Monday, July 28, 2008

Problems in financing urban infrastructure

This post will examine why infrastructure sector is not a homogenous group, and what are the reasons why private investments are easier attract in certain sectors than others. It is also a reiteration of the need for developers to have access to capital at the lowest costs, given the risks inherent in the nascent stages of development of some of these sectors.

Infrastructure financing has moved a long distance over the past couple of decades. Till the eighties, Governments used to finance all infrastructure expenditure in India. The nineties saw the emergence of private sector as possible investors in infrastructure sector. Private investments in infrastructure took off initially with the telecommunications sector and the roads being developed under the Golden Quadrilateral, and has now gained momentum with the interest shown by private developers in the development of projects in ports, airports and power generation.

The telecommunications sector was the first success story in the privatization of infrastructure. The entry of private sector ushered in a spectacular spurt in investments in network and capacity expansion, and the intense competition arising from multiple licence holders in circles led to steep declines in telephone tariffs. In India, given its low penetration, telecom service was not seen as a basic public utility, thereby evoking less opposition on its privatization. The culture and habit of user charges and cost revovery was already established in the telecom service market.

The spectacular economic growth of recent decades and the attendant spurt in internal mobility within the country, and more importantly commercial traffic, have provided a major filip to road infrastructure projects. Though, I do not have figures offhand, it will not at all be surprising if the critical revenue streams for most of the interstate highways bidded out under BOT by the NHAI, come from commercial vehicle traffic.

In fact, the biggest successes in BOT road projects have all been in major freight corridors. Private operators view the substantial and rising toll revenue streams as adequate and robust enough to finance road projects profitably, thereby minimizing their commercial risks. Again, the relatively upstream nature of the sector (being highways and not regular internal or link roads) and the consequent limited public interface ensures that there are a few of the other commercial and political risks associated with investments in infrastructure.

Sectors like ports, airports, and power generation, all of which involve single location activities, are inherently suited for private management. The private sector, with its operational flexibilty and incentive driven structure, is much better suited to operating and maintaining these facilities more efficiently. Further, the fact that these sectors are at the upstream end of the service supply chain (except maybe airports), means that commercial and financial viability by collection of user charges and cost recovery are not a major risk. Even in airports, the economic profile of the users ensures that commercial viability risk is minimal.

But water, sewerage, solid waste, electricity distribution and public transport services are still heavily subsidised across the country. Further, these services are widely percieved as basic public services, being accessed by everyone, rich and poor, and therefore to be delivered at affordable prices. There are therefore considerable commercial risks and financial viability issues associated with investments in these services. Further, in all these sectors, the private partner will invariably have to utilize existing assets.

All these are potential sources of political opposition. The only way private participation can be introduced in these utilities is by projecting the choice of better quality services at cheaper or only slightly higher prices. Conventional explanations like infusion of superior technology or efficiency impovements may not cut much ice, if they involve higher user charges/tariffs.

Given these problems and the substantial risks associated with them, it is important that private sector participants are incentivized by being able to access capital at the lowest cost. This is all the more important for those few sectors where private investments are still only marginal, posing as they are, considerable risks to the investors.

Wednesday, July 23, 2008

Infrastructure spending as a fiscal stimulus

There is an interesting reply by Megan McArdle to Mark Thoma's suggestion that infrastructure spending can provide an effective fiscal stimulus to an American economy struggling with recession. Prof. Thoma had argued that "a one dollar increase in government spending has a bigger impact on GDP than a one dollar tax cut". Since it involves creation of permanent capital assets and is capital intensive, infrastructure is thought of as one the most effective means of capital infusion and Keynesian demand management.

McArdle differs and argues that infrastructure spending has a long time lag and therefore may be less effective than other fiscal and monetary policy measures. She claims that the time taken to conceive, design, source finances and tender out major infrastructure works typically takes many years. She writes, "Between the environmental impact statements, public review periods, and byzantine bidding process, the development cycle for anything more complicated than painting a bus station is now measured in decades, not years."

She pumps for monetary and fiscal policy, "The reason we rely mostly on monetary policy and tax cuts for stimulus is that it is possible to rapidly implement whatever stimulus you decide on. With the exception of a few transfer programs such as food stamps and unemployment insurance, which are hard to funnel very large sums of money through, there is nothing on the spending side that matches tax cuts for speed. You could allocate the money, to be sure, but by the time it actually hit an agency and went through the bureaucratic procedures necessary to actually spend it, the window for effective stimulus would have passed."

Given the enormous supply side constraints and the legacy of delays associated with tendering our works in government, infrastructure projects in India too suffer from similar problems. Does this mean that infrastructure spending has even less utility as a demand management tool in developing economies like in India? Does it also mean that if have to spend money on infrastructure projects as a demand management policy instrument, we should rely only on smaller infrastructure projects which are easier to contract out? It also means that the first step in such times should be to ensure the immediate release of the full amounts for all those projects which have been already tendered out, but are progressing slowly for lack of adequate funds.

Biofuels and foodgrains inflation

The rise in global foodgrain prices have been attributed to factors as wide ranging as increased consumption in India and China, diversion of crops and land for biofuel cultivation, and speculation in the commodities futures markets. However, there is mounting evidence that biofuels may have been the major contributing factor to the rising foodgrain prices.

First there was a leaked internal World Bank study which suggested that biofuels have forced global food prices up by 75%. Now here comes an OECD study which find that biofuels were a significant element in the 2005-2007 food price surge as they accounted for 60% of the growth in global consumption of cereals and vegetable oils.

Another OECD study which does an assessment of the subsidies offered in the developed economies for biofuel production finds that their effectiveness is disappointingly low, with public support costing between $960 and $1700 per tonne of greenhouse gas emissions saved.

Tuesday, July 22, 2008

Financing urban infrastructure projects

It is estimated that our cities would require anything between $250 bn to $500 bn over the next five years to finance basic infrastructure needs, that are a precondition for them becoming vibrant growth centers. Here are a few methods, other than the simple government and private financing models, of funding urban infrastructure projects.

1. Project finance
Project finance for a capital asset, invloves creating a legally independent project company, typically a Special Purpose Vehicle (SPV), and then financing that company exclusively with its cash flows or non-recourse debt. The project assets are mortgaged to the SPV and the cash flows are escrowed into a separate bank account, with the first charge on its belonging to the investors or lenders. By financing the investment by an off-balance sheet entity, rather than on its own balance sheet, the company will be able to mitigate its risks and also finance larger investments than otherwise, by leveraging more external resources.

Further, it also helps even financially weak companies, with negative legacy costs, raise resources at lower cost for important and economically viable projects. Besides, it brings in greater discipline and professionalism to the process of project conception, execution and operation, thereby enhancing the value of the investments. Typical project finance debt is for long tenors of atleast 15 years. Apart from all this, unlike simple loans, project finance minimizes interest burden by releasing finances for the project according to requirements.

The large proportion of leverage in project finance, typically 70-80%, and the need to repay this, brings in financial discipline to both the project financing and the post-construction management process. It reduces the possibility of asset stripping and cash flow siphoning off by the parent company. Many infrastructure projects generate large cash flows, and project finance model ensures that the project cash flows are not wasted or squandered away and are optimally utilized to repay the debt. which can be utilized to repay the debt.

2. Value capture method
Typically used in land development. Urban Development Authorities across the country raise considerable revenues from land by selling after minimal or even no development of the land. From the seller's perspective, this is an inefficient method since the major portion of the value of an undeveloped land is embedded in the future revenue streams arising from its development. In other words, the seller exits at the lower end of the value chain.

The developer, in turn garners a windfall after full commercial development of the land. He benefits from both the land value shooting up and from the incoming revenue streams, whose NPV is in most cases many times more than the land value itself. The seller of the land (government agency) loses out from partaking a share in this future revenue streams.

The seller can maximize his returns by an arrangement wherein the land gets leased to the developer for a fixed period at an annual rental value and a share in the future revenues streams (a developement premium). Another model is where the developer transfers a portion of the developed commercial or residential built-up area.

3. Tax Increment Financing (TIF)
TIF is a mechanism that allows municipalities to earmark the increased tax revenues from property value growth, due to land re-development or renewal, within a designated area suffering from blight (a TIF district) in order to finance development in that same area. It dedicates the increased property tax and other revenues from redevelopment to finance debt issued to pay for the project. It is therefore a method of using future gains in taxes to finance the current improvements that will create those gains.

Re-development benefits the municipality by creating more taxable property (and hence tax revenues) and by increasing the values of land held by it. Vacant land, if any, can in turn be leveraged to earn more revenues and property tax.

After a municipality designates a TIF, local government units are barred from collecting taxes on the area’s property value growth. They can tax only the "frozen" property value and properties, as it stood when the TIF was designated. The tax revenue from growth – the tax increment – accrues instead to the TIF, to be spent on loan repayment, capital improvements, developer and rent subsidies, job training, and other expenditures meant to spur new development. The value of this new development is taxed, the taxes ploughed back into the TIF, and the TIF revenues spent on creating still more development.

TIF is a popular method of financing investments in poorer areas, since it does not involve any immediate increase in property taxes and also beacause it mandates the spending of money raised from the area in that area itself.

4. Pooled Finance Development
Is an approach under which an appropriate mix of urban infrastructure projects are bundled together, and the bundle is then posited before the debt market. The projects should be chosen so as to diversify away and mitigate the individual project risks. This can be achieved by choosing projects with robust enough cash flows, which imparts an element of credit protection against revenue shortfall in the other projects.

This method of financing is typically used to leverage investments into smaller municipalities, whose credit worthiness is often suspect, by mixing them with projects from more credit worthy and larger municipalities. It can also be used to finance projects with smaller revenue streams, by bundling them with those having larger revenue streams.

Pooled Finance Development Funds (PFDF), set up by governments, can also provide ratings enhancement facility by functioning as a Credit Rating Enhancement Fund (CREF) and raise the credit worthiness of the bond offerings (to finance a bundle of projects) to investment grade.

5. Credit Enhancement Facility
Given the virgin nature of debt market for urban infrastructure, it is natural that lenders have apprehensions about the riskiness of their investments. In order to facilitate the development of this market, it may be necessary to increase the credit worthiness of these investments by providing additional layers of credit protection. Such additional protection would make the project investment grade, and thereby lower the cost of capital.

Such credit enhancement can be provided directly through a guarantee fund, or by purchasing guarantees from financing 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 a debt market in urban infrastructure projects.

6. Construction risk transfer
Wherever, the construction risks are substantial, due to possible problems with land acquisition and work site clearance, the cost of capital tends to reflect this higher risk. The project (or the borrowing agency) is left holding this high cost debt, well after the construction is completed and the project operationalized.

In the circumstances, it may be cheaper to raise short term loan and complete the construction. After off-loading the construction risk, the short-term loan can then be swapped for long tenor structured debt at lower cost. This model has been elaborated here.

7. Venture financing model
This approach uses a higher equity share to leverage debt at lower cost, on the condition that the equity holder can progressively withdraw his equity. In other words, the equity is used to "crowd in" lower cost debt. Under this model, the project commits to achieve certain operational and commercial benchmarks in its performance, within a specified time schedule, thereby demonstrating its ability to counter its commercial and operational risks. Once the project stabilizes and the revenues streams get established, it becomes possible to attract debt at lower cost. The equity investor can then progressively exit with a handsome return. The equity can then be invested in newer projects.

This arrangement is similar to the venture financing or angel investing model, in which promising ideas and projects are financed by providing seed capital. The venture capitalist or angel investor, exits with a handsome profit once the project becomes established as a success. There can be institutions that specialize in making such investments.

8. Impact fee financing
Major infrastructure investments results in increased land and rental values in the area. Since the land owners do not contribute anything to this increase, it is only appropriate that they are priced for this unearned increment. The gains accruing to the landlord from the positive externality arising from the investment, is partially internalized by way of an impact fee. This impact fee can be by way of a higher property tax, a higher building permission fee, or a direct levy.

9. Tradeable infrastructure assets
The infrastructure assets can be created by short term debt or financed by government. An appropriate pool of such infrastructure assets can then be bundled together, securitized and sold off as a tradable financial product. Their price and true cost of capital will be determined by the market. These tradebale assets would be similar to the infrastructure funds that are floated in the debt market to raise capital for creating specific infrastructure project assets.

The O&M of the assets can then be auctioned off to franchisees by competitive bidding, thereby helping consumers get the best deal in service pricing. More about this model here.

10. Viability gap funding or bridge financing
This approach is suitable when an investment is financially unviable, since the investment costs are too large to be compensated (or repaid) by the relatively smaller revenue streams. In such projects, the government does the bridge financing required to make the project financially viable, most often as a grant. This amount can be offset against the subsidy provided by the government, by way of lower tariffs on water or sewerage systems.

11. Government guaranteed debt
In major projects, where the SPV accesses the debt market, the cost of capital is invariably higher than if the debt was raised by the government or any of its agencies. In emerging markets like urban infrastructure, no private entity, however established and credible, will be able to convince lenders that it has adequately addressed the issue of construction, commercial and operational risks. This inability to signal convincingly enough to lenders will translate into higher cost of capital for the project, thereby saddling the project with often unsustainable debt service burdens, under the weight of which it fails.

The portion of such government raised debt, can vary depending on the type of project and its financial viability. This debt can become a junior debt tranche, to senior debt raised in the regular debt markets. More on this is available here.

Monday, July 21, 2008

Health care vouchers

After food and housing vouchers, here comes health vouchers. It has been argued for some time that vouchers are a less distortionary and more efficient way of delivering subsidies to a category of citizens.

Ezekiel J. Emanuel of the National Institutes of Health and Victor R. Fuchs of the Stanford University, have come up with a proposal for a Universal Healthcare Voucher System (UHV), (PPT here) which seeks to achieve universal health coverage by entitling all Americans to a standard package of benefits comparable to that received by federal employees.

Enrollment and renewal are guaranteed regardless of health status, as is the individual's right to buy additional services beyond the standard benefits with aftertax dollars. Health plans would receive a risk-adjusted payment (i.e, you get a lot more money for a diabetes patient than a healthy 23-year-old) based on their enrollment. Under this virtual single payer system, the actual provision of health insurance is contracted out to competing private companies. All existing plans, including private plans, get subsumed into the single payer (Government payer) system.

UHV is proposed to be funded entirely by a dedicated value-added tax (VAT) with the rate set by Congress, so as to cover costs. A VAT of approximately 10 to 12 percent would insure all Americans under age 65 at a cost no greater than current public and private health care expenditures. By funding it fully from VAT, the citizens will have to make a choice between paying more VAT or more expansive insurance options.

Ezra Klein sums up the plan, "The government gives you a voucher. Various insurers compete to offer such good coverage that you'll give your voucher to them. The insurers then give your voucher to the government, and the government pays them some money, raised through a type of national sales tax."

The link between your job and your medical coverage is forever severed. People now secure care by giving a voucher to the private insurer that best fits their needs. The private employer has no role in employee insurance and all tax breaks given for providing employee insurance can be withdrawn. Private insurers can't deny coverage to anyone, they can't price folks out. Since the government pays them on a risk-adjusted basis, it doesn't even make much sense to discriminate based on conditions.

Sunday, July 20, 2008

Economics of water pricing

California is experiencing a drought and naturally water is a scarce commodity. The Governor has even asked citizens to prepare for water rationing. It is in this context that George Mason University economist, David Zetland has come up with a new water tariff plan for California.

Zetland argues that the problem in California and many other places is a demand-supply mismatch, arising out of inefficiently structured tariffs, which under-price water. He therefore, proposes a tariff structure that assures a basic minimum of supply at the lowest cost, and then increasing the tariff progressively for higher consumption. Many South African cities like Durban, go one step further and provide a minimum quantity free of cost and then charges progressively higher tariffs for higher consumption.

He writes, "As it stands, Los Angeles households pay $2.80 for the first 885 gallons they use per day. That's enough water to fill 18 bathtubs. The next 18 tubs cost $3.40, which is only 20% more. Most L.A. households don't even see this price increase, since the average household of three uses just 350 gallons - about seven bathtubs - each day. For that water, the household pays only $35 a month. If they use twice the amount, the bill merely doubles. I propose a system where every person gets the first 75 gallons, or 1.5 bathtubs, per day for free but pays $5.60 for each 75 gallons after that. Under my system, the monthly bill for the average household of three would come to $95."



While providing a basic quantity of water free of cost is a good option, its financial viability depends on the consumer mix. If there is a sufficiently large enough bulk or high consumption users, as in Durban, then it becomes an appropriate strategy. The higher value consumers end up cross-subsidizing the minimum free quantity. But in most Indian cities, where the numbers of high value consumers are small and that of low quantity consumers are huge, this model may not work out. Further, though the average per capita supply is large (150-200 lpcd) in many Indian cities, the high Non Revenue Water (NRW) component ensures that actual water availability for the middle class is far less.

A similar proposal was considered by the Vijayawada Municipal Corporation (VMC) and was found not financially viable. Of the 164 MLD supplied to a population of 1 million and 75000 connections, only 66 MLD was being billed. It was proposed that 10 kl be provided free of cost, and then the tariff go up progressively from Rs 8.50 per kl from 10kl to 25 kl, and Rs 12 per kl from 25kl-50kl, and Rs 15.50 per kl beyond 50 kl. It was found that only 35% of consumers would fall into the paying bracket, and of them too only 5% were those consuming more than 50 kl.

Hat tip : Freakonomics

Krugman feels oil prices will fall

Paul Krugman believes that oil prices may fall in the medium term. In the short run, the price elasticity of demand for oil is very low. But slowly consumers respond to the higher prices by moving to fuel efficient cars and rearranging their commutes, causing the price elasticity to increase. It is assumed that supply will be unresponsive. Therefore, as the diagram shows, the price falls from P1 to P2.

Saturday, July 19, 2008

Investing in sporting talent

Have you ever wondered why venture funds and corporate groups do not invest in cricketing talent in India? In an age where money managers are constantly scanning the market for every imaginable money making opportunity, how could they have missed one of the biggest money making opportunities?

Consider this. Here is Batboy, an 8 year old with a precocious talent for scoring big runs, and currently making waves in the local school cricket league in Jharkhand. But Batboy comes from a poor family and his family has to struggle to ensure that Batboy's promising career is taken forward. There are times when Batboy almost gives up the game, as the trade-off between cricket and studies appeared to have tilted in favor of studies. But Batboy is one of the luckier ones and manages to struggle his way to the top and ten years down the line gets selected to play for India. Under Indian colours, Batboy becomes an instant hit, and is soon heralded as the new Sachin Tendulkar. Corporate endorsements and millions of rupees follow suit.

Given the huge popularity of cricket in India, the massive money involved in it, and the recent emergence of platforms like the IPL, it does not require a Sachin Tendulkar to make any reasonable investment look like a windfall. Further, the early age at which cricketers get to don the national colours in India, reduces the probability of failed investments. In any case, the commercial stakes involved in the game makes cricketing talent investments a very profitable one, even with a high failure rate. With the game expanding beyond the traditional bastions of the game, to even the remote and interior villages, the opportunities for massive profits increases.

Brazilian corporates appear to have realized the opportunities available and are investing in footballing talent. The modus operandi is something like this. Buy contracts of young talented soccer players, using the company's own money and that raised from investors. These players are then leased out to Brazilian football clubs, who pay them a salary and provides a platform to showcase their talents. If they perform well and get recruited by a European or another Brazilian club, the contract holder gets a large share of the transfer fee. The player gets his signing fee and hefty salary. Last year, 1085 Brazilian players were transferred to places as diverse as Vietnam, Qatar and the Faroe Islands, according to the Brazilian Football Confederation.



Julio Mariz, the President of one of the largest such firms, Traffic, is spot on when he claims, "Instead of investing in the stock market or real estate, these people are investing in buying the economic rights to football players." Traffic pays dividends every six months, raised from player trades. When a player is traded, investors split the transfer fee with clubs, according to their ownership percentages.

Several funds like Traffic have sprung up over the last year, and some major Brazilian companies — including supermarket chains (like Grupo Sonda) — are creating football departments to invest in young players they hope will one day send European clubs reaching for their checkbooks. Grupo Sonda has been investing over $10 million a year and growing fast, and has been providing returns in excess of 150%.



Brazilian clubs embrace the new investor model because the clubs get to raise cash without having to trade their players as quickly or as often. They can loan the players from the individual investors or funds, who hold a share in the player's value. And when they do, inevitably, trade the players, the huge sums, as much as $50 million, guarantee the clubs’ survival. It is good for fledgling players from poorer backgrounds who struggle to get access to good training and other facilities, and a platform to showcase their talents.

But there are also problems associated with such models. The NYT writes, "Investors could be tempted to sell a player as soon as his value increases, robbing the team of a key figure at a vital moment. If funds control players on opposing teams, there is the appearance of conflict of interest. And many supporters fear that people with no emotional attachment to a club might exert too much control". Then there is the danger of exploitation of players, especially with contracts that seek to capture a share of all the future revenue streams associated with a player.

The day is not far when the Indian fund managers will be getting into the business of scouting out and buying contract rights for Batboys and Spinboys. How about a Dhoni inspired Jharkhand Cricketing Talent Fund?

Update 1 (19/11/2010)

NYT reports of investors from the United States investing in Latin American up-and-coming baseball players, some as young as 13 and many from impoverished families. They expect to subsequently sell these players to major league teams for multimillion-dollar contracts.

Analysing the Iran-Israel nuclear stand-off

Well respected Israeli historian Benny Morris writes in an NYT op-ed that it is inevitable that Israel will mount an attack on Iranian nuclear facilities in the next four to seven months. He also hopes that the pre-emptive strikes are successful in atleast significantly delaying the Iranian nuclear program, failing which the region faces a near certain nuclear holocaust. This is understandably the Israeli view now, when Iran is in the process of acquiring nuclear weapons, but has not yet acquired it.

Prof Morris discounts the possibility of the Americans mounting air strikes to take out the Iranian nuclear capability, given the mess in Iraq and Afghanistan. The article has contradictions at certain places. On the one hand while he claims that any pre-emptive airstrike would achieve the purpose only if it takes out Iranina nuclear capability, he also concedes that the Israeli military and airforce does not have the intelligence and strikeforce required to completely eliminate Iranian nuclear capability. Therefore the Israeli attack will only leave things in a limbo, exacerbating the instability, and making Iranians even more determined to continue their nuclear program.

His contention that the best possible outcome would be for Iran to back off from its nuclear program, while being best from Israeli point of view, will always be unstable given the Middle Eastern reality. It will continue to keep the balance of power tilted decisively in favour of Israel, and always leave wide discontent in the Arab world. This unstable balance will result in the nuclear program getting revived in Iran or eslewhere.

Benny Morris' is the perspective from TelAviv. Here is what the nuclear stand-off matrix would look like, taking into account the view from Teheran.



Here is the classic stand-off. Israel does not trust the "fundamentalist, self-sacrificial mindset of the mullahs who run Iran" and believes that the Iranians will make good their promise to "wipe out Israel from the face of earth" once they acquire nuclear weapons. Iran in contrast, feels that it is never safe and will continue to have a weak negotiating position, both with Israel and more importantly US, in a scenario of nuclear weapon assymetry.

Further, the Israeli fear that the Iranians may mount a nuclear attack on acquiring nuclear weapon capability, may be misplaced. This will surely not gain the support of any of the other Arab powers. The Middle East politics has moved a considerable distance from the early days of the Palestinian intifadah of 1987. The numerous rounds of negotiations between both sides, directly and indirectly, since the Oslo accords, have been positive developments when seen in the overall perspective of the tumultous history of Middle East for the past 63 years.

There are many reasons to suspect that, ironically enough, the persisting nuclear and resultant political imbalance may be a strong contributor to the continuing support for militant groups like Hezbollah and periodic bouts of open hostility and verbal skrimishes between both sides. A nuclear Iran may have the impact of substantially toning down the Arab bellicosity and increasing their self-confidence and bargaining position in dealing with Israel. The example of Pakistan, vulnerable to the same levels of perceived militant Islamic influences, is a case in point. Once the nuclear assymetry with India was bridged, sometime in the early to mid-nineties, and the local balance of power restored, the verbal aggression subsided.

There is an undefined level of restraint that Arab governments, including Iran, have exercised in recent years, when translating their words into actions. Thus even as public opinion was strongly in favor of Osama Bin Laden and Saddam Hussein, all the Arab governments refrained from even supporting, leave alone acting in favour of them.

It is clear from the game matrix that Middle East suffers from a major "confidence deficit" between the Israelis and Arabs. Since the Yom Kippur war of 1973 (the pre-emptive air attack on the Iraqi Osirak reactor in 1981 was a smaller one, given the context), despite periodic cross-border air-strikes by Israel and retaliation by Arabs, there have been no major wars directly between Israel and the Arabs. The American led misadventures since the early nineties, during which they were often seen pursuing Israeli political agenda in the region, did open up some of the wounds. But on the whole, by Middle East standards, over the past three to five years a low intensity equilibrium has been stabilizing. The wounds of history, while too deep to heal easily, were surely getting some semblance of treatment.

Any Israeli air attack on Iran will have to be seen in this context. It needs to be borne in mind that, unlike the other Arab nations, Iran is the ideological fountainhead of pan-Islamic Nationalism and its (populist) definition as the anti-thesis of the Israeli and Jewish identity. It is in this background that we need to analyze any consequences of any Israeli pre-emptive attack on Iran. It will be catastrophic and long-lasting. It will almost invariably suck in the other Arab states, and become the first direct war between the Israel and Arabs in 35 years. The time healed wounds of the last attack 35 years back, will get immediately re-opened.

What Middle East needs is more time, so that the mutual confidence will increase. Till a critical mass of mutual confidence, between Israel and atleast a couple of major Arab powers, gets established the low intensity conflict will continue. The major powers, especially America, needs to do everything it can to prevent any mis-adventure by Israel that would uspet the delicate equilibrium, and take the reqion back to 1973.

Update 1 (28/3/2010)
Times draws attention to a Brookings Institution simulation of an Isreali attack on Iran's nuclear facilities.

Friday, July 18, 2008

Bleak outlook for the US economy

Though not yet formally in a recession (to be announced by a panel at the NBER - "a significant decline in economic activity spread across the economy, lasting more than a few months"), it is widely acknowledged by many experts that the US economy slipped into recession sometime in November 2007. Paul Krugman has these predictions for the US economy

1. There is likely to be a further 30% fall in housing prices, before the recovery starts somewhere in 2011. According to the Case-Shiller index, house prices rose 70% in the 2000-06 period, before falling by 17% last year, but is still 30% above 2000 level.

2. Unlike many of the previous recessions, which were engineered by the Fed to control inflation, the present one is a result of a dangerously unbalanced and even insolvent financial system and global rise in commodities and energy prices. This leaves the government and the Fed with limited policy levers to significantly influence the direction of policy making.

3. The return to normalcy will be a prolonged period of flat or at best slowly improving performance, rather than a V-shaped rebound. There is likely to be a long period of sluggish economic growth and rising unemployment that would appear to most Americans like a continued recession. By this pattern, the economy will stay depressed till atleast 2010 or 2011.

He also has prescriptions for the new President - a bigger and sustained fiscal stimulus (Jason Furman's role will be interesting if Obama comes to power) and social security cushions like universal health care.

The NYT has this interesting graphic and analysis, drawing on the work of Carmen Reinhart and Kenneth Rogoff, that predicts further 15% fall in home prices over the next three years, stock markets falling throughout 2009, and atleast four times more job losses than now and falling well past 2009.







Economists like Nouriel Roubini, who as early as 2005 predicted the sub-prime bubble collapse followed by a recession, warns that the mortgage excesses are only a part of the mess that the US financial markets are currently embroiled in. He argues that thanks to excesses in credit cards, auto loans, corporate and municipal debt, the banks and other financial institutions will require much more squaring up of their balance sheets. The great unravelling has only started and in all the losses could reach $2 trillion.

The resultant credit squeeze could be staggerring and painful. And it will require a more proactive and internventionist, big government to cushion Americans from the adverse impact of these hard times. As Paul Krugman writes, the Democrats are ideologically and historically best placed to administer such policies.

A case against lowering direct taxes in India

It has become some sort of a scared cow that any "successful" budget contain atleast a few proposals for cutting direct taxes. Newspapers and other opinion makers have distilled this wisdom deep into the minds of their audience. Tax cuts have therefore become the touchstone for populism and public acceptance of any budget! Are taxes so high and are we one of the highest tax paying nations? It is therefore instructive to go beyond the surface and examine this sacrosanct claim.

The government’s revenue collections through personal income tax rose by Rs 32,759 Cr in fiscal 2007-08 to touch Rs 1,18,320 Cr. One of the chief reasons for this increased tax collection is the hike in the number of income tax payees — from 25 million in financial year 2006-07 to 30 million in 2007-08. Corporate tax collections grew 29% from Rs 1,44,306 Cr in 2006-07 to Rs 1,86,125 Cr in 2007-08. The 2008-09 budget estimates for IT is set to grow by 16.9% to Rs 1,38,314 Cr and corporate tax by 21.6% to Rs 2,26,361 Cr.

The tax revenues grew at 20.5% in 2007-08, and an average of 22% for the last five years or doubling every three years. This buoyancy has boosted the tax-GDP ratio to an all time high of 12.5. Contrast this with when economic liberalisation was initiated 16 years ago - the share of direct and indirect taxes in gross tax revenue were 22.5 per cent and 73 per cent respectively, to an almost even share today.

Well respected commentators and analysts indulge in sophistry and invoke this buoyancy to call for lowering the direct tax rates. They claim that the taxes have increased at a massive rate and it is therefore only appropriate that we pass on some concessions to the tax payers, or reward them for their taxes. A closer look at our tax figures and comparison with other countries, reveal an interesting story. Consider the following sets of statistics.

1. In 2005-06, only 2.94 crore people submitted personal income tax returns. That is under 6% of India's population in the age group of 25-69 years. Of these, 88% claimed taxable income of Rs 2 lakh per year or less.

2. Only 5.62 lakh people filed taxable annual income of Rs 10 lakh or more. That was less than 2% of the total returns, and comprised 0.1% of India's population of 25-69 years.

3. In the UK, a single filer with a taxable income exceeding £34,600 will pay 40% tax at the margin. In the US, the highest rate is 35%. In Australia, 30% kicks in very early, and the highest marginal rate is 45%. In contrast, India's marginal tax rate was only 30%. Even with the surcharge of 10%, plus an education cess of 3%, our marginal rates are lower than that of the aforementioned countries. And we were taught that developed countries have lower tax rates than developing ones!

4. The recent aam aadmi ka budget sought to put more money into the hands of the consumers by among other things increasing the income tax (IT) floor rate from Rs 1.1 lakh ($2750) to Rs 1.5 lakh ($3750). Now we have one of the highest IT floor rates, exceeding even the US, where people start paying taxes at a lower income level of $3400 (Rs 1.36 lakhs). China, a more appropriate basis for comparison, has a much lower threshold level of $1400 (Rs 56000).

5. The Finance Minister resisted vociferous calls for lowering corporate taxes, already one of the lowest in the world. Taking advantage of various exemptions and rebates, the corporate sector paid taxes at the rate of 20.60%, substantially lower than the statutory tax rate of 33.66%.

6. Interestingly, public sector companies paid taxes at the rate of about 23% while private sector paid at the rate of about 20%. These companies earned Rs 5,56,190 crore as profits before taxes, but declared taxable income of Rs 3,41,606 crore only, or only 60% of their profits, during the financial year 2006-07, thereby getting total tax concessions worth Rs 58,655 crore, an increase of 30% over the previous year.

7. IT companies and ITes and BPO firms pay some of the lowest tax rates anywhere in the world, at 6% and 7% respectively.

It is estimated that the government lost Rs 2,78,644 crore of potential revenue during 2007-08 on account of various exemptions, rebates and concessions provided to individual and corporate tax payers. To put this in perspective, we have these sets of figures
a) This is 3.26 times the capital expenditure of Rs 85,256 Cr of the Central Government.
b) This is 42% of the total Central Government expenditure of Rs 6,73,842 Cr in 2007-08.
c) The total GoI expenditures on education and health care were Rs 24,249 Cr and Rs 11,757 Cr respectively.

Such rebates are effective subsidies to specific categories of tax payers. This marks an increase of over 16% over similar revenues foregone in the previous financial year. The revenue foregone is about 48% of total tax collections. Including Rs 58,416 Cr worth export related subsidies and exemptions, the revenue foregone reached a whopping Rs 3,37,060 crore, or about 58% of actual tax collections. Further, exemptions to individual tax payers, like those provided under Section 80C, will result in tax concessions worth Rs 38107 Cr in 2007-08, an increase of over 30% over last year. But the cry for concessions continues.

All this raises important questions about our fiscal policies. Is our tax buoyancy due to the increased honesty of our tax payers, that we need to reward them? Is the tax collection volume high enough to justify easing off? Why and when do we change our tax rates? What is the objective of our tax policy? Is it that our policy goal is to ultimately do away with all direct taxes?

It has been clearly established that our tax volumes have surged in the main due to the robust near double digit economic growth experienced this decade, and also due to the more stricter enforcement of tax regulations. It was inevitable that given the massive tax evasion, as the economy progressed and we deployed more technology to regulate our tax system, the revenues increased.

Our investment needs are staggering, and the resources scarce. It has become a fashion to claim that the private sector and PPP can be a panacea for our infrastructure deficits. No country in history has developed its basic infrastructure through a private sector dominated strategy. Different countries have tried this strategy at various times in their development trajectories, but had been disappointed. We only need to look at our giant Northern neighbour to realize the importance of public investments.

We sorely lack basic civic infrastructure in both the rural and urban areas. Drinking water, sewerage and sanitation facilities, internal roads and drains, public transport, reliable electricity supply, quality health care and education logistics loom large on the deficit side of this balance sheet. No PPP or private sector can replace government investments in such sectors, even in our cities. There exists considerable potential for private investments in core infrastructure like power, telecommunications, highway roads, ports, airports, etc. But here too Government will continue to be the overwhelmingly dominant investor, both in the less remunerative rural areas and in viability gap funding in other areas.

The Planning Commission has estimated that we need to invest $500 bn over the next five years in infrastructure alone. To put this in perspective, this is almost half our GDP. Our total tax collections in 2007-08 was only $145 bn, of which 60% went into transfers, interest payments etc, leaving the Government with only about $60-70 bn.

The Central Government spending in education, health care, rural development, and Agriculture, as projected in the 2008-09 budget were respectively a mere Rs 38703 Cr ($9 bn), Rs 17591 Cr ($4bn), and Rs 23831 Cr ($5.5 bn), Rs 9660 Cr ($2.4 bn). The entire allocation for the social sector was a mere Rs 95919 Cr ($44 bn) or 25% of the total budget outlay. Now, these are hardly the magintude of allocations that a country where 70-80% people depend on government for most basic services. It is clear from the meagre amounts we are able to allocate for critical social sector investments, that our tax collections continue to be too small to meet our massive demands.

All our major, capital intensive transport projects like highways, ports, airports etc benefit the rich and well-off more than the poor. The massive investments in urban and other civic infrastructure benefits the rich disproportionately more than the poor. In any case, it is well acknowledged that the poor gain access to many of these services very late, and often never.

On closer introspection, contrary to widely held perception that the rich people end up paying taxes for the welfare of the poor, it is the rich who actually benefit from the expenditures made out of their taxes. After all, who benefits from the massive investments being made in capital intensive sectors like express highways, ports, airports, telecommunications facilities, urban infrastructure, power etc. In contrast, the majority of the population residing in villages, have no or limited utility with all these magnificient wonders of modern India. Also, the rich and middle class are atleast equal beneficiaries of even many of the agriculture subsidies, as they help keep foodgrain prices low for its major consumers.

Update 1 (3/11/2010)

David Leonhardt writes that in all of 2009, tax exemptions, deductions, credits and other loopholes (collectively, tax expenditures) cost the federal government $1.05 trillion - the sum total of all personal income taxes paid was only $915 billion!

Wednesday, July 16, 2008

Are alphas just plain lucky?

In the stock market lexicon alpha represents the fund manager's unique stock picking ability. It is widely acknowledged that there are very few alpha fund managers, who consistently beat the market over a sustained period of time. However, what has come as a surpise is the findings of a study by Laurent Barras, Olivier Scaillet and Russ Wermers of about 2100 US mutual funds in the 1975-2006 period, that far from a small numbers of alpha managers, there actually may be none who beat the market consistently over a long period.

The study discounts for false positives (good luck) and false negatives (bad luck), by using a "False Discovery Rate" (FDR) method. Lucky funds have significant estimated alphas, while their true alphas are equal to zero. To address this issue, this paper quantified the impact of luck with new measures built on the FDR.

The study says,"Using a large cross-section of U.S. domestic-equity funds, we find that about one fifth of the funds in the population truly yield negative alphas. These funds are dispersed in the left tail of the alpha distribution. We also find a small proportion of funds with truly positive performance, which are concentrated in the extreme right tail of the alpha distribution."

With every passing year, the number of fund managers who pass the positive alpha tests decrease. If in 1990 (from 1975), there would have been 14.4% of fund managers had genuine stock picking ability, whereas the number had declined to a statistically indistinguishable 0.6%. Over smaller time frames, many fund managers beat the market.

The study attributes the reasons to the following
1. High fees and expenses. The researchers’ tests found that, on a pre-expense basis, 9.6% of mutual fund managers in 2006 showed genuine market-beating ability — far higher than the 0.6% after expenses were taken into account. This suggests that one in 10 managers may still have market-beating ability. It’s just that they can’t come out ahead after all their funds’ fees and expenses are paid.
2. Migration of good fund managers to hedge funds.
3. The market has become more efficient, thereby eliminating or trading away easy profit opportunities.

Hat tip: NYT

Monday, July 14, 2008

Financing Water and Sewerage Infrastructure

The World Bank estimates that the 5161 Indian cities, housing 30% of its population, would require investments of around Rs 1,50,000 Cr over the next decade, just to provide safe drinking water and basic sanitation services.

Hitherto these projects were financed mainly through internal revenues, dominated by property taxes and assigned revenues, apart from state grants. These revenues while adequate for financing smaller works are but a trifle when it comes to financing capital-intensive major infrastructure projects, even for the larger Urban Local Bodies (ULBs). Further, internal cash flow streams are uncertain and irregular, thereby resulting in spillovers and cost over-runs. The adhoc and limited nature of such financing fosters a piece-meal approach and acts as a road block to long-term planned project conception and execution. It is therefore inevitable that such projects be fully or partially funded through long term debt – bonds, project finance or pooled finance.

However, there are serious demand side impediments to accessing the debt markets. Most ULBs suffer from inefficient property tax collection and relatively small tax base due to large numbers of un-assessed and under-assessed properties. This, coupled with the over dependence on government grants and assigned revenues, and the uncertainty associated with it given the fiscal imbalances affecting State and Central governments, have lowered their credit worthiness. The deficiencies in accounting and financial reporting conceal the deep rooted financial rot and mars the potential for improvements.

Further, infrastructure projects, especially in the urban sector, often suffer from the vagaries of inadequate and uncertain revenues streams, therefore making them highly risky for private investors. There are very few successful examples in the country of large private investments or project finance in urban infrastructure.

Water and sewerage projects have certain inherent characteristics that make them ideal for project finance or other debt funding. They are capital intensive, have long operational lives and generate assured and periodic cash flows. Further, typical integrated projects in these sectors have stand alone characteristics, with the assets being distinct entities, making them eminently suitable for off balance sheet funding. The basic components of both water and sewerage are essentially the same - treatment facilities, pumping mains, storage reservoirs (or sump cum pump houses) and distribution (or collection) network. Each of these entities or an appropriate bundle of them are amenable to being financed by non-recourse project debt.

Both have two revenue streams - a one time connection charge and monthly tariff. The connection charges are a significant up front cash inflow, and if appropriately priced, can pay back atleast a third of the project cost immediately. The monthly tariffs are either metered or a flat rate for water, and flat rate or a proportion of the water charges, for each water closet connected to the sewerage system. The connection charges and tariff cash flows can be escrowed to pay off project debt.

There are three major credit risks associated with project financing for such projects – cash flow (tariff), collection and coverage risks. It has been observed globally that 76% of all PPP contracts in water and sanitation have had to be re-negotiated - on average within 1.6 years of signing the contracts - due to credit risks materializing. Contracts with price caps on user fees or tariffs are especially vulnerable, as they adversely affect both the regular Operation & Maintenance (O&M) and system expansion investments. A high collection efficiency, high coverage ratio, and assured and known cash flow figures, can considerably mitigate these risks.

Some small steps can go a long way towards ensuring that the aforementioned objectives are achieved with minimum risk. Water and sewerage tariff collection can be bundled together with robust and regular revenue stream like the Property Tax so as to improve collection efficiency. Since expenditure on fixed assets is independent of the number of connections, economically efficient utilization of the assets demands maximizing the coverage. Lowering connection charges and permitting payments in installments coupled with rationalization of procedures, will help more people access these services. Removing public taps, except in exceptional cases, and disconnecting ground water sources, will also incentivize household water connections.

Aggressive public awareness campaigns on the benefits of taking a sewerage connection, by highlighting the possibility of eliminating clogged, unhygienic and mosquito breeding open drains, can be very effective in ensuring universal coverage of sewerage. Once the sewerage line is laid, households could be penalized for letting out their waste water into the storm water drains. Other steps like re-laying roads only after everyone takes connections, and selectively invoking penal public health provisions can also incentivize universal coverage. The success of these measures requires the active participation of all local stakeholders like Residents Welfare Associations and people’s representatives.

Providing continuous water supply and installing water meters can substantially reduce the Non Revenue Water and lower the O&M costs, and thereby improve the project finances.

Appropriate measures to insulate tarrifs and other revenue streams from political interference or decisions based on such considerations will certainly assist in reassuring investors. Construction risks, arising from delays in obtaining clearances, taking possession of site, finalizing tenders, removing encroachments and other unforeseen contingencies results in time spill overs and cost over-runs. This can be avoided by handing over in advance the possession of work site, appointing professional Project Management Consultants, achieving financial closure before starting work, and expediting Government level clearances. Another alternative is for the Government or its agencies to assume the entire construction risk.

Fortunately, thanks to external and internal compulsions, all the aforementioned desirables are already under implementation in many ULBs, albeit at varying pace. With the JNNURM providing 50-70% of the project cost for the over-Rs 25,000 Cr worth water and sewerage projects sanctioned, there is a great opportunity for cities to leverage private capital to finance all their water and sewerage investments.

Update 1 (15/3/2010)
This NYT article explains the problems facing the old sewer and water lines in many American cities, which manifests itself in frequent leakages, discharges of overflowing sewerage into rivers etc.

Evidence that big government is back

In the aftermath of the recent sub-prime crisis we are witnessing a definitive trend in governments stepping in to guarantee and even bail out failing financial institutions. This trend threatens to encourage a climate of moral hazard in lending practices, and carries the seeds for more such disasters in future. Armed with the virtual guarantee arising from a growing impression that the government cannot afford to let their large institutions fail, the already cavalier fund managers will now have the final stamp of authority for reckless lending.

The latest example is the problems facing the giant mortgage finance firms, Fannie Mae and Freddie Mac. With the crisis deepening, the Bush administration yesterday asked Congress to approve a sweeping rescue package that would give officials the power to inject billions of federal dollars into the beleaguered companies through investments and loans. The Fed announced extension of its short term lending facilties (discount window) to these two firms, so as "to promote the availability of home mortgage credit during a period of stress in financial markets."

Another example of such moral hazard is in the sector of education loans. As commercial banks concluded that the business of lending to college students was no longer quite so profitable, the Bush administration promised in May to buy their federally guaranteed student loans, giving the banks capital to continue lending.

Ironically enough, in the bastion of free market and free enterprise and in a sector (financial markets) considered most unfettered and unregulated, these trends have had the effect of bringing back big government into the public realm. The government is now fast becoming the lender of last resort to failing lenders, the numbers of whom are rising fast. The moral hazard unleashed by the actions of the US Government will take some rolling back!

Labour mobility as an anti-poverty intervention

It has for long been argued that the biggest remaining distortion in the global economy is that of the massive wage differentials for similar wages across countries. Michael Clemens, Claudio Montenegro and Lant Pritchett use micro data from 43 countries and come up with the following wage ratios.



Controlling for various socio-economic parameters, a worker moving from Nigeria to the US enjoys an 840% increase in wages, while a worker moving from Bolivia to the US experiences a 240% increase. The authors of the study finds that immigration to the US is the most effective anti-poverty tool. They compare the relative importance of various anti-poverty interventions with immigration to the US.



Chris Blattman calls it the biggest known wage discrimination in history and the largest remaining price distortion in the world markets. Is there a case for claiming that labour mobility (within and between nations) is the best anti-poverty strategy?

Update 1
Felix Salmon summarizes the debate here. Lant Pritchett estimates annual gains of about $300 billion — three times the benefit of removing the remaining barriers to trade, and therefore recommends creation of 3 million jobs for guest workers in the US.

Update 2
An interview in which Prof Pritchett makes out his case in favor of labour mobility. He calls it the biggest distortion in the world economy today.

Sunday, July 13, 2008

Infrastructure financing Models III

This post is a continuation from earlier posts here and here.

The privatization of utilities in the UK, based on the model that the private owner owns the assets (or Regulated Asset Base - RAB), operates them and delivers the service (OPEX), undertakes investments for network and capacity expansion (CAPEX), and also co-ordinates OPEX and CAPEX, is now coming under attack from various quarters. There appears to be a growing realization that the asset ownership should be separated from the operational and expansion dimensions. An example is that of France, where water utility assets are publicly owned while OPEX and CAPEX are auctioned off to franchises.

Oxford economist Dieter Helm has recently reviewed the experience of British utility privatization and come to the aforementioned conclusion. By drawing a clear distinction between the RABs and the operational activities, he focusses on the possibility of trading RABs and competitive tendering of the operational activities of the utility business.

These regulated utilities have been financed based on a split cost of capital assumption - a cost of debt for the purchased RAB, and a cost of debt and equity for the operating part of the business. Large utility service providers are natural monopolies which are capital intensive, long-lived assets and sunk costs. Further, the marginal cost is typically low when compared to average cost. This gives regulators and governments an incentive to expropriate by allowing marginal not average costs, especially after the RAB investments have been sunk.

In order to reassure the investors in utility networks, a Regulated Capital Value (RCV) is assigned to the clearly defined RAB, additional investments made are added to the RAB, and a rate of return is fixed for these assets. The return on the RAB is a charge on customers for the past (or sunk) investment. The risks associated with RABs on the one hand and OPEX and CAPEX on the other hand, are very different. The risk associated with RABs are mainly political and regulatory, whereas those with the later are more mangerial in nature.

Accordingly, their respective financing patterns varies. Since they have few assets to act as a collateral, the typical private sector comparator to OPEX, CAPEX and co-ordination, is financed by a mix of debt and equity, with equity dominating. The RAB, on the other hand, only has equity risk to the extent that it is exposed to regulatory and political risk, which can be mitigated with appropriate legal protection. Ideally, the RAB should be financed by the public sector, which has access to debt at the lowest cost, and which is best able to take on regulatory and political risks.

In the UK, under the existing regulatory framework, once the asset is formally in the RAB, its RCV is virtually guaranteed, thereby leaving little or no equity risk in the RAB investment. However, oblivious to this guarantee on equity, instead of limiting the guaranteed returns (or cost) on financing the RAB to the cost of the debt, the regulators continue to allow the calculation of the cost at the Weighted Average Cost of Capital (WACC), which takes into account both equity and debt.

This is an open invitation for financial arbitrage. Investors finance their purchase of RAB at the cost of debt, while they are guaranteed returns at WACC. This has led to investors buying off assets, replacing their equity with debt, and skimming off value worth over trillion pounds a year. The weak oversight on gearing ratios has only helped this equity exit.

The customers have been ultimate bearers of these premiums by way of cost pass-throughs in utility services. They are also exposed to the risks imposed by the high gearings (debt), by way of adverse external shocks. Further, given their limited equity, and having already made their profits, the operators have less incentive in effective opearation of the assets (OPEX) and especially CAPEX.

Helm however feels that this is an ideal situation for hiving off RABs and OPEX, CAPEX and co-ordination as separate entities. RABs can be securitized and traded as a separate financial product, and its price and true cost of capital can be determined by the market. These tradebale RABs would be similar to the infrastructure funds that are floated in the debt market to raise capital for creating specific infrastructure project assets. Customers would not need to pay for the non-existent equity risk. The OPEX, CAPEX and co-ordination would then be auctioned off to franchisees by competitive bidding, thereby helping consumers get the best deal in service pricing.

Martin Wolf argues that under this model, it becomes obvious that the public sector, with the access to capital at the lowest cost, appears best positioned to finance investments in assets. The most sensible solution would therefore appear to be for the public sector to finance the assets, with operating and investment activities contracted out.

Update

See this presentation from Dieter Helm.

Rating agencies and conflicts of interests

The aftermath of the recent sub-prime mortgage bubble had raised serious questions about the accuracy of ratings given to financial instruments and institutions by reputed creidt rating agencies.

Here is a study that claims that reputational concerns, far from lowering the chances of rating agencies making mistakes, may actually end up incentivizing them to overlook the available private information. It identifies two major reasons why rating agencies cannot be trusted.

1. It is likely that market participants are more likely to find out about a mistake when a rating agency gives a good rating than when it gives a bad one - good ratings entail more investor interest and analyst coverage, and a wider range of investors will end up holding the securities of the rated firm. In a situation in which a rating agency faces no competition, it might want to be conservative, issuing bad ratings too often, ignoring both publicly and privately available information that indicate otherwise, as this behaviour minimises the chances of being identifiably wrong. In a situation in which a rating agency faces tough competition, it might prefer to be bold and issue good ratings too often, ignoring both publicly and privately available information that indicate otherwise, in order to gamble on increasing its reputation relative to its competitors.

2. A rating agency assigns a rating based on information that is publicly available to all market participants and information that is privately assembled by its analysts or provided by the firm. This information goes through the rating agency’s credit model to produce a rating. If privately available information is inaccurate or difficult to interpret, or if the credit model is flawed, this may prompt a rating agency to make mistakes and issue an incorrect rating. When a rating agency that is aware of the imperfections in its ratings process finds itself in a situation in which a strongly held public opinion and its interpretation of its private information diverge, a rating agency might just conform to public opinion, issuing the rating that everyone expects, because of fears of being wrong.

Update 1
NYT article on how the rating agencies failed the markets.

Update 2 (2/5/2010)
The Times reports that from 2004 to 2007, agencies made hundreds of millions of dollars rating thousands of deals in residential mortgage-backed securities and collateralized debt obligations. Their fees could exceed $1 million per transaction, on top of annual 'ratings surveillance' fees of tens of thousands of dollars.

Ninety-one percent of the triple-A securities backed by subprime mortgages issued in 2007 have been downgraded to junk status, along with 93 percent of those issued in 2006 and 53 percent of those issued in 2005. On Jan. 30 of 2008 alone, Standard & Poor’s downgraded over 6,300 subprime residential mortgage-backed securities and 1,900 C.D.O.’s.

Crisis at Fannie Mae and Freddie Mac

The past week has been tumultous for the giant US mortgage finance firms - Fannie Mae and Freddie Mac. With home foreclosures rising, mortgage holders defaulting in ever larger numbers, and home prices falling steeply, the two major firms are left holding increasing quantities of worthless paper. In 2008, till date the shares of the former have plummeted 74% to $10.25, while that of the later has dived 77%, closing at $7.75. So far, they have lost more than $11bn in the sub-prime mortgage crisis.

Combined, these two shareholder owned companies guarantee or own more than $5 trillion in home mortgages, almost half the nation's $12 trillion mortgage market. At a time when the sub-prime mortgage is continuing to unravel, any serious trouble with these two morgage finance firms will reverberate across the financial markets.

While originally formed by the Government to supply liquidity to the mortgage market, both have subsequently become private shareholder companies. However, the government origins and the massive size of these two firms continues to give the widespread impression that they are government backed and hence cannot fail. This in turn means that they get capital at much lower cost than their competitors. Further, they also were not subjected to the same levels of oversight and did not have to meet the regular capital adequacy requirements, other financial standards and tax burdens.

Contrary to popular perception, neither Fannie Mae nor Freddie Mac make any home loans. They take in mortgage loans from banks by charging a guarantee fee for the risk it is undertaking, pools and repackages them in the form of mortgage-backed securities (MBS), and then sells them to investors in the open market, with a repayment guarantee. There are limits on the types and size of loans it can guarantee. Both also borrows money from the debt markets, traditionally at a rate much lower than other banks, and uses it to buy mortgages it holds as its own investments. By buying these loans, Fannie injects new money into the housing economy.

By taking on the mortgage loan risk, Fannie and Freddie provide stability and liquidity to the mortgage market, and allows banks to make even more mortgages. If it is harder for them to borrow money, mortgage interest rates will rise. If Fannie and Freddie stop buying loans, banks may stop making new loans, freezing the United States housing market.

Virtually every Wall Street bank and many overseas financial institutions, central banks and investors do business with Fannie and Freddie. The Wall Street banks have reaped rich fees by issuing debt for them. The consequences of a contagion effect on the entire financial system could be devastating.

Ironically, as Fannie Mae and Freddie Mac have grown in size and taken in more and more risk, they have also succeeded in transferring those risks to the entire financial system. Given their size and depth, it has become a fait accompli that the Government will step in and bail them out if problems become severe. As the saying goes, "If you owe a bank $100, then you have a problem. But if you owe the bank $100 million, then the bank has a problem"! Much the same applies to Fannie Mae and Freddie Mac today!

Update 1
Paul Krugman believes that it is inevitable that Fannie Mae and Freddie Mac will be bailed out, as the economy cannot afford them to fail.

Saturday, July 12, 2008

Financing Infrastructure II

There is an increasing belief among multi-lateral lending agencies and policy making circles in India that the private sector resources can replace Government funds in meeting the massive requirements of funding the infrastructure sector. This post will argue that this belief is misplaced and end up harming the development of our infrastructure sector (atleast certain sectors), if not dispelled conclusively and at the earliest.

The last couple of decades have seen pathbreaking developments in infrastructure financing. Till the eighties, Governments used to finance all infrastructure expenditure in India. The nineties saw the emergence of private sector as possible investors in infrastructure sector. The whole idea of private investments in infrastructure took off initially with the telecommunications sector and the BOOT/BOT projects in the roads developed under the Golden Quadrilateral. It gained further currency with the interest shown by private developers in the development of ports, airports and power generation.

Buoyed by the recent successes in privatization of national highways, ports, airports, and power generation, an impression has gained ground that there is massive amounts of private funding available and Governments can therefore exit from making investments in infrastructure. It is felt that at best, the Government role in infrastructure should be confined to providing viability gap funding or bridge financing investments.

It is in this context that three proposals pending before the US Congress deserves attention. These proposals come at a time when high profile events like the Minnesota bridge collapse and the sewer line bursting in New York's Times Square has brought to focus the bad state of infrastructure in America.

The National Infrastructure Bank (NIB) would be an independent federal entity with a five-member board of directors appointed by the President and confirmed by the Senate. The bank would evaluate and finance infrastructure projects "of substantial regional and national significance" with a potential federal investment of at least $75 million. It would be authorized to issue $60 billion in bonds, the proceeds of which could be used to finance direct subsidies, loans, and loan guarantees.

The Treasury would pay the interest on the bonds, and although the bills specify that the NIB would be responsible for paying the bonds’ principal, the Treasury would have ultimate responsibility for that also, because the bank would be a federal entity and the bonds would carry the full faith and credit of the United States.

The National Infrastructure Development Act would create a National Infrastructure Development Corporation (NIDC) and a subsidiary National Infrastructure Investment Corporation (NIIC). Initially, both would be federal corporations, but the bill would give the NIDC five years to develop a plan to convert both entities to Government Sponsored Entities (GSEs).

The NIDC would be capitalized with up to $9 billion in appropriations authorized over three years. Thereafter, it would be self-financed through business income, presumably through fees on users of infrastructure, and (once converted to a GSE) through the sale of public stock. The NIDC would be authorized to make senior and subordinated loans and to buy debt and equity securities issued by others to fund infrastructure projects; the NIIC would be authorized to insure and reinsure debt instruments and loans, insure leases, and issue letters of credit.

The Build America Bonds Act would grant consent and recognition to a transportation finance corporation established by two or more state infrastructure banks. The corporation would be under the control of the participating states, but it would be authorized to issue up to $50 billion in bonds providing federal tax credits in lieu of interest. The rate of the credits would be set so as to equal the average yield of longterm corporate debt obligations at the time the bonds were issued.

All the three involve substantial commitment of Government investments in infrastructure. The underlying premise, as CBO Director, Peter Orzag said in his testimony before the Senate Finance Committee, is that Government is able to raise funds at much lower rates than the private sector. He writes, "an infrastructure entity (like an SPV) that issued its own debt would incur higher interest and issuance costs than the Treasury does and could expose the federal government to the risk of default on such debt".

The four major dimensions of any infrastructure project are - project selection, project financing, project construction and operation and maintenance (O&M). The private sector has a core competency in more efficiently operating and maintaining utilities and assets, and it is therefore appropriate that private operators maintain public utilities. It is also best positioned to bear the risks associated with construction of the project assets. Further, the fact that the projects are proposed by the private sector will ensure that it is demand driven and commercially viable, and thereby eliminate some of the common project selection problems associated with government infrastructure projects. About financing such projects, the "best practice" model assumes that the financial markets are best suited to financing them.

However, such "best practice" assumptions fail to take into account the reality that private finance most often comes at a very high cost, and this incremental burden becomes the deciding factor between the viability or otherwise of a project. It is therefore important that we pay attention to "second best" models like loans from Government agencies and credit enhancement support from Government. The importance of lower cost of capital in infrastructure projects, and the role government can play in achieving it has been outlined in an earlier post here.

In developing economies like India, where the infrastructure projects have deep and inherent linkages with the Government and its agencies, no private entity, however established and credible, will be able to convince lenders about having mitigated the risks involved. These risks include construction risks, Operation and Maintenance (O&M) risks, and expansion risks. This inability to signal convincingly enough to lenders will translate into higher cost of capital for the project, thereby saddling the project with often unsustainable debt service burdens, under the weight of which it fails. This is especially true of sectors like water, sewerage, solid waste management, electricity transmission and distribution, and even urban mass transit systems, all of which involve significant public service dimension and interface with citizens.

There is therefore a strong case for the Government (or its agencies, backed by a sovereign guarantee) to borrow money and finance major infrastructure projects. The extent of funding can vary depending on the project, and should preferably be limited to the amount required to make the project financially viable and thereby incentivize private investments.

Another alternative to mitigate risks and lower the cost of financing is to provide credit enhancement support that would act as an effective guarantee against default. The extent of credit enhancement support can vary from a share of the debt to the total debt, depending upon the project and the sector being financed. This should be decided based on a detailed financial and economic analysis of the viability of the project without the support.

The Government of India have recently set up a Pooled Finance Development Fund (PFDF) of Rs 400 Cr ($100 mn) for the 10th Five Year Plan period for financing urban infrastructure projects. 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 Urban Local Bodies (ULBs) and the lenders/investors is expected to reduce the costs of capital. The ULBs will have to access the market through a State Pooled Finance Entity (SPFE). While laudable, the amounts involved are modest and will hardly make a dent in our huge infrastructure financing requirements.

In this context, our massive and growing foreign exchange reserves can be deployed more efficiently by utilizing a small share for providing credit enhancement support for infrastructure projects involving External Commercial Borrowings. It may also be worthwhile to explore options with lending institutions whereby the same credit enhancement support can be used to guarantee multiple projects with appropriately balanced risk patterns.

However, such direct Government loans or credit enhancement support should be provided only after strict and professional due diligence that clearly establishes the financial and economic viability of the project. It is important that this activity is not done within the traditional institutional framework like the Planning Commission and involves more professionally competent agencies with adequate sectoral and financial experience. It should also be confined to sectors like water and sewerage, solid waste, power distribution, and urban mass transit, where there are considerable commercial risks.

The flip side with such Government loans raised from the market, would be its effect on "crowding out" private capital requirement. It may be interesting to quantify the extent of this effect. If the benefits accruing by way of cheaper cost of capital for the infrastructure projects, exceeds the crowding out effect, then such government intervention would be beneficial. I am inclined to believe that this benefits would be greater since every rupee spent in infrastructure exerts a larger multiplier effect on the economy than a similar consumption in another sector by a private investor.

Infrastructure sector testimony of the CBO Director

US Congressional Budget Office (CBO) Director, Peter Orzag's testimony before the Senate Finance Committee on infrastructure investment has many interesting observations about the infrastructure sector. Among other things, the testimony also underlines the critical fact, suggested in an earlier post, that Governments can borrow at much cheaper rates than private or public-private infrastructure entities.

1. Need to make asset management a priority. Asset management relies on monitoring the condition of equipment and the performance of systems and analyzing the discounted costs of different investment and maintenance strategies. For existing infrastructure, the key issue is making efficient choices about maintenance and replacement. In constructing new infrastructure, asset management involves evaluating
total life-cycle costs—both the initial capital costs and the subsequent costs for operation, maintenance, and disposal—to ensure not only that projects are prioritized appropriately, but also that they are built cost-effectively. In the case of highways, asset management can involve making a larger initial investment in thicker pavement, which could provide a morethan-proportional increase in pavement life.

2. Options for meeting infrastructure demand includes
a) Increase federal spending
b) Improve cost effectiveness of tax expenditures - by delivering the tax benefits more effectively using Tax Credit Bonds (which gives tax credit on federal income tax liability, thereby freeing up State and Local Bodies from the burden of paying interest on their bonds/Munis)
c) Reduce the cost of providing infrastructure through proper asset management practices.
d) Promote eduction in demand by trying to recover atleast the Marginal Cost and by imposing user charges, congestion pricing etc.

3. The cost of capital experienced by private or public-private entities in funding infrastructure investments is much higher than that for Government. Therefore the US Government is considering three proposals - setting up a National Infrastructure Bank (NIB), a National Infrastructure Development Corporation (NIDC) and a subsidiary National Infrastructure Investment Corporation (NIIC) and a Build America Bonds Act - to raise money, mainly from the market through sovereign guarantee, and then fund public and private investments in infrastructure.

4. Most of the US federal government’s programs for surface transportation are financed through the Highway Trust Fund, about 90 percent of whose revenues come from two taxes on motor fuels. The tax of 18.4 cents per gallon on gasoline and gasoline–ethanol blends currently accounts for about two-thirds of the trust fund’s total revenues. The levy of 24.3 cents per gallon on diesel fuel accounts for about one-quarter more. Both tax rates have been unchanged since 1993. In 2007, receipts to the Highway Trust Fund from those taxes totaled about $38.8 billion. The states provide matching funds — generally about 20% of a project’s costs — on most highway projects that they undertake using federal money.

Thursday, July 10, 2008

Prices show speculation theory wrong

Speculation in the commodity futures markets has been widely blamed for the current rise in food, commodity and oil prices. I have already posted here and here as to why this hypothesis is a mere fantasy. Now here is more proof from the market against such wild theories.

The Financial Express compares the prices of those commodities in whom futures trades have been barred. The graphic below is self explanatory.

Polls Vs Prediction Markets

With elections around the corner in India, both political parties and candidates are naturally eager to assess their respective electoral prospects. The media feed this appetite by indulging in a frenzy of polling as the election day draws closer. News papers and news channels compete with each other in publishing opinion polls and also claiming greater credibility based on selective interpretation of thier previous poll results and the final election verdict.

These opinion polls survey the preferences of a representative enough sample (and this is most often a subject of debate and controversy) of voters and a reasonably large enough number of voters. The voters make their choices based on their present perceptions of the respective parties or candidates. This in turn is generally based on their assessment of the past performance or actions of the political parties and candidates. Opinion polls are therefore largely a reflection of the past performance of the candidates.

Justin Wolfers argues that Prediction Markets are a better indicator of the actual result than opinion polls because, unlike the latter, the former makes its assessments based on the expectations of the future performance. He writes that prediction market traders even take cue from the opinion poll results and change their predictions assuming that the contestants respond to their poll results by changing strategies.

Prof Wolfers quotes the works of Robert Erikson and Christopher Wlezien, who find that opinion poll results tend to be skewed by time inconsistency problems, and therefore needs to be discounted for. The initial advantages or leads generally tend to get dissipated over time, and the voting public tends to be more strongly anti-incumbent three-and-a-half years into an administration than they are on Election Day. Further, polls are slow to reflect economic conditions.

Prediction markets are "information markets" or "speculative markets created for the purpose of making predictions" where the participants trade in contracts whose pay-offs depend on outcomes of unknown or uncertain future events. It is based on one of the basic maxims of classical economics - in a truly efficient market the market price will be the best predictor of an unknown future event. James Suroweicki had claimed that prediction markets are a more reflective statement of the reality as it represents the "wisdom of the crowds".

In the most basic prediction markets, the "winner-takes-all" market, the contract costs, say Rs 5, and pays off, say Rs 25, if and only if a specific event occurs. The price on a winner take all market represents the markets expectation of the probability that an event will occur.

In an "index contract", the payoff varies in a continuous way based on a number that rises or falls, like the percentage of vote received by a candidate. The price of such a contract represents the mean value that the market assigns to the outcome. In "spread betting", trades differentiate themselves by bidding on the cutoff that determines whether an event occurs or not, like a candidate receives more than a certain percentage of the popular vote.

The Iowa Electronic Markets, run by the University of Iowa Tippie College of Business, is one of the most successful prediction market in the world and has predicted many US Presidential elections. Our own informal and illegal "satta" markets are another example of a crude prediction market, though these are more one-off markets than continuing markets.

Given the coming elections and the amount of time available to make meaningful trades, it may be a good idea for some university or newspaper to run a prediction market on the election results. Besides, it will also throw up interesting statistics and information, which can be analyzed to better understand the preferences and motivations of the Indian voter.