Archive for August, 2007

Impossible Trinity: Basics and Facts

August 21, 2007

I am finding another source of learning apart from textbooks and academic papers- speeches. I am noticing the quality of speeches by policymakers is getting better by the day. So much so, I have put a seperate link in my blog to cover speeches.

Here is another excellent speech (summary is here) by BIS Deputy General Manager, Hervé Hannoun. He discusses impossible trinity and helps understand it by providing case studies of Asian-Pacific nations.

What is Impossible Trinity? Wikipedia explains:

….the hypothesis in international economics that it is not possible to have

  • A fixed exchange rate
  • Free capital movement
  • An independent monetary policy

Suppose a country is growing and in order to grow further would need to  increase its investments. So far, its savings have been enough and now it needs foreign savings as well. As a result, the policymakers liberalise capital flows (inwards and outtwards) in the country. Given this choice, the hypothesis says the country can either look at exchange rate stability or price stability but not both. Why?

Now suppose, the country is Japan whose currency is yen (“this is just an example”) and it has both objectives price and exchange rate stability. To achieve former, it maintains fixed exchange rate and for latter, it maintains an inflation target (implicit or explicit).

  • As capital inflows are allowed, foreign investors take exposure in Japan and bring their dollars, convert it into yen and invest it.
  • As a result the demand for domestic currency goes up. Ideally as demand goes up so should the price meaning exchange rate should appreciate (or go up from Rs 45 per dollar to say 40)
  • But as currency is fixed, the Central bank needs to maintain the level and instead gives the foreign borrower the desired yen and keeps the dollars with itself.
  • Now, as supply of yen increases in the economy so does inflation (too much money chasing few goods). As inflation stability is also an objective the entire thing comes on its head, hence the impossibility of making all 3 objectives work together.
  • Note that higher inflation can also be controlled by sterilizing the flows i.e. Central Banks issue govt. securities and suck the money supply. But that means more expenditure for government and is not a long-term solution as govts are supposed to direct their expenditure towards enhancing capital base of the country and not for monetary and exchange rate stability.

So after some concepts, let us get back to the speech. On Page 4, it has a table that summarises what each Asia-Pacific nation is doing. Some e.g.

Hong Kong, with open capital markets and a currency board, implicitly accepts foreign monetary policy, which can at times be too tight or too easy. The fixed exchange rate provides a stable environment for importers and exporters.

Countries such as Australia and New Zealand have chosen domestic price stability in the form of an inflation target, and accept a high degree of exchange rate volatility.

India has a multiple indicators approach and looks at everything.

As surging capital flows is a problem with most, he goes on to discuss the possible solutions to contriol the situation which are straight from textbook:

1. Allow curreny to appreciate
2. Intervene to prevent appreciation
3. Impose retrictions on capital flows

Then he cites evidence that Asian countries generally have been reluctant to let their country appreciate. Meaning given the two choices after allowing for capital flows , they have preferred to keep exchange rates stable and have not allowed them to appreciate.

Countries like Korea, NZ and Philippines have inflation targets and capital flows have been a problem with them. Ideally we should have seen some appreciation in these countries.

Now, see the table on Page 10. It shows currency has appreciated only in India, Korea and China (now, China is a surprise) from 1994 levels.

This is what makes the entire learning so good. You not only know what impossible trinity is, you also know which country is doing what?

The consensus in economic circles is that have free capital inflows, and have a stable monetary policy & let the currency float. His speech also discusses the same and suggests ways in which Asia-Pacific nations can move towards floating/flexible exchange rates.

Super stuff. Highly recommended. 


I have  written two papers on the subject, one a general overview on Impossible Trinity and two, a specific report on how RBI is managing the Impossible trinity.


Assorted Links

August 21, 2007

1. MR points out to this FT interview with Ned Phelps, the 2006, Nobel Laureate.

2. This is why US is so interesting. Thanks to WSJ blog. It also has this interesting story. Also, the latest Stephen Roach comments.

3. Mankiw has number of interesting readings.  Seehow the VIX index has risen, ranking of eco blogs, and eco in cyberspace.

India’s Venture Capital Industry

August 18, 2007

SEBI (India’s securities market regulator) has been giving some data releases recently. This helps increase transparency and disseminate data on various facets of India’s securities markets. I had posted y’day about activity in India’s Corporate Bond market.

I just found another release on the VC industry in India which mentions where  they are investing and how much? The data is limited to India VC’s and foreign VC registered with SEBI. So far number of VC is 90 and foreign VC is 80. Some observations:

  • Both categories of VCs have increased their investments over the period Sep 06 to Jun 07. Former by 59% and latter by 98.8%.
  • Other is the category which has the maximum share. What does other mean? The categories mentioned seperately are:
    Information technology
    Media/ Entertainment
    Services Sector
    Industrial Products
    Real Estate
  • In Sep 06, real estate had the max share apart from others. This share had gone down in June 07. Why do VCs invest so much in real estate? VCs are supposed to nurture companies in high-tech and innovative products/services. One reason could be that lots of real estate companies have gone for an IPO during Sep 06- June 07 and may be VCs have exited these companies.
  • BioTech, Media, Pharma struggle to get VC eyeballs.
  • Then there are seperate categories liek services and industrial products. Could there be some clarity on that?
  • Real estate contribution has declined over the period and the gains have all beein in others sector. So not much can be analysed.

Anyways, a nice initiative from SEBI to atleast start sharing some data on so many unknown things in India.

Fed Discount rate vs Fed Futures rate

August 18, 2007

Fed announced a cut in the discount rate yesterday from 6.25% to 5.75%. The idea is to calm the financial markets and Fed even released a statement for the motive which shows that Fed is now concerned over growth. The statement says growth has so far been at a moderate pace but downside risks remain. Financial Markets are very important after all.

One might wonder why the discount rate? What is it? This is not Fed’s benchmark rate – Fed Funds rate. What is the difference between the two?

As usual WSJ Blog comes to rescue. It explains Fed Futures rate as:

The fed funds rate is the rate banks with excess reserves charge when they lend money to other banks overnight. It moves according to a traditional supply-demand path. When there are more institutions looking to borrow than lend, the rate goes up. When there are more lenders, it goes down. The Federal Reserve sets a target for this interest rate, and the Trading Desk at the Federal Reserve Bank of New York adds or drains funds to keep the rate near its target, which is now 5.25%

Each morning, reserve forecasters at the New York Fed and at the Board of Governors in Washington compile data on bank reserves for the previous day and make projections of factors that could affect reserves for future days. They consult with Treasury Department officials, and then the Trading Desk officials in New York make a plan for the day. The plan is then reviewed by at least one voting FOMC member.

And the discount rate as:

The discount window is a channel for banks and thrifts to borrow directly from the Fed rather than in the markets. Until a few years ago, the discount rate was set below the fed funds rate and loans were subject to numerous conditions.

Banks were reluctant to access the window because it was associated with a stigma usually reserved for distressed banks. A few years ago the Fed overhauled the discount window to try and alleviate that stigma; the rate was then set one percentage point above the funds rate and subject to far fewer conditions. In spite of that, discount window borrowing has remained paltry.

The difference:

Open market operations, under which the Fed buys and sells securities to adjust the supply of bank reserves and keep the federal funds rate on target, primarily operate through a network of primary dealers, some of whom are large banks. Thus, they have only indirect impact as a supply of funds for the thousands of banks that are not active in the money market. The discount window, however, is available to any bank or thrift, and the terms are easier than for fed funds loans. For example, banks may submit mortgage loans, including subprime loans that aren’t impaired, as collateral, and many probably will.

To draw similarities, FFR is like the reverse repo and repo rates of RBI and Discount rates are like the Bank rate of RBI.

Discount rate cut has increased the probability of cut in FFR when Fed meets on Sep 18 to decide on latter.  Data from CBOT tells me that Fed Futures rate for Sep closed y’day at 95.07 implying a Fed Funds Rate of 4.93%. So rate cut has been factored in Sep. Dec Future closed at 95.45 implying a FFR of 4.55% a cut of 75 bps from current FFR of 5.25%.

Read the Economists’ reaction to the same.

WSJ blog provides further clarity and says the impact may not be as much because the discount window is only open to select institutions.

This is excellent stuff from WSJ Blog. Keep up the good work.

India’s Corporate Bond Market

August 17, 2007

We all know corporate bonds have a big role to play in development of Indian economy. Despite numerous reports (This one by RH Patil and Committee is the latest and the most popular) nothing seems to have happened.

R.H Patil said there is no will to reform corp bonds market. SEBI responded saying out of the 14 recommendations made by Patil report 8 have been implemented. 

But overall there is lot of confusion. 

  • BSE and NSE, the two premier stock exchanges both are to report corporate bond deals (OTC and on exchange).
  • NSE has a trading platform (NSE was formed to develop corp bonds not equities!) and BSE has also floated a new platform as well.
  • Still there is hardly any trade.
  • Now SEBI has asked FIMMDA to develop a new trading platform.

Can anyone explain?

There is a recent press release from SEBI which shows the trading activity in both the exchanges. It includes both OTC and exchange deals.  So one is not sure how much deals are already on the exchange.

To put things in perspective, let us look at NSE equity numbers.

  • Both the number of trades and volume is just about a fraction.
  • Number of trades in debt compared to equity on average for August 2007 is just 0.003%
  • value of trades in debt compared to equity is 4.21%

Lots needs to be done. I would try and look at US numbers to draw a better perspective.

Assorted Links

August 17, 2007

1. WSJ Blog has a nice primer on How Fed manages its benchmark rate.

2. Ashok Gulati has drawn an interesting comaprison between India and Pakistan agriculture.

3. TCA points to a new paper on Public Private Partnerships.

4. Ravi Mohan of S&P India, says turbulent markets are not a cause of concern. Then what is?

Assorted Links

August 16, 2007

1. WSJ Blog points out to this excellent article from Martin Wolf. Read Stephen Cecchetti’s comments. Wow!

2. WSJ Blog pointsout to a study that says UK could have the largest exposure to US subprime mortgages.

3. Mankiw points to an article on P/E ratios.

4. Fin Prof tells me how funds ran by Bear Stearns and Goldman Sachs reacted differently to the sub-prime crisis.

 5. Earning millions while creating frauds is fine but if you are caught, it is a nightmare. Read how Tyco’s CFO Swartz is faring in the prison.

6. Americans attach a price to everything.

Assorted Links

August 14, 2007

1. MR points to this interesting story:

When an investment banker set out to buy a $1.5 million home on Long Island last month, his mortgage broker quoted an interest rate of 8 percent. Three days later, when the buyer said he would take the loan, the mortgage banker had bad news: the new rate was 13 percent.

2. WSJ Blog asks which Central bank has the right idea?

3. WSJ Blog points to this article that discusses Chinese Bubbles. China has 3 bubbles: equity, product-safety and pollution.

Sovereign Wealth Fund Primer

August 13, 2007

Peterson Institute of Economics is a terrific research centre. It has some great economists doing superb research.

Read this primer on Sovereign Wealth Funds by Edwin Truman. This is emerging as the hot topic of discussion amidst economics and finance experts.

Why the attention? These are funds formed by sovereign itself,  are pretty large and mostly have a global portfolio, and a problem with them could send financial markets for a toss. Hence, there is a need to understand the nature of these funds and build regulation to monitor the same.

Read the primer for details. I just wished the font-size was larger. It is too small to read.

Update 1: Ajay Shah shares his thoughts on the same and provides  number of links on the subject.

Update 2: Simon Johnson, Chief economist at IMF, shareshis views on the same in Sep-07 Finance & Development Issue. He does number analysis to understand their impact. Interesting.

Update 3: IMF has taken up research on SWFs. The GFSR Sep 2007 issue hasan excellent classification of SWFs. See Page no 45 of the report.

Update 4:Dr. Reddy gives an interesting speech on the same.

Update 5: WSJ Blog points to this article by Matthew Lynn where he says concern about SWF’s is overstated.

Update 6: Knowledge @ Wharton’s view on SWF  

India’s Foreign Trade update: Q1 2007-08

August 13, 2007

A. V. Rajwade (his articles are pretty good) has lately been focusing on problems with India’s Balance of Payments. Earlier he had written in BS that RBI does not include data for trade credit (as it does not have a record of the same) which means our current account deficit is much larger than we would think it to be. It was a very intriguing piece of analysis.

In today’s BS, he points out to India’s growing trade deficit. Commerce Ministry has released the recent foreign trade data covering Q1 2007-08. The findings:

1. Exports have increased by 18% to $ 34.3 bn. In Q1 2006-07, the growth was 14%.
2. Imports by 34% to $ 54.9 bn. Oil imports by 4% to $14.8 bn and non-oil imports by 50% to $ 40 bn. In Q1 2006-07 the growth was 37%.
3. As imports have increased faster, Trade deficit has increased by a 75% to $ 20.6 bn. Last year, Q1 it grew by 100%.

Hence, all is within the trend. So what is the concern?

1. With rupee appreciating and since it works with a lag, exports would slow down and imports would increase.
2. That would mean higher trade deficit
3. We would need higher service exports to manage the deficit.
4. As rupee is appreciating, getting higher service exports would be tough.
5. Hence, most likely we would see higher current account deficit and to finance it, the capital flows would be higher, compounding the problems further.

Further AVR criticises EAC report which has underestimated the trade deficit and overestimated the growth in exports.

It would be sad if the EAC is taking a “politically correct” stand in its projections, by not analysing the impact of a rising rupee on the trade and current account deficits. Surely one expects a more analytical stance from such an august body. This apart, measures like tinkering with interest rates on export credits, tweaking duty drawbacks, micromanaging ECB end-use, and so on, would do little to correct the sharply growing deficit. We seem to be going back to the old habits of micromanaging the external sector, avoiding facing the root problem, namely the exchange rate. It did not work then, and is unlikely to work now!

I share similar feelings for EAC for its analysis here. Keep watching this space for more developments.

Articles on Basics of Sub-Prime Mortgage Markets

August 13, 2007

Sub-prime is the flavor of the season and every second article in Indian news papers focuses on the same (every other article is on rupee appreciation). I had posted about some academic papers covering the same topic.

I came across 2 pretty-good articles explaining basics of sub-prime mortgage markets. One in BS and the other in ET.

Assorted Links

August 13, 2007

1.Nouriel Roubini in his excellent blog, raises concerns overt the current crisis.  He says this crisis is worse than the LTCM crisis in 1998.

2. WSJ Blog has a primer on how Fed injects liquidity. Econbrowser has an excellent explanation as well.

3. Read Central Bank’s response to liquidity crisis.

4. Read the new war of words amongst blogging economists.

5. PSD Blog points out to comics from World Bank addressing global issues.  I read one, not as good as the one by RBI to improve Financial Literacy.

6. Ajay Shah points out to interesting posts on Indian education system.

7. ET has a nice interview of R.H. Patil, in which he says there is no will to reform corporate debt market in India. He expresses his strong views on many current topics- rupee appreciation , MIFC etc.

8. ET reports SEBI supports dedicated selling channel for MFs. 

Indian Mutual Fund Industry’s outsider

August 10, 2007

I came across this story in ET of Ajit Dayal, Director of Quantum Mutual Fund, India. I knew that Quantum does not give the distributors any money and markets its MFs by word of mouth and distributes mostly by internet. What I didn’t know was the reason.

Most MFs pay huge monies to distributors for increasing former’s assets under management. So much so, that last year distributors made more money than AMCs (Asset Management Companies) themseleves.

Here is Ajit Dayal’s story:

The story behind Quantum Mutual goes back to late 2005, when after getting permission from Sebi to start his own AMC, Ajit Dayal met several distributors to create awareness about his funds. But he was shocked to see them put forth ‘a pricing sheet’. For 6% commission, you’ll get Rs 6,000 crore, for 5%, Rs 500 crore and so on, distributors told him. “Without bothering to check whether a product is suitable for investors, they came up with a sliding fee structure,” reminisces Mr Dayal, who is one of the first stock analysts and investment managers of the post 1991 era. “But who is going to pay for all this?” he asked them.

The last straw came when Mr Dayal went to a senior broker and asked him to recommend his funds to investors, but refused to pay him the hefty commission that he demanded. “We make elephants in the industry dance to our tune, you are just an ant,” thundered the broker. The decision was made. 

He has taken this agenda of selling Mutual Funds to people with as low cost as possible and has some useful articles on its website on how distribution costs can lower returns . 

How about the performance?

The AMC just has 2 funds one equity and one liquid.

Equity fund is called Quantum Long Term Equity which was launched in Feb-06. As per Valueresearch, the AUM is just about Rs 37 crores (Rs 370 million) compared to giants like HDFC Equity which is at about Rs 4600 cr. It ranks 139th in AUM size out of a list of 167 equity schemes.

In terms of returns, it has given around 30% in last one year compared to JM basic which has given 70%+. It ranks 131 in 161 schemes. The numbers for other tests like Sharpe Ratio, Alpha are not calculated as it is just about an year old. 
So performance of the quantum equity fund has to be spruced up as it lacks behind its peers by a huge %. It may have lower costs but can only be recommended if it produces returns higher net of costs. Other funds may have higher costs but produce higher returns as well.

But still, a great initiative and as it is only one year old, only time will tell how well Quantum fares in its objective.

I have a suggestion which could lower further costs. The equity fund still has high expense ratio = 2.5% which is just like its peers. It has its office in Nariman Point, the area which has the highest commercial rent and is one of the costliest in the world. It could do with an office at a less costly place in Mumbai.

Assorted Links

August 10, 2007

1. Percy Mistry responds to all the comments on MIFC (Mumbai International Financial Centre). It was a series of 6 articles in BS which Ajay Shah has compiled in his blog.

2. New economics points out to The economics of pre-school.

3. European Central Bank added about USD 130 bn into the system to calm down markets as participants scramble for liquidity. Fed too entered the market twice to inject Cash. Read insightsfrom WSJ Blog.

4. Finance Prof has nice collectionof articles on BNP Paribas scare y’day.

5. BS points to 2 academic papers which look like a good read. First by TCA on US Supreme Court and second by Bloomberg on Fed which says Fed is less transparent that its peers.

Global Imbalances: IMF Strategy to correct it

August 9, 2007

First, what do we mean by Global Imbalances?

  • US spends more than it saves resulting in huge current account deficits (Basics are here). Ideally the dollar should depreciate to correct the huge current account deficit (Note I mention ideally, in reality it may not happen. This research shows for US current account to correct, US needs to save and dollar depreciation may not work; but then it is just research) . But dollar does not depreciate or in other words US continues to finance its current account deficit. How?
  • China runs huge current account surplus (on account of its exports) and the surplus is mostly invested in US treasuries. Which means demand for dollars continues and the dollar does not depreciate but appreciates.
  • High inflows in US are also from Oil exporting nations especially middle east counties that invest their pertodollars in US treasuries
  • Another source of demand for dollar is South East Asian Nations like Korea, Indonesia etc which are maintaining huge forex reserves, a learning from the crisis in 1997.
  • Then you have problems in Japan like yen carry trade which have global implications
  • As Europe continues to struggle (now, it is showing resurgence post Germans showing strong growth), it cannot take much of the pressure from the US. As US assets are still considered to be safer most surplus money from China, India, Middle-east etc continues to be parked in US and not in Euro. But after Euro adoption, Euro Region is as big as US and has some developed economies, but has not taken off. There are some reforms needed as factors of production (labour, capital) are still not fully mobile in Euroregion.

As imbalances continue, how does one solve the problem? As it is a global program we need coordination of all involved.

IMF has come out with this approach which it calls as Multilateral Consultation on Global Imbalances. In this it brings all the top policymakers of the countries/regions involved in the imbalances. It began in June 5 2006. The press release says:

The first multilateral consultation will focus in a comprehensive and collective way on the issue of global imbalances and involve several systemically important members and groups of members—China, the Euro Area, Japan, Saudi Arabia and the United States—all of which have agreed to participate in this first consultation.

“These economies are either ones with large current account surpluses or deficits, or they represent a large share of global output,” Mr. de Rato noted, adding, “Their cooperative action can play a major role in the orderly unwinding of these imbalances and in sustaining global growth as savings, consumption and investment patterns adjust.”

IMF just came out with its latest report on the same which is pretty good as it summarises what those imbalances are and what each country/region is doing to correct the imbalance.

So what is each country doing about it:

  • China : indicated that the reduction of external imbalances had been elevated to a major national objective in 2007. In this connection, they are pursuing measures to boost domestic demand—particularly rural consumption; to reform the trade system; accelerate financial sector reform; and gradually increase exchange rate flexibility.

  • Euro area, the authorities are pressing ahead with structural reforms across a broad front to strengthen competition and productivity. In product markets, the main planks the implementation of the Services Directive and the development of more competitive network industries in individual countries. In labor markets, steps are being taken to foster greater labor utilization and productivity and the mobility of labor. Financial market reforms include measures to facilitate mergers and acquisitions, and implementing a range of initiatives aimed at harmonizing and integrating financial markets.

  • Japan: the authorities plan to advance structural reform to strengthen competition and enhance flexibility. This included additional steps to enhance labor mobility; facilitate inward foreign direct investment, including through reform of the tax treatment of mergers and acquisitions; broaden the application of deregulation already in force; reform and privatize some government-owned financial institutions; and further advance fiscal consolidation to sustain domestic confidence.

  • Saudi Arabia: the authorities intend to continue to increase spending on social and infrastructural investments in key areas, including expanding oil sector capacity. As these investment programs have a high import content, their execution would significantly reduce the current account surplus in the coming years.

  • United States: authorities plan to raise national saving through further fiscal consolidation over the medium term, including the achievement of a balanced unified federal budget by FY2012, accompanied by measures to reform the budget rocess and slow the rate of growth in health care costs; and measures to support private savings, as well as to enhance energy efficiency, strengthen capital market competitiveness, and ensure the United States remains an attractive environment for foreign investment.

  • Excellent stuff this. Read it to develop good understanding of the issues involved.

What is Sub-prime market? Some Basics

August 9, 2007

All problems in financial markets and economies are attributed to sub-prime mortgage markets.

To get a good understanding of what is this all about there is some good material. One is a speechby Bernanke and the other is a simple conceptual paper from St. Louis Fed.

There is another recent paper from IMF Staff which discusses whys and hows of sub-prime mortgage markets.  This paper could have been much simpler. It explains a lot of jargon used in housing markets but not convincingly though. Could have added a bit of graphs.

After a number of warning signs, the U.S. “subprime mortgage crisis” became a headline issue in February 2007. Notwithstanding the bankruptcy of numerous mortgage companies, historically high delinquencies and foreclosures, and a significant tightening in subprime lending standards, the impact thus far on core U.S. financial institutions has been limited. This paper reviews the history and structure of the subprime market. The results suggest that new origination and funding technology appear to have made the financial system more stable at the expense of undermining the effectiveness of consumer protection regulation. Potential solutions to the management of this trade-off are then explored.

Read on.

Assorted Links

August 9, 2007

1. WSJ Blog compares 2007 with 1998. In all measures we seem to be better off today except for US economy. It was better placed in 1998.

2. In US know-how about economics needs to be improved. Read the WSJ Blog posting.

3. WSJ Blog says European Central Banks won’t bail out the imprudent investors.

4. Mankiw explains some basics of international economics.

5. Financial Rounds has some interesting links. Lot of spelling mistakes which could have been avoided.

6. Free Exchange points out to an excellent article on how Kishore Biyani run stores (Big Bazaar etc) have built their success by mimicking the chaos and grime of traditional Indian markets.

7. TT Ram Mohan in ET says financial markets may be in a state of bother but economic conditions continue to be sound. Only time will tell.

8. Shankar Acharya in BS shares his piece of mind on current exchange rate problems.

9. Percy Mistry respondsto Shankar Acharya’s comments on MIFC.

Raghu Rajan’s solution for Failed States

August 8, 2007

These days most economists are focusing on growth and development – Michael Spence (got nobel for work on role of information in markets; now heads the growth commmission) , Avinash Dixit (a leading contender for nobel every year; for his work on International trade, I have reviewed his thoughts on the development subject here) are some famous ones.  Raghu Rajan (who focuses on financial markets)  has also been working on the same agenda for a while. He has written a fantastic paper on why underdevelopment persists which I have reviewed here.

I just came across this short piece written by Rajan where he has a solution for states/countries that continue to fail despite all possible ways to reform them. He begins right away:


The scenario is depressingly familiar in some parts of the world. A civil war ends. The battling warlords, having exhausted their resources, agree to elections. The people, having endured years of rape and pillage, go wild with joy. But their choice in the United Nations-monitored election is really between parties set up by former warlords, because no one else has the money, the muscle power, or national recognition to compete with the two. One wins, and then proceeds to destroy the few state institutions that curb his power even while he uses the instruments of the state to pick off his opponent. Once that is done, he proceeds to loot the country under one-party rule until an opposition eventually organizes. Since elections have now become a farce, the opposition has to resort to force to overthrow him, and the whole cycle resumes. The people get poorer and poorer, kept from starving only by handouts of international aid. The lucky leave while the unlucky endure.

Why does this continue?

As we know you need a sound economic environment to fucntion properly which means you need right kind of institutions in all possible activities affecting human life.

Now how do you build that? For this we have some research which saus it depends on whose colony you were? If you were colonized by British which had common-law system compared to French which had civil you would be better-off.

Now what explains the difference in performance of US and India whuch were both colonized by British? The research answers that it depends on the population level and mortality rates. Where population levels were low and mortality was less (like US) the colonizer set better institutions and where it was not it set up extractive institutions which continue to haunt these countries till today.

This is clearly unacceptable. As it means the countries cannot do anything as all the deternminants of growth were laid by the colonizers. Read Avinash Dixit’s humourous paper on the on the same.

And as Rajan points out that countries like Liberia had everything right still it continues to fail.

Rajan says development happens when people have economic power through their property holdings or human capital. When that is widespread people want better institutions that protect these rights and the erstwhile powerful are controlled. You have countries like Japan and Germany which changed their basic authoritarian structure to democratic and managed to grow spectacularly.

So how do you provide basic rights i.e proporty, human capital etc to people?

You need effective governance to begin with. How do you get it when the powerful keep making a comeback first in elections and ever after by removing most opposition and creating institutions that support them.

So, what is Rajan’s solution?

Let a foreigner (a trained bureaucrat) run the country alongwith his team for a while till he cleans the system and warlords are not as powerful.

The solution would probably not be liked at all by anyone. He says a bit of it is already happening as in most failed states UN, NGOs etc already provide much of the infrastructure and run it.

He says let the UN decide whom the foreign leader could be (choose two for competition) and let the electorate decide his credentials. He should given a mandate under which he has to perform and would be evaluated.

He asks will people accept? He is hopeful:


…… modern times a significant portion of the world’s population have accepted rule by outsiders in preference to rule by their own – we call this voluntary choice immigration. Instead of people voting with their feet to where governance is enabling, I am advocating a process of moving governance to where the people are.

For more details read on. Nice food for thought. 🙂 !

Assorted Links

August 8, 2007

1. The factor most world looks at, Fed Futures rate has been maintained by Fed at 5.25%. Inflation continues to be a concern.

WSJ Blog says Fed mentions global factors (Fed says US economy would grow at moderate pace on account of robust global economy) after a long time. See various Economists’ reaction.

2. Dani Rodrik reviews his latest paper on Industrial Policy. He has always believed in a bit of government and this is what he seeks to address in this paper.

Just as economists think about how to improve market institutions, they can devote their talent to improving the institutions of government.  The informational and rent-seeking costs of government intervention can be ameliorated through appropriate institutional design.

3. Free Exchange criticises Rodrik’s support for Import Substitution strategies.

Finance Ministry imposes Capital Controls

August 7, 2007

Finance Ministry of India imposed some capital controls to control the surging dollar inflows and prevent further rupee appreciation. This time also they have imposed controls on External Commercial Borrowings (ECB).

Capital Controls could be of various types and so far policy makers have been targeting External Commercial Borrowings. These are loans Indian companies raise in Dollars/Pounds etc for financing their expenditure. Earlier, a control was imposed via which companies could not raise loans by offering interest rates higher than stipulated.

This time they have categorised ECBs:

  • Any company raising External Commercial Borrowings of more than USD 20 million would be permitted to use the same only for financing permissible foreign expenditure i.e. imports, acquisitions abroad. This implies that dollars raised via ECBs will have to be spent overseas and cannot be used to finance rupee expenditure.
  • Companies raising ECB less than USD 20 million for financing expenditure in India, would require permission from RBI for doing the same.

So some development on rupee appreciation. Let us see the impact.

Update: Ajay Shah feels the capital controls would not be effective.

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