Wednesday, April 30, 2008

Tale of two tax concessions

Two major policy decisions yesterday by the Government of India.
1. Export duties on steel products increased, customs duty on pig iron and mild steel scrapped, import duties on skimmed milk powder and butter oil lowered. These came as part of the Government's inflation control measures involving removing supply side constraints. The lowering of import duties is aimed at keeping imports cheaper, while the higher export duties are aimed at discouraging exports.

They achieve their objective when the producers transfer a significant share of the duty cuts to the consumers, thereby lowering the prices. How do we ensure this? Does the market mechanism and its functioning ensure the allocation? Eco 101 teaches us that the incidence of tax between the consumers and producers is determined by the price elasticities of demand and supply.

In the instant case, for say, steel and cement, demand is soaring and given the massive ongoing infrastructure and construction projects and overflowing work orders of major firms, we can safely say that demand is likely to be extremely inelastic to prices. On the supply side, the steel and cement prices are ruling high in the world markets. In an integrated global market, these products will flow to those markets where the prices are highest (some of the committed orders will be willing to pay higehr prices) and which are the largest (which we surely are one). Therefore, we can assume that supply will be more elastic, especially when it comes to large markets like India.

In this context, Eco 101 tells us that any tax cut is most likely to be cornered by the producers, both domestic and external. The Government's objective would therefore fail, and the tax cuts would only add to the producers' bottom-lines, already swelling from the historic high prices. The challenge therefore is to get the producers to transfer a greater share of the tax concessions to the consumers, so that the general price level comes down.

There is recent precedent too on this. The large tax concessions given in this year's budget has all gone into swelling the producer's coffers and has contributed little to lowering prices. The Finance Minister has been talking to steel and cement manufacturers and has threatened action if the producers do not pass on the tax cuts by way of lower prices. Maybe such non-market action is necessary to achieve the objective. But can even this achieve it? Let us evaluate after two or three months!

2. Fiscal concessions to STPIs and EOUs extended by a year till March, 2010, and duty on newsprint lowered to 3%. The concession to the software companies will benefit them to an extent of 5-7% on the effective tax rate. These subsidies to the producers are surprising since software and newspaper industry in India is not facing any crisis other than that arising from competitive pressures while competing in a world economy.

The tax concessions under Section 10A to software companies could have been justified in the initial stages when our software industry was finding its feet. But now after having established themselves as highly competitive world-wide, protection and support by way of tax concessions are no longer required. The only purpose to be served by continuing these concessions is to boost the bottom-lines of software companies. In that case, the same logic will be applicable in March 2010 too - for further extension!

Tuesday, April 29, 2008

Why rice trade will not solve the problem?

This post is in continuation to my previous post on the role of trade in lowering global rice prices. Globally rice prices have risen spectacularly, with the FAO figures showing that the price of medium-grade Thai rice is up 120% since February, from $310 to $795 on 2nd April, 2008.

Experts argue that the major reasons for high rice prices include rising long-term demand in as continent sized numbers of Asians emerge out of poverty every year, weather and pest induced supply shocks in some large rice exporters, urbanization and diversion of land for industrial purposes (SEZs etc), and increased demand for alternate staples like rice due to biofuel induced higher corn prices. The relevance and relative importance of each reasons can be verified only with more controlled studies.

This post is from a largely Indian perspective. India is the 2nd largest producer, 3rd largest exporter and one of the biggest consumers, and is currently experiencing foodgrain price inflation. Indian rice production though has been robust, and is estimated to grow to a record 94 mt in 2008. The Government of India had recently responded to the rising inflation by imposing an export ban on all non-basmati category rice grains. The Government hopes that this will keep rice inflation under control here.

Too many of the arguements in the ongoing blog debates has been about how higher prices will incentivize farmers to expand their rice production. It is also felt that farmers will get a better deal from this. And international trade will facilitate all this. However, arguements that price signals will incentivize farmers to move into expanding their rice farmlands is not borne out by reality. Unlike other commodities, rice farming has many distinct characteristics that are likely to come in the way of the aforementioned simple benefit transmission.

1. Farmers do not automatically get higher prices merely by producing. In the absence of adequate access to credit, storage facilites, markets, and other linkages like commodity futures, the major share of the higher prices is skimmed off by the traders and middlemen. The overwhelming share of farmers in developing Asia face this dismal scenario. And breaking this stranglehold is not a simple issue of more investments in agriculture. More about this in a later post.

2. The returns from other produce intended mainly for the rich country markets are much higher, while that from farm diversion to other activities is many times higher and immediate. Thanks to contract farming and the presence of the major export companies, the production of export crops are more organized. But unfortunately, these organized groups prefer the larger farmers, and see limited utility in the smaller farmers.

3. The incentive of higher prices is not likely to expand rice production also because, unlike other foodgrains and agriculture commodities, the overwhelming share of rice is cultivated by farmers in small landholdings. They have limited resources and flexibility to respond to higher price signals.

If higher prices translated into better deal for farmers, then Thai and Vietnamese farmers ought not be giving away their valuable farmlands at alarming rates. For example, land under cultivation in Thailand fell 13% in the 1995-2005 period, and Vietnam is losing about 1 lakh acres of rice growing lands to construction activites every year. Merely promoting trade without addressing these more deeper issues will only lead to a deepening of the crisis. As I wrote earlier, it will only get "the wheat producers in the Gangetic plain and rice producers in the Krishna-Godavari basin in India shift to sugar cane, in response to a massive demand for sugar cane based ethanol bio-fuel".

There is an interesting analogy here with the sub-prime crisis. The US Fed and a number of commentators treat it as a liquidity crisis and have been inclined to keep lowering the interest rates, so as to ease the financial sector out of the crisis. However, the more important and serious issue of solvency which dictates that somebody has to, at some time, own up these massive losses on their balance sheets, (unless we can roll over indefinitely from one bubble to another) has been quietly sidelined. Similarly, ignoring fundamental issues and focussing on rice trade will only fuel the party further, till the spectre of starvations looms large!

Theoretical principles rarely give simple solutions to complicate socio-ecconomic problems. There is a lot of distance to be travelled between theory and solutions. Economic trade theory needs to be distilled in light of the specific contexts of each commodity and country, for drawing meaningful conclusions.

Food security (and energy security) is too important an issue to be left to the workings of a long-term strategy that promotes trade. The present food crisis only highlights the fact Governments need to have clear policies on food security issues. Democratic governments, especially those facing elections, can apply logically consistent economic principles, without any tangible short or medium-term results, only at their peril. If not, in the real world, ruling parties will lose elections and as Keynes said, "in the long run, we are all dead"!

Update 1
Gary Becker traces the current price pressure on foodgrains to "the boom in petroleum prices and subsidies to ethanol and other biofuels". During the past year, one quarter of American corn production, and 11 percent of global production, was devoted to biofuels, and the acreage devoted to corn in the United States increased by over twenty percent in 2007-8, while that devoted to soybean production declined by more than fifteen percent.

He argues against export restrictions like those imposed by countries like India, Argentina, Russia and Vietnam. He feels that while these controls help in temporarily keep a lid on domestic prices, it harms domestic farmers and prevents them from getting the best deal for their produce.

Prof Becker's contention that these restrictions adversely affect the farmers and favor the urban consumers may be off the mark, especially in the context of the developing countries. Unlike in the developed economies, the overwhelming share of rice and other foodgrain farming in countries like India are done by small farmers, on smaller land holdings. In the absence of adequate upstream linkages, the predominant share of farmers - small and marginal farmers - are likely to benefit little from higher global prices. The middlemen knock away these benefits. In any case, the domestic foodgrain procurement policies, as that involving the Minimum Support Prices (MSP) in India, most often reflect the rising international market prices.

Sunday, April 27, 2008

Coasean bargains on civic issues

There is an interesting blog debate going on between Megan McArdle and Kathy G on the application of Coase Theorem.

The debate was triggered off by Megan McArdle's suggestion that Coasean bargain would take care of any conflict of preferences between two neighbours on enjoying loud music and silence. Kathy G reponded that a Coasean bargain is not possible in such a situation, since both transactions costs (information costs on locating the relevant rules, enforcement costs in getting police to register cases) are high and property rights ill-defined (Rules on loud music, silence etc).

The Coase Theorem states that, in a dispute concerning an externality, if transaction costs are low (or nonexistent) and property rights are well-defined, the parties can bargain their way to an Pareto efficient outcome(with no one being worse off and at least one person being better off). The Coase Theorem is value neutral, in so far as it is silent on fairness.

Kathy G illustrates this with an example, "A poor person living near a toxic waste dump may have a very strong preference indeed to see that waste dump removed. But even if transaction costs are zero and property rights are well-defined, that doesn't mean she'll prevail in a Coase bargaining scenario. If she has less money than the polluter, her preference, no matter how strong, will not be realized. All the Coase theorem says is that, after bargaining, she won't end up worse off. But if her resources are less than her opponent's, her preferences would not be satisfied."

Kathy G writes, "Libertarians tend to be fond of the Coase theorem, but that is because they often misunderstand it. They're likely to be enamored of the idea of autonomous actors in a free market bargaining their way to an efficient solution, with government staying out of the matter entirely. They especially prefer the Coase solution to the Pigouvian mechanism, in which the externality is internalized via a tax. But in the real world, a Coase solution to an externality is not necessarily going to be any more efficient than a Pigouvian one."

Though it is widely accepted that a Coasean bargain is difficult in the real world, Coasean-style transaction costs can be used as an analytical tool to understand how, and under what conditions, markets work.

I had dwelt with the possibility of Coasean bargains in urban areas in an earlier post in the context of Kaldor-Hicks test to determine whether an outcome is efficient or not.

It is commonplace to have complaints against some objectionable shop or commercial establishment located in predominantly residential areas, causing inconvenience to its neighbours. There is a simple solution to this problem. Assume Mr Welder wants to set up a welding shop in Soundfree Colony. Assume also that the Plant generates costs on the neighbours amounting to Rs A, and it would cost Mr Welder Rs B to relocate elsewhere. If Rs B > Rs A, then there is a possibility for a mutually beneficial bargain between the parties and Mr Welder continuing his business in Sound free colony. (The cost could for example be the amount required for setting up sound proofing system)


The problem, as Kathy G points out, lies in the transaction costs and definition of property rights that are necessary to strike the locally negotiated bargain. This is why libertarian solutions to neighbourhood civic problems fail, thereby necessitating intrusive Government regulation. But such regulations invariably develop a web of bureaucracy, with its attendant corruption and other distortions, that detracts from achieving its objectives. In the circumstances, the right way forward would appear to be taking adequate steps to lower transaction costs (local dispute settlement/negotiating mechanisms) and more clearly define individual and common property rights.

Update 1 (2/8/2010)

NYT reports of a windfarm in Oregon paying $5000 to buy silence of neighbors on the sounds made by wind turbines.

Rice trade and lower prices

Tyler Cowen feels that the solution to lowering foodgrain prices is to have more trade in foodgrains. In view of the recent restrictions on rice exports in rice-producing countries like India, Indonesia, Vietnam, China, Cambodia and Egypt, global trade in rice is expected to decline by 3%. Cowen feels that restrictions on rice trade, which sees trade and production as a zero-sum game (one country's gain is another's loss), distorts the long run incentives for producers and chokes production.

He writes, "Export restrictions send a message to farmers that their crops are least profitable precisely when they are most needed. There is little incentive to plant, harvest or store enough rice — or any other crop, for that matter — as a hedge against bad times."

Cowen also argues that the very fact that an increasing proportion of major foodgrain production comes from poorer countries itself contributes to an inability to adjust quickly to global demand-supply mismatches. These poor countries are more likely to be protectionist, have stifling regulations, have restrictions on internal trade, and Government monopolies in trading.

These poor countries are also constrained by corruption in the rice supply chain, poorly conceived irrigation systems, terrible or even nonexistent roads, insecure property rights, ill-considered land reforms, and price controls on rice. Cowen argues that these countries could easily increase their production manifold, if they could adopt many of the aforementioned practices and institutions, and thereby incentivize their farmers to respond quickly to global demand-supply mismatches.

I am inclined to believe that Cowen has got this one wrong on many counts. In the first instance, the article has little to illuminate as to how the central problem, that of higher rice prices, can be controlled by merely opening up economies to trade.

Secondly, the trade in agriculture commodities is very low not because of lack of incentives to trade, but because all these commodities have large captive domestic markets. In fact, in many countries, the domestic demand itself is too large to be covered by domestic production alone.

Third, rice and other staple food grains like wheat, especially in the poorer countries, are unlike other commodities. They exhibit inelastic characteristics - both from the supply and demand sides. On the demand side, these staple food grains do not have any substitutes and will have atleast the same demand, whatever be the price rise. On the supply side, it is very difficult to increase production significantly in the short term by bringing more land under cultivation or shifting from other crops or introducing technology and innovative practices to increaswe productivity.

Fourth, most countries and their farmers do not need the incentives of global trade to increase their production. The internal demand itself is booming in countries like China and India and their producers are not able to keep up with the growing demand. It is true that easing the internal restrictions and constraints that Cowen writes about, will help in incentivizing farmers to produce more.

Fifth, even higher production need not necessarily lead to lower prices, given the large and complex factors that determine global food prices - weather, bio-fuels, energy prices, agriculture policies in developed countries etc. Historically, foodgrain prices have fluctuated sharply in response to many of these aforementioned factors.

Sixth, even if global agriculture trade is deregulated and farmers have the full freedom to shift production in response to price signals, it will not ensure that the poor consumers in Asia and Africa are insulated from price rises for their staple grains. In fact, a free and unregulated market will exacerbate the crisis. Imagine what it would do to food security in India and across the world, if the wheat producers in the Gangetic plain and rice producers in the Krishna-Godavari basin in India shift to sugar cane, in response to a massive demand for sugar cane based ethanol bio-fuel!

Seventh, the major demand for rice and similar staple foods are mainly in the poorer developing countries, whereas the major demand for competing substitutes like bio-fuel crops etc come from the developed world. In an open global market in agriculture commodities, the price signals will always incentivize farmers to cater to the developed markets.

Finally, the whole objective is not to have, as Cowen claims, trade in rice "flow to the places of highest demand", but to have food security for all. It is undoubtedly true that trade will ensure that rice will flow to the countries with highest willingness to pay. Translation, the rich and well off will get their rice, while the others starve!

It is therefore critical that there be pro-active Government intervention to both ensure that staple foodgrain production is increased and these grains are available to the poorest at affordable prices. The answer to food security surely does not lie in Milton Friedman.

Saturday, April 26, 2008

Role of rating agencies

The aftermath of the sub-prime mortgage crisis has brought to sharp focus on the role played by the credit rating agencies in inflating the bubble. Roger Lowenstein chronicles the anatomy of these ratings and the evolution of rating agencies in a revealing NYT article.

Frank Partnoy, a professor at the University of San Diego School of Law who has written extensively about the credit-rating industry, says that thanks to the industry’s close relationship with the banks whose securities it rates, they have behaved less like gatekeepers than gate openers. This was best manifested in the numerous sub-prime mortgage loan backed securities being rated tiple -A! Last year, Moody’s had to downgrade more than 5,000 mortgage securities — a tacit acknowledgment that the mortgage bubble was abetted by its overly generous ratings.

Friday, April 25, 2008

End of Easterlin Paradox?

Justin Wolfers and Betsey Stevenson have just presented their latest paper which claims to lay to rest the "Easterlin Paradox", which had argued that only relative income matters to happiness. They claim that "the relationship between subjective well-being and
income within a country (that is, contrasting the happiness of rich and poor members of a society) is similar to that seen across countries (contrasting rich and poor countries), which in turn is similar to the time series relationship (comparing the happiness of a country as it gets richer or poorer)".

In 1974, Richard Easterlin, then an economist at the University of Pennsylvania, published a study in which he argued that economic growth didn’t necessarily lead to more satisfaction. Justin Wolfers describes the Paradox as the juxtaposition of three observations:
1) Within a society, rich people tend to be much happier than poor people.
2) But, rich societies tend not to be happier than poor societies (or not by much).
3) As countries get richer, they do not get happier.

Numerous subsequent studies, including by Nobel laureate Daniel Kahneman, pointed to a "hedonic treadmill", in which we must keep consuming more just to stay at the same level of happiness.

Marshalling an impressive array of post-war data, especially from happiness surveys from across the world, Wolfers and Stevenson observed the evolution of GDP and happiness through time, and conclude that
1) Rich people are happier than poor people.
2) Richer countries are happier than poorer countries.
3) As countries get richer, they tend to get happier.

Plotting the average level of happiness against average national incomes (log scale)for 132 countries from the 2006 Gallup World Poll, they find an incredibly high correlation of greater than 0.8.



Wolfers argues that far from there being an income "satiation point" beyond which you just don’t benefit from greater income, the slope gets steeper after national income crosses $15000! Further, a $100 rise in income has many times more effect on happiness in low income countries than in the high income ones.

Justin Wolfers tracked the evolution of happiness with increasing incomes in US, Japan and Europe (9 nations) in the 1973-2007 period, and found that in general happiness increased with incomes, though there were a few notable exceptions.

Comparing happiness within countries over a period of time and between countries, the authors get more conclusive evidence that comparisons of rich and poor yield the same conclusions as comparisons betweene rich and poor countries. The arrows in the figure below shows the slope of the well-being-income gradient for each country, while the dots show the average level of happiness and G.D.P. for each country. The dashed line shows the best fit through these dots.



Angus Deaton had dealt with the issue earlier here.

Update 1
Chris Dillow links to evidence suggesting that happiness is infectious and how other people’s high incomes might make us more aware of our relative poverty.

Thursday, April 24, 2008

Role of mega-regions in the global economy

Richard Florida claims that the real drivers of global growth are mega regions.

He writes,"While there are 191 nations in the world, just 40 significant mega-regions power the global economy. Home to more than one-fifth of the world's population, these 40 megas account for two-thirds of global economic output and more than 85% of all global innovation.

The world's largest mega is Greater Tokyo, with 55 million people and $2.5 trillion in economic activity. Next is the 500-mile Boston-Washington corridor, with some 54 million people and $2.2 trillion in output. Also in the top 10 are mega-regions that run from Chicago to Pittsburgh, Atlanta to Charlotte, Miami to Tampa, and L.A. to San Diego. Outside of the U.S., you can find megas around Amsterdam, London, Osaka and Nagoya, Milan, Rome and Turin, and Frankfurt and Stuttgart.

Mega-regions are the true force driving the rise of emerging economies. Some 40% of Brazil's total economy is made up of a corridor stretching from Rio to São Paolo. Russia is propelled by the Moscow mega. India's economy is shaped by the mega-regions of Bangalore and Mumbai."

He argues in favor of urban policies that favor densification, improving fast-rail transit between mega-region nodes, modernizing airports, and achieving greater cross-border flows of goods and people.

Paul Krugman however feels that mega-regions may not contain the density necessary to reinforce the positive spillovers from a large concentration of talent. He favors considering a smaller geogrpahical area as the basic economic unit because they are amenable to greater labor mobility and noer positive externalities arising from information spill-overs and network effects.

The Free Exchange differs and favors larger geogrpahical areas as the basic unit of economic growth. It highlights the importance of "forward and backward linkages--that is, the importance of being near to suppliers and customers in a world where transportation costs are non-negligible".

Quoting a paper by Anthony Venables and Stephen Redding, it argues that market potential--the nearness of a place to other economically vibrant places - can explain quite a bit of the differences in global wealth.

Florida's hypothesis is the policy logic behind the fast risisng support among policy makers in India for the Mumbai-Delhi and Chennai-Bangalore growth corridors. The Government of India have been actively pursuing this idea. The Japanese Government has evinced considerable interest in the Mumbai-Delhi mega region growth corridor, and a Detailed Project Report (DPR) is currently under preparation with Japanese government assistance.

However, I am more inclined to believe that while such mega regions may promote and hasten growth in those regions with an already established critical mass of entreprenuerial or industrial activity, it may achieve little in under and un-developed areas. In these areas, it may be necessary to concentrate on more important specific policies that can stimulate the local economy. Further, a mega region approach, while very efficient for promoting manufacturing and industrial gorwth, may not be relevant in case of knowledge-based industries like software and biotechnology R&D, which do not involve the same extent of linkages.

A mega region approach may be more appropriate to the Mumbai-Delhi corridor, as it would string together the numerous, already established industrial growth centers there, and promote backward and forward linkages among them. This would take care of the many inefficiencies inherent in the economic growth in these regions. In contrast, it may achieve little in the barren and undeveloped space between Chenna and Bangalore. In many ways, mega regions are something similar to the concept of integrated regional economic planning.

Monday, April 21, 2008

Futures Trading in commodities

There is an interesting debate raging in India about the role of futures trading in driving up commodity prices. Many opinion makers, including the vocal left parties in the ruling coalition, allege that forward trading in commodities has played a significant role in raising prices. Faced with mounting pressure to control foodgrain prices, the Government first banned futures contracts in rice, wheat, and pulses. Now there have been calls for banning futures trading in other commodities, including most recently on metals and mnerals.

However, a reality check indicates that these attempts have yielded limited results. The ban on futures trading in foodgrains have had little impact on their prices which have continued to rise unabated. In contrast, sugar and potatoes which are traded in the futures market, have not experienced any rise in prices.

Paul Krugman highlights an interesting observation on the role of speculative trading and the recent commodity price increases. He explains that the high global commodity prices are the result of a huge global demand-supply mismatch, and not the result of any speculative bubble or high interest rates. He has this graph from the World Economic Outlook 2008, which shows how global metal inventories have been declining since mid 2003, even as the prices have been rising.



As Krugman argues, any speculation driven higher futures prices will ultimately result in higher spot prices only if there is a shortage of commodities. In case of speculation this occurs by way of hoarding, which would naturally translate into increase in inventories. But in contrast, inventories have been falling, thereby laying to rest the theories of speculation driven commodity price rise.

Friday, April 18, 2008

Role of for-profit MFIs

The Mexican microfinance bank Compartamos, run by Carlos Danel and Carlos Labarthe, has emerged as one of Mexicos's most profitable banks. It has even gone public and, in the one year since, given a return on equity in excess of 40%. It is estimated that 23.6 percent of Compartamos’s interest income went to profits. But its success has generated an interesting debate about how microfinance institutions (MFIs) should be run and what should be their objectives.

Compartamos went commercial in 2000 from being a non profit institution. Last April, Compartamos’ owners sold 30 percent of their stock on the Mexican stock market in an initial public offering, which brought in $458 million. Compartamos grew to 840,000customers last year, from 60,000 in 2000. The success of Comparatamos and other commercial microfinance banks have set off a scramble to get into this market. Major Wall Street Banks like the Citigroup have recently sprouted their own microfinance arms. These commercial banks have been attracted by the high, 25% to 45% range of interest rates charged for microloans in much of the world.

Mr. Danel and Mr. Labarthe say microfinance will help more poor people by tapping the boundless pool of investor capital rather than the limited pool of donor money. But others disagree and say that such microfinance banks that focus on the investors and their returns, instead of the borrowers, end up defeating the very purpose of micro loans.

This debate about the role of MFIs is beside the point. Deutsche Bank estimates the global demand for microfinance loans at about $250 billion, 10 times the amount that has been lent. This huge demand cannot be met from donor assistance alone, and will have to tap into the general investor pool. Therefore banks like Compartamos have an important role to play in complementing the efforts of donor financed MFIs like the Grameen Bank.

It would have been fine if non-profit MFIs were ready to step in and replace for-profit microfinance banks like Compartamos. But given the huge gap between the demand for microloans and the available pool of non-profit microloans, any effort to ban institutions like Compartamos will only hurt the poor. The world of microloans is large enough to accomodate both non-profit and commercial MFIs, and still leave enough space for others too. And in any case, the progression from the moneylender culture with all its attendant and well documented problems to organized microloans is itself a welcome development.

Update 1 (14/4/2010)
Times captures this debate on the pros and cons of for-profit MFIs who charge large interest rates and use the MFI cover to penetrate the market at the bottom of the pyramid.

Wednesday, April 16, 2008

Interpreting statistics

That the same set of statistics can lead to impressively contrasting sets of conclusions is well acknowledged. Here is one such example, courtesy Geoff Colvin in the Fortune (April 14, 2008).

The US IRS statistics for 2005, the most recent year for which data are available, reveals that the top 10% of tax payers paid 70% of the total income tax. The top 1% paid almost 40% of all income tax, a proportion that has jumped dramatically since 1986. Further, the bottom 40% of Americans by income had, in the aggregate, an effective tax rate that is negative - receiving more money through earned income tax credit, than they paid. All this gives the clear impression that American tax system has suddenly become progressive.

Or is it that simple? Are the rich being penalized for their wealth and industriousness? Closer analysis reveals that the rich are actually paying lower effective taxes. In fact, the top 1% paid an effective tax rate of 23% in 2005, down from 27.5% in 2001.

If the rich are paying more income tax, despite being taxed at a lower rate, it only means that their incomes are growing much faster than the rest of the population. While in 1986, an income of $119,000 got you into the top 1%, in 2005 it rose to $365,000. Adjusted for inflation, the price of admission still rose by 72%. In contrast, the inflation adjusted definition of a median tax payer did not budge.

About the Bush tax cuts, while it is true that the bottom 50% got a much bigger tax cut than the top 1%, its dollar value went mostly to the rich! Why? Again because the incomes of rich grew much faster, thereby reducing their effective tax rates.

Geoff Colvin feels that the whole tax debate should be about why some people's incomes are growing so much faster than the others, and not why the rich should pay most of the income tax.

Update 1
Harvard Professors Claudia Goldin and Lawrence F. Katz in their forthcoming book traces "the sharp rise in inequality (in the US) due to an educational slowdown."

Greg Mankiw sums up the work of Prof Goldin and Katz thus, "According to Professors Goldin and Katz, for the past century technological progress has been a steady force not only increasing average living standards, but also increasing the demand for skilled workers relative to unskilled workers. Skilled workers are needed to apply and manage new technologies, while less skilled workers are more likely to become obsolete."

In 1980, the top 0.01 percent of the population had 0.87 percent of total income. By 2006, their share had more than quadrupled to 3.89 percent, a level not seen since 1916. One out of every 10,000 American families has income in excess of $10.7 million. These lucky duckies number less than 15,000.

In 1980, each year of college raised a person’s wage by 7.6 percent. In 2005, each year of college yielded an additional 12.9 percent. The rate of return from each year of graduate school has risen even more — from 7.3 to 14.2 percent.

Monday, April 14, 2008

Cities and taxes

The Free Exchange has a post about how city residents get taxed at higher effective rates, as uniform federal taxes do not account for the higher cost of living in cities. It therefore flags off a debate about the utility of a cost of living adjusted tax rate.

While the point about higher cost of living and uniform tax rates is well taken, this argument ignores the dimension of the much higher individual welfare gained by living in cities. This welfare can be both in terms of personal convenience and a better lifestyle, and the more important professional advantages that come with living close to the workplace.

It is more appropriate to therefore argue that, if the gains in individual welfare by living in a city is less than the burden imposed by the higher cost of living there, then uniform taxes fail the fairness test. On the contrary, if the individual welfare gains exceed the incremental burden of higher cost of living, then a uniform tax regime may actually be favoring city residents.

If individual welfare is the demand side variable and cost of living the supply side one, then the interaction between them produces an equilibrium which determines who are likely to live in the cities and who prefer the suburbs. Clearly, those who place a very high premium on the advantages of a city life, will prefer to live in cities, even if the cost of living is high. Similarly, those who cannot afford the high cost of living will fore go the conveniences of a city life and settle in the suburbs.

Going by this logic, residentially congested cities would appear to be ones providing disproportionately high enough individual welfare than the incremental burden of cost of living. In other words, these cities have lower effective rates of taxation than their suburbs. Similarly, the more suburbanized cities suffer from higher effective taxes which disincentivizes residents from settling in the city center. Of course, this is a simplified ceterus paribus analysis, but nevertheless provides useful insights.

Now, I am personally inclined to believe that in many developed countries, the costs of living in cities is much more than the individual welfare gained, thereby incentivizing people to commute from the suburbs. Or conversely, the presence of good public transport and cheaper and larger housing, encourages more people to settle in the suburbs. In contrast, in many developing countries, the cost of living is much less than the individual welfare gains of living in cities, thereby encouraging an exodus to the city. Conversely, the poor public transport and smaller differential between land costs and housing rentals between the city and suburbs, means that residents do not have the incentive to move to the suburbs.

From a regulatory perspective, there may be case for higher taxes on the more congested cities, so as to offset the higher individual welfare and decongest it. Conversely, lower taxes will help densify the sparsely populated cities. But the problem with this approach lies in identifying what is the appropriate residential density. As Eco 101 would teach us, this may be more efficiently located by the market itself. The possible incentive distortions that can be triggered off by regulatory approaches are many and have serious consequences.

However, there is an economic case to be made in favor of ensuring the minimum number of users for the construction and sustenance of a world class civic infrastructure and public services. But this too is a minefield given the widely varying differences in the individual willingness of different residents to pay user charges for these services.

Either way, it is surely an interesting challenge to tailor fiscal policies for cities. The incentives and disincentives are too numerous and exhibit a complex interplay, that makes it very difficult to structure efficient, distortion-free policies. I had argued in a previous post about how good public transport can alter a lot of incentives and bring about significant demographic and social transformation in any city.

Cause of poverty is poverty?

Mark Thoma draws attention to a Boston Globe article about an alternate explanation for poverty by Charles Karelis, a philosopher and former President of the Colgate University.

Arguing that traditional economics does not help understand poverty, it writes, "When we're poor our economic worldview is shaped by deprivation, and we see the world around us not in terms of goods to be consumed but as problems to be alleviated. This is where the bee stings come in: A person with one bee sting is highly motivated to get it treated. But a person with multiple bee stings does not have much incentive to get one sting treated, because the others will still throb. The more of a painful or undesirable thing one has (i.e. the poorer one is) the less likely one is to do anything about any one problem. Poverty is less a matter of having few goods than having lots of problems. Poverty and wealth, by this logic, don't just fall along a continuum the way hot and cold or short and tall do. They are instead fundamentally different experiences, each working on the human psyche in its own way."

Karelis argues that poverty introduces a diminishing marginal utility to putting in effort, "One doesn't have enough money to pay rent or car insurance or credit card bills or day care or sometimes even food. Even if one works hard enough to pay off half of those costs, some fairly imposing ones still remain, which creates a large disincentive to bestir oneself to work at all."

Karelis's arguement is therefore not to worry too much about the fragility of the work ethic among the poor. This goes against the traditional neo-classical explanation that more social security like unemployment benefits and aid to poorer countries, generate moral hazard concerns by making the poor dependent on the dole or aid, and thereby undermines their work ethics.

Therefore, reducing the number of economic hardships that the poor have to deal with will actually make them more, not less, likely to work, just as repairing most of the dents on a car makes the owner more likely to fix the last couple on his own. Simply giving the poor money with no strings attached, rather than using it, as federal and state governments do now, to try to encourage specific behaviors - food stamps to make sure money doesn't get spent on drugs or non-necessities, education grants to encourage schooling, time limits on benefits to encourage recipients to look for work - would be just as effective, and with far less bureaucracy.

While the empirical data to make a strong case in favor of Karelis's arguement is limited, its logical foundation is more impressive.

Sunday, April 13, 2008

Latest IIP figures

The latest IIP figures (graph from ToI), for February 2008, reveals that the economic growth is on track, albeit at a slightly reduced rate. The comparative April-February figures for 2006-07 and 2007-08 reveals only a slight slowdown. The capital goods sector bounced back to show 10.4% growth, from the 2.1% growth in January, 2008.



This slight slowdown is in keeping with the increasing probability of a US recession inspired global economic slowdown and rising global inflation. It may also be a welcome slowdown, as there were enough indications that the economy was overheating (rising inflation being the most prominent) and supply side constraints like infrastructure bottlenecks were beginning to assert themselves. This is also a reminder that we cannot sustain high, close to double-digit economic growth rates, without substantially ramping up our investments in agriculture and infrastructure.

Comparing inflation in Indian and world economy

Amidst all the heart beating about rising inflation, we have yet to appreciate how much India has been spared the global inflation trend. The ET has this graphic which captures the comparison of global and Indian price rises for various commodities in the Q4 of 2007-08.

Saturday, April 12, 2008

America grows while Americans stagnate!

David Leonhardt draws attention to the remarkable fact median incomes have remained essentially stagnant for most families during the recent economic expansion. This should lay to rest a lot of debate surrounding the inclusivity of the economic growth in the new millennium.

According to the Census Bureau, in 2000 the median American family made about $61,000at the end of the previous economic expansion, whereas in 2007, at the end of the most recent expansion, the median family made even less - $60,500! This is the first economic expansion since the World War II, when the buying power of most American families actually declined. In other words, while America grew richer, Americans grew poorer!



Leonhardt traces this trend to the decline in the bargaining power of large sections of the workforce due to the technological trade and rise in global trade. The health care costs and the favorable tax concessions to the rich aggravated the problem. The internet and housing bubbles camouflaged the adverse effects of this phenomenon for some time. He writes, "the modern American economy distributes the fruits of its growth to a relatively narrow slice of the population. We don’t need another decade of evidence to feel confident about that conclusion."

Leonhardt calls for active government role in bringing growth back to all Americans. He writes about the income gains of the postwar period, "They were the product of a deliberate program to build up the middle class, through the Interstate highway system, the GI Bill and other measures." His prescription is for job-creating investments in biomedical research, alternative energy, roads, railroads and education.

This and other well documented literature, points to an important role for Governments in containing the ever widening inequality divide. This however is not an endorsement to go back to the bygone era of interventionist redistribution, but for adopting a more subtler approach that focuses on facilitating the achievement of outcomes rather than outcomes themseleves.

Friday, April 11, 2008

The challenge of high steel prices

News reports claim that the Government of India is actively considering a series of measures to contain the rise in steel prices. This follows futile efforts to get the steel companies to voluntarily rein in prices.

Consider this. Steel prices have gone up by over 60% in the past year, with a 25-30% rise in the last three months. Prices of inputs have gone up rapidly over the past year - iron ore has doubled and coking coal trebled. The Governments itself had contributed its share to the recent price rises, with the National Mineral Development Corporation (NMDC) hiking iron ore prices last October. This hike may be taking its full impact now. The stell companies recently raised steel prices by almost 15% by levying a raw material surcharge of Rs 5000.

It is now becoming increasingly clear that the Cabinet Committee on Prices (CCP) will soon announce a package to contain steel prices. The following measures are being proposed
1. Removing the 5% customs duty on imports of steel, pig iron, mild steel, zinc, ferro alloys, and metcoke.
2. Reduction in excise duty from 14% to 8% on pig iron, sponge iron, iron and steel scrap, granules and powder of pig iron, semi-finished products, pencil ingots, bars and rods, angles, shapes, sections and wires.
3. Elimination of the 14% countervailing duty on TMT bars and structurals.
4. Increase in export duty on iron ore to 15% advalorem rate, from the existing Rs 50-Rs 300 per tonne.

Other measures being considered include reversal of railway freight hike, and suspension of futures trading in iron and steel for six months.

I will stick out my neck and argue that all these measures are going to do precious little to contain steel prices rises. They may at best mildly attentuate the price pressures, and that too only in the short-term. The reasons have been extensively discussed in previous posts here and here.

There is another dimension to these regulatory and fiscal measures to ease supply constraints. It is unlikely, even almost certain, that the producers are not going to pass on the lower excise duties to the consumers. Similarly, the lower customs duties are most likely to be captured by the foreign exporters, who are most likely to hike their prices to offset the lower duties. This happened with edible oil imports from East Asia, and will happen with iron products too. Given the relatively small share of exports compared to domestic demand, the higher export duties will achieve little else other than decreasing the competitiveness of our exporters.

A little understanding of tax incidence will help clarify these aforementioned conclusions. Eco 101 teaches us that for products exhibiting inelastic price elasticity of demand, the incidence of tax burden is more on the consumer. If we draw parallels to the present situation, things become clearer. Steel and other metals, facing tight demand conditions in light of a booming economy and buoyant growth in construction and infrastructure sectors, are therefore price inelastic with respect to demand. All fiscal measures are more likely to help producers partially offset higher costs, than benefit the consumers.

The steep rises in raw material and other input prices across the world and the competition arising from a global market place, has placed considerable cost pressures on producers and manufacturers. In this context, they are more likley to keep all tax cuts, and pass on as little as possible to the consumer. The tax cuts therefore end up as corporate welfare, instead of being a relief for the consumers.

The solution to this conundrum has to come from the market itself. Once the prices cross that level when demand starts getting adversely affected, the producers become forced to pass on a greater share of the fiscal concessions to the consumers. The prices of TMT bars had fallen two weeks back as the high prices had started impacting demand. The problem is that there is no way of estimating this threshold price, so as to time Government fiscal interventions accordingly.

US importing inflation

The dual coincidence of a falling dollar and rising inflation in emerging economies is putting upward pressure on the prices of American consumption imports from them. Since developing countries now produce nearly half of all American imports, the higher prices contribute a significant share to American inflation. The falling dollar is making imports more expensive, while the rising inflation in the producing countries is incraesing their production costs. The NYT chronicles this change here.

So far the Asian exporters had been taking cuts in their bottomlines, rather than pass on the increasing costs to the American consumers. Now, with no end in sight to the declining dollar, exporters appear to be no longer willing to subsidize the American consumers.

Sunday, April 6, 2008

"Many recipes" in development strategy

Harvard Professor Dani Rodrik has written about how our quest for the best solution often leads us astray and prevents us from finding the most optimal solutions to our problems. He has written a deeply insightful article in which he explores the world of second-best, third-best and other alternative approaches to solving the numerous challenges facing global economies.

We need to start our journey of discovering solutions to complex socio-economic problems by acknowledging that these problems act in multiple dimensions with numerous implications, and each problem often has more than a single solution. In fact, all social issues involving interaction among individual economic agents provide fertile ground for numerous emergent situations, with differing permutations and varying probabilities. The development problems facing extremey diverse settings like that in developing societies require multi-pronged responses, which cannot be straitjacketed into any single consistent and overarching logic.

Most of our development schemes adopt the comprehensive and systemic approach to policy formulation and implementation. In an effort to encapsulate and capture the requirements and demands of all areas and different categories of people, we over-standardize a development scheme into a monolithic set of guidelines and thereby curtail the program's effectiveness. Given the diversity and resultant complexity of problems, it is futile to capture all the possible solutions into a single policy framework.

One of the major challenges faced while formulating policies is the need to put in place adequate checks and balances to limit the role of discretion and thereby reduce the probability of the scheme being subverted or exploited by vested interests. This requirement often becomes an alibi for bringing in multiple layers of bureaucracy, which end up losing sight of the very objectives of the scheme.

In order to avoid getting trapped in this bureaucratic gridlock, we need to aim at getting the outcomes right and not be obsessed with the form of the institutions and processes that gets us there. Therefore, we should focus on cultivating all possible institutions and processes, and not just the "best possible", that provide security of property rights, enforce contracts, stimulate entrepreneurship, foster integration in the world economy, maintain macropeconomic stability, manage risk-taking by financial intermediaries, supply social insurance and safety nets, and enhance voice and accountability. The challenge is to get the incentives right within the institutions and the processes so as to achieve the objectives. But this alignment of incentives should be achieved without significantly disrupting the tenuous local political equilibrium.

In fact, once the incentives get aligned towards achieving the desired outcomes, the means too tend to get aligned along the lines of the broader societal interests. Quite often, the outcomes carry within themselves the seeds for institutional reforms which are directed at moving towards the best practice model. Further, for every reform initiative there is an appropriate pace and sequence, which varies widely across different social and economic contexts, without which the reform risks destabilizing the domestic socio-economic and political balance.

China is the best example of how the non-traditional or the best practice model, need not be the only means towards achieving certain desirable economic outcomes. The spectacular story of Chinese economic growth is an excellent example of how economic growth can be achieved by innovative and practical policy decisions without disspiating scarce resources and valuable efforts in dismantling entrenched power structures. In the absence of any strong legal and institutional framework for enforcing contractual obligations, the role of the guanxi type relational contracting in the Chinese and East Asian way of contracting cannot be under estimated. Foreign firms which quickly grasped this reality were able to take advantage of the tremendous potential offered by these markets. Let me illustrate a few other examples of how alternative approaches to the best practice can help solve development problems.

Multi-lateral agencies and academicians tend to focus more on the institutional and procedural requirements necessary to achieve the desired social and economic goals. They believe that the objectives can be achieved only through institutions that are built on certain universal ideas. Universal ideas like decentralization, deregulation, opening up economies, transparency, stakeholder participation etc need not be seen as sacrosanct and inevitable accompaniments in any institutional reform necessary to achieve development goals. We will explore some examples of such obsession with best practice or standard models, going astray.

The traditional IMF and WB prescriptions view economic open-ness and deregulation as pre-requisites for high economic growth rates. Developing countries are forced into inculcating these ideas into any institutional or policy reform. This arguement misses the critical point that these ideas are only a means towards providing a competitive environment and aligning incentives appropriately. Quite often wholesale and sudden changes, like the "shock therapies" in much of Eastern Europe after the fall of communism, destroys all existing institutions without putting in place any alternative. As the examples of East Asia and China proves, competitive environment, exposure to external market forces, and efficient allocation of resources can be done in more ways than one. All these countries experienced their spectacular growths as closed economies (to both goods and capital), and bureaucratically guided allocation of resources.

Traditional development models stress the need to create strong formal legal institutions, and see informal contract enforcement arrangements as being detrimental to the development agenda. But many academicians refers to the utility of "relational contracting" with all stakeholders, or long-term, personalized relationships built through repeated interactions, in the absence of strong legal enforcement machinery. Such contracting arrangments should be strengthened and developed as a substitute for regular legal systems. In the absence of a strong legal enforcement system, foreign investors in China rely on the "guanxi", or long-term relationships built on trust, which demand immediate payment, screens out unreliablke firms, and re-negotiate when things run into trouble. Dani Rodrik argues in favor of strengthening these relational contracting channels, by iniatiating measures like providing more information about firms, that lowers the information assymetry between them.

Encouraging entreprenuership is one of the most commonly advocated reforms for any developing economy. Lowering entry barriers by reducing licensing and registration requirements is a common prescription for reducing rent seeking and promoting entrepreneurship. But Prof Rodrik argues that "rents may well be a necessary condition for adequate levels of entrepreneurship to emerge in non-traditional economic activities". Most often, free or minimal entry costs, acts as a deterrent to encouraging entrepreneurs. Again the example of many successful East Asian countries, with their heavily regulated business environment and high domestic market prices, provide adequate incentives for entrepreneurs to thrive.

Another example of form taking precedence over susbtance is that of encouraging democracy by forcing down multi-party elections. Many developing countries are socially and ethnically diverse, and in the absence of standard conflict resolution and group bargaining institutions and forums, are often held together by an informal and tenuous consensus or balance of power among the elites or a few groups. A sudden introduction of the elements of multi-party democracy and elections unsettles this unstable equilibrium and brings to the fore the latent differences and long-felt grievances. Civil wars and domestic strife ensues instead of democracy. There are numerous such examples in Africa and East Europe.

Decentralization of authority and decision making powers is a favorite reform theme with multilateral aid agencies. It is argued that decentralization would induce stakeholder participation, improve efficiency of public service delivery, and reduce corrupution. Accordingly funds, functions and functionaries have been decentralized in many countries and many externally assisted and other regular development programs are implemented this way. But there are numerous instances of these powers being delegated to institutions and agencies without the requisite expertise or capacity to administer the delegated powers. The result is increased rent seeking, decreased quality of public services, and wholesale administrative paralysis. Such remedies leave the system worse off than in the first place. While the objectives of decentralization are laudable, the extent to which this reform can be successfully implemented varies widely between and within nations.

Another holy cow with multilateral lending agencies and standard governance theories is transparency. Transparency has emerged as the antidote to cronyism and corruption, and as being vital towards ensuring the effectiveness of governance. This theory fails to acknowledge the reality of the tenuous equilibrium that pervades many societies, where decisions are often made on informal platforms and work flow follows the path of least resistance. Many times, infusion of transparency into such contexts unleashes a cascade of divisive and fissiparous forces that mutates resource draining sub-conflicts that detracts attention form the original objective.

Standardization of procurement and tendering procedures is often a pre-condition for any kind development assistance or soft loans. The objective of having a transparent and fully standardized contracting process is to eliminate rent seeking and ensure quality in the sanctioned works. The standard contracting procedures and documents leaves limited flexibility to accomodate the local needs and requirements. For example, adding or deleting certain components in a work, or changing the specifications of the items to be procured, or adopting slightly informal contracting procedures, are not possible under this arrangement. The rigid procedural requirements overlook the fact that these contracting markets have limited depth and breadth, and often operate through informal mechanisms like sub-contracting and political contracting. Such procedural rigidity contributes significantly towards time over runs and lowering of work quality.

It is observed that local politicians, either directly or indirectly, are most often the major contractors for engineering works and other regular government procurement contracts. Standard models argue that this involvement of political representatives in contracting services and works, breeds corrupt practices and comes in the way of development. It therefore favors eliminating their role in such contracting completely and accordingly puts in place specific controls on this. However, in the real world, these attempt most often end up subverting the whole development agenda and diverting the terms of the debate. The energies get dissipated trying to prevent the involvement of the politician or local vested interest, that the ultimate objective itself remains unachieved.

In many ways, the contracting environment for both engineering works and procurement is very complex and is strongly influenced by local factors (like labor issues, local conflict resolution, tying up of all linkages, rent seeking chains etc) which a local politician is better positioned to combat. Indeed getting the local politician on board is often the best hedge against local uncertainities, including political risks. Instead, we should acknowledge the reality of political representatives involved in contracting, and focus on getting those institutions in place that helps us achieve our objectives. China, with its established arrangement of local party bosses doubling up as entrepreneurs, has achieved precisely the same without unsettling the local political equilibrium.

None of this is to argue that there should not be de-centralization, formal procurement procedures, transparency, legal institutions, deregulation, multi-party elections, and neo-classical growth models. My contention is that all these are ultimately only the means towards certain specific objectives, mainly the effective delivery of governance and public services. Given the compex and often delicately balanced socio-political and economic settings in which these institutions and attributes have to function, it is more appropriate if they are introduced carefully in a phased manner.

Saturday, April 5, 2008

Inflation concerns rise

The inflation story is assuming alarming proportions. Figures for the week ended March 22, reveals that inflation has risen to a three year high of 7%.

Earlier this week, the Government of India announced measures to ease supply side constraints by abolishing import duty on crude form of edible oils, cutting rates on refined edible oils and banning non-basmati rice exports. The Government scrapped import duties on all crude edible oil forms, while cutting duties on refined palm, sunflower, soyabean, coconut oils and hydrogenated vegetable fats to 7.5 per cent. This follows previous measures like ban on futures trading in wheat, rice and pulses, and ban on exports of pulses. These were follwed with the withdrawal of incentives for export of basmati rice.

On a year-on-year basis, the wholesale prices have risen by 27% for iron and steel category, 21% for edible oils, 6% for cereals, 11% for vegetables, 10% for milk, 9% for dairy products, 5% for cement, and 9% for both mineral oil and coal. As can be seen, the major cause for concern comes from iron and steel and edible oils.



The problem faced by the Government is that the recent price rises are not an isolated Indian phenomenon, and cannot be solved by even addressing all our supply side concerns. Global commodity prices - energy, minerals and raw materials, and foodgrains - have been an upward rise for over two years now, and shows no signs of abating. IMFs commodity price index shows that since 2005, food prices are up 65%, metal prices 70%, and petroleum products are up 175.7%. The reasons for the price rises have been well documented here, here, here and here.

Inflation in all our neighbours is much higher than here. Apparently, we are only 79th among high inflation countries. Chinese inflation for February touched 8.7%, an eleven year high. Developed countries too are facing unprecedented inflationary pressures. In an interdependent and integrated global economy, India cannot continue to remain isolated from this global trend.



As has already been written about in previous posts, the Indian growth story is not likely to be affected much by the inflation. The strong demand side pressures will ensure that investments in infrastructure, real estate, inputs to infrastructure sector etc will remain robust. India Inc's order books are already overflowing. The corporate sector has reported a 35 per cent growth in orders in FY07 at Rs 74,568 crore. Order books during the second and fourth quarter of FY08 grew by more than 100 per cent, while the biggest order inflows, in absolute terms, were recorded in the second quarter ended September 30, 2007 at Rs 59,253 crore. The order inflow in the fourth quarter totalled Rs 40,729 crore compared with Rs 19,280 crore in the fourth quarter of FY07, belying slowdown concerns.

The rise in prices has also had little impact on the sales of consumer durables and non-durables. This can be partly explained by the fact that in a nascent and fast growing consumer market like ours, the demand for such products are likely to exhibit inelastic characteristics. The consumer base, especially in the villages and small towns, is expanding very fast, even faster than the supply, and more than off-sets any fall in demand in the older markets due to higher prices. Experts say that consumers have become more value-conscious and less price-sensitive in the mid-priced segment and above, and this segment is also expanding very fast.

The government intervention till date have been focussed on easing supply constraints on food grains. But the major contributor to the 7% inflation has been from non-food primary articles, which have risen 14.6% and basic metals and alloys which have risen 22.9%. In contrast, the food basket has become dearer by only 8.2%. There is precious little the government can do to ease the supply pressures on the non food and metal categories. The high global market prices for these commodities and our dependence on imports means that we have little choice but to live with these higher prices. Further, the relatively small quantities of our imports in relation to the total demand for those commodities, means that the influence of these policies are likely to be only minimal.

Given the cost push, rather than demand pull, nature of the present inflationary pressures, any monetary tinkering is likley to have little impact. Credit growth was at a very reasonable 22% for the last fortnight of February. In fact, they are likely to rebound with adverse consequences on the economic growth. This has been explained in previous posts.

The only hope is for the recession in US to weaken demand for raw materials and other inputs in exporting nations, thereby causing a fall in prices of commodities. The global economy has been growing at a scorching pace over the past decade, stretching the supply side to its seams and resulting in capacity over-utilization. It was only to be expected that such growth cannot be sustained for longer periods, and the supply side bottlenecks develop and inflationary pressures start to emerge. The trend in global commodities prices for the coming quarter will be critical to the propsects of the Indian economy.

The increasingly integrated global economy has severely limited the ability of individual nations to successfully implement domestic policies to contain inflation. In this context, it is a moot point as to whether it is possible to contain inflationary pressures in India, even if the domestic supply side contraints are removed. In an integrated global economy, even with domestic surplus, global demand-supply conditions will determine prices. For example, India has surplus production in iron ore, yet prices have more than doubled in the past year, from $60-70 per tonne in 2007 to $140 per tonne now. This has been a major contributing factor to the rising steel prices too. Domestic policy measures like lowering import duties, are most likely to be offset by the producers in exporting countries raising their prices, thereby capturing the benefits of the lower duties. Regulatory controls and easing supply side restrictions can at best ease inflationary pressures slightly, but cannot contain it when global prices are rising.

The uncertainty and volatility calls to focus the need to maintain social security mechanisms like Public Distribution System and various welfare schemes. Such systems provide a comfort cushion to insulate the poor from the adverse effects of globalization and emergence of this integrated global economy.

There is a case to be made against this weekly WPI-based inflation scare mongering that has gripped the financial media in India now. In the first place, no major economy publishes weekly inflation figures. Second, a distinction needs to be made between core inflation, which strips out the large fluctuations in specific commodities, and nominal inflation. The former conveys a more accurate reflection of the reality.

Friday, April 4, 2008

Surface Railways - the real economic cost

While on a fairly long train journey recently, I glanced through an article about the various urban transport options facing developing countries. From a cost-benefit analysis of surface rail transport and underground railway lines (metro), the article concluded that surface rail was a much cheaper and viable option. Concidentally, the train journey gave me an opportunity to observe some of the more unquantified costs of the presence of surface railway lines, especially in urban areas. I will list out a few of these uncaptured costs.

1. Falling land values. All along the margins of railway tracks, land values remain depressed and turns off high value investments.
2. Sound pollution and other costs discourages many economically productive activites from railway track margins. A buffer of economically unproductive zone in created all along the length of these tracks. However, this is something that technology can surely help mitigate.
3. Unorganised residential slums develop along the margins of these tracks. The margins of rail tracks in all our cities, without exception, is dotted with numerous such slums. The health and other social costs imposed by this development on the residents and the neighbourhood is huge.
4. Railway lines divides the areas on both sides into distinctly separated entities, which are difficult to link with regular transport infrastructure. Unlike roads, which seamlessly gets integrated into the area, railway lines creates sharp disconnects between adjacent areas.
5. Railway tracks are generally lined by an unhygenic strip of land on both sides of the track, which become a breeding ground for many health hazards.
6. Surface Railway lines do not have the same potential for leveraging commercial spaces development as underground lines. The entire area on top of a metro station can be developed commercially, while surface railway stations are constrained by lack of space for similar exploitation.

In other words, surface railway lines produce a huge amount of unquantified negative externalities, which impose a prohibitively high cost. In contrast, underground railway lines, while undoubtedly expensive to lay, are free from all these negative externalities and help us make optimum use of our land resources. It is as though a railway track comes along with a package of negative externalities - pollution, slums, health and social problems, falling land values etc.

My contention is not to abandon all surface railway lines, but to include the opportunity cost of surface railways in making choices between alternate modes of railway transport.

Wednesday, April 2, 2008

Regulating Wall Street

The nineties and this decade were years of financial deregulation that sought to liberate financial institutions and their instruments from the shackles of regulators. The free hand given to financial regulators and the resultant wave of financial innovation saw the emergence of a number of exotic financial instruments with an alphabet soup of names and off-balance sheet entities that sought to purchase and sell risk.

The whole objective of all this financial engineering was the diversification of risk as wide and deep as possible, and increasing the liquidity available by a continous chain of onward lending through securitization of debt. In the process risk got disseminated into unknown terrain, where it became impossible to even locate, leave alone price risk. The versatile financial creatures called Structured Investment Vehicles (SIVs) even emerged as a convenient alibi for hiding risks.

The massive deregulation saw the proliferation of unhealthy practices like abusive loans by independent mortgage brokers; risky and opaque transactions by financial institutions; credit-rating decisions that turned out to be wildly optimistic; and the underwriting of loans by mortgage brokers that were often based on fraudulent or inaccurate information.

The wave of deregulation climaxed with the bursting of the bubble in sub-prime mortgage backed securities. A series of other asset backed securities followed suit - Collateralized Debt (and Loan) Obligations, and Credit Default Swaps. Wall Street Banks, hedge funds, and insurers all ran into crisis as margin calls induced forced sell offs to cover losses.

Now there have been growing calls for tightening supervision of the risk-management practices of Wall Street investment banks and perhaps requiring them to keep higher cash reserves as a cushion against unexpected trading losses. This school of thought demands the same tight regulation that banks had for decades to be extended to Wall Street firms. There have been calls for setting up a regulator to re-examine capital reserves, risk-management practices and consumer protection without regard to whether companies were commercial banks, investment banks or nonbank mortgage lenders.

The actions of the Fed in recent weeks, in its capacity as lender of last resort, may have unleashed powerful moral hazard factors. The Fed had offered a $30 billion credit line to JPMorgan Chase to help it take over failing Bear Stearns, and also announced the opening up of its "discount window" - an emergency loan program that had been reserved strictly for commercial bank - lending to big investment banks. The later is an effective acknowledgement of the blurring of lines between Wall Street banks and commercial banks.

Commercial banks submit to greater regulation, partly in exchange for the privilege of being able to borrow from the Fed’s discount window. But with the throwing open of the "discount window", Wall Street firms were getting the same protection without subjecting themselves to additional scrutiny. As Roger Lowenstein writes in the Times, "Since the bank runs of the 1930s, federal protection of retail depositor institutions has been a hallmark of American capitalism. The Federal Reserve, in a sweeping extension, has now extended the privilege to gilt-edged investment firms."

The opponents have the usual explanations - higher cash reserves will dry up the liquidity available for lending, trading and underwriting new securities; tighter regulation will inhibit financial innovation, and so on. As the events of recent months have amply demonstrated, this is something akin to arguing for more of the deregulated environment that was instrumental in promoting moral hazard, greed, recklessness, all of which inflicted so much damage.

Paul Krugman has this excellent reminder of what lessons we should have, but did not, learnt from the Great Depression. He feels that Wall Street chafed at regulations that limited risk, but also limited potential profits and created a “shadow banking system” that relied on complex financial arrangements to bypass regulations designed to ensure that banking was safe.

He writes, "For example, in the old system, savers had federally insured deposits in tightly regulated savings banks, and banks used that money to make home loans. Over time, however, this was partly replaced by a system in which savers put their money in funds that bought asset-backed commercial paper from special investment vehicles that bought collateralized debt obligations created from securitized mortgages — with nary a regulator in sight.

As the years went by, the shadow banking system took over more and more of the banking business, because the unregulated players in this system seemed to offer better deals than conventional banks. Meanwhile, those who worried about the fact that this brave new world of finance lacked a safety net were dismissed as hopelessly old-fashioned."

Tuesday, April 1, 2008

Entry Barriers in Infrastructure contracting

Two observations about the urban infrastructure contracting market in India.
1. The VMC had called tenders for outsourcing the Operation and Maintenance (O&M) of its entire sewerage network. After a long drawn out National Competitive Bidding process, one of India's leading sewerage contractors emerged as the successful bidder. It had quoted Rs 10.8 Cr in its financial bid. But after negotiations they lowered the bid value to Rs 3.9 Cr, without altering any of the contract conditions. The actual cost incurred by the VMC in doing this work is Rs 1.6 Cr!

2. There are only a handful of qualified contractors and suppliers for major water, sewerage, solid waste, and urban tranpsort contracts. Therefore, in the context of the massive boom in such works and the consequent spurt in demand for these services and equipments, sub-contracting of work has become a common practice. In many cases, the involvement of the primary contractors, who are invariably a major infrastructure company, are confined to merely pocketing a commission from the sub-contractor.

These two observations give a fair assessment of the Indian market for urban infrastructure services. Despite the rapidly increasing policy focus on investments in urban infrastructure, the market for these services remain under developed and in its incipient stages. At a time when it is estimated that over $200 bn will be invested in urban infrastructure over the next five years, it is therefore imperative that there be rapid development of the market for urban infrastructure contracting and the proliferation of such contractors. This post will focus on the second problem.

This nascent market in urban infrastructure contracting is populated by a very few major contractors, with many of them not meeting all the basic requirements of professionalism and expertise. But unfortunately, instead of encouraging the development of this market by encouraging more competition, government regulations may actually be stifling its development. Very high entry barriers have constrained competition and prevented the expansion of the numbers of contractors beyond the limited pool of those presently eligible.

Government agencies have to follow a process of tendering for sourcing any service, contracting any work, or procuring any material. The entire bid process, with all the steps involved and the specifications and requirements, are outlined in detail in numerous Government Orders. The typical bidder pre-qualification norms for any Government tender are
1. Financial qualification for similar category of work - generally 50% of the Estimated Contract Value (ECV) over any one of the previous three years
2. Technical qualification for similar category of work - generally 50% of the contract volume over any one of the previous three years
3. Financial eligibility of the contractor, quantified in terms of the total turnover to be a minimum amount.

In an emerging market for urban infrastructure services, there are very few contractors who meet these stiff requirements. A virtually closed group of few contractors alone become eligible and corner all the contracts.

As already mentioned, the major contractor bids and then sub-contracts it out to a sub-contractor, who though capable of doing the work, fails to meet the financial and technical requirements. The primary contractor charges anywhere between 2-5% of the ECV as his profit. This is effectively an unearned increment, or a backdoor subsidy, arising from the rigid government regulations. In a few other cases, the ineligible sub-contractor seeks out big primary contractors and enters into joint venture with them. This will help them gain valuable experience, which can be used for future works. But the profit margins demanded by the primary contractors for such arrangement are higher and goes upto 10% of ECV.

This seller's market has boosted the margins available and the major contractors are no longer satisfied with the regular 15-25% profits. This partially explains why our publicly listed infrastructure majors are the hottest scrips in the equity markets and private equity majors are chasing them.

The differences in contracting procedures across states, and even departments in the same state, is another cause of major market distortions. For example, while some states like Rajasthan follow the World Bank norms and do not place any limits on the tender premiums, others like Andhra Pradesh impose a 5% limit. While some states like Tamil Nadu permit taking into account private sector experience for financial and technical qualifications, others like Andhra Pradesh insist on Government sector experience. Some states allow for only manual earth excavation work, while others permit machine excavation. Some departments provide for additional contractors profit margin in the Estimated Contract Value (ECV), while others disallow the same. These distortions in a seller's market ensures that contractors gravitate towards where the profit margins are the maximum.

All this ensures that the market for urban infrastructure contracting does not expand to keep pace with the rapidly growing demand. As Eco 101 teaches us, a market with the same limited suppliers and fast growing demand, and inhibited by high barriers for entry, will give rise to monopoly pricing and economic inefficiency.

I have tried to list out a few other problems being increasingly felt in procuring services and materials
1. There are no standard model contracts or concession agreements for outsourcing civic services. So, every city invariably ends up re-inventing the wheel and preparing their own RFQ and RFP documents. Very often, such agreements are prepared by the bidder(s) and i many cases, accepted in full, by the Government agency. As can be expected, such agreements fail to fully take into account the interests of the Government and thereby produce incomplete contracts.

2. The pre-qualification norms in many states do not take into account the experience of works done in private sector. Thus we have ridiculous situations where some of the biggest real estate developers in the country do not qualify to bid for much smaller housing projects of the Government.

3. Many services like use of energy saving devices in streetlighting, Supervisory Control and Data Accquisition (SCADA) in water supply and sewerage, intelligent transport systems etc involve procuring sophisticated equipments and devices whose specifications and rates are not available in the SSR. Given the huge value of such contracts and the absence of standards, it becomes difficult to scrutinize the tenders and finalize their procurement.

4. Many services like hiring a professsional communication strategist or a consultant to manage a Project Management Unit (PMU), cannot be fitted into the traditional unit rate procurement process. These are all human resource dependent services, which are extremely expensive. Government procurement guidelines do not account for the high premium commanded by quality HR personnel. There are serious audit related limitations on such procurements.

5. Contracts do not factor in the volatility in prices. Steel prices rose from Rs 34,502 per tonne for the 16 mm steel in December 2007 to Rs 39,390 per tonne in February 2008, to Rs 56,000 per tonne in second week of March 2008. Cement and Bitumin prices have also been showing siognificant volatility. Contractors, who bid for a long construction period contract, ends up bearing the entire price risk. The price escalation provisions introduced by a few states like Andhra Pradesh (price escalation based on the WPI) and Tamil Nadu (price escalation once a quarter, to be decided by a Committee) are at best feeble efforts at reflecting the market prices. It is necessary for contracts to accurately reflect the market rates, especially in times of high market volatility, at least for the mandated construction period.