Economic Modernization and Finance

1. Economic Modernization and Finance Panelist Hrishikesh D. Vinod vinod@fordham.edu

2. Open Economy & Financial Burden of Corruption Hrishikesh D. Vinod Professor of Economics, Fordham University, Director: Institute of Ethics and Economic Policy E-Mail: Vinod@fordham.edu Web page: http://www.fordham.edu/economics/vinod

3. Joke • How many Chicago economists does it take to change a light bulb? • None • If the bulb needed changing, market would have already done it. • As long as the Govt. leaves the light bulb alone, it would screw itself in the socket. But democracy and free markets don’t always help reduce corruption

4. Open Economy Corrup Burden • (i) Economic Modernization, Financing Infra structure (energy, Enron in India) • (ii) International Financial Flows and Economic Volatility. Comments on downside risk of international investment. • (iii) a study of new tools including “value at risk” and how they might adversely affect foreign direct investment (FDI) in India.

5. Infrastr: Water, Energy, Comm, Ins. Modernization of India needs capital. Tapping domestic savings for K and FDI Sunshine is the best disinfectant, India has plenty of it, yet corruption no trust in K markets, hurts K-formation for infrastr. Use e-government, all Gov. trans on Internet. Enron in India used corruption and wrong techn. (LiqNGas) cancel energy projects

6. Modernization by Improved Infra • Telecommunications is very important for IT sector exports, but the telecom sector is in trouble in US due to governance issues including fraud and corruption by CEOs • Internet can be used to fight corruption. Despite digital divide, it can reach millions as other media report on it (Tehelka). Vinod (1999) J Asian Ec micro econ paper

7. Corruption hurts infrastr • 1) direct destruction. 1993 Stock Exch. Attack possible due to RDX brought in India using corrupt customs officers • 2) Goodwill is hurt (e.g. Bank of NY, Russian mob connection or Jack Welch GE perks.) • 3) hurts ordinary investors. Rs 680 crore ONGC corporate funds were credited in Harshad Mehta's account (no 1028 with the UCO Bank, Hanuman Street, Mumbai) by a corrupt official

8. Two Cows joke update for Enron • Under feudalism, you have two cows. Your lord takes some of the milk. Under fascism, you have two cows. The government seizes both, hires you to take care of them and sells you the milk. Under communism, you have two cows. You must take care of them, but the government owns all the milk. Under capitalism, you have two cows. You sell one and buy a bull. Your herd multiples; you sell out, invest the money and retire on the income.

9. 2 Cows joke update for Enron2 • You borrow 80% of the forward value of the two cows from your bank, then buy another cow with 5% down and the rest financed by the seller on a note, bearing interest at twice the prime, callable if the market cap of your publicly listed company, whose stock you've put up as collateral, goes below $20 billion. You sell the three cows to your publicly listed company, using letters of credit opened by your brother-in-law at a second bank, then execute a debt/equity swap with an associated unit, so that you get four cows back, plus a tax exemption for five cows.

10. 2 Cows joke update for Enron3 • Transfer milk rights of six cows (via intermediary) to a Cayman Islands (secretly owned by the majority shareholder) who sells the rights to seven cows back to you. Annual report trumpets: company owns eight cows, with an option on one more. All transactions cheerfully blessed by your independent auditors, who, of course, served as consultants.

11. Sad end & how to de Enronize • Big Press Release and conference call with analysts: Enron will begin trading cows over the Web. Analysts proclaim Enron the prototypical New Economy Company, shares ↑ enabling insiders to sell and got out before bankruptcy. • A company can de-Enronize itself by better disclosure (Sarbanes-Oxley Act)

12. Banking distress, collapse of the Thai Baht in 1997LossesRebalancing portfolios Rapid worldwide transmission stock /currency markets. This is facilitated by corruption, fraud, money laundering havens, crony capitalism & enronitis. Modern tools of managing risk unavailable in India. (interest swaps) International financial distress and volatility is increased by corruption

13. Financial Flows & Econ Volatility 2 • Undeveloped ‘derivative securities’ markets make the risk from stress-induced volatility difficult to manage for Indian firms • Asymmetry of ‘home bias’ (Americans fail to diversify abroad, but Indians do invest abroad if allowed) and the effect of corruption on the value at risk (VaR) (Worst case scenario 1 percentile becomes worse with corruption)

14. Home Bias • E (excess return) = • [JWWW/JW ]E2 + [JWF/JW ]E(covar’ce), where [JWWW/JW ] measures risk using constant relative risk aversion CRRA. The covariance term hedge component. India corruption is so high that home bias does not work. There is foreigner bias.

15. Joke • What do you get when you cross a Godfather with an economist? An offer you cannot understand My full paper is accepted for publication by J of Asian Ec. Contact vinod@fordham.edu. Here I give nontechnical highlights

16. Incomplete Insurance Available • (i) Credit risk refers to the ability of the borrower to generate revenue to pay back the debt. (ii) Default risk is with reference to collecting when default occurs. (iii) Transaction risk (currency devaluation), (iv) corruption risk • Very limited insurance available to Indian entrepreneurs to manage these risks.

17. S&P, Moody’s grade India Low A positive contribution of private rating agencies and hot money transfers is that they create a countervailing power to government propaganda. But daily $1Trill transfers cause volatility, hard to manage. Ordinary investors need to be convinced that investment in India will yield profits. Socialism and mistrust of profits hurts. VaR tools make corruption seem worse.

18. Our theory predicts: Corrupt countries with low CPI (corrup. perception purity index) by Transparency International have • (i) extra capital flight controls, (IMF data) • (ii) low foreign direct investment (FDI). • (iii) high cost of capital (Price-Waterhosue Data) All are supported by Asian data, forthcoming paper in J of Asian Econ. E.g.,Corr(CPI, FDI/GDP) =0.6, FDI goes to purer (less corrupt) countries.

19. Correlation Results: New Measures • Correlation between CPI and (Trade/GDP ratio) is even higher at 0.7341 • Corr(CPI,“capital flow control index”) 0.7522,(New data from IMF reports) • Corr(CPI,“cost of capital % penalty”) 0.827. New ‘cost of capital’ measure from Price-Waterhouse-Coopers’ data.

20. Indian Rupee was largely immune to the volatility induced by the contagion due to India’s capital controls (cause corruption). Mexico controls < Indian. K-flight to US problem, Peso fluctuates more than Indian Rupee, but FDI is much more in Mexico than in India. Cost of K is high for India. China gets many times more FDI Isolation of India w.r.t. FDI

21. Conclusion • India needs infrastructure (+insurance) but Corruption hurts India’s microeconomy • Open Economy Burden of Corruption is also High (VaR worsens it) High cost of K hurts. • Corruption can be reduced if everyone understands the burden and tries to reduce it. China has death penalty. • Hopeful signs: CVC, Internet, IT sector • Discouraging signs: ban criminal MPs, supreme court decision overturned by all parties