Economic Modernization and Finance

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Economic Modernization and Finance

• Panelist
• Hrishikesh D. Vinod
• vinod_at_fordham.edu

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Open Economy Financial Burden of Corruption
Hrishikesh D. Vinod Professor of Economics,
Fordham University, Director Institute of
Ethics and Economic Policy E-Mail
Vinod_at_fordham.edu Web page http//www.fordham.ed
u/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 dont always help
  reduce corruption

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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.

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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

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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

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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

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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.

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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.

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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.

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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)

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International financial distress and volatility
is increased by corruption

• 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)

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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)

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Home Bias

• E (excess return)
• ?JWWW/JW E?2 ?JWF/JW E(covarce),
• 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.

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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_at_fordham.edu. Here I give
  nontechnical highlights

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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.

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SP, Moodys 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.

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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.

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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.

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Isolation of India w.r.t. FDI

• Indian Rupee was largely immune to the volatility
  induced by the contagion due to Indias capital
  controls (cause corruption). Mexico controls lt
  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

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Conclusion

• India needs infrastructure (insurance) but
  Corruption hurts Indias 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