Sunday, August 30, 2015

Weekend visualization and other links

1. Very cool data visualization of the respective sizes (nominal) of major world economies. The ball constitutes the world economy and the shares of each country are proportionately distributed, and within each of them the respective shares of manufacturing, services, and agriculture.
2. Another one, which puts in perspective America's military might, in terms of defense spending.

3. Japan faces a problem of housing in plenty outside of its largest cities - declining population and vacant houses, with no buyers and owners (more specifically, their children) unwilling to tend for them. "We have too much infrastructure. We can't maintain it all," says Takashi Onishi, an urban planning professor and the president of the Science Council of Japan, as large numbers of towns surrounding Tokyo depopulate.

4. FT captures China's importance for the world economy in four graphics,

5. FT has a nice article highlighting the resurgence of conflicts of interest in the large audit firms as their consulting practices race ahead of their staple audit and tax advisory services. While the consulting wing offers everything from legal services and insolvency procedures to capital markets advisory and advise on cyber security, their audit wing offers verification and certification services on the same areas, raising serious conflicts of interests which cannot be mitigated.

Though in 2002 the Sarbanes-Oxley Act prohibited auditors from offering non-audit services, forcing the Big Four to divest their consulting arms, they have found ways since mid-2000s to build back their empires. Now, through aggressive acquisitions, non-audit work makes up about 60% of the Big Four's total global revenues and is the fastest growing and most profitable practice division.

6. Gillian Tett highlights the growing importance (they form more than half all US stock trades) and risks posed by high-frequency trading,
These machines are being programmed to link numerous market segments together into trading strategies. So when computer programs cannot buy or sell assets in one segment of the market, they will rush into another, hunting for liquidity. Since their algorithms are often similar (or created by computer scientists with the same training) this pattern tends to create a “herding” effect. If a circuit breaks in one market segment, it can ripple across the system faster than the human mind can process. This is a world prone to computer stampedes.
On the scale of technology sophistication, sample this from Alvin Roth's new book on market design,
Before 2010, market news between Chicago and New York was transmitted fastest on cables that ran along the rights-of-way of roads and railways. But that year, a company called Spread Networks spent hundreds of millions of dollars to build a high-speed fiber-optic cable that went in a much straighter line and cut round-trip transmission of information and orders from 16 milliseconds to just 13. That 3 millisecond differential basically meant that only traders who used the new cable could make a profit by trading on momentary price differences between Chicago and New York. 
7. A crime-infested Mexican slum, Las Palmitas, has sought to graffitize itself out of neglect and despair with bright paints for its houses and public landmarks, as part of a $300,000 federal government crime and violence prevention program,
Las Palmitas, now an abstract and beautiful 20,000 sq metre mural that bursts out of the browny-grey landscape, marks “a new stage in Mexican muralism”... the mural, which covers 209 houses and which used 20,000 litres of paint in 190 colours... Painting houses cheerful colours is only part of the programme to revitalise a community rife with drug and alcohol abuse, violence and scant prospects. Las Palmitas, which had no electricity until about seven years ago and still has no internet access, now has video surveillance cameras. Police officers include the neighbourhood in their rounds; the government is working with residents to help them develop businesses; and high school dropouts now have access to scholarships funded by a major Mexican university... In Las Palmitas, officials say the programme, of which the mega-mural is part, led to a 79 per cent drop in the crime rate in the first half of this year, compared with levels in 2012. They see such grassroots campaigns as vital in a country struggling with rampant drug cartel-related violence and crime. 
8. From Martin Sandbu's myth-busting piece in the FT on the Eurozone, this graphic appears to over-turn the conventional wisdom that a sovereign debt default would have devastating consequences and would confine the country to a long period of ostracism.
The graphic shows that both credit worthiness and economic growth improved after the sovereign debt restructuring. The former would reflect the easing of uncertainty after the restructuring.

9. Finally, the age of million dollar parking spots in apartment complexts has arrived! I had written earlier about how a melange of policies, including higher parking charges or scarcer parking slots are necessary to addressing urban traffic problems. 

Friday, August 28, 2015

India's courts need more "sunlight"

Livemint has a rare statistical peek at India's higher judiciary, with this article on a study documenting the time taken between court hearings for different categories of cases across High Courts in India. The graphic below documents the wide variance in hearings per judge and the time between hearings across High Courts. 
You cannot improve what you cannot measure. Given the near total absence of dynamic information about court work, performance monitoring of judiciary is a non-starter. In this context, the words of Justice Louis Brandeis who is reported to have said with reference to transparency that "sunlight is said to be the best of disinfectants", carries great relevance. Nowhere is it more necessary than our judiciary. And data and its analysis can shine light on the performance of India's judicial systems. 

Even the most basic data on the performance of judicial officers is currently difficult to obtain. How many orders have been passed by each judge annually, individually and in a bench? What is their average time between the final hearing (reserving for orders) and passing of orders? How many orders of the judge have been appealed against? How many of the orders have been reversed in appeal? How many orders have been passed in favor of the petitioner and how many rejected? How many orders have been passed against the government and how many in favor? What is the average number of adjournments in a case for each judge?

Admittedly the judges are over-burdened with case load. But much the same could be said about every public functionary from the ANM to the District Collector. Answers to each of these questions and more, and their comparative analysis across judges and courts, would undoubtedly be a massive step in ushering greater transparency to the functioning of India's judicial system. 

Wednesday, August 26, 2015

This time is no different - EM shocks spares none

The contrast in economic fundamentals with the May 2013 US Fed taper-tantrum days and today's China contagion could not have been more stark. At that time India was one of the most vulnerable, even among the 'Fragile Five'. Now the country has become so much of a positive outlier that it does not even figure in assessments of emerging market (EM) risks.

The two graphics from FT conveys the relative strength of the Indian economy. The first conveys how insulated the country is from the two biggest risks - exposure to Chinese market and foreign currency bond borrowings.
The country is among the only two EM economies not overly exposed to the trifecta of unwinding Chinese leverage, US QE, and domestic debt. 
Clearly, India is as insulated as markets can be from any triggering exogenous shock, with its accompanying portfolio re-balancing by foreign institutional investors. Further, its macroeconomic balance, both domestic and external, as well as inflation, are stable. But the events of Monday shows that very little of this is material, atleast in the immediate aftermath of the triggering exogenous shock. The battering of the equity markets and the rupee this week, especially given the relative strength of the Indian economy and the depth of weakness among almost all of its emerging market peers (a position that it has never been in), is the strongest possible reminder that such global shocks are largely divorced from fundamentals and spares none. As the RBI Governor found out, no central banker (or anyone) has a magic wand to ward-off or talk up the markets. 

The trajectory of the current bout of market volatility in India will be contingent on the trends across other emerging markets. If the markets adjust to the potential adverse consequences of a Chinese slowdown or the Chinese government is able to postpone the denouement to its bubble valuations, the Indian market too would be calmed. However, if the EM weakness persists, the volatility will continue to haunt the Indian markets. In that case, stability will return only when the broader EM sentiments stabilize (and not with country-specific events), as happened in August 2013. 

This should also serve to put in perspective the despair that followed similar trends in the aftermath of the May 2013 taper-tantrum and the subsequent uptick that was popularly attributed to the entry of the new central bank governor. 

Tuesday, August 25, 2015

Limits to growth with Chinese characteristics

Another carnage, and the China doomsday season accelerates. George Magnus writes the latest obituary. Michael Schuman joins the bandwagon questioning the infallibility of the Chinese technocrat. The collateral damage from China's travails are everywhere - equities are plungingcommodities are declining unabated, currencies are being battered, and the retreat from emerging market bonds may have been triggered. So are we near the end of capitalism with Chinese characteristics?

In very simple terms, the nearly thirty years of China's rapid economic growth was underpinned by a top-down (guiding hand of the communist party at all levels) and inputs-driven (infrastructure and manufacturing investments) structural transformation that capitalized on the country's vast supply of cheap and skilled labor, high savings rate, and a continental sized markets. An opportune moment in world history, coinciding with the high-noon of the latest round of globalization, boosted global trade and China was best positioned to capture its benefits. It is fair to assume that China is nearing the end of, or has already exited, this phase of its economic growth. 

Thanks to the benign leadership of the same technocrats, China seized the moment to achieve more than a quarter century of spectacular growth that has pulled hundreds of millions out of poverty. The externalities from the juggernaut were just as impressive - it sucked commodities spurring a boom in commodity prices and driving up the fortunes of the commodity exporters, its cheap exports contributed in no small measure to fueling the extended low-inflation period of Great Moderation, and its huge trade surpluses financed the credit appetites of countries like the US. In a just world, instead of celebrating its obituary, the world economy should have left the biggest "Thank You" note at the door-step of Beijing. 

Leave that aside. Moral-politik is rarely the nature of international relations. The more relevant issue for consideration is whether the next phase of China's growth is amenable to similar benign guidance. It would arguably involve transition into more knowledge and technology-intensive manufacturing, diversification and expansion of the services sector especially the creative knowledge-based activities, deregulation and external opening up of its financial markets, and domestic structural adjustment towards a normal and more consumption-based economy. And all this will have to be achieved without upsetting the socio-political balance that is essential to managing change and reforms with the least discordance. 

The challenge is whether the pacing and sequencing of this new phase can be managed in the same way as was possible with the manufacturing and infrastructure investment led current phase. More precisely, the challenge is whether such trends can be achieved in a socially-repressed and politically-controlled environment. Each of the aforementioned transitions contain too many moving parts and involve behavior and perception changes that are normally achieved through the dynamics of incentives and market mechanism, with adequate regulation, and may be beyond the powers of even the best of the Communist Party's technocrats. 

Will the communist party be willing to loosen its iron-grip on the country's society and polity? And more importantly, if that happens, will the disruption, which will inevitably follow, be acceptable enough for the mandarins in Beijing to allow the transition to progress? Or can the mandarins in Beijing manage a calibrated social and political deregulation, just as they did the economic deregulation? It is difficult to credibly prophesy all this except through backward-looking assessments, which may not be as relevant given China's uniqueness. 

I am not sure whether the Communist Party has the stomach, much less the enlightened self-interest, to bite the bullet. Encouragingly, in this context, China has precursors. Japan and a few North and South East Asian neighbors achieved similar long-periods of top-down, inputs and exports-driven growth which laid the foundations for a phased transition towards a more deregulated and liberal democratic environment. But then, these countries were smaller and far less authoritarian than China when they embarked on their similar growth phases. 

Monday, August 24, 2015

Another teachable moment in currency management

After spending $28 bn over two years propping up the tenge, late last week, Kazakhstan's central bank announced a regime shift from exchange rate targeting to inflation targeting. The decision, prompted by the Chinese and Russian devaluations and falling oil prices, resulted in a steep plunge in tenge's valuation by nearly a quarter in a single day. 

As the graphic shows, even by Kazakhstan's usual standards, with bouts of sharp devaluations, this one has been exceptionally steep.
Especially when compared to its oil exporting peers.

Oil dominates the country's export basket and contributes the lions share of the government's revenues, as seen from this 2013 export products graphic
For such countries, a floating exchange rate regime can be a useful automatic stabilizer. As commodity price falls and current account balance weakens, a gradually depreciating currency would serve to both keep exports competitive and squeeze imports, thereby restoring the external balance. Similar forces work in the reverse with rising commodity price and appreciating currency so as to moderate capital inflows during the commodity upturns. Further, this dynamic would also serve to promote manufacturing diversification and mitigate the "resource curse" effect during good times, which is characterized by a hollowing out of the non-commodity tradeables sector, especially manufacturing. Most importantly, it would leave the country with the monetary policy autonomy to combat the headwinds arising from external shocks. 

In this respect Kazakhstan is no different than many commodity exporting emerging market peers. In order to maximize revenues during good times, these countries play the foreign exchange markets to keep their currencies over-valued, thereby fueling asset price bubbles, only to be forced into depreciating sharply when the tide has turned and the central bank can no longer hold on. Such unpredictable reversals erode the country's macroeconomic policy credibility and markets punish it with violent swings. Inflation and economic stagnation, accompanied by banking crises, soon follow. Monetary policy discretion goes out of the window as the country is forced to hike rates to retain capital and rein in inflation. It is not devaluations per se that erode credibility and disrupts the markets, but sharp and unpredictable devaluations.

Nigeria, which has stubbornly kept its currency pegged to the US dollar, thereby suffering a steep drop in its oil revenues, looks most likely to soon burn out its reserves and be forced to let the over-valued naira depreciate steeply. 
An example of such macroeconomic prudence, with the attendant credibility and stability that anchors inflation expectations and limits cross-capital flows volatility, which enables countries to weather the storm, is Colombia, another country dependent on oil exports. The FT writes,
Under successive presidents, Colombia put together a framework that aimed for structural fiscal balance, instituted inflation targeting and achieved relatively broad-based growth... Over the past year, the economy’s exposure to the oil price (more than 50 per cent of exports) has resulted in the Colombian peso being one of the weakest freely-traded currencies in the world, by falling 36 per cent over the past 12 months. Like most EM currencies, it received another kick downwards from China’s renminbi devaluation last week. The rapid depreciation alongside falls in dollar-denominated oil prices means that in recent months, Colombia’s oil revenues in domestic currency terms have fallen relatively little, even compared with other oil economies. Economists at Barclays calculate that oil priced in Colombian pesos fell just 1.3 per cent from early May to late July, compared with falls of 6.2 per cent in Russian rouble terms and 14.4 per cent if priced in Nigerian naira...

(unlike its peers) the Colombian central bank has left monetary policy on hold since last August. Colombian consumer price inflation has recently risen to 4.5 per cent, just above the central bank’s 2-4 per cent target band, but inflationary expectations have remained well anchored... the IMF forecast that the economy would expand 3.4 per cent this year, below last year’s 4.6 per cent but far better than the recessions forecast in Russia and Brazil, and that inflation would drop back below target.
Kazakhstan may well have now embraced an inflation-targeting regime. But on the issue of which monetary policy regime best suits such countries, Jeffrey Frankel has written here about the possible superiority of NGDP targeting. Writing in the aftermath of a shift in the nominal anchor from US Dollar to a basket of currencies in September 2013, Prof Frankel had cautioned against any adoption of inflation targeting,
An example illustrates the point.  If a truly serious CPI target had been in place five years ago at the time of the global financial crisis, then Kazakhstan would have faced a difficult and unnecessary dilemma when it was hit by adverse shocks in oil prices, the housing sector, and the banking system. The country would have had either to forego the necessary February 2009 depreciation of the tenge or else to violate strongly the CPI target as the devaluation pushed up import prices.  The former choice would have been dangerous for the economy, while the latter choice would have largely defeated the purpose of having announced IT in the first place (that purpose being long-term monetary credibility).
Instead, he suggested an NGDP targeting nominal anchor for monetary policy as the best automatic stabilizer for oil exporters like Kazakhstan,
Kazakhstan is vulnerable to a variety of possible shocks, such as a fall in the world oil price, which would be better accommodated by a more flexible exchange rate regime... An alternative anchor for monetary policy, in place of either the dollar exchange rate or any version of the CPI, is nominal GDP... the innovation would in fact be better suited to middle-income commodity-exporting countries like Kazakhstan. The reason is that supply shocks and trade shocks are much larger in such countries. In the event of a fall in dollar oil prices, neither an exchange rate target nor a CPI target would let the tenge depreciate. An exchange rate target would not allow the depreciation by definition, while a CPI target would work against it because of the implications for import prices. In both cases sticking with the announced regime in the aftermath of an adverse trade shock would likely yield an excessively tight monetary policy. A nominal GDP target would allow accommodation of the adverse terms of trade shock: it would call for a monetary policy loose enough to depreciate the tenge against the dollar.

Saturday, August 22, 2015

Weekend Reading Links

1. Ambrose Evans-Pritchard hints at an OPEC obituary, arguing that the Saudi bet on driving out shale producers as oil price falls may not materialize, 
The North American rig-count has dropped to 664 from 1,608 in October but output still rose to a 43-year high of 9.6m b/d June... Gas prices have collapsed from $8 to $2.78 since 2009, and the number of gas rigs has dropped 1,200 to 209. Yet output has risen by 30pc over that period.

He argues that while the shale producers may be able to innovate and remain competitive despite the falling prices, the fiscal burden may be prohibitive for Saudi Arabia to weather, 
Tyler Durden though thinks that all the talk of increasing productivity and the dawn of era of low oil prices is kool-aid. Very difficult to predict such trends since there are too many other factors at play. Only time will tell.

2. Fantastic investigative essay in the Indian Express on the not-so-glamorous under-belly of India's e-commerce system, the parcel delivery boys (and yes, they appear to be mostly boys!). I am not surprised at all with this. Such practices will continue so long as the benefits (by way of cheap labour in plenty with limited alternative employment opportunities) out-strip the costs (of high attrition rates and resultant limited skill-set employees etc).

Interestingly, coming in the same week as this scathing indictment of Amazon's work practices, this essay on India's own Amazons appears to have hardly raised a flutter. Does it reflect poorly on the quality of public debates in India? As an aside, the real story with e-commerce would be one which shows how most of these firms are bleeding capital and it could be a very prescient curtain raiser on what looks certain to be India's first real dot-com bubble and bust. 

3. When Anat Admati and colleagues advocated capital reserve requirements upwards of 20 per cent, it elicited strong reaction from Wall Street. Now, Alan Greenspan, of all people, advocates higher capital reserves,
If average bank capital in 2008 had been, say, 20 or even 30 per cent of assets (instead of the recent levels of 10 to 11 per cent), serial debt default contagion would arguably never have been triggered. Had Bear Stearns and Lehman Brothers continued as capital-conscious partnerships, a paradigm under which both thrived, they would probably still be in business. The objection to a capital requirement of 20 per cent or more, even when phased in over a series of years, is that it will supress bank earnings and lending. History, however, suggests otherwise...
If history is any guide, a gradual rise in regulatory capital requirements as a percentage of assets (in the context of a continued stable rate of return on equity capital) will not suppress phased-in earnings since bank net income as a percentage of assets will be competitively pressed higher, as it has been in the past, just enough to offset the costs of higher equity requirements. Loan-to-deposit interest rate spreads will widen and/or non-interest earnings will increase. An important collateral pay-off for higher equity in the years ahead could be a significant reduction in bank supervision and regulation.
4. Livemint points to a report on ownership of equities in the Indian stock markets. Foreign participation has been rising in recent years, as reflected in the steadily rising share of foreign holdings on BSE 200 equities...
... and the declining and rising shares of Indian and foreign institutional investors respectively in BSE 200.
5. From FT, on the distortions induced by the extended period of ultra-low interest rates, which arises from the transformation of central bankers to creating demand (by low rates) from their original role as lenders of last resort,
By lowering interest rates we can weaken our exchange rate and take demand from our trading partners. We can also take demand from the future by inducing more borrowing against future income and also by a “wealth effect” when lowering interest rates makes future cash flows appear more valuable. So we can steal demand from foreigners, induce people to borrow more than they otherwise would, or make rich people appear richer. 
6. Nice article in Times which shows why the Federation of Quebec Maple Syrup Producers is the new OPEC,
Quebec's trees produce more than 70 percent of the world’s supply and fills the majority of the United States’ needs. The federation, in turn, has used that dominance to restrict supply and control prices of the pancake topping. It is effectively a cartel, approved by the provincial government and backed by the law. In 1990, the federation became the only wholesale seller of the province’s production, and in 2004, it gained the power to decide who gets to make maple syrup and how much... In 2003, a majority of federation members voted to make production quotas mandatory, meaning farmers could sell only a certain amount each year. Farmers are required to sell all of their syrup through the federation or its designated agents... When the federation suspects farmers are producing and selling outside the system, it posts guards on their properties. It seeks fines from producers and buyers who do not follow the rule. In the most extreme situations, it seizes production... 

It defends the system, saying it keeps prices high and stable... To keep prices high, the federation enforces strict quotas for the province’s 7,400 producers. Instead of flooding the market during years with bumper crops, all syrup produced beyond that amount is stored in the federation’s warehouse, which helps prop up prices by limiting supply. When seasons are lean, it releases the syrup, to maintain stable supply and pricing... Stacked in barrels nine high, the reserve currently holds about 60 million pounds of maple syrup. Prices are set by the federation, in negotiation with a buyers’ group. The federation holds most of the power, given that it controls a majority of the world’s production.
7. Share-holder friendly activities, share buy-backs and mergers and acquisitions, both driven largely by cheap borrowings and cash hordes of large corporates, have underpinned the equity boom in the US. FT points to this data from Dealogic,
Companies have raised $290bn of debt to buy competitors this year — almost triple the level in the same period in 2014. The number of issues, however, has risen only 46 per cent, so the average size has been much larger. In the first half of the year there were $987.7 bn of deals in the US... the highest since records began in 1980. 
8. Mexico is distributing 10 million 24 inch flat-screen television sets at a cost of $1.6 bn to the beneficiaries of two social welfare programs Prospera (campaign against hunger) and Liconsa (subsidized milk program) in what it calls the world's largest television distribution program. That moniker though may belong to the Indian state of Tamil Nadu, which in the 2006-11 period distributed 16.4 million 14 inch color TV sets.

The Mexican government hopes to promote internet penetration with these digital televisions which have USB and HDMI ports to access digital content. 

9. Business Standard has this story which highlights that housing is simply out of the reach of all but businessmen, self-employed, and a handful of top-flight executives. A Liases Foras study finds that housing is unaffordable within India's eight largest cities, but for double-income households. 
As I have blogged on numerous occasions, affordable housing may turn out to be the biggest brake on India's urban growth engine. 

Friday, August 21, 2015

Cross-subsidizing inefficiencies Vs direct subsidy transfers

Livemint reports that the Indian Railways is considering purchasing stressed power assets since they are an attractive opportunity to buy power assets at a cheap price. The argument for such purchases is that it would kill two birds with one stone - provide captive power assets for Railways at a cheap price and thereby de-stress the asset and help banks eliminate their non-performing loans. But does the cheap price alone make the asset attractive?

Consider this. The vast majority of power generation projects currently distressed are so because either their tariff is prohibitive or because they are unable to access assured fuel supplies. The former can happen because of high construction cost, high fuel price, or inordinate delay which cause cost over-run and accumulation of interest during construction. Since the contributory factors are not easily mitigated, if at all, the majority of these assets are most likely to remain high-cost generators. The lure of the cheap price would generally be more than off-set by the high life-cycle cost and sunk-cost effects (such projects generally require further large capital investments). After all, if the assets were really that cheap, wouldn't they be equally attractive to those with far bigger pockets, the infrastructure funds and other asset managers, leave aside other competing power generators. 

This brings us to the issue of efficiency and public policy. Governments are attracted by the prospect of such apparent free-lunches that typically ends up cross-subsidizing inefficient public entities. They are everywhere - mandating that government officials travel by Air India, forcing LIC to purchase shares during disinvestment, regulating that power generators can buy coal only from state-owned coal miners etc.

The Railways would surely have to incur higher transaction costs in running power stations and pay more (than if it were purchased from the market) to purchase that power, apart from suffering greater unionization and resultant politicization. The former would crowd-out resources available for its core activity, while the latter would exacerbate the bureaucratic inefficiencies of the organization. The cumulative costs (which are effectively another form of subsidy) of all these are most likely to be far more than the simple cross-subsidy (either as a tariff or investment subsidy) that would have enabled the project to begin generation. All this would force an otherwise efficient entity to now bear the cost of some one else's failures, with attendant knock-on effects on its operations.   

This raises the question whether governments should abjure from such stealth cross-subsidy to prop-up demand or keep running inefficient entities, with its numerous distortions, and instead directly finance them through its budget resources. Reinforcing the second welfare theorem, conditional on the political economy constraints that necessitate such choices, direct budgetary support is a cleaner and efficient approach. 

Wednesday, August 19, 2015

Mitigating last-mile gaps in irrigation

Mihir Shah has a nice reminder in the Indian Express where he advocates to "push irrigation not dams". Pointing to large numbers of dams constructed with disproportionately low irrigation coverage realized, he argues in favor of a participatory and multi-disciplinary approach to the development and management of irrigation structures. 

This is not dissimilar to last-mile gaps elsewhere - schools where no learning happens, hospitals which do not cure, toilets which are not used, no-frills bank accounts which are not transacted, and so on. At a fundamental level, it is also a reflection of how weak state capability comes in the way of achievement of transactional outcomes. 

In case of irrigation, the incentives associated with major irrigation projects and minor irrigation works are grossly mis-aligned. In fact, it strikes as disturbing that irrigation sector stands out with contracting which is divorced from outcomes. Irrigation structures like large and small dams and water harvesting units, by themselves contribute little to irrigation, unless complemented with canals and field channels. 

Contractors though are more interested in the former. They find the single-location, regular construction work associated with dams far more easier and attractive than the right-of-way acquisition problems and other transaction costs that characterize widely-spread canals and channels. In case of larger projects, the dam and canals are given as separate contracts, and it is common place to find the dams and other large engineering structures in place without the canals. 

Similar incentives drive government stakeholders. Irrigation departments, most often interested only in contracting out works, too push projects, making unrealistic irrigation coverage estimations. In cases of projects done with assistance from Government of India, state governments routinely make over-optimistic irrigation coverage claims to get project approvals. The tortuous process of acquiring right-of-way for canals and field channels, which involves engaging and negotiating with local land owners and resultant transactional challenges, is severely constrained by weak state capability. All this, coupled with the problems of siltation and maintenance for canals and channels, makes dams the primary objective and irrigation a distant and secondary objective. 

The physical salience of the dam or water harvesting structure being dominant and its relative ease of site acquisition, compared to the long-drawn process of getting right-of-way clearance for long-winding canals and channels, makes everyone more interested in the dam instead of the canals. It is therefore no surprise that dams have been built with vast difference between the promised and actually delivered coverage. In fact, an audit of the original estimate of the irrigation potential and the realized coverage from all major and minor irrigation contracts is most likely to reveal a scandal as big as anything we have seen. 

While there are no easy answers to the problem, one possible strategy would be to package construction contracts as irrigation contracts rather than dam construction contracts. Instead of constructing a dam, the terms of reference in the bid should be clearly redefined as "creation (or stabilization) of 5000 Acres", with levels of water access. This would require much closer engagement among the contractor, irrigation officials, and the beneficiary farmers, and far more rigorous project preparation work. The project reports for each structure would have to evolve bottom-up, capturing local requirements and practical considerations, so as to ensure that outcomes remain at the center of the project.

The risks associated with not getting the coverage estimations right can be mitigated by appropriate safeguards with respect to upstream water availability. I am not aware of any state which have procured even minor irrigation contracts through irrigated land coverage tenders. 

Monday, August 17, 2015

India's construction risk problem

This blog has long held the view that infrastructure projects in countries like India are optimally structured in terms of their life-cycle costs and management by off-loading construction risk and subsequent long-term contracting. The scale of construction and commissioning risks are so large that their presence distorts the incentives of any long-term concessionaire. Worse-still, private developers have limited control over such risks, which are best borne by the government.

An examination of the Project Risk Index components compiled by the Business Monitor International (BMI) reveals certain interesting insights. The BMI's index, a measure of the risk associated with carrying out an infrastructure project in the country, is calculated in terms of financing, tendering and construction, and operation. Each of these three components is dis-aggregated into three more sub-components - cost of capital, finance availability, and sophistication of financial markets (for finance); ease and credibility of tendering, potential for delays, and contract enforcement (for construction); and demand, operation, and foreign exchange (for operations). Each of the three categories and sub-categories are weighted equally, and the scores are allotted in a scale of 0-100, with the higher score representing lower risk.

The country specific risk parameters for the India shows that project risk is aggravated dramatically by construction risks. In fact, timeliness risk, a measure of time and cost over-runs, is among the highest in India, ranking a dismal 82nd among the 84 countries covered.
A comparison among all BRICS countries shows that India is the riskiest country for infrastructure projects, with construction and operation risks being the highest.
India's rambunctious democracy, with its judicial, political, and bureaucratic arms often working at cross-purposes, means that site acquisition and construction are fraught with  unknown unknows. The contributory factors are beyond the control of any private project developer, and causes inordinate delays resulting in snow-balling construction costs. While mitigating policy frameworks are essential, it is important to bear in mind that the private developers are least able to assume these risks. 

Sunday, August 16, 2015

Weekend reading links

1. The mezzogiorno, the southern part of Italy, has long been considered a poor cousin of the prosperous north. But the extent of economic divide is truly stunning,
While Italy’s economic output as a whole contracted by 0.4 per cent in 2014, it fell by 1.3 per cent in the south. Before the crisis, in 2009, the gross domestic product per capita of residents of Italy’s southern regions was 56.2 per cent of that of Italians elsewhere. By 2014, that share had dropped to 53.7 per cent, its lowest level in 15 years. More than 60 per cent of southerners lived off less than €12,000 a year in 2014, against 28.5 per cent in the rest of Italy.
2. San Francisco has borrowed a unique nudge experiment from Hamburg to stop urination at public places. It has covered nine public walls with repellent paint which makes pee spray back on the person's shoes and pant!
Public urination on city walls by night revellers is a big problem in the city and has not been controlled despite a legislation banning it as well as fines of upto $500.

3. Fabulous taxonomy of logical fallacies (via @Noahpinion)

4. As it seeks to advance its soft-power, China is doing it the only way it can, spreading wealth around to "buy respect",
And it is backing up its soft-power ventures with serious money: $50 billion for the Asian Infrastructure Investment Bank, $41 billion for the New Development Bank, $40 billion for the Silk Road Economic Belt, and $25 billion for the Maritime Silk Road. Beijing has also pledged to invest $1.25 trillion worldwide by 2025. This scale of investment is unprecedented: even during the Cold War, the United States and the Soviet Union did not spend anywhere near as much as China is spending today. Together, these recent pledges by Beijing add up to $1.41 trillion; in contrast, the Marshall Plan cost the equivalent of $103 billion in today’s dollars.
5. Bill Easterly links to this evocative photo of volleyball being played with the US-Mexico border as the net.
6. Robert Solow describes the failure of real wages to keep up with productivity in terms of 'monopoly rents', a third component to return to labor and return to capital,
There is a third component which I will call “monopoly rent” or, better still, just “rent.” It is not a return earned by capital or labor, but rather a return to the special position of the firm. It may come from traditional monopoly power, being the only producer of something, but there are other ways in which firms are at least partly protected from competition. Anything that hampers competition, sometimes even regulation itself, is a source of rent. We carelessly think of it as “belonging” to the capital side of the ledger, but that is arbitrary. The division of rent among the stakeholders of a firm is something to be bargained over, formally or informally... It is essential to understand that what we measure as wages and profits both contain an element of rent...
The suggestion I want to make is that one important reason for the failure of real wages to keep up with productivity is that the division of rent in industry has been shifting against the labor side for several decades. This is a hard hypothesis to test in the absence of direct measurement. But the decay of unions and collective bargaining, the explicit hardening of business attitudes, the popularity of right-to-work laws, and the fact that the wage lag seems to have begun at about the same time as the Reagan presidency all point in the same direction: the share of wages in national value added may have fallen because the social bargaining power of labor has diminished.
And he feels that the growth of casual labor is amplifying the trend,
This shift toward more casual labor interacts with the issue of the division of rents. Casual workers have little or no effective claim to the rent component of any firm’s value added. They have little identification with the firm, and they have correspondingly little bargaining power. Unions find them difficult to organize, for obvious reasons. If the division of corporate rents has indeed been shifting against labor, an increasingly casual work force will find it very hard to reverse that trend.
7. Brilliant essay in the Times on the punishing work culture at Amazon, the place "where overachievers go to feel bad about themselves" and one "which is running a continual performance management algorithm on its staff". 

8. Finally, a very interesting graphical representation of the quality of football matches in various European football leagues using the dynamic ELO rating data for football clubs. It maps the top 50 highest quality matches based on average quality (average of the ELO rating of the two clubs) and well-matched opponents (lowest difference in their ELO ratings)
The graphic clearly shows why the Spanish Primera League trumps all others in terms of both quality and intensity of matches. 

Friday, August 14, 2015

Office in a laptop!

Andrew McAfee points to this fantastic Harvard Innovation Lab video which shows how the office table from 1981 would fit into a laptop and phone in 2014.

the evolution of the desk by the harvard innovation lab from designboom on Vimeo.

Thursday, August 13, 2015

The GENCO muddle in India's power sector

Business Standard reports of a Memorandum of Understanding (MoU) between BHEL and the Telangana Power Generation Corporation for three power plants with 5880 MW capacity at a cost of Rs 26,640 Cr. Since the three projects were approved before the current guidelines on mandatory tariff based bids were issued in early 2011, their tariffs would be determined under Section 62 of the Electricity Act, 2003, on a cost-plus basis. 

This draws attention to the reforms on the generation side, particularly at the level of  state generating companies or GENCOS. It is well known that most of these entities are poorly managed, corruption-ridden (on coal and other procurements), operationally inefficient (high station heat rates), over-staffed, debt-laden, and have very high construction cost which translate into high tariffs. On their revenue-side, having the last charge on discom revenues (after independent power producers,IPPs, and central power generators), they are forced into accumulating payment dues from discoms on the power sales. It is estimated that these receivables are well above Rs 1 lakh Cr and mounting. 

Consider the example of the three new Telengana Genco plants. At a time when the discoms are deep in the red, and with no signs of any improvement, and have stopped purchases across the country, such large capacity addition is unlikely to find buyers. It is most likely that their construction costs are on the higher side and will therefore generate high-cost power. This would make discoms even less interested in purchasing this power since it is unlikely that they will be able to pass on the cost of purchase in the form of higher tariffs. Further, the coal linkage (almost 30 mt would be required) and transmission capacity for the project are uncertain. It would entail more recruitment and further unionization. 

In this context, the Government of India and states should consider a few of the following options

1. All the MoUs signed by State GENCOs under Section 62 where construction has not started should be immediately annulled. These projects can be recast as Section 63 contracts, where discoms would purchase power based on competitive bids. 

2. Public finance, through PFC or REC or Public Sector Banks, should be curtailed so that GENCOs (and also discoms) do not have access to easy funding of the like that the Telangana and other GENCOs routinely access. Rigorous commercial due-diligence, in the same manner as is done to IPPs, should underpin any lending to GENCOs. 

3. The cozy arrangement whereby GENCOs fill the order books of public sector entities like BHEL, with liberal payment terms, should be broken up immediately. All Boiler-Turbine-Generator (BTG) and other procurements should be done only through competitive bidding. Such cozy arrangements between GENCOs and state entities like BHEL and PFC are inflicting enormous damage to the sector by crowding out more competitive projects and increasing the burden on consumers. 

4. Finally, GENCOs should form part of any restructuring of discom losses. Apart from their chronic distribution and commercial losses, discoms are saddled with high cost power purchase from GENCOs. States should be encouraged to sell some of their high cost generating stations. Such sales should be made conditional on buyers investing in retrofitting the stations or augmenting capacity so as to lower the cost of service.

Over the years, GENCOs have doubtless played an important role in capacity addition, especially when IPPs could not have shouldered the burden. Further, state generating stations today play an important role in keeping IPPs honest. But now, when IPPs form more than 60% of the capacity addition in recent years, the time may have come to pull the plug on state support and preferential terms, and let GENCOs compete in the market on level-playing terms with IPPs. 

Tuesday, August 11, 2015

Another orthodoxy falls - foreign exchange interventions may be effective

Olivier Blanchard has presided over arguably the most tumultuous period in the IMF's history. His tenure as Chief Economist has seen several dramatic reversals in the conservative institution's long-held positions. Even as he enters his last lap, the latest reversal comes from an acknowledgement that foreign exchange interventions may after all be useful.

Capital flows management has emerged as one of the biggest challenges facing emerging economies. As the evidence from recent events show, no country can insulate itself from cross-border capital flows volatility. Irrespective of their economic fundamentals, markets tend to lump all emerging economies into one category. And cross-border flows are characterized by episodes of massive capital inflows followed by sudden-stops. 

The orthodoxy on capital flows, long espoused and propagated by the IMF, has advocated capital account convertibility and floating exchange rates, and the futility of policies that seek to manage capital flows. In 2011, the edifice started to crumble with the acceptance that capital controls may be useful on occasions. Now, in a just released NBER working paper, Blanchard and two others go one further step to support foreign exchange interventions to manage currency volatility arising from capital flows. They write,
Many emerging market economies have relied on foreign exchange intervention (FXI) in response to gross capital inflows. In this paper, we study whether FXI has been an effective tool to dampen the effects of these inflows on the exchange rate. To deal with endogeneity issues, we look at the response of different countries to plausibly exogenous gross inflows, and explore the cross country variation of FXI and exchange rate responses. Consistent with the portfolio balance channel, we find that larger FXI leads to less exchange rate appreciation in response to gross inflows... The magnitude of the effect is relevant from a macroeconomic perspective, suggesting that FXI can be a valid policy tool for macroeconomic management.
Comparing the respective exchange rate performances of countries following floating exchange rate (floaters) and those intervening in forex markets (interveners) in response to exogenous shocks, they find,
The difference in FXI responses between the two groups is sizeable, close to 1 percent of quarterly GDP (0.25 percent of annual GDP) on impact. Interveners display a smaller appreciation of their currencies in response to the gross inflows. Specifically, we find a 1.5 percentage point differential in appreciation between interveners and floaters over the first 3-4 quarters. The differential fades afterwards. This difference is significant, both statistically and economically... Moreover, comparing the differential between the two groups of FXI and ER responses suggests a large effect of FXI: a quarterly annualized intervention of 1 percent of GDP (0.25 percent non annualized) leads to about 1.5 percent lower appreciation on impact. There is no evidence of a different interest rate behavior between the two groups, at least on average, suggesting that neither interveners nor floaters rely on the interest rate to ‘defend’ their exchange rates in response to exogenous capital flow shocks... Consistent with the predictions of the simple model presented earlier, gross capital inflows respond equally or more markedly in intervening countries, in comparison to floaters. Gross outflows increase for both groups, pointing to an offsetting role by domestic investors, but more in floaters.
They interpret the negative correlation between the sizes of FXI and gross capital outflows as being explained by causality running from FXI to outflows. Central banks indulge in sterilized foreign exchange market interventions, which limit exchange rate depreciation, and thereby contains capital outflows. 

Monday, August 10, 2015

Affordable housing - just build it!

Sharon Barnhardt and Co have an NBER working paper which provides empirical proof for the widely held belief that slum relocation beneficiaries sooner or later go back to squatting. They examined the impact of a lottery-based allotment for a low-income housing colony in Ahmedabad, which moved people from a city-center slum to the suburbs. They tracked the 110 families over a 14 year period and found,
Fourteen years later, relative to lottery losers, winners report improved housing farther from the city center, but no change in family income or human capital. Winners also report increased isolation from family and caste networks and lower access to informal insurance. We observe significant program exit: 34% of winners never moved into the subsidized housing and 32% eventually exited. Our results point to the importance of considering social networks when designing housing programs for the poor... Our findings suggest that alternative policies such as neighborhood-wide relocation programs may be more appropriate for slum- dwellers. Alternatively, slum upgrading programs that do not try to move people at all may be a less wasteful approach to public housing policy in developing countries.
At a theoretical level, this is a reinforcement of the Schelling segregation model, where forced admixture of heterogeneous communities invariably result in desegregation. I have blogged about it in the context of housing and school choice.  

However, the policy takeaways suggested are pretty much dead-ends. Neighborhood-wide relocation runs into the constraint of land availability. As to slum upgradation by redevelopment (PPP or not), it is too complex and challenging to do in any reasonable scale. Slum upgradation by improving infrastructure while keeping the existing stock runs into execution challenges (5-10 feet roads, and that too varying widely, makes infrastructure augmentation a nightmare, even an impossibility) given the extremely congested nature of most slums and squatter settlements. If, for implementation in scale, upgradation of any kind is less that satisfactory and neighbourhood relocation is prohibitive, then we are left only with relocation to the suburbs as a decidedly second-best alternative. 

This blog has consistently held the view that it may be a wrong framing to assess low income housing programs in terms of its ability to retain residents. Such programs, including the recently launched Government of India's Housing for All program, should be seen as instruments to increase the supply of formal affordable housing stock. At a time when land has been priced out of the reach of low income households, any low-income stock addition happening is basically in the informal sector, most often by way of densification of already congested slums and squatter settlements. 

In fact, in view of the near absence of formal affordable housing, the low-income migrants in any case mostly squat in the suburbs. The units sold away by the original allottees are merely transferred to the newer migrants, thereby providing formal low-income housing for them. The relocation colonies, by adding to the housing stock, are actually limiting the further slumification of the city. 

Further, given the implementation challenges (identification etc), resource constraints (massive demand likely from new migrants), and the political difficulty associated (with targeting newer migrants when older ones are themselves without housing), this process of internal transactions between the original beneficiaries and the new buyers may be a less-distortionary and acceptable second-best affordable housing strategy. This would be the case even with the inevitable political cronyism that accompanies such transactions.

Sunday, August 9, 2015

Indian economy weekend reading links

1. Livemint points to an Fitch Ratings report which claims that banks may have to take haircuts amounting to more than a trillion rupees on their exposures to power, roads, steel, and other infrastructure sectors. It is estimated that nearly Rs 93000 Cr would be on public sector banks.

2. The RBI's latest survey on capacity utilization shows that in the manufacturing sector, it has plunged to its lowest level is seven years for the March-April quarter. Business expectations index too is declining sharply. Make in India is clearly facing very strong headwinds.
3. Mary Hallward-Driemeier and Lant Pritchett (via WSJ here) find "almost zero correlation" between the World Bank's popular Doing Business Survey's and the surveys of business enterprises done by the Bank and others across the world. The former is based on surveys of local lawyers, accountants, and other professionals and their estimations of the time and cost of complying with local regulations. The latter asks firms themselves about the costs and delays they actually deal with. 

They find that, on average, the amount of time companies tell surveyors they spend on obtaining construction permits and operating licenses, and importing goods is "much, much less" than that recorded in the DB Survey. They attribute the divergence to the "gulf in poor countries between the laws and policies that exist on the books and the ones that prevail - or perhaps don't prevail - in reality". They write,
It is commonly observed that policy implementation often deviates from the stated policy in firm-specific ways, but this hypothesis has not been easy to document. It appears that when strict rules meet weak state capability—or, more broadly, “institutions”—the rules bend and become more like individuated “deals” where outcomes are not the result of a neutral application of policy to the facts but rather have to be negotiated case by case... Given our evidence, it is a completely open question how reforms that altered the Doing Business indicators will actually affect the investment climate that most firms actually experience... firm performance was affected by measures of the variability of the policy implementation they faced, more so than the level. From this perspective, one can imagine that initiatives that have minimal impact on de jure policy but which signal a decisive shift in policy implementation might have substantial impacts on investor expectations and initiate an acceleration of growth. 
This carries a note of caution for countries like India, which have made the DB Survey the basis for their ease of doing business interventions. Tweaking the form (rules and regulations) without strengthening the state may not be very effective. Even with the best-practice form, the real constraint will be the state capability. 

4. Talking about enterprise surveys, here is a comparison of the findings from World Bank's enterprise surveys from 2006...
... and 2014 (9281 firms chose the biggest constraints among 15 business environment obstacles).
Electricity, tax rates, and corruption are the top three in both, though the informal practices and access to finance have recently emerged as important constraints. Note that labour regulations etc are marginal constraints in both periods.

5. I had blogged earlier urging caution with India's metro rail ambitions saying that global experience shows that farebox recovery ratios on railways can rarely cover half the operating expenses. Business Standard has this examination of the operating balance sheet of the Delhi Metro Rail Corporation (DMRC),
In FY14, the latest year for which finances are available, the company produced a meagre Rs 9 in revenue for every Rs 100 worth of investment in fixed assets. Specifically, the utility generated revenues of Rs 2,952 crore on a gross block of Rs 34,385 crore in FY14... Given the current interest rate of 10 per cent, a similar depreciation charge and 15 per cent expected return on equity, the capital cost for DMRC works out to be around Rs 7,500 crore per annum. Throw-in the running and maintenance costs, the DMRC system would need at least Rs 10,000 crore worth of revenues to be financially viable in the conventional sense.
DMRC operating expenses were Rs 2,136 crore or 72 per cent of its revenues from operations.The above calculation doesn’t show in DMRC numbers because it has been liberally capitalised by the government. At the end of FY14, DMRC paid-capital (or seed capital) was Rs 14,187 crore twice that of NTPC and three-times that of Power Grid Corp, two of the most capital intensive government owned companies. Besides, government tops-up DMRC equity base every year with Rs 2,100 crore pumped as equity in fiscal 2014 itself. The debt part of the DMRC has been taken care of by concessional loan from Japan’s Overseas Development Agency (ODA) at the rate of 2 per cent with 10 year moratorium on interest and principal repayment. A private sector enterprise will never get this comfort.
6. That India's power sector is in a mess is well known. Livemint points to a recent ICRA report which has a few interesting factoids about the dismal story,
In fiscal 2015, power deficit had reduced to 3.6%, but that is just the reported number. Ratings agency Icra Ltd reckons that the actual power deficit is 15%. Simply put, power plants are idle at such a high level of power deficit because state electricity boards are not buying. In the June quarter, merchant demand on the exchanges declined 22.3% from a year ago. Even on a sequential basis, it fell 9.3%, despite it being high summer. The last major power purchase agreement signed by a state electricity board was Kerala in 2013.... The accumulated losses of state discoms at the end of March 2013 were close to Rs.3 trillion. Wiping out these losses will take time. Even to recover regulatory assets—those expenses approved by state electricity regulatory commissions for recovery through future tariffs—over a period of five years, tariff hikes as high as 23% would be required in some states, such as Rajasthan.
Update 1 (21.08.2015)

More on the DMRC's finances, a foretaste of what is to come from other metros,
DMRC earned a total revenue of Rs 3,198 crore in 2013-14, including Rs 1,364 crore (43 per cent) from fare box collection and Rs 1,833 crore (57 per cent) of other revenues, including those from real estate, consultancy and external projects... The growth in revenue from fare box collection, the company’s core area of operation, has dropped sharply from 80 per cent in 2010-11 to 11 per cent in 2013-14, the latest year for which numbers are available. Also, the share of other revenues in the total revenue has risen from 43 per cent in 2009-10 to 57 per cent in 2013-14. Further, the company’s total expenses jumped 29 per cent to Rs 2,006 crore in a single year ending March 2014, indicating how profitability came under pressure. DMRC’s fares were last revised in 2009 when the minimum fare was raised from Rs 6 to Rs 8 with the maximum fare raised from Rs 22 to Rs 30. For comparison, consumer price index (CPI)-based inflation stood at 9.9 per cent a month on an average for the five year period between 2009 and 2014.

Saturday, August 8, 2015

India's health care challenge in two graphics

Two graphics from a Livemint inforgraphic series on India's health care system sums up the enormity of the challenge that the country's health sector may be facing.

First, like with suppressed demand of electricity (which, ironically, makes state governments who resort to 12-14 hour power cuts claim that they are power surplus!), India appears to have a massive suppressed demand for health care services, which may be reflection of the public health care access deficit. Cross-state data on illness reporting and hospitalization rates from the NSSO national health survey 2014 reveals an inverse correlation between illness reporting and hospitalization rates and the state's social indicators (and presumably per capita incomes). 

In other words, a large share of people in the country's poorest and most backward areas do not even report illness or show up in hospitals. Describing them as "missing patients", Livemint writes,
The NSSO report put the average figure for people reporting illnesses in rural India at 8.9%. But if one assumes that the true extent of under-reporting is the difference between the national average and that between the top five states in terms of reported illnesses (excluding Kerala, given that it is likely to be an outlier), the true national average will then be 15.6%. In other words, 6.7% of the rural population, or roughly 55 million people, is missing from the official estimate of the ill.
The graphic below captures the same data stratified based on rural and urban incomes and shows the inverse relationship (admittedly, some of the difference may be a measure of differences in lifestyles etc) between incomes and health outcomes,
Since poor quality of public health care facilities and affordability are arguably important contributors, this graphic on the rate of increase in health care costs is a cause of great concern.
In simple terms, even as there exists massive under-reporting of illness, undoubtedly atleast partially due to access problems, the rising health care costs are pricing more people out from accessing health care. 

Friday, August 7, 2015

China urbanization fact of the day

From a Brookings study (pdf here)of 100 largest metropolitan areas in the Asia Pacific region (East Asia, Oceania, western parts of North and South America), this factoid and graphic about China and rest of the world is simply staggering,
Chinese metro areas averaged 11.2 percent annual GDP per capita growth since 2000, compared to just 1.3 percent per year in the rest of the world’s major cities.
As this FT feature, which chronicles the downside of the Chinese urbanization, informs, urban area's share of population surged from about 20% in 1980 to over 50% now, and share of GDP has grown from nearly 70% to more than 90% in the same period.

China's much-discussed quarter century of economic growth in general has been spectacular, but in particular its less discussed urban growth has been unprecedented. The country's sustained and rapid urbanization, managed without much of the problems of unplanned sprawls and slum proliferation that characterize the same in countries like India, should count as arguably its biggest social and political achievement. Unorthodox, 'second-best', instruments like hukou permits, development of satellite townships etc have doubtless played an important role in managing the inevitable externalities and problems associated with rapid urbanization.

Thursday, August 6, 2015

The problem with 'best-practice' models

This blog has consistently held that India's implementation deficit is largely a reflection of state capability weaknesses. This weakness is often amplified by the embrace of best practice models. As the cliche goes, "best becomes the enemy of the good" and to rephrase Dani Rodrik, scalable best-practices  are "second-best, at best". Ricardo Hausmann makes a reference to this in his most recent Project Syndicate article.

Consider the example of any regulation which provides the best-practice protections to consumers. In developing countries, many goods and services are offered without the full range of consumer satisfaction standards. They range from product development to safety to functional to servicing requirements. In fact, a significant portion of the value chain of the product or service is typically done in the informal sector. All this naturally lowers the cost of production and producers pass on atleast a share of the savings to consumers in the form of lower prices.

Accordingly, the plastic or steel vessels purchased at your local store, haircut from the 'barber shop', and driving lessons from the neighbourhood 'driving school' are cheap and affordable. Much the same applies to an apartment unit bought from the local developer. Alternatively, for the buyer, the transaction cost associated with the risk of buying a house without clear land title, construction quality assurance, and delivery time commitment is offset by the cheaper price of the housing unit. In an extremely price-sensitive market, such sub-par production, product/service-quality, consumer protection and servicing standards engenders a low-level equilibrium. I have blogged about similar low-level equilibriums in public service delivery here, here, and here

In this context, best practice regulation, which seeks to formalize and standardize processes and quality standards, can have unexpected consequences. One immediate impact is that the cost of production rises as the layers of processes and standards take effect. This in turn prices out a large share of the consumers, leaving a market for that product or service which is unaffordable for the vast majority of consumers.

Another effect is that it amplifies state capability weaknesses. Higher standards in an environment where even the lower standards are not effectively enforced is a recipe for more failures. Worse-still, since producers will struggle to comply with the increased requirements at their prevailing (or even slightly higher) price points, it increases the opportunities for harassment and rent-seeking by inspectors and other public officials concerned with monitoring the rule.

Finally, these best-practice models increase informality. As the cost of compliance increases, firms prefer to go informal so as to continue servicing their existing customers. Perversely enough, the quest for higher standards would end up lowering the informality threshold and increasing the share of the informal sector in the market for that product or service.

Such reform attempts fail because its proponents only ask, "what is the best strategy to improve the quality of a good or service?". Instead, the question should have been, "what is the best strategy to improve the quality of the good or service, conditional on the market constraints and enforcement capability of the public system?". We just can't wish away the real world!