Wednesday, November 30, 2011

Sustainable growth and the resource productivity challenge

The spectacular growth in the demand for energy, water, food, and commodities has ressurected the Malthusian spectre of a world running out of these resources. In this context, a new report by the McKinsey Global Institute brings some cheer claiming that this resource challenge can be met through a combination of expanding supply and resource productivity improvements (ranging from capping water supply leakages to building energy efficiency).

It claims that it is possible to save $2.9 trillion by extracting and using the world’s resources more productively. With carbon dioxide emissions priced at $30 a tonne these saving rises to $3.7 trillion. Resource productivity improvements - change in the way they are extracted, converted, and used - are the focus of the report, and it writes,

"Such resource productivity improvements, using existing technology, could satisfy nearly 30 percent of demand in 2030. Just 15 areas, from more energy-efficient buildings to improved irrigation, could deliver 75 percent of the potential for higher resource productivity."


The report advocates action by governments on three fronts to expand supply and improve prodcitivity. It writes,

"Policy makers should consider action on three fronts: unwinding subsidies that keep prices artificially low and encourage inefficiency; ensuring that enough capital is available and that market failures associated with, for instance, property rights and incentives are corrected; and bolstering society’s resilience by creating safety nets to help very poor people deal with change and educating consumers and businesses to heed the reality of future resource constraints."


As national incomes rise, as is happening at a swift pace with China and India, per capita resource consumption increases.



A reflection of a resource crunch is the steep increase in the prices of commodities...



... and also the price volatility of these resources.



Fifteen resource productivity improvement opportunities represent 75% of all such opportunities.



Developing countries account for 70-85% of these resource productivity opportunities.



Fortunately, considerable gaps exist between different countries on these productivity areas. This also means there exists considerable catch-up opportunity for the lagging countries.



See this post in Free Exchange which describes the findings of the report as a summary of market failures, whose correction would result in the promised resource productivity improvements.

Tuesday, November 29, 2011

Fiscal Policy Matters - Big Time?

Christina Romer is anguished about the fiscal policy debate,

"Policymakers and far too many economists seem to be arguing from ideology rather than evidence... the evidence is stronger than it has ever been that fiscal policy matters — that fiscal stimulus helps the economy add jobs, and that reducing the budget deficit lowers growth at least in the near term. And yet, this evidence does not seem to be getting through to the legislative process. That is unacceptable. We are never going to solve our problems if we can’t agree at least on the facts. Evidence-based policymaking is essential if we are ever going to triumph over this recession and deal with our long-run budget problems."


She writes about the inherent difficulty of estimating the impact of fiscal policy on people's consumption decisions because there are other things happening in the economy and other unanticipated factors which might influence the policy. She points to the omitted variable bias while illustrating the case with the early 2008 Bush tax cut. The contribution of this tax rebate to holding up household consumption spending was offset by the tumbling houseprices and resultant lowering of household wealth which in turn squeezed disposable incomes. In other words, the omitted variable bias skews our understanding of important relationships, nowhere more so than in our assessment of fiscal policy.

Prof Romer also points to tax cuts made when the economy is slipping into recession and tax increases in response to increased spending needs (like, say, war). In the former, unless tax cut was very large and for a sustained period, the outcome would still be weak growth - the tax cut would have only mitigated the adversity. In the later case, there is a behavioural sleight of hand - the impression gains ground that the tax increase caused increase in spending, whereas it was only a small contributor to an already rising spending.

In order to address the omitted variable bias, she and husband David Romer excluded from their empirical analysis the tax changes taken in response to economic conditions and confined their dataset to tax changes made for ideological reasons (Reagan tax cut, Clinton tax increase etc). The graphic below shows two estimates of the impact of a tax cut of 1% of GDP on real output. The red line shows the result using the conventional measure of tax changes — the change in cyclically-adjusted revenues. The blue line shows the estimates based only on the relatively exogenous tax changes we identified from the narrative analysis.



The graphic shows that limiting omitted variable bias results in larger and more statistically significant estimated impacts of tax changes. Prof Romer also argues that nobody has done a similar study (one that controls for motivation) to assess the true impact (on output) of a government spending increase. In its absence, there is no way to derive more definitive conclusions about the real impact of direct government spending increases nor adjudicate beween the relative superiority of tax cuts and spending increases.

She highlights the counterfactual problem of what would have happened without the ARRA in the US,

"The metaphor I find helpful is to a patient who has been in a terrible accident and has massive internal bleeding. After life-saving surgery to stop the bleeding, the patient is likely to still feel pretty awful and will have a long way to go before he is fully healed. But that doesn’t mean the surgery didn’t work. You have to judge the effect of the surgery relative to what otherwise would have happened. Without surgery, the patient would have died."


She points to three studies which, albeit incomplete, point to the ARRA playing an important role in propping up demand and ensuring that the economy did not get any worse.

She also points to similar omitted variable bias in the study of Alberto Alesina and Silvia Ardagna which has become the touchstone for advocates of expansionary contraction to argue that fiscal austerity is generally expansionary. They mined budget data for a large number of advanced countries over the past 35 years and identified large fiscal consolidations by looking for times when the cyclically-adjusted budget deficit fell sharply. They find that output tended to rise on average after these consolidations, especially those focused on reductions in government spending. She writes about the omitted variable bias in their analysis,

"Some of their fiscal consolidations weren’t deliberate attempts to get the deficit down at all. Rather, they were times when the budget deficit fell because stock price booms were pushing up tax revenues. Stock prices were a big omitted variable. They were driving the deficit reduction and were likely correlated with rapid output growth. This omitted variable made it look as though deficit reduction was expansionary, when it really wasn’t."


An IMF working paper, about which I blogged earlier, sought to address the deficiencies of the Alesina-Ardagna study and found that austerity programs hurt. Their dataset was limited to deliberate fiscal consolidation - for reasons unrelated to short-run macroeconomic developments - moves in 15 advanced countries over the last 30 years. They find that unemployment typically rose and output fell following such austerity programs.

Monday, November 28, 2011

Superstar effect and skewed labour markets

I have blogged earlier about "superstar" effect wherein a small number of star players, artists, executives and other professionals command a disproportionately higher compensation premium than everyone else in the market. Superstar effect and its consequent out-sized compensations has been a major contributor to amplifying the attractions of financial sector as a career choice.

Chris Dillow has an excellent post where he points to the cognitive biases that exacerbate the "winner-takes-all" effect of such labour markets. Availability bias preys on our mind and makes us feel that the out-sized success of an always-on-television superstar can be emulated more easily than would be the case in real world. Overconfidence bias makes us over-estimate our own talent and conditions and thereby the probability of success. Probability misperception bias causes us to over-weight smaller probabilities (like winning lotteries).

All this results in misallocation of resources atleast in certain labour markets. Conventional wisdom on the cricket's Indian Premier League (IPL) and the numerous television talent shows is that they provide opportunities for talented youngsters to showcase their abilities and thereby make a livelihood in that field. The sudden emergence of these platforms and the sharp increase in the numbers of people benefiting, amplifies all the aforementioned behavioural biases and makes such vocations even more attractive.

Consider talent shows. A typical parent faces several perception distorting trends - there are a large number of vernacular television channels, most with their own heavily promoted talent shows; the strong memory of the ubiquity and fame of all the winners of the superstar shows (among such talent shows) like the Indian Idol; and the strong possibility of being connected to a relative or neighbour or workplace colleague whose child succeeded in a talent show and knowledge about their initial flush of fame and money. They therefore find the attraction of grooming their child to succeed in such talent shows irresistible.

Apart from all the three aforementioned cognitive baises, the parent faces another bias, the representativeness bias. It makes parents over-estimate the probability of their ward's success using available data as opposed to using an objective Bayesian calculation. Such over-estimation works at four-levels. One, given the large number of participants in each channel, parents fail to appreciate that the probability of their child's success is remote even in the particular show. Two, since their child is participating in a particular show, they over-estimate its importance over and above that of its possibly more influential (among talent hunters) competitors. Three, since any success in a talent show is followed by an initial flush of fame and money, parents over-estimate its importance and tend to see this as an inevitable precursor of things to follow, overlooking the strong probability that such a peak is less likely to be sustained. Finally, an increased number of parents now think the same way and try to encourage their children to participate in talent shows, which in turn significantly increases the market competition and thereby lowers the probability of success.

A Bayesian calculation will bear out the true magnitude of risks associated with attaching the fortunes of their children with such talent shows. However, cognitive biases overcome human beings and they unwisely yoke their children's careers to such professional choices. The same assessment would apply to parents encouraging their children to play cricket in the hope of IPL selection and success.

PS: In fact, a more critical assessment of these markets would reveal that even the argument about the market being able to accommodate an increased number of high paying professionals is questionable. True there is a demand for a greater number of singers and cricketers. But the superstars will always remain few in number. The rest will earn only a moderate amount, and that too only for a smaller shelf-life than with a regular occupation.

Sunday, November 27, 2011

Negative interest rate for microloans

This announcement by the Andhra Pradesh state government is certain to be another defining moment in the history of competitive populism in India, one that is certain to be emulated by atleast a few other states.

"The members of Self Help Groups in the Andhra Pradesh will get interest-free loans up to Rs 5 lakh from January 1... However, women would be eligible for interest waiver only if they ensure prompt repayment. As banks were now charging 14 per cent interest on loans to self help groups, the interest-free loans would cause a financial burden of Rs 1,400 crore on the State Government... To cater to the micro credit requirement, the government has set up a cooperative credit society under the name 'Stree Nidhi' with an initial corpus of Rs 1,054 crore."


Andhra Pradesh has an SHG bank linkage lending target of Rs 10000 Cr this year, nearly half the national target of Rs 22000 Cr. Of this Rs 10000 Cr, Rs 9000 Cr is in rural areas while the rest is for SHGs in urban areas. The state has 1.11 Cr women in SHGs.

Given the nearly 10% rate of inflation, the state government would actually be lending at minus 10% to these SHGs. It would form the most generous bank-lending program in scale anywhere (possibly anytime) in the world.

Saturday, November 26, 2011

Friday, November 25, 2011

The school learning outcomes crisis

I have blogged earlier about why learning outcomes, and not enrolment or retention, have to be the top priority in any meaningful primary school education reform agenda in India. The graphic below highlights how learning outcomes have more or less plataeued off in recent years.



Pratham's ASER assesses learning competency in Math on four parameters - recognition of randomly chosen numbers from one to nine, recognition of randomly chosen numbers between 11 to 99, subtraction of two-digit numerical problems with borrowing and division of three-digit by one-digit numerical problems. In 2010 merely 37% of the children in class III in rural areas could recognise numbers up to 100; just 27% of the students could do two-digit subtraction. The proportion of children reaching the highest test level has consistently declined since 2005 - at least 15% of children in class III in 2005 could perform all the tests, while in 2010 only 9% of them could do so; while 70% of children in Class VIII could reach the highest level in 2005, merely 67% of them could do so in 2010.

The Italian mess in a graph

The Eurozone authorities, both governments and the European Central Bank (ECB), have to bear a great deal of the responsibility for worsening the impact of the American sub-prime crisis and the Great Recession and taking the region to the brink of a potential collapse of the Euro project.

The graphic below captures the magnitude of ECB's failure. Even as the Italian economy lurched into crisis, ECB's tight monetary policy squeezed the Italian credit markets. All the three major credit growth indicators plunged steeply.



Update 1 (26/11/2011)

The Times likens the ECB to "a fire department that is letting the house burn down to teach the children not to play with matches". It writes that though the ECB "has a fire hose — its ability to print money... the bank is refusing to train it on the euro zone’s debt crisis". Influential ECB members and Germany believe that ECB cannot be a lender of last resort to backstop falling bond prices and its charter forbids them from using bank resources to finance governments.

Thursday, November 24, 2011

How European sovereign debt became the new "sub-prime"?

Sovereign debt has been at the center of the Eurozone crisis. In the aftermath of the US sub-prime mortgage meltdown, European banks fled to what they saw as safety - bonds issued by countries in Europe’s seemingly ironclad monetary union. As Europe tethers on the brink, even triple-A rated sovereign bonds of the peripheral economies have been exposed for their true colors.

The Times has this nice summary of how European sovereign debt became the new sub-prime,

"How European sovereign debt became the new subprime is a story with many culprits, including governments that borrowed beyond their means, regulators who permitted banks to treat the bonds as risk-free and investors who for too long did not make much of a distinction between the bonds of troubled economies like Greece and Italy and those issued by the rock-solid Germany.

Banks had further incentive to overlook the perils of individual euro zone countries because of the fees they earned for underwriting sovereign debt sold to other investors... As the subprime crisis peaked on Wall Street, banks sharply increased their underwriting of European sovereign debt. In 2007, the world’s big banks made $113.9 million in underwriting fees; by 2009, that number had more than doubled to $273 million...

Their special relationship with governments sometimes also presented a unique dilemma: it gave banks little incentive to publicize red flags even if they were suspicious about sovereign debt...

For most of the last decade, bond yields among Germany, Greece, Portugal, Ireland, Italy and Spain traveled in a tight pack. That meant investors buying and selling those bonds acted as if the countries were almost equally safe simply because they were members of the euro zone, despite shaky finances in Greece, real estate bubbles in Ireland and Spain and high debt in Italy...

Regulators bear much of the responsibility. Before 1999, when Europe forged its monetary union, regulators permitted banks to treat as risk-free the debt of any country that belonged to the Organization for Economic Cooperation and Development, a club of developed nations that includes the United States and most of Europe."


The graphic below illustrates the foreign debt exposures to various Eurozone countries and the contagion dangers of European sovereign debts.



And the graphic below has the summary of the latest Eurozone sovereign debt exposures.

Wednesday, November 23, 2011

Limits to outsourcing in health insurance

Third Party Administrators (TPAs) are the preferred means of claims settlement for health insurers across the world. In simple terms, the insurers outsource the claims settlement activity to these TPAs so as to save costs as well as time and help insurers focus on their core business.

So it comes as a big surprise that many insurers in India are cancelling TPA contracts due to customer dis-satisfaction due to health cards not reaching in time, and delays in pre-authorization, cashless issuance and processing of payment claims. A Businessline report says,

"Insurance companies also say that the claims can also be settled faster if done in-house. The claims settlement time has gone down by 50-70 per cent (depending on case to case) for ICICI Lombard since it shifted the process in-house in 2008... For Future Generali, customer complaints have gone done by 80 per cent after they moved to in-house claim settlement models in November 2010...

In-house claims settlement is faster as there is no loop in between the customer and the insurer. The industry benchmark is about 6-8 hours to approve a cashless request, whereas the approval from... in-house claims settlement team takes only 40 minutes due to... image-based process."


Is this another example of how transaction costs associated with outsourcing exceeds the efficiency benefits of specialized treatment screening and claims processing? See earlier posts here, here, and here.

India's human resource skill deficit fact of the day

A report on India's infrastructure requirements by realty consultant Jones Lang LaSalle for Royal Institution of Chartered Surveyors (RICS) has a glimpse of the formidable challenges facing India's infrastructure sector.

It projects that about 97 million jobs are likely to be created over the 2010-20 period across different sectors in the country. This is estimated to result in the construction of an average of 8.7 billion sq ft of real estate space every year, adding up to a whopping 95 billion sq ft in the ten year period. Its concerns about the deficiency in skilled manpower in construction sector is instructive,

"As of 2011, the supply of professionals in built environment comprises nearly 50 million people, of which only 2 million are professionally qualified (across core and non core professionals). The remaining are mainly unskilled workers. Built environment, comprising construction and real estate related activities... accounts for approximately 17.7% of GDP in 200910.

There is a demand-supply gap in the range of 82-86% in the core professions group comprising civil engineers, architects and planners. To deliver potential real estate space and planned infrastructure, India needs nearly 4 million civil engineers, 396,000 architects and 119,000 planners on an average, over the next decade. However the corresponding average supply available would only be 642,000 civil engineers, 65,000 architects and 18,000 planners.

A sustained period of shortfall in annual supply, coupled with an increasing year on year demand, could result in a cumulative demand of nearly 45 million core professionals, over 2010-20, with a cumulative demand-supply gap of approximately 44 million core professionals over the same period."

Tuesday, November 22, 2011

Thinking beyond stage one with incentives

Last week I blogged about the possibility of perverse incentives being generated in teachers by off-school hours remedial education. The larger purpose of the post was to highlight how specific policies can have unanticipated secondary or emergent consequences which could even end up subverting the desired objective.

In this context, Uri Gneezy, Stephan Meier, and Pedro Rey-Biel have an excellent paper which looks at the similar consequences caused by incentives in public policy. They write,

When explicit incentives seek to change behavior in areas like education, contributions to public goods, and forming habits, a potential conflict arises between the direct extrinsic effect of the incentives and how these incentives can crowd out intrinsic motivations in the short run and the long run... In the emerging literature on the use of incentives for lifestyle changes, large enough incentives clearly work in the short run and even in the middle run, but in the longer run the desired change in habits can again disappear...

A considerable and growing body of evidence suggests that the effects of incentives depend on how they are designed, the form in which they are given (especially monetary or nonmonetary), how they interact with intrinsic motivations and social motivations, and what happens after they are withdrawn... we believe that the discussion should not be whether incentives negatively affect contributions to public goods, but when incentives do and do not work.


They discuss the different dynamics of extrinsic incentives and its impact on intrinsic motivation - "bribes" reduce intrinsic motivation; "pay enough or don't pay at all"; when incentives are so high, people choke under pressure; clarity in incentive message - "read these books" rather than "read books"; incentives can break social norms of trust and weaken pro-social behaviour or reduce image motivation; motivation is crowded out after incentives are removed; differing impact of incentives on students, teachers and parents, etc.

In the context of extrinsic incentives crowding out intrinsic motivation and pro-social behaviour, it may be interesting to explore whether this effect would be same at all initial levels of motivation. Intuitively, it would appear that such crowding out becomes pronounced in case of individuals with higher initial levels of motivation. Alternatively, in case of individuals with lower motivation levels, extrinsic incentives may not have much adverse effect. In such people, they neither enjoy their activity nor do they place as much a premium on their image vis-a-vis others.

Does it mean that extrinsic incentives may be more effective or have less adverse long-term consequences in many developing countries among cutting edge public functionaries who are largely characterized by low levels of self-esteem and motivation?

Monday, November 21, 2011

Improving decision making quality through pre-mortems

Been reading Daniel Kahneman's excellent latest book, Thinking, Fast and Slow. Among several fascinating ideas and concepts, he points to Gary Klein's idea of pre-mortem.

One of the biggest challenges for any decision-making team is to overcome the danger of group-think and the strong possibility of a failure to examine all dimensions of the issue. A combination of cognitive biases, personal prejudices, and group dynamics conspire to obscure certain critical aspects of the project. This results in incomplete project implementation plans, whose fault-lines get revealed when faced with unanticipated obstacles.

How do we overcome such blind-spots? How can project teams locate weaknesses in their implementation plans? Gary Klein advocates the use of pre-mortems, wherein the possible failure channels in any project plan can be identified through prospective hindsight. It is based on a 1989 research work by Deborah J. Mitchell, Jay Russo, and Nancy Pennington, who found that prospective hindsight — imagining that an event has already occurred — increases the ability to correctly identify reasons for future outcomes by 30%. He writes,

"A premortem is the hypothetical opposite of a postmortem... A premortem in a business setting comes at the beginning of a project rather than the end, so that the project can be improved rather than autopsied. Unlike a typical critiquing session, in which project team members are asked what might go wrong, the premortem operates on the assumption that the "patient" has died, and so asks what did go wrong. The team members' task is to generate plausible reasons for the project’s failure.

A typical premortem begins after the team has been briefed on the plan. The leader starts the exercise by informing everyone that the project has failed spectacularly. Over the next few minutes those in the room independently write down every reason they can think of for the failure — especially the kinds of things they ordinarily wouldn’t mention as potential problems, for fear of being impolitic...

Next the leader asks each team member, starting with the project manager, to read one reason from his or her list; everyone states a different reason until all have been recorded. After the session is over, the project manager reviews the list, looking for ways to strengthen the plan."


The effectiveness of pre-mortem lies in its clever use of framing effect. The team members are primed by telling them that the "project has failed". Their prospective hindsight analysis is based on this failure assumption. This frees them up from their cognitive shackles that restrained the team members from giving full vent to all their apprehensions while doing the project conceptualization brain storming.

Given the aforementioned dynamics of pre-mortems, its effectiveness is critically dependent on the most appropriate technique of framing. In simple terms, how do convey the "project failure" message in a manner that cognitively detaches and transports team members from their present ex-ante analysis role to one that enables prospective hindsight?

Pre-mortem, if effectively executed, is an obviously powerful tool to strengthen project implementation plans in both private and public sectors. In fact, I am inclined to believe that it is likely to be even more effective in public bureaucracies where ex-ante analysis is always held back by strong currents of political correctness and bureaucratic hierarchy norms. Pre-mortems on effectively primed (about the program failure) team members has the potential to yield remarkable results.

Here is the chronology of a pre-mortem

Step 1: Preparation. Team members take out sheets of paper and get relaxed in their chairs. They should already be familiar with the plan, or else have the plan described to them so they can understand what is supposed to be happening.

Step 2: Imagine a fiasco. When I conduct the Pre-Mortem, I say I am looking into a crystal ball and, oh no, I am seeing that the project has failed. It isn’t a simple failure either. It is a total, embarrassing, devastating failure. The people on the team are no longer talking to each other. Our company is not talking to the sponsors. Things have gone as wrong as they could. However, we could only afford an inexpensive model of the crystal ball so we cannot make out the reason for the failure. Then I ask, "What could have caused this?"

Step 3: Generate reasons for failure. The people on the team spend the next three minuted writing down all the reasons why they believe the failure occurred. Here is where intuitions of the team members come into play. Each person has a different set of experiences, a different set of scars, and a different mental model to bring to this task. You want to see what the collective knowledge in the room can produce.

Step 4: Consolidate the lists. When each member of the group is done writing, the facilitator goes around the room, asking each person to state one item from his or her list. Each item is recorded in a whiteboard. This process continues until every member of the group has revealed every item on their list. By the end of this step, you should have a comprehensive list of the group’s concerns with the plan as hand.

Step 5: Revisit the plan. The team can address the two or three items of greatest concern, and then schedule another meeting to discuss ideas for avoiding or minimising other problems.

Step 6: Periodically review the list. Some project leaders take out the list every the list every three to four months to keep the spectre of failure fresh, and re-sensitise the team to the problems that may be emerging.

Internet penetration graph for the day

India may be the leader in the software industry among emerging economies. However, in the use of the platform that delivers this software, internet, it lags badly behind as this graphic illustrates.



And, as FT writes, despite the low base, it is the slowest growing market among the BRICS,

India, however, may have a decent number of people online (around 100m) but that’s only 8 per cent of the population. India’s online users growth rate is 13 per cent, which sounds fast until compared to the other three – China and Brazil are at 18 per cent and Russia is 14 per cent.

Sunday, November 20, 2011

Capital gains and income inequality

Capital gains, mainly from financial assets, is the biggest source of income growth for those at the top of the income ladder. Consider this from an Economix post by Laura Tyson,

According to the Congressional Budget Office, from 2002 to 2007 more than four-fifths of the increase in income inequality was the result of an increase in the share of household income from capital gains, with the remainder the result of an increase in other forms of capital income. Capital and business income are much more unevenly distributed than labor income and have become more so over time. Capital gains income is the most unevenly distributed — and volatile — source of household income. The top 0.1 percent earns about half of all capital gains, and such gains account for about 60 percent of the income of the top 400 taxpayers.




Ironically, it is also that income stream which is taxed at the lowest rate. Capital gains tax was lowered from 28% to 20% by Clinton in 1997 and then to 15% by Bush in 2003. As "carried interest", President Bush extended this rate to fees earned by hedge fund and private equity managers. In other words, while wages are subject to both federal income tax and the payroll tax, capital gains and dividends are taxed at 15% and are not subject to the payroll tax.

These trends are not unique to the US and has become the norm across the world. In fact, in India, long-term capital gains, defined by investment of more than one year, in many assets are tax exempt. Apart from the dramatic concentration of wealth and the widening inequality, the incentives created by the lower capital gains taxes is responsible for the skewed growth of the financial sector itself. Raising this tax to the level of that for other labor income streams, would curtail outsize compensation in the financial sector. Besides, in these times of fiscal crisis, it would provide a much needed boost to government finances.

Oligopoly in the market for credit rating agencies

"At least one of the three biggest credit-rating companies was hired for 98 percent of municipal bonds bigger than $50 million this year, up from 94 percent in 2007, according to data compiled by Bloomberg. About 99 percent of U.S. corporate issues have a grade from one of the three, compared with 98 percent four years ago, the data show...

The three companies provide 97 percent of all credit ratings, the U.S. Securities and Exchange Commission said in a September report. S&P leads with a 42 percent share, Moody’s holds 37 percent and Fitch, majority-owned by Paris-based Fimalac SA, is at 18 percent...

It’s very hard to convince someone to stop using S&P and Moody’s ratings because they’re such a market norm... If you don’t have one, people will wonder what’s wrong with you."


See more on the distortions in the market for credit rating agencies in this excellent Bloomberg story.

Saturday, November 19, 2011

The government-private interface for India's rich and poor

A strong perception has been gaining ground in the mainstream debates that private sector in India has acquired enough strength to replace the government in many areas. However, this impression may not quite match up with the reality of life for the overwhelming majority of Indians.

The graphic below tries to summarize the respective roles of the government and the private sector in the lives of the three categories of Indians - those in the bottom half of the income ladder, the elites, and the remaining population.



As can be seen, the government interface for the corporate elites is limited to facilitating the regulatory and other clearances required to run their businesses. And even this role is receding as the economy becomes increasingly deregulated. In contrast, the government continues to play the overarching role in the lives of the poorer half of Indians (and even the others excluding the elites).

Friday, November 18, 2011

The dismal European landscape

One of the most contentious debates surrounding the sovereign debt crisis in Europe is that about the institutional mechanism to provide the necessary liquidity support to the embattled economies.

The European Central Bank (ECB) is not empowered to provide the unconventional monetary policy actions that the Fed did in the US and thereby backstop losses and unfreeze credit markets as a lender of last resort. Further, there is strong ideological and political opposition to printing money to buy the debts of individual members for fear of stoking inflation.

Therefore, as a compromise, the Eurozone leaders had established the European Financial Stability Fund (EFSF) to provide financial assistance to these governments. The IMF joined hands with the EFSF in structuring a first round of Eurozone financial stabilization fund of 440 m Euros.

Its mandate and firepower was designed with the objective of rescuing Greece, Ireland and Portugal. However, now with the turmoil spreading to Italy, Italian bond yields crossing the seven percent mark, and the country facing the danger of losing market access, the stabilization fund clearly looks under capitalized. A "big bazooka" appears necessary.



There is also a growing realization, given the magnitude of market uncertainty surrounding the Eurozone, that the current liquidity crunch being faced by otherwise sound economies like Italy (and maybe France later) could turn into a solvency crisis. And if this happens to the country with the fourth largest public debt, it will be the final nail in the Euro project and have devastating consequences for the world economy itself. The frantic search for possible solutions to provide adequate liquidity cover for Italy is understandable. Nouriel Roubini writes,

"Once a country that is illiquid loses its market credibility, it takes time – usually a year or so – to restore such credibility with appropriate policy actions. Therefore unless there is a lender of last resort that can buy the sovereign debt while credibility is not yet restored, an illiquid but solvent sovereign may turn out insolvent. In this scenario sceptical investors will push the sovereign spreads to a level where it either loses access to the markets or where the debt dynamic becomes unsustainable. So Italy and other illiquid, but solvent, sovereigns need a 'big bazooka' to prevent the self-fulfilling bad equilibrium of a run on the public debt. The trouble is, however, that there is no credible lender of last resort in the eurozone."


One option which has found favor with a number of opinion makers but has been rejected by Germany and the ECB is to issue Eurobonds. It is argued that such bonds, issued initially through the EFSF, could simultaneously solve two problems. One, it would help raise the cash required to refinance the debts of countries finding it difficult to access the debt market. Second, it could complement the German bund and provide an alternative risk-free investment avenue. Such assets can help stabilize the financial markets by providing investment avenues for institutional investors to rebalance their portfolios as they exit the struggling peripheral economy bonds.

In an FT article, Wolfgang M√ľnchau has rejected the notion of leveraging the EFSF to purchase Italian and other PIIGS debt. He describes his Eurobond proposal,

"The EFSF could announce that it would make unlimited purchases of national sovereign bonds to keep their spreads under an agreed cap – say 2 per cent for 10-year bonds. The European Central Bank would refinance the EFSF for as long as it takes. Once the Eurobonds are in place, EFSF liabilities would simply be transformed into Eurobonds. This would not constitute an illegal monetisation of debt, as long as the endgame for the EFSF is credible."


But there are strong reasons to cast doubts on success with the Eurobond plan. For a start, the issuance of Eurobonds would require changes to the Treaty itself. Before that could happen, it would have to overcome entrenched opposition in Germany. Further, it will consume valuable time. After this even if it arrives, it may be too late to save the monetary union.

In any case, monetary policy support is only one side of the policy requirement spectrum. Another formidable challenge facing the new Italian government involves the fundamental restructuring of the economy, especially its labor market. The country has lost labor cost competitiveness against Germany by more than 50% since the mid-nineties. The reforms required include dismantling the two-tier jobs market, which protects the jobs of older workers in dying industries but traps youngsters in temporary work; and the industry-wide wage bargains that mean businesses cannot match wages to productivity. The closed-shop professions and trades, and the mircro-sized family businesses, are a barrier to innovation and efficiency. The business landscape which is dominated by small firms should accommodate more bigger sized firms. The pension system should be further reformed and a clampdown on tax evasion enforced.

However, as Nouriel Roubini writes, structural reforms like raising taxes, cutting spending and getting rid of inefficient labour and capital during structural reforms have a negative effect on disposable income, jobs, aggregate demand and supply. The recessionary deflation that Germany and the ECB are imposing on Italy and the other periphery countries will make the debt more unsustainable. He feels that there can be only one denouement,

"Even a restructuring of the debt – that will cause significant damage and losses to creditors in Italy and abroad – will not restore growth and competitiveness. That requires a real depreciation that cannot occur via a weaker euro given German and ECB policies. It cannot occur either through depressionary deflation or structural reforms that take too long to reduce labour costs.

So if you cannot devalue, or grow, or deflate to a real depreciation, the only option left will end up being to give up on the euro and to go back to the lira and other national currencies. Of course that will trigger a forced conversion of euro debts into new national currency debts...

Only if the ECB became an unlimited lender of last resort and cut policy rates to zero, combined with a fall in the value of the euro to parity with the dollar, plus a fiscal stimulus in Germany and the eurozone core while the periphery implements austerity, could we perhaps stop the upcoming disaster."


Even without going into any of these, the details of sustainably financing and paring down its massive public debt of €1,900bn (120% of GDP) is frightening. This problem, difficult in normal times, is amplifed by a weak economy (it is the only major economy where per-capita GDP declined annually in the 2001-10 period) and severe austerity measures. Though much of its debt is short-term, as much as €350 bn of debt comes due next year. An FT article argues that any increase in bond yields (and therefore cost of capital) will weaken the economy and deepen the debt crisis,

"The impact of crisis interest rates is likely to increase the annual debt burden by less than 1 per cent of GDP next year, compared to what would happen with 'normal' interest rates... With medium term nominal GDP growth likely to be in the doldrums at 2 per cent per annum, interest rates at 6.5 per cent would mean that Italy needs to run a primary surplus of 5.5 per cent of GDP indefinitely in order to stabilise its debt/GDP ratio at 120 per cent."


In simple terms, if Italy is to make a significant dent on its public debt problem, it will have to pull off reforms that ease the economy into a growth path that can create a primary budget surplus of over 5% of GDP for several successive years. And all this with a depressed economy, weakness among major trading partners, and a severe bout of austerity. As the FT writes, "If such a large fiscal consolidation can be achieved in the teeth of a recession, it will be very impressive, to say the least".

Update 1 (28/11/2011)

Wolfgang Munchau offers a three pronged approach to resolving the Eurozone crisis. First, aggressive intervention by ECB to provide massive temporary short-term liquidity and unlimited guarantee of a maximum bond spread or a backstop to the EFSF. Second, end the current process of cross-broder national guarantees and float joint-and-several liability eurozone bonds of credible size. Third, a fiscal union.

Thursday, November 17, 2011

A few thoughts on remedial education

Arguably one of the biggest failures of school education in India is its one-size-fits-all approach wherein teachers cover the prescribed subject syllabus on a single-track mode for the entire class. This approach overlooks the differential learning abilities within a group of children. Under the circumstances, certain children fall behind and this lag gets carried forward to the next class and so on (since there is a system of automatic passing in all primary classes).

In order to address this problem, remedial education aimed at the laggards, has emerged as the favored solution. However, there is considerable ambiguity about how this remedial education should be administered. One area of debate is about when this remedial instruction should be imparted. Should it be integrated into the regular classroom instruction and imparted along with regular teaching during the classroom hours itself? Or should it be done outside the regular classroom hours?

There are merits and demerits with both approaches. This post will skip this issue. However, there is an important behavioural dimension to the latter approach that is often overlooked in such debates. If the remedial instruction is shifted to off-school hours, then it may do little to change the status quo or the incentives of the regular teachers.

The deficient model of pedagogy will persist. More damagingly, it may crowd-out any remaining motivation to get all the children in the class to achieve the grade-specific learning competency during the regular classroom hours. Reassured that the laggard student would be brought upto speed through off-school hours remedial instruction, the teacher may be further emboldened (or feel less guilty) to continue with the prevailing inefficient mode of instruction. So will the off-school hours remedial instruction model end up exacerbating the problem of single-track teaching?

What would be the effect of the possibility of off-school hours remedial education on students? Logically, some would loath the possibility of having to sit through more hours of classroom instruction and therefore be encouraged to learn during the regular classes. Some others would let their attention down during the regular class hours in the firm reassurance that there would always be the off-school hours classes to fall back on. Which of these two effects would dominate?

A more appropriate solution, one that takes into account the aforementioned failings, is to have a mix of both approaches. To the extent possible the remediation should be integrated into the regular classroom instruction. However, those extremely deficient students could be remediated through off-school hours instruction.

Update 1 (8/4/2012)

Esther Duflo, Pascaline Dupas, and Michael Kremer have evidence that appears to, among other things, also support my aforementioned thesis, from this study of additional contract teacher assignment to certain schools. They find great benefits from a complementary strategy that involves decentralized hiring of contract teachers, and School-Based Management training programs. They write,
"We examine a program that enabled Parent-Teacher Associations (PTAs) in Kenya to hire novice teachers on short-term contracts, reducing class sizes in grade one from 82 to 44 on average. PTA teachers earned approximately one-quarter as much as teachers operating under central government civil-service institutions but were absent one day per week less and their students learned more. In the weak institutional environment we study, civil-service teachers responded to the program along two margins: first, they reduced their effort in response to the drop in the pupil-teacher ratio, and second, they influenced PTA committees to hire their relatives. Both effects reduced the educational impact of the program. A governance program that empowered parents within PTAs mitigated both effects. Better performing contract teachers are more likely to transition into civil-service positions and we estimate large potential dynamic benefits of contract teacher programs on the teacher workforce."
The governance program involved giving the parents in the PTA committee School-Based Management (SBM) training how to  interview and select job applicants, monitor and assess teachers’ effort and performance, and perform a formal review of the contract teacher’s performance to decide whether to renew her contract.They write about how empowering parents mitigates the negative effects among civil service teachers,
First, in schools with SBM training, civil-service teachers were more likely to be present in class and teaching; second, in those schools, relatives of civil-service teachers were less likely to be hired as contract teachers; third, those relatives who were hired anyway performed as well as non-relatives (which could comefrom better selection of the remaining relatives, or stronger incentives).
However, on contract teachers, I have reservations about their political acceptability and consequent scalability.

Wednesday, November 16, 2011

Purchasing and pricing health insurance

As health insurance assumes centerstage in health policy debates in India, it is critical that we make informed decisions on the two critical factors in any health insurance model - purchase and pricing of medical care services.

In this debate there are two issues - how care is purchased and how much is paid for that service. There are two conventional approaches to purchasing medical services. Insurers can pay the service providers a specific amount for each discrete service (fee-per-service model) or make bundled payment for all of the care a patient needs over the course of a defined clinical episode.

The former is the prevailing purchase model across countries and has its set of inefficiencies. The biggest problem with this approach is that it becomes difficult to manage the incentive of doctors and hospitals to prescribe more diagnostics and treatments than is required. Insurers manage this problem by increasing the effectiveness of their pre-authorization and/or with conditions like prohibiting payments for certain basic tests. In contrast, the later approach effectively addresses this incentive problem. However, it fails with implementation problems.

Regarding the pricing of these services, different insurers can either individually negotiate with the service providers and arrive at their different price schedules or they could collectively bargain and fix standardized prices for all insurers. The US health insurance market is a classic example of such price differentiated market and its inefficiencies are well documented. Government-run health insurance systems undertake collective bargaining and fix standardized prices for each service.

Uwe Reinhardt summarizes the merits and demerits of both approaches and advocates the All-payer model,

"In developed nations that rely on multiple, competing health insurers — for example, Switzerland and Germany — the prices for health care services and products are subject to uniform price schedules that are either set by government or negotiated on a regional basis between associations of health insurers and associations of providers of health care. In the United States, some states — notably Maryland — have used such all-payer systems for hospitals only. Elsewhere in the United States, prices are negotiated between individual payers and providers. This situation has resulted in an opaque system in which payers with market power force weaker payers to cover disproportionate shares of providers’ fixed costs—a phenomenon sometimes termed cost shifting—or providers simply succeed in charging higher prices when they can. In this article I propose that this price-discriminatory system be replaced over time by an all-payer system as a means to better control costs and ensure equitable payment."


In particular, Prof Reinhardt points to the successful example of Maryland, which has historically deviated from other states in the US and has had an all-payer model of health services pricing. Maryland’s rate-setting system is widely believed to be one of the most enduring and successful cost containment programs in the United States. In his excellent paper, Prof Reinhardt finds evidence of price differentiation efficiencies at many levels. Private insurers pay much more for all services than public insurers, who use their larger bargaining power to lower prices.



For the same service, the variations in service fee are large in case of hospitals as against other treatment centers. There is an obvious high premium extracted by certain hospitals. The variations in payments across hospitals for the same service can be substantial.





The effectiveness of India's health insurance market will depend on it being able to get both the health service purchase and pricing model right. It is fortunate that being a nascent health insurance market, governments are not constrained by any legacy models. Since governments will be able to provide adequate health insurance to only a small proportion of the population, it is important that private health insurers too are able to keep their costs low and sell policies at affordable prices. Public policy should play a catalytic role in facilitating this.

The purchase model is more complex and not easily amenable to policy fixes. However, governments should encourage private insurers to adopt a purchase model that bundles services and makes payment for treatment of the medical condition. It is possible for governments to get health service providers as far away from the fee-per-service model of charging insurers. While it may be easier for large specialty hospitals to accept this, this model may end up excluding smaller diagnostic centers and clinics. Encouragingly, India's nascent health insurance model is, for various reasons, moving more towards the bundled purchase model than the fee-per-service model.

In case of pricing though, there is a more direct role for governments in assisting insurers arrive at standardized prices for services in all hospitals within a particular area. The model of all-payer price fixing, as is done in many continental European countries, would reduce the administrative and other transaction costs, and help keep insurance premiums at affordable levels.

In some ways, there is a free lunch here. Governments, both state and center, have an increasing leverage over private health service providers due to various newly announced state and central health insurance schemes. This strength should be used to bargain out standardized rates for services by participating hospitals within a geographical area. The private insurers could differentiate by offering variants of the basic service with top up prices.

Unfortunately, failure in this front is already evident in public health insurance. As I have blogged earlier, one of the critical failings with the Aarogyasri program was its inefficient price-fixing model. Other state governments, eager to embrace the wild populism inherent in Aarogyasri, may end up making the same mistakes.

Update 1 (3/3/2012)

Two excellent posts by Uwe Reinhardt on payment and pricing health insurance. The first dwells on the relative merits of the three purchasing models - fee for service, medical condition-based bundled payments, and capitation fee model. The second examines the three price determination models between the insurers and the insured and insurers and health care providers (doctors, clinics, hospitals etc) - free market negotiations, price-setting in quasi-markets (all payer system where the associations of health insurers within a region would negotiate with corresponding associations of hospitals, doctors etc uniform fee schedules that then would apply to all payers and providers in that region), and administrative price fixing by the government.

See also this paper by Prof Reinhardt on pricing in US hospital services.

Tuesday, November 15, 2011

The Eurozone crisis in perspective

The crisis facing the Eurozone today is in someways inevitable given the impossibility of managing a monetary union without some form of fiscal union and a fully committed central bank.

To put the folly in its true perspective, let's compare the different Indian states to Eurozone members. Imagine 28 independent countries federate into a single country with a single monetary policy. All the countries embrace a single currency, rupee, and all monetary aggregates, including the interest rates, are harmonized across all states. Trade barriers have been brought down and there is unrestricted cross-border trade across states.

However, both the central bank, the Reserve Bank of India (RBI) and the central government at New Delhi will not make monetary and fiscal transfers to help any state if it runs into economic problems. All taxes are levied by the states and they refuse to allocate a share of their tax revenues to the central government. Driven by moral hazard concerns, the RBI is traditionally averse to monetary accommodation and banking bailouts.

In this context, consider this scenario. Maharashtra and Tamil Nadu are booming. In contrast, Uttar Pradesh and Rajasthan are experiencing a deep recession. The later two have a serious competitiveness problem, since their wages have been driven up by a positive economic shock. In this period, both state governments have indulged in populist fiscal profligacy and run up massive debts, including from neighbouring states and their banks. Both now stand at the verge of sovereign defaults.

Further, when the the states form the monetary union, the initial conditions of the different states vary widely. The economies of Uttar Pradesh and Rajasthan are uncompetitive in relation with Tamil Nadu and Maharashtra. The former have much lower labor productivity, though wages and prices remain more or less the same. There are also critical structural imbalances in these two states and they also suffer from high fiscal deficits.

There is more. Even as Rajasthan and UP struggle, the increasingly competitive states of Maharashtra and Tamil Nadu prosper, partly by increasing their exports to Rajasthan and UP, and in the process, atleast partially, displacing local production and driving out local jobs. Clearly, Maharashtra and Tamil Nadu are, atleast partially, prospering at the expense of Rajasthan and UP. So what is the way out for these two struggling states?

If Uttar Pradesh and Rajasthan were independent countries with their own currencies and interest rates, they would have responded to such a supply shock by either devaluing their currencies or lowering interest rates or both. They may even have welcomed a bout of moderate inflation to reduce the real debt burden and narrow the gap in labor costs. The objective in all these cases would have been to lower real wages and costs and thereby increase competitiveness and investments. Now that these states are part of a monetary union, they do not have access to these traditional options.

In the real world, India is a monetary and fiscal union. Faced with such a situation, the central government will invariably step in with fiscal transfers (packages, as they call it politically!) and restructure their loan books with help of the RBI. The central government will be committed to ensuring that even a solvency crisis will be averted. Sure, tough conditions will be imposed and the state will be forced to implement reforms that will help improve its competitiveness.

The only strategy to restore economic strength in these two states without compromising on the monetary union is for the central government to step in and provide fiscal transfers to these states and the RBI to open liquidity windows and ensure that the credit tap is kept open. Simulataneously, the two states will have to undertake structural reforms to increase their medium and longer term competitiveness. It has to be hoped that these measures will buy adequate time to restore the health of both the state economies.

Replace Rajasthan and UP with Greece and Italy, Maharashtra and Tamil Nadu with Germany and France. The problems facing Eurozone economies today are not much different. In this context, in an FT op-ed, the former British Prime Minister, John Major had this observation of Eurozone economies locked in Germany's embrace,

The powerful German economy is still locked within the same currency as weaker economies. She racks up huge trade surpluses within the eurozone while others have comparable deficits. Since Germany has an estimated 30 per cent currency advantage within the euro, this seems likely to continue. It is undesirable and unsettling.

In a sensible world, the southern states would devalue to become competitive – but they cannot. They are locked in a single currency. And because they cannot devalue their currency, they must devalue their living standards and promote reforms to enhance efficiency. This will take years. Meanwhile, wages must fall, unemployment will rise and social unrest will increase. The severity of this medicine may not be bearable in a liberal democracy.


His solution is similar to what India is today,

It must become a fiscal union; a union of transfer payments to off-set regional disparities; or it must shrink. The latter option – essentially expelling Greece – has political consequences. There is no mechanism to do it. What would Greece’s future be? Would she remain democratic in the chaos that might follow? Pushing Greece out is not a risk-free option.

Nor is a transfer union. Germany would hate it and transfer payments would institutionalise inefficiencies. That leaves fiscal union as the most likely destination. But it has huge political consequences. It implies a far greater level of integration, and is an escalator to a federal eurozone. This may be sensible economically, but it is profoundly undemocratic. It would drive voters and decision-makers dangerously far apart. More top-down Europe imposed by a remote elite could provoke a powerful antipathy.

Monday, November 14, 2011

Rating agencies are back in focus

Rating agencies continue to make news, for all the wrong reasons. Over the past few days, there have been three illustrations of how decisions of rating agencies have contributed towards their declining credibility.

Just before the market close on Thursday last week, the Standard & Poor’s (S&P) erroneously sent out an e-mail suggesting that it had lowered the rating on France’s sovereign debt. The mail shook the markets and forced up French bond yields,

"In a statement, S&P attributed the message to "a technical error" and affirmed that the rating was unchanged. But the yield for France’s 10-year benchmark bond jumped more than a quarter point, to 3.48 percent, and the spread between French and German bonds of that duration reached 1.7 percentage points, a euro-era record... The erroneous S.&P. message went out shortly before 4 p.m. Paris time, and the correction was issued almost two hours later, after most European markets had closed."


Simultaneously, in India, Moody's Investors Service revised its outlook for India's banking system to negative from stable. It attributed the downgrade to increasingly challenging operating environment that will adversely affect asset quality, capitalisation, and profitability of Indian banks; high inflation; monetary tightening and rising interest rates; and the crowding out effect of government's massive borrowing program.

Just a day after the Moody's downgrade, S&P went the opposite direction and upgraded the sector from group '6' to group '5', the same as the other similar economies. Its argument

"Dependence on stable bank deposits due to an extensive branch network and limited dependence on external borrowing made India's banking system low-risk on system-wide funding... In our view, banking regulations in India are in line with international standards and the regulator ( RBI) has a moderately successful track record".


So what do we make of these contrasting ratings signals? Do investors and financial market actors go by the fact that since S&P is larger entity, its ratings should be given greater credence? In this context, The Gold Standard has an excellent post where it compares the Moody's decision on India's banking sector with that on China's similarly troubled banking sector. He wrote,

"The price India has paid for its relative transparency on its problems is a negative outlook. The more opaque it is, the higher the rating. That is why these agencies gave AAA ratings to CDOs, CDO-squared and to CDOs on CDOs...

Its giant neighbour to the North has an entirely State dominated banking system and an economy with even greater financial repression. It systematically under-counts and under-reports its bad debts. Those who dare to raise their voice are forced to withdraw their reports.

Banks have large exposure to local governments who are dependent on land banks sales for their revenues. Banks have exposure to developers who want the prices of land banks to decline. Their apartment prices are dropping and transactions are plunging. So, we have no idea of the true health of Chinese banks or, for that matter, the whole economy. We will never have one. Yet, on November 8th, Moody’s reaffirmed its ‘stable’ outlook for Chinese banks."


It is hard not to be baffled by the clear inconsistency in these rating decisions. In fact, during the ongoing European debt crisis, on several occasions ratings downgrade decisions by one or the other of the three big rating agencies have triggered market downslides. There is a strong and credible enough view that the decisions of ratings agencies could contribute towards turning a liquidity crunch into a solvency crisis. It is therefore no surprise that a growing number of opinion makers hold the view that the ratings agencies hold disproportionate power, whose exercise has, as numerous events of the past four years have shown, been questionable.

Price controls are back?

The Andhra Pradesh government has announced its decision to set up a price monitoring committee to control inflationary pressures.

Taking serious note of the rise in the prices of essential commodities, Mr. Kiran Kumar Reddy announced plans to form a price monitoring committee to tackle the situation. The new mechanism will not only deal with people involved in hoarding and black-marketing of produce with an iron hand, but also play a key role in fixing prices.


"Fixing prices"? Hmm!!

Saturday, November 12, 2011

The Kingfisher bailout request - saving capitalism from capitalists!

In the past four years, bailouts have been at the center stage in many developed economies. Financial institutions, companies, and even countries have been bailed out in the aftermath of the bursting of the sub-prime mortgage bubble.

It should therefore come as no surprise that the B-word should find favor among struggling Indian companies. Sample this request from Kingfisher Airlines

"Facing serious financial turbulence, Kingfisher Airlines has sought government help for a bailout... The seriousness of the crisis was underlined by the urgent request Kingfisher owner Vijay Mallya made to finance minister Pranab Mukherjee and civil aviation minister Vayalar Ravi to help Kingfisher in infusion of funds through banks at low interest rates, besides other concessions in line with what Air India was getting."


And there are indications that this may be just the beginning. It is certain that all the other similarly struggling airlines will express their solidarity with Kingfisher and come forward with their own bailout requests. In fact, request for government help has already started,

"India’s private airlines have asked the government to cut taxes on jet fuel and force state-controlled Air India​ Ltd to raise fares, as losses mounted at private carriers that control at least 83% of the local passenger market. The airline firms have lost Rs. 3,500 crore in the six months ended September, more than the Rs. 2,900 crore they had lost in the last fiscal, according to an airline lobby group."


And what has been the government's preliminary response to this request,

"Union civil aviation minister Vayalar Ravi on Friday said he would talk to finance minister Pranab Mukherjee​ to get financially-troubled Kingfisher Airlines​ assistance from banks. The minister is also talking to state governments to reduce sales tax on aviation fuel."


The government does not need to be defensive on this. It is a great opportunity for the embattled government to atleast begin the process of its redemption. The sheer audacity and hypocrisy of the request is staggering. Kingfisher, the flag-bearer of hedonistic capitalism in India, wants equivalent treatment with a public sector entity. It wants the dregs of its orgy to be cleaned up with tax payer money. In simple terms, it is a request for socialization of private losses.

The fundamental tenet of Capitalism 101 is that market competition creates and destroys companies. In this case, a badly mismanaged Kingfisher and some other larger airlines, are reaping the sins of their earlier excesses (see this earlier blog post). Capitalism 101 tells us that when faced with such circumstances in a competitive market, we should let the market dynamics prevail. This would mean letting Kingfisher go bankrupt. Its equity holders and promoters should lose their shirts to repay the company's liabilities.

The details of the bankruptcy proceedings and resultant restructuring will vary and are debatable. There are real dangers of crony capitalism rearing its head. If the government intervenes to assist Kingfisher, there is the possibility of sweetheart debt restructuring deals, wherein portions of its debt owed to public sector banks will be foisted on them as equity without forcing the existing shareholders to take losses. In fact, there are already signs of something unpleasant brewing,

"A group of 13 lenders, including State Bank of India​ and ICICI Bank Ltd, bought a 23.21% stake in Kingfisher Airlines in April this year. SBI picked up a 5.67% stake and ICICI Bank 5.3%. The airline converted Rs. 750 crore of its total debt of Rs. 7,000 crore into equity at a 61.6% premium over its share price in what many considered a sweetheart deal. It allotted shares to lenders on 31 March at Rs. 64.48 apiece."


Kingfisher shares closed at Rs 19.65 on Friday, less than one-third the price at which the banks purchased their stakes. It was clear in April (when the stakes were purchased) that Kingfisher was on terminal decline. So why were the share purchased at such a premium? It would also be worth investigating the share transactions of the original promoters and largest equity holders in the aftermath of these deals and in recent months. It could turn out to be an excellent case study for corporate governance (or malfeasance) standards in India.

However, a note of caution is that the government should not be tempted into taking it over and merging with Air India. This would be letting the promoters of Kingfisher get away too lightly. It would be unfair on Air India. It will also generate long-term moral hazard concerns. More than anything else, it would reek of crony capitalism.

Fortunately, Kingfisher is neither too-big-to-fail nor does its bankruptcy pose any systemic risk within the industry or the financial markets. There were enough indications of this coming for some time now. It is widely known that the company is neck-deep in troubles and owes money to banks, oil companies, other airlines, DGCA, and the government (by way of taxes).

In fact, a Kingfisher bankruptcy will have several positive externalities. For a start, this outcome would be an acid test for India's bankruptcy laws. It would send out a strong signal to corporate India that private losses have to remain private and will not be borne by tax payers. The resultant disincentivization of bailout moral hazard will strengthen the institutional foundations of India's emerging capitalism. Furthermore, it will provide a much-needed boost to the beleaguered government in New Delhi. It will be a rare triple win for the government - political populism converging with sound economics and equally sound public policy.

An important dimension to this development is the role of the Director General of Civil Aviation (DGCA). What was the aviation regulatory authority doing when Kingfisher was merrily running up its Rs 7000 Cr debt? Why did it not pull the plug early? Should it not have raised the alarms much early than the belated attempts now? What powers should it be vested to ensure that such failures do not recur? Answers to these and the public policy response to the post-mortems will be a test of the government and corporate India's commitment to uphold high standards in corporate governance.

In conclusion, the Government of India is faced with the dilemma of saving capitalism from capitalists. Unfortunately, when faced with this dilemma governments have traditionally failed the test. Will this time be different?

Postscript - The fear of failure and the possibility of losing your equity through a bankruptcy is the "invisible hand" that disciplines risk-taking in any market. If this deterrent is removed, excessive risk-taking and other undesirable business practices - whose catastrophic effects have been made amply clear by the events across the world over the past few years - will be left with no institutional restraints.

Update 1 (17/11/2011)

After so many days, finally one piece of meaningful analysis of the KF crisis from Businessline.

Kingfisher's interest costs as a proportion of sales were as high as 22 per cent in the latest September quarter, compared to 6.9 per cent for Jet Airways and a negligible 1.2 per cent for low cost carrier SpiceJet. Costs other than interest payouts and fuel also seem to have had a role in Kingfisher's poor performance.

The airlines' cost per available seat kilometre (CASK), a key metric used to assess how competitive an airline is, was Rs 4.31 in the September quarter. This was much higher than the Rs 3.31 reported by Jet Airways. Of this number, Kingfisher incurred as much as Rs 2.46/SKM on costs other than fuel, 45 per cent higher than the Rs 1.69 for Jet Airways.

Incidentally, fuel cost, which is often painted as the biggest villain of the piece accounted for 54 per cent of sales for Kingfisher, compared with the 48 per cent for Jet Airways and 63 per cent for SpiceJet.

Friday, November 11, 2011

The emergence of corporate monopolies in the US

Nancy Folbre points to a Monthly Review article which notes that in 1995, the six largest bank-holding companies (JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley) had assets equal to 17 percent of gross domestic product in the United States. By the third quarter of 2010, this had risen to 64 percent. This graphic from Mother Jones captures the evolution of this concentration of market power over the last decade.



The Monthly Review article points to similar concentration of market power and emergence of monopolies across different industries. The number and percentage of US manufacturing industries that have a four-firm concentration ratio of 50 percent or more have risen dramatically since the 1980s. More and more industries in the manufacturing sector of the economy are tight oligopolistic or quasi-monopolistic markets characterized by a substantial degree of monopoly.



This concentration of market power has been a constant theme across sectors. The graphic below shows the rise in four-firm concentration ratios in six key retail sectors and industries, over the fifteen-year period, 1992-2007. Most remarkable was the rise in concentration in general merchandise stores (symbolized by Wal-Mart), which rose from a four-firm concentration ratio of 47.3 in 1992 to 73.2 percent in 2007; and computer and software stores from a four-firm concentration ratio of 26.2 percent in 1992 to 73.1 percent in 2007.



Another graphic highlights the rising share of the top 200 US corporations as a percentage of total business revenues in the US economy over the 1950-2008 period. The revenue of the top two hundred corporations has risen steeply since the mid-nineties.



In this context, a pathbreaking scientific study of the network of global corporate control by Stefania Vitali, James B. Glattfelder, and Stefano Battiston has thrown up several astounding insights. They mined the Orbis 2007 database of 37 million companies and investors worldwide and mapped the ownership and control networks of all the 43060 trans-national corporations (TNCs). Then they constructed a model of which companies controlled others through shareholding networks, coupled with each company's operating revenues, to map the structure of economic power. They write,

"We find that, despite its small size, the core holds collectively a large fraction of the total network control. In detail, nearly 4/10 of the control over the economic value of TNCs in the world is held, via a complicated web of ownership relations, by a group of 147 TNCs in the core, which has almost full control over itself. The top holders within the core can thus be thought of as an economic "super-entity" in the global network of corporations. A relevant additional fact at this point is that 3/4 of the core are financial intermediaries."

Thursday, November 10, 2011

The simplification of public debates

At the outset, let me clarify that this post is not a defence of any government. Nor is it an attempt to blame anybody. It is only a reflection of the environment in which public debates are taking place in modern societies.

Why is the government unable to lower inflation? Why is the government failing to provide employment to the massive numbers of people joining the workforce? Why is the government raising the prices of petrol and cooking gas periodically? Why is the government unwilling to tackle corruption? Why are governments failing to provide good quality utility services? Why are governments increasing the utility tariffs?

These are the dominant themes in our public debates today. The agenda of the debate is framed in a manner that puts governments at the center of the issue. The audience, mostly passive recipients, have come to believe that governments are either "failing", "unable", or "unwilling" to resolve these important and universal issues. Even when there is a rare attempt to search for the causes, it ends up in a circular manner reverting back to the government.

This framing of the agenda and questions suits all sides to the debate. The villain of the piece, government, is easily identifiable. This narrative fits nicely into the widely accepted stereotype of governments being the source of all evils. In this simplified world-view, citizens find easily identifiable villains. Most often, these debates end up as opportunities for collective middle-class catharsis. It is perfect staple for tweets and Facebook comments. They also make for good media events - soundbites, short op-ed columns, blog posts and half-hour television debates involving 4-6 people. The opposition and intelligentsia love it. The former's job is after all to oppose the government, while the later are known to just criticize, without offering solutions.

Ironically, governments too may not be unhappy. It helps them to avoid confronting the difficult issues that need to be addressed to meaningfully settle the issue being debated. In fact, it makes governments try out populist band-aid solutions which merely kick the can down the road. In many respects, we have a classic collective action problem.

The fundamental issues are complex, not amenable to quick-fixes, requires hard-thinking, and painstaking and long-drawn out action on multiple fronts. It involves all stakeholders facing up to bitter truths that unsettles and often discards the settled conventional wisdom. Most importantly, it requires communicating to all of us certain fundamental realities and the need to accommodate our opinions and ideologies based on them.

These issues are important for developing economy democracies like India, which are in the middle of far-reaching social and cultural transformations. These countries have a strong and deeply entrenched legacy of dominant government role in all walks of life. All the surviving generations are used to relying on governments to resolve all their problems. Accordingly, the dominant discourse invokes the language of regulations, enforcement, punishments, subsidies, and so on.

When governments are making pretences of controlling inflation by coming down on hoarders, or helping farmers by raising the minimum support price, or protecting consumers by keeping tariffs and oil prices unchanged, or controlling corruption by sending the corrupt to jail, it is this discourse that is being played out. This discourse has limited space to explain the complex dynamics of modern markets and the limitations of governments.

The theatrics associated with these debates means that we lose the opportunity for informed debates about critical issues of concern to all of us. In all these cases, since the government is the perceived villain, we stop or refrain from examining these issues in greater detail in search of "real" answers. Take the case of the debate surrounding inflation. What are its causes? What can be done to mitigate, in the short-term, and resolve, in the medium and long term, the causes of inflation? What should be the responsibility of governments, academicians, media, citizens and the society in this endeavour?

Or take the case of corruption. What are the major sources of corruption? What are the different categories of corruption and what are its dynamics? How can we systemically prevent rent-seeking for each category of corruption? What should be the role of different stakeholders in collectively addressing this problem?

This is not to be fatalistic - the resolution of all these problems require collective effort, and since such efforts are difficult to mobilize, we are left with no choice! But a more nuanced perspective of these issues and their challenges helps all participants in the debate to atleast appreciate the complex nature of the problem. I am sure all of us realize that we stand a better chance of success with addressing a complex issue when we have a well rounded understanding of the forces contributing to the problem.

If we are able to elevate public debates to this level, all of us will quickly realize that controlling inflation, job creation, keeping tariffs and user charges constant, and so on are issues that are increasingly beyond the competence of mere governments. They require long-term structural changes and societal adjustments, where all of us have an important role to play, either directly or by co-operating with and assisting in the process. The governments have to take the lead (sadly, even this is missing!).

However, as mentioned at the beginning, none of this is to underplay or overlook the central role of governments. They can, and should, play an important role (though their degree of control varies from situation to situation), in both mitigating the adverse consequences of these problems and putting in place the mechanisms to enable their effective resolution. Addressing market failures are the basic responsibility of governments. Public debates and policy making will be much the richer for this realization.