The Real reform agenda

My column in Wealth Insight Jan edtion is here. The unedited original follows:

Policy reform – different strokes

Speak to a day trader in India’s equity market, and government policy “reform” equals changes that help equity markets go up for the day. Removal of STT (securities transaction tax) is a significant “reform” measure. Speak to foreign brokerages (as the current finance minister often does) and reform implies allowing foreign investment without restrictions and without taxes in all sectors of Indian economy.  But what reform would actually change the Indian economy in a meaningful and sustained manner – and would be good for Indian citizens and businesses? A possible candidate is “administrative reform”.

Administrative reforms fall in the category of “most boring” reforms. A paean on such reforms is unlikely to feature in the “must-do” list of any equity strategist. Importantly, a government order is often all that is needed to implement it – quite unlike many others that require “coalition dharma” to be violated. Of many administrative reforms, one that can make an immediate impact on the economic scenario of India is legal reform.

The economic effect of poor legal systems

A study carried out some years ago found that in India, for every 1000 citizens, only 1.2 cases were filed as against 17 in Malaysia and 14 in Korea. Does that mean that Indians are less prone to litigation? Details of pending cases do not suggest so. There are approximately 3.5 million cases pending in High Courts and over 20 million cases in subordinate courts. It appears that lower per capita cases files is a sign of fatigue - litigants do not expect to receive a judgement in their lifetime through the formal judicial system – and do not approach it for resolution. This fosters informal or alternate mechanisms – many that operate outside the legal system to “fix” problems. There are several consequences – societal and economic.

Higher borrowing costs, lower leverage

Consumer lending in India has suffered considerably due to lenders inability to recover dues from defaulters. Typically, lenders build in 6% or more as default risk. Borrowers of good credit worthiness are charged almost 50% much more than they would need to pay, if defaulters could have been legal proceeded against, and recovery achieved in a time bound manner. 

Small and medium enterprises (SME’s) are even worse affected. Since a lender knows that loan contracts cannot be legally enforced, practices such as demanding a personal guarantee of a “promoter” for a limited liability company have become commonplace. The purpose of limited liability itself is lost – leading to slower growth in the organized sector.

Not only is lending cost padded up for potential losses, multiple collateral is expected for every loan. This reduces the borrowing power of small business in no small measure. Despite this, rising levels of non-performing assets with banks reveals that liquidating collateral itself may be a difficult legal process.

Delayed justice – slower development

India’s judicial system has civil suits lasting over 20 years. Decades old land disputes prevent development of prime real-estate, leading to artificial land scarcity and higher costs of living.

Commercial contracts require quick and just remedies for them to be effective. With no hope of achieving that in India, corporate India has to often agree to use international jurisdiction (say Singapore) for international contracts. This has an adverse impact on the legal business in India. Longer term, it restricts the sovereignty of the Indian State. 

Cost of justice

Another deterrent for going to court is cost. Often, cases drag on through various levels of judiciary – with ever increasing costs of advocate fees. The reimbursement of fees in event of a win is totally inadequate compared to the real cost of legal representation in higher courts. Even a win will often represent a pyrrhic victory. More often, less well-to-do litigants will simply give up despite having a strong case – leading to miscarriage of justice – and increasing social disparity.

Economic and human loss

Despite several judicial reform commissions and studies, the problem of an ineffective judicial system continues to prove a drag to the Indian economy. While no study seems to have estimated the economic costs of delayed justice, it would not be difficult to accept that direct and indirect effects reduce GDP growth by 0.5% to 1% per annum – and that may be a serious underestimate.

The effect of this slower growth in terms of human cost of unemployment - and consequent poverty, and unrealised potential of Indian youth needs serious soul searching. Besides economic costs, demonstration effects of unscrupulous behaviour going unpunished results in erosion in faith in rule of law and leads to distortions in social behaviour and ethics that are far reaching.

Simple solutions can help

In the current calendar year, the Supreme Court was on “vacation” for 7 weeks – from 13^th May till 30^th June – (13.5% of the year). Other courts too have similarly long vacation periods. This is a colonial vestige and can be immediately removed.

While judges often lament the lack of resources and infrastructure, courts can utilise existing infrastructure in two shifts and manage the court calendar better to avoid having to postpone hearings repeatedly. Studies have suggested the need for special courts to take up cases of similar nature or requiring detailed domain knowledge. These can be implemented without significant cost or effort.   

Other more elaborate methods have also been suggested by Judicial reform commissions. However, the urgency with which reform needs to be implemented is sorely lacking. Perhaps judges too need reminding that like politicians, they exist to serve the masses, not rule them!

Low brokerage alone will not bring investors

My interview in Business Line yesterday. Since this is based on a face-to-face interaction, I have been quoted in brief. I am reproducing the article with some additions to clarify what I mean:

The regulator has made a major disservice by making exchanges ‘for profit’ organisations. — Anand Tandon, CEO, JRG Securities 

The Government and capital market regulator SEBI’s effort to attract retail investment in equities has had little impact. Retail investors have incurred huge losses in the last few months. Even as broking firms are trying to woo retail investors with low brokerages, exclusive research reports and stock recommendations, the wild swing in the stock market has scared retail investors. The capital market is dominated by foreign institutional investors and domestic institutions, and needs a major overhaul to gain investors’ trust, says Anand Tandon, CEO, JRG Securities, in an interview with Business Line.  

Excerpts:

Why are retail investors shying away from market?

It is actually a simple problem, but also extremely complex. It is simple, because an investor will invest if there is a chance of making money. If eight out of 10 times he makes money, the possibility of losing twice is acceptable. On the other hand, if you loses eight times and make money just twice it is not acceptable, even if you hit a jackpot twice and cover up all the losses. Essentially, retail investors have not made money.

What has changed dramatically for small investors in the market?

Intense competition. In fact, the regulator has made a major disservice by making exchanges ‘for profit’ organisations. The original function of exchanges was to provide people access to capital. As opposed to that, today, as a ‘for profit’ organisation, exchanges provide liquidity pools. In the process, they create their own transaction charges. With new exchanges coming in, there is no proportionate increase in liquidity. The liquidity pool is getting divided. So, there is more and more illiquidity.

What is the impact on market intermediaries?

The competition among exchanges will have a trickle-down effect on market intermediaries. Some 20 years ago, one had to shell out Rs 4.5 crore to become a BSE member. Today, you do not even need Rs 45 lakh. An investment of Rs 4.5 crore would have become Rs 20 crore, even if it was invested in a safe product. But by bring in more exchanges, you have to pay Rs 10 lakh deposit, and become a trading member. Essentially, my investment of Rs 4.5 crore 20 years back, is equivalent to Rs 45 lakh today.The entry barriers are lower, resulting in poorer quality of new members

But competition is good for investors …

It is true to a certain extent. However, If there is such a plethora of intermediaries in the market, clients will be induced to trade more. Effectively, the market will become more short-term in nature. Providing a quality service will become a big challenge. If my competitor is willing to provide a trading account for free, I will need to match it. Of course, the compliance cost has gone to the roof.

We have to provide the infrastructure, dealing terminals, telecom backbone, and watch through every trade and keep records for eight years. The return I get is decided by the next door mom-and-shop competitor. I feel we have got into this vicious trap of over capacity. Consequently, brokerages have gone to the suboptimal level. There is no incentive for providing advisory services which will benefit investors.

What is the remedy?

In the interest of banks, the RBI can restrict banks from competing on certain services offered by them. Public insurance companies are not allowed to under cut. The Aviation Ministry, which has no business of regulating tariff, can express its concern to airlines about under cutting prices. Why does SEBI not monitor the fees charged by intermediaries, so that service quality is maintained?

Lower charges are beneficial for investors. Isn’t it?

No, not always. Take the case of the power sector. All the companies have bid the lowest price at which they can supply the power. Now, they are struggling to fulfil their commitment. Lowering brokerage charges alone will not bring retail investors back. There was a time when you could not charge more than 2.5 per cent.Now, even 2.5basis points is difficult to retain. Development of the market cannot be done in the absence of intermediaries.

Figures seem credible but what about the emphasis?

My budget comment in DNA - the edited version. The unedited view is below.

The budget, as an exercise in accounting credibility, seems better than many in the recent few years. If we were to accept for a moment, the assumption that GDP growth for FY14 will exceed 6% (as forecast by the economic survey), a 15% increase in excise collection, or a 17% increase in corporate tax made in the budget does not appear to be very challenging. Some figures seem optimistic – a 35% increase in service tax, high growth in divestment and dividend income and high telecom license revenues. However, this is nitpicking. Largely, the budget seems to have a reasonably consistent set of assumptions – so where is the nub?

The issue seems to revolve around the question of growth. While it may be credibly argued that the budget is not expected to resolve all policy problems, one usually looks at the budget more from the point of view of the stated goal of the fiscal policy and not just from the prism of numbers. This is where budget fails to provide an inkling of government’s plans to increase growth. Why will growth rate go up – other than because it will?

If resumption of high growth is a major concern and the private sector is not investing, would it not be logical to increase government spend on capex? Instead, we see government reducing capital expenditure in the current year by 22% lower than the budgeted amount. Why the excessive focus on fiscal deficit in a cyclically weak year? The argument that interest rates will go up have been proven to be untrue – we continue to have negative or near zero real interest rates. And, inflation remains high because of government policy of passing on price of its inefficiency to the public.

The economic survey itself is confused on its understanding on interest rates. At one point, the survey states that household savings in financial assets have fallen since inflation reduces attractiveness of financial instruments and suggests that inflation linked bonds should be introduced – a suggestion which the finance minister too takes up. This would imply that interest rates should go UP.

However, the survey promptly then blames high interest rate for lower investment by the private sector. The survey itself admits that private investment is down because of Rs7500bn worth of stalled projects. “Analysis of 20 individual projects (making up 70% of the total cost of the shelved projects) suggests difficulties in land acquisition, coal linkages, and mining bans as major causes.” None of this suggests a problem with interest rates. Presumably, since this seems an implied criticism of government’s inability to frame workable policies, the problem must be laid at that door of monetary policy.

To borrow a term from Paul Krugman, the “confidence fairies” have made their way to India as well. Somehow, unless the fiscal deficit is contained, interest rates will go up – despite evidence to the contrary. So the path to growth remains shrouded in mystery.

Overall corporate earnings growth is likely to be downgraded by a couple of percentage points to accommodate the increase in surcharge and other changes in tax rates proposed. This will likely reduce sensex earnings estimates to below 1400 for FY14. With little likelihood for a rapid reduction in nominal interest or inflation in the near term, markets will continue to be in the grip of global shifts in risk perception. Unless we have more and better policy action following, the outlook for equity in the current year continues to remain subdued.  

Retail - End of the debate

Finally, the government of the day was able to get parliament to approve foreign investment in multi brand retail. It is indeed a sad reflection of  Indian democracy that while most speakers and parties in Parliament were opposed to the policy, fear of CBI and perhaps their own party calculations forced some to stage either a walkout, or as in the case of BSP, to actually vote in favour of the government.

MJ Akbar's latest article summarises the issues well.

Some related issues get highlighted -

1. Power of the central government to manipulate the smaller parties through a threat of CBI action. The "lokpal" proponents had long argued that an "independent" CBI, which does not require government approval to investigate and pursue the corrupt is needed to weed out the evil of corruption. The current vote shows the dangers of a CBI that is handmaiden of the centre.

2. The need for a "bipartisan" body that investigates and prepares the background paper for financial impact of government decisions - along the line of the CBO in the US Congress. Debates on policy in India are rarely backed by a common set of assumptions and figures. Consequently, there is little that the public is able to get out of debates - with most speakers talking AT each other rather with each other. Another by-product of this would be to restrict the discretion that the Centre has to offer largess to "compliant" states while holding back financial assistance to those who dont agree with them. 

And for those who continue to treat all foreign investment "liberalization" proposals as "reform" a shift is  happening in economic thinking  - a slow move away from the extreme right. As always, when there is a stress in society, "left" leaning thinking becomes more acceptable. Read Krugman here.

Whose side is SEBI on ?

My latest blog on SEBI's recent directives on Mutual Funds is here.  The post follows:

Assume we are living at a time when we still used boats to travel long distances. Imagine a large, leaky boat about to set out on a stormy sea. Imagine that this boat is about to make a journey that in the normal course will last over a year. Additionally, the boat has had a history of capsizing a few times in the past, often taking with it the passengers. However, each time, the owners are able to pull the boat out from the sea put up a few patches and declare it seaworthy. It would seem obvious that tickets for the trip would be hard to sell especially to people staying in the vicinity of the port of launch.

Now imagine that there is a regulator whose job is to protect the passengers. The regulator is charged with certifying the sea-worthiness of the boat so that the passengers have a safe journey. Over the years, seeing that the boat has not proven to be particularly safe, the regulator declares that all passengers have to decide for themselves what the journey is worth to them. Sellers of tickets are to be paid for their services directly by the passengers not by the boat owners. Meanwhile, the seas become stormier, and ticket sales fall.

The boat owners now demand that the ticket prices should be raised (They obviously form a cartel if you want to use the boats, you have to deal with them). This extra money is to be used partially for rewarding those who sell tickets to passengers. Importantly, more money is to be paid to those sellers who sell tickets to unsuspecting passengers, who live far away, and are therefore less likely to have heard of the experience of earlier passengers. Even more intriguingly, passengers who have already bought the tickets should be charged extra every time a "new" passenger from afar agrees to board the leaky boat. What should the regulator do?

It could of course ignore the lobbying of the boat owners, and insist that they spend money building a more robust boat. It could insist that boat owners pay more to cartographers who can help determine a less risky path to the destination. It could insist that buyers have a right to know that that besides the boat, there were other less dangerous paths to the destination as well. It could mandate the creation of boats that are safer. It could insist in fact, that their primary mandate was to protect the passenger, and not the well being of the boat owners.

What would you say of a regulator that instead, agrees whole heartedly with the boat owners, caps the payment to the cartographers, increases the price of the tickets and increases incentives for those getting unsuspecting passengers to the boat even forcing existing passengers to pay more. Who am I talking about replace "boat owners" with "Mutual Funds" and you have your answer.

Undoing its own logic

In 2009, SEBI decided to ban entry loads for mutual funds the argument then was that investors should determine for themselves what services of "fund advisors" people who sold them funds was worth to them. Investors could decide how much they would pay. A laudable objective.

This change effectively killed a whole range of distributors where clearly, the investor did not feel that enough value was being added to be worth paying. Inflows into equity mutual funds fell as well.

The moot point is whether the inflows fell as a result of poor market and fund performance or because of a lower distributor base.

A look at the graph above shows that the problem is not that the assets did not increase. Just that equity fund assets did not grow. Most equity funds in the period post the ban of entry load (August 2009) have delivered poor returns to investors (category average for 3 years for equity large cap has been 4.5% per annum while even liquid debt funds have delivered 7% per annum). Since the equity markets have performed poorly, long-only funds too have performed poorly some more so than others. Long-only refers to a situation where fund managers are only allowed to buy before they can sell. An alternative would be to sell first and then buy back at a lower price if the market were falling. Almost all mutual funds are "long-only". In such an environment, would it be expected that there would be a rush of investors into equity funds? Not in the view of this writer.

What therefore was the rationale to re-impose the entry load which is what SEBI has mandated as per its latest guidelines? Under the guise of increasing investor participation, SEBI has made the following changes (a) entry load has been increased if mutual funds were to raise money from centres other than the top 15. 

Astonishingly, it has allowed mutual funds to charge the extra load to other investors of the fund as well not only the far-away ones (b) it has passed on the service tax that was earlier paid by the asset management company to the investor (c) it has capped the brokerage that can be paid to the broker who provides research and trade execution to the fund house and incidentally provides the fund manager the inputs to enable him or her to make investment decisions after considering multiple view points.

The product is faulty, not the sales effort

First and foremost, SEBI could have allowed mutual funds to have investment styles which are not only "long-only". The market offers enough instruments today to allow a skilful fund manager to trade both ways and generate "alpha". By allowing manager to only buy, the ability to sensibly exploit shorting opportunities is unavailable to managers. The recent Alternative investment fund guideline is a step in direction of allowing shorting as well, but the large ticket size per investor (currently Rs 1 crore is the minimum per investor) is a big entry barrier.

Another could have been the ability to manage a multi-asset fund. Here of course the plethora of regulators offers an impediment. So we have the strange conundrum that each individual can be a "multi asset class hedge fund" by himself there is no bar for an individual to trade in equity, commodity, currency, gold or real-estate, but no investment professional or fund house can offer such an investment vehicle to investors. A mutual fund cannot invest in commodities for example an asset class that has done well in the same years that equity has performed poorly. But if this is the problem, should it not have been addressed?

Clearly this is a case where the wrong question has been posed and answered. Many representatives of mutual funds and distributors would have presented their view points to SEBI. I wonder how many investor associations did. 

The views expressed are the personal views of the author.

What to expect from the new CEA

I have a new blogpost on CNN-IBN's India Blog site. The link is here. I am also copying the blogpost below:

Last week, the Indian government appointed Dr Raghuram Rajan, a distinguished economist, as its chief economic adviser (CEA). The CEA advises the government on possible policy options and priorities. There are no executive responsibilities other than to prepare the various economic reports that are presented to Parliament - including the Economic Survey. In this context, it may be useful to look at the policy preferences of the new CEA.

In April, Rajan made a speech in New Delhi in the presence of the PM where he signed off with "I have been frank as an academic, that is the only value I bring". This suggests that perhaps he thought that his speech would not be to the liking of his listeners. But was it really that radical?

The speech (along with my somewhat liberal translation for the non-economists) identifies some issues with recent economic policy:

"Rent, patronage, or entitlement enhancing measures have sailed through."

"Private consumption, especially in rural areas, is growing strongly on the back of rising incomes, strong credit growth and continuing government transfers and subsidies. The result: The gap between our spending and our saving is making us dependent on short term foreign inflows to a dangerously high extent."

My translation:

Policy paralysis led to bureaucratic/political adhocism, encouraging corruption. India's unwashed masses have been satisfied through hand-outs in the form of subsidies for which there is no apparent way to fund.

The Government has raised minimum support prices for agri commodities at much higher rates than the rate of inflation. Along with free hand-outs (referred above), and forced lending to rural sector through compulsory priority sector lending, we are consuming well over what we save. Soon we will need China to fund us!

So far, I see no problems with the diagnosis. The problem starts now!

Rajan says: "We need a common minimum programme across all sensible political parties to ensure that we stabilise the economy and foreign investor perceptions quickly."

Here we have it. By implication, democracy in India is a problem. If you don't agree with policy wonks of the government, you are not "sensible", and foreign investors are more important than local.

In reality, democracy is good for the economy as are policy disagreements. Enough data exists to prove it. One example is that India's growth rate has gone UP significantly in the period since we have had coalitions ruling the country.

Additionally, most large Indian houses have been investing overseas (perhaps in quanta at least as large as inflows) over the past few years. That should cause policy makers to pause and see why domestic industry does not see the potential in India while we are supposed to invite foreigners.

Rajan goes on to suggest that by 2000's, "powerful elements of the political class which had never been fully convinced about giving up rents from the License Raj ..., had by then formed an unholy coalition with aggressive business people ..... The new post-License Raj equilibrium became the Resource Raj."

The statement is misleading seeming as it does to suggest that the unholy politician/industry alliance is new. When did India ever have a strategy to offer national resources in a transparent manner? It was always through licensing which is by its nature open to corruption. Only difference this time the scale of corruption is unprecedented under the current dispensation.

So what is the solution that Rajan prescribes? He says, "simply moving our millions from low productivity agriculture to rural industry or services will give us growth for years to come, provided we are willing to do the minimum necessary to collect the low hanging fruit."

How do we do this? "We need to liberalise sectors like education, retail and the press, freeing entry and improving customer choice. We need to transform more government-owned firms into well-managed publicly owned firms which are free from political influence or government support. And we need to evolve transparent means of pricing and allocating the bountiful natural resources in our country."

Get the connection? Huh? Well I don't too. How does letting foreign investment in the press, retail or higher education (he speaks of higher education, not primary, when he speaks of liberalisation somewhere else in the speech) help in increasing rural industry or services? Privatisation of government-owned companies has already been ruled out of the policy tool box of the current government and is unlikely to find its way back.

Unfortunately, the rest of the prescriptions too don't offer anything new: increase fuel prices (instead of curtailing wasteful government expenditure), find a policy for allocation of natural resources (non contestable except that no format has been suggested, so this is a motherhood statement and no more) and look out for foreign investors (I fail to see why it is not necessary to be kind to Indian investors as well).

So far, what one sees of the new CEA seems to be only old wine in new bottle. Worse, it does not seem to be based on fact or cogency of argument. Hopefully the reality will be better for India's economic future.

Pulling fewer punches

The start of a new year - though only a change of calendar, invariable leads to some amount of introspection and, sometimes, a resolve to make some course corrections for the future. One such resolve I have made of myself in 2010 is to pull fewer punches. Even in the past, I have tried to express my thoughts without trying to be "politcally correct". However, I have evaded a few topics that I thought would be too controversial. Not any longer. My apologies to people who may feel offended. These are my own thoughts and readers can chose not to read them.

The year started with the two stock exchanges engaged in a juvenile competition of "my (timing) is longer than yours". Clearly, the BSE now suffers from the same sense of irresponsibility towards its constituents that used to be the hallmark of  NSE thus far. No one in the administration of either exchange bothered to explain WHY it was necessary to extend market timings. Despite the majority of members of the exchanges being against such a move, the change was introduced.

The exchanges called a meeting of "leading brokers" for "consultation" having already announced their intent. These brokers, predictably, and in contrast to the majority, came out with rhetorical statements in favour of the exchange move - adding one hour will make our markets "International" they said! Privately, people close to these "industry spokesmen" have told me that these spokesmen were themselves not in favour this extension. So why is it necessary to lie in public?

In India, where sycophancy starts from the highest political level, can there be any other expectation. Opposing the views of "the powers" serves no purpose - much better to create regulatory "goodwill". No doubt, this will lead to some quid pro quo at an appropriate time. This in itself is only a small example of "crony capitalism" - once the bane of Japan, then of South Asian economies, and now of the USA. Private gain again dominates general good. However, it is for these "leaders" to ponder on what example they are setting to the youngsters of the country by such blatant falsehood.. But then - they did not get where they are by worrying about such spiffy things! All the best - and look out for yourselves - your "leaders" are doing just that - looking out for themselves!

Tracking US dollars in country reserves

Jeffrey Frankel is James W. Harpel Professor of Capital Formation and Growth at Harvard. He was appointed to the Council of Economic Advisers by President Clinton in 1996, and subsequently confirmed by the Senate.

His recent blog post on Dollar share in FX reserves of Central Banks is worth a read.

I am including the graph he puts in his article in this note. The US dollar (and the country) achieved international hegemony post World war II. A strong economy made a strong country and dollar became the "reserve currency". The world has come a full cycle. Arguments about - TINA - there is no alternative, will eventually have to face up to reality. When an alternative becomes a desperate enough need, it emerges.

Confused Economists

Krugman continues to blog on the inadequacy of the US fiscal stimulus. Alan Greenspan appears to see unemployment going to 10%, but does not "support another stimulus package". So what are we to make of this debate.

Greenspan's policies now stand discredited and the popular view is that his refusal to take the punch bowl away at an appropriate time was largely responsible for the mess the US and the world finds itself in. But what are we to make of Krugman's insistence that a higher fiscal deficit is the answer to the US problem. All that we learned of economics - especially in the context of India, seems now to have been turned on its head. It was always argued that small government is important - so are the rules different for the US and for other economies? Intuitively, if the answer to a problem caused by excess liquidity is to infuse more liquidity, I'm afraid I find this completely unsatisfying. But Krugman is a nobel prize winner, so must know his stuff.

In my defense, I offer three arguments
(1) If the economists really had the world modeled correctly, why are we in the mess we are in?
(2) I quote Fischer Black (1986)

In the end, a theory is accepted not because it is confirmed by conventional empirical tests, but because researchers persuade one another that the theory is correct and relevant.

(3)Emanuel Derman, in a presentation on quant finance in 2002 - had this to say on financial modeling

There is no fundamental theory in finance. There are no laws.
That s why many of the textbooks are so mathematically rigorous.

I recommend that we stick to the tried and tested - if the model does not seem to be sensible, stick to the sense and chuck the model.

Smart Managers for Smart Cards

Swaminathan Aiyar's article in the Times of India today on Nandan Nilekani's appointment in the government is worth a read. One can only wish Nandan Nilekani good luck and hope, for all our sakes, that his term is successful.

Correcting our Education system

Kapil Sibal, the new Education Minister recently unveiled his 100 day plan for "reforming" the education system in India. A proposal that seems, surprisingly, to have met with almost universal enthusiasm, has been that of abolishing examinations at the 10th grade. Speaking of education, he said

"We need to de-traumatise it and reduce the burden on parents and children. We could, for instance, think of abolishing the class 10 board exam. Why does a child need to appear for a board exam in class 10 if he/she is continuing in the same school?"

There a many things wrong in our education system - but eliminating competition in the name of "de-traumatising" is a huge mistake. In recent years, the world has woken up to the fact that India produces one of the largest numbers of technologists - scientists, engineers et al. In a U.S. Senate Committee Hearing on "Strengthening American Competitiveness", Bill Gates reportedly said:

"Unless we transform the American high school, we'll limit the economic opportunities for millions of Americans...we need to adopt more rigorous standards and set clear expectations. We must collect data that will enable students, parents and teachers to improve performance.And if we are going to demand more from our students, we'll need to expect more from teachers."

Those in India who hold the US education system as epitomizing the best should keep in mind the statement by Senator Enzi made at the same hearing :

"A year ago I was in India. We were trying to find out why they graduate so many scientists and engineers. I did have one person that I thought had some great insight. They said that they didn't have any professional sports teams. (Laughter.) So the highest pay and the most prestige that they could get was being a scientist or an engineer or a doctor, something in that kind of field."

Though almost farcical, there is a glimmer of truth in the statment that the votaries of "no stress" need to bear in mind.

The world does not seem to think there is much wrong with the Indian system. Japan has, seemingly, a cult following for "Indian" Maths.
A special reporter accompanying a business delegation from Japan in 2008 remarked

"After making a deep assessment of educational systems all over the world, particularly the developed countries, a majority of our educators have concluded that the teaching system in the Indian subcontinent can do wonders for Japan."

A story erroneously attributed to Bill Gates is none the less correct in the extreme. Charles Sykes when writing an op-ed on dumbing down of school education commented:

Your school may have done away with winners and losers. Life hasn't. In some schools, they'll give you as many times as you want to get the right answer. Failing grades have been abolished and class valedictorians scrapped, lest anyone's feelings be hurt. Effort is as important as results. This, of course, bears not the slightest resemblance to anything in real life.

Is anyone listening?

The Budget Agenda – making India competitive

As the first budget of the new government, the market is looking for the government to set the agenda for the next few years. High fiscal deficit will restrict maneuverability with regard to tax reduction. The popular mandate, as interpreted by the ruling party, is one of continuity of fiscal policy with a bend to offering direct assistance to farmers and the fiscally weak. This limits the ability to reduce expenditure.

The agenda therefore has to focus on improvement in efficiency of expenditure and better tax collection. Besides, steps are needed to reduce of size of government, and bureaucracy to speed growth. Some steps I would look for are:

1. Financial Reporting – remove the obfuscation. The Fiscal Responsibility and Budget Management (FRBM) Act was expected to form the blue print for India to the path of fiscal prudence. Instead, it has led to the government resorting to a policy of smoke and mirrors to hide its inability to manage the budget. Obvious ones include the non-inclusion of fuel subsidy in the budget deficit. The more pernicious ones are reduction of state transfers – with states being asked to approach the market. While this reduces the apparent expenditure of the Central government, it does not actually reflect better fiscal management. What is needed is to:
a) Move to a system of accrual accounting instead of cash accounting. This will help focus policy debate on not only the immediate term issues, but the longer term ones of ballooning pension liabilities, and debt servicing.
b) Reflect all governmental revenues and liabilities through the budget – all non-budgetary items to be avoided – to prepare a true and fair picture of the state of government finances
c) Prepare accounts that are consolidated – which represent the accounts of the state governments as well as the centre
d) A key area of reform has to be to measure all salaries paid by the government and its agencies and by public sector companies on a cost-to-company basis. This will likely throw up interesting information especially when measured against productive output!

2. Establishment of efficiency parameters – for the most part, the budgetary focus is on revenue and expenditure and not on measuring the efficiency of use of the money spent. Most government departments do have review mechanisms. However, these are not transparent – a case in point is the inability of the Ministry of Human Resources to explain where the money collected (as a cess) for secondary education actually goes. Besides, rarely is the measurement of delivery of efficient service a goal. As part of smaller government, the government needs to move out of providing services itself and instead set up monitoring agencies that set out goals and monitor results while using private enterprise to deliver.

3. Privatization – not disinvestment – This debate seems to have been set-back by the present government. While it continues to desire selling off bits of public owned companies, the approach is essentially episodic in nature. Efficiency of operations can only increase if there is a change of ownership that leads to a change of management style. Arguing that 51% stake would allow better performance is not demonstrable. On the contrary, the use of oil marketing company balance sheets to offer fuel subsidy, that of banks to write off loans and the “donation” by Gujarat state owned companies (where the government is in a minority) suggest that government ownership in any amount detracts from the commercial nature of business.

4. Economic friction in the form of ill conceived taxes (FBT, dividend tax, cash withdrawal) and the discretionary nature of multiple tax rates have crept in the taxation system over the past few years. While the nineties had established a clear road map of tax reforms, the previous UPA tenure marked the reversal of the trend towards simplification and instead returned ad hocism in tax matters. This needs immediate rectification. Another key area remains the implementation of GST – where the time frame of implementation does not seem feasible given the lack of preparedness of the government. Another key area of friction is the restriction on capital flows. The present FII registration requirements serve little purpose. In fact, with limited control over foreign institutions, government has less knowledge of who is the final investor than if it were to allow the normal “know your client” requirements of brokers to work in the case of foreign clients. We need to now drop “I” from “FII”

5. Land and labour reform remain glaring unfinished agenda for faster economic growth. While labour reforms are contentious, land reforms need not be so. Clarity in land titles, and land use planning are two areas that, if sorted out, can reduce corruption significantly.

The Judicial sector needs serious attention. The pile up of unresolved legal cases renders the system incapable of being used. While this is not an agenda for the budget, this has to be one of the key areas of focus for the government if they are serious about increasing the economic growth of India on a sustainable basis.

Unlearn the old

“Change is inevitable - except from a vending machine.” – Robert Gallagher

Usually, Geographic texts remain the same across generations. You would not expect your child to learn about one less continent, or one more Sun. But in these changing times, even this is not true. Since 2006, we are now missing a planet. Our solar system now has 8 planets and not nine as we were taught. Something fundamental has changed here.

The same seems to be happening to the rules of investing. For the past many decades – almost since the concept of “fiat money” came into existence, it has always been assumed that earnings determine stock prices – atleast over an unspecified “long term”. Millions of trees have been sacrificed to propagate this thesis, and many investment gurus have made their reputations based on this “style” of investment – not least the great Warren Buffet.

It appears we are now in the midst of a change of tectonic proportions – much like the removal of “Pluto” for the count of planets – where we will take away cash flows and earnings as the primary sources of stock performance and replace them by regulatory and government action.

Two proposals merit attention. The first, originating in the USA, is a proposal by the Financial Accounting Standards Board (FASB), to allow creative accounting (obviously couched in more acceptable language). This will now be discussed and put to vote on April 2. Girdle up for “Ostrich Accounting” from here on – defined as “if I refuse to see it, it ain’t there”. If you assume that most companies already use some variant of this – this report mentions that GE Capital Corp. uses mark-to-market on only 2% of its assets – you understand why most brokerage reports use the words “we believe” so liberally. Whoever claimed that that an analyst was paid to analyse, not believe!

The other report is from our own shores. In an obvious attempt to keep up with the Joneses, in India, the National Advisory Committee on Accounting Standard (NACAS) has recommended a deferment of AS-11. While there is a flicker of hope that this will be rejected – the Ministry of Corporate Affairs has not yet accepted the recommendations, it seems highly unlikely. India will therefore pad along the footsteps of the “most advanced” market in the world.

Key changes – looking at accounting books of companies for clues of financial performance will soon become like reading fairy tales – it already is in many cases – but will now become entrenched policy – not meant for grown-ups. Equity markets will now behave much like debt markets. Debt traders are trained to look at the key market rigger (the Central Bank) for direction on how to trade. Equity traders soon have to look in the same direction – if the Bank prints more green-backs, buy equity, if it prints more bonds, sell equity. Did anyone mention earnings here?

To paraphrase a quote “Every time I find the meaning of investing, they change it”

Regulating the regulators

Imagine a school with a strict teacher in every class. In one such class, are a bunch of kids playing with fire. While the teacher watches, the kids set fire to the window curtains. The fire spreads, and engulfs the school and burns down most of the infrastructure. It then spreads to the neighbourhood and affects the nearby buildings. While trying to bring the fire under control, and examining the cause of the fire, the school principle suggests that one way to prevent another such occurrence would be to appoint the errant teacher as the fire warden for the neighbourhood.

Sounds like a fantasy out of Alice in Wonderland? Welcome to the real world – this is how the financial system of the world operates cica 2009. Gordon Brown, in preparation of the G20 summit on the financial crisis, exported to the world by the USA and UK, writes

“I have learned from this financial crisis that the disciplines we expect of markets cannot be guaranteed without strengthened supervision. “

Uh? Let’s see which part of the financial system that caused the breakdown was unsupervised. The most maligned are the hedge funds. Did these loathed vehicles need a bail-out – not really – for the most part, they just quietly wound down and exited. However, we have had multi-billion (totaling trillions of dollars) of bailout for supervised entities - banks, insurance companies, and investment banks. So don’t you see, the solution to the problem must be more supervision!

Having efficiently “supervised” an excellent problem situation, the regulators in the US have now suggested a Geithner plan to fix it. The plan involves a “put” to investors of banks and distressed asset funds, while transferring the entire risk to the tax payers. As Paul Krugman writes,

"Treasury has decided that what we have is nothing but a confidence problem, which it proposes to cure by creating massive moral hazard."

Mark Twain could have been speaking about regulators when he wrote

"All you need in this life is ignorance and confidence then success is sure"

especially if success is measured by negating the principles of free markets, and forcible propping up defunct organizations.

Reality check for executive factories

The IIM’s have long justified the rapid and unchecked increase in their fees on the grounds that students are assured of a good placement. Consequently, the institute and its dependents (the teaching staff) should charge “appropriately” to deliver “quality” education. In the case of IIM A, fees have increased from approximately Rs 1.5lakhs in 2004, to Rs 6lakhs in 2009 (CAGR of an astounding 32%). The unstated position appears to be that rather than being non-profit institutes of research and education, IIM’s should now be viewed as glorified placement agencies and finishing schools for graduate students. Incidentally, IIM’s make in excess of Rs2crs per year from placement fees alone.

The recently concluded placement session has been a much needed reality check for the IIM’s. Placement was slow, and students witnessed a salary drop averaging 30% across most IIM’s.

Maybe this will lead to some serious, and much needed soul searching. If the argument is that rising salaries are in some ways related to the “value add” that the institute delivers – then, one has to conclude, that the institute has actually added lower value to the current crop of students. I wonder if the students then entitled for a refund in fees!

The IIM’s seem to suffer from unbridled greed - that has been at the bottom of the current meltdown in the US. No justification can be offered for a 30% increase in fees year-on-year for over a decade (it started well before 2004). Linking fees to salaries ensures that students may need to take loans, and this restricts their ability to explore options of entrepreneurship and of working in socially relevant, but poorly paying jobs. This, when as a public institution, the IIM’s are adequately supported by the State (they have existed for over four decades, and have built their reputations over 3 decades of public support). Operating independence for a public institution cannot be divorced from responsibility to the public and its government. Rather than competing on increasing salaries and costs, it would be more appropriate if the IIM’s focused on creating a management education paradigm suited for the needs of a diverse and uneven economy as India.

The key success factor for the IIM’s has been their ability to draw within their fold, the cream of aspirants – and government ownership, a merit based entrance and low fees have each played a significant role in this. Change one, and the IIM’s will not be the same again. I hope the IIM’s are listening.

What's wrong with pledged shares?

Post SEBI's directive requiring "promoters" to declare if the shares they own are pledged, markets are reacting unkindly to the disclosures. The disclosures itself suffer from serious limitations - most arising out of the definition of "promoter" groups. Since many sponsors continue to hold shares in the name of front companies that are not classified as "promoter" companies, it is entirely possible that the disclosures are inadequate at best and misleading at worst.

The more fundamental question, however, arises on whether the market is correct in selling off shares of companies where promoters have pledged shares, or, does this behaviour present a buying opportunity. In my view, the latter.

For the most part, companies in India are still largely owned by a family or by a first generation entrepreneur. Resources for investment are clearly limited. That being the case, if a new investment opportunity were to present itself, what is the man to do other than to pledge assets (in this case the shareholding) and raise funds. Why should that not be viewed as a case of being bullish on the prospects of the investment opportunity?

A possible reaction to this argument would be that this increases the risk in the business, since the equity is essentially debt in disguise. This may well be. However, is it substantially different if the equity of one venture is pledged to raise finances for another - say like in the case of the Tata Group. Isn't this too a case of overleverage, and prone to the same risks? Afterall, most "promoters" do not distinguish between companies that belong to the group - when it comes to crunch time, the cash flows of all companies are used to feed the weak - notwithstanding the presence of minority shareholders that may be and most likely are - different. That this practice is wide spread, and the market is aware of it and tolerates it itself points to the inconsistency of the current response.

An alternate to pledging shares would be that the "promoter" find ways to cheat the minority shareholder of his due share by extracting an unfair proportion of the cash in the business to fund his own investment needs. To me, a pledge is anyday more palatable. So, next time a share price falls sharply because of pledge disclosure, and the business does not look to be in trouble - go BUY.

Overestimating the effects of policy reform?

Mr. Vijay Kelkar, Chairman Finance Commission, recently delivered the convocation address at the Indira Gandhi Institute of Development Research. The speech largely addressed itself to the benefits that a Goods and Services Tax (GST) would bring to the economy. While the benefits of GST need no reiteration(the speech itself makes a cogent case), the figures that Mr. Kelkar puts out seem suspect. He argues that there can be a saving of 1.4% of GDP which translates to $15bn annually. He then proceeds to discount it at 3% to yield an NPV of $500bn.

The question to ask is why use a discount rate of 3%? Unless we argue that the nominal interest rates will average these levels over the next several decades, the case for using such a low interest rate is not clear. In fact, using a 5% rate reduces the implied benefits by more than 50%.

Another area where I find myself skeptical is the contention that more services will get taxed under GST. It appears to me that most services are already being taxed now - banking, telecom, brokerage, consulting etc. Large value services that do not get taxed are largely those that are provided by the government - say the railways. Even these can be viewed as being taxed, since railways are a department of the Central Govt and not a company. It appears that the net addition through taxation of services may not be significant - though I have no estimates, and may therefore be in error.

The downside of GST is often higher prices, lower private consumption. This too is a cost that needs to be kept in mind. As also, the fact that in ensuring that all states agree to the proposals, it is more than likely that GST will not be introduced in the true spirit, and States will continue to impose some form of Octroi or other local taxes. This will again kill the purpose of GST.

In all, the simplicity of the concept itself makes it worth implementing - despite the much lower than projected benefits that may arise.