaction. If the conventional mandi model is followed there would not be too many players at the terminal and the price discovery process would be less robust. So, it was necessary to get in more players with trading ability.Treating commodities as a financial product has its own set of issues as it becomes analogous to dealing with shares of a company. The difference is that when it comes to a share, there is no underlying risk and the only people affected by the share price going wrong are the owners of the company. But when it comes to commodities, the players who determine the price, especially in the spot market case, were generally investors who probably would not have known what commodity they were dealing in. But their decisions can affect the price of the product across the country and hence the ultimate consumers.Intuitively the concept of treating commodities as a financial product is compelling because inflation is normally always positive, which means that one will always gain in such a situation. There can be seasonal variations that add to volatility and make it an attractive investment option. Thus, in the medium term, one has to gain in commodities and any statistical exercise on returns on commodities which is found in presentations made to potential investors talks of returns of 20% on bullion, 10-20% on metals and 8-15% in farm products, in normal times. Add a crop failure and the returns on farm products could be upwards of 30-40%.An interesting question posed is whether financialisation of commodities also poses a conundrum for the commodity futures market. Does the futures price drive the spot price? If it does, then such trading runs the risk of being responsible for price inflation, which was the reason behind various bans imposed. On the other hand, if it is not, then there is no sanctity to such a market because we are not really talking of price discovery.Quite clearly, the commodity market has gotten into yet another controversy with the futures segment living with a shadow of bans while the present story would mean revisiting the ground rules of a spot market. The FMC will now be the regulator, but the question really is once we set the house in order, will the market ever be what it was like before?A corollary is whether commodity markets, either in the physical form or as financial futures, better off if they are overseen by a regulator which is savvy in terms of the product being dealt with. As both e-spot and futures in commodities are financial products, there is now a strong case for shifting the FMC to the ministry of finance. This has been debated for a long time with the clinching argument for being that the ministry of consumer affairs is more tuned to commodities. But as things have turned out, commodity trading without a large element of financialisation is not sustainable. Thus, the case can be transferred to the ministry of finance for better oversight with FMC, like Sebi, being made an independent regulator.

A twist in the rupee tale: Financial Express 20th August 2013

If FY12 and FY13 were the years of our battle against inflation, FY14 has been a war against the falling rupee. The decline in the value of the rupee has been quite prodigious from R53.74 as of May 1 to R62.35 on August 19. We have taken our balance of payments for granted for a long time and have been liberal with imports with the comfort that foreign inflows would protect the current account deficit. But there has been, what Jeffrey Archer would have called, a twist in the tale, this time when the inflows got converted to outflows, and the rupee went down.
RBI, as usual, has been left holding the baby, as it is the case when anything goes amiss. It also runs the risk of facing the flak because every economic decision has a tradeoff, and some constituency gets affected. The latest buzzword is ‘collateral damage’ caused by too much intervention as bond yields have zoomed and the stock market has plummeted. The alternative would have been to do nothing and let the market decide the exchange rate, in which case the participants would have panicked in the expectation that RBI was targeting a higher number. The more uncharitable would have likened the state to that of Nero. Really, a hard choice to make under these circumstances.To cut short the often-explained story, the rupee has fallen due to fundamentals turning sour and adverse sentiment caused by the QE withdrawal. The government and RBI have acted together to control the fall in the value of the rupee and the approach has been, to use the oft-repeated cliché, calibrated. The fundamentals have been drawn down in a granular fashion and measures have been invoked to control the outflow of dollars and increase the inflows. The inflows will increase through FDI only over a period of time as India is no longer a hot destination under the given circumstances. ECB norms have been relaxed, which will help. NRI deposits have been provided an impetus with the increase in interest rates, which could get in more dollars in the medium run only. But none of these measures will get in dollars on a daily basis to strengthen the coffers. Sadly, a declining rupee has not quite spiked exports, which appear to be driven more by demand conditions in the West, which are still lacklustre.The so-called crusade against outflows has started off with the war against gold where the duty is now 10% and channels of finance have been cut drastically with only exporters and jewellery makers having relatively easy access. This has helped, going by the government data on import of gold, though one is not really sure whether the harvest and festival season will cause a reversal.More recently, curbs have been put on current account with the reduction in limit on outflow through remittances. Add to this restrictions on outward FDI, and the measures have been fairly stiff. Given that there are not too many companies that are investing 4 times their net worth or even a multiple of 2, and that there are not too many opportunities overseas given the stagnation there, the savings in dollars will not be significant. The curbs on external remittances are more of a nuisance at the household level, and will not really help to shore up the rupee. The next target could be non-essential imports, which cannot be ruled out considering that a very determined FM has averred with certainty that the CAD will be at 3.7% just as the fiscal deficit will be at 4.8%. Making imports more expensive is a good way of installing a deterrent as was the case with gold as a combination of additional 6% in duty plus depreciation of 16% actually pushes up the cost by over 20%. Has this worked?The answer is ‘not really’, because while imports have slowed down, at least for the time being (these months are also not the marriage season), the fall in the value of the rupee appears to be almost continuous. RBI has simultaneously squeezed liquidity by tightening the CRR norm, half closed the LAF window, sold bonds through OMOs, introduced weekly CMB auctions to ensure that no speculative positions are taken in the forex market on account of arbitrage opportunities. This worked in a time frame of 1-2 days, after which it appeared to be a ‘fall as usual’. The NDF market has been held responsible at some point of time, but all legitimate participants have to inform RBI of their actions, and while the volumes are substantial in this market, the impact would be low as it is only the difference in price that has to be paid for which will impact the spot market locally. The forex derivative market which is mainly on NSE and MCX-SX have witnessed volumes halve in the last month with curbs being placed on margins and position limits. The average daily volumes on NSE have come down from R25,000-30,000 crore to R10,000-12,000 crore. The rupee still seems to keep falling. FIIs in August have been positive in equity and negative in debt.RBI had sold $1.8 billion up to June (the number would be higher in July) while our foreign currency reserves have declined by $8.4 billion. The decline in reserves is symptomatic of the decline in the value of the rupee while the sale of dollars by RBI indicates that this also has not really helped. Quite clearly, the sentiment factor has been working in pushing the rupee down.What next then? It looks like once we put in additional curbs on imports, the government and RBI would have done all that is possible from the point of view of fundamentals. Speculative activity, to the extent that they are being played through the institutional route, has also been addressed. The impact has been limited. In a way, it is more like what Shakespeare would have said, “full of sound and fury, signifying nothing”. The logical corollary is to now sit back and let the rupee find its own level. That would lead to market equilibrium. But yes, we have to bear judgment here that a free fall in the value of the rupee is self-fulfilling—FIIs keep out, ECBs come down and FDI starts rethinking. Are we prepared for that?

Getting behind poverty numbers: Financial Express August 12th 2013

The recently-released data on poverty is quite interesting. The poverty ratio as measured by the Tendulkar methodology has come down to 21.9% in 2011-12 from 37.2% in 2004-05. This is certainly a major achievement. There can be debate about whether the criteria used is right or wrong, as the average monthly expenditure (which is the route chosen here) has been pegged to R816 per month in rural areas and R1,000 in urban areas. But, in economics, once we define a criteria and stick to it, there is nothing amiss as long as we are using the same yardstick at two periods of time. At a broader level, one can ask whether anyone can actually live on an income of R26-27 a day, which is a third of what the World Bank would define as a poor person based on $1.25 a day, which comes to around R78 based on exchange rate of 2011-12? But, even so, the fact that the level of deprivation has come down based on certain criteria is a good sign.
In the current context, two questions arise. The first is when we are going for food security, we are covering around 70% of the population, and while it has been admitted that the aim is not to cover just the poor but also the not so poor, the difference in numbers is quite large. The Food Security Bill (FSB) makes sense if we link it to the $2 a day criteria of the World Bank, which, by the 2010 estimate, comes close to the number of 800 million population. The conundrum is that if the government gives importance to the Tendulkar poverty ratio, it would actually be opening the door for controversy because by these criteria we have only 269 million poor people in India and, by covering 800 million under FSB, we could be overdoing it. Alternatively, we should not pay heed to the Tendulkar criteria and use it more as a theoretical reference point as it cannot really be linked to the actions of the government.The second contextual issue raised is how has this number come down sharply from 407 million in 2004-05 to 269 million in 2011-12, while it remained flat between 1993-94 and 2004-05 (404 million in 1993-94)? Of late, there has been a war of words, which is quite typical in the context of economists, between Sen and Dreze at one end and Bhagwati and Panagariya at the other. The former have been stressing on tackling poverty directly through schemes and measures which include things like the MGNREGA while the latter have followed the capitalist model of growth from above which will trickle down. Now, if poverty has come down so drastically in the last 7 years, is it due to high growth or direct intervention?GDP growth was 8.5% in the period 2005-06 and 2011-12 while in the preceding 7 years or the period from 1993-94, it was around 6.2-6.4%. But under the UPA government, we have had the largely successful MGNREGA programme, which has provided about R25-30,000 crore on an annual basis to the rural families, which has also helped to push up the average wage in the country for unskilled labour from R60 to R130 per day. Thus, it looks that both the factors have been at play; but given that rural poverty has fallen sharply (by 110 million while that in urban by 28 million) and most of the growth has been urban-centric, one may tend to support Sen and Dreze here. Any way, such data is a scoring point for the present government as it shows improvement in poverty numbers.The other interesting takeaway from the poverty data is the spread of this ratio across states (the smaller states of north-east are ignored as they tend to have extreme numbers due to their small size). The lowest poverty rates are in states like Andhra Pradesh, Himachal, Delhi, Kerala, Tamil Nadu, Punjab, etc. Andhra is significant because it is also a large state with a ratio of just 9.2%. Rajasthan, once a part of BIMARU states, does very well with 14.7%.The unsatisfactory numbers come from the usual suspects who are also large like Chhattisgarh (39.9%), Bihar, Jharkhand, MP, Orissa and UP. The surprise package here is Karnataka that has a high rate of 20.9% considering it is one of the better performing states in other respects. Quite clearly, action needs to be taken here to lower these numbers not just from the point of view of alleviating the condition of the poor but also because it has other social consequences, which include the birth of extremist activity that is also visible in some of these states. Overall, there are 10 states that have higher poverty ratios than the national average. States such as Maharashtra, Gujarat and West Bengal have a median level ratio of 15-20%.These high numbers are also reflected in the rural poverty ratios in these states with Chhattisgarh and Jharkhand crossing 40% followed by Bihar, UP, MP and Orissa. Maharashtra also comes quite high with 24.5%. Urban poverty ratios are also higher in these states though Maharashtra does well with 9.1 (13.7% for the country).Some thoughts pop up when looking at these distribution numbers. First, our poverty alleviation programmes should probably begin from the states that have higher numbers so that we are able to address their concerns and lower this rate. Second, at the political level, the state governments in power must divert more funds from their budgets for such programmes to supplement the efforts of the Centre. Third, given the wide scale disparity across states, there could be two repercussions. The first is migration to the better performing states and the second is the threat of insurgency given our experiences from the past. Fourth, we need to draw lessons from what states like Andhra have done to bring down this number as given the size, the progress has been remarkable. The same holds for Tamil Nadu. There is, hence, hope for the food security programme as these two states are definitely the success stories for PDS. Last, while it is nice to have these numbers down, the next line of action must be to sustain the same and push these households on to the next step of the consumption ladder. That would be a real achievement.

Understanding federal systems: Book Review in Financial Express 11th August 2013

The approach and process of reforms are extremely important in countries that have a federal structure. There are some measures that can be implemented unilaterally with ease by the Centre such as those relating to, say, financial reforms or delicensing or foreign trade. These are ‘national’ in level and do not prima facie affect any of the sub-nationals such as state or local governments. However, when reforms involve the ‘power’ or ‘finances’ of the sub-nationals, there is an inherent conflict of interest, which makes the reforms process more challenging because it is necessary to ensure that there is responsibility and accountability at each and every level for the system to succeed. In fact, invariably, reforms are always targeted at the national level to begin before moving over to the second level, where alternative approaches have to be used to assure compliance before being implemented.
Howes and Rao, authors of the book, Federal Reform Strategies, study in great detail the structures that exist and the success attained in countries like India and Australia, while there are also contributions on China and Indonesia. While they do not attempt to come up with a prescription, they do create theories on how things could work, based on experiences in these countries. The conclusions drawn by them are engaging. In a federal set-up, reforms related to economic integration, or natural resource or environment management, cannot be made effective without the active participation of sub-national governments. They look at the issue more on how central governments can motivate, influence and ensure the coordination of sub-national policies. The authors believe that there are certain structural pre-requisites that are needed for success. First, there needs to be a hierarchy of governments in any country, which are clearly laid out, preferably by statute. Second, sub-nationals should have priority in their own regions or territory so that they are responsible for the same. Third, the national should be allowed to police the sub-nationals or else it will get chaotic. Fourth, all of them should have budgets and work under this constraint so that they have something to look forward to from the central government. Last, there has to be allocation of responsibility across each levels, which can be done institutionally, like, say, the Constitution for India.Studying the way federal systems operate, the authors interestingly conclude that there are basically five strategies, which, though similar in nature, are used to make federalism work. Cooperative federalism is probably the best option where tax reforms are concerned as the Centre works with the sub-nationals to garner and allocate resources. There can be conditional federalism, wherein states are provided benefits subject to certain conditions being met. A variant is programme federalism where the linkage is with a specific programme such as, say, an education or health scheme that has to be implemented from above. Parallel or centralised federalism is where the Centre changes policies for the states, which becomes imperative if the other systems do not work, while in case of competitive federalism, the state which does better based on certain performance parameters is allowed to go ahead with Centre’s support. Their own observations are that most reforms fall within these categories of federalism. In Australia, they have used cooperative approach for taxes, conditional recipe for reforms, programmed structures for transfers, centralised solution where there are disputes such as in case of the use of water and competitive strategy to provide more funds to the state of Victoria where the state had spent a lot on health facilities relative to others. In India, we have a federal structure where the Constitution lays down the structure of devolution of power, while the finance commission addresses issues of allocation of funds. Of late, however, there has been a case of the polity becoming complex with regional parties dominating in states and the Centre being run by coalitions. Federal reforms become necessary for further progress. With the abolition of, say, licensing, investment will automatically go where the environment is the best, which should lead to competitive federalism. Gujarat has been a beneficiary here. The states have also agreed to follow VAT which is an achievement though the GST has gotten stuck with states wanting compensation for potential revenue loss on account of this system. The pictures of China and Indonesia are also interesting. Both countries have grown from starting off as controlled economies but the challenges have been significant. Indonesia has had to provide incentives to states for protecting forests as they were a state subject and there was revenue to be foregone if deforestation was stopped. To ensure that this was curtailed an incentive programme had to be launched. China faces problems in controlling the emission of carbon. While the Centre is keen and aggressive, once it goes to the states, there is little will to do the same. But given that the powers exercised are higher for the Centre and the parties in power similar at both levels, the task became easier in case of China. Do they have preferences for any form of federalism? The Indian system faces challenges while adopting their models. The authors show how the centralised model has been followed by imposing rules through the department of personnel for, say, the arbitrary transfer of IAS officers by state governments especially when the parties change. In Uttarakhand, there had to be intervention from the Centre to ensure that the environment was protected even as the state was keen on leveraging on the hydro-electricity potential. States are trying to get competitive and the best examples are Bihar and Gujarat where higher governance levels have delivered success. In fact, they feel that structures based on ‘conditions’ may not work. This was seen in India, too, where grants were linked to certain conditions being satisfied. But they were not attractive enough to prompt any action. Centralised solutions are required when all else fails, especially in issues relating to environment or water. But still strains remain when the parties in power are different at the two levels in which case there has to be cooperation. But the important message they leave behind is that the Centre has to take the lead any which way to ensure that the goals are met. For this to be successful, it has to be proved that the measures to be implemented have an impact on the target goals. Further, the incentives provided to the states must be strong to make them act irrespective of their political affiliations. It would work then. This volume of collection of articles would be more useful for policy makers, especially in India where such conflicts have arisen on a number of occasions leading to an impasse quite often. While it is not unequivocal that a single system works, we need to have a combination of all these models depending on the situation to ensure that policies can be made to work through the appropriate federal reform module.

Can Rajan make a difference as RBI Governor? - YES: Hindu Buisness LIne 9th August 2013

While much of the conjecture on what Raghuram Rajan will do differently has been on monetary policy, little attention has been paid to his core competence in banking systems and regulation, where he has made a major contribution. Having authored the Report on Financial Reforms and gone through the financial crisis advising what to do, he would be expected to take the Indian banking system to a new level, given the twin goals of meeting the regulatory challenges while bringing about financial inclusion.

On the side of monetary policy, there is a lot of guesswork especially within India Inc, given the impatience at the current interest rate policy. However, monetary policy options are always driven by theory and presently it is not known whether Rajan is a monetarist or Keynesian or follower of rational expectations. Normally it is difficult for any central bank Governor to be committed to any specific school of thought, as the response is always situational.

Continuity, alongside tweaks

Today the currency is the major challenge and the present stance is that a free fall is not advisable as it is destabilising and therefore, intervention is necessary. All options, such as curtailing liquidity, restricting advances for gold, discipline in derivative trading and intervention through currency sale, have been tried out. If anything more has to be done, then it will have to be more of the same, or similar indirect options. Therefore, till the rupee stabilises, it is unlikely that the die can be cast on the growth-inflation trade-off. The only change in approach can be that we allow the rupee to slip to what the market dictates, which is not presently the RBI’s stance.

Today, inflationary expectations are high as the impact of rupee depreciation has not yet been felt on core inflation. Yet, Raghuram Rajan can take a call that the present conservative monetarist approach to policy has not quite brought inflation down and therefore, we can move the trade-off to a higher level by lowering interest rates. Anecdotal experience in the last year shows that lowering of the repo rate has not quite brought down lending rates.

Therefore, there is weight in the argument that if high levels of interest rates have not brought down inflation, lowering the same has also not brought about growth. This will be the conundrum for the new Governor.

He has already indicated that he does not have a wand. Lowering rates in the next policy cannot be ruled out to provide a fillip, but it may not keep the engine going forward. Given that monetary policy is only a facilitator and one of the many factors that bring about growth, continuity in general with tweaks here and there could be the short-term response.

Correcting the fault lines: Financial Express 8th August 2013

The appointment of Dr Raghuram Rajan as the Governor of RBI does not really come as a surprise but certainly ends speculation on the issue. The obvious question that arises is whether or not there will be change of stance in monetary policy once he takes over and, as a corollary, will the solutions be any different given the multiple conundrums we face on growth, inflation and currency.
First, the choice of Rajan appears to be more on the global lines where the Bank of England has appointed Mark Carney from Canada. We have opted for this route as Rajan brings with him a lot of experience from the West, especially the IMF, and has the reputation of the one who saw the crisis coming. The fact that we are exploring options of raising funds from international markets is pertinent here as he could steer the ship in this direction. This is a big advantage for us too when we talk of Basel III and banking regulation in India at a time when the entire system is under various pressures imposed by the new regulatory regime.Unlike Carney, Rajan has the added advantage of having worked with the PMO and the finance ministry and hence understands what goes on at the ground level to better appreciate how various segments are affected by policy measures. This is important because Indian banking has different priorities given the focus on inclusion, which is not the case in the western countries. Further, the fact that he has studied and authored an entire report on financial sector reforms indicates his expertise in all areas.The next question is more speculative in nature on how he sees the economy going and the kind of measures that would be taken. On the face of it, so far, the CEA has been in consonance with the moves made by RBI and hence there has never been any overt disagreement on the approach taken by RBI. Therefore, one may expect continuity in approach in general. So far, RBI has a priority list of currency, inflation and growth in the pecking order. Will this change? This could be possible because there are evidently multiple views even among economists on what should be the main priority. And also it is quite possible that conditions could be different in September when he takes over in which case it could be a no-brainer.Assuming the present situation prevails, can anything be done differently on the currency? RBI along with the government has covered virtually all possibilities. Measures have been invoked to curtail imports, while the government has worked to increase exports. RBI has curbed the speculative routes to influence the rupee by tightening liquidity. More elbow room has been provided for higher ECBs and FIIs flows (along with Sebi) while the government has done its bit on the FDI front. So, it looks like all options have been covered that also includes direct intervention where our reserves have been drawn down too since April. Can anything more be done? Probably not, unless the new RBI Governor takes a view that the rupee is not properly valued presently and should be allowed to gravitate towards a lower number of, say, R65. That would be self-fulfilling. But, at any rate, irrespective of who occupies the position, the rupee has to be brought under control or else it could retard the flow of foreign funds, which is but natural when the currency is considered to be weak.On the issue of growth versus inflation, Rajan could have a different view. The ministry of finance has felt often that we should change gear and move towards growth and not get obsessed with inflation. While the CEA has not taken this stance, this view could get a prominent place in the scheme of things provided there is conviction. This can be a change of stance where we accept a higher inflation rate on grounds of it being structural in nature and pitch for growth. Hence, it could become a valid possibility and, theoretically speaking, there is nothing right or wrong in either of these stances, because when there is a tradeoff, the Governor has to choose the line of best fit in this scatter graph, which, in turn, will guide the market. Since we have been living with low growth and high inflation in general, there are expectations that the stance will change. It may or may not work, but still a change could be worth experimenting with.Thus, Rajan will actually be taking over at a time when the economy is in a difficult state. For three years now, growth has been down, and inflation not really at a comfortable level. This would not have been an issue in the past, but after being used to 8% growth number with visions of 10% growth being spoken of, 2 or more likely 3 years of low growth is hard to digest. Expectations from RBI have been high and while RBI has lowered rates, banks have not followed suit to the same extent, which creates another set of problems for the Governor. In fact, another task will be to ensure the stability of the banking system in the midst of high NPAs and restructured assets and an economy that is sliding downwards. Add to this the challenge of banks adjusting to the new capital framework, banking regulation and supervision becomes as important as monetary policy.The real point of interest would be of any change of stance which can possibly turn things around. We normally tend to personalise such policy priorities which may be interpreting more than what may actually be. Normally the approach is of the central bank as an institution that is driven by members of the institution rather than a single view. Nonetheless, it is still interesting to formulate conjectures as the market is always looking for the same.

Decoding Nandy: Book review in Financial Express : 4th August 2013

Ashis Nandy has been described in a dualistic manner by author Christine Deftereos in her book on his persona, Ashis Nandy And The Cultural Politics of Selfhood. First, he is a political psychologist and second, an intellectual street fighter, who takes on both the politics of psychology and the psychology of politics with equal ease. In this process, it is not surprising that he rubs people the wrong way. While there has been a lot of psychoanalytic theory that goes into his thought process, the author focuses essentially on his writings on secularism and the rise of Hindu fundamentalism, and its influence on the way politics is carried out in India. His critique of Indian secularism has produced intense controversy in the past and has proved to be a dynamic case to explore the relationship between the critique, method and the critic.
The book characterises the mode of dissent in Nandy’s work. He tends to be critical of secularism and feels that the imported content of the western ideal is not compatible with the existing home-grown concept of tolerance and social cohesion. His anti-secularism tirade cannot be taken as being just an anti-western ideology. He carefully demonstrates the processes of subjection and the making over of the ‘ideal’ secular subject within Indian politics. His detailing of the forewarning of the flaws of secularism can be juxtaposed with the ascent of Hindu fundamentalism in the nineties. For him, the claims of Indianness advanced by Hindu nationalists and the promise of unity and security that accompany their claims, foreclose the ambivalence and contradiction of Indian traditions, culture and identity. Nandy has argued that the clash between modernity and religious traditions in Asia and Africa emanates from four political responses to ethnicity. These are: Western man as the ideal, the westernised native, the zealot and the non-modern peripheral ethnic. The western man as the ideal political man is a familiar cultural archetype and central to the victory of western colonialism. The rational and secular mindset goes with progressive deals, which has been successful in the West. He becomes the reference point for us to follow and could be the ideal that we aspire to be. The westernised native, where the best example is Jawaharlal Nehru, internalises the imago of the western man, thus accepting the conditions of subjection. He is the non-believer in public and private, though Nehru was prone to the use of advice of astrologers at times, thus showing ambivalence. This native continues to work towards the consolidation of ontological security derived from the identification and subjection in service of the culture. The zealot could be Sikh, Muslim or the Hindu revivalist. In fact, he has argued that the rise of Hindu nationalism is intimately connected to the pathologies of secularism. This person has hatred for the westernised ethnic as having proverbially sold out to the western man. Further, the non-modern peripheral ethnic is the most significant subject type where Gandhi fits in, which could be a disruptive subject. The author also traces Nandy’s views on the rise of Hindutva ideology, which has been associated with the eruption of violence in the 1990s. He argues that this is not a sign of communal politics, but connected to a secular political culture; as such, violence has to be viewed from the point of view of being a part of a larger defensive force operating in politics around Indianness, national identity, national integration and democracy. For Nandy, the political seeds giving rise to these events had been planted earlier and have to be understood as continuing effects of distortions of a dominant secular ideology, altering cultural, social and political priorities. He is basically against both secularism and Hindutva, which he classifies as faulty ideologies. He, in fact, chastises the Congress under Rajiv Gandhi for playing on the epic serial Ramayana to reach out for votes. As a corollary, he links violence in Gujarat in 2002 to political machinations as seen by the localisation of such incidents to areas where the BJP did not have a stronghold. According to the author, Nandy confronts and traverses the dominant view that communal amity can only be safeguarded through a more aggressive pursuit and commitment to the ideology of secularism. He treats such fantasy structures as chimera and ruptures the existing meanings and assumptions. By rejecting the secular ideal, he explores features of Indian politics that are excluded from the discussion table. Now, critics do aver that Nandy and his work are based on beliefs that represent an intellectual basis of anti-secularism and anti-modernism in India. They believe that his work carries forward a threatening and disruptive quality, which moves toward what is called regressive traditionalism. These responses represent his ideas and identity within a particular ideological and intellectual framework. Some critics even say this only shows that he is leaning towards the Hindu right. The author emphasises that his commitment to psychoanalytic processes of revolt does not foreclose his commitment to maintaining the dynamism of these internal resources, which include societies or cultures of revolt. He feels that it is within these features of Indian tradition that a culture of revolt can be found. Deftereos does a fairly commendable job of daring to take on critically one of the most confrontational and incendiary of Indian political scientists and also presenting a balanced and intuitively agreeable assessment of the intellectual works of an anti-intellectual public thinker. The author has put forward the view that the approach taken by Nandy is geared toward the psychoanalytic mode. This mode of engagement is revealed in his capacity to generate critical analytic perspectives that expose and regenerate subjectivity, including his own. His psychoanalytic commitment comes out in all his writings, and argues the importance of this approach. She, therefore, argues that the purpose is not to offer a correct reading of Nandy’s position but to demonstrate how these responses fit in his methods. She best summarises his contribution as being an attempt—and a brave one, too, to discuss the tensions between the past and the present, tradition and modernity, public and private selves within a society; the recovery of selves, the politics of knowledge, formation of political cultures, the health of a democracy and the global culture of common sense. The book is definitely not for the common man, but the follower of politics or rather the psychology of politics as the discussion level is of an esoteric nature.

Food for thought: Book Review, Financial Express 28th July 2013

Picking up the book, Indian Financial Reforms: Priorities and Policies Post Global Financial Crisis, one does tend to be a bit sceptical. The 19 articles in the book have been written by three governors or former governors of the Reserve Bank of India (RBI), three deputy governors, two executive directors and three other authors, two of whom served with the RBI and the ministry of finance, and Joseph Stiglitz. Will these pieces deliver anything new, considering that most of what the RBI top officials say is already available on its website?

With this apprehension, the reading of the book was embarked upon, and it has been an amazing experience. The collection of articles is quite brilliant, which is the case for most RBI pieces, and one of the former RBI authors, NA Majumdar, brings in a breath of fresh air where he attacks the famous Raghuram Rajan Committee Report. Stiglitz is always a pleasure to read and this time, he talks of why quantitative easing (QE) does not make sense.
Governor D Subbarao takes on Basel III in an FAQ format and asks 10 questions that everyone wants answers to. He admits that there are short-term costs, which are worth the while as even nations like China, Singapore and South Africa have stiffer targets than the RBI. At another level, he talks of the importance of the G20 in the aftermath of the crisis. Here, his view is that governments should be accountable for their actions, as in this globalised world, all countries finally get affected by each others’ actions. There has to be a balance between short-term goals and stability in terms of monetary and fiscal policies. In another piece, he dwells on how the traditional trilemma of balancing fixed exchange rates, monetary policy independence and capital flows has now been replaced by price stability, financial stability and sovereign debt in light of the two crises that have taken place. He subtly hints at how with long-term refinancing operation (LTRO), there has been a tendency for fiscal dominance over monetary policy—something that is debated in India too over RBI independence. There are evidently limits to the use of non-conventional measures.
Talking about non-conventional measures, such as quantitative easing, Stiglitz is at his acerbic best, where he blasts these measures that have been introduced at a time when US companies are sitting on a pile of cash. What QE does is provide cash that can be invested outside the US, which makes no sense from the point of view of reviving the US economy. And these funds have created problems of overheating in some other geography. He refers to the Stiglitz Greenwald model, which shows that monetary policy ceases to work after a point of time, as it is no longer banks that dominate the landscape, but the financial system, which includes the shadow banks. This phenomenon is serious as it has come up essentially to dodge regulation.
Majumdar, a votary of the Indian banking system, is critical of the report, which spoke of a hundred small steps. He has enough to show that we should be proud of the RBI and the progress made by the banking system in the past 40 years or so, and it should not be viewed with condescension. He shows how the Indian banking system, led by public-sector banks, delivered a lot, thanks to nationalisation. The entire concept of inclusion that we talk of today was possible because of this effort. Therefore, he is against the use of the International Monetary Fund (IMF)/World Bank/Washington Consensus approach, which has proven to be a failure all over. Also, he is against the privatisation of public-sector banks (PSBs). When PSBs have delivered both stability and reach, why change them? He is caustic on the homework not done by the committee and gives an example of the talk on warehouse receipt finance, which was an old concept of 1956 and did not work. He feels that the committee should have worked out why it did not work rather than make such banal recommendations.
YV Reddy also writes on society and economic policies relating to the financial sector. An interesting point brought out, which makes one think, is on ‘regulatory capture’ in India. This happens when the regulator depends on the regulated for advice. Further, when academics are brought into such committees, they have links with market participants, voice their view and are hence not really independent. Also, based on experience, he articulates that often the financial sector offers jobs in the higher-ended treasury functions for those in the ministry. Clearly, this is not how the system should ideally function. His points are pertinent and while he does not take names, it is not hard for the reader to guess who the references are to in all these areas.
Deepak Mohanty is very clear about his vision for the money market. The movement has to be towards interest rate changes rather than quantitative measures. However, the transmission of interest rate changes has not been swift and has worked at the shorter end of the curve, helped a lot through the open market operations (OMOs) of the RBI. Alongside, he shows that the liquidity adjustment facility (LAF) is not the most efficient way out and we need to develop the term repo market. In another article, he stresses on the need for financial stability, which is as important as price stability and this holds across the world. His takeaway is that central banks across the world have to collaborate and as the responsibility is shared today, it cannot be left to only some of them.
On the same issue, Anand Sinha is quite eloquent as he points out that while financial stability is robust in India, there are still downside risks to the domestic economy on account of global inter-linkages. Internally, we have to be prepared for Basel III and banks and financial institutions (FIs) have to work with the RBI to ensure that we are on the right path. Here, he emphasises the need to pay more attention to risk management as non-performing assets (NPAs) are bound to rise along with the macro-economic cycles and we need to be prepared by having our systems in place. Stress testing and development of early warning signals will be the way forward for maintaining the sanctity of the financial system.
There are also two interesting articles on financial inclusion by Subbarao and RBI deputy governor HR Khan, which ask banks to look at priority sector lending as a business, which should set them thinking. Bank credit to Khan’s mind should be treated as a public good—very broadly speaking. The focus should continue to be on self-help groups (SHGs), micro-finance institutions (MFIs), BC (business correspondent) model, etc. Technology should be harnessed to deliver results here. Subbarao goes on to admit that critics of priority sector lending do have a point when they say banks should have the freedom to lend where they want to, but such laissez faire approach does not work in India given the necessity of addressing the requirements of the underprivileged. Therefore, we need to have a policy for extending financial inclusion.
Uma Kapila has brought out a very nice compilation of interesting articles and views that should keep us thinking. This is a superb update on everything one wants to know about the financial sector of India, coming as it is from some of the best minds in this segment.

Damned if you do, damned if you don’t: Financial Express 25th July 2013

It is not surprising that the Reserve Bank of India’s decision to tighten liquidity in the system last week has been met with umbrage on grounds that we may be choking growth for a longer period of time. Given that there was hope that RBI will lower interest rates with relatively low inflation numbers, this move comes as a shocker. RBI becomes the favourite whipping boy for everyone because it has become fashionable for market players to expect the central bank to do everything to please it, and when this does not happen, there is resentment. But RBI has to look beyond the markets.

There is a method in the measures that have been taken so far by the central bank to tackle the falling rupee. It started on the exporter’s side in May to ensure that they bring in their earnings. Gold import curbs were next imposed on trading agencies. Telcos were allowed to refinance rupee loans and low-cost builders could access the ECB route. Buyback period for FCCBs was extended next and further curbs put on banks with respect to gold dealings. Provisioning requirements were imposed on banks dealing with corporates with unhedged forex positions and limits were increased on derivative trading. Therefore, the present liquidity curbs are just another step in this direction and should be interpreted within this context and not as an isolated instance of tinkering with the money market. In fact, further curbs have been imposed on gold imports by linking them with exports. Quite clearly, it has been a calibrated approach to tackling the problem.
Will these measures work? To the extent that the rupee is driven by such events and sentiments, there is an impact as was seen by the rupee regaining ground. But it becomes mean reverting in the range of 59-60, which has been the case in the past too. It has happened again this time, meaning thereby that these measures have had a limited impact on the market. The impact of any such measure is transient, but it does successfully address the objective of curbing speculative activity to the extent that it was present.
Now, the R75,000 crore norm under LAF is not really out of sync with RBI’s often stated stance that repo borrowings should not be more than 1% of NDTL. Besides, when there is adequate liquidity in the market, there is little reason for the repo window to get a long line of customers. In fact, a couple of years ago, RBI had cautioned on excess borrowing from this window by banks where funds were being diverted for lending which could create an ALM problem. One can guess that this measure is temporary as the purpose is to ensure that this liquidity does not flow into the forex market. Once RBI is convinced, one can expect a walk back on this measure. Similarly, increasing the MSF rate is pragmatic as once banks borrow at 10.25% there will be less scope for using it for speculative purposes, to the extent that it was happening.
Where does this leave us? The panic in the markets lasted a few days and the fact that the OMO and T-bills auctions did not elicit the desired response shows that either banks wanted better yields under the given conditions or that there was no excess liquidity in the system to begin with. However, banks which rely on short-term funds will face the brunt though it is unlikely that long-term rates will move up across the board. The call market will become volatile and the band will be 7.25% to 10.25% with pressure mounting in the reporting fortnights. Liquidity should not really be an issue. RBI data show that in the first quarter of the year, deposits increased by R3,397 billion while credit increased by R1,546 billion and investments by R1,307 billion as of June-end. Therefore, there is no fundamental threat to the credit process, which is normally muted till August-September. The GSec yields have become volatile with the 10-year yield hitting the 8% mark in a short while. It looks like that this scene will last till the end of the month, when RBI comes out with its policy statement where a stance and view will be provided.
RBI is really on what can be considered the prudent path given the state of the economy. True, the economy is stagnating as the latest industrial growth numbers show. But that is not RBI’s fault and whenever it has lowered rates to please the markets, the response has been lukewarm. Merely lowering interest rates does not lead to growth as not only is the transmission mechanism not efficient, but so is the demand situation. Capacity utilisation data collated by RBI show that the rate is around 75% as of December and, therefore, there is less of a need to invest when demand conditions are low and interest rates high. Consumers are not spending because they have to allocate a larger part of their income for food items. Therefore, there is a view that we should unbundle the issues and not read too much into the growth aspect of these moves, howsoever tempting it may be.
What about policy rates? RBI has been targeting inflation which has largely been driven by food and fuel prices. Core inflation was under control and has reached one of its lowest levels in June even though generalised inflation has inched up. This does not provide comfort because the impact of imported inflation, which will be primarily in fuel and manufactured items, has not yet been felt. RBI will hence have to wait and watch before taking any call on interest rates. Further, given that the rupee is slippery and FIIs are in a sell mode on the debt side, retaining interest rates at the present level may not exactly be a deterrent, but lowering it would hasten the outflow.
This brings us to the final point: how important then is the exchange rate considering that all efforts are on to control the slide in the rupee even though industry feels we are barking up the wrong tree and impeding growth. We have had several measures invoked to control the rupee slide and RBI has also sold dollars in the market—with limited success. An alternative extreme thought could be why not allow the rupee to find its own level, say, R70 per dollar. Automatically imports of non-essentials will diminish and the CAD will improve. The only fear is that while inflows gain, outflows lose and this can be a dangerous trigger for FIIs which can exacerbate the situation. This being the case, it becomes more essential for us to keep control over the rupee so that stability is maintained in an otherwise fragile balance of payments state.
The central bank has a difficult role here. If it does nothing on the rupee, it is damned. If it does something, which invariably means pain somewhere else, it is damned again. Not really the best of the positions to be in.

Where Is The Dart Board? Business World 29th 2013

Schwager is brazenly irreverent, but never sounds irrelevant. He is quite direct in his attack of generally accepted theories

eading Jack Schwager is entertaining as he demolishes several established shibboleths on market and exposes theories that have been held sacrosanct for years. He takes on as many as 50 investment misconceptions and con­vinces the reader that he has been ‘had’ in case he follows such advice. For one, Schwager shows from CNBC clips as to how experts proved to be an embarrassment during the financial crisis. How does he explain these fallacies? When we try to explain how markets work, we use neatly constructed models and theories as they are convenient. Often, the data we use for building models is not representative of the current situation and this is why we tend to go wrong. So, there are biases inherent in such approaches.

Theories are erroneous and models unrealistic and with our cognitive biases and unsubstantiated beliefs, we err often.

Further, the much sacrosanct ‘efficient market hypothesis’ is demolished easily by the author as the assumption that the price reflects all information is incorrect as past data is not relevant and we cannot beat the market by using public information because everyone has it! Schwager says following experts is as good as aiming at a dart board without looking.

Often, we use volatility as a measure of risk and link returns accordingly; and hence run the risk of using an incorrect metric that does more damage than not using any such indicator. It is something like driving sans a speedometer being better than having an incorrect indicator.

Interestingly, Schwager also dwells a lot on the pitfalls of going by track records of stocks as we end up looking at irrelevant data. Even more blatant is how he attacks the misconception of ‘manager skills’ and shows how portfolios have done well due to the high risk carried rather than the manager’s acumen. And we should never be guided by the names of fund managers — something which we often do.

While bursting all these bubbles, he does not spare the VAR models (value at risk) that in 2007 showed how the portfolios were stable when the risk inherent was enormous. At a later stage, he moves to hedge funds and is, in fact, a fan of them. He debunks the theory that a hedge fund portfolio strategy is riskier than the traditional approach. In fact, by combining short selling with long positions, managers are able to provide better returns to investors. But he admits that technical analysis has less to do with the success of these funds.

The author is brazenly irreverent at times but never sounds irrelevant. He is quite direct in his approach to attack generally accepted theories and has a view on virtually all aspects of the thought processes in this filed. Let us look at some of them. He says: expert opinion does not matter; markets are not efficient; buying when the market is low to sell when it rises is not the most prudent practice. And more: the past is no indicator of future returns and as a corollary, concentrating on funds that had the best past record is fallacious. In fact, hedge funds do better than mutual funds because decisions are not linked with the market. Leveraged portfolios often carry less risk and therefore it depends on the assets in the portfolio. Therefore, leverage does not tell you anything about risk.

It is a delightful book, and should be read by everyone in the market. Mainly by those that want to take a shot at the dartboard.
-Market Sense And Nonsense: How The Markets Really Work (And How They Don’t); Jack D. Schwager, Wiley ;Pages 336; $39.95 -