Will oil prices derail the Indian economy?

Could soaring oil prices wreck short-term growth prospects? The pessimistic view is that it can - especially because it comes on top of troubled conditions in international financial markets.

Not so, methinks- and I said as much in my ET column, Please, this is not the 90s economy.

• First, I don't buy the proposition that prices above $125 are here to stay. The imbalances in oil supply and demand are very small - and feverish speculation is at the root of the present spike. Saudi Arabia's decision to step up oil output in response to President Bush's plea will have the necessary softening effect.
• Oil prices of around $100 are not a big deal for the world economy- in real terms, these would be close the peak of the seventies. But the developed world is far more energy efficient today than i the seventies.
• A high inflation- high interest rate cycle putting the brakes on India's economic growth is unlikely. Inflation will moderate in the months to come. Interest rates have risen but, in real terms, are way below those in the nineties.
  
• The structural characteristics of the Indian economy are far superior to those of the nineties, so the chances of a lapse into a 6-7% growth band are negligible.
• The prospects of the international financial market crisis receding are brightening by the day- the latest addition to the ranks of the optimists is Fitch, the credit rating agency. Ftich estimates total losses on account of the crisis at $400 bn, with banks accounting for half of this. Of the total $200 bn in estimated losses, banks have already provided for $160 bn.
  

RIchard Nixon the wierdo

Much has been written about Nixon's mental make-up and temperament. His bizarre behaviour when he was under pressure over Watergate has been particularly well documented- one story is about how a wild-eyed Nixon would go racing down the stairs with Secret Service personnel in hot pursuit.

A recent biography, reviewed in the Economist, adds to the repertoire of stories of Nixon's weird behaviour:

Nixon hardly has a reputation as Mr Normal. But it is still astonishing to be reminded of quite how odd Nixon and his circle were. He wore a necktie when he was in his dressing gown. He once visited his mother, camera crew in tow, to wish her a happy birthday—and shook her by the hand. He sent memos to his wife, Pat, about how “RN” would like his furniture arranged. Nixon matter-of-factly ordered H.R. Haldeman to draw up a list of the “big Jewish” contributors to the Democratic Party. “Could we please investigate some of the cocksuckers?” Chuck Colson, Nixon's general counsel who famously said that he would run over his grandmother for his boss, once contemplated firebombing the Brookings Institution, a stately think-tank, and then sending in FBI officers dressed as firemen to steal a document that Nixon wanted.

To think that such a man was in charge of America's nuclear button!

OBC quotas-uncertainty continues

I was away over the past week. I found I couldn't escape the OBC quota row even while away from the campus.

The SC has stayed the Calcutta High Court's own stay on the operation of OBC quotas in IIM- Calcutta. The Hindu's report provided more detail than most others:

the Chief Justice said: “It is strange that such an order has been passed by the Calcutta High Court. Once the Act has been upheld by us where is the question of stay? We don’t think the [Calcutta] High Court can sit over the judgment of this court.”

When counsel for respondents — K.K. Venugopal, Harish Salve, P.P. Rao and Rajeev Dhavan — opposed the stay on the Calcutta High Court order, the Chief Justice said: “Your argument is very strange. If you feel our judgment is being violated, you file a contempt [against the Centre]. We can’t allow the stay order to operate.”

The way I understood the various petitions filed in the High Courts, the principle of OBC quotas in central educational institutions is not being questioned. The issue now is whether the HRD ministry's directive on this subject is in conformity with the letter and spirit of the SC judgement in the case.

The CJ's remarks suggest that the remedy, in the event that the HRD ministry directive is in any way violative of the judgement, is to file a contempt petition against the government, not to seek a stay of OBC quotas in IIMs and elsewhere.

But I am at a loss to understand what would happen if the government were to be found guilty of contempt- say, because some of the admissions made were not in strict confirmity with the SC's observations and guidelines on the 'creamy layer'. The present SC order says that admissions made wil be 'provisional' subject to final disposal of the present bunch of petitions filed in various High Courts ( a point missed in the Hindu story).

What happens if some of the admissions made in accordance with Ministry's directive are seen to be violative of the SC judgement in the OBC quota case? Will the concerned students have to withdraw? Suppose this happens several months after they have joined one of the central educational institutions?

There are more fundamental issues that have been raised. One is whether the proportion of 27% would be valid if the OBC population after excluding the creamy layer turned out to be lower than this. The appropriateness of the figure of 27% was one of the issues raised when the SC heard the petitions against the central educational institutions' Act. The SC then took the view that since Parliament had accepted this figure, there must be some basis for it.

C K Prahalad on corruption

Management guru inveighed against corruption at the CII:

On the civic side, he said the prerequisites for growth were an emphasis on individual rights as against group rights and the urgent need to treat corruption as treason. "A nation becomes less corrupt before it gets rich."

Rousing stuff - and no doubt the money-bags at CII cheered lustily- but not something that withstands critical scrutiny. If Prahalad's statement is correct, China should have become poorer by now, not richer. When you look at the rankings of, say, Transparency International, you find that there is no precise correlation between these rankings and growth performance. Some corrupt economies flounder- as in Africa. Others prosper.

As a nation gets richer, petty corruption diminishes- the traffic constable is not going to wave you on if you pay him Rs 25 because this is small change in relation to his salary. But big ticket corruption is not eradicated as easily- and is indeed embedded in the very fabric of most economies, modern or antiquated.

More broadly, the evidence on the relationship between institutions and growth is suspect. Historian Gregory Clark points out in his monumental work, Farewell to Alms, that the quality of institutions in pre-industrial England was as good as it is in modern societies today. Yet, the existence of sound institutions did not cause growth to accelerate. America's own rapid growth at the turn of the last century happened against a background of some pretty weak institutions- banking and capital market scandals were rife at the time.

It may be well that a society that is not corrupt, that sets store by all sorts of norms, is a nicer place to live in. But it is not necessarily more prosperous.

Credit crisis receding?

Warren Buffett has sounded bearish earlier- he was among those quoted as saying the crisis was the worst since the Great Depression. But he's among those who think the crisis is showing signs of receding at least for Wall Street.

The worst of the crisis in Wall Street is over,'' Buffett said on Sunday. ‘‘In terms of people with individual mortgages, there's a lot of pain left to come.''

A number of Wall Street CEOs have said much the same thing (although some still sound grim). The Bank of England has weighed in on the side of optimists. The Bank echoed what I had said several times in my posts: the credit markets are overstating the losses because of inaccurate mark-to-market accounting practices.

The Bank joins issue with the IMF, which swung from an extreme of optimism last year to an extreme of pessimism in its most recent update. The IMF estimated financial sector losses at $945 bn. This, as the Bank points out, confuses "true credit losses and losses implied by market prices". If the marked-to-market losses are taken at face value, that would imply that 76% of prime loans would default with a recovery of less than 50% !- something that not even the gloomiest types subscribe to.

I stick to my forecast made at the beginning of the year: the market crisis and its real economy effects should start receding from the second half. This may well go down as the crash that never was.

Educational loan subsidy

Business Standard today has a news story on a concessional education loan scheme being crafted by the ministry of HRD. The essence of the scheme appears to be waiver of interest on educational loans.

"At present, students who take loans from banks get a moratorium period in the sense that they don't have to pay interest till they complete their studies. But with the launch of this scheme, the entire interest amount would be subsidised (waived)," an official told Business Standard.

The loan amount taken by the student should be commensurate with the course fee he/she is paying the institute, according to the contours of the scheme. Loans taken from any bank under the Indian Banks' Association will be eligible.

...The scheme assumes significance in the wake of premier educational institutes like Indian Institutions of Management (IIMs) announcing a sharp hike in fees.

Growth in education in management, medicine and engineering is being driven by private institutions. So, having a concessional education scheme is a good idea. However, the availability of concessional education loans does not mean that there is a case for steep fee hikes in public institutions.

First, the principal amount still has to be repaid. Second, if the state is provide some subsidy in public institutions, it might as well do so directly through lower fee. Why go through the cumbersome route of raising the fee and then subsidising the loan that would be required?

It could be argued that when fees are pegged a low level in public institutions, that is not good for their finances. Not true. The government can compensate for lower fee through direct grants. As I said, no need to involve banks.

Two other points are worth making. One, fees in state-run universities in the US are lower than those in private universities even though the US has an excellent student loan scheme. Two, even with a concessional loan scheme being available, private universities have a subsidy element built into the fee- this subsidy comes from private endowment.

In other words, it would be incorrect to say that once a concessional educational loan becomes available in the country, that is a signal for institutions, private or public, to charge what the "market can bear". There are huge externalities to higher education- public benefit exceeds private benefit. So, there is always a case for not recovering the cost of education in full.

Why MNCs have taken a beating

HBR (March 2008) has an article, "How local companies keep mulitnationals at bay", which explains why MNCs have taken a beating in several emerging markets, including India. I wrote a critique of this paper in my ET column, Keeping MNCs at bay on home turf.

The authors mention six strategies that homegrown companies have used in fending off the MNC challenge:

• Create customised products or services
  
• Develop business models to overcome obstacles (eg. products that are impossible to pirate in a market such as China's where privacy is common)
• Use the latest technologies: Amul has state of the art technology that enables it to collect 6.5 million litres of milk each day andyet weigh the milk, measure the fat content and pay the farmer in all of five minutes
• Invest in inhouse training: this happens not just in software companies but also others such as Apollo Hospitals
• Scale up quickly
• Invest in talent: local companies have shown impressive managerial and entreprenuerial abilities

I would have liked to know whether the successes are confined to private sector firms or whether state-run companies have also taken on MNCs successfully. China has a car manufacturer, Chery Automobile, that is a leading exporter- it is state-owned. In India, LIC has shown an amazing ability to match international firms in customer service and has clawed back some of the market share it lost initially.

Why RBI governor is bullish on Indian growth

I noted earlier RBI's bullish tone in its latest monetary policy. Yesterday, I watched a fascinating interview with RBI Governor Y V Reddy on CNBC yesterday in which the Governor explained why growth in the present period is different from growth in the early nineties. He was seeking to rebut the view that we could witness the sort of deceleration the Indian economy went through in the late nineties:

• In the nineties, the investment boom was on account of anticipated demand, now it is in response to pent-up demand. (There's a world of difference between the two; the first will peter out if anticipated demand materialises; the uncertainty in respect of the second is smaller)
• Savings and investment rates are a good 10 percentage points higher today and can sustain a higher growth rate
• Manufacturing was in the doldrums in the nineties, it has since reinvented itself and has turned competitive.

For these reasons, Reddy can't see Indian GDP growth slipping below 8%.

Reddy also explained why the idea of allowing the rupee to appreciate in order to combat inflation was misplaced.

The question of using an exchange rate for fighting inflation will be an interesting intellectual proposition. If you say that the exchange rate should essentially be determined by the market forces, where is the question of using an exchange rate?

Secondly, you have to have some policy on exchange rate, that has to be consistent with macroeconomic balance. You cannot keep changing the exchange rate at will because it is not like an interest rate that you can change. But exchange rate is determined as much by what others do and what you do. So, therefore the degrees of freedom that you have to handle as an instrument are to be considered.

Thirdly, if you just take empirical evidence and take ECB for instance, it is appreciating like never before, but has the highest inflation for decades. So, that type of correlation is misleading. So, the whole concept that exchange rate can be used as an instrument to fight inflation on a one-to-one basis is a proposition to which I won’t agree to.

Finally, Reddy had a pretty good explanation for why the RBI had raised the CRR and left interest rates untouched:

There is maximum flexibility for CRR and there is certainty of considerable overhang of liquidity. So, there is certainty of a problem and flexibility of an instrument, which is mostly related to identifiable problem. With regard to repo rate, it is a policy rate and in some senses it is reflective of fundamental view.

Domestically there are underlying demand pressures but there is also been a supply shock in the last one-quarter. Globally, what will happen after 4-5 months is that people are uncertain about the type of impact on the economy. So, when there are too many uncertainties, you don’t get locked in an instrument.

RBI stays bullish

The RBI's growth forecast in its just unveiled annual monetary policy, I am pleased to say, is identical to mine:

In view of these factors, overall, for policy purposes, real GDP growth in 2008-09 may be placed in the range of 8.0 to 8.5 per cent, assuming that (a) global financial and commodity markets and real economy will be broadly aligned with the central scenario as currently assessed and (b) domestically, normal monsoon conditions prevail.

The central bank, being a central bank, has hedged its forecast with the mandatory qualifications but these are not terribly consequential. I don't see any reason to think that the global outlook will change materially; and the news on the agricultural front has been good.

Remember, every single forecast on the Indian economy in the past five years has been an under-estimate. So, I wouldn't be surprised if growth hits 9%. That would be the decisive deathblow to those who claim that the spurt in economic growth was a fluke created by the global boom. If you can grow at 8-9% in these conditions.........

MBA education- old wine in new bottle

I zoomed in on an article in today's ET by Yale Management School Dean , Joel Podolny, with high expectations. It's titled "Transforming the MBA for the 21st century". I must confess I was more than mildly disappointed. The problem Podolny identifies is familiar enough but I can't see anything novel or striking in the solutions he proposes.

The problem:

There are two fundamental drivers behind the demand for changes in business education and MBA curricula. The first is that the world of management has changed tremendously from the 1950s. Then, a typical manager could spend his or her entire career within a single function — say, marketing or finance — of a large bureaucratic organisation.

There was thus a strong alignment between these careers and MBA curricula that were siloed by related disciplines. But organisations have become increasingly flat, and the leaders of modern enterprises competing in the global economy are looking for managers who are capable of leading and managing across the boundaries of function, geography, and sometimes even organisation, industry, and sector....

The second driver is that today’s students learn in a way wholly different from the way students learned in the 1950s or even in the 1980s. The Internet, the 24-hour news cycle, the popularity of social networking, and almost instantaneous ‘on-demand’ access to knowledge have all contributed to a significant shift in the mindset and the learning process for the 20-somethings now entering our MBA programmes.

Okay, so what are the solutions? Podolny proposes two. One is a "raw case". This, it turns out, is not a case in a specific area- finance, marketing or production- but one that spans multiple areas and contains reams of text and material, perhaps running into a thousand pages! The other idea is to put the material online.

Sorry, I am not bowled over. The "raw case" that Podolny talks about is already there in many places, including, I daresay, IIMA. We call it an "integrated case" and we often have three or four faculty in the classroom teaching it together. If this is new to Yale, all I can say is IIMA is way ahead.

As for putting material online instead of giving it out as hard copy, that too has been practised by several b-schools for years now- and, yes, we have it this too at IIMA today.

If this is Yale's idea of "transforming the MBA", my suggestion to American (and overseas) students is that they consider applying to IIMA.

Too many IITs ?

I would not have thought this merited a serious debate but since one is on in right earnest, let me add my two cents to it.

Creating an IIT in a state has an impact similar to setting up a railway junction- also sorts of developmental impulses radiate out of it. The state or area in which IIT is located certainly gets a boost. So, if you have the resources, go for it. IITs can command resources of a higher order than plain colleges or universities, there is a certain discipline which the IIT system brings along with it, and there is also scrutiny and assessment that is qualitatively superior.

The problems will be there- notably, finding good faculty- of course but those problems would be there even if were to invest in colleges that did not carry the IIT tag. A potentially favourable factor is returning NRIs- some may just find it worthwhile to be in their home states and may be willing to sacrifice the prestige of being with one of the older IITs especially if these are people in their forties and above and have already made a reputation for themselves.

I also think that creating competition from IITs - and IIMs, for that matter,- is a good thing although it will be a long time before the new entrants pose a threat to the entrenched players.

What about the problem of "brand dilution"? I don't see any cause for apprehension. The three top IIMs have not suffered in the slightest because three other IIMs have come up and a fourth one is due. Nor have IIM- Indore and IIM- Kozhikode been able to ride on the reputations of the older IIMs. The pecking order in most rankings is the top four IIMs followed by several other non-IIM institutions with IIM-I and IIM-K coming way below. We can see the difference clearly in the new fee structures that the IIMs have proposed- the market leader, IIMA, is way ahead of the rest.

SC judgement in OBC quota case

The SC judgement in the OBC quota case is seen as a politically correct judgement- it allows quotas (which will please the reservationists) but disallows the creamylayer, which will please opponents of quotas.

Well, that may well be the outcome but it would not be correct to suggest that was the intention. A careful reading of the judgements suggests that it is based on a careful interpretation of the Constitution and the formidable case law that has accumulated on reservations. I read the judgements and was left with a sense of admiration for the fundamental justness of the verdict. My comments on a couple of legal aspects and the implications of the judgement are there in my ET column, Expect quota battles to continue.

The thirteen key legal questions and the answers to these are summarised in Chief Justice Balakrishnan's judgement. I reproduce this portion:

Questions:

1. Whether the Ninety-Third Amendment of the Constitution is
against the "basic structure" of the Constitution?

The Constitution (Ninety-Third Amendment) Act, 2005 does
not violate the "basic structure" of the Constitution so far as it
relates to the state maintained institutions and aided educational
institutions. Question whether the Constitution (Ninety-Third
Amendment) Act, 2005 would be constitutionally valid or not so far
as "private unaided" educational institutions are concerned, is left
open to be decided in an appropriate case. (Paragraph 79)

2. Whether Articles 15(4) and 15(5) are mutually contradictory,
hence Article 15(5) is to be held ultra vires?

Article 15(5) is constitutionally valid and Articles 15(4) and
15(5) are not mutually contradictory. (Paragraph 100)

3. Whether exclusion of minority educational institutions from
Article 15(5) is violative of Article 14 of Constitution?

Exclusion of minority educational institutions from Article
15(5) is not violative of Article 14 of the Constitution as the minority
educational institutions, by themselves, are a separate class and
their rights are protected by other constitutional provisions.
(Paragraph 102)

4. Whether the Constitutional Amendment followed the
procedure prescribed under Article 368 of the Constitution?

The Ninety-Third Amendment of the Constitution does not
affect the executive power of the State under Article 162 of the
Constitution and hence, procedure prescribed under Proviso to
Article 368(2) is not required to be followed.
(Paragraph 103)

5. Whether the Act 5 of 2007 is constitutionally invalid in view of
definition of "Backward Class" and whether the identification
of such "Backward Class" based on "caste" is
constitutionally valid?

Identification of "backward class" is not done solely based on
caste. Other parameters are followed in identifying the backward
class. Therefore, Act 5 of 2007 is not invalid for this reason.
(Paragraph 142)

6. Whether "Creamy Layer" is to be excluded from SEBCs?

"Creamy Layer" is to be excluded from SEBCs. The
identification of SEBCs will not be complete and without the
exclusion of "creamy layer" such identification may not be valid
under Article 15(1) of the Constitution. (Paragraph 152)

7. What should be the para-meters for determining the "creamy
layer" group?

The parameters contained in the Office Memorandum issued
by the Government of India, Ministry of Personnel, Public
Grievances and Pensions (Department of Personnel and Training)
on 08.09.1993 may be applied. And the definition of "Other
Backward Classes" under Section 2(g) of the Act 5 of 2007 should
be deemed to mean class or classes of citizens who are socially
and educationally backward, and so determined by the Central
Government; and if the determination is with reference to caste,
then the backward class shall be after excluding the creamy layer.
(Paragraphs 153 and 155)

8. Whether the "creamy layer" principle is applicable to
Scheduled Tribes and Scheduled Castes?

"Creamy Layer" principle is not applicable to Scheduled
Castes and Scheduled Tribes. (Paragraph 163)

9. Whether the principles laid down by the United States
Supreme Court for affirmative action such as "suspect
legislation", "strict scrutiny" and "compelling State
necessity" are applicable to principles of reservation or
other affirmative action contemplated under Article 15(5) of
the Constitution?

The principles laid down by the United States Supreme
Court such as "suspect legislation", "strict scrutiny" and
"compelling State necessity" are not applicable for challenging the
validity of Act 5 of 2007 or reservations or other affirmative action
contemplated under Article 15(5) of the Constitution.
(Paragraphs 184)

10. Whether delegation of power to the Union Government to
determine as to who shall be the backward class is
constitutionally valid?

The delegation of power to the Union Government to
determine as to who shall be the "other backward classes" is not
excessive delegation. Such delegation is constitutionally valid.
(Paragraph 186)

11. Whether the Act is invalid as there is no time limit prescribed
for its operation and no periodical review is contemplated?

The Act 5 of 2007 is not invalid for the reason that there is
no time limit prescribed for its operation, but a review can be made
after a period of 10 years. (Paragraph 187)

12. What shall be the educational standard to be prescribed to
find out whether any class is educationally backward?
The contention that educational standard of matriculation or
(10+2) should be the benchmark to find out whether any class is
educationally backward is rejected. (Paragraph 189)

13. Whether the quantum of reservation provided for in the Act is
valid and whether 27% of seats for SEBC was required to be
reserved?

27% of seats for other backward classes is not illegal and
the Parliament must be deemed to have taken into consideration
all relevant circumstances when fixing the 27% reservation.
(Paragraph 193)

Damn those meetings!

I have alway felt that meetings everywhere and always are unproductive and a bore. If meetings are held at all, the time spent on these should be minimal. I was happy to see these views echoed in an FT article:

Does anyone ever walk into a meeting fired up with enthusiasm? Or do they groan in anticipation of the politicking, the bureaucracy and the office bore taking up what little oxygen remains in the room? And, in any case, all the decisions have probably already been taken, haven’t they?

Jim Buckmaster, the unconventional chief executive of Craigslist, the internet classified advertising company, is no fan of meetings. “I’ve always found them to be at best unproductive and boring, and at worst toxic and destructive,” he says. “The people who want to show off do, the brown-nosers brown nose, everyone else wastes their time. I also think the larger the meeting, the worse it is.”

Sixth Pay Commission Report

I had meant to post this comment long back but it just escaped me. I wrote about the Sixth Pay Commission (SPC) report in my ET column. Let me just add a few thoughts here.

• As I point out in my column, the perception that the Commission has gone overboard in increasing government servants' pay is wide of the mark. Yes, they have been generous with grade A employees and there too only in respect of those of the rank of Joint Secretary and above. For the rest, the increases recommended are modest. The ratio of top pay to lowest pay has, as a result, moved up from around to 12. The nominal increase on the average is of 13%, including pensions. Excluding pensions, the increase in pay and allowances may be slightly higher- 15-20%. My guess is that, in real terms, the increase relative to the pay of a decade ago is negligible.
• In the months preceding the Commission's report, commentators had set up a terrific drumbeat as to how the SPC would devastate goverment finances. In fact, the fisc will hardly feel the impact- 04% of GDP is the first year impact, including arrears. In about three years' time, the impact wears off. What on earth were these commentators talking about?
• There is a perception that government is getting fatter. Wrong. It is getting leaner. In two ways. One, through attrition- jobs falling vacant through retirement are not getting filled. Two, increases in manpower have not kept pace with increase in government revenues or GDP. Compensation to government revenues has fallen by a third over the past decade. This is a measure of downsizing. People don't see it because employees have not been fired. But this is cleverer downsizing- let revenues rise, don't let manpower costs rise as fast. It is a form of downsizing that doesn't hit the headlines and hence is politically more manageable. It is the only sort of downsizing that makes sense in a democracy such as ours.
• How to make government more efficient? One element is reasonable compensation. Not that pay in government can ever be on par with the private sector but private sector pay does serve as a distant benchmark. The problem today is that private sector pay has soared into the stratosphere, so pay in government lags behind. The answer, as I point out in my column, is more frequent revisions in government than once in 10 years. The SPC has failed to make this recommendation. However, there are other sensible proposals- running pay bands that end stagnation in a given pay scale is an overdue reform. At present, people are stuck at the top of their scale for years!
  
• Instead, the SPC takes the view that there be selective rewards linked to performance- a private sector idea. I'm afraid given the problems in measuring performance in government and politicians' tendency to abuse such schemes, this just won't work.
• One last point: the SPC favours market-based pay for regulators. The chairman of SEBI or IRDA can make Rs 3 lakh per month. Alas, this won't fly. I can't see the top bureaucrats allowing this. If the cabinet secretary must get less than the president, why should regulators be in a different category?
  

Justice Raveendran on OBC quotas

In my last post, I had flagged an issue that troubles people in states such as Tamil Nadu. There is a huge quota for OBCs. On top of this, OBCs get in through the merit pool. The total OBC representation thus exceeds the quota limit which itself is generous. Can this happen in central educational institutions now that the Supreme Court has rejected the challenges to the 93rd Amendment?

Justice Raveendran flags this issue in his judgement but refrains from expressing an opinion:

<>

<>I would however leave open the question whether members belonging to other backward classes who get selected in the open competition field on the <>basis of their own merit should be counted against the 27% quota reserved for other backward classes under an enactment enabled by Article 15(5) of the Constitution, for consideration in an appropriate case.

My guess is that this may not be a problem in the elite institutions to start with. Once the 'creamy layer' is excluded, it will not be easy to fill up the 27% earmarked for OBCs.

But, yes, over time, it could be an issue. That is why I say that we must monitor total OBC representation: watch the percentage of OBCs in the quota category and also in the general category. Cut-offs for quotas and definitions of OBCs must be revised periodically so that total OBC representation amounts to 27%.

OBC quotas and the 'creamy layer'

The SC judgement on OBC quotas is in. The focus now turns to implementation. There are two issues as I see it:

i. How do we define the 'creamy layer' for education purposes;

ii. Whether the 27% quota is to be introduced at one go or in phases as the Moily committee had recommended.

On the latter, I just saw on TV that Ramadoss wishes to have 27% at AIIMS right away. I have favoured phased implementation not just because it is politically more acceptable ( to those adversely impacted) but also because we are not clear as to how OBC representation in educational institutions will be impacted by the 27% quota. Let me, therefore, focus on (i) above.

I have not had a chance to go through the judgements myself. From what I could make out from newspaper reports, the 27% quota is subjected to several constraints:

• 'Creamy layer' to be excluded. For jobs, the definition was those from families with income of Rs 2.5 lakh per annum. It appears that, on top of this, the present judgements impose several other criteria: children of those occupying certain high posts or belonging to certain vocations, graduates, etc. Whether these are mandatory or indicative is not clear. On TV yesterday, I heard several people say that each state has evolved its criteria for determining the 'creamy layer'. It is upto the HRD ministry, I suppose, to clarify what criterai would apply to central educational institutions.
• Private unaided institutions are not covered by the existing legislation. On whether fresh legislation can be framed to cover them, all judges except Justice Bhandari are reported to be silent. Justice Bhandari is said to have taken the position that private, unaided instiutions fall outside the ambit of the 93rd constitutional amendment.
• Graduates do not qualify as backward, hence there will be no OBC quota in post-graduate courses. This is one issue that needs to be resolved quickly because we have to determined whether quotas apply to the likes of IIMs or not.
• There is to be a review of the quota level after five years. Again, whether this is merely a suggestion or a direction needs to be clarified.
• The OBC quotas will be subject to minimum eligibility criteria. According to some reports, the difference between the eligibility cut off for the general pool and for the OBC quota should not exceed 5 marks (some say 5%). What this means for IIMs which follow the percentile system is not clear- is the OBC cut off 5 percentile below the normal one or 5 marks below the normal one. My guess is that the latter would be much lower than the former. The Moily committee itself had a sentence to the effect that quotas should not be at the cost of institutional quality- this meant that institutions could exercise their discretion in judging how far they should go to accommodate OBCs.

On the face of it, it would appear that the constraints imposed by the SC will result in a representation for OBCs below the 27% intended. On TV yesterday, I heard dalit activist and scholar, Kancha Iliah, say that the combination of 'creamy layer' and higher fees at educational institutions would prove lethal to the cause of OBC quotas- those with incomes below Rs 2.5 lakh would be sufficiently intimidated by the increasing levels of fees not to seek admission; those could afford the fee would be ineligible. The 27% quota would remain a dream.

Iliah argued that the additional seats being created for OBC quotas would end up being appropriated by the higher castes ( the SC judgement apparently says that seats not filled by qualifying OBCs must go the general pool). Thus, OBC quotas would have the perverse effect of giving greater representation to the higher castes than they enjoy at present!

How plausible is this scenario? Health minister Ramadoss (who was on the same show on Times Now) made the point that 17 years after the implementation of Mandal I, OBC representation in government was just around 5%. If the same happens with educational institutions, I guess the upper castes would be richer by 22%!

However, I am not sure we can extrapolate from the experience with government jobs. People have cited some surveys done in educational institutions (where quotas do not exist at present) that show that OBC representation is quite high even now- on the TV show yesterday, somebody mentioned a figure of 24%. It may well be that OBCs who graduate from good institutions do not seek government jobs, hence the representation in education does not translate into commensurate representation in government.

Iliah may be right: outside the 'creamy layer', not enough people may qualify to meet the quota of 27%. But he overlooks one fact: 'creamy layer' OBCs may be getting in without any concessions, on pure merit, that is. The objective should be overall OBC representation of 27%, not 27% through quota plus whatever OBCs get in the general category. This translates into a higher than mandated representation for OBCs in many states such as Tamil Nadu and is the cause of much of the anti-reservation sentiment.

So we need to monitor OBC representation in the general pool and that in the quota pool and see whether the total approaches 27% or not. This is why phased implementation is desirable. Start with 7% or 10% in the first year for quotas and see what the total OBC representation, including that in the general pool, is. Adjust the definition of 'creamy layer' accordingly.This gives us an empirical basis for defining the 'creamy layer'. It will be so defined as to ensure that OBC representation in the general pool plus that in the quota category amounts to 27%. It also gives us a basis for setting cut-off levels of marks for quotas.

HBS is 100

Harvard Business School, the mother of them all, turned 100 on April 8. There is a critique by Stella Bradshaw in FT. It's a critique as much of the MBA degree as of HBS:

Strip away the hype surrounding the MBA, though, and it is difficult to come up with hard evidence to prove that 100 years of management education, and the MBA degree in particular, have been beneficial to business or society. Indeed, even among its proponents, many are questioning whether business schools teach the right things, in the right way, to the right people.

..........Given the obvious popularity of the MBA, it may seem strange that business schools, particularly in the US, are facing a crisis of confidence about what they teach. One of the biggest issues is surprisingly similar to the dilemma faced by Harvard 100 years ago: that is, the extent to which business schools should teach the practical and research the theoretical.

The 'crisis of confidence' in the quote above is for real. Unlike in law and medical schools, faculty lack the conviction they are adding value. Motivation is low amongst students in the second year because only the first year grades are made available to recruiters. This means that how you fare academically in the second year doesn't have a bearing on the job you will land. Take care of the first year grades and you have made it.

I liked the variations in the FT article on what MBA has come to mean: Mediocre but Arrogant, Master of Brainless Axioms. A student from Insead is quoted in the article as saying that the MBA programme is a 'bullshitter's paradise'.

Soros on the financial crisis

George Soros lashes out at market fundamentalism:

For the past 25 years or so the financial authorities and institutions they regulate have been guided by market fundamentalism: the belief that markets tend towards equilibrium and that deviations from it occur in a random manner. All the innovations – risk management, trading techniques, the alphabet soup of derivatives and synthetic financial instruments – were based on that belief. The innovations remained unregulated because authorities believe markets are self-correcting.

Regulators ought to have known better because it was their intervention that prevented the financial system from unravelling on several occasions. Their success has reinforced the misconception that markets are self-correcting. That in turn allowed a bubble of excessive credit to develop, which extended through the entire financial system. When the subprime mortgage crisis erupted it revealed all the weak points. Authorities, caught unawares, responded to each new disruption only after it occurred. They lacked the ability to foresee them because they were in the thrall of the market fundamentalist fallacy. They need a new paradigm

HRD ministry okay with IIMA fee hike

That's what the media has reported today:

After a meeting with HRD minister Arjun Singh, IIM-A board chairman Vijaypat Singhania ruled out a review, but added that enough scholarships would be available to support meritorious but poor students. Against Rs 40 lakh earmarked for scholarship, the amount now would be Rs 8.5 crore, covering 62% of students.

There are two issues here:

1. Do scholarships address the problem? Let's see... Rs 8.5 crore for 62% of students or around 360 students. That's Rs 2.4 lakh per student against the fee of Rs 11.5 lakh. On the average, qualifying students (the eligibility limit now is Rs 6 lakh of family income) would have to cough up Rs 9 lakh- nearly double the existing fee. This is the extent of help that IIMA's tuitution waiver and need-based scholarship will give- where ordinary students face a tripling of the fee, "needy" students face a doubling. IIMA's move to increase financial support is laudable but, on the average, the increase in the burden on the students remains high.

2. Should educational institutions pass on full costs to those who can afford to pay? This is taxen as axiomatic by many. But the principle that subsidies through scholarship are required only for needy students while the rest pay market-related fees is open to question. As I have said repeatedly, quality, non-profit institutions do not accept this principle. Higher education is subsidised for all. It's just that the subsidy is greater for the needy.

In the best schools, costs are seldom recovered in full through fees from students on the ground that students have the capacity to service loans. Fees cover only a portion of the costs for any student. I read that the IITs follow the rule that one-third of costs are recovered from students, one third from consulting and one-third from government funding.

At the best universities in the US, private endowments cover part of the costs for any student. On top of this, Harvard has a total exemption from tuition fee for those coming from families with income of upto $60,000 and a slightly lower subsidy for those coming from families with income of upto $100,000. And this in a culture where the family does not necessarily bear the educational costs of the child. At IIMA itself, the practice has been to cross-subsidise PGP through other income. If the IIMs do not wish to accept government funds, it would be worthwhile for them to explore fully other sources of income - consulting, endowments- that will help them cover a portion of the cost of the PGP.

Anyway, HRD minister Arjun Singh may have been convinced about the rationale for the IIM fee hike but not his precdecessor, Murli Manohar Joshi:

''It is a decision of the elite, by the elite and for the elite,'' Dr Joshi remarked, adding ''it will put a damper on Indian middle class dreams of good management education. Dr Joshi called for an audit of educational institutions built with taxpayer funds. ''It is high time there is an academic and financial audit of institutions built on public money and government mandate.''

Sorry, the Hyde Act does apply to us

We have been going back and forth on the Indo- US nuclear deal for a while now. One of the strongest arguments mounted in favour of the deal has been that the Hyde Act is a purely domestic legislation of the US. We will be bound only by the 123 agreement with the US. Advocates of this line will be swiftly disillusioned by this report in Rediff from its Washington correspodent about the recent discussions that a US Congresionnal delegation had with the Indian government:

The Massachusetts Democrat (Ed Market) reiterated, "So what I did was just to raise for them what the law of the United States is with regard to the impact that a nuclear explosion would have since the section, which is being amended is the Section 123 of the Atomic Energy Act and the Non-proliferation act of 1978, and obviously the Hyde Act amends that to make it possible for have a transaction with India."

Markey said that while the delegation was in India, the debate continued to rage 'inside India as to whether or not -- the Hyde Act was the final arbiter'.

The delegation had impressed upon all Indian officials and parliamentarians that India has to abide by the provisions of the Hyde Act, he added.

He said the delegation had pointed out to the Indian officials and parliamentarians that US Secretary of State Condoleezza Rice [Images] had assured the US Congress that 'the Bush Administration intends on abiding by the Hyde Act and we made it clear that the Hyde Act was the law of the United States when we were there -- when we were speaking with all of the various groups that we met with."

Asked if there was an appreciation by Dr Singh and his senior Cabinet colleagues and others that it was the Hyde Act that superseded the 123 Agreement, Markey said: "I hope so. The discussion turned exclusively while we were there on the Hyde Act -- that was the discussion. And, whether or not, the Hyde Act was binding upon the President of the United States, which we assured them, it was."

Business Standard on IIM fee hike

BS today has an edit today on the IIM fee hike. Let me dissect a couple of points it makes because these reflect the conventional wisdom:

1. Amazingly, faculty at the IIMs and IITs, being government institutions, are subject to these (UGC) pay-scales too. They not only lag their global counterparts by a huge margin — even in purchasing power parity terms — but also their colleagues in private institutions in India who are by no means generously paid.

We should expect compensation (including housing) at the IIMs to amount to around Rs 15 lakh after the Sixth Pay Commission. This does not include consulting income. Now, Rs 15 lakh is about Rs 45 lakh in PPP terms- or $ 110,000. That does not strike me as "lagging global counterparts by a huge margin".

2. To be sure, the UGC scales will continue to apply, but with higher fees the IIMs will have the flexibility to consider solutions similar to those followed by many public sector banks. Like any government-owned institution, senior bankers in public sector banks suffer the malady of low pay scales. To get round this, many such banks offer valued senior executives contracts that are more in tune with private sector salaries and outside the purview of government scales.

I don't know of many quality institutions that offer superior pay to faculty on a contractual basis. That's because you can't set targets for output over a contracted period. Even chair positions at top schools abroad are on a tenured basis.

In any case, I must question the presumption that higher fees will translate into higher pay for faculty. None of the IIMs, so far as I know, has made this connection. As far as I can make out, higher fees are meant to cover increased costs on the existing basis and to preempt the need to go to government for funds.

IIMA fee hike

I had a post yesterday on the IIMA fee hike. The figures I mentioned have been overtaken by events. The IIMA board, at its meeting yesterday, has approved an increase in fee to Rs 5.5 lakh in the first year and Rs 6 lakh in the second year, making the total cost of the PGP Rs 11. 5 lakh- up over 140% from the present level of Rs 4.4 lakh.

Oh no!- IIM fee hike again stirring up a storm

IIMA had announced a fee hike from Rs 2 to 3 lakh per annum. IIMB wants to raise- or has decided to raise- fees from R2.5 lakh to Rs 4 lakh. As I have argued repeatedly, IIM fees set the benchmark for other schools. I read in the papers this week that MDI is going to raise its two year fee to Rs 7.9 lakh; SP Jain to Rs 2.5 lakh. Others are following suit.

The IIMA move is being opposed by the central and state governments, TOI reports. There are two issues here. One is the principle of raising fees in order to recover costs. My contention is that in the non-profit model- which is where you get quality in education- you do this only upto a point. For the rest, there is a subsidy. The subsidy may come from government - as in Europe and most parts of the world- or it may come from private endowments- as in the US.

The top IIMs say they do not wish to take money from the government as that may compromise their autonomy. I am not sure. Whether the IIMs take funds or not, they remain public institutions accountable to government. Just as SBI or Bhel is accountable for government no matter that they give funds to government- through dividends- and don't take any.

Alright, the IIMs don't want to take funds from government. They must then declare where they will raise funds from- other than from student fees. Student fees can form only a small proportion of revenues. The rest must come from consulting- to an extent- and from government or private charity. Passing increasing costs on to students is inconsistent with the non-profit model and not just for financial reasons. Dependence on student fees for funds means more courses, more programmes and more teaching load. That works to the detriment of research which is the big strength of the non-profit model.

The second reason why higher fees for IIMs are a matter of concern is that fees at lower business schools go up. And lower busines schools cannot place students at quite the same salaries- so the load of loan repayment for the middle class goes up. Besides, I don't know how many private business schools have generous scholarships of the sort that the IIMs have whereby those from families with income of under Rs 2 lakh are given support.

Higher fees at IIMs thus have implications for the long-term business model at the IIMs themselves and for inclusion in education in general. The danger that leading educational institutions have to guard against is the gradual dilution of the non-profit model with its implications for quality and reduced access to quality education for large numbers of people. Caution must be the watchword.

Northern Rock: FSA does some introspection

The UK's FSA has done an internal audit of what went wrong in its supervision of Northern Rock.
FT comments:

Wednesday’s report is a catalogue of internal failures: Northern Rock was passed between three heads of department in the space of a year; financial analysis of the bank was inadequate; risks identified in the FSA’s own Financial Risk Outlook did not feed into supervision of Northern Rock; ongoing meetings with the bank were few and poorly documented; and FSA management lacked the information to challenge Northern Rock’s supervisors.

Savings and investment in Indian economy

Shankar Acharya is bearish about the savings and investment prospects for the Indian economy:

The big question today is will this massive surge in savings and investment ratios continue into 2008/9 and beyond? The chances are that it won’t and here’s why. The household savings ratio will probably continue to increase gradually for much the same reasons that have prevailed over the last two decades, except that in 2008/9 we might see some moderation due to negative wealth effects stemming from lower asset prices (equity and real estate).

The corporate savings boom is more likely to peter out as the industrial economy continues to slow in the face of global headwinds from the international credit crunch, domestic business cycles and high interest rates. Depending, obviously, on earnings performance, the ratio of corporate savings to GDP could easily drop below 8 percent. Central government savings will be impacted by the Sixth Pay Commission, the budget’s income tax bonanza, slower growth in company taxes, farm loan waiver costs and rising major subsidies. Public enterprise savings will bear the brunt of growing oil sector “under-recoveries”. On balance, public savings is likely to dip below 3 percent of GDP. Taken together, aggregate savings in 2008/9 may be in the range of 34-35 percent of GDP, compared to the 36-37 percent peak probably achieved in 2007/8. So aggregate investment could also drop one or two percentage points from the 2007/8 advance estimate of 38.4 percent of GDP.

Well, Acharya was bearish about Indian growth prospect as recently as two or three years ago. I do not share his pessimism. I think the upswing in investment will continue and growth momentum will be maintained:

• Even if the rise in domestic savings rate slows down, it will be offset by savings inflows from abroad
• With the continuing shift towards the services sector, the ICOR will decline, so we will get a better growth bang for a given investment buck
• True, government savings may be hit temporarily the Sixth Pay Commission effect but there is attrition happening in government, so this will compensate for the higher wages
• The rise in corporate savings may be slower but rise it will. Industrial growth will decelerate only slightly this year and not much in the years ahead.
  

I do not know whether there are instances of the savings rate declining in an economy that has moved to a high growth trajectory.

Bear saga not over yet ?

It appears the Bear saga is not over yet. JP Morgan is said to be willing to raise its offer price for Bear's shares from $2 to $10. The offer was prompted by the possibility of Bear shareholders moving to block the deal.

One detail that caught my eye in an FT report was about a clause in the deal announced last week that says that JP Morgan will guarantee Bear's trades even if the deal was voted down! How on earth was such a clause include or overlooked?

JPMorgan and Bear were prompted to renegotiate after shareholders began threatening to block the deal and it emerged that several “mistakes” were included in the original, hastily written contract, according to people involved in the talks.

One sentence was “inadvertently included,” according to a person briefed on the talks, which requires JPMorgan to guarantee Bear’s trades even if shareholders voted down the deal. That provision could allow Bear’s shareholders to seek a higher bid while still forcing JPMorgan to honour its guarantee, these people said.

When the error was discovered, James Dimon, JPMorgan’s chief executive, who was described by one participant as “apoplectic,” began calling his lawyers at Wachtell, Lipton, Rosen & Katz to seek a way to have the sentence modified, these people said. Finger pointing over the mistakes in the contracts began as bankers blamed the lawyers and vice versa.

Central banks and liquidity

I noted in an earlier post how the Fed has introduced a new instrument for liquidity in the present crisis, one intended to help prime brokerages.

There is a larger issue as to how central banks should address problems of liquidity. One school of thought is that they should do what the Fed has now done and what the European central bank has long done- that is, accept lower quality securities as collateral.

But this can only be a solution in a crisis. Once things settle down, banks must be incentivised to have adequate liquidity, else the assurance of greater liquidity in a crisis is bound to create moral hazard. Why would banks have adequate liquidity on their own when this means investing in low return assets?

Is the Fed compromising itself by offering government securities in return for lower grade securities held by banks and investment banks? No, says the Economist. The securities acceptable to the Fed are still AAA- rated bonds that are not on review for a downgrade. A 'haircut" will be applied to protect the Fed against a decline in the value of the collateral. And the Fed retains the right to demand other collateral if pledged collateral turns bad.

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.