The Economics of Arbitrage

The Economics of Arbitrage

By Gaurav Sadarangani

A middle aged economist and a young Wall Street banker were walking down a street and stumbled across a $100 bill. They both noticed it at the same time. The economist looked up to the sky while the Wall Street broker immediately pounced to grab the bill. A hot dog vendor noticed this and asked the economist why he didn’t pounce at the opportunity to make an easy $100. The economist replied “Well, its simple. Markets are efficient and hence if there was $100 on the street, someone would have already picked it up and it wouldn’t be there.” The Wall Street broker on the other hand argued, “$100 on the street represented money to be made with minimal work and risk and hence I pounced at the opportunity.” This is a classic example of arbitrage or a transaction involving little effort with a definite resulting profit by capitalising on inefficiencies in markets.

In India, the exploitation of arbitrage is evident everywhere. If a street has no policemen and an abundance of people, hawkers set up shop on the footpaths in the hope that a market for their products definitely exists. The risk of getting fined is low and so is the fine itself so in order to make a quick profit; most hawkers are willing to take the risk to exploit this economic arbitrage. In Australia, a higher Australian dollar results in a sharp increase in imports from overseas due to pricing and foreign exchange arbitrage.

Several forms of arbitrage are visible in everyday life. My housemate is perhaps the most networked person in several circles across Melbourne. He excels in linking up people from various disciplines. For example, at a bar, he carefully listens to people on the lookout for a job and then links them up with others that he’s had a conversation with in another bar that could benefit from their expertise. It could be argued that this is a form of skills arbitrage. If he were to link up a single mate he knows with a single woman also looking to meet that someone special, that’s relationship arbitrage. Of course, some may argue that this isn’t arbitrage since it disputes the theory of maximising profit. However, he would reason that he does profit in the form of goodwill from a relationship that may blossom into a marriage and he scores an invite, which in turn is a form of profit, albeit non-monetary.

Australia and India are deeply involved in arbitrage exploitation on either side of the Indian Ocean. Australia, a highly efficient and developed economy provides India with the ability to setup world-class efficient businesses. Take Woolworths for instance that recently entered into a joint venture with the Tata Group to establish a chain of stores called ‘Croma’ along the lines of its Dick Smith’s distribution and storefront format.
Earlier this year, I walked into a Croma store in India and noticed the intricate similarities in the front end leading to a very similar shopping experience as in Australia with no haggling over price or returns. This is a classic example of knowledge and experience arbitrage in that an Australian company is able to fill knowledge and experience gaps in another country with minimal risk and make super normal returns relative to the work involved. This form of arbitrage exists in several markets and there’s huge money to be made by simply replicating your bread and butter business in one market and seem revolutionary in another under-developed market. Of course, some would argue that this isn’t rocket science and in the purest form of ethics, making money from nothing in developing countries is unethical, especially since there are millions of people starving in India. Economists, on the other hand are able to sleep soundly at night by rationalising that such transactions are simply a form of arbitrage exploitation. Woolworths have provided India with something revolutionary at a much lower price than what it would cost Tata to establish a similar model from scratch.

India, through its relatively cheap and educated labour force provides Australian companies with low-cost offshore services in the Information Technology, call centre and operations arenas. This is the most basic form of cost arbitrage that Australian and Indian companies capitalise on resulting in a win-win situation for both countries. However, invisible to the naked eye lies the exploitation of cultural arbitrage by Indian businesses in Australia. Cultural arbitrage is visible when one culture lacks something that another culture is able to enrich. Australian culture has predominantly been based on Christian values with a strong emphasis on the notion of ‘fair go’ and has until recently remained culturally isolated from Asia.
The surge in international students from India into Australia was primarily due to institutional arbitrage in that Australian institutes offered a reasonably good quality of education that Indian institutes were unable to offer at the time. A majority of these international students and other migrants chose to make Australia their home due to the skills arbitrage that existed between Australia and other parts of the world. This surge in international migrants over time has resulted in a greater appreciation of other cultures and has resulted in a form of cultural arbitrage exploitation in that is now not uncommon to witness Indian businesses marketing Bollywood movies or dance lessons to native Australians.

While arbitrage exploitation is generally a positive experience for the global economy, there are some cases that are not so black and white. Exploiting Tax arbitrage, for example, involves recognising revenue or income in a low tax region while recognising expenses in a high tax region. This enables companies and individuals to minimise their tax bill. In India, the general public has been protesting against unaccounted money held by politicians and businessmen in Tax Havens such as Switzerland and Lichtenstein. Such a form of tax and legal arbitrage is deemed unethical and is now one of the top political issues being debated in the country’s parliament. Many Indian’s argue that such corrupt practices do not occur in developed countries. I beg to differ. The recent sale of Myer by the private equity firm, Texas Pacific Group (TPG) resulting in a profit of $1.58 billion is a classic example of legal and tax arbitrage that most Australians argue is highly unethical and most legal practitioner’s argue is 100% legal. The case revolves around a complex network of companies setup by TPG in various tax havens such as the Caribbean islands and the Grand Duchy of Luxembourg with a goal to avoid paying any capital gains tax on the profits from the sale.

It could be argued that Australian tax law up until recently has been a direct reflection of the culture of its people that revolves around mateship. Mateship in turn is reflected by the notions of caring for friends and family, sheer fun and good humour, easy-going lifestyle and can be summarised by words such as larrikin, fair-go, egalitarian and pluralist. The thought of a multi-national private equity firm entering the country, buying out a household name, laying off people, making a profit and then having the audacity to not pay any tax on the gains is simply incomprehensible to most Australians because a good Aussie bloke just wouldn’t do that. We are after all, generally an honest bunch. Since such a complex transaction involving cross border arbitrage exploitation hasn’t been attempted at such a scale in Australia, a legal precedence hasn’t been established for such an activity, leading to an untested legal system for such transactions or as the Private Equity firms envision; tremendous scope for tax, legal, social, cultural, knowledge and ethics arbitrage.

Love them or loathe them, arbitrage exploiters are here to exploit intricate dissimilarities in every market until the world becomes a single homogenous market with harmonized cultures, laws and social patterns. Until then, cherish all that you consider sacred, for sooner or later, it will be exploited in the name of profit. That’s ‘arbitrage’ folks!

The author holds no interests in any of the companies mentioned. Any opinions expressed in this paper are those of the author and are not based on any legal or regulatory frameworks.