SK – Page 135 – Pertinent Observations

Rupee against emerging market currencies

One common argument by experts who claim that there is nothing to be worried about the decline and fall of the Indian Rupee in recent times is that the Indian Rupee is not the only currency that is falling, and that other emerging market currencies are also falling equally badly. In order to test this out, we will look at the movement of the rupee as a function of other so-called “emerging market” currencies.

I’m just going to offer the graphs here (of movements of various currencies against the rupee) without any comment. All graphs are of the form “how many units of foreign currency does it take to buy a rupee”. So the higher this graph, the higher the level of the rupee compared to this particular foreign currency. And it is on purpose that I’ve drawn all charts starting from Jan 1st 2008, so that the US financial crisis is also captured.

Data for all charts is taken from oanda and charted using quantmod for R.

Managing households and economies

Two years ago next next week, I was laid off from a large investment bank. Thanks to my then boss, I had a heads-up – it was only a question of when. I had started making contingency plans – which is the business I run right now. In fact, I had been planning to do this before I got to know that I wouldn’t last much longer at that firm, but that is an incidental point.

The point is that on one particular day two years back I realized that there was going to be a drastic reduction in my (and thus my family’s) cash inflows. And so we begun to make contingency plans. Now, remember that I already knew what I wanted to do next, but I knew that it would take time before it would begin to produce positive cash flows (in fact it would take a year). So the challenge was on how we were going to finance our living in the interim.

What puts me on a weaker footing in such discussions is that I’m not organized. If you ask me how much I spend in a month, I can’t tell you without checking my bank account statement. I believe I don’t spend too much but don’t calculate too much at the time of spending either. Yes, I’m a data scientist but I don’t quantify my life.

Coming back, we made an estimate of how much we spend and realized that there would a deficit that we would have to finance. I had ruled out taking up another job, as I had believed that the time was right for me to do my business. One option was dipping into savings – I had a fair bit tucked away in fixed deposits, and could break one of them. However, the wife wasn’t sure if we should dip into savings for day-to-day expenses. “Let us see how we can cut our expenses”, she said.

And so we sat and tried to analyze how we could reduce our spend without significantly affecting our quality of life. “Use the car only when absolutely necessary” she said, and I agreed it was a good idea. Then she suggested that we shouldn’t eat out (we were already paying a cook a fair sum every month), which I again agreed with. So we proceeded, line item by line item, trying to weed out unnecessary expenses.

Soon, we were out of low hanging fruit (eating out, car, etc.) and things started getting absurd. “Why should we spend Rs. 1000 per month on electricity? We should cut it down by 10%”. “We don’t need two business newspapers. Let’s stop getting Business Standard”. “We should cut our respective phone bills by 10%”. “Do we still need a land line?” While all these are excellent ways to cut expenses, the problem is that it did little to solve the problems. The deficits that we would have to finance every month was of a different order of magnitude, and while measures such as this helped chip away at the deficit, they had little impact on the overall deficit itself.

I’m telling you this long story now because it reminds me of how the Central Government is trying to save the rupee from falling further. For a long time, there were steady foreign exchange inflows into India, thanks to foreigners wanting to invest in our country. This flow of dollars made us complacent, and we weren’t particularly worried by our high import bill. We continued importing heavily, and with the fund flows subsidizing the dollar imports remained cheap, too. We didn’t bother to take steps to boost our exports, though.

So now, the fund flows have stopped coming. And the government needs to do something to make sure our deficit doesn’t grow. And so they have started chipping away at corners. They have increased taxes on gold imports. They want to restrict timings when petrol can be sold. They want to further tax import of apples (the fruit, not the computer). Yes, each of them will make a small dent in our burgeoning current account deficit. However, it will remain just that – a small dent. The deficit is of orders of magnitude more than these dents.

Just like we would not be able to manage the household budget by simply cutting down on small corners (newspapers, electricity, etc.) the country cannot manage to finance the deficit with small measures such as these. What we need is structural change (at least in my personal situation I knew I was starting a business so the structural change was coming; there is no such thing on the horizon at the government level). Currently it is not clear how that is going to happen. Analysts are predicting further fall in the rupee. Given how the government has gone about trying to defend the rupee, that wouldn’t surprise me one bit.

My household budgeting problem was partly solved by the generous severance pay that my employer gave me along with the pink slip. It kept us going for quite a while, then I cashed out some small savings and then my business started producing cash flows. Unfortunately for the country, investors are not in the habit of giving “severance payouts” when they remove their investments from a country.

Normal and power law distributions

About a week back, I had sent a long email to my client espousing the virtues of the power law distribution, and how it was relevant to the project that I was working on. To be honest, I didn’t really expect a reply to that mail. It was fairly long, and parts of it were technical, while most of my clients are primarily business people. In the best case, I decided after sending the mail, it would be ignored, and in worse cases, the client would think of me as a freak and start wondering why I’ve been engaged.

The next morning I got a rather long reply from my client. It appeared that he had taken great pains to understand my model and its relevance to his problem, and he responded with the model that he had built for similar analysis. While the model he built was simplistic (during the course of his email he repeatedly pointed out his non-statistical background), I found it to be amazingly accurate, and that it modeled the behaviour we were looking to model rather accurately. The only drawback of the model was that it wasn’t a particularly scalable model, and it wasn’t easy to modify.

Given my experience at a rather large and successful investment bank that used to work for (documented here), this was indeed a pleasant surprise. The modeling department of that bank had been virtually taken over by people skilled in continuous math and linear algebra, and the people there had little patience for any model that didn’t follow some variation of Brownian motion (of course, most of that firm’s systems were set up assuming one such distribution). Despite having been through the lows of the 2008 Financial Crisis, the modelers there steadfastly refused to let go of their supposedly time-tested models, and any comments of distributions not being normal were seen with suspicion.

Over a year and half back, when I decided that I should move out of the investment banking industry (where I found quant having saturated to some extent) and into other sectors where there wasn’t much utilization of quantitative techniques, one of my apprehensions had been that I would frequently run into business people who simply wouldn’t touch modeling with a barge pole. I had been apprehensive of working with people with absolutely no quantitative background.

After my recent experience, though, I’m happy to have made the transition. I do hope that other clients are also as receptive to new ideas in quantitative techniques.

Insurance Funds Should Invest in All Classes of Bonds

Earlier today, I was going through some “Exposure drafts” that the IRDA has put out proposing some changes to the way Insurance and Pensions are regulated in India. The part that has got some people excited is that now insurance companies are going to be allowed to invest in corporate bonds that are rated AA (hitherto, they were only allowed to invest in AAA rated securities). An article in Monday’s Business Standard makes the usual noises about “gambling with people’s hard earned savings”.

Reading through the draft today, I realized that even this investment in AA rated securities is limited to 15% of the insurer’s assets, of which a whopping 50% needs to be invested in government and other “approved” securities. The question I ask, therefore is, “why only AA?”

As a class of investors, insurance and pension funds are unique in terms of the horizon over which they need to invest. They have cash inflows over the short term, but need to invest for large potential cash outflows over the long term. In that sense, they are among the most stable investors since they are able to tide over short-term blips due to the far-sightedness of their investments. Additionally, their massive corpuses also gives opportunity for significant diversification, and that allows them to make the odd risky investment.

The reason that corporate bond trading is next to dead in India is because insurers have hitherto only been able to invest in bonds rated AAA. With the regulator now permitting investments in AA bonds, there is a chance for that market to develop in a tiny fashion (though the 15% cap that the regulator has imposed, and this includes AAA securities, means it will only lead to minor development). However, unless insurance and pension funds are allowed to invest in bonds of lower grades, there is absolutely no chance of those markets developing, and that only means greater strain on the banking sector. Let me explain.

In another world where corporate bonds were widely traded, it would be extremely unlikely that Kingfisher Airlines would have raised as much bank debt as it has. It would have instead gone to the corporate debt market, and sold paper to the public. And the investors who had invested in Kingfisher’s debt would, as the company steadily declined, have been able to cut their losses and trade out of the company, and be replaced by a different set of investors with a greater risk appetite (you can notice that this has happened in the widely traded and liquid equity market. On the debt side, though, SBI and a few other banks are stuck with tonnes of bad loans).

The systemic risk in banks owning too much risk is that it encourages good money to go after bad. Knowing that the money it has lent to KFA is as good as gone should the airline go down, there is a perverse incentive for SBI to continue lending to KFA in the hope that it would somehow be kept afloat. Had it invested, instead, through the bond market, the bank could have steadily traded out of KFA’s debt and there wouldn’t be one player with perverse incentives saddled with the entire debt.

So where do insurance companies come in? As I explained earlier, they have a long-term horizon in investing and they are huge and hence diversified. Hence, they are the ideal catalysts for building a domestic corporate bond market. Due to their investment horizon, they won’t suddenly desert bonds as a class when the equity market jumps up. Due to their size, if one of the companies they have lent to (via the bond market) goes down, it is likely to be absorbed by some of their other investments that would have done well. World over, it has been seen that insurance and pension funds (and endowment funds of large universities) have played a critical role in creation of liquid markets for new asset classes (including Michael Milken’s junk bond market in the 1980s).

So what should be done? Insurance companies should be allowed to invest in whatever the hell they want to invest in, as long as they keep a certain risk-weighted score under control. The current mandate is for 50% to be in government and other “approved” securities. Instead, the risk-weight for these securities can simply be made to zero. AAA securities can have a higher risk weight, AA even higher and so forth with junk bonds having the highest risk weight. And the regulation can be of the form of an insurer’s weighted average risk being bounded from above by a certain number (this is similar to the Basel II norms for banks – something I’ve ranted about before, but I’ll save that for another day). What risk-weighted regulation does is to allow investors to choose their own investment profiles – for example, one investor might choose to invest all his money in AAA bonds, while another might invest 90% in government securities and the rest in junk.

Now what of the “playing with people’s life savings” argument? The answer is that people don’t keep all their life savings in insurance or pension schemes. They keep a significant proportion of their savings in banks also, and what the provisions I’ve proposed does is to reduce the stress from the banking system. If KFA goes down tomorrow, depositors in SBI and other banks (notwithstanding SBI’s de facto sovereign guarantee) stand to lose. The regulation I propose will simply diversify this risk between depositors of SBI and investors in SBI Life – thus taking one dimension out of the headache people might face in their investment decisions; and at the same time reduce the overall risk in the financial sector.

The problem with current financial regulation in India is that it is siloed. We have one regulator for banks, another for capital markets and yet another for insurance and (maybe) another for pension funds (PFRDA). All this ensures is that each regulator tries to decrease the risk within his sector, without regard to risk to the financial sector as a whole. The sooner we recognize this, the safer the life’s savings of our people will be.

Ants and God

Two days back I had polished off a plateful of pancakes (made by the wife, of course) with maple syrup and left the plate in the sink. Unlike usual, I had not bothered to run water over the plate before I put it in the sink. I happened to return to the sink half an hour later (to deposit my coffee cup) and noticed a swarm of ants over my pancake plate, trying to feed on whatever maple syrup was still stuck to the plate.

The more compassionate among you might argue that I should have left them alone. After all, they were eating what I had not eaten, and who was I to grudge that? But I’m not one who tolerates arthropodes of any kind in my house, and I decided to wreak havoc on the ants. It is not often that you find so many ants in one place that you can destroy. So I (belatedly) ran water over the plate. Historically, this event might go down among one section of the ants as “the great flood”. Yes, a few ants managed to scurry away to tell the tale.

Now, these ants had no clue about my existence. All they knew was that there was the plate with maple syrup stuck to it, which they could feed on. And they were going about their business when an external entity who they were not aware of created a flood, drowning most of them. As far as the ants were concerned, I was like an external “greater power”. Someone who had the ability to destroy. And destroy I did.

Note for a moment that this was not a predator-prey relationship. If I were their predator (a spider perhaps) they would have been aware of me. However, here I was, of a species that doesn’t normally interact with ants, much much bigger than the world they know, destroying so many of them.

Like me to the ants, some people like to argue, there is a “greater unknown being” who controls all our lives. This greater unknown being (commonly nicknamed “God”) is in control of our lives, they say. And so, we need to pay obeisance to him and do things that keep him happy. We are all at the mercy of this greater being, they say, and hence we must pray. Pray that this greater being is kind to us. Pray that in the flood that he unleashes from time to time we are among the lucky few that manage to scurry away and live to tell the tale. Pray that he doesn’t cause the flood at all.

While the Ant:Man::Man:God analogy might make sense in terms of the larger creature being significantly superior than the smaller one who is not aware of him, it still does not explain why one needs to pray or do any rituals or even make any attempts to make the larger creature take pity on you.

Ants have no way of communicating with me. Maybe they think there exist creatures such as humans, who should be prayed to so that they are now flooded. I’m sure they might have tried, as they saw me stand over their plate of maple syrup with my hand on the tap. It didn’t make a difference to me. I opened the tap anyway, and unleashed the flood. By a similar analogy, that the “greater creature” will even bother to take cognizance of you and try and understand you and do as you please is a massive leap of faith.

Workforce Participation of Women

Krish Ashok and Puram Politics have been collecting data from various government sources and converting them to excel. This data contains a wealth of information on social indicators in India. You can expect the next few issues of RQ to be based on this dataset. Data is drawn from various government sources including the Ministry of Statistics and Program Implementation (MOSPI).

Today we will look at the workforce participation of women across the states of India. First, let us look at rural women. Notice that the all India average participation is close to 60%. Himachal Pradesh ranks the highest with over 83% while (perhaps surprisingly, developed states such as ) Delhi, Kerala and Punjab bring up the rear.

Next we will look at the workforce participation of urban women. Note now that the all India average drops to an abysmal 20%! While migration to urban areas is generally associated with increased standard of living, it is interesting to note that more and more women don’t work in urban areas. It is perhaps a reflection of the kind of jobs that are available in urban India.

Notice that once again, Himachal Pradesh is top and Punjab and Delhi bring up the rear. Actually there seems to be a correlation between workforce participation of rural and urban women across states. Let us explore that with a scatter plot.

Notice that there is a strong positive correlation. Interestingly, Himachal Pradesh and Tamil Nadu (states associated with excellent education levels) display superior participation of urban women in the workforce relative to the participation of their rural women. Karnataka, Andhra Pradesh and Rajasthan are also found to be above the regression line. Interestingly, it is hard to draw a pattern from this data in terms of which state is more developed.

Perfect and imperfect interviews

The movies give this impression of what is a “perfect” job interview. This usually happens during the stage of the movie when the protagonist has started turning things around, things are looking up for him/her. The “perfect” job interview barely lasts minutes, and the protagonist returns with the offer letter. As good as it can get. Unfortunately, this reversal of fortunes for the protagonist (who has hitherto been jobless, and desperate) happens only towards the end of the movie. And we don’t really get a chance to know how his job went.

I had one such “perfect” interview once. To be fair, I had sent my CV in advance and had done a couple of telephonic rounds (which were primarily about my would-be bosses telling me about what the company did, without them asking me too many questions) before I was called in for the interview. I remember going in around 10 am or so, first meeting the HR person in charge of recruitment and then the India head. No questions asked. I then met my would-be immediate boss. Again, few questions asked. Most time spent explaining what the role would be about. By lunch time I had an offer letter. As perfect as it could get, you might think.

The perfection, unfortunately, didn’t last too long. Within a few weeks (yes, back then I counted my tenure in a job by weeks, as I hadn’t ever lasted more than ten in any earlier organization), it was clear that there was a mismatch of expectations. Given my (then spectacular-looking) CV they had expected me to pull rabbits out of hats. I soldiered on. A year later I announced that there were no rabbits in the hats. Helpfully, two months later, I suggested how the design of the hats could be improved (all this is metaphorical, of course). But they were disappointed that I wasn’t able to produce rabbits. Soon, we parted.

Coming to think of it, given my disastrous career as an employee (which I don’t hope to resurrect), it’s hard to find a “happy” story. But to contrast the one above I must tell you about this other job I did, where I was significantly happier (while it lasted) and lasted longer. This time I faced sixteen rounds of interviews. Yes, you read that right. Sixteen. All extremely difficult. Each of which told the firm a different dimension of me. And more importantly, each of which gave me insight into what the team I was going to join did and the kind of people I was going to work with. After the last of these interviews, the firm took ages to decide on my offer. But when I joined, I slotted in easily. They knew me and I knew them. Yes, it might have unraveled once again (eighteen months on) but till then I could have only dreamed of eighteen months of being happy in a job!

So I was thinking about it yesterday when I was thinking of a meeting I have this week to explore a potential business opportunity. At first I imagined myself closing the deal quickly. Then I corrected myself. Considering that this is a longish engagement that I’m thinking of, it would be important for them to know me and me to know them well before we sign. It is important to know what each of us is bringing to the table, and for expectations to be clear. So yes, multiple rounds of talks could potentially delay this engagement, but it will put it on a firmer base.

And that’s what you should be thinking of every time you want to get into a potential assignment. Unless of course your intention is to fraud your counterparty.

PS: Think of how campus placements work given this framework. I think of it as purely an option value investment by the employer.

Chennai Gets Metered Autos

During my talk at the Takshashila Chennai Shala in 2011 (related Pragati article here), I had argued that the underlying reason for market failure in Chennai autorickshaws was regulatory failure. Despite costs for auto rickshaws going up significantly, I had argued that the regulated fare was a lowly Rs. 7 per kilometer, because of which no auto rickshaw in Chennai traveled by meter.

In the same talk I had argued about the benefits of having a regulated fare (no time wasted in haggling, etc.) so this new move by the Tamil Nadu government to regulate auto rickshaw fares is welcome. Note at the end of the article that someone from the Auto Rickshaw Drivers union has welcomed the new fares. This, and the fact that the fare has been set rather high (compared to other Indian cities) should hopefully lead to wide uptake in the use of meters among auto rickshaws in Chennai.

This stabilization in price, I argue, will lead to greater use of auto rickshaws by the general public (since there is no uncertainty now) and should also contribute to greater revenues for the drivers, thus creating a strong ecosystem.

The graph below compares the per kilometer auto rickshaw fares in different cities in India. Note here that Chennai is the most expensive. My argument, however, is that given the unregulated market that is in place now, this higher fare is a reasonable price to pay for good regulation and fair fares.

Religion, yet again

I think religion is an exercise in finding loopholes. Religious people I think will make great tax consultants.

So this evening I was at an uncle’s place where he had organized a Vedic recital. Some fifty or more people from the Vedic school he goes to (after having retired after an outstanding career as a space scientist) were there and they were chanting the Vedas. Now, today is a Saturday in the Hindu month of Shraavan (bastardized as Saavan), and the devout are supposed to keep fast (which I discovered only this evening) . However, given that it is not nice to not serve food to people whom you’ve invited home, my uncle had arranged for what people in Bombay term as an “upvaas feast”.

It absolutely beats me how rice is considered to be “food” while avalakki or “beaten rice” (which, as the name suggests, is made from rice), is not! No, I’m not joking. So this evening I learnt that as long as you don’t eat rice, your fast is still maintained! So you had the rather devout gurus of the Vedic school who were supposed to keep fast tonight gorging on Bisibelebhath and Kesari Bhath (among a rather long list of items) – just because the former wasn’t made out of rice, and the latter doesn’t contain rice anyway.

I’m reminded of the time some six years ago. My father had just died and (much against my will) I was being forced to perform a hundred post death ceremonies. Now, protocol for these death ceremonies is that you do it on an empty stomach. You only eat once that day, and that is a rather late lunch after you’ve offered the pinDa (cooked rice mixed with milk and curd and black sesame seed), first to your departed ancestors and then to crows and cows. However, during the course of time, people have made exceptions. Apparently you are now allowed to have coffee or milk in the morning before you perform the ceremony. And over the course of time that has come to be understood as “milk with additives”. And so I was fed cereal with milk (lest I revolt on an empty stomach) as I made my way every day for five days to one dirty “tithi hotel” to supposedly ensure my father’s soul went to heaven, and was tied to those of his ancestors.

Oh, and needless to say, that “only one meal in the day” rule for death ceremonies has been relaxed, too, in the course of time. Now you’re allowed to have dinner also, as long as (surprise, surprise!!) you don’t eat rice!

Then there is the concept of maDi or ritual cleanliness. This evening, my uncle took pains to announce to his guests that the food had been cooked under “strict maDi conditions”. Yet, when I happened to walk in to the kitchen, it was hard for me to walk any more as the floor was insanely sticky, with spilled food, I would guess. Ritual cleanliness I think doesn’t really imply real cleanliness. More significantly, maintaining the conditions or ritual cleanliness gives you an illusion of cleanliness and since you’ve followed the rituals you don’t see any need to keep your kitchen actually clean. It reminds me of what a friend maintains – that the religious are less likely to be moral than the irreligious.

And then I have mentioned on this blog earlier about how during religious functions hosts don’t really bother with serving lunch/dinner on time. For the record, this evening’s dinner was at 9:30, which I’m not sure is a particularly healthy practice (and which is probably I’m still awake).

So the net effect of this is that every time I attend a religious function I get further repulsed by religion. That people don’t answer my questions doesn’t help (I must mention that I’ve stopped asking questions, for I seldom get satisfactory answers. The only person who I still bombard with questions on religion is my mother-in-law who makes a patient and honest attempt at answering them more often than not). It is probably due to my upbringing (I might have mentioned here earlier that my father was atheist. I do one better than him in that I regularly wear my sacred thread, though I probably over-compensate for it by eating meat), but sometimes it actually amazes me that people believe in the kind of things they believe in.

I must consider myself lucky that my long-term gene-propagating partner is quite okay with my lack of religiosity (huge sigh of relief considering that on our first date she had demanded to examine my sacred thread), though occasionally she suddenly declares that we must resurrect our lives and we should “start praying”. Nothing concrete usually comes out of this.

Oh, and this evening my uncle castigated me for serving food while wearing jeans (as the wife remarked later, it was a good thing I was wearing jeans. Wearing a dhoti would have exposed the risk of my dhoti falling into people’s leaf plates).

And I’m still amazed that despite the advent of writing and recordings, people still choose to expend their valuable mental bandwidth in rote learning the Vedas, rather than trying to understand the philosophy behind them.

PS: Here is a post on why I don’t do my parents’ death ceremonies any more

Arbit Raj

“Email alarm made government close arbitrage window“, screams the headline in this morning’s Business Standard. Upon reading further, you will find that the said “arbitrage” opportunity in question consists of remitting rupees abroad now and then bringing it back as remittances once the rupee has depreciated further. There are so many things wrong with this approach that I can hardly get started.

1. Technically speaking, arbitrage refers to a situation where through a set of trades one can make riskless profit. The riskless point is important here. If I were to convert my rupees to dollars today and then convert the dollars back to rupees later, it would be arbitrage if and only if the price at which I would sell the dollars is guaranteed (as of today) to be higher than the price at which I buy dollars. If I buy dollars today in the hope that the rupee will depreciate, it is NOT arbitrage.

2. By calling this process “arbitrage” the government is admitting that the rupee is expected to drop further, and significantly in the coming months (the extent of capital controls being imposed now suggests this). This is bad signaling

3. Regulating arbitrageurs is futile, and can be counterproductive. Arbitrageurs are quick to spot any price inconsistencies in the market and ruthlessly exploit them by means of their trades. Thus, if it is expected that (say) the USDINR will trade at 65 tomorrow, it is arbitrageurs who make sure that this expectation is reflected in today’s price (through a set of spot-future currency trades). By trying to curtail the operations of arbitrageurs, the government is missing out on valuable price signals. In other words, they are beheading the messenger (a la the Khwarizmian Shah, and everyone knows what happened to his empire once he did that).

The measures the government has been taking in recent times to help prevent further depreciation of the rupee are so ad hoc and badly thought out that it would make eminent sense to call the current dispensation an “arbit raj”.