Friday, November 30, 2007

Optimal strategy for goalkeepers-stay at center!

A couple of Israeli researchers have some evidence to suggest that goal keepers save more goals when they stay still, instead of jumping to the right or left. Their analysis of 286 penalty kicks taken in elite matches around the world showed that keepers saved 33.3 per cent of penalties when they stayed in the centre, compared with just 12.6 per cent of kicks when they jumped right and 14.2 per cent when they jumped left.

The researchers believe the anomaly may be a reversed manifestation of what is known in economic psychology as the inaction effect or the omission bias. That is, people tend to suffer more regret after a negative outcome follows something they've done, compared with something they haven't done. In the case of keepers, the researchers surmised, they feel greater regret at letting a goal in after standing still in the centre, compared with jumping. If the ball ends up in the back of the net after they've jumped, at least it will have felt as though they had made a decent attempt to save it.

There is an article on the same subject by Tim Harford, World Cup Game Theory, in which he argues that, "Game theory, applied to the problem of penalties, says that if the striker and the keeper are behaving optimally, neither will have a predictable strategy... Professionals such as the French superstar Zinédine Zidane and Italy's goalkeeper Gianluigi Buffon are apparently superb economists: Their strategies are absolutely unpredictable, and, as the theory demands, they are equally successful no matter what they do, indicating that they have found the perfect balance among the different options."

Mundra Port & SEZ IPO

The Initial Public Offering (IPO) of the Mundra Port & SEZ Ltd, promoted by the Adani family, was wildly oversubscribed at 115 times. The port itself is located about 70 km from Bhuj in Gujarat and will handle 30 mt of cargo this year, and the funds are being raised to help Mundra set up cargo and coal terminals, besides infrastructure for the SEZ. It is the first port and SEZ company to be listed. Mundra Port is primarily engaged in providing bulk cargo services, container cargo, crude oil cargo and value-added port services, including railway services between Mundra Port and Adipur.

The Red Herring Prospectus for the IPO describes it thus, "In accordance with Rule 19 (2) (b) of the Securities Contract (Regulation) Rules, 1957 (“SCRR”), this being an Issue for less than 25% of the post–Issue capital, the Issue is being made through the 100% Book Building Process wherein at least 60% of the Net Issue will be allocated on a proportionate basis to Qualified Institutional Buyers (“QIBs”), out of which 5% shall be available for allocation on a proportionate basis to Mutual Funds only. The remainder shall be available for allocation on a proportionate basis to all QIBs, including Mutual Funds, subject to valid bids being received from them at or above the Issue Price. If at least 60% of the Net Issue cannot be allocated to QIBs, then the entire application money will be refunded forthwith. Further, up to 10% of the Net Issue will be available for allocation on a proportionate basis to Non-Institutional Bidders and up to 30% of the Net Issue will be available for allocation on a proportionate basis to Retail Individual Bidders."

The IPO had sought to raise about Rs 1770 crore ($446 mn), by selling 40.3 million shares at Rs 400 to Rs 440 apiece. The massive oversubscription meant that the investors bid for 4.6 billion shares by depositing $51 billion. The Qualified Institutional Buyers’ (QIB) portion was subscribed nearly 160 times while the High Net Individuals (HNI) portion has been subscribed 156 times, while the non-institutional segment was subscribed by nearly 11 times.

When the shares got listed on 27.11.2007, the performance was even more spectacular. The shares, which were initially priced at Rs 440 ($11.06) got listed at Rs 770 ($19.35), and touched 161.4% to Rs 1150 ($28.90) on the Bombay Stock Exchange. It reached Rs 962.90($24.20), up 119% on the National Stock Exchange. This spectacular listing was despite the benchmark Sensitive index going down 0.6% at 19,127.73 during the day and a trend of overall weakness in the markets. More than 14.8 million shares got traded during the day.

DSP Merrill Lynch & Co, Enam Securities, JM Financial Consultants, SBI Capital Markets and SSKI Corporate Finance arranged this share sale through 100% book building route. DSP Merrill Lynch, JM Financial Consultants and SSKI Corporate Finance were also the global coordinators for the IPO. But despite the presence of all these big names, this IPO has failed to garner a good deal for the promoter. The underwriters clearly failed to gauge the market sentiment and underpriced the offering, thereby causing considerable loss to the promoters. The share closed at Rs 885.65 at BSE on 29.11.2007, or slightly more than double the issue price. At this price, the lead managers failed to mobilize atleast an additional Rs 1770 Cr, which was left on the table free! In other words, the transaction was not an economically efficient one and resulted in considerable deadweight loss.

In any IPO, the company going public would seek to get the highest offer price so as to maximize the amount raised. The underwriters, while also seeking to maximize the amounts raised, are concerned with ensuring that they do not price it so high that the IPO is undersubscribed. There is a price determination problem. This is compounded by an inherent moral hazard problem, as the underwriters have an interest in pricing the offer at a not so high price, so that their favored clients (mainly QIBs) are rewarded when the shares get listed. These clients in turn return the favor by giving the underwriters lucrative investment banking business. Everybody - underwriters, their clients, and investors - are happy, leaving only the promoter hard done!

In the traditional book-building route for an IPO, the lead underwriter sets an initial filing price, then takes provisional orders from institutional investors that it uses to gauge demand. The filing price can be adjusted upward if demand is strong enough, but in general the offering price for a company going public is considerably below the market-clearing price. As a result, investors who are able to get in on an IPO have a very good chance of reaping some easy gains, thereby opening up the possibility for considerable fraud. In fact, IPOs, especially of the more well run and fundamentally strong companies, are very attractive to investors, in particular the institutional ones, due to the potential "first day pop" of instant bonanaza, arising from a higher listing price than the offer price.

As compared to the underwriter determining the rate, a better option is the Dutch auction , which leaves the price discovery role to the market. In this method, the price is essentially determined by the investors, who submit the highest price they're willing to pay and the number of shares they want at that price. The people who bid the highest (and, if they bid the same price, the earliest) gets allotted the shares in the descending order of the bids till all the shares are allotted. However, no matter what you bid, the price you pay is the lowest price that any investor who got shares bid.

There are also other methods of issuing an IPO. The hgh profile and highly successful, Google IPO of 2004 is the most famous example. The Google IPO was a "sealed-bid, uniform-price" auction. The bidders make their bids in sealed covers. The Google auction first eliminated all bids it considered "speculative" and then priced the IPO at or near the auction clearing price, the level at which there is enough demand to sell the shares. The valid bids were then arranged in the descending order of bid price and irrespective of the individual bid prices, the shares were allotted at the price at which the last share was bid or at which the market got cleared. In other words, to "win" shares, the bidder needed to bid below the speculative price and at or above the IPO price. A brief description of the other auction variants are outlined here.

Though there are some reservations, auctions are a superior way of pricing an IPO because no one gets shares on the basis of who they know, and because it ensures that the company going public isn't going to leave too much money on the table by going public at a lower price than the one the market was willing to pay. It eliminates the moral hazard problem and lets the market do the price discovery.

Wednesday, November 28, 2007

Naomi Klein chronicles Latin America

There is an excellant chronicle of the recent economic experiments in Latin America by Naomi Klein, Latin America's Shock Resistance.

Ms Klein is at her best in tearing into the duplicity involved in the right establishment's railings against the policies of Chavez and Co, "Chávez's many critics have derided these initiatives as handouts and unfair subsidies, of course. Yet in an era when Halliburton treats the US government as its personal ATM for six years, withdraws upward of $20 billion in Iraq contracts alone, refuses to hire local workers either on the Gulf Coast or in Iraq, then expresses its gratitude to US taxpayers by moving its corporate headquarters to Dubai (with all the attendant tax and legal benefits), Chávez's direct subsidies to regular people look significantly less radical."

Klein refers to the Bolivian Alternative for the Americas (ALBA), which is the continent's retort to the Free Trade Area of the Americas. She writes, "Though ALBA is still in its early stages, Emir Sader, a Brazil-based sociologist, describes its promise as "a perfect example of genuinely fair trade: each country provides what it is best placed to produce, in return for what it most needs, independent of global market prices." So Bolivia provides gas at stable discounted prices; Venezuela offers heavily subsidized oil to poorer countries and shares expertise in developing reserves; and Cuba sends thousands of doctors to deliver free healthcare all over the continent, while training students from other countries at its medical schools."

She describes Chavez's experiments, "Chávez has made the cooperatives in Venezuela a top political priority, giving them first refusal on government contracts and offering them economic incentives to trade with one another. By 2006 there were roughly 100,000 cooperatives in the country, employing more than 700,000 workers. Many are pieces of state infrastructure--toll booths, highway maintenance, health clinics--handed over to the communities to run. It's a reverse of the logic of government outsourcing: rather than auctioning off pieces of the state to large corporations and losing democratic control, the people who use the resources are given the power to manage them, creating, at least in theory, both jobs and more responsive public services."

Only time will tell whether this experiment will be sustained and succeed. But the emergence of the likes of Evo Morales, has surely resulted in a massive popular (read indigenous) awakening in the continent. For the time being, the "peak oil factor" has sustained the massive social welfare and poverty eradication efforts. The true test of the success or otherwise of these policies will be when the commodity prices fall or stop rising. In any case, the present experiments of Chavez and his comrades is only further proof of the fact that Latin America is the undisputed global "laboratory for economic experiments"!

Update
Richard Gott writes about the Bolivarian Revolution in Hugo Chavez's Venezuela. He says, "The Chávez revolution remains the most original and democratic experiment in Latin America, and is clearly here to stay."

Why supply side arguements persist?

James Surowiecki writes about why the "snake oil remedy", as Paul Samuelson castigated it, still dominates the right wing opinion on taxation. The argument that "tax cuts pays for itself" has become one of the sacred truths of the Republican and right wing establishment. Calling it the "great lie of the supply side economics" in Tax Evasion, he argues tht it is a smokescreen for cutting taxes for the rich. The article contains a few links to the supply side position and the studies that conclusively debunks it.

WSJ on the Indian economy

A few points from today's WSJ article PURSUIT OF HAPPINESS: India's Surging Economy Lifts Hopes and Ambitions

1. About one-third of India's population is under the age of 15. Over the next five years, India will be responsible for nearly 25% of the increase in the world's working-age population, according to an October World Bank report. China's population, in contrast, is rapidly aging; its working-age population is expected to fall to 57% of the total in 2050 from 67% in 2000, according to a separate World Bank report issued in September.

2. In 2004, 83% of rural Indian wage earners aged 18-59 were in the lowest-earning section of society, making less than 61,125 rupees a year, roughly $1,540, according to a new study by IIMS Dataworks, a New Delhi-based market-research firm. By mid-2007, that number had increased to 86.4%, the survey found. In contrast, the ranks of the lowest-paid workers in India's urban areas fell to 73.2% of the working population from 79.5% three years earlier. Lowest rural earners were defined as making less than 71,700 rupees a year (roughly $1,800) in 2007. Lowest urban earners were defined as making less than 99,612 rupees a year ($2,500).

3. For 2005-06, Asia accounted for 56% of all academic enrollments in US Higher Education institutions. India sent 76,503 students, China 62,582, Korea 58,847, Japan 38,712, and Canada 28,202. Only 17% of Indians in their mid-20s and older have a secondary education. However, for the sixth consecutive school year in 2006-07, India was the leading place of origin for international students in the U.S., with 83,833 students enrolled.

4. India's economic growth has averaged about 8.6% a year for the past four years, tantalizingly close to rival China’s 10.4% pace. If sustained, India's rate would double average incomes in a decade.

5. Overall, accounting for inflation, people in India have become more solvent, are earning more and are better off in money terms than in 2004. In 2007 mid-year, 321.4 million Indians 18 to 59 years old had direct cash earnings. Of these, 258.1 million were in the lowest income bracket, 43.1 million in the lower-middle bracket, 7.7 million in the upper-middle bracket and 12.5 million in the highest bracket.

More statistics in an interactive guide, Indian Dream.

Monday, November 26, 2007

Land value as an unearned increment!

We are living in an age when house prices have risen to unprecedented levels and the rise shows no sign of abating. Experience from across the globe shows that its impact on the economy and its participants, have been varied and interesting. Unlike other economic processes, asset bubbles add to the incomes of the owners with them not having contributed anything to it. It is a simple case of being at the right place at the right time. Economists call it a "free-rider problem", wherein the beneficiaries partake of a windfall from an event, at no cost to them. In the instant case, the positive externalities generated by specific developments in an area causes all land values to rise..

David Ricardo, the nineteenth century British economist had said that land has a rental value, which is an unearned increment endowed on the owner, and hence can and should be taxed. Ricardo's Law of Rent, postulates that a substantial portion of the wealth generated through any economic activity ends up in increased land values, which benefits only the landowners, who ironically enough do not contribute anything whatsoever to this increase in value.

Unlike other endowments, land and natural resources confer benefits on the owner by the mere fact of being owned, without the need for any value addition to be done by the owner. Further, the rise in value of land or of any natural resource is generally independent of the amount of effort or value addition done by the owner, and is dependent on various exogenous variables. But the full value of the rise is captured by the owner, without the need for sharing or parting with any part of this increase. Land values rise in leaps and bounds due to community activity like new roads, transport links, commercial developments etc. In fact, all these activities, called public goods, generate large amount of positive externalities, most of which are captured by the land owners in terms of increases in land values.

In fact one of the major economic benefits and economic consequence of increased economic and commercial development in an area is captured by way of increased land values, all of which accrue to the land owner, with nothing being shared with the community. We therefore have a situation wherein the landowners become richer at the expense of taxpayers whose incomes are used to generate the positve externalities that causes the rise in land values. And the unkindest cut is that the taxpayer does not get any share of this massive wealth generation, achieved using his taxes.

A typical story goes like this. Mr Realtor buys land in Realtyland I. The Government announces its decision to set up a Software Park in the vicinity of Realtyland I. Land prices in Realtyland I immediately doubles. The Software Park is completed, and infrastructure facilities including roads, water and sewerage, transport links, schools, hospitals, commercial centers and residential enclaves come up around Realtyland I. In three years, the land prices goes up by another five times. What is Mr Realtor's contribution to this growth? None. But Mr Realtor and his ilk are the largest beneficiaries of this boom! He then sells off a part of his land and goes to Realtyland II and buys another 5 acres. The Government then announces the setting up of an Special Economic Zone (SEZ) near Realtyland II, and land values double. The story goes on. There are any number of real world examples like the aforementioned. Replace any part of the new Hyderabad or Visakhapatnam with Realtyland, and the numerous land owning nouveau riche (and this is an increasingly substantial number) with Mr Realtor, and you have a glimpse of this boom economy.

One of the central concerns of economics is about reconciling the principles of individual freedom with social justice, without distorting the market incentives. Surely, no one can deny the right of any individual to own land. But by any yardstick, the principles of natural justice demands that tax payers get value from the expenditures incurred by their taxes in atleast some proportion. It is thus the poor subsidising the rich to become richer still. It is a form of private appropriation of public value, embedded in land rents or increased land values.

Further, there are inherent structural conditions in our economy that favors the already well endowed. These conditions play a major role in widening the income gap between them and the not so fortunate people. Land and natural resources confer on its owners substantial advantages, that are denied to those not possessing it. Given that the amount of these resources available in the world is limited and increasingly scarce, those in possession of the same have considerable advantages, which persists throughout their lifetime.

Social and economic justice is not the only concern arising from rising land values. It distorts other economic incentives also. Experiences from across the globe shows that rising land prices have led to huge increase in household debt as people borrow massively to invest in the real estate market. It results in a drop in savings as people lulled by the "wealth effect" induced by higher land values, stop saving altogether (witness America this decade). The attraction offered by rising land values leads to a crowding out of investment in more productive enterprises, as the short term returns from it far outweigh other investment options. So much so that even financial and manufacturing sector firms start investing in real estate! High land prices have its impact on housing rents, thereby inhibiting internal mobility within a country, as people find it difficult to find affordable housing in cities.

It is therefore natural and just that landowners share a part of the increase in value of their assets with the community or the Government, that is responsible for the activity responsible for causing the rise in value. There is a school of thought, with origins in the ideology of David Ricardo, that argues for taxing ownership and exploitation of natural resources, instead of taxing human effort and enterprise. This tax would be a tax on un-earned income and therefore would not distort the market incentive structure. Adam Smith had argued that such a tax would "not distort the people's incentive to work, save and invest". Unlike labor and capital, the quantity of land is fixed, and hence taxation would not lead to any change in the amount of land available in the market. However, if this were done, it would reduce the incentive for hoarding land. Land ownership would be therefore spread out more evenly. This is equitable, and stands the Rawlsian test, in so far as it promotes equality in access to basic economic opoortunities.

There are many ways of assessing a land tax. One approach is to tax land transactions. This is already being done in a small manner, by way of stamp duty and suffers from substantial evasion and pilferage. Such a tax would be a deterrent on a valuable economic activity, and encourage people to evade detection of the transaction or report lower transaction values. Another method is to tax the capital value of the land on an annual basis. Still another model is to tax the annual economic rent, or the amount of money the land would generate if leased out for a year. These two approaches minimizes market distortions. Besides they are easier to levy and collect, since you cannot parcel away your land to some tax haven like Cayman Islands or to hide it someway.

But there are other important issues to be addressed. Do we levy the land value tax on all lands or only on vacant lands? Do we levy tax on the land value or on the increase in land value or the capital gains? Do we levy tax only on vacant lands or also on developed lands?

A land value tax has many advantages. It will bring more land into circulation and therefore reduce land prices, thereby making it affordable for more people to own land. This will ensure more economically and socially beneficial use of land, by way of construction or agriculture, which would add value to the economy and promote development. The extra supply of land would reduce urban land and building rents, and thereby the accommodation costs for houses and businesses. This would also help reduce urban sprawl. An unused vacant land is a drag on the economy and is an unproductive investment. Such a tax will also help the Government reduce its reliance on other forms of taxation that penalise enterprise and effort. Finally, since land assets are fixed and scarce, and economic efficiency demands that we make the most optimum use of scarce resources, it is only appropriate that we incentivize land development and disincentivize hoarding of land.

The critics of any land value taxation plan will point out that while land values may rise without any value addition by the owner, land is a store of economic value like any other asset. It can be an attractive source of investment for those who earn their incomes through entreprenuership and effort. So would it not be against the principles of economic justice to tax such land owners. My argument against this would be that, even accepting this, are we not right in incetivizing these investors to invest their wealth in other more productive avenues? All of us would agree that there are ceratinly other more productive sources of investment which generate jobs, which are in need of the scarce savings available in the economy.

Land tax is already under implementation in different forms in some countries. Many towns and local councils in Denmark, Australia, South Africa, New Zealand, and some US states, have different variants of land value tax. In Hong Kong, there is no private ownership of land. All land is owned by the State and is leased out. Alsakan oil welath is similarly taxed and its proceeds paid out as a dividend to its citizens.

Interestingly, under the Hyderabad Municipal Corporation Act, there is a provision for imposing an annual vacant land tax amounting to 0.25% of the capital value of the land. This is intended to discourage hoarding of land and incentivize land development. There are also available provisions in Town Planning related rules and orders, for imposing an impact fees to capture the value addition on lands due to external developments like road widenings, land use changes, or other development notifications issued by the Government.

Instead of being a Federal government tax, any land value tax should be a decentralised one. Since all land taxation is generally vested with the local bodies, it is only appropriate that any land value tax be levied and collected through them. Such tax revenues can be used to finance local infrastructure expenditure, and can be a substantial source of revenue for the local bodies. In fact, the local bodies can even dispense with the Property Tax levied on buildings and can impose land value tax on the land housing the building.

Sunday, November 25, 2007

Is Micheal Hussey "spectacular"?

What is common to Micheal Hussey, the three Brads - Haddin, Hogg, and Hodge, Stuart Clark, Phil Jacques, and now Misbah ul Haq? For a start, they are all cricketers who have achieved spectacular success in their baptism to international cricket. They are also distinct in so far as they have all amassed substantial first class experience before their international success.

A close observation of all these aforementioned players reveals certain similarities. All of them do the simple things better than the others. None of them are spectacular in the way we associate this adjective with! Hussey and Co play straight and exhibit excellent shot selection, while Clark and Co bowl straight and let the batsmen make the mistakes. While the former makes full use of bad bowling, the latter takes wickets when batsmen make mistakes. And unfortunately there is plenty of both on offer nowadays by all teams!

Having watched these batsmen, I have observed that they rarely get out in front of the wicket, a statistic that underlines their shot selection capabilities. They price their wicket dearly and will never throw it away. The bowlers have to get them out, and this requires a good ball or good bowling spells, again very rare commodities! The fact that they get out mostly to good balls is highlighted by their general mode of dismissal - bowled, leg before, caught behind, or caught in slips. Similarly, Stuart Clark is a classic example of a bowler who bowls wicket to wicket, plays on the patience of the batsman and wears him out before snaring him. During the recent India-Australia one day series, Brad Hogg's bowling discipline was repeatedly manifested in the remarkable bunching of balls bowled by him.

Now these prized attributes - shot selection, batting and bowling straight, control over line and length, perseverance and patience - are all functions of experience. The more you play the game, at a reasonably appropriate level, the more you are likely to perfect these skills. Such batsmen are more likely to be successful in tests and bowlers more successful in the shorter versions.

With plenty of bad balls and batting mistakes on offer, and scarcity of good balls and bowling spells, the probability of the clear headed, technically competent test batsman and bowler succeeding increases substantially. I am not saying there is no need for talent, for without talent nobody can survive even in the weaker domestic leagues. Anybody who prospers in the grind of a domestic league, is more likely to imbibe these attributes and the mental toughness that can translate this experience to success at international level. But, with a reasonable amount of talent, and the right amount of experience and ability to inculcate the lessons of that experience, we have the ingredients for a successful test batsman and bowler. The power and safety offered by modern cricketing gear fortifies these ingredients.

Do we have a lesson here? Especially for the Indian selectors, with their current obsession with youth and new faces? What are the conclusions to be drawn from the success of these players? Is technique and some of the good, old fashioned attributes of batting and bowling making a comeback, after a period when raw talent and power, and hand-eye co-ordination appeared to be taking over? Or is it simply that we are passing through a phase when there are very few good bowlers, or a golden age for batsmen? Is Micheal Hussey and all that he exemplifies, the new definition of the "spectacular"?

Friday, November 23, 2007

Private Equity and the widening returns inequality

I have a case that global financial markets have contributed their more than fair share towards increasing inequality. More specifically, I am talking about the steeply widening gulf between the highest winners and the regular small investors. I am also convinced that the emergence of hedge funds and private equity firms have seen a massive shift in the respective shares of financial market incomes, from retail investors to the high net worth individuals who invest in these funds and their smart fund managers. Here is why.

The overwhelmingly major share of investments in private equity and hedge funds are those of high income individuals and corporates, who have a high apetite for risk and therefore demands higher returns. Since they manage assets of mostly private individuals and institutions, these funds and firms are outside the net of regular financial sector regulation. Further, they are not subjected to the short time horizon pressures of equity markets and the detailed disclosure requirements of the publicly listed companies. Further, unlike public listed firms, these firms can gear up the balance sheets of the companies they buy with many times more debt.

Private equity firms and hedge funds have a serious problem with their image and reputations. They have been bedevilled by serious accusations of asset stripping, selling off assets for a fast buck, unconsiderate and ruthless lay-offs and lack of concern for the welfare of employees, heavy and unsustainable leveraging so as to maximize immediate returns, and no commitment to build up long-term relationships for the firm.

But the most damaging allegations relate to unjustly benefitting from certain anachronistic tax provisions. This tax provision defines fund managers' fees as capital gains, thereby entitling them for the lower taxes (15% as opposed to 35% on the regular income of ordinary Americans) charged on capital gains. The fund manager's share of the funds profit, "carried interest", is treated as a capital gain on invesment rather than as income from employment. This concession is ironical since these managers earn income by playing around with other people's money, leveraged many times over, and only risking a miniscule share of proprietary capital. Further, given their massive leverage ratios, these firms also capitalize from the tax breaks given to interest payments on debt.

Hedge fund managers gets a fee of 2% of funds under management, plus 20% of whatever the fund earns. Private equity firms take home the major portion of the returns from their investments. In the former, the incomes come from palying around with other people's capital, and in the latter it comes from both other people's capital and the massive debts raised. Paul Krugman writing in the New York Times therefore describes them thus,

"Except for the fact that he might make a billion dollars a year, he resembles a waitress whose income dependes on a mix of wages and tips, or a salesman who lives on a mix of salary and commissions, more than he resembles an entrepreneur who sinks his life savings into a new business. Fund managers do not put their own assets on the line."


In the extremely competitive global fiancial markets, with fast diminishing margins, private equity and hedge fund managers have been spectacularly successful in locating and squeezing out every available profit opportunity. The successes of private equity firms like Blackstone, Carlyle, Kohlberg Kravis Roberts (KKR), Texas Pacific Group, and Cereberus Group stand testimony to their impressive performance. These managers thrive by hiving off loss making sections, cutting costs ruthlessly, maximizing returns on other assets of the company and working on the more profitable operations of the company.

A major source of profits for hedge fund and private equity firms is the leveraged buy out (LBO) route. Badly run and ailing firms are purchased, and then handed over to professional managers who are experts in restructuring. Such firms are invariably undervalued and often with minimal tinkering they represent great potential for profit opportunities. This often results in massive layoffs and cost cutting as these managers go in for cutting down the huge inefficiencies inherent in such companies. The PE and hedge funds make their profits generally by exiting through Initial Public Offers (IPO) or by selling to other PE firms. In many cases, poorly run and languishing public listed companies are taken private at rock bottom price and restructured and then again taken public.

It can also be safely concluded that the private equity led M&As and LBOs have contributed significantly to the recent stockmarket rally across the globe. Shares of many companies have been boosted by fears and hopes that they could be the next takeover target of private equity firms.

The aforementioned cases represent some form of transfer of resources and profits from the public financial market to the private market. The small retail investors and financial institutions managing pension and other public funds invest their funds in the public equity and bond markets. The private market consisting mainly of hedge funds and private equity firms, generally manage the funds of high net worth individuals and wealthy corporates. In the typical public equity market route, the margins and captured incomes are shared with retail investors. But in case of private equity and hedge fund firms, the profits are captured by a few high net worth individuals and the firms managing their portfolios.

The hedge fund or private equity firm, by being more eneterprising and competitive, skims off the fatter margins which would otherwise have been shared by investors in the public market. We need to acknowledge that in an extremely competitive environment, undervalued and badly run firms are lucrative storehouses of dormant margins. In fact, they are the few remaining high margin opportunities in the financial markets. We are therefore seeing an unmistakable trend of increasing profits for the participants in the private financial market, at the expense of the investors in the public equity markets.

The breadth and depth of the global financial markets have increased impressively in the recent few years. The proliferation of new actors and growing competition has meant that the fat margins have come down. The hitherto plentifully evident opportunities for arbitrage are giving way to the more subtler variants. The high return opportunities are increasingly concealed in complex financial instruments, which are generally out of the reach of the small investors. Ironically enough, as the financial market is becoming ever more efficient, by way of increased competition, lower margins, and newer trading instruments, its participants are experiencing an ever widening gap in returns.

Critics may argue that these complex instruments are risky and hence command high returns. But then the very complexity of these instruments and the need for vast amount of real time information, makes them inherently inaccessible to the vast majority of individual investors. Understanding the risk embedded in these complex instruments and identifying the fast changing profit opportunities require access to real time information and expensive investment advisory or analysts.

To conclude, the rich are increasingly cornering the few remaining high profit opportunities in the global financial markets, leaving the small investors with only the residual crumbs. This will undoubtedly make these high net worth individuals richer still, and make retail investors less well off than they otherwise would have been. And this is increasingly being borne out by statistics.

Update:
In 2006, three hedge fund managers took home more than $1 bn, led by James Simmons who took home $1.7 bn, or 38000 times the average income. The top 25 together made $14 bn. Paul Krugman has more on this in Gilded Once More.

Tuesday, November 20, 2007

Outsourcing O&M in ULBs

I have argued in previous posts about the absence of sufficient supply side depth and breadth in the infrastructure sector in our country. This naturally gets reflected in the limited number of companies with expertise in Operation and Maintenance (O&M) of urban infrastructure sectors like water supply, sewerage, solid waste management and streetlighting. Each of these services consist of a series of components and functions - electrical and mechanical equipments, pumping and distribution network, treatment and disposal facilities, transport logistics etc.

While there are a number of examples of labor and service contracts for each of these components or functions, and even a few O&M contracts of the electromechanical systems, there are no examples of integrated O&M of the entire system. While this is understandable given the virgin nature of such market, it also means that there is limited understanding of the practical issues related with successfully running an O&M contract in these sectors. There are significant uncertainties arising from the information asymmetry between the ULBs and the private operators. The O&M operator invariably hedges these risks by costing them into the contract. Therefore, apart from the lack of competition arising from the presence of a small number of firms, the absence of successful examples of complete O&M and the inherent uncertainties have also contributed to the high costs of O&M contracts in these sectors. Let me illustrate this with a few examples from Vijayawada.

About two years back, we initiated steps to outsource our entire water supply, underground drainage (or sewerage), streetlighting and solid waste transportation logistics. Though there were some labor and service contracts already in operation in these sectors, it was felt that an integrated O&M contract of all the functions in these sectors would be a better option. The objectives included improving operational efficiency, reducing wastages and pilferages, inducting better management practices and technology, and importantly reducing costs.

These efforts provoked a very vocal resistance, with even the Council of the Vijayawada Municipal Corporation (VMC) passing blanket resolutions banning outsourcing of O&M in any sector. A campaign to educate the opinion makers about the need to outsource such services and its benefits failed to cut much ice. This was understandable given the impersonal and technical nature of the problems and the benefits arising from outsourcing. However it was hoped that the financial savings expected from the contract would convince the opponents of outsourcing.

The major components of the O&M cost are labor and establishment, electricity charges/POL, consumables, and repairs. It is widely believed that a private O&M operators will be able to reduce costs by
1. Better labor management and greater worker productivity
2. Using technology (energy saving devices and better maintenance) to reduce energy consumption
3. More efficeint utilization of consumables and preventing wastage and pilferage
4. Reduce repairs by better maintenance

The National Competitive Bidding process in each of these sectors took 6-9 months to be completed. In the absence of similar examples elsewhere, the bid documents had to be prepared, more or less afresh, and repeated pre-bid meetings organized to clarify the numerous doubts and misgivings. In fact, it took sometime for us to document and prepare an inventory, with all the relevant information, about the assets which were to be outsourced.

The actual cost of O&M for the water supply chain upto the storage reservoirs, incurred by VMC is Rs 1.1 Cr per year(or say, Rs 3.5 Cr for three years), excluding the electricity charges. But the lowest quoted bid was Rs 8.30 Cr for a three year period. While the actual cost of O&M for sewerage was Rs 0.60 Cr, excluding the electricity charges, the lowest bid was for Rs 1.30 Cr. However, in both streetlighting and solid waste transport logistics, the final bids produced substantial savings. As a consequence, it was possible to sell the O&M of both streetlighting and solid waste transport logistics to the Council, while both water and UGD failed to get approved.

On closer analysis, there emerges several reasons for the higher costs quoted by these firms, especially in water and sewerage sectors. Some of the major reasons are listed below.

1. In the labor contracts under operation in most ULBs, labor is sourced at rates much lower than the notified minimum wages. Typically, ULBs identify their labor requirements of various categories and call for tenders, inviting response from labor contractors who can procure and supply the required numbers at the lowest cost. The market, in all but the more skilled categories, is very competitive and hence gets bidded below the minimum wage. For example, while the minimum wage for unskilled labor is Rs 120 per day, the actual wage rate varies from Rs 75-100. The average wage proposed by the O&M operator is Rs 150 per day. The major O&M operators, bound as they are by contractual obligations and mandatory internal requirements, do not have this flexibility and end up paying atleast the minimum wage.
2. Under the standard ULB maintenance arrangement motors, pumps and different equipments get repaired only when they break down. O&M contractors, in contrast, have a preventive or precautionary maintenance schedule for each equipment and device depending upon their age and use. This not only helps in preventing repairs, but also palys a significant part in incresing the operational lives of these devices. These costs get loaded into the O&M rates quoted by these contractors.
3. The ULBs or Government agencies do not employ specialists and do not take their services in the O&M of these systems. O&M contractors utilize the services of various specialists like environmental engineers, chemists, structural engineers etc, whose services are expensive and get added to the O&M cost. The salaries of the skilled regular engineering personnel are also much higher than correpsonding salaries paid by the Government.
4. Standard maintenance schedules like painting and other external servicing is done very infrequently in government run installations. The sewerage O&M contract, for example, includes work components like desilting of all sewer lines, which is never done, unless the lines overflow, when maintained by the ULB. O&M contractors factor these costs into their bids.
5. In the absence of clear information about the age and other operational history of devices and equipments, the O&M contractor is forced to quote higher rates for anticipated repairs. This often gets reflected in higher operational costs too.
6. Different taxes, that are not incurred when the ULB or Government agency does the O&M, increases the cost by over 20%. The service tax is 12.25%, income tax 2.25%, and other taxes on procurement often goes beyond 5%.

Another factor that is responsible for the lack of competition is that such integrated O&M services require cross-sectoral expertise, which only the major contractors have. Such barriers to entry, invariably excludes all the smaller, local operators whose expertise is often limited to a few functions and not the full spectrum of activities involved. The high technical and financial qualification norms and experience prescribed in Government bidding regulations also militates against the smaller contractors.

Friday, November 16, 2007

Dhoni and the Noble Savage!

The New Indian Express carries one of the most delightful socio-economic writing on cricket I have read in a long time. In a celeberation of Dhoni and the new Team India, The Magic of Dhoni, Shiv Visvanathan sees Dhoni as exemplifying the new India. He calls the big three - Tendulkar, Ganguly and Dravid - as the "past continuous", and Dhoni the "future". He writes,
"Dhoni is small town, small time India’s next story. Move over Mumbai and Bengaluru, Jharkhand is here. Rousseau’s natural savage has found his metier — the cricket bat. Dhoni excites rather than inspires. He cuts to the core of India’s merging middle class dream. Dhoni is a new brand in a world where brands have to resonate differently because the social grammar of success is changing."

"Dhoni is small town India’s symbol accidentally discovered by cricket. He is Eklavya without Drona or Arjun, all fingers intact, all thumbs up. He is first among the new equals. He represents small town India whose time has come."

He draws lessons for the marketing professionals, "To put it bluntly, a marketing strategy that is based on the Big three will not be that successful. Vintage is not what India wants. It needs ambush, surprise and in this sense Dhoni is closer to the social genius of India unfolding. Today one has to model one’s malls and marketing on Dhoni. Indigenous firms should realise that marketing strategies based on the Dhoni model could out think the Wall Marts and other external threats. They must remember that Dhoni brand while being desi is not swadesi."

"It is desiglobal, the local spiraling out to the world but not losing its emotional location. In marketing terms, the big three are horizontal. Dhoni is vertically integrated. He is symbol of the new chain of being that links the little town with the big dream to the theatres of global India. He is scalable, fitted to any niche from Jharkhand to Mumbai and the Diaspora. Scalability, integration, charisma, a sense of evoking a social genius makes Mahendra Singh Dhoni, the Indian of the year, sociologically."

Sociologists like Shiv Visvanathan are right in drawing these conclusions. But given the yo-yo nature of our teams fortunes and the ultimate test of an Australian summer awaiting, the marketing men may better advised to wait till Dhoni's men get back from Down Under, before pitching full time for Team India.

Liquidity crisis

It may not be too much out of place to claim that all the recent financial market crises have their origins in liquidity problems faced by various categories of investors. In many ways, liquidity, or atleast the perception of liquidity, is the most critical determinant in global financial markets.

Every now and then a bout of "irrational exuberance" builds up on some asset or financial instrument or technology or an industry, and investors flock there in herds. A bubble builds up and over-investment results. Investors, even leverage their positions to be a part of the investment race. Then, suddenly reality dawns, sparked off by some event, generally some default, and the bubble gets pricked. The unravelling starts. Investors rush for the exit door in a mad scramble, and asset values fall precipitously. New investors naturally stay away, and all the sources of liquidity for the sector dries up. A liquidity crisis is experienced.

The Bank of International Settlements (BIS), in its latest annual report remarks, “There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-taking...Moreover, should liquidity dry up and correlations among asset prices rise, the concern would be that prices might also overshoot on the downside.”

A list of all the specific liquidity crises afflicting global financial markets

1. The household mortgage takers, especially those No-income-no-job (NINJA) sub-prime borrowers, felt the rising interest rates and the cooling housing market and saw their "income effect" due to home ownership disappear. With the cooling housing market, they found it difficult to repay their debts and started defaulting.
2. The mortgage lending companies, suddenly realised the true magnitude of the sub-prime portfolio. Mortgage lending dries up.
3. The Wall Street lenders and banks had purchased these mortgage loans as bundles of securitized Collateralized Debt Obligations (CDOs). With the collateral showing up as being of dubious quality, they stopped purchasing or lending on CDOs. This dried up the sources of revenue for the mortgage lenders.
4. The Institutional investors like hedge funds, pension funds, and private equity firms, had also piled up massive investments in CDOs. They had leveraged the CDOs to raise money from the Wall Street Banks. Now the Wall Street Banks refused to lend against any mortgage backed securities. Hedge Funds and institutional investors are choked off liquidity.
5. The Special Investment Vehicles (SIVs), set up as off-balance sheet entities by Wall Street banks and institutional investors, raise money from the market by issuing Commercial Paper (CP). Now the market for CP takes a hit, as investors become aware that some of these SIVs own mortgage backed securties like CDOs, some of whom may be of suspect quality. Investors for CP dry up. Wall Street banks and especially hedge funds and private equity firms, who rely on such SIVs to raise their investment capital, face liquidity crunch.

This complex and multiple entangled web of liquidity crises, is now being played out and nobody knows when it will bottom out. Till that happens, the Federal Reserve and other Central Banks will have no option, but to either keep lowering interest rates or atleast keeping them low. Even faced with inflationary pressures from both the high oil prices and weakening dollar (and hence costlier imports - important given the predominant role of consumption in US GDP growth), the US Federal Reserve could have limited room to manoeuvre with monetary policy. Given the rising commodity prices, especially "peak oil", it is no different in the other economies. The most important leg of the Impossible Trinity becomes defunct! Milton Friedman had famously said, "An easy money policy is an invitation to higher interest rates."

Wednesday, November 14, 2007

Rising Inequality: Why is the rising tide not lifting all the boats?

The global economy is enjoying an age of unprecedented growth, but unfortunately inequality appears to be growing even faster. Why is the Gilded age, with its goldilocks economies and stable and high economic growths, not resulting in equitable outcomes? Why is the rising tide not lifting all the boats?

There are different views on the causes for the widening inequality

1. The major share of increasing inequality is accounted for by the sharpening wage divide. Lawrence Katz argues that the major portion of the rising wage inequality since 1980 can be attributed to the increasing educational wage differential. This school highlights a trend of increasing returns to investments in skills - an increasing wage premium on more school education, more training and greater skills and capabilities set.

In 1980, people with college degrees made on average 30 percent more than those with only high school diplomas. That disparity has widened to 70 percent. In the same year, the average earnings of people with advanced degrees were 50 percent more than those with only high school diplomas; today it is more than 100 percent.

2. The emergence of IT and its tools helped companies capture the performances of employees and their contribution to the company more accurately, thereby enabling them to differentiate between employees with differring capabilities and skills. Professor W. Bentley MacLeod of Columbia University, Thomas Lemieux of the University of British Columbia and Daniel Parent of McGill University found that performance based pay accounted for 25% of the increase in wage inequality in the 1976-1993 period. They also found that the proportion of jobs with a performance-pay component rose to 40 percent in the 1990s from 30 percent in the late 1970s. In 2003, the authors note, 44.5 percent of workers at Fortune 1000 companies received some form of performance-based pay, up from 34.7 percent in 1996. “Since companies are better able to measure precisely what an employee contributes, we’ve seen a greater range of incomes among people doing roughly the same jobs,” says Professor MacLeod.

3. Another view attributes this trend to the increasing share of profits and dividends in national income, and the corresponding decline in the shares of wages. Unlike payroll tax, capital gains and dividends (most famously the "carried interest" of hedge fund managers and private equity partners) are taxed only at 15% in the US.

However Emmanuel Saez of the University of California at Berkeley and Thomas Piketty of the Paris School of Economics, argues that the the share of top incomes coming from capital is much lower now than it has been historically. He claims that for the richest Americans — those in the top 0.01 percent of the distribution — the percentage of income derived from capital fell to 25 percent in 2004 from 70 percent in 1929. But their data clearly shows that this income share is rising steeply in the US, since 1980. They however argue that "the decline of progressive taxation observed since the early 1980s in the United States could very well spur a revival of high wealth concentration and top capital incomes during the next few decades." Prof Greg Mankiw claims, "The leisure class has been replaced by the working rich."

It is a different matter that this "working rich" is a miniscule minority and have emerged as the "new leisure class", and are pulling away from the rest of the society. This is a sleight of hand, as the "working rich'" also includes a very small but extremely rich category of managers, who are by any yardstick more than mere employees of their companies. To make a more meaningful analysis, we will need to separate them from the regular working rich, who are ordinary employees of their companies.

In fact, in the same study, Saez and Piketty also reveal that the share of gross personal income of the top 1 percent of American earners rose to 17.4 percent in 2005 from 8.2 percent in 1980. This is a more pertinent piece of information, which clearly points towards incresing inequality.

4. An excellent NBER working paper by Professors Frank Levy and Peter Temin, of the MIT, Inequality and Institutions in 20th Century America, lays the blame on public policies and says that "income distribution in each period was strongly shaped by a set of economic institutions." They argue that in the period 1955-80, was dominated by "unions, a negotiating framework set in the Treaty of Detroit, progressive taxes, and a high minimum wage - all parts of a general government effort to broadly distribute the gains from growth". This grand bargain between labor and corporate America involving New Deal-era protections for workers and high marginal tax rates (the top rate was 90 percent in the 1950s) led to the Great Moderation. The middle class grew dramatically, income inequality decreased, and corporations generally enjoyed labor peace.

"The stability in income equality where wages rose with national productivity for a generation after the Second World War was the result of policies that began in the Great Depression with the New Deal and were amplified by both public and private actions after the war. This stability was not the result of a natural economy; it was the result of policies designed to promote it. We have termed this set of policies the Treaty of Detroit."

Since 1980, due in part to the Reagan era shift in political environment, unions have weakened, minimum wage hasn’t come close to keeping up with inflation, and marginal income tax rates have been cut (the top marginal rate is now 35 percent, down from 70 percent in 1980). They argue that "the recent years have been characterized by reversals in all these dimensions in an institutional pattern known as the Washington Consensus, whose effects have been amplified by the skil based technical change" of recent years. This has resulted in declining bargaining power for workers and the rise of a winner-take-all environment.

"The elements of the Washington Consensus were adopted in the name of improving economic efficiency. But there is growing recognition that the current free-market income distribution – the combination of large inequalities and stagnant wages for many workers – creates its own “soft” inefficiencies as people become disenchanted with existing economic
arrangements."

"Only a reorientation of government policy can restore the general prosperity of the postwar boom, can recreate a more equitable distribution of productivity gains where a rising tide lifts all boats."

Update 1
Temin and Levy's article from Vox, Inequality and institutions in 20th century America. They write, "Rising American inequality stems from efficiency-enhancing policy changes in the 1970s and 1980s. There is growing recognition that the current free-market income distribution – the combination of large inequalities and stagnant wages for many workers – creates its own “soft” inefficiencies as people become disenchanted with existing economic arrangements."

Update 2
A recent NYT article says that Report Says That the Rich Are Getting Richer Faster, Much Faster. The poorest fifth of households had total income of $383.4 billion in 2005, while just the increase in income for the top 1 percent came to $524.8 billion, a figure 37 percent higher. On average, incomes for the top 1 percent of households rose by $465,700 each, or 42.6 percent after adjusting for inflation. The incomes of the poorest fifth rose by $200, or 1.3 percent, and the middle fifth increased by $2,400 or 4.3 percent. It says, "Much of the increase at the top reflected the rebound of the stock market after its sharp drop in 2000, economists from across the political spectrum said. About half of the income going to the top 1 percent comes from investments and business."

Update 3
Paul Krugman explores how hedge fund managers, the top 25 of whom made more than $14 bn in 2006, are contributing to the widening inequality.

Update 4
It is often argued that measures of income inequality are misleading because an individual's income is, at best, a rough proxy for his or her real economic wellbeing. Because we can save, draw down savings, or run up debt, our income may tell us little about how we're faring. They argue that on the contrary, consumption surveys, which track what people actually spend, sketch a more lifelike portrait of the material quality of life. Again consumption numbers, too, conceal as much as they illuminate. They can record only that we have spent, but not the value—the pleasure or health—gained in the spending. According to one 2006 study, by Dirk Krueger of the University of Pennsylvania and Fabrizio Perri of New York University, consumption inequality has barely budged for several decades, despite a sharp upswing in income inequality.

Update 5
Income and wealth have become more concentrated than at any time in the past 80 years, and those at the top are now taxed at lower rates than rich Americans have been taxed since before the start of World War II. Taxpayers who bring home over $5 million annually now pay less than 22 percent of their incomes in federal tax, on average. Managers of hedge funds, private-equity partners, and many venture capitalists are paying no more than 15 percent -- since their earnings are, absurdly, treated as capital gains. This means that America's wealthiest, who have been receiving most of the economy's bounty, are paying a smaller percentage of their income in taxes than are middle-class Americans. Financiers who are raking in hundreds of millions -- last year, each of the 25 highest paid hedge-fund managers took in an average of $560 million -- are paying at a lower rate than many of America's working poor who barely clear $20,000 annually.

Update
Here is an arguement that claims inequality may not be as bad as the income figures show, since consumption differences between the top and bottom quintile are not so marked. The share of national income going to the richest 20 percent of households rose from 43.6 percent in 1975 to 49.6 percent in 2006, and families in the lowest fifth saw their piece of the pie fall from 4.3 percent to 3.3 percent, or a 1:15 ratio. The top fifth of American households earned an average of $149,963 a year in 2006 and spent $69,863 on food, clothing, shelter, utilities, transportation, health care and other categories of consumption, with the rest going largely to taxes and savings. The bottom fifth earned just $9,974, but spent nearly twice that — an average of $18,153 a year, sources of spending money that doesn’t fall under taxable income - portions of sales of property like homes and cars and securities that are not subject to capital gains taxes, insurance policies redeemed, or the drawing down of bank accounts. This means a consumption ratio of only 1:4.

Update
Here is Bernie Saffran Lecture by Frank Levy, where he examines the role of social, political and economic institutions that contributes towards widening income inequality. He argues how the institutions – unions, the minimum wage, the tax system, accounting conventions and ultimately the tone set by the government – have the power to either moderate or reinforce the underlying market. He describes how "U.S. institutions abandoned a moderating role sometime after 1975, when market forces were already tending toward greater inequality."

Credibility premium and cities

It is commonplace in world of finance to refer to country risks, or the political and strategic risks associated with investing in a country. Country risks are factored in by rating agencies in their sovereign ratings and by investors when making their investment decisions. It reflects in the cost of capital for investment in the country. A similar risk premium is associated with cities too. For lack of better word, I will call this a credibility premium.

Vijayawada has a serious problem with its credibility, and this gets manifested as a risk premium. Any investor or developer who ventures into Vijayawada will be hedging himself with a few percentage points of additional credibility premium, over and above his normal expected rate of returns. The external investment can be in capital investments, contracting for Goverenment agencies etc.

What are the reasons cities experience a lack of credibility? The most commonly cited credibility problems arise from
1. Political opposition to reforms
2. Precedent of going back on contracts
3. Precedent of loan default
4. Resistance to adopting newer ideas, processes and technologies
5. Labor militancy
6. Political factionalism and strife
7. Payment defaults and weak finances

The Vijayawada Municipal Corporation (VMC) had floated a few projects under Public Private Partnership (PPP) for development of vacant land assets owned by it. These projects, under both the revenue sharing BOT and floor space sharing models, evoked good response from potential bidders. However, an analysis of these bids revealed a trend of bidders hedging themesleves against the potential city specific risks and adding the credibility premium to their expected rate of return. This meant that VMC ended up getting a worse deal than it would have got without the attendant credibility risks.

Similarly, the VMC had called various tenders for outsourcing the Operation and Maintenance (O&M) of its water, sewerage and some other services. In all these bids it was observed that the bidders factored in the credibility premium in their financial bids and quoted more than they would have in other cities.

The Council of VMC has been consistent in its opposition to reforms in its City governance structures. Blanket opposition to ideas like PPP, outsourcing, water meters, user charges, tax increases etc has not helped in improving the credibility. Absence of a good track record of project execution, financial strength, process re-engineering, manifested by lack of good working examples has incresed the credibility premium.

Despite being one of the major Tier II cities, it has not received any notable industrial investments in the past few years. Its impressive strength as an educational center has not helped attract software and other knowledge based industries. Some of the richest entrepreneurs in the State come from Vijayawada, and interestingly very few of them have invested their wealth in their own City.

A credibility premium is a deadweight loss, in so far as its benefits do not accrue to anybody, and is an economically inefficient situation. The premium is mostly transferred out of the City by the external investors, while its costs are borne by all the entreprenuers and citizens of the City. It is effectively a penalty or a tax imposed on the City and its citizens for the additional risks specific to the City. The entreprenuers face a higher than necessary cost of capital, and the citizens suffer by way of higher taxes, lower and poorer quality civic infrastructure facilties and services. The investor too does not benefit by way of the additional credibility premium, as he expends a significant amount of time and resources in combatting the local problems.

How do we lower this credibility premium? The surest way to do this is to get some runs on the board by getting a few successful examples of reforms and external investments. Such examples would go a long way in allaying the fears of outsiders on investing in the City. Bringing in financial discipline, reducing wastage and inefficiency, adopting newer technologies can all go a long way in reducing teh credibility premium. But all this takes time.

Tuesday, November 13, 2007

Taxation issues

Two interesting things about taxes.

1. There is a NBER working paper E-ZTAX: Tax Salience And Tax Rates, which claims that reduced salience and visibility of tax collection lowers resistance to tax collection and even higher taxes. It studies the automated toll collection systems and argues that "because these electronic systems automatically deduct the toll as the car drives through the toll plaza, and the driver therefore need no longer actively count out and hand over cash for the toll, electronic payment arguably reduce the visibility of tolls." Further, this reduced visibility also comes at the cost of higher tolls, and passes off without much resistance. The study concludes that "drivers who pay the toll electronically don't notice price hikes as readily as manual-toll users do. So public resistance to toll increases lessens as more and more drivers pay electronically, and thus transportation authorities are able to push through more toll increases."

Other taxes where there is possibility of reducing visibility of tax collection include user charges on garbage collection (on an electronic tag attached to the bin), congestion pricing etc. Further, the amount of tax collected should be reduced by increasing its periodicity (this increases transaction costs, but should be overcome by making the collection electronic). Interface between the assessed and the assessee should be minimized or even eliminated.

2. In his latest blog post, Billionaires, Gary Becker has argued that a very heavy tax on the very wealthy may not produce too many distortions. He writes, "I believe that individuals with wealth in excess of hundreds of millions of dollars would tend to work about just as hard when their estates would be heavily taxed as they would without estate taxes, as long as they would still have a very large after-tax estate." In anticipation of attempts at tax eavsion he also writes, "One justification for such high taxes that has some appeal even when only modest sums are collected is that high taxes have encouraged the very wealthy to create large tax-exempt educational and charitable foundations in order to reduce their taxes."

I am inclined to believe that Bill Gates or Warren Buffet, would not lose their incentive to work just as hard and amass wealth if their incomes are taxed at 50% (in fact, Mr Buffet, himself claims that he pays only 17% of his income, mainly dividends and other capital gains, as income tax), instead of the present marginal tax rate of 35%. In otehr words, given the massive amount of wealth that would still be remaining after the tax, those very rich may be "indifferent" to the marginal tax rate. This new dimension to taxation comes in the context of the sharp rises in the wealth of the very rich in the recent years and the increasing of the very rich. (All of the world's 100 richest individuals are worth much more than $7billion.)

Previously, with smaller base and smaller levels of wealth, it may not have been efficient to tax them at very high marginal rates. Now, even with all the transaction costs and the possibility of evasion, the figures involved are too big (The total wealth of the Forber Top 10 being $600bn) to raise a handsome tax revenue, with limited misallocative effects.

Monday, November 12, 2007

Carbon Tax Vs Emissions trading

One of the most interesting public policy debates today involves addressing the issue of climate change. Governments across the world are faced with the challenge of reducing emissions of greenhouse gases, which depletes the ozone layer and thereby promotes global warming.

The two policy options available are the cap and trade emssions trading scheme and direct taxes on carbon emissions. The cap and trade scheme, which is already under implementation in the European Union and as part of the Kyoto Protocol, limits the carbon emissions and permits surplus emitters to purchase carbon credits from the market. It is argued that a system of cap on carbon emissions coupled with the creation of a market in carbon credits would result in efficient allocation of resources. Those carbon emitters who can reduce their emissions at the least cost can sell their saved carbon credits to those emitters facing higher marginal costs.

Ever since the cap and trade scheme became established, several distortions have crept into the market. It has distorted incentives and has not significantly reduced emissions. Some studies show that emissions by the biggest carbon emitters, involved in the trading scheme, have actually increased. It has also resulted in misallocated subsidies as projects which would have come through in the normal course have been subsidized on the grounds of energy efficiency. In many cases the caps have been placed at very high levels and allowances allotted very liberally thereby defeating the very purpose of such schemes. All these aforementioned problems have meant that while the cap and trade scheme has not made any significant dent on carbon emissions, its benefits too have been captured by vested interests and corporate groups.

Harvard Professor Greg Mankiw has described the cap and trade scheme as a "tax on carbon emissions with the tax revenue rebated to existing carbon emitters, such as energy companies". He describes it appropriately as

Cap and trade = Carbon tax + Corporate Welfare

The other option is of a carbon tax, originally proposed by AC Pigou, and called a Pigouvian Tax. The carbon emissions are a classic negative externality, and the carbon tax would internalize the costs inflicted by the externality producer. The electricity or fuel producer and its consumer will bear the cost of carbon emitted by their actions. Taxing the carbon content of the fuel, or the amount of CO2 emitted per unit of energy, would put a uniform price on carbon emissions. This would align the incentives by discouraging the carbon intensive fuels like coal and oil, and encourage low carbon fuels like natural gas. Further, with a carbon tax, some of the renewable energy sources start looking commercially attractive options.

Prof Mankiw has emerged as one of the foremost advocates of carbon taxes today. He lays out a case for carbon tax in his New York Times, Economic View column, One Answer to Global Warming: A New Tax . He advocates that the tax can be sold politically by sugar coating it with a proposal for lowering payroll or some other tax with a wide base. This tax would transfer the cost of global warming and climate change on to the carbon emission producers - the oil companies and the thermal electricity producers.

Update 1:
Thomas Friedman has thrown in his weight in favor of a Gasoline Tax, that would discourage oil consumption and thereby reduce and even partially reverse the flow of American consumers' money to the oil producers. He quotes Prof Greg Mankiw, “(a Gasoline tax would cause) the price of oil would fall in world markets. As a result, the price of gas to [U.S.] consumers would rise by less than the increase in the tax. Some of the tax would in effect be paid by Saudi Arabia and Venezuela.”

Update 2:
Joseph Stiglitz made a case for a Carbon Tax on the eve of the UN Climate Change Conference in Bali in December 2007, Carbon Taxing the Rich. He writes, "Economic efficiency requires that those who generate emissions pay the cost, and the simplest way of forcing them to do so is through a carbon tax. There could be an international agreement that every country would impose a carbon tax at an agreed rate (reflecting the global social cost). Indeed, it makes far more sense to tax bad things, like pollution, than to tax good things like work and savings. Such a tax would increase global efficiency."

"Polluting industries like the cap-and-trade system. While it provides them an incentive not to pollute, emission allowances offset much of what they would have to pay under a tax system. Some firms can even make money off the deal. Moreover, Europe has grown used to the concept of cap-and-trade, and many are loathe to try an alternative."

Sunday, November 11, 2007

Municipal Bonds in India

With 30% of its population residing in its 5161 towns and cities and growing fast, it is estimated that our cities would require investments of over $200 bn in urban infrastrucutre over the Eleventh Five Year Plan period (2007-2012). The World Bank estimates that atleast $37 bn is needed over the next decade, just to provide safe drinking water and sanitation to city residents. Property taxes and assigned revenues (stamp duty, entertainment tax, motor vehicle tax), apart from state grants, form the overwhelmingly major share of municipal finances. These revenues while adequate for financing smaller works, are nowhere large enough to finance capital intensive infrastructure projects. It is therefore imperative that our Urban Local Bodies (ULBs) look at raising reources externally to fund its huge requirements.

The Government of India have recently thrown open the doors for atracting urban infrastructure investments through the pooled financing mechanism. A Pooled Finance Development Fund (PFDF) of Rs 400 Cr ($100 mn) for the 10th Five Year Plan period, has been set up to help ULBs finance their investment needs. This PFDF will provide ratings enhancement facility through a Credit Rating Enhancement Fund (CREF) and raise the credit worthiness of all bond offerings to investment grade. This additional credit protection to the ULBs and the lenders/investors is expected to reduce the costs of capital and encourage ULBs to shed their apprehensions and enter the Municipal debt market to finance their investment needs.

The ULBs will have to access the market through a State Pooled Finance Entity (SPFE). Further, it is also proposed to purchase guarantees from financial institutions willing to underwrite the risk of a cash-flow shortfall. All this additional layers of credit protection, over and above the Project cash flows, is meant to mitigate the risks, lower the cost of capital and thereby encourage the growth of Municipal debt market in India. While credit enhancement facility may be a good short term intervention to facilitate the emergence of an active Municipal Bond market, there is no substitute for the ULBs getting their financial houses in order.

Under the pooled financing mechanism, a number of infrastructure projects will be pooled together and debt finance raised. The cash flows from them will be escrowed into a special bank account from which the bond investors will be repaid. This arrangement has many advantages
1. Helps risk diversification. Even if one project is doing badly, the others can make up the loss due to that
2. Less economically viable, but socially useful projects, can bandwagon on the more bankable projects.
3. By pooling together a number of projects, it can help finance more projects.

While most smaller municipalities are surely constrained by their dismal balance sheets, this should not prevent them from financing major investments in civic infrastructure by the pooled financing option. The project mix, refinancing pattern and schedule may be appropriately structured, so as to give the financiers enough confidence in mitigating their risks.

In the US it is common for the various State governments to fund major infrastructure projects by issuing municipal bonds (or munis) by leveraging the federal, state and local body finances. The US Municipal Bond market is $2.2 trillion strong and forms nearly 10% of the total debt market. With more than $300 bn worth such bonds issued in 2005-06, given its tax deductible nature, it is one of the highest yielding debt instruments.

In contrast, a mere Rs 850 Cr ($210 mn) has been raised through Municipal Bonds in India since the first Municipal Bond issue by Bangalore in 1997. Municipal Bonds form nearly 10% of the debt market in the US. Tamil Nadu and Karnataka are the only tow states to have raised resources from the market through the pooled finance route. Further, all the Municipal Bonds issued by Indian ULBs have been more in the nature of general obligation bonds, financed by escrowing property tax or other internal ULB revenues. Again in contrast, the US Municipal Bonds are mainly revenue bonds, financed by the revenue streams associated with specific projects.

The Indian debt market suffers from the crowding out phenomenon, both from the short term markets and Government debt. Short term investments in banks lock up over 40% of the household savings in India. Long term investment is distributed between Government debt securities, 17.7%, insurance, 14.9%, and pension funds, 13%, and more or less all of this ends up financing Government fiscal deficits. The high interest rate offered by investments in Government instruments, has also prevented the development of greater depth and breadth in the Indian debt market.

There is an element of the lemon problem facing municipal bond market in India. A recent study of the 63 JNNURM cities by the Waer and Sanitation Program (WSP) found that the major demand for debt is coming from those ULBs that are strapped for finances and have weak balance sheets. In contrast, the stronger and richer ULBs are trying to fund their investments from internal revenues, reluctant as they are to venture into the debt market. The potential adverse selection problem is getting reflected in the municipal bond market in the higher interest premiums demanded. This risk can be mitigated by moving away from financing the ULB to financing specific projects.

One of the biggest concerns for investors in ULBs arise from political related risks. It is therefore necessary to put in place all possible measures to insulate Project financing structures from political interference or decisions based on political and other external considerations. More than any credit guarantees, investors will value guranteeing such Projects from politically populist interventions. Tarrifs and other revenue streams from such projects need to be fully insulated from the vagaries of all politics. Given the weak institutional capacity of ULBs to monitor the implementation of such arrangements, it is also imperative that release of funds is followed by capacity building to monitor its implementation.

The Government is also considering utilizing atleast a part of its burgeoning foreign exchange reserves to fund infrastructure requirements. These reserves can be used for non-inflationary spending by financing imports of capital equipment and technology for bigger infrastructure projects.

Friday, November 9, 2007

Why cities die?

Declining cities get trapped in a vortex of self fulfilling prophecies. Investments and jobs fall, resulting in a drop in incomes and spending, thereby generating a negative feedback of income and economic decline. This turns away the more well off and attracts the poorer, and so on, thereby triggering off another negative feedback loop of social degeneration. How do these cities get out of this poverty trap? What is the role of Government in such situations?

A similar logic applies to the Old Town areas of many of our cities. Having failed to keep pace with the requirements of the modern economy, these areas start declining. This in turn sets off a vicious cycle of falling land and rental values (relative to the other areas), thereby attracting the poorer residents. Slowly these areas develop slum like characteristics, and degenerate into oblivion. Crime and violence follows soon, and the downward spiral gathers pace.

Old Town streets and roads are typically narrower and are marked by perpetual traffic congestion. The absence or poor enforcement of zoning and building regulations in those times have resulted in buildings packed cheek-by-jowl with a riotous manifestation of mixed residential and commercial usages. Most of these buildings are old, located on small land holdings and with little or no open space. Given the stringent setbacks and parking requirements, there is limited possibility of reconstruction in such small landholdings without consolidation.

Further, the old and declining areas attract hawkers and street vendors for two reasons. First, their cheaper products have a bigger and more willing market in these areas. Second, they find cheaper accomodation in such areas. Given the poor public transport and the large commuting times, the attraction of a work place closer to their homes is invaluable. The presence of hawkers and street vendors in turn attracts more of them and the cycle builds up, converting areas into hawker markets. Hawkers invariably end up occupying road margins and vital junction spaces, thereby further reducing the road carriageway and exacerbating the traffic problems.

For historical and other reasons, old town areas are also the trading centers of a City. These locations are characterized by wholesale shops and large godowns. This in turn generates employment for headload workers, laborers, and push cart and other transport vehicle drivers. Given the availability of cheaper accommodation and the need to live close to their workplaces due to their odd working hours (Given the restrictions on entry of heavy vehicles to the City during daytime, most trading logistics have to be operated in the night), these people end up residing in the Old Town area itself.

Some element of demographic dynamics is also at work in promoting the decline of these areas. A disproportionately high share of households in the older areas of many Indian cities consist of joint families living in these old houses. Those joint families whose members have moved away, divides the accommodation into small portions and leases it out, so as to maximize their rental incomes. That the major demand is from the poorer migrant working families helps. Such social cultures encourage the development of large numbers of small scale economic activities, that invariably get located on the street margins. For example, the large number of families in each house and the lack of space, means that street side food vendors are patronized.

Harvard Professor, Edward Glaeser has chronicled the dramatic decline of the City of Buffalo from its pre-war era pomp, as one of the leading cities of US. In Can Buffalo ever come back?, he claims that cities fall into poverty because of relocation of industry and drop in labor demand, and declining areas becoming magnets for poor people attracted by cheaper housing. "The influx of the poor reinforces a city’s downward spiral, since it drives up public expenditures while doing little to expand the local tax base."

Prof Glaeser also argues that many old cities managed to stave off their decline through investments in the promotion of human capital. He writes,
"The cities that bounced back did so thanks to smart entrepreneurs, who figured out new ways for their cities to thrive. The share of the population possessing college degrees in the 1970s is the best predictor of which northeastern and midwestern cities have done well since then."

Vijayawada as a whole and different areas within the City have many learnings from Prof Glaeser's study. Being a major center for trading and other services, Vijayawada attracts a substantial number of migrant population. Over the years, the City's development has driven a very distinct wedge between the newer Patamata and Governorpeta areas and the Old Town area. While the former has propsered and is fast accquiring all the trappings of modernity and prosperity, the latter has been on a slow decline, which threatens to fall into an uncontrolled downward spiral. (or it may be waiting for the appropriate downward tipping point!) Apart from other socio-economic and political factors, massive Government investments in civic infrastructure has contributed in no small measure to the development of the newer areas. It has provided them with atleast the basic facilities required to attract migrants and the newer residents of the City.

Government policies may have unwittingly exacerbated the divide by relocating numerous slums and encroachments from these areas to the Old Town and Ajith Singh Nagar areas, which have in turn become more slummified. This may have occurred due to the scarcity of vacant Government lands in the newer areas and the availability of such lands in the Ajit Singh Nagar side. Further, given the much higher land values in the newer areas, utilizing these areas for resettling slums will have very high opportunity costs. This divide has been so internalized and subliminally institutionalized that all encroachment relocations today are invariably to these areas. There are only a couple of slums in the newer areas of the City and these too have been provided with all the basic civic infrastructure.

Good quality basic civic serices like water supply, sewerage, sanitation, and transport are today one of the primary pre-requisites for attracting residents. The best indicator of this trend is seen by the increasing differential in rents between areas with such facilities and those deficient in them. Wide roads and good transport facilities play a crucial role in enhancing the economic utility of any area. The newer areas of Vijayawada have benefitted enormously from road widenings, which have set in motion a chain of regeneration and renewal activities in the economy.

Prof Glaeser also brings out numerous examples of failures of massive Government investments in infrastructure in these failing cities, and drives home the ineffectiveness of such responses alone in stemming migration and the attendant decline. It is something similar to good money thrown in after bad money!

Policy makers have an interesting dilemma here. Investments in infrastructure are necessary and are the basic pre-requisite for giving these declining cities and areas, atleast the slightest chance of a revival. Choking off that opportunity would be the surest way of ringing thier death knell. But it is also true that many investments, especially in transport infrastructure end up being white elephants or being disproportionate to the need and requirements. Many modern infrastructure investments require a critical mass of consumer base who can afford to pay for its use. But declining and poorer areas of a City cannot muster this critical mass, thereby necessitating Government support. In any case investments in mega infrastructure projects require more rigorous due diligence and cost-benefit analysis and most importantly, substantial private sector participation for its sustainability and success.

But merely developing good civic infrastructure will only help attract those newer migrants to Vijayawada to such areas, but will not by itself contribute towards attracting migrants to the City. Similarly, massive investments in human physical capital will by itself not be able to stave off a decline. Both are necessary pre-requisites, they are not by themselves sufficient. While basic civic infrastructure is necessary to sustain a regeneration or redevelopment of the City or area, development of human physical capital is the major ingredient in incubating a regeneration.

As we have seen, a number of social, demographic and economic forces are in operation in declining areas of any City. Any effort in reviving these areas will have to account for these forces. There cannot be simple tailor made solutions. Road widenings can be useful in triggering off some of these activities and redeveloping these areas. Government policies making it mandatory to bring down very old buildings, coupled with policies incentivizing consolidation of holdings can promote redevelopment in these areas.

Government intervention is necessary to catalyse private investment in both physical infrastructure and human capital. Very often policy makers tend to get carried away by the mega infrastructure projects, and make masssive investments in one or two projects in the belief that it can regenerate old and declining cities. But as the Glaeser study shows, the world is littered with similar mega investments which have failed to achieve the objective. Further, in the absence of investments in human capital to develop local entrepreneurial skills, no amount of investments in physical infrastructure can prevent the decline of cities.

Thursday, November 8, 2007

End of Hegemony dreams!

Antonio Gramsci coined the term hegemony to describe the dominance of one ruling group over another, by willing consent as opposed to force. He traced this power of the hegemon to the "spontaneous consent" of the populace through intellectual or moral leadership, what Harvard Professor Joseph S Nye Jr popularized as "soft power". History is replete with numerous examples of the dominant political and economic power of the time trying to impose its hegemony over other nations. The ideologies and policles of successive American Governments after the collapse of communism, have clearly pointed towards continuation of that trend. However this effort was at a more benign cultural and economic hegemony initially, but became more overtly political as the neo-conservatives asserted power.

Post 9/11, the hegemony project gathered pace, and Dick Cheney and Donald Rumsfeld team felt that the shadow of terrorism and international security could be a convenient alibi to expedite the hegemony. The wise men at Pentagon and the Foggy Bottom also saw the Iraq threat and a quick, presumptive strike as an excellent opportunity to impress on the free world, the benefits of American leadership and military prowess and instill fear among the recalcitrant "rogue nations". And this is where it all started to go terribly wrong.

"Squandering the immense influence of the US in such a short period has required monumental effort. Now the fog of war clears. On the ruin of the neocons' new world order emerges the old world disorder on steroids", so writes Sidney Blumenthal in Tyranny on the March.

He describes Gen Parvez Musharraf's recent imposition of national emergency and martial law, despite strong American protestations, as the surest indicator of the end of American hegemony. "Gone are the days when the stern words of a senior US official prevented rash action by an errant foreign leader and when the power of the US served as a restraining force and promoted peaceful resolution of conflict. In the vacuum of the Bush catastrophe, nation-states pursue what they perceive to be their own interests as global conflicts proliferate. The backlash of pre-emptive war in Iraq gathers momentum in undermining US power and prestige."

Benign hegemony of the sort cultivated by the US and USSR during the Cold War had geo-strategic benefits. Despite all the detrimental effects on the society and economy of both the subordinates and the hegemons, it was a fact this benign (and sometimes not so bengin) hegemony papered over civil wars and moderated or atleast kept a lever of control over the actions of tyrannical dictators and military rulers. The utility of such hegemony became very visibly evident in the aftermath of the Cold War with the eruption of civil wars, break-up of countries, re-alignment of alliances, and the loss of any control over the actions of rogue leaders. International diplomacy will have to step into this vaccum, before some other pernicious element takes its place.

Wednesday, November 7, 2007

When both SRK and Sony refused to "chicken"!

There are two big blockbuster film releases for this Diwali weekend. Saawariya, directed by Sanjay Leela Bhansali, and produced by Sony Pictures Entertainment, will be the first Indian movie produced by a Hollywood production house. Om Shanti Om (OSO) is the latest film of Shahrukh Khan (SRK) and is produced by his own production house, Red Chillies Entertainment. Here is a high stakes game if there ever was one - a Hollywood studio's first foray into Bollywood and a movie acted and produced by SRK!

Now game theorists would call this setting similar to a classic two player, Chicken Game. The name "Chicken" has its origins in a game in which two drivers drive towards each other on a collision course. One must swerve, or both may die in the crash. But if one driver swerves and the other does not, that driver will be called a "chicken". While the most desired solution for each driver is for him to go straight and for his opponenet to swerve. Both drivers think likewise, and may refuse to swerve, and end up crashing into each other. This game has been used to model many games of brinkmanship, including the posturing between nuclear weapon powers.

Here are two films under production. Both are big-budget, big banner, star studded and highly anticipated releases. Both want to capture the Diwali weekend market. But if both are released at the same time, there is large possibility of each film cannibalizing the other's market. If both were released separately, each would be able to dominate the market and maximize their revenue earnings. But Diwali is a special opportunity, with higher payoffs (both financially and in terms of star quotient/reputation/ego, and I am inclined to believe that it is the former that is the dominant consideration), which both producers are not willing to forego.

In such circumstances, if Saawariya blinks and postpones its release, it leaves the entire Diwali market to OSO. The producer of OSO thinks likewise. A stalemate is reached, with both not wanting to leave the market open to the other. It is a different matter that given their high profile, both films will be able to rake in its share of profits irrespective of the release time. But during Diwali, by going head on against each other, it gives the audience and its merchandise customers a choice between the two. In the absence of a choice, as would be the case if they are not competing against each other, each film would have had the entire market for itself, and would have been able to maximize revenues.

In such circumstance, the equilibrium solution is when both production houses refuse to blink and go on to release their films together for the Diwali weekend. So both SRK and Sony refused to chicken out!