The journey of Indian finance

by Ajay Shah.

A great tool for making sense of things is a sense of history. At each point in time, we should wonder: what was the situation, what was the problem that was sought to be solved, what was done, how did it work out? This helps in all fields; e.g. we understand special relativity better when we understand the journey of ideas leading up to Einstein.

In this spirit, economic history is central to understanding economics. One of the great failures of modern economics is the loss of the economic history perspective. Most people in a formal education in economics do more convex optimisations than economic history, and that's unwise.

Latika Chaudhary, Tirthankar Roy and Anand V. Swamy invited me to write for their edited book, the Cambridge Economic History of Modern South Asia (forthcoming). I wrote a paper on the journey of Indian finance, starting at 1947. Many odd features of Indian finance make sense when viewed in this economic history perspective.

There is an important kind of economic history, an epsilon-delta tradition, where data, archival texts and documents are precisely pinned down. Alongside this, it is good to also have a strategic view. The paper has such a high level treatment of the journey of ideas, interests and institutions. It is organised as 10 sections on banking, the equity market, other financial firms, capital controls, bankruptcy, monetary policy, household finance, systemic risk, the working of financial agencies and the policy process.

In each of the 10 areas, I try to offer the birds eye view, a sense of what happened and why, of what got done and what didn't, and the forces at work. There is a unified chronology, evaluation and bibliography. Many epiphenomena are glossed over, so as to focus on the essence of finance: the play of time, risk, information, individual optimisation, and principal-agent problems. Each of the 10 area-essays needs to be turned into a full blown economic history paper, including epsilon-delta style work. This paper can help others get started on such research projects.

There are two ways to interpret the journey of Indian finance: a market failure view, and a public choice view.

On one hand, there was a journey of ideas, with learning (in some areas) about how state coercion can counter the market failures in finance. This is a story of building knowledge about the place of the state in Indian finance, and then building state capacity to try to help with useful interventions. The story contains many crises, some useful feedback loops, and some loss of institutional memory.

And then, there was the power conflict. The financial system constitutes the commanding heights of the economy. The Indian state has tried to control the financial system, and direct its resource allocation in ways that suit the state. There has been an ebb and flow of different degrees of state control, and different methods through which the control is achieved. Alongside this, policy makers have sought praise through isomorphic mimicry.

A lot was done in the two phases identified in the paper. But it is far from finished. The basic machinery of markets and financial firms is quite incomplete. State coercion in finance requires fundamental reorientation towards state capacity in addressing market failure, through clarifying the objectives of financial agencies and establishing their checks and balances. These difficulties are an important source of Indian economic underperformance: finance remains central to the journey of Indian economic development. The future of Indian finance lies in building the knowledge and the community for these tasks.

Review of "The Rise of the BJP: The Making of the World's Largest Political Party" by Bhupender Yadav and Ila Patnaik

by Josh Felman.

In 2014, the BJP secured a remarkable victory. They won an absolute majority in the Lok Sabha elections, the first time any political party had done so in three decades. Then, five years later, they repeated this feat, increasing their majority. Now, they dominate the national landscape in a way not seen since the heyday of the Congress party, half a century ago.

How did this happen? Most analysts give a one-word answer: Modi. Others give a two-word answer: Modi-Shah. Without doubt, Narendra Modi and Amit Shah are exceptional politicians and strategists. But life is complicated, and great men cannot entirely determine the course of history.

One reason why the BJP won in a landslide in 2014 is that Congress completely mismanaged the economy. The party proved unable to deal with the fundamental problems that emerged after the Global Financial Crisis, such as the sizeable non-performing loans at the banks. Instead, they tried to resuscitate the economy through lax fiscal and monetary policy, a strategy which failed to revive growth, producing only double-digit inflation. Then came a spate of scandals, and the government became paralyzed, unable to do anything at all.

Even so, it is wrong think that the BJP was merely the accidental beneficiary of Congress' collapse. As this book stresses, the BJP has been rising for a long time.

Sometimes a picture is worth a thousand words. So consider the following chart. It shows that despite a notable dip in the 2000s, there has been a clear trend to the BJP's representation in the Lok Sabha. And that trend is upward. The BJP was formed in the 1980s, initially earning just a few seats. By the mid-1990s, it had become the largest party in Parliament.

How can we possibly explain this development? This book provides an answer. Not "the" answer, of course, but a particularly valuable answer, for the explanation comes from a BJP insider. Unlike most books written by politicians, this work avoids the intricacies of long-forgotten debates and refuses to engage in score-settling. Instead, this is a serious work, covering the entire sweep of independent India's history, documented with extensive footnotes -- exactly as one would expect from the co-author, who is a noted, non-political academic. (Full disclosure: I have also been a co-author with Ila Patnaik.)

The aim of the book is to explain how we have arrived at the current political pass. Of course, it does so from a BJP perspective. But that is exactly the need of the moment: we need to understand what the BJP believes, as these beliefs will translate into actions that affect all of us.

So, what explanation does the book provide? Essentially, it argues that the rise of the BJP stems from two factors: its organizational ability and its message. Of the first, the book makes a convincing case. Indeed, no reader – no matter what his or her political view – can finish this book without a sense of awe. It’s not just that the party has come up with one brilliant idea after another, such as "multiplying" their Prime Ministerial candidate by projecting 10-foot holograms of Modi in 200 cities across the country. Even more astounding is the BJP's ground game.

Consider the BJP's strategy for the 2014 election. The party developed a booth management strategy, under which leaders were assigned to every single one of the 1 million voting booths in the country. Each leader supervised around 50 individuals, whose job it was to meet with around 30 voters and convince 15 of them to vote for the BJP.

This arrangement required an incredible amount of effort, coordination – and manpower. Simple arithmetic shows that 50 leaders for 1 million booths required no less than 50 million party workers. For the 2019 election, the party mobilized 110 million members. How on earth did the BJP manage to convince so many people to work so hard for the party?

One strategy has been to convince members that they are part of a family. They even have a slogan for this: Mera Parivar, Bhajpa Parivar (My family is the BJP family.) In practice, this means that the life of a party worker is dominated by an endless calendar of events: campaigns, followed by political activities, interspersed with visits from seniors. Particularly strenuous efforts are made to nourish connexions amongst members from all strata of the party, with seniors being asked to share meals with workers on their visits to the regions.

Another strategy is to employ the highly motivated swayamsevaks (volunteers) of the RSS. The authors are unequivocal about the links between the RSS and the BJP. They emphasize that the predecessor of the BJP, the Jana Sangh, was founded with the explicit purpose of giving a political voice to the RSS' vision for India. And they note that the BJP was born when the leaders of the Jana Sangh were forced to choose between their commitment to the RSS philosophy and their political career in the Janata Party. They chose to stay true to their ideology.

The devotion to this ideology remains strong to this day. Prime Minister Modi has said, 'I am connected to the mission and not ambition. In my life, mission is everything, not ambition'.

So, what exactly is this mission? Put another way, if the second reason for the BJP’s success is that it has developed an attractive message, what exactly is that message?

In some areas, the book gives a clear answer. It says that right from the start the BJP has focused on the fight against corruption. Its first major success came in 1987 when it was able to pin the Bofors scandal on the Congress Party, accusing their senior officials of taking bribes in return for granting a large defence contract. In 2002, Venkaiah Naidu became BJP President partly on the strength of his credentials as convener of an anti-corruption movement in Andhra Pradesh. And of course corruption was a major theme of the 2014 election.

Another key element of the BJP mission, according to the book, is improving the standard of living of the poor, the people whom the Jana Sangh used to call the 'last man in line'. The Modi government came up with a particularly effective way of doing this, by providing the poor with tangible benefits such as LPG gas cylinders and toilets – and cash transfers, paid directly to newly created Jan Dhan bank accounts. These programs created a direct link between the party and the poor, earning in particular the loyalty of female voters.

In other areas, however, the book is much less precise. For example, we are told repeatedly that the BJP believes in "nationalism". But it is not clear what this means. After all, Congress is also a nationalist party; indeed, they led the independence movement against the British.

Some commentators claim that the BJP's nationalism is different because it is a communitarian vision, focusing on building a Hindu nation-state. The BJP strenuously denies this charge. Indeed, the word Hindutva is not to be found anywhere in this book. Instead, the BJP views itself as the party of true secularism, devoted to the principle that no group should be treated differently by the state. Accordingly, they oppose triple talak divorce and special status for Kashmir – because these policies treat different groups differently.

But this argument sits uneasily with the claim that the BJP believes in 'cultural nationalism'. The book takes great pains to stress that this phrase refers to an all-Indian culture, coming out of many traditions: Hindu, Muslim, even Western. But the only traditions the BJP has mobilized to defend – at least the only ones mentioned in the book are Hindu traditions.

Particularly striking is the framing of the dispute over whether to build a Ram temple on land where a mosque was standing. As the book puts it, for the BJP, Ayodhya was not a land dispute; "it was a mission to unite India with the thread of cultural nationalism". The argument seems to be that the country should have united behind this plan, since it honoured an important tradition, the place where Lord Ram was reputed to be born. But many people did not see things this way, and the dispute proved enormously divisive.

That said, the BJP's message of cultural nationalism does resonate with a significant section of the population, giving it a compelling message to go with its superb organization and millions of devoted members. That makes the BJP a formidable vote-getting machine. No wonder it has just risen and risen.

But history teaches that a relentless rise is often followed by a disastrous fall. Indeed, one doesn't have to look very far to see an example of this process at work. Right after independence the Congress Party bestrode the political landscape like a colossus, winning 364 out of the 489 contested seats in the first parliamentary election. But since the 1970s it has gradually decayed, to the point where it holds only 52 seats in the current Lok Sabha.

The BJP has thought long and hard about this example, concluding that Congress declined because it failed to nourish its roots during its long period in power. To make sure this doesn’t happen to them, the BJP not only pays considerable attention to sustaining morale amongst its party members (as already mentioned); it also takes great care to avoid the perils of dynastic leadership. The BJP offers a clear path for ambitious young supporters, who can start with party work, progress to a role in government, and then take up role of an elder statesman. To ensure that this career ladder is not blocked by elderly seniors, members are expected to step aside from active operational roles once they reach the age of 75. It will be interesting to see whether this practice continues, now that the party has a firm hold on power.

Beyond the constant need to replenish the party with new energy, the BJP faces another challenge, one that will be even more difficult to manage: it must meet the needs of the nation. Without doubt, the BJP has found a way to satisfy what we could call 'Cultural India'. But meeting the needs of Aspirational India, the hundreds of millions of young people looking to find good jobs and raise their living standards, will be a far more difficult task.

The current government is fully aware of this problem, having inherited an economy that was in shambles. Accordingly, it has implemented reform after reform, including Inflation Targeting, the Insolvency and Bankruptcy Code, and the Goods and Services Tax. But the economy has still failed to take off, as investment has remained stubbornly low.

So far, there have been no political consequences, as the public has accepted that it will take time to restore an economy that was in such bad shape when the current government arrived. But the BJP knows that at some point, the public will demand results.

Accordingly in 2020, the government decided to change tack, abandoning the post-1991 policy of opening up the economy in favour of a new approach, Atmanirbhar Bharat ('Self-Reliant India'), whereby tariffs are being increased to encourage import substitution while production subsidies are being given to firms selected by the government. It is still early days, but there is little in India’s history or that of Asia more generally that suggests this strategy is likely to work. In that case, trouble for the BJP may lie ahead.

For far too long, the nature of the BJP has remained a mystery to the English-reading public. Finally, we have an authoritative presentation of their point of view, one that allows us to understand better how the BJP has risen and what it believes. For anyone who wants to understand how India arrived at the current juncture – and where it is likely to go in the future – this book is a must read. Buy it and read it carefully.

 

Josh Felman is the principal at JH Consulting.

The rise of government-funded health insurance in India

by Harleen Kaur, Ila Patnaik, Shubho Roy and Ajay Shah.

The National Health Protection Scheme (NHPS) announced in the Budget 2018-19, targets providing affordable health care to 100 million poor households in India. It is arguably the world's largest health insurance scheme and an indicator of transformation of the role of government from being a health care provider, to that of a health care financier. Before independence, India focussed more on public health through interventions like water supply, sanitation and vaccination than providing health care through hospitals. The reorganisation after independence was a result of policy changes that merged public health and health care responsibilities within the same officers of the government, the doctors. A remarkable development in the field of health policy in India is the rise of government funded health insurance programs.

These programs feature purchases of health care services from private health care providers health insurance from health insurance companies. In a recent paper titled, The rise of government-funded health insurance in India, we discuss the history of health policy in India in three phases; pre-independence British India, independent India until the 2000s and independent India after 2000s, to understand the factors contributing to the shift in the health system of the country.

We offer fresh insights into these developments by placing them in a historical perspective. The roots of Indian health policy lay in British India, which laid the foundations of public health. This was done after the Royal Commission of 1859 was set up to investigate the health status of the army in India. The Royal Commission studied not just the army, but the civilian population as well. By and large, their emphasis was on public health and not on health care. The findings of Royal Commission can be summarised in two quotations:

1. The need for public health rather than health care

"Native hospitals are almost altogether wanting in means of personal cleanliness or bathing, in drainage or water-supply, in everything in short, except medicine."

2. The need for interventions outside of soldiers

"The health of the English army is indissolubly associated with the health of the population of the country which it occupies"

The legislative and institutional apparatus that was established in British India involved a prime focus upon public health, and a major role for sub-national governments (states, cities). When the Constitution of India was drafted, it largely reiterated this design.


The changes after independence came from two sources; the shift of power to the union government, and adoption of the Bhore Committee report. While the Constitution envisioned a federal arrangement, in practice, power shifted to the union government after independence. The union government designed programs, and financed state governments to implement these programs. There was a consequent atrophying of policy thinking and execution at the state and local government level. This had an impact on many aspects of public policy in India. In the present context, there was an adverse impact upon public health, as a large part of the field of public health consists of local public goods.

The Bhore committee report shifted focus from public health to health care, and gave a leadership role to doctors in health policy. It was adopted by independent India and became the gospel for health system thinking in India. There is an interesting tension in Bhore Committee report, between its recognition of the need for public health as a distinct problem from health care:

 The health services may broadly be divided into (i) those which may collectively be termed public health activities and (ii) those which are concerned with the diagnosis and treatment of disease in general.

versus its emphasis on health care:

Preventive and curative health work must be dovetailed into each other if the maximum results are to be obtained and it seems desirable, therefore, that our scheme should provide for combining the two functions in the same doctor in the primary units. (Emphasis added).

This document was accepted into the thinking of the Planning Commission, and translated into schemes and outlays in the following decades. There was a large scale attempt at building a public sector health care system.

For many decades, this induced the main paradigm of Indian health policy: an emphasis on health care at the expense of public health, weaknesses in local government, a big role for the public sector in the production of health care, and domination of doctors in policy thinking.

This approach worked badly. By the early 1980s, some policy thinkers began questioning this framework. By the 1990s, a great deal of evidence and literature had accumulated, that criticised this approach. Weaknesses in public health were giving a high disease burden. Alongside this, the public sector health care system was not effective. An unregulated, private sector health care system sprang up, to respond to the requirements of the citizenry.

While the mainstream health policy establishment proposed intensification of effort within this paradigm, by spending more money on it, politicians became increasingly concerned that the paradigm was delivering poor results. On the ground, it was apparent that private sector health care was the dominant feature of Indian health care.

This led to the ideas of public funding for the purchase of private health care, implemented through health insurance companies. This approach was attractive as it appeared to more directly translate fiscal outlays into tangible benefits for citizens. This policy innovation, which began in Maharashtra in 1997, spread rapidly across the country. By early 2018, there were 48 Government Funded Health Insurance Schemes (GFHISs).

We argue that there are four areas of concern with this approach. The first problem is the lack of emphasis on public health. The most effective public policy interventions in health are the public goods of public health, which were introduced in the British period. It is an incorrect strategy to have a high disease burden in the first place, and then build a curative layer on top of it. It is better to clean the air than to produce health care services for sick residents.

The second concern is about the conduct of the largely unregulated private health care sector, which yields poor outcomes for citizens. This calls for establishment of a regulatory strategy for the health care industry.

The third concern is about the weaknesses of consumer protection and micro-prudential regulation of health insurance companies, which yields poor outcomes for citizens. This calls for reforms of the regulation of health insurance companies.

Finally, there are important fiscal risks in this journey. Once voters get used to entitlements, they are politically difficult to withdraw. Population-scale health care is expensive, particularly in the context of weaknesses in public health which are giving a high disease burden. This is analogous to the field of pensions, where decisions about pension reforms need to be made only after estimating the implicit pension debt over 75-year horizons. There is a need for greater fiscal analysis, and caution, in the construction of government programs in health which make promises to households about future health care expenditures.


The authors are researchers at the National Institute of Public Finance and Policy.

Why is India's business history important?

by Tirthankar Roy.

Remembering Dwijendra Tripathi

In September this year, Professor Dwijendra Tripathi passed away. Until recently, he was the only business historian of India whose works were internationally recognized and respected. In the last twenty years, he produced as author or co-author a set of books, the Oxford History of Indian Business. The deep knowledge of the facts, love of the field, and a direct writing style, for which Tripathi was known, are in full display in these books.

I had interacted with Professor Tripathi closely in the 1990s, reviewed his books, visited his home, and admired him for his warm personality, scholarship, and his distance from ideological camps. On the last occasion we were in touch (7th July 2017), I emailed him the draft of a paper where there was a reference to Tripathi and Jumani in a mildly critical fashion, asking him if he would think that my criticism was unfair. He wrote: “Please go ahead with your paper; criticism is the life blood of scholarship.” Few Indian scholars I know of are so sporting.

With Tripathi’s benchmark books in existence, why write another book called "business history of india"? For that is what I did earlier this year (Cambridge University Press, 2018).

What is the idea of this new book?

This book is different, because it asks two questions that I have not seen others ask before. The first question is, how does a study of history help us understand the resurgence of private enterprise in India in recent times? We can ask this question for all emerging economies, which have seen dramatic transformations led by private capital. What are the historical roots of this emergence? I will call this the emergence question and come back to it ahead.

The second question is this. In a Bengali essay from the 1980s, Ashin Dasgupta wrote, “the more I browse the history of the last 300 years, the more I believe that Indian business has certain Indian features.” Dasgupta was writing about the descendants of Akrur Datta, a Bengali merchant of the 18th century. If this is true, if capitalism – like human beings – have different personalities, we should ask, what is Indian about Indian capitalism?

When I was a student, we learnt a way to connect the present with the past, according to which India was a great place for business until the 18th century -- a dark age unfolded when the British made money exploiting Indian resources, and Indians struggled to get a share of it -- and after 1947, a new dawn broke out. Most professional historians do not believe in this epochal transition model, because its facts are mostly wrong. But what is the alternative model linking the present with the past?

Observe any emerging economy today, and what we should see are hubs of private enterprise that are wealthy, innovative, and institutionally advanced, against the backdrop of a poor countryside that is changing slowly, even regressing by some benchmarks. The past looked exactly like this. Hubs of dynamic, wealthy, innovative capitalists did business in the backdrop of a poor countryside. We find such hubs in the Mughal cities, in the 18th century textile trade, in 19th century port cities, and in the IT or garment clusters today. We can then connect the past with the present by asking, are these hubs similar or are they different? That is what the book does.

We see surprising parallels across time. The most dynamic business towns of the past and those in the present are cosmopolitan, outward-looking, globally connected places. They traded with the world. Whether they exported textiles, or raw cotton, or software is a matter of detail. The people whom trade made rich had access to state-of-the-art knowledge and technology of their times, and knew the value of such knowledge. As an example, without the rich Indian merchants of nineteenth century selling cotton or indigo, you would not get the Presidency College of Calcutta (Kolkata) or the Elphinstone College of Bombay (Mumbai).

But this isn’t a happy story. Making money was a struggle against enormous odds. Interest rates were high, institutions were undeveloped, politics often unfriendly. Have these obstacles disappeared today? Hardly. Capital is still costly in India, all global metrics measuring institutional quality still place India towards the bottom of the list, and politics is still unpredictable. Why does capitalism work at all in an environment of expensive capital and dangers of expropriation by State agencies? The book answers, cosmopolitanism helped. And so did some very Indian resources, such as the idiom of caste or community, if only in some situations. These obstacles and the resources used to overcome them make Indian business history Indian. This is my story.

Who am I writing it for?

Three types of audience: business historians, economic historians, and India-watchers.

Business history emerged in the US and until recently was North American in its choice of examples and theoretical frameworks. This is changing and there is a drive to include more emerging market examples. While the book was not written with that aim, it helps that project.

My own field, economic history, has been preoccupied with a different question. For us, the big question is, “why do some countries grow rich while others stay poor”? While the modern West forged ahead (from early-1800s), why did countries like India and China stagnate and fall behind? Writers like Daron Acemoglu and James Robinson call this one of the most important questions for the social scientists. I am not sure of that, but certainly divergence has been the only game in town for some time.

I think this is a bad question to ask, for many reasons. Let me show only one reason here: The question prejudges India to be a basket case. Those who think this is the greatest question are forced to ignore and overlook the hubs of enterprise that I talked about above.

Business history does not judge. It does not carry the burden on its shoulder as economists do, that we must answer the greatest question in social science. It treats individual business decisions as context-bound, which is a more flexible approach to doing history.

My third intended reader is anyone interested in the historical roots of economic emergence. Many people try to answer the emergence question, and the answers can be odd. Around 2007, a team of 11 people published an article in the IIMA house journal about India’s emergence. The authors were top professionals, and like many thinking people, they felt compelled to say something about history. This is what they said. We should not be surprised that Indians are so good at buying and selling things, they have been doing that for centuries. Still, until now they failed in their historic mission to create a world-class capitalism thanks to “foreign invasions”. The authors wisely left the identity of the invaders open, you can write your favourite invader (Turks, Europeans) in the blank space.

But this cannot be right. India has not had a foreign invasion in the last 70 years, and still scores poorly on Ease of Doing Business index. Indeed, India has not been a cradle of capitalism, not now, not in the past. Doing business has always been a struggle to overcome obstacles. Economic history tends to exaggerate the obstacles. Business history shows the struggle as it was, and helps us understand the struggle today. My book is about that endeavour.

 

Tirthankar Roy is an Economic Historian at the London School of Economics.

UIDAI's public policy innovations

by Ram Sewak Sharma.

Unique Identification Authority of India (UIDAI) had the goal of issuing unique identification numbers to every resident of India. In a country as large as ours, this was a difficult task to achieve. UIDAI has largely accomplished this within a short period of about six years. I believe it was able to do this only because it took many innovative and bold decisions. In a recent paper I examine some of these innovations. The paper also tries to derive lessons from UIDAI that could be applied in other government projects.

The Use of Iris Scans

The UIDAI felt that unless iris images were used in addition to fingerprints, it would not be able to fulfil its mandate of unique identification. However, there were many concerns related to the use of iris images. Was this technology mature enough? Was it too expensive? Were there enough vendors in the market to prevent lock-in?

The UIDAI set up a committee to deliberate on the issue of which biometrics to collect and what standards to use for unique identification. This committee recognised the value of using iris images in improving accuracy. However, it fell short of recommending the inclusion of the iris in the biometric set and left the decision to UIDAI.

After a detailed examination, the UIDAI came to the conclusion that the inclusion of iris to the biometric set was necessary for a number of reasons, such as ensuring uniqueness of identities, and achieving greater inclusion. In retrospect, this turned out to be one of the most important decisions of the UIDAI.

On-field trials

The practice of conducting on-field trials was an important innovation. When UIDAI began its mission, there were many questions inside and outside the organisation on whether the very idea of unique identification for every resident was feasible at all. The idea of using biometrics to ensure the unique identification and authentication of all residents in India was an untested one. There were many assumptions behind it, and the data required to test the validity of these assumptions was not available. For instance, most of the research done on using biometrics for identification or authentication was done in western countries, and that too, on relatively small numbers of people.

The knowledge which had been produced by Western researchers was not applicable in the Indian context. Could the fingerprints of rural residents and manual labourers be captured successfully, or would they be excluded from Aadhaar? What about the iris images of old or blind people? Do the devices available in the market serve the purpose? What would be the most efficient and effective way to organise the process of enrolment? These questions needed to be answered if the project was to be successful.

The strategy adopted at UIDAI was to conduct a set of trials (called Proofs of Concept, PoCs) in several states across the country. The areas were selected to be representative of real-life enrolment and authentication. A number of biometric capture devices of different makes were used, and several different enrolment processes were tried out. The PoCs were carefully designed to answer sharply articulated questions, either to verify UIDAI's assumptions, or to capture the data required to fill in gaps in the UIDAI's knowledge. In essence, the scientific method was applied to create the knowledge that was pertinent to the decisions that had to be made at UIDAI. Resources had to be allocated to this work, and in return for that, major sources of project risk were eliminated.

The results of the PoCs indicated that the major hypothesis of the UIDAI was correct: that it was indeed possible to capture biometric data that was fit for the purpose of deduplication and verification. The results also showed that iris capture did not present any major challenges. An efficient enrolment process was devised using the data captured during these trials.

Competition

The last innovation considered in the paper relates to competition. Given the scale and importance of the project, the UIDAI felt it was important to increase efficiency and reduce costs by leveraging the competencies available in the private sector. At the same time, it was also essential to avoid a situation where any one private player could exercise significant power over the effective functioning of the Aadhaar system: the Authority wanted to ensure that there was a competitive market for providing services to it. To promote such a competitive market, the Authority used a two-pronged strategy of using open standards (creating standards where there were none), and using open APIs (Application Programming Interfaces).

The Authority used this strategy in procuring vendors for deduplication. Algorithms for deduplication had never been tested at the scale required in this project. To reduce the risk of poor quality deduplication, the UIDAI came up with a novel solution. It decided to engage three biometric service providers (BSPs), instead of just one. These BSPs would interface with the UIDAI systems using open APIs specified by the Authority. This decision helped avoid vendor lock-in, and increased scalability.

The UIDAI selected the three top bidders on the basis of the total cost per deduplication. Even after these three vendors were selected, the Authority was able to set up a competitive market among them, using an innovative system to distribute deduplication requests among them. Vendors were paid on the basis of the number of deduplication operations they were able to carry out, and the Authority allocated operations to them on the basis of how fast and how accurate they were. This led to a situation where the BSPs were constantly competing with each other to improve their speed and accuracy.

Where standards were not present, the UIDAI was willing to create new standards in order to increase competition. At the outset of UIDAI's work, every biometric device had its own interface, distinct from the interfaces of other biometric devices. If a capture application wanted to support 10 commonly used devices, then the application developer would have to implement 10 different interfaces. This would have made it costly to bring new devices into the project, even if these new devices were cheaper and better. In order to avoid this situation, the UIDAI created an intermediate specification. Vendors could implement support for this specification, and their devices could be certified. This allowed all capture applications to work with all certified devices.

Lessons

The success of the UIDAI offers many lessons for other government projects. Perhaps the first lesson that can be drawn from it is that innovation is indeed possible within the government. Government processes need not prevent it from taking innovative decisions. In fact, processes commonly used within the government, such as expert committees and consensus-based decision-making, can provide methods to examine difficult issues in a credible manner. High-quality procurement and project management skills can help the government outsource many functions that are currently housed within it.

The paper also suggests that scale and complexity need not be deterrents to private sector participation: in fact, the large scale of government projects can make the project more attractive to private parties. Another lesson government agencies could learn from the UIDAI is the need to test major hypotheses through field trials before launching projects at scale. Conducting such field trials provides an opportunity to change the design or the implementation roadmap well in time, thus saving precious public money from being wasted.

Conclusion

The UIDAI could achieve its objective because it adopted a different approach from most government organisations. It took tough decisions, such as the one to use iris images; it expended resources on building pertinent knowledge, by constantly experimenting on the ground and learning from these trials; and it exploited private-sector competition to achieve its task at the lowest cost. It should be noted that this is not an exhaustive list of its innovations, but without these three decisions, it is unlikely the UIDAI would have been able to fulfil its mission.

Even large government projects can be done fast and efficiently. Government processes need not be obstructive. In fact, the mechanisms of bureaucracy, such as committees, adherence to financial regulations, and desire for consensus, can help to resolve difficult issues and take tough decisions. Well-designed pilots and field-tests can help the government evaluate the effectiveness of large programs, so that it can deploy public resources more usefully. High quality procurement and contract-management processes can enable the government to leverage the dynamism of the private sector to provide public goods effectively.

Acknowledgements

I am grateful to Prasanth Regy and Ajay Shah, both of NIPFP, for stimulating discussions.




The author is Chairman, Telecom Regulatory Authority of India (TRAI) and was part of the founding team at UIDAI.

Expert committee reports in Indian finance

Expert committees play an important role in the evolution of financial economic policy in India. Committees can be a way to merely delay action. But as Isher Ahluwalia says: "Nothing ever got done by writing it in a committee report, but nothing ever got done without writing it in committee reports". In the hands of sensible people in the world of policy, the committee process is an important tool.

Committees sift through debates, analyse rival viewpoints, draft consensus statements, bring heretical ideas into the mainstream, work out nuts and bolts of implementation particularly when there is a need for inter-agency cooperation, and sometimes draft legal instruments such as regulations or laws. I generally find that the highest quality drafting of reglations and laws is done in India through the committee process.

What follows here is a collation of what seem to be, with the benefit of hindsight, some of the more interesting and important reports in Indian finance. I was quite excited about many others at various points in time, but in the end, they turned out to be dead ends.


Full name: Report of the committee to suggest steps for fulfilling the objectives of price discovery and risk management of commodity derivatives markets, Department of Economic Affairs, Ministry of Finance, April 2014. Chairman: D. S. Kolamkar.
Short name: Kolamkar committee report.
Claim to fame: First clean thinking on the role of commodity futures.
Downstream: This will shape the evolution of commodity futures regulation.
Factoid: This was the first fruit of shifting commodity futures to DEA, which took place on 6 September 2013.


Full name: Report of the Committee to Review the FCCBs and Ordinary Shares (Through Depository Receipt Mechanism) Scheme, 1993. Ministry of Finance, November 2013. Chairman: M. S. Sahoo. Blog post.
Short name: Sahoo Committee report, or to the cognoscenti, the Sahoo 1 report.
Claim to fame: Drafted the new capital control regulation for Indian firms issuing ADR/GDRs. The cleanest and best drafted financial regulation as of November 2013.
Downstream: The regulation was issued.
Factoid:  The first report which was accompanied by a video.
Lag:  0.94 years. The shortest gap in Indian history between the committee report and its complete implementation.


Full name: Report of the Financial Sector Legislative Reforms Commission. Ministry of Finance, 22 March 2013. Chairman: B. N. Srikrishna. Blog post.
Short name: FSLRC or Srikrishna Commission report.
Claim to fame: Drafted the Indian Financial Code (IFC).
Downstream: Handbook, MIS on Handbook implementation, and task forces.
Factoid: The biggest ever team in Indian public policy for the purpose of drafting one bill. While the Commission is termed FSLRC or the Srikrishna Commission, the main output of the Commission was the IFC.


Full name: Report of the Working Group on Foreign Investment, Department of Economic Affairs, Ministry of Finance, 30 July 2010. Chairman: U. K. Sinha.
Short name: U. K. Sinha Report, or WGFI report.
Claim to fame: First talked about the rule of law as applied to capital controls, invented the single window QFI system (ht: C. B. Bhave).
Downstream: The thinking on rule of law which began here ultimately laid the foundation for FSLRC. Hopefully this report may yield a single QFI framework one day. The QFI idea is in the IFC.
Factoid:  Embarassing fumbles in the alphabet soup of FPI, QFI, etc., where the implementers seem to have not understood the report. An element of that journey.


Full Name: Financial Well-Being: Report of the Committee on Investor Awareness and Protection, Ministry of Finance. Order Issued 17 March 2009. Report submitted December 2009. Report made public 22 May 2014. Chairman: D. Swarup.
Short name: Swarup Committee Report on Consumer Protection.
Claim to fame: Built an argument for moving to a full trail model instead of the high up-front commission retail model followed by the financial sector. Triggered a public turf conflict between regulators. Also triggered the ordinance issued by the Government of India to decide the turf war in favour of the insurance regulator [blog post].
Downstream: Mutual funds went no load in 1 August 2009, even before the committee submitted its report. Ulip cost structures were reduced to be compatible with mutual funds. The traditional insurance policies continue with a 40% front commission. The knowledge and perspective produced in this committee fed into the idea that consumer protection must be at the heart of the IFC.
Amusing: For many years, the report was buried; it was probably inconsistent with the MoF decision to do the ordinance. Insurance agents burnt effigies of committee chair protesting the recommendation that the industry move to a no-load incentive structure. Links. Images.


Full name: A hundred small steps: Report of the Committee on Financial Sector Reforms, 2009. Chairman: Raghuram Rajan. Video: Part 1. Part 2.
Short name: CFSR report, Raghuram Rajan Report.
Claim to fame: Raghuram Rajan's views when he was an independent economist. Chapter 7, titled "Creating a robust infrastructure for credit".
Downstream: Fed into FSLRC.
Factoid: The chairman signed the report, but recanted in 2014. Response #1, Response #2, Response #3, Response #4.


Full name: Report of the Internal Working Group on Debt Management, Department of Economic Affairs, Ministry of Finance, 31 October 2008, Chairman: Jahangir Aziz. Blog post.
Short name: Jahangir Aziz Report, or WG DMO report.
Claim to fame: This drafted a DMO Bill.
Downstream: This got subsumed into the draft Indian Financial Code that was drafted by FSLRC. The IFC extended this to place cash management for the government also at the DMO.
Factoid: The agency was named `National Treasury Management Agency' in this report. This turns out to be the name of the Irish DMO. FSLRC shifted to the name `Public Debt Management Agency'.


Full name: Report of the High Powered Expert Committee on Making Mumbai an International Financial Centre, Department of Economic Affairs, Ministry of Finance, 10 February 2007. Chairman: Percy S. Mistry. Buy. Blog post.
Short name: MIFC report, Percy Mistry committee report.
Claim to fame: The first committee report in India's history which thought on the scale of the entire financial system. In 2008, Jayanth Varma described this as the only honest committee report in Indian finance. A lot of the things that are considered obvious today first appeared here. E.g. this is the first official document which talks inflation targeting. These were heretical ideas then.
Downstream: Fed into FSLRC.
Factoid: The chairman did not sign the report, but stands by it.


Full name: Report of High Level Expert Committee on Corporate Bonds and Securitisation, Department of Economic Affairs, Ministry of Finance, 23 December 2005. Chairman: R. H. Patil.
Short name: R. H. Patil committee report.
Claim to fame: First focus on the corporate bond market.
Downstream: Corporate bonds went demat. All trades are now reported at NSE, BSE or FIMMDA.
Factoid: In early 2004, Rakesh Mohan as Secretary (DEA) chaired a meeting which simultaneously setup the Percy Mistry Committee and the R. H. Patil Committee; the two reports were (put together) to show the light for the next phase of Indian financial sector reforms.


Full name: Report of the inter-ministerial task force on convergence of securities and commodity derivative markets, 2003. Chairman: Wajahat Habibullah.
Short name: Habibullah committee report, Convergence committee report.
Claim to fame: The first step towards unification of all organised financial trading.
Downstream: On 6 September 2013, the allocation of business rules were modified to place commodity futures into DEA.
Factoid:  A remarkable high minded report, where the Secretary of a department (Habibullah was then Secretary of the Department of Consumer Affairs) supported doing the right thing even when it reduced the turf of his department.
Lag: 10.3 years from report date to the change in allocation of business rules.


Full name: The Project OASIS report. Ministry of Social Justice and Empowerment, 11 January 2000. Chairman: Surendra A. Dave.
Short name: OASIS report or Dave Committee report.
Claim to fame: Designed the New Pension System. Anticipated the consumer protection crises of later years. Anticipated the computer and telcommunications technology that was going to become ubiquitous, but was considered space-age then.
Downstream: In December 2002, the Union Cabinet decided to create the NPS and make it mandatory for all new recruits from 1/1/2004 onwards, and to create PFRDA.
Factoid: Within the committee, it was Dave's insight that the only way to make a pension system work for poor people was to ratchet up to the frontiers of technology.
Lag:  2.93 years from the report date to the decision, and 10.75 years from the decision to the PFRDA Act.


Full name: Report of the committee on derivatives, SEBI, March 1998. Chairman: L. C. Gupta.
Short name: L. C. Gupta committee report.
Claim to fame: Laid the foundations for the start of exchange-traded derivatives in India, along with a pair of Jayanth Varma committee reports which worked out the risk management.
Downstream: Equity derivatives trading started in June 2000.
Factoid: Was the slowest committee process for a report of this complexity. It took 1.3 years from committee creation (November 1996) to the report.
Lag: 3.57 years from the creation of the committee to the start of trading.

Elections in Maharashtra: Have the fires of nativism subsided?

by Naman Pugalia, Renuka Sane, Viral Shah.

The results of the Assembly polls in Maharashtra are anxiously awaited. The four main contenders, the Congress, the NCP, the Shiv Sena, and the BJP have all been part of one of the two principal coalitions, the Democratic Front (Congress and the NCP) which ruled the state for the last 15 years, and the Mahayuti (Shiv Sena and the BJP) that has been the principal opposition alliance.

The battle against the `other'

After these two principal alliances in Maharashtra broke up, ahead of the assembly elections, political parties have been quick to rouse nativist sentiments to secure the Marathi vote. Each political party contesting in Maharashtra, and especially in Bombay, has been vying for the "marathi manoos": the BJP by bringing together Narendra Modi and Chattrapati Shivaji, and the Shiv Sena and the upcoming Maharashtra Navanirman Sena reacting strongly against such a comparison, comparing the BJP leaders as foot soldiers of Afzal Khan, the commander of the Adil Shahi, who was killed by Shivaji. At heart seems to be the idea that the son-of-the-soil will never prefer an outsider as the ruler of the state.

The roots of this angst date back to the Samyukta Maharashtra Movement launched in 1955 in Pune. As Kumar Ketar in the Asian Age says:

the business lobbies, mostly consisting of the Gujarati's and Marwaris wanted Mumbai to be an independent city state or a bi-lingual or autonomous city state. But the mass movement led by Samyukta Maharashtra Samiti foiled that plan. The Marathi angst of the time was one of the reasons for the Shiv Sena's rise, and continues to the reason for the undeclared hostility between the Gujarati-Marwari business community and the Marathi working class.

The Gujarati-Marathi antagonism was mostly restricted to Bombay. In other parts of Maharashtra, it has always been a "Maratha" vote, something that the Congress and the NCP had capitalised on over the last few decades. In the 54 years since Maharashtra was formed, the Congress has ruled the State for 49 years. Of its 17 Chief Ministers, 10 have been Marathas. The outgoing cabinet did not have a single non-Maratha!

By this logic, you would have expected that a national party, with a low support base in Maharashtra in the past, with a Gujarati leader and a Gujarati campaign manager, would not fare that well in the coming elections.

Several commentators, have, however argued that the new Marathi middle class has moved on in its economic and cultural ambitions. It no longer shares the sense of injustice that was the cornerstone of the Samyukta movement, and is in fact, brimming with enthusiasm to participate in the new India. In addition, over the years, migration on a large scale has taken place into Bombay and it's environs, and into Poona, which has created a new set of immigrant voters.

How relevant is the issue of the "marathi-manoos"?

FourthLion Technologies has been conducting message testing polls in the run up to the elections in Maharashtra to tease out voter preferences using its Instavaani. The methodology involves using a control and multiple treatments, and comparing the treatments to the control to get a relative understanding of the persuasion power of different messages.

In a message testing poll, the control is a simple horse-race poll, that asks voters to pick the party or candidate of their choice. The poll on October 1, 2014, showed that 41% of voters preferred the BJP, 11% Congress, 14% Shiv Sena and 11% the NCP. BJP was comfortably in the lead. This is the control.

In each treatment, a particular message is read out to the listener, and then the horse-race question is asked again. Differences from the control give us a sense of the immediate short-term impact of this message on the minds of the populace. These polls are conducted by randomly sampling phone numbers across the entire state. The poll typically strives for 200-400 observations. With assumptions of perfect random sampling of a small sample from a representative population, the margin of error is 0.98/sqrt(n). At 200 samples, the margin of error is 7%, and at 400 samples, it is 5%. These polls are typically carried out as soon as news breaks out, and situations develop in real-time, allowing the observation of the mood of the people within hours after an event.

Here are some results which illuminate attitudes to nativism:

1. `Prithviraj Chavan is a true son of Maharashtra. He went to school in Karad, which is in south Maharashtra. His mother and father, Premalakaki and Dajisaheb Chavan, went to jail because they fought for an independent state of Maharashtra. No other candidate for Chief Minister has the same legacy of fighting for Maharashtra as Prithviraj Chavan'.
   

   Would you vote for	% of respondents
   BJP	31%
   Congress	26%
   Shiv Sena	15%
   NCP	11%
   Others	17%

   This shows that the CM's background matters quite a bit, and led 10 percentage points of voters to switch from the BJP to the Congress. This also explains why Prithviraj Chavan led the Congress' campaign in the state - his popularity is higher than the party's.
2. `In 1960, Gujarati minister Morarji Desai ordered police to fire on activists of the Samyukta Maharashtra Samiti, killing 105 Marathis. The Samyukta Maharashtra Samiti activists won their fight to create an independent state of Maharashtra. Today, the BJP is bringing Gujaratis such as Amit Shah to again place Maharashtra under Gujarati dominance'.
   

   Would you vote for	% of respondents
   BJP	33%
   Congress	14%
   Shiv Sena	25%
   NCP	11%
   Others	17%

   If there was indeed strong antagonism about Gujaratis, this question should have caused a lot of people to switch votes out of the BJP. However, only 8% of the voters seems to have moved away from the BJP, mostly to the Shiv Sena.
   
3. `The BJP has no leaders in Maharashtra who are clean, honest and capable of running the state government. That is why the BJP has to parachute in outsiders like the Prime Minister and Amit Shah to campaign for them. The BJP is afraid to announce who their CM candidate will be because their local leaders, including Devendra Fadnavis and Eknath Khadse, are inexperienced and unqualified to run the second-largest state in India, and also have dozens of criminal charges against them'.
   

   Would you vote for	% of respondents
   BJP	39%
   Congress	15%
   Shiv Sena	19%
   NCP	10%
   Others	17%

   This yielded the least movement away from the BJP: only two percentage points, which is not statistically significant. 39% of voters continue to root for the BJP. It shows there is far greater confidence in the BJP leadership than in that of any other parties.
   

This post is about nativism, so we don't talk about other measurement of how voters feel. But one point must be made. None of these treatments work as well as other treatment messages that talk about construction of roads, public works, anti-corruption, etc. These results suggest that the passions of caste and creed are now less important; that the history of the Gujarati-Marathi antagonism has faded from memory. By this logic, the BJP was perhaps on the right track in breaking away from the Shiv Sena, and focusing on its core messages of development and good governance. This is what voters in Maharashtra seem to care about.

Implications

We may conjecture that three things are going on:

1. Part of the reason for this move away from nativist sentiment is the personal appeal of the Prime Minister. His approval ratings, measured in a survey FourthLion did for Mint on August 16, 2014, were highest in Maharashtra and West Bengal. In the bye-polls, there was very little involvement of the Prime Minister, and the BJP did not do well. It is no surprise then that the BJP is seeking votes under the Modi banner, with messages like "Chalo chale Modi ke saath" ("let's walk with Modi") and "Ab ki bar Modi sarkar" ("this time let's make it the Modi administration").
2. Anti-incumbency against the state government, and the 2 parties (INC + NCP) that jointly governed the state for 15 years, has voters looking for an alternative. Given the BJP's own brand, their assessment of being able to achieve a majority on their own, and the country beginning to taste the benefits of a clear mandate, the BJP has an edge in asking voters in Maharashtra and Haryana to give it a clear mandate in the states too, so that they can work well with the Centre.
3. But most important is the fact that the Indian electorate has moved on. The desire of the voter to look beyond tribal considerations is the reason why Maharashtra might be the first state to throw up a verdict that challenges preconceived notions about the eternal power of old hatreds.

Does this have implications for regional parties elsewhere in India? Many regional parties may have to go in for radical reconstruction if nativist fires are subsiding. Some, like the BSP, have begun doing this. The entire eastern and southern belt, which sees strong regional parties - West Bengal, Orissa, Telangana, Andhra Pradesh, and Tamil Nadu - could see change. While Jammu and Kashmir and Jharkhand will give us some more intuition in the coming few months, Bihar is going to be the next big test in 2015.

One possible argument is that Maharashtra is a better state, with greater exposure to new ideas, low levels of violence, and a successful economy. In contrast, the backward parts of East India may still be trapped in the old nativist ways. But what about the South? The developments in Maharashtra could be particularly portentious for the better states of the South.

The politics of Bombay has long been benighted by the problem of nativism. What was once a great metropolis has been bogged down by decades of nativist politics. These results show a possibility for becoming a normal city, where the political questions that matter are about efficiently producing local public goods.

Inflation targeting is the new gold standard

I have a column in the Economic Times today of this title.

I should like to call you all by name

• China: Worse than you ever imagined by Ian Johnson in the New York Review of Books.
• Totalitarianism, Famine and Us by Samuel Moyn in the Nation.
• Stalin's cannibals by Ron Rosenbaum, on Slate.
• The worst of the madness by Anne Applebaum in the New York Review of Books.
• Stalin and Hitler: Mass murder by starvation by Timothy Snyder in the New York Review of Books.
• Kakfa in Beijing by John Garnaut and Sanghee Liu in Foreign Policy.
• Bloc heads by Louis Menand in the New Yorker magazine.
• Yegor Gaidar's story about the dying days of the USSR is fascinating. This is not going to be the endgame of the PRC.
• Requiem, by Anna Akhmatova.

What the computer revolution has done

That computing has become immensely more powerful in recent decades veers on the cliche. I recently got a few reminders of precisely how much distance we have moved.

Cory Doctorow tells us that the computation that goes into one google query is roughly the same as all the computing done for the entire Apollo program.

Jay Goldberg is astonished to discover pretty powerful no-name tablets now go for $45. One can see whole new world opening up with ubiquitous use and firm-deployment of tablets.

And most astonishing of all: the ipad (2012) matches the floating point performance of the Cray 2 supercomputer (1989). That's a gap of 23 short years. Also note the completely different slope seen on the right hand set of dots:

Source: Slideshow by Jack Dongarra and Piotr Luszczek, linked to by Michael Larabel.

This story has been going on for decades but it isn't finished yet. Just this year, my laptop got four cores, and I'm steadily shifting all my R programs to utilise parallel processing. For all X, it's interesting and useful to ask How would X change if computation, communications and storage got cheaper and better?. On this theme, you may like to read this post -- The new world of computers -- from earlier this year.

As an old timer, I always worry that we used to do Things That Mattered using the Cray 2 supercomputer, like forecast the weather or simulate nuclear explosions, whereas the bulk of the ipad's compute power is being deployed to watch cat videos on youtube. We have yet to re-imagine our world in terms of these new powers.

Has monetary policy in India helped or hurt?

Carlos Vegh and Guillermo Vuletin have an article Overcoming the fear of free falling: Monetary policy graduation in emerging markets, in `The role of Central Banks in financial stability: How has it changed?', Federal Reserve Bank of Chicago, 2012. They have drawn on this to write a column on voxEU titled Graduation from monetary policy procyclicality.

In an ideal world, monetary policy should stabilise business cycle conditions. When times are good, the central bank should raise rates, thus reining in a boom. When times are bad, the central bank should cut rates. As an example of how this might not arise, recall that on 16 Jan 1998, in what was arguably a pretty bad time for the Indian economy, RBI raised rates by 200 basis points. Economists have a delicate and damning phrase for monetary policy that fuels a boom and exacerbates a bust: it is termed "procyclical" monetary policy.

Vegh and Vuletin construct a measure of monetary policy procyclicality : the correlation between the cyclical component of the short-term interest rate and GDP. This is computed for a large number of countries for the 1960-1999 period. Here is the result:

The bars in black are advanced economies and the bars in yellow are developing countries. There is a striking pattern: All the countries with a negative correlations -- i.e. interest rates are raised in bad times -- are developing countries. This is a striking demonstration of the faulty monetary policy frameworks that are found in developing countries: Every country which suffers from procyclicality in this period is a developing country.

India fares pretty badly in this list: Starting from the bottom, we have Uruguay (Rank 1 from the bottom), Chile, Mexico, Venezuela, Gambia, and then India (Rank 6 from the bottom).

Things got better after 1999. Vegh and Vuletin repeat the analysis for 2000-2009 and find that India did much better. The correlation swung to a positive value. India moved up, to the middle of the distribution. You could find one developed country -- Japan -- which did worse than India in this period.

In my assessment, there are two elements to this story: (a) Is there room to manoeuvre for monetary policy and (b) Is the monetary policy process properly constructed? The first is largely a question about exchange rate flexibility. If the central bank pursues exchange rate goals, this uses up the instrument of monetary policy. The second is about how monetary policy is conducted.

The figure above shows how India's exchange rate regime evolved towards flexibility. The structural break dates (23 May 2003 and 23 March 2007) are computed using the methodology of Zeileis, Shah, Patnaik, 2010. For 4.74 years, we had INR/USD volatility of 2.31% per year. On 23 May 2003, the contradictions of this regime became unbearable, and the exchange rate regime changed: volatility jumped up to 3.93% per year: a rough doubling. On 23 March 2007, the contradictions of this regime became unbearable, and the exchange rate regime changed: volatility jumped up to 9.05% per year: another rough doubling.

From 23 March 2007 onwards, we have finished 5.43 years -- the longest single period out of the three shown here -- in this zone of high exchange rate flexibility. On the subject of the Indian exchange rate regime, you may like to read this post.

I believe these changes have substantially, though not completely, freed monetary policy of the burden of pursuing exchange rate goals. This is one half of the story of Indian monetary policy reform. The second half is that of setting up a sound monetary policy process. Now that you have a lever of setting the short rate in your hands, what would you like to do with it? The first stage is a relatively easy and nihilistic one: it requires getting out of trading in the currency market. By 23 March 2007, this was completed. The second stage is harder: it requires institution building. We have not yet begun on this phase.

This increase in exchange rate flexibility is consistent with the Vegh & Vuletin calculation which shows that the procyclicality of Indian monetary policy was reduced in the 2000-2009 period.

The inflation crisis has not ended

The most important measure of inflation in India is the year-on-year change of the CPI-IW index. This time series, for 120 months, is shown above. From 2006 onwards, India slipped into a new phase of macroeconomic instability, where inflation has strayed far outside the informal target zone of inflation at four-to-five per cent.

Has inflation subsided?

In recent months, there has been a surge of optimism that the inflation crisis is coming to an end. However, a careful look at the seasonally adjusted data reveals that there is cause for concern.

Month	P-o-p SA	Y-o-y
Sep 2011	17.49	10.06
Oct 2011	2.01	9.39
Nov 2011	3.11	9.34
Dec 2011	-2.14	6.49
Jan 2012	8.22	5.32
Feb 2012	12.01	7.57

In September 2011, point-on-point seasonally adjusted (annualised) inflation was at 17.49 per cent. The year-on-year inflation was running at 10.06%.

We then had three good months: October, November and December, where the point-on-point seasonally adjusted (annualised) inflation dropped to 2.01, 3.11 and -2.14 per cent. This yielded a sharp decline in the year-on-year inflation to 6.49 per cent in December 2011 and further to 5.32 per cent in January 2012.

But after that, things haven't gone well. Point-on-point seasonally adjusted inflation, which is the thing to watch for in understanding what is happening every month, is back up to 8.22 per cent in January 2012 and 12.01 per cent in February 2012. Year-on-year inflation is back up to 7.57 per cent in February 2012.

A casual examination of the key graph (shown above) shows that the worst of double digit inflation seems to have ended. But we are not inside the target zone of 4 to 5 per cent, and neither are we likely to achieve this in the rest of this year. It would be unwise to declare victory over the inflation crisis, with this information set in hand.

Looking forward

Looking forward, there are two main problems worth worrying about. The first is the expectations of households. At the heart of India's inflation spiral is the problem that the man in the street has lost confidence that inflation will stay in the four-to-five per cent target zone. Survey evidence about household expectations has shown double digit values. This generates persistence of inflation; idiosyncratic shocks tend to not quickly die away. The mistrust of households is rooted in the lack of commitment to low and stable inflation at RBI, and this problem is not going to go away quickly. Despite all the problems faced in fighting inflation, RBI continues to communicate, through speeches and official documents, its lack of focus upon inflation.

The second problem is that of the exchange rate. Exchange rate depreciation feeds into tradeables inflation. With a large current account deficit, with policy impediments putting a cloud on capital inflows, rupee depreciation has taken place and may continue to take place. This would be inflationary. Indeed, if RBI chooses to cut rates on the 17th, there will be further weakening of the rupee (since the interest rate differential will go down thus deterring debt flows), which will further exacerbate tradeables inflation.

The media and financial commentators treat it as a given that on 17th, RBI will cut rates. However, the outlook on inflation is worrisome. India's inflation crisis, which began in 2006, has not ended. Year-on-year CPI-IW inflation has not yet got into the target zone of four-to-five per cent, nor is this likely to happen anytime soon.

Our thinking on this needs to factor in the general elections, which are looming at the horizon in May 2014. Given the salience of inflation in India for the poor, the ruling UPA coalition is likely to be quite concerned about getting inflation back to the informal target zone of four-to-five per cent, well ahead of elections. This also suggests that the time for hawkish monetary policy is now, so as to get inflation under control by mid-2013, well in time for elections in mid-2014.

A historical perspective

Inflation went out of control in 2006/2007 because RBI's pursuit of the exchange rate peg required very low interest rates at a time when the domestic economy was booming. (The capital controls that were then prevalent failed to deliver monetary policy autonomy; the only way to get towards exchange rate goals was through distortions of monetary policy). Given the lack of anchoring of household expectations, that inflation crisis has not yet gone away. Today, RBI is substantially finished with exchange rate pegging; we are mostly a floating exchange rate. In the future, inflationary expectations will not get unhinged owing to a pursuit of exchange rate policy by RBI. But while a pegged exchange rate pins down monetary policy, a floating exchange rate does not define monetary policy. RBI has yet to articulate what it wants to do with the lever of monetary policy. The first task for the lever of monetary policy should be the conquest of the inflation that is in our midst, owing to the monetary policy stance of 2006/2007.

In the early 1990s, unsterilised intervention in the pursuit of Rs.31.37 a dollar gave an inappropriate stance of monetary policy, which kicked off an inflation. Dr. Rangarajan wrestled it to the ground, even though the monetary policy transmission was weak then. In 2006, we ignited another inflation, once again owing to exceedingly low policy rates in the pursuit of exchange rate policy. Dr. Subbarao's challenge lies in wrestling this to the ground. His job is easier when compared with what Dr. Rangarajan faced, thanks to the progress which has taken place on financial reforms and capital account decontrol.

New insights into the events on the Indian stock market in the mid-1990s

by Ajay Shah. 

Liquidity matters

One of the most important features of a financial market is liquidity. In a well functioning market, a trader faces low costs of transacting and can confidently expect that at future dates, across many states of nature, the cost of transacting will prove to be low.

The immediate impact of a low cost of transacting is that it imposes a lower `tax' upon the speculator, who brings new information into prices, and the arbitrageur, who removes obvious mistakes in prices. The long-term impacts that are obtained when the trader can confidently expect that transactions will be inexpensive are in two parts. When investors expect to waste money in buying and then selling a certain security, they demand higher rates of return from it: i.e., the cost of capital for the issuer goes up. And, when traders are confident that high liquidity will persist into the future into a diverse array of states of nature, they will more confidently embark upon dynamic trading strategies which are required for producing useful securities such as options.

Measurement of liquidity

In an electronic limit order book market, a static concept of liquidity is eminently visible: you look at the order book and work out what is the impact cost faced when doing transactions of a desired size. E.g. it is easy to take order book data from NSE and work out the impact cost seen for doing a transaction of Rs.10,000 for all companies.

Impact cost accurately measures the instantaneous cost faced when placing an order of the stated size. It is a observed precisely in a modern exchange setting. There are two weaknesses. No large order is going to be placed as one single market order into the order book. Hence, the analysis of the NSE order books does not guide us in understanding liquidity when doing large sized transactions, e.g. Rs.1,000,000. The moment we think of orders that are spaced over a short time (e.g. I break up an order for Rs.1 million into 100 orders of Rs.10,000 each) or over a long time (e.g. dynamic hedging of an option book) I have to worry about the fluctuations of impact cost, or my liquidity risk.

The biggest problem lies in the fact that in numerous market situations, order book information is not observed. Two key areas are: the deep past, before order book data existed, and the OTC market, where there is no order book. E.g. the CMIE daily returns data for BSE starts from 1/1/1990. NSE equity trading began in 11/1994. But NSE's order book snapshots (thrice a day) only exist from 4/1996 onwards. For the period prior to 1996, there is no data on liquidity.

The power of range

The first flush of the financial economics focused on returns. It was amazing, the amount of interesting work that could be done once you had assembled a dataset with daily returns. This was first done at the Centre for Research on Security Prices (CRSP) at the University of Chicago, and it made possible an entire generation of financial economics.

As an example, the ARCH model is a very clever way to utilise pure returns information and construct a time-varying notion of volatility. Models of the ARCH family assumes that volatility is deterministic, and that it responds to realisations of returns.

A remarkably important fact looks beyond returns to the range between the day's high and the day's low price. When volatility is high, the range is higher. Range is a volatility proxy. This has been known for a while -- e.g. On the estimation of security price volatilities from historical data, M. B. Garman and M. J. Klass, page 67--78, Journal of Business, 1980.

In the late 1990s, people got back to looking at this in a new way. We understood that range is an enormously informative volatility proxy. There is much more information in the range of the day than is found in the squared returns of the day.

Another new volatility proxy is `realised volatility', where you difference intra-day returns to construct a time-series of returns within the day. As an example, in an 8-hour trading day, there are 480 minutes. So you could difference returns into 5-minute intervals, and you have 96 readings of returns on each day. The standard deviation of this is a good measure of the volatility of the day. As an example, the recent paper by Grover and Thomas, Journal of Futures Markets, August 2012, does performance evaluation for a VIX estimator by asking for better predictions of future realised volatility.

In the ARCH world, volatility of the day was not observed, and squared daily returns was a poor proxy for this. Realised volatility is a highly precise estimator of the volatility of the day, and range is also remarkably good.

Constructing a deep history of stock volatility

Using intra-day data, it is possible to construct a realised volatility for every security for every day. This is obviously infeasible for the period when intra-day data is not observed - e.g. in India before electronic trading came along, i.e. before November 1994.

But as long as the day's high and the day's low are observed, one can construct a range-based measure, and thus push deeper into history.

Constructing a deep history of stock liquidity

When trading is electronic, it is possible for the exchange to produce `snapshots' of the limit order book, as has been done by NSE from April 1996 onwards. Using these, it is easy to get precise estimates of the spread for all stocks. But what about the period before that?

I just read a fascinating paper: A Simple Way to Estimate Bid-Ask Spreads from Daily High and Low Prices by Shane A. Corwin and Paul Schultz, Journal of Finance, April 2012. Their key insight is that the day's high is almost always at the ask and the day's low is almost always at the bid. When the high/low is computed over two days, the variance is doubled but the spread component is intact. This generates a mechanism for extracting a spread estimator using only high-low data.

I liked the paper a lot. At its best, finance is close to data, the data has low measurement error, the work is careful and grounded in a detailed institutional understanding of reality, and the results open up new lines of inquiry.

Using these new ideas, it becomes possible to dig into history, using the CMIE data for BSE which goes back to 1/1/1990, and construct liquidity measures for that deep period.

The authors do precisely this:

They show a big and dramatic drop in the spread at the time when electronic trading came in. There are three key dates here: NSE started electronic trading on 3 November 1994, BSE started electronic trading on 14 March 1995 and in November 1995, NSE became the dominant exchange [link]. This is a valuable addition to our understanding of these events. I do worry about mistakes in measurement of the day's high and day's low, however, prior to the onset of electronic trading at NSE in November 1994.

I found it fascinating, how a 2012 paper has produced a better understanding of our history of the mid-1990s.

Understanding the badla episode

What is equally interesting, and what is not mentioned by the authors, is the dog that did not bark prior to the launch of NSE. This is the event where SEBI forced BSE to stop badla trading.

I had worked on this question at the time (in 1996). I had rigged up a matching scheme where each A group company (where badla trading used to take place) was matched against a partner from the B group (where there had never been badla trading). This allowed you to construct a hedged portfolio: long the A group companies and short the B group companies. The performance of this portfolio is:

This hedged portfolio has a most satisfying zero return in the days before SEBI's decision. This gives us confidence that the matching is done well. The two big dates of SEBI decisions -- 12 December 1993 and 12 March 1994 -- show big negative returns for A group companies. And from 4 November 1994, when trading at NSE began, we start seeing a recovery.

At the time, this was interpreted at the time as a liquidity premium. See Short-term traders and liquidity: A test using Bombay Stock Exchange data by Berkman and Eleswarapu, Journal of Financial Economics, 1998, who worked this out nicely.

But the new evidence for the deep history of spreads on the BSE, by Corwin and Schultz, suggests that there was no big change in liquidity in 1993 or 1994. This raises new questions about why such large price reactions were observed. I used to think this was a great liquidity premium story; now I'm not so sure. I'm pretty certain that A group companies had sharp negative returns in early 1994, but I am now less sure that we know why.

Business cycle conditions in India: It's mostly cycle, not trend

There is a lot of gloom in India today about the broad-based failure of the UPA strategy of combining left-of-centre populism, fiscal profligacy, theft, and a lack of interest in the foundations of India's growth. We learn from history that we learn nothing from history; India has clearly learned very little from its escape from the Hindu rate of growth. The moment we got a little bit of growth, the old style socialism and theft reared up again. In one of the many pessimistic articles of this theme, Shekhar Gupta in the Indian Express says:

What is the Hindu Rate of Growth two decades after reform? It certainly can’t be the 2-3 per cent of India’s socialist Brezhnev decades. The new Hindu Rate of Growth is 6 per cent, and on all evidence, from macroeconomic data to the empty billboards of Mumbai, we are headed there next year.

In thinking about GDP growth, it's always useful to think about both growth and fluctuations. Growth is about the underlying trend growth rate.  In the olden days, this was all you needed to worry about. The economy trundled along at roughly the trend growth rate (the Hindu rate of growth of 3.5 per cent), being kicked up or down by good or bad monsoons. In that period, macroeconomics in India required thinking in completely different ways, when compared with standard Western textbooks.

But from the early 1990s onwards, India changed. The market-oriented reforms, which began with the Janata Party in 1977 and gathered momentum in the 1980s, had started creating a market economy. And every market economy in the world experiences business cycle fluctuations. So, in addition to the trend, we got a cycle about the trend. There were good periods and bad periods, and the story running in there was much like that found in mainstream Western textbooks, with a prominent role being played by profitability, inventories and investment by firms.

From this viewpoint, it's useful to decompose two elements of what we are seeing after 2009. On one hand, trend growth has been influenced by decisions of the UPA. Any perceptive observer also tends to rage at the lost opportunities, of policy decisions that should have been taken, which would have accelerated trend growth. But the second big story is that of fluctuations. Corporate investment is a major driver of business cycle fluctuations in India, and there has been a certain deceleration in this. This may have set off a downturn.

The bulk of the drama that we're now seeing, and what will play out in 2012, is business cycle fluctuations. This is about fluctuations, not the trend. When trend growth is 7 per cent, the fluctuations make GDP growth range from 4 per cent to 10 per cent. Even if trend growth does not change by even a bit, business cycle fluctuations can take us from a high of 10 per cent to a low of 4 per cent, which is a huge swing of 6 percentage points.

Many elements of economic policy are pro-cyclical: when times are good, they make things better and when times are bad, they make things worse. The financial system tends to suffer from pro-cyclicality: when times are good, bankers lend exuberantly (thus expanding the boom) and when times are bad, bankers tend to be cautious (thus accentuating the bust). It is important to look for a framework for stabilisation, of tools that will counteract business cycle fluctuations. India has crossed one major milestone, in getting to a floating exchange rate. The floating exchange rate is stabilising, in and of itself. In addition, it opens up the possibility of stabilising monetary policy.

As of today, by and large, I think of both fiscal policy and monetary policy as being part of the problem and not part of the solution. While floating the exchange rate (decisions from 2007 to 2009) opened up the possibility of sound monetary policy, the logical next step did not materialise. As of yet, we do not have a sound monetary policy regime. We're going to require far-reaching surgery to laws and institutions, in order to craft frameworks for fiscal policy and monetary policy that do stabilisation. Until these changes are made, Indian GDP growth will have the high volatility that is characteristically found in countries with weak institutions.

A lot of our work in the Macro/Finance group at NIPFP is rooted in this conceptual framework. In particular, you might like to see two relatively non-technical articles: New issues in macroeconomic policy and Stabilising the Indian business cycle.