Sunday, September 30, 2012

The importance of decentralization - Lessons from Camden

Times has this (HT: Andrew Fraker) story of the county of Camden in New Jersey which has decided to disband its ineffective and unionized police force. 
The police acknowledge that they have all but ceded these streets to crime, with murders on track to break records this year. And now, in a desperate move to regain control, city officials are planning to disband the Police Department. The reason is that generous union contracts have made it financially impossible to keep enough officers on the street. So in November, Camden, which has already had substantial police layoffs, will begin terminating the remaining 273 officers and give control to a new county force. The move, officials say, will free up millions to hire a larger, nonunionized force of 400 officers to safeguard the city, which is also the nation’s poorest...Camden’s decision to remake perhaps the most essential public service for a city riven by crime underscores how communities are taking previously unimaginable steps to get out from under union obligations that built up over generations... the plan to put the Police Department out of business has not prompted the wide public outcry seen in the union battles in Chicago, Ohio or Wisconsin, in part because many residents have come to resent a police force they see as incompetent, corrupt and doing little to make their streets safe.
And what was the trigger for this reorganization? Budgetary problems arising from the Great Recession.
Camden’s budget was $167 million last year, and of that, the budget for the police was $55 million. Yet the city collected only $21 million in property taxes. It has relied on state aid to make up the difference, but the state is turning off the spigot. The city has imposed furloughs, reduced salaries and trash collection, and increased fees. But the businesses the city desperately needs to attract to generate more revenue are scared off by the crime.  
Camden's police force is characterized by features that are commonplace among police and other public systems in countries like India - unionization, generous salaries and benefits, erosion of professional standards, and indiscipline manifesting in rampant absenteeism (30% at anytime!). And worst of all, they are ineffective. But the difference is that the people of Camden have decided that enough is enough and disbanded the entire system. This post is not to debate the merits and demerits of the correct contracting model of a police force for Camden, but about the popular indignation that led the residents of Camden into exercising their rights.

Why is it that Camden can take such decisions to enforce accountability, while small towns and villages in India, faced with even more apathy and neglect from the public officials appointed to serve them, can't? I will argue that the difference is decentralization. The police department of Camden are a distinct police force, appointed by the Camden county, paid for by them, and therefore accountable only to them. The accountability relationship of any Camden policeman is directly to the residents of Camden. The firing of one policeman or disbanding of the entire force itself is therefore a matter of concern only to the people of Camden and their police force. It has no regional or national consequences.

In contrast, most public functionaries in India are appointed by the state government. They form part of a large statewide labour force. They are transferred and posted by the state government officials and even receive their salaries from there. Their service conditions are part of a statewide set of standards and their powerful unions will do whatever it takes to ensure that no attempt is made to dilute its generosity. In other words, their fortunes are almost completely linked to their masters in the distant state capital. Their only link with the local community they are supposed to serve is that they just happen to have been posted there, and that too temporarily. Given this massive incentive incompatibility, is it any surprise that we have things as they are?

The teacher or the policeman could care less what the local residents think about them and their work ethic, however bad or perverse. In simple legal terms, the local residents have no role in deciding who should serve as their local school teacher or doctor, and can do nothing to punish errant officials. They cannot even stop their salaries, leave alone suspension and dismissal. Any action to change their service conditions to suit local requirements, leave alone disband them, will have statewide ramifications and is therefore not a possibility. Local residents have to accept whoever are foisted on them. And they do so with resignation because they have come to realize that it makes no difference and they don't anyway pay for these services.

In the prevailing regime, no Indian panchayat or municipality will face the budgetary nightmare that Camden faces, foreclosing that "forced" reform option.   

Friday, September 28, 2012

The commodities super-cycle?

Amidst the gloom surrounding the Great Recession, one of the less discussed stories surrounds the boom in commodity prices in the aftermath of the sub-prime mortgage meltdown. There is a very strong view that the latest spurt in this "commodity super cycle", which has been on the ascendancy for more than a decade now, was triggered off and is being sustained by the ultra-accommodative monetary policy regime followed by the Federal Reserve in the US.
















The excellent graphic from Quartz puts the commodity super-cycle theory in perspective. Ruchir Sharma had a very persuasive article in the FT recently. And he argues that the biggest threat to deflating this bubble will come from China's weakening growth prospects. 

Thursday, September 27, 2012

China foreign aid fact of the day

In 2009 and 2010 China agreed to lend about $110 to developing countries, $10 bn more than the World Bank in that period... The Chinese Eximbank lent $67.2 bn to sub-Saharan Africa between 2001 and 2010, $12.5 bn more than the $54.7 bn lent by the World Bank. 
(HT : FT

Tuesday, September 25, 2012

Charter Cities project gets a rude wakeup call

So Paul Romer has officially ruled himself out of the first Charter City project in Honduras. Prof Romer had originally joined hands with the government of Honduras to pursue his dream project of establishing a  RED (Region Especial de Dessarrollo) on public private partnership basis to develop a model city. He was appointed a member of the five-member Transparency Commission and made to believe that it would have sweeping powers in ensuring the effective implementation of his new rules-based RED. 

It appears that all that was mere posturing and the Honduras government has been taking the professor and his colleagues for a ride. The Honduras government has entered into an agreement with a private party, without apparently any of the required due diligence, and have even refused to share a copy of the agreement with Prof Romer. 


Now there is nothing surprising about this turn of events. In fact, the Honduras establishment clearly saw the Charter Cities project as a very convenient alibi to push through a public private partnership agenda which had cronyism and corruption written all over it. There is no need of the wisdom of hindsight to have perceived the preferences of the Honduras government. For this would have been the case with the overwhelming majority of governments who volunteered for such projects. One can think of many state governments in India not being averse to accepting an offer from a reputed professor which would provide the fig leaf for them to pursue massive rent-seeking resource theft. 


In fact, one could say that there is an adverse selection problem with government motivations. Given the practically far-fetched nature of the project (and why that is impractical is another debate, partially covered here), governments which would agree to embrace such projects are more likely than not be motivated by desires other than national economic development. The stakes are simply too high and incentives too misaligned for the final outcome to be anything different. 


Consider this parable. A group of robbers pass up the opportunity for their biggest ever heist as a treasure is being moved from one place to another. Furthermore, they also take the trouble of guarding the treasure from being looted and also ensuring that it reaches its final destination. Inconceivable?

Monday, September 24, 2012

India's latest power sector reforms - A recipe for failure?

The Union Government has announced an ambitious plan to restructure the debts of the massively indebted state electricity distribution utilities. As part of the "Financial Restructuring of Discoms" package, worth nearly Rs 2 trillion (~$38 bn), the state governments will immediately take over half the outstanding short-term liabilities upto March 31, 2012 and convert them into state government guaranteed bonds. In the second stage, the the remaining half of the liabilities will be restructured by rescheduling loans and by providing a three year moratorium on the principal repayment.

The electricity utilities will have to enter into a tripartite debt restructuring agreement involving the state and union governments. As part of the deal, they will have to undertake periodic tariff revisions and reduce their aggregate technical and commercial losses. The Union government will reimburse states 25% of the principal they repay if they meet the conditionalities and exceed their loss reduction targets. The plan is voluntary and states will have time till 31st December to embrace the plan.

There are a few immediate concerns. The bonds will not get the statutory liquidity ratio (SLR) status, thereby making them less attractive for banks and other financial institutions. It will also raise the coupon rates for the state governments. Also, state governments will almost certainly breach the Fiscal Responsibility and Budget Management limits and strain an already stretched state fiscal balances. The biggest beneficiaries, apart form the utilities, will be the public sector banks, who face the threat of these loans becoming non performing assets. The RBI data reveals that Indian banks' loans outstanding to the power sector rose to Rs 3.4 trillion as of July 2012, up 17.4% from Rs 2.9 trillion in July 2011.  

On closer analysis, this scheme looks like throwing good money after bad. Such performance based incentives to reimburse loans has been at the center of all the major central government programs in the sector for more than a decade. In fact, in the early part of the last decade, as part of the "big bang" electricity reforms, the debts of the bundled state utilities were similarly restructured. The two rounds of the APDRP reforms have had similar loss reduction and other reform commitments. And even after all these efforts, distribution losses remain at a shockingly high 27% and worse still, it appears to have plateaued.

Further, loss reduction, as I have blogged earlier, is more a political, than technical or enforcement problems. Allowing for the 10% technical losses (itself a high estimate), the remaining are commercial losses, which consists of both theft and fraud, apart from a share of the unaccounted for agriculture consumption. For sure, enforcement will contribute to commercial loss reduction. But it will have to be complemented with political commitment to crack down on those pockets of heavy losses, which are also unfortunately powerful electoral vote banks.

Mandating tariff revisions, based on cost of service, too is not easy to enforce. Currently, most of the larger utilities provide for tariff revisions in their annual tariff filings before the state regulatory commissions. However, even when they are agreed to, the state governments quickly step in to subsidize the incremental tariffs, especially on residential consumers. Further, though the subsidy has to be a budgetary transfer, the state government force the utilities, through creative accounting practices, to raise debt to cover for the higher burden.

In the circumstances, any meaningful attempt to wipe the slate clean and initiate genuine reforms in the finances of state utilities has to go beyond loss reduction and tariff revision mandates. There are atleast two areas which require immediate attention.

One, the most urgent challenge is the problem of free agriculture supply. Agriculture is critical because it not only contributes to the commercial losses, but also a large proportion of the free power subsidy burden gets transferred to the balance sheets of the utilities. In fact, agriculture is one big black hole in energy audits into which all undesirable and unaccounted for supply units are lumped. A more reliable audit could reveal even higher losses in many utilities. Therefore agriculture supply has to be metered and audited. Incentives have to be introduced to optimize and ration consumption and improve feeder level energy audits within utilities. It will also make rural supply sufficiently remunerative for utilities to focus on improving supply quality and reducing losses.

Second, there has to be a mechanism to take the burden of costly power purchases - mostly peak-time and summer spot market purchases - off the utilities books. Whether they are passed through to consumers, atleast certain categories, is a matter of important detail. Borrowings to finance such purchases have come to  form an increasingly large share of the accumulated debts on utilities' balance sheets. Both these measures will not be easy and will risk strong political opposition. But without addressing these two issues, especially the former, it is certain that the state utilities will require another round of debt restructuring in a decade.  

Wednesday, September 19, 2012

Outsourcing urban water sector services

This blog has consistently argued that outright privatization, especially in certain sectors like urban infrastructure, stands very remote chance of success in countries like India. Instead, a more realistic route to bring private participation in urban infrastructure services is to un-bundle and outsource specific service categories.

In particular, though water and sewerage has been the subject of several explorations at private participation, there have been very few successes. Conventional wisdom has it that the biggest impediment is the low prevailing water tariff and the political difficulty of achieving cost recovery by commercial pricing.

In this context, a nice study from CRISIL questions conventional wisdom and suggests a model for private participation in urban water sector. It examined nine water utilities and finds that a lifeline supply of water (80 lpcd or 12 kl per household per month) can be delivered with reasonable commercial tariffs, which are much smaller than the monthly electricity bill though higher than the current water rates, while ensuring operations and maintenance (O&M) cost recovery. The graphics below tell the story.



















The critical element in the model suggested is the assumption that the capital expenditure be made by the urban local body, while the O&M will be outsourced to a private agency and cost recovery achieved through commercial pricing. This itself is a significant achievement given that only 7 of the 65 cities covered by the flagship urban renewal program currently achieve O&M cost recovery. Such concessions stand the best chance of success in highly sensitive sectors like water. But there are a few concerns

1. The study uses the O&M expenditure currently being incurred by the utilities. This can be a misleading indicator since this is most often far lower than that required to manage the network optimally. The shoe-string reactive O&M, borne out of the utilities' budgetary constraints, most often ends up increasing maintenance costs and contributing to service quality problems. If the higher O&M costs are taken into account, then the commercial tariff for cost recovery could be much higher.

2. In the circumstances, it may be required to keep the tariffs for the urban poor as low as possible and achieve cost recovery through an appropriately designed Increasing Block Tariff (IBT) structure that charges higher rates on the bigger consumers.

3. The most important element will be in the details of the concession structuring. Factors like the baseline supply standards, obligations of the service provider, extent and scope of services outsourced, and so on need careful attention since they are typically the elements that derail such concession agreements.   

Sunday, September 16, 2012

The dangers of more monetary accommodation

Over the past few days, monetary authorities on both sides of the Atlantic have announced further extraordinary monetary accommodation policies. 

In Europe, the ECB finally bowed to pressure and announced  an ambitious program, dubbed "outright monetary transactions”, to purchase an unlimited amount of eurozone sovereign debt with maturities of between one and three years. The ECB's bond buying program, though conditional on governments signing up to a European Financial Stability Facility or European Stability Mechanism programme for fiscal and structural reforms, comes despite strong opposition by the German Bundesbank. Further, the ECB would not be treated as a preferred creditor in the event of default, thereby signalling to investors that the ECB purchases will not subordinate their own holdings of peripheral country bonds. This is part of ECB's determined effort to do "whatever it takes" to save the Euro. 


In the United States, spurred into action by the persistent dismal unemployment figures, the Federal Reserve announced its third round of quantitative easing program, QE3. It has decided to inject an extra $40bn into the economy each month through purchases of mortgage-backed securities for an unlimited time till the labour market improves. The FOMC reported
The Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative... the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.
As the FT reports, this marks a significant strategic shift in the Fed's policy stance. It has now, for the first time tied policy to developments in the economy – and promised not to shift policy until it succeeds.

For the record, the QE1 in 2008-09 involved purchases of $600 bn in mortgage backed securities and agency debt, $1.25 trillion of agency MBS, $200 bn in agency debt, and $300 bn in Treasuries.  The QE 2, from November 2010 to July 2011, involved purchases of $600 bn in similar securities. The most recent Operation Twist in September 2011 involved a swap of $400 bn of Treasuries to achieve maturity transformation and lower long-term rates.

The underlying premise behind both these actions in the US and Europe is the belief that liquidity injections will somehow help address the underlying problems and help the respective economies back on recovery path. In other words, this view sees the current problems as mainly liquidity problems, which can be tided over by an extended period of monetary accommodation.  

Unfortunately, this view may be deceptively misleading and could lead us down the path of even more pain. The best that can be said in favor of this policy is that monetary accommodation will help buy the time required to address the fundamental structural and fiscal problems. Though extraordinary monetary accommodation has been going on for nearly 5 years now, governments have done precious little to address the fundamental problems in the real economy. Nor is any inclination on their part to do anything different. And all along, things may have steadily gotten worse.

Europe's problems, certainly that of Greece, cannot be addressed by merely buying time and hoping that the denominator in the debt-to-GDP calculus improves with time. Fiscal austerity has already deepened it to a level from where all the possible options may have been shut off. In case of the US, while financial institutions' balance sheets have been repaired, very little has been done to address the balance sheet problems of the households. Further, no amount of central bank aggression will address the real problem of persistent unemployment rate and output gap, as well as the longer term debt problem arising from health insurance expenditures.  

And associated with any cheap money policy is the resource mis-allocation dangers, both domestically and globally.  Ruchir Sharma summed it up nicely,
The Fed can print all the money it wants - but it cannot dictate where it will go. The frst two rounds of quantitative easing fuelled a commodity bubble, increased income inequality and set a bad example for the rest of the world. During the 16 months of round one, up to March 2010, the CRB commodity price index rose 36 per cent, while food prices rose 20 per cent and oil prices surged 59 per cent. During round two, in the eight months up to June last year, the CRB rose 10%, with food up 15%, while oil prices rose a further 30%... Now, there is a tight link between stocks and commodities, with prices rising and falling in lockstep. This link neuters monetary policy makers, because rising commodity prices negate the stimulative impact of looser credit... a third round of quantitative easing... could be more counterproductive than the first two, since oil and food prices are now dangerously close to levels that have acted as a tipping poing for the global economy in the past.

Financial market distortions caused the sub-prime crisis and if conditions of extended accommodation persist for too long another bubble may get inflated somewhere in the wide markets. More worryingly for the developing countries, in a world awash with liquidity in search for returns, their economies offer attractions for speculators looking for quick bucks. This is all the more so given the diminishing investment options in the developed economies. Such capital flows, as we already know from several recent experiences, can have damaging consequences. In the circumstances, from the perspective of developing economies, is some form of capital controls desirable?

Wednesday, September 12, 2012

Climate change and traffic congestion

What's common between addressing climate change and traffic congestion? Disincentivizing private vehicle usage will help mitigate carbon emissions and control traffic congestion. As the graphic below shows, transportation is a large contributor to global carbon emissions.
















Happily for environmentalists, the sheer immediacy of the problem of traffic congestion, makes it an issue demanding urgent attention for policy makers. In simple terms, climate change advocates stand a greater chance of succeeding in their fight against carbon emissions by joining hands with urban transport managers in addressing traffic congestion.

Any effort to reduce carbon emissions has to involve aggressive action by US, China, and India. Given the magnitude of the problem - deteriorating traffic and air quality - it is therefore unsurprising that in recent weeks all three have initiated policies aimed at restricting vehicle usage and/or reducing the carbon footprint from vehicular emissions.

Following Shanghai and Beijing, Guangzhou, the third largest Chinese city, has embraced license plate auctions and lotteries to restrict the growth of vehicles. It is estimated to halve the number of new vehicles entering the market. Even the usually lethargic Indian government has been spurred into action and is contemplating urban transport tax to discourage vehicle ownership and congestion pricing to disincentivize vehicle use. In the US, President Obama recently announced stricter energy efficiency standards which are expected to nearly double the average fuel economy of cars and light trucks to about 54.5 miles a gallon by 2025.

However, as the Times points out in a recent article, a more effective way to address this challenge may be by simply taxing carbon fuels. This blog has consistently argued in favor of carbon tax as the preferred strategy to achieve carbon abatement, based on considerations of both economic efficiency and practical implementation challenges. This graphic from the Times article highlights the potential gains from a carbon tax in the US.
























Nevertheless, as this McKinsey report shows, improvements in emission standards is one of the cheapest carbon abatement options.















But with the issue of discouraging vehicle use, we need to realize that we can make a meaningful dent only by simultaneously deploying all the three policy options available - making vehicle ownership costly (vehicle tax, license plate auctions etc), internalizing the social costs of vehicle usage (carbon tax, congestion pricing, high parking fees etc), and encouraging the use of public transport. In countries like the US, among these options, carbon tax, despite its certain political opposition, is likely to be the least distortionary and most effective way to address both traffic congestion and climate change.

Monday, September 10, 2012

The dismal economic landscape on both sides of the Atlantic

The FT has a nice graphic of output gap that captures the dismal economic situation on both sides of the Atlantic.













The coming Wednesday is important on many counts. The German constitutional court will determine whether it is right for German public funds to be contributed to the European Stability Mechanism, which underpins the ECB's recently announced short-term unlimited government bond buying program. The Bundesbank has already criticized the move "as being tantamount to financing governments by printing banknotes". The same day, voters in Netherlands could give a signal of their commitment to stay on or leave Europe in the country's national polls. Finally, in light of Chairman Bernanke's pessimistic comments on the US economic prospects, the Fed will decide on whether or not to go ahead with another round of quantitative easing.

Sunday, September 9, 2012

"Spectrumgate" Vs "Coalgate"

Corruption in the allotment of coal mine blocks is the latest in India's season of auditor-exposed scams. The Times of India reports that Jindal Power Limited (JPL), a subsidiary of Jindal Steel and Power Limited (JSPL), owned by a Congress MP, benefited by way of accessing captive coal mine block for its 1000 MW merchant power project in Chhattisgarh's Raigarh district. 

The project which turned fully operational in 2008 and is the first merchant power plant in the country (which can sell power at spot rates to any buyer, instead of being bound by tariffs fixed through long-term power purchase agreements) got coal at a concessional rate. The report writes,

Over the next year, it sold power at an average price of more than Rs 6 per unit. By 2010, the high returns had not only covered its running costs but also investments of Rs 4,338 crore. According to infrastructure experts, it takes a minimum of 5-7 years to repay debt incurred for capital investment in power projects... Jindal Power has become debt-free within two years of operation due to strong cash flows on account of low cost. A big component of the low cost was cheap coal obtained from its captive coal mine just 10km away — Gare Palma IV/2 and IV/3 with combined reserves of 246 million tonnes of coal...
The Jindal Group is the largest beneficiary of coal block allocations. It has reserves of 2,580 million tonnes of coal, while the second largest beneficiary in the private sector has just 1,500 million tonnes...  The problem is not that the company got access to massive reserves of coal. The issue is that it uses cheap coal to sell power at prices much higher than the others... documents show that JPL sold 22 million units of power last October for a price as high as Rs 5.47 per unit.
The Times's comparative analysis of three power projects in north Chhattisgarh — Sipat project of NTPC, Amarkantak project of Lanco group, and JPL's Raigarh project - which came into existence around the same time makes for compelling reading. The difference in coal prices could not have been starker, 
Lanco Amarkantak and NTPC Sipat buy coal from South Eastern Coalfields, a subsidiary of Coal India. JPL mines its own coal. NTPC's average fuel cost last year came to Rs 1,200 per tonne while Lanco's cost worked out to an average of Rs 1,020 per tonne. Jindal officials refused to share the company's coal cost figures. But sources in Chhattisgarh's mining industry said JPL's cost could not exceed Rs 300-400 per tonne as it extracts coal from an open cast mine for which it had bought land at low prices. Taking an even broader estimate of Rs 500 per tonne of coal, based on Coal India's current margins, would still leave JPL with half the coal cost of its competitors...
Jindal sold power at the highest prices — Rs 3.85 per unit in 2011-2012, compared to Lanco's Rs 3.67 and NTPC's Rs 2.20. The previous year, JPL had sold power at an even higher rate of Rs 4.30 per unit. The combination of cheap coal and high power prices explains why Jindal posted Rs 1,765 crore as profits, or 60% of its income, while Lanco made a profit of just Rs 155 crore, just 12% of its income. 
Now, if the figures in the ToI report are correct, this is a classic example of private gain at public cost. It is also here that the parallels with the other major scandal of our times, telecommunications spectrum allotment, ends. In case of telecoms, a significant share of the gains from discretionary low cost acquisition of the spectrum was passed on to the consumers in the form of high quality services delivered at very low cost. In other words, the rent-seeking involved in the spectrum allotments generated certain positive externalities. The competitive pressures created subsequent to the allotment process, by design or otherwise, contained incentive compatibilities that forced the companies to share their excessive gains.

However, in case of the mining blocks, despite its fundamental similarity with telecom spectrum, the winners have sought to corner all their disproportionate gains. They have, as the Jindals have done, sought to take advantage of the market structure (the freedom to sell the power so produced on a merchant power route). Or, as most others have done, they have sought to keep the allotted blocks undeveloped, assured by the belief that they were sitting on potential gold mines. In fact, it is a damning indictment of the whole policy framework that barring a few, most of the mines have been allowed to keep them undeveloped despite being allotted at extremely concessional rates.

In other words, unlike the telecom spectrum, where market competition and a policy framework kept the spectrum owners honest and thereby forced them to share the benefits arising from low capital costs, the coal block owners were not constrained by any policy framework.

Update 1 (12/9/2012)

Between June 2004 and 31 March 2011, the coal ministry allocated 194 coal blocks on a nomination basis to various firms for captive use. Mint unpacks more skeletons,

Between 1996 and 2009, JSPL and its unit JPL were allotted nine coal fields in the mineral-rich states of Orissa, Chhattisgarh, Madhya Pradesh and Jharkhand, translating into reserves of 2.59 billion tonnes, or 5.97% of the 43.35 billion tonnes doled out by the Centre... The coal blocks allocated to JSPL on its own and as part of a partnership were Gare Palma IV/1 (1996), Gare Palma IV/2 (1998), Gare Palma IV/3 (1998), Gare Palma IV/6 (2006) in Chhattisgarh, Utkal B-I (2003), Ramchandi Promotional (2009), Urtan North (2009) in Orissa, and Jitpur (2007) and Amarkonda Murgadangal (2008) in Jharkhand.

Saturday, September 8, 2012

The mis-directed debate on Aid

Whether external aid is effective or not is arguably one of the most controversial topics of debate. Critics point to the several examples of corrupt and under-developed aid recipient countries, especially in Africa, and argue that aid programs have been ineffective. Some go further and argue that aid has positively damaged governance systems in these countries by, among other things, increasing rent-seeking opportunities and thereby increasing corruption and promoting governance failures.

I am inclined to believe that the critics of aid miss the point on the following counts

1. Failures in aid utilization are no different from the inefficiencies (and wastage and corruption) that characterize the regular public programs in these countries. An appropriate comparison would be the relative performances (in terms of achievement of outcomes) of similar programs in a sector in different parts of a country (after controlling for the regional differences) run with aid and domestic finances. My feeling is that the externally funded program, despite all its failures, would have been more effective than the domestic program.

There cannot be any absolute touchstone for measuring the effectiveness of aid utilization. Its effectiveness has to be seen in light of the general governance standards of the recipient country.

2. It may not be appropriate to paint all aid with the same brush. There exist wide variations across countries and programs/sectors. A more helpful and serious criticism would be to identify areas or regions/countries where aid may not be having the desired effect and similarly where they are successful. In countries like India, which have received huge amounts of aid, there is little to show that aid money has been less efficiently spent than the domestic government funds nor has it failed to achieve substantial (albeit less than would have been originally hoped) gains. 

3. Considering that aid is an external cashflow aimed at supplementing the local government finances, it is no different from any other sudden one-time domestically generated cashflow. Extending the logic that aid corrupts polities, one could as well argue that these countries should be denied access to any lumpy finances. The same logic underlies the "resource curse" faced by countries with huge natural resource reserves. Again extending the logic, we would have to argue that since the resource stocks are harmful to that country (by corrupting its polity), it should be deprived off those resources.

Apart from these there are several other more commonly argued responses in support of aid. If we are to make an meaningful dent in addressing the issue of effective aid utilization, it may be more appropriate to focus on identifying areas and sub-sectors where the marginal returns from such funds can be very high. Most of the aid falls into a general routine pattern across the world, flowing into health, education, and livelihood creation. Such programs, however well-crafted, are likely to get subverted as it winds its way through the domestic bureaucratic systems.

In conclusion, I am inclined to believe that the rightful indignation at the perceived shortcomings of aid programs is rooted in its obvious failure to achieve the desired objectives. But the moot point is whether the objectives were themselves too unrealistic, given the governance standards in the recipient countries. 

Wednesday, September 5, 2012

Unintended consequences of financial repression

In the context of China's still inflating property bubble, Yichuan Wang has an interesting post where he attributes the housing boom to an absence of alternative investment opportunities. He writes that housing has become a "savings vehicle" for ordinary Chinese citizens,
Chinese citizens face a severe shortage of effective ways to save money or preserve value. Bank deposit rates consistently run below the rate of inflation. When better investment opportunities come along, those deposit rates don't necessarily rise. There are securities companies, but it's very difficult for the people to trust them... The stock market is seen as a capricious creature...
Housing is special because it is much more concrete than other investments. It depreciates relatively slowly and is easy to verify; this is unlike many other investment opportunities such as equities or securities. It is useful, because you can immediately start to live in it or rent it out. Also, because of rising incomes across China, it seems very reasonable that demand for housing will increase and therefore building a house will have a high return.
In other words, China's financial market repression - artificially low interest rates, capital controls, strongly regulated capital markets etc - has been fueling the residential property bubble. He sees this as a constrained revealed preference,
Large scale housing investment is not necessarily a neutral “revealed preference”. Rather it can be a dangerous “constrained preference”. Given the option between negative real rates in a bank account or housing, Chinese citizens choose housing. But if they had the option of higher deposit rates, we might have seen a shift away from housing towards regular bank deposits. This is very similar to the problem developmental economists face when discussing whether people in poor countries have too many children. While parents might prefer to take care of fewer children, they choose to have more children so that enough of them survive to take care of their elderly parents. So similarly, poor people choose to have a lot of children given their constraints, but with enough financial innovation they would consider having fewer children.
In fact, I am inclined to argue that this preference for housing investment as a savings vehicle may be also contributing to keeping savings very high and consumption suppressed. The large amounts required to buy housing, as opposed to other smaller but diversified investment alternatives, increases the need to save more. The rising property values exacerbates this trend. And this in turn is keeping consumption heavily constrained. This is one more reason for Beijing to start addressing the underlying causes for the disproportionately large propensity among households to save. See this and this for an analysis of the underlying reasons.

In this context, it is tempting to draw parallels with Indian households' attraction to investment in gold. In the absence of adequate, easily accessible, low-risk, and liquid enough investment opportunities, they find gold a very good investment opportunity. In terms of gold imports adding to the country's unsustainable current account deficit and the gold stocks locking up a significant share of savings, its dead-weight loss and larger economic cost is clearly bad for the economy. The financial market uncertainty in the aftermath of the sub-prime crisis and the surge in gold prices has only amplified the resource mis-allocation problem.

A recent report by Macquarie (via FT) found that India's net gold imports worth $23 bn (1.3% of GDP) in 2011-12 was almost half of its $44bn current account deficit. It wrote,
Our estimates suggest that net gold imports alone have contributed nearly 40bps to the 130bps widening in India’s current account deficit between FY08 and FY11 (from 1.3% to 2.6% of GDP).
Both these examples of resource mis-allocation which are directly related to financial market repression is a reminder about its adverse consequences on the national economy. 

Monday, September 3, 2012

Time to do away with hourly billing

The persistence of hourly billing in many knowledge-based service professions comes across as an anachronism in this age of outcome-focused work ethics. Many of the leading consultancies and professional service providers, who lose no opportunity to drive home the critical importance of outcome-focus to their clients, bill them in terms of the man-hours of work done.

The idea of hourly billing has its roots in the manufacturing shop floor. Here the highly specialized work output was clearly defined (or definable), with each employee being expected to deliver a certain work output each hour for a specified number of hours each day. It was also important to quantify this given the widely prevalent practice of over-time work done by factory workers.

However, in modern knowledge based sectors, where team-work and individual effort are equally important and their interaction affects the quality of their output, hourly billing has the potential to severely distort incentives. The absence of clearly defined work output and time schedule for each individual worker only amplifies this risk. Primarily, hourly billing ends up distorting incentives and encouraging the employee or hired worker to bill excessively.

For example, in software and consulting, it incentivizes professionals to shift work (otherwise doable during regular office hours) to off-time hours (such as weekends), so that they can claim the much higher hourly rates during such times. Similarly, the leading management consultants bill exorbitant rates for the hours devoted by their top executives. But the terms of reference of this time is only defined very vaguely and often generates limited marginal value addition. Such pricing enables these firms to justify the huge rates they charge their clients.

The time may have come to debate the need to junk hourly billing and embrace the more efficient outcomes-based billing route in all knowledge-based sector labor markets.