Curbing ECBs- some new proposals

The hottest topic in policy debate today is curbing capital flows into India. Amazing. Barely five years ago, people were talking about the things we should do to attract capital! One item in capital flows that has ballooned is external commercial borrowings (ECBs), foreign loans obtained by Indian companies. This is worrisome because, given the interest differential between India and the industrial economies, it makes sense for Indian companies to raise loans abroad. The appreciation of the Indian rupee makes this even more attractive.

ECBs can become unmanageable if not curbed. The government announced several measures last August, such as limiting the use of such loans in India to $20 mn, the rest of the borrowing having to be spent abroad. The government also has in place a ceiling on the spread over LIBOR that Indian companies can borrow at- this means companies that do not have high ratings will be automatically restricted from raising ECBs.

There is a sense that these measures are not enough and some new proposals have been mooted: auction of ECB loans among corporates and a sterilisation tax that will be borne by companies.The latter is meant to compensate the government for the cost it incurs on sterilising foreign inflows- the government sells securities at Indian interest rates when it sterilises inflows; the foreign exchange that it buys fetches it foreign interest rates. The difference in rates is the cost to the exchequer.

I contributed to a debate in ET on the subject. I don't believe these measures will be effective enough. The government should have a better capacity to sterilise. For this, it needs to have a bigger war chest of market stabilisation bonds and it also needs to bring down domestic rates. It must also act to make returns to investment in India less attractive through, for instance, introducing long-tax capital gains tax on equities.

ICICI Bank cops it again

ICICI Bank has been slapped with a cost of Rs 5.5 mn in a consumer dispute. The Delhi Consumer Commission levied the penalty in a case involving the use of goons to recover a vehicle financed by the bank. As happens often in such cases, the wrong guy got beaten up- not the owner of the vehicle but his friend's son and ended up in hospital.

Only a few weeks ago, ICICI Bank was in the spotlight when a home loan borrower in Mumbai committed suicide- the bank entered into a settlement with the deceased borrower's family on that occasion.

Banks must beware- the RBI has warned that banks that attract strictures from a court will not be allowed to use recovery agents.

Rediff reports:

"No civilised society governed by rule of law can brook such kind of conduct," the Commission's president Justice J D Kapoor said, adding the violent methods adopted by the recovery agents were serious violation of "human rights".

Holding the ICICI Bank guilty of "unfair trade practice," the Commission termed such miscreants as "yahoos" and said they are boorish and a brutal lout, who care a fig for legal and judicial authorities, including the Supreme Court. While taking to task the leading bank, it vented its anger on ICICI for flouting the apex court's direction that restrained all the financial institutions from employing musclemen to recover a loan amount or possession of a vehicle.

The Commission, also comprising member Rumnita Mittal, issued notices to the collection manager of ICICI Bank and the CEO of the recovery agency, seeking their explanations over blatant violation of the direction of the highest court of the nation.

Fear not the Sixth Pay Commission

Some sort of panic has gripped economic commentators as the Sixth Pay Commission award draws nearer. There is talk that this will again deal a crippling blow to public finances.

I don't think so. I think the improvement in both central and state finances has been sufficiently impressive that we can withstand the impact of any SPC award. But, also, as I point out in my
latest ET column, Booming Sensex, smiling GoI, the government could easily mobilise the extra funds needed through disinvestment.

True, the unions and the Left oppose disinvestment. But this opposition can be overcome. I argue, by linking a generous award with: a. approval for disinvestment and b. assurance (if necessary by legislation) that government equity in PSUs will not be allowed to fall below 51% consequent to dinsvestment.

By holding on its to investment in PSUs and public sector banks, the government has ended up a big winner from the rise in the Sensex- and don't forget it was the Left that forced the government to hold on!

A primer on leadership for Wall Street CEOs

Stan O'Neal, CEO of Merrill Lynch, has had to exit his job following huge losses on the sub-prime portfolio. It wasn't just the magnitude of the writedown- $ 8bn- that appalled the board and analysts. O'Neal was seen to have failed to provide the right guidance- the estimate only a few weeks earlier was of $4.5 bn. This was seen as a poor reflection on risk management at the firm.

O'Neal was also faulted for having approached Wachovia Bank for a possible merger without prior discussion with his board.

These are both failures, all right, but are they big enough to cost a CEO his job? Wall Street's standards, you might say, are exacting. You earn big money as the CEO of a Wall Street firm and you must expect the margin for error to be narrow.

However, as former star analyst Abigail Hoffman points out, others have got away with failures of the same order.

I find it odd and odious that Mr O’Neal has been hounded from office while other chief executives linger on. At Citi, Mr Prince has presided over third-quarter fixed-income losses and a lacklustre share price performance; Bear Stearns, under James Cayne, has stumbled badly; and Ken Lewis, Bank of America’s chief executive, had the wrong people in charge of the investment banking division, where net income fell by $1.33bn in the third quarter.

Hoffman notes that O'Neal had conspicuous success at Merrill:

Mr O’Neal changed Merrill and, in my opinion, he changed it for the better. He diversified the business away from its traditional retail broking focus and oversaw significant profit growth. Net earnings rose 47 per cent last year to a record $7.5bn.

So, why was O'Neal singled out for heavy punishment? Hoffman says the problem was not the failures he ran up recently. It is just that he antagonised people through his cost-cutting and, more critically, failed to pack the board with supporters. As a CEO, you need to perform, of course, but there are other things you need to keep in mind:

Mr O’Neal’s departure was not inevitable. Nevertheless, this squalid incident has lessons for us all. Chief executives must be careful to keep the board on side. And the maxim: “On your way up, be cautious who you step on because you may meet these people on the way down” remains true.

Service quality in London

London. Financial capital of Europe? Yes. Throbbing metropolis? Yes. Great amenities and services befitting an advanced economy? NO- says Sudeshna Sen in today's ET.

there’s nothing I can do to be politically correct about the fact that average customer service standards in London - across the spectrum from banking, hospitality, utilities, telecoms, retail, internet, IT et al - is, to put it mildly, appalling.

And yes, to make another sweeping generalisation, it’s much worse compared to what you get in urban India today — even more in higher end services like telecom or banking. It can take up to two months to set up a bank account, another three weeks to three months for an internet connection, a week to check a faulty phone line, an hour for an order to be delivered in some of the poshest restaurants.

What could be the reason for such poor quality of services? Sen has her hypotheses:

From what I’m able to make out, it has little to do with employees - more with corporate attitude. Service providers here seem to have business models that are all carved in stone, possibly invented in pre-Thatcherite times, and no real new competitors in decades to drive innovation in any segment. Another reason, I’m told, is the European obsession with employee rights has pushed customer rights completely off the map.

I don't believe this is the whole of the explanation. I think the privatization of key services has been a disaster- government monopolies have given way to quasi-monopolies in the private sector. Whereas there is a certain accountability in government, thanks to parliament and the media, the private sector is free to operate as it pleases. No amount of regulation seems to help.

I shudder to think of what we can expect when we in India too make a wholesale shift from government to the private sector in respect of education, health, telecom, banking and the rest.

No certitudes in bank regulation

In today's BS, Shankar Acharya has an article that shows how the certitudes underlying bank regulation in industrial economies have been shaken by recent events. The certitudes were:

first, a nation’s central bank should be accorded statutory independence from government; second, the central bank should be charged with the single (or primary) target of keeping inflation low; and third, all financial trading and intermediaries should be brought under a separate single regulator.

Following the collapse of Northern Rock in UK, the Bank of England could not fend off pressures from government to effect a rescue of depositors. This was after all the tough talk from Bank of England Governor Mervyn King. So much for central bank independence.

As for focusing on inflation alone, the US Fed found itself obliged to cut interest rates in order to maintain financial stability. As for having a single regulator, Acharya rightly points out that there cannot be a uniform prescription for all contexts- you have to see what will work in a given context.

Acharya has some kind words to say about the criticism that RBI has attracted for its efforts to contain rupee appreciation:

Against this background it should be easier to sympathise with the Indian authorities’ recent and somewhat untidy efforts to grapple with the unprecedented surge in foreign capital inflows and their destabilising consequences. The shrill and simplistic critiques of over-zealous “market fundamentalists” are not very helpful. Nor, of course, is blind defence of any and all public regulatory interventions.

A swipe at risk management techniques

Naseem Talib, a former trader, is something of a maverick when it comes to risk management. He has produced articles and books that question the value of many modern tools of risk management. In FT, he takes another swipe at these:

MPT (Modern Portfolio Theory) produces measures such as “sigmas”, “betas”, “Sharpe ratios”, “correlation”, “value at risk”, “optimal portfolios” and “capital asset pricing model” that are incompatible with the possibility of those consequential rare events I call “black swans” (owing to their rarity, as most swans are white). So my problem is that the prize is not just an insult to science; it has been putting the financial system at risk of blow-ups.

I was a trader and risk manager for almost 20 years (before experiencing battle fatigue). There is no way my and my colleagues’ accumulated knowledge of market risks can be passed on to the next generation. Business schools block the transmission of our practical know-how and empirical tricks and the knowledge dies with us. We learn from crisis to crisis that MPT has the empirical and scientific validity of astrology (without the aesthetics), yet the lessons are ignored in what is taught to 150,000 business school students worldwide.

.......The environment in financial economics is reminiscent of medieval medicine, which refused to incorporate the observations and experiences of the plebeian barbers and surgeons. Medicine used to kill more patients than it saved – just as financial economics endangers the system by creating, not reducing, risk

Caste discrimination in Indian industry

Indian industry claims it has no caste bias and that its hiring policies are entirely meritocratic. It uses this claim to oppose caste-based job quotas. The Economist had a feature on the subject largely supporting industry's contention and arguing that quotas would hurt industry while doing little for the underprivileged. Much of the discrimination, the feature suggests, may have to do with class rather than caste:

There is no strong evidence that companies discriminate against low-caste job applicants. Upper-class Indians, who tend also to be high-caste Hindus, can be disparaging about their low-caste compatriots. “Once a thicky, always a thicky,” is how a rich businessman describes Ms Mayawati. Yet this at least partly reflects the fact that low-caste Hindus tend also to be low class; and in India, as in many countries, class prejudice is profound.

Two academics, Paul Atwell, Professor of sociology at City University of New York and Katherine Newman, Professor of sociology at Princeton, contest these claims in a letter to the editor. Their empirical study bears out what those who favour quotas have been saying: caste discrimination may not be overt but it exists and improving the educational credentials of lower castes alone will not be enough.

Our two-year study, which we will soon present, found widespread discrimination against highly qualified low-caste individuals. We sent out 4,800 applications in response to advertisements for graduate jobs in Indian and multinational companies. These applicants bore distinctively upper-caste names, Muslim names and dalit surnames, but were otherwise identical in educational qualifications and work experience.

The odds of a dalit being invited for an interview were about two-thirds of the odds of a high-caste applicant with the same qualifications. The odds of a Muslim applicant being invited to an interview were even worse: only one-third as often as the high-caste Hindu counterpart.

The evidence is solid. Serious policies, coupled with an overhaul of India's education system, a required to overcome this pernicious form of social exclusion. Maybe then the widespread relegation to the bottom of the barrel of India's poorest castes will begin to diminish.

The difficulty I see with quotas in industry is that they will be hard to implement- bureaucrats and politicians alike will be bought off by businessmen and anybody who leans too hard on industry will find it hard to survive in politics- he or she will not be able to access the kind of funds that political surivival requires these days.

A more stable world economy

The world economy is more stable today in the past, it is growing faster than at any time except the 1960s, deep recessions have disappeared in the industrial economies and emerging markets have grown stronger since the east Asian crisis. Facts worth emphasising when there are long faces over the sub-prime crisis in the US and its possible impact on the world economy.

The IMF's World Economic Outlook makes the point that better economic management has helped in a big way- monetary management especially, based on the insights developed in monetary theory, has had huge pay-offs. The WEO does not mention the role of central bank coordination in dealing with economic crises- I believe this too has been a big factor. As a result, central banks are better placed today to deal with the fallout of crises in financial markets of the sort we are facing now and to limit their impact on the real economy.

More on this in my ET column, Good times last longer.

Craze for emerging markets

Investors have rediscovered emerging markets after being burnt in the east Asian crisis. But net inflows into emerging markets as a whole are still lower than their historical highs. That is because the rise in gross inflows has been matched by outflows from emerging markets into other economies.

That was the position until last year. Things may have changed dramatically after the sub-prime crisis. Money is flooding the emerging markets on an unbelievable scale. FT reports:

Brad Durham of EPFR Global, which tracks fund flows, says that of the $29bn (£14bn, €20bn) in net inflows to emerging markets so far this year, 82 per cent has arrived over the past seven weeks, “which is astounding”.

By contrast, during the same period, US equity funds tracked by the group saw outflows of $6.3bn, European equity funds (excluding east European funds) surrendered $6.9bn and Japanese equity funds gave up $3.9bn.

There you have it. Funds are being switched out of industrial economies and into emerging markets. As a result, the price-earnings ratio in emerging markets is at a small premium to that in industrial economies. Macroeconomic conditions in emerging markets are today seen as sounder than before- growth is strong, 50% of global growth was contributed last year by China, India and Russia and foreign exchange reserves of emerging economies exceed inflows into emerging markets, making these economies net creditors for a change.

India is particularly favoured among emerging markets and that must explain the dizzying rise in the Sensex in recent weeks.

Restrictions on capital flows- Sebi proposals

Not to sound boastful but I wasn't perturbed at all when I learnt this morning that trading had been halted after a steep fall in stock prices triggered the circuit breaker. I was awaiting "clarifications" from official sources that would calm the markets. That's exactly what happened. After the PM and the SEBI chairman came on the air, the market recovered to end the day around 400 points lower- a considerable recovery from the fall of 1700 points earlier.

The draft regulations circulated by Sebi, which will become law with or without some minor modifications by October 20, are intended to curb capital inflows into the country. It will do so by curbing the volume of Overseas Derivative Instruments (Participatory Notes), instruments through which foreign investors can invest in India even if they are not registered as Foreign Institutional Investors.

PNs constituted 51.6% of Assets under Custody (AUC) in August 2007, 30% of which had derivatives as the underlying. The RBI has long been in favour of phasing out PNs but the finance ministry was resisting because it didn't want the stock market run to stop. With the kind of rise in the Sensex we have seen in recent weeks, the ministry, no doubt, reckons that a correction is affordable.

Sebi's proposals are as follows:

1) FIIs and their sub-accounts shall not issue/renew ODIs with underlying as derivatives with immediate effect. They are required to wind up the current position over 18 months, during which period SEBI will review the position from time to time.
2) Further issuance of ODIs by the sub-accounts of FIIs will be discontinued with immediate effect. They will be required to wind up the current position over 18 months, during which period SEBI will review the position from time to time.
3) The FIIs who are currently issuing ODIs with notional value of PNs outstanding (excluding derivatives) as a percentage of their AUC in India of less than 40% shall be allowed to issue further ODIs only at the incremental rate of 5% of their AUC in India.
4) Those FIIs with notional value of PNs outstanding (excluding derivatives) as a percentage of their AUC in India of more than 40% shall issue PNs only against cancellation / redemption / closing out of the existing PNs of at least equivalent amount.

So, the idea clearly is to limit investment in the Indian market through PNs. There has always been a problem about the identity of investors holdings PNs. For that reason alone, restrictions on PNs are welcome. But will it help meet the objective of curbing capital inflows? In the short run, yes. In the long run, no, for the simple reason that the volumes waiting to enter India are enormous. Once PNs are barred, we should see an increase in those wanting to register as FIIs.

I am sure the finance ministry and Sebi recognise this. But a breather on the capital inflows is welcome- and the present proposals will provide just that. JP Morgan estimates that the ouflows on account of the unwinding of PNs with derivatives as underlying could be $4-7 bn; the unwinding on account of PNs issued by sub-accounts of FIIs will be even larger. Of course, all this will happen over a 18 month time horizon although it may not be evenly spaced out over that period.

Forex additions this year have been $50 bn- the addition considered comfortable was around $25 bn. In relation to overall capital inflows, the outflows that will be triggered by the Sebi move
will be a minor speed-breaker. International factors remaining the same, it will slow the rise in the Sensex over the next few months. But it does provide some breathing space for RBI in terms of managing the exchange rate- the way things were going, it appeared the rupee would soon touch Rs 35 to the dollar.

In macroeconomic terms, the Sebi move does not amount to much over the long term. It does little to alter the trend towards rupee appreciation. But, as I said, it gives a little time for adjustment to appreciation- and that is exactly what Indian industry needs and can expect at best. Rupee appreciation can be managed, not eliminated.

The combination of a rising stock market and rupee appreciation would have meant capital inflows on an uncontrollable scale. That would have had a severe impact on the Indian economy. The speed-breaker imposed by Sebi is good for the economy. It is also good for the stock market. I think the market will recognise this - and continue its climb.

"Overpaid" US executives

Many think US executives are overpaid but not many would expect the executives to say so. Well, in a poll carried out by the National Association of Corporate Directors, four out of six CEOs or presidents polled acknowledged this was the case, FT reports.

Four out of six chief executives or company presidents polled by the NACD in July and August said the compensation of top executives was high relative to their performance.

Only 2.2 per cent of the nearly 70 chief executives and presidents involved in the survey said compensation was too low, while a third deemed it “just right”.

Their views were backed up by outside directors, with more than 80 per cent of them saying chief executives were overpaid.

“There is an overall realisation that executive compensation is an area that boards and management are struggling with,” said Peter Gleason, chief operating officer of the NACD.

The issue is particularly sensitive because the gap between rich and poor in America has reached its widest point in more than 60 years.

Figures released last week showed the share of national income claimed by the wealthiest 1 per cent of Americans had reached 21.2 per cent – a postwar record – partly because of booming company profits.

This is not a problem that can be addressed by "restraint" among corporate executives- I can't see these guys practising self-denial. It cannot also be solved by boards of directors as they are constituted at present.

There is a fundamental problem with corporate boards- and this includes corporate boards. The "independent" directors are, in fact, chosen by CEOs and are beholden to them for the fat fee and commissions they get these days- in the US, $100,000 is pretty common. The figures I have seen in the papers for Indian boards are an average of Rs 9- 10 lakh. A CEO requests you to join the board and he pays you Rs 10 lakh - do you think many people would question the CEO or oppose the CEO in the knowledge that that would be the end of the goodies they get? Not a chance!

We will have truly "independent" directors only when institutional shareholders get to nominating directors on boards. Then, we will have directors independent of management. Today, the word "independent" is construed to mean anybody who does not have a pecuniary relationship with management. That's not enough- to be independent, a director must not owe his job to management.

A peep into IIM-C's board room

Ajit Balakrishnan, Chairman of IIMC's board, has a piece about a recent board meeting. The board was reviewing proposals for a revamp of the PGP course curriculum.

The interesting thing to me is that not the comments made at the meeting. It is that Balakrishnan has thought fit to share some of the proceedings with his readers. This is hardly typical of boards. The agenda item itself would be "secret". The proceedings would be "confidential". So much that even at supposedly "faculty-governed" academic institutions, faculty have little clue as to what is discussed in their own boards. True, there are faculty nominees on these boards but try eliciting information from them!

I concede that not all matters discussed in the board of an IIM can be shared with a wider audience. But many matters can. And matters related to the strategic direction of the Institute certainly should be shared.

Changes in MBA curricula are a matter of intense discussion worldwide. What IIMC board members and what IIMC faculty have to say on the subject is certainly a matter of public interest. Balakrishnan has rendered a valuable service by giving us a peep into IIMC's board room. Congrats, Balakrishnan- and more power to those who favour greater disclosure rather than less.

Lack of Ph Ds threat to IT industry

Microsoft MD Ravi Venkatesan thinks the shortage of computer science Ph Ds threatens the future of the IT industry, FT reports. I was taken aback at the figure mentioned in the report- just 35 Phds in a year in India compared to 1000 in the US !

“It’s an incredibly urgent and important issue,” Ravi Venkatesan told the Financial Times. “It affects the pipeline of future talent because the teaching institutions aren’t getting enough qualified faculty and, of course, if you really want to do cutting edge innovation in computer science, you’re restricted by the pool of talent out there.”

While Indian companies have until now relied on the difference between Indian wages and those in developed markets to attract business, the strategy is not sustainable, Mr Venkatesan said.

“It’s inevitably a matter of time before these wage disparities disappear and the only thing that’s going to matter is the quality of ideas coming out of an employee,” Mr Venkatesan said.

Fashions in bank regulation

Until the other day, the ruling wisdom was that it makes sense to separate the conduct of monetary policy from bank supervision. Combining the two roles, as the RBI does, is folly, we were told - among other things, there could be lack of focus and conflict of interest in doing so. The British separation of the Financial Services Authority from the Bank of England was held up a role model and the RBI was portrayed as being cussed in resisting any separation of roles.

That wisdowm is being turned on its head in the wake of the collapse of the British bank, Northern Rock. Now, we are told that the collapse could have been averted but for the fact that three players were involved- the UK Treasury, the BoE and the FSA- and none of them regarded as its primarily responsibility to avert disaster. Here is a sample from a comment in FT

It is, incidentally, worth noting that compared with the problems of mounting and co-ordinating a last resort lending operation to a big multinational bank, a Northern Rock bail-out should have been child’s play. But the tripartite division of responsibility between the Treasury, the Bank of England and the FSA has become the Bermuda triangle of the British financial system.

Evidently, fashions in bank regulation keep changing as they do elsewhere.

Lean times for Indian economy gurus

Swaminathan Aiyar has a piece in today's ET on how the mystery underlying the growth of the Indian economy. He says it is not clear why India should be growing at an average rate of 8.6% in recent years when there are still so many negatives in the scenario.

A different way of putting this would be to say-as I have been saying for long- that economic pundits have simply been wrong about the Indian economy. They warned us that there was no way the Indian economy could grow at 8% plus without "reforms". Many of these reforms have not been implemented or implemented in full. But that has not kept the economy from growing.

Aiyar mentions several hypotheses that attempt to explain the Indian economy's performance- "tipping point" or the cumulative effect of past reforms, steady improvement concealed by external shocks such as the east Asian crisis or the IT bus, the revival of manufacturing, the global boom. He is not sure they adequately explain the outcome. In particular, governance remains weak and the fiscal deficit is disconcertingly high.

I have never bought the governance thesis- that shifting coalitions or even political instability can be a growth inhibiting factor. Look around and you will find countries wracked by insurgencies doing quite well in terms of economic growth- Sri Lanka is a striking example. The fiscal deficit may be high in absolute terms but the trend towards improvement is unmistakeable.

I happen to think that the biggest factor in the improved performance of the Indian economy is the increase in savings and investment rates. The savings rate has risen by nearly 10 percentage points over the past decade. Fiscal improvement has been an important factor underlying the increase in the savings rate. Fiscal improvement, in turn, has been made possible by falling interest rates. And lower interest rates are the result of huge foreign inflows.

Why have foreign inflows risen so fast? Remittances have risen sharply after the exchange rate became market determined and hence it made sense to remit money through official channels and not through the havala route. FII flows have shot up as the stock market was modernised and foreigners realised that here was an economy that had grown at over 6% for two decades and would grow even faster. FDI has risen for the same reason. Falling interest rates have also boosted corporate profitability and corporate savings.

When an economy of India's size shows sustained growth, it becomes a magnet for global savings. Once the savings start pouring it, domestic savings rise because of the impact on the fisc and corporates of falling interest rates. The momentum imparted to the economy is sufficiently strong that it does not require "second generation" reforms. That's bad for economic pundits- they are left with little to preach. But it's just fine for the economy.

Would we have been even better off with a further dose of reforms? No- and here I think the political class got it right in preferring to move gradually. More reforms would have been socially disruptive- vocal segments would have been alienated and that would have created serious governance issues. The trick was to recognise the trend towards improvement and let the economy be. In this the politicians were right, the pundits wrong.

I have said this before: the performance of the Indian economy is ultimately a tribute to the democractic process and a warning against setting too much store by experets.

Why can't the media get its facts right?

Today's Indian Express carries an interview with outgoing IIMA director Bakul Dholakia. The report carries the following item in a box:

No three-month extension for Bakul

IIM-A directors have always been given three-month extension after the expiry of their term. This was done to facilitate the handing over of the charge process to the next director, as the selection process for the same is a time-taking affair. For Prof Bakul Dholakia, however, October 9 is the last day of his term as also his last day in office. Sources in IIM-A said the chairman of the governing body of IIM-A, DrVijaypat Singhaniya, had written to Union HRD Ministry seeking an extension of Bakul's term until the next director is appointed.

It has been learnt that an "explicit" communiqué has been issued to Dholakia to hand over the charges on the last day of his term

The report is factually incorrect. In 2002, the then outgoing director too was asked to hand over charge the day his term expired. If the suggestion is that Prof Dholakia is being single out for special treatment by the MHRD, that is completely erroneous.

In previous rounds, yes, there were occasions when the director's term had got extended until the appointment of his successor but not all the time.

Leaving aside the historical record for the moment, isn't it a good idea to have fixed terms for such positions? Is it not a healthy practice for the director to step down when his term expires and for somebody else to hold temporary charge till the new director takes over? IIMA and its governing council should have instituted this practice on their own in the interests of good governance- that is the least one expects of the nation's top business school, many of whose faculty have made careers out of preaching governance to the rest of the world.

If they failed to do so and if the MHRD has now instituted an altogether healthy practice- of adhering strictly to the a director's term limit- then the ministry surely deserves bouquets, not brickbats.

Illusory surge in FDI

I remember an interview with P Chidambaram sometime ago- as I recall, he was being interviewed by an Indian business channel and the interview was in London. He was asked whether the opposition to reforms was not coming in the way of greater foreign direct investment (FDI) into sectors such as insurance. Chidambaram said he wasn't too worried because largely flows of FDI were happening anyway. If lack of progress on reforms made it difficult for foreign investors to enter some sectors, "so be it".

There is a certain smugness, I notice, about FDI since the official figures place FDI at $16 bn. As a proportion of GDP, FDI in India would today not compare unfavourably with China's. I have been taking a close look at the numbers and I find that nearly $ 8bn of FDI is private equity. Now, private equity is not the same as firm- or MNC- related FDI. It is in the nature of secondary market investment, with no immediate addition to capital stock or jobs.

Now, it's true that FDI from MNCs is also mostly of the secondary market variety, as it happens through mergers and acquisitions. But there is always the prospect of additions to capacity down the road, infusion of technology and export linkages with the parent. With private equity, you have a ruthless focus on efficiency- and this often takes the form of asset-stripping and paring of jobs- but the other benefits that arise from MNC FDI are not there. Much of the private equity flowing into India has gone into the services sector,including real estate. It is more akin to stock market investment with the prospect of additional gains from an appreciating rupee.

Take away the private equity component and changes in accounting practices in relation to FDI and the figure of FDI in 2006-07 falls to $5 bn. It does seem that the hype over FDI in India is misplaced. More on this in my latest ET column, Are FDI flows into India for real?

Investment banking losses

Banks and investment banks are unlikely to go under in the present market crisis but their earnings are bound to take a hit.

Deutsche Bank and Merrill Lynch are the latest additions to a growing list of investment banks hit by losses in fallout of the sub-prime crisis. Earlier, Citigroup, UBS and Credit Suisse all had issued profit warnings. Lehman is among the few banks to have weathered the storm better than expected. The losses are in billions of dollars and heads are rolling merrily.

The sources of loss in banking are the following:

• Direct losses from exposure to sub-prime securities
• Loans for takeovers that have ended up on the books of banks- this will require higher allocation of capital and the terms on which these were negotiated are unfavourable in the changed context in which interest rates have shot up
• Fee income from structured products will decline
• Private equity income will be hit
• Interbank financing costs are higher, this will impact margins

How to ride out the storm? Having a large retail base helps. Also, equities have risen and this may compensate for weaker fixed income markets. Banks will also look to boost income from emerging markets- this may well explain the surge in flows into markets such as India and the boom in the Sensex in recent weeks.

Celebrity woes!

I read this with some disbelief and I hope the report I saw is correct. Newly crowned Vishwanathan Anand was quoted ( sorry, I forget which paper or website) as saying that he wanted to see what sort of crowds he would attract when he returned home. He said he had heard about the rapturous welcome accorded to the Indian cricket team after their T20 win and he wanted to see how he would be received. (Reader Guru has since provided the link to TOI- http://timesofindia.indiatimes.com/articleshow/msid-2416546,prtpage-1.cms)

I am sympathetic to the hockey players being deprived of cash rewards after their Asia Cup win but I thought Anand's remarks were rich! Anand takes home $400,000 as prize money, so he isn't exactly financially deprived. As for the crowds any winner draws, doesn't that have to do with the popularity of a sport? Like so many Indians, I rejoice in Anand's win but, sorry, I am not going to be able to show up at the airport when he arrrives.

In defence of Northern Rock

I commented earlier on the Northern Rock debacle (the UK bank that went under recently)- I mentioned how the reliance on capital markets for funds had proved the bank's undoing.

In the latest Economist, its chairman offers a spirited defence. He argues that the conventional wisdom has been that as long as a bank's loan portfolio is good, funding is always available. Northern Rock maintained a high quality of loans. So there was good reason for either the wholesale markets or retail depositors to desert it. For no apparent reason, the capital markets decide one day that they are not in a mood to take risk. Boom!- there go the institutions that had accessed funds from capital markets.

Northern Rock's strategy was at all time transparent to the market and to the regulator. Our lending was and is prudent. We have half the industry average of arrears and no subprime loans. To manage liquidity risk, our funding is deliberately diversified, both geographically and between four funding streams—retail, wholesale, securitisation and covered bonds. Of the non-retail funding, less than 20% has a shorter term than the average three-year duration of a mortgage on our balance sheet.

We were repeatedly advised that liquidity in wholesale markets depended on lending quality: good loan books would continue to attract funding when bad loan books began to default. Instead, from August 9th, liquidity has dried up across all wholesale markets, making no distinction between loans of different quality, for much longer than even the most extreme forecast. In America and Germany, where many subprime loans have ended up on banks' balance sheets, the liquidity crisis has been managed smoothly, whereas in Britain, with low arrears, a bank with a high-quality loan book nonetheless found itself in a situation where its retail depositors temporarily felt threatened.

Northern Rock's Chairman has a point. But his bank's debacle only highlights a shortcoming in the present way of managing risk. Capital in a bank is viewed as a cushion against as a defence against loan deterioration, most of the focus is on managing credit risk or market risk. But banks have not been adequately mindful of liquidity risk. You really cannot have capital to take care of liquidity risk, you will need lines of credit for contingencies of the sort that Northern Rock faced. The management of liquidity risk is an area that will preoccupy regulators and banks alike in the near future.

Some reciprocity, please

US banks are itching to get into India. Senior US officials make it a point to lecture India on the virtues of opening up the Indian banking sector even more to foreign banks. The RBI has plans to liberalise entry further post 2009.

There is a vexatious issue involved here that can't be wished away. Most industrial economies are reluctant to allow Indian banks into their turf for one reason or another. They do not believe in reciprocity in this area. The soundness and management of Indian banks was an issue for long. Now that Indian banks have proved their mettle, the issue is money laundering and terrorist funding. As Indian Express reports, the Indian security establishment's warnings that Indian financial institutions are vulnerable to terrorist groups has now provided a convenient handle to the US treasury.

There are some who advocate unilateral opening up of the Indian banking sector- they contend that we benefit from unilateral liberalisation. They have a point but how far do we go?

Finance minister P Chidambaram had to do some tough talking in the US on this subject recently.

Chidambaram told the US team that India would have to review its policy if ndian banks aren’t allowed to open branches in the US. While there are 52 branches of US banks in India, including 19 opened in the past four years — four branches of US banks have been approved in Tier II cities this year — Indian banks have just around a dozen branches in the US.

........Chidambaram emphasized that Indian Banks were Basel II (international standard to safeguard solvency and market risks) compliant and the Money Laundering Act was in place to guard against any questionable transfers.

Awash in liquidity

The rise in the Sensex beats anything we have experienced in the recent past. I mean, we are supposed to be in the midst of a serious international financial maket crisis. Some think the probability of a US recesssion is still pretty high and that global economic growth will be dragged down in consequence.

If the Sensex has taken note of these, it's not showing. For some reason, funds continue to pour in. The statistics I saw on TV are: FII inflows of $1 bn in the past week, net inflows of $ 3 bn in September. And the best annual score thus far has been around $10 bn!

Deepak Parekh was on one of the channels a couple of days ago. He suggests that whole new classes of investors are waking up to India: US insurance and pension fund investors (as distinct from mutual funds and hedge funds, thus far the prominent US investors in India), Japanese retail investors, the newly set up sovereign wealth funds. Then, you have huge oil surpluses looking for alternatives to US and Europe. A tiny percentage allocation to India turns out to be a flood so far as we are concerned.

The biggest surprise to me is the rebound in IT stocks. I thought they were headed relentlessly southwards in the wake of an appreciating rupee. But, this week, the stocks are up again. I asked a street corner broker whether he had an explanation. He said Infosys' Nandan Nilekani had indicated on TV from New York that Infosys was in a position to weather the impact of the rising rupee. That did the trick this week. Whether this will last we will know when the first quarter results start pouring in from October 5.

Tough justice in Scandinavia

An investment bank in Sweden inflates profits by overstating trading positions. When the truth is revealed, it has to write down profits by a huge amount.

The price for this sort of behaviour? The regulator asks the entire board to step down, not just the CEO. That's the sort of tough justice you find in Scandinavia- it's hard to think to sounder corporate governance norms elsewhere in the world. FT reports:

Carnegie in May said its net profits from 2005 to 2007 would be cut by SKr227m after three employees had inflated profits by overstating trading positions. The bank eventually took a SKr315m write-down as a result of the scandal.

”All this is very serious. We could have pulled their licence, but we see that there is hope that their measures are sufficient,” said Ingrid Bonde, director general of the regulator.

”We demand that the board replaces the CEO who must not be allowed to remain a board member either. The guidance and control which we have criticised involves the entire bank and the bank management,” Ms Bonde said at a news conference.

Containing "moral hazard"

Much has been written about "moral hazard" created by central bank intervention in times of financial crises- the danger that such intervention encourages market players to take undue risks in the knowledge that the central bank is always there to help them out.

In my posts on the subject, I have been sceptical of this line of reasoning. When you are faced with a financial crisis that threatens to impact the real economy- note, not just a crisis that is confined to the financial sector- you don't sit around twiddling your thumbs. You don't use the possibility of "moral hazard" to justify inaction. That is because the costs of systemic failure can be huge where banks are involved- in the East Asian crisis, the countries there were set back by years when it came to economic growth.

I also believe that another criterion is valid: has intervention by central banks or governments actually led to increased moral hazard? Are banks more prone to failure today than before? Impressionistic evidence suggests this is not the case. In the US, banks are better capitalised than before, their risk management practices have improved hugely and they are better placed to present a crisis than before.

Larry Summers' article in Business Standard today makes clear why moral hazard cannot be allowed to come in the way of timely intervention. Summers provides three good reasons for this.

First, ......... the prospect that people may smoke in bed is not usually taken as an argument against the existence of fire departments. Moreover, if there is “contagion” as fires can spread from one building to the next, the argument for not leaving things to the free market is greatly strengthened.



Second, ......moral hazard and confidence are opposite sides of the same coin. Financial institutions can fail because they become insolvent, as misguided lending or borrowing causes their liabilities to exceed their assets. But solvent institutions can also fail because of illiquidity simply because creditors rush to withdraw their funds and assets cannot be liquidated fast enough. In this latter case the availability of external support averts needless panic and contagion.



Third,.....much of what financial authorities do in response to crises does not impose any costs on taxpayers and may actually make them better off. In the much criticised LTCM case no taxpayer money, except perhaps the cost of a lunch, was spent. ....Monetary policies that prevent deflation of the kind that cost Japan a decade of growth in the 1990s are another example of how a policy can respond to stress without imposing costs on taxpayers or the economy.

Summers goes on to spell out the conditions under which central bank intervention would be worthwhile:

First, are there substantial contagion effects? Second, is the problem a liquidity problem where a contribution to stability can be provided with high probability or does it involve problems of solvency? Third, is it reasonable to expect that the action in question will not impose costs on taxpayers? If the answers to all three questions are affirmative, there is a strong case for public action.

Harish Salve on Mid-Day case

In my post yesterday, I indicated that I had doubts as to whether the media had gone overboard on the Justice Y K Sabharwal case. My doubts were about the manner in which the case was reported, the point on which the Delhi HC based its decision to hold the journalists concerned in contempt of court.

In today's Indian Express, Harish Salve goes further. He is dismissive of the allegations themselves and he also makes the point that Sabharwal's judgement in the sealing case must be viewed in the broader context of several bold judgements he had made:

Every judge has his “foot print”. Justice Sabharwal’s footprint is that of a judge who took on controversial cases and dealt with them squarely. This is reflected in his judgments in the case relating to the expulsion of members of Parliament, the office of profit controversy, Bihar Assembly dismissal, the forest matter, and the Ninth Schedule matter.

His decision in the sealing case follows the same trend. There is nothing odd or curious about his decision in the sealing cases — and the bench hearing the case after his retirement continues to pass orders in the same direction notwithstanding the hamhanded attempt by the government to browbeat the court manifested in the intemperate (and rehearsed) outburst of one of its law officers.

The allegations against him that sought to cast aspersions on his motives in deciding the sealing cases, pursued after his explanation, ought to have been treated with contempt rather than in the contempt jurisdiction.

Salve, however, argues that the judiciary might show greater consideration to the media in such instances, especially where media reports may be well-intentioned. Stringent action against the media, while perhaps defensible on technical grounds, may have the effect of weakening the institution of a free press. And, after all, when it comes to enforcing accountability, the media and the judiciary are on the same side.

In a perfect world the intrusive methods of the Indian media would be an intolerable invasion of privacy and an unbearable encroachment on a citizen’s reputation. In contemporary India these methods have gone a long way in serving a larger cause of the fragile democracy of this nascent republic.

The action of the newspaper in publishing these allegations was clearly ill-devised. But in the circumstances, stern action of the kind taken by the court may have a “chilling effect” and may turn out to be a remedy worse than the disease.

Mid-day contempt of court case

Mid-Day's three journalists and one publisher have been sentenced to four months in jail by the Delhi High Court for contempt of court. They were sentenced in the case relating to the reports the daily had carried about Y K Sabharwal, former Chief Justice of the Supreme Court, and the Delhi sealing drive. The Delhi High Court had taken suo moto cognizance of the Mid-Day stories.
The media is understandably incensed. It believes that this is an attempt on the part of the judiciary to shield itself from scrutiny and accountability. Senior journalists have said that the Delhi High Court should have gone into the veracity of the allegations made by Mid-Day against the former CJ. This view has been echoed by some eminent lawyers- TOI quoted Prasant Bhushan as saying that the judgement was an "attempt to muzzle the media".

The SC will now decide on the contempt issue. It is important, however, not to miss the nuances to the Delhi HC ruling, whatever opinion one may have about the actions of former CJ Y K Sabharwal. I caught some of the nuances only in one report, that in the TOI of September 22.

The Delhi HC was not pronouncing on the merits of the Mid-Day story. The HC bench headed by Justice R S Sodhi is quoted in TOI as saying:

"The nature of the revelations and the context in which they appear, though purporting to single out former Chief Justice of India, tarnishes the image of the Supreme Court."

How so? Because "by imputing motive to its presiding member, (it) automatically sends a signal that the other members were dummies or were party to fulfil the ulterior design (of Justice Sabharwal)." Besides, Soli Sorabjee, among others, has expressed the view that the cartoon carried by the paper was contemptuous.

In other words, the report had the effect of casting asperions on the SC as a collective, hence the veracity of the report was irrelevant to the issue of contempt of court.

Ordinary people may find it difficult to digest such nuances but those with a nodding acquaintance with the law will know that technicalities such as these can have a crucial bearing on the outcome of a case.

The question then arises: how does a paper report on the actions of a judge or former judge that raise doubts in the minds of the public without in any way appearing to cast aspersions on the Court as a whole? Does it merely highlight the actions of a judge without in any way questioning a given judgement, especially where other judges are involved?

In other words, is there a proper way of reporting such matters in the public interest without inviting action under contempt of court? One hopes that the SC ruling in the matter will shed light on this subject so that the ground rules for media reporting in such matters are clear to all concerned.

More on the ongoing sub-prime saga.....

My latest thoughts on the sub-prime saga in my ET column, More solid than Rock. I think the risks to the world economy are still manageable, that central banks will bring it off. I also discount the possibility of a US housing crash triggering a similar crash in India- the two markets are quite different in character.

Will the Bernanke 'put' work?

I suggested yesterday that there was a Bernanke 'put' in operation out there in the markets, much like the much-maligned Greenspan 'put'- when push comes to shove, nobody wants plummeting markets to drag down the larger economy. A commentator in FT today endorses this view but suggests that the Bernanke 'put' may not solve the underlying problems:

The positive response of global equities highlights how the move was both unexpected and welcome. Now that the Fed cites “developments in the financial markets” as influencing their policy assessment, investors have good reason to believe in the “Bernanke put”.

........The problems in credit markets stem from unsustainable financial structures brought on by many years of unregulated financial innovation. It would be naive to think that these structural problems could be spirited away by a 50bp rate cut.

Well, the Fed's response may or may not work but, as I argued yesterday, no central bank can fail to respond to market conditions as bad as the ones we are seeing now- this it not some unpleasant invention of Greenspan's.

Bernanke vs Greenspan

The Fed cut its benchmark rates by 50 basis points yesterday. Those who liked the move called in 'bold'. Those who didn't like it called it 'risky'.

Earlier, when Bernanke had held out against a large cut in interest rate, people had called him 'bold' and compared him favourably with the supposedly trigger-happy Greenspan. Greenspan, they said, was Wall Street's central banker, only too happy to cut rates in order to appease the financial markets. Bernanke was the academics' central banker, guided by larger theoretical considerations.

Greenspan's interest rate cuts, the critics said, had fostered moral hazard in the financial markets, they had caused firms to take up excessive risk. Now, we were all paying the price for those excesses. Bernanke was diferent, they said. He was out to make a point to market players: if you take excessive risk, be prepared to pay the price for it.

Much of this gets blown away by yesterday's interest rate cuts. A trigger point, perhaps, was the collapse of Northern Rock, a mortgage lender, in the UK, with the Bank of England rushing to its rescue. No regulator anywhere wants crowds queueing up outside banks and the prospect of a similar run on banks in the US, caused by protracted uncertainty in the markets and a sharper downturn in the US economy, no doubt helped focus minds in the US Fed.

So where does that leave us in terms of policy? Is Bernanke going the Greenspan way? Is the 'Greenspan put' , the floor on asset prices caused by interest rate cuts, now a 'Bernanke put'? Are central bankers obliged to take steps to prevent steep falls in asset prices that impact on financial institutions and especially banks? The answer to the last question at least does appear to be in the affirmative. The consequences of not responding are just too fearful for central bankers to contemplate.

Does this mean that Greenspan and Bernanke are abetting 'moral hazard' and we are bound to be swept by excesses of the kind that led to the present crisis? That would be too sweeping a judgement. There is a difference between some of the earlier financial crises and the present one.

In the present crisis, it is non-bank financial institutions that are primarily involved. Banks are involved indirectly either through lines of credit they have extended to troubled institutions or because they are holding securitised assets. Banks are much better capitalised today than before (especially US banks) and they are well placed the absorb the losses to which they are exposed.

The markets are jittery because it's hard to put a precise figure on the losses, given the accounting and valuation issues involved. The resolution of the crisis will take time and markets will remain jittery. But the financial system is better equipped to absorb the shock than on many earlier occasions. You can't argue that central banks have caused moral hazard to worsen through their actions.

Ah, Calcutta!

This news item from FT may not gladden the comrades in New Delhi but they are sure to boost Buddhadeb Bhattacharya's standing:

Starwood Capital and Walton Street Capital, two US real estate investment firms, have teamed up to invest in a $1.25bn property development in Kolkata, India, that will rank as one of the largest private equity deals in the country.The buyers will team up as equal partners with Shriram Properties, an Indian developer, to launch the project on 20m sq ft of land previously occupied by a Hindustan Motors plant. It will be classified as a “township” including residential, retail and commercial real estate properties designed by HOK, the architecture firm.

....People close to the deal, which is expected to be announced on Tuesday, said it reflected India’s ability to absorb a new supply of property developments and the business-friendly nature of Kolkata’s regional government.It also highlights the attractiveness of deals in emerging markets such as India for private equity and real estate groups whose opportunities have been dramatically reduced in their home markets by the global credit squeeze

Making the judiciary accountable

Magsaysay winner Arvind Kejriwal has a hard-hitting piece in today's TOI on the absence of accountability in the Indian judiciary.

It was news to me that the Delhi High Court had initiated contempt proceedings against Mid Day journalists for publishing a story questioning the acts of former chief justice of India (CJI) Y K Sabharwal. Kejriwal is highly critical of this move:

If the inquiry concludes that Mid Day journalists were wrong, they could be proceeded against. But by gagging the media, the Delhi high court is only lending credence to the allegations against Justice Sabharwal. The Delhi high court in its judgment against Mid Day journalists said that they were guilty of lowering the dignity of Supreme Court in the eyes of the public. If the voice of the media were to be gagged, the dignity of the Supreme Court would be lowered for ever.

Exposure of corruption in any institution might seem to lower it in the eyes of the people but in the long run strengthens the institution by allowing it to take corrective action. Suppressing exposure increases suspicion and indeed the people's 'contempt' for such institutions. Complete transparency and honest efforts to bring truth out in the public domain enhance the dignity of individuals and institutions.

Kejriwal makes the point that the Campaign for Judicial Accountability called a press conference in New Delhi and "released more damaging facts against Justice Sabharwal than what appeared in Mid Day." Justices JS Verma and V R Krishna Iyer, both former Supreme Court judges, called for an independent enquiry. Why then single out Mid Day journalists for contempt proceedings, Kejriwal asks.

Kejriwal then makes the case for greater accountability in the judiciary:

The judiciary lacks accountability. One needs the CJI's permission to file an FIR against a judge, which effectively rules out an FIR. One cannot publicly discuss the conduct of judges for fear of contempt. No agency has the powers to enquire into charges against them. Of late, the judiciary has expressed its desire to be kept out of RTI.

Contempt powers of the court should be subject to scrutiny. We have a right to hold the courts accountable. If there is a prima facie case of wrongdoing against any judge, it ought to be inquired into through a fast and effective mechanism. It is time that we asserted our right to discuss the conduct of judges and courts, the way we discuss that of any other democratic institution. Only then would the dignity of the courts rise in the eyes of the people.

And now a bank bail-out in UK

Today's papers noted with some sorrow that the Sensex came off the day's high and took a dive towards the end of the day following news about a bank failure in the UK. The culprit was Northern Rock, one of the smaller British banks. The bank could not get finance to service its liabilities and had to be rescued by the Bank of England.

Is the Bank of England merely providing liquidity or this is a bail-out of a failed bank? We do not know yet except that the line of credit provided is said to be large. Indications are that the bank may have turned insolvent - FT reports that market capitalisation is below thevalue of Tier I equity. If so, the Bank of England has really eaten humble pie- its Governor has been very vocal about central banks not rescuing institutions that made imprudent business decisions.

The Bank's predicament is made worse by the fact that Northern Rock is a small bank and its failure would not pose a threat to financial stability. Inevitably, there is talk of political pressure- Gordon Brown does not want a financial mess on his hands so early in his tenure.

FT's Lex column summarises the cause of failure at Northern Rock:

Should the end come, the rise and fall of Northern Rock will become a case study in failed alternative banking models. Compared with the UK banking average of 7 per cent, Northern Rock used wholesale market securitisation for 43 per cent of its funding. Eschewing customer deposits kept down costs – the bank has just 72 branches – and facilitated a rapid expansion of the loan book. But this over-reliance on one form of funding now looks foolish, irrespective of exceptional credit market conditions.

The Bank of England will soon look for buyers for Northern Rock- among the possible suitors being mentioned are Lloyds TSB and HSBC.

One cannot help noting that India's commercial banks provide a study in contrast to the likes of Northern Rock- not only are they well capitalised, the retail deposit to total liabilities ratio is among the highest in the world and a big chunk of liabilities is low cost current and savings account.

With a business model of that sort, you are likely to be pretty stable. Then, on the asset side you have a large slice of housing loans (with among the lowest default rates in the world) and corporate loans in a time of 8-9% economic growth. Retail is the key to stability in banking- it makes for stable liabilities and it provides for stability in income streams as well.

This must explain why foreign banks are positioning themselves for the retail market post 2009 when barriers to foreign entry will come down. Foreign banks have been making big money on fees on cross-border transactions but they refuse to take their eyes off the retail segment. Northern Rock's failure tells you why.

India Sparkling!

A government-owned power transmission company launches an IPO for around Rs 3000 crore. It gets bids worth Rs 190,000 crore. And these are said to be troubled times for financial markets! This is not India Shining, it is India Sparkling.

PowerGrid Corporation has nearly 45% of the share of power transmision in the country. But that in itself is not what is attracting institutional investors (this segment is said to have been oversubcribed 115 times). Investors are attracted by earnings growth. Investors see earnings growth potential in PowerGrid. That clearly means they expect to see more transmission, which means more power generation.

This perception is signification because the power sector has long been one of the areas of failure in the reforms era. Now, with mega-power projects going ahead, this sector is also poised for a sea-change. That would complete the overhaul we are seeing in every other segment of infrastructure- airports, ports, telecom, railways, roads. Investment in infrastructure and broader investment demand driven by infrastructure investment and improvements in infrastructure will be the key element in the India growth story in the next few years.

How NOT to promote financial inclusion

Financial inclusion is the talk of the day- everybody wants it, nobody knows how to make it happen.

In today's BS, Christopher Butel puts forward the sort of non-solution that market players often favour. He says that banks don't have much of an incentive to invest in branches and ATMs in under-served areas because the transaction volumes don't justify these investments.

I am not very sure. Banks really don't collect charges for volumes - issue of cheques or usage of ATMs of banks where they have accounts- unless volumes exceed a certain level. Even in urban areas, most people would tend to stay within the limit. I don't see how increasing transaction volumes hold the key to greater income for banks.

Suppose we grant this. How are we to increase volumes? Butel has two ideas. Let employers change the payment cycle- hand out pay in two instalments instead of a single payment every month. But wouldn't this increase transaction costs for employers and for employees? Are they to bear more costs so that banks can benefit?

Secondly, Butel wants some of the post office infrastructure to be made available to banks. That would help banks reach out without having to make big investments in infrastructure. Sorry, but India Post is planning to offer banking services itself, so why would it fall for such an idea?

One cannot help telling the corporate types: get real.

C Rangarajan on bank consolidation

Former RBI Governor and Chairman of the PM's Council of Economic Advisors, C Rangarajan, takes stock of the Indian banking sector in the first R K Talwar memorial lecture instituted by SBI and the Indian Institute of Finance.

R K Talwar was the legendary chairman of SBI in the seventies and must rank among the most respected figures in Indian banking. Rangarajan rightly refers to his pioneering role in the financing of small firms.

Talwar was just as respected for his integrity. He fell foul of the Indira Gandhi regime during the Emergency. The story goes that Sanjay Gandhi wanted SBI to grant a loan to one of his cronies. Talwar was not willing to oblige. The SBI Act was amended to permit the removal of the SBI chairman before his tenure had ended. Talwar did not wait to receive marching orders: he proceeded on leave and subsequently resigned.

To come to Rangarajan's views on bank consolidation. I note that Rangarajan is guarded on the subject. Yes, there will be possibilities for mergers but these should be driven by the market, not by government dictat, nor should banks consider themselves doomed if they don't go in for bigger size through mergers.

As the bottom lines of domestic banks come under increasing pressure and the options for organic growth exhaust themselves, banks in India will need to explore ways for inorganic expansion. This, in turn, is likely to unleash the forces of consolidation in Indian banking. However, there are two caveats.

<>First, any process of consolidation must come out of a felt need for merger rather than as an imposition from outside. The synergic benefits must be felt by the entities themselves. The process of consolidation that is driven by fiat is much less likely to be successful, particularly if the decision by fiat is accompanied by restrictions on the normal avenues for reducing costs in the merged entity. Thus, any meaningful consolidation among the public sector banks must be driven by commercial motivation by individual banks, with the government and the regulator playing at best a facilitating role.

Second, the process of consolidation does not mean that small or medium sized banks will have no future. Many of the Indian banks are of appropriate size in relation to the Indian situation. Actual experience shows that small and medium sized banks even in advanced countries have been able to survive and remain profitable. These banks have survived along with very large financial conglomerates. Small banks may be the more natural lenders to small businesses.

Market players try to estimate losses

One reason nervousness is rife in the international markets is that market participants do not have a clear idea of what their assets are worth- and how much losses they have incurred because of the turbulence in the market. This uncertainty, more than anything else, underlies the panic in the markets and the aversion to risk.

Incredible as it may seem, nearly a month after the problems began, banks and investment banks are yet to get a reasonable fix on their losses. Partly, this could be because they believe that disclosure could undermine market confidence. Partly is because the players themselves do not know what their assets are worth.

The latter is especially true of complex derivative portfolios. But banks and investment banks are also in a fix about valuing debt finance they had committed for takeovers and other purposes. Banks are stuck with large amounts of these debt- and interest rates have shot up. On a mark to market basis, these would entail huge losses. But banks are also trying to renegotiate rates with clients, so would like to delay the valuation.

Another issue is whether market players should be subject to uniform valuation norms. Central banks are inclined to believe this should so for banks. But the SEC, FT reports, would leave it to investment banks to use their discretion.

The SEC, which stepped up checks of how five of the largest US investment banks are valuing mortgage-related securities, is comfortable with valuations being different between firms – as long as their valuations are consistently applied and checked. “We don’t substitute our opinion for our firms’,” said one senior SEC official.

John Dugan, Comptroller of the Currency, regulator for some of the top US banks, gave a warning last week that banks should use market prices, rather than “models”, to value securities even if trading volumes were far below normal

.

As John Gapper notes in the FT, the market will soon provide solutions to these overhanging problems. There are funds being created to buy distressed debt at huge discounts. Historical experience suggests that returns on such purchases can be attractive.

There is probably a huge weight of money building up to clear the debt overhang that banks are now suffering. The reason the market is not already clearing is that banks are wary of selling off mortgage-backed debt at a huge discount now, only to watch the prices trade upwards again after a few months.

This game of chicken between wary sellers and astute buyers is bound to end at some point and, when it does, I suspect that liquidity will return to the debt markets as abruptly as it vanished this summer.

We should see plenty of action on this front once the first flush of panic subsides. I remain optimistic about the resolution of the present market crisis and the outlook for the global economy.

Economists who left a lasting impact- and who didn't

There's a terrific article by John Kay in the Financial Times on the two economists who last a lasting impact on their times- Keynes and Friedman, others- Schumpeter, Galbraith- who didn't and yet others- Sen and Stiglitz- who won't. No student of economics should miss it.

In a nutshell, Kay argues that academic leadership is not just about scholarly ability, it requires sustained effort in creating a school of thought and the ability to draw followers- in other words,
perseverance as well as human qualities. Otherwise, you remain a renowned scholar, not the founder of a school of thought.

Here's Kay's take on Schumpeter and Keynes.

Schumpeter rivalled Keynes in range of experience and subtlety of thought, and surpassed him in breadth of scholarship. But his impact on intellectual life and practical affairs was slight compared with that of his English rival......

Schumpeter knew that his rival’s work had far greater influence. His critical essay on Keynes in History of Economic Analysis both displays his bitterness and identifies the reasons for Keynes’s greater success. Schumpeter expresses genuine admiration for the courageous publication of The Economic Consequences of the Peace. Keynes was, Schumpeter recognises, a natural leader who gave others confidence and inspiration.

Schumpeter would observe of himself: “I singularly lack the quality of leadership – with a fraction of my ideas a new economics could have been founded.” That new economics did not happen. There would be a Keynesian school, a Keynesian economics, but no Schumpeterian school, and really no Schumpeterian economists.

As for the contest between Friedman and Galbraith, in terms of lasting impact, there was no contest- Friedman has won hands down.

In the generation that followed Keynes and Schumpeter, John Kenneth Galbraith (born 1908) and Milton Friedman (born 1912), were the two most prominent public intellectuals among economists. If Schumpeter is more admired than read, Galbraith is more read than admired.....

Like Schumpeter, Galbraith never had time or inclination for the university and the gift for dry, academic observation which was his stock in trade was best deployed in perpetual opposition. If Schumpeter lacked qualities of leadership, Galbraith chose not to exercise them.

The method of dissemination of the Chicago school (led by Friedman) was similar to that of the Keynesians: a relatively simple ideological message for communication to the world outside; a new, difficult, yet extensive theoretical framework; and a dedicated band of supporters who would entrench the doctrine in other economics departments.

What about Amartya Sen, Joseph Stiglitz and Paul Krugman, today's reigning gurus?

Sen is, in a natural sense, the Schumpeter of our times. He shows a breadth of erudition and subtlety of mind unparalleled among other economists. But, like Schumpeter, Sen is an isolated figure. There will be no Sen school. Nor, it would seem, will there be a school of Stiglitz: a generation of students looks for a counterweight to Chicago, but the school’s potential leader has not found the application to develop a coherent and comprehensive critique that such a leadership role would today require, or the aptitude or inclination for academic
politics. And the dissonance between Paul Krugman as polemical columnist at The
New York Times, and his professional work at Princeton, seems too great.

"Solutions" to the market crisis

You may not guess it from the buoyant state of the Sensex but international markets are still gripped by fear and uncertainty. There are some who believe that the most obvious solution- interest rate cuts effected by central banks- will not suffice, although central banks, and especially the Fed, have been careful in using this instrument.



I see two other solutions being tossed around:

• Fiscal intervention, that is, government bail-outs of distressed institutions, not just banks. This is based on the premise that interest rate cuts will not be adequate. In the US, the government-backed agencies such as Fannie Mae have been asked to step in to save mortgage institutions.


• A rescue of distressed institutions by private banks and investments a la the rescue of the hedge fund LTCM in 1998. An article in FT proposes the creation of something akin to an asset reconstruction corporation for various credit instruments for which there is no market at present.

What do we make of these solutions? First, I don't believe that the situation is so bad that fiscal intervention will be widely required. As for private institutions doing a rescue act, don't forget that LTCM was rescued under "moral suasion" exercised by the Fed, it wasn't entirely voluntary. For banks to do so now, they would have to be convinced that this is a profitable exercise. As the FT article makes clear, there is a problem in making this determination: it's very hard to put a fair price on many of the distressed credit assets.

I don't see private banks, accountable to shareholders, undertaking this task. The first order of business, really, is for all concerned parties, to come clean on their distressed exposures. Only then can central banks get a fix on the magnitude of the problem. Central banks must make liquidity available. Some banks may have to be bailed out.

That's about it. For the rest, we should wait for some of the panic to subside- and like grief, it will over time. Then, private parties will swoop on attractively valued distressed assets and the clean-up will begin. There is enough capital sloshing around to do this job. Governments are not required to do this. And private firms need not be mandated to do so.

As you can see, I'm rather more optimistic about the resolution of the present uncertainty than many others.

Analysts back in favour !

Analysts were in the doghouse after the American stock market bust of 2001. There were sweeping changes in the leading investment banks relating to research (including the much-trumpeted separation of analysts from investment bankers). Now, the Economist reports, analysts are back in demand. For various reasons:

• In bad times, analyst calls and research in general are more valued than in good times- in good times, everybody is just focused on piling on to the usual stocks.
• Analysts performance is better monitored and rewarded at investment banks with bold (and correct) calls earning high bonuses.
• Quantitative models have performed badly of late leading to a revival of "fundamental analysis".

The Economist contrasts the improved performance of analysts with the miserable performance of the rating agencies.

The audacity of some analysts stands in contrast to the spinelessness of Moody's and Standard & Poor's, which showered complex structured products with top-notch ratings and then twiddled their thumbs until they could no longer avoid downgrading them. By growing too cosy with their paymasters in structured products—the banks that package them—the rating agencies have ended up hopelessly in knots. A bit like equity analysts during the dotcom boom, in fact.

.

Chinese firms vault to the top!

The dizzying rise of the Chinese stock market has propelled Chinese firms to the top in terms of market capitalization, according to the Economist.

China has three companies now in the world's top ten- Industrial and Commercial Bank of China, Petrochina and China mobile. All but two of the rest are American. ICBC has overtaken Citigroup as the world's largest bank.

The Economist, however, sounds a warning:

In 1989, just before its bubble bust, six of the world's ten biggest banks were Japanese. Look at what happened to them.

Defining the 'basic structure' of the Constitution

'Judicial overreach' has become a vexed issue for the political class and even those outside it will agree that the judiciary sometimes goes overboard in its activism. More than anything else, the Supreme court's ruling in 2007 ( IR Coelho vs state of Tamil Nadu) has the potential to create big waves on this subject.

In that case, the SC ruled that the power of judicial review extends to the Ninth Schedule of the Indian constitution. Under the Constitution, as amended in 1951, legislations inserted into the Ninth Schedule cannot be challenged on the ground that they violate the fundamental rights of the Constitution. In the 2007 ruling, however, the SC pronounced that it had the power to review legislations in the Ninth Schedule if they violated the 'basic structure' of the Constitution. The doctrine of 'basic structure' was propounded by the SC in the now famous Kesavananda Bharati case in 1973.

In the EPW (August 4-10), Madhav Khosla notes that following the ruling in the Coelho case in 2007, it is now open to the SC subject all legislations incorporated into the Ninth Schedule post April 24, 1973 to judicial review. One immediate implication, as others have pointed out, that the provision of quotas upto 69% in Tamil Nadu can now be challenged.

Khosla believes that, given the record of judicial activism in the recent past, such 'unbridled power of judicial review' is not desirable. He suggests that the SC clearly define what it means by 'basic structure' instead of preferring to apply the test of 'basic structure' on a case by case basis.

I am no legal expert but I doubt that it is possible or desirable for the SC to define the 'basic structure' to encompass all possibilities. Situations could arise that are incompatible with the spirit of 'basic structure' but that had not been taken into account in any definition. It is far more preferable for the courts to exercise judicial restraint and, of course, to push ahead with proposals to usher in greater accountability in the judiciary in general.

Was Jinnah secular?

I suppose this is one of those questions that will be never settled like the one about partition being inevitable. People will keep coming up with answers based on whatever new information is unearthed.

In EPW (August 11-17), Pervez Hoodbhoy tries to answer the question: was Jinnah only in favour of a Muslim majority state (where non-Muslims would have equal rights) or did he want an Islamic state?

Much is made of two speeches where Jinnah is seen as expressing himself against a theocratic state. However, sifting through Jinnah's various pronouncements at other times, the charitable conclusion that Hoodbhoy comes to is that Jinnah preferred to maintain ambiguity on the subject. He was not beyond declaring that Pakistan would be governed by the fundamental principles of the Shari'ah when it suited him.

Hoodbhoy contends that Jinnah's ambiguity was aimed at retaining leadership in Pakistan- had he been entirely forthright in his views, he may not have been able to do so. More interestingly, Hoodbhoy argues that even if Jinnah favoured an Islamic state, that would not be saying much given that the true nature of the Islamic state has been highly contentious in history.

I am surprised that Hoodbhoy does not state the obvious. Having propagated the two-nation theory, it would have been difficult for Jinnah to argue wholeheartedly in favour of a secular state. If such a secular state was possible, why create a separate nation in the first place?

Hoodbhoy concludes:

He (Jinnah) certainly did not want a theocracy or a Taliban state, nor
one in which the non-Muslim minorities would be persecuted and harassed (as they are today). But Jinnah's statements at different times and circumstances are far too widely spread out to conclude anything substantial beyond these
truths.

An exit tax for IIT/IIM products?

I wouldn't have thought brain drain would be a big issue today, seeing that we are seeing a modest return of highly qualified NRIs. Apparently, it is.

Outlook magazine has a story on the parliamentary standing committee of the HRD ministry considering an "exit tax" or IIT/IIM graduates leaving the country:

The panel's report, submitted to Parliament last week, has sparked off a heated debate within government and academic circles. Some feel students who enjoy the benefits of a highly subsidised education should serve the country—or be penalised. Others find the proposed tax impractical, impacting only poorer students who may be unable to pay up even though they get lucrative job offers or scholarships from abroad.

............ an IIT graduate pays Rs 40,000 per annum as fees while the state spends nearly Rs 1.50 lakh on him for the period. The state subsidy for an IIM student is higher at Rs 3.5 lakh per annum. Interestingly, almost a year before passing out, students from these premier institutions are wooed by companies with annual salaries of at least Rs 6 lakh—it's higher for those going abroad. So, isn't the state fair in asking for its share, runs the argument.

These arguments are not new. But the implementation issues have been formidable. At what point is the tax to be collected? Is a candidate expected to make a declaration to the Income tax department that he or she is an IIT/IIM product and leaving the country and, therefore, wishes to have a clearance certificate? What if the compensation is understated? Is the passport supposed to carry a stamp saying the candidate is from IIT/IIM? In the case of fresh graduates leaving immediately after graduation, they may not have the resources to pay the tax. So, are they expected to raise a loan? Will banks provide loans to departing individuals? And what about graduates who return after a few years' experience? Are they eligible for a tax refund? And why only IIT/IIM products?

Get the idea? The more you think about it, the more you realise the problems in implementing such a scheme. And what would the total collection amount to? Would it serve any purpose other than satisfying some people that a 'penalty' has been imposed on those betraying their 'lack of patriotism'?

I must mention here that there is already a means available to the IIMs to recover some of the subsidy incurred on their products. There is a fee that is levied on recruiters and the fee has risen steeply for foreign recruiters. Perhaps, this can be jacked up even further. The graduate does not pay out of his or her pocket but the institution does recover some of the subsidy. The calculation of the subsidy itself is a vexed issue and there is reason to believe that the figures tend to be inflated.

Some of those interviewed by Outlook think the answer is to phase out the subsidy through higher fees. That is clearly not the way to go, in my view. The IIMs accepted this when they agreed to take care of a portion of the costs of those coming from families with an income of less than Rs 2 lakh. Any increase in fees at the IITs and IIMs will mean an increase in fees in all other institutions and this will undoubtedly go against the idea of greater inclusion in higher education. It will not just not fly with the political class- so forget about higher increase in fees.

I also think that we can afford to be a little more relaxed about the issue of 'brain drain'. Indian professionals who go abroad contribute in various ways: they send remittances, they create networks between foreign firms and Indian firms, they play a role in getting foreign firms to invest in India and, over time, there is diffusion of the intellectual wealth they create abroad. So the "loss" on account of brain drain, it turns out, is not as high as was previously supposed.

Not least, the departure of these brains has not come in the way of India touching a growth rate of 9%- so what are we fretting about? Let me put it this way. When India was trapped in a growth rate of 3.5%, we didn't do anything about the emigration of highly qualified professionals. It does seem a little odd to think of an 'exit tax' at at time when the Indian economy is doing much better and professionals are also thinking twice about leaving.

I say: tax the recruiters through stiff fees at the campuses- and leave it at that.