Nation building and economic development

One of the most intriguing areas of social science research is that looking into the determinants of nation states, economic growth, and liberal democracy. Specifically, the examination of the paths of development. 

Francis Fukuyama's Political Order and Political Decay explores these themes (see review here by David Runciman). He explains development in terms of a framework which involves the interaction between ideas/legitimacy, social mobilisation, rule of law, state capacity, democracy, and economic growth. In this framework, in no particular order, national identities are forged, rule of law gets established and state building happens. A combination of these feeds into and also feeds from both democracy and economic growth.

Not only is the sequence of emergence of each of these attributes important, but also the time taken for their emergence. The latter is important given the time required for their strengthening and maturity. 

His comparative assessment of Europe, E Asia, Latin America, and Sub-Saharan Africa is illuminating. I made the table below to capture the sequence of development trajectories of some selected regions (1 indicating the first to emerge and 5 the last to emerge).

It is to be noted that state nor economic development has fully emerged in S Asia nor SS Africa, though the sequence of efforts in that direction is indicated.

This about geography and climate is important,

Certain topographies were better suited to the raising and deployment of large armies. In Eurasia (China and Russia primarily), relatively open land encouraged consolidation of large centralized states, while in sub-Saharan Africa, the difficulties of projecting power across vast deserts and tropical forests inhibited state formation. Europe was somewhere in between: its geography encouraged the formation of medium-sized political units, but it prevented any one of them from growing to a size that allowed conquest of the entire region... Latin America’s geography put it closer to sub-Saharan Africa than to Europe.

Europe experienced a long period of bitter and painful wars, which led to the strengthening of national identities and emergence of strong states. In the eighteenth and nineteenth centuries Europe underwent violent upheavals,

One of the principal reasons for this was the extraordinarily high level of violence experienced by Europe during this period, beginning with the French Revolution and Napoleonic Wars, continuing through the wars of Italian and German unification, and ending with the cataclysms of the two world wars. High levels of military competition led to the formation and consolidation of strong, modern states, as in the Stein-Hardenberg reforms in Prussia. At the same time, rapid industrialization was drawing millions of peasants off the countryside and into dense, diverse cities. This shift created the conditions for the emergence of modern ethnolinguistic concepts of national identity, which in turn provoked further military competition. Nationalism helped to facilitate the consolidation of modern states... And both internal revolution and external war succeeded in wiping out entire social classes, like France’s venal officeholders and the Junker class in Germany, which had been pillars of the old oligarchic order... By 1945, Europe’s exhausted elites were ready to concede both liberal democracy and redistributive welfare states to ensure social peace.

In Europe generally state formation has been more recent, happening after national identities were forged and rule of law was established. In contrast, in East Asia, thanks to relative ethnic homogeneity, national identity formation did not require violent upheavals. Further, state formation too had much earlier roots. In fact, state with its modern trappings (centralised, bureaucratic, and impersonal) can be traced back to the Qin dynasty in the 2nd century BC in China. 

China and surrounding countries like Japan, Korea, and Vietnam developed governments based on the strong-state model and succeeded in reaching levels of political organization substantially higher than any of the indigenous societies of Latin America and sub-Saharan Africa. These state-building efforts were enhanced by great ethnic homogeneity, the result of many centuries of conquest and assimilation. These societies had a strong sense of shared culture based on a common written language and widespread elite literacy... China, Japan, Vietnam, and Korea could seek to modernize their economies while taking for granted the existence of a strong and coherent state as well as a well-established national identity.

On the contrast between Europe and E Asia,

The strong states of East Asia developed bureaucratic institutions before they had a rule of law, while in Europe the sequence was reversed. The precociously strong East Asian state was for centuries able to head off the emergence of independent social actors that could challenge its power. While European liberal democracy grew out of a rough balance of power between state and society, the state-society balance in East Asia favored the state. This meant that, in contrast to most of the rest of the developing world where state weakness was the central issue, what is lacking in East Asia is the limitation of state power through law or political accountability.

Latin America started out with a very unequal order where white settlers controlled the economic and political system over the indigenous labour and mestizos, and it did not experience anything like the violent wars and revolutions to unseat that oligarchy. It remains to this day. Further, ethnic diversity and slow or absence industrialisation meant that national identities were weak. 

Sub Saharan Africa was characterised by numerous small ethnic groups. Neither did it experience the violent wars and revolutions nor did it enjoy the economic growth necessary to create a large enough prosperous economic group (grounded either on aristocracy or trade or industry) who could be the elite class with the interest in building national identity or promoting rule of law and building states. Further, the European colonialism too reached Africa late in the nineteenth century, by when it was on its last legs. The colonists too therefore pursued a cheap "indirect rule" of relying on local African agents to extract taxes and slave labour for the American colonies. 

This is important 

The newly independent countries in sub-Saharan Africa, by contrast, could not, and they needed to do everything at once—build modern states, establish national identities, create rule-of-law institutions, stage democratic elections, and promote economic development at the same time. While Europe and East Asia sequenced institutional development differently from one another, they had the luxury of doing this sequencing over long periods of time.

Further, by delaying the adoption of democracy till later into industrialisation and development of strong states, the North East Asian countries were able to avoid the problems of clientelism that affected countries like the United States, India, Latin America, and elsewhere. More on this in another post.

Fukuyama's theory finds resonance in the argument of the likes of Devesh Kapur about precocious democracy in  the context of India. 

Rethinking interest treatment and limited liability

My joint column with Ananthanageswaran in Mint on rethinking some of the important rules of the game, on the treatment of interest expenses and the limited liability structure, in the context of the rising global corporate debt burdens.

Constraints to scale manufacturing in India - lack of a cluster approach?

As India looks at the rare opportunity to attract global value chains (GVCs) in manufacturing, it faces formidable challenges. While the constraints like labour issues, cost of capital, difficulty of doing business, and infrastructure bottle-necks are well know, there are a few other equally important factors. I blogged earlier about the entrepreneurship deficit.

This post will cover the deficiency of a distinguishing feature of large scale manufacturing - the need for an eco-system to support such manufacturing facilities. This demands a cluster-focused approach in certain sectors. 

A feature of modern manufacturing is the disaggregation of production stages into a multiplicity of activities and tasks and their outsourcing. This puts the large factory which churns out the finished product at the apex of a massive chain of suppliers, some of which cluster around the factory and others are dispersed globally. For example, Volkswagen has around 5,000 first-tier suppliers, each with an average of 250 second-tier suppliers, so it could end up with as many as 1.25 million suppliers. 

In other words, an essential requirement for scale manufacturing is the presence of a large component manufacturing industry. Take the example of footwear industry. Unfortunately, like with other sectors, components are imported from China. This is not just the case with soles and uppers. Even islets, insoles, and laces are imported from China. It is stunning that even buckles in belts are largely imported from China. 

I blogged here about the strength of China. Over the years, the country has built up an unmatched manufacturing eco-system. Sample this,

Its industrial base has unparalleled depth and has only grown more competitive. In 2005, 26% of the value of China’s exports was added abroad; by 2016 that was down to 17%, according to the OECD. In other words, more of the bits and bobs that end up in Chinese gadgets are themselves made in China.

In contrast, India's manufacturing ecosystem in any product line is limited. Even the large non-leather contract manufacturers like Apache and Lotus import uppers and soles from China, Indonesia and Vietnam and only stitch them together in India. In the case of iPhone manufacturing in India, while  Wistron and Foxconn assemble phones using imported components, the local suppliers merely make packaging materials, chargers, and batteries. 

Large manufacturers are therefore unlikely to relocate to India without being able to replicate an eco-system of suppliers near their locations. This, in turn, calls for a cluster-based approach to manufacturing. It requires public policy to focus not just on the big manufacturing firm but also  to support the emergence of an eco-system of ancillaries and suppliers. Such suppliers may be co-located or located elsewhere in the country, in which case it is necessary to facilitate integration of the supply-chains by removing bottlenecks on inter-state logistics and taxation issues.

Catalysing and nurturing component manufacturing is not easy. They aggregate, grow and become more productive under the umbrella of the large manufacturers. This means that some of the larger branded manufacturers will have to be encouraged to take the lead in this regard. While they could provide the market assurance, the government may have to offer some fiscal incentives and/or interest subvention subsidy also for the suppliers. In simple terms, the government efforts have to go beyond the current policy of focusing only on courting the large manufacturers like Foxconn or Feng Tay or Pou Chen or Toray and ignoring their suppliers.

The fundamental point is that if India has to succeed in attracting GVCs, it has to adopt a policy that is centred on creating manufacturing eco-systems (or clusters) than just assembly-line factories. This demands primarily the government playing an important and very active co-ordination role. Large manufacturers will need the support of the government in co-ordinating both set-up and operations to attract suppliers and ancillaries.

Once the enabling policies and regulations are in place, this would involve actively supporting and facilitating both the big manufacturers and their suppliers with activities like acquiring land, different starting permissions and clearances, and hassle-free transactions with government during their operations. In short, it requires a different culture of operations, especially one which needs to pay as much attention to the eco-system of suppliers as much as the large companies themselves.

Apart from the ecosystem constraints, there are the limitations of the Indian market which prevents leveraging economies of scale. For example, in 2010, while Apple sold 30 million iPhones in China, its Indian market was just 2 million. Apple therefore pays 60% more per unit for Wistron to assemble iPhones in India. A takeaway is perhaps that instead of chasing big names like Apple, it may be prudent to court the likes of Oppo and Xiaomi, who are more likely to find a large enough local demand and also therefore have the incentives to invest in volumes and create eco-systems. They are also likely to support their smaller component manufacturers compared to the likes of Foxconn.

Weekend reading links

1. Reeling from the impact of the pandemic, Airlines in the US are finding out ingenious ways to raise money. A friend sent this report about airlines mortgaging frequent flier miles.

United Airlines Holdings Inc. will mortgage its frequent-flier program to secure a $5 billion loan from three banks as it seeks to build a cash cushion to see it through the coronavirus pandemic. The scramble for cash has been one of the biggest challenges for airlines in recent months, as the pandemic and the travel restrictions put in place in response caused travel demand to dry up. On Friday, American Airlines Group Inc. made a similar move to United’s, saying it intends to offer its frequent flier program as collateral for a $5.8 billion government loan...

Loyalty programs are a rich vein for airlines to secure cash. Co-branded credit cards associated with the programs essentially allow carriers to book revenue from a slice of all customers’ spending. That comes in handy at times like this, when bookings have nearly dried up, but customers continue to use airline-branded cards for other purchases. United said its MileagePlus program generates over $5 billion in cash a year and is worth over $20 billion. The program earns most of its revenue selling miles to third parties such as JPMorgan Chase, its credit-card provider, which then awards them to customers for making purchases... Airline loyalty programs can be alluring to banks because of their typically high-value membership: United says it has more than 100 million members in MileagePlus program, many of whom earn above-average incomes and spend more than typical customers. United said it expects fewer people to redeem their miles for travel due to the pandemic, which means more money stays within the loyalty program... In past crises, airlines have pulled cash from frequent flier programs by selling big chunks of miles to their bank partners.

Another example of financialisation.

2. A proposal for installing smart meters in discoms by supporting the emergence of meter asset providers.

3. As foreign policy gets politicised and hindsight analysis and blaming takes over, is there a risk of the foreign policy establishment and IFS officers becoming the latest victims of decision paralysis? Read Shyam Saran here.

Phunchok Stobdan has a good article pointing to a pattern in China's border disputes management with other countries. Hitherto, the border disputes on the eastern (Arunachal) and western (Aksai Chin) presented different priorities, with concessions on the former being difficult for India and perhaps the latter for China (given Tibet). Now, with its latest incursion, the Chinese are perhaps seeking to de-link the two parts and then leave it with the opportunity latter to focus exclusively on the eastern front.

China seems to be pushing for a formal settlement along the LAC in Ladakh, where they have nothing to lose. Probably, they also assume that India has accepted fait accompli. And, to our disappointment, it may not involve swapping India’s claims over Aksai Chin for China’s claims over Arunachal Pradesh, which many in India thought to be a pragmatic thing to accept. This time, Chinese may be making a tricky move to let India, in the first step, forego its claim over 38,000 sq km (Aksai Chin), thereby de-link Ladakh from the overall boundary dispute. But, should that happen, India, by implication, will have to give up not only Aksai Chin, but also cede its notional claim over the 5,047 sq km (Skyasgam valley) and the Menser Enclave (five villages) near the Mansarovar Lake. China’s “minimal demand” that Tawang is non-negotiable had been aired through Chinese academics. This tactic was also applied with Central Asian states. If India falls for some kind of Chinese position over Aksai Chin, Beijing will then shift the focus to Arunachal to emphatically claim 90,000 sq km from India. Ceding Aksai Chin would fundamentally alter the status of J&K and Ladakh. By implication, India would have to forget about PoK and Gilgit-Baltistan as well. India should tread carefully unless both sides are willing to make a move for grand bargaining.

As India evaluates its options, Tibet and Taiwan should be on the table. Taiwan's success in dealing  with Covid 19 can be an opportunity to engage with them in a reasonably high enough manner.

4. Vivek Agarwal points to the problems with the emerging partnerships in India's telecoms market between telecom providers and tech companies. The article also highlights its similarity with the trajectory of growth of railroads in the US in the 19th and 20th centuries.

The internet, given its increasingly essential role in trade and commerce, may be referred to as the "railroad" of our times. State authorities must learn to break the vicious cycle of allowing the creation of monopolies only to break them to reinstate competition, as was the case with the "railroads" in the 19th century. As a closing remark, I am reminded of what Charles Francis Adams had said about the railroad problem in 1878. He said that the time was nigh “when the railroads would manage the state, if the state did not manage the railroads”. Nothing much seems to have changed since, except that the new railroad of the 21st century is big data which may get concentrated in tech magnates in the absence of apposite regulation of these big tech-telco combinations.

5. As Q4 results indicate, the Indian economy was already slowing when Covid 19 hit. Business Standard reports that the 1002 listed companies - excluding banks, non-bank lenders, insurers, brokerages, and IT companies - reported combined pre-tax loss of around Rs 2700 Cr in Q4 2019-20. It was the first loss in 24 quarters and fell from Rs 1.05 trillion profit before tax in Q3.

6. A feature on cloud kitchens business in India.

Cloud kitchens, also known as dark or ghost kitchens, have been around for a while but have flown under the radar. These are essentially low-cost models where kitchens in places with cheap real estate are rented out, and from which deliveries are fulfilled mostly through an aggregator. Since they’re not attached to a proper restaurant, there are no overheads like lighting, décor, front-of-the-house salaries, and so on. Low capital cost is why cloud kitchens with curious names (Bhookemon, for one) are quickly scaling up to deliver the same menu at different pin codes with consistency. Apart from low rentals, the sourcing of ingredients is centralised, the R&D happens at a base kitchen and once a recipe is finalised, it can be easily replicated at different locations.

7. Neelkanth Mishra writes about a secular decline in food prices due to changing food habits, efficiency improvements and associated lower unit production costs.

8. A new low in solar power rates. The latest tender for 2000 MW by Solar Energy Corporation of India (SECI), which allows the developer to set up the project anywhere, Spain's Solarpack Corporation bid Rs 2.36 per unit for 300 MW. Now the challenge is to get Solarpack to go ahead with fulfilling its bid commitment.

This is important because this is what happened to the previous record low,

The previous lowest bid was Rs 2.44/unit by ACME Solar in 2018 for a 600 mw project to be set in Rajasthan. The project is currently under litigation as ACME wants to withdraw from the same.

It is hoped that SECI has learned from that experience. It ought to have greater bid information clarity to be comfortable that the bids are based on strong economic logic, and stronger contractual terms to ensure that that bidders are likely to fulfil their commitments. It is necessary for bid managers now to go beyond the market knows best approach and also start scrutinising the bid assumptions and satisfy themselves that the bid can be met.

Another interesting this is the composition of bidders. It is reported that SECI received bids for 5280 MW, against the requested 2000 MW, with major global developers too. Amidst them is Ayana Renewable Power, backed by Britain's international DFI, CDC. Wonder what's CDC's capital doing here, competing with market finance, as against its mandate of crowding in market finance. Unless, of course, one argues that competition is also crowding in!

9. An interesting point made by Vivan Sharan in the context of the Indian government's bans on Chinese apps.

According to Ericsson, global mobile data traffic was around 456 exabytes in 2019, of which India accounted for approximately 75 exabytes, or 16%. Around 14% of the global population resides in India, and therefore, it punches slightly above its weight in terms of mobile data consumption. However, India has not begun to generate commensurate economic value from this outsized data consumption yet. In fact, the global digital economy seems to mimic its physical counterpart, with the US and China making up the lion’s share.

According to the United Nations, the US and China account for 90% of the market capitalisation of the 70 largest digital platforms in the world. They also account for 75% of all patents related to blockchain technologies, 50% of global spending on the Internet of Things, and more than 75% of the global market for public cloud computing. It’s clear that the two countries will remain at the forefront of global technological developments, which will feed their dominance in the digital economy. The emergence of this bipolar digital landscape narrows India’s strategic choices. The world’s largest digital democracy must foster innovation, competition and scale in the private sector, as well as increase State capacity to govern new markets in parallel.

In simple terms, India is contributing an outsized share to the absolute usage numbers (albeit not value added usage), whereas its share of the commercial value captured from the digital economy is disproportionately small.

For a country which had all the advantages at the dawn of the digital age, with several leading software companies and the government not being a stumbling block, what has happened? Where did digital entrepreneurship in India go wrong? Where are the Indian TikToks or WeChats?

10. The beneficiaries of Fed's corporate bond buying program includes some of the largest US corporates.

Apple, Verizon and the U.S. divisions of several foreign auto makers are among the largest direct beneficiaries of Federal Reserve efforts to support the corporate-debt market, according to disclosures Sunday. In all, the Fed on Sunday identified 794 companies whose bonds it will be buying directly to support the market for investment-grade corporate debt. In addition to Apple and Verizon, the recipients include AT&T. and the U.S. units of Toyota Motor, Volkswagen  and Daimler. Together those six companies accounted for 10% of debt purchased from a broad list of borrowers the Fed is supporting.

11. Staying with Fed, James Grant laments the overprescription of the monetary medicine by the US  Fed as addicting the US economy. He writes that Jerome Powell has become Dr Feelgood.

Ultralow interest rates are a financial psychotropic. They induce feelings of neediness (on the parts of savers to reach for yield), grandiosity (by corporate deal-doers to reach for the moon) or fantasy (for any who would try to rationalize otherwise insupportably high stock prices with reference to the tiny cost of a loan). Ground-scraping interest rates turn savers into speculators and quarantined millennials into day traders. They facilitate overborrowing, suppress market signals, misdirect investment dollars, and promote the dubious business of turning well-financed public companies into heavily indebted private ones... With opioids, the habituated patient needs ever higher doses to achieve a constant effect, and so it is with dollars. Massive credit creation (which the Fed achieves by buying bonds and mortgages with money it materializes with a tap on a computer keypad) is a kind of financial painkiller. The record of the crises of the past 20 years, beginning with the post-millennium dot-com crash, is one of lower and lower interest rates, and of greater and more aggressive bond-buying.

12, A damaging practice in the power sector in India has been the trend of discoms reneging on power purchase agreements (PPAs) on the face of low spot prices of exchange traded power.

13. A sobering balance sheet of India's public sector units

According to a 2019 report of the Comptroller and Auditor General of India, in 2017-18, there were 184 public sector companies with accumulated losses worth over Rs 1.4 trillion. The net worth of over 70 companies had been completely eroded. Business Standard Research Bureau numbers show PSEs have seen a sharp drop in their market capitalisation, and continue to underperform the broader market. In the last 10 years, the combined market-cap of the top 17 PSEs that were part of the BSE 200 index (excluding banks and financials) has declined over 40 per cent, against a 91 per cent rise in the Sensex. It is also worth noting that over 70 per cent of the PSE profits in 2017-18 came from sectors such as petroleum and coal, where the presence of the private sector is limited.

14. Rathin Roy argues that reduction of imports from China will not hurt India and makes the case for focusing on improving domestic productivity. 

Meanwhile data from Credit Suisse tells that India's import share from Chin has been declining. 

Of the wide range of policy options available (from non-tariff measures to production-linked incentives (PLI), to import duties), different sectors could see differing tactics. Where India seeks to develop exports (e.g. handsets) or increase share of domestic value-add (e.g. drugs), PLI schemes are likely, and are already in place for handsets (link), and organic chemicals (link). Where import substitution is the objective and India is a large share of global demand, like in appliances or solar panels, import duties are used. These have worked in ACs and handsets, but not in solar panels. Imports of capital goods have fallen only due to a weak local investment cycle.

15. An FT article looks at the big crisis facing pension funds globally. It points to a WEF assessment that the retirement savings gap (the shortfall between what people currently save and what they need for an adequate standard of living when they retire) would rise from $70 tn to $400 tn in 2050 in just 8 countries.

Observations on the fintech world

I have always found the idea of fintech beyond payments/transfers perplexing. I have blogged here, here, here, and here about fintech, micro-pensions, and financial engineering in general.

In the backdrop of Wirecard, Tamal Bandopadhyay has a very good article putting fintech in perspective. He writes about the importance of regulation of fintech providers,

Roughly, the fintechs here can be classified into three categories. The first set operates in the financial market as intermediaries between the customers on the one hand and the banks and NBFCs on the other, offering services ranging from customer acquisition to disbursing loans and collecting repayments; the second set operates in the insurance space; and the third set works for stock and commodity exchanges, broking firms, mutual funds, clearing houses, depository participants and even corporate houses (could be for systems application and data processing). The RBI, the Insurance Regulatory and Development Authority of India and the Securities and Exchange Board of India regulate, the entities that engage the fintech companies but the fintechs themselves are not regulated. That’s the crux of the problem.

Some of them make the most of the regulatory arbitrage. For instance, an NBFC needs 15 per cent capital adequacy ratio to run its business — a capital of Rs 5 for every Rs 100 worth of loan, depending on its risk weightage. A fintech can source money from an NBFC at, say, 14 per cent, acquire customers on its platform, and lend to them at, say, 22 per cent, keeping a wide margin. Typically, it offers a 5 to 10 per cent first loan default guarantee (FLDG) to the NBFC. This means, if a loan goes bad, the fintech takes the responsibility of making good up to this limit. So, the fintech can leverage itself 20 times (5 per cent FLDG for Rs 100 loan), that too with someone else’s money, while the NBFC is leveraged around seven times (15 per cent capital for Rs 100 loan). This makes it imperative for the fintechs to behave with responsibility and transparency.

With Wirecard, the focus on fintech regulation globally will only increase and regulatory arbitrage has to come down. But as Tamal cautions, regulatory oversight should not end up killing the innovations in this space. 

There is another dimension to fintechs. In the impact investing world, it is the prevailing narrative that fintech providers are actually substitutes for banks and insurers. What is lacking is a realisation about what is the role that fintech providers can technically offer. This is a big problem,

The Reserve Bank of India (RBI) issued a release saying many fintech platforms “tend to portray themselves as lenders without disclosing the name of the bank and NBFC at the backend”... The RBI wants them to let the borrowers know which banks or NBFCs such platforms represent, sanction the loans on the letterhead of the banks and the NBFCs that are lending money and, finally, wants the lenders to take the responsibility to ensure that such platforms behave well. In other words, such platforms should function the same way the banking correspondents (BCs) do. The BCs are engaged by banks for loan disbursements and deposit collections.

I can understand fintechs in digital money transfers and payment services. That's their terrain. I can also understand them doing intermediation between banks/NBFCs and borrowers/depositors. But I cannot understand the idea of a full-service financial products (selling savings, loans, and insurance products) fintech. I struggle to understand how such a creature can exist at scale. 

It is therefore not surprising that there is not one fintech provider outside of China (where they have their unique reasons) that has scaled. Not one even in the US. There is a compelling argument that the techfin trend, where the likes of Google, Facebook, and Amazon get into digital finance, is emerging only because of their access to ultra-cheap capital from the extraordinary monetary accommodation. For sure, they are well placed to do payments/transfers, but beyond that it is difficult to imagine a sustainable business model without the Fed's misguided benevolence. 

The fundamental problem with fintechs is the viability of their business model. In the absence of a banking license, a fintech company does not have access to lower cost capital. If it tries to lend with higher cost capital, then it is surviving on a regulatory arbitrage which can be plugged anytime besides having to offer capital to retail customers at no better rates than that offered by the more benign money lenders. And you cannot have a business model intermediating higher cost long-term capital (raised from bonds etc) to essentially do short-term lending (which is what retail customers want from their banks). 

Then there is the issue of desirability. If we believe they have a role to play in supporting banks with financial intermediation (identifying and screening borrowers), then we run into the issue of banks ending up outsourcing credit origination. Do we want to encourage the practice of banks moving away from an incentive compatible relationship banking towards an outsourced credit origination model, and that too in weak regulatory environment contexts, and thereby set the stage for financial market problems and distortions? We all know the adverse consequences of perverse incentive problems from taking mortgage and credit card loans out of banking balance sheets through securitisation.

Even on the credit-worthiness assessments and big data/AI, there are now emerging limitations to the role of fintechs. See this and this. 

In summary fintech companies perhaps have two roles. One, as a digital payments/transfers provider. Two, as an efficiency enhancing force in banking and downstream financial intermediation. 

The 'over-rating problem' at the last tier of investment grade assets

That the ratings industry survived the global financial crisis intact, with the top three - Moody's, S&P and the smaller Fitch - having 95% of the market share, is a damning indictment of the financial market regulatory system. Worse still, since 2000, the top two firms stocks have vastly outperformed the S&P 500, with the growth being vertiginous since the GFC.

It is fair to argue that credit rating agencies have played a critical role in facilitating lax lending and the deluge of corporate bond issuances since the GFC, itself caused, among others, by their own indiscretions. With central banks now purchasing corporate bonds, their importance as credible gatekeepers has soared.

A recent article in The Economist draws attention to the re-emergence of ratings inflation, which was a major contributor to the GFC,

A report by the OECD in February found that agencies gave borrowers more leeway on leverage, relative to earnings, in 2017 than a decade earlier.

The article also highlights this out about ratings,

In a working paper, Edward Altman of New York University finds what he calls “an over-rating problem” just above junk. Based on analysis of a batch of metrics including leverage, liquidity and sales, he concludes that over one-third of corporate debt that was on the bottom investment-grade rung going into the pandemic should have been at least one grade lower. In other words, it was junk in all but name. This bears on the most pressing question facing rating agencies today: what to do about the more than $3trn of corporate debt rated triple-B, on the precipice above junk. In 2010, 45% of all investment-grade debt was in this bottom tier; now it is just shy of 60%.

An OECD study found that downgrades from triple-B to junk are rarer than those elsewhere on the ratings spectrum, suggesting that agencies may be reluctant to force borrowers across that Rubicon. An alternative explanation is that firms make particularly strenuous efforts to avoid such a demotion, to so-called “fallen angel” status, aware that it can mean a sudden spike in borrowing costs.

In other words, an important source of the incentive distortions associated with rating agencies may be in the lowest tier of investment grade rating, both in rating a security afresh and in its periodic assessments.

Needless to say, if a forensic analysis of the ratings in this tier is taken up, it could uncover countless cases of unscrupulous practices and outright fraud.

This calls for a particular focus on assets rated in this tier. Some of the well-known rating reform proposals could be prioritised for this tier.

1. Limit the possibilities for ratings shopping. Accordingly, instruments being issued by this tier could be mandated to be rated by multiple agencies. Or issuers could be mandated to have such issuances by a firm rated by a rotating pool of an expanded set of 7-8 rating agencies. Or they could be issued by a financial market body which collects fees from everyone and get the ratings done.

2. Ensure rigor in reassessments. The ratings in this tier should be subjected to a greater rigour in surveillance and re-assessments. How about mandating re-assessments by another rating agency?

The regulators too could keep track of the various market trends to identify ratings inflation. The trends in the break-up among the different ratings categories over a business cycle, both for the market (or market segment) as a whole and for individual rating agencies. Or particularly, the share of triple-B ratings in the ratings basket of an agency.

Infrastructure companies in India

Even as Reliance has been on a deleveraging drive, the Adani Group has been on a leveraging binge. Devangshu Dutta, in a rare example of excellent reporting on corporate India, raises red flags on Adani Group's debt fuelled growth. Sample the deceptive numbers about Adani Gas,

AGEL had consolidated 2019-20 income from operations of Rs 2,548 crore with profits before tax of Rs 74 crore and a net loss of Rs 61 crore, after finance costs of Rs 995 crore. Adjusting for exceptional items, depreciation and amortisation, finance costs, and others, the operating profits (Ebitda) would have been around Rs 1,580 crore for an impressive operating margin of 62 per cent. The problem is debt. AGEL has an equity base of Rs 2,356 crore. It has debt (current and long-term) of just over Rs 14,000 crore.

And this pattern of high debt-to-equity ratio is replicated in every listed group company. But it is the narrative about the company that rivets investors,

Professor Aswath Damodaran of Stern School of Business, New York University says that the valuation of investments are based on narrative or on numbers. The narrative about the Adani Group is compelling. It is a major infrastructure player, which has grown at great speed as it moved into sector after sector. It is India’s largest private port operator. It is a power producer and transmission player. It is a big player in city gas distribution. It has interests in coal. It has successfully bid for multiple airports and would be the biggest private airport operator, once the civil aviation sector gets going post-pandemic. It is a major renewables player. It has an agricultural joint venture. It’s looking at a huge data centre operation. It is looking at water management. The group has delivered roughly 20x growth in the past 15 years.

And this narrative has been underpinned by problematic corporate governance issues, 

The strategic “structure” is fascinating. There is an “incubator” in the holding company, Adani Enterprises. Once a business looks to have matured, it is spun off and listed. Managing the regulatory environment is crucial for infrastructure plays and the group’s closeness to the current government helps in this respect. Like most group that have grown quickly, this one has also made its share of bad bets. It ran into problems with Indonesian coal imports. The legal issues there are still live. It has faced environmental backlash while developing coal operations in Australia. Mundra Port has been accused of many environmental violations. Reports suggest serious investor resistance to the current attempts to delist Adani Power. The numbers indicate the group has massive debt distributed across the balance sheets of many sister-companies. How much debt there is, is hard to ascertain, given the many unlisted subsidiaries and SPVs (Special Purpose Vehicle) which take care of projects. Various group companies including listed and unlisted ones have borrowed from each other, and invested in each other, and also borrowed from banks, floated bonds, tapped overseas funding, pledged shares etc. It’s hard to get a complete picture. The complex chain of financial relationships implies a problem in one business could spiral to impact apparently unrelated businesses.

And the numbers raise more questions, 

The listed companies all have high debt:equity ratios. Other key ratios like interest cover and debt: Ebitda are also in what may be considered dangerous territory. Sovereign downgrades have meant downgrades of overseas borrowings, and a falling rupee represents another danger. Most Adani businesses like ports, gas, power, airports, are in regulated areas with set tariffs. These are difficult times. Port traffic is down; power demand is down; aviation traffic is down. Hence, top-line growth is hard to generate. But the group has not defaulted. It has met its debt commitments.

But this is the nub of the matter

But the group has not defaulted. It has met its debt commitments. Given easy money regimes from central banks, it may be possible for the group to lower the interest burden and extend debt-tenure. Marrying the narrative to the numbers, the group has to keep scaling up since that allows it to raise more money. Can debt be reduced to reasonable levels? The answer to that question is critical.

In many respects, it cannot be denied that it could be accused of being India's biggest infrastructure Ponzi. At the extensive margin, get into more sectors. At the intensive margin, deepen presence in each sector. And being a large infrastructure company helps on both margins with getting new projects. Further, at both margins, a new project adds to the assets side, thereby enabling the company to add more leverage and generate cash flow. 

The problems are two-fold. One, most of the group investments are in greenfield projects. This, in turn, means there will be problems of commissioning and cash flow generation by the projects in the future. There is the near certainty of cost over-runs and delays with all these projects. One can be certain that there were strategic misrepresentations in the financial closures of all these projects. But then, globally, optimistic project viability is critical to attracting investors into risky infrastructure sectors, especially greenfield ones. See this paper.

Two, related to the first point is the tenuous balance in cash-flow management. The low cost debt availability aside, there is the issue of managing the cash flows among these complex interlocking related parties. There are too many moving parts with uncertainties (not risks) at every node. We know what happened with one similar infrastructure group, and that too not too distant back. 

For banking and securities regulators looking at Adani Group and wanting to decipher the numbers from the narrative, Wirecard is only the latest example. This FT investigation of the Group should count as a rare example of investigative journalism in the financial markets.

But the issue also presents another perspective. The Adani Group has been instrumental in developing PPPs in ports, airports, and city gas projects. And that too investing mainly in the risky greenfield projects. It is perhaps the country's best bet in the emergence of a major player in solar panel manufacturing. In all these areas, even incumbents have displayed reluctance to assume risk, bid and invest in new projects.

It therefore begs the question whether for a country at India's stage of development, atleast in terms of risk appetite and ambition, isn't is desirable to have a handful of Adanis and Reliances? Also, isn't the history of private participation in infrastructure sector countries in their early development trajectories filled with stories of such risk appetite and corporate governance and financial sustainability concerns?

In any case, the scale of ambition and risk appetite is unmatched, even by global standards. And that is important in a country with chronic scale entrepreneurship deficit.

But this view has to be matched with the systemic risks and other concerns, which are significant.