Sovereign wealth funds

Governments may have retreated from running businesses everywhere through privatization but they are not getting into businesses as investors. Developing countries are sitting on huge hoards of foreign currency on which they would like better returns than they get on US bonds. So, many countries are now investing in equity. They do this through their own funds, called sovereign wealth funds (SWFs). The amounts these funds command is enormous- $ 2.5 trillion according to Morgan Stanley.

Is this a good thing or a bad thing? We have two contrasting views from former US Treasury Secretary Larry Summers and the Economist.

In an article in Business Standard today, Summers argues that the issues are not only transparency, reciprocity (industrial countries must have the same freedom to invest in developing countries) and investment in strategic sectors or sectors that impinge on national security.

Summers says that there is fundamental difference between private investment funds and SWFs. The former focus only on profit maximization. The latter might have other objectives: getting technology for domestic firms from firms in which they had made investment or managing their investment in such as way as to help national champions. It would be a different matter if foreign governments routed their investments through mutual funds, not their own SWFs. So, policy on SWFs must emerge after a careful review of how governments have behaved as investors.

The Economist takes a more benign view. No problem if the Qatar government acquires Sainsbury's, Britian's oldest supermarket or Russia's Gazprom controls energy utilities in Europe. As long as competition and regulation are ensured, there's no cause for worry.

The only problem, according to the Economist, is lack of tranparency. Because SWFs control huge amounts of funds, their actions can be potentially destabilising.

There is one other issue I would flag. Government-owned funds may not add value by of improving management or governance they way private equity or mutual funds do. The funds they acquire are the government's monopoly, it is not that SWFs have to garner funds from the public. So SWFs may contribute less to improved governance and performance than private funds. The pressure to deliver returns in less intense.

Growth rate to touch 10%

ET reports today that the revised growth rate for 2006-07 may be 10%. A key factor underlying the higher growth rate would be a rise in growth rate in agriculture to 4%.

The numbers had been pinching myself in disbelief. A growth rate of 4% in agriculture was seen until recently as something of a mirage. A 10% overall growth rate would put a quite different complexion on the various fiscal deficit targets. It would explain why the FM is confident of reducing the revenue deficit to zero by 2008-09.

Does a high growth rate for 2006-07 mean a lower growth rate for the current year? Not really. The forecasts of 8.5-9% have been arrived at independently of the base for last year.

Stay on OBC quota

I was under the impression that the stay on OBC quotas issued by the two judge bench of the SC before the summer recess was final and that it was only the validity of the Constitutional amendment that had been referred to a larger bench headed by the Chief Justice.

It turns out that the larger bench that will be hearing the challenge to the Constitutional amendment next month will also hear the fresh plea for vacation of the stay on July 31. The ministry for HRD has filed the application on the ground that the stay will impose hardship on hundreds of OBC students who had applied and qualified for the quota for the present academic year. The IIMs are more than a month into their session. How would they respond if the stay were vacated? We could be in for a fresh round of acrimony.

Are India's public sector banks ready for 2009?

The RBI is set to liberalise norms for foreign bank entry into India in 2009. To what extent it will do so will depend partly on how far it judges Indian banks to be ready for foreign competition. Are they?

I doubt very much. The problem is not, as many people believe, the size of Indian banks relative to their international peers. And the solution is not consolidation among public sector banks (PSBs). Nobody knows precisely what is the right size today for Indian banks, so to urge consolidation on grounds of scale economies is so much loose talk.

The main problem is the sheer lack of the necessary skills among PSBs. These banks have an ageing workforce. There has been virtually no recruitment, much less recruitment of officers, for years. Some recruitment is taking place now but it is just not enough for 2009. In other words, HRD is the no. 1 issue and should be the no.1 priority at PSBs, as I argue in my ET column, PSBs must get cracking on HRD.

Both the finance ministry and the top management of banks are responsible for the sorry state of affairs. The ministry because it simply does not recognise that you need continuity in management at the top. Top executives, including chairmen, are routinely moved from one bank to another in one or two years' time. The Board has no role in the matter and is in no position to hold people accountable.

The composition of the board itself leaves much to be desired. It includes politicians, which is not a problem in itself, except that the political appointees are not always the smarter lot amongst politicians. At Punjab and Sind Bank, we had the bizarre spectacle of the Chairman going public with his complaint about the behaviour of the political appointees- they were not letting him get on with his job. The sitting fee for directors is a paltry Rs 5000- is this because they are expected to make money in other ways? A top bank like SBI should have a galaxy of people of national and international repute. But who will want to join unless they are decently compensated?

Bank management has shown complete indifference to the HRD challenge. There are instances where unions have pushed for new recruits but chairmen are not willing to oblige. More people means more costs, possible more problems with insiders. So chairmen are happy to milk the existing bank for what is worth. This has produced results. The same workforce or a downsized one has produced more and more revenues and profits. Bank chairmen can thus claim to have produced results- and now they can even collect their performance- linked incentives. As for the future, who cares?

I am among those who argued over a decade ago that PSBs were capable of turning around if given clear commerical objectives and subjected to stock market discipline. I have been proved right. But I could not have imagined that PSBs would simply rest on their laurels.

When the RBI came out with its plan a few years ago for a gradual opening up to foreign banks, it was on the presumption that PSBs would have got their acts together by 2009. They have failed to do so.

As if this is not bad enough, the government is not willing to let PSBs raised badly needed capital as this would require government ownership to fall below 51%- and this is something the Left will not allow.

So what are the prospects? Well, the possibilities are as follows:

1. The government and the RBI realise that further opening up would undermine PSBs and continues to go slow after 2009.

2. The government and the banks, by some miracle, manage to get PSBs in better shape by 2009.

3. The PSBs are not ready and foreign banks start marching in. This would cause their value to be eroded and the government, as owner, would be the loser.

If (1) and (2) are not feasible, then it is best that the government readies some of the PSBs for sale and maximises the value it realises on its shareholding. That is at least better than (3)

Chinese bank stake in Barclays

Foreign banks have been busy positioning themselves for an opening up of the retail market by buying stakes in Chinese banks, often at huge prices. Now, comes the news that a Chinese bank will, for a change, be buying a stake in a foreign bank.

Barclays Bank of the UK has got two foreign banks, China Development Bank and Temasek of Singapore, to buy its equity so that it gets cash to up its offer in the continued battle for Dutch bank ABN Amro. The immediate objective is to strengthen its bid but one long-term payoff could be access to the Chinese banking market. Caveat: as FT notes, CDB has corporate clients but no retail base. Still, there is something to be said for getting a toehold in the Chinese banking market by having the other guy pay for it! The Chinese banking market, incidentally, is far more restricted than India's with foreign banks still being limited in being able to do local currency lending.

From China's perspective, this is another bold move on the international stage, as Tony Jackson notes in the FT. It brings China a 3.1% stake in Barclays and, if the acquisition goes through, a stake in a Dutch Bank. By agreement, CDB's stake in Barclays cannot rise beyond 10% over the next three years. But after that what happens is anybody's guess.

Following China's purchase of 9.9% stake in the premier US private equity firm Blackstone, China is clearly on the prowl in the international arena. It has huge foreign exchange reserves to play with. How foreign governments react to growing Chinese equity holdings in their companies, especially in sectors such as banking, is hard to tell.

Plain speaking on Doha Round

India has come in for scathing criticism at the hands of the US and also the western media for supposedly wrecking the Doha Round of trade negotiations. The best riposte to this I have seen is a letter to the editor in the Economist (July 12, 2007):

The breakdown at Potsdam was America's fault, not India's. Ms Schwab offered to lower the ceiling on America's distorting agricultural subsidies to $17 billion. As America currently spends only about $11 billion, a ceiling of $17 billion would actually allow it to raise its subsidy level in the future.

In Ms Schwab's world, however, what is sauce for the goose is not sauce for the gander. Regarding manufacturing, she insisted that India (and Brazil) not merely lower their subsidy ceilings, but that they do so to such an extent as to bring the actual tariffs down below current levels. Aside from the double standard of the American position, India has already undertaken significant unilateral liberalisation—it cut its top industrial tariff to 10% in 2007 from 38.5% in 2001—for which it has received little credit.

The significant additional access demanded by Ms Schwab would require India to cut its ceiling by nearly 80%. But then, under the July 2004 Doha framework, such a large cut would have to be matched by near-zero tariffs in the developed countries. Ms Schwab was unwilling to make that concession...... During the Doha round it (India) is doing what America and Europe have done for virtually the entire post-war period: engage in tough bargaining to obtain maximum concessions for its offers.

And the letter writers? Our own Jagdish Bhagwati and Arvind Panagriya, both professors at Columbia University.

Indian economy: news gets better and better

I read the latest news and projections on the Indian economy with some amazement:

• The PM's Economic Advisory Council (EAC) projects GDP growth for 2007-08 of 9%, the upper band of most projections. The finance minister says that in 2008-09, growth could touch 10%.
• The index of industrial production grew by 11.1% in May 2007 YoY. True one or two sectors such as food have seen very high growth rates and this has boosted the overall index but, even if we adjust for this and any future deceleration, we should be seeing industrial growth of around 10% at least in 2007-08. The EAC projects industrial growth of 10.6%.
  
• The EAC, however, thinks it will be difficult to meet the target of reducing revenue deficit to zero by 2008-09. Can be done says FM.
• Two of the tallest figures in Indian finance, Deepak Parekh and K V Kamath, think interest rates have peaked and are due to soften.
• The current account deficit for 2006-07 has ended up at 1.1%, way below the earlier alarmistic forecast of 3%. A rising trade deficit has been offset by larger flows of "invisibles" ( comprising software exports, remittance and one truly 'invisible item' that is nearly $23 bn and for which the RBI has no explanation).
  
• Capital inflows continue to be large with FDI for the first time becoming larger than portfolio flows. The rise in forex reserves is set to continue.
• On top of it all, the Sensex has shot past the 15,000 mark and risen further, putting analysts (who thought it was overvalued and due for a correction) to shame.
  

All this is happening against the background of a four year average growth rate of 8.5%, over two years of monetary tightening and with oil prices poised to cross $80 per barrel.

So, what is driving Indian economic growth today? As the EAC points out, investment has emerged as the key driver outstripping consumption. In 2006-07, investment contributed 4.75 percentage points towards growth compared to 4.62 percentage points contributed by consumption out of a total growth of 9.35%. Despite this increase in investment (which tends ot be inflationary in the short run), the EAC thinks the inflation rate can decline to 4%.

What could wrong? Not much. In the short-run, a big monsoon failure could derail growth prospects. Over the medium term, the EAC sees the farm sector and power sectors as something of a drag. I believe this is unlikely. Farm sector growth will remain low but this has been the case for a while now. As for power, if the economy could grow in the face of low addition to capacity for over a decade, I would reckon the prospects are better now since we are big additions to capacity now.

Shock but not awe at IIM

Today's TOI carries a story about how the ad for the post of director at three IIMs has come as a "shocker" for IIMA faculty.

And, pray, why is it a "shocker"? Because some in the IIM fraternity understood the ad to mean that the process followed hitherto - of setting up a search committee which went through a list of candidates nominated by IIM/IIT directors and some others- was being bypassed. They thought that IIM faculty would no longer be 'consulted' in the matter of appointment of director.

As a clarification provided by the ministry and carried in ET makes evident, these fears are unfounded. The search committee is still there, the board of governors is still represented, it will also be free to go beyond applications received in response to the ad and reach out to eminent academics.

So what are we left with? Well, a clear improvement over the existing process! Earlier, if you considered yourself suitable you would have to beseech some IIT/IIM director to nominate you. Those outside the charmed circle had no chance of staking a claim. Now, the field is open to anybody and, of course, the nominations process is still on and the search committee is free to seek inputs from IIM faculty. It does appear that some IIM faculty have muddied the waters through their knee-jerk reaction.

I would say that the ministry should go further and advertise in international journals such as the Economist . Foreign schools frequently advertise the post of Dean. A recent issue of the Economist carried an ad for faculty positions at the Indian School of Business and another for that of Director for an unnamed private business school in India. I would only ask that the ad be couched in more upbeat terms- it should mention the perks that go with the job, possible consulting income and the opportunity to make a big difference in India.

Incidentally, I have often wondered about the presumption amongst IIM faculty as to their right to be consulted about the choice of director. Agreed, faculty are important stakeholders but does consultation mean that the director should be somebody with a high or the highest acceptability to faculty? When a company appoints at CEO, does the board go round asking the GMs and VPs whom they would like best for the job?

The choice of director cannot be reduced to a popularity contest amongst faculty. Perhaps a minimum of acceptability is necessary but the director need not be somebody who gets the highest number of "votes" from faculty. Such a requirement can only promote demeaning behaviour among the contenders for the job at an IIM- and it does. You have people soliciting votes from colleagues, the very colleagues they are expected to supervise if they land the job. That apart, where an institution needs radical change and an individual stands for such change, lack of acceptability could be a virtue.

If at all faculty are to be consulted, the consultation can only be about ascertaining the requirements of leadership at a given point in time and the attributes that would go towards meeting the requirements. In other words, the Search Committee may interact with faculty with the idea of drawing up a profile of the director-to-be, not to find out which particular individual from amongst the insiders finds favour with the faculty. This important distinction, alas, has not always been borne in mind by either the Search Committee or the faculty.

Once the Search Committee has drawn up a profile of the "right" candidate for the post, the policy should be one of letting the best person win. It could be a person nominated by somebody or it could be somebody who has responded to the ad or it could be somebody whom the search committee on its own thinks fit to consider. There should not be any presumption in favour of either an insider or outsider.

Wanted: directors for IIMs

Today's ET carries an inconspicuous ad on the last page of a four page ad pullout. It is a small ad and jostles for attention with assorted trade items. The total compensation is stated to be Rs 50,000. The advertisement is for the directorships at three IIMs: Ahmedabad, Kolkata and Bangalore. Applicants have been asked to send their letters to a designated official in the ministry of HRD.

This is the first time ( in many years at least) that the post is being advertised openly. To the extent that this makes for a transparent, competitive search, it is welcome. The earlier procedure was to constitute a selection committee that wrote to heads of various IITs and IIMs to make nominations. For the most part, the search was confined to the IIM fraternity and at least IIMA has had a tradition of having insiders as directors. Advertising the job makes it possible for anybody to apply.

But surely the post merited a more prominent ad? And if compensation was to have been mentioned at all, surely the full range of benefits should have stated? A more positive way of marketing the position would have been to state that, including income from consultancy, the total package would not compare unfavourably with industry benchmarks. I don't know what message the ad will send out and whether the intention was to downplay the job.

OBC quota in the news again

With the Supreme Court having convened after its summer recess, OBC quotas are in the news again. The legal battle over the constitutional amendment extending quotas in educational institutions to OBCs has been resumed with the government again moving the SC for a vacation of the stay on quotas.

The stay had been granted by a bench before the summer break. Now the plea for a vacation of the stay is being heard by a bench headed by the Supreme Court Chief Justice KG Balakrishnan. The court has posted the case for hearing on July 31, according to a TOI report. The government is arguing that hundres of OBC students who would have made it through the quota route are being left high and dry.

What happens if the SC lifts the stay now? I don't know about other colleges but the IIMs' new session will have been more than a month old. Is it feasible all to admit them in the current academic year? I have my doubts.

The larger issue of referring the challenge to OBC quotas to a constitutional bench will be taken up by the SC next week, the report says. Somehow, I was under the impression that the matter had already been referred to a constitutional bench by the two judge bench that heard the petition earlier.

Stiglitz on East Asian crisis tenth anniversary

Stiglitz notes that most East Asian economies have built up a formidable war chest of foreign exchange reserves, so are better equipped today to deal with any big outflows of capital. But he believes two lessson of the crisis have still not be absorbed.

Indeed, the two most important lessons of the crisis have not been absorbed. The first is that capital market liberalisation — opening up developing countries’ financial markets to surges in short-term “hot” money — is dangerous. It was not an accident that the only two major developing countries to be spared a crisis were India and China. Both had resisted capital market liberalisation. Yet today, both are under pressure to liberalise.


The second lesson is that in a highly integrated world, there is a need for a credible international financial institution to design the rules of the road in ways that enhance global stability and promote economic growth in developing countries. With the IMF so dominated by the US (it is the only country with a veto) and Europe (which, by custom, appoints its head), the Fund was long seen as representing the interests of international creditors. Its failures in the 1997 crisis further undermined its credibility, and its failure to do anything about the massive global financial imbalances that represent the main threat to global financial stability today, have underscored its limitations.

Potter-mania

The seventh and forthcoming Harry Potter book has had already seen 2 million orders placed for it. Its 42 year old author J K Rowling is said to be the world's first author billionaire, her books having sold 325 million copies and turned into films.

The item that took my breath away was the one about the elaborate 'security cover' for the forthcoming book to prevent any details leaking out in advance. The bill for the security? 10 million pounds. Talk of Z-plus security!

Banking sector reforms in India

I had a chance to lay out my current views on banking sector reform in the Economic and Political Weekly.

Many people think that banking sector reforms have been too slow or too conservative because public sector banks are still around and dominate the banking system. I question this. I see an improving trend in competition and efficiency in the system. I believe that public ownership has provided the system with a measure of stability within which efficiencies could be pursued. I also think that financial deepening has happened in recent years in a way in which people did not think possible a few years ago.

I am aware that public sector banks need to improve a great deal now in some areas, especially HRD. But the improvement they have shown over the past decade or so is real and substantial and it is very much part of the India Shining story. They remain relevant in the coming years because increasing credit availability to the rural sector is going to be an area of concern for some time.

Raghuram Rajan on selecting a leader for the IMF

Appointing the World Bank president is the prerogative of the US; in return for this favour, the US allows the EU to select the MD of the IMF. Many such as Joseph Stiglitz have been critical of the manner in which the top jobs at the two multilaterals are filled. They would like selections to be made on merit.

In an article in FT, Raghuram Rajan, who quit recently as IMF Chief Economist to return to Chicago GSB, says that if the IMF is to be effective, it needs legitimacy. It can have legitimacy only if large developing countries have a voice. Yet, the odds are that current discussion on IMF reform will yield anything more than token increases in quotas (that determine voting power) for developing countries.

Rajan thinks this will cast a shadow on the IMF's functioning in two areas: removal of barriers to cross-border investment and the determination of the "right" exchange rates (a task that the IMF has recently assigned to itself). The latter especially has the potential to stir a hornet's nest.

An impartial referee will be even more necessary in the task the IMF has now taken on: evaluating equilibrium exchange rates and deviations thereof. There will be a temptation for the Fund to follow the US lead and accept that the only truly undervalued exchange rates are those where the government intervenes explicitly in exchange markets, not those where the exchange rate is “market determined”.

But this interpretation biases the rules against non-industrial countries, where the government substitutes more for the market. In a country with a closed capital account, there is no way for households to buy foreign financial securities directly. The build-up of central bank foreign exchange reserves, in part, may be a substitute for this missing market. In practice, therefore, there will be enormous scope for judgment in assessing the level of exchange rates and the validity of government intervention.

To resolve matters such as these, getting the right leader is important. Rajan wonders why India and China are silent on this subject. He goes on to provide the answer:

I would conjecture that they have little faith that the system can be changed or produce outcomes they can buy into. Why give the process more legitimacy by making noises about the selection of the managing director, noises that will only lead the EU to “consult” widely about the choice they have already made? Far better to keep quiet now, and allow the EU to dig a deeper grave for the multilateral financial system.

Foreign ownership in India's financial sector

Nobody could have missed the flurry of action on the part of foreign firms in India's financial sector. Foreign banks and investment banks are strengthening their presence. The top three investment banks- Merrill, Goldman and Morgan Stanley- now have a strong presence, either going it alone or with majority control. Lehman Brothers has set up shop recently. Bear Stearns is said to be exploring possibilities.

Foreign banks have gained exposures either in NBFCs or brokerage firms or both. They are clearly positioning themselves for 2009 when the RBI is due to review the restrictions on foreign bank expansion in India.

I dissect this phenomenon in my column in ET today and spell out its implications for domestic players (The shape of things to come).The worrying thing for Indian firms is that business related to cross-border activity is booming. Over time, this could end up getting large enough so that foreign firms can focus on this piece of the action without having to worry about the domestic market. In the next phase, they can attack the juicier segments of the domestic market.

I don't believe this will wipe out Indian firms. But my guess is that Indian firms in brokerage and investment banking will be marginalised and will end up being niche players in the domestic market. What happens in banking depends on how regulation unfolds. Here again, Indian banks will cede market share. But because the domestic market is under-penetrated, there will still be growth possibilities. The biggest concern at public sector banks is human resources. They are stuck with an ageing profile and have not cared to replenish their resources. Unless they can show drastic improvement in this area, the prospects are beginning to look bleak for them.

Q &A on East Asian economies

There's been a lot of coverage to mark the decade of the East Asian crisis. Commentators have regurgitated material about the "lessons of the crisis". Some of it obscures crucial questions. I address these.

1. Did the economies shrug off the crisis quickly?

Not really. The Economist (June 28) notes, "Income per head returned to pre-crisis levels in South Korea and Malaysia by 2000; in Thailand and Indonesia it took until 2003 and 2004 respectively." In other words, it took five to seven years for the economies to get back to square one.

2. Have the economies got back on a fast growth track?

No, growth since 2000 has averaged 5%, 2.5 percentage points below the rate in 1990-96.

3. Has governance improved in thse economies?

No. I quote the Economist again:

The ADB uses data compiled by the World Bank to rate Indonesia, Malaysia, the Philippines, South Korea and Thailand relative to the rest of the world on six measures of governance: accountability, political stability, government effectiveness, regulatory quality, the rule of law and control of corruption. Comparing 2005 with 1996, the scores for East Asia have got worse in 22 of the 30 comparisons (ie, six measures for five countries). If international rankings are compared, these countries have fallen in 28 of the 30 comparisons. Only in South Korea did governance scores improve on more than half of the measures.

4. Are these economies sold on reforms?

Well, we are seeing some signs of backsliding. Thailand imposed limits on equity investment briefly last year and has recently imposed curbs on foreign ownership, Taiwan slapped limits on mutual fund investment abroad, South Korea is thinking of ending restrictions on chaebols' investment in banks .... good times do tend render policy lax.

5. Are the economies headed for another crisis?

Not likely. They have abandoned fixed exchange rates, they have huge reserves, money supply growth is under control and their is no sign of an asset bubble. Like India and China, they do face problems of managing capital inflows but have not made big errors in this department.

The basic lesson of the crisis, I think, remains valid for these economies and for India: completely unregulated capital flows can pose serious problems given that regulatory capacity in
these economies is still underdeveloped.

Private equity versus hedge funds

Private equity and hedge funds are the two hottest investment vehicles. When the management company goes public, which of these is more attractive? FT's Lex column believes that private equity has the edge mainly because of their longer time horizons.

First, assets (in private equity) are tied up long-term. Kohlberg Kravis Roberts, which plans an initial public offering, says 73 per cent of its assets are committed for as much as 18 years. While KKR is highly unlikely to hold any investment for that long, it does give huge flexibility to ride out tough times. And it provides a steady stream of cash from the 2 per cent management fee – alongside the bigger and more volatile 20 per cent share of investment gains. Private equity funds also juice fees with a charge for each deal they do and sometimes a cut for syndicating equity to third-party investors. That can take underlying management fees closer to 3 per cent.

By contrast, hedge fund investors can pull their money quickly if performance is bad, making the underlying fee stream less secure. In addition, poor investment returns can quickly inflict a double whammy on a hedge fund manager’s earnings – of weak performance fees and falling AUM as investors withdraw money.

Second, private equity firms feel more solid. They have established brands such as Blackstone and KKR, they buy full control of businesses people know, and buy-outs have largely avoided financial trouble in recent years. Hedge funds, for some, conjure up images of whizz-kids rolling the dice on behalf of clients, leading to high-profile blow-ups such as Amaranth and recently some mortgage funds at Bear Stearns.

Finally, private equity firms have a “cookie jar” of unrealised gains on their illiquid investments that should emerge as cash flow when the businesses are sold. (At least, that is the case in today’s strong market.)

Nuclear deal in rough waters

The deal was supposed to have been done in 2006. Now they are talking of end 2007 or early next year and some in the government are not willing to set a date. With each day, the Indo-US nuclear deal seems to be getting into rough water.

Asian Age reported yesterday that Justice V R Krishna Iyer and former AEC chief P K Iyengar have written a letter to MPs raising questions about the deal in its present format. It also said government had tried and failed to selectively bring on board some of the top retired nuclear scientists who had expressed their concerns.

It was former diplomat M K Bhadrakumar's commentary in Rediff that gave me a jolt. Bhadrakumar focuses on the recent "lobster summit" between Bush and Putin in Maine where, other differences notwithstanding, the two powers seem to have drawn up a blueprint for regulating civilian nuclear programmes. He suggests that time may be running out for the Indo-US nuclear deal and that it may soon be overataken by the US- Russian architecture for the use of civilian nuclear energy.

<>

<>In essence, Washington and Moscow have entered into an unprecedented format of cooperation whereby they will supply nuclear power reactors; will ensure 'reliable access to nuclear fuel and fuel services for the lifetime of reactors'; and even arrange the necessary funding packages for any country that may view nuclear power as a means of economic development.

Of course, the spent fuel will have to be sent back to certain designated 'international nuclear fuel cycle centres', which will be the sole authority for the management of all spent fuel and for providing 'nuclear fuel cycle services', under strict IAEA safeguards.

According to Ambassador Robert Joseph, US special envoy for nuclear non-proliferation, this format of US-Russia cooperation targets the anticipated business in nuclear energy production 'not just in countries like India and China but a wide range potentially of other countries'

.... Where does all this leave India?

Clearly, India finds itself in an awkward spot. The ground has again shifted beneath its feet in the negotiations over the nuclear deal with the US.

It is unclear if the United Progressive Alliance government has been taken by surprise. The spin-doctors in Delhi must be scurrying for cover. It is pretty much impossible anymore to obfuscate the plain truth that as far as Washington is concerned, the Indo-US nuclear deal is about nuclear non-proliferation.

Whatever ground the UPA government's negotiators held until last week in seeking the rights to reprocess spent fuel and in gaining access to the reprocessing technology, has completely eroded.

Rule- versus principle-based regulation

One of the strongest criticisms against the RBI is that it still adheres to rule-based regulation. There is a plethora of rules that players in the system are expected to follow. This inhibits risk-taking and innovation. Indeed, this was one the points made in the recent report on the creation an international financial centre in Mumbai (on which I had commented earlier).

Advocates of principle-based regulation point to the success that the FSA has had in UK.- it will intervene only if a situation warrants such intervention, say, if certain undesirable outcomes have resulted. In the FT, Peter Wallison argues that it just won't work in the US for a number of reasons. Some of those reasons apply to India as well. A key issue is that principles- based regulation confers huge discretionary powers on the regulator- you can't tell what will provoke intervention. The potential for misuse in a context such as India's is enormous.

In a principles-based system, how a principle will be applied remains at the discretion of the regulator. Thus, ironically, given any regulation at all, a rules-based system offers more freedom for those who are regulated.

But apart from this, principles-based regulation reduces the rules transparency essential for a competitive market. A rules-based regime tells everyone what is required to enter a field and compete. A principles-based regime is open to interpretation by a regulator and could be used to deny entry to would-be competitors. A recent example is Wal-Mart’s effort to acquire a bank-like entity known as an industrial loan company. The US banking industry strongly opposed this and – even though there was no legal authority to do so – the FDIC, under industry and congressional pressure, imposed a one-year moratorium on applications by retailers such as Wal-Mart to give Congress time to enact restrictive legislation.

If this is what occurs when there is no authority at all to restrict entry, imagine what would happen in a principles-based environment where a regulator has the discretionary authority to interpret its regulations so as to prevent new competitive entry.

These considerations apart, Wallison contends that in a litigious country such as the US, the absence of clear rules leaves the door open for unlimited private class actions. Americans file suits even when there are clear rules. Where the rules are broad, imagine the good times for lawyers!

Governance issues in US judiciary

You think the Indian judiciary faces corruption and other governance problems? Well, if it does, it is in good company. The Economist has a story on the problems in the US judiciary that had me squirming.

A whole series of judicial misdemeanours, ranging from the titillating to the outrageous, has emerged over the past year. Take the Florida state judge, John Sloop, who was ousted after complaints about his “rude and abusive” behaviour. This included an order to strip-search and jail 11 defendants for arriving late in traffic court after being misdirected. Or the Californian judge, José Velasquez, sacked in April for a plethora of misconduct, including extending the sentences of defendants who dared question his rulings.

Then there was the Albany city judge, William Carter, in New York, censored for his “utterly inexcusable” conduct after jumping down from the bench during a trial, shedding his robes and apparently challenging a defendant to a fist-fight. Another time, he suggested that the police “thump the shit out” of an allegedly disrespectful defendant. Mr Carter wasn't carrying a gun; many judges now do. In Florida, Charles Greene, chief criminal judge in Broward County, had to step down after describing a trial for attempted murder involving minority defendants and witnesses as “NHI” (No Humans Involved). Then there are the sexual peccadilloes. In Colorado, a (male) judge resigned after admitting having sex with a (female) prosecutor in his chambers. In California, a former judge was jailed for 27 months for downloading child pornography. And in Oklahoma Donald Thompson, a judge for more than 20 years, was jailed for four years for indecent exposure and using a “penis pump” to masturbate during trials.

More serious are the cases of corruption. On June 5th Gerald Garson, a former judge in Brooklyn, New York, was jailed for taking bribes to rig divorce cases. Another judge was convicted of accepting money to refer clients to a particular lawyer. Rumours of buying and selling of judgeships in the district abound. At one time, one in ten Brooklyn judges were said to be under investigation for sleaze.

You think judges in India are underpaid? Well, low salaries are a problem in the US as well although US judges aren't exactly below the poverty line.

The meagre salaries of judges, whether at state or federal level, do not help raise standards either. Federal judges have not had a real pay rise for 17 years; a district court judge earns $165,000 a year, about the same as a first-year associate in a top law firm. John Roberts, chief justice of the Supreme Court, earns just $212,000—half the salary of England's top judge and one-fifth of the average income of a partner in the majority of America's 100 top-grossing law firms. Around 40 judges have left the federal bench over the past five years.

Independent directors at Infosys and TCS

Being an independent director on Infosys or TCS can be a rewarding experience- in more senses than one. In 2006-07, independent directors at Infosys were paid commission the range of Rs 2- 2.2 mn.

TCS was more generous in terms of cash payments although more discriminating. It paid independent directors total fee of Rs 0.9 -5.7 mn, "depending on their attendance and contribution at board and certain committee meetings as well as the time spent on operational matters other than at meetings".

Infosys is stepping up fees in the coming year- base pay to directors will be Rs 3.2 mn. Also, many independent directors hold shares in Infosys, the result of exercise of stock options. If these are taken into account, the Infosys package may be more attractive.

How large is the bottom of the pyramid?

The fortune at the bottom of the pyramid is management guru C K Prahalad's pet theme. He has argued that people there may lack water, health and housing but they can still constitute a market for a range of products- cellphones, for instance. Prahalad puts the size of the market at $13 trillion in PPP terms, large enough to make the world's MNCs salivate.

Prahalad's colleague, Aneel Karnani, has long been sceptical of this claim. He has argued that the size of the BOP is smaller. In a recent article in Business Standard, Karnani reiterates his point using recent data from a report, The next 4 billion, released by the IFC. The report, Karnani says, puts the size of the market at $ 5 trillion. Karnani thinks this too is an over-estimate, although much lower than Prahalad's.

The IFC report arrives at its estimate using $3000 as the cut-off for the poverty line. Karnani says this is too high. Using a cut-off of $1000 in PPP terms and IFC data, Karnani arrives at a market size of $1.42 trillion in PPP terms. The fortune at the BOP, he says, is a 'fantasy'.

Karnani's more interesting point, made in a paper, is that the whole idea of treating poor people as customers whom large companies can profitably cater to is ridiculous. The way to attack poverty is to treat poor people as producers and to augment their income, not to treat them as customers.

Karnani's point is a compelling one. The danger in seeing poor people as customers for various consumer items, he says, is that the deprivations that they suffer in other ways- in terms of healthcare and housing- can be easily forgotten. So can the government's role in addressing these deprivations. When poverty alleviation is reduced to the production of goods for the BOP market by large companies, it can harm the cause of removing poverty.

A more prosperous world

It has been 20 years since Alan Greenspan became chairman of America’s Federal Reserve Bank. The years since then have seen the fastest global average income growth rate of any generation, as well as remarkably few outbreaks of mass unemployment-causing deflation or wealth-destroying inflation.

Thus, Bradford deLong in an article in ET today. Very true. He might have added that, in recent years, the world economy has seen the highest growth rates in several decades in the face of high oil prices.

As deLong notes, it is not as if the world economy has not faced shocks in the past two decades. There was the US stock market plunge in 1987, Saddam Hussein's invasion of Kuwait in 1991, the east Asian crisis, the dotcom collapse in 2000 and, of course, 9/11. How come the world economy remains resilient?

deLong cites three reasons commonly put forward: luck, greater skill shown by central bankers and less short-termism in the financial markets. He rejects the first and third explanations. Only the second, he contends, is valid.

Indeed, what deLong says is largely true. Central bankers have learnt to be far more focused- they have been single-minded in fighting inflation. Moreover, there is greater coordination among various central banks in times of crisis. Central bankers have understood the importance of maintaining liquidity in the markets, the lack of which is said to be one of the reasons for the Great Crash of 1929 and the Depression that followed. Much of this, of course, represents a triumph for Milton Friedman and his followers.

I would cite a few other factors that have contributed to resilience in the world economy. One, the shift to services in the developed world and diminished oil intensity of output. This has given the world economy a measure of insularity from oil shocks. Two, greater globalisation- of trade as well as capital flows- and its efficiency-inducing effects. In particular, by dispersing manufacturing activity, globalisation provides a buffer against terrorist or other disruptions. Three, the absence of large, extended wars and the uncertainties these create. The US invasion of Iraq, for instance, had a surgical precision that was missing in Vietnam.

Managing capital inflows- Is China doing better?

As I've noted earlier, managing capital inflows is presenting headaches for policy makers. If you let the money roll in, the rupee appreciates. This poses a threat to export growth. Moreover, if you don't intervene to check rupee appreciation, that draws in tons of speculative capital- people bring in money knowing that, when the rupee appreciates, that can take back more in foreign currency. More inflows mean even more appreciation..... where does it all stop?

So the RBI intervenes to check rupee appreciation. It buys up foreign currency. This causes money supply to expand, which can be inflationary. Hence, the RBI resorts to 'sterilisation'- it sells government bonds to absorb some of the money it has pumped in. When the supply of bonds increases, its price falls, which means the interest rate rises. The rise in interest rates, in turn, can dampen growth over time. So, you are damned if you intervene in the forex market, you are damned if you don't.

Since comparisons between India and China are all the rage, we have people who say: look China seems to have done a better job of managing capital flows, their inflation rate is low and their currency pretty stable. Today's BS has an article by two IMF officials that refutes this view. China, they say, is not having a high rate of inflation because of excessive investment in the past. In India, demand has run ahead of investment. But that is not to say that China is free from problems.

Encouraging investment growth are a plethora of tax incentives; low costs of land, energy, water and—most important—capital; and the undervalued exchange rate. The low cost of capital, averaging around 2 per cent in real terms in the last five years, has skewed production toward capital-intensive techniques, and has dried up job creation; the 10 per cent growth in the past few years has created only 2 per cent employment growth.

The undervalued exchange rate has also encouraged import substitution. The
caricature of China as an assembly line, processing imported inputs into cheap consumer goods, is fading into the recesses of history. Assembly-line exports make up less than 10 per cent of China’s trade surplus. Instead, China’s exports are predominantly capital-intensive goods with rising domestic content. As a result, the economy has become more dependent on exports and more vulnerable to fluctuations in external demand.

These imbalances raise concerns that China’s rapid growth may not be sustainable. Continued expansion of capacity could eventually lead to price declines that would cut into profits, increase loan defaults and undermine investor confidence. The price declines could be worse if, at the same time, the global economy slows and protection by and/or competition from other countries makes it more difficult for China’s firms to sell their products abroad.

In other words, while India is making adjustments to high capital inflows here and now, China seems to be storing up problems for the future- some will say, this is true of China in other ways as well.

TCS lends a helping hand to SMEs

The reinvention of Indian manufacturing has been a big part of the India growth story. It is the big corporates that are mostly in the news. But opportunities are opening up in a big way for SMEs as well, FT reports. That is because US businesses, wary of how China will shape up, would like to diversify their supplier basket and are keen to use Indian suppliers- provided they can deliver on quality and reliability of supplies.

TCS is involved in a project that will help SMEs do just that. Mind you, this is is the consulting arm of TCS and does not appear to involve software in a big way.

TCS’s project in Coimbatore – a sprawling city 300km south-west of Bangalore – could become the forerunner of a service the consultancy would offer across India. Its plan is to link small Indian businesses with the companies’ international clients in fields such as automotive and aerospace manufacturing, particularly in the US and western Europe.

TCS has identified just over 100 companies in Coimbatore – including Geekay – which it thinks could play a role in making parts and complete engineering products on behalf of its clients. It is also working in a similar way with about 90 companies in two other Indian cities, Pune and Bangalore. These 190 businesses could become a core group of potential suppliers for western companies, and which could be added to later as the service expands, so TCS believes.

.....TCS hopes that by the end of the year the companies it is working with might be able to win export orders worth a few million dollars, with its part in fixing up the contracts being rewarded by additional fees from its clients.Assuming the project works well, TCS could extend it to several hundred India-based suppliers for its foreign clients. The prize: a new source of income for TCS as a “supply chain manager” and the chance to boost growth at its big customers as well as India’s network of small suppliers.

Will it work? As the report makes clear, a key problem for Indian SMEs is access to finance. Indian banks are not too keen on SMEs because there have been bigger opportunities elsewhere (retail finance, for instance). But with competition hotting up, some are bound to see SMEs as an opportunity- especially if projects such as this one work out and SMEs are able to bag lucrative orders from abroad.

Outsourcing pioneer

The Economist (June 21) has a profile of outsourcing pioneer Krishnan Ganesh. Ganesh is a serial entrepreneur whose latest venture is Tutorvista, an online tutoring service based in India and catering to American children.

TutorVista further hammers home its labour-cost advantage through its pricing model. It offers unlimited tuition in a range of subjects for a subscription fee of $100 per month in America (and £50 a month in Britain, where the service launched earlier this year) rather than charging by the hour. Tutors are available around the clock; appointments can be made with only 12 hours' notice.

TutorVista has 2,200 paying subscribers at the moment (most of them in America) and hopes to boost that figure to 10,000 by the end of the year. The company is expected to become profitable in 2008. Even cheaper pricing packages are on the way. Launches of the service are planned for Australia and Canada. Mr Ganesh is also investigating the potential of offering tuition in English as a second language to students in South Korea, where high rates of broadband penetration make the market attractive. Get that right, and China looms as an even bigger prize.

Ganesh's profile is amazing. He started off in 1990 with IT&T, a computer maintenance firm and stepped down as CEO in 1998 by when revenues had touched $200 mn, worked for a telecom joint venture for two years, started a call-centre that was then sold to ICICI, then became chairman of a data analysis start-up that was later sold before he went to Tutorvista. Some guy!

Presidential leniency for "Scooter" Libby

FT reports:

President George W. Bush on Monday commuted the 30-month prison sentence handed to Lewis “Scooter” Libby, former chief of staff to vice president Dick Cheney, for lying and obstructing justice.

.... ..“I respect the jury’s verdict,” said Mr Bush, in a two-page statement explaining his decision. “But I have concluded that the prison sentence given to Mr Libby is excessive.”

...Mr Bush declined to pardon Mr Libby, leaving intact a $250,000 fine and two years probation – a move that legal experts described as highly unusual.

....Mr Libby was convicted in March of lying to authorities and obstructing the investigation into the 2003 leak of a CIA operative’s identity by a Bush administration official in the run up to the war in Iraq.

Mr Bush is not the first US president to exercise his power of clemency in a questionable way- Bill Clinton earned notoriety by doing the same in several cases just before he demitted office. Ford had similarly pardoned Nixon.

Here in India, we complain about how the judicial process simply cannot deal with the rich and the powerful. In the US, the judiciary does its bit but the executive can swiftly undo the good work of the judiciary. I don't know which is worse. I guess this ties up with my post yesterday on Indian politics not being as bad as it is made out to be.

Something rotten about Indian politics?

I read Bimal Jalan's recent book, Indian Politics: a view from the backbench recently. It is one long dirge on the Indian political system- how things have gone from bad to worse. I remain unconvinced that things are as bad as Jalan makes them out to be. I said so in my recent column.

Jalan's complaints and solutions are the familiar ones:

• Criminalisation of Indian politics: bar people with a criminal record from contesting elections
• Political corruption: introduce state funding of elections
• An unresponsive bureaucracy: free bureaucrats from excessive political control, remove constitutional protection from prosecution provided to bureaucrats
• Oversized government: prune the role of government, confine it to its core functions
• Parliamentary disruptions: penalise disruptions heavily

He also has a solution for a more recent problem, the dominant role of small parties in a coalition. He wants their veto powers over decision making removed by introducing a new law that will cover withdrawal of parties from coalitions, once formed. The law will disqualify members of the party concerned.

What do we make of Jalan's diagnosis and his solutions? First, many of the solutions bristle with practical problems. Sundry committees have proposed these solutions but there are serious problems of implementation. As for instability created by small parties, please note that the NDA coalition duly created its term and the UPA promises to do so.

Yes, there is the prospect of instability arising from the growing power of regional parties. But this is an aspect of Indian democracy and its federal structure. The growing clout of regional parties merely signifies their ability to better articulate the aspirations of particular groups. This may make for parliamentary instability but it makes for political stability in the larger sense because various groups have the sense that they able to make themselves heard. They don't feel disenfranchised. India survives as a result.

Instability may viewed as evil by large national parties but that is not what the BSP thinks. Its founder Kanshi Ram openly said that he favoured instability because that worked to the advantage of the BSP and the Dalits it represented. The greater the instability, the greater was the clout of the BSP, he argued.

On a broader note, I find it difficult to go along with the view, popular in the media, that Indian politicians are an especially venal or criminal lot. Politics is tinged with criminality in almost every major democracy- the US, the UK, France, Germany, Japan, Israel. (Israel's president has just pleaded guilty to charges of rape- I thought such crimes happened only in Bollywood films).

In many countries, politicians who make it to the top have a dubious record. (Small countries such as those in Scandinavia may be exceptions). Once they win the race, however, all is forgiven. Thereafter, politicians are judged only by their accomplishments. If they perform, the very people who denounced them earlier (academic s included) will happily line up to applaud them. The means they used to obtain power are forgotten. See how the press lauded Mayawati's triumph in the UP elections- when the celebrations were on, there was little mention of the Taj corridor case or the case of disproportionate assets pending against her.

To modify Shakespeare, the good that politicians do lives after them, the evil is oft interred with their bones. Politicians know this and will stick at nothing in the ruthless pursuit of power- this is the immutable law of politics everywhere. India is no special case. If anything, in the fair conduct of its elections as well as the willingness of large numbers of people to exercise their vote, Indian democracy retains a certain vibrancy.