The Economist on India's bureaucracy

Bashing the Indian bureaucracy is pretty much in fashion today, so one is not surprised to find the Economist weighing in:

Some economists see India's malfunctioning public sector as its biggest obstacle to growth. Lant Pritchett, of the Kennedy School of Government at Harvard, calls it “one of the world's top ten biggest problems—of the order of AIDS and climate change”.

....In India's corrupt democracy, the collectors' burden is made much heavier by interfering politicians. The problem is most grievous in north India, where civil servants tend to attach themselves to politicians for enrichment, advancement—or in despair of otherwise getting their jobs done.

The reasons trotted out for poor performance are familiar enough: declining quality of recruits (one is not sure how far this is true, the IAS remains extremely competitive), poor pay, interfering politicians, permanence of tenure, etc. But those who criticise the bureaucracy need to do some explaining: if it is all that bad, how come Indian economic growth has sprinted over the past two decades? Do we give the bureaucracy some credit for this or not?

The Economist notes that significant downsizing has taken place: some 750,00 jobs remain unfilled, so a leaner bureacracy is supporting higher volumes of work. Just to look at the brighter side, let me mention two areas where the bureaucracy does deliver. One is disaster management- the response to major catastrophes is much better in India than in many other parts of the world (think of the US response to the hurricane in New Orleans). The other is the conduct of elections in remote, insurgency-infested areas.

These are not the work of the office corps alone. It's the people down below, the much maligned clerks and peons, who contribute a great deal. Surely, there must be some merit in a system that can produce outcomes in these two situations?

It's only the markets, stupid

Markets are crashing everywhere, including in India. Watching stock price declines on TV screens, it's easy to think this is the end of the world.

Hold on. Markets are only an imperfect barometer of the economy. They may get the direction right but not the magnitude. So, a falling market could indicate a slowdown but a crash need not mean a recession. Similarly, a sharp rise in the market does not mean growth has accelerated. Asset prices are prone to "overshooting" in either direction.

I emphasis this because the recent crash in the Indian stock market is being interpreted by some as sign of a serious slowdown- to say 7% or even 6%. People point to the decline in industrial growth rate in January and see this is as confirmation.

I am not sure that the prospects for either the Indian economy or the world economy are as grim as some are painting it. My detailed comments in my Et column, Is it just a blip or a slowdown?

Was Bear unlucky?

Liquidity risk explains Bear's downfall more than any other factor. Bloomberg has some interesting statistics on this. Model-derived assets that are hard to value, known as level 3 assets, amounted to 239% of Bear's equity. But other investment banks seem to have about the same levels. They are safe- so far. The Fed announced a special facility for prime brokers only after Bear's collapse. That may have saved Lehman. But Bear was allowed to go under. Was Bear unlucky? John Gapper, writing in FT, puts it all down to poor leadership.

So Lehman got more support than Bear. But you make your own luck and Lehman had already taken firmer action to bolster its balance sheet – its cash cushion was double the size of Bear’s. It also mounted a tough and disciplined campaign to reassure the waverers; on its Tuesday results call Erin Callan, its 42-year-old chief financial officer, rattled off lots of figures to prove its strength.

Bear’s leaders were nothing like as hard-working or assertive in defending their bank in the year leading up to its demise. Mr Schwartz, a laid-back corporate financier and former analyst who lacked any experience of running a securities trading business, had put more effort into outreach but lacked the time, and perhaps the appetite, to fight back effectively.

The truth is that Bear’s leadership was old, self-satisfied and inbred. It had become used to telling the same jokes, travelling to the same bridge tournaments and treating the rest of Wall Street with disdain. And when the going got tough, it allowed its institution to perish.

Gillian Tett, writing in FT, has a slightly different take. She thinks Bear Stearns became a "sacrificial lamb" in the Fed's efforts to stabilise the market. The Fed had to organise a rescue of Bear; at the same time, it had to guard against moral hazard. Rescuing Bear while wiping out shareholders seemed the best course:

In place of a tethered goat, in other words, we now have a stricken Bear being offered up to attone for Wall Street sins – and, perhaps, slay the demons of moral hazard, at the same time.

Hmmm, sounds plausible. Could it be also that Bear paid the price for its hauteur and aloofness on Wall Street? Remember, Bear Stearns was the only top investment bank to refuse to get involved in the LTCM rescue orchestrated by the Fed in 1998. It ignored a key maxim for all financial players: always stay on the right side of the regulators

Lessons from sub-prime crisis (contd)

I had a post earlier on this topic. The Economist reviews a book, The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash -Charles R. Morris, that makes a number of suggestions:

He offers a raft of suggestions: originators should retain the riskiest portion of securitised loans; prime brokers should stop lending to hedge funds that fail to disclose their balance sheets; trading of credit derivatives should be brought onto exchanges for the sake of safety, even if this raises costs; and some version of the old Glass-Steagall act, which separated commercial banking and capital-markets activities, should be re-introduced. Ultimately, he argues, after a quarter-century of “market dogmatism” it is time for the regulatory pendulum to swing the other way.

The Fed crosses into new territory

The Fed broke new ground this week in trying to avert a financial collapse. First, it took direct exposure to Bear Stearns' assets worth $30 bn- people would be justified in viewing this as quasi-nationalisation.

Secondly, it created two new faciliies allowing it to act as lender of last resort to non-bank financial institutions- in this instance, primary dealers. John Berry of Bloomberg describes these:

Aside from helping in the sale of Bear Stearns, the extraordinary actions the Fed took included creation of a term securities lending facility on March 11 and a primary dealer credit facility on March 16.

Both involved the group of 19 securities dealers known as primary dealers — companies that have qualified to participate as counterparts in the New York Federal Reserve Bank’s daily open market operations used to keep the federal funds rate close to the FOMC’s chosen target. Bear Stearns was on the list until its abrupt sale.

Under the first facility, the dealers will bid at weekly auctions beginning March 27 to obtain 28-day loans of Treasury securities in exchange for certain other collateral such as mortgage-backed securities insured by Fannie Mae and Freddie Mac. There will be separate auctions for exchange of Treasuries for AAA/Aaa-rated private label mortgage-backed securities that are not on review for downgrade.

The point is to take some of the pressure off the stressed mortgage-backed securities market. The other facility began yesterday to give primary dealers access to overnight credit from the Fed in exchange for collateral such as mortgage-backed securities, municipal securities and investment grade corporate securities. Normally, only financial institutions can borrow directly from the Fed.

Valuation of Bear Stearns

They say Bear was sold for a song- around $230 mn. Not true. JP Morgan has taken a charge of $6 bn, so the cost comes to $6.3 bn. The building costs $ 1bn. So, we could say the financial assets were valued at $5.3 bn. Last week, the market was a little over $7 bn. So, we are talking a discount of 25% to market price before this week's run on Bear. I read that Sanford Bernstein had valued the bank at $7.7 bn before this week's crisis.

Nothing wrong with the valuation- except that Bear shareholders have almost wiped out.

Alan Greenspan on risk management

The erstwhile Oracle of the Fed holds forth on risk management in FT:

I do not say that the current systems of risk management or econometric forecasting are not in large measure soundly rooted in the real world. The exploration of the benefits of diversification in risk-management models is unquestionably sound and the use of an elaborate macroeconometric model does enforce forecasting discipline. It requires, for example, that saving equal investment, that the marginal propensity to consume be positive, and that inventories be non-negative. These restraints, among others, eliminated most of the distressing inconsistencies of the unsophisticated forecasting world of a half century ago.

But these models do not fully capture what I believe has been, to date, only a peripheral addendum to business-cycle and financial modelling – the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve. Asset-price bubbles build and burst today as they have since the early 18th century, when modern competitive markets evolved. To be sure, we tend to label such behavioural responses as non-rational. But forecasters’ concerns should be not whether

Bear Stearns' collapse- LTCM all over again !

Bear Stearns, one of the top five investment banks in the US, ends its 85-year old existence as an independent bank. JP Morgan announced on Sunday that it is acquiring the firm for $2 per share or a total value of $235 mn. This does not reflect the full cost to JP Morgan. Bear Stearns faces several lawsuits relating to the collapse of its hedge funds, so Morgan has to set aside $ 6bn towards litigation costs. Morgan acquires the $1 bn headquarters of Bear.

What a fall, my countrymen! Bear's share was valued at $169 last year and $30 last Friday. Bear's top management and hundreds of employees who have been rewarded heavily through stock options- think of what happens to their investment!

Jimmy Cayne, the chairman, himself was said to be poorer by more than half a billion dollars in a week's time. His holdings were worth $ 1 bn at one time. Now, it's said he gets all of $12 mn. People will say he asked for it- he must bear responsibility for pushing Bear into high-risk mortgage securities. That's not all. FT reports that JP Morgan is likely to sell off many of the pieces of Bear, including the investment bank, and lay of many of Bear's 14,000 employees.

Bear Stearns was different on Wall Street. It did not rise to the top meteorically. It clawed its way gradually without fanfare, without headline-grabbbing acquisitions, for instance. Its management culture was distinctive. It was an aggressive risk-taker and prided itself on its ability to manage those risks. Insiders used to talk of 'sweat sessions' between top management and leading traders where management would grill traders on their positions- the grilling was so intensive that those who concealed anything would start sweating.

Until about a decade ago, Bear shunned MBAs and management consultants. It hired ordinary guys with spunk and trained them to deliver. Base salary for top management was among the lowest on Wall Street; the firm believed in heavily compensating those who delivered. A big chunk of the firm's shares were held by employees awarded stock options over the years- that's why Bear's collapse will hurt its employees even more. Bear was also less diversified than other Wall Street firms and less international in its operations. But it kept shareholders happy year after year until it was undone by the disaster that hit its hedge funds recently.

Did Bear deserve such a fate? Of course, it was highly leveraged. Its capital of %11 bn was used to support a balance sheet of nearly $495 bn. But that's not new. Lenders have been happy to make funds available to Bear. It's just that, in today's conditions, confidence is scarce. That makes all the difference to a highly leverage institution.

Rumours have been rife about Bear's troubles, so every lender wants to pull out. The only way Bear can meet their demands is to sell assets. Asset prices tumble, the liquid assets disappear and then only illiquid assets are left. A liquidity problem quickly becomes a problem of solvency. Those who watched the collapse of LTCM will have a sense of deja vu.

Farm loan waiver: net impact on banks

Okay, the FM has given the details of the farm loan waiver package. I notice that the commercial banks' exposure in the overdues of Rs 60,000 crore is 35% or nearly Rs 21,000 crore- a lot higher than the figure of Rs 10,000 crore that papers had mentioned earlier. Cooperatives and regional rural banks account for the rest.

As for the package itself, the government will provide cash to lenders as follows:

• Rs 25,000 crore in 2008-09
• Rs 15,000 crore in 2009-10
• Rs 12,000 crore in 2010-11
• Rs 8000 crore in 2011-12

I am still not clear as to whether the Rs 60,000 crore constitutes gross NPAs or net NPAs. The figure is said to constitute "all farm overdues" in the eligible categories. That sounds like gross NPAs.

This means that banks that have made provisions can write back these provisions and make gains as a result. But, in 2008-09, they will have to write off the entire amount, including the unprovided portion. So, in 2008-09, their bottomline will take a hit in net terms. In the subsequent years, there will be gains to the bottomline as cash flows in against amounts written off.

However, if the banks are writing off Rs 60,000 crore, the compensation in present value terms is smaller than this amount. Banks will gain to the extent of provisions already written off; they will lose to the extent that the compensation is less than Rs 60,000 crore in present value terms.
It's hard to say what the net effect is. Probably a small gain, although this could vary from bank to bank. On the whole, listed bank stocks should gain.

Some rosy forecasts for the Indian economy

Interesting.....Investment banks' and commentators’ pessimism about the outlook for the Indian economy in 2008-09 is not shared by others. J P Morgan has revised its GDP forecast for India downwards to 7% for 2008-09.

In contrast, Finance minister P Chidambaram thinks the Indian economy will grow at 8.5% this year. So does the PM’s economic advisory council headed by C Rangarajan. India’s chief economic statistician, Pronob Sen, forecasts growth of 8%. The CMIE expects growth of 9.1%, higher than the 8.9% it projects for 2007-08!

Fair value accounting in the financial sector

I have flagged this issue before. Fair value accounting has come to the fore as a vexed issue in the present financial market crisis. Loans are not marked to market, so banks should not have had to worry. But they hold marketable securities and have huge positions in derivatives, both of which are marked to market. That is why banks- and not just investment banks or hedge funds- are feeling the heat this time around. FT carries a detailed report:

As the losses rise, anxiety is growing over the way these hits are being
measured. At present, accounting is dominated by a concept of “fair value”: companies are expected to report the value of their holdings in as “current” a manner as possible, which in practice means marking to market prices.

However, there is mounting concern that this approach creates distortions when markets are as dysfunctional as they are now. Indeed, some bankers fear that the system is actually making the crisis worse. Far from offering a reassuring yardstick, it is forcing banks and hedge funds to sell assets in a manner that is stoking investor panic...

...Many investors are sceptical about the accuracy of models used to
estimate the price of untraded assets. “When markets dry up there are problems with mark-to-market disclosure because there are no markets. Then people have to use mark to model but there are big problems with that too,” observes Charles Goodhart, professor of finance at the London School of Economics.

US will avoid recession?

I don't get this. When US economic prospects looked grim a couple of months, the stock markets seemed not to notice. Now even the occasional good news, including the Fed's determined effort to stave off recession, gets shrugged off by the markets.
I am among those who believed- and still believe- that the US economy could ride out the financial crisis without a serious slump. The University of California's quarterly Anderson forecast, released this week, is upbeat compared to some of the other stuff we have seen recently. The forecast expects US GDP growth of 1.5% this year, rising to 3% next year. Growth in 2007 was 2.2%.

The other good news comes from the Fed. The Fed still believes that the US will avoid a deep and prolonged recession such as that experienced by Japan in the nineties. Why? Because US policy makers will do what it takes to avoid recession.

Joy on Wall Street!

Wall Street continues to be rocked by the sub-prime crisis but there is some joy from an unexpected source. Mark Spitzer, Governor of New York and former attorney general of the state, is in trouble over his alleged involvement in a high class prostitution ring. Spitzer has tendered an apology of sorts and is under pressure to quite after federal wire-taps are said to have implicated him as a client of the prostitution ring.

Spitzer went after Wall Street firms in a big way and was responsible for the multi-billion dollar settlement with top firms after the Internet bubble collapse in 2002. Spitzer also prosecuted those involved in two prostitiution rings at the time. Seeing this crusader of yesteryear the receiving end has given some delight to investment bankers who took some pounding from him.

Legions of Wall Street’s bankers, traders and investors relished the dark clouds enveloping New York governor Eliot Spitzer, who on Monday informed his most senior administration officials that he had been tied to a prostitution ring, the New York Times reported.

.....“The guy is a quintessential hypocrite,” said Jeffrey Gundlach, chief investment officer of TCW Group in Los Angeles, which invests $160 billion. News of Spitzer’s political fall from grace, however, did little to lift the mood on Wall Street. “I would think the markets would rally off this news as it brings some relief to Spitzer’s dealing with Wall Street and traders,” said Gundlach of TCW

Incidentally, bashing Wall Street has been one sure route to high office in the US. Spitzer is not the only one to have made it big. He was only following in the footsteps of former New York Rudolph Guiliani who made a name for himself in an insider trading scandal when he was New York attorney general.

Objections to loan waiver scheme

I read that the financing of the loan waiver scheme announced in the budget has been firmed up. The FM will disclose this to parliament on March 14.

I have been a guarded supporter of the scheme as readers of this blog would know. I think it's a good scheme as long as the burden is borne by the government and not by the banks.

In the meantime, I have seen a barrage of criticism, mostly misplaced. In TOI on Sunday, Gurcharan Das called the scheme 'immoral' saying that the government should not break the bond of commitment that the borrower has towards the lender. As immoral, I suppose, as the US Treasury which has asked banks to restructure many of the sub-prime debts.

The contractual relationship between borrower and lender is redone all the time- it may not be at the best of the government. But when this happens to businesses, there's not a squeak from anybody. Think of some of the big names in Indian industry that have benefited from such restructuring, which often includes sacrifices from banks.

Das says that hereafter farmers will not have incentives to repay. Not true. As we know in the case of businessmen, you can get away with default only once. Once you default, you lose access to credit. So there are huge penalties to wilful default. This holds for farmers as well. I would only say that we should extend the newly created credit bureau to the rural areas and keep tabs on individual payment histories to strengthen incentives to repay.

Swaminathan Aiyar, writing again in the Sunday TOI, says that banks will hereafter be wary of making loans to farmers and such loans will be hard to come by. Not necessarily. Most of the bigger banks are government-owned. Both government and the RBI will be leaning on banks to meet loan targets (which is why rural credit has doubled in the past three or four years). Banks may try to get around this by avoiding small farmers but keeping separate targets for each category of farmer could address this issue as well.

Aiyar also says that farmers who have been repaid loans will be angry that others are being cosseted and this will cost the UPA dearly at election time. Do businessmen, who have repaid loans, get upset when businesses in distress get special treatment from banks? I don't know why farmers should behave any differently.

Subir Gokarn, writing in Business Standard, says that we need to ensure proper incentives hereafter giving a concessional rate on fresh loans to those who have made repayments this time. This makes sense- and indeed ties in with the idea of a credit bureau I mentioned above that will monitor payment histories.

The scheme brings a smile to farmers' faces. Banks will have their balance sheets cleaned up. Government can minimise the burden to itself by raising funds through disinvestment- and seeking the Left support for this, saying it's for a good cause. It's win-win for the most part. Who loses? Economists and columnists!

No housing bubble in India

Housing prices elsewhere have collapsed. There has been talk that India might witness such a correction. Rubbish. There's no real estate bubble here, as Keki Mistry, MD of HDFC pointed out recently.

True, housing prices have shot up. True also that EMIs have gone up thanks to the increase in interest rates. But, compare affordability- income in the relevant segment to EMIs- with those of 15 years ago and you realise how far we have travelled. This ratio is 4.9 today, according to Mistry, compared to nearly 15 about ten years- an improvement by a factor of three!

Affordability is better for a number of reasons:

• Sharp increases in income
• Lower interest rates
• Tax incentives for housing

Remember this the next time somebody comes up with a doom scenario for India arising from a collapse in housing prices similar to what we have seen elsewhere.

Exaggerated bank 'losses' in sub-prime crisis

ICICI Bank makes a provision of $265 mn against mark-to-market positions. The stock tanks- and so does the Sensex. Does this make sense?

I think not. There is huge overshooting of asset prices in panic conditions- that is, prices go well below "fair" value. Naturally, mark-to-market losses will be commensurately high. Once the market bounces back, these provisions will be written back.

We have it on the authority of Fed Chairman, Ben Bernanke, no less, that bank writedowns have been overdone in the present crisis. He said as much in his congressional testimony on February 28. How does this happen? Many of the assets are not traded. So marking to market is done using certain indices. These indices' movements don't correctly reflect actual losses. One analyst points out that one index shows an 8% potential loss in commercial real estate when the real loss has been one quarter of 1%. As the Yanks would say, the thing sucks.

There is a larger issue here: how do we enforce mark-to-market requirements in such crisis situations? As Gillian Tett points in the FT, "The western financial system is caught in a trap. On the one hand, there is an urgent need for clearing prices to be established for impaired assets to restore confidence; on the other hand, if this is done in a mark-to-market world, there is a risk that some banks will run out of capital."

One solution proposed is a six month grace period for marking to market. But this could undermine investor confidence- people won't know what sort of losses a bank is hiding. I can't see an easy way out. But I am glad we don't have mark-to-market requirements for bank loans although investment bankers have long demanded this in the interest of having a level playing field between investment banks and commercial banks. Can you imagine the havoc that could wreak in such conditions?

Coming back to ICICI Bank, the stock price is close to its last FPO price. If I were an analyst taking a long view, I would put a 'buy' recommendation.

PIL challenge to loan waiver scheme

The Supreme Court has refused to hear a challenge to the Rs 60,000 crore farm loan scheme proposed in the recent budget, TOI reports. Chief Justice Balakrishnan said that the SC could not entertain the PIL at the present stage when the proposal was being discussed in Parliament. Any hearing could happen only after the proposal had been approved by Parliament.

However, the TOI reporter says that the legal challenge could still continue. He points out that in the case of Mandal II, a bench of the SC decided to entertain a challenge even before the relevant Bill had been passed by Parliament:

Going by Justice Balakrishnan's reasoning, the PIL should not be entertained till at least the proposal is pending in Parliament. In other words, it should be dismissed outright. But since it could come up before any of the benches, there is no predicting the outcome of the PIL.

Barely two years ago, a bench headed by Justice Arijit Pasayat entertained a PIL on another contentious issue, Mandal II, even before the Bill concerned was introduced in Parliament. And when the Bill was subsequently introduced, Justice Pasayat stretched the system to the extent of telling Parliament not to proceed with it till the court decided its validity. It was only after the government's counsel protested that the judiciary could not interfere with legislative functioning, Justice Pasayat toned his order down to saying that a copy of the parliamentary standing committee's report on the Bill should be "placed in a sealed cover before this court."

In the event, the sealed cover was rendered meaningless as the government gave the report to the court only after it was tabled in Parliament.

The general rule, however, is that since a Bill is merely a proposal and not legislation, it falls outside the domain of the courts. This is because a Bill has no legal force and is liable to be changed or even dropped by Parliament.

As for the farm loan package itself, I think the opposition to it is overdone. The cost of Rs 60,000 crore is eminently affordable. It is a one-time cost whereas the tax deductions given on income tax - which would amount to Rs 4000 per month for those earning more than Rs 10 lakh- are forever. My main concern, as I point out in my Et column, is that the banking system should not be loaded with the cost. The government should pick up the tabs.

There are , of course, many implementation issues. Farmers who have repaid their loans are being penalised. So are banks that have already made provisions. But the point about such packages is that you help those in distress. Those who can pay or who can cover the cost do not need government support.

There are other issues. Distress may not have to do only with the size of the farm- somebody with over 5 acres in a rainfed area may be worse off than somebody with a small farm in an irrigated area. I have also seen reports that the package may not help those who have borrowed heavily from money-lenders. Note, however, that the Radhakrishna committee on distressed farmers had favoured help to this category as well through a long-term loan.

Code on bankers' pay

As somebody who was amongst the earliest to raise the issue of incentives in banking as a source of instability, I am gratified to note that a code on bankers' pay is under consideration at the Institute of International Finance.

Ideas being floated include bonuses being deferred until the full impact of bankers’ strategy is clear to prevent them benefiting from short-term high-risk bets that subsequently turn sour.

Another variant would see those who lost money for their businesses having to earn it back before they secured new bonuses. However, the concept is likely to prove highly controversial, particularly among investment bankers in London and New York. “It does not sound workable,” said a senior Wall Street executive, who argued that it was highly unlikely Wall Street banks would agree to any kind of uniform compensation rules for fear of giving up a competitive advantage.

Centre's subsidy bill

How large is the central government's subsidy bill? The latest budget papers show a figure of Rs 66, 537 crore. Fertiliser and food subsidies acount for Rs 32,000 crore and Rs 31,000 crore respectively. Then, there are petroleum, interest and other subsidies.

In addition to these figures, the budget shows off-balance sheet bonds on account of over Rs 18,000 crore. This is just 0.3% of GDP. According to the Economic Survey, subsidies as a proportion of GDP have been declining over the years- they have come down from 1.7% of GDP in 2002-03 to 1.1% in 2007-08. Add the 0.3% of off-balance sheet subsidies to the figure of 2007-08 and it is 1.4% - still lower than the figure of 2002-03. So, it does appear that even if the absolute amounts of subsidy are going up, as a proportion of GDP, subsidies have, in fact, been contained.

The fly in the ointment is the estimate of off-balance sheet subsidies. The PM's Economic Advisory Council estimates off-balance sheet bonds on account of subsidies at 2% of GDP, way above the government's figure of 0.3% of GDP. The IMF had estimated at 1.2% of GDP.

The differences arise because the government has not met its subsidy commitments in full. But these commitments have to be met and we should expect more issuance of bonds. If we add the EAC's estimate of 2% of GDP to the figure shown in the budget, the total cost comes to nearly Rs 3.2% of GDP. That would be a significant increase over the level of subsidies in earlier years.

We need some clarity on the total amount of subsidies- in the budget and outside it.

What is the correct fiscal deficit figure?

The budget for 2008-09 shows a fiscal deficit to GDP ratio of 2.5%. Critics scoff at this figure. They say it does not include three things: the proposed loan waiver of Rs 60,000 crore, the Sixth Pay Commission report and off-budget subsidies.

The details of the loan waiver, we are told, will be revealed later. The key issue is what proportion of the burden will be borne by the exchequer and what proportion by banks. The costs of the exchequer, it is reasonable to suppose, will be borne through the issue of bonds. That too in instalments. Assume that Rs 40,000 crore is the burden on government and this is borne over three years. The annual impact of the fisc would be insignificant- 0.3% of GDP.

The Sixth Pay Commission is estimated to cost around 0.5%of GDP annually. Arrears may be staggered over a few years.

The FM claims that,for the first time, there is transparency in respect of off-balance sheet subsidies. These are shown in 'budget at a glance' at around 0.35% of GDP. The PM's Economic Advisory Council estimates these at 2% of GDP. Queried on this point by Business Standard, the FM retorted that the question should be put to the EAC!

Where lies the truth? Well, the FM js technically correct in that the figures shown in the budget show the value of bonds issued thus far. But the bonds issued so far do not cover the dues payable to fertiliser and oil companies in full- this figure is the correct figure for contingent liabilities of the government of India because the government is committed to paying these.

If the disclosure in the budget is what is meant by transparency, we can do without it.

Incidentally, going by the above assumptions, the adjusted fiscal deficit would be closer to 5.5% of GDP if you include the value of subsidies payable in full.

Some thoughts on the Economic Survey (2007-08)

The Economic Survey came out yesterday and I was on CNBC TV to give my comments.

There are a couple of issues I would like to flag. The Survey notes that we could achieve one of the FRBM targets by 2008-09, namely, the reduction in fiscal deficit to 3% of GDP. We are unlikely to meet the target of reducing revenue deficit to zero. I have a problem with the suggestion that we should consider even further reduction in the FRBM targets.

What's the rationale for a further reduction? The Survey argues that such a reduction would make monetary policy more effective- it would be easier to bring down interest rates. I do not find this line of argument persuasive.

We have had even higher levels of fiscal deficit in the post-reform years and yet interest rates declined. Why? Because in an open economy, interest rates are not determined only by domestic savings- we have access to savings from outside. Secondly, as the Survey itself notes, there has been a trend towards narrowing of the interest rate differential between India and the developed world in recent years.

The danger with pursuing the Survey's line of argument is that we lose out on a key item of expenditure, public investment. As I argued in my recent ET column, I actually favour a relaxation of the FRBM limit so as to permit larger public investment in infrastructure (and here I include investment in agriculture) which has been languishing in recent years.

This will upset fiscal purists. But the point is that we should not get carried away by slippages in respect of deficit targets at the center. The states have been doing better than expect and as a result the combined fiscal deficit of the centre and the states, which is what we should be focusing on, is likely to be within the 6% limit stimulated by the Eleventh Finance Commission by, say 2008-09- perhaps even if we include off-budget bonds and the Pay Commission impact !

All our deficit targets were set at a time when the optimistic expectation was of growth of 7-7.5%. Once you move into the 85.-9% range, you have that much more flexibility in respect the deficits you can run up. Timidity is likely to be our greatest enemy.

The other comment is about the laundry list of "reforms" that the Survey proposes. I notice that this is no longer the list we saw through the nineties and until a few years ago- cuts in subsidies, downsizing of government, labour market reforms, privatisation, all taken straight out of the infamous "Washington Consensus".

No, today's list includes a more liberal FDI regime for insurance, retail trade and banking, private sector entry into coal, deregulation of fertilisers, sugar and drugs, etc. Now, we can debate the merits of these proposals but how critical are these to growth? Are they saying that we can't get to 9% growth without these? If they are, then they are dead wrong.

None of the earlier "reforms" was seriously implemented and yet we move from 6.5% to 8.5%. I daresay that without the latest set of reforms we will get to 9%. Stay focused, I say, on creation of capacity in physical and social infrastructure and growth will take care of itself.

Are corporate leaders noble souls?

Look at material on corporate leadership and you will find loads of stuff on "values", empathy, caring, integrity, social responsibility, etc. Listen to corporate leaders on TV and you will find the same stuff- they will come across as decent folks with strong family values and lots of humility, concern for colleagues, society and nation. In other words, noble souls who are wonderfully balanced - and with loads of intelligence and drive to boot.

How far does this accord with reality? Well, apparently the film, There will be blood, for which actor Daniel-Day Lewis won the Oscar this year, has a different view. It shows an oil prospector who goes on to make fortune and destroys people along the way. The history of business enterprise is replete with such leaders, not the evolved souls portrayed in the business media. Luke Johnson, chairman of Channel 4, writes in FT:

As you claw your way to the top of the capitalist heap, the struggle can blunt your senses. All too often self-made men have come up the hard way and they see existence as survival of the fittest. Commercial success is about endless tough decisions – getting out of messy situations that haven’t worked, beating the competition, running a low-cost operation and so forth.

But sometimes the oxygen in the boardroom can get mighty thin and bosses lose perspective. Partners, family and friends can get sacrificed for another deal, another dollar. Occasionally paranoia sets in: it appears everyone is out to steal your money, seize your crown. Bright rising stars are seen as a threat, and are dispatched.

Loyal supporters are suddenly seen as spies. Too often, the super-rich end up surrounded by flunkeys and parasites, the most apocalyptic example being desperate old Howard Hughes with his Mormon handlers, going mad in a Las Vegas hotel.

Alas, there is great truth to all this. Those who have watched CEOs and business tycoons from close quarters are often struck by their utter lack of scruple and often at how emotionally unbalanced they are. That is because, in hacking their way to the top, many of these people manipulated, deceived, cheated and sucked up as required.

A certain lack of scruple- and particularly the ability not to strike a dissenting note- is virtually a requirement for making it to the top. Most people have no difficulty associating this trait with politicians. But there are politicians in every organisation- and they are no different from those who practise politics for a living.

Why business doesn't care for b-school academics

Managers don't take b-school academics and their output seriously- most journal papers are not even read by the academics themselves, leave alone by practising managers.

How come medical and law school academics' papers are read? How come those schools influence practice more? Michale Skapinker has an explanation in FT:

Law, medical and engineering schools are subject to the same academic pressures as business schools - to publish in prestigious peer-reviewed journals and to buttress their work with the expected academic vocabulary.

The reason that real-life lawyers, doctors and engineers have no problem with their research is not because they are smarter than business people, but because the research assists them in what they do.

Lawyers and doctors proceed from a corpus of knowledge and build on it. They look at what their colleagues do and try to do it better.

They are also dealing with more predictable material. People's hearts, lungs or nervous systems behave in similar ways. The way people behave in the office is far more mysterious. What works in one company may not work in another.

Managers tend to be practical rather than theoretical, proceeding by trial and error: this works, that doesn't. Rather than building on competitors' achievements, the best often seek to do something different.

Business schools can describe what innovative companies have done: Harvard's case study method does just that. But this is, by definition, backward-looking. Business school professors will struggle to tell us what innovators will do next. If they knew, they would surely do it themselves.

Northern Rock nationalisation shocker !

There is shock and dismay in some circles in UK over the decision to nationalise the failed bank, Northern Rock. Many in Thatcherite Britain see it as a huge ideological setback when, in fact, it is no more than an acknowledgement of the ground reality that a private acquisition was just not possible.

It is one of those situations when the government is compelled to step in. Will Hutton points out in the FT that this compulsion has manifested itself before. Governments took over major private enterprises in the UK and re-privatised them when their fortunes improved. Further, private enteprises do benefit from a variety of government actions that fall short of nationalisation:

As the postwar period wore on, nationalisation became more obviously justified only by pragmatism, whatever the rhetoric. The government of Edward Heath did not nationalise Rolls-Royce for any reason of socialism; it took it into temporary public stewardship because its technology was deemed too important to allow it to slide into bankruptcy – a decision amply justified by events. The government of Harold Wilson could justify the nationalisation of the bankrupt shipbuilding industry and British Leyland only because it was the last hope of saving them and, as it transpired, organising their orderly dispatch. The Bank of England did not “nationalise” the secondary banks in 1974; it operated a financial lifeboat for the same pragmatic reason that today’s government has ended up owning Northern Rock. It was likewise for this reason that the US government came to own Continental Illinois in the 1980s.

......There are few companies in the FTSE 100 that have not in some way had their franchise today shaped, supported and helped by government action. One obvious example is BP, which was nationalised by Winston Churchill in 1913 in part for the pragmatic rationale of securing oil supplies. But Vodafone, which was given the 900 MHz spectrum on which to launch mobile phone services by Margaret Thatcher, and GlaxoSmithKline, which was until recently accorded generous margins by National Health Service procurers to support pharmaceutical research, are other examples. Whether it is ITV, BAE Systems, Tesco, HSBC, Johnson Matthey or Standard Chartered Bank, every corporate history is intertwined with the state.

In other words, it is not always public versus private ownership. There is a continuum in ownership with nationalisation at one end and zero government support at the other. Most enterprises come in between. At which point in the continuum particular businesses should be located is a determination one makes on pragmatic, not ideological grounds. But die-hard advocates of the market just can't see that.

Measuring returns to investment banks

I noted a Bloomberg report that said that four out of the five top investment banks - Merrill Lynch, Morgan Stanley, Bear Stearns and Lehman Brothers- suffered a decline in market value of $83 bn last year. That cut the annual average rate of return for those firms in the past nine years fro 16.8% to 9.7%. Presumably, this refers to the returns that investors in stocks of these firms made.

What about the return on equity of the firms themselves? Investment banks have enjoyed a return on equity that is the envy of their peers in other businesses. Long term on equity for the top investment banks has been 16%- there have been periods when RoE has been as high as 48%. It would be interesting to see what the returns look like over a typical business cycle- say, after taking into account RoE in 2007 and 2008. The RoE would fall quite a bit.

This suggests that RoE figures for investment banks at any given point in time are deceptive because they don't quite factor in risk. We need really to measure risk-adjusted return on equity for investment banks. Or return on risk adjusted capital. Investment banks must put out these numbers so that market valuations can be based on these.

True, investment banks and banks are perceived to be riskier than the broader market which is why they trade at a discount to the market multiple. But these discounts may not be taking into account risks at a given point in time. More importantly, these discounts may not be taking into account institution-specific risk. The only this can happen is if these institutions are valued and compared on the basis of returns to risk adjusted capital.

Valuing investment banks on the basis of RoE can lead to huge distortions and inflated values at any given point because the underlying risks are not quite taken into account

More on leadership 'lessons'

I had a post earlier in which I expressed scepticism about leadership courses and training sessions. By a curious coincidence, I came across a reference to this subject in HBS professor Rakesh Khurana's recent book, From higher aims to hired hands, a lengthy polemic about how b-schools have changed from aspiring to provide professional education to becoming recruitment agencies for companies.

Khurana notes that somewhere along the line b-schools changed their objective from producing managers to producing leaders. He thinks the latter is a spurious or delusory objective because the entire literature on leadership fails to shed light on what precisely are the ingredients of leadership or how these can be acquired:

Despite tens of thousands of studies and writings on leadership since the days of the Ohio State Leadership Studies, several scholarly reviews of the literature on leadership have found little progress in the field since Chester Barnard observed in the 1930s that leadership in general, and particularly the "Great Man" view of the topic popular in his day, was "the subject of an extraordinary amount of dogmatically stated nonsense".

For example, Ralph Stodgill in 1974 and Bernard Bass in an independent study conducated in 1981, exained more than 4,700 separate studies of leadership and found little ni the way of a conceptual framework or frameworks in this field. Stodgill stated that an "endless accumulation of empirical data has not produced an integrated understanding of leadership" Bernard Bass found a surprising lack of clarity for a subject that was supposedly being examined in a scholarly manner, noting that most studies failed to even define the terms leader and leadership.

NISM chair professorships

I read that the National Institute of Securities Markets, which has been promoted by SEBI and has a collaboration now with Sterns School of Business NYU, is planning to offer 25 chair professorships.

The composition of the search committee is interesting. Neither the director nor the chairman of the board heads the committee- the chairman is M G Bhide, formerly of Bank of India and National Institute of Bank Management. The sole representative of the Institute on the search committee is director G Sethu. All the others are eminent professionals from outside. In governance terms, NISM certainly has made a very good start.

Leadership 'lessons' and all that

Open any issue of the Harvard Business Review and the chances are you will see more than one article on leadership. Executive programs on leadership seldom fail to attract enrolments. Since so much has been preached for so long on leadership, it is fair to conclude that, perhaps, this is something that cannot quite be taught.

But that does not deter management professors and trainers from drawing 'lessons' in leadership all the time. There are lessons from literature, from movies, from the Bhagvad Gita, from war. The implication is that it is possible to distil from various experiences a set of ideas as to what leadership is all about, ideas that any manager can then practise. I recall the Indian cricket team being put through a commando training module. There are leadership programs where you climb mountains, trek across the countryside, spend time in camps and so on.

How refreshing, then, to come across a piece in FT that debunks this whole idea. Stefan Stern ran into a survivor from a plane crash in the Andes mountains. Pedro Algorta was one of 16 (out of 45 people on board) who survived 72 days in the worst possible conditions- -30 C temperatures, avalanches, having to eat the flesh of dead passengers.

He then did his MBA at Stanford and went on to become a successful CEO. You might think the ordeal he went through and the heroism he had displayed earlier contributed. Not at all! Algorta attached very little importance to his experiences and never even talked about these to anybody.

So why the silence until now? “I was busy being a chief executive,” Mr Algorta told me. Did you ever speak to colleagues about your experiences? No, he said. Did you draw on them consciously? I never thought about it, Mr Algorta maintained.

Which leaves me struggling with a paradox. Of course, those events of October to December 1972 were extraordinary. It must have been a terrifying, shattering experience. It was a privilege to hear about it at first hand.

But even Mr Algorta suggests that, for him personally, these events had no specific impact on his business career. (You may or may not believe this. But it is what he says.) He got on with the life he had been planning to lead before the crash happened. And, while many people around the world will queue up to hear his story, Mr Algorta himself remains disarmingly modest. “I’m not a guru, I’m not a prophet,” he told me.

If there were no great 'lessons' from Algorta's ordeal- at any rate, lessons that contributed to his business success- surely a three day mountain climb or cross-country trek is not going to produce the next Jack Welch.

Is global gloom overdone?

I have been saying for a while now the situation in the financial markets is not of catastrophic proportions. That would be the case only if there was the prospect of major bank failures- and there is little evidence of this so far. Yes, banks will face lower profit margins and bankers' bonuses will shrink but neither of this is such a big deal. I can't see the real economy being impacted to the extent that financial market pundits think. Of course, growth in the US will take a beating but the global economy should grow in line with rates seen before the recent boom- or so I have been saying.

I am gratified, therefore, by the comments of a manufacturing head in Europe. BASF CEO Jürgen Hambrecht is quoted in the FT as saying:

“I am glad to say that business in general does not show the panicking approach of the financial industry. The reality is better than the words [written about the scale of problems] and I am sleeping well at night. ...In the real economy – in much of manufacturing – many companies have a big order backlog and are extremely busy with meeting demand. In this context, why should there be a big, big crisis? I can’t see this happening."

The FT report adds:

European manufacturers remain optimistic that sales will increase in 2008 and their businesses will remain immune from deepening gloom over the US’s economy and in its companies.<>In a pan-European survey of expectations by the NTC Economics consultancy, 56 per cent of European manufacturers expected sales volumes to rise in the coming year compared with 12 per cent forecasting a decline

It makes me wonder.... How much of the panic in the financial markets is intended to be self-serving? You create a big hullabaloo so that the Fed keeps cutting rates and this helps shore up asset prices. Good for bankers and their bonuses but does the world economy need all this pessimism and the Fed response to it?

PPP in Indian schools

Outlook (Feb 18) reports that the MHRD has plans to experiment with PPP in the provision of schools shortly. It wants to open 2500 schools all over the country alone the lines of Kendriya Vidyalayas, the central schools that have some reputation for standards.

The details are yet to be worked out but it seems three models are being considered:

• Fully-managed private schools.

• A joint venture where the state invests in infrastructure and frames the syllabus. The industry takes care of providing tuition to students and managing the welfare of teachers.

• Limited role for the industry under which it will provide and maintain school infrastructure.

What do we make of the proposal? PPP is all the rage today and I'm certain that it is only a matter of time before it finds its way into education. But we need to be clear as to the rationale for private sector participation and what we can realistically expect.

Why private sector?: Government lacks resources to set up schools with adequate facilities. Government cannot run these schools well- witness, the high rates of teacher absenteeism and dropouts amongst students and also the low level of skills that many students display. The private sector can do a better job of running such schools.

There is a certain smugness about such arguments as though the problem and the solutions are self-evident. Public sector is bad, so let in the private sector. It is possible to disagree.

First, there could be other answers to teacher absenteeism, such as empowering parents or the local community. Secondly, high student dropout rates may have to do with socio-economic compulsions which won't go away even if the private sector steps in. (How many successful private schools exist in the remote rural areas, I would like to know).

Thirdly, the problem could the insistence of state governments on providing education in the local tongue when the clamour all round is for education in English. Parents and students don't see value in local language education provided by state schools. The preference for private schools in metros amongst the lower strata of scoeity could be just a preference for English education.

What value would the private sector add?: Krishna Kumar of NCERT has a critique of the PPP model in education in EPW (January 19-25, 2008). He says that if funding or facilities are the problem, the private sector could step in with financial support. Why can't telecom companies provide rural schools with free telephone facilities, for instance? The private sector could help not just with physical infrastructure but with 'software' such as teacher training on a big scale, given that there is hug gap in this area today.

But, no, these are not things that interest the private sector. Krishna Kumar also makes the point that PPP is something of a misnomer for what its advocates have in mind. They are not thinking of collaboration with government as the word 'partnership' suggests- meaning, the government provides the infrastructure and the private sector manages the school, so that government schools become more efficient.

What is meant by PPP more often than not is simply allowing the private sector into schools in a bigger way with generous government support. If this is intended, why make a big deal about it? We have had government-aided schools for decades now, so the idea itself is not novel. Calling it PPP is simply a way to give it greater acceptability.

The key issue in PPP is whether the private sector is willing to go with the second model mentioned above- the government provides the infrastructure and the private sector runs the school well. Also key is whether the private sector is willing to run it without wanting to make profit. Several snall-scale NGOs may be willing to do so but not necessarily corporate NGOs.

Arguments about private sector 'quality' can be easily overdone- as I keep asking all the time, how come, despite all the opportunities given to them, the private sector has not been able to produce quality in higher education comparable to what the IITs and IIMs have done? I would like to hear from readers about a quality schools run by the private sector in remote rural areas and that also offers education in the regional language.

State's role in education: Krishna Kumar points out that nowhere in the world has the state abdicated its responsibility for primary education. It should not happen that PPP here just becomes a euphemism for the state not living up to its duty to provide basic education to all. If there is any conclusion to be drawn from the proliferation of private institutions in higher education, it is that the profit orientation in the private sector tends to lead to escalating fees and under-hand payments that, in turn, lead to the exclusion of the economically disadvantaged.

We have a huge youth population that needs education. Any model of education that is non-inclusive can result in a social explosion.

Regulatory lessons from sub prime crisis

What are the regulatory lessons from the sub-prime crisis? In the barrage of comment, I flagged the following:

• Liquidity risk needs more attention than hitherto
• Rating of securitisation tranches needs to be put under the scanner
• How much of securitisation is permissible- and how much of the loans should remain with the originator- may need thinking through
• We need better pricing of risk although where the models have gone wrong is not clear
• Greater transparency is required in respect of derviatives exposures- in credit default swaps, for instance, the total volume of contracts written on an underlying credit must be known

Fair enough but let me mention two others that I think require even closer attention. One is higher capital at banking. In my ET column, Revisiting bank regulation, I argue that this is required not so much for the conventional reason, as a first line of defence against risk, but for containing incentives in banking. High leverage is creating incentives for managers to take undue risks and one way to rein this in is to impose a higher capital requirement.

But this is not enough. We need a more direct attack on incentives- and this may require regulatory action because I doubt that the banking industry will want to do anything about it once the crisis blows over. I have written about this in earlier posts but, very briefly, three steps are in order:

• the magnitude of bonuses needs to be contained
• bonuses at the top must be in the form of stock options that vest over a period of at least five years
• bonuses must not be paid out in full for a given year of performance; a big percentage must be held over for, say, five years and it must be used for adjustment against any losses that a manager inflicts on the bank.
  

Banking bonuses

Incentives in banking have emerged as a key regulatory risk. Daniel Heller, writing in FT, has three proposals for dealing with bonuses in the banking sector. (Heller is director at Swiss National Bank). The first of these is one that I had myself proposed a couple of months ago:

First, bonus schemes need to be more long-term oriented. Instead of being primarily based on last year’s performance, the bonus should take the performance of several years into account. One way is to pay out only part of the bonus in profitable years. The non-distributed part would be set aside as “reserves” that could be used to cover any losses in the future.

.....Second, the level of the average bonus in investment banking should be reduced in order to take into account that potential losses are not borne by the employee. One way is to limit the maximum bonus in a bank to the bonus of the chief executive. The fact that in the past some rewards exceeded that of the chief executive illustrates that schemes were not designed in an economically efficient way. In a profit-maximising, privately owned company the chief executive is supposed to be the employee with the most skills, who adds the most value.

Third, guaranteed bonuses should be abolished. They are a contradiction in terms, since a bonus is by definition the variable component of the compensation. Guaranteeing bonuses releases the employee from the requirement to make at least a small contribution to cover the losses he may generate.

Global economic outlook

The IMF has revised downwards its projections for global growth for 2008- from 4.9% estimated last year to 4.1%. US economic growth is pegged at 1.5% instead of the earlier forecast of 1.9%. My own forecast for 2008 made in December was a little lower than 4.4%, the trend growth before the recent boom, the IMF's revised figure is in line with my forecast.

The IMF sees US growth at only 0.8% in the fourth quarter of 2008, which implies a slow recovery from the present problems. I am rather more optimistic on this count, so global growth might end up a little higher than the IMF's revised forecast.

The IMF sees China's growth decelerating moderately from 11.4% to 10% but the World Bank sees a steeper decline- to 9.4%. Decelerating exports will contribute to this, according to the Bank. My reckoning is that the severe snowstorms in recent days will be an equally big factor.

On balance, I think the US will do better than the IMF thinks and China a little worse, so I see global growth in the region of 4-4.4% for this year.

Student fees and subsidies

There is a clamour all the time to reduce subsidies in higher education. Higher fees are perfectly okay as long as loan finance is available- this is the new mantra of those sold on market economics. The IIMs have been raising fees over the past several years and the coming year will see a big jump in fees in some of the IIMs, including IIMA.

When former HRD minister MM Joshi sought to peg fees at Rs 30,000 there was a huge uproar. What was overlooked subsequently was that the IIMs quitely accepted under Arjun Singh the principle of a big subsidy in fees for those coming from families with income upto Rs 200,000.

Those who advocate the proposition that fees should be market-related or that fees must recover costs of education overlook one crucial fact: nowhere in the world, certainly not in quality institutions, is this proposition rigidly adhered to. On the contrary, as a story in the Economist points out, top universities in the US are stepping up subsidies.

Formidable financial-assistance policies have eliminated fees or slashed them deeply for needy students. And last month Harvard announced a new plan designed to relieve the sticker-shock for undergraduates from middle and even upper-income families too.

Since then, other rich American universities have unveiled similar initiatives. Yale, Harvard's bitterest rival, revealed its plans on January 14th. Students whose families make less than $60,000 a year will pay nothing at all. Families earning up to $200,000 a year will have to pay an average of 10% of their incomes. The university will expand its financial-assistance budget by 43%, to over $80 mn.

Harvard will have a similar arrangement for families making up to $180,000. That makes the price of going to Harvard or Yale comparable to attending a state-run university for middle- and upper-income students. The universities will also not require any student to take out loans to pay for their tuition, a policy introduced by Princeton in 2001 and by the University of Pennsylvania just after Harvard's announcement.

Why would Harvard and Yale want to provide subsidies to "middle and even upper income families"? After all, anybody who studies at these places should be able to earn to repay student loans?- the point that is made ad nauseam with respect to IIMs. I can think of several reasons.

One, to attract the broadest possible range of talent. High fees, it is implicitly conceded, constitute an entry barrier for some talented students at least. Two, even in the US, where young people are on their own from an early age, it is families that bear some part of the burden of fees. This would be even truer in India where the graduating student has responsibility for his or her larger family even after taking up a job.

Three, quality institutions do not operate on the principle that they must recover costs (plus profit) through student fees. Just as newspapers recover costs through ads, not the sticker price, so also educational institutions get their funding from other sources- either government (as in much of Europe) or through endowments (as in much of the US). The idea of a subsidy is thus built into higher education, the only issue is the source of subsidy. It follows that if the leading IIMs are loath to accept government assitstance, they must find ways to generate endowments. Higher fee is not the answer.

Four, when we talk of a subsidy, we should know exactly what the costs are. To simply say that costs are rising and therefore fees need to rise is not enough- the costing of a particular programme must be done rigorously with proper allocations of overheads and this must be certfied by an appropriate authority.

One final thought. I recall my days at IIT Bombay at a time when the fees were laughably low. The one thing that astonished me was the number of people who had come from small towns- these constituted the raw, intellectual firepower of the school and many went on to make waves in the US. They came in because the fee was eminently affordable (student loans were hard to come by at the time). I have little doubt that high fees would have acted as a deterrent to many of these families even if loan finance had been available.

That experience gives me the utter conviction that escalating fees in higher education are the route to exclusion and elitism and the snuffing out of great talent.

Dalai Lama at IIMA

He came, he was seen, he conquered. Ahmedabad has the reputation of being a Hindutva haven. IIMA is no great affinity towards matters religions. Yet, when the Dalai Lama came calling a couple of weeks ago, we had a full house, with some of the leading celebrities in the city in attendance. He is not completely at ease in the English language but he has an accomplished interpreter to supply him the necessary word or phrase whenver he fumbles.

I tend to put a safe distance between Godmen and myself but, then, the Dalai Lama's attraction is that the does not pose as a Godman at all- he's quick to repudiate the familiar description of him as the 'living incarnation of the Buddha'.

No, the Dalai Lama commands respect more on account of his moral stature- as the leader of an oppressed people and as the propagator of a secular version of ethical living. As he said at IIMA, ethics can be founded on theistic religion, on non-theistic religion and on a wholly secular basis. As far as he was concerned, any version was fine. The Dalai Lama is refereshingly from dogmatism.

The Dalai Lama gives the impression of being completely down to earth- his laughter is infectious- but his whole persona suggests that the appearance is deceptive. He is relaxed, energetic and exudes a certain serenity- for all his attempts to downplay his holiness, he comes across as an evolved soul.

The Dalai Lama did mention Tibet and his hopes for it during his interaction at IIMA. As China grows in strength, the aspirations of Tibetans or at least the Dalai Lama's flock appear to wane. Politics in recent decades has been full of surprises- the break up of the Soviet union, the return of East Europe to democracy and capitalism, the crumbling of apartheid were all sudden and dramatic events. Likewise, a sudden twist in Tibet's fortunes cannot be ruled out. But it's hard to visualise one in the near future.

I have more impressions on the Dalai Lama in my ET column.

Indian growth rate on a high

Travel and other commitments have kept me away from my blog for a week.

I return to highlight the growth peak of 9.6% the Indian economy touched n 2006-07- this is said to be the highest growth rate in 18 years.

My immediate responses:

• The achievement is all the more remarkable because it comes on top of three years of high growth prior to 2007-08.
• For four years now, the actual growth rate has exceeded most forecasts. For 2007-08, the forecast was in the range of 8.5-9% and the earlier estimate 9.2%. For 2007-08, the RBI forecasts 8.5% and the Economic Advisory Council 9%. These two forecasts rested on the previous estimate for 2006-07. Now that we have a higher base for 2006-07, will the forecast growth for 2007-08 materialise? Going by recent experience, yes it will!
• More interesting is the outlook for 2008-09. The EAC, the RBI, the Deputy Chairman of the Planning Commission and the Finance minister are all sanguine about growth prospects despite the enveloping gloom arising from financial market turbulence. In government, it is fair to say, the consensus forecast remains close to 8.5% for 2008-09. More than the growth rates of the earlier years, it is an 8.5% growth rate in 2008-09- if it materialises, as I think likely- that will define in emphatic terms the turnaround in the Indian economy. The high growth rates upto now have been ascribed to the global bloom. To grow at the same rate in the midst of global turbulence will be some achievement.
  
• Higher than expected growth in 2006-07 changes one key fiscal number- the fiscal deficit as a proportion of GDP. It means that the fiscal deficit so defined was lower than shown earlier in 2006-07 and the forecast for 2007-08 will be surpassed. My guess is that despite the impact of the Sixth Pay Commission, the fiscal deficit target of 3% of GDP by 2008-09 will be achieved, although the off-budget subsidies on food, oil and fertilisers do understate the fiscal deficit.
  

Explaining the Indian stock market's fall

Business Standard carries a report on how margin requirements contributed to the steep fall in the Indian stock market earlier this week:

According to stock brokers, the real pain in markets started with the over-zealousness on the part of stock exchanges in collecting margin money after the 700 points fall on January 18 and another 14,00 points fall on January 21.

The trading terminals of nearly 90 per cent stock brokers were shut on Tuesday when the markets hit the lower circuit of 10 per cent within a few minutes of opening bell, as the National Stock Exchange doubled the margin money overnight.

"The exchanges wanted stock brokers to pay additional margin money immediately. How can we do this when our clients' cheques take at least two days to clear?" asked a Bombay-based broker who deposited an overdue margin of about Rs 1,000 crore (Rs 10 billion) with the exchanges on Wednesday.

A payment crisis was already looming in the aftermath of the Reliance [Get Quote] Power IPO.

The call for more margin money, from stock exchanges, had a domino effect on the markets.

How far is this explanation valid? Well, increased margin requirements for brokers at a time of falling markets are always a reason for the sharpness of market declines. But, it is not as if the problem will go away if the cheque settlement system is improved.

That's because many of the investors who get into payment difficulties are those who have borrowed in order to speculate in the market. They borrow for day-trading, for IPOs and for any other investment in the stock market. They will have to sell their shares any way in order to meet margin calls. Whether the shares are sold by the brokers on whom margin demands are made or by the investors makes no difference- there will be huge sales and there will be overshooting in the market.

Theoretically, banks can provide finance to investors but they will be wary of lending when markets are in a state of free wall. As the BS report mentions elsewhere, there has to be some proportionality between margin payments made by investors and their brokers- the less stringent the margin requirement, the greater are the chances of a decline in the stock market escalating into a crash.

US crisis does not spell crisis for world economy

I have been saying this for a while now and am glad to have the formidable backing of financier George Soros, writing in the FT:

Although a recession in the developed world is now more or less inevitable, China, India and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline of the US and the rise of China and other countries in the developing world.

The danger is that the resulting political tensions, including US protectionism, may disrupt the global economy and plunge the world into recession or worse.

If you accept this, then it follows that what we are seeing in the Indian stock market is an over-reaction and the market should bounce back.

World Bank on brain drain

The World Bank's latest Global Economic Prospects (2008) has a section of emigration of highly skilled professionals from developing countries and its impact. Page 124 in this section has two graphs. One shows the percentage of Ph D students from various countries still living in the US after graduation. China tops with over 90%, followed by India (over 80%). Iran and Argentina also have a share of more than 50%. But a number of other countries including Brazil, Chile, Indonesia and South Korea have a share of under 50%- their doctorates prefer to return home.

Another graph alongside shows that the higher the percentage of Phds returning home, the higher is the per capita national income. But correlation, we know, does mean causality. We cannot conclude that because more Phds come back, a country will be more prosperous. It could well be that when a country become prosperous, its nationals would like to return home after studies.

I say this because the growing brain drain in recent years has gone hand in hand with an accleration in economic growth in both India and China (just as it has gone hand in hand with the decline in the quality of economists in government!). The loss of highly skilled professionals may be notional because the home country is not in a position to utilise talent of a certain order.

Moreover, once highly skilled professionals succeed abroad, they may be in a position to contribute to their parent country- remittances are an obvious way but the creation of knowledge networks and initiation of investments from MNCs abroad are other ways in which non-residents can contribute. In other words, brain drain may less of a loss than is commonly supposed.

Anil poised to overtake Mukesh Ambani

Anil Ambani is poised to overtake Mukesh Ambani as well as Lakshmi Mittal as the richest Indian, FT reports:

Anil Ambani, the controlling shareholder in Reliance Power, is set to leapfrog his brother Mukesh Ambani, as well as steel tycoon Lakshmi Mittal to become the richest Indian on the back of record investor demand for shares in his company.

.....Mr Mittal and Mukesh Ambani topped a list of richest Indians published by Forbes in November, with fortunes worth respectively $51bn and $49bn. But the value of their companies has not risen since, while Anil Ambani is creating billions of dollars of paper wealth overnight.

Reliance Power is listing just over 10 per cent of its shares at Rs450 each on the Indian stock market next month to raise $3bn. The flotation will value the company at about $30bn. Mr Ambani’s interests will be valued at about $13.5bn. He indirectly controls about 45 per cent of the company.

Interesting. When the famous spat occurred between the Ambani brothers, Anil was soon as the loser since he got a smaller portion of the assets and Mukesh walked away with the flagship, Reliance Industries. But, in the stock market, asset size is not everything. Earnings growth is what matters. Communications, finance, infrastructure- the areas that Anil inherited or is moving into are hotter areas than chemicals. They are seen as high growth areas and will attract greater interest from institutional investors, that is why Anil Ambani is forging ahead.

Bottomline for businessmen: don't be obsessed with size, think earnings growth. Go for mergers and acquisitions not if you believe it will boost earnings growth, not because you will have a larger company in your stable.

Reining in bankers's incentives

Martin Wolf weighs in on the side of those believe that incentives in banking are flawed and need to be reined in:

By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.

We would be better off with Jupiter’s 12-year “year”, since it takes about that long to know how profitable strategies have been. The point is that a year is an astronomical, not an economic, phenomenon (as it once was, when harvests were decisive). So we must ensure that a substantial part of pay is better aligned to the realities of the business: that is, is made in restricted stock redeemable over a run of years (ideally, as many as 10).

Yet individual institutions cannot change their systems of remuneration on their own, without losing talented staff to the competition. So regulators may have to step in. The idea of such official intervention is horrible, but the alternative of endlessly repeated crises is even worse.

.....all bonuses and a portion of salary for top managers should be paid in restricted stock, redeemable in instalments over, say, 10 years or, if regulators are feeling generous, five.

Yes, locking in rewards over a long period will help as will payment in stock. If rewards are to be in made in cash, only a portion of the rewards announced for a year should be paid out; the rest should be held back over the business cycle and adjusted for losses bankers' run up. When one bank poaches people from another, the vesting period of options assumed by the hiring bank should remain unchanged.

China's economy not that export-dependent!

China is not as dependent one exports for its growth as is made out to be, according to the Economist. Investment accounts for 40% of China's growth. This won't be heavily affected by a drop in exports because over half of it is domestically driven- it has to do with infrastructure and property. It cites a research report that forecasts that a downturn in the US economy will result in China's growth slowing down from 11.5% to 10%- hardly catastrophic. The US may be more export-dependent than China- exports contribute 30% to US growth.

The high share of exports to GDP- 40%- in China may be deceptive. Exports are measured as gross revenues whereas GDP is the value added. A UBS analyst has attempted to measure China's exports in value added terms and measure these as a proportion of GDP. The ratio is much lower- 10%. This, the analyst suggests, is a measure of "true" export dependency of the Chinese economy.

I guess this reinforces my position that growth in China and India will help mitigate the effects of a US downturn on the world economy.

The price of dissent in the CIA

The Iraq war under the junior President George Bush highlighted how intelligence agencies could be pressure to produce reports that satisfied their bosses. Evidence is now emerging that much the same thing happened in respect of Pakistan's pursuit of nuclear weapons under the now disgraced scientist A Q Khan.

The Economist has a review of a recent book, The Nuclear Jihadist, that details how the US disregarded reports about Pakistan's flouting non-proliferation laws in order to secure the bomb. Worse, an intelligence agent who protested about the cover-up of the growing evidence ended up paying a heavy price:

The book's most revealing passages are about America's role in the affair. The authors argue that successive American administrations knew a lot about Mr Khan's activities, but for larger strategic foreign-policy reasons, chose to do nothing about them. Mr Khan was able to flout international rules on nuclear non-proliferation because American policymakers thought that securing Pakistan's assistance in defeating the Soviet Union in Afghanistan—and, more recently, President Pervez Musharraf's help in fighting terrorism—were more important than limiting the spread of nuclear bombs.

The story of Richard Barlow, a CIA agent who once worked in its directorate of intelligence on proliferation, sums up the American attitude. Mr Barlow had protested that intelligence was being manipulated by the Pentagon to suit the policy adopted by President Bush senior's administration of turning a blind eye to Pakistan's nuclear development. He lost his job. The authors find Mr Barlow at the end of the book denied his state pension, living with two dogs in a motor home.

World Bank optimistic on growth outlook

I have placed myself unambiguously in the optimists' camp when it comes to the economic outlook for the world in 2008- I've said that we will see a sharp slowdown in the US but not a recession and a deceleration in the world economy that will still leave emerging markets in good shape.

The World Bank takes much the same line, I'm heartened to note, in its latest Global Economic Prospects. The world economy slowed from 3.9% in 2006 to 3.6% in 2007; the Bank sees a further slowdown to 3.3% in 2008- in other words, a soft landing. Growth in developing countries will moderate only somewhat over the next couple of years- in 2008, the Bank expects growth of 7.1%. For India, the Bank projects growth of 8.4% and 8.5% in 2008 and 2009 respectively, down marginally from 9% in 2007.

The Bank does see the risk of a US recession and its impact on the rest of the world but does not appear to think this is the likely scenario. It thinks that the impact of the housing sector on the US economy will be mitigated by export growth; it also thinks that the financial markets crisis will be contained as risks are not likely to be concentrated in a few institutions.

Why neither the banking channel nor the consumption channel is likely to lead on to a recession in the US is an issue I address in my latest ET column, Liquidity, not solvency the issue.

Bankers' pay

I have written in an earlier post and in other posts about how the incentive system at banks and investment banks needs to be overhauled if recurring financial crises are to be avoided.

The problem I have been highlighting is the heads-I-win-tails- the- firms- loses syndrome. Bankers rake in bonuses when they do well. When they run up losses, it is for the firm to pick up the pieces. At the most, bankers may lose their jobs and a portion of stock options that have not vested. But they would still have the accumulated bonuses of the past to enjoy life.

I have argued that only a portion of bonuses due should be paid out in a given year; the rest should be credited to an account in which there will be entries for bonuses for profits and negative bonuses for losses. At the end of, say, five years, the balance would be paid out to managers.

I note with satisfaction that my view finds endorsement from Raghuram Rajan, former Chief Economist of the IMF. Writing in the FT, Rajan says:

Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialise, encourage the creation of fake alpha. Significant portions of compensation should be held in escrow to be paid only long after the activities that generated that compensation occur.

Rajan also makes the point that excess returns- that is, returns in excess of that warranted by a given level of risk- are rarely achieved. What a manager claims as excess return is actually a level of return for which the appropriate risk has not been factored in. Very often, the risk shows up much later in the form of a loss, not in the year in which performance is being measured. That's why a big chunk of bonuses must be deferred.

Anti-business bias in European text books

High school text books in Germany and France take a dim view of business enterprise, says Stephen Theil, Newsweek's European economics correspondent in an article in a Foreign Policy article reproduced in FT. This, the writer says, must explains the profound mistrust towards the free enterprise economy in those countries- in France, only 36% of the people supported free enterprise in a 2005 poll and in Germany support for socialist ideals was running at a high of 47% in 2007.

Theil cites intances:

Economic growth imposes a hectic form of life, producing overwork, stress, nervous depression, cardiovascular disease and, according to some, even the development of cancer,” asserts Histoire du XXe siècle, a text memorised by French high-school students as they prepare for entrance exams to prestigious universities. Start-ups, the book tells students, are “audacious enterprises” with “ill-defined prospects”. Then it links entrepreneurs with the technology bubble, the Nasdaq crash and massive redundancies across the economy. Think “creative destruction” without the “creative”.

In another widely used text, a section on innovation does not mention any entrepreneur or company. Instead, students read a treatise on whether technological progress destroys jobs. Another briefly mentions an entrepreneur – a Frenchman who invented a new tool to open oysters – only to follow with an abstract discussion of whether the modern workplace is organised along post-Fordist or neo-Taylorist lines. In several texts, students are taught that globalisation leads to violence and armed resistance, requiring a new system of world governance. “Capitalism” is described as “brutal”, “savage” and “American”. French students do not learn economics so much as a highly biased discourse about economics.

German textbooks emphasise corporatist and collectivist traditions and the minutiae of employer-employee relations – a zero-sum world where one loses what the other gains. People who run companies are caricatured as idle, cigar-smoking plutocrats. They are linked to child labour, internet fraud, mobile phone addiction, alcoholism and redundancies. Germany’s rich entrepreneurial history is all but ignored.

I do not know how far the material in textbooks can influence and explain popular attitudes. After all, there is the mass media as well. Are the media too hostile to business enterprise in Germany and France? I doubt that would be the case because they would not be able to survive commercially if that were so. US text books, one would imagine, are not ill disposed, yet popular distrust of at least big business is widespread there.

I don't know that Indian text books have much to say either way but celebration of business is common today among the intelligentsia- so much say that many want government to vacate even education and health.

The Indian electorate has been either indifferent or negatively disposed towards a big chunk of economic reforms even though most of the media is pro-reform. People cannot be brainwashed through school text books, certainly not beyond a point. They can think for themselves. It is somewhat facile to ascribe popular attitudes in France and Germany to biases in school text books.

Priorities for the next US president

Strobe Talbott, Deputy Secretary of state in the time of Bill Clinton, spells out the priorities for the next US president in FT. It's reassuring to see that sane voices are not absent from US political discourse. But I have serious doubts as to whether the agenda that Talbott outlines has any chance of being implemented in full- the Conservative strangehold on policy-making is far too strong to permit it.

the next president should, shortly after coming into office, affirm full adherence to the Geneva and UN torture conventions, restore the right of habeas corpus for US-held detainees, and “re-sign” the treaty establishing the International Criminal Court, which the Bush administration “un-signed” in 2002..

To make up for lost time, the next administration should undertake an array of initiatives, starting with one directed to Moscow. Drastic reductions in the American and Russian nuclear stockpiles are important as an example to other countries....The US should also resume negotiations with Russia on anti-missile missiles.

....The US should work with all the current nuclear-weapon states to impose a moratorium on the production of fissile material, pending a formal, verifiable, universal and permanent ban. To attain that goal, America should join its principal allies and partners in direct, sustained negotiations with Iran and North Korea to bring them back into the NPT as fully compliant non-nuclear weapons states.

...Kyoto will expire in 2012. That means the next US president will have fewer than four years to play a decisive role in the design of an effective successor to the treaty. The US must do this through diplomacy and by example. Only if it passes legislation imposing stringent limits on itself, while offering other countries – especially developing ones – substantial incentives to be part of a global effort, will Kyoto be replaced by an accord mandating universal reductions.

Exaggerating sub-prime losses

Many expect sub-prime related losses to rise sharply. But some of the estimates appear to be on the wilder side- the figure of $400 bn, which is the upper end of present estimates, for instance.

Bloomberg columnist Jonh Barry explains why:

There are two reasons why the losses aren't likely to be so large.

First, the mortgages are backed by collateral, a house or condominium, and in a foreclosure a home typically retains significant value. When it is sold, the lender often will get 50 percent to 60 percent or more of the loan amount after foreclosure expenses.

Second, most subprime borrowers aren't going to default. Suppose even one in four does and lenders recover somewhat more than half the mortgage amount. A fourth of $1.3 trillion in subprime mortgages is $325 billion, and a 55 percent recovery would mean a loss of about $145 billion.

To reach a $300 billion loss would require foreclosures on about half of all subprime mortgages with a 55 percent recovery upon sale of the property. And a $400 billion loss would take about a 60 percent foreclosure rate with recovery of about half the value from the sale.

Credit crisis- a managerial failure?

The sub-prime crisis in the US and its impact on financial markets are seen as a failure of regulation to keep pace with innovation. Securitisation is good but we need to ensure that the risks inherent in it are properly understood and priced. Rating agencies are seen as contributing to the failure.

This is now common wisdom but it's interesting to look at the issue in managerial terms. I wrote in my previous blog about how a clever manager can emulate Mao Zedong's methods to achieve rewards not commensurate with his success. In many ways, the financial sector provides fertile ground for such managers. That's because banks are hugely leveraged. This creates huge incentives for managers to take high risks- if they succeed, there are large bonuses; if they fail, the shareholders get wiped out. Managers may lose out on stock options not cashed in but, by the time failure reflects in financial results, they will have made their pile.

John Kay has an interesting point on this in an article in FT. Managers typically go unsung and, perhaps, unrewarded when they take premptive action to avoid disaster. It is those who take calculated risks and win who get all the laurels.

Al Dunlap of Scott Paper declared his admiration for Rambo: “Here’s a guy who has zero chance of success and always wins.” But Mr Dunlap’s company was acquired by Kimberly-Clark, whose chief executive for 20 years, Darwin Smith, avoided the storm by taking the company out of the competitive coated paper businesses and into high-value-added consumer products. Mr Dunlap was a celebrity but Mr Smith is little known.

We prefer to read about Lee Iacocca and Lou Gerstner, who held the helm in the storm, or Jack Welch, ho managed the ship through turbulence largely of his own creation.

How do we deal with this syndrome? We need to encourage risk-taking, of course. But incentives for top management must be more carefully designed, as I have argued earlier, to take care of possible losses down the road than they are today. Secondly, the degree of leverage in financial firms must come down- I think this will happen in banks with the implementation of Basel II. Thirdly, the media must celebrate the triumphs of the quiet leader as often as they do those of the flamboyant variety.