India’s Monetary Policy Update: Q1 2007-08

The much awaited monetary policy from RBI is out. There are largely 3 current problems in Indian economy that need immediate attention- Inflation, Surplus Liquidity and Appreciating Rupee.

Let’s see what does RBI say for each of the three issues: (The measures are in italics and my comments in normal)

• Inflation: It has kept the policy rates unchanged in line with market expectations- Bank Rate – 6.0%, Repo rate -7.75%, Reverse repo rate – 6.0%.
  
  RBI still sees inflation as a concern mainly on account of rising food prices and oil prices worldwide. But as, Mon pol works with a lag, RBI could be feeling that monetary transmission is beginning to work, as inflation has been below 5 for couple of months now. Hence, has kept the interest rates where they are.
• Surplus Liquidity: RBI views this needs to be addressed. For this, it has taken two measures:a) It has withdrawn the ceiling of Rs. 3,000 crore on daily reverse repo under the LAF w.e.f August6, 2007.  However, RBI keeps the option to revise this if need arises.

  As huge capital inflows continues to be a problem, RBI has taken this step.

  b) Cash Reserve Ratio has been increased from 6.5% to 7.0%.
  

• Rupee Appreciation: I was expecting RBI to atleast raise some ideas on how can capital flows be abated and rising rupee level be controlled. But there is nothing in the report. It simply states facts that how much rupee has risen and mentions the various sops provided by Commerce Ministry to the ailing exporters. This is disappointing. It simply says:

The exchange rate policy in recent years has been guided by the broad principles of careful monitoring and management of exchange rates with flexibility, without a fixed target or a pre-announced target or a band, coupled with the ability to intervene, if and when necessary. The overall approach to the management of India’s foreign exchange reserves takes into account the changing composition of the balance of payments and endeavours to reflect the ‘liquidity risks’ associated with different types of flows and other requirements.

Plain Mumbo-Jumbo.

The other important measures taken are:

• RBI used to do two auctions under Liquidity Adjustment Facility (basically it helps manage liquidity in the system), one in the morning (10:30 AM to 12:00 noon) and one in afternoon (3 Pm to 3:45 PM) . Now, it would only do one auction in the morning.  
• RBI has the flexibility to conduct repo/reverse repo auctions at a fixed rate or at variable rates as circumstances warrant.
  
  Why variable rates? For instance, fixed repo rate is 6% and say RBI absorbs money at 5.5%. Would repo rates be 6% or 5.5%? And as usual, there is no explanation. 

As I am still reading the report, I would update this page if I find something else. Keep watching this space. 

Update: Ajay Shah also shares his thoughts.

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Indian Economy review: Q1 2007-08

RBI meets 4 times ( April, July, Oct, Jan) in a financial year to review its credit & monetary policy.

Before the meeting, RBI also presents a report on developments in Indian economy and financial markets in previous quarter. For instance, if it meets in July, it would review the developments in the Apr-Jun quarter.

As RBI meets today (31st July, 2007), the macroeco report was out yesterday and is available here. As the report is 84 pages long, one can also go through the summary here.

I am still going through the report and would post my comments later.

Assorted Links

1. WSJ Blog points out that US debt markets are also shrinking amidst competition.

2. Dani Rodrik has a new paper on globalization.

3.  Prithvi Haldea has written an interesting article in ET on financial literacy.

Is India’s Growth rate sustainable?

With Indian economy growing leaps and bounds, the question is is it sustainable? IMF and Brookings Institution organised a forum over this topic on March 8, 2007.

It was moderated by Lael Brainard (Vice President and Director of the Global Economy Development Program at Brookings) and economists present were:

• Charles Kramer is Chief of the IMF’s division that covers India,
• Shantayanan Devarajan is Chief Economist, World Bank’s Human Development Network and
• Nirvikar Singh is Professor of Economics, University of California, Santa Cruz

The transcript of the forum is here.

 The discussion is a pretty useful one and they discuss this report prepared by IMF Staff, alongwith the inputs of the economists.

Most of the points have been known for quite sometime. Like for instance  the issues (power, water, labour reforms, etc.) and the possible solutions (importance of institutions etc) .

However, it is nicely done and we have a nice summary of thing so far. The IMF report should be interesting. Let me read it and get back.

Assorted Links

1. Ajay Shah hopes RBI does something about its messy monetary policy. Rajeev Malik has some prescriptions for RBI.

2. MR has a posting on one of the next generation economists – E. Glen Weyl

3. WSJ Blog points out that US GDP has been revised downwards for the previous 3 years. The latest GDP numbers show Savings rate in US have increased.

4. Rodrik points out to an article which explains growth and development by monkeys, trees and jungle. Funny and quite a thought.

5. Arvind Panagriya has a nice article in ET. He says unlike the general view, agriculture is not as important to India’s growth as it is made out to be. Well, the problem is not growth in agriculture, but to move people out of agriculture into services and industry. He has given a good solution to this problem which I have discussed here. He does mention the solution in the article albeit briefly. 

RBI’s novel way to impart financial education

RBI has taken some initiatives to impart financial education to common man. It has floated a website which I had mentioned here.

Now, within the website it has put a comic strip which goes by the title ‘Raju and the Money Tree’. The website says it is fro school kids but the comic is worth reading for everybody. It is also available in Hindi. It is very simple and full of humour and valuable insights. Great stuff from RBI.

Financial literacy is a primary concern for Indian policymakers. India’s Finance Minister raised his concern for the same here.

Update: RBI plans to distribute CDs and use FM radio to spread financial literacy.

IMF: World Economic & Financial Market Update

IMF despite all its crisis, is doing some good research work . It publishes two reports bi-annually (i.e. in April and in Sep) on world economy and world financial markets. I had covered the April Eco Outlook here.

Now, it has started to update its forecasts between the two reports i.e. for its April outlook in 2007, it has presented its update now. The Economy update is here and the financial market update is here. This is a great initiative. The summaries are as follows:

World Economy

• IMF has revised the world economy growth upwards for 2007 from 4.9% (projected in April 2007) to 5.2%.
• For US, the growth has been revised lower from 2.2% to 2%. For most of European nations the growth has been revised upwards. I particular for Germany- by 0.8% to 2.6%. For Japan also, it has been revised upwards.
• The growth revision has been pretty high in emerging markets. Russia by 0.6% to 7%, China by 1.2% to 11.2%, India by 0.6% to 9%.
• The risks:
  

  With sustained strong growth, supply constraints are tightening and inflation risks have edged up since the April 2007 World Economic Outlook, increasing the likelihood that central banks will need to further tighten monetary policy. The risk of an oil price spike remains a concern.

Financial Markets:

• Despite strong macroeco performance, financial markets are a concern mainly in credit markets.  Credit markets risks have increased on account of sub-prime concerns.
• WEO update predicts rates rising on account of higher inflation, so this would make sub-prime markets worse as mortgage rates would rise.
• Sizable LBOs could pose a problem as interest rates increase.
• See the fabulous charts in the report especially the one which shows volume of covenant lite loans has increased quite substantially.

 This is good stuff from IMF. A nice simple read.

Assorted Links

1. WSJ Blog points out that futures market expects Fed to cut rates by the end of this year. Econbrowswer says the same thing as well.

2. Rodrik points out to a paper which says why Economists in top departments are publishing less in top field journals. Answer online dissemination.

3. PSD Blog points out to a new paper which says bank regulation across the world has infact been in areas which are less important and might prove to be detrimental to the stability of the banking system.

4.   Manoj Ahuja has an interesting piece in ET on financial inclusion.

Institutions and their impact on India’s growth

I have been noticing one thing lately- the work of number of  (born in India /having Indian roots) economists has been increasingly being focused on Indian economy. It is quite a good thing as they understand India better and hence their research should have a better understanding of the nuances involved. As we hardly do any worthwhile research in India, atleast we get some perspectives.

I was just reading this paper by Arvind Subramaniam (AS from now on, I had done a review of his papers earlier as well, here and here) which talks about evolution of India’s institutions and their impact on Indian economy. Unlike his other papers this one is really well done and stands out for its simplicity.

The papers explains a number of paradoxes:

1.  Why has growth taken off despite the general consensus that institutional standards are falling?
2. Why hasn’t growth led to better institutions?

AS answers:

India’s founding fathers bequeathed a strong set of institutions, much stronger than for the average country. These institutions have played a key role in the turnaround in India’s recent economic performance, a fact that has been overshadowed by, and because of, the more dramatic and necessary reduction in the ownership/regulatory functions of public institutions (a process that is usually described as policy reforms). Over time, though, it is not obvious that India’s public institutions are keeping up with the demands of a rapidly evolving economy. Thus, contrary to the near-universal views that the binding constraints to sustained Chinese-style rates of growth are the need to finish the unfinished task of rolling back the frontiers of the state, giving full play to the energies of the private sector, this paper implies that a future reform agenda should focus equally on strengthening, or reversing the decline in, public institutions.

AS answers something which I have been wondering all along. How does one measure the performance of India’s institutions (insti from now on) ? To this, AS presents 3 ideas:

1. Stylized facts on insti outcomes: this means looking at statistics like murders, power-related losses etc. He offers a caveat though:

Of course, outcomes are determined by a number of factors, including the quality of institutions. So, it is difficult, if not impossible, to draw inferences about institutions and their evolution over time from outcomes, unless we can control for these other factors. For example, if disposal rates of judicial cases declines it could be due to inadequate resources (judges, lawyers etc); or to corruption; or to the fact that murder rates themselves are increasing for extraneous reasons (guns are more readily available, income leads to more crime and so on);or some combination of the above.

In this AS points to following:

a) Power losses/thefts: it has increased over time.
b) Disposal rate for murder related cases: it has gone down meaning the backlog of murder cases is rising
c) Conviction rates for murder cases: this has also fallen

(All the above can be looked at positively as well, read the paper for details)

2. Perception-based measures of institutions: These are subjective measures and are based on surveys. AS explains various papers that have calculated these measures. His findings on India are:

In 1960, India’s rating was close to 1.5 standard deviations above the mean, a very high rating, placing it amongst the very top of the 74 countries surveyed by Adelman and Morris (1971). In the last decade, India’s score has been close to zero, denoting an average rating. If these measures are at all plausible, the picture they convey is one of decline—substantial decline—since the 1960s.

3. Isolating the effect of institutional quality: AS explains this by doing a case-study of Indian customs. He in another paper has done a study of evasion(difference between the recorded exports at the origin and the recorded imports at the India) by Indian custom officials at Indian ports. And they find evasion increasing overtime. 

So whichever way you look at it, quality of institutions is falling. AS says but growth has been happening since 1980’s and the institutions quality has been falling, so what has led to growth?

Another puzzle is most countries started reforms in 1980s and 1990s (Latin America, Sub-Saharan Africa etc) but none have achieved the growth levels of India (except China). Infact reforms in latter have been more and deeper than in India.

Yet the growth response in these other countries has not been close to that in India. Since 1985, Latin America and sub-Saharan Africa have grown by about 1 percent per capita per year, while India has grown at about 4 to 4.5 percent.

What explains all this? AS’s main point is that India had good quality institutions pre-1980 which led to economic growth after 1980s. But since then institutions’ quality has been falling and it is this aspect which needs to be corrected alongwith  hard infrastructure like power, roads etc.

As says reserach has shown that rising incomes lead to better institutions but this has not happened in India, which is surprising given the fact, that lot changed in India after reforms. (transparency increased due to media, licence raj was dismantled, greater decentralization of power etc should have led to better institutions).

The effect of poor quality of instis has been that despite fall in poverty divergences have increased and public institutions are not able to attract talent.

Hence, we should focus on improving institutions. The final message is:

A starting point has to be the recognition that allowing institutional decline could well come back to haunt not just policy-makers but the private sector as well, whose fortunes depend crucially on strong and effective public institutions. Rehabilitating the institutions bequeathed by Mahatma Gandhi, Pandit Nehru and others, and not just finding creative ways of working around them, should consume the energies of Midnight’s grandchildren. A rich and relatively unexplored research and policy agenda lies ahead.

After Mr. Panagriya’s paper, I found this one quite stimulating. Keep up the good work Sirs. We need more of such papers to understand Indan economy. After all as AS says is a BS article:

As Joan Robinson famously noted everything and its opposite are guaranteed to be true in India.

Assorted Links

1. The latest Beige Book (basically it summarisess economic acivity by the 12 Feds in their respective districts) is out. WSJ Blog has few postings here and here.

2. WB PSD Blog points out on ABC of SMEs.

3. Econbrowser has a decent post on Chinese economy. China’s gross domestic product expanded 11.9% in the second quarter, on top of an 11.1% gain in the first three months.

4. Roopa Purushothaman (she was the co-author of the BRIC report) of Future Capital in her latest report says that divide between rural and urban India is actually narrowing. Need to see the report in detail.

5. In ET, TT Ram Mohan provides some advice for Public Sector Banks to fight competition post opening up of the Banking Sector in 2009.

RBI reports on rural sector

RBI has 2 interesting reports on rural/agricultural isector. One is on moneylending and the other is on distressed farmers.

The first one is on the increasng role of moneylenders in rural credit and what should be done about it. Should we legalise moneylenders within the system or not? If yes, then how do we go about it. It has a very interesting table which looks at sources of loan in farmer households in different states.  It says:

The survey reveals that out of every Rs 1,000 outstanding of farmer households in the country, Rs 257 was sourced from moneylenders. The share of moneylenders in the indebtedness of farmer households in Bihar, Manipur, Punjab, Rajasthan, Tamil Nadu and Andhra Pradesh were well above the national average, with Andhra Pradesh at the top. The penetration of moneylenders is significant even in States that are regarded as being adequately banked (Andhra Pradesh and Tamil Nadu).

The Banks contribute the highest on all India level – Rs 356 per Rs 1000.

And the second one is all about distressed farmers . It defines distress:

A farmer will be considered as distressed if it meets any or both of the following criteria:

a) The farmer is indebted to the formal and informal sources of credit to the extent of more than the monetary value of the land and other productive assets owned by the family [negative net worth] and/or,

b) The interest liability on loans from formal and informal sources exceeds 50 per cent, of his gross family income [liquidity crisis leading to inability to meet even consumption requirements].

It looks at the story of distressed farmers in a comprehensive manner and suggests some useful (well-known though) measures to control distress in farmer community.  

Both the reports look at the problems of rural/agricultural sector with financial market perspective.  I have just quickly glanced through the reports. Look like very good reads. It should help RBI and others develop some perspectives on financial inclusion as well.

Assorted Links

1. WSJ Blog pointsto Bernanke’s busy hours.

2. I didn’t know S& P also rates colleges’ finances. Thanks to WSJ Blog for the pointer.

3. Raghu Rajan may help India in its financial sector reforms.

4. Akash Prakash in BS cautions on India story. Not very convincing though.

5. BS informsthat FTSE (UK based index provider) and IDFC have developed an infrastructure index. It would have infra companies listed on BSE and NSE. Here is the factsheet of what it means and what are the companies.

What is regulation?

I noticed this policy paper on regulation sometime in August 2006 (when it was released on planning commission website). On first glance, it did not look very good and hence ignored it.

However, a friend of mine asked me for this paper sometime back and I just went through the paper once again and found it to be really good. It discusses concepts and approach to regulation in a very simple and elegant manner.

(Addendum: People can write their comments/ suggestions/ criticisms on this paper till 31 Aug., 2007. Details are here. This is a welcome move and is a big development in public policy. Most of these documents are nowadays available to general public for comments.)

First what is regulation? The paper defines it really well:

Regulation may be broadly understood as an effort by the state ‘to address social risk, market failure or equity concerns through rule-based direction of social and individual action.’

Note: every word is important in the definition.

Economic regulation is seen to be that part of regulation which seeks to achieve the effective functioning of competitive markets and where such markets are absent, to mimic competitive market outcomes to the extent possible. It also identifies and addresses subsidies and cross-subsidies in the pricing of infrastructure services.

However, governments have a broader role for regulation:

States generally use economic regulation in a broader context to achieve a range of non-market objectives which include ensuring universal and equitable access, consumer protection and maintaining safety and health standards.

The paper applies the basic regulation concepts to infrastructure sectors. Before discussing the basics it lists the status of regulation in each of the infrastructure sectors in India.

What is special are the observations on the nature of regulation in each of the sectors. In most, there is no regulatory authority. Wherever there is, there is no accountability and is mostly run by respective ministries.

So what are the core principles of regulation design?

1. Seperation of Power: means the constitutional powers and functions are divided among the three branches of government: legislature, executive and the judiciary.

The paper says, rightly so, whenever we try and combine the two or all three functions in any institution, the institutions fails. The paper says:

In the case of regulatory institutions, this problem is aggravated as a single institution makes rules of law, administers them, and finally adjudicates disputes which may arise. This multi-dimensional character of regulation raises complex problems of compliance with the separation of powers principle. The separation of judicial power from executive and delegated legislative power has been litigated repeatedly in the case of the securities markets regulator, the telecom regulator and most recently the competition authority.

Needless to say, but with India this seperation is the basic cause why nothing happens.

Inter-institutional bargaining is essential to secure liberty in a plural democracy where different interest groups have varied levels of access and control over the diverse institutional apparatus of the state. So if the liberty of citizens is at stake then the separation of powers must be ingrained in regulatory institution design. Moreover, this is a constitutional imperative.

2. Democratic Accountability: How to ensure both- independence of regulator and make it accountable as well. Three ways,

• make regulatory bodies answerable to legislative (i.e. ministry),

• make former answerable to public (this is possible by adopting processes and systems whereby interested citizens or groups of citizens may seek and acquire information, make representations and be accorded full process and participation rights),

•  appoint competent regulators having full integrity

3. Federal Principle: As the subjects of economic regulation are often divided between Union and State competencies, the regulatory structure should reflect this distribution.

The paper sumamrises very precisely the nature of regulation in US, UK, Australia and Sri Lanka.

Then it presents a case of what should be done to build a proper regulatory structure for infrastructure. It categorises various infrastructure sectors nicely:

Each of the infrastructure sectors can be broadly divided into carriage and content segments. Content normally refers to electricity, gas, data or voice. On the other hand, carriage refers to transmission lines, networks, exchanges, airports, ports, highways and other fixed assets.

While carriage is typically regarded as a natural monopoly, the content is eminently amenable to competition. In order to enable competition in the content segment, the carriage should be subjected to non-discriminatory open access under close regulatory oversight including determination of tariffs. Where technology or market structure enables adequate competition in carriage, its regulation could remain light handed. These aspects would have to be clearly addressed in the overarching approach to regulation.

And then it applies the principles of regulation design(discussed above) to build an institutional structure for regulation in infrastructure sector. .

An excellent initiative I must say, to explain basics of regulation. What it lacks is a reference list. I do not understand why our policy makers do not provide references to the various topics addressed in the papers. It helps a lot as firstly it builds credibility and secondly, provides the readers a nice list of papers to read. It could have also done some empirical analysis on the subject.

Anyways, a must read paper.

Assorted Links

1. Finance Professor points to Hedge Fund Clones.

2.Stocks are trading at all time highs and sub-prime bonds falling. WSJ Blog explains the divergence.

3. Abheek Barua in BS writes a nice article on dollar depreciation.

4. A.V. Rajwade also has a very good article in BS on sub-prime mess.

5. World Bank PSD Blog has a nice posting on Microfinance meets Islam.

6. ET has a super candid interview of Alan Bollard, Governor, Reserve Bank of New Zealand.

Adaptive Market Hypothesis

On surfing, I came across this term ‘Adaptive Market Hypothesis’. I got interested and decided to do some research. Andrew Lo, an MIT Prof. has coined the term. I know him as he has written the famous book- Econometrics of Financial Markets.  

So what is this AMH? He has written couple of papers on the subject. This is the paper I read. The abstract says it all:

One of the most influential ideas in the past 30 years of the Journal of Portfolio Management is the Efficient Markets Hypothesis, the idea that market prices incorporate all information rationally and instantaneously. However, the emerging discipline of behavioral economics and finance has challenged this hypothesis, arguing that markets are not rational, but are driven by fear and greed instead. Recent research in the cognitive neurosciences suggests that these two perspectives are opposite sides of the same coin. In this article I propose a new framework that reconciles market efficiency with behavioral alternatives by applying the principles of evolution—competition, adaptation, and natural selection—to financial interactions. By extending Herbert Simon’s notion of “satisficing” with evolutionary dynamics, I argue that much of what behavioralists cite as counterexamples to economic rationality—loss aversion, overconfidence, overreaction, mental accounting, and other behavioral biases—are, in fact, consistent with an evolutionary model of individuals adapting to a changing environment via simple heuristics. Despite the qualitative nature of this new paradigm, the Adaptive Markets Hypothesis offers a number of surprisingly concrete implications for the practice of portfolio management.

This is one of the few papers in finance, which is without all that maths and statistics jazz. It is a paper that gives an idea on the way new developments in finance should be understood and further research would be needed.

So how does one reconcile the 2 divergent streams of finance (i.e. EMH and BF):

Specifically, the Adaptive Markets Hypothesis can be viewed as a new version of the EMH, derived from evolutionary principles. Prices react as much information as dictatedby the combination of environmental conditions and the number and nature of species” in the economy or, to use the appropriate biological term, the ecology.

By species, I mean distinct groups of market participants, each behaving in a common manner. For example, pension funds may be considered one species; retail investors, another; marketmakers, a third; and hedge-fund managers, a fourth. If multiple species (or the members of a single highly populous species) are competing for rather scarce resources within a single market, that market is likely to be highly efficient, e.g., the market for 10-Year US treasury Notes, which reacts most relevant information very quickly indeed.

If, on the other hand, a small number of species are competing for rather abundant resources in a given market, that market will be less efficient, e.g., the market for oil paintings from the Italian Renaissance. Market efficiency cannot be evaluated in a vacuum, but is highly context-dependent and dynamic, just as insect populations advance and decline as a function of the seasons, the number of predators and prey they face, and their abilities to adapt to an ever-changing environment.

Wow! that makes finance so exciting. Read the whole thing as it is a great paper which builds on views of leading economists and their philosophies. Now, what about the practical implications, as that is what matters:

1. The first implication is that to the extent that a relation between risk and reward exists, it is unlikely to be stable over time. Such a relation is determined by the relative sizes and preferences of various populations in the market ecology, as well as institutional aspects such as the regulatory environment and tax laws. As these factors shift over time, any risk/reward relation is likely to be affected. A corollary of this implication is that the equity risk premium is also time-varying and path-dependent…..

2. Contrary to the classical EMH, arbitrage opportunities do exist from time to time in the AMH.

3. Investment strategies will also wax and wane, performing well in certain environments and performing poorly in other environments. Contrary to the classical EMH in which arbitrage opportunities are competed away, eventually eliminating the profitability of the strategy designed to exploit the arbitrage, the AMH implies that such strategies may decline for a time, and then return to profitability when environmental conditions become more conducive to such trades.

 4. Innovation is the key to survival. The classical EMH suggests that certain levels of expected returns can be achieved simply by bearing a sufficient degree of risk. The AMH implies that the risk/reward relation varies through time, and that a better way of achieving a consistent level of expected returns is to adapt to changing market conditions. By evolving a multiplicity of capabilities that are suited to a variety of environmental conditions, investment managers are less likely to become extinct as a result of rapid changes in business conditions.

5. The AMH has a clear implication for all financial market participants: survival is the only objective that matters. While profit maximization, utility maximization, and general equilibrium are certainly relevant aspects of market ecology, the organizing principle in determining the evolution of markets and financial technology is simply survival.

This is a must read for all finance professional. It helps build and develop new perspectives. This is what research is all about.

The Economics of Sovereign Defaults

Why does a country default? What happens when a country defaults on its loans? This paper from Richmond Fed answers a few of these questions in simple English. It is in a way a like a literature survey.

First what is a sovereign default? The authors say:

There are different definitions of a sovereign default. First, from a legal point of view, a default event is an episode in which a scheduled debt service is not paid beyond a grace period specified in the debt contract.

Second, credit-rating agencies consider a “technical” default an episode in which the sovereign makes a restructuring offer that contains terms less favorable than the original debt.

Why does a government need to borrow? Simple, when its expenses are more than the revenues, in order to finance the public goods and pay its salaries, the government borrows from the creditors in forms of loans or by issuing bonds. Here, they are similar to private agents:  

Like private agents (households and corporations), governments can borrow to finance long-lived investments. Furthermore, in the same way households borrow to preserve living standards through periods of temporary hardship, governments borrow if they do not want to decrease expenditures when tax revenues are low.

However, there is difference between government defaulting and any private agent defaulting:

It is easier for households and firms to post appropriable collateral in order to improve borrowing conditions. If a private agent defaults, the government forces him to hand over the assets posted as collateral. On the other hand, a sovereign cannot commit to hand over its assets if it defaults, and in general there is no authority that can force it to do so……..Thus, sovereign debt is typically unsecured.

While for households and firms an important part of the costs of debt repudiation is determined by bankruptcy law, there is no international legal framework that imposes costs on a defaulting sovereign. 

Politico-economic factors affect the issuance of government debt. For example, a politician who cares mostly about the period during which he will be in office may not fully internalize the costs of issuing debt. Moreover, governments can borrow strategically to bind the hands of future governments with different preferences. Such strategic behavior would be more important in economies where policymakers’ interests are more polarized.

Why govts default?

1. When current resources to pay are very low.
2. When borrowing costs i.e. interest rates become high.

The importance of external factors for the borrowing cost of developing countries is suggested by empirical studies that  find that the interest rates paid by these countries have tended to move in the same direction as U.S. interest rates.

 3. Political angle

Apart from this, the paper has tabulated all sovereign defaults from 1824 onwards. They basically pick it from one of the numerous papers they have reviewed.

In one of the tables it tells how much the creditors recovered on neogotiations after the default. Like for the much known Russian default in 1998 (which lead to famous LTCM collapse) the creditors recovered 38-45% on average (basically a government takes many kinds of loans each with different of profie) of the total credit given. In Argentina crisis, sovereign paid 58% of domestic and just 27% of International borrowing.

A nice simple paper worth reading.

Assorted Links

1. MR points to a new paper on income inequality. It is pretty detailed one. What caught my eye is this:

…the top 25 hedge fund managers combined appear to have earned more than all 500 S&P 500 CEOs combined (both realized and estimated).

2. Dani Rodrik points out to an interesting graph- why Asia and Africa grew? Basically Asia gre on account of undervalued currency. He says (look at the graphs first) :

In Asia, growth accelerations are preceded by a period of sustained increase in undervaluation, which is maintained during the period of high-growth. In Africa, by contrast, growth accelerations are preceded by growing overvaluation; the currency always remains in the overvalued zone (= negative undervaluation).

Here is the simplest explanation. In Asia, growth is typically engineered by increasing the profitability in manufacturing and other tradables. But in Africa the typical growth spurt is preceded by aid inflows and other transfers, which appreciate the exchange rate, and render future growth less sustainable. This is the so-called Dutch disease.

He has also written a new paper which he explains how an undervalued real exchange rate can promote economic growth.

3. WSJ Blog points out the problems with FOMC forecasts.

4. Jungle Economics….pretty interesting

EAC’s Indian economy outlook 2007-08

Finally after a long wait we have Economic Advisory Council’s outlook for 2007-08. The report is here. [What a messy website. There is a need to revamp the website completely. The websites of most government (or sponsored) entities really need to be redone (I don’t understand this fascination for putting flashing photos on the homepage). Look at Planning Commission, SEBI…  all rich in content but the presentation, less said the better.]

Let me say at the onset, this report is disappointing. Agreed their mandate is to give an outlook on Indian economy and not explain what should be done to ensure the growth follows, still this eminent panel could have done much more. 

Especially, in these times when we have no communication from policymakers on any of the important issues bothering the Indian economy as of now- surplus liquidity, capital inflows, currency appreciation etc. (Off course, we have India’s Finance Minister talking about monetary policy!)  I would have expected some good empirical analysis on what is needed rather than pureplay of words and economic theory. 

Some quick findings from the report:

1. The report projects GDP growth at 9% higher than projections given by others. Report says RBI has given around 8.5%, IMF – 8.4%, NCAER- 8.5%, Private international banks till a month ago mostly had forecasts of around 8.5%, although some major banks have recently revised it to 9.0% and over.

However, there are problems with the estimates itself. RBI, CSO includes Construction sector in Services and EAC includes former in Industrial sector. So which is correct?

2. I would skip the rest of the projections, as they are simply numbers. The report raises its concerns over agriculture and power. In agriculture, the issues are well known and widely discussed. In Power, the report tells me :

The capacity build-up that we have planned has thus been in respect of an attenuated demand, and then even that capacity has failed to materialise in time. It is instructive to note that during the Tenth (2002–2007) Plan period, we had planned to add 41,110 MW and succeeded in implementing some 18,000 MW. In sharp contrast, it is understood that China implemented 101,170 MW of power generating capacity (mostly thermal) in calendar year 2006 alone.

The gap is of many orders of magnitude and holds serious implications of the consequences of not doing enough. The initial thinking in formulating the Eleventh Plan (2007–2012) was that additional power generating capacity during the plan period would be about 50,000 MW; this was revised upwards to 60,000 MW in the Approach Paper for the XIth Plan (December 2006). More recently this number has been further raised to 68,869 MW, with a “best effort” commitment to bring another 11,545 MW forward, i.e., a total of 80,414 MW. Some may argue that given the record of slippages in implementation, we should be guided by the past and accordingly we ought to lower our sights, and adopt a “realistic” target, which is not in excess of 40,000–50,000 MW.

EAC says it is high time we start thinking big in power sector and 11th plan should be looking at augmenting power generation capacity by 100,000 MW and above.

3. In last report EAC had said India’s growth has largely been consumption driven ( I have summarised it here) and there is a need to shift it to more investment driven. This time they say it is happening (I had also suggested the same here).

4. The previous report had no analysis on emplyment and this report covers the latest 61st round survey by NSSO. I had covered the findings of the survey previously and found that story is pretty grim and most of the increase has happened in low income/low productive jobs.

The EAC outlook acknowledges it but that is all in very few words. It should have focused on lack of value-added employment; instead, it says employment scenario has undergone a fundamental change! Why can’t they refer to/provide references to what has already been done on the subject. It makes a huge difference as one gets a complete view of what is actually happening. For instance, had I not read the paper on employment I covered here, I would have thought, well employment is not a problem as of now.

5. The last chapter is perhaps the most important and something which most analysts had been waiting for. It is aptly titled ‘Monetary, Exchange Rate and Inflation Management’. This has also been the most talked about in the media as well.

It says the usual stuff- Central Bank should mange the inflation, things have to be balanced etc. For instance it says, capital inflows have been much larger than current account deficit and this puts a pressure in the currency to appreciate. As currency appreciates, the current account deficit widens and we have capital flows equivalent to the current account deficit. So all balances. But then we need to look at the magnitude. At present cap flows are 5 times so for a current account to widen by that much would means huge adjustments as currency appreciation would reduce exports massively….and so on…

So, to control appreciation, RBI should intervene and it should be directed towards “orderly conditions” as has been the RBI Policy for long…..What is it supposed to mean?

The media has been talking about 3 measures suggested by EAC to control capital inflows:

1. Let currency appreciate
2. Absorb capital flows and sterilise the excess
3. Liberalise outflows and discourage inflows by putting restrictions

At best you would expect that EAC to analyse which ones should be used when but you get this disappointing line, which is also the end of the report:

Instead of arguing for the exclusive use of any one of the instruments, there must be a judicious mix of all of the three instruments. There are limits to which each instrument can be used by itself.

This is something most people know about as media and number of economists have commented about them. What is new? They could have done some empirical work doing costs and benefits of each policy measure or provided references to the same. In today’s ET, one of the EAC member comments:

So should we seek an unchanging exchange rate? Not unless we wish to emulate the boy on the burning deck. Should we then hold our heads in our hands and let the exchange rate go where it wills, much like the nineteenth century stereotype of the fatalistic Oriental? No, for we don’t fit that stereotype. Which brings us back to the opening issue of the dimension of time and the PM’s Economic Advisory Council’s (EAC) advice of a “judicious” mix of three instruments to deal with the current situation, a term that the editorial of this paper a couple of days ago found rather elusive to pin down, suspecting perhaps of it being more illusory than real!

To me, after reading the article it is still illusory.

They have added some annexures on select issues like agri, power, cement industry, banking sector etc.

Another dampener is this report is 87 pages long which is longer than the previous outlook for 2006-07 which was 52 pages.

Update: Surjit Bhalla (of Oxus Research) also criticises the report in his usual (witty, full of sarcasm) manner.  His point of view is that EAC has overestimated export growth as rupee continues to appreciate.

Assorted Links

1. Ajay Shah has a nice posting on India’s currency market. In shirt, it is highly inefficient with a rampant illegal market.

2. One of my favorite economists Hal Varian has joined Google as a Chief Economist. WSJ Blog points out to a super interview of Varian.

3. WSJ Blog points out to a paper by Raghu Rajan et al which says Aid does not cause growth. The paper was written few months ago and is recently being covered in media and blogs (see for instance blog posts from Dani Rodrik, Greg Mankiw; all seem to be discussing this). I am expecting a few fireworks from aid supporters especially Jeff Sachs.

4. TCA Srinivasa in his Friday column in BS points out to a new paper on corporate pay system in India.

5. BS has  an excellent interview of Bimal Jalan, former RBI Governor. He says Financial Crisis are different because of couple of reasons:

In a financial system the real crisis occurs within a very short period — before you know it, you are gone. You don’t realise it and do not get enough time to prepare. All other crises take time to pan out. The key thing that I want to emphasise about a financial system crisis as was witnessed in east Asia is the short time duration in which it happens.

The second point, which is also important, is the contagion effect.

The third thing, unfortunately for policymakers, is that the crisis may already be there before they know it!

6. Ravimohan has written a decent article in BS on current market developments.

Growth Crisis in Agriculture

Yesterday, I had talked about employment issues in India. While just scanning the EPW site, I came across a paper on Indian agriculture By Ramesh Chand et al., which presents a detailed picture on woes of India’s agriculture. (a quick reminder: download it as EPW becomes a paid site from 1 August 2007)

I have posted a few times on agriculture and all have a common theme- Indian agriculture is in a mess. One might ask, why post only depressing stuff on India’ s economy? Well, that is reality of the growth story. No wonder, policy makers are talking about inclusive growth in such a big manner.  Inequality has been rising and this is the flavor of most economic debates even in USA.

Some quick findings from the paper:

1. Growth is agriculture between 1980-81 to 89-90, 1990-91-1996-97, 1996-97 to 2004-05 is 3.1%, 3.6% and 1.7% respectively. The growth in non-agri in contrast has been 6.9%, 7.0% and 7.1% respectively. As employment in agri has not fallen the disparities have increased.

2. Most of the (whatever) growth during 1980-97 in agri & allied sector has come from 2 sectors – fisheries and horticulture. Since 1996-97 the growth has started falling in these 2 sectors. Table 2 shows growth rates in sub-sectors of agriculture has fallen in all sectors. Crops and cereals infact stagnate between 1996-97  to 2004-05. As rural population has increased by more and so has workforce employed in agriculture, we have declining per capital incomes in agriculture.

3. They have done regression analysis of what drives agriculture in India.

GDPA = f(rainfall, terms of trade (ToT) between agriculture and non-agriculture, fertiliser, irrigation, crop intensity, institutional credit, public investment in agriculture).

To counter multicollinearilty, instead of one regression analysis, they have 3 of them. Some findings are:

In model I, rainfall, terms of trade, public sector capital stock and institutional credit were used as explanatory variables. All these variables turned out to be statistically significant with level of significance varying from 0 to 2.1 %.

Rainfall showed the most significant impact on output; 1 % increase in rainfall resulted in 0.21 per cent increase in GDP agriculture.

Improvement in terms of trade for agriculture by 1% led to a 0.42 % increase in output. Similarly, a 1% increase in existing level of capital stock and institutional credit increased agricultural output by 0.61 and 0.14 %, respectively.

4. They have done an analysis of how the various factors that drive agriculture have fared. Post 1996-97, all factors barring credit to agriculture has declined. The authors say:

Thus, the main factors which led to a slowdown in agriculture at national level after 1996-97 are: (a) decline in the area under cultivation, which seems to be a result of expanding urbanisation and industrialisation,
(b) deterioration in the terms of trade for agriculture,
(c) stagnant crop intensity,
(d) poor progress of irrigation and fertiliser,
(e) decline in supply of electricity to agriculture &
(f) slowdown in diversification.

They also point out that risk in performance of agriculture has increased. The standard deviation of growth in GDP from Agriculture has gone up from 4.16 in 1985 -96 to 6.58 in 1996-95.

5. The authors also do a state-wise analysis.

The growth experience of the two periods shows that before 1995-96 the growth rate of agriculture in most of low productivity states was much higher than the national average and after 1995-96 their growth rates not only declined, but also turned out to be much lower than the national average.

To sum up, the story is much the same. The solutions to revive are also the common ones. This paper tells the story using empirical analysis and that is what is the feature of this paper.