Is India investment constrained or saving constrained?

I think this is a fantastic research paper to attempt in Indian conditions.

Those who read this blog and Rodrik’s blog would know what to expect. This time he lends some support for his feelings for financial globalisation- It isn’t as good as it is promised.  His earlier paper which is often referred to in research papers is here.

This is an excellent paper and helps you think about these problems from a developing economy front. I am sure his upbringing in Turkey helps him think about the issues in a more realistic manner. As a result, he is radical and different.

This time he has something different to say on financial globalisation. The economists usually have heaps of praise for financial globalisation and how foreign savings can be useful for pumping growth in an economy.

But so far the evidence is at best mixed and this surprises the economists (not surprising though). This has led to variety of responses from the surprised economists – data is not right, looking at wrong side of the problem and finally financial globalisation has led to number of indirect benefits – better institutions, financial development etc.

Rodrik reviews all these arguments and says he doesn’t really agree. If the benefits exist it should show. Further, Rodrik points out a different framework for analysing the problem.

He says the research clubs the developing countries as one and analyses whether it has worked or not. Where as most developing countries are in two traps:

1) Saving constrained (SC): in a saving-constrained economy, real interest rates will be high, borrowers will be chasing after lenders, and any (exogenous) increase in resource transfers from abroad will finance mainly investment rather than consumption. If you ask entrepreneurs what they would invest in if you gave them $50 million, you would hear in response a long list of projects.

2) Investment constrained (IC): In economies constrained by investment-demand, by contrast, real interest rates will be low, banks will be sitting on top of mountains of liquidity, and it will be lenders who are running after borrowers. When you query entrepreneurs about investment ideas in such economies, your question will be met by a long silence, followed by the riposte: “do I have to invest the $50 million here?” Any resource windfall will be eaten up by consumption rather than investment.

The paper then goes on to discuss how the 2 economies are different. In an SC the problem is not as much

In a saving-constrained economy, capital-account liberalization works in the conventional fashion: a reduction in domestic interest rates and the increase in the availability of external finance spurs domestic investment, as firms travel down their investment demand schedule. Consumers meanwhile face a change in intertemporal relative prices, inducing them to consumer more and save less. The increase in domestic investment and reduction in saving are financed by capital inflows. The economy grows more rapidly as a consequence of the boost to investment. This is the standard textbook story on capital-account liberalization.

The problems are in an IC:

But in an investment-constrained economy, the investment demand schedule is vertical, so the effect of liberalization is purely to boost consumption. Investment is unaffected because the equilibrium level of investment is determined primarily by the perceived returns, which are presumed to be low. Foreign savings simply substitute for domestic savings, with no net effect on investment or growth.

Further, the capital inflows appreciates the currency in an IC and this excarberates the problem.

Actually IMF has also shown in its research that the investment rates in the world have been lower than previous highs and what was perceived as a saving glut was actually a investment deficit. So, we need to apply the Rodrik framework in other devloping economies to understand whether capital flows can be helpful or not.

What about India?

I have shown in this paper that it is a bit of both. Earlier it was SC and capital inflows led to higher growth. But over a period of time investment opportunities declined and it became IC. With capital inflows continuing,it led to appreciation of the rupee, leading to number of problems (sterlization, inflation) for the supervisors of the economy.

This leads to a question- how come the equity markets continued to rise? (data available in my research is till 2005-06). My best guess is that the industry was busy making profits from speculating in financial markets, commodities, exchange rates etc (Classified as other incomes in the balance sheets). All this now seems to be coming to an end and we keep hearing about some or the other organisation having derivative position going wrong.

 

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Assorted Links

1. IDB has a nice analogy on Micofinance.

2. MR on capital controls

3. WSJ Blog on Fed’s regulatory future

4. Chris Blattman has a nice post on popularity of random experiments

How right is criticizing India’s financial sector policies?

There are two flavors of the season people are writing on:

1) India’s financial sector policies and
2) Financial Innovation.

The majority of the articles says Indian policy framework is poor and financial innovation is useful.

I don’t know the reason why our financial sector policymakers are criticised. Experts say they have curbed our financial system, made it antediluvian, have limited variety of financial products.

Most criticism (perhaps entirely) is directed towards the Central Bank. The reasons are:

• Managing the impossible trinity – Some even say if RBI has to manage the exchange rate it should give up monetary policy!. I have looked at the problem here and have shown it is not really RBI’s fault. It is sticking on the mandate given to it by the government. So, it is not right to criticise RBI but instead ask government to change RBI’s mandate. All Central Banks work as per the mandate given to them by their respective governments.
• Inflation Management:  The analysts didn’t like RBI not cutting the rates in the January Monetary Policy meeting. RBI maintained its inflation stance and as current inflation numbers show, it former seemed to be right. The same analysts criticised RBI earlier in 2007 saying inflation is very high if we look at the CPI numbers and RBI is not tightening enough. RBI didn’t raise the rates as it expected inflation to come down (which it did) and didn’t cut rates as it expected inflation again to surge (which it did again).
• Not allowing capital account convertibility- Well the experts hold empirical research close to their heart on first point which shows in an open economy central banks should only manage inflation and let exchange rates float. But on this topic they seem to ignore the research. The most comprehensive research from Rogoff et al shows benefits from capital inflows are at best limited.
• For not allowing exchange traded derivatives in exchange rate products, interest rate etc: This is perhaps one of the most funny things I have heard. The experts have now started blaming the RBI for the recent exchange rate derivative mess. Just because the Banks and corporates got greedy and took bets on the currency doesn’t mean exchange rate derivatives would have helped. These derivatives essentially trade on an OTC market as they are designed on the basis of the client . Introducing exchange traded derivatives would have hardly helped.

  And then most experts criticising RBI have been on committees that looked at developing these derivative markets. The markets didn’t take off and then it took sometime to launch them again.

The idea behind this post is not to defend the Central Bank but to point it is not really its fault. No one disputes the benefits of the reforms in the financial sector but it has to move ahead with real sector.

The monetary transmission in India is still not as robust as developed economies and things work with a bigger lag. So we have to wait. The main issue is we need reforms in real sector to let things become better. The Doing Business report shows it is becoming more difficult to do business in India. Finance and its policies only work if we have things moving in real sector. Most analysts assume it to be an assumption which we all know is just that- an assumption.

However, one area where the Central Bank can surely do better is to communicate. The markets need more cues from the Central Bank especially in India where we have very little data coming and enormous focus on Indian markets.

I will write on the financial innovation debate later. I have actually expressed my initial views here

Assorted Links

1. WSJ Blog points to a Possner speech where he says don’t overestimate monetary policy. It also has a nice explanation of the Fed Soup.

2. WSJ Blog points to Jo Stigilitz’s prolific paper writing

3. Fin Prof on Bear Stearns after fallout effects. It also points to a paper on technical analysis

Literature Survey on Microfinance

Microfinance has been a hot topic of discussion ever since Mohd. Yunus and his team got a Nobel Prize in 2006.

I cam across this good literature surveyon Microfinance by Rajdeep Sengupta and Craig P. Aubuchon. It covers the entire issue in detail and covers what has worked and what has not in microfinance

Using behavioral economics to address development

This paper from Sendhil Mullainathan looks at how we can apply the various findings in BE to address development problems. Infact it is a great literature survey on the subject.

Economists conceptualize a world populated by calculating, unemotional maximizers. This view shapes our understanding of many crucial elements of development economics–from how rural villagers save, to how parents decide on whether to send their children to school.

Psychological research, however, has documented the incompleteness of this perspective. Individuals have self-control and time inconsistency problems. They can give into shortrun temptations and later regret it. They can have strong feelings about others that drive them to commit both generous and spiteful acts. They often passively accept defaults rather than make active choices. They let the institutions around them make choices for them. And they may misread new data in a ways that fit their beliefs. In short, the rational maximization model may not be a very good approximation of human behavior.

In this paper, I present some of the psychological evidence that I believe helps us to better understand a few core issues in development economics, such as savings, education, and property rights. This gives us new ways to interpret a variety of behaviors in these contexts, and enriches the set of policy tools we should consider. This evidence also suggests not only the need for dramatically new tools, but suggests small cost changes that may dramatically improve their efficacy of existing policies.

India’s policy to push rural banking lowered poverty

It is getting tough to write or cover research papers in detail because of the time constraint. So, I will just be pointing to the interesting research papers I have read till I can get some time to get back to detailed writing.

I came across this paperby Rohini Pande which shows how the policies to push rural banking between 1977 and 1990 led to lower poverty in rural areas.

We exploit the introduction and removal of a nation-wide bank branch licensing rule which sought to increase and equalize bank branch presence across Indian states to estimate the e¤ect of rural bank openings on poverty. Between 1977 and 1990, to qualify for a license to open a branch in a census location which already had one or more bank branches an Indian bank had to open four branches in locations with no bank branches. This policy caused banks to open relatively more rural branches in Indian states with lower initial .nancial development between 1977 and 1990. The reverse was true outside this period. We use these policy-induced trend reversals in the relationship between a state’s initial financial development and rural branch expansion as instruments for rural branch expansion and that rural branch expansion in India significantly reduced rural poverty.

This paper is a must read for all those constant Indian policy critics who believe Indian policies have done all things wrong. And that too it shows the rural bank push was beneficial when most believe it was detrimental. It will be interesting to get a paper criticising this paper as well.

Assorted Links

1. WSJ Blog points to lot of Fedspeak: Mishkin, Stern, Lockhart, Rosengren. It also points to how Bernanke’s research prepares him for the crisis.

2. Mankiw points to a article that grades Fed

3. Buiter points to new and old wisdom in finance

4. TTR comments on India’s saving and investment rates in future

5. Fin Prof points to a new paper on CEO compensation

Assorted Links

This blog is back after a long vacation. Lots of developments. Here are a few links:

1. WSJ Blog points to a recent Fisher speech where he says monetary policy isn’t useful for fixing financial markets.

2. Ajay Shah on the 6th pay commission and on financial innovation

3. JRV supports the recent SEBI move.

4. TTR says it is not right to blame Indian bureaucracy for all the ills.

5. Krugman onrising commodity prices. Econbrowser also has an interesting post

6. Rodrik’s new paper on financial globalisation

7. PSD Blog pointsto another paper on subprime crisis.

8. EPSA Blog has a nice thought on beggar they neighbor policy.

9. Econbrowser points to some quick links explaining the recent events.

Mostlyeconomics wishes its visitors Happy Holi

Wishing all the visitors a very Happy Holi!

Mosltyeconomics is on a holiday. The blogging should resume on 27 March, 2008. Till then have a great time and keep the comments flowing.

A request to India’s Ivy Leagues- show us some research

It is March and the media is rife with developments on the placement scenario in India’s elite Business Schools. The placement season has begun and news is filtering on the compensation packages received at the various schools. The news of who and which school has received the highest compensation package is doing the rounds.

I still don’t understand this placement mania in the media. One can understand a weekly column to cover the issue but we see a regular full page dedicated to the events. It is sad that the only way these elite colleges engage the media is on the placement prospects. Is that the only thing that these education temples have to offer?

The most important parameter for a good school is its quality of research and unfortunately, this is something we never get to read. Unlike the west, where the media profiles faculties and their research, all we get to hear from these schools is on placements.

An important way one can judge the quality of research is via peer reviews. The academia makes references to other people’s work in their research and more such references, better is the quality of the research. Though this practice has been abused lately but is still the best way to judge the quality of a research. It is actually surprising that after reading many a research papers (even on Indian economy), you hardly come across a reference that comes from these elite schools. Whenever one comes across an Indian name it is mostly from a foreign university.

There is a huge interest on Indian economy and some Universities have even set up India centers. So, the faculty can’t even blame “times” saying no one is interested in Indian economy/companies etc. The academia can’t even blame the media saying it isn’t interested in covering research. These days awe come across a lot of newspaper articles that explain the developments using research papers. Some newspapers even have dedicated columns profiling research but it mostly covers research done in Universities abroad. Infact, one leading economist who writes a column lamented on the same fact- lack of research in India.

Then there are other events that these schools organize – seminars, symposiums, conferences etc. to discuss various research papers on a particular topic. There is hardly any mention of the same in the media. All we get to read is about the cultural festivals and marketing events.

This is not to say that the faculties do not research but they need to use better ways to propagate their research. They should make efforts to use web and print media to inform people about the new research undertaken in these schools. It is very good if the faculty can get their research published in leading journals but discussing it with the public is be an equally good first step.

The elite schools may not realise but they have led to development of a very dangerous precedent. All the schools seem to be just focused on placements and not on the curriculum. The students also take up a course looking at the lucre and not understanding the suitability. The students should ask their respective schools what they can teach not how much salaries they can help them get.

It is a request that the elite schools take up this matter seriously and lead from the front. They should limit all these press releases on salaries and placements and instead channelise their energies on showcasing their research output. At the end, I wanted to point to an interesting trivia. The financial assistance for one the most profound idea in economics – The Market for Lemons written by George Akerlof – was given by Indian Statistical Institute. So, it is not that the Indian schools can’t do it, all they need is to re-focus.

If David Ricardo was granted a wish

If David Ricardo was granted one wish, I am sure he would want arrange a conference for all the economists and address this issue: The impact of trade – good or bad?

When Ricardo developed the theory of comparative advantage, it was supposed to be the central idea on which the subject of economics was based. So mush so there is a nice trivia on the topic:

Nobel laureate Paul Samuelson (1969) was once challenged by the mathematician Stanislaw Ulam to “name me one proposition in all of the social sciences which is both true and non-trivial.” It was several years later than he thought of the correct response: comparative advantage

Theories of trade was also built on the same principle. Then we had refinemenmt from number of economists but the main idea remained- if you had a comparative advantage, you should specialise in that good/service and trade on it.

Then came empirical evidence which showed trade doesn’t lead to growth and infact leads to inequality. The economists weren’t bit amused but more and more research shows that trade doesn’t lead to growth.

The issue is still pretty divided and we keep getting to read on the debate time and time again. For instance read this Mankiw’s article (who supports trade) and read this article by Dean Baker (pointed by Dani Rodrik who is always suspicious of such blank arguements).

Dean Baker’s article in particular gives a lot of food for thought:

1) Trade does create winners and losers, and given current patterns of trade, the winners are likely to be owners of capital and highly educated workers, with the rest of the population ending up as losers.

2) It is possible to redistribute from the winners to the losers. However, the taxes necessarily to pay for any redistributions are themselves distortionary. It is not possible to determine a priori whether the distortions created by taxes to finance redistribution are more or less distortionary than the trade barriers that were eliminated.

3) There are trade barriers that have the effect of protecting workers in the most highly paid professions, such as doctors, lawyers, and accountants. There are large potential economic gains from eliminating these barriers. Removing these barriers would both increase economic efficiency and reduce inequality.

The last point brought this article to my mind where India’s leading legal expert says – The liberalisation of the legal service sector is undesirable at this point in time.

Unless Ricardo is granted his wish, I am sure we will see more heated debate on this topic in times to come.

SEBI further clips mutual fund earnings

I had earlier pointedout that SEBI has waived the entry load for those investors that purchase mutual funds directly from MF company (via their distribution centre or via Internet).

This time SEBI further clips the earnings of MF by reducing the entry load:

…. AMCs shall not charge entry as well as exit load on Bonus units and of units allotted on reinvestment of Dividend.

SEBI has been very active recently and this is a welcome step. I never understood at first place, why entry/exit load was charged on bonus units.

The use of Quant Mutual Funds in India

The quant mutual funds are making an entry in India. After Lotus India AMC has launched a Quant Mutual Fund, Reliance Mutual Fund has converted its index fund to a quant fund. ET says:

Reliance Quant Plus Fund  will invest at least 90 per cent of the assets in an actively managed portfolio of 11 to 15 stocks  from S&P CNX Nifty index on the basis of a mathematical model. The model will shortlist stocks on the basis of stock price movement and financial/valuation aspects, the fund house said. 

I don’t mind these quant funds but converting an index fund into a quant fund surprised me. I still don’t know why index funds are not treated at par in India. This also brings me back to a point I have made earlier- Are our markets getting efficient? If they are we should perhaps be seeing active funds being converted to a passive fund, not the other way round.

Moreover, the conversion is not to an active fund but a quant fund. The recent Phelps article and Mint edit points the dangers of these quant models and financial engineering.

Above all these funds are being offered to the retail investors!! Do they expect a retail investor to understand these funds? The Lotus Fund has about 230 cr of assets under management. I don’t know how much is retail but it is scary. Lotus also has a tax saver fund based on quant models.

These funds would say we disclose the information and the investor can decide whether to invest or not. I don’t really agree as financial literacy is low worldwide and people don’t understand even simple concepts of finance (even high literate ones). This paper points how investors’ investment in equity markets increases with sensex where it should be the other way round. So to expect them to understand a mathematical model is asking for too much.

It will be better if we concentrate on basics and simpler mutual fund schemes. Alternatively, these funds should only be for institutions and not retail.

Assorted Links

1. Fed lowered the benchmark rates  by 75 bps. WSJ Blog points to the two dissenters. It points to the economist’s reaction. Read Krugman’s view as well

2. MR on how bad news can be good news. It also points to a nice discussion on  GDP vs GDP per capita.

3. Ajay Shah points a post for the debt waiver. He expects the US economy to not do as bad as it seems.

4. WSJ Blog points to a new paper which might help silence the RBI criticisers

5. DB Blog on the credit registries

6. Econbrowser says Bear Stearns is no bailout.

Importance of social issues in financial inclusion

I have added another paper to my website on the need for financial inclusion and it focuses on India. The paper puts forth a couple of ideas:

• Use behavioral economics/finance,
• Address social issues
• Real-sector inclusion is as important

I have written a lot about behavioral finance and even pointed a paper which looks at using BF to enhance financial inclusion.

As far as the other two points are concerned, I found some material which confirms my belief.

This speech from Prof Yunus shows how Grameen Bank addressed various social issues. He shows how he convinced more women to take micro-credit in what was otherwise a male dominated bastion. Without addressing these issues, this revolution would not have succeeded. As we see very similar conditions in India, we need to understand these issues in detail.

I came across this article from James Surowiecki where he says just providing finance is not enough. If we provide microfinance we expect them to open some small business from the finance. As not all people are entrepreneurs and most actually work for someone else, the problem doesn’t end.

The author goes a step further and advocates the need to promote small and medium enterprises which will employ people.

In any successful economy most people aren’t entrepreneurs—they make a living by working for someone else. Just fourteen per cent of Americans, for instance, are running (or trying to run) their own business. That percentage is much higher in developing countries—in Peru, it’s almost forty per cent. That’s not because Peruvians are more entrepreneurial. It’s because they don’t have other options.

They need more small-to-medium-sized enterprises, the kind that are bigger than a fruit stand but smaller than a Fortune 1000 corporation. In high-income countries, these companies create more than sixty per cent of all jobs, but in the developing world they’re relatively rare.

Good Stuff.

What leads to change in share prices ?

I know in these times it may not be the right question to ask. The share prices seem to be changing due to any news for instance, Bear Stearns had little to do with India but markets have crashed.

Coming back to some fundamentals, we know share prices are equal to the discounted value of future cash flows. So, it is mainly two things- cashflows and discount rate.

I came across this excellent speech from John Cochrane (of Chicago University). The main idea is:

In the early days, the “expected” part took center stage: Researchers focused on the “efficient” incorporation of information into prices. Since the early 1980s, however, our focus has been much more on the “discounted” part.

What led to this shift – the research which discovered anomalies didn’t correct as per expectations.

Empirical discoveries forced this shift.  Pretty much any time we see information, we find that it is quickly reflected in market prices. But prices also move a lot (over time and across securities) when there is no cashflow information.  Every expected-return anomaly turns out to correspond to a source of common movement.  Even the momentum stocks rise or fall together.  These are just the sort of observations that suggest variation in discount rates, i.e. expected returns, or risk premia. 

So it is discount rate that changes often leading to the changes in share prices. The share prices change as everyone has his own discount rate which in turn is is influenced by many factors like overall market conditions, personality (high or low risk averse), job profile (if he is an equity analyst/follower), mental conditions (happy/sad/stressed) etc.

This is also in line with findings of behavioral finance. I doubt whether Cochrane advocates BF. Though with Richard Thaler at Chicago, the effect seems to be happening.

Assorted Links

1. WSJ Blog asks can markets swallow a smaller rate cut?

2. TTR says LTCM is being revisited. He also points to an Alan Greenspan article in which the oracle advocates the need for behavioral models (indirectly though).

3. Krugman says we are pretty close to the liquidity trap. He also points that in this crisis there is no one you can call for help.

4. Frankel expains why commodities’ prices have been rising.

5. Mankiw says it is a great time for a Fed watcher. It surely is.

6. PSD Blog pointsto the microfinance hype.

Why wasn’t Alban William Phillips given a Nobel Prize?

I will not be surprised if the reader of this post says Alban William Phillips who?

Well, he is the guy who developed perhaps the most important concept in macroeconomics – The Philips curve. It says there is a trade-off between inflation and unemployment and policymakers have to decide what they want. If they want lower inflation they need to live with high unemployment and vice-versa. The way Philips derived the theory is itself a superb story. He first conducted the experiment on the UK economy in 1958 and found this inverse relationship. This relationship was then tested for other countries and found to be somewhat true. Then policymakers started teaching this as a bible.

Since then, it has been one of the most fiercely debated topic. Later, Milton Friedman and Edmund Phelps thrashed the Philips Curve and showed that there is no trade off and infact there is always a case for some unemployment in a country which leads to non-accelerating inflation (also called as NAIRU).

But still, there are so many discussions centred around this curve -whether the slope of the curve has changed (like they say it has flattened now) or whether the curve has shifted (downwards) etc.  Like Wikipedia says:

But still today, modified forms of the Phillips Curve that take inflationary expectations into account remain influential. The theory goes under several names, with some variation in its details, but all modern versions distinguish between short-run and long-run effects on unemployment. The “short-run Phillips curve” is also called the “expectations-augmented Phillips curve”, since it shifts up when inflationary expectations rise….

For more on Philips Curve, read this primer from Richmond Fed.

Now, coming to the main question, why didn’t Philips get a Nobel Prize (or some other honour). It is surprising. He should have atleast copyrighted the use of the term Philips Curve (like people say Nash should have copyrighted Nash equilibrium), would have atleast got some royalty from heavy usage of the term. Well, Wikpedia profile answers the question: 

Had he lived longer, Phillips’ contributions may have been worthy of a Nobel prize in economics. …..He had a stroke, prompting an early retirement and return to Auckland, New Zealand, where he died in March, 1975.

I checked his birth details, born in 1914 and dies in 1975. He was 61 when he dies. So by Nobel Prize standards, he was quite young.

But there is more to the story. He actually was trained as an Engineer and moved to Economics after 1946 and was around 31 years by then. (Ok here is another after thought- would he have developed the Philips Curve if he was an economist from the beginning? How much did the engineering background help?)

So, he was quite a sharp guy and learnt the tricks of the game quite fast. He went on to become a full tenured Professor in Economics by 40. Simply amazing!

Assorted Links

1. Fed is in action again and this time I expect the criticism to be much bigger than ever. It has cut discount rate by 25bps to 3.25 % , provide funds to securities firms and provided support to Bear Sterns via JP Morgan Chase.

WSJ Blog points to comments over increasing moral hazard. It also pointsthe reason behind Fed’s support to Bear Sterns. Read Mankiw’s comments as well. FIn Prof has detailed post

2. Econbrowser on recession

3. Jeff Frankel questions why commodity prices continue to rise despite the world economic growth slowing down? The answer will come in next post.

4. JRV saysBerkshire Hathaway is more like a hedge fund than an investment company. Well, so is the case with most financial firms.

5. TTR points to the mechanics of the debt waiver. He also points to the diverse views over India’s economic forecast

6. Rodrik asks whether he should start reading the economist again?